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World Bank urges nations to rethink role in finance

Ela Dutt
India Abroad Correspondent in Washington

The World Bank continues its drumbeat on the need for a strong financial services sector.

In a report released on Tuesday, the World Bank maintained that countries where the government owns a large share of the banking sector have lower economic growth and higher poverty than countries where there are fewer government-owned banks.

In what seemed like a direct recommendation to countries like India, the bank said that countries that made the effort to reduce government ownership of banks and allow reputable foreign banks to operate in their financial markets benefit from the resulting competition and increased efficiency and enjoy less financial volatility, higher economic growth, and lower poverty.

At the same time the bank conceded that "privatising state-owned banks and allowing in foreign financial firms can be complicated and mistakes can be costly".

Too often privatised banks quickly collapse and wind up back under the government's management in worse shape than before privatisation, conceded Gerard Caprio, Director of the World Bank's Financial Policy and Strategy Group, and a former US Federal Reserve Board economist, and co-author of the report.

The report, entitled 'Finance for Growth: Policy Choices In A Volatile World', broadly reviews the experiences of countries around the world financial crises, such as those that swept East Asia and other emerging markets in the late 1990s, and current financial sector uncertainties in countries such as Turkey.

"…getting the big financial policy decisions right has thus emerged as one of the central development challenges of the new century," the bank emphasises.

"The rapid evolution of online financial services means that we are moving to a world of finance without frontiers," says Caprio.

"Countries must decide which financial services to buy and which to build at home. Just as all countries need access to airline services, but do not necessarily need their own national airlines, so too is the case with finance. What matters for growth is access to financial services, not who supplies them."

The bank recommends that developing countries go beyond mechanical compliance with international standards to tap market forces so that bank owners, participants in the financial markets, and bank supervisors have incentives to monitor one another and to avoid excessive risk; that they open the financial sector to foreign banks, and sell off state-owned banks, "provided this is done carefully."

Other steps include keeping authorities at arm's length from transactions to reduce the opportunities for conflict of interest and corruption; and removing distortions that lead to too little direct investment, insufficient equity, long-term finance, and lending to small firms and the poor.

"This research demonstrates conclusively something that many of us have believed to be true for a long time, that a sound financial sector is a critical ingredient for poverty-reducing economic growth," says World Bank chief economist Nicholas Stern.

"Some argue that the services in the formal financial sector only benefit the rich. But poor people suffer from the effects of a weak financial sector and from financial crises, even if they don't own shares or have a bank account."

The bank said its research had found no concrete evidence that the entry of foreign banks destabilises the flow of credit or restricts credit access by small firms. Instead, it is associated with significant improvements in the quality of regulation and disclosure.

"Opening the market for financial services, allowing foreign financial institutions to operate in the domestic market, should not be confused with liberalising the capital account, that is, easing restrictions on the movement of money in and out of the country," says Stern.

"Opening the market for financial services can lower risk in the financial system and can often help to pave the way for capital account liberalisation."

The report finds that government ownership of banks continues to be remarkably widespread, despite the evidence that the goals of such ownership, for example, channeling savings to small firms or development priorities, are rarely achieved.

Pointing to Indonesia as an example, the bank says that repeatedly re-capitalising failed banks imposes a heavy price on the financial system and national economy for years to come, diverting resources from education and health sectors.

Small financial systems face special challenges, and even the largest developing country's financial systems are small relative to the size of global financial flows, the report points out.

Of all the developing countries, only China and Brazil constitute one per cent or more of the world's financial system.

"The smaller a country's financial system, the more vulnerable it is to external shocks, unless the financial system is itself securely integrated in the world financial system."

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