Banking reform: Compliance with best practice

For more than a century, economists have debated the role, financial structure, the advantage and disadvantage of bank based financial system relative to market based system. German economists argue that the German bank based financial system had helped Germany overtake the United Kingdom as an industrial power. During the 20th century, the debate expanded to the United States and Japan (Vogel 1994; Porter 1993). Recent debates concentrating on financial system were: Should policy makers concerned with promoting growth and poverty reduction, focus on developing banks or developing stock markets or depend on state financing? Some argue that banks have an advantage over the market when complementary institutions are weak (Gerschenkron 1962). Even countries with weak legal and accounting systems and poor contract enforcement, face pressure from powerful banks who can force firms to reveal information and pay their debts, thus facilitating industrial expansion (Rajan and Zingales 1999). Scholars further argued that well functioning banks spur technological innovation by identifying and funding those entrepreneurs with the best chances of successfully developing new products and implementing innovative production processes (Hicks 1969; Bagehot 1873; Schumpeter 1934).

Preparing for reform: The steps that guide bank and enterprise restructuring efforts are: (a) Determining the size of losses--the stocks and flows; (b) Choosing a centralised or decentralised debt restructuring solution; (c) Reducing flow losses resulting from continued exposure to loss-making enterprises and thereby improve intermediation; (d) Determining whether the write-off of enterprise debts will be done by banks or by the state; (e) Determining whether to restructure banks before privatisation and restructuring of enterprises; and (f) Determining the appropriate role of banks in enterprise restructuring. While the process of bank restructuring will vary from country to country depending on initial conditions and financial structure, several principles and objectives should guide the design of bank restructuring programmes:

First: The financial condition of the banks need to be improved so that they can efficiently intermediate funds. Bank losses often reveal themselves in large spreads, leading to both negative real deposit rates and high real lending rates. Banks should be "cleaned" so that spreads narrow to revive saving and investment. The cleaning-up process would facilitate the privatisation of banks, including meeting minimum capital adequacy requirements.

Second: Since bank losses generally stem from lending to loss-making enterprises, the debt burden of enterprises must be relieved to improve their recovery and income generation capacity and facilitate privatisation of state holdings and general economic restructuring. Related to the problem of bank restructuring is the issue of "pass through" -- how debt relief for the banks can be passed through to the enterprises to facilitate their restructuring and recovery. Restructuring also must reduce the backlog of enterprises in liquidation or bankruptcy, since these tie up scarce economic resources.

Third: The burden of past losses of state enterprises and banks should be shared by the state, non-state bank shareholders, borrowers, and depositors. The rationale for using state funds to relieve banks of their stock of non-performing loans is to improve the allocation of scarce resources. The higher the level of state assistance, the greater the burden of losses that is shifted to taxpayers, instead of to future borrowers or depositors or even current shareholders. The "carving out" of bad debt through swaps of bad debts for long-term bonds spreads the costs over several years.

Fourth: It must be determined how the losses can be absorbed by the budget without threatening fiscal discipline and macroeconomic stability. In many post-centrally planned economies it is unclear how the state can finance such losses given these countries' tenuous fiscal situation. This is further complicated by the governments' heavy reliance on tax revenues from state-owned banks.

Fifth: The choice of restructuring options may depend not only on the fiscal cost, but also on time and administrative costs. For example, pushing numerous failed debtors into bankruptcy proceedings without established court procedures resulting in trained personnel creating bottlenecks that allow asset values to deteriorate as banks await court decision. Thus solutions should foster competition and transparency and avoid overly bureaucratic measures.

Finally, bank restructuring must address incentives in such a way as to prevent excessive debt leveraging, avoid weakening credit discipline, allow market forces to operate on a level playing field, and improve competition, resource allocation, and risk management. Any scheme that preserves monopolies or oligopolies (state or private) will only perpetuate existing distortions and increase future costs of resolution. The restructuring scheme should improve incentives that reward competition and efficiency and punish agent behaviour that raises social costs.

Sequencing of reform: Market-based solution and government intervention are the two broad mechanisms that have been suggested by the experts (Sheng, 1996). The market base solution comprises: shareholder capital injection, sale or merger, privatisation and liquidation without deposit compensation while government intervention includes nationalisation, liquidation with deposit insurance, asset recovery trust, bank hospitals, supply side solutions and forced conversion into bonds. Bank restructuring cannot be undertaken independent of the real sector. The debate remains open on whether the state should first deal with enterprise-borrower problem or the banking problem. Special audits need be conducted and Terms of Reference for special audits of banks should include: (a) Accounting diagnosis; (b) Institutional diagnosis.

Distribution of responsibility: First identify the ingredients of banking reforms such as macroeconomic environment, link to markets, recapitalisation, enabling environment, political commitment, stakeholder incentives, technical assistance and training, sequencing of reforms, governance and management, and privatisation. Second, define the role of the government and the banks.

Models of bank restructuring: The techniques of a reform process depends on its application varying across countries depending on individual conditions. Sheng suggested the process of bank reform may be distilled into four main phases some of which may be overlapping: (i) Diagnosis; (ii) Damage control; (iii) Loss allocation; and (iv) Re-building profitability and Creating incentives. Models of bank reforms are: UK: Life boat fund (1974); USA: Deposit Insurance (until-1989) and Resolution Trust Corporation (after 1989); Spanish: Bank hospital and Crave out mechanism; and Chile: Variation

Comparison the matrix with Bangladesh's: Nigel et al (1998) prepared nine parameters of reform by setting them on scale of 4 reform matrixes where 1 indicate very little, 2 to some extent, 3 fairly good and 4 showing best performance in reform process. These were compared with the reform process of Bangladesh. Results of comparison on each criterion are: Large scale privatisation (2); Small scale privatisation (4); Enterprise restructuring (1); Price liberalisation (3) Trade and foreign exchange system (3); Competition policy (4); Banking reform (2); Capital markets (2) and Legal reform index, rules on pledge, bankruptcy and company law (2). Policy decision on privatisation can be done with a stroke of pen yet changing the fundamental governance, developing market supporting institutions such as legal and financial system takes years, even decades, because it involves such a fundamental change in skills, organisation and attitudes. Complexity have not always been the only reason for delay of reform, politics impedes the process, as often happened in reforming social programme.

Reformist leader: In search of a manual reformist politician, Williamson (1994), suggested interesting idea of gathering a group of high-ranking technocrats to talk about their experiences with the hope that from some common lessons, emerges a list of hypotheses drawn from the literature about what makes reform feasible and successful and which were asked to examine from their own individual perspective. These are: (a) Policy reforms emerge in response to crisis; (b) Strong external support is an important condition for successful reform; (c) Authoritarian regimes are best at carrying out reforms; (d) Policy reform is a right wing programme; (e) Reformers enjoy " honeymoon period'' of support before opposition builds up; (f) Reforms are difficult to sustain unless the government has a solid base of legislative support; (g) A government may compensate for the lack of a strong base support if opposition is weak and fragmented; (h) Social consensus is a powerful factor impelling reform; (i) Visionary leadership is important; (j) A coherent and united economic team is important; (k) Successful reform requires a comprehensive programme capable of rapid implementation; (l) Successful reforms economists are in position of political responsibility; (m) Reformers should mask their intention from the general public; (n) Reformers should make good use of media; (o) Reform becomes easier if the losers are compensated; and (p) accelerating the emergence of winners can enhance sustainability. By contrast, Bangladesh lacks a visionary leader, economists have no political commitment with the exception of a few and politicians are often corrupt, undereducated or not educated.

Reform calls for joint identification of programme goals, consensus within the government leadership, upfront actions to demonstrate intellectual conviction and broad outreach regarding reform goals within the body politic. Experiences over the past decade show that countries embrace reform when three conditions prevail: (a) a political party changes and the party in power develops a new programme or, the party in power may change its stance on the reforms when the country finds itself in serious crisis; (b) either the bureaucracy through which a ruling party implements its programme changes when the political party changes, or it is persuaded to accept new policies; and citizens change their perception of reform.

Dr Jamaluddin Ahmed FCA is Partner Hoda Vasi Chowdhury & Co, Chartered Accountants.