Good banks can be a major force for economic growth. They can transfer the public's savings to those businesses that need capital for productive investments. Unfortunately, many banks in poor countries have turned out to be pyramid schemes in which most of their loans are bad (non-performing) and the banks are insolvent.
However, as long as deposits are growing, they can use new deposits to pay the interest on the old and thus remain liquid. Such banks can continue to operate sometimes for decades until something causes new deposits to decline such as a macro-economic shock. The result is a banking crisis.
According to a World Bank inventory, about two-thirds of the 140 low or medium-income countries have had a banking crisis since 1976. Sixteen have had more than one, with Argentina holding the record with four.
After each crisis, the government has usually had to bail out the insolvent banks because the banks are state-owned or it insured bank deposits at private banks. The cost to taxpayers has been huge, totaling more than $1 trillion. This total will grow when current bank pyramid schemes crash. In China alone, it is estimated that banks have bad loans totaling $500 billion that probably can never be repaid and will eventually become a liability of the government.
Many of these pyramid schemes, for example, in China, have been carried out by state-owned banks that made loans to unprofitable state-owned enterprises. Private bank pyramid schemes involve owners and managers making loans to themselves or their cronies, which they do not intend to repay. After Chile privatized its banks in 1972, many become insolvent because of such insider loans--the cost to the government of bailing them out equaled 40 percent of the country's GDP.
Another such collapse in Mozambique ended with human tragedy. After the Astral bank was privatized, it became insolvent probably because of bad loans made to the owners and politicians. In 2001, the central bank appointed Antonio Siba-Siba Macuacua, a dynamic young economist, to investigate why the bank failed. He was found dead after being thrown down the stairwell of the bank.
Is there a solution to these widespread problems? Experts from the rich countries argue that governments everywhere must regulate banks to ensure that they are properly managed and introduce deposit insurance to ensure bank stability. Ironically, this approach has not worked particularly well in the rich countries, even though they presumably have more honest and capable regulators than are likely in poor countries. The percentage of the large, rich countries that have had one or more banking crises is just as high as poor countries, though the crises were usually not as severe in the rich countries. One of the biggest was the failure of thousands of U.S. savings and loans in the late 1980s, a crash that cost the government $180 billion.
It's also a fact that government deposit insurance for private banks reduces the incentive for depositors and other creditors to monitor the financial health of these institutions. In 1933, the United States was the first country to introduce national deposit insurance after the widespread failure of mostly small banks during the Great Depression, but not because of pressure from depositors. Instead, Congress bowed to pressure from the many small, high-risk banks that wanted to be protected from competition from large, low-risk banks. Unfortunately, many countries both rich and poor have followed the U.S. example.
Banking crises are largely caused by weak regulation coupled with deposit insurance. I doubt, however, whether it will be possible to improve regulatory agencies in most poor countries enough to stop future bank pyramid schemes and banking crises.
There is an alternative. New Zealand's unique system of bank regulation is a solid model for poor countries. The first step is privatization because politicians will use state-owned banks for political purposes, such as subsidizing unprofitable state-owned enterprises or to enrich themselves and their cronies.
Second, foreign banks should be allowed to enter the local market. If depositors don't trust domestic banks, they at least have the option of switching to reputable foreign banks.
Third, bank deposits should be regulated like any other financial security, primarily through information disclosure. A regulatory agency should require a bank to disclose enough financial information so that its depositors and other creditors can assess risk. Bank executives would be subject to civil and criminal penalties if they provided misleading or inaccurate information. This is the approach used to regulate companies issuing stocks and bonds in most rich countries.
Fourth, and most importantly, bank deposits, like stocks and bonds, should not be insured by the government. As with other investments, "depositors beware."
Admittedly, this alternative is not foolproof, and pyramid schemes may continue because banks provide inaccurate information. As a result, smaller, less sophisticated depositors may withdraw their deposits because they are not protected by deposit insurance and instead invest, for example, in a small business owned by family or friends, real estate, or informal financial institutions, sometimes referred to as rotating savings and credit institutions, found in many poor countries.
The formal banking system may decline in size, but this is far better than allowing pyramid schemes to squander the public's savings. Bad banks are worse than no banks.