Assessing the Post-Crisis Recove

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       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


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