Banks and governments: dangerous liaisons

Florencio Lopez de Silanes, professor of finance and head of a research programme on regulation and mutual fund governance at the EDHEC Risk and Asset Management Research Centre gives his insight on the government?s involvement in the Banking sector.

What is your view of the different ways in which governments have intervened during the current financial crisis? 

[...] These interventions have basically brought us back to the 1970s level of government ownership of banks in industrialised countries. A consequence of the crisis is therefore a reversal of 20 years of privatisation in the banking sector around the world.

Your research has shown an historically negative connection between government ownership of banks and bank performance. Does this mean that investors can expect the recent government intervention in the banking sector to lead to poor results from financial institutions in the future?

[...] Government intervention in the banking sector in fact led to lower financial sector development and lower productivity growth in the second half of the 20th century. These bad results for the financial sector and the economy as a whole come at the expense of consumers and small and medium-sized firms.

You have shown that government ownership of banks is associated with misallocation of resources in the economy. What do you think are the reasons for this?

[...] First, there is no evidence that interest rate spreads come down with more government banking. Second, the share of the lending pool of the top 20 firms in the country actually increases when the State owns the bank. This is the opposite of democratisation of credit and demonstrates a large element of politicisation of lending. [...] It may mean that banks themselves exhibit higher profitability as they only lend to the best borrowers. What lessons from previous privatisations should be considered if and when there is a return to private bank ownership after the crisis?

Most governments in industrialised in countries have vowed to return banks to the private sector as soon as possible. [...] The biggest threat for those governments that do privatise is that they may be tempted to avoid serious restructuring of regulation and a push for transparency and disclosure on the part of financial institutions because this would mean lower future profitability for privatised banks and thus lower privatisation prices of those institutions. [...] Governments may pass on the opportunity to make the industry transparent. These were the main faults of the previous rounds of privatisation of government banks in the 1990s.

What should the focus of the current regulatory drive be?

The new banking regulations should aim at making government banks more transparent and forcing them to disclose information not only to regulators and central banks, but also to all market participants.