Development Brief Number 29
March 1994

Bank reforms can't wait

Putting enterprise restructuring and privatization before banking reforms in transitional economies is putting the cart before the horse

After the fall of communism in Eastern Europe and the former Soviet Union, the focus of economic debate was on macroeconomic stabilization and privatization. Little attention was paid initially to the reform of finance and banking. But the past three years have shown that banks and financial instruments are critical to private sector growth. Both small and strategic investors need access to credit, investment capital, and convertible currency---whether to start new businesses or to transform large state-owned enterprises into profitable private ventures.

Yet most transitional economies have adopted gradual financial reforms, maintaining the banking system's passive role. This leaves banks and state enterprises with inherited and growing bad debts that endanger their solvency and hence that of the economy.

Socialist remains

Recent work by Bank researcher Boris Pleskovic concludes that the main goal of financial reform in the transitional economies should be to make commercial banks participate actively in the economy, as they do in market economies.[1] The reform should include restructuring, resolution of bad debts, recapitalization, and privatization to make banks efficient through independence from political interference.

Despite the growing number of private banks (in many cases with full or partial foreign ownership), huge state-run commercial banks still dominate the loan and deposit markets. In most countries their regulation and supervision is inadequate, as proven by a series of recent bank scandals.

Attempts to deepen the financial sector in most of the transitional economies either have been inadequate or have not had time to take hold. For example, stock exchanges were set up in some economies in an effort to mobilize capital, but these are still embryonic, and access to credit and capital is still dominated by the large domestic and foreign commercial banks. New mechanisms for financial intermediation---mutual funds, private pension funds, and insurance companies---can also play a useful role. But their development will take time.

Since the large banks will probably retain their role as the major source of external funding in the medium term, the reform of the banking sector is urgent. But the process is hampered by the large and growing portfolios of non-performing loans held by commercial banks. By international accounting standards, many banks and large enterprises are technically insolvent.

Dealing with commercial banks

Popular options recommended for the financial restructuring of commercial banks include:

• Debt cancellation, with the government assuming the bad debts carried by the banks and the delinquent enterprises. This would resolve a problem for which the present administration is not responsible. If both creditor banks and debtor enterprises are state-owned, it is assumed that no net losses are involved. This policy option has not been widely used, since debt cancellation means enormous redistributive transfers to many unsalvageable enterprises.
• Debt transfer, with debt obligations remaining on the firms' books, but with bad assets transferred from the commercial banks' balance sheets to a "bad debt" bank. In this option, the book value of the commercial banks' assets is reduced and government securities are issued to recapitalize the banks. This technique has been adopted by several Central and Eastern European countries. In the Czech Republic, the Consolidation Banka is a good example of a specialized institution that handles bad debts.
• Debt repayment to banks (which accumulate provisions against bad loans to meet capital adequacy requirements) is encouraged, with clients repaying through debt workouts or bankruptcy proceedings. In this option, however, profitable companies carry the burden of restructuring through higher costs of bank services. Among these three options, most Eastern European countries are using a combination of debt transfer and debt repayment.

Dealing with enterprises

Bank and enterprise indebtedness are closely linked---the enterprises' inability to repay debts threatens the solvency of the banks. So, financial restructuring needs to include debt-equity swaps between banks and heavily indebted enterprises. For these swaps, only viable debts should be included. The restructuring effort should divide public enterprises into three categories:

• Indebted but viable enterprises that are candidates for restructuring and subsequent privatization. Their debts should be reduced before, or as a part of, privatization.
• Nonviable enterprises battered by ongoing financial crisis that are candidates for closure. A clear timetable should be drawn up---and explicit subsidies provided---for gradual labor shedding if immediate closure is not feasible.
• Public utilities, including infrastructure and natural monopolies, and remaining state enterprises to be reformed. Government regulations should be established to restructure these enterprises into commercially run service companies.

These measures should help reduce the burden of enterprise debts on the banks' portfolios and speed privatization. Commercial banks should be active in enterprise classification, restructuring, and supervision.

Dealing with both

The transitional economies must develop banking systems that allocate credit efficiently. Commercial banks must screen borrowers and monitor and discipline enterprises. The role of the government or the central bank should be limited to regulation and supervision.

The financial restructuring of banks and enterprises should be undertaken simultaneously and should start early in the transition. Commercial banks should play an active role in the financial restructuring of enterprises. Governments must take responsibility (through the budget) for the debts of nonviable enterprises in a transparent manner and for the recapitalization of banks after their cleanup.

The speed of financial reform will depend greatly on the availability of skilled banking professionals, on access to technical assistance from abroad, on fiscal constraints, and, of course, on specific country circumstances. For example, for most countries of the former Soviet Union (except for the Baltic states) a prerequisite to successful financial restructuring is macroeconomic stabilization and the reduction of high inflation rates.

The most important lesson from countries further along in reform is that financial reform should not be delayed, but should start as soon as possible. Delays reduce living standards (burdening the healthy parts of the economy with direct taxes or high financial costs), discourage small-scale entrepreneurs, inhibit the entry of new firms, and cause the economy to stagnate further.

Options for the financial sector

Prevailing policy options for financial sector reform:

• Simultaneously restructure banks and enterprises, starting early in the transition process. Ensure an active role for commercial banks in the financial restructuring of enterprises, and finance bad debts as write-offs from the budget in a transparent manner. After the cleanup, recapitalize banks by issuing government bonds financed from the budget. Privatization should soon follow.
• Restructure and partially recapitalize banks at the earliest possible date (through state write-off of bad debts or debt-for-equity swaps), and follow immediately with privatization, leaving additional restructuring of enterprises and banks to the private owners so as to improve the incentive structure and avoid the moral hazard problem.
• Rather than recapitalize the old system, use the same public funds to develop an entirely new banking system. Cut back existing state banks to a viable core, and create new private financial institutions.

No matter what option or combination of options policymakers select, financial restructuring should encompass the breakup of bank monopolies, changes in the enterprises' ownership structure (privatization), improvements in the payments system, and efforts to adopt market-based financial legislation as rapidly as possible.