There should be no rush to privatise government owned banks

Panicos Demetriades, Svetlana Andrianova, Anja Shortland, 20 January 2010

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In a recent article on this site, Igan et al. (2010) examine the role played by lobbying in the run up to the financial crisis. Drawing on their research and other sources, they show that lobbying not only prevented a tightening of laws and regulations related to mortgage lending, but was also a factor contributing to the deterioration in credit quality. Their findings highlight the frequently neglected, albeit crucial, political economy dimension of the crisis. Moreover, they provide concrete evidence in supports of the view that unless the enormous political power of the financial industry is contained, financial reforms are unlikely to succeed (e.g. Johnson 2009).

Post-crisis, the recently nationalised banks, including the likes of Citibank and Royal Bank of Scotland, constitute important marks on the financial landscape. Their reincarnation from privately owned – “too big to fail” – banks to government controlled, if not wholly owned, banks offers an opportune moment to reduce the political power of bankers and to carry out much needed financial reforms. President Obama’s plans for financial reform – the details of which are discussed by Acharya and Richardson (2010) – appear to be very timely. Nonetheless, his reference to an army of lobbyists in Washington trying to counter them, suggests that even at this juncture, the political power of the financial industry has not waned.

Pressures on governments to privatise

Pressures on public sector finances – as a result of the banking bailouts and fiscal stimulus packages and the recession – are mounting. Bank privatisation could generate substantial amounts of cash, which can be very appealing prospect for finance ministers under pressure to generate new revenues. Moreover, the widespread distaste for government ownership of any business, particularly in the US, makes privatisation almost inevitable, only its timing is what remains uncertain. Martin Wolf of the Financial Times summarises the antipathy towards government ownership very neatly: “…crisis prone private banking is bad, state monopoly banking is even worse”.
Moreover, bankers themselves are unlikely to be a very happy bunch in the hands of government. Surely, it can only be adding insult to injury when Treasury officials have the final say on their bonus pot. It would, therefore, be very surprising if the banking industry were not doing its utmost to relieve itself from the helping hand of government as soon as possible.

Government owned banks: A symptom of bad regulation

Recent research that we have carried out under the World Economy and Finance research programme (Andrianova et al. 2008) warns against privatising the recently nationalised banks too soon. This research shows that privatising government owned banks before an effective system of regulation is in place can result in financial disintermediation. This can not only undermine the ability of the banking system to finance economic growth, but it can also trigger bank runs if depositors’ confidence in regulation remains low.

Specifically, we show that if financial regulation is ineffective depositors are likely to prefer to place their money in government owned banks, which are frequently more trusted than private banks. This is particularly true after banking crises, because it takes time for the public to regain confidence in financial regulation even if reforms are put in place. If government owned banks are privatised prematurely, depositors will shift their funds not to private banks but to alternative assets that are deemed safer, such as domestic or foreign currency or real assets (such as houses, gold, or consumer durables). This, in turn, means that the ability of the banking system to provide credit to businesses and households will be impaired. Moreover, rapid outflows of funds from one bank can create panic and may cause more widespread bank runs due to asymmetric information and lack of confidence in regulation.

But aren’t government owned banks bad for growth?

Naturally, there are concerns that governments may be unable to run nationalised banks efficiently. Follow-on research we have carried out (Andrianova et al, 2009) suggests that such concerns may be unwarranted. The new research shows that government ownership of banks has, if anything, been robustly associated with higher long run growth rates.

Using data from a large number of countries for 1995-2007, we find that – other things equal - countries with high degrees of government ownership of banking have grown faster than countries with little government ownership of banks. We show that this finding is robust to a battery of econometric tests. Specifically, we utilise extreme bounds analysis which reveals that the finding is not the result of omitting other important determinants of growth, such as openness, inflation, overall financial development or FDI. Moreover, when we control for bank privatisation in addition or instead of government ownership of banks, bank privatisation is not statistically significant, except when a significant transition dummy is omitted. We also use instrumental variables estimation, which reveals that the main result does not reflect reverse causality or common driving factors, although the latter, if important, would likely have biased the relevant coefficient downwards. When we instrument government ownership of banks using variables that proxy financial market failures, we find that the main result remains intact. However, because the need to find appropriate instrument restricts the sample to half the original one, we refrain from drawing the conclusion that government ownership of banks leads to higher economic growth, although we argue that this hypothesis can be maintained.

We provide a novel political economy explanation for our findings. We suggest that politicians may actually prefer banks not to be in the public sector. When banks are – in theory – controlled by their shareholders, in practice they are more likely to be controlled by their top managers because of agency problems. Conditions of weak corporate governance in banks provide fertile ground for quick enrichment for both bankers and politicians – at the expense ultimately of the taxpayer. In such circumstances politicians can offer bankers a system of weak regulation in exchange for party political contributions, positions on the boards of banks or lucrative consultancies. Activities that are more likely to provide both sides with quick returns are the more speculative ones, especially if they are sufficiently opaque as not to be well understood by the shareholders such as complex derivatives trading.

Government owned banks, on the other hand, have less freedom to engage in speculative strategies that result in quick enrichment for bank insiders and politicians. Moreover, politicians tend to be held accountable for wrongdoings or bad management in the public sector but are typically only indirectly blamed – if at all - for the misdemeanours of private banks. It is the shareholders who are expected to prevent these but lack of transparency and weak governance stops them from doing so in practice. On the other hand, when it comes to banks that are in the public sector, democratic accountability of politicians is more likely to discourage them from engaging in speculation. In such banks, top managers are more likely to be compelled to focus on the more mundane job of financing real businesses and economic growth.

Concluding remarks

At the beginning of the second wave of the crisis in October 2008, Northern Rock was the only government owned bank in the UK. It experienced a very sudden influx of funds because it was considered a safe haven for depositors while privately owned banks were not. While we did not observe depositors in other banks queuing to withdraw their deposits – as had happened to Northern Rock before it was nationalised a year earlier – a bank run was in fact happening in the background. Institutional investors were trying to shift their cash from the major banks to government backed investments including Treasury Bills. That was precisely the time – and in all likelihood the trigger – for the UK government putting together the bailout package for the four major banks. Only then did the panic recede.

At the moment, there is calm among bank depositors but premature privatisation of government owned banks could change that. Our research suggests that the very existence of government owned banks has its roots in bad regulation. Privatising banks without fixing the underlying cause could result in greater financial instability, not less. Moreover, as experience and other research shows, privatising banks can only increase the power of bankers which can create fertile ground for more bad regulation. And if you thought that government owned banks are bad for long run growth, you need to think again. Our research suggests that government ownership of banks during 1995-2007 has, if anything, been associated with higher growth rates.

Is there an exit strategy? We think that there is one. It contains three key ingredients in sequence (the order is critical):

  • reduce the political power of banks, including their ability to thwart or sidetrack reforms by lobbying or other means – now is an opportune moment because many banks are in public hands;
  • overhaul financial regulation in a much more open and transparent way that has been customary – getting together the bankers and politicians of the past is a non-starter;
  • convince the public that whatever problems led to the financial crisis have been fully addressed – too many statements of intent accompanied by little or no action may, if anything, produce the opposite result.

Putting the above three ingredients in place requires strong political will and considerable time. Meanwhile, we will be sleeping more soundly if the nationalised banks remain in public hands.

References

Acharya, Viral and Matthew Richardson (2010), “Making Sense of Obama’s Bank Reform Plans”, VoxEU.org, 24 January.

Andrianova, Svetlana, Panicos Demetriades, and Anja Shortland (2008) “Government Ownership of Banks, Institutions and Financial Development”, Journal of Development Economics, (85):218-252.

Andrianova, Svetlana, Panicos Demetriades, and Anja Shortland (2009), “Is Government Ownership of Banks Really Harmful to Growth?”, University of Leicester Discussion Paper in Economics 09/11.

Igan, Deniz, Prachi Mishra, and Thierry Tressel (2010), “Lobbying and the Financial Crisis”, VoxEU.org, 27 January.

Johnson, Simon (2009), “The Quiet Coup”, The Atlantic, May.

Topics: Financial markets, Global crisis
Tags: financial regulation, global crisis, nationalised banks

Svetlana Andrianova
Reader (Associate Professor) in Economics, University of Leicester
Panicos Demetriades
Professor of Financial Economics, University of Leicester
Lecturer at Brunel University and Researcher at Deutsches Institut fuer Wirtschaftsforschung.