8 Banking Sector Reform in Central and Eastern Europe

Saleh Nsouli, and Oleh Havrylyshyn
Published Date:
April 2001
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Lajos Bokros

The history of the last 10 years of banking sector reform and restructuring in Central and Eastern Europe (CEE) is a fascinating story, because in most of these countries, what existed before the political transformation could not be called a banking sector at all. Rather it was a mechanism for redistributing funds according to the central plan or, in those countries where central planning had diminished in importance by the time of the political transformation, according to some other mechanism. In either case, there was nothing resembling true financial intermediation because there was no risk management in the system, nor were the banks themselves making responsible, independent decisions about resource allocation or to attract the savings of households and other financial actors.

The Pillars of an Effective Banking Sector

The three most important pillars of prudent and efficient banking are competition, good corporate governance, and effective prudential regulation and supervision (Figure 1). The optimal situation is to have all three. But a country that has only two of the three is still better off than if it had none, which is, unfortunately, the case in most of CEE. Even in those countries considered the most developed, only two of these pillars are in place today. Prudential regulation and, first and foremost, supervision and the implementation of regulation are very weak in all the transition countries.

Figure 1.Pillars of an Effective Banking Sector

In Hungary, which is regarded as one of the leading reformers, the government was obliged last December to recapitalize Postabank, one of the few remaining partly state-owned banks, with a capital infusion of almost $700 million, or more than 1 percent of Hungary’s GDP. This happened because, among other reasons, the regulatory and supervisory authorities were unable to identify the bank’s problems in time. Management had engaged in serious abuses, and losses had accumulated over a very long period. Political corruption was also involved. Of course, similar examples could be cited in many other transition countries.

Ten Key Factors in Banking Sector Restructuring

The three pillars listed in Figure 1 can be thought of as the goals toward which countries in CEE and the former Soviet Union are striving in the reform of their banking sectors. Table 1 lists 10 factors that will determine the pace and degree of success in moving toward these goals. It is important to analyze each of these factors because a wide variety of development patterns can be seen across the region. Indeed, it is difficult to pinpoint any generalized pattern that all countries have followed. It is also hard to say unequivocally which countries’ banking sectors are more developed than the others, precisely because progress depends on so many factors and dimensions. All banking sectors in the region have structural and institutional weaknesses, as evidenced by the continued recurrence of situations in which the viability of the banking sector is questioned. Therefore we have to be very careful, for even in the region’s most advanced countries the banking sector requires careful attention all the time. The problem is not something that one can fix once and for all and then sit back and relax. Rather, the dynamics of financial sector development are so unpredictable and so fast-paced in most of these countries that the authorities are always at least two steps behind.

Table 1.Ten Key Factors in Banking Sector Restructuring
  • Initial conditions: the two-tier system

    • The competitive model

    • The segmented model

      • Sectoral segmentation

      • Regional segmentation

  • Liberalization

    • Entry and exit

    • Regulation of banking activities

      • Interest rate regulation

      • Regulation of the client base

      • Regulation of products and services offered

  • Development of new, private commercial banks

  • Rehabilitation of existing banks

  • Privatization

    • To foreign strategic investors

    • To domestic investors

  • Corporate governance

  • Regulation and supervision

  • International liberalization

  • The enabling environment

  • Linkages between bank and nonbank financial institutions

Initial Conditions

The first factor to be taken into account is the initial condition of the two-tier banking sector, which was tailored differently in different countries. In this regard we can speak of two alternative models: the competitive model and the segmented model. By a competitive model, I mean one in which there were no restrictions of entry into any kind of financial services and products, and therefore no administrative limitation on banks seeking to enter each other’s business. This allowed a competitive environment to be created from within.

In countries adopting the segmented model, this was not the case, because the two-tier system was tailored in such a way that either sectoral or regional monopolies were carved out of the one-tier banking system at that time; this was later, of course, relaxed. But even today, in some countries, some banks find themselves in difficulty because they have been obligated to focus their lending in certain sectors, leaving them unable to spread their risk across a wide swath of the economy.

There are also examples of regional segmentation, especially in the case of the former Yugoslav republics, where a two-tier banking system did exist, at least formally, well before the political transformation. In terms of competitiveness and efficiency, this system was no better than any of the monolithic, formally one-tier banking sectors in place elsewhere. And even today, these systems have some drawbacks that put them at a relative disadvantage.


The second important factor is the ongoing liberalization of the banking sector, and in this regard, the importance of entry and exit regulations cannot be overemphasized. What we are seeing in terms of financial sector development—and precisely the same thing is happening in the real sector as well—is not the privatization of the existing banks. Rather the appearance of new players in the market is driving the sector’s development and creating the bulk of new, more efficient products and services. Therefore, not only the regulation of entry—but also the regulation of exit—is proving to be a critical ingredient in putting together a more or less efficient and competitive banking sector.

In some countries, regulation of banking activities at first included limits on the interest rates that at least some banks could charge. Banks were also restricted in the client base they could serve, reflecting the sectoral segmentation already noted, and in the range of products and services they could offer. All this was later eliminated in most countries, but the legacy of these restrictions remains important today.

Development of New, Private Commercial Banks

The third factor that is shaping the future of the banking sector has been the development of new, private commercial banks. Here one needs to distinguish between domestic and foreign banking, because serious restrictions on foreign entry apply even today. In some countries, the newly established domestic commercial banks have taken over the role of the former state-owned banks and developed in a very energetic way. In other countries, however, their role has been and remains marginal.

It is difficult to say which of these paths was the right one to follow, because in most countries in the region the development of small domestic commercial banks has a very bad track record. Regulation of entry was very liberal, and this proved to be a double-edged sword. Some private entrepreneurs who were allowed to establish banks used them to finance nothing else but their own connected businesses, and in so doing they grossly abused their public responsibility. And in many countries, at the end of the day this was a recipe for disaster.

Rehabilitation of Existing Banks

Having compiled this more or less dismal record, governments in all countries—at least once, if not repeatedly—have decided to rehabilitate some of the banks. Of course, bank rehabilitation and recapitalization have proved to be a time-consuming, painful, politically controversial, and costly exercise. Unfortunately, these government-orchestrated rehabilitations turned out not to be a very efficient vehicle for recreating efficient, sound, and competitive banking, even in the countries considered the strongest performers. Many governments have spent a fortune on rehabilitating banks yet have little to show for their efforts.

Hungary, for example, has spent the equivalent of roughly 10 percent of its GDP over the course of at least three attempts at rehabilitation, restructuring, and consolidation. Nevertheless, this rehabilitation was not itself the key to success in the end; rather it was the subsequent, rather quick privatization of those banks that had been rehabilitated.


Indeed, the important lesson from our experience with bank restructuring is that privatization is the crucial issue. This may seem paradoxical: if these countries have a dubious track record at developing new, private commercial banks that are safe and sound, how can privatization be the ultimate solution? Does that not once again put shaky owners in the driver’s seat, where they can run their banks into the ground just as they did before?

Therefore privatization must be accompanied with some strong qualifications. Many different approaches to privatization have been tried, and not all have proved successful. And radical as it may sound, the important common factor in the bulk of the banking privatizations—the successful ones, at least—has been the involvement of foreign strategic investors. This is what has contributed the most to the development of safe and sound, competitive, and prudent banking in the region.

But here another qualification is in order: not all foreign banks are safe and sound, either. One has to be very careful in privatizing banks even when foreign participation is allowed. At issue here is the cultural dimension of banking: prudent banking is something that was not part of the culture of the CEE countries or of the former Soviet Union. What privatization needs to achieve, therefore, is not only the recapitalization of banks, and not only their greater operational efficiency. One must also make sure that prudent behavior will be the norm and will be the most important factor considered when assessing bank management.

Corporate Governance

That, in turn, depends on the quality of corporate governance. In any privatization, the important question is whether the transaction will contribute to an improvement of corporate governance or not. If it does, then privatization is a blessing. If instead it contributes to a deterioration of corporate governance, privatization should be avoided, or at least postponed until it can be done right.

John Nellis’s paper (in this volume) rehearses the agonizing discussions about real sector privatization in the transition. Nellis concludes that, for the real sector, the “how” of privatization matters as much as, if not more than, the fact of privatization itself. But this is even more important in banking, because in running a bank, bank managers are not just playing with the bank owners’ money, they are playing with other people’s money—with depositors’ money—as well. Therefore, the principal issue in corporate governance and privatization is how to protect the interests of the depositors.

Russia today presents the best available example of the potential for conflict between the interests of the depositors and the interests of shareholders. Almost all of the big Russian banks and most of the smaller ones have lost sums exceeding several times their capital. They have huge holes in their balance sheets. Yet many of the shareholders seem unconcerned about this insolvency because they can easily walk away, set up a new bank, and leave all the losses to the depositors and to other stakeholders.

In short, when trying to understand the real level of security and soundness achieved in the banking system, as well as the challenges of cyclical vulnerability, it is crucial to highlight the interlinkages among government-orchestrated rehabilitation, the method of privatization, and the resulting improvement or lack thereof in corporate governance.

Regulation and Supervision

Bank regulation and supervision are not a straightforward matter; no transition country in Europe or Central Asia has yet achieved anything close to perfect regulation and supervision thus far. We have learned the lessons of the first decade of transition the hard way, and there is a lesson here for both the International Monetary Fund and the World Bank. We have to spend much more time improving the legal and institutional structures of regulation and supervision as part of the enabling environment. In all of these countries there is a systemic risk of still more banking crises, and indeed in some of these countries the next crisis is already in the making. Therefore, we have to devote much more time and effort toward helping those countries that have a genuine desire to strengthen their banking structures.

International Liberalization

International liberalization of the financial sector is an important issue as well. The opening of the sector to foreign entry has contributed to the varied development of the financial sector in most of the transition countries. There is no uniform pattern that all countries have followed in the last decade, but a few lessons have been learned. To the extent one wants to strengthen competition, one has to liberalize almost immediately the establishment of subsidiaries and joint ventures of foreign banks. But at the same time one has to be very careful, because if financial liberalization goes ahead without a proper restructuring of the whole macro- and microeconomy, it can contribute to vulnerability and exacerbate the difficulties. The history of many countries shows how difficult it is to calibrate the proper level of international liberalization at any single point of time without putting the whole economy into a dangerous position.

In this respect again, sequencing is very important, and a gradual approach is probably better. One can start by liberalizing foreign direct investment and from there move almost immediately to liberalize portfolio equity investment. If instead liberalization begins by allowing short-term institutional money to flow into speculative areas, problems will arise. Unfortunately, the Russian government securities market was nothing but a short-term speculative arena, which ultimately came to a bad end. Financial liberalization was used simply as a means of postponing real reform because it created the illusion that everything was already in place and that the government could go ahead without undertaking any serious public finance reforms.

The Enabling Environment

Another important factor is the enabling environment. It is possible for the financial sector to be too much in the limelight. As a consequence of the crises in East Asia, Russia, and Brazil, we tend to look almost exclusively at macrofinancial parameters and banking sector issues. Yet this may lead us to disregard the interlinkages between real sector development and financial sector development.

The quite uneven development of the financial sector in many transition countries is to a large extent explained by the fact that the development of the real sector is very uneven as well. To put it bluntly, in some countries banks can find virtually no good clients. Even the best banks, under the best circumstances and with the best corporate governance structures, cannot find enough profitable business out there. Therefore, it is only natural for them to go after short-term speculative instruments and try to generate a relatively high level of profit in foreign exchange dealings, in trading government securities, and even in investment banking. Yet all this is just another way of deteriorating their risk profile. In many transition countries supply-side adjustment has not reached the stage where sustainable growth can be achieved in the long run, and thus the problems of the financial sector, including banking, are nothing more than a mirror image of the way the real sector is developing.

In this respect, two issues may prove to be more important in most transition countries than privatization. The first is the organic, de novo development of small- and medium-size businesses, and the second is the role of foreign direct and portfolio investment. In some countries, privatization was successful only because it was well coordinated with these two lines of development.

Needless to say, in many countries the fact that banking is very much in the limelight has led to important political impediments. Banking is a very easily abused sector. The interlinkages between influential political groups—the oligarchs and politicians on the one hand and the banking sector on the other—is so intimate, again even in the most developed environments, that one has to be careful when looking at the real dynamics.

Linkages Between Banks and Nonbank Financial Institutions

Last, but not least, it is important to highlight the interlinkages between bank and nonbank institutions in the financial sector. Insurance, contractual savings institutions, stock exchanges, and all kinds of investment vehicles are becoming increasingly widespread. But banking remains the core of the financial sector in all transition countries, with all the blessings and shortcomings that stem from that fact.

It remains to be seen how this situation will change in the second phase of transition. Here, again, a certain kind of sequencing is called for. There is no way to have a healthy financial sector without a healthy banking sector. In this respect, it is also true that banking is the core of financial sector development.


The experience of banking reform in the past decade suggests three main lessons. First, all countries, no matter their level of development or their initial conditions, must aim at establishing the same three pillars of an effective banking sector: competition, good corporate governance, and solid prudential regulation. Second, banking reform is a long, incremental process that is far from complete, even in the most advanced transition economies. Third, weak banks are seldom transformed by rehabilitation, which is both costly and rarely effective. Rather, the solution to weak banks lies in privatization built on good governance and strong bank management. Just as the best inoculation against banking problems is to avoid politically motivated lending, so too the best antidote to problem banks is to avoid rescuing them artificially.

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