The Threat of Capital Drain: A Rationale for Public Banks?

Abstract

This paper yields a rationale for why subsidized public banks may be desirable from a regional perspective in a financially integrated economy. We present a model with credit rationing and heterogeneous regions in which public banks prevent a capital drain from poorer to richer regions by subsidizing local depositors, for example, through a public guarantee. Under some conditions, cooperative banks can perform the same function without any subsidization; however, they may be crowded out by public banks. We also discuss the impact of the political structure on the emergence of public banks in a political-economy setting and the role of interregional mobility.

Keywords: Public banks, cooperative banks, capital drain, credit rationing, financial integration, privatization

JEL Classification: G21, F36, H11, L33