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«Public Financial Institutions in Developed Countries—Organization and Oversight Lev Ratnovski and Aditya Narain WP/07/227 © 2006 International ...»

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WP/07/227

Public Financial Institutions in Developed

Countries—Organization and Oversight

Lev Ratnovski and Aditya Narain

WP/07/227

© 2006 International Monetary Fund

IMF Working Paper

Monetary and Capital Markets Department

Public Financial Institutions in Developed Countries—Organization and Oversight

Prepared by Lev Ratnovski and Aditya Narain

Authorized for distribution by David Marston

September 2007

Abstract

This Working Paper should not be reported as representing the views of the IMF.

The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

While public financial institutions (such as public development banks) are commonly associated with developing countries, in fact they are prevalent in the developed world as well. We study a sample of public financial institutions in industrialized countries and identify dominant trends in their organization and oversight. While practices in developed countries may be a useful reference point, a more nuanced approach, accounting for the disparity of institutional environment, regulatory capacity, and government accountability and effectiveness, may be required in developing countries. Further investment in the accumulation of evidence and formulation of best practices in the organization and oversight of public financial institutions seems warranted and necessary.

This paper was prepared while Mr. Ratnovski was working in the Financial Supervision and Regulation Division during January–April 2006. The authors are grateful to Jonathan Fiechter, David Marston, and participants of an MCM seminar in April 2006 for their helpful comments.

JEL Classification Numbers: G21, G28, H81 Keywords: Financial institutions, banking regulations, banking supervision Authors’ E-Mail Address: Lev.Ratnovski@bankofengland.co.uk and anarain@imf.org 2 Contents Page Introduction: Access to Finance and Public Policy

A. Access to Finance

B. Fundamental Policies

C. Public Provision of Financial Services

D. Regulatory Perspective

E. Study Scope and Method

II. Rationale of Public Financial Institutions in Developed Countries

A. Housing Finance

B. Small- and Medium-size Enterprises/Innovation Finance

C. Agriculture

D. Are These Rationales Always Valid?

E. Other Common Types of Public Financial Institutions

III. Organization of Public Financial Institutions in Developed Countries

A. Typical Financial Instruments

B. Financing

C. Ownership

D. The Importance of Focus

IV. Oversight of Public Financial Institutions in Developed Countries

A. Need for Strong Oversight

B. Oversight in Practice

C. Capital Requirements

D. Challenges of Oversight

E. Principles of Oversight

V. Conclusions

References

–  –  –

We understand access to finance (or financial access) to mean the opportunity for individuals and firms to use, at a fair cost, financial system instruments that facilitate personal and

commercial economic transactions, such as:

• Credit instruments;

• Insurance (hedging) instruments; and

• Savings, payment, and remittance instruments.

In the ideal Modigliani-Miller world, individuals and firms can obtain financing to undertake all worthwhile (positive net present value (NPV)) projects. This benchmark result holds subject to a set of restrictive assumptions. Available information should be perfect, contracts complete and costlessly enforced, markets complete and efficient, and transaction costs, taxes, and bankruptcy costs absent. In reality, these restrictive assumptions do not hold.

Therefore, it is natural for agents, even in the most financially developed economies, to be unable to obtain financing for some positive NPV projects—access to finance is always imperfect.

However, there are two significant concerns. Firstly, access to finance is unequal on average across countries. Agents in developing countries typically have access to a narrower range of financial instruments than that available in more developed economies.

Low average access to finance is called insufficient financial depth. Secondly, access to finance is unequal across agents within a country. Wealthier individuals and larger established firms typically have better access to financial instruments than the middle class and small- and medium-size enterprises (SMEs), because they have accumulated more collateralizable wealth, may have longer credit histories, and, as incumbents, do not suffer from common discriminatory arrangements such as entry restrictions. Financial access for poor individuals and micro enterprises can be severely restricted and may not even be possible at all. Developing countries typically have a higher degree of distributional inequality of access, referred to as insufficient financial breadth (see Claessens and Perotti, 2005).

One can relate across-country and within-country variations in access to finance to the closeness of a country’s financial system to the ideal Modigliani-Miller benchmarks. Access to finance is deeper and wider under better institutions (more transparency, better property rights) in more developed financial markets, and in an environment less distorted by taxes, unnecessary regulations, and other avoidable costs. Recent literature suggests that access is significantly influenced by institutional factors, such as transparency and a contracting 4 environment. For a detailed review of the literature on financial access determinants and effects, we direct the reader to Levine (2005).





–  –  –

Deepening and broadening of financial access should be an important public policy objective. Better financial access translates into robust economic growth, as more firms are able to make profitable investments. It also enhances financial stability, for example, by allowing firms to hedge their risks, or more easily obtain refinancing if in financial distress.

Lastly, broader access to finance also reflects the values of social justice by contributing to equal economic opportunities.

To achieve a fundamental increase in financial access, public policy should target its main determinants—institutional and financial system development.

The principal institutional dimensions are:

• Well defined commercial property rights, including:

–  –  –

• An environment that fosters transparency, including adequate accounting principles and other mechanisms enabling credible disclosure

The principal financial system dimensions are:

• Efficient financial regulation and supervision;

• An ownership structure of financial institutions, reflecting:

• A clear and focused role for state financial institutions, if they exist;

–  –  –

• An entry and competition policy that balances entry opportunities with preserving the charter value of financial institutions;

• Crisis resolution tools, such as deposit insurance, liquidity support mechanisms, effective financial institutions bankruptcy procedures; and

• Financial infrastructure, such as the payments system and credit databases.

The institutional and financial system development policies are necessary to achieve a fundamental increase in financial access, and should, therefore, be regarded as a priority.

However, there can be a number of problems in their implementation. Firstly, even the best fundamental development policies, especially those targeting institutional improvements, may have very long gestation periods. The government may have the need to provide more immediate transitory solutions. Secondly, there can be genuine market failures restricting access to finance, which cannot be resolved by improving the overall economic environment, but may require more targeted and direct government interventions. The examples of such

market failures in financial markets are:

• Insufficient collateral endowment of agents;

• Lack of statistical information (e.g., credit histories) for agents with historically low economic activity, or in volatile economies;

• Incomplete, illiquid, or not deep enough markets;

• Underinvestment in financial infrastructure or the public’s financial literacy due to coordination problems and sunk costs; and

• Underinvestment in industries exhibiting positive externalities.

In addition to these economically objective reasons that restrict the effects of fundamental policies, there may be significant political resistance to the fundamental improvement of financial access. The resistance is commonly associated with economic incumbents, who see the widening of the public’s financial opportunities as a threat to their domination and monopolistic rents. While such special interests lobbying may lead to socially detrimental results, even a well-intentioned government may be unable to withstand its pressure.

The effects of political resistance can be overt, in the form of the country’s unwillingness to adopt fundamental policies. Or they can be subtler, when the design or implementation of formally well-intended policies is “captured” by established interests. As a result, instead of expanding economic opportunity, the “development” policies could end up benefiting a few 6 who are already better off. Such captures can often be traced, for example, in the analysis of unsuccessful financial liberalizations.

–  –  –

When fundamental financial access policies do not work—due to long gestation, genuine market failures, or political opposition—governments may choose to correct for the lack of market-based finance by the public provision of missing financial services. Undoubtedly, well-designed interventions by a “noble” and efficient government can indeed provide transitory solutions to complement long-term development policies and correct financial market failures. But, in practice, governments are commonly not fully “noble,” but influenced by special interests. The efficiency of governments is also commonly limited by bureaucratic incentive structures.

As a result, even when market failures create a theoretical field for social welfare improving interventions, practical government failures may in fact be more distortionary than the market shortcomings they were intended to address, and render public involvement undesirable. Put differently, market failures by themselves do not warrant public intervention. Recognizing its limitations, government should act only if it can address the economic imperfection better than the market. In practice, however, governments around the world are often excessively interventionist, in which case their policies may compromise rather than improve social welfare.

There are, therefore, a number of major problems in the public provision of financial

services:

• Distortionary, excessive or otherwise improperly designed interventions, generated by political pressures or bureaucratic incentives.

• Prevalent inefficiencies, including politically connected lending, often to political allies or powerful incumbents (“national champions”).

• Entrenchment, reluctance to downsize, reform or liquidate once the market is able to take over their functions. Public financial institutions can create strong vested interests, where their beneficiaries exercise organized political pressures aimed at the preservation of enjoyed rents.

–  –  –

Therefore, the net economic effect of public financial institutions is ambiguous. On the one hand, a strong case can be made for the merits of public interventions in providing transitory solutions or addressing market failures. On the other hand, the common costly inefficiencies of public financial institutions may not be ignored. Therefore the “big” question, of whether a particular public financial service should or should not be provided, is a highly complex one.

This paper aims to address one dimension of this question, taking the standpoint of financial regulators and supervisors, and considering what can be the basis of crafting a regulatory approach to public financial institutions.

D. Regulatory Perspective

Despite the recognized risks and costs, public financial institutions are an important part of the financial landscape around the world. Public financial institutions are commonly associated with developing countries, which turn to them when their growing real sector potential seems to outrun financial system capacities. In practice, however, public financial institutions exist and are often prominent even in the most financially developed countries.

The establishment of government financial services is typically a political decision on which financial regulators may have only limited influence. Therefore, they view the decision on the creation, preservation, or liquidation of public financial institutions as given. The relevant question is how the regulators should respond to such decisions. The response should seek to maximize possible benefits of enhanced financial access, while seriously acknowledging potential costs and risk, and seeking to contain them. While possibly not having direct authority, regulators may contribute to the public discussion on the rationale and optimal design of public financial institutions.

Addressing public financial institutions can be a challenging task for financial regulation and supervision. These institutions often have significant systemic, fiscal, and economic policy importance. Yet they frequently suffer from a common lack of market discipline, low profitability, and owner and managerial myopia, which may create significant mismanagement risks. Also, the chance of regulatory forbearance induced by political pressures is high. To perform their functions adequately, regulators need to be to be equipped with sufficient (international) evidence, where possible, distilled to best practices.



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