bank privatization in developing countries 4

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Bank privatization in developing countries:A summary of lessons and findings

George R.G. Clarke a,*, Robert Cull a, Mary M. Shirley b

a Development Research Group, The World Bank, MSN MC3-300, 1818 H Street NW,

Washington, DC 20433, United Statesb Ronald Coase Institute, 5610 Wisconsin Avenue, #1602, Chevy Chase, MD 20815, United States

Available online 25 March 2005

Abstract

Although a large and growing literature shows that privatization can improve the performance

of non-financial enterprises, there is less evidence on how it affects the performance of the bankingsector. This paper summarizes the results from the papers in the special issue of the Journal ofBanking and Finance on bank privatization. It concludes that although bank privatization usuallyimproves bank efficiency, gains are greater when the government fully relinquishes control, whenbanks are privatized to strategic investors, when foreign banks are allowed to participate in theprivatization process and when the government does not restrict competition. 2005 Elsevier B.V. All rights reserved.

JEL classification: G21; D21

Keywords: Bank privatization; Foreign entry

1. Introduction

Although state-owned banks dominate the banking sectors of few developedeconomies, they play an important role in many developing countries. In 1999, gov-ernment controlled banks held more than 30% of banking sector assets in a quarter

0378-4266/$ - see front matter 2005 Elsevier B.V. All rights reserved.doi:10.1016/j.jbankfin.2005.03.006

* Corresponding author. Tel.: +1 202 473 7454; fax: +1 202 522 1155.E-mail address: [email protected] (G.R.G. Clarke).

Journal of Banking & Finance 29 (2005) 19051930

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of the developing countries for which we have information. In comparison, this wastrue for only two of the 20 developed countries for which data were available (Barthet al., 2001a).

The continued importance of state-owned banks in developing countries is worry-ing given the large, and growing, literature that finds that state ownership hurtsenterprise performance, especially in competitive sectors. Although privatized enter-prises are often less efficient than new private entrants, there is considerable evidencethat they outperform state-owned enterprises. This suggests that privatizing state-owned banks might improve bank efficiency and boost financial sector performance.

The papers in this symposium present new evidence on bank privatization. Muchcomes from a series of country case studies that are based on detailed panel datasetsfor many and in some cases all banks in each country. These data enable theauthors to measure performance gains or losses following privatization and to com-

pare these changes with trends for other banks in the country. The case studies coverfive individual countries (Argentina, Brazil, Mexico, Nigeria, and Pakistan) and tworegions containing eleven more countries (Eastern Europe: Bulgaria, Croatia, theCzech Republic, Hungary, Poland, and Romania; East Asia: Indonesia, Korea,Malaysia, Philippines, Thailand), chosen because they had high state ownership be-fore privatization and because they privatized many banks. The evidence from thecase studies is reinforced by several cross-country studies, which take a broader lookat similar issues.

One of the lessons from these studies is that privatization often although not al-ways improves bank performance. The studies also suggest things that affect thesuccess of reform: whether the government continues to hold shares in the bank fol-lowing privatization; whether the bank is sold to a strategic investor or shares aredispersed widely through a share-issue privatization; whether the government per-mits foreign investors to participate in the privatization process; and what stepsthe government takes to encourage or discourage competition.

Although many governments in developing countries have privatized state ownedbanks, some have resisted, others have renationalized previously privatized banks,and many have privatized using approaches that failed to yield the full gains fromprivatization. To understand why they did this, it is important to understand how

politics affects privatization decisions. The papers in this symposium also identifypolitical factors that have affected the design and timing of bank privatization anddiscuss how this has affected its success.

2. Effect of privatization on firm performance: Non-financial enterprises

A large theoretical and empirical literature, summarized in Shirley and Walsh(2000), looks at how government ownership and privatization affect enterprise per-formance. Arguments in favor of government ownership often assume that govern-

ments are well or even perfectly informed and that they try to maximize socialwelfare. If this was true, government ownership might be an easy and cheap wayfor governments to correct market failures (Sappington and Stiglitz, 1987), tackle

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natural monopolies (Millward, 1982), reduce inequality, and meet other social goals(Willner, 1996). Governments could use state owned banks to raise capital for pro-jects with high social, but low private, returns and provide finance to poor borrowers

that are neglected by less well informed or motivated private bankers.Public choice theories of government challenge the idea of a benevolent all-know-

ing government, suggesting that politicians and bureaucrats might instead use stateownership to secure political office, accumulate power, or seek rents.1 If politiciansdo this, they might be especially likely to do so in weak institutional environments,where voters have less information and are less able to monitor enterprise perfor-mance in other words, in developing countries. Empirical evidence that state-owned enterprises have been used to finance politically motivated projects and, thatthey hire too many employees and open too many offices support the public choicetheory of government (Donahue, 1989; Jones, 1985; Kikeri et al., 1992; Li and Xu,

2004; World Bank, 1995).There are three main reasons why public enterprises might perform less well than

private, and privatized, enterprises: political intervention, corporate governanceproblems, and problems associated with competition (Shirley and Walsh, 2000).The first problem is that politicians and bureaucrats can use state-owned enterprisesto further their political or personal goals. Although politicians can also encourageprivate firms to subsidize their constituents, private owners might be better moti-vated and more able to oppose such interventions than public bureaucrats (Galal,1991; Shirley and Nellis, 1991; Shleifer and Vishny, 1994; World Bank, 1995). Forexample, the profit-oriented owner of a private bank, especially if foreign, mightbe more motivated to protect the banks prudential lending policies or costs minimi-zation rules from government intervention than a public manager would be.

Privatization could also prevent state-owned enterprise employees and otherinterest groups from either capturing the government body charged with monitor-ing the state enterprise (Borcherding et al., 1977; Borcherding et al., 1982) or bribingcorrupt politicians to protect their interests (Shleifer and Vishny, 1994). Althoughcapture or corruption can occur with private ownership, the direct ownership linkraises the likelihood. Empirical observation supports the argument that state-ownedenterprises are more subject to intervention (Claessens and Peters, 1997; Djankov,

1999; Shirley and Nellis, 1991; World Bank, 1995).The second reason why public enterprises might perform worse than privateenterprises is that corporate governance might be weaker in state-owned enterprisesthan in private firms because of agency problems. State-owned enterprises havemany objectives and many principals who have no clear responsibility for monitor-ing (Alchian, 1965). Large private corporations also have many small shareholders,information asymmetries between owners and managers, and problems defininggoals and holding management accountable. Yet even private firms with highly dif-fuse ownership will be better governed than state-owned enterprises according tothese studies. Alchian (1965) argues that because all citizens of a country jointly

1 See, for example, Buchanan (1969), Niskanen (1971, 1975).

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own the state-owned enterprise, its ownership is more widely distributed than a pri-vate firms ever could be. Also, because individual citizens cannot sell their shares ina state-owned enterprise, they gain less from monitoring performance. Without a

market for ownership, information on firm performance will be scarce and non-com-parable (Lin et al., 1998; Vickers and Yarrow, 1989). In an opposing view, Yarrow(1986) argues that the government is the sole, concentrated owner of the state-ownedenterprise. Without the checking influence of smaller owners, politicians and bureau-crats are able to use state ownership to pursue inefficient goals (Vickers and Yarrow,1989; Vining and Boardman, 1992).

In addition to being less well monitored, public enterprises have other corporategovernance-related problems. Because public managers do not face a market fortheir skills or a credible threat of losing their job for non-performance and are lesslikely to receive performance related pay, they are less motivated than private man-

agers would be.2 Poorly performing state-owned enterprises are also less likely to be-come bankrupt, be liquidated or taken over in hostile takeover, further weakeningmanagerial incentives (Berglof and Roland, 1998; Dewatripont and Maskin, 1995;Schmidt, 1996; Sheshinski and Lopez-Calva, 2003; Vickers and Yarrow, 1989; Vick-ers and Yarrow, 1991).

The final reason why state-owned enterprises might perform worse than privateenterprises is that they might face less competition than private firms. As discussedabove, self-interested politicians might use state-owned enterprises to providepatronage jobs or subsidies to favored constituents (Jones, 1985; Shapiro and Willig,1990; Vickers and Yarrow, 1991). If they do this, state-owned enterprises will be un-able to compete in competitive markets and will therefore need subsidies or govern-ment guaranteed debt to cover their losses. To reduce the need for subsidies,politicians and bureaucrats might then protect the state-owned enterprises fromcompetition, by making entry more difficult and restricting trade, with a negative im-pact on efficiency (Boycko et al., 1996; Shleifer and Vishny, 1994).

Even if politicians do not give the state-owned enterprise monopoly power, stateownership can undermine competition in other ways. Subsidized state-owned enter-prises can undercut private rivals that need to be profitable to survive ( Sappingtonand Sidak, 2003). For example, a state-owned bank might have more branches,

higher deposit rates and lower lending rates than its rivals because it can cover itslosses through government subsidies. Rather than using restrictions on competitionto reduce the need for subsidies, the subsidies undermine market competition.

The empirical evidence supports both views of competition. In some cases govern-ments protect state-owned enterprises by giving them market power and in othersthey undermine competition by giving subsidies (Jones, 1985; Kikeri et al., 1992;World Bank, 1995).

Greater political intervention, weaker corporate governance and less competitionare strong arguments against state ownership. But it does not always follow that

2 Even when managers of state-owned firms are given performance related contracts, Shirley and Xu(1998) note that it is difficult to find third parties to enforce these contracts, especially in weak institutionalenvironments.



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privatization will cure these ills. The same government officials responsible for thepoor performance of state-owned enterprises are responsible for designing and exe-cuting privatization programs. Political objectives, poor information, and principal

agent problems compromise the privatized firm and might keep it from performingas well as a de novo private enterprise would.

Does this mean that a privatized firm will perform better, the same or worse thanit would under state ownership? Many critics of privatization note that privatizedfirms do not mimic private firms perfectly (Stiglitz, 2000a,b; Cook and Kirkpatrick,1988; Caves, 1990; Kay and Thompson, 1986). Some authors go so far as to arguethat if the root cause of poor state-owned enterprise performance was an institu-tional environment that hampered voters from holding politicians accountable, thenprivatization will be as prone to error as state-owned enterprise management (Stig-litz, 2000a,b). Others believe that underdeveloped capital markets, weak court sys-

tems, and inadequate procedures for bankruptcy or takeover will preventprivatized firms from performing efficiently, especially in developing countries wherethese market and institutional failures are common (Adam et al., 1992; Caves, 1990;Commander and Killick, 1988; Cook and Kirkpatrick, 1988, 1997; Stiglitz, 2000a).

But these criticisms are misguided if privatized firms outperform state-ownedenterprises. The empirical evidence suggests that, while privatized firms might notbe as efficient as private firms, they are usually more efficient than state-owned enter-prises (see studies reviewed in Boardman and Vining, 2004; Borcherding et al., 1982;DSouza and Megginson, 1999; Megginson and Netter, 2001; Millward and Parker,1983). The most important exceptions are firms sold to incumbent managers andemployees in the former Soviet Union, especially Russia, in the early 1990s. Thismight not be surprising; when these firms were sold to managers and workers, thisprevented needed restructuring and limited capital infusions (Barberis et al., 1996;Claessens and Djankov, 1999; Dyck, 2001; Earle et al., 1995; Frydman et al.,1999; Havrylyshyn and McGettigan, 2000; Kane, 1999; Nellis, 2000). When majorityshareholdings were sold to outsiders in the former Soviet Union, performance alsoimproved there (Black et al., 2000; Bornstein, 1994; Earle, 1998; Earle and Estrin,2003). In summary, the evidence suggests that privatization usually improves effi-ciency (Megginson and Netter, 2001).

3. The impact of bank privatization

Although few studies deal explicitly with bank privatization, the privatization liter-ature provides good reason to expect that bank privatization will be beneficial. Thequestion is whether, and under what circumstances, privatization will improve bankperformance. The papers in this symposium, many of which were financed by the Re-search Department at the World Bank, provide new evidence on this importantsubject.3

3 Megginson (this issue) summarizes the existing literature on bank privatization in greater detail.



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The studies allow us to explore five questions: how privatization affects bank per-formance on average; whether benefits are smaller when the government retainssome ownership in the privatized bank; whether the method of privatization (i.e., di-

rect sale or share-issue privatization) affects outcomes; whether outcomes are betterwhen foreign owned banks are allowed to purchase privatized banks; and what theinteraction is between privatization and competition.

In many cases, these questions overlap. For example, governments that intend tointervene in bank operations after privatization might be more likely to hold ontosome shares and be less willing to sell foreign strategic investors. Competent strategicinvestors might also be wary when the government continues to hold onto shares,forcing governments to privatize through share-issue privatizations in these cases.So share-issue privatizations may be the preferred sales tactic of governments wish-ing to loot. Governments that wish to divert bank funds will also prefer to limit com-

petition and may confer oligopolistic powers on political cronies.

3.1. The impact on bank performance

The privatization literature suggests that privatized banks should outperform sim-ilar state-owned banks. But the success of privatization will depend on how success-fully privatization resolves the corporate governance problems associated withpublic and private ownership and the effect that privatization has on competition.In this section, we propose several hypotheses and consider the empirical evidencefrom the studies in this symposium that support or refute them.

Hypothesis 1: Bank performance will improve after privatization.

Theory suggests that privatization improves performance by limiting harmfulgovernment intervention in state-owned enterprises. In non-financial enterprises,politicians and bureaucrats often provide jobs or subsidized goods or services topolitical constituents. Banks, however, provide greater opportunities for politicalintervention. Besides providing interest rate subsidies and jobs, politicians can alsoloot banks and divert deposits. Because banks move money, politicians can use them

to subsidize supporters in more ways than they can use non-financial enterprises andthese interventions will often be harder to detect.Despite variations across countries and across privatized banks in the same coun-

try, the studies in this symposium suggest that bank performance improved afterprivatization in most cases (see Tables 1 and 2). The results from the case studiesare supported by cross-country evidence. Using data from 81 privatizations in 22low- and middle-income countries, Boubakri et al. (this issue) find that several,but not all, performance measures improved after privatization. But the results werenot uniform; performance improved more in some countries than in others and onecross-country study of share-issue privatizations found few gains from privatization

(Otchere, this issue).The detailed information in the case studies allows us to analyze the role of envi-

ronmental factors. For example, the improvements observed during the second round



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of privatization in Nigeria suggests that privatization can improve bank performanceeven in an inhospitable macroeconomic and regulatory environment and even whenthe government sells the weakest banks (see Beck, Cull and Jerome, this issue). But

this episode also shows how an adverse macroeconomic and regulatory environmentreduces the benefits of privatization: the performance of privatized banks improved inthe first year after privatization but did not improve after that. Further, privatizationdid not stimulate performance improvements among non-privatized banks and banksthat focused on retail lending performed worse than banks that invested in govern-ment bonds and engaged in other non-lending activities.

Although some performance measures improved, not all measures improved in allstudies. Measures of costs and cost efficiency improved less often than measures ofprofitability and profit efficiency. For example, although profit efficiency and loanportfolio quality improved in Argentina after privatization, cost efficiency did not

improve (see Berger et al., this issue). One reason for this is that the privatizationcontracts in Argentina imposed restrictions on firing and branch closing, preventingthe new owners from lowering their costs.

The studies also emphasize the importance of looking at the impact of privatiza-tion several years after the initial event. Some changes, such as improving portfolioquality, introducing information technology, or rationalizing a branch network,could take several years to implement. Further, restructuring can be costly and, there-fore, might lead to a temporary increase in costs or reduction in profits. Several of thestudies found results consistent with this idea. Bonin, Hasan and Wachtel (this issue)find that banks in Eastern Europe that were privatized earlier were more efficient thanbanks that were privatized later. Similarly, Boubakri et al. (this issue) find thatalthough credit risk and economic efficiency improved over time in their cross-coun-try sample, the benefits were not immediate.

Another reason to focus on the long term impact of privatization is that someapparent benefits might decline over time. For example, in Argentina, large partsof the public provincial banks loan portfolios were transferred out of the banksportfolios at the time of privatization, leading to an large improvement in portfolioquality at the time of privatization (Berger et al., this issue). In this case, althoughportfolio quality declined slightly over time, the decline was small relative to the

large improvement suggesting the potential for long term gains.Only one case study, Argentina, looked at whether the privatized banks changedtheir lending strategies after privatization. Privatized banks in Argentina cut totallending and lending in local currency, signaling greater prudence. Immediately afterprivatization, mortgage lending and agricultural lending also fell, although lendingto these sectors grew in later years. The quality of lending to these sectors improvedafter privatization, probably because screening improved.

Hypothesis 2: Performance gains will be smaller when the government retains sharesin the privatized bank.

As with non-financial enterprises, we expect that performance will improve lessafter privatization when the government retains partial ownership of the privatized



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Table 1Effect of privatization on the performance of privatized banks in papers in symposium

Country case studies Improved No change/mixed

Argentina Profit efficiency, return on equity,non-performing loans

Cost/assets, cost effic

Brazila Return on equity, return on assets,costs/assets, total factor productivity

Czech Republic (voucher privatization) Profit efficiency, costEast Asia (Indonesia, Korea, Malaysia,

Philippines, Thailand)Profit efficiency Cost efficiency

Eastern Europe (Bulgaria, Czech Republic,Croatia, Hungary, Poland and Romania)b

Profit efficiency, return on assets, cost ratioc

Net interest margin,cost efficiency

Mexico (first privatization)d Mexico (second privatization)e Costs/assets Interest margin

Nigeria Return on assets, return on equity,non-performing loans

Overhead costs, costprofit efficiency

Pakistan Profit efficiency Cost efficiencyCross-countryBoubakri et al. (this issue)f Net interest margins, non-performing

loans, capital adequacyReturn on equity

Otchere (this issue) Provisions to loansg Impaired assets to loreturn on assets, net


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Note: Improved means (statistically significant) improvements observed in main model specification. No change/mchanges or mixed results (i.e., some negative and some positive results depending on model specifications or varia(statistically significant) deteriorations in performance. In some papers, statistical significance of performance measurIn these cases, we generally rely upon the authors description of results or authors preferred model specification.Source: Berger et al. (this issue); Beck, Crivelli, and Summerhill (this issue); Beck, Cull and Jerome (this issue); Bon

Bonin, Hasan and Wachtel (this issue); Boubakri et al. (this issue); Haber (this issue); Nakane and Weintraub (this isNguyen (this issue).a Cost efficiency improved only for banks that were privatized by the state governments and return on equity improv

after being taken over by the federal government.b Study includes results for several other measures of bank performance. The measures summarized in the table are

from other studies.c Profit efficiency improved only for banks with a strategic foreign investor. Profit and cost efficiency results are

privatized banks. Other measures are based upon comparisons of pre- and post-privatization performance.d Banking crisis occurred with most banks being intervened, aggregate performance measures (e.g., non-performine Several aggregate measures of banking sector performance improved including capital/asset ratios, non-performif The effects reported are three years after privatization. These effects are modified if the method of privatization

accounted for. The largest impact of those factors is felt on net interest margin, risk and capital adequacy. See Boubg

Although provisions to loans fell for privatized banks after privatization, it remained higher than for always privh Paper includes additional measures that also showed no improvement. The measures summarized in the table arefrom other studies.


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bank. Because banks manage other peoples money, continued state-ownership willallow politicians to continue to loot and will therefore have an unambiguously neg-

ative impact on bank performance.As expected, privatization produced modest benefits when governments retainedmajority control or even sizable minority stakes in the privatized banks (see Table 2).For example, the first rounds of privatization in the Czech Republic and Poland,when the governments maintained large ownership stakes, were less successful thanthe second rounds, when the governments divested most or all their shares (Boninand Wachtel, 2000, 2003).

In the first round of privatization in Poland, the Treasury retained a 30% stake,employees purchased up to 20% of the shares on preferential terms, and theremaining shares were divided between branches for large and small investors.

The performance of the privatized banks improved a little, but the subsequentdivestiture of all government shares led to more obvious gains (Bonin and Wach-tel, 2000, 2003).

Table 2Bank performance after privatization in country case studies, by extent of government ownership

In cases in which the government kept NO SHARES of stock in the banks

Two showed notable improvementArgentina (direct sale to strategic investor)Brazil, privatization (direct sale to strategic investor)

Five showed some improvementCzech Republic, second phase of privatization (direct sale to strategic investor)Hungary (direct sale to strategic investor)Poland, second phase of privatization (direct sale to strategic investor)Mexico, second phase of privatization (direct sale to strategic investor)Nigeria, second phase, full divestitures (share offering, foreign ownership not permitted)

Only one showed no improvementMexico, first phase of privatization (direct sale, foreign ownership not permitted)

In cases in which the government kept a MINORITY SHARE of stock in the banksOne showed notable improvementPakistan (direct sale to strategic investor)

None showed some improvementOne showed no improvement

Nigeria, first phase of privatization, maintained minority shareholding

In cases in which the government kept a MAJORITY SHARE of stock in the banks

None showed notable improvementOne showed some improvement

Poland, first privatization (share offering, foreign ownership permitted)Two showed no improvement

Brazil, restructuringCzech Republic, first privatization (share offering, foreign ownership not permitted)

Note: Evidence from case-studies was supplemented with additional information based upon discussionswith authors of case studies.Source: Bauhmol-Weintraub and Nakane (this issue); Beck, Crivelli, and Summerhill (this issue); Beck,Cull and Jerome (this issue); Berger et al. (this issue); Bonaccorsi di Patti and Hardy (this issue); Bonin andWachtel (2000, 2003); Bonin, Hasan and Wachtel (this issue); Haber (this issue).



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In the first round of privatization in the Czech Republic, the Czech governmentdistributed vouchers, with most invested in funds that were often created by banks.These investment funds gained large stakes in financial and non-financial firms,

resulting in interlocking ownership between the banks and their clients. The statealso retained shares and therefore a substantial influence over the banks operations.Not surprisingly, neither cost nor profit efficiency improved for these banks (Bonin,Hasan and Wachtel, this issue). The banks continued soft-lending to many of theirlarge voucher-privatized clients resulted in bank performance deteriorating; govern-ment bail-outs were needed before foreign investors could be attracted in the secondround (Cull et al., 2002). Bank performance improved after the second round (seeTable 2).

The experience in Brazil and Nigeria lead to a similar conclusion: continued gov-ernment ownership is associated with weaker bank performance. State governments

in some Brazilian states sold their state-owned banks to strategic investors, whileothers retained control as they tried to restructure their banks. Performance im-proved in the fully privatized banks, but remained unchanged or deteriorated inthe restructured banks (Beck, Crivelli, and Summerhill, this issue; Nakane and Wein-traub, this issue).

The Nigerian government maintained a minority interest in some of its privatizedbanks. There was some improvement in profitability and portfolio quality in thosebanks where the government fully divested its shareholdings, but not in the bankswhere the government retained minority shareholdings (Beck, Cull, and Jerome, thisissue). In fact, the banks with continued minority ownership performed nearly aspoorly as the state-controlled banks for some measures of profitability. In short,the experience in Nigeria highlights the negative performance effect of even minoritygovernment ownership, while the experience in Brazil offers reasons to be skeptical ofstate restructuring of government-controlled banks.4

The cross-country analyses in this symposium also support this hypothesis. Using asample of 21 share-issue privatizations from nine developing countries (Croatia,Egypt, Hungary, India, Jamaica, Kenya, Morocco, the Philippines, and Poland), Otc-here (this issue) finds that the shares of the privatized banks under-performed the mar-ket and there were only modest improvement in the banks operating performance.

The share of ownership retained by the government appears to explain a substantialpart of the under-performance. Although, as noted above, Boubakri et al. (this issue)found some performance improvements in the 81 banks in their sample after privati-zation, profitability did not improve and interest rate risk actually deteriorated. Manybanks in their sample were only partly privatized however only one-quarter of thebanks in the sample were fully privatized and, on average, the government retainedover one-quarter of bank shares after even three years after privatization.

Although performance usually improved after privatization, privatized banks donot always appear to perform as well as new private entrants. Bonin, Hasan and

4 One might be worried that selection effects are driving these results. However, the pre-privatizationperformance of those banks where the government fully relinquished its shareholdings was worse than thatof the restructured banks in Brazil and the minority government owned banks in Nigeria.



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Wachtel (this issue) found that foreign greenfield banks were the most efficient banksin the six countries in Eastern Europe in their sample. In Pakistan (Bonaccorsi diPatti and Hardy, this issue), when the Pakistani government started the privatization

process, it also liberalized entry restrictions, allowing new private banks to enter.These private banks outperformed the privatized banks in the period followingprivatization.5

Hypothesis 3: Sales to strategic investors, which result in concentrated ownership,will lead to greater performance gains, than share-issue privatizations,which result in dispersed ownership.

The third hypothesis is that performance improvements will be greater when astrategic owner takes control of a privatized bank than when shares are sold to many

small investors in a share-issue privatization. In studies of transition economies, per-formance improvements in privatized non-financial firms have been greater whenownership has been concentrated in the hands of a strategic investor (Frydmanet al., 1998; Nikitin and Weiss, 1998). Drawing on the corporate governance litera-ture, which argues that managers will try to serve their own interests at the expenseof profitability and owner welfare, they argue that concentrated strategic owners arebetter able to control managers.6 Although information asymmetries always givemanagers some leeway when negotiating contracts, they will be more pronouncedwhen ownership is dispersed:7 small individual owners have an incentive to free rideoff the costly monitoring efforts of others, resulting in a less monitoring.8 Suchagency problems are more likely in weak institutional settings where informationis poor and safeguards for minority shareholders are weak or non-existent.

The case studies covered in this symposium support this hypothesis. The perfor-mance of most banks privatized through share-issue privatizations did not improveafter privatization, while the performance of banks privatized through sales to stra-tegic investors did (see Table 2). The only case where sales to strategic investors didnot result in performance gains was the first privatization in Mexico, an episode thatis discussed in greater detail in the next section of the paper. In contrast, share-issueprivatization resulted in even modest performance gains in only a few cases: perfor-

mance improved slightly after share-issue privatizations in Nigeria in which the gov-ernment divested its entire shareholding and in the first round in Poland. A similarconclusion can be drawn from the cross-country analysis in Otchere (this issue),

5 The performance of the new entrants, however, declined after a second round of liberalization.6 See Berle and Means (1932), Jensen and Meckling (1976), Fama and Jensen (1983), Vickers and

Yarrow (1989), Stiglitz (1993), Shleifer and Vishny (2000), Lin et al. (1998), Kane (1999), Dyck (2001), andShleifer et al. (1999).7 See Hart (1983), Willig (1985), Yarrow (1986), Vickers and Yarrow (1989), Stiglitz (1993), and Kane

(1999).8 See Furubotn and Pejovich (1972), Yarrow (1986), Vickers and Yarrow (1989, 1991), Shleifer and

Vishny (2000), Dyck (2001); and Kane (1999).



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which shows few performance gains in banks sold through share-issue privatiza-tions.9 The strong association between share-issue privatization and large residualgovernment ownership suggests that governments use share-issue privatization to en-

sure that private owners do not gain full control over the privatized bank.One notable exception to this pattern is a share-issue privatization in Australia

(Otchere and Chan, 2003). The Commonwealth Bank of Australia outperformed acontrol group of private banks on several financial ratios and on share price afterit was privatized. This suggests that share-issue privatizations can successfully spurperformance improvements, but only when the stock market and the associated mar-ket monitoring by informed investors are well developed.

Hypothesis 4: Performance gains will be greater when foreign ownership ispermitted.

The fourth hypothesis is that bank privatization will be more successful when for-eigners participate. Several studies find that foreign owners have improved the per-formance of privatized non-financial enterprises in developing countries, perhapsbecause they have greater experience and technological knowledge than domesticinvestors (Cull et al., 2002; DSouza et al., 2001; Frydman et al., 1997). But, it mightalso be because governments that are willing to sell to foreigners are more willing togive up control of the privatized bank indeed foreign investors might only partic-ipate when there is little risk of intervention.

Foreign ownership is associated with greater performance improvement in thestudies in this symposium. In the first rounds of privatization in the Czech Republicand Mexico, when the governments prohibited or tacitly discouraged foreign owner-ship, performance failed to improve (Table 2). Performance did improve howeverafter subsequent rounds in which foreigners participated.

But poor performance cannot be solely ascribed to restrictions on foreign owner-ship. In the Czech Republic the government used share-issue privatizations and re-tained large shareholdings in the privatized banks. Bonin and Wachtel (2000,2003) suggest that foreign ownership produced a more stable banking sector in thesecond round, at least compared with the experience after the first round of bank

privatization. The authors also point to the positive post-privatization performanceof banks in Hungary, the first country in the region to fully embrace foreignownership.

Mexicos banks were privatized unsuccessfully to local investors, renationalizedafter a systemic crisis, and then sold to outside investors, many of whom were foreign(Haber, this issue). The foreign investors that participated in the second round ofprivatization helped created a more stable and efficient banking sector, althoughone that has responded to the failure of Mexicos legal system to enforce propertyrights by lending little and charging high margins. As in the Czech Republic, the

9 Similarly, Boubakri et al. (this issue) find in their cross-country analysis that economic efficiency islower when banks privatized through share-issue privatizations, although they also find that return onequity is higher.



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poor performance of the first privatization in Mexico cannot be wholly attributed tothe prohibition on foreign ownership; competition was also curbed. Haber (thisissue) also argues that political problems resulted in a flawed privatization program

during the first round, a topic that is developed in the next section.Cross-country evidence also suggests that foreign investors can improve post priv-

atization performance. In a study of 11 transition economies (Bulgaria, CzechRepublic, Estonia, Croatia, Hungary, Latvia, Lithuania, Poland, Romania, Slove-nia, Slovakia), Bonin et al. (2005) find that while private banks were more efficientthan state-owned banks, foreign owned banks outperformed other private banks.10

In a sample of 22 countries, Boubakri et al. (this issue) find that economic efficiencyand capital adequacy were higher for banks that were privatized to foreigners.

Although less widely studied, sales to foreign owners might also benefit the indus-trial firms that are clients of the privatized banks. Djankov, Jindra and Klapper (this

issue) find that when distressed banks were sold to foreign buyers in East Asia, therewas a rise in the long-run value of related firms. They argue that this is attributableto investors valuing foreign capital and know-how.11 There is also evidence that priv-atization can benefit the foreign banks and firms involved in the transactions. In asample of developing and developed economies, Gleason, McNulty and Pennathur(this issue) find positive abnormal short-term returns for the foreign firms purchasingthe privatized banks. They interpret these results as suggesting that investors thoughtthat the foreign firms would benefit from the performance improvements associatedwith privatization.

Hypothesis 5: Privatization will be more successful in competitive banking sectorsand will result in more competitive banking sectors.

Although competition is usually beneficial, theory suggests that competition in thebanking sector might encourage bankers to take excessive risks, especially when reg-ulation and supervision are weak and deposit insurance discourages monitoring bydepositors (Akerlof and Romer, 1993). The emerging empirical evidence, however,strongly suggests that denying entry to new applicants is not a solution to this prob-lem: banking sector stability and development are adversely affected by restrictions

on competition (Barth et al., 2001a; Beck et al., 2003a,b).Because few of the case studies provide detailed information on competition, andbecause it is hard to assess how much state-owned banks compete with privatelyowned banks, it is harder to assess the impact of competition on post-privatizationperformance. The first privatization experience in Mexico, described in detail in the

10 Participation by international institutional investors, such as the European Bank for Reconstructionand Development and the International Finance Corporation, raised returns on assets and profitabilityeven more, but did not have an additional impact on cost efficiency. Bonin et al. (2005) note that almost allbanks in which institutional investors were involved were foreign-owned, most with a strategic foreigninvestor.11 Conversely, the Czech Republics initial failure to privatize majority control over its banks may explain

the poor performance of its larger privatized firms that were the banks preferred customers (Cull et al.,2002).



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next section, however, suggests that giving buyers an oligopoly can be harmful: thisepisode was the only case where bank performance unambiguously declined afterprivatizing to strategic investors.

The studies in this symposium do however show that privatization even share-issue privatization can boost competition in the banking sector. Chen, Li andMoshirian (this issue) find that the privatization announcement of the Bank of ChinaHong Kong resulted in significant losses for some rival banks and non-bank financialinstitutions in Hong Kong. This suggests that shareholders in the rival institutionsexpected greater competition and lower returns after the Bank of China HongKong was privatized. The more negative responses for non-bank financial institu-tions might be because the privatized bank was expected to become more involvedin non-banking financial activities after privatization. Otchere (this issue), whichlooks at share-issue privatizations in nine countries, also finds that rival banks suf-

fered abnormally negative returns following privatization announcements. The re-sults from these studies are consistent with similar results for Australia in Otchereand Chan (2003).

The results from Otchere (this issue) are especially interesting given that there waslittle evidence of improved performance in the privatized banks.12 This suggests thatprivatization can have pro-competitive effects even when the privatized banksperform below market standards.

3.2. The impact on government finances

The general conclusion that emerges from the studies in this symposium is thatbank privatization improves profitability, portfolio quality, and operating efficiency,when it is done correctly. Because state banks have many, often competing, objec-tives (for example, to extend credit to underserved market segments) and they oftenlend for political reasons, this might not be surprising. Indeed, Hanson (2004) pointsout public banks often cannot lend to underserved market segments at market inter-est rates, because these rates would appear exorbitant for political reasons. The sub-sidies implicit in the rates that they do charge mean that portfolio quality andprofitability will suffer at even the best-run public banks.

A relevant question, then, is how big are the costs associated with those subsidies?Although the performance improvements found in the studies listed above suggestthat the costs could be large, only one recent study has directly estimated the fiscalcosts of maintaining public ownership. Based on the loss rates uncovered in detailedpre-privatization audits, Clarke and Cull (1999) find that the cost of re-capitalizingArgentinas provincial banks was more than twice the net costs associated with priv-atization (i.e., the costs of removing non-performing assets from the banks balancesheets and re-capitalizing the privatized entity less the price paid for the privatizedbank). The estimated median saving for provinces that privatized were equal to

12 In contrast, the pro-competitive effects in Australia (Otchere and Chan, 2003) are less surprising sincethe privatized bank was large and its performance improved substantially.



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about a third of their annual spending, which suggests that the gains associated withsuccessful privatization are large.

3.3. The impact on other aspects of financial sector development

The studies in this symposium show that state-owned banks are often less efficientthan similar private banks. But efficiency is not the only justification for state own-ership. If state-owned banks successfully correct serious market failures, state own-ership might improve social welfare even when state-owned banks are less efficientthan private banks.13

Theory suggests several market failures that state-owned banks might potentiallybe able to correct. One is that private banks might provide too little credit if bankingsectors become too concentrated when banks are privately owned (Caprio and Hono-

han, 2001) or if imperfect information or incomplete contracts prevent private banksfrom lending to some borrowers (Greenwald and Stiglitz, 1986). If state-ownedbanks are able to overcome informational or contracting problems (i.e., if they havebetter information than private banks or if the states monopoly over force allows itto solve contracting problems more easily) or they do not exercise market power tothe same degree that private banks would, then state-ownership might lead to greaterlending and improved social welfare. Borrowers that are informationally opaque orfor whom contracting is especially difficult, such as small and medium-size enter-prises, might be especially vulnerable when private banks dominate. State ownershipmight improve access for these vulnerable borrowers even if it has only a small im-pact on total lending.

As well as restricting access to credit, private banks might take greater risks thanare socially optimal. Because the private owners do not bear the entire loss if thebank becomes insolvent, they might be willing to lend recklessly. This reckless behav-ior could result in more frequent bank crises (Caprio and Honohan, 2001).

Even if these market failures are important, state ownership might not resolvethem. Corporate governance problems might prevent state-owned banks from effi-ciently resolving market failures or politicians might use state-owned banks to raisetheir own welfare (for example lending to important constituents) rather than to cor-

rect market failures. As a result, the impact on lending and stability is an empiricalquestion.The available empirical evidence suggests that state-owned banks do not resolve

these market failures. State-owned banks are associated with less financial develop-ment, slower growth and lower productivity, especially in low income countries andcountries where property rights are poorly protected (Barth et al., 2001b; La Portaet al., 2002). These is also little evidence that state-owed banks improve access tocredit even for small and medium-size enterprises. In a sample of 3000 firms fromover 30 countries, Clarke et al. (2001) found no statistically significant link betweenstate ownership and access to credit for enterprises of any size. And state banks in

13 Megginson (this issue) notes that bank privatization might also be important in hardening soft budgetconstraints for loss-making state-owned or privatized enterprises.



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Argentina and Chile lend less to small and medium size enterprises than other banks(Clarke et al., 2005).

State-owned banks are also not associated with greater stability. Instead, they

might cause instability. Barth et al. (2001b) find that systemic banking crisis areno less common in countries where state-ownership is more common, while otherstudies find state-owned banks raise the risk of bank crises and instability (Caprioand Martinez Peria, 2002; La Porta et al., 2002).

4. The political economy of bank privatization

The privatization literature summarized in Section 2 shows how political incen-tives and institutions affect privatization. Given the intimate connection between

government finance and the banking sector, it is not surprising that many studiesin this symposium find that politics played a decisive role in the nature, timing,and eventual success or failure of bank privatization.

Politicians privatize firms when the political benefits of privatization more rev-enue for spending on constituents and the benefit of removing a poorly performingstate-owned enterprise that has become a political liability outweigh the politicalcosts layoffs, price increases, and an end to services or subsidies for favored groups(World Bank, 1995). But the political economy of privatization is more complicatedthan this simple argument suggests: the costs, benefits and design of privatization arealso affected by a countrys political institutions. Electoral laws affect politicianstime horizons. The strength of political parties affect the weights that politiciansput on national and local preferences. And constitutional provisions that affectwho can veto privatization decisions affect the likelihood that the policy will be sus-tained through changes in leadership. Even so, the bank privatizations studied heresuggest that there are regularities in the interplay between privatization and politics.

When the fiscal burden of maintaining public ownership of inefficient state-ownedbanks is high, governments are more willing to privatize. Poorly performing publicbanks were more likely to be privatized than better performing banks in most although not all of the countries covered in this symposium, including Argentina

(Clarke and Cull, 2002), Brazil (Beck, Crivelli, and Summerhill, this issue), Pakistan(Bonaccorsi di Patti and Hardy, this issue) and Nigeria (Beck, Cull, and Jerome, thisissue).14 Cross-country evidence is also consistent with the results from the case stud-ies. Using data for 101 countries over a 20-year period, Boehmer, Nash and Netter

14 This does not appear to be true, however, in East Asia, where the point estimates from the estimationsuggest that banks that were privatized were generally more efficient than banks that remained state-owned (Williams and Nguyen, this issue). The evidence for Eastern Europe is mixed. Bonin et al. (2005)find that banks in Eastern Europe that remained state-owned in 1999 were less efficient than private banksin the same year although the difference was not highly significant. They note that this would beconsistent with the hypothesis that better banks were privatized first in transition economies. However, itwould also be consistent with the hypothesis that state-owned banks are less efficient than similar privateand privatized banks. Further, Bonin, Hasan and Wachtel (this issue) do not find any evidence of aselection effect in the six Eastern European countries in their sample.



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(this issue) show that bank privatization was more likely in developing countries withpoor quality banking sectors.15

Fiscal concerns also affect privatization in other ways. Fiscal transfers between

national and local governments allow national governments to influence the privati-zation decisions of provincial or state governments. Brazilian states that were moredependent on federal transfers and whose banks were already under federal interven-tion relinquished greater control during the privatization process than other statesdid (Beck, Crivelli, and Summerhill, this issue).

The strength of opposition to privatization also affects the likelihood of privatiza-tion. In Brazil, the federal government offered several privatization options that af-fected the amount that state governments relinquished control over their banks(Beck, Crivelli, and Summerhill, this issue). States relinquished greater control whenthey were able to establish a development agency, which could assume some of the

mandate of the former state bank and thus assuage political opposition.16 Similarly,in Argentina, large, overstaffed banks in provinces with higher unemployment andmore public sector workers were less likely to be privatized: privatization was lesslikely when public employees were more influential and job losses more controversial(Clarke and Cull, 2002). Also consistent with this idea, Boehmer, Nash and Netter(this issue) find that governments that were more accountable were more likely toprivatize their banks in the low and middle-income countries in their cross-countrysample. Although slightly different from the results for Argentina, one could arguethat overstaffing and more public sector jobs are signs that a government is depen-dent on a small group of favored constituents rather than the full electorate.

There is also weak evidence that party affiliation or ideology might affect privati-zation decisions. Provinces with governors from the more fiscally conservative ofArgentinas two major political parties (Partido Justicialista) were more likely to pri-vatize than those with governors from the other major party (Unio n Cvica Radical)(Clarke and Cull, 2002). Similarly, right-wing governments were more likely to pri-vatize state-owned banks than left-wing governments in the cross-country sample oflow and middle-income countries in Boehmer, Nash and Netter (this issue). Neitherof these results, however, were highly robust.

Political factors can also affect the approach to privatization and the steps the

government takes to influence the future behavior of the privatized bank. In Argen-tina, provinces with high fiscal deficits agreed to privatization contracts that allowedmore layoffs and guaranteed a larger part of the privatized bank s portfolio but re-ceived higher prices (Clarke and Cull, forthcoming). Exogenous factors also some-times affect political decisions. The Tequila Crisis and the associated fiscal costscaused politicians to agree to conditions that protected fewer jobs and retained ahigher share of the public banks non-performing assets in a residual entity.

15 Boubakri et al. (this issue) find a similar result in their cross-country analysis. Banks were privatizedwere less efficient and had lower capital adequacy than other state-owned banks.16 The development agencies were not true banks. They were unable to take deposits from the public and

could only invest in priority areas defined by the state government (Beck, Crivelli, and Summerhill, thisissue).



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Because political factors affect the timing of privatization and the design of priv-atization contracts, they can also affect post-privatization performance. Becausemost banks effectively stopped operating during Argentinas latest crisis, it was

not possible to test directly whether specific features of the privatization contractsharmed bank performance. But there are some regularities that suggest they did.Privatized provincial banks improved profitability, profit efficiency and portfolioquality, while showing no improvement in cost efficiency or the ratio of operatingcosts to assets (Berger et al., this issue). These results suggest that the contract pro-visions that protected workers and prohibited branch closures might have preventedthe privatized banks from cutting their costs.

Comparison of privatization experiences in the transition countries also providesindirect evidence that politics can affect privatization outcomes. Early in the 1990s,Hungary moved decisively to privatize its banks and allow entry by foreign banks.

This strategy paid substantial dividends, allowing the country to develop a strong,stable banking system long before its neighbors did. But speed alone does not ensuresuccess. The Czech government sold some of its ownership stakes in the four largebanks that dominated the financial system quickly through a voucher privatizationprogram. As noted earlier, however, they also chose to retain sizable, and in somecases controlling, interests in these banks (Bonin et al., 2005; Cull et al., 2002). Asa result, performance failed to improve, as the banks maintained their old links withtheir most influential former clients, whom were channeled funds to prop up unpro-ductive firms. It was not until the government cut its stakes further in the late 1990sthat performance improved. Although the authorities moved more slowly in Polandthan in the Czech Republic, they avoided the near-crisis situation faced by the Czechs.

The decisive effect that political factors can have on the success of bank privati-zation were most clearly evident in the first round of privatization in Mexico (Haber,this issue). Before 1997, Mexicos one party political system, dominated by the PRI(Partido Revolucionario Institucional), meant that there were few constraints on thegovernments authority and discretion. The lack of constraints had three importantconsequences: (i) the risk of expropriation was high; (ii) privatization policy could bedistorted to serve the PRIs political needs; and (iii) mechanisms to enforce contrac-tual rights were weak. Together these resulted in a flawed privatization program.

The lack of constraints on government action meant that the risk of expropriationwas high.17 Potential buyers would not bid unless they were compensated for the riskof expropriation with the promise of high rates of return secured by protection fromcompetition.

It also meant that privatization policy could be distorted to meet the governmentsshort-term political goals. Facing a fiscal crisis and needing to shore up political sup-port in the face of rising political competition, the government designed a programthat would maximize revenues. First, the government did not break up Mexicoshighly concentrated banking system but sold the banks as is. Second, the banks were

17 PRI-controlled governments expropriated Mexicos banks twice in the twentieth century, in 191516and in 1982. In addition, they had also carried out de facto expropriations through drastic increases in themoney supply or draconian regulation of interest rates.



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auctioned sequentially, which led to greater competition and pushed up the bid tobook ratio in every round. Third, new banks needed permission from the Secretaryof the Treasury, who could decline a charter for any reason, before they could start

to operate. This raised the charter value of the privatized banks. Fourth, the govern-ment failed to bring Mexicos accounting standards in line with international stan-dards, allowing banks to substantially overstate their assets and reported rates ofreturns. Fifth, the government did not allow foreign banks to bid and the NAFTAagreement was structured so that only the smallest banks could be foreign owned.These features signaled to bidders that they were buying the secure oligopoly theyneeded to compensate them for expropriation risk, contributing to much higher thanexpected prices.18 On average Mexicos banks sold for over three times book value,higher than in either the United States or Western Europe countries where expro-priation and default risk are lower.

The new owners of the privatized banks lent aggressively and opened newbranches to quickly earn high returns. The stock of lending nearly doubled in realterms between 1990 and 1994. Many of these loans were poor quality, while manyothers appear to have been to groups and individuals closely linked to bank owners.Non-performing loans rapidly grew from about 13.5% of loans in 1991, to 17.1% in1994, and 52.6% in 1996.19

As bad debts accumulated the third weakness the lack of mechanisms to protectcontractual rights became important. Delays and obstructions in Mexicos legal sys-tem meant that banks could not repossess collateral on their bad loans. Relationalloans to family and network members were no easier to collect. In short, there wereno checks on bad banking. Unlimited deposit insurance gave bankers little reason tore-create the strong networks that they had once used to monitor each others behavior.Instead the prospect of a bailout encouraged them to lend more to family and friendswho planned to default (La Porta et al., 2003). Moreover, because the privatization pro-gram had allowed the new owners to pay for the banks with borrowed money, they hadlittle of their own capital at risk, further weakening their incentives to lend prudently.

Mexicos political economy had created a fragile banking system poised for col-lapse. The devaluation in December 1994, which led the Central Bank to raise inter-est rates, exposed the unsustainable situation. As the banks faltered, the 100%

deposit insurance system bailed out depositors and the government took over insol-vent banks. To re-capitalize the banks, the government removed all restrictions onforeign bank ownership. The second privatization in 1996 lowered operating costsand raised the capital/asset ratio from 6% to 11%. The government assumed allthe bad debts, and Mexicos banks started to follow more prudential policies. But

18 A less charitable interpretation is that the government was tacitly permitting the new owners to attractdeposits that its owners could later divert to their own accounts through loans to insiders (Haber, thisissue).19 Estimates are from Haber (this issue) and include non-performing loans omitted from official figures.

Since Mexicos weak accounting standards underestimated the size of non-performing assets, the officialnumbers were lower. At the same time the banks were undercapitalized the capital ratio was probablyonly 6.5% during this period while operating costs stayed high, averaging about 7.5% per loan.



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because contracts are still difficult to enforce, banks lend little: bank lending averagesonly 15% of Mexicos GDP compared with 150% in the United States, 200% inJapan, and 20% in Mexico in 1991.

Although politics is not the primary focus of the other studies in this symposium,they offer some examples of politics affecting privatization outcomes. For example,Beck, Cull, and Jerome (this issue) discuss the preponderance of ex-military officialsand politicians who were and are owners of Nigerian banks. They also argue that thegovernments multiple exchange rate regime created arbitrage opportunities forfinancial institutions that had privileged access to foreign exchange, fostering a bank-ing sector focused on rent seeking rather than financial intermediation. Bonin,Hasan and Wachtel (this issue) describe how privatization was infeasible in Bulgariaand Romania until the late 1990s because of the unstable macroeconomic situation.By that time, the state banks had suffered such large losses that substantial re-capi-

talization was needed to ensure investor interest.

5. Conclusions

The cases studies and the cross-country analyses strongly support the conclusionthat privatization improves performance and raises competition. But several policieslessen the benefits:

Continued state ownership, even of minority shares, harms the performance ofprivatized banks.

Share offerings produce lower performance gains than direct sales to concentratedstrategic investors in weak institutional environments.

Prohibiting foreigners from participating in the privatization process reduces thegains from direct sales and share-issue privatizations.

Competition alone will not secure performance improvements in privatized banks,but oligopolistic banking is likely to lead to poor outcomes for the banks and thefinancial system.

Foreign banks tend to be more prudent, which might result in less lending in weak

regulatory environments. Although this is a reasonable response to the true haz-ards, it might be politically problematic. The best solution is not to sell banks torisk-loving owners, or to provide government subsidies or bail outs, but to putbetter safeguards against expropriation in place, protect lenders property rightsbetter, and improve access to creditor information. Although some of thesereforms might have to wait for a change in a countrys political economy, othersare amenable to short-term reform.

Although poor regulation lessens the gains from privatization, privatization im-proves performance even in poor regulatory environments. This suggests that it is

better to privatize even with weak regulation, rather than await reforms that mighttake a long time. Because foreign banks face regulation in their home country thatmight curb their opportunism and encourage them to behave more prudently, it is



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especially important to allow foreigners to participate in the privatization process inpoor regulatory environment. They might also lobby for regulatory improvementsand legal reforms if they cannot take full advantage of regulatory or judicial lacunae.

More research is needed to find out whether this is the case.The Mexico and Argentine cases also suggest some political economy lessons.

Mexicos experience illustrates that some policies that raise the price investors arewilling to pay also raise the risk of crisis, especially when prudential regulationsare weak and deposit insurance is in place. Seeking to boost revenues by restrictingcompetition is short sighted. Politicians with a short time horizon might not be dis-posed to heed this advice; but their preference for revenues should not be encouragedby outside advisors who are also sometimes focused on short-term public deficitsrather than long-term efficiency gains. Other steps to make privatization more polit-ically palatable can also be risky. The restrictions on bank closures and firings in

Argentina appear to have raised costs. In short, the less the political process dictatesthe specific features of the privatization transaction the better.

Acknowledgements

We would like to thank Thorsten Beck, Allen Berger, John Bonin, Jerry Caprio,Jean-Claude Cosset, Stephen Haber, Jim McNulty, Bill Megginson, Isaac Otchere,and Paul Wachtel for comments on earlier drafts. This paper has not undergonethe review accorded to official World Bank publications. The findings, interpreta-

tions, and conclusions expressed herein are those of the authors and do not necessar-ily reflect the views of the International Bank for Reconstruction and Development/The World Bank and its affiliated organizations, or those of the Executive Directorsof The World Bank or the governments they represent. The World Bank does notguarantee the accuracy of the data included in this work.

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