Decentralization of Banks in Eastern Europe and the Soviet Union

Decentralization of Banks in Eastern Europe

And the Soviet Union

As Soviet communism collapsed in Eastern Europe in 1989, the countries of Central and Eastern Europe began the unprecedented transition from a centralized command economy to a market economy. The stages of transition included, liberalization, stabilization and privatization. All of these steps required decentralization of government assets and financial institutions. One of the most crucial parts of the transition was the decentralization of the banking system, which wiped out the centrally planned Soviet and Eastern European societies. Unlike most banking systems in market economies, the bank in the centrally planned economies acted as administrative agencies and had almost no common features with any commercial bank. These countries had to accomplish hundreds of years of economic evolution in a matter of a few years. In this paper I want to discuss how the command economy banks were decentralized and the causes of bank failure after decentralization. The second aspect I want to talk about is how laws and regulations were used to recover banks failure and eventually lead to a functioning system of commercial banks.

All of the post-communist countries of Central and Eastern Europe share a common political, economic and social background. The Soviet communism was implemented in the Eastern and Central European countries in the late 1930's and early 1940's. This change in government resulted in the transformation of the existing pre World War I political, economic and social structures of the countries. Existing governments were replaced with administrations that controlled the various regions through a standardized set of rules and formal norms that removed all social connections from the earlier years. Under these new rules all political, economic and social activities were controlled by a state dominated single party. When the party fell in 1989, the newly freed countries all took a separate path politically and economically. The main elements that all the countries had in common were the need to decentralize the government agencies and form an adequate banking system. (Lavigne)

Within the communist system, the banking system was based around a single Central bank which performed both the central bank operations and extended credit to industry within the country. The central bank was assisted by savings banks which collected deposits. No commercial banks existed. The bank was property of the government and only the central planner could decide on capital allocation and production levels. The functions of money did not exist within the command economies. Within the governing area, money was simply used as an accounting tool. The currency was based on convertible rubles and had no use outside of the council for mutual economic assistance trade zone countries. When more currency was needed, they simply printed more money (Lavigne). There were no interest rates to be effected by money supply, prices or demand. The bank was property of the government and only the central planner decided the ways in which money was dispersed throughout the country. Money passed through the economy through a planned central economy where resource efficiency was not a priority. The plan allocated cash to the specialized banks that represented each sector of the economy. Loans were given without consideration on whether or not they could be repaid. These loans were simply issued to industries to cover losses and production requirement failures. This type of the policy encouraged poor management, inconsistent repayment plans and reduced money circulation (Boone).

Once the government decentralized, the one bank system was transformed to a two tier banking system. This two tiered system broke the one bank system into a Central bank and independent commercial banks. The system was switched from a scenario where there was no outside money, to a system that included inside money, (the liabilities of the bank rather than the state). The banks were created to help serve three roles: support stabilization, finance the economy and facilitate in privatization of enterprises. The creation of these new banks did not mean that the old bad debts disappeared. The new banks inherited all the bad debts that were given throughout the communist rule. Another problem occurring with bad debts happened with the issuance of new loans. These new banks began issuing loans to help the various industries trying to privatize. The problem with these loans is that they were non-performing loans and were immediately in default. The transition economies had a very high ratio on these non performing loans compared to actual performing loans. Soviet countries Georgia and Tajikistan led the way with more than forty percent of the loans issued were under default. The formally owned government banks were the overall leader in nonperforming loans. Overall more than ninety percent of the nonperforming loans were from the previous state owned banks. (Fries)

The second problem with the new private banking sector was the lack of overall banking skills, mismanagement and corruption. Under the old banking system, banks and their workers had no need to make assessments whether or not an institution was credit worthy. These bankers had no experience in credit risk assessment, financial analysis of borrowers, cash flow analysis or profit making abilities. In the market system the need to determine if a company can repay loans is a major part of determining if they will receive the loan. These skills were not needed or available in the planned economy system. Bank workers now had to analyze the current situations of these new banks and determine their credit worthiness. The created many dead loans that never had a chance to be paid back. (Lavigne)

Along with the skills the workers needed, the overall information to determine credit worthiness was not available. Since these new enterprises had just recently been created and have never been subjected to market economy forces, the financial data was not available for determining credit risk. In return, many loans were given based on desire resulting in very poor decisions and an increased number of defaulted loans. (Gros)

Mismanagement by bank authorities was also a factor. With unrealistic assumptions of the new commercial banks credit worthiness, ability to repay, and the overall low capacity to recover delinquent loans, bank managers took positions that involved excessive risk. Many bank managers recognized the weakness in the banking laws and in return tapped into bank resources to take the risky investments. Managers had the ability to gives loans to a company, the company in return deposits the money into the bank. With the