Banking and Monetary Policy in Eastern Europe

Ten years ago, when the transition process in Central and Eastern Europe started, almost nowhere were the differences between the systems and the East–West divide manifested more starkly than in the financial sector. Whereas in market economies the financial sector plays a key role in the coordination of economic activities, central banks and stateowned commercial banks in Central and Eastern Europe had been merely responsible for passively accommodating and monitoring the payment flows between enterprises, as dictated by the central planners. In no way was the financial system actively involved in allocating resources to maximise the efficiency of their use. The task facing the transition economies was thus ‘to create a functioning financial system where none had existed before’ (EBRD 1998, p. 92).

Financial sector development in Central and Eastern Europe has proved to be a very dramatic process characterized by some well-trumpeted success stories, but even more so by many unexpected collapses of seemingly decent institutions and some systemic meltdown as well. The overall record of transition in the area of financial sector development is much less impressive than achievements in macroeconomic stabilization, economic liberalization and privatization of formerly state-owned enterprises. There are several reasons for this. Among others I would highlight the specific complexities of the financial business and the intense political as well as emotional sensitiveness attached to any major move in this area. Influential stakeholders such as politicians, government officials, business and media people tend to overestimate the real value of particular institutions and at the same time overemphasize their importance to the national economy. In the absence of strong external and internal governance structures managers and at times also owners of banks, brokerages and insurance companies abuse this situation to increase their own influence and perceived importance. The story and history of financial sector development in most countries of Central and Eastern Europe in the first decade of transition ending 1999, therefore, has been an uphill struggle to restore reliable channels and prudent practices of financial intermediation – to create a new culture of trust and confidence against all odds of a dire legacy sometimes characterized by crime and corruption, cronyism and collusion.

Banking reform in transition economies has been discussed controversially for the past decade and is likely to be a crucial policy issue for at least the next decade to come. Whereas some of the advanced reform countries have made substantial headway with regard to banking reform, some countries still have a long way to go. The recent currency crisis in Russia, for instance, has rendered almost the entire banking sector insolvent and has burdened policymakers with the task of creating an efficient financial system from scratch. The relevant policy issues are numerous: the problem of non-performing loans on the balance sheets of commercial banks has to be dealt with, the macroeconomic implications of banking reform need to be considered, an appropriate regulatory framework needs to be chosen and enforced, and the optimal sequence of internal and external financial liberalization must be selected. Eventually, reforms must solve the complicated issue of how to establish proper incentive, i.e. corporate governance mechanisms, in the banks and how to ensure an efficient intermediation between savers and investors.

Kreditanstalt fur Wiederaufbau (KfW), the German ‘Reconstruction Loan Corporation’ as the original name read, primarily conducts credit activities aimed at promoting the German economy: infrastructure financing, export and project finance, small and medium-sized enterprise financing as a second-tier institution, refinancing of venture capital companies, and many other operations. Another section works for the promotion of developing and transforming economies, mostly as an implementing agency for the German Federal Government within the framework of official German Financial Cooperation, but also as an agent of the European Commission or of other individual countries. Here KfW finances projects in various economic sectors, such as energy, water supply, health, infrastructure and others. Another important field of activity is the promotion of efficient and stable financial sectors. At present, financial sector support accounts on average for roughly 10 per cent of KfW’s annual commitments.

Financial vulnerability became a much-studied topic in recent years. The Mexican crisis of 1994–5 reinvigorated interest in developing country capital market crises, and the 1997 events in East Asia widened the range of possible causes and mechanisms. The Russian crisis of 1998 brought the issue especially close to the transition countries in Central and Eastern Europe, where exchange rate, banking and stock market upheavals have been quite frequent. Countries with a view towards joining the Economic and Monetary Union (EMU) must regard vulnerability to crises as one of their most important concerns, since preconditions of candidature explicitly require that violent movements in certain financial variables, such as exchange and interest rates, do not occur.

The first decade of post-socialist transformation in Poland, i.e. the 1990s, proved to be a remarkable success. In ten years Poland switched from the chaos of the late 1980s to an economic system rapidly converging towards European Union standards. Political and institutional changes not only allowed for a quick economic recovery and enduring growth, but also led to the opening of accession negotiations with the EU in the spring of 1998.

Interest in the macroeconomics of financial sector problems has greatly increased since the Mexican and Asian crises in the second half of the 1990s. While there were certainly financial and banking crises reaching macroeconomic proportions before these episodes – for example, in the Nordic countries in the early 1990s – it is fair to say that these were generally not seen as a genuine complicating or contributing factor to macroeconomic imbalances. This state of affairs, however, has changed drastically since, even to the point that accepted journalistic wisdom mentions the importance of the financial sector in – depending on which newspaper or magazine one happens to read – emphasizing, accelerating, or even triggering macroeconomic problems.

After the euro had been launched successfully, the European Central Bank (ECB) and the accession countries began to discuss the processes which would lead to Economic and Monetary Union (EMU) membership of these countries. It is not surprising that at this stage the Helsinki Seminar which brought together central bankers from accession countries and from the ECB on 12 November 1999, has led to rather general conclusions.

This chapter deals with experience gathered in introducing the idea of ‘New Development Finance’ to the countries of transition in Central and Eastern Europe. In particular, the goal is to improve the access of micro and small enterprises, small farmers and other comparatively weak economic units – the so-called target groups – to credit, deposit facilities and payment services.

The first decade of transition has seen tremendous changes in Eastern European economies. While in the first decade the focus of politicians was primarily on privatizing firms and setting up institutions necessary for a market economy, the focus of the second decade will need to be on developing the financial sector and making the financial institutions work. In this chapter we look more closely at the banking sector in Eastern Europe and we discuss three main questions. Below, we ask what the banking sector should look like; in particular, how competitive we would wish the banking sector to be. Next, we investigate how the initial conditions and the reforms strategies chosen in different countries have shaped the banking sector in Eastern Europe. We then contrast this picture of the banking sector as it is today with the desired market structure discussed below. Finally, we discuss what needs to be done in order to achieve the banking sector as we would like to see it.