metadata: authors: 0: author: Bertay, Ata Can
1: author: Demirguc-Kunt, Asli
2: author: Huizinga, Harry
count: World
docna: 0: docna: Bank ownership and credit over the business
            cycle : is lending by state banks less procyclical?
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,National Governance,Government Policies,Private Sector Economics,Industrial Economics,Financial Regulation & Supervision,Private Sector Development Law,Youth and Governance,Economic Growth,Inflation,Governance Indicators,Marketing
teratopic: Macroeconomics and Economic Growth,Finance and Financial Sector Development
abstracts: cdata!: This paper finds that lending by state
            banks is less procyclical than lending by private banks,
            especially in countries with good governance. Lending by
            state banks in high-income countries is even
            countercyclical. On the liability side, state banks expand
            potentially unstable non-deposit liabilities relatively
            little during booms, especially in countries with good
            governance. Public banks also report loan non-performance
            more evenly over the business cycle. Overall the results of
            the analysis suggest that state banks can play a useful role
            in stabilizing credit over the business cycle as well as
            during periods of financial instability. However, the track
            record of state banks in credit allocation remains quite
            poor, questioning the wisdom of using state banks as a
            short-term countercyclical tool.
repnme: repnme: Bank ownership and credit over the business
            cycle : is lending by state banks less procyclical?
display_title: Bank ownership and credit over the
            business cycle : is lending by state banks less procyclical
listing_relative_url: /research/2012/06/16447559/bank-ownership-credit-over-business-cycle-lending-state-banks-less-procyclical
topicv3: Private Sector Development m1326060 1921,Economic Growth m1326241 471,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Governance Indicators m1327488 834,Trade Guarantees m1505111 3906
publishtoextweb_dt: 2012-06-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Finance and Financial Sector Development
no_of_pages: 36
model_extractions: WPS6110

# Policy Research Working Paper 6110

Bank Ownership and Credit over the Business Cycle Is Lending by State Banks Less Procyclical?

_Ata Can Bertay Asli Demirgüç-Kunt Harry Huizinga_ The World Bank Development Research Group Finance and Private Sector Development Team June 2012
Policy Research Working Paper 6110

# **Abstract**

This paper finds that lending by state banks is less procyclical than lending by private banks, especially in countries with good governance. Lending by state banks in high-income countries is even countercyclical. On the liability side, state banks expand potentially unstable non-deposit liabilities relatively little during booms, especially in countries with good governance. Public banks also report loan non-performance more evenly over the business cycle. Overall the results of the analysis suggest that state banks can play a useful role in stabilizing credit over the business cycle as well as during periods of financial instability. However, the track record of state banks in credit allocation remains quite poor, questioning the wisdom of using state banks as a shortterm countercyclical tool.

This paper is a product of the Finance and Private Sector Development Team, Development Research Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at ademirguckunt@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Bank ownership and credit over the business cycle: Is lending by state banks less procyclical?**<sup>**1**</sup>

Ata Can Bertay World Bank Asli Demirgüç-Kunt World Bank Harry Huizinga Tilburg University and CEPR

**Key words** : state banks, lending, procyclicality **JEL Classification** : G21, H44

> 1 Bertay: World Bank (Abertay@worldbank.org); Demirguc-Kunt: World Bank (Ademirguckunt@worldbank.org); Huizinga: Tilburg University and CEPR (Huizinga@uvt.nl). This paper‟s findings, interpretations, and conclusions are entirely those of the authors and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.
# **1. Introduction**

During the recent global financial crisis, several countries were forced to nationalize failing private banks. Abn Amro in the Netherlands, for instance, is now fully owned by the Dutch government. As a result, the average share of government ownership of banks by bank assets has increased in high-income countries form 7.3% in 2007 to 10.8% in 2009, to fall back slightly to 9.9% in 2010. The increased prevalence of state banks is providing renewed impetus to the debate on the economic costs and benefits of state banking. While previous research has shown that state banks tend to perform badly, misallocate resources and lead to lower economic growth, relatively little is known about how state banks react to business cycle fluctuations. To fill this gap, this paper examines the lending behavior of state banks over the business cycle, and also fluctuations in the main types of bank funding that make this lending possible. In addition, this paper considers the relative accounting for non-performing loans by state banks, as differences in the reporting of bad loans over the business cycle by state and private banks are a potential mechanism to explain different capacities to provide new loans. Our analysis is based on a sample of 1,633 banks from 111 countries over the 1999-2010 period.

We find that lending by state banks is less procyclical than the lending by private banks, especially if the bank is located in a country with good governance. We capture good governance by an index of government effectiveness, which increases with perceptions of the quality of public services, the degree of independence from political pressures and the credibility of a government‟s commitment to its own effectiveness. Moreover, lending by state banks located in high-income countries is even countercyclical. State banks also expand their credit relatively more during banking crises, which points at a stabilizing influence of state banks at a time of financial instability. Among private banks, we find that foreign-owned banks‟ lending is especially procyclical, perhaps because these banks have ready access to funding from their international parent firms to take advantage of local lending opportunities during economic upswings.

On the liability side, state banks increase their non-deposit liabilities relatively little during booms, especially if these banks are located in countries with good governance. Since non-deposit liabilities tend to be less stable than deposits, private banks‟ increased reliance on 2
them during economic booms potentially puts these banks at risk during downturns. Private banks also report relatively higher loan quality during economic expansions, increasing their ability to ramp up new lending during upswings compared to state banks. In contrast, state banks report loan quality more evenly over the business cycle. Hence during recessions, state banks are able to maintain higher rates of loan growth, as they are able to achieve higher rates of growth of non-deposit funding and report lower increases in the growth rate of non-performing loans.

Overall our results suggest that state banks can play a useful role in stabilizing credit over the business cycle as well as during periods of financial instability. However, the track record of state banks in credit allocation remains quite poor, questioning the wisdom of using state banks as a short-term countercyclical tool. For this purpose, alternative policy tools in the form of macroprudential bank regulation, including procyclical capital requirements and monetary policy are more appropriate, as they are more flexible than state ownership of banking and would not lead to credit misallocation resulting in low economic growth.<sup>2</sup> There is a substantial literature on the impact of state ownership of banks on banking performance and economic outcomes. A large number of cross-country studies show that state ownership of banking is associated with low bank efficiency and lower levels of financial development (Barth, Caprio and Levine, 2001, 2004, La Porta, Lopez-de-Silanes and Shleifer, 2002). State bank ownership lowers banking sector outreach (Beck, Demirguc-Kunt and Martinez Peria, 2007), and leads to wider intermediation spreads and slower economic growth as well as greater financial instability (La Porta, Lopez-de-Silanes and Shleifer, 2002; Caprio and Martinez Peria, 2002). Dinc (2005) shows that state bank lending is politically motivated, since state banks in emerging markets increase their lending relative to private banks in election years.

Banking outcomes also worsen with state ownership. For example, Mian (2003) finds that state-owned banks report higher loan loss provisioning and achieve lower profitability than private banks using data for a large set of emerging economies. Micco, Panizza and Yanez (2007) report that state-owned banks located in developing countries tend to have lower profitability and higher costs than their private counterparts. Cornett et al. (2010) find that stateowned banks in 16 Asian countries operated less profitably and had greater credit risk than

> 2 For an analysis of countercyclical bank regulation in Basel III, see Repullo and Saurina (2011).

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privately-owned banks prior to 2001, although this performance gap was largely closed after the Asian financial crisis.

Individual country studies provide consistent results. Berger et al. (2005) find that the performance of state-owned banks in Argentina, for instance as measured by cost efficiency, was low in the 1990s, and improved considerably after privatization. Lin and Zhang (2009) find that the “Big Four” state-owned commercial banks in China are less profitable, are less efficient, and have worse asset quality than other types of banks that involve some domestic or foreign private ownership. Importantly, country level studies also show that politicians use government bank lending to provide political patronage leading to significant credit misallocation. (See, for example, Cole (2009) for India, Khwaja and Mian (2005) for Pakistan, Carvalho (2010) for Brazil, and Sapienza (2004) for Italy.) Not only is state bank lending more politicized and inefficient, it also generally does not serve the more credit constrained segments of the population, such as small and medium enterprises (Berger et al., 2008; Ongena and SendenizYuncu, 2011) . Hence, there is an overwhelming amount of consistent literature suggesting that state ownership of banks lowers bank performance, with negative consequences for economic growth.

In contrast, the literature examining the lending behavior of state banks during business cycles is quite sparse with mixed results. Micco and Panizza (2006) relate bank credit growth to GDP growth and an interaction term of GDP growth and a state ownership variable for an international sample of banks over the 1995-2002 period, finding that credit growth of state banks is less procyclical than for private banks. In contrast, using a sample of 210 Western European banks over the 2000-2009 period, Iannotta et al. (2011) do not find a statistically significant difference between state and private bank lending for the smaller European sample. Cull and Martinez Peria (2012) examine the impact of bank ownership on credit growth in a sample of Latin American and Eastern European developing countries before and after the global financial crisis, finding mixed results. They show that state banks in Latin America acted in a countercyclical fashion during the crisis, whereas those in Eastern Europe did not, hence emphasizing regional differences.

4
In this paper our approach is similar to Micco and Panizza (2006) and Iannotta et al. (2011), but unlike these two studies we control for possible endogeneity of GDP growth to credit growth by using system GMM estimation. In addition, we consider a large worldwide sample of banks for the period from 1999 to 2010, including the recent global banking crisis. Furthermore, unlike previous papers we consider the dynamics of the main categories of bank funding and of the accounting for non-performing loans and loan loss provisioning to better understand the various „channels‟ that influence state bank lending over the business cycle. Finally, we also examine differences in lending behavior among domestic private banks versus foreign banks for a large number of countries.

The remainder of this paper is organized as follows. Section 2 discusses the data including our bank ownership classification. Section 3 presents the econometric methodology, and the empirical results. Section 4 concludes.

# **2. Data**

The empirical analysis is based on an international sample of 1,633 banks from 111 countries for the period 1999-2010. See Table A1 in the Appendix for details on the number of banks per country. The main data source is Bureau van Dijk‟s Bankscope, which provides information on statements of banks and their ownership structure.<sup>3</sup> To create time series information on the ownership of banks, we used Bankscope CDs starting from 1999 and Wharton Research Data Services (WRDS) for recent years. The CDs include snapshots of ownership structures in relevant years. In addition, we use various websites to classify the owner as private or state including Bankscope‟s online database, Factiva, Banker‟s Almanac and company websites of the banks. In our sample, we only include banks that we can identify to be owned by another entity with a 50 percent or higher ownership share. Thus, a bank is categorized as a state bank if it is majority-owned by a state-owned entity.<sup>4</sup>

> 3 For all banks, we consider the financial statements at the highest level of consolidation within a country to avoid duplication of the data. 4 Alternatively, La Porta et al. (2002) and  Cornett et al. (2010) use a 20% government ownership threshold to identify state banks yielding  comparable data.

5
Figure 1 illustrates the development of the average share of state ownership by bank assets. Specifically, the figure plots the average state ownership share for all countries, and separately for the groups of developing countries (and emerging markets), and high-income countries. The average state ownership share in each instance is the average of country averages for pertinent countries. During the last decades, the share of state ownership in developing countries has tended to decline, from 34.6% in 1999 to 19.4% in 2010. This decrease was especially pronounced during the years from 2007 to 2010. Average state ownership in highincome countries, instead, has increased somewhat from 7.9% in 1999 to 9.9% in 2010, with most of the increase occurring after 2007. Overall the state ownership share has been rather stable around 19%, although it declined from 17.5% in 2009 to 13.5% in 2010. These trend data suggest that government ownership of banks is likely to remain prevalent in future years. In the empirical work, as a robustness check we also consider a further breakdown of privately-owned banks into domestic and foreign banks.

Table 1 provides summary statistics for our sample of banks. The main variable of interest is the loans variable, which is the log of net loans in local currency and deflated using the national GDP deflator (see Table A2 in the Appendix for variable definitions and data sources). We consider several variables to represent the sources of bank funding: total liabilities, deposits, non-deposit liabilities, short-term funding, long-term liabilities, and equity. These variables are also constructed as the logs of amounts in local currency and deflated by the GDP deflator. To proxy for the cost of bank funding, we construct the net interest expense ratio as the log of one plus the bank‟s interest expenses over interest bearing liabilities net of the government T-Bill rate taken from the IMF International Financial Statistics database (IFS, 2012). As indices of the quality of lending, we consider the loan loss provision and non-performing loans variables.

The state bank variable is a dummy variable that equals one if a bank has a majority state ownership share. In our sample, 11.4% of bank-year observations concern state-owned banks. Privately owned banks can have domestic or foreign ownership. The domestic bank variable indicates majority private domestic ownership, while the foreign bank variable signals majority private foreign ownerships. Domestic and foreign banks constitute 52.8% and 35.8% of our observations.

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To represent business cycles, we use per capita real income growth in percentages, with a mean value of 1.96%. The impact of state ownership on the procyclicality of banks lending possibly depends on the general effectiveness of the government bureaucracy, i.e. good governance. As a proxy of this, we use a composite indicator of the government effectiveness from the World Governance Indicators (WGI) database (Kaufmann et al., 2010), which includes perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures. This variable is reported on an annual basis only after 2001, limiting regressions that include this variable to the period 2002-2010.

We consider several bank-level control variables, all lagged one year. Among these, assets are the log of total assets in constant 2000 dollars to capture the impact of a bank‟s toobig-to-fail status. Equity is the ratio of equity to total assets, to control for bank soundness, averaging 10.6% in our sample. Cooperative bank, real estate and mortgage bank and savings banks are dummy variables that are one if a bank is in the pertinent bank category. The loans over assets variable represents the relative importance of lending in a bank‟s activities, with a mean of 0.540. Liquidity, constructed as the ratio of liquid assets to total assets, can be a measure of bank soundness and its ability to sustain its lending, as well as an indicator of inefficiency (since too much liquidity comes at the cost of bank intermediation). In addition, deposits over total liabilities is a measure of the stability of a bank‟s funding, since non-deposit funding tends to flee quickly during periods of instability. In our sample the bulk of the funding source consists of deposits, with a share of 0.771.

We consider two macroeconomic controls from the World Development Indicators (WDI, 2011) database. These are GDP per capita in thousands of constant 2000 dollars, and inflation measured as the percentage change in the GDP deflator. Finally, the bank crisis variable is a dummy variable signaling a country is experiencing a banking crisis (Laeven and Valencia, 2010).

# **3. Methodology and empirical results**

In section 3.1, we describe the system GMM estimation that we apply to our empirical specifications. In section 3.2, we present our results regarding the relative procylicality of state 7
banks regarding their lending, funding volumes and costs, and reporting of non-performing loans and loan loss provisioning. Section 3.3 reports some robustness checks on the relative procyclicality of lending by state banks.

# **3.1 Estimation methodology**

Our empirical specifications take the form of Arellano-Bond dynamic equations as follows: where is the dependent variable for bank i in country j in year t, Xi.j.t is a set of explanatory variables, ηi is a bank fixed effect, is a time fixed effect and εi,j,t is an error terms. In a regression to test for the procyclicality of lending by state banks, for instance, the dependent variable is the loans variable, while the set of explanatory variables includes the growth rate of per capita GDP and its interaction with the state bank variable. First differencing (1) serves to eliminate the bank fixed effect as follows: We apply the system GMM estimator (Arellano and Bover, 1995; Blundell and Bond, 1998) jointly to (1) and (2) using lagged first differences as instruments.<sup>5</sup> We take all explanatory variables - except GDP per capita growth, the bank ownership variables, government effectiveness and relevant interaction terms - as predetermined, meaning that current values of these variables can be correlated with post and current error terms but not with future error terms. In addition, the error terms are assumed to be serially uncorrelated, and lagged first differences of right-hand side variables are assumed to be orthogonal to bank specific fixedeffects to obtain consistent GMM estimation. Furthermore, we use two-step GMM estimation

> 5 We do not use the first lag of levels and current first differences of endogenous variables as instruments, but include all other lags, to ensure the exogeneity of our instruments and to avoid having too many instruments reducing the power of overidentifying restrictions tests. The second lag of endogenous variables, specifically, is not correlated with the current error term, while the first lag is. The difference estimator applied only to (2) has several drawbacks. It only exploits the time series dimension of data as it uses first differences, and not the cross-sectional dimension. In addition the lagged variables become weak instruments if the explanatory variables are persistent over time deteriorating asymptotic properties (see Beck (2008)). For an application of system GMM estimation to economic growth regressions, see  Levine, Loayza and Beck (2000).

8
and the Windmeijer (2005) correction, which adjusts the covariance matrix for finite samples to minimize the downward bias in standard errors.

We report two main tests to determine the appropriateness of our dynamic GMM estimations. The first test is the Hansen test of the overidentifying restrictions with as the null hypothesis that instruments are exogenous. If the null hypothesis is not rejected, the instruments are valid. A further test is the Arellano-Bond test for autocorrelation of the errors, with as a null hypothesis no autocorrelation in differenced residuals. Specifically, the second-order test in first differences tests for autocorrelation in levels.

# **3.2 Empirical results**

We first examine the cyclicality of lending by state-owned banks relative to privately owned banks. To do this, we specify a regression where the dependent variable is the loans variable, and where the set of explanatory variables includes the growth rate of GDP per capita, the state bank variable, and an interaction of these two variables. The coefficient on the growth rate of GDP per capita informs about the cyclicality of lending by private banks, while the sum of this coefficient and the coefficient on the interaction of GDP per capita growth and the state bank variable measures the cyclicality of lending by state banks.

Tabe 2 reports 4 regressions of the loans variable. Regression 2 differs from regression 1 in that it includes a larger set of bank variables as controls. Starting from regressions 1 and 2, regressions 3 and 4 in addition include the government effectiveness variable and a triple interaction of this variable with GDP per capita growth and the state bank variable. In all regressions, real GDP per capita growth enters with positive coefficients that are significant at the 1% level, indicating that lending by private banks is procyclical. Estimated coefficients vary between 0.017 and 0.020, suggesting that a 1% increase in per capita GDP growth is associated with 1.7-2.0% increase in credit growth. In regressions 1 and 2, the estimated coefficients for the interaction of GDP per capita growth and the state bank dummy are -0.013 and -0.014, respectively, and they are significant at 1%. Thus, an increase in GDP per capita growth by 1% is estimated to increase lending by state banks by 0.7% and 0.6%, which suggests that lending by state bank is procyclical but less so than for private banks.

9
In regressions 3 and 4, the interaction of GDP per capita growth and the state bank variable obtain coefficients of -0.011 that are significant at 1%. The triple interaction variable obtains a negative coefficient of -0.005 in regression 3 that is significant at 5%, and a coefficient of -0.004 is regression 4 that is marginally insignificant with a p-value of 0.105. These negative coefficients suggest that state banks are even less pro-cyclical in countries with good governance. Based on regression 3, we infer that a 1% increase in GDP per capita growth causes a domestic bank to increase its lending by 1.7%, while a state bank in a country with average government effectiveness of 0.888 increases its lending by 0.156% (=0.017-0.011+(0.005*0.888)). Thus, lending by a state bank in a country with average government effectiveness is procyclical, but far less so than for a private bank. Our estimated coefficients also imply that lending by state banks is countercyclical if the government effectiveness variable exceeds 1.2 (note that the maximum value of government effectiveness is 2.374 from Table 1).<sup>6</sup> The regressions also pass the AR(2) and Hansen OIR specification tests, indicating the validity of the instrumentation.<sup>7</sup> Less procyclical or even countercyclical lending by state banks suggests that the funding of public banks and potentially also the cost of funding are relatively insensitive to the business cycle. Next, we examine which type of funding of state banks expands relatively less than that of the private banks during the upswing of the business cycle (and vice versa), and whether public banks are rewarded for the low procyclicality of their lending by relatively small increases in their funding costs during boom periods (and vice versa). The funding categories we consider, as found on the liability side of banks‟ balance sheets, are total liabilities, deposits and non-deposit liabilities, short-term funding and long-term liabilities, and equity. Our funding cost variable is the net interest expense ratio, defined as the log of interest expenses over total interest-bearing liabilities minus the government T-Bill rate. For each of these funding quantity and funding cost variables, we specify two regressions analogous to regressions 3 and 4 of Table 2. The results are reported in Table 3.

> 6 Similar results are obtained if we include an election variable to control for the impact of the electoral cycle on bank lending as in Dinc (2005) (unreported).

> 7 Results reported in Table 2 are robust to excluding countries with fewer than  5 bank or  10 observations or 20 observations (unreported).

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In several regressions in Table 3, we observe negative and significant coefficients on the interaction of GDP per capita growth and the state bank dummy, and/or on the triple interaction of these two variables and the government effectiveness variable, indicating that funding at state banks is less procyclical than at private banks. To start, in the total liabilities regressions 1 and 2, the interaction of GDP per capita growth and the state bank variable obtains negative coefficients of -0.007 and -0.008 that are significant at 5%, indicating that the growth rate of total liabilities of state banks is relatively low during economic booms. In the non-deposit liabilities regressions 5 and 6, the double and triple interactions obtain negative coefficients with significance of at least 10%, indicating that non-deposit liabilities that grow less at state banks during booms, especially if these banks are located in countries with high government effectiveness. Estimated coefficients in both regressions suggest that non-deposit liabilities at a state bank in a country with average government effectiveness are countercyclical. From regression 5, for instance, we see that a 1% increase in GDP per capita growth leads to reduction of non-deposit liabilities of - 0.976% = (0.026-0.018-0.020*0.888). In the short-term funding regression 8, the interaction of GDP per capita growth and the state bank variable receives a negative coefficient of -0.006, suggesting that short-term funding at state banks is less procyclical. In the equity regressions 11 and 12, he triple interaction variable obtains negative coefficients of -0.007 and -0.008 that are significant at 5%. Parameter estimates imply that equity growth is less procyclical for state banks in a country with average government effectiveness, while it is countercyclical in countries with government effectiveness exceeding 1.286. In the net interest expense ratio regressions 13 and 14, none of the interaction variables is statistically significant, suggesting that the funding costs are equally procyclical for private and state banks. In regression 14, the GDP per capita growth variable obtains a positive coefficient of 0.001 that is significant at 10% so that generally funding costs appear to be procyclical. The Hansen test of the overidentifying restriction is passed throughout Table 3, while the AR(2) test is also passed except in the equity regressions 11 and 12 where they are rejected at 5% and 10%, respectively.

Next, we consider whether private banks are able to expand their lending relatively more during booms, because they report higher loan quality during economic upswings. In particular, we consider the relative reporting on non-performing loans and loan loss provisioning by private and state banks over the business cycle. The non-performing loans variable is the dependent 11
variable in regressions 1-4 of Table 4, while the loan loss provisioning variable is the dependent variable in regressions 5-8. In each instance, the 4 reported regressions differ in the number of included bank-level control variables and in whether government effectiveness and its interaction with GDP per capita growth and the state bank variable are included.

In the non-performing loans regressions 1-4, GDP per capita growth obtains a negative coefficient -0.003 that is significant at 1%, while its interaction with the state bank variable obtains positive coefficients of 0.002 with significance of at least 10%. Thus, the reporting of non-performing loans by state banks is less countercyclical. This could mean that the actual occurrence of non-performing loans at state banks is less countercyclical, or alternatively that state banks report loan non-performance more evenly over the business cycle. Analogously, in the loan loss provisioning regressions 5 and 6, the GDP per capita growth rate obtain negative coefficients of -0.002 that are significant at 1%, while its interaction with the state bank variable obtains positive coefficients of 0.001 that are significant at 1%. Hence, reporting of loan loss provisioning by state banks appears less countercyclical, either because loan deterioration is less countercyclical at state banks or because the accounting for loan deterioration by state banks is relatively conservative during booms. In the latter interpretation, loan loss provisioning at private banks is overoptimistic during booms, perhaps to enable these banks to take full advantage of perceived lending opportunities during economic expansions. However, in regressions 7 and 8, the triple interaction of the GDP per capita growth, state bank, and government effectiveness variables obtains a negative coefficient of -0.010 that is significant at 1%. This suggests that loan loss provisioning at state banks becomes more countercyclical as government effectiveness increases, perhaps because state banks undertake additional loan loss provisioning during economic downturns in an environment of high government effectiveness. Overall, our results on the relative procylicality of loan loss provisioning by state banks are inconclusive. In the loan loss provisioning regressions 5 and 7, Hansen overidentification tests are rejected at 10% level, indicating the instruments are not valid. In the corresponding regressions 6 and 8 that include additional bank-level controls, however, these tests are passed.

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# **3.3 Robustness checks on the procyclicality of lending**

Private banks can be domestic or foreign-owned. Foreign-owned banks tend to be subsidiaries of international banks. This potentially enables them to obtain additional funding from the international parent bank in case their local profitable lending opportunities expand. Thus, with a more elastic supply of funds, foreign banks may be able to expand their lending relatively more during economic upswings. To test this, we re-estimate regressions 1 and 2 of Table 2 after including a foreign bank variable and its interaction with GDP per capita growth. The results are reported as regressions 1 and 2 of Table 5. In the two regressions, the interaction of GDP per capita growth and the foreign bank variable obtains coefficients of 0.009 and 0.008 that are significant at 1%, implying that lending by private, foreign banks is more procyclical than lending by private, domestic banks. In both regressions, the interaction of the GDP per capita variable and the state bank variable obtains a coefficient of -0.008 that are significant at 5%, indicating that lending by state banks is less procyclical than for private, domestic banks. Regressions 3 and 5 include interactions of the GDP per capita variable with alternatively the state bank, domestic bank, and foreign bank variables. In both regressions, the three interaction terms are estimated with coefficients with significance of at least 10%. Estimated coefficients confirm increasing procyclicality of lending from state banks to private, domestic banks, and to private, foreign banks. Specifically, a 1% increase in GDP per capita growth leads to a credit supply growth of 0.5-0.6% for state bank, 1.1-1.2% for private, domestic banks and 2.1-2.2% for private foreign banks.

Next, we consider whether the relative procylicality of lending by state banks depends on the level of economic development. In particular, we estimate regressions 1-4 of Table 2 separately for the samples of high-income countries and developing countries (and emerging markets), using the World Bank classification. The results are reported in Table 6. In the highincome countries regressions 1 and 2, the interaction of GDP per capita and the state bank variable is estimated with negative and significant coefficients.<sup>8</sup> Interestingly, point estimates

> 8 Similarly, Iannotta et al. (2011, Table 6) report that credit growth at state banks in Western Europe over the 20002009 period is relatively less procyclical, although this effect is not statistically significant. The difference in results could reflect a difference in sample size : 976 banks and 3439 observations in our high-income sample in regression 1 of Table 6, and 210 banks and 1541 observations in Iannotta et al. (2011). A further difference is that we define 13
suggest that credit in high-income countries is procyclical for private bank, and countercyclical for state banks. Specifically, a 1% increase in GDP per capita growth is estimated to lead to a 1.3% increase in lending by private banks, and a 0.4% decrease in lending by state banks. Regressions 3 and 4 have similar implications, although the coefficients for the interaction of GDP per capita growth and the state bank dummy are marginally insignificant. In regressions 5-8 for the sample of developing countries, the interactions of GDP per capita growth and the state bank dummy obtain negative coefficients in the range from -0.011 to -0.008. Parameter estimates imply that credit by state banks is procyclical, but less so than for private banks. Throughout, the government effectiveness variable and the triple interaction of this variable with GDP per capita growth and the state bank variable are estimated with insignificant coefficients. Thus, variation in government effectiveness within the samples of high-income countries and developing countries does not appear to affect the procylicality of lending by state banks, even if is it shown to affect this procyclicality in the pooled sample in Table 2.

Banking crises may lead to a scarcity of bank credit. Thus, the stabilization of credit by state banks is potentially most useful during a banking crisis. To conclude this section, we consider how relative lending by state banks and its degree of procylicality vary over crisis and non-crisis periods. To start, regressions 1-4 of Table 7 include a banking crisis variable, and its interactions with the state bank variable and jointly GDP per capita growth and the state banking variable in regressions 1-4 of Table 2. These additional variables are statistically insignificant in the 4 regressions. Hence, we cannot detect a different degree of procylicality of credit by state banks during crisis and non-crisis periods. Alternatively, regressions 5-8 include these additional variables, but delete the interaction of GDP per capita growth and the state bank variable, and the triple interaction of these two variables with the government effectiveness variable. The resulting regressions test how credit growth of private and state banks is different during crisis and noncrisis periods. The banking crisis variable itself enters with a negative coefficient of -0.020 that is significant at 10% in regression 8, providing some evidence that lending by private banks is lower during banking crises. The interaction terms of the banking crisis variable and the state bank variable obtains coefficients in the range 0.123-0.155 with significance of at least 10%, state banks as majority state-owned, while Iannotta et al. (2011) alternatively consider any and at least 20% state ownership.

14
implying that credit growth of state banks during a banking crisis is higher than for private banks. Estimates of coefficients suggest that the growth rate of loans provided by of state banks is positive during banking crises, counterbalancing any negative growth in the credit supply of private banks.

# **4. Conclusion**

This paper finds that lending by state banks is less procyclical than the lending by private banks, especially if the bank is located in a country with good governance, as proxied by indicators of government effectiveness. Moreover, lending by state banks in high-income countries is even countercyclical. Among private banks, we find that foreign-owned banks‟ lending is especially procyclical, perhaps because these banks have ready access to funding from their international parent firms to take advantage of local lending opportunities during economic upswings. State banks also expand their credit relatively more during banking crises, which suggests a stabilizing influence of state banks at a time of financial instability.

On the liability side, state banks expand their non-deposit liabilities relatively little during booms, especially if these banks are located in countries with good governance. In contrast, the relative increase in non-deposit liabilities of private banks during economic booms puts these banks at some risk, as this type of funding may be less stable than funding through deposits.

Public banks report relatively high additional non-performing loans during economic upswings. This may reflect either that the relative loan quality of state banks deteriorates during expansions (improves during economic downturns), or that state banks report loan nonperformance more evenly over the business cycle. Overall our results suggest that state banks can play a useful role in stabilizing credit over the business cycle as well as during periods of financial instability. However, the track record of state banks in credit allocation remains quite poor, questioning the wisdom of using state banks as a short-term countercyclical tool. Furthermore, an important question is whether this credit expansion during the downturn is the result of lending to the most constrained borrowers, such as small and medium enterprises, or to larger politically favored enterprises. Another issue is whether state bank lending retrenches 15
after crises consistent with the spirit of countercyclical lending. We leave these questions for further research.

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