The Challenge of Banking in a highly Uncertain Future- R V Lago

INTRODUCTORY

STUDY

UDK: 336.71

The Challenge of Banking in a highly ^ 1 Uncertain Future Ricardo Lago*

INTRODUCTION

M

ost studies of banking in transition follow the approach of analysing the initial shortcomings that these economies have in the pursuit of a sound financial system. Typical limiting factors include: initial lack of financia! skills; inadequate regulatory framework; weak procedures to repossess collateral; related lending practices; ineffective supervisión; under-capitalised banks; macroeconomic instability; and reckless bankers and oligarchs that cheat on depositors, lenders and minority shareholders. The menú is sometimes completed with subservient central bankers ready to bail out government, bankers and depositors 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 with American bankers, British supervisors, Germán auditors, the Frenen legal framework and Swiss supervisory boards. Further, let us also assume that the chairman of the central bank 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 a money-losing proposition, at least until such time that a critícal thresholdti transformation and relative stability had been achieved.

The obligatory point of departure for any analysis of the financial sector in transition economies 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 payments for transactions take place as due and that economic agents abide by the relevant solvency 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 Jernov for their comments.

2 SeeKorna¡ (1993), page315.

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Chart 1 : Bail - out cost of banking failures

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INTRODUCTORY

subject to credit and solvency constraints when dealing with non-CMEA Western lenders and exporters.

The task for transition economies was therefore not reform of the existí ng financial sector but, rather, the building of one from scratch where there was

REAL COSTS OF FINANCIAL INTERMEDIATION The transaction costs incurred in intermediation and in managing the payments systems of the economy are obvious. The level of these costs depends on the market structure, competition, entry rules and efficiency of the intermediaries.

However, these costs are often modérate compared to the costs to depositors ana taxpayers arising from recurrent banking failures, as the current financial crisis ¡n Argentina bears witness. In Chart 1 we present a cross-country overview of the costs in "bailouts" arising from failed banks over the last three decades. These costs need to be added to the strict inter-mediation costs in order to calcúlate the total cost of financial inter-mediation in the economy.

Why do banks fail so often ¡n emerging markets? The short answer is: because of a combination of the fragility of banks as enterprises and the instabilily, uncertainty and weak institutions of emerging markets. Let us examine first the characteristics of banks.

Compared to other types of firm, banks are fragile because they are highly leveraged and illiquid. Their capital-to-assets ratio is low and their liabilities bear much shorter maturities than their assets. Further, banks deal with a non-homogeneous "commodity", loans, the valué of which resists mechanical valuation. One euro (or tolar) lent to one borrower is a different "commodity" from another euro lent to another borrower. The true

STUDY

valué of the transactions and the portfolio of a bank is difficult to ascertain because ¡t depends on the credit quality of each and every single loan.

To compound the picture, banks function under a complex chain of principal-agent relations amona its stakeholders. Bankers and back-office staff are agents of managers; managers are agents of shareholders; shareholders are agents of creditors and depositors. Each agent tends to pursue his own objectives at least as much as those of his principal, unless effectively constrained by law enforcement, supervisión or disclosure. The stronger these institutions are, the closer agents abide by the objectives of their principáis.

Sound financial intermediaries and stable valued "money" are sine qua non conditions for a working market economy.

In the presence of explidtor implidt deposit insurance, the state ¡s also a principal of all the other stakeholders because it takes a big portion of the downside ¡n the event of

bankruptcy. Deposit insurance can elicit high risk-taking behaviour by managers and/or shareholders, and heavy deposit-taking by unsound banks. This is one of the reasons why banks need to be subject to tight prudential rules and strong supervisión by the state.

Advanced market economies have developed institutions to deal with both the fragility of banks as enterprises and the potential moral hazard resulting from the complex chain of principal-agent relations. These institutions range from accounting and auditing rules, to prudential and disclosure requirements; from the discipline of enforceable corporate, securities and banking laws, to the oversight of bank supervisors and rating agencies. As noted above, however, in the wake of the ENRON scandal and other scandals the effectiveness of these institutions has recently been called into question, even in the US, the country with the most advanced market-based institutions.

One of the problems during the early stages of transition is that these institutions are at best under construction, and at worst completely absent.

The inherent fragility of banks therefore becomes fully exposed. Henee, banking failures often follow.

It is here that financial intermediaries with a "strong reputation" play a central role. Preserving the valué of their reputation may be conceived as a partial substitute for weak institutions and surveillance. This is the model that Hungary pioneered in Eastern Europe: the privatisation of public banks to strategic investors with strong "ñames" to put at stake. Since local investors initially lacked the necessary reputation, banks were sold largely to foreign investors. As Chart 2 shows, the same strategy was later adopted in earnest by the Baltic countries.

Chart 2: Ownership of Banks in Transition Economies (share of assets) 1999 1 OU 7o " 80 % "

60 % 40 % " 20 % -

foreign BV 7-8/2002

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| prívate

state

INTRODUCTORY

STUDY

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

r* = 10 O %

By contrast, the Czech Republic opted until recently (1998-99) to keep the large banks ¡n state hands. Further, some of these banks created investment funds to intermedíate vouchers for privaHsafion. This approach left not only the banks but, ¡ndirectly, many enterprises vulnerable to political lending and ¡nfluence. The outcome was a delay ¡n restructuring and massive financial crisis in 1997-1998.

In turn, since 1991 Russia has followed an approach of liberal entry for local banks - some of them linked to financial-industrial groups - and restrictive entry for foreign banks. All this is in a framework of weak supervisión and unsustainable fiscal déficit, and treasury bilí financing. This model led to the total collapse of the financial system in August 1998, when the government defaulted on its bonds and GKOs, and the rouble lost three quarters of its valué.

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

Borrowers Perform

TRANSITIONAL UNCERTAINTY

Compared to other types of firms, banks are fragüe because

they are highly leveraged

and illiquid. been in place ¡n the early stages of transition, a central problem would still remain: uncertainty. Only when a country has achieved a critical mass of progress in transformation does banking become commercially viable.

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

100

Performing Non-Performing

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EMERGING

DEVELOPED

In advanced economies, financial institutions are able to bank on measurable risk and established track records. Creditors are exposed to severe counterparty risk as debtors are faced unexpectedly with adverse developments beyond their control. As key relative pnces change and new domestic and foreign competitors erode monopoly profits, and as new markets emerge and oíd ones vanish, previously viaole enterprises and projects become non-viable and previously creditworthy borrowers may become insolvent.

All these stresses and strains are of course present, qualitatively, even in an economy that does not suffer macroeconomic instability (e.g.

Slovenia throughout its transition). In principie, macroeconomic balance can be consistent - in a dynamic, evolving economic system - with a considerable amount of microeconomic flux at the sectoral and individual firm levéis.

During the transformation from plan to market- a process involving macroeconomic stabilisation and structural adjustment on an unprecedented scale - the problems and risks facing enterprises and banks become acute. This is obviously true as regards the backlog of loans incurred during the pre-reform era (the so-called balance sheet or stock problem}. It also remains true for new loans now that reform appears to be here to stay (the flow problem).

Even competent Western bankers would have little evidence on which to base their assessment of the creditworthiness of loan applicants. Few potential borrowers have much of a track record or credit history. For those that do, the past is likely to be a poor guide to the future: what made for enterprise success under central planning may bear little relation to what is required for effective enterprise BV 7-8/2002

INTRODUCTORY

performance ¡n a market regime more so when the market structure ¡s rapidly evolving and its dynamics bear a high degree of un-measurable uncertainty. This flow problem of financial intermediation thus stems from the difficulty encountered by banks (and other lenders) ¡n screening out the good from the bad risks when extending new loans.

This problem ¡s ¡llustrated in Charts 3 and 4. In a successful transition economy, the average expected returns on investments are higner than the returns on similar ¡nvestments in a developed economy. However, as shown in the chart, the dispersión ("the variance") of the returns ¡s much higher in the transition economy. The reason for is that, in the latter, the pace of change of relative prices and market conditions leads to volatility ¡n the cashflows of enterprises.

In a developed economy, of 100 investment projects only five would yield a return lower than the interest rate (in the chart, assumed at 1 O %), whereas in a transition economy as many as 35 would yield lower returns.

Such a dispersed distribution of outcomes ¡s often referred to as the "fat tails" problem. In ¡ts presence, debt progressively tends towards equity risk but without upside.

3

Stiglitz and Weiss (1981) argüe that, in a situarían such as this, rationing of credit - at lower interest rotes - allocated to lower-risk borrowers is the only possible approach.

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STUDY

The end result is that the ratio of non-performina loans ¡n the transition economy will be high. To compénsate for the losses, banks will have raise spreads. With higher interest rafes (over 10%), however, additional borrowers will be unable to service their debts. In addition, the higher rotes will lead to the adverse selection of borrowers: those unlikely to repay are the ones most eager to borrow.3 Transitional uncertainty may thus render banking commercially non-viable until a critical mass in transformation has been achieved. The experience of transition economies with the recapitalisation of public banks and banking failures - at a cost presented in Chart 1 - seems to back this thesis.

CONCLUSIÓN George Kaufman has compared the annual average ratio of bank failures to total banks with the ratio for non-banking enterprises in the United States from 1 870 to 1995. He concludes that, excluding the period of the Great Depression of 1929-33, both ratios are similar.

Thus, he claims that the ¡nherent fragility of banks (as enterprises) does not necessarily imply failure. Rather, it implies "handle with care". The breakage rate for fine wine glasses is likely to be lower than for ordinary drinking glasses!

That "care" has to be delivered by both the establishment of the right institutional framework for banking, as well as the economic reforms that would take the economy beyond the "critical threshold" of transformation.

By 2002 all Central European countries ¡n the process of accession to the EU appear to have left transitional uncertainty behind. However, in the field of advancement and consolidation of the ¡nstitutions that would ensure sound banking, the road ahead is still a long one.

REFERENCES: 1. Buiter ,Willem ,Ricardo Lago ,and Hellene Rey (1997). "A Portfolio Approach to a Cross-Sectoral and Cross-National Investment Strategy in Transition Economies". Working Paper Series 5882 .National Bureau of Economic Research (NBER). Cambridge, Massachusetts 2. Buiter, Willem, Ricardo Lago, and Hellene Rey (1999). "Financing Transition: Investing in Enterprises during Macroeconomic Transition." In Mario Blejer and Marko Skreb (Eds), Financial Sector Transformation (pp. 150-192). Cambridge University Press. Cambridge, United Kingdom 3. Kaufman, George G. (1999)." Central Banks Asset, Asset bubbles, and Financial Stability." In Mario Blejer and Marko Skreb (Eds), Central Banking, Monetary Policies, and the Implications for Transition Economies (pp!43-l 83). Kluwer Academia Publishers. Norwell, Massachusetts 4. Kornai, Janos (1993)." The Evolution of Financial 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 Imperfect Information". American Economic Review , June 1981, Vol.71 (pp.393-410).

CONTENTS

EDITORIAL

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

STUDY

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

STUDIES

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

9

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

17

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

25

Pawel Pniewski: The Polish Banking System

35

Vello Vensel: Banking Sector Development in Estonia

41

Marko Kosak and Tomaz Kosak: The Banking Sector in Slovenia

51

Davor Pojatina: The Banking Sector in Croatia

61

Mirko Puljic: The Banking System in Bosnia-Herzegovina

69

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

77

Aleksandar Radulovic Banking in Montenegro: Past, Present and Future

85

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

91

COMPARATIVE

ANALYSIS

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

99

APPENDIX

Matjaz Noc: Selected Economic and Banking Indicators

107

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