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a
Development Research Group, The World Bank, MSN MC3-300, 1818 H Street NW,
Washington, DC 20433, United States
b
Ronald Coase Institute, 5610 Wisconsin Avenue, #1602, Chevy Chase, MD 20815, United States
Abstract
Although a large and growing literature shows that privatization can improve the performance
of non-financial enterprises, there is less evidence on how it affects the performance of the banking
sector. This paper summarizes the results from the papers in the special issue of the Journal of
Banking and Finance on bank privatization. It concludes that although bank privatization usually
improves bank efficiency, gains are greater when the government fully relinquishes control, when
banks are privatized to strategic investors, when foreign banks are allowed to participate in the
privatization process and when the government does not restrict competition.
2005 Elsevier B.V. All rights reserved.
1. Introduction
*
Corresponding author. Tel.: +1 202 473 7454; fax: +1 202 522 1155.
E-mail address: gclarke@worldbank.org (G.R.G. Clarke).
0378-4266/$ - see front matter 2005 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankfin.2005.03.006
1906 G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930
of the developing countries for which we have information. In comparison, this was
true for only two of the 20 developed countries for which data were available (Barth
et al., 2001a).
The continued importance of state-owned banks in developing countries is worry-
ing given the large, and growing, literature that finds that state ownership hurts
enterprise performance, especially in competitive sectors. Although privatized enter-
prises are often less efficient than new private entrants, there is considerable evidence
that they outperform state-owned enterprises. This suggests that privatizing state-
owned banks might improve bank efficiency and boost financial sector performance.
The papers in this symposium present new evidence on bank privatization. Much
comes from a series of country case studies that are based on detailed panel datasets
for many – and in some cases all – banks in each country. These data enable the
authors to measure performance gains or losses following privatization and to com-
pare these changes with trends for other banks in the country. The case studies cover
five individual countries (Argentina, Brazil, Mexico, Nigeria, and Pakistan) and two
regions containing eleven more countries (Eastern Europe: Bulgaria, Croatia, the
Czech Republic, Hungary, Poland, and Romania; East Asia: Indonesia, Korea,
Malaysia, Philippines, Thailand), chosen because they had high state ownership be-
fore privatization and because they privatized many banks. The evidence from the
case studies is reinforced by several cross-country studies, which take a broader look
at similar issues.
One of the lessons from these studies is that privatization often – although not al-
ways – improves bank performance. The studies also suggest things that affect the
success of reform: whether the government continues to hold shares in the bank fol-
lowing privatization; whether the bank is sold to a strategic investor or shares are
dispersed widely through a share-issue privatization; whether the government per-
mits foreign investors to participate in the privatization process; and what steps
the government takes to encourage – or discourage – competition.
Although many governments in developing countries have privatized state owned
banks, some have resisted, others have renationalized previously privatized banks,
and many have privatized using approaches that failed to yield the full gains from
privatization. To understand why they did this, it is important to understand how
politics affects privatization decisions. The papers in this symposium also identify
political factors that have affected the design and timing of bank privatization and
discuss how this has affected its success.
natural monopolies (Millward, 1982), reduce inequality, and meet other social goals
(Willner, 1996). Governments could use state owned banks to raise capital for pro-
jects with high social, but low private, returns and provide finance to poor borrowers
that are neglected by less well informed or motivated private bankers.
Public choice theories of government challenge the idea of a benevolent all-know-
ing government, suggesting that politicians and bureaucrats might instead use state
ownership to secure political office, accumulate power, or seek rents.1 If politicians
do this, they might be especially likely to do so in weak institutional environments,
where voters have less information and are less able to monitor enterprise perfor-
mance – in other words, in developing countries. Empirical evidence that state-
owned enterprises have been used to finance politically motivated projects and, that
they hire too many employees and open too many offices support the public choice
theory of government (Donahue, 1989; Jones, 1985; Kikeri et al., 1992; Li and Xu,
2004; World Bank, 1995).
There are three main reasons why public enterprises might perform less well than
private, and privatized, enterprises: political intervention, corporate governance
problems, and problems associated with competition (Shirley and Walsh, 2000).
The first problem is that politicians and bureaucrats can use state-owned enterprises
to further their political or personal goals. Although politicians can also encourage
private firms to subsidize their constituents, private owners might be better moti-
vated and more able to oppose such interventions than public bureaucrats (Galal,
1991; Shirley and Nellis, 1991; Shleifer and Vishny, 1994; World Bank, 1995). For
example, the profit-oriented owner of a private bank, especially if foreign, might
be more motivated to protect the bankÕs prudential lending policies or costs minimi-
zation rules from government intervention than a public manager would be.
Privatization could also prevent state-owned enterprise employees and other
interest groups from either ÔcapturingÕ the government body charged with monitor-
ing the state enterprise (Borcherding et al., 1977; Borcherding et al., 1982) or bribing
corrupt politicians to protect their interests (Shleifer and Vishny, 1994). Although
capture or corruption can occur with private ownership, the direct ownership link
raises the likelihood. Empirical observation supports the argument that state-owned
enterprises are more subject to intervention (Claessens and Peters, 1997; Djankov,
1999; Shirley and Nellis, 1991; World Bank, 1995).
The second reason why public enterprises might perform worse than private
enterprises is that corporate governance might be weaker in state-owned enterprises
than in private firms because of agency problems. State-owned enterprises have
many objectives and many principals who have no clear responsibility for monitor-
ing (Alchian, 1965). Large private corporations also have many small shareholders,
information asymmetries between owners and managers, and problems defining
goals and holding management accountable. Yet even private firms with highly dif-
fuse ownership will be better governed than state-owned enterprises according to
these studies. Alchian (1965) argues that because all citizens of a country jointly
1
See, for example, Buchanan (1969), Niskanen (1971, 1975).
1908 G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930
own the state-owned enterprise, its ownership is more widely distributed than a pri-
vate firmÕs ever could be. Also, because individual citizens cannot sell their shares in
a state-owned enterprise, they gain less from monitoring performance. Without a
market for ownership, information on firm performance will be scarce and non-com-
parable (Lin et al., 1998; Vickers and Yarrow, 1989). In an opposing view, Yarrow
(1986) argues that the government is the sole, concentrated owner of the state-owned
enterprise. Without the checking influence of smaller owners, politicians and bureau-
crats are able to use state ownership to pursue inefficient goals (Vickers and Yarrow,
1989; Vining and Boardman, 1992).
In addition to being less well monitored, public enterprises have other corporate
governance-related problems. Because public managers do not face a market for
their skills or a credible threat of losing their job for non-performance and are less
likely to receive performance related pay, they are less motivated than private man-
agers would be.2 Poorly performing state-owned enterprises are also less likely to be-
come bankrupt, be liquidated or taken over in hostile takeover, further weakening
managerial incentives (Berglof and Roland, 1998; Dewatripont and Maskin, 1995;
Schmidt, 1996; Sheshinski and Lopez-Calva, 2003; Vickers and Yarrow, 1989; Vick-
ers and Yarrow, 1991).
The final reason why state-owned enterprises might perform worse than private
enterprises is that they might face less competition than private firms. As discussed
above, self-interested politicians might use state-owned enterprises to provide
patronage jobs or subsidies to favored constituents (Jones, 1985; Shapiro and Willig,
1990; Vickers and Yarrow, 1991). If they do this, state-owned enterprises will be un-
able to compete in competitive markets and will therefore need subsidies or govern-
ment guaranteed debt to cover their losses. To reduce the need for subsidies,
politicians and bureaucrats might then protect the state-owned enterprises from
competition, by making entry more difficult and restricting trade, with a negative im-
pact on efficiency (Boycko et al., 1996; Shleifer and Vishny, 1994).
Even if politicians do not give the state-owned enterprise monopoly power, state
ownership can undermine competition in other ways. Subsidized state-owned enter-
prises can undercut private rivals that need to be profitable to survive (Sappington
and Sidak, 2003). For example, a state-owned bank might have more branches,
higher deposit rates and lower lending rates than its rivals because it can cover its
losses through government subsidies. Rather than using restrictions on competition
to reduce the need for subsidies, the subsidies undermine market competition.
The empirical evidence supports both views of competition. In some cases govern-
ments protect state-owned enterprises by giving them market power and in others
they undermine competition by giving subsidies (Jones, 1985; Kikeri et al., 1992;
World Bank, 1995).
Greater political intervention, weaker corporate governance and less competition
are strong arguments against state ownership. But it does not always follow that
2
Even when managers of state-owned firms are given performance related contracts, Shirley and Xu
(1998) note that it is difficult to find third parties to enforce these contracts, especially in weak institutional
environments.
G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930 1909
privatization will cure these ills. The same government officials responsible for the
poor performance of state-owned enterprises are responsible for designing and exe-
cuting privatization programs. Political objectives, poor information, and principal
agent problems compromise the privatized firm and might keep it from performing
as well as a de novo private enterprise would.
Does this mean that a privatized firm will perform better, the same or worse than
it would under state ownership? Many critics of privatization note that privatized
firms do not mimic private firms perfectly (Stiglitz, 2000a,b; Cook and Kirkpatrick,
1988; Caves, 1990; Kay and Thompson, 1986). Some authors go so far as to argue
that if the root cause of poor state-owned enterprise performance was an institu-
tional environment that hampered voters from holding politicians accountable, then
privatization will be as prone to error as state-owned enterprise management (Stig-
litz, 2000a,b). Others believe that underdeveloped capital markets, weak court sys-
tems, and inadequate procedures for bankruptcy or takeover will prevent
privatized firms from performing efficiently, especially in developing countries where
these market and institutional failures are common (Adam et al., 1992; Caves, 1990;
Commander and Killick, 1988; Cook and Kirkpatrick, 1988, 1997; Stiglitz, 2000a).
But these criticisms are misguided if privatized firms outperform state-owned
enterprises. The empirical evidence suggests that, while privatized firms might not
be as efficient as private firms, they are usually more efficient than state-owned enter-
prises (see studies reviewed in Boardman and Vining, 2004; Borcherding et al., 1982;
DÕSouza and Megginson, 1999; Megginson and Netter, 2001; Millward and Parker,
1983). The most important exceptions are firms sold to incumbent managers and
employees in the former Soviet Union, especially Russia, in the early 1990s. This
might not be surprising; when these firms were sold to managers and workers, this
prevented needed restructuring and limited capital infusions (Barberis et al., 1996;
Claessens and Djankov, 1999; Dyck, 2001; Earle et al., 1995; Frydman et al.,
1999; Havrylyshyn and McGettigan, 2000; Kane, 1999; Nellis, 2000). When majority
shareholdings were sold to outsiders in the former Soviet Union, performance also
improved there (Black et al., 2000; Bornstein, 1994; Earle, 1998; Earle and Estrin,
2003). In summary, the evidence suggests that privatization usually improves effi-
ciency (Megginson and Netter, 2001).
Although few studies deal explicitly with bank privatization, the privatization liter-
ature provides good reason to expect that bank privatization will be beneficial. The
question is whether, and under what circumstances, privatization will improve bank
performance. The papers in this symposium, many of which were financed by the Re-
search Department at the World Bank, provide new evidence on this important
subject.3
3
Megginson (this issue) summarizes the existing literature on bank privatization in greater detail.
1910 G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930
The studies allow us to explore five questions: how privatization affects bank per-
formance on average; whether benefits are smaller when the government retains
some ownership in the privatized bank; whether the method of privatization (i.e., di-
rect sale or share-issue privatization) affects outcomes; whether outcomes are better
when foreign owned banks are allowed to purchase privatized banks; and what the
interaction is between privatization and competition.
In many cases, these questions overlap. For example, governments that intend to
intervene in bank operations after privatization might be more likely to hold onto
some shares and be less willing to sell foreign strategic investors. Competent strategic
investors might also be wary when the government continues to hold onto shares,
forcing governments to privatize through share-issue privatizations in these cases.
So share-issue privatizations may be the preferred sales tactic of governments wish-
ing to loot. Governments that wish to divert bank funds will also prefer to limit com-
petition and may confer oligopolistic powers on political cronies.
The privatization literature suggests that privatized banks should outperform sim-
ilar state-owned banks. But the success of privatization will depend on how success-
fully privatization resolves the corporate governance problems associated with
public and private ownership and the effect that privatization has on competition.
In this section, we propose several hypotheses and consider the empirical evidence
from the studies in this symposium that support or refute them.
Hypothesis 2: Performance gains will be smaller when the government retains shares
in the privatized bank.
1913
1914 G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930
Table 2
Bank performance after privatization in country case studies, by extent of government ownership
In cases in which the government kept NO SHARES of stock in the banks
Two showed notable improvement
Argentina (direct sale to strategic investor)
Brazil, privatization (direct sale to strategic investor)
Five showed some improvement
Czech Republic, second phase of privatization (direct sale to strategic investor)
Hungary (direct sale to strategic investor)
Poland, second phase of privatization (direct sale to strategic investor)
Mexico, second phase of privatization (direct sale to strategic investor)
Nigeria, second phase, full divestitures (share offering, foreign ownership not permitted)
Only one showed no improvement
Mexico, first phase of privatization (direct sale, foreign ownership not permitted)
In cases in which the government kept a MINORITY SHARE of stock in the banks
One showed notable improvement
Pakistan (direct sale to strategic investor)
None showed some improvement
One showed no improvement
Nigeria, first phase of privatization, maintained minority shareholding
In cases in which the government kept a MAJORITY SHARE of stock in the banks
None showed notable improvement
One showed some improvement
Poland, first privatization (share offering, foreign ownership permitted)
Two showed no improvement
Brazil, restructuring
Czech Republic, first privatization (share offering, foreign ownership not permitted)
Note: Evidence from case-studies was supplemented with additional information based upon discussions
with authors of case studies.
Source: Bauhmol-Weintraub and Nakane (this issue); Beck, Crivelli, and Summerhill (this issue); Beck,
Cull and Jerome (this issue); Berger et al. (this issue); Bonaccorsi di Patti and Hardy (this issue); Bonin and
Wachtel (2000, 2003); Bonin, Hasan and Wachtel (this issue); Haber (this issue).
bank. Because banks manage other peopleÕs money, continued state-ownership will
allow politicians to continue to loot and will therefore have an unambiguously neg-
ative impact on bank performance.
As expected, privatization produced modest benefits when governments retained
majority control or even sizable minority stakes in the privatized banks (see Table 2).
For example, the first rounds of privatization in the Czech Republic and Poland,
when the governments maintained large ownership stakes, were less successful than
the second rounds, when the governments divested most or all their shares (Bonin
and Wachtel, 2000, 2003).
In the first round of privatization in Poland, the Treasury retained a 30% stake,
employees purchased up to 20% of the shares on preferential terms, and the
remaining shares were divided between branches for large and small investors.
The performance of the privatized banks improved a little, but the subsequent
divestiture of all government shares led to more obvious gains (Bonin and Wach-
tel, 2000, 2003).
G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930 1915
In the first round of privatization in the Czech Republic, the Czech government
distributed vouchers, with most invested in funds that were often created by banks.
These investment funds gained large stakes in financial and non-financial firms,
resulting in interlocking ownership between the banks and their clients. The state
also retained shares and therefore a substantial influence over the banksÕ operations.
Not surprisingly, neither cost nor profit efficiency improved for these banks (Bonin,
Hasan and Wachtel, this issue). The banksÕ continued soft-lending to many of their
large voucher-privatized clients resulted in bank performance deteriorating; govern-
ment bail-outs were needed before foreign investors could be attracted in the second
round (Cull et al., 2002). Bank performance improved after the second round (see
Table 2).
The experience in Brazil and Nigeria lead to a similar conclusion: continued gov-
ernment ownership is associated with weaker bank performance. State governments
in some Brazilian states sold their state-owned banks to strategic investors, while
others retained control as they tried to restructure their banks. Performance im-
proved in the fully privatized banks, but remained unchanged or deteriorated in
the restructured banks (Beck, Crivelli, and Summerhill, this issue; Nakane and Wein-
traub, this issue).
The Nigerian government maintained a minority interest in some of its privatized
banks. There was some improvement in profitability and portfolio quality in those
banks where the government fully divested its shareholdings, but not in the banks
where the government retained minority shareholdings (Beck, Cull, and Jerome, this
issue). In fact, the banks with continued minority ownership performed nearly as
poorly as the state-controlled banks for some measures of profitability. In short,
the experience in Nigeria highlights the negative performance effect of even minority
government ownership, while the experience in Brazil offers reasons to be skeptical of
state restructuring of government-controlled banks.4
The cross-country analyses in this symposium also support this hypothesis. Using a
sample of 21 share-issue privatizations from nine developing countries (Croatia,
Egypt, Hungary, India, Jamaica, Kenya, Morocco, the Philippines, and Poland), Otc-
here (this issue) finds that the shares of the privatized banks under-performed the mar-
ket and there were only modest improvement in the banksÕ operating performance.
The share of ownership retained by the government appears to explain a substantial
part of the under-performance. Although, as noted above, Boubakri et al. (this issue)
found some performance improvements in the 81 banks in their sample after privati-
zation, profitability did not improve and interest rate risk actually deteriorated. Many
banks in their sample were only partly privatized however – only one-quarter of the
banks in the sample were fully privatized and, on average, the government retained
over one-quarter of bank shares after even three years after privatization.
Although performance usually improved after privatization, privatized banks do
not always appear to perform as well as new private entrants. Bonin, Hasan and
4
One might be worried that selection effects are driving these results. However, the pre-privatization
performance of those banks where the government fully relinquished its shareholdings was worse than that
of the restructured banks in Brazil and the minority government owned banks in Nigeria.
1916 G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930
Wachtel (this issue) found that foreign greenfield banks were the most efficient banks
in the six countries in Eastern Europe in their sample. In Pakistan (Bonaccorsi di
Patti and Hardy, this issue), when the Pakistani government started the privatization
process, it also liberalized entry restrictions, allowing new private banks to enter.
These private banks outperformed the privatized banks in the period following
privatization.5
5
The performance of the new entrants, however, declined after a second round of liberalization.
6
See Berle and Means (1932), Jensen and Meckling (1976), Fama and Jensen (1983), Vickers and
Yarrow (1989), Stiglitz (1993), Shleifer and Vishny (2000), Lin et al. (1998), Kane (1999), Dyck (2001), and
Shleifer et al. (1999).
7
See Hart (1983), Willig (1985), Yarrow (1986), Vickers and Yarrow (1989), Stiglitz (1993), and Kane
(1999).
8
See Furubotn and Pejovich (1972), Yarrow (1986), Vickers and Yarrow (1989, 1991), Shleifer and
Vishny (2000), Dyck (2001); and Kane (1999).
G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930 1917
which shows few performance gains in banks sold through share-issue privatiza-
tions.9 The strong association between share-issue privatization and large residual
government ownership suggests that governments use share-issue privatization to en-
sure that private owners do not gain full control over the privatized bank.
One notable exception to this pattern is a share-issue privatization in Australia
(Otchere and Chan, 2003). The Commonwealth Bank of Australia outperformed a
control group of private banks on several financial ratios and on share price after
it was privatized. This suggests that share-issue privatizations can successfully spur
performance improvements, but only when the stock market and the associated mar-
ket monitoring by informed investors are well developed.
The fourth hypothesis is that bank privatization will be more successful when for-
eigners participate. Several studies find that foreign owners have improved the per-
formance of privatized non-financial enterprises in developing countries, perhaps
because they have greater experience and technological knowledge than domestic
investors (Cull et al., 2002; DÕSouza et al., 2001; Frydman et al., 1997). But, it might
also be because governments that are willing to sell to foreigners are more willing to
give up control of the privatized bank – indeed foreign investors might only partic-
ipate when there is little risk of intervention.
Foreign ownership is associated with greater performance improvement in the
studies in this symposium. In the first rounds of privatization in the Czech Republic
and Mexico, when the governments prohibited or tacitly discouraged foreign owner-
ship, performance failed to improve (Table 2). Performance did improve however
after subsequent rounds in which foreigners participated.
But poor performance cannot be solely ascribed to restrictions on foreign owner-
ship. In the Czech Republic the government used share-issue privatizations and re-
tained large shareholdings in the privatized banks. Bonin and Wachtel (2000,
2003) suggest that foreign ownership produced a more stable banking sector in the
second round, at least compared with the experience after the first round of bank
privatization. The authors also point to the positive post-privatization performance
of banks in Hungary, the first country in the region to fully embrace foreign
ownership.
MexicoÕs banks were privatized unsuccessfully to local investors, renationalized
after a systemic crisis, and then sold to outside investors, many of whom were foreign
(Haber, this issue). The foreign investors that participated in the second round of
privatization helped created a more stable and efficient banking sector, although
one that has responded to the failure of MexicoÕs legal system to enforce property
rights by lending little and charging high margins. As in the Czech Republic, the
9
Similarly, Boubakri et al. (this issue) find in their cross-country analysis that economic efficiency is
lower when banks privatized through share-issue privatizations, although they also find that return on
equity is higher.
1918 G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930
10
Participation by international institutional investors, such as the European Bank for Reconstruction
and Development and the International Finance Corporation, raised returns on assets and profitability
even more, but did not have an additional impact on cost efficiency. Bonin et al. (2005) note that almost all
banks in which institutional investors were involved were foreign-owned, most with a strategic foreign
investor.
11
Conversely, the Czech RepublicÕs initial failure to privatize majority control over its banks may explain
the poor performance of its larger privatized firms that were the banksÕ preferred customers (Cull et al.,
2002).
G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930 1919
next section, however, suggests that giving buyers an oligopoly can be harmful: this
episode was the only case where bank performance unambiguously declined after
privatizing to strategic investors.
The studies in this symposium do however show that privatization – even share-
issue privatization – can boost competition in the banking sector. Chen, Li and
Moshirian (this issue) find that the privatization announcement of the Bank of China
Hong Kong resulted in significant losses for some rival banks and non-bank financial
institutions in Hong Kong. This suggests that shareholders in the rival institutions
expected greater competition – and lower returns – after the Bank of China Hong
Kong was privatized. The more negative responses for non-bank financial institu-
tions might be because the privatized bank was expected to become more involved
in non-banking financial activities after privatization. Otchere (this issue), which
looks at share-issue privatizations in nine countries, also finds that rival banks suf-
fered abnormally negative returns following privatization announcements. The re-
sults from these studies are consistent with similar results for Australia in Otchere
and Chan (2003).
The results from Otchere (this issue) are especially interesting given that there was
little evidence of improved performance in the privatized banks.12 This suggests that
privatization can have pro-competitive effects even when the privatized banks
perform below market standards.
The general conclusion that emerges from the studies in this symposium is that
bank privatization improves profitability, portfolio quality, and operating efficiency,
when it is done correctly. Because state banks have many, often competing, objec-
tives (for example, to extend credit to underserved market segments) and they often
lend for political reasons, this might not be surprising. Indeed, Hanson (2004) points
out public banks often cannot lend to underserved market segments at market inter-
est rates, because these rates would appear exorbitant for political reasons. The sub-
sidies implicit in the rates that they do charge mean that portfolio quality and
profitability will suffer at even the best-run public banks.
A relevant question, then, is how big are the costs associated with those subsidies?
Although the performance improvements found in the studies listed above suggest
that the costs could be large, only one recent study has directly estimated the fiscal
costs of maintaining public ownership. Based on the loss rates uncovered in detailed
pre-privatization audits, Clarke and Cull (1999) find that the cost of re-capitalizing
ArgentinaÕs provincial banks was more than twice the net costs associated with priv-
atization (i.e., the costs of removing non-performing assets from the banksÕ balance
sheets and re-capitalizing the privatized entity less the price paid for the privatized
bank). The estimated median saving for provinces that privatized were equal to
12
In contrast, the pro-competitive effects in Australia (Otchere and Chan, 2003) are less surprising since
the privatized bank was large and its performance improved substantially.
1920 G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930
about a third of their annual spending, which suggests that the gains associated with
successful privatization are large.
The studies in this symposium show that state-owned banks are often less efficient
than similar private banks. But efficiency is not the only justification for state own-
ership. If state-owned banks successfully correct serious market failures, state own-
ership might improve social welfare even when state-owned banks are less efficient
than private banks.13
Theory suggests several market failures that state-owned banks might potentially
be able to correct. One is that private banks might provide too little credit if banking
sectors become too concentrated when banks are privately owned (Caprio and Hono-
han, 2001) or if imperfect information or incomplete contracts prevent private banks
from lending to some borrowers (Greenwald and Stiglitz, 1986). If state-owned
banks are able to overcome informational or contracting problems (i.e., if they have
better information than private banks or if the stateÕs monopoly over force allows it
to solve contracting problems more easily) or they do not exercise market power to
the same degree that private banks would, then state-ownership might lead to greater
lending and improved social welfare. Borrowers that are informationally opaque or
for whom contracting is especially difficult, such as small and medium-size enter-
prises, might be especially vulnerable when private banks dominate. State ownership
might improve access for these vulnerable borrowers even if it has only a small im-
pact on total lending.
As well as restricting access to credit, private banks might take greater risks than
are socially optimal. Because the private owners do not bear the entire loss if the
bank becomes insolvent, they might be willing to lend recklessly. This reckless behav-
ior could result in more frequent bank crises (Caprio and Honohan, 2001).
Even if these market failures are important, state ownership might not resolve
them. Corporate governance problems might prevent state-owned banks from effi-
ciently resolving market failures or politicians might use state-owned banks to raise
their own welfare (for example lending to important constituents) rather than to cor-
rect market failures. As a result, the impact on lending and stability is an empirical
question.
The available empirical evidence suggests that state-owned banks do not resolve
these market failures. State-owned banks are associated with less financial develop-
ment, slower growth and lower productivity, especially in low income countries and
countries where property rights are poorly protected (Barth et al., 2001b; La Porta
et al., 2002). These is also little evidence that state-owed banks improve access to
credit even for small and medium-size enterprises. In a sample of 3000 firms from
over 30 countries, Clarke et al. (2001) found no statistically significant link between
state ownership and access to credit for enterprises of any size. And state banks in
13
Megginson (this issue) notes that bank privatization might also be important in hardening soft budget
constraints for loss-making state-owned or privatized enterprises.
G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930 1921
Argentina and Chile lend less to small and medium size enterprises than other banks
(Clarke et al., 2005).
State-owned banks are also not associated with greater stability. Instead, they
might cause instability. Barth et al. (2001b) find that systemic banking crisis are
no less common in countries where state-ownership is more common, while other
studies find state-owned banks raise the risk of bank crises and instability (Caprio
and Martinez Peria, 2002; La Porta et al., 2002).
14
This does not appear to be true, however, in East Asia, where the point estimates from the estimation
suggest that banks that were privatized were generally more efficient than banks that remained state-
owned (Williams and Nguyen, this issue). The evidence for Eastern Europe is mixed. Bonin et al. (2005)
find that banks in Eastern Europe that remained state-owned in 1999 were less efficient than private banks
in the same year – although the difference was not highly significant. They note that this would be
consistent with the hypothesis that better banks were privatized first in transition economies. However, it
would also be consistent with the hypothesis that state-owned banks are less efficient than similar private
and privatized banks. Further, Bonin, Hasan and Wachtel (this issue) do not find any evidence of a
selection effect in the six Eastern European countries in their sample.
1922 G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930
(this issue) show that bank privatization was more likely in developing countries with
poor quality banking sectors.15
Fiscal concerns also affect privatization in other ways. Fiscal transfers between
national and local governments allow national governments to influence the privati-
zation decisions of provincial or state governments. Brazilian states that were more
dependent on federal transfers and whose banks were already under federal interven-
tion relinquished greater control during the privatization process than other states
did (Beck, Crivelli, and Summerhill, this issue).
The strength of opposition to privatization also affects the likelihood of privatiza-
tion. In Brazil, the federal government offered several privatization options that af-
fected the amount that state governments relinquished control over their banks
(Beck, Crivelli, and Summerhill, this issue). States relinquished greater control when
they were able to establish a development agency, which could assume some of the
mandate of the former state bank and thus assuage political opposition.16 Similarly,
in Argentina, large, overstaffed banks in provinces with higher unemployment and
more public sector workers were less likely to be privatized: privatization was less
likely when public employees were more influential and job losses more controversial
(Clarke and Cull, 2002). Also consistent with this idea, Boehmer, Nash and Netter
(this issue) find that governments that were more accountable were more likely to
privatize their banks in the low and middle-income countries in their cross-country
sample. Although slightly different from the results for Argentina, one could argue
that overstaffing and more public sector jobs are signs that a government is depen-
dent on a small group of favored constituents rather than the full electorate.
There is also weak evidence that party affiliation or ideology might affect privati-
zation decisions. Provinces with governors from the more fiscally conservative of
ArgentinaÕs two major political parties (Partido Justicialista) were more likely to pri-
vatize than those with governors from the other major party (Unión Cı́vica Radical)
(Clarke and Cull, 2002). Similarly, right-wing governments were more likely to pri-
vatize state-owned banks than left-wing governments in the cross-country sample of
low and middle-income countries in Boehmer, Nash and Netter (this issue). Neither
of these results, however, were highly robust.
Political factors can also affect the approach to privatization and the steps the
government takes to influence the future behavior of the privatized bank. In Argen-
tina, provinces with high fiscal deficits agreed to privatization contracts that allowed
more layoffs and guaranteed a larger part of the privatized bankÕs portfolio but re-
ceived higher prices (Clarke and Cull, forthcoming). Exogenous factors also some-
times affect political decisions. The Tequila Crisis and the associated fiscal costs
caused politicians to agree to conditions that protected fewer jobs and retained a
higher share of the public banksÕ non-performing assets in a residual entity.
15
Boubakri et al. (this issue) find a similar result in their cross-country analysis. Banks were privatized
were less efficient and had lower capital adequacy than other state-owned banks.
16
The development agencies were not true banks. They were unable to take deposits from the public and
could only invest in priority areas defined by the state government (Beck, Crivelli, and Summerhill, this
issue).
G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930 1923
Because political factors affect the timing of privatization and the design of priv-
atization contracts, they can also affect post-privatization performance. Because
most banks effectively stopped operating during ArgentinaÕs latest crisis, it was
not possible to test directly whether specific features of the privatization contracts
harmed bank performance. But there are some regularities that suggest they did.
Privatized provincial banks improved profitability, profit efficiency and portfolio
quality, while showing no improvement in cost efficiency or the ratio of operating
costs to assets (Berger et al., this issue). These results suggest that the contract pro-
visions that protected workers and prohibited branch closures might have prevented
the privatized banks from cutting their costs.
Comparison of privatization experiences in the transition countries also provides
indirect evidence that politics can affect privatization outcomes. Early in the 1990s,
Hungary moved decisively to privatize its banks and allow entry by foreign banks.
This strategy paid substantial dividends, allowing the country to develop a strong,
stable banking system long before its neighbors did. But speed alone does not ensure
success. The Czech government sold some of its ownership stakes in the four large
banks that dominated the financial system quickly through a voucher privatization
program. As noted earlier, however, they also chose to retain sizable, and in some
cases controlling, interests in these banks (Bonin et al., 2005; Cull et al., 2002). As
a result, performance failed to improve, as the banks maintained their old links with
their most influential former clients, whom were channeled funds to prop up unpro-
ductive firms. It was not until the government cut its stakes further in the late 1990s
that performance improved. Although the authorities moved more slowly in Poland
than in the Czech Republic, they avoided the near-crisis situation faced by the Czechs.
The decisive effect that political factors can have on the success of bank privati-
zation were most clearly evident in the first round of privatization in Mexico (Haber,
this issue). Before 1997, MexicoÕs one party political system, dominated by the PRI
(Partido Revolucionario Institucional), meant that there were few constraints on the
governmentÕs authority and discretion. The lack of constraints had three important
consequences: (i) the risk of expropriation was high; (ii) privatization policy could be
distorted to serve the PRIÕs political needs; and (iii) mechanisms to enforce contrac-
tual rights were weak. Together these resulted in a flawed privatization program.
The lack of constraints on government action meant that the risk of expropriation
was high.17 Potential buyers would not bid unless they were compensated for the risk
of expropriation with the promise of high rates of return secured by protection from
competition.
It also meant that privatization policy could be distorted to meet the governmentÕs
short-term political goals. Facing a fiscal crisis and needing to shore up political sup-
port in the face of rising political competition, the government designed a program
that would maximize revenues. First, the government did not break up MexicoÕs
highly concentrated banking system but sold the banks as is. Second, the banks were
17
PRI-controlled governments expropriated MexicoÕs banks twice in the twentieth century, in 1915–16
and in 1982. In addition, they had also carried out de facto expropriations through drastic increases in the
money supply or draconian regulation of interest rates.
1924 G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930
auctioned sequentially, which led to greater competition and pushed up the bid to
book ratio in every round. Third, new banks needed permission from the Secretary
of the Treasury, who could decline a charter for any reason, before they could start
to operate. This raised the charter value of the privatized banks. Fourth, the govern-
ment failed to bring MexicoÕs accounting standards in line with international stan-
dards, allowing banks to substantially overstate their assets and reported rates of
returns. Fifth, the government did not allow foreign banks to bid and the NAFTA
agreement was structured so that only the smallest banks could be foreign owned.
These features signaled to bidders that they were buying the secure oligopoly they
needed to compensate them for expropriation risk, contributing to much higher than
expected prices.18 On average MexicoÕs banks sold for over three times book value,
higher than in either the United States or Western Europe – countries where expro-
priation and default risk are lower.
The new owners of the privatized banks lent aggressively and opened new
branches to quickly earn high returns. The stock of lending nearly doubled in real
terms between 1990 and 1994. Many of these loans were poor quality, while many
others appear to have been to groups and individuals closely linked to bank owners.
Non-performing loans rapidly grew from about 13.5% of loans in 1991, to 17.1% in
1994, and 52.6% in 1996.19
As bad debts accumulated the third weakness – the lack of mechanisms to protect
contractual rights – became important. Delays and obstructions in MexicoÕs legal sys-
tem meant that banks could not repossess collateral on their bad loans. Relational
loans to family and network members were no easier to collect. In short, there were
no checks on bad banking. Unlimited deposit insurance gave bankers little reason to
re-create the strong networks that they had once used to monitor each otherÕs behavior.
Instead the prospect of a bailout encouraged them to lend more to family and friends
who planned to default (La Porta et al., 2003). Moreover, because the privatization pro-
gram had allowed the new owners to pay for the banks with borrowed money, they had
little of their own capital at risk, further weakening their incentives to lend prudently.
MexicoÕs political economy had created a fragile banking system poised for col-
lapse. The devaluation in December 1994, which led the Central Bank to raise inter-
est rates, exposed the unsustainable situation. As the banks faltered, the 100%
deposit insurance system bailed out depositors and the government took over insol-
vent banks. To re-capitalize the banks, the government removed all restrictions on
foreign bank ownership. The second privatization in 1996 lowered operating costs
and raised the capital/asset ratio from 6% to 11%. The government assumed all
the bad debts, and MexicoÕs banks started to follow more prudential policies. But
18
A less charitable interpretation is that the government was tacitly permitting the new owners to attract
deposits that its owners could later divert to their own accounts through loans to insiders (Haber, this
issue).
19
Estimates are from Haber (this issue) and include non-performing loans omitted from official figures.
Since MexicoÕs weak accounting standards underestimated the size of non-performing assets, the official
numbers were lower. At the same time the banks were undercapitalized – the capital ratio was probably
only 6.5% during this period – while operating costs stayed high, averaging about 7.5% per loan.
G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930 1925
because contracts are still difficult to enforce, banks lend little: bank lending averages
only 15% of MexicoÕs GDP compared with 150% in the United States, 200% in
Japan, and 20% in Mexico in 1991.
Although politics is not the primary focus of the other studies in this symposium,
they offer some examples of politics affecting privatization outcomes. For example,
Beck, Cull, and Jerome (this issue) discuss the preponderance of ex-military officials
and politicians who were and are owners of Nigerian banks. They also argue that the
governmentÕs multiple exchange rate regime created arbitrage opportunities for
financial institutions that had privileged access to foreign exchange, fostering a bank-
ing sector focused on rent seeking rather than financial intermediation. Bonin,
Hasan and Wachtel (this issue) describe how privatization was infeasible in Bulgaria
and Romania until the late 1990s because of the unstable macroeconomic situation.
By that time, the state banks had suffered such large losses that substantial re-capi-
talization was needed to ensure investor interest.
5. Conclusions
The cases studies and the cross-country analyses strongly support the conclusion
that privatization improves performance and raises competition. But several policies
lessen the benefits:
Although poor regulation lessens the gains from privatization, privatization im-
proves performance even in poor regulatory environments. This suggests that it is
better to privatize even with weak regulation, rather than await reforms that might
take a long time. Because foreign banks face regulation in their home country that
might curb their opportunism and encourage them to behave more prudently, it is
1926 G.R.G. Clarke et al. / Journal of Banking & Finance 29 (2005) 1905–1930
Acknowledgements
We would like to thank Thorsten Beck, Allen Berger, John Bonin, Jerry Caprio,
Jean-Claude Cosset, Stephen Haber, Jim McNulty, Bill Megginson, Isaac Otchere,
and Paul Wachtel for comments on earlier drafts. This paper has not undergone
the review accorded to official World Bank publications. The findings, interpreta-
tions, and conclusions expressed herein are those of the authors and do not necessar-
ily reflect the views of the International Bank for Reconstruction and Development/
The World Bank and its affiliated organizations, or those of the Executive Directors
of The World Bank or the governments they represent. The World Bank does not
guarantee the accuracy of the data included in this work.
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