metadata: authors: 0: author: Thorne, Alfredo
1: author: DEC
docna: 0: docna: Eastern Europe's experience with
            banking reform : is there a role for banks in the transition?
docty: Policy Research Working Paper
subtopic: State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Banks & Banking Reform,Capital Markets and Capital Flows,Non Bank Financial Institutions,Capital Flows,Privatization,Energy Privatization,Deposit Insurance,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development
abstracts: cdata!: Are there lessons to be learned about
            how Eastern European countries have dealt with problems in
            their banking systems?  What role have these countries
            assigned to banks during the transition?  How have they used
            banks in dealing with the enterprise problem?  The author
            addresses these questions by analyzing experience in
            Bulgaria, Hungary, Poland, Romania, and the former Czech and
            Slovak Federal Republic.  Most of these countries have made
            substantial progress in restructuring their banking systems,
            but few have used their banking systems to improve the
            allocation of credit and hence stimulate the supply
            response.  The author finds the following.  The problem is
            not whether banks hold nonperforming loans but how banks can
            avoid accumulating more nonperforming loans.  The underlying
            problem is how to close loss-making and nonviable
            enterprises.  The countries that have encouraged the
            establishment of new private banks, that have introduced
            regulation and supervision, and that have tried to make
            banks more competitive have been more successful at
            improving the allocation of credit and achieving more
            control over loss-making enterprises.  Banks must focus on
            assessing risk - and for this, capital, private ownership,
            and adequate regulation are crucial.  How quickly banks
            achieve independence in credit decisions depends on how fast
            new governance structures can be introduced.  In this, the
            five countries have been less successful. The objectives of
            bank recapitulation should be to prevent banks from
            accumulating more nonperforming loans (that is, dealing with
            the enterprise problem) and to give them the governance
            structure that would prevent them from incurring new
            nonperforming loans.  This requires introducing a system of
            risk and reward - by making banks comply with capital
            adequacy requirements, by privatizing a critical number of
            banks, and by introducing strong regulation and supervision.
            Government should see that banks provide efficient payment
            systems, the basis for trust in banking systems. Introducing
            adequate regulation and supervision has been difficult as it
            requires knowing what the banks' role should be.
            Evidence strongly supports the need to recapitalize and
            privatize a critical number of banks. Authorities cannot
            rely on banks to exert control on enterprises early in the
            transition.  In the early stages, control over state-owned
            enterprises should be exercised by a semipublic institution.
repnme: repnme: Eastern Europe's experience with
            banking reform : is there a role for banks in the transition?
display_title: Eastern Europe's experience
            with banking reform : is there a role for banks in the transition
listing_relative_url: /research/1993/12/698719/eastern-europes-experience-banking-reform-role-banks-transition
topicv3: Commercial Banking m1326069 1236,State Owned Enterprises m1326323 721,Investment Funds m1326718 341,Deposit Insurance m1326722 322,Privatization m1327236 1283
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: UNKNOWN
no_of_pages: 48
model_extractions: **POI.cY** RESEARCH WORKING **PAPER** 123 5

# **Summary findings**

Are there **lessons** to he learned adiut how Fastern F.uropean countries have dealt with **problems** in rheir bank.ng systems? What role have these con ttries assigned to banks duiring the transition? How li_ve they used banks in dealinig with the enterprise problemi?

TIhorne addresses **thcse** questions by analyzing experiences in Bulgaria, HuIngary, lolanii, loiiRania, arid the former Czech and Slovaik Federal Rt public. olist of these countries have made substantial progress in restructuring their banking systems, but few have used their banking systems to improve the allocation of credit and hence stimulate the supply response.

Among other things, Thorne finds that:

* The problem is not whether banks hold nonperforming loans but how banks cai avoid accumulating more noniperforming loans. The underlying problem is how to close loss-making and nonviable enterprises.

* The countries that have encouraged the establishment of new private banks, that iave introduced regulatiotn arid supervision, and that have, tried to niake banks more competitive have **beezn** mor: successful at improving the allocationl of credit and acILieviig ntiore control over loss-making enterprises.

.

crucia!. I ow quiickl hanks achieve iMdep-nd'idnc in c.eihT d cisiojns dLpenlds on how fast nriw voverntaucc struct i rs n bot i n riodocd. In thi K thie ti s **e ci** inn r ie riv been less sLICLce(s I.

* [h tl( (bye.tivs of batik recapuhaliz **ariTi** s!notld le to prevent hanks tr(om ac:imniilatim rg lore nonpertti rniinrg lo.in (rhlt is, dealing with the enterprise pleOl km) an d to ivethenI tile go'etrlialLe strilCtLire that wioIld prevent the in front inca rrinig new noniperforming loans. T 1his reqlires introducing a systemii of risk anid reward - by makinig banks comply with capital adequacy requiremernts, b privaltizig a critical nLiniber ot hanks, and by itintrodticinig strong regulation and supervision.

* Governments should see that banks provide etticienit payment systems, thi basis for trust in banking svstenis. * Introdticinig adequat regtiglatioll mwd so pervision has been (ditficult as it requires knowin ; whait the hanks' rolt slhiold be.

* Evidetnce stronglv smLpports the neted **ti'** recapitalize and privatiie **.i** critical umbier ot blIoks.

* Authorities cannot relY on hbank to exert Lontrol on enterprises early in tih tratisition. lIn thi early stages, control over stare-owned enterprises Should be exercised h1 S eouipUblic insritrtionu.

* Baniks mtist focuis on assessing risk - and for this, capital, private ownershii, and adequate regulation are

Thisppaper-aproduictofthelPrivate SectorandFinaice Tam, Intiro a dC(entrail **i** c si,,arid.MliddleiFaist andclNo rthAfrica Regions Technical Departmenit-is part of a larger effort in the l.ank ro cxrract lesonis from rthe refolrmi ot E:astern ti Fropeani economies. Copies of the paper are available free from the World Bank, I 8 18 H Street NW, Washington, 1( 204.433. Please contact Noni Jose, room 18-168, extension 33688 (38 pages). December 1993.

_i nie Policy Research Working Plaper Series disseminates the findings ruf_ **_UoYk_** _in proigr,ss tii cnac)jrage the exbaenii ,/ ideas bioit_ S _development_ **_issues._** _An objective of the series is_ **_roget_** _the findings out quickli. et-en il the prescntations_ **_are_** _less th.7n fuilx p4ished. 1he papers carry the names of the authors and shou!d be used and cited according1s. 1h fiindings. interpretoi,nms, and cionclusions are the authors' own and should not be attributed to the World Bank, its Executive Board of Directors, or anr of its member countries._ Produced by the Policy Research Dissemination Center
# **EASTERN EUROPE'S EXPERIENCE WITH BANKING REFORM:**

# **Is there a Role for Banks in the Transition?**

by: Alfredo Thorne'

# The World Bank

ECA/MENA Technical Department Washington D.C., 1993 In writing this paper I have benefited from very interesting discussions at difkcrent mornents with my colleagues and friends: Jenny Corben, F^brizio Co.icelli, Arist6bulo de Juan, Manucl Hinds, Mitja Gaspan, Millard Long, Cohn Mayer, Gerhard Pohl and Roberto de **Re-** zende Rocha. I would also want to thank the participants of an EBRD conference held in London in October 1992.
TABLE OF CONTENTS

|A. INTRODUCTION<br>.......................................|**I**|
|---|---|
|B. PAST LEGACIES: THE STARTING CONDITIONS ............|3|
|1. Abandoning the Basic Socialist Banking System<br>..|3|
|2. The Starting Conditions .....................................|S|
|C. RESTRUCTURING BANKING SYSTEMS: fHE GOVERNMENT POLICIES .......|<br>6|
|1. Introdu^ing a New Regulatory and Supervisory Framework<br>........<br>.<br>...<br>.|<br>7|
|2. Institutional Measures<br>..|12|
|Overcoming the Payment System's Inefficiencies<br>.............|12|
|Macroeconomic Conditions and SchemesforDealing with Banks' Bad Loans<br>.<br>. .|14|
|3. Bank Privatization .......|26|
|D. EFFICIENCY OF BANKING SYSTEMS: AN ASSESSMENT ATTEMPT<br>...<br>...|<br>29|
|1. Credit Allocation<br>..|29|
|2. Real Lending Rates and Interest Rate Spreads.<br>.................|31|
|E. CONCLUSIONS: ARE THERE ANY LESSONS?<br>.<br>.33||
|REFERENCES .........................................|37|
Page I

# A. INl1RODUCTION

In 1989, most Eastern European countries began changing from centrally-planned to market-oriented economies. Some countries undertook comprehensive macroeconomic reform programs aimed at stabilizing their economies and introducing market forces. Programs typically '.onsisted of liberalizing product markets, reforming labor and financial markets, and integrating their econoraies to the world economy by removing trade restrictions. In addition, most countries privatized their small-scale state-owned enterprises (SOEs) through public auctions and a few countries also introduced schemes for restructuring and privatizing large state-owned enterprises.

Although the experience with macroeconomic reform differs across countries, the most successful countries managed to stabilize their economies, to liberalize prices and introduce competition, ending the goods shortages of centrally planned economies.<sup>2</sup> But few managed to restructure and privatize the SOEs or the banking system. Yet both the .:'C)Es' and the banking system's restructuring and privatization will have important effects on macroeconomic stability. Their postponement could undermine the governments' ability to balance the budget and to pursue non-inflationary monetary policies.

The introduction of market forces made apparent the large number of SOEs needing restructuring and privatization. The magnitude of the problem was not fully apparent before because centrally-planned economies relied on price controls and subsidies. Loss-making SOEs continued to have access to finance from the banking system because their closure would have had a substantial impact on employment and could have halted the reform effort. Also policies to restructure, liquidate, or privatize these enterprises are not yet in place. This is undermining macroeconomic stability and is endangering the future of the well-managed enterprises. It is resulting in a perverse allocation of 2 **See Bruno** (1992) **for a** rmcent critical macroeconomic assessment ot the five more advanced **Eastem** European countries (Hungary, **Poland, CSFR, Bulgaria and Ronania).**
Page 2 resources: loss-making enterprises are accessing credit while the new emerging private sector is being crowded out.

A number of studies have analyzed the problems in restructuring and privatizing the SOEs by focusing on the enterprises' problems. This paper attempts to analyze the problem from the perspective of the banking system. It seeks to understand the role that the banking system is playing in the transition. It attempts to understand the starting conditions and the governments' reform strategies. The focus is on the institutional aspects of financial sector reform, drawing on the experien,.e of the five more advanced former centrallv planned Eastern European countries: Hungary, Poland, the former CSFR,<sup>3</sup> Bulgaria and Romania.

Although Eastern European governments made substantial progress in reforming their banking systems, it still plays a passive role. Few countries have successfully 'ised their banking systems as an instrument to accelerate the supply response, for instance, by ensuring an efficient credit allocation, or by using banks to exert control on loss-making SOEs. Most banking systems are s.ill dominated by large state-owned banks which hold a large proportion of nonperforming loans. Countries that have establihed new private banks, introduced new regulation and supervision, and enhanced bank competition show an improvement in the allocation of credit and greater control of loss-making SOEs.

The organization of the paper is as follows. Section B opens the discussion with the analysis of the legacies of the past. Section C compares the policies adopted by each government for restructuring the banking system. Section D compares the efficiency of the five banking systems in an attempt to assess the consequences of the government policies undertaken. Finally in Section E the conclusions highlight the lessons that can be learnt from these reforms and underlines the problems that remain.

**To avoid confusions and since the analysis ends in end-1992, throughout I have refermd to the fonmer CSFR as 'the CSFR.-**
Page 3

# **B. PAST LEGACIES: TH1E STARTING** CONDITIONS

Until the early-1980s, the socialist banking system that prev'iled in most eastern European countries consisted of a mono-bank that performed the roles of central bank and commercial bank, and a savings bank that provided services to households. The mono-bank was responsible for issuing currency and granting short-term credit to enterprises. In addition, the specialized banks provided long-term finance for investment. Unlike banks in western countries which granted credit based on credit risk analysis, bar ks in former socialist countries granted credit based on central plan decisions. Banks, therefore, allocated credit passively and performed the role of government ageneies.

# 1. Abandoning the Basic Socialist Banking Syste

The five countries began tne reform towards a market economy in 1989. Each country differs from the others in their timing and methods of reform (see table 1). The ',reakup of the mono-bank, the establishment of a two-tier banking system and the abolishment of the central plan targets signaled that reform was underway.

Table 1. Banking Systems Starting Conditions

|Date of political opening.|1989|April 1989|November 1989|Novemnber<br>1989|<br>December<br>1989|
|---|---|---|---|---|---|
|Date of breakup of the mono-bank and<br>atartofthe two-tier banking syatem.|January 1987|January 1989|January 1990|January 1990|December<br>1990|
|Number of atate-owned commercial<br>banks. 1/|4|9|2|59|4|
|Number of private or foreign owned<br>comrnercial bank.1/|2<br>_|_5_|0|0|2|
|Number of sp~cialized banks (excluding<br>foreign exchange**banks).**1/|10|I|I|8|2|
|Numnber of**banks**specialized in foreign<br>exchange**trnsactions. 1/**|**1**|3|2|**1**|**1**|
|Number of Savings**Banks.**1/|**1**|**1**|2|**1**|**1**|
|Date of**last**revision of last legislation.**1/**|**January**1987|**January**1989|January 1990|May 1990|**April**1991|

Source: World Bank (1989,1990 and 1991b) and Thome (1992).

**1/ Estimated** at the date of the breakup of **the** mono-bank.
Page 4 _Hungary_ was the first country to introduce changes in its banking system. It started very early on and fo'lowed a gradual process. Unlike the other countries, the change in economic policies was not m.arked by a single date when a big bang stabilization program was undertaken. In the early 1970s, with the New Economic Mechanism, it abolished the centrally-determined targets and allowed enterprise managers greater freedom. Managers were granted a greater role in decision-making and in the management of enterprises, thus starting the experience in enterprise self-management under socialism. In 1987 the authorities established a two-tier banking system and broke up the mono-bank into a central bank and two i;tate-owned banks.

_In Poland_ the authorities started introducing changes in the banking system in the early 1980s. In early 1982 the authorities granted more autonomy to the mono-bank, allowed banks more itexibility in meeting the centrally-determined targets and provided for the establishment of new banks.

Significant changes started in the late 1980s. In 198' the government separated the savings bank from the mono-bank and, in January 1989, the government broke up the mono-bank into nine state-owned commercial banks and established a two-tier banking system. The authorities also granted bank management a greater role in credit allocation.

In the _CSFR, Bulgaria_ and _Romania,_ the break up of the mono-bank and the establishment of a two-tier banking system followed the political opening of 1989 (see table 1). Enterprise and bank managers were granted more freedom simultaneous with the authorities' abolition of the central plan targets. In these three countries, there was no tradition of enterprise self-management as there was in Poland and Hungary.

In the _CSFR,_ the authorities broke up the mono-bank by establishing three new banks, two state-owned commercial banks (one for uiie Czech and one for the Slovak Republic) and one bank specializing in long term finance, which served both republics. In Bulgaria the government broke up the mono-bank into 59 commercial banks and established 8 specialized banks. Moreover, the
Page 5 govermw nt decided to transfer ownership of banks to the state-owned enterprises. In _Romania_ the mono-bank's commercial banking activities were transferreu to a recently vstablished state-owned bank and the emerging banking system consisted of few banks.

- L , Jling Conditions

The banking systems of the five countries were similar in terms cf the institutional problems confronted. **These** were:

- (a) slow progress in introducing market-oriented payment inechanisms with long delays in paymerk; and lack of contract enforcement, leading to a large "float" in the banking system;

- (b) a lack of a regulatory and supervisory framework adapted to the needs of a market-economy, and supervisors ill-prepared to supervise banks operating in a market economy;

- (c) a large proportion of bank nonperforming loans, especially held by the large state- Yned (SO) banks, which resulted from the lending practices during the central plan period;

- (d) an inexperienced group of bankers appointed by government officials and ill-trained for managing banks in a market-economy and for assessing risk of potential customers; and

- (e) close ownership links between state enterprises and banks which prevented banks from taking independent credit decisions with respect to their matin customers.

There are, however, a number of differences that distinguish these five countries. The first difference is the relative importance of the commercial and specialized banks (see Table 2). Hungary and the CSFR relied more on commercial banks than on specialized banks. In both countries, once the authorities b;oke up the mono-banks, commercial banks held most of the banking systems' assets. In Poland, Bulgaria and Romania, the opposite was true, the specialized banks account for the bulk of hank assets and were more important than the commercial banks. The importance of specialized banks was particularly true in Poland and Bulgaria, nations that established the largest number of state-owned commercial banks.
Page 6 The second difference is the importance of the savings bank. This indicated the segmentation between a group of banks that were net borrowers and lent to the enterprise sector (e.g., the commercial arnd specialized banks) and a group of banks that were net lenders and captured most of the deposits. This is also an indicator of bank competition, since net borrower banks depended on funding by net lender banks.

Table 2. Structure of the Banking Systom

|**Ratio of all**qecialized banks'**asets**to<br>**total assets.**<br>,I<br>V_|47 7<br>_<br>_<br>_<br>_<br>_|79.1<br>_<br>_<br>_<br>_<br>_<br>_<br>_|32.2<br> <br>_<br>_<br>_<br>_<br>__<br>_<br>_|54.0<br>_<br>_<br>_<br>_<br>_<br>_|52.3<br>_<br>_<br>_<br>_<br>_<br>_<br>_|
|---|---|---|---|---|---|
|**Ratio ofcommercial**banks'**asset**to<br>**totalasset**_1,2/_|35 0|8**_5_**|67.8|**25.5**|18.2|
|Ratio of**totl savings**bank deposits to<br>total deposits.**1/**|**'.5**|12.1|**52.3**<br>___|46.2<br>I<br>__|80.8<br>_|
|Savings Bank's houaeh&ds' deposits**as**<br>ratio of total household deposits.1/|81.3|**70.5**|100.0|100.0<br>_|**100.0**|
|Ratio of Ssvings Bank loans to deposits.|100.0|61.3|16.9|33.5|4.9|

Source: World Bank (1989,1990 1991b and 1991c) and Thome (1992).

i/ Estimnated at the date of the breakup of the mono-bank. Bec4.us in Hungary the centrl bank held a large portion of the banking systens' total Issets the sum of the ratios of conunercial and specialized banks' assets to total assets is low relative to the other countries.

2/ In the ease of CSFR, these ratios are calculated using total loans instead of total asuts, as assets by group of banks were not available.

In Hungary and Poland this segmentation was less sharp. The high ratio of savings bank loans to deposits indicates that they were not a source of funds for commercial and specialized banks. Instead, savings banks used their resources to grant mortgage and other types of loans to households.

In the CSFR, Bulgaria and Romania, the savings banks were net lenders to the specialized and commercial banks. When the Bulgarian authorities broke up the mono-bank in 1990 the Bulgarian Savings Bank was using nearly 70 percent ot its deposits to fund the commercial and specialized banks. In the CSFR and Romania, it was 83 and 95 percent respectively. Savings bank deposits in these countries accounted for larger proportions of total and households deposits.
Page 7

# **C.** RJITRUCTURING BANKING SYSTEMS: **THE GOVERNMENT POLICIES**

Starting n 1990, the five Eastern European countries' ba-king system started to char.ge as a result of the polit-.al opening and th9 introduction of market forces. Between 1987 and 1989, some governrnents relaxed restrictions or. he establishment of new banks to encourage bank competition. This resulted in an increase i . the number of banks. In Hungary, the number of banks increased from 19 in late 1987 to 37 in late 1991; in Poland, from 18 in early 1989 to about 86 in late 1991; in the CSFR from 7 in early 1990 to 27 in late 1991; in Bulgaria from 69 in early 1990 to 75 in late 1991; and in Romania from 10 in late 1990 to 16 in early 1992.

In most countries, though, the major restructuring bega.n in 1990. Some governrnents introduced changes in theil monetary and credit policies as part of their macroeconomic adjustment programs. Usually the bank restructuring scheme consisted of a new regulatory and supervisory framework, a policy framework for dealing with bank nonperforming loans as part of the enterprise restructuring, and bank privatization plans. We now turn to the discussion of these three aspects of the restructuring schemes as a way to understand the policy measures adopted by each government and the way governments linked bank and enterprise restructuring.

# 1. Introducing a New Regulatory and Supervisory Framework

Between 1991 and 1992 the five countries introduced a new regulatory and supervisory framework. But some countries kept important asPects of the old iegislation. By mid-1992 Hungary, the CSFk and Bulgaria had introduced a new central bank and banking laws, modeled on western economies legislation. Although Poland and Romania introduced a new central bank law, they amended the existing banking laws and key elements of market-economies banking legislation were still missing by late 1992. By contrast, Hungary is the only country of the five to have introduced a new bankruptcy law that defined the legal role of banks in restructuring and privatzing 1OEs.
Page 8 These five countries have tollowed two very different banking m.dels (see Table 3). Hlungary nas opted for the Anglo-Saxon model **of** separating commercial and investmenit banking functions. **The**

**Table 3. Regul&tory Frameworks**

||||a...s.t..|..||
|---|---|---|---|---|---|
|Date of enactment by<br>Parliament of new<br>banking regulation|November<br>1991|April 1992<br>(tAmendn-<br>itsto<br>existing L|December<br>1991|March 1992|March 1991<br>(Arendrenta<br>being<br>considered)|
|Separation<br>between<br>commercialand<br>binking investment<br>activities?|Yes|No, univeral<br>banking|No, universal<br>banking|No, univerul<br>banking|No, universal<br>banking|
|Limitson the volume<br>of equity ban,acan<br>hold|I Commercial<br>and<br>specialized<br>banks arc<br>allowed to hold 15 %<br>and 100% of adjusted<br>capita!in long term<br>investments,<br>respectively;<br>and<br>excludes collaterals<br>taken posse.sion<br>by<br>banks which must be<br>sold within 3 years.|Up to 2S % of total<br>capital and reserves<br>and is planning to<br>increase it to 50_%._|Up to 25zof total<br>capital and<br>reserves and<br>excludes<br>collaterals taket,<br>possession by<br>banks which must<br>be sold within 2<br>years.|Up to 100% of<br>to.'lcapitalin<br>long-term<br>investments<br>ar.J<br>excludes<br>collaterals taken<br>porsesion<br>by<br>banks which must<br>be sold within 3<br>yeaq.|Up to 20% of<br>totalcapitsland<br>reserves and<br>N3R pLans to<br>increase it to<br>100%|
|Capital adequacy|opercent<br>of<br>risk-weighted<br>assets to<br>be met in January<br>1993|8 percent of<br>risk-weighted<br>assets|8 percent<br>of<br>risk-weightcd<br>assets to be met<br>end-1995|8 percent<br>of<br>risk-weighted<br>assets, transitional<br>period to be<br>determined|Propowed to be 8<br>percent<br>ot<br>rii-weighted<br>**assets**by<br>end-1994|
|Limits on lending to<br>a singlecustomer|Up to 25% of<br>adjusted capital|Up to 15% of<br>assets.|Up to 25% af<br>capital|Up to 25% of<br>capital|Up to20%of<br>capital|
|Limits on lending to<br>shareholders|Up to 5% of adjusted<br>capital|Up to 15% of<br>capital.|Determrined by the<br>bank statutory<br>body|Up to1%of<br>paid-in capital|Up to 15% of<br>the banki capital<br>andremerveh|
|Deposit insurance|Banks should have a<br>mandatory deposit<br>protection by<br>end-1992|A new deposit<br>insurance should be<br>in effect since<br>March 1993.|State-owned bakas<br>and governments<br>deposits|By law banks<br>shouldoffer<br>deposit inaurance<br>up toanamount<br>to be specified|Onlystte<br>savings bank'a<br>deposits|
|Minimumcapitalfor<br>new banks|USS 13.3m for<br> <br>commercialandUS$ 6.6mfor specialized<br>bank|INo explicit limit<br>except that it should<br>be proportional to<br>the size of<br>anticipated<br>activities.|Determined by the<br>central bank|USS 10.0m|USS 3.Sm|
|Limits on ownership|State anda single<br>individual rmy hold<br>more than 25_%_of<br>equity. No restriction<br>oaforeign banks|Maximum<br>ownership is 50%<br>by a single<br>individual or firm.|Nolimiut|Authorization<br>from central bank|No limnits|
|Institution<br>responsible for<br>supervision|State Banking<br>Supervision Agency<br>(SBA) and NBH|National Bank of<br>Poland|State Bank of<br>Czechos!ovakia|National Bank of<br>Bulgaria|National Bank of<br>Rom**a**n ia|
|Standards<br>for loan<br>classification and<br>provisioning|_No,_in preparation|No, in preparation|_No,_in preparation|No, in<br>prepartion|No, in<br>preparmtion|

Source: **Countrica** central bank and banking law acts and World Bank (1992).
Page 9 other four countries have opted for the German model of universal banking. This has defined the role of banks in the transition. In Hurgary commercial banks can attract deposits and grant loans but are restricted on the volume of investments they may hold. Investment banks cannot attract deposits but can engage in enter:-rise restructuring and other types of investment activities. Their investments are only limited by their capital and reserves. In the other four countries, however, banks are empowered to performed both the commercial and investment bank functions and the legislation is very liberal in allowing banks to make long-term investments in areas such as real estate and securities.

The Bulgarian and Romanian legislation is the most liberal, since it allows banks to invest up to 100 percent of their capital and reserves. By contrast, the Polish and the CSFR bank legislation limits long-term investments to 25 percent of the bank capital and reserves.' Although all five countries introduced similar monetary and credit instruments, by imposing bank reserve requirements, credit ceilings and interest rates, some small differences remain. Hungary nlone has retained interest rate ceilings and it also has the highest reserve requirement. The level of reserve requirement is only a relevant indicator in Hungary and Poland.' In the other three countries most deposits are held by savings banks, and commercial banks are funded by the interbank market or the central bank (see table 2).

All five countries have opted in principle for a capital adequacy of 8 percent of risk-adjusted assets, a choice that conforms with the Basle Agreement. In practice they use different methods to calculate risk-adjusted assets. To date, Hungary has a method for calculating the risk-adjusted assets, but the CSFR and Bulgaria are still drafting reguiations, and Poland and Romania have not drafted the 8 percent capital requirement. In addition, Hungary and the CSFR have defined a transitional period In Hungary, **CSFR** and Bulgaria the **law** excludes from long-terrn investments any collateral or pledge that banks might have taken **poe-** seuion of **as a** result of foreclosing on guarantees provided by their borrowers. In Hungary reserve **requirement** were 16 percent and remunerated in end-1992, in Poland it **was** 30 **and** 10 percent for **short** and long terrn deposis, respectively, and remunerated. Ir the former CSFR, Bulgaria **and** Romania, reserve requirements were 8, **7 and** 10 percent rempectively, **and also remunerated.**
Page 10 for compliance. Hungarian banks should have complied with a 7.25 percent risk-weighted capital by January 1992 and 8 percent by 1993. CSFR banks should comply with 6.25 percent by end-1993, and 8 percent by end-1995. Bulgaria is in the process of defining the transitional period; in Romania banks will be required to comply with the 8 percent ratio by end-1994; and Poland will soon enforce this requirement.

All five limit exposures to a single borrower and shareholders. The banking law limits the risk of losses and prevents shareholders from benefiting from bank ownership. Limits on exposure to a single borrower range from a high of 25 percent of capital in four of the five countries, to a low limit of 15 percent of capital for Poland. The Bulgarian and Hungarian legislation is the strictest limiting lending to shareholders to 1 and 5 percent, respectively, whi; CSFR and Poland have a limit of 15 percent.

The legislation is different in other important respects as well. First, few countries have a deposit insurance scheme. In Hungary, Poland and Bulgaria the banking law requires that banks offer deposit insurance, but the schemes have yet to be introduced. The CSFR and Romania have the old deposit protection whereby only state- owned banks and government deposits are protected. Providing a deposit insurance scheme for banks with a large proportion of nonperforming loans is problematic. Such banks have a higher probability of default, and hold a large proportion of all banking system loans, which increases the overall cost of the deposit insurance and imposes a high burden on well-managed banks with low nonperforming loans.

Second, countries impose different restrictions on establishing new banks and on bank ownership. The Hungarian and Bulgarian bank legislation have the highest minimum capital requirements. In Hungary the government's share is limited, and together with Poland, limits the proportion of shares held by a single individual and/or institution. The CSFR and Romania are more
Page 11 liberal concerning the entry of new banks. Entry of new banks is only limited by the minimum capital requirements, while in Poland new banks only need the National Bank of Poland's approval.

Third, in practice, bank's ability to initiate foreclosure procedures is weak because few countries have a well-functioning bankhuptcy law and/or have defined property rights. Yet this is key for the development of the banking system. Such statutes define the instruments banks use to exert pressure on borrowers and it defines the protection provided for insolvent enterprises. Because most bank loans have been granted to SOEs and banks cannot foreclose on state-owned assets, banks have been inhibitu from using foreclosure and liquidation as instruments to impose discipline on loss-making SOEs and force their restructuring. Without clearly defined property 2.ghI bank cannot use SOEs' assets as collateral on loans and therefore their absence limits the supply of credit. In most cases banks are demanding personal mortgages, bank deposits or cross-guarantees as a condition for granting a loan, all factors which have increased the borrowers' risk.

Hungary and CSFR have introduced bankruptcy legislation, and Poland, Bulgaria and Romania plan to introduce it soon.<sup>6</sup> However, only Hungary has a market-oriented bankruptcy law. To forestall the massive failure, the CSFR granted enterprises a one-year transition period. Aside from Poland, there is no scheme for restructuring enterprises before they fall into bankruptcy. There are a large number of enterprises in weak financial situation. In fact, the large number of financially weak enterprises in most countries will overload the courts and postpone liquidation. An example is the case of Hungary which introduced a type of Chapter 11 clause in their bankruptcy law. But to protect themselves by the end of March 1992 more than 2,000 enterprises filed for bankruptcy.' This flood of cases resulted in large losses for banks and postponed enterprise restructuring and liquidations.

> ***** In **Romanua** the authorities introduced the so-cailed Law 76 which allowed banks to foreclose **onb** on enterprises that failed to **repay** their global compenstion bank **loans** in 1992. However, anecdotal evidence indicates that banks refrained from **foreclosing** on enterpriwes **because** of property rights **isues** and because the legal procedure would have been too long. Insad, some anecdotal and enpirical evidence indicates that banks refinanced **enterprises'** overdue global conmpensation bank **loans.**

7 See Bwuineu **Eastern** Europe (1992)
Page 12 A key problen common to all countries has been delay in instilling market-oriented banking supervision capable of enforcing the banking law. Bank supervisors must be able to carryout on- and off-site bank examinations. These are key for developing the banking system because it assures depositors' trust on the soundness of the banking system, ensures strong bank governance. It assures that bank problems will be corre.ed on time and/or banks will be removed from the system. Hungary is the only to have made progress in: retraining existing supervisors, bringing u3lified supervisors acquainted with western practices, introducing new accounting star **for** barks and providing the institutional strength needed for conducting bank supervision. It w_. thr -nly country that established a new bank supervision institution (e.g., SBS), while the other four coimnries left the old central banks' departments responsible for bank supervision (see table 3).

None of the five countries have introduced standards for loan classification and provisioning. As a temporary arrangement most countries had relied on external bank audits. Yet loan classification standards are central for bank supervision. Disclosure and classification of loans by banks should enable depositors to select a bank to deposit their savings. Hungary and CSFR are close to introducing such a regulation, Poland, Bulgaria and Romania are planning to do it at a later date.

# 2. Institutional Measures

Institutional measures were taken to deal with the inefficiencies of the payment system and to address the banks' nonperforming loans. Few countries have undertaken measures to overcome problems with the structure of the banking system. Problems with the structure include: the segmentation of the banking system between a circuit of banks serving enterprises and another serving households, and the oligopolistic competition resulting from the coexistence of a few large banks holding most of the bad assets and of a large number of small banks. Most countries decided to deal with these problems by enhancing bank competition and removing the bank specialization by allowing banks to undertake most banking activities.
Page 13

# Overcoming the Payment System's Inefficiencies

Because of its importance for enhancing bank competition and making monetary policy effective, most countries started their institutional reform with the reform of the payment system (see table 4). Most countries began from scratch because centrally planned economies did not rely on such a system. Unlike a market-based banking system, in a centrally planned economy there was no need to link all banks; it was desirable to segment the banking system.

The five countries followed a similar approach; in all progress was slow. Establishing a payment system was a cumbersome and complicated undertaking. It required creating a national electronic network for settling and clearing payments. It also required introducing a regulatory **aid** a policy framework to guide the operation of the system.

Most countries took a long time before starting to operate the payment system and some are still experiencing delays in bank transfers. The delays are worst in Bulgaria and Romania, which got a late start. Moreover, delays in verification of transfers and settlements led some central banks to assume the liability of banks with insufficient funds in their correspondent accounts.

The inefficiencies of the payment system have hindered bank competition. The largest banks with more developed branch networks can offer better payment services to their customers and therefore have obvious advantagus over the small ones. The inefficiencies also has impeded the efficient management of monetary policy. The central bank had to keep large outstanding balances to ensure their liquidity and when the authorities made monetary policy restrictive it resulted in bank illiquidity rather than in an increase in the inter-bank interest rate.
Page 14

|Date of Introduction of<br>lhepaymentsystem<br>**land**avernge delay in<br>ettlingabankcheque|1988 and takes 10<br>**days**|1990andtakea<br>between 10and<br>20 days|_<br>_<br>1991andtakes<br>about 3 days|_<br>_<br>1991**and takes**<br>between 15 and 20<br>days|<br>1992 and**takes**<br>between 15 and<br>21 days|
|---|---|---|---|---|---|
|**Remnoval**<br>of banks bad<br>!,%ana<br>and/or<br>r.capializationof<br>**bankb**<br>**using**fiscal<br>leources,|Yes, 50 percent of<br>threeLargest<br>banks<br>nonperforming<br>loans<br>inherited in 1987,<br>which accounted for<br>1.7percent of total<br>SOEsloansby<br>end-1987.|Yes, banks'<br>foreign exchange<br> <br>losses were<br>covered in 1991<br>and a new bank<br>recapitalization is<br>being considered<br>in 1993.|Yes, 30 percent of<br>all outstanding<br>loans to the<br>enterprisesectorin<br>January 1991.|Yes, 100 percent<br>of enterprises<br>loansiuanding<br>at end-1990 were<br>gusrarteed by the<br>state.|Yea, 90 percent<br>ofallenterprise<br>nonperforning<br>loans outsanding<br>in December<br>1990.|
|Auditswere used to<br>dletrtmined<br>amount of<br>ecapitalizations|Yes|Yes|No, based on<br>banks' own<br>assessment|No, based on totAl<br>loans granted in<br>end-1990|No|
|Instrun**-it**for<br>removingbanks' bad<br>loans and/or<br>recApitalizingbanks|government<br>guarantees callable<br>upon the initiation<br>of liquidation<br>procedures.|government bonds<br>denorninated in<br>foreign currency;<br>and for the new<br>recapitalization<br>15-vears<br>government bonds<br>includingSyears<br>of grace|Nonperforming<br>loans were<br>transferred to the<br>Consolidation<br>Bank and<br>govemment honda<br>were issued for<br>recapitalizing<br>banks|government<br>guarantees and<br>bonds|Proposed to be<br>4-year<br>government<br>bonds.|
|Amountof<br>nonperfromingloans<br>coveredby the budget|Pt 10.5 bn in<br>government<br>guarantees or 1.7<br>percent of total<br>banks' loans<br>outstanding with<br>enterprises by<br>end-1987|<br>USS 5.5 bn in<br>dollar-denominate<br>d government<br>bonds issued to<br>finance the<br>foreign exchange<br>losses; and an<br>undetermined<br>amount for the<br>new bank<br>recapitalization<br>scheme.|Kcs 120 bn of<br>banks<br>nonperformning<br>loans were<br>transferred to the<br>Consolidation<br>Bank and ,in<br>addition, a transfer<br>of Kcs 50 bn was<br>made for covering<br>enterprises'<br>nonperformiing<br>loans and for<br>recapitalizing<br>banks.|Lev 4.1 bn in<br>government bonds<br>**and**the<br>government<br>provided<br>guaranteed on toe<br>Lev 46 bn bank<br>outstanding in<br>end-1990.|Lei 150 bn in<br>banks<br>nonperforrning<br>loans, Lei 50 bn<br>for bank<br>recapitalization.|
|Link bank<br>recapitalization to<br>enterpriseprivatization|Yes, indirectly|Yes, directly|Yes, indirecUy|Yes, directly|No|
|Link bank<br>recapitalization<br>to bank<br>privatization|No|No|No<br>_|No|No|
|Do banks have to<br>approve enterprises in<br>armarears,eitfitiorhno<br>plans?|Yes|Yes, in the new<br>scheme|Yes|No|No|
|Enterprise privatization<br>involved a giveaway<br>scheme.|Subsidized loans<br>have been offered to<br>nationals purchasing<br>shares|Yes, the Mass<br>Privatization|Yes, the Voucher<br>Scheme|It is being<br>considered<br>I I I I|Yes,**similar**to<br>Poland**and**<br>CSFR's**schemes**<br>usingprivate<br>investment funds.|

Source: World Bank (1992), Demekas and Khan (1991) , OECD (1991), The National Bank of Hungary (1991) and Thorne (1992).
Page 15

# Macroeconomic Conditions and Schemes for Dealing with Banks' Bad Loans

In 1991, the SOEs in most countries started experiencing difficulties. The causes of the problem were multiple: the introduction of market forces, the trade shock from the collapse of the CMEA, the economic recession resulting from the macroeconomic adjustment and the introduction of new accounting standards. All these factors, in combination, made the fragile financial situation of most enterprises apparent. The enterprise crisis led to a sharp fall in overall production. Moreover, even though most governments had undertaken very drastic cuts in their expenditures and introduced new tax systems, the SOEs crisis undermined the government's ability to balance the budget.

The crisis of the enterprise sector showed up in the banking system. Banks in Hungary and Poland, which posted large profits until 1990, started showing large nonperforming loans by 1991. In Poland, CSFR and Bulgaria, banks started to allow SOEs to capitalize the interest on their loans as a way of helping them to cope with the crisis. In Poland the capitalization of interest accounted for 100 percent of the credit expansion in 1991; and in Bulgaria banks, on average, capitalized about 50 percent of the interest on loans in 1991. In Hungary, Poland, CSFR, Bulgaria and Romania, SOEs' resorted to inter-firm credit as a way of coping with their illiquidity. At one point, in Romania the inter-firm credit problem became so acute that it trapped both creditworthy and noncreditworthy SOEs and threatened the collapse of the entire enterprise sector had the government not stepped in.

INITIAL MLACROECONOMIC CONDmONS. It seems straightforward that the countries' ability to overcome the bad debt problem and to introduced bank reform would be influenced by the initial macroeconomic conditions, in particular, by the fiscal costs. Yet. in all countries the proportion of nonperfroming loans to total loans was quite similar despite different macroeconomic conditions (see table 5). Countries such as Hungary, Poland and the CSFR faced more favorable initial macroeconomic conditions: first, the size of total bank loans (and thus of bad loans) as a ratio of GDP was relatively low and, second, the macroeconomic adjustment programs were most successful. Both of these
Page 16 conditions implied that dealing with banks' bad debts ! would be less costly in fiscal terms. In Hungary and Poland the total enterprises' loans as a share of GDP was less than 20 percer.t but ..! Bulgaria and Romania these were about 50 percent. This might be explained by the fact that Hungary and Poland started the banking reform several years before the political openingtook pIace. polItIcal opening took place. In particular, the size of the

|**Table S. Macroeco**|**nomic**<br>**Indic**<br>|**ators, Nor**<br>**Costs**|**perform**|**ing**<br>Loans**a**|**nd Fiscal**|
|---|---|---|---|---|---|
|_||||||
|_Ratio of Enterprises'Bank_<br>_CredittoGDPrinpercent)_||||||
|In end of 1990|25.8|<br>15.6|<br>60.5|<br>78.8|<br>38.6|
|InJune 1991|24|<br>18.4|<br>62.4|<br>47.8|<br>44.6|
|_Real InterestRates_||||||
|In end of 1990'|1.9|<br>-44.4|<br>-32.6|<br>-35.5|<br>-96.8|
|In 3rd Quarter of 1991<br> <br>|8.1|<br>15.6|<br>2.3|-71.9|<br>-31.7|
|__na_<br>_a_<br>_fhiito_<br>i<br>_AnnaaJ Rate of lrMJanon O?n_<br>_percent)_||||||
|In end of 1990|33.4|<br>250|<br>16.6|<br>64|<br>150.1|
|In June 1991|36|<br>79.9|71.3|<br>554.6|<br>224.9|
|_Memo Items:_||||______||
|Estimnated Ratio of<br>Nonperforrning to Total<br>Loans in 1991 (in percent)|50|<br>40<br>_|55|44.2|36.6|
|Estimated Fiscal Cost of<br>Removing all Bank<br>Nonperforming Loans Cin<br>percent of GDP) in June<br>1991'|5.4|6.5|5.6|17.7|<br>22.9|

Source: Countries official **statistics** and author's **estimates** I Because the end of 1990 CSFR's real interest rate was not available, I have used the **first** quarter of 1992 .

2 It is the interest cost of either swapping government bonds for bank nonperforming loans or of providing a governrnent guarantee on these loans. Since there is no market government bonds in these countries, I have used the average nominal lending rate **as a** proxy.

monetary overhang in these two countries was relatively small in early 1990, while in Bulgaria and Romania it was very high. Furthermore, Hungary, Poland and the CSFR were very effective in stabilizing their economies and in lowering the inflation rates.

The low ratio of total loans to GDP and the successful macroeconomic conditions had two very imDortant consequences First, the lower inflation rate, by lowering the nominal interest rate, reduced die fiscal cost of overcoming the enterprises' bad debt problems. For instance, had governments assumed all bank bad loans, the fiscal cost would have been about 6 percent of GDP in Hungary, Poland and the CSFR, while it would have been about 20 percent of GDP in Bulgaria and Romania.

While assuming all bad loans would not be good economic policy, it illustrates the likely effect of such
Page 17 a decision on macroeconomic performance. Therefore, the authorities in Bulgaria and Romania were less inclined to provide a bold solution to the bad debt problem and more willing to let the high inflation rates and negative real interest rates reduice the real value of the bad debts even though this undermined the economic stabilization effort.

Second, the shift to positive real interest rates in Hungary, Poland and the CSFR (most likely as **a** result of the macroeconomic stability and lower inflation rates), by increasing the demand for bank financial assets, enabled banks to expand, to reduce the proportion of bad loans and to increase their cash income. The positive real interest rates, by rationing the demand for loans, also may have encouraged financial discipline among borrowers.

SCHEMES **FOR DEALING** wiTH ENTRPRisEs BAD Lo-Ns. Although all the countries introduced schemes for dealing with enterprises' bad debts and for reforming their banking systems, there were important differences among them. These are summarized in Table 4 and are briefly described and evaluated for each country below.

_Hungary_ followed a gradual approach to the problem of the nonperforming loans and tried to distinguish the solution of banks' nonperforming loans from the solution for overcoming SOEs problems. Until end-1989 the authorities argued that banks were in good financial condition. But this situation started to change in late 1989 when the auditors applied stricter standards and the size of the nonpirforming loans in the three large banks became apparent (amounting to Ft 10.5 bn or 1.7 percent of total bank loans outstanding with enterprises by end-1987).<sup>8</sup> In December 1991, the government recognized this problem. The government responded by (a) providing government guarantees on 50 percent of the three banks' nonperforming loans still outstanding by the end of 1987;9 (b) exempting from income tax additional loan loss provisions on the

> 5 **See** **_Nyers_ and Rosta Lutz** (1992) for **a** discussion of **the** whole enterprise privatization process. **These five-year guarantees were only** callable when liquidation proceedings on **the debtors had** initiated;
.e 18 nonperforming loans; (c) limiting distribution of dividends until the nonperforming loans have been fully provided; (d) allowing the large commercial banks to swap its inherited stock of nonperforming loans for equity;'° and (e) accelerating the privatization of banks in order to attract new capital into these three banks.

There are two important aspects of the Hungarian scheme. First, the scheme might fail to take full account of the total nonperforming loans in these three banks. According to independent bank audits, nonperfroming loans hovered between Ft 50 bn and Ft 100 bn by the end of 1991." Second, the scheme link,d the recapitalization of banks to the effectiveness of the bank managers in dealing with bad debtors. This was done by limiting the use of guarantees to the initiation of liquidation proceeding on the debtors and by forcing the debtors to seek approval of restructuring schemes from the banks. This approach relied on the effectiveness of bank managers' assessment of enterprises' future. Preliminary evidence indicates that bank managers requested additional guarantees and granted additional loans to debtors to improve their portfolio, and to limit the required loan loss provisions.

Aware that the true problem originated in the enterprise sector, the authiorities decided to accelerate the privatization of enterprises through the appointment of a Minister without portfolio. The authorities, committed to the gradual approach, increased the number of enterprises for sale and provided low interest finance to citizens to purchase shares in these enterprises. The National Bank of Hungary (NBH) introduced a series of refinance credit lines at subsidized interest rates (subsidy amounted to 25 percent of the base rate) to encourage the sale of enterprises and starting up new ones. The NBH argued that the subsidy would not result in NBH losses because the proceeds would be used to retire the 6 percent interest government debt."<sup>2</sup>

> I° An **example** is **the** Hungarian Credit Bank which swapped Ft 6.42 billion of Tungram's bad loans for 91 percent of its **equity.** A controlling interest of 51 percent was later sold to General Electric. See Radio Free Europe Research Report (1992).

> "1 **This is** a very conservative estnimte, **sone** other **studies** based on estimrated arrears calculate **the** size of nonperfroniing **loans** in as **much as** Ft 500 **bn** or 50 percent of **total loans** in 1991.

> 11 Se National Bank of Hungary (1991) for a discussion of the refinance schemes available to national willing to **buy** or dart new **enterprises.**
Page 19 _Poland,_ in a recent attempt linked the recapitalizatiun of the nine commercial banks to the restructuring of the SOEs. Poland started confronting the problem of banks in 1990, when both the banks' and the enterprises' financial statements showed a .ry good financial situation. The authorities only dealt with the foreign exchange losses held by two specialized banks and amended the regulatory and supervisory framework,'<sup>3</sup> The authorities improved the management of the commercial state-owned banks through twining arrangements with western banks and by establishing supervisory boards. Little was done to establish a regulltory and supervisory framework.

In 1991, the situation of the enterprises and banks deteriorated quickly and, as a result, the economy experienced its second year of recession. By mid-1991, the first audits of some commercial banks already showed a rapid accumulation of nonperforming loans. According to bank audits the proportion of nonperforming loans increased from about 15 percent of total loans in end-1990 to 40 percent in June 1992. This prompted the government to design a scheme for dealing with both the banks' and the enterprises' problems.

The government s improving the nine banks' governance by: (a) recapitalizing the nine commercial banks to a 12 percent of capital adequacy level using 15-years and 5-years of grace govermnent bonds; (b) granting banks' supervisory boards greater control of and oversight over bank management; and (c) introducing a market-oriented regulatory and supervisory framework. The nine banks now, more effectively governed, would participate in the restructuring and privatization of enterprises. Using tools such as partial debt write-downs and debt-equity swaps, the banks are anticipated to play a key role in enterprise restructuring and privatization. Legislation will place limits on banks' activities and thus prevent banks from granting new loans to enterprises and limit the maximum volume of enterprises shares that banks could hold to 50 percent of bank capital. Debt relief would be contingent on enterprises submitting restructuring proposals acceptable to banks. Enterprises

> **LIn** mnid-1991, **the government** issued USS **_5.5_** bn in foreign currency-denominated bonds with **a** miaturity of **twelve** and **a** ':!f **years** for rccapitalizing **these** two banks.
Page 20 that became nonviable even after debt-relief or whose managers would fail to provide a restructuring plan acceptable to the banks, would be forced into liquidation.

Because the success of the scheme depends on limiting the social consequences of massive lay offs, the government will establish a special fund for enterptises w/hose liquidation might have important social consequences. This fund will be sanctioned in the 1993 budget law and will be used for restructuring and/or paying the costs of enterprises considered socially important, for example, enterprises whose liquidation would have important social effects or enterprises the government wants to retain.

For the successful implementation of this scheme the competence and independence of bank managers is critical. Bank mandgers are responsible for determining the viability of enterprises and the size of the financial subsidy. This, however, requires very strong bank governance like that that prevails in Japan and Germany. To some extent, the authorities have provided this through the recapitalization of banks and through bank regulation and supervision. And the scheme as it stands seems to have been well designed to reward managers for good credit decisions, but not necessarily to penalize them in case of bad credit decisions. A good governance structure must include an incentive structure with "reward and risk" features that are a common feature of corporations in market economies. In a market economry private ownership means that the losses resulting from bad loans are paid directly out of the owner's capital and the managers face the risk of being removed. These penalties are difficult to introduce as long as banks are state-owned. In a state-managed bank the manager faces no risk in addition to the risk of being removed and even this threat is somewhat doubtful because there are not enough trained replacements. Perhaps for these reasons the authorities have found it necessary to establish a unit in the Ministry of Finance to monitor the state-owned bank-led enterprise restructurings.
Page 21 _CSFR_ chose rapid privatization of banks and anterprises. In May 1992, the government started the first wave if voucher privatization by offering 1,491 enterprises for sale, among which were offered about 50 percent of the shares of the two state-owned commercial banks. It also put about 50 percent of the shares of the other state-owned banks in the second wave. The government plans to use the other 50 percent of the banks' shares for restitution and to attract a controlling partner.

Prior to the privatization the government adopted measures to manage the banks' nonperforming loans. As in Hungary, it provided for a partial bank recapitalization while relying on banks, as Poland had done, to identify the viable enterprises. Yet unlike Hungary and Poland, CSFR has accelerated privatization to impose control on both state-owned enterprises and banks. The govermment proceeded in two steps.

In January 1991, under pressure from banks, the government decided to remove a portion of the nonperfroming loans. These perpetual loans, the TOZ loans, were yielding six percent interest and had no amortization schedule. SOEs were compelled to take these loans to re-lend to the government, which was, by the early 1970s, experiencing a cash shortage. To decide the amount of the recapitalization, the government asked the banks to select the TOZ loans they wanted removed from their balance sheets.

In February 1991, of the total Kcs 170 bn of TOZ loans held by the two state-owned commercial banks, the government transferred Kcs 120 bn in loans and liabilities out of the commercial banks and into to a newly established Consolidation Bank (KON), which had the sole function of holding and collecting these nonperforming loans. The liabilities transferred were deposits from the central bank, the state-owned insurance companies and the Savings Bank held by the two commercial banks. Moreover, the transferred loans were retained as claims on the enterprises and the conditions were renegotiated by increasing the interest rate to 13 percent and fixing the maturity at 8
Page 22 years. Similarly, the commercial banks also renegotiated the TOZ loans they kept by increasing the interest rate to 22 percent and fixing the maturity at _5_ years.

Second, in late 1991, the government concerned with the over-indebtedness of enterprises that otherwise could be viable and with the low capital adequacy of some of the banks, decided to make Kcs 50 bn available for these two purposes. It provided banks with Kcs 38 bn for overindebted viable enterprises, and Kcs 12 bn for recapitalizing the four commercial banks and the two savings banks. While banks were responsible for identifying the enterprises eligible for the debt-relief (provided that enterpris-c incurred this debt before 1990), a specially designed commission was responsible for reviewin- the bank,-' selection. In addition, the government used the Kcs 12 bn to recapitalize the four commercial banks to a 4.2 percent level of capital adequacy and the two savings banks to 3.2 percent level. In doing th.s the government assumed that the banks held no more nonperfoiming loans.

But although the government had provided the banks with Kcs 170 bn for bank recapitalization purposes (amounting to about 30 percent of all enterprises' loans outstanding by end-1991), anecdotal evidence and preliminary estimates indicated that state-banks held about Kcs 145 bn more in nonperforming loans (or about 25 percent of all enterprises' outstanding loans by end-1991). The government indicated its commitment to avoiding further recapitalization of banks because of fiscal constraints.

But the presence of banks with large nonperforming loans inclined to take greater risks together with very liberal restrictions for establishing investment funds for participation in the voucher scheme, established yet another new link between banks and eniterprises. As a way of growing out of their difficulties, the former state-owned banks established their own investment funds and bid for enterprises. However becauise they used a separate institution, such as the investment fund, there have been limited negative consequences on the banks' portfolios. Evidence indicates that the former state-owned banks' investment funds accounted for a large number of the more than 400 registered
Page 23 investment funds, banks' investment funds made the highest redemption offers and thus banks' funds were the most popular.<sup>14</sup> While the complete investment strategy of the state-owned banks is not yet entirely clear, at least one part of the strategy appears to be making high redemption offers in order to accumulate a large volume of the vouchers and then bid for their client enterprises. This will enable banks to influence their client enterprises' market value through the bidding process and to gain full control of the enterprises' management. The investment law currently limits an investment fund to no more than 20 percent of the holdings of a single enterprise. Banks have circumvented this rule by establishing several funds. Therefore, bank investment funds mirror the role of investment bank in **the** pre-1930s U.S. and/or in the pre-1980s Japan.

Three important aspects of the CSFR scheme stand out. First, it illustrates the complexities of designing a strategy for dealing with banks and enterprises. While it might be desirable to use banks to enhance enterprises' corporate governance, it is risky to rely on banks subject to moral hazards. Because these banks have large nonperforming loans they mighlt not be the best instruments.

Second, voucher privatization was a key instrument for determining market value ani enterprise viability. This, in turn, contributed to financial reform by providing banks information about the financial condition of enterprises. Through voucher privatization bank managers learned the market value of the enterprises in their own portfolios thus enabling them to focus on viable enterprises.

Third, investment funds and privatized banks were the main instrument to impose control on enterprises. There is evidence that investment funds and privatized banks strengthened their corporate governance by getting technical assistance from western banks. For instance, the privatized, formerly state-owned, banks have sought technical assistance and established joint ventures with foreign banks.

14 **Preliminary** infornation indicates **that out** of **the** six finds which are expected to control 30 **percent** of **the assets, four are owned by state-owned banks or insurance** companies. Moreover, state-owned banks' funds redemption **offers hover between 10 and 15 times, while** **_the_ other funds made** much lower offers.
Page 24 In this respect, the CSFR scheme is different from the Polish one where state-owned banks will establish control of enterprises.'<sup>5</sup> _Bulgaria_ and _Romania_ are still designing their strategies for restructuring their banking systems; in this sense they are behind Hungary, Poland and CSFR. Most of the measures taken were still partial and in some respects responded to the problems faced.

Although _Bulgaria_ is designing a program for dealing jointly with the bank and enterprise problems, it has made little progress in enterprise privatization and restructuring. It has started with land and small-scale enterprise privatizations and will soon start a pilot project for the privatization of large-scale enterprises.

Concerning the strategy for dealing with banks' nonperforming loans, the government has guaranteed _all_ bank loans granted by end-1991, which amounted to about Lev 46 bn (or 37 percent of 1991 GDP). To limit the effect on the budget deficit, the government plan-s to make these guarantees available gradually. There will be fixed annual ceilings and requirements regarding the restructuring and privatizing enterprises. If the arnount needed for enterprise liquidation and privatization is less than the ceiling, then the bonds can be used for bank recapitalization based on portfolio reviews. However, since the privatization law is still expected to be passed by Parliament and the progress in privatizing and restructuring enterprises is slow, the government is allowing the different government agencies and sectoral Ministries to use the bonds for granting debt-relief based on sectoral priorities. In the future, it is expected that the Privatization Agency will be responsible for the coordination.

Moreover, since banks' nonperforming loans (which were estimated in Lev 17 bn by mid-1991) might lead to bank liquidity problems because of bad debtors not paying interest en the loans, the government has allowed banks to capitalize the interest on the central bank deposits held by banks (which are distributed among banks in the same way as the nonperforming loans). In addition, to u I thank Richard **Salzmann** for naking this point to me at an EBRD conference
Page 25 preventing debtors from taking advantage of the government guarantee and to forcing banks to collect on these loans, the government has prevented banks from lending to enterprises that fall into arrears with the banks.

To reestablish control on banks, the government has created a Bank Consolidation Company (BCC). The government has required that all state-owned enterprises or banks holding shares of other banks transfer them to the BCC, and by early-1992 the BCC held about 70 percent of all banks' shares. This was considered a necessary precondition for enabling banks to take independent credit decisions from their borrowers which at the same time were their owners. Once this process and the bank portfolio reviews are completed, the government plans: (a) to merge the large number of small banks into eight medium-sized banks; (b) to recapitalize the banks by substituting government bonds for the nonperforming loans; and (c) to start the process of bank privatization.

In _Romania,_ the government focused on dealing with banks' nonperforming loans and, as in Bulgaria, the enterprise privatization is still in an early stage. The government has taken three measures. First, in July 1991 the government guaranteed 90 percent (or Lei 150 bn) of all bank nonperforming loans outstanding at the end of 1990. It also compelled banks to take responsibility for the remaining 10 percent over a period of several years by building up their provisions.

Second, in December 1991 the government introduced a scheme for clearing up the accumulation of inter-firm arrears. By the end of 1991 inter-firm arrears had reached about Lei 500 bn or 40 percent of total bank loans outstanding to enterprises. The inter-enterprise arrears threatened the collapse of the whole enterprise sector since it linked go^d and bad enterprises. The gover'iment netted out and cleaned up these arrears by enabling enterprises with outstanding inter-enterprise credits to discount them with the commercial banks until January 1991. Banks should then grant debtor enterprises a special loan (a global compensation bank loan (GCBL)) at market interest rates. To avoid the deterioration in bank portfolios and force enterprises to repay the bank loans, the government
Page 26 guaranteed the loans that became due in September 1992 and provided the creditor bank initiated foreclosure proceeding leading to the liquidation of the debtor enterprise. To accelerate enterprise foreclusure, the government passed the so-called Law 76. But until the end of 1992 there was no case of enterprise liquidation and anecdotal evidence suggest that banks refinanced most of the overdue GCBL.

Third, in 1993 the government is planning to provided Lei 50 bn in additional funds for bank recapitalization.

Although the measures taken by the Bulgarian and Romanian authorities for dealing with the banks' institutional problems have important differences, they both emphasize re-capitalization of banks as the way to improve banks' corporate governance. In this sense they resemble some aspects of the Polish scheme and thus, are subject to similar comments. Unlike the Polish scheme, the link between the bank recapitalization, on the one hand, and bank restructuring and enterprise privatization, on the other, was not clearly defined. Both the Bulgarian and Romanian schemes can lead to an across-the-board debt forgiveness. For instance, in Romania available evidence indicates that because the debt write-off was neither linked to enterprise nor to bank restructuring ent.rprises, banks granted new loans to these same enterprises. By the end of 1990 bank audits suggested that these same enterprises accounted for a large proportion of the post-1990 bank bad loans and for the global compensation overdue loans. The post-1990 bad loans accounted for about two-thirds of the total bad loans outstanding in September 1992, close to 30 percent of total bank loans.

The notable difference about Bulgaria was the guarantees provided. Bulgaria is the only **country that has** openly recognized _all_ enterprises loans. All other countries have been reluctant to make such acknowledgments because of the large fiscal costs involved. Instead, most other countries have opted for guaranteeing only the proven nonperforming loans. In Bulgaria, for instance, the total guarantees amounted to Lev 46 bn or 44 percent of total bank loans outstanding with enterprises by
Page 27 end-1991, while in Romania the government assistance for bank recapitalization amounted to Lei 200 bn or 10 percent of total bank loans outstanding with enterprises by end-1991. In Hungary, Poland and the CSFR the government has agreed to guarantee a smaller proportion of total enterprises loans. While it is important that the government recognize the old bad debts, it is also important to link that to the overall objective of enterprise privatization and restructuring.

# 3. Bank Privatization

All five countries have as the final objective of bank restructuring the privatization of banks. Few countries have succeeded in this difficult task. Of the five countries, the CSFR has privatized the largest number of banks. One bank was completely privatized through direct sales, while the others were partially privatized through voucher schemes. Poland might be close to privatizing two banks. Yet except for the CSFR, none of the five countries has conditioned bank recapitalization on the privatization of banks. A controlling investor is needed to ensure a strong bank governance. Despite this, all five countries see bank privatization as the only way of improving banks' corporate governance.

There are three reasons for stressing bank privatization as the final and most important goal in bank restructuring. First, recapitalization of banks and transfer of ownership to the private sector is the only way of assuring an adequate corporate structure, that is, the only way of assuring bankers' credit decisions are made independently of their creditors' interests. This is the key for ensuring banks take an active role in the transition. Private ownership of capitW generates a system of risks and rewards that is the basis of the corporate governance structures found in market economies.

Second, a sufficient number of banks with an adequate corporate governance structure are required to guarantee a competitive banking system. This will ensure that bankers reward for lending is linked to their ability to minimize risk, and that they pay dearly for assuming high risks. When this
Page 28 does not happen, the bad bankers will set the rules of the game and the good bankers will be pushed out of competition."6 Third, bank privatization should influence the design of the bank restructuring strategy. Because the objective of any privatization strategy is to maximize the discounted present value of the assets subject to privatization, the authorities should ensure that any investment should be in line with this principle. However, this is difficult in the case of banks because the quality of the bank portfolio, which is the most important asset in a bank, can be subject to different assessments depending on the criteria used. It is likely that bankers' opinions differ in assessing bank loans. Because the value of a banks' assets is maximized at the time of recapitalization, it is argued that the assessment should occur immediately upon privatization.

Although the five countries have not been very successful in privatizing banks, some have followed altemative strategies for enhancing the banking system corporate governance. Interesting examples are the cases of Hungary and the CSFR. Both countries have tried to introduce market discipline in the banking system by encouraging the establishment of banks with a stricter corporate structure. Hungary did this by encouraging the entry of foreign-owned banks and the CSFR by encouraging both foreign and domestic-owned banks. In Hungary the number of joint-ventures increased from 2 in 1987 to 15 in 1991, and the number of commercial non-state-owned banks increased from 2 in 1987 to 11 in 1991. In the CSFR between January 1990 and March 1992, 34 new banks were established.

Although the strategy had the expected effect of enhancing competition, two problems have arisen. First, the new banks and, in particular, the foreign-owned banks, as expected, took advantage of their better position and focused on the less risky activities such as the foreign trade financing activities. Second, while a large number of new banks were established in both Hungary and the I Soo de **Juan** (1987) for a vivid account of how goods banks can **turn** into bad in an environn ent subject to **noral** hazards.
Page 29 CSFR, they only accounted for a small share of the market and could not swing the rules of the game in favor of the good banks and impose market discipline on the bad banks. The large banks holding most of the nonperforming loans have dominated bank competition. In addition, while this option has been available to Hungary, Poland and the CSFR, it might not be an option for Bulgaria and Romania not to mention some of the CIS countries since they have received less international attention and have received smaller foreign investment flows.

# E. **EFFICIENCY OF BANKING SYSTEMS: AN ASSESSMENT ATTEMPT**

In assessing the banks' performance, I will focus on two types of evidence: (a) trends in domestic credit allocation by sector and, in particular, allocation of credit to private sector enterprises; and (b) trends in domestic banks' real lending rates and interest rate spreads. This evidence should enable us to judge whether domestic banks have been allocating credit efficiently and whether the interest charged for these credits to the productive sector have been competitive. As is well known, if banks misallocate credit and/or charge high interest rates, they could preempt the economic recovery.

Because the available information is limited, the conclusions should be taken as preliminary. The available evidence should enable us to make a preliminary assessment of the role of banks in the transition and to extract some important lessons. To limit the data quality problems, I have decided to analyze trends in these variables and to focus on Hungary, Poland and the CSFR, the countries which are more advanced in restructuring tlhir banking system.

# 1. Credit Allocation

Using the available information on bank net domestic credit, we can assess the role of banks in the allocation of credit. Efficient banks will try to diversify their loan portfolio by lending to new good customers and limiting their lending to the old borrowers that have accumulated arrears with banks and account for most of banks' nonperforming loans. Moreover, it is possible to associate this
Page 30 diversification with the allocation of credit between private and SOEs. An increasing trend in bank lending to private sector enterprises should indicate that banks are trying to diversify, in particular, because SOEs account for most of the stock of nonperforming loans. This does not mean that all SOEs are nonviable enterprises, but rather that as the private sector develops, banks should be encouraged to lend to the potentially profitable private sector and therefore should target a larger proportion of their loans to them than to SOEs.

However, banks will respond to this behavior depending on the incentives they face ana the ability to minimize their own losses. For instance, if banks with nonperforming loans dominate in the market and they can by-pass regulations on required provisions on nonperforming loans, credit resources will be misallocated. Insolvent banks holding large nonperforming loans might decide to limit their provisions on nonperforming loans by granting new loans to their bad customers as a way of helping them to overcome their difficulties and turning them into good customers. Moreover, it could also happen that bankers behave as in the previous regime and grant credit to the old SOE customers because they have no incentive to diversify, or because the government compels bankers to lend to SOEs. In any case, this will have the consequence of crowding out the good borrowers from the banking system and thus lead to a misallocation of credit.

Evidence for Hungary, Poland and the CSFR indicates that banks, on average, have increased their loans to the private sector very quickly (see Graph 1). However, this growth in credit to the private sector was less rapid than the growth in private sector activity. In Hungary, the proportion of net domestic credit allocated to private sector enterprises increased from 0.6 percent of net domestic credit and 2.2 of total enterprise credit in December 1988 to 3.3 and 8.3, respectively, in December 1991. In Poland, bank credit to the private sector (which includes households) increased from 8.1 percent of net domestic credit and 9.7 percent of total enterprise sector in March 1989 to 20 and 23
Graph 1: Credit Allocation to the Private Sector <!-- Start of picture text --> Hungary<br>.. . _... . ...<br>3.- .. _<br>% oI of- Total Enterp -- % of Domeat Cred<br>A. Poland<br>.0<br>m , O a W.,- . - 0 3~O .. , go M- - 5 9<br>1S ~ ~ ~ CF<br>'A~ ~~/'<br>O - / '~~~~~<br>'I ~ ~ ~ ~~ L % or Total E:::rp - - %f D rne: 1 CT.H~<br>o~~~~~~~~~~~~~~~~~~~<br><!-- End of picture text -->
Page 31 percent, respectively, in November 1991. In the CSFR, these ratios increased from 0 percent in December 1988 to 5.6 and 6.1, respectively, in November 1991.

Another source of evidence for assessing the role of banks in the allocation of credit is the proportion of credit allocated to the private sector by type of bank. This information is provided in Graph 2 for Poland and the CSFR. This graph shows the proportion of credit allocated to the private sector by state-owned banks and by private banks. This indicates the extent to which bai'x holding nonperforming loans, such as the state-owned banks, have diversified their lending.

Both in Poland and the CSFR, private banks have increased their creiit to the private sector faster than the state-owned banks have. For instance, in Poland the private banks have increased their share of private sector loans from less than _5_ percent in December 1989, to about 40 percent in December 1991. In contrast, the state-owned banks allocated less than 10 percent of their total loans to the private sector. Similar conclusions follow from the evidence of CSFR's banks. In December 1991 the non-state-owned banks allocated more than 25 percent of their loans to the private sector, but the large state-owned banks only 5 percent.

# 2. Real Lending Rates and Interest Rate Spreads

Comparing Eastern European banks' real lending rates to those of German and U.S. banks is another way of assessing Eastern European banks' efficiency. If efficient banks dominate in the market and their commercial risks are similar, their average real lending will be comparable to that of the German and U.S. banks adjusted for devaluation and risk factors. Efficient domestic banks will charge a lending rate to their prime customers more or less in line with the alternative cost of finance, that is, the international lending rate. This will enable efficient domestic banks to attract low-risk customers. Differences in the lending rate might prevail if the cost of attracting ueposits is higher in Eastern Europe than in Germany and the U.S.
Graph 2: Allocation of Credit to the Private Sector by Type of Bank Poland <!-- Start of picture text --> 40<br>30<br>20 -<br>D; ,,,* t-~~~~~~~.-.. ............... *<br>10<br>Dec,89 Jun,90 Dec,90 Jun,91 Sept,91 Dec,91<br>--- State-Owned Special --- State-Owned Commer w Private Cammerci&l<br><!-- End of picture text --> <!-- Start of picture text --> CSFR<br>30 -.<br>A<br>Jo<br>O-Jan-91 0 lMar-SI T- 3 13po 1Sat- On JuBank iep-91 I~~~M Nkv-sI<br>|.- State-Owned Banks -^-- Other Banksl<br><!-- End of picture text -->
Page 32 If domestic banks have a larger proportion of nonperforming loans and are subject to high reserve requirements, they will have to charge a high lending rate and/or a large spread to compensate the income foregone. Since reserve requirements on commercial banks are relatively low (except for savings banks and banks in Hungary) the costs of nonperforming loans might be the most important cost driving the lending rates and/or the interest rate spreads. These costs, however, will result in high average lending rates (and/or low deposit rates) and interest rate spreads, only if most banks hold large nonperforming loans.

The comparison of the average real lending interest rates for each of the three Eastern European countries with those prevailing in Germany and the U.S., are shown in Graph 3. Differences in the real lending rates consist of changes in real lending rates and in real exchange rates."<sup>7</sup> The trends are illustrative of banks' policies.

In all three countries real lending rates have increased relative to international levels. Real lending rates increared very fast starting in 1991 and by end-1991 they were higher than those of Germany and the U.S. This change in the real lending coincides in most countries with policy changes. In the case of Hungary the increase in the lending rate in i991 coincided with the introduction of new bank legislation and the requirement for provisions on banks' nonperforming loans. Notice the large difference between Hungarian banks' and German banks' real lending rates in 1991, which was between 5 and 10 percentage points.

In Poland the increase in real lending rates coincided with the SOEs' crisis and the surge in banks' nonperforming loans. Polish banks' real lending rates were more than 15 percentage points higher than those of U.S. banks in 1991. This suggests that Polish banks needed to increase their revenue in order to compensate for the interest forgone of nonperforming loans.

> " To **calculate the rtal** lending **rates and** the **real** interest rate spreads I have used the following equation: {[(I +i)*(l +E)/(I +p)J-l)*l00, i **is the nominial** lending **rate** or **intrest** rate spread of Gerrrany or **the U.S.,** E is **the** devaluation of the **domestic** currency **against** the DM **or the** USS **and** p **is** the annual **donestic** inflation.
Graph 3: Real Lending Rates of East.European Countries, Germany and the U.S. (In Percent per Quarter) Hungary <!-- Start of picture text --> 10<br>5 -o S . ...... . .....- . -<br>-10 _ . _... _,_,,__..,,,, .. ......... . .. _,____.... .......................... . .......<br>Jan-90 Apr-90 Jul-90 Oct-90 Jan-91 Apr-91 Ju1-9,<br>Months<br>Hungary *-*-- Germany -a-- U.S.<br>Poland<br>30<br>L 10 '.' '- '' '-<br>-1 0 I.. ....... ....... ............<br>-30 -1 20 ::-, ^_1 a......... .....<br>-30Apr-90 Jul-90 Oct-90 Jan-91 Apr-91 Ju1-91 Oct-91<br>Months<br>|-Poland _.-- Germrany _-_U S<br><!-- End of picture text -->

CSFR <!-- Start of picture text --> 4 - ^-...... ' ; ..-.... .<br>4 - ---- . . .. ..... .,;: ............... .. ....... ......... .......... ......... ........... . ...... , .,........ ..........<br>-8 .. . .. . .. . ..... . .<br>-10<br>Apr-91 Jun-91 Aug-91 Oct-91 Dec-91<br>Months<br>| CSFR ~-h-* Germany --- U.S l<br><!-- End of picture text -->
Page 33 In the CSFR the increase in real interest rates coincided with the introduction of bank legislation and the requirement for loan loss provisions. Unlike Hungary and Poland, real lending rates in the case of CSFR's banks remain similar to those of Germany and the U.S.

Information concerning interest rate spreads is provided in Graph 4. This graph shows the decomposition of CSFR's bank spreads by type of borrower and by type of bank. It shows that CSFR's banks charge their highest bpread to private enterprises and the lowest to the households and SOE sectors. In fact, it could be argued that CSFR's banks supplemented their income by expanding credit to the private sector and charging, at the margin, the highest spread .

The differences in interest rate spread by type of bank are also very revealing. In Graph 4 the bank spread is broken down into the portion taken by a deposit-taking bank, such as the Savings Bank, which lends its resources in the interbank market, and the portion taken by nondeposit-taking banks, which borrow from the interbank market. Most of the non-state banks raise their funds by oorrowing from the interbank market because they don't have a deposit base. This indicates that the high spread is explained by the large state-owned banks which need to generate income to subsidize their other loans.

# F. CONCLUSIONS: ARE THERE ANY LESSONS?

In all five Eastern European countries, the governments have undertaken important measures for restructuring their financial qystems. The task was not an easy one, since all five countries inherited a heavy legacy. Banks in a centrally planned economy were designed to play a role very different from the one they have to play in a market economy. In centrally planned economies, banks are passive institutions, and the transition to a market economy requires that governments turn banks into active institutions capable of participating in the economic restructuring effort.
Graph 4: Decomposition of CSF'R's Nominal Interest Rates Spreads

# By 'Type of User

<!-- Start of picture text --> 15 -r--<br>*5 -- - -<br>10- *-- _<br>5 -<br>O- '10~* __ ___.__________--._ -__ _____<br>,, * , * --- I~~~~~~U-<br>-5 i 0 - . - I - -r , --<br>Apr-91 Jun-91 Aug-91 Octd91 Dec-91<br>- lotal Average a SOEs<br>-A- Private Enterprises -i- Households<br>By Type of Bank<br>10<br>AR<br>**<br>- ".<br>O-Apr-91 Jur-rl Aul-91 Oct-91 Dv1<br>Total Average * Non-Depcoit Base Bk -a-- Pure Savlnsr k<br><!-- End of picture text -->
Page 34 Although it is too early to assess the relative success of each country, it is possible to suggest a few elements that can serve as lessons from the reform so far.

_First_ is the relation between the problem of banks and those of enterprises. It is difficult to pretend to solve the banks' problems without confronting simultaneously the problems of enterprises. In the final analysis, the true problem is not whether banks hold nonperforming loans or not, but rather how to prevent further accumulation of nonperforming loans. This, in turn, implies that the real problem lies in how to close the loss-making and nonviable enterprises.

_Second_ is the role of banks in dealing with loss-making and nonviable enterprises. This is difficult because it is necessary to grant bank managers enough independence from their customers, loss-making enterprises. The key question is how fast a new bank governance structure can be introduced which will grant bank managers independence in credit decisions. It is crucial that banks focus on what banks know best: assessing risk. Here the roles of capital, private ownership and adequate regulation and supervision are crucial. In fact, the role assigned to banks in the transition will depend on providing banks with adequate governance structures. In this regard, few of the five countries have been successful.

_Third_ is the role and timing of bank recapitalization. This is related to the corporate governance. Bank recapitalization only removes the moral hazard problem posed by the presence of nonperforming loans. In practice it consists of an explicit acknowledgment by the government of the old nonpe-forming loans. However, this involves an explicit guarantee. The objectives of a bank recapitalizatRon should be: (a) to prevent banks from acc.imulating more nonperforming loans, that is, dealing with the enterprise problems; and (b) to provide banks with a new corporate governance that will prevent them from incurring in new nonperforming loans. This requires introducing a system of risk and reward by making banks comply with the capital adequacy requirements, privatizing a critical number of **banks** and introducing strong regulation and supervision.
Page 35 _Fourth_ are the other roles of banks. The complexity in untangling the relation between banks' and enterprises' problems has led some governments to overlook other important roles that banks should perform, such as providing an efficient payment systems. The institutional problems that the governments have confronted in introducing efficient payr nnt systems underlines the need to put greater emphasis on this task, since it is the basis for the development of trust in the banking system.

_Fifth_ is the role of regulation and supervision in enhancing banks' governance structure. While it appears to be an easy task, in practice it has proven to be difficult. Deciding which regulation and supervision to adopt implies knowing what the role of banks should be. It is of no practical use for the authorities to enact a new banking law with which most of the banks will be unable to comply.

There is also the problem of upgrading the skills of bank supervisors. This requires considerable technical assistance and strong collaboration from western countries. It requires time to retrain bank supervisors capable of efficient on-site and off-site bank supervision.

_SWxth_ is the presence of banks with a large proportion of nonperforming loans and which account for a large portion of the market. When these are not controlled, credit resources are misallocated. It is common for these banks to grant more credit to borrowers that have accumulated nonperforming loans and to increase the interest rate spreads. This usually has negative consequences because good borrowers are either crowded-out from the financial system or have to pay a very high interest rate. Some countries have tried to limit the extent of credit misallocation by encouraging the entry of new banks. But because the banks with nonperforming loans dominated in the market the new banks have been unable to change the large banks' behavior. Preliminary evidence suggests that the new banks are more efficient both in terms of credit allocation and in terms of interest rate spreads.

This evidence strongly supports the need to recapitalize and privatize a critical number of banks. Moreover, it would be desirable to privatize banks by selling a controlling stake to a group of private investors as a way of attracting new capital (foreign and domestic) into the financial system and
Page 36 establishing strong bank governance. In fact, the combination of botk recapitalization and privatization of banks is optimal because it ensures strong bank governance. The number of banks to be recapitalized and privatized will depend on such factors as reestablishing market discipline and enhancing bank compe.ition. Altho%,h shrinking (by canceling both nonperforming and household deposits<sup>1</sup> ') or removing banks with large nonperforming loans from the market will be optimal, in the case it is not feasible strong domestic competition by a critical number of private banks with adequate levels of capital should reestablish the market discipline and prevent large banks with nonperforming loans from dominating in the market.

The most important conclusion from the analysis of the five Eastern European countries' experience is that banks play a very important role in the transition. However, all five countries have found it difficult to rely on banks without prior change in banks' corporate governance. This leads to a key conclusion, that the authorities cannot rely at the early period of the transition on banks to exert control on enterprises. In the early period the control over SOEs should be exercised through a semipublic institution like the Treuhandanstalt in East Germany, the State Privatization Agency in Hungary or the National Property Fund in the CSFR.

There are three reasons for this: (a) banks are weak and do not posses the needed corporate governance; (b) banks do not posses all the legal instruments to impose control on enterprises; and (c) banks are not in a position to take some key political jiecisions which only the government can make, such as the proportion of debt write-off that each enterprise should be granted, whether or not to force the liquidation of large enterprises which will result in great social problems, or whether or not banks should grant loans to loss-making enterprises. These are decisions that only the govermnent can make. As the government provides banks with an adequate corporate governance through recapitalization, privatization and introduction of new regulation and supervision, the government will " _See_ **Frydman** et &1(1992) for **an** interesting explanation for shrinking the existent **large** state-owned banks
Page 37 be able to rely on banks to exert control over enterprises. Initially, banks' control over enterprises has to be indirect through credit allocation and in close collaboration with the semipublic institution in charge of enterprise restructuring and privatization. Only when banks are provided with strong corporate governance will they be able to participate directly in controlling enterprises. Whether banks direct control over enterprises should be performed by special investment banks, like in Hungary and CSFR, or by universal banks, like in Poland, Bulgalia and Romania, will depend on whether banks with strong corporate governance will emerge, assuring banks' independence in their credit decisions.

My personal preference would be that during the transition only investment banks should specialize in controlling enterprises. This should limit the effect of ban-k failure on the rest of the financial system and on d'jpositors, while allowing banks to contribute to the development of the enterprise sector by permitting them to take greater risks. In a way this is the option taken by CSFR. However, to be effective this would need to be a scheme for valuing enterprises and their loans, such as the voucher privatization or by auctioning the bad loans as I have proposed elsewhere.'<sup>9</sup> However, it will be a mistake to postpone the banking system restructuring because it takes time. The key conclusion from the five Eastern Europeain countries' experience is that the role of banks in the transition is of great importance, but its effectiveness will depend on how soon the authorities start with banking restructuring and how they sequence it with the enterprise restructuring and privatization.

# **REFERENCES**

Bruno, Michael i992). 'Stabilization and Reform in Eastern Europe: A Preliminary Evaluation." Miroeo, IMF.1 Washington D.C.: IMF, March.

Business International (1992). 'Hungarian Bankruptcies' Impact on Business." Business Eastern Europe. weekly report. London: Business International, May 11.

Calvo, Guillermo A., and Fabrizio Coricelli (1992). 'Stagflationary Effects of Stabilization Programs in Reforming Socialist Countries: Enterprise-Side vs Household-Side Factors," The World Bank Economic Review. Vol. 6 No. 1: 71-90.

i **Sec Coricelli and Thome (1992)**
Page 38

- Calvo, Guillermo A. and Jacob A. Frenkel (1991). 'Credit Markets, Credibility, and Economic Transformation" Journal of Economic Perspectives. Vol 5 No 4: 139-148.

- Coricelli, Fabrizio and Alfredo Thorne (1992). 'Dealing with Enterprises' Bad Loans' Economics of Transition. Vol 1, No 1: 112-115.

- de Juan, Arist6bulo (1987). "From Good Bankers to Bad Bankers: Ineffective Supervision and Management Deterioration as Major Elements in Banking Crises." Mimeo, The World Bank. Washington D.C.: The World Bank, June. Processed.

- Demekas, Dimitri G. and Mohsin S. Khan (1991). "The Rornanian Economic Reform Program." IMF, Occasional Paper Series No 89. Washington D.C.: IMF, November.

- Dervis, Kemal and Timothy Condon (1992). "Hungary: An Emerging 'Gradualist' Success Story?". NBER Working Paper. Boston: NBER.

- Frydnan, R., E. Phelps, A. Rapaczynski and A. Shleifer (1992). "Notes on Banking Reform in Eastern Europe." EBRD, Mimeo processed.

- McQuaid, David (1991). "Art-B and the Pathology of Transition." Report on Eastern Europe. September 11.

- Nyers, Rezso and Gabriela Rosta Lutz (1992). "The Structural Reform of the Banking System in Hungary, the Solution of the Problem of Bad Debts in the Hungarian Banking System: The Hungarian Case Study." Mimeo, OECD. Paris: OECD.

- OECD (1991). "The Creation of Financial Markets in the Czech and Slovak Federal Republic." Mimeo, OECD. Paris: OECD

- Radio Free Europe Research Report (1992). 'Privatization." April, 1992

- The National Bank of Hungary (1991). The Financial Sector in Hungary. Mimeo, OECD. Paris: OECD.

- The World Bank (1989). "Hungary: Development and Reform of Financial Markets." Report No. 6941.HU. Washington D.C.: The World Bank.

- The World Bank (1990). "Hungary: Financial System Modernization Project.' Staff Appraisal Report No. 8200-HU. Washington D.C.: The World Bank.

- The World Bank (1991a). "Poland: Report and Recommendation of the President of IBRD to the Executive Directors cn a Proposed FIDE." Report No. P-5535-POL. Washington D.C.: The World Bank.

- The World Bank (1991b). "Bulgaria: Report and Reconmmendati **o** n f the President or the IBRD to the Executive Directors on a Proposed SAL." Report No. P-5588-BUL. Washington D.C.: The World Bank.

- The World Bank (1991c). 'Romania: The Challenge of Transition." Report No. 9497-RO. Washington D.C.: The World Bank.

- The World Bank (1993). "Poland- Report and Recommendations of the President of the IBRD to the Executive Directors on a Proposed EBRP." Report No P-5940-POL. Washington D.C.: The World Bank.

- Thorne, Alfredo (1992). "Issues in Reforming Financial Systems in Eastern Europe: The Case of Bulgaria." PRE Working Paper No 882. Washington, D.C.: The World Bank, April .

- Thorne, Alfredo (1988). "Why a Market Solution to Financial Crises Might be Infeasible: The Case for Restructuring Financial Systems Through 'Ie Analysis of Twelve Cases." The World Bank, Mimeo.

- van Wijnbergen, Sweder (1992). "Economic Aspects of Enterprise Reform in Eastem Europe." Mimeo, The World Bank. Washington D.C.: The World Bank, May.
**Policy Research Working Paper Serles**

|**Title**|**Author**|**Date**|**Contact**<br>**for paper**|
|---|---|---|---|
|WPS1221 Does Research and Development<br>Contribute to Economic Growth<br>in Developing Countries?|Nancy Birdsall<br>Changyong Rhee|November 1993|S. Rajan<br>33747|
|WPS1222 Trade Reform in Ten Sub-Saharan<br>Countries: Achievements and Failur|Faezeh Foroutan<br>es|November 1993|S. Fallon<br>38009|
|WPS1223 How Robust Is a Poverty Profile?|Martin Ravallion<br>Benu Bidani|November 1993|P. Cook<br>33902|
|WPS1224 Devaluation in Low-Inflation<br>Economies|Miguel A. Kiguel<br>Nita Ghei|November 1993|R. Luz<br>39059|
|WPS1225 Intra-Sub-Saharan<br>African Trade:<br>Is It Too Little?|Faezeh Foroutan<br>Lant Pritchett|November 1993|S. Fallon<br>38009|
|WPS1226 Forecasting Volatility in Commodity<br>Markets|Kenneth F. Kroner<br>Devin P. Kneafsey<br>Stijn Claessens|November 1993|F. Hatab<br>35835|
|WPS1227 Designing Water Institutions:<br>Market Failures and Institutional<br>Response|Marie Leigh Livingston|December 1993|C. Spooner<br>30464|
|WPS1228 Competition, Competition Policy,<br>and the GATT|Bernard M. Hoekman<br>Petros C. Mavroidis|December 1993|L. O'Connor<br>37009|
|WPS1229 The Structure, Regulation, and<br>Performance of Pension Funds in<br>Nine Industrial Countries|E. P. Davis|December 1993|P. Infante<br>37642|
|WPS1230 Unemployment in Mexico: Its<br>Characteristics and Determinants|Ana Revenga<br>Michelle Riboud|December 1993|R. Stephen<br>37040|
|WPS1231 Making a Market: Mass Privatization<br>in the Czech and Slovak Republics|Nemat Shafik|December 1993|A. Correa<br>38549|
|WPS1232 Will GATT Enforcement Control<br>Antidumping?|J. Michael Finger<br>K. C. Fung|December 1993|**N.**Artis<br>37947|
|WPS1233 Hedging Cotton Price Risk in<br>Francophone African Countries|Sudhakar Satyanarayan<br>Elton Thigpen<br>Panos Varangis|<br>December 1993|D. Gustafson<br>33714|
|WPS1234 Price Formation, Nominal Anchors,<br>and Stabilization Policies in Hungary<br>An Empirical Analysis|Andres Solimano<br>: David E. Yuravlivker|December 1993|S. Florez<br>39075|
**Policy Research Work'ng Paper Series**

|**Thle**|Author|Date|Contact<br>for**paper**|
|---|---|---|---|
|WPS1235 Eastern Europe's Experience with<br>Banking Reform: Is There a Role for<br>Banks in the Transition?|Alfredo Thorne|December 1993|N. Jose<br>33688|