BANK PRIVATISATION AND ITS INSTITUTIONAL ...

European Association for Comparative Economic Studies (EACES) 9th Bi-Annual Conference: Development Strategies - A Comparative View

BANK PRIVATISATION AND ITS INSTITUTIONAL EFFECTS: WHICH WAY IS RUSSIA GOING?

Andrei Vernikov, Institute of Economics of the Russian Academy of Sciences and Higher School of Economics, Moscow, Russian Federation (+7-495-120-9387, [email protected] )

Paper presented at the European Association for Comparative Economic Studies (EACES) 9th Bi-Annual Conference: Development Strategies - A Comparative View

Bank privatisation and its institutional effects: Which way is Russia going?


ABSTRACT This paper looks at strategy of bank privatisation and finds more similarities between Russia and China than between Russia and Central Europe. Unlike European transition economies, Russia keeps a high share of state-owned banks and a low share of foreign organisations. This ownership structure is one of the reasons why imported financial institutions take hold in the local environment with significant difficulty. The uncertainty about bank privatisation and the pursuit of non-economic values and goals raise questions about the essence of economic transition in Russia. Introduction of institutions of market economy could be accelerated by a bolder bank privatisation.

CONTENTS I. Introduction ............................................................................................................................. 3 II. Bank Ownership Transformation: Russia Compared to Central Europe and to China ......... 3 III. Import of Institutions and Import of Organisations.............................................................. 8 IV. Institutional Impact from Direct Foreign Investment in the Banking Sector..................... 10 V. Bank Ownership Transformation within an Institutional Context ...................................... 13 VI. Conclusions ........................................................................................................................ 15 Notes…………………………………………………………………………………………..16 References…………………………………………………………………………………….18


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I. INTRODUCTION This paper examines the connection between ownership changes in the banking sector and development of institutions1 inherent to a market economy. In Central Europe (CE)2 the process of bank privatisations in favour of strategic foreign owners was driven primarily by considerations and expectations of positive institutional impact rather than by fiscal interests or external pressures. After strategic foreign investors replaced the government as banks’ owners, the financial system stopped being the ‘black hole’ of the economy and became a source of stability and a contributor to institutional change. A real privatisation of banks has been deferred in China as well as in Russia. We see incoherence in that a transition country – Russia – shares strategic goals concerning banks with China rather than with CE countries. China and Russia have protected national actors, while CE countries replaced them with foreign-owned banks which are more likely to quickly adapt to a desired institutional environment. Conservation of control and ownership structure in the banking system hinders institutional change and acts in favour of the entrenched cultural norms and traditions that are not necessarily beneficial for a market economy; it leaves the risk of assimilation of imported institutions. This aspect of Russia’s economic transition has so far deserved little attention. The rest of this paper is organised as follows. In Section II we identify two main types of strategy for bank privatisation and compare Russia to CE and to China. Section III describes interconnection between import of financial institutions and import of financial organisations, i.e. banks owned by foreign capital. Section IV is devoted to the institutional impact of foreign-owned banks in areas such protection of private property and enhancement to private sector development, lending and resource-allocation, creation of a competitive environment, improvement of corporate governance, and eradication of the shadow economy. Section V puts bank privatisation in a broader context of institutional change, highlighting an incoherence of Russia’s approach to banks. Concluding remarks are offered in Section VI. II. BANK OWNERSHIP TRANSFORMATION: RUSSIA COMPARED TO CENTRAL EUROPE AND CHINA Alternative Strategies Two different patterns of transforming bank ownership on a national scale emerge from empirical evidence in post-communist countries and China. We summarise them under the headings of Strategy 1 and Strategy 2 (Table 1). Table 1: Comparison of strategies for bank ownership transformation Strategy 1 Strategy 2 Goal Complete ownership trans- Improved performance of formation state-owned banks, maximisation of revenue Triggered by a banking crisis Usually Yes No, but poor asset quality a major problem Preceded by rehabilitation of Yes Yes state-owned banks


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Envisaged role of the government Envisaged role of the national private capital Envisaged role of foreign direct investors in privatised banks Envisaged role of foreign portfolio investors Method of privatisation

Withdrawal of government Controlling stake in core from commercial banks banks Not targeted Not targeted

Full control over privatised Junior partner; source of banks technology, capital and management skills Some room, but second best Source of capital option Auction of controlling stake IPO for a minority stake, an outright sale of minority stake, or a combination thereof Fiscal revenues Not the main driver. Some- High, despite costs of rehatimes neutral impact if costs bilitation of rehabilitation are included Pace of privatisation High Slow Accompanied by opening up Yes Yes, but in a measured and of the banking sector to forgradual way eign competition Regime for foreign direct in- Liberal after privatisation of Selective and restrictive; vestors in ‘greenfield banks’ core banks case-by-case approach Part of a broader international Yes. EU membership is a No, except for compliance integration effort driver of paramount impor- with WTO requirements tance Possibility of reversal No Yes, if performance of banks unsatisfactory from political viewpoint Institutional impact Strong Weak Countries that follow(-ed) Czech R., Hungary, Slovakia, China; with qualifications – this strategy Estonia, Lithuania, Croatia, Russia Bulgaria and Romania; with qualifications – Poland, Slovenia and Latvia

Strategy 1 and Strategy 2 might be regarded as mutually complementary rather than alternative. The pursuit of Strategy 1 is usually preceded by an evolutionary period of ‘muddling through’ when no radical transformation of ownership of core banks takes place. On the other hand, implementation of Strategy 2 in China may prepare necessary conditions for a subsequent shift to a farther-reaching strategy of bank privatisation, i.e. essentially Strategy 1. All transition countries in CE have migrated to Strategy 1. Slovenia might appear as leaning towards Strategy 2 because it has refrained from run-away bank privatisation in favour of non-residents and now has a lower market share of foreign-controlled banks (36%) and a higher share of national private banks than other CE countries. Slovenia’s divergence from the


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‘Central European pattern’ can be tactical and not strategic. Privatisation of state-owned banks was postponed but not rejected in principle; the share of state-owned banks in Slovenia (19.1%) is comparable to that in Poland (21.6% at the end of 2004) and much lower than in Russia. Slovenia’s EU membership, the adoption of all essential institutions of a market economy and opening-up to foreign competition has created an environment for a strong and competitive banking sector. Poland has maintained a relatively high market share of state-owned banks and a lower share of strategic foreign property. Tactical deviations from Strategy 1 do not suffice to classify any CE or South Eastern European economy as following Strategy 2. A subsequent radicalisation of China’s strategy on bank privatisation cannot be ruled out a priori, but it depends on the fundamental goals pursued. Strategy 1 is part of a broad plan of transition from socialist to capitalist economy. Strategy 2 as currently implemented by China does not aim that high: whether China is at all a country in transition is a matter of theoretical debate.3 We include China in the scope of analysis for three reasons: (a) its banking sector faces problem that are generic for all post-communist countries in early stages of transition; (b) the Chinese ‘model’ has an appeal to Russia and a few other countries in transition; and (c) implementation of Strategy 2 might in the future pave road to further transformation of stateowned banks. Russia and Central Europe The role of each of the three main sectors of the banking system – public, foreign and national private – differs greatly in CE and in Russia. Structure-wise, the Russian banking system is more similar to that in Slovenia than in any other CE country (Fig.1), even if this numerical similarity disguises substantial differences in policies. 100% 80% national private

60%

foreign 40%

public

Hungary

Slovakia

Czech R.

Slovenia

Poland

0%

Russia

20%

Figure 1: Structure of the banking sector by type of ownership (in %, by end-2004, for Russia – by end-2005) Source: Raiffeisen, 2005; Central Bank of Russia; own calculation


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Like other European economies in transition, Russia created a two-tier banking system and forced state-owned banks to operate in a quasi-market environment by transforming them into joint-stock companies and exposing them to competition. Unlike in CE, poor asset quality played a minor role as a catalyst of bank privatisation in Russia where banking crises have thus far been related more to liquidity disruptions and exchange rate risks than to asset quality. Russia has declined to bail out the failed banks as in most CE and in some of the South East European countries.4 Public funds have been injected in state-owned banks for the purpose of supporting their market expansion and acquisition of private-sector companies, often for political reasons. According to our estimate, there are no less than 40 banks in Russia owned and/or controlled by the broad government, including state corporations. Their combined market share reaches 44% of total assets5 and even shows an upward trend. This level is substantially higher than in other transition economies in Europe (Fig.2). 70 60

Slovakia

50

Russia*

Slovenia

40 30

Poland

20 10 0

Czech Rep.

Hungary

2001

2002

2003

2004

2005

2006

Figure 2: Market share of banks owned and/or controlled by the state, in % of total assets *own calculation Source: Raiffeisen, 2005 Another distinction between Russia and CE is the role of national private capital. By privatising core banks quickly and liberalising the sector, CE countries with the exception of Slovenia did not give national banking entrepreneurs much chance to stand up to foreign competition. Out of 100 largest banking groups in Central and Eastern Europe (by Tier 1 capital) 80 are under foreign control. By contrast, Russia allocated more room to national private sector by transferring financial and other assets to nominally private banks and by allowing easy entry to hundreds of ‘greenfield banks’. Currently Russian private banks control approximately 44% of total assets. Twenty-two of them appear on The Banker’s list of the world’s 1,000 largest banks. Russia has formed a nation-wide consensus regarding unacceptability of the ‘East European scenario’ with foreign investors taking over the banking and financial system.6 That view is now broadly endorsed by all elements of the national elite – political, intellectual, financial


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and economic. Russia has reiterated the need to maintain direct ‘national control’ over core banks and the banking system in general, where ‘national’ refers to the government and, under certain conditions, national private capital. Russia’s regime of foreign direct investment in banking is regulated by case-by-case decisions, although foreign banking subsidiaries enjoy national treatment with few exceptions. The market share of banks controlled by foreign owners does not exceed 10% which is the lowest indicator among European transition economies. Russia and China Russia’s strategy of bank ownership transformation shares common features with that under implementation in China. Both countries have made it clear that they do not plan to fully privatise the core banks nor to surrender control over them to private investors, regardless national or foreign. The strategy for the banking sector approved by the Russian government and the Central Bank in 2005 contains just a vague indication of the authorities’ intention to maintain participation in the capital of banks (Government, 2005). China and Russia have tried ‘to commercialise’ the dominant state banks, i.e. to increase banks’ immunity from government policy interference and to make banks economically selfreliant. China sold stakes at some of the largest banks (Bank of China, Industrial and Commercial Bank of China, China Construction Bank, and the Bank of Communications), plus in several second-tier banks, on the stock market or directly to foreign investors. Russia has followed similar course. Shares of its largest bank, Sberbank (The Savings Bank), have long been trading on the stock exchange. The Russian government rejected plans to bring a strategic foreign investor into the capital of the second-largest bank – Vneshtorgbank and decided instead to place some of its shares through an initial public offering (IPO), similarly to what the Polish government did to its largest bank (PKO Bank Polski). The state-controlled company (Gazprom) that owns Russia’s third-largest Gazprombank chose to sell a 33% stake to a captive pension fund. In its strategy of public flotation of state-owned banks Russia is following China’s steps. Both countries are now trying to maximise the financial effect from the partial disposal of banking assets of the public sector.7 Russia, however, has gone farther than China in liberalising the regime of foreign direct investment in the banking sector and cross-border banking. The share of foreign-controlled banks in Russia is higher than in China (8.3% and 2%, respectively). China still maintains a legal ceiling of 25% of foreign capital in each individual bank and a maximum of 20% for each foreign investor. In Russia there is no ceiling on the foreign share in a local bank. In China the subsidiaries of foreign banks face various restrictions with regard to the range of performed operations, the right to transact in local currency, the number of branches to be opened in each region per year, etc. By contrast, in Russia such entities enjoy national treatment with few remaining exceptions. China joined WTO with the commitment to liberalise its banking sector by 2007. Russia’s eventual accession to WTO is likely to remove some of the remaining barriers to foreign direct investment. On balance, as suggested by statistical data and empirical evidence, Russia has not strictly followed either of the alternative strategies of bank privatisation implemented in CE and in China, respectively. It has some common features with both strategies; however we find greater alignment with the Chinese ‘model’.


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III. IMPORT OF INSTITUTIONS AND IMPORT OF ORGANISATIONS Institutions have crucial importance for the success, speed and cost of transition of postcommunist countries towards a full-fledged market economy (Williamson, 1985; Eggertsson, 1990, 2005; North, 1990; Nesterenko, 2000; IET, 2003; Rodrik et al., 2004; Banerjee and Ghatak, 2005; Bardhan, 2005; Belloc, 2006). Basic institutions such as the rule of law, respect and protection of private property, contract enforcement and competition may be not ready or mature enough, in which case a country can opt to ‘import’ these institutions, together with respective institutional mechanisms and with the organisations to be put in charge of proper functioning and oversight of those mechanisms. ‘Import of institutions’ refers to the process of conscious copying of institutional arrangements from one society and their introduction in another socio-economic system.8 CE countries adopted the European acquis communautaire and introduced entire blocks of laws and regulations that govern banking, central bank powers, competition in financial services market, deposit insurance, banking secrecy, anti-money-laundering procedures, etc. The new EU member countries had to adopt a uniform regime of foreign direct investment in banking, granting unrestricted establishment rights to other European banks and liberalising cross-border banking. Russia’s original institutional setup is not consistent with free markets – it has a solid matrix reproducing relations of redistribution (Naymushin, 2004; Kirdina, 2004). Since early1990s Russia has imported a variety of formal institutions, including entire blocks of civil, contract and financial law, court and arbitration, stock market institutions, deposit insurance and many others. Russia’s specific feature is that, unlike CE countries, it borrowed institutions from more than one source – from EU, USA, and Asian countries. ‘Off-the-shelf’ method has produced a mix of inconsistent institutional arrangements – e.g., most of the institutions governing commercial banking are from continental Europe, while stock market institutions replicate those in the USA. The cost of introducing imported institutions depends on their compatibility with formal and informal norms that prevail in the importing country (Oleynik, 1999). The greater the misalignment between traditional and imported institutions, the more significant the cost is. A proxy for such a cost can be found in the expenses on additional bureaucracy and administration needed to enforce the new formal institutions. In Russia the rapidly growing number of Central Bank and other civil servants in charge of supervision over commercial banks (foreign exchange control, prudential regulation, financial monitoring of suspicious transactions, commercial arbitration) indicates a lack of voluntary acceptance of new institutions by banks. Imported institutions of market economy may fail to take root and function properly if they are not voluntarily embraced by local agents, be it private individuals or economic entities. This institutional conflict can be resolved in two ways: (a) imported institutions are adapted and modified to become aligned with traditional arrangements; and (b) economic agents change their behaviour. The prevailing pattern of economic behaviour can change over a period of time whose length depends on the changing composition of market participants. One of the lessons of economic transition is that a cardinal change in economic behaviour and motivation depends on the type of ownership and cannot be achieved otherwise. Banks controlled by the government tend to act in ways disruptive for macroeconomic stability by engaging in politically-motivated lending and building up portfolios of poor quality assets. At


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the same time, a simple transfer of property right from the state to the national private entrepreneurs may produce mixed results, as demonstrated by reckless policies of Russian banks immediately prior to the financial crisis of 1998. A country willing to import institutions can also import organisations, i.e. foreignowned market actors. It can be done by transferring local companies and banks into foreign ownership and promoting foreign direct investment. Campbell (1993) evaluates the influence of foreign actors on reform in capitalist and post-socialist societies. In CE countries the functioning of state-owned and quasi-private local banks was deemed unsatisfactory, and the authorities replaced them by foreign organisations whose private nature was a natural fact. Genesis of truly private ‘greenfield’ banks would have taken more time and incur additional social cost in the meantime. Import of financial institutions (acquis communautaire) was aligned with import of organisations (banks) and quickly yielded result in terms of confidence in the financial system, improved investment climate and convergence with European standards. Like other countries trying to close the gap with more advanced societies, both Russia and China have undertaken a similar institutional change at some point in history. In China it was branches of British banks that launched modern banking in the 19th century; they demonstrated superior efficiency and phased out traditional financial intermediaries based on Confucian institutions. In the late 19th-early 20th century in Russia the European banks dominated the nascent industry. At the contemporary stage, though, both countries take a more cautious evolutionary approach. A rapid institutional change is enhanced when the number of market participants of a new kind (in our case, subsidiaries and branches of foreign banks and the local banks taken over by foreign investors) constitutes a critical mass and creates a synergetic effect. There is no fine scientific method to quantify the critical mass for each national banking system because it is a function of too many structural and institutional variables; the number of actors in the system is discretionary. A qualitative estimate tentatively suggests that a synergetic effect emerges after the foreign banks’ share exceeds 20-25% - a level not reached in Russia or China but now approached by Ukraine. The concept of a critical mass is applicable to the micro-economic level as well. Not every foreign stake in a bank makes equal difference. Empirical evidence shows that the level of foreign ownership, not its mere existence, has a positive association with the bank return and a negative association with the bank risk (Choi and Hasan, 2005). On a scale between 0 and 100% of foreign ownership there is a certain point beyond which a foreign stakeholder begins to have an impact on the decision-making. After such a point the organisation’s identity and market behaviour may be expected to become different, thus increasing alignment with the institutional environment setup. It turn, the institutional environment is a major factor that determines the location of the threshold point of control. Ceteris paribus, the more mature the legal and cultural institutions, the lower the stake needed to exert an impact on the decision-making of a firm. Bonin et al. (2005) suggest at least a 50% stake as the threshold of control over a bank by one or several foreign investors. Grigorian and Manole (2002) consider a lower threshold of 30%. The nature of the foreign investor (-s) matters as much as a controlling stake. Bonin et al. (2005, p.35) divide majority foreign-owned banks into two categories: (a) banks with a single strategic foreign investor, i.e. majority foreign owned and controlled by a single owner,


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and (b) those without such single investor. A minority stake held by a strategic foreign investor can influence decisions made by the bank managers and thus change its behaviour, while a combined controlling stake held by a group of foreign portfolio investors may fail to achieve such a change. A dispersed group of foreign owners may hold a significant stake but not dominate the organisation because the controlling owner could remain the government with its residual stake or even the management of the bank. IV. INSTITUTIONAL IMPACT FROM DIRECT FOREIGN INVESTMENT IN THE BANKING SECTOR There is strong literature on the impact of foreign investment on growth, efficiency, performance, structural change, employment and other aspects of transition (Borensztein et al., 1995; Kokko, 1996; Aitken et al., 1997; Blomstrom et al., 1999; Yudaeva et al., 2003). More specifically, Grigorian and Manole (2002) identify determinants of commercial bank performance in transition economies. Weill (2003) focuses on the role of foreign ownership as factor of bank efficiency in transition economies to find that on average foreign-owned banks are more efficient than domestic-owned banks. Fries and Taci (2004) compare cost efficiency of different types of banks in 15 countries in transition and conclude that banks privatised by foreign investors reach the highest efficiency ratios, followed by ‘greenfield’ private banks, banks privatised by national entrepreneurs and finally by state-owned banks. Bonin et al. (2005) arrive at a consistent set of conclusions: foreign-controlled banks are more costefficient than others, and state-owned banks are the least cost-efficient. Due to the low shares of foreign-owned banks in Russia and in China, this factor has not yet acquired sufficient statistical relevance to study causalities between foreign direct investment and various parameters such as banks efficiency and profitability. The same applies to the role that foreign direct investment plays in supporting the basic institutions of the market economy. We nevertheless indicate several areas where institutional impact can be identified. A private foreign bank solely pursues profit maximisation while local state-owned banks may be driven by extra-economic motivations. From a methodological viewpoint, it is less obvious why a foreign bank represents a different type of organisation as compared to local private banks because all private organisations must pursue similar goals.9 Qualities that make foreign-owned banks act differently have their origin in the adaptation of the parent companies in mature economies to a mature institutional environment. These qualities embodied in the ‘corporate culture’ are likely to be transferred to subsidiaries in a transition economy. Protection of Private Property and Enhancement to Private Sector Development In emerging markets, including countries in transition, foreign banks support the institution of private property, i.a., by being a ‘safe haven’ for private savings and by supporting private sector development. During periods of macroeconomic and political instability and banking crises, ‘flight to quality’ allows local economic agents to protect their savings and holdings from expropriation, enforced ‘freezing’, conversion at disadvantageous exchange rate and other forms of loss.10 As for enhancement of private sector development in transition economies, foreign-owned banks predominantly intermediate financial flows of the private sector whose share in the structure of foreign banks’ assets is higher than the share of private sector in the host country economy (Vernikov, 2005, p.166). Preferential access to financial re-


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sources helps local private sector to grow faster. As a rule, foreign-owned banks in transition economies did not take part in the privatisation of non-financial assets that was accompanied by illegal appropriation of other agents’ property; they do not finance hostile takeovers. Foreign banks normally refrain from dealing with companies whose assets and capital have doubtful legitimacy and opaque origins. Lending and Resource-Allocation The state may wish to keep core commercial banks under direct control by continuing to own them because it intends to influence banks’ lending decisions and pricing. Distorted price signals and political interference lead to suboptimal resource allocation in favour or riskier projects and less viable borrowers without appropriate reward. Politically motivated lending results in unsustainable portfolios of non-performing loans (NPLs) on banks’ balance sheets and requires large expenditure of public funds to rehabilitate the banks. Since 1999, the Chinese government transferred billions of dollars in non-performing loans to 4 ‘asset management companies’ and injected billions of dollars directly into the capital of state-owned banks to keep them viable.11 Another practice widespread in all emerging markets is ‘related lending’ to firms controlled by the bank’s owners.12 A reason behind related lending is often institutional: legal mechanisms of contract enforcement are ineffective and/or expensive and time-consuming. CE countries have employed the advantage of foreign banks in that these banks usually hold no industrial assets and therefore assess each loan on an arm’s-length basis, using criteria of viability and credit-worthiness; foreign banks do not need to bend to political pressures to finance senseless ‘white elephants’. The average quality of foreign banks’ loan portfolios tends to be the highest. The same factors might appear as potential disadvantages in the eyes of the authorities of both Russia and China: the implicit fear is that a foreign bank can decline to finance an infrastructural, industrial or social project important for political, military or other non-economic reasons. Competition Competition is an essential institution of a market economy which may not necessarily emerge spontaneously in every transition economy. In the beginning the banking systems of transition countries represent highly protected and tightly controlled oligopolies. The number of market participants can mislead: Russia has around 1,200 banking franchises; however most of them have marginal importance for the system. Market structure for any product segment and regional market reveal a high degree of concentration on the top 3 or 5 actors. Incumbents always invoke national interest to demand protection from external competition. The interest margin (difference between average interest rate charged by a nation’s banks on their commercial loans and average interest rate paid on deposits) tends to be higher in those transition economies with lower market share of foreign-controlled banks (Vernikov 2005). In view of a more favourable structure of liabilities consisting of relatively cheap longterm borrowings, foreign bank subsidiaries can offer longer maturities on their lending than other market participants and can afford reducing interest rates when competition intensifies. There is no reason why a foreign investor would, by his very nature, be more interested than local firms in promoting free competition in the new market. Any normal market firm seeks market imperfections (where conditions deviate from perfect competition) and not a per-


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fect competition. The essence of strategic planning is to move from a competitive market to a niche where monopoly can be achieved, albeit a temporary one. For how long the firm will be able to enjoy a local monopoly depends on how effectively it can block the entry of new players (Cyert et al., 1993). Foreign banks entering transition economies do not have an original motivation of enhancing competition or exerting downward pressure on the interest rates. In fact, they are attracted by unbalanced market situation, possibilities of monopolising certain sectors or product niches, and abnormally high profitability.13 However, the activity of foreign players objectively leads to a stronger competition otherwise unachievable in an oligopolistic market dominated by local players. Consolidation of local market participants combined with entry of foreign players might reduce rather than enhance competition, but empirical evidence dos not support that concern. In a number of emerging markets the changes in the banking market structure did not destroy a competitive environment, and it is competition from foreign entrants that compensates for loss of competition resulting from consolidation of local banks (Gelos and Roldós, 2004). The institution and concept of free competition may come into conflict with local informal institutions embodied in people’s traditions, beliefs and instincts. In Russia the emerging market economy cannot fully enjoy the benefits contained in free competition (Avtonomov, 1997, p.10). The Russian ethos attaches more value to personal merit and human relationship. Collusion is the norm of business behaviour rather than exception, while free competition is perceived as undesirable, unfair and anti-social because it impedes favouring another actor with whom there is some sort of personal relationship. Corporate Governance Despite concentration of ownership, neither of the ‘standard’ foreign models of corporate governance (capital markets-dominated or banks-dominated) has clearly prevailed in any of the transition countries (Radygin et al., 2004). It illustrates the fact that incoherent institutions have been imported and that they came into conflict with traditional institutions. Some of Russia’s cultural values, such as reliance on networks, equalitarianism, mistrust of outsiders, secrecy and opacity, and redistribution of benefits, may inhibit the development of open and transparent corporate governance (Greif, 1994; McCarthy and Puffer, 2004; Prokhorov, 2004). Puffer and McCarthy (2004) examine the emergence of national model of corporate governance in Russia and find that Russia’s approach to capitalism initially followed the AngloAmerican model, which emphasises agency theory. However, absence of developed market institutions which guide the requirements of good corporate governance may push Russia toward its own nationally-specific model of corporate governance. Such a model might turn out to be closer to a German-Japanese network-based model reflecting a stakeholder approach with lesser primacy of shareholder rights. Whichever model of corporate governance (AngloAmerican or German-Japanese) Russia may choose to implement, it will rely on institutional arrangements such as protection of shareholders’ rights, contract enforcement, law compliance, trust, transparency and disclosure. These institutions are largely the same in the two main models, so the choice in favour of one of them is less relevant than it appears. Conservation of ownership structure in Russian banking sector will support the culturally embedded institutions, so modern corporate governance has to rely on new types of players. Foreign subsidiary banks do not contribute much to the shaping of the national model of corporate governance because they are not really stand-alone corporations but divisions of


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larger organisations (Vernikov, 2005, pp.186-199). Demand for general improvement of corporate governance will come from portfolio investors and new shareholders of Russian banks, especially minority stakes, because they need a mechanism to protect their rights. Law and Contract Enforcement The institution of legal contracts’ enforcement in Russia is hindered by an inadequate legal system. Russians tend to have an ethical, not legal, attitude towards law; opportunistic behaviour is deemed acceptable at all levels. Local commercial banks have been reported to actively assist clients to evade tax, labour, corporate, foreign exchange and other law. Lack of protection of a lender’s rights increases the risks in lending and leads to requirement of collateral in loan agreements. Facing this institutional environment in the Russian market, foreign banks (a) set a different standard by renouncing opportunistic behaviour and strictly adhering to law and contractual requirements, and (b) promote the adoption of new laws. After 1998 when courts denied legal protection to non-deliverable forward contracts, inflicting massive losses to lenders, foreign banks have pushed for changes in legislation (still inconclusive). Support is offered to initiatives increasing the independence of regular courts, arbitration courts and self-regulating professional bodies. Strengthening of law and contract enforcement reduces transaction costs in the economy, improves trust and promotes economic growth. Shadow Economy Successful transition in Russia implies that ‘pervasive underground economy and rampant corruption, both antithetical to a market and capitalistic economy, must be curbed’ (McCarthy and Puffer, 2004, p.34). Subsidiaries of well-established foreign banks adhere to strict international regulations and work only with legal funds; they would not risk damaging their respective global brands by intermediating for the shadow economy even if this puts them in disadvantage as compared to less scrupulous local competitors. The activity of foreign-owned banks involves a growing share of national financial flows into the official banking system and thus improves the proportion between the legal economy and the shadow economy. V. BANK OWNERSHIP TRANSFORMATION WITHIN AN INSTITUTIONAL CONTEXT Success or failure of either strategy of bank ownership transformation can only be assessed within a broad context of national policies and priorities. Those differ substantially across countries under consideration. As of mid-1990s, CE had the paramount goal of EU accession and, by adopting the acquis communautaire, imported a full set of market economy institutions. Empirical evidence collected during the early stage of transition demonstrated that proper functioning of financial institutions is impaired by the existence of unreformed government-controlled banks. Therefore a large-scale privatisation of banks was not an isolated policy but an integral element of the ‘project Europe’. It was undertaken by committed governments in a representative group of countries consciously, even if it was actively endorsed by international institutions and private foreign investors.14 The opportunity cost of this strategy is foregone revenue from selling


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financial assets after they have sufficiently appreciated. In Russia, privatisation of banks did not affect the key players. State withdrawal from commercial banks in favour of strategic foreign investors has created a critical mass of actors of a totally new type, familiar with the functioning of market institutions and willing to accept the rule of law, thus facilitating transition in the financial sector and far beyond it. Central European countries found out that the key is control over banks, meaning direct control through ownership, not merely supervision and regulatory control. High share of foreign banks ensured that all other market participants assimilated to the changing institutional environment. Fiscal result was not the main driver, which indirectly confirms that institutional considerations prevailed. Timely membership in the EU and rapid convergence with EU standards signals the success of that strategy. In China the transformation of ownership in the banking system reflects different set of goals and different logic. It is too early to determine whether recent steps in the direction of partial privatisation of state banks and introduction of foreign stakeholders represent a guideline for future change or merely a tactical tool to improve the performance of state-controlled banks. Resulting changes in the institutional environment need to be carefully monitored. So far, considerations of control and ‘national identity’ were attributed primacy over potential benefits from market institutions development associated with shift of control to private investors. ‘Commercialisation’ of state-owned banks supported by partial state withdrawals is expected to change the behaviour of banks. ‘Commercialisation’ has its limits, however: if control does not shift to new stakeholders, then changes in behaviour will take much longer and they will not be sustained. The government continues to rely on banks in the implementation of its monetary and structural policies. If banks become strict in their lending decisions, then many unviable state-owned enterprises will go bankrupt, unemployment will grow and the government will not be able to implement its plans. This might trigger a reversal from the current strategy back to direct state control and guidance. Russia in its modernisation effort imported various economic and financial institutions from other countries, without targeting any specific institutional system. In the absence of exogenous enforcement, Russia has experimented with elements of alternative strategies of bank ownership transformation. CE countries and especially Poland and the Czech Republic pushed would-be foreign investors to acquire state-owned banks, but Russia acted differently: it made entry of foreign players through ‘greenfield’ subsidiaries relatively easy, while refusing to privatise the core state-owned banks. On reasons of ‘national security’, ‘financial independence’ and ‘transitional stage’, the authorities have maintained direct control over the banking system; market share of state-controlled banks is on the rise. State-controlled banks remain instruments of the government and follow political guidance. In the meantime, Russia opportunistically intends to collect financial benefit from sale of minority stakes in banks, more or less the way the Chinese government does. Russia has allowed more freedom to foreign and private domestic participants than China, however a growing cumulative amount of foreign investment in Russian banks may or may not produce serious changes in the banks’ market behaviour. It depends on whether foreign investors can influence and effectively control those organisations. During the financial crisis of 1998, minority stakes in the leading Russian banks held by international financial institutions (EBRD and IFC) did not prevent those banks’ non-delivery on contractual obligations, irresponsible reckless behaviour, asset stripping and looting. On the other hand, imma-


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turity of basic institutions has until recently impeded foreign investors from participating in the Russian banking market via any modality other than 100%-owned subsidiaries. This trend may actually be beneficial for the establishment of market institutions because foreign banks represent a different type of organisation, on the assumption that market-shares of these banks will make up to some critical mass and constitute a cluster strong enough to resist assimilation. Now the share of foreign-controlled banks in Russia (8.3%) is far from being a relevant factor of institutional change. Sympathy for the Chinese ‘model’ of bank ownership transformation denotes an incoherence of the Russian ruling paradigm. Being nominally a transition economy and trying to introduce market institutions, Russia at the same time gives primacy to values like control, full autonomy and avoidance of any exogenous dependence. It is a common feature with another big country – China; however China is not necessarily in transition toward a capitalistic economy based on private property. The future institutional environment in Russia will to a great extent be shaped by actions of the Russian authorities with respect to their own banks. If private and/or foreign ownership over the bulk of lending institutions turns out to be incompatible with the pursuit of Russia’s national priorities, then regardless of the reasons of such incompatibility one has to reconsider the essence of the country’s transition. VI. CONCLUSIONS We identify two distinct patterns of privatisation of banks and liberalisation of the banking sector – one followed in countries of Central and South Eastern Europe, and the other followed by China. The former is featured by cardinal ownership transformation and withdrawal of the state; the latter implies slow gradual changes and maintenance of control over banks in the hands of the government. Russia has implemented selected elements of both strategies; however we find more affinity with the general thrust of the Chinese model in that a real privatisation of remaining core state-owned banks has been avoided. There is a strong connection between import of financial institutions and import of organisations able and willing to operate under new institutional constraints. Where there is no critical mass of participants of a new type, imported institutions fail to function properly and assimilate to the prevailing institutional environment which may be quite inconsistent with requirements of a market economy. The concept of critical mass equally applies to actors on the microeconomic level in the sense that the share of foreign property in a bank and the nature of foreign investor (-s) matter for the behaviour and performance of the bank. Despite a modest market share of foreign-owned banks in Russia, their presence is already producing institutional impact, particularly in the areas of protection of private property and enhancement to private sector development in the host country, higher-quality lending and resource-allocation, creation of a competitive environment, improvement of corporate governance, and eradication of the shadow economy. The Russian national model of corporate governance is emerging spontaneously under the influence of local culturally-embedded norms and an accidental mix of imported institutions. Local traditions such as reliance on networks, mistrust of strangers, opacity and law defiance will impede acceptance of an open corporate governance model unless and there are enough market actors to follow them voluntarily. The degree of success of the strategy of bank ownership transformation can only be assessed within a broad context. Both the countries of Central Europe and China succeeded in


15


their own ways. CE countries managed to dramatically overhaul the entire institutional setup at the cost of surrendering banking systems to foreign investors. Timely EU accession and a solid banking system embody the success of that strategy. China starts to gradually decrease direct involvement in core banks, while maintaining control and collecting privatisation revenue. We see Russia as falling in between the two alternative strategies – it has gone further than China but not nearly as far as CE countries. The authorities plan to maintain direct control over a substantial portion of the commercial banking sector. Piecemeal approach and timid partial privatisations may fail to generate a required change in the institutional environment. Time can be wasted, and efforts evaporate. Russia is nominally a European transition economy and it has introduced many of the market institutions, however with regard to banking it has given primacy to values unrelated to economic freedom. We find affinity between the strategies implemented in China and in Russia. This may cast doubt over the essence of Russia’s transition because China is not necessarily in transition to market economy based on private property. The question remains, whether Russian state-owned banks will eventually be privatised and to whom.

NOTES 1

Following the fundamentals of institutional economic theory, we apply the term ‘institution’ to people’s steady norms of behaviour, traditions and concepts. Those might be either formal or informal. Institutions can also be viewed as humanly devised and accepted constraints that shape interaction between people. If institutions are the rules of the game in a society, then organisations are the players (North, 1990). We distinguish ‘institutions’ from ‘organisations’ (e.g., commercial banks), although many authors use these terms as interchangeable. 2

‘Central Europe’ hereinafter refers to 5 countries (Czech Republic, Hungary, Poland, Slovakia and Slovenia) that have joined the European Union by the time of writing of this paper.

3

Views differ on China as an economy in transition (Kolodko, 2000). On the one hand, it has undertaken a remarkable departure from previous patterns of command economy. On the other hand, the essence of China’s modernisation effort may not be indeed a transition to a fullfledged market economy based on private property but an improvement of its existing socioeconomic system, i.e. socialism.

4

At the early stage of transition in CE the core banks were left in the hands of the government after some commercialisation and reshaping, presumably in order to maintain monetary stability and to support reforms in the enterprise sector. Privatisation of banks was postponed until later on. That strategy failed. State-owned banks became a hindrance to reform in other sectors and a source of instability; they were building up bad loan portfolios over and over again, thus demanding injection of public funds. Then the strategy of the authorities changed. Within a compressed period of time the balance sheets of state-owned banks were relieved of bad assets and their controlling stakes were auctioned off in favour of strategic foreign investors. 5

Raiffeisen (2005, p.41) and most of the Russian official sources use a lower figure in the order of 32% for market share of state-owned banks, but we believe that the coverage of our


16


calculation is broader because it includes ownership by federal, regional and municipal authorities and by state corporations. 6

The debate about acceptability of foreign bank ownership in Russia has never been held in professional terms. Emotions, instinctive fears, slogans and vague concepts have phased out theoretical and practical economic considerations. The dominant fear is that of ‘losing sovereign control’ over the financial system which is associated with a relatively high market share of foreign-controlled banks. 7

In China the sale of stakes in state-controlled banks to foreign investors generates high revenues. The total amount of transactions completed in 2005-6 is estimated at USD 19.65 billion (The Economist, May 20th 2006, A survey of international banking, p.23). 8

Statistical analysis indicates that basic institutions related to the rule of law, such as freedom of speech, matter more than specifically economic institutions (IET, 2003). For the purpose of this paper we limit the scope to economic and predominantly financial, institutions. 9

One group of market participants cannot be expected to pursue more or less ‘noble’ or ‘patriotic’ goals than another group. Goal is actually something that individuals may have, but not collectives (Cyert and March, 1963, р.26). A firm (in our case – a bank) is always a coalition of individuals whose prioritisation of goals substantially differs. 10

García-Herrero (1997) finds that the presence of foreign banks reduced capital flight during banking crises in Argentina, Paraguay and Venezuela and prevented complete erosion of trust in the financial system. 11

In 1999 the Chinese government took an equivalent of 17% of GDP off the books of the state-owned banks in an attempt to clean them up. In 2003 the government announced a recapitalisation of the Bank of China and the China Construction Bank at the cost of USD 45 billion from state reserves. The restructuring of another state-owned bank, the Industrial and Commercial Bank of China may cost up to USD 80 billion (The Economist, May 20th 2006, A survey of international banking, p.23).

12

La Porta et al. (2003) analyze data from Mexico to show that related loans are 33% more likely to default and, when they do, have 30% lower recovery rates than unrelated ones. In some important settings related lending is a manifestation of looting.

13

Over many years the foreign bank subsidiaries have been offering sub-market interest rates negative in real terms (lower than CPI rate) to Russian private depositors in search of a safe haven, while charging market interest rates on loans. 14

Kolodko (2000) recalls that in Poland foreign investors lobbied hard for an early privatisation of banks but showed little interest in industrial assets.


17


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