state banks on the rise

In many of the economies of the former Soviet Union, state banks accounted for more than half of all banking assets in 2016 (the last year for which comprehensive data are available), with figures of 67 per cent in Belarus, 59 per cent in Russia and 53 per cent in Ukraine, for instance (see Chart 3.1). Levels of state ownership in the banking sector are also high in China (59 per cent), Ethiopia (61 per cent), India (67 per cent) and Syria (71 per cent). In some large Latin American countries, such as Brazil and Argentina, more than 40 per cent of banking assets remain in state hands. And in Turkey, three large state banks account for a third of the banking system. While state banks used to play a minimal role in most high-income countries, bailouts and nationalisations in the wake of the global financial crisis have also increased the level of state ownership in countries such as Iceland (66 per cent) and Portugal (37 per cent). In Germany, too, state banks account for 37 per cent of total banking assets, as regional Landesbanken continue to play a major and heavily debated role in the economy.2

This chapter describes the rise of state banks over the last decade and analyses the state’s growing role in the area of financial intermediation. There are, broadly speaking, two main dominant views on the economic role of state banks. The first highlights the role that governments play in addressing credit market failures, fostering financial inclusion and industrial innovation, and maintaining financial stability. According to this positive perspective, state banks are able to fund projects that create beneficial externalities but are either too opaque, not profitable enough or too long-term in nature for private banks to finance.3 Moreover, state banks can also act as economic shock absorbers, stepping in when information asymmetries widen in times of crisis and private banks increase their rationing of credit for riskier firms.4

The second, negative, perspective argues that politicians often pressure state banks to provide employment, subsidies and other benefits to their supporters, in the hope that they will return the favour in the form of votes, political contributions or bribes. To the extent that lending by state banks is indeed driven by political motivations, state banks will distort the allocation of capital, with adverse implications for the productivity of firms and the economy as a whole.5 This chapter ends with a discussion about how countries can reduce the inherent risks that are associated with state banks (other than through privatisation).

The EBRD regions now have the second-highest percentage of state-owned banking assets in the world (after Asia), having overtaken Latin America following the global financial crisis (see Chart 3.3). This owes much to the high levels seen in some of the largest countries in the EBRD regions (such as Egypt, Russia, Turkey and Ukraine). While state-owned banks can also be found in Africa and western Europe, they play a less important role than private banks in those regions.

The assets of state-owned banks and private banks increased in tandem until the onset of the global financial crisis in 2008 (see Chart 3.4). In that year, private banks saw a sharp decline in their access to cross border wholesale funding, including syndicated borrowing.6 At the same time, foreign-owned private banks’ access to parent bank funding was also sharply curtailed, forcing them to start a decade long de-leveraging process.7 In contrast, many state-owned banks had been less reliant on relatively volatile wholesale funding, instead funding more of their assets using more stable customer deposits. Moreover, various governments used state banks as vehicles for the swift distribution of public funds to the real economy. In Russia, for instance, the government gave state banks capital injections and preferential loans on favourable terms, as well as long-term deposits.8 Thus, state banks at least partially filled the credit gap left by de-leveraging private banks and were able to increase their assets much faster than their private counterparts.

Academic evidence points to the importance of geographical proximity in lending relationships between banks and firms.9 For instance, a recent study of relationship lending in Italy during the global financial crisis found that credit was cheaper and more stable for firms that were located closer to their banks.10 Thus, banks’ ability to lend to households and firms (especially smaller companies) remains strongly dependent on the geographical scope of their branch networks. Many state banks have expanded their branch networks over the last decade as their assets have grown, particularly in Turkey, Central Asia and the CEB and SEE regions (see Chart 3.5; note that 2020 data are not yet available for Russia or the SEMED region). In contrast, state banks’ share of total branches shrank across the EBRD regions between 2000 and 2010, with the exception of the SEMED and SEE regions. The expansion of state banks’ branch networks in the decade following the global financial crisis reflects both stronger organic growth in the branch networks of state banks relative to private banks and changes to the ownership of existing branches following nationalisations in countries such as Hungary, Poland and Ukraine.

The results of the survey indicate that, when it comes to lending to small and medium-sized enterprises (SMEs), domestic state banks are most likely to be regarded as serious and strong competitors in Turkey, Russia and the SEMED region (see Chart 3.6). Indeed, after the global financial crisis all participating CEOs in Turkey and more than 80 per cent of participating CEOs in Russia indicated that domestic state banks were strong competitors in the SME lending market. Banks’ CEOs were also asked about their competitors in the retail and corporate lending markets, and the results for those questions were very similar to those shown in Chart 3.6.

Foreign state banks are generally regarded as less of a competitive threat (see Chart 3.6). In fact, foreign state banks are seen as posing the least threat in terms of competition in those economies and regions where domestic state banks are most dominant – notably Turkey, Russia and the SEMED region. This indicates that the two types of state bank are substitutes, possibly because governments that own state banks are less likely to allow foreign state-owned competitors to enter the domestic market.

Before the global financial crisis, domestic state banks were significantly less likely than private banks to report that their corporate lending (defined as lending to firms with at least 250 employees) was held back by loan applicants having an inadequate credit history (that is to say, a poor credit history or no credit history at all; see top panel of Chart 3.7). This suggests that private banks may have been more demanding, or more conservative, in terms of the types of borrower that they lent to (see Box 3.2 for evidence from Turkey). That difference between state and private banks was also observed after the global financial crisis (see bottom panel of Chart 3.7). However, at that point, state banks were also significantly less likely to report that their lending was constrained because firms did not have sufficient cash flow or profits. And they were also less likely to worry about incomplete loan applications.

Thus, in the years that followed the global financial crisis, state banks felt less constrained by the poor quality of borrowers (in terms of their ability to generate cash flow, their credit history or the completeness of their loan applications). This helps to explain why state banks were more able to expand their activities in the decade after the crisis.

There are also important differences between state-owned and private banks in terms of the main strategies that they use to attract new clients (see Chart 3.8). Before the crisis, state banks were less likely than their private-sector peers to increase staff numbers, invest in the training of staff and other personnel, or introduce new and innovative banking services. In contrast, they were significantly more likely than private banks to attract new clients by participating in special lending programmes run by the government or international agencies. After the crisis, these differences in strategy disappeared, with the exception of state banks’ participation in government lending programmes targeting certain groups of corporate or retail borrowers.

Taken together, the above results suggest that state banks tend, on average, to invest less in their staff’s lending and customer acquisition skills. Partly as a result of that, their screening of potential clients may be less stringent than that of their privately owned peers. While this strategic difference allows state banks to scale up lending more quickly in times of crisis, it may of course come at a cost, potentially resulting in a decline in average loan quality in the medium to long term.

In both of the periods under consideration (that is to say, both before and after the global financial crisis), state banks generated lower returns than private banks on average assets (see Table 3.1). Indeed, over the period from 2010 to 2019, state banks’ annual return on assets was, on average, 1.1 percentage points lower than that of equivalent private banks. That represents a substantial difference, given that the average return on assets was only 0.76 per cent during the period in question.

There are two underlying reasons for that substantial difference in profitability. First of all, state banks have been operating on the basis of lower net interest margins in the post crisis period. Relative to similar private banks in the same country and the same year, they have been charging borrowers lower interest rates and/or paying higher rates to depositors. Davydov (2018), for example, found that Russian state banks charged lower interest rates than their private-sector peers during the global financial crisis. Second, the non-performing loan (NPL) ratios of state banks were, on average, 1.6 percentage points higher than those of their private counterparts in the period 2010-19 – a substantial difference relative to the average NPL ratio of 11.6 per cent across all banks in that period. That greater tendency to accumulate bad loans on their balance sheets is consistent with state banks’ greater propensity to lend to clients with weaker credit histories or cash flows. Earlier studies looking at the Middle East and North Africa confirm that state banks underperform relative to private lenders, with that weaker performance reflecting both operational inefficiencies (especially larger numbers of staff) and the negative impact that policy mandates have on loan quality.12

That de-leveraging by foreign private banks during the global financial crisis was slowed down by the Vienna Initiative and the related Joint IFI Action Plan – a cooperation platform involving multinational banking groups, home and host country supervisory and fiscal authorities, the EBRD, the IMF, the World Bank, the EU and the EIB, which sought to ensure macroeconomic stability in emerging Europe by preventing a large-scale withdrawal of foreign bank lending. As part of that initiative, parent banks signed commitment letters pledging to maintain exposures and support their subsidiaries in emerging Europe, with the subsidiaries of those parent institutions proving to be significantly more stable than other banks as a source of credit.13

In sharp contrast, state banks stepped up their lending as private banks were de-leveraging – especially in 2008 and 2009, at the height of the crisis. Evidence from Latin America and emerging Europe shows that state banks stepped up their lending activity during the global financial crisis and in the immediate aftermath, when private banks had to de-leverage because of funding difficulties, with lending by state banks being less affected by economic cycles.14

Evidence from Spain shows that state lending after 2009 had a positive impact in terms of supporting economic activity, but this came at a cost, resulting in an increase in defaults on loans issued by state banks.15 In order to assess whether similar effects were observed in the EBRD regions, this chapter now turns its attention to a group of 291 subnational regions in central and eastern Europe, the Caucasus, Turkey and Ukraine. That analysis looks at differences in average income growth across regions (with state banks varying across those same regions in terms of the extent of their presence), controlling for average regional income prior to the crisis and country fixed effects.

The data confirm that there is a strong positive correlation (with a coefficient of 0.23) between the percentage of branches that are owned by state banks in a particular region and regional income growth in the period 2008-10 (see Chart 3.10). This suggests that the presence of state banks may have helped to soften the decline in economic activity during the global financial crisis.

Similarly, the results of the 2010 and 2016 rounds of the Life in Transition Survey, a large-scale representative household survey carried out across the EBRD regions (see Chapter 1), suggest that state banks softened the impact of the financial crisis for households. An index variable (ranging from 0 to 1) can be used to summarise the extent to which each household was negatively affected by the global financial crisis, combining information on job losses in the household, the closure of family businesses, reductions in working hours or pay, wage arrears, declines in remittances received from abroad, family members returning home from abroad, the need to take a second job or additional work, increased working hours in an existing job, and a set of 19 possible consumption responses (including reduced consumption of staple goods such as milk, reduced use of one’s own car and an inability to make utility payments on time).

Regression analysis shows that state banks having a presence near the household (that is to say, in the Life in Transition Survey primary sampling unit where the household lives) is associated with the crisis having a smaller impact at household level (see Table 3.2). When account is taken of the respondent’s country of residence, age, employment status (employed or unemployed), level of education, income and location (rural or urban), as well as the distance to the country’s capital city, a 1 standard deviation increase in the presence of state banks is associated with a reduction of 12 per cent of a standard deviation in the severity of the crisis’s impact on the household. Overall, these findings suggest that state banks can soften the economic impact of financial crises at local level, for instance by making it easier for households and small businesses to access emergency credit lines to tide them over in difficult times. State banks may, therefore, have acted as bridging lenders or relationship lenders during the crisis.16

Earlier studies have shown that economic shocks caused by bank deleveraging can erode people’s trust in and preferences for market economics and private ownership.17 That is supported by the results of this regression analysis, which show that households which were worse affected by the global financial crisis were indeed much less likely to trust banks (see Table 3.2). Interestingly, trust in banks declined less in regions where state banks played a greater role. Moreover, the 2016 round of the Life in Transition Survey showed the lasting impact of that effect, revealing that eight years after the start of the global financial crisis, households living in areas where state banks had more of a presence still tended to trust banks more.

Overall, these findings support the notion that state banks can help firms and households to weather the impact of economic downturns through their role as counter-cyclical lenders.18 However, the beneficial effects of state banks’ presence in the short term should be weighed against the potential for distortionary effects in the longer term. A recent study looking at Brazil, for example, shows that areas where government banks had more of a presence received more loans and experienced better employment outcomes during the global financial crisis.19 However, that lending was politically motivated and allocated inefficiently, and it reduced productivity growth in the longer term.

Firms’ propensity to borrow from state banks has also increased in a group of comparator countries (Djibouti, Israel, Yemen, Italy, Malta and Portugal; see Chart 3.12), albeit the percentage of firms borrowing from state banks in such countries remains much lower than it is in the EBRD regions.

Next, this chapter examines the factors that influence a firm’s decision to borrow from a state-owned or private bank, using a regression framework which explains the probability of a firm borrowing from a state bank rather than a private bank (conditional on it borrowing in the first place). All regressions include country-industry fixed effects, which take account of any industry-specific patterns in lending to firms in the country in question.

Four results stand out in this regard. First of all, firms in areas where state banks account for a higher percentage of branches are significantly more likely to borrow from a state bank (see Chart 3.13). This effect has strengthened in recent years, perhaps reflecting the expansion of state banks’ branch networks and assets over the last decade. This also suggests that credit markets across the EBRD regions remain largely local in nature, as a result of both transport costs and the information advantages of local lenders.20

Second, firms in smaller localities (those with fewer than 50,000 inhabitants) are more likely to borrow from a state bank, while private banks tend to focus on larger cities. This could suggest that state banks care more about employment generation, especially in more remote parts of the country. Third, consistent with that, firms with lower sales relative to the size of their workforce are also more likely to borrow from a state bank. And fourth, foreign-owned firms and firms that export are less likely to borrow from a state bank, reflecting the fact that such firms tend to be run more professionally and find it easier to access other sources of credit (such as foreign-owned private banks and trade credit).

What are the implications of firms borrowing from state banks rather than private banks? Economic theory is ambivalent on the question of how government ownership of banks affects firm-level outcomes. On the one hand, state-owned banks could alleviate market failures in the funding of innovative and profitable projects, which arise as a result of the intangible nature of innovation related assets, making those assets difficult to collateralise.21 On the other hand, however, political influence and/or non-commercial objectives could result in the misallocation of credit.

This question can be explored using instrumental variables regressions that seek to explain various firm-level outcomes on the basis of a number of firm-level characteristics, as well as a variable capturing whether a firm’s last loan was granted by a state bank. One concern in this regard is that a firm’s decision to borrow from a specific bank could potentially be based on firm-level characteristics that also have a direct impact on that firm’s outcomes. For instance, foreign ownership may make a firm more likely to borrow from a private bank and, at the same time, increase that firm’s propensity to innovate. In order to alleviate such concerns, the regressions in this analysis use state banks’ share of local branches as an instrument for the likelihood of a firm borrowing from a state bank.22 This allows us to study the impact on firm-level performance of variation in borrowing from state banks that arises as a result of differences in local credit markets. One necessary assumption in this regard is that the structure of local credit markets only has an impact on firm-level productivity through the firm’s choice of banking relationship.

This analysis shows that firms which borrow from a state bank subsequently expand their workforce faster than similar firms which borrow from a private bank (although the same is not true of sales; see Chart 3.14). This suggests that the management of firms which borrow from state banks may be less inclined to invest in new labour-saving technologies that can boost firm-level productivity. Indeed, these results show that firms which borrow from a state bank are significantly less likely to engage in either product innovation or process innovation. They are also less likely to invest in R&D, an important input for subsequent innovation outcomes. Importantly, these differences are not attributed to a lack of access to bank credit, only to the ownership of the bank that the firm borrows from.23 Thus, an increase in the presence of state banks may not necessarily eliminate market failures associated with the funding of innovation and growth-enhancing investment.

Indeed, regression analysis covering 130 subnational regions indicates that an increase in state banks’ presence in a particular region is associated with greater dispersion of a revenue-based measure of the total factor productivity of firms within that region (see Chart 3.15), taking into account country fixed effects and various regional characteristics. Indeed, a 5 percentage point increase in state banks’ share of branches is associated with an increase in productivity dispersion that drags down aggregate regional productivity by 10.5 per cent. This finding is in line with the results of earlier cross-country studies, which found that an increase in the percentage of bank assets that are controlled by the state is associated with weaker growth and a more shallow financial system, especially in poorer countries.25 However, privatising state banks’ assets is not a panacea: it only leads to stronger growth when banks have fewer political connections and regional property rights are better protected.26

Such economic distortion is partly a reflection of state banks’ susceptibility to political interference in their lending. For example, politicians may use state banks to provide employment and other benefits to supporters, in the expectation that these favours will lead to more votes. Box 3.1 takes a closer look at distortion caused by political interference using data on Turkey. Similarly, it has been shown that Brazilian firms which are eligible to receive loans from state banks on favourable terms tend to increase employment in politically attractive regions just before elections, especially when those elections are closely contested.27

The analysis in this section looks at whether there is a special relationship between state banks and state enterprises, using data on 3.6 million enterprises (both privately owned and state-owned) across 102 countries over the period 2000-17. State enterprises are defined here as firms that are at least 20 per cent state-owned. Regression analysis is used to explain firm-level leverage (debt as a percentage of total assets) as a function of the firm’s ownership (that is to say, whether it is privately owned or state owned) and an interaction term combining state ownership with the state’s share of total banking assets in the economy. Those regressions take account of a firm’s total assets, its profitability, the size of the non-debt tax shield and a measure of assets’ tangibility, as well as country-industry-year fixed effects (which ensure that state enterprises are compared with similar privately owned enterprises in the same country, industry and year).

The results of the analysis show that while state enterprises tend, on average, to be less leveraged than similar private firms, they benefit considerably when state banks dominate the lending market (see Chart 3.16). In particular, in countries where state banks play a more prominent role, state enterprises have significantly higher debt-to-asset ratios than private firms. At the same time, higher levels of foreign ownership in the banking sector are associated with less leveraged state enterprises. This suggests that, relative to domestic private banks, foreign-owned banks and state-owned banks exercise more and less financial discipline respectively.

State banks’ ability to successfully balance their commercial and non-commercial objectives depends on their corporate governance structure and the institutional environment in which they operate. A number of preconditions may need to be met in that regard if state banks are to contribute to long term economic growth.31

First of all, there should be no political interference in state banks’ management or credit allocation. The appointment of banks’ managers should not be guided by political considerations. More generally, state banks need to apply standard principles of sound banking (although the profitability objective may be traded off against explicit and well-articulated social and development objectives).

Second, state banks should publish annual reports (including full financial statements) and be transparent about their social objectives and mandates. Moreover, a clear monitoring system is required to assess whether a bank’s performance is in line with its mandate. Making state banks’ non commercial goals explicit and subject to public monitoring has the potential to enhance both transparency and accountability. More generally, the accounting, auditing, transparency and disclosure standards applicable to state banks need to be comparable to those governing publicly listed firms.

Third, there needs to be an appropriate legal framework and clarity about the entity that is acting as the banks’ “owner” on behalf of the state. In addition to setting out clear disclosure requirements and accounting and auditing standards, the relevant laws and regulations also need to identify and delimit the objectives of state banks (including as regards any public policy objectives). Steps also need to be taken in order to make banks’ boards more effective, such that they are better able to deliver on their mandates.32

Fourth, in order to guarantee financial sustainability, state banks should cover their own operational costs. The interest rates that they charge should cover their funding costs. Mandates that force state banks to offer credit at low interest rates – either to specific politically connected individuals or across the board – often hamper their recovery of costs.

More generally, policymakers need to encourage contestability in the banking system through the healthy entry of well-capitalised institutions and the timely exit of insolvent ones, including state banks. A strengthening of market competition in banking, coupled with improvements to the governance structure of state banks, is likely to be particularly beneficial in countries with weaker governance and limited state capacity to enforce regulations.33

Over the last 15 years, state banks across Turkey have significantly increased their presence in government strongholds (defined as provinces that have been governed by the party controlling the central government throughout that period), expanding their operations far more strongly in those areas than in other regions (see Chart 3.1.1).35 There is no such differential in terms of the opening and closing of branches for private banks. On the one hand, this pattern is consistent with politicians’ patronage of core supporters, whereby elected officials seek to improve the welfare of citizens in provinces that have supported them strongly at the ballot box. On the other hand, however, it may also reflect the government’s strategy of increasing financial inclusion in previously underserved segments of the Turkish population. For instance, the World Bank’s Global Findex Survey shows that the percentage of Turkish women with formal bank accounts rose from 33 per cent in 2011 to 54 per cent in 2017. Similarly, state banks have been busy establishing Islamic participation banks as subsidiaries in order to reach out to more conservative segments of society. (Those banks operate on a non-interest basis and follow Islamic law. In practice, they make a profit through equity participation that requires a borrower to give the bank a share in their profits.)

In order to shed more light on the drivers of those differential patterns for state and private banks, the analysis in this box draws on Turkish credit data, which are aggregated separately for state and private banks by province over the period 2003-17.36 A single party had control of the central government throughout that period, exercising direct authority over the three state banks that operate nationally, which account for a combined total of around a third of all banking assets. If state banks are at least partly guided by political motivations, lending patterns in a particular province could be correlated with the political affiliation of the relevant mayor and the degree of electoral competition in that province. Analysis comparing lending by state banks and private banks in election and non-election years and across provinces with different political characteristics yields two main findings.

First, state banks engage in strategic lending around the time of local elections. In contrast with private banks, state banks lend more in provinces where the incumbent mayor is affiliated with the party controlling the central government and faces strong competition from political opponents in the run up to local elections. Similarly, state banks reduce their lending in competitive provinces where the incumbent mayor represents an opposition party (see Chart 3.1.2). This finding is in line with the notion of “tactical redistribution”, whereby governments use public resources (in this case, lending by state-owned banks) as a strategic tool to improve their chances of re-election.37 This pattern can be observed in state banks’ lending to firms, but not in their lending to consumers, which is consistent with the view that local politicians are judged largely on local economic performance.

Further evidence of tactical redistribution can be seen in the responses of firms surveyed as part of the fifth round of the Enterprise Survey (see Table 3.1.1). In provinces where support for the party controlling the central government is traditionally strong, an average of around one in five businesses report having received a loan from a state bank. In contrast, that ratio is only one in ten in the provinces where opposition parties have their highest levels of support. Average interest rates on loans to firms are consistent both across regions and between state and private banks, implying that state banks price their loans on the basis of market rates. However, state banks are more likely to require collateral in provinces where support for opposition parties is higher. As a result, those provinces have higher percentages of firms reporting that access to finance is a severe obstacle to doing business.

A second finding is that these systematic differences in firms’ access to credit matter for the real economy. Industries with high levels of state bank lending that are located in politically contested provinces experience substantial reductions in employment, sales and assets in the run-up to local elections if the incumbent mayor represents an opposition party. Meanwhile, the opposite is true of closely contested provinces where the incumbent mayor represents the party controlling the central government. In opposition strongholds, credit growth declines particularly strongly in relatively efficient industries in the run-up to local elections.

As otherwise efficient industries respond to the tightening of financial constraints by shedding employment and assets, politically motivated bank lending may have long-lasting adverse effects on the allocation of capital, aggregate productivity and growth in regions that experience political lending cycles. It has been estimated that political lending may lower local aggregate productivity by nearly 2 per cent, which would explain a 10th of the overall productivity differential across firms in Turkey.38

The rapid expansion of lending by Turkish state banks over the last decade may have increased access to credit for previously underserved segments of the market. To the extent that productive enterprises benefited from this additional credit, state banks may have helped to improve the overall competitiveness of the economy. However, the existence of political lending cycles implies that the newly available credit was not always allocated to the most deserving companies. Overall, the evidence so far suggests that productivity losses stemming from the misallocation of credit outweigh potential gains from the increased availability of credit.

This box presents analysis of access to credit for start-ups and other young firms in Turkey. It draws on a credit registry that covers all loans issued in the country since 2006. That analysis is based on a sample of first-time borrowers spanning all sectors and regions of the country. These are typically newly registered firms with just a handful of employees, often referred to as “micro enterprises”.

This analysis looks at private and state banks’ appetite for lending to those first-time borrowers from a risk perspective, removing any common effects stemming from the year the loan was issued and the size of the firm. It then divides the universe of first-time borrowers into 20 equally sized bins by firm age and reports the average risk rating assigned to those borrowers by their banks, whereby a higher risk rating indicates a greater likelihood of default.

The vast majority of borrowers have been in operation for less than five years when they first take out a loan (see Chart 3.2.1). Regardless of their age, however, first-time borrowers that receive a loan from a state bank are perceived to be riskier than equivalent firms that borrow from a private bank. This suggests that state banks may have a greater willingness to lend to start-ups and other young firms that private banks deem less creditworthy. To the extent that state banks lend to young firms with profitable projects that would otherwise not come to fruition, they can improve the performance of small businesses and boost economic activity in a meaningful way.

Even if they have a profitable project and a clear business plan, start-ups and other young firms are often unable to access credit for the simple reason that they lack the necessary collateral. In that kind of situation, state banks with a greater appetite for risk in respect of younger firms have the potential to play an important role. Indeed, the patterns in Turkish credit data would suggest that Turkey’s state banks are playing that very role (see Chart 3.2.2). As before, this analysis accounts for the fact that banks may be more likely to require collateral in certain years or from firms with fewer employees.

Less than half of all loans issued by state banks to first-time borrowers in this sample required collateral to be provided up front. In contrast, around 80 per cent of all loans issued by private banks to equivalent first-time borrowers required collateral. For young firms with at least a year of financial statements, state banks required collateral only 60 per cent of the time, whereas private banks did so more than 75 per cent of the time. Thus, state banks would appear to have lower collateral requirements than private banks when it comes to firms that are less than two years old.

In the EBRD regions (as in most emerging markets), weaknesses in the registration of collateral, the enforcement of contracts, bankruptcy procedures and judicial processes all serve to discourage banks from lending to the youngest and smallest enterprises.39 This box presents evidence showing that state banks can play an important role by bridging the financing gap faced by young firms, which represent an inherently dynamic (and risky) segment of the economy. Importantly, state banks’ greater ability and willingness to lend to riskier clients should not come at the expense of lending by private banks. If private and state banks can achieve such complementarity, they can both boost the incomes of traditionally unbanked sections of the population and maintain low rates of delinquency.40

Against this background, it is worrying that firms in many emerging markets have recently experienced a sharp decline in their access to correspondent banking services. Global banks have severely restricted the provision of correspondent banking services in response to the rapidly increasing cost of complying with financial crime regulations (abandoning those services entirely in some cases).42 The resulting limitations on access to correspondent banking could potentially have serious consequences for international trade, growth and financial inclusion.43 One key factor that has contributed to the withdrawal of correspondent banking services is the record US$ 8.9 billion fine that was imposed on the French correspondent bank BNP Paribas in June 2014 for violating sanctions against Sudan, Cuba and Iran, which was issued because the bank allowed international transfers to be made to banks in those countries. The ruling in that case made it clear that any bank which facilitates global transactions that threaten the integrity of the US financial system can, in principle, be tried in a US court. That penalty has led to a sharp reassessment of the cost of compliance – as regards both the required level of due diligence and the fines that could be expected – and contributed to correspondent banks’ withdrawal from countries with a high risk of financial crime.44

The EBRD regions have not been immune to those developments, with the number of active correspondent banks in those economies declining by an average of 24 per cent between 2012 and 2018 (see Chart 3.3.1). There is, however, significant variation across countries. While the number of correspondent banks fell by less than 15 per cent in countries such as Croatia and Turkey (and even increased in Georgia), Latvia saw a 29 per cent decline, Tajikistan a 48 per cent decline and Moldova a 55 per cent decline. Some of those countries were the subject of significant money laundering concerns, which resulted in global banks terminating correspondent banking services. However, in a number of countries – including Egypt, Tunisia and Ukraine – major foreign correspondent banks switched their correspondent relationships from smaller private banks to state banks. Intelligence from market participants suggests that this reflects the fact that working with state banks may involve simpler and less costly know-your-customer procedures – and, in some cases, lower levels of credit risk and reputational risk.

In order to assess the economic consequences of this sharp and sudden fall in the availability of correspondent banking, De Haas et al. (2020b) surveyed local respondent banks in the EBRD regions. That survey was conducted at the end of 2019, with questions covering the period between 2009 and 2019. Of the 131 banks that were invited to take part, 91 banks in 28 economies completed the entire questionnaire – a response rate of 69 per cent.45 That survey yields three main insights.

First, correspondent banking networks have changed over time. In 2013, 75 per cent of all correspondent banks were located in the United States of America or Germany, but those two countries had a combined market share of only 54 per cent in 2019. Correspondent banks now hail from a wider range of countries, with Russian and Austrian banks now accounting for a larger percentage of the total. Replacing US correspondent banks with banks from other regions may increase costs as a result of longer intermediation chains.

Second, respondent banks report that accessing correspondent banking services has become more difficult and more costly. For example, local banks are finding it particularly difficult to access US dollars. In 2013, only 7 per cent of banks found it difficult or impossible to access US dollars, but by 2019 that figure had increased to 26 per cent. Accessing other cross-border services, such as payment services, currency clearing and trade finance, has also become more difficult. For instance, the percentage of banks reporting that they had difficulty accessing payment services (or no access at all) rose from 5 per cent in 2013 to 13 per cent in 2019, while the equivalent figure for currency clearing increased from 20 per cent in 2013 to 27 per cent in 2019, and the figure for trade finance rose from 11 to 19 per cent over the same period. Around 10 per cent of banks report that their access to the US export market has been severely limited (or even disappeared completely) as a result of the withdrawal of correspondent banks.

Third, local banks indicate that the most important reason for the decline in correspondent banking services is the fact that correspondent banking relationships do not generate sufficient business to justify the cost of carrying out additional due diligence on customers (with this being reported by 67 per cent of respondents). In addition, 51 per cent report that foreign correspondent banks have terminated relationships as a consequence of the stricter enforcement of regulations tackling money laundering and the financing of terrorism.

How has this sharp decline in access to correspondent banking affected exports across the EBRD regions? De Haas et al. (2020b) combine those survey data on the withdrawal of correspondent banks with bank-level data from Bankfocus, information on bank branches from BEPS II and firm-level export data from the Orbis database. They show that firms in towns and cities that have experienced a substantial loss of correspondent banking services are now less likely to export, and that exporters in those localities export less than firms in towns and cities that have not seen such a withdrawal of services. This suggests that the decline in active correspondent banking across the EBRD regions has had a substantial negative impact on both local banks and their exporting clients. Similarly, a recent study found that a decline in the availability of letters of credit in destination countries for exports during the 2008-09 financial crisis had a negative impact on Turkish exports to those destinations.46

Ensuring that firms regain access to correspondent banking is especially important in times of heightened uncertainty such as the Covid-19 pandemic.47 Because of Covid-19-related disruptions to supply chains, many importers have had to source inputs from different suppliers, often from more remote countries. This has resulted in more complex transport routes, entailing longer financing periods for the trade cycle and a need to hold larger stocks, while foreign exporters have been more likely to request payment by documentary credit. These changes have significantly increased demand for trade credit. In the first seven months of 2020, for example, the EBRD’s Trade Facilitation Programme (TFP) financed trade transactions with a total value of €1 billion, a 40 per cent increase relative to the same period in 2019.

In order to address the loss of correspondent banking relationships on account of the increased challenges of complying with financial crime legislation, the EBRD – in close cooperation with international compliance bodies – has set up a three-pronged programme to promote international standards in the area of compliance, which involves the following:

1. Compliance training and certification, whereby bank staff will have the opportunity to obtain professional certificates awarded by the International Compliance Association (ICA) in areas such as due diligence on customers, prevention of financial crime, and money laundering risks in correspondent banking
2. Policy dialogue with the relevant national central bank, focusing on efforts to bring best international practices to the country in question, including specialist training to improve banks’ know your customer profiles
3. Individual advisory services for selected banks to help bring banks’ compliance procedures up to the required international standard