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Banking Reform in Transition Economies

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1995
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COUNTRIES making the transition to a market economy have pursued a variety of approaches to banking reform. To become globally competitive, however, transition economies will need to accelerate bank privatization and the reform of bank management and governance.

The former centrally planned economies of Central and Eastern Europe, and the Baltic countries, Russia, and the other countries of the former Soviet Union (BRO) face a formidable challenge: their banks, traditionally passive conduits for funds, must be transformed into efficient financial intermediaries and active agents of market discipline. Despite progress, weaknesses persist in many transition economies’ banks because of the unsatisfactory pace at which market discipline is being introduced. The absence of sound banking systems has hindered the development of nonbank financial markets, private sector investment, and the conduct of monetary policy.

To correct structural weaknesses in their banking systems, transition economies have financially restructured banks, improved enabling environments, and reorganized banking sectors through consolidation and privatization. Significant systemic risk remains, however, because of excessive exposure to weak enterprises and unsound management and governance. Most transition countries have made progress toward market-based banking systems, but none has succeeded in fully meeting the needs of the emerging private sector. There is evidence that, unless banking reforms accelerate, companies will find it difficult to obtain adequate and affordable working and investment capital, as well as noncredit services of high quality.

To restore bank liquidity and solvency and meet the private sector’s financing needs, transition countries need to develop banking sectors that operate on commercial principles in a competitive environment and that have strong management and internal supervision. To increase competition and improve service, governments need to open markets to foreign banks and allow the most competitive domestic banks to expand their locations and operations. The success of banking reforms will also require the curtailment of funds for loss-making banks and enterprises, the acceleration of bank and enterprise privatization, an improved legal and regulatory framework, and efficient payment systems.

Different approaches

Central and Eastern European countries recapitalized state banks out of the belief that removing old loans from bank balance sheets would restore solvency and allow state banks to compete with private banks. Some progress has been made, but most state banks are still not efficient. The BRO countries have taken a different approach. These countries privatized branches of the monobank system without recapitalizing. Hyperinflation erased the nominal value of old, nonperforming loans—a de facto financial restructuring of the banks’ balance sheets. However, as in Central and Eastern Europe, management and governance practices have not fully adapted to competitive markets. Although privately owned, many BRO banks operate according to uncompetitive or monopolistic principles. The performance of banks in the Baltic countries has been mixed: Estonia has made progress by applying hard budget constraints on loss-making enterprises, while Latvia’s banking system is in disarray because of excessive risk-taking and unsound trade-financing practices.

Recapitalization. Recapitalization of state banks (see box) in Central and Eastern Europe bought time for restructuring. Without a radical overhaul of policies, procedures, practices, and incentives, however, bank performance has remained poor, and state banks have made demands for additional capital at high fiscal cost. The cost of four recapitalizations in Hungary, for example, has been $3.2 billion—equivalent to 7.5 percent of Hungary’s GDP in 1994.

Carve-outs have been the most common form of recapitalization: governments have issued bonds to replace nonperforming loans made before a cutoff date, restoring bank solvency. Banks have been held responsible for loan collection and loss-provisioning on non-performing loans made after the cutoff date. While loss-provisioning practices have improved, nonperforming loans continue to be a problem, partly because of inadequate credit policies and poor risk management.

Restructuring bad loans. Countries have pursued a variety of bank-led approaches to deal with nonperforming loans. In the past, bad loans were rolled over. State guarantees were meant to support banks if enterprises failed to repay their rolled-over debt. But guarantee coverage was never clearly specified, and many state banks in Central and Eastern Europe face a major write-down of asset values unless agreement is reached with outside creditors and former trading partners.

Four countries have established bank restructuring agencies, which can clean up loan portfolios and restructure bank management and operations in advance of privatization. However, shallow markets and a scarcity of experienced staff have been the main impediments to broader use of such agencies. Slovenia has moved to restructure banks with capital-adequacy ratios below 4 percent, starting with its three largest banks. Ownership ties between enterprises and banks have been cut, and the restructuring agency has led loan recovery by supervising bank workout units and applying pressure on debtor enterprises to repay loans. Croatia is developing rehabilitation plans for at least four troubled banks that hold 25 percent of the book-valued assets of the banking sector. The bank restructuring agency of the former Yugoslav Republic of Macedonia has the power to issue bonds to recapitalize troubled banks once needed writeoffs have been determined, and to prepare restructuring plans for bank privatization. The process terminates ownership of banks by public enterprises. Bulgaria has concentrated on consolidating the banking system before privatization.

Some banks have established workout units to recover problem loans. Workout units can be useful in restructuring loan portfolios, particularly when accompanied by privatization programs for the enterprises to which the loans were made. However, portfolio problems often exceed banks’ capacity to restructure loans. Workouts are also undermined by weak legal and regulatory frameworks for loan recovery (courts, collateral legislation, property registries), insufficiently developed market mechanisms for effecting loan repayment from secured credits (valuation, repossession, liquidation, sale), and local pressures on banks to roll over loans or forgo repayment.

Bulgaria is supporting workout units to collect $1.6 billion in loans to state enterprises (usually the banks’ owners) made since 1991. Hungary has subsidized workout units to encourage banks to restructure loans to state enterprises. Poland has used workout units and out-of-court procedures to restructure nearly $1 billion in nonperforming loans. The experience of Poland and Slovenia shows that workout units can be effective when used to restructure problem loans, achieve specified capital-adequacy targets, and move banks toward privatization.

An alternative to workout units is the good bank-bad bank approach of the Czech and Slovak Republics. The Consolidation Bank, set up by the former Czech and Slovak Federal Republic to recover nonperforming loans held by the largest state banks, is one of the “bad banks”—loan collection agencies established to wind down the bad operations of state banks to allow them to become “good banks.” This approach is feasible when governments are committed to fiscal prudence, rapid bank privatization, and changes in bank management and governance. The Czech and Slovak Republics have shown their commitment to fiscal prudence and (partial) privatization. However, serious concerns remain regarding management and governance practices and the magnitude of bank operational restructuring still needed.

Some banks have used debt-equity swaps to write down loan values. Banks end up owning shares in enterprises and gaining direct control or supervisory authority over enterprise management. The downside is increased exposure to risky investments and diversion of resources from core bank business. Croatia allows banks to exchange nonperforming loans for equity after first writing down the loans; such swaps accounted for nearly 8 percent of the banking system’s assets at the end of 1994, up from 3 percent at the end of 1993. Poland encourages the exchange of equity for nonperforming loans through out-of-court resolution of disputes; about 50 of 200 resolution agreements have involved debt-equity swaps.

It is too early to tell if banks are delaying write-offs or taking on too much risk through swaps, particularly in the absence of enterprise restructuring. As shares obtained through swaps increase as a percentage of total assets, bank supervisors will need to factor the associated risks into capital-adequacy ratios. To avoid putting deposits at risk, regulations could require banks to create separately capitalized subsidiaries to manage assets and equity obtained through swaps.

Loan sales and asset swaps are related options, although their use in transition economies is limited by the absence of interbank and secondary markets, including non-bank financial institutions specializing in discounted loan transactions. There is little demand for such instruments because banks are more concerned with ensuring liquidity and recovering nonperforming loans than with gambling on the future value of deeply discounted but low-quality assets.

Banking sector indicatorsSelected transition economies, 1993-94
AlbaniaBulgariaHungaryPolandSloveniaEstoniaLatviaKazakhstanRussia
Number of state banks311111033383
Number of private banks3233163271952150>2,000
Total assets (million dollars)1,00025,00033,00045,0006,5009001,9002,400122,000
State-owned commercial bank assets
(percentage of total assets)99907075-8553<5014>8030-35
Nonperforming loans
(percentage of total loans, estimated)505015<209>43327
Minimum capital requirement
(million dollars)1115>116351.83.61.50.1
M2/GDP (percentage)244695036312329346
Sources: IMF data, The World Bank Atlas 1995, internal World Bank reports, and World Bank staff estimates.

Requirements for commercial banks with full licenses. (Russia recently increased minimum capital requirements for new banks.)

Broad money supply as percentage of GDP.

Data not available.

Sources: IMF data, The World Bank Atlas 1995, internal World Bank reports, and World Bank staff estimates.

Requirements for commercial banks with full licenses. (Russia recently increased minimum capital requirements for new banks.)

Broad money supply as percentage of GDP.

Data not available.

Different approaches to bank recapitalization in selected transition countries

Albania planned to issue $72 million in bonds for loans made before mid-1992, when new banking legislation was introduced, but is holding back more than half this amount until a restructuring and privatization plan is in place for the country’s largest bank.

Although Latvia has recapitalized and Lithuania and Uzbekistan are exploring the possibility of limited recapitalization, banks in Russia and most BRO countries were privatized without recapitalization or operational restructuring. Hyperinflation and privatization of branches of the monobank system made recapitalization unnecessary and fiscally unattractive. Hyperinflation eroded the nominal value of earlier loans, benefiting borrowers. At the same time, bank balance sheets showed revalued loans or interest capitalization, artificially inflating the value of the loans. Once inflation slowed, enterprise and bank losses were exposed at higher nominal (and real) levels, shrinking bank balance sheets, making access to new credit more difficult, and devastating depositors’ savings.

Bulgaria is recapitalizing banks with $4.6 billion to cover nonperforming loans made before 1991, while requiring bank workout units to recover an additional $1.6 billion in loans made since 1991. It has consolidated the banking sector, and several small private banks have opened, but public ownership and control impede the emergence of a market-based commercial banking system. Bulgaria is expected to begin privatizing its six consolidated state-owned commercial banks in 1995.

Croatia issued $750 million in bonds to enterprises in 1991. These bonds were transferred to banks to replace nonperforming enterprise loans. In exchange, banks and enterprises were expected to operate on commercial principles to avoid the need for future recapitalizations. However, little was done to change the ownership, management, or governance of banks, which were essentially the captive finance companies of the state enterprises that owned them. The largest state banks need further recapitalization. New legislation requiring public enterprises to give up majority ownership of banks is intended to rectify the situation.

The former Czech and Slovak Federal Republic recapitalized the commercial banking system in 1991, injecting $5 billion. A Consolidation Bank was established to recover nonperforming loans, estimated at 20 percent of loans made before the collapse of communism. The recapitalization, though expensive, was handled in a fiscally responsible manner. Recapitalization was part of a multifaceted effort to improve the enabling environment for the financial sector, privatize banks, and maintain fiscal balance.

Hungary has recapitalized its large state banks four times since 1991 through guarantees and bonds exceeding $3 billion. Because Hungary has used these banks as a conduit for loans to large loss-making state enterprises, racking up large quasi-fiscal deficits, the recapitalizations have not been accompanied by needed reforms in bank ownership, management, and governance, and have been undermined by the lack of fiscal discipline and resistance to privatization and liquidation.

Poland recapitalized seven regional state banks for $750 million in 1993, raising capital to 12 percent of assets after provisioning for loan losses and accrued interest. Recapitalized banks had to undergo financial audits, isolate nonperforming loans in workout units, and submit plans for restructuring their loan portfolios to the Ministry of Finance for approval. At the same time, the Government introduced a plan for privatizing the recapitalized banks.

Romania is providing $300 million in recapitalization for nonperforming loans made to state enterprises through 1992. At the end of 1990, the Government issued guarantees for 90 percent of nonperforming loans and, at the end of 1991, for 90 percent of accumulated interenterprise arrears. Privatization is to be carried out in phases over seven years. Foreign investment in the banking sector is likely to increase competitiveness and improve management and governance.

Slovenia’s $1.3 billion recapitalization of its three largest banks is directly linked to a formal restructuring program administered by the Bank Rehabilitation Agency to bring the banks’ risk-weighted capital-adequacy ratios to 8 percent by 1995. In exchange for debt forgiveness (including anticipated loan losses), state-owned enterprises had to give up their ownership of banks. Initial results have been good: loan portfolios have been cleaned up, capital-adequacy levels have improved, and internal operations and systems have become more efficient in advance of privatization.

The right environment

To improve resource allocation, countries have introduced policies encouraging positive real interest rates and limiting the use of directed credits and other subsidies to preferred sectors. The supervision of commercial banks by central banks has been strengthened, and indirect methods of monetary control (reserve and liquidity requirements, treasury bill markets) have been introduced.

Laws and regulations. Despite substantial progress, the legal and regulatory framework remains weak in most transition economies. Weaknesses include excessive risk-taking in investments (cross-ownership, swaps) and trade financing; savings deposit monopolies (distorted funding market, excess interbank exposure); and poor enforcement of prudential regulations. The difficulties of loan recovery are compounded by ambiguous property and collateral rights, slow bankruptcy proceedings, and underdeveloped out-of-court resolution methods. In the absence of a strong market-based legal tradition, independent courts, experienced judges and lawyers, and systems of commercial valuation, bankruptcy and liquidation proceedings are laborious. Where they do occur with regularity—Hungary and Poland—the heavy backlog of cases slows contract enforcement and loan recovery.

Legal reforms have addressed some shortcomings. Two-tiered banking systems have been established. The independence of central banks has been clearly specified. Out-of-court mechanisms have been introduced to accelerate dispute resolution and circumvent the weaknesses of the court systems. However, stronger laws and institutions are still needed in transition countries.

On the regulatory front, countries have tightened licensing standards to clarify capital requirements, scope of operations, management and shareholder responsibilities, and reporting requirements. Stricter standards have been developed for loan classification, risk weighting, loan-loss provisioning, capital adequacy, and treatment of interest accruals and principal rollovers to conform to international standards. Some countries now limit bank exposure to large borrowers, shareholders, and managers to a certain percentage of bank capital. Foreign-exchange operations are more tightly monitored, and liquidity requirements are better enforced. Credit policies and procedures have been tightened. Implementation is sometimes undermined, however, by inadequate training of senior bank management, local pressures on loan officers, and weak supervision.

Corporate governance. Corporate governance of banks and enterprises still suffers from the absence of market mechanisms, weak standards of information disclosure and accountability, lack of trained management and board supervisors, and a stunted tradition of private ownership. Some progress has been made: supervisory boards have been restructured and encouraged to monitor management performance according to commercial criteria; management has been replaced or reorganized; and performance incentives have been introduced. More changes are needed, however, to strengthen daily bank operations, guidelines, procedures, and planning.

Institutional capacity. Bank supervision remains weak. Supervisors have little of the experience with risk management that is needed for inspection and surveillance. Poor information systems weaken off-site surveillance and early warning capacity. Bank supervision is focused on liquidity and other immediate concerns, while longer-term risk-management issues are often overlooked. Supervisors are unable to use their enforcement powers because many of the largest banks are still state owned and, in BRO countries, because of a weak legal framework.

Accounting practices in centrally planned economies were not designed to monitor bank solvency and liquidity. Liquidity problems were obscured by the improper classification of loans; risk weighting was inaccurate or nonexistent; and there was little, if any, provisioning for loan losses. Under these conditions, accounting and auditing professionals’ never developed the skills needed for managing commercial banks in a market economy. Most transition economies have revised their accounting laws to bring them into line with international standards. The new standards are beginning to expose solvency and liquidity risks. The challenge now is for management and boards to use such information to strengthen the competitive position and financial condition of their banks.

The BRO countries have had a particularly acute problem with inefficient payment systems, leading to long delays in bank transfers, verifications, and settlements. Reforms have emphasized more efficient payment methods and clearinghouse systems, the introduction of checks, settlement systems to accelerate processing between banks and countries, and courier systems to upgrade service. Russian banks have developed their own payment system, which has improved vastly since 1994.

Ownership, scale, and scope

Most transition economies need to address issues of appropriate ownership, scale, and scope in banking. In Central and Eastern Europe, the dominance of state banks distorts the banking system and constrains market development (see table). To remove this distortion, privatization must accelerate. However, privatization alone is not enough. It must be accompanied by thorough restructuring. Czech banks, most of which have been privatized (by voucher), risk significant losses and capital erosion from direct loan exposure and indirect equity exposure (through bank-owned Investment Privatization Funds) to private but insufficiently restructured enterprises.

In the BRO countries, there are numerous small banks, most of which are poorly capitalized and supervised. Consolidation is needed in many of these countries to increase capital and facilitate supervision. However, efforts to consolidate banking systems should coincide with efforts to increase diversification opportunities within prudent guidelines. The recent failure of Latvia’s largest bank, which held 20 percent of the country’s total deposits, demonstrates the importance of qualitative guidelines in containing imprudent, highly leveraged diversification strategies.

Another legacy of central planning is excessive bank specialization, which limits opportunities for portfolio diversification and unnecessarily fragments banking systems. Raising minimum capital requirements, strengthening bank supervision, and allowing weak banks to fail could provide needed stability to the banking sector without unduly obstructing entry or market-based specialization.

Early lessons

Some general lessons can be extracted from the different outcomes of reform programs so far:

• Bank recapitalization can restore bank solvency and shore up public confidence if reinforced by fiscal prudence, hard budget constraints on loss-making banks and enterprises, and reform of incentive structures. However, because these conditions have not been fully met, recapitalization has instead often delayed the necessary restructuring of banks (and debtor enterprises).

• Bank restructuring agencies can help consolidate banking systems and restructure loan portfolios. However, they can be expensive and can drain scarce personnel from banks. As an alternative, governments could write off problem loans up front, allow banks to expense loan losses as a pre-tax item, and encourage banks to develop workout units.

• Debt-equity swaps, loan sales, and asset swaps can strengthen bank balance sheets and generate large profits once markets are stronger. However, banks would be better off making their core businesses as profitable as possible, rather than assuming equity risk in weak companies in an uncertain economic climate.

• Reforms in the legal and regulatory environment should include establishing an orderly bank liquidation process that allows banks to fail without undermining depositor confidence; raising capital-adequacy ratios above the standard target of 8 percent; rationalizing deposit-insurance systems to limit government liability and remove distortions impeding competition for savings; containing the use of highly leveraged formulas to attract deposits when portfolio risk exceeds prudent guidelines; and improving bankruptcy and liquidation mechanisms for enterprises to make resource management more efficient.

• Bank supervision is still weak. Bank supervisors must have the authority to enforce prudential regulations and the institutional capacity to monitor risk.

• Bank governance has improved. However, management and governance weaknesses are still pervasive, and concentrated enterprise ownership of private banks remains problematic.

• Privatization and restructuring of large state banks are necessary to improve the performance and competitiveness of the banking sector. When governments try to maintain control of bank and enterprise operations, economies are likely to pay the price over time in lost competitiveness and slower growth.

This article is adapted from World Bank Discussion Paper No. 279, Restructuring Banks and Enterprises: Recent Lessons from Transition Countries, January 1995, by the authors.

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