23251 A,, Oka*', ~~~~~~~, July 2001 rINANCIAL RANSITION IN EUROPE AND C ENTRAL ASIA Challenges of the New Decade A W O R L D F R EE OF P OV E RTY inancial Transition in Europe and Central Asia Challenges of the New Decade Edited by Lajos Bokros Alexander Fleming Cari Votava The World Bank Washington, D.C. U Copyright 2001 The International Bank for Reconstruction and Development / the world bank 1818 H Street, N.W. Washington), D.C. 20433, USA All rights reserved Manufactured in the United States of America First printing July 2001 1 2 3 4 04 03 02 01 The findings, interpretations, and conclusions expressed in this book are entirely those of the authors and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. 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For permission to reprint individual articles or chapters, please fax a request with complete information to the Republication Department, Copyright Clearance Center, fax 978-750-4470. All other queries on rights and licenses should be addressed to the Office of the Publisher, World Bank, at the address above or faxed to 202-522-2422. Cover design by Tomoko Hirata ISBN 0-82.13-4814-0 Library olfCongress Cataloging-in-Publication Data Financial transition in Europe and Central Asia: challenges of the new decade / edited by Alex Fleming, Lajos Bokros, Carn Votava. p. cm. Basecd on two seminars and a conference in respectively Prague and Benesov in the Czech Republic at the time of the World Bank-International Monetary Fund Annual Meetings in Sept. 2000. Includes bibliographical references. ISBN 0-8213-4814-0 1. Finance-Europe-Congresses. 2. Finance-Asia, Central-Congresses. 3. Banks and bankig-Europe-Congresses. 4. Banks and banking-Asia, Central-Congresses. I. Fleming, Alexander. II. Bokros, Lajos. III. Votava, Cari, 1957- HG186.A2 F573 2001 332'.094-dc2l 2001026282 To Ilham Zurayk 1941-2001 Sector Manager, World Bank "Dedicated to assisting in the historic process of economic and financial transition" Contents FOREWORD .................................................................. vii PREFACE .................................................................. ix ACKNOWLEDGMENTS .................................................................. xi CONTRIBUTORS .................................................................. Xiii OVERVIEW ................................ ................................... xv PART I GLOBAL FINANCIAL MARKETS AND THE TRANSITION ECONOMIES Chapter 1 Transition Economies in the Evolving Global Financial Markets ................................. 3 Jacques de Larosiere Chapter 2 Financial Integration in Western Europe: Can the East Catch Up? ................................ 7 Tommaso Padoa-Schioppa PART II FINANCIAL SECTOR DEVELOPMENT IN PERSPECTIVE Chapter 3 A Perspective on Financial Sector Development in Central and Eastern Europe .13 Lajos Bokros Chapter 4 Challenges of Financial System Development in Transition Economies .29 Stefan Kawalec and Krzysztof Kluza PART HI BANKING SECTOR RESTRUCTURING Chapter 5 Estonia: The Financial System in Retrospect and Prospect .47 Helo Meigas Chapter 6 Financial Sector Restructuring: The Croatian Experience .59 Marko Skreb and Velimir Sonje Chapter 7 Financial Sector Restructuring in Bulgaria 1997-2001 .73 PetarJotev Chapter 8 Financial Markets in Hungary: Achievements and Prospective Challenges .77 Istvan Szalkai Chapter 9 Restructuring the Russian Banking System .89 Marina Chekurova Chapter 10 Evolution of the Banking Sector in Central Asia ............................................. 97 Tune Uyanik and Carlo Segni PART IV CAPITAL MARKETS: READY TO TAKE OFF OR STALLED IN FLIGHT? Chapter 11 Stock Markets in Transition Economies .................................................. 109 Sti;n Claessens, Simeon Djankov, and Daniela Klingebiel v Financial Transition in Europe and Central Asia Chapter 12 Emerging Stock Markets in Central Europe: Where Do We Stand? ............................. 139 Wieslaw Roziucki Chapter 13 Emerging Capital Markets: A Slovenian Perspective ......................................... 145 Draiko Veselinovij Chapter 14 Czech Capital Markets: Illusions and Disillusions .......................................... 153 Vladimir Rudlov&ik Chapter 15 Capital Market Development in the Russian Federation ..................................... 161 Dmitri Vasiliev PART V LESSONS LEARNED AND FUTURE CHALLENGES Chapter 16 Banking Transition: A Comparative Analysis .............................................. 173 Stephen Fries and Anita Taci Chapter 17 Financial Deepening and the Role of Financial Crises ....................................... 189 Stephen Peachey and Alan R. Roe Chapter 18 Aspects of Banking Supervision ......................................................... 207 Christian Durand and Wim Fonteyne Chapter 19 Finance in the New Millenium ......................................................... 221 Stijn Claessens, Tom Glaessner, and Daniela Klingebiel PART VI THE ROLES OF THE WORLD BANK AND THE INTERNATIONAL MONETARY FUND Chapter 20 The Evolving Role of the World Bank in ECA Financial Sectors ............................... 239 Paul Siegelbaum and Alexander Fleming Chapter 2.1 Financial Policy in Transition Economies: An IMF Perspective ................................ 255 Stefan Ingves INDEX .....265 vi Foreword T he financial sectors of the post-communist economies of Europe and Central Asia are perhaps where the most intractable problems existed and where the most difficult reforms were forced to begin. This element of the transition experience has been extremely educational not only for financial practitioners, regulators, and policymakers, but equally so for those of us in inter- national institutions who consider ourselves "experts" in the field. We at the World Bank are still try- ing to comprehend fully what the concept of transition really means. This book seeks to take that learn- ing process one step farther. This publication, as well as the seminars in Prague and The chapters contributed to the book came predomi- Benesov on which it was based, brings together the views nantly from those who have lived through, and played of a wide range of financial sector experts, and shares active roles in, the economic and financial transformations. some of the lessons learned from the past decade. With the This is appropriate. Every effort was made to include a benefit of hindsight, it also looks toward the second decade wide range of country experience, as well as the experience of financial transition. I believe this is a very valuable of partners such as the International Monetary Fund and the exercise, as some countries have quite successfully com- European Bank for Reconstruction and Development. I pleted the toughest part of their financial transition, while want to personally thank all who participated in this impor- others still have this hurdle to overcome. tant effort for their invaluable contributions. Johannes F. Linn Vice President Europe and Central Asia Region World Bank vii Preface T he transition countries of the Europe and Central Asia (ECA) region experienced a remarkable transformation over the past decade, not least in their financial sectors.1 In fact, while many sectors of the economy had difficult adjustments to make, the financial sector was unique in having to be reestablished virtually from scratch. In the former Soviet Union-with the exception of the Baltics-the business of finance, at least as it is known in the West, had not existed for more than 80 years. In Central Europe and the Baltics, experience with market-based financial systems is more recent, but significant restructuring of the infrastructure and structure of financial markets had to take place even there. This presented serious challenges to financial sector policymakers in the ECA countries. The breadth and depth of this challenge can be especially the Western European component-has evolved, gleaned from this collection of papers, which were pre- and how these developments have both influenced and sented at two seminars and a conference on transition challenged different types of transition economies. finance that took place, respectively, in Prague and the his- The book also provides an opportunity to take stock toric town of Benesov, Czech Republic, at the time of the of progress in the financial systems of ECA countries over World Bank-International Monetary Fund Annual the past 10 years and to identify the main challenges con- Meetings (September 2000). Even in countries where the fronting financial policymakers during this period. starting points appeared similar following the breakup of As would have been expected, the banking systems in the Soviet Union, experience with the implementation of the transition economies have spearheaded financial devel- reforms was markedly different. opment, but it has not been a linear process by any means. Important to financial transition was the global eco- The need to develop the legal, regulatory, and supervisory nomic and financial environment in which the ECA coun- framework for banks from scratch has been a challenging tries evolved. Had world financial markets-and in partic- one, especially as the personnel needed to operate and ular those in neighboring Western Europe-stood still this supervise the banks had to be trained from the outset. past decade, the path of financial transition for ECA coun- The institutional context from which each financial sector tries might have been smoother. But they did not, and glob- has evolved in each transition economy has differed great- al financial markets are likely to continue to grow apace ly. But in most cases, early lapses in regulation led to the and to evolve in ways unimaginable even a few years ago. emergence of a superfluity of banks. Therefore, much of The financial systems of ECA have had to adapt quickly. the history of banking development in ECA has sur- This book examines the factors that influenced, and rounded the question of how the banking system could will influence, this process of adaptation, starting from an consolidate into a more manageable number of players. examination of how the global financial system- Sometimes the consolidation took place through mergers 1. The ECA region, for the purposes of this book, is defined to include Albania, Armenia, Azerbaijan, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, the Czech Republic, Estonia, the former Yugoslav Republic of Macedonia, Georgia, Hungary, Kazakhstan, the Kyrgyz Republic, Latvia, Lithuania, Moldova, Poland, Romania, the Russian Federation (Russia), the Slovak Republic, Slovenia, Tajikistan, Turkmenisran, Ukraine, and Uzbekistan. ix Financial Transition in Europe and Central Asia or an orderly process of liquidation. In other cases, it took how successful policy reform has been in stimulating a place in the context of serious banking crises. deepening of the financial sector and improving private Consiclerable effort has gone into the establishment of sector access to finance. The book seeks to address this capital markets, particularly stock markets, in ECA coun- question. tries, but this has not been an easy process. Much of the Looking ahead and through to the end of the new stimulus to the growth of these markets has come from the decade, it is clear that a fresh set of challenges will confront privatization of state enterprises and the specific financial ECA's financial systems. It may prove difficult for the ECA mechanisms used to bring this about. Controversy has sur- accession economies to catch up with, and fit into, an inte- rounded the role and impact of the use of vouchers, for grated European financial system that has been subject to instance. Ns with the banking sector, the legal, regulatory, the twin stimuli of the euro and rapid technological change. and supervisory framework for the capital markets has The latter, in particular, may create a new set of challenges evolved to different degrees of sophistication in different for financial markets and their regulators. But for many of transition economies. But these markets have not become the nonaccession transition countries of Eastern Europe a significant source of new financing for private enterpris- and Central Asia, the challenge will remain simply one of es. Moreover, the movement to integrate stock markets restructuring the financial sector so that it has a core of across national boundaries is calling into question even the sound and efficient market institutions. need for local stock market capacity. Finally, the book seeks to examine the changing role of A sufficiently long set of data pertaining to the tran- the World Bank and the International Monetary Fund in sition economies is now available, allowing us to draw out the financial sectors of the ECA countries. some of the lessons of experience by applying appropriate analytic techniques. In particular, there is a question as to Lajos Bokros, Alexander Fleming, and Cari Votava x Acknowledgments T he editors would like to thank all the authors who contributed chapters to this book. This book is based on a series of seminars held in the fall of 2000 in Prague and in the town of Benesov, in the shadow of the famous Konopiste castle, Czech Republic. The findings and opinions expressed in this book are those of the authors and do not necessarily reflect the views of the institu- tions with which they are affiliated, the World Bank, its board of directors, or its member countries. The editors also would like to express their apprecia- Roberta Lovatelli, Kenneth Mwenda, Sylvia Torres, and tion to the following World Bank staff who provided logis- Rizalino Zamora. Special thanks go to Elizabeth Forsyth, tical support for the two seminars and for preparation of who edited the volume, and to Sylvia Torres, who handled the book: Sophia Cox, Gerardo Corrochano, Sandra the extensive flow of papers from, and communications Darrie, Rosamund Garner, Lynn Gross, Yong Hong, with, the authors. xi Contributors Lajos Bokros, director of financial advisory services, Europe and Central Asia Regional Office, World Bank Marina Chekurova, first deputy director, Agency for Restructuring Credit Organizations Stijn Claessens, former lead economist, Financial Sector Vice Presidency, World Bank Simeon Djankov, senior financial economist, Financial Sector Vice Presidency,World Bank Christian Durand, advisor, Monetary and Exchange Affairs Department, International Monetary Fund Alexander Fleming, sector manager, Europe and Central Asia Regional Office, World Bank Wim Fonteyne, economist, Monetary and Exchange Affairs Department, International Monetary Fund Stephen Fries, director of policy studies, European Bank for Reconstruction and Development Tom Glaessner, lead economist, Financial Sector Vice Presidency, World Bank Stefan Ingves, director, Monetary and Exchange Affairs Department, International Monetary Fund Petar Jotev, deputy prime minister, Bulgaria Stefan Kawalec, chief advisor, Bank Handlowy w Warszawie S.A. Daniela Klingebiel, senior financial economist, Financial Sector Vice Presidency, World Bank Krzysztof Kluza, advisor, Bank Handlowy w Warszawie S.A. Jacques de Larosiere, advisor to the board, Paribas Bank Johannes F. Linn, vice president, Europe and Central Asia Regional Office, World Bank Helo Meigas, former deputy governor, Bank of Estonia Tommaso Padoa-Schioppa, member of the executive board of the European Central Bank Stepben Peachey, consultant, Institute for International Business Development, Kyiv Alan R. Roe, former principal economist, Europe and Central Asia Regional Office, World Bank Wieslaw Roziucki, president and chief executive officer, Warsaw Stock Exchange Vladimir Rudlovjdk, board member and senior specialist, Cautor Consulting, Czech Republic Carlo Segni, consultant, Europe and Central Asia Regional Office, World Bank Paul Siegelbaum, director, Europe and Central Asia Regional Office, World Bank Marko kreb, chief advisor to the governor, Croatian National Bank Velimir Sonje, Raiffeisen Bank, Zagreb Istvan Szalkai, former president of Hungarian Banking and Capital Market Supervision Anita Taci, economist, European Bank for Reconstruction and Development Tune Uyanik, senior financial specialist, Europe and Central Asia Regional Office, World Bank Dmitri Vasiliev, chairman of the board of directors, Investor Protection Association Dragko Veselinovic, president and chief executive officer, Ljubljana Stock Exchange, and professor of International Finance, Faculty of Economics, University of Ljubljana, Slovenia Cari Votava, financial sector specialist, Europe and Central Asia Regional Office, World Bank xiii Overview T his book brings together 21 papers-organized into six parts-that address a wide range of issues pertaining to financial sector transition in the countries of Europe and Central Asia (ECA). The initial chapters (Part I) place the transition economies in the context of recent and prospective developments in global financial markets. Part II then looks back at the experience of the past 10 years and takes stock of progress in the move from a command financial system to a market- based one, identifying some of the key characteristics of the financial transition. Parts III and IV exam- ine in more detail-and with reference to specific countries-financial transition in the banking sector and the capital markets respectively. Part V takes a cross-country, analytic approach to addressing a number of key policy questions pertaining to the course of financial transition. It also looks forward, drawing out some of the lessons culled from the experience of the past 10 years that have relevance for the future, but also speculating on those factors that are likely to shape the next 10 years. The book con- cludes with Part VI, which describes the roles that the World Bank and International Monetary Fund (IMF) have played in supporting financial transition and how they are likely to evolve in the future. Part 1. Global Financial Markets and the tion of the euro and financial innovation. This makes the Transition Economies catch-up process all the more difficult. Padoa-Schioppa One of the key themes that run through the book is explains why accession countries would be advised to look developed in the context of the chapters by De Laroisiere closely at the evolving financial systems of the EU countries, and Padoa-Schioppa. De Laroisiere's chapter makes the for they are integrating quickly and in ways that are not point that ECA countries can no longer be considered a obvious to the casual observer. Policymakers in accession homogeneous group. A two-speed ECA clearly has countries will have to track these developments closely. emerged. The faster reformers-mainly the countries of Central Europe and the Baltics-are those countries that Part I. Financial Sector Development in Perspective aspire to accede to the European Union (EU), an aspiration The chapters by Bokros and by Kawalec and Kluza that is providing a major impetus to the reform effort. The step back from the 10 years of financial transition and other group-predominantly the countries of Eastern seek to draw general conclusions about the process. Europe and Central Asia-are those countries that still Bokros-who focuses on 10 Central and Eastern European have, even 10 years into the transition, fundamental countries-develops a typology of financial sector devel- reforms to undertake in the financial sector. Padoa- opment. He emphasizes that financial sector development Schioppa develops this theme further, stressing that even in has been an uphill struggle and much less successful than the case of the fast reformers the catch-up process with the reforms in some other areas. It has had to overcome a dire EU is not a simple one. The financial systems of current legacy of crime, corruption, and collusion. Therefore, members of the European Union, for instance, also are financial transition will take a long time to complete. changing rapidly in the face of the twin forces of introduc- Bokros stresses-as did the authors in Part I-the large and xv Overview growing differences between countries in their financial ing sector with strong prudential regulation and supervi- sector development and points to the fundamental factors sion. Bulgaria has learned this lesson the hard way. that determine the scope, nature, and quality of emerging Szalkai provides a succinct overview of the develop- financial institutions: specifically, internal and external ment of financial markets in Hungary, which highlights governance structures, domestic and international compe- some of the structural vulnerabilities remaining in the tition, and prudential regulation and supervision. banking sector. These include a need to cleanse portfolios The chapter by Kawalec and Kluza highlights the need of remaining losses on the books of privatized banks. But for the banking sector and capital markets to develop in a the main challenges for the future will be associated with balanced way in transition economies. They make 21 readying the financial sector to join the European Union. insightful observations about the nature of the financial sec- This will require removing the remaining structural imped- tor transition. Looking to the future, they emphasize that, iments in the financial system. Further banking consolida- except for small and open economies, countries without a tion is expected. The nonbank financial institutions also are sound domestic stock market may be handicapped in their expected to develop quickly, driven in part by the growth economic and social development. of the fully funded pillars of the pension system. The intro- duction of a unified agency for financial supervision reflects Part Ill. Banking Sector Restructuring the integration that is under way across financial institu- Part III examines the widely divergent experience of tions in Hungary. ECA countries in relation to banking sector reform. The The chapter by Chekurova examines the restructuring chapters examine experience ranging from Estonia, where of the Russian banking system, focusing especially on the restructurlig of the banking sector is virtually complete, to role of the Agency for Restructuring Credit Organizations Central Asia, where the process of restructuring has a sig- (ARCO). The analysis is centered on the period since the nificant way to go. The chapter by Meigas highlights the Russian financial crisis in the summer of 1998. The critical rapid change that has taken place in the banking sector stage of the banking crisis is now over, and the Russian over recent years. Increased competition has resulted in banking system is gradually adapting itself to new eco- several major mergers, and many weaker and inefficient nomic conditions. Chekurova cautions that the banking institutions have left the market. The banking market is system remains vulnerable, however. Moreover, she believes now almost totally foreign owned and heavily concen- that banking development will require recapitalization of trated. This is a unique outcome within the set of ECA private sector banks, improvements in legislation and transition economies and probably not one that is broad- supervision, and the introduction of private deposit insur- ly replicable. ance. These are needed to rekindle public confidence in the The chapter by Skreb and Sonje takes up a very specific banking system. issue on banking sector policy: the relationship between the The evolution of the banking sector in Central Asia is central bank and the ministry of finance in their pursuit of addressed in the chapter by Uyanik and Segni. Compared financial sector restructuring. This analysis is undertaken in with other parts of the ECA region, banks in Central Asia the context of Croatia, but the question of coordination typically have remained relatively small, undercapitalized, between the central bank and the ministry of finance is per- and poorly governed, with underdeveloped technical and tinent to other ECA countries as well. Skreb and Sonje call operational capacities. This situation changed somewhat in for much closer coordination between the two institutions. the second half of the 1 990s, with an improved economic In the absence of proper coordination, financial restruc- environment and enhanced legal and supervisory infra- turing wilL be slower, less efficient, and more expensive. structure for banks. There has been only a modest move As Jorev vividly explains in reference to the Bulgarian toward banking consolidation in this part of the ECA experience, transforming the banking sector can be a cost- region, with consolidation being most marked in ly business. The state-owned banks funded inefficient and Kazakhstan. More needs to be done to improve the over- loss-making enterprises, contributing to the almost total all soundness of banks in Central Asia and to restore con- collapse of the Bulgarian economy in late 1996. fidence in the banking system at large. Recapitalizing the Bulgarian state-owned banks-prior to their privatization-cost about 25 percent of gross domes- Part IV. Capital Markets: Ready to Take off or tic product. Jotev concludes that there is strong evidence Stalled in Flight? that the most efficient and stable economic systems are In the first decade of financial transition, govern- those that combine little or no state ownership in the bank- ments-supported by the international financial institu- xvi Overview tions and bilateral aid programs-put considerable effort tization scheme under a mass privatization program. into the establishment of capital markets, particularly the Despite the problems encountered in its early develop- stock market component. Such markets were viewed as ment, the structure of the stock market has improved, being the cornerstone of market-based financial systems. and about 150 core companies are now listed. The estab- Although the infrastructure for most ECA stock markets lishment of the Securities Commission in 1998 was an has been put in place, the volume of stock trading and the important step in the creation of a standard regulatory number of new stock issues have been modest, for the environment for the market, and a strong infrastructure most part. At issue, therefore, is whether these markets are for the capital market now exists. However, in Rudlovcak's now poised to play an important role in the next decade of view, the market has not yet played a visible and effective transition, or whether they are more likely to go into role in the economy nor fostered the efficient allocation of decline or be absorbed into larger international stock funds, but there are signs that the capital market might be exchanges. maturing. Claessens, Djankov, and Klingebiel conclude that stock Vasiliev tracks the development of the Russian capital markets in transition countries are small and dormant and markets, which was initially ignited-like that of the Czech that most of these markets will not achieve minimum Republic markets-by the trading of privatization vouch- economies of scale in the foreseeable future. They note ers. Vasiliev describes three stages of capital market devel- that in the era of globalization, stock market services will opment up to the onset of the financial crisis in 1998, be readily available abroad, both for companies wanting to which saw the collapse of the Russian securities market. raise capital and for investors wanting to invest in stocks. The crisis brought to the surface structural weaknesses in Thus, they recommend that transition economies avoid the Russian market, but the period since 1999 has given developing costly stock markets and concentrate instead on grounds for optimism. The relatively stable macroeco- building basic legal infrastructure to protect creditor and nomic and political situation has served to rekindle the shareholder rights and on supporting development of the markets. Vasiliev takes heart from the fact that, while the banking sector. development of the fledgling securities market has encoun- Kawalec and Kluza-as intimated above-disagree tered difficulties, these are not unique to the Russian with the thrust of the Claessens, Djankov, and Klingebiel Federation (Russia). It already has contracted some of the analysis and instead stress the likely impetus that will be diseases typical of a young market and has developed some provided to domestic stock markets when the reformed immunity against them. But addressing all of the issues in pension schemes mature. Such schemes hold out the the Russian capital market must await the resolution of prospect, in the longer term, of generating large volumes of some of the deep-seated structural problems confronting investible funds that will be channeled through the capital the Russian economy. markets. Furthermore, Rozlucki, in the context of a chap- ter analyzing the factors that have shaped capital market Part V Lessons Learned and Future Challenges development in Central Europe, believes that internation- In Part V, the analysis of 10 years' worth of key cross- al capital markets can perform few of the functions of a country data for the financial sector yields important find- domestic stock exchange in a transition economy. The fail- ings, with implications for the conduct of financial sector ure of local capital markets would deprive ECA countries policy and the determinants of financial sector deepening. of important national assets. The chapter by Fries and Taci considers whether the Veselinovic examines ECA's evolving capital markets policies espoused by the World Bank and IMF in support of from a Slovenian perspective. He highlights factors that financial sector reform in transition countries have been suf- would lead to the development of a successful stock mar- ficient to encourage the development of sound, market-ori- ket and indicates political constraints on the process. ented banking systems. Their analysis assesses the develop- Veselinovic believes that in the future, Central and Eastern ment of banks in transition economies at both the aggregate European stock markets will be either regional or local and level and the level of individual banks. The analysis finds that they all eventually will have to integrate into the glob- that at the aggregate level the expansion of banking activi- alized (European) markets. ty, particularly lending to the private sector, has been asso- Rudlovcak undertakes a detailed review of the politi- ciated with progress in structural and institutional reforms cal economy of capital market development in the Czech and growth of output. The analysis at the individual bank Republic, which was initially spurred by a voucher priva- level broadly supports this finding. In particular, banking xvii Financial Transition in Europe and Central Asia regulation and supervision-especially capital adequacy changing economic, financial, and technological environ- requirements-are helping to establish a firm foundation for ment around them. The thorny question of whether foreign the expansion of bank lending. Banking development banks should be welcomed into ECA financial systems is nonetheless remains stunted, as the real expansion of lend- broached, and recent evidence on foreign bank penetration ing to the private sector has failed, on average, to keep is presented. A number of countries around the world are pace with output growth. Analysis contained in the chapter moving to one or another variant of a unified supervisory also points to the need to strengthen the supply response of body that could incorporate banking, securities, insurance, banks. The measures proposed include the more effective and pension fund supervision. Durand and Fonteyne exam- regulation of the entry and exit of banks, improvements in ine the case for ECA countries moving in this direction (as the corporate governance of banks, removal of obstacles to is already the case in Estonia, Hungary, and Latvia). They the expansion of foreign banks, strengthening of the judi- also address the difficult question of the supervisory ciary, and protection of investor rights. response to banking failure that has been a common feature The chapter by Peachey and Roe analyzes the factors of the past decade and is likely to persist in the foreseeable that influence the path of financial deepening and the role future. The authors set out specific principles that should that financial crises play in the process. The authors put govern the sequencing of prudential supervision and bank down differences in progress toward financial deepening to restructuring policies. They conclude that ECA countries the nature of the macroeconomic disruptions associated should establish effective banking supervision, fulfill the with the early transition years and to the quality of the prerequisites for its proper functioning, and ensure that its recovery from those disruptions. They point to the fact that design is consistent with the stage of development of the several countries, including Russia and Ukraine, have side- economic and financial system it oversees. stepped the macroeconomic pressures coming from tight Looking to the future, Claessens, Glaessner, and monetary and fiscal policies by allowing high levels of barter Klingebiel examine the broader global financial sector envi- and nonpayment in their economies. As a result, significant ronment in which ECA financial systems are going to have damage has been done to the prospects for the early recov- to operate in the years ahead. They discover that some ery and deepening of their financial systems. The propensi- transition economies are starting to participate in the e- ty of somle countries to protect high-cost and inefficient finance revolution and that this is having a significant, pos- banks also contributes to the slow pace of financial deep- itive impact in some markets. E-finance can assist some ening. Peachey and Roe propose a menu of policy propos- transition economies to leapfrog the formal stages of finan- als that would reduce bank costs and lead to deeper bank- cial sector development through which many developed ing systems. These include the reform or elimination of countries have progressed. The form in which this e-finance most government policies that contribute to the high cost of revolution will come about will be shaped by the forces of banking (such as directed lending), the radical reform of sys- supply and demand as well as by regulatory and other bar- tems of nonpayment or barter in all countries in which riers. To reap the fruits of the e-finance revolution, ECA these practices are widespread, and the adoption of an countries will need to give priority to improving the frame- increasingly low supervisory tolerance of the high operating work for financial and other information, modernizing and costs and low ratio of earnings to total assets that are char- strengthening their legal systems, and improving technolo- acteristic of many large state and former state banks. The gy-related infrastructure (such as telecommunications). authors also call for the adoption of explicit supervisory policies to accelerate bank consolidation so as to concen- Part VI. The Role of the World Bank and IMF trate a bigger percentage of banking business on the lower- The concluding chapters by Siegelbaum and Fleming of cost banks. They take the view that banking crises can rein- the World Bank, and Ingves of the International Monetary force strong regulation, provided the end result is Fund examine the changing role of their respective institu- intermediation increasingly focused on a smaller group of tions in fostering financial sector development in ECA more efficient banks. Accordingly, politicians in transition countries. Siegelbaum and Fleming explain how the nature countries should not fear crises as much as they typically do. of the Bank's involvement has changed over time, reflecting One of the critical policy areas that impinges signifi- both the changing needs of its ECA clients and changing cantly on the evolving structure of ECA financial systems perceptions in the Bank as to what constitutes good prac- relates to banking regulation and supervision. Durand and tice in analysis and operational design. All ECA coun- Fonteyne examine the role of banking supervision and the tries-with the exception of the Czech Republic-have challenges it will face as ECA banks adapt to the fast availed themselves of Bank support for financial sector xviii Overview reform. This support has focused mostly on restructuring ments for monetary policy implementation. Support also banks and building a sound legal, regulatory, supervisory, has been furnished in the area of banking supervision, and institutional framework for financial activity. An analy- accounting reform for banks, development of payment sis of Bank involvement is undertaken with reference to five systems, and, most recently, the application of standards categories of ECA countries. The various categories of and codes to different fields of financial sector activity. countries have drawn on different mixes of Bank lending The basic challenge over the next decade, from the stand- instruments and different types of policy intervention. In point of the IMF, is to have countries complete fundamen- the future, the Bank is likely to concentrate its support tal tasks, while responding to and assisting them in an less on the EU accession countries and more on the remain- appropriate and timely manner when specific problems ing ECA countries. arise, even where the fundamental institutions, instruments, Ingves explains how IMF support for ECA countries practices, and procedures are in place. Inevitably, the IMF was initiated, focusing on developing the central banking will be guided by certain international standards and best function, while promoting the independence of central practices in its assessment of the basic work that remains to banks. This has involved assistance in developing instru- be done in a particular context. xix Part I Global Financial Markets and the Transition Economies Chapter 1 Transition Economies in the Evolving Global Financial AMarkets Jacques de Larosiere he role of the financial sector in all countries is of paramount importance. Banks are the inter- mediation agents between savings and investment, and only solid institutions are able to attract deposits and to channel them in a professional way toward productive opportunities. The efficiency of the banking sector and of financial markets is a well-recognized factor of lasting growth. Freedom of capital flows is now present in almost all little more than "a bookkeeping mechanism for tabulating countries. Combined with deregulation and a more and the authorities' decisions about the resources to be allo- more integrated international financial system, this freedom cated to different enterprises and sectors" (European Bank is creating many opportunities for emerging economies. for Reconstruction and Development 1998, Transition Net financial flows to emerging countries have increased Report, pg. 92). Securities markets were absent, since no enormously over the past years, boosting economic growth. marketable securities were available, and there was no But this freedom is also creating more vulnerability. Indeed, need for prudential and supervisory regulations. The chal- short-term capital is volatile, and, as the experience of lenge for the transition economies after 1989 was huge: to Southeast Asia has shown, the lack of a robust, well-capi- create from scratch a functioning financial system. talized, and properly managed and monitored banking The progress made in the banking system has been system can be a major source of weakness when investor quite significant, albeit uneven and incomplete. The prob- sentiment changes and capital movements start to shift. lem was all the more difficult to resolve in that state banks This chapter examines how these trends are affecting had portfolios dominated by nonperforming loans and transition economies and what progress has been made in personnel with few technical skills in the field of banking. developing their financial institutions. It also addresses the Transition countries acted to create a true banking future and outlines the possible avenues offered to transi- system in two ways: tion countries regarding banking systems and capital mar- * Privatization of state banks kets. This discussion also addressses the European Union * Development of new banks (private). (EU) accession process. Methods of privatization varied from country to coun- try. For instance, in the Czech Republic the rapid move Financial Sector Development in a World of Free toward privatization based on a voucher scheme had the Capital Movements political advantage of speed but led to a number of prob- To understand the developments of the financial sector lems related to the absence of new equity and know-how in transition countries, it is useful to look back at the start- inherent in that method. Other countries, like Hungary and ing point. Under central planning, the financial system was Poland, took more time to privatize their banks but did so 3 de Larosiere by allowing strategic partners (most often foreign) to par- transition economies have a relatively underdeveloped sys- ticipate in the process, which eventually brought significant tem of financial intermediation. benefits (equity, corporate governance, and worldwide An examination of the ratio of bank credit to the pri- presencel. The European Bank for Reconstruction and vate sector relative to GDP by the countries' level of income Development played a useful role in the process. per capita reveals that transition economies, except for the In the Russian Federation (Russia) and many other Czech Republic, are well below the corresponding market transition economies, the weakness of the regulatory economies. But this gap is gradually eroding, as progress is authorities allowed the creation of numerous small private made in strengthening the banking systems in transition banks, which generally were not prepared to perform the countries. banking functions in a professional way. Indeed, enormous progress has been made in a number The banking sector in transition countries has been of transition countries in terms of banking supervision, subjected over the years to a number of crises. Those crises privatization, and consolidation. Hungary, for instance, occurred in countries where the financial environment had has a widely privatized banking system, which is now con- been liberalized, but where the regulatory framework had trolled largely by foreign strategic partners and is well not been developed sufficiently to contain the risks stem- supervised. Poland also has advanced far in that direction, ming from capital liberalization. Crises also have emerged and the Czech Republic is catching up rapidly, with the pri- in countries where macroeconomic stabilization has failed. vatization of its banking system. In Russia, the systemic cri- A banking crisis was experienced in Estonia in 1992 and in sis of the banking sector persists, and the process of restruc- Latvia and Lithuania in 1995. The Czech Republic saw the turing needs more clarity. failure of several medium-size and large local banks in In a number of less-advanced transition countries, the 1996. Bulgaria faced a full-fledged banking crisis in the consolidation and privatization of banks are among the same year, and in 1998 Russia faced a financial crisis that major tasks ahead and are most often the centerpiece of led to the collapse of much of its banking system. International Monetary Fund (IMF) programs. The causes of those crises differed from country to country, but in all cases a combination of two factors was Progress in Building Local Capital Markets at work: Capital markets in transition economies have less * Accumulation of bad loans (either inherited from the depth and breadth than those in market economies at com- communist period or developed under the new con- parable levels of development (where development is mea- ditions, in particular because governments insisted sured by gross national product per capita). on protecting loss-making companies) Comparing the market capitalization of local corpo- * Insufficient regulation and supervision of the bank- rations with that of other emerging-market economies ing system. reveals that the stock market capitalization in transition Repairing the banking sectors in transition countries economies remains relatively low, although it has developed has been a major task that has developed over the years and over recent years in countries like the Czech Republic, is still ongoing in some countries. It has implied massive Hungary, Poland, and Slovenia. Stock markets in the region injections of capital by the state. In order to make privati- also have seen considerable volatility in recent years. zation possible, governments either have to provide equity In this regard, it is interesting to look at the balance directly to the ailing privatizing banks or have to carve out between risk and return offered by the stock markets in impaired assets from their balance sheets. transition economies. The industrial market economies These actions to repair the banking systems have typi- and developing countries have tended to offer a more cally cost on the order of 10 percent of gross domestic prod- favorable balance between risk and return over the past uct (GDP) per country. This is by no means unique to tran- four years than have the transition economies as a group. sition economies. Banking sectors in other countries, be they Except for Hungary, the price to book value ratios are industrialized (such as the Scandinavian countries and Japan) lower in the transition countries than in developing coun- or emerging (Latin America and Southeast Asia) also have tries. Firms that are successful in investing their capital as experienced crises that have led, in some cases, to more well as their borrowings clearly tend to have strong heavy injections of equity than in transition countries. prospects for earnings growth and to have low discount Moreover, these banking crises in transition countries rates applied to their future earnings. Price to book value did not always produce the severe economic disruptions ratios can be viewed as a reflection of the business climate typical to many other countries. This is probably because in the interested countries. 4 Transition Economies in the Evolving Global Financial Markets Looking to the Future * Protection of minorities' rights Long-lasting growth in transition economies requires * Progress of privatization the conjunction of two major elements: * Improvement of the business climate and openness * Stronger local savings toward foreign investors * Higher investment in the productive sector. * Development of pension systems In order for this to happen, macroeconomic stability * Strong macroeconomic fundamentals. needs to be pursued. This is indispensable for reassuring These are some of the conditions that eventually will savers that their deposits and investments will not be wiped reinforce the already encouraging, but still limited, progress out by inflation. (In this respect, there has been a trend, in that has been made in this field in a number of transition some countries, toward a somewhat excessive recourse to countries. foreign debt and higher current account deficits). A favor- Transition countries need a modern capital market able business climate is also needed, with clear rules of the and a good banking system to help their corporations and game and a competitive business environment. Eliminating their many small and medium enterprises raise funds more subsidies to loss-making companies, enforcing bankruptcy easily. laws, and eradicating state intervention in the conduct of In 1993 the European Council in Copenhagen adopt- enterprises are some of the prerequisites for improving the ed the principle of the European Union (EU) enlargement. business climate. Ten countries-the Czech Republic, Estonia, Hungary, All countries, and in particular the European ones, Poland, Slovenia, followed by Bulgaria, Latvia, Lithuania, are exposed to the powerful changing trends that have Romania, and the Slovak Republic-are now in the process characterized the international financial system during the of negotiation. The process started in December 1998 with past decade. These trends are forcing banks to consolidate the first wave of five candidates, followed later by the sec- and adapt to new information technology. They are leading ond wave. to the emergence of financial conglomerates and are shift- The preaccessions' strategy consists of combining ing financial resources from commercial banks to mar- reforms by the candidate countries with some financial kets. These trends are particularly evident in the United assistance by the EU. The idea is to help the candidates States, but they are affecting Europe and the rest of the before accession to conform with the acquis communau- world as well. They are posing new challenges to regulators taire. The procedure is based on the negotiation with each and supervisors. Under such conditions, how should the country of an accession partnership. These partnerships Eastern and Central European economies react? outline the list of priorities-short- and medium-term-that It might be imagined that, starting from scratch, their have to be met before accession. The partnerships also lay financial systems would have adapted to the new trends, out the amount of resources that will be allocated to each thus circumventing the process of rebuilding a classical candidate (total of 3 billion euros a year starting in 2000). network of commercial banks. But that was not possible This financial assistance is conditional on the achievement given the existence of banking systems (albeit inefficient) in of reforms: it can be suspended in the event of unsatisfac- those countries. Therefore, the transition countries will tory performance. have to strengthen their financial systems and allow them Each country is assessed continuously according to its both to adapt to the changing trends and to adopt new performance and becomes a member of the EU when it has technologies and best industry practices. met the obligations that apply to all member states. Banks must be adequately capitalized, and they must Negotiations are conducted on a bilateral basis between the make their decisions on the basis of a professional risk EU and each candidate. Each country is assessed toward assessment analysis. They must be independent in the way the month of November of each year in terms of its that they act, and they must be seen as independent. progress toward accession. The commission's November Supervisory authorities have, of course, a major role to play 1999 paper stresses, for example, that "Apart from in monitoring the capital adequacy ratios and the risk Hungary and Poland, all of the candidate countries need to assessment methods of the financial institutions under their make major efforts to ensure financial control. The devel- control. opment of internal control system requires particular atten- As far as the development of capital markets is con- tion" (European Commission, November 1999, Report cerned, the following factors are especially important: on Progress Towards Accession). * Clear regulation More recently, the European Commission has pro- * Strong supervision posed strengthening the process regarding financial insti- 5 de l.arosiere tutions. The commission notes that "From the moment at Ideally, if all conditions are met, first accessions could which their countries join the EU, financial institutions be ready by the end of 2002. Given the usual delays in rat- from Central and Eastern Europe countries should receive ification, the first accessions could become effective in a 'European passport' allowing them to operate under 2004. This is a purely theoretical notion, and the process home country supervision in the entire EU." In view of this, may well take more time. the accession countries will have to fully adopt all EU An economic and monetary union is an integral part of financial services legislation. The commission will contin- the accession process. Accession implies that the new mem- ue its current efforts to monitor the transposition of the bers commit themselves to participate in the monetary acquis communautaire. However, formal transposition of union (as long as they meet the convergence criteria fixed the acquis into national law is not all that is required. in the Maastricht Treaty). But the observance of those cri- Supervisory bodies also are needed with sufficient admin- teria is not a necessary condition for acceding to the istrative capacity to implement the national law in practice. European Union. Candidates very probably will enter the Therefore, it will be necessary to: union first and the monetary union later on. Each country * Provide technical assistance to candidate countries will have to negotiate thoroughly, and, at least in some an-d help them to build this capacity, and fields, some may have to go through a transition period. * Assess the resources, experience, and prudential In summary, considerable progress has been made in techniques of supervisory bodies in these countries, strengthening the banking and financial institutions in tran- possibly by way of peer review procedures. sition countries. This is all the more remarkable in that it Since the commission by itself cannot provide the nec- has been accomplished in less than 10 years, starting from essary assistance to the financial services supervisors in a very low point. But there is still much to be done. those countries, nor check their efficiency, it is looking to The accession process is proving a powerful engine for the pru(dential authorities of member states for assistance pushing strategic reforms and for consolidating and and advice. expanding what has already been achieved. Evaluation in this context should be based on reviews One of the difficulties of the exercise is that the acquis carried out by supervisors from EU countries or on assess- communautaire has become, in a world of integration and ments made under the Financial Sector Assessment increasing competition, a moving target. Present members Program of the International Monetary Fund in coopera- of the European Union themselves have much to do in tion with the World Bank. The results either should deter- improving the functioning of their financial and banking mine further needs for institution building or should help markets. The creation of the euro should be a catalyst in to judge the effective transposition of the acquis by a given this respect. Candidate countries have to think of their country. In view of this, the results, after being seen by the financial future in terms of the changing requirements of an appropriate supervisors at the EU level, should be trans- integrated global world. A constant collaboration with the mitted to the Enlargement Group of the Council. monetary, regulatory, and supervisory authorities, but also Contrary to the wish of certain candidates, the with the private financial institutions and practitioners, European Council has fixed neither a timetable for the will be of the essence if those candidates want to reap the enlargement nor an objective date for the first accession. benefits of more efficient integrated financial markets. What the 15 countries have agreed on is that the European Union will be ready by the end of 2002 to accept new References members if three conditions are met: European Bank for Reconstruction and Development. * Sufficient financial resources 1998. EBRD Transition Report 1998. London. * Completion of the institutional reform of the EU European Commission. November, 1999. Report on * Satisfactory bilateral negotiations on accession. Program Towards Accession. 6 Chapter 2 Financial Integration in Western Europe: Can the East Catch Up? Tommaso Padoa-Schioppa T t S his chapter examines the development of financial systems in transition economies-specifi- cally in those countries in the process of accession to the European Union (EU)-against the backdrop of recent developments in the Western European financial sector. It then address- es the changes in the EU financial landscape following introduction of the euro, focusing on the issue of how to strengthen the public policy side of the process in step with private market developments. Finally, the chapter examines more specifically the relations between the EU and its neighbors, 12 of which are now accession candidates. Nowadays, postcommunist countries of Central and A good illustration of the catching-up problem is the Eastern Europe and the former Soviet Union are not the process of building payment systems. A process has been only countries undergoing a transition: the EU financial sec- under way in Western European countries to build real-time tor is also experiencing a profound change. The EU mem- payment and settlement systems, which reduce systemic ber states, and perhaps even more so those that have adopt- risk because they do not entail counterparty risks but are ed the euro, have become the standard of reference for quite costly to build and run, particularly if volumes are many of the transition economies in the region. But, as small. Central bankers of the transition economies have many Western European countries are experiencing signif- tended to boast that they are in the process of launching or icant changes of their own, they, in fact, represent a rapid- contracting for the development of such systems. ly moving target. First, forces as intense as deregulation, Meanwhile, EU development suggests that, when financial disintermediation, and technological change are, in gener- markets integrate within a larger area, tendencies toward al, shaping the financial systems. Second, the introduction cross-border consolidation emerge. Payment and settlement of the euro has provided a further impetus for change in the systems have begun to consolidate across Western European countries participating in the single currency. Hence, while countries. Therefore, separate national payment and settle- the transition economies are in the process of building ment systems may not be the reality of tomorrow. Given the political and economic systems based on those in Western small scale of the markets in at least some accession coun- Europe, the financial systems in these "model economies" tries and the high cost of establishing market infrastructures, are evolving rapidly into new models. The financial land- these countries perhaps could anticipate this development scape in Western European countries may well have under- and consider the opportunities it may offer. gone a major transformation by the time the transition The same argument applies to securities markets. economies reach their current goals or the objectives set for Securities markets tend to be strongly country-specific them as a condition of membership in the EU. when they are currency-specific, with the markets for gov- 7 Padoa-Schioppa ernment securities or foreign exchange providing good securities markets, all of which are based predominantly on examples. But when the national currency is replaced by a the national currency. regional currency and the national currency ceases to The signs that the banking industry is becoming a sin- exist-as has occurred in the euro area-the securities mar- gle euro-area banking industry are much more noticeable kets redirect their operations beyond national borders. if one looks beyond the facade. Ordinary people view a Today, this evolution is taking place very rapidly in the euro banking system from the consumer or retail banking per- area. The money markets in euro practically integrated spective. Retail banking is very much anchored to the ter- within a few days of the launch of the euro on January 1, ritory and local elements, which are often even subnation- 1999. As far as the bond and equity markets are con- al or regional. For example, in a country such as Germany, cerned, the pricing conditions have been equalized, and only a few banks are operating nationwide, and the five market liquidity has radically increased, providing an impe- largest banks account for less than 20 percent of the total tus for private issuers in particular to increase the use of banking market in the country. Other evidence of the local capital market financing. The remaining regulatory fric- nature of retail banking activities is apparent from the still tions blocking the achievement of integrated securities mar- significant price differences across German Lhnder. Exactly kets are under lively debate at the moment. Despite this the same phenomenon of market localization can be seen in fundamental transformation of markets, the development the United States, as well as in many other countries. There of securities markets is viewed in many transition is a single banking system because there is a single curren- economies in isolation from the evolution of markets in cy, but the system is not crucially formed by retail banking, Europe at large, or the full potential of securities markets is although this is on many people's minds. Proximity is an not recognized, the focus being mainly on financial insti- intrinsic characteristic of the retail market, at least for the rutions. time being, with or without the emergence of a currency embracing a wider area. The EU Financial Landscape after the Euro Another common yardstick for measuring the degree A decade ago, the EU had barely liberalized capital of banking market integration has been the extent to which movements. The basic directives concerning banking and cross-border mergers have taken place. This yardstick is financial services that have opened up the European mar- also erroneous because it overemphasizes the ownership kets, permitting access to financial institutions and cus- structure, which should not be used as a key criterion for tomers beyond national borders and harmonizing the basic assessing an industry's level of integration. Until recently, regulations governing prudential supervision, had not yet very few cross-border bank mergers had taken place in taken effect. Naturally, 10 years ago, the world was total- Europe, as most of the many mergers had been conducted ly different for the transition economies, which had just within national borders. This also has been the case in the emerged from the Soviet bloc. United States, where cross-state mergers were quite rare The two most significant developments that have after the restrictions on interstate banking were lifted. changed the European financial landscape over the past 10 Because both Europe and the United States have seen rela- years have been, first, the creation of a single market and, tively few important cross-border bank mergers, consoli- second, the move to a single currency. The second step dation of ownership in the United States and Europe has represents a very consequential step toward integration, been rather similar. since as long as different national currencies exist, finance Going beyond the facade, it can be seen that the bank- is fundamentally linked to currency, even if the markets ing and financial system in Europe is emerging in many have been unified by common regulations and the opening respects as a single banking system, as in the United States. up of borders for external competition. Indeed, the multi- First, corporate banking and asset management are increas- plicity of currencies in the single market was the funda- ingly important activities for banks, although they are not mental factor behind the preservation of segmentation of immediately visible to the public. Exploiting economies of the banking industry. Interesting questions that have been scale in these activities has led to a rapid move toward con- raised in this context-also by myself on other occasions- centration and consolidation, which has effectively uni- are, first, whether signs of a single financial banking and fied the market for both corporate finance services and securities system already are emerging in the euro area asset management activities. and, second, to what extent the euro area resembles or is Second, the other large segment of the financial system, approaching what has historically been a single-country which involves securities transactions, is probably moving model with a unified banking system, stock exchange, and even faster. There are daily news stories about the attempts 8 Financial Integration in Western Europe: Can the East Catch Up? to merge large stock exchanges. The bond market is uni- An important aspect of public policy in Europe is the fying rapidly as well, involving the technical infrastruc- idea that banks can provide services over the whole spec- ture of the market and the clearing and settlement sys- trum of financial activity, while the legal framework is tems, which do not, however, always make headlines in the very strict in requiring a license. To provide financial ser- media. The greatest cost savings are possible in the unifi- vices, an institution needs an appropriate license, and, cation and standardization of these aspects of trading. So, hence, it becomes subject to the regulations in force for the in many respects, the euro area is becoming almost one particular type of financial activity it conducts. Compared country with its own financial system. with the American approach, Europeans prefer more rigid- Finally, one could, of course, say that a banking system ity on the issuance of licenses and more flexibility with is, by definition, a single banking system from the very regard to the principles of universal banking. There also moment it has a single currency and a single central bank, have been movements on this front in the United States, but a single lender of last resort, a single payment clearing sys- Europe has basically never abandoned the universal bank- tem, a single money market, and a single interest rate at the ing principle as the United States did in the 1930s. short-term end of the market. In the case of banks, we talk On the whole, the EU is evolving from national seg- about a system precisely because of the common currency mentation toward integration of the financial industry. and the central bank. The existence of a common frame- Throughout this evolution, it has been relatively successful work for accessing central bank liquidity is tying together in combining the rapid changes driven by market forces euro-area banks to a much larger extent than is usually with developments on the regulatory, public policy side. acknowledged, thus creating an integrated euro-area bank- The debate in Europe over the past two years has con- ing system. centrated on the implications of the euro for financial supervision, both of banks and of securities markets. The Policy Aspects of Integration first wave of discussions addressed the issue of whether Much of the unification of the markets to date has banking supervision should remain a national responsibil- been driven by private business motives. Even the consoli- ity in spite of the fact that monetary policy and other cen- dation of stock exchanges has become possible only as a tral banking activities were being integrated at the euro- result of a recent development, in which stock exchanges area level. The ECOFIN Council has launched a debate on have become a business in themselves, a service-providing similar problems related to the securities field. A commit- industry that can be run as a profitable enterprise. Stock tee has been convened to analyze these issues and is due to exchanges have been privatized and have become limited report its conclusions in a few months. companies. Some, in fact, are even listed on a stock A system in which major components of the financial exchange themselves. This process has been driven by prof- industry are integrated on a euro areawide basis, while it motives rather than policy motives. Ultimately, however, the public and supervisory functions are not, would result every financial system needs to be ruled both by market in a dichotomy. Regarding supervision, much discretion is considerations, reflected in private arrangements, and by left to the power of secondary legislation and to the method policy considerations, reflected in regulations. Therefore, of implementation by the supervisory agencies. This one must ask whether these two elements have moved suf- dichotomy raises the question of whether or not the current ficiently in parallel to ensure that public interests are pro- supervisory functions are adequate. The European Central tected. In my view, what is needed at this point is to Bank (ECB) has taken the position that this arrangement is strengthen the policy side of the integration process. adequate as long as cooperation among national supervi- Of course, this issue exists in all countries, because the sors and the exchange of information among them and public policy side always tends to move more slowly than between supervisors and the central banks develop in par- the private side. This is the case at the national, the allel with consolidation of the banking system. At the same European, and the global level. On the whole, the EU has time, the authorities need to work toward an effective been quite effective in developing regulations in parallel area-wide perspective. with the process of European integration. At the global level, by contrast, there is no formally recognized rule- The EU and the Transition Economies making capacity, although much has been achieved on a de Of the some 200 sovereign countries in the world, facto basis. In the EU, this capacity exists: the EU is a leg- 100 or so lie between Finland and South Africa. This part islator that produces binding and enforceable laws sup- of the world could be referred to as the European and ported and implemented by the judiciary. African sphere, to distinguish it from the Western sphere, 9 Padoa-Schioppa which refers to about 40 countries, and the Asian and Far these reasons, the Eurosystem also has a specific interest in Eastern sphere, including Australia, which amounts to sound financial structures in the accession countries. some 60 countries. Looking at the world in this way, the More broadly, in the monetary field, the accession European and African sphere has the largest number of process has a degree of flexibility and allows diversification independent states. in the formulas, the paths, and even the timetables that is Virtually all countries in the European and African not possible in other areas. Accession itself does not auto- sphere have a close relationship with the EU, which is their matically imply adopting the euro, nor does adopting the primary trading and financial partner. For each of them, euro as an official currency automatically follow partici- there is a treaty of association and cooperation on trade- pation in the exchange rate mechanism, ERM II. So there related issues, as well as activities to foster economic devel- are actually four steps: first, preaccession developments; opment.. In addition, one of the most striking changes dur- second, attainment of the status of membership; third, par- ing the latter half of the 1 990s was the growing presence of ticipation in the ERM II arrangement; and fourth, adoption foreign banks in the local banking and financial system, of the euro itself. often through the acquisition of previously state-owned This multistep process basically reflects the path that banks or through the establishment of subsidiaries. the original members have followed over the years. At the The fact that the EU provides a natural and actively beginning, there was only membership of the European used model for other countries-and the fact that this Economic Community, which did not have a monetary model itself is constantly changing-imposes an obliga- system of its own. Later, ERM was set up. Finally, the euro tion on the EU to be very open and transparent as regards was created. Even the present members of the single cur- the changes it is undergoing. The ECB maintains a close rency have approached this final stage at different speeds, relationship with accession countries, as well as with a and some EU member states are still outside the euro area wider group of countries, to ensure that the systems that or even outside ERM II. So the considerable flexibility in exist in EU countries are sufficiently open and transparent. the aspects of the accession process that concern the mon- The ECB plays a specific role in the accession process. etary field may not exist in other areas of the accession It is not in charge of banking supervision, and it has no spe- process. cific functions in guiding the transformation of the financial system. Nevertheless, it has a strong interest in the stabili- Conclusions ty of the banking system and has the expertise that every A broad and long-term perspective is needed when central bank has, even though it is not entrusted with the dealing with issues related to the financial system. The task of supervising the banks. euro-area financial system provides a model for the transi- One reason for the ECB to maintain and develop close tion countries, but the model itself is evolving at a rapid ties with the accession countries is to ensure that monetary pace. The euro area is quickly developing into a more inte- policy is both sound and stable. Since the Eurosystem (the grated financial system, particularly in wholesale banking European Central Bank and the participating national cen- operations and, increasingly, in capital market structure. In tral banks) follows the principle of equal treatment in the long term, separate national financial systems may not selecting its counterparts for monetary policy operations, it continue to coexist. A lively policy debate in the EU has also can deal with the branches or subsidiaries of the banks started to address the consequences of the integration from the accession countries, which may also participate, in process, which the accession countries would be advised to a broader sense, in the single interbank market in euro. For follow. 10 Part II Financial Sector Development in Perspective Chapter 3 A Perspective on Financial Sector Development in Central and Eastern Europe Lajos Bokros F 1l inancial sector development in Central and Eastern Europe has proved to be a dramatic process characterized by some well-trumpeted successes, but even more so by many unexpected collapses of seemingly decent institutions and some systemic meltdown as well. The overall record of tran- sition in the area of financial sector development is much less impressive than the achievements in macroeconomic stabilization, economic liberalization, and privatization of formerly state-owned enterprises. There are several reasons for this. Chief among them are the complexities of the financial sector and the intense political as well as emotional sensitivity attached to any major move in this area. Influential stakeholders such as politicians, government officials, business, and media people tend to overestimate the real value of particular institutions and to overemphasize their importance to the national economy. In the absence of strong external and internal governance structures, managers and owners of banks, brokerages, and insurance companies abuse this situation at times to increase their own influence and perceived importance. Therefore, financial sector development in most countries of Central and Eastern Europe in the first decade of transition has been an uphill struggle to restore reli- able channels and prudent practices of financial intermediation-to create a new culture of trust and confidence against all odds given a dire legacy of crime, corruption, cronyism, and collusion. Trust Based on Culture and Tradition dition back into a market-oriented one will take a long It is, of course, crucially important that financial inter- time, even if the political class understands what it takes to mediation be reestablished in a credible way since there is recreate this trust and behaves accordingly. But the first no economic growth unless the financial savings of the decade of transition has shown that the elements consti- enterprise and household scctors are channeled effectively tuting this trust are neither fully understood nor promoted and efficiently into investment. This is precisely what was in practice. In most countries there has been some abuse of lacking in the transition world after the devastating expe- the incipient public trust, and in some countries-notably rience of communism, where funds were reallocated by the Russian Federation (Russia)-abusive degradation of orders rather than business decisions based on calculated the financial system has systematically destroyed the pub- risk taking. This clearly created a culture and tradition lic trust altogether. Many Russians who put their money that did not require trust. To change this culture and tra- into licensed banks lost it twice: when hyperinflation in the 13 flo k r o s first half of the I 990s wiped out most savings and when the * A low level of financial intermediation in the range banking sector collapsed in August 1998. Those who kept of 5-40 percent of gross domestic product (GDP) their savings in foreign currency, either under the mattress * Relatively poor asset quality and serious undercap- or abroad, still have it. Capital flight is not only a phe- italization nomenon reflecting illegal and massive exportation of funds * A narrow range of services, especially in nonbanking by wealthy businessmen and a few criminals but also a - Largely immature external and internal governance well-established, everyday practice of the common man structures that has been reinforced by hard experience. * An increasingly sophisticated legal and regulatory framework Initial Conditions * Shallow implementation and enforcement capacity. Some countries started to reform their financial sys- Compared to either the developed industrial countries tem-first and foremost banking-even before the politi- or even some of the fast-growing Asian or Latin American cal changes. Hlungary and Poland had established a two- ones, financial intermediation in Central and Eastern tier banking structure as early as 1987 and 1988, Europe is still very shallow. The level of savings channeled respectively. Yugoslavia, having had a formal, two-tier through the banking and insurance systems lags behind that arrangement throughout the socialist period, started to lib- of mature economies, and the amount of funds injected eralize banking regulation gradually in the second half of directly into the real sector in the form of loans, corporate the 1 980s. Bulgaria, Czechoslovakia, Romania, and mem- bonds, and secondary share issues seems to be well below ber states of the former Soviet Union were much less for- comparative standards and genuine demand. Even the most tunatc; financial sector reform could start only after the advanced Central European economies-the Czech rather turnultuous political events and under the auspices Republic, Hungary, and Poland-show a large deficit in of the first democratic governments. However, in all couIn- corporate lending: the outstanding amount of loans to the tries regulations for the establishment and operation of real economy does not exceed 40 percent of GDP. This banks and other intermediaries were quite liberal-some- marked shortfall is the direct result of several factors. All times evmn too liberal-and this unleashed substantial ini- countries experienced excessive and generous lending for tiatives leading to rapid growth in the number and size of some years, followed by a credit crunch and extreme risk these institutions. The good news was that-apart from aversion after the collapse of some banks and brokerages initially restricting banks' ability to collect household and the tightening of both monetary policy and prudential deposits or engage in foreign exchange-related transac- rules applicable to asset classification, valuation of collat- tions-there were no significant administrative restric- eral, and provisioning. While the expansion in the first tions on attracting clients and setting fees and interest period clearly was assisted by directed and insider lending rates. Competition was not restricted by administrative promoted by influential members of parliament, govern- limitations on the range of clients, lines of business, and ment officials, and well-connected businessmen, this lavish product pricing. The bad news was that prudential regu- and sometimes imprudent behavior eventually starved even lation did not exist either, and minimum capital standards, the most creditworthy and viable ventures. Many banks in liquidity ratios, the concept of solvency and capital ade- the transition world continue to act like brokerages in quacy, rcquirements for asset classification and provi- money and capital markets by trying to link their business sioning, and adequate tax rules were all missing at the partners directly and offering them fee-generating services beginning of transition. This created a "wild east" type of rather than properly intermediating the available funds. environrnent for liberal capitalism, where clients and man- Consecutive government attempts to clean up the agers of state-owned financial institutions as well as own- mess and improve the quality of assets also proved to be a ers and rr anagers of newly established private ones could double-edged sword. Although rehabilitation of the largest use and sometimes abuse many of the legal and regulato- state-owned banks clearly was inevitable given the siz- ry looph(oles for their own personal advantage and at the able amount of inherited bad loans, state-orchestrated expense of depositors, creditors, and ultimately taxpayers programs of bank recapitalization and restructuring were as well. too generous, too broad, too many, and too costly. Managers of state-owned banks were inclined to under- Common Features in 2000 state the true size of their losses before it was too late and After 10 years of transition, the financial sector in then rushed to overstate it once a program of rehabilitation (entral and Eastern Europe is characterized by: had been announced. It was very difficult to distinguish 14 A Perspective on Financial Sector Development in Central and Eastern Europe between bad assets truly inherited from the past and those ing maximum productivity were concepts largely unheard generated after the political changes, and it was almost of or clearly misunderstood. Private businessmen, local impossible to establish who was responsible for the sharp governments, and even some churches wanted to establish deterioration of the loan portfolio in light of the collapse their own banks in order to attract other people's money to of a good number of corporate clients. Governments had finance their own particular businesses and related activi- no choice but to admit defeat and pump fiscal funds into ties. In the name of promoting the establishment, expan- ailing flagships of the banking sector. This was not a good sion, and proliferation of new firms, banks-private and excuse, however, for the lack of serious efforts to define public alike-were expected to accumulate a largely illiquid and enforce an adequate set of time-bound, quantifiable, investment portfolio of corporate equity. Government offi- and monitorable performance criteria against which to cials openly criticized state-owned banks for not bailing out evaluate the achievements of old and new management. important enterprises and for placing too much money For this reason and also for the rather loose design of into risk-free government debentures. And the tax police other aspects of the rehabilitation plans, coupled with raided those few managers who attempted to set aside serious flaws in understanding and realizing the magnitude more reserves to cover eventual losses of their banks. of implicit losses in the case of individual banks, quite a Government did not establish a consistent set of behavioral few governments were forced to repeat bank and insurance guidelines for the managers of state-owned banks. consolidation, thus spending a disproportionately large Representatives of various state institutions sitting on amount of fiscal resources on an economically unavoidable boards and supervisory boards of state-owned banks were but politically very painful process. Even Hungary, which following either the narrow interest of their government has achieved the best results in financial sector develop- department, at best, or their own personal interests, at ment so far, spent more than 10 percent of its GDP in more worst. These representatives were replaced frequently and than three rounds of banking sector rehabilitation. In in many cases were sent to promote specific political inter- Romania, the flagship bank Bancorex, the former foreign ests of their own constituencies. There were no prudential trade bank, was recapitalized five times before the gov- rules guiding their activity either. Modern banking legis- ernment finally liquidated it. In other countries-most lation was introduced late and changed frequently. notably Croatia-governments felt obliged to rehabilitate Regulatory and supervisory agencies remained weak and large private banks as well in order to avoid a systemic col- overly politicized, even in the most advanced economies. lapse. But in countries where private commercial banks did In sum, the structure of both internal and external gover- not play any significant role in collecting household nance remained largely inadequate, except for those finan- deposits and channeling them to the real sector, even a sys- cial institutions that were finally privatized and sold to temic collapse did not necessarily trigger any meaningful strong and prudent investors, in most cases to first-rate government action for banking sector rehabilitation. and reputable foreign strategic partners. Russia is the best-known example of this rational inaction. Increasing Differences among Countries in "Banks Have Much Money, but It Belongs to Financial Sector Development Other People" Behind this generally opaque picture, there are huge There is terrible confusion about the nature and role of and growing differences in financial sector development banking in the transition world. People tend to have dis- among countries, and these can be explained mainly by torted views about the essence of banking, especially if variations in the degree of government policies and the they make judgments while having only a superficial under- reforms implemented for modernization. Since these diver- standing of financial intermediation. In the early period of gences are gaining increasing importance by the day and the evolution of banking, it was quite common and publicly contribute to the ever-growing differences in mid-term acceptable to demand that banks pay high interest on development potential as well, it is indispensable to high- deposits, charge low interest on loans, and still remain light them in more detail. profitable in order to maximize dividends after corporati- This chapter compares the experience of 10 Central zation. Managing risks and liquidity in a prudent manner, and Eastern European countries, which can be categorized keeping growth in check, and optimizing the costs of gain- in five groups:1 1. There are other important subgroups in the transition world: the Baltic republics, the reconstruction economies of the Balkans, and the countries of the Caucasus and Central Asia. 15 B ok ros * Ac.vanced reformers: Poland and Hungary * Internal corporate governance is close to Western * Reluctant modernizers: the Czech Republic and practices. Slovenia * The quality of services is improving rapidly in cor- * Countries struggling with a double legacy: the porate business. Slovak Republic and Croatia * Retail banking is developing rapidly, and there is a . Desperate reformers: Bulgaria and Romania wide selection of services. * Prolonged crisis cases: Russia and Ukraine. * Capital markets (government bond and equity mar- This classification reflects the level of progress achieved kets) are fairly large and liquid. in financial sector modernization only, and the countries in * Regulation is advanced, and enforcement is improv- question may not have reached a similar degree of devel- ing. opment in other areas of structural reform. In contrast to * The environment is competitive, and entry and exit macroreforms, where shock therapy and comprehensive are well regulated. packages of adjustment can be devised and implemented * Cross-border financial services are almost com- successfully all at once, in the case of structural and insti- pletely liberalized. tutional r eforms at the microlevel, only gradual progress * There are pockets of resistance in privatization and has been made in an evolutionary path that shows a cycli- regulation. cal pattern over time. Nevertheless, after the first 10 years * Pension reform and fund management are at an of transition, one lesson is clear: the maturity and consis- advanced stage. tency of reforms aimed at financial sector modernization Poland and Hungary both adopted a liberal approach have proved to be the most important factor behind the to attracting foreign direct investment in their move to sustainable and healthy growth of financial intermedia- modernize the financial sector. Newly established foreign tion.This., in turn, has contributed to the rejuvenation and subsidiaries and joint ventures with state-owned banks and emergence of a competitive and rapidly expanding real insurance companies appeared in the market even before the economy producing sustainable growth. political changes. Interestingly enough, Hungary had sold One more caveat: other factors, such as initial condi- off the controlling stake in its two large state-owned insur- tions (fot example, the degree of freedom tolerated and ance companies by 1993 just to avoid bankruptcy and achieved under the communist system, the relatively free eventual liquidation. Moreover, foreign strategic investors flow of people and ideas, the openness of higher education, acquired all other newly established smaller ventures in the the level of private property, and the experience in entre- insurance business in the first half of the 1 990s. Poland, in preneurship at large), geographic location (proximity to turn, was much more cautious and somewhat timid in this western markets), political factors (democratic stability area: its single state insurance firm has been restructured and maturity and cultural attitudes like popular senti- only partially and still awaits privatization. ments toward foreign investment), and widespread and Banking was much more exposed to fast-track mod- genuine desire to access the North Atlantic Treaty ernization in Poland than in Hungary. Large state-owned Organization (NATO) and European Union (EU) also banks, originally established to serve certain well-defined played an important role in determining overall progress regions and partially modernized through twinning arrange- in economic adjustment and modernization in the 10 ments with experienced Western financial institutions, have countries in question. There is no doubt that all of these all been absorbed by foreign investors and are competing at factors have shaped policies and reforms targeted toward the level of the national market. The only exception is by far financial sector restructuring and that the results and fail- the largest bank-part of the former specialized savings ures of these policies and reforms have modified the bank, PKO BP, which is still owned completely by the state impact of all other factors as well. treasury and keeps being overburdened with the unresolved stock of nonperforming housing loans. This is a primary Advanced Reformers example of the more sensitive and complex nature of sav- Advanced reformers such as Hungary and Poland ings bank restructuring; the political class tends to nurture share the following characteristics: the illusion that it is a very special type of business, a crown * Foreign strategic investors control most large banks. jewel not to be sold to foreign investors. * Foreign capital has a dominant role in overall banking. Hungary also fell into the same trap to a certain extent * Most banks have good portfolios, adequate reserves, when Postabank-a newly established and formally pri- and adequate capital. vately owned large spin-off emerging from the postal sav- 16 A Perspective on Financial Sector Development in Central and Eastern Europe ings business-went bankrupt in 1998 as a consequence of ment) and a high level of transparency, which was made brutal mismanagement and eventual fraud. The govern- possible by adopting and enforcing the latest Western stan- ment felt obliged to rehabilitate this bank with a huge dose dards of information dissemination, listing rules, price for- of taxpayers' money, and there was extensive debate mation, and clearing and settlement. A high level of self- whether to keep it in state ownership or to privatize it regulation has characterized both institutions all along, again and, if the answer was to privatize, whether to sell which has helped to recreate the culture and trust needed control to a strong and prudent strategic investor or to aim for a steady growth of turnover in capital market transac- at an initial public offering only. The former savings bank, tions. Apart from trading in equity, the Warsaw Stock OTP, was privatized in this manner. (Postabank was intend- Exchange has developed a sizable corporate bond market, ed to be sold to OTP without any tender, but the while the Budapest Stock Exchange has become very active Hungarian government would not accept the price offered in trading government securities. Derivative instruments, by OTP, which was considered ridiculously low. As of such as options and futures, also are traded, albeit this April 2000, the government was talking about selling or market is still in an incipient stage in both countries. transferring Postabank to the state-owned post office.) Poland and Hungary already have initiated a compre- In Poland, Bank Handlowy was proud of having no hensive overhaul of their pension system by establishing a controlling stakeholder for a long time, just to be swal- three-pillar structure with fully funded and privately man- lowed almost completely by Citibank at the beginning of aged mandatory and voluntary schemes. These pension 2000, after the treasury opposed a thinly disguised takeover funds-together with the private insurance companies-are bid from the German Commerzbank. This example clear- now providing the backbone of domestic institutional ly shows that, despite political resentment and fierce debate, investment by channeling a growing amount of contractu- privatization by selling control to a reputable foreign strate- al savings through the recognized capital markets. gic partner is by far the most successful way of stabilizing The deepness of financial sector reform in these two and modernizing ailing state-owned banks. Keeping control countries is reflected by the high and sustainable level of cffectively either by the government or by self-serving man- economic growth achieved in the past four to five years. A agement, even in the case of majority private ownership, wide choice of financial services is readily available for can easily lead to a sharp downturn in the fortunes of the real sector firms on a competitive basis. Due to the broad bank. In turn, if and when management is prudent and sup- liberalization of cross-border financial transactions, at least ported by quality investors, the bank may fall prey to large in the longer end of the market, the largest ventures- strategic bidders in a rapidly consolidating market. including the foreign ones-can easily finance themselves Foreign strategic investment in most leading banks even from abroad. Mid-size companies have dozens of has proved to be an unqualified success in both Poland and banks wooing them and also have access to the less heavi- Hungary, after several consecutive efforts of government- ly regulated segments of the private capital market. Small orchestrated and government-financed consolidation of firms, however, still face difficulties, as only a few banks insolvent state-owned banks. Foreign strategic partners have decided to serve this market segment. At the same have been able and willing to provide not only much-need- time, the difficulty for banks of keeping a track record of ed additional capital and management skills but also prod- these small ventures, assessing their risk-return profile, and uct development and innovation, modernization of risk foreclosing collateral in case of default has to be acknowl- management and treasury operations, internal audit and edged as well. control, and information technology. It is no coincidence that Poland and Hungary provide Reluctant Modernizers the best example of capital market development as well. Reluctant modernizers such as the Czech Republic Both countries have a fairly large, well-capitalized, and and Slovenia share the following characteristics: rather liquid equity market by regional standards. This * The largest banks are still under government control leading position is a significant achievement in light of or were just recently privatized. either the absence (Hungary) or the subordinated impor- * Moves to invite foreign strategic investors have been tance (Poland) of a mass scheme of privatization. Instead, postponed or are half-hearted. governments and market participants relied on two impor- * Rehabilitation of leading banks is under way or tant factors: a gradual and, by the mid-1990s, complete lib- recently completed. eralization of foreign portfolio investment (coupled with - The portfolio of other, mostly mid-size, banks is rel- early capital account convertibility for this type of invest- atively healthy. 17 Bokros * Corporate governance needs to be strengthened con- their clients' capital was seen as copying the seemingly siderably. positive German practice of establishing an intimate rela- * Both the quality of services and retail banking are tionship between banks and industrial enterprises without developing rapidly. having the burden of German regulation or German * Capital markets are smaller, quite fragmented, and investors themselves. Slovenia used to have a similar aver- rather illiquid. sion toward foreign investors. Even large banks, broker- * Regulation is improving, with few loopholes, but ages, and insurance companies have not always welcomed uneven enforcement. foreign financial investors. The Yugoslav way of mass pri- * Competition is increasing in domestic financial ser- vatization created even more conflicts of interests because vices. banks often were owned by their less than fully creditwor- * Nonbank financial intermediation is in need of fur- thy clients rather than the other way around. This is clear- ther reforms. ly the most dangerous way of interlocking ownership, rep- * There is some resentment and resistance against fur- resenting a vicious cycle. ther liberalization. The cost of reluctance and complacency has proved to * Pension reform and fund management are still at an be especially high for the Czech Republic. This is perfectly incipient stage. reflected in the forced renationalization and immediate The Czech Republic and Slovenia are prime examples sale of the failing IPB to Ceskoslovenska Obchodni Banka of countries where certain favorable initial conditions have in June 2000, which was an unprecedented move in the his- become a, mixed blessing. These include, most notably, a tory of bank consolidation and privatization. Several high level of income per capita based on a rich industrial lessons can be drawn from this case. tradition, a sophisticated economic structure well devel- First, there is no point in selling even a relative major- oped by regional standards, and freedom from the obliga- ity stake to any foreign entity without transferring real tion to support less-developed parts of the country as a con- management control and responsibility. Second, not all sequence of the breakup of both Czechoslovakia and good-sounding foreign names represent trademarks of Yugoslavia. Both countries enjoyed unprecedented political truly prudent strategic partners. Third, and most impor- stability and an extended honeymoon period, with the tant, governments should prepare very carefully the legal same government or a grand coalition for a long time. The documentation for all transactions, making sure that, after tremendous success of early macrostabilization, coupled due diligence, the value of the assets is assessed reasonably with a successful shift of export orientation to western and realistically, any remaining uncertainties regarding markets, has produced a sense of complacency and great asset value and contingent liabilities are perfectly identi- reluctance to undertake more substantive and painful struc- fied, and the assets involved are clearly ring-fenced. tural reforms such as financial sector modernization. Both Unfortunately, none of these fundamental conditions countries undertook an early recapitalization of their seems to have been met when the formal transaction of largest financial firms and then decided to stop there. selling IPB to Nomura took place in 1997. As a conse- Governments were clearly and publicly against selling con- quence, a textbook case of moral hazard emerged where trol of the flagship banks and insurance companies to any the private partners were able and allowed to privatize all foreign investor. Either they claimed that banks were of the gains and the (new) Czech government finally was already in private hands (in the Czech Republic, large obliged to socialize all of the losses. The cost of rehabili- banks were formally half privatized as a consequence of tation for the three large Czech banks eventually will mass privatization) or they decided that, in the absence of exceed 10 percent of GDP. It could have been much lower strong domestic investors, it was better to keep banks had these banks been sold to reputable and prudent for- under close state control (Slovenia). eign strategic investors right after the initial cleanup, which Mass privatization does not seem to have helped finan- happened well before the breakup of Czechoslovakia, cial sector modernization. In the Czech Republic at least eliminating all nonperforming assets inherited from the two of the largest banks-Komercni Banka and Investicni communist period. Even though the Czech Republic can a Postovni Banka (IPB)-felt obliged to continue financing easily afford the resulting increase in its public domestic many of their traditional and still unrestructured clients, a debt, this is a serious loss of opportunity in terms of slow- good number of whom also became owned by them er growth and delay in catching up with the EU. through the investment management companies they estab- Slovenia has been less complacent in making policy lished. The bank practice of increasing equity holdings in and issuing declarations, but equally reluctant in inviting 18 A P erspective oT1 Fi tan lclaI Scct or l)evclopIIIent I n (.eintralI and EasterII Eur ope foreign stakeholders in financial sector institutions. The Negative sentiments, especially among foreign portfolio two largest banks-Nova Ljubljanska Banka and Nova investors, and the heroic efforts of some enlightened officials Kreditna Banka Maribor-are still controlled by the trea- of the otherwise weak and politically targeted supervisory sury, and no specific plans for their final privatization are agency have resulted in tighter regulations just to recreate in sight. Although some foreign banks established wholly trust and confidence, which either have been lost or never owned subsidiaries and started to compete with the two were created. The Prague Stock Exchange delisted hundreds large banks as well as the smaller regional financial insti- of firms in the last couple of years, but despite introducing tutions, the small Slovene market has become so over- and enforcing tough rules for listing and continuous disclo- crowded that the two large public banks may lose market sure, its overall turnover was still less than one-third that of share quickly, especially when free branching will be the the BLudapest Stock Exchange in 1999. (Hungary consti- rule of the game by the time of EU accession. In addition, tutes by far the best comparator for the Czech Republic: its in an apparent move to defend the domestic currency, economy and population are roughly the same size, with Slovenia imposed quite a few brakes on the flow of short- GDP of $50 billion and a population of lO million people, term and equity capital and kept them in place until very which is shrinking and aging quite rapidly.) recently. The country even discouraged direct investment in nonfinancial firms, perpetuating the inefficiencies of enter- Countries Struggling with a Double Legacy prises caused by the flawed mass privatization program. Countries struggling with a double legacy, such as These inefficiencies, in turn, have effectively blocked any Croatia and the Slovak Republic, share the following char- major restructuring by making it impossible to reduce acteristics: excessive labor and keeping salaries much higher than is * The largest banks are, or are about to be, sold to for- affordable, sustainable, and reasonable. eign strategic investors. Government policies did not facilitate quick adjust- * There is a strong drive to privatize all banks after ment and deep restructuring either. Payroll taxes are intol- costly systemic rehabilitation. erably high just to support a generous and hardly reformed * A number of insolvent banks still have to be reha- pay-as-you-go pension system and an overextended health hilitated or finally liquidated. care system. Private initiative in managing pension funds as * The quality of the portfolio is largely poor except for well as insurance premiumiis and other conitractual savings some mid-size banks. is in an incipient stage, only partially accessible to foreign * Prudential behavior is still marginal in corporate players. In sum, the Slovene financial sector is clearly governance. underperforming its potential because-apart from suc- * Both the quality of services and retail banking are cessful bank rehabilitation-it has not yet been exposed to slowly improving. any major fundamental reform. * Capital markets are small and illiquid, and foreign It is an irony of history that both the Czech and participation is low. Slovene equity markets are much smaller and less liquid * Regulation is improving, but still timid, and enforce- than the Polish and Hungarian ones, not so much despite ment is uneven. but largely because of the unfavorable initial conditions cre- * Competition is weak, with regional and sectoral seg- ated by the mass privatization schemes. Again, the Czech mentation. equity markets constitute a perfect example of what went * Nonbank financial intermediation is in an incipient wrong. At first sight, mass privatization programs seem to stage. have provided a magnificent one-time boost for the formal * The intention and efforts to liberalize cross-border capitalization of open markets, especially in the absence of transactionis are serious. any meaningful criteria for listing stocks and disseminating * Fiscal and structural problems are deep, and pension information on them. Ideological extremists have even reform has been postponed. praised the lack of requiremenits for entry in the name of The political and economic development of the Slovak unlimited liberalism to create markets first rather than kill Republic and Croatia during the first decade of transition them with burdensome regulation and heavy supervisory is strikingly similar and in marked conitrast to that of the structures. But the lack of transparency and enforceable Czech Republic and Slovenia, with which they shared a rules has proved to be an open invitation to abuse and cre- common fate and history for almost 70 years. Both coun- ated a backlash of widespread disillusionment withi and tries had nationalist and autocratic governments for a pro- even hatred against stock markets. longed period after regaining independence in the early, 19 Bokros 1990s. Since Croatia was involved in an armed struggle to countries and covered almost the whole sector, public and restore its own territorial integrity, and also was involved private financial institutions alike. indirectly in Bosnia, nationalist tendencies have become The legacy of this futile experiment with oligarchic more deeply rooted and caused more distortions in the development is as damaging as that of the communist sys- weak economy and fragile social fabric than in the Slovak tem. Broad coalitions of democratic parties are now trying Republic. Charismatic and populist political leaders to overcome the dire consequences of these distortions by attempted to create a domestic oligarchy in both coun- implementing bold reforms aimed at catching up with the tries, and this oligarchy gained prominence quickly as a most advanced transition economies. result of insider transactions following the mass privatiza- In the Slovak Republic, the government has cleaned up tion programs that had been started in Czechoslovakia the portfolio of the three largest state-owned banks- and Yugoslavia. Vseobecna Uverova Banka, Investicna a Rozvoja Banka, Initial conditions were much less favorable for the and Slovenska Sporitelna-and announced its determina- development of financial institutions in many respects. tion to sell controlling stakes in all of them to first-class for- Both countries have inherited a more inward- and east- eign strategic partners as quickly as possible. (The sale of ward-oriented and less competitive real economy, with dis- Slovenska Sporitelna to Erste Bank has already been com- proportionately high emphasis on less than state-of-the-art pleted.) Legal and regulatory modernization, as well as heavy industries (for example, shipbuilding in Croatia and corrections of insider privatization deals, is occurring rapid- armaments in the Slovak Republic). Markets for these ly, together with a strong drive to attract foreign direct products have collapsed very quickly, and neither of these investment in large nonfinancial firms. Sweeping financial countries has been able to regain sustainable export-led liberalization and other bold structural reforms resulted in growth since. Overall, real sector modernization has proved Slovakia's becoming the 30th member of the Organization to be painstakingly slow, as weak insiders-in most cases, for Economic Cooperation and Development in 2000. former managers and newly emerging political clients- Croatia, for its part, has successfully completed the effectively blocked external participation, including much- privatization of its flagship bank, Privredna Banka Zagreb, needed foreign investment. Relatively high growth in the while continuing serious efforts to attract strategic partners mid-1990s was short-lived because it was based on an for a number of mid-size banks. The sale of control to artificial boost in demand fueled by corporate borrowing in strong foreign professional investors in Rijecka Banka and both counLtries and by a reconstruction boom in Croatia. Splitska Banka also has been finalized. However, the liqui- Because both countries inherited minimal foreign debt, fis- dation of a number of deeply insolvent mid-size banks- cal overspending made it possible to hide structural weak- including one of the largest and most important, nesses and postpone serious reforms addressing them. Dubrovacka Banka-needs to be completed before good Major financial institutions became formally private governance can take hold in managing financial institu- almost by definition as a consequence of the mass privati- tions. Insurance remains largely unrestructured in both zation schemes. Croatia-like any other former Yugoslav countries, while foreign players are gaining ground very member srate-experienced the least advantageous form of quickly at the expense of the state-owned former monopoly. privatizat on. When workers' self-management was trans- Again, the irony of history is that the Slovak and most formed into share ownership for insiders, banks immedi- likely the new Croat authorities probably will show a more ately and almost automatically fell into the hands of their genuine desire to introduce the most advanced best practices still unres:ructured clients. In addition, the strong region- of corporate restructuring, insolvency, liquidation, and alization of Croatia-reflected also in the name of its restructuring and, at the same time, will woo much-needed banks-created local monopolies with little or no compe- foreign direct investment just to compensate for the poor tition. Autocratic governments in both countries actively image their countries have acquired among international promoted a sense of national unity by assisting the estab- investors compared with the Czech Republic and Slovenia. lishment of interlocking ownership between local firms Given their double legacy and their less-developed econom- and financial institutions blessed and sanctioned by local ic structure, the Slovak Republic and Croatia are encounter- governme; Its. An intimate web of mutual services and a ing more difficulties in attracting a sizable amount of foreign lack of transparency created extremely fertile ground for direct investment carried out by truly reputable foreign firms. political abuse and corruption, which finally resulted in the This is especially true in the case of financial institutions, collapse of many banks in 1997-98. Rehabilitation proved where foreign strategic investors are motivated not so much to be an unusually broad and expensive exercise in both by the present net asset value of existing ventures but rather 20 A Perspective on Financial Sector Development in Central and Eastern Europe by the future growth potential of the whole econorny and the * Desperate attemipts have been made to sell systemic chances that the country will access quickly to the EU. The banks to foreign strategic investors. Slovak Republic tends to be much more fortunate in this * A number of insolvent banks still have to be reha- regard. It may even be able to catch up with the first-tier bilitated or liquidated. accession candidates and join the EU at the same time as they * Good portfolios are expanding slowly, because cred- do, while Croatia has yet to enter serious negotiations at all. itworthy clients are few. As far as capital market development is concerned, * Prudential behavior is still marginal in corporate mass privatization coupled with the lack of adequate regu- governance. lation and enforcement proved to be detrimental to sub- * The quality of services is improving slowly, but retail stantive takeoff. Within the equally bleak picture, the Slovak banking is expanding faster. equity market seems to have more stocks and perhaps more * Capital markets are very small and illiquid, with liquidity, while the Croat market has some larger firms low foreign participation. with better quality (Pliva, Podravka, and Zagrebacka Banka * Regulation is improving, with uneven and unpre- are well-known names even in the international arena). dictable enforcement. Legislation and regulation have improved recently, but * Competition is weak, and foreign subsidiaries play a enforcement still leaves much to be desired. Latecomers marginal role in Romania. are struggling not only with the legacy of oligarchic devel- * Nonbank financial intermediation is in an incipient opment but also with the lack of enthusiasm for going and stage. remaining public. The small size of the domestic market and * Liberalization of cross-border transactions is yet to the lack of institutional funds to be invested constitute addi- be achieved. tional impediments in the short run. Fiscal constraints and * Institutional investors are lacking, and no pension strong vested interests in maintaining generous pension reform is in sight. privileges, especially in Croatia, will make any effort to Except for Albania and the former members of the boost contractual savings highly unlikely in the foreseeable now defunct Soviet Union, Romania and Bulgaria have future. Conversely, government bond markets have a better inherited nothing but the worst from the communist system chance of expanding quickly due to sizable fiscal deficits and in Eastern Europe. Both countries used to have extremely debt in both countries. rigid, neo-Stalinist systems of economic management, with It is an interesting feature of the institutional arrange- more tolerance toward small-scale auxiliary ventures in ment in both countries that the central bank plays a crucial Bulgarian agriculture and especially devastating autarchic role not only in overall banking regulation but also in tendencies in Romania. Although preserving national state- supervision and oversight. Since both institutions assumed hood after World War II may have been an asset, public the role of a proper central bank and started issuing money institutions have proved to be very weak, with a quite and regulating money supply only 10 years ago, it is no sur- shallow implementation capacity ever since. prise that there is a relatively weak institutional capacity to Political fragmentation, especially in Romania, has fur- carry out all these new functions. Both central banks have ther weakened the reform drive, and no critical mass of con- implemented strict monetary policies, and this contributed sistent measures has been introduced in any important area significantly to the maintenance of macroeconomic stabil- of the transition agenda. Romania lost not only the first six ity throughout the 1990s. Prudential regulation and super- years of transition by postponing structural reforms but also vision, in turn, proved to be politically sensitive and con- the next four, when a center-right multiparty coalition gov- troversial because strong vested interests worked against ernment remained largely paralyzed by constant factional prudent practices more often than not. It is not so much the fighting. Bulgaria, in turn, has been more fortunate. Since weak intellectual capacity but the lack of political support the deep crisis of 1996 and 1997, an unusually strong and that has prevented the implementation of tough rules of unified government has tried to make up for lost time not prudential regulation and supervision. only by restoring macrofinancial stability but also by initi- ating corporate restructuring, privatization, and financial Desperate Reformers sector modernization. Despite the negative impact of exter- Desperate reformers such as Bulgaria and Romania nal factors, such as the Russian crisis, the war in Kosovo, share the following characteristics: and the disruption of trade and transportation links, * Few large insolvent banks are still in government Bulgaria has managed to distinguish itself as having an hands. economy with the best mid-term perspectives in the whole 21 Bo k r o s Balkans. Nevertheless, both countries have a long way to go Bulbank, which covers almost 40 percent of the economy- before thliy can truly satisfy membership criteria for EU and was successfully completed in 2000, despite fierce and close the income gap with other candidates for accession. open resistance of the incumbent management to the sale of Banking sector development was started with the cstab- control to foreign strategic interests. Only two large state- lishment of three or four large state-owned banks (each owned banks remain to be sold-Biochim and Savings typically oriented toward foreign trade, industry, and agri- Bank-and this process may not be too difficult given the culture) without transforming the old savings bank into a momentum generated by recent transactions. universal financial institution. The left-leaning socialist gov- Romania has been able to make much less progress in ernments in the first half of the 1990s did not consider both bank rehabilitation and privatization. Although bank privatization seriously. All they did was allow the BancPost, a newly established and healthy state-owned proliferation of new and small private commer cial banks as bank, was easily sold together with the relatively clean a consequence of a liberal policy on entry, which also could and small Development Bank, little or no real progress be interpreteed as a lack of adeqiuate regulation on minimum has been made on privatizing the large, truly systemic capital standards and prudential requirements of ownership. banks. On the contrary, the flagship bank Bancorex-the These small banks constituted a mixe(d blessing because formler foreign trade monopoly-was recapitalized five miost of Ihem turned out to be almost like pyramid schemes times, costing more than $1 billion to the Romanian tax- and quickly went bankrupt, providing a good excuse for payer, only to be liquidated in 1999. Banca Agricola also those who opposed privatization of banks altogether. was rehabilitated several times and was cut drastically in Hlowever, the large state-owned banks did not perform bet- size without any hope of a quick sale, apparently due to the ter eithei; and virtually all of them in both countries proved lack of political agreement on a coherent privatization to be technically insolvent by the mid-1990s as well, strategy and, lately, very little outside interest. Banca Reac.ions to this disappointing developnment were C(omerciala Romana (BCR), which was perceived as the somewhba- different in the two couLntries, mostly becanLse of healthiest of the three largest banks, remains in government divergent political solutionis to the emerging crisis. In hands as well. Given the volatile political environment and Bulgaria, the whole unreformed economy collapsed at the the excessive bargaining power of the managers of the end of 1996, and the new autholrities made a complete U- state-owned banks-who were appointed on the basis of turn in policy. They decided to rehabilitate all state-owned their political affiliation according to coalition agree- banks by cleaning up their loan portfolio and announiced ments-there seems to be no quick fix either for these two an uncornpromising and ambitious privatization program large state-owned banks or for the recently corporatized involving foreign strategic investors. The Bank Savings Bank. Consolidlrtion Company (B1CC), established in 1992 to Given these circumstances, it is almost inconceivable to nmanage the rehabilitation of state-owned banks, was expect substantive inprovements either in corporate gov- empowernd to direct individual transactions selling control ernance and prudent behavior or in the quality of services, to reputable foreign iiivestors. Given the dire situation of assets, internal audit, risk management, or credit allocation. the Bulgarian economy in 1996-97 and the negative image Although legislation improved considerably in the second of the counltry among global investors, it has been extreme- half of the 1 990s in both countries, enforcement remained Iv difficult to attract prudIent foreign partners. But the gov- uneven, unpredictable, and sometimes politically condi- ernment's steadfastness and perseverance have paid off. tioned, especially in Romania. Shallow implementation The BLulgarian governmnent has m nade wise and careful capacity constitutes a real bottleneck in both jurisdictions. decisionis on timing and sequencing and has been able to None of the two central banks has ever been up to the build up momentunm and gradually change the perceptioni requirements of crisis prevention and management. of the out-side world of the prospects of the Bulgarian econ- The lack of confidence and the confusion about rules oinv. The easiest target, Postbank-a newly established aiid values to be upheld are highlighted clearly by the series and hence relatively unspoiled, small, state-owvned bank of small bankinig crises hitting Romania in 2000. As a side plus a spi ioff of the large foreign trade mlonopoly, the effect of the collapsc of a sizable investment fund, there was United Bulgarian Bank-went off the hook first, followed a run on BCR, and three other mid-size banks were by two soinewhat larger, regionally important, and more brought under receivership. (One of them was the proud- easily restructured state-owned banks (Expressbank and Iy named International Bank of Religion.) In the meantime, llebrosbark). The privatization of the largest and by far- thl courts rejected the request of the National Bank of most important bank-the former foreign trade monopoly, Romania (NBR) for declaring a powerful regional bank, 221 A Perspective on Financial Sector Development in Central and Eastern Europe Dacia Felix, bankrupt-precisely two years after the ment of domestically owned small and medium-size enter- request was submitted. And when the bank finally was prises. Due to the rapid contraction of the state sector, the declared insolvent, the new leftist government forced NBR incipient and vibrant private sector simply has not been and the Savings Bank to accept a partial settlement in order able to compensate for all the losses in overall output. In to pull Dacia Felix out of liquidation in early 2001. This addition, small and medium-size enterprises are much less reflects the lack of clear interpretation and enforcement of "bankable" and have little access to open capital markets banking regulations as well as the continuation of arbitrary as well. Thus the state of affairs in the financial sector is a political interference in managing the financial sector, mirror image of the hardships in the real economy. Capital markets are very small and illiquid in Romania Apart from the growing arrears in certain enterprises, and Bulgaria despite or because of the flawed and botched especially in large public utilities, and the ballooning inter- mass privatization programs that flooded the initially corporate debt, which reflects soft budget constraints and underregulated equity markets with hundreds-in the case lack of strong market discipline involving credible threats of Romania, thousands-of poor-quality stocks. Despite of bankruptcy and liquidation, both countries largely main- heroic efforts in both countries to introduce serious confi- tained fiscal prudence in the second half of the 1990s. dence-building measures by creating all the necessary infra- Bulgaria clearly was helped by the currency board arrange- structure for trading, clearing, and settlement as well as list- ment introduced in the summer of 1997, but even ing and information dissemination, so far neither domestic Romania, which reportedly was on the verge of a financial nor foreign participants have invested any meaningful collapse from time to time, maintained fiscal discipline amount of money in those two markets. and outperformed even Hungary in terms of general gov- The underdeveloped nature of banking, insurance, and ernment balance. The sad irony is that fiscal prudence capital markets in Romania and Bulgaria is strongly corre- alone is not a recipe for restarting economic growth, espe- lated with the incipient results of efforts to restructure the cially if there is no supply-side adjustment in the economy real economy. Severe distortions caused by inept and irre- due to the lack of flexible micro structures able to respond sponsible communist megalomania clearly render the lega- to market signals. Postponing structural reforms time and cy extremely difficult to deal with, again, especially in again might render prudent macroeconomic policies large- Romania. A large number of sizable industrial firms are not ly useless or even harmful. Romania has proved to be an candidates for privatization, even after financial liquidation almost textbook case for this lesson. and dismemberment. In quite a few important cases, only the physical closure of enterprises makes sense because Prolonged Crisis Cases markets are completely lost, the technology involved is out- Bulgaria and Ukraine are experiencing a prolonged dated and harmful to health, the ecological degradation is crisis with the following characteristics: immense, and there are financial liabilities rather than assets. * Most banks are in private hands and are insolvent. In light of these extremely disadvantageous initial con- * Rehabilitation is selective, and there is a reluctance ditions, the predominance of mass privatization schemes to invite foreign strategic partners. was even more harmful in these two countries than in * A large number of banks need to be delicensed and more mature industrial economies, like the Czech Republic liquidated. and Slovenia. Mass privatization not only created an illu- * Portfolio quality is very poor and hardly improving. sion of real positive value but also erected a formidable * Corruption, crime, and cronyism are rampant. obstacle to painful restructuring and an aversion to losses. * The quality of service is low, and retail banking is It is no surprise that prudent banks find it extremely diffi- rudimentary. cult to lend to the real sector because creditworthy clients * Capital markets are small, discredited, and abused. with manageable risk are few and far between. This is * Regulation is weak, and enforcement is openly especially true in Bulgaria, where most of the systemic politicized. banks are now in the hands of reputable and strong foreign * Domestic markets are fragmented and monopolized. strategic investors. * Nonbanking financial intermediation is almost The establishment of a market economy depends large- nonexistent. ly on new ventures, both domestic and foreign. Since for- * The attitude toward financial liberalization is large- eign direct and portfolio investment have been almost neg- ly hostile. ligible in nonfinancial sectors, both economies have * The country is experiencing a permanent fiscal crisis, depended mostly on the expansion and organic develop- in which pension reform is not on the agenda. 23 Bokros Russia and Ukraine represent such peculiar cases that considerable market share to new and private financial they hardly find their place in international comparison. institutions. Russia is very special for its sheer size and strategic impor- Another common feature of banking sector develop- tance, while Ukraine is unique for its truly permanent cri- ment in Russia and Ukraine was the rapid proliferation of sis and apparent lack of opportunities. Russia could well small private financial houses in the first half of the 1 990s. afford not to implement any serious structural reform Like in Romania and Bulgaria, this tendency was the result because its vast exportable natural resources and ability to not so much of a genuine drive for liberal market reforms extract large amounts of financial assistance from the but rather of the lack of meaningful and consistently Western countries have helped it to survive the worst crises. applied legislation and regulation. Although banking laws Ukraine has given up its nuclear arsenal and does not pos- and rules have been improved considerably in the last three sess any rneaningful amount of natural wealth. Moreover, years in both countries, central banks are still struggling regaining full sovereignty after 300 years of Russian dom- with the immense backlog of small, frequently nonoperat- inance is not an easy task. The Ukrainian state is particu- ing, bank-like creatures that await delicensing. larly weak and fragmented and has easily fallen prey to the From a systemic point of view, it is more important to emerging local oligarchy. Russia's ruling elite (the political analyze the situation and health of the large banks operat- class and the oligarchy) is largely unwilling, while in ing nationwide. In both countries even the large banks play Ukraine it is unable, to introduce substantive market-ori- only a marginal role in financial intermediation in general ented reforms. and in financing the real sector in particular. That is one of Financial sector development in the two countries was the most important reasons why the collapse of the whole very similar until the mid-1 990s. Like in Romania and Russian financial system in August 1998 did not trigger a Bulgaria, three to four large state-owned banks originally serious downturn in the real economy. Nevertheless, the were carved out of the mainframe of the former central insignificant role of banks in financing real sector activity bank of the Soviet Union. Saving banks that were operat- did not prevent the same banks from accumulating huge ing throughout the communist period maintained their losses in their loan and investment portfolios. Although narrow focus for many years. And hyperinflation elimi- the August 1998 meltdown was triggered basically by the nated the value not only of banking assets but also of lia- collapse of the government debt market and was exacer- bilities, creating a very special "bank rehabilitation bated further by the devaluation of the Russian currency, the scheme" financed exclusively and involuntarily by the crisis was only making already insolvent banks illiquid. At depositors. This devastating crisis, however, created a mag- present, the reverse is also true; the refloating of the Russian nificent window of opportunity for strengthening the hard economy as a consequence of the exceptionally high export core of th- banking sector by privatizing the state-owned prices for oil and some other natural resources coupled banks of systemic importance in a prudent and efficient with the newfound fiscal discipline and real sector growth way. Unfortunately, this moment was lost because the polit- largely due to opportunities of import substitution have ical class in both countries remained suspicious, if not restored liquidity for quite a few banks, without addressing openly hostile, to the idea of selling their perceived crown the more fundamental problem of deep insolvency. jewels to foreign investors. Instead, they decided to create There are at least two more reasons why financial a domestically rooted echelon of large entrepreneurs by intermediation has not developed in a more satisfactory allowing some well-connected people to acquire immense manner. First, real sector decline was dramatic in both chunks of former state property for a symbolic price. This countries. Russia lost roughly half of its former output, artificially and deliberately accelerated "original accumu- while Ukraine lost more than 60 percent in the 1990s. lation of catpital" was assisted first by selective licensing of Contrary to what happened in Romania and Bulgaria, foreign trade transactions in a largely closed economy, even small and medium-size enterprises could not develop then by the mass privatization schemes that concentrated a fast enough in these rapidly declining economies due to self- large amotnt of wealth in the hands of insiders, and final- serving bureaucratic bottlenecks, devastating criminaliza- ly-mostly in Russia-by the loan-for-share schemes in tion of economic and social life, and rampant corruption. which a handful of privileged individuals were allowed to Rent-seeking behavior and public acceptance of corruption take over the controlling stakes in large chunks of extrac- are predominant, crippling almost all economic activity, tive industries. In Russia the emerging oligarchy acquired but, first and foremost, productive investment. As a con- control over the large state-owned banks as well, while in sequence, except for firms in the export sector, creditwor- Ukraine most are still in government hands but have lost thy clients are few and far between, while opportunities to 24 A Perspective on Financial Sector Development i0 Central And Fastern Europe make money in corporate lending are scarce, and prof- tic financial firms. This is also true in most other countries of itability is much higher in other areas. the Commonwealth of Independent States. To reverse this Retail banking was even less lucrative, and banks did trend will require heroic efforts and a sea change in behav- not put high priority on developing these services. Banks ior on the part of governments and ruling oligarchies. were, and have largely remained, much more interested in acting as brokerage firms in the incipient but-at least in Three Pillars of Financial Sector Development Russia at one stage-fast-expanding capital markets. As is obvious from even a sketchy analysis of the polit- Capital market developments are very different in the ical economy of financial sector development in the tran- two countries. Russia was a magnet for foreign portfolio sition world, the formation and evolution of reliable chan- investors at least before the crisis, even though legislation nels of financial intermediation throughout the 1990s were and regulation concerning property rights, transfer of title, very different from one country to the next, and there is no minority protection, clearing and settlement, and foreign reason to believe that this trend will soon be replaced by exchange controls were far from perfect (as they are even strong convergence toward well-developed and mature today). This exceptional appeal of investments in Russia structures. Some countries will join the dreamland of the was explained by the sheer size of the potential rather than European common market within a very short historic the actual market, the overall attractiveness of the export- period of time. Others perhaps will wait another generation oriented extractive industries, the marked liberalization of before getting in. There might be a tendency toward equal- foreign portfolio investment, and the significant amount of ization in income-generating capacity among the transition public borrowing, which created a speculative market for economies after another decade of differentiation. But there state debentures. None of these factors was present in will be no easy reversal of the culture and tradition that are Ukraine, except for the last one, which proved to be insuf- so detrimental to the expansion of healthy financial inter- ficient in light of political instability and lack of strategic mediation fostered by efficiently managed and prudent importance. institutions. The emergence and dominance of local oli- Things changed considerably after the onset of the garchies, sometimes stronger than the state itself and char- Russian crisis. Since influential people, including reputable acterized by rent-seeking behavior, asset stripping, state foreign firms, lost a fortune when capital and foreign capture, crime, and corruption could well become so exchange markets collapsed, it is unlikely that the same embedded in the social fabric that it is no longer possible to enthusiastic rush for Russian equity and government paper get rid of them without a devastating, full-blown crisis of will materialize in the foreseeable future. Russia is not the economic and societal system. keen to step into the same river either. Recent efforts to The Slovak Republic and Bulgaria have been fortunate keep tight budget controls and at the same time implement to have changed course relatively early on; Croatia has fundamental reforms in taxation suggest that the authori- every hope of following suit. Romania, however, is fast ties do not intend to restart massive foreign borrowing approaching a historic crossroad: the results of parliamen- even after the oil bonanza. There is more hope of seeing a tary elections in 2000 clearly strengthened nationalist and gradual revitalization of equity markets in the long run, if populist elements. Some other countries, most notably and when much needed changes in basic legislation and Russia and Ukraine, do not seem to have a historic chance corporate behavior take place. of breaking the overarching influence of their oligarchies in Although there clearly is opportunity, if not certainty, the short run. But the strongly appealing perspectives of EU for the Russian real economy to take off, Ukraine is likely accession and the genuine desire of the local electorate to to prolong its permanent crisis. The political class is more achieve Western economic standards by embracing not only fragmented than ever, and the government-which is led by the values of an open and competitive market economy the former central bank governor as a last resort to tech- but also its consequences can be crucial in a mid-term hori- nocratic leadership-does not seem to have either the impe- zon and may bring about substantive change. It clearly is in tus or the political support to undertake any of the des- the interests of people involved in the development business perately needed basic reforms. Unfortunately, in terms of to facilitate the accumulation and strengthening of all cre- implementing efficient public policies and micro reforms, ative elements that promote prudent civic culture and to there is no one single bright spot on the horizon of Ukraine establish a tradition of individual integrity and honesty in in the short and medium run. business and civic life. It also is their moral obligation. The vast majority of the population in Russia and In the area of financial sector development, there are Ukraine have lost their trust in public institutions and domes- three fundamental pillars determining the scope, nature, 25 Bokros and quality of emerging institutions and influencing the might be. PKO BP in Poland and OTP in Hungary are basic course of development on which these institutions good cases in point. embark: People might find it strange that a kind of universal * Internal and external governance structures panacea is being offered to remedy most, if not all, funda- * Domestic and international competition mental illnesses of the financial sector. The experience of * Pruidential regulation and supervision. continental Europe does not seem to justify this peculiar These three pillars are mutually complementary and type of sweeping privatization either; there are quite a few overlapping: improvements in one area clearly help to countries, like Germany, France, and Italy, where state-or modernize and strengthen the other two. Nevertheless, a at least local government-control as well as dispersed critical mass in all three areas must be achieved in order ownership of domestic nonfinancial institutions and indi- to develop a mature financial system, put it on a secure viduals have characterized important segments of banking, path of sustainable expansion and development, and insurance, and capital markets without substantially dete- maintain a high level of trust and confidence. riorating the quality of governance. Why is it not possible Unfortunately, none of the transition countries has for Central and Eastern Europe to follow their example? reached this stage of development yet; the regulatory and There are several reasons for this, some of them deci- supervisory structures need to show considerable sive. First, communism lasted too long and was too suc- progress, even in Poland and Hungary. cessful in destroying trust in domestic private institutions and a tradition of prudent behavior in economic and social Corporate Governance life. Second, when the futile communist experience in eco- The following recommendations are offered to nomic management finally ended, world markets were improve internal and external governance structures: characterized by massive cross-border transactions, and * Once and for all, rehabilitate viable state-owned international competition was producing new and banks of systemic importance. improved services at a scale never seen before. Third, the * Recapitalize private commercial banks only in demonstrational impact of liberal capitalism-very much exceptional cases. magnified by modern telecommunication-coupled with * Privatize state-owned banks immediately after the strong desire to catch up with the developed world pro- restoring minimum solvency by selling a controlling duced an almost insatiable thirst of clients in Central and stake to reputable foreign strategic investors. Eastern Europe for getting access to the latest and best * Depoliticize and professionalize financial intermedi- services without delay. The interplay of these and many ation. other factors make it impossible for people to wait anoth- * Discontinue all directed and insider lending and er 50 years before enjoying the same quality of services as investment practices. their Western counterparts. But people demanding the best * Draw up management contracts with time-bound as customers are unfortunately unable to create them as and monitorable performance criteria. producers. Consumers demand reliable and proven foreign * Ensure adequate representation of the interests of all products and services while they may refuse to accept the stakeholders in supervisory boards. structures, including those of foreign governance, that cre- * Institute proper checks and balances in internal ate and maintain the high level of quality for those products management and credit allocation. and services. Communist deputies of the Russian parlia- * Implement management information systems and ment have indicated privately that, although they cannot internal audit. accept foreign control in flagship domestic banks, they In light of the growing tide of antiforeign sentiment would place their own money mostly in foreign banks and fierce debate about the "desirable and acceptable" domiciled in Russia or abroad. Nationalism and populism level of foreign participation in the financial sector, it just perpetuate the rule of the oligarchy. seems impractical and unwise to advise governments to sell Selling control in financial institutions to foreign strate- their largest and systemically most important financial gic partners is the best way to bridge the huge gap between institutions to foreign strategic investors. Even enlight- the very demanding and fully Westernized consumer men- ened and pragmatic governments are reluctant to offer tality and the ignorance of what it takes to be a prudent management control to foreign professionals, at least in provider of the same quality of products and services. Since the large saving banks and insurance firms, no matter there is no point in resisting or slowing down the influence how prudent and reputable the prospective foreign buyers of consumer capitalism, the only path is to accelerate the 26 A Perspective on Financial Sector Development in Ce ntral and E asterni ELtrope (re)creation of the culture of confidence and the tradition of tee schemes, one-timiie granits to cover initial costs, trainillg prudence inherent in an efficient, well-functioning market and marketing subsidies, and infrastructure support make economy. a lot of sense, as do the strict and even enforcement of reg- ulations on bankruptcy, liquidation, secured lending, fore- Competition closure of collateral, title transfer, share and company reg- The following recommendations are intended to istration, minority protection, and taxation. improve domestic and international competition: * Provide equal opportunities for entry and exit with Prudential Regulation and Supervision maximum transparency. The following recommendations are aimed at strength- * Mount a decisive drive against all sectoral and ening prudential regulation and supervision: regional market fragmentation. * Implement Basle core principles on banking. * Eliminate administrative limits on credits, interest * Set even higher capital adequacy and solvency stan- rates, and fees. dards. * Gradually liberalize cross-border transactions and * Strictly apply the rules on portfolio classification. capital flows. * Gradually increase provisioning requirements. * Introduce simple, reasonable, transparent, and equi- * Extend deposit insurance only to reputable institu- tably enforced rules for taxation. tions. * Create a strong culture and regulation of creditor * Use independent rating of leading financial inter- protection in corporate life. mediary firms. * Enforce insolvency strictly across the whole spec- * Foster close cooperation or consolidation of super- trum of clients. visory agencies. * Create a level playing field in all areas of financial * Maintain the political and financial independence of intermediation. supervisory agencies. * Use fiscal preferences only temporarily to increase * Foster strong cooperation between host- and home- the creditworthiness of clients. country regulators. * Involve the state directly in building physical and * Fight relentlessly against crime and corruption, human infrastructure. cronyism, and collusion. Managing transition is an art rather than a science, and Finally, the weakest point: after 10 years of transition, timing and sequencing are key. While fostering unlimited there is no one single country in Central and Eastern domestic competition is indispensable from dav one, inter- Europe where the financial regulatory and supervisorv national competition could be increased gradually, accord- agencies are free from--sometimes very open and bru- ing to a well-established, publicly announced set of opera- tal-political interference and where the highest profes- tional criteria. Countries preparing themselves deliberately sional standards could be applied without compromise. for adopting the single market of the EU will be able to This is less of a problem in those jurisdictions where gov- catch up more quickly in terms not only of income and pro- ernance in and competition among individual financial ductivity but also of culture and tradition. Enhancing the institutions are strong enough to support prudent behav- creditworthiness of corporate and individual clients by ior. Nevertheless, this is still a very dangerous situation introducing proper incentives for stimulating financial sav- because the churning out of new financial products and ings and investment could multiply the growth and profit services is acceleratiig, arid this requires constanit attention opportunities for financial intermediaries, thus creating a to market developments, frequent licensing, deep analysis virtuous cycle of trust and prudence. of complex problems, and increasing reliance on discre- Competition, while being a strong incentive and disci- tionary judgments. If the underlying values anid mandates plinary force to enhance quality and increase efficiency, also governing the behavior of management and staff of these should be properly managed. Governments should focus on agencies are shaky or inconsistent, there is little hope that creating their own single market by eliminating all remain- public confidence will prevail in these financial markets. ing administrative barriers, on the one hand, and helping The first task for the next decade is to strengthen consid- disadvantaged clients, like small and medium-size enter- erably the institutions of prudential regulation and super- prises, on the other. Transparent, easily accessible guaran- vision. 27 Chapter 4 Challenges of Financial System Development in Transition Economles Stefan Kawalec and Krzysztof Kluza T ransition economies are the economies of the former socialist countries and states of the for- mer Soviet Union, which in the early 1990s started to transform their economies from a social- ist to a market system. Building a market-type financial sector constituted a key element in these efforts. However, after a decade of change, the results and the experience are mixed. Most tran- sition economies still have a long way to go to build a robust and efficient financial system. This chapter assesses the present situation of the finan- * Bank-dominated model. In this model, individuals cial sector in transition economies and discusses what are, keep their savings predominately in banks, which are and how to face, the challenges that lic ahead. Three seg- the main source of external financing for the corpo- ments of the financial sector-banks, corporate debt mar- rate sector. Banks also are the dominant investors in ket, and equity market-are examined. Based on the expe- equity and corporate debt markets since stocks, rience of developed countries, some observations are made bonds, and commercial paper function as bank about the role of these segments in the financial sector and products, alongside traditional loans. the economy as a whole. Then the actual role of these seg- * Capital market-oriented model. In this model, bank ments in transition economies and future challenges are dis- deposits are not the dominant savings and invest- cussed. Findings are formulated in the form of twenty-one ment instruments for individuals. Individuals invest concise observations, some of which are supported by sta- directly in the capital market, buying stocks and tistical analysis presented as figures.1 corporate debt instruments and, to a growing extent, investing through nonbank intermediaries like pen- Bank-Dominated Versus Capital Market-Oriented sion funds or investment funds. Accordingly, banks Financial Systems in Market Economies play a smaller role in financing the corporate sector A healthy financial system should generate an ade- than capital and corporate debt markets, which are quate level of population's savings, allocate these savings to dominated by nonbank investors (Mellyn and Saal efficient uses, and provide efficient tools of corporate con- 1998). trol. To support attainment of this goal, two models of For years many observers praised the advantages of the financial sector structure can be distinguished: bank-dominated model exemplified by financial sectors in 1. These observations mostly describe the prevailing features of the financial sectors in the whole group of 28 transition countries in Europe and Central Asia. Some of these observations may not apply to a few Central European countries that have the most robust financial sectors. 29 Kawalec and Kluza Germany and Japan. Advocates of this opinion underlined Observation 3. At the start of the transformation, that banks, having insight into companies' financial situa- the main goals of financial sector reform were to (1) tion, may effectively control their managements, while replace the monobank system with a genuine bank- assuring the stability that is necessary for developing and ing system and (2) create basic equity and corporate implementing long-term strategy. They also stressed that in debt markets. the capital market-oriented model-exemplified by finan- Over the past 10 years financial systems in transition cial sectors in the United States and United Kingdom- countries have undergone significant changes as a result of dependence on the capital market may force managers to the successes and failures of macroeconomic and micro- concentrate on current profits at the cost of neglecting economic reforms and changes in the institutional frame- long-term development. work. Today, the shape of financial sectors in transition However, in the 1990s, as a result of problems in the economies varies significantly in regard to their relative size, Japanese economy, flaws of the bank-dominated financial structure, health, and efficiency. sector were widely acknowledged. At the same time, in con- junction with the successes of the U.S. economy, more atten- The Present Status of Financial Systems in tion was devoted to the significance of the stock market. In Transition Economies the United States, in the second half of the 1990s, the stock Three segments of the financial sector are examined market boom and high valuation of information technology here: banks, the corporate debt market, and the equity stocks-which raised concerns about, on the one hand, a market. The following aggregates are used to indicate the bubble economy, and on the other hand, a possible crisis- size of these segments: value of bank deposits, value of out- meant easy access to capital for new technology companies. standing corporate debt instruments (corporate bonds and This enabled the reallocation of capital from traditional commercial paper), and stock market capitalization. The industries to information technology sectors, with a speed aggregate sum of these three components can be regarded and scale that would be unthinkable in countries without a as a proxy for the size of the financial system. This section developed stock market and where banks constitute the uses this aggregate (in relation to gross domestic product) main source of external financing for companies. Thus, to compare the structure of the financial sector in transition there is growing evidence that the underdevelopment of the economies and selected developed economies and then dis- stock market may hamper an economy's ability to restruc- cusses the health and efficiency of the financial sector in ture in response to technological changes (Hale 2000). transition economies. Observation 1. The banking sector, corporate debt market, and equity market all play an important Relative Size of the Financial Sector role in the financial sector. It is important for all of The size of the financial sector as a percentage of gross these to develop in a balanced way. domestic product (GDP) in Organisation for Economic Observation 2. It is advisable that banks not dominate Co-operation and Development (OECD) countries and in the equity and corporate debt markets. To achieve this transition economies is shown in figures 4.1 and 4.2. The goal, nonbank financial intermediaries are necessary, unweighted average for financial sector size is 198 percent as is a broad group of individual investors. of GDP in OECD economies and 34 percent in transition economies. The size of the financial sector in OECD Goals in Financial Sector Reforms at the Start of economies ranges from 100 to 450 percent (the only excep- Transformation tion being Mexico, with 53 percent). The range for transi- Bank deposits were the only officially available savings tion economies is 2 to 90 percent. and investment instruments for individuals in socialist Observation 4. The relative size of the financial sec- economies. The exclusive source of financing for the enter- tor is, on average, much smaller in transition than in prise sector was bank credit, provided on the basis of developed economies. investment and production decisions by central planning Observation 5. There are significant differences in bodies. Banks themselves did not make credit allocation the relative size of financial sectors among transition decisions and did not need to evaluate credit risk. Thus countries. there were no equity or corporate markets. Although insti- Figure 4.3 illustrates the relation between the relative tutions called banks existed, they functioned as govemment size of the financial sector in transition economies in 1998 agencies having little to do with modern commercial bank- and cumulative inflation in 1989-98. The trend line shows ing institutions. that higher cumulative inflation coincides with the smaller 30 Challenges of Financial System Development in Transition Economies FIGURE 4.1 SIZE OF THE FINANCIAL SECTOR IN OECD COUNTRIES, 1998 4500/ 400% / S _ el~~~~~~~outstanding corporate bonds and commercial paper P_ 300% __c __ E3 stock market capitalization z | _ *~~~~~~~~~~~~ bank deposits 2500/_- 0 0 0 o; As I . .IIS O% 0 lb~ Note: "OECD countries without Iceland, Luxembourg, Turkey and Czech Republic, Hungary, Poland." Source: BIX, FIBV, IMF, Morgan Stanley Dean Witter, OECD, World Bank. relative size of the financial sector The coefficient of 0.77 have smaller financial sectors than implied by the trend. All indicates a strong statistical relation. things being equal, voucher privatization seems to con- Figure 4.4 illustrates the relation between the size of tribute to a larger size of financial sector. the financial sector in 1998 and the change in cumulative The statistical relation with a change in cumulative GDP in 1989-98. The trend line shows that the higher is GDP is stronger when focus is placed on the banking sec- the contraction in cumulative GDP, the smaller is the finan- tor (shown in figure 4.5). The trend line shows that the cial sector's relative size. The coefficient of 0.57 indicates a higher is the contraction in cumulative GDP, the smaller is modest statistical relation. This figure also illustrates the the banking sector's relative size. The coefficient of 0.71 significance of the primary mode of enterprise privatization indicates a strong statistical relation. (as depicted by the European Bank for Reconstruction and Figure 4.6 illustrates the relation, in 1998, between the Development [EBRD] 1999). Out of nine countries with a relative size of the financial sector and the average EBRD dominant system of voucher privatization, all but one have grade of progress of reforms in the financial sector (EBRD larger financial sectors than it is implied by the trend (locat- 1999). The trend line shows that the smaller is the progress ed on the right side of the trend line). However, most of the in financial sector reforms, the smaller is the financial sec- countries with a predominance of other methods of priva- tor's relative size. The coefficient of 0.58 indicates a mod- tization (direct sale or management or employee buyouts) est statistical relation. 31 Kawalec and Kluza FIGURE 4.2 SIZE OF THE FINANCIAL SECTOR IN TRANSITION ECONOMIES, 1998 1000/C 750/ outstanding corporate bonds and commercial paper 03 stock market capitalization S *~~~~~~~~~~~~~ bank deposits (U 50% o~~~- , Source: Alfa Capital (Ukraine), BIS, EBRD, FIBV, IFC, IMF, JPMorgan Securities, OECD, Reifeissenbank Romania, Slovenska Sporitelna, Troika Dialog, World Bank, national stock exchanges, trading systems, central banks and depository authorities. Figure 4.7 illustrates the relation between the relative structure of the financial sector, and (d) low GDP per size of the financial sector in 1998 and the level of eco- capita. nomic development in the same year, measured by GDP per Observation 6 describes statistical relations that, in capita. T he trend line shows that the lower is the level of themselves, do not explain the relation between cause economic development, the smaller is the financial sector's and effect. In general, it can be assumed that the small size relative size. The coefficient of 0.48 indicates a modest of the financial sector is an effect rather than a cause of statistical relation. The relation becomes stronger when inflation, a decline in GDP, a weak institutional frame- the banking sector is highlighted (shown in figure 4.8). work, and low GDP per capita. It is clear that the cir- The trend( line shows that the lower is the level of economic cumstances (such as adverse economic policies, external development, the smaller is the banking sector's relative shocks, and civil wars) that triggered high inflation, cur- size. The coefficient of 0.66 indicates a reasonably strong rency depreciation, and prolonged economic decline did statistical relation. not create a climate for the development of equity and Observation 6. The very small relative size of the debt capital markets. financial sector in transition economies in 1998 usu- Very often, a deep decline in GDP reflects a signifi- ally coincides with (a) very high cumulative inflation cant shift from the official to the unofficial ("gray") over the preceding 10-year period, (b) a highly neg- economy, where funds are neither kept in nor transferred ative change in cumulative GDP over the preceding through banks within the reach of the government or the 10-year period, (c) weak legal and institutional infra- tax authorities. An example of such a situation is 32 Challenges of Financial System Development in Transition Economies FIGURE 4.3 RELATION BETWEEN THE SIZE OF THE FINANCIAL SECTOR AND INFLATION Cumulated inflation (consumer price index) in 1989-1998 (1988=100) [log scale] 100,000,000 - 0 Georgia Armenia 10,000,000 *Ukraine 0 Kazakhstan Azerbaijan\ 1,000,000 - Russian Federation BulgX *~ Moldova 100,000 Kyrgyz Rep. * T Slovenia Romania @ Latvia Estoni Ia 10,000 - \ y = 8997447+0.6e 12.12x \R2 = 0.7742 1,000 - Hungary Czech Rep. Slovak R\ 100 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Size of the financial sector as a percentage of GDP in 1998 Source: Alfa Capital (Ukraine), BIS, EBRD, FIBV, IFC, IMF, JPMorgan Securities, OECD, Reifeissenbank Romania, Slovenska Sporitelna, Troika Dialog, World Bank, national stock exchanges, trading systems, central banks and depository authorities. Ukraine, where in 1998 official GDP in real terms was Financial Sector Structure just 37 percent of its 1989 level. The relative size of the In developed economies, all three segments of the gray economy is reportedly very high, and bank deposits financial sector play significant roles (see figure 4.9). Bank constitute barely 8 percent of GDP (see Sultan and deposits account, on average, for 35 percent of financial Mishev 1999). sector size, stock market capitalization for 49 percent, and In some cases, however, a sudden contraction of the corporate debt for 16 percent. financial sector causes a surge of inflation and a severe In most transition economies, the financial sector is decline in GDP. In Bulgaria, in 1996, a mounting situa- dominated by bank deposits, which account, on average, tion of bad debts undermined confidence in the banking for 63 percent of financial sector size (see figure 4.10). system and led to a run on banks and a depreciation of Stock market capitalization accounts, on average, for 35 the domestic currency. Inflation rose sharply, and the percent. However, in several countries (Moldova, value of the domestic currency declined in real terms to Lithuania, Kazakhstan, and the Kyrgyz Republic) stock less than one-sixth of the level before the crisis. Real market capitalization represents 60-80 percent of the GDP dropped cumulatively 18 percent over 1996 and financial sector size. Corporate debt markets are notice- 1997. able in only a few countries and, on average, have a 33 Kawalec and Kluza FIGURE 4.4 RELATION BETWEEN THE SIZE OF THE FINANCIAL SECTOR AND CHANGE IN GOP 140- Primary method of privatization: u ~~~~~~~~~~~~~~~~- Direct sales o + ~~~~~~~~~~~ ~~Vouchers ON ~~~~~ ~~~~~~~ ~~~- Management or employee buyouts 0 120- initial level of GDP * Poland y = 74.55x + 42.844 (1989=100) R2- 0.5721 -o : Slovenia 100 Soa Re. m Hu * Czech Rep. (C 80 Estonia _ Macedonia * Romania * W Kazakhstan a aria * Lithuania 60- Kyrgyz Rep. tvi Russian Federation * Azerbaijan U 40 * Arme-nin * Ukraine Georgia O Moldova 20 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Size of the financial sector as a percentage of GDP in 1998 Source: Alfa Capital (Ukraine), BIS, EBRD, FIBV, IFC, IMF, JPMorgan Securities, OECD, Reifeissenbank Romania, Slovenska Sporitelnai, Troika Dialog, World Bank, national stock exchanges, trading systems, central banks and depository authorities. rather marginal share (2 percent) of the total financial sec- Financial Sector Health and Efficiency tor size. The size of the financial sector and its components is Observation 7. Compared to developed economies, not always a good indicator of their contribution to eco- transition economies usually have smaller banking nomic growth. In looking at the financial system's health sectors in relation to GDP. However, these small and efficiency, it is important to analyze separately the banking sectors usually dominate the financial sec- banking sector and the equity market. tor, as other financial sector segments are even less Observation 8. The shapes of banking sectors differ developed. (a) Compared to developed economies, dramatically among transition countries, and three stock market capitalization in transition economies typical groups can be distinguished. (a) The first is lower in relation to GDP and, in most cases, also group, composed mostly of Commonwealth of in relation to the aggregate size of the financial sec- Independent States (CIS) countries exemplified by tor. However, market capitalization is quite signifi- Russia and Ukraine, has extremely small banking cant in some countries. (b) Corporate debt markets sectors as a result of the deep deterioration of bank in transition economies are hugely underdeveloped, balance sheets.2 There is a lack of confidence in and in most countries they hardly exist. banks, which have a limited role in financial inter- 2. The CIS includes former republics of the Soviet Union except the Baltic states (Estonia, Latvia, and Lithuania). 34 Challenges of Financial System Development in Transition Economies FIGURE 4.5 RELATION BETWEEN THE SIZE OF THE BANKING SECTOR AND CHANGE IN GDP 140 * - Voucher privatization 00 -120 |Initial level of GDP | *Poland (1989=100) * Slovenia Slovak Rep. 'IO 100- s eO* Hungary Czech Rep. y = 22.503Ln(x) + 110.99 u 80 IR Q -------- ~~~~~~~~~~~~R2= 0.709 6 z 80 0Est Croatia ez M aced o U~~~~~~~~ e0 Kazakhskan ehuania * Bulgaria 4 60 . * + yrep. Latvia Russian Federation i 'jAzerbaijan 40 / * Armenia 0 * Ukraine . eorgia * Moldova 20 0% 10% 20% 30% 40% 50% 60% Ratio of bank deposits to GDP in 1998 Source: Alfa Capital (Ukraine), BIS, EBRD, FIBV, IFC, IMF, JPMorgan Securities, OECD, Reifeissenbank Romania, Slovenska Sporitelna, Troika Dialog, World Bank, national stock exchanges, trading systems, central banks and depository authorities. mediation. The fundamentals for an efficient bank- the first half of the 1 990s, without undermining the ing sector have yet to be created in these countries. general confidence in banks. They created healthy (b) The second group, exemplified by the Czech and fundamentals for their banking systems and priva- Slovak Republics, consists of countries with a siz- tized the bulk of bank assets with the participation of able, but unhealthy, banking sector, where banks foreign strategic investors. are overburdened with a stubbornly high share of Observation 9. In some transition economies stock bad debts. However, stable macroeconomic policies market capitalization is quite significant. However, and firm government support for the banking sector this indicator may be misleading, as it is related to in these countries have made it possible to maintain the ability of companies to raise funds on the stock confidence in banks and avoid destabilization of the exchange. In some countries, stock market capital- system. The intermediary role of banks in these ization is inflated as a result of voucher privatization. countries is very significant, although their efficien- In some countries, strategic holdings, mostly by for- cy is poor: banks allocate savings to inefficient uses eign investors or the state treasury, represent the and provide inefficient tools of corporate control. (c) bulk of market capitalization. The role of the stock The third group, exemplified by Hungary, Poland, market as a source of capital for domestic companies and Estonia, consists of countries with banking sys- is very limited. tems that are relatively small but are healthy and There are no data on the amount of capital (as a per- growing. These countries overcame banking crises in centage of GDP) raised by companies through new share 35 Kawalec and Kluza FIGURE 4.6 RELATION BETWEEN THE SIZE OF THE FINANCIAL SECTOR AND PROGRESS OF FINANCIAL SECTOR REFORMS 4- oo O * Hungary o 0 Poland 01649 X ~~~~~~~~~~~~~~~~~~~y = 3.0494x14 * Estonia2 Slovenia Rt= 0.5814 Czech Rep. u3 Lithuania U E ~~~~~Latvia = Latvia MacedonS Croatia 0 Slovak Rep. Z ~Macdn. Armenia *Kr e.Blai bc 0 /Kazakhstan *Romania 0 Moldova Ukraine Azerbaijan 0 Russian Federation Georgia > 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Size of the financial sector as a percentage of GDP in 1998 Source: Alfa Capital (Ukraine), BIS, EBRD, FIBV, IFC, IMF, JPMorgan Securities, OECD, Reifeissenbank Romania, Slovenska Sporitelna, Troika Dialog, World Bank, national stock exchanges, trading systems, central banks and depository authorities. issues-which would be an important indicator for judging trusted and appropriate savings and investment instru- the stock market's contribution to economic growth. ments. Given the shortage of such instruments, individuals Fragmented evidence indicates that the ability to raise cap- may follow several strategies: ital throlagh primary share offerings for companies in tran- * Increase spending, which on a macroeconomic level sition economies is very limited-much lower than data on translates into higher consumption and a lower sav- market capitalization would suggest. ings rate. 0)bservation 10. Except for a few countries in tran- * Invest abroad, which translates into capital flight sirion, there is a lack of trusted and appropriate and fewer domestic savings available to finance savings or investment instruments for individuals. investments in the country. This absence hinders the growth of financial sys- * Invest in the gray economy, which translates into tems, hampers economic development, and consti- fewer savings available to finance investment in the tutes a source of instability for transition official economy. economies. * Keep money under the mattress, which translates Except for a few countries in the Central European and into fewer savings available to invest in the country. the Baltic region, there is a lack of public confidence in All in all, the lack of an appropriate savings or invest- banks and capital markets in transition economies. People ment instrument hinders the growth of the financial system feel that the official financial sector does not offer them any and results in fewer savings being available for financing 36 Challenges of Financial System Development in Transition Economies FIGURE 4.7 RELATION BETWEEN THE SIZE OF THE FINANCIAL SECTOR AND LEVEL OF ECONOMIC DEVELOPMENT 10* 0 Slovenia 0 71 ;8 u, 0 c0 *Czech Rep. O Croatia O Hungary .Wn ~~~~~~~~~Estonia *Pln lvkRp u Y .270.6742 X~~~~~~~4 Latvia W= 0.4842 3-i 0 Macedonia Russ eaion ^ ~~~Romania ~Ka_ztan *0 Georgia Bulgaria * / ^ kraine e rmeni Ky Rep. * Moldova 0 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Size of the financial sector as a percentage of GDP in 1998 Source: Alfa Capital (Ukraine), BIS, EBRD, FIBV, IFC, IMF, JPMorgan Securities, OECD, Reifeissenbank Romania, Slovenska Sporitelna, Troika Dialog, World Bank, national stock exchanges, trading systems, central banks and depository authorities. investments in the official economy, which has a negative Accounting and Auditing Standards impact on official GDP growth. A number of transition economies have made progress In cases where foreign capital inflows substantially com- in bringing their national accounting and auditing stan- pensate for low domestic savings as a source of financing for dards broadly in line with international accounting stan- the corporate and government sector, the small size of the dards (IAS) and international standards on auditing (ISA). domestic financial system in relation to foreign flows makes There are, however, still material differences between economies vulnerable to financial and currency crises. national and international standards in many instances. Challenges for Future Development Consolidated basis. A very important weakness of pru- After 10 years of transformation, most transition dential regulations and reporting and auditing standards in economies still have a long way to go to create a robust and transition countries is the lack, or insufficient level, of con- efficient financial system. Actions in several fields are need- solidation requirements. This makes it difficult to supervise ed to build long-term confidence in the domestic financial banks on a fully consolidated basis, and banks may sweep system. some problems away into their affiliates.3 Without full 3. "The implementation of these regulations on a solo rather than a consolidated basis enables banks to bypass the spirit whilst oper- ating within the 'letter of the law' should they so choose" (FITCH IBCA 1998: 2). 37 Kawalec and Kluza FIGURE 4.8 RELATION BETWEEN THE SIZE OF THE BANKING SECTOR AND LEVEL OF ECONOMIC DEVELOPMENT 0 Slovenia 0 7; 8 X 8 .-~~~~~~~~~~~~~~~~~~~~~~~~~~~~~083 -r y 8.8333x 8235 R2= 0.6555 o ~~~~~~~~~~~~~~~~~~~~~Czech Rep. z 5 ~~~~~~~~~~~~~Croatia > ~~~~~~~~~Hungary * / cr ~~~~~~~~~Estonia * Slovak Rep. Lithuana c 3 3 L~~~atvia/ Macedoni. Kazakhstan ussian Federation Ge ori *Romania Georgia /Bulgaria 0 * *AUkraine Aze ba r doma v 0 /) yrgyz Rep. (% 10% 20% 30% 40% 50% 60% 70% Ratio of bank deposits to GDP ratio in 1998 Source: Alfa Capital (Ukraine), BIS, EBRD, FIBV, IFC, IMF, JPMorgan Securities, OECD, Reifeissenbank Romania, Slovenska Sporitelna, Troika Dialog, World Bank, national stock exchanges, trading systems, central banks and depository authorities. consolidation, not only the public and supervisors may be The introduction of the substance-over-form rule is misled, but also bank management may not properly getting more urgent, as transactions become more compli- understand the risks borne by their institutions. cated and their economic substance is being changed by derivative instruments. Presentation of accounts based on Application of the substance-over-form rule. One of the the legal form of transactions often is misleading. In these most important shortcomings of the accounting regula- circumstances, banking supervisors, who may have diffi- tions in transition countries is the precedence of the legal culty catching up with innovations in the commercial sec- form of a transaction over its commercial substance tor, would find it difficult to assure adequate enforcement (Cunningham 1998). Application of the substance-over- of the substance of prudential regulations. form rule is one of the most important tools against unfair reporting practices. This tool is not available to auditors in Application of the truth-and-fairness principle. Auditing most transition countries.4 regulations in transition economies emphasize compliance 4. The concept of substance over form that is absent from accounting legislation usually is recognized in tax legislation; see Cunningham (1998). 38 Challenges of Financial System Development in Transition Economies FIGURE 4.9 STRUCTURE OF THE FINANCIAL SECTOR IN OECD* COUNTRIES, 1998 S~~~~~~~~~ 5 0% -,~~~~~~~~~~~~~J \~~~~~t~ ~ | |f a | * bank deposits El stock market capitalization 53 outstanding corporate bonds and commercial paper| Note: "OECD countries without Iceland, Luxembourg, Turkey and Czech Republic, Hungary, Poland." Source: BIS, FIBV, IMF, Morgan Stanley Dean Witter, OECD, World Bank. with regulations and do not provide the auditor with an Protection of creditor rights. In order to carry out their overriding principle of truth and fairness, which is key in business, banks need tO have the ability to secure their LAS and constitutes an important tool for countering prac- loans with various types of collateral and be able to quick- tices that formally comply with, but are against the spirit of, ly seize the collateral in case of loan default. Bankruptcy the regulations. procedures should allow creditors to effectively recover Observation 11. Accounting and auditing standards loans through liquidation. In addition to the proper legal should be brought fully in line with international framework, there is a need for efficient courts and other standards: companies should be obliged to present institutions to assure that creditor rights are effectively fully consolidated accounts; the substance-over-form exercised. rule as well as an overriding truth-and-fairness prin- ciple should be applied. Protection of shareholder rights. Shareholders need ade- quate information about the company's standing, and they Legal Framework should have the ability to put up their representatives as Key tasks of a modern legal framework are to protect supervisory board members and to change management. the rights of creditors and shareholders and to protect indi- Any privileged transactions that transfer value to insiders viduals and firms from excessive and arbitrary taxation. (dominant shareholders, management, or employees) at 39 Kawalec and Kluza FIGURE 4.10 STRUCTURE OF THE FINANCIAL SECTOR IN TRANSITION ECONOMIES, 1998 a ,I a 00 ,0N 55 C o/- - - - -0 't - -e _ _ U~~~~~~~~~~~~~~~~~~~~~~~ U bank deposits [1 stock market capitalization a outstanding corporate bonds and commercial paper Source: Alfa Capital (Ukraine), BIS, EBRD, FIBV, IFC, IMF, JPMorgan Securities, OECD, Reifeissenhank Romania, Slovenska Sporitelna, Troika Dialog, World Bank, national stock exchanges, trading systems, central banks and depository authorities. the expense of the company's shareholder value should be tax system and an effective tax administration. When properly disclosed and preapproved by shareholders. banks act as tax collectors and tax authorities have the Minority shareholder rights should be protected from ability to garner transfers coming into bank accounts to abuse by dominant shareholders. cover tax or wage arrears, then firms tend to avoid trans- The EBRD survey on corporate governance in transi- acting through banks (Sultan and Mishev 1999). Giving tion economies supports the view that, while many laws in tax authorities priority over secured creditors undermines the region theoretically provide a sound basis for protect- the value of secured loans. Long-term investors' confi- ing shareholder rights, the implementation and enforce- dence can hardly be built if companies' financial situations ment of these laws are lagging (Ramasastry, Slavova, and may be unexpectedly affected by the discretionary actions Bernstein 1999). of tax authorities. Observation 12. Laws and law enforcement institu- Protection from excessive privileges of tax authorities. tions should adequately protect creditor and investor Effective tax collection is a prerequisite of macroeconom- rights. ic stability and a level playing field in business activity. Observation 13. Tax rules should be clear-cut, with However, granting excessive privileges to tax authorities no room for discretion in tax administration. Tax should not be treated as an easy substitute for an efficient authorities should not have excessive privileges over 40 Challenges of Financial System Development in Transition Economies other creditors. In case of a dispute with tax author- For some countries, a pressing need is to deal with cri- ities, taxpayers should have an effective possibility to sis situations where the large share of nonperforming assets appeal to court. threatens the liquidity or solvency of a significant part of the banking sector. A banking crisis constitutes an acute Financial Sector Supervision problem if it happens in a country with a relatively sizable Independent, strong, and decisive supervision is a nec- banking sector, like the Czech Republic, Slovakia, Croatia, essary condition for building confidence in the financial sec- or Romania (Kawalec 1999; Banka 2000). tor. The growth of the relative size of the financial sector A banking crisis affects the economy in various ways. further increases the macroeconomic risk of a financial It undermines overall confidence in the economy and sector crisis and thus increases the requirements for prop- causes misallocation of resources. It may result in a major er regulation and effective supervision. banking destabilization, in which major banks lose liq- Observation 14. Independent, strong, and decisive uidity or a bank panic resulting in downsizing of the supervision is a necessary condition for building banking sector's balance sheet. Such destabilization is confidence in the financial sector. (a) In order to likely to be connected with a drop in GDP (as occurred in become more effective, supervision of the financial Bulgaria in 1996 and 1997). Even if a one-off destabi- sector should be highly focused, putting as much lization is avoided, an unresolved banking crisis under- responsibility as possible on the private sector and mines the confidence in banks and threatens their liquid- market discipline; public disclosure requirements ity, contributing to the systematic erosion of bank balance should be strengthened; and the responsibilities of sheets (as happened in Romania). A prolonged banking auditors should be expanded (see Kawalec 1999: crisis, even if it neither destabilizes nor erodes the bank- 33-34). (b) Interdependency among various seg- ing sector, is likely to have a deep negative impact on eco- ments of the financial sector calls for organization- nomic growth (as happened in the Czech Republic and al integration under one regulatory roof in order to Japan). Dealing with a banking crisis both decisively and make regulation more consistent and effective as in a way that inspires confidence may minimize the dis- well as diminish industry's cost of dealing with reg- ruptive impact on economic growth. The recapitalization ulators. (c) Supervision of the financial sector needs of banks, however, usually requires significant budgetary very good professional staff who are adequately resources.5 remunerated. To enable this, the financial industry Observation 16. For a group of countries facing could pay special fees to finance supervision. banking crises, the pressing need is to deal with these crises both decisively and in a way that supports Macroeconomic Stability rather than undermines confidence. In case of high inflation, financial assets are likely to lose part of their real value. When unsound macroeco- Bank Privatization nomic policies result in a currency crisis or default of gov- Political influence in the selection of management and ernment domestic debt (as happened in Russia in 1998), in credit and investment decisions adversely affects bank capital market investors as well as bank depositors may efficiency, asset quality, and confidence in banks. experience severe losses. Once confidence is lost, it requires Governments should withdraw themselves as owners and many years to rebuild. not influence bank business decisions. If there is a shortage Observation 15. Long-term growth of the financial of sound domestic investors who understand banking busi- sector requires sound and stable macroeconomic ness, the involvement of reputable foreign banks as share- policies. holder in local banks is warranted. Observation 17. Banks should be privatized and Dealing with Unresolved Banking Crises separated from politics and government influence. For most transition countries, the priority is to lay The key objective of bank privatization should be to down institutional fundamentals to allow the development create the best conditions for long-term develop- of a sound banking sector and stimulate its growth from an ment, soundness, and efficiency of the privatized exceptionally small relative size. institution. 5. Opinions on various ways to recapitalize and restructure banks are presented in Kawalec (1999: 30-31) and Simoneti and Kawalec (1995). 41 Kawalec and Kluza Observation 18. A specific task, still not carried out invested in the domestic market. However, in the case of in a number of transition economies, is the restruc- transition countries that have a domestic savings deficien- turing and privatization of former specialized savings cy and substantial domestic investment needs, it does not banks. seem rational to create a forced saving scheme in order to export capital. Another solution would be to force pension Pension System Reform: Opportunities and Risks funds to invest the bulk of their assets in government debt. for the Capital Markets However, this likely would dilute and diminish the benefits All transition countries face the challenge of develop- of pension fund reform. Thus other solutions should be pre- ing capital markets capable of playing a significant role in ferred. providing funds to the corporate sector and constituting an Privatization policy may contribute to the growth of effective instrument of corporate control. Pension system stock market free float, through more privatization trans- reform-of the type introduced in Chile in the 1980s or in actions and preferences to initial public offerings as Poland in 1999-creates a stream of mandatory savings opposed to direct sales or employee buyouts. that is channeled into specially created, privately managed It also is critical to increase the availability of attractive pension funds. This might constitute a substantial cure for debt instruments. Adequate regulations are needed con- a weak base of domestic investors and a lack of long-term cerning commercial paper, corporate bonds, and municipal portfolio investors.6 Pension funds soon may become sig- bonds, as well as mortgage securities and other asset-based nificant investors, sharply increasing the capacity of domes- securities. An adequate regulatory policy is needed that tic capital markets to absorb new issues. Pension reform allows pension funds to invest a substantial portion of creates tremendous opportunities for capital market devel- their assets in various nongovernmental debt instruments. opment. There are, however, associated risks: Observation 19. Reform of the pension system - One concerns the introduction of pension reform through the creation of privately managed pension when the legal and institutional framework for cap- funds may have a substantial impact on capital mar- ital markets is too weak. If investor rights are not ket development and thus contribute to the improve- protected and there is a lack of transparency, as well ment of financial sector structure. However, the as a lack of effective supervision, then widespread introduction of pension reform when the legal and fraud might undermine the realizable value of pen- institutional framework for capital markets is too sion fund investments. This could destroy confi- weak or macroeconomic policies are unsound may clence on the part of pension fund members, leading result in failure. to dangerous frustration. Observation 20. Pension reform, creating a growing * ligh inflation or a financial crisis as a consequence stream of forced savings channeled into the capital of unsound macroeconomic policies may cause a market, may contribute to a stock market price bub- negative return from pension fund investments. ble. To diminish this risk, there is a need to increase * Another risk concerns the possibility of a stock mar- the availability of assets in which pension funds can ket price bubble if growing investments of pension invest. To this end, privatization polices should aim funds constitute too big a part of stock market free to increase stock market free float. It also is critical float. Stock prices might increase sharply, exceeding to increase the availability of eligible, attractive cor- any conceivable estimates of the fundamental value porate debt instruments. connected with future earnings. Sooner or later a price bubble has to end with a market crash, leading Is There a Role for Domestic Capital Markets in to a severe loss of the value of the investments. Transition Economies in the Future? In order to diminish the risk of a price bubble, there is In this paragraph we react to suppositions presented in a need to increase the amount of assets in which pension Claessens, Djankov, and Klingebiel (2000) that domestic funds could invest. Technically, the easiest way would be to stock markets will have no significant role in transition increase the percentage of pension fund assets that may be economies in the future. Claessens, Djankov, and invested abroad and limit the percentage that may be Klingebiel analyze the present situation and best-case sce- 6. The introduction of funded pension schemes has been presented as "the single most important decision Baltic governments can make to support equity culture" (Hansabank Markets 2000: 9). 42 Challenges of Financial System Development in Transition Economies narios for market capitalization and market turnover in tic stock market may contribute to creation of the Third transition economies until 2005. They conclude that stock World type of structural division of the economy, in which markets in transition economies are small and dormant a separate group of international companies predominate- and that most of these markets will not achieve minimum ly bypasses the local legal system, using foreign jurisdiction economies of scale in the foreseeable future. They notice and foreign listing, and in which little pressure is brought that, in the era of global stock markets, services will be eas- to bear on improving the domestic legal and institutional ily available abroad, both for companies wanting to raise framework. capital and for investors wanting to invest in stocks. Thus, With the exception of very small and open economies they recommend that transition economies should avoid (with very high ratios of foreign trade to GDP) efforts to developing costly stock markets and instead should con- develop domestic stock markets make sense, as countries centrate on building basic legal infrastructure to protect without them will be handicapped in their economic and creditor and shareholder rights and support development social development. Of course, the existence of a domestic of the banking sector. stock market does not exclude the possibility of coopera- As far as the present situation of stock markets in tion links (including co-listing agreements) with other stock transition economies is concerned, the findings by markets. Claessens and his co-authors are compatible with obser- Observation 21. Except small and open economies, vations presented here. We also subscribe to their insistence countries without a sound domestic stock market on building basic legal infrastructure and developing the may be handicapped in their economic and social banking sector. However, their conclusions and recom- development. (a) For potential issuers, a domestic mendations concerning the future role of stock markets in stock market cannot be fully substituted by foreign transition economies are less convincing. listings, as direct access to foreign stock markets may Claessens and his co-authors' conclusions-that most be practical only to a relatively small group of com- of the stock markets in transition economies have no panies. (b) Lack of a domestic stock market will slow chance of achieving minimum economies of scale-could down economic education of the elite and broader be different if they took a long-term perspective of 10 to 20 public and will slow down development of equity cul- years instead of 5 years only. With a longer perspective, the ture. (c) Without a domestic stock market, investors effects of pension reform on the capital market would be interested in stocks will be forced to invest abroad, dramatically bigger than in their five-year scenarios. which would diminish the level of domestic invest- In our view, there is interdependence between devel- ment. (d) Lack of a domestic stock market may con- opment of a domestic stock market and pension reform tribute to creation of a Third World type of structural based on the introduction of mandatory funded pension division of the economy characterized by the exis- schemes. From one side, introduction of mandatory fund- tence of a separate group of international companies ed pension schemes may dramatically speed up develop- that predominately bypasses the local legal system, ment of the stock market. From the other side, without the using foreign jurisdiction and foreign listing, and an existence of a domestic capital market including a stock absence of pressure on improving the domestic legal segment, a macroeconomic rationale for mandatory fund- and institutional framework. (e) Without the exis- ed pension schemes is questionable, as it would mean tence of a domestic capital market including a stock mandatory export of capital from countries that have a segment, the macroeconomic rationale for mandato- domestic savings deficiency and huge domestic investmenit ry funded pension schemes is questionable, as it needs. would mean mandatory export of capital from coun- We do not agree that foreign listing may adequately tries that have a deficiency of domestic savings and a substitute for a domestic stock market. For a substantial huge need for domestic investment. group of smaller companies, which could consider listing on the lower tier of the domestic market, foreign listing References may not be practical because of additional costs resulting The word "processed" describes informally repro- from dealing with different legal systems, the necessity to duced works that may not be commonly available in library present documentation in a foreign language, and distance systems. to investors. We also think that a domestic stock market hardly can be substituted in its important educational role Banka [Croatia's Business and Finance Magazinel. 2000. for the elite, media, and broader public. Lack of a domes- "Special EBRD edition." (May). 43 Kawalec and Kluza Claesser[s, Stijn, Simeon Djankov, and Daniela Klingebiel. Bulgaria, Czech Republic, Hungary, Poland, 2000. "Stock Markets in Transition Economies." Romania, and Slovakia." CASE Reports 23. CASE Financial Sector Discussion Paper 5. World Bank, Center for Social and Economic Research, Warsaw. Washington, D.C. September. Processed. Processed. Cunningham, Peter. 1998. "Interpreting the Figures: How Mellyn, Kevin L., and Matthew I. Saal. 1998. "A Rcl: able Are They?" Paper presented at a conference Perspective on the Risk and Regulatory Implications of Bank Credit Risk in Central and Eastern Europe and Market: Centric Financial Systems." In 1998 Essay the Commoinwealth of Independent States, organized Competition in Honor of Jacques de Larosiere. by IBC UK Conferences, sponsored by Moody's Winning Essays. Washington, D.C.: Institute of Investor Service, Prague, June 30-July 1. International Finance. EBRD (European Bank for Reconstruction and Ramasastry, Anita, Stefka Slavova, and David Bernstein. Development). 1999. Transition Report 1999. Ten 1999. "Market Perception of Corporate Governance: Years of Transition. London. EBRD Survey Results." Law in Transition, pp. 32-39. . 2000. Transition Report Update 2000. London. London: European Bank for Reconstruction and May. Development. Autumn. FITCH IBCA. 1998. "The Czech Banking System and Simoneti, Marko, and Stefan Kawalec, eds. 1995. Bank Prudential Regulations." [London]. May. Rehabilitation and Enterprise Restructuring. Ljubjana, Hale, David. 2000. "Can America Achieve a Soft Landing? Slovenia: Central and Eastern European Privatization Or Why the Equity Market Boom Is an Experiment in Center. Corporate Resources Reallocation." Zurich Financial Sultan, Khwaja M., and Dimitar G. Mishev. 1999. Role of Services, Chicago. Processed. the Financial System in Economic Growth in Hansabank Markets. 2000. "Creation of Equity Culture in Transition Countries: The Case of Ukraine's Banking the Baltic States: What Do You Need to Make It System. Vol. 1. Working Policy Series. Kiev: Harvard Happen?" Paper presented at the annual meeting of Institute for International Development, the European Bank of Reconstruction and Macroeconomic Policy Unit; Cambridge, Mass.: Development, Riga, May 19. Processed. Harvard lnstitute for International Development. Kawalec, Stefan. 1999. "Banking Sector Systemic Risk in October. Selected Central European Countries. Review of 44 Part III Banking Sector Restructuring Chapter 5 Estonia: The Financial System in Retrospect and Prospect Helo Meigas T his chapter investigates how prospective changes in the business environment are likely to affect the banking sector in Estonia and, by examining whether global pressures are likely to dom- inate country-specific factors, assesses the extent to which the changes expected to take place in the global banking sector will be replicated in Estonia. Two main areas are considered: * Changes in the structure of the banking industry * The future of banking. Among many trends that are having an important Partly due to the implementation of policy and region- effect on banking, this chapter emphasizes the signifi- al integration, financial markets in Estonia generally have cance of competition (both internal and global) and new adopted the model of "universal banking," in which the technology. But these trends first must be examined separation of banking and securities is not mandatory, against the background of Estonia's emerging financial and different segments of the financial market are inte- market structure. grated, giving banking groups the leading position in financial intermediation. The two largest banks account Evolution of Estonian Banking and Securities Market for 85 percent of the banking sector, 90 percent of leasing Estonian banking has changed dramatically since the and investment funds, 60 percent of life insurance, and 70 new economic and legal framework was introduced in the percent of transactions on the Tallinn Stock Exchange early 1990s. The number of credit institutions dropped (TSE). sharply from 42 banks in 1992 to 11 by the end of 1997 The securities market started to develop in 1994 when (see table 5.1). A second wave of restructuring occurred in the Estonian Central Depository for Securities (ECDS) was 1998. Increased competition resulted in several major founded. The ECDS maintains the central register for secu- mergers, and many weaker and inefficient institutions left rities and is the clearinghouse for securities transactions. the market. Consolidation was followed by an inflow of The securities market is comprised mainly of equities, while foreign capital from Scandinavia. Swedish banks acquired the share of debt securities is modest. The fixed exchange majority stakes in Estonia's two biggest banks, increasing rate supported by the currency board system has reduced the market share of foreign-owned banks to more than 90 the possibility of introducing monetary policy instruments percent. In autumn of 1999, the Bank of Estonia issued a based on the Estonian kroon. The budget of the central license to a new bank for the first time since 1993, increas- government has been balanced on the whole, and the secu- ing the total number of banks to seven. rities market has developed without short-term central 47 Meigas TABLE 5.1 STRUCTURE OF THE ESTONIAN BANKING SECTOR, 1992-99 Indicator 1992 1993 1994 1995 1996 1997 1998 1999 Number of commercial banks 42 19 22 18 13 11 6 7 Number of private banks 38 17 21 17 12 11 5 6 Number of state-owned banks 2 2 1 1 1 0 1 1 Concentration index 21 (percent) - 31 37 41 45 49 85 84 Concentration index 42 (percent) - 57 62 68 72 81 94 98 Total assets of banks (millions of EEK3) 4,788 6,391 10,067 14,857 21,902 40,582 40,995 47,071 Growth cf domestic credit 1.34 1.56 1.60 1.54 1.74 1.82 1.12 1.12 Ratio of bad to total loans - - 1.5 1.1 2.4 1.2 1.4 1.7 Capital adequacy (percent) - 18.1 13.4 13.7 12.1 13.5 17.0 16.2 Share of foreign ownership (percent) - - 14.7 29.0 33.4 44.2 60. 61.6 - Not available. 1 The percentage of two largest banks' assets from total banking sector assets 2 The percentage of four largest banks' assets from total banking sector assets 3 1 EUR = 15.65 EEK (Estonian Kroon) Source: Bank of Estonia government securities. The private sector has taken over that year. In 1998, the TALSE fell another 68 percent, and benchmarking to a large extent. market tumover fell 50 percent; it has yet to recover fully. The Since 1996, the TSE has operated an electronic on-line relatively low level of stock prices encouraged foreign interactuve trading system offering continuous quotation investors to acquire a majority stake in several Estonian com- within an order-driven system, and all securities are dema- panies. The share of foreign investors in the equity market terialized. Clearing and settlement are processed on a deliv- increased to more than two-thirds and is dominated by ery versus payment basis. Swedish and Finnish capital. The more than twofold growth Fromr November 1996 to September 1997, the number in the capitalization of the stock market in 1999 was mainly of traded companies grew from 5 to 26. As a result of the due to the listing of Estonian Telecom shares.1 excessive optimism of local investors, the abuse of leverage, Despite the rapid development of the securities market, and changes in the external environment, Estonia's stock the banking sector remains dominant (see figure 5.1). exchange index, TALSE, more than tripled. Market size grew Strong relations between banks and other financial inter- sevenfold in 1997, reaching 38 percent of gross domestic mediaries allow banks to exert a significant influence on the product (GDP). The volatility in global markets has had a rip- development of the financial sector at large. At issue is ple effect in Estonia. The first crisis hit in October 1997, when whether global trends are going to alter Estonia's pattern of the TALSE index fell 60 percent from its peak in August of financial development. 1. The shares of Estonian Telecom constituted approximately half of the EEK 40 billion capitalization of the stock market at the end of the first quarter of 2000 (Estonia's currency is the kroon). 48 Estonia: The Financial System in Retrospect and Prospect FIGURE 5.1 ASSETS OF BANKS AND OTHER FINANCIAL INTERMEDIARIES IN ESTONIA, 1996-99 45 ~ ~ ~ ~ ~ ~ ~ ~ ~ 12~~~~~F Collected premiums of 45 insurance companies 40 I Portfolio of leasing - * ~~~~~~~~~~companies n 35 _ Assets of 8 - - B ~~~~~~~~~~~~~~investment funds M 30 * * * notes , 25 1 Shares :q * * * * ~~~~~~~~~~~~~~~financial assets 15 *ll~f __ 1 0 6 1 F| i 1996 1997 1998 1999 1996 1997 1998 1999 1996 1997 1998 1999 Banks Securities market Nonbanks Source: Bank of Estonia. Changes in the Structure of the Financial Service because the market was expanding and margins were wide. Industry: Concentration and New Competitors Since 1998, when consolidations took place, banks have Internationally, the main driving force behind consol- been trying to lower their costs by reducing their staffing idation has been the need to enhance competitiveness by and closing branches. As a result of these efforts, banks expanding activities geographically and offering a wider likely will again enjoy upward-sloping returns. variety of services. The obvious implication of consolida- When internal resources for streamlining costs have tion has been the reduction in the number of banks.2 been used up, the only way for banks to remain compet- In Estonia, the number of banks has decreased from 42 itive is to expand their activities to neighboring markets in 1992 to 7 today. The profit margins of banks have been using cross-border and cross-business acquisitions. Both relatively high, and mergers have been triggered mostly by of these have occurred on a wide scale in Scandinavian the need to strengthen the balance sheet of weaker banks. countries and on a smaller scale in the Baltic states during There is almost no room for further consolidation through the past two to three years.3 By 1996-97, several Estonian mergers, and each institution must find the means to banks had established leasing subsidiaries and were about increase efficiency within itself. to open subsidiary banks in other Baltic countries. Recent mergers show that consolidation helps to Instead, the Russian crisis forced them to lower their own increase efficiency. Until 1998, banks did not target costs cost base and to concentrate mainly on domestic organi- 2. In the United States the number of banks decreased from 9,881 to 7,152, or 28 percent, during 1988-98 (Mishkin and Strahan 1999); in Europe the drop was from 12,256 to 9,285, or 24 percent, during a slightly earlier period (ECB 1999). 3. For example, in the case of MeritaNordbanken or Skandinaviska Enskilda Banken (SEB), the initial building blocks came from one country. During the 1990s they were transformed into pan-Scandinavian financial conglomerates offering a wide range of financial products. After establishing a presence in Scandinavia, Skandinaviska Enskilda Banken, MeritaNordbanken, and Swedbank enlarged their scope to the Baltic region by entering all three countries during 1998 to early 2000. MeritaNordbanken made the last acquisitions, buying banking subsidiaries from Societe G6n6rale in Latvia and Lithuania. The deal went into effect on March 31, 2000. 49 Meigas zational structures. As a result, financial organizations Banks are the main intermediaries and dominate the consolidated in 1998-99, revising and postponing pan- business side of the bond market. Several analysts in Baltic strategies. Estonia have argued that there is no good reason why Geographic expansion has been accompanied by diver- other institutions could not offer similar services at better sification into other financial services. Leasing offers good prices. Nonbanks have been able to compete successfully possibilities for diversification and is growing rapidly.4 Life with banks primarily in public offerings. The development insurance is included in organizational structures, but the of pension funds should increase the demand for fixed- market is immature and volumes remain low. income products, which are traded on the secondary mar- The structure of the Estonian banking sector is expect- ket. As a consequence, big, high-quality borrowers (such as ed to follow international trends. Based on recent devel- municipalities, telecommunications firms, and utility com- opments, the number of banks in Estonia probably will be panies) will shift away from banks. The small and medium- roughly the same in 10 years as it is today. Consolidation size enterprises, which are difficult to analyze and in which is not likely to proceed further. Three (at most four) banks lending risks are higher, likely will become the main clients will offer a wide range of financial services, and a few for banks. smaller, niche banks will compete mostly with nonbank Two factors are offsetting this trend in Estonia. First, institutions, largely because they are oriented toward asset banks have established themselves firmly in the commercial management. All banks are either predominantly or fully paper and bond market and have good client relationships owned by foreign capital. They maintain efficiency by with larger corporations. Their main advantage is their expanding to neighboring countries and by looking for ability to offer combined services, because nonbank finan- sources of revenue outside traditional banking services. cial institutions do not have sufficient balance sheets to offer underwriting. Looking at the liabilities' side of The Asset Side of the Banking Sector Estonian enterprises shows that banks are very dominant It is an international trend for borrowers to bypass (see figure 5.3). banks. Offering access to bond markets has become a prof- Banks' superior ability to assess the credit risk of a itable business for nonbank financial institutions. Through borrower historically has been a major comparative advan- the elimination of one middleman, borrowed funds have tage of banks. Banks also have been able to access funds at become less costly, and that, in turn, has opened up the better rates. Today, credit rating agencies in developed mar- market to nonbanks and led to a boom in the commercial kets are taking business away from banks, and the market paper market. This has caused banks to shift their assets is now able to estimate the credit risk of borrowers. from lending to securities.5 Investors feel comfortable lending directly to companies In Estonia, the volume of the bond market historical- without the intermediation of banks, making it possible ly has been low, with no significant increase in recent for companies to obtain competitive rates. Estonia, in con- years.6 Compared with the banking sector's loan portfolio, trast, does not have local rating agencies. International rat- capital markets have not established themselves as an alter- ing agencies are not likely to establish themselves in the mar- native for financing the economy. Commercial paper has ket, because local companies are too small to afford the been dominating the market, and only very recently has costs of rating. Banks are the only other companies that pos- turnover increased in the maturities of 3-12 months; longer sess ratings from international rating agencies, and that is maturities are still almost nonexistent (see figure 5.2).7 not likely to change significantly in the near future. 4. The income earned from the leasing activities of the total consolidated banking groups in Estonia reached as high as 44 percent of total interest income and 16 percent of total revenues as of the first quarter of 2000. In recent years, when the economic slow- down brought a decline in lending, growth was restored first in lending to financial institutions, mostly leasing companies. In the first half of 2000, total banking sector lending to financial instiutions was double lending to corporations. S. According to Saapar and Soussa 2000, the share of loans in big banks in the Organisation for Economic Co-operation and Development (OECD) countries decreased and investments into securities increased over the period of 1991-98. The sample incLided 74 OECD banks with total assets of 100 billion or more as of December 31, 1998. 6. The total volume of new bond issues registered in ECDS at the end of 1999 was less than EEK 800 million. Total bond market capitalization at the end of the first quarter of 2000 was EEK 3.6 billion (less than 5 percent of GDP), whereas the loan port- folio of the total banking sector in the first quarter of 2000 was EEK 27.5 billion (36 percent of GDP). 7. In absolute terms, it amounted to EEK 750 million. 50 Estonia: The Financial System in Retrospect and Prospect FIGURE 5.2 NEW ISSUES OF DEBT SECURITIES IN ESTONIA, 1997-99 _ Up to 3 _ 3 -12 LII1 - 3 More than 3 Interest months months years years rate 2000 18 1800 16 1600 - 1 4 1400 12 -1200 - FA ~~~~~~~~~~~~~~~10 8 000- Z 600 -m 400 nul4 200 111 IIE I 2 0 0 e e 01 01. C 1 ', e! } e,>>~~ ;4 + ' e'~ ,+' /; ' / + + K@ cd ' c( (, g Cs cg / ?g Source: Bank of Estonia. Infrastructure companies and banks are the only companies government issuing debt or from foreign investors hedging likely to be able to tap directly into (international) bond their local currency positions. In connection with the forth- markets. Banks, with their strong ownership structure, are coming pension reform, various foreign experts have rec- in a relatively good position to access capital markets.8 ommended issuing central government securities in the Consequently, the cost of funds to nonbank and industrial local market. But from the point of view of long-term borrowers tends to be higher than the cost of funds to financial safety, it may not be advisable to generate gov- banks. If smaller enterprises were to issue a public bond, ernment deficit just to create domestic investment oppor- they still would need a bank either to underwrite the issue tunities for the second pillar of pension reform. The gov- or to provide a guarantee. ernment's financial discipline in avoiding significant Second, the size of the market in absolute terms will amounts of external or internal debt has contributed to work against the development of a local bond market. The macrostability and enhanced credibility in the currency capitalization of the debt securities market is EEK 3.6 bil- board arrangement. After Estonia joins the European lion or 8 percent of bank assets (as of March 2000). Monetary Union, foreign investors will no longer have to Additional supply to the market can come either from the issue kroon-denominated securities to cover foreign 8. Recent improvement of Hansabank credit rating to BBB by Standard and Poor's has brought its rating to the level comparable to that of the Republic of Estonia, and the recent 150 million euro bond issue was priced significantly lower than even the sov- ereign debt of the neighboring countries (that is, Eurobor + 109 basis points, including costs). 51 Meigas FIGURE 5.3 SHARE OF BANK LOANS IN TOTAL CORPORATE In Estonia, local factors (the smallness of the market, LIABILITIES IN ESTONIA, 1994-98 the dominant market position of banks, and the small size of local companies) suggest that disintermediation will 35 - _ take much longer than in other countries. In the coming * Bank loans years, banks will lose some of their largest clients, but as the 30 -Leasing fixed-income market for medium-size companies is not [2 Debt securities | likely to pick up rapidly, most of the financing will come 25 either from banks or directly from parent companies. In Estonia, capital markets do not seem to be signifi- = 20 cantly threatening the position of banks in the lending Iu * * *market. This may not be beneficial from the point of view l5 of competition and efficiency of the financial markets. To take a more active approach to developing the infrastruc- 10 tore, authorities will need to analyze which segment of the fixed-income market is most likely to succeed and develop S that particular market segment. Within the context of the globalization of financial markets, a full-fledged local bond 0 market may turn into an inefficient undertaking, suffering 1994 1995 1996 1997 1998 from low liquidity and high volatility. Source: Bank of Estonia. The Liabilities Side of the Banking Sector exchange risk. Today, the main players in the debt securi- Internationally, pension funds and mutual funds have tics market arc Nordic financial institutions, whose bond been fighting for access to houschold savings. By purchas- issues cover two-thirds of the primary market and approx- ing a diversified portfolio of assets, they have been able to imately half of the secondary market. This trend is chang- offer investors the possibility of holding a well-diversified ing as Estonia is increasingly perceived as a home market, and liquid portfolio with a much higher yield than that pro- and therefore, neither financial institutions nor real sector vided by a bank deposit. Adequate regulation has helped enterprises hedge their investment positions in local cur- such intermediaries to offer their clients the same level of rency. As -he supply to the bond market is fairly limited, the confidence as that offered by banks. demand for fixed-income investments (coming from pen- The structure of personal savings (bank deposits versus sion funds and from other institutional investors) is likely securities market versus insurance premiums held by pri- to go to foreign issuers, which are rated by independent vate individuals) shows the dominant position of bank agencies and have a longer track record. deposits in Estonia (see figure 5.4). Neither the equities Securitization of the loan portfolios of banks will market nor investment funds have been able to advertise remain relatively limited because the secondary market for themselves as safe alternatives for personal long-term sav- fixed-income products is not active enough, and little local ings. 10 Most of the money in the securities market has expertise is available to assess the securitized credit risk. been speculative, as proved by the market's relative liquid- Also, the cost of setting up the legal and institutional frame- ity despite its smallness in absolute terms.1 1 In order to gain work for starting an efficient securitization is relatively a reputation and growth rate similar to those of banks, high compared with the limited volume of the market. securities markets and fund managers must demonstrate a Until their capitalization remains high and they need their good track record in order to attract savings instead of earning assets, banks will not be interested in selling loans.9 speculative money.12 Another illustration of the lack of 9. Average capital adequacy of the Estonian banking sector in the first quarter of 2000 was above 17.3 percent. 10. The tctal investment of private residents at the end of 1999 was EEK 1.4 billion in shares and EEK 37 million in investment fund units. Total private resident deposits in the commercial banks had risen to more than EEK 10 billion. 11. The liquidity ratio of the Estonian equity market has been relatively high throughout its history. In 1997-98 the liquidity ratio (turnover to market capitalization) for equities was more than 100 percent. It dropped to 15 percent, though, in 1999, both because of a decrease in turnover as well as an increase in market capitalization due to the listing of Estonian Telecom. 12. The average annual growth rate of bank time deposits for the period 1993-99 was 54 percent. 52 Estonia: The Financial Systemn in Retrospect and Prospect FIGURE 5.4 STRUCTURE OF PRIVATE SAVINGS BANKS AND but the overall trend is likely to be similar to the interna- OTHER INTERMEDIARIES IN ESTONIA, 1996-99 tional one. International investments will be favored over products specific to local markets. With products based on 19,000 - *Units of invest- local securities, banks, which have a better distribution o 8,000 - ment funds network, will have an advantage over nonbanks, which will - 7,000 aDebt securities have difficulty achieving adequate volume. Nonbanks in 'n 6,000 - Shares Estonia will attract local savings that are largely specula- .5,000 D ostI o 4,000 tive. Clients looking for higher returns (and willing to take 3,000 higher risks) will go to asset managers offering venture 1,000 - capital funds. Decisions concerning pension reform may _ _ _ _ _ l l l l l l influence the competitive position of nonbanks. If the pay- \C) <9 ' 9) 9 9 9 ,.9 as-you-go system becomes dominant, the banking sector fiOe& sob fiOeS fiOeS sOeS S @ @ will not be challenged. But if the government decides to cC/> je place more emphasis on funded pension schemes, the devel- opment of the securities markets will be encouraged at the Source: Bank of Estonia. expense of banks. Developments in Banking Business: Reorientation confidence is the very small volume of pension funds, of Business, New Channels of Distribution which, despite generous tax benefits, have not been able to Internationally, it has been argued that a need to get off the ground.13 Population trends also will be influ- improve return on equity and assets and to compensate for encing the structure of savings-demographically the pop- a decrease in net interest margins will be the driving forces ulation is aging fast, but retirees have smaller savings and leading to restructuring in the banking system. Banks need less knowledge of securities markets than the general pop- to change the way they do business, both by restructuring ulation. Their conservatism is very high, and consequent- their operations as well as by increasing their risk taking in ly they choose bank deposits with smaller returns. order to achieve higher margins and larger volumes. If this There is, nevertheless, little doubt that the interna- trend leads to a decline in their credit rating below that of tional trend of investments flowing from bank deposits their customers, this may lead to a further decrease in their into higher-yield products will be replicated in Estonia. traditional business and to an acceleration in their search Even if the local market is unable to offer alternative prod- for nontraditional services that offer higher returns. ucts with a suitable degree of risk, accession to the In Estonia, the ownership structure of banks will have European Union will make it easier for European institu- a significant effect on how banks operate. In order to tions to offer standard products in Estonia.14 This would improve profitability, Swedish (and Finnish) banks, present- expand the choice of investment products, making invest- ly operating in Estonia under the slogan "offering local ments in funds more attractive. Also local banks are devel- banking," will most likely turn banks into branches. As a oping products that serve as alternatives to bank deposits. result, many services will be outsourced to the parent bank, Most banks have established mutual funds, have acquired, and branches will be run under strong central supervision. or are in the process of acquiring, licenses for pension For this reason, banks in Estonia are unlikely to decompose funds, and offer life insurance products. By cross-selling their services in order to subcontract specialist services to products offered by different companies in the group, they other companies. Such processes will be increasingly con- are able to sustain the loyalty of their clients. ducted through parent banks. An Estonia-specific feature It is likely that Estonian households will continue to may be that some development of information technology use bank deposits as an important instrument of savings, will take place in Tallinn; for example, Internet banking 13. Up to 15 percent of annual income invested in pension funds is tax deductible. 14. As of June 2000, four Estonian banks offered retail investment products of Europe-oriented funds, managed mainly by their Nordic owners. MeritaNordbanken branch in Tallinn offered three funds (a fixed-income, a mixed, and an equity fund) man- aged by Merita Rahastoyhtid. Minimum investment was $300. Chispank offered two funds managed by SEB with no limitations on minimum investment. For investments into foreign funds, Hansapank has set a minimum limit of $5,000. 53 Meigas will be conducted in Estonia for the whole banking FIGURE 5.5 NONINTEREST REVENUE OF BANKS IN group.15 ESTONIA, 1998-2000 Developing new lines of business would mean putting more emphasis on investment banking and asset manage- + Groups' ratio of noninterest ment. The limited supply of local investment products 60 revenue to total revenue will force banks to look increasingly toward other mar- (consolidated) kets. This will put them into direct competition with banks 50 1 Banks' ratio of noninterest already well established in the business (banks and fund revenue to total revenue (solo) managers operating in that particular market). 40 Consequently, instead of developing tailor-made products based on securities from other markets, banks are likely to , 30 act as agents for global fund management companies or \ parent banks and to offer their products for an interme- 20 - diation or agency fee (recent campaigns where banks offer funds managed by their parent banks are first examples of 10 such a trend). As the value added by such services is very limited, they will not become a major source of revenue for 0 - l l l l l local banks. Therefore, the ratio of noninterest income to o 0O 0)t 07) Q0C 0) 0) 0) total income, which for Estonian banks has been between N N i N \N S\ X 20 and 40 percent in recent years, is not likely to change ,9 N significantly (see figure 5.5). It is unlikely that on-bal- c, g$' ance-sheet items will shift to off-balance-sheet items in the income structure to the extent that this is happening in Source: Bank of Estonia. banking internationally. Instead, offering alternative investment vehicles is necessary for banks to keep cus- In an environment in which banking is largely for- tomers within the bank and to avoid losing them to non- eign-owned, local factors probably will be subordinated to bank financial institutions, which are intensively compet- the needs of the group, because of the high costs of main- ing with them in this market. The central role of traditional taining separate structures and operations in each country. banking services is well reflected in the income statement It remains to be seen whether this will lead to inefficiencies of banks. The share of noninterest income increased in the local market and open up business opportunities to sharply-by roughly 20 percentage points-until 1997 local nonbank financial institutions, thus strengthening due to the booming stock market. After the crash and their position in the market. The ownership structure of subsequent crises, however, this proportion is again return- banks will limit their activity in asset management. Acting ing to "normal."'16 as an agent to global managers and offering the standard Profitability will not be a great problem for banks in products of parent banks will keep the margins from such Estonia because competition is fairly relaxed. The entrance activities low. Moreover, competition in this market seg- of strong newcomers from abroad offering traditional ment will be fierce, because a limited amount of invest- banking services is not likely, as the market is too small and ments will be required to start operations. As a result, in the the cost of establishing a business is too high relative to the next 10 years the share of revenues earned from tradition- potential increase in business volume. This will allow larg- al banking services (loans) in the Estonian banking sector er banks to charge fairly high rates for their services and will remain relatively high, in contrast to the international consequently to sustain high earnings. As a result, in com- trend. ing years capital likely will remain in Estonia rather than be Internet banking has been available in Estonia for employed more profitably elsewhere. Assets in Estonia many years (see figure 5.6). Because commercial banking have a potential to offer good returns. as an industry is only 10 years old, there have been fewer 15. As an example of this, the Union Bank of Estonia and SEB formed an information technology consortium on May 15, 2000, to be located in Tallinn, Estonia. That institution will develop new electronic solutions for the whole group. 16. Noninrerest income for banks on a solo basis was 38 percent in the first quarter of 2000. 54 Estonia: The Financial System in Retrospect and Prospect FIGURE 5.6 USE OF DIFFERENT PAYMENT CHANNELS AND INTERNET PENETRATION IN ESTONIA, 1997-99 1,800 - 24 1,500 - 20 r~~~ 0 1,200 0 16 5-~~~~~~~~~~C 900- <*e-124 o ~~0 ' 600 8 E 300 4 0 0 - Cash -_-- Debit orders o Telebank -o- Internet Internet/total payments (right scale) Source: Bank of Estonia. opportunities to develop costly branch networks. The trend.18 Customers seem ready to accept electronic bank- number of branches per 1,000 inhabitants has never ing. Consequently, the spread of Internet banking will not reached levels common in Europe.17 Instead, in the past constitute a cultural change for people in Estonia, where two years, this number has been decreasing, as branches Internet has been offered continuously in parallel with closed and banks opened Internet service points in rela- developing new services. tively remote areas. The percentage of clients making pay- The development of Internet banking may even occur ments through electronic means shows a steep upward much faster in Estonia than in many countries in Europe. 17. The number of branches in Estonia was 0.17 per 1,000 people in 1999. Compared with a European average of 0.48 in 1997, this is a modest number. 18. The slight drop in the number of Internet payments and a consecutive increase in debit orders are due to the introduction of a fee for Internet payments by the major bank in April 2000. 55 Meigas Developments in the telecommunications sector strongly more easily. Although, historically, having a branch net- support this. Last year, the number of people using the work has been seen to support the strong position of Internet in their everyday banking increased significantly, banks, the relative balance between banks and nonbanks and by early 2000 more than 15 percent of all accounts probably will not shift considerably with the wide adop- opened at banks used the Internet. The number of Internet tion of new technologies. Using the Internet to offer finan- users in Estonia is one of the highest in Eastern Europe.19 cial services is still an investment-intensive strategy, which, Even the state administration is making full use of the although it increases efficiency in the sector in general, will technology.20 In addition, Estonia is well positioned not change the relative position of banks versus nonbank regarding mobile devices, which, in turn, will allow fast financial institutions. introduction of mobile financial services. This favorable The only likely competitors in the local market will be technological background will allow the fast implementa- international banks with strong brand names (from neigh- tion of electronic means of conducting business. Also labor boring countries). An increase in the use of electronic trans- laws, which are an impediment to change in many coun- actions will open the door for international banks to com- tries in continental Europe, provide Estonian workers no pete in the retail market. As their level increases, deposit protection against redundancies. As a result, banks can insurance and sophisticated Internet portals, which have streamline their business as technological advances allow been developed to be used globally and benefit from high them to close branches and switch increasingly to elec- volumes, will have a fair chance of attracting customers tronic banking. away from local banks. Electronic banking will substantially improve the effi- Estonia is not likely to suffer from the "conservatism" ciency of banking in Estonia. Although the amount of of European households, which has limited the spread of investment required to make full use of modern technolo- Internet-based banking services. As far as technological gy is very high, electronic banking enables banks to advances are concerned, and the impact that they have on decrease the costs of offering banking services in the long the way business is done, Estonia is in the forefront in run (the cost of a transaction conducted over the Internet Europe. Innovative attitudes to offering services to clients, is only a fraction of the cost of a transaction conducted in and a lack of preconceived ideas about what banking a branch). As a result, banks have a strong incentive to offer should look like, will make it easier to develop banking in a wide range of products to support such investments. a more up-to-date manner. Obviously, such fast develop- Consequently, banks put high priority on product devel- ment will be a major challenge for supervisors who have to opment. Today, only one brokerage company is capable of keep themselves up to speed. Although improving efficien- selling shares through the Internet, whereas most banks cy, this is not likely to substantially increase competition in have offered this service for several years.21 Because of the the financial services market. High investment costs, which small customer base and relatively high fees, this company are sustainable only with high volumes, make it very like- is not yet popular among day traders. ly that the position of banks versus nonbank financial Banks have detected a source of value (both for them- institutions will remain strong. selves and for their customers) by intermediating customer transactions in so-called "bank malls." Information sys- Conclusions tems will allow banks to create a secure environment in The Estonian banking sector probably is not applica- which customers can pick up the merchant from the bank's ble to the Europe and Central Asia region in general. website, choose the goods, and pay for them. The next step Consolidation has already taken place in Estonia, and the will be adding such possibilities to mobile devices, which market is almost totally foreign-owned. In the near future will he Lp banks to retain old and gain new customers banking in Estonia is likely to develop in the same direction 19. The degree of Internet usage among Estonians between the ages of 15 and 74 almost tripled during past 2.5 years, from 10 per- cent in the third quarter of 1997 to 26 percent in the first quarter of 2000. 20. An example of such innovations is the initiative of banks and tax authorities this year to offer individuals the possibility of fil- ing their personal income taxes using Internet banking facilities. The number of people who filed their personal income taxes over the Internet was 11,760 (approximately 0.75 percent of the banks' base of private clients). Only two banks offered this service in 2000, but a higher rate of activity is expected over the coming years. 21. Historically, more than 75 percent of domestic securities trading is performed through or by banks. 56 Estonia: The Financial System in Retrospect and Prospect as banking in Europe. At the same time, there are several somebody else. As a result, the market is practically closed areas in which global trends will not be fully replicated. to newcomers. If competition comes neither from non- The main factor shaping the banking market interna- banks nor from the outside, the efficiency of the financial tionally is competition. A limited volume and client base in markets in general will deteriorate and may begin to Estonia will not encourage sufficient competition from depress economic growth. The demand for banking (and outside. The market is so dominated by banks that it is other financial) services likely will continue to rise, along increasingly difficult for nonbanks to gain sufficient market with the income of the population. This will pose a serious share in order to offer services at competitive prices. As a challenge for regulators if the developments described here result, banks in Estonia are well equipped to preserve their take place. In order to use the securities market as a com- competitive edge against nonbanks. The ability to adjust plement to bank services, more attention should be paid to the cost base and a strong market position will help them providing a favorable environment for the development of to keep their customers. Even a very fast spread of elec- nonbank financial institutions. tronic banking services may not be sufficient to allow non- bank financial institutions to improve their position References because very high investments are needed to develop com- European Central Bank. 1999. "Possible Effects of EMU petitive Internet-based solutions. on the EU Banking System in the Medium to Long Concentration likely will remain high unless regulators Term." intervene. The market is small and well divided among Mishkin, F. S., and P. E. Strahan. 1999. "What Will the largest players, with concentration much higher than is Technology Do to Financial Structure?" National considered normal in European countries. As a result, Bureau of Economic Research, WP No. 92, 1999 smaller institutions find it difficult to establish themselves Saapar, I., and E Soussa. 2000. "Financial Consolidation in the market. Special attention needs to be paid to possi- and Conglomeration: Implications for the Financial ble malpractices, which may further decrease the ability of Safety Net", "Financial Stability and Central Banks: new institutions to enter the market. Banks have the advan- Selected Issues for Financial Safety Nets and Market tage of using cross-subsidies for new products developed by Discipline," CCBS, Bank of England, 2000. 57 Chapter 6 Financial Sector Restructuring: The Croatian Experience Marko Skreb and Velimir Sonje inancial sector restructuring is a very demanding task in countries in transition, both in theo- ry and in practice.1 There are at least two reasons for this. First, before the transition began, the financial sector was one of the least-developed sectors in the socialist economy. Second, even in developed economies, there is no consensus on many of the issues surrounding financial sector reg- ulation, restructuring, and institution building. This chapter seeks to analyze the relationship between stability. The central bank and the ministry of finance are the central bank and the ministry of finance in their pursuit the main institutions behind financial sector reform, and of financial sector restructuring. This approach is taken for their relationship is crucial for the soundness of the finan- three reasons. First, those two institutions are usually cial sector. responsible for regulating, supervising, and restructuring The analysis is framed in terms of the coordination the financial sector. Even if some specialized agencies are between monetary and fiscal authorities in the process of formed, they are usually under the auspices of the ministry transition.2 These authorities need to coordinate their activ- of finance or the central bank. Second, their joint effort is ities, while remaining independent in pursuing their specific needed to produce an efficient, stable financial system, a objectives at the same time. Because the subject of overall necessary condition for sustained growth. Nevertheless, coordination is very broad, the analysis narrows the focus their coordination is rarely analyzed. Third, a healthy to two topics: (a) macroeconomic issues of fiscal and mon- financial sector relies on the following ingredients: "...the etary policy coordination and (b) the coordination between reform of the banking sector, the restructuring of the enter- monetary and fiscal authorities in the banking sector and, prise sector, and the attainment and preservation of macro- in particular, in the resolution of banking crises. economic stability." (Blejer 1999: 385). This chapter there- Both features are essential for successful financial sec- fore addresses the question of banking and macroeconomic tor restructuring. First, without macroeconomic stability The authors would like to thank Messrs. Andrew Lovegrove and Evan Kraft for their useful comments and suggestions. 1. For more details, see, for example, Blejer and Skreb (1999); European Bank for Reconstruction and Development (1999). 2. In this chapter, the terms fiscal authority-authorities responsible for implementing fiscal policy-and monetary authority- authorities responsible for making decisions on monetary policy, banking regulation, and supervision-are used extensively. Thus the monetary authority is assumed to be the supervisory authority; that is, it performs the function of supervising banks. Monetary authority has a broader meaning than just institution(s) responsible for monetary policy. The terms central bank and monetary authority are used as synonyms. s9 Skreb and Sonije (including low inflation), no meaningful financial sector dition. Long-term sustainable econoillc growth can be restructuring can take place. Second, as all transition supported by an independent central bank only if at least economies had a banking crisis and as banks are the most three political and economic mechanisms, which link cen- important financial intermediaries, resolving crises in the tral bank independence and growth, function properly: banking sector is essential for financial sector restructuring. * Reasonably low inflation With time, the need for state intervention will diminish. * The successful operational coordination between Transition economies did not inherit well-developed fiscal and monetary policy institutions from the past, and institution building is one of * The clear division of responsibilities between fiscal the main priorities of reforms. Genuine coordination and monetary policy in the process of resolving a between monetary authorities and fiscal authorities is scarce. financial crisis. There is the risk that one side will dominate the other (usu- These three conditions are equally important. The ally the fiscal authority tries to dominate the monetary simultaneous proper functioning of all of them makes cen- authority). Neither side shares the same perception of the tral bank independence good for economic growth. On the same problem nor necessarily has the same objectives. The one hand, it is still an open question as to whether or not legal framework within which monetary authorities and fis- central bank independence, when it leads to a central bank cal authorities operate is sometimes poorly defined and "going it alone" in its commitment to low inflation, is changes frequently. This can exacerbate the problem of good for the economy (Wagner 1998). For example, if coordinat on, which affects the speed and quality of finan- commitment to low inflation is followed in times when cial sector reform. Besides, not everything can be written money issues are used to finance the resolution of a large- down in [aws. The quality of coordination and reform scale financial crisis, this probably will lead to a classical depends in large part on day-to-day business, habits, relative clash between fiscal and monetary policy. A clash can show political power, and (sometimes) the strength of personali- up either as a clash between the domestic and external ties that head the monetary and the fiscal authorities. (exchange rate) goals of economic policy (Bordo and The analysis is based on the case of Croatia, but the Schwartz 1996) or as an "unpleasant monetarist arith- conclusionis have broader applications. metic." This kind of "arithmetic" can show, ex post, that low inflation is not an optimal solution if fiscal policy Macroeconomic Issues dominates monetary policy (Sargent and Wallace 1981). The literature on central banking usually distinguish- On the other hand, a society can extract great benefits es among the three basic types of central bank indepen- from low inflation even when the legal independence of the dence: goal independence, instrument independence, and central bank is incomplete. This probably will occur if the legal independence. Numerous authors assume indepen- benefits of low inflation are broadly understood among the dence to be a value in and of itself. It is generally believed population, if there is successful operational coordination that central bank independence brings about low infla- of independent monetary and fiscal policy, and if there is a tion, which is good for economic growth (Cukierman clear division of responsibilities between the central bank 1992; Cuiierman, Miller, and Neyapti 1998). and the government in the resolution of financial crises The Croatian experience indicates that this view over- (that is, if there is no confusion concerning who is respon- simplifies the independence-growth agenda. Although high sible and who bears the costs of the insolvency of financial inflation slows economic growth, there are other important intermediaries). In these circumstances, reputation or habit- mechanisms for linking central bank independence and ual independence will substitute for imperfect legal inde- growth. Two of them proved to be very important in the pendence. case of Croatia. The first is the operational coordination between fiscal and monetary policy. The second is the clear The Legal Environment and Inflation division of responsibilities between fiscal and monetary The Croatian Central Bank Law was enacted in 1992, policy during the resolution of a financial crisis. when many transition countries were passing Bundesbank- type legislation. At the same time, many technical assistance Central Bank Independence and Fiscal-Monetary missions from the International Monetary Fund and other Coordination institutions were shaping local legislation (Coats and Skreb Four conditions are related to the positive impact of 1999). Since imitation is never perfect, departures from independent monetary policy on growth. The legal inde- legal independence occurred. In the case of Croatia, there pendence of the central bank is not the only necessary con- were two main departures. 60 Fin a nci al Sector Restr Uct Liriig: The Croati an Exper-ience First, the central bank was allowed to lend directly to political party or coalition controls both the government government. Lending to the government was constrained and the parliament. The main danger to the independence by the obligatory repayment of loans by the end of the year. of the Croatian National Bank (CNB) comes from the par- This legal provision put a strong limit on the financing of liamentary ability to dismiss the governor and members of budget deficits. An additional limit was provided by the the Central Bank Council by a simple majority vote. Also provision that lending to the government within a fiscal the law does not address the dismissal of the governor, and year could not exceed 5 percent of the annual budget plan. the government can take a long-term loan from the central However, the mere fact that the government could ask for bank if the parliament enacts such a law. a short-term loan, coupled with the fact that the loan could Figure 6.1 shows that Croatia is ranked below be payable at an interest rate below money market levels, advanced transition countries according to the value of seriously undermined central bank independence.3 the Cukierman-Miller-Neyapti (1998) index of central The second departure from best practice was related to bank independence (the higher is the value of the index, the the relationship between the central bank and the parlia- more independent is the central bank). Despite this, ment. The mere fact that the central bank is accountable to Croatian central bank independence is at a medium level. parliament, and not to the government, is a necessary but Although the possibility of removing the governor and insufficient condition for independence, since the same members of the governing council by a simple majority vote FIGURE 6.1 INDEX OF CENTRAL BANK INDEPENDENCE AND AVERAGE INFLATION RATE IN SIX TRANSITION COUNTRIES, 1994-98 0,8 - 25 LYlE Index 0,7 - Inflation - & /\ - -20 0,6 --U N~~~~~~~~~~~~~~~~~~~~~~~a - 0,4 C 0,3 10 O~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 0 0,2 03 cC 0,1 Czech Republic Hungary Slovak Republic Slovenia Poland Croatia Source: Cukierman, Miller, and Neyapti (1998). 3. Loans to the government are charged at a discount rate, while the main interest rate in lending to banks is the Lombard rate. Despite the fact that there are no legal limits on the discount rate, historically it has been lower than the Lombard rate. 61 Skreb and Sonje is a sign of weakness, the clear expression of goals proved the government is legally forbidden). In conclusion, fight- to be a source of the central bank's strength.4 The same ing for actual independence on the basis of weak legal goals are written in the constitution and the law on the independence may lead to less coordination than is optimal Croatian National Bank: currency stability and general in the short run. liquidity in domestic and international payments.5 This is clearly not socially optimal. Maxwell J. Fry Both in relative (given the level of independence) and (1997) shows that monetization of the fiscal deficit has a in absolute terms, inflation in Croatia was the lowest negative impact on economic growth in developing coun- during 1994-98 among the countries presented in figure tries. Inflation can be minimized for a given fiscal deficit by 6.1. This suggests one conclusion and raises two ques- relying on a transparent market for domestic public debt. tions. The conclusion is that low inflation is possible with Hence, the government and the central bank have a clear a low degree of legal central bank independence. long-term interest in cooperating to develop a stable and (Actually, this is just a case study confirmation of an old transparent market for public debt (it is impossible to build finding.) The following questions arise: What is the main this market without proper coordination). An underdevel- mechanism that ensured low inflation with a very imper- oped market for public debt in a low-inflation environment fectly independent central bank? Was low inflation is a sign of a suboptimal solution (lack of coordination achieved at the expense of some other valuable econom- because of weak legal independence). ic goal? Additionally, in a financial crisis it sometimes is impos- sible to distinguish between the operational coordination of Coordination and Independence: Is There a fiscal and monetary authorities and the clear division of Short-Tern Tradeoff? responsibilities between them. Central bank lending to Legal independence and inflation are measurable and banks in distress can become lending to the government if can be used to classify different countries. The other two ex ante information on the banks' solvency is highly imper- criteria (the operational coordination of fiscal and mone- fect (which is often the case). Since fiscal policymakers tary policy and the clear division of responsibilities between sometimes partly or entirely refuse to bear responsibility for them in times of financial crises) are not so well established expenditures related to the banking system, this conflict can or measurable. grow. In the extreme, the central bank can absorb fiscal Assume that in most countries in the world (and in losses without intending to do so (due to lending to banks transition economies and emerging markets in particular), that appeared to be illiquid but solvent, but later proved to central bank independence is highly imperfect.6 There is a be insolvent). permanent strain between fiscal and monetary policy. This In summary, the following three characteristics were strain may lead to a short-term tradeoff between the coor- present in Croatia in the 1990s, indicating a short-term dination of fiscal and monetary policy and actual inde- tradeoff between coordination and independence: pendence. This tradeoff is realized in the following way: First, the lack of operational coordination between imperfectly independent central bankers may fear that fiscal and monetary policy was reflected in three main defi- operatioinal coordination would lead to additional pres- ciencies: sures to extend loans to the government. However, fiscal * The lack of a clear institutional setup for coordina- policymakers work under the daily pressures of public tion (no public debt committee or similar institution finance, which can lead to unproductive fiscal-monetary was established, so that coordination emerged on an meetings where discussions, instead of focusing on coordi- ad hoc basis). nation on equal grounds, instead elaborate government * The absence of a single treasury account and lack of requests for loans from the central bank (or ask for a par- coordinated liquidity planning, which led to sud- ticular type of open-market operations if direct lending to den loan requests from the ministry of finance, while 4. This came to be true in April 2000, when rhe newly elected parliament (after the January 2000 elections) refused to confirm the central bank's financial reports after strong political and media pressure was exerted on the governor and council to resign. 5. Politicians still find some ambiguity in this definition and emphasize that the three goals might be in conflict (that is, domestic liquidity versus currency stability). In public discussions, people tend to interpret these goals as they like. However, currency sta- bility being listed in the first place shows a public choice and makes a case for monetary policymakers to defend their policies. 6. Indeed, indexes for individual countries cluster around 0.5, which we assume not to be a consequence of rules of measurement, but more a reflection of the true imperfection of central bank independence around the world. 62 Financial Sector Restructuring: The Croatian Experience some other governmental spending units had large transparent market for public debt without fearing volumes of funds in their accounts. that the fiscal authority would abuse its role. * The lack of a deep and transparent market for trad- * Decreasing central bank independence to the point able government debt.7 where the monetary authorities would be clearly Second, the lack of strategic coordination between fis- subordinated to the fiscal authority. cal and monetary policy was reflected in three main defi- Developing the central bank's institutional indepen- ciencies: dence halfway to where it should have been was a dubious * The government planned annual central bank attempt. If, throughout the 1990s, Croatia was under a fis- seigniorage on its own, without formal consultation cally dominated regime, then the central bank's attempts with the central bank. were futile and created social costs. If the country was * The government refused to coordinate main macro- under a monetarily dominated regime, then these attempts economic expectations (real gross domestic prod- represented good efforts, both in terms of the current uct growth and inflation) with the central bank, impact of monetary policy as well as in terms of investment which led to widely divergent estimates of growth into building up a culture of price stability. This issue is that confused the public. explored further in the next section, because answering this * The government refused to recognize the expected question is crucial for determining where the transition costs of resolving the banking crisis in the budget process will go in the next decade or so. Clearly it could go despite the fact that the expected cost calculations both ways. were presented to it by the central bank on the basis of legally binding obligations (mainly related to the Some Unpleasant Monetarist Arithmetic: expected costs of insured deposit payouts in banks Measuring Fiscal and Monetary Dominance that failed or were expected to fail). This section does not give a definitive answer to the Third, the lack of a common understanding of basic crucial question concerning whether Croatia is under a macroeconomic principles was reflected in two main defi- regime dominated by a fiscal authority or a monetary ciencies: authority. In other, more precise, words, the key questions - While the central bank was preaching financial dis- are as follows: If the regime is dominated by the fiscal cipline, the government was generating financial authority, is the accumulation of government arrears worse delinquency, accumulating 6.2 percent of gross than the central bank's lending to the government? Or domestic product (GDP) in arrears on payments for should the central bank's commitment to achieving low goods and services until early 2000 (according to inflation be viewed as an investment in a more stable and anecdotal information, the accumulation of arrears fiscally viable future? largely began in 1995). The time series are too short to come to an answer * While the central bank was preaching price stability, with a critical degree of analytical precision. Therefore, we its critics were emphasizing the central bank's limit ourselves to a conceptual discussion of a few basic responsibility for "liquidity in domestic payments"; numbers. A discussion follows presentation of the basic the- these were actually calls for monetization of gov- oretical facts. ernment arrears. Following the seminal paper by Sargent and Wallace If all of these weaknesses in the coordination mecha- (1981), economists' interest has centered on the issue of fis- nism were clear expressions of a short-term tradeoff cal solvency or, more precisely, on the following question: between coordination and independence, then the tradeoff Who sets the anchor for the economy: fiscal or monetary (a socially suboptimal outcome) could have been avoided policy? Money does not necessarily determine prices. in either of two ways: Moreover, some authors think this to be a rather special * Increasing central bank legal independence up to case (Woodford 1995). In the real world, it is more likely the point where the central bank could promote a that we live in a fiscally dominated regime, according to 7. The only notable exceptions are short-term T-bills. However, the central bank issued its own short-term paper for sterilization purposes (CNB bills) because it could not rely on the government's ability to recognize the need for sterilization. The CNB was always afraid that it would not be able to reach agreement with the ministry of finance about the amount of monev collected by government paper issues, which should be kept in the sterilized account with the central bank, but not spent for fiscal purposes. 63 Skreb and Sonje Woodford. In this case, if there is a currency peg, monetary Third, the primary surplus may not be a good measure policy alone cannot ensure its sustainability. Fiscal policy for a country that has a low initial level of indebtedness and needs to ensure solvency if a peg is to be viable (Canzoneri, is engaged both in the large privatization of public enter- Cumby, and Diba 1997). prises as well as in large investment programs (recovery and HoAv can we distinguish between regimes dominated return of displaced persons to their homes, financed entire- by the fiscal authority and regimes dominated by the mon- ly by the state). Fiscal solvency is particularly hard to mea- etary authority? If primary fiscal surpluses respond to the sure when the desire of market participants to hold gov- level of government debt in a way that assures fiscal sol- ernment debt instruments is expected to increase and jump vency, then money and prices can be determined by the sup- to the new sustainable (higher) level in the long run. Issues ply and demand for money. In other words, in a regime on how to account for privatization receipts and investment dominated by the monetary authority, a fiscal surplus can be resolved by looking at current surpluses instead of should pay off part of previously accumulated public debt. primary surpluses and by looking at them in comparison to So, for example, if the debt to GDP ratio falls after an inno- the debt to GDP ratio, keeping in mind one-off shocks to vation in the surplus to GDP ratio (like in the United this ratio.9 Finally, looking at basic ratios during a six-year States), we are in a monetarily dominated regime period gives just a preliminary impression about the nature (Canzoneri, Cumby, and Diba 1997).8 of the system. This calculation is impossible for Croatia for at least The data in table 6.1 reveal how problematic, in fiscal three reasons. First, comparable data are available only for terms, was the year 1999. Contrary to government expec- a period of six to seven years, which is too short a period tations of 5 percent real growth rate, GDP fell 0.3 percent for drawing conclusions. Second, the debt to GDP ratio in real terms, and government consumption continued to has been changing mainly due to one-off expenditures run high, due to the political cycle (1999 was a de facto related to: election year, since the elections were held on January 3, * The consolidation of the transitional banking system 2000).1o Consequent sharp drops in the current surplus (such as payouts of insured savings and bonds issued and in the overall balance underestimate the true fiscal for bank recapitalization) shock, which was much stronger on an accrual, than on a * Postwar reconstruction cash, basis (numbers are on a cash basis). As of early in * The regularization of external debt inherited from 2000, the new government had inherited 6.2 percent of the former Yugoslavia. GDP in fiscal arrears from the former government. Arrears TABLE 6.1 MAIN FISCAL INDICATORS OF THE CONSOLIDATED CENTRAL GOVERNMENT AS A PERCENTAGE OF GDP, 1994-99 (cash basis; that is, without arrears estimated at 6 percent of GDP as of early 2000) Indicator 1994 1995 1996 1997 1998 1999 Overall balance 1.6 -0.9 -0.4 -1.3 0.7 -2.0 Current balance 2.8 1.8 4.0 3.1 5.2 1.1 Public debt to GDP 22.0 19.3 28.5a 27.3 31.4b 39.2 of which: Domestic 21.0 18.0 16.0 12.5 16.3b 18.2 Foreign 1.0 1.3 12.5a 14.8 15.0 21.0 a. Effect of regularization of foreign debt inherited from former Yugoslavia. b. Effect of recognition of HRK (Croatian Kuna) 7.5 billion as a domestic debt to pensioners. Source: Authors' calculations on the basis of CNB Bulletin. 8. With one additional condition: the surplus to GDP ratio cannot be negatively correlated with the surplus to GDP ratio in the future. 9. The implicit assumption is that public investment can be cut as soon as capital revenues from privatization stop flowing in. 10. As of late 1998, the central bank publicly announced its expectation of a growth rate around 0 percent. 64 Financial Sector Restructuring: The Croatian Experience were accumulated at an unknown pace, probably begin- utmost importance for the efficient functioning of the ning in 1995. financial system and the overall economy as well. This was a clear break from previous years. The coun- Coordination between monetary authorities and fiscal try had begun with practically no external debt, which authorities on those issues is extremely important. Banking meant a fairly relaxed fiscal constraint after the regular- crises are (unfortunately) a common feature of transition ization of inherited external debt and, particularly, after (but are in no way limited to transition), and coordination winning a sovereign investment grade as of early 1997. If is needed to resolve them. One could argue that if the two "debt recognition shocks" are disregarded and it is monetary authorities and fiscal authorities coordinate suc- kept in mind that, in 1996, 1998, and 1999, there had been cessfully in times of crises, they will do so in "peaceful" a debt buildup due to bank rehabilitation programs, fiscal times when discussing regulation, deposit insurance, and solvency seems to have been obeyed until 1999, when a stability safeguarding. The coordination between mone- major shock emerged. Besides the cash-accrual problem, an tary and fiscal authorities on the resolution of the banking additional problem stemmed from guarantees, which were crisis in Croatia and its implications for the financial sys- issued largely in the period from 1997 to 1999 and are not tem are analyzed next. included in table 6.1. In conclusion, it is not at all clear whether Croatia has The Role of Banks in Transition a fiscally or a monetarily dominated regime. Until 1999, it Substantial transformation is needed if the banking seemed to be closer to a monetarily dominated regime industry is to play a vital role in the economy. Commercial since fiscal surpluses were used largely to repay debts, banks have played, do play, and will continue to play an while cash deficits were very small. When a country stops important role in transition economies. But, to fulfill the to recognize transition-related one-off debts, fiscal solven- demanding task of an efficient financial intermediary, the cy will be achieved. The year of 1999 marked an obvious banking sector had to undergo significant changes. It had break with a sound fiscal history. (and in some cases still has) to be de-politicized, restruc- Croatia is now at a crossroads. The government elect- tured, and privatized; in short, it had to be completely dif- ed in early 2000 is trying to implement new fiscal strin- ferent from what it was before the transition. gency but is having difficulty doing so following the major The starting point for the development of the banking fiscal failure in 1999. It is not at all clear whether the industry in transition was very problematic. In centrally recognition of one-off debt increases is over, because there planned economies, money was an accounting unit that is pressure to recognize more debts to pensioners, which the served to accommodate planning goals in the real sector, new government promised to do. Three years ago it seemed goals usually expressed in physical quantities (see Sheng that Croatia was heading firmly toward a monetarily dom- 1996; Coats and Skreb 1999). The financial sector was not inated regime despite weak legal fundamentals; three years an intermediary, nor did prices reflect the relative scarcity later Croatia has reached the crossroads. of goods. Risk and its pricing were virtually unknown in The Croatian experience points to the fact that having such an environment. Enterprises could not fail, and work- a legally weak but very ambitious central bank in terms of ers could not be jobless. The financial system was stable achieving low inflation creates pressure for the expansion- because no one was allowed to go bankrupt (especially not ary fiscal policy to adjust. Fiscal inertia leads to the accu- the banks). Banks paid no attention to credit risk (the allo- mulation of arrears and strain between monetary and fis- cation of funds was based on plans), foreign exchange cal authorities, implying lack of operational coordination risk, or any other type of risk (with the notable exception between monetary and fiscal policy. This strain becomes of the noncompliance risk, meaning the risk of not com- obvious when a country experiences banking sector prob- plying with the plan and instructions of party officials). It lems. makes sense to think of socialism as a big insurance com- pany, where implicit insurance premiums were collected Banking Sector Issues regardless of the risks. Moral hazard behavior was very The banking system is usually the core and the largest common in such an environment. At that time, there was part of the financial system, especially at relatively early no difference between the central bank and commercial stages of transition, when other financial markets (like banks (it was a monobanking system). Overall credit allo- the capital market or insurance market) are both shallow cation was based on the plan. and narrow. Therefore, questions of regulation, supervi- Croatia was not a typical centrally planned economy. sion, and systemic stability of the banking system are of It started to transform its monobanking system in the mid- 65 Skreb and Sonje 1960s (when it was part of the former Yugoslavia). But and households of a bankrupted bank, and, ultimately, many behavioral patterns and consequences of the social- lost economic growth. On a net basis, the revenues side ist system remained. should include benefits from "possibly" avoiding a wide- All the economies in transition inherited socialist, inef- spread systemic crisis and taxes paid by the bank, which ficient banking systems, which operated in a centrally remained operational. In the Croatian example, only the planned environment. The change to a market environment concept of gross fiscal costs is used. resulted in bad loans and insolvencies of existing banks. Despite the absence of a well-defined analytical frame- Besides the problems inherited from the past, new banks work (which cries out for much more research on the sub- were created with financing from nouveau rich individuals, ject), it is clear that Croatia has, over the past 10 years whose aim was to finance their own conglomerates. (since independence), undergone two banking crises: Accordingly, most transition economies experienced severe * The first was the crisis of the old banks with their banking crises not only due to their socialist past but also inheritance (of bad assets) from the previous eco- due to the failure of new banks. In many cases, the two nomic system and the legacy of war and disintegra- types of crises followed (and overlapped) each other. tion of the former Yugoslavia. It could be called a structural or inherited crisis. The Costs of Banking Crises * The second crisis occurred in banks founded during The costs of a banking crisis differ widely from coun- the transition, because of weak management, includ- try to country. Generalizations and conclusions are rela- ing fraud, connected and insider lending, increased tively difficult to make (Frydl 1999; Caprio and Klingebiel competition in the market as the transition period 1996). Therefore, this section illustrates the costs of the progressed, and inadequate regulation and supervi- banking crisis in the case of Croatia alone. sion of the banking industry. Before doing so, a word on the methodological prob- The first banking crisis-the crisis of the old banks- lems of defining the costs of banking crises is warranted. started with the beginning of the transition process (and First, there is no well-defined analytical framework for even before it) and is even now ending with the sale of reha- defining a banking crisis. Even worse, there is no clear bilitated state banks to foreign strategic investors. The framework on how to account for all of the costs of bank- costs of this crisis include the following (for more details, ing (financial) distress. This is very surprising, especially see Jankov 2000; Skreb 2000a): because some banking crises can cost in the range of 40 to * The issuing of the so-called big bonds in 1991, in the 50 percent of GDP. Very often they exceed 10 percent. amount of about $990 million One would expect such big numbers to initiate much more * The 1992 conversion of foreign currency savings research. into a public debt, in the amount of $3.1 billion One might distinguish between the concept of fiscal * The rehabilitation of the four major banks during (resolution) costs and the concept of the economic costs of the period from 1995 to 1996, at a cost of $473 mil- banking crises. For simplicity, it is assumed that fiscal and lion (for more details, see Lovegrove 1998). At that resolution costs are the same. Both economic and fiscal time, those banks represented about 40 percent of costs could be viewed on a gross (only costs and expendi- total banking assets. The total costs of these crises tures) and net (costs minus revenues and benefits) basis. may be seriously underestimated because the reso- Fiscal costs can be defined as all those costs that the lution with the Paris and the London club creditors budget had to pay out to resolve the banking crises. They (and their effect on banks) was neglected. may include the costs of bank recapitalization, the carving All told, the first banking crisis cost an estimated $4.6 out of bad loans (and the issuance of bonds instead), the billion. These high costs are typical of countries caught up payout of insured deposits, and so forth. They can be in war, like Kuwait and Israel at certain points in their his- defined on a gross or a net basis. The net basis should tory (Frydl 1999). deduct from total costs budgetary revenues from the pri- At the beginning of 1998, another-the second-bank- vatization of rehabilitated banks (if they are nationalized in ing crisis started in Croatia. In 1998, the government decid- the process of rehabilitation) or proceeds from bank bank- ed to rescue two banks that represented about 7 percent of ruptcy. total banking assets. The costs were estimated at $347 The economic costs of banking crises are a broader million. The second feature of the crisis was the costs of concept. They could encompass (on top of fiscal costs) a fall paying insured savings deposits in banks where bankrupt- in deposits in the overall system, indirect costs to companies cy proceedings had been started (on request from the cen- 66 Financial Sector RestrUCtLLring: The C.roatian Experience tral bank). These costs were a charge on the budget, authorities. They speak only about "authorities" as if they because not enough premiums had been collected by the were one homogeneous decisionmaking body (Frydl 1999; State Agency for Deposit Insurance and Bank Sheng 1996). We argue that this is not the appropriate Rehabilitation. During the period from 1997 to 2000, the approach, as in reality they are heterogeneous institutions Croatian National Bank initiated bankruptcies or revoked with different objective functions. Based on the Croatian licenses for 22 deposit-taking institutions. experience, in particular, the problem of postponing the res- The costs of paying out insured savings in the case of olution of a banking crisis lies partly in the lack of adequate banks and savings banks where bankruptcy proceedings coordination between monetary authorities and fiscal had already started were in the region of $450 million. authorities. Accordingly, the total costs of the second banking crisis can Speed is important in resolving banking crises, which be estimated at about $800 million. raises the question: Why are the (unavoidable) decisions to If the costs of the first and the second crises (with the resolve banking crises delayed? Frydl (1999) distinguishes renewed qualification that this is a matter of gross costs) are between a perception lag (a lag between the time when a added together, the total costs are about $5.45 billion. Of problem occurs in the banks and when the authorities this, about 85 percent are accounted for by the first crisis become aware of it) and an action lag (measures that are and 15 percent by the second. This amount represents taken to resolve a problem). about 27 percent of 1999 GDP (at $20.1 billion)."1 This is a useful concept, but it should be amended because of the differences between monetary and fiscal Coordination between Monetary and Fiscal authorities. Consider the resolution process (which is a Authorities in the Resolution of Banking Crises lengthy process, not a onc-timc event) in the following Banking crises are not specific to transition economies. way. What is essential is that banking crises are swiftly and Before a banking crisis is resolved, time passes because completely resolved, meaning that the full costs should be of several lags: adequately expressed and dealt with.12 An adequate legal 1. Perception lag. This is the time period between the and regulatory framework must be put in place, and new occurrence of problems within a bank (or banks) supervision enforced. The relationship between monetary and when monetary authorities (assuming that the authorities and fiscal authorities on the issue of building up monetary authority is the bank supervisor) learn a sound and robust banking system is very delicate. Usually about them. This period can be lengthy because of the central bank is the supervisor, but the costs of resolving inadequate accounting standards in banks, lags in a banking crisis to a large degree are fiscal. In Croatia this reporting data from banks to the monetary author- is the case regardless of whether market discipline was ity, deliberate fraud that hides the real numbers in enforced by liquidation or bankruptcy, as a too generous banks, lax commercial audits, ill-defined or unen- deposit insurance scheme had to be financed from the bud- forced reporting requirements to the monetary get, or whether recapitalization (or rehabilitation) by the authority, or inadequate data analysis within the state was used as a means of dealing with the problem monetary authority. The last issue is particularly banks. disturbing because all relevant information on banks The resolution of the banking crises can be viewed as may be in the monetary authority, but no one ana- a complex exercise in cost allocation. Resolution has seri- lyzes it properly or no one is aware of the problem. ous distribution impact on different socioeconomic groups. 2. Action lag 1. This is the time period between the Because of the different objective functions of monetary moment when the monetary authorities learn authorities and fiscal authorities, there might be a dispute (become aware) of the problem in banks and decide on how to allocate costs. Therefore, it is somewhat sur- on what action to take alone (or propose an action prising that articles on banking crises and their resolution plan to fiscal authorities). Due to the lack of human rarely distinguish between monetary authorities and fiscal capital (inadequate people in banking supervision 11. Jankov (2000) estimates total costs at 31 percent, but the methodology is somewhat different. It just proves the lack of coher- ent methodology for examining the costs of banking crises. 12. It would be very interesting to develop a formal model based on the game theory framework (war of atrrition) used in Alesina and Drazen (1991) to analyze this problem. We do not do it here. 67 Skreb and Sonje ard problems in their communication with top man- may take from one to six months to initiate bank- agement of the monetary authority), this process ruptcy proceedings. Courts may accept the bank- may take time. It is not an easy task to find an ade- ruptcy petition, which may cause greater delays in quate solution for the resolution of bank problems, the overall process. Another question is relevant: especially if several distressed banks are involved at How long may it take to complete the bankruptcy the same time. Even when the monetary authority is proceedings? It is a relevant question for creditors, aware of the problem in a bank, the decisionmaking who do not know how long they will have to wait to may be delayed. Concerns about systemic stability get (at least part of) their claims back. may urge the monetary authority to be softer than Lags 1 and 2 are problems of the data collection and warranted. There are two arguments. The first one reaction curve within the monetary authority alone (a is the usual argument: too big to fail. What should micro-micro issue) and could be very important, especial- the monetary authority do when it has information ly if the legal and regulatory framework is inadequate and that a big bank is insolvent? The second one is a banking supervision is inexperienced. Lag 5 is completely question: Why should the monetary authority reveal outside the control of monetary and fiscal authorities (but bad results in a bank, as it will be blamed, as a nevertheless is very important). Lags 3 and 4 are a coordi- suLpervisor, for not acting sooner? On top of this, one nation problem between monetary authorities and fiscal should expect very strong lobbying in an attempt to authorities. convince the monetary authority not to resolve the What problems are evident in lags 3 and 4? Based on p-oblem. Predatory behavior of overpaid manage- the Croatian experience, the fiscal authorities have to real- ment or bank owners can affect inexperienced and ize that there is a banking crisis or banking distress in the sometimes unmotivated (and badly paid) staff at the country. There is an information asymmetry between mon- monetary authority. All these (and other) factors, etary authorities (which are usually responsible for col- combined with lack of prioritizing or failure to real- lecting data on banks) and fiscal authorities (which bear at i2e the importance of the problem from top man- least part of the costs). This is the first coordination prob- agement of the monetary authority, can seriously lem. There also may be an asymmetry of understanding the delay swift action. problem. If there are large differences in the speed of accu- 3. Persuasion lag. This is the time period between the mulation of human capital between the central bank (mon- moment when the monetary authorities learn about etary authority) and the government (fiscal authority), they the problem and decide what to do and the moment may have a completely different perception of basic notions when they persuade the fiscal authorities to get and events, such as insolvency and the reasons leading to it. involved in the resolution. This lag does not exist if In this case, for example, the fiscal authority can accuse the the monetary authorities propose bankruptcy as a monetary authority of being "too rigid" in the classification solution for a distressed bank (in which case, one can of quality of assets. "If just the classification would be immediately go to lag 5-legal lag). But if the reso- softer, banks would become solvent" is an argument heard Iltion requires public funds, the persuasion lag may all too often. A similar argument applies to loosening mon- be important. etary policy as a "tool" for resolving banking problems. It 4. Action lag 2. This is the time period between the is true that additional liquidity may hide the insolvency and moment when monetary authorities and fiscal delay (only delay, not remedy) the inevitable, but at the authorities agree that there is a banking crisis (or at expense of rising inflation. In the case of Croatia, the "kill least a big problem) and the moment when sufficient the messenger" syndrome has been experienced. This per- m-easures are taken to end the banking crisis. This is ception asymmetry can seriously impair coordination in the the second coordination problem between mone- resolution of banking crises. tary authorities and fiscal authorities. The fiscal authorities rarely are fully informed about 5. Legal lag. This is the time lag between when the the situation in banks. However, bad news takes time to monetary authority initiates bankruptcy proceed- digest. The fiscal authorities may suffer from the denial syn- ings against a bank and the legal system takes it up. drome (unwilling to accept either the existence of the prob- Lag 5 does not apply if bank rehabilitation is a solu- lem or its size). Even when the monetary authorities are tion. The bankruptcy proceeding is usually within fully convinced that there is serious distress in the banking the decisionmaking power of the courts and not the industry and that a systemic crisis is possible, it will take central bank. The Croatian experience shows that it time for the fiscal authorities to agree on this. 68 Financial Sector Restructuring: The Croatian Experience Governments, including the fiscal authorities, rarely act get), (c) the owners of a bank, meaning shareholders (loss quickly and decisively. of capital), (d) the private sector (deposits) and households Even when the problems of coordination between the (savings), (e) or by any combination of these. Obviously, all monetary and fiscal authorities are resolved, other agents parties involved try to bear as few costs as possible. (interest groups) will place political pressure on the fiscal The Croatian experience indicates that the fiscal authorities to alter the outcome in their favor. First, the authorities may even change some outcomes necessary for management of the banks will try to influence the decision the resolution, proposed by the central bank, in an effort to to their advantage. They have clear vested interests (high minimize expenditures for the budget without prior con- wages, influence, a motive to hide the incorrect decisions sultation with the monetary authorities. This may under- made in the past). Second, the bank owners will try to put mine the efficiency of the final result. political pressure on the government to bail them out. What is the best timing? Conventional wisdom usual- Third, bank personnel know that either all or part of them ly assumes that the action should be speedy. It is well known will be unemployed. Fourth, politicians (other than the that if a bank is insolvent or has a very low net worth, it has fiscal authorities) will try to minimize the problem in the an incentive to gamble even more. The problem of moral hope that this will not hurt their "image" or make them less hazard behavior is obvious, and asset stripping can occur. popular. In short, there will be resistance to admitting the All of this increases the costs of bank resolution. problems in the banking industry, not only from the fiscal Even if the monetary authority opts for a quick reso- authorities but also from other agents in this political game. lution of banking problems, the fiscal authority incentives Every decision on bank resolution is a redistribution prob- need not be the same. Not only do they often try to mini- lem; there are always welfare losses for some interest mize the problem (and minimize the costs for the budget), groups, so everyone should be aware of very strong lob- but also they try to postpone the payments in two ways- bying, corruption, ruthless behavior, or vested interests by postponing the unpopular decisions as much as is polit- seeking to alter the decision. Needless to say, lobbying ically bearable, preferably beyond the political cycle (after implies the use of scarce resources to influence the outcome. the elections), and by issuing bonds and not cash, for exam- Predatory behavior has a lot of incentives in transition and ple, by redistributing those costs to future generations particularly in the banking industry. (intertemporal distribution). When lag 3 is resolved and the monetary and fiscal The fiscal authorities are part of the government, authorities agree that there is a banking crisis or distress which is subject to political elections. If elections are and that it has to be dealt with in a coordinated fashion, approaching, the government, including the fiscal author- there is much room for disagreement on what is the best ities, has a strong incentive to pass the fiscal burden on to course of action (lag 4). The main problems are deciding the next government (even if the same government remains what measures to take for resolving the bank crisis, includ- in power) and to spend the money on more popular and ing cost and timing for action. voter-sensitive issues. The problem with deciding what measures to take is The process of coordination between the fiscal and more than a source of possible professional disagreement. monetary authorities in Croatia was very difficult and It can arise due to the different objective functions of the lengthy. Lessons for the future can be learned from the monetary and fiscal authorities. The objective of the mon- experience. Croatia did not "avoid" the banking crisis by etary authorities is to have a stable banking industry as "printing" more money; that is, by trying to postpone the soon as possible. Therefore, the monetary authorities resolution of the problems by passing the burden to the should normally want full disclosure of banking problems future and the economy at large (by creating inflation). The and rapid action (which need not always be the case). The pressures to act in such a way were very strong, but suc- objective function for the fiscal authorities in resolving cessfully avoided. Better coordination is warranted espe- banking distress is to take the least-cost approach for the cially in two areas: overcoming the information and human budget. Therefore, resolving a banking crisis is an exercise capital constraints and improving the definition and mutu- in intersectoral and intertemporal redistribution. The rest al understanding of the roles of the fiscal and monetary of this section deals with intersectoral redistribution; the authorities in the banking industry. following section deals with intertemporal distribution. Intersectoral distribution means deciding whether the The Future of the Financial Sector Restructuring costs should be born by (a) society as a whole (inflation), It is reasonable to expect that the need for state inter- (b) taxpayers (the socialization of costs through the bud- vention in financial restructuring in transition economies 69 Skreb .iind Sorlje will diminish in the future. Financial market development responsible for supplying transparency, and the private will bring to the market more agents capable of recogniz- sector should demand transparency (as well as be trans- ing a future problem institution as well as capable of rais- parent itself). Optimum transparency constitutes an equi- ing the capital required for mergers and acquisitions. librium between the two sides of the market-that is, Experience, transfer of knowledge, and competition will between the two sectors. improve the ability to recognize a problem institution long However, transparency without education and public before it produces negative externalities on a large scale. relations is worth nothing. This second factor is crucial in Coordination among public institutions will increase as times of financial crisis, which should be resolved by some well. It also is clear that institutional solutions in a small degree of state intervention. Education and promotion country in the neighborhood of the largest monetary union should be the permanent tasks of public bodies in order to (the European Monetary Union) cannot diverge substan- encourage private sector responsiveness in a transparent tially from the rules in the union itself. Institutional con- environment. Active public relations are crucial in times of vergence will quicken with the entry of international banks crisis, when media can be problematic, especially if some to local markets. In some of these countries, such as are controlled by interest groups linked to the banking Hungary and Croatia, international banks already play industry (which is often the case, not only in transition much more important roles than domestically owned countries). Policymakers, including their advisors from banks. This puts international cooperation of bank super- international financial institutions, do not pay enough visors high on the agenda for the future of financial sector attention to these facts.14 Most of the time they assume supervision. that the general public knows or believes the same sound Despite the generally positive outlook, many wrong principles that they share at the basis of sophisticated the- roads can he taken and many mistakes made. Even in the oretical and empirical experience. That many will per- most developed countries with developed market infra- ceive the world differently than they do comes as an structures, policymakers can make mistakes. How can unpleasant surprise, sometimes leading to confusion and a these be avoided or their effects minimized? reluctance to act. The general public in a transitional envi- Three factors of key importance, and under the direct ronment still fails to understand the basic principles of cap- operational control of policymakers, are transparency, edu- italism, such as knowing the difference between money cation (public relations), and institutional specialization and capital or understanding the tradeoff between risk and (efficient judicial processes). 1-3 All three factors should act return. to minimize the five coordination lags. The third key factor for the future of financial sector Transparency, education, and institutional specializa- restructuring is institutional specialization. Since many tion should act in this way regardless of the shape of insti- professionals who manage different institutions lack tutions and processes that manage financial sector restruc- knowledge, experience, and expertise to deal with banking turing. After all, the shape of institutions is subject to problems, bankruptcies, and antitrust or complex com- political decisions. Basic principles, however, should not be mercial cases, the principle of specialization is the only subject (only) to political decisions; they should be the one that can help the system to function. This is relevant focus of policymakers. This should be the task of policy- not only for all institutions in the financial system but also makers regardless of their political orientation, back- for other social systems, especially for commercial courts. ground, reputation, and targets. In a small country (and transition countries are very small, By transparency is meant transparency of financial with the notable exceptions of Russia and, to a certain data (their regularity, accessibility, and conformity to inter- extent, Poland), it is impossible to expect that every region- national accounting standards), transparency of institu- al commercial court will be able to conduct complex cases tions (their openness in expressing goals, means, and in an equal way. Specialization means concentration of results), and transparency of processes (who acts, when, experience and expertise, which leads to efficiency, speed, and how). Both sides of the market for transparency should and equality of treatment. Of course, the optimum level of be active: the government and central bank should be specialization will depend on circumstances. 13. WTe emphasize operational control here. Many strategic issues are not under policymakers' direct operational control because of interference from political processes. 14. For more details on the lack of public relations in times of financial crisis in the case of Croatia, see Skreb (2000b). 70 Financial Sector Restructuring: The Croatian Experience Concliusions result in optimal solutions for a country. Of course, as long Some light has been shed on the consequences of inad- as it is not completely clear that the country is in a fiscally equate coordination between monetary authorities and fis- dominated regime, it pays to insist on, and build, central cal authorities for financial sector restructuring. The analy- bank independence and conduct in-depth banking sector sis in this chapter has focused on the coordination problem reform. However, putting too much of a burden on the between monetary and fiscal authorities. There is a genuine monetary authority alone is not a sustainable option in the need for coordination, because monetary authorities acting medium run. Either the fiscal authority will have to imple- alone cannot reach their goals, whether price stability, finan- ment sound policies, or the transition will take longer than cial sector stability, including an efficient banking system, or warranted. In other words, it takes two to tango. The tango the resolution of banking crises. Coordination is needed. is a difficult dance, which requires patience to learn. Even The central banker's point of view based on the before that, monetary and fiscal authorities should agree Croatian experience has been illustrated in this chapter. whether they want to dance a tango or a waltz. If they can- Some recommended courses of action for small and open not agree on this, the crucial issue is the willingness of the emerging-market economies arise from the Croatian expe- monetary authority to act-if necessary alone. Acting alone rience: is suboptimal, but better than no action at all. Therefore, the * Invest resources in sharing the same (professional) monetary authority has to stand ready for a Pareto inferior perception between the monetary and fiscal author- solution (inferior as compared to successful coordination). It ities (avoid large differences in the speed of human is clear that in such an environment, financial sector restruc- capital accumulation in the two institutions). turing will be slower and more expensive (less efficient). In * Increase the central bank's legal independence to a other words, there is a price to be paid when the monetary maximum, with a transparent legal framework, but authority and fiscal authority do not act together. make it responsible for developing the transparent market for public debt as well. References * Invest as much as possible in banking supervision, The word "processed" describes informally repro- especially in early warning systems, and use the duced works that may not be commonly available in library reports of the early warning system as triggers for systems. supervisory action. * Impose some kind of fiscal rule or establish a fiscal Alesina, Alberto, and Allan Drazen. 1991. "Why Has stabilization fund, which will accumulate resources Stabilization Been Delayed." American Economic that can be used to resolve banking problems with- Review 81(5):1170-88. out triggering a conflict between the monetary and Blejer, Mario I. 1999. "Financial Sector Transformation." fiscal authorities. Make the rules as transparent as In Blejer and Skreb. 1999:385-95. possible and use the fund as long as the fund of Blejer, Mario I., and Marko Skreb, editors. 1999. Financial deposit insurance premiums is thin. Sector Transformation. Lessons from Economies in * If a fiscal rule or stabilization fund cannot be imple- Transition. Cambridge University Press. Cambridge. mented (for various reasons), establish a fund at the Bordo, Michael, D., and Anna J. Schwartz. 1996. "Why monetary authority to act independently of the fiscal Clashes between Internal and External Stability Goals authority to resolve banking problems; such a fund End in Currency Crises, 1797-1994." Open may not be sufficient to cope with a larger crisis, but Economies Review No. 7:437-468. it may provide the basis for a more rapid response in Canzoneri, Matthew, R. E. Cumby, and B. T. Diba. 1997. the initial phases of a crisis. "Fiscal Discipline and Exchange Rate Regimes." * For the need for state intervention to decrease in the November. Processed. future, ensure that both the monetary and fiscal Caprio, Gerard, and Daniela Klingebiel. 1996. "Bank authorities work on transparency, education (includ- Insolvencies: Cross-Country Experience." Policy ing better public relations), and the formation of Research Working Paper 1620. World Bank, Policy specialized institutions (like specialized courts for Research Department, Washington, D.C. Processed. financial issues), as the financial world is becoming CNB Bulletin Croatian National Bank. Zagreb. Vol. V more and more complex. No. 48. The central bank's independence is very important, but Coats, Warren, and Marko Skreb. 1999. "Ten Years of isolation in conducting sound economic policy may not Transition Central Banking in the CEE and the 71 Skreb and Sonje Baltics." Paper prepared for the Fifth Dubrovnik Lovegrove, Andrew. 1998. "Bank Rehabilitation in Conference on Transition Economies, Croatian Croatia." Glendale Consulting Limited, Surrey. National Bank., Dubrovnik. Processed. Available by Processed. request from the Croatian National Bank. Sargent, Thomas J., and Neil Wallace. 1981. "Some Cukierman, Alex. 1992. Central Bank Strategy, Credibility Unpleasant Monetarist Arithmetic." Federal Reserve and Independence: Theory and Evidence. Cambridge, Bank of Minneapolis Quarterly Review Vol. 5. No. Mass.: MIT Press. 3:1-17. Cukierman, Alex, Geoffrey P. Miller, and Bilin Neyapti. Sheng, Andrew, editor. 1996. "Bank Restructuring. Lessons 1998. "Central Bank Reform, Liberalization, and from the 1980s" World Bank Group Washington, D.C. Inflation in Transition Economies: An International Processed. Perspective." Paper prepared for the Fourth Dubrovnik Skreb, Marko. 2000a. "A Speech at the Parliament." Conference on Transition Economies, Croatian Available at www.hnb.hr/releases. Processed. National Bank Dubrovnik. Processed. . 2000b. "The Transition Process. It's All About European Bank for Reconstruction and Development. People, Isn't It?" Jacques de Larosiere Lecture 2000, 1999. EBRD Transition Report 1999. London. annual meeting, European Bank for Reconstruction Fry, Maxwell J. 1997. Emancipating the Banking System and Development, Riga, Latvia. Available at annd Developing Markets for Government Debt. www.hnb.hr/releases. Processed. London: Routledge. Wagner, Ilelmut. 1998. "Central Banking in Transition Frydl, E. J. 1999. "The Length and Cost of Banking Countries." Working Paper 126/98. International Crises." Working Paper WP/99/30. International Monetary Fund, Washington, D.C. Processed. Monetary Fund, Washington, D.C. Processed. Woodford, Michael. 1995. "Price Level Determinacy Jankov, Ljubinko. 2000. "Banking Sector Problems: without Control of a Monetary Aggregate." Carnegie Causes, Solutions, and Consequences." Croatian Rochester Conference Series on Public National Bank Surveys S-1 (March). Zagreb. Croatian PolicyCarnegie-Mellon University, Pittsburgh. National Bank. Processed. Processed. 72 Chapter 7 Financial Sector Restructuring in Bulgaria, 1997-2001 Petar Jotev T he transition from a centrally planned to a market-oriented economy has been a dramatic, sometimes painful, process for Bulgaria in the past 10 years. Unfortunately, the country made many mistakes along the way. For almost seven years, from 1990 to mid-1997, Bulgarian gov- ernments were hesitant to give up ownership and administrative control over the banking sector as well as many key industrial and commercial enterprises. The state-owned banks continued to fund ineffi- cient and loss-making enterprises, contributing to the almost total collapse of the Bulgarian economy in late 1996. Hyperinflation resulting from the huge fiscal deficit translated into a dramatic loss of pur- chasing power for both enterprises and consumers. There was a chronic and severe shortage of even basic food supplies, as imports necessary for production became unaffordable as a result of an inflat- ed domestic currency. In January 1997, the government was facing a forceful outcry from Bulgarian citizens demanding a fundamental change in policy. In April 1997, new elections resulted in an unusually ing an effective mechanism for collecting taxes, Bulgaria strong mandate for the Union of Democratic Forces, which, achieved general government equilibrium by 1998. in turn, created favorable conditions for sweeping eco- Starting in 1997, Bulgaria also adopted an aggressive nomic reforms. Macroeconomic stabilization started with privatization strategy, and the private sector now con- the adoption of a currency board arrangement in July tributes approximately 70 percent of gross domestic prod- 1997, and the Bulgarian currency, the lev, was pegged to the uct (GDP). This policy was especially radical in the area of deutsche mark. Bulgaria immediately experienced curren- commercial banking. The new Bulgarian government suc- cy stability, which has characterized its economy ever since. cessfully privatized five of the six large state-owned banks The currency board arrangement also forced fiscal disci- existing in 1997, and the last one-Biochim Bank-is pline, producing positive monetary and budgetary results. expected to be sold fairly soon. All five state-owned banks Gross inflation was reduced sharply from annualized were sold to strong and reputable foreign strategic investors monthly increases of approximately 522 percent in January with the capability of infusing significant capital and man- 1997 and 2,916 percent in February 1997 to only 6 percent agement expertise into Bulgarian banking. This is in in 1999. Although the annual inflation rate rose to 11 per- marked contrast with how Bulgaria privatized a substantial cent in 2000, this was mostly due to the substantial increase part of the nonfinancial sector, which was accomplished in the price of imported oil and gas rather than to Bulgaria's mainly through various mass privatization schemes as well fiscal or monetary policies. Despite difficulties in develop- as management buyouts, with no increase in much-needed 73 Jot e v investment or infusion of management expertise. In hind- the new owner would manage the acquired banks in a sight, the benefits of a large number of these deals were safe and sound way. Obviously, it would not make sense to questionable, despite the fact that the general objective of get a few extra millions of dollars when selling a bank and increasing the role of private ownership was at least for- then have to pay out many times more in deposit insurance mally achieved. and rehabilitation when the bank fails some years later. Consequently, only large and well-managed foreign banks Early Efforts of Bank Restructuring and nonbank financial institutions were allowed to partic- In 1992, the Bulgarian government established the ipate in the privatization tenders for Bulgarian state-owned Bank Consolidation Company (BCC) for the purpose of banks. Although it might be considered controversial to restructuring and privatizing the state-owned banks. At allow only foreign banks to compete for domestic financial that time, there were more than 70 banks in the country, institutions, from the viewpoint of maximizing post-sale most of them very small, regional ones with insufficient efficiency of the banking sector, there was hardly any bet- assets to achieve any reasonable level of operational effi- ter choice for the authorities. ciency. The BBC accomplished its primary goal of restruc- Due to the determination of the Bulgarian govern- turing the banking sector rather effectively by consolidat- ment, especially the concentrated efforts of the BCC, five ing small banks into larger entities with branch networks large state-owned banks out of the six controlled by the covering the whole country. However, these banks contin- BCC in mid-1997 have been successfully privatized. All of ued to operate under state ownership, with little or no these banks have been sold to first-class foreign investors, movement toward privatization for the next several years. such as Societe Generale, UniCredito Italiano, and AIG Although some minor efficiency gains in operation were Group. Much of this period was characterized by relative- achieved, most banks remained quite inefficient by main- ly poor market conditions due, first and foremost, to the taining unprofitable branch networks and even more so by weak international reputation and perceived low-growth offering irrecoverable loans, mainly to state-owned nonfi- potential of the Bulgarian economy, later to the Asian and nancial enterprises but also to other insiders, affiliated per- Russian financial crises, and, last but not least, to the mil- sons, and entities. itary conflict in Kosovo. Given this background, selling five In order to clean up the balance sheets of the state- large state-owned banks-basically the whole sector-in owned banks, the government issued bonds to replace the four years is a good record by any reasonable standard. nonperforming loans. The total cost of recapitalizing the One of the most important factors that clearly con- banking system has not been quantified precisely, but it is tributed to this successful privatization drive was the struc- estimated to have been more than $3 billion, roughly 25 ture of the entity responsible for the process. The BCC was percent of the GDP of Bulgaria today. (This amount created as a corporation and capitalized through an initial includes the cost of covering deposits and public debt infusion of capital by the Ministry of Finance and the resultinig from the issue of state bonds and the reduction of Bulgarian National Bank. It required the shares of the sales proceeds received by the government on privatization state-owned banks to be restructured and privatized as as a consequence of ring fencing the remaining nonper- well, so that it became the nominal titleholder for the state- forming loans in the balance sheet of the banks.) owned banks. It functioned much like any other corpora- By mid-1997, all state-owned banks had been recapi- tion, with the same structure of governance, despite having talizec to the extent necessary for them to meet the mini- government entities as majority shareholders. Furthermore, mum capital adequacy standards established by the the general privatization law did not apply to banks under Bulgarian National Bank. This factor was critical in start- BCC control. This provided a great deal of flexibility in ing the privatization in an effective manner, particularly in establishing policy and making specific decisions as market light of the intention of the newly elected government to conditions permitted and dictated. target reputable international strategic investors. These results are especially impressive in light of the far less successful privatization of enterprises in the real The Objectives of Bank Privatization economy. When selling state-owned banks, the Bulgarian gov- ernment clearly sought to receive the highest possible return Policy Considerations in Privatizing from strong, financially sound, and reputable strategic State-Owned Banks investors rather than to maximize the price regardless of the The bank privatization program was successful buyer The government wanted to have confidence that because the government applied a few simple rules, which 74 Financial Sector Resrructuring in Bulgaria, 1997-2001 are sometimes forgotten or overlooked: seller due dili- approval for the offer. One lesson here is that pushing for gence, marketing, valuation, investor due diligence, and deadlines in completing transactions, especially publicly contract terms and conditions. announced ones, could be counterproductive by weakening "Seller due diligence" refers to the need for BCC to considerably the position of the seller. know exactly what it was going to dispose of. It involved Perhaps one of the biggest hurdles in privatization is a comprehensive and detailed assessment of the financial gaining a level of comfort with fair valuation. From a polit- condition of the banks to be sold as well as management ical point of view, this constitutes the most sensitive and and operational audits. Once the level of attractiveness of controversial issue. There can be a negative reaction if the banks was determined, further restructuring was carried opponents of privatization claim that a particular asset of out before privatization in order to enhance their fran- national importance was sold at a very low price. chise value. This exercise proved that it was more beneficial Nevertheless, setting a minimum acceptable price could either to transfer all remaining bad loans and investments be counterproductive both to obtaining a fair price and to to a separate entity specializing in asset workout or to sell generating competition. Setting the minimum price too them to a professional resolution agency than to keep them low clearly will discourage higher offers. Setting it too high in the banks, because the potential buyers would severely might produce only a few offers or no offers at all, forcing discount their value in any case. the seller to lower the threshold. And changing conditions Once banks were in salable conditions, the second ex post never produces better results. phase of the seller due diligence involved putting together Of the six banks offered by the BCC, there were only an information memorandum so that potential buyers two cases where valuations were obtained, and, even in could have detailed knowledge before investing a lot of those cases, the valuation was never used to set a minimum time in gathering information at their own expense. This price. In practice, only the market itself can determine the was to help not only buyers but also the BCC in identify- real value of an asset. That is another reason why it is so ing issues that needed to be addressed either in marketing important to expose assets to the assessment of markets for or in the sales contract. a reasonable period of time. The BCC typically spent three to six months preparing Prospective investors also need a considerable amount a complete information package detailing all legal issues of time to perform their own due diligence. They usually (such as litigation cases, title problems with buildings, and need to hire local legal and financial experts capable of ana- problem loans) as well as the banks' financial and operat- lyzing the records of the banks to be acquired. In addition, ing conditions; a list of major loans and deposits and terms serious investors inevitably make an on-site inspection of and conditions thereof; and information technology sys- their own and need adequate time to prepare their internal tems. This perfectionist approach to putting together pri- valuations after completing the due diligence, to alter the vatization memoranda greatly enhanced the powers of the terms and conditions in the draft share purchase agreement, BCC to attract wide interest from foreign investors because and to obtain necessary management or board approvals the authorities already had performed part of the required for the final offer. due diligence. When the BCC wanted to sell the state-owned banks, Perhaps one of the biggest problems for Bulgaria in it did not establish a deadline for bids at the outset of the the whole process of bank privatization was the lack of marketing period because the time required for investor due adequate time for marketing. One way to get around this diligence depended very much on the number of potential problem was not to set any final deadline until the initial interests, which, in turn, were not known in advance. marketing efforts had indicated what level of interest Nevertheless, as time passed, it was important to set a could reasonably be generated. By having the flexibility to final deadline for bids to arrive in order to avoid a situation set the parameters for the sale during the marketing peri- where offers based on outdated information no longer od itself, the BCC could better avoid noncompetitive could be considered valid. offers and maintain a higher level of interest throughout Contract terms and conditions were essential for the the period. successful closure of privatization transactions as well. Unfortunately, most privatization transactions in The BCC always attempted to provide a standardized Bulgaria's real sector implied a very short time frame for contract to all potential bidders in an effort to facilitate the offers (usually 30 days), which made it very difficult, if not selection of the best offer. The contracts were drafted in impossible, for many bidders to decide to participate, per- view of what the potential acquirers might demand. The form due diligence, prepare a bid, and obtain internal BCC offered relatively extensive representations and war- 75 Jo t e v ranties regarding the financial condition of the banks. Concluding Remarks Although it was made clear that all bidders should perform Bulgaria has come a long way since the deep econom- their ow/n due diligence and determine the net asset value ic and social crisis of 1996-97. Despite the many years it of the bank concerned, the BCC provided wide assur- takes for reforms to produce meaningful improvements in ances and guarantees with respect to the legal validity of the living standard of the majority of the population, there claims and obligations of the banks. Since the risks are already some impressive results. GDP per capita- involved were considered minimal from the government which was declining more than 4 percent a year in 1995 side, this was an excellent tool for eliminating many ele- and 1996-increased more than 4 percent a year in the past ments of discounts that investors might have asked for oth- three years, including a 5 percent increase in 2000, based erwise. on preliminary numbers. Budget revenues, which stood at One major difference between the contracts offered by 5.6 billion leva in 1997, reached 9.7 billion leva in 1999 the BCC and those established by the Bulgarian and 11.1 billion in 2000, an increase of almost 100 percent Privathzation Agency and various ministries responsible in three years. Foreign currency reserves grew from $400 for the privatization of nonbanking assets was the post-pri- million in January 1997 to almost $3 billion at the end of vatizati3n commitments placed on buyers. The BCC, in 1999 and $3.5 billion at the end of 2000. Average month- fact, placed very few, if any, restrictions or requirements on ly salaries increased from the equivalent of only $12. 1 0 in investors after the sale. Typically, there was a clear com- January 1997 to $120.00 in January 2001. mitment to holding the acquired shares for a period of at Confidence in the banking system has been largely least two to three years. But no requirement was placed on restored. While total bank assets were only $1.8 billion in the number of employees to be retained, additional capital January 1997, they reached $4.2 billion by the end of to be infused (except in the case of banks marginally above 1999 and $4.7 billion at the end of 2000, an increase of the minimum adequacy), or business lines to be developed more than 160 percent in less than four years. in the future. There is strong evidence that the most efficient and sta- This relaxed attitude toward future requirements ble economic systems around the world are those that proved to be a wise policy. First, in the nonbanking sec- combine little or no state ownership in the banking sector tors these commitments resulted in a costly administrative with strong prudential regulation and supervision. Bulgaria burden for the government in monitoring compliance has learned this lesson the hard way. By privatizing large with legal and administrative obligations embedded in banks of systemic importance, the financial sector has been thousands of privatization contracts. Second, it was liberated from political and administrative intervention, extremely difficult to enforce such provisions in light of while at the same time prudent governance and behavior the fast-changing business environment. Sometimes are enforced by adequate regulation and supervision. The enforcement did not make much sense from a business task for the future is to modernize the nonfinancial sectors point of view. Modifying these conditions was a tricky rather quickly in order to provide a good opportunity for issue as well. Therefore, an important lesson of a sweep- banks to live up to their full growth potential. Banks need ing privatization drive is to try to minimize "social oblig- creditworthy clients and new lending opportunities. There ations," as enforcing them is next to impossible even if is high hope that further reforms will deliver them quickly, there seems to be good rationale for them, which is rarely thus contributing to the modernization and sustained fast- the case. pace growth of the whole Bulgarian economy. 76 Chapter 8 Financial Markets in Hungary: Achievements and Prospective Challenges Istvdn Szalkai n Hungary, the need to reform financial markets and institutions was recognized as early as the middle of the 1980s, and this recognition produced several institutional and policy reforms before the beginning of the political transition. These included the introduction of the two-tier banking system, the establishment of the basic pillars of a money market, and the liberalization of inter- est rates. The decade of the 1990s brought new challenges: earlier policy reforms had to be revitalized and enhanced as the country became more open and the external economic environment became less favorable. This required coordinated efforts to strengthen the institutional framework in which the cen- tral bank, credit institutions, securities firms, and other financial undertakings operate. Several legislative steps proved to be instrumental in Law on Credit Institutions allowed banks to provide bank- achieving these objectives. The 1990-92 reforms in finan- ing and investment services under one roof and opened the cial legislation resulted in the introduction of safe and possibility for universal banking. The Law on Single sound prudential regulation in banking. They took into Supervision, which entered into effect on April 1, 2000, consideration several recommendations of the Basle merged the formerly separate Hungarian Banking and Commission and directives of the European Union (EU), Capital Market Supervision, Insurance Supervision, and including comprehensive and up-to-date rules on securities Pension Supervision in an effort to improve the supervision business, stock, and commodity exchanges. They also of financial groups that emerged in the second half of the were supported by the enactment and strict implementa- 1990s in Hungary. tion of market-oriented accounting and bankruptcy rules As a result of legislative changes in the 1990s, in 1992. Beginning in 1996, new foreign exchange legis- Hungary achieved a significant level of harmonization in lation permitted the current account convertibility of the its banking and capital market legislation in relation to Hungarian forint and liberalized international financial that of the EU. Several further steps need to be taken, transactions. The 1996 Law on Credit Institutions estab- however, in order to reach full compliance by the time lished the basic framework for banking supervision on a Hungary's accession to the EU is realized (see box 8.1). consolidated basis and, in accordance with this, merged The amendment to the Law on Credit Institutions and the formerly separate Banking Supervision and the related modifications in the financial legislation intro- Securities and Stock Exchange Supervision into a new duced enhanced consolidated supervision requirements supervisory institution called the Hungarian Banking and as well as market risk capital requirements (including Capital Market Supervision. The 1998 amendment of the rules for keeping trading books) in accordance with the 77 S z a I k ai BOX 8.1. AMENDMENTS OF LEGISLATION Additional amendments to existing legislation stem from regu- introduction of universal banking, provisions were applied latory experience based on recent market developments. The equally to banks that offered investment services. Another rea- need foD additional amendments draws on the suggestion of a son is the need to strengthen investment service providers, in governrnent committee headed by Mr. Ferenc Pacsi. the light of failures following the Russian crisis as well as the Harmonization of different fields of financial legislation. introduction of stricter regulatory requirements that promote Different fields of financial legislation were drafted and enacted investor protection, including better disclosure and reporting at different times and later were interpreted and developed on rules. Regulations on cross-border activities also need to be their own. The introduction of the "single supervisor"-with the enhanced. aim of ensuring efficient consolidated supervision of financial Revision of the law on bond issues and related regulations. groups--reveals that supervisory procedures are very different Stipulations of this law need to be revised in an effort to facili- for banks, securities firms, insurance companies, and pension tate the development of rudimentary corporate and municipal funds. onsolidated supervision requires harmonization of bond markets. This requires removing the restriction that lim- these to a considerable extent. Prudential requirements remain its bond issues for companies (except credit institutions) in the highly influenced by sector specifics, but some harmonization amount of their shareholders' equity. The regulation on contin- is possible in this area, too. Reconciliation is needed among the uous issues, bond programs, and so forth, which have become separate pieces of legislation for collective investment products more frequent and important, also needs to be improved. like mutual or pension funds and certain life insurance products. Modemization and unification of rules on exchanges. There Moreover, reconciliation is required between the provisions of is professional support for replacing the segmented sui gener- the corporate and securities laws referring to the same or relat- is regulations on exchanges with unified rules based on profit- ed issues of regulation. oriented corporate form. Revision of the lawon securities. The reason for this comes Improvement of regulation on collateral and taking posses- partly fr:m the introduction of universal banking. Originally, pro- sion of collateral. This can be a catalyst in real estate and small visions it this law were applied to investment service providers, and medium enterprise finance and would make the payment meaning brokers, dealers, and underwriters. Following the and settlement systems more safe. directives of consolidated supervision and capital ade- competitive position of the Hungarian banking system and quacy.1 cannot be expected prior to accession. The amendment of The insured amount in the deposit insurance scheme the Law on Credit Institutions included all of these stipu- and the minimum capital for savings cooperatives also lations up-front and indicated when the specific changes need to be increased. In Hungary, anonymous deposits would enter into force. still exist (and are not covered by deposit insurance). These Hungary has achieved good compliance with the Basle deposits have to be discontinued according to the require- core principles. Specific areas where compliance with Basle ments of the European Union. Although regulations can be core principles continues to be insufficient mirror those changed overnight, the practical implementation will be where compliance falls short of the directives of the gradual and can probably be completed by the time of European Union, that is, the need to enhance supervision accession. The legislation allows foreign banks to have and the enforcement of prudential rules on a consolidated branches, in Hungary. Existing rules, however, are more basis, to measure and capture market risk (and the risk restrict:ive than the regulations required in the countries of management process), and to use specific capital charges the European Union. Present regulations maintain the cap- against this. Measures to be taken include the following: ital requirements of subsidiaries, supplemented with a spe- * The supervisory right to exercise regulatory powers cial asset maintenance ratio for branches. Liberalization of needs to be reestablished in order to ensure quick branching would significantly influence the structure and regulatory responses to market developments and 1. The amendment became effective on January 1, 2001, and supportive regulation on the use of trading books went into force on April 1, 2001. 78 Financial Markets in Hungary: Achievements and Prospective Challenges violations of the rules. There is no understanding by the end of 1992 in comparison with the banking sector's among the institutions interested in regulation and total equity capital, and several large banks were forced to enforcement on how to implement this requirement seek capital replenishment to an extent that appeared out in practice. of their reach. In an effort to avoid the spread of a systemic * The evaluation of banks' policies, practices, and banking crisis, the government launched a bank rehabili- procedures for granting loans needs to be improved. tation program. The rehabilitation program of 1993-95 Other investments and the management of loan and covered the troubled banks as well as their large debtors. investment portfolios have to be strengthened, espe- These banks were rescued partly through the restoration of cially the evaluation of management responsibili- their loan book and partly through direct capital infusion ties. Regulations and enforcement of connected lend- following the submission of restructured recovery plans to ing should be stricter. These requirements can be the government institutions responsible for bank rehabili- treated partly through the forthcoming amendments tation. As a consequence of this, capital adequacy returned of the Law on Credit Institutions and the tightening to the statutory minimum corresponding to the Basle min- of supervisory practice. imum requirements. The total cost of this program . The possibilities for correcting regulatory violations amounted to about 10 percent of Hungary's 1993 gross and enforcing corporate governance in financial domestic product (GDP; see table 8.1). institutions need to be enhanced. Several proposals The legislative steps taken, coupled with the govern- to amend the Law on Credit Institutions have been ment's bank rehabilitation program and the restructuring made to increase the flexibility of supervision. activities carried out by bank management, opened up the Tightening of supervisory practice, however, also is Hungarian banking system to foreign strategic participa- required. tion and integration in the European and global financial * The consolidated supervision of internationally markets. Following restructuring and recapitalization, active banks needs better cooperation, and memo- banks were mostly privatized, typically through sales to for- randa of understanding (MOUs) among superviso- eign strategic investors. By the end of 1999, banks under ry authorities of partner countries are required. foreign control represented a 65 percent share from the MOUs have been signed with several securities total registered capital of the Hungarian banking system. supervision agencies. The legal framework is in The share of the public sector in the registered capital of place, but no MOU has been concluded with foreign credit institutions was reduced to 19 percent. bank supervision agencies. An important task for the These changes have contributed to a more transparent Hungarian authorities in the next couple of years ownership structure. The professionalism of management will be to more actively cooperate with bank super- typically has improved in banks with foreign strategic visory authorities of the EU members and other investors, reflecting the deeper experience of foreigners in important partners in international financial trans- banking, coupled with local familiarity with market cir- actions. cumstances. Management's motivation also has changed; their lending practices have been revised, and internal and Remaining Structural Vulnerabilities of the external audit systems have improved in general. At the Banking System outset, restructured banks remain risk averse and concen- In the beginning of the 1990s, when Hungary lost a trate their traditional lending activities mainly on blue- considerable part of its traditional markets due to the col- chip customers. lapse of the Council for Mutual Economic Assistance, a Bank losses may remain hidden for years when owners' simultaneous enforcement of stricter accounting, bank- control of bank activities continues to be weak, corporate ruptcy, and prudential banking rules-loan classification governance and external audit are insufficient, and the and provisioning-accelerated the necessary structural supervisory authority lacks efficiency in conducting super- changes in the economy and inevitably led to an abrupt vision on a consolidated basis. The case of Postabank in increase in the stock of nonperforming loans in the bank- 1998 illustrates that a mismanaged private bank without ing system. Part of these already accrued in earlier years as appropriate control can accumulate hidden losses and a consequence of inexperience in credit evaluation and col- increase the threat of systemic consequences by forcing lateral management. Another-probably smaller-part the government to undertake a costly rescue action. was related to the ongoing difficult market conditions. In spite of the widespread portfolio cleansing, losses The stock of nonperforming bank loans became very large may remain in the loan, securities, and real estate portfolios 79 Szalkai TABLE 8.1 COST OF RESOLVING BANKING SECTOR PROBLEMS: INTERNATIONAL COMPARISONS Estimate of total costs Country and time period as a percentage of annual GDP of problems during restructuring period Latin America Argentina (1980-82) 13-55 Chile (1981-85) 19-41 Mexico ' 1995) 15-17 VenezueTLa (1994-95) 17 Transition countries Bulgaria (1990s) 14 Hungary (1992-95) 10 Industrial countries Finlanc ' 1991-93) 8-10 Japan (1990s) 3 Spain (1977-85) 15-17 Sweden '1991-93) 4-5 United States (1984-91) 5-7 Source: Crockett (1997); IMF (1998: 78). of privatized banks. When revealed, these need to be cov- it cooperatives). In recent years there has been a tendency ered by provisions or written off. Owners have to accept for increasing concentration, and the numbers of both these consequences in the form of additional capital. joint-stock banks and cooperative institutions have Deferring the infusion of capital in very competitive mar- declined. Ten major banks represent 73 percent of total ket circumstances, like the present one in Hungary, might banking activities at present. The concentration is more compound the difficulties, partly through the delay in striking in the retail sector, where the National Savings restoring confidence. Bank (OTP) has a dominant position, and 10 major banks Another challenge for Hungary's future is the sharply control about 90 percent of the market. increasing operational risk due to an outdated and seg- The process of concentration is expected to continue. mented Information technology, and unreliable manage- In the cooperative sector, bank regulation promotes further ment information systems, especially in the case of some concentration, with a gradual increase in capital require- medium-size and large banks. These banks are forced to ments to the level of the European Union. As regards joint- absorb very high costs in order to accelerate investments stock banks, the privatization of the remaining two com- and catchi up with their competitors. mercial banks, which are under direct state control at Any remaining structural problems of banks might present, could create considerable demand from banks prove to be a serious competitive disadvantage and may already operating in Hungary. Hungary's entry into the even be disastrous when integration with the EU financial European Union probably will set in motion a further system accelerates. wave of consolidation, the direction of which will be influ- enced by bank mergers in the European market. The rea- Financial Sector Depth and Concentration sons for these mergers will be the commercial banks' efforts By the end of 1999, there were 260 credit institutions to improve cost savings under competitive pressures, and in Hungary, of which 43 operated as joint-stock entities and the geographic and functional diversification of their activ- 217 operated as cooperative institutions (savings and cred- ities. It also will reflect efforts to achieve appropriate size in 80 Financial Markets in Hungary: Achievements and Prospective Challenges order to increase profitable activities and sustain a com- shares and longer-term government bonds. The growth of petitive edge in a larger and unified market. institutional investors (mutual funds, pension funds, and The degree of financial intermediation carried out by insurance companies) could explain why the degree of the banking system can be measured by the ratio of bank banking sector depth-measured by the ratio of bank deposits to GDP. This ratio was 44 percent at the end of deposits to GDP-grew less than expected in circumstances 1999, having demonstrated only a modest average annual prevailing between 1995 and 1999. The share of claims of growth from the 40 percent level registered in 1995. The the household sector in the form of mutual fund units and ratio is low in Hungary compared with member countries contractual savings increased from 2.2 percent in 1995 to of the European Union (see figure 8.1). The reason for 7.9 percent of GDP in 1999 (see figure 8.2). Throughout this is the level of income per capita, like the regional dis- the period, this also contributed to an increase in market tribution of economic activities (inequalities) and the capitalization, volume traded, and depth and liquidity of urbanized character of society, which influences the densi- the capital market. ty of bank branches and the use of bank services. In It is probable that deposits will grow faster than GDP Hungary, the number of bank branches per million inhab- and that banking sector depth will increase gradually from itants, for instance, falls well below that of Western the present low level. The share of mutual fund investments European countries. The depth of the banking sector and contractual savings, compared with both total financial appears to be low, relative to Hungary's economic devel- assets and GDP, will continue to grow. The speed will be opment. significantly influenced by the availability and extent of tax Hungary has a higher level of banking sector interme- incentives as well as the regulation of the level of contri- diation than most of Eastern Europe and countries of the butions to the compulsory, fully funded pillar of the pen- former Soviet Union. This divergence in banking sector sion system. This means that due to the availability and depth was considerably influenced by the level of inflation development of securities markets, companies can rely on experienced during the 1990s. relatively more financing from equity and bond issues than Following the 1995 stabilization program, economic they will receive from the banking system. The capitaliza- growth revived and accelerated, while inflation declined tion, depth, and liquidity of capital markets are expected to steadily in Hungary. Against this background, a strong grow significantly. When companies can raise financing by increase in the degree of financial intermediation carried issuing equity and bonds at lower cost than the cost of bank out by the banking sector would be expected. This was also financing, banks have to respond with services that increase the period when mutual funds' and contractual savings their off-balance-sheet noninterest income. (especially in pension schemes and life insurance products) Until 1999, Hungarian banks could not apply for a began to grow markedly in Hungary. This, in turn, brought license for full-scale investment services, but they could about a considerable increase in demand for corporate offer these services-and also insurance-through sepa- FIGURE 8.1 DEPTH OF BANKING INTERMEDIATION IN PROSPECTIVE EU MEMBERS AND GREECE, 1997 14000 80 12000 70' io1000 60 D 8 0000 5 l / _ 60 vtZ GDP per capita in USD 40G 60 -i + + Bank deposits as a 6000 ~~~~~~~ ~ ~~30 -`4 ~ percentage of GDP J~~~~~~~~~~~~~~~~~~r O O 4000 20~ cz 2000 1 0 0 0 Source: OECD (1999); IMF (1997). 81 Szalkai FIGURE 8.2 COMPOSITION OF FINANCIAL ASSETS OF HOUSEHOLDS (WITHOUT CASH HOLDINGS) IN HUNGARY, 2000 Percznt/ 1 3o boc 80 70 60 50 40 30 20 10 0 1995 1999 Corporate w Treasury bills * Units of mutual * Bank deposits bonds and and funds,pension shares government funds and life dons insurance Source: National Bank of Hungary (2000). rate subsidiaries. Banks established subsidiaries for other groups that banks belong to, and the bank typically is the financial or supplementary financial services like financial main operating company of the group. At the same time, leasing and factoring. In this regulatory environment, bank- five banks use insurance companies as agents for selling ing and financial groups engage in a wide range of financial their banking or joint products. services. Pension funds are organized as mutual societies Banking and financial groups usually have originated and do not belong to the financial group. All services relat- from banks' efforts to offer a broader range of financial ser- ed to pension funds, however, are provided by subsidiaries vices and their response to changes in the structure of sav- in the group. The largest banks typically have subsidiaries ings of their clients. It is expected that the successful large for nearly all of these services in their groups (with insur- banks and some of the medium-size banks (six to eight ance being the least frequent). In the case of medium-size banks) will continue to move in this direction and offer, in and smaller banks, the provision of investment services addition to bank deposits, a wide range of investment fund through separate subsidiaries is common (most banks, products at different levels of risk as well as contractual except specialized ones, have their own securities firms). savings opportunities. They also provide different forms of Since the beginning of 1999, several banks have obtained financing, in addition to bank lending, including leasing approval to provide investment services directly. Some of and factoring. Groups of institutional investors can invest them already have merged the separate subsidiary for in different securities and contribute to a more balanced investment services with the bank. corporate and household financing structure, especially Bank assurance activities are carried out in different through the availability of long-term funds. Commercial forms. At present eight joint-stock banks and the majority banking, investment banking, fund management, and of savings cooperatives have received approval to sell insur- insurance already are concentrated to a significant extent ance products as agents of insurance companies. Insurance within the existing groups around these banks, and this companies are mostly members of the same financial concentration will increase further in the future. 82 Financial Markets in Hungary: Achievements and Prospective Challenges Other small and medium-size banks, including spe- ing a 16 percent increase in loans outstanding in real terms. cialized institutions such as mortgage and home saving In the structure of bank assets, the share of loans increased banks, will be partly taken over by the dominant groups to 44 percent, while the share of securities showed a cor- and partly transformed into branches of foreign banks responding decline to 16 percent. In the years ahead, the when legal provisions on branching are eased. Given the ratio of loans to GDP and the share of loans in total assets increasing familiarity with and access to electronic banking are expected to grow further. Their present level is fairly from major international banks, the viability of savings low by international standards. Since the share of house- cooperatives over the next 10-year period is questionable, holds in the total stock of credit is very low and there are even with improved capital strength and a better institu- better prospects for their income growth, a large increase is tional framework. expected in the demand for household credit, which basi- Banks already have made substantial investments in cally will be satisfied by credit institutions. the development of Internet banking in Hungary. Banks As a result of the portfolio cleansing that occurred typically own these facilities themselves. Internet banking during the bank rehabilitation program, a number of indi- can supplement the branch network and even replace it. It vidual rescue actions, and cautious lending activity, the will also typically be a way to offer financial and invest- loan portfolio of banks operating in Hungary is very sound. ment services abroad, possibly as an alternative to cross- In 1999 and early 2000, the share of bad components in border mergers. Besides households, there appears to be a total assets remained below 2 percent. At the end of 1999, remarkable increase in demand for on-line services from the share of sound components was 92 percent of total small and medium-size businesses, where savings of cost assets. Of the remaining components, the share that need- and time are important. The challenge for supervisors in ed special attention was 4.5 percent of total assets, the this field is that several elements of this progress are out of share of substandard and dubious components was 2.3 supervisory oversight. Supervisors have to study and under- percent, while the share of bad components was only 1.1 stand the process, estimate the speed and scope of expan- percent. Although management expertise and methods of sion, and respond with appropriate explanations for cus- credit evaluation have improved, the move toward small tomers as well as regulations to mitigate emerging risks. and medium-size business and household lending as well as the general acceleration in lending activities most probably Soundness of the Banking System will result in an increase in problem items as a share of total The 1993-95 bank rehabilitation and the subsequent assets as well as in an increase in bad components as a share 1995 economic stabilization program-through more strin- of total qualified items in the years ahead. gent lending practices, high real interest rates, and initial- In 1997, credit institutions in Hungary had a return on ly declining domestic demand-had a negative impact on assets (ROA) of 1.3 percent and a return on equity (ROE) the ratio of outstanding bank loans to GDP. The ratio of 14.6 percent (see table 8.2). Profitability turned negative declined from 28 to 25 percent in 1996, then recovered in 1998 due to revealed losses at Postabank and Realbank slightly in 1997 and 1998. The share of loans accounted for as well as losses suffered at several other banks through their 40 percent of total assets of credit institutions in 1997 and subsidiaries in the securities business. In 1999, both ROA 1998, securities holdings for the purpose of trading or and ROE improved compared with 1998, but they still investment constituted about 20 percent of assets, while were lower than they were in 1997, when ROA and ROE claims on the central bank and other banks constituted were 0.7 and 8.0 percent, respectively (see figure 8.3). The about 29 percent of assets during these years. Relying on major reasons behind the decline in profitability have been exchange and interest rate policies of the central bank, disinflation, the concomitant decline in nominal interest banks could count on low-risk, profit-making possibilities rates, and a parallel decline in interest margins due to a for converting their foreign currency funds to government sharp increase in banking competition. At the same time, securities and central bank instruments denominated in there is no apparent improvement in cost efficiency either, national currency. Conditions in the money and exchange which in 1999 can be explained by the efforts of banks to markets became less predictable after the Russian crises. expand their retail network as well as by expenditures on Several banks suffered losses through subsidiaries involved system development connected with the Y2K problem. In in the securities business. By the end of 1998, the resulting the future, interest margins likely will remain under pres- profit squeeze forced banks to revitalize their lending activ- sure, since competition continues to be fierce and addition- ities toward the corporate and household sectors. In 1999 al pressures will come as Hungary's financial system the ratio of loans to GDP increased to 30 percent, reflect- becomes more integrated with that of the European Union. 83 Szalkai TABLE 8.2 THE BANKING SYSTEM IN HUNGARY, 1998-99 Concentration Profitability Number of Number Market share (percent) ROA (percent) ROE (percent) loss makers Type of institution 1988 1999 1988 1999 1998 1999 1998 1999 1999 Large banks 10 10 72.8 72.8 -1.9 0.8 -24.6 11.1 2 Large banks excluding Postabank 1.4 0.9 15.9 11.4 Medium-size banks 9 9 16.4 17.4 0.4 0.5 4.6 6.1 2 Small banks 12 10 5.1 4.3 -4.0 -0.7 -3.4 -5.1 6 Small banks excluding Realbanik -0.5 -0.7 -3.4 -5.1 Specialized institutions 13 14 5.7 5.5 -12.8 0.5 -5.9 -1.2 7 Specialized institutions excludin-g Hungarian Development Bank -3.0 -0.5 -15.3 -3.3 Bank system 44 43 100.0 100.0 -2.2 0.7 -24.7 8.0 17 Bank system excluding removed banks 1.0 0.7 10.6 8.3 Note: The government recapitalized Postabank in 1998. The bailout was partly undertaken by the Hungarian Development Bank. Realbank failed in 1998. The figures do not cover saving and credit cooperatives. Source: Ainual reports of the Hungarian Banking and Capital Market Supervision, 1997-99. Banks that can improve their cost efficiency and expand fee- New Financial Markets based business (partly through increased securitization will A number of new financial markets or market seg- be able to maintain or increase their profitability. ments have begun to evolve in Hungary. These include The capital adequacy ratio (consistent with Basle real estate finance and home construction by households, guidelines) showed a declining trend, reflecting both the small and medium-size enterprises, agricultural produc- acceleration of higher-risk lending and the decline of prof- ers, and municipalities. itability of credit institutions. This ratio was 17.5 percent In recent years credit to households accounted for in 1997 and 14.2 percent in 1999. The present level of cap- about 110 percent of total credit stock, and half of total ital adequacy provides room for further risk taking in the credits to households financed home construction. general banking system in the medium term. Foreign strate- Following the termination of the system of subsidized hous- gic partners have declared their readiness to contribute ing loans of the former economic regime, the stock of infusions of capital in case of need. Despite this, the expan- housing loans declined steadily due to high financing costs. sion of the activity of certain banks may be constrained The overwhelming majority of housing credit stock has temporarily by an insufficient capital base. remained with the National Savings Bank, which, until 84 Financial Markets in Hungary: Achievemiienits and Prospective C.hallenges FIGURE 8.3 HUNGARY: BANKING SYSTEM, RETURN ON EQUITY, AND RISK-FREE RATES IN HUNGARY, 1995-99 Return on equity (percent) -| Risk-free rate (percent per year) 40 30 20 10 -10 1995 1996 1997 1999 -20 -30 Source: Annual reports of the Hungarian Banking and Capital Market Supervision 1997-99 and monthly reports of the National Bank of Hungary. recently, was practically the only player in the market. With the enforcement of this new arrangement, how- Financial sector legislation also has been introduced, which ever, the long-term viability of home savings banks may has addressed these issues. Two years ago, parliament become questionable. It also means a deviation from the enacted laws on home savings banks (in line with the original model of mortgage banks and creates competitive German Bauspar model) and mortgage banks (also in line distortions in this sector. These anomalies need to be with the German mortgage bank model). Four home sav- redressed, and a sound way for system development needs ings banks and two mortgage banks have started opera- to be established. tions. Mortgage banks are the only institutions that can Although some years ago there was a general short- issue mortgage bonds. At the beginning of their operation, age of credits to small and medium enterprises in they concentrated mainly on finance to commercial and Hungary, medium-size enterprises now have better access industrial real estate. Products of home savings institu- to credits. The increased competition and the profit tions include preannounced government subsidies for home squeeze have driven banks toward small and medium construction. In order to accelerate home construction, in enterprises, and this has been supported by new institu- 2000 the government selected-as a government-support- tions that moderated the lending risks of banks (credit ed institution-one of the mortgage banks as a channel for guarantee funds, credit information systems) and also by the provision of new subsidies for homebuilders and also as new instruments like public warehouse warrants that a basic institution of the secondary market for mortgages. were used mainly by agricultural producers as collateral This mortgage bank has contracted with commercial for their short-term credit requests. Lending to small banks, insurance companies, and savings cooperatives in an enterprises, however, continued to be insufficient com- effort to expand the provision of housing loans under the pared with the economic importance of this sector. Credit new subsidy scheme. Besides channeling subsidies, the gov- to small enterprises accounted for only 3-4 percent of ernment-supported mortgage bank provides liquidity to total credit stock, although this sector accounted for more primary market lenders and improves market efficiency than 10 percent of GDP. The access of small and medium by moving toward standardized mortgage lending. Having enterprises to financing in the years ahead can be this special government-supported status, the selected mort- improved further by revising the regulations on venture gage bank enjoys a better market standing. Purchased loans capital funds, which may be prepared to invest in antici- are kept in the portfolio of this bank and are financed by pation of improved exit opportunities. These funds can issuing mortgage bonds. The new arrangement has pro- provide valuable support to firms with their expertise in vided an incentive for borrowing and-with the establish- strategic planning, marketing, and ability to access com- ment of the secondary mortgage market-also for prima- plementary financing. Regulations on taking possession of ry lending. collateral need to be made more flexible, and the regis- 85 Szalkai tration of liens, as well as the system of credit informa- market leaders in offering specialized banking services (real tion, has to be improved in Hungary. estate, home, and car finance) as well as nonbanking finan- During recent years, credits to municipalities accounted cial services (leasing and factoring). Some of the smaller for aboat 1.5 percent of total credit of the banking system. banks will be transformed into branches of foreign banks The amount of municipal deposits exceeded significantly if the regulation is eased. Foreign nondeposit-taking insti- the amount of their credits. Very few banks lend to munici- tutions in consumer finance will increasingly penetrate the palities. M4unicipalities with idle funds also avail themselves market, but they may fund themselves basically from of the portfolio management services of securities firms. At abroad. Only a few small banks can survive as niche play- present, public sector borrowings are centralized. Municipal ers. With increasing familiarity and access to electronic bond markets-which existed earlier in Hungary-need to banking from major international institutions, the viabili- be revitalized if significant longer-term financing is needed ty of savings cooperatives over the next 1 0-year period is for local development projects. The revitalization of the questionable even with improved capital strength and a bet- municipal bond market requires the revision of the present ter institutional framework. In the second half of the next Law on Bond Issues. Since local rating agencies already pro- decade, the concentration process will continue, but due to vide services in Hungary, the introduction of mandatory the overwhelming foreign ownership, mergers and acqui- ratings for municipal bond issues is possible. A municipal sitions in a wider European framework will determine the bond rating would help investors to estimate the risk they outcome. Among the reasons for mergers will be the efforts undertake with new issues, and continuous monitoring by of commercial banks to improve cost savings under com- rating agencies would provide additional information on petitive pressures. the financial position of municipalities. Banks already have made substantial investments in the development of Internet banking in Hungary, which Major Challenges for the Next Decade they typically own. Internet banking is suitable to supple- Hungaary's membership in the European Union and ment a branch network and even to replace it. It also is a further integration with the international financial systems typical way to offer financial and investment services require ftill harmonization of Hungarian financial regula- abroad, and therefore it can be an alternative for cross-bor- dions with those of the European Union, as well as full com- der mergers. Besides households, there is a significant pliance with the Basle core principles during the next three increase in demand for on-line services in small and medi- to five years. There are five major issues to be treated in this um-size businesses. The challenge for supervisors in this field: (a capturing and measuring market risk, (b) enhanc- field is that several elements of this progress are out of ing consolidated supervision, (c) strengthening the regula- supervisory oversight. Supervisors have to study and under- tory powers of financial supervision, (d) improving the stand the process, estimate the speed and scope of expan- possibiltites for timely corrective supervisory measures, sion, and respond with appropriate explanations for cus- and (e) achieving better international supervisory cooper- tomers as well as regulations to mitigate emerging risks. ation iri order to implement consolidated supervision, Outsourcing of banking activities will gain momentum including cross-border transactions. during the next decade. Supervisors will have to ensure that Integrating Hungary's financial system with the this process remains under their control. With specific legal European and global financial system will require remov- stipulations as well as licensing requirements, all activities ing the remaining structural problems of financial institu- covered by the outsourcing will have to remain-in prin- tions. With a further increase in competition in the finan- ciple-under supervisory jurisdiction, which is then exer- cial markets, these structural problems could provide cised in accordance with the concentration of risks. serious competitive disadvantages. One of the major chal- The low average level and high variance in profitabil- lenges in rhis field is to minimize the high operational risk ity, together with the large number of loss makers, pose a in institutions where the development of information tech- challenge in the next three to four years for the Hungarian nology was not well devised and management information banking system. It is expected that, where capital replen- systems are weak. ishment is required, owners will provide for this in the The concentration of market players, especially in near future without major difficulty. In light of further banking, is expected to increase further. By the middle of pressures on profit margins due to increased competition, the next decade, six to eight financial institutions providing it may take longer for several banks to achieve a break-even universal banking services will control the majority of the status. Although problems with systemic consequences are Hungarian financial markets. These groups will be the unlikely to emerge, the owners' behavior in such cases is 86 Financial Markets in Hungary: Achievements and Prospective Challenges less predictable and might raise supervisory concerns at a cannot maintain their competitiveness. It is expected that later stage. during the next five years, they will develop into a region- As a result of liberalizing the entry of the products of al association of national exchanges. foreign investment funds in the Hungarian market, the Analysis, rating, and evaluation by shareholders, audi- strengthening of the fully funded pillars of the pension sys- tors, and supervisors can work only with appropriate dis- tem, and the growing share of bank assurance activities in closure requirements. In Hungary, availability or periodic- financial groups, intermediation through institutional ity of consolidated accounts needs to be improved for investors is likely to grow rapidly. Institutional investors credit institutions, and disclosure rules for investment ser- will contribute further to the development of capital mar- vice providers have to be revised. In light of recent devel- kets both in terms of depth and liquidity, while reducing opments, there is a need to improve accounting and audit- risks by increasing the demand for improved disclosure and ing procedures and practices. risk rating as well as corporate governance. Changes in the In Hungarian circumstances, foreign owners who are structure of intermediation may cause problems for certain represented in the boards of directors and other supervisory credit institutions. The majority of the market, however, boards typically provide the strategic guidance to financial will be controlled by financial groups, which, through their institutions. This kind of corporate governance can be diversified activities, can manage these changes without dif- regarded as quite developed in comparison with other ficulties. countries in the region. Laws in force, especially corporate One of the major challenges for the next 5 to 10 years and banking law, establish the accountability of boards, but is the development of a secondary mortgage market. This their stipulations and transparency of requirements need to would potentially provide liquidity to primary market be improved. Laws regulate the composition of boards of lenders and improve market efficiency by moving toward banks in detail. This requirement, however, has to be eased standardization in mortgage lending. It is already apparent in the future, giving the owners of institutions more room that during this process there will be a movement from the for discretion. German to the American model of mortgage finance (the Following the integration of banking, securities, insur- core of the secondary market will be one, or more, gov- ance, and pension fund supervisory institutions, one of the ernment-supported institution). Another challenge in this basic supervisory challenges for the future is to establish a process is the long-term viability of home savings banks, credibility on the level of the most efficient agencies of the which need to be maintained, while home savings former institutional setup, while harmonizing the different (Bauspar) and mortgage finance have to stay complemen- supervisory cultures and preserving supervisory values of tary. The improvement of financing for small and medium specialized agencies. An efficient "change management" enterprises is critical in Hungary in order to stabilize high process should be put in place. Consolidated supervision economic growth rates. The access of small and medium based on integrated supervisory structures needs to be enterprises to financing in the years ahead can be improved enhanced and requires amendments in the legal framework further by revising the regulations on venture capital funds, as well as improvements in supervisory practice. More inter- which may be prepared to invest in anticipation of national supervisory cooperation has to be established in improved exit opportunities. In a 10-year period, venture order to monitor cross-border business more efficiently. capital funds could grow to play an important role in The most important challenge for supervisors in the next Hungarian capital markets. decade is to recognize that the traditional "compliance" Corporate and municipal bonds have to be developed. approach does not work anymore. In a rapidly changing Not only multinationals but also large companies will business environment, characterized by increasing finan- divert their financing from Hungary if they do not find cial innovations and possibilities for regulatory arbitrage, appropriate maturities at reasonable costs. Progress in the supervision needs to be proactive and the supervisor must be corporate and municipal bond markets can contribute to a sure that risks undertaken by different institutions are cou- more balanced financing system, which can benefit pro- pled with an adequate level of risk management and capital ductive investments and bolster savings and stability when backup. Besides a better regulatory framework, this requires adverse shocks come. In an effort to achieve this, support- more cooperation in the control carried out by owners, ive changes are required in legal regulations as well as internal and external auditors, and supervisors. During the market infrastructure. next decade, the role of self-regulatory organizations will With a higher level of integration to European and increase and will become an important component in the global financial systems, small Central European exchanges overall regulation of market developments and behavior. 87 Szalkai References Crockett, Andrew. 1997. "Why Is Financial Stability a . 1998. World Economic Outlook, 1998. Goal of Public Policy." Paper presented at the sympo- Washington, D.C. May. sium Maintaining Financial Stability in a Global National Bank of Hungary. 2000. Monthly Report Economy, sponsored by the Federal Reserve Bank of (February). Kansas City, Jackson Hole, Wyo. OECD (Organisation for Economic Co-operation and IMF (International Monetary Fund). 1997. International Development). 1999. "Bank Profitability." Paris. Financial Statistics. Washington, D.C. 88 Chapter 9 Restructuring the Russian Banking System Marina Chekurova ince the beginning of 1998, the Central Bank of Russia (CBR) has been restructuring the bank- SJ ing system in an attempt to improve the overall quality of commercial banks and to increase their liquidity. An important part of this program was the creation of the Agency for Restructuring Credit Organizations (ARCO), which was intended to address some of the problems resulting from the country's systemic banking crisis. This chapter examines the role of ARCO in restructuring the Russian banking sector. Recent Developments deposits and savings in the banking system have grown In the summer of 1998, a financial crisis occurred in markedly. From January 1999 to December 2000, ruble the Russian Federation (Russia), leading to a sharp decline household deposits, foreign currency household deposits, in the ruble exchange rate and, consequently, a crisis in the and corporate deposits grew significantly. However, banking system. The crisis was sparked by complex inter- deposits with maturities exceeding one year remained low. national economic circumstances and fueled by domestic Over the same period, the volume of consumer lending economic factors. The fragile banking system was unable to increased, as did the volume of foreign currency and ruble protect the financial system at large against external shocks. loans, but at a slower rate than deposits. The volume of Those banks suffered most of all that held large blocks of lending to Russian enterprises increased quite sharply (fig- government securities, had long positions in national cur- ure 9.4). rency, or had finalized many forward contracts to sell for- The critical stage of the banking crisis is now over, and eign currency. A significant number of banks suffered heavy the Russian banking system is gradually adapting itself to losses of capital and liquidity, and a number of banks failed new economic conditions. The banking system still (see figure 9.1). Further, a substantial reduction in the remains vulnerable, risks associated with banking activity number of bank branches also occurred after the CBR sus- are still considerable, and banks are hesitant to increase pended the banking licenses of major Moscow banks. their lending activity because accurate risk assessment in Between January 1999 and December 2000, a total of 648 the current economic climate is still very complicated. bank branches were closed, 295 of which belonged to Moreover, bank managers are still inexperienced in com- Sberbank (the Savings Bank). mercial lending activities. A large increase in the volume of In 1999 and 2000, the banking system rebounded lending to the real sector at this time would inevitably from the crisis. Aggregate assets of banks increased 2.2 increase systemic risks to the banking system. times over this period (figure 9.2). Aggregate capital in Nevertheless, banks are once again ready to pursue inter- banks also increased between March 1999 and July 2000 mediation functions by offering the traditional range of (figure 9.3). Since the beginning of 1999, household bank products and services, including lending and pay- 89 Chekurova FIGURE 9.1 NUMBER OF BANKS IN THE RUSSIAN BANKING SYSTEM, 1998-2000 ,, 1556 =~~~~~~~~~10 1476 E~~~~~~~~~~~~~~~14 133 133 132 C z End Quarter Source: BLilletin for Banking Statistics, CBR. FIGURE 9.2 AGGREGATE ASSETS OF OPERATIONAL BANKS IN THE RUSSIAN BANKING SYSTEM. 1998-2000 Billions of Russian rubles mettrrsfrsevcs.Iore to , diversify the riks of Althoghth aggregat captalf ank is curretlyo syciae lending soul be-:Si;:p deD'vi elopd anSEiSda ?)supporj ted Bak are stil searching for suitable means wit whichtI unde cls suerison rais captal inidn atrctin frinnvstmets ofer laucke: publeicon fidenceking Sthetistics, ThsCwBatrs tiuetRhepoesb.efrigtxpliyadeulz areinextriablye serinkes. becus orderstodvrsincofidnei the insk taxe Atong prfthe aggreganks capita efbnteprss in currenwthyo banknr etrwudpooe the inflowfvalal agreat foreital candith gendexpally n acctedintrntional Th pgvractient als capitld base tal and encourage the establishment of foreign-owned also would improve if banks were allowed to provision for banks in Russia. loan losses before taxation. 90 Restructuring the Russian Banking System FIGURE 9.3 AGGREGATE CAPITAL OF BANKS, EXCLUDING FIGURE 9.4 STRUCTURE OF THE CREDIT PORTFOLIO IN SBERBANK, IN THE RUSSIAN BANKING SYSTEM, THE RUSSIAN BANKING SYSTEM AS PER JANUARY 1, 2001 1999-2000 Banks Individuals _ ~~~~~~~~~~~~~5% 30 -o 28| 12 i% 250- 200 - 150- 102 ~~~111.3 - 100 50 41.2 0 Source: CBR Vestnik. Enterprises 83% To restore confidence in the banking system, the gov- Source: Bulletin for Banking Statistics, CBR. ernment and the CBR should promptly complete the process of liquidating banks whose licenses have been introduction of amendments to current legislation in the revoked. This would further consolidate the banking indus- field of accounting and financial reporting. try, eliminate banks that represent significant risks to the Public confidence in the banking system will improve system, and stimulate bank mergers and acquisitions. To if bank supervision is strengthened in a credible manner. accomplish these objectives, appropriate amendments The CBR has recently introduced a new system to analyze should immediately be made to legislation on banks and the financial condition of banks with a goal of detecting banking activities and on bankruptcy of credit institutions. potential problems at an early stage. These results will be The existing regulations on bank liquidation and bank- used to determine remedial and supervisory measures and ruptcy are overburdened by unnecessary procedures, do not will give bank examiners a clearer picture of the current protect the interests of creditors, and artificially expand the financial position of a bank, as well as trends over the past timeframe for reaching settlements with creditors. year, taking into consideration possible changes in external According to statistical data, 40 percent of liquidation pro- parameters. However, in order to improve the quality of cedures do not begin until one year after a license is CBR supervision, the financial data on which its analysis is revoked. This lengthy delay almost always results in the dis- based need to be more reliable and accurate. appearance of bank assets. The revocation of a bank license In the field of bank technology, Russia is substantially should automatically trigger immediate liquidation proce- behind international standards. One key element of bank dures analogous to bankruptcy, and court actions should be reform should be the implementation of new technology, initiated with a view toward simplifying procedures. including further development of payment card systems Russian banking officials should continue their efforts and extensive implementation of payment transfer and set- to improve the transparency of banking activities in accor- tlement systems through the Internet. In this regard, laws dance with international principles of bank supervision on electronic transfers of funds are necessary. and should complete the transition to international To sum up, since the crisis of 1998, the Russian bank- accounting standards (IAS). The implementation of IAS ing system has shown some improvement. Much remains requires certain measures to be undertaken, including the to be done, but the system appears to be moving in a pos- 91 C: hek u ro va itive direction. For example, the level of household deposits * Apply market infrastructure capacities to achieve in banks is rising steadily. This may indicate an improve- restructuring targets. ment in public confidence. However, to attract further * Upgrade the level of professional skills among household deposits, a system of deposit insurance still is bankers. needed, as are relevant laws and regulations. Banks in Russia can be divided into three groups: Summary of Restructuring Projects (on a Voluntary financially stable banks, banks whose licenses have been Basis) revoked due to negative capital, and banks placed under The board of directors approved ARCO's program of management of ARCO. activities for voluntary bank restructuring on March 2, 1999. This program laid out the basic approaches for bank The Objectives and Techniques of ARCO rehabilitation. It stipulated that decisions concerning the In November 1998, the government and CBR issued continued operation of banks under ARCO's management declarations on measures for restructuring the Russian should be made on the basis of detailed analysis of finan- banking system and credit organizations. These legal acts cial performance. ARCO set forth criteria for selecting laid the Framework for establishment of the Agency for banks for restructuring assistance on a regional basis. This Restructuring Credit Organizations and set general princi- approach allowed ARCO to concentrate on eliminating ples for r2structuring the banking system. They also classi- bottlenecks in the banking system. fied banks and financial institutions based on state partic- In the three months prior to adoption of the federal ipation, clarified obligations with respect to implementing law on restructuring of credit institutions, ARCO con- remedial rehabilitation measures, and designated regional ducted negotiations and examined the documents of 46 banks as responsible for regional banking development. banks that had applied for restructuring assistance. The ARCO was established by the Russian Federal board of directors agreed to provide restructuring assis- Property Fund, an agency specializing in asset manage- tance to 14 banks, subject to agreement of the owners. ment for government property. It was created initially as a These banks were from eight regions of the Russian nonbanking financial institution with 10 billion Russian Federation, and restructuring is currently under way in rubles of charter capital ($400 million). accordance with contracts signed between ARCO and the ARCO began its operations on March 22, 1999. At banks' owners and shareholders. Bank rehabilitation mea- first, ARCO was only permitted to restructure banks sures include the following: requesting assistance on a volunteer basis and pursuant to * Reorganization of branch network and reduction written agreement with the bank and its owners. A feder- of unprofitable divisions al law on restructuring of credit institutions, which took * Management of substandard assets aimed at improv- effect on July 13, 1999, only recently gave ARCO the legal ing the structure of the balance sheet and quality of authority to impose restructuring measures on banks. This the loan portfolio law also Teconstituted ARCO as a state corporation instead * Development of asset operations and rehabilitation of a publ lc corporation. of profitability ARCO seeks to overcome the consequences of the * Diversification of the client and customer base. Russian banking system crisis and to restore the ability of Because ARCO regards financial restructuring of banks to make settlements, make loans, and ensure the banks as important as operational and organizational safety oi bank deposits. ARCO has the following goals: restructuring, an important goal of bank restructuring is to Miinimize state budget expenditures by implementing help banks to change the manner in which they conduct effective procedures for restructuring banks and rein- business. vesting revenues into further restructuring programs. In 1999, ARCO undertook to improve the liquidity and * Restructure banks by implemeniting objective, clear, enhaince business development in tvo large multiple-branch cotnsistent, and transparent procedures. Russian banks. These projects were not referred to ARCO * Imolement consistent policies for bank restructuring by the CBR and are not under management of ARCO. in accordance with clear and thorough criteria, reg- An ARCO examination of Vozrozhdeniye Bank indi- ulations, and procedures. cated that the bank suffered from insufficient short-term * Ensure restructuring plans to take into account the liquidity. In collaboration with the bank's staff, ARCO interests of creditors as well as depositors and developed 14 scenarios to assist the bank, and it was agreed improve the safety of deposits. that ARCO would purchase one of the bank's larger loans 92 Restructuring the Russian Banking System under the condition that the bank repurchase the loan the period of time exceeding seven days due to lack of liq- after a three-year period. This repurchase agreement has uidity. significantly improved the bank's liquidity and economic Once the CBR refers a bank for restructuring, ARCO status. ARCO representatives were nominated as mem- institutes bank examination procedures that may not bers of the bank's board to assist in supervising implemen- exceed 90 days. Once this process has begun, shareholder tation of the plan. rights are suspended, and the CBR appoints a temporary The financial crisis of 1998 weakened the branch net- administrator to manage the bank. On the basis of the works of major Russian banks, creating a lack of good- results of the examination, ARCO decides whether taking quality banking services in many regions, weakening the over management of the bank is feasible or not. ARCO has interregional payment system, and preventing real eco- the right to reject a bank for restructuring on the basis of nomic integration in the regions. To begin solving this the following: problem, ARCO started a project of regional financial * There are no valid reasons for the referral. infrastructure rehabilitation. Due to the likely costs * Rehabilitation would be inefficient. required to support development of regional banking, * Restructuring measures are needed beyond ARCO's ARCO chose a less costly alternative of branch networking institutional or financial capabilities. to provide support. When ARCO rejects a proposal to restructure a bank, ARCO extended a loan to Alpha Bank to enable it to the CBR must decide whether to suspend the bank's license establish branches in regions lacking access to good-qual- within 15 days. Furthermore, ARCO has the right to liq- ity banking services. The project provided target financing uidate the bank if there is sufficient reason to believe that for up to 1 billion Russian rubles for a fixed two-year rehabilitation is impossible. If ARCO accepts the bank for term, secured by collateral of securities and other bank restructuring, it can write down the charter capital of the property and at a commercial rate of interest. To supervise bank. If the value of the capital of the bank is negative, the use of the loan resources and monitor financial perfor- charter capital shall be stated as one ruble. ARCO may mance of the bank, 25 percent plus one share have been then decide to increase the charter capital by issuing addi- entrusted to ARCO, and ARCO has two seats on the board tional shares or a capital contribution. of the bank for the duration of this project. General prin- ARCO may restructure banks pursuant to a restruc- ciples of cooperation have been agreed by contractual turing plan, the duration of which may not exceed three arrangement among ARCO, the bank, and its shareholders. years. Restructuring has three main goals: - Restructure liabilities Mandatory Restructuring in Accordance with * Reestablish reserves in accordance with federal laws Federal Laws and CBR regulations Currently, ARCO only restructures banks referred to it * Reestablish norms of financial performance pur- by the CBR that meet at least one of the following criteria: suant to federal laws and CBR regulations. 1. The share of household deposits is more than 1 per- In accordance with the law, a bank and its creditors cent of total aggregate household deposits in all have the right to enter into voluntary restructuring agree- Russian banks. ments. The purpose of a voluntary agreement is to restruc- 2. The share of corporate loans (excluding loans to ture the bank's obligations on one hand, and to maximize banking institutions) is more than 1 percent of payments to creditors as compared to the bank's bank- total aggregate assets of all Russian banks. ruptcy on the other hand. ARCO also has the right to rep- 3. The share of household deposits is more than 20 resent the interests of the Russian Federation regarding percent of the total aggregate amount of house- overdue payments and interest owed the Russian hold deposits of regional banks (including bank Federation. branches). The voluntary settlement procedures have been com- 4. The share of corporate loans (excluding loans to pleted in five banks to date, including four regional banks banking institutions) is more than 20 percent of (Amurpromstroybank, Bashprombank, bank Voronezh, total aggregate assets of regional banks. Dalrybbank) and a large Moscow bank-Rossiyskiy A bank also can be taken over by ARCO if (a) the cap- Kredit Bank. In all five banks the agreements have been ital adequacy ratio of a credit organization does not exceed approved by the creditors (minimum legal requirement of 2 percent or (b) a credit organization does not meet the 50 percent supporting creditor votes passed) and ratified claims of creditors or fails to make customers' payments for (as required by law) by arbitration courts. All banks began 93 Chekurova settlements with creditors in accordance with the terms of ticipating banks located in 12 regions of the Russian the agreements. Federation (see table 9.1). ARC(O also has drafted the voluntary settlement agree- The overall limit for financing of projects approved in ment for creditors of SBS-AGRO, which the creditors sup- 1999 was 7.46 billion Russian rubles (approximately $260 ported at their meeting on February 2, 2001. The docu- million). ments for ratification of the agreement were submitted to the Arbitration court of Moscow. Conclusions To sum up, as of January 1, 2001, ARCO had 15 The future development of the banking sector in restructulring projects under implementation, with 20 par- Russia will depend on three factors: TABLE 9.1 RESTRUCTURING PROJECTS OF ARCO, AS OF JANUARY 1, 2001 Date of referral Agency's actual Restructuring Bank Region under management shareholding (percent) period, years AvtoVAZbank Samara August 31, 1999 88.1 3 Investbank Kaliningrad November 10, 1999 85.2 3 Rossiyskiy Kredit Moscow October 18, 1999 25 percent + 1 share (+50 percent in trust) 3 Regional project in Kemerovo Kemerovo a) Kuzbassugolbank September 21, 1999 90.9 3 (core bank) b) Kuzbassprombank, c) Kuzbassocbank, and January 31, 2000 99 1.5 d) Kenmerovo Eurasia Izhevsk, November 23, 1999 75 3 Udmurtskaya Republic RNKB Moscow November 16,1999 46.1 2.5 Vyatka Kirov December 10, 1999 61 3 Peter the First Voronezh August 10, 1999 96.6 3 ChelyabComZemBank Chelyabinsk September 16, 1999 76.3 3 Bank Voronezh Voronezh January 27, 2000 99 1.5 Dalrybbank Vladivostok December 20, 1999 99 3 SBS-AGRO Moscow November 16, 1999 99.9 3 Amurpromstroybank Blagoveshensk March 29, 2000 99 3 Bashprombank Ufa July 21, 2000 99 3 Source: ARCO. 94 Restructuring the Russian Banking System * Availability of free funds for recapitalization of * Regional banks working primarily with small and banks in the private sector middle-size regional customers (depending on the * Further development of the legislative environment development of regional economies, there can be for bank operations, including tax laws 50-60 such banks) * Improvement in the risks of corporate and house- * Special-purpose banks and nonbanking credit insti- hold customers of the banks, including further devel- tutions with limited licenses (mortgage agencies, opment of bank supervision and introduction of a mutual funds, banking cooperative societies). private deposit insurance system. The first three groups are already in the market. The The process of bank consolidation is taking place fourth group may emerge as institutions capable of mobi- quickly, as a number of smaller regional banks are becom- lizing household savings. ing integrated in multiple-branch banks. The process of consolidation in the banking sphere will If a new system of deposit insurance is introduced, be driven primarily by the necessity to reduce costs and to new competitors may appear in the consumer banking increase the efficiency of banking operations. market that truly are capable of competing with the Savings Although no specific legal constraints impede the entry Bank of Russia. Nevertheless, it is likely that in the next five of foreign banks to the Russian banking system, the lack of to seven years Russian banking will be dominated by four transparency with respect to corporate clients of banks types of banks: continues to subdue foreign investment. Foreign banks are * Banks with state participation (possibly partly pri- entering the Russian banking market more often by estab- vatized, but still with a significant share of state cap- lishing subsidiary banks than by acquiring existing banks. ital) The main reasons for this are the high risks associated * Multiple-branch private banks (7 to 10 banks with with nontransparency of Russian banking institutions (hid- actively developing banking services and major cus- den losses, for example) and the poor quality of corporate tomers coming from export-oriented industries) governance. 95 Chapter 10 Evolution of the Banking Sector in Central Asia Tune Uyanik and Carlo Segni S oon after independence, the governments of Central Asia recognized that the transition to a mar- ket economy would require the supportive development of their banking and financial system, involving considerable capacity building in a sector that needed to be reestablished virtually from scratch. As a result, reform programs were designed and implemented throughout the 1990s, aimed at restructuring and modernizing the components of a financial system so as to create conditions for sustainable economic growth. Essentially, the reform programs took place in two and badly managed. Governments at this stage of the tran- phases. In the first phase, between 1993 and 1997, mone- sition did not demonstrate or possess the capacity, experi- tary stabilization-except for Tajikistan-became a prior- ence, and political will to restructure the system. Specialized ity. During this phase, governments also tried to implement state-owned banks were considered "too big to fail," and ambitious privatization programs in the small scale area their liquidation was perceived to be too expensive given and to develop a legal framework supporting a market tight domestic budgets. Between 1993 and 1996, most of economy. In the second phase, governments focused on the governments were forced to subsidize these banks with strengthening the banking system, developing financial budget resources, and the underlying problems in the finan- and legal infrastructure, and fiscal stabilization. cial sector were not addressed. Fundamental financial sec- tor reform, including the privatization of state banks and The First Phase capacity building in financial institutions, came more as During the first phase, the introduction of sovereign sporadic initiatives than as part of a comprehensive currencies was accompanied by restrictive monetary poli- approach. cies, to contain inflation. As a result, high interest rate Compared with other Commonwealth of Independent policies and formal and informal restrictions on convert- States (CIS) and former Soviet Union countries, banks in ibility were introduced and implemented. High interest Central Asia remained relatively small, undercapitalized, rates, low level of reserves, lack of liquidity, economic and and poorly governed, with underdeveloped technical and political instability, and devaluation continued throughout operational capacities. Most important, losses continued to 1995-96, together with consistent dollarization of the mount in their balance sheets. Enterprises struggled to ser- financial system and an outflow of funds. vice their debts, and banks, with large amounts of direct The banking sector, which was based on a two-tier sys- lending to loss-making state enterprises, simply rolled over tem, struggled during these years in all of the Central Asian the losses. economies. Specialized banks, mostly state-owned, domi- Moreover, financial misinformation became a major nated the assets and liabilities side, and banks were fragile problem. Inadequate accounting, poor supervision, and 97 lJvanik and Segni insufficient information disclosure within the enterprise local currencies, which remained relatively stable until the and banking sectors, all contributed to the lack of trans- Russian financial crisis of 1998. In addition, at the end of parency of the participants in banking markets. Only in late 1997 real gross domestic product (GDP) began to grow in 1995-1996, when some improvement in transparency had the region (see figure 10.1) taken place did the extent of the deterioration of the bank- The improved economic environment and legal and ing systems became more apparent. technical infrastructure (including the enhanced capacities Governments, as part of this first phase, began the of central banks, the existence of laws and regulations on process of developing legal frameworks and modernizing bankruptcy and banking activities, and an improved finan- financial infrastructure, especially in the area of accounting, cial information framework) enabled the governments to auditing, and supervision. However, the process lacked address problem banks. Throughout the region, govern- coordination and enforcement. Many laws and regulations ments contemplated consolidation and rationalization of directly contradicted each other, and large loopholes exist- the banking system, primarily through (1) higher mini- ed on crucial issues, such as the responsibilities of managers mum capital requirements, to force weaker banks either to and shareholders in cases of insolvency or liquidation. exit the system or to merge with a sounder institution; (2) Similarly, clarity in defining banking activities was rare, a more comprehensive reconciliation of accounts, liquida- and there were few clearly stated obligations with respect to tion of bad assets, and institution of mechanisms for recov- property rights, capital requirements, insolvency, liquida- ering assets, collecting bad loans, and facilitating mergers tion, reporting requirements, and accounting standards. and forced bankruptcies; and (3) introduction of prudential In parallel, governments tried to address the lack of regulations in line with international standards, including information flows throughout the system and the inade- capital adequacy, loan classifications, and provisioning quate supervision and monitoring capacity of the central and liquidity requirements. banks. Accounting reforms were initiated to get national Enforced and supported by improved supervision and accounting closer to international standards. The account- tighter prudential regulations, banking consolidation ing reforms moved slowly in this first phase, especially in achieved some notable results, especially in ensuring and the area of implementation and enforcement. The supervi- improving the overall soundness of the commercial bank- sion and accounting departments of central banks were ing system. The specialized -still dominant in Central developed and strengthened relatively faster. The avail- Asian banking systems-were partially restructured or liq- ability of a legal framework supporting central banks' uidated, but their consolidation was limited. instituticnal role and activities, and their new role within Moreover, the lack of strategy and delays in imple- the framework of market mechanisms, set the pace and mentation, as well as corruption and lack of political will challenged governments to expedite their development. of governments, limited the outcomes of the consolida- New accounting systems required new technical and ana- tion and rationalization efforts. To sum up, consolidation lytical skills, together with the modernization and automa- and rationalization could have been significantly improved tion of data collection and statistics. Central banks largely if some of the following conditions had been met: met this challenge, improving their supervision, monitoring, * Bank consolidation and rationalization should have resolution, and regulation capacities. Improved confidence involved a comprehensive restructuring of the sector in the central banks' capacity to manage financial flows and leading to the privatization of healthy and systemic monetary bases allowed governments to initiate reforms of banks and liquidation of all others. the payment system. Even with major delays due to inex- * Foreign strategic investors should have been invited perience and lack of financial resources, governments start- to take part in the privatization of large state-owned ed to reform the payment system during the early stages of banks. the 1990s. * The consolidation and restructuring of the banking systems should have been addressed in parallel with The Second Phase enterprise sector restructuring. The combination of improved monetary policies, struc- * Governments only dealt with portions of the bad tural and institutional reforms, and improved fiscal disci- debts and with banks in crisis or severe distress, pline eventually brought economic stability to the Central without adequately addressing issues such as poor Asia region by the mid-1990s. Inflation was contained and management and governance. dropped from hyperinflationary levels in 1993 to around * In a few cases, central banks intervened directly in 15-20 percent in 1997-98, slowing the devaluation of bank restructuring, taking direct financial exposure 98 Evolution of the Banking Sector in Central Asia FIGURE 10.1 REAL GOP IN CENTRAL AMERICAN COUNTRIES, 1992-99 Real GDP Real GDP (annual percent change) (annual percent change) 1992 1993 1994 1995 1996 1997 1998 1999 1992 1993 1994 1995 1996 1997 1998 1999 20 15 15 - ,10 -_- -15 -30 5 -5~~~~~~~~~~~~~~~~~~ -5- -/ -15- -10- /-2 -25- -15- 3 -20 -35 ------ Turkmenistan ------ Kazakhstan - - - Uzbekistan - - - Kyrgyz Republic - CSI Tajikistan Countries 1992 1993 1994 1995 1996 1997 1998 1999 Kazakhstan -5.3% -9.2% -12.6% -8.2% 0.5% 1.7% -2.5% 1.7% Krygyz Rep. -13.9% -15.5% -20.1% -5.4% 7.1% 9.9% 2.3% 2.2% Tajikistan -28.9% -11.1% -21.4% -12.5% -4.4% 1.7% 5.3% 3.7% Turkmenistan -5.3% -10.0% -17.3% -7.2% -6.7% -11.3% 5.0% 16.0% Uzbekistan -11.1% -2.3% -4.2% -0.9% 1.6% 2.4% 4.4% 4.1% CSI -8.8% -3.8% -2.9% 1.7% 1.6% 2.3% 1.8% 1.4% Source: World Economic Outlook WEO, April 2000. to these banks, in the expectation that the cost of remained relatively stable throughout the period under restructuring would be paid by the budget. In this analysis. way, the deterioration of central banks' financial Further consolidation and rationalization still are need- situation increased the risk of systemic liquidity cri- ed to address overall soundness and to restore confidence sis and hyperinflation. in the remaining banks. Much more needs to be done to The consolidation efforts succeeded in reducing the strengthen the infrastructure of the financial system. The number of both public and private banks in some of the pace of reforms in this area slowed during this second countries (see table 10.1). In 1994, for example, phase. Although central banks took the lead and fostered Kazakhstan had 184 banks, six of which were state-owned. further reform of the accounting and payment system, In 2000, only 48 Kazakh banks remained. In Tajikistan, the delays were experienced in strengthening the legal envi- number of banks decreased between 1997 to 2000, as 11 ronment and the judicial system and creating suitable debt- banks exited the system. In contrast, the number of banks recovery mechanisms. Moreover, the devaluation of local in the Kyrgyz Republic increased, despite the liquidation of currencies and the increase in inflationary pressures fol- three state-owned banks between 1995 and 1996. In lowing the Russian financial crisis of 1998 led to a further Uzbekistan and Turkmenistan, the number of banks deterioration in the quality of bank portfolios. 99 Uyanik and Segni TABLE 10.1. NUMBER OF LICENSED BANKS Country 1993 1994 1993 1996 1997 1998 1999 2000 Kazakhstan 204 184 130 101 81 71 55 48 Kyrgyz RepLiblic 20 18 18 18 20 23 23 22 Tajikistan 15 17 18 23 28 20 20 17 Turkmenistan* - - 67 68 67 13 13 13 Uzbekistan 21 29 31 29 30 33 35 35 -Not available. * In 1995, 56 agriculture cooperative banks were established as spin-off of Agroprom Bank. These institutions were eventually re- merged into Agroprom Bank in 1998. Source: EBRD Transition Report 2000. Country Experiences the development of the business environment and the Financial sector developments in the five countries rationalization and restructuring of the banking sector. that cornprise Central Asia are influenced by a number of Banking sector development relies heavily on the confi- general factors: (a) macroeconomic imbalance and uncer- dence of depositors and banks in the enforcement of the tainty; (b) weaknesses related to the legal and judicial sys- terms of the contract. A transparent and effective legal and tem, especially the enforcement of laws and regulations; (c) judicial framework that assures speedy, efficient, and inadequate banking supervision and regulation; (d) limited impartial settlement of claims is necessary to achieve this competition and credit market distortions due to govern- objective. Courts and judges in the region are sometimes ment sabsidies and guarantees, as well as the dominance of influenced by political or personal interests, and judges specialized banks, mostly state-owned and politically affil- lack adequate resources, training, and technical skills. iated private interest groups in the banking sector; and (e) This situation impedes the development of a healthy busi- the absence of uniform accounting, reporting, and auditing ness environment. standards and the existence of inefficient payment systems. In some Central Asian countries, the banking and cen- Before turning to the country-specific factors that influence tral bank laws and regulations do not create sufficient financial sector development, the general causes of banking incentives for bank owners and managers to abide by the fragility in these five countries are discussed. rules. Prudential banking legislation does not define clear Macroeconomic instability is reflected in high inflation, eligibility criteria for owners and top managers of banks; balance of payment difficulties, price and foreign exchange and adequate supervision and enforcement of strong fines controls, real exchange rate appreciation, and growing and criminal penalties for violations are lacking. subsidies and external borrowing. These create an ineffi- Governments have a role to play in creating the necessary cient price structure for goods, services, and factors of pro- institutions, mechanisms, and incentives for ensuring imple- duction, which distorts economic decisionmaking. Credit mentation of prudent banking practices and proper regu- decisions made on the basis of prices that later are realigned lation and monitoring of the banking system. However, in substantially have a negative effect on the solvency of most of these countries, this is a politically very sensitive financial institutions. In addition, in environments where issue. the exchangc rate is significantly overvalued or thcre is State-owned banks create incentivcs for fiscal and significant flight from domestic currency assets, the real- quasi-fiscal subsidization and undermine confidence in the ization of foreign exchange risks increases the share of system. Widespread state ownership and intervention in the nonperforming loans in bank portfolios. banking sector limit financial development and lead to Legal uncertainties, loopholes, and lack of regulatory unfair competition and higher spreads. State banks often harmonization undermine enforcement in Central Asia, are used to channel funds to favored groups and sectors. severely limiting the capacity of governments to address Political will is lacking to recognize losses in these banks, 100 Evolution of the Banking Sector in Central Asia and governments eventually cover them with capital from In the first years after independence, banking sector the state budget. As a result, almost 70 percent of loan port- assets were highly concentrated and extremely sensitive to folios of state-owned banks in the region are nonperform- external shocks, including the worldwide demand for oil ing or at least doubtful. This situation has led to capital ero- and mineral products as well as currency fluctuations. sion in state banks. Governance problems, corruption, and The economic downturn that followed-together with insider lending usually lead to the transfer of large funds to the drop in worldwide demand for oil products and severe a few companies or families, and in the event of a crisis, devaluation of the new Kazakh currency-exposed the governments typically have to assume the related losses and fragility of the Kazakh banking sector. Banks shouldered fiscal costs. the burden of this economic contraction, and losses from Although uniform charts of accounts have been devel- the real sector accumulated in bank balance sheets. By the oped in some of the countries under discussion, they are not end of 1995, 50 percent of total commercial loans-or 11 fully compatible with the international accounting stan- percent of GDP-were classified as either doubtful or dards (IAS), and related accounting standards for financial nonperforming, leading to the apparent insolvency of the reporting have not been developed. This situation does banking system. At this point, the authorities began to not guarantee provision of timely, accurate, and transpar- address this problem. ent information. As a result, the valuation and quality of Although accounting and financial disclosure stan- assets, recognition of income, calculation of capital ade- dards were deficient, the NBK began identifying nonviable quacy, exposure violations, assessment of risks, and man- banks and initiated liquidation procedures, starting the agement of asset liabilities often are subject to serious mis- process of consolidation and rationalization of the banking statements and misrepresentation. Thus, financial problems sector. NBK first began withdrawing licenses from banks, can be hidden from supervisors and stakeholders. If prop- most of which exited the system or merged (although banks erly complied with, standards based on IAS provide a basis were given five years to comply with the new prudential for accountability and transparency as well as under- regulations). NBK applied a case-by-case approach to four standability and comparability. Currently, the services of of the largest banks, wherein nonperforming assets were credit information bureaus or rating agencies are either evaluated and carved out from the balance sheets and then very limited or nonexistent in Central Asian countries. As transferred to special debt-recovery agencies. This ratio- a result, neither the banks nor other lenders or investors can nalization and consolidation program reduced the number readily access information such as credit histories, includ- of banks to 55 by the end of 1999 and then further to 48 ing the total indebtedness of potential borrowers. Thus, the by the end of 2000. Nonperforming assets remained above banks become more vulnerable to credit risk. 40 percent of total assets, or 11 percent of GDP, by the end The following is an examination of how these general of 1996. factors work with country-specific factors in each of the Despite this, the banking system remains highly con- five countries of Central Asia. centrated, and the quality and level of intermediation have not improved significantly. The five largest banks account Kazakhstan for 63 percent of total assets and 73 percent of total After independence in 1992, Kazakhstan went through deposits. Total deposits decreased as a percentage of GDP a difficult period of macroeconomic instability. From 1992 from 72 percent in 1996 to almost 9 percent in 1999. to 1995, inflation reached as much as 3,000 percent and Lending decreased from 64 percent of GDP in 1996 to 4 GDP declined 35 percent cumulatively. Authorities reacted percent in 1999. At the same time, the monetary unit to this difficult situation by adopting a comprehensive (Tenge) was devalued further. This had an adverse effect on market-based reform program and restructuring the finan- bank soundness, harmed operating margins, and accumu- cial sector. One of the goals of the restructuring program lated losses throughout the system. Gains from devaluation was to strengthen and rationalize the banking sector. In against hard currencies were recognized in the balance 1992 the banking system comprised the National Bank of sheets of banks, since almost 50 percent of banking assets Kazakhstan (NBK), five state-owned specialized banks, in 1999 were denominated in hard currency. However, and 72 commercial banks. By the end of 1994, there were doubts remain on the overall quality of these assets and the 179 privately owned banks. This rapid expansion was capacity of the real sector to service these debts. related mainly to the nature of intermediation, which ver- The next few years will be critical for banks in tically stratified banks along lines of specific production Kazakhstan. The banking sector has grown substantially, sectors and industrial conglomerates. and it appears that a supportive legal framework is in 101 Uyanik and Segni place, together with the basic technical infrastructure (for Historically, the banking system in the Kyrgyz example, payments system), and a modernized accounting Republic developed relatively early compared with the system is taking hold, albeit slowly. Moreover, the banking other Central Asian countries. After independence, the sector has demonstrated its resilience in recovering from the banking sector adopted the two-tier system, where spe- Russian financial crisis. Savings grew 54 percent in fiscal cialized banks were organized as affiliates to industry, run- 2000, with real interest rates at between 5 to 6 percent, ning limited banking services and providing funding to while inflation remained stable at around 10 percent. favored industrial sectors. At the same time, the absence of However, banks still struggle to diversify their investments. a banking culture, credit discipline, and a healthy business Portfolios remain concentrated in a few core industrial climate-as well as the economic difficulties due to the sectors, and the dollarization of investments is still increas- transition from a socialist to a market economy-encour- ing, which puts the banking system at risk of external aged the stripping of assets, which caused substantial loss- shocks. In addition, banks still need to build necessary es to bank portfolios. capacity in corporate governance, risk assessment, and liq- But the Kyrgyz authorities sought to move fast on uidity management. Operating expenses are high, earn- reforms. Between 1993 and 1996, a two-stage restruc- ings from basic intermediation are low, foreign exchange turing plan was implemented. In the first stage, bank risk is poorly managed, and the quality of loan portfolios supervision and licensing requirements were strength- continues to deteriorate. ened, while minimum capital requirements were To deal with the current situation, the NBK needs to increased. As a result, a few small banks had to exit the pursue policies that will result in further consolidation system or merge, and the number of new, nonqualified through liquidation and mergers. Fewer more financially entrants was substantially reduced. In the second stage, stable banks would increase competition, efficiency, and the authorities introduced IAS-based accounting and product innovation, and as a result, confidence in the sys- addressed insolvency of the largest banks on a case-by- tem likely would rise. This would cause domestic and for- case basis. The Savings Bank and the Promstroi Bank eign investors to channel more resources through the bank- were closed and liquidated. Other problem banks were ing system. The NBK also should continue to improve quickly restructured or merged. The reform was quite monitoring and supervision as well as improve the disclo- successful: by the end of 1997, the banking system was sure of financial information by adopting better accounting essentially in compliance with new capital requirements, standards. In this regard, the NBK does not yet have access and aggregate nonperforming assets decreased from 75 to consolidated financial data that include the activities of percent (in 1994) to 7 percent. bank af-filiates. To further improve the financial condition of the sys- Finally, the government and the NBK should focus on tem, the authorities also decided to create a special bank, the development of alternative forms of investment for Kairat Bank, fully owned by the National Bank of Kyrgyz banks and other financial institutions. Kazakhstan has an Republic (NBKR), which acquired the assets and liabili- operating stock exchange, which attracts funds for for- ties of the two state-owned banks that had been liquidat- eign exchange transactions (60 percent), treasury securities ed. At the same time, in 1996, the authorities established and euionotes (37 percent), and corporate securities (3 an asset resolution agency, DEBRA. This institution per- percent). The basic legal framework is in place, as is a forms the debt collection function for insolvent banks moderr supporting technical infrastructure. However, and receives their assets. Its creation coincided with the banks and pension funds-the main operators on the mar- development and initial implementation of the govern- ket-struggle to find alternative longer-term investments. ment's comprehensive consolidation and rationalization program. This strategy involved building the capacity of Kyrgyz Republic the NBKR and continuing to consolidate the banking With total assets estimated around $60 million, or 4.9 sector. percent of GDP at the end of 2000, the formal banking In the meantime, the NBKR and the minister of finance sector in the Kyrgyz Republic is still small, weak, and used government securities and central bank notes to sus- struggling to develop both a commercial and a public tain troubled banks. Despite the effort, the financial con- institutional infrastructure. The main problems are the dition of the system further deteriorated in the wake of the quality of bank assets, the lack of liquidity and capacity, Russian financial crisis of 1998. The local currency (sum) and a weak legal and institutional infrastructure support- was devalued significantly, losing almost S5 percent of its ing banking activity. value within one year. The largest industrial conglomerate 102 Evolution of the Banking Sector in Central Asia in the country-Kyrgyz Gas Munaizat-was declared * Reform of the judiciary system and development of bankrupt, and the insolvency of its affiliated banks revealed the existing legal framework the gaps in institutional capacity, corporate governance, * Tightening and enforcement of banking regulations, banking supervision, auditing, and the legal environment. closure of insolvent banks and recognition of fiscal Between 1998 and 1999, three of the largest banks in the costs through the DEBRA country collapsed, and the banking sector lost the confi- * Strengthening of the technical capacity of the NBKR dence of investors and depositors. Following devaluation, so it can improve supervisory and monitoring func- bank capital declined 54 percent between 1998 and 2000 tions in U.S. dollars. Depositors also withdrew funds from - Development of responsible corporate governance banks, reducing total deposits approximately 35 percent in and technical capacity within banks nominal terms. In the aggregate, the level of deposits * Upgrading of banking infrastructure, including the decreased from 70 percent of GDP before the Russian cri- payment system sis to almost 10 percent in 1999. * Further movement toward an IAS-based system. Despite these stark losses of funding resources, banks managed to improve profitability. Because assets were Tajikistan denominated largely in hard currency, the devaluation of Tajikistan has an embryonic financial system. The the sum (together with the sharp decrease in deposits) dras- banking sector, which is the main component of the finan- tically raised interest margins. Yet extensive dollarization of cial system, does not yet perform basic intermediation the system increased the debt-servicing obligations of the functions. Household deposits account for only 2 percent economy. Banks continued reflecting gains from devalua- of GDP compared with an estimated household savings tion in their balance sheets, although the overall quality of ratio of 7 percent of GDP. On the other side of the balance their investment portfolios deteriorated further. Losses con- sheet, banks have been performing very limited lending tinued to mount, since the real sector did not have the nec- activities, as total loans accounted for only 10 percent of essary liquidity for debt repayment. This situation contin- GDP at the end of 1999. ued throughout the end of 1999, when the currency finally The reason for the low level of intermediation is the stabilized, and inflation decreased from 37 to 10 percent in extremely low public confidence in the banking system fiscal 2000. and political turmoil, which have fueled the informal sec- Problem loans place a heavy burden on the financial tor and depressed the demand for financial services from system in the Kyrgyz Republic. Bank assets are invested in the private sector. Despite the low level of intermediation, state-owned entities. In addition, mismanagement, ineffi- however, progress has been made since independence. Prior ciency, and economic instability contribute to the erosion of to 1992, the National Bank of Tajikistan (NBT) was the financial condition of the banking sector. As a result, responsible for allocating resources to the economy through most of the existing 22 banks are having liquidity or sol- five specialized banks, directed toward the main econom- vency problems. The liquidity crises in the Kyrgyz Republic ic sectors of the country. appeared even more critical after the latest increase in cap- Banking regulations were first introduced in 1991, ital requirements by the NBKR, in August 2000. As of then revised in 1995 and 1998. At the beginning of 1998, July 2001, only two banks fully complied with the new the number of banks operating in the country grew to 28, requirements. most of them "pocket banks." The five largest banks sur- Judicial reform is needed as well as improvement of the vived the transition and took the lead in the banking sec- legal framework for the financial sector. Legally, enforce- tor, with 76 percent of loans and 97 percent of deposits. ment capacity is very weak, and creditor rights clearly are In the meantime, four of the five state-owned banks were not enforceable. Furthermore, prosecution is heavily influ- privatized in 1998, following a restructuring plan stipu- enced by personal and political interests, making corrup- lated between the government and the NBT. The plan pro- tion rampant. In this environment, the supervision and hibited the NBT from further financing banks with direct regulatory authority of the NBKR is weakened. There are lending. cases in which the NBKR has revoked banking licenses, and The agreement also focused on reorganization of the banks have continued to operate by the consent of the NBT's Banking Supervision Department, modernization courts. of the legal framework supporting banking activities, and Thus, a strong commitment to a comprehensive reform consolidation and rationalization of the banking sector strategy is necessary, with the highest priority being: through increases in minimum capital requirements. 103 Uyanik and Segni Thus, the banking system has remained relatively weak result, tight exchange controls were adopted, together with and concentrated. Progress has been made in consolidation, import/export restrictions, making the soum practically with the number of banks falling from 28 to 17 at the nonconvertible by the end of 1995. Inflation stabilized at beginning of 2000. Minimum capital requirements had about 30-40 percent on an annual basis, but in 1996 the been increased early in year 2000, but the most serious monetary aggregates expanded once again. Bank financing problems remain the general lack of compliance and the from the budget, broad money, and credit to industry poor quality of the loan portfolios, which have continued increased substantially. At this point, in conjunction with a to worsen in the past two years. During the year 2000, the collapse in worldwide prices, the authorities were forced to NBT again began to finance the banking sector. As a result, tighten monetary policy again in an attempt to stabilize the government guarantees and NBT direct lending facility economy. provide for some 50 percent of the funding mix of banks. Tight monetary policy continued until mid-2000. The Moreover, the banking sector remains highly concen- government, in an attempt to control inflation and finan- trated, with the four largest banks accounting for 84 per- cial flows, monopolized intermediation. It provided subsi- cent of total assets, 80 percent of total loans, and 95 per- dies through the commercial banking system by issuing cent of total deposits. In addition, the economy is becoming state guarantees to back the credit exposure of banks. At increasingly dollarized. Deposits in hard currencies are 2.2 the end of 2000, the state guaranteed the majority of all times deposits in local currency, exposing the financial sec- banking loans. tor to serious foreign exchange risks. These policies had detrimental effects, as some banks From the banking infrastructure point of view, failed to develop the necessary operational skills because of Tajikistan has progressed in developing the legal frame- the noncompetitive business environment created by the work, even though much more needs to be done to fully government's policy of continuing to guarantcc risks. As a implement and harmonize it (most of the laws governing result, the financial condition and institutional capacity of banking activities contradict other laws and regulations). the banking system have not improved. The payment system is still based on cash, although it is rel- Six state-owned banks account for approximately 96 atively efficient due to the extensive branch network of percent of all bank credit. Total loans represent approxi- banks. The accounting reform, which began in 1998, is mately 66 percent of total banking assets, or 20 percent of progressing slowly. The conversion to IAS-based account- GDP. Total deposits of the banking system stand at only 10 ing was initiated in early 1999, and is almost complete, but percent of GDP. Out of these six banks, one in particular- banks lack the necessary technical skills to make the switch the National Bank of Uzbekistan-dominates, with over 60 complete. Finally, the NBT needs to further strengthen and percent of total assets. update its own technical capacity and enforce full compli- The government is currently moving ahead in restruc- ance wi th minimum capital requirements. turing and rationalizing the banking sector and in trying to liberalize financial flows throughout the system. During Uzbekistan spring 2000, the Cabinet of Ministers issued a number of With a sizable banking sector, compared with the other resolutions addressing the need to initiate a comprehen- countries of the region (total assets equaling $4.3 billion, or sive privatization program. The program will include the 25 percent of GDP, at the end of 1999), Uzbekistan began creation of a centralized collection mechanism, which implementing modern financial sector reforms later than will permit the restructuring of the nonperforming loan the other countries of Central Asia. The main reason for portfolios of these banks and the resolution of the issues this delay was the monetary policy pursued by the author- related to the outstanding government guarantees ities throughout the 1990s. attached to these loans. The authorities also will address In 1994, the monetary authorities introduced the the full convertibility of the soum. In May 2000, the offi- soum, the new national currency, and in 1995 and 1996, cial rate was fixed to incorporate a depreciation of 57 per- the government adopted the law on foreign investments cent, and a few commercial banks were authorized to and the first banking law. The expansive monetary policies open exchange bureaus and apply a floating rate based on that followed the introduction of the new currency-aimed market rates. at stimilalating economic growth-had the side effect of In the near future and to restructure the banking sec- increasing inflation. The monetary authorities then decid- tor further, the authorities will have to revisit their financial ed to give priority to the stabilization of monetary aggre- sector reform strategy and address some urgent and impor- gates, and immediately sterilized capital inflows. As a tant issues: 104 Evolution of the Banking Sector in Central Asia * Further strengthening banking supervision and mon- standards, in accordance with IAS, are now implemented itoring for most of the major banks in the country, and further * Initiating comprehensive classification and assess- implementation will take place in 2001. New regulations ment of loans and evaluation of the financial posi- on loan classification and provisioning were introduced in tion of banks 1999. At the same time, minimum capital requirements * Establishing executive loan recovery mechanisms were increased, together with new limits on maximum * Building capacity within the banking system and exposure to single borrowers and shareholders. These were stratifying and fragmenting the commercial banks the first steps toward a comprehensive bank rationalization * Accelerating the reform of national accounting stan- process. In addition, on-site supervision capacity was dards, initiated in 1997, to meet full compliance improved, and the collection of information within the with IAS. central bank was automated and centralized. Despite these efforts, the quality of loan portfolios is doubtful and diffi- Turkmenistan cult to evaluate. Turkmenistan has been slow to modernize and devel- Progress has been achieved in the development of legal op its financial system, mainly due to the difficult eco- infrastructure, including the strengthening of banking laws nomic situation following independence in 1991. The dis- and regulations. The first banking law was adopted in ruption in oil and gas exports, poor harvests, and weak 1993, and bank supervision regulations were brought more economic management led to a fall in GDP between 1992 in line with international standards in 1995. Bank for and 1997 of about 50 percent in comparison with other International Settlements capital adequacy was enacted in CIS countries. The discontinuation of gas exports to 1997, but compliance has remained poor. There are signs Ukraine in 1997 had an adverse effect on the economy at of excessive restrictions on trade, such as registrations, the beginning of 1999, but the economy has started to licensing, and continuous government interference in the grow again, fueled by an increase in agricultural output and private sector through a proliferation of government agen- energy exports. cies. As a result, the banking sector remains small, and In 1993 a two-tier banking system was created, togeth- access to financing by the real sector is limited. er with the introduction of the new currency, the Manat, The central bank is currently developing a system of and the foreign exchange law. Against this background automated and computerized payments, although there and improving economic conditions more generally, the continues to be significant use of non-cash transactions government initiated a comprehensive process of bank between enterprises. The foreign exchange regime is high- restructuring and consolidation. The number of banks ly distorted. In 1998, the interbank currency market was decreased from 22 to 15 in 1998 and to 13 in 1999. The closed, and, currently, participation in foreign exchange government still controls most of the banking system, with auctions is carefully screened and restricted. Moreover, seven state-owned banks controlling almost 95 percent of new restrictions banning citizens from holding foreign all commercial bank loans in local currencies and almost all bank accounts were introduced in 2000. of the loans extended in hard currencies. Financial information disclosure is still deficient and Consolidation was achieved by paying off sharehold- inaccurate, and international auditors have yet to audit the ers (other than government or public entities), by netting banks, largely because accounting reform is still under way. shares with outstanding loans or tax obligations, and by engineering mergers, liquidations, and closures. Conclusions The bulk of bank lending takes the form of channeling It is important that governments in Central Asia make directed credits and foreign loans to designated and affili- the development of comprehensive financial sector reform ated state enterprises, mostly in the cotton and oil sectors. strategies a high priority in order to foster further eco- The previous banking structure has survived, and the state nomic and private sector development. Specific emphasis still uses banks as channels through which to subsidize the should be given to: economy from the Central Bank of Turkmenistan (CBT). * Improving information disclosure Moreover, most credits to industry currently are collater- * Implementing accounting reforms alized with sovereign debt or guarantees. * Enhancing and developing the capacity of lower courts The CBT initiated the development of its bank super- * Strengthening the capacity of supervisory and regu- vision capacity early in the 1990s, but only quite recently latory agencies (central banks, ministries of justice, has modern bank accounting been introduced. Accounting higher courts, and specialized commissions). 105 UJyanik ind Segni Adclitionally, priorities should include liberalizing and attention and controls should be dedicated to interbank stabilizing economies, clarifying the role of state banks lending, blanket guarantees, and provisioning. within the economy, and limiting public intervention in the Proper assessment of the overall soundness of the economy, while at the same time strengthening banking banking and financial system is critical. Banking assets are supervision. As a first step in this direction, the authorities generally of doubtful quality, liquidity is scarce, and the risk should assess on an individual basis the strengths and of capital flight and runs by depositors is increasing. weaknesses of their banking systems, develop medium- Authorities should focus their efforts on improving the term strategies, and set intermediate objectives and targets overall creditworthiness of the system. Bankruptcy laws to achieve effective long-term and sustainable growth and need to be tailored, taking into consideration the scarcity of development. Efficient banking sectors need to respond financial resources and financial information, the quality of effectively and quickly to the needs of the real sectors, accounting and financial reporting, and the relative lack of which are in a constant state of evolution. As a result, experience in financial analysis. Many of these issues need reform strategies should reflect the need for flexible inter- to be addressed simultaneously by legislators and supervi- mediate objectives. sory authorities, considering that transparency and sound- Governments are responsible for creating an environ- ness carry social implications. ment that can foster sustainable financial sector develop- Another issue to be addressed is the role of savings ment. While improved government policies can reduce banks, which have large branch networks and protected shocks to the economy and banking system, banks also monopolistic positions in providing banking and quasi- can protect themselves by improving the management of fiscal services. If not properly carried out, the privatization risk to limit exposure and by strengthening their capital of these banks could have very negative social and fiscal base. The legal and judicial environment must encourage implications due to conflicting interests, which arise in act- proper behavior of bank managers and owners, market ing as transfer agent of government funds for pension and participants, and supervisors by providing proper incen- other budgetary payments, performing fiscal collections tives and penalties. Strengthening the legal and judicial as agent for the government, and usually being the main framework for debt collection and contract enforcement is holder of household deposits. Sufficient assurance for the essential to increasing the number of creditworthy clients uninterrupted delivery of these services should be put in for banks. place through alternative methods prior to privatization. A Governments also should create the necessary institu- detailed strategy should identify options (such as the cre- tions, rrechanisms, and incentives for ensuring implemen- ation of postal banks), which could supplement or substi- tation c,f prudent banking practices and proper regulation tute delivery of these services or functions prior to com- and monitoring of the banking system. Government inter- pletion of the privatization process. If privatization is ference in the banking system should not go beyond these concluded before ensuring the continued delivery of basic objectives. It also is important to ensure independence and banking and quasi-fiscal services, the conservation of exist- autonomy of central banks and courts from political and ing capacity (branch network) should be guaranteed prior private interests. These authorities need enhanced capaci- to transferring ownership. In parallel with these banking ty and credibility within the banking sector in order to deal sector issues, governments also should promote greater with hcluidation and privatization of weak financial insti- diversification in the financial markets, through deepening tutions. Bailouts or recapitalization of ailing banks by state the government and corporate bond markets. In this con- subsidies reinforces wrong behavior and moral hazard of text, reforming and strengthening the insurance and pen- owners and managers. Major bank creditors also should sion systems have an important role to play in increasing participate in enforcing effective market discipline. More the availability of long-term funds. 106 Part IV Capital Markets: Ready to Take Off or Stalled in Flight? Chapter 11 Stock Markets in Transition Economies Stijn Claessens, Simeon Djankov, and Daniela Klingebiel W V X r ell-developed stock markets provide many benefits (see Levine 1997 for a survey). They enhance economic performance by enabling growing companies to raise capital at lower costs. Because these companies do not have to rely as much on internal financing, they are able to grow faster. Stock markets also have advantages over other sources of financing. Companies in countries with developed equity markets are less dependent on bank financing, which can reduce the risk of a credit crunch. Equity markets also allow companies to rely more on equity and less on debt, creating a less risky financial structure in the event of an economic downturn. Finally, stock markets can increase the efficiency of The first stock market in transition economies emerged corporations' investment and management by enhancing in the Czech and Slovak Republics in 1992; Bulgaria, their governance. Overall, a mix of bank-intermediated Lithuania, FYR Macedonia, Moldova, and Romania fol- funds and stock markets can enhance growth (Demirgiuc- lowed soon after (table 11. I). 'fhe basic feature of this first Kunt and Maksimovic 1998). group of markets was the transfer among investors of own- Stock markets are not new in transition economies- ership rights to mass-privatized companies. At first these the Warsaw Stock Exchange was opened in 1817, and markets listed a large number of stocks, many of which were the Prague Stock Exchange was established in 1871- illiquid. But once the markets became more established, although all stock markets were closed under socialism. through transactions at stock exchanges, the number of During the transition from plan to market, stock stockholders fell, and ownership became more concentrated.' exchanges reemerged or were created in 20 of 26 transition A second type of market-developed in Croatia, Estonia, economies. These exchanges are used mainly for the Hungary, Latvia, Potand, and Slovenia-started with a small mandatory listing of shares of mass-privatized companies number of stocks, all of which were offered in traditional and for voluntary initial public offerings (IPOs). ways using IPOs. Many stocks had fairly liquid trading. 1. Claessens and Djankov (1999) find that this was the case in the Czech Republic, and similar patterns occurred in most countries that adopted mass privatization. However, Earle and Telegdv (1998) find little evidence of ownership concentration on the Rasdaq in Romania. Recent studies argue that foreign investors misunderstood the mass privatization of markets and poured in money only to discover that disclosure requirements were weak and that they did not have much legal recourse because the regulatory framework was not developed (Black, Kraakman, and Tarassova forthcoming). In some countries these foreign portfolio flows seem to have slowed the concentration of ownership. 109 CI lac sselb tD s an, .)i nk and K Ii n ge 1hi c TABLE 11.1 ORIGINS OF STOCK MARKETS IN TRANSITION ECONOMIES Mandatory listing Voluntary iiritial Mandatory listing of minority after mass privatization puiblic offerings packages during privatization Bulgaria Croatia Armeinia Czcch Republic Estonia Azcrbaijan FYR Macedonia Hungary Kazakhstan Lithuania l atvia Kyrgyz Republic Moldova lPolanda Poland& lRomaniia Slovcnia Russia Slov.ak Republic Ukraine Uzbekistan a1. Polaild also hLid 111il.r iistiiigs of Inalt-privati7zcd coniponies atd National ltivestment Fuids after 1996. See Hashi (200C) for a ldetailcd dleCrCipt1on of the prograni. S'ource: Con piled by thc autbors. A third group of stock markcts set up in scven transition regulator or supervisory body was not even established, as econornies-Armeria, Azerbaijan, Kazakhstan, the Kyrgyz in the Czech Republic. Most companies in these markets Republic, the Russiani Federation (Russia), Ukraine, and were not natural candidates for raising capital through Uzbekistart--straddled these two types. All these countries stock markets and did not see much purpose in being list- had mass privatization programs, but the initial exchange of ed. For example, in 1999 the median company on the voucher shares took place off the stock exchanges. Although Sofia (Bulgaria) Stock Exchange in terms of market capi- some of the companies in the privatization programs were talization, a textile company, had annual revenues of $4 publicly listed, SUChI listings were not mandatory for all corn- million, and the largest owner controlled 64 percent of panies. In several countries (Kazakhstan, the Kyrgyz the shares. Given its small size and concentrated ownership Republic), the plan was to develop the privatization program structure, it seems unlikely that the company would have and the stock market in parallel. To that end, during priva- been willing to list in the first place, float more equity, or tization the stock market was built around public offerings raise new capital from equity offcrings. of companies whose majority ownership was sold to strate- As a result, starting with the Czech Republic in 1996, gic invcstors. The governmeint then floated a small percent- Bulgaria, Lithuania, and the Slovak Republic in 1999, and age of the listed shares on the market, creating broader Bulgaria in 1998, the number of listed companies fell in the ownerslhip. Finally, six transition economies-Albania, first group as illiquid stocks were delisted (figure 11.1; table BelarLus, Bosnia and Hcrzcgovina, Georgia, Tajikistan, anld I1.Ai). Several other factors also explain the decision of TIurk-menistan-have not established stock markets. corporations not to trade publicly and to delist. First, by list- ing on stock markets, corporations were less likely to be able Features of Stock Markets in Transition Economies to avoid paying taxes. Second, the cost of external capital Because markcts in thic first group were designed to was quite high relative to the cost of bank credit. This was facilitate a rapid tranisformation of ownership, the regula- especially the case in countries where large firms could tory framework was intentionially left light. And because lobby politicians for directed credit. Finally, the extensive r egulators in mass-privatized markets had to oversee many disclosure requirements of listed companies made it harder companies, enforcemeut was limiited. Sometimes a formal for corporations to conduct nonmarket-based transactions. 110 Stock Markets in Transition Economies FIGURE 11.1 NUMBER OF LISTED FIRMS IN TRANSITION ECONOMIES BY MARKET ORIGIN, 1994-2000 Number of Firms 700 +- Mass -EIPO 600- - Mixed 400/ 50C 200/ 100 _ 1994 1995 1996 1997 1998 1999 2000 Note: The mass privatization line represents the median number of publicly traded firms in Bulgaria, the Czech Republic, Lithuania, FYR Macedonia, Moldova, Romania, and the Slovak Republic. The IPO line tracks the median number of publicly traded firms in Croatia, Estonia, Hungary, Latvia, Poland, and Slovenia. The hybrid group includes Armenia, Azerbaijan, Kazakhstan, the Kyrgyz Republic, Russia, Ukraine, and Uzbekistan. Source: Stock exchange websites and information departments. In contrast, the IPO markets in the second group of Market Capitalization countries (such as Hungary and Poland) saw increases in the Countries with better fundamentals (a more stable number of listed companies, starting from a low base. In the macroeconomy, better laws and accounting rules, and third group of countries-as in the IPO markets-the num- stronger disclosure requirements) generally have larger ber of companies listed was significantly below that of mass stock markets as measured in market capitalization as a privatization markets but rose in the second half of the share of gross domestic product (GDP). Of the 20 stock 1990s. Here some corporations were sold directly to inter- markets in transition economies, only three-the Czech national investors, with the residual free float offered domes- Republic, Estonia, and Hungary-have ratios of capital- tically. Of the 45 percent free float offered to investors of the ization to GDP comparable to those of other emerging Polish oil refinery Polski Koncern Naftowi, for example, 30 markets (figure 11.2). Market capitalization is very low in percent was sold to international mutual funds and foreign- countries in the Commonwealth of Independent States managed domestic investment funds, while 15 percent was (CIS), with the exception of Russia (see table 11.A2). At an available on the market in tradable employee shares. average of 11 percent of GDP, market capitalization in 111 Claessens, Dj ankov, and Klingebiel FIGURE 11.2 MARKET CAPITALIZATION IN TRANSITION AND COMPARATOR ECONOMIES AS A PERCENTAGE OF GDP Uzbekistan FYR Macedonia Azerbaijan Armenia Romania Slovakia Kyrgyz Rep. Ukraine Moldova Kazakhstan Bulgaria Latvia Average Lithuania Slovenia Croatia Russian Fed. Poland Czech Rep. Hungary Estonia Turkey Korea, Rep. of Brazil Egypt Mexico Thailand Germany Average Portugal United States United Kingdom 4I _____ 0 20 40 60 80 100 120 140 160 180 Note: Data are for March 2000 for transition economies and December 1998 for comparator countries. Source: Stock exchange websites and information departments and author's calculations. 112 Stock Markets in Transition Economies transition economies is significantly lower than in compa- Foreign Financing rable emerging market economies. Many large, publicly listed companies in transition economies have sought equity financing abroad. At the Market Turnover end of 1999, 72 corporations from transition economies "Market turnover," defined as the value of trading had American depository receipts (ADRs) listed on the over market capitalization, is an important indicator for New York Stock Exchange or the Nasdaq, and 61 corpo- measuring the effect of stock markets on growth (Levine rations from transition economies were listed in London. and Zervos 1998). Among transition economies, market Corporations listed abroad (in New York, London, and turnover is highest in Hungary (93 percent), the Czech Frankfurt) account for an average of 18 percent of domes- Republic (81 percent), and Poland (69 percent; see figure tic stock market capitalization in transition economies and 11.3; table 11.A3). Most other transition markets are illiq- for almost two-thirds in Kazakhstan (figure 11.5). In uid, particularly in Central Asia-market turnover is less Estonia, Hungary, Latvia, and the Slovak Republic com- than 5 percent in Kazakhstan, the Kyrgyz Republic, and panies listed abroad account for about one-third of domes- Uzbekistan. tic market capitalization. Overall, markets in transition economies are less liq- On average, the value of the shares traded abroad is uid than their comparators in both developed and other almost half of the value traded on local markets, and the emerging markets. Only the most liquid markets in number of shares traded abroad is twice as high as the Central Europe compare favorably to Latin American number of shares traded locally. The turnover of Russian markets, where market turnover is about 50 percent. But depository receipts in Frankfurt, for example, was more these markets significantly trail those of developed coun- than twice as high in the first three quarters of 1999 as the tries. Market turnover is 167 percent in Germany, for turnover of the same instrument in Moscow (Creditanstalt example, and 127 percent in Portugal. On average, stock 1999). Incentives to list abroad are particularly strong in markets in transition economies have a turnover of 30 transition economies that have had trouble establishing percent, compared with 121 percent in 10 comparator credible frameworks for corporate governance (Black and countries. This lower market turnover can be attributed Gilson 1998). But the tendency to list and trade abroad has mostly to ownership concentration, a relatively limited not been limited to markets with weak minority rights: of free float, and the international migration of trading the 14 countries with good investor protection, 9 have among large firms. more than 20 percent of their stocks traded abroad. Stock markets in transition economies are dominated This offshore migration has been especially strong by a small number of firms. As a result, the concentration among big companies-for example, 7 of Russia's 10 of market turnover-defined as turnover of the top 5 per- largest listed stocks have depository receipt programs. cent of listed firms as a percentage of total turnover-is Many of the firms listed abroad are involved in resource high in most transition economies. Yet at an average of 75 extraction or telecommunications. But new, Internet-relat- percent, it is similar to that of other stock markets. At ed firms also are listing and raising capital abroad, espe- about 40 percent, Poland is the least concentrated market cially firms from the Czech Rcpublic and Hungary. The dis- in terms of turnover (figure 11.4). Armenia, Azerbaijan, appearance of big companies that trade only domestically Bulgaria, Kazakhstan, Latvia, FYR Macedonia, Moldova, -the average size of companies that are cross-listed or Romania, Ukraine, and Uzbekistan all have turnover con- that have depository receipts is 12 times that of companies centrations above 80 percent. listed only domestically-deprives local exchanges of liq- Although similar concentration levels are found in uidity, discouraging foreign investors from considering the Germany and the United Kingdom, a larger number of remaining stocks. Even large stock markets in transition firms account for the concentration. For example, on the economies are hurt by this development, because foreign London Stock Exchange 112 listed equities (5 percent of portfolio managers may avoid them in the belief that trad- 2,274) account for 85 percent of market turnover. In con- ing in these markets is not worth their research time and trast, five or fewer companies account for all of the mar- money. ket turnover in Azerbaijan, FYR Macedonia, and Uzbekistan and for more than 95 percent of the market Determinants of Stock Market Development in turnover in Armenia, Bulgaria, Kazakhstan, the Kyrgyz Transition Economies Republic, Lithuania, Moldova, Romania, Slovenia, and There is some empirical literature on what determines Ukraine. successful stock market development (see Levine and 113 Claessens, Djankov, and Klingebiel FIGURE 11.3 MARKET TURNOVER IN TRANSITION AND COMPARATOR ECONOMIES, MARCH 2000 Kyrgyz Rep. Kazakhstan Uzbekistan Bulgaria Croatia Lithuania Azerbaijan Armenia Latvia Ukraine Estonia Slovenia Slovakia Atverage FYR Macedonia Russian Fed. Romania Moldova Poland Czech Rep. Hlungary Mexico Egypt Brazil United Kingdom I'hailand Average Portugal United States Germany _ Turkey Korea, Rep. of _I 0 50 100 150 200 250 300 350 Source: Stock exchange websites and information departments and authors' calculations. 114 St,.ck Nia rkLt ii fa,jii iti ir i t Fi. ic i i?oic FIGURE 11.4 CONCENTRATION OF MARKET TURNOVER IN TRANSITION AND COMPARATOR ECONOMIES, MARCH 2000 (percentage of market turnover accounted for by the top 5 percent of listed companies) Poland Czech Rep. Croatia Hungary _ Slovak Rep. Slovenia Russian Fed. Lithuania Kyrgyz Rep. Estonia Average__ Latvia Ukraine - Moldova Romania Bulgaria Kazakhstan Armenia Uzbekistan FYR Macedonia Azerbaij an Korea, Rep. of Thailand Turkey Rio de Janeiro (Brazil) New York Stock Exchange Portugal Mexico Sio Paolo (Brazil) Average I Egypt _ I Nasdaq _ i U nit d Kgdo _ _ _ _ 30 40 50 60 70 8( 90 100 Source: Stock exchange websites and information departments and authors' calculations. 115 C kessen,, Di jnkov, and Kli igebicl FIGURE 11.5 MARKET CAPITALIZATION OF TRANSITION ECONOMY COMPANIES LISTED ABROAD, 1999 (percentage of domestic market capitalization) Kazakh stan Slovakia _ Estonia _ Latvia Hungary Czech Rep. _ Moldova _ Aveirage Poland Russian Fed. Croat'a Slovenia Romania Lithuania Bulgaria Ukraine Macedonia Kyrgyz Rep. Armenia 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 Source: Stock exchange websites and information departments and authors' calculations. Zervos 1998). The basics are clear: for any market to exist, Loayza, and Beck 2000). These rules include protection of there neec[s to be a demand and a supply for the product. minority rights, disclosure of the activities of corporations, In the context of stock markets, the product is the external and proper accounting rules and practices. equity financing of firms. Companies that do not have a The size of a market also will play a large role in sufficient low of retained earnings want to tap stock mar- determining its long-term viability. A small country will kets. The supply of funds typically comes from institu- have a hard time supporting a stock market because there tional investors like pension funds, investment funds, life will be a small number of firms suited for public listing, insurance companies, and mutual funds. the costs of running a stock market will be relatively But the professed demand and supply are not enough. high, and firms may find it cheaper to raise money Countries that experience high inflation are unlikely to see abroad. The desire of market participants for larger, more equity markets develop, because investors will not invest or liquid markets and lower transaction costs-including will keep their money in foreign assets (Boyd, Levine, and trading, clearing, and settlement systems-is illustrated by Smith forthcoming). Or, if the return on government secu- the recent cross-border mergers of large stock exchanges rities for bank deposits is higher than that on corporate (as with the integration of the London Stock Exchange, stocks and bonds, a stock market will not develop because the Deutsche Boerse, and the Nasdaq). This trend toward the supply goes elsewhere. In addition to favorable macro- market consolidation is aided by Internet technology, economic conditions, adequate regulations for listed cor- which makes it easier to link stock markets. In that porations and proper governance of institutional investors respect, the minimum size of a stock market has increased are needed to ensure proper intermediation (Levine, substantially. 116 Stick Markers in Transition Econ(omies To assess the potential for stock markets in transition companies, as stipulated in securities or company laws economies, it is important to understand what determines (Shleifer and Vishny 1997 and Glaeser, Johnson and Shleifer their current development. Their recent establishment plays 2001). Stock market development is more likely in countries a large role, but the development of stock markets in tran- with strong shareholder protection because investors do sition economies also depends on the degree of macroeco- not fear expropriation as much. Moreover, ownership in nomic stability, the evolution of securities and corporate such markets can be relatively dispersed, which provides liq- laws, and the assets accumulated by institutional investors uidity to the market. La Porta and others (1998) provide in each country. formal support for the importance of minority rights' pro- tection by using indicators of the quality of shareholder pro- Macroeconomic Stability tection as written in laws. They show that the quality of Only four of 26 transition economies-Croatia, the shareholder protection is correlated with the capitalization Czech Republic, the Slovak Republic, and Slovenia-aver- and liquidity of stock markets in 49 countries around the aged single-digit inflation during 1994-99, in contrast to world. Pistor (2000) extends the analysis by constructing most comparator emerging markets (except Brazil, Mexico, identical indexes for transition economies. The results of and Turkey). Several transition economies-Armenia, both studies are presented in table 11.2. Azerbaijan, Bulgaria, Ukraine, and Uzbekistan-had triple- The indicators of minority rights' protection show digit inflation over the period (see table 1 1.A4). Stock mar- that, starting from no legal basis whatsoever, many transi- ket development is difficult in a high-inflation environment. tion economies have made significant strides in improv- High inflation meant that during 1994-99 the real ing-at least on the books-the legal environment for return on stock market investments in transition economies investors. All but six transition economies (Azerbaijan, was often negative before adjusting for risk and was large- Croatia, the Kyrgyz Republic, FYR Macedonia, the Slovak ly negative on a risk-adjusted basis. Stock market returns Republic, and Ukraine) have better investor protection also compared unfavorably with those on bank deposits: laws than Egypt, Germany, Mexico, and Turkey. The rela- before adjusting for risk, only stock markets in Hungary, tively high scores for Eastern European countries are per- Russia, and Slovenia offered investors higher returns than haps not surprising because these countries have started bank deposits during 1994-99. On a risk-adjusted basis, harmonizing their stock market laws with those of the only two of 20 markets-Hungary (16 percent returns) and European Union. But the scores are surprising for the coun- Russia (42 percent)-likely outperformed bank deposits tries of the former Soviet Union.2 (this calculation does not take into account losses on bank These indicators of formal shareholder rights do not deposits due to bank failures). In Bulgaria, Croatia, the indicate how well these laws and regulations are enforced Czech Republic, Latvia, Lithuania, Romania, and the in transition economies. Slavova (2000) expands on the for- Slovak Republic, bank deposits yielded a positive, but low, mal laws by creating an index of effective shareholder pro- annual return of about 2 percent in real terms. In contrast, tection. Among transition economies, Hungary has the stock market investments in these countries yielded a neg- highest score of effective protection-71 percent of that in ative average annt]al return on a risk-unadjusted basis in the United States-followed by Poland, Estonia, and 1994-99. Especially in CIS countries, holding foreign cur- Bulgaria. The other transition economies fall far short in rency would have yielded the highest returns. For example, their enforcement. Armenia, Azerbaijan, and FYR in Kazakhstan and Ukraine holders of U.S. dollars saw the Macedonia have effective enforcement that is just over 20 worth of their holdings appreciatc 5 and 10 percent, respcc- perccnt of that in the United Statcs. Ineffective enforccmcnt tively, in real terms over 1994-99. of shareholder protection can be attributed largely to cor- ruption, a weak judicial system, and limited disclosure of Legal Framework information (Pistor, Raiser, and Gelfer 2000). For example, Another key determinant of stock market development Armenia has formal levels of shareholder protection simi- is the level of shareholder protection in publicly traded lar to those in the United States. Yet its ability to enforce 2. Pistor (2000) points out that 10 transition economies, including Armenia, Kazakhstan, the Kvrgyz Republic, Latvia, Moldova, Russia, Ukraine, and Uzbekistan, have received technical assistance from the U.S. Agency for International Development in draft- ing capital market legislation. This assistance has resulted in well-designed shareholder protection laws that borrow extensively from U.S. laws. 117 C Iaessens, D jairikov, a n d Kliingebiel TABLE 11.2 SHAREHOLDER PROTECTION IN TRANSITION AND COMPARATOR ECONOMIES, 1998 Country Shareholder protection ratinig Effectiveness of shareholder protection (U.S. 100) Armenia 5 21.2 Azerbai jan 2 25.2 13ulgaria 4 62.3 Croatia 2 44.7 Czech Rep. 3 51.4 Estonia 3 62.1 FYR Macedonia 2 23.7 Hungary 3 71.0 lKazakhstan 4 56.2 Kyrgyz Rep. 2 28.6 Latvia 3 49.7 Lithuania 3 52.9 Moldova 3 45.5 Poland 3 68.6 Roiiania 3 43.7 Russian Fed. 5 49.1 Slovak Rep. 2 56.5 Slovenia 3 39.8 Ukrainle 2 53.9 Uzbekistan 3 27.6 Brazil 3 Egypt 2 Gernianiy 2 1 1g Stock Markets in Transition Economies TABLE 11.2 (CONTINUED) Country Shareholder protection rating Effectiveness of shareholder protection (U.S. = 100) Korea, Rep. of 4 Mexico 1 Portugal 3 Thailand 3 Turkey 2 United Kingdom 5 United States 5 Note: The shareholder protection rating is a sum of the following indexes: proxy by mail is allowed (true = 1; false = 0); shares are not blocked before a shareholder meeting (true = 0.5; false = 0); there is no registration cutoff date before the meeting (true = 0.5; false = 0); cumulative voting for election of supervisory board is allowed (true = 0.5; false = 0); other rules to ensure proportional representation are in place (true = 0.5; false = 0); shareholders can take judicial recourse against decisions by executives (true = 0.5; false = 0); shareholders can take judicial recourse against decisions made at shareholder meetings (true = 0.5; false = 0); preemptive rights are allowed in the issuance of new shares (true = 1; false = 0); and shareholders representing 10 percent or less of the vote can demand the convocation of an extraordinary shareholder meeting (true = 1; false = 0). The shareholder protection rating can have a maximum value of 6. Effectiveness of shareholder protection is estimated based on structured interviews with securities and exchange commission officials in transition economies. EBRD consultants conducted the interviews in June 1998. Source: La Porta and others; Pistor (2000); Slavova (2000). compliance with these rules is only a fifth of that in the for an average of just 7 percent of GDP-much less than in United States-even though there are only four actively other emerging market economies. In only 3 of 20 countries traded companies in Armenia. (the Czech Republic, Hungary, and Poland) do institu- Even these indexes of effective enforcement may paint tional investors have assets averaging 18 percent of GDP, an overly rosy picture of investor protection in transition and even that is lower than in other countries with similar economies. While Russia scores as high as the United States per capita incomes (table 11.3). on legal protection of shareholders, and is only twice as bad There are three types of institutional investors. as the United States in securities law enforcement, basic Investment and mutual funds form the largest group in property rights stemming from company laws are often transition economies. Investment funds largely emerged neglected. Troika Dialog (1999) and Fox and Heller out of the mass privatization funds used to transfer own- (1999), in reports on corporate governance in Russia, doc- ership during privatization. The funds collected vouchers ument many cases of minority as well as majority share- from citizens and invested them in corporate securities. holder expropriation by incumbent managers or by local The mutual fund industry is still in its infancy in transition governments. While the disregard of investor rights is economies. Hungary is the region's leader: by early 2000 beyond the narrow scope of stock market enforcement, it mutual fund holdings accounted for 8.5 percent of GDP. is of primary importance in the provision of public and pri- Pension funds are another class of institutional vate funds to equity issuers. investors. Because funded pension schemes have yet to be established or were set up only recently in transition Institutional Investors economies, pension funds are insignificant in terms of the The developmcnt and particularly the liquidity of a size of assets under management. In only 4 of 20 countries stock market depend on the development of a class of do these funds amount to a few percentage points of GDP. well-governed institutional investors. Institutional investors In most transition economies assets in pension funds do not are small in transition economies, with assets accounting even amount to 1 percent of GDP. Hungary was the first 119 C.laessens, [Djankov, and Klingehiel TABLE 11.3 ASSETS HELD BY INSTITUTIONAL INVESTORS IN TRANSITION AND COMPARATOR ECONOMIES, 2000 (percentage of GDP) Investment and Pension Country mutual funds funds Insurance Total Armenia 4 0 0 4 Azerbaijan 0 0 0 0 Bulgaria 5 0 1 6 Croatia 2 0 2 4 Czech Rep. 8 2 9 19 Estonia 5 0 3 8 FYR Macedonia 4 0 0 4 Hungary 12 4 3 19 Kazakhstan 2 3 1 6 Kyrgyz Rep. 2 0 0 2 Latvia 5 0 1 6 Lithuania 6 0 0 6 Moldova 4 0 2 6 Poland 8 2 5 15 Romaria 8 0 0 8 Russian Fed. 2 1 1 4 Slovak Rep. 6 0 4 10 Slovenia 5 0 4 9 Ukraine 0 1 0 1 Uzbekisr-an 0 0 0 0 Brazil 16 10 1 27 Chile 5 40 13 58 Germany 28 13 32 73 120 Stock Markets in Transition Economies TABLE 11.3 (CONTINUED) Investment and Pension Country mutual funds funds Insurance Total Korea, Rep. of 20 2 16 38 Mexico 4 3 2 9 Portugal 21 11 10 42 Turkey 3 1 1 5 United Kingdom 60 101 89 250 United States 129 90 43 262 Note: Data are for June 2000 or most recent available period. Source: Authors' calculations based on OECD (1999); Mercer (2000); World Bank data. transition economy to introduce a funded occupational of stock market development and turnover in transition pension scheme (in 1993) and a defined contribution economies. We constructed time series for 1994-99 for scheme (in 1998). By March 2000 the assets of the defined market capitalization, market turnover, inflation, institu- contribution scheme amounted to 3 percent of GDP, and the tional assets, and minority shareholder protection. The assets of the occupational pension scheme accounted for 1 simple correlation coefficients among these variables sug- percent of GDP. A number of countries followed Hungary gest that market capitalization is positively correlated with in establishing defined contribution plans and funded occu- single-digit inflation, the size of institutional investor assets, pational pension schemes. By June 2000 Croatia, the Czech and high shareholder protection, and it is negatively cor- Republic, Kazakhstan, Poland, Russia, Slovenia, and related with triple-digit inflation and low shareholder pro- Ukraine had created defined contribution schemes, and tection. Market turnover is positively related to the size of Bulgaria, Estonia, Latvia, and FYR Macedonia will have institutional investor assets and is negatively related to established such a pillar by the end of 2001. triple-digit inflation and low shareholder protection. These The insurance industry in transition economies started correlation coefficients are all statistically significant at the developing only after 1996. Thus the assets of the third type 5 percent level. of institutional investors-insurance companies-are no These simple correlations do not control for other more than a few percentage points of GDP in most transi- explanatory variables, such as initial income and integra- tion economies.3 One exception is the Czech Republic, tion with more developed countries, proxied by geograph- where the insurance market is relatively well developed and ic location. To establish more formally the importance of is dominated by foreign players. Foreign players also dom- various factors in stock market development, we used inate the insurance sector in Hungary, where they account regression analysis while controlling for income (proxied by for more than 90 percent of assets. the log of GDP per capita) and distance from Europe (prox- ied by the log distance from Vienna). The ordinary least- The Importance of Each Factor squares regressions are shown in table 11.4.4 To show the relative importance of different factors in The analysis shows that low inflation, good share- stock market development, we analyzed the determinants holder protection, and the size of institutional investor 3. It is not always possible to distinguish between life and nonlife insurance, so these numbers overestimate the potential liquidity that insurance assets can inject into capital markets. 4. Between regressions (ordinary least-squares regressions on means) and random regressions show that the results for market cap- italization are robust to alternative specifications, while the association between market turnover and high shareholder protec- tion turns insignificant. As a robustness check, we repeated the regression analysis described in table 11.4, this time using data 121 Claessens, Diankov, and Klingebiel TABLE 11.4 DETERMINANTS OF MARKET CAPITALIZATION AND MARKET TURNOVER IN TRANSITION ECONOMIES, 1994-99 Market capitalization Market turnover Dependent variable (1) (2) (3) (1) (2) (3) Inflation < 10 percent a year 3.54* 3.15* 2.84* 9.24 4.56 5.65 (3.09) (2.58) (2.61) (2.07) (1.02) (1.20) Inflation 10-50 percent a year 0.33 0.29 0.05 10.47*i 9.90*- 8.92 i (0.42) (0.35) (0.12) (2.93) (2.67) (2.38) Inflation 50-100 percent a year -0.41 -0.34 -0.63 5.53 6.28 4.35 (0.52) (0.42) (0.76) (0.91) (1.04) (0.73) Medium shareholder protection 0.61 0.44 0.75 10.94* 12.84* 10.15* (0.92) (0.64) (1.17) (3.58) (3.94) (3.32) High shareholder protection 6.28 * 6.73 * 5.93 * 10.37 15.85-* 8.61 (3.69) (3.85) (3.49) (2.51) (2.21) (1.22) Institutional assets 0.64* 0.S7? 0.56: 3.07` 2.19:* 2.68 * (6.80) (5.31) (4.88) (5.07) (3.18) (4.01) Log distance from Vienna -0.62 -7.48 * (1.38) (2.72) Log GDI' per capita 0.82 4.21 (1.61) (1.61) Number of observations 156 156 156 156 156 156 Adjusted R2 0.61 0.61 0.61 0.41 0.44 0.42 * Statistically significant at the 5 percent level. Note: Standard errors are heteroskedastic-consistent. A constant term is included in every regression. Medium investor protection is defined as a Pistor (2000) score of 2 or 3. High investor protection is defined as a Pistor (2000) score of 4 or 5. TIhe t-statistics are in parentheses. Source: Authors' calculations. for the 26 transition economies as well as the 1O comparator countries. The six transition economies that do not have function- ing stock markets get a score of 0 for market capitalization and market turnover. Table 1 1A.5 shows that the importance of low inflation in explaining market capitalization doubles in comparison to the sample of transition economies only, shareholder pro- tection is no longer statistically significant, and the role of institutional investor assets declines slightly. In contrast, the importance of shareholder protection increases in the market turnover regressions, and the role of institutional investor assets decreases sig- nificar,tly (table 1 1A.5, col. 4). In both cases a country's per capita income is the most robust explanatory variable for both mar- ket capitalization and market turnover. 122 S -t %I j rl 1. c rs 1l1 I i :I11 su,-I t I 1. ,, loIII I assets are important in explaining market capitalization, should improve over time. Today few couintries hasve doLl- even after controlling for income or distance. The patter n Mle-digit inflatioin, and legal framieworks have imlprovedl is less clear for market turnover. The size of institutional coiisict rably, althouLgh mulXch remains to be dtone in improv- investor assets is positively associated with high turnover, ing enforcemiienit in most transition econolnlies. Experienices and this association is statistically significant. But the asso- in other emilerginig markets show I liat it takes considerable ciation between market turnover and inflation or share- timne and effort to protect minority righits. Relatively well- holder protection is not monotonic. As lonfg as iniflation is developed stock markets in East Asia, for e\xample, still not above 50 percent and shareholdcr rights are average or experieinced large expropriation of minlority sha.lrcholdlers ii high, market turnover increases. This is consistent with the late I 990s (Claessens and others 1 999). the findings of Boyd, Levine, and Smithi (2000) for othel- Market capitalization is lpositively correlated with equity markets. These regressions highlight the imnportance ratios of private credit to GDP in transition economiiies of mild inflation and institutiorial investor assets in enhanc- (figure 1 1.6). Low ratios of private credit to ("DP indciczltc ing the development of stock markets in transition that basic financial sector infrastructure is lacking in trail- economies. sition economies. Many transition economies have very The results in table 11.4 suggest that the underdevel- shallowv banking systems, with credit amouniting to le,s optnent of stock markets in transition economies can be than 10 percent of GDP. Because banking sy stems typical- traced to these countries' unstable macroeconomic envi- ly develop before stock markets, conntries should focus on ronment, weak minority shiarelholder rights, and limited dIeveloping the basic infrastructure-inivestor protection , asset base of institutional investors. Many of these factors contralct enforcement, sound accouliting standlairds--for FIGURE 11.6 PRIVATE CREDIT AND MARKET CAPITALIZATION IN TRANSITION ECONOMIES, 1994-99 (percent) 35 _ _ _ _ _ _ _ _ . . qJ 3o -------_-____-__ 204 - 15 _ ___. -___ a210 -____ _,__._-__.__ _ _ ___ _ _ .____ a~~~~~~~~~~~~~~~~ _2~~~~~~ ~ ~~~~~~~~~~ I ,. -* tt~~ ~~ ~ ~~~~~~~~~~~~ + + .- C,~~ ~ * * R," * *02') U~~~ *- 4 ** eg + + *~+ + 10 -_--- -, --- W--so-- , ----1 0 10l 20 ()4() 510 0( ( -5 _5 __ _ -_-*--- - _--4- _ ---__ --_ --_ _-- ___ _ __ Private Creclit to GDP Note: The sample is based on a panel set, 1994-99, totr 26 transition eot)ionlites Source: Authors' calculations. 12 Claesse- s, Diankov, anid Klingebiel both credit and equity markets. The benefits of focusing on equity investment could rise. Fewer restrictions also will the institutional framework are confirmed by a growing lit- allow institutional investors to diversify their portfolios erature stressing the importance of creditor rights in devel- by investing abroad. But this beneficial development will oping banking systems (La Porta and others 1998; Levine, reduce the resources available for domestic investment. Loayza, and Beck 2000; Rajan and Zingales, 1998). In Phasing out restrictions on foreign investment will be addition to macroeconomic instability and low per capita important; otherwise, countries will create a captive income, weak creditor rights are an important reason that investor base that may impede institutional development banking systems are underdeveloped in transition and result in inefficient resource allocation. economies. The better is the quality of creditor rights, the more developed is the banking system (figure 11.7). Thus, Prospects for Stock Markets in Transition Economies before considering equity markets, transition economies To investigate the potential for and economic viability should focus on improving and enforcing creditor rights to of stock markets in transition economies, we used the foster development of their banking system. This also is the regression analysis to simulate the future development of most effective way to foster the development of small and stock markets under different policy assumptions (for sim- medium-size enterprises, a key source of economic growth. ilar policy experiments, see Beck 2000 for Brazil and Levine Several transitioin economnies could foster funded pensioni 2000 for capital markets in Latin America). In particular, schemes to boost the demand for shares of listed securities. we simulated the market capitalization and market Yet under current policies, the projected assets of funded turnover that could materialize if policymakers achieve occupational pension funds will remain fairly small in most macroeconomic stability (as indicated by single-digit infla- transition economies. By 2005 assets are expected to be 10 tion), the highest score on shareholder rights, and the pro- percent of GDP in Kazakhstan, 8 percent in Hungary and jected accumulation of new pension fund assets (table Poland, 7 percent in the Czech Republic, 6 percent in 11.5). These represent best-case scenarios in which coun- Croatia, and 4 percent in Estonia, Latvia, and the Slovak tries achieve and maintain the highest scores on all three Republic. But not all of the increase in funds will flow to variables. stock markets, because regulations often limit the share of Such scenarios may not be realistic, however, and pro- assets that can be invested in stock markets. In Kazakhstan, jecting that all three best-case policies will materialize may for example, this share is just 10 percent. be overly optimistic for some transition economies. Indeed, Over time these restrictions will be phased out in coun- a number of countries have backtracked rather than pro- tries vying for European Union (EU) membership, and gressed. In Bulgaria, inflation increased in 1996 after an ini- tial stabilization. The Slovak Republic saw a deterioration in shareholder rights after 1996. And Croatia's parliament FIGURE 11.7 CREDITOR RIGHTS AND RATIO OF PRIVATE recently retracted a draft pension fund law after more than CREDIT TOGPIRNIINEOa year of deliberations. The simulation results also assume 30T___ that shareholder rights will remain well protected, at least on the books. 25 -- In the results presented in table 11.5, a country sees an increase in market capitalization only if it has not already achieved the highest scores for each variable. For example, Bulgaria already has single-digit inflation and a share- holder protection score of 4. Thus, it would not see an Xv 10 -- - * - -increase in market capitalization due to either factor, but .> > > > > only due to further accumulation of pension fund assets. r_1 5 * - - - At the other end of the spectrum, 11 of 26 transition 0 economies-Belarus, Bosnia and Herzegovina, Kazakhstan, 0 1 2 3 4 the Kyrgyz Republic, FYR Macedonia, Moldova, Romania, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan-stand to gain from macroeconomic stability Note: The higher is the index of creditor rights, the better cred- and improved shareholder rights. Under the best possible itors are protected. For details, see Pistor (2000). policy outcomes, six stock markets (in Croatia, the Czech Source: Authors' calculations. Republic, Estonia, Hungary, Poland, and Russia) could 124 TABLE 11.5 BEST-CASE SCENARIOS FOR MARKET CAPITALIZATION AND MARKET TURNOVER IN 2005 (percentage of GDP) Market Change in Market Market capitalization market capitalization from capitalization turnover In In Macro Investor Institutional Increase In In In Increase In Country 1999 2000 stability rights assets from 2000 2005 1999 2000 from 2000 2005 Albania 0 0 0 5 0 5 5 0 0 16 16 Armenia 1 1 0 5 5 10 11 15 18 25 43 Azerbaijan 1 1 0 5 0 5 6 13 10 16 26 Belarus 0 0 3 5 0 8 8 0 0 16 16 Bosnia and Herzegovina 0 0 3 5 0 8 8 0 0 16 16 Bulgaria 6 5 0 0 3 3 8 98 6 20 26 Croatia 11 13 0 5 7 12 25 5 7 40 47 Czech Rep. 19 25 0 0 14 14 39 61 81 15 96 Estonia 31 36 0 0 5 5 41 44 21 28 49 FYR Macedonia 1 1 3 5 5 13 14 45 36 31 67 Georgia 0 0 0 5 0 5 5 0 0 16 16 Hungary 31 34 0 0 12 12 46 103 93 9 102 Kazakhstan 2 5 3 5 3 11 16 68 45 28 73 Kyrgyz Rep. 5 3 3 5 2 10 13 2 2 20 22 Latvia 6 8 0 0 4 4 12 21 19 22 41 Lithuania 12 11 0 0 2 2 13 13 7 13 20 Moldova 5 5 3 6 2 11 16 81 62 29 91 (Table continues on the following page.) s TABLE 11.5 (CONTINUED) Market Chanre in Market Market capitaiization market capitalization from capitalization turnover In In Macro Investor Institutional Increase In In In Increase In Country 1999 2000 stability rights assets from 2000 2005 1999 2000 from 2000 2005 Poland 18 21 0 0 17 17 38 62 69 10 79 Romania 2 2 3 6 4 13 15 58 45 33 78 Russian Fed. 25 19 3 0 5 8 27 27 40 7 47 Slovak Rep. 4 3 0 6 8 14 17 48 25 46 71 Slovenia 11 12 0 6 6 12 24 28 22 42 64 Tajikistan 0 0 3 5 0 8 8 0 0 16 16 Turkmenistan 0 0 3 5 0 8 8 0 0 16 16 Ukraine 3 4 3 5 1 9 13 12 19 18 37 Uzbekistan 0 0 3 5 0 8 8 2 4 18 22 Average 7 8 1.5 3.5 4 9 17 31 24.3 21.8 46 Source: Authors' calculations. Stock Markets in Transition Economies see market capitalization of 25 percent of GDP or more by entry of foreign financial institutions. International equity 2005, which would put them at about the average of mid- issues have grown substantially, from $120 billion in 1997 dle-income emerging markets.5 to $214 billion in 1999 (Bank for International Settlements The elasticity from policy changes is higher for market 2000). Within these international equity flows, depository turnover, so even countries that do not have stock markets receipts-global depository receipts (GDRs), American with any liquidity (such as Turkmenistan) could reach 16 depository receipts (ADRs), and the like-have been the percent market turnover by 2005. Under the best-case sce- most popular instrument for raising capital. In 1999 a nario, market turnover of more than 50 percent may be record $22 billion in new capital was raised in U.S. markets reached in nine countries, namely the Czech Republic, through depository receipts, bringing the total equity cap- Hungary, Kazakhstan, FYR Macedonia, Moldova, Poland, ital raised through ADRs to $133 billion since 1990. Other Romania, the Slovak Republic, and Slovenia. But even financial centers have seen similar trends. under the best scenario, turnover remains far below that of Depository receipts are used not just to raise capital but other markets in Europe (such as London or Frankfurt) and also to effectively cross-list a stock in more markets. In in many other emerging markets. Low liquidity not only 1999, 1,800 depository receipt programs from 78 countries implies that these markets will not be providing corpora- were in existence in the United States, compared with 352 tions with the opportunity to raise new capital at relative- from 24 countries in 1990. The combined market capital- ly low cost, but also that investors will be more reluctant to ization of these companies exceeded $6 trillion at the end trade given the high implicit costs of price movements. of 1999 (Bank of New York 2000). In London the use of Perhaps most important, low liquidity means that it will be depository receipts is more limited, and cross-listing is harder to support a local market with its own trading sys- mostly direct. At the end of 1999, 512 of 2,274 companies tem, market analysis, brokers, and the like, because the vol- listed on the London Stock Exchange were foreign. ume of business simply would be too low. Trading is also moving offshore. During the 1990s the trading value of ADRs grew 22 percent a year, reaching The Influence of International Developments $758 billion in 1999 (Bank of New York 2000). As a result Stock market developments in transition economies of these trends, listing and trading are concentrating, with cannot be analyzed without reference to global develop- the combined capitalization of the top five markets (New ments. While some transition economies may be able to York Stock Exchange, Nasdaq, Tokyo Stock Exchange, develop reasonably liquid stock markets in the next few London Stock Exchange, and Deutsche Boerse) accounting years, such progress could be stalled by global events. for about three-quarters of global capitalization and trad- Around the world, stock markets are changing rapidly. ing. Thus activity outside these centers is only one-quarter They are becoming increasingly global, with large increas- of global capitalization and trading (table 11.6; see also es in cross-border capital flows. Listing, trading, and new Clayton, Jorgensen, and Kavajecz 1999). issuance are concentrating in fewer markets. And alterna- Increased cross-listing and use of depository receipts tive electronic trading networks are gaining market share. and other means of raising international capital reflect the These trends are starting to affect stock markets in transi- recognition among large corporations worldwide that larg- tion economies. er stock markets offer more financing, lower capital costs, Globalization is proceeding in all forms of financial greater liquidity, and better name recognition than smaller services, through capital flows, cross-border provision, and ones. Empirical evidence provides strong support for this 5. The increase in market capitalization reported in table 11.5 will be enhanced in countries that have not achieved low inflation if the estimated coefficients in table 11A.5 are used instead of the coefficients in table 11.4. But this will be counterbalanced by a reduction in the positive effects from increases in the value of institutional investor assets and improvements in investor pro- tection. On net, this leads to a reduction in the projected market capitalization across all transition economies, especially in coun- tries that have poor shareholder protection-such as Albania, Armenia, Azerbaijan, Belarus, Bosnia and Herzegovina, Croatia, and Georgia. Projected market turnover also decreases across transition economies, but not uniformly. Countries that have made significant strides in accumulating institutional investor assets stand to gain less. But countries that can still improve investor pro- tection record a higher increase in market turnover. These robustness checks show that the results reported in table 11.5 should be seen broadly as the most optimistic scenario, the upper bound of growth potential of stock markets in Central and Eastern Europe and the former Soviet Union. 127 Claessens, Djankov, and Klingebiel TABLE 11.6 FEATURES OF THE WORLD'S LARGEST STOCK EXCHANGES, 2000 Average daily Market trading volume capitalization (billions of (billions of Links with other exchanges Market or exchange U.S. dollars) U.S. dollars) or electronic communication networks New York 35 12,000 Preliminary talks with Toronto Stock Exchange, Stock E.xchange Euronext, and Mexico's Bolsa; cooperative links with Tokyo Stock Exchange Nasdaq Stock Market 41.5 5,020 All electronic communication networks trade Nasdaq stocks; deals with Osaka Stock Exchange, Deutsche Boerse, London Stock Exchange, Quebec government, Hong Kong Stock Exchange, and Australian Stock Exchange Tokyo Stock Exchange 6.8 4,100 Cooperative links with exchanges in the Republic of Korea, Philippines, Singapore, and Thailand, as well as with the New York Stock Exchange Deutsche Boerse 4.53 1,500 Merger with London Stock Exchange, Nasdaq joint venture, MarketXT joint venture London Stock Exchange 13.5 2,800 Deutsche Boerse merger, Nasdaq joint venture Hong Kong Stock Exchange 1.5 568 Co-listing agreement with Nasdaq and New York Stock Exchange Paris Bou-rse 4.18 1,500 Euronext alliance Sao Paulo Bovespa 0.4 208 London Stock Exchange, Lisboa Stock Exchange, Argentina's Caja de Valores; New York Stock Exchange Australian Stock Exchange 0.8 370 Nasdaq; Singapore; New York Stock Exchange Toronto Stock Exchange 2.85 1,700 New York Stock Exchange, Euronext, Hong Kong Stock Exchange, Mexican Bolsa, Sao Paulo Bovespa Globally total 148.8 35,005.4 Source: W/all Street Journal; Federation Internationale de Bourses de Valeures. assessment. When firms from emerging markets use ADRs 2000). Trading in foreign markets is typically much more or GDRs or list on U.S. equity markets, their financing con- liquid than in local markets. For example, Mexican stocks straints are relaxed-that is, their new investment becomes with ADRs see more trading in New York than in the less sensitive to internal cash flow (Lins, Strickland, and domestic market, with mixed benefits for investors Zenner 1999). In addition, domestic firms that enter inter- (Domowitz, Glen, and Madhavan 1998). national markets obtain better financing opportunities and Because corporate governance rules are more strin- extend their debt maturities (Chaplinksy and Ramchand gent for international listings, corporations have used them 128 Stock Markets in Transition Economies to signal that they are willing to protect the rights of minor- York Stock Exchange) will cease to exist in their current ity shareholders. Corporations from countries with weak form, reflecting changes in corporate structure, physical corporate governance laws are more likely to list (cross-list) trading location, and institutional organization (such as the abroad if they are allowed to do so (Reese and Weisbach distinction between specialists and retail brokers). 2000). And by raising bonds abroad (in the United States), Reflecting these competitive pressures and the general corporations certify to act in the interests of investors and desire for increased liquidity through larger markets, many so lower their borrowing costs and increase shareholder stock exchanges in developed countries have established wealth (Miller and Puthenpurackal 2000). links or even merged. Recent examples include the pro- New Internet-related startups in Latin America and posed mergers of the Amsterdam, Brussels, and Paris Israel, for example, are establishing their legal domicile in exchanges and of the London and Frankfurt exchanges; the the United States to facilitate the raising of new capital. joint ventures and alliances between Nasdaq and stock Cross-listing will be further facilitated by the recent exchanges in Australia, Canada, Japan, and Hong Kong announcement that the International Organization of (China); and a joint venture between Nasdaq and the pro- Securities Commisisons, the club of stock market regula- posed London-Frankfurt exchange focusing on growth tors, will develop more complete international accounting stocks (table 11.6). The Singapore and Australian stock standards. Incoming multinational corporations could use exchanges recently agreed to cross-list all traded shares. these standards in cross-border offerings and listings. The New York Stock Exchange has formed alliances with the Tokyo Stock Exchange, Australian Stock Exchange, Trading Systems Are Consolidating and Toronto Stock Exchange, Mexican Bolsa, Sao Paulo Going Global Bovespa, and Euronext to trade through linked exchanges These trends are being influenced by advances in infor- 24 hours a day. The consolidation of these markets, which mation technology that make it easier for market participants account for more than 60 percent of global market turnover, to trade from remote locations. Trading is moving toward is leading to a small number of very large markets. electronic forms that are not tied to any particular location. Nasdaq's computers are based in Turnbull, Connecticut, for Most Transition Economies Have Missed Out on example, but traders are located around the globe. These Developments A number of electronic communication networks have With few exceptions, transition economies have not emerged in recent years. These networks started as pools of participated in these consolidation trends. The only merger liquidity feeding into existing markets, but they increasingly has been among the three Baltic exchanges (Estonia, Latvia, serve as alternative trading outlets. Electronic communi- Lithuania), which also have established links with Helsinki cation networks now account for a large share of trading in (Finland). Other countries are still pursuing a "made at some developed stock markets-for example, they account home" strategy. Global trends suggest that many of these for one-quarter of the dollar volume of Nasdaq trading. import substitution approaches are doomed to fail. Even Alternative trading systems are also being set up under a best-case scenario, most transition markets will around the world, often with links to existing trading sys- remain small even relative to most emerging markets-let tems. For example, Instinet started out as a brokerage ser- alone compared to developed markets. This raises the ques- vice but now has automatic routings to a number of stock tion of whether transition-economy stock markets will exchanges.6 There is speculation that a few trading systems achieve the economies of scale needed to compete interna- will emerge globally that allow investors to trade 24 hours tionally alone, or whether they need to join global alliances. a day. Existing exchanges are recognizing that their ser- To reach the point where increasing market activity is vices-trading systems-are becoming a commoditized associated with decreasing costs in the processing of trades, product offered through other means.7 Many observers a market needs to have capitalization of more than $15 bil- predict that traditional stock markets (such as the New lion (Malkamaki 1999). Using the best-case scenario for 6. For purposes of executing cross-border transactions involving foreign securities, retail invesrors are, in effect, connected to for- eign markets through an electronic "pass through." A U.S.-based investor may, for example, be linked electronically to a U.S. bro- ker-dealer, who in turn is linked electronically to foreign markets, either directly or through a local broker-dealer. 7. To the extent that they have not done so already, many exchanges are considering demutualizing-that is, becoming for-profit organizations-to survive in an increasingly competitive environment. 129 Claessens, Djankov, and Klingebiel market turnover from table 11.5, only four of 26 transition Low economies of scale are corroborated by the cost economies will reach this point by 2005-the Czech structure of stock markets in transition economies. Republic (with an estimated $19 billion in market capital- Domowitz, Glen, and Madhavan (2000) use data from 42 ization in 2005), Hungary ($16 billion), Poland ($46 bil- developed and emerging markets to calculate the explicit lion), andl Russia ($53 billion). The next largest markets, and implicit costs of equity trading, where explicit costs Romania and the Slovak Republic, will each have market include commissions and fees and implicit costs represent capitalization of less than $5 billion. This suggests that, indirect trading costs (the main one being the price impact given their scale, most stock markets in transition of trades). Even though most transition economies do not economies will not be able to compete with other markets have explicit taxes that raise trading costs and lower liq- in providing trading services. Moreover, these estimates uidity, total costs in the leading transition markets are based on existing economies of scale. The globalization (Budapest and Prague) are twice the sample average, about of stock markets is continuously increasing the scale need- three times the costs in Germany and the United States, and ed for trading systems to operate competitively and provide about 60 percent higher than in leading Latin American the desired liquidity, making an independent stock market and East Asian markets. This analysis suggests that even the an increasingly difficult proposition even for those transi- largest transition-economy stock markets will have a hard tion economies that today appear to have sufficient size. time competing internationally. 130 Stock NM:rket ill 1r ii l titoll l.cii o n iss Appendix TABLE 11A.1 NUMBER OF LISTED EQUITIES IN TRANSITION AND COMPARATOR ECONOMIES, 1994-2000 March Country 1994 1995 1996 1997 1998 1999 2000 Armenia 1 1 10 59 82 86 95 Azerbaijan 0 0 0 1 2 2 2 Bulgaria 16 26 15 15 998 828 842 Croatia 29 61 66 77 50 59 59 Czech Rep. 1,024 1,635 1,588 276 261 164 154 Estonia 0 0 0 22 26 25 23 FYR Macedonia 0 0 2 2 2 2 ? Hungary 40 42 45 49 52 66 65 Kazakhstan 0 0 0 13 36 24 20 Kyrgyz Rep. 0 1 ( 27 40 581 63 66 Latvia 0 1 7 34 51 69 70 64 Lithuania 13 351 460 607 60 54 54 Moldova 0 11 16 48 61 58 28 Poland 44 65 83 143 198 221 221 Romania 4 7 17 76 5,753 5,825 5,578 Russian Fed. 72 170 73 208 237 207 218 Slovak Rep. 18 18 816 872 837 845 843 Slovenia 25 17 21 26 28 98 34 IJkraine 0 96 99 102 113 117 120 tJzbekistan 0 0 0 4 4 4 3 Brazila 472 Egypt 1,051 Germany 851 Korea, Rep. of 723 Mexico 185 Portugal 125 'f'hailand 39( Turkey 298 United Kingdom 2,274 United Statesb 3,025 Note: Excludes over-the-counter (OTC) traded issues. For example, in NLarch 2000, 5 L comparnic wCre rcgistered withi th e Altiaty (Kazakhstan) Stock Exchange and traded OTC, hut onily 20 comiipanies were traded on the exchange. NMor-e than 100 companies are prelisted on the Macedonian Stock Exclhange, more than 500 are prelisted in Moldova, and more tha.n 2,000 are prelisted in IUJkraine. a. Sao Paulo Bovespa only. b. New York Stock Exchange only. Source: Stock exchange websites and informatioin departments; Beck, Dremirgiiu-Kunt, and Levine (1 999). 131 (Claessers, Djankov, and Klingebiel TABLE 11A.2 MARKET CAPITALIZATION IN TRANSITION AND COMPARATOR ECONOMIES, 1994-2000 March Country 1994 1995 1996 1997 1998 1999 2000 Armenia 0 1 1 1 1 1 1 Azerbaijan 0 0 0 0 0 1 1 Bulgaria 0 1 0 1 8 6 5 Croatia 3 3 15 21 15 11 13 Czech Rep. 14 30 31 24 21 19 25 Estonia 0 2 10 11 28 31 36 FYR Macedonia 0 0 0 0 0 1 1 Hungary 3 5 12 33 29 31 34 Kazakhstan 0 0 0 1 1 2 5 Kyrgyz Rep. 0 0 1 5 7 3 3 Latvia 0 1 3 6 6 6 8 Lithuania 1 2 11 18 10 12 11 Moldova 0 0 0 2 6 22 19 Poland 3 4 6 8 13 18 21 Romania 0 0 0 2 3 2 2 Russian Fed. 2 5 9 8 7 25 19 Slovak Rep. 8 7 12 9 5 4 3 Slovenia 4 2 4 9 13 11 12 Ukraine 0 0 0 0 2 3 4 Uzbekistan 0 0 0 0 1 6 6 Brazil 27 24 24 30 27 Fgypt 8 10 16 23 28 Germany 23 22 27 36 45 Korea, Rep. of 44 42 34 22 24 Mexico 45 39 31 33 29 Portugal 15 17 24 34 57 Thailand 92 82 66 44 29 Turkey 19 14 15 25 17 United KEingdom 116 119 137 146 161 United States 74 82 101 122 151 Note: Excludes over-the-counter (OTC) traded issues. Source: Stock exchange websites and information departments; Beck, Demirgiuc-Kunt, and Levine (1999). 132 Stock Markets in Transition Economies TABLE 11A.3 MARKET TURNOVER IN TRANSITION AND COMPARATOR ECONOMIES, 1994-2000 (percentage ol market capitalization, mid-period) March Country 1994 1995 1996 1997 1998 1999 2000 Armenia 0 2 2 7 5 15 18 Azerbaijan 0 0 4 12 12 13 10 Bulgaria 0 8 1 1 2 4 6 Croatia 8 8 13 10 5 5 7 Czech Rep. 26 33 50 47 37 61 81 Estonia 0 0 59 78 108 44 21 FYR Macedonia 0 0 3 24 41 45 36 Hungary 22 17 42 76 112 103 93 Kazakhstan 0 0 0 2 2 2 3 Kyrgyz Rep. 0 2 8 2 6 2 2 Latvia 8 12 15 35 24 21 19 Lithuania 0 37.3 9 18 16 13 7 Moldova 0 0 12 81 173 81 62 Poland 177 72 85 78 54 62 69 Romania 2 7 72 73 66 58 45 Russian Fed. 367 7 11 20 11 27 40 Slovak Rep. 96 69 134 109 74 48 25 Slovenia 68 71 82 31 35 28 22 Ukraine 0 5 11 6 4 12 19 Uzbekistan 0 3 19 12 3 2 4 Brazil 76 47 61 85 70 64 54 Egypt 19 11 22 33 22 38 47 Germany 98 109 123 137 145 152 167 Korea, Rep. of 172 97 109 171 183 223 288 Mexico 44 31 42 40 28 32 35 Portugal 36 48 59 67 96 114 127 Thailand 60 41 36 39 70 86 89 Turkey 87 221 139 128 141 167 193 United Kingdom 78 78 37 44 53 62 73 United States 70 85 92 104 106 117 141 Source: Stock exchange websites and information departments; Beck, Demirgiiu-Kunt, and Levine (1999). 133 1 s c sn s , I ;i n k o , a n d K 1i n g, llic I TABLE 1IA.4 INFLATION IN TRANSITION ECONOMIES, 1992-2000 Average (C9-'atnv 1992 1993 1994 1995 1996 1997 1998 1999 2000' 1994-99 Arnicm:l 1,341.0 10,896 1,885.3 31.9 5.8 21.8 -1.3 8.2 - 325.2 Azerhbiijan 1,395.0 1,294.2 1,788.4 84.5 6.5 0.3 -7.6 1.7 - 312.2 Bulgaria 79.0 63.8 121.9 32.9 310.8 578.6 1.3 1.8 7.2 174.5 C'roatia 938.2 1149 -3.1 3.8 3.4 3.8 5.4 4.0 5.5 2.9 (Czcch Rcp. 12.7 18.2 9.7 7.9 8.6 9.8 6.8 3.5 4.3 7.7 Estonia 953.5 35.6 42.1 28.9 15.1 12.4 4.4 3.1 4.7 17.7 VYR Macedonia 1,935.0 241.8 55.1 9.0 -0.6 2.6 -3.1 2.2 - 10.8 FiLungarv 21.6 21.1 21.2 28.3 19.8 18.4 10.3 8.1 9.2 17.7 Kazakhstan 2,984.1 2,169.3 116.1 60.4 28.6 11.3 1.9 19.6 14.2 39.7 Kvrgyz Rep. 1,259.0 1,363.2 95.7 31.9 35.4 14.7 18.3 40.1 - 39.3 L.atvia 959.0 35.3 26.2 2.3.1 13.1 7.1 2.8 2.1 2.9 12.4 [ithualnia 1,161.1 188.8 4.5.2 35.5 13.1 8.5 2.4 2.5 3.5 17.9 Moldova 2,198.0 837.2 115.8 23.8 15.1 11.2 18.2 29.7 n.a. 35.6 Poland 44.3 37.6 29.4 21.4 18.5 13.2 8.6 6.5 n.a. 16.3 Romawa 199.2 295.5 61.7 27.8 56.9 151.4 40.6 38.9 40.5 62.9 Russian Fed. 2,506.1 840.1 204.4 128.6 21.8 10.9 84.5 45.3 18.2 82.5 Slov3lk Wep. 9.1 25.1 11.7 7.2 5.4 6.4 5.6 14.5 14.3 8.5 Sloveni;a 92.9 22.8 19.5 9.1 9.2 8.8 6.5 6.4 n.a. 9.9 Ukraine 2,73)0.0 10,I55 401.2 181.3 39.7 10.1 20.1 17.2 25.2 111.5 Uzbeki,taii 910.1 885.2 1,281.2 117.4 64.1 49.8 26.2 42.3 n.a. 263.4 -- Not available. a. Projected. SoLarce: [ntcrnationni Mloncrarv Fund (2000). 34 Stock Markets in Transition Economies TABLE 11A.5 DETERMINANTS OF MARKET CAPITALIZATION AND MARKET TURNOVER IN TRANSITION AND COMPARATOR ECONOMIES, 1994-99 Market capitalization Market turnover Transition Comparator Transition Comparator Dependent variable economies economies econonhies economies Inflation <1O percent a year 9.13* 5.04* 21.09'- 11.38 (3.79) (2.28) (2.34) (1.31) Inflation 10-50 percent a year 2.76 0.76 9.29 6.58 (1.47) (0.49) (1.17) (0.86) Inflation 50-100 percent a year 2.08 0.46 7.41 15.42 (1.02) (0.25) (1.70) (1.11) Medium shareholder protection -1.24 -2.75 31.21 19.10*> (index of 2 or 3) (0.59) (1.38) (5.29) (3.83) High shareholder protection 2.13 0.35 40.59*> 20.87i* (index of 4 or 5) (0.83) (0.13) (4.71) (2.77) Institutional assets 0.46* 0.43 * 1.60* 0.90*5 (11.66) (10.06) (3.18) (1.97) Log GDP per capita 3.19* 25.34* (3.42) (9.11) Number of observations 216 216 216 216 Adjusted R2 0.81 0.82 0.23 0.46 * Statistically significant at the 5 percent level. Note: The table reports findings for a panel of 26 transition economies and 10 comparator countries (Brazil, Egypt, Germany, Republic of Korea, Mexico, Portugal, Thailand, Turkey, United Kingdom, and United States). Transition economies that do not have stock markets have a score of 0 on market capitalization and market turnover. The shareholder protection indexes are constructed from La Porta and others (1999), and Pistor (2000). Data on institutional investor assets are reported in table 11.3. Standard errors are heteroskedastic-consistent. A constant term is included in every regression. The t-statistics are in parentheses. Source: Authors' calculations. 135 Claessens, Djankov, and Klingebiel References Clayton, Matthew J., Bjorn N. Jorgensen, and Kenneth A. The word "processed" describes informally repro- Kavajecz. 1999. "On the Formation and Structure of duced works that may not be commonly available in library International Exchanges." New York University, systems. 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Processed. 137 Chapter 12 Emerging Stock Markets in Central Europe: Where Do We Stand? Wieslaw Rozlucki T he past 10 years have brought an unprecedented scale of change in the structure and orga- nization of European stock exchanges. Different forces have shaped their development in both the western and eastern parts of Europe. In the west, changes were driven by three main factors: * Technological progress toward electronic trading observed in the concept, extent, performance, and speed of e Harmonization of the regulatory framework exem- development of capital markets in Central and Eastern plified by the Investment Services Directive Europe. It is surprising, taking into account initial condi- * Introduction of the euro. tions in the early 1990s, how differently capital markets in These changes resulted in the consolidation of stock Central and Eastern Europe evolved over the past decade. market infrastructure as four consecutive developments occurred, beginning in the 1990s: The Establishment of Markets * The gradual disappearance of regional (subnational) In almost all the countries in the region, privatization exchanges was the primary impetus for the formation of capital mar- * Mergers of stock and derivatives exchanges kets. In contrast to typical emerging markets on other con- * The consolidation of exchanges, clearing, and depos- tinents, thousands of enterprises, comprising the bulk of itory organizations national economies, were privatized in a relatively short * Alliances and mergers of national exchanges. time. There was no precedent for privatization of this scale During the same period, the transition economies of and speed, and little wisdom and advice based on past Central and Eastern Europe witnessed the emergence of experience were directly applicable. Therefore, those who new securities markets and exchanges. Many of them designed the strategies for privatization and the formation resumed operation after 50 years of suspension. In 1990, the of capital markets in Central and Eastern Europe were Ljubliana and Budapest exchanges started trading, followed breaking new ground. by Warsaw in 1991 and Prague and Bratislava in 1993. Despite this, there was a universal sense that speed was The development of capital markets in Central and essential. In other words, in contrast to other countries, Eastern Europe has been a complex and often controversial many hundreds of state-owned enterprises had to be pri- process, both in its initial conceptual phase in each country vatized as quickly as possible. In most countries of the and in its subsequent evolution. There is, however, one region, the privatization process was expected to benefit common element: capital markets emerged in the process of ordinary citizens who had neither the financial resources to economic transition from a planned to a market economy. own shares nor the basic knowledge of what owning shares In all the remaining aspects, wide differences can be meant. 139 Rozlucki Capital markets were expected to provide the neces- The idea of voucher privatization has always been sary infrastructure for privatization and secondary trading popular in Poland. It took rather long, however, to design in securities. Taking into account privatization contingen- and implement the mass privatization program, covering cies, the basic structures of capital markets had to be estab- 500 enterprises and managed by 15 national investment lished rapidly. This was possible because of a relatively funds. By the time the program was launched in 1995, the developed industrial structure, a high level of education, structure and organization of capital markets were com- and general acceptance of the principles of a market econ- pleted. The mass privatization program was shaped to fit in omy and private ownership. The urgency of mass privati- the existing structures of capital markets, as opposed to the zation and its impact on the structure of capital markets other way around. were not uniform in the region. In Hungary and Slovenia, Clearly, developments in the Czech Republic followed for example, the development of capital markets was not a different philosophy and strategy. Absolute priority was shaped by mass privatization. In other countries, however, given to voucher privatization. Transfer of ownership was privatization to a large extent influenced the development the main goal, and capital markets were seen merely as a of dome,tic capital markets. means to achieve this goal. The authors of voucher privatization in the Czech Mass Privatization and Capital Markets: Republic treated capital markets instrumentally and not as A Difficult Marriage a public good in their own right. The infrastructure of Interrelationships between mass privatization and cap- voucher privatization (the RMS) was to be used later as a ital markets can be discussed drawing on the experiences of network leading to concentration of equity ownership. two neighboring countries: Poland and the Czech Republic. The speed of this process was considered essential for mar- Although the idea of mass privatization originated in ket reform. Common features of modern securities markets Poland (the concept of J. Szomburg and J. Lewandowski in such as the high level of regulation and transparency or the late 1980s), it was implemented first as voucher priva- minority protection were seen as premature and poten- tization in Czechoslovakia. As early as 1990, Poland and tially conflicting with the concentration of ownership. then Czechoslovakia had different concepts of capital mar- This approach was not uniform in the Czech Republic. kets. At a World Bank conference in Washington, D.C., in Those responsible for establishing the Prague and 1990, two different strategies of privatization and devel- Bratislava stock exchanges had different views on the sub- opment of capital markets were presented for the Czech ject. The conflict between stock exchanges and the RMS Republic and Poland, respectively. drained scarce resources from those institutions. The Polish approach was more conventional, if not During the past 10 years, a radical laissez-faire orthodox. The desire was to follow, as much as possible, approach was modified in the Czech Republic and, for the patterns of regulation, organization, and practices of different reasons, in the Slovak Republic. Foreign investors mature, developed securities markets. In building capital played an important role because they were only comfort- markets, Poland clearly preferred a tested solution and able with standards similar to their own. In hindsight, it is compliance with international standards. It was thought still surprising how deeply initial concepts influenced the that regulation should precede trading practices. Trading subsequent development of capital markets. Despite recent was to be centralized to concentrate the initial low liquid- improvements in regulation and transparency of the Czech ity. In technical terms, electronic trading with dematerial- market, certain habits were difficult to overcome, as evi- ized settlement and a depository was to be introduced. denced by the problems of the Securities Commission early The licensing of brokers became obligatory, along with in 2000. strict prospectus requirements for issuers of securities. The In Poland, in contrast, the Securities Commission and market was open to small investors, who were to be pro- regulation in general have always been very strong. To tected from the very beginning. many observers, Poland has an overly regulated market. As a result, early in 1991 basic infrastructure for the Both the Czech and Polish markets must evolve toward a capital market was established in Poland, consisting of a European model, which is being formed within the stock exchange, a central securities depository, licensed European Union (EU). The structure of the capital markets brokerage houses, and a securities commission. The regu- in Poland in 2000 is probably closer to the EU model. latory and functional structure was based on practices of More time is needed to judge how mass privatization pro- modern securities markets, notably France and the United grams contributed to the development of capital markets as States. well as to economic transformation and growth in general. 140 Emerging Stock Markets in Central Europe: Where Do We Stand? East and West: Bridging the Gap? much less favorable. The figures for eastern and western Given the differing approaches to economic transition markets are quite divergent. In general, the smallest mar- and capital market development in Central and Eastern kets in Western Europe are several times larger than the Europe over the past 10 years, which countries have been biggest markets in Central Europe. The only exception to more successful in building their capital markets? As any this rule is Vienna, where market capitalization is smaller qualitative judgment is difficult and subjective, it is safer to than that of Warsaw and trading volume is smaller than use standard quantitative measures of stock markets. To that of Warsaw and Budapest. allow comparison, smaller securities markets in Western In the terms of size, European stock markets are very Europe can be used as a benchmark. different, not only between east and west but also within The question to be answered is whether the stock each part of the continent. Market capitalization of markets in Central and Eastern Europe still belong to dif- Warsaw is 50 times bigger than that of Bucharest or Sofia. ferent categories, or whether some convergence has Those markets, in turn, are much bigger in comparison to occurred. In comparing five Central European markets to the very small, embryonic markets at the end of spectrum six smaller western markets, figure 12.1 indicates that, in (for example, FYR Macedonia). After 10 years of acceler- terms of the number of listed companies, there is a con- ated development, the most advanced stock exchanges tinuum and not a sharp divide between eastern and west- from Central Europe managed to bridge the gap, dividing ern parts of Europe. Some figures should be examined them from their smaller western counterparts. Some with caution, as exemplified by Bratislava, where only 9 exchanges have achieved more than just catching up with companies out of 846 are "listed" in a proper sense of the small western exchanges. Both Budapest and Warsaw, word. In Poland, however, all 221 companies, no matter which recently developed their derivatives markets, man- the segment of the market in which they are traded, fulfill aged to overtake Vienna, Oslo, and Copenhagen in trading strict admission and reporting requirements to be classified index futures. In sum, the process of convergence between as "listed." stock exchanges of Western and Central Europe is clearly In terms of market capitalization and trading volumes under way, producing a continuum of ranking rather than (figures 12.2 and 12.3), the situation in Central Europe is two different classes of markets. FIGURE 12.1 NUMBER OF LISTED COMPANIES IN CENTRAL AND WESTERN EUROPEAN MARKETS, MARCH 2000 900 850 800 |UP Domestic companies U Foreign companies 750 700 650 600 550 500 450 400 350 300 250 200 150 100 50 0 Source: FIBV and Standard & Poors. 141 Rozlucki FIGURE 12.2 MARKET CAPITALIZATION OF DOMESTIC COMPANIES IN CENTRAL AND WESTERN EUROPEAN MARKETS, MARCH 2000 USD billion 180 160 140 120 100 80 60 40 20 0 2 ~ ~ ~ ~ ~~.s 0: 0 .| ,| | Source: FIBV and Standard&Poors. FIGURE 12.3 AVERAGE MONTHLY TRADING VALUES IN CENTRAL AND WESTERN EUROPEAN MARKETS, JANUARY-MARCH 2000 USC' million 151000 14000 1 3000 12000 11000 10000 9000 7000 - /7ooo 51000- 'iOOO- 4000 2000 2-000 Source: FIBV and Standard&Poors. 142 Emerging Stock Markets in Central Europe: Where Do We Stand? Consolidation in Central Europe? Bratislava, Budapest, and Ljubliana expressed their "sur- As some exchanges from Central Europe have reached prise" with the Vienna/Frankfurt initiative. At the same a level of maturity and sophistication similar to western meeting, the participants decided to coordinate their activ- exchanges, the question arises whether they also will be ities toward meeting the standards of the stock exchange in affected by the consolidation trend of Western Europe. At the European Union. the national level, this has already taken place. For exam- From the Polish perspective, the Ost Boerse/Newex ple, the Warsaw and Budapest exchanges run both cash and project has not been favorably received. One concern is the derivatives markets. They also own important stakes in risk of market fragmentation. Even in the United States, their clearing, settlement, and depository institutions. current discussion concentrates on excessive fragmenta- Even within the existing structures, much can be done tion of trading. to increase market capitalization, the number of listed The markets of Central Europe are not big by inter- companies, and the involvement of local investors, both national standards, and the risk of splitting liquidity is individual and institutional. No stock market in Central, greater, leading to inefficient price formation and increased riot to mention Eastern, Europe has reached a level ade- costs of trading. Several studies have shown that the major quate to the size of its population and economy. At the end element in trading costs clearly is not the direct fees charged of 1999, market capitalization reached 5 percent of GDP in by intermediaries, but the so-called market impact, which Slovakia, 11 percent in Slovenia, 20 percent in Poland, 21 is inversely proportional to the liquidity of each stock. percent in the Czech Republic, and 33 percent in Hungary. Fragmentation reduces liquidity, thus raising the real costs Those figures are several times smaller than corresponding of trading. indicators in Western Europe and show an untapped poten- Trading equities requires complicated price-discovery tial of domestic markets in Central Europe. The recent mechanisms based on complex information. This infor- development of pension funds in Poland, as well as con- mation is usually centered on domestic factors, including tinued activity of retail investors, shows that the shortage economic policies, the political environment, company of domestic capital should not be viewed as a factor limit- laws, and tax regimes. Moreover, economies of scale pre- ing the development of a domestic stock market. This argu- sent in trading and settlement do not extend to listing, sur- ment assumes a continued policy of free and easy access of veillance, and regulation. It is doubtful, therefore, that the foreign investors to those markets. concentration of trading that took place in foreign Cross-border investment raises a question of suprana- exchange, money markets, and interest rate products can be tional consolidation of trading and other functions of easily replicated in equity trading. national stock exchanges. If new attractive solutions are not Fragmentation of trading would have a negative found, the process of consolidation can be as long, complex, impact on the development of national markets. and political in Central and Eastern Europe as in the West. Transferring the main center of price formation outside national borders would discourage the natural growth of Foreign Listings and the Risk of Fragmentation listings and the number of investors. It would be negative, At present, foreign investors can trade securities from not only for the Polish market but also for the European Central and Eastern Europe both directly in domestic mar- securities market in general. It is the mission of the Warsaw kets and outside the region, the main place traditionally Stock Exchange to develop equity culture in Poland, being London. To a smaller extent, such trading has been increasing the number of investors in the country. No other going on also in Vienna and several German exchanges. A exchange intends to do anything about it. Yet very shortly, joint project of Vienna and Frankfurt called Ost Boerse, Polish investors will start buying stocks in other markets. and recently renamed Newex, has been in progress for Therefore, the number of investors and their level of edu- some time. Its designers hope to concentrate trading of cation will have a positive impact on many European mar- blue-chip companies from Central and Eastern Europe. Its kets. Anything that hampers this process cannot be seen in target group comes from institutional investors of Western a favorable light. Europe. From the very beginning, the Ost Boerse/Newex pro- Joining the Network or Building Domestic Markets ject has not been discussed with Central European In order to minimize the threat of fragmentation, exchanges. It is no surprise, therefore, that their reaction national exchanges must provide open access (and exit) was not positive. At a meeting in Prague in 1999, repre- and high-quality, low-cost services according to European sentatives of stock exchanges from Warsaw, Prague, standards. They must watch carefully the integration 143 Roziucki process in the West, preparing themselves to become nodes exchanges is almost irrelevant. First and foremost, inter- (hubs) in the inevitable electronic network of European national stock exchanges are interested only in listing or exchanges. trading a limited number of blue-chip companies originat- To achieve this, they must act on two fronts: techno- ing from the Europe and Central Asia region. Most poten- logical a;nd regulatory. Technological platforms must be tially listed companies are beyond their scope of interest. In compatible with those standards that are now being estab- a scenario where domestic stock exchanges do not play lished in Western Europe. Regulation must be harmonized their proper role, most companies will be deprived of alter- with EU directives, as well as the market model developed native sources of capital and valuation. The same argument by the leading European exchanges. In terms of corporate holds for local individual investors, who will never grow in structure and ownership, domestic exchanges do not have numbers and size if the only place to trade their local to be owned by domestic institutions. Stock exchanges in stocks is outside national borders. Central Europe should be transferred gradually into demu- Building a domestic investing community requires tualized, for-profit organizations open to foreign partici- much more than efficient trading and settlement mecha- pants and( shareholders. The natural partners in such devel- nisms, which probably can be supplied at the lowest cost by opment are foreign stock exchanges, investment banks, big international exchanges. Educating investors, attracting providers of information technology, and telecommunica- new companies, and monitoring reporting obligations are tion services. best done by domestic market operators and regulators. The emerging electronic network of European Even when it comes to the costs of trading, it is important exchanges will set high standards in all aspects of technol- to remember that the fees charged by stock exchanges and ogy, organization, and regulation. It seems that few estab- central depositories are only a small fraction of the total lished exchanges in Central and Eastern Europe will be able cost of trading paid by an investor. to achieve those standards in the near future. For them, the Few of the functions of a domestic stock exchange in challenge will be to secure appropriate positions in the a transition economy can be performed by international European network. For the remaining exchanges, the main capital markets. The failure of local capital markets would task will be to build domestic or local markets serving deprive countries in Europe and Central Asia of important their national economies and local businesses, while at the national assets. The new Internet-based technology facili- same tirne being open to foreign investors. The new tates low-cost, efficient trading and settlement platforms. Internet-based technology makes this strategy feasible. Other elements of regulated markets can be learned and When it comes to building domestic capital markets, constructed relatively quickly if there is adequate determi- the question of competition of bigger, foreign stock nation among decisionmakers in individual countries. 144 Chapter 13 Emerging Capital Markets: A Slovenian Perspective Drasko Veselinovic t is still quite unbelievable that territories the size of Slovenia could break away from the former J Yugoslavia and achieve international recognition as independent states. The same goes for the for- mer Czechoslovakia and the other countries that were part of the former Soviet Union. The rea- sons for the breakups were political, and there was relatively little rational economic strategy behind them. Although a major factor was the inefficiency of the socialist nonmarket economies, most of these break-away states soon will find economic advantages in establishing economic ties with one anoth- er in areas like banking and capital markets. These ties will develop all the more strongly in the con- text of accession to the European Union (EU). This chapter analyzes capital market development in range, measured in gross domestic product (GDP) per capi- emerging countries with special emphasis on Slovenia. It ta per year. The World Bank, for example, defines countries defines what constitutes a transitional or emerging econo- in transition as those with more than $10,000 GDP per my and financial market and addresses some of the devel- capita per year.1 According to the World Bank's criteria, opmental challenges of emerging stock markets, including Slovenia falls into the world's high-income bracket, yet it the question of whether a stock market is necessary for the still is classified as a transitional or emerging economy. economic development of transitional economies. Finally, the chapter examines the path of capital markets develop- Creating a Stock Market ment in Slovenia and assesses its future prospects. The the- In setting forth a strategy for national economic devel- sis explored is that, if the financial sector mirrors the real opment, small or emerging economies must decide whether sector, a developed financial sector is not possible with an developing a stock market should be a part of that strategy. underdeveloped real sector, although the converse is possi- Determining whether to go forward with the development ble. Slovenia represents a small and relatively successful of a stock market and stock exchange requires serious con- transitional economy. sideration of many important issues, because establishing a The generic phrases "transitional" or "emerging" often properly functioning and credible system requires a rather are used in reference to post-communist countries of the for- heavy front-end investment of money and political will. mer Soviet Union (FSU) or those economies "transitioning" The question of whether small or emerging countries from low- or middle-income status to a higher-income need an organized stock market at all is one that has 1. Approximately 70 percent of the European Union average. 145 Veselinov'ii attracted much debate. Stiglitz (1995) claims that stock unethical and fraudulent practices of market participants. markets are, by definition, irrational and inefficient in The self-regulating role of the market (stock exchange, emerging economies and that resources flowing through central depository or registry, associations of brokers, them are irrationally allocated and, consequently, con- dealers, investment societies, and similar) will grow as the tribute negatively to GDP growth. This idea was adopted market develops, just as the capacity of the regulatory in part by early reformers in the Czech Republic, who system must grow. advocated an extreme model of political and economic A well-functioning securities registry is a prerequisite liberalization (Klaus 1994; Triska and Simoneti 1994). for a successful stock market. The stock market has to The early Czech economic reformers decided that there was win the confidence of the public by providing a reliable sys- no need for a stock exchange at all. Despite their view, a tem of registration and transfer of securities. stock exchange was created with a very minimal regulato- Dematerialization of all issued securities is desirable ry infrastructure. because it tends to be cheaper and more efficient, affords It soon became clear that the Czech stock market was fewer opportunities for forgery and fraud, and makes the too unregulated and needed to improve its regulatory struc- market more attractive to foreign investors. If this is not tures anc enforcement mechanisms. However, this extend- possible, securities should at least be immobilized, as the ed period of relatively disorganized trading, together with traditional (materialized) securities environment is much the lack of adequate enforcement mechanisms and a sub- less desirable, although it is still used in many large finan- stantially unregulated over-the-counter market system (the cial centers. A virtual central marketplace for listed securi- so called RM system), perpetuated many destructive (that ties also provides better liquidity and transparency, which is, nontransparent and unethical) trading practices, which is of particular importance in emerging markets. Discussion resulted in a near collapse of the stock market when many of the value of electronic communications networks or foreign anid domestic investors pulled investments out in the alternative trading systems is of lesser importance here, as middle-to-late 1 990s. The Czech stock market has not yet new emerging markets should focus more on providing the fully recovered from this costly period, although the regu- basic instruments and centralized liquidity. However, Rice lation progress has been made in improving securities, cor- (1999) points out that new technology also brings new porate governance, and bankruptcy laws, as well as financial instruments. enforcement mechanisms. Ideally a centralized marketplace with proper infra- Other economists take the position that stock markets structure should be the main goal, although with as little are necessary for economic development in emerging market segmentation as necessary. Where market segmen- economies (see, for example, McKinnon 1976). According tation is necessary, adequate safeguards should be in place to Bishop (1989), there are many important factors to be to prevent monopolistic pricing by market providers. considered when deciding which model of a stock market Listing and disclosure requirements may vary among seg- or stock exchange to adopt. One of the most important ments, but these requirements should be clear and strictly issues is whether to implement a mass privatization scheme (but fairly) enforced within segments. Market segmentation (vouchers or other forms of mass privatization; see Pirie can be quite costly and may not always increase efficiency 1991). The next policy question then becomes whether or decrease transaction costs. A study by Malkamaki such markets are necessary after privatization is completed (2000) illustrates that increasing the size of individual stock to spur ownership restructuring and dilute concentration. exchanges does not always increase their relative efficien- Newly created stock markets tend to be over-regulat- cy. The Irish Stock Exchange is very efficient, although ed at the beginning, and this can damage the market at an relatively small, as is the New Zealand Stock Exchange, early stage. However, if the market is not adequately reg- while Amex, one of the largest, is the most inefficient. ulated, a, demonstrated by the early Czech model, irregu- Serious consideration should be given to selecting the larities can cause mistrust to flourish in the market and methods by which trading will take place. The two obvious even in the financial system, which can be equally costly. methods are price-driven (sometimes called quote-driven) It is impossible to establish a formula for the optimum or order-driven. Whether to choose direct (order) or indi- level of regulation. Each market must have an appropriate rect (quote or price) trading also depends on circumstances governmental or quasi-governmental body with legal and such as sophistication, risk awareness of financial inter- regulatory authority to enforce relevant laws, regulations, mediaries, financial soundness of intermediaries, and actu- and sanctions and to intervene in the market when neces- al size of investors. Overall, the direct trading system seems sary to ensure fair trading and transparency and to deter to offer more advantages for emerging markets. Price- 146 Emerging Capital Markets: A Slovenian Perspective driven trading loses some ground given the revolutionary auditing practices (in line with international standards) technological changes that are taking place, including are an absolute prerequisite for the development of a stock Internet trading. A direct-order system is simpler, easier to market. In many emerging countries, this has proven to be handle, and probably more transparent. Smaller or emerg- problematic, as is adequate development of the legal sys- ing markets should consider continuous trading systems for tem, which goes hand-in-hand with low ethical standards liquid stocks, one auction (fixing) per day for illiquid (Steinmann 1999; Veselinovic 1999 ). Corruption is a par- stocks, and a few auctions per day for stocks that are trad- ticularly serious problem (Mesko and others 2000). ed irregularly during the day, but in waves. Integration with international markets is, in the long After the fundamental decisions about infrastructure, run, probably most crucial for all small or emerging coun- organization, and methods of trading are made, the choice tries. In 2000, the developed European markets put much of technology is the final decision to be made. Such deci- effort into cooperation and even mergers. London and sions about technology are complicated by the fast pace of Frankfurt have concluded deals with Vienna and Dublin, the technological revolution. Most important is to deter- while Paris, Amsterdam, and Brussels have concluded deals mine the technical conditions in a particular country (espe- with Luxembourg. There are a number of other initiatives cially the level of telecommunications development and as well. The end result eventually may be one large "super- availability of programmers), and these should be ana- bourse" or "pan-European" network. lyzed against the requirements of the available technologies. Emerging countries will have to focus much attention Electronic trading is probably always the right course, but on narrowing the technological and development gaps consideration must be given to whether to trade electroni- with respect to western European countries. Emerging cally on the "floor" or to employ remote methods. Other stock markets should intensify cooperation among them- factors to consider are the quality of telecommunications selves, while competing among themselves to spur advance- infrastructure in the country as well as logistical and other ment. Such relations already exist, for instance, among the customs of the financial community. Vishegrad group of countries.2 The Vishegrad countries (except Slovakia) are first-round candidates for full EU Constraints on Stock Market Development membership. In their development process, the emerging stock mar- There also exist a number of regional political initia- kets have many hurdles to overcome. The primary one is tives, including the South Eastern Cooperation Initiative creating a stock market from the ground up in an environ- (SECI) as well as the Southeastern Europe (SEE) initiative, ment still lacking strong supporting sectors (banking, pub- or Stability Pact countries (based on Skoda 2000, which lic, regulatory, and private). This is complicated by the sets forth the new Marshall Plan for southeastern Europe).3 fact that these stock markets typically are developing much There is also a Federation of European and Asian Stock faster than stock markets in developed countries. Exchanges initiative (FEAS).4 Turkey is increasing its Large local companies and international firms often involvement in some of these, and Slovenia is playing a very seek original listings, parallel listings, or the so-called glob- important role in SEE (the Stability Pact) and in SECI. al depository receipts (GDR) programs abroad, because Austria is taking steps to emerge as the regional center for the local markets are too small (too volatile and illiquid). the most important public companies from the southeast- Some studies have tried to establish that foreign listings ern European region-a role so far quite successfully cast and GDR programs are endowing local markets with by London and partly also by Frankfurt. additional liquidity (Bank of New York 1998; Bankers' Stock exchanges can be divided into three categories: Trust Company 1998). But many are of the opinion that global, regional, and local. Global exchanges are large GDR programs actually deplete local markets of needed international exchanges in international financial centers liquidity. that attract the majority of local, regional, and global cap- Unstable macroeconomic conditions prevent a faster ital and companies. Regional exchanges are those that are and more efficient development of the local stock mar- too small to be global and too large to be local and that can kets. Adequate and credible accounting standards and attract regional capital and companies. Local exchanges are 2. Czech Republic, Hungary, Poland, Slovak Republic, and Slovenia. 3. Albania, Bulgaria, Romania, and the former Yugoslavian countries (with the exception of Slovenia). 4. East Balkans, the southwestern territories of the former Soviet Union, western Asia, and even some parts of the Middle East. 147 Veselinovic usually the national exchanges in small countries; they Slovenian financial market, however, lags behind the devel- may act in a regional capacity with respect to larger coun- opment of the Slovenian economy (compare table 13.1 tries, but their focus remains local. with table 13.2). Slovenia could improve its relatively high and stable growth rates if the financial market were more Future Issues developed. The financial sector in Slovenia has undergone In the future, Central and Eastern European (CEE) a successful process of banking rehabilitation. It is tradi- stock markets will be either regional or local, and all even- tionally banking oriented, but with the insurance subsector tually will have to integrate into the globalized (European) playing a major role. Investment banking, brokerage hous- markets. The position they achieve will depend on whether es, different types of investment funds (closed- and open- they lose some global companies and remain regional or end), and other institutional investors are still developing local financial centers or networks. However, Malkamaki niches within the Slovenian financial sector. and Topi (1999) have predicted the likely trends in stock The Ljubljana Stock Exchange (LJSE) is a relatively market development: well-organized secondary market. The primary market is * Increasing cross-border investment activities and underdeveloped, and it is still hard for private companies enhanced competition between marketplaces and to raise money on the market, although this is not a prob- providers of financial services lem for the government, central bank, and the financial * Growing involvement of the largest institutional sector itself. The level of Slovenian savings is relatively investors in direct trading, leading to efficient and high, by European standards, although rather short term cost-effective trading infrastructures in nature. The result of the privatization process chosen by * Continuing integration of trading and settlement Slovenia is that company insiders and employees hold a infrastructure via mergers, alliances, links, agree- majority of shares in 90 percent of privatized companies. ments, or other forms of cooperation The remaining 10 percent of privatized Slovenian compa- * Increasing emergence of new electronic exchanges nies are listed on the organized markets, and shares are ancl alternative trading systems operated by mem- held by the general public and investment funds. If a com- bers of stock exchanges or off-exchange companies pany issues publicly transferable securities of any kind, * Growing numbers of Internet brokers. they are traded automatically on the free market segment If these trends prove correct, efforts to expand coop- of the stock exchange. To be listed on the stock exchange, eration among ECA stock markets, in order to improve there are many requirements-both quantitative and qual- their position for integration with developed stock markets, itative-of which the most important are disclosure is crucial. But parallel cooperation between the developed requirements. and ECA markets is imperative as well. Today, the devel- Slovenia combined two methods of privatization: the oped markets influence the development of technologies buyout (with 50 percent discounts) and voucher schemes. and the need for electronic trading, clearing, settlement, and The mass privatization process caused an oversupply of registry systems. However, to a certain extent, they also equity securities on the market. Closed-end investment drain local exchanges of listings. funds were used in company privatizations. Under the The most developed of the CEE stock markets are Slovenian privatization scheme, 10 percent of the compa- Hungary, Poland, and, to a certain extent, Slovenia, the Czech nies were transferred to the National Pension Fund, 10 per- Republic and Estonia (see table 13.1). cent were transferred to the Restitution Fund, 20 percent Some of the stock markets noted in the table are were transferred to the Development Fund (which auc- already developing rapidly and are gaining in national tioned this portion to closed-end privatization funds), 20 prominence and credibility. They do not yet play a major percent were transferred or sold to insiders or employees international role, although they are gaining global accep- (subject to certain conditions pursuant to law), and the tance and recognition. Many of these countries will have to remaining 40 percent were made available for public sale focus on further organizational and developmental and/or to insiders (employees). Foreigners were not allowed improvements to gain greater credibility locally. to participate directly in the privatization process in Slovenia. Slovenian Financial Sector Development The ownership structure of Slovenian companies is Slovenia is a small transitional country with an emerg- not advantageous to the development of the capital market. ing financial market. It is one of the most developed of the The financial behavior of Slovenian companies is still inef- CEE countries (see table 13.2). The development of the ficient, which is considered to be a remnant of the nearly 50 148 TABLE 13.1 MARKET PERFORMANCE OF CAPITAL MARKETS IN SELECT COUNTRIES OF EUROPE AND CENTRAL ASIA Market capitalization Market in 1999 Turnover GDP capitalization Number (millions of (millions of Turnover (millions of as a percentage of listed Country Country U.S. dollars)a U.S. dollars)b velocityc U.S. dollars)d of GDP companies risk ranking Bulgaria 706.3 53.2 0.08 11,737 6.02 828 84 Croatia 2,584.5 70.0 0.03 21,249 12.16 59 70 Czech Republic 11,796.0 4,705.3 0.40 53,800 21.23 195 44 Estonia 1,789.3 229.0 0.13 7,856 22.78 25 55 Hungary 16,317.0 14,847.9 0.91 48,400 33.71 66 42 Latvia 390.9 35.0 0.09 6,221 6.28 70 59 Lithuania 1,138.4 284.0 0.25 10,760 10.58 54 61 Poland 29,576.7 10,820.0 0.37 135,915 21.76 206 43 Slovak Republic 1,100.0 488.5 0.44 20,347 5.41 830 66 Slovenia 2,854.0 1,203.1 0.42 20,011 14.26 134 32 Romania 873.1 300.2 0.34 34,700 2.52 5,825 107 Russian Federation 72,205.0 3,352.0 0.05 276,120 26.15 207 133 a. Capitalization excluding investment funds and including domestic companies only. b. Turnover of main and parallel markets, including investment funds. c. Ratio of total annual turnover of shares to market capitalization of shares. d. GDP data for Russian Federation, Croatia, Poland, Hungary, Estonia, Latvia, Lithuania, Ireland, and Malta are for 1998; GDP data for Cyprus and Romania are for 1997. Source: Standard & Poor's (2000a, 2000b); Bank of Slovenia (2000a, 2000b); Iceland Stock Exchange (2000); Focus. Monthly Statistics. FIBV, Paris (2000); unpublished IMF country statistics and EBRD reports; Country Risk, Commodity prices boost emerging markets, Euromoney 371 (March 2000): 106-10. D~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Veselinovic TABLE 13.2 SELECT MACROECONOMIC INDICATORS FOR SLOVENIA, 1995-99 (percent) Budget Current External deficit Public account debt as a debt as (millions (billions Real GDP percentage percentage Unemploy- of U.S. of U.S. Year growth of GDP of GDP Inflation ment a dollars) dollars) 1995 4.1 - 0.0 - 8.6 7.4 - 36 2.970 1996 3.1 + 0.3 22.8 8.8 7.3 + 39 4.010 1997 2.9 - 1.1 23.2 9.4 7.1 + 37 4.760 1998 3.8 - 0.6 23.6 6.5 7.9 - 3.8 4.959 1999 4.9 - 0.7 23.8 8.0 7.4 -581.0 5.491 - Not available. a. From the International Labour Organisation. Source: Bank of Slovenia (1996, 1998, 2000); Institute of Macroeconomic Analysis and Development (2000); unpublished data from the Ministry for Economic Relations and Development. years of socialism. The LJSE plays an effective and active is still some potential for developing the Slovenian capital role in post-privatization restructuring with respect to own- market, although some Slovenian macroeconomists claim ership concentration. However, there is no effective demand that this window will close quickly (Ribnikar 1999). for equity. Institutional investors (funds, insurance, pension Prasnikar and others (2000), for instance, believe that all funds) are not yet generating a significant demand for long- larger companies will be listed abroad and that company term assets. Mutual funds are growing rapidly, but closed- managers will be not be willing to accept their rewards in end privatization funds are not yet in a position to make equities or options if local (emerging) stock markets remain any substantial demands on the market because of their illiquid. The largest listed Slovenian company is Krka phar- lack of cash, and private pension fund schemes have only maceutical company.5 Two Slovenian companies are listed recently been established (in 2000). through the GDR program in London. Nevertheless, it is The government and central bank both offer relative- expected that, since privatization has been completed, the ly attractive and safe financial instruments on the capital primary market will begin to function. The LJSE also is market. Fiscal policy provides good incentives for bank sav- considering the establishment of a "new market" for fast- ings. Although minor restrictions on foreign portfolio growing companies. As Slovenia is in the first round of EU investor, have been retained in the market, foreign accession countries, the continued integration of all sectors, investors represent 1.5 percent of total volume of LJSE including the financial sector, will help the capital market and less than 5 percent of total market capitalization of the to play a stronger and more effective role. LJSE or the Slovenia capital market. Slovenia's market capitalization, volume of trading, References and turnover velocity are average for an economy of its Bank of New York . 1998. Depositary Receipt Issuers' size. Concentration in the market is relatively high. Guide for Central and Eastern European Companies, Liquidity is focused on a few of the most active stocks. All 1998. New York. privatization closed-end funds are listed in the free market Bank of Slovenia. 1996. Monthly Bulletin (April). section on the LJSE and are relatively liquid. All in all, there Ljubljana. 5. Worth just $0.5 billion (market value as of May 2000, according to LJSE 2000). 150 Emerging Capital Markets: A Slovenian Perspective . 1998. Monthly Bulletin (April). Ljubljana. to Be Paid in Stocks and Stock Options? CEO . 2000a. Factbook 2000. Ljubljana. Compensation in a Transitional Economy. Ljubljana: -. 2000b. Monthly Bulletin (April). Ljubljana. University of Ljubljana, Faculty of Economics, Bankers' Trust Company. 1998. Liquidity Analysis: Case March. Study of the Effect of DR Issuance on Home Market Ribnikar, Ivan. 1999. "Restrukturiranje finan nih posred- Liquidity. New York. nikov in (nastajajo ih) finan nih trgov." In Letna kon- Bishop, Walter. 1989. Model Basic Rules for a Stock ferenca Znanstvene sekcije Zveze ekonomistov Exchange. New York: Selfprinting. Slovenije Sedanjost in prihodnost tranzicije v Sloveniji, FIBV (International Federation of Stock Exchanges). 2000. vol. 3, pp. 153-68. Maribor: Ekononomsko-poslovna "Monthly Statistics." Focus. Various issues. Paris fakulteta. Iceland Stock Exchange. 2000. Factbook 2000. Reykjavik. Rice, T. Davis. 1999. "Securities in Cyberspace: New Institute of Macroeconomic Analysis and Development. Directions in Capital Markets." Annual Review of 2000. Economic Mirror. Ljubljana. February. Developments in Business Financing. San Francisco Klaus, Vaclav. 1994. "Privatization Experience: The Czech FIBV. Case." In Privatization in Central and Eastern Europe Skoda, Bojan. 2000. Strategy of Integration of the Republic 1993, pp. 15-19. Ljubljana: C.E.E.P.N. Publications. of Slovenia in the Economic Reconstruction of the LJSE (Ljubljana Stock Exchange). 2000. LJSE Monthly South-Eastern Europe. Ljubljana: Center Marketing Statistical Report. Various issues. Ljubljana. International. Malkamaki, Markku. 2000. Economies of Scale and Standard & Poor's. 2000a. Emerging Stock Markets Implicit Mergers in Stock Exchange Activities? Review. A McGraw-Hill Co., New York. Helsinki: Bank of Finland. . 2000b. Frontier Stock Markets Review. January. A Malkamaki, Markku, and Jukka Topi. 1999. Strategic McGraw-Hill Co., New York. Challenges for Exchanges and Securities Settlement. Steinmann, Horst. 1999. "Business Ethics in Central and Discussion Paper 21. Helsinki: Bank of Finland. Eastern Europe: Convergence or Divergence?" In McKinnon, Ronald, ed. 1976. Money and Finance in Chemnitzer Ostforum-Wirthschaftstechnik in Mittel- Economic Growth and Development. Essays in Honor und Osteuropa, vol. 4. Chemnitz: Technische Universitat of E. S. Shaw. New York: Marcel Dekko. Chemnitz, Fakultat fur Wirtschaftswissenschaften. Mesko, Gorazd, Anzic Andrej, and others. 2000. Stiglitz, Joseph E. 1995. Whither Socialism? Cambridge, Corruption in Central and Eastern Europe at the Turn Mass.: MIT Press. of Millennium. A Collection of Essays. Ljubljana: Triska, Dusan, and Marko Simoneti, eds. 1994. Investment Open Society Institute. Funds as Intermediaries of Privatization. Workshop Newby, Andrew. "Commodity Prices Boost Emerging Series 5. Ljubljana: C.E.E.P.N. Publications. Markets." Euromoney 371 (March 200), London: Veselinovic, Drasko. 1999. "(Business) Ethics in Emerging, 106-10. Transitional, and Developing Financial Sectors." In Pirie, Madsen. 1991. Privatization: Theory, Practice, and Chemnitzer Ostforum [Business Ethics in Central and Choice. London: Wildwood House. Eastern Europe]: Wirthschaftstechnik in Mittel-und Prasnikar, Janez, Anuska Ferligoj, Andreja Cirman, and Osteuropa, vol. 4. Chemnitz: Technische Universitat Aljosa Valentincic. 2000. Do Managers Always Want Chemnitz, Fakultat fur Wirtschaftswissenschaften. 151 Chapter 14 Czech Capital Markets: Illusions and Disillusions Vladimir Rudlovcdk n the middle to late 1990s, debates concerning the development of the Czech capital markets became quite animated until eclipsed by topics of a more global consequence, namely the finan- cial crises in Asia (1997) and Russia (1998). This chapter attempts to revive a number of those debates and looks back on some of the issues raised, admittedly with the benefit of hindsight and with more data and information. Privatization and Stock Market Development: local post offices. The relative prices of various stocks Synergies and Conflicts (expressed in vouchers) fluctuated in accordance with The Czech stock market arose out of the voucher auc- demand, and generally, the final sale prices were considered tion, a specific component of the large-scale privatization fair and adequate. This sent a positive signal to eager that began in the former Czechoslovakia in 1992. In the five traders ready to begin trading stocks for real money. Most rounds of the auction, citizens purchased vouchers for a important was that the auctions provided the chance for the symbolic fee, and these vouchers were traded for stocks of economy to begin to develop out from under the com- about 1,600 privatized companies, which became publicly mand of state bureaucrats. State enterprises which devolved held companies. The second wave of the large-scale privati- into the hands of private shareholders were given a new zation was launched in 1994 in the Czech Republic, which, lease on life. in the meantime, had separated from the Slovak Republic. This auction lasted nine months and consisted of six rounds Large-Scale Privatization Goals in which shares of more than 800 privatized companies The large-scale privatization process, and particularly were traded. The uncertificated, dematerialized shares were its voucher component generated extensive debate and dis- registered in the Securities Center (SCP), which, supported by cussion. Approaches differed somewhat as to the methods a large branch network, maintains records of share transfers, to be applied, the institutional mechanisms, and ultimate stockholders, publicly traded companies, and investment goals. The transformation of the entire economy was a funds. After the second wave of large-scale privatization, the major process with many components, including privati- SCP registered more than 2,000 issues of shares and had zation. Privatization was an important step, which served approximately 6.5 million accounts of individuals, more a number of purposes: than half of the entire population of the Czech Republic. * Suppressing the role of the state in the economy and The voucher auctions proceeded smoothly, affording weakening the links between the state and the enter- all participants equal treatment, and the rcsults proved prises satisfactory. In each round, bids for the outstanding shares * Starting a long-term and supposedly complicated of simultaneously auctioned companies were collected via process aimed at creating efficient structures of own- 153 Rudlovcdk ership, partly through gradual concentration of the proceed in accordance with supply and demand to enable massively, more or less evenly, distributed ownership investors seeking to acquire larger blocks of shares to do so, rights and allow those interested in divesting ownership in favor * Supporting development of a core private sector, of short-term profits to do so, in the hope this would expe- based on small and medium enterprises from which dite company restructuring. Naturally, this approach ush- a niarket economy would develop most rapidly ered in organized trading of newly acquired shares as well * Enabling a technologically backward and artificial- as introduction of the model of corporate governance used ly expanded heavy industry sector previously depen- in mature economies. What still remains unclear is whether dent on Comecon to function without state subsidies this model of corporate governance was the best for an and guidance, gradually separating, through natur- adolescent market and whether the use of this model hin- al selection, enterprises capable of efficient restruc- dered fulfillment of the original goals of privatization and turing from those without prospects to survive development of the Czech capital market. * Enabling all interested citizens to profit directly from liquidation of the centrally planned economic system Stock Trading as an Instrument to * Creating external pressures and incentives for fast Accelerate Privatization development of institutions and rules of a function- Once the decision was made to promote trading in ing market economy. ownership rights as the primary incentive to improve the To a large extent, the voucher auctions and other com- initial ownership structures, it became evident that an effi- ponents cf the large-scale privatization sent the appropri- cient system supporting mass securities trading was vitally ate impulses through the economy. There was little dispute necessary. A number of mass privatization models failed to that an important by-product of the privatization process a considerable extent due to the introduction of an insecure and, more generally, a goal of the transformation as such, system of registration of ownership rights. Primarily, the was to introduce capital markets. Nevertheless, debates system required the support of a robust and secure process flourishecl over the steps necessary to achieve this. Those for registering securities capable of preventing "evapora- who expected the instant creation of a Western-style capi- tion" of the fragile new ownership rights in the massive tal market system did not fully comprehend the limita- transfer of those rights. tions involved in the large-scale privatization of a non- The centralized, electronically supported share reg- market economy, which still lacked the appropriate istry system, with its backbone, the Securities Center, paved institutional and legal infrastructure, and, primarily, appro- the way for an electronic system of trading. Technology priately Finctioning enterprises. Functioning capital mar- was important as the system had to be user-friendly and kets require an environment that includes stable, prosper- easily accessible, and most trading was conducted directly ous, and transparent enterprises. But privatization alone and not through intermediaries. Additionally, it had to be does not make companies instantly transparent and pros- efficient, secure, able to deal with direct trades as well as perous. In a post-communist environment, companies need special auctions, and capable of accommodating a volume time to re-structure and adapt to new structure to operate of trading that was expected to decline over time. in a free market environment. Originally, there were two views concerning suitable Legal and Technical Facilitation of the conditions for the further restructuring of the privatized Privatization Securities Market enterprises. Some anticipated that the rapid sale of shares by The RM-System was equipped with a large branch early voLicher investors would encumber the process of and communications network, which covered the whole company restructuring. In an effort to mitigate this risk country and was originally designed to serve the needs of and spur restructuring, it was proposed that the quick sale the privatization securities market and was not to support of shares by early investors be somewhat restricted, and that a sophisticated stock market or a full-fledged capital mar- internal structures of corporate governance be simplified on ket. Having acquired the position of a securities market the grounds that the standard corporate governance mod- organizer, the RM-System extended its functions support- els were not the most appropriate for shareholders, officers ing the initial voucher auction. It served the Securities and directors with a little experience in managing non-stan- Center, supported the execution of direct trades outside of dard restructuring tasks. Others warned that share owner- the organized markets, and introduced periodic auctions in ship that was too thinly spread might also impede efficient 1993 when the securities market began. In the course of a company restructuring. It was decided to allow trading to period of several weeks, buy-sell orders were collected and 154 Czech Capital Markets: Illusions and Disillusions processed simultaneously, resulting in confirmed trades for well-performing enterprises have emerged. Profitable, sta- some orders and denials for others. These periodic auctions bilized enterprises should be the first to float their shares were, in many respects, similar to the procedures of the publicly, and market participation should be limited ini- voucher auctions. Improvements were made until orders tially to sophisticated investors trading on their own were processed in a continuous auction. The system was account. Exposing the savings of small investors to the equipped with clearance and settlement functions and later risks of an underdeveloped capital market operating in an was able to accommodate on-line orders from individual unstable and risky environment, where even deposits in customers or brokers. banks are not considered absolutely safe, is the best way to From the beginning, the RM-System functioned as a endanger successful development and completion of a mod- division of a privatized company, with little participation ern financial system in the country. from the state. Consistent with the general goals of trans- Experiments in the financial sphere can prove risky. In formation and privatization, the RM-System accommo- the Czech Republic, individual savings that accumulated dated trading of all securities generated by large-scale pri- during the former system were to a large extent insulated vatization. Legally, the RM-System was introduced by the from turmoil of the transition process. In the early 1990s, Law on Securities, which set forth a legal definition of it was a high priority of the government to take all rea- "security" and the principles for uncertificated securities, sonable precautions to safeguard the savings of the popu- established the Securities Center, enumerated rules for secu- lation, despite the enormous transitional burden carried by rities registration, authorized the Ministry of Finance to the banking system in the adjustment to the market econ- perform some essential regulatory functions in the area of omy. This is why a parallel system for trading in securities, securities, and defined legal obligations and activities of as opposed to the privatization securities market support- market organizers and broker-dealers. The original legis- ed by the RM-System, was introduced. Stock exchanges lation contained weak disclosure and other requirements were originally established in the two capitals (Prague and that are standard for capital markets. Initially, there were Bratislava) of the former Czechoslovak Federation. few legal requirements for the issuance and trading of secu- In 1993, the Prague Stock Exchange (PSE) was estab- rities, and enforcement capacity was rather weak. The law lished by a special law that contained all the necessary required basic information to be contained in a prospectus, provisions for the gradual development of standard capital but there were limited means for the regulator to require market mechanisms with the attributes of a mature market. companies to update this information as necessary. It was The PSE was based on the principle of membership of expected that the privatization securities market would many respectable institutions that were capable of full help companies consolidate and stabilize their structure of compliance with the rules and procedures necessary for ownership, and, most probably, leave the area of public proper regulation of the stock market. companies in order to undergo deep restructuring. One scenario for capital markets development could have been based on the parallel, but separate development Capital Market Development: Initial Problems of the two securities market organizers, the PSE and RM- Little was known at the outset about the proper System. The RM system could have focused fully on activ- sequencing of phases in the process of creating a full- ities related to the specific privatization market, aimed pri- fledged capital market, yet it was generally agreed that marily at optimizing ownership structures in privatized this was an important task for the economy. Many ques- enterprises, with the prospect of covering some special seg- tions still had no answers, including whether certain types ment of the future capital market; and the PSE could have of companies should be the initial impetus for establishing served as the securities market with more rigorous rules, a new capital market or what was the minimum level of making full use of the powers given to it by the Law on institutional infrastructure necessary in view of the matu- Stock Exchanges. Had more attention been paid to sepa- rity of potential market players. rating the functions and operations of the PSE and the The most appropriate way to initiate a market is to RM-System, the PSE might have implemented strict dis- promote a domestic bond segment with debt securities closure requirements, and a process for categorization of issued both by the state and by prosperous companies. In listed companies into different tiers according to size, effi- a transition economy, it is only worth considering launch- ciency, and frequency of trades. ing a stock market after the economy has entered a path of Unfortunately, this did not happen. In an effort to steady growth, the banking and insurance sectors have remain faithful to the initial principles of the transition attained a certain level of maturity, and some profitable and strategy which favored allowing market forces to promote 155 Rudlovcak competition over centralized control mechanisms, privatc period of 1993-95. From the beginning, the most fre- interests emerged as dominant where a better balancing of quently discussed shortcoming was a lack of transparency. the public and private sector interests might have been Initially, many shortcomings were attributed to the absence beneficial. of an advanced clearance and settlement system and other As the legislation setting forth the roles of profession- imperfections of a technical nature. When these technical al market participants was rather vague, these players problems were resolved, it became obvious that many proactively pursued carving out their longer-term niches problems still remained, including the insufficiency of the and functions in the developing capital markets system. price-discovery function and consequent lack of uniformi- Both the PSE and the RM-System felt that their expensive ty of stock pricing and block trading in large blocks of equipment and prestige would be wasted if they cooperat- stocks and, in this respect, predominance of direct trades. ed, and as a result they began competing for the same Special attention was given to the lack of shareholder pro- clients. This was likely one source of many of the institu- tection (a very complicated and controversial issue under tional problems, shortcomings, and misunderstandings specific conditions and goals of large-scale privatization) that complicated the development of the Czech securities and to problems related to the investment funds and unit markets hindering the effective conclusion of privatiza- trusts. As a consequence, a limited number of initial pub- tion. lic offerings were quoted. The initial trading volumes, artificially calculated mar- Many problems of the market originated from the fact ket capitalization, and other quantitative parameters that the privatized enterprises fell short of public expecta- looked very promising and caused an unrealistic optimism tions regarding profitability, and certain aspects of a cor- on which future prosperity and evolution were thought to porate culture could not be enforced by market regulation. be well grounded. As a result, thousands of people active- A rather serious problem resulted from the fact that the ly participated in the market as brokers, dealers, and invest- same stocks were simultaneously treated as belonging to ment advisors, not to speak of those who joined in the busi- the privatization securities market, and traded in the frame- ness of collective investments. For instance, after quite a work of the standard stock market. The privatization mar- short period of time, there were more than 500 licensed ket was a temporary phenomenon intended to create own- broker-ciealers. This created tensions in the securities mar- ership structures of privatized enterprises to support kets that wvere becoming more visible as the potential of the privatization. Typical for this market in its more advanced privatization market to generate the expected initial prof- phase was dealing with high-volume direct trades, implying its was gradually being exhausted. a non-uniformity of the prices and, consequently, unique The unjustified, and to some extent misleading, regulatory circumstances that were supporting specific pri- "advertising" campaigns inviting investors, enchanted for- vatization goals. Yet the more standard component of the eign investors greatly. Smaller domestic investors had rather securities market-covering a very limited number of suf- bearish te ndencies. The main trading base consisted of a set ficiently large, well-performing companies-needed a more of publicly traded joint-stock companies with very uncer- traditional kind of regulation. Regretfully, these and other tain chances for success and unclear corporate values. The questions have not been thoroughly analyzed, and the rel- result was a substantial oversupply of securities on the evant discussions have been limited to simplified argu- market, while the interest of active investors was concen- ments on deviations from standard legislation and regula- trated on a limited number of enterprises that effected tory structures, leaving many questions unanswered. share prices. Shortly after the PSE trading floor opened in 1993, the PX-50, which is the official index of the Prague Transparency in the Framework of the Stock Exchange, exceeded 1,200 points, and remained Privatization Market around the 1,000 level through the beginning of 1994. Lack of transparency in the market was the most fre- Shortly thereafter, a long-term decline began which ended quent criticism. However, it must be admitted that the in 1995 at 400 points. The index then oscillated between concept of transparency becomes rather elusive in the con- 400 and 500 points, and saw little growth until the year text of a post-communist transitional economy. The size 2000. Early investors in Czech securities had reason to be and coverage of the privatization market and the millions disappointed, and hence began the wave of criticism of the of citizens participating in the voucher privatization and Czech capital markets. other forms of privatization (restitutions, small-scale pri- Critics concluded that the stock market was not well vatization) meant that the Czech population had rather regulated, and not transparent enough, especially for the good access to the relevant information. But there are 156 Czech Capital Markets: Illusions and Disillusions many barriers to the distribution of information in a tran- circumstances. Punishing the managers seemed the better sition economy. Transparency has two basic aspects: (1) alternative but did not wholly solve the problem. Even transparency of the processes related to operations on the more difficult was finding appropriate sanctions when dis- securities markets and (2) transparency of the material closure requirements were not sufficiently met. Standard base of the market, the current state, and performance of information and accounting data may often prove insuffi- the publicly traded companies. cient for investment decisions in a transition economy and These separate concepts often get mixed together and may even be misleading. Under the circumstances, it is not it becomes unclear what kind of information is missing and surprising that for years the disclosure obligations of some how the alleged lack of transparency can be improved. 2,000 publicly traded companies were met by only 30-40 The availability of information on market operations percent of the companies. In sum, newly privatized enter- relates primarily to appropriate technical support and prises need time before they are capable of producing reli- development of the trading systems. The situation has been able financial information that might serve to encourage improving, however, and the development here is not sole- investors. ly dependent on the improving and enforcing of disclosure Standard transparency requirements and criteria as requirements, improving technology, or the proliferation of understood in countries with developed capital markets firms which provide information and analyze data related clearly are not so easy to apply in the early stages of a stock to the securities markets. Also important is the reduction in market created from a recent, large-scale privatization. A the number of small trades associated with sales of stocks special aspect of transparency, relating to the actual struc- by those who acquired them in the voucher auctions. These ture of ownership, was not recognized in the early stages of trades tended to avoid organized markets and were exe- market development. Initially, legislators consistently cuted primarily by registration through the Securities assumed that shareholders were anonymous. In the context Center. As substantial volumes of these trades were of privatization and, especially, the privatization market, exhausted, closing an initial phase of the privatization mar- this approach was deficient. From the point of view of the ket, direct trades were transferred to the PSE and RM- privatization market, the ability to obtain updated infor- System, and the criticism softened. Thus it was not entire- mation on the ownership structure is vital to potential ly clear whether the complaints concerning transparency investors interested in attaining an influential position were related to the lack of information on prices and vol- among shareholders. This problem was rectified by the umes related to direct trades from the privatization market, 1996 requirement for obligatory disclosure of shareholders or whether they were simply coming from market orga- with 10 percent or more of a company's stock. nizers who felt excluded from profits in the direct trade market when there was no role for them to play. Initial Public Offerings The issue of access to company information in the Many of those promoting rapid development of the context of the privatization market is even more problem- capital markets based on large-scale privatization presumed atic. First, it is important to consider the state of a recent- that access to capital would be readily available to priva- ly privatized company. To disclose publicly the information tized companies after their transformation into public com- describing the current situation and its unclear future panies. This expectation was probably somewhat naive. As prospects can cause misunderstanding and serious financial the banking sector develops and the banks become more harm. Privatizing a company under a large-scale scheme is experienced and understand better the enormous riskiness a somewhat artificial operation. Before undergoing restruc- of the enterprise sector, a transformation economy experi- turing and stabilization, the company has a rather cloudy ences a heavy credit crunch. Even obtaining a simple bank future, and standard financial information, even if proper- loan for reasonable interest rates becomes quite difficult for ly disclosed, would be of very limited use to investors. any company. However, it was argued that functioning Finally, there is an issue of enforcement. It is not easy capital markets offer financial services cheaper than banks, to enforce disclosure requirements, let alone assess the because, for example the amount and payment of divi- quality and timeliness of the information disclosed. To dends can be made on a discretionary basis, yet interest punish a company by prohibiting trade in its stocks con- payments must be paid at agreed rates and intervals. tradicts the goals of privatization and the very purpose of In reality, the Czech capital market saw only a small the privatization securities market but serves the interests of number of initial public offerings (IPOs). This was pri- managers of the company and some stockholders. To pun- marily evident due to the lack of sufficient protection of ish the stockholders did not seem productive under the shareholder rights (especially minority rights) and the 157 R Li I o vc C k alleged unwillingness of controlling shareholders to dilute shares issued by a bank involved no risks, or were the rel- their interests by allowing entry of new shareholders. On ative equivalent of purchasing bonds or depositing money closer analysis, the matter was not quite so simple or in a bank account. Shortly after new shares were issued, straightforward. Usually, a newly privatized company share prices fell sharply (fell to about 25-30 percent of the needs structural changes such as layoffs, reorganization, original value), and some companies and banks went reorientation and upgrading of production, and modern bankrupt. This left many investors, both domestic and managerial expertise. Such restructuring typically requires foreign disillusioned and disappointed. These problems a strategic partner. If the IPO is the mechanism through were not limited to the performance of particular compa- which small investors are to acquire ownership rights in a nies, but were closely related to the performance of the company, they must first be convinced of the likelihood that economy as a whole. Thus, the duration of declining share the purchase of shares will generate revenue. In the case of prices has been a serious obstacle to the launch of IPOs. funds targeted for fundamental restructuring, the question This situation will likely resolve itself as progress is made is whether this process will ensure sufficient returns for the in the development of the corporate sector, the overall current shareholders (most having purchased shares with maturity of the financial institutions, and general growth vouchers) as well as for the new shareholders who invest- of the economy. ed cash. Inevitably, other difficulties in privatization include Investment Funds: A Principal Problem the unccrtainty of risk assessment in a non-mature market The manner in which investment funds were intro- (so investors have some idea as to what risks they are duced was also a constraint to the successful development assuming when they invest) and identifying a fair sale price of the capital market, as well as to a more efficient priva- for shares. In resolving some of these issues, perhaps the tization. In the beginning, the initial concepts of privatiza- case-by-case method of privatization can more aptly pro- tion, and its voucher component in particular, did not vide solutions rather than relying on the questionable abil- involve detailed considerations of investment funds or ities of the nonstandard market. But the case-by-case other institutions of collective investment. The pragmati- approach is costly and not necessarily acceptable for all cally conceived, rather simple, model was based on the shareholders. Therefore, the privatization securities market idea that such investment mechanisms would allow the fulfills t very specific and limited function of concentrating small groups of investors to accumulate a joint package of ownership to enable a limited group of shareholders who vouchers and use the voucher auction to gain a significant have an ownership stake in an entity to take decisions interest in a company. It was envisioned that this process toward productive corporate restructuring. would help resolve the problem of thinly dispersed owner- Initially, in the Czech Republic, few investors pur- ship and foster more direct interaction between share- chased shares for cash, and a large majority of those who holders and the companies they owned. There was little acquired shares through vouchers shortly disposed of them. consideration of the sophisticated rules as to organiza- Thus, in spite of all the criticism, imperfections, unethical tional structures of investor associations or funds. or fraudulenit practices of investment fund managers, and The legislation finally adopted introduced funds in a failure of some privatized companies, the purchase of manner similar to that present in standard capital markets. shares lor vouchers through auctions and their sale in the Under the law on investment funds, an investment fund privati2ation market proved to be, on average, quite prof- was not permitted to acquire more than a 20 percent inter- itable, wvhich was an intended goal of the voucher privati- est in the joint-stock company's total registered capital. In zation. On the other hand, the privatization market was not practice, fund managers had very limited powers to influ- meant as an instrument of teaching ordinary people to ence the companies whose shares they held. Trading in the become investors and, consequently, actively participate in stocks of privatized companies began at relatively high buying shares offered through IPOs. prices. Subsequently, though, a long-term fall in stock There were also more tangible reasons to reduce the prices prevailed in an environment where the prices of attractiveness of IPOs in the Czech Republic. In the very most of the stocks were uncertain. Under these conditions, early stages of the capital markets, many companies, it was not possible to assess which steps taken by a fund including banks, increased their capital through IPOs. manager were appropriate and which were not. For exam- Extensive advertising campaigns were launched to attract ple, total passivity could prove to be much more effective investors. Such investment risks were perhaps not wholly than attempts to modify a portfolio with the aim of understood by small investors, who thought that buying improving it. In the situation characterized by the overall 158 Czech Capical Markets: Illusions and Disillusions price decline, only a few funds decided to retain their orig- improved the structure of the market. About 150 core inal portfolio. companies are listed with the stock exchange. The yearly The first wave of the large-scale privatization saw the volume of trades in securities supported by the systems of establishment of 264 investment funds, whose advertising the PSE amounts to more than 90 percent of all trades. campaigns generated an unexpectedly high number of Privatized companies have not yet finished leaving the pub- voucher investors. The funds gained around two-thirds of lic markets, but, in general, the original number of about all vouchers and, consequently, a corresponding share of 2,000 public companies has been substantially reduced. assets. The second wave introduced unit trusts (mutual Presently, the RM-System registers about 1,200 companies funds), which resulted in the participation of 195 invest- with access to its trading systems. After the latest amend- ment funds, 37 open-end unit trusts, and 121 closed-end ment to the Law on Securities, more than 700 publicly held unit trusts, which acquired roughly two-thirds of available companies are expected to leave the organized markets, giv- assets. One positive aspect was that about 50 percent of ing new impulse to standardization of the stock markets. assets managed by funds were in the hands of approxi- Despite all the shortcomings of the costly process of mately 10 large funds or groups of funds, with some of capital market implementation, the legal and institutional them being founded by large financial institutions. This support of the market is, as of today, functioning and up- guaranteed a certain level of professionalism and trust- to-date. The same is true of the technological support for worthiness. These investment funds introduced certain dis- the relevant systems. The privatization market has enabled tortions into the trading process resulting from the fact that many people to become highly qualified specialists, such as most trading of these funds was done in larger blocks and securities dealers, investment consultants, and analysts. primarily outside the scope of the central market. It is also The most advanced informational technologies-including not clear that the aims of participants in the funds and the Internet and e-mail trading-are proliferating rapidly in the fund managers were consistent. Authorities were fully Czech Republic, giving stock market participants direct aware of these problem but were reluctant to take any access to information systems of the PSE, RM-System, strong measures, as there were concerns about undermin- Securities Center, and other agencies. There are many ing new ownership structures at the outset. Moreover, the opportunities for trading in securities, including foreign funds wielded too much economic power to trifle with. It securities, with the assistance of a licensed broker. was clear at the outset that future developments would The establishment of the Securities Commission in bring problems and disputes. In the beginning, it was not 1998 was an important step in the creation of a standard clear how long the negative influence of such funds would regulatory environment for the market. The commission prevail. It was obvious that many small funds would not has raised the quality of the disclosure procedures to the last, but this also could have been the case of a large fund extent that the updated information concerning public if the shareholders themselves had made a joint decision to enterprises is going to be available on the Internet. Of liquidate the fund. more than 500 brokerages (including licensed physical per- Imperfections related to the inadequate role of funds sons), less then 30 percent have received new licenses. New gradually became more visible, and a number of events in legislative initiatives are aimed at making the Czech secu- 1995 publicly exposed many of these problems. Some rities legislation fully compatible with that of the European asserted that the largest funds founded by large banks cre- Union and, more generally, with the relevant international ated a special structure in the economy that controlled a standards. The relevant regulations of the PSE and RM- significant part of the enterprise sector. It became clear System are being modified. The PSE also is preparing a spe- that funds were becoming an obstacle to successful fulfill- cial trading system for derivatives trading, and another ment of the privatization goals, not to speak of the capital new system (the New Market) is being created to support market development. These problems were resolved by IPOs of middle-size companies. opening closed funds and placing new requirements on Nevertheless, the market has not yet played a visible fund performance. The process of opening funds has been and effective role in the economy nor fostered the efficient started, and its completion is scheduled for 2002. allocation of funds. The latest situation in the area of open- end unit trusts, which have developed more rapidly than Conclusions other financial institutions, seems quite promising. Despite the problems encountered in the early devel- However, there are signs that the capital market finally opment of the capital markets, the steps taken in recent might be maturing. The corporate sector seems to be com- years by the Prague Stock Exchange have substantially ing to an important point in its restructuring and develop- 159 Rudlovcak ment. The substantial group of enterprises constituting the crossroads. Many of these entities will not survive, while the core of the industrial system of the former centrally planned others will have to streamline their activities and modify economy and fully dependent on the former Soviet Union their products in accordance with demand. New invest- and other Comecon markets, after having supported for a ments will be necessary for the final restructuring and devel- time the new developing market economy, is now at a final opment, opening new opportunities for the capital market. 160 Chapter 15 Capital Market Development in the Russian Federation Dmitri Vasiliev T he securities market plays a significant role in a modern economy, and the transitional nature of the Russian economy has had a strong impact on the functions and operation of its secu- rities market. This chapter tracks the development of the Russian securities market over the period 1991-2000 and makes predictions as to its future evolution. Economic Reform and the Securities Market ment short-term bonds (GKOs) and federal loan bonds (1991-99) (OFZs)-were issued in book-entry (paperless) form. In As a result of reforms initiated at the end of 1991, the 1992, the Ministry of Finance issued internal hard curren- Russian Federation (Russia) is moving toward a market cy loan bonds (OVVZ) denominated in U.S. dollars and economy. Several major events have determined the devel- state savings loan bonds denominated in rubles in coupon- opment of the Russian securities market: the large-scale bearer form. massive voucher privatization program, the financing of Domestic commercial banks were major investors in federal and local government deficits, the appearance of government securities, and some smaller banks had more pyramid schemes, the nonpayment crisis, loan-for-share than half of their assets in them. These banks suffered auctions, and the August 1998 banking crisis. most from the collapse of this market. Fast growth of gov- From 1992 to 1994, the large-scale massive voucher ernment debt, excessively high yields (50 percent and more privatization and related events had a significant effect on annually in dollar terms), and the perceived reliability and market development. About 147 million privatization liquidity of federal government debt resulted in the flow of checks (vouchers) were issued as freely transferable bearer a major portion of domestic savings into this market. This securities, accepted by the state as payment for shares of crowding-out effect inhibited the development of the equi- privatized enterprises. State-owned enterprises were trans- ty market and depressed growth in the real sector of the formed into joint-stock companies, and shares of the pri- economy. vatized enterprises were issued. Voucher privatization From 1993 to 1994, new commercial institutions, resulted, among other things, in the emergence of more including unlicensed financial companies, issued a mas- than 40 million retail shareholders (individuals) and the sive amount of securities and substitute securities, and establishment of the first Russian institutional investors financial pyramids were widespread. In 1993-94, more (voucher investment funds). than 1,000 financial pyramids attracted funds from some From 1993 to 1998, the deficits of the federal and 30 million retail investors. The collapse of these companies local budgets were financed by issuing securities, and this in 1994-95 undermined individuals' confidence in securi- resulted in the collapse of the government securities market ties venture capital companies. At present, fewer than 5 per- in 1998. Government short-term debt securities-govern- cent of individuals are willing to invest in such financial 161 Vasiliev instruments, and in 1994-97 the main task of the state in By spring of 1992, various types of securities had this area was to assist citizens in recovering the funds they appeared, with a wide range of maturities, issued mainly by had invested in venture capital companies. After these the state and corporations. The regulatory framework for pyramids collapsed in the summer of 1994, as well as in the securities market was formed in this stage. In December light of the development of the government securities mar- 1991, the Council of Ministers issued a resolution (RSFSR ket and strengthening of the regulatory regime for the mar- 78 about approval of the provision on issuance and circu- ket, the absorption of funds by venture capital companies lation of securities and stock exchanges) that was to govern almost stopped in early 1995. the securities markets for the next five years (except for pri- From 1992 to 1998, a nonpayment crisis occurred, vatized enterprises). accompanied by soft budgetary policy and the issue of The main milestones of the second stage were the sys- specific instruments-treasury notes, tax waivers, and tem of privatization legislation in 1992-94 and the creation promissory notes. The crisis of nonpayment in the nation- and development of an organized government securities al economy-explained, in particular, by the challenges market (from 1993 onward). The starting point was a for enterprises of adapting to market discipline and the presidential decree issued in July 1992 (president decree weak application of bankruptcy-resulted in a signifi- 721 about organizational measures for the reorganization cant issuance of specific "securities," which were used for of state-owned enterprises and voluntary merger of state- settlements among economic entities. After this, in owned enterprises into joint-stock companies), which had 1994-95 the Ministry of Finance issued a massive amount a significant impact on the development of the market in of treasury notes to be used for settlements with enter- 1992-94. Voucher privatization technology became, in prises that had liabilities toward the federal budget. These turn, a decisive factor in the development of securities mar- notes were exchanged for tax waivers, which were accept- ket infrastructure. able for payment of federal taxes. In some cases, region- In 1994, the Russian securities market exerted a strong al author ities also issued promissory notes, which allowed influence over both economic and political developments in them tc, avoid complicated procedures for registering the the country (both positive and negative). Thus, the sudden prospectuses of municipal bond issues at the Ministry of expansion of government short-term discount (noncoupon) Finance. A large issuance of promissory notes has infla- bonds (GKOs) in 1994 permitted a decrease in the amount tionary implications and, in Russia, resulted in a great of free monetary resources, which temporarily reduced the number of scandals related to the bearer form of these pace of inflation. At the same time, the government secu- securities. rities market inhibited investment activity on the corporate In 1995-96, loan-for-share auctions accelerated the segment of the market and became one of the reasons developrnent of the power of oligarchs and increased the behind the 1998 financial crisis. instability of ownership rights, weakening confidence in The sharp increase in the population's savings encour- reforms. aged the appearance of a large number of issuers (often On the one hand, the August 1998 crisis seriously financial pyramids) oriented to retail citizens. At the same undermined the development of the securities market in time, the government failed to address the problem of general. On the other hand, it put an end to the pyramid of financial pyramids, either through alternative and reliable GKOs, the overvalued ruble, and the strong power of financial instruments or through an efficient system for banks, creating the conditions for economic growth in controlling and preventing fraud. 1999-2000. In 1994, securities first started being used as a means of resolving the nonpayment crisis (treasury notes). In that Establishment and Growth Stages (1991-97) year also, Russia saw the first large investments by foreign The securities market in Russia began to develop in the investors in equities of privatized enterprises. The absence first half of 1991, after the adoption of a resolution by the of an adequate regulatory system and mechanisms for stim- Council of Ministers in December 1990 (RSFSR 601 about ulating domestic investment in corporate equities (through approval of the provision on joint-stock companies). This taxes and an appropriate macroeconomic and legal envi- first stage was characterized by rhe appearance of the first ronment) up until the crisis of 1997-98 made the Russian open joint-stock companies, the beginning of the trading of equity market highly dependent on the cyclical flows of state bonds on exchanges, the creation of hundreds of mostly speculative portfolio investments from abroad. exchanges, and the start of operation of the first investment Therefore, two quantitative shifts coincided in 1994. companies. On the one hand, the supply of securities increased sharply 162 Capital Market Development in the Russian Federation because of heavy issuance activity (securities issues by pri- cial crisis of 1998 dramatically altered the situation in the vatized enterprises, the government, and financial pyra- securities market. mids). On the other hand, the demand for securities grew dramatically as a result of the involvement of foreign Causes and Lessons of the 1998 Financial Crisis investors, the formation of a stable layer of the population The world financial crisis started in 1997 and hit with longer-term savings available to invest in securities, as emerging markets most of all. Russia was no exception. well as the involvement of banks and other financial insti- Russia, like other emerging markets, felt the global reori- tutions in this market, a result of the drop in returns on entation of investment institutions' strategies in 1998. At hard currency and credit market operations. the same time, the crisis on world financial markets led to By the time the mass privatization program had been relatively volatile national stock indexes throughout 1998. completed (1992-94), the initial stage of institutional Both the Asian crisis and the drop in world prices for change in Russia was over. Its most important result was primary goods were just the external causes of the financial the formation of the corporate sector of the economy, the crisis in Russia, which had its own specific origins. The cat- emergence of exchange and over-the-counter markets astrophic downfall of the Russian stock market in 1998 (including the trading infrastructure and secondary market cannot be explained solely by unfavorable world financial for shares of privatized enterprises), and the appearance of conditions. These only aggravated the negative trends pre- institutional investors. sent in the Russian economy. Internal factors such as the These factors determined market dynamics. Because GKO market, overvalued ruble, and poor regulation and the market grew so rapidly, the needs of issuers and supervision of the banking sector exacerbated the general investors exceeded the capacity of the market infrastruc- situation in 1998. ture. In 1992-93 the development of infrastructure was The situation on the domestic state debt market was ahead of market development; by 1995-96 the situation the mirror image of what was happening in the Russian had inverted. Fast market development also highlighted the equity market. The unique feature of the domestic state need to develop new legislation and market infrastructure. debt market was its short-term nature and significant share The third stage of securities market development of foreign investors. Domestic debt was largely in short- (1996-97) was characterized by development of the leg- term (mainly less than one year) securities. As a result, the islative framework (introduction of the Joint-Stock monthly amount required to redeem previously issued Company Law and Securities Market Law), infrastructure bonds (without taking into account coupon payments on development (growth of the number of professional market two- to three-year OFZs) reached the level of 10-15 per- participants, appearance of licensed registrars and deposi- cent of monthly gross domestic product (GDP). The sizable tories, creation and development of the Russian trading sys- participation of foreign investors in the financing of the fed- tem, and shaping of the self-regulatory system of profes- eral budget deficit heightened the dependence of the sional market participants). These developments were Russian economy on world financial markets. At the same accompanied by generally positive macroeconomic trends, time, the corporate equity market from 1995 to 1998 was a significant potential for growth of market liquidity and totally dependent on the government securities market in capitalization, and increased market stability. At the same both volume and dynamics. time, poor corporate governance made Russian securities The collapse of the GKO pyramid led to the collapse of rather risky investments. the Russian equity market, and global investors stopped During this stage of market development, interna- viewing Russia as a profitable investment after the country tional recognition was growing, as was the access of var- defaulted on domestic debt. Indirectly, the market also was ious types of Russian issuers to world financial markets. affected by the indecision of the Russian government and Key events in this area were Russia's entry into the the central bank regarding devaluation of the ruble: International Organization of Securities Commissions investors "incorporated" devaluation risks into the price of (IOSCO), assignment of international credit ratings, a suc- government securities, which, through growth of yields, cessful eurobond issue, publication of the International resulted in the further fall of equity quotations. Finance Corporation (IFC) Global Russia Index, and the Of course, the significant decline in stock quotations structuring of programs for American depositary receipts and market liquidity during the year beginning in the (ADRs) and global depositary receipts (GDRs) by a num- autumn of 1997 was connected to a range of factors: ber of companies. At the same time, the pyramid of GKOs * The danger of overall economic recession increased was growing at an exorbitant speed. The resulting finan- sharply, followed by a corresponding decrease in 163 Vasiliev profitability of Russian enterprises and a deteriora- The subsequent period from September 1998 through tion of their financial condition. the first half of 1999 can be characterized as post-crisis * Default on government debt securities, which stagnation. Although some segments of the Russian finan- domestic and foreign investors justly regarded as cial market were reignited by autumn of 1998, many key judicial nihilism, seriously undermined the confi- issues remained unresolved until mid-1999 (uncertainty dence of investors in the securities of Russian issuers regarding debt principal and interest, the GKO restructur- and led to a freezing of large amounts of investors' ing scheme, a clear program of regulation and sanitation of assets. the banking sector in crisis conditions, and overall uncer- * A sharp decrease in the liquidity of shares of first-tier tainty with respect to the prospects for Russian economic issuers and the complete illiquidity of second- and development). All of this deprived active economic entities third-tier shares on the Russian equity market also of any clear short-term markers and led to stagnation in the resulted in a freezing of investors' assets, which led market. to a sudden decrease in market demand. The financial crisis revealed serious impediments in the * Banking crisis, related not solely to losses on finan- domestic securities market: cial markets but also to the abolition of the primary * The strong orientation of market participants source of revenues (the GKO and OFZ market), toward speculative revenues and the lack of interest aggravated nonpayments, which had a direct impact in long-term investments on securities market participants. * The very low level of participation of domestic * The difficult financial situation of almost all Russian investors in the market (both retail and institution- brokers and the crisis of commercial banks paralyzed al) the securities settlement system and increased sys- * Minimal interest of investors in transparency of the temic risks. market (in part as a result of the continued struggle As a result, the drop in quotations and liquidity of for control within enterprises) Russian shares directly affected investment perspectives. * Weak protection of investor rights and a poor cul- Russian companies were no longer able to attract funds by ture of corporate governance issuing securities on domestic and foreign markets. The * Poor coordination of efforts of the state regulatory state was unable to borrow or sell blocks of shares of authorities on the securities market and persistent Russian firms to financial investors. Market evaluations of conflicts of interests within the respective regulatory Russian companies decreased significantly, which made it authorities, for instance, inside the central bank impossible to sell strategic blocks of shares to foreign * Preservation of significant gaps and contradictions in investors. Direct investment funds, which had been plan- the regulatory framework for the securities market. ning in August 1998 to invest about $1 billion in shares of Russian issuers, temporarily lost interest in Russian pro- Post-Crisis Growth (1 999-2000) jects. The period from 1999 to early 2000 gives grounds for The financial crisis of 1998 posed a serious challenge optimism regarding the prospects for development of the for professional market participants. Market participants, Russian securities market. Some positive assessments are holding assets in government securities, incurred significant based largely on the revitalization of Russian industry after losses, which affected the business of market intermediaries devaluation of the ruble and the rise of world oil and gas as a whole. Before July 1998, the number of professional prices, which increased the tax revenues of the budget and market participants (brokerage, dealing, and fiduciary secu- the revenues of exporters. Such positive dynamics were rities management) and their capital were increasing; after witnessed in the majority of industries, including the chron- August the situation had changed completely. The strongest ically depressed ones (such as electrical manufacturing decrease took place in pure brokerage services as a result of industry, consumer goods, and agricultural products pro- the termination of the so-called "vacuum cleaner" era of cessing). The year 2000 was perhaps the most favorable for the mai-ket's functioning (when smaller regional brokers economic development in Eastern Europe over the past were buying shares for Moscow brokers, who were selling 10 years. them to foreigners). At the same time, in 1998 the dealer Several trends had a positive impact on the Russian market for foreign investors also experienced a crisis, securities markets during this period: the post-crisis eco- whereas traditional exchanges turned out to be the most nomic growth in 1998-99 (with GDP growing 3.2 percent viable in crisis conditions. and industrial production growing 8.1 percent), a relative- 164 Capital Market Development in the Russian Federation ly stable macroeconomic situation, and positive political Privatization and Corporate Governance developments in 1999-2000. In 1999, the Russian securi- The Russian model of privatization practiced from ties market was among the three most rapidly growing 1992 to 1994 (called the biggest sell-off of state property markets in the world. The price of Russian debt grew to in the twentieth century) determined the basic structure of 60-70 percent of its face value in 1999. The market capi- corporate ownership and governance in Russia (loan-for- talization of the blue chips grew 185 percent in one year. share auctions in 1995-96 did not change the overall The RTS-Interfax Index became the second fastest-growing direction of development, although they somewhat index in the world (after Turkey). In January 2000, strengthened the position of oligarchs). Three-fifths of investors became interested in second-tier companies, Russian open joint-stock companies in operation today which is a sign of reorientation from purely speculative arose as a result of privatization, and they account for short-term investments to a longer-term strategy. four-fifths of all industrial production. This, in turn, pre- In 1999, for the first time since the financial crisis, a determined to a great extent the nature and specific char- number of Russia's largest companies issued depositary acteristics of the development of the Russian corporate receipts. Meanwhile, most Russian corporate borrowers on securities market. the eurobond market tried to fulfill their current obligations The principal features of the Russian model of priva- in a timely manner. Interest in Russian corporate bonds also tization can be summarized as follows: renewed in 1999, and some of the largest companies issued * Mass corporatization in the course of privatization debt that year. (more than 30,000 open joint-stock companies were Against this background, Russia's international credit created in Russia, and there are more of these com- rating is likely to improve gradually, which will have a panies in Russia than in the rest of the countries of direct influence on the ability of the government and cor- Eastern and Central Europe and the CIS combined). porations to attract capital in international financial mar- * Significant special advantages for insider employees kets. Agreements reached in February 2000 between the and managers and their widespread participation in Russian government and the London Club of Creditors privatization (at the very onset of the privatization support these optimistic views in the medium term. process, 50-60 percent of shares were transferred to However, problems still remain. The Economic Freedom insiders for vouchers or were sold for cash). Index, for instance, historically published by the American * A large-scale (or free) distribution of shares in pri- Legacy Foundation, estimates the investment climate in vatized enterprises for vouchers, which were issued 161 countries. Russia occupies 121st place, being classified to all citizens for a symbolic charge. as "a mostly dependent country." Almost all countries of * The freely transferable nature of the vouchers and Eastern Europe and the Commonwealth of Independent their free circulation on the market, which made it States (CIS) are classified under the same category, although possible for processes involving the concentration of with better scores. ownership to begin considerably sooner than the The following trends for the securities market are actual sale of shares (approximately 25-30 percent expected in the near term: of citizens sold the vouchers they received, and one- * Reduction in the number of professional market third of the vouchers sold went into the hands of for- participants and an increase in competition eigners). * Post-crisis redistribution of ownership in financial * The sale of shares under certificate-based privatiza- groups and corporations (which could result in tion both directly and through intermediaries (some many violations of shareholder rights) 25 million citizens became shareholders in 450 cer- * Appearance of financial instruments new to the tificate investment funds, which were the first col- Russian market, caused by the attempts of corpora- lective investment institution in post-communist tions to find alternative sources of capital (corporate Russia). bonds, warehouse certificates, and mortgage securi- * The open nature of joint-stock companies created in ties) the course of privatization, which allowed the * Gradual development of new collective investment processes of redistribution of ownership through mechanisms (closed real estate unit investment the free sale of shares. funds) The initial structure of corporate ownership that * Efforts to improve the quality of corporate gover- emerged was the result of the implementation of this type nance. of privatization model. 165 Vasiliev On average in 1994 insiders accounted for 60-65 per- go the same vigorous development in Russia as they did in cent of shares held in privatized enterprises, while out- the Czech Republic. For example, investment funds hold 60 siders accounted for 18-22 percent. The state's ownership percent of the shares in Czech enterprises and are the real was as high as 17 percent. owners of Czech industry. Investment funds in Russia hold In cornection with the state's hold on large blocks of approximately 10 percent of the shares in Russian enter- shares in so-called strategic enterprises and by virtue of the prises, and they usually are minority outside shareholders. size of these enterprises (which are typical of countries such They could potentially play a positive role as a champion as Hungary, the Czech Republic, and Poland as well), the of minority rights. structure of corporate ownership and the subsequent tra- At the same time, managers of Russian investment jectory of rhe development of corporate governance differed funds are infringing on the rights of small shareholders, as sharply. This was the case across enterprises in the petrole- are the managers of Czech funds. The problem of "dor- um and gas industry, the electric power industry, and mant shareholders" of investment funds is even more press- telecommunications, where the state's stake was usually ing for Russia, and up until 1998 the regulation of these around 38-51 percent. The insiders' stake was 20-30 per- funds was too lax. cent. This compared with the majority of enterprises in light During the course of large-scale privatization in industry, the food industry, and the production of building Russia-and the majority of other countries with transition materials, in which the state's stake was nonexistent or in the economies-there were no market quotations or reference 10-15 percent range, and insiders played a dominant role. points for the purchase of shares (as was the case with pri- Continuing participation by the state in the capital of vatization in the 1980s in Western countries, such as the many Russian enterprises is one of the main reasons for the United Kingdom under Margaret Thatcher). Shares of inefficiency of their economic operations and the source of enterprises being privatized appeared on the market for the a number of Russian political and corporate scandals. first time in 1992-94. As the market developed further, Therefore, the privatization of these blocks is important, quotations of many stocks appeared, providing an oppor- not just for eliminating the budget deficit but also for tunity for firms to obtain a market valuation of their assets. improving the efficiency of the Russian economy. The gov- This is likely to reinvigorate the market for privatization ernment has announced privatization plans involving the fund stocks, which will create new stimuli and incentives quick sale of minority (up to 25 percent) blocks of state- for funds to act as shareholders of enterprises and as play- held shares in thousands of privatized enterprises but has ers in the stock market. not carried them out. The structure of stock ownership that took shape after Generally speaking, the substantial dominance of insid- the completion of mass privatization is changing fairly ers at the initial stage of development after privatization is rapidly. Specifically, the following changes have occurred the most important feature of corporate ownership and since 1994: governance in Russia. This dominance by insiders and the * A substantial reduction in the proportion of employ- inevitable problems and conflicts arising from it, which are ee-shareholders (who play a minor role in manage- related to the violation of shareholder rights, also charac- ment because most of them delegate their votes to terize other post-communist countries. For example, they the administration) are occurring in Armenia, Croatia, Georgia, Lithuania, * An increase in the role of the administration (man- FYR Macedonia, Mongolia, and Slovenia. agement) Certificate-based privatization resulted in a major dis- * An increase in the role of large outsider shareholders persion of owners in Russia, as in other countries (in July * A decrease in the role of the state. 1994 there were 40 million small shareholders in Russia, The struggle for control at Russian joint-stock com- but this n umber is smaller now). In the Czech Republic, for panies is becoming more intense as a 50/50 balance of example, the struggle for control began as soon as mass pri- forces between insiders and outsiders has developed at vatization was complete. As in many other countries in many enterprises. This struggle for control has resulted in Eastern and Central Europe, the managers of the enter- numerous violations of shareholder rights (especially on the prises played, and are continuing to play, a major role in part of managers) and created disincentives for the disclo- this process. sure of information about enterprises. For example, man- For a number of objective reasons, such as excessive agers who want to buy shares at a lower price have no advantages offered to insider employees and the use of interest in disseminating information about their joint- investment intermediaries, investment funds did not under- stock company. This struggle for control can lead to the 166 Capital Market Development in the Russian Federation domination of Russia's over-the-counter market, since it is Similarly, no united regulatory authority was in charge not profitable for brokers to disclose prices and the volume of the securities market. Until the beginning of 1995, mar- of transactions to their clients. It creates a situation in ket participants were regulated and licensed by the central which enterprises do not have sufficient interest in new bank (all securities operations of banks), the Ministry of stock issues out of fear of losing control of the enterprise Finance (all nonbanking institutions, except for voucher (although there clearly are other obstacles to new stock investment funds and registrars), and the State Property issues, such as competition with monetary privatization and Committee (voucher funds and registrars). The placement of government securities). Finally, this struggle is Commission for Securities and Exchanges, established in hindering the effort to transfer the management of registers 1992 by the then president of Russia, existed from 1992 to to independent registrars. 1994 only as an interministerial consultative agency. The creation of a system for transforming savings into By the beginning of 1996, the joint efforts of the pres- investments will require a major effort to restore the pub- ident, the government, and the federal assembly changed lic's trust in investment intermediaries (banks and collective the situation. Parts 1 and 2 of the civil code were adopted investments) after the widespread scandals involving pyra- and enforced, as were the Joint-Stock Company Law and mid schemes from 1994 to 1995 and the losses of individ- the Securities Market Law. In November 1994, a presi- uals stemming from the banking crisis of August 1998. dential decree created the Federal Commission for Restoring the public trust is a complex and long-term task Securities as a united authority responsible for regulating all that can be achieved only with a serious tightening of gov- types of professional activities on the securities market. Its ernment control over the securities market and a targeted powers were set out in the Securities Market Law (April public information and promotional campaign. 1996) and the Joint-Stock Company Law (December Currently, banks, investment funds, and foreign 1995), as well as a number of presidential decrees. investors are not significant sources of financing for the Over the period 1996-99, the Federal Commission enterprise sector. As economic growth accelerates, howev- for Securities adopted more than 100 regulations for all er, the situation is changing. The acceleration of this process aspects of market functioning, reissued licenses to profes- is primarily attributed to: sional market participants, prepared materials for initiating * A decline in the profitability and scale of government criminal proceedings against more than 800 financial pyra- borrowing on the securities market (which for a mid builders, introduced more rigorous requirements for long period of time crowded out investments in the the registration of securities issues and disclosure of infor- real sector) mation by issuers, and strengthened enforcement. . Development of the legal framework, for example, The legislative framework improved rather slowly the creation of an institution for securing credits from 1996 to 2000, except for the adoption of the Law provided to the real sector on the basis of the priva- about Protection of Rights and Legitimate Interests of tization of land and real property, the development Investors in spring of 1999. Many important issues, con- of a mortgage lending system, and the strengthening nected with the adoption of amendments to the criminal of the legal position of creditors procedural code and civil procedural code, joint-stock com- Introduction of legislative and enforceable liability pany law, and law on investment funds, remained unre- for violation of shareholder (creditor) rights, which solved. In particular, two programs connected with the will increase the level of interest in investing in enter- protection of investor rights, which were adopted by the prises government in 1996 and 1998, were not implemented. * The success of efforts to increase the openness of Russia is characterized by very weak enforcement of enterprises to investors (disclosure of information existing legislation on the protection of shareholder rights. and accounting reform). Concentration of ownership has become widespread, but this may change as the quality of accounting improves and The System of Legal and Corporate Governance the legislation is enforced. The delay of legal reform during 1991-98 not only had The legislation in force in Russia now incorporates a a material impact on the development of the securities number of important measures to protect shareholder market during those years but also permitted the creation rights (for all practical purposes, the only elements missing of financial pyramid schemes. Market participants were are mandatory dividends and the right of a minority of forced to use outdated, Soviet-style civil and penal codes shareholders to overturn management decisions). The main and other laws. reason for Russia's problems, however, is poor enforcement 167 Vasiliev of the legislation. Russia is lagging far behind other transi- be adopted only by a general shareholders meeting of the tion economies in this regard, including a number of CIS given joint-stock company. This provision was subse- countries. quently written into the federal Law on Protection of the The most typical violations of shareholder rights Rights and Legal Interests of Investors in the Securities include violation of a shareholder's right to participate in a Market. general shareholders meeting, dilution of capital, violation of shareholder rights in the course of reorganizing and Information Disclosure consolidating companies (especially in the process of con- Progress has been made on information disclosure. In verting to a single stock), and the violation of information 1997-99, the Russian Federal Securities Commission, pur- disclosure requirements. It also includes asset stripping suant to the requirements of the Law on the Securities and the transfer of assets to friendly companies, transfer Market, adopted several regulations identifying the nature pricing, conclusion of sweetheart deals in violation of estab- of the information to be included in the quarterly reports of lished procedure, and fraudulent bankruptcies with the issuers and establishing the procedure for its disclosure. In subsequent purchase of assets being sold. addition, requirements were established for the disclosure of information provided by issuers in the course of a secu- Shareholders' Rights rities issue. In spite of the crisis conditions in 1998-99, there was Progress also has been made through publication of the no significant decline in stock-issuing activity by joint- Law on Protection of the Rights and Legal Interests of stock companies. This can be explained by the fact that the Investors in the Securities Market. Under this, the Russian mechanism involving the placement of securities was Federal Securities Commission obtained the authority to employed not as a means of attracting needed investments, impose penalties for violations in the area of information but as an instrument in the struggle for control of a com- disclosure. This same law established a ban on public trad- pany through the "dilution" of shares held by undesirable ing of securities of issuers that do not disclose the amount shareholders (primarily small and mid-size shareholders of information required or do not follow the procedure who hold a so-called "blocking" parcel of shares). established by the legislation. The boards of directors, taking advantage of the opportunity afforded by law to adopt decisions that The Post-Presidential Elections Period increase authorized capital, often placed shares through a When the 2000 presidential race was over, Russia closed subscription to affiliated persons at what were clear- entered a new stage of its development. The main basis for ly belovw-market prices, frequently without notifying share- political stability is now in place, and this is critical for the holders. The conditions of the placement were based on the securities market. "bottleneck" principle-the idea was to make it impossible Still, the president of the Russian Federation and the or extremely difficult for shareholders to acquire stocks. government face a number of political problems. The solu- For example, the stocks of a large issuer were placed on a tion is important for reform in general and for the securi- single d.ay, and a shareholder had to appear in person to ties market in particular. These include the danger of depri- conclude the transaction. vatization (reprivatization and nationalization). A positive Violations of shareholder rights involving the reorga- solution would be to shorten the period of limitation for nizationi of joint-stock companies also were widespread. reviewing privatization transactions and to apply other The purpose of reorganization was to allow a "controlling" measures aimed at protecting the rights of investors- shareholder to convert a profitable business into new com- good-faith purchasers in the case of nationalization. The panies. The remaining shareholders inherited the financial main challenge, which is critical to development of the problerns of the "old" company. In other words, some securities market, is to reform the state. shareholders were forced out of the company and given The main mid-term challenges facing the president in shares in new companies with an unfavorable financial the sphere of capital market development are as follows: status. 1. Macroeconomic and structural reforms, primarily To prevent such violations, the Russian Federal tax reform, reduction of macroeconomic risks and Securities Commission included a number of provisions in improved efficiency of sovereign debt management, its regulatory acts aimed at protecting shareholder rights in introduction of international accounting standards, the process of issuing securities. These provisions required banking system reform, development and circula- that a clecision to place stocks through a closed subscription tion of a system for regisrering real estate titles of 168 Capital Market Development in the Russian Federation ownership, development of an insurance industry, ation of conditions for the development of existing and pension reform and development of private instruments (corporate bonds); development of the pension funds. system of insurance (guarantee) of investors' risks; 2. Improvement in the quality of corporate gover- and improvement in compliance with the rules on nance, through more rigid regulation of issuers' the securities market. behavior, increased activity of investors themselves on behalf of their own rights, and stronger infor- Conclusions mation disclosure requirements. The development of the fledgling securities market has 3. Acceleration of legal reform, especially enforcement encountered difficulties, but these are not unique to Russia. and improvement of the court system. The securities market was born less than 10 years ago and 4. Strengthening of the securities market through an has grown rapidly. It already has contracted some of the increase in the efficiency of market infrastructure, diseases typical of a young market (such as building pyra- including the establishment of a central depository; mids and pumping up the governmental securities market) creation of preconditions for the development of and has developed some immunity against them. It is as collective investment vehicles, including closed-end volatile as any other emerging market, and it is as risky. funds that are investing in real estate; introduction Solving all of these difficulties must await the resolution of of new financial instruments to the market (ware- some of the deep-seated structural problems confronting house certificates and mortgage securities) and cre- the Russian economy. 169 Part V Lessons Learned and Future Challenges Chapter 16 Banking Transition: A Comparative Analysis Stephen Fries and Anita Taci T he development of sound, market-oriented banking is fundamental to the postcommunist tran- sition. Banks in a market economy must provide monetary payments, without which markets can function only at high cost. Although this is taken for granted in industrial market economies, there has been an unprecedented proliferation of nonmonetary forms of payment in some transition economies (Seabright 2000). Banks also must mobilize and allocate capital efficiently and prudently to facilitate the process of saving and investment and to promote long-term growth. But bank intermediation remains stunted even after a decade or more of reform (EBRD 1998: ch. 5). These persistent symptoms raise concern that the banking reforms implemented so far have failed to spur adequately the development of banking in transition economies. The transformation of socialist banking systems was Most transition economies have followed the same bound to be difficult. While cement factories still could broad paradigm for transformation of the banking sec- produce cement, the services of socialist banks were of lit- tor-a paradigm associated with, but not confined to, tle use in a market economy. These institutions were pri- the policy advice of the International Monetary Fund marily bookkeepers for the planned allocation of (IMF) and the World Bank (see, among others, Calvo resources, providing "monetary" accounts for resource and Frenkel 1991; Fisher and Gelb 1991; Caprio and flows. However, these accounts differed fundamentally Levine 1994; Fries and Lane 1994). The so-called from bank deposits in a market economy. There were Washington consensus on banking transition called for tight restrictions on the use of the monetary balances of separation of commercial banks from the central bank, enterprises and households, and interest rates on these abolition of restrictions on internal convertibility of balances were set administratively. Credits were allocated money, liberalization of interest rates, restructuring and to enterprises on the basis of planned investment priorities, privatization of state banks, and entry of new private and the repayment of credits was subject to bargaining. banks regulated by minimum capital and licensing Bankruptcy and legal enforcement of creditor rights were requirements. At the same time, the state had to take on nonexistent. Moreover, to facilitate their role in the plan- important new roles to provide effective prudential regu- ning process, socialist banking systems were highly con- lation and supervision of banks. This involved develop- centrated, with little separation of central banking and ment of significant new state capacity in terms of the commercial banking activities. Some banks specialized by enactment of new banking laws and regulations and their activity, particularly in industry, agriculture, foreign trade, effective enforcement by the supervisory authorities and and household savings. the courts. Although most countries have followed this 173 Frics andc Taci broad paradigm, the pace and sequencing of reforms have both country-level and bank-specific factors in a reduced- differed significantly. form model that includes variables expected to be associat- The advocated reforms clearly were required to over- ed with the demand for and supply of bank loans to cus- come some of the legacies of socialist banking, but have tomers. This analysis finds that progress in banking reform they been sufficient to spur the development of sound, has been the sine qua non of banking development. Where market-oriented banking systems? A basic measure of the there has been little progress in banking reform, there is no development of banks is the scale of their activity. The significant association between the real growth in customer level and growth of deposit taking and lending are useful loans and the potential supply and demand factors. indicators of banking development because deposits and Where banking reform has advanced, however, the real loans ernbody the payment and intermediation services growth in bank lending displays a number of distinctive provided by banks. features. Output growth is significantly associated with an This chapter assesses the development of banks in tran- expansion of bank lending, although growth in lending has sition economies at both the aggregate level and that of indi- failed on average to keep pace with that of output. This is vidual banks. The aggregate analysis covers all countries of consistent with the lack of evidence at the aggregate level of Central and Eastern Europe, the Baltic region, and the increasing depth of transition banking systems. There is a sig- Commonwealth of Independent States (CIS) except Bosnia nificant, positive association among bank capitalization, the and Herzegovina, Georgia, Tajikistan, Turkmenistan, ratio of shareholder equity to total assets, and loan growth. Uzbekisi:an, and the former Republic of Yugoslavia for the This suggests that financially stronger banks are attracting years 1994-99. At the bank level, the chapter focuses on 14 resources with which to expand, an indication that loan countries in Central and Eastern Europe and the Baltic growth is based on a sound foundation where banking region (all except Albania, Bosnia and Herzegovina, and the reforms have advanced. At the same time, the larger banks- former Republic of Yugoslavia) and four CIS countries- primarily those that emerged from the old regime-are Belarus, Kazakhstan, the Russian Federation (Russia), and expanding relatively slowly or are contracting their cus- Ukraine (16 in all)-for the period 1994-98. This sample of tomer lending. This reflects a declining role of old institu- banks is selective across and within countries, because it tions, even after their restructuring and privatization, and the excludes those banks that do not disclose publicly their relatively stronger growth of smaller, less dominant banks. A financial accounts-typically small banks or those that are surprising finding is that bank ownership-newly estab- chronically loss making. The banks included in the sample lished private, privatized, or state-owned-is not associated tend to be the larger commercial and savings banks in each systematically with loan growth, while foreign ownership is country, and they account for the vast majority of the bank- associated strongly with loan growth only in one country. ing operations in their respective countries. The empirical findings suggest that, while progress in Thc chapter finds at the aggregate level that expansion banking reform is shaping the development of banks in of banking activity, particularly lending to businesses and transition economies, the supply response of banks remains households, was associated with progress in structural and weak, particularly given the weak association between institutional reforms and growth in output. Where there bank ownership and growth of customer loans. Policies was lirtle progress in structural and institutional reform that could complement the consensus banking reforms and (including banking reforms) and growth in output, there spur a strong supply response are discussed in the conclu- was little development of banks. Only a few countries in sion to the chapter. Central and Eastern Europe and the Baltic region saw over the period 1994-99 an increase in bank loans outstanding Implementation of Banking Reforms to the private sector relative to gross domestic product One measure of progress in reform of the banking (GDP) in 1999-Bulgaria, Croatia, Poland, the Slovak sector is the transition indicator of the European Bank for Republic, and Slovenia. Moreover, the ratio of private sec- Reconstruction and Development (EBRD) for banking tor crecdit to GDP in all transition economies remained reform. This indicator provides a ranking of progress in lib- well below the estimated benchmark for a sample of 127 eralization and institutional reform of the banking sector, developing and industrial market economies in 1995, and on a scale of 1 to 4* (4.3). A score of 1 represents little evidence points to the crowding out of credit to the private change from a socialist banking system apart from the sep- sector by government borrowing. aration of the central bank and commercial banks, while a The analysis of lending to businesses and households at score of 2 means that a country has established internal cur- the level of individual banks allows for the influence of rency convertibility and has liberalized significantly both 174 Banking Transition: A Comparative Analysis interest rates and credit allocation. A score of 3 means implemented. Figure 16.1 shows that, in Central Eastern that a country has achieved substantial progress in devel- Europe and the Baltic states (the Czech Republic, Estonia, oping the capacity for effective prudential regulation and Hungary, Latvia, Lithuania, Poland, the Slovak Republic, supervision, including procedures for the resolution of and Slovenia), liberalization and institutional reform in bank insolvencies, and in establishing hardened budget the banking sector have advanced in parallel with the state's constraints on banks by eliminating preferential access to withdrawal from the direct provision of banking services. concessionary refinancing from the central bank. A score of This approach is balanced in the sense that the state has lib- 4.3 represents a level of reform that approximates the insti- eralized the market for banking services and developed tutional standards and norms of an industrial market econ- the capacity for effective prudential supervision and regu- omy, as represented, for example, by the Basle Committee's lation in step with the growing role of private banks in the Core Principles on Effective Banking Supervision and system. Regulation. The scoring assessments are by EBRD country The countries of Southeastern Europe (Albania, economists (see EBRD 1998, 2000). Bulgaria, Croatia, FYR Macedonia, and Romania) have A second, complementary measure of the transforma- followed a similar approach, albeit at a much slower pace tion of the role of state in the banking sector is the share of (see figure 16.2). This reflects at least in part the more dif- private banks in the total assets of the banking system. This ficult economic and political conditions at the start of tran- indicates the extent to which the state has withdrawn from sition in these countries, particularly the misallocation of direct provision of banking services through the privatiza- resources, macroeconomic imbalances, trade flows, geo- tion of state banks and entry of new private banks into the graphic location, and turnover of old political elites (see de system. The measure also captures the potentially differ- Melo and others 1997; EBRD 2000: ch. 2). The banking ential rates of growth of private versus state banks. systems in these countries remained a source of indirect With these two measures of the transformation of the subsidy for troubled enterprises well into the transition, role of the state in the banking sector, it is possible to show which constrained the pace of banking reforms, such as the how the broad paradigm for banking reform has been implementation of prudential regulations and bank priva- FIGURE 16.1 PROGRESS IN BANKING REFORM AND PRIVITIZATION IN CENTRAL AND EASTERN EUROPE AND THE BALTICS, 1989 TO 1999 4 -100 Indices of banking reform & interest rate liberalization 3 Private bank share in total assets 90 3.5 -280 70 3. 1989 1990 199 199 193 194 195 196 997 998 199 609 .5~~~~~~~~~~~~~~~~~~~~~~~~7 2.5 - 50 su '4-4 cCC 2 C ~~~~~~~~~~~~~~~~~~~~30 20 1.5 _ _ _ _ _ _ 2 . 10 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Source: EBRD (2000). 175 Fries aiid Taci FIGURE 16.2 PROGRESS IN BANKING REFORM AND PRIVITIZATION IN SOUTHEASTERN EUROPE, 1989 TO 1999 4 100 4- Indices of banking reform & interest rate liberalization | Private bank share in total assets 90 3.5 80 70 3- 60- E 2.5 50 . C ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~U 40 - * 2- 3 0 1.5- 1 0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Source: EiBRD (2000). tization. These practices ultimately culminated in banking Development of Banking Systems crises (Bulgaria in 1997 and Romania in 1999) that even- After a decade of extensive reform of the banking sec- tually helped to spur a stronger pace of reform. tors of the region, it is time to take stock and to assess The transformation of banking in CIS countries, in whether the Washington consensus on banking transition contrast, has followed a markedly different sequence and has succeeded. The measure of success, however, is not pace. Figure 16.3 shows that the state withdrew more simply whether the policy prescription has been followed rapidly from its role in the direct provision of banking ser- but also the extent to which the tonic has proved to be the vices in the CIS (except Georgia, Tajikistan, antidote to socialist banking and the spur to the provision Turkmenistan, and Uzbekistan, where data are missing) of banking services to the private sector. At the most basic than in Central Eastern Europe and the Baltic states. This level, this includes the provision of deposit-taking and reflects, in part, the political strategy of those seeking to lending services. Measures of this activity can be used both break up the former Soviet Union by promoting the devo- at an aggregate level for banking systems as a whole and at lution olf economic power away from the Soviet federal the disaggregated level of individual banks. An advantage governient largely through the spontaneous privatization of disaggregation is that it reveals the process of adjustment of state assets. Central to this strategy were the transfer of by individual banks and the potential influence of some fac- most state banks into private hands and the laissez-faire tors associated with the supply of banking services. At the formation of new banks. However, the implications of this same time, an aggregate analysis can help to identify factors approach for other dimensions of banking reform have at the country level that influence the development of bank- been problematic. The proliferation of nonviable banks ing, such as output growth and progress in structural and created significant interests that were opposed to sound institutional reform. prudential regulation and mechanisms for the exit of non- One aggregate measure of banking development is the viable banks. The slow pace of banking reform in these ratio of domestic credit or broad money to GDP. countries reflects, in part, this resistance to further Following EBRD (1998: ch. 2), figure 16.4 shows the reforms. ratio of domestic credit provided by banks to GDP for 176 Banking Transition: A Comparative Analysis FIGURE 16.3 PROGRESS IN BANKING REFORM AND PRIVITIZATION IN THE COMMONWEALTH OF INDEPENDENT STATES, 1989 TO 1999 4- - Indices of banking reform & interest rate liberalization 100 Private bank share in total assets L90 i __3.5- 0t 80 a 3 , A___ -70 60 3 2.5- 0 5 4 0 2 - 30 Z 20 1.5- o10 l- +, +, O, , , | | | g o0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Source: EBRD (2000). countries at different levels of development. The solid trajectory of change between 1994 and 1999. The share of line shows the fitted regression relationship for a sample bank credit to the private sector is well below the market of 127 developing and advanced market economies economy benchmark in 1999, and only in Bulgaria (after worldwide, excluding the transition economies with 1997), Croatia, Poland, the Slovak Republic, and Slovenia which this chapter is concerned. The relationship is esti- is there significant convergence toward the benchmark mated by regressing the ratio of domestic credit to GDP in over time. In contrast, the share of bank credit to the pub- 1995 on the log of per capita gross national product lic sector (not shown) is well above the market economy (GNP) in international U.S. dollars at purchasing power benchmark in 1999, and this ratio has tended to increase parity for 1995 and its squared value. The transition over time in many transition economies, reflecting fiscal economies are represented in the figure by their position pressures in transition. in 1999 (the solid dots) as well as by the trajectory of This aggregate assessment of banking development change between 1994 and 1999 (the lines connected to shows that the expansion of credit to the private sector rel- the dots). The figure shows clearly that virtually all tran- ative to GDP over the period 1994-99 is confined largely sition economies lie below the market economy bench- to a few countries in Central Eastern Europe and the Baltic mark for the ratio of domestic credit to GDP. Moreover, region. These countries are also those that have witnessed apart from a few countries in Central Eastern Europe output growth and significant progress in structural and and the Baltic region, there is little convergence toward institutional reform over the period (see EBRD 2000: ch. 2, the benchmark over time. 3). This association suggests that output growth and reform Figure 16.5 also shows that it is primarily the private progress, including that in the banking sector itself, con- sector that suffers from the underdevelopment of the bank- tribute to the development of banking. However, even in ing sector. It is bank credit to the private sector, rather the few examples of development at the country level, the than credit to the public sector, that is undersupplied rela- response to reforms is relatively weak. This leaves open the tive to that in comparable market economies. Again, the possibility that reforms within banking sectors have been solid lines show the estimated nonlinear relationship insufficient, particularly with respect to spurring a strong between the ratio of bank credit to the private sector to supply response by banks. There are also potential con- GDP and per capita GNP for a sample of 127 developing straints from outside the banking sector on the growth of and industrial market economies. The transition economies bank lending, including the lack of legal protection of are represented both by their position in 1999 and by the investor rights. 177 Fries and Taci FIGURE 16.4 RATIO OF TOTAL BANK CREDIT TO GDP IN TRANSITION ECONOMIES RELATIVE TO MARKET ECONOMY BENCHMARKS 120 - c 110 Market Economies Credit Benchmark 100 * Actual Total Credit to GDP .5 90 Change between 1994/1999 80 70 60 s 50 Czech Rep. 4 40 Estonia Slovak Rep. X 20 PolandAlbani * 4 o I 10 0 5000 10000 15000 GNP per capita at purchasing power parity in 1995 US$ FIGURE 16.5 RATIO OF PRIVATE SECTOR CREDIT TO GDP RELATIVE TO MARKET ECONOMY BENCHMARKS u 90 c 80 - Market Economies Credit Benchmark * Actual private sector credit to GDP 0 70 - Change between 1994/1999 o 50 0 5 u 1 \ ~~~~~~~~~~~~~~~~Czech Rep. 00 X 0 \ ~~~~~~~~~~~~~~Slovak Rep. > :30 S 1 Croatia lovenia .; 1 / / ~~~~~~~~~Hungary 14.- 20 -N 10 - >ulg--Po land lo 0- 0 5000 10000 15000 GNP per capita at purchasing power parity in 1995 US$ 178 Banking Transition: A Comparative Analysis Growth of Bank Lending to Customers factors over time, it is possible to estimate a reduced-form Given the significant and persistent underprovision of equation that relates the real growth of bank loans to their credit to the private sector at the aggregate level, an analy- customers to observable demand and supply factors. It is sis of the real growth of customer loans to businesses and important to recognize, however, that the behavior of households by individual banks can help to identify a broad- banks and their customers is not necessarily constant across er range of factors associated with banking development in countries and over time. In fact, there is reason to expect transition economies. The observed rate of real growth in that the supply and demand for bank loans would vary sys- customer loans reflects the interaction of the demand for tematically with progress in banking reform. This particu- banking loans and their supply by individual institutions. lar factor is likely to have a significant impact both on the Factors at the country level that are likely to increase the real confidence of banks in the repayment of loans by their bor- demand for bank loans by customers (businesses and house- rowers and on the confidence of depositors in banks. In holds) over time are the growth of output and the compet- particular, where there is little progress in banking reform, ing demands for domestic savings by the government. the activities of banks are likely to remain stunted or dis- Demand for investment and consumer durable goods and torted, both in terms of deposit taking or customer lending, the debt-carrying capacity of businesses and households even though other factors, such as output growth, may con- are likely to increase with output and incomes and to tribute to a rise in demand for bank services. decrease with competing demand for finance by govern- The appendix to this chapter describes the models ment. The response of banks to the demand for loans is, in deployed and estimation techniques applied. One impor- turn, likely to be influenced by a number of country-level tant finding of this analysis is that the behavior of the sup- factors, such as the confidence of depositors in banks and ply and demand for bank loans changes significantly with the protection of creditor rights. Both tend to increase with progress in banking reform. It is therefore necessary to measures of progress in banking reform. estimate the reduced-form equation for the real growth of Observable factors at the level of individual banks, bank loans to their customers for two separate subsamples. such as the extent of competitive pressures (market share), One is for the countries and years in which progress in bank capitalization, and the nature of ownership (newly banking reform has reached a relatively advanced level established private, privatized, or state-owned; with or (2.7 according to the EBRD transition indicator for bank- without foreign participation) may also influence the sup- ing reform), and the other is for countries and years in ply response. For example, banks faced with greater com- which progress in banking reform remains below this level. petitive pressure may be more responsive to customer demands and offer more competitive terms on loans. Those Regression Results banks with higher levels of equity capital relative to total Table 16A.1 reports the results of the regressions for assets are likely to be more financially sound and may the subsample of high-reform countries and years. The instill greater confidence in depositors. Highly capitalized model estimations, which allow for country fixed effects, banks therefore may be better able to attract financial yield a number of significant results: resources for growth, but not necessarily in the form of * Loan growth is significantly and positively associat- lower interest rates on deposits because of comprehensive ed with growth in real GDP lagged one year, but the deposit guarantees in most (but not all) countries. Bank estimated coefficient is about 0.60. This means that, ownership may be associated significantly with the quali- on average and across countries and years, in high- ty of bank management and staff, reflecting in part the reform states, lending to customers is expanding less functioning of corporate governance and the process of rapidly than growth in output, which is consistent selecting senior management. Bank size is also likely to be with aggregate data showing little sign of financial related significantly to real loan growth, with smaller banks deepening in transition economies. It is not possible registering higher rates of real loan growth than larger to identify on the basis of this reduced-form estima- banks, even though in absolute terms the changes are small. tion, however, whether this is due to a demand or a Of course, many other factors unobservable to researchers, supply constraint. such as the quality of bank management and staff and the * There is only weak evidence that general government extent of investment in information technology, are poten- deficits crowd out real growth in customer lending. tially significant as well. The coefficient on general government balance is Since the observed real growth of customer loans by positively (correctly) signed, but insignificantly dif- banks arises from the interaction of demand and supply ferent from zero. As an alternative specification (not 179 Fries and Taci reported), the nominal interest rate was used rather and then expanding their lending to conceal or to than the general government balance. While nega- overcome their bad loans. tively signed and statistically significant, the interest * There is no evidence that bank ownership (newly rate and real GDP variables are highly correlated, established private, privatized, or state-owned) and the estimated coefficient on lagged real GDP affects real loan growth. This result stands in sharp turns insignificant. In FYR Macedonia, there is a contrast to a robust finding from the analyses of strong statistical association between the general enterprise performance in transition economies that government balance and real growth of bank loans newly established private firms in industry and non- tc' customers, with a larger government deficit being financial services grow significantly faster than do associated with lower loan growth. This points to either privatized or state-owned enterprises (see, for significant crowding out of lending to businesses example, Djankov and Murrell 2000; Carlin and and households by government demand for domes- others 2001). One interpretation of the finding for tic savings. enterprises is that market selection has a strong effect * Both the market share of deposits and the size of the on the performance of firms that remain in the mar- total balance sheet are significantly and negatively ket. In other words, the ability to enter and survive associated with real growth in customer lending. in the market is strongly associated with strong per- This may reflect a number of factors. The most sim- formance, at least as measured by growth. However, ple is the effect of size in calculating percentage rates there is no evidence of such a market selection effect of loan growth, with a given absolute increase in real in transition banking. This may reflect the fact that lending by a small bank implying a larger percentage the panel of banks allows for the entry and exit of increase than for a large bank. It may also be the case banks from the sample, whereas the many cross- that the larger banks tend to be those that emerged sectional studies of enterprises suffer from survivor- from the old regime and must restructure extensive- ship bias in the sample. It may also reflect the fact ly their operations and resources to serve effectively that the regulation of bank entry through the appli- customer demands. The inherited client bases of the cation of minimum capital requirements and licens- oldl banks tend to be concentrated on the declining ing tests and the exit of failed banks from banking sectors and enterprises in the real economy. Finally, systems through bankruptcy have not functioned a smaller bank is likely to face greater competitive well in many transition economies. pressure and therefore to be more responsive to cus- * There is little evidence that foreign bank participation tiomer demands for services (see Fries, Neven, and in the ownership of banks is associated with higher Seabright 2001 for related evidence on the prof- rates of loan growth. Only in Croatia is there a strong itability of banks in transition economies by market positive association between foreign ownership and share). However, in Estonia, bank size is positively bank lending. This country-specific finding may a,sociated with growth in bank lending. This may reflect, in part, the fact that foreign banks benefited reflect the early privatization and restructuring as from the outflow of customers and depositors from w.ell as the rapid growth of large Estonian banks troubled Croatian banks, particularly in 1998. The through mergers with smaller institutions. more general finding is surprising in that foreign * Bank capitalization is positive and significantly asso- investment in banks would be expected to bring with ciared with the real growth in customer loans. On it the transfer of valuable banking skills and tech- the surface, this association suggests that those banks nologies and home-country prudential supervision that are more financially sound are attracting the that should help to boost performance. However, for- resources that enable them to expand their customer eign banks may face particular obstacles to expanding loans. This is encouraging from the perspective of in local markets, given the information advantages financial stability. Further, strong regulatory capital that local bankers may possess. There also may be requirements may prevent thinly capitalized banks constraints outside the banking sector on the expan- from expanding their lending activities to the private sion of bank lending to customers that affect all sector. However, there are potential problems with banks, including those with foreign ownership, such the measurement of bank capital: some troubled as the lack of legal protection of investor rights. banks may have overstated their capital by not pro- Table 16A.2 reports the estimation results for the sub- visioning adequately against their problem loans sample of low-reform countries and years. These results 180 Banking Transition: A Comparative Analysis stand in sharp contrast to those for the high-reform sub- relative to local banks. Both of these results also are con- sample. None of the estimated coefficients is significantly sistent with the presence of constraints outside of the bank- different from zero, with the exception of market share of ing sector, such as the functioning of the judiciary and the deposits and size of the total balance sheet. This suggests legal protection of property rights, which can impose a sig- that the growth of bank lending where there has been little nificant constraint on banking development (see, for exam- progress in banking reform is not strongly associated with ple, Levine 1999 on evidence worldwide). the demand and supply factors that could be expected to At the same time, the dominant banks in most transition influence the growth of bank lending in a market economy. economies have emerged from the old regime, and these This result raises serious concern about the functioning of institutions have been losing their market share. Some have banking systems where there has been little progress in been restructured and privatized, while others remain in reform, as in Belarus, Russia, and Ukraine. Any expansion state hands. In either case, the main clients of these banks are of bank lending in this environment appears to be signifi- often the enterprises that existed under the old regime (that cantly influenced by nonmarket factors, including possible is, the privatized and state-owned enterprises), which tend to government interference. grow much more slowly than ab initio private enterprises. There is, therefore, likely to be a significant mismatch Conclusions and Policy Implications between sound lending opportunities in the private sector One of the key findings of the analysis of the determi- and the operational focus of the dominant banks. The com- nants of real growth in bank lending to customers is that bination of profitable lending opportunities and competitive progress in banking reform is the sine qua non of sound pressures should, in time, shift the operational focus of these development of banks. Moreover, there is evidence that banks, although measures aimed at building capacity for banking regulation and supervision, in particular capital lending to small and medium-size enterprises could help adequacy requirements, are helping to establish a sound this reorientation. For example, the banking sector activities foundation for the expansion of customer loans. These of the EBRD aim to strengthen the supply response of banks efforts must be sustained and intensified. To this extent, the to lending opportunities in the real economy. This includes so-called Washington consensus on banking reform has facilities for local banks that are specially designed to provide succeeded. However, even where banking reforms have finance for small and medium-size enterprises and to build advanced, banking development remains stunted. The real the operational capacity for such lending activities. expansion of customer loans has failed, on average, to Taken together, the evidence in this chapter points to the keep pace with output growth. This may reflect govern- need to strengthen the supply response of banks to progress ment deficits that crowd out customer lending, although in banking reform. These measures include the more effec- the evidence at the banking level is not significant. tive regulation of the entry and exit of banks, improvements A number of variables expected to be associated with in corporate governance of banks, removal of obstacles to the supply response of banks to increases in demand for the expansion of foreign banks, strengthening of the judi- customer loans show little sign of significance. Bank own- ciary, and protection of investor rights. Reforms that focus ership is not significantly associated with real growth in on strengthening the supply response of banks are essential bank lending. In contrast to extensive evidence on enter- complements to the Washington-consensus reforms that prise performance in transition economies, ab initio private focused on financial liberalization, separation of commercial banks do not grow more quickly than privatized or state- banks from the central bank, and effective prudential regu- owned banks. This may reflect inadequate regulatory con- lation. The evidence shows that these reforms did not fail; trol of entry into and exit from the banking sector. rather the initial reform agenda was too narrowly focused. Although minimum capital and bank licensing require- Further empirical work, however, is necessary to iden- ments have been significantly strengthened in recent years tify the specific supply constraints on banks. The conclu- in many transition economies, approaches to the resolution sions that can be drawn on the basis of a reduced-form of failed banks remain often highly politicized and hap- model for the supply and demand of customer loans and hazard. In addition, foreign banks, which in principle have aggregate development of banking systems are inherently access to superior banking skills and technologies and ben- limited. The aim is to complement this analysis with relat- efit from home-country supervision, in general are not ed research into other dimensions of banking performance. expanding more rapidly than other banks. This suggests This includes analyses of factors that influence bank prof- that foreign banks may face other obstacles to the expan- itability and of cost efficiency in the provision of banking sion of their lending, such as an information disadvantage services. These issues are the focus of ongoing research. 181 Fries and Taci Appendix. Modeling and Estimation for Reconstruction and Development, Transition Reports. The reduced-form equation for estimation is: The measure of progress in reform of banking laws and regulations is the EBRD transition indicator on banking Lii t = Y'Cx, + E flixi, + E 6jYv. (1) reform published in the Transition Reports. / I } Two concerns about the quality of the data arise from where L, j t denotes real growth in customer loans of bank the wide variation in practices regarding the writing off of i in country j in year t, are country intercept terms, x is nonperforming loans and the lack of consistent information a vector of country-level explanatory variables, and Yi ),t is on the extent of nonperforming loans across banks. First, a vector of bank-level explanatory variables. Real loan the extent to which measured loan growth is distorted by growth is measured as the percentage change in total cus- this consideration depends on how the misreporting of tomer loans outstanding, where the stock of customer total loans net of write-offs changes over time for each loans is cleflated using the consumer price index. The vec- bank. Second, any underprovisioning against nonper- tor of country-level variables includes the annual rate of forming loans results in an overstatement of both bank growth in real GDP lagged one year, the general govern- equity and total assets. These potential data problems must ment balance in the current year, and the EBRD transition be recognized when interpreting the regression results. indicator of banking reform for the current year. The bank- There is also a problem of multicolinearity between level var[ables include the share of the deposit market two variables-deposit market share and balance sheet (defined as the ratio of a bank's customer deposits to total size. These variables are highly correlated and, when broad money in that country and year), bank size (defined entered together in the same model specification, lead to as total assets in U.S. dollars at market exchange rates), much higher levels of statistical significance than when bank ownership (dummy variables to represent state- entered in separate regressions. Therefore, all tests of the owned, privatized, and foreign bank ownership stake above reduced-form model of loan growth have been undertaken 10 percent), and bank capitalization (ratio of equity to separately for each of these variables. The results do vary total assets). This general specification allows for both significantly with the choice of variable. country-s pecific intercept (country fixed effects) and coun- The real loan growth equation is initially estimated for try-specific slope terms. the entire panel of 466 banks over the period 1994-98. The Estimation of the reduced-form equation for the real general specification of model 1 is then tested against a ver- growth of customer loans covers 466 banks from 16 sion that restricts the country-specific slope terms to be the countries over the years 1994-98. Of the total number of same across all countries. This model is: banks, 9 are in Belarus, 26 in Bulgaria, 44 in Croatia, 29 in the Czech Republic, 14 in Estonia, 11 in FYR Li'i=' (XI+ -F3XI,t+ XYlxt (2) Macedonia, 35 in Hungary, 14 in Kazakhstan, 22 in Latvia, 12 in Lithuania, 49 in Poland, 22 in Romania, 105 A Wald test comparing the two models strongly rejects in Russia, 20 in the Slovak Republic, 29 in Slovenia, and the restricted version. This could reflect the fact that the 25 in Ukraine. The data for individual banks and coun- restricted version of the model assumes that the behavior of tries are annual. The source of data on bank balance banks and their customers is the same across countries sheets (loan growth and capitalization) as well as on own- (and years), even though progress in banking reform varies ership is dlie BankScope database produced by the Bureau considerably both across countries and over time. As sug- van Dijk. The BankScope data are supplemented with gested, there are strong reasons to expect this behavior to the data and information from annual reports of the change with the progress in banking reform. banks anc! from EBRD banking staff research on bank The data set is therefore partitioned into two subsam- ownership. ples, one for countries and years in which the EBRD tran- Aggregate data on their banking systems for use in cal- sition indicator for banking reform is in the range 1 to 2.3 culating market shares in deposit-taking activities are from and the other for countries and years in which the indica- the central banks of the countries and from the tor score ranges from 2.67 to 4. International Monetary Fund, International Financial This is done by constructing a banking reform dummy Statistics. Sources of the macroeconomic data for the coun- variable, R, that takes values of 1 for values of the EBRD tries (output growth, consumer price inflation, and gener- transition indicator for banking reform between 1 and al government deficits) are various issues of the 2.33 and 0 otherwise. To check whether the estimation International Financial Statistics and of the European Bank coefficients (both intercepts and slope coefficients) differ for 182 Banking Transition: A Comparative Analysis two ranges of values for the banking reform index, the are made of the joint significance of these estimated para- banking reform dummy variable was introduced in front of meters both by type of explanatory variable and by coun- all coefficients in the general equation in a more general try, along with tests that all the other estimated parameters form as: for other variables or countries are the same across coun- tries. For example, tests are made that the estimated coun- Li, = Ej + E 3ylX ,I + X 3IYiJt + try-specific parameters on real GDP growth are jointly sig- / 1 1 (3) nificant, along with tests that the parameters on all other R(2 O + (p I-Xi,t + Y,j, t variables are the same across countries, that the country parameters for each country are jointly significant, and The F-test of the joint significance of the estimated that all other countries have the same estimated parameters. coefficients on the terms interacted with the banking reform The country-specific slope coefficients are jointly significant dummy variable, which compares models 3 and 1, does not for three explanatory variables-general government bal- reject the hypothesis that the behavior of real loan growth ance, deposit market share or balance sheet size, and for- depends on the level of banking reform. eign ownership-and for three countries-Croatia, The general model 1 must, therefore, be estimated Estonia, and FYR Macedonia. In fact, for each of these allowing the coefficients to differ for the two subsamples. countries only one country-specific slope parameter is sig- Whether the model should be estimated in a single regres- nificantly different from zero: foreign ownership for sion, as in model 3, or in two separate estimations of model Croatia, deposit market share or balance sheet size for 1 for each subsample depends on whether the variances of Estonia, and general government deficit for FYR the error terms in the two estimates of model 1 differ sig- Macedonia. nificantly. If the variances of the error terms differ, pooling If the three country- and variable-specific parameters together the observations of the two subsamples in model for the subsample of high-reform countries and years are 3 would bias the estimates of the variances of both error retained in the model specification, it is not possible to terms. In addition, the standard estimate of the variance- reject the hypothesis that all the other country-specific covariance matrix would be incorrect. slope parameters are insignificantly different from zero. The The likelihood ratio test of group-wise heteroskedas- pooling of observations for the high-reform subsample is ticity comparing the error variances of model 1 estimated therefore justified, with the three exceptions of foreign over the two subsamples shows that they do, in fact, differ ownership for Croatia, deposit market share or balance significantly. This estimation excludes the index of banking sheet size for Estonia, and general government deficit for reform as one of the country-level explanatory variables, FYR Macedonia. However, it is not possible to reject the because there is relatively little variation in this variable hypothesis that there are significant country fixed effects, so within the subsamples, particularly for low-reform coun- the country intercept terms are retained in the model spec- tries and years. Therefore, the reduced-form model of real ification. loan growth is estimated separately for the two subsamples A test is also made of a random-effects model specifi- of states with "low" and "high" banking reform. This cation rather then a fixed-effects model as in equation 1 allows the estimated parameters of the reduced-form model based on the two subsamples of high- and low-reform of real loan growth to vary across countries and over time, states. A random-effects model would allow for country- but in a way that is linked systematically to progress in specific distribution of the error terms rather than for coun- banking reform. try intercept terms. A Hausman test clearly rejects the ran- Using the two subsamples, the general model 1 and dom-effects model in favor of the fixed-effects model. A test restricted model 2 are again compared. We also test for the also is made of the random effect versus a simple regression joint significance of the country-specific intercept terms model with a single constant term. The Breusch and Pagan (country fixed effects). For the subsample of low-reform LM tests reject the hypothesis that the single constant term countries and years, it is not possible to reject a version of regression is appropriate for our data. The LM test suggests the model that restricts both the slope coefficients and the that the random-effects model is more appropriate for the intercept terms to be the same across countries. data set than a single constant term model, and the In contrast, for the high-reform subsample, it is still Hausman test indicates that the fixed-effects terms are not possible to reject the version of the model that restricts both correlated with other regressors. Therefore, the fixed-effects the coefficients and intercept terms. To identify possible model is better than the random-effects and single intercept patterns in the country-specific slope terms, parallel tests specifications. 183 Fries anld Taci TABLE 16A.1 ESTIMATION RESULTS FOR COUNTRIES AND YEARS WITH HIGH BANKING REFORM Real loan growth Independent variable Equation 1 Equation 2 Lagged real GDP growth 0.59* 0.58* (0.17) (0.17) Deposit market share -0.16** (0.08) Total assets in U.S. dollars -6.7e-07* (0.00) General government balance 2.21 2.04 (1.61) (1.55) State-owned banks (dummy) -0.25 -0.32 (1.72) (1.66) Ab initic private banks (dummy) 0.19 0.61 (3.28) (3.29) Foreign banks (dummy) -2.11 -1.97 (1.93) (1.85) Ratio of equity to total assets 0. 16 6;- 0.16' (0.09) (0.08) Croatia country dummy and foreign ownership 17.02 F* 17.29** (8.01) (8.05) Estonia country dummy and total assets 2.8e-06** (0.00) FYR Macedonia country dummy and fiscal balance 19.82* 20.34* (6.36) (6.33) Country (dummy (Bulgaria) -12.05 -12.42 (8.99) (8.90) Country dtummy (Croatia) -15.77 -15.62 (01.95) (10.74) Country clummy (Czech Republic) -10.25 -9.32 (8.91) (8.60) 184 Banking Transition: A Comparative Analysis TABLE 16A.1 (CONTINUED) Real loan growth Independent variable Equation 1 Equation 2 Country dummy (Estonia) -12.65 -14.38 (10.22) (10.54) Country dummy (FYR Macedonia) 20.26 20.65 (14.81) (14.59) Country dummy (Latvia) -6.05 -6.53 (9.06) (8.99) Country dummy (Lithuania) -5.68 -7.06 (4.70) (4.91) Country dummy (Poland) -10.67 -10.22 (6.64) (6.37) Country dummy (Romania) -8.48 -8.95 (5.83) (5.78) Country dummy (Slovak Republic) 2.58 2.25 (3.42) (3.38) Country dummy (Slovenia) -15.27 -15.25 (10.09) (9.91) Constant 15.81 14.94 (10.38) (9.91) Number of observations 863 887 Adjusted R2 0.08 0.08 * Significantly different from zero at the I percent level. * * Significantly different from zero at the 5 percent level. * * '> Significantly different from zero at the 10 percent level. Note: The robust standard errors are in parentheses. The number of observations changes with the substitutions of deposit market share for total assets, since the panel is unbalanced and there are more data for total assets than for deposit market share. Equation 1 includes deposit market share, while equation 2 includes the total assets of banks. 185 Fries and Taci TABLE 16A.2 ESTIMATION RESULTS FOR COUNTRIES AND YEARS WITH LOW BANKING REFORM Real loan growth Independent variable Equation 1 Equation 2 Lagged real GDP growth 23.7 22.4 (17.1) (16.0) Deposit market share -23.8 * * (22.8) Total assets in U.S. dollars -4.8e-05* (0.00) General government balance 43.5 -60.8 (32.5) (47.4) State-owned banks (dummy) 545.1 466.6 (534.0) (454.8) Ab initio private banks (dummy) 24.7 40.5 (130.7) (116.2) Foreign banks (dummy) -126.1 -130.8 (132.4) (131.2) Ratio of equity to total assets -0.09 1.02 (1.34) (1.82) Constant -69.1 -237.4 (73.9) (203.1) Number of observations 337 347 Adjusted R2 0.02 0.02 *Significantly different from zero at the 1 percent level. * * Significantly different from zero at the 5 percent level. Note: Robust standard errors are in parentheses. The number of observations changes with the substitutions of deposit market share for total assets, since the panel is unbalanced and there are more data for total assets than for deposit market share. Equation 1 includes deposit market share, while equation 2 includes total assets of banks. 186 Banking Transition: A Comparative Analysis References Transition: An Assessment of the Evidence." World The word "processed" describes informally repro- Bank, Washington, D.C. Processed. duced works that may not be commonly available in library European Bank for Reconstruction and Development systems. (EBRD). 1998. Transition Report 1998: Financial Sector in Transition. London. Calvo, Guillermo A., andJacob A. Frenkel. 1991. "Obstacles - . 2000. Transition Report 2000: Employment, to Transforming Centrally Planned Economies: The Role Skills, and Transition. London. of Capital Markets." In Paul Marer and Salvatore Fisher, Stanley, and Alan Gelb. 1991. "The Process of Zecchini, eds., The Transition to Market Economy in Socialist Economic Transformation." Journal of Central and Eastern Europe. Paris: Organisation for Economic Perspectives 5 (4):91-106. Economic Co-operation and Development. Fries, Steven, and Timothy Lane. 1994. "Financial and Caprio, Gerard, and Ross Levine. 1994. "Reforming Enterprise Restructuring in Emerging Market Finance in Transitional Socialist Economies." The Economies." In Gerard Caprio, David Folkerts- World Bank Research Observer 9 (1):1-24. Landau, and Timothy Lane, eds., Building Sound Carlin, Wendy, Steven Fries, Mark Schaffer, and Paul Finance in Emerging Market Economies. Washington, Seabright. 2001. "Competition and Enterprise D.C.: International Monetary Fund. Performance in Transition Economies: Evidence from Fries, Steven, Damien Neven, and Paul Seabright. 2001. a Cross-Country Survey." Working Paper. European "Bank Profitability in Transition Economies." Bank for Reconstruction and Development, London. Working Paper. European Bank for Reconstruction Processed. and Development, London. Processed. De Melo, Martha, Cevdet Denizer, Alan Gelb, and Stoyan Levine, Ross. 1999. "Law, Finance, and Economic Tenev. 1997. "Circumstance and Choice: The Role of Growth." Journal of Financial Intermediation 8 Initial Conditions and Policies in Transition (1/2):8-35. Economies." Policy Research Working Paper 1866. Seabright, Paul. 2000. "Introduction: Barter Networks World Bank, Policy Research Department, and 'Information Islands."' In Paul Seabright, ed., The Washington, D.C. Processed. Vanishing Rouble: Barter Networks and Non- Djankov, Simeon, and Peter Murrell. 2000. "The Monetary Transactions in Post-Soviet Societies. Determinants of Enterprise Restructuring in Cambridge, U.K.: Cambridge University Press. 187 Chapter 17 Financial Deepening and the Role of Financial Crises Stephen Peachey and Alan R. Roe S ocialist, and especially Soviet, banking systems had limited functions compared with those in advanced Western economies. The "banks" of the pre-1989 period were administrative agen- cies of government rather than banks in the accepted Western sense of the word. So the transi- tion of these banking systems after 1989 was certain to involve some characteristics that Western observers would fail to predict. This chapter identifies how these characteristics have influenced finan- cial deepening in the transition economies. In particular, it examines the role of banking crises in the process of financial deepening. Banking crises that have been seen in many transition economies-for example, the Baltic states in the mid-1990s and the Russian Federation (Russia) and Ukraine in 1998- seem to have been different in nature and generally far less disruptive of productive economic activ- ity than similar crises in other parts of the world, including Mexico (1994) and East Asia (1997). At issue here is whether judgments about the economic consequences of crisis need to be amended to accommodate the peculiarities of transition. This chapter couches the analysis in terms of three but the implicit guarantees of the state diluted the impor- easily measured indicators of banking sector perfor- tance of that fact. Concepts such as capital adequacy, the mance-bank deposits, volumes of cash in circulation, and creditworthiness of borrowers, portfolio concentration, per capita deposits-and then uses them to assess some and insider lending were of only peripheral relevance to the basic hypotheses about the transition process. financial durability of banks-their "failure," in any case, was not a possibility to be entertained.1 Characteristics of Financial Transition This situation was expected to change as general eco- Paradoxically the socialist banks of the pre-1989 era nomic reform took hold in these countries through the were quite safe, as were the hybrid "reforming" banks of early 1990s. Considerable emphasis in the first-stage the early transition period. Since they were owned by the reforms for banks, as articulated by the International state, as were their major clients and borrowers, failures on Monetary Fund (IMF), the World Bank, the Bank for loan repayment were contained within the budgetary International Settlements (BIS), and others, was placed on sphere. Many banks may have been technically insolvent, (a) strengthening the regulatory regime under which banks 1. This proposition has been argued in greater detail in Roe, Siegelbaum, and King (1998). 189 Peachey and Roe worked and on (b) improving their own risk management of the socialist period. In the space of about two to three and othe r banking skills. This advice was posited on the years, these overhangs were eroded by the combination of key assumptions that the interlocking between budgetary price liberalization and near hyperinflation, especially after and banking finance would rapidly diminish, that individ- the January 1992 Yeltsin reforms. The economic theory ual banks would soon face the threat of their own failure, explaining how the initial shocks of price liberalization and that this, in turn, would threaten depositors and the affected the size of banking sectors and the ratios of finan- economv more generally with significant losses. cial depth, such as the ratio of M2 to gross domestic prod- Strengthening the internal financial soundness of banks uct (GDP), is well documented (see, for example, Conway and the regulatory regimes within which they worked was 1995). Equally, it is clear that the decline in the levels of seen as an important public good and the obvious way to intermediated savings was a decline in involuntary sav- mitigate these dangers. All transition economies accepted ing.3 Since the initial collapse of the monetary overhang this advice. during 1989-92, there has been considerable variation in In reality, though, only a subset of the Central the recovery of the financial depth ratios between countries. European and former Soviet Union (FSU) transition This recovery also seems less well understood than the economios behaved in a manner fully conformant to this original collapse. The situation through mid-1999 for a expected pattern of the financial sector transition. A sec- representative group of 15 transition countries is summa- ond and significant subset that includes some of the largest rized in figure 17.1, which contains three basic financial and most important countries, such as Russia, Ukraine, sector indicators: and several of the Central Asian states, instead retained * The ratio of bank deposits to GDP-horizontal axis significant elements of their pre-1989 patterns of behavior. * The ratio of cash in circulation to bank deposits- Certainly these were amended in various ways to accom- vertical axis4 modate to new patterns of ownership and to new eco- * Average bank deposits per head of population (in nomic incentives and pressures. But a strong bank-state dollars adjusted for purchasing power parity)-bub- nexus rernained in several countries. In most of these, var- ble size. ious degrees of protection of "bad" banks via discre- Figure 17.1 indicates that the transition economies of tionary state interventions paralleled the protection of the Commonwealth of Independent States (CIS) have seen failing enterprises. Although substantial progress was only a limited recovery of the ratio of bank deposits to GDP made in introducing stronger regulation and supervision of toward the 1989 levels of around 70-80 percent. In the banks in almost all transition countries, the improvements Baltic states, recovery, although stronger, still has a long arising from these reforms were disappointing in both the way to go to reach the levels of financial depth in the euro quality and quantity of banking services.2 Certainly, the zone. Most of these FSU states are still operating with very emergence of serious Western-quality banking, and the high ratios of domestic cash to bank deposits, and they associated benefits, was much slower than expected in mostly have per capita levels of bank deposits that are many transition countries. very small compared with comparator countries in the euro zone. Again, the Baltic states have progressed much Recovery of Financial Depth: How Quick and further toward normalization than the CIS bloc. The situ- How Large? ation in Eastern and Central Europe is significantly differ- Most transition economies, certainly those located in ent: the initial declines in financial depth ratios were much the FSU, entered the postsocialist period with very large smaller there, and performance subsequently has been gen- monetary overhangs associated with the repressed inflation erally better. 2. A report prepared by rhe International Monetary Fund in 1997 for the countries of the FSU indicated that, in the area of bank- ing supervision, 8 out of 15 countries had made "substantial progress," three had made "moderate progress," and only four had made just "limited progress." In the area of bank restructuring, the corresponding number of countries in each of the three cat- egories was six, four, and five, respectively. However, some countries with strong ratings in both of these categories showed very little progress in deepening their banking sectors. Sec International Monetary Fund (1997). 3. For that reason, the extremely high pre-1989 levels of M2 to GDP found in the FSU could not meaningfully be compared with the similar levels found in some Western economies. 4. The term "cash" in figure 17.1 and most other figures in this chapter refers only to domestic currency. Many countries in our sam- ple also have significant dollar currency balances. This phenomenon is considered in more detail in box 17.1. 190 Financial Deepening and the Role of Financial Crises FIGURE 17.1 COMPARISONS OF FINANCIAL DEPTH IN FIFTEEN TRANSITION COUNTRIES, MID-1999 2Z 160% X Bubble size denotes purchasing power 5 140% parity adjusted average total deposits per head in US $ '7 1 20%1 v Azerbaija, * Kyrgyz Republic 3000 O 100%/-, n -, 80/ .>} 1500 u 8 Ukraine 500 0 60%- Kazakhstan , Latvia Armenia@l 40%- Lithuamna Slovak/Czech -= Russian Federation! I stonia Hungary Republics 20% Bulgaria > o ~~~~~~~~~~~~~Poland C)_l 1 tl Z>q 0%_ :.~~~~~~~~~~~~~~ Soveniai l l-A , 10% 30% 50% 70% 90% Importance of banking (ratio of domestic deposits to GDP, percent) BOX 17.1 A DIGRESSION ON DOLLARIZATION Lack of confidence in domestic money in the first two phases also deep-seated dollarization became, especially in the FSU states, has been reflected in mosttransition countries-especially in the during the hyperinflationary period. This was most noticeable FSU-in the significant use of (a) dollar and other foreign cur- when the introduction of a credible national currency was rency and (b) foreign-denominated bank accounts. Reliable com- delayed (as in Armenia, Lithuania, and Ukraine, for example). parative data on dollar and other foreign currency accounts are High rates of dollarization persisted in such countries even not available, but the pattern of this usage in relation to foreign- when the new currencies stabilized, possibly by being pegged denominated bank accounts can be observed. This is summa- against well-known hard currencies (such as the dollar-pegged rized, for a cross-section of transition countries, in figure 17.2. Lithuanian lita and the Latvian lat, which both have held up well Clearly, the higher the degree of dollarization is, generally the against the U.S. dollar). It is hardly surprising that the reemer- lower the level of monetization is. However, this relationship is gent states that came out of the FSU should have more trouble not linear nor entirely smooth. Dollarization has remained high establishing credible domestic currencies after a 50-80 year in most FSU countries and some Eastern European countries gap than Central European transition economies (where there such as Bulgaria. This is almost certainly a reflection of how was a continuity of their domestic currencies). To understand how the specifics of this process differ simplified schematic form in figure 17.3, with emphasis country-by-country requires more than just the snapshot of placed on inflation (vertical axis) and real interest rates countries at different stages of demonetization and subse- (horizontal axis). The figure shows five stylized steps-the quent remonetization that figure 17.1 represents. A starting point plus four others-in the process of stabi- schematic mapping is needed of how the banking sector in lization, together with the pressures on banks that occur at a transition economy adjusts to the initial chaos of the early each of these stages. reform period and the subsequent-often faltering- This simple framework suggests why different coun- process of stabilization and recovery. This is shown in a tries have progressed at different rates through the process 191 Peachev and Roe FIGURE 17.2 DOLLARIZATION AND BANKING SYSTEMS OF TRANSITION ECONOMIES, 1999 80% Bubble size denotes purchasing U ~~~~~~~~~~~~~~~~~power parity adjusted average c Armenia 0 total deposits per head in US $ C 60% /7 60% Bulgariae A U ~~~~~Lithuan i -40% .; ~~~~Ukraine Slovak/Czech > 2 40% - o Russian Federationnd/H 20% C._ c- -20% -10% 10% 30% 50% 70% 90% Importance of banking (ratio of domestic deposits to GDP, percent) FIGURE 17.3 A SCHEMATIC REPRESENTATION OF STABILIZATION OF TRANSITION BANKING SYSTEMS 1. Hyperinflationary Chaos Massively negative real 2. Beginnings of Stabilization interest rates / real size of state bank Currency reform, tight money, and balance sheets collapses along with swing to positive real interest rates / their operating profitability / low inflation still forgiving of high-risk I real capital requirements allow lending / easy profits from financing N many new entrants to speculative trading activity (goods banking system and currency) / margins very high Start: False 4. Genuine 3. Through the Black Hole C) Stability Stability Inflation falls followed by interest N Suppressed Reasonable inflation/ rates / margins narrow sharply / real Inflation / low modestly positive real state bank balance sheets start to nominal and real interest rates / fewer recover / impact of weak lending interest rates / few banks / faster-growing policy feeds through more quickly! state banks with balance sheets and forced consolidation of banks bloated balance realistic margins sheets and lowv margins INTEREST RATES 192 Financial Deepening and the Role of Financial Crises of demonetization and remonetization and also why state the banking system is still suppressed below its nat- banks have often survived in some form to be a larger part ural level relative to GDP, and the ratio of cash in cir- of transition banking systems than might have been expect- culation to deposits can be relatively high. ed. At the heart of this is the move-or, in some cases, the * The third phase sees the rebuilding of public confi- failure to move-through step 3 to step 4. Several factors dence in the banking sector as an integral part of the influence this: new market economy. This occurs initially by reduc- * The willingness, or otherwise, of the authorities to ing the reliance on cash as a medium of exchange allow-or, better still, encourage-consolidation of and increasing deposit-based transactions. This is the banking system during the "black hole" phase of greatly helped where real deposit rates turn mar- narrowing bank margins (step 3) described in figure ginally positive so that deposits offer an inflation- 17.2, even if that sometimes involves bank failures proof home for enterprise working capital and per- on a significant scale. sonal spending money. * The willingness of bank owners and management- * And finally, phase 4 sees the slow process of rebuild- particularly at private banks-to move through the ing confidence in deposits as a store of value, first by black hole. This means replacing the speculative getting cash out from "under the mattress" and into profits that allow small banks to become rapidly bank deposits and ultimately by rebuilding voluntary self-capitalizing during the chaotic hyperinflationary savings in the economy. and early stabilization phases by making real profits. To the extent that they do this, they enter the much The Process in the Former Soviet Union harder phase of making a profit from basic inter- These different phases, and the impact that progressing mediation and using such profits to capitalize fast- through them at different speeds has on the degree of growing balance sheets.5 remonetization, are illustrated in the four charts presented One pattern is broadly apparent, certainly in the FSU. in figure 17.4. These show the progression through time of The countries where the state retains a high degree of the same three variables plotted in figure 17.1 for four involvement in both state-owned and private banks seem to FSU countries in different phases of the transition process. have had the greatest problems in progressing through the These are Ukraine (only just entering the second phase), black hole of narrowing bank margins. Such countries Armenia (rapidly progressing through the second phase), have yet to reach a new stability where fewer banks con- Russia (stuck in the third phase), and Estonia (now starting centrate on doing expanding volumes of traditional inter- the fourth phase). mediation at realistic margins that are compatible with The contrast between Estonia and the Russian affordable real lending rates. Federation is particularly striking and is discussed in more The impact of progress through these various stages on detail below. the overall degree of monetization also can be described as a four-phase process: The Process in the Central European * The first phase is one of catastrophic dislocation Transition Economies from near hyperinflation when there is no confi- The situation in the Central European transition dence in any form of money, either cash or deposits. economies such as Poland and the Czech Republic is dif- * The second phase is one where sound cash money is ferent than the experience in the FSU (see figure 17.5), but established-possibly through currency reform- it is complicated by country-specific differences in the run- combined with more stable inflation, but where the up to transition: population and many entrepreneurs are not yet con- * Poland shows almost exactly the same pattern as fident enough of banks to use deposits. In this phase, Estonia, but played out over a much longer time 5. In many ways, the state banks (or their successors) do not face the same dilemma as their private banking counterparts-they typ- ically have no choice but to be in intermediation because of their large branch networks. Disinflation and the return of positive real deposit rates (step 3) actually help them to rebuild their real liabilities. Provided they control the quality of assets, this should enable them to spread their high fixed costs over a larger base of income-earning assets. Therefore, they should be better placed to cope with falling margins than newer private banks that have only operated with small real balance sheets and high cost bases. The real risk to state banks arises if they lose control of asset quality through either their own poor management or political forces that keep their costs high and their earnings low. 193 Peachey and Roe FIGURE 17.4 DIFFERENTIAL PROGRESS TOWARD REBUILDING THE MONETARY BASE OF FOUR FSU ECONOMIES 96/97 - (ratio of cash (A) Ukraine A to deposits (B) Armenia CIQ 90% 98 090%_____'q3.120 -140%) o 90% v 900/ 4 80/ 96 .99 0 2000 802000 70~ % 700/ 98 000 0 500 93 0500 0 5 60'?' cc5u60% 9 e c 50''J 9945 200 e u 0 o 200 41 SO%' 09 50% 9 c 40b% -a 40%/ 30b c 30/ St 10% 0% -1C% -10% -10% 10% 30% 50% 70% 90% -10% 10% 30% 50% 70% 90% Importance of banking (ratio of domestic deposits Importance of banking (ratio of domestic deposits to GDP, percent) to GDP, percent) (D) Estonia (C) Russian Federation 90%/ 90% 80% 9394 02000 80% 2000 O~~~ 60% ~~95 01000 % 0%0 500 60%D/ 09 tlO0 60% O0 rz5S0 u 96 0500 OS, 030200 4 s200/o 92D/-7 @ 40% 92 '9 8 7 30% 98399 0;~ ~0"o0 30%0 10 3% 5%9% -20% -~9 u 10 92 ----- u C) (D 2~~~~kIJ/0% --u10% 10% 30% 50% 70% 90% 1 70% Importance of banking (ratio of domestic deposits Importance of banking (ratio of domestic deposits to GDP, percent) to GDP, percent) scale-20, not 10, years. Inflation rose significantly enterprise sector was heavily indebted to banks at the start of the 1980s, and the sliding exchange because accumulated capital had been stripped out rare predated even this. By 1989 the ratio of deposits by the state and returned to the household sector, to GDP had fallen below 15 percent from very near- leaving Czechoslovakia with a banking system three Iv 50 percent a decade earlier, and by 1992-93 the times as large relative to its economy as Poland. The rario of cash to deposits had jumped to 40 percent initial price liberalization was short-lived, and hyper- from 20 percent. Since then, despite relatively high inflation was avoided. A one-off rapid, but con- inflation, the exchange rate and inflationary envi- tained, depreciation of the exchange rate created ronment have been much more predictable. Together relatively benign conditions for households and with positive real deposit rates, this has encouraged enterprises. Only when the need for fundamental strong growth in bank deposits and a rapid return to restructuring (as opposed to a change of ownership) a normal ratio of cash to deposits. Instrumental in became apparent in the late 1990s did the system this has been a steady consolidation of the banking come under sustained pressure. This meant that, system, often driven by foreign capital. while both countries retain large banking systems by *In the Czech and Slovak Republics, the level of regional standards, the gap with Poland has closed forced saving was much lower than under the Soviet significantly. Part of this reflects the failure, until regime, and generally higher productivity meant that very recently, to push through the restructuring of price repression was less significant. Moreover, the large state banks. 194 Financial Deepening and the Role of Financial Crises FIGURE 17.5 DIFFERENTIAL PROGRESS TOWARD REBUILDING THE MONETARY BASE IN POLAND AND THE CZECH REPUBLIC (A) Poland (B) Czech Republic o 90% o 90% -! 800 5000 2i 700 2u 700 70s 2 60/c . 70% 02000 50% U 01000 - 50% 100 / 300 __ ~~~~~~~~~~~)300/ - 20% 9/000 1980 /89 U ~~~~~~~~~~9 -10% 1% 3% 5% 7% 0% 10% -10% 10% 30% 50% 70% 90% ~ -10% 10% 30% 50% 70% 90% Importance of banking (ratio of domestic deposits Importance of banking (ratio of domestic deposits to GDP, percent) to GDP, percent) Other Central European economies, apart from term pan-European strategies. But even foreign share- Hungary, show a range of outcomes. Bulgaria, with its holders do not have infinitely deep pockets, and there are successful implementation of a currency board arrange- signs that some consolidation is beginning to take place, ment, shows the first signs of a recovery from its 1997 as some of them seek to exit by way of sale to other for- banking and currency crisis that may well be very similar to eign owners. that of Estonia (also a currency board country). Romania, until recently, has shown the sporadic improvement and Inhibitors of Banking Sector Development reversals displayed by Russia. It, too, may just be starting There are several possible explanations for why dif- a more sustained recovery now that its central bank is ferent transition economies have experienced such dis- forcing through meaningful observance of prudent banking parate progress in recovering their 1989 levels of financial ratios, even though this already has involved the failure of depth. But one conclusion is certain: reforms in banking some of the largest state- and privately owned banks. regulation and supervision that have been accepted by all Hungary started with a very low level of banking transition countries as the appropriate first-stage banking development (with a ratio of deposits to GDP around 25 reforms correlate relatively poorly with that recovery. Table percent in the early 1980s) and a high reliance on cash 17.1 maps FSU countries by their level of monetization (equivalent to some 50 percent of deposit balances). By (mid-1998) and the degree to which they had restructured 1989 the ratio of deposits to GDP had reached almost 40 the state banking sector and established BIS-style bank percent, and the reliance on cash was reduced somewhat supervisory regimes by that time. The table shows that (equivalent to a third of deposits). Probably because of countries achieving the greatest progress with bank restruc- high ongoing inflation (only just covered by deposit rates), turing and supervision (toward the right-hand side of the Hungary has consistently failed to raise its ratio of table) manifest considerable variation in their progress deposits to GDP since then, although the country's toward restoring financial depth. restructured banking system has mobilized large volumes Table 17.1 suggests that regulatory reform is not in of new deposits on an annual basis. Two special factors itself a sufficient condition for ensuring a stable and grow- may be at play here. First, Hungary has moved faster ing banking system. Nor indeed is regulatory reform a than other transition economies to establish a significant good predictor of the relative speed at which different nonbank financial sector. Second, the high penetration of countries reestablish higher levels of financial depth. foreign ownership may have blunted local pressures to Kazakhstan and Moldova, for example, have consistently compete more on grounds of cost efficiency. With regards received high ratings from the IMF and BIS for banking to the latter point, foreign strategic investors tend to view reforms, and yet they are among the worse performers in their entry into the transition markets as part of longer- the comparisons of financial depth shown in figure 17.1. 195 Peachey and Roe TABLE 17.1 MONETIZATION AND PROGRESS ON BANK RESTRUCTURING AND REGULATION IN FSU Progress on bank restructuring and introduction of BIS-style supervision Deposits as a percentage of GDP Limited progress > Good progress > 20 percent Estonia 10-20 percent Lithuania Latvia Russian Federation < 10 percent Belarus Azerbaijan Georgia Kazakhstan Tajikistan Turkmenistan Kyrgyz Republic Ukraine Uzbekistan Moldova Two alternative explanations of country differences The Nonpayment Phenomenon and the in financial depth are suggested here. These explanations Protection of Enterprises are associated with different attitudes and policies toward The connection between the nonpayment phenomenon the following: and financial sector reform and deepening comprises two T The protection of loss-making enterprises and the main elements: associated tolerance of barter, nonpayment, and * The widespread tolerance of nonpayment, as well as mutual offsets as alternatives to money-based pay- the widespread granting of discretionary tax privi- ments.6 Those countries displaying exceptionally leges, stifles the incentives for enterprises to pursue high levels of such tolerance cannot expect to make greater efficiency as the route to increased market real progress in banking development. share. Inefficient enterprises are allowed to survive * The protection of "bad" banks. Those countries and even to achieve reasonable levels of post-tax choosing to offer such protection pay the price by profitability. In some cases, these profits can even achieving a relatively slow pace of banking consoli- compare favorably with the post-tax profits of effi- dation. The evidence from the FSU suggests that sig- cient enterprises. In short, enterprise efficiency, on nificant banking failures-even crises-may be a the one hand, and the levels of enterprise after-tax key element in the consolidation process and not the profitability, on the other, are disconnected.7 Banks major negative force that they sometimes are as a result lose the empirical basis needed to guide assumed to be. the allocation of scarce funds effectively to the more 6. The countries most implicated in this type of behavior purportedly have achieved a high level of fiscal discipline and have oper- ated for some years with tight monetary policies. The tolerance of barter and nonpayment thus emerges as the new device for trans- ferring subsidies to failing enterprises. 7. This point first came to prominence through the 1999 McKinsey Global Institute study on selected industrial and service sectors in Russia (McKinsey Global Institute 1999). The study found, among other things, that old enterprises from the Soviet days have seen their productivity halved because these enterprises have seen almost no restructuring in spite of large falls in the demand for their products; that the more productive enterprises in world terms are paradoxically often the least profitable and, in general, have riot been gaining market share; that in 9 out of 10 sectors studied, the direct cause of poor economic performance is mar- ket distortions motivated either by attempts to address social concerns or by corruption; that in the manufacturing sectors, region- al governments channel implicit subsidies to unproductive enterprises in the form of lower (even zero) tax and energy payments that are allegedly intended to prevent companies from closing down and laying off workers; that this puts potentially productive enterprises at a serious cost disadvantage and blocks growth and new employment creation by these better enterprises; and that in the service sectors, investments by efficient companies are discouraged by the presence of well-connected incumbents who ben- efit from favorable regulations, weak law enforcement, and privileged access to land or government procurement. 196 Financial Deepening and the Role of Financial Crises efficient enterprises. Hence economic growth is also cases, as figures 17.1 and 17.4 confirm, financial sector stifled. Banks for this and other reasons find their development also has been particularly weak. Other tran- own performance weakened and so are put under sition countries where the budget constraint, as mea- pressure to operate according to the opaque prac- sured by the extent of unpaid tax bills, is high include tices of the hybrid economy.8 This fact becomes Georgia, Azerbaijan, Armenia, the Kyrgyz Republic, and especially critical as a determinant of passing (or Moldova. All of these countries also have very low finan- not passing) from step 3 through step 4, as described cial depth.1' in figure 17.3. There is a question, however, as to the underlying poli- The widespread informal payments also crowd out cies that lead to this high tolerance of barter or nonpayment conventional banking by providing large amounts of and so inhibit financial sector development. Recent papers cheap (to some users) and wholly unregulated alter- on this phenomenon by Commander and Mumssen (1999) natives to the more conventional payment and cred- on Russia; Pinto, Drebentsov, and Moroz (1999) also on it arrangements provided through banks and other Russia; and Roe and others (2000) on Ukraine have financial institutions. Survey evidence for Ukraine, reached broadly similar conclusions, specifically: for example, indicates that most enterprises make * The tax avoidance motive cannot explain the growth some use of banking services for both payment and and flourishing of the nonpayments phenomenon. credit, but that the use of parallel arrangements is Tax avoidance is certainly an important consequence often dominant, especially in the case of larger enter- of nonpayment, but not the initiating cause. prises. For example, more than 60 percent of enter- * The perpetuation of soft budget constraints for loss- prises surveyed in 1998 had overdue trade credits, making enterprises (the alternative to closure or and more than 50 percent had tax arrears. Almost restructuring) is a far more generic explanation. The 99 percent of enterprises used wage arrears as a policy channels through which these implicit subsi- form of enterprise financing, while only 5 percent dies have been channeled (subsequent to 1994-95, used long-term bank credits.9 when open budgetary subsidies and monetary per- Data to substantiate the connection between a high missiveness were phased out) are numerous and tolerance of nonpayment or barter and financial sector complex. development are not available for most transition * The nonpayments system is incentive-driven, and economies. However, it is significant that the incidence of many economic agents now have strong financial nonpayment or barter is highest in the two largest coun- incentives to participate in that system and keep it tries of the FSU, namely Russia and Ukraine.t0 In both alive. These beneficiaries include, but are no longer 8. What this means in practice is spelled out more fully in Roe, Siegelbaum, and King (1998). Paradoxically, arbitrary tax con- cessions and arbitrary hidden subsidies are likely to reduce, rather than increase, credit flows. This is because they add two extra dimensions of uncertainty to credit risk appraisal: concessions to enterprises can be removed as arbitrarily as they are grant- ed, and those concessions distort the allocation of resources, thereby increasing the underlying economic risk of lending as a whole. 9. Preliminary results are from a survey and study by Dr. Volkhart Vincent, Osteuropa Institut Munich, and German Advisory Group at the Government of Ukraine. 10. In Ukraine, for example, (a) around 35 percent of industrial turnover is paid for via barter, (b) a similar percentage involves non- payment or the use of quasi payment via the issue of veksels, (c) more than 20 percent of consolidated government revenues are typically collected through mutual offsets rather than monetary payments, (d) accumulated arrears among enterprises easily exceed nominal GDP; and (e) even wage arrears are the equivalent of more than 6 percent of GDP. In both Russia and Ukraine, nonpayment is fueled crucially by the rising arrears extended by power companies and especial- ly the electricity-supplyinig energos. The amounts outstanding to such entities in both countries have risen significantly since 1996 and now exceed 7-8 percent of GDP. In Ukraine only about 10 percent of energy bills are paid for in conventional ways. 11. Noncompliance with tax obligations is not a particularly good indicator of the extent of overall financial discipline and the inci- dence of barter or nonpayment in general. Hence we cannot use this indicator for the purposes of making robust statistical state- ments about the link between barter or nonpayment and financial development. For example, on this indicator alone, the Czech Republic has a softer budget constraint than either Russia or Ukraine. See Carlin and others (2000). 197 Peachey and Roe confined to, financially weak enterprises that were 1998 and 1999. Cumulatively, the banking system has the initial recipients of the hidden subsidies associ- shrunk from around 50 banks in 1993 to just 5 now. ated with nonpayment.12 Overall domestic deposits stand at 25 percent of GDP, and * T'he system could not have grown to its present large over the past four years for which we have data (1996-99 size and been sustained without the explicit or inclusive) the equivalent of 10 percent of GDP annually has implicit connivance of the state-by accepting barter been injected into the economy by way of new credit, more payments of taxes, by allowing or requiring the ener- than half of which has been domestically funded (tablc gos to operate with such large amounts of nonpay- 17.2). Although the banking sector is now predominantly ment, by being guilty of substantial amounts of pay- foreign-owned and the leading banks ultimately may ment arrears for pensions, wages, and so forth. become branches of foreign banks, the consolidation took Again the initiating motive was the desire to keep place while the banks concerned were domestically con- loss-making enterprises in business. trolled. In short, explicit policies linked to the need to protect These developments have resulted in the smooth failing businesses represent a large part of the tolerance improvements in financial depth and deposit growth toward nonpayment or barter. It follows that such policies reflected in figure 17.4d. There is, however, a question as to need to be fundamentally reformed if those countries are to the mechanism through which this takes place. One sug- see financial sector development at the levels already gestion is that there are always huge potential gains to be achieved in several comparator countries. achieved by closing down high-risk, undercapitalized, high- cost banks during the black hole phase described in figure The Failure of Bank Consolidation 17.3. This form of consolidation allows domestic banking Tra nsition countries, and especially those in the FSU, activity to concentrate around the better-managed, lower- have displayed considerable variation in the speed at which cost banks, thus improving the overall efficiency of inter- they have consolidated banking systems after the initial mediation. Estonia appears to have exploited this fact, and burst of unregulated new entry that most countries expe- the result has been rapid growth of the banking sector. rienced in the early 1990s. Countries that have moved By contrast, Russian reform has been sporadic at best, quite successfully in all three of the dimensions reflected in with a large degree of politicization of the banking system figure 1 7.1 have been the most aggressive in this regard. involving the overt favoring of selected banks as well as This is best exemplified by comparing the graphs for protection for both depositors and shareholders from the Estonia and Russia in figure 17.4. consequences of failure. As a result, the Russian Federation Estonia followed an aggressive reform path, with little has never suffered a single crisis of the same magnitude as or no protection for weak banks. In the early 1990s banks the Estonian one in 1993, but neither has it experienced accounting for around 40 percent of total banking system such a strong and sustained recovery. Despite starting 1993 assets failed. This cost the economy the equivalent of 11 with a banking system 20 percent larger than Estonia's, it percent of GDP in lost real savings, but within five years now has a system not even two-fifths of Estonia's when this had all been recovered. Estonia now boasts the largest measured relative to GDP.13 Over the past four years, its and thii-d largest banks in the Baltic states (despite being the banking system has injected less than 4 percent of GDP, on smallest of the three economies). Both now have strong average, annually by way of new domestic finance, and less strategic investors and are expanding abroad. Additionally, than half of this has gone to the nonbank, nongovernment aggregate domestic activity kept growing through the twin sector to fund potentially growth-supporting investment shocks of the Asian and Russian crises now appears to be (table 17.2). The failure of historic banking reforms to accelerating again. This is despite further bank failures in encourage rising market shares for lower-cost banks is 12. Commenting on Russia, Pinto, Drebentsov, and Moroz (1999) write as follows: "The system grew and persisted because prof- itable companies realized that they could take advantage of it provided that they linked up with unviable companies that were the o.riginal targets of the soft budgets. This in turn created natural alliances between the managers of viable and unviable com- panies, who could personally enrich themselves by siphoning off part of the subsidy. This led nonpayments to spread diffusion- like as ever more complicated networks developed, eventually creating a new form of industrial organization linking suppliers and final goods producers." A similar story for Ukraine is recounted in Roe and others (2000). 13. Based on comparisons of per capita purchasing power parity-adjusted deposits in U.S. dollars. 198 Financial Deepening and the Role of Financial Crises TABLE 17.2 LENDING AND NET SUPPLY OF FUNDS BY SECTOR FOR SEVEN TRANSITION ECONOMIES, 1996-99 (PERCENT OF GDP ANNUALLY) (A) (B) (C = A+B) (D) (E = A-D) (F) New lending Net flow Net lending New deposits by Net finance Net foreign Country to private sector to statea to economy private sector of private sector finance Fast adjusters Hungary 4.4 2.7 7.2 5.5 -1.1 0.0 Poland 5.8 0.9 6.8 6.8 -1.0 0.7 Estonia 7.2 2.4 9.6 5.0 2.2 3.3 Slow adjusters Russian Fed. 1.4 2.4 3.8 2.4 -1.1 -1.2 Ukraine 0.9 0.2 1.1 1.5 -0.6 -0.9 Lithuania 1.6 1.3 2.9 1.7 0.0 0.3 Czech Rep. -0.6 2.2 1.5 4.4 -5.0 -4.3 Slovak Rep. 3.7 -0.1 3.7 5.2 -1.4 -0.4 a. Includes buildup of cash holdings and reserves at the central bank (ultimately available to fund government). b. Change in commercial bank net foreign assets, sign reversed (minus means bank export of funds). Source: IMF International Financial Statistics. reflected in Russia's very slow and sporadic pace of finan- annual new deposit mobilization worth the equivalent of cial deepening, as indicated in figure 1 7.4c. Equally, there 5.5 percent of GDP. Poland lies in a similar position on fig- is a real risk that if the bank restructuring effort currently ure 17.1 to Hungary, despite having started the 1990s in a under way does not soon result in the closure of banks that much worse position. It too has seen the banking sector are no longer viable, then the real preservation of domes- consolidate, partly under pressure from foreign capital, tic savings that has been achieved since the 1998 crisis will but at no cost to the supply of domestic finance. In Poland, be undermined. an average of 7 percent of GDP has been injected into the A few other country examples serve to confirm the domestic economy annually by way of new bank financing, importance of banking consolidation as a main source of and the bulk of this has been domestically financed. Both high financial depth. Figure 17.1 shows that Hungary has countries now have banking systems with ratios of deposits preserved a relatively high level of financial depth (espe- to GDP in the 35-40 percent range: three times the Russian cially when nonbank financial intermediation is included) level. and also has avoided excessive dependence on cash. This Lithuania offers the contrast of an initially very slow record is associated, among other things, with Hungary's adjustment that failed to keep pace with, for example, actions in restructuring its state banking system, privatizing Estonia in its overall level of monetary development (fig- it, and opening the sector to foreign competition. The ure 17.1).14 None of the other Baltic governments did restructuring of state banks was undertaken while they more to protect domestic depositors from the conse- were still publicly owned. Such a rigorous approach has quences of bank failure than did Lithuania. As a result, yielded significant benefits in terms of the ability of banks Lithuania has the lowest ratio of bank deposits to GDP of to finance both government and the enterprise sector- all three of the Baltic states. In the last few years, this sit- average annual new lending to the economy has been the uation has begun to change markedly. Real progress start- equivalent of just over 7 percent of GDP based on average ed once Lithuania began serious preprivatization work 14. Currency reform was delayed and staggered over two years. Lithuania had a major banking crisis that eliminated some of its largest banks (state and private). 199 Peachey and Roe on the two remaining state banks and established a fully * The operational costs of banking that are potential- functioning and credible deposit insurance fund. The ly under the direct control of banks. These include deposit insurance fund has been operational for two years wages, the costs of owning and operating fixed and has successfully covered two payouts. The ratio of assets, the burden of nonearning assets, and so forth. deposits to GDP has risen to recover all of the ground lost Figure 17.6 assembles some initial evidence on this over the previous three years, when the Lithuanian gov- point for nine of the transition economies shown in figure ernment was spending far larger sums on informal bailouts 17.1.15 It shows first the share of leading banks' total of failed banks. The Lithuanian economy entered 2000 assets in each country that actually earn income-an indi- with significant consolidation of its banking system well cator that is sensitive to the degree of political interference under way, the two remaining state banks moving toward in what should be commercial decisions. Second, it shows privatization, and a growing presence of foreign capital. the ratio of operating costs to interest-earning assets. After years of disappointing performance, its banking sys- When this ratio is inflated by the existence of too many tem is rapidly catching up with that of other Baltic states small banks and too high a burden of policy-induced and, in all probability, has begun to move from the slow- costs, it ultimately must result in a higher spread between to the fast-adjusting group. deposit rates and lending rates, thus increasing the real cost of borrowing. Does this affect financial depth? And, The Economic Costs of Trying to Avoid Banking Sector if so, how? Consolidation The share of earning assets and the ratio of costs to Most of the countries with low levels of monetary earning assets for the two least-monetized banking systems development (that is, countries located toward the upper- in this set-Ukraine and Armenia-are both significantly left quacdrant of figure 17.1) are characterized by either or worse than for more advanced banking systems. The aver- both of the following: age cost of banking in these least-developed systems is * A high lcvcl of tolerance of alternativc financial also very high (up to 10 pcrccnt) relative to industrial- arrangements that damage banks country norms of around 2-3 percent of total assets. More An unwillingness to see the rapid consolidation of detailed analysis of the data behind these charts reveals the banking sector. that the best of the large Ukrainian banks has a lower ratio Both factors have a direct bearing on the efficiency of of total assets actually earning income than the weakest a country's banking system as a way of mobilizing and banks in comparator countries such as Poland, Estonia, intermediating the domestic savings needed to support and Latvia. Similarly, cost ratios in even the better banks investment and economic growth. They share one fea- in the least-monetized countries are high relative even to ture-they both raise the costs of the business of banking. those in weaker banks in many of the better-performing This suggests an important avenue of further enquiry in the countries, including Hungary, the Slovak Republic, and search for an explanation of intercountry differences in Poland. Although these better-performing countries all financial depth. This is an enquiry into the cost bases of dif- have some banks with quite high costs, the key point is ferent banking systems. In doing this, it is analytically help- that they have a sufficient core of efficient banks to sup- ful to subdivide banking costs into two separate elements: port effective and, above all, low-cost intermediation. * "Policy-induced" costs-costs on banks directly These comparisons suggest that high costs in banking associated with policy interventions and therefore must have an obvious and direct impact on spreads (the not under the control of the banks themselves. lending rate relative to the cost of funds) and that these Evcamples in the population of countries we are con- higher spreads must, in turn, exert a significant influence on sidering include unremunerared reserve require- the ability of the banking system to mobilize saving and rwents, unreasonable taxation arrangements for thereby increase financial depth. This is confirmed by com- banks, administrative interventions such as the parisons of real deposit and lending rates for a similar set Kartoteka systems found in Russia and Ukraine, the of transition economies ranked by their ratio of domestic costs associated with volatility of key money market deposits to GDP, as shown in figure 17.7. i[terest rates, and the costs of large loan losses The evidence reveals great variation among countries caused by high levels of state-directed lending. in their level of real deposit and lending rates as well as 15. The country selections are based merely on the availability of detailed and comparable cost data on individual banks in the coun- tries concerned. 200 Fin3ncinI Deepening and the Role of Finincial Crises FIGURE 17.6 KEY BANKING EFFICIENCY RATIOS AND RATIOS OF DEPOSITS TO GDP IN CENTRAL AND EASTERN EUROPE, 1998 (A) Income-Earning Assets as a Percentage of Total 100%/0------ --- - - - - - - - 100% 75% U 75% 50%- 50% 25%- 25% n/a* * 0% , 0% 21 20 17 13 12 7 5 -25%-- - 35- 31 --25% 38 -50%-_ 56 -50% -75%- _78 -75% -100%----- - - -100% | Depth in 1998 (percent of GDP) *Average of banks in best quartile for asset ratio | (B) Costs as a Percentage of Income-Earning Assets 10. --0 % . 10.0% 7.5%- _-7.5% 5.0% || * 5.0% 2.5%- _" 2.5% n/a * *, , 7 0.0% 2 0 I 13 12 7 5 -0.0% -2.5%- - - 35 3 1 - -52.5 -5.0%-- -38 --5.0% 60 56 -7.5%-- --7.5% 78 ______ -10. 0 % -10.0- 6. C t; ;> U~~~~~~~~~~~ -V a Depth in 1998 (percent of GDP) Average of banks in best quartile for cost ratio-l 201 Peachev and Roe FIGURE 17.7 REAL INTEREST RATES, SPREADS, AND RATIOS OF DEPOSITS TO GDP IN CENTRAL AND EASTERN EUROPE, 1998 60 o 60.0% 40%/o 40.0% 20%/o 20.0% 0% 0.0% -200 -20.0% -40 38/ -40.0% 56 :X;:00060 tf0 -60_0% --60.0% 78 -80 0 < 1 -80.0% O X- X~ C ct en c: 'L c r 'C 3- C C 3 N P4~ ~~~ a2 0'* ~ L Depth in 1998 (percent of GDP) U Real deposit rates in 1998 El Real loan rates in 1998 financ al depth-Ukraine and Armenia again stand out as rates (for example, Ukraine and Poland; Ukraine and the clear outliers. Russia, for these purposes, can also be brack- Slovak Republic; Lithuania and Hungary) add further eted with these two countries.16 But equally clearly there is weight to this idea. They hint at the possibility that high no simple explanatory link running from high real deposit real lending rates restrain feasible rates of asset growth and rates, on the one hand, to financial depth, on the other. that this is a more critical determinant of financial depth Several countries that offer apparently very attractive real than the adequacy of real deposit rates. deposit rates have small banking sectors. Ukraine, Armenia, This points to a structural banking industry explana- and Ra,sia are the obvious examples-all three countries tion for the persistence of high real interest rates as a fea- have suffered high real interest rates for several years. ture of transition economies even after inflation seems to Figure 17.7 suggests that there is a stronger correlation have been brought under control. Standard macroeco- between financial depth, on the one hand, and the spread nomic analysis argues that stabilization should give rise to between deposit and lending rates, on the other. In other lower actual inflation, which, after some lag, should also words, where the cost of intermediation is high and puts a result in lower expectations of future inflation. These more significant wedge between deposit and lending rates, then benign expectations should, in turn, encourage increased financial depth seems to be reduced. Pair-wise compar- money holdings that then mean low inflation can be sus- isons between countries with similar levels of real deposit tained at a lower cost and on an ongoing basis. If real 16. It is worth highlighting the experiences of Russia, which fails to show up in figure 17.7 because of the choice of year. Real inter- est rates in Russia generally became significantly positive (20 percent or above) in late-1994 and remained at very high levels in real terms for almost three years, until May 1997. There was a further burst of high real rates in the spring of 1998. No coun- try in Eastern Europe had to deal with such protracted periods of such severely high rates. 202 Financial Deepening and the Role of Financial Crises interest rates stay high during this process and for sus- sis suggest that it is the surface gloss of reform that attracts tained periods (that is, more than six to nine months), the good scores-the serious commitment to the real intent then the macroeconomic programs that have produced of reform is another matter entirely! these simply are not credible, and a relaxation is called for. But this has proved to be difficult advice to follow, and Financial Crisis and Financial Deepening there are several examples in the FSU where real interest What, if any, conclusions can be drawn from this rates have been demonstrably higher than is credible for analysis about the significance of highly publicized banking lengthy periods of time. crises in the transition economies, such as the Russian cri- Based on this logic and the comparisons among coun- sis in the fall of 1998? Should regulatory and supervisory tries presented here, it can be argued that the real cost of efforts be intensified to head off such crises, or do they play borrowing is unlikely to fall to credible levels until the a different role in the transition economies than they do in intermediated financial savings of an economy consolidate more settled banking systems? around a smaller number of lower-cost banks. In effect, the In financial systems that remain in phases 1 and 2 of failure to bring about consolidation of the banking sector the transition, the economic costs of a financial crisis will raises the cost of intermediation to the whole economy be quite low relative to those in the more mature banking and thereby reduces domestic funding of the heavy invest- systems that sustained crises in Mexico, East Asia, and ment requirements typical of transition economies. This is elsewhere in the 1990s. As figure 17.1 indicates, those confirmed by the comparisons in table 17.2. These show banking systems typically have ratios of deposits to GDP of the volume of funds mobilized in three fast-adjusting only around 10 percent. Consequently, the capitalization of economies where the banking sector operates on a rela- banks in those systems is unlikely to be more than around tively commercial basis and in five other economies where 1.5 percent of GDP. Even generous compensation of the government has used various direct and indirect means to depositors of those banks that fail during a crisis is unlike- manage the process of consolidation or to protect banks ly to involve a cost of more than about 1-2 percent of GDP. from the consequences of failure. This compares with the estimated costs of the crises in The evidence presented suggests that a high level of tol- other parts of the world, which are frequently more than 10 erance of alternative financial arrangements that damage percent of GDP and can go as high as 50 percent.17 banks or an unwillingness to see the rapid consolidation of Second, in those phase 1 and 2 economies where toler- a country's banking sector ultimately reduce financial depth ance of barter and nonpayment is a key part of the expla- and starve an economy of affordable domestic finance for nation of low financial depth, barter intermediaries represent investment. There is a strong link between these two points. a large alternative source of working capital for productive The protective instincts that lead to implicit subsidies to enterprises. Hence, even a significant short-term interruption failing enterprises-provided via mechanisms including in the availability of finance from some banks-or an barter and nonpayment-are the same instincts that argue increase in its cost-will have a muted effect compared to in favor of extending the lives of failing banks. In the that same shock in a more normal banking system.18 hybrid stage of transition in which countries such as Russia, The threat of crisis should not be accepted as an argu- Ukraine, and some of the Central Asian states now operate, ment in favor of enhanced protection to systemically high- the motives behind this are no longer attributable directly cost and "bad" banks. On the contrary, if the authorities to the state socialism that drove events before 1989. Today, have any choice in the timing of a banking crisis, they the residue of such politics interacts with the complex should let it happen in phases 1 and 2, as indeed was the struggles for the private ownership and control of valuable case in the Baltic states. Whether the benefits of crisis can economic assets to generate this type of result. This pattern be achieved-that is, the accelerated consolidation of the of behavior seems quite capable of coexisting with appar- banking sector around a lower-cost core-is another mat- ently good performance in relation to standard scorecards ter. The experiences of both Russia and Ukraine in 1998 of reform, including reform of banking regulation and indicate that it is as easy to let the opportunity presented by supervision. But where this coexistence occurs, the analy- crisis slip away as to grasp it. 17. See, for example, Evans (2000), who notes that the 1997 crises in Indonesia and Thailand, for example, involved costs of 40-45 percent of GDP. The crises in Argentina and Israel in the early 1980s had costs of s5 and 30 percent of GDP, respectively. 18. In both Russia and Ukraine, this point and the large exchange rate depreciation associated with the crisis are probably sufficient to explain the recovery in real economic activity seen in both countries in 1999 and 2000. 203 Peachey and Roe Conclusions and Future Prospects forgoing a substantial contribution to investment financing There are significant differences in the level of financial and economic growth as a result. Since reasonably devel- intermediation established in different transition economies oped banking systems are also a prerequisite for the emer- across the FSU and in Eastern Europe. These differences are gence of broad and deep capital markets, those same coun- strongly linked both to the nature of the macroeconomic tries are unlikely to see early progress in capital market disruptions associated with the early transition years and to development. the quality of the recovery from those disruptions. In those The critical questions for the future are whether the countries that have suffered from episodes of hyperinfla- lagging countries identified in figure 17.1 can catch up tion, a critical factor has been the policy stance in the peri- with the more advanced countries. If this is possible, what od following the early inflation-stabilization programs, policy measures are needed to achieve this? Recent econo- which almost all such economies have undergone. In this metric research shows that the initial conditions of coun- period, banks lose the easy access to profits arising from tries in 1989 (including geographical location) appear to be specular-ion and delayed debt write-offs and need to earn a significant explanation of differences in growth perfor- the profits to fuel future banking sector growth by offering mance in the period 1989-99. Most of the countries iden- serious banking services at increasingly lower margins. tified by this research as having unfavorable initial condi- Several countries in the FSU have side-stepped the tions also show up prominently in the list of countries macroeconomic pressures coming from tight monetary and with poorly developed financial sectors (for example, in fig- fiscal policies by allowing high levels of barter and non- ure 17.1).19 This suggests that there may be some inevitabil- payment in their economies: Russia and Ukraine are the ity and common cause in the different patterns of both eco- main examples. These practices serve to keep alive failing nomic growth and financial sector development-both enterprises even after formal budget and credit subsidies are being rooted in the geography, the history, the politics, no longer available. But they also do significant damage to and the cultures of the countries being compared. However, the prospects for the early recovery and deepening of the the same econometric research also notes the gradual decay financial systems of the countries in question. The instinct in the effect of initial conditions on growth performance as of some countries to protect high-cost and inefficient banks the forces of market economics take root. This suggests an is a second, very important reason for the slow deepening increasing convergence of growth performance over time. of financial sectors. This is because, even when positive real It seems likely that a similar pattern is possible in relation deposit interest rates are established, high-cost banking to financial sector development-with the possibility of implies lending rates in real terms that are too high for seri- convergence to levels of financial depth at something like ous enterprises to afford. So banks have little basis on the present levels in Poland and the Baltic states (25-30 per- which to expand their businesses. The alternative that cent of GDP) becoming the norm for most FSU countries seems to be associated with more rapid financial deepening during the next 5-10 years. is the expeditious consolidation of banking around a much However, the evidence mobilized in this chapter sug- lower-cost core of banks. This has occurred in some of the gests that this convergence is by no means inevitable. If it Baltic states as well as in several transition countries of is to occur in any particular country, reform of the financial Central Europe. sector will have to deepen. The standard indicators of All of the European transition countries seem to have progress with economic reform (whether the general tran- established the basic foundations of improved bank super- sition indicators of the World Bank and the European Bank vision and regulation. But several countries, including some for Reconstruction and Development or the specific bank- in the FSU that have accomplished reasonably sound super- ing sector indicators of the BIS and IMF) correlate quite vision and regulation, still find themselves with small bank- poorly with the differences in financial sector development ing sectors representing only around 10 percent of GDP. As noted in this chapter. The patterns of behavior that lie the comparisons in table 17.2 indicate, these countries are beneath these indicators seem to matter more than most 19. In a principal components analysis of the European Bank for Reconstruction and Development, for example, the first princi- pal component-explaining almost 50 percent of the variance of initial conditions across countries-is extremely high (unfa- vorable) for Azerbaijan, Georgia, Kazakhstan, the Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan. It is low (favor- able) for all the Central European economies and moderately low for the Baltic states. Russia and Ukraine both have scores lying betvween those of Central Asia and those of the Baltics. See, especially, Falcetti, Raiser, and Sanfey (2000). 204 Financial Deepening and the Role of Financial Crises previous analysis has recognized. Unfortunately, these pat- operate with costs approaching industrial-country norms. terns are inherently much more difficult to measure and This, in turn, would both expand the potential volumes of compare across countries. The chapter has focused partic- new lending that can be provided to sound enterprises and ularly on the costs of different banking systems and has enable those banks to achieve the profits needed to fuel suggested that the convergence of the cost to asset ratio of their own more rapid expansion. The alternative protec- the typical bank in a country toward industrial-country lev- tive stance that is still observed in many transition els is likely to be required before a lagging country can economies short-circuits both of these beneficial devel- expect to achieve significant financial sector deepening. opments. This logic leads naturally to a consistent menu of cost- How does this idea relate to some of the more con- reducing policy reforms to produce deeper banking sys- ventional prescriptions for banking sector development, tems. That menu comprises, inter alia, the following: such as the accelerated privatization of banking and * The reform or elimination of most government poli- increased foreign bank entry? The answer is that it relates cies that contribute to the high cost of banking. This to them only indirectly. The analysis presented in this chap- would include the elimination of all politically direct- ter suggests that privatization, for example, would have lit- ed lending, but it also would include the elimination tle substantive impact on financial sector development of institutions such as the Kartoteka in Russia and unless it could be accompanied by all or most of the cost- elsewhere, improved domestic debt management to reduction measures listed in this chapter. Private ownership reduce the volatility and costs of money market of banking is common in most of the countries displaying operations (a particular problem in Russia and the lowest levels of financial depth. But the private banks Ukraine after the 1998 crises), improved collateral are relatively powerless to (a) achieve really low operating procedures to lower the costs to banks of collateral costs and (b) increase market share on the back of those enforcement, and lower or better-remunerated low costs because the policy and operating environment for reserve requirements. banking prevents this. Equally, the presence of foreign * The radical reform of systems of nonpayment or banks in most of those same countries is quite significant barter in all countries in which these practices are (20 percent of total assets in Ukraine, for example). But widespread. These practices also raise the costs of most foreign banks cannot be expected to push hard to doing conventional banking by (a) obfuscating the broaden and deepen their operations in these countries information available to banks about potential lend- when the policy and operating environments have so many ing prospects and (b) establishing unregulated alter- features inimical to sound banking. natives to conventional banks in relation to both These and some other standard prescriptions for finan- the credit and the payment functions. cial sector development, including stronger regulatory and * The adoption of an increasingly low supervisory tol- supervisory structures, are better regarded as necessary erance of the high operating costs and low ratio of conditions for eventual financial sector deepening, but not earning to total assets that are characteristic of nmany as sufficient conditions. large state and fornmer state banks in the FSU. Bank While no case has been made that banking crises are an restructuring efforts in relation to such banks have inevitable step along the route to building fundamentally often focused narrowly on rebuilding the capital stronger banking systems, this chapter has illustrated that base of these banks. A broader approach that rec- large-scale banking failures should not be seen as invali- ognizes the critical role of lower operating costs to dating tough regulatory regimes. Rather, banking crises support the expansion of banking capacity is now can reinforce strong regulation, provided the end result is required. Banks that cannot aspire to industrial- intermediation increasingly focused around a smaller group country cost ratios will need to be phased out. of more efficient banks. In this respect, politicians should * The adoption of explicit supervisory policies to not fear crises as much as they do; recovery can be achieved accelerate bank consolidation to concentrate a big- easily within a three- to five-year time horizon, and avoid- ger percentage of banking business on the lower-cost ing necessary consolidation is a high-cost, not a low-cost, banks. This would include a lower degree of super- solution to banking instability. visory tolerance of marginal performance by small- The likely outcomes in the next few years in those er banks as well as explicit efforts to broker mergers. countries that are presently lagging hinge far more crucial- As much banking business as possible should be con- ly on the willingness of policymakers to embrace systematic centrated on those banks in a system that are able to cost-reducing and bank-consolidating reforms of the type 205 Peachey and Roe advocated here. Once this is done, the lagging countries Evans, Huw. 2000. Plumbers and Architects: A Supervisory likely will move rapidly (5-10 years) along the same tran- Perspective on International Financial Architecture. sition path as has been observed in countries such as FSA Occasional Paper 4. January. The Financial Estonia (figure 17.4d) and Poland (figure 17.5a). This will Services Authority, London. enable threm to have ratios of deposits to GDP of around Falcetti, Elizabeth, Martin Raiser, and Peter Sanfey. 2000. 25-30 percent and an associated annual flow of interme- "Defying the Odds-Initial Conditions, Reforms, and diated finance to the economy several percentage points of Growth in the First Decade of Transition." Paper pre- GDP higher than is possible today. This development also pared for the Centre for Economic Policy Research and will bring closer the point at which significant capital mar- Economic and Social Research Council conference on ket development can be seriously contemplated in these transition economics, Edinburgh, August 24-25. countries. Processed. International Monetary Fund. 1997. "Status of Market- References Based Central Banking Reforms in the Countries of the The word "processed" describes informally repro- Former Soviet Union." Report to the tenth co-ordi- duced works that may not be commonly available in library nating meeting of co-operating central banks, Basle, systems. May. Processed. McKinsey Global Institute. 1999. "Unlocking Economic Carlin, Wendy, Steven Fries, Mark Schaffer, and Paul Growth in Russia", October, Moscow. Seabright. 2000. "Competition and Enterprise Pinto, Brian, Vladimir Drebentsov, and Alexander Moroz. Performance in Transition Economies: Evidence from 1999. "Dismantling Russia's Non-Payments System." a Cross-Country Survey." Paper presented to the World Bank, Washington, D.C. September. Processed. Centre for Economic Policy Research and Economic Roe, Alan, Paul Siegelbaum, and Tim King. 1998. and Social Research Council conference on transition "Analysing Financial Sectors in Transition: With economics, Edinburgh, August 24-25. Processed. Special Reference to the Soviet Union." Policy Commander, Simon, and Christian Mumssen. 1999. Research Working Paper 1982. World Bank, Policy "Understanding Barter in Russia." Working Paper 37. Research Department, Washington, D.C. Processed. European Bank for Reconstruction and Development, Roe, Alan, Stephen Peachey, Angela Prigozhina, Katherine London. Processed. Forgacs, and Andriy Olenchyk. 2000. "Ukraine: The Conway., Patrick. 1995. "Saving in Transition Economies: Financial Sector and the Economy-A Framework for The Summary Report." Policy Research Working the Next Stages of Reform." World Bank, Private and Paper 1509. World Bank, Policy Research Department, Financial Sectors Development Unit, Washington, D.C. Washington, D.C. Processed. July. Processed. 206 Chapter 18 Aspects of Banking Supervision Christian Durand and Wim Fonteyne his chapter addresses the main policy issues relating to the supervision of banks that the ECA countries' have met, are now encountering, or are likely to meet according to their stage in the transition process. Main Purposes of Supervision is required to enforce the regulation, adapt it to changing Although banks have a semipublic policy role, their circumstances, and help build public confidence. main objective is-or should be-to make a profit.2 A healthy banking sector is maintained through the However, profit maximization requires taking risks and combination of bank licensing rules, which determine the may often lead banks to undertake actions that go against criteria for entry, and banking supervision, which allows the public's interest. Therefore, to reconcile banks' profit- the detection of unqualified competitors and forces them maximizing objective with their semipublic policy function, out. However, adequate supervision does not guarantee the an appropriate regulatory and supervisory framework is elimination of failure. A plethora of factors could lead a required. Such a framework needs to promote prudent bank to fail, and it would be unrealistic to seek a system banking-among other things, by putting reasonable lim- likely to eliminate all of them. Moreover, there is virtually its on the risks that banks are allowed to take-in order to no country that has never experienced a bank failure. reduce the probability that institutions will fail. It also Due to the macroeconomic shocks and structural needs to organize competition in an efficient way, so as to changes of the transition process, the inheritance of the past, prevent banks from gaining monopoly power and to ensure the proliferation of commercial banks after the onset of eco- that a wide range of banking services is available at low nomic liberalization, and initial limited supervisory capaci- costs, without placing excessive restrictions on the com- ties, ECA countries experienced an unusually high number mercial freedom of banks. A reliable supervisory capacity of bank failures and banking crises during the 1990s.3 Major 1. For the purpose of this chapter, ECA countries refer to countries in Europe and Central Asia receiving assistance from the World Bank, namely Albania, Armenia, Azerbaijan, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, the Czech Republic, Estonia, Georgia, Hungary, Kazakhstan, the Kyrgyz Republic, Latvia, Lithuania, FYR Macedonia, Poland, Romania, and the Russian Federation. 2. For a discussion of the role of the financial sector in economic development and growth, see, among others, Beck, Levine and Loayza (2000); Demirguc-Kunt and Maksimovic (1998); Easterly, Islam and Stiglitz (2000); Levine (1997); Levine and Zervos (1998); and Rajan and Zingales (1998). 3. Boot and van Wijnbergen (1995) note the absence of regular commercial banks in Eastern Europe (except in the Federal Republic of Yugoslavia) and the former Soviet Union as recently as 1987. However, by 1994, thcrc wcre more than 3,600 banks 207 Durand and Fontevne banking crises occurred in Bulgaria, Estonia, Hungary, able initial licensing process that prevents new entry or sets Latvia, Poland, Romania, and the Russian Federation capital adequacy requirements so high that investment in (Russia). In Russia alone, more than 200 banks failed in the the banking industry is being discouraged. In this regard, 1990-95 period. During the same time frame, there were when establishing a banking business, the first major more than 45 bank failures in Kazakhstan and more than 20 impediment to overcome is the need to meet the required each in Armenia, Estonia, and Latvia (see Gorton and level of minimum capital. The next step would be to decide Winton 1998). on the additional capital needed from shareholders to Banking supervision should not try to prevent risk tak- increase business activity within the established key pru- ing altogether, since risk is a quintessential part of financial dential capital ratios. intermediation. However, supervision should seek to ensure Capital is the key indicator of banking soundness for that banks are able to identify, measure, and monitor the two main reasons. First, it is well known that strongly risks they take. This entails ensuring that banks have a well- capitalized banks can better withstand shocks than their function] ng risk management system. Furthermore, financial weaker counterparts. Second, it is a simple indicator to sector regulation should not distort the market. It should be define and use-far simpler than the traditional regula- designed carefully so as not to favor a particular activity or tor's rating system based on capital, assets, management, a specific type of institution (for example, by putting banks equity, and liabilities (CAMEL). Clearly, imposing a high at a comlpetitive disadvantage vis-a-vis nonbank financial level of capital tends to reduce banks' return on equity. institutions). In this respect, the tax regime, monetary poli- Therefore, it is advisable to have a balanced approach cy, and exchange regime also play a considerable role. aimed at requiring the level of capital that is really need- Finally, a strict regulatory framework should foster compe- ed and not more. However, this requires sophisticated tition among banks in order to achieve an optimal allocation tools and a long, consistent series of accurate data, which of resources. Conservative practices aimed at stabilizing rarely are available in ECA countries. At the same time, banks and their customer base should be avoided. bearing in mind that capital is the only cushion protect- At no point should supervisors take over manage- ing customer deposits, the lower the capital is, the more ment's role. Supervision has to limit itself to making sure deposits are at risk. The realization of this risk will that bank managers stay within the constraints set in the depend on the time that the supervisory authorities need regulations and maintain at a reasonable level the risks to take action when problems occur and losses start eat- associated with their banking activity. However, in extreme ing away at capital. Obviously, the faster the authorities cases, when strong remedial action is needed, the gap are able to take action, the lower is the minimum level of between supervision and management may become very capital that can safely protect bank deposits. The thin. Supervisors may even need to intervene to oust and response time of the authorities will, in turn, depend on replace an incompetent management team. the efficiency of their monitoring and a series of ele- ments of the general environment, such as accurate Designing a Supervisory System for ECA Countries accountancy, absence of political intervention, and good Banking is an unusual business based on confidence law enforcement. between lender and borrower, banker and depositor. This Another typical capital-based regulation is the limit on confidence should be supported by a strong regulatory large credit exposure to a single borrower. Concentration system, particularly in countries with a limited banking cul- of lending is sometimes difficult to avoid in countries ture. Because it takes more time to build credibility than to where the economy is dominated by a limited number of lose it, iir makes sense for the supervisory authorities to sectors (for example, due to the country specialization build an effective bank regulatory system cautiously and prevailing in the centralized organization within the former gradually. Comecon framework) served by a limited number of finan- However, bank regulation, when excessive, can have cial institutions. Avoiding concentration of loans is even adverse effects on the way banks are managed, thus limit- more difficult when the economy is based on the primary ing the potential for market development. Examples of sector. Here again, regulations may hurt by limiting the such excessively strict regulation could be an insurmount- financing available to large quasi-monopolistic compa- in the countries of the former Soviet Union alone, of which more than 2,500 were in Russia (see Dziobek and van der Vossen 1999). Also in 1994, there were about 70 banks in Poland, about 60 in the Czech Republic, about 40 in Hungary, and about 30 each in Bulgaria, the Slovak Republic, and Romania (see Gorton and Winton 1998). 208 Aspects of Banking Supervision nies. Transitional arrangements such as credit pools could banks in the former Soviet Union from 3,600 in 1994 to be organized, but such arrangements do not foster com- about 2,500 in 1997 (see Dziobek and van der Vossen petition. 1999). As long as a country's financial markets are not well enough informed to impose market discipline, and the Should International Standards Be Adopted public is not sufficiently educated to distinguish between in ECA Countries? financial institutions, the problem that regulators face is International standards, established by organizations how to determine the optimal level of regulation among the such as the BIS (Bank for International Settlements) and many tradeoffs between development and stability. To do IOSCO (International Association of Securities this well, the authorities must be able to phase in an effec- Commissions), reflect years of experience. As such, emerg- tive system of bank regulation within the overall reform ing economies can benefit from their expertise in defining process. To illustrate the feasibility of such sequencing, the the most efficient tools for effective bank supervision. phasing in of bank supervision and financial restructuring Adhering to international standards also facilitates the measures can be classified into three progressive stages of dialogue with foreign investors, since all parties involved implementation (see Sundararajan 1999). The first of these are "speaking" the same language. However, adopting stages-the preparatory stage-focuses on the legal basis of these standards also raises concerns. On the one hand, it bank supervision restructuring, together with a minimal is possible in the early stages of banking system develop- program of financial restructuring to initiate stabilization ment that banks will have difficulty meeting internation- and prepare the ground for financial market development. al standards. It clearly would not be advisable to set high As market-based instruments of monetary policy are intro- standards that banks would not be able to meet. The duced to initiate financial liberalization in the second stage, solution is usually to phase in reforms in a manner con- a critical mass of reforms in prudential supervision and in sistent with the type of activity and the level of risks bank and business enterprise balance sheets is implement- acceptable at a point in time, to maintain international ed in parallel. This initial group of reforms helps accelerate standards as an objective, and to design a step-by-step the adoption of indirect instruments, improve their effec- path to achieve them. Conversely, it is possible that inter- tiveness, and set the stage for more comprehensive reform national standards may not be stringent enough to reflect of prudential supervision and bank restructuring in the accurately the risk exposure in some countries. This might medium term. As markets develop, prudential norms, be the situation in the case of two key ratios: capital ade- supervisory procedures, and restructuring actions are pro- quacy and liquidity. The capital adequacy ratio, together gressively refined and modified in line with market devel- with the large loan exposure ratio, probably should be opment and internal governance of financial institutions, more stringent when the legal framework for loan recov- thereby helping to consolidate financial market develop- ery is weak. ment in the third stage. Throughout this process, an impor- Moreover, often the capital adequacy ratio chosen by tant question is how closely international standards should developed-country regulators is calibrated for industrial be followed. countries whose economies are generally larger and less In the ECA countries, major efforts have been under- vulnerable to exogenous shocks. These ratios may not be taken to develop an appropriate regulatory and supervi- strict enough for some transition economies. Imposing sory framework (for an overview, see Knight et al., 1997, higher requirements may appear onerous and possibly and Dziobek and van der Vossen 1999). In all countries, pose an impediment to financing development, but it may the central bank also became the banking supervision be inevitable if regulators are to have a realistic chance of agency. During the first half of the 1990s, most ECA intervening in a failing bank before all its capital is erod- countries adopted new banking laws, often with rather ed. The establishment of appropriate capitalization levels lenient bank licensing rules. Later on, in many countries for country circumstances is a matter that needs to be con- and especially in the former Soviet Union, rules had to be sidered on a country-by-country basis. Clearly, there is a made stricter to stem the proliferation of small, weak, risk that increased capital requirements could lead to dis- and inefficient banks. From 1992-95 onward, minimum intermediation and to banks shifting loans from their capital and capital adequacy requirements were raised books into offshore subsidiaries; issues of international throughout the region, licensing and exit policies were coordination may arise. Capital requirements have been tightened, and overall banking supervision capacities substantially raised in ECA countries since the beginning were reinforced, contributing to a fall in the number of of the 1990s, and they are currently at or above the BIS 209 Durand and Fonteyne standard of 8 percent of risk-weighted assets in most ed incentive structure. At the same time, it sometimes is countries.4 argued that such standards tend to make it more difficult Finally, the assignment of a zero risk weighting to a for national institutions to emerge, thus raising the question country'; own government debt, as is done in industrial of sovereignty. countries, may not be appropriate in countries where direct and indirect government arrears are still common or in Should Local Regulators Welcome countries that recently have defaulted on outstanding gov- Foreign Institutions? ernment bonds, such as the Russian Federation and Ukraine. There is, of course, a tradeoff between sovereignty It often is argued that a government can always print its own and efficiency in financial markets. Allowing foreign insti- money to repay banks, thus never being in default. However, tutions to compete in the market makes it possible to fos- this may not be the case when a currency board is in place, ter the development of banking by bringing in competent, or when a government has rejected the use of monetary experienced, and skilled professionals with the requisite financing for external reasons, such as the desire to be part know-how. Claessens, Demirgui-Kunt, and Huizinga of a monetary union or to adhere to a stabilization program. (1998) find that, for a sample of 80 countries, increased Even when governments have confronted their loan delin- foreign entry tends to improve the functioning of national quencies. they have on occasion secured preferential con- banking markets, with positive welfare implications for solidation, which has been tantamount to a partial default, banking customers. However, as a corollary, they also find at least as far as the bank's profit and loss account is con- that foreign entry makes life harder for domestically owned cerned. In the end, there are sufficient reasons to consider the banks, reducing their profitability. In this regard, Bonin and possibility that lending to a country's own government may Wachtel (1999) note that foreign bank entry risks creating not necessarily be free of risks. a two-tier system in which strong banks with foreign part- Liquidity ratios should reflect the risk that banks may ners attract the best customers and other banks are left with not easily be able to find refinancing when needed, because less financially sound and less profitable clients. The chal- the monetary market is not efficient or is too narrow or lenge for the regulator is to find a level playing field, in possibl) because the secondary market for securities-if which foreign-owned banks can compete with domestical- present--is not liquid. When this is the case, consideration ly owned banks in a healthy competition that strengthens should be given to whether or not the central bank can act and improves the entire system. Bonin and Wachtel (1999) as a lender of last resort. argue that one approach to this problem is to promote for- International standards should no doubt be used as a eign entry in the form of joint ventures and equity stakes in reference point, although they must be placed in a context. existing banks. Thus globalization, often thought of as a This has been the objective of the joint International threat, can become an advantage, potentially strengthening Monetary Fund (IMF) and World Bank Financial System the resilience of a small economy's banking system. Assessment Program (FSAP) in analyzing the different com- Among ECA countries, the countries of Central and ponents of the financial system, together with the macro- Eastern Europe and the Baltic countries have-in general- economic framework, while conducting standards assess- been much more open to foreign entry than the countries of ments. Results of standards assessments conducted in the the Commonwealth of Independent States (CIS; see Tang, context cf an FSAP can be disclosed and can provide the Zoli, and Klytchnikova 2000). In addition, economic devel- internaticinal seal of approval needed to promote the need- opments so far have made the former countries more 4. Armenia, Azerbaijan, Belarus, Estonia, Latvia, and Lithuania have minimum capital adequacy ratios of 10 percent. Bulgaria, Czech Repub 'ic, Hungary, Poland, Romania, and the Kyrgyz Republic essentially have adopted the BIS standard capital adequacy ratio of 8 percent. Georgia has introduced a gearing ratio of 10 percent. Kazakhstan has introduced a 12 percent requirement, with a phase-in provision. The decision to opt for 12 percent was adopted in part because of recognized problems with accounting and reporting-by requiring 12 percent, there is some comfort that at least 8 percent is actually achieved. It also may reflect the view that in developing and transition economies commercial exposure should be risk weighted at more than 100 percent and that sov- ereign debt might properly attract a risk weighting of greater than zero. Russian regulations (Regulation 1) prescribe minimum risk-weighted capital of 10 percent as of January 1, 2000, for banks with own funds of 5 million euros or more (countervalue) and 11 percent for banks with own funds between 1 million euros and 5 million euros (countervalue). They do not require spe- cific banks to meet varying ratios. Ukraine has a capital adequacy ratio of 8 percent. As of January 1, 2000, there were plans to introduce individual solvency ratios for banks, which could be as high as 12 percent. No information is available about whether the plan has materialized. 210 Aspects of Banking Supervision attractive to foreign banks than the latter. As a result, the marketed derivative instruments linked to objective indica- relative presence of foreign banks is now highest in the tors correlated to national economic conditions could pro- Baltic countries. For example, the consolidation process in vide a vehicle for diversification. The alternative, and more Estonia resulted in a series of mergers. After these mergers practical, option is greater involvement of foreign-owned were completed, two major Swedish banks acquired con- banks in a country's domestic banking. For example, heavy trol of the country's two largest banks-accounting for loan losses at the local branch of a multinational bank will more than 85 percent of total banking assets-as part of not entail failure of the entire bank. their strategic plans to gain a substantial presence in the Similarly, in considering the problems of macroeco- Baltic states. Foreign banks also have an increasingly strong nomic shocks and the pressure of government ownership, presence in Central and Eastern Europe. They account for the advantages of greater participation of foreign banks about 60 percent of the banking system in Hungary and 80 become clear, since they generally have long experience percent in Bulgaria, and they might reach 90 percent in the and come from strong banking systems. Foreign banks are Czech Republic once the privatization process is finalized more likely to impose strict controls on their international there. By contrast, foreign participation remains very lim- branches and subsidiaries. Therefore, concentration of ited in the banking systems of the CIS countries, and the lending is less likely to be condoned, especially if it is to par- existing foreign participation often originates from fellow ties related to the local management. Local loan approval CIS countries (see also Dziobek and van der Vossen 1999). is also less likely to be given free reign, and government In many instances, ECA countries have sought to limit pressure can often be more readily resisted. Such mecha- foreign entry in their banking systems. In Poland, the gov- nisms of internal control are likely to be much more effec- ernment refused to grant any licenses to foreign banks tive than external regulations and supervision. from 1992 until 1994, an episode that may have con- An important obstacle to this approach is the common tributed to the relatively low share of foreign banks in perception that foreign ownership of banks compromises a Poland's financial system, in comparison with other Central country's sovereignty. Conversely, when foreign banks are and Eastern European countries. In Kazakhstan, foreign welcomed, they may not always be rushing to enter. banks cannot own more than 25 percent of a domestic Experience to date of foreign-owned banks in transition bank's stock. countries varies, but often such banks have tended to con- fine themselves mainly to servicing the local activities of for- Should Internationalization Be Fostered? eign enterprises and the trade finance requirements of the Although there is much concern that increased global- largest domestic enterprises. Partly as a result of this, but ization of financial markets can increase the volatility of also because of better management procedures and less capital flows, globalization also can provide opportunities to pressure from governments, the failure of foreign-owned diversify some of the risks facing a small financial system. banks has often been far more rare than among domestic Small economies would do well to develop policies to banks-even though foreign banks' lack of local informa- strengthen the resilience of their financial systems. Innovative tion can sometimes lead them to make hazardous lending risk-sharing financial instruments can help, but achieving the decisions. Nevertheless, the relatively modest response to full potential may require stronger ownership links between the opportunities created by the changes in Eastern Europe financial institutions at home and abroad. As the network of and the Soviet Union, and in the single European market, financial institutions has become more diverse and more suggests that industrial-country banks will remain highly complex, sophisticated financial systems have become more selective in their entry decisions. resilient to isolated failure (Honohan and Vittas 1996). Not Obviously, there are no simple and immediate solu- every country can expect to build a comparable complexity tions. But the traditional view that liberalization of the by itself, but by becoming more integrated into the interna- capital account needs to be delayed in order to protect the tional financial network it can obtain the benefits of domestic financial system from destabilizing capital flows increased resilience as well as diversification. must be adapted to take into account the argument out- In the end, most macroeconomic shocks for a small lined here, based on the insulating properties of the global country are only regional or sectoral shocks for the global financial network. economy. The risk of such shocks can, in principle, be diver- sified. One theoretical option is to diversify through market How Many Supervisory Institutions? instruments. Banks might find ways of selling or swapping The debate on the benefits that could be obtained part of their loan portfolio to banks in other countries. Or from having a single national financial services regulator 211 Durand and Fontevne instead of several specialized supervisory agencies is not In practice, and despite the recent attention given to closed (for an overview, see Fleming and Taylor 1999, this approach, few countries have (so far) adopted the 2000; Abrams and Taylor 2000). Goodhart and others IFSSA model. Among developed countries, Denmark, (1998) may well be correct in stating that "there is no uni- Iceland, Japan, Norway, the Republic of Korea, Sweden, versal model," not only because markets have developed and the United Kingdom have a single supervisory agency. differently in various countries, but also because the regu- Among ECA countries, Latvia, Estonia, and Bulgaria are latory framework reflects different cultures of regulation considering introducing one. and control. Among the factors to consider before opting Whatever the merits of the single regulator approach, for one or another solution are the following: before making any decision on the establishment of an * The number of institutions to supervise5 IFSSA, the following issues should be considered: (a) what * The interrelations among the financial sector com- criteria will be used to select the existing institution that will ponents6 form the backbone of the IFSSA, (b) what are the costs of * The complexity of financial business activities merging existing supervisory institutions, (c) should there * T he number of agencies to merge. be a specific role for the central bank, and (d) what powers The case for a single integrated financial sector super- shall the regulator be responsible for? The selection of the visory agency (IFSSA) has, of course, both positive and neg- regulator, in turn, should take into account the following ative arguments. The most important positive arguments questions: are that one can expect economies of scale and scope from * Which agency has the skills at this point in time? combining regulatory responsibilities within one or two * Which agencies have established a high degree of bodies, that supervision of financial conglomerates is bet- credibility? ter done by an IFFSA, and that an IFFSA guarantees com- * Which ones are likely to be more independent from petitive neutrality in the supervision of different types of politicians and from the professionals supervised?7 financial institutions. Among the negative arguments, the * Are any of the existing institutions internationally most important are that the division of functions and duties recognized? among different government agencies could be unclear or Mergers of supervisory institutions present a number of even contradictory, that their mutual relationships and organizational and process challenges. When the agencies supervisory powers could be insufficiently coordinated, involved are mature, the merger process is likely to be more and that there could be differences in the level of compe- complicated and may involve a loss of efficiency or, even tence among the supervisory agencies and differences in the wvorse, a loss of credibility, at least during the transition powers granted to them by laws and regulations. phase. The key challenge is to preserve existing and acquired The case against unified regulatory agencies argues knowledge and experience, on the one hand, while harmo- that it is difficult for an IFSSA to strike an appropriate bal- nizing the supervisory approach, on the other. To achieve ance between the different objectives of regulation, that it that under the merged structure, each component of the may suffer from diseconomies of scale, that the different financial sector (such as credit institutions and insurance) kinds of ftnancial institutions require a very different super- needs to be entrusted to a specific team of counselors to help visory approach, and that there is a risk that customers and ensure expertise, consistency, and coordination. creditors of nonbank financial institutions will expect all Central banks rarely supervise any institutions (for institutions supervised by a single agency to enjoy similar example, insurance and securities firms) other than banks. protectiorn (for example, deposit insurance) in case of failure. According to a survey conducted on a sample of 123 coun- 5. A relatively small financial sector could make it possible to realize significant economies of scale from the sharing of informa- tion technology platforms, data collection, and administrative support infrastructure of the agencies involved in the regulatory process. 6. A unified supervisory agency would offer improved oversight of financial conglomerates, especially those combining banking and insurance activities. Regulatory independence is important in whatever structure of regulation is adopted. For instance, the Basel core principles explic- itly require (CP1) the bank regulatory agency to possess independence and adequate resources. Similar statements appear in both the IOSCO objectives and principles of securities regulation and the International Association of Insurance Supervisors' (IAIS) principles of insurance supervision. Operational independence implies freedom from direct political pressures and influence and is important in all fields of regulation. 212 Aspects of Banking Supervision tries, central banks were in charge of banking supervision bank and in the commercial banks) to assimilate quickly in 89 countries, with the central bank just dealing with the new regulatory and accounting concepts proposed. banks in 69 countries.8 Therefore, once an option is chosen, it is important to Central banks are responsible for the integrity and inform key participants in the financial sector and the pub- stability of the financial system, as a necessary corollary of lic of the reasons behind the decision as well as the results their monetary policy objectives. There also is a growing it is expected to achieve. recognition of the need to reduce risks in the payment sys- Once a regulation is accepted, it must be strictly tem, particularly credit exposure by the central bank. When enforced. Ignoring enforcement procedures is counterpro- central banks are not involved in the supervisory process, ductive, since it reveals the inefficacy of supervisory author- they are at a disadvantage, since they often have to provide ities and thus makes them lose credibility. Sanctions taken lender-of-last-resort facilities without first-hand knowl- must be made public and explained. edge of the viability of the banks in need of liquidity sup- A comprehensive approach to transparency issues fac- port. In transition economies, the segmentation of the ing central banks and financial agencies is outlined in the banking system, and the underdevelopment or absence of Code of Good Practices on Transparency in Monetary and an interbank market, may require that the central bank act Financial Policies (the code) designed by the IMF (see box as a liquidity broker so as to facilitate the exchange of liq- 18.1).9 This code discusses the need for transparency and uidity, for example, through the organization of both cred- identifies the key elements of good practices regarding it and deposit auctions. In addition to the use of collateral, transparency. precise knowledge of the situation of each bank allows the central bank to limit the risks it takes in such opera- The Case for Transparency tions. Finally, there is a need to address the question of the The case for transparency of monetary and financial three levels of supervision (issuing regulations, implement- policies is based on two main premises. The first is that the ing the regulations, and taking sanctions when violations effectiveness of monetary and financial policies can be occur) and to determine whether the same institution strengthened if the goals and instruments of policy are should be in charge of all three functions. known to the public and if the authorities can make a As a whole, no arrangement is ideal. Unifying the credible commitment to meeting them. Hence, in making role of the central bank and overall responsibility for available more information about monetary and financial supervision is probably not feasible and could cause con- policies, good transparency practices promote the potential cern over the concentration of power. Coordination efficiency of markets. The second premise is that good between agencies is an option, but it is labor-intensive governance requires central banks and financial agencies to and limits efficacy in rapidly developing situations. be accountable, particularly when they have been granted Unification reduces coordination problems in theory but a high degree of autonomy. In cases where conflicts might may hinder effective market management and the ability to arise between or within government units (for example, if reduce systemic risk through effective and economical use the central bank or a financial agency acts as both owner of lender-of-last-resort facilities. and supervisor of a financial institution, or if the responsi- bilities for monetary and foreign exchange policy are Transparency Issues shared), transparency in mandates and clear rules and pro- Bank regulation must be understood by all profes- cedures in the operations of the agencies can help to avoid sionals in the sector. Accordingly, it is important to have and resolve such conflicts, strengthen governance, and them participate in the drafting of new regulations, to have facilitate policy consistency. their views heard, and, to the extent possible, to have them Transparency by bank supervisors, particularly in clar- accept at least the rationale behind proposed regulations. ifying their objectives, should also contribute to policy Experience has shown that regulators often have been too effectiveness by enabling financial market participants to optimistic about the capacity of staff (both in the central better assess the context of financial policies, thereby reduc- 8. Courtis (1999). The central bank was supervising banks and insurance companies in 16 countries, banks and securities firms in seven countries, and banks, insurance companies, and securities firms in three countries. 9. The term financial agencies refers to all institutional arrangements for the regulation, supervision, and oversight of the financial and payment systems, including markets and institutions, with a view to promoting financial stability, market efficiency, and client asset and consumer protection. The website address is www.imf.org/external/np/mae/mft/code/index.htm. 213 Durand and Fonteyne BOX 18.1 KEY ELEMENTS OF GOOD TRANSPARENCY PRACTICES The code identifies desirable transparency practices for central * Consistent with confidentiality and privacy of information banks (or other regulatory bodies) in their supervision of banks on individual firms, aggregate information on emergency (see International Monetary Fund 1999). Following the code, financial support by financial agencies should be publicly these practices can be grouped under four headings: disclosed through an appropriate statement, when such 1. Clarity of roles, responsibilities, and objectives of financial disclosure will not be disruptive to financial stability. agencies responsible for financial policies. The broad objec- * Financial agencies should establish and maintain public tive(s) and institutional framework of financial agencies should information services. be clearly defined, preferably in relevant legislation or regulation. * Financial agencies should have a publications program, The following points should be publicly disclosed: including a periodic public report on their principal activi- * The responsibilities of the financial agencies and the ties issued at least annually. authority to conduct financial policies * Texts of regulations and any other generally applicable * Where applicable, the broad modalities of accountability for directives and guidelines issued by financial agencies financial agencies should be readily available to the public. * Where applicable, the procedures for appointment, terms * Where there are deposit insurance guarantees, policy- of office, and any general criteria for removal of the heads holder guarantees, and any other client asset protection and members of the governing bodies of financial agencies schemes, information on the nature and form of such pro- * The relationship between financial agencies. tections, the operating procedures, how the guarantee is 2. Open process for formulating and reporting of financial financed, and the performance of the arrangement, all policies. It is essential that the following occur: should be publicly disclosed. * The regulatory framework and operating procedures gov- 4. Accountability and assurances of integrity by financial erning the conduct of financial policies should be publicly agencies. The main practices recommended are the following: disclosed and explained. * Officials of financial agencies should be available to appear * The regulations for financial reporting by financial institu- before a designated public authority to report on the con- tions to financial agencies should be publicly disclosed. duct of their policies. * Significant changes in financial policies should be publicly * Where applicable, financial agencies should publicly dis- announced and explained in a timely manner. closed audited financial statements of their operations on * Proposed substantive technical changes to the structure of a preannounced schedule. financial regulations should involve consultations with the * Internal governance procedures necessary to ensure the public within an appropriate time period. integrity of operations, including internal audit arrange- 3. Public availability of information on financial policies. ments, should be publicly is closed. This would include the following issues: * Standards for the conduct of personal financial affairs of * Financial agencies should issue a periodic public report on officials and the staff of financial agencies should be pub- the major developments of the sector(s) of the financial licly disclosed as should rules to prevent exploitation of system for which they carry designated responsibility. conflicts of interest, including any general fiduciary oblig- * Where applicable, financial agencies should publicly dis- ation. close their balance sheets on a preannounced schedule * Information about legal protections for officials and stall of and. after a predetermined interval, publicly disclose infor- financial agencies in the conduct of their official duties mation on aggregate market transactions. should be publicly disclosed. ing uncertainty in their decisionmaking processes. of the game and an additional mechanism for enhancing Moreover, by enabling market participants and the gener- the credibility of financial agencies' actions. There also al public to understand and evaluate financial policies, may be circumstances in which public accountability for transparency is likely to be conducive to good policymak- decisions can reduce the potential for moral hazard. ing. This can promote financial and systemic stability. For countries considering adopting good transparency Transparent descriptions of the process of policy formula- practices in monetary and financial policies, the benefits tion provide the public with an understanding of the rules have to be weighed against the potential costs. In situations 214 Aspects of Banking Supervision where increased transparency in monetary and financial and World Bank so far have completed transparency assess- policies could endanger the effectiveness of policies or ments of the banking supervisory agencies in four ECA harm market stability or the legitimate interests of super- countries: Bulgaria, the Czech Republic, Estonia, and vised and other entities, it may be appropriate to limit the Russia. For Bulgaria and Estonia, the assessments reveal extent of such transparency. Limiting transparency in that overall transparency is quite good and mostly in line selected areas needs to be seen, however, in the context of with international best practice, although further improve- a generally transparent environment. ments could be made in several areas. In the Czech Some aspects of the transparency of financial policies Republic and in Russia, the assessments reveal several could raise additional concerns. Considerations of moral important areas in which increased transparency would be hazard, market discipline, and financial market stability welcome. may justify limiting both the content and timing of the dis- closure of some corrective actions, emergency lending deci- Limits to Bank Supervision: Systemic Failures sions, and market-sensitive or firm-specific information. In In the context of a systemic crisis, when the scope and particular, there is a need to safeguard the confidentiality severity of banking problems threaten the entire system, and privacy of information on individual firms (common- supervision is not the appropriate answer. In fact, if the ly referred to as commercial confidentiality), in order to banking system as a whole is weak, strengthening the reg- maintain their trust and access to sensitive information. ulatory framework will, at best, spark a banking crisis by Similarly, it may be inappropriate for financial authorities exposing the extent of bank weakness to the public, as hap- to make supervisory deliberations and enforcement actions pened in Latvia. Therefore, in cases where systemic bank public, when these relate to specific financial institutions, restructuring is needed, the first priority must be to imple- markets, and individuals. ment it quickly and thoroughly. Transparency practices differ not only in substance, but A wide range of countries have experienced systemic also in form. With regard to informing the public about banking problems, and their approaches to handling these monetary and financial institutions and their policies, an problems have varied substantially. A recent IMF working important issue concerns the modalities under which such paper looks into the experience of 24 countries and sum- public disclosure should take place. In monetary policy in marizes policies that have proved to be successful in a wide particular, several issues arise, such as whether transparency range of circumstances (see Dziobek and Pazarbasioglu practices should have a legislative basis in a central bank 1997). law, whether they need to be based on other legislation or An important component of successful restructuring regulation, or whether they should be adopted through programs consists of a thorough and correct diagnosis of other means. the nature, causes, and extent of the problems in the bank- A variety of arrangements can lead to good practices in ing system. In all countries, multiple factors contribute to transparency. On matters pertaining to the roles, responsi- the systemic problems, and the countries that have made bilities, and objectives of central banks (and for principal the most substantial progress in bank restructuring are the financial regulatory agencies), it is recommended that key ones that identified the underlying causes and designed a features be specified in the authorizing legislation (for bank restructuring strategy aimed at systematically address- example, a central bank law). Specifying these crucial ele- ing each of them. ments in legislation gives them particular prominence and Furthermore, successful bank restructuring requires avoids ad hoc and frequent changes. Rules about less cru- prompt corrective action and firm exit policies, both of cial aspects of transparency-such as how policy is for- which are essential for a quick resolution of a systemic cri- mulated and implemented or how and what information is sis. Subsequently, continuous monitoring of bank restruc- provided-can be specified in other texts. However, all turing policies and of individual bank restructuring opera- these texts need to be readily accessible, so that the public tions is necessary. Successful restructuring also requires a can obtain and consult them without unreasonable efforts. comprehensive approach, addressing not only the imme- Historically, the centrally planned economic systems of diate stock and flow problems of weak and insolvent the ECA countries were characterized by an inherent lack banks, but also correcting shortcomings in the accounting, of transparency. However, since the start of transition, eco- legal, and regulatory frameworks, while improving super- nomic policies have become much more transparent, often vision and compliance. Structural factors that stand in the approaching or even surpassing western levels of trans- way of efficient financial intermediation, such as excessively parency. In the area of financial policy, staff from the IMF high reserve or liquidity requirements, interest rate controls, 215 Durand and Fonteyne and distortions in the tax system (for example, a tax large-scale liquidation of banks in most of the CIS countries, exemption for state banks), may need to be removed. which had experienced hyperinflation and had relatively Operational restructuring is a necessary condition for undeveloped financial systems; and (c) a combination of banks to return to profitability and sustained solvency. bank liquidation and restructuring in the Baltic states. Management deficiencies were identified as a cause of the As for the results achieved under these three different banking problems in all sample countries, and progress in strategies, Tang, Zoli, and Klytchnikova (2000) conclude bank resrructuring was highly correlated with whether or that the countries of Central and Eastern Europe incurred not such deficiencies were addressed. substantially higher fiscal costs but ended up with sounder The central bank must stand ready to provide liquidi- and more efficient banking systems. The approach in the ty support during restructuring to viable banks. However, CIS countries was less costly but resulted in weak banking it shoulcl refrain from providing liquidity support that systems and low levels of intermediation. The Baltic coun- keeps nonviable institutions in business, and it should not tries incurred modest fiscal costs but substantially improved provide any long-term financing to banks. Nor should it be the soundness and efficiency of their banking systems. involved in commercial banking activities, as this risks cre- ating quasi-fiscal deficits and conflicts with its monetary Limits to Bank Supervision: Political Interference policy objectives. As stated in a BIS working paper, political interference Although bank restructuring programs may be initiat- is the Achilles's heel of any regulatory system (Honohan ed and successfully carried out during a time of economic 1997). Political protection of unsound banks has repeatedly stagnation, positive economic growth helps banks to inhibited a quick response to emerging banking problems. resume lending and return to profitability. The resulting delays have deepened the ensuing crisis and Furthermore, assuming that the banking system as a complicated or derailed the macroeconomic stabilization whole has been restructured, the maintenance of fair com- process. All too often, the problem with political interfer- petition and a sound banking system after the successful ence is not that the supervisors do not know or suspect it, resolution of a crisis depends on the existence of a favorable but that the bank owners are too well placed politically for environment and the absence of the factors that led to the their actions to be curtailed by supervisors without the crisis in the first place. most conclusive evidence. To varying degrees, all ECA countries experienced Designing institutional and political arrangements that bankinig system distress or banking crises as part of the make such protection less likely is a difficult challenge. transition process. Tang, Zoli, and Klytchnikova (2000) Different possibilities have been suggested: study the experience with banking crises in 11 ECA coun- * Limited deposit protection, under the assumption tries plus Ukraine in the 1990-98 time frame.10 They find that unprotected depositors not only will be more that the crisis resolution strategies adopted by these coun- cautious about where they place their funds but also tries depended mainly on macroeconomic conditions at will see the regulators as their agents and support the beginning of transition-in particular, inflation-and early regulatory intervention on the development of the banking system in the early * Increased internationalization and privatization, stages of the transition process. Inflation mattered because under the assumption that the management of pri- in countries that had experienced hyperinflation the real vatized and foreign-owned banks will not have ready value of pretransition bad loans was drastically reduced. access to political contacts who can forestall or over- The degree of development of the banking system helped to rule regulators, as often happens in the case of gov- determine the ease with which banks could be closed. ernment-owned banks Hence, countries with similar initial conditions chose * Arrangements to ensure the indepcndence of regu- similar crisis resolution strategies, leading to three broad cat- lators, while at the same time making them account- egories of strategies: (a) extensive restructuring and recapi- able so that they have an incentive to do their job talization of banks in the countries of Central and Eastern properly Europe, which had not gone through a period of hyperin- * Strict disclosure rules, which may shorten the time flation and had relatively developed financial systems; (b) interval between the emergence of liquidity and sol- 10. Bulgaria, the Czech Republic, Hungary, FYR Macedonia, Poland, Estonia, Latvia, Lithuania, Georgia, Kazakhstan, and the Kyrgyz Republic. 216 Aspects of Banking Supervision vency problems, by improving the information on tation of economic policy. Adopting an exhaustive set of which depositors and other lenders to the banks regulations before the economic and political circumstances make their decisions. are ready is a recipe for disaster if the regulations are * Greater transparency of the supervisory process, enforced and will cause a potentially irreparable loss of which is probably the best solution in the long run. credibility for the supervisory authorities if they are not In some countries, the role and functioning of the enforced. banking sector are closely connected with the financing of It is by now well recognized that the timely imple- the government and the financing of the economy on behalf mentation of bank restructuring and supervisory policies, of the government. The government's involvement in the in addition to adequate stabilization procedures, is essential banking sector can take many forms, ranging from gov- to avoid major disruptions to growth and stability in the ernment ownership, through programs of directed lending course of financial liberalization. This has led some econ- or investment, to complex and distorting tax and subsidy omists to suggest a delay in interest rate liberalization and regimes, implicit as well as explicit. As a result of these link- external financial liberalization until banking supervision is ages, government policy objectives permeate the activities adequately put in place and banks are sufficiently sound. In and decisionmaking processes of the banks, which are no practice, however, policies to restructure banks (and enter- longer autonomous profit-seeking entities, but-to a prises) and to strengthen prudential supervision can-and greater or lesser extent-quasi-fiscal tools of government should-be phased in appropriately alongside interest rate policy. and external liberalization. Appropriate sequencing The banking systems in centrally planned economies- requires paying attention to technical linkages between which formed the core of the transition economies' initial bank restructuring and supervisory policies, their macro- financial systems-represented an extreme form of gov- economic effects, and the scope for market discipline and ernment-permeated banking. Under central planning, internal governance. Some specific principles govern the bankers did not have to assess borrowers' creditworthiness. proposed sequencing of prudential supervision and bank Their job was merely to implement and monitor a credit restructuring policies: plan decided at a higher level-independent of the bank. * Policies to strengthen prudential supervision- The evolution of banking systems in transition has including the phasing in of prudential regulations, followed a variety of paths (see Claessens 1998). Among the development of a balanced application of off-site the dimensions in which transition systems have diverged analysis, on-site inspections and external audits, and are the degree to which new privately owned banks have the enforcement of firm exit policies-should be emerged to deal with new clients, the degree to which such combined with policies to restructure banks and to new banks are adequately managed and capitalized, the establish institutional arrangements for recovering dependence on central bank refinancing, the extent to loans and restructuring enterprises. Such a compre- which restructuring and recapitalization of state-owned hensive package, encompassing both supervisory institutions have taken place and hard budget constraints systems and restructuring options, is necessary to have been imposed, the degree of privatization of these avoid adverse incentives toward excessive risk taking institutions, and the persistence of sector specialization by banks and debtors. among institutions. On the basis of statistical analysis of * Reforms of the commercial bank accounting sys- expert ratings, Claessens suggests that radical change leads tem, the establishment of early warning systems, to a healthy banking system more quickly than gradualism. and the phased introduction of prudential standards for capital adequacy, foreign exchange exposure, Conclusions loan concentration, and loan classification and pro- The financial system has a key role to play in achieving visioning can support stabilization objectives and growth, development, and stability of the economy. Banks facilitate financial restructuring of banks. Therefore, constitute the backbone of the financial system and play a these measures should be part of the critical mass of specific, semipublic policy role. Therefore, banking super- reforms introduced at the outset of financial liberal- vision is essential for the health of the financial sector and ization. the rest of the economy. However, the introduction and * A package of financial restructuring policies to development of banking supervision in transition strengthen banks' asset portfolios and profitability, economies must be seen as part of the overall reform reduce the debt-equity ratio of nonfinancial firms, process, which includes structural changes and a reorien- and eliminate interest subsidies and directed credits 217 Durand and Fontevne also should be implemented early in the process as Former Soviet Union. Budapest: Central European part of the critical mass of reforms. This elimination University Press. of interest rate subsidies would free up funds that Claessens, Stijn. 1998. "Banking Reform in Transition could be used to finance the fiscal costs of bank Countries." Journal of Policy Reform 2 (No. 2):115- restructuring, thereby containing the overall fiscal 33. burden of bank restructuring in the initial stages. Claessens, Stijn, Asli Demirguc-Kunt, and Harry Huizinga. Such a financial restructuring program should be a 1998. "How Does Foreign Entry Affect the Domestic component of, and be accompanied by, an action Banking Market?" Policy Research Working Paper plan for comprehensive restructuring of both banks 1918. World Bank, Policy Research Department, and enterprises that would be phased in over the Washington, D.C. Processed. medium term. The action plan should include steps Courtis, Neil, ed. 1999. How Countries Supervise Their to develop supporting institutional arrangements to Banks. London: Central Banking Publications. ensure that operational restructuring (including pri- Demirguc-Kunt, Asli, and Vojislav Maksimovic. 1998. vatization) will be carried out alongside financial "Law, Finance, and Firm Growth." Journal of Finance restructuring. 53(December):2107-37. In conclusion, a safe banking system has an important Dziobek, Claudia, and Ceyla Pazarbasioglu. 1997. role to play in helping transition economies face the chal- "Lessons from Systemic Bank Restructuring: A Survey lenges o01 a new era. And banking supervision is an essen- of 24 Countries." IMF Working Paper 97/161. tial component of a safe banking system. Therefore, ECA International Monetary Fund, Washington, D.C. countries need to establish effective banking supervision, Processed. fulfill the prerequisites for its proper functioning, and Dziobek, Claudia, and Jan Willem van der Vossen. 1999. ensure that its design is consistent with the stage of devel-- "Banking Sector Reform." In Malcolm Knight, Arne B. opment of the economic and financial system it oversees. Petersen, and Robert T. Price, eds., Transforming Conversely, the public as a whole and depositors in partic- Financial Systems in the Baltics, Russia, and Other ular have a right to expect the supervisory authorities to Countries of the Former Soviet Union. Washington, perform their task in a transparent and efficient manner. D.C.: International Monetary Fund. Easterly, William, Roumeen Islam, and Joseph Stiglitz. References 2000, "Shaken and Stirred: Explaining Growth The word "processed" describes informally repro- Volatility." World Bank, Washington, D.C. Processed. duced works that may not be commonly available in library Fleming, Alex, and Michael W. Taylor. 1999. "Integrated systems. Financial Supervision: Lessons of Northern European Experience." Policy Research Working Paper 2223. Abrams, Richard K., and Michael W Taylor. 2000. "Issues World Bank, Policy Research Department, in the Unification of Financial Sector Supervision." Washington, D.C. Processed. IMF Working Paper 00/213. International Monetary . 2000. "Integrated Financial Sector Regulation and Fund, Washington, D.C. Processed. Supervision in the Context of EU Accession." In Beck, Thorsten, Ross Levine, and Norman Loayza. 2000. European Union Accession: Opportunities and Risks "Finance and the Sources of Growth." Journal of in Central European Finances. Washington, D.C.: Financial Economics 58:261-300. World Bank. Bonin, John, and Paul Wachtel. 1999. "Toward Market- Goodhart, Charles A. E., Philip Hartmann, David T. Oriented Banking in the Economies in Transition." In Llewellyn, Liliana Rojas-Suarez, and Steven Weisbrod. Mario I. Blejer and Marko Skreb, eds., Financial Sector 1998. Financial Regulation. London and New York: Transformation: Lessons from Economies in Routledge. Transition, pp. 93-131. Cambridge, Mass.: Cambridge Gorton, Gary, and Andrew Winton. 1998. "Banking in University Press. Transition Economies: Does Efficiency Require Boot, Arnoud W. A., and Sweder van Wijnbergen. 1995. 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"Prudential Supervision, Bank International Monetary Fund. 1999. "Code of Good Restructuring, and Financial Sector Reform." In Barry Practices on Transparency in Monetary and Financial R. Johnston and V. Sundararajan, eds., Sequencing Policies: Declaration of Principles." Available at Financial Sector Reforms. Washington, D.C.: http://www.imf.org/external/np/mae/mftlcode/index.htm. International Monetary Fund. Knight, Malcolm, Susana Almuifia, John Dalton, Inci Otker, Tang, Helena, Edda Zoli, and Irina Klytchnikova. 2000. Ceyla Pazarbasioglu, Arne Petersen, Peter Quirk, "Banking Crises in Transition Economies: Fiscal Costs Nicholas Roberts, Gabriel Sensenbrenner, and Jan and Related Issues." Policy Research Working Paper Willem van der Vossen. 1997. Central Bank Reforms in 2484. World Bank, Policy Research Department, the Baltics, Russia, and the Other Countries of the Washington, D.C. Processed. Former Soviet Union. IMF Occasional Paper 157. Washington, D.C.: International Monetary Fund. Levine, Ross. 1997. "Financial Development and Economic Growth: Views and Agenda." Journal of Economic Literature 35(June):688-726. 219 Chapter 19 Finance in the New Millennium Stijn Claessens, Tom Glaessner, and Daniela Klingebiel E conomic integration within and across countries, deregulation, advances in telecommunications, and growth of the Internet and wireless communication technologies are dramatically changing the struc- ture and nature of financial services. Drawing on Claessens, Klingebiel, and Glaessner (2000), this chapter illustrates that, because financial services are highly dependent on technology and well suited to remote delivery, technological advances and the advent of the Internet are causing dramatic changes in the industry. Internet and related technologies are more than just a new channel of distribution-they are a dif- ferent way of providing financial services. This revolution could accelerate financial sector development by lowering costs, increasing breadth and quality, and widening access to financial services. This chapter analyzes the changes in the industry. It Increased financial integration. Reductions in trade barri- focuses mainly on developed countries but also draws out ers and transportation costs and advances in communica- the implications for transition economies, in particular tion technology have accelerated international economic those related to e-finance. It highlights three implications of integration. Between 1987 and 1997 world trade in goods these changes for public policy: a need and an opportuni- increased from 21 to 30 percent of global gross domestic ty to reduce the financial sector safety net over the longer- product (World Bank 1999). The complementarity of trade term; enhanced measures to limit the extension of the safe- in financial services with trade in goods and a greater abil- ty net in the short run; and more emphasis on competition ity to trade services across borders havc increased the policy, consumer protection and education with respect to demand for financial services. financial services. Cross-border capital flows have been the most impor- tant mechanism for delivering financial services. Recent Trends in Financial Services Commercial bank claims on foreigners-the largest conduit The globalization of financial markets, as well as tech- of international capital flows-increased from $7.7 trillion nological and structural changes, is driving many of the in 1980 to $11.0 trillion in 1999. Private capital flows to recent trends in financial services. These changes include the emerging markets rose from $50 billion in 1980 to more lowering of regulatory barriers. than $200 billion in 1999 (World Bank 2000). But capital flows are just one way that financial insti- Globalization tutions in one country can provide a loan or facilitate a The globalization of financial services has increased finan- security issue to an entity in another country. A financial cial integration, increased mergers and acquisitions within institution also can obtain a physical presence in another and across borders, and lowered barriers between markets. country by acquiring a financial institution or by opening 221 Claessens, Glaessner, and Klingebiel a branch or subsidiary. As the costs of establishing a phys- cial services. These technologies are more than just a new ical presence have declined, cross-border entry has channel of distribution-they are a completely different increased. way of providing financial services. Using credit scoring and other data mining techniques, Increased mergers and acquisitions within and across bor- for example, providers can create and tailor products over ders. Governments have removed entry barriers through the Internet without much human input and at very low legal and regulatory measures such as the Riegle-Neal Act cost. They can better stratify their customer base through in the United States and the Single Market Programme in analysis of Internet-collected data and allow consumers to the European Union (EU). Aided by technological devel- build preference profiles on-line. This not only permits opments, these changes have lowered barriers to entry and personalization of information and services, it also allows encouraged bank consolidation and mergers and acquisi- much more personalized pricing of financial services and tions among financial institutions, both within and across much more effective identification of credit risks. At the borders same time, the Internet allows new financial service Globally, mergers and acquisitions in financial ser- providers to compete more effectively for customers vices jumped from $85 billion in 1991 to $534 billion in because it does not distinguish between traditional "bricks 1998 (BIS 2000). In the United States, mergers and acqui- and mortar" providers of financial services and those with- sitions rose from $25 billion (1998 dollars) in the mid- out a physical presence. All these forces are delivering large 1980s to $250 billion in 1998. Since 1980 the number of benefits to consumers at the retail and commercial levels. U.S. banks has dropped 40 percent. In the European Union the nunmber of banks has fallen 25 percent since 1985. Changes in industry structure. These technological Similarly, Argentina, Brazil, Chile, the Republic of Korea, advances are changing the face of the financial services and Mexico have seen a significant decline in the number industry (see box 19.1 and figure 19.1). New types of ser- of domestic banks in recent years. vice providers are entering the market within and across countries, including on-line banks and brokerages and so- Lower barriers between markets. The dismantling of regu- called aggregators (which allow consumers to compare latory barriers separating banking, insurance, and securities financial services such as mortgage loans and insurance activities also is driving consolidation. Boundaries between policies). Nonfinancial entities also are entering the market, different financial intermediaries are becoming blurred, and including telecommunication and utility companies that universal (or integrated) banking is becoming the norm. The offer payment and other services through their distribution merger of Citigroup (banking) and Travelers Group (insur- networks and customer relationships. To reap the benefits ance) is the most dramatic example of this trend. of the new technology, and in response to this new entry, An important market incentive for this reduction in banks, insurance companies, and the like are joining in the barriers has been the disintermediation of bank assets and electronic delivery of financial services by setting up in- liabilities by capital market transactions. Commercial paper house on-line activities or completely new ventures such as and corporate bonds have substituted for bank loans, and virtual banks. mutual funds and securities have substituted for bank Thus, the delivery of financial services is moving away deposits. These forces pressure banks to expand their finan- from a brick-and-mortar delivery channel to a multitude of cial services to cater to all customer needs and preferences. electronic and other channels, with portals and aggregators Advances in information and communication technology offering new channels of distribution and advertisement for further facilitate the delivery of a broad array of financial financial services. Vertically integrated financial service services rhrough one provider. companies are growing rapidly and creating synergies by combining brand names, distribution networks, and finan- The New World of Financial Seruices cial service production. For example, companies associat- Technology is revamping the ways in which financial ed with portals (America Online, Yahoo!, Microsoft) and services are produced and delivered. In addition, technol- major telecommunication companies (Deutsche Telecom, ogy is fundamentally changing the industrial structure of Telefonica) are developing strategic relationships or own- the financial services industry worldwide. ership links with major financial service companies, with banks (such as the Bank of East Asia with Yahoo!), or Technological advances. Internet and wireless communi- with each other (Telefonica and Lycos). At the same time, cation technologies are having a profound effect on finan- many major financial institutions (Morgan Lab, Goldman 222 Finance in the New Millennium BOX 19.1 THE NEW WORLD OF FINANCIAL SERVICE PROVIDERS Financial services are now offered through a multitude of deliv- block reverse auctions of mortgage loans or insurance products ery channels, from traditional brick-and-mortar branches to wire- (as with DollarDEX in Singapore). Finally, other specialized less devices. Six steps can be distinguished in the production and companies are undertaking functions on behalf of larger banks distribution of financial services, although in practice these steps or insurance companies and are developing on-line techniques often overlap or are vertically integrated (see figure 19.1). to mine data and offer personalized financial products to con- Access devices (rather than a teller or branch) are becoming sumers. many customers' first point of contact with financial services. Financial institutions serve as conglomerate providers of These devices include personal computers, personal digital financial services that are global brands (Citigroup, Deutsche assistants (such as Palm Pilots), televisions equipped with Bank, Warburg) and as specialized financial service companies. Internet access, cellular phones, and other wireless communi- Partly in response to the entry of new competitors and to reap cation devices. In the future, these channels will be comple- the benefits of new technology, incumbents (banks, large insur- mented by low-cost "branches," kiosks (stand-alone comput- ance companies) are consolidating around recognized brand ers connected to bank systems), and other public access names to position themselves in an environment of increased devices located in supermarkets, convenience stores, and com- commoditization and electronic delivery. Merrill Lynch and mon areas (airports, train stations). HSBC, for example, recently announced a joint venture in private Portals are becoming the critical link between access devices banking that combines HSBC's network with Merrill Lynch's and financial service companies. Portals offer access to a range range of products. Large telecommunication companies that of financial service providers, often for free or a fixed price; already have access to a large distribution network of cus- they generate revenue from fees paid by providers referred tomers are starting to provide payment and other services. In through the portal. These include specialized portals developed addition, telecommunication companies are forming alliances by financial service companies as well as general portals such as to extend their global network to financial services delivered on- the U.S.-based America Online, Lycos, Yahoo!, and Microsoft, line. Examples include Deutsche Telecom, Telefonica, AT&T, along with others in emerging markets (Paxnet and Thinkpool in and Telemex. And increasingly specialized financial service the Republic of Korea, Terra in Latin America). Portal companies providers-so-called mono-liners in all mainline financial ser- attempt to process and personalize information to capture con- vice areas, from mortgage lending or personal loans, to insur- sumers. Portals are proliferating rapidly, even in emerging mar- ance, to brokerage, and to payment services-are establishing kets. The Republic of Korea, for example, is home to 300 portals, on-line operations. many of which function as a gateway for financial service Financialproductsare being commoditized ortailored to the providers. In addition, customers can access financial service needs of customers. Such products are distributed through spe- providers through many private networks, and some financial cialized financial service providers or financial conglomerates. service providers have established their own specialized portals. Enabling companies support existing financial service Aggregators complement portals, allowing consumers to providers as well as specialized providers and virtual banks. compare mortgage, insurance, or lending products offered by Specialized software engineering companies such as S1, suppliers of financial services. In addition, quasi-aggregators Checkfree, Sanchez, and System Access provide e-finance sys- are emerging that aggregate or display prices of financial prod- tems that are completely integrated and permit the rapid adap- ucts offered by different suppliers or even conduct single or tation needed in today's world. Sachs, Chase, Merrill Lynch, Morgan Stanley) are part These developments are not confined to developed owners of promising Internet start-ups. And goods-pro- countries. Electronic finance is now spreading quickly ducing companies are taking advantage of bank distribu- around the globe, including to emerging markets. Through tion networks (Citidollars with a variety of consumer-relat- various delivery channels (computers, cell phones, and ed companies). These developments are changing the kiosks), penetration of e-finance has grown quickly every- competitive landscape for financial services and will con- where. Although there is some variation by markets and tinue to erode the franchise value of existing financial ser- regions-in terms of the preferred media for delivering vice providers that are inefficient or do not adopt compet- financial services, the types of financial services provided, itive business models. and the rate of penetration-there is significant common- 223 Claessens, Glaessner, and Klingebiel FIGURE 19.1 THE NEW WORLD OF FINANCIAL SERVICES Electronic enablers Financial products Financial "institutions"l Aggregators Portals distribution Access _____________l_l_l devices ality across the globe. Several emerging markets have Combined with globalization, these forces are putting leapfrogged to the new technologies, including Brazil, the pressure on incumbent stock exchanges, which have Republic of Korea, and some transition economies like responded with mergers and alliances (table 19.1). Because Estonia (see box 19.2). One might well see a rapid conver- many exchanges are self-regulating organizations, the pres- gence in e-finance across many countries. sures for change rarely come from within the industry. Rather they come from users or investors who want to pay Cbanges in trading systems. Driven by advances in com- smaller commissions, effect trades more quickly, or main- munications technology, trading systems are consolidating tain anonymity on placed orders (box 19.1). and going global. Trading is moving toward electronic platforms not tied to any location. (Nasdaq's computers Effects of the Changes are based in Turnbull, Connecticut, for example, but Figure 19.2 summarizes recent developments in finan- traders are located around the globe.) New electronic sys- cial products and services along two dimensions: ease of tems have lowered the transaction costs of trading and commoditization and existence of entry barriers. Entry improved the determination of prices because electronic has been particularly strong in financial services that execution and matching techniques offer fewer opportu- could be easily unbundled and commoditized and that nities for market manipulation. These advantages are espe- offer attractive initial margins. These include many non- cially important in markets that have not yet converted to banking financial services, including brokerage, trading electronic trading (such as the United States) than in those systems, some retail banking services, and new services where electronic trading is the norm (such as Europe). such as bill presentment or even payment gateways for The new technology also allows for much easier cross-bor- business-to-business (B2B) commerce. Because these ser- der trading and, over time, for the development of inter- vices are subject to less regulation, new entrants can eas- market trading systems. ily innovate with new technology and can show limited or 224 Finance in the New Millennium BOX 19.2 THE MASSIVE SHIFTS IN STOCK MARKETS AND EXCHANGES A revolution is under way in the way financial (and nonfinancial) traditional stock markets such as the New York Stock Exchange contracts are traded. These changes involve traditional will cease to exist in their current form. exchanges as well as business-to-business (B2B) transactions. Reflecting these competitive pressures, and the more gen- A number of electronic order routing and trading networks eral desire for increased liquidity through larger markets, many have emerged in recent years. These networks have evolved into stock exchanges in developed countries have established links, order-driven matching systems that are provided electronical- merged, or even demutualized (that is, become for-profit orga- ly to participants seeking anonymity. Electronic communication nizations rather than cooperative, not-for-profit organizations). networks started out as pools of liquidity feeding into existing Recent examples include the merger of the Amsterdam, markets, but they now serve as alternative trading outlets in sev- Brussels, and Paris exchanges, joint ventures and alliances eral developed and some emerging capital markets. In some between Nasdaq and stock exchanges in Australia, Canada, markets these networks account for a large share of total trad- Hong Kong (China), and Japan, and a joint venture between ing (one-quarter of the dollar volume of Nasdaq in the United Nasdaq and the proposed pan-European market that is focused States). on growth stocks. The Singapore and Australian stock Other alternative trading systems are being set up around the exchanges recently agreed to cross-list all traded shares. The world, often with links to existing systems. For example, Instinet New York Stock Exchange has formed alliances with the Tokyo began as a local interdealer broker and dealer but now has auto- Stock Exchange, Hong Kong Stock Exchange, Australian Stock matic routings to a number of stock exchanges. There is spec- Exchange, Toronto Stock Exchange, Mexican Bolsa, Sao Paulo ulation that a few trading systems soon will allow investors to Bovespa, and Euronext to trade through linked exchanges 24 trade 24 hours a day. Exchanges are recognizing that their ser- hours a day. The consolidation of these markets-accounting vices-trading systems-are increasingly becoming a com- for more than 60 percent of global market turnover-is leading moditized product offered through other means. Eventually, to a smaller number of very large markets. no earnings without raising supervisory concern. As these costs have fallen for consumers, and new entities (including new entrants gain market share and consolidate their telecommunication and utility companies) are providing position, some start to diversify into more highly regu- financial services. lated banking services. An example is E-trade's acquisition of a bank to provide the full range of financial services to Lower costs of providing financial services. The technolo- its retail clients. gy on which the financial service industry depends has Services involving sunk costs and low commoditiza- become much cheaper, and in the past 20 years computer tion, such as corporate advisory services or mergers and power has risen by a factor of 10,000 (World Bank 1999). acquisitions within investment banking, have seen much Similar changes are occurring in telecommunications-in less new entry. Instead the trend has been toward global the past 20 years the cost of voice transmission circuits has consolidation to reap the advantages of reputation, brand fallen by a factor of more than 10,000. Communication name, and economies of scale. Although deposit taking and costs have fallen sharply in most countries, and the rapid- many traditional payment services exhibit large potential ly growing importance of broadband and wireless internet- for commoditization-through on-line banks, payment based communication systems-such as Bluetooth or wire- services using "smart" cards, and other technologies- less application protocol-indicate that costs will continue entry has been limited, in part because of regulatory barri- to fall, and Internet access will continue to widen. The ers. From a production point of view, however, these ser- Internet eliminates many processing steps and labor costs, vices could easily migrate to the high commoditization, while avoiding or reducing the fixed costs of branches and low-entry-barrier sector. related maiiitenaince. A typical customer transactioln Widely available real-time market information lowers through a branch or phone call costs about $1, but that the cost of financial services by easing uncertainty, miti- same transaction costs just $0.02 on-line (see figure 19.3). gating asymmetric information, and reducing transaction Overhead expenses for Internet banks are 1 percent of costs associated with paper processing or human error. In assets or less, compared with 2 to 3 percent for brick-and- addition, new distribution channels have opened up, search mortar banks. 225 Claessens, Glaessner, and Klingebiel TABLE 19.1 FEATURES OF INTERNATIONAL STOCK MARKETS AND EXCHANGES Average daily Market trading volume capitalization (bil ions of (billions of Links with other exchanges or Market or exchange U.S. dollars) U.S. dollars) electronic communication networks New York Stock Exchange 35.0 12,000 Talks with Toronto Stock Exchange, Euronext, and Mexico's Bolsa; cooperative links with Tokyo Stock Exchange Nasdaq Stock Market 41.5 5,020 All electronic communication networks trade Nasdaq stocks; deals with Osaka Stock Exchange, Deutsche Boerse, London Stock Exchange, Quebec, Hong Kong Stock Exchange, and Australian Stock Exchange Tokyo Stock Exchange 6.8 4,100 Cooperative links with exchanges in the Republic of Korea, the Philippines, Singapore, and Thailand, as well as with the New York Stock Exchange London Stock Exchange 13.5 2,800 Nasdaq joint venture Toronto Stock Exchange 2.85 1,700 New York Stock Exchange, Euronext, Hong Kong Stock Exchange, Mexican Bolsa, Sao Paulo Bovespa Deutsche Boerse 4.53 1,500 Nasdaq joint venture, MarketXT joint venture Paris Bourse 4.18 1,500 Euronext alliance Hong Kong Stock Exchange 1.5 568 Co-listing agreement with Nasdaq, New York Stock Exchange Australian Stock Exchange 0.8 370 Nasdaq, Singapore Stock Exchange Sao Paulo Bovespa 0.4 208 London Stock Exchange, Lisboa Stock Exchange, Argentina's Caja de Valores Total 148.8 35,005.4 Source: Wall Street journal; Federation Internationale de Bourses de Valeures. 226 Finance in the New Millennium FIGURE 19.2 POTENTIAL COMPETITION AND COMMODITIZATION IN FINANCIAL SERVICES High Deposit and *- Bill presentment Stock markets payment services Brokerage services Lending to large firms Lending to small firms Ease of / Deposit substitutes commoditization Lending to medium - Retail banking services size firms Investment | advice and corporate services Low High Low Barriers to entry FIGURE 19.3 THE INTERNET SLASHES THE COST OF TRANSACTIONS 1.20 - e 1.00 - 0.80 - v 0.60 0. u 0.40 3- 0.20 0 0.00 I Branch Telephone ATM PC banking Internet Source: Goldman Sachs and Boston Consulting Group. The Internet and other technological advances have tage. For most credit, however, economies of scale have shrunk economies of scale in the production of financial become small, because the fixed costs associated with services (table 19.2). The main financial service still exhibit- screening small borrowers (less than $100,000) have ing increasing returns to scale is the medium-size loan mar- dropped significantly. ket, because large databases of credit history are required Financial service providers using the Worldwide Web to build a credit-scoring model for medium-size clients, can avoid many technological conflicts, such as separate This gives larger lenders a potential competitive advan- interface-to-core systems for transactions through auto- 227 Claessens, Glaessner, and Klingebiel TABLE 19.2 CHARACTERISTICS OF FINANCIAL SERVICE PROVISION IN AN INTERNET WORLD Up-front costs; Economies branding, Network of scale Commoditization advertising externalities Retail services Paymeni- *- Lending and mortgage 0 .. Discount brokerage services Investment advice . 0. Mutual funds .. .. Insurance ..0 Wholesale services Commercial lending Large .. 0. Mediurn-size Corporate services (underwriting, mergers and acquisttion advice, risk management) *000 Large-value payments systems ... . .. 0 .. . Markets Trading systems and exchanges . . ... . .... B2B exch anges *o** so.. New ser'ices E-paymenit providers s.. so .... Enablers .. es .. ... Financial portals .s . .. .... Aggregators sso * None. ** Low. oo* Medium. *... High. Source: Authors' assessments. mated teller machines (ATMs), branches, call centers, or The lowering of scale economies has heightened com- kiosks. Web-based financial services unify the Internet as a petition, particularly among financial services that can eas- communication standard by combining a web browser, a ily be unbundled and commoditized through automation display standard, and a web server as the access point into (figure 19.2). These include payment and brokerage ser- back-end operational systems. As a result, cross-selling of vices, mortgage loans, insurance, and even trade finance. products becomes easier and economies of scope increase. Most of these services require limited initial capital outlays 228 Finance in the New Millennium and no unique technology. Lower transaction costs can vices depends largely on the degree to which users adopt a substantially increase competition for providers and cost common standard. The financial service provider that savings for consumers. To retain market share, on-line manages to create this common standard will capture a brokerage firms have been forced to radically restructure large share of the market, decreasing competition. Similar the way they deliver brokerage services. Brokerage com- characteristics apply to trading systems and exchanges missions and fees fell from an average of $52.89 a trade in (traditional or B2B), financial portals, and, to a lesser early 1996 to $15.67 in mid-1998-and by end-2000 some extent, e-enablers (table 19.2). on-line brokerage services had reduced their commissions to zero. Commissions on electronic communication net- Benefits for consumers and corporations. Providers and works, now at $0.05 a share, are continuing to fall. Barriers consumers will share the benefits of cheaper financial ser- to entry based on ownership of physical facilities are dis- vices. With the advent of new types of intermediaries, such appearing, and incumbent institutions are being forced to as aggregators, consumers can increasingly compare prices merge or, in some cases, to demutualize to even have a for financial services. Aggregators can bring together many chance of remaining viable. suppliers of financial services and coordinate information In the past, sunk costs were important entry barriers in flows in a rational way. Lending Tree in the United States, the financial services industry. Examples of sunk costs for example, allows customers to compare a wider base of include branch networks, knowledge about local borrow- potential lenders than is possible or cost-effective using ers, access to payment systems, branding advantages traditional loan agents or channels of direct communica- involving large up-front advertising expenses, perceptions tion. Since Lending Tree prequalifies loan applicants, of size and safety, long-lasting customer relationships, and lenders can find creditworthy customers inexpensively. The substantial up-front investments in technology. But sunk Internet also helps consumers to combine financial ser- costs are becoming less important in financial services, vices from different providers. This is done through com- partly because electronic delivery does not rely on a branch parison-shopping companies and through portals. network (see table 19.2). Commercial borrowers that undertake B2B transac- At the same time, new entry barriers are being created tions and Treasury operations also will benefit from lower through first-mover advantages. Once a new entrant is transaction and search costs and from increasing access to established as a service provider, other new entrants will financial services. In the case of small and medium-size have to spend a lot on advertising to attract new customers enterprises, new on-line companies such as garage.com (as E-trade and Ameritrade have done in the United States). and techpacific.com provide a full array of services to start- In product areas such as underwriting and mergers and up companies, including legal services, web design, acquisitions advice, financial services exhibit low levels of accounting services to assist in preparing accounts and commoditization and still require relationship capital, a cer- meeting disclosure standards, branding and advertisement, tain size, and a brand name to compete effectively. These investor relations, and so on. Investors (venture capital services enjoy few or no network externalities and are arms of nonfinancial and financial companies) use these increasingly subject to global competition. The scope for a companies to screen potential start-up ideas. In addition, contestable market will depend on the size of the market. the use of the Internet for data mining in lending holds A limited number of financial institutions involved in promise for improving the outreach of financial services to underwriting, but operating on a global basis, present a very small companies. very different competitive environment than would a few players in a small market (say, less than $1 billion). Implications for Public Policy Although declining economies of scale, increasing These changes, particularly the emergence of e-finance, standardization and commoditization, and declining up- offer great benefits to consumers worldwide. The changes front costs foster competition, this need not be the case for can accelerate financial sector development by lowering services that exhibit network externalities. A financial ser- costs, increasing breadth and quality, and widening access vice exhibits network externalities if the value of the ser- to financial services. But the changes also require a reassess- vice rises with the number of market participants using it. ment of the approach to financial sector development, par- Payment services, for example, have decreasing economies ticularly in emerging markets. of scale, low up-front costs, and ease of commoditiza- All governments, even the most market-oriented, reg- tion. But payment services are subject to large network ulate and supervise the financial sector for reasons of safe- externalities, because the value of electronic payment ser- ty and soundness, competitiveness and antitrust concerns, 229 Claessenis, Glaessner, and Klingebiel and consumer protection. The recent changes in financial which profits will decline and shift between financial prod- services raise questions about whether the current approach ucts and institutions. to financial sector regulation is adequate, whether tradi- tional reasons for regulation and supervision remain valid, Competition Policy and what areas (competition policy and consumer protec- From the point of view of competition policy, markets tion) deserve more emphasis. The key public policy find- for financial services can be treated like other markets. ings, summarized in table 19.3, relate to three areas: safe- Technology is reducing asymmetric information-often a ty and soundness, competition policy, and consumer and reason for treating financial services differently from other investor protection. In addition, new global public policy products. Risks are being addressed through continuous issues have emerged. mark-to-market and collateral arrangements. And products are becoming more homogeneous. Safety and Soundness At the same time, the ability to reap the benefits of Developments in technology and deregulation are technological innovations increasingly depends on the eroding the nature of what has made banks special. On the degree to which entry is allowed and uncompetitive struc- lending side, e-finance allows nondeposit-taking financial tures are avoided. Competition policy for financial ser- institutions and capital markets to reach far more bor- vices thus is both more feasible and more important. rowers, including small and medium-size enterprises. On Freer trade in financial services will be critical for con- the deposit and payment side, many deposit substitutes sumers to obtain the benefits of technological gains. (such as stored value cards issued by merchandisers) are Defining markets, a critical element of competition tests, is emerging, and many nonbanks (such as mutual funds) are becoming more difficult. Many nonfinancial products are offering payment accounts. These and other changes make taking on the properties of financial contracts, and many banks less special and challenge authorities to reevaluate markets are going global. Competition policy for financial the need for a financial sector safety net-broadly defined services will need to be harmonized worldwide, and differ- to include public deposit insurance, a lender of last resort ent regulators should coordinate sanctions for violations. facility, and prudential regulation. For most financial services and markets, economies of Incentives for private parties to challenge the special scale and scope are unlikely to be sufficient barriers to nature of banks depend on the degree to which govern- entry, because technology is reducing the extent of increas- ments pr9vide banks with preferential treatment. If the ing returns to scale. Some sunk costs can be entry barriers, safety net is not shrunk, banks could continue to remain although this should not be overstated. More important, special, hut not necessarily for the right reasons. These network externalities can create entry barriers. Entry poli- developments raise a number of issues for public policy. cies for self-regulating organizations involved in network- Over the long run, there may be less need for a finan- oriented services, such as trading systems, will become more cial sector safety net, including prudential regulation and important. Tradeoffs will arise among preventing first- supervision of banks. Authorities should be wary of extend- mover advantages, protecting intellectual property rights, ing guarantees to new deposit substitutes, as the moral and meeting the desires of consumers for such services. hazard implications could be substantial. Over the short Links between banking and commerce and increased run, authorities could require nonfinancial corporations to vertical integration could hamper competition. New strate- provide payment services through bank subsidiaries. Over gic alliances-say, between telecommunication companies the long run, authorities may want to consider separating and financial service providers-could allow for joint con- payment from other credit services and allow freer entry in trol of carriage and content in certain financial services, pos- payment services. sibly denying consumers access to a full array of services. Changes make it necessary to adjust traditional super- Competition policy will increasingly require authorities visory processes (assessment of risk controls, definition of simultaneously to define technology and information poli- fit and proper tests) and address emerging issues (require- cies. In some cases, authorities may even need to subsidize ments for opening a virtual bank, requirements for related the development of technology if the externalities are not financial service providers). And most important, e-finance adequately internalized (as when a basic technology needs will lower the franchise value of incumbent institutions. to be shown to be technologically feasible). Mergers and Thus failure resolution processes will become more impor- joint ventures by information companies and their relation tant, and bank assistance systems will have to be reviewed. to financial service companies are one of many areas that Stability issues require careful analysis of the degree to will require a lot more scrutiny. 230 TABLE 19.3 PUBLIC POLICY ISSUES FOR THE FINANCIAL SECTOR Current issues Future issues Transition issues Safety net Safety net Safety net -Banks are considered special because they * Banks are no longer special because many * Authorities should be wary of extending the extend essential credit to firms, provide substitutes have emerged for deposit safety net to nondeposit-taking activities and payment services, and are inherently fragile and lending products. There may be deposit substitutes. They should require financial and susceptible to runs. less of a need for a public safety net service providers with nondeposit-taking activities *Governments have provided safety nets- and correspondingly less need for to adopt a bank holding company structure or a regulation and supervision, deposit prudential regulation and supervision. narrow banking structure. insurance, lender of last resort facilities- * Government should increasingly allow * With increased competition and the decline in to minimize the adverse effects of bank the private sector to find mechanisms franchise value, decapitalized institutions will failures. to curb excessive risk taking. have incentives to gamble for resurrection. * Safety and soundness regulation and * More efficient interbank markets reduce Governments need to strengthen failure deposit insurance pose barriers to the entry the need for lender of last resort facilities. resolution mechanisms and reduce extensive of new firms and favor incumbent firms. * Banks' special role in the payment guarantees that often apply to all financial system The safety net also raises moral hazard issues. system is declining as technology allows liabilities. for the unbundling of payment and credit services. Authorities may want to separate payment from other credit services and allow freer entry to the payment system. Competition policy Competition policy *Because banks are considered special, As the safety net is eliminated, markets for competition policy is subsumed under financial services can be treated like any other prudential policy. Competition policy product from a competition policy point of aims to ensure an adequate franchise view. This means that: value for banks to enhance their *Freer trade in financial services will become soundness and incentives for prudent even more important. behavior. ( (Table continues on the following page.) TABLE 19.3 (CONTINUED) Current issues Future issues Transition issues *Tools of competition policy include * Scale and scope economies are unlikely to minimum capital requirements, capital be effective barriers to entry. adequacy, and fit and proper test. * Sunk costs, externalities, and vertical integra- tion may be barriers to entry and could hamper competition. *Market and product definitions, which are critical for competition tests, will be difficult to define. With globalization, competition policy will have to be coordinated worldwide. Consumer protection Consumer protection * Issues relate to security risk, privacy, * A challenge will be to modify legislation and transparency of information, and regulations credibly to permit proper enforcement investor protection. including the area of minimum disclosure. * Key public policy areas include defining consumer protection standards, defining minimum standards for self-regulating organizations, and ensuring incentives for enforcement of such standards. Finance in the New Millennium Consumer and Investor Protection reach, the location of providers becomes more difficult to E-finance has made consumer and investor protection pinpoint, solicitation becomes harder to define, and the def- a more important function of public policy. Issues include inition of a financial service becomes more complex. security, privacy, and transparency. Consumer and investor Regulators will have to decide on the best way to phase out protection raises issues such as the role of standards, who such limits. A comprehensive approach would be the glob- can best develop such standards, and who should enforce al equivalent of the EU approach of a single license (pass- them. port), allowing full cross-border provision with home-rule Security risks are being dealt with but will continue to regulation. require oversight. With technological developments-cryp- Today competition and market forces resolve many tographic techniques, cards with built-in chips, and other investor protection issues because consumers and investors verification techniques-complete security is already or choose the environments that provide them with the great- nearly possible. Still, regulators may need to encourage or est certainty. But as e-finance expands, less-informed con- require operators to adopt best-practice standards. Further sumers will gain access to markets, raising issues for cross- protocols and legal changes, including those for digital sig- border investor protection and transparency. Even with a natures, will be needed to facilitate electronic transactions. global passport approach and harmonized standards, reg- Privacy issues are becoming more important. The ulators may need to protect consumers who are accessing Internet has greatly simplified the collection and sharing of offshore financial services. credit and other data on individuals and businesses, and Increased globalization requires increased coordina- technology has lowered the costs of processing and using tion. Greater use of technology with global externalities such information. Global standards and protocols will be involves operational risks (such as computer breakdowns). needed to assure desired levels of privacy, to enable cross- Access of new trading systems to contingent financing is border provision of financial services, and to allow global also unclear, especially on a global basis. In general, the service providers to operate efficiently. links between operators and resulting systemic risks have The proliferation of financial products, delivery chan- become harder to understand. Risk safeguards will have to nels, and institutions, along with the speed of innovation, be extended within and across countries, with greater infor- has improved the ability of consumers to compare prices mation sharing among regulators and self-regulating orga- and products. But the links between infomediaries and nizations. financial service providers can lead to less transparency on The easy spread of information-and misinforma- the service being offered. An important transparency issue tion-could make asset prices and capital flows more in capital markets will be assuring fairness and best execu- volatile. Herding, turbulence, and contagion may tion and trading practices. Solutions likely will vary by increase, and countries may become more vulnerable to country and market. attacks on their currency. Capital account restrictions With increased cross-border transactions, it will be will be more difficult under e-finance, and the growing difficult to identify the legislative or regulatory authority for number of creditors complicates coordination prior to investor protection. Furthermore, the emergence of non- or during a financial crisis, particularly in emerging mar- traditional service providers complicates investor protection kets. Although these problems are not new, policy solu- mechanisms based on current institutional frameworks. tions have been elusive. Government agencies need not directly intervene to combat these problems, however. Instead, more intense efforts Impact on Transition Economies should be made to educate consumers. Authorities should In transition countries, where access to and the quali- set minimum standards of disclosure for new financial ty of financial services are limited, e-finance and global- intermediaries and possibly for self-regulating organiza- ization offer many important opportunities. E-finance has tions-including entities that certify information providers, great potential to improve the quality and scope of finan- such as credit bureaus, credit rating agencies, accounting cial services and to expand the opportunities for trading boards, and auditors. risks; it also can widen access to financial services for a much greater set of retail and commercial clients by offer- Global Public Policy ing more cost-effective delivery of services. Some transition Although e-finance offers many gains, it may increase economies are starting to participate in the e-finance revo- risks. Limits on cross-border financial services will become lution, and this already is having a significant, positive costlier and more distorting as the Internet expands its impact in some markets. 233 Claessens, Glaessner, and Klingebiel To allow this to happen most productively, e-finance case for many transition economies, where e-finance offers will require a reassessment of the approach to financial sec- the opportunity to leapfrog. Many transition economies are tor development. E-finance facilitates access to global cap- characterized by relatively unsophisticated financial systems ital and financial service providers. As financial services are with limited services. To the extent that financial services imported, the need for a domestic safety net and for corre- are being provided, they often reach only selected segments sponding- regulation and supervision declines. The question of the economy, such as higher-income segments in urban arises whether small, undiversified economies should have areas, state-owned enterprises, and large agro-businesses, domestic equity and debt markets and, in the extreme, rather than the general population, small and medium- banking systems. Instead, policy issues related to the infra- size firms, and farmers. Many financial systems in transi- structure and enabling environment for financial services tion economies also have poor allocation of resources and provision are critical to realizing the benefits of technolo- relatively high intermediation costs. Furthermore, many gy and globalization. These include the regulatory frame- have had problems with establishing a credible and inde- work for providing telecommunication services, the regu- pendent supervisory system and have had to incur large fis- latory framework for security and related public and cal costs from the occasional (or repeated) financial recap- private key infrastructure, the standards and enforcement italization of banks. Given the low efficiency and poor in place for information and privacy, and the framework quality of financial services in many transition economies, for contract enforcement and credit risk assessment. migration toward e-finance will be high, leading to more E-finance will impose limits on these choices, particu- rapid decapitalization of incumbent financial institutions. larly for economies with poorly capitalized banking sys- For many transition economies with relatively shallow tems, weak regulations, and extensive guarantees on lia- financial sectors, e-finance can be a revolution. There is evi- bilities. E-finance will accelerate the move of business and dence that this already is happening. Indeed, some transi- profits from incumbents, putting their franchise values, tion economies, like Estonia, are at the forefront of e- and incentives to act prudently, at risk. To reduce the risk finance developments, with e-finance penetration on par of financial crises, regulatory approaches in transition with or above that in many developed countries (see box countries should recognize their weak governance and 19.3). Other country experiences show that it is possible to institutions, scarce human resources, and concentrated leapfrog the technology. In several emerging markets, such ownership structures. These impairments make textbook as the Czech Republic and the Republic of Korea, on-line solutions difficult and argue for simpler approaches. E- brokerage is already above that in developed countries. In finance will make this all the more urgent. several transition economies, electronic cash cards are being With these changes in policy emphasis in mind, e- introduced that offer savings and payment services to cus- finance of fers many opportunities. This is especially so for tomers who often do not even have a formal bank account. countries with an underdeveloped financial system, as is the The cards will store customer information and thus become BOX 19.3 EXAMPLES OF E-FINANCE IN TRANSITION ECONOMIES: ESTONIA AND RUSSIA Eston,'a's progress in information technology has been management. Today, about 17 percent of 1 million customers very impressive. After the collapse of communism, this nation bank on-line, and the bank processes 90 percent of its 2 mil- of 1.5 million people moved straight to wireless technologies, lion operations completely electronically-through secured with almost 30 percent of the population now owning a mobile personal computer links for small companies, Internet con- phone and about 35 percent having access to Internet ser- nections, automatic issuing of debit or credit standing orders, vices. E-finance has taken off similarly. Of the seven Estonian or automated teller machines. banks, five have on-line services, making for more than Renaissance Insurance Group was the first Russian insur- 250,000 Internet banking clients, a penetration almost as er to go on-line in 1999. Clients of the company can pay for high as in the Nordic countries. As elsewhere, banks in eight different insurance policies using its CyberPlat payment Estonia see internet banking as a cost-efficient way of expand- system. In April 2000, Ingosstrakh, the largest Russian insur- ing, avoiding expensive new branch offices. Hansabank, the ance company, launched its internet site allowing clients to largest Estonian bank, is considered among the best of the on- apply for an insurance policy on-line. So far, however, payments line banks in Europe and a pioneer in personalized finance can be made only in the offices of Ingosstrakh. 234 Finance in the New Millennium the basis for the extension of credit or other financial ser- cial services has prevented the entry of new providers. But vices to these customers, not just by banks, but also by non- other barriers also have been large. These countries will bank institutions. In other transition economies, on-line need to give far greater priority to improving the frame- insurance products are being introduced. work for financial and other information, modernizing The form in which this e-finance revolution will come and strengthening their legal systems, and improving tech- about will be shaped by the forces of demand and supply nology-related infrastructure (such as telecommunica- as well as by regulatory and other barriers. In countries tions). like Estonia, the lack of regulatory barriers and existence of favorable initial markets have made new entry attrac- References tive. The low development of existing financial services has The word "processed" describes informally repro- further facilitated the penetration of e-finance in this coun- duced works that may not be commonly available in library try. In other transition economies, entry has been more systems. specialized, in part as existing banking systems have been offering at least basic financial services at reasonable cost BIS (Bank for International Settlements). 2000. and quality. This includes many of the Central European "International Banking and Financial Market countries. But, in part, incumbents in these countries have Developments." Quarterly Review. Basel, Switzerland. been protected in the past from full competition, among Claessens, Stijn, Daniela Klingebiel, and Tom Glaessner. others through preferential access to government support. 2000. "Electronic Finance: Reshaping the Financial Over time, these countries should expect a rapid rise in the Landscape around the World." Financial Sector penetration of e-finance, as their telecommunication infra- Discussion Paper 5. World Bank, Washington, D.C. structures are relatively good and internet penetration is August. Processed. increasing. In the transition economies of Eastern Europe World Bank. 1999. World Development Report 1998: and Central Asia, the quality of financial services is very Knowledge for Development. New York: Oxford poor, making e-finance a good opportunity to widen access University Press. to and improve financial services, at least in principle. To . 2000. Global Development Finance. Washington, date, however, the lack of "bankable" demand for finan- D.C. 235 Part VI The Roles of the World Bank and the International Monetary Fund Chapter 20 The Evolving Role of the World Bank in ECA Financial Sectors Paul Siegelbaum and Alexander Fleming Az decade of financial sector development has taken place in the transition economies. The speed of financial evolution has not been uniform, even though the starting points-for countries of the former Soviet Union at least-were similar in many respects. The process of financial sector transition has raised significant challenges for those international financial institutions that have provided support in this area. Support programs have been tailored to the very specific circumstances of each country. The nature of the World Bank's involvement in the financial sector in the transition economies has evolved over time, reflecting both the changing needs of its clients and changing per- ceptions in the Bank of what constitutes good practice in analysis and operational design. Given the unique nature of the transition, the type of support provided has been the result of a learning process not only by each country but also by the Bank. This chapter reviews the challenges of financial tran- and each of the main sectors of the economy, including the sition in the economies of the former Soviet Union and financial sector-for each country. In many instances, spe- Central and Eastern Europe and how the Bank has sought cific in-depth studies of the financial sector also were pre- to address them. It then looks ahead to the next phase of pared. These examined the initial conditions of the post- financial sector evolution and examines how the Bank is socialist economy, among other issues, and led to a first positioning itself to respond to it. A concluding section generation of lending operations, including some that sup- draws out the lessons of experience. ported early reform in the financial sector.1 The initial con- ditions presented a range of complex challenges for project The Challenges of Financial Sector Transition design. As a backdrop to structuring its initial support for the transition economies, the Bank undertook a range of ana- The Starting Point lytic studies shortly after each country joined the institu- The special and limited role of banks and other finan- tion. This effort included compiling a country economic cial institutions in a centrally planned economy constitut- memorandum-a broad-based study of the macroeconomy ed the starting point for financial sector reform in the tran- 1. Poland and the Federal Republic of Yugoslavia, having been members of the World Bank for years before the transition began, each had lending operations in earlier years, although those operations did not focus on the changing role of the financial sector during the years after the fall of socialism. 239 SiegeihaLim and Fleming sition economies. A significant complicating factor was without adequate funding, education, training, and expe- the absence of the legal, institutional, and business envi- rience, not to mention political support and, where neces- ronment necessary for financial institutions to fulfill their sary, independence, these "institutions" were a shadow of role as financial and risk intermediaries in a market econ- what was required to support an effective market-based omy. Economies that were able to supply these critical financial sector.3 As the transition progressed, it became a supporting frameworks relatively rapidly were more suc- special challenge to dismantle and rebuild these initial cessful than other economies in developing a financial sec- efforts at filling the institutional vacuum, often from with- tor capa ble of driving growth in the real sector. An impor- in and in the face of strong political opposition. Again, this tant cha llenge for the transition countries was to develop effort was undertaken in a number of early Bank projects. those frameworks. In this environment, the incentives shaping the behav- Under central planning there was no need to provide ior of banks were very perverse. Indeed, in the beginning of any special legal infrastructure to support bank opera- the transition, the incentive structure favored precisely the tions, since commercial risks of any sort were not a concern opposite of what most would agree are the fundamentals of of banks. The state budget absorbed credit, market, inter- prudent banking. Box 20.1 illustrates this point. est rate, and currency risks, and the system was designed to Overcoming the perverse incentive structure in the eliminate all of these risks for domestic transactions.2 As a context of Bank projects proved to be very difficult. result, there was no need for specialized supervisory regu- Imposing financial discipline and introducing competition, lations (other than those, mostly political, applicable to all for instance, required a multisectoral approach to improv- state organs), collateral legislation, laws on the enforcement ing energy sector arrears, boosting the collection of tax rev- of contracts and other property rights, such as leasing and enue, and reducing inter-enterprise and wage arrears. These conditional sales, or legislation protecting the rights of problems have not been fully addressed even today in some creditors or regulating the consequences of the insolvency of the slower-reforming countries, but in the faster-reform- of debtors. For the most part, these provisions were seen as ing countries, they were resolved over time. Introducing counterproductive "friction" in a system that adjusted proper analysis of creditworthiness in the place of con- rights and allocated resources centrally and in response to nected or directed lending was part of the institutional needs identified by politicians and bureaucrats. Many of the development effort accompanying many of the Bank's Bank's initial projects in the transition countries supported financial intermediation loans (credit lines channeled government policy measures aimed at introducing the basic through domestic banks). Meanwhile, the policy compo- legal and regulatory frameworks for the financial sector. nents of Bank loans supported efforts to strengthen the It also was significant-possibly more so than was legal, regulatory, and supervisory framework for banks. But apprecia-ted at the time-that the regulatory and other in many cases, it took time to alter the incentive structure institutions on which market economies rely so heavily as in a way that supported the development of a market- umpires, facilitators, and providers of public goods were based financial sector. virtuallv absent at the starting point of the transition. The marriage of politics and commerce under socialism ren- Subsequent Financial Sector Developments dered western-style financial regulatory bodies, disclosure As the financial sector transition got under way, new systems, aw enforcement and administrative systems, self- challenges emerged. In some cases, these were not fully regulatory bodies, and dispute resolution mechanisms irrel- anticipated either by the country concerned or by the Bank. evant. Another challenge in this early period was that, But they had to be addressed, and in many cases the Bank although government entities did exist, or emerged early (often in cooperation with other international financial on, they fulfilled the institutional regulatory functions only institutions or bilateral donors) developed operational sup- nominall y, often at the behest of Western aid providers. Yet port to deal with them. 2. As it became more common to borrow funds externally and to expand international trade relations, specialized banks were estab- lished to deal with these transactions. The inescapable fact was that these borrowings and transactions had to be conducted on a comrnercial basis, not subject to the plan. 3. Often, in an environment where social and legal controls on the power of corrupt politicians and bureaucrats were weak or nonex- istent, these new institutions served little more purpose than rent production and were avoided and circumvented by commer- cial interests because of that. This situation was almost the worst imaginable starting point from which to develop the trust and cooperation that must exist for effective regulation to operate in a market economy. 240 The Evolving Role of the World Bank in ECA Financial Sectors BOX 20.1 THE PERVERSE INCENTIVE STRUCTURE IN TRANSITION BANKING state-owned enterprises, is still a political decision, it is far Financial discipline and competition. In many economies in more important for bankers to understand and influence these transition, the most effective competitors of banks are not political decisions than to understand the financial prospects of other banks. They are the tax collector, energy suppliers, potential borrowers. employees, and enterprise suppliers, as well as the state bud- Relationships with supervisors. In an environment charac- get. For "financing" in the form of accumulated arrears, the terized by weak and politicized supervision of banks, the best rational enterprise manager naturally turns to these informal bankers are suspicious of "prudent innovations" like trans- sources of funds well before considering formal borrowing parent accounting systems, effective auditing processes, and from banks. Another form of financing is budget subsidies, prudential limits on connected and concentrated lending. The often through the exploitation of political connections. These operation of these regulations in a highly distorted environment atypical sources of financing have clear advantages. Subsidies more likely serves as an invitation to rent collection, hostile and tax, wage, energy, and inter-enterprise arrears are usually confiscatory taxation, and penalty enforcement by inexperi- interest-free, automatic, unsecured, and, as often as not, for- enced regulators than as a route to lowering banking risk. At given in the next round of fiscal "reform." the starting point of transition, the prudent banker lent as Creditworthiness analysis skills. In a business environment much as possible to insiders and politically powerful enter- characterized by a lack of financial discipline, credit analysis prises, worked hard to conceal profits from the tax collector, skills are seriously devalued in competition with political con- and tried to keep banking regulators as far as possible from nections and "relationship banking," in which shareholdings true knowledge of the business. This activity yielded very high and other connections give banks some edge in terms of infor- rents for some players, but at the expense of the state budget mation and customer access, relative to their banking com- and the new private enterprises trying to expand on commer- petitors. And where the success of enterprises, particularly cial terms. During the early 1990s, four factors had a dispropor- much more dramatic, surge lasted from 1991 through tionate impact on the initial financial sector developments 1995. These inflationary pressures significantly weakened in the transition economies: (1) inflation, (2) the breakup of the inexperienced banks and eroded public confidence not the all-union banking system in the former Soviet Union, only in the banks but also in many national currencies, (3) early official efforts to stimulate the growth of the which by this time had been introduced. Inflationary commercial banking sector by lowering barriers to entry, episodes like this had a number of adverse impacts on and (4) mass privatization. Financial sectors across Europe banks. and Central Asia (ECA) are still feeling the impact of these As the rate of inflation rose sharply, inexperienced developments. bankers did not realize how important it was to raise their lending rates in parallel, with the result that real lending Inflation. At the beginning of the transition, the release of rates entered negative territory, eliminating real profit mar- pent-up inflationary pressures from the socialist period, gins. In addition, depreciation of the local currency, which coupled with the tendency of many of the transition econ- accompanied the inflationary surges, had positive and neg- omy governments to pursue an inflationary monetary pol- ative impacts. It wiped out the banks' liabilities, at least in icy to compensate for the costs of trade disruptions, fueled hard currency terms, but it also eliminated the real value of a major inflationary surge across the region (see figure the banks' assets and thus their capital. In these early stages 20.1). In some cases, inflation rates surged to hyperinfla- of the inflationary experience, the only banks that profited tionary levels. In Central and Eastern Europe and the Baltic were those with long foreign currency positions, which states, the inflationary surge lasted from about 1990 to accumulated extraordinary foreign exchange gains in a 1993 in most cases,4 while in the countries of the brief period. This positive factor also sowed the seeds of a Commonwealth of Independent States (CIS), a similar, but later disaster, since it demonstrated to these new bankers 4. The surge of inflation started even earlier in some cases, such as Poland, but never reached the levels of some CIS countries. 241 Siegelbaum and Fleming FIGURE 20.1 INFLATION IN SELECTED ECA COUNTRIES 1991-1999 (ANNUAL AVERAGES, PERCENT) Percent - - Albania 1400i 2OG / \ =A- Estonia 1000- 800- /- Poland 600- 400- x Russian Federation 200--I 0-- Xn, X Uzbekistan 1991 1992 1993 1994 1995 1996 1997 1998 1999 Source: International Financial Statistics (IFS) and Central Bank websites. that real wealth could be found in currency speculation, not As before, the presence of very high real lending rates prudent enterprise lending. fueled an explosion of moral hazard among bank bor- At the crest of the inflationary wave-and particular- rowers, as the most sophisticated and creditworthy simply ly in the hyperinflationary countries of the CIS-there were turned away from bank-based finance until the storm extraordinary profits to be made, although not in tradi- abated. The remaining desperate borrowers sowed the tional banking. Currency speculation was still profitable, as seeds of the problem of nonperforming loans that arose in was financing the trade in certain metals and commodities the mid- 1990s. of dubious legality, but the extraordinarily high nominal In the last phase, as stabilization was achieved more interest rates the bankers were forced to charge created a broadly and inflation rates sagged to single-digit levels in serious rnoral hazard among potential bank borrowers, most transition economies, new challenges emerged for such thar only those enterprises literally facing extinction the banks. The profit was squeezed out of currency specu- were willing to pay the quoted rates. Moreover, these lation, and access to profits finally came to depend on unsustainable inflationary levels were typically quite good banking-that is, adequate credit analysis skills, volatile, which exacerbated the challenges of asset-liability workout capabilities, professional asset-liability manage- management for the bankers. Again, it was precisely the ment, and reasonable cost containment. However, nothing wrong set of skills that proved valuable in this period- in the past years had taught the banks these essential skills skills that would serve to complicate reform efforts long and, burdened with mounting volumes of nonperforming after inflation was tamed. loans and a high fixed cost base, many banks were driven As inflation rates eased, which occurred when the into insolvency. Large state and state-connected banks in prudent monetary and fiscal prescriptions provided by several countries frequently were treated differently than the International Monetary Fund and the World Bank other banks-an ambivalent and broadly protective policy took hold, a different dynamic developed-again, one for stance often standing in place of the decisive closure strate- which these nascent bankers were unprepared. Having gies advocated by most Western advisors (for example, learned their lesson on the way up, bankers were reluctant the Russian Federation and Ukraine). This marked the end to reduce rates quickly as inflation eased and stabilization for many of the smaller commercial banks, but it was, for was achieved. While this produced highly profitable lend- the larger state-owned and former specialized banks, the ing spreads, the positive cash flows also concealed the beginning of another period of ineffective, and hugely dragging weight of these banks' inefficient cost structures. expensive, government bailout efforts. 242 The Evolving Role of the World Bank in ECA Financial Sectors Strategies for dealing with the monetary and infla- tors of the economy, governments were slow to take effec- tionary implications of the transition were supported under tive corrective action. World Bank and International Monetary Fund programs in A number of Bank projects sought to address the issues the first years of the transition. In the case of the Bank, of state bank restructuring. The Bank typically played an macrocconomic conditionality was invariably attached to important role in structural issues vis-a-vis other interna- structural adjustment loans or sectoral adjustment loans. tional financial institutions. The Bank provided this type of This conditionality typically promoted fiscal restraint, bal- support in various operational contexts. In some cases, it anced budgets, management of interest rates to positive real was part of policy-based lending (structural adjustment levels (followed by liberalization of rates), and cessation of and sectoral adjustment loans), while in other cases, it was government borrowing from central banks. part of financial intermediation loans. Success in restruc- At an early stage, institutional strengthening was rec- turing state banks was relatively rare, as governments were ognized as critical to controlling the financial sector risks politically unable to implement the necessary painful mea- that flowed from the turbulent environment, risks that sures. In a number of countries, efforts were made to pri- often had to be carried by the state budget in the final vatize troubled banks in lieu of restructuring, but this rarely analysis, as inadequate financial and human capital in the proved to be a viable strategy, at least as it was originally banks led to inevitable failures. Thus, building a modern (implicitly) conceived, which was an inexpensive method of legal infrastructure for central banking, bank supervision, selling restructuring responsibilities to private strategic and commercial banking was reflected in both condition- investors. Even the least sophisticated potential investors ality and technical assistance projects, as were the applica- were reluctant to "purchase" banks with negative net tion and enforcement of prudential regulations, the limita- worth, obsolete technology, inadequate procedures, com- tion of directed credits to politically connected and socially plex and nontransparent governance structures, and unsus- significant (but not creditworthy) enterprises, and the build- tainable cost structures. ing of capacity in the central bank or other supervisory Where bank privatization did work, it was more in agency for dealing with troubled banks. the nature of controlled liquidations, sometimes with for- The state-owned and formerly state-owned banks eign banks purchasing the few worthwhile assets, typically bore the brunt of the financial risks that inflation pro- branches. The notable exceptions to this general trend duced, burdened as they were with the legacy of noncom- occurred in Central Europe and the Baltics, where early mercial lending, weak banking skills, and a customer base decisions were made to replace management, aggressive- heavily weighted toward the largest of the state-owned ly clean up balance sheets, and provide extensive training enterprises, which were the hardest hit by trade disruptions and technical assistance to build modern banking skills. in the early transition. As a result, these large banks were The best examples of this process done right are Unibank absorbing far too much of the budget's precious resources, in Latvia and the North Estonia Bank. Much work so they were targeted early on for intervention by both remains to be done on bank restructuring in the CIS coun- adjustment loan conditionality and technical assistance. tries, as well as in Central and Eastern Europe, particu- The diagnosis and targeting often were sidetracked by the larly in the Balkans, where foreign entry presents signifi- protective attitudes of local politicians and vested interests cant political problems. The Bank is finding, that the toward these banks. delays in dealing with the serious problems faced by these banks have gradually eliminated strategic alternatives to All-union bank restructuring. The restructuring of the spe- liquidation. A major dilemma for large state banks in cialized all-union banks that occurred on the political oligarch-dominated economies is to avoid privatizations breakup of the former Soviet Union placed severe stresses that merely hand the target banks to undesirable elements on many countries (outside of the Russian Federation). having little real interest in building sound and stable Assets were held in the Russian central office, while liabil- banks. In many cases, delay and half-hearted efforts to ities were left in the regional offices, which eventually were permit insolvent banks to "grow out of their problems" reconstituted into independent institutions. Because of the simply transformed potentially recoverable institutions "missing assets," most of these banks-primarily the sav- into fiscal black holes. ings banks-were severely insolvent. For these banks, there was an early and critical need for restructuring, recapital- Growth in banks; cowboy banking. Many governments in ization, and, in some cases, liquidation. Because they often transition countries initially responded to the lack of com- served powerful political interests and financed critical sec- mercial banking in their economies by setting excessively 243 Siegelbaum and Fleming low barriers to entry.5 Low initial and minimum capital payment system, and maintaining preferred access to gov- requirements were embraced, and virtually no "fit and ernment payments, loans, and subsidies were relatively proper" restrictions were placed on who could obtain a unrestricted, and, without modern accounting and audit- banking license from the state or how they had to perform ing, the condition of the banks was anything but transpar- once they had this license. At the same time, the privileges ent. An excessive number of banks were established in of accepting deposits from the public, participating in the relation to the size of the economy (see table 20.1) TABLE 20.1 NUMBER OF BANKS IN CENTRAL AND EASTERN EUROPE AND CENTRAL ASIA, 1993-2000 (YEAR-END) Country 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 CEE and Baltics Albania - - - 6 6 8 9 10 10 - Bulgaria 78 59 41 45 47 35 34 34 35 35 Croatia - - 43 50 54 58 61 60 53 45 Czech Rep. - - 52 55 55 53 50 45 42 40 Estonia - - 21 22 18 15 12 6 7 6 FYR Macedonia - - - 6 6 22 22 24 23 21 Hungary 35 35 40 43 42 41 41 40 39 39 Latvia 14 50 62 56 42 35 32 27 23 22 Lithuania - - 26 22 15 12 12 12 13 14 Poland - - 87 82 81 81 83 83 77 75 Romania - - 20 24 31 33 36 34 35 Slovak Rep. - - 18 19 25 24 25 24 25 22 Slovenia 40 45 45 44 41 36 34 30 31 25 CIS Armenia - - - 41 35 33 30 31 32 31 Azerbaijan 43 120 164 210 180 136 99 79 70 59 Belarus - - - 48 42 38 38 37 - 27 Georgia - 75 179 226 101 61 53 43 34 33 Kazakhsran 72 155 204 184 130 101 81 71 55 48 Kyrgyz Rep. 10 15 20 18 18 18 20 23 23 22 Moldova 15 16 16 21 22 21 22 23 21 20 Russian Fed. 1306 1747 2009 2456 2295 2576 2526 2451 2376 2084 Tajikistan 1 10 15 17 18 23 28 20 20 17 Turkmenistan* - - - - 67 68 67 13 13 13 Ukraine 76 133 211 228 230 229 227 214 203 195 Uzbekistan 30 30 21 29 31 29 30 33 35 35 - Not available. * In 1995, 56 agriculture cooperative banks were established as spin-off of Agroprom Bank. These institutions were eventually re- merged into Agroprom Bank in 1998. Source: Central bank bulletins and web sites. 5. This approach had its antecedents in the 1987 reform of the Soviet Union's banking laws in wvhich, in response to the Perestroika- induced expansion of "private" cooperative enterprises, citizens were allowed to establish private cooperative banks. The assumption was that the stare banks would not be interested in serving privare enterprises. The strategy worked all too well, as all manner of entities, including some churches, moved to establish what came to be called "pocket" banks to serve their finan- cial needs, often with funds from household depositors. 244 The Evolving Role of the World Banik in ECA Financial Sectors Minimal barriers to entry accompanied an unsophis- in all domestic banking, it would appear that the end game ticated supervisory system and ineffective enforcement of already has been defined. Purely domestic banks, if they prudential regulations. In many countries-particularly in have any hope of survival at all, will have to define the former Soviet Union-there were virtually no limits on extremely tight niches for themselves. Whether they can do what banks could do and what risks they could take. Many so and still remain profitable remains to be seen. household depositors perceived these risks early (often, however, not early enough to avoid losing their savings in Enterprise privatization. Privatization was a common hyperinflationary episodes). As a result, the volume of denominator in the reform of the real sector in the transition household deposits at risk was relatively low in early tran- economies. Those countries that opted for one of the mod- sition banks. Instead, households turned to "mattress els of mass privatization, in which the population received banks" for their savings and to foreign currency, especial- either direct or indirect ownership interests in formerly ly dollars, for their investments.6 Enterprises, that required state-owned enterprises, were immediately faced with the payments services, could not avoid placing funds into need to establish capital market mechanisms to manage banks. As for the banks themselves, in the early transition the purchase, sale, and valuation of these equity interests. years few domestic investments were more profitable than For the most part, this was not accomplished well, but it did simply purchasing and holding hard currency against the define a specific area of assistance that was to become a rapidly depreciating local currency. As the risks of "cowboy focus of Bank attention in the first five years of the transi- banking" came home to roost, many of these deposits tion, a focus that has continued until the present. were lost, with a very substantial negative impact on the As in the banking sector, the earliest interventions were production, employment, and growth of these enterprises. in the form of conditionality and technical assistance in the The Bank consistently tried to assist the transition creation of a modern legal and supervisory system for the countries in moving toward a more consolidated banking capital markets. Rapidly, however, it became clear that sector, proportioned to their economies. Often this involved one feature critical to the viability of an efficient capital support for government programs aimed at tighrening cap- market-timely and accurate information on which to ital ratios and raising minimum capital standards as a way assess the value of investments-was going to be a binding tO rid banking systems of weak banks through mergers or constraint. As a result, the Bank became involved at an orderly liquidations. Consolidation took place in Central early stage in the promotion of modern enterprise account- Europe and the Baltics, but this process was less marked in ing and auditing systems (for banks as well as for enter- the other ECA countries (table 20.1). Other initiatives with prises), disclosure systems, and market regulation. In ret- the same goal included pressures to eliminate local barriers rospect, achievements in this area were modest. Although to the entry of foreign banks and foreign investors in local formal institutions were created in many cases, accompa- banks. Thus far, all of the best results in banking sector nied by a reasonably complete legal and supervisory infra- restructuring have been driven by the participation in-and structure, capital markets remained extremely thin or even domination of-the local banking sector by foreign- nonexistent in most of the ECA countries. ers. The earliest of these initiatives was probably the bank Another significant impact of the privatization pro- twinning program in Poland, supported by the World Bank grams in the transition economies was a radical change in and other donors, but the Polish success with this strategy the risk profile of banking, especially of banks servicing the has been hard to replicate elsewhere. Even enthusiastic state-owned enterprises. Before privatization, state-owned reformers, such as Slovenia, have found it difficult to enterprises were among the best credits in the system. They embrace foreign banks fully. Some foreign banks have were supported by the budget, without regard for their secured a foothold in the CIS countries, but, for the most profitability, their efficiency, or their business prospects. part, they have not competed hard for domestic business. There was no need to assess the creditworthiness of these Indeed, considering that the eventual EU accession, which enterprises before lending to them. At most, an assessment is the goal of most of the Central and Eastern European of the likelihood of continued government support was countries, will eliminate the barriers to foreign participation needed, and even that was not critical if the bank managers 6. Mattress banks included, in some cases, the savings banks around the ECA region that received at least a nominal government guar- antee and retained an element of customer loyalty. For example, in Ukraine in 2000, the average U.S. dollar value of a household deposit account in the banking system was well under $5.00. Many of these accounts continued to exist because they were too small to bother with, particularly in rural bank branches, where the lack of liquidity resulted in a de facto freeze on withdrawals. 245 Siegelbaum and Fleming believed that their loans to these enterprises were implicit- tant to recognize this in any formal way that would relieve ly guaranteed by the state. And the political analysis was the pressure on bank portfolios (at least until it was too not difficult-the bigger the enterprise, the more visible, late). In short, traditional banking skills were in demand at and the more citizens it employed, the less likely was the a time when they were most severely lacking. withdrawal of government support. After privatization, the situation became more complex The World Bank's Operational Response and demanding for bankers. Some formerly state-owned The varying levels of success with which governments enterprises were still too big to fail, and they continued were able to deal with these early challenges began to drive business much as usual, often with implicit state subsidies in significant differences in financial sector development. the forrr. of directed credits, monopoly positions, cheap Furthermore, the operational response of the Bank was tai- energy, or tariff protections instead of the traditional direct lored to meet the emerging needs of the different transition payments. But the system was becoming less transparent as countries. The Bank's operational work in the financial subtle pclitical pressures were exerted on enterprises in the sector is summarized in table 20.2. Box 20.2 describes the face of anti-subsidy conditionality and other pressures to main lending instruments that the Bank deployed. reform from the international financial institutions. Other Five groups of countries began to emerge as the finan- privatized enterprises were simply cut off from both direct cial transition unfolded (see box 20.3). The first was what and indirect subsidies and were left to flounder, building up might be called the rapid reformers of Central Europe, significant tax, wage, and inter-enterprise arrears to compete including Poland, Hungary, the Czech Republic, the Slovak with the banks' claims. Often the large banks had significant Republic, and Slovenia, where the governments had, for the exposure to these enterprises, originating in government- most part, the political discipline and commitment, as well directed credits, but the governments typically were reluc- as the technical capacity, to manage the impact of these BOX 20.2 THE WORLD BANK'S LENDING INSTRUMENTS FOR FINANCIAL SECTOR DEVELOPMENT The Bank's lending operations comprise what might be divided on to private sector entities. In the poorer countries-those with loosely into top-down and bottom-up lending instruments. The rudimentary financial systems-these credit lines often take the top-down instruments are targeted at the policy environment for form of agricultural credit operations or micro-credit operations finance. These typically are structural adjustment loans (SALs), that are channeled through special-purpose entities, bypassing or structural adjustment credits (SACs) in the case of International the formal financial sector entirely. In the more advanced Developrnent Association countries, with financial sector com- reforming countries, more broadly based credit lines, catering ponents or sector adjustment loans that place a heavy emphasis to the needs of a broader set of private sector borrowers, are put on the financial sector. In the early days of transition, a number in place. Most credit lines are designed not just to transfer of countries received rehabilitation loansthat were effectively one- resources to final borrowers but also to encourage institution- tranche SALs. Sectoradjustment loans (SECALS) can take many al development through the strengthening, and in some cases forms, bit the two main ones are financial sector adjustment restructuring, of the participating banks and, in some cases, the loans ancl enterprise and financial sector adjustment loans. In the enterprise subborrowers. case of the latter, the enterprise and financial sectors often are Institution-building loans (IBLs) for the financial sector also addressed simultaneously in transition economies because the are deployed in some countries. Such technical assistance problems of both sectors are interrelated. These types of projects loans normally finance experts who assist in strengthening the are used to support policy reform for a range of countries at dif- infrastructure-broadly defined-of the financial sector. ferent stages of financial sector development. They typically dis- Guarantees sometimes are used in the ECA region to cover burse directly to the government in two or three tranches once a range of noncommercial risks that otherwise would impede specific conditionality has been met. the flow of finance to private enterprises, but their use in the Financialintermediaryloans (FILS) also are used in the ECA early transition period was quite rare, since the Bank did not context for institution building in the financial sector. These bot- mainstream guarantee operations until the late 1990s and the tom-up instruments include credit lines channeled from the International Development Association does not yet have full Bank through commercial banks in the recipient countries and guarantee authority. 246 TABLE 20.2 FINANCIAL SECTOR COUNTRY INTERVENTIONS, 1991-2001 Commercial bank insti- State Number tutional State Laws and bank Commercial Nonbank of restruc bank re- Central regu- Payment privati- Capital bank re- Creditor Deposit financial Country and fiscal year projects -turing structuring bank lations system zation markets structuring rights insurance institutions Rapid reformers Hungary, 1993-98 3 4*. 4. *: . *:. 4* Poland,,1991-98 4 4_ *:. 4 *: * * 4. 4*: *: Slovak Republic, 1994 1 : * : 4 * Slovenia, 1994 1 * * 4. 4. . 4*: 4. Intermediate reformers Bulgaria, 1991-99 7 *: *4 4 : 4*: 4* *: *. *: 4 Croatia, 1996-97 2 4 4 C. A.. 4* Estonia, 1993-95 2 4** 4*: 4*: 4* 4* Latvia, 1993-95 2 4: 4* 4*. 4 Lithuania, 1993-95 2 *:4 *. * *. Hampered reformers Albania, 1993-2000 5 4: . : 4: * * * Armenia, 1993-98 6 4*: 4* 4* 4* 4* 4* Azerbaijan, 1996-98 3 * 4* 4. * Bosnia, 1999 2 4*: 4 *: Georgia, 1995-98 6 44: 4 . FYR Macedonia, 1994-2001 3 4: 4*: *: 4* 44 4:* 4* Moldova, 1994-96 3 * C' 4 4 4 Reluctant reformers Belarus, 1993-94 2 4: 4 4* Kazakhstan, 1994-95 4 4* 4* 4. 4 *. 4* 4* *: 4: * Kyrgyz Republic, 1993-99 5 *4 *: 4 * 4* 4* (Table continues on the following page.) " TABLE 20.2 (CONTINUED) 4o Commercial baknkl?St?- tate Number tutional State Laws and bank Commercial Nonbank of restruc bank re- Central regu- Payment privati- Capital bank re- Creditor Deposit financial Country and fiscal year projects -turing structuring bank lations system zation markets structuring rights insurance institutions Tajikistan, 1996-99 2 *4 4* * *. 4* Turkmenistan, 1995 1 4* 4* 4 LJzbekistan, 1994-99 2 *4 *4* 4* 4* Chaotic reformers Romania, 1992-99 4 4* 4. * 4. Russian Federation, 1994-99 6 * *: *: *: *4. 4. *: *: Ukraine, 1993-98 6 *: 4. 4. 4. **4* Total country interventions 24 23 21 20 18 18 14 12 8 8 5 Explanatory Notes: The entries in the table show where bank interventions (either individual elements of conditionality or specific areas of financial support) havc been concentrated in the context of all of the projects containing financial sector components that have been identified for each country. Fiscal Year(s) The year, or period of years, during which at least one project with financial sector content was launched(the Bank's fiscal year runs from July I to June 30) No. of projects The number of projects with financial sector content that were launched during the year, or years, cited. Conditionality or technical assistance provided to the following: Commercial Bank Institution Building To stimulate Institution building within commercial banks (MIS development, credit skills development, etc.); State Bank Restructure To audit and restructure state banks; Central Bank To develop the infrastructure of the Central Bank (structuring departments, training staff, etc.) and strengthen its banking supcr- visory capacity; Law & Regulation To introduce or strengthcn laws and regulations pertaining cither to the Central Bank or to the banking sector; Payments system To develop the payments system; Statc Bank privatization To privatize state banks; Capital Markets To introduce or strengthen laws and regulations pertaining to the capital markets, strengthen supervision, and dlevelop infra- structure such as securities depositories, securities rating agencies, etc.; Commercial Bank restructuring To restructure commercial banks; Creditor Rights To introduce collateral laws or bankruptcy laws or procedures; Deposit Insurance To introduce (or in some instances prevent the introduction of) deposit insurance; NBFI (nonbank financial institutions) To develop the legal, regulatory or supervisory framework for insurance companies, pension funds or 3rd pillar pension reform, and the legal, regulatory, or supervisory framework for other NBFIs (such as leasing companies). The Evolving Role of the World Bank in ECA Financial Sectors early stresses on their banks, to put competent institutions straint, which both weeded out the worst loss-makers and in place, and to impose discipline in both the financial and promoted the commercially oriented business culture on the real sectors. This group of countries (with the exception which banking depends. of the Czech Republic, which chose not to borrow from the The second group-which might be called the inter- Bank in support of financial sector reform) benefited great- mediate reformers-was, for a variety of reasons, less suc- ly from Bank operations such as financial sector adjustment cessful in dealing with the initial financial sector problems, loans supporting institution building in banking regulation, although progress was made in many areas. This group, bank privatization, and restructuring.7 Such loans also which includes Estonia, Latvia, and Lithuania, as well as provided technical assistance in support of financial Eastern European nations such as Bulgaria and Croatia, accounting reforms, capital market development, tax faced a deeper and more resistant set of problems at the reform, and the general opening of the financial sector to outset, including banking sectors dominated by more foreign investment and competition. In this first group, deeply insolvent state and former state-owned banks, more moreover, the challenges of privatizing the real sector were, intense and more prolonged inflationary periods, a shal- for the most part, met aggressively and successfully, and pri- lower commitment to reform, particularly in privatization, vatized enterprises were subjected to a hard budget con- and trade and financial links more oriented to the East and BOX 20.3 PROGRESS IN THE TRANSITION OF ECA COUNTRY CATEGORIES, 1991-1999 BANKING REFORM (EBRD TRANSITION INDICATORS) 4.0 3.5- 3.0- 2.5 2.0 -_______ 1.5 1.0 1991 1992 1993 1994 1995 1996 1997 1998 1999 l Rapid -- Intermediate+- Hampered* ReluctantA Chaotic| The European Bank for Reconstruction and Development The chaotic reformers are the only group that changed its rel- assigns ratings to the status of institutional development in the ative ranking among the country groupings, as it surpassed the banking sector in each of the ECA countries. These ratings hampered reformers in mid-decade, only to fall back, relative to range from 1 for a very low level of institutional development to that group, by the end of the 10-year period. This was the 4 for a high level of development. For the purposes of figure result of significant progress made by Romania and Ukraine in 20.1, the grading shown for each category of country is the 1995 in the introduction of new banking legislation and pru- unweighted average for all countries in that group. Each group dential regulations, achievements that were eroded by 1998 as has a different ranking and, which is important, a different path a result of the banking sector problems in Romania and outright of development in its ranking for the decade of the transition. financial crisis in Russia. 7. While it is true that Hungary undertook multiple rounds of bank recapitalizations before an appropriately aggressive change in management strategy was accepted, the important points were that (1) reform of the banks' custonmers-that is, the enterprises- continued aggressively and (2) the Hungarian government did not give lup on the banks, even in the face of multiple failures. As a result of these two factors, problems in the banking sector never deteriorated beyond the point of no return. 249 Siegelbaum and Fleming its even slower-recovering economies, than to the West, establishment of payment systems, the strengthening of the with the contestable competition of the European Union banking supervision function, and the introduction of (EU). In some of these countries-notably the Baltics- bank accounting and audit standards. Much of the Bank's financial sector reform was punctuated, and indeed driven, operational involvement in this group of countries came by severe banking crises. The Bank provided a significant through institution-building loans. level of support in the financial sector for this set of coun- The final group-the chaotic reformers-is the most tries (table 20.2). Much of it was aimed at restructuring and difficult to characterize, although it contains some of the privatizing state banks as well as providing a sound legal most systemically important countries in the region: Russia, and regulatory framework for development of the private Ukraine, and Romania. The early transition experience in banking sector. Development of the payment system was each of these countries was deeply traumatic and long- another area of support. Much of the support for financial lasting, with an uncertain and shifting political commit- sector development was provided under the initial umbrel- ment to reform leading to a long delay in their return to la of rehabilitation loans, but subsequently also sector growth. The commitment to financial sector reform, in adjustment loans. Financial intermediation loans also particular, was shallow, as was the willingness to address worked well in these countries and provided an effective problems with state and former state banking institutions. vehicle for the institutional development of commercial Privatization was often a destabilizing force in these coun- banks. tries, accompanied by significant levels of corruption and The third group of countries-the hampered reform- organized crime, and they experienced a continuing series ers-is characterized by comparatively less progress in finan- of banking crises and near crises, as continuing efforts cial sector reform, largely the result of a web of circum- were made to fit the pretransition, socialist banking model stances, including their small size, history under socialism, into the new economic model that was emerging. Bank sup- geography, shortage of human capital, historical trade links port in these countries straddled a wide range of areas of and neighbors, and internal and external conflicts, which the financial sector, mainly through the vehicles of struc- dramatically hampered the reform process in the real sector tural adjustment loans and sector adjustment loans. Some overall. T'his group includes Albania, Bosnia, Moldova, the of this effort was directed toward bank restructuring, Kyrgyz Republic, and Azerbaijan. For these countries, Bank although there was little subsequent privatization of these support for the financial sector was provided through the banks (except in Romania). The Bank also sought to devel- vehicles of structural adjustment credits and institution- op the foundations for the capital market in these countries building loans. Much of this support was foundational in (legal, regulatory, and supervisory framework and market nature, focusing on restructuring and privatizing state banks, infrastructure). on strengthening the legal and regulatory framework for Figures 20.2 and 20.3 summarize the Bank's financial banking, and on establishing sound accounting for banks. sector involvement in the ECA countries as a whole. Figure Developing a more robust banking supervision function in 20.2 illustrates that the hampered reformers received more the central bank was also a priority. adjustment and investment lending than any other group. The fourth group is characterized as the reluctant This reflects both the willingness of these countries to reformers, including Belarus, Uzbekistan, Tajikistan, and work closely with the Bank on financial sector reform Turkmenistan. These countries, through conscious choice, and the intractability of the problems faced by these coun- were the most reluctant to let go of the security of the com- tries. The fundamental need to reform the policy environ- mand economy's principles and to risk enduring what ment for the financial sector, coupled with their some- they saw as the "chaos of the market" in countries around times significant balance of payments financing them. Ironically, many of these countries experienced a rel- requirements, is reflected in the strong emphasis on adjust- atively shallow drop in output in the earliest stages of the ment lending. The reluctant reformers, in contrast, transition. This-and the fact that they refused, in the absorbed more investment lending, aimed at strengthening main, to commercialize, let alone privatize, their real sec- the infrastructure for the financial sector, and less adjust- tors-meant that banks and other financial institutions ment lending, given the relatively weak commitment to remained relatively stable and healthy, if their historic, fundamental policy reform. limited role in financial intermediation is taken into Figure 20.3 summarizes where the Bank placed most of account. In countries where commitment to state bank pri- its interventions (either individual elements of condition- vatization was weak, emphasis was placed on building a ality or specific areas of financial support) across all ECA sound foundation for finance through support for the countries. The most common interventions were the 250 The Evolving Role of the World Bank in ECA Financial Sectors FIGURE 20.2 TYPES OF WORLD BANK LENDING PROJECTS Improvement of the legal infrastructure for banking also IN ECA COUNTRIES received attention, except in countries where the task was undertaken outside of Bank projects and in those reluctant ----- --<---v-- _ _ reformers where governments were not willing to change Reluctant I existing legislation. Hampered Reform of the payment system was also a common intervention, in light of the enormous monetary float that Chaotic was available for release to the economy with relatively I I simple technological improvements in processing payments. Intermediate Similarly, at least in those countries where privatization was _ Investment seriously entertained, the state banks became the common Rapid I Adjustment subject of privatization strategies. In about half the coun- tries, capital markets and commercial bank restructuring 0 5 10 15 20 were pursued, although in the case of capital markets, with limited impact. Specific interventions were rarely addressed restructuring of state banks and the institution building of to improving creditor rights and the infrastructure for non- commercial banks, along with assistance to central banks bank financial institutions (other than in the capital mar- (especially the strengthening of bank supervision). This kets, such as insurance companies and pension funds), reflects the early realization that (a) adequate regulatory reflecting country priorities. And there were only eight institutions were a key to prudent banking, (b) the state countries where the Bank was involved in implementing banks, with their inefficient structures, yet monopoly mar- (and in some instances preventing the establishment of) ket positions, were crucial obstacles to the growth of com- deposit insurance schemes, reflecting the judgment that mercial banking, and (c) banking skills and structures were such schemes were premature in most of the transition seriously deficient, even in the new commercial banks. banking systems. FIGURE 20.3 NUMBER OF WORLD BANK INTERVENTIONS IN ECA COUNTRIES Capital markets Deposit insurance Creditors' rights Law & regulation Payments system Institution building Restructuring Privatization Audit and restructuring Central bank _ 0 10 20 30 40 50 60 251 Siegelbaum and Fleming The Next Phase of Financial Sector Transition countries will increasingly strive to catch up with Western Considerable progress was made in financial sector Europe (see also chapters 1 and 2). This will be a significant reform in ECA countries over the past decade. This is espe- stimulus to the pace of their financial sector reform. cially true given the fact that-unlike in other sectors of the Without this stimulus, the financial sectors in the remain- economy-the process of financial reform had to start ing Eastern European and Central Asian countries will essentially from scratch. This progress subsequently took evolve rather more slowly. place at different speeds in different categories of the tran- In considering how the different categories of countries sition economies. Over this period, a number of ECA coun- will evolve over the next few years, it is useful to consider tries engineered a consolidation in the number of banks where they are in the sequence of financial sector reform. and, in particular, managed to deal with the remnant of the Figure 20.4 provides one way of illustrating the phases of Soviet specialized banking system through their liquidation, financial reform. The vertical axis measures the institu- merger, or privatization. This led to leaner, more efficient tional capacity of the financial system-its corporate gov- banking systems, especially in the EU accession countries. ernance and human resource capacity. Developing this The institutional framework for the capital markets evolved capacity requires a commitment by regulatory authorities adequately in most ECA countries, but this was not, by and and market participants over a number of years. Gradually, large, reflected in a significant role for these markets in as this capacity develops, participants acquire the technical financing the private sector, and institutional knowledge to process more sophisticated ECA's financial sectors are likely to be subject to a financial products (as reflected on the horizontal axis). number cf significant forces for change over the next 5-10 Under this schema, it is clear that many EU accession years. Onc force will be the strong pull of technological countries-that is, the rapid reformers and the intermediate change that will affect all aspects of financial business. reformers-are now well into the intermediate phase. The Another will be the integration of the financial sectors of involvement of foreign investment in the banking sectors of the EU countries, particularly under the weight of the move many EU accession countries is improving institutional to the euro. The ECA countries are likely to become capacity. Over the next 5-10 years, therefore, many of these increasingly polarized in terms of their financial sector countries will move into the advanced phase. In due course, development over the next 10 years. The EU accession some could come to closely resemble EU countries in the FIGURE 20.4 SEQUENCING OF FINANCIAL SECTOR REFORMS High ~~~ADVANCED/ .>> ~~~~~~~~~~~PHASE D 5- INTERMEDIAT) z dFIRST PHASE Low Directed Short-term Leasin Medium- Long-term Project Venture Derivatives Securitization ending lLending term lending lending finance capital Commercial Treasury Equity paper bonds finance Treasury Commercial bills bonds 252 The Evolving Role of the World Bank in ECA Finanicial Sectors breadth and depth of their financial systems. The regulato- the general problems of financial transition were gradual- ry challenge that has evolved relates to the fast-changing ly solved in some countries, a number of specific issues per- European financial system and the resulting influence that tinent to the later stage of transition required analytic this will have on the nature of financial business in the EU attention. Such issues relate to, for instance, how to devel- accession countries. This means that the supervisory frame- op mortgage markets or how to facilitate the development work will have to adapt quite quickly also. This will be a sig- of second-tier pension funds. A number of second-genera- nificant challenge for many countries. In some instances, the tion regulatory issues also arose, such as issues relating to organization of regulation is already adapting to perceived the appropriate structure of the organization of regula- risks, as some countries move to a unified regulatory model. tion. However, many of these issues related more to the It is possible that the Eastern European and Central advanced transition countries, while those countries in the Asian countries-for the most part, the hampered reform- former Soviet Union (excluding the Baltics) had to contin- ers, the reluctant reformers, and some of the chaotic ue grappling with the basic issues of financial transition. reformers-will remain in the first phase of figure 20.4. The The nature of the analytic work continued to reflect this. slower-reforming countries will have to continue address- Another avenue for analytic work furnished by the ing many of those problems that the faster reformers tack- Bank was occasioned by the Asian financial crisis of 1997 led in the first 10 years of transition. First, they will have to and the Russian financial crisis of 1998. In some countries, continue to strengthen the legal, regulatory, and supervisory where the effects of financial contagion were a concern, framework for the financial sector. Second, they will have interest emerged in having the Bank perform vulnerability to encourage the consolidation of their banking sectors reviews that focused on weaknesses in the financial sector or and hence reduce the costs of banking, while improving macroeconomic framework that could precipitate crises. their overall efficiency. Third, they will need to devise con- In parallel, the boards of the Bank and International tingency plans for dealing with banking crises should they Monetary Fund expressed increasing concern that countries occur as the pressures for consolidation and improved effi- worldwide should identify weaknesses in their economic ciency intensify. Many of the banking problems will remain performance and financial sectors and should take precau- in the state or semi-state banks in these countries. Dealing tionary measures to mitigate emerging risks. These con- with state or former state banks likely will be among the cerns gave birth to the joint World Bank and International greatest challenges in the financial sectors of these countries Monetary Fund Financial Sector Assessment Program during the coming decade. (FSAP), which involves a major study of the risks and vul- nerabilities in the financial sectors of all 180 member-coun- The Future Role of the World Bank tries. A significant number of countries from the ECA region The Bank's response to the evolving needs of ECA's were the subject of FSAPs in 2000. These studies seem like- financial sectors over the coming 5-10 years can be con- ly to continue and to displace much of the analytic work sidered under two broad headings: analytic studies and that typically was performed in the earlier stage of transi- technical assistance, on the one hand, and operational tion. The FSAP analyses are yielding conclusions regarding involvement, on the other. weaknesses in the financial sector that require follow-up technical assistance. Some of this assistance will be provid- Analytic studies and technical assistance. The analytic work ed by the Bank or by supportive donor governments. that the Bank has undertaken in the financial sector in the past has provided the intellectual backdrop for subsequent Operational work. During the first 10 years of financial operational involvement. Much of the focus in the early transition, the Bank, as illustrated in table 20.2, was days of transition was on diagnostics aimed at the basic involved in a range of lending operations that affected the legal, regulatory, and supervisory framework for the finan- financial sector across a wide swathe of transition coun- cial sector and how to develop an infrastructure for a cap- tries. The Bank's operational work over the next decade is ital market. Other analyses focused on bank restructuring likely to be targeted more finely to a narrower group of strategy-to assist in converting the Soviet banking insti- countries, specifically the less-advanced transition countries tutions into market-based ones-and in studies that sought of Eastern and Central Europe. Increasingly, the Bank will to understand the web of relationships between the emerg- withdraw from financial sector work in Central Europe ing banks and the state and private enterprises. and the Baltics, where the focus will be less on undertaking As the transition evolved, so did the nature of the ana- fundamental structural reform and more on meeting the lytic work the Bank performed in the financial sector. As requirements for joining the EU and the euro system (for 253 Siegelbatim and Fleming which EIJ technical assistance will be largely available). simply warehouses for the problems of their cus- This may involve additional help from the Bank in the tomers. As a result, banking and enterprise reform regulatory and supervisory field. What financial sector must move forward in tandem. And this applies as operational work remains will likely be in very specialized well to the slower reformers. It is pointless to reform fields such as housing finance and pension reform. It is pos- the banks if there is no will to reform the real sector sible that from time to time structural adjustment loans- more generally. which also serve to assist governments with budget or bal- * Developing a capacity for banking supervision is a ance of payments financing-will have elements of time-consuming and costly process, yet risks must be financial sector reform as part of them. dealt with even before supervisors are trained and The focus of the Bank's financial sector work in experienced enough to do so to the standards of Eastern Europe and Central Asia will likely continue to be Western economies. on dealing with problem banks. In large part this reflects * As a tool for financial sector reform, foreign bank the slow pace of reform of the enterprise sector and hence and strategic investments are far more effective than the impact of poor enterprise performance on the balance either restructuring or privatization of domestic sheets of banks. Until the real and financial sectors have banks. Indeed, cross-border banking is inevitable in effectively stabilized-with the banking sectors consoli- all the transition economies. dating and becoming stronger in terms of both capital- * Financial sector reform must be seen holistically in ization and efficiency-these countries are likely to expe- the context of the reform of other parts of the econ- rience periodic banking crises. For the foreseeable future, omy that provide support and services analogous to the Bank is likely to have to use the full array of loan banks, such as wage payments, tax administration, products at its disposal to support the financial sector inter-enterprise obligations, and energy payments. reform effort. Again, all these elements must move to a degree in tandem for effective reform to take hold. Lessons Learned * While the development of capital markets holds out The Bank has learned much about the process of finan- the hope that they will provide alternative new fund- cial transiti on during the 10 years or so in which it has been ing sources for the private sector in the longer term, involved with the ECA countries: in the initial phases of reform, their most important * Financial sector transition is not a linear process. It function is as a mechanism for transferring the own- typically is punctuated by banking crises and other ership of enterprise shares. forms of financial dislocation. This is to be expected * It is important to tailor operational interventions to as part of the "financial sector learning process." meet the specific needs of each transition country * Banking crises do not have a profound effect on the and to be flexible in the use of lending products to real economy during the early phases of transition, support financial sector development. yet they do appear to have an enormously salutary * In its most successful financial projects, the Bank impact on the seriousness with which politicians typically works closely with partner international take financial sector issues in the post-crisis period. financial institutions and donors to provide a * The state of the financial sector cannot be divorced groundswell of support for policy reform in client from the condition of the real sector, since banks are countries. 254 Chapter 21 Financial Policy in Transition Economies: An IMF Perspective Stefan Ingves ince the late 1980s, the International Monetary Fund (IMF) has been working with the coun- S tries included in the Europe and Central Asia (ECA) region on various aspects of financial sec- tor reform and development. The ECA countries are defined here to include Albania, Armenia, Azerbaijan, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, the Czech Republic, Estonia, Former Yugoslavian Republic of Macedonia (FYR Macedonia), Georgia, Hungary, Kazakhstan, the Kyrgyz Republic, Latvia, Lithuania, Moldova, Poland, Romania, the Russian Federation (Russia), the Slovak Republic, Slovenia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan. The IMF helped these coun- tries to create two-tier banking systems from the monobanking systems inherited from the formerly centrally planned economies and to develop central banking functions, while promoting the inde- pendence of the central banks. A major objective has been to get the countries to the point where they rely on the use of indirect instruments for monetary management. To this end, the countries have been encouraged to develop instruments for open-market operations and to deepen and integrate money, government securities, and foreign exchange markets. In light of the strong link between the soundness of the encouraged the ECA countries to adopt international banking system and the effectiveness of macroeconomic accounting standards and has assisted them with drawing policy, another objective in assisting the ECA countries up and introducing a modern chart of accounts for their has been to develop the fundamentals of bank supervision central banks. and regulation: organization and staffing, the legal and In the past few years, especially, when some of the regulatory framework, manuals and training programs, banking systems of the ECA countries have come under reporting and off-site supervision methodology and ana- stress, the IMF also has assisted the countries with other lytical techniques, and inspection and follow-up proce- measures to strengthen their banking systems, both sys- dures. Complementary to this exercise, the IMF also has temically and by improving governance in individual I would like to thank my colleagues in the Monetary and Exchange Affairs Department of the International Monetary Fund for their assistance in writing this paper. I would also like to thank the staff of the European I and European ll Departments for their com- ments on an earlier draft. 255 Ingve s banks. This has led not only to enhancing the focus on the The basic challenge over the next decade, from the basics of bank supervision but also, which is even more standpoint of the IMF, is to have countries complete fun- important, to supporting bank restructuring efforts of those damental tasks, while responding to and assisting them in countries. Among other things, this has involved helping an appropriate and timely manner when specific problems some of the ECA countries in developing the principles and arise, even where the fundamental institutions, instruments, practices involved in the closure of insolvent banks; in practices, and procedures are in place. Inevitably, the IMF agreeing memoranda of understanding with bank man- will be guided by certain international standards and best agement t-o improve internal governance, limit lending practices in its assessment of the basic work that remains to operations, and institute loan recovery programs; and in be done in a particular context. determining how the cost of restructuring would be dis- The rest of this chapter assesses where ECA countries tributed among the banks' shareholders, depositors, and now stand and the challenges ahead and states some of the the government. likely responses of the IMF. One difficulty confronted at the The IMF also has promoted sound and efficient pay- outset is trying to group into categories, for analysis, such ment systems in the ECA countries. In the process, it has a large number of countries that have grown even more dis- underscored that the payment system influences the speed, parate in their policies over the past decade. financial risk, efficiency, and reliability of domestic and internationial transactions and that the payment system Banking System Issues affects the effectiveness of monetary policy, among other The ECA countries today face a whole range of chal- ways through its impact on the transmission process in lenges in banking and bank supervision. At one extreme are monetary management, the pace of financial deepening, countries, like Bulgaria, Estonia, Latvia, and Lithuania, and the efficiency of financial intermediation. where the banking systems have been transformed and Particularly over the past two to three years, the IMF appear to be reasonably sound, due to recent measures has emphasized transparency in data collection and dis- (sometimes in response to crisis) to restructure the banking seminaticn, as well as transparency and accountability in system and make changes in management of major banks in the governance arrangements for state enterprises, govern- the system; privatize state-owned banks and foster competi- ment fiscal policies, and monetary and financial policies. tion, including via encouraging foreign entry; capitalize Hence, promoting international standards in the collec- banks in order to bring their capital adequacy at least up to tion and dissemination of statistical data, accounting, and the Basle minimum standards; clean up balance sheets and auditing, together with a sound legal framework for mon- remove existing nonperforming loans, sometimes sending etary and financial policies, has taken on added significance these loans to a work-out unit; strengthen credit appraisal in in financial sector reform. The importance of doing so has granting loans; introduce sound prudential regulations that been heightened by incidences such as the misreporting or conform to best international practices; and further strength- misclassification of data or the discovery of nontransparent en supervision, both off-site and on-site. The major challenge financial relationships between sectors and institutions that for virtually all of these countries is maintaining high stan- had adverse macroeconomic effects. dards in bank supervision, including keeping up with new All of t-is work has been done mainly in the context of techniques for supervising increasingly complex products technical assistance delivered through missions from head- and markets and maintaining adequate and well-trained quarters, short-term expert visits, long-term residence staff. But even among these countries, there are pockets of assignments of experts, and multiple-country (regional) serious weaknesses in the banking system. For instance, workshops. In this work, the experts used have been drawn there is a feeling, in one or two cases, that minimum capital not only from IMF staff but also from current and retired requirements are, at times, met by using questionable devices staff members of central banks and supervisory agencies. that inflate capital. In addition, attaining and maintaining Moreover, in this technical assistance (both in doing the high standards of transparency and good governance will be work and in financing it), cooperation with the World a challenge for these and other ECA countries. Bank and other international financial organizations and At the other extreme are the countries with weak, and wvith governments, central banks, and the United Nations sometimes even fragile, banking systems, like Azerbaijan, Development Programme has been extremely important. Belarus, FYR Macedonia, Georgia, the Kyrgyz Republic, For obvious reasons, the cooperation with the World Bank Tajikistan, Turkmenistan, and Uzbekistan. The qualities has been special, with the two institutions often working as that make these systems weak differ greatly from one case partners in designing a particular program or strategy. to another. Hence generalization is difficult. Depending 256 Financial Policy in Transition Economies: An IMF Perspective on the country, one can find a government that directly inate directed credit and to introduce more sophisticated influences the lending decisionmaking, state enterprises procedures for analyzing credit. Indeed, the countries are that dominate the portfolios of banks, state-owned banks making efforts, but the weak systems are finding it hard to that dominate the banking system, capital adequacy mea- stay the course and to sustain the effort on all fronts. In all surements that are not risk-weighted, and loan classifica- such cases, there is a need to sequence measures appropri- tion systems that are distorted by government guaranteed ately and to encourage the authorities to keep politics out of loans (sometimes resulting from directed credit). In the process to ensure continued progress in strcngthening Turkmenistan and Uzbekistan, some old Soviet habits even the banking systems and bank supervision. persist, such as controls on the withdrawal of cash, resis- In Azerbaijan, for example, some bank restructuring tance to the adoption of international accounting stan- has taken place, but privatization is being delayed. dards, and heavy dependence of commercial banks on the Meanwhile, despite some progress in strengthening bank central bank for loanable funds. All in all, in the weakest supervision, capacity remains inadequate, especially regard- systems, state-owned banks dominate, and their loans are ing resolution of weak and insolvent banks. In some coun- directed overwhelmingly toward state-owned enterprises. tries, the legal framework and procedures (for example, the In many of the ECA countries-particularly those of the lack of a framework for prompt corrective action, a slow former Soviet Union outside the Baltics-a substantial por- and ill-defined resolution process for failed banks, or lack tion of bank assets and liabilities are denominated in foreign of support from the courts in upholding sanctions) are currencies, raising concerns for the vulnerability of the sys- frustrating the process of supervision. tem to exchange rate movements. In addition, in some of As another example, to illustrate the challenges ahead, these same countries, slow economic growth and large in Turkmenistan, the authorities introduced a bank restruc- macroeconomic imbalances (huge budget deficits, unsus- turing program (Presidential Decree 3970) in December tainable balance of payments deficits, and inappropriate 1998. As a result, the total number of banks dropped from exchange rate policies that produce disequilibrium exchange 67 at the end of 1998 to 13 at the end of 1999. Each state- rates given the monetary policy stance), together with major owned bank was given a specific sector of the economy to structural weaknesses due mainly to slow or incomplete service. In addition, the decree formalized segmentation enterprise restructuring, will continue to make banking sys- already present in the banking sector: government enter- tem reforms slow and prevent bank supervision authorities prises and organizations were not permitted to use the from accomplishing their desired objectives fully. For bank- nongovernment commercial banks to conduct their bank ing system soundness and effective bank supervision to business, while the nonstate banks were permitted to pro- become a reality in these countries, fundamental macroeco- vide loans to state sectors. Official figures indicate that nomic and structural reforms must be pursued resolutely. the solvency of banks may not be an immediate concern. Probably a majority of the countries with weak bank- The risk-weighted ratio of capital to assets tends to be well ing systems and weak bank supervision are making efforts over 20 percent, but this ratio reflects the fact that the to strengthen their systems and their bank supervision. In a bulk of lending is to state sectors with a zero risk weight. basic sense, then, the challenge is getting countries to move Hence, the high capital adequacy ratio could overstate the resolutely in addressing the weaknesses. The majority of the capital adequacy of the banks. On the positive side, the ECA countries are being encouraged and advised by the Central Bank of Turkmenistan has made some important World Bank, European Bank for Reconstruction and progress in the area of bank supervision, including new reg- Development, European Union, and the IMF, and some- ulatory standards for the banks as well as improvements in times by the U.S. Agency for International Development and its off- and on-site supervision capacity. other bilateral donors, (a) to restructure their banking sys- In between the two extremes are countries like tems, through improving the legal framework governing Albania, Croatia, Moldova, Romania, Russia, the Slovak bankruptcy proceedings, mergers, change of management, Republic, and Ukraine, that have made good progress in revocation of licenses, privatization, and increased partici- reforming their banking systems and bank supervision but pation of foreign banks; (b) to bring their prudential regu- have yet to achieve desirable levels of soundness in both lations up to the Basle standards; (c) to modernize loan areas. All these countries have access to technical assistance, classification and provisioning systems; and (d) to raise the including from the IMF; the challenge, in a few cases, is to level of their bank supervision and regulation to comply elicit the political will to complete the process that is well with the Basle Core Principles as soon as realistically possi- under way and to resist pressures to reverse what already ble. Where relevant, countries also are being urged to elim- has been accomplished. 257 Ingves In Albania, the Savings Bank holds about 80 percent for further restructuring measures may appear less urgent of bank assets. But, since 1997, its operations have been for some observers. Such complacency risks leaving the circumscribed by a governance contract imposed by the banking system in an extremely vulnerable condition government. That contract restricts the Savings Bank's should economic conditions begin to deteriorate again. operations to deposit taking and investments in Treasury One of the main unresolved issues relates to the future of bills. The purpose of this action was to stop the bank's state-owned banks. The crisis has resulted in a migration of large losses due to mismanagement and to prepare it for bank customers back toward these banks, and there is privatization. In Romania, in the last year there has been substantial support in Moscow for a major expansion in a major cleaning up of balance sheets, some bank mergers, the role of public banks. There is also a need to complete the setting up of an Asset Recovery Agency, and the the financial and strategic audits of the savings bank, strengthening of the institutional and organizational Sberbank, which dominates the banking system, and to framework for bank supervision. But the legal system and determine the conditions under which private and public enforcement remain weak, and some major state-owned banks will be permitted to compete with each other. banks need to be privatized. In Russia, though, there has been substantial progress In the Slovak Republic, important steps have been in strengthening the regulatory framework. The main task taken to restructure and privatize state-owned banks and for bank supervisors is to prevent a renewed accumulation improve the legal framework. The authorities decided to of losses in the banking system. The Central Bank of Russia sell a majority of the state's stake in the Slovak Savings needs to impose prompt corrective actions on weak banks Bank and the state's entire stake in the General Credit and to initiate liquidation of insolvent ones. Political sup- Bank and the Investment and Development Bank. They port is clearly crucial. also transferred nonperforming loans from these three In Ukraine, there has been some encouraging progress banks to the Consolidation Agency and the Consolidation in both bank restructuring and bank supervision, but vig- Bank, injecting capital into them. The effectiveness of the ilance is needed to sustain the effort and continue the Bank Privatization Unit has been improved through exter- reforms. The Bank Supervision Department has been reor- nal technical assistance and the recruitment of additional ganized and staffed, improving efficiency. New capital reg- staff. In addition, the government amended the Banking ulations have been introduced, and provisioning regula- Act in order to strengthen the supervisory power of the tions have been strengthened. An examination manual National Bank of Slovakia, and parliament recently consistent with international best practices has been com- approved a number of amendments to strengthen the bank- pleted, and inspections are being conducted using CAMEL ruptcy law rating. There remains a need to clarify definitions of insid- In Russia, following the banking crisis of 1998, restruc- er and related-party transactions and to further strengthen turing has been slow. In the context of the authorities' loan loss provision and reserve policy. A new banking law strategy discussed with the IMF and World Bank, the that would facilitate bank liquidation has recently been licenses of six large, insolvent Moscow-based banks were passed and its effective implementation should significant- withdrawn in mid-1999, and liquidation of three of them ly improve compliance with the Basle core principles. As is firmly under way. It has on occasion proven difficult to regards bank restructuring efforts, the authorities have move other elements of the process forward. However, the focused on improving the capitalization and operating effi- restructuring agency, ARCO, has made some progress in ciency of the seven largest banks based on action plans restructuring a small number of regionally important agreed with the National Bank of Ukraine in 1999. The banks. A total of 20 banks are under ARCO's administra- capital positions of five of the seven banks have thereby tion. In order to increase the number of banks undergoing improved. Structural deficiencies identified during diag- restructuring, there is pressure to increase the financial nostic studies are being addressed, with several of the banks resources available to ARCO and to ease the criteria for receiving technical assistance from EU-Tacis , while others submitting a bank to ARCO. These pressures need to be are addressing deficiencies on their own. Of five insolvent resisted. Another interesting development in the Russian banks identified during diagnostic studies, three now have case is that higher oil prices and stronger macroeconomic significantly positive capital and are progressing satisfac- performance contributed to an improvement in the finan- torily toward capital adequacy. The two remaining banks cial condition of the banking system during 2000. Many continue to have negative and deteriorating capital posi- banks that would have been judged insolvent a year ago tions and the authorities will urgently need to take appro- now appear to be marginally viable. As a result, the need priate steps to resolve the situation. 258 Financial Policy in Transition Economies: An IMF Perspective Monetary Operations for sterilization purposes, but it has not done so due to cost In the area of monetary operations, countries could considerations and technical legal impediments. usefully be divided into four groups. First, there are those, In Albania, also among the countries in the second like Bosnia-Herzegovina, Bulgaria, Estonia, and Lithuania, group, the Bank of Albania conducts monetary policy with that have a currency board arrangement. In principle, this a view to ensuring low inflation consistent with the overall leaves them little or no room for monetary operations. But macroeconomic objectives in the framework of the these countries do have some monetary policy instruments Enhanced Structural Adjustment Facility and Poverty at their disposal. Bulgaria and Bosnia-Herzegovina, for Reduction and Growth Facility and in the context of a flex- instance, use reserve requirements, but they tend to ratio- ible exchange rate. Monetary policy is conducted through nalize them as a prudential tool. Lithuania uses reserve open-market operations using Treasury bills, typically in requirements, standing facilities, and open-market opera- the form of repos and reverse repos, supported by mini- tions to achieve its principal objective, namely, the stabil- mum lek deposit rates in the Savings Bank. There is only ity of the domestic currency. But it also has backing for the limited participation of private banks in the T-bill and lek domestic currency in gold and foreign exchange reserves, deposit markets, where the Savings Bank enjoys a near- which it maintains well above 100 percent (the backing is monopoly position. The Bank of Albania has been taking currently equivalent to some 140 percent). Bulgaria also steps to develop the secondary T-bill market. In addition, it has excess foreign exchange coverage for its domestic cur- has been phasing out other instruments of direct monetary rency. control, such as removing the floors on the 12-month Second, are those countries, like Albania, Croatia, deposit interest rates. Kazakhstan, Latvia, Moldova, Romania, Russia, and the The third set of countries are those, like Azerbaijan, Slovak Republic, that are well advanced along the road to Tajikistan, Turkmenistan, and Uzbekistan, that have bare- consistent use of indirect instruments of monetary man- ly started down the road of sustained transition to the use agement and policy, even though the interbank money and of indirect monetary management. Depending on the coun- exchange markets may be thin and, in some of the coun- try, this could be for one or more of the following reasons: tries, poorly developed. In those countries, the central lack of independence of the central bank; limited range of banks typically have adequate instruments of monetary monetary instruments, particularly to mop up liquidity; and control, have the independence to apply the instruments, unwillingness to allow market determination of interest have developed a reasonably good framework within rates and exchange rates. Some of these countries continue which to design policies, and are willing to allow market to rely on direct controls in monetary management or to determination of interest rates, given exchange rate policy. depend on intervention in foreign exchange markets as Of course, even countries in this group typically will their major tool for managing liquidity. leave themselves free to use more direct methods of liquid- In Tajikistan, since the scaling down of central bank ity management in "emergency" situations. In addition, intervention in the foreign exchange market, after adopting given the fragile state of the money markets and a lack of a floating exchange rate system, the only instrument avail- real depth and liquidity in those markets, and given a lack able to the National Bank of Tajikistan for managing liq- of deep trust in the liquidity of government securities, some uidity has been credit auctions. The auctions, however, countries do find that the activity in the money and have become ineffective because directed lending has been Treasury bills market can disappear overnight as a result of channeled through them, and thus the amount of credit a slight adverse change in the macroeconomy (especially the offered is not determined according to the liquidity needs government budgetary situation). In Russia, for example, of the system and the interest rate has not been market- the default on government securities, which precipitated the determined. Treasury bill auctions were started about three banking crisis in 1998, as well as the persistence of insol- years ago, with the aim of creating a securities market in the vent and weak banks, has eliminated activity in domestic country, which would permit open-market operations. So money markets, and has diminished the ability of the cen- far, however, the T-bills market has failed to reach a criti- tral bank to engage in effective open-market operations for cal size to enable a start of these operations. the time being. As a consequence, the main monetary In Turkmenistan, apart from reserve requirements, instruments now available to the Central Bank of Russia three other types of monetary instruments are available, in are variations in reserve requirements and a deposit facili- principle, to the Central Bank of Turkmenistan (CBT): ty (which is widel)y used). It has been suggested that the credit auctions, an auxiliary credit facility, and overdrafts Central Bank of Russia might begin to issue its own paper (intraday and overnight). Weekly credit auctions are avail- 259 In g v e s able, in principle, to allocate CBT refinance credits. Access, daily to weekly, the credits were to be collateralized, and which is subject to ceilings, is restricted to banks that corn- interest rates were to be market-determined. Auctions of ply with reserve requirements and have no overdraft. But 28-day central bank bills were to be held weekly, and the credit auctions have been suspended since February 1997; interest rate was to be set by the market. Repo operations since then, foreign exchange sales have been CBT's main were to be conducted as soon as the volume of outstanding instrument of monetary policy for regulating bank liquid- central bank bills would permit. But implementation of the ity. The auxiliary credit facility is available on demand, new system has experienced problems, mainly because of although access is limited on the basis of the same criteria the lack of interest in purchasing central bank bills. In any as credit auctions. In addition, banks can use the facility event, regular credit auctions have been discontinued and only twice a month, and the credit is subject to a ceiling of are now conducted only to meet seasonal liquidity needs; 75 percent of required reserves. It is a facility hardly used. no auctions have been conducted since April 2000. As regards overdrafts, intraday overdrafts are interest-free, In Ukraine, reforms in developing monetary operations whereas overnight overdrafts carry a fee (equivalent to initially resulted in substantial progress such as in the devel- 1.7 times the refinance interest rate). No ceiling is imposed, opment of a secondary market for Treasury bills and and no collateral is required. The overdraft facility is hard- improvement in the short-term liquidity management frame- ly used at the moment. In contrast, there has been heavy use work. But progress has slowed, and even been reversed, due of directec credits, particularly to the agricultural sector. to a difficult macroeconomic situation. The weak fiscal posi- In Uzbekistan, the most important commercial banks tion has required central bank financing, and the ministry of are contro]led by the government and follow policies set by finance has not been willing to pay market interest rates on the Republican Monetary Policy Commission, which prac- Treasury bills. The unattractiveness of Treasury bills has tices selective credit allocation policies. The monetary contributed to the drying up of the Treasury bill market instruments available, in principle, to the Central Bank of and halted progress toward improving the monetary opera- Uzbekistan-namely, reserve requirements, a refinance tions of the National Bank of Ukraine in the secondary mar- facility, sale of certificates of deposit, and credit auctions- ket. In the absence of a well-functioning Treasury bill mar- are not actively used. The instrument used most potently in ket, the National Bank of Ukraine has introduced central liquidity management has been the sale of foreign bank certificates of deposit for liquidity management and is exchange. But targets for the level of gross international aiming to develop the use of this instrument. reserves es:-ablished by the governmioenit have limited the ability of the Central Bank of Uzbekistan to use even this Foreign Exchange Operations instrument over the past couple of years. The countries in Europe and Central Asia cover almost Somewhat between the second and the third groups the whole range of classifications of exchange rate arrange- mentioned Is a fourth group of countries, namely those, like ments used by the IME The currency board arrangements Armenia, FYR Macedonia, and Ukraine, that have ade- have been mentioned. There are fixed pegs against a single quate fundamentals for the use of indirect instruments currency (FYR Macedonia, Turkmenistan) or against a (because cf appropriate independence of the central bank, composite (Latvia), managed fLoating rates with no prean- the existence of a fair range of instruments, and a reason- nounced path for the exchange rate (Azerbaijan, Belarus, the able framework for monetary and liquidity management) Czech Republic, the Kyrgyz Republic, Romania, the Slovak but are having difficulty using the instruments consistent- Republic, Slovenia, Tajikistan, Ukraine, Uzbekistan), and ly for a number of reasons. These include, especially, an independently floating rates (Albania, Armenia, Georgia, unwillingness to allow interest rates and exchange rates to Kazakhstan, Moldova, Russian Federation). move in line with market forccs in difficult economic times. Virtually all the ECA countries operate within unified In FYR Macedonia, in April 2000, the authorities exchange markets. Among them are those, like Kazakhstan adopted a package of measures with the specific aim of and Latvia, that, given monetary policy, allow the level of adopting indirect instruments of monetary management the rate to move in line with market conditions (or have and of movi ng closer to EU standards. The package includ- reserves to stabilize the rate via intervention without sig- ed the removal of bank-by-bank credit ceilings; the increase nificant controls), while there are those, like Turkmenistan, in the allowed intraday use of reserve requirements to 60 that use controls to prevent the rates from attaining equi- percent fronm 40 percent; and changes in the design and librium levels. procedures for credit auctions and central bank bill auc- In Latvia, for example, the authorities use spot and tions. The frequency of credit auctions was reduced from swap auctions in their foreign exchange operations, offer- 260 Financial Policy in Transition Economies: An IMF Perspective ing a range of maturities in their swap auctions. The mar- investing short-term funds. Third, when a government is ket is functioning well. In Turkmenistan, since 1998, when running huge budget deficits and financing them via base the commercial bank foreign exchange window was closed, money creation (borrowing from the central bank), and at the central bank has the only foreign exchange window in the same time there are few safe and profitable local outlets the country. There is also a very high surrender require- for investment funds and foreign outlets are constrained by ment. The major challenges over the next decade, in the a transfer problem (foreign exchange "shortage"), the vast area of foreign exchange, will be to liberalize the market, majority of the banks tend to have excess reserves; there is creating a regime that permits market determination of no interbank market to be made. Fourth, governments were the rate, and to liberalize payments and transfers for cur- sometimes reluctant to allow interest rates on their securi- rent international transactions. The president's foreign ties to rise, typically in consideration of the adverse bud- exchange reserve budget is currently responsible for the getary consequences. Fifth, in the case of government secu- management of foreign exchange reserves. The process is rities, there were sometimes technical problems in the design not transparent and, to the knowledge of IMF staff, has of the instruments (maturity structures, most notably), defi- never been audited. ciencies in the issuance and auction procedures, or restric- In Uzbekistan, there is currently an official rate (used tions on the transfer or use of the instrument in secondary mainly for government transactions and imports of high- markets. Sixth, central bank rediscounting and other fairly priority capital goods) and a commercial bank exchange easily accessible facilities at the central bank sometimes rate. Resistance to adjustment of these controlled rates has hampered the development of secondary markets. fueled an illegal curb market. The success of countries in addressing these problems In the coming decade, the appropriate response would has greatly affected the development (liquidity, turnover, seem to be to continue the attempt to convince countries interest rate spreads, commissions, and use of government with exchange controls and other devices that obstruct securities as collateral and in repo and swap operations) of market determination of rates to implement supporting their interbank money and government securities markets, policies that would permit flexibility and adjustment in which in turn has affected the ability of their central banks the exchange rates in line with market forces. Such an to develop effective instruments for use in open-market approach would leave countries free to choose any operations. The vast majority of the ECA countries have a exchange arrangements they prefer. But then they would be long way to go in having well-functioning money and gov- encouraged to design and implement monetary and finan- ernment securities markets, and the Czech Republic, cial policies that are consistent with ensuring appropriate Hungary, and Poland appear to be much further along the (sustainable, market-related) exchange rates. way than the others. Interbank Money and Government Securities Markets Payment Systems Interbank money and government securities markets, Without exception, the F,CA countries accept the and especially secondary markets, have been slow to devel- importance of the payment system in the financial system, op in the majority of the ECA countries. Many factors have and they are giving serious attention to its overall devel- been at play. In the case of money and government securi- opment. All the countries are paying attention to safety and ties markets, first, there were problems with developing efficiency in their most systemically important systems, the institutional and technological infrastructure (legal, although there are, not surprisingly, often difficulties in organizational, and accounting framework, depositories, determining when particular designs, procedures, and gov- clearing and settlement systems, and telecommunication ernance arrangements have attained acceptable standards systems), followed by the microstructure (primary dealers, of safety and efficiency. The countries also differ in the brokers) for primary and secondary markets. Second, there appropriateness of the development of their payment sys- were risk management issues. Banks took some time to tems, given the actual and prospective activity in the finan- begin to trust each other or to develop appropriate risk cial markets, level and growth of income per capita, and management tools for understanding counterparty risks monetization of the economy. The most advanced systems and setting appropriate limits. Countries with weak or frag- from this perspective seem to be those of the Czech ile banking systems have had particular problems in this Republic, Latvia, Lithuania, and Poland. In particular, all regard. Even government securities-assets with zero risk these countries have a well-functioning, large-value trans- weights in the Basle Accord-often were not considered safe fer system (which includes real-time gross settlement capa- investments when compared to, say, foreign exchange for bility) for large and time-critical payments, while the other 261 Ingves components of their payment systems seem to be working Another issue, likely to be of major importance over at satisfactory levels of operational efficiency, so that float, the next few years, is credit policy in support of payment processing, and settlement delays are not serious prob- settlements. A few of the ECA central banks still see auto- lems. matic lending to cover shortfalls by banks in settlement All the other ECA countries ultimately seem to want to balances, particularly at the end of the day, as a necessary develop RTGS systems to handle large-value and time-crit- part of their role as lender of last resort and as guarantor ical payments. But for budgetary and technical reasons, of financial system stability. For this and other reasons, many of these countries will continue with deferred net set- some of the countries of the region may need technical tlement cr batch systems or with near substitutes to tradi- assistance in the development of credit policy in their pay- tional RTGS systems-all of which seem to work reason- ment systems (limits, collateral, interest rates, and intraday, ably well for the countries concerned-until they can build overnight, or longer-term central bank lending) and its RTGS systems. Bosnia-Herzegovina, Croatia, and FYR relationship with monetary policy. Macedonia inherited systems of state payment bureaus from Yugoslavia and need to replace them with normal Conclusions bank-based systems with final settlement at the central The IMF will continue to provide technical assistance banks. In Croatia, in the spring of 1999, the National to help countries to reform their banking, monetary, and Bank implemented an RTGS system owned and managed exchange systems, all tailored to the needs of the countries. by itself, which operates outside the monopoly state pay- In doing so, it will continue to work cooperatively with ment bureau (known as the ZAP). In Bosnia-Herzegovina, experts from many institutions and organizations, espe- the payment bureaus were scheduled to close by the end of cially current and retired staff members of central banks 2000; the central bank was to have an RTGS system fully and supervisory agencies. operational by that date. In FYR Macedonia, also, the In addition, in the next few years, many of the ECA central bank is working toward introduction of an RTGS countries will benefit from the Financial Sector Assessment system. A few countries, notably Armenia and Georgia, Program (FSAP). The FSAP was launched in mid-1999 in have e-mail systems that can settle payments on a gross response to calls from the international community, in the basis. Many countries, including Albania, Azerbaijan, aftermath of the Asian and Russian crises, for the IMF and Estonia, and Russia, are at advanced stages of developing the World Bank to step up their efforts to help strengthen their RTGS systems. countries' financial systems. The program is designed to All the ECA countries will be encouraged over the identify strengths and vulnerabilities of financial systems next few years to assess their systemically important sys- so as to reduce the potential for crisis and cross-border tems to ensure that they comply with the Core Principles contagion. The emphasis of the program is on prevention for Systemically Important Payment Systems. Indeed, these and mitigation, rather than on crisis resolution, through principles are already being discussed with them in work- the preparation and delivery to national authorities of shops and during technical assistance missions of the IMF. comprehensive assessments of their financial systems. All the countries also seem to want to move away, as Undertaken jointly with the World Bank, the FSAP also soon as it makes economic sense to do so, from paper and involves experts from national authorities and interna- toward electronic payments for retail systems. A major tional standard-setting bodies, particularly in the area of issue facing all the countries is deciding the role of the cen- assessing the observance of internationally accepted stan- tral bank in the development of these retail payment sys- dards, codes, and good practices. The FSAP is a major tems. Some countries want the central bank to play an enhancement to the work (some of it described here) that active (hanrds-on) role in determining which instruments are the IMF has been doing for some time in strengthening the promoted and encouraged and which are discouraged, as monitoring of financial systems, in the context of Article well as in determining the design of the particular instru- IV consultation discussions with member countries. It is ments and systems. The challenge for the IMF and others also the expectation that the FSAP process will prove an advising them is to convince the countries to allow the effective means for identifying areas in which countries interplay c,f market demand and decisionmaking by banks could use technical assistance from both the IMF and the to play the major role, while the central bank and other World Bank. public authorities confine themselves to developing the Finally, economic difficulties often diminish the resolve legal framework and performing appropriate oversight, of countries to sustain reforms, particularly in monetary and for consumer protection and other reasons. exchange policies, while lack of political will and political 262 Financial Policy in Transition Economies: An IMF Perspective interference serve as obstacles in major banking system and excellent context in which to push for major structural bank supervision reforms. For these reasons, the IMF has reforms in the financial sector. It is important to keep in found the process of reaching understandings in the design mind that the financial reforms and the macroeconomic pol- of programs to be supported by use of its resources as an icy measures in such programs complement each other. 263 Index access devices, 223, 224 Banca Agricola, 22 accession, 10 Banca Comerciala Romana (BCR), 22 EU, 5-6 Bancorex, 22 accountability, 214 Bank Consolidation Company (BCC), 22, 74-76 Croatia, 61 Bank Handlowy, 17 accounting standards, 37-39 bank malls, Estonia, 56 Central Asia, 98, 101 Bank of Albania, 259 Kazakhstan, 101, Bank of Estonia, 47 Kyrgyz Republic, 102 bank-dominated financial systems, 29 Russia, 91 banking crises, 4 acquis communautaire, 5, 6 Croatia, 66-67, 71 acquisitions. See mergers resolution, 67-69 action lag, 67-68 Russia, 92, 164 advanced reformers, 16-17 unresolved, 41 Agency for Restructuring Credit Organizations (ARCO), banking reform, 24, 173-187 89, 92-94, 258 all-union, 243 restructuring projects, 94 Bulgaria, 74 aggregators, 223, 224 estimation results for countries and years with high Albania banking reform, 184-185 bank assets, 258 estimation results for countries and years with low currency, 259 banking reform, 186 Alpha Bank, 93 Hungary, 83 analytic studies, 253 implementation, 174-176 ARCO. See Agency for Restructuring Credit modeling and estimation, 182-186 Organizations policy implications, 181 Armenia privatization and, 175-176, 177 bank consolidation, 200 regression results, 179-18 1 financial recovery, 194 Russia, 89-95 assets, bank, 200, 257, 258 banking sector Central Asia, 106 assurance activities, Hungary, 82 Estonia, 49, 50-52, 54 business developments, Estonia, 53-56 income-earning, 201 Central Asia, 97-106 Kyrgyz Republic, 102, 103 Croatia, 65-69 managcment, 54 development, 176-179 Russia, 89-90 economic development, 38 auditing standards, 37-39 efficiency ratios, GDP and, 201 Azerbaijan, 257 Estonia, 47, 50-53 265 Financial Transition in Europe and Central Asia EU and, 8-9 capital, 208 Hungary, 79-85passim adequacy ratio, 84, 209-2 10 IMF and, 256-258 aggregate, Russia, 89-90, 91 inhibitors to development, 195-200 flight, 14 Kazakhstan, 101-102 flow, 221-222 Kyrgyz Republic, 102-103 capital markets, xvi-xvii, 25 progress, 3 Bulgaria, 23 role, 15 Central Europe, 140 services, Hungary, 86 Czech Republic, 153-160 size, GDP and, 35 development, 5 stabilization, 191-192 domestic, 42-43 stanclards, international, 209-210 ECA, 149 Tajikistan, 103-104 Estonia, 52 Turkmenistan, 105 financial systems and, 29-30 Uzbekistan, 104-105 local, 4 see al'so consolidation; supervision Romania, 23 bankruptcy, Russia, 91, 162 Russia, 161-169 banks, 5, 244 Slovenia, 145-151 bad,196, 203 capitalization, banks, 5, 180, 193 Bulga-Lria, 74-76 cash, 193 Central Asia, 97, 100-101 see also currency Croatia, 65-66 Central and Eastern Europe (CEE), 148 Estoria, 49, 53 Central Asia, banking sector, xvi, 97-106 grovth, 243-246 central bank, 212-213 Kazakhstan, 101 coordination and, 62-63 new, 3 Croatia, 60, 63, 71 ownership, 53, 180, 181, 211 independence, 60-62 regulation, 14 role, 21 role, 30, 65-66 transparency, 215, 216 Russia, 89-90 Central Bank of Russia (CBR), 89, 91, 92, 93 state-owned, 14-15, 16, 17, 22, 74-76, 97, Central Bank of Turkmenistan (CBT), 105, 259-260 100-101, 104,193, 243 Central Europe Turkmenistan, 257 consolidation, 143 Uzbekistan, 104 financial recovery, 193-195 barriers, 2.29, 245 stock markets, 139-144 barter, 19;3 central planning, 240 Biochin, 22 Ceskoslovenska Obchodni Banka, 18 bond market, 9 change management, Hungary, 87 Estonia, 50-51 chaotic reformers, 248, 249, 250, 253 Hungary, 78 CIS. See Commonwealth of Independent States Russiia, 161, 162 Citibank, 17 brokers, 140 collateral, Hungary, 78 Budapest Stock Exchange, 19 commercial banks Bulbank, 22 accounting system, 217 Bulgaria, 16, 21-23, 23-25 borrowers, 229 banking, xvi paper, Estonia, 50 financial sector, 73-76, 195 Commission for Securities and Exchanges, 167 inflation, 33 commoditization, 227 Bulgarian Privatization Agency, 76 Commonwealth of Independent States (CIS), 34, 97 business development, Russia, 92 financial recovery, 190-191 266 Index market capitalization, 111 creditors' rights, 39 communication networks, 129 creditworthiness, 241 communism, 26 Croatia, 16, 19-21, 25 companies, listed, 141 banking, xvi, 15 competition, 14, 27, 227, 230, 231-232, 241 financial sector,59-72 Estonia, 57 future, 69-70 compliance, banks, Hungary, 78-79, 87 macroeconomic issues, 60-63 concentration Croatian National Bank (CNB), 61, 62 Hungary, 80 cross-border transactions, 26, 233 Kazakhstan, 101 cross-listing, 126-128 Tajikistan, 104 currency confidence, 22-23, 36, 193 Bulgaria, 73 Bulgaria, 76 Central Asia, 97 Russia, 91, 161-162 EU, 8 consolidation, banks, 4, 198-200 IMF and, 259-260 Central Asia, 98-99 Kazakhstan, 101 Central Europe, 143 loan bonds (OVVZ), 161 costs of avoiding, 200-203 Turkmenistan, 105 Estonia, 47, 50 Uzbekistan, 104 requirements, 37-38 see also monetary operations Russia, 95 Czech Republic, 16, 17-19 Turkmenistan, 105 banking, 4 consumer protection, 232, 233 capital markets, xvii, 153-160 contracts, bank privatization, Bulgaria, 75-76 financial recovery, 193-195 coordination, fiscal and monetary policy, Croatia, 62-63 mass privatization, 140 corporate bonds monetary base, 195 Hungary, 87 privatization, 3, 140, 153-157, 159 Russia, 165 stock market, 146 corporate governance, 26-27, 128-129 legal system and, 167-168 Dacia Felix, 23 Russia, privatization and, 165-167 data mining, 222 corporate liabilities, Estonia, 52 DEBRA, 102 corruption, 24 debt, 23 costs, 228-229 corporate, 33-34 bank consolidation avoidance, 200-203 Croatia, 64-65 financial services, 225, 227-228 domestic, Russia, 163 Internet, 227-228 securities market, Estonia, 51-52 streamlining, Estonia, 49-50 demand and supply, 116 cowboy banking, 243-245 deposit insurance credibility, Hungary, 87 Hungary, 78 credit, 4, 178 Russia, 95 domestic, GDP and, 176-177 depository receipts, 126 households, 84 Russia, 163 Hungary, 84-86 deposits, 216 portfolio, Russia, 91 ratios of, GDP and, 202 ratings, Russia, 165 deregulation, 230 risk assessment, Estonia, 50 desperate reformers, 16, 21-23 credit institutions devaluation, Kyrgyz Republic, 103 Estonia, 47 Development Bank, 22 Hungary, 80, 83 disclosure, 216-217 267 Financial Transition in Europe and Central Asia Czech Republic, 157 European Monetary Union, 70 Hungary, 87 European Union (EU), 25 Russia, 168 Estonia, 53 disintermediation, Estonia, 52 financial sector, 7-9 diversification, Estonia, 50 membership, 5-6 dollarization, digression, 191-192 policy and, 9 domestic investing community, Central Europe, 144 transition economies and, 9-10 domestic markets, Central Europe, 143-144 exchange market, Hungary, 83 double legacy countries, 16, 19-21 exchange rates, 10 Dubrovacka Banka, 20 Estonia, 47 exchanges rules, Hungary, 78 earning assets, 200 Expressbank, 22 ECA. See Europe and Central Asia ECB. Se,? European Central Bank federal loan bonds (OFZs), 161 economic reform, Russia, 161-162, 164 Federation of European and Asian Stock Exchanges economic stability, Central Asia, 97, 98-100 initiatives (FEAS), 147 economies of scale, 130, 229 financial assets of households, Hungary, 82 education, 70 financial crises, xviii, 62 e-finance. See Internet financial deepening and, 189-206 elasticity, 126 future prospects, 204-206 electronic banking. See Internet Russia, 89, 93, 162, 163-164 electronic enablers, 224 financial depth, xviii electronic network, 144 Central Europe, 193-195 enabling companies, 223, 224 comparisons, 191-192 enforcement financial crises and, 189-206,203 Czech Republic, 157 FSU, 190, 193 Russia, 167-168 recovery, 190-193 enterprises financial discipline, 241 loss-making, 196 Kazakhstan, 101 privatization, 245-246 financial industry, integration, 9 Russia, 89, 91 financial institutions, 223, 224 equity markets, 19 EU and, 5-6 Erste Bark, 20 financial intermediary loans (FILS), 246 Estonia, 47-57 financial markets, Hungary, 77-88 banking, 48, 198 new, 84-86 e-finance, 234 financial policy, IMF perspective, 255-263 financial recovery, 194 financial products, 223, 224 Estonian Central Depository for Securities (ECDS), 47 financial restructuring, policies, 217-218 euro, 9 Financial Sector Assessment Program (FSAP), 262-263 Europe and Central Asia (ECA) financial sector, xv-xvi, 3-4, 25-27 homogeneity, xv bank reform and, 217 bank restructuring, 216 Bulgaria, 73-76 supervision, 206-213 Central Asia, 105 transparency, 215 country differences, 15-25 World Bank interventions, 247-248, 251 Croatia, 59-72 World Bank's role in financial sectors, 239-254 depth, 17, 80-83 European Bank for Reconstruction and Development development, 24, 240-46 (EBRD), 31, 174-175, 249 economic development and, 37 European Central Bank (ECB), 9, 10 features in 2000, 14-15 European Council, 5-6 future, 252-254 268 Index GDP and, 34 Hungary, 86-87 health and efficiency, 34-37 Hungary, 80-83 GDP. See gross domestic product initial conditions, 14 Germany, 18 OECD countries, 39 GKO. See government short-term bonds reform and, 36 global depository receipts (GDR), 147 sequencing, 252 global financial markets and the transition economies, xv size, 30-34, global financial sector, xviii Slovenia, 148, 150 global public policy, 233 structure, 33-34 globalization, 126, 211, 221-222, 233 supervision, 41 transition economies and, 233-235 transition characteristics, 189-190 goals, start of transformation, 30 transition economies, 40 government Uzbekistan, 104-105 debt securities, Russia, 164 World Bank interventions, 247-248 financing, 217 World Bank role, 239-254 lending to, Croatia, 61 financial services ownership, 211 Estonia, 49-56 role, Central Asia, 106 Internet and, 228 government securities markets, 261 new world, 222-224 government short-term bonds (GKOs), 161-164passim providers, 223 gray economy, 32-33 public policy implications, 229-233 gross domestic product (GDP) , 30-33, 111 recent trends, 221-229 bank credit and, 178 transition economies and, 233-235 bank loans and, 174 Financial System Assessment Program (FSAP), 210 bank supervision and regulation, 204 firms, listed by market origin, 111 banking efficiency ratios and, 201 fiscal authorities banking reform and, 35, 177, 179-180 Croatia, 59-60 Bulgaria, 73, 74, 76 see also inonetary authorities Central Asia, 99 fiscal-monetary coordination Croatia, 64 Croatia, 60, 62-63 domestic credit and, 176-177 independence and, 62-63 Estonia, 48 fiscal policy, Croatia, 63-65 financial crisis and, 203 foreign banks. See foreign investors financial sector and, 34 foreign exchange, 260-261 Hungary, 81, 83 Hungary, 77 interest rates, spreads, and ratios of deposits to, foreign investors, 17, 18, 19, 26, 113, 180, 210-211 202 Czech Republic, 156 Kyrgyz Republic, 102, 103 Estonia, 54 private sector credit and, 177-178 Hungary, 78, 87 Turkmenistan, 105 Russia, 25, 162 Uzbekistan, 104 foreign listings Central Europe, 143 guarantees, 246 former Soviet Union (FSU) bank consolidation, 198, 204 hampered reformers, 247, 249, 250, 253 banking restructuring and regulation, 195-196 harmonization, financial legislation and regulations, financial recovery, 190-191, 193 Hungary, 78, 86 fragmentation, risk of Central Europe, 143 Hebrosbank, 22 funds, supply of, 199 home savings banks, Hungary, 85 future challenges housing loans, Hungary, 84-85 Croatia, 69-70 Hungarian Banking and Capital Market Supervision, 77 269 Financial Transition in Europe and Central Asia Hungary internationalization, 216 bank consolidation, 199 Internet, 129, 222, 225, 227-228, 233-235 banking, xvi, 4, 14, 15 Estonia, 53-54, 54-56 financial markets, 77-88 financial service and, 228 financial recovery, 195 Hungary, 83, 86 financial sector, 16-17 Investicna a Rozvoja Banka, 20 privatization, 3-4 Investicni a Postovni Banka (IPB), 18 investment banking, Estonia, 54 IAS. See accounting standards investment funds, 119, 120 incentive structure, perverse, 240-241 Czech Republic, 158-159 independence, banks, 5, 216 Russia, 166 industry structure, 222-224 investment, 13 inflation, 32-33, 42, 117, 134, 190, 241-243 individuals, 36-37 Central Asia, 98, 10 productive sector, 5 Croatia, 60-62 investors central bank independence and, 61 Hungary, 82 Kazakhstan, 101 protection, 233 informal payments, 197 rights, 42 information and information technology, 225 Russia, 164, 167 Central Asia, 98 Hungary, 80 joint-stock companies, Russia, 162, 166-167 initial public offerings (IPO), 109-110, 111 Joint-Stock Company Law, 163, 167 Czech Republic, 157-158, 159 institutionalization, 210 Kairat Bank, 102 institutions Kazakhstan, banking sector, 101-102 -building loans (IBLs), 246 Komercni Banka, 18 inveitors, 119-121 Kyrgyz Gas Munaizat, 103 specialization, 70 Kyrgyz Republic, banking sector, 102-103 insurance industry, 121 integrated financial sector supervisory agency (IFSSA), Latvia, foreign exchange, 260-261 212--213 Law about Protection of Rights and Legitimate Interests integration, with European and global financial system, of Investors, 167, 168 Hungary, 86, 87 law enforcement, 40 interbanik money, 261 Law on Credit Institutions, Hungary, 77 interest rates Law on Securities, 155 Estonia, 53 legal environment, 39-41, 117,119, 240 GDI' and, 202-203 amendments, 78 intermediate reformers, 247, 249-250 Central Asia, 98, 100, 106 intermediation, 204 Croatia, 60-62 cost. 203 Czech Republic, 154-155, 156, 158, 159 Hungary, 81 Hungary, 77-79, 85 TajikListan, 103 Kyrgyz Republic, 103 international competition, 26 Russia, 92, 95, 162, 167-168 international developments, 126-130 Turkmenistan, 105 International Monetary Fund (IMF) legal lag, 68 policy, xvii-xviii, 255-263 lending, 174, 199 role, xviii-xix bad loans, 4 International Organization of Securities Commissions consumer, Russia, 89, 91 (IOSCO), Russia, 163 customer, 179-180 international standards, 209-210 Estonia, 52, 270 Indcx growth, 179 reforms, Central Asia, 98 Hungary, 79 stabilization, Central Asia, 97-98 Turkmenistan, 105 see also currency World Bank, 251 monetization, 62, 195-196 lending instruments, 246 money market, Hungary, 83 Lending Tree, 229 mortgage banks, Hungary, 85 lessons learned, 254 municipal deposits, Hungary, 86 liabilities, 257 mutual funds, 119, 120 liability, Russia, 167 Estonia, 52-53 liberal capitalism, 26 see also unit trusts liberalizing economies, Central Asia, 106 licensing, 207 National Bank of Kazakhstan (NBK), 101, 102 liquidation, 91,258 National Bank of Kyrgyz Republic (NBKR), 102 liquidity, 129, 210 National Bank of Romania (NBR), 22-23 Russia, 92, 163-164 National Bank of Tajikistan (NBT), 103 Lithuania, bank consolidation, 199-200 National Bank of Uzbekistan, 104 Ljubljana Stock Exchange (LJSE), 148, 150 Nomura, 18 loan-for-share schemes, 24, 162 non-cash transactions, Turkmenistan, 105 loans. See lending noninterest revenue of banks, Estonia, 54 local, 147-148 nonpayment phenomenon, 196-198, 205 financial crisis and, 203 Macedonia, currency, 260 Nova Kreditna Banka Maribor, 19 macroeconomics, 211 Nova Ljubljanska Banka, 19 issues, Central Asia, 100 principles, Croatia, 63 operating costs, 200, 205 stability, 117 operational work, 253-254 Slovenia, 150 Ost Boerse/Newex project, 143 malpractice, Estonia, 57 OTP savings bank, 16, 17 management information systems, Hungary, 80 outsourcing, banking, Hungary, 86 marketing, bank privatization, Bulgaria, 75 ownership markets shares, 154 capitalization, 111-113, 116, 121-126, 132, 135, Slovenia, 148, 150 141-143, 150 see also government, owned; banks, state-owned discipline, 209 economy, establishment, 23 payment systems, 7, 251, 261-262 players, Hungary, 86 IMF, 256 regulatory barriers between, 222 informal, 197 size, 116 see also nonpayment phenomenon turnover, 113-115, 121-122, 124-126, 133, 135 pension funds, 119-121 mass privatization. See privatization, mass Estonia, 52-53 memoranda of understanding (MOUs), Hungary, 79 Hungary, 82 mergers, 8, 129, 212, 222 pension system, 17 Estonia, 49 reform, 42 monetarist arithmetic, Croatia, 63-65 perception lag, 67 monetary operations personal savings, Estonia, 52-53 authorities, Croatia, 59-60, 67-69, 71 persuasion lag, 68 base, 195 Pliva, 21 IMF and, 259-260 pocket banks, Tajikistan, 103 policy, Croatia, 63-65 Podravka, 21 policy, Uzbekistan, 104 Poland 271 Financial Transition in Europe and Central Asia bank consolidation, 199 rapid reformers, 246, 247, 249 banking, 4, 14 rationalization, Central Asia, 98-99 financial recovery, 193-195 regional, 147 monetary base, 195 regulation, xviii, 4, 14, 27, 181, 195, 204, 205, 208-209, financial sector, 16-17 213, 222 privatization, 3-4, 140 Central Asia, 98 policy, 233 Central Europe, 144 bank consolidation avoidance, 200 framework, 258 banking, 205 Hungary, 78-79 EU and, 9 institutions, 240 financial sector development and, 229-233 local, 210-211 issues, 231-232 reform, 195-196 World Bank and IMF, xvii-xviii Russia, 91 politics, 27, 262-263 Tajikistan, 103 bank supervision and, 216-217 see also legal environment; supervision; transparency Russia, 168-169 rehabilitation program portals, 223, 224 cost, 80 Postabank, 16-17, 22, 79 Hungary, 79-80 Prague Stock Exchange (PSE), 19, 109, 155-156, 159 reluctant modernizers, 16, 17-19 preaccessions strategy, 5 reluctant reformers, 247-248, 249, 250, 253 present status, 30-37 rent-seeking behavior, 24 price bubble, 42 restructuring programs, 215-216 privacy, 233 banking sector, xvi private banks, 175, 205 retail banking, 8, 25 private credit, 123 return on assets (ROA), Hungary, 83-84 private rinancial houses, 24 return on equity (ROE), Hungary, 83-84, 85 private sector credit, GDP and, 177-1 78 Rijecka Banka, 20 privatization, 3-4, 17-22passim, 34, 41-42, 205, 216, risk-free rates, Hungary, 85 243, 245-246, 257 risk profile, 245-246 banking reform and, 175-176, 177 RM-System, 154-155, 156, 159 Bulgaria, 73-76 Romania, 16, 21-23, 25 capital markets and, 140 banking, 15 Central Europe, 139, 140 financial recovery, 195 Czech Republic, 153-159passim RTGS systems, 262 legislation, 162 RTS-Interfax Index, 165 policy, 42 Russia, 24, 25, 258 Russia, 161-167passim banking, xvi, 4, 15, 89-95 Slovenia, 148 capital markets, xvii, 161-169 voucher, 35, 140, 161 consolidation, 198-199, 204 Privredna Banka Zagreb, 20 e-finance, 234 professionalism, 27 financial recovery, 194 Hungary, 79 nonpayment, 197 profitability, 207 public trust, 13-14 Hungary, 86-87 restructuring projects, 92-93 Kyrgyz Republic, 103 Russian Federal Property Fund, 92 Russia, 167 Russian Federal Securities Commission, 168 prolonged crisis cases, 16, 23-25 Promstroi Bank, 102 safety net, 231-232 prudential supervision, 217 savings public relations, 70 Estonia, 53 272 Index Kazakhstan, 102 stock local, 5 ownership, Russia, 166 Russia, 167 trading, privatization and, 154 savings banks, 14, 24, 22, 102 stock exchanges Central Asia, 106 global, 147 Estonia, 53 shifts, 225 savings, individuals, 36-37, 245 world's largest, 128 Russia, 95, 162 stock markets, xvii, 4, 19, 42, 43, 109-137 Czech, 155 capitalization, 35-36 secondary mortgage market, Hungary, 87 Central Europe, 139-144 sector adjustment loans (SECALS), 246 creating, 145-147 Securities and Stock Exchange Supervision, Hungary, 77 Czech Republic, 153, 146 Securities Center (SCP), 153 determinants, 113, 116-124 Securities Commission, 140, 159 development constraints, 147-148 securities law, Hungary, 78 domestic, 43 Securities Market Law, 163, 167 Estonia, 48 securities features, 110-111, 226 Czech, 156 future issues, 148-150 registry, 146 international, 147 Russia, 162 international developments and, 127-130 transactions, 8-9 origins, 110 securities markets, 7-8, 261 prospects, 124-127 establishment and growth, 162-163 shifts, 225 Estonia, 47, 48 Slovenia, 148-150 legal and technical facilitation, 154-155 trading volume, 141, 142 Russia, 161-162, 164-165 transition economies, 111 trends, 165 trends, 148 securitization, Estonia, 52 structural adjustment credits (SACs), 246 security, 233 structural adjustment loans (SALs), 246 seller due diligence, Bulgaria, 75 substance-over-form rule, 38 services, new, 222-224 sunk costs, 229 shareholders supervision, 27, 205, 207-219, 230, 241, 257 protection, 117-119 Central Asia, 98 rights, 39-40, 168 ECA, 208-213 Russia, 168 Hungary, 77 single market and currency, 8 institutions, 210-212 Slovakia, 16-25passim, 258 limits, 215-217 Slovenia links, 216-217 capital markets, xvii, 145-151 politics and, 216-217 financial sector, 148, 150 purposes, 20-208 macroeconomics, 150 see also regulation and supervision; transparency Slovenska Sporitclna, 20 Sweden, Estonia and, 47 South Eastern Cooperation Initiative (SECI), 147 Southeastern Europe (SEE) initiative, 147 Tajikistan specialized institutions, Hungary, 83 banking sector, 103-104 Splitska Banka, 20 currency, 259 stability, macroeconomic, 41 TALSE, Estonia, 48 Stability Pact countries, 147 taxation stabilizing economies, Central Asia, 106 authorities' privileges, 40-41 State Property Committee, 167 avoidance, 197-198 273 Financial Transition in Europe and Central Asia Bulgaria, 73 Ukraine, 16, 23-25, 258 law, 40-41 bank consolidation, 200, 204 Russia, 162 currency, 260 technical assistance, 253, 256 financial recovery, 194 IMF, 262 gray economy, 33 technology, 230 nonpayment, 197 advances, 222 United Bulgarian Bank, 22 Central Europe, 144 unit trusts, Czech Republic, 158 costs, 225 universal banking, Estonia, 47 Russia, 91 unofficial economy. See gray economy securities market, 154-155, 159 Uzbekistan telecommunications, Estonia, 56 banking sector, 104-105 trades, processing costs, 129-130 currency, 260 trading, 126 foreign exchange, 261 equities, 143 methods, 146-147 valuation, bank privatization, Bulgaria, 75 telecommunications, 147 Vishegrad group, 147 volume, Czech, 156 voucher auctions, 153, 154 trading systems, 129 voucher privatization. See privatization, voucher changes, 224 Vozrozhdeniye Bank, 92 traditional banking services, Estonia, 54 Vseobecna Uverova Banka, 20 transformation, goals at the start, 30 transpa.rency, 70, 213-215, 217, 256 Warsaw Stock Exchange, 109 Czech Republic, 156-157 Washington consensus on banking reform, 173, 181 Hungary, 79 World Bank INIF, 256 future, 252-254 key elements, 214 interventions, 247-248, 251 Russia, 91 lessons learned, 254 trends, .5 operational response, 246-251 stock market development, 148 policy, xvii-xviii trust, 25, 26 role in ECA financial sectors, 239-254 culture and tradition and, 13-14 role, xviii-xix truth-arid-fairness principle, 38-39 TSE, Estonia, 48 Yugoslavia, 14, 18 Turkmenistan, 257 banking sector, 105 Zagrebacka Banka, 21 currency, 259-260 zero risk, 210 foreign exchange, 261 274 en vears after the fall of the Berlin VWall. THE WORLD BANK I the countries in Central and Eastern Europe 1818 H Street, NA. and the Commonwealth of Independent WVashington, D.C. 20433 tISA States still face major challenges: although Telephone: 202-477-1234 much has been achieved in the transition to Facsimile: 202-477-6391 market-based democracies, nmiuch remains to Internet: wwwworldbank.org be done. The World Bank has been an active partner in helping countries design and im- E-m ail: feedbaek@w-orl dbanik. org peetterrfrs plement their reforms. The region has witnessed many successes, as well as setbacks, in the transition process. This series of publications is part of the Bank's con- tribution to the debate about the unfinished agenda and possible approaches to future clhal- lenges. The first 14 titles in the series cover the issues of resurgent poverty and inequality, the importance of sound corporate citizenship, strategies for better education systems, social and environmental protection, institution building, investments, and livable cities. This publication was based upon two seminars and a conference on finance in the transition economies that took place, respectively, in Prague and Benesov in the Czech Republic at the time of the World Bank-International Monetary Fund Annual Meetings in September 2000. The seminars and conference took stock of the first decade of financial transition and, with the benefit of hindsight, looked forward to the challenges that will likely be confronted by policymakers over the next ten years. 0-821 3-4814-0