Banking Reform in Central Europe and the Former Soviet Union by Jacek Rostowski

CHAPTER 1 
INTRODU CTION 
Jacek &stowski 
Across the great land mass from Brandenburg to the Bering Straits 
the business of banking is reviving, as market economies are 
established. A process that took hundreds of years in Western
Europe and decades in Japan is being telescoped into a few years in 
Central and Eastern Europe and the Former Soviet Union (FSU). 
The policy issues are of exceptional importance, as decisions made 
now will shape the financial systems of the region for decades to 
come. The developments also give researchers a unique opportunity 
to engage in comparative analysis, as the various countries have 
approached the building of their banking systems in very different 
ways. 
At the beginning of the transformation process, the 'first wave' of 
Central European reformers looked to the West for a model of how 
to transform their state-controlled monobanking systems so as to 
make them suitable for a market economy. The reform of the Central 
European banking systems, though far from complete, is now 
sufficiently far advanced for lessons to be drawn from the - quite 
different - experience of the three countries concerned. These 
conclusions are important for the 'second wave' reformers in the FSU 
and the Balkans. For this reason, the book starts with five thematic 
chapters which analyse the Central European experience. These are 
followed by five chapters reviewing the experience of banking reform 
so far in some of the 'second wave' countries (Estonia, Georgia, 
Romania, Russia and Ukraine), and considering what the implications 
of the Central European experience are for each country.

I. Deficit balance sheets: causes and systemic solutions
Bad loans plague banks in all the countries in the region that have
undergone macroeconomic stabilization. As a result, given implicit
deposit insurance, bad loans plague the governments and taxpayers 
of these countries. Rostowski (Chapter 2) traces this to the fact that 
under communism loans were not allocated on a commercial basis. 
Thus, it is hardly surprising that in the new commercial environment 
many of them should turn out to be unrecoverable. Furthermore, 
bank staff, having had no experience in allocating loans 
commercially, will continue to misallocate credit for a significant 
period after hard budget constraints have been imposed on state-

owned enterprises (SOEs). Such misallocation of credit also occurred 
in Poland in 1989 and in Russia in 1990-4, where some loans were 
notionally allocated on a market basis, but real interest rates were so 
massively negative, due to very high inflation, that only the most 
incompetent borrower could fail to repay his debt at maturity. 
Banking skills and bank supervisory skills of necessity take a long 
time to acquire, yet if the threat to the stability of the financial system 
from bad loans is to be avoided, then these skills need to be learned 
instantaneously upon the transformation of the old communist 
monobank into a two-tier banking system or upon stabilization. This
is the paradox of the 'jump from bad credit to good credit', which 
the process of banking reform that has recently been followed in 
Central Europe seems to require. 
A number of 'systemic' solutions designed to prevent the bad debt 
problem from appearing in the early transition period have been 
proposed. They all involve major departures from the usual process. 
One is the complete wiping out of bank debt at the beginning of the 
transition (Begg and Portes 1991). However, this is a partial solution 
as it deals only with the stock of bad debt inherited from the previous 
system, and does not help to avoid new bad debt which builds up 
rapidly as banks start allocating credit on a commercial basis for the 
first time in a highly unstable macroeconomic and microeconomic 
environment.

Banking Reform in Central Europe and the Former Soviet Union by Jacek Rostowski