The transformation of a socialist banking system is very difficult. Banks in centrally planned economies were primarily bookkeepers for the planned allocation of resources. Credits were allocated to enterprises on the basis of planned investment priorities and repayment was subject to bargaining, and was sometimes simply forgiven.
The socialist banking system was highly concentrated, with little separation of central banking and commercial activities. Some banks specialised by activity in industry, agriculture, foreign trade and household savings.
Most transition economies have followed a similar pattern: the separation of commercial banks from the central bank; the abolition of restrictions on the internal convertibility of money; the liberalisation of interest rates; and the restructuring and privatisation of state banks and licensing of private banks.
The state was responsible for the regulation and supervision of banks. Governments had to adopt new banking laws and regulations, and enforce them through the courts.
Although the pace of banking system transformation differed among post-communist counties, common characteristics can be observed. First, all instituted liberal policies for licensing banks, which led to the creation of many undercapitalised banks. Some regulations allowed banks to be founded using capital borrowed from other banks. Many banks were founded by companies wanting faster and cheaper access to credit than was available from existing credit institutions.
Growth in bank deposits was driven by a lack of alternatives for saving, especially since the equity and bond markets in the post-communist countries were in their initial stages of development.
Second, management at newly incorporated banks had little experience or understanding of banking activities. At the same time, customers of the new banks were mainly new companies, which had little in the way of credit histories. Managers of these companies travelled between banks to convince loan officers of their business plans in the hope of receiving loans. Meanwhile, large state-owned companies saw their financial situations deteriorate and some stood on the brink of bankruptcy.
Third, a general conviction existed among policymakers that an environment conducive to the growth of banks needed to be in place – one that would increase competition among banks, lower interest rates on loans and simultaneously hasten the development of the private sector in the economy.
As a result of the 1991 collapse of the the Council for Mutual Economic Assistance (Comecon) – an Eastern Bloc equivalent to the EU – all of the post-communist countries experienced recessions at the beginning of the economic transformation. Due to the elimination of price controls, many countries experienced high inflation and, in some cases, hyperinflation.
This led to an increase in delinquent loans, whose collection was hindered by a lack of legal regulations on loan collateral. Most banks had very liberal policies for granting loans, which contributed to the accumulation of losses.
Profits obsession
Banking systems developed rapidly, which, in the initial stages of the transformation, coincided with a lack of banking regulation. In the early stages of the banking transformation, management typically put pressure on loan officers to attain the highest possible profits, which led to excessive risk-taking when granting loans.
This behaviour stemmed from the fact that banking supervision was weak or non-existent. Bank supervision agencies were only beginning to be formed and lacked the necessary tools, such as sanctions that could be placed on banks.
Estonia, in 1992, was the first country to experience a serious crisis in its commercial banking sector. Bulgaria, Lithuania and Latvia followed in 1995, the Czech Republic in 1997 and Russia in 1998.
The loan portfolios of Russian banks deteriorated on two fronts: rising interest rates led to a sharp increase in the number of rouble-denominated problem loans while the large devaluation of the rouble hurt borrowers holding loans denominated in foreign currencies.
As a result, many banks lost financial liquidity and several stopped redeeming deposits. Due to liquidity problems, many banks were unable to extend new loans and the payments system in the country essentially collapsed – payments were held up and interbank settlements were halted. Depositors withdrew their money in runs on banks, which led to further decreases in banking assets. As a result, equity trade was suspended and transactions in the financial and currency markets nearly ground to a halt.
Therefore, there are two distinct periods in the development of the banking sectors in the post-communist countries. In the first half of the 1990s, problems for banks grew, as did the foundations for financial crisis. In the second half of the decade, policies were adopted to root out the causes of financial crisis.
These precautionary measures differed widely among countries in terms of pace, scope and form. The banking crises, and their resulting impact on real economies, led to the introduction of modern systems of insuring deposits and of effective banking supervision.
Completing privatisation is one of the main priorities in the financial sector in transition countries. Privatisation is usually a necessary component of a successful bank restructuring programme and “diminishes the scope of distortion in the form of directed policy lending or moral hazard in the form of reliance on future government support”, according to James Barth, Gerald Caprio and Ross Levine in a paper entitled Banking systems around the globe: do regulation and ownership affect performance and stability?
Most domestic banks have been privatised with foreign strategic investors. Foreign investors encourage innovation, competition, bring strong corporate governance, and more sophisticated risk management systems. The entrance of foreign banks has significantly increased the standards and efficiency of the banking systems of transition countries.
Foreign strategic partners have been able and willing to provide not only much needed additional capital and management skills but also product development and innovative modernisation of risk management skills and treasury operations, internal audit and control and information technology.
Playing catch-up
Notwithstanding the significant progress made in banking sector development in transition countries in the past 15 years, the financial sector still lacks the depth and breadth of that of the eurozone. No country’s system has yet progressed to the point that it can be described as possessing a mature, fully functioning, market-oriented and efficient banking sector.
The degree of financial intermediation by the banking sector in transition countries is still relatively low. Although, there is some variation between countries, the level of bank intermediation, measured by the ratio of domestic credit to GDP, is lower in all accession countries when compared with eurozone members. The low level is explained by the lack of long-term funding as well as the lack of banking capabilities and weak enforcement of the legal framework for creditor protection.
The liquidity ratios of the banking sector in transition countries are worse compared with those of the eurozone. Although the banking sector in transition countries is highly concentrated with a few large banks dominating the market, further consolidation among fringe competitors consisting of small, weak and inefficient banks is expected.
In May 2004 eight European transition countries joined the EU. Bulgaria and Romania hope to become members in 2007. Financial integration with the 15 EU countries has increased the supply of finance for new members. The competitive pressure has led to a more efficient financial market with better credit conditions for firms and households. Financial integrity requires an improvement in the regulation and supervision of the national financial market. Issues such as banking suspensions, corporate governance, accounting standards and auditing procedures need to be brought into line with best practices in the integrating area.
EU accession has contributed to a better perception of banks in these countries. Their banking sectors had become unstable, with growing resistance to economic change. Accession resulted in the banks being forced to react to EU competition. Accession should also result in the further improvement of banks’ finances, profitability and efficiency due to the acceleration of economic development and expected rise in loan demand. The relatively low relation of banking assets to GDP shows great potential for further expansion.
Therefore, the past 15 years have witnessed enormous change for banks in the former communist countries. These financial institutions have become modern competitive banks, very similar to those functioning in developed economies.
Hanna Gronkiewicz-Waltz is a professor at Warsaw University, a former president of the National Bank of Poland and a former vice-president of the European Bank for Reconstruction and Development.
