financial markets in the baltic states: fit for the eu?

POLICY ARENA

FINANCIAL MARKETS IN THE BALTICSTATES: FIT FOR THE EU?

GERHARD FINK,* PETER HAISS AND NOBUKO INAGAWA

Institute for the Danube Region and Central Europe, Vienna, Austria

Abstract: The paper deals with the question whether banks in the Baltic States are in a

position to exert a positive in¯uence on enterprise performance. E�ective, market-driven

corporate governance by banks is discussed along the following four questions: are

banks sound enough, large enough, strong enough, and skilled enough to have an

impact on improving the e�ciency of ®rms? Data on ®nancial sector in the Baltics

compared with other formerly communist Central European countries that signed

associated agreements with the European Union (Bulgaria, Czechia, Hungary, Poland,

Romania, Slovakia, and Slovenia) forms the basis of analysis.

It is argued that the widespread banking crisis in the CE-10 is not a consequence of

communist heritage any more, but of weak, slow, and sometimes contradictory policies

of the post-communist governments.

While `bad debt' constitutes the banks' most visible problem, it is argued further that

two other problems really endanger the reform processes not only of the ®nancial sector

in the Baltics, but of the entire reform countries' economies: ®rstly, the size of these

®nancial markets is about equivalent to the rounding error of US ®nancial statistics,

causing an inherent volatility bomb. For investors, this implies diversi®cation strategies,

short-termism and risk-adjusted-ROI goals. For the respective regulators, this recom-

mends co-ordination strategies for the various capital markets, and setting up ®nancial

markets that serve not only a small number of speculators but industry and population

at large.

Secondly, using a stakeholder approach it is argued that strong tendencies prevail for

non-prudent banking. Therefore, supervisors, foreign investors and bankers should

analyse the `degrees of freedom' of local bank owners and bank managers by depend-

ence analysis. For supervisors and regulators it is also important to consider the links

between reliable corporate governance practices, foreign direct investment and the

stability of the countries' currencies.

* Correspondence to: Gerhard Fink, Secretary General of the Institute for the Danube Region and CentralEurope, Bergasse 21/14A, A-1090 Vienna, Austria

CCC 0954±1748/98/050659±21$17.50# 1998 John Wiley & Sons, Ltd.

Journal of International DevelopmentJ. Int. Dev. 10, 659±679 (1998)

The conclusion is drawn, that due to asymmetric information, small high-risk `bubble'

markets and uncertain bank privatization, capitalization and supervision, it is not easy

to see how banks which have di�culties to manage themselves can exert a positive

in¯uence on the management of corporations and increase the e�ciency of ®rms. How-

ever, even if the more general answer is negative, this does not imply that individual

banks or ®nancial institutions are not in a position to positively in¯uence enterprise

performance. # 1998 John Wiley & Sons, Ltd.

1 INTRODUCTION

After seven years of transformation it is getting more and more di�cult to blame thecommunist heritage for the state of the ®nancial markets in the Baltics and the otherCE-10.1 Governments and Central Banks mostly took measures half-heartedly,hesitantly, and often too late. Thus, the banking sector in the Baltics still can beconsidered as a sector where capital disappears. Depositors and the state, i.e. thetaxpayers, are losing money. It is of major importance to the future economicdevelopment in the Baltics that banks will be in a position to exert a positive in¯uenceon enterprise performance. In the following, e�ective, market-driven corporategovernance by banks is discussed along the following four questions: are banks soundenough, large enough, strong enough, and skilled enough to have an impact onimproving the e�ciency of ®rms?

2 HOW HEALTHY IS THE FINANCIAL SECTOR IN THE BALTICS2

Estonia

`The ®rst commercial bank in the Soviet Union was set up in Tartu, Estonia's secondcity in 1989' (Dillon and Vensel, 1995). After independence from Russia an indepen-dent Bank of Estonia was set up and about 40 private banks were established (Berger,1995). As a consequence of the money reform three of the largest banks faced seriousliquidity problems. Bank of Estonia refused to rescue the banks. `Clients lost about$14 million' (Dillon and Vensel, 1995). Tartu bank (the largest bank) was closed(Jones 1997) the others merged (Mullineux, 1995). After another big bank (EstonianSocial Bank) collapsed new and additional prudential requirements were imple-mented in September 1994 (Vensel, 1995).

The enhanced capital adequacy standards could not be met by numerous bankswhich consequently were closed or merged with other banks. At the beginning of 1996the number of local banks had declined to 14 from 40 in 1992. In addition, twoforeign banks maintain branch o�ces and seven foreign banks operate representative

1 CE-10: Bulgaria, Czechia, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, Slovenia,i.e. the ten EU-associated Central European countries which eventually will become members of theEuropean Union.2 For the history of post-communist banking 1988±1995 see Fink and Haiss (1996a; 1996b; and 1997a).

# 1998 John Wiley & Sons, Ltd. J. Int. Dev. 10, 659±679 (1998)

660 G. Fink et al.

o�ces in Estonia (Bank of Estonia, communication January 1996). Hansa Bank withassets of $550 mn is the largest Estonian bank (NfA, 11/06/1996).

Di�erent from the other two Baltic states the general impression is that lessons werelearned and at the moment `most Estonian banks are in good shape' (Korkonen,1996).

Latvia

Latvia experienced a major banking crisis during 1994±95. After independence in1991 the number of banks grew quickly to 63 in 1993. Many of these banks had largeRussian shareholders and were committed to a large single borrower (FT, 06/06/1995). Forty-two per cent of the credits was provided for trade ®nancing (NfA, 07/04/1994). In 1993±4 about half of the former `commercial branches' of the BoL (Bank ofLatvia) were privatized and the remainder was merged into a state-owned bank(Universal Bank) (Mullineux, 1995; Korkonen, 1996).

Problems became clearly visible during 1994 when 11 banks folded (FT, 06/06/1995). Some banks had o�ered 25 per cent interest on dollar deposits. Depending onpresumably hot money in¯ows interests rates ¯uctuated erratically (NZZ, 07/27/1995). In May 1995 four more large banks reported liquidity problems and wereclosed down, ®nally (DP, 06/29/1995). Among them the largest bank of Latvia,Banka Baltija (NZZ, 05/19/1995). At ®rst the government indicated willingness torescue the bank (WSJ, 05/23/1995) where one-third of the population and 20,000businesses held their accounts. But the estimated losses of Lat 200 million (400 milliondollars) were too large for the strained budget and the bank was ®led for bankruptcy(NZZ, 06/22/1995, and FT, 07/11/1995).

These banks disposed of 40 per cent of all deposits (FT, 01/30/1996). The collapsecaused a decline of GDP by 2.3 per cent in 1995 (NfA, 01/19/1996). Because ofdelayed action the government failed to prevent asset stripping by the topmanagement of Banka Baltija (NZZ, 08/03/1995). In 1996 only 11 banks of 35 stillhad a licence to take deposits (HB, 09/12/1996). A signi®cant improvement ofbanking supervision is needed which takes more e�cient measures at earlier stages(FT, 07/11/1995; and NfA, 01/10/1996). The largest bank is Parex Bank with assets ofabout $230 mn, closely followed by Latvian Universal Bank (HB, 09/12/1996).

Lithuania

The bank of Lithuania was established in 1990 as central bank of the newly indepen-dent state which engaged itself also in commercial business until 1992 when theseactivities were transferred to the newly established State Commercial Bank ofLithuania (Mullineux, 1995). During the ®rst half of 1995 nine banks were reportedlyilliquid (NfA, 06/21/1995).

At the end of 1995 the two largest private banks folded (Innovation Bank andLitimpex Bank) which together held 23 per cent of all deposits. Out of 28 banks 11were ®led for bankruptcy (WSJ, 12/21/1995; and NfA, 01/19/1996) and more bankssu�er from inadequate capital endowment and insu�cient reserves (NZZ, 01/29/1996). Weak and ine�cient bank supervision, insider privatization and large lending

Financial Markets in the Baltic States 661


to dominant shareholders are the main reasons for the di�culties in the bankingsector. The crisis of 1995±96 hit the taxpayers. $325 mn capital injection is needed.This is about 10 per cent of government spending (HB, 03/11/1996). The requiredamount could only be raised abroad and contributed to an increase in foreign debt(NfA, 03/22/1996). In June 1996 an amendment to the National bank law and the lawon the creation of a deposit insurance fund were adopted by the parliament. Thelargest bank is Vilniaus Bankas which is 87.5 per cent foreign owned (WSJ, 02/05/1997).

The situation in other CE-10 is mostly similar to the banking developments in theBaltic states. In Bulgaria 14 banks were closed during the banking crisis of 1996±97.Total losses are estimated amount roughly to 1.7 bn US$. Only in course of thebanking crisis and on pressure by the International Monetary Fund a depositinsurance system was implemented. In Poland an open banking crisis was avoided byvarious rounds of re-capitalization. In 1995 the Agrobank was closed. Privatization ofone of the largest state controlled banks, Bank Handlowy, started in June 1997.During 1995 and 1996 several of the larger private banks of Romania were closed. InSlovakia several re-capitalizations kept the banking system a¯oat. The largest bank ofSlovakia was classi®ed as strategically important by the Slovak parliament andprivatization should be postponed until 2003. In the Czech Republic 12 banks were insevere ®nancial di�culties during 1993±96. Since bank supervision did not prevent¯eecing of the owners of two investment funds by several 100 mn KCS the responsiblevice-minister of ®nance had to resign in April 1997. Later the minister of ®nanceresigned, too.

In Hungary the collapse of the state-owned banks was avoided by several re-capitalizations. Nevertheless there was a run on Postabank in early 1997. Theparliament decided about the implementation of a deposit insurance only inNovember 1996 (Fink and Haiss, 1996a, 1996b; 1997a; 1997b).

General Observations

Perhaps with the exception of deposit insurance, most countries have established allthe institutions needed to perform the ®nancial market functions. However, thereremains a lot to be done to make the ®nancial system function in a way that itcontributes to economic growth, which so far is generated by factors outside thebanking system, and to `create an e�ective and stable framework for monetary policy'(Kozinski, 1995; Groszek, 1995). The ®nancial sector in the Baltics still is ridden bytroubles, state owned and newly founded private banks are in distress. Bank super-vision is weak due to lack of adequate rules and lack of e�ciency. Asset stripping offaltering banks could not be avoided. Initial recapitalizations could not prevent moralhazard. Privatization is hardly progressing. There are hardly any signs that thebanking sector of the Baltics could be opened to EU competition after 2000 asenvisaged in the association agreements with the EU. The weak ®nancial sector maybecome a stumbling block for EU-membership.

Thus, it is not easy to see how banks which have di�culties to manage themselvescan exert a positive in¯uence on the management of corporations and increase thee�ciency of ®rms. One can rather expect tinkering around with debt. Slow withdrawalfrom troubled enterprises, but predominant balance sheet cosmetics to avoid visible

662 G. Fink et al.


problems as long as possible. Supported by policy makers banks are making use ofmarket imperfections: high spreads of interest rates and increasing re®nancing abroadwhile governments tend to keep domestic interest rates high and the domesticcurrency overvalued.

3 IS THE FINANCIAL SECTOR LARGE ENOUGH TO EXERCISESIGNIFICANT CORPORATE GOVERNANCE?

Given the small size of the three Baltic states it is no surprise that the ®nancialmarkets of the Baltics are small, too. Lithuania with a population of 3.7 mn isreporting a ®nancial market size of 1.4 bn US$ at the end of 1995. Estonia (1.5 mninhabitants) is the second largest market with 1.1 bn US$ and Latvia with a slightlyhigher population (2.6 mn) is the smallest ®nancial market in the Baltics with 728 mnUS$. Another small country among the CE-10, Slovenia which has only 1.9 mninhabitants, too, reports a ®nancial market size which is about three times the total®nancial market of the three Baltic states (Table 1). Thus, the ®nancial markets ofthe Baltic states are smaller than the rounding error in US ®nancial statistics(Table 2).

Equity of the largest banks in Estonia, Latvia and Lithuania is less than 2 per centof equity of KomercnõÂ banka which is the largest bank in the CE-10 (Tables 3 to 6).

In Estonia and Latvia banking business is also small in relative terms. The share ofdomestic credits supplied by banks in percentage of GDP is 11 and 14.5 per cent

Table 1. Absolute size of Baltic ®nancial markets in international comparison. (Source: Finkand Haiss (1996).)

Size of Financial Markets: Assets in bn US-$

Average 1989±91 Average 1992±94 Year 1995

Latvia 0.949 0.728

Estonia 0.496 1.103

Lithuania 0.893 1.396

Romania 28.708 11.150 9.680

Slovenia 5.737 6.717 10.826

Slovakia 32.082 17.967 11.065

Hungary 21.082 22.135 20..216

Poland 23.418 36.215 40.377

Czechia 32.048 36.138 56.090

Portugal 72.524 104.442 119.479

Austria 275.980 313.824 397.710

Spain 643.213 653.936 764.500

Italy 1,206.230 1,201.869 1,392.322

UK 2,152.872 2,175.458 2,648.609

Germany 2,311.230 2,928.130 3,835.507

USA 4,782.133 5,002.100 5,556.600

Japan 9,726.164 13,566.768 15,623.748

Data: IFS 6/96.Note: Latvia & Lithuania: data available from 1993 on; Slovenia & Estonia: data available from 1991 on;CSFR for Czech and Slovak Republics up to 1992; latest ®gures for Portugal: 1994.



respectively. Only in Lithuania banking seemingly has recovered during 1995 andreached a degree of intermediation of 60.8 per cent measured by the ratio of domesticcredit in percentage of GDP. This share of Lithuania is comparable to a degree ofintermediation reached in Hungary and Slovakia but still less than in Italy, the CzechRepublic, in Portugal and in other west European countries (Table 7).

From the relatively small degree of ®nancial intermediation one has to draw theconclusion that banks cannot have an overall strong impact on economic e�ciency ofthe economy even if the banks were strong, healthy and well organized. Thisobservation goes parallel with the observation of continuous trouble in the bankingsector. The spread between lending and deposits rates were particularly large inLatvia and Lithuania but also very large in Estonia in international comparison.Banks apparently try to cope with a higher risk involved with lending by maintaininglarge spreads (Table 8). Since most people do not trust the banks and the spreadscharged are very large people do not keep their money with banks. Therefore theseeconomies are rather cash-driven economies and the degree of ®nancial intermedia-tion is low.

As to internationalization of ®nancial intermediation Estonia and Latvia report arelatively high degree of internationalization. The share of foreign assets andliabilities in percentage of total assets and liabilities is reaching 38.8 per cent in Latvia

Table 2. Relative size of Baltic ®nancial markets in international comparison (Source: Finkand Haiss (1996).)

Country 1995 Bank Assets inbn $

In % of Line Above In % of USA

Japan 15,623.748 100.0% 281.17%

USA 5,556.600 35.6% 100.00%

Germany 3,835.507 69.0% 69.03%

UK 2,648.609 69.1% 47.67%

Italy 1,392.322 52.6% 25.06%

Spain 764.500 54.9% 13.76%

Austria 397.710 52.0% 7.16%

Portugal 119.479 30.0% 2.15%

Czech Republic 56.090 46.9% 1.01%

Poland 53.046 94.6% 0.95%

Hungary 20.216 38.1% 0.36%

Slovakia 11.065 97.8% 0.20%

Slovenia 10.826 97.8% 0.19%

Romania 9.680 89.4% 0.17%

Lithuania 1.396 14.4% 0.03%

Estonia 1.103 79.0% 0.02%

Latvia 0.728 66.0% 0.01%

Bank Bank Assets in bn $ In % of Czech Banks In % of USA

Citicorp 256.853 457.9% 4.6%

Bank of Boston 47.397 84.5% 0.9%

Bank Austria 68.165 121.5% 1.2%

Data: IFS 6/96.Note: Latvia & Lithuania: data available from 1993 on; Slovenia & Estonia: data available from 1991 on;CSFR for Czech and Slovak Republics up to 1992; latest ®gures for Portugal: 1994.

664 G. Fink et al.


and 21 per cent in Estonia at the end of 1995. Only in Lithuania the share is signi®-cantly smaller (7.9 per cent). A share which is comparable to Czechia or Hungary(Table 9).

The Baltic stock markets are quite often called ¯ea markets. They are very small asto market capitalization. Even the most developed stock exchange of Lithuania doesnot reach a market capitalization which goes beyond 1 bn US$ (Table 10). By com-parison the stock markets of the Visegrad 4 countries (Slovakia, Hungary, Polandand Czechia) were already signi®cantly larger in 1995 (Table 11).

Corporate governance through anonymous securities markets, therefore, has notbeen possible in the early stages of transition (Stern, 1995). While theoretically thestock exchange is a market with perfect information for both investors and capitalseeking corporations, in fact it is not in the Baltics and the other CE-10. In theeconomies in transition `stock markets with their distinct shareholder structure arenot capable of circumventing the negative e�ects of asymmetric information whichare prevalent with debt ®nancing' (Linne, 1995).

4 ARE BANKS SUPERVISED ENOUGH?3

Banks have to be geared towards prudent banking. Positive e�ects of prudentbanking are a public good (Co�ee, 1996). Economic stability generated by prudentbanking leads to an increasing propensity to save. The increasing savings will bechannelled by the banks into e�cient investment and thus contribute to growth and

3 This section is strongly based on Fink and Haiss (1997b).

Table 3. The largest banks in terms of equity in EU-associated Central Europe in 1995.(Source: Fink and Haiss (1996).)

Rank in Bank ranked in terms of equity Land Equity Assets Capital RoACE World

1 295 KomercnõÂ banka CZ 988 14.652 6.74 1.58

2 386 Bank Handlowy s Warszawie PL 725 4.310 16.82 5.60

3 431 CeskaÂ Sporitelna CZ 636 13.828 4.60 0.07

4 442 Bank Gospordarki Sywnosciewej PL 610 3.815 15.99 3.84

5 498 CeskoslovenskaÂ obchondõÂ banka CZ 537 7.152 7.51 1.64

6 525 InvesticnõÂ a PostovnõÂ banka CZ 494 7.841 6.30 0.73

7 602 VseobecnaÂ uÂ verowaÂ banka SK 403 5.430 7.41 1.81

8 617 Bank Pekao PL 391 8.212 4.76 1.59

9 661 Bulbank-Foreign Trade Bank BUL 349 3.101 11.27 2.58

10 731 Powszechna Kasa Oszczednosci PL 297 11.292 2.63 1.71

Total Top CE banks in worlds top 1.000 ('95) 5,430 79.633

Average Top CE banks in world top 1.000 ('95) 543 7.963 8.40 2.12

4 Citicorp US 19,239 256.853 7.49 2.18

50 Internationale Nederland Bank NL 6,254 154.049 4.06 0.65

116 Bank Austria A 3,059 68.165 4.49 0.39

Data: Blanden and Rowley 1996.

Note: In the above ranking, only banks from EU-associated transition countries are included. The

following Croation bank would make the CE-top ten in terms of equity:

7 565 Privredna Banka Zagreb HR 437 3.506 12.47 ÿ1.11



Table 4. Top ®ve Estonian banks in 1995 ($ million). (Source: The Banker (Oct. 1996).)

Tier OneCapital

% change Totalassets

% change Capital/assets%

Pre-taxpro®ts

% change Pro®t/capital%

Employees Branches BIS ratio%

Hansapank 20 33.6 302 68.5 6.5 18 195.4 94.3 621 18 12.60

Eesti Uhispank 16 78.6 229 55.6 7.2 3 42.1 19.3 800 58 na

Tallinna Pank 11 222.5 94 70.9 11.7 3 156.0 26.6 450 9 13.00

Eesti Forekspank 5 192.4 43 190.9 11.2 2 144.3 32.1 na na 18.25

Evea Pank 5 85.5 23 34.5 20.2 0* ÿ171.3 ÿ2.3 166 9 na

* Loss of ÿ0.11.$� 11.462 krooni (12/95). Average in¯ation 1995� 28.9%.

Table 5. Top ®ve Latvian banks in 1995 ($ million). (Source: The Banker (Oct. 1996).)

Tier OneCapital



Pre-taxpro®ts



Parex Bank (31/12/95) 27 71.8 190 23.1 14.4 13 272.3 48.2 545 43 na

Latvijas Universala

Banka (31/12/95)

26 20.8 216 65.1 12.3 7 35.2 26.6 na na na

Rigas Komercbanka

(31/12/95)

17 13.5 136 21.1 12.2 1 ÿ74.5 6.1 672 11 23.0

Baltijas Tranzitu Banka

(31/12/94)

10 na 45 na 21.7 0 na 4.7 116 0 na

Zemes Banka (31/12/95) 7 2.6 83 19.5 8.1 0 ÿ72.0 3.3 331 22 na

$� 0.5370 lats (12/95). Average in¯ation 1995� 25%.Note: The ®gures are based on either statutory Latvian accounting standards or international accounting standards.

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Table 6. Top ®ve Lithuanian banks in 1995 ($ million). (Source: The Banker (Oct. 1996).)

Tier OneCapital



Pre-taxpro®ts



Lietuvos Zemes Ukio

Bankas

15 na 286 45.4 5.1 8 ÿ65.8 52.9 2,406 46 11.71

Lithuanian Joint-Stock

Innovation Bank

11 ÿ0.4 156 ÿ7.6 6.7 ÿ40 na ÿ385.0 754 47 na

State Commercial Bank

of Lithuania

10 ÿ27.6 269 19.3 3.7 ÿ5 ÿ206.5 ÿ47.5 1,625 30 7.60

Bankas Hermis 8 46.5 83 104.5 10.1 2 101.7 27.4 741 14 na

Vilniaus Bankas 8 119.7 96 10.7 8.3 6 na 70.2 561 14 12.09

$� 4.0 Litas (12/95). Average in¯ation 1995� 36.4%.Note: The ®gures are based on either statutory Lithuanian accounting standards or international accounting standards.

Financia

lMarkets

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States

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increase the prosperity of nations. The production of public good justi®es governmentaction.

Short-term gains from non-prudent banking mainly accrue to insiders (dominantowners, managers, high rank employees). If bank supervision is ine�cient there is astrong tendency that insiders shift to non-prudent banking to internalize quick andlarge gains from (risky) opportunities while losses from these undertakings have to beborne by outsiders. With bank supervision not existing `new banking licences mayinitially be nothing more than a licence to steal' (Akerlo� and Romer, 1994; quotedby Baer and Gray, 1996).

If e�ciency and strength of supervision ¯uctuates, there will be a tendency thatinsiders show a preference for holding liquid assets. These assets can easily be takenaway by insiders or diverted to high risk ventures to the bene®t of insiders whensupervision is getting weaker.

Thus, weakly supervised banks will tend to:

(i) hold overproportionately high liquid assets (Myers and Rajan, 1997); and(ii) provide credit for high-risk ventures if the pro®t of these ventures accrues to

insiders/strong stake holders, but in case of failure the loss has to be covered bydepositors, naive minority equity holders or the public.

Although the negative e�ects of insu�cient bank supervision are well known ingeneral, Baer and Gray (1996, pp. 107±8) conclude after their analysis of corporategovernance in Hungary and Poland: `For reasons we do not fully understandcountries that liberalise chartering policies almost always fail to follow up withreforms mandating adequate disclosure and creating a well functioning supervisory

Table 7. Domestic credit relative to GDP. (Source: Fink and Haiss (1996).)

Domestic credit in % of GDP

Average 1989±91 Average 1992±94 Year 1995*

Estonia 60.6% 10.2% 11.0%

Latvia n.a. 20.4% 14.5%

Lithuania n.a. 19.2% 60.8%

Romania 81.1% 23.7% 23.6%

Poland 29.0% 39.1% 28.2%

Slovenia 36.8% 29.3% 35.9%

Hungary 82.5% 67.4% 55.7%

Slovakia 110.0% 83.5% 62.4%

Italy 78.1% 86.1% 85.7%

Czechia 110.0% 92.3% 91.5%

Portugal 74.0% 87.9% 93.2%

Spain 104.6% 101.1% 104.5%

UK 120.2% 119.1% 125.8%

USA 116.6% 120.5% 129.6%

Germany 115.8% 133.1% 148.7%

Austria 124.6% 140.1% 149.7%

Japan 140.9% 138.8% 136.0%

Data: IFS 6/96.Note: CSFR for Czech & Slovak Republics up to 1992; data for Slovenia & Estonia is available from 1991on; for Latvia from 1993 on, for Lithuania from 1994 on.* For Slovakia & Portugal: latest ®gures for 1994.

668 G. Fink et al.


system.' Similar observations were also made for some developing countries (Lewisand Stein, 1997). An answer can be found by analysing the direct gains from prudentand non-prudent banking which accrue to important stakeholders (Table 12).

Most of the short-term e�ects of prudent banking accrue to politically weakstakeholder groups (depositors) or to insider groups whose individual members as analternative could generate signi®cantly larger direct gains from non-prudent banking(managers, employees, individual shareholders of banks).

The state as an owner is rather weak in exercising corporate governance (Fink andSchediwy, 1992) since other interests, e.g. `protecting jobs' and avoiding politicaltrouble, override the interest in reasonable pro®ts of banks and state owned corpora-tions. In addition, the direct gains of the state from prudent banking are small (if notnegligible) in comparison with earnings from taxing banks and their industriala�liates. Some element of non-prudence may even be welcome to political rulers sincenon-prudence gives leeway in exercising power. It helps to get access to ®nance forpolitical purposes and to serve the politicians' clientele. Reportedly the 1992 electioncampaign of Mr Klaus was largely funded through a 60 million Korun loan from thethen state run Investicni Banks, in 1994 to be merged into Investicni a Postovni Banka(WSJ, 12/27/1996). Thus, there may be also a lack of political will to have exercisedstrong bank supervision (Baer and Gray, 1996, p. 78).

The political pressure for establishing reasonable disclosure rules and banksupervision is weak in transition economies since the major preoccupation of all

Table 8. Interest rate spreads. (Source: Fink and Haiss (1996).)

Spread b/n lending and deposit rates


Latvia n.a. 37.9% 19.8%


Estonia n.a. n.a. 7.3%

Slovenia n.a. 26.9% 9.5%

Slovakia 4.4% 6.1% 7.1%

Hungary 6.6% 8.5% 6.5%

Czechia 4.4% 6.5% 5.8%

Poland 142.5% 1.6% 1.7%

Average CE n.a. 18.1% 9.6%

Av. Vise rad 39.5% 5.7% 5.3%

Germany 3.2% 6.7% 7.1%

Portugal 8.4% 6.0% 6.6%

Italy 7.3% 6.6% 6.0%

Austria 4.8% 3.5% 4.3%

USA 4.1% 2.9% 3.6%

UK 2.0% 1.9% 2.8%

Spain 5.2% 1.7% 2.4%

Japan 3.7% 2.5% 2.3%

Average 4.8% 4.0% 4.4%

Data: IFS 6/96.Note: Latvia & Lithuania: data available from 1993 on; Slovenia & Estonia: data available from 1991 on;CSFR for Czech and Slovak Republics up to 1992.* Latest ®gures for Portugal: 1994.



people is with the redistribution of wealth by privatization. People are much moreconcerned about getting rich quickly by redistribution of property than by regularwork. As long as privatization is not settled and its outcome broadly accepted by thegeneral public there is a political dominance of those people which can gain fromredistribution of wealth over those who could gain from stable economic and politicalconditions and ordinary economic growth.

The use of instruments for corporate governance by banks is in¯uenced by the waybanks are governed and supervised. Corporate governance can be exercised by four

Table 9. Internationalization of ®nancial intermediation. (Source: Fink and Haiss (1996).)

Foreign assets and liabilities in % of total assets and liabilities


USA 2.8% 2.3% 1.9%

Hungary 3.6% 5.2% 5.5%

Japan 8.0% 5.4% 5.9%

Estonia 7.3% 20.2% 21.0%

Latvia n.a. 21.7% 38.8%


Czechia 5.1% 6.0% 8.6%

Poland 17.5% 11.6% 8.9%

Slovakia 5.1% 7.4% 10.7%

Romania 4.9% 8.9% 11.7%

Germany 12.0% 12.6% 13.5%

Italy 12.6% 14.9% 14.4%

Spain 7.7% 14.5% 16.3%

Slovenia 9.5% 20.5% 17.9%

Portugal 16.1% 19.6% 22.1%

Austria 24.6% 23.8% 23.9%

UK 47.6% 49.5% 50.1%

Data: IFS 6/96.Note: Latvia & Lithuania: data available from 1993 on; Slovenia & Estonia: data available from 1991 on;CSFR for Czech and Slovak Republics up to 1992.* Latest ®gures for Portugal: 1994.

Table 10. Flea markets. (Sources: Nomura, BCE.)

Baltic and Balkan stock exchanges, January 1997

number of listedcompanies

market capitalization,$m

average daily turnover,$m

Bulgaria 1 na na

Croatia 2 1,900 1.30

Estonia 8 555 4.00

Romania 17 60 0.01

Slovenia 17 657 1.60

Moldova 18 na na

Latvia 32 156 0.12

Lithuania 460 900 0.41

Total 555 4,228 7.44

Quoted by April 1997, Business Central Europe, p. 54.

670 G. Fink et al.


channels: control by equity rights (share holding); by admitted rights (proxies forsmall shareholders and dormant institutional investors); by ®nancial rights (claims ofcreditors); and by assumed stakeholder power of outsiders.

In the European context of the 1990s the strongest impact on corporate governanceof banks so far was generated by international organizations. A successful approachtowards future EU membership is regarded as an important element for internallegitimization of governments in the CE-10. Becoming member of the Council ofEurope, the WTO, the OECD, and ®nally of the EU is indicating the steps which haveto be taken in order to become ®nally member of the ivy-league of prosperousEuropean nations. These steps require the adoption and application of rules andcodes of conduct which are constituting elements of the common body of valuesamong the members of these organizations.

The association agreements with the EU foresee that the CE-10 will open their®nancial markets to foreign banks and ®nancial institutions after 31 December 1999.Another precondition for EU membership is the adoption and application of theacquis communautaire also in the ®eld of banking, including bank supervision, depositinsurance etc. (Commission, 1995ÐWhite paper). If the CE-10 do not comply withthese rules EU-membership will not be possible. Thus those countries which considerthemselves as the ®rst round candidates for enlargement hesitantly begin to comply.

5 ARE BANKERS STRONG AND SKILLED ENOUGH TO EXERCISECORPORATE GOVERNANCE?

While in the previous chapter the impact of stakeholders on corporate governancewas discussed from an agency±theory point of view, it is also revealing to elaboratewhether banks are strong enough to exercise corporate governance by reviewing the

Table 11. Stock markets of visegrad 4 in international comparison (Source: Fink andHaiss 1996).)

Stock market capitalization (SMC) 1995

in bn $ in % of GDP in % of total bankassets

Slovakia 1.53 8.8% 13.8%

Hungary 2.19 5.0% 10.8%

Poland 3.59 4.0% 6.8%

Czechia 15.98 35.0% 28.5%

Austria 30.57 15.5% 7.7%

Spain 196.76 35.2% 25.7%

Italy 200.85 18.0% 14.4%

Germany 582.02 27.6% 15.3%

UK 1,347.79 122.0% 50.9%

Japan 4,426.53 86.0% 28.3%

USA 6,401.88 90.0% 67.0%

Visegrad 4 23.29 8.8% 16.6%

in % of Austria 76.2% 56.6% 215.8%

Data: Federation of European Stock Exchanges (1996/7); Patrick/Bank Austria (1996); Economist May 4& 13 � Sept. 14. 1996.



Table 12. Possible gains from prudent and non-prudent banking. (Source: Fink and Haiss, 1997b).)

Stakeholder Possible gains from prudent banking Possible gains from non-prudent banking E�ects in case ofbank failure

direct e�ects(short-term)

indirect e�ects(spillovers)

direct e�ects(short-term)

spillovers (long-term)

General public None Highly positive economic and

political stability, e�cient

institution building

None, if dirty money is not

reinvested locally

Highly negative Highly negative in particular

in case of large retail bank

Depositors (predominantly

small depositors)

Small positive interest rate safe

deposits

Increasing trust in banking

system, increasing propensity

to save

Larger interest income Risk of loss of non-insured

deposits

Sizeable loss

National bank Good reputation for top

management

Increasing trust in monetary

and ®nancial policy making

None, tendency of capital

¯ight

General accusation of

insu�cient supervision, bail

out requirements



out requirements

Political circles (individuals

close to power)

None None Personal access to large credit Repeated recapitalizations

foster political connections

loss of high rank post

Political parties (organization) Ruling: stability opposition:

none

Ruling party: good reputation Access to ®nancial funds,

®nance for election campaigns

Large bank collapse may

trigger later loss in elections

With large losses risk of

political turmoil

Financially sound private

owners

Easy access to ®nancial funds Safe capital investment Diversion of own equity to

other people's advantage

Limited investment

opportunities

Loss of equity

Financially weak private

owners

Restricted access to new

®nance

None Easy access to ®nancial funds Larger investment

opportunities

Loss of equity likely smaller

than open credit

State as owner None Increasing trust in monetary

and ®nancial policy making

privatization faster

None General accusation of


out requirements



out requirements

Privatization agency Higher privatization revenue Privatization slower Low privatization revenue,

privatization not possible

Privatization not possible

Managers Reasonable salary Safe job (but political pressure

not excluded)

Easy access to ®nance and

large property large salary,

political protection by

bene®ciaries of non-prudent

banking

Loss of position in case of

severe bank crisis, dependence

on political circles

(bene®ciaries)

Loss of position in case of

bank failure

Employees Reasonable salary Safe job Easy access to large credit Loss of position Loss of job

672

G.Finket

al.

#1998JohnWiley

&Sons,Ltd.

J.Int.Dev.

10,659±679(1998)

Table 13. Stakeholders in¯uences. (Source: Fink and Haiss, 1997b.)

Type of liability External stakeholders' interest and strength Power of externalstakeholder

Due to credit institutions

(inter bank ®nance)

Save deposits, strong position in re®nancing the bank, interest of other bank owners Strong

Due to Central Bank Keeping the bank a¯oat, permanent threat on bank managers, strategy: to avoid trouble Very strong

Due to private savers Save deposits, reasonable interest, position weak, mostly dispersed and politically not organized.

Proof: lack of deposit insurance in some CE-10

Very modest

Due to companies Save deposits, reasonable interest, strong position only when deposits are signi®cant Modest/strong

Securitized liabilities Save investment, reasonable interest, depending on holder of securities Modest/strong

Subscribed capital State as owner, strategy: to avoid trouble Very strong

Private owners with signi®cant share Very strong

Private owners with dispersed ownership Very modest

Managers as owners Strong

Employees as owners Strong

Reserves Increase leeway of managers and employees None

Contingent liabilities:

from circulated bills of exchange Position varying by investor and issuer

from guarantees and collateral Position varying depending on partners

Type of asset Stakeholders' interest and strength Power of external

stakeholder

Cash Bank managers' leeway increased None

Balance with Central Bank Bank managers' leeway increased Modest

Debt instruments issued by public

authorities

Government, ®nancing de®cits. Reduces power of government, increases leeway of bank

managers

Modest

Claims on credit institutions Strong position of bank management, dependence on good will of other banks Modest/strong

Claims on private customers Small amounts, widely dispersed clients Very weak

Claims on corporations The larger the amount the weaker the bank management Strong/modest

Own shares Strong position of bank management None

Shares in other banks and

corporations

Strong position of bank management with respect to small companies, weak position with respect

to large debtor corporations

Weak/strong

Financia

lMarkets

intheBaltic

States

673

#1998JohnWiley

&Sons,Ltd.

J.Int.Dev.

10,659±679(1998)

room to manoeuvre of bank management in various positions of the balance sheetand the presumed strength of relevant stakeholders which have an impact on therespective items.

In their decision making, East European bankers have to consider the interests ofmajor stakeholders. These include the minister of ®nance, the national bank,privatization agencies, own bank sta�, depositors, large stage-owned corporations,sometimes also shareholders and new private investors. Timing and intensity of bankreform are determined by the vested interests of these groups.

. The minister of ®nance: often the major debtor, but also representative of the stateas the owner of large banks.

. The national bank: often the major supplier of funds. Both together play a role inbanking supervision, nomination of bank managers, and decision on bankrecapitalization. Both share an interest in às little trouble as possible'.

. Privatization agencies: in¯uence if, when and to whom banks are privatized, andalso if, when and to whom the banks' major corporate clients are privatized, that is,which corporations can web ties with banks and vice versaÐand at what debtlevel.

. Bank sta�: Employees want to keep their positions, and for their career often theyare rather slow and hesitant in their decision making. They tend to delegatedecision making to their superiors (risk avoidance).

. Depositors: the providers of retail re®nance have little impact on bank manage-ment. They have a relatively weak position, can exert in¯uence only indirectly asvoters in parliamentary elections. This again enhances the interest of the minister of®nance in às little trouble as possible'.

. Large state-owned corporations: in particular corporate debtors have somein¯uence on bank managers' behaviour. They can cause trouble by deciding onhow, when and what credit to honour.

. New private investors: have little in¯uence, but they want to get access to bankcredit. They are seeking to gain in¯uence on the bankers' decision making. Theyfeel crowded out by the state as a debtor and by large (still or formerly state owned)corporations. (See Table 13).

This analysis reveals the dilemma in bank politics. As long as banks are stateowned, repeatedly capitalized and/or re®nanced by the Central Bank, the interest ofthe minister of ®nance and the governor of the Central Bank in às little trouble aspossible' prevails. Corporate governance by banks can only assume modest moves towithdraw slowly from major debtors, otherwise the bank itself may be threatened inits existence and due to the collapse of large corporations unemployment would soar.

As soon as the state is not involved in a bank, the managers theoretically get moreroom to move towards stricter corporate governance. However, powerful asset sidestakeholders often get in a position to dominate the bank by purchasing a reasonableshare in the bank. Since private depositors have little impact on bank management,the pressure to exercise corporate governance on major debtors remains weak if thesedebtors become owners of a bank. Thus, bank managers again have little powerto exercise e�cient corporate governance. In several instances managers formedcoalitions with preferred borrowers. These coalitions opened the opportunity of assetstripping in case of ®nancial distress.

674 G. Fink et al.


During the last seven years of economic transition, thousands of bank managersand employees enjoyed training provided by West European and Americancommercial banks, central banks, and international institutions. In the frameworkof the PHARE programme the EU still is providing assistance in training and inresearch on banking. Considering these e�orts we have two possibilities in ourassessment. Either the training or the legal conditions and property structures areinadequate in the CE-10. In the light of our analysis we come to the conclusion thattraining was enough. Since both state-owned banks and the new private banksrepeatedly are in ®nancial distress, the widespread banking crisis in the CE-10 during1995 to 1997 is not a consequence of communist heritage, but of weak, slow, andsometimes contradictory or ill conceived policies of the post-communist governments.

The weak position of bank managers with respect to corporate governance ofmajor debtors is due to signi®cant weakness in regulation and supervision of banking.In many of the CE-10 standard rules and procedures (capital adequacy requirements,risk assessment, asset valuation rules, deposit insurance, etc.) are not yet fullyimplemented. There is also missing a code of conduct in case of ®nancial di�cultiesand bankruptcy procedures. In many instances of bank failures asset stripping byowner/managers could not be prevented. There is also a lack of stable rules for bankprivatization.

In addition, more attention has to be paid to speci®c shareholder/stakeholderrelations. It seems appropriate to enhance the general `single borrower rules'. Theserules should limit lending not only to individual corporations, but also to clustersdominated by a single or a few owners. Single borrower rules should also comprise abank's holdings of bonds and shares of companies. Signi®cant limits should beimposed on lending to shareholders, on holding of own shares, on cross shareholdings among banks, and among banks and enterprises. Among banks and amongbanks and enterprises only one-way share holding should be permitted. Share hold-ings in other banks and enterprises should be subject to additional capital require-ments. A temporary relief may be granted only when a bank acquires a stake in anenterprise through a debt for equity swap in course of a bankruptcy procedure.

In the case of the CE-10 the issue of bank-company clusters comes up as an `agencyproblem of privatized ®rms' (Blommenstein and Spencer, 1993). Only a few of the(still nationalized) commercial banks charge risk spreads based on market criteria.The situation is even worse considering the often narrow, illiquid capital markets andthe in¯uence of information asymmetries on these markets (Mayer, 1992; Smith andWalter, 1992). Therefore, those countries' people cannot trust the newly establishedcapital markets.

There is possibly an exception to the rule. Subsidiaries of West European orAmerican banks are subject to governance by their parent banks and thus much betterdesigned for exercising corporate governance also in the CE-10. If e�ective reportingsystems are established at the stock exchange (as e.g. in Poland and Hungary) thenforeign owned investment banks can have a signi®cant impact on the conduct ofcorporations with listed stocks. Thus, in these small segments of the CE-10 economiescorporate governance by banks can be e�ective. The policy advice for bank super-vision is to promote access of well established foreign banks to the CE-10 ®nancialmarkets (opposite to the predominant attitude in the CE-10).

As to the distribution of foreign exchange risk and solvency risk, there are severaloptions available depending on the setting of actual transactions. If banks take



credits in foreign exchange and convert those into local currency which is thenprovided at competitive interest rates to enterprises, the banks earn most of theinterest rate di�erential, but carry also the full exchange rate risk. If the order ofmagnitude of this kind of business is getting large, banks will get into di�culties aftera consequent depreciation of the currency.

Banks may also act as intermediaries and o�er exchange denominated credits totheir clients which are re®nanced abroad. Then the borrowing enterprise is convertingthe foreign exchange into local currency and carries the full exchange rate risk.However, if the higher local market interest rate would be a too high ®nancial burdenfor the borrowing enterprise, then a future depreciation of the currency in the order ofmagnitude of the interest rate di�erential, too, cannot be borne by the borrower. Thusborrowing enterprises and consequently the lending banks will get into trouble.Therefore, some banks try to avoid direct involvement into such transactions, butadvise and handle the issue of global depository notes on ®nancial markets abroad.Thus the bank acts as an advisor to the issuing company and earns an appropriatefee while the full solvency risk of the issuing company is to be borne by a third party,i.e. the foreign investor.

Given the typical risk of these transactions, policy makers are advised to keepexchange rate adjustments and interest rate di�erentials in line. As long as the realinterest rate di�erentials re¯ect di�erentials in productivity gains they could bemaintained since the current account remains in surplus, re¯ecting better earningopportunities in economies with faster productivity gains and inducing capital in¯owsinto the real sector of the economy.

In times of increasing or rapidly falling rates of in¯ation, governments (centralbanks) are also advised to keep interest rates in line with price movements. Negativereal interest rates (mostly observed in periods of soaring in¯ation) put a brake onreal investment and real economic activity. Too high positive real interest rates,which may occur when in¯ation goes down and the interest rates are not adjustedaccordingly, destroy even very productive enterprises which are credit ®nanced. It ishardly possible to earn 20±30 per cent real interest in competitive product markets.Thus the advise is to keep real interest rates positive at modest levels of about2±5 per cent.

6 CONCLUSIONS

Seven years of ®nancial market reform in Central Europe is a su�ciently long time toput the house in order. Thus, the recurring banking crises in the Baltics and otherCE-10 are not a consequence of communist heritage any more, but of weak, slow, andoften contradictory policies of the post-communist governments. Even after theEuropean Union had listed the minimum requirements for ®nancial market reform inthe white book of 1995 an appropriate pre-accession strategy is only slowly forth-coming. New industrial-political clusters are apparently strong enough to prevent theestablishment of a strong bank supervision and of adequate rules of prudent banking.Strong tendencies for non-prudent banking prevail.

Apparently, sound banking can hardly be established without experienced banksfrom the EU or the US entering the market at a larger scale, thus privatization of thelarge former state owned banks is taking place with strong involvement of renowned

676 G. Fink et al.


foreign banks. It is a good sign that the largest bank in Lithuania is largely foreignowned.

Given the strong tendencies towards non-prudent banking in most of the CE-10,the small size of the ®nancial markets, asymmetric information, as well as uncertainbank privatization, capitalization and supervision, it is not easy to see how banks atlarge will exert a positive in¯uence on the management of corporations and increasethe e�ciency of ®rms. However, this does not imply that individual banks or ®nancialinstitutions are not in a position to exert a positive in¯uence on enterpriseperformance.

For the Baltic states the conclusion to be drawn is that there is still some way to gountil best Western practices are established. Ine�cient bank supervision and lack ofadequate rules of prudent banking may be one of the stumbling blocks for the Balticstates to become member of the EU only at a later stage. However, Estonia seeminglyhas achieved more than the other two Baltic states.

ACKNOWLEDGEMENTS

Earlier work was presented at the 19. SUERF Colloquium in Thun, Switzerland,October 1995, at the 1997 annual session at the Allied Social Sciences Associations inNew Orleans, USA and at the 20. SUERF Colloquium 1997 in Budapest, Hungaryand published in Fink and Haiss (1996a, 1996b and 1997a, 1997b). The opinionsexpressed are the authors' personal views and do not necessarily re¯ect those ofBank Austria, the Institute of European A�airs or the Institute of European Studies.The authors wish to thank Paul Marer, Bloomington, Indiana and Blue RibbonCommission, and the following coordinators of PHARE ACE projects for extremelyhelpful support in providing information about their ongoing research andworking papers published by their research institutes: D. Bailey, London, M. Fry,Birmingham, G. Fuolega, Venice, C. Green, Loughborough, Y. Katsoulacos,Athens, B. Kavic, Ljubljana, M. Koparanova, So®a, R. Macdonald, Strathclyde,E. Miklaszewska, KrakoÂ w, V. PaÂ lenik, Bratislava, U. Plowiec, Warsaw, J. Sgard,Paris, M. Sha�er, Edinburgh.

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financial markets in the baltic states: fit for the eu?

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