A healthy private banking sector needs effective regulation

Private banks can be more efficient than state-owned banks. But in many poor countries government ownership of banks is still widespread as the conditions needed for private banking to thrive are lacking. Rather than subsidising state banks, governments should introduce effective regulation.

A well-functioning financialsystem can contribute to economic growth in poor countries. But many countriesthat have tried to transform their financial systems have suffered bankingcrises and financial instability – especially where reforms have not beenaccompanied by improvements to regulation. Some commentators believe that thecontinued presence of state banks is partly to blame.

Research from the University of Leicester and BrunelUniversity, UK, examines what determines the share of government-ownedbanks in a country’s banking system. As state banks are less efficient – andhave been linked with slow economic growth and financial instability – why dothey still exist? The researchers ask: what determines customer behaviour wherethere is a choice between private and state banks?

The research highlights theproblem of ineffective rules and regulations. Public mistrust of banks is aserious problem in many poor countries. People believe that without adequaterules and regulations in place to protect them, private banks might refuse tohonour their contracts. Where regulation is weak and public mistrust of banksis high, customers will either choose state banks or turn away from the bankingsystem altogether.

The institutions identifiedas most important for increasing public trust in the private banking system include: the overall quality of the regulatory system,strong disclosure requirements, contract enforcement systems and the broaderrule of law.

The research finds that:

• Good institutions are keyto encouraging the growth and development of a private banking system.
• Effective market regulation increases publicconfidence in private sector banking practices.
• Strict disclosure rules prevent rogue privatebanks from entering the market.
• Banking crises cause public mistrust of theprivate banking system.
• Better regulation and improved disclosure lead toa reduction in government ownership of banks.

Poor countries need toestablish effective rules and regulations in order to benefit fromwell-functioning financial systems. But institution-building is a lengthyprocess which can get interrupted by political pressures (opposition toreform).

The implications of theresearch include:

• Governments should build institutions whichencourage the growth of private banking.
• However, state banks can play a useful rolebefore quality institutions are put in place.
• Enhancing market regulation and strengtheningdisclosure rules are particularly effective ways of raising publicconfidence in private banks.
• State banks should not be subsidised orprivatised prematurely before effective regulation is in place.
• More research into the political forces thatsupport or oppose financial system reform would be useful.