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4 Financial Sector Evolution: Challenges in Supporting Macroeconomic Stability and Sustainable Growth

International Monetary Fund
Published Date:
May 2002
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Dora Iakova and Nancy Wagner 

In the run-up to EU accession—a setting of real convergence and sizable, possibly volatile, capital inflows—the role of the financial sector in supporting broadly based and stable growth will move to center stage for a number of reasons. First, successful reform of the banking sector is a necessary condition for fiscal and monetary stabilization. Second, a well-functioning financial sector helps enforce corporate control, contains potential quasi-fiscal losses in the enterprise sector, and is, therefore, key in fostering sound enterprise development. Third, financial sector resilience is crucial for a flexible interest rate policy and a predictable and effective monetary transmission. Fourth, effective supervision, regulation, and risk management can help mitigate vulnerabilities associated with capital flows. More broadly, empirical evidence has shown convincingly that countries with better developed financial systems enjoy substantially faster and stable long-run growth through channeling savings into productive investments.

Many of the challenges facing the CEC5 in the financial sector are similar to those in existing EU members—but there is a particular need for institutional deepening and, to varying degrees, addressing residual legacies. Slovakia and the Czech Republic are now engaged in major efforts to ensure a healthy financial structure. They have recently privatized the remaining state-owned banks—and made explicit quasi-fiscal costs, but completing the bad debt workout still lies ahead. Slovenia needs to privatize its largest state-owned banks and move away from an oligopolistic banking structure. Hungary and Poland have the most advanced financial systems, but face increasing competition—which will narrow margins, impact profitability, and spur consolidation. These pressures are becoming increasingly evident across the region, and will intensify as the five countries enter a common market for financial services. Adequate regulation and supervision will be essential to avoid excessive risk-taking, particularly in the presence of heavy capital inflows. In all five countries, the legal system and judiciary need to be strengthened in areas such as collateral enforcement, which provide key underpinnings to financial sector activity. Improving corporate governance, in both the financial and enterprise sectors, will also be core to ensuring financial sector soundness.

To shed light on financial sector challenges in the accession period, including interlinkages with the macroeconomic framework, this chapter explores three main issues. What are the key priorities in this sector to support broadly based growth and help avoid macroeconomic disruptions? How can its structure best support fiscal and monetary policies? What changes are needed if it is to cope effectively with large scale capital flows? Success in these areas is interrelated and will reflect progress in restructuring, deepening of market and institutional structures, and effective regulation and supervision—including an appropriate incentive structure to contain moral hazard. While the focus here is on the role of sound financial systems in supporting macroeconomic policy, linkages go both ways: a setting of sound macroeconomic policy is crucial for supporting financial sector development.

Financial Sector Development and Growth

As the CEC5 approach EU membership and ultimately the adoption of the euro, the litmus test for the financial sector will be its success in supporting sustainable economic growth. This involves harnessing the diverse roles of the sector in mobilizing and reallocating savings; facilitating the hedging, diversifying, pooling, and trading of risk; and, through the operation of both banks and capital markets, strengthening corporate governance in the enterprise sector. Through these activities, well-developed banking systems and financial markets have a significant positive impact on total factor productivity, which translates into higher long-run growth.18 The empirical literature also shows that initial levels of financial development are good predictors of subsequent growth, capital accumulation, and efficiency improvement in the real economy—even after controlling for income, education, political stability, and measures of monetary, trade, and fiscal policy.19 There are broad positive feedback effects between financial and economic development.

Bank-Based or Market-Based Financial System?

The financial systems in the CEC5 have developed more in the direction of “bank-based” systems—as in Germany or Austria—than “market-based” systems as in the United States and the United Kingdom. Banking sector assets in the CEC5 account for about 85 to 95 percent of overall financial assets, compared to a little over 50 percent in the United Kingdom, which is more typically regarded as heavily securities- or market-based. In the CEC5, bank monitoring plays a more important role in corporate governance as opposed to the threat of hostile takeovers that may characterize more market-based systems. Claims on banks are more important in household portfolios than securities. Thus, banks dominate the provision of financial services.20

Analysis of market-based versus bank-based financial systems, however, has found no conclusive evidence that the type of system matters for growth performance. Countries at the same stage of economic development and with similar rates of long-run growth have a different mix of financial institutions (Levine, 2000). Banks and capital markets provide different services in response to different market imperfections. The presence of both types of financing can also allow for better diversification and risk sharing. More important than the debate on bank-versus market-based systems is the recognition that effective and well-supervised financial structures are key in achieving rapid and sustainable growth.

The banking systems in the CEC5, to differing degrees, share characteristics such as high concentration, increasing competition, and dominance within the financial sectors. The main findings are as follows (with a more detailed discussion in the next section):

  • Credit to the private sector as a share of bank assets, at 40 to 50 percent, is lower than the typical 60 percent for the advanced economies. This also reflects, to some degree, the large share of direct external financing enjoyed by corporates in several of the countries. Nevertheless, private sector credit growth has been on the uptrend in Hungary, Poland, and Slovenia in recent years.
  • Concentration in the banking sector is high. There is particularly strong concentration of deposits, while the credit market is somewhat more fragmented.
  • The efficiency of financial intermediation has room for further improvement. Net interest margins are higher than the EU average. In some of the CEC5, state enterprises still enjoy financing at more favorable terms due to implicit or explicit government guarantees.
  • Competition, however, has strengthened as evidenced by declining intermediation spreads and a shift in bank portfolios from government securities to private sector lending. Moreover, with the blue chip marker saturated in some of the CEC5, lending to small- and medium-size businesses is on the rise.
  • In each of the CEC5, with the exception of Slovenia, foreign strategic investors control the majority of banking sector assets.
  • In the Czech Republic and Slovakia, the large share of nonperforming loans and persistent negative average returns—at least until recently—pointed to a need for significant restructuring, which is now well underway.

Size of the Financial Sector and Banking Sector Performance

Financial sectors in most of the CEC5 are still small relative to economic activity. To assess their level of development, several frequently used measures for size and performance allow comparison with advanced economy benchmarks (Tables 4.1 and 4.2). In the euro area, bank assets exceed 210 percent of GDP, while in the CEC5 they are between 60 and 180 percent of GDP. Only the Czech Republic and Slovakia have relatively high ratios—at 181 percent and 100 percent of GDP, respectively.21 However, poor asset management and large shares of non-performing loans hinder efficient intermediation in those countries, and asset size may not be a good benchmark of financial sector effectiveness. Bond markets are also relatively small: issuance averages less than 30 percent of GDP, with the majority being government bonds.

Table 4.1.Banking Sector Statistics
Czech RepublicPolandSlovakiaSloveniaHungary
Number of licenced (commercial) banks454242837773252321242525373633
of which
Majority state owned (number)544137755422222
As % of total assets23.
Majority foreign owned (number)13141831394611101035527
As % of total asset15.526.816.647.269.628.930.24.94.815.661.465.466.7
Number of banks accounting for:
25% of total assets2222222211122
Asset share of the 3 largest banks45.645.85252504038.5
Asset share of the 5 largest banks66.
Total bank assets as % of GDP
(excl. Central Bank)174.0181.358.059.462.3111100.495.572.278.779.168.667.865.2
FX denominated assets (as % of total)19.921.516.018.329.730.232.836.137.036.4
FX denominated liabilities (as % of total)18.218.315.217.51816.216.217.430.631.234.136.936.136.5
Contingent and off-balance sheet accounts [as % of total]
Average lending spread (lending - deposit rate)
Nonperforming loans (as % of total loans) (overdue 30 or more days)26.432.129.510.913.715.331.723.715.210.411.512.610.48.87.9
Risk-weighted capital/asset ratio (in percent)12.113.714.911.713.212.96.712.612.516.014.013.516.514.913.5
Sources: Data provided by IMF staff; EBRD Transition Report; NBP, Summary Evaluation of the Financial Situation of Polish Banks, 2000; NBH, The Hungarian Banking Sector, 2000; Bank of Slovenia.
Sources: Data provided by IMF staff; EBRD Transition Report; NBP, Summary Evaluation of the Financial Situation of Polish Banks, 2000; NBH, The Hungarian Banking Sector, 2000; Bank of Slovenia.
Table 4.2.Equity Market Indicators
(Percent of market capitalization, mid-period)
Market Turnover
Czech Republic26335047376181
United States708592104106117141
(Percent of GDP, mid-period)
Market Capitalization
Czech Republic14303124211925
United States7482101122151163
Number of Listed Companies
Czech Republic1,0241,6351,588276261164154
United States23,025
Source: Claessens, Djankov, and Klingebiel (2000).

As of March 2000.

NYSE only.

Source: Claessens, Djankov, and Klingebiel (2000).

As of March 2000.

NYSE only.

Broad money (M2) to GDP is another common indicator of the depth of bank intermediation. This ratio has been steadily increasing in Hungary, Poland, and Slovenia, but is still under 50 percent, compared to almost 70 percent in the euro area (Figure 4.1). In Poland and Hungary, this reflects several factors, including: the relatively recent restructuring and consolidation of this sector; the large and growing share of multinational corporations in the domestic economies, with recourse to direct borrowing from abroad; the riskiness of lending to the consumer sector and to small and medium-scale businesses; the tendency of domestic firms to finance themselves from retained earnings; and the stabilization and restructuring required during transition, which temporarily depressed income and savings—followed more recently by a progressive catch-up in consumption. In addition, in Hungary, in 1999, about half of household savings were invested in securities and half in bank deposits, while the share of securities investment in household portfolios is much lower in the other countries. Slovenia went through a hyper inflationary period in the first years after independence that resulted in loss of wealth for depositors and demonetization. Only since 1995 has inflation stabilized and money returned to the banking system, but a cartel agreement has kept real deposit rates low, therefore discouraging savings. In contrast to the other CEC5, Czechoslovakia entered transition with very high ratios of money to GDP, and this is reflected even today in high ratios in the two successor countries. Inflation was relatively low and stable throughout the 1990s in those two countries. However, the higher ratio of broad money to GDP does not seem to correspond to higher quality financial intermediation or a healthier banking system.

Figure 4.1.Broad Money (M2)

(Percent of GDP)

Sources: IMF, World Economic Outlook; and IMF staff estimates.

The quality of intermediation can be assessed better by looking at private sector credit growth, concentration in the banking sector, interest rate spreads between loans and deposits, private sector loans as a share of banking assets, and measures of bank performance. Due to the poor conditions and the cleanup of the banking systems, credit to the private sector has been declining since 1997 and 1998 in the Czech and Slovak Republics, respectively, with virtually no new net credits being extended. In the other countries, private credit has grown rapidly in the last three years, albeit from a rather low base (Figure 4.2). Concentration in banking is high in all of the CEC5, with four or five banks accounting for more than half of all bank assets. Since the countries are relatively small, high concentration is to be expected and may even be desirable given that upon EU accession, larger banks may be better placed to compete successfully. In most cases, the presence of a fairly large number of commercial banks, as well as significant foreign presence, attest to the already high degree of competition.

Figure 4.2.Real Growth of Private Credit, 1996–20011

(12-month growth)

Sources: International Financial Statistics; and IMF staff estimates.

1Deflated using current CPI.

Figure 4.3 indicates that intermediation has been becoming more efficient, with a broad downward trend in interest rate spreads since the late 1990s in most countries. It also illustrates an interesting divergence between corporate lending spreads and spreads on household lending in Hungary and the Czech Republic. While corporate margins have been steadily declining, those on household lending have increased substantially as this portfolio has grown. For the Czech Republic, corporate lending is disaggregated between state and private enterprises. The large state-owned firms, with an implicit or explicit government guarantee, enjoy much lower interest margins than private firms. These observations lend support to the hypothesis that there has been credit rationing for households and smaller firms. As competition has resulted in banks increasing the share of those sectors in their portfolio, lenders have required a higher return to compensate for the greater risk.

Figure 4.3.Interest Rate Differential, 1995–2001


Sources: Data provided by national authorities; and International Financial Statistics.

For some of the CEC5, the share of government securities in balance sheets has fallen, with a corresponding increase in loans to the private sector. There has also been a strong increase in consumer lending, with demand outstripping real income and a declining propensity to save. While these factors may increase risk, they also indicate that banks are increasingly playing their appropriate role of intermediation—and they should underpin growth in the private sector. The shares of claims on the private sector have been on steady uptrends in Hungary, Poland, and Slovenia, although they are still substantially below that of Germany. In contrast, the share of private sector claims has declined markedly in the Czech Republic since 1997, reflecting in part the recession, but also the deteriorating state of the banking sector and the cleanup of loan portfolios. The ratio has begun to decline in the Slovak Republic, although it continued to rise through 1998. This may reflect the earlier stress on directed lending to privatized enterprises whose owners were associated with the government.

In Table 4.3, some measures of profitability and efficiency are compared to those in the EU. Net interest margins are uniformly higher in the CEC5 banks, as spreads between deposit and lending rates are higher than in comparable market economies, suggesting inefficiencies and oligopolistic banking sectors in the CEC5. Another notable feature is the sharp decline in bank profitability from 1995 through 1998 for all five countries, with a subsequent improvement beginning in 1999. Competition has brought about increased efficiency of intermediation as evidenced by the generally downward trend in interest rate spreads (Figure 4.3), and has also lowered net interest margins.

Table 4.3.Profitability and Efficiency Measures, 1995–2000
Czech Republic
Net Interest Margin3.232.632.653.081.972.52
Return on Average Assets (ROAA)0.67-0.51-0.58-3.12-1.460.35
Return on Average Equity (ROAE)9.85-7.72-9.47-50.42-22.385.83
Cost to Income Ratio50.6164.3243.9491.5939.2162.50
Net Interest Margin5.233.793.143.923.663.61
Return on Average Assets (ROAA)0.780.830.750.020.680.97
Return on Average Equity (ROAE)19.0318.8315.020.3012.2415.63
Cost to Income Ratio71.8571.0772.1884.7681.9971.59
Net Interest Margin5.075.564.814.714.043.77
Return on Average Assets (ROAA)
Return on Average Equity (ROAE)59.4225.2915.637.2910.1212.59
Cost to Income Ratio40.3151.4752.7257.8460.0361.84
Net Interest Margin4.453.122.992.782.142.89
Return on Average Assets (ROAA)0.960.60-0.40-1.434.091.75
Return on Average Equity (ROAE)16.0211.18-8.02-31.5388.9028.03
Cost to Income Ratio45.0753.3161.3859.5861.7268.47
Net Interest Margin3.804.033.494.563.444.10
Return on Average Assets (ROAA)1.421.461.301.111.331.67
Return on Average Equity (ROAE)13.8213.3411.6510.7913.4916.37
Cost to Income Ratio63.7853.7953.1863.3856.2951.05
Net Interest Margin2.001.801.601.52
Return on Average Assets (ROAA)0.440.470.490.56
Return on Average Equity (ROAE)8.969.5410.0111.31
Cost to Income Ratio66.8166.1765.2165.84
Sources: Bankscope; Bank of Slovenia.
Sources: Bankscope; Bank of Slovenia.

The return on assets and equity differ significantly between domestic and foreign banks. In the period 1996–1998, foreign-controlled banks had significant positive profits, while domestic banks actually showed negative asset-weighted average returns (IMF, 2000c). The results for domestic banks are biased by the inclusion of one or two large state banks with significant losses that are being restructured, but for most countries it is indeed the case that domestic banks in general have lower profit margins. This is consistent with two hypotheses—one is that foreign banks are more efficient and bring better technology and human capital with them; the other is that they cherry pick the most creditworthy customers. A few exceptions are notable: some foreign banks in Hungary have suffered losses in an intensely competitive environment (see NBH, 1999), and the Czech IPB had to be taken over from Nomura after suffering a run (see Box 4.1 for details).

Box 4.1.Troubles with IPB

Investicni a Postovni Banka (IPB) was the first of the four large state banks in the Czech Republic to be privatized by selling the state’s 46.6 percent share to Nomura Europe in 1998. The government did not carve out nonperforming loans prior to the sale, nor did it provide any guarantees extending after the sale, so it seemed that the sale involved minimum fiscal outlays. Nomura, however, did not behave as a strategic investor, but rather as a portfolio investor and did little restructuring of the bank. During the recession of 1998 and 1999, the asset quality of IPB deteriorated even further. The information provided by the bank to Czech National Bank (CNB) supervisors did not reflect accurately IPB’s financial situation.1 Inadequacy of provisioning was concealed by the bank through selling nonperforming assets to related entities, recording assets at overstated values, and misclassifying receivables. Independent outside auditors also failed to give a timely notice to banking supervision of the true financial state of IPB. Even after the extent of the problem became apparent to banking supervisors during audits in 1999, action was delayed due to the time required to finalize the documents from the audit. IPB attempted to delay the process further through legal actions. The excessively slow court process also prevented a rapid response by banking supervision.

In mid-June 2000, there was a major run on the bank,2 and it was taken under forced administration by the CNB. Nomura, meanwhile, had sold some of IPB’s stronger industrial assets and, according to some estimates, realized as much as $300 million profit. Faced with the alternative of closing the bank, the administration quickly sold IPB to a strategic investor—ČSOB (Ceskoslovenska Obchodni Banka, with Belgian KBC Bank the largest shareholder). At the time of sate, the government agreed to a framework for cleaning the balance sheet of the bank. This entailed bad loan carve-outs as well as guarantees on deposits and on the quality of assets for a certain period after the sale. While the full cost of IPB losses is still unknown, initial costs alone may amount to as much as 5–10 percent of GDP.

The troubles with IPB demonstrate that foreign ownership by itself is not enough to bring stability, that the right incentive structure needs to be in place to attract strategic investors and encourage them to increase the bank’s value, that accounting standards and their enforcement need to be strengthened, and that delayed reaction to problems may magnify fiscal costs considerably.

1For the most recent statement from the CNB on the IPB case, see “Statement of the Czech National Bank on the ‘Concluding Report of the Chamber of Deputies Fact-finding Commission for Clarification of Decision Making by the State in IPB from the Time of its Founding until the Imposing of Receivership and its Sale to ČSOB, for the Purposes of Deliberation by the CD PCR’,” at prior to the run, IPB accounted for 22 percent of all household deposits.

Positive real interest rates are necessary to ensure financial and macroeconomic stability. In the CEC5, from 1996, real lending rates remained positive, but there were several periods in which real deposit rates have fallen below zero (Figure 4.4). Depositors’ financial assets were being eroded, resulting in transfers of real resources to banks. In some periods there were exceptionally large spreads between real lending and deposit rates, implying excessive transfers to banks. This may reflect inefficiencies in intermediation, low quality of portfolios, and/or differentials in consumer and producer price changes.

Figure 4.4.Real Deposit and Lending Rates, 1998–2001

(Percent; Annualized)

Source: International Financial Statistics.

1Real lending rates deflated by 3-month forward looking PPI.

2Real deposit rates deflated by 3-month forward looking CPI.

Most of the CEC5 have made considerable progress in improving the quality of banking portfolios (Table 4.4). In particular, both Hungary and Poland have seen sharp reductions in the share of classified loans, although Poland’s share rose again in 2000. In contrast, the Czech and Slovak Republics, in the first ten years of transition, made little progress in addressing the issue of nonperforming loans; a major effort is now underway to deal with these problems, with most of the nonperforming loans having been transferred to consolidation banks, and the remaining issue being how to dispose of those assets given the weaknesses of insolvency regimes.

Table 4.4.Classified Loans/Assets as Share of Total Loans/Claims
Czech Republic333026.726.432.229.5
Slovak Republic403031363022
Sources: National Banks, EBRD. The data are not comparable across countries due to definitional differences. For Poland, the ratio is given for the 15 largest banks, and for Slovenia, it is classified assets to total assets; using assets gives a downward bias relative to using loans. Data for 2000 is as of September for Hungary and June for Slovenia.
Sources: National Banks, EBRD. The data are not comparable across countries due to definitional differences. For Poland, the ratio is given for the 15 largest banks, and for Slovenia, it is classified assets to total assets; using assets gives a downward bias relative to using loans. Data for 2000 is as of September for Hungary and June for Slovenia.

The Evolving Role of Banks and Securities Markets

The inroads of new information technology, competition from capital markets, and EU integration should make the banking sectors of the CEC5 increasingly competitive. There is already a fledgling online banking sector in the CEC5 that calls into question whether banks should be emphasizing a bricks-and-mortar or an Internet-oriented development strategy. Indeed, distribution channels such as the Internet or telephone banking will allow customers to change banks easily, boosting competition and further depressing interest margins. Moreover, the growth of nonbank financial intermediaries will present a challenge for banks with respect to retail deposits as a cheap source of funding. Against this background of falling margins and needed heavy investment in information technology, banks in the CEC5 will struggle to maintain profits. These competitive pressures could lower the franchise values of some of the largest domestic banks and accelerate the process of bank consolidation across central and eastern Europe.

In this competitive setting, and likely some initial overinvestment in traditional banking by foreign and domestic parties, pressures on profitability will spur consolidation across the sector. As one of the financially most advanced accession countries, Hungary already provides a case study of these pressures. Households are allocating an increasing portion of their portfolio to securities as opposed to traditional bank accounts, and banking sector assets have failed to keep pace with GDP growth. There is a strong sentiment among bankers and analysts in Hungary that the number of banks in Hungary will decline significantly over the course of the decade.22 The significant disparity in returns for individual banks may also encourage an acceleration of consolidation. Mergers among parents of foreign banks will also be a driving factor behind consolidation in the CEC5. Indeed, the merger between Bank Austria Creditanstalt and Germany’s Hypovereinsbank, both of which already have an important presence in the CEC5, was a first step in this direction.

While growing, bond markets in the CEC5 currently remain underdeveloped. Bond market capitalization is currently about 30 percent of GDP on average in the CEC5, compared to about 110 percent of GDP in western Europe. The vast majority of bonds in the CEC5 are government issues, as the corporate bond market is almost negligible in the five countries. Bank loans are seen as a lower cost and less demanding approach to raising money, with the additional advantage that banks often provide a revolving credit line. A handful of the largest corporations have issued Eurobonds, but, even for these, the share of bond financing is lower than that of retained earnings and bank loans. There are a number of reasons for the current underdevelopment of private local bond markets. Blue-chip companies obtain bank financing at low interest rate margins, and those which are foreign-owned receive financing from parent companies at even lower rates. The majority of the remaining companies are small and cannot issue debt in large liquid denominations.23 Moreover, stringent legal requirements and the need to comply with international accounting standards could make bond issuance too costly. Thus, only the largest enterprises, often with explicit or implicit state guarantees on their debt, find issuing bonds to be a cost-effective alternative to other sources of finance.

Equity markets are still rarely used as a source of finance. Market capitalization and turnover are the two most frequently used measures for assessing the liquidity of equity markets and the capacity of such markets to provide finance. Market capitalization remains low in the CEC5 relative to comparable market economies (Table 4.2), and typically only a few large companies are actively traded, reflecting in part the short time span for their existence, inadequacies in the legal and regulatory framework (insufficient shareholder protection, for example), and still low levels of public confidence. Growth in market capitalization has been due mainly to privatization and price changes rather than to new share issues.

Nevertheless, there are several reasons why funding through domestic securities markets is likely to increase. Pension reform and rapid growth in the insurance market would, if done successfully, support the development of domestic institutional investors (and long-term finance) in the coming years, which should feed through into greater liquidity and turnover on the stock exchanges (Table 4.5). Pension reform would also spur local demand for domestic paper. Raising money locally could become increasingly attractive against a background of falling inflation, lower interest rates, and improved legislation. Moreover, the ongoing revolution in communications and information technology may shift the balance of advantages toward market-based finance as opposed to bank-based finance. The Internet, for example, may assist market participants in overcoming information barriers which impede financial development. Thus, the CEC5 could well see a growing role for securities markets in financial resource allocation.

Table 4.5.Assets Held by Institutional Investors in Transition Economies(In percent of GDP; June 2000 or most recent information)
CountryInvestment and Mutual FundsPension FundsInsuranceTotal
Czech Republic82919
United States1299043262

While empirical studies suggest that the initial level of stock and bond market liquidity affects subsequent growth positively,24 the physical location of the intermediary does not necessarily matter and could well be in another country. An illustration of this is the growing access to capital market financing via global or American Depository Receipts. Domestic stock exchanges may prove to not be a cost-effective means of raising capital owing to the lack of economies of scale. There is thus likely to be a consolidation of stock exchanges, either on a regional basis or by merging with larger European exchanges.25 But as with many of the financial market developments in the coming years, this is not so much an outgrowth of the transition process as it is a feature of increasing global integration.

These developments, in sum, point to systems that could be increasingly diversified in structure and ownership—key strengths in a world of potentially volatile capital flows and a domestic setting of rapid structural change. The “existence of multiple avenues of financial intermediation” can be important in preventing financial crises from causing sustained knock-on effects on the real economy.26 If a crisis strikes the banking system, for example, and a credit crunch occurs, well-developed capital markets can help to fill the ensuing funding gap. Thus, for the CEC5, ensuring financial stability is closely related to financial market deepening and maturing, and to cite the same source, creating “flexible institutions that can adapt to the unforeseeable needs of the next crisis.”

Improving Access to Finance for Underserved Sectors

Improving access to financing for small and medium-size enterprises (SMEs) will support growth by fostering entrepreneurship and innovation. When the financial sector is underdeveloped, it is primarily the private sector which suffers from inadequate financing. In the CEC5, the more risky market segments—SMEs and households—still have only limited access to financial markets. With SMEs frequently the engine of economic growth in many countries, developing financing mechanisms for these markets should be a key policy priority. These markets have already started to expand as banks—facing increasing competition for blue chip corporate loans—seek to expand their client base in the underserved markets for mortgage lending, household loans, and SME financing. As this occurs, investment in housing and in fixed assets of firms should increase, while households’ savings may tend to level off or decline as they become increasingly leveraged.

These market segments are, however, particularly prone to problems of asymmetric information—making risk assessment difficult for intermediaries. Asymmetric information can lead to adverse selection, moral hazard, principal-agent problems, and financial contagion, all of which can undermine efficiency and result in financial vulnerability. Banks are likely to remain of paramount importance for these smaller borrowers, since banks have a comparative advantage in screening projects and monitoring clients, mitigating problems of asymmetric information. Thus, one way to support development in these markets is to improve (and, in many cases, create) interbank information systems which can provide reliable and timely data on consumer and commercial credit information, including loans outstanding, collateral registers, past debt defaults, etc. These markets can also be supported by strengthening the legal framework, especially regarding creditor rights, bankruptcy laws, and recovery of collateral. Some of these countries, however, are resorting to government intervention—providing public guarantees for SME loans or subsidizing mortgage lending. Such approaches can ultimately put pressure on the fiscal accounts and impede the healthy development of a fully market-based financial system.

Venture capital could be increasingly viewed as a potential financing source in the CEC5. Bank lending is often seen as the lowest cost (and perhaps only) financing source for SMEs with limited track records, while securities markets are sometimes viewed as the more cost-effective source for large, well-established firms. However, venture capital firms, which are more closely associated with securities-based finance, could find a firmer foothold in these economies through providing finance for new enterprises undertaking high risk, high return projects. This is due to the risk-sharing features of venture capital firms as opposed to bank creditors. Banks typically charge a predetermined rate of interest and do not benefit from excess returns to successful high-risk projects. On the other hand, venture capital firms, as part equity holders, do share the benefits of the upside returns, and their losses are limited to their stake in the new enterprise.

The success of venture capital firms in Hungary suggests that, given a stable macroeconomic environment and strong legal system, venture capital may provide a viable source of funds for small entrepreneurs. Venture capital firms have been active in the country for almost a decade, and there has been a national association with 14 members since 1992. The number of projects undertaken as of 2001 has been relatively small, but there is increasing interest from both local and international funds. In 1998, the government passed a law aimed at encouraging venture capital investment. Nevertheless, the success of the government in providing macroeconomic stability—and a favorable business environment conductive to growth—has no doubt been the key attraction for investors.

Interlinkages to Macroeconomic Policy

A weak financial sector can heavily constrain the flexibility and effectiveness of fiscal and monetary policy, and shift the policy emphasis away from long-run growth. Significant contingent liabilities prevent credible fiscal planning, divert resources from productive investments, and may lead to debt sustainability issues. Monetary authorities may be unwilling to tighten policy if that would threaten the health of financial intermediaries. Thus, completing the remaining reforms in the financial sector should facilitate the tasks of macroeconomic policy—removing constraints on interest rate movements, enhancing the effectiveness and predictability of the transmission mechanism, and recognizing and/or reducing quasi-fiscal losses—which can serve to add to fiscal transparency. Of course, linkages work in both directions, as financial sector soundness not only affects the macroeconomic policy environment, but is also affected by the macroeconomic environment (Box 4.2). The focus here is primarily on the linkage between the financial sector and the conduct of macroeconomic policy.

Box 4.2.The Macroeconomic Environment and Financial Sector Stability

The macroeconomic environment clearly has an impact on financial sector developments. Indeed, the soundness of the financial sector is, to a large degree, a reflection of the economy’s health. Business cycles affect the financial sector through a number of channels, including: changes in asset prices, credit quality, interest rates, and liquidity; balance sheets, through changes in the amount and composition of indebtedness; and, ultimately, perhaps a boom-bust cycle precipitated by the bursting of an asset price bubble. Structural changes, particularly as embodied in financial liberalization (whether domestic or external), can have a significant impact on financial vulnerability. Closely related, and often structural in nature (particularly for the CEC5 in the early years of transition), are shocks, including the disappearance of markets (e.g., the collapse of CMEA trade) or substantial relative price changes (such as domestic price liberalization or terms of trade shocks). Open economies, such as the CEC5, are even more exposed to external shocks, underscoring the importance of adequate risk management capacity in the financial sector.

The choice of macroeconomic policy instruments has important implications for financial sector soundness. On the fiscal side, tax policy—such as nondeductible loan-loss provisions, bank specific taxes, or heavy capital gains taxes—can undermine financial sector development. On the monetary side, unremunerated reserve requirements, sharp and frequent changes in reserve requirements, direct monetary instruments (e.g., interest rate ceilings), or the absence of a properly functioning lender-of-last resort mechanism could adversely affect banking sector soundness. Even the transition from direct to indirect instruments entails a period of increased risks. The choice of exchange regime can also undermine financial sector stability, if, for example, it leads to a prolonged period of over- or under-valuation of the exchange rate or is subject to substantial volatility, particularly in the absence of sufficiently developed markets for hedging risks.

An excessively expansionary or restrictive macroeconomic policy stance can exacerbate financial sector vulnerability. A loose policy mix, fueling inflationary pressures, reduces the information provided by prices and interest rates, can lead to an overly rapid expansion of domestic credit (increasingly allocated to riskier market segments), and can distort asset prices or even create an asset price bubble. Eventual stabilization or, similarly, a restrictive policy mix—particularly one heavily reliant on monetary restraint—can place strains on the banking system—including through balance sheet effects (depending on the degree of adjustment attained through the interest rate and exchange rate channels) and rising credit risks—and could even induce a liquidity crisis in the banking sector. Large structural fiscal imbalances can severely complicate macroeconomic stabilization—placing the burden of adjustment on monetary policy and the banking sector, putting pressure on the exchange rate, increasing overall debt levels and associated vulnerability, crowding out credit to the private sector, and generally constraining the fiscal response to exogenous shocks. Moreover, an inappropriate policy mix can lead to a loss of foreign and domestic investor confidence, triggering sudden capital outflows or a significant deterioration in external financing conditions, either of which increases the vulnerability of the domestic financial sector.

The Remaining Privatization Agenda

Liberalization of the banking system in the CEC5 at the beginning of the 1990s took place against the background of a contraction in real output, monetary instability, and attempts to put in place radically new institutional structures. The success of financial market reform was crucially dependent on progress in real sector adjustment, the establishment of market-based mechanisms of corporate control for both banks and enterprises, and the degree of disengagement of the government from the private sector.

Bank restructuring and privatization remain, to some degree, to be completed in most of the CEC5 and the experience of the past decade points to useful lessons for the future. In particular, the experiences of the forerunners—Hungary and Poland—can provide lessons not only for the Czech and Slovak Republics and Slovenia, but for most of the other transition countries, in which much remains to be done in their financial sectors. Completing privatization is one of the main priorities in the financial sector. Privatization is usually a necessary component of a successful bank restructuring program: it diminishes the scope for distortions in the form of directed policy lending, or moral hazard in the form of reliance on future government support.27 Restructuring cum privatization programs often present the government with a difficult task. Ideally, they should be designed in a way that minimizes the present value of fiscal costs. However, for whatever reasons, reforms have at times shifted the burden of adjustment to the future, potentially leading to much higher costs in present value terms (Box 4.1).

State ownership of the banking sectors in the CEC5 has been declining rapidly (Table 4.1). As described more fully in Box 4.3, the CEC5 followed quite different approaches to privatization and restructuring:

Hungary’s policy was to sell controlling shares in state-owned banks to strategic foreign investors as rapidly as possible. Privatization of the banking sector has been largely completed—the remaining share of state-owned banks is only about 12 percent of assets, most of which is concentrated in Postabank. The foreign parents brought with them skills for credit evaluation, risk management, and more sophisticated financial instruments, which increased the knowledge capital and efficiency in the banking sector as a whole. Currently, Hungary has one of the most modern and advanced financial systems among the transition economies.

In contrast, the voucher privatization in the Czech and Slovak Republics left controlling ownership of the largest banks with the state. Banks assumed ownership stakes in their voucher-privatized clients, which led to continued soft lending practices and repeated bailouts. This magnified problems with connected lending and nonperforming loans, complicating efforts to find strategic foreign owners in the absence of cleanups or guarantees. Moreover, persistent political interference in the banking system depressed foreign investor interest. Recently, however, the environment has changed. The bad debts have now been recognized and have been—or are in the process of being—transferred to consolidation banks in their respective countries, and privatization has been largely completed, with foreign shares in excess of 80 percent, the highest in the CEC5.

Poland’s approach to restructuring resulted in the lowest overall fiscal cost among the CEC5. In the early 1990s, a bank-led enterprise restructuring program was implemented using a variety of instruments, including debt-equity swaps through which banks acquired ownership stakes in their financially weak clients. The government attempted to minimize explicit guarantees and create incentives for market-based workouts that took place in the mid-1990s. In the last few years, Poland has attracted significant strategic foreign investment, and given the high proportion of foreign ownership of the share capital of banks with dispersed ownership, banks controlled by foreign capital effectively had a market share of about 70 percent by 2000.

Meanwhile, Slovenia maintained a high share of state ownership in the banking sector, resulting in an oligopolistic banking structure with limited competitive pressures. Foreign ownership is limited to less than 20 percent of all assets. However, in the process of legislation alignment with the EU, competition strengthened.28

Allowing reputable foreign banks to enter the domestic market has proved to encourage innovation and competition, while underpinning institutional soundness. As suggested by the literature on growth, foreign capital stimulates the development of local markets, including through market liquidity.29 Foreign banks often bring stronger corporate governance to the market as well as more sophisticated risk management systems. While there are cases of longer-established foreign banks taking a passive approach and benefiting from high local margins, more typically they spur competition and render the sector more efficient—introducing new skills, products, and technology. More intense competition leads to lower profits and puts pressure on all banks to reduce costs. This prepares domestic banks to cope with competition in the single market after accession. The presence of reputable foreign banks may also reduce the risks of capital flight or widespread depositor runs, as they may be seen as more immune from a crisis in the domestic banking system. Hungary has had the most liberal policy toward foreign bank entry of any of the CEC5. In both Hungary and Poland, more than 60 percent of the banking sectors’ capital is held by foreign investors. The Czech and Slovak Republics have, over the past year, followed this path towards greater strategic foreign ownership, and foreign ownership in the Czech and Slovak Republics now exceeds 80 percent. But, as exemplified by the experience with Investicni a Postovni Banka (IPB) in the Czech Republic, privatization to foreign investors is not a panacea: appropriate incentive and supervisory structures need to he in place to ensure soundness.

Box 4.3.Privatization Methods and Fiscal Costs of Bank Restructuring

Czech Republic

The first round of government recapitalization of the Czech banks took place in 1991-1993 when the three big banks were partially privatized through participation in the voucher program. The government retained a controlling stake in most banks. Banks participated on both sides of the voucher privatization since they managed the largest investment funds and therefore became indirect holders of their own shares and partial owners of many of their loss-making enterprise clients. As a result, soft lending continued and future rounds of recapitalization followed, as both banks and enterprises had little incentive to restructure and improve their operations. The history of repeated bailouts and the existence of three centralized asset management agencies created a serious moral hazard problem. The resulting fiscal burden was higher than in any of the other central European countries. Tang and others (2000) estimated that the total cost of bank bailouts, in the period 1991–98, exceeded 25 percent of 1998 GDP, while the FSAP conducted in early 2001 indicated somewhat lower total costs.

Following the currency crisis in May 1997, the authorities introduced stricter loan classification and provisioning rules. Reported classified loans exceeded 30 percent of all loans in 1998 and 1999, with the large state-controlled banks having a disproportionately high share of nonperforming loans. A multifaceted approach (using a revitalization agency for the most complex cases and selling pools of loans in other cases) was used to work out the bad debt problem. An ambitious program of rapid privatization of the four largest banks to strategic investors was put in place. With the sale of the government’s stake in Komercni Banka in mid–2001, privatization has been completed and foreign strategic investors now control roughly 90 percent of assets of the banking sector.


Negative shocks to the real sector and recognition of the inherited nonperforming loans led to a significant deterioration in bank balance sheets in the initial years of transition. The government intervened repeatedly through replacing bad loans with government bonds. Interventions however, were not accompanied by efforts to reform the operations and management of the banks. In the mid-1990s, having learned the lessons from the ineffective interventions in the first years, the government started to impose much stricter conditions on bank bailouts. Recapitalization followed by privatization (typically to strategic foreign investors) became the major form of bank resolution. The program was successful, and the newly privatized banks were, in almost all cases, well capitalized and well managed. However, some weaknesses of supervision were revealed in 1998 when two of the privatized banks—Postabank and Realbank—failed, although problems with their operations were known to supervisors well ahead of the failures. The government decided to keep Postabank in state hands in the wake of its collapse. The supervisors had restricted power to take actions in a timely manner, as intervention was authorized only on the basis of audited accounts, not on the basis of inspection only. Some of those weaknesses have been recognized, and efforts are being made to address them. The total fiscal cost of bank resolution was estimated by Tang and others (2000) at 13 percent of 1998 GDP.

Presently Hungary has one of the most modern and competitive banking systems among the CEC5. The Russian crisis in 1998 provided a market test of the resilience of the system, and although certain vulnerabilities were revealed—with a few brokerage subsidiaries of foreign banks failing—the system withstood the shock well, and, in many cases, the foreign parents stepped in to provide additional capital where needed.


The high inflation in 1989-90 helped reduce the real value of nonperforming loans inherited from the socialist regime. In 1993, a law on financial restructuring of banks and enterprises was adopted. Between 1993 and 1996, the government recapitalized the ten larger state-owned banks by providing them with long-term treasury bonds. In exchange for government support, banks had to get involved in enterprise restructuring—typically a debt for equity swap was implemented, with the result that banks became partial owners of companies. The central bank participated in the rehabilitation of a number of small private banks—some of them were restructured and then sold, others were taken over by other banks in exchange for long-term soft financing and/or a waiver of mandatory reserves. A third channel of support for ailing banks came from foreign banks applying for banking licenses. In exchange for the license, they were required to spend certain amounts to support troubled banks (by either taking them over or providing financing at favorable terms). There was also a commitment from the government that there would be no future rounds of recapitalization. Tang and others (2000) estimated the fiscal cost at about 8 percent of 1998 GDP, the lowest among the five countries.

Recovery on classified loans was also higher in Poland than in the other CEC5—a decentralized approach was used in which banks kept ownership of the loans and any proceeds they could recover. Banks gained experience with the workout of nonperforming loans, and harder budget constraints were imposed on enterprises. Although soft lending to certain enterprises continued, some weak companies were liquidated, and the banks had incentives to adopt a more prudent portfolio strategy, investing heavily in government bonds and imposing more stringent credit rules for new clients. Vigorous economic growth, prudent leverage ratios, and government protection helped Polish banks to return to profitability. Emphasis on protecting domestic banks led to delays in lifting all legal and political restrictions to foreign participation until early 1998. In 1999, there was a sharp increase in foreign ownership—banks with majority foreign equity accounted for about 50 percent of assets, loans, and deposits at the end of 1999 compared to about 17 percent in 1998. According to some observers, the rapid rise in foreign ownership triggered a backlash from the government, with some takeovers/mergers thwarted amid fears that some foreign banks were mounting a “Trojan horse attack” on the banking system. With competition increasing, banks became subject to pressure to improve efficiency, increase the range of provided services, and expand availability of credit to the private sector.


The Czechoslovak government, in its first round of bank recapitalization in 1991–1992, spent about 13 percent of 1992 GDP on the three largest Slovak banks. Two of them participated in the coupon privatization program, and, like their Czech counterparts, wound up with the government holding a controlling share. Proper restructuring of those three state-owned banks was not undertaken until 2000, and soft lending practices continued, resulting in nonperforming loans exceeding half of total loans. When liquidity problems surfaced in 1997 with IRB, the third largest bank, the central bank provided a liquidity injection, and the large state insurance company had to acquire a controlling share and return the bank to solvency. Continued political interference in lending practices and ownership magnified the problem, creating large contingent liabilities for the government. The same three state-owned banks—VUB, SLSP, and IRB—still held about half of all bank assets in 1999 and were dangerously undercapitalized, with two thirds of their loan portfolio in the classified categories. The seventeen smaller banks also had significant problems—four banks in this group failed in the ten months up to July 2000. Many banks did not meet the 8 percent minimum capital adequacy requirement. Risk management practices were very weak, including noncompliance exposure limits in many instances.

In 1999, the government designed a comprehensive program for the restructuring of Slovakia’s three largest state-owned banks, with the intention of bringing capital requirements to international standards, and then privatizing them. The restructuring involved both cash injections and a swap of part of the classified loans for claims on the consolidation agency, which were converted to government bonds in 2001. Two stages of the recapitalization in late 1999 and mid–2000—the first involving a direct equity infusion and the second a carve-out of bad loans—resulted in an estimated cost of 12 percent of 2000 GDP. The classified loans were transferred to Konsolidacna Banka (KOB) and the newly established Slovak Consolidation Agency (SKA) and were replaced by state-guaranteed loans from the restructured banks to SKA and KOB. The privatization of the three state-owned banks to strategic foreign owners gained momentum in 2001, with the share of foreign banks rising from only 30 percent of total assets in 1999 to more than 80 percent. At the same time, the Slovak government passed a package of laws aimed at improving banking supervision and bankruptcy procedures.


At the time of independence from former Yugoslavia, the Slovene banking system lost some of its assets (foreign currency deposits placed at the former Yugoslav central bank were confiscated, and assets held in other federation republics were frozen) and the sharp deterioration in economic conditions contributed to a plunge in the quality of banks’ loan portfolios. As a result, nonperforming loans reached 30 to 40 percent of all bank loans. The government nationalized three large banks that were close to bankruptcy and launched a rehabilitation plan. It involved exchanging nonperforming assets and contingent liabilities with bonds for an amount equivalent to 10 percent of Slovenia’s 1993 GDP (DM 1.9 billion). The banks shared the cost of the bailout by retaining about 15 percent of their bad loans. Between 1993 and 1996, the agency acquired additional classified assets for DM 1 billion, 32 percent of which were recovered. The success of the rehabilitation program, and the absence of major disruptions in the real sector helped the revival of banks—most of the banks registered positive profits within three years after recapitalization. As a result of the renationalization, public sector ownership increased from about 12 percent to over 50 percent of banking assets.

In 1995, Slovenian banks entered into a binding arrangement according to which they all set deposit interest rates below an agreed maximum rate. The agreement had the blessing of the Bank of Slovenia and resulted in limiting competition and reducing the cost of funds to the banks. The only way of increasing market share was through increases in equity, increases in international borrowing, or consolidation. As a result, the concentration in the banking system remained high, the structure was oligopolistic (see Feyzioğlu, 2000), and competition was limited. Other consequences of the deposit rates agreement were relatively low savings rates and high costs of capital for the enterprise sector. Slovenian banks were consistently among the most profitable in the region since they maintained high interest rate margins (Figure 4.3). The interbank agreement formally expired in March 1999, but, until the second half of 2000, the banks still followed the Bank Association recommendation for caps on deposit rates. Since then, however, banks’ deposit rates have been set more competitively.

Foreign banks were prohibited from establishing branches in Slovenia until 1999. The restriction was relaxed to meet EU requirements, but very few banks took advantage of the opportunity due to the high cost of penetrating the concentrated retail market. The recent easing of capital controls and the relaxation of conditions for foreign banks should increase competition over time.

Minimizing Fiscal Costs and Stabilizing the Macroeconomy: Lessons for the Future

In view of the large share of insolvent banks at the start of transition, government intervention was unavoidable to provide a clean start for financial institutions and to remove incentives for risky behavior. The state-owned banks in the CEC5 faced large volumes of nonperforming loans—often the legacy of central planning and directed lending—as they began the transition process. In some cases, bad loans also accumulated in the initial phase of transformation. In each of the countries, bank recapitalization required substantial fiscal resources in the early 1990s, and, in the case of the Czech and Slovak Republics, continues to have significant fiscal implications. But simply intervening via recapitalization was not enough. The success of such interventions was determined largely by the degree to which bank restructuring and privatization programs were designed to impose hard budget constraints on both enterprises and financial intermediaries.

With government involvement in bank recapitalization and restructuring often reflecting substantial fiscal or quasi-fiscal transfers to banks, it is imperative to put in place an incentive structure that minimizes the need for future intervention—to avoid increasing the future tax burden and impairing the stabilizing and growth-enhancing role of fiscal policy. These fiscal infusions added to the public debt and, through higher interest payments, restricted the flexibility of fiscal policy.30 Cumulative transfers to banks in the last decade were by far the largest in the Czech Republic, and current quasi-fiscal liabilities are highest in the Czech Republic and Slovakia. Although highly uncertain, the costs for the current restructuring in the Czech Republic, for example, are estimated to be in the order of 15 percent of GDP or more.31 The sustainability of public debt is not a dominant issue for those countries.

A decisive and comprehensive response—combined with successful enterprise restructuring and the imposition of hard budget constraints—is key to dealing with problem banks. Approaches achieving “too little, too late” allowed problems to reach systemic proportions, as authorities tried to minimize costs through incomplete recapitalization, avoiding market-based workouts, preserving insolvent institutions of nonsystemic importance, and postponing major changes in the legal and institutional framework. In the most successful cases, weak institutions were closed or privatized quickly—avoiding a mounting quasi-fiscal cost. The managements of deeply insolvent banks do not have the proper incentives to improve the performance of the portfolio, and, indeed, sometimes engage in risky “gambling for redemption,” which can lead to a further deterioration in asset quality. Improving bank performance is difficult without privatization and imposition of hard budget constraints on enterprises as well. Severing the links between banks and their weak clients or putting in place the proper legal and incentive structure for bank-centered loan workouts are necessary conditions for successful restructuring.

The choice of approach to asset recovery—particularly as regards the incentive structure—can significantly influence the outcome. While the CEC5 differed in their approaches to resolving nonperforming loans, asset recovery, following bank restructuring, was for the most part, poor in the CEC5. Most of the countries set up a government-owned centralized asset management agency (AMC) that assumed responsibility for the collection of bad assets. These agencies were not very successful in the recovery of assets for a number of reasons: lack of clear mandate, lack of legal powers to dispose of assets or to force restructuring, and no specific timeframe for winding down operations. In the Czech Republic, for example, the AMC initially functioned as a bank and was subject to all prudential regulations for banks, including capital adequacy requirements. It also was used for government-directed lending, and for many years was simply a passive collection agency instead of an active manager of its asset portfolio.32 AMCs often had an explicit or implicit mandate to prolong the existence of enterprises. Poland, on the other hand, resorted to a decentralized approach in the mid-1990s; after banks were recapitalized with government bonds, as part of the package, they were expected to work with some of the delinquent enterprises and could keep any recovered nonperforming assets. At the same time, the government made clear that it would not be involved in further recapitalization efforts, and hard budget constraints were imposed on the enterprises. This led to the highest recovery rates among the CEC5 on classified loans (Tang, Zoli, and Klutchkova, 2000). While this was a highly successful approach, it has not been replicated elsewhere.

In general, a multi-track approach to asset resolution provides the greatest likelihood of success. This might involve banks working out the better quality bad loans (substandard and doubtful categories, for example), bundled sets of loans sold at auction or open tender, and an AMC to work out more complex loans. Such an approach better distributes the burden of debt workout across a broader range of participants. Indeed, in the mid-1990s, Hungary employed a combination of workout methods, including asset sales, transfers of some loans to an AMC, etc., which succeeded in setting the banks on a strong footing and created incentives for more prudent behavior in the future. More recently, both the Czech and Slovak Republics have also used a multifaceted approach to their bad debt problems.

A combination of market-based approaches to asset resolution as well as private sector expertise, enhanced legal powers, and minimum political intervention have been important ingredients of successful AMCs. Again, the design of the incentive structure is of paramount importance. The AMCs put in place after the crisis in Korea and Malaysia followed best practices learned from Sweden, the United States, and other successful cases.33 These experiences suggest that AMCs can be effectively used if they have clearly defined nonconflicting statutory objectives and political interference is minimized (for example, by limiting management discretion, enhancing accountability, and imposing high disclosure standards). Making full use of private sector expertise—and employing a variety of methods for the management of distressed loans—has lead to higher recovery rates. If bankruptcy laws are deficient or poorly implemented, it is important to provide the AMCs with special legal powers to speed up the process of loan resolution, since slow resolution often leads to asset stripping and rapid decline in collateral values. Unless an explicit time limit for asset recovery or disposal is determined at the outset, AMCs may have an incentive to prolong the process to remain in existence.34 Since centralized AMCs typically have full government guarantees, they may not use the most efficient methods for disposing of nonperforming assets.35 Application of commercial criteria and the principle of value maximization is crucial for the choice of methods of restructuring and asset disposal.

While support for weak banks may at times prevent major macroeconomic disruption, assistance needs to be designed to avoid a recurrence of problems—notably by reducing incentives for moral hazard behavior. When banks cannot simply be closed, due to their systemic role, sufficient recapitalization, combined with measures to address sources of weakness, is needed to provide a sound basis for future operations. Hungary’s experience in the early 1990s was a good example of this—several rounds of incomplete recapitalization in consecutive years created incentives for commercial banks to engage in rent seeking and trying to maximize future assistance. In 1995, in a major overhaul of the macroeconomy (including the real, fiscal and monetary sectors), the authorities decided to combine bank support with privatization and the imposition of hard budget constraints that led to a much stronger and more competitive banking sector and minimal subsequent fiscal transfers. As described in Box 4.2 above, the experience of IPB in the Czech Republic showed that privatization in the absence of an appropriate incentive structure may create a recurring problem and increase the present value of government obligations. Privatization of banks with significant nonperforming loans may attract portfolio investors in search of quick profits instead of prudent strategic owners, leading to further destabilization of the system. The IPB case also demonstrates the need for particularly vigilant supervision of weak large banks, on top of regular audits from independent auditing firms.

If there is a single pointer for future success, it is to design assistance in ways that provide incentives to improve banks’ operations.36 A crucial supporting element is improvement in the overall macroeconomic environment and a simultaneous restructuring of the real sector. The recapitalizations in the early 1990s often did not significantly change the behavior of the financial intermediaries. In the Czech Republic and Slovakia, repeated government interventions created a perception of soft budget constraints and led to moral hazard behavior. Reforms in the economy were delayed, since enterprises which had relatively easy access to finance, independent of their creditworthiness, had little incentive to restructure. This lack of progress in enterprise restructuring, in turn, created a feedback effect leading to further deterioration of bank balance sheets.

In a macroeconomic context, concern about the fiscal impact of recapitalization is often misplaced. Recapitalization may significantly increase the headline deficit, raise concerns about undesirable aggregate demand effects, and/or about sustainability of the debt path. Lane (1996) argues, however, that the first-round fiscal effects of a bank recapitalization (resulting from the direct fiscal transfer), under certain conditions, are economically irrelevant.37 If bank deposits carry an implicit or explicit guarantee, and it is common knowledge that an insolvent bank will have to be recapitalized at some point by the government, then the nonperforming loans are effectively already a claim on the government. He recognizes, however, that there are second round effects which violate the irrelevance argument through the incentives that bank recapitalization can create for future bank lending behavior. Whether these effects are expansionary or contractionary depends on the extent to which the moral hazard problem is addressed.38 Debt sustainability does not appear to be an issue for any of the CEC5 under present estimates of implicit government liabilities—and, in any case, making quasi-fiscal liabilities explicit in a timely manner may actually speed up the fiscal adjustment necessary to address potential debt sustainability problems.

The full fiscal implications of government assistance should be transparently recorded in the budget to promote fiscal discipline and accountability, and to allow for the creation of credible forward-looking medium-term fiscal frameworks. Interventions, in the past, were sometimes conducted in a nontransparent manner, through the central bank or quasi-government management agencies. A selective reduction or waiver of reserve requirements and selective tax reductions for some banks were commonly used tools of intervention in all five countries. More often than not, the government assumption of bad debt has been in a quasi-fiscal form—liabilities have not been explicitly recognized on the budget at the time they were incurred. This has led to the accumulation of “hidden” debt in some countries. The sales of IPB and Ceska Sporitelna in the Czech Republic involved “ring-fencing,” or government guarantees on the quality of the portfolio extending after the sale. While this speeded the sales and minimized the immediate need for recapitalization, it ran the risk of creating incentives for both the borrowers and the new owners that would result in an unpredictable stream of claims for the government.

In summary, the impact of recapitalization and privatization programs on incentives is key. Reform of the financial sector in transition economies is likely to be successful only if accompanied by reforms in the real sector and the imposition of hard budget constraints. There is no valid economic reason for delaying bank restructuring—the demand impact of recapitalization is usually fairly small, and delays or incomplete restructuring have proven to magnify the problem, ultimately leading to a higher present discounted value of government liabilities.

Monetary Policy and the Financial Sector

Underdevelopment of financial markets and vulnerabilities in the financial sector can complicate the conduct of monetary policy and may seriously limit the policy choices both in day-to-day operations and in response to external shocks. A banking sector crisis can directly affect monetary stability through the need to inject liquidity into banks. The monetary authorities could fear allowing the exchange rate to depreciate if there has been heavy unhedged foreign borrowing, or could avoid raising interest rates if banks are in poor financial condition. Raising interest rates to defend the currency can weaken the repayment capacity of banks’ clients and lead to banking sector problems with liquidity and solvency. That is, the authorities can be caught straddling two horses—trying to maintain monetary stability but at a cost of financial stability or vice-versa.

The trade-off between monetary and financial stability is likely to be harsher in countries with less mature financial markets, such as in the CEC5, than in more advanced economies. In the face of a financial sector crisis, there may be a switch into foreign assets from domestic assets, bond markets become more illiquid, and a liquidity injection to the banking system may cause a sharp depreciation in the exchange rate, further exacerbating the crisis through solvency problems related to open foreign currency positions.

Developing a systemic liquidity policy is one approach to dealing with this trade-off. An important objective of a systemic liquidity policy is to enhance confidence in the banking system. A good liquidity framework encompasses a broad range of supporting elements, including: a safety net (lender-of-last-resort facility, credible deposit insurance) and day-to-day liquidity management infrastructure (prudential liquidity rules, creditor rights, reliable payments system, information disclosure, etc.).39 As discussed by Powell (2000), such a liquidity policy could also require that the country have sufficient reserves to cover all internal and external public sector debt coming due within the year, with internal debt included since problems in domestic capital markets can quickly turn into external problems.40 At a minimum, there should also be some regular monitoring of the unhedged liabilities of the nonfinancial private sector. As shown in Figure 4.5, Poland and Slovenia are particularly well-positioned with respect to one measure of external liquidity, and the Czech Republic and Hungary also fare quite well, particularly when compared with other middle income countries which have faced outflow pressures in the recent past.41

Figure 4.5.External Liquidity Position: Selected Countries, 1999

(Percent of GDP)

Sources: OECD\IMF\WB\BIS Joint Database; and International Financial Statistics.

1Debt falling due within one year.

Weaknesses in the financial sector may also lead to a highly unpredictable monetary transmission mechanism—and understanding the transmission mechanism is especially critical now for the CEC5, with most of the countries having recently moved to an inflation targeting framework for monetary policy. A stimulative monetary policy could be expected to be rather ineffective if the banking system is burdened by nonperforming loans.42 As examples, declines in the policy rates in Slovakia and the Czech Republic in 1998–2000 did not translate into credit growth. As banks struggled to meet the stricter provisioning requirements, credit to the private sector continued to decline (Figure 4.2). A restrictive monetary policy, on the other hand, could have a much stronger effect than desired.43 In the aftermath of the 1997 currency crisis in the Czech Republic, the central bank tightened monetary policy to prevent the exchange rate from further depreciation, and also strengthened bank supervision.44 These moves, together with higher provisioning requirements and the imposition of hard budget constraints on enterprises, induced credit contraction, which contributed, along with a tight fiscal policy, to a rapid fall in inflation (from 8 percent per annum to a brief period of deflation) and a prolonged recession.

The most obvious channel for the transmission of monetary policy is the direct interest rate effect. The responsiveness of lending and deposit interest rates to changes in policy rates depends on several factors, including the degree of competition in the banking sector, the depth of financial markets, and alternative sources of financing. Thus, for example, the banking sectors in Hungary and Poland are highly competitive with respect to the corporate lending market, so that policy rate changes should feed through quickly to loan interest rates. On the other hand, Slovenia’s banking sector is oligopolistic in nature, so that the responsiveness of interest rates may be more sluggish.45 Furthermore, in Slovenia, and until recently in the Czech Republic and Slovakia, the banking sectors have been dominated by large state-owned banks, which could diminish the sensitivity of lending and deposit rates (Figure 4.6).

Figure 4.6.Deposit, Lending, and Key-Policy Rates, 1998–2001


Sources: Data provided by national authorities; and International financial Statistics.

1 Two-week Repo rate.

2 Reverse Repo 1 month (2-week since March 1 st 1999).

3 NBP intervention rate.

4 Repo rate.

The pattern of household consumption and the approach to corporate finance in the CEC5, however, reduce the effectiveness of monetary policy—through the interest rate channel—to influence economic activity and domestic demand. With respect to household behavior, consumption is often financed through personal savings, and short-term consumption credits are only now growing at a rapid pace—but seemingly regardless of the level of interest rates—as a result of the catch-up effect after years of depressed consumption. In the corporate sector, much of investment is financed either through retained earnings, cross-border borrowing, or foreign direct investment (FDI) inflows. In Hungary and Poland, for example, foreign bank loans to the nonbank commercial sector account for 50 percent or more of all foreign loans directed toward those countries. With transition very advanced, foreign banks are often willing to bypass the local banking system and provide finance directly to the private sector. The Hungarian economy, in particular, with its heavy presence of multinationals, is characterized by a corporate sector with extensive access to offshore financing (Figure 4.7), which greatly reduces such firms’ exposure to domestic monetary policy conditions. And, particularly in the Czech Republic, Hungary, and Poland, FDI inflows have accounted for a significant portion of corporate investment. Leasing has also grown substantially in some of the CEC5; for example, in the Czech Republic, leasing exceeded 10 percent of lending to enterprises and households by 2000. Banks are, therefore, constrained in their ability to raise interest rates in the face of a policy tightening, since many of the blue chips will shift to foreign or other sources of financing.

Figure 4.7.Credit to Private Sector, 1995–2000

(Percent of GDP)

Sources: international financial Statistics; IMF World Economic Outlook; and IMF staff estimates.

Note: The panel for the comparator countries is on a different scale.

In view of the relatively low interest-rate sensitivity of consumption and investment, the credit availability channel is likely to be a more important one for the CEC5. When monetary policy is tightened, banks are likely to not only raise lending rates but to also increase the standards for creditworthiness, since relying exclusively on the rationing effect of higher interest rates can result in an adverse selection problem of attracting the most risky borrowers. This channel is particularly important with respect to credit availability to SMEs, for which there are much higher costs for acquiring information. Similarly, a contractionary monetary policy is mostly likely to affect the household sector through a restriction in the supply of credit. Thus, a tightening in monetary policy in the CEC5 is likely to disproportionately affect the SME and household sectors, which usually do not have alternative sources of financing.

For the CEC5, the exchange rate may be the most important asset price affected by monetary policy, in view of the less developed markets for real estate, equities, and bonds. Indeed, the low responsiveness of domestic demand to changes in interest rates or monetary aggregates is a reason consistent with most of the CEC5 countries’ initial choice of exchange rate targeting as the primary monetary framework.46 In addition to the relative price effect (which affects the demand for domestic goods relative to foreign goods as well as aggregate supply through changes in import costs), changes in the exchange rate will also exert an impact on the balance sheets of households and corporates which hold foreign currency assets and liabilities, much of which is intermediated through the domestic banking system. Unless foreign currency liabilities are fully offset with foreign currency assets, changes in the exchange rate may have a significant impact on net worth, triggering adjustments in borrowing and spending behavior.

The effectiveness of monetary policy is likely to improve naturally as the financial markets mature and once a stable legal environment has been established. Part of the maturation process would be a catching-up effect in the aftermath of repressed domestic demand. To this effect, the volume of outstanding credit to the private sector is likely to expand substantially over the medium term, especially credit to households and small businesses. Empirical research on advanced economies indicates that the most sensitive sectors to interest rate changes are residential investment and consumer durables purchases. As the share of consumer credit and mortgage loans increases in bank lending, this development should enhance the impact of monetary policy. In addition, as fiscal adjustment (and financial liberalization) in the CEC5 has increasingly released financial resources for the private sector, this should underpin the responsiveness of aggregate demand to monetary policy over time.

The completion of legal and institutional reforms and the process of privatization in the financial sector should increase market efficiency and strengthen the balance sheet of banks, both of which should lead to a more predictable transmission mechanism. Indeed, the firm establishment of market discipline on financial intermediaries through limiting government intervention to its role as a regulator and supervisor, requiring better and more timely financial information disclosure and improving the rights of creditors and stockholders, are among the most effective ways to improve market liquidity and strengthen the resilience of financial institutions to monetary and other shocks.


The financial sector is at the crossroads of the macroeconomy—with immense potential to enhance and broaden growth or to impair economic stability. As evidenced by past experience in the CEC5, the more rapid is the pace of financial sector reforms, the less is the uncertainty about growth and stability—easing the path to develop and adhere to a realistic macro-framework. In a context of potentially heavy and volatile capital flows, moreover, the importance of sound banking and financial systems for stability cannot be overemphasized. While this section has illustrated the role of sound financial systems in supporting macroeconomic policy, the relationship is, of course, a two-way street; a setting of sound macroeconomic policy is crucial for supporting financial sector development.

After a decade of transition has come a period of stock taking, but also important progress, with all countries undertaking initiatives to address remaining problems. The Czech and Slovak Republics have moved towards mote transparency in acknowledging quasi-fiscal liabilities, sales to strategic investors, and market-based methods for disposition of nonperforming assets. Slovakia has amended its tax laws to make it easier for banks to write off bad loans. Slovenia has new legislation allowing greater foreign penetration and competition in the banking sector. Poland liberalized its policies toward foreign investors in the financial sector. Hungary implemented supervision on a consolidated basis, and the other countries have adopted legislation requiring reporting on a consolidated basis.

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