metadata: authors: 0: author: Pohl, Gerhard
1: author: Claessens,Constantijn A.
2: author: DEC
count: Russian Federation
docna: 0: docna: Banks, capital markets, and corporate
            governance : lessons from Russia for Eastern Europe
docty: Policy Research Working Paper
subtopic: State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Banks & Banking Reform,Capital Markets and Capital Flows,Capital Flows,Inflation,Privatization,Energy Privatization,Democratic Government,Economics and Finance of Public
            Institution Development,Financial Sector Policy,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The financial sector should be active in
            enterprise restructuring in the transitional economies, and
            should help channel resources to the private sector.  What
            will best help the sector achieve these tasks: gradual
            reform or radical reform?  Liberalization and privatization
            are the most urgent tasks transitional economies face.  But
            for market reform to succeed, reforms of banking and capital
            markets must keep pace with enterprise reform and
            privatization.  Central and Eastern Europe have pursued a
            gradual approach to financial reform, splitting the former
            state bank (or monobank) into a central bank and several
            large state-owned commercial banks, eventually to be
            privatized.  Russia has taken a more radical approach,
            creating many new private commercial banks that have already
            taken over most of the business from state banks.  The
            reform of banks and capital markets in transitional
            economies should not be modeled too closely on patterns in
            western economies, with their large institutions, complex
            financial instruments, and extensive regulation.  A simpler
            process in required, compressing in a short period the
            historical development of financial systems - starting with
            small banks and accepting imperfect regulation and
            supervision as a fact of life.  Systemic risks remain
            manageable if financial institutions are small and numerous
            enough.   A system with many private banks is more likely to
            produce a financial sector that plays an active role in
            enterprise restructuring, channels resources to the private
            sector, and thus accelerates restructuring and economic
            growth.  Historical comparisons confirm the benefits of such
            a liberal, weakly regulated banking system.
geo_reg_key: 517208,517198,82689,517190,517191
repnme: repnme: Banks, capital markets, and corporate
            governance : lessons from Russia for Eastern Europe
display_title: Banks, capital markets, and
            corporate governance : lessons from Russia for Eastern Europe
listing_relative_url: /research/1994/07/698161/banks-capital-markets-corporate-governance-lessons-russia-eastern-europe
topicv3: Commercial Banking m1326069 1236,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Capital Markets m1326967 332,Privatization m1327236 1283,Financial Sector Development m1327681 1920
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Development Economics and Chief Economist
no_of_pages: 22
model_extractions: l POLICY RESEARCH WORKING PAPER 1326

# Summary findings

Tfhe financial sector should be active in enterprise restructuring in the transitional economies, and should help channel resources to the private sector. What will best help the sector achieve these tasks: gradual reform or radical reform?

Liberalization and privatization are the most urgent tasks transitional economics face. But for market reform to succeed, reforms of banking and capital markets must keep pace with enterprise reform and privatization. Central and Eastern Europe havc pursued a gradual approach to financial reform, splitting the former state bank (or umonobankn) into a central bank and several lacrg stae-owned commercial banks, eventually to be privatzed. Russia has taken a more radical approach, creating many new private commercial banks that have alrcady taken over most of the business from state banks.

The reform of banks and capital markets in tmnsitional economies should not be modeled too closely on pattems in western economies, with their large institutions, complex financial instruments, and extensive regulation. A simpler process is required, compressing in a short period the historical development of financial systemsstarting with small banks and accepting imperfect regulation and supervision as a fact of life. Systemic risks remain manageable if financial institutions are small and numerous enough. A system with many privatc banks is morc likely to produce a financial sector thar plays an activc role in enterprise restructuring, channels resources to the privatc sector, and thus accelerates restructuring and economic growth. Historical comparisons confirm the benefits of such a liberal, weakly regulated banking system.

- This paper a product of the Private Sector and Finance Team, Europe and Central Asia, and Middle East and North Africa Technical Deparrment- is part of a largcr effort in the department to analyze developments in the financial systems of trnsition economics. Copiesof the paper are available free fromthecWorld Bank, 1818 HStreetNW, Washington, DC20433. Pleasecontact Luz Hovsepian, room H8-093, extension 37297 (16 pages). July 1994.

_Tbe Policy Rewarca Wor,ig Paper Sres disseminates the findns of work i proges to encourage the ecxange of ids about developmen isumAx objective of the series isto get the fjdip out quickly even if thc presntionsare kss thn fidly polisbe& The papers carry the name of the au and shoud be sed and cited accordingly. The find;ngs, interpretatios and conclssionsare the autors' own and_ **_sould_** _not be attributed to the Wodd Bank is Executi Bod of Dirctors oran of its manbercowtrieLs_ Produced by the Policy Research Dissemination Center
# **Banks-, Capi'tal Markets and Corporate Governance: Lessons from Russia for Eastern-Europe**

Gerhard Pohl and Stijn Claessens THE WORLD BANK The opinions expressed are those of the authors and do not necessarily reflect those of the World Batk We would like to fthnk participants in seminars at the World Bank, the European Bankidng Forwn, Prague, March 2 1-23, the CEEPN workshop on Linking Bank Rehabilitation with Enterprise Restructuring and Privatiztion, Budapest, June 24-25, and Millard Long, Nils Fostvedt and Anil Sood for their comments.
'A-,= .. -

# Banks, Capital Markets and Corporate Govemance: Lessons from Russia for Eastern-Europe

## Summary

The financial sector in transition economies should play an active role in enterprise restructuring and channeling resources to the private sector. What type of fnancial reform is best suited to achieve these tasks, a gradual approach or a fundamental approach?

Liberaltion and privafization are, without doubt, the most important and urgent tasks in transition economies. If market reforms are to be successful, banldng and capital markets reform needs to keep pace with enterprise reform and privatization.

In Central and Eastern Europe, a gradual approach to financial sector has been pursued, splitting the former state bank, or "monobank", into a central bank and several large, stateowned commercial banks, to be privatized eventually. A more fundamental approach has been pursued in Russia where a large number of new private commercial banks has been created which have already taken over most of the business from state banks.

Banking and capital market reforms in transition economies should not be modelled too closely on today's pattems in Western economies with large institutions, complex financial instruments and extensive regulation. Rather, a simpler process is required, compressing the _-_ historical development of financial systems starting with small banks and accepting imperfect regulation and supervision as a fact of life. Systemic risks remain manageable if financial institutions are numerous and small enough. A large number of private banks is more likely to lead to a financial sector which plays an active role in enterprise restructuring, channels _remsources_ to the private sector, and thus accelerates restructuring and economic growth. Hlistorical comparisons confirm the benefits of such a liberal, weakly regulated banldng system.
! I4-m 4.-:-

# **Banks,** Capital Markets **and** Corporate Govemance: Lessons from Russia for Eastern-Europe

Economic reforms in transition economies means market reforms Despite massive resources mobilization and high investments, socialist economies have experienced dismally low growth of living standards (see, for example, Easterly and Fischer, 1994). The main reason was the gigantic misallocation of resources. Hierarchical decision making led to irrational production patterns and an ifl-adapted capital stock. Unclear responsibilities and conflicting signals for managers led to poor performance, a lack of initiative, slow technological progress, and low productivity.

The ultimate objective of reforms in transition economies is clear: higher economic growth and welfare. The main vehicle is market reforms, including liberalization of prices, removal of administrative controls, priatization, and legal and institutional reforms (see further, for exGample, (elb and Gray, 1991). Each of these is a momentous undertaking, none of which can succeed without simultaneous progress in the other areas. But, privatzation is the linchpin. Not only need firms be privatized, but, equally important, gradually dismantled into a **large** number of much smaller firms. This will take more than an initial<sup>3</sup> "mass privatization process and will only happen if poorly performing enterprises are forced to spin-off assets and lay-off workers. Financial institutions have to play a crucial role in this process. Early -and fundamental financial sector reform is thus a key prerequisite.
**2**

**Fi-andial** refonm in transition economies

Right from the start of the transformation of socialist econoinies, there has been widespread recognition that fundamental financial sector reform in transition economies is required.' In-practice, different financial sector reform strategies have been followed. In Central1and Eastern Europe, a gradual approach has been pursued, splitting the former state bank, or 'monobank", into a central bank (with the usual monetary and regulatory functions) and several large commercial banks, inheriting most of the assets and liabilities. Financial reform has mostly been limited to better accounting and auditing, better povernment regulation and supevsion, and some financial restructrring (recapitalization). It was hoped that this would lead financial intermediaries to play a positive role in the restructuring of enterprises and new lending.2 Unfortunately, this has proven to be insufficient, and sometimes counterproductive. Instead of lending to new and successful firms, bank managers have continued to lend to large unprofitable entexprises or financed government deficits. The overhang of bad old loans - nonperforming loans account for as much as 30 percent -- means that the net worth of many banks in Eastern Europe is a large negative number, in spite of sometimes repeated infusions of capital by governments.3 Few banks have played an active role in the restructuring of loss-making firns, largely because these banks are still state owned and hold the majority of assets.' Gradual banking reforms have not succeeded. Even more than for other enterprises,
**3**

private ownership of banks is critical and a direct stake of managers desirable. While lossmaldng production enterprises sooner or later have to adjust, banks can go on lending to insolvent enterprises unfil both are in deep trouble.

A more fundamental approach to financial sector refonn has been pursued in Russia.' The old state banks have shrunk and an entire class of new commercial banks has been created, not burdened by old loans and old management practices. More importantly, the new bank managers and owners have a direct stake in the financial success of their banks and are more likely to allocate resources to productive purposes.

We argue, also in light of historical evidence, that financial sector reform in Russia presents a useful model for Eastern European countries. We first describe the Russian reform in detail and then compare it to the East-European approach.

**Much progress** in **micro-economic reforms in Russia: little** in **macro-economic stabilization**

Since the break-up of the Soviet Union in December 1991, the Russian economy has undergone profound economic changes: the command economy has largely been dismantled, many prices have been liberalized, the exchange rate has been floated, private property rights have been expanded, trading monopolies eliminated, and a large number of enterprises have been privatized. Most progress has been made in micro-economic areas, particularly privatization and the replacement of administrative allocation by markets.
**4**

However, political and economic reforms have also brought enormous economic and social dislocations, often because of policy inconsistencies. Old command structures have been dismintled before new structures or rules were put in place or even agreed. An advance in some areas has often led to unforeseen consequences, accelerating, widening or, sometimes, delaying reforms somewhere else. A case in point is the loss of macro-economi **c** ontrol during 1992z aid 1993 that led to high inflation and rapid depreciation of the ruble.

It is too early to say whether the Russian reforms will succeed. The transformation of the Russian society into a democracy and market economy is a far greater challenge than nearly anywhere else. Nowhere else has central planning been taken as far, nowhere else were economic, structures as centralized and distorted as in the formner Soviet Union (see the World Bank, 1992 and IMF 1993). But in comparison to Russia's much more difficult starting point, considerable and unexpected progress has been made. The unsuccessful attempts at macroeconomic stabilization to date should not be allowed to cloud the judgement. Neither Germany nor Japan were able to attain price stability during their massive economic reallocation. following the war.. Hyperinflation facilitated then a new start by wiping out old debts. The same is true now in Russia. With structural reforms in place, there is a realistic chance for stabilization now to succeed.
F~~~~~~~~~~~~~~ Banking reforms In Rusia happened very early and unintentionally Daring the socialist period, the state bank (Gosbank) had responsibility for money supply, clearing and settlement, accounting and auditing, and public budget management. Initialy, all investmnent funding came from the budget, but Gosbank was not really a bank. Rather, its role was to serve as the state's accounting and auditing arm. Later, more investment funding was provided on credit, with the Savings Bank (Sberbank) collecting savings from households and the Construction Bank (Stroibank) lending these funds to enterprises. However, investment decision-making did not really change and the Construction Bank mainly supervised implementation of projects decid&l by the planning authorities.

In 1987-88, under perestroika, a "two-tier" banking system was introduced by carving out all commercia bankidng functions from Gosbank and creating three sectoral speciaized **ctommercialu** banks: Agroprombank, Promstroibank and.Jilsotzbank (agriculture, industry and services, respectively), similar to elsewhere in Eastern Europe. Even more important was a new law which authorized the establishment of cooperative banks: the number of banks mushroomed from only five in 1987 to over one thousand in 1990.

The first democratic elections at the republican levels in 1990 led to a reform movement and incrasing conflict with the more conservative Unoion government. In the sphere of finace, the R-ussian parliament passed several laws in 1990, effectively challenging the power of the USSR Gosbank within the, Russian territory. Enterprises were permitted to establish banks and
6 to chose their main bank freely. The three state banks changed their legal status to joint-stock banks and several split into many regional banks with enterprises as shareholders. The number of banks expanded rapidly to over two thousand in 1993.

While the new commercial banks were de-facto independent and responsible for their lending decisions, they initially controlled only a small part of the financial resources: the current account deposits of enterprises. The largest source of credit continued tc be household deposits at the Savings Bank and directed credits of the central bank (which were onlent through the remaining state banks). But this was short-lived: rapid inflation since 1992 has sharply reduced the real volume of credit and accelerated this transformation.

Starting with perestroika, nominal wages increases exceeded the production of consumer goods. Market-clearing was achieved by shortages and forced savings, creating a monetary overhang. With the liberalizaton of prices and the switch to a market economy in 1992, market-cleanng was achieved through increased prices. Lacking appropriate wage and credit restraints, enterprises simply passed-on cost increases, workers obtained compensating wage increases, and the central bank issued more credit to keep enterprises afloat Inflation accelerated and financial disintermediation followed. By 1992 credit expanded by over 800 percent and inflation by 2300 percent. The consequence was a rapid decline in the real value of financial claims. By late 1993, inflation had eroded the value of household savings to less than 2 percent of GNP, compared to 37 percent in 1990 (Table 1). The balance sheet of the Russian banling system became limited to short-term deposits, which were increasingly held at
7 commercial banks. Today, the government's ability to finance expenditures and enterprise losses -,-:--through -. a large inflation tax is sharply reduced.

Table 1

|(p|ercent o|f**GDP**|**,**unless|otherw|ise noted|)|||
|---|---|---|---|---|---|---|---|---|
||_198P_|_1i8r_|_19_|_19r_|_19_|_im_|_1m9m_|M|
|**Donad Credit**|65|67|**72**|73|91|46|**22**|**i5**|
|**Cluuoa anGowmaot**|9|IS|26|32|**55**|7|4|**3**|
|**Clabn_**am<br>**1trpr**<br>**uand Housduoh**|**_56_**|52|46|41|37|39|**13**|12|
|**Money**<br>-51<br>||**57**|61|64|sO|**62**|31|16|
|Curnw**OuldnmBub**|9<br>**p11**|10<br>|10||12|Y|4|4|
|**Rubl**BDepodh|42<br>|**47**<br>|**S1**<br>|S3<br>|**67**<br>|43<br>|14<br>|6<br>|
|**FXDepouiIs**|**0**|**0**|**0**<br>|**0**<br>|**1**|11|13|6|
|**Nomnal GDP (IL Diao)'**<br> <br>|06<br>|830<br>|_373_<br>|<br>_951_<br>|639<br>|1923<br>|37811<br>|323693<br>|
|**_elmn_**<br>**Rate (ab1eU**<br> <br>|0.63<br>|**0.53**<br>|0.61<br>|9|23|169|**415**<br>|1247<br>|
|lo-d<br>Per Capit GDP<br>**(ES**at**unrts exchange**ra)|**40R8**|4887|4977|-|-|-|614|1747|

Data for the USSR.

**b** December GDP annualized.

For the years 1989-1991 no data for GDP per capita are reported as there was not a well functioning foreign exchange market.

# The new tussian banks: small, but entrepreneurial

The two-thousand new commercial banks are either entrely new banks - so called "zero' banks - or regional spin-offs from the thr sectoral state banks. By now both 'zero" and "spin-of banks are represented among the largest commercial banks (Table 2). For example Inikombank is a zero-bank, Mosbusinessbank a former Zhilsotsbank branch, and ICB ifi St. Petersburg a former Promstroi branch.

"Zero' banks were usually created by groups of enterprises, sometimes with only a small number of large enterprises as shareholders (so called "pocket" banks), sometimes with hundreds of shareholders. The heavy concentration in bank shareholding has been reduced over time.
E t.

B Even before privatizadon, the banks acted independently and were de-facto the most marketoriented sector in Russia. With the mass privatization program for enterprises, most banks are now majority privately owned.

Table 2: Assets of Russia Banks (as of July 1, 1993)

||Total Asset|s|
|---|---|---|
||Rb billon|% of GNP|
|Specialized Banks<br>of which:<br>|14.366<br>|12.1<br>|
|Vneshtorgbank|7,597|5.4|
|Rosselkhozbank|3,984|3.4|
|Sborbank|1,926|1.6|
|Promstrolbank|1,273|1.1|
|20 Largest Commercial Bunks|14,479|12.6|
|Total Assets Banking System|41,304|34.9|
|TotalCredit to Non-Banks<br>(notofinterbank credit)|17,697|16.4|

Many enterprises have switched their accounts to the more successful banks and have oftn also become shareholders. Ownership in 'zero" banks is usually fairly concentrated, with the five largest shareholders controlling as much as half of the shares.' Ownership of "spin-off' banks is more diversified, with the largest shareholder accounting for 5-10 percent of equity, and the largest five for about 25 percent.

The new banks act as corporate treasurers to their owners and customers. Many enterprises continue to rely on their banks to monitor their own financial conditions and to prepare financial statements.7 In addition, banks provide payments services, deposit accounts, short-term working capital loans, etc. Some sixty banks had general foreign exchange licenses in 1993 and served as correspondent banls to handle foreign exchange transacdons for enterprises and other banks.
9 There are few limits on the scope of activities that banks can undertake. They can enpgag in deposit-taking, lending, investments, securities trading and underwriting. Portfolio diversification, liquidity, capital adequacy and other prudential regulations exist but are liberal. Banking supervision in Russia remains wea, and regulations are poorly enforced. Due to high inflation, minimum capital requirements were at times very low and permitted de-facto free entry into bankIdng.' Recently, international accounting and loan loss provisioning requirements have been introduced and will eventually improve the ability of the Central Bank to supervise banks.

The new Russian commercial banks remain small by intemnational standards. The largest commercial banks have a staff of two or three thousand, a balance sheet total of about $1-3 billion and a total share capital of about $50-150 million (Table 3). As a consequence of high inflation, the three sectoral state banks have rapidly shrunk in real terms. Only Vneshtorgbank (with large foreign exchange assets) and Rossellcozbank (with most of the directed ruble credit) still exceed the largest private banks.

Table 3: Indicators for 20 Large **Russian** Commercial Banks (Averages)

|Employees|11000|
|---|---|
|Branches|20|
|Assets|$ 450 million|
|Net worth|$40 million<br>|
|Foreign exchange assets|$ 230 million|
|Capital/asset ratio|15% (range: 2-40%)|
|Loantassets ratio|34%|

The new banks operate mostly on a regional (oblast) basis, with the larger banks handling international transactions for the regional banks. In every major city there are a handful of banks competing, with many more in Moscow. But strong relationship baning prevails, as enterprises have to shift practically all their ruble business if they want to change banks.

The small size of banks in Russia and their regional oxientation is probably an advantage at this time. The small size largely eliminates any systemic consequences of bank failures, a
**10**

realistic possibility given the limited supervision capacity and a poor lender of last resort. With _pboir communicatons, unclear legal rights and remedies, and limited managerial skills, the local focus enable banks to reduce risks. Extensive branching would entail substantial monitoring and control risks. Some of the larger banks have started to branch out and some mergers have happened, but even the largest hanks have less than fifty branches, most within their region.

# Privatization, banking and corporate governance

The mass privatization progranm, started in 1992 has been the most significant element of Russian economic reforms. It involved, first, the sale of many small firms and assets by local government through auctions, leases, management buy-outs and similar means. Second, for large enterprises, a mass privatation program was introduced, transferring ownership to managers, workers and the population through voucher auctions.' In response to political pressures from a strong managerial lobby, managers and workers were allowed to obtin large blocks of shares at highly preferential conditions. As a result, privatation became a huge success, at least in terms of enterprises privatized. By the end of 1993, over 8,000 enterprises had been privatized, employing nearly 9 million employees, or 44 percent of the industrial labor force, and one-thousand medium and large enterprises were being privadzed each month. By mid-1994, three-quarters of the Russian industrial workforce will be working in privatzed enterprises.'<sup>0</sup> Workers hold around half of the shares, managers about 10 percent, and only another 20 percent of the shares have been sold to the population at large ffirough voucher actions." Writh limited outside ownership, firms are effectively controlled by managers and workers and are likely to maintain a strong collective character. The greatest danger with so much inside control is that enterprise governance deteriorates in a Yugoslav workers' collective, with inappropriate incentives, low productivity and low profitability. Whether it will come about will depend, in part, on whether workers will be able to sell their shares to strategic investors. Managers have tried to restrict sale of shares by workers (e.g., by controlling share registers, limiting voting
3 rights). But this has been. averted by a government decree in 1993, requiring independent share registries for enterprises with many employees. Worker-owners can now sell their shares fr-eely and are likely to do so.

Japanese or German practices labor practices, with lifetime employment and a strong voice - of labor in the management of enterprises, represent the most optimistic outcome and perhaps the model to follow. While managers have a strong position, they will have to tread carefulfly with respect to restructuring measures. Large reductions in the workforce appear unlikly, unless a privatized firm runs into financial difficulties. Thbis need not be an insurmountable obstacle to restructuring. If su'bsidies or external funding are not forthcoming, troubled enterprises will be forced to reduce wages, eventualy prompting a good part of the labor force to leave. Since the social safety net is largely provided by enterprises, open unemployment is likely to remain low, but with large wage differentials between profitable and unprofitable finms.

Improved corporate control will lairgely come about as a result of fbactor market pressures. With the present low level of financial internediation, banks have very little leeway (and incentive) to keep troubled enterprises afloat. Unprofitable and unviable enterprises will thus -not receive any new r-esources and will need be liquidated. For these enterprises, banks will mainly be the undertakers to the dead. In exchange for supporting viable enterprises with - - negative current cash flow through debt or equity injections banks will require significant changes in ownership. Similar, the creation of new ventures will strongly depend on bank financing. Banks are thus likely to become the main agents for capital and outside-control over managers, including ownership changes. Corporate governance wfi then be '<sup>M</sup> state contingent: **u12** managers of profitable enterprises wil remain unchallenged and de-facto owners, while bankcs (or other potential rescuers) will assume ownership and oversight roles for unprofitable enterprises. Unless limited by regulatory intervention, this will probably entail a development along the liries of Japanese, post-war experience.

One of the consequences could be rapid emergence of cross-ownership links between banks and enterprises. Indeed, this has already happened. If Japanese experience is a guide, it could
12 also involve a mapid decline of worker ownership, as workers sell out to institutional investors, -such as banlk, insurance companies or investment funds." Given the strong concentration of financial skIlls in the banldng sector, such an outcome would be highly desirable.

The emergence of some sort of a capital market is essential. This could take the form of a securities marlet Anglo-Saxon style. However, in view of the paucity of financial information, this is unlikely to be the case. Banks are likely to become the main monitors of enterprise perfonnance. The speed of banking development is thus likely to become a major determinant for the speed of restructuring and productivity growth in Russia.

# Lessons from Russia for Eastem-Europe

Banldng reform in Eastern Europe has not much moved beyond the perestroika reforms used in Russia before 1990. This is unlikely to generate a situation in which banks will take a lead role in active enterprise restructurings and lending to the new private sector. Many of the old state bansl are likely to go on as in the past, lending money passively either to enterprises with little future or to the government, and little enterprise reformn will take place.

Banks have to take the lead role in enterprise restructuring, mostly by saying no to request for new resources, and only in few cases saying yes. If efficient enterprises and markets are to emerge, financial sector reform needs to keep pace with privatization as without thorough banldng -reforms enteprise reform will remain incomplete. Even more than for enterprises, good corporate governance of banks is crucial. To turn around the management culture of the state banks is probably more difficult than to create an entirely new banling sector.

An accelerated approach to banking reform in Eastern Europe is thus called for. Russia presents a useful model for East-European countries. The dismantling of the old state banks and the emergence of new commercial bank not burdened by old loans and old management practices in Russia is much more likely to lead to a financial sector which plays an active role in enterprise restructuring and channels resources to the private sector than under the East-
,-t5l w 13

# Europn, gradual approach to banking reform.

Under an accelerated approach, the remnants of the former state banks would be converted into fiscal agents for the govemment and a whole new banking system would emerge in parallel with the old banking system. Enterprises that are not yet privatized (or liquidated) would continue to bank with the old state banks until they are privatized or liquidated. Privatized enterprises would take their banking business to new banks.

Under this vision, many small and entrepreneurial banks would anse through entry and spinoffs. Large banks are not needed now. The former socialist countries suffer from too many, too large enterprises. Large investments, if needed, can be made from the internal cash flow of large enterprises. What is needed is many small investments in new enterprises, spin-offs or joint ventures to finance marketing and distribution, or quality and productivity improvements. Small banks can provide the short tenn working capital, payments services and equity investnents in new ventures needed. Eventuay some of these banks will merge, but only when legal infrastructure and management prctices permiL Small banlcs are also more appropriate during the transition, as their failure does not pose systemic risks and banldng supervision will for the time being be at best highly imperfect and at worst corrupt.

In the short-term, the most powerful technique banks will have for enforcing corporate govemance will be to pull their credit lines. In the medium-term, equity will be come important and the banlks should therefore be universal banks. For one, in the risky economic and financial environment of the transition economies, equity stakes paradoxically entail lower risk than commercial loans, other than small amounts of worldng capital.'<sup>4</sup> Furthennore, equity stakes also confer direct control over management, and possibly more rapid intervention when things go wrong.

Other than Russia, the most direct precedent and model can be found in the early years of the second industrial revolution, the late 19th and early 20th century. Many new joint stock banks were then created to undertake the financing of new industial ventures. In most
14 countries, these banks were even less regulated and supervised than in Russia today. Whie -- many banks failed, this did not pose systemic risks quite to the contrary, this was essential to the efficient functioning of the t.apital market. However, there is one significant difference between then and now. Then was a time a rapidly rising scale-economies and the emergence of-large industria organizations. The problem in transition economies now is the opposite: to reduce gigantic organizations to a more human and manageable scale. Many small investments are now required;. which requires familiarity with local circumstances.
~

- --

i >

-

~~~~~~~~~~~~~15

# References

Aoid, Mashiko, 1994, "Controlling the Insider Control: Corporate Governance Issues In Trarsitional Economies," mimeo, the World Bank.

Bohm, Andreja and Vladimir Kreacic (eds.), 1991, Privatization in Easter Eurp: Implementation Issues, ICPE, Ljubljana.

Current Boycko, Maxim, Andrei Schleifer and Robert Vishny, 1994, "Privatizing Russia," Brookdngs Papers on Economic Activity, Fall, No 2.

Brainard, Lawrence J., 1991, *Eastem Europe: Creating a Capital Market," in Richard O'Brien and Sarah Hewin (eds.), Finance and the International Economy, No. 4, The AMEX Bank Review Prize Essays.

Easterly, Wiliam and Stanley Fischer, 1994, "The Soviet Economic Decline: Historical and Republican Data," World Bank Policy Research Paper, no. 1284.

Gelb, Alan H. and Cheryl W. Gray, 1991, "The Transformation of Economies in Central and Eastem Europe: Issues, Progress, and Prospects in Socialist Economy Reform," Policy and Research Series, 17, The World Bank.

Hinds, Manuel, 1990, "Issues in the Introduction of Market Forces in Eastern Europe Socialist Economies," EMENA Discussion Paper, No. IDP-0057, The World Bank.

# IMF, 1993, Russian Federation. Economic Surveys. No. 8.

Miyajima, Hideaki, 1994, "The Privaftizaon of ex-Zaibatsu Holding Stocks and the Emergence of Bank-Centered Corporate Groups in Japan," mimeo, the World Bank.

Phelps, Edmund, Roman Frydman, Andrzej Rapaczynski and Andrei Schleifer, 1993, "Needed mechanism of corporate governance and finance in eastern Europe," Working Paper No. 1, EBRD, March.

Roe, Alan, 1992, "Financial Sector Reform in Transitional Socialist Economies,' EDI Policy Seminar Report, No. 29, the World Bank.

World Bank, 1992, Russian Economic Reform: Crossing the Threshold of Structural Change, World Bank Country Study.
-jt

16

1. For early analysis see Hinds, 1990, Gelb and Gay, 1991, Braird, 1991, and BG3hm and Kreacic, 1991. A reent analysis is Phelps, Frydman, Rapaczynski and Schleifer, 1993.

2. For a proposal along these lines see Brainard, 1991.

3. In a worst case scenario, the total net worth of all former slate banks could be a negative 5-20% of GDP, depending on the level of debt outstanding.

4. Newly enterng foreign bankcs have mostly focussed an foreign trade related activities and have done littlo lending to domestic entrprises. And lack of domestic capital has prevented the emergence of new domestic banks.

S. A few other countries, mostly in the former Soviet Union (e.g., Estonia), have pursued a similar appa.

6. Central Bank of Russia regulations require that banks have at least three shareholders, and no shareholder can hold more than 35 % of a bank or credit institution.

7. This is not unusual. Japanese firms relied initially on their banks fcr financial management and services, as financial skills were scarce.

8. At times, the minimum was significantly less than US $10,000. An increase to ECU S million (and indexed) is to be phased-in over the next several years.

9. For more details and data see Boycko, Schleifer and Vishny, 1993.

10. Data from Boycko, Shleifer and Vishny, 1993.

- I1. The state property funds bold the remaining 20%.

12. See Aoki, 1994.

13. The dismantling of the Zaibatsu' conglomertes in Japan in the late 1940s also involved Iarge employee ownership that was later reduced as workers sold their stakes (Miyajima, 1994).

14. Equity stakes can compensate losses with large capital gains. Commercial loass, by conarast, offer only downside risks and are appropriate only if losses can be held to very low levels. At high default rates, required intermediation margins become so large that only speculative or fraudulent borsowers will be willig to take loans at such high real interest rates.
Policy Research Working Paper Series

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|---|---|---|---|
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|WPS1314 The Significance of the 'Europe<br>AgreernentsW<br>for Central European<br>Industrial Exports|Barilomiej Kamninski|June 1994|M. Patenla<br>37947|
|WPS1315 Global Tradable Carbon Permits,<br>Participation Incentives, and<br>Transfers|Bjom Larsen<br>AnwarShah|June 1994|C. Jones<br>37754|
|WPS1316 Preserving the CFA Zone: Macroeco-<br>nomic Coordination After the<br>Devaluation|Shantayanan Devarajan<br>Michael Walton|June 1994|C. Jones<br>37699|
|WPS1317 Estimating the Efficiency Gains<br>of Debt Restructuring|Jeremy Bulow<br>Kenneth Rogoff<br>Ning S. Zhu|July 1994|FLVo<br>33722|
|WPS131B Exchange-Rate-Based Stabilization<br>in Argentina and Chile: A Fresh Look|Miguel A. Kiguel<br>Nissan Liviatan|July1994|M. Divino<br>33739|
Policy Research Working Paper Series

|**Tte**|Author|Date|Contact<br>for paper|
|---|---|---|---|
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