9 Revising Financial Sector Policy in Transitional Socialist Economies: Will Universal Banks Prove Viable?

Timothy Lane, D. Folkerts-Landau, and Gerard Caprio
Published Date:
June 1994
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David H. Scott1

This paper focuses on efforts under way in most transitional socialist economies to revise and update financial sector regulatory policy. It questions whether the banks that emerge under the new policy framework will be supervisable or prove viable. The paper offers a model of financial sector structure designed to foster the development of a sound banking system.

This paper briefly summarizes the environment in which financial sector policy is being revised. It notes that the extraordinary challenges facing policymakers may significantly influence the shape of the new policy framework and raises the concern that policies designed to promote a sound banking system may be overlooked or sacrificed. It examines in more detail the diverse objectives of policymakers, grouping those objectives into two broad categories: fundamental objectives and transitional objectives. Fundamental objectives, those that are important to long-run economic well-being, include establishing and maintaining the integrity of the payment system and the safety of depositors’ savings and ensuring the functioning of the money markets. Transitional objectives, on the other hand, primarily relate to the immediate task of enterprise restructuring and privatization. A key challenge for policymakers is to design a policy framework that balances inherent conflicts among and between these fundamental and transitional objectives, and thereby promotes achievement of both sets of objectives.

The paper observes the tendency in many transitional socialist economies to adopt a policy framework envisioning universal banking, and assesses the consequences of the immediate emergence of financial conglomerates, or banks of the universal type. It questions the potential viability of financial conglomerates pursuing conflicting objectives in the context of limited managerial and institutional capacity, limited capacity for financial market supervision, and extraordinary financial market risks. A policy framework built around such institutions may not achieve policymakers’ objectives.

An alternative policy framework is offered. It advocates delaying the emergence of financial conglomerates until skills are developed and market turmoil subsides. Over this transitional period, regulatory policy would assign to banks primary responsibility for achieving fundamental objectives, and would promote the role of nonbank financial institutions in pursuit of transitional objectives. Policy would be designed to promote the financial soundness of the banking system so as to control the potential costs to government of assuring achievement of its fundamental objectives.


Policymakers in European and Eurasian transitional socialist economies are confronted with complex challenges regarding both the financial and real sectors of the economy. The financial sector typically is dominated by a limited number of large state-owned banks. The financial condition of the banks largely reflects that of the real sector, which requires restructuring, debt relief, and new investment. Governments wish to transfer ownership of many of these financial institutions and enterprises to the private sector over time, and the privatization process is entangled in organizational and financial restructuring.

While the authorities are attempting to deal with restructuring and privatization, they are at the same time completely overhauling financial sector legislation. New laws relating to banking, central banking, securities markets, investment funds, and insurance will sharply redefine the regulatory policy framework. Supervisory bodies are being established or reoriented and are developing regulations that further redefine the policy framework.

In establishing the new policy framework, policymakers are striving to achieve divergent, often conflicting, objectives. Prominent among them are those dealing with the challenges of administering and financing the transition. For example, in the face of insufficient fiscal resources and limited available private capital, the authorities may directly or indirectly tap the state-owned banks for needed finance. These banks may be asked to play significant roles in enterprise restructuring and in enterprise privatization. More generally, they may be called upon to take the lead in financing and administering the development of the capital markets. As the challenges of transition are likely to be viewed as priorities by policymakers, there is a risk that transitional objectives such as these will be major determinants of the emerging policy framework. More fundamental objectives geared toward fostering a sound banking system that lays a foundation for higher and more stable long-run growth may be overlooked or sacrificed.

Objectives of Bank Regulatory Policy

Regulatory policies governing banking systems reflect diverse and conflicting objectives. It is common for countries to adopt certain fundamental objectives relating to the role of banks in a modern economy. Beyond these, governments frequently adopt ancillary objectives, such as those directing finance to certain sectors or enterprises. In the context of economies in transition, these ancillary objectives often relate to the challenges of transition.

Fundamental Objectives and Financial Soundness

The achievement of certain fundamental objectives of bank regulation can serve as a foundation for economic stability and growth. These fundamental objectives include safeguarding depositors’ funds and thus promoting confidence in the financial system; precluding systemic threats to the payment system; ensuring orderly implementation of monetary policy; and promoting efficient intermediation.

In the transitional environment, banks are the major deposit-takers, the only participants in the payment system, and the dominant players in the money markets, on which implementation of monetary policy depends. Therefore, the authorities can achieve many of the fundamental objectives by ensuring the financial soundness of the banking system. A financially sound banking system is one comprised predominantly of solvent and liquid banks. Depositors’ funds are safeguarded by the ability of the system to absorb the losses of banks that become insolvent. The ability of the system to settle its obligations eliminates potential threats to the payment system and the money markets. When the banking system is financially sound, the need for extraordinary intervention to support the solvency or liquidity of banks is minimized. Required interventions can be effected within the normal operating authority and capability of the central bank or deposit protection scheme.

Financial soundness is jeopardized when the risks incurred by banks are excessive in relation to their capital. Usually excessive risks arise from intermediation; resources are poorly allocated and loans are not repaid. Without systemic financial soundness, the system is unable to meet the collective obligations of its members to depositors and money market creditors. The payment system and the money markets can be compromised. Moreover, distorted incentives in the relatively larger number of troubled banks will threaten the overall efficiency of intermediation.

When the banking system lacks the financial capacity to meet its collective obligations, achievement of many of the fundamental objectives can only be assured through extraordinary intervention; the authorities must step in to fulfill the obligations of failing banks. In practice, governments or central banks almost invariably fulfill failing banks’ obligations to other financial institutions for payment system settlements, including the settlement of maturing money market transactions, to prevent an individual bank’s failure from triggering systemic collapse. And with only somewhat less frequency, payments are made to depositors on behalf of failing banks. Lacking systemic financial soundness, the interventions required can be frequent and sizable.2

Transitional Objectives

Policymakers understandably pursue objectives in addition to those noted above. Some transitional objectives may be consistent with the financial soundness of the banking system, but others may not be. Among the most common, often conflicting transitional objectives are ceasing financing and liquidating nonviable firms; continuing to provide quasi-fiscal finance to less than creditworthy borrowers to minimize unemployment; working with enterprise managers to develop restructuring proposals and supporting those proposals by writing-off and restructuring enterprise debts and lending for new investment; participating in the privatization of enterprises by financing the purchase of enterprises by the private sector, acquiring enterprises on behalf of customers (for example, via mutual funds), acquiring enterprise equities as portfolio investments, and underwriting share offerings; and supplying the capital base necessary to support development of the capital markets industry, and perhaps the insurance industry.

Many of these transitional objectives involve capital market activities for which there is little recent precedent in most transitional socialist economies.

Balancing Conflicting Objectives

In designing financial sector policy, policymakers must reconcile the manner in which conflicting objectives are to be achieved in a modernized financial sector structure. To avoid destabilizing interventions, policymakers must balance the desired role of banks in fulfilling fundamental and transitional objectives with the goal of maintaining the financial soundness of the banking system. A key factor in making this trade-off is the role that bank supervision can be expected to play. Supervision might be relied upon to ensure the financial soundness of the system regardless of the risks inherent in the policy framework. But experience demonstrates that bank supervision is often excessively relied upon to preclude problems whose root is poor or overly ambitious policy.

In the environment of economies in transition, bank supervision will evolve slowly, and must not be relied upon as the means to maintain financial soundness. Without effective supervision, it is the policy framework itself that must be designed to offer a reasonable expectation of engendering a financially sound banking system. The policy trade-offs involved might imply sacrificing some price efficiency in intermediation (a fundamental objective) to support higher risk-adjusted returns that can contribute to bank financial soundness. Further, they might imply limiting the role of banks in riskier financial market activities, many of which are inherent in the transitional objectives.

Financial Sector Structure

The new policy framework will largely reshape financial sector structure in transitional socialist economies. It will define permissible types of financial institutions, determine the range of activities in which each type can engage, and govern ownership and control of financial institutions. What emerges as the new structure of the banking and financial systems will significantly influence the means by which the fundamental and transitional objectives of bank regulation are to be achieved.

Financial sector structures in the world’s largest financial markets serve as important models for policymakers in transitional socialist economies. In those markets, clear trends have been evident over the past few decades. These countries have seen an erosion of the historic distinctions between different types of financial institutions and financial products, and the easing of many regulatory barriers to activities outside financial institutions’ traditional lines of business. The result of these trends has been the emergence of diversified financial services conglomerates that can conduct a broad range of financial activities, including commercial banking, securities, funds management, and, most recently, insurance.3

In many transitional socialist economies a tendency exists to adopt a financial sector structure that entails the immediate emergence of financial conglomerates, in universal bank form or otherwise. This tendency not only reflects developments in the largest markets, but is also consistent with the existing high degree of concentration in financial sectors in economies in transition, where large state-owned banks dominate the financial system. Policymakers may attempt to ascribe to these banks virtually all roles in the recast financial sector. The intent of this section is to assess the consequences of a financial sector structure envisioning the immediate emergence of large financial conglomerates that play extensive roles in all financial markets. Is this path consistent with achieving the varied objectives of regulatory policy?

By definition, banks have a key role to play in fulfilling the fundamental objectives. If banks can be put on a financially sound footing, and can maintain their financial soundness, most fundamental objectives of bank regulation are likely to be achieved without further extraordinary government intervention.4 Limited government resources can be directed toward other uses. On the other hand, if financial sector structure is to be based on financial conglomerates, the existing banks will form the core of these conglomerates, and those banks will be relied upon to play the lead role in pursuing transitional objectives. Should this role impair banks’ financial soundness, governments may be forced unexpectedly into extraordinary interventions to meet the obligations of failing banks, at a potentially destabilizing fiscal or monetary cost. Moreover, the failure of such banks would likely jeopardize achievement of transitional objectives by threatening the operations of the fledgling capital markets and disrupting key components of the bank and enterprise privatization process. Therefore, in adopting a policy framework allowing the immediate emergence of financial conglomerates, policymakers must be aware of the incremental obstacles to potential bank viability inherent in such a structure.

Key Issues for Viability of Financial Conglomerates

With the evolution of banks into financial conglomerates, they will be expected to pursue transitional objectives by participating in the financing and administration of the restructuring and privatization of enterprises. The resulting expansion in the scope of activities of banks and the wider variety of risks they incur must be evaluated in the context of (1) managerial and institutional capacity and (2) the capacity for effective financial market supervision.

Managerial and Institutional Capacity

Probably the most important determinant of the soundness of a financial institution is the quality of its management. But with few exceptions among transitional socialist economies, bank managers have little experience running large financial organizations subject to market forces. Their ability to evaluate comprehensively financial and operational risk is not well developed. An expansion of banks’ scope of activities and riskiness will magnify the challenge facing management. Large, diverse financial conglomerates may be inconsistent with existing management capacity.5

The task facing management is exacerbated by banks’ lack of institutional capacity. Accounting and data processing systems are not in place. Internal controls exist only in piecemeal fashion. Management information systems are rudimentary, and their reliability is compromised by the lack of accounting and internal control integrity. As a consequence, institutional capacity may not adequately support existing operations, much less a substantial expansion of banks’ activities. Management’s efforts would best be employed reorienting banks’ policies, procedures, and processes toward basic banking operations in a market economy.

If policy precipitates an expansion of banks’ activities, the greater number of customer classes and the wider range of roles played by banks in the financial markets will increase the extent to which they confront situations involving potential conflicts of interest. Conflicts will arise between the interests of the bank and its customers, and between various classes of customers (such as depositors, trust beneficiaries, securities purchasers, borrowers, and securities issuers). Conflicts of interest pose substantive operational risks that are normally contained by rather sophisticated institutional procedures intended to segregate information flows and decision-making responsibilities. Such procedures do not exist in banks in economies in transition and will not easily be adopted. As a result, the operational risks arising from the greater incidence of situations involving conflicting interests may threaten the integrity and potential viability of banks.6

To fulfill transitional objectives, banks will be asked to participate extensively in the capital markets. Although some capital market activities may be viewed as roughly equivalent to traditional bank lending activities (for example, investment in bonds), extensive participation in the capital markets, and particularly the equity market, will expose banks to new and substantial risks. Equity holdings are more difficult to value than are loans or bonds, and their values are more volatile.7 Beyond the difficulty of valuation, equity holdings give rise to substantial, perhaps unmanageable, interest rate and liquidity risks.8

In pursuing transitional objectives, banks may be left with sizable direct equity holdings—the consequence either of the conversion of enterprise debt into equity or of the acquisition of equities during the privatization of the enterprise. Banks also may find themselves indirectly exposed to equity risks where they finance the acquisition of state-owned equities by managers or other private sector investors, and when they sponsor equity mutual funds. These exposures, beyond presenting substantial financial risks, will compound the demands placed on bank management and will exacerbate the incidence of conflict of interest situations. If bankers are asked to play the role of shareholder in nonfinancial firms, they are distracted from the major task of establishing and managing soundly functioning banks. If banks are asked to play the role of investor, underwriter, distributor, and funds manager in the equity securities markets, the potential for corruption and abuse of conflicts of interest will be substantially increased.

Supervision Capacity

The capacity for effective financial sector supervision in most transitional socialist economies is limited. Managers of supervisory agencies are struggling with organization, recruitment, and training. Some have inherited a large complement of unqualified individuals. Others are starting from scratch. Where the agency is part of the central bank or finance ministry, these efforts take place in the context of the reorganization of much larger institutions with diverse and conflicting goals. In most cases, supervisory processes have yet to be developed. The procedures and processes necessary for off-site analysis, on-site inspections, enforcement, and failure resolution are not in place.

The difficulty in achieving effective supervision is compounded by the state of development of banks and the financial markets. Since accounting and management information systems are poor and lack transparency, supervisors cannot rely upon the routine availability of accurate information on individual transactions or overall risks. Since the financial markets are underdeveloped and subject to many distortions, assessing the riskiness of transactions is difficult. Since ownership of many assets is changing, and shareholdings in bearer form are common, supervisors are hard pressed to determine linkages among banks, managers, major shareholders, and related nonfinancial firms. Under conditions such as these, the ability to supervise banks effectively is limited.

An expansion of the scope of banks’ activities at this time will exacerbate the demands placed on the agency responsible for effecting the consolidated supervision of the institution, regardless of the precise form of financial conglomerates envisioned in each country.9 For example, where policy permits universal banks, bank supervisors need either to supervise all financial services activities or to oversee the work of specialized functional supervisors responsible for supervising certain activities conducted by the universal bank. Where policy requires that banks conduct some activities through subsidiaries, the bank’s exposure to risks incurred by its subsidiary cannot be limited to its investment in that subsidiary.10 Again, bank supervisors need to either supervise the subsidiary directly or oversee the work of specialized functional supervisors. Finally, where the conglomerate is so structured that the parent is not a bank, the exposure of banks to risks run by nonbank financial institutions within the conglomerate would be constrained by “fire walls” intended to limit access by nonbanks to the capital of the bank. But in practice such fire walls are not likely to be effective, and again the bank supervisors have to oversee the work of other supervisors.11

As the scope of activities and the diversity of banks expand, the nature of bank supervision changes. It has been the experience in the larger financial markets that supervisors can rely less on prudential rules to control overall risk adequately in financial conglomerates. Supervision of these diverse institutions is more dependent on qualitative assessments of institutionalized risk management and control systems, and on assessments of capital adequacy in terms of the reported and perceived overall riskiness of the institution.12 But as noted, such systems generally do not exist in banks in economies in transition. This lack of information integrity and transparency will preclude supervisors’ ability to assess the overall riskiness and financial condition of the conglomerate. In contrast, banks operating in a limited number of markets or with a limited role in those markets can be supervised more readily by the application of prudential rules designed to limit risk and ensure the maintenance of a certain level of liquidity, reserves, and capital. Determining compliance with prudential rules can be accomplished by supervisors who have a basic level of training and experience. Thus, the rapidity with which effective bank supervision is implemented can depend substantially on the nature of the banks to be supervised.

To conclude, the design of financial sector policy should promote achievement of both fundamental and transitional objectives. There are numerous substantive obstacles to the prospective financial soundness and viability of financial conglomerates in the environment of economies in transition. Effective bank supervision cannot be relied upon to prevent problems that may arise as banks attempt to assume a vastly expanded role in the financial sector. Given these constraints, a strategy that envisions the immediate emergence of large, diverse financial conglomerates and that relies on those institutions to achieve all financial sector objectives may prove unsuccessful. Policymakers might best consider alternative financial sector structures.

An Alternative Approach to Financial Sector Policy

This section proposes an alternative approach to developing the financial sector during the early years of transition. In broad terms, this approach would promote the role of banks, funded primarily by deposits, in achieving the fundamental objectives, and the role of nonbanks, funded with liabilities other than deposits, in achieving transitional objectives. After some time, the roles of both sets of institutions could converge.

The policies proposed here could be effected under a variety of legal arrangements. Particularly where financial sector legislation has yet to be revised, they could be reflected in the new legislation. Alternatively, they could be largely proscribed under the prudential rules adopted by supervisors, provided that the legal framework empowers bank supervisors to restrict the scope of operations of new banks and to narrow the scope of operations of existing banks. As such, this policy framework can be compatible with legislation permitting financial conglomerates and banking of the universal type. In effect, it would guide the manner in which such institutions emerged.

Nature and Role of Banks

Policy with regard to banks would aim to achieve the fundamental objectives by promoting the financial soundness of the banking system, thereby minimizing the potential for required extraordinary government interventions. Through the use of strict licensing procedures, only a limited number of banks would be permitted. Banks would be granted the exclusive right to raise funds through instruments labeled “deposits.” Deposits would be protected by a government-backed protection program. It would be mandatory for the savings and transaction accounts of households to be covered by the deposit protection program, and thus banks would have the exclusive right to offer such accounts to households. Banks and the central bank would share responsibility for ensuring the integrity of the payment system settlement process. Prudential rules would limit the risks banks could run and require the maintenance of relatively high liquidity, reserves, and capital. (The appendix provides a detailed listing of sample prudential rules.) Adherence to prudential rules and sound banking practice would be closely supervised. Ownership and managerial linkages between banks and nonbanks, both financial institutions and enterprises, would be initially restricted.13

Policy would strive to balance the trade-offs involved in permitting banks to play as great a role in transition as is consistent with financial soundness. This trade-off is most important when determining the role of banks in corporate finance. Corporate lending in the environment of economies in transition is highly risky. To foster sound lending, loan portfolios must be well diversified, mostly secured, and mostly short term. Prudential rules would mandate such practices. Loan diversification would be promoted by applying a relatively conservative, large exposure limit.14 Other prudential rules would establish conservative collateral and maturity requirements. As a consequence, the banks’ role would be to offer primarily secured working capital finance to small and medium-scale companies. Credits to larger borrowers could be arranged on a consortium basis. By utilizing the best available credit skills, such lending might be conducted without systematically jeopardizing financial soundness.

Banks would provide a safe place for those who are averse to risk to maintain their deposits in virtually unlimited amounts. The fundamental objective of deposit safety would be assured through government backing of a deposit protection program. The essential characteristics of the program are that it should apply to all banks, that its coverage limits should be relatively high, and that it should have unequivocal government backing. To reflect the value to depositors of the protection provided by the government, and to minimize moral hazard, interest rates payable on bank deposits would be regulated. Deposit interest rates generally would not exceed those on government paper of comparable maturity. Moreover, deposit interest rates might be held to slightly negative real terms, in part to promote the growth of nonbanks.15

Banks would be permitted to conduct only limited activities in foreign currencies. Funding and investment in foreign currencies would be subject to conservative limits on open positions (precluding mismatches in currencies and in time). If banks are not required by regulation to on-lend foreign currency deposits to the central bank, permissible foreign currency investments would be prescribed. Lending in foreign currency would be limited to borrowers that clearly generate sufficient foreign currency revenues to service the debt.

The banks’ role in the capital markets would be limited. Banks would be permitted to invest in, trade, and lend against government securities. They would be permitted to invest in corporate debt securities, subject to the exposure limits applicable to lending, and to lend to securities firms against such securities issued by third parties. Investments in or lending against equities would be permitted only in exceptional circumstances. Banks could take equities as part of the renegotiation of bad debts provided that the equity was booked at a nominal value and was sold within a short period. Underwriting, distribution, and trading of corporate debt or equity securities would be prohibited. Banks would not be permitted to offer pooled investment management services (for example, mutual funds).16 With the prior approval of the relevant supervisors, banks could play certain fee-based agency and advisory roles, such as acting as corporate advisor on capital market transactions, serving as a depository for mutual funds, or engaging in securities transactions on an agency basis at the request of a customer. Given these restrictions, banks would play virtually no formal role in the management of enterprises and would fulfill only administrative roles in enterprise privatization.

The banks’ role in the insurance market would be limited. They would not be permitted to underwrite insurance. With the prior approval of the bank and insurance supervisors, they would be permitted to distribute insurance products underwritten by others for a fee.

Additional prudential rules would serve to limit riskiness and ensure sufficient capital. Rules limiting interest rate mismatches would minimize the interest rate risk incurred by banks. Rules requiring maintenance of minimum levels of liquid assets would foster liquidity and serve as a trigger point for supervisory attention.17 To minimize the risk of insolvency, banks would be subject to high provisioning requirements and high capital ratios.

Part of the earnings necessary to generate reserve and capital formation would be derived from the indirect subsidy banks receive from the government’s protection of bank deposits, on which relatively lower rates of interest would be paid. The benefits of this low-cost funding base would accrue directly to the banks, and no policy constraints would attempt to pass these benefits on to certain classes of borrowers. The higher spreads would enable banks to build high mandatory provisions and capital, and to generate sufficient returns on capital. Consistent with the goal of financial soundness, tax policy would promote the accumulation of provisions by banks.

As a consequence of this policy approach, banks would be simpler and thus better matched to the skills of managers and institutional capacity. Limits on banks’ scope of activities would reduce the incidence of conflicts of interest and promote increased transparency. Rules designed to preclude direct or indirect exposure to equity markets would preclude many potential conflicts of interest, prevent the assumption of substantial financial risks, minimize the potential for systemic losses in the capital markets from spreading to the banking sector, and reduce the burden on limited managerial resources arising from the banks’ role in enterprise governance and management.

Under this policy approach, bank supervision can rely more upon the application of basic prudential rules regarding asset riskiness and diversification, liquidity, provisioning, and capital, and less on the qualitative assessments necessary to gear capital requirements to the perceived riskiness of more complex institutions engaged in a wider range of activities. With a modest skill base, bank supervisors are likely to be able to make substantial progress in achieving effective supervision. To support early implementation of effective bank supervision, banks would have to be audited annually by independent and competent auditing firms acceptable to the supervisors. The auditors would initially focus on the development of sound accounting practices and internal controls, would be required to perform standardized testing to determine compliance with prudential rules, and would play a role in assisting the bank in implementing corrective action when violations of law or noncompliance with prudential rules were detected. With this cooperative approach, the banking system is more likely to be effectively supervised within a reasonable time.

Nature and Role of Nonbanks

Although banks would be limited in number and highly regulated, policy would promote the proliferation of nonbank financial institutions, some forms of which would be subject to little or no regulation. Nonbanks could conduct any type of financial service activity, except that they would not be permitted to fund themselves through instruments labeled “deposits.” These institutions would not be permitted to use the word “bank” in their title; rather they might be known legally as “finance companies,” “industrial loan companies,” “trust companies,” “mutual funds,” “private investment companies,” “insurance companies,” etc.18

Nonbanks would be permitted to raise retail funding, provided that retail interest-bearing funding takes the form of “investment certificates” or similarly labeled instruments having a fixed maturity of at least one month. The funding of nonbanks would not be covered by the government-backed protection program, and explicit notification that the instrument is not protected by the government would be required.19 Interest rates would be set by the market, serving both to promote the emergence of nonbanks and to minimize any adverse consequence on savings mobilization arising from interest rate restrictions on bank deposits.

Nonbanks would be granted considerable latitude in financial market activities. Nonbanks that deal only with wholesale customers (including enterprises), or that accept funding from a limited number of individuals, would be virtually unregulated. Nonbanks that solicit funding from individuals more broadly would be subject to regulation and to varying degrees of supervision. Supervision could in many cases be organized around self-regulatory arrangements designed to promote acceptance of various types of institutions by investors. Generally, entry-level capital requirements would be minimized to promote the emergence of nonbanks.

Policy would promote the role of nonbanks in achieving transitional objectives. For example, nonbanks would be expected to play a major role in enterprise privatization, primarily by sponsoring open-and closed-ended mutual funds, or similar such vehicles, that solicit funds for investment in the shares of newly privatized enterprises. The regulation of such entities would focus on adequate disclosure, particularly with regard to any conflicts of interest, and fair marketing practices. Open-ended funds would be subject to diversification rules.20 Nonbanks similarly could solicit funds for long-term investment lending to enterprises, perhaps by purchasing convertible or equity-linked bond issuances. Nonbanks would be expected to function as stockbrokers and would operate stock exchanges.21

Nonbanks could offer payment services to corporate entities. However, most nonbanks would have to settle their payment transactions through a bank. Only certain individual nonbanks would be permitted to settle directly, subject to the approval of the central bank and representatives from the bank-based organization responsible for managing the settlement process.

Relationship of Banks, Nonbanks, and Government

A key challenge in balancing the achievement of fundamental and transitional objectives under this policy framework is to prevent losses incurred by nonbanks from either jeopardizing the financial soundness of the banking system or being so large that direct government intervention is required on behalf of failing nonbanks. Several policies are critical in achieving this balance. First, the customers of failing nonbanks would be expected to bear fully the losses associated with that failure. Second, policy for nonbanks would try to limit market concentration to minimize the potential that a nonbank grows so large that its imminent failure would itself represent a systemic threat requiring extraordinary government intervention. Third, most ownership and management linkages between banks and nonbanks would be precluded, both to minimize direct financial and moral linkages between them and to ensure arm’s-length decision making on transactions. Finally, all bank transactions with nonbanks would be subject to the same exposure limits that apply to corporate entities.22

Despite these policies, a considerable volume of bank/nonbank transactions will occur. Banks will need to settle payment transactions for nonbanks and will likely engage in substantive money market transactions with nonbanks. Banks may have to cover the potential illiquidity of nonbanks. These advances, in addition to other credit exposures, would be put at risk if the nonbank became insolvent. The insolvency of nonbanks can potentially lead to the insolvency of a bank and threaten the financial soundness of the banking system. Therefore, an important function of banks would be to monitor their credit exposures to nonbanks and to promote the prudent operation of their nonbank clients. Initially at least, banks might insist that most operations with nonbanks be conducted on a secured basis.23

After managerial and supervisory skills are developed, the financial markets become better established, and market turmoil subsides, cross-ownership restrictions between banks and other financial institutions could gradually be lifted to allow the emergence of diversified financial services conglomerates. At the same time the activities of the various supervisory agencies would have to be harmonized to ensure the consolidated supervision of those institutions.


George G. Kaufman

David Scott considers the very important issue of what should be the optimal banking structure, particularly initially, in the transitional socialist economies. In private market economies, the banking structures reflect the joint long-run economic, social, and political heritage of the respective country. As heritage differs substantially among countries, the banking structures also differ substantially. With respect to the United States, it is nearly impossible to understand the existing banking structure without first understanding the longstanding and deep-rooted public fear of big banks and the excessive economic concentration and power that they can wield. This fear is only now dying out as the banks are visibly losing market share. As a result, the United States has “narrow” banking and is on one end of the banking structure spectrum. German “broad” universal banks are on the other end. Recent changes in technology are narrowing the spread between the two extremes.

Although subject to considerable study in recent years, economists have not reached agreement on what is the optimal banking structure for any individual country, least of all for countries in transition. However, those who advocate narrower banks for reasons of safety and soundness need to be concerned about the poor performance of U.S. banks in recent years. Indeed, the narrowest banks, for example, the savings and loan associations, did worst. However, outside the United States, broader banks have also been in difficulties, particularly in Japan and the Scandinavian countries.

Scott enumerates four fundamental and a larger number of transitional objectives for a financial or banking system. The fundamental objectives are safeguarding depositors’ funds; precluding systemic threat to the payment system; ensuring orderly implementation of monetary policy; and promoting efficient intermediation. These are reasonable goals for any economy. Scott notes, however, that they may or may not be consistent with some of the transitional objectives, such as continuing credit flows to less than creditworthy large borrowers to avoid shocks, disruptions, and even temporary increases in unemployment. To achieve the fundamental objectives, Scott places great emphasis on government regulation and supervision, but recognizes that bank supervision is not born fully grown overnight. Indeed, in transitional economies, bank supervision is likely to come with considerable “baggage” that weakens its effectiveness. Thus, Scott argues that regulation and supervision alone must not be relied upon as the means by which financial soundness will be maintained. This suggests at least a partial market solution to achieving the first two fundamental objectives, but unfortunately the nature of the appropriate market structure to achieve financial soundness consistent with a proposed system of deposit guarantees is not discussed.

Scott recognizes that in practice the major shortage in banking in economies in transition is human resources—trained and knowledgeable market-oriented bank managers, regulators, and supervisors. As a result, he recommends a cautious, measured, step-by-step approach to achieving the fundamental objectives. This approach starts with narrow banks. He believes that universal banks are beyond the current capabilities of managers and supervisors in transition economies. In addition, potential conflicts of interest lie in wait as the necessary detection and monitoring systems are not in place and there is great pressure to satisfy the subsidiary and transitional objectives. Scott also rejects equity ownership. His bottom line is—in transitional socialist economies, start simple; walk before you can run. He correctly notes the frequent tendency to do just the opposite and the adverse implications of such a strategy for minimum government regulation and intervention.

Scott’s narrow banking structure includes a limited number of banks to restrict competition; funds raised through a bank monopoly on deposits; household deposits fully guaranteed by the government; only short-term and highly diversified loans; no insurance for securities activities; ceilings on deposit rates; high capital, liquidity, and reserves; and a clear-cut distinction between banks and nonbanks. Indeed, the proposed system looks very much like the U.S. banking system of the 1940s through 1970s. But, as noted earlier, despite good intentions with respect to safety and soundness, the U.S. system deteriorated badly. The reasons for the breakdown were largely independent of narrow versus broad considerations, although the geographic narrowness of U.S. banks was a contributing factor as it hampered diversification. The major problem was the poor structure of government deposit insurance—that is, a regulatory breakdown. Thus, it is important to examine and understand the incentive system that government deposit insurance provides for both bankers and regulators.

In the United States and most other countries, the structure of government deposit insurance inadvertently gave (1) bankers the incentive to take greater risks by reducing their capital and assuming more credit and interest rate exposure as discipline by depositors was reduced and (2) regulators and the government the incentive to forbear and delay intervening in troubled institutions to avoid unfavorable political backlash. The latter was possible as there were no deposit outflows or runs to force closure automatically of known insolvent institutions as had happened in the pre-insurance era. Therefore, public policy needs to deal with the deposit insurance problem at the same time if not before it deals with the banking structure problem.

Indeed, errors in establishing a deposit insurance structure are likely to be more costly to the economy than errors in establishing a banking structure. The two are in part interrelated, as poorly structured deposit insurance with broad universal banking could lead to the worst of all worlds—a bailout of all industries, not only of banking. That is, it could lead to an economy-wide federal safety net and a return to the bad old days of centrally planned socialist economies. Deposit insurance structure does not appear to have been thoroughly considered in planning the banking structure in economies in transition.

If the United States is to play a role model, it is important to understand what happened. The high cost of the regulatory failure ultimately led to potentially important deposit insurance reform through the structured early intervention and resolution provisions of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991. This is the most important banking act since the Glass-Steagall Act of 1933, and one of the most misunderstood. The underlying theory of the prudential provisions of the Act is to keep at least some government deposit insurance, but to offset the undesirable side effects from reduced market and regulatory discipline by mimicking the appropriate actions. It is designed to modify the incentive structure of both the bankers and the regulators.

Structured early intervention and resolution is divided into two parts. The first part—structured early intervention—is implemented through a series of bank capital zones with progressively harsher and more mandatory sanctions imposed on institutions by their regulators as their performance deteriorates and they sink down the capital ladder. The purpose is to turn the institution around before it is too late by applying a carrot-stick approach. Carrots include greater powers and reduced supervision. As long as it appears that a bank will be playing with its own money (capital), almost any activity that can be adequately monitored by the insurer could be permitted. But if the structured early intervention fails, early resolution is required through recapitalization by current shareholders, sale, merger, or liquidation before the institution’s capital turns negative. In theory, losses are restricted to shareholders and do not accrue to depositors and the Federal Deposit Insurance Corporation (FDIC). This structure effectively makes deposit insurance redundant and thus represents deposit insurance reform.

Although the Federal Deposit Insurance Corporation Improvement Act incorporated structured early intervention and resolution provisions, it did so in weakened form so that losses to uninsured depositors and the FDIC from failures are likely to be greater than zero. Its passage was vigorously fought by the regulators, who perceived these provisions as diminishing their power, visibility, and the “fun” of the job by reducing their discretion. Because the Act gives the agencies the power to interpret many of the provisions and to draft and implement the supporting regulations, the regulators can either reinforce or weaken, indeed even sabotage, the intent of Congress. To date, the regulators are, at best, weakening the effectiveness of the prudential provisions. This is possible as the banks are healthier now than they have been in a number of years, and the crisis is out of the daily headlines. But the regulators are playing with fire. It will not take much of a reversal in the economy or in interest rates for the brave new world to return suddenly to the broken old world. That is why this Act is only potential deposit insurance reform and not reform per se.

Structured early intervention and resolution is good deposit insurance policy in all countries. It keeps the best of both deposit insurance and market systems. It can work with narrow or universal banking, particularly if current or market value accounting is adopted. Indeed, if market value accounting is used and an effective “closure” rule is applied, the different prudential implications of narrow and universal banking diminish in importance. It would be possible to permit the banks to hold any asset that can be continuously valued at market. But market value accounting is just as difficult even in the United States as it is in economies in transition. The optimal banking structure in any country depends on the regulatory rules adopted. It is thus difficult to answer the question in the subtitle of Scott’s paper—“Will universal banks prove viable?”—without this important piece of information.

If transitional socialist economies can deal satisfactorily with the structure of deposit insurance, I could support Scott’s cautious, step-by-step approach, although there would be less need for the restrictive regulations that he proposes. In addition, Scott needs to pay more attention to an aspect of universal banking that has recently been receiving more attention—namely, its impact on corporate governance. Bank equity investment in firms may improve managerial monitoring and discipline and lengthen managers’ time horizons. Both results are generally viewed as beneficial. Moreover, in countries plagued by a shortage of financial managerial skills, universal banking may permit the few qualified managers to do “double duty.”


Sample Prudential Framework for Banks

This prudential framework reflects the policy proposals set forth in the paper. It is designed to promote the financial soundness of the banking system over the transitional period, defined here as five years, by limiting banks’ overall riskiness and promoting the maintenance of adequate levels of reserves and capital. This framework would be established by legislation and the rules of the supervisor.

Financial Sector Structure

  • Banks would constitute a clearly defined and delineated class of financial institution. Ownership of banks by other legal entities (or related individuals and legal entities) would be limited to 25 percent of the bank’s shares. Some exceptions to this limit might be permitted, such as for ownership by a well-supervised foreign bank. After five years, this limit would be phased out for ownership by other financial institutions.
  • Banks would be allowed only limited ownership interests in nonbank financial institutions, such as securities, funds management, and insurance companies, primarily to facilitate divestitures that might be required for banks to conform with the regulatory policy framework outlined in this paper. Investments in and loans to such companies would be limited to 10 percent of bank capital for each institution, and 25 percent in aggregate. The ownership interests of a bank would be limited to 20 percent of the nonbank institution’s capital. Directors and managers of banks could not be employed by or serve as directors of nonbank financial institutions, and vice versa. These limits and restrictions would be phased out after five years.
  • Investments in and loans to nonconsolidated nonbank financial institutions would be deducted from capital when assessing compliance with the minimum capital standard.
  • Banks would be prohibited from investing in institutions whose shares are in bearer (nonregistered) form.
  • Banks’ shares would have to be issued in registered form.
  • Banks would require the prior approval of the supervisors to invest in nonbank financial institutions, to open new branches, and for all merger and acquisition transactions.

Credit Risk and Asset Powers

Generally, banks would be permitted to hold a diversified portfolio of small and medium-scale corporate loans24 and consumer loans.

  • The large exposures limit25 applicable to each obligor (or group of related obligors) would be 15 percent of banks’ capital, with a 5 percent sublimit for unsecured lending. A phased-in increase to 25 percent and 15 percent, respectively, would begin after five years.26 Qualifying collateral would be defined and would include current accounts receivable, current inventories, and, for securities firms, corporate bonds issued by third parties.
  • The sum of all per-obligor credit exposures in excess of 10 percent of banks’ capital would be limited to 400 percent of banks’ capital. A phased-in increase to 800 percent would begin after five years.27 All such exposures would be reported periodically to the supervisors.
  • Lending for the construction or acquisition of commercial and industrial real estate would be subject to an aggregate limit of 200 percent of banks’ capital. Conservative maximum loan-to-value limits would be established for all forms of real estate lending.
  • The holding of equity securities of nonfinancial firms would be prohibited except when taken to satisfy previously contracted debts. Such holdings would be booked at a token value, unless traded on a regulated stock exchange, in which case they would be booked at the lower of cost28 or market. Such holdings would have to be divested within one year.
  • The financing of the purchase of shares by customers would be limited to 50 percent of the cost of the shares (that would have to be held as collateral), and limited in aggregate to 50 percent of banks’ capital. Aggregate financing for the shares of any one firm would be limited to 25 percent of the firm’s shares.
  • Lending to managers, supervisory board members, and shareholders would be limited to an aggregate limit of 10 percent of capital.
  • Underwriting, distribution, and trading of corporate debt and equity securities would be prohibited.

Capital Market Activities

  • Pooled investment management would be prohibited. Banks could offer such fiduciary services only on an individual, segregated basis.
  • Prior approval would be required to offer advisory services, act as depository for mutual investment funds, or conduct agency transactions on behalf of customers.

Insurance Activities

  • Underwriting insurance products would be prohibited. With prior approval, banks could sell insurance products underwritten by others.

Reserves and Capital

Generally, lending would be subject to high provisioning requirements, and a conservative minimum capital rule would be applied. Bank supervisors would have the power to mandate capital in excess of the minimum when considered necessary to support the operation of the bank.

  • A general reserve of 2 percent of total loans would be required.
  • Specific reserves against nonperforming loans (interest or principal past due for 90 days or more) would be created progressively such that the reserve equals 100 percent of the exposure (face amount less 75 percent of the estimated realizable value of tangible collateral) no later than two years after the loan becomes nonperforming. Reserves would be required earlier should the likelihood of loss become apparent.
  • Prudential rules would define situations presumed to constitute nonperformance. Rollovers of interest would be limited to six months’ interest in any two-year period. Banks would be required to maintain documentation relating growth in working capital lines to nondistressed increase in borrower’s requirements (for example, increased sales).
  • The minimum capital standard would utilize the features of the Basle accord (risk-weighted assets and off-balance-sheet exposures, and conservative definition of capital). The minimum ratio would be set initially at 12 percent, and would be phased down to 8 percent after five years.29 Alternatively, an 8 percent capital requirement could be employed, and weights of 150 percent applied to corporate lending.
  • In principle, the capital standard must be met on a continuous basis.
  • Dividend payments would be subject to restrictions to ensure maintenance of adequate capital. For new banks, no dividends could be paid in the first three years of operation unless approved in exceptional circumstances by the supervisors. No dividends could be paid if the supervisors have notified the bank that its loan loss provision is inadequate, or if the general reserve has not been established, or if the minimum capital standard is not met.

Interest Rate Risk

  • Fixed-rate loans of over two years’ maturity would be limited to 100 percent of capital (net of fixed assets) and 80 percent of long-term funding, which would include savings accounts without fixed maturity. Longer-dated asset maturities could be limited in decreasing proportions to long-term funding.

Foreign Exchange Rate Risk

  • Open foreign currency positions would be limited to 5 percent of capital per currency. The sum of the absolute value of all open positions would be limited to 15 percent of capital. Interest rate mismatches in foreign currencies would have to be confined to less than six months forward. Beyond six months forward, all positions must be matched.
  • Foreign currency lending would be restricted to sound borrowers generating sufficient foreign exchange to cover debt service and would be limited in aggregate to 50 percent of capital.


  • Banks would be subject to an asset-based liquidity requirement. Twenty percent of banks’ assets would be held as cash, sight deposits in banks, or in government paper (or equivalent liquid paper).

Interest Rates on Protected Deposits

  • Interest rates on bank deposits would be restricted. At their highest, they would be equivalent to the rate on government paper of comparable maturity and rate structure.

The views expressed should not be attributed to the World Bank, its Board of Directors, its management, or any of its member countries.


The authorities may attempt to avoid a permanent transfer of resources by supporting the liquidity of failing banks. But with limited exceptions, what is intended to be temporary liquidity support evolves into permanent solvency support and results in a higher long-run cost.


This paper defines a financial services conglomerate (or more succinctly, a financial conglomerate) as any financial institution that conducts more than lending and deposit-taking, whether directly or through subsidiaries. One form of financial conglomerate is the truly “universal” bank, which conducts the full range of financial activities in a single legal entity. In another form, certain activities (most commonly insurance underwriting) are conducted through subsidiaries. Still another variant is where the parent is not a bank, such as in a holding company structure.


This paper does not address the extraordinary government intervention required to recapitalize insolvent banks and thus put banks on a financially sound footing initially.


The quality of management will be influenced by incentives arising from the nature of bank ownership, Sound management may be threatened where policymakers permit controlling ownership of financial conglomerates by nonfinancial firms.


The incidence and consequence of conflict situations will be greater still if policymakers permit controlling ownership of financial conglomerates by nonfinancial firms.


Assessing the value of a performing loan requires a determination that sufficient cash flow will continue to be generated to service the debt over its life. Assessing the projected value of the borrower’s equity over the same period cannot be accomplished with any comparable degree of certainty. Even an assessment of a nonperforming loan supported by collateral is more assured. Only with an unsecured nonperforming loan is the task of evaluation comparable to evaluating the equity of the firm.


If equity holdings exceed the bank’s capital, they may be funded by interest-bearing liabilities. No ready means exists to manage the resulting interest rate exposure. Similarly, a portfolio of equity securities in a transitional socialist economy is likely to be illiquid.


The principle of consolidated supervision is a basic tenet of internationally accepted bank supervision practice.


In times of crisis, banks usually are compelled to extend additional credits to the subsidiary.


Considerable skepticism exists about the potential effectiveness of fire walls in the larger financial markets; fire walls tend to break down just when they were designed to become operative. In the words of a prominent U.S. bank supervisor, fire walls become “walls of fire.”


The adoption of an international standard for capital adequacy by the Basle Committee on Banking Supervision was a significant first step in this direction.


The small cooperative institutions encountered in most transitional socialist economies would have to form and be members of one of a limited number of “central institutions,” each of which would be licensed and regulated as a bank. The central institution would clear and settle payments for its members, act as lender of last resort, provide technical assistance, and bear responsibility for their prudent operation. Although cooperatives would have the same powers as banks, their activities might be restricted either by the central institution or by the bank supervisors.


Large exposure limits, or tending limits, establish the maximum amount that a bank can lend to a single obligor or related group of obligors. The limit is typically expressed as a percent of the bank’s capital. See the appendix.


This paper presumes that the government will protect most deposits, even where no explicit coverage exists. Adopting explicit deposit protection coupled with interest rate regulation for protected accounts is an equitable means of passing on to depositors part of the cost of this protection. The value of such protection might be great given the level of financial market risks, conceivably justifying negative real interest rates.


Individual fiduciary services could be offered.


Simple asset-based liquidity rules will likely prove sufficient, at least until the money markets develop further.


The fundamental role played by insurance companies may more closely parallel that of banks, and thus insurance companies should be subject to specialized regulation and supervision. Insurance company regulation and supervision are not addressed further in this paper.


To promote this policy, nonbanks that accept interest-bearing funding might be required to use standardized or preapproved contracts that clearly differentiate the instrument from a bank deposit.


See EC Council Directive 85/611 for appropriate diversification rules.


Since banks would not be permitted to be clearing members of stock exchanges, by implication, government securities would not be traded on stock exchanges under this policy framework.


With possible exceptions for short-term money market transactions.


For example, clearing and settlement conducted on behalf of nonbanks could be supported by pledged government securities.


Including similar instruments otherwise defined legally as securities or financing leases.


On- and off-balance-sheet exposures.


Under a proposed directive of the European Commission (EC), large exposure would be limited to 25 percent of banks’ capital. The EC does not propose a sublimit for unsecured tending.


The proposed EC limit is 800 percent.


Where cost is equivalent to the nominal amount of debt written off.


The Basle minimum is 8 percent. Many Croup of Ten countries require higher levels for most banks.

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