Benefits and Costs of Privatization of
State-Owned Banks
Lessons for Development Banks
Lemma W. Senbet
University of Maryland
UN Ad Hoc Expert Group Meeting
“Rethinking the Role of National Development Banks”
New York, December 1-2, 2005
Bank Privatizations
Relevance to Development Banks
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In the wake of extensive financial sector reforms and
financial globalization, development banks are being
increasingly privatized.
While development is still central to the agenda of
development banks, they are, nonetheless, expected to
maintain their financial viability in terms of asset quality,
profitability, and efficiency.
Commercial banks do also foster development. Growing
evidence for positive linkage between banking
development and economic development. Privatization
experiences of these banks relevant to development banks.
Yet, development gap due to financing gap to be bridged
Background

Continuing debate on bank privatizations
– Pro-privatization reformers
– Resisters to privatization; at the extreme even hostile to
privatization of finance altogether

Pro and anti privatization experience of Africa – a
region of highly volatile economics and politics
– Privatization reformist experiments without getting underlying
governance and incentives right (e.g. Nigeria)
– Extreme resisters, even hostile to privatization of finance
altogether (e.g., Ethiopia)

The available evidence is mixed depending on the
developing regions (say Latin America versus Africa)
– Both reformers and resisters are reassured!
Resistance to Bank Privatization
Illustration: Ethiopia


100% government ownership of the Commercial Bank of Ethiopia
(CBE)
Gradual and encouraging entry of private banks
–
–

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But the CBE has a lion’s share of the banking market
Private banks are not only just small but 100% domestically owned
No foreign ownership in the financial sector, including insurance
market; nor is new foreign entry allowed in the financial sector
No stock market
– Hence, no market-based privatizations; no basis for financial cooperation
and integration with other emerging economies in Africa

Thus, no privatization of finance in Ethiopia. Just a command
financial economy!
Conceptual Framework:
Multiple Functions of a Financial System
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The firm as a nexus of contracts (Figure 1)
Mobilization of domestic financial resources
Risk sharing and risk diversification
Information production and price discovery
Promotion of corporate governance
Mobilization of global capital and promotion of
financial globalization
Summing up: Mere existence of banks and stock
markets – value?
The Public Firm: A Network of Contracts
Management
Outside
(New) Equity
holders
Other Stakeholders
(Product and Factor Market)
Firm
Government/
Society
Debt holders
Classes of
Agency
Excessive Perquisites
Underinvestment
Overinvestment
Risk Shifting
Asymmetric Information
Bankruptcy and Financial Distress
Management
Debt holders,
Stakeholders
Government/Society
Debt holders, Government
New Equity holders
Debt holders,
Stakeholders
Potential Benefits of Bank
Privatization

The government (politicians and
bureaucrats) is not a benevolent social
guardian
– State-owned banks can be used for political and
personal gains
Privatization improves bank governance
 Privatization improves bank competition
 Privatization improves bank efficiency and
performance; and fosters stability

Potential Costs of Bank Privatization




Private banks shun underserved markets (e.g.,
rural sectors)
Private banks engage in excessive risk lending and
hence engender banking crisis and instability
Private banks provide insufficient but concentrated
lending if the banking sector is concentrated postprivatization
Borrowers with informational and contractual
difficulties are rationed out by private banks
Bank Privatization and Performance
Available Evidence
There has been sharp decline in the state
ownership of banks, particularly in low
income countries (Cull, et al, World Bank Data)
 The available evidence is primarily on bank
performance and efficiency

– Post-privatization profitability versus pre—
privatization and private banks (Performance)
– Cost reductions (Efficiency)
– Factors affecting performance (e.g.,
governance, regulation, competition)
Government Holdings of Bank Assets
Source: George Clark, Robert
Cull, Mary Shirley (2004)
Available Evidence
(contd)
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Recent studies based on World Bank project
Performance effects of privatizations vary across
countries.
In most cases, performance improved.
Cost efficiency improved less than measures of
profitability (e.g., ROE.)
Performance gains were smaller when
governments retained partial ownership.
Greater gains when bought by strategic investors.
Greater gains with more foreign participation.
Bank Privatization and Performance
African Experience



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Widespread privatization of banks in Sub-Saharan
Africa in the wake of financial sector reforms
Africa experienced the sharpest decline in state
ownership during the 1999-2002 period (see
earlier charts)
Otchere and Senbet, 2005; Based on World Bank
Privatization database and supplemental appendix
to Megginson (2000)
Are they gains from African privatizations? (see
tables)
Gains from African Bank
Privatizations?

Measures of performance looked at:
– Asset quality, profitability, cost efficiency, etc.

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There was deterioration in asset quality.
Profitability worsened post privatization.
No significant improvement in efficiency.
Privatized banks experienced negative abnormal
returns.
Possible factors
– share issue privatizations and partial privatizations
Bank Privatization and Performance
Table 7
Operating performance of Privatized Banks in Africa
This table contains the median operating performance measures for the sample firms the operating performance measures analyzed include Asset quality, Management efficiency, Earnings
ability and Labor (employment levels and labor productivity). The z-statistics for the Wilcoxon signed rank test of the difference in median ratios between the two samples are presented in
Panel C. The median ratios and z-statistics are reported where enough observations exist to compute the z-statistic.
Panel A: Asset Quality Ratios:
Year
Difference
Privatized
Banks
Rivals
Difference
(Priv-Rival)
Privatized
Banks
-1
2.38 (0.89)
0
3.06 (1.34)
0.27 (1.36)
2.79
(1.74)*
-----
1
1.97 (1.89)
1.43 (2.61)***
0.54
(0.80)
5.73 (0.01)
2
3.69 (1.89)*
1.42 (3.60)***
2.27
(1.33)
3
2.00 (2.10)**
0.94 (4.19)***
1.06
4
2.54 (2.10)**
1.31 (4.61)***
1.23
5
1.04 (1.64)*
Pre-mean
2.83 (1.86)
Post-mean
3.05 (2.72)**
Difference (Post-Pre)
-0.22 (0.12)
Panel B: Profitability
----7.33 (1.90)*
-1.6
31.61 (0.89)
6.45 (2.62)***
25.16 (1.06)
(0.80)
6.33
(1.34)
7.29 (3.03)***
-0.96 (0.51)
(0.57)
20.25 (1.34)
7.25 (2.77)***
13.0
(1.27)
1.21 (3.97)***
-0.17 (0.33)
15.26 (0.89)
6.09 (1.70)*
9.18
(1.15)
1.44 (15.10)***
1.61
21.64 (2.40)*
9.34 (6.58)***
12.30 (1.35)
(1.43)
Return on Assets (ROA)
Year
Rival
Privatized Banks
(0.59)
Return on Equity (ROE)
Rivals
Difference
Privatized Banks
Rivals
Difference
-3
3.41 (0.89)
28.19 (0.89)
-2
4.27 (0.89)
27.55 (0.89)
-1
3.53 (1.34)
12.52 (1.34)
0
4.23 (1.33)
1.89 (1.90)*
2.34 (0.30)
16.25 (1.33)
33.25 (1.90)*
17.0
1
3.56 (1.64)*
2.43 (2.10)**
1.13 (0.96)
16.52 (1.64)*
29.24 (2.10)
-12.72 (1.39)
2
1.24 (0.54)
2.05 (3.55)***
-0.81 (0.63)
13.94 (0.54)
21.77 (3.44)***
-7.83
(2.11)**
3
2.22 (0.25)
2.32 (4.07)***
-0.10 (0.60)
12.58 (0.59)
16.86 (3.58)***
-4.28
(0.59)
4
1.49 (0.51)
1.88 (3.77)***
-0.39 (0.33)
15.35 (0.71)
16.19 (4.02)***
-0.84
(0.62)
5
2.22 (1.10)
1.70 (2.05)**
0.52 (1.19)
21.97 (0.93)
15.89 (1.83)*
6.08 (1.00)
Pre-Mean
3.23 (2.36)
Post-Mean
2.55 (1.62)
1.84 (5.40)***
0.41 (0.69)
10.60 (2.80)***
-0.15 (0.17)
Difference
0.68 (0.22)
(1.19)
21.47 (1.84)
10.45 (1.23)
11.02 (0.63)
Bank Privatization and Performance: Africa (Senbet and Otchere, 2005)
Operating performance of Privatized Banks in Africa
This table contains the median operating performance measures for the sample firms the operating performance measures analyzed include Asset quality, Management efficiency, Earnings
ability and Labor (employment levels and labor productivity). The z-statistics for the Wilcoxon signed rank test of the difference in median ratios between the two samples are presented in
Panel C. The median ratios and z-statistics are reported where enough observations exist to compute the z-statistic.
Panel A: Asset Quality Ratios:
Year
Difference
Privatized
Banks
Rivals
Difference
(Priv-Rival)
Privatized
Banks
-1
2.38 (0.89)
0
3.06 (1.34)
0.27 (1.36)
2.79
(1.74)*
-----
1
1.97 (1.89)
1.43 (2.61)***
0.54
(0.80)
5.73 (0.01)
2
3.69 (1.89)*
1.42 (3.60)***
2.27
(1.33)
3
2.00 (2.10)**
0.94 (4.19)***
1.06
4
2.54 (2.10)**
1.31 (4.61)***
1.23
5
1.04 (1.64)*
Pre-mean
2.83 (1.86)
Post-mean
3.05 (2.72)**
Difference (Post-Pre)
-0.22 (0.12)
Panel B: Profitability
----7.33 (1.90)*
-1.6
31.61 (0.89)
6.45 (2.62)***
25.16 (1.06)
(0.80)
6.33
(1.34)
7.29 (3.03)***
-0.96 (0.51)
(0.57)
20.25 (1.34)
7.25 (2.77)***
13.0
(1.27)
1.21 (3.97)***
-0.17 (0.33)
15.26 (0.89)
6.09 (1.70)*
9.18
(1.15)
1.44 (15.10)***
1.61
21.64 (2.40)*
9.34 (6.58)***
12.30 (1.35)
(1.43)
Return on Assets (ROA)
Year
Rival
Privatized Banks
(0.59)
Return on Equity (ROE)
Rivals
Difference
Privatized Banks
Rivals
Difference
-3
3.41 (0.89)
28.19 (0.89)
-2
4.27 (0.89)
27.55 (0.89)
-1
3.53 (1.34)
12.52 (1.34)
0
4.23 (1.33)
1.89 (1.90)*
2.34 (0.30)
16.25 (1.33)
33.25 (1.90)*
17.0
1
3.56 (1.64)*
2.43 (2.10)**
1.13 (0.96)
16.52 (1.64)*
29.24 (2.10)
-12.72 (1.39)
2
1.24 (0.54)
2.05 (3.55)***
-0.81 (0.63)
13.94 (0.54)
21.77 (3.44)***
-7.83
(2.11)**
3
2.22 (0.25)
2.32 (4.07)***
-0.10 (0.60)
12.58 (0.59)
16.86 (3.58)***
-4.28
(0.59)
4
1.49 (0.51)
1.88 (3.77)***
-0.39 (0.33)
15.35 (0.71)
16.19 (4.02)***
-0.84
(0.62)
5
2.22 (1.10)
1.70 (2.05)**
0.52 (1.19)
21.97 (0.93)
15.89 (1.83)*
6.08 (1.00)
Pre-Mean
3.23 (2.36)
Post-Mean
2.55 (1.62)
1.84 (5.40)***
0.41 (0.69)
10.60 (2.80)***
-0.15 (0.17)
Difference
0.68 (0.22)
(1.19)
21.47 (1.84)
10.45 (1.23)
11.02 (0.63)
Panel C: Efficiency
Year
Privatized Banks
Rivals
Difference (Priv-Rival)
Privatized Banks
Rival
Difference
-1
80.85 (0.89)
73.92 (1.66)*
6.93
(0.69)
3.10
(0.89)
0
70.03 (1.64)*
65.66 (1.90)*
4.73
(0.12)
12.36 (1.34)
4.40
(1.66)*
7.96
(1.95)*
1
73.17 (1.65)*
66.20 (2.61)***
6.97
(0.08)
7.09
3.20
(1.90)*
3.89
(0.01)
2
83.04 (1.89)*
68.54 (3.60)***
14.5 (1.18)
2.67 (1.88)**
7.05 (2.61)***
-4.38 (0.27)
3
81.03 (2.10)**
71.85 (4.19)***
9.18 (1.48)
3.52 (1.89)*
3.20 (3.60)***
0.32 (0.55)
4
85.04 (2.09)**
72.08 (4.36)***
12.96 (1.98)**
2.32 (2.10)**
4.10 (4.27)***
-1.78 (2.10)
5
70.55 (1.65)*
73.46 (3.81)***
-2.91 (0.61)
3.10 (1.64)*
3.03 (3.71)***
0.07 (0.43)
Pre-mean
80.35 (5.63)
75.64 (8.85)***
4.71 (0.30)
3.10 (1.56)
Post-mean
80.61 (20.39)***
83.65 (13.87)***
-2.91 (0.24)
4.10 (5.81)***
5.08 (11.53)***
-0.90 (1.01)
Difference (Post-Pre)
-0.26 (0.03)
-8.01 (0.47)
(1.34)
-1.00 (0.62)
Panel D: Changes in Employment
Year
Privatized Banks
Rivals
Difference
1
-1.21 (0.01)
0.12 (0.01)
-1.33 (0.61)
2
0.70 (0.01)
2.66 (1.94)*
-1.96 (1.03)
3
-1.22 (0.27)
2.66 (2.87)***
-3.88 (1.21)
4
1.54 (0.51)
0.87 (1.95)*
-0.67 (0.59)
5
-2.06 (1.01)
1.10 (3.39)***
0.316 (0.38)
Post-Mean
-4.67 (1.00)
1.33 (2.69)**
-6.00 (3.14)***
Difference (Post-Pre)
(1.35)
Results:: Asset Quality ratios:Loan loss provision has increased in the post privatization period. The privatized firms’ loan loss provision of 3.05 is significantly different from that of rival banks at 1%.
Impaired assets of the privatized banks have also worsened in the post privatization period.
Profitability
ROA: Profitability has reduced in the post privatization period, even so the privatized banks are more profitable than rivals albeit the difference is not statistically significant.
ROE of the privatized banks have also fallen. This could be due to the increase in equity following the privatization and the issue of more equity.
Efficiency
No perceptible change in the efficiency of the privatized firms vis-à-vis the rivals.
Changes in staff levels:
The privatized firms have significantly reduced their staff levels. The change in staff levels of -4.67% is significantly different from that of the rivals of 1.33% at the 1% level.
Overall observation:
Consistent with Otchere (2004) the privatized firms have not significantly improved upon their operating performance.
Challenges to African Bank
Privatizations
Volatile economic and political environment
Quality of data
Measurement issues (e.g., benchmarking)
 Limited measures of privatization gains
(private gains versus social gains)
– Bank profitability (ROE, ROA, NPL)
– Cost efficiency
Gains from Bank Privatizations?
Incomplete!

Performance and cost efficiency effects are
incomplete in terms of judging the overall gains of
bank privatizations (Private vs. social gains)
– Lending to government vs. private sector
– Non-intermediation (lending to government and nonbanking activities) dominates in terms of performance
– Rent-seeking and dysfunctional banking system
 Thus, apparently positive performance is a reflection
of malfunctioning banking system and rent-seeking
behavior
Toward Complete Gains from Bank
Privatizations
 Improvements in quality of financial intermediation (notice
exorbitant bank spreads in Africa)
 Improvements in in capacity to manage and control risk
 Improvements in bank governance
– Management, compensation structure, ownership, board
effectiveness

Bank privatization and stock market development
– Market depth and liquidity; Pricing efficiency; Risk management

Quality of bank regulation
– (Cull, Sorge, Senbet, JMCB, 2005)
Conclusions
Lessons for Development Banks

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Development banks should play a role in creating
an environment for gains from bank privatizations;
gains from bank privatizations are linked to
economic development
Thus, an indirect role of development banks in
economic development through the development
of traditional financial institutions
Strengthening institutions: bankruptcy code,
contract enforcement, rule of law, etc.
For share issue privatizations: get corporate
governance right; concentrated ownership, yet
protection of minority shareholders
Conclusions
Lessons for Development Banks

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Development banks should play a role in the
development of benchmark bond markets as well
as stock markets – e.g., regional integration of thin
local markets – regional stock markets
Human capital and financial manpower
development; also, regional synergy in skills
development
Ultimately helping establish an appropriate
platform for the development banks themselves to
be privatized
Separating the development agenda from
ownership structure; development banks need not
be owned by governments