[Preliminary draft for discussion. Please do not quote] Banking Systems’ Transition in Central and Eastern Europe and Central Asia: An Overview Fernando Montes-Negret and Thomas Muller Finance & Private Sector Development Department Europe and Central Asia Region, The World Bank i Over the past fifteen years, the countries of Central and Eastern Europe (CEE) and Central Asia (CA) have experienced nothing short of a dramatic change in all political, economic and social aspects. This paper provides a brief overview of financial sector developments in this increasingly heterogeneous region, following chaotic, prolonged and costly episodes of crises in the 1990s. After the end of the monobank system, most countries experienced more or less severe systemic financial crises. Based on varied policy responses implemented, they went through several phases of reform, starting with severe defaults, followed by lax bank entry early on, a second wave of bank failures, and then through restructuring, consolidation, and privatization — often through opening to Western financial intermediaries — conditions stabilized and they ended will well functioning financial intermediaries. Somewhat surprisingly, CEE countries ended with remarkably similar bank-dominated financial systems. Nonetheless, even today, though, some CIS countries are still left with severe vulnerabilities in their banking systems, often rooted in weak legal and institutional arrangements, as well as limited political will to adopt the necessary reforms. i The findings, interpretations and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent. We want to thank and acknowledge Steen Byskov‟s contribution to explaining the Turkish case. 2 The first part of the paper outlines the background and specific departure point of most countries in the region which, with the exception of Turkey, all went through a process of transition from state-planned to market-based economies. The second part gives a brief summary of the current state of and differences in financial sector development in different countries. The third part looks at crises experiences in Russia, Turkey, Poland and Hungary, highlighting different approaches and drawing a few lessons learned. The fourth part outlines some current issues and challenges ahead. Background — Transition, Financial Deepening and Financial Crisis With the exception of Turkey, the countries in the region entered the 1990s as centrally planned economies structured along socialist principles of economic organization. The specific crisis experiences and characteristics of post-crisis financial development in many of the countries are framed by the process of transition from state-planned to market-driven economies that most of the countries embarked upon following the fall of the Berlin Wall. It is important to distinguish the crisis experiences in the transition countries from other financial crises around the world in the 1990s. The process of transition implied a crisis of the entire social and economic model of organization. Crises in the financial sector were a direct result of — and should not be separated from — the much more fundamental crises of the public sector that all transition countries faced and in some cases have not yet fully overcome. In centrally-planned economies, “banks” functioned as administrative agencies of the state that collected deposits and allocated funds according to the decision of the central planning agencies. “Financial intermediation” with financial institutions competing for deposits and competitively allocating funds to their most productive uses did not exist. Banking systems were more or less limited to functioning as “accounting control and cash disbursement vehicles” for the state, although they simultaneously provided deposit-holding and payment systems services to companies and individuals.ii Peachey and Roe (2001) summarize the implications of this form of organization for their financial systems: “Paradoxically the socialist banks of the pre-1989 era were quite ii Borish and Montes-Negret (1998) 3 safe, […]. Since they were owned by the state, as were their major clients and borrowers, failures on loan repayment were contained within the budgetary sphere. Many banks have been technically insolvent, but the implicit guarantees of the state diluted the importance of that fact. Concepts such as capital adequacy, the creditworthiness of borrowers, portfolio concentration, and insider lending were of only peripheral relevance to the financial durability of banks — their “failure”, in any case, was not a possibility to be entertained.” iii Chart 1: Monobanking Systems in Centrally Planed Economies MONOBANK: Central Bank (Monetary CENTRAL PLAN & Policy) Commercial Bank: CREDIT PLAN Household Deposits Non-commercial Lending STATE OWNED ENTERPRISES As shown in the above chart, monobanks were responsible for both monetary and commercial banking. However, monobanks were not responsible for screening, monitoring projects and enforcing the repayment of loans, but rather with channeling funds allocated to state-owned enterprises (SOEs) according to the physical and credit plans. The fall of the Berlin Wall, symbolizing the beginning of political and economic reform in the socialist countries, also marked the beginning of the transformation of the monobank into decentralized financial institutions, in theory, able to perform the iii Peachey and Roe (2001), page 189 4 functions assigned to them in market economies. At this stage countries started the establishment of a two-tiered banking system,iv separating central and commercial banking activities, creating multiple, smaller, units and allowing the entry of new banks.v In most of the CIS countries and Romania, the exception was the preservation of the Savings Bank (Sberbank) as a unit playing the role of monopolist of the collection of household deposits. The latter has been a serious drag for the development of more “normal”, commercially oriented, banking systems in the region. Central banks were charged with two new tasks: (i) initiating a semblance of an autonomous monetary policy, through the imposition of credit ceilings and giving credit to the new “spin off” banks through their refinancing windows; and (ii) regulate and supervise the newly established commercial banks. Unfortunately central banks were totally unprepared to implement and enforce these tasks, lacking the expertise and experience and being, generally, politically weak. As to the new commercial banks, there were initially little more than accounting units which had inherited the old bureaucratic network, staff and low quality fiscally-originated assets in the form of “loans” granted to SOEs. Being still state-owned banks (SOBs) with loan portfolios placed with SOEs there were no incentives and mechanisms to collect and large non-performing loans (NPLs) were generally rolled over, often through granting new loans funded by the central banks. This perverse but not unexpected mechanism became a source of large inflationary pressures. On the SOBs side, households were quite liquid since they had accumulated large liquid deposits inherited from the times pervasive shortages of consumption goods. These massive “monetary overhang” fuelled the inflationary process and the traumatic hording of goods observed in most early transitions. When central banks attempted to introduce some monetary discipline in the early 1990s, reinforced by hard budget constraints on the fiscal side, a credit crunch followed, resulting in enterprise defaults and bank failures, leading to the first wave of banking crises in the region.vi iv The creation of a two-tier bank system began in 1987 in Hungary, 1989 for Poland and 1990 for the Czech Republic. See McDermott (2004). v See Erik Berglof and Patrick Bolton (undated mimeo). vi Idem, page 2 . 5 The response to cleaning the banks‟ balance sheets was very different across transition countries.vii However the inescapable reality was that most countries needed to inject substantial financial resources to recapitalize their banking systems and address the high levels of non-performing loans (NPL). The latter skyrocketed, reflecting, to a large extent, the collapse of their productive systems with dramatic cuts in output as domestic and international markets collapsed. NPLs — to the extent that accounting figures were credible — as a share of total bank loans were estimated to be as high as 29% in the Czech Republic, 9% in Hungary and over 33% in Poland in 1991viii. “Many of these loans were to large industrial companies that were overstaffed, uncompetitive, and unlikely to emerge as sound credit risks even with the introduction of some operational changes” ix. The fragmented and specialized way in which the banking system had been organized meant that the newly established, now commercially-oriented, banks often had to support large concentration risks to sectors, geographic regions and individual state- owned enterprises, for the first time outside of the “protected fiscal cocoon.” Cleaning the banks‟ balance sheets was approached both directly and indirectly, complemented with different strategies for privatizing SOEs and SOBs (see Table 1). In all cases regulatory and supervisory capacity and banking skills were lacking. Also the legal framework was seriously inadequate (banking and central banking laws, bank resolution and company bankruptcy law, creditors‟ protection, collateral recovery, etc.) and the enforcement capacity was very limited (supervisors and courts). The various waves of bank recapitalizations and purchase of NPLs created perverse incentives to create more NPLs and were done in a non-transparent and ad hoc way. Te centralized approach to NPL collection was in general a failure. Corporate governance shortcomings and conflicts of interests among SOEs as owners and borrowers were not resolved until bank foreign entry became more widespread. vii Matous ek (undated). viii Borish and Montes-Negret (1998), page 80 ix Borish and Montes-Negret (1998) , page 79 6 Table 1: Sample of Measures to Deal with First Wave of Bank and Enterprise Insolvencies Country Dealing with Bank Insolvencies Dealing with SOE Other Key Policies Insolvencies Adopted Hungary Four SOBs established. Rehabilitation Case by case method of Legal and judicial reforms. Approach: recapitalization and privatization. Cross- Prospect of EU accession consolidation of SOBs. Widespread border M&A. provided impetus for reform. foreign bank penetration. Moderate Significant external TA.. Hard increase of new banks. Initial centralized budget constraints. collection of NPLs. (AMC) Czech Five SOBs: lack of banking services Mass voucher Legal and judicial reforms. outside Prague. Privatization of SOBs privatization scheme Prospect of EU accession Republic under voucher privatization scheme. (controlling Investment provided impetus for reform. Initial resistance to foreign ownership of Funds). Cross-border Significant external TA banks. Large bank failures changed M&A. provided. Hard budget approach. Moderate entry of new banks. constraints. Centralized collection of NPLs. Baltic Dramatic increase of new entrants. High Cross-border M&A. Legal and judicial reforms. share of foreign ownership to banks Prospect of EU accession Countries from Scandinavian countries. provided impetus for reform. Significant external TA provided. Hard budget constraints. Currency Board (Estonia). Poland Nine regional banks established: good Out of court corporate Legal and judicial reforms. geographic coverage but limited restructurings.Moratorium Prospect of EU accession competition. Management buyouts and on bankruptcies. De facto provided impetus for reform. limited entry of foreign strategic write off of tax claims Significant external TA investors (Government retaining Cross-border M&A. provided. Hard budget strategic stake). Twinning arrangements. constraints. Decentralized collection of NPLs. Russia and Free entry of mostly local banks. State Late “crony” Limited and late legal and retaining control over Savings and Exim privatizations judicial reforms. Soft budget Ukraine Banks. Opaque ownership. constraints. Romania Lax entry of new banks followed by Slow privatizations. Soft budget constraints. Ponzi schemes. and Albania Sources: Berglof and Bolton, Matous, Mody and Negishi, and Authors assessment. 7 In the first phase of transition, reform efforts focused on strengthening the regulatory regime and establishing a legal framework “following OECD standards.” The general thinking presumed that economic reforms and market dynamics would eventually force banks to adjust to the new economic reality and, given sound supervision and regulation, they would start allocating resources in an efficient manner, avoiding failure by stopping lending to failing enterprises. However, while the legal and supervisory frameworks were quickly adapted to international best practice, the actual capacity of supervisors and banks to monitor, evaluate and manage risks was not sufficient to transform the existing institutions into efficient financial intermediaries overnight. In most cases there was not sufficient political will to act on enforcing the newly minted rules. Governance problems and insider lending prevailed, and the banking systems in Russia, Ukraine, many Central Asian and some South Eastern European countries practically collapsed. Many of the banking systems still retain characteristics of the pre-1989 period, in particular, the predominant role of the state through bank ownership, managing the majority share of household deposits in the largest retail financial intermediaries and protecting inefficient and even some failed banks. Notable exceptions are the new EU member states, which following early crises transformed their banking systems quickly and — largely relying on foreign investors (with the exception of some Baltic countries) — upgraded capacity and management of the sector. As mentioned above, banks in ECA countries remained wholly state-owned up to the first waive of banking crises. However, from 1994 onwards, a sharp increase in new entrants of small, undercapitalized and under- managed domestic banks was at the root of the subsequent banking crises. Some country governments encouraged the establishment of new private banks by lowering minimum entry requirements for management capacity and capitalization, which in the most prominent case of Russia led to the establishment of over 2500 banks at its peak in 1997. Many of these new banks were serving a negligible social purpose by simply providing services to industrial holdings that typically had the same owners (“pocket banks”). Remarkably, 8 one can observe an inverted “U” pattern in the number of banks in the banking systems in many transition countries. Early break ups and entry of new private banks increased the total number of banks, but subsequently many individual bank failures and systemic crises significantly reduced the number of banks towards the end of the 1990s. From 1993 to 2000, the number of banks in Latvia decreased from 62 to 22, in Kazakhstan from 204 to 48, in Azerbaijan from 164 to 59, and in Georgia from 179 to 33. The success of bank restructuring in the region varies dramatically. In Poland and the Baltics, governments initiated wide-ranging and painful restructuring very early in the transition period. In the most successful cases the governments‟ response included, as a necessary condition, fiscal and monetary discipline. “Without fiscal discipline, private investment is crowded out or discouraged by the looming threat of macro-instability. Lack of fiscal discipline has also been a symptom of other ills, like a lack of commitment to close down loss-making firms, poor enforcement of property rights and low tax compliance”.x While fiscal discipline was a necessary condition to provide the right incentives, central banks actively promoted restructuring and consolidation and support the entry of foreign investors. Some of the most successful CEE countries —like Hungary, Poland and the Baltics — developed early in the transition successful banks equipped, in theory, to support sustainable private sector-led growth. However, in general, financial sectors played only a very small role in the early restructuring of the manufacturing sector. Banks might have been too risk averse after the crises and lacking of the required know-how, then opting to lend more to their governments than to enterprises. As a result, credit to the private sector as percentage of GDP remained quite low and in the case of Hungary experienced a drastic decline.xi More recently, the three Baltic banking markets have seen the emergence of a number of sizeable banks operating on a regional rather than national level. Hansa Group, the largest Baltic bank with operations in all Baltic markets, compares in size to the largest private banks in the much bigger Russian market and has performance ratios ahead of x Berglof and Bolton, Page 12. xi The ratio of domestic credit to GDP declined from 45 percent in 1990 to 24.7 in 1994. See Berglof and Bolton. Page 3. 9 most ECA peers. In Poland, the government managed to set incentives such that the market quickly pushed ahead with consolidation in the sector driven by foreign capital. Foreign investor-controlled banks now account for roughly 80 percent of banking sector capital and 70 percent of banking sector assets creating a more competitive Polish banking sector and resulting in healthy growth of intermediation and sustainable net interest margins. Russia and Ukraine, on the other hand, have seen only limited progress in bank restructuring. State-owned banks and banks with political and corporate connections still dominate the system. Politically weak central banks lacking enforcement capabilities has retarded the necessary restructuring undermining the potential for market forces to promote consolidation and increased efficiency in the banking sector. The 1998 crisis did not trigger a sufficiently broad and deep bank restructuring, in spite that many banks failed. Moreover, the state banks were able to use the crises to consolidate their dominance in the sector as they attracted depositors based on implicit and explicit state guarantees. “Policymakers displayed little apparent interest in actively encouraging consolidation of the type that is common sequel to disruptive financial crisis: in their eyes this would have only delayed the return to the pre-1998 status quo „stability‟.”xii Given the starting point from which most ECA countries departed in the early 1990s, it is not surprising that almost all countries experienced some form of financial crisis within the past fifteen years, for in many countries bank failures — and therefore the appearance of a “crises” — continued to be absorbed in the state budget through constant life support to “zombie” banks through regulatory forbearance, capital support etc. However, when comparing the costs and impacts of crises in the region to the more prominent crises of the 1990s in Asia, Latin America, and Turkey in 2000-2001, it is apparent that the fiscal costs and impact on economic output were significantly less severe in the transition countries. This is primarily a result of the low levels of financial depth with which the transition countries entered the 1990s. In the early stages of transition the economic costs of financial crises were much lower than in those countries that relied to a much greater extent on extensive financial intermediation in allocating resources. Low levels of xii World Bank (2003) 10 deposits limited the need to put up fiscal resources to bail-out depositorsxiii. Moreover, the large extent of alternative financing and frequent use of barter exchange and trade credit provided alternative access to funding which limited the impact of output losses in the real economyxiv. TABLE 2: COMPARATIVELY LOW COSTS OF FINANCIAL CRISES Country Crisis Period Fiscal Outlay Output Loss Output Loss (% GDP) (IMF) (Barro) Czech Republic 1989-91 12.0 0.0 Hungary 1991-95 10.0 14.0 36.4 Poland 1992-95 3.5 0.0 0.1 Slovenia 1992-94 14.6 0.0 6.2 Russia Fitch Ratings 2004 stress 5.0 - - test on basis of 1998 scenario Turkey 2000-1 26.6 0.0 12.9 Japan 1991- 24.0 48.0 4.5 Mexico 1994-2000 19.3 10.0 14.5 Indonesia 1997- 2002 55.0 39.0 35.0 Thailand 1997-2002 34.8 40.0 26.7 South Korea 1997-2002 28.0 17.0 10.0 Source: Claessens, Klingebiel, Laeven (2004), Fitch Ratings (2004) and own calculations Some important lessons can be drawn from the general crisis experience in the transition countries: The transition from a centrally planned to a market-oriented economy invariably led to financial crises for the reasons explained in this section, including the legacy of a bad credit portfolios, distorted incentives, lack of banking skills, monetary overhang, etc.. Financial institutions are key elements of the xiii See Peachey and Roe (2001) xiv In the case of Russia, observers even argue that the financial crises promoted output growth, because banks reacted by re-allocating credit from government bonds to the private sector and thereby enhancing available funding for investment and growth. See, for example, Huang, Marin and Xu (2004) or Peachey and Roe (2001). 11 organization of an economy, and their modus operandi and the incentives under which they operate, particularly the presence or lack thereof of hard budget constraints, are intrinsically linked to the structure of the economic system as a whole. An economic transformation of such magnitude and speed made very difficult to address and sequence the issues arising from the interrelationship of public ownership of banks and enterprises, the lack of experience of banks and supervisors, the absence of informational capital to screen borrowers, as well as the lack of an enabling legal framework. The experience of the Central European and Baltic states demonstrates that painful restructuring and the acceptance of failure of banks at the early stages of economic transformation allowed a relatively less costly “creative destruction”, because financial systems were typically smaller and the cost of almost inevitable crises were lower. Simultaneously, early intervention provides more lead time for the development of sustainable financial intermediation as a driver of economic change. Delaying adjustment generally increased costs and required future stronger responses. Probably Hungary was the country that best managed the transition, also reflecting a better starting point in view of reforms adopted under the socialist model. Non- or incomplete reformers (Russia and Ukraine) still are saddled with rather dysfunctional financial systems with “hidden” insolvent banks. The various resolution models adopted confirmed that multiple waves of recapitalizations and purchases on NPL are very detrimental and only contribute to increase the cost of crises, indicating, de facto, the willingness to provide continuous bailouts, a form of soft budget constraint. Granting licenses for new private financial institutions is not enough to transform and make more competitive the financial sector. A successful approach to transformation needs to actively manage the restructuring of existing institutions, including privatization of SOBs and allow only the entry of first rate foreign banks bringing financial, reputational and human capital. 12 Supervisory enforcement capacity, beyond laws and regulation,xv and political backing are critical to enforce and promote the right incentives for the development of sustainable prudential behavior in the financial system. Company privatizations, with clear ownership rights and tough bankruptcy systems (Hungary), brought stakeholders with well aligned incentives to strive for efficiency in a context of financial accountability. Overall banks‟ initial contribution to corporate restructuring, maybe with the exception of Poland, was very limited, as well as their contribution to real sector development since they did not increase by much their lending to the private sector as percentage of GDP,xvi nor extended long-term finance. Notice that none of the countries developed well functioning and liquid capital markets. Last but not least, monetary and fiscal discipline was crucial to create an environment conducive to successful financial transitions. The entry of foreign banks could be seen as the importation of one additional tool for the enforcement of economy-wide hard budget constraints. Financial Sector Development in the ECA region today Today, countries in the ECA region vary substantially in terms of economic and financial sector development. It is obvious that the region has become increasingly heterogeneous. While the perception of ECA is often dominated by middle-income countries like Russia, Turkey, Poland, Slovenia and the other new member of the European Union, it also includes a host of low-income countries, in particular in Central Asia and South East Europe, as well as enormous regional differences (particularly in Russia). It is impossible to look at financial sector development in ECA without making clear distinctions between different groups. However, there are also some important commonalities. xv See McDermott (2004) for an analysis of the politics of supervisory reform in Hungary, Poland and the Czech Republic. xvi Some countries have experienced rapid Growth of domestic real credit during 1998- 2002, particularly Bulgaria, Estonia and Latvia. See Cottarelli et. al. (2005). . 13 Output Most transition countries suffered substantial output losses in the early stages of transition,xvii and the weakness of the real sector put substantial pressure on the financial systems. Many countries have only managed to recoup real output losses in the past couple of years, but the current favorable environment forms a good basis for sustained growth of financial sectors across the region. Structure of Financial System The legacy of state planning and limited capital ownership by individuals is mirrored in the structure of the financial systems in ECA today. The systems are bank dominated and the development of capital markets and non-bank financial institutions (NBFI) is one of the remaining key challenges in today‟s financial systems. Even in the most advanced financial systems in the region, banks account for almost the entire set of assets in the sector. In the EU8, significant increases in the number of NBFIs and relatively more dynamic growth in this sector have not translated into a significant increase in their share of total financial assets. A recent World Bank study on the EU8 states points that: “Most EU8 countries have initially focused on stabilizing and developing their banking systems, with stock market development to date largely a by-product of privatization, and pension and insurance systems as well as other non-bank financial institutions remaining small and underdeveloped. As the EU8 xvii Transition (2002). 14 enter the EU, they are well placed to reap the benefits of financial system deepening and widening in the years ahead, provided they follow financial sector policies that are conducive to the further development of both bank and non-bank forms of financial intermediation.”xviii On the other hand, in a number of countries, namely Russia, Turkey and Poland, equity markets have grown substantially. Equity market capitalization as percentage of GDP across the region as a whole has displayed a more dynamic growth trend than bank credit, accounting for over 20 percent of GDP in 2003, almost the same share of bank credit to the private sector. However, this stage of development largely reflects the situation in some of the larger ECA countries and cannot be taken as a general indication of general access to finance through stock markets in the region. Turkey and Russia drive the volatile growth of stock market valuations, while stock markets in many other ECA countries display a much less dynamic, but also less volatile growth path. 15 Financial Depth One of the most prominent and persistent features of financial systems in the region is the low level of financial depth resulting from the limited role that financial intermediation played in the pre-1989 period. Financial depth is generally very low compared to more advanced countries, where deposits as a percentage of GDP usually are significantly above 70 percent. On average, CEE countries like Hungary, Poland and the Czech Republic started with much higher levels of financial depth (around 50%-60%) and generally kept those levels, but have not managed to deepen financial intermediation significantly since then. Slovenia and Croatia display significant growth in line with growing public confidence in the banking system. The economies of Russia and Turkey remain constrained by low levels of financial depth. In both countries trust in the safety of banks and crowding out by the public sector are significant issues. Private sector access to finance. In ECA only a few countries have reached the point where their financial institutions effectively fulfill their important role as financial intermediaries collecting deposits and allocating funds to the private sector. Many banking systems are not only too small when compared to the size of their economies, but also fail to intermediate funds 16 efficiently to fund the private sector. In many of the ECA countries, banks still collect deposits for on-lending to the government. Average private sector credit in the region — just below 25% of GDP — is insufficient to provide the funds needed to grow economic activity. Generally, the provision of private sector credit is improvingxix, but the growth rates are not sufficient to leverage pronounced output growth, and access to finance for productive use in the private sector remains a key bottleneck in the region. This is confirmed by firm-level survey data: Companies are still heavily reliant on internally-generated funds to finance new investments. The survey results indicate that in Russia, Turkey and many former CIS countries more than 70 percent of new investments are financed out of internal funds. Companies in the accession countries in general profit from the more advanced financial sectors, with internal funds financing 40-55% of investments, while FDI and cross-border borrowing grow in importance. Against the background of these general themes of financial sector development in the region, one can differentiate a number of distinct country experiences across the region: New EU member states and accession candidates. The eight ECA countries that joined the European Union in 2004 (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic and Slovenia) clearly outperformed their other transition country peers in restructuring their financial systems, stabilizing the macroeconomic environment and implementing sound supervisory regimes. The prospect of EU accession provided necessary political capital and substantial technical and financial assistance for reforming institutions. xix Slovakia and the Czech Republic registered a marked decline in the measurement of private sector credit / GDP, which is largely a result of the delayed removal of substantive amounts of non-performing loans from the balance sheets of the banks, which stem from the pre-transition period and were not replaced by new lending to the private sector. 17 Subsequently, the countries attracted foreign capital and promoted market entry of foreign banks and financial institutions, which contributed substantially to enhance institutional capacity and strengthening of financial intermediation. However, the depth and scope of financial sector development remains significantly below the more developed EU and other OECD countries. The remaining accession candidates, in particular Romania and Bulgaria, started from a lower level and have experienced dramatic crises and still are faced with a challenging restructuring and privatization agenda in the banking and corporate sectors, as well as low depth and access of the population to banking services.xx Russia. has benefited greatly from a favorable macroeconomic environment in recent years with fiscal and monetary discipline and a huge commodity boom. However, its small and fragmented banking system is the Achilles‟ heel for the development and diversification of its private sector. Russia — and to a lesser extent Ukraine — displayed a unique pattern of quick economic recovery from the financial crisis in 1998. Yet, the banking sector did not develop accordingly, and reform efforts have seen limited in success. The banking system is still dominated by a few state banks that hold a substantial and growing share of household deposits and assets, while the rest of the banking system consists of a vast number of small banks. Out of roughly 1500 banks, only 220 banks have capital of more than USD 10 million and 490 banks have a capitalization level below US$ 1 million. The Russian financial system continues to suffer from a lack of confidence, insider lending, opaque ownership, and the potential for self- fulfilling bank runs. Supervision has made progress, but still it has a long way to go, particularly in getting the autonomy and political support to impartially enforce all the regulations, promote the orderly exit of insolvent banks and promote further consolidation. There might be also problems in the sequencing of the reforms, as a deposit insurance regime was adopted prior to having an efficient bank resolution regime. xx Bulgaria experienced a late (1996-97) and severe banking crisis. A currency board was adopted in 1997 to impose monetary discipline after reaching a rate of inflation of 300 percent in 1996. Lending to non- financial enterprises as a share of GDP reached only 14 percent in 2001. Only one in three Bulgarians have a bank account (Hackethal et al., 2003). 18 Turkey. Following the 2000/1 crisis and successful financial stabilization, profit opportunities shifted, and banks are began to aggressively pursue retail banking opportunities, including a vibrant credit card market and a rapidly growing consumer loan portfolio. Still, however, credit to the private sector remains below 20 percent of GDP. The state maintains a heavy presence in the banking sector, with almost one third of banking sector assets held by three public banks. All three are scheduled to be privatized, but it is likely to take several years before the privatization process is completexxi. The prudential framework has been considerably improved since the crisis, and a new banking law will lay the foundation for a modern risk-based supervision framework. Central Asia and the Caucasus While most of the countries in the Caucasus and Central Asian Region (Armenia, Azerbaijan, Georgia, Kyrgyz Republic, Tajikistan, Uzbekistan, Turkmenistan) display different levels of financial sector development, they are all characterized by being trapped in a “low level equilibrium”, consisting of low levels of monetization and high levels of cash transactions, large informal economies, and low demand for loans resulting from widespread enterprise distress and very high real interest rates. Financial intermediation remains low even by regional standards, and financial sector reform is stuck at a much less advanced stage of transition compared to the EU accession states or Kazakhstan. The banking systems suffer from underdeveloped regulatory and legal systems and the failure to resist political pressures to make imprudent loans. Kazakhstan stands out from other countries in the CA region, having adopted sound reforms early. However, the banking system is still highly concentrated, possibly with limited competition, significant insider lending, and lack of transparency in terms of ultimate shareholder control over the banks. South Eastern Europe The financial sector development experience in South Eastern Europe is very heterogeneous. While Slovenia is now an EU member country, Serbia and Montenegro, Bosnia and to a lesser extent Croatia experienced significant delays in financial sector reforms in the wake of the civil conflict of the 1990s. In the medium term, these countries are expected to benefit xxi The Government is planning on privatization through an public offering process in several steps 19 from their likely membership of the EU and entry of major European banks. However, their regulatory regimes and legal frameworks still require substantial reforms and strengthening. Financial systems in Macedonia and Albania are shallow and display characteristics similar to the CA countries, including poor governance and underdeveloped regulatory oversight. Crisis experiences in ECA The following three case examples look at three very different crises. Hungary and Poland in the early 1990s represent typical cases of “transition crises” with high NPLs and a history of inadequate lending practices inherited from the state-planned economy at the heart of the earlier crises. At the time of the Russian crisis in 1998, Russia‟s banking system also suffered from the legacy of its state-planned economy, however, the actual crisis was triggered by a fiscal default and many banks collapsed because of their exposure to government securities and currency risk. Turkey did not face the economic upheaval of transition and needs to be differentiated from the rest of the countries discussed in this paper. The Turkish crisis in 2000/1 was a typical twin crisis, with macroeconomic pressures driven by high government short-term borrowing, loss of confidence, and a currency crisis transmitted to an already weakened banking system. Hungary and Poland — Foreign banks to the rescue Hungary and Poland both experienced substantial financial crises in the early 1990s. The crises were largely the result of the historic malfunction of the banking system under state planning. In contrast to other transition countries, both countries, but in particular Poland, proceeded quickly to restructure and privatize their state banks, and the governments faced the unpleasant realities right at the start. The early privatization efforts gave immediate visibility to the underlying problems, and the weaknesses of the financial system could not be ignored by absorption through budget support and forbearance. The Hungarian experience illustrates the need for banking sector reform to tackle existing non-performing assets and institutions and simultaneously improve supervision and risk- 20 management to avoid a repetition of the same problemxxii. Following early progressive reforms, the weak financial situation of most Hungarian state banks became a priority for the government. A large portion of the loan portfolios was non-performing, and some of the largest state banks were considered insolvent. The scope of the problem transpired only with the introduction of new accounting standards and a new banking law, which - combined with a possibly over-strict bankruptcy law — revealed the significantly weakened position of the banks, which previously had been hidden within the “fiscal cocoon.” The Hungarian government decided to recapitalize the state banks, hoping that the capital injection and franchise value would allow successful privatization attracting foreign investors. Due primarily to subsequent requirements to reevaluate the deteriorating asset quality in the state bank‟s loan portfolios, the Hungarian government had to initiate a series of recapitalizations, causing significant moral hazard. However, it was ultimately able to attract strategic foreign investors and signal credibly the end of bank bailouts. Today, four of Hungary‟s formerly SOBs are owned by foreign banks and are the core of a strong financial system. Only the privatization of Országos Takarékpénz tár és Kereskedel mi Bank (OTP) did not result in immediate foreign participation , as the government preferred, for political reasons, to limit foreign control over Hungary‟s largest bank. However, OTP has been transformed into a successful bank, and it is a prime example of the positive xxii See Bonin and Wachtel (2002) 21 impact foreign competition can have on the performance of banks that remain domestically owned. Poland has been relatively successful in implementing an administratively driven restructuring process that was sensitive to market forcesxxiii. Three key contributing factors included: (i) the state‟s ability to create a credible commitment to banking sector and overall economic privatization at the outset of the reform period; (ii) Poland‟s firm intention to “rejoin” the West, bolstered by signing the Europe Agreement with the European Union in 1991 as a first step toward full EU accession; and (iii) active foreign bank involvement in the banking sector since the beginning of the reform period. Poland initiated banking sector reforms, as well as its overall economic reform program, in 1989. At that time, the Polish banking sector consisted of SOBs and 1,663 small local, mainly rural, cooperative banks affiliated with Bank Gospodarki Zywnosciowej (BGZ), one of the SOBs. Initially, the number of Polish banks increased significantly: nine new state- owned banks and 70 new Polish-owned banks opened during the next three years. Also, seven banks with majority foreign ownership opened in December 1989. However, most of the new banks were relatively small, and as of early 1993, SOBs continued to account for approximately 85 percent of total banking assets. After this initial period, when licensing requirements encouraged the entry of private banks to stimulate competition (without the adequate regulatory framework in place), the Polish government ventured to gradually restructure its state-owned banks prior to privatization. Poland‟s efforts to establish an independent banking sector by restructuring fell victim to inconsistent policies that switched from attracting a strategic foreign investor to attempting to arrange a large politically motivated bank merger, in which the three weakest of the commercial banks were merged with a state savings bank to form the largest financial group in Poland. However, the Polish banking sector entered a more successful second phase of restructuring in the late 1990s with a series of post-privatization consolidations. Foreign owners were instrumental in promoting post-privatization mergers as a means of expansion. Foreign-investor controlled banks now account for roughly 80 percent of xxiii See World Bank (2003) 22 banking sector capital and 70 percent of sector assets, with intense and lower but still attractive net interest margins. The experiences in Hungary and Poland illustrate that privatization of SOBs, especially through substantial foreign participation in the banking system, is an effective way of creating strong banking systems and resolving the fall-out of financial crises. With EU accession being a dominant political concern, both countries had stronger political capital to reform their banking sectors and foster acceptance of foreign bank ownership. Russia — 1998 crisis a missed opportunity? Following a period of high volatility in the Russian financial markets in the wake of the Asian crises and an earlier liquidity crisis in 1995, the Russian Government suspended its payments on short-term domestic debt in August 1998. Ensuing departures of foreign portfolio capital caused a collapse of the bond marked, a sharp depreciation of the ruble, drying up foreign funding, of which some Russian banks had become more and more reliant upon. At the time of the crisis, most private sector banks were carrying significant portfolios of government debt funded by deposits. S&P estimates that Russian banks had about 100 percent of their equity invested in government securities.xxiv The depreciation of security positions and the sensitivity to ruble depreciation — caused by sizable open foreign exchange positions — caused the failure of a significant number of larger and small private banks. The subsequent systemic liquidity crunch in the banking system caused the government to restrict deposit payments and suspend foreign debt service for a three month period. However, the government did not provide any support to private sector banks and let many of them fail. As a result of the crisis, the number of banks in the Russian banking system declined by 10 percent and 15 out of the 18 largest banks xxv became insolvent. However, the large SOBs — who collectively dominated the market — profited from implicit state guarantees and increased their share in deposits and assets even further. Sberbank, which is 100 percent state-owned, was seen as a safe haven by most depositors and following the crisis had 75 percent of all deposits in the Russian banking system. xxiv Standard and Poors (2003) xxv See Bonin and Wachtel (2002) 23 The Russian government‟s response to the crisis was constrained by the lack of clear rules and procedures and the absence of strong institutions with the capacity to intervene efficiently. The establishment of the Agency for Restructuring of Credit Organizations (ARCO) and some key legislative reforms only took place in 1999 as a late response to the crisis. The general bankruptcy law adopted in 1997 excluded banks, and the specific law dealing with bank insolvencies was only adopted in 1999. Hence, most bank failures resulting from the 1998 crisis were not covered from the provisions of this law. The lack of institutions and transparent rules of the game slowed down the restructuring of the banking system in the aftermath of the crisis. Many foreign investors and observers were very critical of the handling of the banking crisis. S&P commented in 2003: “The law on bankruptcies has not worked smoothly. The withdrawal of banking licenses is at the discretion of the Central Bank of Russia, which is not always objective. Central bank intervention and the effective resolution of the failures of large banks have been slow, and the bankruptcy process has generally favored restructuring over liquidation, to the detriment of creditors[…] ARCO was successful in restructuring several small regional banks, but was unable to cope with large problem banks, due to its limited financial, administrative and lobbying resources”. Trust in the Russian banking system has suffered due to the handling of the crisis, as well as from the poor track record and weak response of 1995. Lack of trust is a key determinant of the low level of financial depth of the Russian banking system, as evidenced again in 2004 when failures of a few smaller and one medium-sized Moscow banks caused volatility in the interbank market and increased withdrawals of retail deposits from privately-owned banks. The recent developments, however, also demonstrate the effect that a strong regulatory response mechanism has on the avoidance of crises. The prompt revoking of banking licenses a tighter supervisory regime, and a more skillful government‟s response is widely credited with the containment of a potentially more severe crisis. The introduction of a deposit insurance scheme in 2005 as a screening device, in theory to insure only the “best” banks, constitutes a promising measure to support confidence into the banking system, if it is implemented objectively without political pressures on the supervisors and it is complemented by continued improvement in the capacity of supervisory oversight and stronger enforcement actions. 24 The lackluster performance of the banking sector stands in sharp contrast to the good performance of the commodity boom-driven Russian economy. Such contrast makes the banking sector even more of a bottleneck for a wider-based and more sustainable economic recovery, while increasing the risk of capital flight and financial disintermediation. Figure 11 illustrates the very fast and strong recovery of output in the years following the crisis, which is atypical for crisis countries. The commodity boom (mainly much higher energy prices) and sound fiscal and monetary policies explains the rapid GDP rebound. However, Figure 11 also illustrates another driver of GDP growth: In response to the crisis, Russian banks shifted assets from government securities into private sector funding. Before the crisis, most banks collected deposits investing them in government bonds, earning a comfortable (and supposedly “risk free”) interest margin without incurring capital charges (since the risk weight for these assets is zero for calculating the banks‟ capital- asset ratio (CAR). Some estimates indicate that up to 75 percent of all Russian ruble deposits were invested in ruble government securities at the end of 1997xxvi. The pronounced price fall of short-term government securities that triggered the 1998 crisis caused many Russian banks to finally turn to the private sector for new lending opportunities. Uniquely, the Russian crisis was followed by a credit hike and not a credit crunch to the private sector. This unintended effect of the crisis has been credited by xxvi See Huang, Marin and Xu (2004) 25 some observers as a key variable in explaining the strong recovery and increase in output of the non-oil sector following the crisisxxvii. The Russian crisis illustrates the need for a strong institutional and legal framework (supported by political will) in order to deal with its fall-outs. In many ways the Russian crises represents a missed opportunity, as the banking sector took a step backward to a more state-dominated system rather than triggering further bank restructuring, consolidation and foreign bank entry. The aim of achieving short-term „stability‟ by relying on the state banks (and ultimately the budget) as anchors was achieved at a the expense of delayed banking system restructuring without increasing the public‟s trust in the system as the basis for increasing financial depth. Turkey — Third-Generation Financial Crises The Turkish banking crisis was a result of external vulnerability, weak fiscal sustainability, and high-risk exposures in a weakly capitalized banking system. On the macroeconomic front, vulnerabilities accumulated and fiscal consolidation lagged. The latter was partially mitigated by privatizations, but these did not provide a sustainable solution to the structural fiscal problems. At that point, the anti-inflation program used the exchange rate as a nominal anchor, resulting in a real appreciation of the Turkish lira and a loss of competitiveness, leading to an increasing current account deficit. Foreign investors were increasingly concerned about the sustainability of Turkey‟s economic program and chose to invest in shorter term assets with two implications: (i) the current account deficit was increasingly being financed with short-term inflows, and (ii) the yield curve became steeper with higher interest rates for longer maturities. xxvii See Huang, Marin and Xu (2004) 26 Turkish banks also used the large portfolio of tradable government securities on their balance sheets to speculate heavily in foreign exchange and money markets. Several smaller banks increasingly resorted to securities trading to remain profitable. In particular, betting on the success of the anti-inflation program agreed with the IMF looked like a very profitable, albeit risky, strategy. If the program was successful, interest rates would come down, and it would be profitable to invest in longer term assets. Several smaller banks did just that. They exposed themselves to interest rate risks by funding themselves in the collateralized repo market, purchasing government bonds and treasury bills with longer maturities. Such directional bets with highly leveraged positions allowed them to create portfolios with very long durations, i.e. very high-risk exposures to an increase in interest rates. In addition, the banks exposed themselves to exchange rate risk by taking short positions in foreign currency. This was very easy to do, since a sizable share of the banks deposits were denominated in foreign currency. The currency came under increasing pressure ending with a sharp depreciation of almost 40 percent in late February of 2001, with most Turkish banks incurring very large losses. The real sector was also strongly affected by the steep increase in real interest rates and the sharp currency depreciation. These currency and interest rate risks materialized as credit risk for the banks facing sharply rising NPLs. The government responded to the crisis by issuing a blanket guarantee on deposits and taking over a large number of banks. Before the crisis, a number of smaller banks had already been taken over. Three large deposit-taking state banks were an important part of the restructuring process, but their losses were less related to speculation and more related to poor lending practices. Very large losses had accumulated due to directed lending at below-market rates, for which the Government did not compensate the SOBs. From November 1997 to 2001, the government intervened a total of 20 banks. The total estimated fiscal cost related to the liquidation and restructuring of banks was as high as 26.6 percent of GDP, comparable to some of the worst crisis in Latinamerica (i.e.; the cost of Mexico‟s 1994-95 crisis is estimated to have been about 20 percent of GDP). 27 Table 3: Turkey Fiscal Cost of Bank Restructuring Source Bill US$ % of GDP SDIF (Deposit Insurance Fund) 17.3 11.7 State banks 21.9 14.8 Banks total 39.3 26.6 Private sector 7.9 5.3 Total 47.2 31.9 Source: BRSA. Banking sector restructuring costs were mainly related to the recapitalization of the SOBs and not directly to the crisis. The losses in the SOBs accrued over time and were not properly accounted for, but they became evident as the government was forced to recapitalize the banks in order to create confidence in the banking system in response to the crisis. In addition to the direct resolution cost of the financial sector, real sector companies were restructured under the so-called Istanbul approach to debt work-outs sponsored by the government at a cost of 5.3 percent of GDP. The approach used fiscal incentives to restructure debt. Table 4: Net Cost of Restructuring Billion US$ Actual outlays 21.8 Interests 18.0 Total 39.8 Realized collections 1.8 Expected collections 4.6 Net cost of the SDIF (Deposit Guarantee Fund) 33.4 Source: The World Bank. Note: Not including Imar Bank that failed in 2003 due to fraud. Interestingly, most of the recouped outlays are from the majority shareholders. The deposit insurance fund has been quite successful in getting agreements from the 28 shareholders, while collections on the receivables only make up 16 percent of the expected collection in NPV terms. Table 5: Assets Resolution by Source In net present value terms Bill. US$ Share/Percent Collections from majority share holders 3.2 52.7 Other corporate/individual receivables 1.0 16.0 Sales of companies activities 1.3 21.4 Sales of subsidiaries/real estate 0.6 9.9 Total 6.1 100.0 While the fiscal implications of the crisis were certainly severe, a substantial portion of the expenses were related to the recognition of accrued losses in the state banks. Restructuring of the private banks came with a substantial price tag of 12 percent of GDP, but the resolution of the banks also helped the speedy macroeconomic recovery following the crisisxxviii. The crisis experience also highlights the severe risks of the combination of external vulnerability, poor fiscal discipline and a poorly capitalized and poorly supervised banking sector. Turkey's experience provides some key lessons that have been prevalent in financial crisis throughout emerging markets. First, market risk exposures in the banks were excessive and should have been monitored and addressed by the Supervisor. Second, weak capitalization of the banking system left the Government with a large part of the losses incurred by the crisis. Supervisors should ensure adequate capitalization not only to limit fiscal costs in the case of a crisis, but also to ensure the integrity of the financial system. Third, the combination of a weak fiscal and external position and the ambitious economic program left Turkey exposed to international investors' confidence. It is a xxviii Turkey grew by 7.5 percent on average for the period 2001-2004. 29 risky venture to reduce inflation and maintaining a pegged nominal exchange rate with high Government debt, high external debt, a vulnerable current account and a weak fiscal position. Sustaining the program becomes contingent on the Governments ability to maintain the international investors' trust in the success of the program Some Concluding Remarks Reflecting on Current Issues Some authors have argued that crises can bring beneficial consequences, claiming “that many inefficiencies in prevailing institutions arise to serve organized special interests, and the entrenched political power of these groups prevent reforms that would be beneficial in the aggregate. Crises weaken or dissolve these special interests, and allow a fresh start.”xxix These “useful crises” did indeed happen in some countries in the Europe and Central Asia region, but there were also “indecisive or useless crises” which did not result in a serious revamping of the banking system and the hoped for start of depth- enhancing reforms. Even in cases where crises “opportunities” were not well used some benefits resulted from loosening the tight grip of governments in the capture of loanable funds (i.e. Russia). After all the turmoil of the transition, ECC countries ended up with rather similar bank- centric financial systems. Going forward there are still unfinished tasks which include the following: Broadly defined institutional development remains the main challenge (again with various degrees of severity), specifically in the area of banking supervision. The CEE countries have made remarkable progress in developing all the institutions and capabilities for a market economy, with the incentives generated by the accession process and complying with the EU‟s Acquis. Other countries like Turkey are also making considerable progress after the severe financial crisis of the late 1990s. Nonetheless, as indicators of the limited degree of compliance with the Basle Core xxix Dixit (2005), page 19. 30 Principles show, there are still many areas where further progress is required. In our view, there are four key areas where there is significant scope for making progress: o Consolidated supervision, granting adequate powers to supervisors to investigate the composition and cross-shareholdings inside of financial, non- financial, and mix complex conglomerates; o Autonomy, funding, and adequate remuneration and staffing of supervisory agencies, and legal protection for bank supervisors; o Better risk management systems in financial institutions, while supervisors move to risk-based supervision. In view of the EU decision to adopt Basle II within the proposed timetable, the challenges are going to be more pressing for the EU subset of countries, but all ECA countries are well advised to prepare realistic “road maps” to transition to better risk- management systems. o Contingency plans, including adequate legislative frameworks and institutional capacity, which should be in place to respond effectively to, hopefully, less frequent and less severe, banking crises. Several countries are migrating to a single, consolidated supervisory agency model a la FSA of the U. K.. In our view, the focus should continue to be efficiently discharging of regulatory and supervisory tasks. Merging agencies with different cultures and interests (supervision and promotion of, for example, capital markets) are difficult tasks which require years for implementation and resolution of potential conflicts of interest. The development of financial intermediation is not an end in itself, but financial institutions and markets play an important role in promoting a better allocation of resources in the economy — including facilitating access to under-served segments, particularly SMEs — hopefully leading to faster sustainable growth and poverty reduction. Against such a high benchmark, countries still have a long way to go in the development of financial intermediaries, markets and institutional capabilities. In general, and in spite of tremendous recent progress, indicators of financial intermediation remain low in a broader international perspective. 31 BIBLIOGRAPHY Marie-Renee Bakker and Alexandra Gross, “Development of Non-Bank Financial Institutions and Capital Markets in European Union Accession Countries”, World Bank Working Paper No. 28, The World Bank, 2004 ,Washington, D.C. 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