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In this paper we develop a theoretical model with a representative bank whose ownership is shared between state and private sector. The bank faces a risk of failure and provides private and public explicit deposit insurance. Banks owned to a larger extent by the government are more able to counteract a restrictive monetary policy because of their capacity to raise additional volume of deposits. Therefore, the greater the state’s share in the bank ownership, the less the impact of a monetary tightening on the level of loan supply

The recent experience of countries rising the limits of deposit guarantee or providing full protection for deposits shows the importance of deposit insurance policy in periods of financial instability. Specifically, countries like Belgium, Greece, Luxembourg, Netherlands, Portugal and Spain increased in 2008 the deposit guarantee up to EUR 100,000, whereas Ireland provided a full protection on savers’ deposits (Schich, 2008). In Austria, after a temporary provision of unlimited deposit guarantee, the deposit insurance coverage changed to EUR 100,000 in 2010 (Schich, 2008). These series of unilateral adjustments in the limits of deposit-guarantee schemes for several European Union (EU) member countries were followed by the decision of EU Ministers of Finance to raise the common threshold of deposit guarantee from EUR 20,000 to EUR 50,000 in October 2008. Thus, deposit insurance represents a financial safety net commonly used by governments so as to restore depositors’ confidence in the banking system and consequently avoid bank runs in periods of financial instability.1 While the effects of cross-country heterogeneities2 or cross-bank disparities3 within a country concerning the deposit-guarantee schemes have been largely discussed in terms of bank competition, their potential impact on monetary policy has been rather neglected. This paper is an attempt to fill this gap by providing a theoretical model that analyzes the impact of government ownership and deposit insurance on monetary policy transmission.4 Building on Freixas and Rochet, 1997 and Cecchetti and Krause, 2005, we show that a greater state share in the bank ownership lowers the effectiveness of monetary policy. More precisely, banks owned to a larger extent by the government can benefit from a more stable deposit base (Micco and Panizza, 2006) and raise additional volume of deposits owing to the provision of a better deposit guarantee. This enables state-owned banks to insulate their loan portfolios against a restrictive monetary policy. Following the bank lending channel (Kashyap and Stein, 1993),5 a monetary contraction, implying a sale of securities by the central bank through open-market operations, entails a decline in banks’ reserves. This leads banks to scale down their lending and pushes firms relying on intermediate finance to cut back on investment. This means that a greater state participation in the bank ownership lessens monetary policy effectiveness and diminishes the wiggle room policy makers have at their disposal to pursue their objectives. Our paper is related to several empirical studies which emphasize the impact of state ownership6 on bank lending behavior. There are several views characterizing government motivations in state-owned banks (Sapienza, 2004). First, the social view stresses the social welfare maximization objective of the government-owned firm. Thereby, state-owned banks are expected to supply credit to those firms located in depressed areas, or to (strategic) industries whose credit is rationed by private banks. Secondly, the agency view highlights the lack of incentives that face ‘lazy’ managers in state-owned banks to grant credit optimally, as they serve their own interests. Finally, the political view argues that politicians may have interest to allocate resources strategically in order to maximize their probability of reelection (La Porta et al., 2002). In line with the political view, Dinç (2005) compares the lending behavior of government-owned banks and private banks around election periods using data on the ten largest banks of 19 emerging countries and 17 developed economies between 1994 and 2000. He provides cross-country, bank-level evidence that lending in emerging countries is politically driven in government-owned banks, through an increase of loans in election years. However, this result does not hold for advanced economies. Using a sample of 457 German savings banks from 1994 to 2006 and observations on local elections, Vins (2008) studies the political influence on lending practices of state-owned banks in the German case. He finds that the growth rate of state-owned banks’ loans is significantly higher in election periods. This result confirms the findings of Micco et al. (2007), who point out that the rise in bank lending in election periods is driven by the loan supply of state-owned banks. Micco and Panizza (2006) empirically test the drivers of credit stabilization of state-owned banks with respect to the business cycle, without making any assumption about banks’ objectives. Using a large international data set over the 1995–2002 period, Micco and Panizza (2006) regress the growth rate of loans on an interaction variable between the GDP growth, a proxy for macroeconomic shocks, and a dummy indicating the state majority in the bank ownership. The growth rate of loans is also regressed on interaction variables between the GDP growth and other variables controlling for the bank size and foreign ownership. Finally, in order to test the political influence on bank lending, the growth rate of loans is regressed on an interaction variable between the public sector ownership dummy and an election dummy. They show that state-owned banks have a less procyclical lending behavior than private banks. Moreover, the credit lines granted by banks located in developing countries are at least not more procyclical than that of banks established in industrial countries. In their empirical study, Micco and Panizza (2006) aim to explain the smoothing behavior of state-owned banks over the business cycle and to find out the factor to which this behavior can be attributed. The authors cannot determine however if state-owned banks adopt a smoothing behavior because of the political or agency views hypothesis. Focusing on the German case Foos (2008) shows that within the German banking system, the lending of savings banks7 is less volatile with respect to GDP fluctuations than that of cooperative and commercial banks. Foos (2008) assumes that this result is consistent with an ‘economic support’ objective of savings banks. In contrast to Micco and Panizza, 2006 and Foos, 2008, this paper does not focus on the lending fluctuations of state-owned banks over the business cycle. Instead, we show that by combining government ownership and deposit insurance, state-owned banks exhibit a credit stabilization pattern with respect to a monetary policy impulse. This finding is consistent with the econometric results of Cecchetti and Krause (2001) reporting that a reduction in state bank ownership is related to a gain in monetary policy efficiency. Note that we do not refer to the social, nor to the agency and political views. In our model the change in monetary policy effectiveness only emerges from the joint presence of a deposit insurance mechanism and government participation in the bank ownership. The paper is organized as follows: Section 2 presents the theoretical model. Section 3 discusses the results. Section 4 concludes and gives some insights on policy implications that stem from our model.

As pointed out by La Porta et al. (2002), government ownership of banks and explicit deposit insurance schemes are common features of both developing and advanced economies. This is all the more true for periods of financial instability, when states increase either their participation in the banks capital or the minimum level of deposit guarantee for public and private banks in order to restore confidence in the financial system and prevent bank runs. The theoretical literature generally recognizes that states may use such regulation to serve several objectives. The government may be benevolent and provide an economic support to firms that are deprived of financing from private banks. Alternatively, political and agency views respectively stress the attainment of politicians and managers’ personal interests. Building on Freixas and Rochet, 1997 and Cecchetti and Krause, 2005, this paper presents a model of a competitive banking sector with an explicit deposit insurance scheme. Deposit insurance is justified by the existence of a bank failure risk, which in turn depends on the productivity state of private-sector firms. Deposits guarantee also affects the households saving behavior, as it increases the safeness of their deposits and reduces the interest rate on deposits. We rule out capital markets, making firms absolutely bank dependent, in order to focus exclusively on the impact of government share in the bank ownership and deposit insurance on monetary policy transmission. In this paper we show that state-owned banks are less responsive to monetary policy impulses than private banks with respect to credit supply. As the state participation in the bank ownership lowers the probability that households do not get their deposits back, government-owned banks can collect additional deposits allowing them to counteract a shift in monetary policy. This result is of direct practical interest for monetary policy. A country with a greater government share in the banking sector ownership will have a less effective monetary policy. This implies that monetary authorities will have to be more reactive over their policy instruments in order to achieve their objective, with respect to a country with a lower state participation in banks’ capital. In the framework of a single currency area, cross-country discrepancies in the state participation in bank ownership may lead to a heterogeneous transmission of a change in the stance of monetary policy. A similar outcome may also occur with regard to thresholds of bank deposit guarantee defined at the national level. This shows the importance of a closer coordination across governments when setting the level of bank deposit insurance. This is so much so in periods of financial instability when national governments have strong incentives to increase deposit guarantee levels unilaterally. As a possible extension of our model, it would be interesting to consider the bank’s risk of failure as an endogenous variable and to study the effect of deposit insurance and state’s share in the bank ownership on the bank’s manager risk-taking behavior. If the bank’s manager takes more risks, following an increase in the government share in the bank ownership, the effect on bank deposits safeness may be ambiguous. Thereby, the banks’ ability of raising additional deposits may be compromised, enhancing the monetary policy efficiency.