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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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• Private bank-owned cooperatives—Federal Home Loan Banks and Farm Credit System.

Another example of the public-private approach is the Shoko Chukin Bank of Japan, currently planned for privatization, which is a jointly, publicly-privately owned corporation with government majority.

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The United States experience seems to suggest caution on the merits of public ownership or co-ownership of policy-driven corporations. The potential virtues of deeper private involvement, such as improved efficiency or better governance, appear to be limited in practice. At the same time, the option value of the government guarantee creates opportunities and incentives for private owners to seek rents through the socially inefficient expansion of the institution’s operations.

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Beyond lack of efficiency and accountability, the two major problems associated with public financial institutions are the uneven playing field that they create and their entrenchment.

Uneven paying field: Public financial institutions, including those in our sample, commonly have access to cheaper funds and enjoy less regulation. On this uneven playing field, they may out-compete and crowd out potentially more efficient private counterparts. Reform or downsizing of public financial institutions is complicated by the numerous vested interests they create. Vested interests commonly stem from financing recipients as well as lenders benefiting from government support.

Entrenchment: Any public financial institution is likely to enjoy a preferential competitive position and create some vested interests. However, the negative effects can be minimized if the activities of the institution are narrowly focused on the underlying financial market failures. Such narrow focus restricts activities to those that are not performed by markets, alleviating public-private competition. Limiting activities reduces the number of recipients and the vested interests, and helps reform, restructure, or downsize the institution, should that be required in the future. Narrowly-focused institutions are typically more transparent, and, therefore, easier to oversee and govern.

A narrow focus on market failures can therefore be seen as a major precondition for the efficiency of public financial institutions. Optimally, their activities should be undertaken only in response to researched, verified, and tracked marketplace gaps.


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Should the financial supervision of public financial institutions be less or more stringent than that of private ones? On the surface, the answer is ambiguous, as there may be arguments in favor of either looser or more stringent oversight. Arguments for looser oversight are that public financial institutions are nonprofit and, therefore, have lower profit-seeking, risktaking incentives. They also enjoy more stable and longer-term financing sources and have a commitment of government support in the case of financial distress. However, we believe

that the arguments for the need of more stringent oversight are more powerful:


• Public financial institutions are likely to have higher risks. While risk-taking incentives may be lower, risks inherent in the activities seem to be much higher. The housing and agriculture sectors are characterized by high systematic risks. Also, the volatility of the SME sector is typically above economy average. The high risks are amplified by the low diversification and low profitability of the public financial institutions.

• Public financial institutions are likely to have worse managerial incentives. Close government affiliation may create a bureaucratic environment that accommodates low transparency, under-reporting of risks, and concealment of losses. Due to government guarantees, public financial institutions are exposed to limited market discipline.

Lastly, there may be incentives for low-quality, politically driven connected lending.

• The financial distress of public financial institutions may have severe implications, particularly when such institutions are large and have systemic importance. They provide financial services that are missing on the market and their failure may leave target industries (e.g., agriculture) without financing, or even result in an economy-wide credit crunch (as for housing finance). The failures of public financial institutions also carry significant fiscal risks, with high costs of necessary additional taxation.

Keeping these arguments in mind, the supervision of public financial institutions should ideally be at least as stringent as that of private ones.

From the regulatory perspective, public financial institutions have much in common with “too-big-to-fail” (TBTF) banks. Both enjoy implicit or explicit government guarantees that reduce market discipline. The financial distress can lead to systemic instability and large fiscal costs. Lastly, corrective action is problematic—such institutions cannot be easily liquidated or put under external management, recapitalizations are costly, and regulatory intervention may be sensitive in terms of market or political impact. Because characteristics are similar, the supervisory practices for TBTF banks can provide a useful reference. For example, recognizing the difficulty of corrective action for TBTF banks, some regulators adopt so-called “preventive supervision,” where continuous inspection by permanently placed and dedicated on-site teams is designed to reveal and nip in the bud any problems before they become too large and costly to handle.

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In well-functioning systems, government financial institutions are subject to multiple layers of possible stringent administrative oversight and audit. For example in Canada public financial corporations are overseen by the ministries in charge and, through the approval of 23 annual plans, also by other central agencies (including the treasury); they also have their financial statements audited externally by a private-sector auditor and the Auditor General of Canada, and are subject to a special examination conducted by the Auditor General of Canada every five years. Co-financing by the private sector may create incentives for additional scrutiny and impose some market discipline.

In addition to administrative oversight, governments typically exercise control by corporate governance mechanisms. In many of the government-owned institutions studied, the government appoints the CEO and the Board (Table 2, columns 8–9). The Board may consist of public officials, industry representatives, or independent directors (such as CEOs from other industries).

Yet, routine financial supervision may still be helpful and necessary to ensure prudence in such aspects of financial operations as adequate risk management assumptions, or the control of large (and systemically important) exposures with the rest of the financial sector. This is the aspect of oversight that we find lacking in our sample. In contrast to the stringent oversight one might have expected, given the risks and the systemic nature of public financial institutions, the surveyed government-owned financial institutions typically do not have routine external financial supervision. In particular, none of them is fully supervised by the principal financial sector supervisor (Table 2, column 10). Government financial institutions in Japan submit their annual reports to supervisors, but are not subject to the routine inspections regime.

Dedicated and shared supervision

Government-sponsored financial institutions in the U.S. are supervised by dedicated offices, —Office for Federal Housing Oversight for Fannie Mae and Freddie Mac, and Federal Housing Finance Board for Federal Home Loan Banks. Some form of external supervision is considered essential, because in the U.S. the financial institutions are privately owned, and it is the shareholders or cooperative members who exercise corporate governance functions and appoint CEOs and the Boards.

The benefits of dedicated rather than general external supervision of public financial institutions are not clear. Dedicated supervisors may have less experience and resources than mainstream supervisors, and are a likely target for regulatory capture. On the other hand, the supervision of public financial institutions may be viewed as special due to low profitability and un-diversifiable risks typically involved in public financial intermediation. It also likely breeds political conflicts. In such a case, the government may wish to avoid burdening otherwise efficient mainstream financial regulators with problem institutions and choose a separate organizational arrangement instead.

24 The performance of public financial institutions should be assured also for the achievement of entrusted policy aims, which may be best done by the ministry in charge of the relevant industry. This creates a situation in which financial and policy supervision is shared between two separate offices, resulting in a major challenge regarding the distribution of enforcement authority. Inspections may lose effectiveness if the supervisor is unable to enforce necessary corrective action. At the same time, corrective actions may lead to conflicts between financial and policy supervisors, for example, when limits on lending to improve capitalization compromise policy performance. In our sample, Japan represents a case of supervision shared between the financial supervisor and the ministry in charge. While the financial supervisor may review major financial documents, it has limited inspection rights, and can implement corrective action only through the ministry in charge. It is not clear whether such an approach is conducive to financial soundness, or whether a more equal distribution of authority may, in principle, be advised.

C. Capital Requirements

Based on the risk profile with higher and un-diversifiable risks, one would expect public financial institutions to operate under, at least, similar if not more stringent prudential requirements than for private banks. However, we do not observe this in practice (Table 2, column 11). A majority of studied public financial institutions do not have any capital requirements. Some, e.g., in Canada and Germany, voluntarily comply (i.e., operate in a manner consistent) with the major prudential requirements imposed on private banks. Others, such as Fannie Mae, Freddie Mac, and Federal Home Loan Banks in the U.S. have significantly lower capital requirements.

We believe that one can explain this pattern by considering the role of capital in public financial institutions more closely. In private banks, capital has two major roles: reducing shareholders’ risk-taking incentives and providing a cushion in case of financial distress. In public financial institutions, the disciplining function may be redundant, as the owner (government) and managers may have limited risk-taking incentives anyway. As for the insurance function—where a private bank has to draw on its capital to cover possible losses or otherwise go bankrupt—public financial institutions may turn to the government and use its guarantees. Therefore, we interpret our findings on prudential requirements in the studied public financial institutions as the evidence of substitution of capital by government guarantees.

Is such substitution desirable? On the one hand, there may be an economic efficiency rationale for it. When loss events are rare, government may be better off by not investing taxpayers’ money in an idle capital cushion, but rather using its deep liquidity to always cover losses in the case of financial distress ex-post.

25 On the other hand, using guarantees instead of capital may create major accountability challenges. Firstly, fiscal risks need to be properly accounted, but such measurements and contingency planning seem to be commonly lacking in the studied institutions. Secondly, capital requirements impose natural limits on the expansion of an institution’s activities – there can be no lending above the threshold defined by existing capital and capital requirements. Guarantees do not provide such automatic limitation. Instead, they create incentives for expanding operations, in order to capitalize on their option value. Therefore, and given pervasive accountability problems in private financial institutions, it seems advisable to rely on capitalization rather than guarantees as a default solution.

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There are a number of specific challenges in the oversight of public financial institutions, compared to private banks.

• Critically, there may be a within-government conflict of interests between its functions as an owner and a supervisor.

• Preserving financial performance may require a reduction of lending or recapitalizations, which the government may be hesitant to undertake.

• Independence of external supervisors may be compromised by political pressures.

• The lack of market discipline reduces the information content of prices, and deprives regulators of an important source of information.

Independent boards may be one of the mechanisms to alleviate opacity, contribute to independent supervision, and help resolve within-government conflicts of interest. However, while occasionally present (in the U.S.), independent boards are generally lacking in the public financial institutions of our sample. In Canada and Germany, boards commonly include a large proportion of industry representatives, who, although possibly possessing relevant skills, may represent their own vested interests. For example, real estate managers on the board of housing finance corporations are likely to favor the expansion of activities.

Most government financial institutions in Japan have managerial boards with no outside membership. A similar board membership problem applies to developing countries, where, as Marston and Narain (2004) report from a broader sample of public financial institutions, there is commonly no independent representation on the board.

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