Banking Soundness and Monetary Policy

14 The Banking Sector in a Transition Economy: The Case of Poland

Charles Enoch, and J. Green
Published Date:
September 1997
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Financial system reform in Poland started in the late 1980s with the devolution of its single administrative structure, typical for command economies, into one national savings institution and nine, regional, universal commercial banks. This new, two-tier banking system also comprises an independent central bank—the National Bank of Poland (NBP)—and about 90 universal banks, not to mention more than 1,500 small, local, cooperative banks. The NBP as a licensing and supervisory body sets requirements on the banks, including minimum capital requirements, staffing and projected operations, suitable premises, and acceptable articles of agreement.

At the beginning, the main concern of the NBP was to enhance competition among banks, in expectation that it would increase efficiency and speed up adaptation to the new economic circumstances. A liberal attitude toward the licensing of new banks has led to the creation of about 100 private or semiprivate (owned in part by state enterprises and institutions) banks. In the first few years, private ownership of banking was seen as a primary means for ensuring the better allocation of financial resources in the economy. It was deemed important to remove political considerations, which might have been distorting the incentives facing state banks. In May 1991, the government decided to privatize the nine regional banks separated from the NBP in 1989, and the first of them became private in April 1993. Most of the new banks, although undercapitalized and lacking expertise, were very aggressive in looking for new clients. This resulted, after some delay, in a sharp deterioration of their loan portfolios.

Since the beginning of the economic transformation, and the subsequent recession, the financial system has been deeply affected by these banking developments. A sharply deteriorating economic environment was the source of instability and required immediate action. The seriousness of the emerging risks necessitated emergency moves and accelerated the need to find long-run systemic solutions. Those long-term solutions assumed creation of a competitive banking sector, a suitable banking infrastructure, and implementation of an appropriate legal and institutional framework.

Supervisory Issues

Effective banking supervision is critical to any country’s overall economic stability. While the specifics of banking supervision may vary from country to country, the main objectives are to promote safe and sound banking practices, protect depositors, and maintain stability in the financial markets by eliminating likely systemic risks. While banking supervision must safeguard the stability of the whole sector, it must also leave banks free to carry on commercial activities in a way that allows for a competitive allocation of capital in the economy. As such, banks’ freedom of action should be restricted only by prudential standards and practices.

The process of setting up banking supervision in Poland began in 1989, in close cooperation with the relevant international institutions (the World Bank, the International Monetary Fund, and the Basle Committee on Banking Supervision) and with supervisory authorities in developed countries. This was particularly important in developing adequate legal regulations, establishing principles of bank accounting compatible with international standards, preparing a model for bank reporting, and training of staff.

The following key elements of the economic infrastructure received a great deal of attention:

  • a system of business laws, including corporate, bankruptcy, contract, and private property laws;

  • a system of codes of practice;

  • adequate and well-defined accounting principles;

  • a system of independent audits;

  • publicly available information for use by current and potential investors, creditors, customers, and other stakeholders;

  • an efficient payments system for the settlement of debts; and

  • the functioning of rating agencies.

In Poland, it was decided that the president of the NBP would exercise supervisory authority over the operations of banks, within the frame of reference stipulated by the Banking Act. Daily supervisory activity is conducted by authorized NBP staff, who are empowered to enter banks and their offices for this purpose and who report directly to the president of the NBP.

The NBP evaluates bank operations on the basis of the information gathered and may undertake measures specified in the Banking Act. In particular, it may do the following:

  • analyze the balance sheets of banks;

  • review compliance with the requirement that banks maintain certain levels of liquidity;

  • review compliance in relation to loans and advances extended (per legal lending limits);

  • review loan collateral and repayment performance; and

  • review the interest rates charged by the banks on loans and advances; and

  • review the financial condition of banks.

In performance of banking supervision, the president of the NBP may also instruct banks to restore liquidity or comply with certain prudential standards, increase their capital, or desist from particular forms of advertising.

NBP’s Banking Supervision Department, in collaboration with the consulting firm of KPMG, has developed an on-site examination manual. The manual contains chapters covering virtually all areas of commercial bank operations and risk assessment. The department has developed a bank closing manual, also in collaboration with KPMG, which contains a standard set of procedures to be applied in the event of bank failures, together with a draft information/bid package to be used by receivers, trustees in bankruptcy, and potential investors at the distressed institutions concerned. Together with U.S. advisers, the department also has been conducting work to reform the system of banks reporting, to develop adequate information technology support, and to prepare a standard analytical bank report modeled on the U.S. Uniform Bank Performance Report. The new report forms came into use on January 1, 1997. They were designed to correspond to the objectives and requirements of several departments of the NBP, including the Banking Supervision Department, the Credit Policy Department, the Department of Statistics, and the Research Department.

In collaboration with IMF experts, the Banking Supervision Department developed a new Model Bank Chart of Accounts in 1994. The chart in its final form was published as Regulation No. 4/95 by the president of the NBP on February 22, 1995. Work has also been concluded on a summary commentary to the chart of accounts, presenting detailed principles for recording bank products and transactions.1

Problems in the Banking Sector

Along with development of its supervisory functions, the licensing policy of the NBP was tightened, and new prudential regulations were gradually imposed on banks. With the help of the international community, Poland implemented more adequate reporting standards and requirements. Obviously, this could not improve the quality of the portfolios themselves, which reflected the very poor condition of Polish enterprises and which were negatively affected by macroeconomic changes and adjustment requirements. An audit of the nine state banks performed by international auditing firms in 1991 revealed that banks’ positions and, more important, that of their borrowers were dramatically bad. The share of loans classified as doubtful and the loss varied from 20 to 70 percent, depending on geographical location and former specialization.

The accumulation of bad loans during the economic transition, and high, though decreasing, interest rate spreads, led to the inefficient allocation of resources (the relative overtaxation of good borrowers and depositors); the charges resulted from a need to build up provisions against adversely classified loans. In these circumstances disintermediation can occur, with many potential bank customers lost to cheaper and more flexible financing—either in the form of money market instruments in the capital markets or even outside the domestic financial market.

The other fact was the weak position of several banks, a consequence of poor management skills and poor qualifications of the personnel, along with inappropriate procedures and internal regulations as well as the inadequate risk appraisal. A number of banks suffered from insufficient equity and became virtually insolvent; several banks failed in the end. These failures were one of the factors that led the NBP to terminate the liberal licensing policy of 1992.

Where a bank is found to be in persistent noncompliance with recommendations issued to it, or the bank’s operations are in flagrant violation of law or its articles, or represents a material threat to the interests of depositors, the president of the NBP is authorized to apply a series of remedial measures, up to and including revoking the bank’s authorization to operate. The president can issue a liquidation order.

Some small and badly managed banks were gradually withdrawn or expelled from the market (through liquidation), while others were taken over by bigger and sounder banks. In many cases where banks went into default, the banks’ executives were forced to resign and were replaced by administrators nominated by the NBP. The NBP felt responsible for the newly established private banks and intervened in some medium-sized private banks, which accumulated significant household deposits and were important for local communities. The government protected the fate of state banks and eventually decided to recapitalize them.

The prevailing reason for bank default was a range of portfolio problems on the asset side, revealed by external audits and by bank examiners. Excessive lending to a single customer and insider lending to shareholders were other factors that weakened the assets side of the balance sheet in many small and medium-sized banks. Most asset-related weaknesses arose from neglect of credit risk management and inadequate compliance with relevant laws and regulations.

The recession years of 1990-92 led to the erosion of the capital base of many banks, including state-owned banks, because of the high inflation, low profits, and changing taxation rules that did not foster adequate reserves against likely loan losses. According to auditors’ estimates, the share of bank credits considered doubtful rose sharply in 1991-93; the bulk of these credits was granted to the big state enterprises. The creation of numerous new private companies caused new and different difficulties, resulting from a lack of credit history, poor management skills, and sporadic corruption.

The lack of experience with banks and markets was quite natural for new enterprises operating in an economy in transition and was observed in other neighboring countries. Nor was it always possible to evaluate companies’ prospects, their future sales and prices, in the quickly changing conditions, in the fact of high inflation, and in the midst of many dramatic legislative changes. The fundamental questions were how to avoid further deterioration of banks’ assets and how to sort good credit risks from the bad.

Having monitored the mounting crisis within Polish banking during 1992-93, the NBP undertook a series of measures, both systemic and institution-specific, to strengthen the banking sector and to encourage saving. The systemic measures included commencing work on three new pieces of legislation, duly enacted by Poland’s Sejm in 1994:

  • the act amending the corporate income tax, which laid the basis for recognizing as a tax-deductible expense the provisioning for charges against loans and advances classified as loss;

  • the Act on the Restructuring of Cooperative Banks and of BGZ (the nationwide affiliating institution for cooperative banks), which made provision for the financial and organizational restructuring of cooperative banks and the BGZ; and

  • the Act on the Bank Guarantee Fund, which established an institution with the statutory objective of providing financial assistance in bank restructuring and guaranteeing deposits held at all banks in Poland.

In situations where a bank finds itself in jeopardy or adverse rumors begin to appear in the press, depositors take steps to withdraw their funds. When the bank’s operations are suspended, however, and the president of the NBP petitions for a declaration of bankruptcy, the bank’s customers are willing to undertake certain commitments (keeping their funds at the bank for a period of several years earning interest below market rates, waiving interest already accrued, and so forth).

The Act on the Bank Guarantee Fund makes no provision for bank rehabilitation through the buying up of bad loans. However, the fund is empowered to provide repayable assistance for the purposes of bank restructuring (at preferential rates of interest), principally to clean up loan portfolios. The resources available for restructuring are collected from annual contributions from the banks, with a ceiling on these contributions equivalent to 0.4 percent of a bank’s risk-weighted assets.

The following conclusions may be drawn from the experience gathered in Poland during the crisis in the banking system:

  • where a bank’s capital-asset ratio is approaching zero or below zero, the bank usually will be incapable of overcoming its difficulties without external assistance;

  • early identification of problem banks, coupled with relevant restructuring measures, increases the likelihood of these banks being rescued;

  • it is essential for banks to introduce detailed internal procedures for assessing loans and other exposures to insiders (shareholders or members of management);

  • banking supervision requires broad powers to influence the composition of a bank’s ownership and management;

  • consistent application of the principle that losses are to be absorbed by capital, together with notifying law enforcement agencies of criminal offenses committed by bank management, constitutes an effective deterrent with respect to moral hazard—even when the bank receives public funds; and

  • in the circumstances of a large-scale banking crisis, assistance from public funds is indispensable.

The legal regulations concerning banking supervision issued by the NBP president have all been published in the bank’s official journal. Some of the essential regulations include:

  • Regulation No. 11/92 issued on August 7, 1992, on the organization and performance of banking;

  • Regulation No. 16/92 issued on October 1, 1992, on bank procedures in the event of deposit at a bank of funds or other assets constituting the proceeds of crime or those associated with a crime, and in the event of cash deposits exceeding a specified amount;

  • Regulation No. 4/93 issued on March 19, 1993, on the establishment of normative provisions for permissible foreign exchange risk in banking activities;

  • Regulation No. 7/93 issued on May 20, 1993, on capital requirements relating to bank assets;

  • Regulation No. 13/94 issued on December 10, 1994, on procedures for provisioning against the risk of banking;

  • Regulation No. 1/95 issued on February 16, 1995, on detailed principles for bank accounting and for the compilation of additional information;

  • Regulation No. 4/95 issued on February 22, 1995, on the establishment of a model bank chart of accounts;

  • Regulation No. 10/95 issued on December 29, 1995, on detailed procedures for the consolidated financial statements by banks; and

  • Recommendation for banks issued June 1996, concerning the monitoring of financial liquidity (this document covers all qualitative aspects of managing liquidity).

In developing regulations and other prudential standards applicable to all banks, NBP has been faced with a series of challenges. The changing nature of the operations conducted by many banks, the new products and transactions being introduced, and the new legal provisions being adopted all require the regulators to amend existing standards and extend the scope of supervisory regulations to include new areas of activity. One example is Regulation No. 16/92, which requires all banks to develop internal compliance programs to combat money laundering and to notify the public prosecutor’s office of certain account activity. During their routine on-site examinations, bank examiners monitor the adequacy of these compliance programs. The NBP’s Banking Supervision Department is currently considering the possibility of amending this regulation to raise the cut-off amount for sums that require investigation and to express it in european currency units (ECU).

Further, certain amendments have been introduced to the regulations governing provisions against risk assets (Regulation No. 13/94). As a result of the Accounting Act, the need arose to include all impaired assets in provisioning requirements.

The measure of capital adequacy adopted in Poland is based on the concepts developed by the Basle Committee on Banking Regulations and Supervisory Practices, which have since been approved and implemented by almost all agencies of banking supervision throughout the world. Certain modifications that have been introduced in Poland are attributable to the need to adjust this instrument to correspond to the specific circumstances of Polish banking. The minimum risk-based capital requirement considered safe has been set at 8 percent. Observance of this requirement does not automatically guarantee the success of any given banking institution nor its long-term solvency.

The particular significance of the capital adequacy measure and its adoption on an international scale arises from several factors:

  • it provides a precise indication of the attitude of banking supervision to the measurement of capital adequacy, which is assigned a central role in the assessment of safety and soundness;

  • it constitutes a safety mechanism, as it expresses the degree of risk being assumed by a bank in the form of a rising capital requirement; and

  • it demonstrates the need to consider internationally recognized prudential regulations, since the operations of many banks transcend national frontiers.

The procedure whereby the value of particular exposures, multiplied by the relevant risk weights, is related to an institution’s capital base stems from the fact that, in supervisory terms, capital performs several functions: it cushions operating losses; as a permanent investment on the part of the bank’s shareholders, it demonstrates their readiness to cover any associated risk; and it provides the bank with a relatively low-cost source of funding. The provisions on risk-based capital are contained in Regulation No. 7/93 (May 20, 1993), on capital requirements relating to bank assets. This stipulates that a bank’s weighted capital may be no less than 8 percent. Banks that commence activity after the regulation was introduced are required to maintain a ratio of no less than 15 percent for the first 12 months of operations and no less than 12 percent for the following 12 months.

The NBP believes a proper valuation of loan portfolios is impossible without proper knowledge of both the share of particular asset classifications in the total volume of outstanding loans and the level of specific reserves required and actually established. Asset classification represents a particularly sensitive aspect of a bank’s activity. The losses liable to be generated by high-risk assets through the ensuing erosion of capital resources have a direct bearing on the bank’s growth. The level of reserves required compared against those actually established (and thus of the amount “missing”) makes it possible to determine the quality of the bank, its financial capacity, and its overall condition. All of the above measures represent an effort to avoid any sudden slump in bank earnings.

While the concept of large exposures and the related limits vary from country to country, the treatment of such exposures always includes statutory limits for prudential purposes, protection against credit risk, diversification of risk and financial resource allocation, minimum safety standards as assessed by the regulators, proper diversification and segmentation of the loan portfolio, and bank management developing their own policies concerning a safe level of diversification within the loan portfolio. To counter the danger of large losses, it is necessary to introduce appropriate limits by specifying the maximum exposure a bank may have to its customers as a percentage of its capital base. This stems from the need for the bank to apply one of the basic principles of prudential banking practice—risk diversification.

The scope of limits on a bank’s financial exposure must also include off-balance sheet exposures arising from guarantees, endorsements, and letters of credit. The Act on the Bank Guarantee Fund took effect on February 17, 1995. It provides for the operation of three different deposit protection schemes, each of which constitutes a self-contained system based on separate rules regarding payouts to depositors of funds entrusted to banks that become insolvent. The three schemes are a universal statutory system of deposit guarantees operated by the Bank Guarantee Fund, guarantees extended by the Treasury, and a voluntary deposit guarantee scheme.

The Bank Guarantee Fund was set up as a corporate body pursuing a two-fold objective. The first relates to the operation of the compulsory and voluntary deposit guarantee schemes. The second involves assistance to institutions in the system of guarantees. Participants in the compulsory system of deposit guarantees are banks operating pursuant to the Banking Act of January 31, 1989.2 As of the consolidation of financial statements by the regional affiliating structures of cooperative banks—provision for which is made in the Act on the Restructuring of Cooperative Banks and of BGZ—the cooperative banks affiliated to these structures will cease to participate in the guarantee system, and their place is to be taken by these regional institutions. The guaranteed deposits constitute funds in Polish zloty or foreign currencies deposited at a bank participating in the system by the depositor named in the evidence of receipt issued by the bank, irrespective of the number of contractual agreements the depositor has concluded with the bank, up to a statutory maximum ceiling. Those eligible for deposit protection under the compulsory guarantee system are those parties holding funds in a bank account, whether they be natural persons, juridical persons, or organizations not possessed of personality at law.

A guarantee relationship exists between the Bank Guarantee Fund and each depositor, involving the right of the depositor to claim a certain sum of money as of the date the conditions for performance of the guarantee are fulfilled. This date is defined under the act as the day when the bank concerned is declared bankrupt, or when a ruling to reject a petition for bankruptcy on the grounds of insufficient assets to cover the costs of bankruptcy proceedings becomes final and conclusive, or when it is ascertained that a regional cooperative structure is unable to cover the debt exposure and liabilities of a cooperative bank affiliated to it, where such a bank is declared bankrupt or a petition for it to be so declared is rejected on the grounds of insufficient assets. In other words, the conditions for fulfilling the guarantee are met the day the bank’s insolvency is formally recognized, pursuant to the relevant regulations. The act also stipulates the maximum guarantee a depositor may claim from the fund: 100 percent for sums up to ECU 1,000, and 90 percent for sums between ECU 1,000 and ECU 3,000, increased recently to ECU 5,000.

Banks participating in the statutory deposit guarantee system pay the fund an annual contribution not exceeding 0.4 percent of their risk-weighted assets. For three individual banks—Pekao SA., PKO BP, and BGZ SA.—the mandatory contribution to December 31, 1999, cannot exceed 0.2 percent of risk-weighted assets. A participating institution is automatically exempted from the annual contribution if it becomes insolvent.

The fund’s capacity to protect deposits is ensured by requiring participating institutions to establish a guaranteed deposit protection fund. The size of this fund must be determined no later than the end of each calendar year, as a percentage of the funds held at the bank (or regional cooperative institution)—but no higher than 0.4 percent—on all accounts that constitute the basis for computing the regulatory reserve requirement. Banks are obliged to hold the assets that make up the protection fund in the form of treasury securities and NBP money market bills, to be deposited in individual custody accounts at the NBP or the National Securities Deposit.

The operations of the Bank Guarantee Fund are also financed from other sources. They include interest income from loans made by the fund and from treasury securities, funds received as nonrepayable assistance from abroad, central government subsidies, loan facilities extended by the NBP, and other income.

Restructuring and Observed Benefits

Under these circumstances the restructuring program prepared by the Polish Government had to address both banks and their main borrowers—state enterprises. It should be remembered that banks’ restructuring was a precondition to their subsequent privatization, which was intended to make their behavior purely market oriented. Placing private capital at risk would cause the banks to enforce market behavior on their customers, including companies from the public sector.

The key factors in the restructuring proceedings were the scale of the problem, the lack of institutionalized procedures for dealing with restructuring and bankruptcy, and the scarcity of experienced managers. It became necessary to introduce a specially tailored legal framework to start the restructuring process. The special law—the Act on Financial Restructuring of Enterprises and Banks—was adopted in February 1993 to provide banks, as major creditors, with powers to negotiate with borrowers. The act introduced the banking conciliatory arrangement, which gave both creditors and debtors greater latitude to restructure banks and enterprises as needed. The state banks were supplied with extra funds to replenish reserves, and it was expected that the new approach would motivate enterprises to prepare reliable restructuring programs, ones that might justify further financial involvement by the creditors. Both parties were additionally motivated to deal with bad debts; proceedings with all major creditors (except social security and employee remuneration claims) facilitated agreement on the restructuring of major credits or on debt reduction. Other instruments that were suggested included the public auction sale of bad loans and debt-equity swaps. In the end, the restructuring process reduced excessive indebtedness in many viable companies.

The fundamental strategy in the restructuring was a decentralized approach to give the banks a key role in the process. The government assumed that without wide bank participation a new wave of bad loans was likely. It was hoped that the restructuring would radically change firm behavior—imposing on them hard budget constraints and a sense of ownership. The transformation of companies into joint-stock companies was anticipated as a major step toward their privatization.

Other visible results were the attitudes of banks toward lending, as they made use of the experience gained in workouts: banks introduced the new lending procedures, and workout specialists taught credit officers new analytical techniques that were used in the restructuring processes. Banks’ attitudes toward customers also changed dramatically. The fast expansion in the outlets for and number of products and services contrasted with past practice.

Banks are now adjusting their operations from the period of rapid growth in the early 1990s when employment in the sector grew and interest rate spreads were high. In recent years banks have moved from attracting new personnel through competition in remuneration to developing growth potential of their employees and from attracting customers irrespective of cost to greater reliance on reliable borrowers and well-prepared investment projects. They have also moved from competition—the levels of fees and interest rates to a greater emphasis on the range and quality of products and services offered.

In consequence, the quality of banking services has risen, shown in the handling of good, corporate customers and the higher efficiency of interbank settlements. Quality improvements point to further development of the banking sector. The other important consideration is the achievement of almost full compliance with international accounting practices and standards, associated with the accumulation of adequate provisions against classified assets by domestic banks and the strengthening of the banking supervision and enforcement.

The growth potential of the banking sector is supported by numerous factors, a major one being that the zloty has become fully convertible in current and partly convertible in capital account transactions. These factors are augmented by a steadily growing domestic market, increasing stability in financial markets, and a greater range of financial instruments available. The restored confidence in the domestic currency led to the accumulation of a stable deposit base by major banks. Finally, the structure of the banking industry may influence its soundness as well. Too large concentration in the banking sector means that only a few banks will enjoy economic rents and can lead to the inefficiencies resulting from the lack of competition.

The soundness of the newly created system was weakened by macroeconomic shocks that came with transition from a centrally planned economy to a market-oriented one. The banks were negatively affected by hyperinflation, followed by shock therapy (price liberalization and exchange rate adjustment), implying drastic cuts both in domestic and external demand and vast structural and institutional changes. The adjustment process imposed hard budget constraints on enterprises, and the collapse of the COMECON was followed by deep economic recession.

Cooperative banks will be represented by consolidated regional institutions.

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