Banking Reform in Transition Countries

August 1996 The institutional capacity of banks in transition economies improves faster when a new or parallel private banking system is allowed to emerge than it does when the government tries simply to reform existing state-owned banks. Banking reform should stress decentralized institution-building and penalties for weak banks. In reforming the financial sector in transition economies, one important debate is about whether governments should try to reform existing state-owned banks -- the rehabilitation approach -- or whether a new private banking system should be allowed to emerge -- a new entry approach. Or should there be a mix of the two approaches, in which the activities of state banks are restricted while a parallel private banking system develops? Claessens's cross-country comparison of banks' institutional development in 25 transition economies suggests that progress can be faster under the new entry approach, especially relative to initial conditions. Progress under the rehabilitation approach appears to be inhibited by poor incentives. In most countries, even those with a good banking infrastructure and a large segment of good banks, a two-track process has evolved, with large and growing differences between weak and strong banks. Whatever the banking reform approach taken, weak banks have moved very little beyond central planning. Regression estimates suggest that in transition economies three things are associated with slow progress of weak banks: overconcentration, preferential treatment by governments, and limited entry for new banks. The direction of causality is often unclear. Policies and structural conditions can affect bank quality, but whenever a banking system has a certain quality, particular policies may also arise or structures exist. The role of banks will remain limited in many transition economies because of weak legal infrastru...