Reforming Development Banks: A Framework

1. Public Sector Banks and Privatization World Bank Workshop Washington. D.C. 10 December 2002 Reforming Development Banks:A Framework Augusto de la Torre Senior Regional Advisor World Bank

2. Agenda • The problem: under-served sectors’ access to financial services • Traditional response: establish a development bank • Public sector banks • The hard evidence • Parcial solutions • The inherent contradiction • Public sector bank reform – guiding principles • The role of public policy • The enabling environment • What to do with development banks? • Sustainable broadening of access to financial services • Examples of financial market promotion • Final remarks

3. The Problem: Underserved Sectors’ Access to Financial Services • Risks • High, often correlated, and complex – particularly in small farming • Low and volatile incomes • Substantial agency and information asymmetry problems • Screening and monitoring challenges in the absence of reliable financial statements and planning • Weaknesses in enforceability of property and creditor rights • Limitations in the use of collateral, particularly movable • Crowding out (lending to government option) • Reduces appeal of higher return/higher risk combinations • Macro-systemic voltility • Raises liquidity premium, limiting credit in general

4. Traditional Response:Establish a (Public) Development Bank • Perception that private financial entities are inherently uninterested in the under-served • Small farmers, low income families, SMEs, and micro-enterprises • State takes the “bull by the horns” to correct this perceive “market failure” via the creation of public banks • Long-duration finance in national currency as a key missing market • Emphasis is on credit provision and direct State involvement in the sector (R&D, investments, etc.)

5. Developing countries Developed countries State Ownership of Banks: Declining but Still Substantial (Caprio et. al 2000) Share of the assets of the top 10 banks owned or controlled by the government 60 40 20 0 1970 1985 1995

6. 75% - 100% 50% - 75% 25% - 50% 10% - 25% 0 - 10% N.A. State Ownership of Banks, 1998: Popularity is International (Caprio et. al 2000)

7. Public Sector Banks – The Hard Evidence • Greater participation of State in bank ownership leads to (Caprio et al. 2000): • Less financial sector development, less growth, and lower productivity • Greater financial intermediation spreads • Less credit to the private sector • Grater concentration of credit • Some propensity to crises (weaker monitoring) • Recurrent fiscal drains

8. Public Sector Bank Reform – Partial Solutions • Improve governance • More professional directors and administrators • Shields against exesive politial interference • Stricter accountability and greater transparency • Improve regulation and supervisory enforcement • Leveling the playing field vis-a-vis private banks • Abandon first-tier banking, but not second-tier function • Private banks evaluate and take on risks • Second-tier bank evaluates and controls exposure to risk of private banks

9. Public Sector Banks – Inherent Contradiction: Activities versus Social Policy Mandate • The Sisyphus syndrome • Social policy mandate • => concentration on high risk/ low return activities • => systematic losses and recurrent recapitalizations • => improvements in governance and supervision • => re-orientation towards profitable activities, in direct competition with private banks • => insufficient attention to social policy mandate • => political pressures to implement social policy mandate • Neither governance/supervision improvements, nor shift towards second-tier banking eliminate the Sisyphus syndrome

10. Guiding Principles for Public Sector Bank Reform ( 1 ) Reduce, simplify, and re-define the role of the State in financial markets Exit first-tier banking Modernize the enabling environment Role of State Promote financial market development via well-designed instruments (incl. Subsidies) Some second-tier credit activity (subject to adequate governance and accountability) Transfer programs for the non-bankable poor

11. Guiding Principles for Public Sector Bank Reform (cont.) ( 2 ) Avoid major disruption of credit flows during the transition • Anticipate credit flow reductions as result of reform • Adopt compensating measures ( 3 ) Avoid a “central planning” approach to reform • Set up a process that allows for: • Competition and choice • Learning, discovery, innovation • Mistakes – without exesive shifting of risks and costs to the government

12. Public Policy – The Enabling Environment • Market-friendly regulatory and supervisory framework • Financial market infrastructure – to reduce costs of screening, monitoring and enforcement • Information on debtors • Accounting and disclosure standards • Contractual environment: quality, diversity, enforcement • Movable collateral • Shareholder and creditor rights, including in corproate insolvency proceedings • Extreme (unrealistic) option – let the market do the rest

13. Public Policy – What to do with Public Sector Banks? • Radical solution – separate the terms of the contradiction • Development bank without social policy mandate = private bank • Social policy mandate without a bank => vehicle? • Intermediate solution • Emphasize the promotion of financial market development • With limited second-tier lending activity (long-term finance; finance for investment at local government level) • Note: some traditional second-tier lending activities cannot compete under financial globalization (e.g., export finance)

14. Public Policy – Sustainable Broadening of Access to Financial Services • A function of a “development agency”(DA) – not a bank • What is a DA? • Flexible vehicle for focused public policy • Operates principally with budgeted fiscal transfers • Its priorities are determined and scrutinized by Congress within the budgetary process • Own evaluation criteria – e.g., benefits per unit of subsidy, subject to promotion of financial markets • May or may not include risk taking • Can be part of a second-tier development bank

15. Promotion of Financial Market DevelopmentExamples of Instruments Criteria: Align Incentives Increase availability of information, strengthen demand, widen options, do not distort relative prices, lower transaction costs • Matching grants (transitory) • Grouping debtors (collateral; collective monitoring) • “Brokerage” – information, financial services, etc. • Direct subsidies (declining, transitory) for investment • Adoption of new loan technologies • Professional services networks • Creation of market infrastructures • E.g., NAFIN’s system for discounting receivables of SMEs • Partial guarantees (transitory risk sharing)

16. Final Remarks • The re-definition of the role of the State tends to lack behind fast-paced change in financial markets • Segmentation of access to financial services could deepen with financial globalization • A sole emphasis on the enabling environment appears insufficient for public policy • The are potentially constructive roles for some functions of development banks and development agencies • “Better practices” emerging but there is no simple recipe