economic growth, and recurrent fiscal drains.<sup>24,25</sup> The perceived failure of public banking in developing countries contrasts with evidence suggesting that development banks played an important role in the rapid industrialization of Continental Europe and Japan (Cameron, 1953, 1961; Gershenkron, 1952).<sup>26</sup> While cross-country studies tend to find a negative or, at best, neutral impact of government bank ownership, it is necessary to consider that public banks are highly heterogeneous, both across and within countries. Detailed case studies highlight some success stories, such as the Village Bank system of Bank Rayat in Indonesia (Charitonenko, Benjamin, and Yaron, 1998) or the Bank for Agriculture and Agricultural Cooperatives in Thailand (Townsend and Yaron, 2001).<sup>27</sup> The prevalence, on average, of a negative impact of public banks in cross-country empirical studies can be explained by a variety of reasons. For starters, public banks in developing countries have frequently failed at reaching their targeted clientele, typically by wide margins, and even where they have done so, it has been at the expense of unduly high subsidy costs. Also, major incentive and governance problems in the operation of public banks have tended to surface, leading to such recurrent problems as poor loan origination and even poorer loan collection (thereby fostering a non-payment culture), wasteful administrative expenditures, overstaffing, plain corruption, political manipulation of lending with “clientelistic” motives, and capture by powerful special interests. All these factors have typically resulted in large losses and the need for recurrent recapitalizations, at very high fiscal costs. For example, in 2001 the Brazilian government absorbed the non-performing loan portfolios of two public banks (Banco do Brasil and Caixa Economica Federal) at a net cost of about 6 percent of GDP (Micco and Panizza, 2005). In the case of Turkey, the cost of recapitalizing the two largest public banks (Ziraat Bank and Halk Bank) in 2001 amounted to 15.5 percent of GDP (Fouad et 24 IADB (2004) revises the empirical evidence on the impact of public banks and finds that, while the results that government-owned banks have a negative impact are not as strong as previously thought, there is no indication that government ownership has a positive effect. It concludes that public banks, at best, do not play much of a role in financial development.

25 The interpretation of these findings in terms of causality is rather difficult, as the association between government participation in the banking system and poor financial development and macroeconomic performance could stem either from the need for more government intervention in countries with severe market imperfections that prevent financial development, or from a negative impact of public intervention on financial markets. Galindo and Micco (2004) try to address the problem of causality by using the methodology devised by Rajan and Zingales (1998) and find that government-owned banks do not promote the growth of those industries that rely more on external finance, nor do they promote the growth of industries that, due to reduced collateral, face more financial constraints. They conclude that what matters for growth is the development of private financial institutions.

26 Armendariz de Aghion (1999a) compares the successful development banking experience of Credit Nationale in France with the relatively unsuccessful more recent experience of Nacional Financiera in Mexico. She argues that the requirement to engage in co-financing arrangements with private financial intermediaries in the case of Credite Nationale and the type of government involvement (subsidized credit and loan guarantees in the case of France, direct ownership in Mexico) are among the factors that explain the contrasting results.

27 Following Yaron (1992), these papers use a comprehensive framework to evaluate the performance of development banks and their lending programs, mainly in terms of the outreach to their targeted clientele and the degree to which their operations are dependent on subsidies.

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