Bank ownership and financial stability

This paper investigates a politician's choice for state or private control of banks, anticipating how this choice influences actions by citizens seeking exclusive access to finance. We show that when political accountability is low, politicians prefer control over lending and funneling via state banks. As state banks are less efficient, high levels of accountability induce private bank ownership. This transition occurs at intermediate levels of accountability when politicians allow private banks to be captured by a small group of entrepreneurs. These entrepreneurs lend to themselves on preferential terms, inducing a greater chance of bank failure. In an attempt to increase entrepreneurs' losses at default and hence reduce funneling as accountability increases, the politician leaves an increasing share of rents to entrepreneurs. As a result the likelihood of default decreases, but remains positive.Interestingly, the model implies that entry and financial stability are likely to be lowest for intermediate levels of political accountability. We provide suggestive empirical support on bank control and review existing evidence on entry and financial stability.