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Rethink Of Government's Role In Finance Urged By New World Bank Report

Available in: Français, Español, Português
Press Release No:2001/329/S
Contact Person:
Phil Hay (202) 473-1796
Miriam Razaq (202) 458-2931
Cynthia Case McMahon (TV/Radio) (202) 473-2243

WASHINGTON, May 22, 2001
--Countries where the government owns a large share of the banking sector have lower economic growth and higher poverty than countries where there are fewer government-owned banks, according to a new World Bank study released today.

In contrast, countries that reduce government ownership of banks and allow reputable foreign banks to operate in their financial markets benefit from the resulting competition and increased efficiency and enjoy less financial volatility, higher economic growth, and lower poverty. However, privatizing state banks and allowing in foreign financial firms can be complicated and mistakes can be costly.

According to Finance for Growth: Policy Choices In A Volatile World which broadly reviews the experiences of countries around the worldfinancial crises, such as those that swept East Asia and other emerging markets in the late 1990s, and current financial sector uncertainties in countries such as Turkey, show that "getting the big financial policy decisions right has thus emerged as one of the central development challenges of the new century."

"The rapid evolution of online financial services means that we are moving to a world of finance without frontiers," says the report's co-author, Gerard Caprio, Director of the World Bank's Financial Policy and Strategy Group, and a former US Federal Reserve Board economist. "Countries must decide which financial services to buy and which to build at home. Just as all countries need access to airline services, but do not necessarily need their own national airlines, so too is the case with finance. What matters for growth is access to financial services, not who supplies them."

Financial crises will continue but countries can take steps to reduce their frequency and severity, the report says. It recommends that developing countries go beyond mechanical compliance with international standards to tap market forces so that bank owners, participants in the financial markets, and bank supervisors have incentives to monitor one another and to avoid excessive risk.

Opening the financial sector to foreign banks, and selling off state-owned banks, provided this is done carefully, are two steps that countries can take toward establishing such incentives. Other steps include keeping authorities at arm's length from transactions to reduce the opportunities for conflict of interest and corruption; and removing distortions that lead to too little direct investment, insufficient equity, long-term finance, and lending to small firms and the poor.

In a world where online financial services cross national borders at will, the scope for government action is growing more narrow. Governments can focus their attention on policies to ensure the availability of high-quality financial services, and to contain the risks of importing volatility.

"This research demonstrates conclusively something that many of us have believed to be true for a long time, that a sound financial sector is a critical ingredient for poverty-reducing economic growth," says World Bank Chief Economist Nicholas Stern. "Some argue that the services in the formal financial sector only benefit the rich. But poor people suffer from the effects of a weak financial sector and from financial crises, even if they don't own shares or have a bank account."

Some countries have excluded foreign-owned financial firms from their domestic markets, fearing they will destabilize the financial system and put local companies out of business. Yet the report finds no concrete evidence that the entry of foreign banks destabilizes the flow of credit or restricts credit access by small firms. Instead, it is associated with significant improvements in the quality of regulation and disclosure.

"Opening the market for financial services  allowing foreign financial institutions to operate in the domestic market  should not be confused with liberalizing the capital account  that is, easing restrictions on the movement of money in and out of the country," says Stern. "Opening the market for financial services can lower risk in the financial system and can often help to pave the way for capital account liberalization."

The report finds that government ownership of banks continues to be remarkably widespread, despite the evidence that the goals of such ownership, for example, channeling savings to small firms or development priorities, are rarely achieved.

"Government ownership of banks tends to weaken the financial system. In countries where the government owns many banks, credit is more likely to be restricted to a few large firms, interest rates are higher, and the non-bank financial sector, such as stock markets, are weaker," says Caprio. "These countries have less financial sector development and less growth  and therefore higher poverty levels. But bank privatization must be done carefully  too often privatized banks quickly collapse and wind up back under the government's management in worse shape than before privatization."

When crises hit, governments face tricky choices. They may become involuntary owners of banks, and need to focus on getting out of that role as quickly as possible. Repeatedly re-capitalizing failed banks imposes a heavy price on the financial system and national economy for years to come, the report says. In Indonesia, the sums of government money being used to pay down debts accumulated during its financial crisis could have doubled health and education spending for years to come.

Governments can use market signals when deciding which banks merit survival, for example, by re-capitalizing banks only when there are matching private sector funds, and then making sure that the government gets paid back first.

The report warns that it is not always prudent for developing countries to imitate financial institutions in countries with more developed financial sectors. Government deposit insurance, which is becoming increasingly popular in developing countries, can have unintended effects.

"We found that deposit insurance reduces the incentive for depositors and other financial market participants to monitor the banks," says report co-author Patrick Honohan, a World Bank Lead Economist and former economic adviser to the Irish Prime Minister. "Although this may be tolerable in countries where official regulation and supervision can take up the slack, elsewhere it encourages bank managers to gamble with other peoples money, ultimately leading to less financial sector development and increased likelihood of banking crisis."

Moreover, when such safety nets are made available at low cost, there tends to be too much reliance on banking rather than other forms of financial intermediation. For example, firms take on more debt rather than turning to the equity markets, resulting in more fragile firm financing structures.

Some countries have restricted the development of their equity markets in an effort to strengthen their banks, or restricted banks in order to foster the growth of equity markets. The study found no basis for such policies. "Banking and equity financing are complements, not substitutes," Honohan adds. "Indeed, the development of each sector seems to strengthen the performance of the other by maintaining the competitive edge of individual financial firms."

Small financial systems face special challenges, and even the largest developing country's financial systems are small relative to the size of global financial flows. Of all developing countries, only China and Brazil constitute one percent or more of the world's financial system. The smaller a country's financial system, the more vulnerable it is to external shocks, unless the financial system is itself securely integrated in the world financial system.


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