Chapter

Chapter IV.5 Financial Sector Reform

Author(s):
International Monetary Fund
Published Date:
December 1991
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1. THE BANKING SYSTEM

a. Banking prior to the 1987-88 reforms

The Soviet banking system under central planning was viewed as an integral part of the central allocation system. Most financial transactions of enterprises were separated from those of households both physically and functionally. Transactions within the enterprise sector and between enterprises and the state were carried out via transfers of deposits held at Gosbank. Enterprise deposit accounts paid minimal interest,1 were earmarked for specific end-uses in accordance with the plan and their amounts and uses were closely monitored and controlled by Gosbank. Indeed, deposit accounts were often held “jointly” with the state and were frequently reallocated through the budget or the branch ministries. Enterprises used cash almost exclusively for wage payments; holdings of cash for other purposes were virtually prohibited. Consequently, the resources of the enterprise sector provided little liquidity. To the extent they were free to choose, enterprises sought to minimize money holdings in favor of inventories, which provided both a better store of value and some insurance against chronic shortages of materials.

The financial flows of enterprises were regulated through the credit plan. The latter was simply the counterpart of the quantitative production plan, aggregating the planned demand for credit for each enterprise, as derived from its assigned production targets. The credit extended to the enterprises by Gosbank was mainly short-term working capital. Virtually all enterprise investment was financed by budgetary transfers, while most profits were remitted to the budget.2 Certain deviations from the plan—such as shortfalls from planned profits—were automatically accommodated by credit from Gosbank, which thus provided indirect financing to the budget. Gosbank was also frequently forced to provide credit beyond planned amounts to key enterprises which claimed they would otherwise be unable to meet planned output targets. On the other hand, the shifting of enterprise incomes and depreciation funds to the budget left them highly dependent on credit and gave Gosbank some influence over their activities. Finally, Gosbank functioned as fiscal agent for the government, collecting, allocating, and disbursing government revenues.

Households received their money incomes in, and made practically all purchases with, cash. Savings accounts at the state Savings Bank provided households with an alternative financial asset but not a means of payment. At the same time, the savings deposits were implicitly treated as direct resources of the state budget.3 As discussed in Chapter III.2, monetary policy played an essentially passive role under central planning.

In addition to Gosbank and the Savings Bank (Sberbank), two specialized banks were in operation prior to the 1987-88 reforms. The Construction Bank (Stroibank) was created to provide long-term investment credits to enterprises, gradually replacing budgetary grants. All foreign exchange operations were conducted on behalf of the state by the Bank for Foreign Trade (Vneshtorgbank), which also managed international reserves and extended credit to enterprises responsible for foreign trade.4

While the banking system described above was an effective counterpart of the central materials allocation system, it also shared the latter’s increasingly evident defects. To the extent that central allocation led to inefficient use of real resources, financial allocations were similarly distorted. The incentives given to enterprises to invest liquid funds in inventories, for example, resulted in chronically excessive stockbuilding and a waste of resources. The monopolistic position of the banks gave them no incentive to reduce their operating costs and allowed them to interfere arbitrarily in the operations of their client enterprises. At the same time, the lack of a hard budget constraint on either the enterprises or the banks, and the high expectation that loans would, in any event, be written off or automatically rolled over, left both borrower and lender with little concern about the inefficiency with which the resources were used. The reforms introduced in 1987-88 followed a series of generally minor initiatives to improve the functioning of the system.

b. The 1987-88 reforms

The financial sector reforms introduced in 1987 and 1988 had three principal objectives: (1) establishment of a two-tiered banking system, in which all commercial banking operations were detached from the Gosbank; (2) greater independence for the specialized banks in their lending decisions; and (3) development of new instruments of monetary control.

In pursuit of the first objective, three new state-owned specialized banks were established: the Agriculture Bank (Agroprombank), the Industry and Construction Bank (Promstroibank), and the Social Investment Bank (Zhilsotsbank), to channel credit to enterprises in their assigned sectors.5 These banks were to take over all the former commercial banking activities of Gosbank, including both credit and deposit operations, and to act as fiscal agents for the government. The assets and liabilities of the new banks depended on the deposits and loan portfolios assigned to them, and their sectoral specialization was underlined by their subordination to corresponding line ministries, which appointed their chairmen. The other two already existing banks, the Savings Bank and the Bank for Foreign Trade—renamed the Bank for Foreign Economic Affairs (Vneshekonombank)—basically continued their former operations. For the first time since its establishment in 1922, the Savings Bank briefly became institutionally independent, before being reincorporated into Gosbank in 1990. With the reform, Vneshekonombank maintained its monopoly over foreign exchange operations. Its functions were extended, however, to include the granting of foreign currency credits to domestic enterprises engaged in foreign trade, wtih the repayments to be made from export receipts.

The creation of the new specialized banks, carried out from mid-1987 to mid-1988, failed to increase competition in the banking sector. Competition was, in fact, precluded by the strict sectoral specialization of each institution’s activities and the assignment of enterprises to the services of one bank. With the banks dependent on branch ministries, credit allocation remained essentially administrative, with little concern for either the profitability of loans or the creditworthiness of borrowers. Soft credit policies were reinforced by the continued lack of hard budget constraints on either lenders or borrowers. Bank profits flowed to the state budget, and losses were covered by it. Moreover, the delay of price reforms in the real sector militated against the reliance on financial criteria in lending decisions. As discussed below, the specialized banks are now being divided up, largely along the lines of their existing republican and local branches, and converted into joint stock companies. According to the presidential guidelines, they are to be transformed into commercially oriented, universal banking institutions.

New impetus was given to financial sector reform by the 1988 Law on Cooperatives, which authorized the establishment of cooperative banks to serve the needs of cooperative enterprises that were expected to be ignored by the state-owned specialized banks. Soon after, state enterprises were also granted the right to establish their own financial institutions. The number of commercial and cooperative banks (CCBs) grew rapidly reaching more than 400 by September 1990. The CCBs differ from the specialized banks in a number of important respects. First, their activities are relatively unlimited; they are licensed to provide both long and short-term credit and to accept deposits. At least one has been licensed to engage in foreign exchange operations. Second, their customers are not assigned. They can compete freely for both household and enterprise clients, and households and enterprises are also free to choose among banks. Third, the monetary controls applied to the CCBs are largely indirect.

These developments in the financial system were paralleled by significant changes in the enterprise sector. As described in Chapter IV.2, the 1987 Law on State Enterprises gave managers greater freedom to allocate enterprise after-tax incomes. Enterprise financial resources were thus given greater liquidity and fungibility and, in this sense, greater “moneyness”. This, combined with the greater options to depositors and borrowers that accompanied the appearance of the CCBs, created the need for a more active monetary policy (see Chapter III.2). Credit ceilings were apportioned to the specialized banks in accordance with the sectoral demands for credit projected by Gosplan. Within these ceilings, the specialized banks were free (under the continuing guidance of the branch ministries) to allocate credit among enterprises.6 By contrast, lending by the CCBs was controlled via a mandatory reserve requirement, which was raised in August 1990 from 5 percent to 10 percent. Their lending was also constrained by several prudential regulations (see section d).

In summary, enterprises and households have acquired increased flexibility over the past few years in their holdings of financial resources, which complicates the task of the monetary authorities in ensuring macroeconomic stability. At the same time, the banking system has been evolving on two tracks: the division and commercialization of the state specialized banks, and the rapid proliferation of small commercial and cooperative banks. Both tendencies, which could eventually merge into one unsegmented banking system, are consistent with the development of an efficient, competitive financial sector and are supported in the presidential guidelines. As in the enterprise sector, however, both of these developments suffer from gaps in the legal and regulatory framework and from uncertainties regarding ownership rights.

c. Structure of the banking system

In terms of loans outstanding to the economy (households and enterprises), the Agroprombank remains the largest of the lending institutions, even after the substantial writedown of its assets in 1990 (Table IV.5.1). The three major credit institutions—Agroprombank, Promstroibank and Zhilsotsbank—mobilize only a fraction of the monies they lend, the remainder of their funding being provided largely by Gosbank. In contrast, the Savings Bank is the principal mobilizer of financial resources in the system. It is the largest of the banks in terms of numbers of sites and employees, but it does very little direct lending of its own. In the two years following their authorization, the number of activities of commercial and cooperative banks (CCBs) have expanded rapidly. By September 1990, they accounted in the aggregate for just over 5 percent of total credit to the economy.

Table IV.5.1.USSR: Overview of Banking System(As of September 1, 1990)
InstitutionLoans Outstanding to

Households and Enterprises
CapitalNumber

of

Branches
Number

of

Employees
ShorttermLongtermTotal
(In billions of rubles)(Thousands)
Specialized banks261.082.4343.417.763,3951435.8
Promstroibank99.323.6122.92.41,46668.6
Agroprombank109.443.1152.53.73,37491.4
Zhilsotsbank33.97.741.60.871640.6
Sberbank0.38.08.31.056,6371231.2
Vneshekonombank18.118.13.1334.0
Commercial and cooperative banks15.94.220.14.94002
Gosbank1.816910.6
Source: Gosbank.

Includes 52,347 agencies, i.e., offices that provide only savings deposit and withdrawal services.

Number of banks.

Source: Gosbank.

Includes 52,347 agencies, i.e., offices that provide only savings deposit and withdrawal services.

Number of banks.

(1) The specialized banks

The specialized state banks account for the balance of the outstanding bank credit. Their evolution and financial soundness are, consequently, fundamental to the efficiency of the financial sector and to the stability of the monetary system. The Government has announced its intention to transform these institutions into independent joint stock, commercial, universal banking institutions. The details of this transformation have not yet been spelled out, but it is intended that they operate strictly within the limits of their own resources and the funds they succeed in mobilizing, and that they be completely responsible for their own profits and losses. The presidential guidelines enter a caveat, however, that it may be necessary to retain one state bank with budgetary support to channel concessional resources to activities “in the state interest,” and that the Savings Bank would also remain a state bank.7

As a step toward their commercialization, the process of transforming the specialized banks into joint stock companies has already begun. Shareholders are initially expected to consist largely of state organizations, including the union and republic ministries of finance, other ministries at both the union and republican levels, municipal governments, and state enterprises. The future development of the specialized banks is complicated by conflicting ownership claims by the different levels of government, and it now appears that they will be broken up along geographical lines. A major concern with regard to the commercialization and privatization of the specialized banks is the unknown quality of their loan portfolios. While the banks now have greater freedom to allocate credit than they had under the strict control of the credit plan, their loans have, by and large, continued to go to traditional borrowers, responding both to personal relationships and to the still important role of state orders in the resource allocation system. Supervision by Gosbank, once intensive in ensuring adherence to the credit plan, is now largely limited to the quarterly receipt of balance sheet information and annual reports.

The Agroprombank provides credit, deposit facilities and payments services to the farm and agro-industrial sectors of the economy. In addition to its normal credit activities, it performs quasi-fiscal functions, including provision of subsidies to farm organizations and food processors to cover gaps between wholesale and retail prices. Its initial portfolio included a large share of nonperforming loans, rub 73 billion of which were written off in 1990, continuing a long tradition of agricultural credit forgiveness in the USSR.8 Additional write-offs are reportedly anticipated. Agricultural credit has been, in any event, highly concessional. On November 1, 1990, interest rates were raised from 0.7 percent to 9-12 percent on long-term loans. Short-term interest rates were raised to 6 percent on shortterm loans, compared to former rates of 1 percent to collective farms, 2 percent to state farms, and 3 percent to processing enterprises. A penalty rate of 3-5 percent per annum is charged on rescheduled credits.

The Agroprombank was transformed at the all-union level into a joint stock company in September 1990, with similar conversions being carried out at some republican, and possibly municipal, levels.9 The solvency of the institution and its individual branches is highly doubtful, however, in spite of the write-offs noted above and its large outstanding debt to Gosbank. The new share capital of Agroprombank totals rub 8 billion (rub 5.5 billion paid in as of October 1990), of which just under one third is held by the USSR Ministry of Finance. 10 There are almost 4,000 other shareholders, consisting mostly of state and collective farms (whose own solvency may be in doubt) and food-processing enterprises—i.e., Agroprombank’s principal borrowers.

Promstroibank is responsible for serving the credit and deposit needs and providing payments services to much of the industrial sector, including construction, transport, and communications. By Resolution of the Supreme Soviet of December 11,1990, it is to be converted into a joint stock commercial bank before December 31,1991. With its substantial enterprise deposits, Promstroibank is less dependent on Gosbank than are the other specialized banks. Although undoubtedly stronger financially than the Agroprombank, the quality of Promstroibank’s portfolio is nevertheless largely unknown and will inevitably be affected by economic reforms in the real sector and the significant impact they are likely to have on the profitability of different enterprises.

Zhilsotsbank provides banking services to certain branches of light industry, state retail trade, housing construction, individual professional activities, and communal, social and cultural services. It also serves as the collection agent for much of the government’s revenue. The fragmentation of the Zhilsotsbank network is the most advanced among the specialized banks, perhaps because of its close involvement in the financing of local government activities. At the same time that plans were under way at the union level to convert the bank into a joint stock company, republican branches were already being restructured as independent institutions and, in Moscow and Leningrad, branches of Zhilsotsbank were effectively being liquidated and their premises and equipment were to be passed, as of January 1, 1991, to newly established commercial banks in which the respective city councils would have a substantial share ownership.11

The Savings Bank remains essentially a deposit-taking institution for redeposit in Gosbank. It also acts as agent for the sale of government debt to the household sector and its servicing. Although its lending to households has grown rapidly, the total remains small. The appearance, beginning in 1988, of commercial and cooperative banks forced the Savings Bank to raise its deposit interest rates and to offer certificates of deposit at still higher rates.12 To compensate for the higher interest costs, the Savings Bank was authorized to lend, within strict limits, to the commercial and cooperative banks at interest rates of 5-6 percent.13 Consideration has been given by its management to future conversion into a joint stock company and expanding its commercial lending activities. One model under consideration for a national savings bank system, based on the German system, calls for a three-tiered arrangement, consisting of the all-union Savings Bank at the top, the republican branches in the middle, and the major retail operations carried out at the local branch level. Nevertheless, the Savings Bank will undoubtedly be the last of the specialized banks to be commercialized, given the continued short-term dependence of the entire financial system on its mobilization of savings and its relative lack of lending experience.

Some spontaneous denationalization has already begun in the Vneshekonombank network, as its republican branch in Uzbekistan has declared itself an independent joint stock company, with over 100 large enterprises having pledged the initial share capital. Its declared objective is to attract foreign investment into the republic and foster the development of high-technology industry. The approach in other areas to independent entry into foreign currency operations (e.g., in the cities of Moscow and Leningrad) has been to seek the necessary authority for local commercial banks. In any event, as plans for the decentralization of foreign currency holdings of enterprises and other organizations are implemented, it will be difficult for Vneshekonombank to prevent significant shrinkage of its balance sheet, unless it diversifies its activities by developing local currency business. A serious handicap in this regard is Vneshekonombank’s current lack of a broad branch network.

For all the specialized banks, the uncertainties of the present situation make it a particularly difficult time to launch into commercial banking. The difficulties are magnified by the almost total lack of experience of these banks in the types of decisions faced by commercial bankers in assessing and managing the multiple risks involved in financial intermediation. With the exception of the Savings Bank, the specialized banks have substantial familiarity with their sectors and their borrowers. Soft budget constraints have reduced the importance of credit risk analysis, however, while interest rate risk has simply not existed and foreign currency risk has been of concern only to Vneshekonombank. With the bulk of funds coming to them from the Gosbank and from mandatory enterprise deposits, the lending banks have not had to concern themselves with deposit mobilization and liability management.

The Savings Bank, on the other hand, has operated as virtually a pure deposit bank, offering insured savings accounts to households which have few alternatives for safeguarding and earning interest on their savings. Although it has recently begun a small amount of consumer lending, the Savings Bank passes almost all of its deposits to Gosbank. In this way, household savings have been the major source of financing for the budgetary deficit and for the credit lines of Gosbank to the other specialized banks. The commercialization of the Savings Bank may therefore be inhibited in the short term by the lack of alternative significant mechanisms for financing the fiscal deficit, as well as by the lack of necessary staff skills and experience.

(2) The commercial and cooperative banks (CCBs)

As noted earlier, the formation of new commercial banks under cooperative and joint stock forms of ownership began with promulgation of the Law on Cooperatives in 1988. By the end of 1988, 77 CCBs were operating with assets of over rub 2 billion. Twelve months later, their number had almost tripled and, by September 1990, they numbered more than 400, with loans outstanding of rub 20 billion and total assets of rub 32 billion.

Most of CCB lending has been short-term credits to industrial and commercial enterprises, often to the banks’ own shareholders and depositors (Table IV.5.2). They have also engaged in a considerable amount of interbank lending, bringing some capital mobility to the system. Most resources come from enterprise deposits, from their own capital and reserves, and from deposits placed with them by the specialized banks.

Table IV.5.2.USSR: Aggregate Balance Sheet of Commercial and Cooperative Banks,1 End-June 1990
End-June 1990
Millions of

rubles
Percent
I. Assets
Cash134
Reserve accounts5422
Correspondent accounts2,0299
Interbank claims2,85512
Credits to enterprises16,35969
Securities 23671
Factoring claims6463
Fixed assets1571
Other assets6573
Total23,746100
II. Liabilities
Statutory capital3,84516
Loan loss reserves2951
Interbank deposits6,36727
Other deposits11,64649
Other liabilities.1,4516
Profits1421
Total23,746100
Sources: Gosbank, and Business in the USSR, No. 3, July-August 1990.

330 institutions; data are not consolidated.

Including participations.

Sources: Gosbank, and Business in the USSR, No. 3, July-August 1990.

330 institutions; data are not consolidated.

Including participations.

The CCBs are, by international standards, comfortably capitalized. Their own capital, which in many cases has been increased since initial registration, is equivalent on average to 16 percent of total assets, far exceeding the standards set by Gosbank (5 percent of liabilities for commercial banks and 8 percent for cooperative banks). This apparent conservatism, however, may be indicative of the new banks’ difficulty in expanding their deposit resource base. The CCBs as a group appear to be profitable; before-tax profits totaled some rub 220 million in the first half of 1990, equivalent to 5.7 percent of capital at the end of the period. Interest rate margins are high, averaging around 13-16 percent, with lending rates of the order of 20-25 percent and deposit rates of 7-9 percent. Loan losses appear to have been small, around 2 percent of outstanding loans, but the trend is reportedly rising. As of October 1990, there had only been two cases in which a CCB’s registration had been canceled. This action resulted from violation of prudential regulations or from engaging in prohibited activity, rather than from insolvency, and depositors reportedly did not suffer any losses as a consequence.

About one third of CCBs are set up as cooperatives to provide credits and other financial and nonfinancial services to the cooperative enterprise sector. In addition to lending, many are engaged in leasing and factoring, as well as in organizing barter transactions among enterprises.14 Roughly half of the CCBs have been organized by industrial state enterprises, by groups of enterprises in the same industrial sector (e.g., automobiles, gold mining, power generating equipment), and/or by regional organizations, including municipal governments. The remainder of the CCBs consist of so-called “innovation banks,” set up to sponsor the development of high-technology products, and of institutions owned by various associations and organizations (labor groups, cultural organizations) and by governmental bodies. Republican and municipal governments, branch ministries, and the state-owned specialized banks have played a significant role in promoting the formation of CCBs. Promstroibank, for example, is reportedly a shareholder in some 50 CCBs.

The CCBs provide a vehicle for lending outside the restrictions of the monetary authorities’ Credit Plan and for reaching borrowers who normally lack access to the specialized banks. The CCBs have enjoyed considerably greater freedom than do the specialized state banks in their lending decisions, the interest rates they are allowed to pay for enterprise deposits and to charge on loans, and the salaries they can pay to employees. On the other hand, unlike the Savings Bank, their deposits are not guaranteed, acceptance of household deposits cannot exceed their capital, interest rates on such deposits cannot exceed those offered by the Savings Bank,15 and the lack of a real estate market has made it difficult for most of them to acquire well-located premises of adequate size and expansion potential. As of November 1, 1990, interest rate controls were extended to apply equally across the banking sector.

Although still very small in comparison to the specialized banks, the CCBs have constituted a source of competition in the financial system. Nevertheless, some aspects of their development could create serious problems for their future soundness and for competition. As noted, a large proportion of the CCBs have been established by a particular industry or group of enterprises with the explicit purpose, set down in their charters and by-laws, of serving the credit needs of those enterprises. As a result, loan portfolios tend to be concentrated on particular borrowers or in particular branches of industry. Shareholders also commonly include the specialized banks, other cooperative banks, branch ministries and other agencies of the union, republican, and local municipal governments. There is some concern that the newly organized commercial banks could, if they provided loans to their owners on anything other than regular commercial conditions, become vehicles for enterprises to get around the “hard budget constraint”. The concept of conflict of interest does not appear to be well developed in the USSR, and there are currently no regulations to avoid it.

The close relationships being formed between banks and enterprises also poses a threat to competition in the real sector, insofar as it gives preferred access to credit to enterprises that are affiliated with banks. In addition, competition among banks is being threatened by the formation of associations of CCBs that are promoting interlocking ownership among them. Both of these tendencies should be subjected to antimonopoly laws and regulations.16

d. Banking regulation and supervision

Banks provide the basic payments mechanism in virtually all modern economies, and are the principal source of credit to enterprises and households. At the same time, however, given the high liquidity of their liabilities, banks are extremely vulnerable financially to anything that may affect the confidence of depositors, such as the fear of war, a failed harvest, a sudden change of government policies, or simply rumors that a bank is about to fail. Moreover, given the strong interrelationships among the elements of a financial system in a market economy, a sudden drain of deposits from one large bank can easily spread and become a generalized financial panic. Societies thus have a vital interest in assuring the soundness of the banking system, and governments in the major market economies thus tend to regulate and supervise banks much more closely than they do the real sector.

Banking regulations typically have two main objectives: to ensure that banks adequately manage their risks and that a bank’s capital is sufficient to withstand reasonable loan losses without jeopardizing its solvency. Banks are also subject to strict rules requiring disclosure of information about their financial situation. In order to guard against fraudulent behavior, particular rules are applied to transactions involving a bank’s own managers and employees. Finally, in order to protect depositor confidence, many countries have introduced deposit insurance or guarantee programs.

In the past, with neither lenders nor borrowers in the USSR facing a hard budget constraint, and with banks effectively acting as budgetary agents, there was little reason for concern for the financial soundness of the banking system or of its individual institutions. Supervision of the specialized banks or of its own branches by the Gosbank consisted of assuring that resources were being allocated in accordance with the Credit Plan. Even as the specialized banks have acquired some discretion in their credit activities, and as they have begun to move into less traditional banking areas (e.g., leasing and factoring), both bank managers and government authorities have only gradually become aware of the financial risks in their portfolios. There is a general lack of familiarity with basic accounting principles and an almost total absence of rigorous internal auditing procedures as well as external supervisory control. Credit risk analysis is also impeded by the lack of proper accounts in the borrowing enterprises.

(1) Current status of bank regulation in the USSR

Initiatives have been taken by Gosbank in recent years to introduce prudential regulation and bank supervision. These have focused almost exclusively, however, on the CCBs, which account for only a small share of credit. Up to now, Gosbank has not been in a position to exercise effective supervision of the specialized banks. In January 1989, six months after the establishment of the first CCB, Gosbank established a special Commercial Bank Department for the auditing, prudential regulation and supervision of these banks. Detailed prudential standards have since been issued by Gosbank, which has also assumed the authority to seek corrective measures in cases of noncompliance. The quality of supervision, however, needs improvement, given important shortcomings in current accounting standards and the shortage of qualified examiners and other staff, particularly at the republican and local branches of Gosbank. It also appears that exceptions to the prudential regulations are granted by the local branches.17

(a) Licensing standards

In 1988, when the first CCBs were established, an ad hoc registration procedure was put in place and managed by the Promstroibank, which was itself an important sponsor and shareholder of many of the new institutions. Later in that year, responsibility for the registration process was passed to Gosbank, and the banks initially registered by Promstroibank were required to re-register.18 The re-registration process appears to have been a formality, however.

In January 1989, Gosbank and the Ministry of Finance jointly issued provisional regulations (pending passage of the central banking law) setting the minimum requirements for obtaining a commercial or cooperative banking license. The regulations are fairly detailed and reflect an effort by Gosbank to adopt international practices. Among the requirements:

  • The founding shareholders must prepare a document, giving basic information about the bank—e.g., name, location, etc.—and setting out, in a kind of organizational statute (ustav), its intended purpose;

  • An application is to be filed with Gosbank containing the bank’s ustav, a financial plan, a list of the founding shareholders and their respective capital contributions, and the bank’s pro forma balance sheet and income statement in accordance with a specified format;

  • Commercial banks must have a minimum capital of rub 5 million, and cooperative banks a minimum capital of rub 0.5 million.

Registration applications are reviewed initially at the regional (oblast) office of Gosbank, the judgment of which is subject to subsequent review at a higher level. The file is then sent to the head office of Gosbank, which evaluates the application in cooperation with the Department of Money and Credit Operations of the Ministry of Finance. Supplementary to the original regulations, Gosbank also set conditions on the qualifications of the bank’s top manager, specifying that he or she should have a degree in economics, at least 5 years’ experience in banking, and a clean legal record.

Despite Gosbank’s efforts, it appears that the licensing process thus far has involved little more than formal registration, and that eligibility criteria have not been strictly and uniformly applied. The minimum capital requirement, for example, has frequently been circumvented by allowing that only a portion be paid in at the commencement of activities. In response to public pressures, Gosbank was forced to drop eligibility requirements for bank managers and generally to expedite the registration process. The issue of bank licensing has been further complicated by political decentralization, although the recently enacted Law on Banks and Banking Activities may clarify responsibilities. Under that law, licenses are to be issued by the central banks of the republic within whose territory the respective banks will be located. Gosbank will license all-union banks.

(b) Prudential regulation

Two sets of prudential regulations were put into effect by Gosbank in April and May 1989. Inspired by the Cooke Committee’s recommendations on capital adequacy, as well as other rules in effect in the Western industrial countries, these regulations cover liquidity and capital ratios, a limit on individual loans, auditing requirements and the process for securing collateral. Capital-liability ratios of 1:20 and 1:12 are specified for commercial banks and cooperative banks, respectively; household deposits cannot exceed 100 percent of capital; credit to a single borrower cannot exceed 100 percent of capital for commercial banks, or 50 percent for cooperative banks; the ratio of liquid assets to short-term liabilities must exceed 30 percent for banks providing cashier services, or 15 percent for banks that do not; and the ratio of long-term assets to capital plus long-term liabilities should not exceed 100 percent.

Gosbank’s authority to establish capital and liquidity standards, as well as other prudential regulations, is confirmed in the new central banking law. It would also be empowered, jointly with the republican central banks, to take action in the event of a bank’s noncompliance with the standards, including raising the bank’s mandatory reserve requirement and arranging for the bank’s reorganization or delicensing and liquidation.

The present regulations do not require provisioning against bad or doubtful loans, but the new law does empower Gosbank to develop a policy on loan-loss reserves. Gosbank has asked each commercial bank applicant to specify in its ustav the particular provisioning method it proposes to adopt. As a general guideline, it has suggested that 20 percent of profits be placed in a reserve account, until reserves accumulate to 25 percent of the bank’s own capital. In its recent conversion to a joint stock company, Agroprombank committed itself (in its ustav) to a more ambitious eventual target of reserves equivalent to 100 percent of equity, to be reached through annual contributions of at least 5 percent of profits. Moreover, the reserve is to be replenished whenever loans are written off, although the conditions that would trigger a write-off are not specified.19

(c) Supervision

Although an informal supervisory process has been instituted by Gosbank, supervisory practices are not yet fully developed. The regional offices of Gosbank are responsible for monitoring the operations of the CCBs, which are required to open correspondent accounts in Gosbank or in a specialized bank. The CCBs provide monthly financial information, consisting of a balance sheet and the required prudential ratios. A formal balance sheet must be published annually. Although the format for an income statement is set out in the regulations, these statements are not typically collected or evaluated by Gosbank. Indeed, while financial flow data are routinely gathered on the basis of daily transactions recorded in a bank’s books, little use is made of this information and the indications it can provide of a bank’s operating performance and financial position.

In the event of minor noncompliance with regulations, Gosbank may simply send a letter to the bank requesting that the problem be corrected and credit policies strengthened. Where a problem is considered more serious, Gosbank can block (and has reportedly done so) the bank’s correspondent accounts. In an extreme case, registration can be annulled, and the bank liquidated. As of October 1990, as noted earlier, two CCBs had in fact been closed. Nevertheless, the enforcement of existing regulations appears to have been weak. Bank supervision does not appear to have received high priority from the Gosbank branches responsible for it, and CCBs do not appear to have a strong incentive to allocate significant resources to internal auditing and data collection to satisfy banking regulations.

Effective risk management by the banks and related supervision also suffers from scarce and outdated equipment. The computer center of Gosbank is equipped with calculating machines and computers that are, on average, 20 years old. Equipment in the regional branches is even more primitive. More importantly, monitoring and enforcement will be hampered in the medium term by the lack of qualified personnel in the regional and local offices of Gosbank. A strong nucleus of future bank auditors and supervisors does exist in Gosbank’s Auditing Department at the union, republican, and regional levels. However, their past focus has been on the auditing of the branch offices of Gosbank itself, verifying whether cash is safeguarded, bookkeeping accurate, and rules for extending credit followed. More recently, with attention shifting to the CCBs, the auditing process has consisted of checking a sample of loans, including the largest credits, on an annual basis. Loan maturity, profitability, repayment, collateral, and use of funds are all verified.

The positions taken by republican representatives toward banking regulation have in some cases complicated the effort to strengthen supervision. Unless a significant educational effort is mounted to change attitudes, the combination of free-wheeling bankers and political interference in banking decisions will represent a severe threat to the stability of the developing banking sector, and the USSR could be obliged to repeat the painful experiences of the Western market economies in this area.

(2) Deposit protection

Deposits at the Savings Bank are fully guaranteed by the government while deposits in the CCBs are not protected at all. This, along with interest rate ceilings, puts the CCBs at a competitive disadvantage vis-à-vis the Savings Bank.20 While some form of deposit insurance or guarantee covering all banks is probably advisable in order to give confidence and stability to the system, the governments of many market economies that have heretofore supported full protection of deposits (usually up to some maximum absolute amount per account) are now rethinking whether 100 percent coverage is a good idea. With full insurance coverage of deposits, depositors need not concern themselves with the quality of bank management, and the managers may feel free to take on excessive risk in their lending activities.

Many experts now believe, therefore, that an insurance or guarantee scheme that protects only a proportion of each individual’s deposits, say 50 percent, is preferable to full protection. In this way, depositors will more carefully monitor bank performance, and bank owners and managers will be forced to behave more prudently for fear of losing their depositors.

(3) Interest rates

Until recently, different interest rate regimes applied to the specialized banks and the CCBs. The former were not allowed to pay, on average, above 0.5 percent on enterprise deposits and 2-4 percent on household deposits (depending on maturity). Interest rates on loans from the specialized banks could vary according to the financial position of the borrowers but remained, in practice, near or below the refinancing rate charged by Gosbank, which itself varied across sectors.21 The CCBs, meanwhile, were allowed to freely set both deposit and lending rates; their interest rates on household deposits averaged about 6 percent, well above the rate offered by the Savings Bank, while lending rates averaged about 9 percent, but with a very wide dispersion. Interest rates as high as 60 percent have been reported on very short-term loans. As noted earlier, since February 1990 interest rates on household deposits in the CCBs have been limited to the deposit rates offered by the Savings Bank. These, along with other rates, were administratively raised in November 1990 to 5 percent for 1-3 year maturities; 7 percent for 3-5 years; and 9 percent for maturities over 5 years. Lending rates were permitted as high as 15 percent.22

e. Recommendations

(1) Regulatory framework

Macroeconomic stability, public confidence, and the strength of the banking system are closely interrelated, especially in a market economy. For this reason, the Government should proceed as a matter of urgent priority to clarify and strengthen the legal, regulatory and supervisory framework for the banking system. Toward this end, under the new Law on Banks and Banking Activities, a strong supervisory authority should be established, empowered to license banks, both specialized and CCBs, and to ensure their soundness and their safety as depositories. Soundness should be explicitly stated in terms of solvency, liquidity, profitability, and quality of management, with the detailed criteria for licensing and regulation to be defined by the supervisory agency. The latter should also have clear powers to enforce the rules and to impose sanctions for noncompliance, including the authority to close the offending bank and to force it into restructuring or liquidation.

The existing prudential framework and arrangements for enforcement should be improved. Capital adequacy standards for the formation of new banks and governing banks already in operation should be strengthened. Banks should be required to observe adequate standards of risk management, with regard, in particular, to liquidity risks and to solvency risks that may arise from undue loan concentration. Arrangements for containing other risks, such as those related to exchange and interest rates, should be considered at an early stage, even though most banks are not yet involved in activities where these risks arise. Arrangements are also needed to closely monitor and limit the scope for “self dealing”; i.e., operations between banks and their shareholders and between banks and their own staff and managers, with a view to avoiding abuses and conflicts of interest.

(a) Licensing

The current approach to the registration of commercial banks should be transformed into a genuine licensing procedure, involving the application of strict eligibility criteria. Managerial competence and accountability should be assessed, along with regulatory standards and other criteria judged appropriate by the supervisory authority in light of legislated public policy objectives. Immediate measures are needed to counter the present tendency of enterprises and government agencies to organize new banks, which they control. It is recommended that bank applicants, whose ustav sets out the objective of lending to their own shareholders or their affiliates, or whose purpose in applying appears aimed at assuring their access to bank credit, not be registered or given licenses. This restrictiveness could be relaxed, once enforceable limits on loan concentration and insider lending are in place.

(b) Capital adequacy

The existing regulations of Gosbank and the recent banking legislation both emphasize the importance of capital adequacy standards. It should be noted, however, that it is not feasible to set capital requirements so high as to withstand substantial losses in a bank’s asset portfolio. Such requirements provide protection, therefore, only insofar as the other basic prudential rules, such as asset diversification and asset classification and provisioning, have been successfully applied. Given the high concentration found in both CCB and specialized bank portfolios in the USSR, a high initial capital-asset ratio would appear to be appropriate. Present Gosbank regulations require only a 5 percent capital-liability ratio for commercial banks, as compared to the 8 percent capital-assets ratio recommended by the Basel Committee for commercial banks in the Western industrial countries. Under the present start-up circumstances in the USSR, a ratio of 10-15 percent would seem more appropriate; on average, as noted earlier, this ratio appears to be met.23 Dividend payments could be suspended until proper ratios are achieved.

(c) Asset diversification

Extreme concentration of loans in particular sectors and, often, particular borrowers is a characteristic of both the specialized banks and the CCBs. Individual loan amounts also tend to be large relative to bank capital. In the case of many CCBs, a significant proportion of loans has been extended to the banks’ own shareholders. For the specialized banks, concentration problems may be exacerbated by their likely division along geographical lines. The existing limit on loans to a single borrower, or to borrowers joined in a legal association, has recently been lowered by Gosbank from 100 percent of capital to 50 percent. It nevertheless remains too high and leaves banks excessively vulnerable to a single borrower failure. Moreover, it is not clear whether the present limit is being effectively enforced. A uniform limit on loans to a single borrower or associated group of borrowers of no more than 15 percent of a bank’s capital, with secondary limits set on the total outstanding to the three or four largest borrowers, is strongly recommended.

The authorities need to be particularly wary of the danger to the banking system of allowing enterprises and affiliated ministries to control commercial banks.24 Such conflicts of interest not only threaten the soundness of the particular bank, but also impede competition in both the financial and real sectors and can distort the allocation of credit away from higher-return investment possibilities. Regulations should limit the amount of credit extended to shareholders or officers of the bank and to parties related to them to a small fraction of capital and subject them to an absolute ceiling. It should also be required that any such loans be made on the same terms and conditions as applied to other borrowers.

(d) Asset classification

The classification of assets in accordance with their likely collectibility is essential to ensuring that a bank’s financial statements accurately present its financial condition.25 An assessment of asset quality also provides important evidence of the capabilities and competence of managers, and of the adequacy of the institution’s lending policies and procedures. The supervisory authority should thus be empowered and required to review and, as necessary, to correct the classification of each bank’s assets on the basis of an impartial assessment of asset quality based on objective criteria.

Regulations should require that banks classify their loans according to different risk categories. The criteria for defining nonperforming loans should be specified; for example, loans 60-90 days past due, depending on the type of collateral, should be classified as nonperforming. There should also be a precise rule for suspending the accrual of interest and for reversing previously accrued, but uncollected, interest on nonperforming loans. Guidelines should be provided for the formal renegotiation and rescheduling of loan repayments, and the current practice of automatically rolling over bad loans should be explicitly prohibited. The classification of a loan as bad should be reflected in appropriate adjustments to loan-loss reserves.

Finally, bank regulation and related supervision should also deal with contingent liabilities of the banks and other off-balance sheet activities. These are reported to be significant in the USSR, in both the specialized banks and the CCBs.

(e) Disclosure of information

Laws and regulations should ensure that investors and depositors in banks have adequate and reliable information about the bank’s activities and financial condition. Banks should be required to disclose financial information—including audited financial statements—through a publicly available registry at the office of the bank supervisory agency, and to publish such information. Such a requirement gives confidence and protection to the depositors and investors and, in turn, puts additional pressure on the bank’s owners and managers to assure efficient and prudent operation.

(2) Bank supervision

Bank supervision, including on-site inspection, needs to be intensified. The staffs of Gosbank’s Auditing and Commercial Banking Departments, with their wide network and professional experience, would provide a nucleus upon which to build an operational system of banking supervision. Their analysis, however, needs to be refocused, new concepts of financial analysis and risk management must be learned, on-the-job experience gained, and new equipment introduced. The process will necessarily be time consuming. Whether the supervisory function is assigned to Gosbank or to a new agency, the supervisors must be insulated from external interference and political pressure, particularly in light of the substantial interests that ministries and other government agencies currently have in the banks and in their borrowers.

(a) Accounting and auditing

It is urgent that accounting standards be upgraded, with particular regard to the treatment of late and doubtful loans and requirements for loan provisioning. Bank supervisors and auditors should work together with the accountants to improve definitions and practices, with the common objective of better assessing bank performance and financial condition. An intensive training program should be mounted for accountants and supervisory personnel, including auditors and examiners.

(b) Supervisory methodology

Once a basic accounting framework is effectively in place, and an adequate core of auditors and examiners has been trained, an intensive effort should be undertaken to assess the quality of individual bank portfolios and to assure their adequate provisioning and, as necessary, recapitalization. On-site examinations should be introduced as soon as the size of supervisory staff permits. Contacts of the supervisors with bank accountants and managers can hasten and reinforce the learning process for both. Examinations can also expedite compliance, as the results are communicated and a response is required. In preparation for the eventual liberalization of interest rates and increasing foreign exchange activity, special attention should be given to assuring that the attendant risks are properly managed.

Competence in off-site monitoring should also be gradually developed. A data collection format and system should be designed to enable both a mechanical test of compliance with regulations and to develop simple means for spotting possible problems. A bank’s balance sheet and income statement would be evaluated in the light of its portfolio, with particular attention to such factors as delinquencies and problem assets, foreign exchange position, and off-balance sheet liabilities. A program specifying the frequency of data submission should be worked out in accordance with the supervisory staff’s ability to respond. Any noted weaknesses should trigger an immediate follow-up in the form of a communication to the bank’s management or, as needed, a supplementary on-site inspection.

(c) Staffing

Staffing is perhaps the most immediate bottleneck to effective supervision, and efforts should begin urgently to expand staff size and upgrade skills. A career path should be developed for bank supervisors. Training and recruitment could be pursued in conjunction with the banks’ own training and recruitment efforts, given their broad overlap. The upgrading of equipment—computers, etc.—should also be introduced as rapidly as feasible to streamline operations and to limit the demand for relatively unskilled staff.

(3) Modernizing the payments system

Well-functioning financial systems require an efficient payments system, providing fast clearing and settlement at both the central and regional levels. This is a matter of utmost urgency in the USSR. At present, money transfers between banks in different republics may take weeks or even months to clear, involving huge implicit interest costs, greatly complicating liquidity management of banks, and weakening overall control of the money supply. Gosbank is presently seeking to modernize its technological and institutional infrastructure for interbank payments settlement, including the introduction of correspondent accounts not only for the CCBs but also for the specialized banks and their successor institutions and for public sector organizations whose budgets are administered by Gosbank. The new system is expected to become operational in 1991. Reforms in this area are also vital to the development of securities markets, whose operations depend on efficient clearing and settlement systems. It is advisable that the new payments system be based on the most modern technology, allowing effective linkages with international money transfer systems.

(4) The transition to a market-based banking system

In the context of a strengthened regulatory and supervisory framework, the growth of CCBs and the commercialization of the specialized banks should be encouraged. The reinforcement of licensing and regulatory standards might result in a slowing of new bank formation and in the merger or disappearance of some existing CCBs, but the result should be the emergence of a stronger and more stable banking sector. In the meantime, ownership rights and the legal status of different forms of organization should also have been clarified, for banks as well as other enterprises, putting the CCBs on a level competitive playing field with the specialized banks. Similarly, a law on pledge should be enacted, clarifying the conditions for the use of property as collateral, introducing registration requirements for encumbered property, and establishing the procedures for foreclosure (see Chapter IV.7).

At the same time, the denationalization of the specialized lending banks would proceed in much the same way as for state enterprises (see Chapter IV.2): viz., they would be transformed into joint stock companies, the shares to be held in separate state property funds—or holding companies—independent of the ministries and regulatory agencies (including Gosbank). However, the likely reclassification of the assets of the specialized banks could force a reassessment of their overall financial solvency, or that of some of their branches, and cause a slowing of their full commercialization and privatization. New lending operations should be conducted on a fully commercial basis. Before being passed on to new owners, however, bad and doubtful assets should be written down and/or shifted to a special state agency for their collection or liquidation. The government should, in effect, take responsibility for the inherited bad debts. The magnitude of the problem cannot be known until these specialized banks have been subjected to comprehensive portfolio audits, and the economy has adjusted to reforms in the real sector.

During this period of clarifying and rectifying the financial status of the banks, their ownership would remain with the respective property funds. These holding companies, acting through boards of directors, would ensure that managers were held to the new performance criteria of commercial lending on all new credit decisions, and, very importantly, that appropriate training was being provided to managers and staff. The banks’ operations should no longer be subjected to sectoral limits, and both depositors and borrowers should enjoy freedom in their choice of banks. The specialized banks would thus be in increasing competition with each other and with the CCBs. Only as they are placed on a sound financial footing and are adequately staffed for their new functions, however, should they be fully commercialized and the process of privatization begin.

During an initial period, the Savings Bank could, as suggested by the presidential guidelines, remain under state control. With its extensive branch network, it would probably remain, for a time, the principal mobilizer of household savings to the other banks and to the Government. As the Government’s financing needs were reduced and increasingly satisfied through a growing securities market, and as the specialized banks were progressively commercialized, the Savings Bank could expand its own lending activities through the interbank market and, increasingly, directly to private sector customers. It, too, would be put on a commercial, self-sustaining basis, the foundation of managerial and staff skills having been laid during the transition period. A corollary of this evolution would be the withdrawal of Gosbank from its credit intermediation role; in the meantime, it will have developed its indirect tools of monetary control.26

Competition in retail banking could be further enhanced by allowing the post office system to engage in banking operations, such as cash and payments services, retail foreign exchange transactions in tourist areas, the management of savings accounts, and the sale of government securities to small savers. This approach has the advantage that a wide network for the provision of such services is already in place in the postal system. Many countries have exploited this advantage, and, in some cases, the financial services departments of the postal system have eventually been converted into independent, full-fledged commercial banks.

In the course of this transition to a competitive market-oriented financial sector, the banks will have to prepare themselves to meet the vast financial service needs of enterprises, households, and local governments and other public bodies, as the entire economy operates increasingly on market principles. The increasing commercialization and privatization of existing enterprises and the creation of new enterprises of all sizes will place a heavy demand on the nation’s financial resources. An expanding branch network will be required to reach and serve the needs of households and, especially, of small and medium-sized enterprises. A wide range of advisory and other merchant banking services will be needed to assist in the process of industrial restructuring and to support newly-formed enterprises.

Banks can also help their clients to establish commercial and investment linkages with foreign enterprises. The ability of banks to assist in the process of privatization will require massive training of staff in the analysis of enterprise finances and market prospects, and the development of new financial instruments, institutions, and markets through which savings are mobilized and channeled.

As the reforms progress, the entry of foreign banks, on their own or in joint ventures with domestic institutions, can strengthen competition, create effective links with foreign financial centers, introduce needed management skills, and accelerate the process of financial modernization and innovation in the USSR. Foreign banks will remain reluctant to enter or to expand their operations in the Soviet market, however, until the legal basis for their activities and for credit operations generally is firmly established.

Finally, the Government should reconsider its plans to retain one of the specialized banks under state ownership as a vehicle for channeling preferential credit to state-designated activities. Although such institutions are commonly found in other countries, the experience with them has not been good. While originally conceived as development-promoting institutions, their ability to dispense credit on subsidized terms has frequently turned them into vehicles for political favoritism and bad loans. Instead of mobilizing additional resources for development, their lending practices have resulted in a heavy drain on state resources. This same advice applies also to the republican and local governments, which may be tempted to take over one or more specialized bank branches as their own state banks.

As a general principle, it is recommended that a clear distinction be maintained at all levels of government between activities to be determined by the state and financed through the budget, and activities best left to market determination and to the financial system. Overlapping the two tends to subvert both decision-making processes. This suggests that, where there is a public interest in promoting activities that are unable to service credit on full market terms, any subsidies be provided from the state budget, where they can be reviewed in the normal budgetary process, rather than financed from the earnings of banks.

2. THE DEVELOPMENT OF SECURITIES MARKETS AND CONTRACTUAL SAVINGS INSTITUTIONS

The presidential guidelines indicate the Government’s intention in the near future to support the creation of stock and commodities markets and related brokerage companies, as well as insurance companies and other institutions characteristic of developed financial systems. Although of lesser urgency than the strengthening of the banking system, the establishment of such institutions is important, among other things, for the development of long-term instruments of investment finance, risk-sharing and the transfer of ownership rights, and improving the tools of monetary policy. The development of securities markets greatly contributes to the mobilization of resources for investment, by providing the long-term instruments required by investors while at the same time helping to meet the liquidity needs of savers.

a. Securities exchanges

Steps have already been taken toward the establishment of securities exchanges in Moscow and Leningrad,27 and Gosbank is drafting related rules and regulations based on Western models. The only securitized claims currently in the system are a relatively small volume of government debt instruments, some bank certificates of deposit, and a limited number of shares issued by joint stock companies, the most prominent of which is the Agroprombank, discussed earlier. The nature of ownership rights conferred by shares and their negotiability remain unclear.

(1) Existing securities

No private debt securities have been issued to date. However, some government securities have been issued, in addition to the certificates of deposit of the Savings Bank. Three types of government securities were being actively sold in 1990. Zero-coupon lottery bonds, due in 2002, were first issued in 1982 and continue to be issued on an ad hoc basis. As of September 1990, some rub 20 billion of such bonds were outstanding. With the Savings Bank serving as agent, the bonds are sold and can be redeemed at par at any time. The bonds are in bearer form and are available in denominations of rub 25, 50, and 100.28 Lottery drawings are held 8 times per year, and winning amounts range from rub 100 to rub 10,000. Large winnings (rub 5,000 and rub 10,000) can be applied against the price of Zhiguli or Volga automobiles and put the winner at the head of the queue for these cars.

In late 1989, the Government issued rub 75 billion of 16-year, 5 percent Treasury bonds (dated January 1, 1990) to be sold through the Savings Bank. When these bonds failed to sell, the Government agreed to pay two coupons on each interest payment date, effectively halving the maturity and doubling the interest rate to 10 percent, and to reduce the amount available for sale to rub 15 billion. As of September 1990, only about rub 300 million had been sold. The bonds are available in denominations of rub 250, 500, and 1,000, and the Savings Bank is the sole paying agent.

Commodity bonds are a securitized form of advance payment by “investors” seeking to secure access to 16 specific commodities, mostly consumer durables, identified by the Council of Ministers.29 The stated intention is to channel resources to expand production capacity for the specified goods, but it is not clear whether this is, in fact, happening. According to the 1990 Budget Plan, some rub 5 billion of such bonds were to be issued. The bonds are obligations of the Ministry of Finance, with the Savings Bank once again serving as agent. The greatest demand was reportedly for bonds for automobiles and refrigerators.

The Savings Bank has been issuing certificates of deposit since 1988, in denominations of rub 250, 500, and 1,000. These CDs carry a nominal maturity of 10 years, with the interest rate graduated up to 4 percent, depending on the actual holding period. Information was not available on the amount of such paper outstanding, and it is not clear whether the certificates are traded.

(2) Legal and regulatory framework

Important gaps in the legal and regulatory framework affecting securities markets need to be filled before substantial and stable development of these markets is possible. First and foremost, legislation is required to establish the legitimacy of financial claims and the rules and mechanisms of their enforcement. The salability of financial claims, including equity shares, must also be clearly established if savers are to be induced to share the risks of enterprises, and if secondary markets are to play their role in providing the liquidity demanded by most potential buyers of long-term debt or equities.

To provide efficient intermediation of resources, and to enjoy the confidence of both savers and issuers of securities, securities markets must operate under clear rules and regulations. Potential buyers of securities need reliable information, on the basis of which to judge the financial strength and prospects of the enterprises and other entities whose obligations they have the option to buy. Legislation is needed, therefore, requiring accurate disclosure of information on the part of those wishing to issue securities, with strong penalties for misinformation or fraud. Disclosure standards may initially fall short of those applied in more advanced Western financial systems, given the present state of development of accounting practices. The quality of both will need to be raised over time, however, to international levels, if Soviet financial markets are to be made attractive to foreign investors.

Securities investors must be able to rely with confidence on the intermediaries—e.g., brokers—involved in market transactions. A system is needed for the registration and licensing of broker-dealers, with appropriate eligibility requirements concerning the experience, background, and capital base of the applicants. Following registration, intermediaries must be held to high standards of professional conduct. Market intermediaries should be required to disclose any financial interest they may have in the securities they are intermediating. Savers and investors should be protected against the potential monopolistic, collusive, or manipulative behavior of brokers and large market players. Rules against insider trading are of particular importance. Antimonopoly legislation should prohibit the fixing or manipulation of securities prices and broker spreads and commissions. Competition should also be protected by appropriate restrictions on interlocking ownership and directorships among financial institutions and enterprises. The integrity of the exchange itself must also be assured, with strict qualifications set for the exchange’s own personnel and standards set out for member conduct.

For all these purposes, it is necessary that the law provide for the establishment of a strong regulatory agency with jurisdiction over the securities markets and with the authority to issue regulations applying to all the market participants—issuers, intermediaries, investors, the exchanges, and organizations providing the clearing services for exchange transactions. It is important that the regulatory authority have the power to impose sanctions and that it be an independent agency, insulated from political pressures in its activities. This is particularly important in a situation in which the owners of many issuers of securities may continue to include government agencies.

It will probably take two years or more before formal, well regulated securities markets for the trading of enterprise debt and shares would be in place in the USSR. Establishment of the necessary legal and regulatory framework will take time, as will the training of regulatory staff and creation of the required technological infrastructure. Investor confidence will also be slow to develop in the uncertainty of the reform process and restructuring of the economy. The issuance and trading of government debt instruments could, in principle, begin much earlier, however, given their relatively low risk to buyers.30 Since most concerns about investor protection should not arise with respect to government securities, secondary market trading could be permitted and encouraged.

The Government should shift its focus from the long-term end of the market and work to develop the market for shorter-term instruments. These would presumably be of greater immediate appeal to savers, given past experience with government bonds and the inevitable uncertainties of the Soviet economy in the next few years. Short-term government securities are likely to be viewed by savers as a close substitute for government-guaranteed savings deposits, particularly if their liquidity can be assured. Development of the market for such securities offers the additional advantage of serving the interests of monetary policy, allowing the authorities to affect base money through market means. Later in the process, consideration might be given to the conversion of existing government debt, which amounted to about rub 400 billion at the beginning of 1990, into negotiable instruments.

A formal market for enterprise debt should await an adequate regulatory framework, particularly as regards investor protection. No market for long-term securities is likely to develop amid the uncertainties of the transition process. A possible exception could be mortgage lending by banks, which could be made an acceptable risk by the availability of secure collateral. For a mortgage market to develop, however, clear laws on property ownership and debt recovery would have to be in place. Short-term corporate debt, consisting of commercial bills and paper, could be encouraged to promote corporate liability management. Seasonal fluctuations in the cash flow of agro-industrial enterprises, for example, could be partially smoothed through the issuance of short-term commercial paper during low-flow periods and investments in short-term paper during periods when reserves build up. A market for short-term corporate paper might develop initially with banks acting as dealers.

The volume and types of equity issued will depend largely on the plans adopted for the privatization of state enterprises (see Chapter IV.2). If most medium- and large-sized enterprises will be converted into joint stock companies early in the reform process, the shares could be held initially by state property funds. Subsequently, shares in the individual enterprises, in mutual funds formed of a diversified package of enterprise shares, or in the property funds themselves, would be sold to other state bodies, enterprises, and individuals. Although it is advisable to start now to develop the rules and regulations, including improved accounting practices and disclosure of financial information, it is not essential that the issuance and trading of the new equity shares commence on the basis of rigorous standards. Meanwhile, as the formal framework for share trading is being developed, the informal issuance and trading of securities is likely to grow. The Government should not try to stifle this activity, which can play a valuable role in mobilizing risk capital and giving liquidity to the new ownership claims. Without a satisfactory regulatory framework in place, however, the Government should not officially endorse or sponsor this activity, and should publicize the risks involved to its participants.

b. Insurance

The only nonbank institutional investors in the USSR currently are insurance companies. The State Insurance Company (Gosstrakh) dominates the system, with a network of 6,000 branches and 240,000 employees. Like other state agencies, Gosstrakh is organized in hierarchical layers in accordance with the several levels of government. Every republic has its own board of directors, as does every oblast. In addition, inspection sites are located in each municipality and rayon. Gosstrakh offers households and enterprises about 30 different types of insurance, covering life, health, work disability, and property.31 Since 1988, however, a number of new companies have been organized as cooperatives or other forms. Some of these have, in fact, been promoted by Gosstrakh, along with municipal governments and industrial enterprises. It has also entered into a joint venture with a foreign insurance company.

Gosstrakh’s reserve funds, representing future obligations under insurance contracts, total some rub 34 billion; it is unclear, however, how this amount compares to its estimated actuarial liabilities. Some 41 percent of Gosstrakh’s annual gross income (premiums less insurance payout) is transferred to the state budget. This amounted to about rub 1 billion in 1989. In the past, Gosstrakh’s reserves were deposited in Zhilsotsbank at a fixed 3 percent rate of interest.

Recently, however, it has shifted a small amount of its reserves (about rub 4 billion) to higher-yielding CCB accounts. These accounts are not guaranteed, however, and tend to increase the riskiness of Gosstrakh’s portfolio.

Insurance companies in the Western industrial countries provide large and stable sources of long-term finance, including housing finance, and Gosstrakh and its present and future competitors should be viewed by the authorities as potentially important elements of the Soviet financial system. Gostrakh’s immediate evolution depends on how the economic relationships between the union and the republics are resolved. Some republican branches have been more profitable than others, and some have been loss-makers. A break-up of Gosstrakh would increase the riskiness of at least some of the republic operations and could weaken the insurance industry’s competitive position vis-à-vis the banks.

c. Pension funds

Pensions in the USSR have historically been funded from a payroll tax on enterprises supplemented by payments from the state budget. The Savings Bank has served as the paying agent, and a Social Insurance Committee in each district is responsible for pension administration. Under the State Pension Law enacted in May 1990, a new, self-financing pension system was to be put in place as of January 1, 1991. A new independent institution is to manage all pensions in the country as well as specific social welfare payments. Collection will be the responsibility of the republican branches of the new institution. In addition, transfers from republican budgets are to cover military and other pensions. The head office of the pension fund is to manage surplus funds with a view toward maximizing their return; its profits would be exempt from taxation.32

NOTES

For the three decades prior to the reforms of 1987-88, the interest rate on enterprise deposits was fixed at 0.5 percent.

Indeed until the mid-1960s, long-term credit was non-existent. Even after that, the distinction between credit and budgetary grants remained blurred, given the soft terms of the former and the frequency with which arrears were forgiven.

The Savings Bank monopolized the collection of household savings, which it redeposited with Gosbank. Prior to 1963, the Savings Bank was subordinated to the Ministry of Finance. Since then, except during 1988-89, it has functioned as a department of Gosbank.

Foreign trade was also serviced by Soviet-owned banks operating abroad.

Promstroibank took over the operations of the old Stroibank to provide both working capital and fixed investment financing.

If banks mobilize greater deposits than planned, they can exceed their credit ceilings by the same amount, while those with deposit shortfalls can still lend at their assigned ceilings. For the macroeconomic implications, see Chapter III.2.

Article 6 of the Law on Banks and Banking Activities, enacted on December 11, 1990, empowers the union and republican Supreme Soviets to create special commercial banks to finance all-union, republican, regional or other programs. Article 38 of the same law confirms the special emphasis on the Savings Bank as a mobilizer of individual savings, while a resolution of the USSR Supreme Soviet (also dated December 11, 1990), reiterates that the Savings Bank is to remain the property of the USSR. Under that resolution, transfer of a Savings Bank branch to the possession of a republic can be made if the republic accepts a portion of the government debt financed by the savings accounts of its population.

The loans were taken over by the Government. In effect, the assets of Agroprombank were written down by rub 73 billion (equal to about a third of its outstanding loans at the time), and its liabilities to Gosbank were written down by a like amount. At the same time, Gosbank’s loans to Agroprombank were replaced on its balance sheet by an equal amount of state bonds.

The republican branches of Agroprombank in the Ukraine and Belorussia have already become independent joint stock banks.

The pricing of the shares was done administratively. Total assets were estimated to be worth about rub 160 billion after write-offs. Applying the capital-liabilities ratio required of CCBs (see section d) implied a minimum capital requirement of rub 8 billion. The authorized capital was divided into 72,000 ordinary shares, priced at rub 100,000 each, and 800,000 preferred shares priced at rub 12,000 each. The latter shares pay a 15 percent dividend but carry no voting rights.

The disposition of existing assets and liabilities of the converted branches remains unclear.

The maturity of the CDs is nominally 10 years, but they can be cashed in early at any office of the Savings Bank. Interest rates range from 3 percent to 6 percent, increasing with the time held.

As of October 1990, Gosbank paid only 2.77 percent for the monies deposited with it by the Savings Bank.

Financial institutions are apparently exempted from Soviet criminal prohibitions against “speculation” and middle-man activities (see Chapter IV.7), and have served as convenient agents for barter and other trading activities on behalf of enterprises. These possibilities, however, may now have been eliminated. Article 2 of the new Law on Banks and Banking Activities forbids banks from engaging in trade in material goods.

Until 1990, the CCBs were free to negotiate interest rates on household deposits. The present limits were evidently imposed to protect the deposits of the Savings Bank. Like bankers in other countries, however, innovative CCBs have found ways to circumvent these limits through offering premia of various kinds.

Article 9 of the new Law on Banks and Banking Activities permits commercial banks to create unions, associations and other combinations for the purpose of coordinating their activities and protecting their interests. Article 29, however, expressly prohibits the use of such unions, associations or other groupings to fix interest rates, commissions or otherwise restrict competition in banking.

Under Articles 30-36 of the new central banking law enacted in December 1990 (see Chapter III.2), Gosbank is to establish prudential norms for all commercial banks, including the specialized banks. According to the Resolution of the Supreme Soviet that accompanied the law, however, individual norms are to be established for Vneshekonombank, Promstroibank, and the Savings Bank during some unspecified transition period. The responsibility for monitoring and enforcement is shared by Gosbank and the republican central banks.

In accordance with a decree issued in April 1989, banks wishing to engage in foreign exchange operations must obtain a license from Vneshekonombank; some 20 such licenses had been issued by September 1990. Under the central banking law enacted in December 1990, that authority was shifted to Gosbank and the central banks of the republics. At least one commercial bank has already received such a license from Gosbank.

It has been common banking practice in the USSR to roll over unpaid principal automatically, while continuing to report accrued interest as income.

Under Article 38 of the new Law on Banking and Banking Activities, depositors at the Savings Bank will continue to enjoy a state guarantee of their deposits. Other commercial banks are instructed (Article 37) to establish interbank funds to insure the deposits of individuals in accordance with the procedures and conditions to be defined by the central banks of the republics.

In 1989, the average lending rate of Promstroibank was 3.78 percent compared to the 4 percent it paid on refinancing from Gosbank. The comparable paired rates for the other specialized banks were: Zhilsotsbank - 2.89 percent and 4 percent; Agroprombank - 1.77 percent and 1.5 percent. It should be noted that some bank branches also held interest-free government deposits.

Articles 27 and 36 of the new Law on Banks and Banking Activities free commercial banks to set their own interest rates and commissions, subject to the stipulations of Article 17 of the central banking law (Law on the USSR State Bank), which give Gosbank the authority to control interest rates when deemed necessary for monetary control.

Since the specialized banks at present fall far short of these and the other prudential standards recommended below, however, a transition period will be necessary, as discussed in section (2).

Article 8 of the Law on Banks and Banking Activities declares banks independent of the executive and administrative bodies of the state authorities in their decision-making and forbids state agency and administrative personnel to be administrators of the banks.

A general problem affecting the financial system is the present inadequate legal basis in the USSR for the recovery of debt. Severe restrictions exist on the use of state property or of leaseholds and use-rights to secure debt. Private property can apparently be foreclosed, but represents a tiny share of total assets, and there is no mortgage law. (Chapter IV.7 provides a more detailed discussion of the relevant legal framework.)

The bulk of outstanding state debt in the USSR is held on the books of Gosbank, its counterpart being money in circulation and Gosbank’s liabilities to the Savings Bank. Breaking of the credit relationship between Gosbank and the Savings Bank, therefore, must be accompanied by a corresponding reduction in Gosbank’s holdings of government debt, if intolerable monetary expansion is to be avoided. The only practicable approach would appear to be a substantial “securitization” of government debt. In other words, the creation of a large pool of marketable government debt would be a precondition for cutting the institutional linkage between the Savings Bank and Gosbank.

A commodities exchange of sorts is already functioning in Moscow, with the active support of the Moscow City Council. At present, it is essentially a trading room where participants can meet to enter into barter deals; the exchange itself plays no role in executing deliveries.

While they are fully negotiable, it is not clear whether a secondary market for these bonds exists.

These are also referred to as warrants for consumer goods. See Chapter II.2.

Government debt in the USSR has not, in fact, carried a low risk historically. Payments have frequently been suspended, and interest rates lowered unilaterally. As a consequence, Government debt issues are viewed negatively by many.

A separate company, Ingosstrakh, insures external activities such as trade, Soviet tourists abroad, and transportation.

For details on the pension system and its financing, see Chapters III.1 and Appendix III. 1-3, and Chapter IV.6.

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