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. The boundaries, colors, denominations, and other information shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal status of any territory or the endorsement or acceptance of such boundaries. The material in this publication is copyrighted. The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. Permission to pbotocopy items for internal or personal use, for the internal or personal use of specific clients, or for educational classroom use is granted by the World Bank, provided that the appropri- ate fee is paid directly to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; telephone 978-750-8400, fax 978-750-4470. Please contact the Copyright Clearance Center before photocopying items. 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 Mark