Financial Markets in Central and Eastern Europe

Stability and Efficiency

Morten Balling, Frank Lierman, Andy Mullineux

• Publisher: Routledge
• Year: 2004
• Topic: Business
• eBook ISBN:
  9781134292707
• Subtopic: Business General
• Index: Business

The countries of Central and Eastern Europe have been through a profound transition process for more than a decade now. The financial sectors and markets in the region have been subject to major structural reforms including privatization, liberalization and the acquisition by foreign banks of controlling interests in local financial institutions. This important new book includes papers that chart this process. Topics discussed include the implications of future EU membership, and the strategies pursued by the World Bank and International Monetary Fund.

1 Financial-sector development as a tool for EU accession

Luigi Passamonti

I am very grateful to SUERF for having invited me to deliver one of the opening addresses of this Colloquium with a reflection on the role of financial-sector development. But the organizers have also saddled me with a task that represents a big intellectual challenge for somebody that does not work in Brussels: to place my reflection in the context of EU accession. I am glad that SUERF pushed me to take this perspective. In making myself familiar with recent EU policy work, I realized how much EU solutions could help realize the full benefits of the reforms the accession countries have started with World Bank and IMF assistance thirteen years ago. I ask for your prior forgiveness if some of my observations regarding EU solutions are off mark.

The transition

Let me start with a quote drawn from a speech at a World Bank conference in 1990 by the Minister of Finance of a transition country:

We ask ourselves how to unfold the whole process of economic transformation, how to sequence it. That is what we consider the most crucial problem. Then, when the transformation process has already started, as it has in my country, we ask ourselves how not to lose the momentum of the reform; how to build and maintain the necessary political and social consensus; how to maintain credibility of the reform policy; how not to cross the tolerance limit of the population; how to break down the old, unproductive, collectivistic social contract – how to transform it, how to rewrite it; and how to minimize the costs of restructuring in terms of growth, employment, inflation and so on.

These thoughts are indicative of the iron determination with which this Minister was looking at the multiple challenges of transition. He identified many problems. He did not have most solutions. He found them as he went along. He knew he would make mistakes. He did make mistakes. He and others corrected these mistakes. His country will join the EU in 2004.

Seven additional countries successfully mastered the challenges of transition over the last decade. Two more, Bulgaria and Romania, are on the last mile to accession. Croatia is waiting to be admitted to the official race.

World Bank assistance

The World Bank has helped these countries cope with the transition with advice and loans in an aggregate value of about $15 billion, of which $2 billion have been used to support financial sector reforms through restructuring and privatization of state-owned banks and capacity building of supervisory authorities. EBRD, IFC and MIGA have also supported the transition with several billions of dollars of financial support to companies and financial institutions.

The World Bank’s most recent activity has been to conduct thorough assessments of the financial systems of all ten accession countries together with the IMF as part of the Financial Sector Assessment Program. The results have helped the authorities fine-tune their reform strategies. They have also been used extensively by the European Commission to inform their assessment of the performance of financial sector intermediation and financial supervisory arrangements as part of their monitoring of countries’ progress towards accession.

Financial sector reform: key to accession process

Without successful financial sector reform, a fundamental criteria for accession – an economy functioning on market principles – would not have been met. This has been a major accomplishment. To establish a proper legal and regulatory framework for financial intermediation activities and, within this framework, to have several hundreds of independent financial institutions mobilize and allocate the nations’ savings in a profitable and sustainable way has been a very significant accomplishment – given initial conditions.

But I doubt it would be productive today to look backwards at what these countries have accomplished, even though the accomplishments are truly highly significant, especially if compared to those of other emerging countries at comparable level of GDP or of institutional development. Probably only Mexico can claim to have accomplished a similar overhaul of its financial system over a decade.

Obstacles to be removed

Much should be said, however, on obstacles that still need to be removed. The level of performance and efficiency of the financial sector is far from EU levels. Eugenio Domingo Solans, a member of the Executive Board of the European Central Bank said recently:

The traditional role of the financial sector in underpinning investment and realizing growth potential through its intermediation and governance functions is still very limited in most EU accession countries.

There is a long list of ‘teething’ problems. Private sector credit has not grown much and remains at a low level relative to GDP. SME lending accounts for less than 30 per cent of total loans, even though SMEs represent more than 60 per cent of employment and value added. Stock market capitalization and other measures of market-based finance (mutual funds, pensions, bonds outstanding) are low compared to international levels. Enforcement of laws and regulations is less predictable and less mindful of possible market impact than in the EU-15.

But I do not think either that it would be productive today to look at the further reforms needed with the transition lens – as if the race was soon going to be over. Transition is already over. EU accession is happening. I propose to change the lens of our assessment.

A post-accession perspective

Citizens of new member countries aspire to income convergence with the EU as quickly as possible. What are the pre-conditions for this process to continue? How long will this take? Do any of the strategies and approaches need to be adjusted to reap the benefits of EU membership more rapidly?

Income convergence will occur through the realization of productivity gains. They will be made possible by a range of improvements in how economic activity is organized, supported by sustained high levels of investment and organizational efficiencies gains. At the end of the day, each working citizen of the new member countries will need to produce a multiple unit of output than at present. Financial leverage will help accelerate the build-up of fixed and intangible assets that are necessary to support higher economic activity. It is estimated that less than 20 per cent of SMEs capital needs are now met by bank credit. External finance (i.e., private sector credit), whose stock today in the region amounts to approximately 40 per cent of GDP, will need to converge towards the EU level which is three-and-a-half times bigger, that is 140 per cent of GDP.

Of course, rapid credit expansion could happen in a few years. But the risk of creating a bubble through inadequate credit screening is high. The piercing of the bubble forces abrupt de-leveraging – that is, credit contraction. In this region, the memories of the rapid credit expansion in Finland and Sweden, followed by a sharp credit and output contraction, are still vivid. In Finland the ratio of private credit to GDP moved from 55 per cent in 1985 to 95 per cent in just five years before settling back in 2000 to the level where it started 15 years before. In Sweden, after topping 140 per cent of GDP in 1993, it fell to 110 per cent in 1995 before resuming its upward trend.

Conversely, sluggish credit growth caused by extra-prudent banks sets back potential progress of society towards a higher level of personal welfare. It would be inappropriate for authorities to give the signal that credit risk underwriting standards need to be relaxed. Banks burdened with non-performing loans create many distortions in the financial system.

Even with a strong regulatory framework and supervisory practices, complemented by effective market discipline and supported by strong bank governance, sustainable credit deepening might be elusive.

Indeed there are intrinsic limits to how much capital domestic banks can effectively recycle in the local economy given the deposits they can mobilize, the returns available, the intermediation costs to be incurred, the risk profile of potential borrowers, the loan portfolio concentration risk and the equity base that shareholders are prepared to allocate to that particular business in the country.

What I am referring to is the issue of the size of the domestic financial system. In all accession countries, the individual size is very small. The biggest market is Poland: but the total assets of its 84 banks amount to US$120 billion – the size of the world’s seventy-ninth largest bank which is the Commonwealth Bank of Australia. The smallest market is Estonia with US$2.6 billion. The overall size of the banking sector of the ten Central and Southern European accession countries is less than 2 per cent of the EU-15 banking sector. The size of the non-bank financial markets (insurance, pension and mutual funds) and of the equities and bond markets is even smaller relative to GDP.

The constraints of small financial systems

Small financial systems have special challenges. They are penalized by reduced network externalities in the payment and settlement infrastructure. Negative economies of scale apply to both this infrastructure and to the supervisory one. There is a higher cost per euro intermediated to support a small financial system than a larger one. And the policy capacity installed might not be sufficient to deal with emergency situations as it would in bigger markets.

Moving now from the system to individual institutions, the latter try to overcome the small size of the former by pursuing economies of scale in their individual operations. Hence, small systems have higher degrees of concentration than larger systems. But even large banks in small systems operate at sub-optimal scale as their overhead ratios are higher, compensated by higher interest margin spreads. This hampers deposit mobilization. The small equity base constrains their risk appetite. Riskier borrowers are rationed out of the lending market. Loan portfolios are more risky because of a lack of sectoral diversification. Small countries use offshore deposit facilities more extensively than large countries, thus shifting liquidity abroad. Growth of non-bank finance and market-based finance is more constrained in small markets than in larger markets.

The future of market-based finance in small financial systems is questionable – other than possibly for the riskiest segment of small companies where local investors could have a role. Capital market infrastructure is already subject to international consolidation. Listings and liquidity migrate to few trading centres.

Benefits and beneficiaries of the EU single financial market

I believe EU accession offers a silver lining to the constraints of sub-scale financial systems and sub-scale financial intermediaries. The EU acquis communautaire is not a burden to be tolerated for the purpose of being admitted to the European club. The acquis communautaire, which is a fastevolving body of financial sector legislation, could become the fulcrum on which to place the lever of a renewed financial sector development strategy for the new member countries.

The preparation for the EU single financial market, pursuant to the Financial Sector Action Plan, is moving at fast pace. And its implementation is not a matter for regulators. It has the attention of European Heads of State and Government. They are committed to complete it by 2005.

The vision of the single financial market is to create a borderless capital pool, mainly destined for wholesale operators. But the benefits of the economies of scale enjoyed by the operators could accrue to retail investors and small and medium-sized enterprises that have a limited range of choice within national boundaries.

I would like to quote a statement from Alexandre Lamfalussy when he submitted the report of his Wise Men Commission to the European Ministers of Finance:

We urge governments and European institutions to ensure that there is an appropriate environment for the development of the supply of risk capital for the growing small and medium-sized companies. We believe that if our recommendations are followed and effectively implemented the primary beneficiaries will be those SMEs.

The benefits of a single market will be greatest to the users of those national markets that are the least integrated and the smallest. These are the new member countries.

In the new member countries, much more than in any other EU-15 country, the solution for credit and financial deepening could be found at the level of the EU single financial market – and not within the boundaries of their small financial markets.

It is thus time to turn our sights away from the local shortfalls and start looking beyond the national boundaries at what the EU single financial market can provide. This should be the new lens of our assessment. And then we should go back and examine what each new member country needs to do in order to take advantage of the EU solutions.

We start from a good base: the new member countries have adopted a legislative and regulatory framework that is EU-compatible. And they have achieved a degree of financial sector integration with the EU-15 that is incomparably deeper than the one existing among EU-15 countries. In the Euro area, according to the EU Commission, less than 5 per cent of bank branches are owned by banks from other EU countries. In the new member countries, the percentage is of the order of 70 per cent, controlled by less than a dozen of international banks. In the Czech Republic, Hungary and Poland, the scale of cross-border financial intermediation is, in addition, already quite significant: it represents about 30 per cent of domestic private sector credit intermediation.

The benefits of the single financial market for the new member countries

What will the single financial market allow new member states to achieve? It will foster competition. And it will multiply the options for the provision of financial services. The multi-country presence of foreign investors in the region, combined with their leading position in their home markets, creates a connectivity tissue between the single financial market and the local markets for the benefit of local users – be they companies or individuals.

Local companies will have the option to borrow either from locallylicensed banks or from foreign branches or even from non-resident banks, which will be allowed to sell their services at a distance with a comparable degree of consumer protection.

But the biggest benefit for the new member countries, in my opinion, lies in the access for its residents – companies and individuals – to equity and bond investors and the associated institutional investor industry of the single financial market.

Let me give you some figures: Euro-zone investors hold un-intermediated financial assets worth about €25 trillion, of which €16 trillion are equities. As a comparison, the overall private sector credit of new member countries is €120 billion – a mere 0.5 per cent of the euro-zone asset base. A marginal reallocation of the euro-zone investors asset mix over the medium-term would provide the wherewithal for accelerated economic convergence of the new member countries. These are investors that are used to taking calculated risks as they operate in a very competitive market.

Is this just a dream? Yes, today. But it may become reality over the medium-term. With a single prospectus based on common accounting and disclosure standards and a rapidly converging securities market infrastructure, companies of new member countries will be connected to the diverse universe of investors across the single financial market that have a keener risk appetite and much stronger risk absorption capacity than domestic investors.

The credit risk underwriting considerations for a unit of credit risk in a domestic banking market, like Estonia, where three large banks control 91 per cent of the market with a combined €350 million capital base, are necessarily more restrictive than those applied, to same unit of credit risk, by a large group of investors each with total investable funds in the range of several hundreds of billion euro, even after taking into account the advantages of proximity for credit screening purposes of the domestic banks. The risk tolerance of large investors is bigger than those of small investors for a given unit of risk.

Also, securitization techniques allow the reduction of the risk profile of the unit of credit risk by creating a more diversified loan portfolio on the basis of post-credit approval performance information that the one that can be built ex ante on a piece-meal basis by any single bank.

Lastly, within the EU single financial market expanded to ten new member countries, intermediaries will be able to further lower the risk profile by assembling multi-country composite loan portfolios with even smaller credit risk co-variances.

Thus, it may not be far-fetched to think that the solution to SMEs’ term borrowing needs in new member countries can be searched in the single financial market. I will speak later of the obstacles to be removed.

Moving now to the investing side, the mutual funds and pension directives will enable local residents, be they companies or individuals, to take advantage of the expertise, economies of scale and risk diversification offered by an industry operating at a global level. The advantage will be faster asset accumulation or lower pension contributions.

How to unlock the benefits? Considerations and obstacles

The benefits of the single financial market for new member countries could be very significant. How to unlock them? There are two background considerations. First, the pre-accession work focused on the adoption of legal and regulatory practices that are largely independent from the broad reform agenda represented by the fast-moving Financial Sector Action Plan. They reflect predominantly stability considerations. The main recipients are authorities. Second, the Action Plan has conversely a strong development orientation. It involves defining an architecture within which market forces will operate. The main beneficiaries are market participants and users.

And there are two sets of obstacles for the new member countries to reap the benefits of the single market. A first set of obstacles relates to the quality of enforcement of regulatory decisions pursuant to the acquis provisions. Lack of a consistent track record in enforcement will influence perceptions of market participants in this respect. Regular monitoring and continuous peer review assistance by the EU-15 will help bridge this perception and reality gap, if national authorities deepen their commitment to strengthening their capacity in this area after accession.

But, and perhaps more imp...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Contributors
• Acknowledgements
• Abbreviations
• Introduction
• 1 Financial-sector development as a tool for EU accession
• 2 Factors influencing the financial system stability-oriented policies of a small country soon to become an EU Member
• 3 The role of central banks in promoting financial stability
• 4 Banking sector development and economic growth in transition countries
• 5 Financial-sector macro-efficiency
• 6 Financial-sector efficiency
• 7 Challenging the prudential supervisor – liability versus (regulatory) immunity
• 8 Reforms enhancing the efficiency of the financial sector and the implications of future EU membership
• 9 The effect of foreign bank entry on domestic banks in Central and Eastern Europe
• 10 Are foreign banks in Central and Eastern Europe more efficient than domestic banks?
• 11 The efficiency of banking systems in CEE
• 12 The internationalization of Estonian banks
• 13 An early-warning model for currency crises in Central and Eastern Europe
• 14 Institutional vulnerability indicators for currency crises in Central and Eastern European countries
• 15 Financial stability and the design of monetary policy