Corporate Control in Central Europe and Russia: Should Banks Own Shares?

June 1995 A governance system based on bank ownership and control of firms is not yet feasible, but a good case can be made for allowing banks to gradually gain experience through limited equity ownership---especially for allowing the swapping of bad debt for equity. Dittus and Prowse review corporate governance arrangements in the West and conclude that for a system based on bank ownership and control of firms to succeed, the banking system must be free of perverse incentives and state interference, as well as subject to adequate supervision by banking authorities and competition from market forces. Admirable progress over the past few years notwithstanding, these conditions do not now exist in the countries of Central Europe and Russia, so a corporate governance system based on bank ownership is not appropriate. That is not to say that such a system would not eventually be appropriate---but not before much more effort is made to create a competitive, private, well-supervised banking system (which is needed in any case). Changes in the banking system that are prerequisites for any large-scale bank involvement in the ownership and governance of firms are simple to enunciate but less easy to implement: ° Sever existing relationships between the state and banks. Privatization is the strongest guarantee that bank investment decisions will not be subject to state influence, but bank privatization has been slow in most countries. This reflects limited understanding of the financial sector's poor condition, the many institutional and political obstacles to bank reform, and the initial decision in many countries to focus first on the real economy (a decision that in hindsight seems unfortunate). ° Dispel the belief (which still exists in some countries) that poor lending and investments will eventually be underwritten by the government, with few consequences for managers. ° Greatly strengthen competition in the banking system, in part by encouraging new private banks and the entry of foreign banks. (Some countries, such as Poland, have taken the opposite tack, refusing to issue new licenses.) ° Provide effective bank supervision and an effective prudential and regulatory framework. This requires investing substantially in setting up institutions, accounting systems, and information networks, in hiring and training qualified personnel, and in ensuring that the system is immune from political intervention. Developing such a system will surely be long and drawn out, and may require foreign assistance. This paper---a product of the Transition Economics Division, Policy Research Department---is part of a larger effort in the department to explore issues of corporate governance in transition economies. The study was funded by the Bank's Research Support Budget under the research project Corporate Governance in Central Europe and Russia (RPO 678-42).