Features of State Banking in the Non-market System

1. Transforming Public Sector Banks in Central and Eastern EuropeLajos BokrosDirector Financial Advisory ServicesThe World BankApril 9-10, 2003Washington, DC

2. Features of State Banking in the Non-market System • State owned banks (SOBs) in the one-tier system were not supposed to manage risks • SOBs were assigned to serve ring-fenced clientele – no competition was possible • Specialized savings banks were to collect household deposits (monetary overhang) • Profitability, liquidity, solvency, cost control and efficiency did not matter

3. Common Characteristics of Early Reforms in the Early 90s • New SOBs were carved out of the mainframe of central banks initially with sectoral/regional profile – limited competition encouraged • SOBs inherited large non-performing loan (NPL) portfolio due to previous practice of non-market type credit allocation • Most of the original NPL portfolio was taken over by newly created central asset management companies (AMCs) • Hyperinflation “solved” the problem of initial NPL portfolio in many countries wiping out monetary overhang, too • Liberal entry policies resulted in a fast proliferation of new, small, privately owned banks (POBs) • Few foreign banks allowed and willing to establish local subsidiaries initially were engaged only in short term trade related finance

4. Impact of Early Reforms: a Mixed Blessing • Lack of adequate regulation and supervision quickly led to the insolvency of many banks, SOBs and POBs alike • NPLs fast reemerged in SOBs no matter how much fiscal resources were spent on several rounds of rehabilitation • Government were quite reluctant to privatize because of mixed experience with POBs and foreign subsidiaries • Many newly established POBs went openly bankrupt due to gross negligence or explicit fraud (pyramid schemes) • New enterprises, especially small ones had a very hard time to get financing form any bank at all • Governments introduced strong regulation and supervision but improvements were slow to materialize in practice

5. The Missing Element: Good Corporate Governance • Most SOBs remained weak because they were exposed to political pressure and intervention (“social responsibility”) • Some POBs introduced imprudent practices because they were subject to insider influence and mismanagement • Foreign subsidiaries remained small because they found the risk of domestic lending intolerably high • The most important missing element was good governance exercised by prudent management appointed and supported • By strong and prudent investors able to resist both political pressure/intervention and insider influence

6. Lessons Learned the Hard Way • Governments in Central and Eastern Europe spent 10-25% of GDP on several rounds of bank rehabilitation • SOBs not sold immediately after recapitalization usually fell back into insolvency quite rapidly • After much hesitation and wasted fiscal resources most large SOBs and some rehabilitated POBs were sold to • Reputable foreign strategic investors • Assuming management control and • Acquiring majority shareholding

7. The Landscape in Central and Eastern Europe in 2003 • Most large commercial banks of systemic importance are now in the hand of reputable foreign strategic investors • The new owners have provided not only additional capital, know-how, new products, marketing, IT-systems, etc. but • Strong andprudent management control which was instrumental in reestablishing the confidence of depositors • In Baltic 3 and Visegrad 5 most banks are now engaged in both corporate and retail lending (including SMEs) • In the Balkans foreign banks are still reluctant to undertake massive lending to the unrestructured corporate sector

8. Saving Banks and Development Banks – Exceptions from the Rule • Some saving banks have remained in state hands (Poland, Romania and Croatia) or privatized by IPO (Hungary), • Some sold to foreign strategic investors ( Slovakia and the Czech Republic) others wait for privatization (Bulgaria) • Development banks have proliferated as a consequence of government reaction to perceived market failure • They are active in post-war reconstruction (Croatia) and/or infrastructure, housing and SME finance (Hungary) • Development banks are largely inefficient and always need further recapitalization and/or regular fiscal subsidies

9. Lessons of Banking Reform in Central and Eastern Europe • Prudential regulation and supervision are absolutely necessary but far from sufficient; there is a need for • Strong competition (including also the liberalization of cross-border financial services) and • Good governance, prudent management able to reconcile the conflicting goals of liquidity, solvency and profitability • Maintaining deliberately arms lengths relationship to all possible clients and pressure groups • Serving first and foremost the interests of depositors • In order to maintain high level of trust in and integrity of the banking system determined mostly by the behavior and reputation of large systemic banks

10. No more state banking, please !We have had enough !