FRBSF Economic Letter

2000-12; April 14, 2000

 Economic Letter Index

Global Financial Change and the Transformation of Banking in Post-Communist Countries: Principles and Parallels

• Openness and opportunity
• Cross-border entry by large financial institutions
• Adapting financial supervision and regulation
• Conclusion
• References

The transformation of banking in the post-communist countries is an essential part of their transition to market-oriented economies. This transformation is taking place amid broader changes in banking and financial markets both within countries and internationally. Drawing on the experience of the U.S. financial system and on developments in financial globalization, I'd like to outline some principles and parallels that I believe may be useful to post-communist countries as they make the transition, and that may provide guideposts for the role of international financial institutions.

My remarks are organized around three main principles. First, the more open financial markets are, the more effective they can be in meeting the demand for financial services. Specifically, more openness increases the flow of credit and the flow of technology, including financial technology. Second, cross-border entry by financial institutions remains central to the transfer of goods, capital, and technologies. Third, financial regulation and supervision should reflect the changes stemming from financial globalization, including cross-border banking.

Openness and opportunity

The scope of financial globalization is a testament to the market's ability to respond to new opportunities. Some of these opportunities come from the increasing openness in trade and in capital flows, such as we've seen in Europe during the past decade. Other opportunities come from new technologies. By "new technologies" I mean both advances in computers and telecommunications and advances in the theory and practice of finance.

Of course, there have been some bumps along the road of financial globalization--most recently, the troubles in Mexico, East Asia, and Russia. But, overall, financial globalization has been very beneficial--for both developed and emerging economies. It has stimulated competition and innovation in financial services. It has helped ensure that funding flows more readily to projects offering the highest returns. And it has improved risk management.

Cross-border entry by large financial institutions

In the post-communist countries, the process of privatization has resulted in foreign banks having a substantial--and growing--stake in their banking and financial systems. But it is important to note that foreign banking institutions also have a sizable presence in many other countries. For example, in the U.S., they account for around 20% of banking assets. And in some countries in the European Community--Belgium, for example--foreign institutions are far more prominent.

These institutions play several important roles. One is the traditional role of providing support for trade and direct investment. But perhaps more important are two other roles. These institutions serve as a source of capital to the financial sector. And they provide what amounts to the transfer of financial services technology; technology, of course, includes knowledge and expertise.

These latter two roles--a source of capital and technology transfers--also were important in the U.S. banking market's move to interstate banking. This process evolved over a number of years. Before the early 1980s, few states allowed entry by an out-of-state bank. By the early 1990s, though, those restrictions had crumbled under the pressure of market realities. From this process, I'll draw three parallels with post-communist countries.

The first parallel involves one of the main reasons for the initial break in the barriers to interstate banking. As with many countries needing capital infusions, state borders in the U.S. were first opened as a way to let out-of-state institutions acquire troubled banks in-state.

The second parallel is with the role of technology transfers. With interstate banking, states that are too small to support a large in-state bank have access to the broad array of services offered by larger out-of-state institutions. In a number of cases, out-of-state banks account for the great bulk of banking services. For example, in several smaller states--such as Arizona and Nevada--around 90% of their banking assets are held by out-of-state banks.

The third parallel is with the emerging structure of the banking sector. Large interstate banks tend to approach customer needs differently from small local banks. For example, the larger institutions tend to be more centralized and automated in their operations and in some of their decisionmaking. The operations of smaller banks naturally are more localized, and they may be more likely to engage in relationship lending than their larger counterparts. Such differences between large and small banks leave room for smaller and medium-size institutions to remain competitive in serving certain customers. Indeed, even with consolidation, the banking landscape in the U.S. is marked not only by a few large national firms, but also by regional banks and by thousands of independent local banking organizations. This parallels the structure that appears to be arising in the EC.

And I wouldn't be surprised to see the rise of regional and local banks that are able to compete effectively in Central Europe as well. This seems like a real possibility since, with thin financial markets and a low level of banking activity compared to economic activity, there is plenty of room for the supply of financial services to expand. And the scope for expansion will be even greater as the economies in the region gain momentum.

Adapting financial supervision and regulation

Because financial globalization is a private sector development, financial supervision and regulation needs to work with the market, not against it. To do this, regulators need to be flexible and to accommodate market innovations. At the same time, regulators need to ensure against systemic risk without creating undue moral hazard.

Globalization and other dimensions of modernization complicate this task in several ways. For example, institutions are larger and more complex. In addition, there are more inter-institutional exposures--and therefore links--for transmitting adverse shocks. Finally, there is more potential for jurisdictional and legal conflicts. Over the past year and a half, the Federal Reserve has established several task forces to address these issues. I'll focus on three points from this work that are especially important and relevant to banking globally.

First is capital regulation. Over the last decade, the U.S. banking system went from very bad times to great times and to what now looks like a bright future. An important component of this transition has been the buildup in bank capital. But we can't be complacent. Current capital regulations built on international agreements are flawed since they can create incentives for capital arbitrage. The recent Basel efforts to restructure risk-based guidelines promise to be constructive in this regard. But it's important to note that problems can arise from focusing too much on the guidelines for capital ratios and not enough on the goals. The guidelines could be viewed not as a means to the goal, but as the goal itself. Specifically, it's not enough for regulators to ensure that institutions meet capital ratios. Instead, they also must demonstrate that the regulatory process has achieved its goal regarding the overall risk exposure of institutions, especially large, internationally active financial organizations.

Second is taking steps to enhance the effectiveness of market discipline. One step is to put more market participants at risk. For example, a recent Federal Reserve Staff Study (Board of Governors 1999) looks at the idea of requiring banks in the U.S. to issue subordinated debt, because it is sensitive to firm-specific risk. Such a requirement could provide some check on risk-taking as well as an ongoing market assessment of a bank's risk. Another step is to improve transparency. Various Basel Committee reports (for example, Basel 1999) and a recent Federal Reserve study (Board of Governors 2000) strongly support this idea. An important conclusion of the Fed study is that the market should have a major role in shaping disclosure policies. At the same time, regulatory agencies can improve the process in several ways--for example, by releasing nonconfidential data in a timely manner and by using the supervisory process to encourage best practices in bank disclosures.

The third point on regulation is to develop procedures for dealing with failures of institutions. Improving the effectiveness of market discipline is consistent with the goal of fostering competitive and efficient financial markets. It also can be compatible with reducing the effects of moral hazard on risk-taking. But for all this to work, supervisory agencies must have mechanisms in place to deal promptly with problem institutions, especially larger and more complex banking organizations. And for institutions that operate across national boundaries, it is especially critical that both the host and home regulators coordinate the development and implementation of these procedures.

Conclusion

As post-communist countries make the transition to market-oriented economies, they are benefiting from the increasing globalization of financial services. A key dimension of this has been cross-border banking, which brings not only financial resources, but also the critical transfer of financial technologies, such as operating systems and procedures as well as underwriting and risk management practices. But in addition to these kinds of technology, there is also supervisory technology--the procedures, rules, and expertise related to financial supervision and regulation. And the transfer of this supervisory technology has to be effected by official agencies. That is one reason why the Federal Reserve has joined international institutions in consulting with post-communist countries on supervision and regulation as well as on payments systems issues. But there's an even more compelling reason for this involvement. The U.S., like other countries, has a clear interest in the sound functioning of financial systems around the world.

Robert T. Parry
President and Chief Executive Officer

References

Basel Committee on Banking Supervision. 1999. Best Practices on Credit Risk Disclosure. Report No. 52 (July).

Board of Governors of the Federal Reserve System. Study Group on Subordinated Notes and Debentures. 1999. Using Subordinated Debt as an Instrument of Market Discipline. Staff Study 172 (December).

Board of Governors of the Federal Reserve System. Study Group on Disclosure. 2000. Improving Public Disclosure in Banking. Staff Study 173 (March).

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