The risk has several sources, but political risk, macroeconomic instability, limited microeconomic information, and legal uncertainty are the most important. The first two issues are largely resolved. The EU has been successful in reducing local political risk, promoting reform through a top-down approach with strong conditionality. The Baltic governments have shown a credible commitment to stability, and the fragility of domestic financial institutions has been gradually addressed.

The main residual risk premium in the Baltic countries and Poland comes from the weak enforcement of laws and the lack of transparency. The problem is not a shortage of capital but poor governance leading to misallocation and a poor composition of finance.

Even in industrial economies, financial constraints arise from poor information structures or difficulties controlling the use of funds by insiders, but the problem is more serious in the transition economies. Standard, sophisticated legal codes have been introduced, but these laws have not been fully tested and enforced. Business practices have not yet fully adopted the use of legal proceedings, and they remain too reliant on either informal solutions or state intervention. There is still not sufficient experience and ability to use the rules created for promoting an environment supporting decentralized and entrepreneurial activity. Limited public information hinders access to financial markets and undermines proper legal enforcement in a vicious circle. Long delays and ambiguity in enforcement persist, and current economic practices often bypass formal mechanisms. The result is potential illegality, lack of transparency, and vulnerability to corrupt practices.

This institutional gap creates significant financial constraints, particularly for new and smaller companies with limited access to connected lending and other informal enforcement mechanisms. What can be done to fill this gap? The record of national development banks is not encouraging. These institutions saw a massive expansion in the 1960s, then stagnated in the late 1970s and have largely run down or closed since then. State ownership of banks tends to politicize resource allocation, and the state is weak at enforcing financial obligations. Large institutions tend naturally to focus on larger firms. Centralized allocation systems such as state development banks also often outlive their usefulness. Predictably, the creation of development banks has almost invariably led to disasters, with lending directed by political, often regional, interests, leading to very low repayment rates and losses that almost always exceed two-thirds of assets. These banks build little expertise in credit analysis, and their lack of a retail basis means their ties to the local economy are weak. In short, the evidence shows that state development banks lead to financial underdevelopment, reduce productivity growth, and fail to promote economic growth.

Creating such an institution would replicate the top-down approach dominant in the region, applied by the EU and the IMF. The EU has been able to induce significant change through strong conditionality, which has supported the operational ability of the large international financial institutions. The presence of the EBRD, the World Bank, the European Investment Bank, and NIB ensure sufficient funding for large-scale infrastructure and commercial investment. The EBRD and the World Bank have also directed conventional funding to entrepreneurial and smaller firms.

It is thus difficult to argue that there is scarcity of traditional bank lending in the region. Rather, there is a lack of entrepreneurial finance. In countries at a late stage of transition, this lack reflects the institutional gap between the formal rules of a market economy and their concrete use. What is needed is a more bottom-up approach that reinforces grass-roots initiatives to improve access to legal remedies for business, increase public knowledge on new rules and accountability for new institutions, build an implementation record, and create dedicated service institutions with the necessary expertise to guide firms through this process.

A special public agency, a "venture catalyst"—let us call it the Baltic Sea Investment Bank—could help new private initiatives activate the new institutions needed to support market transactions (regulators, courts, arbitrators, independent evaluators, enforcement agencies). This agency, which would have a charter clearly delimiting its life span as a state-sponsored development entity, would pursue a portfolio of service and investment activities. Its focus would be on advice at least as much as investment, with possible areas of service activity including legal advice, consulting, market research, and trade promotion. Its portfolio of activities would include helping to set up venture capital funds and contributing to the creation of exit markets (by helping to create a credit rating institution, for example).

Another critical task should be to establish a policy of helping companies test existing legal institutions—by bringing lawsuits, demanding disclosure or market access, or pursuing bankruptcy procedures, for example. The agency should also promote various bottom-up initiatives promoting entrepreneurial and civil society activities. Constituencies must be built for greater transparency and improved implementation and enforcement of existing laws.

Most important, the institution should bring together private and public interests. From the start, it should be destined for ultimate privatization, wholly or partially, to motivate top-quality personnel. Personnel and management could have an explicit title to shares in the institution after a vesting period.

In designing the charter for such a temporary agency, policymakers must address the following issues: Are there parts of the charters of existing international financial institutions that constrain them from filling the institutional gap? In what significant way would the new agency be different? Is it easier, and cheaper, to change the charters of existing institutions rather than to create a completely new entity?