The initial shock of transition and the emergence of the bad loan problem
Category: Bank Management
In the SU, production and exchange of goods and services had been organized through a network of branch ministries, banks, informal contacts between firms and some “pseudo markets”. While this system had been very inefficient, it had at least assured a minimum co-ordination between firms. When the Soviet Union and COMECON were dissolved and markets were liberalized, these networks were destroyed virtually over night. Many firms lost their network of trading partners, especially those that were doing most of their trade with COMECON states. Countries created their own currencies which increased the transaction costs associated with trade. Firms in many republics of the SU had been dependent on highly subsidized inputs from Russia, such as oil and gas. Now, these inputs had to be paid at world market prices. Liberalization exposed firms to outside competition, and the demand for domestic goods was crowded out by this competition. In one word, it became obvious that most firms could not survive the shock of transition without support.
Given this situation, governments were facing a dilemma. On the one hand, they had to stabilize their budget, on the other hand, they could not simply leave firms to their own devices. Otherwise, a wave of bankruptcies and massive social unrest would have been the consequence. Hence, they reduced subsidization, but did not cut it completely. In this situation the bad loan problem appeared, which has since then been paralysing the banking sector. In order to understand this problem it is first necessary to describe how the banking sector in the CIS changed in the beginning of transition.
Three types of banks emerged in this initial phase of transition: first, spin-offs of state banks; second, so-called pocket banks, i.e. banks that were founded by industrial firms; third, newly founded commercial banks. The first group of banks inherited offices, facilities and staff from state banks. These banks were corporatized as joint stock companies, and the capital was distributed among SOE’s that had been served by the regional branches of specialized banks. The second group of banks was often not much more than a finance department of an industrial firm, founded in order to assure the financial needs of the respective firm, i.e. to make sure that the firm received its “piece of the cake” of state subsidies. These banks were controlled by the managers of the respective SOE. The third group started from scratch. However, since the founders of these banks were often so-called “new commercial structures” that had acquired some wealth (see the subsection on privatization), they often had the financial means to raise their businesses fast.
Subsidies were provided by the respective Central Banks of the countries. All three types of banks were engaging in intensive lobbying activities in order to receive these credits. Given the general recession and the fall of the savings rate (due to inflation), banks found it very difficult to attract funds on the market. Lobbying for centralized credits hence seemed to be less difficult than to compete on the market for funds. It should however be noticed that newly founded banks are less prone to lobby for subsidized loans and appear to be more active on the free market, a fact that will be discussed in 2.4.
Let us now come back to the bad loan problem. The following factors explain its emergence:
1. Since the government wanted subsidies to be allocated quickly in order to assure survival of firms, banks could not take their time to check the credit-worthiness of applicants.
2. Even if banks could take their time, bank staff simply did not have the skills to evaluate credit risks.
3. The dramatic changes in the economic environment altered the relative profitability of different businesses.
4. By intervention of the government credits often had to be allocated according to political interests of the government and not according to expected pay-off and risk.
Besides the bad loan problem, there is a second inefficiency due to the initial phase of transition: corruption. Bankers, managers and bureaucrats of branch ministries faced a high degree of uncertainty in regard to their future. Nobody knew how stabilization efforts, liberalization and competition policy, institution building and privatization would work out. Real interest rates had a large volatility and no one would take the risk for long term lending; there was a high risk that credits would not be paid back, and government was intervening even in day-to-day business of the banks. Consequently, bankers had the choice between waiting for the things to come, or trying to benefit from the chaotic situation. Many of them chose the second option. Bankers, managers and bureaucrats were teaming up in order to benefit from the situation. Semi-private corporations were founded, and much money was transferred from the bank accounts of SOE’s (or from the pocket banks) to these corporations, and often transferred to foreign bank accounts. This capital flight had (and still has) disastrous consequences for the economy as a whole.
These “end games” are not specific for the former Soviet Union, but have also taken place in, for instance, the Visegrad countries. The main difference is, however, that this situation endured for a rather long time, due to the general political unstability, and even today the banking sector and the economy as a whole suffer from the consequences of this early phase.