FINANCIAL SECTORS in TRANSITION

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FINANCIAL SECTORS in TRANSITION

• COURSE on the Economics of Transition
• May 15, 2009
• Matej Marinc

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SUGGESTED LITERATURE

• Berglof, E. and Bolton, P. (2002), The Great
  Divide and Beyond Financial Architecture in
  Transition, Journal of Economics Perspectives,
  Vol. 16. No.1.
• Fries, S. and Taci, A. (2001), Banking Reform and
  Development in Transition Economies, UNCE/EBRD
  Expert Meeting, Geneva
• Caviglia G., Krause, G. and Thimann C., Key
  features of the financial sector in EU Accession
  Countries, ECB, 2002
• EBRD Transition Report 2005, 2006

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WHY FINANCE MATTERS FOR GROWTH?

• Financial system allows the firms to raise
  capital from the outside, at lower costs more
  savings challenged to investments at lower costs
  with developed financial markets
• Outside financing (through capital markets or
  debt) improves the efficiency of resource
  allocation (investments) and firms management
  (corporate governance)
• Banks as corporate monitors
• Financial development might stimulate households
  savings
• Capital markets and banking sector

Levine, Zervos (1998) stock market liquidity
and banking development are both positively and
robustly correlated with contemporaneous and
future rates of economic growth..the findings
also suggest that banks provide different
financial services from those provided by stock
markets.
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FINANCIAL SYSTEMS PRIOR TO TRANSITION
Mono-bank system under the influence of planning
bureaux No capital markets
Bank restructuring and privatization Two-tier
structure of the banking system Entrance of
foreign and newly created banks higher
competition Setting up of the money markets, bond
and money markets
High growth potential!
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EVOLUTION OF THE BANKING SECTOR

• Bank restructuring and privatisation
• Washington consensus separation of
  commercial banks from central banks, abolition of
  restrictions on internal convertibility of money,
  liberalisation of interest rates, restructuring
  and privatisation of banks and their borrowers,
  entry of new private banks, development of
  prudential supervision and regulation

• Economic growth and progress in institutional and
  structural reforms (enterprise restructuring,
  bankruptcy procedures, corporate governance)
  crucial for the development of the banking sector
  (Fries and Taci, 2001)

EBRD Index of Enterprise Reform Index of Private
Bank Share in Total Assets EBRD Index of Banking
Reform
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BERGLOF AND BOLTON (2002) THE GREAT DIVIDE

• Common first steps but later on a Great Divide
  in financial development
• the ability of governments to enforce contracts
  and to achieve fiscal and monetary
  responsibility, together with the commitment to
  refrain from excessively bailing out failing
  banks or loss-making enterprises, determined
  whether economic and financial development took
  off
• Weak evidence (if any) of a link between
  financial development and growth
• -microeconomic restructuring mostly based on
  internal funds
• - INSTITUTIONS QUALITY (ENFORCEMENT!) MATTERS!!!

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BERGLOF AND BOLTON (2002) THE GREAT DIVIDE

• Difference in policies but similar results in the
  countries above the divide
• emergence of bank-based financial systems, high
  concentration, foreign banks entrance, growth of
  bank loans slower than real sector growth
• Three main features of the financial sectors in
  the transition countries
• I - bank dominated financial sectors, (still)
  limited lending to private sector
• II - strong concentration of ownership of firms
  and banks limited role of stock markets
  relatively high (still) bank spreads
• III strong foreign presence

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KEY FEATURES of banking sectors in transition
countriesI. low level (still) of financial
intermediation, large scope for
improvementsII. high concentration of the
banking sectorIII. foreign banks entry
(except for CIS, Slovenia) focusing on household
loans some initial development of domestic
financial sector needed
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I LOW LEVEL OF FINANCIAL INTERMEDIATION

• macroeconomic downturn
• microeconomic factors
• institutional environment

Low level of financial intermediation in general
(except Cyprus and Malta) Banking assets/GDP
well below the EU average Domestic credit/GDP
and deposits/GDP at one third of EU
average Relatively high spreads (in some
countries) low efficiency of the banking
sector
Problems of corporate financing, especially SMEs!
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I LOW LEVEL OF FINANCIAL INTERMEDIATIONHow
easy it is to obtain finance?
FINANCIALLY CONSTRAINED FIRMS (EBRD,2006 See
also table 3.4 on p.48)
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BORROWING FROM BANKS(firms in AC-10)
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SIZE OF THE FINANCIAL SECTOR (Brezigar et
al.,2006)
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BANKING SECTOR SIZE Brezigar et al. (2006)
Figure 2 Evolution of domestic credit as of
GDP in EU 15, CEE countries and other transition
countries, 1995 - 2005 (simple averages)
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BANKING SECTOR SIZE Brezigar et al. (2006)
Figure 3 Evolution of private credit as of GDP
in EU 15, CEE countries and other transition
countries, 1995 - 2005 (simple averages)
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CHARACTERISTICS OF FINANCIAL SECTOR (EBRD, 2006)

• STILL UNDERDEVELOPED (diversity across countries
  in relation to the importance of capital
  markets/banks)
• Substantial increases in the banking reforms and
  private sector credit in CEB countries in
  2000-2005 and SEE (BUT stagnating in the CIS
  countries)
• Increases of loans higher for households than for
  enterprises (31,5 and 52,2 percent of total
  domestic credit in CEB and SEE goes to
  households) lower improvements in mortgage loans
  and lending to enterprises (property rights!
  credit risk)
• The level of financial development still lower
  than expected INSTITUTIONAL FACTORS creditor
  rights protection, courts functioning,
  improving the recovery of default loans)
• see Chart 3.1, p. 48. and table by Cotarelli et
  al., (2003)
• FINANCE affects growth (Chart 3.3) and improves
  firm efficiency and growth

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Brezigar et al. (2006)

• Cotarelli et al. (2003) not simply a reflection
  of lower incomes per capita depth of financial
  market is well below the equilibrium!

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BANKING SECTOR IN TRANSITION (EBRD, 2006)

• BANKING ENVIRONMENT AND PERFORMANCE SURVEY
• (200 banks, 20 countries)
• Increased foreign banks presence (foreign bank
  assets in 2005 70 in most CEB and SEE
  countries) has been proved that foreign bank
  ownership increases the stability and efficiency
  of the banking sector in transition (be aware of
  the large-scale and foreign-bank effect on SMES
  loans)
• High concentration of the banking sector
• Satisfactory and above EU average profitability
  (see Chart 4.2, p. 60)
• Decline in non-performing loans in CEE and SEE
  (Chart 4.2)
• No strong influence of ownership on bank
  performance newly-established foreign banks
  however have lower cost-to-assets-ratios
• Higher net interest margins of smaller banks
  (SMEs, risks, higher cost of financing, higher
  commissions)

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SPREAD BETWEEN LENDING AND DEPOSIT RATES in
(AC-10)
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SPREAD BETWEEN LENDING AND DEPOSIT RATES in
(AC-10)
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BANKING SECTOR IN TRANSITION (EBRD, 2006)

• BANKING ENVIRONMENT AND PERFORMANCE SURVEY
• (200 banks, 20 countries)
• Institutional environment (protection of banks
  through legislation and court functioning,
  regulation and bank supervision) affects banks
  cost-efficiency but not performance
• The growth in lending the strongest in
  newly-established foreign banks and the weakest
  in state-owned banks (technology, knowledge,
  etc.) these banks have managed to grow without
  deterioration in loan quality (note this may be
  a problem in smaller banks!)
• Foreign banks lend a higher proportion of their
  loans portfolio to the households large banks
  lend less than small banks to SMEs state-owned
  banks are more likely to lend to state-owned
  enterprises
• Improved institutional environment increases bank
  lending to the SMEs
• Banks have started diversifying their activities

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NON PERFORMING LOANS as of TOTAL LOANS (AC-10)
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OWNERSHIP MATTERS?
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SIZE MATTERS?
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WHAT DETERMINES THE GROWH OF THE BANKING SECTOR?

• Fries and Taci (2001), analyzing real growth in
  consumer loans in high reform countries
• Increases with real GDP growth but at a slower
  degree
• Effect of governmental deficit (crowding out)
  insignificant
• Increase in lending is weaker in larger banks
  (weak significance)
• Market shares results in higher profitability but
  not in higher loan growth
• Banks with higher capitalization have higher loan
  growth
• Newly founded private banks expand their loans
  less rapidly then privatized banks state-owned
  banks in between
• Foreign-owned banks do not expand their loans
  quicker than privatized of newly formed banks
  (information asymmetry, especially for SMEs) BUT
  they are more profitable and cost-efficient
• Only majority foreign ownership matters in
  low-reform countries

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KEY FEATURES of banking sectors in transition
countriesI. low level (still) of financial
intermediation, large scope for
improvementsII. high concentration of the
banking sectorIII. foreign banks entry
(expect for CIS, Slovenia) focusing on household
loans some initial development of domestic
financial sector needed
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II- CONCENTRATION OF THE BANKING SECTOR Share of
5 largest banks in total bank assets
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KEY FEATURES of banking sectors in transition
countriesI. low level (still) of financial
intermediation, large scope for
improvementsII. high concentration of the
banking sectorIII. foreign banks entry
(expect for CIS, Slovenia) focusing on household
loans some initial development of domestic
financial sector needed
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III FOREIGN ENTRY assets of foreign banks vs.
all bank assets (new members)
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BANK OWNERSHIP (new members)
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BANK OWNERSHIP
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BANK DOMINANCE..WHAT ABOUT THE STOCK MARKETS
(plot of 2001)?
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KEY FEATURES of the capital markets
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BOND MARKETS

• Limited role due to low levels of government
  securities and prudent fiscal policies in the
  accession countries
• Lack of liquid secondary bond markets except for
  Czech Republic, Hungary and Poland
• Short-term and foreign currency dominated bonds
• Limited corporate bond issues

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STOCK MARKETS

• WHY DO WE NEED STOCK MARKETS?
• they provide the companies with ways to raise
  capital at lower costs
• less dependence on banking sources lower risk
  of credit crunch
• increased monitoring over firms management
  better corporate governance better investment
  decisions better growth!
• overall, a mix of bank-intermediated funds and
  stock markets can enhance growth (Demirguc-Kunt,
  Maksimovic, 1998).

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STOCK MARKETS MAIN FEATURES

• Low market capitalisation in absolute terms (2
  of EU in new entrants) and relative terms (16 of
  GDP on average)
• Low liquidity, turnover mostly generated by a
  small number or largest firms
• Development and role of capital markets varies
  according to the chosen privatization strategy
  and institutional development

Mass privatization and consequent de-listing
firms not appropriate for listing
Costly equity relatively to debt
tax reasons
disclosure requirements
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TYPE OF PRIVATIZATION
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MAIN FEATURES cont.

• Stock markets initially mostly designed to
  facilitate a RAPID OWNERSHIP TRANSFORMATION ?
  takeovers and increasing ownership concentration
  further reduced market capitalization and stock
  liquidity (see Berglof and Pajuste, 2004)
• A large percentage of companies were of small
  size and, with high ownership concentration, not
  suited for listing
• FUNDAMENTALS MATTER (macroeconomy, rule and
  enforcement, accounting rules, disclosure
  requirements)
• Lack of enforcement and proper securities
  regulation
• Poor corporate governance
• Reluctance to disclosure and transparency
• ? LACK OF PUBLIC/INVESTOR TRUST IN CAPITAL
  MARKETS
• ? LISTING DOMESTICALLY OR LISTING ABROAD?

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Brezigar et al. (2006)
Figure 1 Evolution of market capitalization as
of GDP in EU15, CEE countries and other
transition countries, 1995 - 2005 (simple
averages)
Note CEE countries Bulgaria, Czech Republic,
Estonia, Hungary, Latvia, Lithiania, Poland,
Romania, Slovak Republic, Slovenia Other
transition Russian Federation, Croatia, Bosnia
and Herzegovina, Macedonia and Serbia and
Montenegro
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Market turnover as percentage of GDP (end of 2000)
Germany 167 Portugal 127
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Percentage of market turnover accounted for by
the top 5 of listed firms
UK 88, Germany 82 but larger number of firms
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Limited free float
Lack of supervision and enforcement
International migration Of trading among large
firms
Ownership concentration
Limited turnover
Off-exchange trading
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Percentage of domestic market capitalisation
listed abroad
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Assets held by Institutional Investors in
Transition Economies, 2000
UK 250 USA 262 Germany 73 Pension system
reforms
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WHO OWNS SHARES ON THE STOCK EXCHANGE (FESE)?
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WHO OWNS SHARES ON THE STOCK EXCHANGE (FESE)?
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WHO OWNS SHARES ON THE STOCK EXCHANGE (FESE)?
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DETERMINANTS OF THE CAPITAL MARKETS DEVELOPMENT

Private credit/GPD creditors rights
Listing abroad (1/3 of domestic cap. in Estonia,
Hungary, Latvia, Slovak republic)
Macroeconomic environment (inflation), legal
framework real stock deposit returns
Claessens and others 2000
Progress in the privatization process (IPO-type
origin in particular)
Corporate governance and investors protection,
enforcement in particular (Hungary, Poland,
Estonia)
Foreign investments, creation of shareholders
culture, firm profitability
Institutional investors investment funds, mutual
funds, pension funds
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MORE ON DETERMINANTS (Caviglia et al., 2002)
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WHERE IS THE POTENTIAL?

• Privatization of state-owned firms
• - Percent of private sector share in GDP
  (EBRD Transition Report,
• 2005)
• Slovenia 65 Croatia 60 Poland 75 (see
  Table 1.1., p.4)
• Creating supply of funds pension reforms,
  stimulation of the foreign institutional
  investors entrance
• INSTITUTIONAL ENVIRONMENT AND ENFORCEMENT OF
  INVESTORS PROTECTION CRUCIAL!
• - protection of minority rights
• - disclosure of companies activities
• - proper accounting rules and practices
• - CREDITORS RIGHTS!
• - phasing out restrictions on foreign direct
  investments!