assets of the ten largest banks in the former and around 65 percent in the latter (banks were fully government owned in transition economies). Public banks became key policy vehicles, used by governments to support the pursuit of their social and developmental agenda through the selective allocation of (often subsidized) credit. Consistently with the market failure rationale, public banks tended to focus on areas where private markets are typically missing, such as long-term finance, lending to SMEs, housing finance, and agricultural credit.

Theoretically, in underdeveloped economies, public banks may have advantages over private banks in dealing with principal-agent problems and transactions costs—as they might, for instance, be better able to access information and exploit economies of scale. The government could increase the number of viable projects that get financed through several means: (i) using privileged information or compelling the disclosure of information to lower the costs of screening and monitoring; (ii) forcing participation in insurance schemes to increase the expected return on the loan; and (iii) internalizing potential externalities and redistributing costs through taxes or government borrowing (Stiglitz, 1994).

Governments can cross-check information with income tax systems and other official records, or compel the disclosure of information that is not available to private investors. This gives publicly owned banks an advantage in selecting and monitoring borrowers, reducing the fixed costs of providing loans, and therefore reducing the breakeven rate of return of external finance.

The government can also help to solve the problems generated by externalities. As mentioned above, if the social rate of return of a project is higher than its private rate of return, private creditors may not be willing to finance it, even if it would be beneficial for society as a whole to do so. This happens because it is difficult for the private sector to internalize the social benefits that may be generated by the project. This instead can be achieved by the government, through the tax system (intra-generational risk sharing) or through government debt (inter-generational risk sharing).

In addition, government ownership of banks may increase public trust in the banking system, leading to more savings and deeper financial markets.<sup>22</sup> Also, if government-owned banks are more trusted by depositors than private banks, they will have an advantage in attracting deposits and will face lower funding costs (see Adrianova et al., 2002 for a discussion of the case of Russia).

Apart from the direct provision of credit through public banks, another widespread tool for broadening access in developing countries was the imposition of lending requirements, which obligated private banks to allocate a certain share of their loans (or even absolute amounts) to specific sectors or regions. In Brazil, for example,

> 22 Note that the government could also increase trust in the banking sector through adequate regulation and supervision of private banks, as well as through the creation of deposit insurance systems. Which type of intervention will have a larger impact in terms of increasing public trust in the financial system depends on the public’s perception of the government’s ability to provide incentives and monitor private banks relative to its ability to monitor its own agents.

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