Enhancing financial stability and reducing the vulnerability of financial systems—with particular emphasis on the banking sector—are key aims in each of the CEC5. In addition to the reform priorities discussed previously, they face additional challenges in securing the path to financial stability: successfully coping with potentially strong capital flows, building up risk management capacity, ensuring the provision of adequate financial safety nets without encouraging moral hazard behavior, and striving to meet international financial market standards. An overarching priority in this regard is to put in place an effective legal and institutional framework, with a focus on the supervisory role in preventing a build-up of risks. The IMF has also been actively developing a broader framework for assessing financial vulnerability to assist its member countries in identifying areas for improvement to enhance stability.
The Legal, Institutional, and Supervisory Framework
The EU accession process has been beneficial in accelerating the needed legal reforms in the financial sector and in providing clear guidance on the direction for such reforms. EU regulations for financial markets are based on the premise of an open EU-wide market and universal banking, and provide minimum standards governing the operations of banks, securities markets, and institutional investors (Box 5.1 on pages 78–79 provides a summary of the major EU banking legislation). All of the CEC5 have either updated or developed banking and securities laws to achieve consistency with the various EU directives, and the flow of capital and financial services has been significantly liberalized (Box 5.2 on pages 80–83 reviews the European Commission’s assessment of progress in the area of financial services, as described in the 2001 Regular Reports).
While the CEC5 have already largely adopted internationally compatible laws on banking and securities markets, the enforcement of the legal framework could still be significantly improved. According to an EBRD assessment, the effectiveness of financial system regulations in the CEC5 typically lags their extensiveness (Table 5.1), where extensiveness refers to adequacy of adopted regulations, and effectiveness refers to the adequacy of their implementation and enforcement. Typical problems include slow and inefficient bankruptcy procedures, low collateral recovery, legal restrictions on disposal of assets backed by real estate, tax laws discouraging write-off of bad loans, low levels of minority shareholders protection, and leniency toward off-market equity trading. Difficulties faced by the CEC5 in raising the standards of enforcement include an overburdened judicial process, lack of trained regulatory personnel, and lack of sufficient authority and independence of the supervisory body.47 The delayed reaction to the problems of IPB in the Czech Republic well illustrated the constraints that supervisors faced in dealing with problem banks owing to inefficient legal procedures and a slow judicial process.
Extensiveness and Effectiveness of Financial System Regulations
Extensiveness and Effectiveness of Financial System Regulations
| Banking Laws | Securities Laws | |||
|---|---|---|---|---|
| Extensiveness | Effectiveness | Extensiveness | Effectiveness | |
| Czech Republic | 3 | 3- | 4- | 3 |
| Hungary | 4 | 4 | 4 | 4 |
| Poland | 4 | 3 | 4 | 4 |
| Slovak Republic | 3 | 2 | 3 | 2 |
| Slovenia | 4 | 3 | 3+ | 2+ |
Extensiveness and Effectiveness of Financial System Regulations
| Banking Laws | Securities Laws | |||
|---|---|---|---|---|
| Extensiveness | Effectiveness | Extensiveness | Effectiveness | |
| Czech Republic | 3 | 3- | 4- | 3 |
| Hungary | 4 | 4 | 4 | 4 |
| Poland | 4 | 3 | 4 | 4 |
| Slovak Republic | 3 | 2 | 3 | 2 |
| Slovenia | 4 | 3 | 3+ | 2+ |
In the new environment of openness to capital flows and financial services, strengthening financial sector supervision should top the agenda—with particular emphasis on consolidated supervision and increased autonomy for the supervisory authorities. The largest banks in the CEC5 function as universal banks—they ate often involved in a wide range of operations, including ownership of brokerage houses, investment funds, insurance and pension funds, and in some cases, corporations. However, in the CEC5, formal reporting on a consolidated basis is either not required or has only recently been adopted (and thus, there is as yet little experience in doing so). Historically, a lack of consolidated supervision has proved problematic. Banks’ holdings of investment funds in the Czech Republic led to banks implicitly owning their clients with the resulting perverse incentives. In Hungary, some banks have engaged in the practice of covering on-balance sheet exposures by taking offsetting positions with their own subsidiaries. As part of recent legal reforms, progress is being made with regard to consolidated supervision. In Hungary, for example, three supervision agencies—for banking and capital markets, the pension funds, and the insurance funds—were merged in a formal move toward fully consolidated supervision in 2000, and Hungary adopted a regulation requiring consolidated reporting in early 2001. In Slovenia, the highly interconnected financial system poses additional challenges for supervision, requiring additional emphasis on related party lending, especially to shareholders, and strengthening cross-sectoral supervision. Enhancing the independence of the supervisory authorities—giving them the power and authority to respond quickly to any nascent financial market risks—is also a crucial issue for most of the CEC5.
EU Legislation Governing the Banking Sector
Legislation governing the financial sector in the EU establishes the legal foundations for a fully integrated market in financial services. Every bank, insurance, or securities company will be able to provide financial services in other EU countries without restrictions. Firms can place securities on any stock exchange in the union, and every individual will have the right to acquire those securities. To achieve these goals, there must be full harmonization of standards for establishment and operation of financial entities, for prudential supervision, and for the protection of investors, depositors, and consumers. It is also necessary to have a uniform level of competence of the supervisory bodies and a uniform level of enforcement of the rule of law.
The two key directives supporting the single market in banking are the Capital Liberalization Directive and the Second Banking Directive. The first one calls for removing all controls on capital flows within the EU and, for the most part, on capital flows between EU members and any third country. In the past, temporary exemptions to this rule were granted to Spain, Ireland, Portugal, and Greece, but exemptions are less likely to be granted to the current applicants. The Second Banking Directive establishes minimum capital requirements for new banks (ECU 5 million), and the principles of a single banking license and home country control. Any credit institution authorized in one member country can establish branches and provide services anywhere in the EU without requiring authorization from the host country. The home country has the responsibility for the consolidated supervision of the bank, while the host country supervises the liquidity of branches on its territory. Complementary legislation establishing common standards of prudential operation is summarized below:
The First Banking Directive determines common rules for granting banking licenses and introduces the basic principle of cooperation between supervisory authorities of member states. The Bank Account Directive harmonizes the format and content of the annual accounts of all financial institutions within the union.
The Consolidation Supervision Directive requires credit institutions to be supervised on a consolidated basis.
The Own Funds Directive defines the concept of own funds, and sets up minimum criteria for determining their composition. According to the Solvency Ratio Directive, credit institutions are required to maintain a minimum risk-adjusted ratio of own funds to total assets of 8 percent. The Capital Adequacy Directive extends the solvency ratio directive by enabling supervisors to set minimum capital requirements for non-bank investment firms and for universal banks.
The Directive on Large Exposures establishes a limit of 25 percent of own capital on lending to a group of related clients, and a limit of 800 percent of own funds on the total value of large exposures. Large exposure is defined as exposure to a single client exceeding 10 percent of the lending institution’s own funds.
Deposit Protection—all EU credit institutions are legally required to provide deposit insurance up to ECU 20,000 for each individual depositor. This directive explicitly states that the level and scope of coverage of deposit insurance should not become an instrument for competition.
Free entrance of foreign banks, as required by the EU, creates additional challenges for bank supervision. At the same time, it could be argued that heavy foreign ownership simplifies the task of supervision to the extent that CEC5 supervisors can rely on effective home supervision and on parental support of local banks. Nevertheless, with foreign bank entry, supervisors must have the ability to assess the health of the entering bank, evaluate the systemic risk of newly introduced financial instruments, and work with other national supervisory authorities to ensure proper consolidated supervision (but may not have alt the requisite skills to do so). In addition, the CEC5 would be more exposed to developments in the banks’ home markets, an asymmetric information complication for local supervisors. Thus, some of the CEC5 have postponed allowing the establishment of foreign bank branches (which are not subject to the host country supervision), Hungary, for example, has been a leader in encouraging foreign investment in its banking system, but still does not permit the establishment of foreign bank branches. This may be prudent to the extent that the cost of failure of such entities may have to be borne by the host authorities, despite having little regulatory and supervisory power over them. Upon EU accession, however, this restriction will have to be abolished.
European Commission’s Assessment of Progress Toward Accession in the Area of Financial Services
In the 2001 Regular Reports, the European Commission (EC) evaluated the progress made by candidate countries toward meeting the economic criteria for accession, and outlined priorities for future reform. In the area of financial systems approximation, all countries have made significant progress toward legislative alignment. However, the institutional capacity for application and execution needs to be further developed. Another shortcoming has been the deficiency in the formulation or implementation of bankruptcy laws, and the slow and inefficient enforcement through the judicial system. A common conclusion has been that, despite increasing efficiency of intermediation, access to financing for small and medium enterprises remains at low levels. The major findings of the EC in the area of financial services are summarized below:
Czech Republic
The Czech Republic has adopted much of the acquis related to the financial sector. However, an important amendment to the Act on Banks, regarding regulation and supervision, has been delayed. The banking sector continues to be overburdened by nonperforming loans, and the lack of efficient bankruptcy procedures has hampered adjustment in the enterprise sector. The May 2000 amendment to the Bankruptcy Act, while somewhat strengthening creditor rights, has produced only modest improvements, and the Bankruptcy Law needs to be amended yet again (the government is preparing a new law to this effect). Bank restructuring has made considerable progress in 2001, and the banking sector’s overall health has improved. But the financial sector’s role in intermediation remains weak; the volume of loans has decreased, with the large amount of nonperforming loans acting as a drag on the sector. The privatization of the last majority state-owned bank in June 2001 should contribute to improving the financial sector’s performance in this regard. Financial sector supervision needs to be further strengthened, especially in the non-banking sector. Legislative progress has been made with the implementation, as of January 1, 2001, of amendments to Acts on Securities, Bonds, and the Stock Exchange. But the securities market still suffers from lack of transparency and price manipulation. Moreover, consolidated supervision is urgently needed, and development of risk-based supervision and supervision of financial conglomerates is yet to be tackled.
Hungary
Hungary has achieved a substantial degree of alignment in the area of financial services, and new legislation on credit institutions, passed at end-2000, provided significant further harmonization. However, the rigid regime for setting up foreign bank branches will need modification for accession. With respect to the securities market, further effort will be needed before Hungary is in full compliance with the acquis. The financial sector is stable and relatively well-regulated and supervised, with substantial foreign participation. The financial sector is dynamically expanding, and this has been associated with a significant increase in profitability. Lending activity is growing, and access to credit for SMEs and households has increased at a very fast pace, albeit from a low base. With the merging of the three supervisory authorities in April 2000—to provide more effective consolidated supervision and to deal with new types of risks—Hungary appears to have the necessary supervisory institutions in place. Major remaining challenges are to strengthen implementation of consolidated supervision and to enhance the regulatory power of the supervisory agency. Prudence remains an important issue, particularly in the aftermath of opening up of capital markets (and the associated rapid changes in the structure of risk exposure) and in the increasingly competitive financial environment. In this regard, the central bank’s biannual “Reports on Financial Stability” reflect well-developed expertise on financial stability issues.
Poland
Poland has already achieved a high degree of alignment with respect to financial services. The regulatory and supervisory framework has been substantially upgraded in the recent past, and, in particular, the amendment to the banking law in September 2001 has been an important step forward, including toward consolidated supervision. The main remaining problem is implementation of the bankruptcy framework, as difficulties remain with the protection of creditors and the ability to seize collateral. The financial sector is developing fast from a low base, in particular through the increased presence of foreign strategic investors. While there is no immediate threat to financial sector stability in the short run, one area of concern is the deterioration in the banking sector’s asset quality since the Russian crisis. Greater competition is also putting pressure on banking sector earnings.
Slovak Republic
Slovakia has achieved considerable alignment with the acquis on financial services, and a new Act on Banks and an amendment to the Act on the National Bank of Slovakia furthered progress. Nevertheless, further effort is needed to strengthen the regulatory, prudential, and supervisory framework for the financial sector, especially as regards effective implementation. A new bankruptcy framework has strengthened creditor rights and allowed for an acceleration of bankruptcy procedures, but the judicial system needs to be strengthened. Legislative proposals to improve the collateral system and corporate governance architecture should be approved and implemented as soon as possible. Slovakia has made excellent progress over the past year in the privatization of the banking sector, following the successful restructuring of the loan portfolios of the three major state-owned banks. This has greatly improved the situation in the banking sector, and the banking sector reported a profit in 2000, compared to a loss in 1999. Moreover, increased foreign participation is expected to enhance the sector’s performance. Nevertheless, the banking sector is still not fulfilling its role in intermediation, as private sector credit growth is contracting in real terms, and new credits are largely short-term. Access to credit for SMEs is especially problematic. Capital markets remain embryonic and illiquid, and progress is still needed in their regulation and development.
Slovenia
Alignment in financial services legislation with the acquis is already advanced. Most of the banking legislation is in place, including the freedom to establish foreign banks, and further progress was achieved with the adoption in July 2001 of amendments to the 1999 Banking Act. The focus should now largely shift toward effective implementation and supervision of the new legislation, as well as on increased cooperation with other European supervisory authorities. The privatization process has now started in the financial sector, with the adoption in May 2001 of a program for partial privatization of the two dominant state-owned banks, but further work remains in restructuring the banking sector. Although the financial system appears sound, there remain concerns about the financial sector’s preparedness to face increased competition, with an ownership structure which has evolved only to a limited extent. Competition needs to be encouraged, and de-indexation would be one important element to stimulate competition in the banking sector. While there have been some improvements regarding bankruptcy procedures, the number of bankruptcies proceedings remains low, reflecting in part concerns that stringent application of some new provisions could have serious economic consequences owing to widespread insolvency, over indebtedness, and capital inadequacy. The stock market remains underdeveloped, but its activities could be boosted from the privatization of banks, insurance companies, and telecommunications.
Adequate protection of the rights of creditors and shareholders should also be a reform priority if the financial sector is to play an increasing role in the efficient allocation of resources and support growth. Measures of the effectiveness of shareholders’ protection, for example, confirm that legal enforcement needs improvement in the CEC5 countries (Table 5.2, page 85). Hungary and Poland scored the highest and, not surprisingly, also enjoyed the most liquid stock markets in the late 1990s.48 A remaining weakness identified in all five countries, although to differing degrees, is the poor enforcement of creditor rights. The most serious problems in this area for the CEC5 are the slow and inefficient bankruptcy procedures. Bankruptcy courts take several years to complete a bankruptcy action and often provide very low recovery of collateral, even in countries with relatively good, internationally-comparable bankruptcy laws.49 Compounding the problem, a common complaint among creditors in most of the CEC5 is creditors’ inability to choose or participate in the choice of the liquidator, and this has raised the specter of corrupt practices within the judicial system. These difficulties have affected the portfolio decisions of financial institutions—banks in the CEC5 invested a disproportionately large share of their portfolio in government securities in the past, although this trend has started to reverse in recent years.50 While there are many reasons for the low level of credit to households and small and medium enterprises (SMEs)—including the usual ones of lack of collateral and prior credit history—the major legal impediment is the costly and slow bankruptcy procedure.
Effectiveness of Shareholder Protection
Effectiveness of Shareholder Protection
| Shareholder Protection Laws, 1998 | Effectiveness of Shareholder Protection, 1998 | |
|---|---|---|
| United States | 5 | 100 |
| Czech Republic | 3 | 51.4 |
| Hungary | 3 | 71.0 |
| Poland | 3 | 68.6 |
| Slovak Republic | 2 | 56.5 |
| Slovenia | 3 | 39.8 |
Effectiveness of Shareholder Protection
| Shareholder Protection Laws, 1998 | Effectiveness of Shareholder Protection, 1998 | |
|---|---|---|
| United States | 5 | 100 |
| Czech Republic | 3 | 51.4 |
| Hungary | 3 | 71.0 |
| Poland | 3 | 68.6 |
| Slovak Republic | 2 | 56.5 |
| Slovenia | 3 | 39.8 |
Intermediating Capital Flows
In the run-up to EU accession and the adoption of the single currency, as the CEC5 complete the restructuring of their economies, capital inflows are likely to increase further and potentially become more volatile. A well-educated labor force, proximity to EU markets, and increased confidence in the countries’ stability have made and will continue to make the CEC5 attractive for foreign investors, as evidenced by the explosive growth of capital inflows over the past decade. In recent years, the improving economic prospects and speculation on interest rate convergence have also led to a steady increase in those capital inflows—such as short-term debt and portfolio investment—which are most easily reversible.51 A sound financial system can provide a needed buffer against major market disturbances affecting the direction and magnitude of capital flows.
Capital controls have been progressively eased in the CEC5 in part owing to OECD membership requirements for some of the countries and also as a result of EU accession commitments. While the Czech Republic, Hungary, and Slovakia have largely liberalized their capital accounts, Poland and Slovenia continue to maintain some short-term capital controls mostly aimed at encouraging nondebt financing and lengthening the maturity structure of external financing. Upon accession, at the latest, remaining controls will have to be removed—in the absence of derogations—potentially stimulating further capital inflows.
Inflows are likely to be very sensitive to the perceived sustainability of policies in the run-up to accession. Contagion effects through trade and financial channels are also likely to intensify as the CEC5 increasingly compete in their main export markets and complete the liberalization of their capital accounts. Temporary surges in inflows during periods when interest rates are bid down toward euro zone levels can be quickly reversed once arbitrage opportunities disappear. A heavier reliance on the securities markets, in itself, may increase the vulnerability of capital flows to shifts in expectations and asset price volatility.
While the benefits of capital flows are many, large capital inflows—it these flows are greater than the recipient economy’s ability to absorb them—could have a potentially negative impact on the financial sector and, ultimately, the real economy. Large capital inflows have been associated with rapid credit expansion and riskier lending practices in emerging markets. Short-term inflows are often driven by speculative considerations—exploiting an interest rate differential and/or expectations on the direction of exchange rate movements—and can be easily reversed if expectations change. Moral hazard distortions—such as an implicit exchange rate guarantee or expectations that the government would bail out the banking system—also underpin short-term flows. Such flows have been responsible for many of the boom-bust cycles in emerging markets in the 1990s, as they are also the first to head for the exits at any signs of economic or financial distress (Box 5.3). Heavy inflows can also lead to excessive real exchange rate appreciation, potentially eroding competitiveness and resulting in a deterioration in performance of some of the banks’ clients, with possible negative repercussions on debt repayments.
Particularly in the case of a relatively fixed exchange regime, heavy inflows can result in currency (and maturity) mismatches for the financial sector’s assets and liabilities. If the fixed exchange rate regime is credible, there can be a shift toward foreign borrowing at lower interest rates, leading to large open foreign exchange positions for banks (Box 5.4). This directly links the health of the banking system to the survival of the fixed exchange rate regime and increases the probability of speculative attacks. However, a robust financial system should reduce the likelihood of speculative attacks, since a strong system is known to be able to withstand an aggressive policy response.
Impact of the Russian Crisis
Cross-border capital flows can serve as a major channel for contagion. In this respect, the Russian crisis in August 1998 was a test for the financial markets and exchange regimes of the CEC5. In Hungary, Poland, and the Czech Republic, stock markets fell sharply,1 but the impact was much less in Slovakia and Slovenia, where the stock exchanges are much less fully integrated with global markets. In fact, Slovenia, with a much more sheltered economy, was practically unaffected by the crisis, and its stock market even reached record highs by end-1998.
Profitability of banks in the CEC5 was negatively affected by a deterioration in portfolios, but the crisis served to foster the strengthening of risk management systems, especially for monitoring country risk and reducing country-specific exposures. The Czech Republic was already in a recession at the time of the crisis, while Slovakia was forced to abandon its fixed exchange rate in the aftermath. Hungary and Poland, on the other hand, weathered the crisis well after suffering temporary capital outflows and pressures on their exchange rates. The crisis contributed to a slowdown in GDP in Hungary and Poland in the first half of 1999, but growth subsequently accelerated and, after a temporary cutback, capital inflows largely resumed on the scale seen before the crisis struck.
Thus, while the immediate market reaction was large, international capital markets quickly differentiated among the transition economies, according to their fundamental strengths and weaknesses. In particular, the capital outflows were associated with both direct and indirect contagion effects, with the direct effect coming from the need for international investors to liquidate some of their portfolios to meet liquidity requirements elsewhere, and the indirect effect arising from a “flight to quality” sell-off of assets in emerging markets. Countries like Hungary and Poland suffered disproportionately from the direct liquidity effect, in part due to more liquid asset markets, but recovered quickly from the indirect “flight to quality” impact.
1The stock market decline was greatest in Hungary, with its narrow exchange rate band at the time, in part because the other CEC5 countries could absorb some of the shock through sharp changes in exchange rates.Flexible exchange regimes allow more transparently for two-way risk, which can limit excessive foreign currency exposures and liquidity mismatches. Exchange rate volatility will change the incentives regarding hedging, naturally spurring the development of markets for hedging instruments.52 Nevertheless, a floating exchange rate regime does not prevent speculative inflows—there can still be excessive borrowing abroad if, for example, there are strong expectations of appreciation that are not fully reflected in the interest rate differential. Sufficient fiscal consolidation can relieve monetary policy of the burden of attempting to curb inflationary pressures with excessively high interest rates that ultimately may attract capital inflows and create an unsustainable current account deficit. A premature opening of the capital account—against a background of immature financial markets and incomplete structural reforms—may magnify any underlying macroeconomic and structural weaknesses and heighten the risk of bank failures.
Capital Inflows into Hungary in Early 2000
In early 2000, short-term capital inflows flooded into Hungary (the only one among the CEC5 which had a relatively fixed exchange regime at that time), with banks borrowing abroad to take advantage of the high interest rate differential on the central bank’s passive sterilization instrument, the two-week deposit facility. This forced the central bank to aggressively cut interest rates to stem the inflows, as well as adopt other measures (including moral suasion and threats of more stringent reserve requirements). Commercial banks in Hungary must observe a limit on open foreign exchange exposures of 30 percent of capital, but some commercial banks were able to maintain higher open on-balance sheet positions by using their own brokerages to cover them partially with off-balance sheet transactions. In response, in mid-2000, Hungary imposed a “tax” via reduced reserves remuneration if a bank’s on-balance sheet open position exceeded 30 percent of capital (this “tax” was subsequently abolished after the introduction of the wide exchange rate band in May 2001). The fiscal costs of sterilizing such inflows were manageable, but Hungary was not immune, in formulating its monetary policy, to the tensions between internal and external objectives.
Effective regulation and supervision can provide the best insurance against capital inflows being intermediated through banks that are poorly equipped to deal with them. Strengthened supervision and regulation, as discussed above, will be key as capital account liberalization continues in a setting of high (and variable) capital inflows. In addition, financial market imperfections associated with asymmetric information (for example, moral hazard, adverse selection, and herding behavior)—which can be magnified by an open capital account—can be limited by putting in place a bankruptcy framework that ensures budget constraints on enterprises, minimizing explicit and implicit government guarantees, and improving the integrity and availability of financial information as well as the corporate governance structure of financial institutions.
Risk Management
Improving risk management practices—both within banks and by supervisory agencies—is particularly important for the performance and robustness of financial institutions in an environment of free capital flows and international trade of financial services. Risk management requires, first and foremost, having sufficient capital to absorb expected losses from market, credit, liquidity, and operational risks. For the most part, however, in the CEC5, only the largest domestic banks have developed risk management models adequately addressing credit risk, liquidity risk, and market risk. Corporate governance, as exercised by banks’ boards and management, also plays an important role in risk management, and, in this regard, foreign-owned banks often have an inherent edge, with strong governance from the parents.53 To instill better corporate governance practices in the CEC5, the roles and responsibilities of management, owners, and boards could be more clearly defined in financial sector legislation. In addition, management, owners, and boards should be held explicitly responsible for imprudent or fraudulent activity, with appropriate remedial or penal actions (such as removal from position) spelled out.
In the CEC5, the mismatch between risk management capacity and the opportunities for risk-taking underscores the need for enforcing discipline through monitoring both by the market and by the official supervisory authorities. Thus, for example, the rapid expansion of the CEC5 banks into new business areas, such as retail lending to SMEs and derivatives markets, creates greater opportunities for taking on risk, without risk management capacity keeping apace. As the financial markets mature in the CEC5, good corporate governance could increasingly be enforced through steadily rising activism among shareholders and deposit-holders, facilitated by greater transparency and the flow of information via the Internet, but the supervisory role will remain most critical. However, the supervisory capacity for assessing risk can be improved in the CEC5, and weaknesses should be addressed in a timely manner. Importantly, this may entail delinking pay scales for supervisory personnel from those of the broader civil service, allowing salaries instead to approach those in the private financial sector.
The development of markets for hedging instruments could facilitate a more efficient allocation of risk. In the CEC5, however, derivatives markets are at a very early stage of development.54 This is due, in part, to a legacy of relatively fixed exchange regimes for all of the countries until recently55 that has discouraged market participants from hedging their foreign currency exposures. It also reflects the lack of skilled professionals in the trading and design of more complex financial instruments. With all of the CEC5 countries now having fairly flexible exchange regimes, and with experience being imported through foreign bank penetration, the markets for risk management should start to deepen in the coming years. At the same time, regulation is struggling to keep pace with the development of these markets, with the laws governing derivatives in some of the CEC5 rather vague. In this regard, it will be important for the countries to bring accounting standards in line with International Accounting Standards and to ensure consistent tax treatment of derivatives.
The supervisory agencies can mitigate the risk stemming from large capital inflows through applying and enforcing prudential regulations—on foreign currency open positions, bank loan exposures, collateral valuations, etc. Such regulations may reduce excessively risky bank lending that can fuel boom and bust cycles. Limits on sectoral credit concentrations (or limits on concentrations of credit to sectors with highly positively correlated returns) limit the risk that a negative impact on a particular industry or sector will feed through into bank failure. Credit risk is affected by the macroeconomic environment and the legal and regulatory environment (such as bankruptcy laws, collateral recovery, etc.), implying that a stable macroeconomy and a strong institutional environment can go a long way in reducing credit risk.
Financial Safety Nets
The expected increase in capital inflows and the larger role of foreign financial institutions in the accession countries may complicate the role of the central banks as lenders of last resort (LOLR). This problem could be magnified after accession. If the obligations of the bank are in foreign currency, it may be more difficult for the central bank to provide adequate liquidity support if the domestic and foreign currencies are not completely fungible. If the bank is of systemic importance, inadequate liquidity support could destabilize the whole system. There are no definite policies in the EU as to who would meet the social costs of bank failure for an internationally active bank. That makes it even more important to strengthen prudential regulations and oversight to limit the effect of individual failures on the system as a whole. In any event, LOLR support should be largely limited to systemic purposes and, in this context, to addressing bank illiquidity, not bank insolvency.56
EU accession requirements will necessitate a large increase in deposit insurance ceilings for a number of the CEC5. Deposit insurance can reduce the probability of a widespread run on deposits, but such insurance should be explicit and limited to the smaller depositors to allow for risk-sharing and enforce better corporate governance through the monitoring activities of larger depositors.57 In view of the much lower per capita incomes in the CEC5 compared to that in the EU, meeting the EU requirements raises the risk of inducing moral hazard behavior. In fact, Garcia (1999) finds that the optimal coverage ratio for deposit insurance to GDP per capita should range between 1 and 2, to ensure financial stability yet minimize moral hazard. However, moving to EU levels of deposit insurance would raise the coverage ratio to between 4 and 6 in the CEC5 (Table 5.3).
Deposit Insurance Coverage
As a ratio of 1998 GDP per capita.
The CEC5 regulations have established a minimum capital adequacy requirement of 8 percent of risk-adjusted assets. But in view of the more volatile economic environment in the transition economies, a higher benchmark ratio may be desirable. Archarya (2002) suggests that uniform capital requirements are only socially optimal if the rescue policies are also uniform across counties. If one country has a higher level of regulatory forbearance with respect to bank rescue policies, it is optimal to impose higher capital requirements on its banks to ameliorate moral hazard. Given the high concentration of the banking systems in the CEC5, lax rescue policies for the largest banks could be more probable, implying that capital ratios higher than 8 percent would be advisable to reduce moral hazard and the cost of bank failures. In fact, the banking systems in each of the CEC5 maintain aggregate risk-weighted capital asset ratios in the double digits, well in excess of the minimum 8 percent requirement. However, accounting standards in the CEC5 may still not fully reflect international standards, suggesting that there could, in some cases, be problems with accurate measurement of capital.
International Standards and IMF Surveillance
The Czech Republic, Hungary, Poland, and Slovenia have already participated in the Financial Sector Assessment Program (FSAP),58 a joint IMF and World Bank initiative which complements the IMF’s surveillance exercise. The FSAP (Box 5.5)—developed as part of the effort to strengthen the architecture of the international financial system—assists the country authorities in identifying areas to further strengthen their financial systems. In this connection, the FSAP assesses countries’ progress in adopting and implementing international financial market standards. These include the Core Principles for Effective Banking Supervision of the Basel Committee on Banking Supervision, the Objectives and Principles of Securities Regulation of the International Organization of Securities Commissions (IOSCO), the IAIS Insurance Supervisory Principles, the Core Principles for Systemically Important Payment Systems, and the Code of Good Practices on Transparency in Monetary and Financial Policies. As confirmed by the outcomes of the FSAP exercises, each of the four participant countries in the CEC5 has made considerable progress with respect to these standards, but a few remaining weaknesses were also highlighted (some of which were discussed above). The CEC5 participants have voluntarily chosen to publish the Financial System Stability Assessments (FSSA)59 and Reports on the Observance of Standards and Codes (ROSCs) related to the financial sector. This transparency increases the accountability of policy makers and should improve the environment for market participants’ investment decisions, ultimately leading to improved policymaking and economic performance.
The Financial Sector Assessment Program
In May 1999, the IMF and the World Bank jointly launched the Financial Sector Assessment Program (FSAP).1 The main output on the IMF’s side is the Financial System Stability Assessment (FSSA) that is discussed by the IMF’s Executive Board in the context of a country’s Article IV Consultation. This box describes the key elements of this program.
Objectives
With crisis prevention the key aim, the FSAP exercise focuses on the soundness and stability of the financial system as a whole. The FSAP offers an assessment of factors that could make the system vulnerable to instability and suggests measures to reduce such vulnerabilities, including developmental priorities.
The FSAP is intended to highlight the linkages in both directions between financial system developments and macroeconomic outcomes.
The FSAP involves an assessment of observance and implementation of relevant standards, codes, and good practices applying to the financial sector.
The FSAP serves as a basis for assisting the participating country in designing an operational sequencing of financial sector reforms.
Scope
The typical scope of an FSAP mission includes: the macroeconomic environment; financial institutions’ structure; financial markets; risk management procedures; the legal and regulatory framework and the system of supervision, including observance of standards, core principles, and good practices; the institutional and legal arrangements for crisis management; and key reforms to minimize systemic risks and reduce vulnerabilities.
The FSAP undertakes an assessment of financial sector vulnerabilities. The building blocks of this include macroprudential analysis, stress tests of the banking system, and an assessment of countries’ observance of the international standards relevant to the financial sector. These include standards in the areas of banking supervision, payments systems, insurance, securities, and monetary and financial policy transparency. Summaries of these assessments of adherence to international standards can also be published as various module(s) of Reports on the Observance of Standards and Codes (ROSCs). The ROSC reports have typically comprised two elements—a description of country practice and an independent commentary by IMF staff on the extent to which these practices are consistent with the relevant standard.
1Further details on the FSAP can be found on the IMF’s website or in Hilbers (2001).In addition to assessing compliance with international standards, the FSAP takes a broad look at a wide range of factors which could affect financial stability and vulnerability, with a focus on the linkages between financial system developments and the macroeconomy. An FSAP, for example, typically includes a series of stress tests, conducted under a variety of macroeconomic scenarios and external shocks, in order to assess the banking system’s vulnerability to market and credit risks. Indeed, the stress tests for the participating CEC5 countries indicated that their banking systems could likely weather most external or domestic shocks. Nevertheless, an FSAP—and stress tests in particular—can only examine vulnerability at a point in time and should not, therefore, be construed as a “bill of health.” For this reason, one of the most important aspects of an FSAP is to encourage the authorities to continue with such monitoring on its own. Indeed, the National Bank of Hungary (NBH) subsequently launched an excellent and comprehensive semi-annual Report on Financial Stability, and the second issue featured the NBH’s own stress test, modeled after that performed during the FSAP (Box 5.6).
Macroprudential analysis—monitoring financial vulnerabilities on the basis of objective measures of financial system soundness—has also been employed in the context of these FSAPs. Indicators for such analyses can include macroeconomic variables associated with financial system vulner ability (for example, current account deficit, composition and maturity of capital flows, exchange rate volatility, foreign exchange reserve adequacy, etc.), aggregated microprudential indicators of the health of financial institutions (for example, the CAMELS framework)60 and market-based indicators (for example, credit ratings and sovereign yield spreads). Figure 5.1 on the next page illustrates, for the CEC5, some of the macroeconomic indicators used to assess financial and balance of payments vulnerability.
Comparisons of Financial and Balance of Payments Vulnerability Indicators, 1998–2000
Sources: IMF, World Economic Outlook; and IMF staff estimates.1Debt falling due within one year.2CPI based REER.Comparisons of Financial and Balance of Payments Vulnerability Indicators, 1998–2000
Sources: IMF, World Economic Outlook; and IMF staff estimates.1Debt falling due within one year.2CPI based REER.Comparisons of Financial and Balance of Payments Vulnerability Indicators, 1998–2000
Sources: IMF, World Economic Outlook; and IMF staff estimates.1Debt falling due within one year.2CPI based REER.Stress-Testing of the Hungarian Banking System
Hungary was one of 12 participants in the pilot project of the Financial Sector Assessment Program (FSAP). An integral aspect of this assessment was a quantitative analysis—stress tests under various scenarios—on commercial banks’ balance sheets to determine the extent of possible systemic vulnerabilities. Since the FSAP, the National Bank of Hungary (NBH) has begun to conduct its own stress tests along the lines of those used in the FSAP. This box provides an overview of the stress tests described in the NBH’s February 2001 issue of the Report on Financial Stability.
Monte Carlo techniques were used to examine the exposure of the Hungarian banking system to market risk (including domestic interest rate, foreign currency, and foreign interest rate risks) and credit risk. Examination of the balance sheets (with banks grouped into six categories by size and profitability) indicated that interest-bearing assets were concentrated at short maturities, and longer loan contracts were generally written with interest rates that adjusted frequently, thereby minimizing repricing risk. The portfolios also indicated a low level of exposure to foreign currency risk. As a result, stress-testing scenarios (both uncorrelated and correlated), using interest rate and exchange rate shocks (based on the largest such changes over specified historic periods ranging from 5 to 10 years) indicated that the overall impact of market risk on the banking system overall was quite modest—with a combined impact in the worst case scenario equivalent to about 7½ percent of Tier 1 capital.
The impact of credit risk was much greater, where credit risk was examined under two scenarios: (1) a shift in the portfolio composition toward loans from government securities, and (2) a deterioration in the loan portfolio measured by a two-standard deviation increase in nonperforming loans. The model relies exclusively on macroeconomic variables and handles both market and credit risks in an integrated framework. While the first scenario indicated an impact of about 5½ percent of Tier 1 capital, the second scenario suggested that, for the banking system as a whole, the additional provisioning requirement could be as great as 42 percent of Tier 1 capital. Although credit risk is, therefore, a significantly greater source of risk than market risk, the stress-testing results suggest that neither source of risk would likely compromise the capital soundness of the banking system.
In addition to the FSAP exercise, the IMF’s regular surveillance also attempts to carefully monitor financial sector vulnerabilities, with an increased emphasis in the aftermath of the emerging market crises of the 1990s. As the IMF builds up experience in the broader framework of vulnerability assessments (including macroprudential analysis, early warning systems, and analyses of reserve adequacy and debt sustainability), it has encouraged country authorities to assist in this effort by compiling and publicly disseminating macroprudential information. Indeed, the CEC5 have been among the early subscribers to the IMF’s Special Data Dissemination Standards (although macroprudential indicators are not specifically part of the SODS), including, notably, the detailed template on international reserves and foreign currency liquidity.
Conclusions
The CEC5 countries have made remarkable progress in reshaping their financial sectors: the challenge is to build on this by deepening the legal framework and institutions that underpin financial stability—transparent accounting and auditing, comprehensive supervision, effective bankruptcy mechanisms, and adequate collateral registration and recovery mechanisms. More specifically, in addition to completing restructuring and privatization, the remaining agenda includes:
enhancing the legislative framework and working toward effective implementation, including, in particular, streamlining the procedures for collateral liquidation;
strengthening the independence of supervisory authorities and their legal powers;
implementing effective consolidated supervision, which should forestall any trend to spin off riskier activities to affiliated nonbanks subject to less regulation;
developing supervisory skills relating to cross-border operations of banks—an especially important task in the integrated market;
enhancing the laws and supervision abilities to meet the needs of a more sophisticated market place—including Internet trading and derivatives;
improving risk management practices, especially in the area of market risk management—but also with respect to credit, operational, and systemic risk;
bringing accounting practices, such as asset valuation, in line with international practice: balance sheets should reflect market values as closely as possible; and
ensuring that a financial safety net (such as deposit insurance or lender-of-last resort facilities) is in place, but is limited so as not to engender moral hazard.
With restructuring and privatization virtually finished in some cases, and well under way in others, completing the remaining agenda for financial sector reform would help ensure that the CEC5 approach EU accession with financial systems able to withstand most shocks. Key elements in this progress have been the effort to harmonize legislation with that of the EU, advances in implementing international financial standards, and participation in recent IMF-World Bank initiatives, such as the FSAP and publication of the associated ROSCs. These efforts should lay the basis for more effective monetary transmission, help parry capital account hazards, and avoid future threats to fiscal sustainability. By ensuring a stable financial environment, they are a critical foundation to allow the CEC5 to close their economic gap with the economies of the European Union.
