metadata: authors: 0: author: Berger, Allen N
1: author: Hasan, Iftekhar
2: author: Klapper,Leora
docna: 0: docna: Further evidence on the link between finance
            and growth : an international analysis of community banking
            and economic performance
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,Social Policy,Legal Products,Judicial System Reform,Industrial Economics,Health Care Services Industry,Rural Microfinance and SMEs,Microfinance,Financial Regulation & Supervision,Economic Growth,Legal Reform,Legislation,Regulatory Regimes
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The authors contribute to both the
            finance-growth literature and the community banking
            literature by testing the effects of the relative health of
            community banks on economic growth, and investigating
            potential transmission mechanisms for these effects using
            data from 1993-2000 on 49 nations. Data from both industrial
            and developing nations suggest that greater market shares
            and efficiency ranks of small, private, domestically-owned
            banks are associated with better economic performance, and
            that the marginal benefits of higher shares are greater when
            the banks are more efficient. Only mixed support is found
            for hypothesized transmission mechanisms through improved
            financing for small and medium enterprises or greater
            overall bank credit flows. Data from developing nations are
            also consistent with favorable economic effects of
            foreign-owned banks, but unfavorable effects from
            state-owned banks.
repnme: repnme: Further evidence on the link between
            finance and growth : an international analysis of community
            banking and economic performance
display_title: Further evidence on the link between
            finance and growth : an international analysis of community
            banking and economic performance
listing_relative_url: /research/2003/08/2483262/further-evidence-link-between-finance-growth-international-analysis-community-banking-economic-performance
topicv3: Common Law m1326145 2071,Economic Growth m1326241 471,Microfinance m1327227 367,Health m1504661 3480,Trade Guarantees m1505111 3906
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Development Research Group (DECRG)
no_of_pages: 44
model_extractions: I POLICY RESEARCH WORKING PAPER 3105

# Abstract

Berger, Hasan, and Klapper contribute to both the finance-growth literature and the community banking literature by testing the effects of the relative health of community banks on economic growth, and investigating potential transmission mechanisms for these effects using data from 1993-2000 on 49 nations. Data from both industrial and developing nations suggest that greater market shares and efficiency ranks of small, private, domestically-owned banks are associated with better economic performance, and that the marginal benefits of higher shares are greater when the banks are more efficient. Only mixed support is found for hypothesized transmission mechanisms through improved financing for small and medium enterprises or greater overall bank credit flows. Data from developing nations are also consistent with favorable economic effects of foreignowned banks, but unfavorable effects from state-owned banks.

This paper-a product of Finance, Development Research Group-is<sup>partofalargereffortinthegrouptostudy</sup> international banking. Copies of the paper are available free from the World Bank,<sup>1818H Street NW, Washington,DC</sup> 20433. Please contact Agnes Yaptenco, room MC3-446, telephone 202-473-1823,<sup>fax202-522-1155,emailaddress</sup> ayaptenco@worldbank.org. Policy Research Working Papers are also posted on the Web<sup>at http://econ.worldbank.org.The</sup> authors may be contacted at aberger@frb.gov, hasan@rpi.edu, or Iklapper@worldbank.org.<sup>August2003.(38 pages)</sup> _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage_<sup>_the exchangeof ideas about_</sup> _development issues. An objective of the series is to get the findings out quickly, even if the presentations_<sup>_are less than fully polished. The_</sup> _papers cariy the names of the authors and should be cited accordingly. The findings, interpretations,_<sup>_and conclusions expressed in this_</sup> _paper are entirely those of the authors. They do not necessarily represent the view of the World_<sup>_Bank,its Executive Directors, or the_</sup> _countries they represent._ Produced by the Research Advisory Staff
# **Further Evidence on the Link between Finance and Growth: An International Analysis of Community Banking and Economic Performance**

> Allen N. Berger

> Board of Governors of the Federal Reserve System, Washington, DC 20551 U.S.A.

> Wharton Financial Institutions Center, Philadelphia, PA 19104 U.S.A. aberger@frb.gov

Iftekhar Hasan Rensselaer Polytechnic Institute, Troy, NY 12180 U.S.A. Berkley Research Center, Stem School of Business, New York, NY 10012 U.S.A. hasanlirpi.edu Leora F. Klapper Development Research Group, The World Bank, Washington, DC 20433 U.S.A. lklapper(worldbank.org JEL Classification Numbers: G21, G28, G34, F36 Keywords: Banks, Community Banking, SMEs, Financial Development, Economic Growth, International.

> The authors thank our conference discussants, Phil Strahan and Giovanni Dell'Ariccia, the editors Bob DeYoung, Curt Hunter, and Greg Udell, the anonymous referees, as well as Asli Demirguc-Kunt, Robert Cull, Jim Hanson, Patrick Honohan, Paul Wachtel, and other participants in the "Whither the Community Bank?" Conference at the

> Federal Reserve Bank of Chicago and the World Bank Economists' Forum for very helpful suggestions that

> improved the paper greatly, and Nate Miller and Mingming Zhou for outstanding research assistance. The opinions expressed do not necessarily reflect those ofthe Federal Reserve Board, the World Bank, or their staffs.
# **Further Evidence on the Linkbetween Finance and Growth: An International Analysis of Community Banking and Economic Performance**

An important research development of the last decade has been the affirmation of a strong<sup>link between</sup> the financial system of a nation and the performance of that nation's economy. Starting<sup>with King and Levine</sup> (1993), the research has generally found that countries with "better" financial<sup>systemstendtohavefaster</sup> economic growth. However, this research has not come to consensus regarding exactly<sup>whichdimensions of the</sup> financial system matter most - the size, efficiency, competitiveness, and regulation of<sup>banks; the roles of nonbank</sup> financial institutions, such as finance companies, buyout funds, venture capital funds,<sup>and insurance companies;</sup> the scale and liquidity of public debt and equity markets; the legal rights of shareholders<sup>and creditors;and so</sup> forth. As well, the exact transmission mechanism from the financial<sup>system to real activity is less thanperfectly</sup> transparent from the research results. It is not completely clear the extent to<sup>which abetterfinancialsystem</sup> improves economic growth primarily through higher levels of investment, or primarily<sup>through targeting</sup> investments to more productive uses.' We try to contribute to the finance-growth literature by focusing on one dimension of the financial<sup>system</sup> and how its effects may be transmitted into economic growth. Specifically, we test<sup>hypothesesabout how the</sup> health of community banks relative to other banks affects a nation's economy. We<sup>hypothesizethat relatively</sup> large market shares and relatively high efficiency for community banks may promote<sup>economicgrowth.One</sup> transmission mechanism may be through improved financing opportunities for small<sup>andmediumenterprises</sup> (SMEs). Community banks may provide more credit to SMEs and may target their credit<sup>toward more productive</sup> SMEs, given the advantages that community banks may have this type of lending. A<sup>stronger SME sector may, in</sup> turn, be an engine of economic growth through enhanced entrepreneurship and<sup>risk-taking, increasedprivate</sup> ownership of businesses, potentially high productivity of these firms, and/or increased<sup>competition that reduces</sup> the market power of entrenched large firms and stimulates their productivity. A<sup>secondmode of transmission may</sup> be through greater overall flows of bank credit. Healthier community banks may<sup>not only have provide greater</sup> credit flows from their own portfolios, but might also compete more effectively with<sup>therestof the banking</sup> industry and reduce the market power of other banks, encouraging them to reduce<sup>pricesand expandlending.</sup> We test the hypotheses using data on 49 nations from 1993-2000, representing<sup>a rich mixture of economic</sup> conditions, market structures, and degrees of development. Our key exogenous<sup>variablesmeasuring the relative</sup> I In the interest of brevity, we will not review the finance-growth literature here.<sup>SeeWachtel(2003)fora recent review.</sup>
health of community banks are the total market shares of community banks<sup>(defined in various ways), and their</sup> weighted-average efficiency ranks estimated using cost and profit functions<sup>for the banks in each nation in each</sup> year. Importantly, these variables measure the health ofcommunity banks relative<sup>to other banks within the same</sup> nation, rather than comparisons of individual banks across nations that operate under<sup>very different conditions.As</sup> a consequence, these relative health variables are reasonably comparable across<sup>nations.</sup> We run three sets of tests separately for 21 developed nations and for the 28<sup>developing nations.First, we</sup> run reduced-form regressions of gross domestic product (GDP) growth on the relative<sup>health of community banks,</sup> controlling for other dimensions of the financial system (public debt and equity markets,<sup>regulation,legal rights,</sup> bank competition) identified in the finance-growth literature. This allows<sup>us to test whether the relative health of</sup> community banks affects economic growth.

Second, we try adding measures of the SME employment share and the ratio of<sup>overall bank lending to</sup> GDP as additional regressors to these GDP growth equations to test the transmission<sup>mechanisms.In a recursive</sup> model of the transmission mechanisms, community bank health would directly affect<sup>oneor bothof these</sup> intermediate variables and then these variables would directly affect<sup>economicgrowth.Thus, to the extent that</sup> improved SME financing is an important mechanism through which<sup>relatively strong community banks improve</sup> economic growth, then we may expect a positive measured effect of the SME employment<sup>share on GDP growth,</sup> and a substantial diminishment of the measured effects of community bank<sup>health on GDP growth when the SME</sup> employment share is controlled for in the regressions. Similarly, if greater<sup>overallflows of bankcredit is a key</sup> transmission mechanism, then we may expect a positive measured effect ofthe<sup>overall-bank-lending-to-GDP ratio</sup> and substantial diminishment of the measured effects of the relative health of<sup>community banks on GDP growth</sup> when the overall bank lending variable is included in the regressions.

Third, we regress the SME employment share and bank lending to<sup>GDP ratioon therelativehealth of</sup> community banks and the control variables. We test whether community<sup>bank healthhas positive effects on the</sup> SME sector and on overall bank lending, as predicted by the two transmission<sup>mechanisms.</sup> In addition to trying to contribute to the finance-growth literature, we<sup>try to add to the community banking</sup> literature in several ways. First, we examine the effects of community banks on<sup>overall economic performance.</sup> Community banking studies often focus on flows of credit to SMEs, but<sup>generallydonotexaminethe</sup> 2
consequences of this flow for the national economy.<sup>2Evenif healthy community banks tendto channelmore</sup> credit to SMEs, this may not translate into higher economic<sup>growth if the credit flows to SMEs are ineffective,or</sup> if there are significant adverse consequences of<sup>the relatively poor health of other (non-community)banks.3</sup> Second, our international orientation and application<sup>to many developed and developing nations differs</sup> from the traditional focus of community banking<sup>studies on a single developednation.We acknowledgethat as in</sup> any study involving international comparisons, some<sup>rather heroic assumptions are needed, because one cannot</sup> control for the many differences in culture, markets,<sup>regulatory structures,and data collectionstandards across</sup> nations. We try to mitigate these problems through<sup>themeansnotedabove-1) analyzingdevelopedand</sup> developing nations separately, 2) using measures of<sup>community banking healthrelative to other banks within the</sup> same nation, and 3) including controls for other important<sup>nationaldifferences.</sup> Third, we allow for different potential definitions of<sup>community banksin our empiricalanalysis,rather</sup> than defining them one way. For developed<sup>nations,weusetheconventionaldefinition-small, private,</sup> domestically-owned institutions - based on the<sup>researchthatsuggests thatthesebankshavecomparative</sup> advantages in lending to SMEs, a core function of<sup>community banks.For developing nations,we allow for the</sup> possibility that state-owned banks and foreign-owned<sup>banksmay also function as community banks when small,</sup> private, domestically-owned banks have difficulty<sup>providing sufficient credit.The market penetrationsof state-</sup> owned and foreign-owned banks are substantial<sup>inmany countriesaround the world,andthere are oftenlarge</sup> differences in the shares of these banks across countries<sup>withinthesameregion.For example, assetsat state-</sup> owned banks are 52% of the total in Brazil versus<sup>12%in Chile,whereas foreign-ownedbanking assets are only</sup> 17% of the total in Brazil versus 32% in Chile<sup>(Barth,Caprio, andLevine2001).As discussedbelow, state-</sup> owned and foreign-owned institutions may be able<sup>to overcomesome of their disadvantagesin SME lending by</sup> using government subsidies, by organizing in<sup>a decentralized fashion,orby usingsuperior technologies.</sup> Finally, we include the average efficiency ranks of community<sup>banks as well as the market shares ofthese</sup> institutions. Community banking research often<sup>focuseson the share or quantity effectof thesebanks without</sup>

> 2 few studies do directly examine the economic consequences<sup>of community banking.One study finds that deregulation of</sup> geographic restrictions on intrastate and interstate<sup>banking by U.S.states raised the rates of new-business incorporationsin</sup> these states (Black and Strahan 2002). Another study<sup>finds that reductions in capital at small banks in U.S. states during the</sup> early 1990s credit crunch led to significant reductions<sup>in the employmnent,payroll, and number of small businessesin these</sup> states (Hancock and Wilcox 1998).

3One study does find positive associations between<sup>the SME employment ratio and both economic growth and development</sup> (Beck, Demirgtlc-Kunt, and Levine 2003a).

3
considering their efficiency or quality. A relatively high share for community banks may not have<sup>favorable</sup> economic effects if these banks are poorly managed. It seems more likelythat communitybanks<sup>will be effective</sup> if these institutions are also relatively efficient. We also include the interaction between market<sup>sharesand</sup> efficiency ranks, with the expectation of a positive interaction effect. That is, we expect the marginal<sup>benefit of an</sup> increase in market share for community banks to be greater, the more efficient are these banks.

By way of preview, the data from both developed and developing nations are consistent with the hypotheses that greater market shares and higher weighted-average efficiency ranks of small,<sup>private,</sup> domestically-owned banks are associated with faster GDP growth. The coefficients on the interaction<sup>terms</sup> between market shares and efficiency ranks are also positive, consistent with the hypothesis that the marginal benefits of higher shares for community banks are greater when these banks are more efficient. The data provide only mixed support for the two hypothesized transmission mechanisms from the relative health of<sup>community</sup> banks to economic growth through improved financing opportunities for SMEs or through greater overall flows of bank credit. For developing nations, the data are also consistent with favorable economic effects from larger market shares for foreign-owned banks, but the converse holds for larger shares for state-owned<sup>banks.</sup> Sections I and 2 briefly review the extant literatures on community banking in developed and developing nations, respectively. Section 3 deals with data and efficiency estimation issues. Section 4 shows our empirical models and results, and Section 5 concludes.

# 1. **Brief review of prior findinis on community bankine in developed nations**

We briefly review the extant research on community banking in developed nations, focusing on which categories of banks have comparative advantages in the core function of SME lending. We discuss available information relevant to the advantages and disadvantages of small versus large banks, state-owned banks, and foreign-owned banks. It will become clear why we choose the conventional definition of small, private, domestically-owned institutions as community banks for our analysis of developed nations.

1.1. **SmaHl versus large banks in developed nations**

There is a significant amount of research on the issue of the advantages related to bank size in engaging in relationship lending to informationally opaque SMEs in developed nations. Under relationship lending, banks accumulate proprietary information through contact over time with the firm, its owner, its suppliers, its customers, and its local community on a variety ofdimensions. Some of this relationship-based information is "soft," i.e., not easilyquantified or verified, such as information about characterand reliability ofthe firm's owner. Relationship 4
lending is distinguished from transactions lending, under which due diligence<sup>and contract terms aregenerally</sup> based on "hard" information that is quantifiable and verifiable at the time of<sup>origination,such as certified audited</sup> financial statements, payments histories, collateral that is easy<sup>to value and sell, or creditscores.</sup> Large banks are hypothesized to have difficulty in extending relationship loans<sup>to informationally opaque</sup> SMEs. Large banks may suffer Williamson-type organizational diseconomies<sup>of providing relationshiplending</sup> services along with the transactions lending services and other services<sup>to their large corporatecustomers because</sup> of the different technologies employed (Williamson 1967, 1988). It<sup>may alsobedifficultforlargebanksto</sup> transmit the soft information associated with relationship lending through<sup>the communication channels of large</sup> banking organizations (Stein 2002). As well, the fact that the loan officer<sup>is the repository for this information</sup> may create agency problems within the banking organization that require<sup>a closely-heldstructurewithfew</sup> managerial layers that large organizations cannot easily accommodate (Berger<sup>and Udell 2002).In addition, large</sup> banks are on average headquartered at longer distances from potential<sup>SMErelationshipborrowers,making it</sup> difficult to process locally-based soft information (Hauswald and<sup>Marquez2002).</sup> The empirical literature using data from developed nations generally supports<sup>the hypothesis thatlarge</sup> banks are disadvantaged in SME lending. Studies often find that<sup>large banks allocate a much lower proportion of</sup> their assets to SME loans than do small banks (e.g., Berger, Kashyap,<sup>andScalise1995) and that the ratio of SMvE</sup> loans to assets declines after large banks are involved in M&As (e.g.,<sup>Berger, Saunders,Scalise, and Udell1998,</sup> Peek and Rosengren 1998, Strahan and Weston 1998). Some<sup>studiesalsoexamine the typeof SMEloans</sup> extended by large banks and find that they tend to a) lend to larger,<sup>older, more financially secure firms (Haynes,</sup> Ou, and Bemey 1999), b) charge lower rates, earn lower yields,<sup>andrequire collateralless oftenon their SME</sup> loans (e.g., Hannan 1991, Berger and Udell 1996, Carter, McNulty,<sup>and Verbrugge 2004), c) have shorter and less</sup> exclusive relationships (Berger, Miller, Petersen, Rajan, and Stein<sup>2002), d) base their lending decisions more on</sup> financial ratios rather than prior relationships (Cole, Goldberg,<sup>and White 1999, Berger, Miller, Petersen, Rajan,</sup> and Stein 2002), and e) lend at greater distances and have less<sup>personal contact with borrowers (Berger, Miller,</sup> Petersen, Rajan, and Stein 2002), consistent with comparative<sup>disadvantagesoflargebanks inextending</sup> relationship credit.<sup>4</sup> _4I_ mportantly, a significant disadvantage for large banks does not<sup>necessarily implyasignificantlackof supplyof</sup> relationship-based credit in their markets because there may<sup>be</sup> "extemal<sup>effects"in whichother existing banks reactand</sup> increase their own supplies (e.g., Berger, Saunders, Scalise, and Udell<sup>1998, Berger,Goldberg, and White 2001,Avery and</sup> Samolyk 2004) or new banks form to help offset the lack of supply (Berger,<sup>Bonime, Goldberg,White,forthcoming).</sup> 5
# **1.2. State-owned banks in developed nations**

State-owned banks that lend to SMEs and potentially serve as<sup>community banks is less of anissue in</sup> developed nations than in developing nations, botui because the market presence<sup>of state-ow,nedbanks is usually</sup> nuch less in developed nations and bec-use these nations<sup>typically have well-developed</sup> -rivate banking industries that lessen any need for government involvement. Nonetheless,<sup>most developednations do havestate-owned</sup> banks. A study of 92 developed and developing nations as of<sup>1995finds only 7 nations with no state ownership of</sup> banks - Canada, Cyprus, Hong Kong, New Zealand, South Africa,<sup>U.K.,andtheU.S.(La Porta,Lopez-de-</sup> Silanes, and Shleifer 2002).5 Because of their lesser importance<sup>in developed nations,we exclude state-owned</sup> banks from consideration from the definition of community banks<sup>in these countries.</sup>

## **1.3. Foreign-owned banks in developed**<sup>**nations**</sup>

roreign-owTieu' **baiI -Sii** .ay **bue** at signifi antdisadvar.aes In pIrviduiI reIaI,iooship<sup>**legII...,**</sup> servL SMEs in developed nations. Foreign-owned banks are usually<sup>large and headquartered far away from localSMEs,</sup> and so may suffer size- and distance-related disadvantages similar<sup>to those of large domestically-ownedbanks.In</sup> addition, differences in economic conditions, language, culture,<sup>and regulatorystructure from the bank's home</sup> market may compound problems in dealing with soft relationship<sup>information.</sup> There is very little direct evidence of the SME lending propensity of foreign-owned<sup>banksin developed</sup> nations, but several types of indirect evidence reinforce the<sup>argument that foreign-ownedbanks are unlikely to be</sup> oriented toward providing relationship-lending services to SNivs<sup>inuhese naLions.</sup><sup>**In**somiecases,'lvreign,-u-w--ud</sup> banking organizations engage in the "follow-yourr-customer"<sup>strategyof settingup officesin nations where their</sup> large corporate home-nation customers have foreign affiliates, and<sup>so arelikely to have a wholesaleorientation</sup> (e.g., Goldberg and Saunders 1981, Grosse and Goldberg<sup>1991).</sup> In addition, foreign-owned banking organizations in the U.S. tend to have a wholesale orientation<sup>(e.g.,DeYoung andNolle1996),and tobuy</sup> domestic banks that already have performance problems<sup>and so may findit difficult to extend credit (e.g., Peek,</sup> Rosengren, and Kasirye 1999). Most studies of the efficiency of<sup>foreign-ownedbanks in developed nations find</sup> these institutions to be less efficient on average than domestically-owned<sup>banks, with the possible exceptionof</sup>

> 5Governments of both developed and developing nations<sup>mayalsopromoteSMEfinancinginotherways.Some</sup> gove* r .er,ts subsi,dize 01 _lendi..g_ **_IA,_** _support_ fp..vat=sector barnks, such **as,** the Sprkassen **in** Germanuy.<sup>**OLthers**</sup> use government guarantees for SME loans, such as the Small Business<sup>Administration guaranteesintheU.S.Some</sup> governments also nromote access to financing is by organizing<sup>public credit information bureaus or by encouraging private-</sup> sector information exchanges. These exchanges may collect,<sup>summarize,and share data aboutloan applicantsthat might</sup> reduce lender costs or increase transparency in ways<sup>that increaseSMEcredit (seeJappelli and Pagano 2002).</sup>
U.S.-owned banks operating abroad (e.g., DeYoung<sup>and Nolle1996, Berger, DeYoung,Genay, and Udell 2000).</sup> Based on the evidence given here, we exclude foreign-owned<sup>banks from considerationfrom the definition of</sup> community banks in developed nations.

# 2. **Brief review of prior findings on community**<sup>**banking in developingnations**</sup>

As discussed in Section 1, small, private domestically-owned<sup>banksindevelopednationsmayhave</sup> advantages in lending to informationally opaque<sup>SMEs. Indevelopingcountries, othertypesof financial</sup> institutions also often make substantial portions of<sup>the SME loans,including state-owned banks, foreign-owned</sup> banks, and large microlenders. When conventionally-defined community banks<sup>havedifficultyproviding</sup> sufficient credit, these alternative types of community<sup>banks may be able to overcome some of their disadvantages</sup> by using government subsidies, by organizing themselves<sup>inadecentralizedfashion,or byusingbetter</sup> technologies to collect and analyze hard credit<sup>information thanother banksin thesenations.</sup>

# **2.1. State-owned banks in developing**<sup>**nations**</sup>

State-owned banks include both direct and indirect state<sup>ownership(via other state-ownedinstitutions,</sup> such as insurance companies), although the government<sup>often namesthe chairmanand other boardmembers.</sup> These banks may have been established by socialist<sup>governments, such as the transition nations in EasternEurope,</sup> or created or nationalized to redirect credit to "underserved"<sup>sectorsand populations, as India.In other cases,</sup> these are former private banks that were nationalized<sup>duringa distress period,as occurredin East Asia.6</sup> State-owned institutions may be directly subsidized<sup>by taxpayers or indirectly subsidized through a higher</sup> likelihood of govemment bailout in the event of<sup>default than similarly-sizedprivateinstitutions. These public</sup> institutions generally have a stated policy agenda<sup>to developa specificindustry,sector,or region, and they often</sup> make loans at subsidized (below-market) rates. These goals may include increasing competition<sup>and</sup> diversification within an industry, assistance<sup>to new entrepreneurs,expansionof exports,etc.</sup> As discussed further below, efficiency ranks for state-owned banks<sup>may not be as relevant for private institutions,since these</sup> banks may not try to maximize efficiency.

Some research shows that state-owned banks in very<sup>underdevelopedfinancialsystemsdirect credit</sup>

**6** A class of state-owned institutions is development banks,<sup>which may operate as fully state-owned government agencies or</sup> corporations and may or may not be subject to prudential<sup>bank regulation versus independentoversightas a government</sup> agency. These banks generally receive most of their<sup>funds from the government,as wellasbilateraland multinational</sup> agencies (such as the World Bank) and may or may<sup>not takedeposits.We do not includedevelopment banks in our analysis</sup> because of data limitations.

7
towards small- and micro-enterprises that would not have received credit otherwise, but that the nonperforming loan rate at many of these institutions is very high (Hanson 2002). Most of the research suggests that large concentrations of state bank ownership have some unfavorable economic consequences, such as reduced overall access to financing, increased likelihood of financial crises, or diminished financial system development (e.g., Barth, Caprio, and Levine 1999, Clarke and Cull 2002, La Porta, Lopez-de-Silanes, and Shleifer 2002). These unfavorable consequences may occur in part because of weak governance, lack of aggressive collection procedures that encourages a poor credit culture, or because some of the resources may be channeled for political purposes (e.g., Sapienza forthcoming). See Appendix I for examples of state-owned banks in developing nations.

# **2.2. Foreign-owned banks in developing nations**

Foreign bank participation has increased in emerging markets around the world, in part because of the removal of barriers to direct foreign ownership of financial firms, bank restructurings, financial crises, and stateowned bank privatizations. These banks may be able to overcome any disadvantages to SME lending due to size, distance, and differing home market conditions described above because they often step into markets where the supply of credit to SME from domestic banks may be lacking for various reasons. Whereas the foreign-owned banks may be disadvantaged in relationship lending to informationally opaque SMEs because of difficulties in using soft information, these banks may have advantages in transactions lending to some SMEs because of better access to information technologies for collecting and assessing hard information. For example, Citibank's "Citibusiness" initiative provides SME financing in 18 countries using industry-level data to make credit decisions. Credit is targeted to SMEs in the industrial segments of the nation identified as having growth potential, in some cases without historical credit information on the specific firms.<sup>7</sup> One study of foreign bank participation in over 80 countries finds that foreign banks have higher profitability in emerging markets, whereas the opposite is true in developed countries (Claessens, Demirgiic-Kunt, and Huizinga 2001). Thus, relative inefficiency of foreign-owned banks in developed nations reported above may be reversed in developing nations in which the competition from domestically-owned banks may not be as strong. Most other studies of lending by foreign-owned banks are also consistent with these banks performing relatively well. One study finds evidence that foreign banks in Argentina and Mexico may provide credit smoothing and

> 7 Another example is GE Capital's Budapest Bank, a former state-owned bank that was privatized. GE Capital offers new technology and U.S.-based training for Budapest Bank SME'loan officers, consistent with exploitation of advantages in transactions lending.

8
financial stability during financial crises<sup>(Goldberg,Dages,andKinney2000).Anotherstudy using data for</sup> Argentina, Chile, Colombia, and Peru<sup>finds that large foreign banks in Chileand Columbia lend slightly more (as</sup> share oftotal lending) to SMEs than<sup>large domestic banks, although their findings are not significant for Argentina</sup> and Peru (Clarke, Cull, Martinez Peria,<sup>and Sanchez 2002). Furthermore, a globalsurvey of firms fnds that firms</sup> of all sizes are less likely to identify<sup>high interest ratesandaccessto long-termloansas obstaclestogrowthin</sup> countries with higher foreign-bank<sup>participation(Clarke,Cull,andMartinezPeria2002). However,foreign-</sup> owned banks may concentrate their lending<sup>in large loans and to SMEs with favorablehard information available.</sup> One study finds that large, foreign-owned<sup>banksinArgentina appear tohaveproblemssupplyingcreditto</sup> informationally opaque SMEs (Berger,<sup>Klapper,and Udell2001).</sup> 23. Large microlenders in developing nations Large microlenders - both private and<sup>state-owned-are additionalpotential providersof community</sup> banking services. Microloans are generally defined<sup>as very small,unsecured, short-term loans tolow-income</sup> clients. These clients are often self-employed<sup>entrepreneursin the informal, unregulated sector of the economy,</sup> such as individuals that sell without business<sup>licensesandmay notkeepaccountingrecordsor pay taxes.</sup> Commercial banks may be unwilling to lend to<sup>such clients using standardcredit practices,but microlenders may</sup> be able to provide credit using alternative practices<sup>(Armendariz de Aghion and Morduch 2000, Robinson 2001).8</sup> We are not able to separately identify the large<sup>microlendersin our empirical analysis.In most countries,</sup> non-governmental organizations (NGOs) and<sup>commercialmicrolenders are not regulatedby the bank regulators</sup> (although some may take deposits) and<sup>donothavepublic filingrequirements,andso theirinformationis</sup> a In recent years, there has been a significant<sup>increasein large, profitablelending by microfinance lenders that have operated</sup> without government subsidies. The trend from<sup>non-profittofor-profit, "commercial"microlendingreduces thissector's</sup> dependence on government subsidies and<sup>outlays, whileimprovingservicestothe poor.The commercializationof</sup> microlenders in Latin America has been<sup>shown to not reducetheir goal of providing credit to the poorer clients (Peck 2000).</sup> It is argued that the majority of successful<sup>microfinanceinstitutionsareprivate institutionsthatlendonmarket-based</sup> principles (CGAP Focus Note 1997). This<sup>report also suggests that state-owned microfinance institutions are often subject to</sup> political influences and suffer from poor<sup>lending practices, such as weak borrower selection criteria and subsidized lending</sup> rates. An example is Bank Rakyat Indonesia<sup>(BRI),a profitable state-owned bank and microfinancelender.It operateswith</sup> US$12 billion in assets, a nationwide network<sup>of 325branchofficesand3,595unit "desas"thatprovidemicrofinancial</sup> products. Until the 1980s, all lending<sup>decisionswere madecentrally,local units had no financialaccountability, and bank</sup> arrears rose to over 30%. The key to the bank's<sup>turnaround success was the that desa staffwere given complete operational</sup> autonomy for their unit, without any government<sup>mandateson reachingspecific "lendingtargets"for specificpopulation</sup> groups. Each unit desa is treated independently,<sup>with its ownbalance sheetand incomestatements. Inaddition, the bank</sup> requires from each unit clear and transparent<sup>financialreportingand imposes local fiscal accountability. Furthermore,unit</sup> managers are held accountable for their<sup>performanceand receivefinancialincentives.This example highlights the potential</sup> benefits from a large organization using decentralization<sup>tooffsetsomeof itsdisadvantagesinSMElending (Robinson</sup> 2001).

9
generally unavailable. In other cases, microlenders may appear in our data set as subsidiaries or departments of state-owned banks or foreign-owned banks, although we cannot separately identify their microlending activities.<sup>9</sup>

# 3. **Data and efficiency issues**

We briefly discuss our data sources, variable definitions, and give some summary statistics. We then briefly outline how the efficiency ranks are computed.

# **3.1. Data sources, variable definitions, and summary statistics**

We employ both bank-specific and national-level variables in our analysis. The bank-specific data are taken from the BankScope database, with informnation on over 7,500 banks each year. The national-level data are taken from the Office of the Comptroller of the Currency, World Bank and Intemational Monetary Fund (IMF) data on World Development Indicators, IMF Intemational Financial Statistics, Wall Street Joumal and Heritage Foundation Govemance data, and several other public sources.

Table 1 shows definitions for most of the variables employed in the analysis, and also shows summary statistics for these variables for the developed nations (Panel A) and developing nations (Panel B). The developed nations correspond to the IMF definition for "high-income" countries, and the developing nations correspond to IME "middle-income" and "low-income" countries. Table 2 shows the names of each of the developed and developing nations and the numbers of banks and potential community banks in each nation in the sample, averaged over the sample period. As discussed, for developed nations, we use the conventional definition of community banks as small, private, domestically-owned institutions (SMALL banks), whereas for developing nations, we include state-owned banks (STATE banks) and foreign-owned banks (FOREIGN banks) as potential community banks as well. STATE and FOREIGN banks are defined as having 50% or more state and foreign ownership, respectively, although govemment and foreign owners may exert effective control with less than 50% ownership in some cases. One other difference is that for developed nations, SMALL banks include institutions with less than US$1 billion in assets, whereas for developing nations, SMALL banks are truncated below $100 million in assets due to the smaller bank sizes in developing nations.1<sup>0</sup> This should not create any difficulties of 9For example, Shorebank Advisory Services, a subsidiary of the U.S.-owned Shorebank Corporation has transferred its expertise in providing commercial and housing loans in underserved markets in the U.S. to international development initiatives around the world. It has ownership relationships with institutions in Asia, Eastern Europe, and Latin America that aim to increase financing to SMEs. For instance, Shorebank began operating in Azerbaijan in 1998 to finance new businesses. By 2002, their credit portfolio in Azerbaijan reached US$1 million and loan sizes increased from US$4,000 in 1998 to US$100,000 (Tumag 2003).

° The US$1 billion and US$100 million cutoffs for SMALL'banks are based on real 1992 dollars using the CPI.

10
comparability, since the data from developed<sup>and developingnationsare never mixed.</sup> An important caveat is that we do not<sup>have data for all banks in every nation.The BankScope database</sup> covers banks in each nation that control<sup>at least85%of the bankingassets,whichmaydeletea significant</sup> proportion of SMALL banks. As well,<sup>STATE banks in somenations may be significantly underrepresentedin</sup> our data set because some STATE<sup>banks do not file the standardaccounting forms used in the BankScopedata</sup> set. In addition, for the earlier years of<sup>our sample,FOREIGN bank coveragein BankScope may have been less</sup> incomplete. Thus, the STATE and FOREIGN<sup>marketsharesmaybesmallerthanthoseinstudiesthatuse</sup> alternative methods of measuring these<sup>shares, but we use the shares drawnfrom BankScopein order to havea</sup> time series-cross section of STATE and<sup>FOREIGNshares that is consistent with our STATEand FOREIGNbank</sup> efficiency measures and the remainder of<sup>our data set.11While the omissionof some potential community banks</sup> reduces the informativeness of our analysis,<sup>this data limitationdoesnot eliminate the value of thefindings.It</sup> seems reasonable to assume that the<sup>market sharesandweighted-averageefficiencyranks forthereporting</sup> community banks are indicative of the<sup>healthof communitybanksas a wholerelativeto other banks.</sup> The three endogenous variables shown<sup>in Table1 are GDP GROWTH,the annual growth rate of GDP,</sup> SME EMP, the employment share held by<sup>SMEs, and BKLENDGDP, the ratio oftotal banklending to GDP.The</sup> summary statistics for these variables are<sup>for the years1994-2000.Data on GDP and totalbank lending are taken</sup> from the IMF International Financial Statistics<sup>(2002).Data on SME EMPdata are takenfrom Ayyagari, Beck,</sup> and Demirgaic-Kunt (2002) and Klapper<sup>and Sulla (2002).This data is collected from official government sources</sup> and includes all businesses with less<sup>than 250 employees -including services, manufacturing,trade,agriculture,</sup> etc. The data for GDP GROWTH and<sup>BKLENDGDP are available for almost every year for every nation, but we</sup> have significantly fewer observations<sup>for SME EMP.</sup> The key exogenous variables for both<sup>developed and developing nations include SMALL SHARE, the</sup> total market shares held by SMALL banks,<sup>and SMALL COST EFF RANK andSMALL PROFIT EFF RANK,</sup> the weighted-averages of cost and profit<sup>efficiencyranksforSMALLbanks.Thesummarystatisticsforthe</sup> exogenous variables shown are for 1993-1999<sup>becausethese variablesare laggedone yearin theempirical</sup> analysis to help mitigate potential endogeneity<sup>problems.The variablesarecomputedfromthe BankScope</sup> database using information on all the available<sup>banks in each nation in each year,and then converted into national</sup> For example, in some cases our STATE<sup>shares aresignificantlylessthan those reportedin Barth,Caprio,andLevine</sup> (2001), which is based on a survey of bank regulators<sup>and supervisors.</sup> 11
totals or weighted-averages for use in our empirical analysis. Importantly, these are measures ofthe relative health of SMALL banks - higher market shares for SMALL banks implies lower market shares for other banks, and higher weighted-average efficiency ranks for SMALL banks means lower efficiency ranks for other banks. For the developing nations, we also include STATE SHARE, STATE COST EFF RANK, STATE PROFIT EFF RANK to measure the relative health of state-owned banks, and FOREIGN SHARE, FOREIGN COST EFF RANK, FOREIGN PROFIT EFF RANK to measure the relative health of foreign-owned institutions.

The control variables for the market, regulatory, and legal environments in which the banks compete, which are shown in other research to be important. We include MKTCAPGDP, the market value of all publicly held debt and equity securities relative to GDP, as an indicator of the development of public capital markets, which is compiled primarily from the IMF International Financial Statistics.1<sup>2</sup> We include ECON FREEDOM, the Heritage Foundation/World Street Journal Index of Economic Freedom, an index that reflects the extent of government intervention in the economy and monetary policy, banking and financial regulations, relative openness of trade, and related factors. This variable ranges from 1 (most freedom) to 5 (least freedom). We include COMMON LAW, a dummy for whether the justice system is English Common Law, taken from La Porta, Lopezde-Silanes, Shleifer, and Vishny (1997). Common law is shown to offer greater creditor rights and be associated with more developed financial systems and improved ownership structures (e.g., La Porta, Lopez-de-Silanes, Shleifer, and Vishny 1997, 1998). We also specify BANK CR3, the three-bank concentration ratio computed from BankScope, to account for differences in market power and access to credit across nations.'<sup>3</sup> The structureconduct-performance hypothesis predicts higher prices and restriction of credit from greater concentration. However, high concentration may encourage banks to invest in lending relationships because the borrowing frms are less likely to find alternative future sources of credit (e.g., Petersen and Rajan 1995). The empirical research

> 12 In some cases, missing information was filled in using the Annual Reports of stock exchanges in the individual nations. 13 The measurement of BANK CR3 may be significantly affected by some of omissions from the BankScope database discussed below.

12
yields mixed findings. 1<sup>4</sup> We also include dummies for region<sup>and year of the observation(not shown in Table 1)</sup>

# **3.2.** Computation of efficiency **mnks**

Cost and profit efficiency ranks measure how well a bank is predicted<sup>to perform relative to other banks in</sup> a particular sample or a peer group for producing the same output<sup>bundle under the same exogenous conditions.</sup> In our case, we estimate efficiency ranks relative to banks<sup>in the samenation inthe same year.</sup> We specify the commonly-used translog functional form to estimate<sup>the cost and profit functions for each</sup> nation for each year. For convenience, we show only the cost function: where C represents the bank's total costs. The cost function includes<sup>three variableoutput variablesy (total loans,</sup> other earning assets, and total deposits), two variable input<sup>price variables w (the noninterestexpenses to fixed</sup> assets, and interest expenses to total deposits), and one fixed<sup>input z (financialequity capital). The In u termis a</sup> factor that represents a bank's efficiency and Inv is a random error<sup>that incorporatesboth measurement error and</sup> luck. The cost function is estimated using the (Inu +<sup>Inv)</sup> as<sup>a compositeerror term.The normalizationby bank</sup> equity (z,) reduces heteroskedasticity, and allows banks of any<sup>size to have comparable residual terms from which</sup> the efficiency ranks are calculated. The normalization by the last<sup>input price (w</sup> 2<sup>) ensures price homogeneity.</sup> The level of cost efficiency of a bank is determined by comparing<sup>its actual costs to the best-practice</sup> 14 For example, many studies find negative effects of bank concentration,<sup>such as higher loan rates and less new firm creation</sup> and expansion (e.g., Hannan 1991, Black and Strahan 2002, Cetorelli<sup>2002, Cetorelli and Strahan 2002).In contrast, other</sup> studies find positive effects of bank concentration, such as higher<sup>growth ratesin the number of new firms and greater access</sup> to financing by consumers, small firms, new manufacturing<sup>firms,andmaturefinns(e.g.,PetersenandRajan1995,</sup> DeYoung, Goldberg, and White 1999, Bonaccorsi di Patti<sup>and Dell'Ariccia2001,Cetorelli2002).One study of Italian</sup> banking finds that concentration has a positive effect on access<sup>to financingby SMEs, but a negative effecton largefirms</sup> (Bonaccorsi di Patti and Gobbi 2001). One study with data<sup>on both developed and developing nations finds that firns in</sup> nations with greater bank concentration are less able to access<sup>bank financing,although theimpact of bank concentration</sup> decreases with firm size and greater national financial development<sup>(Beck,Demirgtlc-Kunt,and Levine 2003b).Another</sup> study of 41 developed and developing nations fnds higher<sup>growth inindustriesin whichyoungfirmsareespecially</sup> dependent on extemal finance in nations with greater bank<sup>concentration(Cetorelliand Gambera 2001).</sup> 13
minimum costs to produce the same output under the same conditions using estimates of the efficiency factor In _u,_ which is disentangled from the estimated cost function residual using some distributional assumptions.'<sup>5</sup> For our purposes, we use the efficiency rank, for which we need use only the ordering of the residuals, which are assumed to be in the same order as the In u. That is, we assume that the bank with the highest cost function residual is the least efficient, the one with the lowest residual is the most efficient, and so forth in between these extremes. We create a rank ordering of the banks in each year within a nation based on the residuals. The ranks are then converted to a uniform scale over [0,1] using the formula (orderit - I)/(nt - 1), where orderi, is the place in descending order of the ith bank in the tth year in terms of its residual and nt is the number of banks in the nation in year t. Thus, the bank i's efficiency rank in year t gives the proportion of the other sample banks in that nation and year with lower efficiency (e.g., a bank in year t with efficiency better than 70% of other banks in the country has a rank of 0.70). The bank with the highest residual has the worst rank of 0 [(I - 1)/(n, - 1)], and the bank with the lowest residual has the best rank of I [(nt - 1)/(n. - 1)].

The use of efficiency ranks is preferred over the efficiency levels because the ranks are more comparable over nations and across time. The ranks for every nation and time period follow the same uniform [0,1] distribution, whereas the distributions of efficiency levels may be very different, depending on conditions in the nation and time period. We wish to abstract from these differences and focus on relative efficiency within a nation and time period. That is, our null and altemative hypotheses are about the health of community banks relative to other banks in the same nation at the same time, and the weighted-average efficiency rank of community banks should mean about the same thing in any nation at any time. For example, a value of 0.50 would mean that community banks are on average equally efficient with other banks in their nation and time period.

Profit efficiency ranks are estimated in a similar fashion. Total profits replace total costs and we add a constant before taking the log to avoid taking a log of negative number. We also rearrange the residuals in ascending order, so that the bank with the highest profit function residual is given the highest rank of **1.16** The profit efficiency ranks may be considered to be the more accurate indicator of the quality of the management of the institution, at least for private institutions, given that profit efficiency is the more general concept and that the managerial goals are more likely achieved by higher profits than lower costs.

> **_'5_** For a general description and examples of bank efficiency estimation, see Berger and Mester (1997).

> **16** The use of output quantities, rather than output prices is necessitated by the lack of accurate data on output prices. Other arguments also favor the use of this alternative profit function (see Berger and Mester 1997).

14
Some caveats apply to the use of efficiency<sup>ranks for STATE banks in developing nations.These banks</sup> may have goals other than minimizing<sup>costs or maximizing profits (e.g.,"directedlending"),whichmay make</sup> their measured efficiency ranks inaccurate<sup>indicators of managerial quality.As well, these institutions often have</sup> unusual balance sheets. STATE banks<sup>in some cases operate with very little equity (their equity is effectively the</sup> nation's treasury). Profit efficiency<sup>measures forthesebanks mayalsobecompromisedinsomecasesby</sup> understated losses or overstated<sup>revenueson problemloans,as STATEbanks oftenrolloverorreschedule</sup> payments on such loans, rather than classifying<sup>them as nonperformingor losses(Hanson 2002).</sup> Similar concerns apply to the measured<sup>efficiency ranks of FOREIGNbanks in developing nations,as</sup> there may be cross-subsidies from the<sup>parent banking organizationin another nation.As well, FOREIGNbanks</sup> may be able to operate with very little<sup>financialcapital, in effect, using the capital of organization as a whole.17In</sup> some cases, FOREIGN banks may<sup>be set up to serveestablished corporatecustomers withoperationsin many</sup> nations, so that some of the related<sup>costs and revenues may be bookedin other nations.</sup>

# **4. Empirical models and results**

We first briefly show our empirical models.<sup>We then give the empiricalresults using SMALL banksas</sup> our definition of community banks<sup>for both developed and developing nations.We also report the findings when</sup> we also allow STATE and FOREIGN<sup>banksto actas community banksfor developingnations.As well, we</sup> briefly discuss some of the measured<sup>effects of the controlvariablesandreport additional robustnesschecks.</sup>

# **4.1. Empirical models**

For our first set of tests of the effects of<sup>the relative health of community banks on economicgrowth for</sup> developed nations, we run the reduced-form<sup>regressions:</sup> GDP GROWTH = a + Pi *SMALL<sup>SHARE + P</sup> 2<sup>*SMALL EFFRANK</sup> + 012*SMALL SHARE x EFF RANK + yi*MKTCAPGDP + y2*ECON FREEDOM + y3*COMMON LAW + **y4*** BANK<sup>CR3</sup> + Control variables for region and year. (2) 7 Our definition of FOREIGN banks<sup>includes both subsidiaries and branches of foreign banks, although we do not makea</sup> distinction in our empirical analysis. In<sup>some nations, subsidiariesand branches are subject to different capital requirements.</sup> 15
The dependent variable is GDP GROWTH. For developed nations, we use the conventional definition of community banks - small, private, domestically-owned institutions with less than US$1 billion - or SMALL banks. The key exogenous variables measuring the relative health of these banks are their total market shares (SMALL SHARE), their weighted-average efficiency ranks (SMALL EFF RANK) measured using either the cost or profit efficiency concept, and the interaction between share and efficiency rank (SMALL SHARE x EFF RANK). We also include the control variables described above (MKTCAPGDP, ECON FREEDOM, COMMON LAW, BANK CR3), and dummies for the region (Asia, Oceania, and Western Europe, with North America excluded as the base case) and for the year of the observation (1994, ... 1999, with year 2000 excluded as the base case). As noted, the exogenous variables (other than the region and time dummies) are lagged one year.

> We estimate 6 regressions with various forms of the specification in equation (2) to check the robustness of the findings. Regression I includes SMALL SHARE and SMALL EFF RANK using cost efficiency rank, and the regional and time dummies (i.e., excludes the interaction effect of share and efficiency rank and the national-

> level control variables). Regression 2 is identical to Regression I except that it is based on profit efficiency rank,

> rather than cost efficiency rank. Regressions 3 and 4 add the interaction term SMALL SHARE x EFF RANK to the specifications, and Regressions 5 and 6 also add the national-level control variables, MKTCAPGDP, ECON

> FREEDOM, COMMON LAW, and BANK CR3.

> We acknowledge the possibilityof simultaneous-equations bias in equation (2)- that higher GDP growth may affect the health of community banks in ways for which we are unable to control in the regressions. We try to

> mitigate this potential problem in two ways, although we cannot entirely eliminate it. First, we use measures of the relative health of community banks rather than absolute values, so that any endogeneity is effective only to the

> extent that higher GDP growth affects community banks more than other banks in the nation. Second, as noted, we also measure our exogenous variables with a one-year lag, which mitigates the potential endogeneity problem

> because the future cannot cause the past. As discussed below, we also try robustness checks with longer lags.

For our second set of tests for developed nations, we add SME EMP and BKLENDGDP as additional regressors to these GDP GROWTH equations in (2) to test the transmission mechanisms. In a recursive model of the transmission mechanisms, the relative health of community banks would affect one or both of these variables and then these variables would directly affect GDP GROWTH. We test for positive effects of SME EMP and BKLENDGDP on GDP GROWTH to see if these variables directly influence economic growth. We also test for diminishment of the measured effects of community bank health on GDP GROWTH, which is expected to occur 16
to the extent that the effects of this health<sup>on economicgrowthare transmitted throughimprovedfinancing</sup> opportunities for SMEs or through increased<sup>overallflowsof bankcredit.Theseregressionsaresubjectto</sup> additional potential endogeneity problems<sup>to the extent that GDP GROWTHdirectly increasesor decreases the</sup> SME employment share or bank lending<sup>relative to GDP.</sup> For our third set of tests for developed<sup>nations, we regress SME EMP and BKLENDGDPon the measures</sup> of the relative health of community banks<sup>andthe control variables,i.e.,usingthe same specificationof the</sup> regressors as in equation (2). We test whether<sup>relative community bank health has the positive effects that would</sup> be predicted by recursive models of<sup>thetwotransmissionmechanisms.Asaboveforthe GDPGROWTH</sup> equation, the SME EMP and BKLENDGDP<sup>equations aresubjectto possible simultaneous-equationsbias if</sup> higher SME employment or greater overall<sup>bank lending affects the relativehealth of community banks in ways</sup> for which we are unable to control. As<sup>examples,the bias may occur if a stronger SMEsector increases demand</sup> for community banking services or if greater<sup>overallbanklendingincreasesGDPgrowththatin tumbenefits</sup> community banks. We again try to mitigate<sup>the potentialproblemby using relativemeasuresof thehealth of</sup> community banks and by measuring<sup>these variables witha one-yearlag.</sup> For the developing nations, we first use<sup>equation(2) and run the same tests as for the developed nations</sup> except for the slightly different definition of<sup>small banks(less than US$100 million in assets, rather than less than</sup> US$I billion), and different regional dummies<sup>(Asia, Africa, and Transition [formerly Socialist Eastem Europe],</sup> with Latin America excluded as the<sup>base case).</sup> For the developing nations, we also<sup>adjust themodeltoallowforthepossibility thatSTATEand</sup> FOREIGN banks may act as community<sup>banks:</sup> GDP GROWTH = a + ,B,*SMALL<sup>SHARE +3</sup> 2<sup>*SMALL EFFRANK</sup> + PI2*SMALL SHARE x EFF RANK + o,*STATE SHARE + 52*STATE EFF<sup>RANK</sup> + 812*STATE SHARE x EFF RANK

- + 01*FOREIGN SHARE + 02*FOREIGN<sup>EFFRANK</sup> + 012*FOREIGN SHARE x EFF RANK

+ y,*MKTCAPGDP + y2*ECON FREEDOM + y3*COMMON LAW + Y4* BANK CR3 17
> + Control variables for region and year.

(3)

> In equation (3), we add the total market shares, weighted-average efficiency ranks, and interaction terms for both STATE banks and FOREIGN banks and treat all three as potential types of community banks. All of the tests using SME EMP and BKLENDGDP are run analogously.

> **4.2. Results for developed nations using** SMALL **banls as community banks**

The results for developed nations are shown in Table 3. Panel A reports the results for the 6 specifications of equation (2) for GDP GROWTH for the first set of tests. Panel B, Regressions 7 and 8 show the effects of adding SME EMP and BKLENDGDP as additional regressors to full specifications of the GDP GROWTH equations. Panel B, Regressions 9 to 12 give the findings from specifying SME EMP and BKLENDGDP as the dependent variables for our third set of tests.

In Panel A, the estimated coefficients on SMALL SHARE and SMALL EFF RANK are positive and statistically significant at the 10% level or better in all 6 cases - using both cost and profit efficiency ranks, including or excluding the interaction of share and efficiency rank, and including or excluding the national-level control variables - consistent with the hypothesis that developed nations with relatively healthy community banks have greater GDP growth, all else equal. The estimated coefficients on the interaction term SMALL SHARE x EFF RANK are also positive in all cases in which it appears, and are statistically significant at least the 10% level in the full specifications using both cost and profit efficiency ranks. This is consistent with the hypothesis that the marginal benefit of a higher market share for community banks is greater, the more efficient these banks are.

We evaluate the economic significance of these findings by evaluating the effects of changing the market share of community banks by 10 percentage points, and (separately) changing the weighted-average efficiency rank of community banks by 10 percentage points. We evaluate the effects for a typical nation with a SMALL SHARE of 0.25 and a SMALL SHARE and SMALL EFF RANK of 0.50 using the most complete specifications shown in Regressions 5 and 6.

The marginal effect of an increase in SMALL SHARE is oGDP GROWTHI/SMALL SHARE = Pi + P12 x SMALL EFF RANK, where PI and 112 are the coefficients on SMALL SHARE and the interaction term as shown in equation (2). Substituting in the coefficient estimates from Regression 5 in Panel A of Table 3 and a value for SMALL EFF RANK of 0.50 gives 0.034 + 0.026 x 0.50 = 0.047. Using the estimates from Regression 6 gives 0.042 + 0.013 x 0.50 = 0.0485. Thus, an increase in SMALL SHARE of 0.10 is estimated to increase 18
GDP GROWTH by about 0.005 (i.e., = 0.10 x 0.05) or about<sup>**1/2**</sup> of one percentage<sup>point, whichis economically</sup> significant relative to the mean GDP GROWTH of 0.030 or 3.0%.

The marginal effect of an increase in the SMALL EFF RANK is oGDP GROWTHISSMALL EFF<sup>RANK</sup> = P2 + P12 x SMALL SHARE. Using the coefficient estimates from Regressions 5 and 6 in Panel A of<sup>Table 3</sup> and a value for SMALL SHARE of 0.25 gives 0.033 + 0.026 x 0.25 = 0.0395 and 0.005 + 0.013<sup>x 0.25 = 0.0083.</sup> Thus, an increase in SMALL EFF RANK of 0.10 is estimated to increase GDP GROWTH<sup>by about 0.004 (cost)</sup> and 0.001 (profit) or about I to 4 tenths of one percentage point.

In Panel B of Table 3, we add SME EMP and BKLENDGDP as additional regressors<sup>tofull</sup> specifications of the GDP GROWTH equations using cost and profit efficiency<sup>ranksin Regressions7and8,</sup> respectively. The estimated coefficients of both SME EMP and BKLENDGDP are positive in all 4 cases,<sup>but are</sup> statistically significant at the 10% level in just 2 cases. In terms of economic significance, an increase<sup>in these</sup> variables of 0.10 is estimated to increase GDP GROWTH by about 2 tenths of one percentage point (SME EMP) and less than one tenth (BKLENDGDP) of one percentage point. The measured effects of community bank<sup>health</sup> on GDP GROWTH do not appear to be substantially diminished by the inclusion of<sup>theSME and bank lending</sup> variables, which casts some doubt on the strength of the hypothesized transmission mechanisms.<sup>As noted, these</sup> regressions may be subject to additional endogeneity problems to the extent that GDP GROWTH<sup>directly affects</sup> SME EMP or BKLENDGDP.

In Regressions 9-12 of Panel B in Table 3, the estimated coefficients on SMALL SHARE, SMALL EFF RANK, and the interaction term SMALL SHARE x EFF RANK are positive and statistically significant<sup>at the</sup> 10% level or better in all cases for both the SME EMP and BKLENDGDP equations. This<sup>is consistent with the</sup> two hypothesized transmission mechanisms, although we are mindful of the potential<sup>endogeneity problemin</sup> which SME EMP or BKLENDGDP may affect the relative health of community<sup>banks.In terms of economic</sup> significance, an increase in SMALL SHARE of 0.10 is estimated to increase SME<sup>EMPby 0.03545using cost</sup> efficiency ranks in Regression 9 and by 0.0785 using profit efficiency ranks in Regression<sup>10,or about 3 to8</sup> percentage points, which are economically significant relative to the mean SME EMP of<sup>0.600 or 60 percent.An</sup> increase in SMALL EFF RANK of 0.10 is estimated to increase SME EMP by<sup>0.01408 (cost) andby 0.05540</sup> (profit) or about I to 6 percentage points. In terms of effects on overall bank lending, an increase in SMALL SHARE of 0.10 is estimated to increase BKLENDGDP by 0.0168 (cost) and by 0.02175 (profit)<sup>or about 2</sup> percentage points, and an increase in SMALL EFF RANK of 0.10 yields estimated effects on BKLENDGDP of 19
0.02045 (cost) and 0.01353 (profit) or about Ihto 2 percentage points.

# **4.3. Results for developing nations using SMALL banhs as community banks**

Table 4 shows our first set of results for developing nations, which specify only SMALL banks as community banks. In Panel A, the estimated coefficients on SMALL SHARE, SMALL EFF RANK, and the interaction term SMALL SHARE x EFF RANK are positive and statistically significant at at least the 10% level, and are robust across the specifications. Consistent with developed-nations results, the developing-nations data support the hypotheses that relatively healthy SMALL banks are associated with faster economic growth, and that the marginal benefit of a higher market share for these banks is higher when these banks are more efficient.<sup>18</sup> With respect to economic significance, an increase in SMALL SHARE of 0.10 is predicted to increase GDP GROWTH by 0.00947 (cost) and by 0.0 1945 (profit) or about I to 2 percentage points, which are large in magnitude. An increase in SMALL EFF RANK of 0.10 is estimated to increase GDP GROWTH by 0.0068 (cost) and 0.00538 (profit) or about **1/2** of one percentage point.

In Regressions 7 and 8 in Panel B of Table 4, the estimated coefficients of SME EMP are positive and statistically significant at the 5% level. An increase in SME EMP of 0.10 is estimated to increase GDP GROWTH by about _V 2_ of one percentage point. The estimated BKLENDGDP coefficients are positive but not statistically significant (and so we do not calculate their economic significance). Again, the measured effects of community bank health on GDP GROWTH do not appear to be substantially diminished by the inclusion of SME EMP and BKLENDGDP.

In Regressions 9-12, the estimated coefficients on SMALL SHARE and SMALL EFF RANK are positive and statistically significant in all cases for both the SME EMP and BKLENDGDP equations, and the interaction term SMALL SHARE x EFF RANK is positive in all cases, and but not always statistically significant. In terms of effects on SME employment, an increase in SMALL SHARE of 0.10 is estimated to increase SME EMP by 0.0091 (cost) and by 0.0266 (profit), or about 1 to 3 percentage points. An increase in SMALL EFF RANK of 0. 1O is estimated to increase SME EMP by 0.021 (cost) and by 0.0205 (profit) or about 2 percentage points. In terms of effects on overall bank lending, an increase in SMALL SHARE of 0.10 is estimated to increase BKLENDGDP by 0.0098 (cost) and by 0.03135 (profit) or about 1 to 3 percentage points, and an increase in

> 18 A related finance-growth study finds that bank efficiency is positively related to economic growth in four developing Asian nations (Ferrier 2001), but it is focused on the efficiency of all banks, rather than the relative efficiencies of community banks versus other banks.

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SMALL EFF RANK of 0.10 yields estimated effects<sup>on BKLENDGDP ofO'01 865 (cost) and 0.02438 (profit) or</sup> about 2 percentage points.

4.4. **Results for developing nations using alternative**<sup>**deinitionsfor communitybanks**</sup> Table 5 shows our second set of results for developing nations,<sup>which includes relative health of STATE</sup> and FOREIGN banks as SMALL banks. In Panel<sup>A, the estimatedcoefficients onSMALL SHARE,SMALL</sup> EFF RANK, and the interaction term SMALL SHARE x<sup>EFF RANKare positive and statistically significantat</sup> least the 10% level in all the specifications. An increase in<sup>SMALLSHARE of 0.10 is predicted to increase GDP</sup> GROWTH by 0.0 120 (cost) and by 0.0 1335 (profit) or about<sup>I percentage point,and an increase in SMALL EFF</sup> RANK of 0.10 is estimated to increase GDP GROWTH<sup>by 0.0085 (cost) and 0.00378 (profit) or about1/3 to one</sup> full percentage point. The data again provide consistent support for the hypotheses<sup>thatrelativelyhealthy</sup> SMALL banks are associated with faster economic growth,<sup>withsomewhat largereffectsforsharesthan for</sup> efficiency. The measured interaction effects again support<sup>the hypothesis that themarginaleffectof a higher</sup> market share for SMALL banks is greater when the banks<sup>aremoreefficient.</sup> The estimated coefficients on STATE SHARE are all negative<sup>and statistically significant.This supports</sup> the hypothesis that a larger state-owned banking sector<sup>isassociatedwithadverseaggregateeconomic</sup> performance, and is consistent with the literature reviewed<sup>above.The coefficients on STATE EFF RANK and</sup> the interaction term STATE SHARE x EFF RANK are<sup>mixedand mostly not statistically significant, consistent</sup> with the arguments above that measured efficiency ranks<sup>maynotbeverymeaningful forSTATEbanks.</sup> Evaluating the economic significance of the STATE<sup>SHAREfindingsgives somewhatinconsistentresults,</sup> presumably because of the difficulties with the efficiency<sup>effects in the interactionterm.We do not evaluate the</sup> economic significance of the STATE EFF RANK findings,<sup>since they are not statisticallysignificant.</sup> The estimated coefficients on FOREIGN SHARE are all<sup>positiveandstatisticallysignificant. This</sup> supports the hypothesis that a larger foreign-owned banking<sup>sector is generally positively associated with faster</sup> GDP growth in developing nations, and is generally<sup>consistentwith theliterature.Similar to the STATE bank</sup> results, the findings for the efficiency ranks of FOREIGN<sup>banksandtheirinteractiontermsarenotentirely</sup> consistent, making it difficult to draw strong conclusions<sup>from themor fromany tests of economicsignificance</sup> based on them. As noted, the efficiency of FOREIGN banks<sup>in developing nationsmay be difficult to measure.</sup> In Regressions 7 and 8 of Panel B in Table 5, the estimated coefficients<sup>of SME EMP are positive, but are</sup> only statistically significant in one of the two cases at<sup>the10%level.AnincreaseinSME EMPof 0.10is</sup> 21
estimated to increase GDP GROWTH by about 1/3 of one percentage point. The estimated BKLENDGDP coefficients are positive but not statistically significant. Again, the measured effects of SMALL bank health on GDP GROWTH do not appear to be substantially diminished by the inclusion of SME EMP and BKLENDGDP, although the measured effects of STATE and FOREIGN bank shares may be diminished.

In Regressions 9-12 of Table 5, the estimated coefficients on SMALL SHARE and SMALL EFF RANK are again all positive for both the SME EMP and BKLENDGDP equations, although in one case, the coefficient on SMALL EFF RANK loses its statistical significance from the inclusion of the STATE and FOREIGN terms (i.e., it was significant in Table 4, but not in Table 5). An increase in SMALL SHARE of 0.10 is estimated to increase SME EMP by 0.01565 (cost) and by 0.0277 (profit), or about I to 3 percentage points, and a 0.10 increase in SMALL EFF RANK is estimated to increase SME EMP by 0.02968 (cost) and by 0.01635 (profit) or about 2 to 3 percentage points. In terms of effects on overall bank lending, a 0.10 increase in SMALL SHARE is estimated to increase BKLENDGDP by 0.03190 (cost) and by 0.01195 (profit) or about I to 3 percentage points, and 0.10 increase in SMALL EFF RANK raises BKLENDGDP by estimates of 0.00595 (cost) and 0.00483 (profit) or about **1/2** of one percentage point. The interaction term SMALL SHARE x EFF RANK is positive in three of four cases, but loses all of its statistical significance when the STATE and FOREIGN terms are included.

Also in Regressions 9-12 of Table 5, the estimated coefficients on STATE SHARE are all negative and statistically significant and the estimated coefficients on FOREIGN SHARE are all positive and statistically significant. Analogous to GDP GROWTH findings above, greater shares for STATE banks are negatively associated with SME employment and bank lending and vice versa for FOREIGN banks. We again do not evaluate economic significance for these shares because of difficulties with the measured efficiency effects.

# **4.5. Selected control variable results**

We briefly note some of the findings regarding the control variables for other dimensions of the financial system on GDP GROWTH, SME EMP, and BKLENDGDP in the three results tables. The measured effects of MKTCAPGDP on GDP growth are positive and statistically significant in all the Panel A regressions in Tables 3, 4, and 5, confirming the standard result in the finance-growth literature that the development of public debt and equity capital markets is positively related to economic growth. The measured effects of MKTCAPGDP on SME EMP and BKLENDGDP are generally statistically insignificant or inconsistent, which is not surprising, given that the transmission mechanism for public capital markets is not expected to provide substantial capital to SMEs orto operate through banks.

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The coefficients on ECON FREEDOM,<sup>the index that reflects the extent of governmentinterventionin</sup> monetary policy, relative openness<sup>of trade, andrelatedissuesarenegativein all theregressions(althoughnot</sup> always statistically significant),<sup>consistentwith thefinancial-growthliteraturefindingsthat morefreedomhas</sup> beneficial effects. The findings<sup>for COMMONLAW, whichidentifiesnations withEnglish commonlaw, are</sup> generally insignificant or inconsistent,<sup>whichmaybesurprising, giventhe strengthof this variablein other</sup> research.

The findings for BANK CR3<sup>aremixed,as also occursin theempirical literature.The coefficientsare</sup> generally negative and significantly<sup>significantfor developednations, consistent with the exercise of market power</sup> under the structure-conduct-performance<sup>hypothesis.However,the coefficients are often positive and insome</sup> cases statistically significant<sup>for developing nations, consistent with the benefits from market power in terms of</sup> investments in lending relationships

# **4.6. Additional robustness**<sup>**checle**</sup>

As shown in the tables above,<sup>the main findings with regardto the economiceffectsof thecommunity</sup> bank health are robust to a<sup>number of factors,including the specification of either cost or profit efficiency ranks, to</sup> the inclusion or exclusion of the<sup>interactionof shareand efficiencyrank,andthe inclusionor exclusionof the</sup> national-level control variables<sup>for factorsidentified in the finance-growthliterature.The main findings are also</sup> shown to hold for both developed<sup>and developingnations.</sup> A number of additional checks<sup>not shown in the tables are briefly describedhere.First, we try altemative</sup> definitions of the endogenous<sup>variables.For example, we try replacing GDP GROWTHwith GDP growth per</sup> capita, replacing BKLENDGDP<sup>with the total-private-sector-credit-to-GDPratio, and replacing SME EMP with</sup> the share of enterprises that are<sup>SMEs,and the main resultsare materially unaffected.</sup> We also try altering the specification<sup>of some of the measures of the relativehealth of community banks.</sup> For example, we replacing the<sup>weighted-average efficiency ranks of the community banks with weighted average</sup> ranks of other financial ratios that<sup>may reflect bank quality- such as the ratio of total costs to assets and the return</sup> on assets ROA. These replacements<sup>yield no materialchangein findings.</sup> As well, we try including some<sup>additional variablesfromthe finance-growthliteratureas extracontrol</sup> variables. We try adding a measure<sup>of international trade (exports plus imports as a ratio to GDP), and the results</sup> 23
remain butare weakened.'<sup>9</sup> We also try using the bank regulation variable from Barth, Caprio, and Levine (2001) - which measures the restrictions on banking organizations engaging in securities, insurance, real estate activities, and ownership of nonfinancial firms - in place of our ECON FREEDOM variable, and the main results are strengthened. However, our results are weakened if we include both the regulation and freedom variables, likely due to collinearity from including two variables measuring regulation. In addition, we try including a measure of education (secondary school enrollment percentage, taken from World Development Indicators), and our results continue to hold in most cases. As well, we try including variables for Government Consumption (from Intemational Financial Statistics) and Composite Risk (taken from the Wall Street Joumal/Heritage Foundation Governance data), and the main results are robust, albeit weakened.

> In addition, we try altering the data sample in several ways. We try excluding the effects of the Asian crisis by dropping all observations from Asia for 1997 and 1998. As a further measure, we try excluding all Asian

> observations. The main results remain robust, but weakened by the reduced numbers of observations. Similarly,

> we find the results to be robust when the Transition nations are excluded. We also experimented with extending the lag structure beyond measuring the exogenous variables with a one-year lag to further mitigate the potential endogeneity problem. We try measuring the dependent variables as two- and three-year averages or growth rates to create additional temporal separation between the endogenous and exogenous variables. The results are robust, but weaker with two-year averages/growth rates, and are no longer significant with three years because of the

> substantially reduced numbers of observations.

> Finally, we try running the models specifying fixed-effect dummies for each nation in place of the national-level control variables (which do not vary much within a nation) and the regional dummies (which are

> constant for each nation). The fndings for the GDP GROWTH and BKLENDGDP regressions remain robust, but the SME employment regressions become insignificant due to the smaller numbers of observations.

> 5. Conclusions

> We test the effects of the relative health of community banks on economic growth and investigate two

> potential transmission mechanisms for these effects. The relative health of community banks is measured by the total market shares of these banks and their weighted-average efficiency ranks - indicators of how well they

> perform relative to other banks within the same nation. The potential transmission mechanisms are through

> 19 We view international trade primarily as an endogenous variable that reflects the vitality of the economy, rather than as exogenous to economic growth.

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improved financing opportunities<sup>for SMEs and throughincreased overallflowsof bankcredit.We allow for</sup> different potential definitions of<sup>community banks,including the p6ssibilitythatstate-ownedbanks and foreign-</sup> owned banks may function<sup>as community banksin developing nationsas well assmall, private,domestically-</sup> owned banks. Our empirical<sup>analysis employsdata over the period 1993-2000on the economic performanceand</sup> financial systems of 49 nations,<sup>as well as detailedfinancial informationon theindividual banksthat operatein</sup> these nations.

We try to contribute to two<sup>important fields in finance -the finance-growthliteratureand the community</sup> banking literature. We try<sup>to add to thefinance-growth literatureby1) focusing on a dimension of the financial</sup> system that is typically not examined<sup>inthat line of research-the relativehealth of community banks -and2)</sup> investigating potential mechanisms<sup>for how its effects may be transmitted into economicgrowth.We try to extend</sup> the community banking<sup>researchby1)examiningtheeffectsofcommunitybanks on overalleconomic</sup> performance, 2) performing<sup>the analysis on an international basis using data from both developed and developing</sup> nations, 3) allowing for different<sup>potential definitionsof community banks,and4)investigatingthe effectsof</sup> efficiency rank as well as<sup>marketshareand their interactions,i.e.,investigating the quality as wellas quantity of</sup> community banking.

The literature on developed nations<sup>generally defines community banksas small, private,domestically-</sup> owned institutions (SMALL<sup>banks)because these banks are found to have comparativeadvantagesin some types</sup> of lending to SMEs.<sup>Our testresultsfrombothdevelopedanddeveloping nationsareconsistentwiththe</sup> hypothesis that relatively healthy<sup>SMALL banks are associated with faster GDP growth.Both the market shares</sup> and the weighted-average<sup>efficiency ranks of these institutions have positive, statistically significant coefficientsin</sup> the GDP growth regressions.<sup>The estimated effects of increasing the market sharesand efficiency ranks of these</sup> banks are also economically<sup>significant. Thecoefficientson theinteraction terms betweenmarketsharesand</sup> efficiency ranks are also positive<sup>and statistically significantfor both developedand developingnations,consistent</sup> with the hypothesis that the marginal<sup>benefits of higher shares for community banks are greater when these banks</sup> are more efficient.

The data provide only mixed support<sup>for the two hypothesized transmission mechanismsfrom the relative</sup> health of community banks to<sup>economicgrowth throughimprovedfinancing opportunitiesfor SMEs or through</sup> greater overall flows of bank<sup>credit.To scrutinize these mziechanisms,we test whether1) community bank health</sup> has positive effects on the SME<sup>employmentshareandtheratioof oVerallbanklendingto GDP,2) these</sup> 25
intennediate variables have positive effects on GDP growth, and 3) the addition of these variables to the GDP 1ouw-ul regressions subs.a;mi ydi. **urnbl.r.e** **_thI_ iuae** **_-su_ of0t1** comumunilybankheeaulm onGDP growth. We find that the relative health of SMALL banks is positively associated with both the SME eemnplment share and the overall-bank-lending-to-GDP ratio in both developed and developing nations. We also find that these intermediate variables are positively related to GDP growth, although the relationship is generally only statistically significant for the SME employment ratio. However, we do not find substantial diminishment of the measured effects of the relative health of SMALL banks on GDP growth when the intermediate variables are included in the GDP growth regressions for developed or developing nations.

The literature on developing nations suggests that tne definition of community banks might be extended to include **At- te-owned bankq** (STAT- **bsnkc) nr** foreia.-nW.sAed **bhanL-c, (TnllPl( Mnha>L Qa,.I. Qs AATT** A bm" These potential alternative types of community banks may be able to overcome some of their disadvantages in SME lending in nations in which SMALL banks have difficulty providing sufficient credit using subsidies, by making use of decentralized organizational structures, or by employing better technologies. Our test results from developing nations suggest that larger market shares for FOREIGN banks are associated with better economic perfornance in terms of faster GDP growth, greater SME employment shares, and higher bank lending to GDP ratios, but worse econornic performance in terms of these outcomes for iarger snares for S TATE institutions. **Thesefindings** sugrst **that at** bast in some c-s, foreign-owned ban r.ay function as comrrunity banks, but that state-owned banks do not appear to play this role in an effective fashion. The evidence on efficiency ranks for STATE and FOREIGN banks do not show consistent patterns, which may reflect difficulties in measuring the efficiency ranks of these institutions. Our findings are robust to a number of changes in specification, samples, lag structures, and so forth.

Our analysis as well as the extent research in both the finance-growth and community banking literatures may help contribute to discussions of public policy toward domestic consolidation, foreign bank entry, priva-ti7tfion of stateow.ned bank!s, a-id -- pport foIr public crfiit info....a:ion **bu.aus znd"I** oULIer HmetL1ods of supporting SME lending. The extant research would appear to be consistent with favorable economic consequences from policies that promote relatively healthy SMALL banks in both developed and developing nations. Notably, policies that simply protect these banks from competition in product markets or from the markets for corporate control have been found to lead to more inefficiency and less growth (e.g., Jayaratne and Strahan 1996, 1998). In developing nations, the extant research would also appear to be consistent with favorable 26
consequences from policies that allow FOREIGN<sup>banks to enter and from policies that privatizeSTATE banks or</sup> reduce their market shares in other ways.

Finally, our findings are subject to significant<sup>caveats.The nature of international comparisons requires</sup> heroic assumptions because of the many important<sup>differences acrossnationsfor whichitisnotpossibleto</sup> control. Although we try to mitigate this<sup>problem in several ways, the results should be viewed as only suggestive</sup> of the relationship between the relative<sup>healthof community banks andoveralleconomicperformance.In</sup> addition, as noted above, we do not have universal<sup>coverageof thebanksineachnation, andmay be missing</sup> significant proportions of SMALL, STATE,<sup>and FOREIGNbanks.Thus,wehaveto assumethat the market</sup> shares and weighted-average efficiency ranks for<sup>the reporting community banksare indicativeof therelative</sup> health of community banks as a whole. Our<sup>findings are alsosubject to possible simultaneous-equationsbias -</sup> higher GDP growth, SME employment, or bank<sup>lendingmay affectthe healthof community banksin waysfor</sup> which we are unable to control in the regressions. We<sup>try to mitigate this potentialproblemby using measures of</sup> the relative health of community banks rather than<sup>measures of absolute health, so that the problem occurs only to</sup> the extent that these variables affect community banks<sup>morethanother institutions.As well, wemeasure our</sup> exogenous variables with lags because the future<sup>cannot cause the past.Although these measures mitigate this</sup> potential problem, we cannot entirely eliminate<sup>it.AdditionalbiasesmaybeintroducedwhentheSME</sup> employment share and the ratio of overall bank lending<sup>to GDP are included in the GDP growth regressions to the</sup> extent that GDP growth directly increases or decreases<sup>these ratios.Despite these caveats, we believe our analysis</sup> provides some useful steps in understanding the role of<sup>community banksin the link between financeand growth,</sup> and in evaluating some of the research and policy<sup>issues regardingcommunity banking around the world.</sup> 27
**Appendix 1.** Examples of state-owned banks in developing nations

India has a relative large presence of state-owned banks. An example of a 100% government owned and operated financial institution is the Small Industries Development Bank of India (SIDBI), which has a mandate to promote growth in small firms and microenterprises. SIDBI provides funding for fixed assets as well as working capital, and also helps promote SMEs in both domestic and international markets, with products ranging from factoring services to microcredit schemes for women entrepreneurs. SIDBI has also established a joint venture with a technical training college to provide IT training. In addition, SIDBI has established venture capital funds using government subsidies to promote the automobile, software and other industries. Note that SIDBI operates as a fiscal expense to the Government of India.

India also has state-owned institutions that receive government subsidies, but operate as commercial banks (Hanson 2002). The largest bank in India is the State Bank of India (SBI), which is over 50% state-owned and has more than US$45 billion in total assets. This bank was formerly privately-owned and nationalized in the 1970s as part of a government initiative to take over private banks and redirect credit to underserved sectors and populations. Currently, over 40% of SBI bank credit is directed to "priority sector lending," which includes agriculture and SME financing, including certain castes, small farmers, and women cooperatives (SBI 2001 Annual Report). Although state-owned banks are generally criticized for overstaffing and having weak IT infrastructures, one study found that foreign-owned and private, domestically-owned banks in India were less efficient than state-owned banks (Bhattacharya, Lovell, and Sahay 1997). However, this finding may be partially explained by the accounting practices of government auditors.

At the other end of the spectrum are state-owned institutions that have been successfully privatized. An example is ICICI, which was formed in 1955 at the initiative of the Government of India and the World Bank to create a development financial institution for providing medium-term and long-term project financing to Indian businesses. During the 1990s, it evolved into a private, full-service bank. ICICI is now India's second largest bank and offers a wide range of banking products and financial services to retail and corporate customers. In 1999, ICICI become the first Indian company to be listed on the New York Stock Exchange.

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Although state-owned banks are generally found to have problems in providing<sup>financialservices and</sup> often require significant government subsidies, there are some exceptional<sup>cases of state-ownedinstitutions that</sup> are able to meet their SME lending objectives without explicit government<sup>subsidies.The Mauritius Commercial</sup> Bank (MCB) has less than 5% direct government share, and is a profitable<sup>andefficientinstitution (Mauritius</sup> Commercial Bank Annual Report 2002). In addition, the Thai Bank for Agriculture and Agricultural Cooperatives (BAAC) is a rare case of a development bank with mandated<sup>lendingobjectivesthatdoesnot</sup> depend on subsidies and succeeds in providing credit to rural farners.<sup>In 1998, the BAAC extended loans to more</sup> than 80% of Thailand's farming households (Townsend and Yaron<sup>2001).</sup> 29