Assessing the Post-Crisis Recovery in Eastern Europe and Central Asia An Overview

Assessing the Post-Crisis Recovery in Eastern Europe and Central Asia An Overview Fernando Montes-Negret, World BankSector DirectorPrivate and Financial Sector DevelopmentEurope and Central Asia "The Financial Sector Post-Crisis: Challenges and Vulnerabilities" World Bank and Brookings Institution conference, April 26-27, 2005 at the Brookings Institution in Washington, DC

A Policy Framework • Crises of Transition • Examples of Crisis Experience in ECA • Poland and Hungary • Russia • Financial Sector Development in ECA today • Conclusions

Crisis of Transition Transition countries experienced a dramatic change in all political, economic and social aspects After the end of the monobank system in the centralized economies, most transition countries experienced more or less severe systemic crises It is important to distinguish the specific crisis experience of transition from other financial crises in the 1990s

Before the Berlin Wall fell: “Financial Intermediation” did not exist: FIs did not compete for deposits; No competitive allocation of funds to their most productive use Monobanks were channeling funds allocated to SOEs according to physical and credit plans: No screening, No monitoring! “Concepts such as capital adequacy, the creditworthiness of borrowers, portfolio concentration, and insider lending were of only peripheral relevance to the financial durability of banks — their “failure”, in any case, was not a possibility to be entertained.” (Peachey / Roe, 2001)

Financial Sector Transition • State-planning history caused high number of NPLs and defaults in the systems. For example: Czech Republic 29% and Poland 31% NPL in 1991 • Early transition management allowed large number of bank entries based on lax entry requirements • Second wave of bank failures, incl. large numbers of new private banks • Restructuring, consolidation and privatization (often through opening to Western FIs) NOT ALL ECA COUNTRIES FINALIZED TRANSITION!

Crises of Transition - Lessons learned (1) - Painful restructuring and the acceptance of failure of banks at the early stages of economic transformation allowed a relatively less costly “creative destruction” (Central European and Baltic countries) Financial systems were typically smaller and the cost of almost inevitable crises were lower. Simultaneously, early intervention provides more lead time for the development of sustainable financial intermediation as a driver of economic change. Non- or incomplete reformers (Russia and Ukraine) still are saddled with rather dysfunctional financial systems with “hidden” insolvent banks. Source: Claessens, Klingebiel, Laeven (2004), Fitch Ratings (2004) and own calculations

Crises of Transition - Lessons learned (2) - Multiple waves of recapitalizations and purchases on NPL are detrimental, indicating, de facto, the willingness to provide continuous bailouts, a form of soft budget constraint. Granting licenses for new private financial institutions is not enough to transform and create a more competitive financial sector. A successful approach to transformation needs to actively manage the restructuring of existing institutions, including privatization of SOBs and allow only the entry of first rate foreign banks bringing financial, reputational and human capital.

Crises of Transition - Lessons learned (3) - Supervisory enforcement capacity (beyond laws and regulation) and political backing are critical to enforce and promote the right incentives for the development of sustainable prudential behavior in the financial system. Company privatizations, with clear ownership rights and tough bankruptcy systems (Hungary), brought stakeholders with well aligned incentives to strive for efficiency in a context of financial accountability. Monetary and fiscal discipline is crucial to create an environment conducive to successful financial transitions.

Crises Experience: Poland and Hungary Hungary and Poland both experienced substantial financial crises in the early 1990s as the result of the historic malfunction of the banking system under state planning. Both countries proceeded quickly to restructure and privatize their state banks, and the governments faced the unpleasant realities right at the start. Need to tackle existing NPL and simulta-neously improve supervision and risk-management to avoid recurrence of the problem Privatization of SOBs and foreign participation in the banking system proved an effective way of creating strong banking systems EU accession: Both countries had strong political capital to reform their banking sectors and foster acceptance of foreign bank ownership.

Crises Experience: Russia • Russian crisis illustrates the need for a strong institutional and legal framework (supported by political will) in order to deal with fall-outs of crises: restructuring agency and FI specific bankruptcy laws only implemented after crises! • Russian crises represents a “missed opportunity”: • Banking sector took a step backward to a more state-dominated system • Reliance on short-term ‘stability’ of the state banks (and ultimately the budget) as anchors of the financial system achieved at a the expense of delayed banking system restructuring, consolidation and foreign bank entry. • Sharp contrast to the good performance of the commodity boom-driven Russian economy: Banking sector now a bottleneck for a wider-based and more sustainable economic recovery, while increasing the risk of capital flight and financial disintermediation.

Financial Sector Development in ECA today (1) Output Recovery a good basis for sustained growth of financial sector Low levels of financial depth constrain ECA economies, in particular Russia, CIS, Turkey

Financial Sector Development in ECA today (2) ECA financial systems remain bank dominated and the development of capital markets and NBFI is one of the remaining key challenges for the region

Financial Sector Development in ECA today (3) Average private sector credit in the region —just below 25% of GDP — is insufficient to provide the funds needed to grow economic activity. Companies are still heavily reliant on internally-generated funds to finance new investments.

Conclusions (1) “Crises weaken or dissolve special interests, and allow a fresh start” (Dixit, 2005) These “useful crises” did happen in some countries in the Europe and Central Asia region, but there were also “indecisive or useless crises” which did not result in a serious revamping of the banking system and the hoped for start of depth-enhancing reforms. ECA countries still have a long way to go in the development of financial intermediaries, markets and institutional capabilities. In general, and in spite of tremendous recent progress, indicators of financial intermediation remain low in a broader international perspective.

Conclusions • Broadly defined institutional development remains the main challenge (again with various degrees of severity), specifically in the area of banking supervision. In our view, there are four key areas where there is significant scope for making progress: • Consolidated supervision, granting adequate powers to supervisors to investigate the composition and cross-shareholdings inside of financial, non-financial, and mix complex conglomerates; • Autonomy, funding, and adequate remuneration and staffing of supervisory agencies, and legal protection for bank supervisors; • Better risk management systems in financial institutions, while supervisors move to risk-based supervision. In view of the EU decision to adopt Basle II within the proposed timetable, the challenges are going to be more pressing for the EU subset of countries, but all ECA countries are well advised to prepare realistic “road maps” to transition to better risk-management systems. • Contingency plans, including adequate legislative frameworks and institutional capacity, which should be in place to respond effectively to, hopefully, less frequent and less severe, banking crises.

Assessing the Post-Crisis Recovery in Eastern Europe and Central Asia An Overview