Chapter

7 Legislative Framework

Author(s):
Robert Price, Malcolm Knight, and Arne Petersen
Published Date:
May 1999
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Author(s)
Tonny Lybek

The reform efforts outlined in the previous chapters must be supported by an appropriate legal framework; that is, one that enforces economic decisions made based on market principles.

Recent Developments

Since the end of 1991, the 15 countries under review have generally achieved significant progress in establishing a sound legal framework for central banks and commercial banks. Some progress has also been made in legislation supporting banking transactions. Laws governing contracts, collateral, and bankruptcy have been passed, but legal uncertainties about the enforceability of these laws may continue to contribute to the generally large spread between lending and deposit rates for financial institutions in most of the 15 countries.

Central Bank Legislation

It is now generally accepted in advanced market economies that price stability with a medium-term focus should be the primary objective of a central bank. Central bank reforms over the last decade have concentrated on the need to assign the central bank the appropriate autonomy in support of this objective. Although it is the prerogative of the state to conduct monetary policy, the government normally has many different objectives. Some of these objectives may be at odds with a medium-term approach and may result in a short-term monetary policy with an inflationary basis, which hampers sustainable growth. Experience shows that delegating the authority over monetary policy—or at a minimum the implementation of monetary policy—to an autonomous central bank can improve the credibility of monetary policy. As a counterpart of this delegation of authority, however, a central bank must ensure that its transactions are transparent and that information is disclosed on a regular basis so that it may be held accountable for its performance. The linkage with the primary objective, together with appropriate coordination between autonomy and accountability, further enhances the credibility of monetary policy.

The Baltics, Russia, and other countries of the former Soviet Union have made significant progress in establishing a sound institutional framework by adopting central bank laws that generally ensure a medium-term focus on price stability and that shield the central bank from the short-term objectives of the government (the time-inconsistency problem). The central bank law established in the Kyrgyz Republic in 1997 is a noteworthy example of how to do this. In particular, this law has incorporated the primary objective of price stability while at the same time establishing central bank political and economic autonomy to implement policies in support of this objective. Moreover, autonomy is balanced by appropriate accountability provisions. The countries under review have also made a great deal of progress in this area. Three countries—Kazakhstan, Kyrgyz Republic, and Lithuania—introduced amendments to their central bank laws in 1997 (Table 7.1). As mentioned, the amendments introduced by the Kyrgyz Republic were comprehensive, and brought the law fully in line with modern standards. In Kazakhstan, the law was already broadly appropriate, but the amendment underscored the important principle that the National Bank of Kazakhstan is prohibited from extending direct credit to the government. The amendment to the central bank law of Lithuania was relatively minor, relating to the enforceability of collateral pledged to the Bank of Lithuania. Five countries—Belarus, Estonia, Latvia, Lithuania, and Ukraine—are in the process of modifying their central bank law. In Estonia, Latvia, and Lithuania, amendments are intended to farther entrench the central bank’s autonomy and accountability. Ukraine is now in the process of developing a comprehensive amendment to its 1991 law to bring it into conformity with modern standards. In Belarus, however, some of the recently proposed amendments to the law of 1995 may, in fact, reduce the national bank’s autonomy.

Table 7.1.Amendments of Central Bank Legislation(Until the end of 1997)
CountryEarlier Amendments of Central Bank LegislationMost Recent Amendment (Date of Adoption)Currently Under Review
Armenia1992, 1993, and 1995June 1996No
Azerbaijan1992June 1996No
Belarus1990, 1992, 1993, 1994, and 1995March 1995Yes1
Estonia1990 and 1993April 1994Yes2
Georgia1991, 1993, and 1995May 1996No
Kazakhstan1991, 1993, and 1995July 1997No
Kyrgyz Republic1991 and 1992July 1997No
Latvia1990 and 1992June 1997Yes2
Lithuania1990, 1994, and 1996April 1997Yes2
Moldova1991, 1992, and 1994September 1995No
Russia1990, 1992, 1993, 1995, and 1996April 1997Yes
Tajikistan1991, 1993, and 1995December 1996No
Turkmenistan1992October 1993No
Ukraine1990March 1991Yes3
Uzbekistan1991 and 1992December 1995No
Source: IMF staff.

The draft banking code is currently being reviewed by the Budget and Finance Commission of the House of Representatives.

Central bank legislation has been amended with a view to achieving consistency with the future European System of Central Banks.

Draft central bank law considered for first reading by parliament in October 1997.

Source: IMF staff.

The draft banking code is currently being reviewed by the Budget and Finance Commission of the House of Representatives.

Central bank legislation has been amended with a view to achieving consistency with the future European System of Central Banks.

Draft central bank law considered for first reading by parliament in October 1997.

In the following section, central bank laws in the countries under study are assessed against four key criteria: primary objective of price stability, political autonomy, economic autonomy, and accountability.1 This assessment is based on the laws as written. Anecdotal evidence suggests that key provisions may be overridden in practice in some countries.2

Objectives

Clearly defined objectives in the central bank law are important, as they give the bank implied authority to achieve these goals and provide a more precise basis for holding it accountable. Most authorities recognize price stability as the primary objective, since experience has shown this to be conducive to sustainable real growth. With that realization, 11 of the 15 countries in this study have made price stability the primary objective of their central banks, either explicitly or by linking the currency to an anchor currency.3 In the remaining countries, price stability is mentioned among other objectives—Azerbaijan, Russia, and Turkmenistan—or indirectly by stipulating monetary or currency stability as one of the objectives, as in Ukraine.

Political Autonomy

As part of the autonomy discussed above, central bank governing bodies should be shielded from the government’s short-term influence on the implementation of monetary policy. The governor of the central bank is responsible for implementing monetary policy and should thus be made immune from potential day-to-day political influence. The governor is also often (with the exception of Estonia and Latvia) the chairman of the board and therefore has significant influence on the decisions of the central bank, even though the power may formally rest with the entire board. A so-called double-veto arrangement for appointments, where one party’s nomination is subject to approval by another arm of government (presuming the various entities do in fact balance one another) can strengthen the governor’s credibility. In almost half of the countries under review—Armenia, Estonia, Georgia, Kazakhstan, Lithuania, Russia, and Uzbekistan—the head of state nominates the governor of the central bank, who then is appointed by the legislature. In Belarus, the Kyrgyz Republic, and Tajikistan, however, the president appoints the chairman with the consent of the legislature. In two countries—Moldova and Ukraine—the legislature appoints the governor, but upon recommendation of the chairman of the legislature. The governor in Latvia is appointed by secret ballot in parliament upon recommendation of at least ten parliamentary members. In Azerbaijan, the chairman is appointed by the president from members of the board. There is no double-veto arrangement in Turkmenistan, where the president appoints the governor.

To avoid subjecting the governor to political pressure, the term should be longer than the political election cycle of the bodies nominating and appointing the governor (generally four years). For instance, in the 15 countries in this study, the respective governors’ terms range between four and seven years.4 The laws covering terms should avoid subjecting the governor to uncertainty of a possible dismissal over conflicts on monetary policy. Removal from office should only take place in extreme cases of breaches of qualification requirements, misconduct, and, if it can be clearly defined, poor performance. With the exception of Azerbaijan, Belarus, Kazakhstan, and Ukraine, the countries in the study have some provision in their respective banking laws that generally protects the governor from arbitrary dismissal. Some countries stipulate that dismissal can only take place for breaches of qualification requirements or only after a conviction in court.5

The boards of directors of central banks in the countries being reviewed have an important role in formulating monetary policy and in monitoring the central bank’s implementation and its financial condition. The composition of the board is therefore important for the autonomy of the central bank. The number of board members varies from 5 to 14.6 In most countries—except, for example, Armenia, where the president appoints the board members—a double-veto arrangement governs the appointment of board members.7 In about half of the countries, the legislature appoints the members, either upon recommendation or nomination by the head of state, as in Azerbaijan, Georgia, and Russia, or the governor, as in Estonia, Lithuania, Moldova, Ukraine, and Uzbekistan. The head of state appoints the members with the consent of the legislature in Belarus. In Kazakhstan, the president, the Supreme Council, and the Cabinet each appoint different board members—with the exception of the chairman, who is appointed by the Supreme Council on the recommendation of the president.

To protect the autonomy of board members, the board’s term should be longer than the election cycle and the terms of its members should be staggered so as to ensure continuity of policy.8 Sound provisions that prevent arbitrary removal of board members are in place in Estonia, Georgia, the Kyrgyz Republic, Latvia, Lithuania, and Moldova.

Economic Autonomy

A basic principle of the legal framework for a modern central bank is that the law should protect the central bank’s authority over monetary policy from government encroachment. In the countries studied in this volume, a few prohibit direct credit to the government, either explicitly in the central bank law, as, for instance, in the Kyrgyz Republic, or implicitly due to a currency board arrangement, as in Estonia and Lithuania. In other countries—Armenia, Belarus, Georgia, Latvia, Tajikistan, and Turkmenistan—there is an explicit limit on government involvement in the law. In the remaining countries, limits on direct credit to the government are incorporated in the annual fiscal budget to be adopted by the legislature.9

A central bank must be financially sound to remain autonomous. Lack of financial resources can influence the central bank to pursue policies contradictory with its objective(s). Thus it is important that only realized profits be transferred to the budget, and separate revaluation accounts should be created for nonrealized valuation gains and losses. The central banks in the 15 countries generally have sound provisions in place requiring recapitalization of any deficiency of authorized capital. Ideally, such a recapitalization should take place through government transfers of interest-bearing securities to the central bank, which are to be redeemed by future central bank profits before profits can formally be transferred to the government. Interest payments will ensure the bank a flow of income. Some of the countries have such provisions in place (Armenia, Georgia, Kyrgyz Republic, Moldova, and Turkmenistan), while other countries do not explicitly specify that the securities shall be interest-bearing (Belarus and Tajikistan). In the remaining countries, losses that may deplete the authorized capital of the central bank will typically have to be covered by future profits of the bank.

To avoid undue influence by the government on the implementation of monetary policy, the central bank should not be subject to short-term appropriation procedures.10 In most of the central banks of the countries reviewed, the board is responsible for approving the budget of the bank. In Armenia and Lithuania, however, the annual budget is subject to approval of the legislature.11

Accountability

The central bank should be accountable to the government, legislature, and the general public for both its monetary policy and its use of public funds. Depending on the institutional structure, most of the central banks in the Baltics, Russia, and other countries of the former Soviet Union are formally accountable to the president, the legislature, or both. The laws all have provisions that require the bank to make at least one published annual statement on monetary policy, although in some instances the statement is subject to government approval. Several laws require more frequently published statements, for instance, twice a year, or when a release of information of importance for monetary policy is deemed necessary by the central bank or is requested by the legislature (Armenia, Azerbaijan, Estonia, Kyrgyz Republic, Lithuania, Moldova, Russia, and Tajikistan).

Because central banks are responsible for public money, including the seignorage created by the issue of the currency, sound business practices are important to establish central bank credibility and to support its autonomy from the government. Provisions that provide for the appropriate governmental oversight of the central bank will thus add to the credibility of the central bank. Several countries’ central bank laws already include a stipulation that financial statements conform to International Accounting Standards (Armenia, Moldova, Lithuania, and Tajikistan).

Commercial Bank and Other Legislation

The 15 countries under review have also achieved significant progress in adopting and amending commercial bank legislation in response to the developing needs of a market-oriented economy. In general, the countries have built a legal framework for licensing banks, issuing prudential regulations consistent with the standards of the Bank for International Settlements (BIS), providing authority to the banking supervisor to conduct on-site and off-site supervision, and allowing the banking supervisor to impose sanctions for noncompliance. Furthermore, in response to the widespread incidence of undercapitalized or insolvent banks, commercial bank legislation has also generally been amended to clarify the regulations for conservatorship, receivership, and liquidation. Since the breakup of the Soviet Union, all of the countries have amended their commercial bank legislation, but addressing shortcomings in the laws has been a continuous effort. Kazakhstan and the Kyrgyz Republic, for instance, adopted substantial amendments in 1997 to bring this legislation in line with modern practice, while other countries—for example, Belarus, Estonia, and Tajikistan—were expected to amend their commercial bank legislation in 1998 to farther improve and clarify the legal framework (Table 7.2). Lithuania also introduced revised amendments in 1997.

Table 7.2.Amendments of Banking Legislation(Until the end of 1997)
CountryAmendments of Banking LegislationMost Recent Current Amendment (Date of adoption)Under Review
Armenia1993Fall 1996Yes
Azerbaijan1992August 1996No
Belarus1990, 1991, 1992, 1993, and 1994December 1994Yes1
Estonia1990 and 1991December 1994Yes2
Georgia1991 and 1996March 1996No
Kazakhstan1990, 1992, 1993, and 1995July 1997No
Kyrgyz Republic1991 and 1992July 1997No
Latvia1995October 1995Yes
Lithuania1992, 1994, 1995, 1996, and 1997December 1997Yes
Moldova1992July 1997No
Russia1990, 1991, 1992, 1993, 1994, 1995, and 1996September 1997Yes
Tajikistan1991 and 19931994Yes
Turkmenistan1992October 1993No
Ukraine1991January 1995Yes
Uzbekistan1991 and 1992April 1996No
Source: IMF staff.

Draft banking code is currently being reviewed by the Budget and Finance Commission of the House of Representatives.

Legislation being amended with a view to achieve consistency with the future European System of Central Banks.

Source: IMF staff.

Draft banking code is currently being reviewed by the Budget and Finance Commission of the House of Representatives.

Legislation being amended with a view to achieve consistency with the future European System of Central Banks.

As growth begins to accelerate and banks begin to diversify into other related activities, such as leasing companies, as already seen in some countries, there is a need to clarify the legislation on such activities. Higher priority must be given to consolidated supervision and coordination with supervisors of nonbank financial companies. In some countries, for example Azerbaijan, the existing legislation may mainly need to be redefined, while in other countries, new legislation may be required on the activities and supervision of nonbank financial institutions, for example, in Turkmenistan and Ukraine, which has already drafted a law on nonbank financial organizations. (For further details on banking supervision and commercial bank legislation, see Chapter 4.)

An appropriate general legislative framework is needed to ensure that commercial banks can make binding decisions with the knowledge that repayment schedules will be respected and that collateral pledges will be enforced. The countries under review have generally made significant headway in adjusting the legal framework to the needs of a market-oriented economy. These advances include basic laws governing property rights and contracts, bankruptcy, and the use of collateral, including registration of liens. The principal weaknesses are now found not in law, although much remains to be done, but rather in the infrastructure required for the administration and enforcement of existing laws to meet the needs of a market-oriented economy.12 In particular, the civil code has been amended to include property rights and contractual law, which better allows for the use of decentralized information, and facilitates debt repayment by individuals and business enterprises. Some countries, including Belarus, Tajikistan, Turkmenistan, and Ukraine, are currently working on additional amendments, while others, for example, Armenia and Azerbaijan, have identified shortcomings or are planning to amend the civil code to farther ensure an appropriate legal framework. Although land ownership or land use is generally accepted, there may still remain judicial and practical impediments for using land as collateral, as in the Kyrgyz Republic.

Country Rankings

Rankings have only been assigned for central banking legislation (see Table 7.3).13 A ranking for banking supervision can be found in Chapter 4. Rankings have been assigned on the basis of a comparison of the provisions in the four key areas described earlier with those of the guidelines discussed above. Six countries have adopted central bank laws broadly consistent with all four criteria, and have been assigned a ranking of substantial progress (Group III). Most of the other countries have also made considerable progress in adopting central bank autonomy, but provisions could be strengthened farther with the result that these countries have accordingly been assigned the ranking of moderate progress (Group II). In this group, Kazakhstan, Latvia, Russia, and Uzbekistan have made the most notable progress. In Kazakhstan, provisions against arbitrary dismissal of members of the governing bodies could be improved, and the government should be explicitly obliged to recapitalize the bank by transferring interest-bearing securities in case of depletion of its authorized capital. Russia should place explicit limits on direct credit to the federal government, prohibit quasi-fiscal activities introduced by other legislation, and pass an explicit provision to recapitalize the bank in case of significant losses instead of using future profits. In Uzbekistan, the term and dismissal conditions for board members, with the exception of the governor, are not explicit, and there is no explicit limit on direct credit to the government.

Table 7.3.Progress on Central Bank Legislation
IIIIII
Limited ProgressModerate ProgressSubstantial Progress
Belarus, 19951Azerbaijan, 1996Armenia, 1996
Ukraine, 19911Kazakhstan, 1997Estonia, 19941
Latvia, 19921Georgia, 1995
Russia, 1995Kyrgyz Republic, 1997
Tajikistan, 1996Lithuania, 19971
Turkmenistan, 1993Moldova, 1995
Uzbekistan, 1995
Note: The year represents the most recent amendment of the central bank law until the end of 1997.

Indicates that the law is currently under review.

Note: The year represents the most recent amendment of the central bank law until the end of 1997.

Indicates that the law is currently under review.

Two countries have made limited progress, but they appear to be headed in opposite directions. In Ukraine, the legislature is currently discussing amendments that will significantly improve the autonomy of the central bank. In Belarus, however, the amendments presently being discussed will profoundly reduce the autonomy of the central bank.

Priorities for Reform

Central bank legislation that does not yet fully conform with the four criteria of price stability, political autonomy, economic autonomy, and accountability should be amended accordingly. Two considerations are particularly important—a rigorous limit on direct credit to the government and strict avoidance of all quasi-fiscal activities. Moreover, to gain actual legal autonomy and achieve price stability, the objectives and functions of the central bank must be explained to the general public.

Price stability reduces some of the uncertainties that confront financial intermediaries and the real sector, but with the stabilization of the economies, the shortcomings of the legal systems in these countries have become more visible. For a market economy to function properly, the government must ensure that generally accepted and transparent rules, clearly defined contractual rights, procedures for resolution of disputes over contracts, and the enforcement of all of the above must be credible and predictable. The introduction of generally accepted accounting principles, disclosure requirements, and the establishment of a core of independent external auditors will also contribute to a consistent flow of reliable information, and thus will also help to reduce uncertainty and facilitate a more efficient resource allocation. The Baltics, Russia, and other countries of the former Soviet Union have made considerable progress in establishing an appropriate legal framework, but reform is an ongoing process, and shortcomings must be addressed continuously. Priority must also be given to enforcing the existing legislation in a predictable way. The legal framework and the government’s policies must be cohesive and create sound incentives that will promote an efficient resource allocation.

1Sound policy formulation means that the central bank can formulate and implement monetary policy consistent with the exchange rate policy and that provisions are in place for coordination and resolution of conflicts with the government. Political autonomy safeguards the bank’s governing bodies from short-term political influence by way of sound provisions for the appointment, term, and dismissal of members of these bodies. Economic autonomy ensures that the central bank can actually manage the liquidity in the banking system through explicit limits on prohibitions against providing direct credit to the government and quasi-fiscal activities and that the bank is in solid financial condition. Accountability implies that the central bank will regularly report and publish transparent information on its monetary policy and financial condition.
2For example, profit allocation in Russia and directed credit at subsidized interest rates to the agricultural sector in Turkmenistan.
3Both Estonia and Lithuania operate under a currency board arrangement, which implies a clearly defined objective.
4Term of governors: seven years in Armenia, Georgia, Kyrgyz Republic, Moldova, and Turkmenistan; six years in Belarus, Kazakhstan, and Latvia; five years in Azerbaijan, Estonia, Lithuania, and Uzbekistan; and four years in Russia. Two countries—Tajikistan and Ukraine—have not explicitly defined a term in the central bank law. In general, longer terms should allow dismissal not just for misconduct, but also for poor performance, if the latter can be clearly defined.
5Ideally, accusations of misconduct should be allowed to be ruled upon by a court or by a special tribunal to avoid arbitrary dismissals, or, at a minimum, be approved or made known to the legislature.
6The number of board members in the transition countries is: five in Moldova and Tajikistan; seven in Armenia and Azerbaijan; eight in Latvia; nine in Estonia, Georgia, Kazakhstan, and the Kyrgyz Republic; 11 in Uzbekistan; 13 in Russia; and 14 in Lithuania. In Ukraine, a specific number is not stipulated, but according to the current draft, the Council of the Bank of Ukraine will include 14 members. The number of board members is not specified in Belarus.
7Nevertheless, board members are explicitly required to act in accordance with the statutory objectives of the Central Bank of Armenia.
8The term varies from four to nine years in the 15 countries: four years in Russia; five years in Armenia, Azerbaijan, and Estonia; six years in Latvia; seven years in Georgia, the Kyrgyz Republic, Moldova, and Turkmenistan; and nine years in Lithuania. (Terms are staggered in Armenia, the Kyrgyz Republic, and Lithuania.) In Kazakhstan, the external members are appointed for the period of their office (i.e., a representative from the Supreme Council and the president, respectively, and two representatives from the Cabinet). However, in Belarus (ex officio members apparently for the period of their office), Tajikistan, Ukraine, and Uzbekistan, the terms for board members are not specified.
9In some countries, the law distinctly prohibits the central bank from participating in the primary market for government securities, which is a sound approach. The central bank, however, could be allowed to submit noncompetitive bids in an effort to build up its portfolio of government securities for open market operations. All 15 countries, with the exception of Latvia and Ukraine, require securitization. In Latvia, the central bank rarely lends to the government, and it is against the sale of treasury bills or drawing down deposits. With the exception of Azerbaijan, Belarus, Latvia, Russia, and Ukraine, all other countries explicitly stipulate that advances to the government shall bear a market-related interest rate. Moreover, several countries have explicit provisions that prevent the central bank from being involved in quasi-fiscal activities and in activities other than those necessary for conducting its primary functions.
10If a central bank believes that it is necessary for the government to monitor the bank, it should probably consider longer budget periods to avoid undue influence by the government, as is the policy in New Zealand.
11The law in Armenia states that the budget be sufficient to allow the bank to fulfill its objectives and responsibilities.
12Moreover, about half of the countries in transition have already adopted or are currently preparing legal provisions against money laundering.
13Advice has been provided by both the IMF’s Monetary and Exchange Affairs and Legal Departments.

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