By Richard Hainsworth
During the last years of the Soviet Union, each of the republics (now independent states) were subtly different whilst sharing much in common. Now each of these states are quite different, whilst sharing subtle common traits. Their banking systems (or more accurately, their banking sectors) reflect this general comment.
In Soviet times, there was a single bank – Gosbank. Finance for companies was arranged through finance departments of industry ministries, and the individuals in those departments tended to be industry specialist first, finance specialists second. This meant that when the transition to a market economy started, there were only a tiny number of people in the whole of the Soviet Union who had been exposed to market banking practices. Even to this day, the banking sector lacks qualified and experienced staff to handle such tasks as lending to retail customers (morgages, consumer loans), lending to small and medium enterprises, project finance, etc. In more developed economies, where banks have been operating for decades, even centuries, the labour market for the financial sector contains specialists with decades of experience – people who have been through the ups and downs of business cycles, and who have seen banking crises around the world. A lack of experience, the relative youth of very senior officials in commercial banks, uneven development of certain parts of the banking sector are all reflections of this common shared history.
The lack of a banking system, as opposed to a banking sector, in all the post-Soviet countries is also partly due to the rapid development of banking, but also to a pervading lack of trust and cooperation between banks. A banking system differs from a banking sector in that a system is not substantially affected if any one of the individual parts of the system fails. Even though a bank failure in a developed economy maybe painful or difficult, all the clients of the bank know that they will not be affected. In other words, all the other banks in the system recognise that it is in their own best interests to protect the users of a banking system from the mistakes of a bad management of a failed bank, even if they must take on some of the losses of the failed bank. This recognition is growing, for example in Kazakhstan and Russia, where recent bank failures have not had any effect on depositors. This is in contrast to the well-known crises in Russia in 1998 and 2004.
One of the remarkable characteristics of banking in a developed economy is that banks are at same time each others’ aggressive competitors and also each others’ largest clients. In the interbank market, banks constantly lend and borrow money from each other, so that at the end of each day they can ensure that their clients payments are made and their own funds are effectively used. The interbank markets in the post-Soviet countries are a good way of measuring the development of the banking sector in that country: the more active the interbank market, the greater the sophistication and understanding banks have about each other. Perhaps the most advanced market, by this measure is Kazakhstan, followed by Russia.
In order for there to be a strong interbank market, banks need to understand each other, and particularly for foreign banks (by this is meant banks in other post-Soviet countries, as well as those outside this super-region), there must be a high level of professional transparency. Clearly, banks need to be careful about the information they release about themselves to a relatively uneducated public. Here transparency is very close to honesty: banks should disclose the real economic nature of their products, and not deceive the public by offering one lending rate in adverts only to add on extra charges that change the actual lending rate that borrowers will pay.
Professional analysts, however, need to know a great deal more about the operations, ownership, and client base of the bank. This information has to be provided to active players in the market for trust and a good understanding of risk to be built. Concealing information from market insiders, who may easily find out from friends and contacts working inside the bank they study, is very short-sighted. An opaque bank will never be able to generate clean and stable credit lines. There is – in each country – a tension over transparency. On one hand, saying too much in public is misunderstood and can be a commercial disadvantage, whilst hiding too much from other professionals prevents the development of a strong interbank market and the development of the banking system. This where rating agencies can play a role. By providing third party analytical research to professional analysts, using language they understand, rating agencies increase the level of professional transparency.
The strength of a country’s banking system has a major effect on its economic growth. Whilst this statement is repeated by many economists and politicians, it is clear that they do not understand why it is true, and what needs to be done to enable a banking system to grow strong. Note that politicians cannot decree or order a banking system to grow, legislators and regulators can only provide the environment for strength. Too many politicians around the world – and the countries of the ex-Soviet Union are not alone – have tried to create strong banking systems by creating strong (State owned) banks. A strong bank does not make a system. At best several strong banks can create a sector.
Banks have a number of functions, including those of settling trade, lending money, gathering resources. But for a strong economy, other functions are more important, namely the control banks exert over the managements of their borrowers, and the extent to which they trade and package risk.
Let us look only at monitoring. When a commercial (non-State) bank lends money to a borrower, it must make sure the money returns. Otherwise the owner of the bank will loose capital and the bank manager will be fired. State banks nearly always are bureaucracies, in which status and connections are more important than measurable results. So State banks rarely exert much influence over borrowers. The pressure to perform and to minimise risk on the side of the bank gets passed onto borrowers. Only effective borrowers get stable credit lines. When a manager of a borrower starts to make mistakes that will lead to losses, commercial banks immediately begin to take actions to protect their investments. Overall, this level of monitoring improves the efficiency of the whole economy.
The way in which banks can trade and manage risk is rarely understood outside the financial world. Few countries in the post-Soviet region even have laws that allow for good risk management. For instance in Russia, all derivative contracts are considered wagers, thus making it impossible to use contract law as the basis for financial instruments that can disaggregate different types of risk. Even syndicated loans (in which a number of banks cooperate to lend to a single borrower) are not arranged under domestic law because of the rules governing the way collateral is divided in the case of a bankcrupsy.
The two words that sum up strength in a banking system are: honesty and trustworthiness. If politicians truly want the best for their country, as opposed to serving the interests of the narrow constituency that keeps them in power, then the regulations and laws they need to put in place must aid banks to become more honest and trustworthy. Hence, for example: It should be in the economic interests of banks to disclose all information about their owners and their businesses; banks need to be allowed to make substantial profits, and to be encouraged to retain those profits in capital within the banks; fraud and corruption in banks should be ruthlessly eliminated (far more rigorously than in the economy as a whole); competition between banks should be encouraged, whilst not allowing any one bank to become much larger than others.
No comparison of banking systems in the post-Soviet region can end except by noting how rapidly and how remarkably this sector has grown and become sophisticated in the few years since dissolution of the Union. From virtually nothing, nearly all the countries in the region now have banks and institutions provide good quality financial products and services to an increasing number of clients. Despite the obvious weaknesses in all the countries, experienced banking analysts continue to be amazed by the development and progress across the region in under two decades, and it is very difficult to predict where banks in the region will be two decades from now.
