Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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Hanna Gronkiewicz-Waltz’s paper provides a comprehensive review of changes that have taken place in Poland, so I will attempt to complement her remarks by bringing in some of the broader issues affecting the evolution of banking systems in transition economies, the experience of some other transition countries of Central Europe, and the implications for monetary policy.

For those less familiar with the transition, two points may illustrate what the transition has meant for banking and monetary policy. First in the planned economy, there was no independent role for banking or monetary policy. From a macroeconomic perspective, the reforms involved in switching from direct (planning-type) to indirect (market-based) instruments were most marked in the role of monetary policy. In the prototype planned economy, the role of money was passive. Money payments essentially validated the planner’s commands, whose task it was to balance real resources in terms of quantities. In contrast, in a market economy, the role of money changes from passive to active, giving the holder of money command over real resources. Thus, monetary policy becomes crucial to financial stability, and a functioning banking system becomes crucial to the effectiveness of monetary policy.

The first step taken by all transition countries was to split the monobank into a two- or three-tiered banking system, separating central from commercial banking activities: China in 1984, Hungary in 1987, the former Soviet Union in 1988, Poland in 1989, the ex-Czech and Slovak Federal Republic in 1990, and the others since then. But a multitiered system does not make a banking system. In most cases, the credit departments of the former monobank were heaved off into separate commercial banks with portfolios, staff, and expertise of commercial banking practices of varying quality.

Second, the transition involved a change in environment that could have baffled even seasoned bankers. The previous regime, to varying extent, set relative prices with a view to building surpluses in large enterprises as an easy means of financing the budget as profits were taxed, returned as dividends, or simply confiscated. The change in relative prices following price and trade liberalization (together with the contraction of output) resulted in a massive reallocation of surpluses. For example, positive profits as a share of GDP in Bulgaria, Hungary, and Poland went from 20-30 percent of GDP in the year preceding the initiation of the transition to 10 percent or less three years later. Thus, while the emergence of bad debts is often ascribed to (in many cases rightly) the capitalization of interest and weak governance in the banking system, it must also be recognized that this was a difficult environment for credit assessments.

What have banks done in this environment? Some have adjusted and some have not. In Poland, which is often held as a model, the restructuring of bank portfolios has taken place under the framework of the 1993 Law on Enterprise and Bank Restructuring. The program relied on three important elements. First, it had the banks confront their problems in a decentralized fashion (through their workout units). Second, it established an incentive structure for the banks as a strict deadline was imposed for initiating action on bad loans; the volume of such loans for which recapitalization was in prospect was fixed ex ante (at the level of end-1991); and eventual recapitalization was conditioned on the creation of workout units and implementation of a restructuring program. And third, banks operated under the commercial code, with ownership exercised by the Ministry of Finance through supervisory boards and with the clear prospect of future privatization. In that way, the government intended to deal simultaneously with the stock and flow aspects of the bad loan problem.

Although the program can be assessed only from a longer-term perspective, it appears to have been successful in removing the burden of old loans while avoiding a flood of new ones. Banks chose conciliation procedures (a streamlined version of a Chapter 11 proceeding under U.S. bankruptcy law) for about one-third of their bad loan portfolio; liquidation or bankruptcy was the second most often chosen path (29 percent); and most of the remaining debts were either sold in the secondary market or debt service was resumed. In return, the government provided the banks involved with about Z1 4 billion in recapitalization bonds, raising their capital-asset ratio to the target level. As for new loans, it is estimated that only 2–4 percent of new credits turned bad, a result also of the tightening of licensing requirements effected from 1992, in conformity with European Union standards, and the experience with supervision since then.

At the other end of the spectrum is the crisis of Bulgaria’s banking system, which follows several years during which the banking system was troubled by widespread liquidity problems and growing insolvencies. The level of nonperforming loans—estimated at about 70 percent in late 1995—resulted from the absence of hard budget constraints on state-owned enterprises as well as poor bank management and lack of enforcement of supervisory standards. The runs on banks took on a more systemic nature in 1996 as fears escalated that foreign currency deposits would be blocked, prompting withdrawals of foreign currency deposits of US$800 million from December 1995 through November 1996 (38 percent of deposits at end-1995) and syphoning off a substantial part of inflows coming through the balance of payments. While clearly unduly delayed, steps were taken in 1996 to deal with problem enterprises and banks. Sixty-four enterprises were closed, and 70 others were isolated while 14 banks were closed in May and September, accounting for about 20 percent of total deposits.

Even in Poland, however, the process has been less than totally successful in improving enterprise governance. A recent study by the World Bank reported on a survey of about 20 percent of the 787 firms initially included in the enterprise and bank restructuring program. Though the survey confirmed that, on balance, the program had a positive impact, several problems remain. For example, even for cases dealt with through the bank conciliation process (the better-off firms), the survey found declining profitability and cash flow in the first two years of the agreement’s implementation. This is perhaps not surprising as the study also concluded that the bank conciliation agreements appear to have dealt primarily with financial conditions—mostly large debt write-offs and renegotiation of payment dates—and included very few tangible requirements for operational or management changes.

Though improving, the inefficiency of banking systems at the microeconomic level is also having effects on macroeconomic policies. This can be illustrated with examples from the Czech Republic and Poland. The first driving force for capital inflows in the Czech Republic was enterprise borrowing abroad. After a time, this came to reflect, in part, lower foreign interest rates; but initially it reflected primarily the lack of domestic availability of longer-term credits as domestic banks tended to match strictly the maturity structure of their liabilities (mostly short-term) and their assets. The problem did not reflect an assessment that long-term lending was too risky—at least initially enterprises were simply not well enough known by foreign creditors—as all loans had to be guaranteed by domestic banks, which therefore carried the full commercial risk. The banks simply refused to transform maturities on their balance sheets. The resulting capital inflows created significant problems of monetary control.

The effect of inefficient banking systems on the conduct of monetary policy can also be illustrated by the weak transmission mechanism. A study by the IMF’s Monetary and Exchange Affairs Department in 1994 analyzed the speed and size of the response of lending rates to changes in money market rates for about 30 countries, both industrialized and developing and including two of the transition economies (Hungary and Poland). The study found the effect on lending rates to be well below average, over all time horizons, for both transition countries, with the exception of the long-run response for Hungary, which was close to the average. Though the study analyzed several factors contributing to the weak response of lending rates to changes in money market rates, two may have been particularly important in the case of transition economies: the low elasticity of the demand for loans to changes in interest rates, which reduces the cost of keeping lending rates out of equilibrium; and a still oligopolistic market structure, resulting in stickiness in adjusting lending rates due to uncertainty about the response of competitors. Some additional weight to the latter argument was provided by evidence that Polish banks, though they were very slow in adjusting lending rates to money market rates, adjusted lending rates very quickly to a change in the National Bank of Poland discount rate as the formal announcement provided a clear signal for all to adjust. It is interesting that, while the functioning of the banking system continually improves, evidence of the lack of response to monetary policy has been repeated recently as the NBP in late 1996 engineered an increase of 2.5 percentage points in market rates, but without a change in headline rates and with only limited effect on lending rates.

Overall, what can be said of the experience so far? There has clearly been substantial progress in the legal and regulatory framework. The Central European banking systems, in particular, now conform to EU standards in terms of minimum capital, capital adequacy ratios, most exposure limits, and licensing practices. Internationally accepted standards of accounting have been adopted, and with them more open disclosure requirements to enhance monitoring capacity. Continuous progress is also being made with supervision, though there remain weaknesses. However, as the examples above show, much progress remains to be achieved in banking practices themselves to enhance the efficiency of banking systems; focus on EU accession can be expected to lead to continued improvements in governance, management, efficiency, service provision, and financial performance.

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