Excerpts from “Strategies for Economic Transformation in Eastern Europe: The Role of Financial Market Reform”

by Lawrence J.
Brainard

Senior Vice President,
Bankers Trust

Growth is central to the
political legitimacy of the reform
efforts [in Eastern Europe]….The
creation of a real market for capital,
where resources are allocated
efficiently, is an essential component of
the economic transformation….[Reform of
the banking system] is central to efforts
to improve the efficiency of resource
use.

***

Enterprise restructuring,
privatization and banking reform must go
forward together….Firms will
not face effective financial disciplines
until the banking system can refuse to
provide additional credit to given
borrowers….The success of
privatization and financial disciplines
for state firms, therefore, is tied to
the creation of banks that are capable of
exercising independent credit judgments.
This is not going to happen unless banks
are forced to protect their own
capital position against credit losses.
Banks cannot defend their own capital
until their existing balance sheets are
cleaned up….

***

Unless the existing banks [in
Eastern Europe] are restructured, the new
Western resources going into the country
will likely be misused, thus
perpetuating the power of the nomenklatura
and the influence of the existing
economic structure over resource
allocation.

***

Many reforms have been launched in
Eastern Europe over the past decade; most
have failed….Economic stabilization
efforts over the past decade in
Yugoslavia, Poland, and Hungary have not
led to a recovery of economic
growth….Serious structural imbalances
in these countries today are lodged in
their banks, which have been the
repository of decades of accumulated
losses of state-owned firms. Socialist
banks are engaged in a misallocation of
resources of massive
proportions….Neither the banks nor the
government(s) have been willing to push
companies into bankruptcy….Questionable
accounting and supervisory practices have
also helped obscure…hidden losses.

***

There are two key reasons why banking
reforms are essential to strategies of
economic transformation in Eastern
Europe. One is that privatization
cannot succeed without a functioning
capital market. And a
capital market cannot be created unless a
thorough reform of the banking system is
enacted.…There are two
distinct aspects to banking reform. Banks
must not be allowed to continue making
bad loans; enterprise restructuring
through privatization and moving
loss-making firms into bankruptcy and
tighter prudential supervision on the
banks’ loan portfolios are essential
steps here. But reforms must go
beyond such measures. For banks to make a
positive contribution to the efficient
allocation of capital resources, it
will be necessary to clean up the banks’
balance sheets by writing off troubled
loans and injecting new capital.

***

[The new state-owned
commercial banks in Eastern Europe]
cannot play a role in any way similar to
the role played by sound banking
institutions active in Western capital
markets. They do not have their
own capital resources. If their loan
assets were marked to realistic values,
the banks would show negative net
worth….The banks have limited leverage
over their borrowers….The
existing banking structure, therefore, is
acting as a fiscal “black
hole,” misallocating loan capital to
cover the losses of the state-owned
enterprises….A substantial
volume of losses is also carried on the
balance sheets of the central banks for
foreign trade banks of these countries.
These losses have resulted from periodic
currency devaluations….The balance
sheet losses from devaluations carried by
central banks are staggering.

***

Attempts to improve financial sector
performance have been included in all
Eastern European country programs of the
IMF and World Bank in recent
years…[with] meager results….The
stock answer in every proposal to reform
Eastern Europe’s financial markets has
always been the same — to increase the
financial disciplines in the system. Such
efforts have so far failed to produce
acceptable results because none
of these reform efforts has yet addressed
the balance sheet losses which lie at the
heart of the problem. Banks and
governments have been unwilling to push
firms into bankruptcy — the banks fear
the financial impact on their balance
sheets and the governments fear the
unemployment consequences. As a result,
firms have never had to pay the ultimate
price for their misdeeds.

The only effective way to
implement financial discipline is to go
beyond the current measures, which focus
on subsidies and credit flows, to clean
up the balance sheets of enterprises and
banks….The issue for
policy makers is how to allocate such
losses among the workers, the creditors,
and the government’s budget. For
enterprises, the mechanisms for
sanitizing balance sheets include
bankruptcy, rehabilitation and/or
privatization….Cleaning up the
balance sheets of the banks [should be
done by restructuring]….The best way to
do this is to recapitalize the banks by
first lifting the bad loans out of their
portfolios and then to provide a
mechanism for injecting new capital.

***

Although the extensive financial
support offered by the Federal Republic
makes the GDR a special case, their
efforts to create a functioning capital
market virtually overnight have
highlighted problems that are relevant to
reform efforts in other Eastern European
countries….[For example,] no
institutional structure is available to
manage the “work-out” of these
[bad] loans; the new joint venture banks
have no direct interest in pressing for
the repayment of the loans. There
is, thus, a strong incentive for good GDR
enterprises to default on their loans,
given a general expectation that West
Germany will pick up the tab for the
losses on the debt….

The GDR experience also serves to
highlight the considerable economic risks
that Western banks opening new branches
or subsidiaries in Eastern Europe are
likely to encounter in any domestic
lending activity during the transition to
market-based economies….Financial
market restructuring in Eastern Europe
could be viewed as a necessary
precondition for the successful and rapid
transfer of western capital into
commercial banking in these economies.

1. The
original draft of this essay was awarded
First Prize by The AMEX Bank Review
under the title Reform in
Eastern Europe: Creating a Capital Market.
Emphasis added throughout.