Pavel Racocha: Joining the EU - Impact on the financial sector of new member
states
Speech by Mr Pavel Racocha, member of the Board of the Czech National Bank, delivered at the
conference entitled "The Single Market for Financial Services in the EU and Its Impact on
Globalization", Sydney, 3 November 2003.
* * *
On May 1st, 2004, ten countries will join the European Union. Will the transition proceed smoothly?
The main concern related to new countries joining the EU, from the point of view of the financial
sector, is what impact the enlargement will have on the functioning of financial markets in new
member states. Will competition in financial services increase and place a strain on institutions in
accession countries or in the EU as well? Will there be visible impact at all? The new member states
consist of eight former transition economies and of Malta and Cyprus. I will focus on developments in
the transition countries, and especially in the Czech Republic, which I know best. I will also try to make
reference to other accession countries to show that the results of developments over the last thirteen
years, at least in the financial sector, are not so different.
This brief presentation cannot do more than deliver only a basic description of the past development of
financial markets in the transition countries and of their current standing. Hopefully the data from this
presentation can serve as background information for those interested in further studies.
The financial sectors of the new Accession Countries have undergone huge and substantial reforms
over last 13 years. When communism collapsed, there were no traces of a market economy, no free
and legal entrepreneurial economic activity, and no institutions necessary for the functioning of a
market economy. If we look at the transition economies - which represent 8 out of 10 acceding
countries - today, we see a completely different picture. The basic institutions are in place and running
(though sometimes slowly and not always predictably). The private part of the economy flourishes and
is the symbol of a new and well functioning economy. How did this happen? And what happened to
the financial sector? And what will be the impact of the accession to the EU on the financial sector,
which in the accession countries is synonymous with the banking sector.
In 1990, the average starting point for reforms in the former socialist countries, the situation in the
financial sector was bleak. There were no services aside from basic banking and insurance functions.
The banking sector was comprised of few specialized institutions, each of them a monopoly in its own
area [one institution had monopoly on collecting deposits from the public, another institution provided
all the foreign trade financing, and yet another institution was allowed to open accounts for individuals
with foreign exchange incomes]. Then there was a monobank, the most important financial institution,
which performed both functions, of a commercial bank and of the central bank [however skewed that
could have been in the centrally planned economy]. We should also understand that commercial
banking was not about evaluating loan applications and looking at projects' fundamentals or clients'
credentials. In the former socialist countries, there was a State Planning Commission that decided how
much of certain production would get produced and by whom. The role of the banks was limited only
to finding funds for financing the planned production.
It is important to acknowledge the situation at the outset of economic and political reforms. This would
also help us to understand some of the problems that the transition economies went through later on.
Thirteen years ago there were basically no real banks, no capital markets, no experienced staff and no
experienced management. In addition to that, there was no capital in the banks. The ratio of capital to
banks' assets was on average well below 1%. At the same time, there was a boom in entrepreneurial
activities, with tens of thousands of new companies sprouting up. Their common characteristic was
that they had no history, no experience, no capital, but great need for debt financing. On top of this, all
the laws were changing, institutions [such as prudential banking supervision] were built only gradually,
and the state as decisive owner in the banking sector was not up to its duties as good manager. As
said above, the banking sector represented the crucial part of the financial sector of the country.
Therefore, it was also the one to be hit the most seriously in the course of the economic reform,
especially on the credit allocation side. On the contrary, deposits continued to grow despite the
negative real interest rate.
The economic transformation included deregulation of most prices, thorough foreign trade
reorientation [after the collapse of the Soviet Union], enterprise privatization, tax system changes, and
foreign exchange liberalization. Given the depth of the economic transformation, the transition
countries achieved relatively quickly a generally stable environment after the initial shock.
This could be illustrated on the table describing developments in the Czech Republic, Poland and
Hungary in terms of inflation and GDP growth:
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
CPI
Czech R. 52,0 12,7 18,2 10,2 7,9 8,6 10,0 6,8 2,5 4,0 4,1 0,6
Poland 60,3 44,6 37,7 29,4 21,8 18,8 13,2 8,4 9,8 8,6 3,6 0,8
Hungary 35,0 23,0 21,9 21,6 29,2 20,3 18,8 10,5 11,4 10,2 6,8 4,8
GDP
Czech R. -11,6 -0,5 0,1 2,2 5,9 4,3 -0,8 -1,0 0,5 3,3 3,1 2,0
Poland -7,0 2,6 3,8 5,2 7,0 6,0 6,8 4,8 4,1 4,0 1,0 1,4
Hungary -11,9 -3,1 -0,6 2,9 1,5 1,3 4,6 4,9 4,2 5,2 3,8 3,3
EIU Country data, national statistics
As already mentioned, since the financial sector consisted mainly of the banking sector, the impact of
economic reform was felt mainly by the banks. There was no alternative source of financing for
corporations, so difficulties in the corporate sector were passed on directly to the banks. The situation
was complicated more by the fact that the government owned some of the most important
corporations, as well as the main banks. Political rationale preceded economics. In most of the
countries, the privatization of most firms happened early in the transformation process. Banks were an
exception to this, and in different countries, the approach to privatization of banks varied. In the Czech
Republic, the privatization of banks had been delayed for several years due to the government's belief
that privatized banks would stop providing soft loans to strategically important firms. This fear was
underlined by the experience with foreign banks that were entering the market since 1992 and
cherrypicking their clients. After several years, the bad debt burden on banks' balance sheets reached such
a scale that government had to step in. Most of the debt ended up with a special governmental agency
and the losses are being paid from the state budget. The cost of the bank clean-up in the Czech
Republic is estimated at approximately 21% of GDP. In some other countries [Hungary, Poland], the
privatization of banks proceeded quicker and the fiscal costs were substantially smaller [est. 6% for
Poland, 13% for Hungary; in Szapáry, National Bank of Hungary, 2001].
Given what I have just described, the financial sector in the accession countries is nowadays in
remarkably good shape. The banking sector is sound and stable, the role of non-banking
intermediation is growing, and clients have access to most of the products and services they have in
the EU countries.
Following table illustrates the importance of the banking sector in three major accession countries
[Czech Republic, Hungary and Poland]:
Structure Structure of of Financial Financial Sector Sector
100%
90%
80%
70%
Credit Unions
60%
Other
Pension funds
50%
IC&IF
Insurance comp.
40%
Banks
30%
20%
10%
0%
CR HUN POL
6
It is evident that the financial sector in Central European countries relies heavily on the banking sector,
which represents approximately 80% of total assets of the whole financial sector. It could be also seen
that despite the dominance of banks in all mentioned countries, the structure of other financial
institutions differs significantly. This is the result of varying approaches to building these institutions.
For instance, in the Czech Republic, we can see the smaller size of the investment business as a
result of the quality of the capital markets, the lax regulation at the beginning of the transformation,
and the subsequent and rather frequent occurrence of frauds in the past. The delayed start of pension
reform has also contributed to this situation.
The largest banking sector in the new member states is the Polish one, followed by the Czech and the
Hungarian sectors. These three biggest countries account for more than 3/4 of the total new member
states banking assets. The banking sector of all new member states is nevertheless very small in
comparison with the EU market. The total banking sector assets in all new member states are only
345 USD billions at the end 2002 (thus just 31,5% of Citigroup, or 43,4% of Deutsche bank, or 45,5%
of HSBC).
Structure Structure of of ACs ACs Banking Banking Sector Sector Assets Assets
2%1%1%
2%
POL
3%
CZ
7%
HUN
CYPR
38%
7%
SVK
SLO
LAT
LIT
15%
EST
MALTA
24%
* As of 31st Dec 2002, recalculated by market exchange rate
A look at financial depth [as measured by banking sector assets to GDP] of individual markets in five
accession countries [Czech Republic, Hungary, Slovakia, Poland and Slovenia] shows that there is still
significant space for growth of financial intermediation. Financial depth in the CR is the highest among
the transition economies, but it is still significantly lower than in the EU [EU average 270%].
Financial Depth (Bank Assets/GDP in %)
Financial Depth (Bank Assets/GDP in %)
130
120
110
100
CR
90
HUN
%
SVK
POL
80
SLO
70
60
50
40
1996 1997 1998 1999 2000 2001 2002
7
Besides developments in banking, we can observe continuous growth also in non-banking financial
intermediation [illustrated by Czech Republic]. In the Czech Republic, the share of non-banking
financial intermediation on GDP increased over last two years from 19% to 21,7%. The highest
increase was in the share of insurance companies and financial leasing institutions. However, the
majority of these non-banking financial intermediators is controlled by financial groups headed by
commercial banks. A relatively low share of investment companies and investment funds were
negatively influenced by missing regulation and supervision in this field, however, there has been
gradual improvement in recent years. In the area of pension funds we also witness gradual
improvement caused mostly by government incentives, but we can expect quicker development if the
government proceeds with intended pension reform.
Increasing Increasing Role Role of of Non--banking Non banking
Intermediation Intermediation
9,0
8,0
7,0
6,0
Insurance C.
Financial Leasing
5,0
Investment C.
Pension Funds
4,0
Other
Credit Unions
3,0
2,0
1,0
0,0
1996 1997 1998 1999 2000 2001 2002
1996 1997 1998 1999 2000 2001 2002
Total 21,2 17,9 18,6 20,0 19,0 20,6 21,7
The banking sector generally consists of previously state owned banks [since privatized to foreign
banks], new banks established after 1990 as private institutions, and subsidiaries and branches of
foreign banks. The approach to bank privatization differed in the new member states, but the results
are now rather comparable. The banking sector is dominated by institutions governed by foreign banks
[mainly from the EU], with exceptions being Slovenia, Malta and Cyprus.
Role Role of of Foreign Foreign Banks Banks
100%
90%
80%
70%
60%
Domestic Private
50% State
Foreign
40%
30%
20%
10%
0%
EST CR LITH SVK* POL LAT* HUN* Malta SLO Cyprus
* Percentage of foreign owned capital, other share of the assets controlled by
9
foreigners
Who are the main players in the market of the new member states? Among the most influential
institutions in the region we find Krediet Bank Bruxelles from Belgium, Erste Bank and Raiffeisen Bank
from Austria, HVB Group and Bayerische Landesbank from Germany, Societé Generale from France
and Unicredito Italiano from Italy. The limited group of non-EU banks is lead by Citibank and GE
Capital. Unlike in Central Europe, in the Baltic states the foreign investors come from the
Scandinavian countries, mainly Sweden and Finland - Hansabank, Group Nordea and Sampo Bank.
Role of Foreign Banks
Role of Foreign Banks
Total
republic
5-
Poland Croatia
Hungary Slovakia Bulgaria
Slovenia Romania
Czech
CEEC
KBC Bank 7 15 3 15 7,5
Bayerische Landesbank 9 0,2 1,2 0,1
Intesa Bci 8 18 2,3 14
HVB Group 6 5 4 7 3 5,9 6 7 2
Raiffeisen 5 1 9 1 2 2,2 7 4 4
GE Capital 3 3 0,6
1,5
Citibank 3 3 3 6 4,3 3
Erste Bank 3 16 15 6 7
Societe Generale 9 0,4 9 3,3 5 8
UniCredito 2 8 27 19 0,5
3,9
* Market shares of Controlled banks multiplied by their capital share, end of
20
As said above, the economic transformation had a large negative impact on balance sheets. Banks
tended to lend to previously existing companies undergoing privatization that were faced with a
sudden loss of foreign demand (mainly from Soviet Union) and had to restructure themselves by laying
off a big part of their workforce. This proved to be a recipe for financial disaster. Financing of newly
established companies with no track record, with business plans based more often on good intentions
than on thorough analysis was no better. In addition, the political elite, who saw bank financing as the
quintessential source of economic growth, encouraged this lending boom. Existing risks were widely
disregarded. This inevitably led to a very grim situation in the banking sector, where many of the newly
established banks collapsed under the burden of bad debts. The state-owned banks had to have their
capital replenished by the government. Balance sheet cleaning was also one of the preconditions for
banks' successful privatization in the late 90's.
BS BS Profitability Profitability
1 5
0,8 4
0,6 3
0,4 2
Gross profit/
assets in %
Net interest
margin in %
0,2 1
0 0
-0,2 -1
-0,4 -2
1995 1996 1997 1998 1999 2000 2001 2002
12
Nowadays, the existing banks are well capitalized, the level of bad loans is relatively low and adequate
provisions and reserves are made. Despite the decreasing net interest margin, the profitability has
improved, especially thanks to an increasing portion of banks' income coming from fees and
commissions.
Improved Improved Indicators Indicators of of Financial Financial Health He alth
40
35
30
25
Capital Adequacy
Classified Credit
%
20
(weighted)
Quick Assets/Total A.
15
10
5
0
1995 1996 1997 1998 1999 2000 2001 2002 1H
2003
Profitability Profitability
Return on Equity
40
30
20
10
0
-10
Banks- ROE
Insurance Comp.
-20
-30
-40
-50
-60
-70
1995 1996 1997 1998 1999 2000 2001 2002
21
The legislative and regulatory framework has been already harmonized with the EU requirements.
Special missions of experts from the EU countries have confirmed this in all of the new member
states. However, the acqui communautaire are still developing and improving. This represents
additional challenge for the new member states, since they must first adopt the existing rules, and also
get ready for the coming changes.
The new member states are ready for application of Single Passport policy [it basically means that any
bank from any EU country could provide services in the whole EU without additional licensing
requirements.]. Since the domestic banking markets in the new member countries are competitive
enough and have already a strong presence of foreign institutions, this should not lead to dramatic
changes in lending in these countries.
Being a part of larger economic area, with banking sectors dominated by foreign institutions, will
represent a new challenge for bank supervisors. The need for greater and more efficient cross-border
cooperation will probably lead to changes in focus of the supervisory agencies.
After their accession to the EU, I do not expect any contagion effect among the Central European
countries in case of difficulties of one of them. The institutional investors do not any longer view these
countries as very coherent group. This assertion can be illustrated on developments of the exchange
rate over the past two years. We can observe that the developments in the individual countries have
little in common and the exchange rates followed paths reflecting domestic developments in the
individual countries.
Contagion Among CEEC Countries?
Contagion Among CEEC Countries?
120
115
110
105
CZK/EUR
PLN/EUR
100
HUF/EUR
SKK/EUR
95
90
85
80
8.7.03
16.6.03 30.7.03 21.8.03 12.9.03
03.09.2001 25.09.2001 18.10.2001 09.11.2001 03.12.2001 28.12.2001 22.01.2002 13.02.2002 07.03.2002 29.03.2002 23.04.2002 17.05.2002 10.06.2002 02.07.2002 25.07.2002 16.08.2002 09.09.2002 01.10.2002 23.10.2002 15.11.2002 09.12.2002 06.01.2003 28.01.2003 19.02.2003 13.03.2003 04.04.2003 29.04.2003 23.05.2003
14
Discussion needs to continue about potential risks, such as increased competitive pressure or
implementation of new sophisticated financial products. It is also expected that some of the most
sophisticated risk management techniques will be done on group wide level and thus outside of the
host country jurisdictions. There will be some risks and potential threats arising from the changes. But
at this time, there is not a single specific risk that would threaten to disrupt the banking and financial
services in the new member states after becoming part of the single market.
Capital markets in the new member states were previously non-existent. In the Czech Republic, a
capital market was developed as a "byproduct" of the voucher privatization. Introduction of regulation
and supervision was delayed and the Securities and Exchange Commission was created only a few
years after the market had existed.
The capital market is stagnating as a result of voucher privatization, during which the number of
shares congested the market. This subsequently lead to large de-listing of the number of shares from
the market (the number of shares traded now is 23 times smaller than in 1995, just after the voucher
privatization). The market was also plagued by frauds and non-transparent behavior. The volumes and
market capitalization has stagnated, 88,5% of total volume is concentrated into 5 shares. There has
never been any IPO, and even the good companies are de-listed from the market after their
privatization (such as Ceska Sporitelna, the largest Czech retail bank). Capital markets in some of the
other new member states function arguably better than the Czech one, nevertheless their significance
is also much less than in more developed countries. The aggregate equity market capitalization in all
new member states represents less than 2% of market capitalization in the EU. The Warsaw Stock
Exchange is the largest one in the region [40% of total].
PSE-- PSE Basic Basic Data Data (Shares) (Shares)
600 000
560
540
500 000
520
400 000
500
Marcet Cap. (L.A.)
480
300 000
Volume (L.A.)
PX50 (R.A.)
460
200 000
440
420
100 000
400
0 380
1994 1995 1996 1997 1998 1999 2000 2001 2002
1994 1995 1996 1997 1998 1999 2000 2001 2002
22
Number of Traded Shares 1024 1698 1628 300 283 181 142 100 79
In bond trading, the situation is slightly more optimistic. The volume traded is approximately eight
times the size of share trading and there is much higher liquidity. Continuous increase in volume is
mainly due to the issuance of new public debt.
PSE-- PSE Basic Basic Data Data (Bonds) (Bonds)
2 000 000 1400
1 800 000 1350
1 600 000 1300
1 400 000 1250
1 200 000 1200
Marcet Cap. (L.A.)
1 000 000 1150
Volume (L.A.)
PXD
800 000 1100
600 000 1050
400 000 1000
200 000 950
0 900
1994 1995 1996 1997 1998 1999 2000 2001 2002
1994 1995 1996 1997 1998 1999 2000 2001 2002
23
Number of Traded Bonds 27 48 80 92 98 95 94 82 72
What will the future bring to capital markets? It is evident that with limited share trading, there is not a
very rosy future ahead. There are discussions about merging the markets in the region and possibly
joining some European Stock Exchange. There are some speculations about the Stock Exchange in
Vienna wanting to be the market for the region [Vienna is the second smallest SE in the EU.].
However, individual countries would prefer to either remain independent, or to cooperate more closely
with some bigger partners - such as the Frankfurt Stock Exchange.
As shown above, the financial sector is generally in good shape. There are some differences among
the individual parts of the financial sector, but the main part [the banking sector] is as sound and
strong as never before. This is due to several reasons, such as the improving legal environment,
improving management, or even outright government financial assistance in the past. However, the
greatest difference is due to the privatization to foreign banking institutions. These institutions have
brought all the necessary components for successful long-term banking.
The legislative and regulatory framework has been harmonized with the acqui communautaire. The
harmonization has been confirmed by EC Peer reviews and by the multinational financial institutions
(such as the IMF and World Bank during their FSAP process). Of course, there is still a lot of work to
be done. The legislation and regulation shall be more streamlined, the area of law enforcement needs
to function more efficiently, changes in accounting standards must be made. But these tasks are not
related purely to the EU accession. They would have to be done under any circumstances.
The financial sectors in the new member states are functioning efficiently, and are stable and
competitive. The majority of financial sectors are in foreign hands, well capitalized and well managed.
Institutions from the EU are governing the largest financial institutions in the new member states.
Introduction of the Single Passport policy will mean a change only de iure, not de facto. Foreign
institutions that wanted to provide their services in the new member states are already present there. I
do not expect any rush of new players to the new countries of the European Union. It is more probable
that with increasing living standards of the population, the space for new financial products'
penetration will increase as well. I expect to see increased competition in this area, as already
established institutions compete for new clients. It is unlikely that many new financial institutions will
enter the market, because the market is already saturated, and players who had a strategic interest in
Central Europe have already established themselves.
Authorities from the new countries are already participating in committees and working groups
established by the European Commission and European Central Bank, so that rules, as well as the
policy thinking are being coordinated and harmonized.
Challenges from the EU accession will therefore not represent any major risk. The problems and
challenges that the new member states will face are not any different from those that are faced by the
"old" member states, such as implementing the new Basle Capital Accord, implementing the IAS,
increasing cross-border cooperation, monitoring activities of large complex financial groups, evaluating
new complicated financial products, understanding risk transfer among different financial institutions.
The transition will greatly benefit from the hard work that has been done during the economic transition
and during the preparatory stages for the EU accession. It will be smooth and I do not expect any
disruption of financial service in the new member states, or in the EU as a whole.
It could be said that the financial sector is already in the European Union.
Useful links
Useful links
• pavel.racocha@cnb.cz
• www.cnb.cz Czech National Bank
• www.nbp.pl Polish National Bank
• www.nbs.sk Slovak National Bank
• www.mnb.hu Hungarian National Bank
• www.bis.org links to other national banks