Financial Development, Bank Ownership, and Growth. Or, Does Quantity Imply Quality?

by Shawn A. Cole

Overview — Government ownership of banks, a common phenomenon, is among the most important policy tools used to influence financial development. But what is the actual effect of such ownership on the financial development of a country? This paper uses a policy experiment in India to evaluate the effect of government ownership of banks on development. Key concepts include:

Had the Indian government required bank expansion into rural areas and set lending targets, without nationalizing banks, rural areas might have achieved the same, or better, outcomes.
Despite a substantial increase in agricultural credit, there is no evidence of improved agricultural outcomes in markets with nationalized banks.
Bank nationalization may have slowed the growth of employment in the more developed sectors of trade and services.

Author Abstract

In 1980, India nationalized its large private banks. This induced different bank ownership patterns across different towns, allowing credible identification of the effects of bank ownership on financial development, lending rates, and the quality of intermediation, as well as employment and investment. Credit markets with nationalized banks experienced faster credit growth during a period of financial repression. Nationalization led to lower interest rates and lower quality intermediation, and may have slowed employment gains in trade and services. Development lending goals were met, but these had no impact on the real economy.