NBER WORKING PAPER SERIES BANKING SYSTEM CONTROL, CAPITAL ALLOCATION, and ECONOMY PERFORMANCE Randall Morck M. Deniz Yavuz Berna
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NBER WORKING PAPER SERIES BANKING SYSTEM CONTROL, CAPITAL ALLOCATION, AND ECONOMY PERFORMANCE Randall Morck M. Deniz Yavuz Bernard Yeung Working Paper 15575 http://www.nber.org/papers/w15575 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 December 2009 The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2009 by Randall Morck, M. Deniz Yavuz, and Bernard Yeung. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Banking System Control, Capital Allocation, and Economy Performance Randall Morck, M. Deniz Yavuz, and Bernard Yeung NBER Working Paper No. 15575 December 2009 JEL No. G0,G21,G28,G32,O15,O16 ABSTRACT We observe less efficient capital allocation in countries whose banking systems are more thoroughly controlled by tycoons or families. The magnitude of this effect is similar to that of state control over banking. Unlike state control, tycoon or family control also correlates with slower economic and productivity growth, greater financial instability, and worse income inequality. These findings are consistent with theories that elite-capture of a country’s financial system can embed “crony capitalism”. Randall Morck Bernard Yeung Faculty of Business National University of Singapore University of Alberta Business School Edmonton, CANADA T6G 2R6 Singapore 117592 and NBER [email protected] [email protected] M. Deniz Yavuz Olin Business School Washington University in St. Louis Simon Hall 1 Olympian Way St. Louis, MO 63130 [email protected] 1. Introduction Economic growth correlates strongly with financial development (King & Levine 1993ab; Demirguc- Kunt & Levine 1996; Levine 1996; Levine & Zervos 1998; Rajan & Zingales 1998; Demirguc-Kunt & Maksimovic 1998; Beck et al. 2000; Levine et al. 2000; Beck & Levine 2002). But financial development is neither inevitable nor irreversible. Many countries never sustained dynamic financial systems; and more surprisingly, many that once did ceased doing so (Rajan & Zingales 2003). One explanation for financial underdevelopment is that growth can undermine the positions of the already wealthy (Schumpeter 1912, 1951; Morck, Stangeland & Yeung 2000, Fogel et al. 2008). Thus, Rajan & Zingales (2004) argue that early 20th century financial development enriched an initial cadre of tycoons who, in many countries, then successfully oversaw financial development reversals that deprived potential competitors and innovative upstarts of capital. This, they posit, locks in a status quo favoring the initial tycoons and their heirs. Morck, Wolfenzon, & Yeung (2005) further argue that many countries block financial development entirely to forestall competition that threatens entrenched economic elites. Consistent with these theses, economies that entrust more of their economies to old-moneyed business families grow slower and sustain lower living standards than otherwise similar countries, suggesting that protecting these families imposes costs on the broader economy (Morck, Stangeland & Yeung 2000). Such countries also have more corrupt government, less efficient judiciaries, and more bureaucratic red tape (Fogel 2006) – all likely barriers to entrepreneurs. However, the most direct way to limit competition from new entrepreneurs is probably to limit their access to capital by controlling the country’s financial system (Rajan & Zingales 2004). Such situations are described as elite capture. This arises if an elite – a minority such as the very wealthy, political insiders, or an ethnic group – controls an economic, political, or other institution to advance the minority’s interests, rather than general social welfare (Glaeser, Scheinkman & Shleifer 2003; Hellman, Jones & Kaufmann 2003; and others). Elite capture of a country’s financial system might occur in various ways, but would be incomplete without control over banks, which Beck et al. (2008) show to be an essential source of capital for small businesses across countries We measure the potential elite capture of each country’s banking system by the fraction of its largest banks, listed and unlisted, controlled by tycoons and business families. For brevity, we refer to this as family control. 1 Controlling for banking system size, stock market size, and other relevant factors we find that more predominantly family-controlled banking systems allocate capital less efficiently, measured either by Wurgler’s (2000) cross-industry correlation of capital spending growth with value-added or by non- performing loans. The efficiency loss is comparable to what La Porta et al. (2002), Caprio et al. (2007) and others find for state-controlled banking systems. However, family-controlled banking systems also correlate with financial instability and slower per capita GDP and productivity growth; while state- controlled banking systems do not. These findings are highly robust - including to reasonable sources of endogeneity. Family control of banks also correlates with proxies for crony capitalism (Murphy et al. 1991, 1993; Shleifer & Vishny 1993; Shleifer & Vishny 1998b; Haber 2002; Krueger 2002; Rajan & Zingales 2004; Daniels & Trebilcock 2008; Fisman & Miguel 2008; and others), such as high income inequality and barriers to entry. We conclude that, on average, entrusting the governance of large banks to tycoons or families provides efficiency losses comparable to those of state-controlled banks, augmented by the inequality consequences associated with crony capitalism. Of course, our results imply neither that tycoon and family control are always inefficient nor that banking systems predominantly controlled by tycoons or families always harm their countries. Our results do, however, indicate such cases to be atypical and therefore especially deserving of study. 2. The economics of bank control The social purpose of the financial system is to allocate the economy’s savings to its highest value uses (Tobin 1989; Wurgler 2000) – especially to innovative upstart firms (Schumpeter 1912). A healthy banking system is therefore key to sustained prosperity (King & Levine 1993a). Consequently, bank governance affects not only banks, but the whole economy. Indeed, policies that maximize the bank owners’ wealth – such as excessive risk taking to exploit deposit insurance or probably bailouts – might adversely affect the overall economy. Such externalities divorce efficient bank governance from maximizing bank shareholder valuations (Saunders et al. 1990). Keeping this distinction in mind, we focus on the implications of bank control for the overall economy, rather than for banks’ shareholders. 2 Our results build on large body of previous work exploring state-controlled banking and family- controlled firms, and on a much smaller literature investigating family-controlled banks. We now review the most relevant parts of these literatures. 2.1 State-controlled versus private sector banks State-controlled banks can rise above market forces to allocate capital where it advances social goals, rather than where it creates the greatest bank-level profit. Such considerations allow that state-controlled banking systems might not only better promote social goals, such as income equality or equality of opportunity, but also allocate an economy’s capital more efficiently than private-sector banks (Lewis, 1950). However, like all state-owned enterprises, state-controlled banks are vulnerable to a range of “government failure problems” (Shleifer & Vishny 1998a). Thus, Krueger (2002, p. 15) writes that state- controlled banking often means “cronies can be favored through the granting of domestic credit when that credit is allocated at rates significantly below market.” Even where such overt corruption is rare, populist political entrepreneurs might still use state-controlled banks to buy political support with unsound lending (Dornbusch & Edwards 1992; Dinc 2005). Which arguments weigh more heavily in a typical country is thus an empirical question. At the bank level, state control correlates with poor financial performance, and privatizations increase financial performance (Megginson et al. 2004; Boubakri et al. 2005). This is consistent with both social goals trumping profit and crony lending. However, at the economy level, greater state control of banking correlates with lower per capita income levels, growth rates and worse financial sector instability (La Porta et al. 2002), and with greater capital misallocation (Wurgler 2000, Taboada 2008). The weight of the evidence is thus consistent with state-controlled banking having major costs in terms of depressed living standards, capital misallocation, and systemic instability, and thus of policy options favoring private bank ownership (La Porta et al. 2002). To explore these issues further, we distinguish two flavors of private ownership – widely held banks versus family held banks, which are described below. 2.2 Widely Held Banks 3 Career concerns are thought to force professional CEOs of widely held firms to maximize shareholder value (Fama 1977), and market forces are thought to fine-tune such CEOs’ incentives towards this end (Demsetz & Lehn 1985). Free