# _Supervision_

In all countries, a regulatory framework has been put in place that is modelled closely on rules in western countries. For example, a capital-to-asset ratio of 8% or more is now required, and 33 new accounting, loan classification schemes and mandatory provisioning have been introduced . While bank regulations have been tightened and to a large degree brought into line with international practice, implementing them has not been easy. This is partly due to the difficulties of establishing reporting systems for banks and to the lack of experience of the supervisory agencies. All countries have established such agencies, either in the form of departments of the central bank (Czech Republic, Poland and Russia) or of a separate government body (Hungary). Initially, as was to be expected, the new supervisory bodies experienced difficulties, partly because of the inexperience of staff and the absence of established procedures for off-site and on-site inspection. These difficulties have been recognised, however, and have begun to be addressed in all countries, often with the help of foreign technical assistance.

Despite substantial progress, two fundamental problems remain. The first is that despite some foreign assistance, there is still an acute lack of human capital and developed information systems that the supervisory authorities can draw on to perform their function. The second is the credibility of bank supervision. If banks do not or cannot comply with the new regulations, perhaps because the gap between the initial situation and the newly required standards is too wide, bank supervisors may be faced with a difficult choice between regulatory forbearance and the closure of banks. Given the banks' initial situation, many of the new rules could not be complied with immediately. To some extent the countries in question have attempted to deal with these circumstances through transitional provisions which phase in the new regulations over time. In some cases, however, even transitional provisions cannot be complied with.

Under these circumstances it is difficult to enforce high regulatory standards. Strict application of the law might require the closure of a large segment of the banking industry or of major banks. Mergers with other banks may provide a partial solution but can work only if potential partners have a strong capital base, which in most cases appears unlikely. The threat to close large banks is not credible because of the large costs associated with it. There is an obvious danger of time inconsistency here. If the regulatory rules are such that banks can comply at reasonable cost to themselves and the economy, then the imposition of such rules can be expected to lead to changed bank behaviour and efforts to comply. The Government and the legislature are then in a position to induce changed behaviour through better regulations and tighter supervision.3 4 This is not the case when banks can argue that compliance with the regulations would be prohibitively costly or simply impossible. The Government can then be expected to show regulatory forbearance if many banks or a large bank do not comply with the rules, and the banks know this.

In practice governments have opted for a mixed strategy to overcome the lack of credibility of the new regulatory regimes. To some extent they have showed regulatory leniency and have extended the period for complying with the new regulations. At the same time, they have helped banks meet the standards in question through measures to improve banks' balance sheets. They have also shown a willingness to merge and even close smaller banks.

There is little doubt that supervision has become increasingly tight. But it is also clear that much room for improvement is left, and that bank supervision is not yet very effective in insuring that 33 An overview of bank regulation and supervision is in Group of Banking Supervisors from Central and Eastern European Countries (1992), Report on Banking Supervision in Central and Eastern European Countries, Basle. See also Dittus (1994), section 3.

34 In game-theory parlance they are able to occupy a Stackelberg leadership position.

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