Journal Issue

Corporate Governance in Transition Economies

International Monetary Fund. External Relations Dept.
Published Date:
January 1995
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INSIDER control is making it difficult for many companies in transition economies to get management oversight and financing. This article draws on Japan’s experience with the role of banks in corporate governance.

During the initial phase of transforming the socialist planned economies, people optimistically assumed that the transition to a market economy could be readily achieved by privatizing state-owned enterprises (SOEs) combined with introducing an equity market. The latter would serve as the market for corporate control, that is, as an instrument for corporate governance and, hence, as an effective mechanism for raising the external finance much needed by privatized enterprises for their restructuring projects. However, the privatization process has resulted in strong insider control—by managers in some cases, and by managers and workers in others. Insider control has virtually blocked the development of an equity market. Managers (and employees) are often conservative shareholders, reluctant to sell their shares for fear of losing control. On the other hand, industrial shares in insider-controlled enterprises are no longer attractive to potential investors because of low dividends and the virtual impossibility of obtaining large blocks of shares. Hence, the equity market tends to be thin and incapable of providing adequate finance for enterprise restructuring.

The cash-starved transition economies need, therefore, to develop a workable system of corporate governance. The experience of Japan immediately after World War II was to use banks to monitor enterprise performance in transition in a way compatible with insider control. The history and socioeconomic conditions of Japan and the postwar international environment are indeed different from those faced today by the transition economies, but the problems that gave rise to the development of a “control-oriented” banking system are similar: insider control and the need for large amounts of external financing, while the capital market was underdeveloped.

Insider control

Insider control varies in scope and degree across transition countries, depending on the independence of the privatization agency from interest groups, management autonomy, and workers’ power at the time of the fall of the central planning authority. It can be either a de facto or a de jure capture of the corporate decision making process. In privatized companies, insiders often hold a substantial block of the share capital. In enterprises still owned by the state, strategic decision making may reflect insiders’ interests—for example, higher revenues from improved productivity might be disbursed internally, perhaps as wage increases.

The range of possibilities is illustrated by experiences in different countries. At one end of the spectrum are Poland and Russia. Even before the fall of socialism, Polish workers’ councils had attained a position analogous to that of corporate boards of directors in the West. Once transition began, workers moved quickly to capture control of enterprise assets through liquidation of old state enterprises and a shift of assets to new enterprises created for the purpose of maintaining control. Russia, where directors of state enterprises seized control after the planning apparatus was dismantled, has succeeded in corporatizing and privatizing a majority of its large- and medium-sized enterprises because the privatization agency has accommodated insiders’ interests—the scheme provided for majority shareholding by managers and workers, whose support was needed for rapid privatization. Russia lags behind some of the other transition economies in privatizing small enterprises (Table 1).

At the other end of the spectrum is eastern Germany, where privatization was undertaken by the centralized privatization authority, the Treuhandanstaldt (THA). Because of its mandate to complete privatization by the end of 1994, THA was not susceptible to the influence of insiders. State enterprises have been privatized mostly through the acquisition of assets by companies in western Germany.

In the middle are the Czech Republic and Hungary. In both countries, insiders were weaker before the collapse of communism, and the state had less political power during transition than in the other former centrally planned economies. More than 50 percent of the Czech Republic’s large and medium-sized enterprises have been privatized through a voucher scheme, but insiders have not received preferential treatment. Although proposals for “privatization” projects can be initiated by anyone, including managers, the Ministry of Privatization has the sole authority to select projects. The tendency toward insider control has thus been curbed.

Table 1Progress in the transition to a market economy1
Private sector share of GDP, 1994


of companies





Czech Republic65443343
Kyrgyz Republic30342332
Macedonia, former Yugoslav Republic of35242342
Slovak Republic55343343
Source: European Bank for Reconstruction and Development.

Score: 4 = market economy, 1 = little progress.

Source: European Bank for Reconstruction and Development.

Score: 4 = market economy, 1 = little progress.

In 1984, Hungary introduced a self-management system similar to Poland’s, but giving more authority to managers than to workers. The Government adopted a decentralized scheme that gave enterprise councils the authority to privatize, subject to approval by the State Property Agency. In contrast with the Czech approach, this scheme seems to have made it easier for managers to retain control and fend off “outsider” intervention. Privatized enterprises tend to be owned by other enterprises, banks, and the state; thus, corporate groups similar to Japan’s keiretsu may emerge. Fewer large enterprises have been privatized than in Russia or the Czech Republic, but all small enterprises have been privatized.

Bank-oriented systems

Initial attempts by transition economies to develop equity markets capable of providing external financing and corporate governance to companies have failed. Because capital markets in these countries are still shallow, they may not reflect the true value of shares. Because of emergent insider control, they have not provided effective corporate monitoring through the threat of takeovers. Thus, strengthening the banking system may be considered an option for the transition economies. However, banks are unlikely to provide the medium- or long-term financing required for restructuring enterprises unless they can gain reasonable control over enterprises, not to mention the fact that most of the banking institutions in transition countries themselves face serious financial difficulties. To ensure their own viability, banks providing long-term financing to enterprises will need to perform certain monitoring functions—enterprise and project appraisal, supervision of day-to-day operations, and corporate restructuring or management changes in the event of financial distress. If banks were their major source of external financing, enterprises in difficulty might be forced to submit to banking control, although management may retain insider control when operations are technically and financially viable.

A distinction can be made between two types of banking systems: arm’s-length and control-oriented. Arm’s-length banking, typical of the United States and the United Kingdom, is “corporate governance by objective.” Banks do not interfere directly with strategic decisions as long as they are paid according to contract and do not need to monitor enterprises because their loans are backed by collateral or security, including the enterprises’ physical assets. This kind of banking faces two obstacles in transition economies. First, because of ill-defined property rights and the lack of legal machinery to enforce contracts, a market for enterprises’ physical assets is unlikely to exist. Second, and more important for the banks, is the question of moral hazard—enterprises may not provide full information on the risks involved, or may be unwilling to repay loans, or both. Furthermore, the sums needed for restructuring may be quite large, and enterprises are not able to raise them in the capital markets..

Since mere reliance on collateral or security to ensure repayment of loans is not possible, the banks would provide investment finance only on certain strict conditions. These would include some control over management, particularly in the event of poor performance. To ensure their own viability, the banks would have to perform certain monitoring functions: ex ante (enterprise and project appraisal), interim (supervision of actual functioning), and ex post (restructuring or change in management in the event of poor performance). The banking system may thus evolve toward a control-oriented system often described as “corporate governance by intervention”—a system somewhat similar to the German-Japanese model.

The enterprises might cooperate as they have no alternative source of financing for restructuring, essential for improved profitability. Furthermore, insider control would not be challenged as long as they are financially viable, for banks would intervene only in the event of financial distress. Mutual trust may be enhanced for two other reasons. First, if an enterprise were assured of a long-term relationship with a bank prepared to share some risk in the event of temporary financial distress or liquidity constraints, the enterprise would have an incentive to provide information. Second, the assurance of adequate financing could provide the enterprise with an additional incentive not to cheat or mislead the bank.

Banks, which have an incentive to expand business, particularly with reliable borrowers, may agree to a long-term relationship if they are satisfied that enterprise management is trustworthy. They may be willing to share some risk with enterprises if they are assured of participation in enterprise governance and the right to make changes to management or undertake financial or technical restructuring when necessary.

The manner in which the performance of the banks in Japan was improved after the war may have some relevance for the transition economies. The banks were forced to give loans to munitions industries during the war when Japan had a command economy on the basis of government guarantees. After the war, the government repudiated these guarantees and they created a serious bad debt problem for the banks. To tackle this, the balance sheet of the banks was divided into old and new accounts. The assets of the new accounts include cash and government bonds, and the liabilities included tax liabilities and a limited amount of deposits, which were protected from write-offs. The assets of the old accounts included all government-guaranteed loans, and the liabilities included unprotected deposits and capital. The banks were allowed to continue their business using the new account, while the losses due to the repudiation were financed by canceling the liabilities and reducing the capital in the old account. The capital was subsequently replenished by issuing new shares, which were purchased mostly by enterprises.

Table 2Bank ownership structures in Russia1(percent of share capital)
Type of shareholderFormer state banksMew banks
State-owned enterprises and other state institutions2411
Privatized enterprises2514
New private companies2665
Source: The Russian Economic Barometer, Bank Survey, January 1994.

January 1994.

Source: The Russian Economic Barometer, Bank Survey, January 1994.

January 1994.

This capital restructuring of the banks enabled the banks to function on sound lines and, later on, made it possible for them to participate actively in the financial/technical restructuring of loss-making enterprises. Such participation improved the monitoring expertise and skills of the banks and thus made it possible for them to provide medium-and long-term finance to enterprises on the basis of ex ante, interim, and ex post monitoring—involving corporate governance through intervention in the event of poor performance. Capital markets were underdeveloped and managers controlled the enterprises (insider control)—a situation similar to the transition economies. Hence the role of banks.

Banking systems improve

Banks in the transition economies have yet to develop the requisite financial expertise or monitoring capacity to function as lead banks in loan syndications. Capital-asset ratios remain weak. And, although the bad-debt problem is improving, it could recur in Hungary and Russia if the directed credit system is not properly monitored. Despite these and other problems, such as weak implementation of regulatory standards by central banks, there are indications that in some countries—for example, the Czech Republic, Poland, and Russia—the banking system is improving (Table 1). Surveys carried out in 1993 show that the environment in which banks are operating and the behavior of banks in the Czech Republic, Hungary, and Poland have changed more than is commonly believed; banks have become more prudent in lending and more profit-oriented. Surveys by The Russian Economic Barometer in 1994 show similar trends, as well as competition for deposits and viable borrowers, and less interest in allocating directed centralized credits.

By 1994, Polish banks had eliminated 80 percent of their nonperforming loans by restructuring the debts of potentially viable enterprises; the balance has been dealt with by initiating bankruptcy proceedings or auctioning off the assets of the nonviable enterprises. In the process, banks have acquired expertise in appraising the soundness of enterprises and monitoring their performance. Three large Polish banks have already been privatized and, under a World Bank program, the regulatory and supervisory capacity of the central bank is being strengthened, and the management capacity and technical skills of banks are being built up through twinning arrangements between Polish and European commercial banks.

The Czech Republic’s five largest banks have been privatized, and banks have cross-ownership. They have also acquired substantial shareholdings in privatized state enterprises through bank-owned funds.

In Russia, some large banks—for example, International Moscow Bank, Tokobank, and Mosbizinesbank—provide medium-term financing in hard currency to enterprises on strict conditions. Bank representatives sit on the boards of directors of borrowing enterprises. These banks have the potential to perform corporate governance functions as well as to arrange syndicated loans. Enterprises are likely to agree to such governance as long as they obtain the financing and foreign exchange needed to import equipment and technology. The ownership structure of 700 former state banks has changed: 75 percent of bank shares are held by the private sector. The new private banks—more than 1,300 at the end of 1993—are 65 percent owned by new private enterprises (Table 2). The biggest banks are competing for household and enterprise deposits (Table 3).

Table 3.Major sources of banks’ borrowed funds in Russia1(percentage of respondents)
Main source of fundsFormer state banksNew banks
Enterprises’ current accounts8054
Directed centralized loans7338
Enterprise deposits4792
Household accounts and deposits4031
Interbank loans3369
Source: The Russian Economic Barometer, Bank Survey, January 1994.

Second half of 1993.

Source: The Russian Economic Barometer, Bank Survey, January 1994.

Second half of 1993.

A necessary task

The success of privatization and restructuring in the transition economies can be initially helped by establishing a banking system that can provide external financing and a governance structure suitable for all enterprises, whatever their ownership, unlike the capital market, which monitors only large, publicly held companies whose shares are traded.

As transition economies mature, they may be able to develop efficient securities markets. The simultaneous development in the transition economies of a sound banking system and capital markets can increase the access of private enterprises to capital. Capital markets can also provide a check on entrenched banking interests. Meanwhile, a sound banking system must be in place first—banks provide the liquidity needed to maintain confidence in the payments system and to facilitate trading. Banks may also provide functions essential to securities market operations, such as underwriting, guarantees, or custodial service. A hybrid system may eventually evolve in which banks compete with capital markets to provide financing.

This article is based on Corporate Governance in Transitional Economies: Insider Control and the Role of Banks, Masahiko Aoki and Hyung-Ki Kim (editors), World Bank, Economic Development Institute, Washington, 1995.

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