I N T R O D U C T O R Y S T U D Y

UDK: 336.71

The Challengeof Banking in a highly ^

Uncertain Future1

Ricardo Lago*

INTRODUCTION

Most studies of banking in transition follow the approach of analysing theinitial shortcomings that these economies have in the pursuit of a soundfinancial system. Typical limiting factors include: initial lack of financia!skills; inadequate regulatory framework; weak procedures to repossesscollateral; related lending practices; ineffective supervisión; under-capital-ised banks; macroeconomic instability; and reckless bankers and oligarchs

that cheat on depositors, lenders and minority shareholders. The menú is sometimes com-pleted with subservient central bankers ready to bail out government, bankers and deposi-tors with yet another run of "inflation tax" levied on the pockets of moneyholders.

All this is true for many countries, but in this paper we take a completely different angle.Let us assume for a moment that, in the beginning, a transition economy is endowed withAmerican bankers, British supervisors, Germán auditors, the Frenen legal framework andSwiss supervisory boards. Further, let us also assume that the chairman of the centralbank were Alian Greenspan and the minister of finance Paul Volker. Well, even if all these"ifs" were to hold, the claim of this paper is that banking may have a high chance of being amoney-losing proposition, at least until such time that a critícal thresholdti transformationand relative stability had been achieved.

The obligatory point of departure for any analysis of the financial sector in transitioneconomies is Janos Kornai's four simple principies defining the "hard budget constraint":buyers pay for the goods they buy; debtors pay back their debts; taxpayers pay their taxes;enterprises pay their costs out of revenues.2

Indeed, these are some of the many functions of the financial system: to ensure that pay-ments for transactions take place as due and that economic agents abide by the relevantsolvency constraints. Far from being mechanical, both tasks are a difficult endeavour. First,* Ricardo Lago, Deputy Chief Economisr, European Bank for Reconstrucción and Development.1 The views expressed are those of the author alone and do not necessarily reflect the views of the EBRD. I would like to thank Alan Bevan and Michel Jernovfor their comments.2SeeKorna¡ (1993), page315.

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— • K53 O O

HFrance91-95

11 Estonia 92-95

H Philippines 98-99

IH Thailand 83-87

luí U. S. 84-91

1 Sweden 91-94

1 Poland 90's

1 Indonesia 94

1 Kazakhstan 91-94

1 Sri Lanka 89-93

1 Malaysia 85-88

1 Paraguay 95

: 1 Colombia 82-87

'_ '. !' '.'. 1 Spain 77-85

1 Russia 98

1 Norway 87-93

IHungary 91-95

IF¡nland91-94

1 Philippines 81 -87

1 Ecuador 96-00

1 Brazil 94-95

1 Bulgaria 90's

1 Slovenia 92-94

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1 Czech Republic 96

1 Malaysia 97-98

1 lapan 90.

1 México 95

Leta

1 Venezuela 94-95

S. Korea 97-99

lUruguav 81-84

1 Thailand 97-99

1 Chile 81-83

1 Indonesia 97-99

1 Argentina 80-82

Chart 1

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subject to credit and solvency con-straints when dealing with non-CMEAWestern lenders and exporters.

The task for transition economieswas therefore not reform of the existí ngfinancial sector but, rather, the buildingof one from scratch where there was

REAL COSTS OF FINANCIALINTERMEDIATION

The transaction costs incurred inintermediation and in managing thepayments systems of the economy areobvious. The level of these costsdepends on the market structure,competition, entry rules and efficiencyof the intermediaries.

However, these costs are oftenmodérate compared to the costs todepositors ana taxpayers arising fromrecurrent banking failures, as thecurrent financial crisis ¡n Argentinabears witness. In Chart 1 we present across-country overview of the costs in"bailouts" arising from failed banksover the last three decades. Thesecosts need to be added to the strictinter-mediation costs in order tocalcúlate the total cost of financialinter-mediation in the economy.

Why do banks fail so often ¡nemerging markets? The short answer is:because of a combination of the fragilityof banks as enterprises and the instabil-ily, uncertainty and weak institutions ofemerging markets. Let us examine firstthe characteristics of banks.

Compared to other types of firm,banks are fragile because they arehighly leveraged and illiquid. Theircapital-to-assets ratio is low and theirliabilities bear much shorter maturitiesthan their assets. Further, banks dealwith a non-homogeneous "commod-ity", loans, the valué of which resistsmechanical valuation. One euro (ortolar) lent to one borrower is a differ-ent "commodity" from another eurolent to another borrower. The true

I N T R O D U C T O R Y S T U D Y

valué of the transactions and theportfolio of a bank is difficult toascertain because ¡t depends on thecredit quality of each and every singleloan.

To compound the picture, banksfunction under a complex chain ofprincipal-agent relations amona itsstakeholders. Bankers and back-officestaff are agents of managers; manag-ers are agents of shareholders;shareholders are agents of creditorsand depositors. Each agent tends topursue his own objectives at least asmuch as those of his principal, unlesseffectively constrained by law enforce-ment, supervisión or disclosure. Thestronger these institutions are, thecloser agents abide by the objectivesof their principáis.

Sound financialintermediaries

and stablevalued "money"

are sine qua nonconditions for

a workingmarket economy.

In the presence of explidtorimplidt deposit insurance, the state ¡salso a principal of all the otherstakeholders because it takes a bigportion of the downside ¡n the event of

bankruptcy. Deposit insurance canelicit high risk-taking behaviour bymanagers and/or shareholders, andheavy deposit-taking by unsoundbanks. This is one of the reasons whybanks need to be subject to tightprudential rules and strong supervisiónby the state.

Advanced market economies havedeveloped institutions to deal with boththe fragility of banks as enterprisesand the potential moral hazardresulting from the complex chain ofprincipal-agent relations. Theseinstitutions range from accounting andauditing rules, to prudential anddisclosure requirements; from thediscipline of enforceable corporate,securities and banking laws, to theoversight of bank supervisors andrating agencies. As noted above,however, in the wake of the ENRONscandal and other scandals theeffectiveness of these institutions hasrecently been called into question,even in the US, the country with themost advanced market-based institu-tions.

One of the problems during theearly stages of transition is that theseinstitutions are at best under construc-tion, and at worst completely absent.The inherent fragility of banks thereforebecomes fully exposed. Henee,banking failures often follow.

It is here that financial intermediar-ies with a "strong reputation" play acentral role. Preserving the valué oftheir reputation may be conceived as apartial substitute for weak institutionsand surveillance. This is the model thatHungary pioneered in Eastern Europe:the privatisation of public banks tostrategic investors with strong "ñames"to put at stake. Since local investorsinitially lacked the necessary reputa-tion, banks were sold largely to foreigninvestors. As Chart 2 shows, the samestrategy was later adopted in earnestby the Baltic countries.

Chart 2: Ownership of Banks in Transition Economies(share of assets) 1999

1 OU 7o "

80 % "

60 % -

40 % "

20 % -

foreign [~ | prívate state

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I N T R O D U C T O R Y S T U D Y

Chart 3: Returns on inveshnent: developed versus transition/emerging economies

r* = 10 O % Borrowers Perform

By contrast, the Czech Republicopted until recently (1998-99) to keepthe large banks ¡n state hands. Further,some of these banks created invest-ment funds to intermedíate vouchers forprivaHsafion. This approach left notonly the banks but, ¡ndirectly, manyenterprises vulnerable to politicallending and ¡nfluence. The outcomewas a delay ¡n restructuring andmassive financial crisis in 1997-1998.

In turn, since 1991 Russia hasfollowed an approach of liberal entryfor local banks - some of them linkedto financial-industrial groups - andrestrictive entry for foreign banks. Allthis is in a framework of weak supervi-sión and unsustainable fiscal déficit,and treasury bilí financing. This modelled to the total collapse of the financialsystem in August 1998, when thegovernment defaulted on its bonds andGKOs, and the rouble lost threequarters of its valué.

However, as we explain below,even if all the necessary institutionsand/or highly reputable banks had

Compared toother types of

firms, banks arefragüe becausethey are highly

leveragedand illiquid.

been in place ¡n the early stages oftransition, a central problem would stillremain: uncertainty. Only when acountry has achieved a critical mass ofprogress in transformation doesbanking become commercially viable.

Chart 4: Loan performance: developed versus transition/emerging economies

100

80-

60-

40-

20-

Performing

Non-Performing

EMERGING DEVELOPED

TRANSITIONAL UNCERTAINTY

In advanced economies, financialinstitutions are able to bank onmeasurable risk and established trackrecords. Creditors are exposed tosevere counterparty risk as debtors arefaced unexpectedly with adversedevelopments beyond their control. Askey relative pnces change and newdomestic and foreign competitorserode monopoly profits, and as newmarkets emerge and oíd ones vanish,previously viaole enterprises andprojects become non-viable andpreviously creditworthy borrowers maybecome insolvent.

All these stresses and strains are ofcourse present, qualitatively, even inan economy that does not suffermacroeconomic instability (e.g.Slovenia throughout its transition). Inprincipie, macroeconomic balance canbe consistent - in a dynamic, evolvingeconomic system - with a considerableamount of microeconomic flux at thesectoral and individual firm levéis.

During the transformation from planto market- a process involvingmacroeconomic stabilisation andstructural adjustment on an unprec-edented scale - the problems and risksfacing enterprises and banks becomeacute. This is obviously true as regardsthe backlog of loans incurred duringthe pre-reform era (the so-calledbalance sheet or stock problem}. It alsoremains true for new loans now thatreform appears to be here to stay (theflow problem).

Even competent Western bankerswould have little evidence on which tobase their assessment of the creditwor-thiness of loan applicants. Fewpotential borrowers have much of atrack record or credit history. For thosethat do, the past is likely to be a poorguide to the future: what made forenterprise success under centralplanning may bear little relation towhat is required for effective enterprise

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I N T R O D U C T O R Y S T U D Y

performance ¡n a market regime -more so when the market structure ¡srapidly evolving and its dynamics beara high degree of un-measurableuncertainty. This flow problem offinancial intermediation thus stemsfrom the difficulty encountered bybanks (and other lenders) ¡n screeningout the good from the bad risks whenextending new loans.

This problem ¡s ¡llustrated inCharts 3 and 4. In a successful transi-tion economy, the average expectedreturns on investments are higner thanthe returns on similar ¡nvestments in adeveloped economy. However, asshown in the chart, the dispersión ("thevariance") of the returns ¡s much higherin the transition economy. The reasonfor is that, in the latter, the pace ofchange of relative prices and marketconditions leads to volatility ¡n thecashflows of enterprises.

In a developed economy, of 100investment projects only five wouldyield a return lower than the interestrate (in the chart, assumed at 1 O %),whereas in a transition economy asmany as 35 would yield lower returns.Such a dispersed distribution ofoutcomes ¡s often referred to as the "fattails" problem. In ¡ts presence, debtprogressively tends towards equity riskbut without upside.

3Stiglitz and Weiss (1981) argüe that, in asituarían such as this, rationing of credit - at lowerinterest rotes - allocated to lower-risk borrowers isthe only possible approach.

The end result is that the ratio ofnon-performina loans ¡n the transitioneconomy will be high. To compénsatefor the losses, banks will have raisespreads. With higher interest rafes(over 10%), however, additionalborrowers will be unable to servicetheir debts. In addition, the higherrotes will lead to the adverse selectionof borrowers: those unlikely to repayare the ones most eager to borrow.3

Transitional uncertainty may thusrender banking commercially non-viableuntil a critical mass in transformationhas been achieved. The experience oftransition economies with the re-capitalisation of public banks andbanking failures - at a cost presented inChart 1 - seems to back this thesis.

CONCLUSIÓN

George Kaufman has comparedthe annual average ratio of bankfailures to total banks with the ratio fornon-banking enterprises in the UnitedStates from 1 870 to 1995. Heconcludes that, excluding the period ofthe Great Depression of 1929-33,both ratios are similar.

Thus, he claims that the ¡nherentfragility of banks (as enterprises) doesnot necessarily imply failure. Rather, itimplies "handle with care". Thebreakage rate for fine wine glasses islikely to be lower than for ordinarydrinking glasses!

That "care" has to be delivered byboth the establishment of the rightinstitutional framework for banking, aswell as the economic reforms thatwould take the economy beyond the"critical threshold" of transformation.

By 2002 all Central Europeancountries ¡n the process of accession tothe EU appear to have left transitionaluncertainty behind. However, in thefield of advancement and consolida-tion of the ¡nstitutions that would ensuresound banking, the road ahead is stilla long one.

REFERENCES:

1. Buiter ,Willem ,Ricardo Lago ,and Hellene Rey(1997). "A Portfolio Approach to a Cross-Sectoraland Cross-National Investment Strategy inTransition Economies". Working Paper Series5882 .National Bureau of Economic Research(NBER). Cambridge, Massachusetts

2. Buiter, Willem, Ricardo Lago, and Hellene Rey(1999). "Financing Transition: Investing inEnterprises during Macroeconomic Transition." InMario Blejer and Marko Skreb (Eds), FinancialSector Transformation (pp. 150-192). CambridgeUniversity Press. Cambridge, United Kingdom

3. Kaufman, George G. (1999)." Central BanksAsset, Asset bubbles, and Financial Stability." InMario Blejer and Marko Skreb (Eds), CentralBanking, Monetary Policies, and the Implicationsfor Transition Economies (pp!43-l 83). KluwerAcademia Publishers. Norwell, Massachusetts

4. Kornai, Janos (1993)." The Evolution ofFinancial Disciple under the Post-socialist System".In Kyklos, Vol.46 (pp 315-336). Basel,Switzerland.

5. Stiglitz, Joseph and Andrew Weiss (1981)."Credit Rationing ¡n Markets with ImperfectInformation". American Economic Review , June1981, Vol.71 (pp.393-410).

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C O N T E N T S

E D I T O R I A L

Mitja Gaspar!: Banks in the Countries of Central and Eastern Europe

I N T R O D U C T O R Y S T U D Y

Ricardo Lago: The Challenge of Banking in a highly Uncertain Future

C O U N T R Y S T U D I E S

Petra Davidova: The Czech Banking Sector at the Start of the New Millennium

Martin Macko: Slovakia's Banking Sector Has Become Global and International

Csaba Moré: Banking Sector Evolution in Hungary: Restructuring, RecentTrends and Prospects

Pawel Pniewski: The Polish Banking System

Vello Vensel: Banking Sector Development in Estonia

Marko Kosak and Tomaz Kosak: The Banking Sector in Slovenia

Davor Pojatina: The Banking Sector in Croatia

Mirko Puljic: The Banking System in Bosnia-Herzegovina

Zivota Ristic and Dragoslav Vukovic: Serbia's Banking System: Past, Present and Future

Aleksandar Radulovic Banking in Montenegro: Past, Present and Future

Vladimir Filipovski and Milico Arnaudova: The Banking System in the Republic of Macedonia:Current Issues and Future Prospects

9

17

25

35

41

51

61

69

77

85

91

C O M P A R A T I V E A N A L Y S I S

Ivon Ribnikar and Peter Zajc: Banking Sectors in the EU and Countries in Transition 99

S T A T I S T I C A L A P P E N D I X

Matjaz Noc: Selected Economic and Banking Indicators 107

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