Journal Issue

Financial Markets and Development Conference: Should state-owned financial institutions be privatized or reformed?

International Monetary Fund. External Relations Dept.
Published Date:
June 2004
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What does the future hold for state-owned financial institutions? Some urge privatization; others suggest that the wiser, more realistic course is improving their management and supervision. Neither side won the day at the 6th Annual Financial Markets and Development Conference in Washington, D.C., April 26-27, but both sides used the event—jointly sponsored by the IMF, the World Bank, and the Brookings Institution—to wrestle with the substantial challenges associated with state-owned financial institutions, review recent research and country experiences, and weigh future options.

In many countries, the state has a major presence in the financial sector. This is particularly so in banking, where, despite several privatization initiatives over the past decade, public sector banks still account for an estimated 40 percent of total banking sector assets. State intervention also extends, albeit to a lesser degree, to insurance schemes and investment funds. And, though it is often more prominent in the developing world, state intervention can also play an important role in the developed world, taking various forms of intervention from explicit (banking in Germany) to implicit (government-sponsored enterprises in the United States).

Why does the state intervene?

Supporters cite a number of rationales for state intervention—notably, information failures, economic disequilibrium, failure of competition, incomplete markets, and the need to redistribute resources according to a social agenda. Detractors insist there are wide–ranging downsides, including distortions in credit allocation, thwarted competitive forces, limited supervisory effectiveness, and clouded budgetary processes. All of which, they argue, lead to frequent recapitalization and increased scope for patronage and corruption.

What seems clear, despite a growing emphasis on private ownership of financial institutions in recent years—especially in Europe and Latin America—is that the state is likely to remain a dominant player in the financial sector for some time to come.

If this is the case, the conference suggested, there is value both in examining the role these institutions play (and how their supervision and governance can be strengthened) and in evaluating experiences with privatization. Not surprisingly, banks remained at center stage, and practices in developing countries received the bulk of attention. One clear view that emerged was that whether bank or nonbank, an institution that represented a contingent liability to the state required effective governance and supervision, though the form of this supervision would need to be shaped by the specific context.

Bolstering supervision and governance

What do we know about supervisory practices? David Marston (IMF) reported on a survey of practices in 22 countries that covered, among a wide range of operations, commercial and development banks, insurance companies, and investment funds. The varied landscape raised questions, however, as to the appropriate regulatory paradigm for these institutions, given that they encompass banks and non-banks, finance and refinance institutions, and for-profit and nonprofit institutions.

In his examination of the performance of state-owned banks, James Hanson (World Bank) suggested that even the best-intentioned governments face a problem of multiple objectives, and measures such as recapitalization and modernization often do not work because providing the right incentives—not just addressing costs—is the central issue. But, if the idea is to run a public sector bank like a private bank, why not simply privatize and reap the gains that privatization has to offer? Hanson added, however, that privatization seems to work best when it involves a sale to a strategic foreign investor.

Where privatization is not an immediate option, management and supervision of these institutions should be improved. Richard Hemming (IMF) noted, for example, that where directed credit and subsidized lending cannot be avoided, banks should be subject to best practice treatment consisting of disclosure, a transparent process of parliamentary approval, and provisioning for costs in the government budget.

Clearly, inadequate fiscal transparency and supervision hold significant dangers. As Nicholas Lardy (Institute for International Economics) estimated in an analysis of the economic implications of the continuing dominant role of the government in China’s allocation of capital, as much as 90 percent of the country’s currently reported nonperforming loans should be considered contingent liabilities of the government. China may also face a new wave of nonperforming loans in the next few years following rapid credit growth since 2002; this could have an adverse effect on long-term fiscal sustainability, he said.

Greg Wilson (McKinsey & Company) underscored the importance of establishing sound corporate governance to protect taxpayers’ interests. If these banks cannot be privatized, he argued, their objectives need to be spelled out in transparent priorities and specific targets; political insulation needs to be ensured; and accountability should be achieved through the kind of full disclosure to which listed companies are subject. This may require, he acknowledged, new standards and skills for risk management, governance, productivity, and performance.

Formal supervision could help mitigate both fiscal and reputational risk. Jonathan Fiechter (IMF) proposed 10 core guidelines that stressed, among other aspects, a clear mandate, authority and independence, adequate resources, and minimum capital requirements. These guidelines have universal applicability, argued Patrick Lawler, Chief Economist of the Office of Federal Housing Enterprise Oversight, which supervises the two giant U.S. government-sponsored enterprises—the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”). These government-sponsored enterprises, he said, face issues similar to those that state-owned institutions face, in that perceived implicit state guarantees render market discipline ineffective. These enterprises also lack the advantage of being able to gain from adopting industry best practice (they are the industry) and see their risks aggravated by a lack of diversification and an absence of checks on their growth.

Senior country officials complemented analyses with firsthand experiences of their own. Shuangning Tang (China’s Banking Regulatory Commission) outlined the 10 guidelines his country is using to improve corporate governance in the state-owned banks. They stress clear governance structures, strategic investors, clear priorities, sound decision making, appropriate human resources management, prudent accounting, secure information technology systems, and gradual restructuring.

A case study of Indonesia’s experience by P.S. Srinivas (World Bank) indicated that the postcrisis restructuring process there actually increased the role of state-owned banks, which now account for 46 percent of all bank assets. And while full privatization is the long-term goal, the authorities are placing greater emphasis for the medium term on improved governance, greater shareholder and board oversight, and more effective supervision. Arminio Fraga (former governor of Brazil’s central bank) seconded the importance of effective and independent supervision but expressed skepticism about the role of state-owned banks in middle-income countries.

Privatization experiences and techniques

Is there a foolproof recipe for privatization? Perhaps not, but country experiences suggested that some methods had greater success than others. Ishrat Husain (Governor, State Bank of Pakistan) shared his country’s experiences in lowering the state share of the banking system assets from 92 percent in 1990 to around 19 percent in 2004. He urged that elaborate and comprehensive restructuring be undertaken in preparing a bank for privatization. Louis A. Kasekende (former governor, Central Bank of Uganda) also suggested that if the size of the bank is substantial, then politics should be taken into consideration. He differed with Husain, however, on the need to prepare a bank for sale. He urged that banks be sold “as is” whenever possible.

A World Bank study reinforced many of the lessons from country experiences with privatization, finding that continued ownership by the state, even when it is a minority shareholder, harms performance and that, in weak institutional environments, public share offerings produce worse results or lower prices than direct sales to strategic investors. Further, prohibiting foreign participation in privatization reduces the gains from both these processes. The study also suggests that privatization improves performance even in weak regulatory environments, though the gains are reduced.

Speakers from the private sector also offered their experiences with various ownership and partnership arrangements. David Binns and Ron Gilbert (consultants) argued, on the basis of five case studies, that a carefully designed employee stock ownership plan can facilitate capital formation. These strategies can fail, however, in the absence of appropriate regulatory guidelines and management checks and balances, or in the face of economic reversals.

In the view of Herman Mulder (ABN AMRO Bank NV), bank ownership was not an issue as long as a bank was run by independent professionals, had good risk management systems in place, and priced its risk accordingly. Besides, he observed, private sector banks can suffer from the same maladies as state-owned banks, including preferential lending and corruption. Could twinning help? Under this arrangement, a foreign bank agrees to transfer knowledge to a local bank for a fee, mainly through assignment of its own personnel for a specified period. William Nichol (Deutsche Bank AG) recounted his bank’s experience with twinning in Asia, noting that twinning is also being motivated by regulatory changes, such as Basel II, and foreign competition, which are driving local banks to seek quick means to improve their risk management systems. But Nichol found very few providers of such services and low economic incentives. Many potential foreign providers preferred to buy stakes in local banks.

As for initial public offerings (IPOs), Fred Huibers (ING Barings) mentioned that 44 percent of emerging economy bank privatizations occur this way. The advantage of the IPO route is that such issues, which are normally large, stimulate stock market capitalization and trading, lower the cost to equity, and attract further investments. The wider share ownership also serves as insurance against later renationalization.

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