centraleuropeanuniversity
department of economics
MONEY, BANKING AND FINANCE
Feasibility of the German-type model of Universal Banks in the Post-Communist Economies. The Case of Russia
Professor: Jacek Rostowski
Prepared by:
Asenka Asenova
MA in Economics, 1styear
ID# 161801
Spring Semester, 2006,
Budapest
Pages of Contents
Introduction
I.The German-type model of universal banks
1.Key characteristics
2.The German model and economic growth
II.Feasibility of the German model in the post-communist economies in the early years of transition
III.Feasibility of the German model in the later stages of transition
IV.The case of Russia
1.General overview of the Russian banking sector
2.Empirical evidence for the bank-enterprise relationships
Conclusions
Appendices List
Appendix no 1: Indices of real credit and real GDP in Russia, 1992-1995
Appendix no 2: Credit and non-performing loans in the Russian banking sector, 1992-1997
Introduction
Banks are essential for each country’s economy, since no growth can be achieved unless savings are efficiently channeled into investment. In this respect, the lack of a full-fledged banking system has often been identified as a major weakness of the centrally planned economies. Therefore, reforming the banking sector in the former communist countries and creating a new culture of trust and confidence has been a crucial task in the process of transition to a market economy.
Because of the vital importance of the banking reforms in the post-communist economies, a considerable amount of literature has focused on the issue of designing an optimal financial system as a critical element of structural reforms. Undoubtedly, the fact that establishment of a German-type model of universal banks in the former communistcountries from Central and Eastern Europe has occurred is probably proof that it was the most desirable outcome, and moreover, an outcome that complies with the ‘spirit of the European financial institutions’ (Grosfeld, 1994).
However, in this paper I shall examine the feasibility and desirability of the German-type model in the transitioncountriesin the early and intermediate stages of transition for the accomplishment of sustainable economic growth. In analyzing this issue I will provide empirical evidence from the evolution of the banking system in Russia in the period between 1991-1995 from the viewpoint of the relationship between enterprises and banks, and the impact of these relationships on investment and economic growth.
I. The German-typemodel of universal banks
1. Key characteristics
Following Grosfeld (1994) I shall use a distinction of three major functions performed bythe financial institutions, while characterizing the main features of the German-type model of universal banks, namely: financing, information and control. Financing is defined by the authoras creating channels to transform savings into investment; the information aspecthere is analyzed from the viewpoint of generation of information on the value of the firms and on different investment opportunities. Finally, control, is viewed as imposing monitoring on the corporate management.
A major distinction of the German-type financial system is the dominance of a relatively small number of banks (the ‘big three’ or ‘big four’ largest banks), involved in both commercial and investment banking and, maintaining close relationships with the industry. German-type banks provide a wide range of financial services but the elementof key importance is the accent on long-term money lendingto enterprises. On the information part, little information on the value of securities is made publicly available; instead, banks have a rather privileged access to it through the established close links with the industries (Grosfeld, 1994). Lastly, with respect to corporate control, the German-type model has as a main feature high concentration of ownership, i.e. companies ownsubstantial stakes of each other. As expected in this situation, banks have both the incentives and the ability to take active participation in shaping the major decisions of the enterprises. The last means that banks are in a position to also influence the investment decisions of non-financial companies. Hostile takeovers and leveraged buy-outs are rare in the German-type model.
In short, the German-type model of universal banks has as a core element the ‘close participation in the ownership and control on non-financial firms’ (Rostowski, 1998, p. 320). Theimpact of this particular system on economic growth has been a source of numerous arguments and thenext section will present some of theseviews.
2. The German model and economic growth
Many authors have eloquently supported the idea of German-type banks. According to Mayer, for example, ‘the distinctive feature of successful financial systems is their close involvement in industry’ (Mayer, 1988). Additionally, Gerschenkron (1968) argues that in the middle of the nineteenth century universal banks in Germany – a combination of commercial and investment banks – strongly contributed to the industrialization of the economy serving as a substitute for the insufficiency of wealth and entrepreneurial expertise (Gerschenkron through Rostowski, 1998). A similar case regarding provision of funds available for investment, has received large support by several authors claiming that a bank’s stake in an enterprise would prevent banks from behaving too cautiously when providing credit through allowing them to reap some benefits from financing riskier projects (see e.g. Dewatripond and Tirole, 1991). Another, mostly theoretical, argument in support of the idea of German-type banks rests on the concept that banks would help reduce the existing moral hazard problem between providers of finance, managers and employees via the creation of long-term commitment.
The first, and probably most obvious, counterargument questions the very idea of Gerschenkron for the universality of the German model, claiming that no particular kind of system by itself could do well in explaining economic growth. One possible reason for this isthe fact that there are too many other factors, such as macroeconomic policy and legal framework that play a considerable role for realization of growth. Empirical evidence showsthat Austria, for instance, had the same banking structure as Germanybut banks had a completely different behavour: they preferred to provide credits to well-established profitable firms, avoiding both risky work out of long-term plans and providing entrepreneurial expertise (Cameron, 1972). More importantly, some authors provide arguments against the introduction of the German model,since banks as large investors might be too soft because they fail to terminate unprofitable projects they have invested in (Gertner, Scharfstein & Stein, 1994).
Naturally,the process of transition from centrally planned to market economy in the post-communist countries has given rise for new arguments in favour and against the German-type banking system. A significant number of economists have been favouring the idea of implementing a German model with strong universal banks in the former communist countries as being the best suitable solution with respect to the needs of these economies. Moreover, they argue that it is exactly this type of system that emerges in these economies, including the particular case of Russia(see eg. Belyanova, Rozinsky, 1995). The main point of introducing such a modelin the post communist countries is that universal banks could mobilize a considerable amount of savings and make them available as capital for investment in strategic projects of the firms, as well as impose a better corporate control structure on the firms; thus,they might play the role of an instrument thought which the economy would catch up with the advanced market economies. However, most authors, who believe in the potential of the German model to boost investment and economic growth in the post-communist economies, often underline that fact that this mechanism is only possible if banks hold concentrated equity of their debtor clients (see e.g. Gorton and Schmid, 1994). This can be regarded as an important precondition for the introduction of this model, together will all other conditions that will be discussed further on.
Another argument supporting the bank-based system in general relies on the idea that the development of efficient security markets on average takes much longer time as compared to the time period needed for the establishment of a stable banking system. (e.g. Popov, 1999).At the same time, however, another body of literature gives rise to various counterarguments claiming that the initial conditions in the transition economies provided little scope to develop banking systems of German type, at least for the early years of transition (Rostowski, 1998). Hence,the main question raised is whether banks in the post-communist countries could play the role of universal banks of German type, taking into consideration the specific conditions in these economies. This issue will be addressed in the next section of the paper from the viewpoint of the situation in transition economies in the early stages of transition and its later evolution.
II. Feasibility of the German model in the post-communist economies in the early years of transition
A key feature of the post-communist economies in the early years of transition was the exceptionally strong degree of uncertainty due to fundamental macroeconomic changes taking place (e.g. trade and price liberalization), as well as to high indebtedness of the state-owned enterprises. At the same time, the new state-owned commercial banks, separated from the Central bank, wereflawed witha major weakness: lack of adequate banking skills. These two factors taken together, led to significant money loss from short-term lending in most transition economies. And, although, it is namely the long-term money lending which is supposed to ensure support for theintroduction of the German-type system, paradoxically it provides a strong argument against the German model,forhad the banks been involved in long-term money lending the scale of the losses incurred would have been even greater (Rostowski, 1998). Moreover, short-term lending would allow the banks to acquire some expertise in dealing with short-term debt – a precondition to develop skills for medium and long-term money lending; the laterbeing an absolutely necessary condition for the feasibility of the German model.
Another point closely related to the feasibility of the German model in the early years of transition concerns the ownership structure of the post-communist economies. Due to the different pace of the reforms in the different macroeconomic sectors, the situation in most transition economies was such that privatization of the state-owned enterprises was done prior to privatization in the banking sector. At the same time, as already mentioned, first and perhaps most noticeable characteristic of the German-type banks is their ‘close participation in the ownership and control on non-financial firms’ (Rostowski, 1998).Consequently, introduction of the German model in a situation where banks remain state-owned and a great deal of enterprises has already been privatizedwould imply re-nationalization of the economy – result neither politically, nor economically desirable (Rostowski, 1998).
An argument very much linked to the ownership structure is also proposed by Grosfeld (1994): on the one hand, a key feature of the German system is that little information on the enterprise value is publicly available, while banks have a privileged access to information on the firms’ value and liabilities; on the other hand, it is crucially important for the restructuring of the former centrally planned economies, aiming at starting an efficient allocation of resources, to generate adequate information on various investment opportunities and strategies. Based on this contradiction,Grosfeld argues that if chosen in the early process of economic transformation, the German model may hinder,rather than facilitate,the quality of the much needed restructuring process.
One last counterargumentfor the introduction of the German model concerns the major aim of the banking reforms in the post-communist economies, i.e. that banks switch from providing ‘systematically bad’ to providing ‘systematically good’ loans (Rostowski, 1998). Thus, the German model creates a risk that banks in the post-communist countries would become a crossing point of various interests: governmental, political or these of large financial-industrial groups (as in the case ofRussia), which might harm the process of their transformation into efficient institutions.
Allthe abovementioned arguments provide enough grounds to conclude that the German model of universal banks is neither desirable, nor feasible in the early years of transition to market economy characterized by state ownership and poor banking skills. Thus, in the next section I shall further the applicability of the German system in the post-communist economies in the later stages of transition.
III. Feasibility of the German model in the later stages of transition
What characterizes the later stage of the transition process is that banks have already developed certain skills for medium and long-term lending; enterprises have started a more efficient allocation of resources and some output growth has been achieved. The later also impliesgrowing enterprise demands for investment capital.
The relevance of the German model for the transition economies in these conditions would depend on various considerations; for instance, one such consideration, is that in this particular situation the German model would provide cheaper sources of long-term funds to firms at the cost of more expensive external equity (Steinherr, Huveneers, 1992), as well as that it provides cheaper capital in general.Of all such factors I will discuss two in more details because of their key importance. These are the implemented method of privatization and the inflationary history of the country.
The role of privatization method for the development of a certain type of banking system in the post-communist economies could be seen in at least two directions. On the one hand, introduction of a particularbank model might be favoured taking into consideration its potentialeffects on the speed and quality of the privatization process; in this respect someauthors argue that banks of universal type lower the incentives to privatizesince they are unwilling to give up their special relationships with the SOE sector (Grosfeld, 1994).Hence, the German-type model would slow down the speed of privatization, although it would possibly increase its quality as ‘flotations would become harder’ (Rostowski, 1998).
At the same time, it has been argued that the type of banking modelthat emerged in the transition economies was not a matter of a conscious choice of policy makers but could be seen as a result of a number of factors, among which the chosen privatization methodtogether with the ownership concentration (Popov, 1999). In this respect,mass-privatization scheme, creating a huge number of shareholders and implying widely dispersed ownership, wouldfacilitate the development of security markets and, thus, an Anglo-Saxon type of banking system[1]. Conversely, directsale ofassets (via auctions or tenders) is much less favourable for the development of the security markets; it creates a concentrated ownership andhence, would facilitate emergence of banking systems of a German-type.One such possible exampleis Poland, where voucher privatization has been rather modest, and banks were given incentives to take equity in holding of firms.
Another factor of crucial importance that shaped the type of the emerging banking system in the post-communist economies is the inflation history of the countries (Rostowski, 1998). The role of the inflation record could be sought in the following direction: high inflation implies high volatility of the nominal interest rates, which, in turn, leads to an increased risk to both creditors and debtors (regardless of the fact whether contacts are based on fixed or non-fixed interest rates). In this situation, choice of a variable nominal interest rate would mean a high depreciation of loans, while at the same time a fixed one would imply extremely high volatility of the real interest rate. In consequence, one can conclude that in these circumstances both suppliers and demanders of capital can protect themselves from interest rate volatility by using equity rather than debt. Hence, these initial conditions provide a strong case in favor of a model of close bank-enterprise relationships.
In the particular case of the post-communist economies a good proxy for the feasibility of the German-type model of banking system is the ratio of bank credit to non-government sector to GDP (Rostowski, 1998). As expected, in countries with higher inflation the general public would minimizeholdings of domestic currency, which in turn, would mean a collapse of real credit available in the economy. This factor, among others, leads to the conclusion that countries with low credit to non-government sector/GDP ratios cannot adopt the German model of banking system simply because the amount of credit available to the banking system would be far from sufficient in order to respond to the enterprises’ capital needs.
All these considerations provide a logical answer to the first main question of the paper:even in the later stages of transition the German-type model of banks is not feasible for most of the countries; in fact, the only countries for which the German type universal banking system was applicable in the intermediate transition stage were the Czech Republic, Hungary and Slovakia (Rostowski, 1998).But this does not answer the question about the situation in Russia, which has quite often proved to be the exception of the rule. In the next section I will focus on the pattern of banking sector development in Russia and the bank-enterprise relationships in the first half of the 1990s, as well as on the impact of the particular banking structure that emerged in the country on investment financing.