Furthermore, in contrast to the _CIS_ and<sup>the</sup><sup>_Baltic_countries where non-performing loans were</sup> generally accumulated during the transition<sup>process, the main cause of banking unsoundness in the</sup><sup>_CEEs_</sup> was the large amount of inherited bad debt<sup>that had not been wiped out by hyper inflation. Since the</sup> newly-commercialized banks were<sup>not viewed as responsible for these bad loans, the</sup><sup>_CEE_authorities</sup> chose to restructure and recapitalize<sup>these banks despite the high costs (section 4). Interestingly and</sup> contrary to what one would expect, despite<sup>their higher level of government indebtedness at the onset of</sup> banking crises, the _CEEs_ did not pursue<sup>a less costly approach to crisis resolution than the other two</sup> country groups.

In addition, financial intermediation was<sup>deeper in the</sup><sup>_CEEs,_and some of the troubled banks were</sup> considered "too big to fail". Given<sup>their size, liquidation would have meant wiping out most of the</sup> banking system, imposing huge economic<sup>and political costs. As a consequence, in the</sup><sup>_CEEs_(with the</sup> exception of _Bulgaria),_ resolution of the<sup>banking crises did not result in any significant downsizing of the</sup> number of banks in the banking system.<sup>Indeed,</sup><sup>_Bulgaria_was the only country among the</sup><sup>_CEEs_that</sup> experienced a significant reduction in the<sup>number of banks, while in</sup><sup>_Hungary_and</sup><sup>_Macedonia_the number</sup> of banks in the system actually increased<sup>through the 1990s.</sup>

# **a. Privatization and Foreign Entry**

In some of the transition countries, operational<sup>restructuring involved privatization of banks,</sup> including to foreign investors. The experience<sup>appears to be that privatization was the best way to</sup> achieve the goal of operational restructuring,<sup>which is to improve the corporate governance of banks.</sup> The countries' experience shows that if<sup>privatization resulted in dispersed ownership or cross-</sup> ownership by enterprises or even the government,<sup>it did not improve corporate governance. This was the</sup> case for all the banks in the _Czech Republic_<sup>after voucher privatization at the beginning of transition, the</sup> state banks in _Georgia, Postabank_ in<sup>_Hungary,_and still the case in many of the banks in</sup><sup>_Macedonia._</sup> Privatization to a core investor which is<sup>a reputable bank appears to have been the best approach for</sup> bringing about independent governance to<sup>the banking sector. Independent governance for banks means</sup> that the banks are free of the control of governments<sup>and clients, can exercise hard budget constraints and</sup> develop capability to manage financial<sup>risks (Bonin et al, 1999). A core investor could also bring very</sup> useful and valuable banking skills to the incumbent<sup>bank.</sup> In a region where experience in commercial<sup>banking was limited and capital insufficient,</sup> privatization to a strategic foreign and reputable<sup>investor appears to have been a useful approach for</sup> strengthening the domestic banking sector<sup>(Bonin et al, 1999; Bonin and Wachtel, 1999). Entry of foreign</sup> banks helped to modernize the domestic<sup>banking sector through introduction of modern banking</sup> practices, as well as product and service<sup>innovation. It also introduced competition into the banking</sup> sector, which is essential for improving the<sup>efficiency of financial intermediation12 .Moreover, for those</sup> countries which had already allowed in de<sup>novo foreign banks, such as</sup><sup>_Hungary,_privatizing state-owned</sup> banks to foreign strategic investors helped<sup>these incumbent banks better compete with the new foreign</sup> entrants.

Two main factors determine the size<sup>of the foreign bank presence in a particular country. The first</sup> is the policy environment. The _CEEs_ and<sup>the</sup><sup>_Baltic_countries were much more open to foreign entry into</sup> their banking systems than the _CIS_ countries.<sup>In fact, the</sup><sup>_CEE_countries under consideration (with the</sup> exception of _Macedonia)_ had actively<sup>attracted foreign banks for bank privatization. The foreign banks</sup> that invested in these countries tended<sup>also to be sound and reputable. The second factor is the</sup>

**12** An econometric study done by Claessens<sup>and others (1998) found that foreign entry increased competition in the</sup> banking sector in 80 countries for the period 1988-95.

17