State banks, institutions and financial development

We present a locational model of banking with two types of private banks, honest and opportunistic, and a state bank that is assumed to be less efficient. Opportunistic banks choose whether to honor their contracts with depositors depending on the probability of contract enforcement. We derive three types of equilibria, which depend on institutional quality: a “low” equilibrium in which private banks choose not to enter the market, a “high” equilibrium in which depositors place all their savings with private banks and an “intermediate” equilibrium in which state banks and private banks co-exist. In the intermediate equilibrium, the share of state banks depends inversely on institutional quality and positively on the proportion of opportunistic banks. We also show that when enforcement of deposit contracts is subject to a resource constraint, multiple equilibria can exist, and that depositors’ perception of whether opportunistic behavior is present determines the type of equilibrium which prevails. We test our theoretical predictions using cross-country data. We find that both the quality of prudential regulation (or rule of law) and disclosure are inversely related to the share of state banks, consistent with our theoretical model. We also find that the incidence of banking crisis, which proxies perceived institutional quality, is positively related to the share of state banks.