Could Spain’s public banks make a comeback?

This is not the time for Spanish company owners to kid themselves. The country is sunk in a long and painful deleveraging process, its financial system needs a bailout and the public deficit is well above 7 percent. Access to credit will not improve in the short term unless the government finally, officially, asks for a rescue and the risk premium drops.

The debate about how to provide financing to firms will become again a main subject in 2013. According to most international observers, the economy will worsen, more companies will be closing and unemployment will increase. As no elections loom in the near future in Spain, this would be the right moment for political parties to focus and find new projects that give Spaniards hope. One such idea the parties of the left seem to be caressing is to re-float public banks.

But this proposal would crash against at least three difficulties. First, the drama of the public savings banks remains in everybody’s retina: these entities under political control were behind the extraordinary credit expansion occurred in Spain before the crisis. Their management was poor, they assumed far too many risks and taxpayers have been the victims in many ways.

After plenty scandals, frauds, privileged financing of ruinous enterprises and plain corruption it would take a huge effort to convince the public opinion that a similarly public model of banking must be reinstated.

Secondly, we have enough academic research to understand that it isn’t a good option. The lack of definition of property rights has negative effects, without shareholders politicians end up governing the entity following their political agenda–at best–instead of social needs.

A paper by LaPorta, López de Silanes and Shleifer, published in 2002 in the Journal of Finance, shows that countries with major presence of public banking have lower income per capita and a less developed finance industry. Microdata reports also confirm that banks subject to politicians control tend to increase lending in election time, and the returns are mostly losses.

And finally, there is the question of how public banks would achieve financial viability. They would need sufficient strength to make a difference to small and medium-size companies–take the Banco de Valencia, for instance; it had €20 billion in assets at the time when it propped up Valencia’s industry. Would the markets trust them? Or would the general budget carry the new burden?

Yet, the truth is that the restructuring of the banking sector in Spain has rapidly cut the number of branches and the gap between companies and banks is expanding. Investment decisions are being made far away from those entrepreneurs than need the support.

Particularly small companies have been left behind. They cannot afford detailed audits and, even though most have an impeccable credit history, finance is denied to them because banks must now explain their every operation. Technological innovation is severely depressed, too, and only public cash injections appear to be available for its continuity.

Nevertheless, all this does not mean public banking should be rejected for ever more. We must learn from past mistakes. Public entities are convenient at some times, when credit is unavailable, but they cannot turn once more into financial institutions separated from economics logic or into rogue organisations. We in Europe need pragmatism, dissect the errors and come up with efficient solutions to the current scarcity of credit that is strangling our productive economy.