metadata: authors: 0: author: Tang, Helena
1: author: Zoli, Edda
2: author: Klytchnikova, Irina
count: Poland,Lithuania,Latvia,Kyrgyz Republic,Kazakhstan,Ukraine,Hungary,Estonia,Georgia,Bulgaria,Czechia,North Macedonia
docna: 0: docna: Banking crises in transition economies :
            fiscal costs and related issues
docty: Policy Research Working Paper
subtopic: State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Banks & Banking Reform,International Trade and Trade Rules,Privatization,Energy Privatization,Bankruptcy and Resolution of Financial Distress,Finance and Development,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!: The authors look at strategies for
            dealing with banking crises in 12 transition economies --
            five from Central and Eastern Europe (CEE): Bulgaria, the
            Czech Republic, Hungary, Macedonia, and Poland; the three
            Baltic states: Estonia, Latvia, and Lithuania; and four
            countries from the Commonwealth of Independent States (CIS):
            Georgia, Kazakhstan, the Kyrgyz Republic, and Ukraine. Three
            types of strategies were used to deal with the crises. The
            CEE countries generally pursued extensive restructuring and
            recapitalizing of banks; most CIS countries pursued
            large-scale liquidation; and the Baltic states generally
            pursued a combination of liquidation and restructuring. The
            strategy pursued reflected macroeconomic conditions and the
            level of development in a country's banking sector.
            There were more new banks in the former Soviet Union
            (FSU-the CIS and Baltic states), but they tended to be
            small, undercapitalized, and not deeply engaged in financial
            intermediation. The CEE countries generally incurred higher
            fiscal costs than the FSU countries but ended up with
            sounder, more efficient banking systems, with many of the
            recapitalized banks being privatized to strategic foreign
            investors. The CIS countries pursued a less fiscally costly
            approach but have been left with weak banking systems and
            low levels of intermediation. The Baltic states appear to
            have struck a good balance, incurring modest fiscal costs
            while making their systems sounder and more efficient. The
            findings suggest the following: a) Operational, financial,
            and institutional restructuring should be undertaken in
            parallel. b) Financial restructuring should involve adequate
            recapitalization to deter moral hazard and repeated
            recapitalization. c) Operational restructuring should entail
            privatization to core investors (particularly to reputable
            foreign banks). d) The enterprise problems underlying
            banking problems must also be addressed. e) Fiscal costs
            were reduced when governments dealt only with bad debt
            inherited from the socialist period; when small banks that
            held few deposits were allowed to fail, where the social
            costs of such failure were low; and when only banks that got
            into trouble because of external shocks were rescued while
            those suffering from poor management were liquidated. f) The
            government, not the central bank, should undertake bank
            restructuring. Central bank refinancing is not transparent
            and could lead to hyperinflation.
geo_reg_key: 517208,517198,545134,82689,517190,517191
repnme: repnme: Banking crises in transition economies :
            fiscal costs and related issues
display_title: Banking crises in transition
            economies : fiscal costs and related issues
listing_relative_url: /research/2000/11/717460/banking-crises-transition-economies-fiscal-costs-related-issues
topicv3: Trade m1326924 698,Bank Regulation and Supervision m1327225 317,Privatization m1327236 1283,Bankruptcy and Liquidation m1327467 1277,Debt Recovery m1504976 2532
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Poverty Reduction/Econ Mngmt (ECSPE)
no_of_pages: 90
author_keys: 0: author_key: NA
1: author_key: NA
2: author_key: NA
model_extractions: POLICY RESEARCH WORKING PAPER 2484

# Summary findings

Tang, Zoli, and Klytchnikova look at strategies for dealing with banking crises in 12 transition economiesfive from Central and Eastern Europe (CEE): Bulgaria, the Czech Republic, Hungary, Macedonia, and Poland; the three Baltic states: Estonia, Latvia, and Lithuania; and four countries from the Commonwealth of Independent States (CIS): Georgia, Kazakhstan, the Kyrgyz Republic, and Ukraine.

Three types of strategies were used to deal with the crises. The CEE countries generally pursued extensive restructuring and recapitalizing of banks; most CIS countries pursued large-scale liquidation; and the Baltic states generally pursued a combination of liquidation and restructuring.

The strategy pursued reflected macroeconomic conditions and the level of development in a country's banking sector. There were more new banks in the former Soviet Union (FSU-the CIS and Baltic states), but they tended to be small, undercapitalized, and not deeply engaged in financial intermediation.

The CEE countries generally incurred higher fiscal costs than the FSU countries but ended up with sounder, more efficient banking systems, with many of the recapitalized banks being privatized to strategic foreign investors. The CIS countries pursued a less fiscally costly approach but have been left with weak banking systems and low levels of intermediation. The Baltic states appear to have struck a good balance, incurring modest fiscal costs while making their systems sounder and more efficient.

The findings suggest the following:

- Operational, financial, and institutional restructuring should be undertaken in parallel.

_*_ Financial restructuring should involve adequate recapitalization to deter moral hazard and repeated recapitalization.

* Operational restructuring should entail privatization to core investors (particularly to reputable foreign banks).

* The enterprise problems underlying banking problems must also be addressed.

e Fiscal costs were reduced when governments dealt only with bad debt inherited from the socialist period; when small banks that held few deposits were allowed to fail, where the social costs of such failure were low; and when only banks that got into trouble because of external shocks were rescued while those suffering from poor management were liquidated.

_*_ The government, not the central bank, should undertake bank restructuring. Central bank refinancing is not transparent and could lead to hyperinflation.

This paper-a product of the Poverty Reduction and Economic Management Sector Unit,<sup>Europe and Central Asia</sup> Region-is part of a larger effort in the region to review lessons of experience<sup>in transition economies. Copies of the paper</sup> are available free from the World Bank, 1818 H Street NW, Washington, DC<sup>20433. Please contact Armanda Carcani, room</sup> H4-326, telephone 202-473-0241, fax 202-522-2751, email address acarcani@worldbank.org.<sup>Policy Research Working</sup> Papers are also posted on the Web at www.worldbank.org/research/workingpapers.<sup>The authors may be contacted at</sup> htang@worldbank.org or ezoli@imf.org. November 2000. (78 pages) _The Policy Research Working Paper Series disseminates the findings of work in progress_<sup>_to encourage the exchange of ideas about_</sup> _development issues. An objective of the series is to get the findings out quickly, even if_<sup>_the presentations are less than fully polished. The_</sup> _papers carry the names of the authors and should be cited accordingly. The findings, interpretations,_<sup>_and conclusions expressed in this_</sup> _paper are entirely those of the authors. They do not necessarily represen_ **_t_** _he view of_<sup>_the World Bank, its Executive Directors, or the_</sup> _countries they represent._ Produced by the Policy Research Dissemination Center
# Banking Crises in Transition Countries:

# Fiscal Costs and Related Issues

Helena Tang, Edda Zoli and Irina Klytchnikova*

*Tang is a Lead Economist at the World Bank; Zoli is an Economist at the International Monetary Fund; and Klytchnikova is a consultant at the World Bank. The paper benefited from valuable comments from Patrick Honahan, Jo Ann Paulson and Stijn Claessens, although the authors alone are responsible for the contents.
# **Contents**

|**Exe**|**cutive Summary**|i|
|---|---|---|
|**1.**|Introduction|**1**|
|2.|Banking Crises in Transition Countries|2|
||2.1.<br>Banking Sector Conditions|2|
||2.2.<br>Episodes of Banking Crises|4|
||2.3. Causes of Banking Crises|10|
|3.|Institutional, Operational and Financial Restructuring of Banks|12|
||in Transition Countries||
||3.1 Institutional Restructuring|12|
||3.2 Operational Restructuring|15|
||3.3 Financial Restructuring|18|
|4.|Costs of Banking Crises|19|
||4.1 Cost of Bank Restructuring for the Government|21|
||4.2 Cost of Bank Restructuring for the Central Bank|26|
||4.3 Cost of Deposit Compensation for the Government|30|
||4.4 Total Fiscal and Quasi-Fiscal Costs of Banking Crises|34|
|5.|Bad Debt Recovery|37|
||5.1 Implications of Choice of Debt Recovery Strategy on Fiscal Costs|38|
||5.2 Country Experiences|38|
||5.3 Results of Bad Debt Recovery|44|
|6.|Results of Crisis Resolution|44|
|7.|Summary, Conclusions and Policy Lessons|47|
|**Ref**|**erences**|50|
# **Executive Summary**

All transition countries have experienced banking crises or severe banking distress during the transition process. Key factors contributing to banking crises in these countries have been the large amounts of bad debt inherited from the previous socialist regimes, and the lack of familiarity of enterprises and banks with the functioning of market economies. Therefore, the resolution of banking crises in these countries can also be viewed as a challenge of transition, or as a challenge of banking sector development in the transition context.

While some transition countries have progressed more than others in developing and strengthening their banking systems, many have not completed the "transition" process. To this extent, new banking crises remain a risk. A pertinent question for policy makers therefore is how to resolve such crises in a way that would minimize the costs to the economy and the risks of such crises recurring in the future.

This paper reviews the experience of banking crises during 1990-98 in twelve transition countries: five countries from Central and Eastern Europe _(CEEs) - Bulgaria, the Czech Republic, Hungary, Macedonia_ and _Poland;_ the three _Baltic_ states - _Estonia, Latvia_ and _Lithuania;_ and four countries from the Commonwealth of Independent States _(CIS) - Georgia, Kazakhstan, the Kyrgyz Republic_ and _Ukraine._ These countries have experienced either episodes of obvious crisis such as bank runs, or episodes of severe banking distress involving a large share of non-performing loans in the banking sector. Both types of episodes are referred to in this paper as banking crisis episodes.

The paper reviews the crisis resolution strategies adopted by these twelve countries, and assesses which strategy minimized fiscal costs while at the same time strengthened the banking sector. A strengthened banking sector will be less prone to future crisis, which also helps minimize fiscal costs over the longer term.

The crisis resolution strategies pursued by the twelve transition countries fall into three broad categories: (a) extensive restructuring and recapitalization of banks, which was generally pursued by the _CEEs;_ (b) large-scale liquidation of banks pursued by most _CIS_ countries; and (c) a combination of bank liquidation and restructuring, which was generally pursued by the _Baltic_ states.

The different strategies adopted by the authorities in these countries appear to depend on two key factors in the early years of transition. First is the macroeconomic condition at the beginning of transition, in particular the developments in inflation. Hyperinflation in the countries of the former Soviet Union _(FSU)_ - the _CIS_ and the _Baltics -_ at the beginning of transition drastically reduced the real value of their inherited bad debts. By contrast, inflation never reached the same hyper levels in the _CEEs,_ and the pre-transition bad loans remained a burden on the banking system. The second factor is the development of the banking system. There was a much larger increase in the number of banks in the _FSU_ countries than in the _CEEs_ in the early transition years. The new banks in the countries of _FSU_ were generally of poorer quality, being small, undercapitalized and not engaged in much financial intermediation. As a result, banks could be closed in the _FSU_ countries with limited economic and social impact. By contrast, in the _CEEs,_ there was much less proliferation of low quality banks, and therefore much less of a need for liquidation of such banks. Furthermore, financial intermediation was also deeper in the _CEEs,_ with some of the troubled banks being considered "too big to fail". Given their size, liquidation would have meant wiping out most of the banking system, imposing huge economic and political costs. For these reasons, the _FSU_ countries pursued bank liquidation on a much larger scale than the _CEE_ countries, while the latter generally restructured and recapitalized banks.

These initial conditions and related bank crisis resolution strategies largely determined the fiscal costs of banking crises, with the _CEEs_ generally incurring higher costs than the FSU countries. In i
addition, the amount of fiscal costs incurred also depended on the extent to which bank shareholders and depositors bore some of the costs. In the _FSU_ countries, the fiscal costs of banking crises were generally lower because governments relied more on recapitalization by private shareholders and when this was not possible, liquidated banks without compensating depositors. Also, the restructuring operations undertaken by the _CEEs_ suffered from several weaknesses (see later para. on lessons), which raised fiscal and quasi-fiscal costs.

For the transition countries covered by this study, the fiscal and quasi-fiscal costs of banking crises - including for bank restructuring and deposit compensation - ranged from 7 to 42 percent of GDP for the _CEEs,_ 0.1 to 18 percent of GDP for the _CIS,_ and from 2 to 3 percent in the _Baltics._ These fiscal costs do not adjust for savings associated with recoveries of bad loans absorbed by the government. However, the experience of the transition countries covered by the study was not very positive in this regard. Among the countries where loan recoveries accrued to the govemment, _Hungary_ had the best results with loan recoveries amounting to 16 percent of total bad loans. _Poland_ also had a similar recovery rate, although recoveries accrued to the banks themselves. In comparison, recovery rates of around 30 percent have been achieved elsewhere in the world.

All three country groups enjoyed positive results from the resolution of banking crises. The outcomes were generally better in the _CEEs_ and the _Baltics_ than in the _CIS,_ particularly in regard to improving banking sector efficiency and raising the confidence in the banking sector. However, there needs to be further financial deepening in all three country groups, and especially so in the _CIS._ Although non-performing loans as a share of total loans have generally declined in these countries, they remained a concem in many of them, especially the _Czech Republic, Macedonia, Lithuania_ and _Kazakhstan._ To sum up, the _CEEs_ incurred the most substantial fiscal costs, but ended up with sounder and more efficient banking systems, with many of the recapitalized banks being privatized to strategic foreign investors. By contrast, the approach pursued by the _CIS_ was less fiscally costly, but they have been left with weak banking systems and low levels of intermediation. The _Ballics_ appear to have struck a good balance, incurring modest fiscal costs, while improving the soundness and efficiency of their banking systems. _Estonia,_ in particular, appeared to have done the best. At a total cost of 2 percent of GDP at end-1998, the crisis resolution strategy pursued by _Estonia_ (combination of liquidation and restructuring, with the strategy differentiated according to the cause of the crisis) has resulted in substantial increase in financial intermediation, a large decline in non-performing loans (which stood at slightly over I percent of total loans in 1998), significant improvements in banking sector efficiency and higher confidence in the banking sector.

The lessons derived from the crisis resolution experience of these countries are consistent with the conventional wisdom on how to restructure banks to minimize the recurrence of banking crises, and hence to minimize fiscal costs. Specifically, the experience of the twelve transition countries suggest the following:

- the three elements of banking system restructuring - operational, financial and institutional - need to be undertaken in parallel for the successful resolution of banking crises;

- financial restructuring of banks should entail adequate recapitalization to deter the risk of moral hazard and repeated recapitalization;

- operational restructuring of banks needs to entail privatization to core investors; the experience in the transition countries indicates that privatization to reputable foreign banks could be a useful way to strengthen their banking systems;

- enterprise problems need to be addressed in parallel with bank restructuring because in many transition economies the former are the underlying causes of banking problems;

ii
- differentiation of the crisis resolution strategy according to the cause of the crisis could help reduce fiscal costs; specifically, for the transition countries covered by the study, fiscal costs were reduced when: (i) governments only dealt with that portion of the bad debt inherited from the socialist period; (ii) small banks were allowed to fail when they did not affect financial intermediation very much (that is they held very little deposits) and when the social costs of such bank failure were low; and (iii) only banks that got into trouble because of external shocks were rescued while those that suffered from poor management were liquidated; and

- bank restructuring should be undertaken by the government and not the central bank because: (i) central bank financing is non-transparent and the costs will eventually fall on the budget; and (ii) central bank financing could lead to hyperinflation with severely negative economic consequences.

The experience of the transition countries under consideration also supports the established principle that for bad debt recovery to be successful, the bad debt collector (be it a central agency or a bank) needs to operate within an adequate legal environment (in particular effective collateral, foreclosure and bankruptcy laws) and be given appropriate incentives, and the enterprises in question need to be subject to hard budget constraints. This implies that if a centralized approach is adopted, then the bad debt collection agency should be private rather than state-owned. It also implies that a "good bank/bad bank" approach to bad debt collection might be preferable as it entails a finite time of operation of the "bad bank". Among the transition countries covered, the approach adopted by Poland - where banks themselves pursued the collection of bad debt - appears to have some merit. Although the Polish model was not very successful in restructuring enterprises (which was one of its objectives), it appeared to have more success in strengthening the institutional capacity of banks. Finally, however, it should be noted that successful bad debt recovery requires adequate capacity for the task. Given the relatively recent introduction of transition economies to commercial banking, the capacity of collecting bad debt which entails restructuring of enterprises will take some time to build up, more so for the countries from the _FSU_ than the _CEEs._ Therefore, only modest results from bad debt recovery may be expected from these countries for some time.

..i
# **1. Introduction**

Over the last few decades, banking crises have occurred<sup>in both developed and developing</sup> countries around the world, and it has been no different with the transition countries. In fact, almost<sup>all</sup> the transition countries have suffered from significant banking problems'. This paper reviews the different approaches to resolving banking crises in the transition<sup>countries and their effects on the</sup> resulting fiscal costs.

The study covers the experience of banking crises during 1990-98 in<sup>twelve transition countries:</sup> - five countries from Central and Eastern Europe _(CEEs)_ Bulgaria,<sup>the Czech Republic, Hungary,</sup> Macedonia and Poland; the three _Baltic_ states - Estonia, Latvia and Lithuania;<sup>and four countries from</sup> the Commonwealth of Independent States (CIS) - Georgia, Kazakhstan,<sup>the Kyrgyz Republic, and</sup> Ukraine. These countries were selected because they had experienced banking crises or severe banking distress, and because they encompass a wide range of experiences.<sup>A number of countries, including</sup> Russia and Romania, were excluded because their crises were still<sup>unfolding at the time the research for</sup> the paper was initiated.

There are many ways of defining banking crises (see Frydl, 1999).<sup>This paper includes episodes of</sup> obvious crisis such as bank runs, as well as episodes of severe banking distress<sup>involving a large share of</sup> non-performing loans in the banking sector, both of which will be referred<sup>to as episodes of "banking</sup> crisis" in the rest of this paper. Analysis in this paper ends in 1998,<sup>and excludes the effects of the</sup> Russian financial crisis on the banking sectors in the sample countries.

Following this introduction, section 2 reviews the banking sector conditions<sup>in transition countries,</sup> the episodes of banking crises and their causes. A key factor that contributed<sup>to the eruption of banking</sup> problems in these countries was the large debt burden inherited from the<sup>previous socialist regimes.</sup> Another key factor that contributed to the eruption of banking problems in these countries<sup>was the lack of</sup> familiarity of both enterprises and banks with the functioning of a market<sup>economy. This may have been</sup> an inevitable cost of transition, as both banks and enterprises were learning<sup>to operate in a completely</sup> new environment. There has been a lot of learning by doing, and a lot<sup>of mistakes made along the way.</sup> Therefore, banking crises in transition countries could be viewed as an<sup>integral element of the transition</sup> challenge, or as an issue of banking sector development in the transition context.

While some transition countries have progressed more than others in developing<sup>and strengthening</sup> their banking systems, many have not completed the "transition" process.<sup>To this extent, new banking</sup> crises remain a risk. A pertinent question for policy makers therefore<sup>is how to resolve such crises in a</sup> way that would minimize the costs to the economy and the risks of such crises recurring in the<sup>future.</sup> Banking crises are costly in two dimensions. First, they can undermine economic<sup>growth by</sup> disrupting credit intermediation. Second, banking crises can also impose large fiscal costs. This is because, unlike in the case of firm failures where shareholders are the residual loss-takers,<sup>when banks</sup> fail governments commonly assume part or all of the cost of the bank failure because of concerns<sup>over the</sup> stability of the financial system, or because of political or social reasons. To the extent that<sup>governments</sup> do not assume the entire cost of bank failure, the residual losses are assumed either by shareholders<sup>or</sup> depositors or both.

Given the poor data and poor accounting in transition countries, the costs<sup>borne by shareholders</sup> and depositors are difficult to ascertain. This paper will instead focus on the fiscal costs of banking See Appendix Table I on experience of banking crises in transition countries.

1
crises, which are the more readily observable portion of the total cost of banking crises<sup>2</sup> . Obviously, these fiscal costs are eventually borne by the public either through higher tax rates or higher inflation.

For the transition countries under consideration, the fiscal cost of resolving banking crisis was determined in large part by the authorities' strategy in restructuring the banking system, discussed in section 3. There are three elements in such a restructuring strategy: operational, institutional and financial. Successful resolution of banking crisis or systemic banking problems requires that all three elements be undertaken. When banking crises are successfully resolved, it means that the remaining banks in the system are strong and the risk of future banking crises is minimized, which also helps minimize fiscal costs. Section 4 reviews the costs of banking crises incurred during the 1990s by the twelve transition countries. The section will review the distribution of these costs between shareholders, depositors and the government. The focus of the discussion will be on the latter - that is, the fiscal costs - for reasons just discussed. The fiscal costs of banking crises include the cost of government assistance to the banking sector, the quasi-fiscal cost assumed by the central bank in assisting the banking sector, plus the direct cost of compensating depositors. These costs could be alleviated by the recovery of bad loans, which is reviewed in section 5. Section 6 discusses the results of the resolution of banking crises, and section 7 summarizes the findings and draws some conclusions and lessons from the experiences of these transition countries.

# 2. **Banking Crises in Transition Countries**

This section reviews the banking conditions in the sample countries under consideration during the 1 990s, the episodes of banking problems they experienced, and the factors that led to these banking crises

# **2.1 Banking Sector Conditions**

While the banking systems differed for transition economies in the 1990s, all regimes had evolved from the Soviet model, under which a unique bank (monobank) was responsible both for monetary policy and commercial banking. Among the countries under consideration, Yugoslavia was ahead in separating out these two functions and creating a two-tier banking system during the 1960s. In the other _CEE_ countries and the _Baltic_ countries, the monobank structure was demolished only in the late 1980s, while the _CIS_ countries introduced the two-tier system in the early 1990s. Generally, the elimination of the monobank system was followed by a rapid expansion of the banking sector with the entry of a large number of new banks.

Among the transition economies, the _CEEs_ have more developed banking sectors than the _Baltics_ or the _CIS,_ as measured by credit to the private sector as a share of GDP, and by broad money as a share of GDP (Table 1). In the _CEEs,_ the average ratio of private credit to GDP through the 1990s (for which data was available) was higher than in the other two groups of countries. In turn, the _Baltics_ had, on average, higher shares of credit to the private sector than the _CIS_ members since 1993.

There was a dramatic increase in the number of banks (in absolute terms and in terms of banks per population) in the early years of transition in the countries of the _FSU,_ followed by a dramatic decline as a

> 2 This paper will not address the issue of the cost of banking crises to economic growth, which is an almost, intractable question.

2
||**T**|**able 1.**|**Banking**|**Sector**|**Developm**|**ent**||||
|---|---|---|---|---|---|---|---|---|---|
||**1990**|**1991**|**1992**|**1993**|**1994**|**1995**|**1996**|**1997**|**1998**|
|**Credit to the Priva**<br>(Percent of GDP)|**te Sector**|||||||||
|**_Central and Easter_**|**_n Europe_**|||||||||
|**Bulgaria**||7.2|5.8|3.7|3.8|21.1|35.6|12.6|12.7|
|**Czech Rep.**||||50.8|59.5|59.4|57.4|66.4|58.0|
|**Hungary**|46.2|38.7|33.1|28.1|26.1|22.5|22.0|24.0||
|**Macedonia**||||59.3|48.8|25.6|29.8|30.6||
|**Poland**|3.1|11.1|11.4|12.2|11.2|12.0|14.9|17.1||
|**Average**||||30.8|29.9|28.1|31.9|30.1||
|**_Baltics_**||||||||||
|Estonia||18.0|7.5|11.2|14.1|14.8|18.0|25.8|25.3|
|Latvia||||17.3|16.4|7.8|7.2|10.5|14.1|
|Lithuania||||13.8|17.6|15.2|9.9|9.6|9.5|
|**Average**||||14.1|16.0|12.6|11.7|15.3|16.3|
|Cis||||||||||
|**Georgia**||||||||||
|**Kazakhstan**||||45.3|24.8|7.1|5.1|5.0||
|Kyrgyz Rep.||||||12.5|9.0|3.4|5.3|
|**Ukraine**|||2.6|1.4|4.6|1.5|1.4|2.4||
|**Average**||||||7.0|5.2|3.6||
|**OECD/1**|74.6|75.4|78.3|74.5|74.5|77.0|78.9|83.0||
|M2||||||||||
|(Percent of GDP)||||||||||
|**_Central and Easter_**|**_n Europe_**|||||||||
|**Bulgaria**||71.9|74.7|77.6|78.0|64.9|71.2|33.6|29.3|
|<br>**Czech Rep.**||||69.6|73.1|80.5|75.4|71.2|68.3|
|**Hungary**|43.8|47.4|51.2|49.6|45.5|42.3||||
|**Macedonia**||||72.9|13.6|13.5|13.0|15.2||
|**Poland**|34.0|32.3|35.8|35:9|34.5|34.1|35.4|37.6||
|**Average**||||61.1|**49.0**|47.1||||
|_Baltics_||||||||||
|**Estonia**||**126.9**|30.2|28.4|26.9|25.5|27.0|30.3|28.4|
|**Latvia**||||31.6|34.2|23.4|23.0|27.4|25.4|
|Lithuania||||23.1|25.8|23.3|15.8|19.0|19.5|
|**Average**||||27.7|29.0|24.1|21.9|25.6|**24.4**|
|CIs||||||||||
|**Georgia**||||||||||
|**Kazakhstan**||||||||10.2||
|**Kyrgyz Rep.**||||||17.2|14.2|13.7|14.6|
|**Ukraine**|||50.1|32.5|26.7|12.7|11.5|13.6||
|**Averae_**||||||14.9|**12.8**|||
|**OECD/2**|79.6|77.5|82.1|71.0|83.8|84.5|87.4|88.4||

_Source: International Monetary Fund, "International Financial Statistics. "_ /I Data for high-income OECD countries except for Germany (1990) and Luxembourg (1993), for which data is not available.

/2 Data for high-income OECD countries except for Germany (1990), Sweden (all years) and UK (all years) for which data is not available.

result of bank crises and bank liquidation. On the other hand, the _CEE_ countries did not experience as large an increase or decline (see section 3).

3
Most of the twelve countries experienced a decline in state ownership of the banking system during the 1990s, as reflected in the asset share of state banks (Table 2). For the _CEEs_ (with the exception of Macedonia), this was the result of privatization of state banks following the resolution of banking problems and, in some cases, the entry of foreign banks<sup>3</sup> . For the _Baltic_ countries (except for Lithuania), this was due to consolidation of state banks through liquidation or mergers, and large entry of foreign banks. For the _CIS_ countries under consideration (except for Ukraine), this resulted from liquidation or downsizing of state banks.

The banking systems in transition economies were marked by extensive non-performing loans (Table 3)4. The incidence of such loans was larger than for many non-transition countries that went through banking crises. For instance, before the start of a banking crisis, the ratio of bad loans to total loans was 9.1 percent in Argentina (end- 1980), 9.3 percent in Finland (end- 1 992), 10.6 percent in Mexico (September 1994) and 9.3 percent in Venezuela (end-1993) (Pazarba*ioglu and Van der Vossen, 1997).

In some countries _(Bulgaria, Hungary, Poland, Georgia_ and the _Kyrgyz Republic),_ the share of bad credits was high in the early stages of the transition, declining subsequently as these countries underwent restructuring programs. In other cases (the _Czech Republic, Macedonia, Lithuania, Kazakhstan_ and, to a less extent, _Latvia),_ non-performing loans were consistently high. _Estonia_ was the only country in the region where the share of non-performing loans had always been moderate.

# 2.2 **Episodes of banking crises**

Most of the twelve countries under consideration suffered from more than one crisis during the 1990s (Table 4). The problems experienced by the different countries were different in nature. Although it is not possible to draw rigid distinctions, two broad types of banking crisis episodes can be identified.

A number of crisis episodes arose from solvency problems in state-owned or formerly state-owned banks that were related to bad loans inherited from the Socialist system. These conditions of severe banking distress led to implementation of bank restructuring programs _(Bulgaria_ in 1991-94; the _Czech Republic_ in 1991-93; _Hungary_ in 1992-1994).

In other cases, non-performing loans were not a legacy of the central planning system, but generally the result of unsound practices during the transition process. These episodes were associated with widespread insolvency in the banking sector _(Bulgaria_ in 1996-97; _Hungary_ in 1995-97; _Macedonia_ in 1994; _Poland_ in 1993-94; _Estonia_ in 1992-4; _Latvia_ in 1995; _Lithuania_ in 1995-96; the _Czech Republic_ in 1996-97; _Georgia_ in 1995-97; _Kazakhstan_ in 1994-96 and the _Kyrgyz Republic_ in 1994-96) or with non-compliance with newly introduced banking regulations _(Georgia_ in 1994 and _Ukraine_ in 1995-98).

In some instances these banking crises involved also significant bank runs. This was the case of _Bulgaria_ in 1995 and 1996-97; the _Czech Republic_ in 1996-97; _Hungary_ in 1997; _Macedonia_ in 1994; _Estonia_ in 1994; _Latvia_ in 1995; _Lithuania_ in 1995-96; _Georgia_ in 1995-97 and _Kazakhstan_ in 1996.

> Foreign banks in Table 2 are defined as banks with foreign ownership exceeding 50%, end-of-year. 4 The definition and measurement of non-performing loans vary across countries and therefore the figures in Table 3 are not directly comparable. However, they are indicative of the magnitude of banking sector problems in individual countries.

4
**Table 2. Structure of the Banking Sector**

|**1990**|**1991**|**1992**|**1993**|**1994**|**1995**|**1996**|**1997**|**1998**|
|---|---|---|---|---|---|---|---|---|
|**_Central and Eastern Europe_**|||||||||
|**Bulgaria**|||||||||
|Number of banks<br>67|75|**79**|**41**|**40**|**41**|**42**|**28**||
|o/w domestic||||39|38|39|21||
|foreign||||1|3|3|7||
|Asset share of state banks, %||||||82.2|**66.0**||
|Banks (per mln people)<br>7.7|8.7|9.3|**4.8**|**4.7**|**4.9**|5.0|3.4||
|**Czech Rep.**|||||||||
|Number of banks|||45|55|55|53|50|45|
|o/w domestic|||33|43|43|40|36|32|
|Foreign|||12|12|12|13|14|13|
|Asset share of state banks. %<br>|||20.6<br>|20.1<br>|19.5<br>|18.0<br>|18.1<br>|18.8<br>|
|Banks (per mln people)|||**4.4**|**5.3**|**5.3**|5.1|4.9|**4.4**|
|**Hungary**|||||||||
|Number of banks<br>32|35|35|**40**|**43**|**42**|**41**|**41**|**40**|
|o/w domestic<br>21|27|23|25|26|21|16|11|13|
|Foreign<br>11|8|12|15|17|21|25|30|27|
|Asset<br>share<br>of<br>state<br>banks_%<br>85.5|81.2|75.3|74.4|74.9|62.8|52.0|16.3|10.8|
|Banks (per mln people)<br>3.1|3.4|3.4|3.9|4.2|4.1|4.0|4.0|**4.0**|
|**Macedonia**|||||||||
|Number of banks||||6|6|22|22|24|
|o/w domestic||||3|3|17|17|19|
|Foreign||||3|3|_5_|5|5|
|Asset share of state banks,**%**||||||0.0|0.0|0.7|
|Banks (per mln people)||||3.1|3.1|11.1|11.0|11.9|
|**Poland**|||||||||
|Number of banks<br>|||87|82|81<br>|81<br>|83|83<br>|
|olw domestic|||77|71|63|56|_54_|52|
|Foreign|||10|11|18|25|29|31|
|Asset share of state banks, %|||86.2|80.4|**71.1**|**69.8**|**51.6**|**48.0**|
|Banks/Population (per mln people)|||2.3|2.1|2.1|2.1|2.1|2.1|
|**_Baltics_**|||||||||
|**Estonia**|||||||||
|Number of banks|||21|22|18|15|12|6|
|o/w domestic|||20|21|14|12|9|4|
|foreign|||I|1|4|3|3|2|
|Asset share of state banks, %|||25.7|**28.1**|**9.7**|**6.6**|**0.0**|**7.8**|
|Banks (per mln people)|||13.9|14.7|12.1|10.2|8.2|**4.2**|

_5_
**Table 2 (Cont.). Structure of the Banking Sector**

||1990|1991|1992|1993|1994|1995|1996|1997|1998|
|---|---|---|---|---|---|---|---|---|---|
|Latvia||||||||||
|Number of banks||14|50|62|56|42|35|32|27|
|o/w domestic||||||31|21|17|12|
|Foreign||||||11|14|15|15|
|Asset share of state banks, %|||||7.2|9.9|6.9|6.8|8.5|
|Banks (per mln people)||5.3|19.0|24.0|22.0|16.7|14.1|13.0|11.1|
|Lithuania||||||||||
|Number of banks||||26|22|12|12|11|10|
|o/w domestic||||26|22|12|9|7|_5_|
|foreign||||0|0|0|3|4|5|
|Asset share of state banks. %||||53.6|48.0|62.5|54.9|48.8|45.3|
|Banks (per min people)||||7.0|5.9|3.2|3.2|3.0|2.7|
|_Cis_||||||||||
|**Georgia**||||||||||
|Number of banks|||75|179|226|101|61|53|43|
|o/w domestic|||||225|98|_55_<br>|45|34<br>|
|foreign|||||1|3|6|8|9|
|<br>Asset share of state banks. %|98.4|92.5|77.6|72.7|67.9|45.8|0.0|0.0|0.0|
|Banks (permln people)|||13.7|32.9|41.7|18.6|11.3|9.8|7.9|
|Kazakhstan||||||||||
|Number of banks|30|72|155|204|184|130|101|82|71|
|o/w domestic||71|154|199|176|122|92|60|51|
|foreign||1|1|_5_|8|8|9|22|20|
|Asset share of state banks. %||19.3|4.6|n.a.|n.a.|24.3|28.4|45.4|23.0|
|Banks (per mln people)|1.8|4.4|9.4|12.4|11.3|8.1|6.3|5.2|4.5|
|Kyrgyz Rep.<br>||||||||||
|Number of banks|6|10|15|20|18|18|18|20|23|
|o/w domestic|6|10|14|19|15|15|15|17|17|
|foreign|0|0|1|1|3|3|3|3|6|
|<br>Asset share of state banks. %|100.0|98.8|n.a.|n.a.|77.3|69.7|5.0|9.8|0.0|
|Banks (per mln people)|1.4|2.2|3.3|4.5|4.0|4.0|3.9|4.3|4.9|
|Ukraine||||||||||
|Number of banks|||133|211|228|230|229|227|n.a.|
|o/w domestic|||||227|229|223|215|n.a.|
|foreign|||||I|1|6|12|n.a.|
|Asset share of state banks. %||||||||||
|Banks (per mln people)||||2.5|4.1|4.4|4.5|4.5|4.5|

_Source: EBRD Transition Report, 1999_ 6
**Table 3. Soundness of the Banking Sector: Non-performing Loans** (Percent of total loans, end of period)

||1990|1991|1992|1993|1994|1995|1996|1997|1998|
|---|---|---|---|---|---|---|---|---|---|
|_Central and East_|_ern Europe_|||||||||
|Bulgaria|54||||7|13|15|13|10|
|**Czech Rep.**||2 /l|19 /1|23/1|37|33|30|27|29|
|**Hungary**||||29|28|20|12|8||
|**Macedonia**||||80||44||36||
|**Poland**||16|30|29|28|21|13|10|10|
|_Baltics_||||||||||
|Estonia||||7|3|3|2|1|1|
|Latvia||||5|10|19|20|10||
|**Lithuania**|||||27|17|32|28||
|CIs||||||||||
|**Georgia**|||||24|41|7|7||
|**Kazakhstan**||||||33|41|25|27|
|Kyrgyz**Rep.**|||||92|72|26|8||
|**Ukraine**/2|||||5|13|12|11||

/I Estimates reported in Capek (1994). According to other estimates, non-performing loans were 50-66% of total loans in the early 1990s (OECD, 1996).

/2 Official data that probably underestimate the actual share of non-performing loans.

_Source: EBRD Transition Report, 1998; International Monetary Fund; Central Banks._ There were significant differences in the magnitude of crises. For those crises arising from nonperforming loans inherited from the centralized system, estimates of bad loans as a share of total loans range from about 21 percent in _Hungary_ to 50-66 percent in the _Czech Republic._ For those episodes of acute financial distress, not related to inherited bad debt, the ratio of bad loans in total loans varied from 40 percent (in _Georgia_ in 1995) to more than 90 percent (in the _Kyrgyz Republic_ in 1994). While quantitative information on the magnitude of bank runs is not available for those crises involving liquidity problems, it appears that on some occasions liquidity problems were widespread (as in _Bulgaria_ in 199697 and in _Kazakhstan_ in 1996), while in others they were limited to one or two banks (as in _Hungary_ in 1997 and in _Bulgaria_ in 1995).

With regard to the ownership structure of the financial institutions involved in banking crises, both state-owned and private banks incurred insolvency and liquidity problems. However, in government restructuring programs directed to clean up banks' portfolios from non-performing loans inherited from the Socialist period, mainly state-owned banks were involved.

7
**Table 4: Episodes of Banking Crises**

|**Country**|**Period**|**Nature of the crisis**|**Magnitude of the crisis**|**Private vs. public**<br>**banks affected**|**Liquidity vs.**<br>**Solvency**<br>**problems**|
|---|---|---|---|---|---|
|**Bulgaria**|1990s.|1991-1994: Clean up of<br>banks' portfolios from<br>bad loans inherited from<br>the centralized system.|In 1990 non-performing<br>loans were about 54<br>percent of total loans.|Former state owned<br>banks.|Solvency.|
|||1995: Solvency and<br>liquidity problems in<br>two state-owned banks.||State-owned banks.|Solvency and<br>liquidity.|
|||1996-1997: Widespread<br>liquidity problems. Also<br>currency crisis.|About one third of the<br>total number of banks<br>was found insolvent and<br>closed.|Both state and private<br>banks.|Solvency and<br>liquidity.|
|**Czech Rep.**|1990s.|1991-1993:<br>Consolidation Program<br>I to clean the portfolios<br>of former state-owned<br>banks/organizations.|A clear evaluation of bad<br>loans size at the<br>beginning of the<br>transition is impossible.<br>Estimates of the share of<br>bad credits vary from<br>2.4-19 percent to 50-66<br>percent.|Former state-owned<br>banks and former<br>trade organization.|Solvency.|
|||1996-1997:<br>Consolidation Program<br>If to clean the portfolios<br>of small-medium banks<br>and Stabilization<br>Program to provide<br>cash-flow relief to<br>distressed banks.|Eighteen banks involved<br>in the Consolidation<br>Program (of which three<br>were liquidated). Six<br>banks involved in the<br>Stabilization Program.|Mainly private banks.|Mainly solvency<br>problems. Also<br>some liquidity<br>problems in 1996.|
|**Hungary**|1990s.|1992-1993: Loan<br>Consolidation Program<br>to clean up of banks'<br>portfolios from<br>inherited bad loans.|According to some<br>estimates, in 1992 non-<br>performing loans were<br>20.7 percent of total<br>loans.|State-owned banks.|Solvency.|
|||1993-1994: Bank-led<br>Restructuring and Loan<br>Consolidation Program.|In 1993 non-performing<br>loans were nearly 30<br>percent of total loans.|State-owned banks.|Solvency.|
|||<br>1995: Solvency problem<br>in a state-owned bank<br>(Agrobank).|<br>s|State-owned bank.|Solvency.|
|||1997: Run on the second<br>largest retail bank<br>(Postabank). Solvency<br>crisis in a small private|<br>bank.|Private banks.|Liquidity and<br>solvency.|
|**Macedonia**|1990s.|1994: Clean up of the<br>portfolio of the largest<br>bank from non-<br>performing loans|In 1993 non-performing<br>assets were about 80<br>percent of total assets.|State-owned bank.|Solvency and<br>liquidity.|
|||.<br>1997: Eight saving hous<br>were closed.|es||Solvency|

8
**Table 4 (Cont.): Episodes of Banking Crises**

|**Country**|**Period**|**Nature of the crisis**|**Magnitude of the crisis**|**Private vs. public**<br>**banks affected**|**Liquidity vs.**<br>**Solvency**<br>**problems**|
|---|---|---|---|---|---|
|**Poland**|1990s.|1991: Clean up of<br>banks' portfolios from<br>foreign exchange losses<br>due to the 1989<br>devaluation.|Four banks had<br>experienced significant<br>foreign exchange losses.|State-owned banks.|Solvency.|
|||1993-1994: Enterprises<br>and Banks<br>Restructuring Program<br>to clean the portfolios of<br>state-owned banks.|In 1992 about 30 percent<br>of total loans were non-<br>performing.|State-owned banks.|Solvency.|
|||1991-1994: Solvency<br>problems in two<br>specialized banks.||State-owned banks.|Solvency.|
|||1994-1998: Solvency<br>problems in agricultural<br>cooperatives banks.|Two-hundred<br>cooperatives qualified<br>for bankruptcy and sixty<br>were suspended.|Mostly state-owned<br>cooperatives.|Solvency.|
|**Estonia**|1992,<br>1994.|1992: Four banks faced<br>solvency problems.|Total bad assets: 40<br>percent of banking<br>system assets.|Private banks.|Solvency.|
|||1994: The country<br>second largest bank<br>(Social Bank) faced<br>liquidity problems and<br>had weak loan portfolio.<br>It was closed in 1995.|Withdrawal of over one-<br>half of this bank<br>deposits.|Private bank, with<br>residual government<br>ownership.|Liquidity and<br>solvency.|
|**Latvia**|1993-<br>1994,<br>1995|1993-1994:<br>Restructuring operation<br>in two banks.|In 1993 non-performing<br>loans were about 5<br>percent of total banking<br>system assets.|State-owned banks.|Solvency.|
|||1995: Closure of the<br>largest private bank<br>(Baltija); three small<br>and medium sized banks<br>declared insolvent.<br>Fifteen bank licenses<br>revoked.|Total compromised<br>assets were 40 percent of<br>banking system assets.<br>|Private banks.<br>|Solvency<br>problems, that<br>produced deposit<br>withdrawals.|
|**Lithuania**|1995-<br>1996.|Insolvency in four<br>banks (including the<br>two largest).<br>Widespread solvency<br>problems in the whole<br>banking system.|In 1996 non-performing<br>loans were 32 percent of<br>banking assets.|Private and state-<br>owned banks.|Solvency<br>problems, that<br>produced deposit<br>withdrawals.|

9
**Table 4 (Cont.): Episodes of Banking Crises**

|**Country**|**Period**|**Nature of the crisis**|**Magnitude of the**<br>**crisis**|**Private vs. public**<br>**banks affected**|**Liquidity vs.**<br>**Solvency**<br>**problems**|
|---|---|---|---|---|---|
|**Georgia**|**1994,**<br>1995-<br>1997.|1994: Insolvency of five<br>state-owned banks. Many<br>small private banks did<br>not conform with<br>regulations.|Bad loans in 1995<br>reached 40 percent of<br>total loans.|State owned and<br>private banks.|Solvency.|
|||1995-1997: Solvency and<br>liquidity problem in a<br>bank (Agrobank).|Insolvent bank's assets<br>were 7 percent of total<br>banking system assets.|Private.<br>|Liquidity and<br>solvency.|
|**Kazakhstan**|1994,<br>1996|1994-95: Restructuring<br>program to clean-up<br>banks' portfolios.<br>1996: Four large banks<br>experienced solvency and<br>liquidity problems.|In 1994 about_50-55_<br>percent of commercial<br>loans were either<br>doubtful or loss.<br>N/A<br>|State-owned and<br>private banks.<br>State owned and<br>private banks.|Solvency.<br>Solvency and<br>liquidity.|
|Kyrgyz Rep.|1994-<br>1996|Clean up of banks'<br>portfolios from bad loans<br>(FINSAC).|In 1994 approximatel<br>92.2 percent of<br>banking loans were<br>non-performing. Also<br>the four largest banks<br>were insolvent.|y Former state-owned<br>banks.|<br>Solvency.|
|Ukraine|1995,<br>1996-<br>1998.|1995: Central Bank<br>intervened in<br>approximately twenty<br>banks.<br>1996-1998: more than 50<br>banks were liquidated.|N/A<br>According to some<br>estimates, in 1998 bad<br>assets were still 40<br>percent of total assets.|State owned and<br>private banks.<br>State owned and<br>private banks.|Solvency.<br>Solvency.|

# **2.3 Causes of Banking Crises**

Several factors contributed to the eruption of banking crises in the transition countries. The most important are summarized below.

The transition process. The transition process led to vulnerability of the banking sector in various ways. First, a large number of commercial banks in the transition economies were carved out from formner state banks. As a result, they inherited loans extended under the central planning system to stateowned enterprises which had not been subject to hard budget constraints under the previous regime and did not have the habit of repaying debts. In addition, the transition process - removal of enterprise subsidies and internal and external liberalization - also cut enterprises profitability in many sectors of the economy and reduced their ability to repay loans. Finally, both enterprises and the newly commercialized banks lacked experience doing business with a profit-oriented approach.

10
External shocks. Transition countries in Europe and Central Asia suffered from the collapse of the Council for Mutual Economic Assistance (CMEA) foreign trade system which had isolated the conditions of foreign trade in socialist countries from those prevailing in the world's hard currency trade. Starting in 1991, foreign trade of the former socialist countries was conducted on a hard currency basis. No payments union among former CMEA countries was established, and trading relationships among these countries collapsed.

In addition, some countries were hit by idiosyncratic external shocks. For instance, certain banks located in some countries of the former Soviet Union (for example in _Estonia_ and in the _Kyrgyz Republic)_ lost access to part of their assets held in Russia after the collapse of the Soviet empire. In _Latvia_ and _Lithuania,_ banks profitability was sharply reduced by the decline of trade financing opportunities resulting from price liberalization in Russia.<sup>5</sup> Macroeconomic conditions. The transition process and external shocks led to severe output contraction in all countries at the onset of transition). These downturns precipitated banking crises in many countries.

**Table 5. Growth**

||1990|1991|1992|1993|1994|1995|1996|1997|1998|
|---|---|---|---|---|---|---|---|---|---|
|(GDP annual per|cent change)|||||||||
|**_Central and East_**|**_ern Europe_**|||||||||
|Bulgaria|-9.1|-11.7|-7.3|-1.5|1.8|2.1|-10.9|-6.9|4.0|
|Czech Rep.|-0.4|-14.2|-3.3|0.6|2.7|5.9|4.1|1.0|-2.2|
|Hungary|-3.5|-11.9|-3.1|-0.6|2.9|1.5|1.3|4.6|5.0|
|Macedonia|-9.9|-12.1|-21.1|-9.4|-2.7|-1.6|0.9|1.5|5.0|
|Poland|**-11.6**|-7,0|2.6|3.8|5.2|7.0|6.1|6.9|4.8|
|**Average**|**-6.9**|-11.4|-6.4|-1.4|**2.0**|**3.0**|**0.3**|**1.4**|3.3|
|**_Baltics_**||||||||||
|Estonia|-8.1|-7.9|-21.6|-8.2|-1.8|4.3|4.0|11.4|4.0|
|Latvia|2.9|-11.1|-35.2|-16.1|2.1|0.3|2.8|_6.5_|3.8|
|Lithuania|_-5.0_|**-6.0**|-19.6|-17.1|-11.2|2.3|5.1|6.1|4.4|
|**Average**|-3.4|-8.3|-25.5|**-13.8**|**-3.6**|**2.3**|**4.0**|8.0|4.1|
|_cis_||||||||||
|Georgia|-12.4|-20.6|-44.8|-25.4|-11.4|2.4|10.5|11.0|4.0|
|Kazakhstan|-0.4|-11.0|-5.3|-10.6|-12.6|-8.2|0.5|2.1|-2.5|
|Kyrgyz Rep.|3.2|-7.9|-13.9|_-15.5_|-20.1|-5.4|5.6|9.9|2.0|
|Ukraine|-3.4|-10.6|-17.0|-14.2|-22.9|-12.2|-10.0|-3.0|-1.7|
|**Average**|-3.3|-12.5|-20.3|-16A4|<br>-16.8|-5.9|1.7|_5.0_|_0.5_|

_Source: International Monetary Fund "World Economic Outlook" (1998, 1999), EBRD "Transition Report" (1997. 1998)._ The implementation of macroeconomic stabilization policies also made some countries more susceptible to crises. In fact, tight monetary policies, introduced as part of stabilization programs, forced up nominal interest rate and reduced inflation, thus raising real interest rates and affecting the borrowers' ability to service their debt. This occurred in _Estonia_ in 1992 following the introduction of the currency board; _Latvia_ after 1993; the _Czech Republic_ in 1996; and _Macedonia_ in 1992.

> 5 Latvian and Lithuanian banks were instrumental in financing East/Wes **t** rade. In particular, special financing opportunities arose in 1993/94, when commodities prices in Russia were well below world market prices.

11
As an interesting aside, there was no obvious correlation between the kind of exchange rate regime arrangement and the occurrence of banking crises or systemic banking distress in the sample countries. Banking crises erupted under flexible exchange rate regimes in _Bulgaria, Georgia, Kazakhstan and Latvia;_ managed floats in the _Kyrgyz Republic_ and _Macedonia;_ an adjustable peg in _Hungary;_ crawling pegs in _Poland_ and the _Czech Republic;_ and a currency board arrangement in _Estonia_ and _Lithuania._ Of the twelve countries, _Bulgaria_ was the only one that suffered a currency crisis in conjunction with its banking crisis, leading to a large devaluation in 1996-97 and subsequent adoption of a currency board<sup>6</sup> . In this regard, the experience of the transition economies is different from that of the experience in Latin America and East Asia, where banking crises commonly coincided with currency crises (Kaminski and Reinhart, 1999).

Deficiencies in supervision and in the legal framework. In the early 1990s the legal framework regulating the banking system was extremely poor in most transition countries. Adequate supervisory systems and prudential regulations were not in place. In addition, central bank and banking laws were weak, being deficient in regards to loan collection and bankruptcy, conflict of interest between banks and their shareholders, and rules on collateral.

Poor internal govemance. Fraud, corruption practices, insider lending, and inadequate disclosure contributed to weaken the banking system in most transition countries. For example, bad loan portfolios were generated by management misconduct and insider lending in two banks in _Estonia_ (these were liquidated respectively in 1992 and 1994), in the largest bank in _Latvia_ (liquidated in 1995), and in the second largest bank in _Hungary_ (which suffered from substantial liquidity problems in 1997).

In addition, extensive use of directed credit and on-lending under government instruction was behind the weak bank portfolios in _Georgia, Kazakhstan, Kyrgyz Republic,_ and _Ukraine_ and, to a lesser extent, also in _Lithuania._ Repetitive banks bailout from the government in the _Czech Republic, Hungary, Bulgaria_ and _Lithuania_ created moral hazard leading to risky lending, thus intensifying these countries' banking sector solvency problems.

# 3. **Institutional, Operational and Financial restructuring of banks in transition countries**

The eruption of banking crises or severe banking distress in the transition countries led the government to restructure the banking system. This section discusses the experiences of these countries in the three key areas of restructuring: institutional, operational and financial. All three kinds of restructuring need to be pursued in tandem for the successful resolution of banking crises.

# **3.1 Institutional Restructuring**

Institutional restructuring addresses the environment within which banks operate. Key elements to be addressed include: the legal framework, prudential regulations, accounting standards and banking supervision.

On the legal side, effective collateral and bankruptcy laws are particularly important for supporting banking operations and loan recoveries. Prudential regulations are aimed at limiting bank _credit risk exposure_ and at creating a _cushion against potential losses_ (Talley et al, 1998). The limits on large credit exposure and enterprise share ownership are especially important for banking systems in transition economies given the prevalence of cross-ownership between banks and enterprises and lending to owners.

**6** The Czech Republic experienced a currency crisis in 1997, although this was not connected to its banking crisis.

12
_Minimum capital, capital adequacy, loan classifications, loan loss provisioning_ and _liquidity requirements_ are aimed at creating a cushion against potential losses. Effective implementation of these requirements require internationally acceptable accounting standards, which are essential for monitoring the banking system, regulating bank performance, and for the implementation of effective banking supervision.

As mentioned earlier, the sample countries began transition with a weak institutional framework for the banking system. Liberal licensing policies and lax prudential regulations resulted in a rapid increase in the number of new banks in the system, most notably in the _CIS_ and _Baltic_ countries (see section 3.2). Many of the new banks were small, undercapitalized and non-viable. In the face of these developments, some countries began to strengthen the institutional framework for their banking sectors by tightening licensing policies and introducing or raising minimum capital and capital adequacy requirements. In some cases, the introduction of accounting standards, loan classification and provisioning requirements revealed the scope of non-performing loans in the banking systems. This led to financial and/or operational restructuring, with banks that could not comply with the requirements being either recapitalized, merged with other banks, or liquidated.

The cases of _Hungary_ and _Poland_ illustrate this sequence of developments. Both countries pursued liberal licensing policies in the early years of transition that led to the entry of new banks, many of which ran up large losses and were undercapitalized. In response to these developments, both countries began to strengthen the institutional frameworks for banking. In 1991, _Hungary_ introduced new accounting standards (the Accounting Act), the Bankruptcy Act, and the Banking Act (which addressed loan qualification, regulations on provisions, large exposure and related party lending). In 1992, _Poland_ revised the Banking Law giving the central bank authority to enforce provisioning requirements, capital adequacy and exposure limits. The new standards and laws made it clear that a major financial and operational restructuring program for banks was necessary in both countries, which they subsequently undertook.

In most of the countries under consideration, the eruption of banking crises led to the strengthening of the institutional framework (Table 6). Prudential regulations were introduced or, if they were already in place, tightened in the aftermath of banking crises or bank restructuring programs. Licensing requirements were tightened in _Estonia_ (1994), _Latvia_ (1995) and _Lithuania_ (1995-96) following the banking crises in these countries, which led to the consolidation of the banking sector through bank liquidation. In some other countries, such as _Georgia_ (1995) and _Kazakhstan_ (1994), institutional restructuring followed the introduction of restructuring programs in the banking sectors. In many countries there was a second wave of prudential regulation tightening in the latter part of the 1990s; for some countries this was to comply with European Union (EU) regulations.

Prudential regulations are generally tighter in the _CEEs_ and the _Baltics_ than in the _CIS._ The _Baltics_ and _CEEs_ have in place a minimum capital requirement of at least (and in some cases exceeding) ECU 5 million as required by the EU regulations, whereas this requirement is lower in all the _CIS_ countries under consideration. All the _CEEs_ and _Baltic_ countries have a capital adequacy requirement (CAR) of at least 8 percent (the _Basle_ requirement), and in some countries even higher. Two of the _CIS_ countries under consideration _(Georgia_ and the _Kyrgyz Republic)_ have a 12 percent CAR (information on CARs is not available for _Kazakhstan_ and _Ukraine)._ The actual CARs in most transition economies in this study are fairly high, exceeding the required level: 15.5% in _Poland_ (1998), 18.3% in _Hungary_ (1997), 12% in the _Czech Republic_ (1998)7 (Table 17).

' Even though the actual CAR in the Czech Republic (12% in 1998) is well above the 8% required by BIS, the IMF does not consider it a comfortable level, when compared to other Central European countries (IMF, 1999).

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**Table 6: Key Elements of the Banking Institutional Framework 1/**

||**_Date crisis_**<br>**_(distress)_**<br>**_peaked_**|**_Date of_**<br>**_introducton of_**<br>**_prudential_**<br>**_regulations and_**<br>**_supervision (date_**<br>**_offurther_**<br>**_tightening)21_**|**_Date BIS CAR_**_3/_<br>**_(8%)enteredin_**<br>**_force (date_**_of_<br>**_increase)_**|**_Date_**<br>**_LMSin_**<br>**_force_**_4/_|**_Current_**<br>**_minimum_**<br>**_capital_**<br>**_requirement_**_5/_|**_1998 EBRD_**<br>**_Ranking_**_of_<br>**_extensiveness_**<br>**_(effectiveness)_**_of_<br>**_financial laws_**<br>**_and_**<br>**_regulations_**_6/_|
|---|---|---|---|---|---|---|
|**Bulgaria**|1996-1997|1997 (1998)|1993(1998:10%;<br>1999:12%)|1998|USD_5.9_ml|4(4-)|
|**Czech Republic**|1991-1993<br>1996- 1997|1995 (1998)|1996|NA|USD 16.8 mln|3 (3-)|
|**Hungary**|1992<br>1995-1996|1993 (1996)|1992|1996|From<br>USD 100,000<br>to 9.8 mln|4 (4)|
|**FYR Macedonia**|1994-1996|NA (1998)|1993|1996|From<br>USD 4.2 min to<br>12.6 mln|3 (3-)|
|**Poland**|1992-1993|1993-1994 (1998)|1993a/|1994|ECU_5 mln_|4 (3)|
|**Latvia**|1995-96|1996 (1999)|1994 (1999:10%)|1992|ECU_5 mln_|3 (3)|
|**Lithuania**|1995-96|1997 (1999)|1996(1997:10%)|1997|ECU5mln|3-_(2+)_|
|**Estonia**|1992; 1994|1997|1994 (1997:10%)|<br>1995|ECU 5 mln|3 (3)|
|Georgia|1995-1997||1996 (1999:12%)|Propose<br>d date<br>12/2000|USD 2.8 min<br>(for new banks)|2 (2)|
|**Kazakhstan**|1994-1996|NA|NA|1997|From<br>USD 0.5 mln to<br>USD 3 mln|2 (2)|
|**Kyrgyz Republic**|1994-1996|1996 (1999)|1995(1999:12%)|1997|From USD<br>850,000<br>to1.4 mln|3- (2)|
|**Ukraine**|1995; 1996-<br>1998|1996 (1998)|NA|1998|ECU I min|2+ (2)|

_Notes._ a/ In 1999 CAR was raised for some banks. For banks that were operating prior to 1993, CAR remained at 8%, and for newer banks it was raised to 15% during the first year of operations, and to 12% in subsequent years of operation. 1/ For detailed explanation of the regulations and their comparison with the BIS and EU standards see Appendix Table 2.

2/This refers to the dates of the introduction or tightening of one or more of the following prudential regulations (for details see Appendix Table 2): capital adequacy requirement, large credit exposure limit, liquidity requirement, open foreign exchange exposure limit, loan classification and provisioning requirements, limits on equity holdings in nonfinancial enterprises, and limits on connected lending.

3/ This is the Capital Adequacy Ratio standard set by the Bank for International Settlements.

4/ IAS is International Accounting Standard. Source: EBRD Transition Reports.

_5/_ Expressed in USD equivalent of local currency at end- 1998 market exchange rate, or in ECU if requirement is expressed in ECU and not in local currency. Where there is only a single number, it refers to minimum capital requirements for banks only. Where there is a range of numbers, they refer to minimum capital requirements for either different types of financial institutions or ownership - for details see Appendix Table 2.

6/ The EBRD rankings are on a scale from I to 4.

However, the extensiveness of prudential regulations does not guarantee compliance. A 1998 EBRD survey found that transition economies had a better record for the extensiveness of financial laws and 14
regulations for the banking sector than for their enforcement<sup>8</sup> . The same survey found that the _CIS_ countries were rated lower in both extensiveness and effectiveness than the _CEEs_ and the _Baltics._ Among the _CEEs, Hungary, Poland_ and _Bulgaria_ were rated higher in both counts than the _Czech Republic_ and _Macedonia. Estonia_ was rated the highest among the Baltic countries.

The issue of effectiveness of financial sector legal framework is closely related to the quality of banking supervision. As in the case of strengthening prudential regulations and introduction of international accounting standards (IAS), improvements in the quality of banking supervision took place in the aftermath of banking crises or after the initiation of financial sector reforms to address banking distress. However, the lack of financial resources and technical expertise have made the implementation of effective banking supervision problematic. Countries that are most advanced in terms of legal reform in the financial sector _(Hungary_ and _Poland)_ are planning to introduce bariking supervision on a consolidated basis, which is important to prevent excessive credit risk exposure and inadequate capitalization in the financial institutions not covered by the regulations.

In sum, a strong institutional framework is a key element for a sound banking sector. The strengthening of the institutional framework in the aftermath of banking crises in the sample countries have helped produce positive results of bank crisis resolution in all of them (see section 6 for results of crisis resolution). By the same token, the greater extensiveness and effectiveness of financial laws and regulations in the _CEEs_ and the _Baltics_ compared with the _CIS_ are accompanied by stronger banking systems in the first two country groups compared with the last one.

# 3.2 **Operational Restructuring**

_Operational restructuring_ of banks is aimed at improving their corporate governance. It deals with the flow problems in banks caused by non-perforning loans and high operating costs. Operational restructuring can take two forms: bank closure and liquidation; or bank restructuring, which could entail change of management or privatization.

The experience of the twelve countries under consideration was that **the** _CEE_ countries generally **restructured banks rather than close them,** whereas **the** **_CIS_ countries tended to favor the liquidation approach. The** **_Baltic_** countries pursued a combination of liquidations and restructuring.

The strategy adopted by the authorities for resolving banking crises seem to depend, in part, on two factors: (i) the development of the banking sector, including the degree of financial penetration; and (ii) macroeconomic conditions. The impact of these factors on the operational restructuring strategy pursued in the different country groups is discussed next.

The _CIS_ and the _Baltics._ At the onset of transition, the banking systems in the _CIS_ and the _Baltics_ were developed mainly through liberal entry of new banks in combination with the spontaneous breakup and privatization of state banks, and in some cases liquidation of old banks. This approach was not always a deliberate choice, but happened spontaneously when the former Soviet Union collapsed. The result was an explosion of the number of new banks that entered the system (in absolute terms and in

> 8 EBRD Transition Report, 1998. Academic and practicing lawyers and other experts familiar with the financial laws and regulations of the region were surveyed. The survey questions were based in part on the core principles developed by the Basle Committee, including questions on: banking regulations and supervision; minimum financial requirements (capital adequacy standards) and criteria for banking operations; use of internationally acceptable accounting standards; and ability of banking regulators to engage in enforcement and corrective action.

15
terms of banks per population) (Table 2).9 Some of the new banks were engaged mostly in financing existing inefficient enterprises (the so-called "pocket" banks). Many of them were small and undercapitalized, and did not even meet the lax licensing requirements inherited from the former Soviet Union (FSU). These banks obviously did not have proper governance, nor did they engage in much deposit mobilization. Therefore, although many new banks were established, financial intermediation in those economies did not increase.

Given the low "value-added" provided by these new banks, the authorities were able to respond to banking crises by closing the insolvent institutions. Indeed, the low level of financial intermediation in these countries also meant that a large number of banks could be closed without generating widespread effects on the economy. At the same time, the authorities did not have to tackle the problem of a large amount of inherited bad debt in the state-owned banks because hyper inflation (reaching 4 to 5 digits)'° had greatly reduced the real value of this bad debt (although depositors bore the costs through erosion of the real value of their deposits). Therefore, resolution of banking problems in these countries did not entail significant restructuring or recapitalization of state-owned banks, nor sizeable fiscal costs (section 4). Furthernore, high fiscal deficits in the CIS countries may also have diminished their appetite for incurring fiscal costs to bail out the banking system.

A large number of banks were closed in the _CIS_ countries. In _Kazakhstan,_ where the numerous small banks accounted for only a very small share of household deposits, the number of domestic banks was reduced from 204 to 71 between 1993 and 1998. In _Georgia,_ where about 80 percent of the new private banks had no more than three to five customer accounts, the number of domestic banks was reduced from 226 to 43 between 1994 and 1998 (Table 2). _Ukraine_ is the only country in this group where there was not much banking consolidation. In none of these countries did substantial consolidation of the banking sector lead to sector-wide systemic risks, high costs, or social problems. Among the _CIS,_ the _Kyrgyz Republic_ stood out in that even major banks, including state-owned banks such as the Savings Bank, were liquidated.

All three _Baltic states_ also experienced a major consolidation in the number of banks through the 1990s, although in some instances there was restructuring and recapitalization. In _Estonia,_ the number of banks fell from 22 to 6 between 1994 and 1998; in _Latvia_ from 62 to 27 between 1993 and 1998; and in Lithuania from 26 to 10 over the same period. Most of the liquidated banks were small. For example, thirteen of the Lithuanian banks that were liquidated accounted for only 3 percent of the deposits. However, there were a few exceptions. For instance, in _Latvia,_ the largest commercial bank was closed in 1995, and in _Lithuania,_ the country's largest bank was liquidated in 1997.

The _CEE_ countries. In the _CEEs,_ the development of the banking system since transition differed from that in the _CIS_ countries and the _Baltics_ in focusing on the rehabilitation and transformation of existing state-owned financial institutions which were then recapitalized to prepare them for privatization. Although the _CEEs_ did allow the entry of new banks to introduce competition into the system, entry was more limited than in the _CIS_ and the _Baltics_ (as can been seen in the smaller number of banks per population in Table 2). Moreover, these new entrants included foreign banks, which were generally sounder than the new domestic private banks". Since the entry of new banks was more limited and the quality of the new banks was better in the _CFEEs_ than in the other two country groups, there was not as much a need for liquidation of these banks.

> 9 Another indicator, number of bank branches per population (rather than banks per population), may have been better, but such information is not available.

> 'Appendix Table 3 presents inflation figures for the twelve countries. For instance, Citibank, an obviously reputable foreign bank, entered Hungary in 1985.

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

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

# **a. Privatization and Foreign Entry**

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

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

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

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attractiveness of local conditions, including the presence of a vibrant private sector and a sound legal framework that is enforced. In this regard, the _CEEs_ and the _Baltics_ were also more attractive than the _CIS._ It is therefore not surprising to find greater foreign presence in the banking sectors in the _CEEs_ and the _Baltics_ than in the _CIS_ countries.

Among the countries under consideration, foreign bank activities are most extensive in the _Baltic_ countries, especially in _Latvia_ and _Estonia,_ while _Lithuania_ had begun to acquire a larger foreign bank presence. In _Estonia,_ foreign banks (from Finland, Germany and Sweden) have played an increasingly important role in the system since 1994. Swedish banks owned majority shares in the two largest domestic banks which accounted for 85 percent of total banking sector assets as of mid-March 1999. In _Latvia_ at end-1998, of the 27 banks in the country, 2 were state-owned and 15 were foreign-owned. Subsidiaries of Estonian, Finnish, German and Russian banks as well as a branch of a French bank operated in _Latvia._ By end-1998, majority foreign-owned banks were responsible for almost 85 percent of total bank assets. Among the _Baltic_ countries, the presence of foreign banks is the lowest in _Lithuania_ although this has recently increased. The two large domestic banks which account for 42 percent of total banking system assets are majority-owned by foreign investors.

There has also been an increasing presence of foreign banks in the _CEEs._ Among the _CEE_ countries, _Hungary_ has been at the forefront in attracting foreign banks for bank privatization. Since the first foreign bank was established in 1979, foreign presence in the Hungarian banking sector has risen substantially. Currently, the share of private sector in total bank equity exceeds 80 percent, and foreign intermediaries own 60 percent of the banks<sup>13</sup> . _Bulgaria_ has recently been actively pursuing the privatization of its state-owned banks to foreign strategic investors and, to date, around 80 percent of the assets in the banking system are owned by foreign banks. The _Czech Republic_ has been stepping up the privatization of its state-owned banks to strategic foreign investors recently. Three of the big five stateowned banks are already privatized to strategic foreign investors (from Japan, the U.S. and Belgium, respectively) and preparations are underway for the privatization of the remaining two, the completion of which will bring foreign-owned banks' market share to about 90 percent of total assets in the system. After an initial period of liberal entry for foreign banks, _Poland_ is now lagging behind in terms of foreign banking presence, with majority-owned foreign banks accounting for only 35 percent of the country's total banking assets. The foreign presence in _Macedonia's_ banking system is even smaller, comprising in 1998 of only one branch of a Russian bank.

Foreign participation in the _CIS_ countries remains very limited, and foreign banks that are present tend to be Russian. _Georgia_ has some foreign presence in its banking sector. In the _Kyrgyz Republic,_ there are banks that have foreign participation. In _Kazakhstan,_ there are 10 foreign banks in 1997, but these banks are limited to own no more than 25 percent of a domestic bank's stock (Kalyuzhnova and Tridimas, 1998). In _Ukraine,_ only thirty of the 190 banks in 1998 boast foreign (largely Russian) capital holdings.

In sum, of the twelve countries under consideration, those which have the larger foreign banking presence also happen to have the stronger banking systems (in particular Estonia and Hungary). This gives some credence to the proposition that privatization to foreign investors could be an important element of bank operational restructuring.

# **3.3 Financial Restructuring**

_Financial restructuring_ deals with the stock problems in banks, that is the problem of negative net worth. Financial restructuring generally employs one or more of the following instruments: (i) injection

**3** Hungary Country Economic Memorandum (1999).

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of new capital; (ii) reduction of bank liabilities; (iii) transfer<sup>of non-performing loans to a special agency</sup> and (iv) improvement in the management of non-performing<sup>loans (Hoelscher, 1998). The last two</sup> instruments are related to the recovery of bad loans, which is discussed in<sup>section 5.</sup> Tables 7 and 8 summarize the main methods of financial<sup>restructuring by the government and the</sup> central bank in the transition countries under consideration.<sup>Financial restructuring by the government</sup> included recapitalization of banks through the issuance<sup>of public debt. Generally, the transferred bonds</sup> were swapped for non-performing loans<sup>14</sup> . In some cases, instead, the issuance was unrequited. Occasionally, governments directly improved banks'<sup>net worth through the transfer of cash or property</sup> assets, the reduction of bank liabilities, repurchase<sup>agreements and the provisions of public guarantees on</sup> outstanding loans. Finally, in a few occasions, governments<sup>intervened in enterprises to facilitate debt</sup> servicing or repayment. Only in _Ukraine_ did the<sup>government not embark on any form of intervention in</sup> support of the banking sector. Financial restructuring<sup>by the central bank involved provision of short and</sup> long terms loans, and refinancing of troubled banks' assets.

In the _CEEs,_ financial restructuring of the problem<sup>banks usually involved injection of new capital,</sup> after which the banks were to be privatized. This was<sup>the case in</sup><sup>_Hungary, Poland,_the</sup><sup>_Czech Republic_</sup> and _Bulgaria._ In the _CIS_ countries, financial restructuring<sup>was limited to the cleaning of balance sheets</sup> (removing bad loans from the books), which basically shrank<sup>the size of the banks' balance sheets,</sup> accompanied by reduction of liabilities and capital (with depositors<sup>and bank shareholders bearing the</sup> loss in most instances). The experience of the _Baltics_ was mixed;<sup>there was injection of new capital into</sup> the banks in _Estonia_ and _Lithuania,_ but not in _Latvia._<sup>The fiscal costs were obviously higher where there</sup> was injection of new capital.

# **4. Costs of Banking Crises**

The cost of a banking crisis can be measured by the shortfall in banks' capital - that is,<sup>the</sup> difference between their assets and the sum of their liabilities<sup>and the regulatory minimum level of</sup> capital. In transition countries, depositors had initially bore some<sup>of the cost of banking crises arising</sup> from inherited bad debt through the hyper or very high inflation at the<sup>onset of transition. The remainder</sup> of the inherited costs, as well as new costs incurred post-transition,<sup>were distributed between the</sup> government, bank shareholders, and depositors.

In the _CEEs,_ governments assumed part of the costs by recapitalizing<sup>banks with government</sup> bonds. For instance, in _Hungary,_ the recapitalization bonds ranged<sup>from 13 to 100 percent of the book</sup> value of non-performing loans. In _Poland,_ this figure ranged from<sup>74 to 90 percent, and in</sup><sup>_Macedonia, it_</sup> was 38 percent<sup>1</sup> 5. To the extent that the recapitalization bonds did not fully recapitalize<sup>the banks, the</sup> remainder of the costs was assumed by bank shareholders.

> **14** See also Appendix Table 4 for the technical aspects of govemment<sup>bonds for bank restructuring and deposit</sup> compensation.

> **15** See Appendix Table 5 for derivation of the numbers for Hungary<sup>and Poland. In Macedonia in 1994, bad loans,</sup> with total nominal value of 13 bln denars, were transferred from the<sup>Stopanska Bank (65% of total banking assets in</sup> 1994) to the state-owned BRA (ratio=0.38).

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|**Table**7.**Methods of Financi**<br>|**al Restructuring and Government Assistance to**<br>|
|---|---|
||**the Banking Sector**|
|**Method**<br>|**Country and date**|
|1. Capital injection<br>||
|A. Bond trasfer||
|A. I Exchange for bad loans|Bulgaria (1991-94, 1995, 1996-97); Czech Republic (1991-92);<br>Hungary (1992-93); Macedonia (1994); Estonia (1992);<br>Lithuania (1996); Kyrgyz Republic (1996-97)|
|A.2 Unrequited|Czech Republic (1991-92); Hungary (1993-94); Poland (1991,<br>1993-94); Latvia (1994); Estonia (1993); Kazakhstan (1996-97)|
|B. Cash transfer|Czech Republic (1991-92, 1993-96); Lithuania (1996)|
|C. Transfer of property assets|Lithuania (1996)|
|2. Reduction of bank liabilities||
|A. Write-off of bank liabilities to the<br>government (in exchange for bank assets)|Georgia (1998)|
|B. Assumption of bank liabilities|Estonia (1995)|
|3. Repurchase agreement|Czech Republic (1993, 1996-97)|
|4. Provision of guarantees on outstanding<br>Loans|Czech Republic (1991, 1993, 1996)<br>Hungary (1991)<br>Lithuania (1997)|
|_5._Short/medium term loan||
|Placement of deposits|Lithuania (1995)|
|6. Actions on enterprises to allow servicing/r|epayment of bank debt|
|A. Assumption of enterprise debt|Georgia (1998) (directed credits extended under government<br>instruction).<br>Kazakhstan (1994-95) (directed credits extended under<br>government instruction and payments of government<br>guarantees) /L.|
|B. Equity conversion of government claims<br>on enterprises.|Hungary (1992)|

C. Rescheduling or writing-off of government Hungary (1992) claims on enterprises.

7. No action Ukraine /1 In exchange the government received an equity position in the enterprises.

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**Table 8. Methods of Central Bank Assistance to the Banking Sector. Method Country and date** Liquidity support Bulgaria (1991-1994,1995,1996-97); Czech Republic (1996); Macedonia (1995); Poland (1993); Estonia (1992-1994); Latvia (1995); Lithuania (1995); Kazakhstan (1994-95, 1996); Kyrgyz Republic (1994); Ukraine.

Loan to asset management agencies Czech Republic (early 1990s, 1997); Macedonia (1994) Capitalization of asset managment Macedonia (1996) agency, through bond issue Transfer of assets (in exchange for Estonia (1997) bad loans). Long term loan to banks Poland (1993) Rescheduling of loans to banks Kazakhstan (1997); Kyrgyz Republic (1994) Writing off of central bank shares in Estonia (1995) banks to cover their losses In the _CIS_ and _Baltic States,_ the governments generally adopted a lower cost approach, relying on recapitalization by private shareholders. To the extent that this was not possible, the banks were liquidated with minimal compensation for depositors. This was the case in _Georgia, Kazakhstan, Estonia, Latvia,_ and to a smaller extent in _Ukraine_<sup>_6_</sup> _._ With the exception of _Lithuania,_ recapitalization with state funds in the _CIS_ and _Baltic_ countries generally occurred only for the inherited portion of bad loans, and even then not for the entire amount.

In most of the countries covered, there is no information on the shortfall in banks' capital, that is, the entire cost of the banking crisis. The only portion of the cost that is observable is that borne by the government - that is, the fiscal cost - which will be reviewed in the rest of this section (4.1 to 4.3). The fiscal cost includes the cost to the government of recapitalizing banks (including with recapitalization bonds, as discussed above) and compensating depositors. It also includes, in some cases, the quasi-fiscal costs incurred by the central bank. These fiscal costs are reduced when governments recover bad loans (section 5).

# **4.1 Cost of Bank Restructuring for the Government**

The cost of bank restructuring for the government includes the bonds issued for bank recapitalization (both unrequited and in return for non-performing loans); cash and property transfers; called government guarantees; bank's or enterprise's liabilities assumed by the government; and transfers to the central bank connected with banking sector restructuring (Table 9), There are also additional costs, not quantifiable, which arise from revenues losses due to lower bank profits. Cumulatively over the period 1991-98, the costs of government assistance to the banking sector ranged from 5 to 27 percent of GDP in the _CEEs,_ 0.1 to 18 percent in the _CIS,_ and I to 3 percent in the _Baltics._

**16** In Ukraine the consolidation of the banking sector has begun only recently under the banking sector reform program that began in 1996. Some small, marginal banks were liquidated. For details see Report of the President for Proposed Financial Sector Adjustment Loan for Ukraine, February 24, 1998.

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|**Table 9: Co**|**st of Ba**|**nk Rest**<br>**(p**|**ructuri**<br>**ercent**|**ng for t**<br>**of GDP)**|**he Gove**<br>|**rnment**|**(1991-9**|**8)**||
|---|---|---|---|---|---|---|---|---|---|
||**1991**|**1992**|**1993**|**1994**|**1995**|**1996**|**1997**|**1998**|**Total/**|
|**Bularia**||||||||||
|Bond issued|0.0|2.1|10.9|23.1|0.3|0.0|_0.5_|0.0|26.5|
|Interest payments on bonds|0.0|1.3|1.3|2.9|2.9|10.7|0.8|0.4||
|**Total**|||||||||**2**|
|**Czech Republic**2'||||||||||
|<br>Bond issued|4.0|0.0|0.0|0.0|0.0|0.0|0.0|0.0|3.4|
|Cash transfers|0.0|0.0|0.9|0.7|0.3|0.0|N/A|N/A|1.5|
|Purchase of bad loans|10.9|1.8|2.7|0.3|0.0|0.1|0.7|1.0|**15.7**|
|**Total**|||||||||**2O6**|
|**Hun2ary**||||||||||
|Bond issued<br>|0.0|2.7|3.6|2.1|0.1|0.1|0.0|1.6|12.4|
|Interest payments on bonds|0.0|0.0|0.0|1.2|1.7|_1.5_|1.0|0.5||
|Guarantees called less recovered|0.0|0.1|0.0|0.0|0.1|0.0|0.1|0.0|**0.5**|
|**Total**|||||||||**12.9**|
|**Macedonia**<br>||||||||||
|Bond issued|0.0|0.0|0.0|3.3|0.0|0.0|0.0|0.0|5.1|
|Interest payments on bonds|0.0|0.0|0.0|0.0|0.4|0.4|0.2|N/A||
|**Total**|||||||||**S.1**|
|**Poland**||||||||||
|Bonds issued|7.1|0.0|1.3|0.8|0.0|0.0|0.0|0.0|8.2|
|o/w placed in Central Bank|1.5|0.0|0.0|0.0|0.0|0.0|0.0|0.0|1.3|
|Interest payments on bonds|0.3|0.4|0.5|0.7|0.6|0.4|0.3|0.2||
|o/w to Central Bank|0.1|0.1|0.1|0.1|0.1|0.04|0.03|0.02||
|**Total**|||||||||**8.2**|
|**Estonia**||||||||||
|Bonds issued|0.0|0.0|2.0|0.0|0.0|0.0|0.0|0.0|1.0|
|Interest payments on bonds|0.0|0.0|0.1|0.1|0.1|0.1|0.0|0.0||
|<br>Purchase of bad loans<br>|0.0|0.0|0.0|0.0|0.05|0.0|0.0|0.0|0.0|
|Recapitalization of Central Bank<sup>3</sup>'|0.0|0.0|0.0|0.0|0.0|0.4|0.0|0.0|**0.3**|
|**Total**|||||||||**I**|
|**Latvia**||||||||||
|Bonds issued|0.0|0.0|1.6|1.9|0.0|0.0|0.0|0.0|2.5|
|Interest payments on bonds|0.0|0.0|0.3|0.4|0.04|0.03|0.03|0.03||
|<br>**Total**|||||||||2|
|**Lithuania**||||||||||
|Bonds issued|0.0|0.0|0.0|0.0|0.0|0.7|0.4|0.5|**1.6**|
|Interest payments on bonds|0.0|0.0|0.0|0.0|0.0|0.0|0.1|0.1||
|<br>Cash|0.0|0.0|0.0|0.0|0.0|0.03|0.0|0.0|0.0|
|Property transfer|0.0|0.0|0.0|0.0|0.0|0.02|0.0|0.0|0.0|
|Called guarantee on interbank loan|0.0|0.0|0.0|0.0|0.0|0.0|0.1|0.0|0.1|
|<br>**Total**|||.|||||||

22
# **Table 9 (cont.). Cost of Bank Restructuring for the Government (1991-98)**

|||**(perc**|**ent of G**|**DP)**||||||
|---|---|---|---|---|---|---|---|---|---|
||**1991**|**1992**|**1993**|**1994**|**1995**|**1996**|**1997**|**1998**|**Total"**|
|**Georgia**||||||||||
|Bank liabilities to government<br>written-off|0.0|0.0|0.0|0.0|0.0|0.0|0.0|0.1|0.1|
|Assumption of enterprise debt|0.0|0.0|0.0|0.0|0.0|0.0|0.0|0.04|0.0|
|<br>**Total**||||||||||
|**Kazakhstan**||||||||||
|Assumption of enterprise debt|0.0|0.0|0.0|0.0|11.0|0.0|0.0|0.0|17.6|
|<br>Recapitalization of banks|0.0|0.0|0.0|0.0|0.0|0.1|0.4|0.0|**0.8**|
|<br>**Total**|||||||||**18**|
|**Kvrevz Republic**||||||||||
|Bonds issued|0.0|0.0|0.0|0.0|0.1|4.3|0.7|0.0|4.4|
|o/w placed in Central Bank|0.0|0.0|0.0|0.0|0.0|4.3|0.0|0.0|3.3|
|Interest payments|0.0|0.0|0.0|0.0|0.0|0.2|_0.3_|0.3||
|<br>o/w to Central Bank|0.0|0.0|0.0|0.0|0.0|0.1|0.2|0.1||
|**Total**|||||||||**_4.4_**|
|**Ukraine**|0.0|0.0|0.0|0.0|0.0|0.0|0.0|0.0|**0O.**|

**i/** Total Cost is the net present value (NPV) at end- 1998 of the annual costs during 1991-98. The NPV is calculated using the relevant interest rate for each cost item.

2/ Assistance to the banking sector provided by the National Property Fund and various asset management companies, financed by the government, the Central Bank and the National Property Fund.

3/ Portion related to central bank losses on loans to troubled banks.

To understand how these costs were generated, it is useful to draw some distinctions between the different country groups, as follows.

# **a.** _Bulgaria, Czech Republic, Hungary_ **_and_** _Poland_

In the _CEEs_ (with the exception of _Macedonia),_ banks were restructured to deal with inherited bad loans, done commonly through recapitalization of troubled banks with government bonds often in exchange for bad loans. In general, the cost of this assistance was extremely high"<sup>7</sup> , for two reasons. First, the amount of non-performing loans inherited from the Socialist system was large. For example, in _Bulgaria_ it was nearly 54 percent of total loans and in the _Czech Republic_ approximately 50-66 percent. Second, the costs were high because the restructuring operations undertaken by the government in most of these countries suffered from several weaknesses which raised fiscal costs, as discussed below.

The financial restructuring programs did not provide adequate recapitalization from the start. Undercapitalized banks face distorted incentives in granting new credit, which created moral hazard resulting in excessive risk taking (Begg and Portes, 1993). This led to recurrent banking crises and successive rounds of recapitalization, raising fiscal costs even further. For example, in _Hungary,_ the first plan (the Loan Consolidation Program, LCP) introduced by the government in 1992-93 to deal with outstanding non-performing loans was too small, given the size of the problem. This necessitated a second round of recapitalization in 1993-94 (the Bank-led Restructuring and Loan Consolidation 17 For _Poland_ a large portion of the fiscal cost is due to the fact that the government in 1991 decided to capitalize banks that suffered from foreign exchange losses after the 1989 devaluation. The Treasury issued nearly $ 5.5 bln in dollar denominated bonds (corresponding to 7.3 percent of GDP) for this purpose.

23
Program). Equally, in _Bulgaria,_ the 1991-1994 operation to clean up banks' portfolios from bad credits did not provide adequate capitalization 8. Further recapitalization was necessary after the eruption of the banking crisis in 1996-97.

Financial restructuring was not coupled with operational and institutional restructuring. This led to renewed banking crisis, requiring further recapitalization and raising fiscal costs. _Hungary_ is a wellknown case in point. Not only did the 1992-93 LCP not provide adequate capitalization (see above point), it was also not accompanied by operational restructuring of banks, and the bad loan problem deteriorated after a temporary improvement'9, necessitating another round of recapitalization. This was also the case in _Bulgaria,_ where the recapitalization of banks in the first part of the 1990s was not accompanied by operational restructuring, with the result that banks continued to roll over outstanding credits to state-owned enterprises while capitalizing interests, leading to the eruption of the large-scale banking crisis in 1996 and 1997. The _Czech Republic_ is another example illustrating how financial assistance not contingent on comprehensive restructuring could be very costly.

Bank restructuring was not coupled with enterprise restructng. In most _CEEs,_ adequate enterprise restructuring was missing. As a consequence, banks continued to lend to bankrupt enterprises, which further worsened their financial positions. As discussed above, in _Bulgaria_ this problem resulted in a more severe banking crisis. Equally, in the _Czech Republic,_ bank recapitalization was not accompanied by a full restructuring of enterprises. _Poland_ was an exception for undertaking a parallel bank and enterprise restructuring program, the Enterprise and Bank Restructuring Program (for details see section 5). While the enterprise restructuring part of the program had mixed results (Gray and Holle, 1 996b), the outcome for the banking sector was more successful.

Repetitive bailouts induced moral hazard behavior. In some _CEE_ countries _(Bulgaria,_ the _Czech Republic_ and _Hungary),_ repetitive bank bailouts because of the reasons just discussed further encouraged moral hazard in lending decisions and induced excessive risk taking. In addition, in _Hungary_ the government established from the beginning its reputation as a soft bargainer, by first moving the date for loans eligible for bailouts from 1987 to 1992 and by renegotiating the terms of the securities it issued for bank recapitalization.

No clear lines between old and new loans were established. The purpose of the government recapitalization operations undertaken in the early years of the transition was to clean banks' balance sheets of inherited bad debt. However, in some cases the authorities also provided support to nonperforming loans extended after the collapse of the socialist system. In _Hungary,_ for example, the government included in the bond/debt swap operation bad loans created during 1992, after the establishment of a market-based banking system.

The government recapitalized banks by placing dollar and local currency denominated bonds in their balance sheet. However, the interest yields on local currency bonds were below market and below banks' cost of funds. Besides, these bonds had a minimum selling price and, so were largely illiquid. As result, the holders of large amount of these bonds suffered from liquidity problems and required further government intervention. **19** There was a temporary improvement in banks' portfolio as bad loans were taken off the books of the banks. The value of bad loans fell from 187bn. forint to 85bn. forint (both figures for the last quarter of 1992), but rose again immediately after the program to reach 186bn. forint in the fourth quarter of 1993 (see Bonin and Schaffer, 1995). Bonin and Schaffer attributed this rise in bad loans to the ex-post recognition of bad loans by banks to reduce their tax burden, rather than the result of new bad lending by banks. Regardless of the reason, the bad loan problem worsened.

24
## **b.** **_Macedonia_**

The _Macedonia_ banking sector was highly concentrated. As a result, the government decided to provide assistance to those banks that were considered "too large to fail". The largest bank (Stopanska Banka) which accounted for 65 percent of banking sector assets was recapitalized.

## **C.** **_Baltic Countries_**

In the _Baltics,_ the authorities differentiated their approach according to the source of problems and the size of the troubled banks. Some banks were liquidated, while others were recapitalized. _Estonia_ liquidated banks which got into trouble because of management problems, while those which suffered external shocks were merged and recapitalized. _Lithuania_ liquidated private banks and restructured and recapitalized state banks. _Latvia_ widely liquidated problem banks.

The fiscal cost of banking restructuring for the government was not very large in _Estonia_ (around 1.4 percent of GDP for the period 1991-98) because the government decided to bail out only two banks that faced solvency problems after they lost access to part of their assets, held in Moscow<sup>20</sup> . The other banks were liquidated. The cost incurred by the government in connection with banking sector problems includes a transfer to the central bank, extended in 1996, that enabled the monetary institution to cover the loss suffered in 1994, partly as a result of banking sector crises (section 4.2).

In _Latvia,_ treasury bills were issued in 1993 and 1994 in conjunction with the restructuring of two state-owned banks. Nevertheless, when a full fledged crisis erupted in 1995 after the publication of the banks' audited reports for 1994, the government did not intervene to recapitalize troubled banks and several banks, including the largest private banks, were liquidated. As a result, the fiscal costs of bank restructuring for the Latvian government were also not very high (around 2.5 percent of GDP for the period 1991-98).

In _Lithuania,_ the banking sector was highly concentrated, leading the government to intervene in support of the banks that were considered "too big to fail", while smaller private ones were closed. Capital injection by the government was directed mainly to three state banks that together accounted for nearly 50 percent of deposits and 50 percent of banking sector assets. Altogether, the costs to the Lithuanian government for bank restructuring was around 1.7 percent of GDP. The _Lithuanian_ case illustrates the point that financial restructuring without operational restructuring is a waste of resources, as one of the recapitalized banks (Innovation Bank) required substantial continuous aid from the state budget and still had to be liquidated at the end.

# **d.** **_Georgia, Kazakhstan the Kyrgyz Republic_ and** **_Ukraine_**

In the _CIS_ countries, government intervention was largely motivated by the decision to compensate banks for the directed credits extended under government instruction and for the unrepaid loans carrying government guarantees.

During the early years of the transition, the _CIS_ governments intervened quite extensively in the credit markets. Specifically, in _Georgia, Kazakhstan,_ the _Kyrgyz Republic_ and _Ukraine_ large amounts of credit were extended directly, under government instruction or under government guarantees (IMF, 1996). The quality of these loans was generally very poor. Because of this and other reasons (discussed in section 2.3), non-performing loans became a serious problem. In response, the governments of 20 The two banks (Northern Estonian Bank and Union Baltic Bank) were merged. The newly created bank was recapitalized and finally privatized in 1997.

25
_Georgia, Kazakhstan,_ the _Kyrgyz Republic_ provided financial assistance to compensate for nonperforming loans that were granted under government pressure or guarantee. In _Ukraine,_ however, the government did not offer any financial compensation. In all the _CIS_ countries, there was large-scale liquidation of private banks, and in some instances even of state-owned banks.

In _Kazakhstan,_ government support was mostly related to compensation for directed or publicly guaranteed credits. During 1994-95 a large share of the banks' bad debt (largely constituted by loans extended under government instruction or carrying government guarantees) was transferred to three newly created asset management institutions. However, this operation did not involve significant injection of capital, nor operational nor institutional restructuring of the banks. In 1996-1998 the four largest banks incurred further financial difficulties. In response, the fiscal authorities decided to bailout and merge recapitalize two of them. The cost of recapitalization was small (around 0.8 percent of GDP). The _Kazakhstan_ case illustrates how bank restructuring without adequate capitalization and not accompanied by operational and institutional restructuring cannot resolve banking sector problems and may require successive government interventions.

In _Georgia,_ government assistance was mainly limited to the repayment of directed credits, which was very small (around 0.1 percent of GDP). Resolution of problems in the state banks basically entailed downsizing and mergers, while private banks were liquidated. In the _Kyrgyz Republic,_ the treasury issued interest bearing bonds during 1995-97 and placed them in troubled banks, in exchange for nonperforming loans. The costs to the Kyrgyz government for bank restructuring were around 4.4 percent of GDP. There was liquidation of both private and state banks. The state banks that were not liquidated were substantially downsized and restructured through private rather than government recapitalization. There was also no major operational restructuring of these banks either.

> Differently from the other three _CIS_ countries, in _Ukraine_ the fiscal authorities did not compensate the banking sector for loans extended under government pressure. In addition, often they did not honor explicit or implicit state guarantees on bank credits. At least until 1998, no formal government financed recapitalization has occurred. Even the simple repayment of guaranteed bad debt would have constituted a significant financial rescue of the banking sector.

# **4.2 Cost of Bank Restructuring for the Central Bank**

As a principle, the costs of banking crises should be borne by the government and not by the central bank (Daniel, 1997). Central banks should only be engaged in liquidity support. However, it is difficult for the authorities to ascertain at the time of a crisis whether it is a solvency or a liquidity crisis. As a result, sometimes the central bank intervenes on the belief that it is facing a liquidity crisis, when the crisis is actually generated by widespread insolvency.

In some cases the central bank assumes a leading role in the bank restructuring process, in addition to its core monetary policy functions. This causes several difficulties. Specifically, direct ownership in banks and medium-term lending by the central bank generates conflicts of interest, in particular when the central bank has a supervisory role. Moreover, active central bank intervention in the banking sector can impose substantial costs on the monetary institution that, ultimately, will be borne by the government budget<sup>21</sup> .

In most of the countries under consideration, the central bank granted only liquidity support, while in some countries, it intervened extensively, providing both short and long term loans and refinancing

**21** See Dziobek and Pazarbasioglu (1997) for an analysis of the different types of central bank instruments to support the banking sector and their costs and incentives.

26
troubled banks' assets. The costs of central bank interventions in these countries mainly consist of provisions and losses on credit extended to distressed banks (Table 10). Overall, for the twelve countries, the direct costs of banking problems arising from government assistance far outweighs the costs arising from central bank assistance.

With regards to the actions taken by the central bank and to the cost suffered by the monetary institution, some distinctions among the different groups of countries can be drawn.22 (a) In _Bulgaria,_ the _Czech Republic, Estonia_ and the _Kyrgyz Republic,_ the monetary authorities intervened extensively in the banking sector and the cost to the central bank was sizable, ranging from 1 percent of GDP to 12 percent of GDP. (b) In _Hungary, Poland, Macedonia, Latvia, Lithuania_ and _Georgia,_ central bank intervention was limited and related costs were low (less than I percent of GDP).

# **a. Problems arising from extensive central bank involvement in bank restructuring**

The experience of _Bulgaria,_ the _Czech Republic, Estonia_ and the _Kyrgyz Republic_ shows how central bank involvement in banking sector restructuring can lead to a number of problems.

First, losses incurred by the central bank are ultimately borne by the government budget. In the _Czech Republic_ the government, through several agencies", bore most of the cost of bank restructuring. The central bank bore the cost of the "Consolidation Program II", launched at the end of 1995, that focused on small and medium sized banks, newly created in the early years of the transition. However, the government had to issue a guarantee (for an amount equivalent to 1.2 percent of the 1998 GDP) to the Czech Republic National Bank to cover losses from this program. As the central bank intends to take 24 advantage of the guarantee ', part of the cost of central bank assistance to the banking sector will eventually fall on the government budget. In addition, in the early 1990s, the central bank of the _Czech Republic_ extended a credit to the asset management company _Konsolidacni Banka._<sup>_25_</sup> _As Konsolidacni Banka's_ obligations are guaranteed by the state, the government budget will ultimately bear the residual cost.

In _Estonia_ the central bank intervened extensively to support the banking sector during the 1992 and the 1994 crises despite the presence of a currency board. Partly as a result of this assistance, the monetary authority suffered losses in 1994. To cover the loss, in 1996 the government recapitalized the central bank to the amount of 0.3 percent of GDP (Table **9).26** In the _Kyrgyz Republic_ the central bank extended sizable loans to the bank specialized in directed credit to the agricultural sector (Agromprombank) in the early 1990s. When this insolvent bank was eventually liquidated, the outstanding loans of the National Bank (equivalent to nearly 4.3 percent of the 1996 GDP) represented a loss. Consequently, in 1996 the government replaced this amount in the central bank balance sheet by a long term, interest bearing, bond.

22 Information on Georgia, Kazakhstan and Ukraine on methods and cost of central bank intervention is extremely scanty, and therefore not discussed here.

> 23 The privatization agency (National Property Fund) and two asset management companies _(Konsolidacni Banka_ and _Ceska Insaksni)._

**24** See Czech Republic National Bank, Annual Report, 1998, p. 4.

25 At the end of 1998 the outstanding credit amounted to nearly 2.4 percent of GDP. A small part of this loan (0.7 percent ) has been provisioned.

26 The central bank dealt with the 1992 crisis differently from the 1994 crises. In 1992 the monetary authority acted quickly to close the troubled banks and rescued only those credit institutions whose problems were generated by exogenous events (two banks, facing solvency problems after losing access to part of their assets in Moscow, were merged and recapitalized with the support from the government and the central bank). By contrast, in 1994 the central bank tried to rescue a large insolvent bank and bail out creditors.

27
A further drawback of direct central bank involvement in bank<sup>restructuring is the loss of</sup> transparencv. This is particularly evident in the case of the _Czech Republic,_ where<sup>the financing</sup> mechanisms among the government budget, the asset management companies,<sup>the privatization agency</sup> and the central bank are quite complex and opaque<sup>27</sup> . In these circumstances, it is very difficult to identify the potential fiscal risks and the actual costs of banking sector<sup>problems.</sup> Central bank support to the banking sector can also generate<sup>significant inflationary pressures. For</sup> instance, in _Bulgaria,_ during the period 1995-97, and especially during<sup>the 1996 crisis, the central bank</sup> largely refinanced distressed banks' assets and extended massive loans<sup>to banks (and to the government).</sup> This produced hyperinflation in early 1997, which was associated with a decline<sup>in GDP. Only after the</sup> introduction of the currency board did the Bulgarian National Bank stop such practices.

**Table 10. Cost of Bank Restructuring to the Central Bank (1991-1998)**

||||Perc<br>|ent of GDP<br>||||||
|---|---|---|---|---|---|---|---|---|---|
||**1991**|**1992**|**1993**|**1994**|**1995**|**1996**|1997|**1998**|**Total**|
|**Bulgaria**<br>||||||||||
|Provisions for losses<br>on credit extended to|NA|NA|NA|NA|2.8|6.6|2.3|0.004||
|banks<br>||||||||||
|Recoveries (-)<br>**Total**|NA|NA|NA|NA|NA|NA|0.05|0.1|**U.S**|
|**Czech Republic**<br>||||||||||
|Cost of Consolidation|0.0|0.0|0.0|0.0|0.0|0.0|2.1|2.9||
|Program (provisions<br>and losses)||||||||||
|Provision on credit to<br>asset management|0.0|0.0|0.0|0.0|0.0|0.0|0.0|0.02||
|agency||||||||||
|**Total**||||||||||
|**Hun2arv**|0.0|0.0|0.0|0.0|0.0|0.0|0.0|0.0|**0.0**|
|**Macedonia**<br>||||||||||
|Bonds issued for<br>capitalization of asset|0.0|0.0|0.0|0.0|0.0|0.6|0.0|0.0|0.7|
|management company<br>Interest payments<br>**Total**|NA|NA|NA|NA|NA|NA|NA|NA|e|
|**Poland**<br>Total cost of central<br>bank intervention|NA|NA|NA|NA|NA|NA|NA|NA||

27 On this aspect, see _Czech Republic: Towards EUAccession,_ 1999, the World Bank, Chapters 3 and<sup>7.</sup> 28
**Table 10 (Cont.) Cost of Bank Restructuring for the Central Bank (1991-1998)**

||||Perc|ent of GDP||||||
|---|---|---|---|---|---|---|---|---|---|
||1991|1992|1993|1994|1995|1996|1997|**1998**|**Total**|
|**Estonia**||||||||||
|Loss on assets|0.0|0.0|0.0|0.4|0.0|0.0|0.0|0.0|**0.2**|
|purchased from||||||||||
|troubled banks||||||||||
|Provisions on loans<br>unrequited by the|0.0|0.0|0.0|0.3|0.3|0.0|0.0|0.0|**0.4**|
|liquidated banks||||||||||
|Writing off of CB|0.0|0.0|0.0|0.0|0.02|0.04|0.0|0.0|0.05|
|shares in banks to||||||||||
|cover their losses||||||||||
|Transfer of assets|0.0|0.0|0.0|0.0|0.0|0.0|0.2|0.0|0.2|
|Recoveries(-)|0.0|0.0|0.0|0.0|0.0|0.002|0.005|0.02|**0.03**|
|**Total**||||||||||
|**Latvia**||||||||||
|Provisions for losses on<br>credit extended to<br>banks|0.0|0.0|0.0|0.0|0.1|0.0.|0.0|0.0|0.1|
|**Lithuania**<br>Losses on credit<br>extended to banks|0.0|0.0|0.0|0.0|0.0|0.1|0.1|0.0|4.|
|Georgia|NA|NA|NA|NA|NA|NA|NA|NA|NA|
|Kazakhstan|NA|NA|NA|NA|NA|NA|NA|NA|NA|
|**Kvrgyz**<br>**Republic**<br>Losses on credit<br>extended to banks|0.0|0.0|0.0|0.0|0.0|4.3|0.0|0.0|8|
|Ukraine|NA|NA|NA|NA|NA|NA|NA|NA|**NA**|

1/ Total Cost is the net present value (NPV) at end-I 998 of the annual costs during 1991-98. The NPV is calculated using the relevant interest rate for each cost item.

2/ Kawalec (1999), p.<sup>29</sup> Central bank involvement can also give rise to conflict of interest and moral hazard. For example, in the _Czech Republic_ the "Consolidation Program II" has been carried out through a subsidiary of the central bank _(Ceska Financni)._ This agency not only buys non-performing assets at a negotiated price, but also engages in direct equity investments in troubled banks. As a result, the central bank is now in the position of supervising banks in which it has a direct economic interest.

Last, continuous assistance to insolvent banks provides perverse incentives and fails to address the underlying problems. The experience of _Bulgaria_ clearly shows how repetitive liquidity injections and refinancing credits do not solve undercapitalized and insolvent banks' problems. In 1994-1995 two state owned banks (Mineral Bank and Economic Bank), accounting for nearly 20 percent of banking system assets, displayed sustained liquidity problems. The central bank provided almost daily cash infusion to meet depositors' demands and assure settlements in the interbank system. However, it did not address the underlying reasons for the problems which were: loans extended without sufficient attention to 29
borrowers' credit-worthiness; inadequate loan-loss provisioning; and inadequate capitalization. At the end of 1994 these two banks accounted for nearly 90 percent of central bank refinancing. Nevertheless, only in 1995 was action taken to improve their level of capitalization and only in 1996 were they placed under conservatorship.

# **b. Experience with more minor central bank intervention**

In _Hungary_ and _Georgia,_ the central bank did not have any significant role in bank restructuring. _In Latvia_ the central bank bore minor losses on credits extended to banks whose licenses were revoked. In _Lithuania_ the central bank response to the 1995 crisis was limited by the currency board arrangement. The monetary authority used its excess foreign exchange reserves to provide liquidity loans to the distressed banks (part of which were not recovered). However, the central bank refrained from extending financial assistance to recapitalize failing banks. In _Macedonia_ the central bank bore the cost of the capitalization of the bank rehabilitation agency.

In _Poland,_ while the government bore the cost of recapitalizing state-owned enterprises, the central bank bore the cost of the rehabilitation or liquidation of several small private banks. In some cases the distressed institutions were taken over by the central bank and sold after restructuring. In others, the troubled banks were taken over by other banks with central bank support (for example, long-tern soft financing from the monetary authority). Nevertheless, the total cost of central bank intervention was not very high.<sup>8</sup>

# **4.3 Cost of Depositor Compensation for the Government**

The third component of the fiscal costs of banking crises is the direct cost incurred by the government to compensate depositors. While adding this component provides a full picture of the fiscal costs involved, it should be borne in mind that this component alone does not represent the full protection to depositors in these countries. In fact, virtually all the fiscal costs assumed by the authorities for bank restructuring are for protecting depositors.

Governments compensate depositors to avert a loss in confidence in the banking system (if the scale of the problem is large), or for social protection reasons. Many countries have deposit insurance schemes which lay out the framework for compensating depositors in the case of a crisis.

_Deposit_ **_Insurance Schemes._** The experience of the sample countries was that the _CEEs_ and the _Baltics_ introduced deposit insurance schemes (DIS) after the emergence of banking problems or banking crises, while among the _CIS_ countries _Ukraine_ was the only one that introduced a DIS after the banking crisis. No DIS has yet been introduced in _Georgia, Kazakhstan_ or the _Kyrgyz Republic_ (Table 11).

The introduction of an explicit deposit insurance scheme after a banking crisis is a common occurrence around the world<sup>29</sup> , with the objective of restoring depositor confidence. In transition economies, however, the objective was primarily to limit governments' liabilities, which were extensive under the previous centrally-planned regimes when all deposits were implicitly guaranteed by the state.

_Macedonia_ introduced a DIS to limit the commitments of the authorities following the freezing of household foreign currency deposits (amounted to over 20 percent of GDP) when the counterpart assets were lost following the breakup of former Yugoslavia. _Bulgaria,_ on the other hand, introduced an ad-hoc

> 28 According to some estimates (Kawalek, 1999), the total cost could have been about 0.5 percent of GDP. 29 Cull (1998) found that the probability of adopting explicit deposit insurance increases by 25 to 30 percent for countries that experienced systemic banking crises within the preceding five years.

30
DIS in 1996 in the middle of a banking crisis in an effort to stem a collapse in public confidence in the banking system (a formal DIS was introduced later in 1999). However, the ad-hoc DIS did not restore public confidence, and the financial situation in the country did not stabilize until early 1997 when the currency board was introduced. This illustrates the point made by some authors that deposit insurance schemes should only be introduced after the banking system has been recapitalized and restructured, but not while it is still weak<sup>30</sup> .

**_Depositor Compensation._** For most of the countries under consideration, depositors were compensated - although not fully in all cases - when banks were liquidated. This meant that most depositors bore some of the costs of banking crises. This addresses the moral hazard problem, which arises if depositors are automatically bailed out by the government, because neither the bank nor the depositors would have the incentive to exercise caution in lending (in the case of the former) or in deciding in where to place their deposits (in the case of the latter) in the future. However, in many of the countries under consideration, the underlying rationale for sharing losses with depositors probably had less to do with moral hazard and more to do with fiscal constraints, especially in the _CIS_ countries. Table 12 provides a summary of the deposit compensation experiences in these countries, and Table 13 the fiscal costs of compensating depositors.

In the _CEEs,_ compensation for depositors follows the framework of the DIS in these countries, which in all cases provide for only partial coverage. The DIS coverage as a ratio of GDP per capita is usually not too high (ranging from a little less than 1 in the case of _Hungary_ to 2.7 in the case of _Macedonia),_ which is positive from the viewpoint of minimizing moral hazard, and compensation is usually partial<sup>3</sup> ".

For the _Baltics,_ depositor compensation in many instances occurred prior to the introduction of DIS. Even without the presence of a DIS to limit the extent of compensation, depositor compensation in those instances was still only partial. In _Latvia,_ for instance, the government had promised partial compensation to be spread over a few years, but it appears that after the first year, the government stopped fulfilling its promise. _Lithuania_ adopted a mix of different approaches to depositor compensation, including conversion of deposits to equity and the issuance of non-interest paying government bonds, all of which imply less than full compensation for the depositors.

The _CIS countries_ engaged in minimal depositor compensation. The governments in _Georgia_ and _Kazakhsatan_ were not involved in depositor compensation at all. In fact, depositors in these two countries were compensated partially from the assets of the private banks which were liquidated. The _Kyrgyz Republic_ was an exception among the group of _CIS_ countries under consideration in that the government budget was used to compensate depositors, although compensation was only partial, with priority given to compensation for small depositors.

> 30 Garcia (1999). Cull (1998) also found that adopting explicit insurance to counteract instability in the financial sector does not appear to solve the problem, as the typical reaction to this type of decision has been negative, at least with regard to financial depth in the three years' after the program's inception.

> _31_ The IMF recommends a ratio of between I and 2 for DIS coverage/GDP per capita, see Garcia (1999). Garcia also has an extensive discussion on the issue of the level of DIS coverage in relation to moral hazard.

31
||||**Table**|**11: Deposit Insuranc**|**e Schemes (DIS)**|||
|---|---|---|---|---|---|---|---|
||**_DIS_**|**Crisis**|**Date DIS**|**1998 Coverae (in LCU)**|**Source of Fundin for the DIS**|**1998**|**DIS**|
|||<br>**Date**|<br>**became**<br>**effective**|**g**|**g**|<br>Maximum<br>**Coverage,**<br>**in LCU***|coverage as<br>**a ratio of**<br>**GDP per**<br>**capita**<br>(1998)|
|**Bulgaria**|yes|91 -'94<br>_'95_<br>'96-'97|1999|Deposits up to BLG 2 min<br>(95% coverage); between BLG<br>2 min and 5_min_(80%)|Initiation fees paid by banks; annual<br>premiums contributed by banks<br>levied on deposit holdings and other<br>sources from banks; DIF may<br>borrow|4,300,000|<br>1.61|
|Czech<br>**Republic**|yes|91-'93<br>'96 -'97|1994|Deposits up to CZK 400000<br>(90% coverage)|Bank premiums, equal to 0.5% of<br>insured deposits|360,000|<br>209|
|**Estonia**|yes|92; '94|1998|Deposits up to EEK 20,000<br>(90% coverage)|Bank premiums, equal to 0.5% of<br>total deposits; the fund is authorized<br>to borrow from commercial banks,<br>the latter borrowings may be covered<br>by government guarantee up to EEK<br>700 ctimulative ceiling|18,000|<br>03 5|
|**Hungary**|yes|'95-'96|1993|Deposits up to HUF I mIllion|One-off fee at time of joining (0.4<br>percent of bank's capital), regular<br>premium payments and if necessary<br>extraordinary annual contributions<br>paid by members; no budgetary<br>source.|1,ODO,00|0<br>0.99|
|**Georgian**<br>**Republic**|no||||||n/a|
|**Kazakhstan**|no||||||n/a|
|Kyrgyz<br>**Republic**|no||||||_n/a_|
|**Latvia**|yes|93 - '94; '95|1998|Deposits up to LVL 500:<br>insurance ceiling will rist to<br>LVL 13,000 by 2008|500||0.35|
|**Lithuania**|yes|95 -'96|1997|DIS coverage was to be<br>increased over time: from Lt<br>25,000 in 1998 to Lt 65,000 in<br>2000; in 2000 the first Lt<br>25,000 (100% coverage), next<br>Lt 20,000 (90%), and the top Lt<br>20,000 (70%). Higher cc-<br>insurance for foreign exchange<br>deposits.|Govemment and premiums on<br>deposit base paid by banks equal to<br>1.5% (in 1997) of deposit holdings|25,000|<br>2.20|
|**Macedonia**|yes|94 -'96|1997|Coverage of75% ofhousehold<br>denar and foreign currency<br>deposits up to DMI 0,000|Founding capital paid by banks and<br>annual premiums contributed by<br>banks (2.50-5%)|232,875|<br>2.65|
|**Poland**|yes|92-'94|1995|Full coverage for amounts not<br>exceeding Ecu 1,000, 90% for<br>the next Ecu 4,000; plans to<br>increase coverage to EU limits<br>(Ecu 8,000 in 1999; Ecu 11,000<br>in 2000; Ecu 15,000 in 2001;<br>Ecu 17,500 in 2002; Ecu 20,000<br>thereafter)|The fund is jointly owned by the<br>NEP, the Treasury, and the<br>commercial banks. Bank premiums<br>are 0.4% of deposit holdings.|18,874|<br>1.40|
|**Ukraine**|yes|95; '96 -'98|1998|Coverage per depositor can not<br>exceed HRN 500|500||0.24|

32
**Table 12: Depositor Compensation**

|**Bulgaria**|**1996:**ad hoc deposit insurance scheme was established during the crisis; household<br>deposits and half of enterprise deposits were fully guaranteed; government securities were<br>issued to cover cost of deposit protection.|
|---|---|
|**Czech**<br>**Republic**|The CNB was obliged to compensate clients in Ceska Banka (closed in December 1995<br>and now being liquidated) to the amount of CZK 4 million.|
|**Hungary**|**1995:**Agrobank suffered a bank run; deposits were fully covered by the deposit insurance<br>fund (not financed by the budget).<br>**1997:**Realbank was put under liquidation; depositors were paid fully by dcposit insurance<br>fund (not financed by the budget).__|
|**Macedonia**|<br>**1995:**The government assumed the obligation for the repayment of households foreign<br>currency deposits that were lost after the dissolution of the former Socialist Republic of<br>Yugoslavia.<br>**March 1997:**large savings house TAT collapsed; over 20,000 clients lost their deposits;<br>every affected household was to receive monthly compensation of 13500 denars for six<br>months (ratio of coverage to GDP per capita around 1) after the enactment of the law on<br>deposit insurance.|
|**Poland**|<br>**1995 to**1997: losses to depositors were paid out of Deposit Insurance Fund which is jointly<br>owned by the NBP, the Treasury and the commercial banks.|
|Estonia|1992: Tartu Commercial Bank was liquidated; depositors were partially paid.<br>1994: Social Bank was liquidated; deposits were transferred to the North Estonian Bank<br>(explicit Central Bank guarantee on deposits).|
|**Latvia**|**1995:**Baltiia Bank collapsed; the government promised to compensate depositors for LVL<br>500 ($1000) per depositor (LVL 200 in 1995 and LVL 100 over next 3 years) but<br>apparently extended compensation only in 1995. Ratio of coverage to GDP per capita was<br>only 0.6 (very low).|
|**Lithuania**|<br>**May**1996: depositors of Litimpex Bank had their deposits converted to equity.<br>**Sept**1996: depositors of Vakaru and Aura Bank were compensated in cash through the<br>emergency deposit law on retroactive compensation.<br>1997 and 1998: depositors of Innovation Bank which had its license revoked (summer<br>1997) received minimal cash compensation (Lt.4000 in 1997 and Lt.4000 in 1998 per<br>person) and non-interest-bearing government bonds ( 5 year maturity) payable in 3 annual<br>installments beginning in 1999; legal entities received non-tradable, non-interest bearing<br>notes for entire claims (10 year maturity), payable in 5 annual installments beginning no<br>earlier than 2002; certain public organizations, embassies, charities, etc received cash<br>during 1998; other creditors received their pari-passu share of residual funds left from<br>collection of Innovation Bank's assets; government deposits were written off.<br>1997: depositors of Tauro Bank were compensated out of DIS fund.<br>1998: State Commercial Bank was liquidated; deposits were transferred to Savings Bank.|
|**Georgia**|<br>**1994:**self-liquidation of small private banks; depositors compensated by these banks<br>themselves because these banks had very few customer accounts.|
|**Kazakhstan**|<br>Depositors were reimbursed from sale of assets of a liquidated private bank (Kramds<br>Bank). Depositors suffered some losses but losses were not large since most deposits were<br>held in the People's Bank (savings bank).|
|**Kyrgyz**<br>**Republic**|<br>**1995:**small commercial banks were liquidated. NBK compensated small depositors in<br>Adil Bank (up to 1000 Soms).<br>**1996:**Elbank was liquidated in February 1996. Payment of small depositors (up to 3000<br>soms) was undertaken immediately (they made up 78 percent of deposit base). Payment of<br>deposits from 3000 to 5000 soms started in April 1996; 5000 to 10000 soms in May 1996.<br>The government promised to return deposits above 10000 soms after small claims were<br>paid out. Deposits of lower priority for compensation were changed into bonds.<br>1997: Agroprombank was liquidated. Depositors were compensated in cash from state<br>budget.|
|**Ukraine**|No information on deposit compensation.|

33
**Table 13. Deposit Compensation Cost for the Government**

||**1991**|**1992**|**1993**|**1994**|**1995**|**1996**|**1997**|**1998**|**Total**|
|---|---|---|---|---|---|---|---|---|---|
|**Bulearia**||||||||||
|Bonds issued|0.0|0.0|0.0|0.0|0.0|3.3|1.3|0.04|**_3.3_**|
|Interest payments|0.0|0.0|0.0|0.0|0.0|1.4|0.2|0.1||
|**Total**||||||||||
|**Macedonia**||||||||||
|Cash|0.0|0.0|0.0|0.0|0.0|0.0|0.2|0.0|**0.2**|
|Increase in government<br>debt2'|<br>0.0|0.0|0.0|0.0|22.5|0.0|0.0|0.0|24.3|
|**Total**||||||||||
|**Poland**||||||||||
||From 199<br>correspon<br>budget.|5 to 1998 th<br>ds to less th|e Deposit<br>an 0.01 pe|Protection<br>rcent of G|Fund paid $ DP per year|51.4 Mln<br>. The Fun|to deposit<br>d is partly f|ors, which<br>inanced by|the|
|**Latvia**<br>Cash|0.0|0.0|0.0|0.0|0.04|0.0|0.0|0.0|O|
|**Lithuania**<br>||||||||||
|Cash compensation and|0.0|0.0|0.0|0.0|0.0|0.3|0.0|0.0|**0.3**|
|write-off of governmen|t|||||||||
|deposits||||||||||
|Bonds issued|0.0|0.0|0.0|0.0|0.0|0.0|0.8|0.0|0.9|
|Interest payments|0.0|0.0|0.0|0.0|0.0|0.0|0.0|0.0||
|Deposit compensation|0.0|0.0|0.0|0.0|0.0|0.0|0.1|0.0|0.1|
|from Deposit Insurance||||||||||
|<br>Fund paid by the||||||||||
|government||||||||||
|**Total**|||||||||*|
|**Kvr2yz ReDublic**||||||||||
|<br>Cash|0.0|0.0|0.0|0.0|0.0|0.0|0.3|0.0||

1/TotalCostisthenetpresentvalue(NPV)atend-1998oftheannualcostsduring991-98. The NPV is calculated using the relevant interest rate for each cost item.

2/ The government assumed the obligation for the repayment of households foreign currency deposits that were lost after the dissolution of the former Socialist Republic of Yugoslavia.

# **4.4 Total fiscal and quasi-fiscal costs of banking crises**

Table 14 gives the total fiscal and quasi-fiscal costs of banking crises in the twelve transition countries. These include the costs to the government and the central bank for restructuring banks, and the costs to the government for compensating depositors.<sup>32</sup> The bulk of these costs comes from bank restructuring costs incurred by the government, which are typically several times the size of direct payments to depositors or the costs incurred by the central bank.

The _CEEs_ incurred by far the largest costs, which ranged from around 7 percent of GDP for _Poland_ to 42 percent of GDP for _Bulgaria_ cumulatively over the period 1991-98. The costs incurred by the _CIS_ 32 See Appendix Table 6 on consolidated fiscal costs.

34
and the _Baltics_ were more moderate; in the _CIS_ they ranged from a mere 0. 1 percent of GDP for _Georgia_ to 18 percent for _Kazakhstan,_ and in the _Baltics_ they ranged from around 2 percent of GDP in _Estonia to_ 3 percent in _Lithuania._

**Table 14: Total Costs of Banking Crises, 1991-98 (percent of GDP)**

|**_CEEs_**||
|---|---|
|Bulgaria<br>|41.6|
|Czech Republic|25.4|
|Hungary|12.9|
|Macedonia|30.3|
|Poland|7.4|
|**_Baltics_**||
|Estonia|1.9|
|Latvia|2.7|
|Lithuania|3.1|
|CIS||
|Georgia|0.1|
|Kazakhstan|18.4|
|Kyrgyz Republic|10.6|

The **much higher fiscal and quasi-fiscal costs incurred by the CEEs than the Baltics and the** CIS can be explained by three factors. First, the different restructuring strategies followed by the three country groups entailed different fiscal costs. The CEE authorities pursued intensive restructuring and recapitalization of banks involving injection of new capital, and incurred large costs as a result. On the other hand, the _Baltic_ and _CIS_ governments rarely restructured or injected new capital into banks, and incurred lower fiscal costs as a result. Second, there was more loss-sharing with depositors and bank shareholders in the _Baltics_ and the _CIS_ than in the _CEEs_ through two channels. The much higher inflation in the FSU countries than the _CEE_ countries implies larger cost-sharing by depositors in the _FSU_ countries. Also, when the _FSU_ countries liquidated banks, the bank shareholders and depositors bore much of the costs. Third, the restructuring operations undertaken by the _CEEs_ suffered from several weaknesses (as discussed in section 4.1), which raised fiscal and quasi-fiscal costs.

The higher fiscal costs incurred by the _CEEs_ are reflected in the higher levels of fiscal expenditures incurred due to banking crises compared with the general government deficits in those countries (Table 15). These fiscal expenditures did not always appear in the central government budget, and did not necessarily contribute to the government deficit; nonetheless, they represent a cost to the public sector<sup>33</sup> .

The fiscal costs raised the government's debt burdens, more so in the _CEEs_ than the _CIS._ For the countries under consideration for which data is available, government debt was raised from a low of 5 percent (in the case of the _Kyrgyz Republic)_ to a high of 11 percent in the case of _Bulgaria_ (Chart 1).34

**33** In the Czech Republic, for example, the deficit recorded in the budget does not include the quasi-fiscal activities undertaken by asset management companies involved in the restructuring of the banking sector. If these off-budget operations were taken into account, the fiscal deficit would be much higher (see _Czech Republic: Toward EU Accession,_ 1999, the World Bank).

**34** See Appendix Table 7 for data on government debt incurred due to banking crises.

35
<!-- Start of picture text --> Chart 1: Contribution of Recapitalization and Depositor<br>Compensation Bonds to Total Domestic Central<br>Government Debt (1998)<br>60 !I I<br>soI<br>a.<br>w4 0<br>U 1998 Outstanding Recapitalization and Depositor Compensation Bonds<br>1998 Central Government Debt less Recapitalization &Depositor<br>* Compensation Bonds<br><!-- End of picture text --> 36
**Table 15. Fiscal Expenditures Due to Banking Crisis"' and Fiscal Deficit**

||**1991**|**1992**|**1993**|**1994**|**1995**|**1996**|**1997**|**1998**|**Total**|
|---|---|---|---|---|---|---|---|---|---|
|**Bulgaria**||||||||||
|FiscalExpenditures,%ofGDP|0.0|1.3|1.3|2.9|2.9|12.1|1.0|0.5|22.0|
|General Govt. Deficit (Surplus), %<br>of GDP|4.5|4.9|12.1|4.6|5.2|15.4|(2.1)|(0.9)||
|**Hungary**||||||||||
|Fiscal Expenditures, % of GDP|0.0|0.1|0.0|1.2|1.9|1.5|1.2|0.5|6.4|
|General Govt. Deficit (Surplus), %<br>of GDP|3.8|7.8|9.2|8.6|6.2|3.1|4.8|4.8||
|Macedonia||||||||||
|Fiscal Expenditures, % of GDP|0.0|0.0|0.0|0.0|0.4|0.4|0.4|0.0|1.2|
|General Govt. Deficit (Surplus), %<br>of GDP||8.7|12.1|2.9|0.7|0.3|0.4|1.6||
|**Poland**<sup>**2**</sup>**'**||||||||||
|Fiscal Expenditures, % of GDP|0.3|0.4|0.5|0.7|0.6|0.4|0.3|0.2|**3.4**|
|General Govt. Deficit (Surplus), %<br>of GDP|3.6|6.1|3.1|3.3|3.3|3.4|2.7|2.4||
|**Estonia**||||||||||
|Fiscal Expenditures, % of GDP|0.0|0.0|0.2|0.1|0.1|0.5|0.1|0.1|**0.8**|
|General Govt. Deficit (Surplus), %<br>of GDP|(5.0)|0.2|0.7|(1.4)|1.3|1.9|(2.2)|0.3||
|Latvia||||||||||
|Fiscal Expenditures, % of GDP|0.0|0.0|0.3|0.4|0.1|0.0|0.0|0.0|0.9|
|General Govt. Deficit (Surplus), %<br>of GDP<br>||0.8|(0.6)|4.0|3.5|1.8|(0.3)|0.8||
|**Lithuania**<br>**3'**||||||||||
|Fiscal Expenditures, % of GDP|0.0|0.0|0.0|0.0|0.0|0.4|0.2|0.1|0.7|
|General Govt. Deficit (Surplus), %<br>of GDP|(2.6)|(0.5)|3.3|5.5|4.5|4,5|1.8|5.8||
|**Kyrgyz Republic**||||||||||
|Fiscal Expenditures, % of GDP|0.0|0.0|0.0|0.0|0.0|0.2|0.6|0.3|1.1|
|General Govt. Deficit (Surplus), %<br>of GDP|(4.6)|17.4|14.4|11.6|17.3|9.5|9.0|8.1||

_Notes:_ The Czech Republic, Georgia and Kazakhstan have been omitted from this table because of the difficulty in ascertaining precisely which of the government costs listed in Table 9 were actually fiscal expenditures.

1/ Fiscal Expenditures include expenditures of the government resulting from bank recapitalization and deposit compensation, such as interest payment on bonds and other expenditures (see Tables 9 and 13 for details).

2/ Excludes compensation paid to depositors from Deposit Insurance Fund (this is only partly financed by the budget; from 1995 to 1998 DPF paid $51.4 Mln to depositors. This corresponds to less than 0.01 percent of GDP per year, see Table 13).

3/ Includes government deposits which were written off.

# **5. Bad Debt Recovery**

The above estimates for the costs of banking crises do not allow for possible cost recoveries on bad debt, which would mitigate some of these costs for the authorities. The choice of the bad debt recovery strategy by a country could have implications on its success in recovering bad loans and therefore on the fiscal costs it incurs from banking crises.

37
There are three basic approaches to bad debt recovery: centralized, decentralized, and "good bank/bad bank". Under the centralized approach, non-performing loans are removed from banks and are transferred to an asset management company (AMC) or a bank liquidation agency, which then pursues recovery of the bad loans. The AMC could be state-owned or private, although in most countries it is the state-owned. Under the decentralized approach, non-performing loans remain on the bank's books, and work-out units are usually created within the banks to pursue the recovery of these non-performing loans. By design, banks act as the "agents of change" and pursue enterprise restructuring or liquidation<sup>35</sup> . The "good bank/bad bank" is a variation of the decentralized approach, whereby a "bad bank" which is spun off from the original troubled bank takes over its non-performing assets and pursues their recovery. The remaining "good bank" may be privatized or merged with a healthier bank.

# **5.1 Implications of the Choice of Debt Recovery Strategy on Fiscal Costs**

The centralized and decentralized approaches to bad debt recovery each has direct and indirect costs and benefits. These have implications on the fiscal costs of resolving banking crises.

Under the centralized approach, the direct fiscal costs of a state-owned AMC are its operational costs. There could be indirect costs as well if there is absence of political will to enforce hard budget constraints on enterprises, which could lead to recurrence of non-performing loan problems and further fiscal costs. This is especially the case with state-owned AMCs, as their mere existence creates moral hazard for continuing bad performance of banks, since banks know that they could always transfer future bad loans to the AMCs. Direct fiscal benefits come from the recovered loans that are channeled to the state directly or indirectly.

Under the decentralized approach, the indirect fiscal costs are the forgone revenues which the government would have received from a state-owned AMC. The extent to which such recoveries do not accrue to the government depends on the profit-sharing arrangement between the banks and the government. The arrangement could entail either the entire amount or a share of the recoveries to be channeled back to the budget. The trade-off here is that revenues retained by the banks provide incentives for the banks to collect.

An indirect benefit under either approaches is that the loan work-out activities could help in the _operational restructuring of banks_ (Dziobek and Pazarbasioglu, 1997). This could minimize the risk of a recurrence of banking sector distress, and hence the long-term fiscal costs of banking crises. Another indirect benefit under either approaches is the _restructuring or liquidation of enterprises_ which is an important element of bad debt collection. This helps improve the corporate governance of enterprises, which could also reduce the possibility of future enterprise and hence banking problems.

# **5.2 Country Experiences**

International experience shows that a centralized approach is chosen over a decentralized one when the following issues are important: (i) quick removal of bad loans from the balance sheet of distressed banks to facilitate bank privatization; (ii) there is a close "symbiotic" relationship between banks and enterprises that needs to be cut and persistent bank lending to loss-making firns that needs to be stopped; and (iii) enabling a centralized agency to pursue enterprise restructuring after gaining control over **36** enterprises

**35** Van Wijnbergen (1998) points out that banks should be the 'agents of change' in the restructuring of enterprises due to the informational advantage they have over publicly owned centralized collection agencies. **36** Fries and Lane (1994).

38
Of the twelve countries under consideration, eight adopted the centralized approach, nine the decentralized approach, and six both approaches (either sequentially or simultaneously for different bad loan categories). The "good bank/bad bank" approach was followed by two countries. Table 16 below presents the strategies adopted for bad asset recovery by the countries in this study.

**Table 16. Approaches to Bad** Asset Recovery

||Centralized|Decentralized|
|---|---|---|
|Bulgaria||As a condition of recapitalization through<br>govemment bonds, banks were required to create<br>**work-out units**to pursue bad debt collections.|
|**Czech Republic**|Konsolidaeny Banka (1991-present): created to<br>restructure inherited debts on books of<br>commercial banks; later also received non-<br>performing loans from commercial banks;<br>Ceska**Inkasni**(1993-present): created to take<br>over debt obligations of foreign trade companies<br>to facilitate privatization of Ceskoslovensko<br>Obhodni Banka, foreign trade bank from pre-<br>transition period;<br>**Ceska Finaneni**(1996-present): established as<br>subsidiary of central bank to finance the 1996<br>Stabilization Program which has the objective<br>of preventing liquidity crises in small banks.|<br>Currently considering adopting the so-called<br>London approach to loan recovery which entails<br>**out-of-court settlements between the banks and**<br>debtor enterprises. This approach consists of a set<br>of rules for reaching out-of court settlements<br>between the banks and debtor enterprises<sup>3 7</sup>. The<br>London rules may enable the reaching of<br>conciliation agreements with government mediation<br>without recourse to enterprise liquidation<br>proceedings on a broad-scale. By following the<br>London rules, KoB management also hopes to avoid<br>excessive enterprise bankruptcies for political and<br>social considerations.|
|**Hungary**|<br>The Credit Consolidation Fund was created at<br>the Hungarian Industrial Development Bank<br>**(MBFB Rt)**in 1992 to manage bad assets. Only<br>1/3 of the total assets that were carved out from<br>banks was transferred to the Fund at MBFB Rt,<br>with the rest remaining on commercial banks'<br>books subject to contracts with the Ministry of<br>Finance.|(I) Decentralized work-out units were created at<br>banks as part of the**1992 Loan Consolidation**<br>**Program;**<br>(2) The 'good**bank/bad bank'**approach was used<br>in the case of Magyar Hitel Banka (MHB); bad<br>assets of MHB were transferred to its newly<br>established subsidiary, Risk Kft (July 1995), which<br>was to be wound up in three years while the good<br>bank was successfull<br>rivatized|
|**Macedonia**|**Bank Rehabilitation Agency (BRA)**<br>(1994-present) exchanged bonds for the equity<br>of enterprises held by commercial banks. BRA<br>accumulated dispersed enterprise shareholdings<br>formerly held by banks to obtain control over<br>enterprises and pursue their restructuring.||
|**Poland**||Enterprise and Bank Restructuring Program: as<br>a condition for participating in EBRP<br>recapitalization, banks were obliged to create work-<br>out units and actively pursue collection through<br>several instruments.|
|**Estonia**|_|Work-out units were created at commercial banks.<br>In addition, the**'good bank/bad approach'**was<br>pursued when good assets from the Social bank<br>were transferred to the Northem Estonia Bank and<br>the remainder of Social Bank was tumed into a loan<br>recovery agency in March 1995 to pursue<br>collections of bad loan until it declared bankruptcy<br>in August 1996.|
|Latvia|_No information was available to the authors abo_|_ut bad asset recovery activities._|
|**Lithuania**|<br>**Turto Bankas**(1996-present) was created as an<br>asset management company out of the shell of a<br>liquidated bank (Aurabankas).||
|**Georgia**<br>.________|Non-performing loans of liquidated banks were<br>transferred to the**bank recovery unit of the**<br>**central bank.**<br>_____________<br>.________________________________________|A**pilot work-out unit**was established (with World<br>Bank assistance) in a former state-owned<br>commercial bank. Work-out units were not<br>established on a large-scale because of the small<br>scale of non-performing<br>loans.|

_37_ The London approach was first introduced by the Bank of England in 1989; a modified version of this approach was subsequently used in Thailand and Korea. For details see Mark Stone (1998).

39
||**Table 16 (cont.). Approaches to Ba**|**d Asset Recove**|
|---|---|---|
||**Centralized**|**Decentralized**|
|**Kazakhstan**|**Rehabilitation Agency**(1994-present) took<br>over loans of largest insolvent debtors (mostly<br>mining and metallurgical enterprises);<br>**Agricultural Support Fund**(1994-present)<br>took over agricultural credits;<br>**Exim Bank (I**994-present) took over most of<br>the outstanding trade-related loans that carried<br>govemment guarantees.|In 1998 the government gave a mandate to a special<br>enterprise restructuring agency to provide**creditor-**<br>led**restructuring**if the farrn or enterprise is viable<br>and has developed a restructuring plan.|
|**Kyrgyz Republic**|**DEBR4 (Debt Restructuring**Agency) (1996-<br>present) was established with the mandate to<br>perform receivership function for liquidated<br>banks.<br>**Kyrgyz Agricultural Finance Corporation**<br>(1997-present) was launched to take over bad<br>debts of the agricultural sector.|The government encouraged commercial banks to<br>create work-out units for pursuing collection of<br>loans to small and medium enterprises. No<br>information was available to the authors on the<br>performance of these work-out units.|
|**Ukraine**|Bank Recovery Unit (BRU) was created at the<br>Bank Supervision Department of the central<br>bank in late 1996 to identify private banks for<br>restructuring or liquidation. No information was<br>available to the authors about the scope and<br>outcome of bank/assets restructuring activities<br>of the BRU.|Work-out units were created at three large former<br>state owned banks to pursue loan recovery.|

Appropriate incentives are important for the collection of bad debts regardless of the approach adopted for bad debt recovery. Similarly, effective collateral, foreclosure and bankruptcy laws are necessary for enabling either debt collection agencies or banks to take control of insolvent enterprises and proceed with their restructuring or liquidation. Finally, the presence of political will to impose hard budget constraints on enterprises is also necessary to ensure that insolvent enterprises are either liquidated or have no access to new financing. The following discusses the bad debt recovery experiences of the countries under consideration in light of these factors.

# a. **Centralized Approach**

The countries under consideration set up three types of centralized agencies for bad debt recovery: asset management companies, bank liquidation agencies and special divisions within a central bank to manage bank liquidation and/or asset recovery. AMCs were created in the _Czech Republic_ (where it was referred to as an "asset hospital"), and in _Lithuania, Kazakhstan_ and _Macedonia._ In Hungary, a separate division of the development bank performed the asset recovery function. The _Kyrgyz Republic, Georgia_ and _Uj'kraine_ all set up bank recovery units in their central banks. Asset Management Companies in all the countries covered in the study, and in the transition economies in general, are typically state-owned<sup>38</sup> . This has some negative implications in light of the above-mentioned factors that are important for successful bad debt recovery.

(i) It is generally more difficult to structure incentives for active loan recovery by a state-owned centralized agency. By contrast, under the decentralized approach, banks are provided the incentives to recover bad loans as they retain at least some (and sometimes all) of the recovered debt.

The experience of the _Czech Republic_ illustrates the importance of having appropriate incentives for loan recovery. The _Czech_ govemment has introduced perverse incentives for bad debt recovery in two

**38** In international practice AMCs are also typically state owned, although there are some examples of privately owned AMCs. One such example is the Japanese Cooperative Credit Purchasing Company, which was "established by Japanese banks to buy non-performing loans from individual banks at market price." Source: Andrew Sheng (1996).

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ways. In the first place, it has either explicitly or implicitly guaranteed repurchase of bad loans at full accounting value from the three loan recovery agencies through a web of complex funding arrangements. In addition, while the ownership of non-performing loans was transferred to two of the debt recovery agencies, _Ceska Finaneni_ and _Ceska Inkasni,_ the assets themselves remained on the balance sheets of the commercial banks which were required to pursue work-out activities. Without ownership of the nonperfortning loans, the commercial banks did not really have any incentive to pursue their recoveries.

(ii) There is a potential disincentive for a state-owned AMC to be successful in collecting bad debt as that would bring the AMC closer to its date of dissolution. The risk of creating a self-perpetuating AMC could in principle be addressed by limiting the length of time during which an AMC will operate. However, the authors found no examples of AMCs among the countries considered which have a predetermined limited operations time. The international experience in this regard has not been much better either, as most AMCs around the world have been self-perpetuating. Another problem with a selfperpetuating AMC is that its mere existence creates moral hazard for continuing banking problems as banks now have a dumping ground for future bad loans.

(iii) Some AMCs also take on other functions, which could lead to undesirable consequences especially if the AMCs are state-owned. The _Czech_ case provides a very good example. _Konsolidacny Banka (KoB),_ one of the three state-owned bad debt recovery agencies in the _Czech Republic,_ is also a development bank which has commercial banking and deposit-taking functions. The high share of bad assets in _KoB_ creates tremendous moral hazard for it to undertake risky activities, which could lead to further fiscal costs.

(iv) A state-owned debt recovery agency is likely to succumb to political pressure and delay enterprise restructuring or liquidation. In other words, it is less likely that hard budget constraints would be imposed on enterprises if the AMC is state-owned. In both the _Czech Republic_ and _Macedonia,_ for example, soft budget constraints have inhibited enterprise restructuring, resulting in low rates of bad loan recoveries. In _Macedonia,_ the Bank Rehabilitation Agency (BRA), created to intervene in failing banks and to sell or liquidate them, was also envisioned to promote enterprise restructuring. However, enterprises whose ownership were transferred to the BRA continued to make losses, with some even setting up subsidiaries to borrow under different names (Paulson, 1999).

(v) Public officials at an AMC are unlikely to be familiar with the clients of the banks, which inhibits successful bad debt recovery.

The AMCs in the countries considered had modest results in recovering bad debt. The recovery rates (defined as loans recovered as a share of the total value of bad loans) were 3 to 5 percent in the _Czech Republic,_ around 5 percent in _Lithuania_ and 16 percent in _Hungary_<sup>_3 9_</sup> _._ By contrast, in other parts of the world recovery rates were over 30 percente.

A bank liquidation agency or a special division within a central bank has the mandate to take receivership of distressed banks and to liquidate them. The quality of assets that are transferred to such an agency is likely to be higher than the quality of bad debts that are carved out and placed in an "asset hospital", as assets placed in the former include performing loans as well as non-performing ones. Of the twelve countries under consideration, the only country which has a bank liquidation agency for which data on asset recovery is available is the _Kyrgyz Republic,_ where the recovery rate was around 10 percent 40 Klingebiel (2000) found that in the U.S. and Ghana, recovery rates were around 32 percent.

39 See Appendix 8 on Asset Management Companies and Bad Debt Recoveries.

41
In some instances more than one agency was created to proceed with different types of loans. Agricultural credits in particular presents a special challenge in transition economies because of the difficulty of reforming the rural sector. Among the countries covered in this study, those with a relatively large agricultural sector have adopted a separate strategy to deal with the recovery of agricultural credits. This was the case in _Kazakhstan,_ the _Kyrgyz Republic_ and _Lithuania,_ where special agencies were created for collecting agricultural credits. In _Poland_ loans to the agricultural sector also did not easily lend themselves to the bank-led decentralized work out procedures which were used for all the other loans<sup>41</sup> . Sometimes a separate agency was also created to deal with the loans that were extended by foreign trade banks because of the special nature of trade-related claims. This approach was followed in the _Czech Republic_ and in the _Kyrgyz Republic._ The experience of the _Czech Republic_ illustrates the potential problems with multiple loan recovery agencies. The three _Czech_ bad debt recovery agencies have overlapping functions and nontransparent financing mechanisms, which multiplied operating costs. The government is now proposing to consolidate the three agencies into one.

# **b. Decentralized Approach**

The decentralized approach allows for the simultaneous treatment of banking sector distress and its underlying problems in the real sector. This could be particularly useful in transition economies where banking problems are usually caused by problems in the enterprises.

Among the countries under consideration, _Poland_ and _Bulgaria_ pursued the decentralized approach solely. _Hungary_ adopted this approach after the centralized approach did not produce good results. The _Czech Republic_ is considering modifying its centralized approach which has not produced satisfactory results to one that is more decentralized, entailing out-of-court settlements between banks and enterprises. In _Georgia,_ the _Kyrgyz Republic, Kazakhstan_ and _Ukraine,_ the decentralized approach is adopted in conjunction with a centralized one, with work-out units being created at banks for pursuing the recovery of loans. _Estonia_ pursued the decentralized approach through work-out units created at commercial banks in addition to the "good bank/bad bank approach".

Under the decentralized approach, bad asset recovery would only be successful if bank management is willing and able to pursue debtor enterprises. However, in transition economies in general, creditors are generally unwilling to pursue their debtors for a variety of reasons (the so-called "creditor passivity" in the literature), which undermines the bankruptcy constraint and slows down the process of resource reallocation and restructuring. Three reasons have been identified for creditor passivity: (i) the persistence of soft budget constraints for banks and enterprises; (ii) the pervasiveness of connected lending; and (iii) the oligopolistic structure of the banking system (Hoshi and others, 1999).

The _persistence of soft budget constraints,_ especially for state banks, may undermine their incentives to pursue debtors, and strong _interdependence between creditors and debtors_ may create a disincentive for bank management to pursue their debtors. This was the case in _Bulgaria,_ where the decentralized bank-led bad asset work out process did not succeed largely because of the pervasiveness of connected lending.

The _oligo olistic structure_ of the banking system may allow a few large banks to retain high margins in spite of the high share of non-performing loans, and create a disincentive to acknowledge bad _41_ Out of all the banks that were covered by the Enterprise and Bank Restructuring Program in Poland, the only bank that remains problematic is BGZ (Bank Gospodarki Zywnosciowej), the bank that supports agricultural cooperatives.

42
debt and pursue debtors. This was a common feature of the majority of the banking systems in transition economies at the early stages of transformation to market economy.

The capacity of banks to deal with non-performing loans is also an important factor in the success of the decentralized approach. In some countries, banks did not have the capacity to become the 'agents of change' in the real sector. It is especially true for most of the countries of the formner Soviet Union. For example, having analyzed the banking sector in the _Baltics,_ Fink and others (1998) concluded that distressed banks which had difficulties managing themselves would probably not be able to improve corporate governance in enterprises.

In addition to these factors, a decentralized approach to bad loan recovery also needs to be part of a _broad design that takes into account economic incentives and the legal framework_ for it to be successful. A decentralized approach that was part of a broad design was adopted in _Poland_<sup>_4 2_</sup> _,_ and in _Hungary_ during the 1993-94 Bank Restructuring and Loan Consolidation Program. On the other hand, _Hungary_ (during the 1992 Loan Consolidation Program), _Bulgaria, Estonia, Czech Republic_ and _Kazakhstan_ (for debts to small and medium enterprises), _Georgia_ (which created a pilot work-out unit) and _Ukraine_ (which set up work-out units in three large state banks) did not follow this comprehensive approach.

In light of these factors, the decentralized approach to bad debt recovery has not been very successful for the countries under consideration. _Poland_ is perhaps an exception, with recoveries for a sample of banks averaging around 17 percent (Johnson, 1999). _Kazakhstan_ appears to have achieved some measure of success, with the integrated approach for bank loan and enterprise restructuring yielding positive results<sup>43</sup> . On the other hand, _Hungary_ and _Bulgaria_ were not very successful, and there is no infornation on how _Estonia, Georgia_ and _Ukraine_ fared with their work-out units, while it is too early to tell for the _Czech Republic._ The relative success of _Poland,_ which is a pioneer of the decentralized approach in the region, compared with the lack of success of _Hungary_ which pursued a similar approach, highlights the importance of incentives and the legal framework in the collection of bad loans. Both countries required banks to create work-out units and pursue financial restructuring of their portfolios through a conciliation process with the enterprises. Comparison of the _Polish_ and _Hungarian_ experiences with the negotiation of these agreements provides useful insights about the _implications of government participation in the negotiation of agreements between banks and enterprises._ In _Poland,_ the government's withdrawal from the out-of-court conciliation and the imposition of strict conditionality on new bank lending together sent a signal to banks that they could not rely on the government for additional support for dealing with problem debtors. By contrast, in _Hungary_ the government's participation in the negotiation of such agreements tended to soften the budget constraint on banks and enterprises (Baer and Gray, 1995).

# **c. 'Good bank/bad bank' approach**

Under this approach, a subsidiary "bad bank" is spun off from the original bank, allowing quick financial restructuring of the balance sheet of the remaining "good bank". The "bad bank" pursues collection of bad assets and is self-liquidated within a limited period of time. Of the countries under consideration, _Hungary_ in 1995 and _Estonia_ in 1996 pursued this approach. In Estonia, the "bad bank" that was spun out of the Social Bank (which was itself liquidated) was turned into a loan recovery agency

> 42 Several authors have undertaken detailed analysis of the incentive structure and evaluation of Poland's Enterprise and Bank Restructuring Program. See van Wijnbergen (1998); Belka (1994; 1998); Baer and Gray (1995) and Gray and Holle (1996).

> **43** Kazakhstan, Implementation Completion Report for Financial Sector Adjustment Loan, June 18, 1998.

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and operated for only a short period of time. In _Hungary,_ the bad bank "Risk Kft" that was spun out from the _Magyar Hitel Banka_ was designed to be wound up in three years while the good bank was successfully privatized. The ability to quickly relieve a bank of its non-performing loans, and yet avoid the creation of a potentially ineffective state-owned AMC, is often seen as the main advantage of the 'good bank/bad bank' approach.

# 5.3 **Results of Bad Debt Recovery**

None of the three approaches used for bad debt recovery by these countries has been very successful. Based on available data, results of bad debt recovery were not very different under the centralized and the decentralized approaches, with bad debt recoveries ranging from 3 to 16 percent under the former, and up to 17 percent (in Poland) for the latter<sup>44</sup> . While the bad debt recoveries under the centralized approach accrue to the government and alleviate the fiscal cost of banking crises in those countries, they accrue to the banks in the case of Poland and therefore do not help alleviate the fiscal costs. However, in Poland's case, the work-out activities have helped build institutional capacity in the banks, which strengthens the banking sector and should help in minimizing recurrence of banking crises and incurrence of further fiscal costs.

The bad debt recovery rates are low compared with those elsewhere in the world, which is not entirely surprising since much of the bad debt in the transition economies have been inherited from the previous regimes, and owed by enterprises which have either collapsed or have not been restructured and continue to have problems. In addition, the poor results were also due to insufficient political will to impose hard budget constraints; lack of an effective legal framework to support debt collection and bankruptcy; and the inability to eliminate connected lending.

# 6. **The Results of Crises Resolution**

All three country groups experienced positive results from the resolution of banking crises, with the outcomes being generally better for the _CEEs_ and the _Baltics_ than the _CIS_ countries. Further improvements are necessary, however, in several areas for all country groups. First, non-performing loans continue to be a major source of concern, especially in the _Czech Republic, Macedonia, Lithuania_ and _Kazakhstan._ Second, financial intermediation is low, particularly in the _CIS_ countries, but also in the _CEEs_ and the _Baltics._ Third, banking sector efficiency needs to be improved in the _CIS,_ and also in the _Czech Republic_ and _Hungary._ Fourth, confidence in the banking sector is still extremely weak in the _CIS._ The generally better performance of the _CEEs_ and the _Baltics_ may have been the outcome of the crisis resolution strategy adopted by the countries, although the results must also have been affected by the overall economic situations in these countries. The generally better economic environment in the _CEEs_ and the _Baltics,_ and the earlier growth recovery (Table 5), in all likelihood contributed to the recovery and better performance of the banking sector in these countries.

The next sections review the results of crises resolution in the twelve countries in terms of financial intermediation, banking sector soundness, banking sector efficiency, and confidence in the banking sector.

# **a. Financial Intermediation**

Two measures of financial intermediation - credit to the private sector as a share of GDP and broad money as a share of GDP (Table 1) - show that there has not been much increase in financial depth as a 44 No data was available on the recovery rates in Hungary and Estonia under the "good bank/bad bank" approach.

44
result of bank crisis resolution in the twelve countries under consideration. If anything, there has been a decrease in financial depth in most of the countries. Financial intermediation in all three country groups remains considerably lower than in OECD countries, with financial intermediation in the CIS being the lowest.

# **b. Banking Sector Soundness**

Two measures of banking sector soundness - the ratio of non-performing loans to total loans (Table 3) and the capital to asset ratio (Table 17) - indicate that the results of bank crisis resolution in the twelve transition countries were generally positive, although improvements are still necessary.

With respect to the ratio of non-perforning loans to total loans, all the _CEE_ countries showed large improvements during the 1990s, ranging from a 20 percent reduction in the case of the _Czech Republic_ to an over 70 percent reduction in the case of _Hungary._ For the _Baltic_ countries, this ratio fell sharply in _Latvia_ and _Estonia,_ but in _Lithuania_ the initial improvements were subsequently reversed somewhat. Among the _CIS_ countries, all showed improvements except for _Ukraine,_ where the ratio actually worsened which is not surprising since there was no bank restructuring in _Ukraine._ Despite the generally positive trend, however, the bad loan problem remains critical in most countries. In fact, at the end of the 1990s, the share of nonperforming loans was close to or higher than 10 percent in all the sample countries except for Estonia, and was significantly higher than 10 percent in the _Czech Republic, MIacedonia, Lithuania_ and _Kazakhstan._ Data on the capital adequacy ratio suggest that the level of capitalization is satisfactory in those countries for which data is available. Even in countries where the authorities did not undertake major injections of capital, as in the _Baltics,_ the restructuring and downsizing operations have produced better capitalized banking systems. Among the _CEEs, Bulgaria_ had the highest capital adequacy ratio in 1998 of around 37 percent due to revaluation gains.

# **c. Banking Sector Efficiency**

The effects of bank crisis resolution on banking sector efficiency were mixed. One measure, interest rate spreads<sup>45</sup> , indicates that the banking sector has become more efficient in the _CEEs_ and _Baltics,_ while it remains far from efficient in the _CIS_ countries. Another measure - central bank credit to commercial banks as a share of GDP<sup>46</sup> - indicate that there were improvements in this area for all three country groups.

In the _CEEs_ and the _Baltics,_ interest rate spreads have, by and large, been declining in the latter part of the 1990s, suggesting increasing banking sector efficiency during that period. In 1998, the average interest rate spreads of the two country groups were around 8 percent, which was still twice the level in the OECD countries. By contrast, in the four _CIS_ countries, interest margins were extremely high, averaging 33 percent in 1998, reflecting the lack of competition and inefficiency in their banking systems.

For all three country groups, central bank credit to banks as a share of GDP generally declined through the 1990s, reflecting a decrease in the reliance of the banking system on the central bank, and suggesting an increase in efficiency. By 1998, this ratio had fallen to around I percent or smaller in the

> **45** See Appendix Table 9 for data on interest rate spreads for the twelve countries and for OECD countries.

> **46** See Appendix Table 10 for data on central bank credit to banks as a share of GDP for the twelve countries and for OECD countries.

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_Baltics_ and the _CIS,_ as compared to around 2 in OECD countries. By contrast, two _CEE_ countries - the _Czech Republic_ and _Hungary -_ had significantly higher shares of 4 to 5 percent.

**Table 17. Capital Adequacy Ratio**

(End of Period)

|**1990**|**1991**|**1992**|**1993**|**1994**|**1995**|**1996**|**1997**|**1998**|
|---|---|---|---|---|---|---|---|---|
|_Central and Eastern Europe_|||||||||
|**Bulgaria**||||8.6|4.6|17.6|26.7|37.3|
|**Czech Rep.**|||||10.2|9.8|9.5|12.0|
|**Hungary**|||||16.9|17.6|18.3||
|**Poland**|||16.5|20.8|18.5|17.5|16.9|15.0|
|**Average**|||||12.5|_15.6_|**17.9**||
|_Baltics_|||||||||
|**Estonia**||||13.4|13.7|12.1|13.5|16.9|
|**Latvia**||||14.0|20.0|23.0|21.0|17.4|
|**Lithuania**||||||**10.5**|10.8|23.8|
|**Average**||||||15.2|_15.1_|19.4|
|_CEE_|||||||||
|**Georgia**|||||4.0||||
|**Kazakhstan' **|||||3.0|19.0|23.0|30.0|
|**Kyrgyz Rep.**|||||5.0||||
|**Ukraine**||||**l.0**|**4.0**||||
|**Average**|||||**4.0**||||

_Source:_ EBRD (1998) "Transition Report", International Monetary Fund, Central Banks. 1/ Data for 1996-1998 are taken from IMF (1999) "IMF Staff Country Report, pp. 69-70." The IMF noted that these figures should be used with care.

# **d. Confidence in the Banking Sector**

The experience of the twelve countries was generally positive with respect to confidence in the banking sector in the aftermath of bank crisis resolution as measured by the currency to deposit ratio<sup>47</sup> and the ratio of MI to M2 (Chart 5)48 Virtually all twelve countries experienced a decline in the confidence in the banking sector during banking crises, as measured by the currency to deposit ratio. Confidence did not recover in all the countries after the crises. Among the _CEEs,_ there was recovery in confidence (that is, the ratio fell) only in _Macedonia_ and _Poland,_ while in the _CIS_ countries, there was recovery only in _Georgia._ On the other hand, in all three _Baltics_ states, and in particular in _Estonia,_ confidence in the banking sector rose after crisis resolution. In 1998, confidence in the banking sector as measured by the currency to deposit ratio was similar in the _CEEs_ and the _Baltics,_ where the ratio was between 90 to 95 percent in these countries, compared with around 30 percent in OECD countries. The confidence in the banking sector was much lower in the _CIS,_ where the ratio was over 400 percent.

Data on the ratio of MI to M2 shows a generally positive experience for all the countries. With the exception of _Macedonia,_ all the countries showed a decline in the ratio in the aftermath of bank crisis resolution, reflecting an increase in confidence in the banking sector.

> **47** See Appendix Table 11 for data on currency deposit ratios for the twelve countries and for OECD countries. 48 See Appendix Table 12 for data on MI/M2 for the twelve countries and for OECD countries.

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# 7. **Summary, Conclusions and Policy Lessons**

# **a. Summary**

The experience of banking crises in transition economies differs from that in many other parts of the world in part because of the very different initial conditions facing these countries. One initial condition that is unique to the transition economies is the large debt stock inherited from previous communist regimes, owed by enterprises that did not have the custom of repaying. Another initial condition unique to the transition economies was the lack of experience on the part of both enterprises and banks in operating under market conditions. Also, the transition process brought along severe growth contraction throughout the transition world, which helped precipitate banking crises in these countries. Given these initial conditions, banking crises in transition countries could be more broadly viewed as a challenge of transition, or a challenge of banking sector development in the transition context.

Broadly speaking, the bank crisis resolution strategy pursued by the countries under consideration could be differentiated according to three country groups. The _CEEs_ generally pursued restructuring of banks coupled with injection of capital; the _CIS_ pursued large-scale liquidation of banks; while the _Baltics_ pursued a combination of bank liquidation and restructuring with injection of capital in some instances.

The different strategies adopted by the authorities in these countries appear to depend on two main factors - initial macroeconomic conditions and development of the banking sector. On the macroeconomic side, the key factor was inflation. Hyper inflation in the countries of the _FSU (CIS_ and the _Baltic_ countries) at the beginning of transition had drastically reduced the real value of the bad debt in the banking system. By contrast, while some _CEEs_ began transition with high inflation, inflation in these countries was far lower than in the _FSU,_ which means that the _CEEs_ were saddled with a much larger stock of bad debt that the authorities needed to tackle.

Banking sector development also had implications for the bank crisis resolution strategy adopted by the different country groups. While both the _FSU_ and _CEEs_ pursued liberal licensing policies initially, entry of new banks was on a much larger scale in the _FSU_ than in the _CEEs._ Furthermore, while in the _CEEs_ new banks were allowed to enter to foster competition in the banking sector, in the _FSU_ many new banks emerged to finance inefficient state-owned enterprises. As a result, that there was a much greater proliferation of banks of poor quality in the _FSU_ compared to the _CEEs._ Also, financial intermediation was much deeper in the _CEEs_ (with some banks considered "too big to fail") than in the _FSU_ countries, which meant that liquidation of banks in the _FSU_ would not have much economic or social impact, whereas it could in the _CEEs._ Because of these reasons, countries in the _CEEs_ did not undertake bank liquidation on the large-scale that the _FSU_ did.

These initial conditions and bank crisis resolution strategies had a direct impact on the fiscal costs of banking crises. Further, the amount of fiscal costs incurred also depended on the extent to which bank shareholders and depositors bore some of the costs. The _CIS_ and _Baltic States,_ the fiscal costs were generally lower because they relied more on recapitalization by private shareholders than by the government. There was also minimal compensation for depositors in the event of bank liquidation in the _CIS_ and the _Baltics._ Also, the restructuring operations undertaken by the _CEEs_ suffered from several weaknesses, which raised fiscal and quasi-fiscal costs.

Taking together the costs of bank restructuring and depositor compensation incurred by the government and the central bank, the total fiscal costs of banking crises were by far the highest in the _CEEs,_ where they ranged from 7 to over 40 percent of GDP, compared with a range of 0.1 to 18 percent of GDP for the _CIS,_ and from 2 to 3 percent for the _Baltics._ The bulk of these costs were incurred by the 47
government for bank restructuring, which were typically several times the costs of direct payments to depositors or the costs incurred by the central bank.

The higher fiscal costs incurred by the _CEEs_ are reflected in the higher levels of fiscal outlays arising from banking crises compared with the general government deficits in these countries. The resolution of banking crises also raised central government indebtedness more in the _CEEs_ than in the _CIS,_ by around _5_ percent in the case of the _Kyrgyz Republic_ to around 1 I percent in the case of _Bulgaria._ While these upfront costs of banking crises (that is costs of bank restructuring and direct depositor compensation) could in principle be offset by recoveries of bad loans, the experience of the sample countries was not very positive in this respect. For those countries for which data is available, bad debt recoveries were low and did not contribute much to reducing fiscal costs. Among the countries where loan recoveries accrued to the government, _Hungary_ had the best results with loan recoveries amounting to 16 percent of total bad loans. _Poland_ also had a similar recovery rate, although bad debt recoveries accrued to the banks themselves. In comparison, recovery rates of around 30 percent have been achieved around the world. The low recovery rate in the transition countries is not surprising since much of the bad debt was owed by enterprises which had either collapsed or not been restructured and not capable of repaying.

All three country groups enjoyed positive results from the resolution of banking crises, although the outcomes were generally better in the _CEEs_ and the _Baltics_ than in the _CIS,_ particularly in regard to improving banking sector efficiency and raising the confidence in the banking sector. There needs to be further financial deepening in all three country groups, and especially so in the _CIS._ Finally, although non-performing loans as a share of total loans has declined, they remain a concern in several countries in all three country groups.

# b. **Conclusions and Policy Lessons**

All transition countries have suffered from banking crises. Governments have a range of options of how to respond, from doing nothing and allowing banks to fail, to absorbing the entire cost of the banking crisis which is not only fiscally expensive but run the risk of moral hazard in the case of private banks.

The incurrence of at least some fiscal costs may have been inevitable for the transition countries because of the need to deal with the inherited bad debt. Because of the moral hazard created by undercapitalization, these banks needed to be recapitalized before sound commercial banking could take place. The _CEEs_ broadly adopted the approach of rehabilitating and injecting capital into banks. Although they incurred quite substantial fiscal costs in the process, the result was a sounder and more efficient banking system, in particular because many of the recapitalized banks have since been privatized to strategic foreign investors.

An alternative approach would have been to close all the old banks and allow new banks to enter. This approach was broadly adopted by the _CIS_ countries, but these countries encountered difficulties in attracting reputable and sound banks to do business in their high risk environments. The outcome was that in the _CIS_ countries, the new banks that entered into the system were generally small, undercapitalized and unsound, and had to be liquidated soon after entry, leaving the _CIS_ countries with weak banking systems and low levels of financial intermediation.

In contrast to the _CEEs_ and the _CIS,_ the _Baltics_ appeared to have struck a good balance in terms of incurring some, but not too substantial, fiscal costs, while at the same time achieving some success in resolving banking crises. In particular, _Estonia_ appears to have done the best in terns of resolving its 48
banking crises while minimizing cost. At a total cost of 2 percent of GDP as of end-1998, the crisis resolution has resulted in a substantial increase in financial intermediation, a large decline in nonperforming loans (which stood at slightly over I percent of total loans in 1998), significant improvements in banking sector efficiency and higher confidence in the banking sector.

The experience of the twelve transition countries also highlights the following lessons - consistent with conventional wisdom - on the approach to bank restructuring which minimizes the recurrence of banking crises and hence minimize fiscal costs. _First,_ the three elements of banking system restructuring - operational, financial and institutional - need to be undertaken in parallel for the successful resolution of banking crises. _Second,_ financial restructuring of banks should entail adequate recapitalization to deter moral hazard. _Third,_ operational restructuring of banks needs to entail privatization to core investors. The experience in the transition countries indicates that privatization to reputable foreign banks could be a useful way to strengthen their banking systems. _Fourth,_ enterprise problems need to be addressed in parallel with bank restructuring because in many transition economies enterprise problems are the underlying causes of banking problems. _Fifth,_ differentiation of the crisis resolution strategy according to the cause of the crisis could help reduce fiscal costs. Specifically, fiscal costs were reduced when: (i) governments only dealt with that portion of the bad debt inherited from the socialist period; (ii) small banks were allowed to fail when they did not affect financial intermediation very much (that is they held very little deposits) and when the social costs of such bank failure were low; and (iii) only banks that got into trouble because of external shocks were rescued while those that suffered from poor management were liquidated. _Sixth,_ bank restructuring should be undertaken by the government and not the central bank because: (i) central bank financing is non-transparent and the costs will eventually fall on the budget; and (ii) central bank financing could lead to hyperinflation with severely negative economic consequences.

The experience of the transition countries under consideration also supports the established principle that for bad debt recovery to be successful, the bad debt collector (be it a central agency or a bank) needs to operate within an adequate legal environment (in particular effective collateral, foreclosure and bankruptcy laws) and be given appropriate incentives, and the enterprises in question need to be subject to hard budget constraints. This implies that if a centralized approach is adopted, then the bad debt collection agency should be private rather than state-owned. It also implies that a "good bank/bad bank" approach to bad debt collection might be preferable as it entails a finite time of operation of the "bad bank".

The approach adopted by Poland, where the banks themselves pursue the collection of bad debts, appears to have some merit. Since the recovered debts accrue to the banks, they have the incentive to collect. Bad debt collection by banks also helped them build institutional capacity, which should strengthen the banking system and help minimize the recurrence of banking crisis. Another key incentive provided for bad debt collection in the Polish model was the complete withdrawal of government participation in the negotiation of agreements between the banks and the enterprises. This addresses the "soft budget constraint" factor that tends to undermine bad debt collection efforts by creditors in other transition economies. The Polish banks were also supported by an adequate legal framework. Other transition countries covered in this study which also adopted a similar decentralized approach to bad debt collection were not very successful because either an adequate legal framework or appropriate incentives or both were absent.

Finally, it is important to note that successful bad debt recovery requires adequate capacity for the task. Given the relatively recent introduction of transition economies to commercial banking, the capacity of collecting bad debt which entails restructuring of enterprises will take some time to build up, more so for the countries from the _FSU_ than the _CEEs._ Therefore, only modest results from bad debt recovery may be expected from these countries for some time.

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