Op-ed

Good moves for banks in eastern Europe: The annual Transition report from the European Bank for Reconstruction and Development finds big improvements in the former Eastern Bloc

By Erik Berglof

BusinessWeek, 15 November 2006

This article also appears on BusinessWeek.com

Eight years after the ruble crisis sent shock waves across Eastern Europe's financial sector, banks in the region are bigger, stronger, better regulated, more profitable and more competitive than ever.

This, more than any other development in the economic sphere, signals that market forces have established a firm footing in former command economies. Most of these "transition" countries are booming, with bank lending a big factor in current economic growth rates that range from over 6% in Russia and Serbia to 5.7% in Ukraine and 5.5% in Poland.

No longer constrained within a socialist mono-bank culture, the sector now boasts a diverse range of institutions. They provide finance to aspiring entrepreneurs, to larger firms seeking to boost their competitiveness, and to households looking for better lifestyles. Banks still dominate, but the financial sector is broadening thanks to stock markets bolstered by tougher disclosure rules, pension funds promoting long-term savings, and private equity. Corporate governance and transparency have improved.

Economic transformation

While much work still has to be done, improvements in the institutional environment, privatizations, and the entry by foreign banks into the market all helped drive change, particularly as nations from Latvia to Poland to the Czech Republic prepared to enter the European Union (EU) in 2004.

Now, banks in the transition zone enjoy returns on assets and on equity well above the EU average, thanks to booming economies and reforms that have given banks greater security in lending. Lending in the region increased on average by 20% in 2005, underscoring the role of banking in the transformation of the broader economy. Deposits are rising in line with domestic confidence in economic stability and in the financial system.

EU accession countries have made the most progress in reforming their banking systems, but indicators in the just released Transition Report for 2006 also show upgrades over the last year for Russia, Ukraine, and Kazakhstan. Tajikistan and Uzbekistan have improved as well, albeit from lower levels. Banks in most of the region now enjoy better legal protection, courts are better at enforcing laws, and banking supervision and regulation have become more effective.

Better ratio of bad debt

It's all a far cry from the 1998 ruble devaluation and debt default, which led to bank and business failures and the evaporation of savings in Russia and beyond. While still vulnerable, the region's financial institutions are much better equipped to weather a downturn in the global appetite for emerging market risk.

The ratio of bad debts to total loans has improved across the region. In the EU accession countries, it is now fast approaching the eurozone average of 3.4%. In the Commonwealth of Independent States, the ratio has tumbled from 18.5% in 2002 to 6.5% in 2005. And in the Balkans, the ratio is falling but remains high at 9.5%.

The presence of foreign-owned banks—mainly Swedish, Austrian, and Italian, but also Citibank (C) and GE Capital (GE)—which control between 60% and 90% of bank assets in most countries, has helped to increase the availability of credit, boosted competition, and also encouraged the widespread adoption of better banking technology and management practices.

Pushing household borrowing

However, the dominant role of foreign banks has raised some worries about the possible knock-on effect in transition countries of a financial crisis in the domestic economy of one of the parent banks. The experience of the 1997 Asian financial crisis is instructive: Japanese banks reduced their lending across Asia in reaction to an initial crisis in Thailand.

Fortunately, evidence thus far suggests that foreign banks in transition countries can actually help stabilize them in times of crisis.

Another issue is that some foreign banks are promoting household borrowing much more than lending to smaller businesses, as individual credit risk is easier to assess than that of micro, small, and medium-sized enterprises (defined as firms with up to 250 employees). Indeed, consumer debt in some countries is reaching Western European levels. That said, there has been an overall leap in lending to smaller firms which, with the right financial backing, have the greatest potential to create jobs and wealth across these emerging economies.

Micro, small, and medium-sized enterprises are now the single most important customer category for almost all types of banks studied in the Transition Report's Banking Environment and Performance Survey. The shift to supporting small business reflects vital reforms in financial laws and regulation, particularly regarding collateral pledges to secure loans. Serbia's ProCredit Bank reports that reforms have allowed it to cut its time for processing loans to small and medium-sized enterprises from 10 days to one.

Limited product range

Of the 1,200 micro, small, and medium-sized enterprises surveyed in Ukraine, Russia, Georgia, and Bulgaria, the number receiving bank loans doubled between 2001 and 2004. Loan sizes increased by one-third, interest rates fell by 12%, and loan maturities rose from 14 to 20 months. Access to bank credit increased average revenue growth by 75% in the companies polled.

Despite many improvements, banking in the region continues to lag far behind Western Europe. For example, the amount of bank credit available relative to gross domestic product in Russia is one-sixth of that in Portugal. In Croatia, it is one-third as high. Many Russian businesses are still completely outside the formal financial system, and the range of products their banks offer is still too limited.

Widening financial access and deepening the financial system requires a raft of new measures. Banking supervision, competition policy, and creditor protection all should be bolstered. The financial sector must grow beyond banks to more fully embrace other sectors such as equity, leasing, pensions, and insurance. Governments and the financial industry must play their parts in ensuring the sector is strong enough to further underpin the growth that is already improving lives and bringing greater stability to Eastern Europe.

Erik Berglöf is the chief economist and special advisor to the president at the European Bank for Reconstruction and Development in London.