13. Roundtable on Financial Reforms and Their Implementation

Timothy Lane, D. Folkerts-Landau, and Gerard Caprio
Published Date:
June 1994
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Manuel Guitián1

In this roundtable, we have been asked to address three basic questions that arose in the various sessions of the conference: How to handle the issue of bank portfolios or how to deal with bad debts; how predominant is the role of banks as intermediaries in the process of transition relative to that of securities and capital markets; and how important is the establishment of a sound banking or financial system for the process of reform. I will endeavor to answer those questions in my presentation, though I will take them in inverse order.

The process of transition from central planning to a market regime, to be durable, will require the establishment of appropriate channels for the mobilization and allocation of savings and investment. And judging from the experience of those economies already operating on the basis of market forces, there can be hardly any doubt of the essential and critical role that a sound banking and financial sector plays on these fronts. Indeed, a strong argument can be made that the existence of sound banks and financial intermediaries is a necessary condition for the proper functioning of market-based regimes of economic organization. I hasten to add, though, that it will not be a sufficient condition, as sufficiency will need to be supported by reforms in other areas, a point I hope also to make clear in these remarks.

The development of a sound and competitive banking and financial sector will entail reforms on a variety of levels, including in particular the central bank and the commercial banks. Further down the line, of course, this process will also involve measures related to the securities and capital markets. In this context, I think that in many emerging market economies initial conditions are such that, at least during the early stages of reform, the bulk of resource intermediation will likely be channeled through the banking sector. In fact, then, banks will in all probability play the primary role of intermediaries, with securities and capital markets developing as needs evolve in those economies for diversified financing and asset holding.

In the banking area, reforms will be required to place the central bank in a position to formulate and conduct monetary policy and to ensure that commercial banks contribute, on a competitive basis, to efficient resource mobilization and allocation in the economy. Many of these points have been discussed at length in the various sessions of the conference and there is no need to repeat them here. I will focus my remarks on the specifics of the roles to be played by the central bank and the commercial banks in the reform effort. In the process, I will illustrate the close linkage that binds monetary policy with the soundness and competitiveness of the banking system. And I will also highlight the extent to which banking sector reform will need to be supported by policy actions in other areas and sectors of the economy.

Central Bank Role in Financial Reform

A first requirement for effective financial reform is the establishment of a monetary authority, which typically means the setting up of a central bank with responsibility (and the means) for designing and conducting monetary management. The mere existence of a central bank does not always ensure the presence of a clear monetary authority, however. One important reason relates to the interaction of the government with the central bank that is typical of many emerging market economies. This interaction often involves monetary financing of the budget, thus subordinating monetary policy to the needs of fiscal policy. But there are other obstacles, such as the prevalence of directed credit flows or subsidies channeled through the central bank, that also impair the character and effectiveness of the monetary authority.

The elimination of these obstacles will require establishing an arm’s-length relationship between the government and the central bank, that is, providing a substantial measure of independence to the central bank. In effect, it will require underpinning the central bank’s responsibility for monetary policy with the authority necessary to design and implement it. In general, the degree of central bank independence varies in market economies, and it is generally nonexistent in reforming countries. In the latter, before such independence can be considered, thorny issues like a significant measure of budget balance and the elimination of subsidies granted through the central bank will have to be resolved. Such a situation illustrates clearly the need to undertake reform efforts simultaneously on a variety of fronts. Central bank authority can hardly be expected to be attained or maintained without decisive fiscal adjustment.

One way of introducing the principle of monetary policy independence is through the adoption of simple policy rules. This is the attractiveness of the currency board principle, but alternative rules can of course be devised, such as the establishment of a nominal exchange rate anchor or the pursuit of a predetermined growth rate in the money stock. All these rules will require a good measure of (sustainable) fiscal balance in the economy, however.

Commercial Bank Portfolios

A necessary complement to the establishment of a monetary authority is the development both of a sound banking sector and of ground rules for competition in banking. The prevalence of competition is critical whether the model followed is one of universal or of specialized banks. But there are many hurdles on the road to bank competition for transition economies. Most are a legacy of central planning, and they include undue concentration, unclear ownership and property rules, dependence on official subsidies and budget support, and, most important, portfolio vulnerability.

Thus, I come to the third question raised for this roundtable discussion: the low quality of bank portfolios and how it should best be handled. There are two aspects to this issue: first, a stock problem, which relates to the outstanding debts to banks, and, second, a flow problem, which refers to new bank loans or more generally to the issue of changing prospective bank behavior. I believe this is one of the problems that most needs to be dealt with decisively. Regardless of what prospects there may be for write-offs of bank assets and liabilities (such as arise in the context of monetary reform), there are two basic routes to address the problem. The first (and possibly the most transparent) is the fiscal route, whereby banks would be restored to financial health by capitalizing them by substituting government paper for nonperforming bank assets. This method strengthens the banks at the cost of burdening the government budget with the servicing of the securities issued to banks, so that ultimately, the cost of cleaning bank portfolios falls on the taxpayer.

The second route requires the banks to earn the resources to strengthen their portfolios, that is, that bank profits be used to provision against low-quality assets. The feasibility of this solution depends on the scale of the portfolio problem and the profitability of banks. Ultimately, this method shifts the cost of portfolio strengthening to bank customers.

Both methods, however, give rise to a potential moral hazard risk that should be contained. The risk, as always, results from shifting the costs of the operation from those responsible for the problem (the banks and the enterprises) to others (taxpayers or bank customers). An important issue raised by the presence of vulnerable bank portfolios is the need to support the process of cleaning the banks’ books with a corresponding rehabilitation of enterprises. Here we have yet another illustration of the need to underpin financial reform with policy action on other fronts.

Bank Supervision

Banking reform, to be effective, must include as one of its critical elements the establishment of an appropriate supervisory framework to foster and safeguard the soundness of the sector. There is much to learn, in this context, from the experience over the last decade in many market economies, a period during which they engaged in deregulating and liberalizing the financial sector without, in many cases, taking commensurate measures in the area of supervision. As this experience makes abundantly clear, economic efficiency will be greatly enhanced by deregulation, decontrol, and liberalization, but the effectiveness of the third element will be greatly helped by the adoption of proper supervisory norms. This is so if only because of the clear connection that exists between monetary policy and the state of affairs in the banking system. Policy signals, which typically point in a given direction, can have adverse effects when bank portfolios are unsound. It should not be surprising then that central banks have a legitimate interest in the broad areas of supervision and prudential regulation. Such interest is actually only a reflection of a traditional central bank responsibility: concern for the soundness and the safety of the banking system. This question is independent of the assignment within the government of the responsibility for bank supervision, which is a separate issue that falls beyond the scope of my remarks.

For the emerging market economies, action in the areas of supervision and prudential regulation entails, first, the adoption of measures aimed at prevention, which include regulatory practices such as market entry requirements, capital adequacy rules, balance sheet control criteria, and on-site and off-site inspection procedures. It involves, in addition, steps aimed at protection, which encompass safeguards for depositors, such as those provided by deposit insurance schemes, and safeguards for the financial system at large through the provision of support by exercising the central bank’s lender-of-last-resort functions. Since moral hazard risks can also arise from the operation of these safeguards, it is desirable to define the boundaries, that is, the terms and conditions of the protection mechanisms transparently from the outset.

Implementation of Financial Reform

Progress in financial sector reforms has been made in most economies in transition, but its extent has varied substantially. In general, much remains to be done in the central banking area to establish full-fledged monetary authorities. In addition to the fiscal adjustment required, the relationship of the central bank with the government will have to be defined, the former’s authority over commercial banks established, and adequate supervision introduced.

On the commercial bank front, there remains the problem of vulnerable portfolios in many cases, with the implications involved for the rehabilitation of state enterprises. But in addition, scope for action remains in the search for competitiveness in banking and in the elimination of bank reliance on public resources and subsidies. These problems have been compounded by undue proliferation of new banking units.

Concluding Remarks

A key point that warrants stressing when discussing the transition from central planning to a market system is the similarity rather than the divergence between the experience of formerly centrally planned and market economies. From a fundamental standpoint, the differences in the problems confronting each type of economy are more a matter of degree than a matter of essence. I grant that, when sufficiently large, differences in degree can become differences in essence from a practical perspective. In fact, however, there are elements of markets in centrally planned economies, just as there are elements of nonmarket forces in market economies. What makes the difference, in effect, is the particular mix of market and nonmarket forces that prevails at a particular time. It is, thus, only natural that many of the problems confronting all economies exhibit a significant degree of commonality.

As far as central banks are concerned, only relatively recently has their independence been stressed in market economies as being essential to achieve price stability—the objective now generally accepted as primary for monetary policy—and a consensus that is also of relatively recent vintage. Let us not forget that neither the absence of an arm’s-length relationship with governments nor the extension of subsidies or selective credit flows are exclusive to central banks in centrally planned economies. And with regard to commercial banks and other financial intermediaries, it is not so long ago that their operations were conducted in restrictive settings with ample official administrative interference in the form of credit controls and interest regulations, among other measures.

Given this background, two central points can be thought of as encompassing the essence of the experience in the West that are worth transmitting to the economies in the East. First, focus promptly on the importance of market forces as guides for resource allocation and define as clearly as possible the role of government in the new environment. And second, since the scope of reforms that formerly centrally planned economies need to undertake is so widespread, there is a strong presumption that speed and depth in the reform effort will be essential. Thus, when it comes to the pace of reform, I am with those who favor prompt and broad actions.

Ian Plenderleith

We have been asked to address three particular aspects of the subject matter of this conference. I would like to offer brief remarks on each, and to add two other comments on relevant issues.

First, we are asked how the emerging market economies should deal with bad debts. I would draw a distinction at the outset between external and internal indebtedness. The servicing and repayment of external debt has a critical impact on a country’s external creditworthiness and hence on the terms on which external financing can be raised. External debt needs therefore to be honored in full, and any restructuring needs to be undertaken in an orderly manner on the basis of negotiation in good faith with external creditors.

Internal indebtedness may need fundamental reorganization, and a variety of techniques for handling that task have been discussed at this conference. Many of these techniques undoubtedly have their uses and the question of which, if any, of them is utilized needs to be assessed on its merits in the context of each particular situation. But at a more fundamental level, it may be necessary to conclude that, as when any edifice collapses, some parts are reusable and others are not. In building a new market-based financial edifice for the economy, some of the accumulated internal assets and liabilities may simply not be reusable—however sophisticated the techniques available for renovating or restructuring them. There may then be no sensible alternative to clearing some of them away through appropriate administrative provisions.

Second, we are asked to indicate what should be the priorities in organizing the architecture of the financial system for emerging market economies. My own view is that there should be three priority areas and two key guiding principles. The first priority area should be the banking system, because only an effectively functioning and soundly based banking system can provide the payment system that is in turn an essential artery for any market economy. The banking system can also be an effective source of lending for regenerating business activity in the economy, but I would place the greater priority on the need for an effective payment system.

The second priority area should be secondary markets in financial assets—money market instruments, bonds, and equities. Such markets are important for a variety of reasons, partly because they provide a means of identifying and calibrating the cost of money and capital and for allocating it among competing uses; partly because they enable individuals and businesses to employ their savings and liquid resources at realistic rates by making them available to those who have outlets to utilize them; partly because financial markets provide a means for governments to fund their budget deficits in a noninflationary manner; and partly because they facilitate privatization of state enterprises.

The third priority area should be a coherent legal and regulatory framework to ensure that these avenues of financial intermediation—the banking system and financial market assets—can function reliably and safely.

The first key guiding principle in developing these priority areas is KISS. Complicated and sophisticated structures are neither necessary nor feasible. At the initial stage, it is perfectly possible to develop relatively basic, simple, elemental structures that will deliver all that is needed and the aim should therefore be to “keep things simple” at the start.

The second key guiding principle is to remind oneself continually that many of the necessary structures will develop spontaneously if given opportunity to do so, as indeed has happened in many of the developed economies. The aim therefore should not be to try to develop detailed blueprints to be imposed administratively from on high but to put the emphasis more on managing the process of spontaneous development so that the desired basic structure can be achieved more quickly, with less cost, and with less chaos than if it was left totally to spontaneous forces.

The third area on which we have been asked to comment is how important a well-functioning financial system is to the development of the emerging market economies. My own view is that it should be regarded as a high priority and I have tried to indicate some of the specific benefits earlier. But perhaps what is more important is not where in the pecking order of priorities the financial system should lie, but how quickly one should try to develop the necessary structures. Just as I believe it is important to keep things simple at the start, so too do I believe that gradualism is likely to provide far more effective results than any attempt at a rapid move to a fully functioning free market financial system. The merit of a gradualist approach is that it enables the economy as a whole, which after all the financial system is there to serve, to adapt progressively to the new system—to learn how to use it and what it implies for the way that businesses and government conduct their financial activity. It also enables financial intermediaries themselves to develop the necessary skills, both on the job and through external training. I recognize however that managing change on this scale at an orderly pace places a considerable premium on a strong and coherent administrative apparatus and that the task is not an easy one.

I would like to add two other remarks on the subject area of this conference. First, I feel that it is important to recognize that embryonic markets may need a quite different approach by those who seek to nurture and oversee their development from that appropriate for fully developed markets. Paradoxically, managing the development of a market-based financial system from scratch may mean being prepared in the initial stages to mount on a temporary basis distinctly nonmarket initiatives, and to intervene at times administratively in ways that would be regarded in a full-fledged system as unwarranted interference with market forces, precisely to ensure that the embryonic structures do actually develop along market-based lines.

Second, the points I have tried to make in these brief remarks have direct application for those of us engaged in offering technical assistance in the financial area to the emerging market economies. In trying to help the architects of the new market economies, we need to think through very carefully how we can best contribute to their work in tackling the difficult and daunting challenges they face. We need in particular to recognize that large numbers of technical experts, or missions comprising large teams, and advice delivered in the form of long written reports may be more than they can digest given the day-to-day demands they are already facing. It may be much more fruitful to try to develop informal bilateral working relationships between individual technical experts and local administrators, with more continuous contact between the two maintained through telephone or fax communication interspersed with regular short visits. In this way the focus is on the day-to-day management of financial reform implemented on a gradualist and ongoing basis. The precise needs of the situation will plainly differ from case to case, but the important point is that effective technical assistance may be less a function of the quantum of help given than of the manner of its delivery.

Salvatore Zecchini

In dealing with the European economies in systemic transformation, financial reform is not the proper term or vantage point to use to evaluate what changes are required in the financial system to underpin the growth of a market economy. There are too few components of the old financial system to be reformed and too many have to be created from a vacuum. The determinant characteristic of the old system was the presence of a primitive financial infrastructure that revolved around a functional relationship between the central plan and the public budget on the one side, and the central bank and a few highly specialized institutions on the other. Financial institutions acted mostly as passive instruments to implement the central plan in a rather exclusive and pyramidal division of labor. The payment system was a monopoly of the central bank, while a few institutions were responsible either for deposit taking or for long-term lending to some economic sectors. The most important financial functions, such as maximization of domestic savings, credit creation, and capital allocation, were fulfilled by the central economic plan, through setting price, investment, and income levels, and by the public budget through capital expenditures and taxation.

If the monopoly of the state over the monetary and credit mechanisms led to financial repression, an even more important consequence was financial suppression. As with the rest of the economy, the removal of oppressive regulations through reforms does not automatically ensure the growth of a financial infrastructure that can foster economic development. Two additional factors are also necessary: market forces that prod financial innovation and a legal and institutional environment that provides transparency and enforceability to financial relationships. As these two factors are still lacking in these economies, the construction of an entirely new system of rules, institutions, and market participants is a task that must be addressed squarely, knowing that financial development will not proceed through shortcuts or quantum leaps. It will instead evolve in a sequence of stages as has been the experience of many developing countries. In this sequence, monetization of the economy usually constitutes the first stage. The other stages generally involve expansion of bank intermediation, securitization, and broadening the spectrum of financial instruments and intermediaries. The experience of economic development in many countries over the last two centuries shows that these stages take place in an order that is not generally predeterminable but is influenced by developments in the enterprise sector and in the regulatory and tax environments. In some countries, such as Germany, bank intermediation has been the pivot of financial development. In others, the expansion of markets for securities, such as shares and debentures, preceded the expansion of banking.

In the economies in transition, the actual sequence among these later stages will be determined eventually by the strength of the regulatory environment, the structure of taxation of different sources and uses of income, the ways and means by which public and private firms meet their capital needs, and the risk profile of banks compared with other intermediaries. Laws and regulations have to build confidence among savers and investors about the transparency of transactions, diffusion of economic information, and enforcement of contractual obligations. Taxation might promote or penalize the formation of financial savings, favor the retention of earnings within the enterprise for the purpose of reinvestment, create an incentive for investment in some financial instruments at the expense of others, and discriminate in favor of some financial intermediaries. Public firms tend to continue differing from private firms on the composition of their funding sources. Banks have to clean up their asset portfolios and achieve radical improvements in their operations before they can channel on a market base large flows of savings toward investment.

In exploring the path to financial development, the economies in transition should clarify the objectives that they intend to pursue and their order of priority. In this respect, four goals are of paramount priority: to establish a viable payment and settlement system, to mobilize savings, to raise the efficiency of capital allocation, and to allow enterprises to reach a balanced capital structure.

The old system of separation of the payments circuits, respectively, of enterprises and households and cumbersome clearing systems cannot support the expansion of the economies in transition in which enterprises have to build a new network of relations with suppliers and customers and widen their market scope. To this end, enterprises need, among other elements, a national currency that can fulfill its function as a medium of exchange and a payment settlement system that operates rapidly throughout the domestic market. Of course, these have to be supported by a degree of stability in the currency’s value because high inflation has proved to be an incentive to the substitution of national currency with a foreign currency or to barter trade.

Savings as a ratio to national income were traditionally high under the old system mainly because they were “forced” as a result of direct public intervention in enterprises’ management and in the level of people’s income. At a given income level, which was generally relatively low, households’ decision to save was also influenced by the government by fully guaranteeing a minimum living standard to all citizens and by planning systematic shortages of consumer goods. These factors more than the return on financial assets affected households’ propensity to save. After moving to a market system, these economies must find new market-based approaches to maximize savings to make it possible to fund the massive renovation of the production base that is necessary.

Likewise, once the central plan is abolished, market-oriented mechanisms need to be established to channel savings to enterprises and other users under conditions of allocative and operational efficiency. Such a function was not exercised by the financial institutions in the old regime, and although they are not structured to this end, they are nowadays the only institutions that can be called upon to fulfill this role. Any other solutions would amount to continuing the old direct interference of the authorities with the distribution of capital, leading to inefficiencies in capital use.

Another major objective of financial development, which should receive more attention than is actually given by the authorities, relates to the capital structure of nonfinancial enterprises. Public firms under the old system were mostly endowed with physical assets while they lacked their own capital base, particularly working capital. After moving to the market system, these firms are at a disadvantage vis-à-vis other firms to the extent that their net worth is insignificant, if not negative, working capital is scarce, and dependence on bank borrowing is relatively high, because access to public funds has been curtailed by fiscal stabilization. Imbalances in capital structure, by raising financial risk, hamper the development of the firm, and must therefore be corrected. But this cannot be achieved unless the economy offers to firms a diversified set of funding sources that can be tapped under competitive market conditions.

Against the backdrop of these target criteria, how far have these economies progressed in approaching them? The process of financial development has been set in motion in all the economies in transition through the issuance of a long array of legal measures, but, given the difficulties of implementing them and their incompleteness, the distance from the target is still considerable. After adopting so many measures, these countries should evaluate the progress made before planning a new round of measures: such evaluation might lead to a strengthening of current strategies or to their reorientation. It is not a simple exercise to measure financial development because the quantitative indicators available for these countries are few and approximate, and descriptive indicators do not give a precise picture. Three main measures are presented: broad money/GDP and credit/GDP ratios, and the difference between bank lending rates and borrowing rates. The first two measures can be used to assess the degree of financial intermediation in the economy whereas the third could signal progress in competition and efficiency among banks.

For the four countries under consideration—the Czech Republic, Hungary, Poland, and the Slovak Republic—the evolution of these indicators between 1988 and 1992 does not yet show any clear trend toward the intensification of financial relationships. After the launching of financial reform, credit to the enterprise and household sectors declined significantly as a ratio to GDP. This contrasts with the experience of developing countries in which financial reform and liberalization are usually followed by a sharp rise in the credit ratios. In the four economies in transition, the decline might reflect the prevalence of the effect of monetary stringency, dictated by macroeconomic stabilization, over a possible growth of credit and deposits following financial liberalization. The evolution of the broad money ratio is broadly in line with that of the credit ratio except in Hungary, where a rising trend is evident. In the same period, the interest rate spread has tended to increase sharply in the four economies, indicating that the benefits of financial reform for depositors and borrowers have so far been rather limited. Such a trend seems linked to the need of banks to provision against losses in the face of an asset portfolio characterized by a high proportion of doubtful loans. In such a case, a structural factor rather than a cyclical one appears to hamper the expansion of bank intermediation. Hence, all these indicators point to the same conclusion: that financial development is proceeding slowly.

Leaving aside these measures, progress could be assessed against the four priority objectives of financial reform. Monetization of the economy—the first goal of financial development—is still far from being completed. In the states of the former Soviet Union, the backward payment system and the rapid erosion of the value of the national currency have brought about a revival of barter trade and currency substitution. In other economies in transition, such a backwardness still impedes trade, tends to segment the national market into limited local areas, adds to business risk, and complicates the central bank’s management of liquidity in the economy. After shedding their commercial banking functions, the central banks have not yet succeeded in strengthening their traditional functions of providing a viable payment and clearing system and restoring confidence in their currencies. Of course, there are differences among these countries, with the Czech Republic and Hungary much more advanced than some states of the former Soviet Union. But overall the situation is not satisfactory and more efforts should be deployed.

As regards the mobilization of savings, in spite of the multiplication of deposit-taking institutions, the expansion of the range of financial instruments, and the rise of the return on monetary and financial assets, savings formation, including financial savings, seems driven more by precautionary considerations, given the instability of the economic and social environment, than by progress in financial development and the return on financial assets. Inflation rates remain relatively high in all these countries, except the Czech Republic, and interest rates on deposits have generally been negative in real terms. There is also anecdotal evidence that large shares of savings are kept in the form of real goods or inventory investment rather than in financial assets.

Concerning the financing of investment, improvements in the efficiency of capital allocation have been delayed by the presence of ceilings on bank credit expansion, the low degree of competition in the banking sector, the “lock-in” effect of banks being forced to continue lending to nonperforming borrowers in order to avoid large debt write-offs, and the slow pace of bank rehabilitation. Ad hoc solutions have been adopted in some countries, such as Hungary, which has established an objective for the share of credit that banks have to devote to the private sector. But these solutions tend to multiply the number of public interferences in capital allocation and do not promote efficient market-based mechanisms.

The establishment of markets for short-term securities, medium-term debt instruments, and equity is an important achievement in widening the system of financial sources. These markets are thin, rather illiquid, and have little resilience, however, and therefore they do not yet offer the enterprises sizable funding alternatives to bank credit. In particular, the modest growth of the equity market and delays in privatization have not permitted substantial adjustment of the high degree of financial leverage of the enterprise sector in funding investment expenditure. The increased share of equity in total financial assets has reflected more the gratuitous transfer of ownership rights from the government to private hands than the acquisition of new risk capital by the firms.

Overall, most of the improvement in financial structures has been made in the foundation of a two-tier banking system and the creation of the legal and regulatory framework. Conversely, progress is lagging with regard to the other objectives, especially the emergence of viable financial intermediaries in addition to the government, higher efficiency in capital allocation, and the expansion of markets for financial instruments.

How should financial development be accelerated? What triggers and sustains the expansion of the financial superstructure of the economy? So far, these economies have relied on the government to promote financial progress, but governments have been guided mostly by the urgency of finding nonmonetary means for financing fiscal deficits. The still very limited number of profitable enterprises, together with the slow pace of privatization of nonfinancial enterprises and of bank rehabilitation, have proved to be major stumbling blocks. Owing to their low profitability and public ownership, public enterprises have not been in a position to bolster the growth of sound finance following economic liberalization. Their major innovation has been in “defensive financing” by building up an unprecedented amount of arrears toward other enterprises, banks, and even the fiscal authorities. Without a viable enterprise sector, it is impossible to expect a sound financial system to emerge. The latter is ultimately the mirror image of the former.

Under these conditions, most financial intermediation has inevitably to go through the nonenterprise government sector, because this is the only sector that can provide borrowers and capital suppliers with adequate guarantees of solvency. However, this pattern tends to perpetuate the inefficiencies of the past. Therefore, an essential precondition for financial development is wide-ranging action by the government aimed at restructuring its nonfinancial firms and rehabilitating its banks and financial institutions. Hence, the appropriate sequencing is restructuring and rehabilitation before financial development.

For nonfinancial enterprises, restructuring has to be carried out mainly through privatization, that is, by the new private owners, whereas for the few enterprises that will remain in public hands, new rules for accountability have to be fixed and enforced. For bank restructuring a solution has to be adopted urgently for the stock of bad assets in banks’ portfolios. Among the three main approaches—government bailout, write-offs, and provisioning—a combination of the first and the third seems most justified. Bank loans were granted to public firms as a substitute for the budget transfers that were due either to cover the gap in input-output pricing or to fund working capital needs or investment expenditure. Price liberalization and high inflation have sharply reduced, for the enterprises, the burden of debt that existed at the beginning of the reform process and that was due to the accumulation of past imbalances between input and output prices. Nevertheless, this has not freed public enterprises from their dependence on bank debt because the lack of equity capital and public funding and heavy operating losses owing in part to constraints on labor shedding have forced them into higher indebtness vis-à-vis banks. It seems appropriate for the government, as the owner of these enterprises as well as of banks, to recognize its hidden liability and to take over such a burden by replacing these bad loans in banks’ portfolios with government debt. This substitution should be tied to the privatization of the debtor firm and would involve full or partial debt reduction. A similar reduction should also be applied to those few firms that will not be privatized but have to be restructured. The new government debt should be of long-term maturity and should be serviced through taxation, that is, by calling on all economic sectors to contribute to its repayment. Bank provisioning can be a complementary and secondary instrument to deal with this problem, because provisioning ultimately raises the interest rate spread and the cost of capital to enterprises. In that respect it contradicts the goal of sustaining economic growth by lowering capital costs. The possibility of write-off should be kept to a minimum, since it would lead to bankruptcy of banks and jeopardize the already fragile stability of the financial system.

These measures would eliminate or drastically reduce the stock problem but would not be enough to deal with the problem of flows stemming from the possibility of new loans to nonperforming firms. To deal with the latter, several characteristics of the banking system have to be improved, in particular through privatization and more effective bank management and supervision aimed at enforcing minimum credit standards. The first aspect concerns the ownership of banks. At present, private banks control only a minor share of the banking industry. The majority is in the hands of public banks operating under outdated procedures, with inadequately skilled labor, and subject to the interference of public authorities. Bank privatization has so far been nonexistent, although plans for a very few banks have been made and are expected to be implemented. Given the long tradition of subordinating bank management to the government and its negative consequences in terms of efficiency, it is advisable to shift the majority of banking firms into private hands. Privatization should be pursued taking account of the need to increase competition and to upgrade the management.

Lack of competition is today a dominant characteristic of the banking system in these countries. Since most of the banking industry is accounted for by a few public banks, their privatization could reinforce oligopolistic behavior with deleterious effects on the cost and distribution of credit. To reduce this effect, the authorities should divide their big banks before privatizing them. Such a division raises the issue of optimal bank size or, in other words, what degree of concentration is appropriate to exploit economies of scale without permitting dominant positions. There are no generalized criteria in this respect, but it is clear that the objective is to create competition in banking services in the largest number of local market areas. Even with only a limited number of banks, it is essential that they compete throughout the entire national market and that their collusion is penalized. Of course, the current ceilings on credit expansion and interest rates are incompatible with the objective of greater competition. But the present weaknesses in bank lending practice and in monetary policy conduct allow only a gradual phasing-out of these ceilings.

Upgrading management is a task that requires large investment in training and building up experience, and only the support of major banks from the most developed countries can help fulfill this task in a reasonably short time. It is therefore important that these foreign banks be called upon to participate in the privatization of the public banks in the economies in transition.

The ownership issue has another dimension that is equally critical for a well-functioning banking system: the ownership interrelationship between banks and nonfinancial enterprises. Should banks be owned or controlled directly or indirectly by such enterprises, and vice versa should they own these firms entirely or partially? Both cases are numerous in the economies in transition. For instance, all Central and East European countries except Hungary have opted for the model of a universal bank. In the current early phase of financial development, following a long tradition of bank lending decisions that are constrained by enterprise demands and in the context of weak profitability of firms, it is not appropriate to allow such a close ownership link. These links would mix lending risk with business risk, leading to a situation of moral hazard for the stability of the banking system. The German model of the universal bank cannot be simply copied by these economies because it reflects a historical experience that has nothing in common with that of central planning in the economies in transition. Banks should instead focus on the objective of maximization of financial savings by assigning priority to the protection of the interests of depositors. In this perspective, it would help if the authorities placed statutory percentage limits on the banks’ exposure vis-à-vis any individual borrower and if they monitored the total exposure of each borrower vis-à-vis the whole banking system by establishing a pool of data on enterprises’ total exposure. Information on total bank exposure vis-à-vis each borrower should be circulated throughout the banking system. Only at a later stage, when these economies have matured, does the shift to the universal bank model seem to involve lower risks than at present.

In considering limitations on the range of assets that banks can hold, the question arises whether these economies should aim at a model of bank specialization, with different groups of institutions fulfilling different banking functions. This approach would not constitute a break with the past, as in the old system a division of labor was explicitly planned, with some banks operating only for the collection of savings and other banks specializing in lending to a specific sector of the economy or in carrying out only certain banking transactions. It is doubtful whether functional specialization fosters the mobilization of financial savings and channels a larger volume of funds to the most profitable sectors or enterprises. In contrast, it is clear that lending specialization tends to a concentration of risks and to a stretching of maturity transformation between sources and uses of funds. As financial development requires that stability of the banking system be the priority, functional specialization should be discouraged. Moreover, the old practice of specialized intermediaries providing subsidized lending to priority sectors should be discontinued, since it gives rise to distortions and inefficiencies in use of capital as well as in intensity of investment of capital. In contrast, a specialization implying a separation by asset and liability maturity, as well as by risk profile, between commercial banks, medium- and long-term credit institutions, and investment banks seems justified by its risk-containment effect. It would determine a matching of maturities between assets and liabilities in the balance sheets of the various financial intermediaries and a clear division of risks, with a coherent reflection of these differences in the risk-adjusted rates of return on different types of assets.

The improvement of the structural framework of the banking system serves to build a stable foundation for financial growth, but it is not sufficient to promote efficiency in capital allocation and a balanced capital structure among nonfinancial enterprises. The experience of some developing countries (Chile and Argentina) shows that financial reform and liberalization are not likely to eliminate, at least in the initial period, the preferential access to credit that the old borrowers used to enjoy. This applies equally to the economies in transition, as banks have better information about old firms than new firms, have limited capacity to scrutinize creditworthiness, and can apply nonprice rationing of credit within given ceilings to credit expansion because of the better guarantees offered by public firms. Hence, in the bank-dominated financial system that characterizes these economies, new and more profitable firms, and particularly private enterprises, tend to be at a comparative disadvantage in obtaining bank financing, and improvements toward an efficient allocation of capital could be delayed. A sign of this problem in some Central and East European countries is given by statistical evidence that seems to indicate that the private sector receives a share of credit far below its contribution to GDP formation.

To provide the private sector with a wide range of funding sources and investment opportunities, markets for financial instruments, particularly secondary markets, have to be developed in parallel with the strengthening of banking structures. In the choice between banks and markets, a sequencing that assigns priority to bank intermediation over financial market development does not seem to be the only viable solution for these economies. Historically, securitization has been a component of the early phases of financial development in several developing and industrial countries even before the share of banks’ assets became preponderant in the total of financial assets. In the economies in transition, securitization can stimulate the growth not only of financial markets but also of nonbank financial institutions. These institutions are also an important factor in improving the monitoring of the evolution of enterprises. It seems advisable, therefore, to pursue a degree of complementarity in development between banks and financial markets, knowing, however, that the former, through their payment-settlement systems and their credit function, underpin the good functioning of the latter. Banks are also particularly important in sustaining secondary markets, especially in a period characterized by the paucity of market makers. If economic development in these countries calls for financial widening through the expansion of financial markets, the same cannot be said for financial deepening. Futures, derivatives, hedging instruments, and the like are not essential for economies that are still developing, and they might even divert savings from more productive uses for the economy as a whole.

Besides all these framework conditions, financial development in such economies also depends on a number of policy actions aimed at eliminating nonregulatory impediments and at creating incentives. A major impediment is macroeconomic instability because it diverts savings from financial assets toward real assets. Fiscal and monetary discipline at the same time influences and is influenced by the expansion of the financial infrastructure. The presence of a wide range of financial institutions, instruments, and markets helps both to carry out monetary policy and to buffer the impact of monetary measures on the real economy. Furthermore, it reduces the scope for continuing direct intervention by the monetary authorities in the creation and allocation of credit.

Another impediment is represented by the lack of transparency of information on the state of borrowers, banks, and financial intermediaries. Greater efforts have to be deployed by these countries in setting accounting standards for nonfinancial enterprises and monitoring requirements and rules for information disclosure. Similarly, bank supervision needs strengthening, not in legislation that has already largely been established, but in enforcing prudential regulations. Gaps in the implementation of bank supervision are still wide because of limitations on the availability of skilled human resources.

Other impediments are related to the tendency of the monetary authorities to make it easier and less costly to finance the budget deficit by playing a dominant role in the financial circuit. Credit controls, constraints on banks’ asset portfolios, and expansion of markets for government securities through tax preferences and other inducements could be used to this effect, and in some economies in transition they have already been used. They ultimately tend to distort financial development by crowding out the private sector that should instead be the engine of renovation of these economies. Authorities should therefore aim at balancing preferences and incentives and resist the tendency developed under the old system to grant hidden financial privileges to some public borrowers. A case could even be made that incentives are needed to facilitate the financing of private enterprises. Such incentives could be justified if they cushioned part of the impact that the relatively higher risk profile, compared with public borrowers, would have on the availability and cost of capital for private firms. For instance, some incentives for issuers of and investors in equity should be envisaged.

To sum up, the growth of market economies in the formerly centrally planned countries is critically linked to the construction of financial infrastructures. These are not the automatic outcome of deregulation, or reregulation, or some legal act. Their growth requires three elements to be in place: (1) the existence of distinct saving and investment units that operate in a competitive context; (2) the emergence of sound intermediaries; and (3) the framework conditions under which intermediaries and markets should operate. On the basis of these elements and through the interaction between government, enterprises, households, and financial institutions, bank and financial intermediation can grow and be instrumental in the development of these economies. To this end, the responsibility of the government is not fulfilled just by issuing and enforcing good financial laws and regulations. It also has to complete two crucial tasks: to restructure public enterprises mainly through privatization and to promote the private sector. These reforming countries should be aware of the fact that, ultimately, the soundness of their financial system is based on the health of their real economy.


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The views expressed in the paper are the author’s, and they should not be attributed to the International Monetary Fund.

List of Participants*

  • Lew Alexander
  • U.S. Federal Reserve Board
  • Jeffrey Anderson
  • Institute for International Finance
  • Wayne Angell
  • Board of Governors, U.S. Federal Reserve
  • Andrew Atkeson University of Chicago
  • Guillermo Barnes Ministry of Finance, Mexico
  • Christopher Beshouri Office of the U.S. Comptroller of the Currency
  • Nancy Birdsall World Bank
  • Hans Blommestein
  • Organization for Economic Cooperation and Development
  • Guillermo Calvo International Monetary Fund
  • Stephen Canner U.S. Treasury
  • Gerard Caprio World Bank
  • Joshua Charap
  • European Bank for Reconstruction and Development
  • Fabrizio Coricelli World Bank
  • Daniel Daianu
  • National Bank of Romania
  • Mikhail Dmitriev
  • Russian Bank for Reconstruction and Development
  • Rudiger Dornbusch Massachusetts Institute of Technology
  • Jacob Dreyer
  • Investment Company Institute
  • Amitai Etzioni
  • George Washington University Stanley Fischer
  • Massachusetts Institute of Technology
  • David Folkerts-Landau International Monetary Fund
  • Richard Freeman
  • U.S. Federal Reserve Board
  • Steven Fries
  • International Monetary Fund Peter Garber
  • International Monetary Fund and Brown University
  • Emil Ghizari
  • National Bank of Romania
  • Linda Goldberg New York University
  • Marvin Goodfriend
  • Federal Reserve Bank of Richmond
  • Manuel Guitián International Monetary Fund
  • Diana Hancock
  • U.S. Federal Reserve Board
  • David Humphrey Florida State University
  • Karen Johnson
  • U. S. Federal Reserve Board
  • Barry Ickes
  • Pennsylvania State University
  • George Kaufman Loyola University
  • Stefan Kawalec
  • Ministry of Finance, Poland
  • Patrick Kehoe
  • University of Pennsylvania
  • Patricia Kellogg
  • George Washington University
  • Linda Koenig
  • International Monetary Fund
  • Brian Kurz
  • U.S. Agency for International Development
  • Alexander Khandruyev Russian Central Bank
  • Laurie Landy
  • U.S. Agency for International Development
  • Timothy Lane
  • International Monetary Fund
  • Ross Levine World Bank
  • Millard Long World Bank
  • Jeffrey Marquardt
  • U.S. Federal Reserve Board
  • Diana McNaughton World Bank
  • Michael Mussa International Monetary Fund
  • Tome Nenovski
  • National Bank of Macedonia
  • Daniel Nolle
  • Office of the U.S. Comptroller of the Currency
  • Dimitri Papadimitriou Jerome Levy Institute
  • Mihajlo Petkoski
  • National Bank of Macedonia
  • Ronnie Phillips Jerome Levy Institute
  • Ian Plenderleith Bank of England
  • Jiri Pospisil
  • Czech National Bank
  • Olga Radzyner Austrian National Bank
  • Lex Rieffel
  • Brookings Institution
  • Liliana Rojas-Suárez International Monetary Fund
  • Jacek Rostowski University of London
  • Randi Ryterman World Bank
  • David Scott World Bank
  • Marcelo Selowsky World Bank
  • PieterStek Ministry of Finance, Netherlands
  • Samuel Talley World Bank
  • Imre Tarafas
  • National Bank of Hungary
  • Kevin Villani Consultant, World Bank
  • Michael Spencer International Monetary Fund
  • Bruce Summers
  • U.S. Federal Reserve Board
  • Georg Winckler University of Vienna
  • Shahid Yusuf World Bank
  • Salvatore Zecchini Organization for Economic
  • Cooperation and Development

The affiliations listed were those in effect at the time of the conference (June 1993).

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