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Banking Reform in India∗ - page 2 / 57

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agriculture and small industry are often mentioned as sectors that do not get their fair share of credit.2 If nationalization succeeds in pushing credit into these sectors, as the Indian government claimed it would, it could indeed raise both equity and efficiency.

The cross-country evidence on the impact of bank nationalization is not very encouraging. For example, La Porta et. al. find in a cross-country setting that government ownership of banks is negatively correlated with both financial development and economic growth.3 They interpret this as support for their view, which holds that the potential benefits of public own- ership of banks, and public control over banks more generally, are swamped by the costs that come from the agency problems it creates: cronyism, leading to the deliberate misallocation of capital, bureaucratic lethargy, leading to less deliberate, but perhaps equally costly errors in the allocation of capital, as well as inefficiency in the process of mobilizing savings and transforming them into credit.

Unfortunately the interpretation of this type of cross-country analysis is never easy, and never more so than the case of something like bank nationalization, which typically occurs as part of a package of other policies. For example, Bertrand et. al. study a 1985 banking deregulation in France, which gave banks much greater freedom to compete for clients.4 They find that deregulated banks respond more to profitability when making lending decisions. After the reform, firms that suffer a negative shock are much more likely to undertake restructuring measures, and there is more entry and exit in bank-dependent industries.

Micro studies of the effect of bank nationalization are rare: an important exception is Mian who examines the privatization of a large public bank in Pakistan in 1991.5 He finds that the privatized bank does a better job both at choosing profitable clients and monitoring existing clients, than the commercial banks that remained public.

Our previous paper uses micro data from a nationalized bank to evaluate the effectiveness of the Indian banking system in delivering credit.6 The conclusion from that paper was that the Indian financial system is characterized by under-lending in the sense that there are many firms

2 See Banerjee (2003) for a review of the evidence. 3 La Porta et. al. (2002). 4 Bertrand et. al. (2003). 5 Mian (2000). 6 Banerjee, Cole and Duflo (2003).

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