IV. Modernization of the National Bank of Poland
- Piero Ugolini
- Published Date:
- November 1996
The economic program of stabilization, which started in early 1990, was designed to reduce inflation and create an environment in which a market-based economic system might thrive.
The maintenance of a fixed exchange rate as an anchor was the central element of the Polish Government’s anti-inflationary strategy. The rationale was that an unstable exchange rate would fuel inflationary expectations, while a stable exchange rate would offer a point of financial stability and reference for the Polish enterprises while they were restructuring themselves. The choice of a fixed exchange rate on January 1, 1990, was partly motivated by the lack of an organized foreign exchange market and was expected to be only a temporary measure before the authorities moved to a crawling peg system on October 15, 1991. The crawling peg is also virtually a fixed exchange rate regime, since the daily rates are preannounced.
The choice of the exchange rate as a nominal anchor to reduce inflation and maintain international competitiveness needed to be supported by appropriate fiscal and monetary policies. Flexibility in interest rates and credit policy was essential to support the nominal anchor system and required an urgent and rapid modernization of the National Bank.
The choice of this fixed exchange rate regime constrained the monetary policy of the National Bank. To avoid capital outflows, it had to adopt policies aimed at achieving a level of interest rates not lower than foreign interest rates, adjusted for the rate of crawl (during the crawling system) and the country’s risk premium. Thus, interest rate and credit policies became crucially important to support the chosen exchange regime.
Role of the National Bank of Poland
The road toward a full use of indirect instruments of monetary policy appeared difficult at the early stage, and some initial conditions in the money market and interbank market posed serious constraints on the introduction of indirect instruments. In particular, since 1988 there had been large inflows of funds into the banking system, which became increasingly liquid despite the tight measures taken by the National Bank. In addition, the Bank continued to provide large refinancing facilities to the entire financial sector, as well as to the agricultural sector via the Bank for Food Economy.
In order to support the Polish authorities’ stabilization program, the National Bank had to strengthen and develop the financial sector and its own capabilities. A major challenge was to increase the flexibility of the interest rates to support the exchange rate regime and anti-inflationary policies, and to develop further indirect instruments of monetary control.
To address the situation, interest rates were partly liberalized in 1989. The Bank had to rely on direct instruments of credit control during the initial phase of building its arsenal of indirect monetary instruments and developing the needed structures to support a market-oriented system, such as accounting, payments, and bank supervision system. Refinance and discount facilities were reformed, and credit auctions and National Bank bills were introduced to bring into the system some flexibility in the interest rate structure. During a second phase, in 1992, the Bank used a mixed approach of both credit ceilings and open market operations. Credit ceilings were lifted in early 1993, and open market operations became the main instrument of monetary policy. Reforms in the accounting and payments system were also crucial to the launching of the Bank’s operations.
An action plan to modernize the National Bank of Poland and pave the way toward the use of indirect instruments of monetary policy was developed by the Bank in early 1990.
The plan to modernize the National Bank was unique insofar as the authorities embarked on a program of reform and change simultaneously in all functional areas of the central bank. The plan’s objective was to achieve a rapid transition to the use of market-based instruments. Because of inadequate accounting and payments systems, as well as supervision, the action plan had to be comprehensive, sequenced, and coordinated to enable the Bank to use indirect monetary instruments within a relatively short time. The rapidity with which the National Bank’s authorities could implement the ambitious action plan became an important element of its success.
While the remainder of the chapter will present the broad sequence of the modernization of each functional area of the Bank and the major problems encountered in its implementation, it is important to highlight two major problems, one technical and one political, that the Bank faced in its efforts.
In 1989, Poland had very poor telecommunication facilities. The technology was obsolete. This had a considerable bearing on the centralization of daily accounts of the National Bank’s 49 branches and of the branches of the 9 newly created commercial banks.9 Because of the poor telecommunications facilities, it also took considerable time for the commercial banks to centralize and consolidate their accounts in the respective headquarters on a daily basis. Thus, for some time, each branch of the main state-owned commercial banks was operating completely independent from the others, with each of the 49 branches of the Bank maintaining a separate account for each branch of the commercial banks operating in its region. As indicated later in the chapter, this led to serious problems of credit allocation and of fraud. Lastly, the poor technology also had a serious impact on the efficiency of the payments system and on the time required for clearing checks and for settling transactions between banks or between clients with accounts in different banks.
The second problem relates to the turmoil created by a banking scandal in July 1991, which resulted in the National Bank functioning for almost a year without an appointed President. It is fair to say that during this period, very little was accomplished of the modernization plan of the Bank. With the appointment of the new President, Mrs. Gronkiewicz-Waltz, the momentum was regained, and the implementation of the action plan took off with greater enthusiasm and vigor.
A summary of the first action plan of modernization of the National Bank of Poland during the initial and intensive phase in 1990–91, prepared by the authorities with the support of MAE under its technical assistance program, is shown in the Appendix.
The National Bank of Poland Act of January 1, 1990, gave the Bank broad powers to execute monetary policy and accorded to it some independence by restricting its lending to the Government to an established limit. At the outset, the National Bank’s officials’ main objective was to create and establish a market-based monetary system in which the Bank could rely on indirect instruments of monetary management rather than on direct controls. The choice made by the Polish authorities to rely on a nominal anchor to reduce inflation and maintain export competitiveness constrained the monetary policy of the National Bank, and required some flexibility in interest rate policy and appropriate setting of other monetary policy instruments in its support. Interest rate policy in Poland had to prevent the flow of capital out of zloty-denominated assets and into assets denominated in foreign currency. The Bank’s authorities realized that the road to the full reliance on indirect instruments of monetary policy was long, bumpy, and difficult and would require a wide range of reforms in the financial sector in general and in central banking in particular. Successful management of the interest rate through indirect and market-based instruments and progress toward convertibility are associated with a relatively stable macroeconomic environment, an interest rate structure that is not in serious disequilibrium prior to liberalization, adequate competition in the banking sector, reasonable financial strength in the banking sector, an active and well-functioning money market, monetary policy instruments that can influence the marginal cost of funds to banks, sufficiently strong banking supervision policies and instruments, and consistent and mutually supportive reforms in the exchange and trade system (trade and payment restrictions, surrender requirement), exchange arrangements, and the institutional framework for foreign exchange trading.
Clearly, in the case of the National Bank most of the above conditions were not met. In addition to the obsolete banking system, it had to face some difficult initial conditions, which seriously constrained its full use of indirect instruments.
• Since 1989, the National Bank had been using refinancing credit as the main source of funds. In particular, it had to fully cover the financing needs for current central investment projects, as well as refinancing credit for agriculture. In 1989, the Bank for Food Economy received about 80 percent of its funds from the Bank’s refinancing, and direct refinancing of the banks by the National Bank represented about two thirds of total credit. As a result, (a) commercial banks had no incentive to attract deposits, and the spread between deposit and loan rates was very large; (b) credit was not entirely allocated on the basis of market economy principles, but was still affected by sectored credit priorities; (c) insofar as funds were made available by the National Bank, an interbank money market had no incentive to develop; and (d) since most of the credit was extended at real negative interest rates, the whole interest rate structure was distorted.
• Savings banks had a dominant function in the financial sector with large deposits and limited loans.
• Commercial banks’ excess reserves were subject to large fluctuations owing to the float in the inefficient payments system. This made the liquidity forecast exercise of the National Bank very ineffective.
• There was no short-term information system on the status of banks for determining monetary policy and forecasting liquidity. The National Bank used to receive monthly information with some delays owing to the decentralization of the branch bank accounts.
After the introduction of the National Bank Act in 1990, the National Bank focused its activities first on halting the economic deterioration by addressing the immediate excess liquidity in the banking sector and reducing inflationary pressures, and second on building a market-based monetary framework. While the first target was broadly achieved in 1993, it took about five years for the Bank to establish the use of indirect instruments. Three main periods could be identified as the major phases of its transformation.
First Phase, 1990–91
In view of the initial constraints, excess liquidity in the banking sector, and the lack of instruments and infrastructure for indirect monetary policy intervention, the National Bank of Poland had to rely in the first phase on credit ceilings for each state-owned bank. During this phase, however, the National Bank began laying the foundation for a market-based system of monetary intervention. As a first step, a new department was created in the Bank, the Monetary and Credit Policy Department. This department was charged with the responsibility of developing a financial market and enriching the National Bank with indirect instruments of monetary policy intervention. An action plan was developed by the Monetary and Credit Policy Department and implemented with the support of the Bank’s management and the Polish Government. One of the first actions taken by this department was the introduction of a short-term (ten days) information system to monitor the liquidity of banks. This allowed the National Bank to perform some initial monetary operations within the established credit ceilings. By the end of 1991, a full-fledged reporting system was developed for commercial banks, providing information for monetary statistics and for management and prudential purposes.
To address the excess liquidity problem, remove initial constraints, and create a better environment for interest rates flexibility, the National Bank took several major steps in 1990. Its strategy was to tighten credit expansion, to absorb excess liquidity in the banking sector by issuing securities, and to introduce some flexibility in the interest rate structure. Its main tasks were to make the National Bank a lender of last resort, encourage banks to attract deposits, and develop an interbank market. Credit expansion or contraction would ultimately be managed at the initiative of the National Bank and not of the banks. To this end, the Bank took the following steps.
• Auctions of one-month fixed deposits with the National Bank of Poland were launched in March 1990, to be replaced on July 26, 1990, by the first weekly tender of one-month National Bank bills. This was the first attempt made by the Bank to reduce liquidity by an indirect instrument, to introduce the flexibility in the interest rates structure, and to stimulate interbank and money markets.
• Refinance policy was modified and tightened significantly to improve monetary control and reduce credit expansion. The design of refinance policy and, in particular, procedures for the allocation of refinance among banks posed difficult questions in part because of weaknesses in interbank markets and other structural factors.
Beginning in January 1990 the basic refinance rate was adjusted monthly on the basis of a set of indicators, including current and projected inflation, developments in net domestic assets of the banking system, and growth in external reserves. The structure of penalty interest rates for overdrafts by banks on their current account with the National Bank—so-called payment or current account credit—was streamlined in the early part of the year and further adjusted in July. About 60 percent of outstanding refinance was converted in July into a medium-term credit (repayable in six years with adjustable rates). The rationale for this measure was to give enough time for banks to repay the large outstanding credit. In this way, the National Bank avoided the potential risk of rolling over large amounts of unpaid debt.10 Some banks were instructed not to make full use of their limits. All additional refinance needs were met either in the form of bill rediscounts or as refinance against the collateral of eligible bills (Lombard credit). The National Bank encouraged banks to rediscount special agricultural bills in the hope that these could become collateral for interbank lending, enabling banks to reduce their dependence on National Bank refinance. Owing to the large dependence of banks on the bank’s refinance,
the National Bank of Poland initially relied on bank-specific agreements to distribute refinance according to projected needs. Subsequently, refinance limits for individual banks were reduced on a case-by-case basis in response to availability of bank reserves from external surpluses. In addition, a payment credit facility was introduced to deal with shortfalls in the clearing accounts of banks, and banks have been offered a bill rediscount facility to encourage a bill market, and a medium-term refinance facility to meet structural needs.11
In addition, the National Bank restructured and streamlined central investment refinance.12
• The National Bank’s Monetary and Credit Policy Department established a monetary programming unit to forecast supply and demand for bank reserves. The forecasts were used to evaluate monetary policy options, including the determination of refinance limits and the volume of National Bank bill auctions. The Monetary and Credit Policy Department also built a daily and ten-day information system for selected National Bank balance sheet items, providing current data on the level and distribution of bank reserves, various types of refinance by banks, and other factors affecting reserve money, particularly transactions budget.
• Reserve requirements were raised three times up to the legal limit of 30 percent. Following the introduction of one-week National Bank bills auctions in mid-1990 to drain the excess liquidity from the banking sector, the Bank diversified its offerings of bills in 1991 by phasing out the one-month bill and by introducing three-and six-month National Bank bills. It also began auctioning one-month and three-month treasury bills in May 1991. As a result of the introduction of the treasury bills to finance the government deficit, the demand for National Bank bills gradually declined. The value of National Bank bills outstanding dropped from ZI 4.3 trillion in April 1991 to ZI 2 trillion in May. On the other hand, demand for treasury bills rose steadily with the outstanding value rising from ZI 2.1 trillion to the end of May 1991 to ZI 9.2 trillion to the end of October 1991.head office in September 1992 As a result, the Bank suspended National Bank bill auctions in January 1992.
Second Phase, 1992
The second phase began in early 1992 when the National Bank of Poland, after succeeding in reducing access to short-term central bank credit, could concentrate more on implementing open market operations and developing money markets. The development of treasury bill auctions and the introduction of one-and three-year bond issues provided the National Bank with the necessary securities to begin the first reverse agreements (repo-transactions) to implement some more sophisticated liquidity management. This was possible because the Bank was able, during this period, to improve its liquidity forecast by virtue of a more refined ten-day reporting system for commercial banks and the consolidation of branch accounts into one account per bank at the National Bank head office in September 1992. As a result, the Bank initiated its first open market operations and commenced work to develop a secondary market for securities. With seven banks with a single current account at the National Bank, a primary dealer system was created to support market making, primary auctions of securities, open market operations, and the distribution of securities. A brokerage system operated by the Bank to encourage trading in the secondary market was also developed.
As a result of the above innovations, an interbank deposit market started developing from overnight to one-month maturity. This market became an important indicator of the state of liquidity in the money market and became the only market in which banks could get same-day funds.13 The primary bill market emerged as an important investment vehicle for banks, amounting to about 20 percent of total bank assets.
To foster secondary market activities, the National Bank initiated a screen-based interdealer brokerage system called Telegazette for central bank and treasury bills. The National Bank brokerage system was the first attempt to create a market and also became a helpful catalyst in the communication of market information. During 1992, as a result of the above developments, a market-based interest rate structure began to emerge. Particularly, treasury bill auctions reflected bank liquidity conditions, and a yield curve as a major determinant of the overall liquidity in the banking system finally began taking shape in Poland.
This development was particularly important and signaled one of the first successes of the National Bank in introducing flexibility in the interest rate structure. As indicated, interest rates were liberalized at a very early stage of the reform in 1989; however, the announced refinancing rate of the Bank continued to play a major role as a reference rate in determining the interest rate structure in Poland during 1990–92. In 1990 about 80 percent of total domestic credit was linked to the refinancing rate. The Bank Powszechna Kasa Oszczędności BP, the largest bank in Poland, which provided mostly credit for housing construction, used as a guideline a 2 percentage point spread over the refinancing rate. Accordingly, other banks followed this principle. Thus, the trend that developed in late 1992 and early 1993 was the first result of the growing importance of the market economy and of the attention that market operators began paying interbank market and treasury bill activities. As a result of the new trend and the improved skills and capabilities of the National Bank to conduct open market operations, credit ceilings were lifted at the end of 1992.
In October 1991 a crawling peg exchange rate regime replaced the fixed exchange rate system introduced in 1989. In the period 1990–92 four devaluations took place to reverse the outflow of foreign currency reserves and the loss of international competitiveness. The Bank played an important role in supporting the exchange rate regime, and domestic interest rates were kept at a level well above competitive German and U.S. rates, thus averting a major outflow of capital from zloty-denominated assets. As a result and, in line with the domestic interbank market, an interbank market in foreign exchange commenced in earnest in May 1992 within the crawling peg system.
Notwithstanding the above progress, several problems still remained and needed to be addressed in the following phase beginning in 1993. In particular, difficulties had to be resolved in clearing and settling bill trades and the erratic float, which was greatly hampering the daily liquidity forecast of the Bank.
Third Phase, 1993–95
In 1993 a third phase began during which open market operations by the National Bank of Poland developed further and became the main intervention tool to implement monetary policy (Chart 1). Two elements in support of the full development of open market operations instruments were the creation of an Interbank Settlement Department in the Bank and the establishment of the first national clearinghouse. As a result of these developments and the consolidation of one current account per bank with the National Bank in late 1992, the Interbank Settlement Department was able to effect final settlement via the current account that each national clearinghouse bank member maintained at the National Bank on the basis of the net settlement position of payment items cleared by the national clearinghouse between each national clearinghouse member. As indicated in Chart 1, from late 1993 to the end of 1995 the total average daily amount of outstanding open market operations per month increased dramatically from ZI 114 million in January 1993 to ZI 13,679 million at the end of December 1995.
Chart 1.Open Market Operations
During this period, the National Bank continued to improve and modernize its operational functions, particularly accounting, payments system, and banking supervision. The number of money market dealers increased from 7 to 28 banks, and the interbank credits in domestic and foreign currency continuously grew. During 1993 two more developments played an important role in improving the efficiency of the open market operations of the National Bank: the introduction of an average system for reserve requirements in August 1994 and the introduction of a book-entry system in July 1995. The first action permitted the use of a portion of the obligatory reserve balances held at the Bank to provide intraday liquidity for settlement purposes. This additional liquidity had the impact of reducing the pressure that had been building and delaying, at times significantly, completion of the daily national clearinghouse net settlements. While this action provided a significant additional source of liquidity to fund settlement obligations, access to this liquidity was operationally cumbersome. The reserves eligible to meet clearing obligations were kept in a separate account at the National Bank and had to be transferred by its staff from the reserve account to the current account for clearing purposes and then back to the reserve account to meet reserve obligations. In November 1994 these two accounts were combined by the National Bank for each bank into a single reserve/clearing account. While this did not increase the level of liquidity available for settlement purposes, it simplified the process of accessing the available funds and thus improved the efficiency of the interbank settlement process and virtually eliminated the net float (Chart 2). The introduction of the book-entry system provided the National Bank with a powerful tool to engage in outright transactions and repurchase agreement in treasury bills. As a result, the one-to-three day repurchase open market operations have had an impact on the yield curve.
Chart 2.Net Float as a Percentage of Reserve Money
The objective of the National Bank in 1993 was to use open market operations to absorb excess liquidity without jeopardizing its monetary policy goals in full harmony with the crawling peg system and the inflation target. An appropriate mix of open market operations was envisaged to achieve both the monetary management and the market development objectives. While defensive and policy open market operations by the National Bank were supposed to be used to modulate or smooth day-to-day volatility in the banking system liquidity and the one-to-three day (overnight, spot, and executed tomorrow for delivery on the next business day) interbank rates, and attaining the target level of domestic credit by using 4—14-day repo operations, outright purchases and sales operations were to be used to sterilize or add liquidity to the banking system on a more permanent basis. Without a book-entry system, the Bank was seriously handicapped in its outright operations, particularly purchases, since its portfolio consisted of physical securities purchased from the Ministry of Finance, each denominated in such a large amount that it was difficult to market them. As a result, and in view of the excess liquidity problem, the Bank until mid-1995 was seriously handicapped in influencing long-term rates and shaping the yield curve and could affect only short-term rates.
Despite some progress in reducing inflation in the early years, the Polish financial sector has always been affected by excess liquidity. The National Bank of Poland has focused on building instruments to absorb this liquidity in the banking sector by making the refinance facility more effective and binding and by implementing credit ceilings until 1992. This has not been easy. While a turning point was the consolidation of commercial bank accounts into one account at the National Bank, the improvement in the payments system also proved to be key. In addition to cyclical budgetary expenditures and a strong balance of payments, the Bank had to deal, at the beginning, with a lack of effective instruments to absorb liquidity. As in other areas, modernization was slowed down by legal obstacles caused by the rigidity of the articles in the National Bank of Poland Act. This was particularly relevant for implementing important changes in the maintenance and application of reserve requirements and for introducing a book-entry system and other required changes.14
Chart 3.Domestic Credit
In addition, as previously indicated, the Economic Analysis and Research Department and the Money and Credit Policy Department began working together on a liquidity forecast and macroeconomic model to test and simulate the economic variables under different shocks and assumptions. A ten-day reporting system for the National Bank and the commercial banks was also introduced and used as relevant input for the short-term monetary interventions of the Money and Credit Policy Department. However, the float in the banking system, the lack of accurate data, and inadequate projections for government cash-flow transactions represented a major problem to the liquidity projection exercise. The opening of the first clearinghouse in late 1993 and the creation of an Interbank Settlement Department in the National Bank were instrumental in reducing the float. The introduction of a monthly average system for the obligatory reserves, which reduced the excess reserves that the banking sector used to accumulate for the closing and settlement of the payments on a daily basis, also helped. During 1993–95, the Bank managed to introduce some flexibility in domestic interest rates while keeping domestic credit within established limits without using credit ceilings (Charts 3 and 4). As a result, since 1995 the share of foreign currency deposits has fallen steadily, which indicates an increasing confidence in the price of the zloty (Chart 5).
Chart 4.Interest Rates Chart 5.Foreign Currency Share of Broad Money
Bank supervision was formally introduced in Poland with the passage by Parliament in February 1989 of the drastically amended versions of the Banking Law and National Bank of Poland Law, which cleared the way for the move to a two-tier banking system. These laws specifically assigned the responsibility for supervision to the National Bank. The Banking Law bestowed on the National Bank comprehensive authority in bank supervision, including licensing, information gathering, examination, limitations on bank operations, sanctions, and liquidation of banks. According to the National Bank of Poland Law, the National Bank’s bank supervision is a direct responsibility of the President.15
A bank supervision department called the General Inspectorate of Banking Supervision was created within the Bank in May 1989, as the National Bank was preparing for the divestiture of its commercial banking operations to nine independent banks. Together with the increase in the number of institutions, a change in the business environment was envisaged that would expose banks to commercial risks unknown under full central economic planning. These trends called for the urgent introduction of prudential bank supervision.
The organization of bank supervision in Poland combined centralized control with decentralized staffing. In addition to the inspectorate staff in Warsaw, bank supervision staff were attached to all National Bank branches in districts where commercial bank head offices were located, plus a few others; all supervisory staff in the branches reported to the director of the inspectorate in Warsaw. It was decided that bank supervision should consist of off-site analysis and on-site inspection. At the end of 1989, total supervision staff was about 60, including employees in the 49 branches.
The main problems faced by the inspectorate were (1) the lack of qualified staff and inspectors, (2) the lack of appropriate modern prudential regulations, (3) poor accounting practices at the level of the National Bank and commercial banks, (4) the lack of an appropriate reporting system to assess the financial conditions of the banks, (5) the large number of banks to supervise (75 banks were operating in Poland by the end of 1990), and (6) the sizable nonperforming loans on the asset side of commercial banks.
The inspectorate introduced a sequencing of specific measures to cope with a critical mass of reform in prudential supervision and in the commercial bank accounting and reporting system. Off-site analysis had a priority while the accounting of commercial banks was being reformed. A more balanced development of both off-site analysis and on-site inspections became possible thanks to the early start on the accounting and reporting system. While building its own capacity and recruiting more qualified staff to be trained, the inspectorate had to get a grip on the current condition of banks and begin some initial form of supervision. In order to perform effective supervision, the inspectorate needed to assess the current financial status of banks and introduce prudential regulations to monitor and regulate their activities to avert a major systemic banking crisis. It needed to design and implement a monthly reporting system to monitor progress in the financial condition of banks. Thus, the inspectorate initially placed great emphasis on improving accounting standards and designing a modern reporting system for commercial banks while conducting an audit of the banks’ portfolio. On-site inspections were not considered a priority at that juncture, since the lack of information on the status of the portfolio of banks and poor accounting practices would have greatly handicapped the effectiveness of the inspections. On-site inspections began at a later stage when information had become available and a better monthly monitoring off-site analysis system had been put in place in the inspectorate.
To cope with the weak accounting standard, the inspectorate began working on a new accounting plan called the National Accounting Plan-91. This plan embodied modern accounting principles to be implemented by all financial institutions reporting to the National Bank under the Banking Law of 1990. Since the implementation of this plan required several years (early 1995), in the interim, banks were asked to report on the basis of a temporary reporting system, which used the old accounting plan but required additional information.
While the National Accounting Plan-91 addressed the problem of modernizing accounting standards, the inspectorate had first to complete an audit of the Polish banks’ portfolios to set prudential ratios, such as capital adequacy, at a realistic level. While waiting for the results of the audit, which would have provided information on the status of the performing and nonperforming loans, interim prudential regulations were issued in 1990. The regulations covered provisioning rules, solvency, liquidity, and distribution of risks among banks. For the capital adequacy ratio, this was set at 8 percent, in line with the Bank of International Settlements/European Community standard. Polish commercial banks had until 1993 to comply with this regulation. As regards on-site inspections in 1992, the inspectorate began a training program for its supervisors. External consulting firms were hired initially to perform on-site inspections, but inspectorate staff used to join these firms in the inspections. This had the dual effect of sending a strong signal to the banking sector that the inspectorate could perform on-site inspections and of providing useful training to the inexperienced National Bank inspectors.
Establishing an efficient Banking Supervision Department requires considerable time for training staff, for implementing an appropriate reporting system, and for building off-site and on-site capacities. In the case of the National Bank, progress was also somewhat slowed down by the salary structure and the reshuffling of the directors of the inspectorate. The National Bank had lost a large number of qualified staff to private banks because the salaries it offered could not compete with those of the private banks. Several inspectors, once they were well trained, left the Bank to join the private sector. This represented a major setback for the capacity building of the inspectorate and proved costly, since new staff had to be hired and trained. Moreover, during the period without an officially appointed National Bank President, the modernization and functions of the inspectorate suffered from frequent changes in the leadership of the department. Ultimately, both problems were solved in 1992 with the appointment of a new President of the National Bank of Poland, who reorganized the inspectorate and received the authority to set the salary structure in the Bank independently from that of the Government at a level competitive with the salaries of the Polish banking sector.
Among all the prudential regulations introduced by the Bank, the most difficult to implement was related to provisioning for bad loans by the commercial banks. In view of its impact on the profits of the commercial banks and on government revenue, considerable time was spent by the National Bank and the Ministry of Finance on this issue. As an interim measure, in November 1992 the banks were obliged to make a provision for their bad loans (from 20 percent for substandard to 100 percent for uncollec-table), but were not allowed to deduct the provision from their annual profits. The capital adequacy ratio was raised from 8 to 12 percent for the seven banks that were restructured with government bonds.16
Central Bank Accounting
The challenge was the introduction of a market-oriented accounting plan and a modern accounting framework for the National Bank and the preparation of a daily balance sheet.
The creation of the two-tier system in 1989 and the desire of moving toward a market-oriented monetary system created an immediate need for detailed information on the Bank’s balance sheet. However, the Accounting Operations Department of the National Bank had to face serious obstacles, which further complicated the modernization process. As indicated earlier, the National Bank inherited 49 branches and very poor telecommunication facilities. The system was highly decentralized. Each of the 49 bank branches maintained an accounting division, responsible for the relations with bank branches in its district, and prepared its own balance sheet.
In addition to the decentralization, the National Bank’s accounting system was burdened by some 700,000 accounts that are not normally maintained by a central bank. The bulk of them comprised some 650,000 foreign exchange accounts for the nonbank public, in addition to some 8,000 budgetary accounts as part of the Bank’s responsibility for monitoring government cash flows.
The decentralized accounting was a legacy of the past when all branches then belonging to the nine credit banks were National Bank branches. The accounting relations of these branches with the National Bank remained essentially unchanged despite their regrouping into independent banks in February 1989. Also, in an accounting sense the commercial banks’ branches continued to operate quite independently of their head offices. The change was the introduction of a tier of district branches between the National Bank’s head office and the commercial bank branches.
After February 1989 the National Bank continued the internal account (ledger) administration of the 9 new credit banks in its 12 data processing centers, as it did for the Bank Powszechna Kasa Oszczędności BP Savings, which became independent in 1987 with its nationwide branch network. These centers also processed all transfers between banks, not distinguishing transfers between branches of the same bank from those between branches of different banks. Also, commercial banks’ reserves and clearing accounts were spread over 49 National Bank branches with bank head offices in their districts. The situation was further complicated in the case of refinancing since refinancing limits were allocated by commercial banks to their branches, and then administered by the National Bank branches.
In summary, to obtain a consolidated balance the Bank had to collect the balance sheets from all its 49 branches, operating as 49 independent central banks. The consolidation by the branches was done only once a month.
The implementation of the project was very much constrained by and subordinated to the development of appropriate technology to connect the 49 branches to headquarters in Warsaw and to simplify the large number of accounts to be held by the National Bank. The centralization of accounts at the head office was indispensable for the production of the steady flow of balance sheet information necessary for financial and monetary control.
A process of modernization and centralization began in early 1990 and took almost five years to complete. This implied a unique general ledger kept at the head office. In the interim, the Bank began the preparations for an “estimated or statistical” consolidated balance sheet every ten days along the lines of the existing monthly balance sheet.
Foreign Exchange System and Operation
At the outset, in early 1990, the National Bank had to face three major tasks with regard to foreign exchange: (1) building up infrastructure to create a foreign exchange market-based system with interbank market operations; (2) managing the country’s international reserves; and (3) administrating, together with the Ministry of Finance and other official entities, the rules of the new Foreign Exchange Law enacted in January 1990.
Foreign Exchange System
The National Bank of Poland’s exchange rate policy has been influenced since 1990 by the goals of reducing inflation and ensuring liquidity for foreign exchange payments. In 1990–91, when the stabilization efforts were most important, exchange rate policy was a main pillar of the stabilization program. Keeping the exchange rate of the zloty fixed against the U.S. dollar for 17 months after an initial devaluation had a strong anti-inflationary impact and helped to reinforce confidence in the Polish currency. It resulted in a decrease in the share of foreign currency deposits in the money supply from two thirds in 1989 to one fourth in 1991. Inflation was also reduced from the hyperinflationary level of 640 percent a year in 1990 to 60 percent in 1991, but the trade balance worsened, foreign exchange reserves fell sharply, and the competitiveness of Polish goods started eroding.
On May 17, 1991, to reduce inflationary pressures further and to restore export competitiveness, the zloty was devalued by 16.8 percent and pegged to a basket of five convertible currencies (U.S. dollar. 45 percent; deutsche mark, 35 percent; pound sterling, 10 percent; French franc, 5 percent; and Swiss franc, 5 percent). On October 14, 1991, a crawling peg regime was introduced. Until August 27, 1993, the monthly rate of depreciation of the zloty was 1.8 percent. This crawling depreciation was supported by a two-step downward adjustment in the value of the zloty (February 26, 1992, minus 12 percent, or 10.7 percent in foreign currency terms; and August 27, 1993, minus 8 percent, or 7.4 percent in foreign currency terms).
Reduction in inflation and improved balance of payments performance created a conducive environment for reducing the rate of crawl of the zloty. Along with the devaluation of August 27, 1993, the rate of monthly depreciation of the zloty was reduced to 1.6 percent, further to 1.5 percent on September 13, 1994, and to 1.4 percent on November 30, 1994. On February 15, 1995, the rate of crawl was reduced again to 1.2 percent a year. Moreover, on March 7, the National Bank widened the bid/ask spread around the central parity from +0.5 percent to +2 percent.
In May 1995, a new exchange rate system was introduced.
Foreign Exchange Reserves Operations and Management
To build up the framework for the creation of a foreign exchange market-based system, the National Bank of Poland had to reorganize first its own internal structure. A new department was created to deal exclusively with managing the foreign exchange reserves and the conduct of foreign exchange operations—the Foreign Operations Department. Another department, the Foreign Exchange Control, was established to deal exclusively with control matters.
The Foreign Operations Department had to build up its capacity, hire and train new staff, and work closely with the commercial banks to conduct its intervention. The initial phase of reform concentrated on improving its organizational structure, recruiting and training new staff, specifying clear exchange of control rules and regulations for transactions between the National Bank and the commercial banks, strengthening exchange management practices and improving reporting, accounting, and analysis of foreign exchange operations. At the same time, the Foreign Operations Department had to build up its capacity for dealing and managing the foreign exchange reserves. It prepared and strictly followed an action plan of modernization.
The implementation of the action plan for the modernization of the Foreign Operations Department went very smoothly and was accomplished very rapidly. In a short period of time it built a very modern and efficient dealing room and gained considerable experience in managing official foreign exchange reserves. The Foreign Operations Department was one of the National Bank departments where progress appeared to exceed expectations. On the other hand, building up the interbank market faced some logistical difficulties and did not take off as early as envisaged. The major obstacle was represented by Article 7 of the Foreign Exchange Law, which was ambiguous regarding the legality of commercial banks conducting business in foreign exchange with institutions other than the National Bank. Ultimately, the National Bank managed to reinterpret Article 7, to develop an interbank market, and to introduce a regulation on limits on foreign exchange exposure by the commercial banks in mid-April 1993.
Monetary and Balance of Payments Research and Analysis
Monetary Research and Analysis
In order to support the formulation and execution of monetary policy with appropriate information and statistics, the National Bank of Poland had to build a modern research department. To this end, a new Economics, Projections, and Analysis Department was created. The main priorities of this department were to improve its capacity quickly to research and analyze monetary and balance of payments developmerits. It began working on (1) building up a short-term monitoring system of the liquidity of commercial banks; (2) preparing a new reporting system for commercial banks in cooperation with the supervision department; (3) working on the establishment of a programming framework for monetary policy/formulation; and (4) improving its expertise and technology for analyzing economic information. The department had the task of coordinating its work with another newly created department, the Monetary and Credit Policy Department in charge of conducting monetary operations. In addition, the Economics, Projections, and Analysis Department began building a small macroeconomic model to analyze and test monetary policy options in Poland.
Balance of Payments Research
As was customary in many Eastern European countries, the collection and production of balance of payments statistics was concentrated in the central bank. In the case of the National Bank, the production of balance of payment statistics was assigned to the Foreign Department. Until Poland ceased being a member of the International Monetary Fund in 1950, the bank compiled balance of payment statistics for publication by the Fund.17 Publication of these statistics was resumed in 1981.
In 1964, the banking system was reformed, and all banking operations dealing with trade, services, transfers, and loan and credit operations with foreign countries were concentrated in the foreign trade bank, Bank Handlowy. Also, at that time, the National Bank staff engaged in collecting the statistics from the banks were transferred to Bank Handlowy (about 40 people). The final compilation and analysis continued to be done at the National Bank. As in many countries, a division of labor existed in Poland between the National Bank and the Central Statistical Office whereby the latter compiled physical merchandise trade statistics and the former statistics on services.
The Foreign Department used to compile the balance of payments only on a cash basis. All receipts and payments effected by the National Bank and other banks involved in foreign transactions, that is, Bank Handlowy and Bank Polska Kasa Opieki SA. Most settlements were in the context of bilateral payment agreements, and in nonconvertible currencies. In addition to the semiannual and annual reports published since 1981, the Foreign Department used to make monthly reports available to the authorities. Balance of payments on a transaction basis was compiled only annually.
The Economics, Projections, and Analysis Department’s modernization process had a quick start and began making significant progress as early as 1991. A ten-day monitoring system was introduced and a committee was created to prepare a comprehensive monthly reporting system for monetary and prudential purposes. The main obstacle encountered by this department in modernizing its functions was the lack of good and consistent statistics. To build even a simple macroeconomic model, it needed information from the past to derive behavioral equations for testing for the future. However, the Polish economy was going through a major transformation in all sectors, and there was no consistent series of economic variables to use for economic analysis. Thus, for almost two years, the research and modeling activities of the Economics, Projections, and Analysis Department were seriously handicapped by the lack of past empirical evidence and consistent data.
In the balance of payment statistics the National Bank had to overcome serious problems of data collection from several sources, and it took almost two years to centralize the information in the Bank and to adopt a modern collection system. In 1992, in the area of capital account, it had to introduce new forms of foreign bank accounts to capture private capital in-and-out flows and information from enterprises on an accrual basis. Surveys to gauge inward direct investments were also conducted initially in 1990 and 1991, and a new classification for residents and nonresidents had to be introduced. In both cases, the lack of modern technology and computer support also militated against modernization in these areas.
The National Bank inherited a poor payments system, which was decentralized and overwhelmed with a variety of independent accounts. In addition, as previously indicated, the telecommunication and postal service systems were inadequate and no clearinghouse was operating in the country. Each of the 49 National Bank branches maintained accounts for the branches of commercial and savings banks in its region. For example, the Gdansk branch of the National Bank maintained 29 accounts, one for each branch of each bank operating in that region. For a variety of purposes, these branches were treated almost as if they were separate institutions. The major savings bank, Powszechna Kasa Oszczędności BP; the two specialized banks in foreign currency business Bank Handlowy and Bank Polska Kasa Opieki SA; and the specialized Bank for Food Economy, all together these banks had 850 offices in Poland, each with an account with the National Bank.
The Bank also maintained 12 computer centers and used to purchase time sharing from 35 privately owned computer centers. The need for all this computing power stemmed from the fact that the National Bank used to do all the internal account administration and general book accounting for each commercial and savings bank branch. The processing was done on a batch basis, with data transferred from the commercial banks to the National Bank via tape, floppy disk (tapes and diskettes were transported by courier to the centers), or telecommunications link. National Bank processing occurred overnight and paper output was delivered to the banks the next morning. Banks used their accounts to deposit and withdraw cash, to process interbank and interbranch transactions, and to maintain reserves and receive various types of refinancing credit. While the National Bank computing centers processed all branch bank accounting, the relationship of the bank branch to the National Bank branch revolved around the maintenance of the branch account with the National Bank. There was no communication between the computing centers and the National Bank branches as to branch accounting detail or payment information.
The Polish payments system depended primarily on credit (giro and debit check transfers) based on cash paper. A telegraphic transfer system was used at times for large intrabank transactions. As a result of the inefficiencies in the system and the large amount of paper documentation to be processed, the clearing of payment documents used to take between 7 and 15 days. Depending on the location of the branches and the National Bank, each local National Bank branch treated each separate commercial bank branch independently. Thus, commercial banks not only had to ensure that their aggregate balance with the National Bank was well managed, but that each branch account was as well. In practice, each commercial bank had an amount of refinance credit supplied to it by the National Bank. The banks allocated this amount to their branches, and each National Bank branch was notified of the allocations. If a commercial bank branch account with the National Bank was negative owing to an imbalance in its payment settlement, the National Bank branch automatically supplied the branch with refinancing in the form of payment credit at that minimum rate. If, however, the branch exceeded its refinance credit allocation, it was penalized at much higher rates. This penalty occurred even if other bank offices with accounts at the same National Bank branch had excess reserves or if the bank was in an overall surplus position.
This process led banks to move funds among their own branches across National Bank books if they saw that an imbalance would last more than a day, and to maintain excess reserves while at the same time paying for payment credit. A large and erratic float was continuously present in the Polish payments system.
For the final reconciliation, all National Bank branches sent data on payment advices to a central computing center in Warsaw. These advices were reconciled at a detailed level to ensure payment: advices sent were received and accounted for. However, no special effort was made to close open items until ten days had passed.
The modernization strategy, largely based on improved technology and transportation facilities, envisaged the creation of an interbank settlement department and of a national clearinghouse, the shortening of the settlement period to reduce risk and float, and the implementation of a National Bank wire for an electronic payment-by-payment, large-value transfer system, to complement the clearinghouse.
The modernization program of the payments system encountered several difficulties. Apart from the technological deficiencies, Polish authorities lacked experience with an efficient payments system in a market-based economy. It was not clear that a safe, effective, and efficient payments system was a necessary condition for the growth and development of a modern economy, with efficient money and capital markets, because the legacy of the old system allowed banks and branch banks to receive credit automatically upon request. Also, within the National Bank, it took time to appreciate fully that an efficient payments system is the main gear in the transmission mechanism of market-oriented monetary policy intervention. In the case of the National Bank, in particular, the existence of a float, which was erratic and thus unpredictable, made the liquidity forecast exercise of the Monetary and Credit Policy Department very difficult. Further, the lack of a quick and safe payments system discouraged the development of interbank and capital markets at a very early stage of the economic transition of the Polish economy. As a result of the low priority placed initially by the Polish authorities on payments system issues and the lack of cooperation of the commercial banks in investing to centralize their accounts, to automate their operations, and to create a clearinghouse, the modernization of the payments system had a slow start. However, a major scam perpetrated by a private holding company called Art-B in July 1991 sent a strong alarm to the banking sector and to Polish officials about the importance of implementing the proposed action plan and the near-term actions elaborated in the technical assistance provided by the Exchange Affairs Department of the IMF.18 Beginning August 1991, the National Bank of Poland began to take steps to close the opportunities for the repetition of such scams, and a momentum was created to accelerate the modernization of the payments system.
The authorities realized that their payments system was inefficient and potentially open to significant settlement risk exposures. By granting immediate credit to a depositing bank without debiting the other bank, the system was open to abuse and potential losses for the National Bank, as the lender of last resort. As a result of the float, the National Bank was effectively extending interest-free credit to the depositing bank. This also greatly complicated the monetary policy actions of the Bank and greatly hampered the effectiveness of the daily liquidity forecast exercise of the Monetary and Credit Policy Department.
To address the above issues, the National Bank of Poland embarked on a major program of modernization of the payments system. It embraced a two-pronged strategy: (1) near-term improvements to address immediate problems by using existing technology, and (2) a medium-term strategy of automation and electronic-based payments. The near-term improvements envisaged a strategy with the following objectives.
• Establishing one account per bank at the National Bank. This would have the impact of facilitating National Bank operations with each bank, particularly credit and debit transactions. On the other hand, this would also require the consolidation for each bank of all branch accounts into one single account in the books of the commercial bank.
• Improving and encouraging the use of the telegraphic transfers for interbank payments, regardless of the location of the banks, and streamlining the processing of telegraphic transfers to the extent possible.
• Sending large-value government payments over the telegraphic transfer system.
• Having the computer centers send the advices of interbank debits and credits directly to the National Bank branch on the same day it sent copies of these advices to the bank branch to speed National Bank accounting.19
• Organizing efficient local and other physical exchanges of paper checks and payment orders.
• Requiring banks to use banking mail or some other method of transporting paper documents that would guarantee delivery within established time frames. The cost could be shared between the sending and receiving banks.
• Establishing the necessary legal or regulatory structure to ensure efficient payments handling.
• Establishing incentives for an efficient debit payments process by eliminating the procedure that grants credits to the depositing banks before debits can be charged to the paying banks.
Other Reforms in the National Bank of Poland
The modernization of the National Bank of Poland was not confined to the above activities but was extended to virtually all sectors, such as internal organization, internal audit, and data processing and automation.
The National Bank gradually rationalized some activities inherited from the monobank system by divesting itself of commercial and nonbanking services to the nonbank public and accounting services to the branches of commercial banks. On the other hand, it was charged with new responsibilities under the 1990 National Bank of Poland Act, and new departments needed to be created and added to the existing structure. The reorganization of the National Bank took a few years, but it was planned with the objective of creating a new structure and allocation of functions to each department to ensure the full and satisfactory performance of the Bank. The main reforms were contained in a document called “Organizational Regulation of the National Bank of Poland,” June 1, 1990. The document addressed the main objectives of (1) disengagement from nontypical central bank activities; (2) reduction of bureaucratic/legalistic procedures; and (3) reorganizing structure. In the last context, a major restructuring of the National Bank took place with the streamlining of the departmental structure and the appointment of one first deputy president, largely responsible for monetary policy decisions and operations and for administrative matters. A second deputy president was also appointed, responsible for the main operational activities of the bank. An executive board comprising the directors of the main departments was also created to discuss the main policy decision of the National Bank. The new organization was more decentralized than the previous one, where the governor was chiefly responsible for decision making. More power was now delegated to the deputies and departments in order to respond more quickly and effectively to the new challenges of the Bank.
The main innovation brought into the National Bank was the decision to improve communication and to share information with its staff and among all its departments. Under the old system, departments did not commonly share information, but rather performed as if in competition with each other over the ownership of information. To rectify this attitude and to create a spirit of cooperation, access to all departments and regular meetings between department heads and the senior management of the bank were introduced. In addition, the introduction of a computer network system linking all main departments was instrumental in creating a different working atmosphere and a sharing of information. Finally, as part of the restructuring, a great emphasis was placed on training staff locally and abroad under bilateral and multilateral training programs offered by central banks and other institutions. Foreign language courses, particularly English, were offered to all staff members.
Internal audit procedures were laid down in 1991. After overcoming an initial problem in recruiting qualified staff, the Internal Audit Department directly responsible to the President of the Bank, began conducting regular audits of the departments in 1992.
Data Processing and Automation
A major restructuring and modernization of the Bank Computing Center began in early 1992. The National Bank took the dual approach of focusing on data-processing resources to the development of transaction-oriented systems, such as accounting, the general ledger and book entry, and providing departments with network support by installing a Local Area Network system.
Any central bank effective in implementing monetary policy needs appropriate internal structure and instruments, and as a counterpart, an efficient financial sector.
The impact of the modernization of the National Bank would have been largely nullified if, at the same time, the Polish authorities had not implemented the necessary reforms to address the problem of the financial sector. As in many other Eastern European countries, Poland had to face the challenge of restructuring state-owned banks (and public enterprises, the banks’ main customers) and supervising new banks and cooperative banks.
In mid-1993 the Polish authorities introduced a Bank Restructuring Program as part of the broader institutional reform of the Polish financial sector. The ultimate objective of the reform was to recapitalize the state-owned banks in order to privatize them. As a first step to this end the Ministry of Finance commissioned an analysis of the financial portfolio of the nine commercial banks. The audits were carried out by international auditing firms and revealed a very high percentage of substandard and nonperforming loans, albeit not evenly distributed among the nine banks. The state of nonperforming loans in the private sector was as high as in the case of public enterprises. As a result of the audit, it was estimated that the capital adequacy ratio of the banks, after provisions, would have fallen well below the average standard of 8 percent. The Polish Government addressed the restructuring of the banks by using a decentralized approach. This consisted of
recapitalizing the banks to such a level that they will be able to create adequate provisions for the bad loans, and introducing mechanisms that will encourage and even force the banks to undertake specific actions with respect to the bad debtors. The amount of ex-ante recapitalization is not dependent on the amount of bad loans to be recovered. This creates incentives for the bank to recover as much as of the had debt as possible.20
Under the program, the nine banks separated the loans classified as doubtful and as loss making and created a unit in each bank to manage the bad loan portfolio. The Government required the bank to provision 100 percent coverage for loss and 50 percent for doubtful loans. The recapitalization occurred by issuing 15-year redeemable treasury bonds, denominated in zloty, indexed to a basket of foreign currencies, and bearing market interest rates. Before the privatization of the banks, the bonds were to be serviced and redeemed by the Treasury. The choice of treasury bonds was facilitated by the existing liquidity in the Polish banking sector. Under the program, all restructured banks had to attain the 12 percent capital adequacy ratio by December 31, 1993. The total recapitalization cost for only seven banks was estimated at approximately US$630 million.
A system of approximately 1,600 cooperatives operated in Poland, accounting for about 6 percent of total banking sector assets. In September 1992, the National Bank became responsible for the supervision of these cooperatives. This has not been an easy task considering that additionally the National Bank had to supervise 86 commercial banks. The National Bank participated in the preparation of a special law on restructuring the Bank of Food Economy and cooperative banks, which was passed by the Parliament in June 1994. The law has introduced some systemic solutions for consolidation of the cooperative banks and improvement of their financial standing. Pursuant to the law, credit decisions for the cooperative banks are made by a committee that includes representatives of the associate bank. Cooperative banks have also lost the authority to extend loan guarantees, which appeared to be a major problem in the past. To improve supervision of these cooperative banks, a plan of reform has been agreed upon with external support. Under the plan, all the cooperatives will be audited and ultimately supervised by a new body called the auditing union.