NOTE NUMBER 12 53770 PUBLIC POLICY FOR THE PRIVATE SECTOR JANUARY 2010 State Financial Institutions FINANCIAL AND PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY Heinz P. Rudolph Can They Be Relied on to Kick-Start Lending? Heinz P. Rudolph T h e n e e d t o k i c k- s t a r t l e n d i n g t o t h e r e a l s e c t o r i n r e s p o n s e t o (hrudolph@worldbank.org) t h e g l o b a l f i n a n c i a l c r i s i s i s l e a d i n g m a ny c o u n t r i e s t o e x p a n d t h e is a senior financial sector specialist in the Financial r o l e of s t at e - ow n e d f i n a n c i a l i n s t i t u t i o n s . T h e e f f e c t i ve n e s s of t h e and Private Sector Devel- s u p p o r t by t h e s e i n s t i t u t i o n s d e p e n d s i n l a r g e p a r t o n t h e n at u r e of opment Vice Presidency of the World Bank Group. t h e s h o c k , o n t h e i r a b i l i t y t o l eve r a g e p r i v at e c o m m e r c i a l b a n k s t o s c a l e u p t h e i r i m p a c t , a n d o n t h e e x i s t e n c e of a s o u n d i n s t i t u t i o n a l This is the 12th in a series of policy briefs on f r a m ewo r k . W h i l e i t i s t o o e a r l y t o ev a l u at e t h e i r e f f e c t i ve n e s s , p a s t the crisis--assessing the e x p e r i e n c e w i t h t h e u s e of s u c h i n s t i t u t i o n s i s s o b e r i n g. W h et h e r policy responses, shedding light on financial reforms c o u n t r i e s w i l l h e e d t h e l e s s o n s of t h i s e x p e r i e n c e r e m a i n s t o b e s e e n . currently under debate, and providing insights Commercial banks in several countries have support lending in specific sectors, such as for for emerging-market been severely affected by the global financial trade finance and for small and medium-size policy makers. crisis and are seeking to raise new capital and enterprise loans (box 1). While some govern- shrink their balance sheets. Internationally ments have not provided additional funding active banks are reducing their cross-border explicitly for this purpose, others have com- exposure and retreating to core markets as part mitted such resources and have even used state of this deleveraging process and in response to financial institutions to recapitalize or provide increased risk aversion. At the same time there liquidity to troubled banking institutions (for has been a severe contraction of aggregate example, Brazil, Germany, and the Russian THE WORLD BANK GROUP demand as households and companies attempt Federation). to cut back on spending and investment. All these factors have combined to slow the growth--and A sad history even reduce the level--of bank lending in many While state ownership of banks has been reduced economies. over the past 20 years, state financial institutions In response to the perceived credit crunch, remain important in many parts of the world (table authorities in many countries have taken mea- 1). OECD countries had the lowest public participa- sures to kick-start lending, including through the tion in bank ownership in 2005, while low-income use of state financial institutions. Governments countries have recently been the most active in reduc- in both developed and emerging economies ing the role of state-owned banks in the financial have used their state financial institutions to sector (Barth, Caprio, and Levine 2000). STATE fiNANCiAL iNSTiTUTiONS CAN ThEY bE RELIED ON TO kICk-START LENDINg? Box Some crisis-related policy responses using state financial institutions 1 Brazil. The government authorized state-owned banks to take equity stakes in private banks and to buy loan portfolios from financial institutions that have liquidity problems or are owed money by companies in financial difficulties. Canada. Besides committing Can$350 million in capital to both Export Development Canada and the Business Development Bank of Canada, the government is increasing their authorized capital and associated borrowing limits. Chile. The government doubled the Tier 1 capital of state-owned Banco Estado so as to increase lending to vulnerable sectors. China. The government instructed state-owned banks to increase lending to specific sectors to stimulate growth. Finland. To increase lending to small and medium-size enterprises, the government raised the ceiling on state-owned 2 Finnvera's commitments for domestic and export financing. In addition, it allowed new countercyclical loans and guarantees and raised the compensation paid by the state to Finnvera for losses arising from their issuance. Germany. The government instructed KfW to increase its lending by up to 15 billion in 2009. It also requested KfW to provide an additional 3 billion to its infrastructure programs and required the bank to lend to larger companies to bridge short-term liquidity shortfalls. KfW and state governments have also provided funding to recapitalize weak regional state banks (Landesbanken). Republic of Korea. The government provided capital injections to state-owned banks, such as Korea Development Bank, the Industrial Bank of Korea, and the Export-Import Bank of Korea, to enable them to roll over existing loans and provide new loans to small and medium-size enterprises. Mexico. State-owned development banks extended guarantees on commercial paper and credit instruments issued by specialized nonbank credit institutions (sofoles). They have also acted as a lender of last resort for large companies and participated in programs to support fragile sectors. They have funded the new exposures using a guarantee fund created by the government and in some cases (such as Bancomext) through capital support. Russian Federation. The government injected US$5 billion of capital into state-owned development bank Vnesheconombank (VEB) to assist with the failures of several smaller banks. The government also allocated 175 billion rubles (Rub) from the National Wealth Fund to VEB for investment in Russian financial instruments with the aim of diversifying the fund's investments. In addition to Rub 960 billion in subordinated loans to the largest state-controlled banks, the government is to inject another Rub 400 billion of state funds into two of these banks in exchange for an increase in their lending to Russian companies. Source: World Bank analysis. Empirical evidence from several authors weaknesses have typically resulted in credit mis- shows that many state financial institutions allocation, high losses, and persistent needs for around the world have been characterized by recapitalization--and have spurred the drive political interference, lack of transparency, low toward bank privatization in recent decades. accountability to stakeholders, inadequate pru- While the literature makes no distinction dential regulation and supervision, and lack of between state development banks and state com- managerial skills and proper incentives. These mercial banks, it suggests that state financial institutions have adversely affected economic Table State financial institutions' share of banking assets, 2005 growth (box 2). La Porta, Lopez-de-Silanes, and Shleifer (2002) find that government ownership 1 Region or country group East Asia and Pacific Europe and Central Asia Share of total assets (%)a 27 15 of banks is associated with slower subsequent financial development, lower economic growth, and lower productivity growth. Beck and Levine Latin America and the Caribbean 23 (2002) fail to find any positive effect of govern- Middle East and North Africa 46 ment ownership of banks on growth. Caprio and Martinez Peria (2002) show that government South Asia 20 ownership of banks is associated with a higher Sub-Saharan Africa 20 likelihood of banking crises. OECD countries 6 Dinc (2005) provides evidence that state Non-OECD high-income countries 7 financial institutions increase their lending Source: Fitch Ratings; World Bank Regulation and Supervision Database. during an election year and that in emerging a. Based on majority ownership. markets they finance the government to a greater Box Classifying state financial institutions 2 State financial institutions can be classified as deposit takers or non-deposit takers and as development institutions with a public policy mandate or commercial institutions without one. Following Scott (2007), this brief uses state commercial bank to refer to a deposit-taking institution that seeks to maximize profit (or value) and has no mandate to pursue public policy objectives (see table). Such banks exist in many countries and are often the legacy of central planning. The brief uses state development bank to refer to an institution that has an explicit public policy mandate. While some state development banks are funded mainly by deposits from the general public, others receive exclusively endowments from the government. The brief uses development finance institution to refer to an institution that is presumed to be financed mainly by nondeposit resources, such as loans from the state, long-term loans from multilateral institutions, and bonds issued in local and international capital markets. All three types of institutions are referred to collectively as state financial institutions. 3 While classifying a state financial institution in a single category is sometimes difficult, this brief focuses mainly on state development banks and development finance institutions with an explicit public policy mandate. Characteristics of state financial institutions Type of institution Profit maximizing Deposit taking Public policy objective State commercial bank State development bank Development finance institution Source: Scott 2007. degree than do private banks. In the same line counterproductive, crowding out private market Micco, Panizza, and Yañez (2007) find that state players and leading to future losses. By helping financial institutions have lower profitability and to artificially boost production, they would also higher costs than commercial banks and that the postpone any adjustments that may be needed gap widens during election years. Evidence pro- in the country's economic structure after the vided by Sapienza (2004) suggests that the pres- crisis. ence of state financial institutions in Italy has The supply-side effects may arise not only distorting effects on the allocation of financial from banks' undercapitalization and deleverag- resources. In particular, the lending behavior of ing, but also from the procyclical behavior of these banks is affected by the electoral results banks' risk aversion independent of the nature of the political party with which they are affili- of the shock. Commercial banks typically move ated: the stronger the political party is in the to safer assets during periods of turbulence or area in which such a bank is lending, the lower recession and tap riskier markets during peri- the interest rate charged by the bank. ods of sustained economic growth, which may increase the depth of economic cycles (de la The ability to respond Torre and Ize 2009). Because state financial How effective can state financial institutions institutions have less volatile risk aversion and be in tackling a crisis-induced decline in lend- therefore provide a more stable source of financ- ing? The answer depends largely on the nature ing, they can play an important role in acting as of the shock and on the capacity of those a buffer and filling the credit gap. In sectors with institutions. marked cyclical behavior, state financial institu- tions should therefore be able to expand their Nature of the shock portfolios during periods of recession and shrink When a crisis-induced decline in lending occurs them during periods of economic growth. as a result of banks' behavior (supply-side effects), A separate but related issue is the relative state financial institutions may be able to play degree of risk aversion of state financial institu- an important role in channeling credit toward tions. Because state financial institutions (partic- underserved sectors. But when the shock results ularly those with a public policy mandate) serve from a severe slowdown in the demand for riskier economic sectors than commercial banks, credit by the real sector, such measures may be and most have reasonable return (rather than STATE fiNANCiAL iNSTiTUTiONS CAN ThEY bE RELIED ON TO kICk-START LENDINg? profit maximization) targets, they can naturally more risk than commercial banks, for example, be expected to have lower profitability. Under by taking the junior debt in syndicated loans or this argument, acceptance of lower returns assuming first-loss positions in guarantees. Lines should not necessarily be confused with higher of credit, insurance products, and technical assis- inefficiency; instead, it is a natural consequence tance may also help state financial institutions of riskier portfolios and higher operational costs scale up their impact by leveraging the opera- as a result of operating in more difficult markets tions of private banks. (Yaron 2004). Of course, even in this case state financial institutions need to develop informa- Key elements of institutional design 4 tion platforms, control systems, and pricing poli- Policies for using state financial institutions to cies consistent with the risks they are taking. support credit growth will succeed to the extent During recessions and financial crises, includ- that they are prudently applied and complement ing the current one, it is no easy task to identify other measures to restore economic stability (de the nature of the shock (Bernanke and Gertler la Torre, Gozzi, and Schmukler 2007). As experi- 1995), particularly the roles of demand- and ence in Africa, Latin America, and Central and supply-side effects. Policy makers have tended Eastern Europe shows, the institutional design to respond to crises by using all instruments at of state financial institutions is also critical to their disposal to ease the effects. When using their successful use (see, for example, Hanson state development banks for targeted credit 2004 and Sherif, Borish, and Gross 2003). support, however, they are well advised to act Restructuring the institutional framework of prudently. state financial institutions may be expensive and take time. Some countries consider restructur- Capacity constraints ing during a crisis period, but it may take years Sheer capacity constraints and lack of manage- before an institution becomes ready to support ment skills can limit the ability of state finan- government initiatives. Emerging economies cial institutions to quickly accelerate their credit have had multiple failed attempts at restructur- operations. For example, it is unrealistic to think ing poorly designed state financial institutions. that a development bank with a 1 percent market Hanson (2004) concludes that while such out- share could solve the problems in an economy in comes can be attributed to timid reforms and which overall credit is shrinking by 10 percent regulatory forbearance, the main problem has a year. While state financial institutions should been the failure of the reforms to address the operate with some idle capacity so as to be able fundamental problems of the institutions. to deal with periods of recession, forcing them Although the empirical evidence leans heavily to significantly expand their lending operations against an overall positive role for state financial might result in poor credit allocation and lead to institutions, some have been successful in fulfill- future losses. This is particularly likely when they ing public policy mandates. The effectiveness are asked to engage in activities in which they of their support depends on a range of factors, have little experience--for example, acting as including a clear and sustainable mandate, high lender of last resort in providing liquidity to com- standards of corporate governance, strong pru- mercial banks struggling with illiquid assets.1 dential regulation and supervision, and reliance During a financial crisis, state financial insti- on market discipline to provide the right signals tutions should look for smart lending strategies. to the main stakeholders (Rudolph 2009). They are unlikely to have much impact by them- selves in cushioning a credit crunch. Thus a more Mandate effective approach may be to leverage the infra- Because state financial institutions are typically structure and expertise of commercial banks. required to address market failures by providing This approach could include using cofinancing financial support to sectors inadequately served arrangements and providing credit guarantees by private institutions, they must have a clear to encourage commercial banks to enter into public policy mandate. The mandate should particular lending transactions. In such cases include at least three elements. First, to avoid state financial institutions may have to absorb the involvement of state financial institutions in the purely commercial and most profitable parts The risk of political interference can be of the market, the mandate should define target reduced by precisely defining the represen- sectors addressing a specific market failure, such tation of the shareholders. In state financial as a lack of finance for infrastructure or for small institutions the individuals functioning as the and medium-size enterprises. shareholders' representatives often come from Second, the mandate should establish a role a number of different government institutions. for state financial institutions that complements This creates conditions for multiple pressures that of commercial banks and set rules of coop- on the board or management, which can result eration with them. This is particularly important in credit misallocation and other inefficiencies. 5 when state financial institutions receive funding Ensuring a transparent, structured process for through government lines of credit at subsidized nominating board members, including mini- rates, which may then be used to underprice mum fit-and-proper criteria, can also help limit products offered in direct competition with com- political interference. The board of directors mercial banks. should then select the senior management of Finally, the mandate should require financial the institution and hold it accountable. sustainability by specifying a minimum rate of Communication between the government return on capital. But while the mandate should and the state financial institution should take request a positive rate of return, the board of place primarily between the government's directors or the shareholders should specify the representative --for example, the minister of exact figure. In general, it is difficult to justify finance--and the president of the board of a target rate that is much higher than the cost directors. A written record of such communica- of funding for the government. tion may help legitimize the role of the board of The mandate also needs to be sustainable. directors and avoid inappropriate involvement Broad mandates run the risk of allowing state of the government in the management of the financial institutions to hide operational inef- institution. ficiencies and crowd out private market partici- pants through "cherry picking" behavior. But Prudential regulation and supervision excessively narrow mandates run the risk of State financial institutions should be subject to being financially unsustainable and leading to prudential regulation and supervision by the dependence on government subsidies. For state relevant authorities. This should apply not only development banks the funding of operations is to deposit-taking institutions but also to state also a controversial issue. Unless their mandate development banks and development finance is related to promoting savings or enhancing institutions that receive exclusively wholesale or the payment system in certain market segments, government funding, since they are also highly retail funding should generally be outside their leveraged institutions that may create systemic scope because it imposes additional challenges in risk (see also de la Torre and Ize 2009 and management, transparency, and supervision. Fiechter and Kupiec 2004). Banking supervi- sors should put special emphasis on governance Corporate governance arrangements, the sustainability of the business Corporate governance principles for state finan- model, and the quality of the bank's manage- cial institutions should be consistent with best ment systems. Government comptrollers or audit practices for private and public companies, as offices are poor substitutes for specialized bank- summarized by Scott (2007).2 Good corporate ing supervision, since these institutions usually governance is particularly important for these lack the expertise to assess the risks inherent institutions because they are subject to two major in banking. and related threats: political interference and lack of board and senior management capacity. Market discipline Both threats typically result from lack of opera- Market discipline can be leveraged to cre- tional and financial independence and from ate positive incentives for management. State opaque communication between the bank and financial institutions can be required to raise its government shareholders. funds from public debt markets without explicit STATE fiNANCiAL iNSTiTUTiONS CAN ThEY bE RELIED ON TO kICk-START LENDINg? guarantees and obtain (where possible) a rating environment and regulating and supervising from a reputable credit rating agency (Moody's privately owned financial institutions. But the Investors Service 2003). These actions introduce crisis is leading to a rethinking of this role in an independent source of evaluation of bank favor of more interventionist approaches, includ- management that can be used by the board or ing the use of state-owned financial institutions shareholders. to promote public policy objectives. Market discipline also represents an impor- State financial institutions can play a use- tant test for the risk management models used ful role in supporting credit growth during a by state financial institutions. Under the tradi- financial crisis under certain conditions. The 6 tional funding scheme using government lines effectiveness of their support depends in large of credit, institutions lack the incentive to fully part on the nature of the shock (whether a credit develop risk management systems because they crunch or a slowdown in credit demand) and on basically lend what they receive. By contrast, their ability to leverage the infrastructure and under a market funding scheme, state financial expertise of private commercial banks to scale institutions can lend as much as they can borrow up their impact. Also critical to their successful and they need to improve their risk management use is a sound institutional framework--with a strategies to reduce their cost of funding. Market clear and sustainable mandate, high standards funding reduces the potentially unhealthy of corporate governance, strong prudential regu- dependence of the state financial institution lation and supervision, and reliance on market on its shareholders, which creates a breeding discipline to provide the right signals to the main ground for corruption and government inter- stakeholders. ference. It might be argued that market disci- While it is too early to evaluate the effective- pline does not help because of the existence ness of support by state financial institutions, of an implicit government guarantee. But an past experience with their use is sobering and implicit guarantee is not always priced similar suggests that in many cases their long-term costs to an explicit one, and it typically includes a could exceed any short-term benefits that they premium that reflects how well the institution provide. Whether countries will heed the lessons is managing its risks on a stand-alone basis and of experience in this area or are condemned to compared with its private sector peers. In South repeat them remains to be seen. Africa, for example, the Development Bank of Southern Africa has paid up to 300 basis points less in yield for bonds issued with a state guar- antee than for those issued without one. Notes Market discipline should be grounded in high The author would like to thank Denisa Mendelsohn for levels of transparency and disclosure because valuable research assistance and Jim Hanson, Augusto they help to increase external monitoring and de la Torre, Roberto Rocha, Alain Ize, David Scott, accountability. For example, some shareholders Tony Randle, Laura Ard, Alex Berg, and Constantinos try to influence credit decisions through opaque Stephanou for helpful comments and suggestions. interactions with bank directors or managers 1. This role is especially important in countries where but take no responsibility for subsequent losses. central banks take only government paper in their As the case of the Business Development Bank discounting and repurchase operations. of Canada shows, transparency results in less 2. These are based on the OECD Principles of Corpo- government interference and greater participa- rate Governance (OECD 2004), the OECD Guidelines on tion by the media and citizens in monitoring the Corporate Governance of State-Owned Enterprises (OECD activities of a state financial institution (Scott 2005), and the Basel Committee on Banking Supervi- 2007). sion's principles in its Enhancing Corporate Governance for Banking Organisations (2006). 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