A healthy private banking sector needs effective regulation

A well-functioning financial system can contribute to economic growth in poor countries. But many countries that have tried to transform their financial systems have suffered banking crises and financial instability – especially where reforms have not been accompanied by improvements to regulation. Some commentators believe that the continued presence of state banks is partly to blame.

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

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

The institutions identified as 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 broader rule of law.

The research finds that:

· Good institutions are key to encouraging the growth and development of a private banking system.

· Effective market regulation increases public confidence in private sector banking practices.

· Strict disclosure rules prevent rogue private banks from entering the market.

· Banking crises cause public mistrust of the private banking system.

· Better regulation and improved disclosure lead to a reduction in government ownership of banks.

Poor countries need to establish effective rules and regulations in order to benefit from well-functioning financial systems. But institution-building is a lengthy process which can get interrupted by political pressures (opposition to reform).

The implications of the research include:

· Governments should build institutions which encourage the growth of private banking.

· However, state banks can play a useful role before quality institutions are put in place.

· Enhancing market regulation and strengthening disclosure rules are particularly effective ways of raising public confidence in private banks.

· State banks should not be subsidised or privatised prematurely before effective regulation is in place.

· More research into the political forces that support or oppose financial system reform would be useful.