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Japan's Main Bank System

and

The Role of the Banking System inRestructuring and Privatizing StateEnterprises in Transitional SocialistEconomies

Satoshi Sunumura

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* CFS Discussion Paper Series No. 105


and

The Role of the Banking System inRestructuring and Privatizing State Enterprisesin Transitional Socialist Economies

Satoshi Sunumura

FOREWORD

These two papers were prepared by Mr. Satoshi Sunumura while he served as a special advisor to the VicePresident of the Cofinancing and Financial Advisory Services (CFS) Vice Presidency of the World Bank. Mr.Sunumura's career includes positions at a variety of levels in Japan's commercial banking system and ininternational banking institutions. In these papers, he draws on these experiences and his insights on howJapan'scommercial banking system helped the industrial sector to respond to the tremendous post-war challenges facedby the country.

The second paper published in this volume attempts to apply these "lessons learned" to formulate a bankingsector strategy that may assist the former socialist economies to successfully make the transition to market-oriented economic systems.

As in all World Bank discussion papers, the views expressed by the author are his own and are not intendedto reflect those of the institution or its staff, but are intended to provoke thought and exchanges of views on twotopics of interest to the international economic development community.

The assistance of Ms. Victoria Phillips in providing editorial support for this volume is gratefully acknowl-edged.

Inder Sud Shyamadas BanerjiDirector Managing EditorCofinancing and CFS Discussion Paper SeriesFinancial Advisory Services Cofinancing and Financial Advisory Services

Table of Contents

Foreword ............................................ i


Introduction ............................................. 3

Section I: Major Qualifications and Functions of Main Banks ............................................. 5

Section II: Building Managerial Capacity in Organizations ............................................. 8

Section III: Credit Risk Management ............................................ 12

Section IV: Business Growth and Relationship Management ............................................ 15

Section V: Implications for Developing Managerial Capacity ............................................ 18

References ............................................ 21

ii

The Role of the Banking System in Restructuring and Privatizing Transitional Socialist Economies

Introduction ................................................................. 25

Section 1: Viable Economic Systems for TSEs ................................................................. 27Figure 1: Economic System Determinants ........................................................... ...... 27Table 1: Preferred Management Styles ................................................................. 27Table 2: TSEs: Similarities and Differences with Post-warJapan ...................................... 28

Section II: Institutional Systems for Handling Macro and Micro Issues ............. ................... 31Figure 2: Transforming Socialist Economies ................................................................. 31Figure 3: Illustrative Difference in Effectiveness in Banking System ................................... 33

Section III: An Accountable, Effective Banking System ............................................ ............. 34Primary Function of Commercial Banks ................................................................. 34Prudent Banking Regulation ................................................................. 35Functions of the Central Bank ................................................................. 36Need to Clean-up Bank Portfolios ........................ ......................................... 37Figure 4: Illustrative Sequencing Issues in Financial Market Maturity and Development.. 38Figure 5: Performance versus Net Worth .................................................. ............... 38Figure 6: Industrial Policy versus Return on Investment (ROI) .................. ....................... 39Figure 6: Social Welfare versus Productivity ................................................................. 39Financing Long-term Industrial and Corporate Investment ..................... ......................... 40

Section IV: Privatization Programs through the Banking System ................... ....................... 41Table 3: Ownership/Management .................................................................. 42Figure 8: Roles of Banks in Restructuring Enterprises ........................................................ 42

Section V: Industrial Policy Considerations ................................................. ................ 46Figure 9: Illustrative Prospects on Productivity/Production ....................... ........................ 47Conclusions ................................................................. 48Table 4: Major Factors Affecting in Economic System ....................................... ................ 49

iii

U Japan's Main Bank System

IntroductionThis study analyzes the experience of Japanese tive by maximizing profit, protecting depositors

main banks in developing their managerial capacity and fostering prospective firms. At the system level,from a practitioner's point of view. It discusses their it needs to organize its operational structure effec-techniques for enhancing staff quality and coordi- tively by establishing accountability in its func-nation, credit risk control, business growth and tions, enhancing efficiencyin its resource allocation,long-term relationship management techniques. minimizing risk in its implementation, and pro-These managerial qualities are shown to be broadly moting credibility in its information services. Atresponsive to societal expectations. the macro level, the bank must be able to respond

A commercial bank, as a licensed financial inter- flexibly to changes in the economic environmentmediary, receives deposits from the general public by complying with the rules of game, filfillingand lends money to creditworthy corporate bor- social expectations, and conforming to economicrowers at a profit. It therefore deals with multiple policy targets.tiers of clients, distinguished by credibility and The Japanese main bank system, defined simplyquality of the relationship established with the as well-cultivated practices or concepts in relation-bank. To cater to the needs of these clients, both ship management, developed in the postwar growth"hard" and "soft" infrastructure must be organized. period of 1955-1973. It is generally recognized as"Hard" aspects include establishing branch net- an effective system for achieving the objectivesworks and computerizing accounting systems; "soft" defined above, and for facilitating industrial as wellinfrastructure consists of information collection, as corporate growth through allocation of scarceapplicarion of technology, know-how, credit ap- investment funds on a roll-over basis. The systempraisal and consulting. In addition, human and has been found effective in monitoring corporatefinancial resources must be effectively organized by governance during uncertain economic circum-the bank's management in order to meet client stances and acute capital shortages, conditions thatrequirements and to adapt to changes in the busi- parallel those which currently prevail in developingness environment. or transitional economies.

Banking is primarily a service industry. As such, The essential factor for effectively running aits ultimate resources and strengths depend mainly banking concern, a service industry, is managerialon the people who provide the services. Account- capacity, since the quality of people involved inability, quality, profitability and diversity within main bank operation is the key element. Bankthe banking business can be achieved and facili- managements must continuously review manage-tated only by developing a competitive managerial rial capacity, upgrading it and building it up at allcapability and culture in bank staff. Moreover, a organizational levels. Ultimately, managerial ca-bank as a going concern under authorized license pacity must fulfill two primary functions: assistingmust comply broadly with economic and social in the sound growth of its corporate dients andobjectives. It does so at three levels: the micro level, complying with social expectations. While bankingthe system level, and the macro level. At the micro principles and functions may be universal, differ-level, it needs to remain sustainable and competi- ences in resource allocation and management styles

4 Japan's Main Bank System

influence overall managerial capacity in terms of ratemonitoringorrestructuringproceduresthroughaccountability, productivity, restructuring capac- the standard mode of credit risk appraisal. Moni-ity and relationship management. toring is shown to respond to changes in individual

Section I of this study examines the major func- corporate performance. Section IV advocates man-tions or qualifications of main banks (both explicit aging business growth and corporate relationshipsand implicit). These functions are interlocking, through overall portfolio review, as well as throughand it is through them that managerial capacity is proactive responses to fundamental changes withinmost effectively employed. Section II analyzes the the economic environment. Section V reviews thenormal course of career development within main overall features and implications of managerialbanks. Staff training should first focus on acquisi- capacity at the micro, system and policy levels.tion of basic skills, then on building managerial Building up management capacity at all three levelscapacity in fields of individual aptitude or prefer- enhances general accountability, productivity, andence. This method enhances general management's diversity, and is crucial for developing or transi-ability to deal with a variety of corporate clients. tional economies attempting to move towards aSection III examines the implicit aspects of corpo- market-oriented system.

* Section 1

Major Qualifications and Functions ofMain Banks

At first glance, the title "main bank" is normally monitoring capacitywhenever necessary. The largeraccorded to the largest lending bank that not only the amount and wider the syndicated members, themaintains a relatively higher share of equity hold- more transparent the arrangement (with detaileding on its own, but also exercises effective influence analysis and extensive counter checking). There-on corporate governance. This influence has tradi- fore, the real basis for main bank qualification is itstionally been based upon de facto equity cross- willingness to stand by or act as lender of last resortholding among group companies, along with bank whenever a borrower faces any difficulty, even ifrepresentation on the borrower's corporate board. not formally contracted.2 If borrowers are unable toHowever, whether these entitlements are currently comply with requests proposed by core bankersaccepted by borrowers is often another story, espe- within a reasonable time, they could risk theircially in recent years of ample resource availability positions by losing the ex-post back-up of the mainand diversification in market instruments. A main bank. Disclosure of information in sufficient time,bank's qualifications and functions, therefore, must credible information, and ethics of corporate man-be backed by the ability to undertake restructuring agement are the points in question.and to accept the ultimate credit risk of clients. Practically speaking, the main bank can be iden-Such an undertaking is only possible through ex- tified generally through six interlocking elementstensive credit appraisal and careful monitoring of of qualification. While these elements are related,corporate performance. Indeed, the major qualifi- each is important on its own. Three of the elementscation the main bank has is its managerial capacity, may be explicit, while the other three are oftenput into practice in in the course of its relationships implicit.with clients. The six elements of qualification are listed from

The main bank effectively plays the role of the most cohesive element within the corporatesyndication arranger or trustee for raising funds.' It client relationship to the least cohesive element:explicitly commits the largest share of loans to * Share of equity holding;corporate clients in order to signal its positive * Whether the bank's commitment to under-attitude to other participating lenders. Specific take restructuring tasks or to act as lenderservices, such as provision of credit information orarranging modality of syndication, is extended for I This includes long-term loans on a roll-over basis, orvarious reasons: to obtain the overall merits of bonds with mortgages for land and machinery. Otherforeign exchange business, trustee fees or large lenders may join the syndication. On agreement withdepsit balances, or to contain cash flow among borrowers, a main bank may take only 10% of theaeposit llenns or ts branch nork. I ding share in popular deals, yet may be prepared to

major clients within its branch netwvork. In fact, take on 25-50% in cases of vitally important or confi-participating lenders can generally save the cost of dential projects.information gathering, credit analysis (periodic or 2 The largest lender is not always the main bank and thead hoc) by relying principally on the main bank's qualification is often vague.


of last resort is formally or tacitly con- equity simply by approaching credit rating agenciesfirmed; and securities underwriters. Neither of these enti-

* Whether the borrower accepts any bank ties, however, can replace the role of lender of lastmember for its board of auditors; resort. Credit rating agencies and securities under-

* The length of time business networking writers are not as dependable in management advis-and other overall benefits have arisen from ing since they cannot assume credit risk on theirthe long-term relationship; own accounts. Neither are they endowed with the

* Whether the main bank is capable of ar- intensive credit and market information main banksranging sufficient funds for the borrowers' possess. Hence, the main bank's support functionbank accounts in cost effective ways (even is specifically effective in times of capital shortage,in times of tight credit), and is able to offer uncertain conditions or credit crunches.lucrative deals and advice on diversification While corporate borrowers could loosen theirof corporate treasury operations; and main bank relationships by entering capital mar-

* The availability of widespread and in-depth kets directly, they rarely do so. Within relationshipintelligence service, such as research data on banking, main bank accounts are rarely replacedmoney markets, corporate credit appraisal with others unless serious distrust arises at theand technology. management level of client and bank. From the

Where all these elements are present, and both main bank's point of view, there may be merely abank and firm are satisfied with each other, the change in the composition of profit and loss items.position of main bank may be firm on a long-term While equity holdings and last resort facilitiesbasis. This is often the case with banks serving the constitute the backbone of the main bank positionsix major Kigyo Shudan company groups.' Not all and qualify the bank to exercise leadership inof these functions are necessarily performed, how- syndications or corporate governance, other ele-ever. In many cases, the relationship is built upon ments can serve as channels of competition withonly two or three of these elements. Each case other banks. Often these can lead to changes in thedepends on the establishment of the relationship order ofrelationship positions with particular firms,and its performance over the years. The cohesive- especially when firms are disappointed with theness of the relationship may differ from case to case quality of service or level of commitment in creditsince a bank's commitment to a firm as well as a undertakings. While equity holding, last resortfirm's mandate to abankdo not necessarilycover all facilities and board representation must be resolvedthese elements. Where the availability of corporate at the top management level, the extent of routineinformation is limited, a bank's managerial capac- business relationships, syndication or trustee roles,ity may also be limited. Loose relationships with and quality of intelligence services are functionsbanks may often be associated with new, rapidly- effectively developed at working levels.growing firms, or with firms experiencing a serious Among the six qualifications, equity holding,credit squeeze. The relationship4 may change, vary- board representation and syndication roles are ob-ing with the depth of coverage of the six elements, vious to all the parties concerned and can be explic-and alterations often occur specifically at times of itly recognized.5 However, factors such as truesignificant change within the credit system and availability of last resort facilities, quality of intelli-capital markets. The occurrence of mergers, acqui- gence services, and special arrangements or tacitsitions and corporate restructurings often provides understandings existing between bank and bor-appropriate times for reviewing the role and func- rower are not always stated up front. Yet thesetion of main banks. Of all the qualification ele- implicit elements are often instrumental in culti-ments, a bank's commitment to act as lender of last vating main or core bank relationships dependingresort and the need for such facilities on the part ofthe firm is indeed the factor most likely to deter- 3 Kigyo-Shudan or Kinyu Keiretsu are closely-knit company

mine the degree of cohesiveness between them. groups which appear impenetrable to outsiders. Practi-

As firms grow bigger and more successful and cally, however, they are groups within which concession,

financial markets are further deregulated and reconciliation or cooperation is more easily obtainable

globalized, corporate borrowers often opt for diver- due to long-term relationships.4 Refer to the examples of Eidai and Daiwa Bank in 1975,

sification in their funding programs and not rely to or Daishowa Pulp and Sumitomo Bank around 1988.

the same degree on main banks. Borrowers can go 5 Any creditor can inquire into reasons for changes in

directly to capital markets to issue public bonds or lending shares, for example.

Japan s Main Bank System 7

on a firm's requirements at a given stage in its shareholders of good reputation, especially if thebusiness development. bank and firm have specifically collaborated in the

A typical successful relationship is built with past on certain symbolic or breakthrough projects.small or medium-sized firms at the venture capital Equity holdings, as well as availability of last resortstage, like the Matushita, Sony or Honda of forty facilities, may be essential elements for fosteringyears ago. These firms were effectively fostered at young and prospective firms. If these are fullytimes of capital shortages by their main or core backed by appropriate management assistance bybanks. Their associations with their main banks main banks, small firms can concentrate on invest-have never weakened despite the fact that these ment and development of their own technology onfirms have virtually outgrown their banks in terms a long term basis.of return on investment or manageability of inter- In sum, main banks have served as effectivenational business. The extent of the main bank agents for corporate growth in the developmentrelationship is judged by firms based on the six process. Under the deregulated global setting, thesefunctions. The opportunity for using a wider range relationship threatened by competition if mainof banking services is completely open to Japanese banks do not sufficiently upgrade their managerialfirms in a global setting.6 capacity and ensure that their qualifications are

Equity holding usually relates to restructuring sufficient to adequately serve client needs. Mainor last resort facilities, board representation and banks must constantly review their portfolio com-syndication or trustee roles. Board representation position while monitoring the quality of all dimen-often reflects historical relationships, while the sions oftheir relationships with clients (see Sectionsfund raising role is closely associated with intelli- III & IV).gence services and credit appraisal. During capitalshortages, fund raising is considered the most impor- 6 US investment and British merchant bankers may excel

tant function of the main bank This was the case in in identifying and arranging attractive overseas packagesJapan during the period of about 1955 to 1973.7 of M&A or capital market deals, while Japanese main

It was assumed that Japanese financial markets, banks may be helpful in appraisal of creditworthiness orgroomed under conservative rules of the game over scrutinizing hidden loss or profit of targeted firms.two decades, had created a competitive, efficient Japanese main banks can afford to stand-by or fund theand effective commercial banking system. Yet the deals (short or long-term); this enables their clients to

system had not yet been sufficiently tested in world choose the right timing of such deals.7Deregulation advanced after 1964 (when Japan becarnemarkets. Banking services offered by foreign a member of Article 8 of the IMF) and the marketbanks-intelligence services in overseas bond or environment by the early seventies enabled Japaneseequity issues, various forms of credit for overseas banks to engage more heavily in international transac-project finance, hedging devices for long-term ex- tions, typically in Euromarkets.change risk, cost-effective arbitrage deals, and in 8 While the role of syndication for long-term domestic

fundraising is primarly derived from the status of largethe 1980s swaps, options, derivatives and invest- lending or equity holding, quality in intelligence servicesment management-were attractions with the po- rendered in overseas deals seems to have challenged maintential to turn corporate treasurers' eyes to banks bank positions under a more liberalized banking envi-other than traditional main banks. Quality of intel- ronment.ligence services may now be the main means of 9 The scope of operation of licensed banks in Japan haschangingc theirebanks' pecking order in specific been confined strictly to pure commercial banking.changing their banks' pecking order in specific Neither equity underwriting nor brokerage is permitted

deals.8 Commercial banks in Japan have survived under Article 65 of the Securities Act. Ceiling rates onover a long period of fierce domestic competition, deposits are effectively imposed. Foreign exchangewhere rules of the game were relatively simple and control systems had been tightly exercised until 1980.strictly followed.9 Banks developed the managerial However, no prime underwriter positions were given tocapacity and sophisticated tehniques of merchant bank affiliates operating in the Euromarket. It is arguedthat over-extended protection for securities companiesbankers in handling corporate clients' overseas may have created the privileged positions of securitiesdeals. Board representation is possible for major houses which led to recent scandals.

E Section//

Building Managerial Capacity inOrganizations

The main bank function can be only fulfilled by four weeks. They are then assigned to branches orqualified banks who, in the eyes of corporate bor- divisions where their on-the-job training begins.rowers, are dependable in times of credit squeeze, There is not much difference in the treatment ofreliable in management consultation-typically in staffat this level in terms of academic career, salary,phases of restructuring, and endowed with the or gender.managerial capacity to deal with any type of finan- The primary objective at this stage is to providecial issue. Such capacity must be applied, utilized, the employee with the basic knowledge, trainingpracticed and developed in line with sound bank- and discipline to become a good banker. Depositing principles, and must meet the specific require- taking, accounting or some research work may be aments of corporate clients. new staff member's initial posting. The new em-

Banking history dates back a few centuries and ployee rotates between these sections, then is placedhas taught bankers four sound banking principles: in a specific team of foreign exchange, bond deal-

* Accountability in operation; ings or credit appraisal.* Quality in service; Here, junior officers learn directly from their* Consistent profit making; and individual seniors on the job. Care is taken to train* Portfolio diversification and sophistication. young members to be disciplined and credible

Such principles are widely recognized, and are bankers. On-the-job training will characterize andacquired through experience and discipline at all form the basis for future individual career develop-levels, from top and mid-level managers down to ment m the owmg four areas:young working-level officers. Each bank's overall * Precise accounting practices, asset valuationcredibility, management quality and business per- * Efficiency in client services effective andformance is judged on these principles: human rElevnt infraion gervin, depoit andresources, information availability and solid com- freign egenso lcathering, deposit andputer systems serve as primary assets. Ultimately, foreign exchange soaciltateon, and clientquality of staff is everything in banking. visitation to facilitate future business ex-

Let us first examine the general career path of pansion;*Extensive research work on industries orbank staff in a typical Japanese bank, noting what capita res,ar rort on per

types ofskills they are expected to acquire, how they capttal markets, or reportcig on, perhaps,serve clients, and how they comply with banking the production system at client factories orprinciples at differents level of responsibility.

Banks recruit candidates direct from schools,and they compete for capable, personable and well- 10 Competition is fierce, with banks starting to recruiteducated students.10 Upon joining, fresh staff are more than one year before graduation. The Japanesefirst placed in intensive training programs orga- Bankers Association does not allow banks to solicitnized by the bank's personnel division for about candidates before the summer of their final year.

Japan's Main Bank System 9

Preparing credit appraisals or corporate ment projects, and medium to long-termclients prospectus for bond issues or a large business plans and restructuring proposals;syndication. * Surveys on industry and new technology;

New employees are expected to learn at least the * Money and capital market dealings, finan-first three, and desirably all four, within five years' cial instrument production through specifictime." Each section is accompanied by extensive engineering (swaps, options, derivatives),manuals that have been compiled over the years by assets and liabilities management and in-previous employees. These manuals serve not only vestment management services;as textbooks on job specifics, but also as case studies * Proposals for structured finance, M&A andof various deals, containing valuable information other deal devices for overall benefit expan-and know-how. sion;

Every staff member is expected to contribute * Proactive client management consultationsnew ideas to the content and substance of these on policy and other issues, or appraisingmanuals. Senior officers are responsible for educat- the potential of new business or ventureing juniors on the job through guidance. New hires capital; andmove ahead according to individual aptitudes and * Personnel allocation.talents. Some may be chosen for overseas training, At this mid-level position, duties in the areas offor further study-such as MBA degrees-or for business strategy, operational effectiveness, man-training in merchant banking, with decisions based agement efficiency and young officers training areon performance assessments, disposition, poten- imposed as a major assignment. Knowledge accu-tial, and employee goals. mulation, hard work, skill building, team work and

Other staff may be put on secondment for a few strategic thinking are all essential to success. Per-years"2 at the treasury offices of corporate clients, or sonality and overall credibility are also important.to another research institution or government New ideas and creative proposals for promotingagency. This allows prospective staff to broaden business are highly esteemed, while any businesstheir basic knowledge and to study subjects from failure, if repeated, may be fatal for further promo-different angles. Secondment at a young age ex- tion. Female staff wishing to pursue professionalpands workers' capacity to learn, and is meant to careers mayaccept reassignment or transfer to otherenhance their management capability later on in positions, either domestic or overseas. The qualitytheir careers. and complexity of services that such mid-level

During secondment, some highly capable staff management provides is evaluated to ascertain themembers may decide to leave the bank to pursue qualification of banks to act as main banks.other academic or professional careers. This gener- Between the tenth and the eighteenth year,ally occurs if the employee becomes discouraged or comprehensive and objective personal assessmentdisappointed with the people, quality or policy of files are completed for each individual. These arehis bank. Periodic formal or private counseling is based upon accumulation of information from pasttherefore indispensable at this level. performance, behavioral patterns, specialties, apti-

Whatever the career path of each staff member tudes and personality, and these findings influenceduring the first fiveyears, various prospective courses basic salary scales and future assignments. By thisawait them. Employees are generally rotated be- time, bank staff may be broadly categorized intotween different divisions during a period ofperhaps several special fields or divisions for future careerten years. Many incumbent bank board members development:are not necessarily on elite courses at this stage. * Corporate finance and relationship build-Instead, recognition and promotion may come ing (mainly in branches);only in ten to twenty years' time.

After approximately ten years, employees often 11 Within the three to five years of full-time on the jobreach the level of section manager. Their assign- training, staff members are expected to acquire the basicments are specialized and upgraded, but diversified skils taught at the MBA level in an American university.in dimensions which include budget control, per- 12 Allocation of staff on secondment is determined by

in . . i.dclient requirements, which vary with prevailing eco-sonnel affairs and general matters. Responsibilities nomic conditions. Some conduct accounting work,

usually cover: others handle forex dealing, credit appraisal or money* Business performance assessments, client market research. Such assistance is appreciated by small

creditworthiness studies, specific invest- and medium firms and institutions.


* Credit or project appraisal; essential managerial functions of a main bank.* Money and capital market operation; Thesequalitiesareacquiredonlythroughhands-on* Accounting and treasury; learning, team work, specialization, competition,* Computerization and system control coordination and discipline at all levels. A main* Overseas business strategy, bank only acquire its credentials through exercis-* Research work; ing quality in corporate governance, and acquisi-* Personnel affairs; and tion of managerial skills in accordance with* Central planning. traditional banking principles.Every staff is given an annual opportunity to Successful general managers with outstanding

express his future career path preference. Any staff performance over a 25-year period may be selectedmember who has achieved high performance and for board membership, if they are not opposed byproved his ability is upgraded to the equivalent level any incumbent board member. Such a career devel-of assistant general manager. opment scheme inside main banks has been framed

Also at this time, certain able staff members may by specific elements of the Japanese corporate cli-be asked by bank clients-often medium and small mate, namely:size firms-to assist their management in a senior * The permanent employment system;post. These employees must then decide whether to * The policy of promotion from within; andremain with their original bank in light of future * The strong seniority element in promo-career possibilities. Quite often these staff members tion."5

will initially be transferred through a secondment These may, however, no longer serve as prereq-assignment and, if this role suits them, they will uisites for career development. Moreover, the abovelater become actual executives of the dient firm."3 elements are not all specific to Japan; rather, theyThis kind of secondment, with bank employees are more or less common to any organization in theoften moving into client firms, effectively facilitates world. However, they seem simple policies to fol-strong long-term relationships. It is an effective low in the face of other important managementmeans for transferring management know-how to issues such as lay-offs, reorganization, personalcorporate clients. motivation problems, lackofcooperation and team-

After seventeen-to-twenty-five years of bank ser- work, declining productivity, and court disputes. 6

vice, some staff reach the general manager level. At Bank management is expected to deal with suchthis stage, they are assigned the full scope of discre- problems with discretion and responsibility.tion in their field of responsibility. Their primary Corporate culture and management style fur-task is to take decisions regularly on all fronts with ther relate to objectives, principles and philosophy.clear vision and leadership. They may, for example,

normally conduct dialogue with top management 13 Nearly forty percent of staff recruited in a given yearof client firms, attend major outside meetings, such leave for other firms or professions by their early forties.

as those of the shareholders, Bankers Association, 14 Bank staff thus trained could be instrumental in assist-local authorities, Bank of Japan, or Ministry of ing, for example, the accounting or treasury divisions of

Finance. Altogether, fifteen years may be sufficient corporate dients, as well as in enhancing their manage-

to raise workers to certain management levels. ment control system.to raise workers to ~ ~ ~ ~ ~ ~ 15Admittedly, there may be risks or shortcomings in a

Thereafter, roughly one-third leave at this stage. such long-term career system. For example, young

This hierarchical career development system has graduates must determine their life-time profession at anproven to be a rational and efficient method of early age, while banks must be selective about new hireoperation in the banking industry, where staff potential at the time of employment, and a great deal ofmembers are trained to be generalists.14 Bank staff time and initial cost may be incurred in providing ap-regularly rotate jobs, learn multiple skills, and propriate training, education, and motivation before

each can really contribute much to business develop-generally improve their abilities in these assignment. There may also be some unfairness in treatingments, as well as developing a sense of coordination new hires better than current staff in terms of salarywith other staff. In such an organization, new scale, academic career and specific postings.

information and suggestions for quality improve- 16 R Ozaki, Human Capitalism, 1991, Chap.2, pp.26 -28ment and productivity gains move from the bot- stipulates 'nevertheless, conventional economics assumesthat labour mobility generally enhances productivity...tom up to higher management. Indeed, the very (However,] the extemal labour market both inhibitsdecision-making processes, sanctions, and respon- firm-specific skill formation, and discourages cooperativesibilities described at the management level are the efforts between workers."


Japanese bankers emphasize quality and long-term services (which are the core features of daily func-relationship management. They know the best way tions). These lead toward overall leadership into educate young employees, and how to motivate management of corporate governance at the topthem to enhance their overall productivity. They level. A successful banker should be experienced,are cognizant of their professional responsibilities mature and quick in decision-making. He shouldto society, and to the going concern. Main banks work successfully in groups, and make decisions inendeavor to build long-term, trustworthy relation- line with the sound banking principles. The qualityships with stable corporate clients. Staff members of a main bank will be judged by whether its clientstudy hard to acquire specific skills. Only full relationships are supported by strong human re-experiences as generalists at working levels enable sources at all levels. These elements or programs forbankers to make sophisticated decisions at the mid- enhancing managerial capacity are not at all cul-level, specifically in group relationships, credit ap- ture-specific, and perhaps only remain to be provenpraisal, fund-raising syndication and intelligence competitive in the global market.

* Sectvio7 ///

Credit Risk Management

The six main bank functions can be effectively The credibility of such information must be prop-managed only by well-trained and experienced erly assessed or confirmed, however, through directbankers. These individuals tend to be shrewd, dialogue with firm treasurers, interviews with theirsensitive, proactive and tough, and their manage- suppliers and buyers, and scrutinization of detailedrial capacity is based on traditional banking prin- financial statements or back-up data not necessarilyciples. For main banks, managerial capacity is appearing in audit reports (ie: off-balance-sheetassessed with respect to credit risk,'7 business growth, transactions). Any major problems are checked andand relationship management. Risk management reconfirmed by the chief, manager, seconded staffis implicitly evaluated in terms of credit quality, and-if necessary-general managers, as well as bymarket exposure, system controls and environmen- board members or auditors.tal changes. Let us explore credit risk management.'8 Each firm may be classified, in order of credit-

Loan officers in charge of particular firms are ability, into: "Super," "Good," "Ordinary," "Watch"responsible for updating credit information files and "Hospital-care" categories. While such classifi-that contain periodic reports, specific analyses and cation is necessary to monitor performance and topiles of ad hoc information on corporate perfor-mance. Company histories, full descriptions of the 17 Main bank credit risk can be established bv consideringcareers and characters of board members, quality the largest lending share. While maximum benefit mayreports on major products, detailed analyses on B/S be obtained by absorbing associated business through

and P/L, debt structures, cash flow features, cost and main accounts, every effort is made to reduce lending

productivity analyses, assessments of unrealized shares through wider syndication. Also, the lending limitprofit or hidden loss, real net worth estimations, for a firm is imposed by prudent regulation; the bank'sand the latest project evaluations are contained in aggregate assets are controlled by the BIS convention

despite each country's differences in taxation systemsthese reports. Most important are reviews of prof- and accounting practices. Therefore, the quality or

itability and strategies for relationship manage- substance of those assets is the crucial issue.

ment. Any staffmember can access these files via his 18 Apart from credit risk, other areas of risk management

or her chief officer. A loan officer usually manages are more or less similar in any bank operation. Market10 to 50 firms, depending on the character and risk is due mainly to volatility in rates and should be

depth of the business relationship. 9 Each credit file controlled by a system and against primary capital,unrealized profits (losses) of equity assets, and subordi-must be scrutinized by the loan officer's chief, nated debt. System controls relate to hard and softbranch manager, and specialist credit officers at the infrastructure.

head office (Shinsa-bu). The officer's abilities and 19 Japanese loan officers' productivity (ratio of revenue to

talents must be amply demonstrated to his col- expenses) and performance (in terms of time and dedica-leagues if he or she wishes to become a general tion to the bank) is comparatively higher than that of

foreign counterparts. See Sakura Sogo Kenkyusho,manager in future years. "Major Banks' Competitiveness (1990)," Economic

Abundantdataisalsoavailableonanylistedfirm Report, April 15, 1992, based upon the annual reports of

from specialized credit information companies. 36 major international banks.


review or determine the extent of the bank's in- has substantially dropped, competitive productsvolvement or credit commitments, other client have emerged, or a firm's expansion has failed. Ifcategorizations may be organized as part of strate- the firm has kept regular consultations with thegies for expanding overall business (see Section IV). main bank in advance of any potential issues, hasBoth are integral parts of main bank managerial diversified its operations reasonably, expects fur-practice. ther new products, or is cultivating a new overseas

Fluctuations in corporate performance by com- market, the main bank will normally stand-by aspanies in the "Watch" and "Hospital-care" groups lender of last resort with firm support from corewill be reflected ex-ante in changes in revenue, banks.terms of bills in receivables and payables, cash flow The real question in the third case, which may bein the main account and mode of activities. The considered by dividing it further into three cases:morale of employees, reputation of the company, * Fundamental changes in revenue due toand rumors among suppliers and buyers-as well as emergence of substitute products or tech-their competitors-are also likely to be affected. nological progress, compelling the firm toSuch effects are easily perceived by loan officers or close down its principal production lines,managers who maintain daily, weekly, or formal with no scope for shift or diversificationcontact with key individuals in these companies. into related industries;Inquiry are widely pursued at various levels to * Substantial losses due to speculation inconfirm fundamental issues. If the problem is non-principal businesses which inevitablycritical, further detailed investigation into the affect normal operation in the principalcompany's factories, accounting or marketing divi- lines of business; orsions, clients and employee unions will take place. * Business failure involving fraud, manage-

At this stage, the chiefofficer is placed directlyin ment ethics or labor disputes.charge of the summary and conclusions for the Even these difficult cases can usually be identi-latest credit appraisal and investigation reports. fied by core banks well in advance of public knowl-Normallyhecanobtainacceptableexplanationsfor edge. Generally, main banks will have consultedperformance changes, or can suggest appropriate with firm management for some time before anymeasures to be taken by the firm. If changes are real difficulty occurs. In this context, liquidationrequired, the officer is expected to devise short- and announcements are simply confirmations of longlong-term restructuring programs. These require consultations, reconciliations or required proce-manager and loan specialist sanctions, and are dures. If problems are discovered too late for re-ultimately authorized by the general manager, since structuring or reconstruction, all members in chargethey often must comply with firms' requests for, of the loan commitment will be either relegated orsay, bridge financing. Daily cash flows on accounts dismissed.are followed by officer and chief. Reassessment of Main bank policy procedure is simple: If identi-collateral or security may take place confidentially. fied at the earliest stage, as in the first case, a special

In serious cases, confidential meetings are orga- rescue team is organized, headed by a task forcenized at the general manager level to develop more leader chosen by the main bank's top management.comprehensive measures. Imminent judgment may The utmost effort is made to maintain the businessbe required by the main bank to determine whether: relationship and existing employment levels. To do

* Quick intermediate rescue packages or this, a part-time system or wage-cut will normallybridge financing will be organized through be proposed, and lines of obviously unprofitablecore banks; operations will be closed immediately. Workforces

* Special stand-by arrangements or overall may be rearranged with related companies or theircurtailment of credit commitments may be suppliers or buyers. The primary objective is torequired to match available security or minimize the size of the loss the main bank maycollateral; or ultimately be obliged to accept. All legal measures

* More fundamental restructuring is necessary. will be taken to seize any possible collateral underFor firms which have maintained a long-term the banking agreements, since the main bank nor-

relationship with the bank and are in an easily mally retains first mortgages. The main bank, how-recoverable position, the first choice will likely be ever, will not use its priority claims simply for loanmade. The second alternative may result when the recovery. Depending on the historical businessmarket share of some of the firms' major products relationship, lending share, equity holding, and


relationship with major shareholders and other value long-term relationships with clients, theycreditors, each case will be carefully evaluated by tend to be sensitive to the quality and variety of thethe main bank's top management in consideration products they offer. Main banks would not con-of the practices, social reputation and specific cost sider M&A operations to be one-time deals, forrequired. This will be done in close consultation example. Rather, the banks look after the firmswith core banks on the shares of final losses. Main even after the deal, and expect to develop routinebanks normally adopt the largest share of write-off business associations with them.to demonstrate their primary responsibility. The heart of main bank managerial capacity

The most common type of rescue operation first rests in well-trained human resources and practicalmitigates debtors' interest payment burdens in credit appraisal teams with at least three levels ofaccordance with lending shares among core banks; experienced bankers. While corporate informationatworst, it writes offsome unrecoverable portion of on Japanese firms is widely available, the mainthe loans. The firm may then be sold to others who bank's research is extensive in its evaluation ofcan afford to take on remaining resources or work- potential client assets and technology. This pro-able assets including staff, franchise rights, technol- duces a strong venture capital climate. More thanogy patents or R&D institutions. Ultimately, 93% of corporate accounts held with city banks, inmergers may be the safest way in normal cases. fact, are with small and medium size firms. Prior to

In the second case, the obvious procedure is to 1973, the nature of competition among Japaneseseparate non-principal business operations, and banks was characterized by the collection of moretransfer or sell them to other reliable firms engaged individual deposits and offering intelligence ser-in the same lines of business. vices; competition was not generally described in

The third case is the worst. While a main bank terms of rates. Yet with interest rate liberalization,rescue or restructuring strategy is simple, team globalization and computerization, competition inmembers must undertake long, demanding toil to the form of rates, innovative ideas, and intelligenceensure its success. After the completion of liquida- services has become fierce.tion operations, all members may be amply com- While unqualified or unsophisticated banks maypensated by special bonuses, or by reassignment to be doomed to merge with others, top quality banksmore relaxed and enjoyable posts. are now comfortably prepared to compete both

The entire reputation of the main bank may rest with universal banking and investment bankers,on its handling of such cases - for instance, its once new regulations are enacted and the use of theability to deal properly with tiers of creditors and yen becomes widely prevalent. The world trenddebtors in the liquidation process. Remember that appears to be moving from one-shot off-balancethere are three primary functions or roles of the transactions toward long-term relationship bank-main bank: exploring and fostering new prospec- ing. In the competitive global environment, dis-tive clients; expanding and diversifying existing parities in performance may lead to major changesbusiness; and organizing the monitoring team to in the ranking of world bankers unless relationshipact as lender of last resort in cases of need. banking or niche-playing is fully recognized by

Skills normally applied to restructuring propos- management. This is currently happening in Ja-als may be more proactively utilized through M&A pan. The current real estate crisis, caused by both andeals. In fact, Japanese main bankers experienced as environment of easy money and the Japanese my-managers or lead-arrangers in project finance and thology surrounding land, has been widely ac-global market syndication are fully equipped to knowledgedduetothetransparencyofinformationundertake M&A deals. Yet these bankers often in Japan. Needless to say, such a failure is a directencounter one problem in deals involving overseas consequence of the poor management of non-bankfirms-the depth and coverage of corporate infor- finance companies, yet it is also a failure of mainmation compiled in the usual prospectus or memo- banks, who have not appreciated the changes stem-randum. Overseas bankers do not normally stipulate ming from interest rate liberalization.21enough information concerning about quality ofassets 20 and management attributes of target firms. 20 See the cases of Fujii Bank's takeover of Walter Heller

These points may only be explored at the later and Mitsubishi Bank's takeover of the Bank of California.Thnese poits may only be explored at the later 21 Assuming bad loans total Y14 trillion and that a 30%stages ofa takeover, which has often been identified reduction in the pricing of collateral may be inevitable,

as a problem in the major deals Japanese firms were this size is still manageable in the current market. At

invited to bid on in the past. SinceJapanese bankers worst, some financial institutions may be taken over.

* Sectikon /V

Business Growth and RelationshipManagement

In addition to individual credit risk control, These strategies are well-grounded. Since a bankmain bank management is concerned with the is a financial intermediary, its performance or prof-prospect of aggregate growth within a 5-10 year itability can be evaluated first by the volume ofspan, the quality and profit structure of the bank's transactions passing through it. The more deposi-business, and the mode of corporate relationships tor and firm accounts a bank handles, the more(since clients' positions may change in different benefit or profit can be expected. This is especiallyeconomic environments).22 true in large or main accounts held by existing

Bank profit structure may be analyzed for each firms. Here, theinterim benefitsare usuallyverylarge.item within profit and loss accounts, as well as for As deregulation, securitization, globalization andthe composition of assets and liabilities affecting computerization progress, financial instrumentsthese items. Usually the accounting division scruti- must be diversified. They must be sophisticated, asnizes movements in every account and makes regu- various interest terms and rates -spot and for-lar inquiries to the divisions in charge. These ward-and currency mixes can be designed. Swaps,inquiries are based upon the budget plan or specific options and derivatives are now in fashion every-policy framework authorized by management at where.24

the beginning of each financial year. The bank's One of the prime social roles filled by mainrevenue can be generated broadly from: interest banks is the fostering of small and medium sizeincome on loans; various fees and commissions prospective firms. Potentially large, long-run dealsfrom guarantees, syndication arrangements, custo-dians, and M&As; trading profit in foreign ex- 22 A bank's planning division or industrial research divisionchange, bonds, swaps, options, derivatives; and is normally put in charge of a three-year business plan on

some capital gain in equity and real estate.2 3 a rollover basis. Growth patterns of corporate businessesmay be broadly categorized into several groups based, for

Main bank strategy is to build quality portfolios example, upon turnover growth, cumulative amount of

and to raise profitability in the long run. The best fixed investment, average employee age, and increases in

ways to achieve this are to: numbers of accounts over a certain time period.

* Increase the number of main accounts and 23 In Japanese banking, interest on loans still provides the

secure repeated transactions, largest source of income, but the weight of trading profit* Diversify trading of varieties of new finan- and fees are increasing fairly rapidly. Some publicly

available data indicate that per capita assets, revenuecial instruments with existing growing income, number of deposit accounts or corporate clients

firms and expand dealings (arbitrage) in of major Japanese banks are quite high in relation to

markets on their own account, overhead costs.

* Explore new firms in growing industries to 24 Control systems over exposure positions (commitment

foster prospective small and medium size structure) and volatility (market risk) have been con-ceived. Netting agreements may be further required to

firms, and reduce grossly aggregated exposures. More diversification* Reappraise the total performance and mer- in handling various instruments, as well as more arbi-

its of maturing or matured firms. trage, is possible.


can be expected in the future from such prospective or unrealized profit) are favorable. Steadily growingfirms in terms of new technology, innovative ideas, firms (I) contribute to the core portion of the mainor venture capital. The most competitive and quali- bank's repeated business. Networking services, fund-fied banks concentrate their relationship strategy ing and transactional market deals are importanton identification of and consultation with such strategies in relationship management, and serve tonewly emerging firms. Many have innovative prod- secure stable profit. Regular monitoring or consul-ucts, like the Matsushitas, Sonys or Hondas of the tation may be desirable for maturing or matured1950s. Most require start-up funding both in eq- firms (P), who tend to welcome any kind of man-uityandloans, aswell as managementconsultation. agement advice, restructuring proposals, M&cABankappraisals andsurveys studytechnology, prod- deals, or networking services. The main bank con-uct quality, entrepreneurial character, management stantly reviews its portfolio in terms of growthstructure, investment requirements, and potential patterns of different groups and corporate relation-suppliers, buyers and competitors. In current Japa- ships, and devises specific strategies for each group.nese banking, finding such promising companies is The managerial capacity of the main bank iscompetitive. After all, the major feature of a main acquired through its organization and exercisedbank is its position as equity holder and lender of through its six functions. These have provided thethe last resort in the development process.25 basis for the strength, merit and reputation of main

A main bank protects the interests of its long- banks. The managerial capacity provided by maintime clients, specifically those firms maturing or banks has been particularly effective during periodsmatured in their performance. The bank uses sec- of capital shortage, economic uncertainty and con-ondment for management assistance and to present fined rules of the game. However, as higher eco-proposals of new market deals, instruments or nomic growth has been achieved, further changesinvestment management. The banks also often in the financial sector through deregulation,suggest some useful merger and acquisition deals securitization, globalization and computerizationfor the client's further business development. have forcedJapanese banks to transform their mode

In bank portfolios, companies at different growth of operations from that which prevailed during thelevels are intermingled. Where some may be grow- 1980s. Since 1990, the managerial capacityofmaining steadily, others may be declining. For our banks has been broadly affected on five fronts:purposes, companies may be broadly grouped into: * Two of the six major functions-equityprospective, steady and secured and maturing or holding27 and last resort facilities2"-must bematured. Calling these A, I and P, respectively, the reviewed in light of equity holding costs andfolling analysis reveals interesting trends in main social reputation in restructuring measures;bank portfolios.26 For example: * Major companies have tended to switch

* A>I>P: expansive portfolio (emphasizing funding methods from domestic bank-future), as in 1950-1973; borrowing to bond issues or overseas eq-

* A<I>P: steady and safe in operation, as in uity-related issues due to cost effectiveness;1973-1992;

* A,I<P: facing multi-faceted structuralchA>I<P: fanges. multi-faceted structural25 The effort may be costly, requiring time and patience.Yet it is often lucrative when companies succeed.

Incumbent bank management might opt for 26 This grouping is possible in terms of business growth asportfolio positions of the second type, or (more well as in terms of company maturity. Example: A'spositively) for the first, but the last may prove quite revenue growth rate may be larger than 12% per annum,challenging for the main banks with their need for I may be 5-12% per annum, and P may be below 5%.future portfolio reshuffling. Certainly positions 27 Kurosawa (1992) points out that main banks' long-termwhere A<P-specifically, where I<A<P-are the equity holdings were possible not only through profit-

where A<P-speificay,whre I.A<P-are the ability expected on dividends and capital gains, but alsoworst. Every preemptive effort is made to avoid a through interest income gained through continuouscase where A<P. In fact, a qualified main bank lending opportunities during the high growth period.always strives to maintain the first position by 28 Main bank loan officers make advance inquiries intoemploying all its managerial capacity. Normally, possible causes of continuous current account losses,main banks exercise strenuous effort to foster new, since they can create negative net worth. Officers also

main banks exercise strenuous effort to foster new, offer remedies. If no specific measure is taken by theprospective firms (A) for which equity holding, firm's management, despite prior consultative advice orcredit information, cash flow analysis and assess- warning, the main bank may gradually decrease itsment of hidden assets (goodwill, new technology, exposure. This may trigger withdrawals of other banks.


* Banks' lending ability has been curtailed cope with paradigm changes and deregulated rulesthrough prudent regulation, including ofthe game. This kind of response-or transforma-ceilings on lending to individual borrowers, tion-isonlypossiblewithhigh-qualitystafftrainedand overall lending limits on weighted risk and sophisticated in their career development. Whileassets under the BIS convention (defined there are a growing number of cases where banksagainst Tier I capital); wish to terminate involvement with poor manage-

* Off-balance-sheet transactions offer new mentor where clients grow to the point ofindepen-business opportunities for banks active in dently managing their treasury operations, perhapsmarkets to achieve better returns on equity, a new balance will emerge where banks become(i.e. yen-dollar swaps for medium term more selective and less committed to acting as mainnote issues or yen-yen swaps between fixed bank for the category below "Ordinary." At theand floating rates); and very least, perhaps banks will implicitly retain the

* Banks are now permitted to move effec- role of lender of last resort.tively into universal banking through their In any case, judging a main bank's commitmentsubsidiaries of securities and trust banks. only from lending amounts or explicit elements is

Managerial capacity groomed under traditional often misleading. The main bank's primary role iscredit risk control systems or restructuring man- to foster new prospective firms. Once firms out-agement can be directly utilized for M&A deals. grow the need for a main bank's back-up facilities,During the period of the internationalization of the relationship must be judged on its merits, thoughbanking(l974to 1989),overseassubsidiariescould most main bank accounts will remain intact.be readily applied to corporate equity-related or Main banks should be able to compete in termsmedium-term note issues. Now, competition for of rates and services on the same footing with otherswaps and deriva[ives is fierce and increasingly banks. Insofar as main banks continue to properlysophisticated among the Japanese market makers. train staff and constantly review relationships andNew financial products-suited to individual cli- portfolios, they should be able to manage anyent tastes-may be forthcoming. In order to ex- difficulty. Ultimately, it is strong managerial capac-ecute all client functions, main banks are ity that enables banks or firms to manage theirreorganizing their strategies through subsidiaries to problems in a new environment.

E Secti'on V

Implications for Developing ManagerialCapacity

Managerial capacity within main banks can be be done. The Japanese firmly believe it is aeffectively exercised through their six major func- banker's social responsibility to foster pro-tions. These major activities, in implementation, spective firms which have potential butmay seem on the surface to be nothing new in generally lack funding, management know-relation to ordinary commercial banking or invest- how or information; andment banking. Differences in effect may arise from * While career development may be orga-the way individual staff are educated and organized to acquire all-around experience, thisnized, as well as from the principles and emphasis may not necessarily be the normal practicebehind management development programs. or strategy of Western business.

There are four distinct features ofJapanese man- It is important to realize that these four featuresagement that contrast with Western management are not culture-specific. They can be implementedstyles: in anyorganization in anycountry. It is more or less

* Bank stakeholders are multi-tiered-client a question of management philosophy or, in par-firms, employees, shareholders, community ticular, investment cost for each employee. Life-and society, the central bank and the Min- time employment, as well the seniority system, areistry of Finance. Not only shareholders exer- not the essential conditions here. Instead, initialcise corporate governance-employees and training and discipline for the first four years, andclient firms with long-term interests may appropriate rotations of eight to ten years, areoften be the most vocal stakeholders. One integral to acquiring the fundamental qualitiescannot ignore strong influence from the relevant to main bank functions.central bank, Ministry of Finance, or soci- Overall, the implications for main bank mana-ety. A typical case is employment policy. gerial capacity may be identified at the three levels:Management may not move immediately micro management, institutional setting and macrofor lay-offs, but may opt for wage-cuts, policy implementation. At the micro level, specialpart-time systems or job reassignment; emphasis is placed on fostering talent from within

* Career development programs are designed on long-term basis. This is done at three levels.for the long-term, in line with the banking Every staff member gains experience in deposits,principles of transparency and equity. business promotion, and credit appraisal. OtherManagement competes through quality features and specialties are pursued through theservices rather than through price; employee's own motivations and talents if he re-

* While the ultimate rationale for running a mains in the banks.bank may be profit maximization, Japan Every effort is made to maximize the merits ofprepares for the education, employment long-term relationships with prospective clientand welfare of its people on a long-term firms. Staff is rotated through different sections andbasis. In contrast, Western business tends to branches throughout a two to four year period.pay wages primarily for the job that must Workers are never put in charge of the same clients

Japan s Main Bank System 19

for at least ten years. Fair personnel files are com- within developing or transitional economies. Thisplied throughout a ten to fifteen year period on is true on four fronts:ability, aptitude, personality and behavioral pat- * Bank credit may be the major source ofterns, with an eye to future assignments. corporate finance due to shortages of sup-

Prospective enterprises are fostered by holding plying funds against potential investmentequity, providing credits and last resort facilities demand and lack of local capital markets.and offering useful management advice. This is the Central bank rediscount facilities for quali-key role of main banks as going concerns in society. fied trade bills or short-term governmentEnsuring proactive communication, sound moti- bonds, even at lower rates of interest, mayvation, credible relationships, effective allocation not be sufficient. Syndication efforts byof resources and flexible responses to changes in the main banks on a short-term roll-over basisenvironment is the key area of management re- may be appropriate ways to support pro-sponsibility. spective corporate finance. This also en-

At the institutional level, networking of corpo- courages participation of other financiers;rate information and provision ofconsultingadvice * Basic skills for prudent banking are moreto concerned parties may be broadly expected of easily acquired under the simple rules ofmain banks. Banks in Japan compete with each commercial banking than under global orother to offer seminars or training programs for universal banking systems, at least untilbasic skills. Cross checking of management infor- basic market mechanisms or financial assetmation and modes of operation is possible among growth or maturities are ascertained. Spe-syndicated members through main banks or specifically, active inter-bank money markets,cialist banks in the field.29 New practices or rules of competitive (narrow margin) foreign ex-the game can be easily implemented in a coopera- change dealings, as well as some kinds oftive and competitive manner. Asymmetric infor- medium-term notes or equity issues maymation can be easily rectified through multilateral well be confirmed before full deregulationdialogue or channels in such an institutional set- or interest rate liberalization could be taken. Ating, saving agency costs. standard case of operation may be demon-

Efficiency and creditability in payment mecha- strated by major banks or their securitiesiisms are the primary function and responsibility subsidiaries, perhaps initially under techni-

of all licensed banks. Their costs must be shared. cal assistance by teams of bankers, accoun-Consensus on system building, adjustment or orga- tants or consultants;nizedactionmaybereadilytaken bytheincumbent * Accountability and effectiveness underchairman of the Japanese Bankers Association. micro and system management may beClosedialogue and representation ofbankinggroup crucial objectives for major banks, not onlyinterests is made to regulatory authorities through for twinning programs but for long-termthe Japanese Bankers Association. Discussion is on career development and enhancement ofrules of the game, practices, system supports, legal managerial capacity. Participation of manyconsiderations, taxation rates, advertisements and institutions for financing new projects un-compliance. der initiative arrangements of main banks

At the macro level, an equitable control system facilitates competition, transparency andor guidlines for credit allocation may be organized accountability; andby the central bank through dialogue with each Interlocking relationships between statemain bank. An effective market operation can be enterprises and state banks due to theirimplemented by identifying the position of major inherited debt -or the privatization pro-banks. Accountability in policy implementation isenhanced as every bank can equitably share infor- 29 In the post-war period, certain specialized banks played

mation on markets and policy guidelines in a unique roles in their individual fields., delivering useful

transparent way. Managerial capacity, developed information on projects and know-how in arrangements,

through such a main bank system, is instrumental and contributing much to enhanced managerial capacityof participating banks in Japan. These specialized banks

in enhancingaccountability, effectiveness, efficiency could be called main banks in their special fields. Theirand equitableness at these three levels. professional functions and equitable contributionshave

There may be, therefore, a significant case for been significant in the development process, and are

developing such managerial capacity in banking highly regarded by current competitors.


cess-may be rectified through prudent stances in developing or transforming economies,regulation exercised over licensed commer- some realistic guidance must be offered in terms ofcial banks. Portfolio clean-up efforts can be whether growth is preferred to stability, or whetheropenly implemented by main banks, even bank credits or security issues can be the majorunder the environment of principal agent sources of funding for new investments.problems. Major state enterprises will have The managerial capacity of main banks, theto be split into several corporations due to multifarious functions they exercise, their traininglimited bank lending to one borrower. of human resources, their fostering of corporateSome debt must be replaced with equity or growththroughrelationshipmanagement,andtheirgovernment bonds, which may then be sold internal competition within government guide-as appropriate in markets. Other units may lines, are the salient features of the main bankhave to be liquidated. Main bank managerial system. Their basic know-how may be adoptedcapacity can be instrumental in restructur- universally ifmanagerial capacity, human resources,ing state enterprises. Technical assistance quality in services, and long-term productivity aremay be indispensable at first. considered key competitive banking elements in

the development process. The effectiveness of suchConclusion managerial capacity can be best proved in the global

market, despite differences in language, currenciesEconomic systems maybe largely determined by and management styles. As one Japanese banker

non-economic factors such as history, community states, "Money is our business. Insofar as our clientsvalues and demographic mentality. Management trust us and are clean in business ethics, we willstyles in banking will likewise be determined not standbyasthelenderoflastresort.Wewishtogrowonly by relevant stakeholders, but also byawareness together with our clients. Together we aspire toof social responsibility, long or short-term costs to achieve our goals, as well as prosperity, in society forcareer development, and price or quality competi- long years to come, as going concerns. Our dutytion. In addition, under the prevailing circum- and responsibility rests together with our society."

References

Bollenbacher, George M. The New Business of Reform in Socialist Economies in Transition."Banking. Bankers Publishing Company, Chi- World Bank, WPS 711, 1991.cago, 1992. Nagaoka, Isao. Nihon Kigyono KabushiktMochiat

Denda, Isao, Nihon no Seisaku Kin-Yu. Shibun- Kozo, Daiichi Life Insurance, Tokyo, 1992.kaku Shuppan, Kyoto, 1990. Ozaki, Robert. Human Capitalism, Penguin

Hertle, Beverly. "Factors Affecting the Competi- Books, New York, 1991.tiveness of Internationally Active Financial Sakura Sogo Kenkyusho. Saiktnno ShuyookokuInstitutions." Federal Reserve Bank of New Ginkoono Ketyei Shihyoo. Kinyuu Group, To-York Quarterly Review, Spring 1991. kyo, 1992.

Horiuchi, Akiyoshi. "Nihonno Main Bank wa Sheng, Andrew. "Bank Restructuring in Transi-donoyoona Yakuwariwo Hatsshitaka." Bank of tional Economies." World Bank, CECFP, 1990.Japan Research Institute, 1987, Vol. 6, No. 3. Shikano, Yoshiaki. "Ginkono Kyosoryoku Ntsuite,"

Isoda, Ichiro. "Toshi Ginko Kenshukai Kogi-shu." Bank of Japan Monthly Bulletin, 1992.Kaikodan, Tokyo Bankers Assoc., 1984, Vol. 51. Sunamura, Satoshi. "Some Notes on External

Isoya, Rei. "America no Ktnyu Seido Kaikakuto Debt Management." Manuscript from a semi-Betginnon Kokusai Kyosoryoku. "In Shoken nar at British Council/QEH, Oxford, 11/4/91.Kenkyu, 1992, Vol. 103. Teranishi, Juro. Nihonno Keizihatten to Kin-yu.

Klitgaard, Robert E. Controlling Corruption, Iwanami shoten, Tokyo, 1982.University of California Press, 1991. Kogyo-ka to Ktn-yu System. Toyo Keizai

Koike, Kazuo. Daisotsu white collar Nojinzai Shinposha, Tokyo, 1991.Kaihatsu. Toyo Keizai Shinpoosha, Tokyo, 1991. Torihata, Yoichi. "Hoginno Kokusai Kyosoryoku

Kurosawa, Yoshitaka. "Business Risk to Shihon- nitsuite. " In Kokusai-ktnyu 3.11.5, 1991.Kosei," In Sangyo Keiei Kenkyu, 1992, Vol. 13. Woody, Kathleen J. Soviet Banking and Finance,

Long, Millard and Silvia B. Sagari. "Financial Woodhead Faulkner Ltd., Cambridge, 1990.

* The Role of the Banking System inTransitional Socialist Economies

IntroductionExtensive debate has surrounded the restructur- interest rates without directives, incentives, or man-

ing and privatization programs of Transitional agement assistance would certainly have manycosts.Socialist Economies (TSEs). Over the past three Specifically, such liberalization is known to causeyears, questions have revolved around the appro- inflation, speculation and political intervention,priate methods for shifting to market-oriented sys- not to mention social costs and time loss. Resourcestems and restructuringenterprise debt. Prescriptions are wasted due to bottlenecks, lack ofknowledge orhave ranged from shock therapy to gradualism, experience, scarce money and goods, vested inter-from budget deficit reduction and the opening of ests, and the unfairness stemming from the lack oftrade systems, to the liberalization of prices and property law or prudent banking regulation.interest rates. Due to the efforts of liberal econo- To avoid these pitfalls of liberalization, fourmists and free-market technocrats, significant main steps should be followed to create an econom-progress is being achieved. ic system in a relatively short span of time. These

All prescriptions aside, however, the prospects measures comply with the rules ofthe game prevail-are not entirely satisfactory to host countries. The ing in the global market, and allow for liberaliza-G-7 nations are either hesitant to undertake polit- tion or transformation efforts to be sustainable andically risky actions, or are saddled with their own successful within a decade. Otherwise, the TSEsbudgetary constraints. International financial in- may be plagued by hyperinflation, social unrest orstitutions (IFIs) believe that both liberalization and repetition of autocracy.democracy require at least a decade more to take The four essential measures are: 1) the establish-effect. Practically no development agency is willing ment and adoption of a new constitution for de-to offer assistance beyond the broad structural mocracy; 2) the creation ofan anti monopoly act toadjustment loans which come with prerequisite dissolve inherited or military complex monopoliesmacro-economic conditions (such as controlling and to restructure them into industries meetingbudget deficits and inflation rates). These condi- current market needs; 3) the establishment of ations, however, pose difficulties, including how to socially receptive economic system for macro-eco-maintain employment while restructuring state nomic adjustment, which will serve its own eco-enterprises; how to sustain the social safety net in nomicandsocialtargets;and4)thedevelopmentoftransition; how to increase production to combat a sound, accountable and effective banking system.anticipated inflation while maintaining tight fiscal The earlier these four measures are applied to theand monetary policy; and how to reorganize the old transi6.ion, the faster and easier the implementationsystem within a new environment. of macro-economic adjustment, and the less the

Historically, the main issues of inherited debt waste of resources, time and cost.'and privatization programs of major state enter-prises and banks have either been handled inade- I Even if only three of these four measures can be imple-quately ord tacklhved einherffeel hduingte- mented, the desired effect can still be achieved by effec-

qaeyotcldieet . u tive enforcement of them. Implementation problems, oftransition from a centrally planned economy to a course, come from entrenched interest groups, whichmarket one, the liberalization of trade, prices, and understandably resist loss of power or influence.

26 The Role of the Banking System in Transitional Socialist Economies

The first and second measures are especially framework must be established before liberaliza-important, as they are the prerequisites for social tion takes place.reform and reflect the will of the people. The third This paper emphasizes the important rolemeasure may be implemented at the discretion of played by the banking system in facilitating marketthe government, and will likely remain controver- orientation, as well as in restructuring and privatiz-sial (since it reflects the country's historical, cultur- ing state enterprises in TSEs. The author examinesal, and demographic values) .2 The fourth measure, basic financial sector issues regarding the effectivecreation of a commercial banking system, is fairly restructuring of state enterprises and banks in Bul-standardized and has been common practice for garia, China, Hungary, Myanmar, Poland, Roma-over two centuries. Banking systems are global in nia, Russia, Czechoslovakia, Ukraine, Vietnam andnature, and remain the key element for shifting to Yugoslavia. The principal strategy suggested herethe market mechanism. There is not much room may be broadly applicable to any transforming orfor political intervention in terms of prudent bank- developing country.ing regulations and general accounting and audit- Whatever economic system or political designing practices. In fact, a sound and accountable may be desired, an effective and equitable marketcommercial banking system will help resolve pend.- can only be built on a sound and accountableing economic issues within transitional mixed econ- commercial (not universal) banking system.omies in a more market-oriented manner. Section I addresses the economic systems appro-

During the postwar economic recovery ofJapan, priate to different countries. The major factorsthe first and second measures were enforced by affecting policy framework are explored. Section IIgovernment headquarters. Also during this time, emphasizes the need to build institutional systemslabor unions were legitimized and a new education- which facilitate the resolution of macro economical system was adopted. The Ministry of Interna- and micro-management policy problems. Sectiontional Trade and Industry (MITI) vigorously III examines the core role of the banking system inpursued the third measure (despite scarce resources handling new investment financing, inherited debt,and capital during the initial 15 years), and the enterprise restructuring, equity investment, andMinistry of Finance organized an efficient and local financial market development. Section IVequitable banking system (complete with prudent describes a general course of privatization whichregulation) which allowed foreffective allocation of may be pursued whatever specific schemes arescarce credits for industries. In practice, this system designed or implemented by government. Sectionserved MITI's guidelines for strategic industries as V addresses controversial aspects of industrial pol-expressed in its five year (roll-over) economic plan. icy. Effective policy is essential to the reshaping ofThe guidelines, however, were not compulsory, a country's economic structure within a short spanand some were rejected by the management of of time (5 to 8 years).4

several companies involved in the new investment

of the 1 950s and 1 960s. 2 In light of the other three measures, however, this coun-Transitional Socialist Economies (TSEs) pos- try-specific policy may not unduly affect the macro-

sess features3 and problems similar to those present economic adjustment or the primary objectives ofin post-war Japan. The military complex of the economic reform.TSE must be converted into a civilian production 3 Refer to Table 2 for a summary of the similarities andsystem, and state enterprises must be released from differences between postwar Japan and, perhaps, Russia.the inlherited debt to state banks. Budget deficits 4 Industrial policy issues, when effectively addressed, canshorten transition time to 5 to 8 years, as opposed to themust be reduced to combat inflation, and acute 15 to 20 year time period which results when economiescapital shortages must be relieved to promote new are not specifically guided, but left to a purely invisibleinvestment. In such transitional economies, a basic hand.

* Section 1

Viable Economic Systems for TSEsSeven fundamental macro factors must be con- constitution after revolution (with new democratic

sidered in determining the direction and speed of representatives in the parliament), then the broadeconomic reform and real growth in transition. economic framework of any specific country mayThese are, inter alia: be largely determined by non-economic factors.

* constitutional framework; These factors include:* non-economic and cultural factors; * historical and cultural background;* features in the budget structure; * religious and community values; and* remaining influences still exercised by the * demographics or international relations

previous monopolistic system; affecting management decision making.* basic supply systems of foodstuffs, money The differences and similarities between Eu-

and foreign exchange; rope, the U.S. and Japan in these respects are* economic bottlenecks and hardware and symbolically illustrated in Figure 1 and Table 1. As

software infrastructure conditions; and shown, the U.S. and Europe maintain common* international relationships with ODA agents, social values of community and religion; Europe

international financial institutions and and Japan identify and appreciate each others'commercial creditors. unique history and culture; and Japan shares a

Assuming that economic movement towards a diplomatic policy-often termed isolationist-withmarket-oriented system is intended under a new the U.S. These cultural factors underlie modes of

Figure 1: Economic System Determinants Table 1: Preferred Management Styles

Major Areasof Operation Choice

| (ACFGIL) 0 Corporate Strategy (A) Longer- (B) Shorter-Term Term

Religion \ . < H Social Importance (c) Employment (D) HigherProfit

/ \I Market / 0 Business Priority (E) Growvth (F) Stabiliy

V USA ,ffiSlation- Japan Interest Party (G) Group (H) Individuals

\ (BDEHJL) \ ism / (ACEGIK) Competition Mode (X) Quality (j) Price

Funding (K) Banking (L) Securities


economic systems, laws, regulations, policy and banking system in Japan rather than through themanagementstyles. The elements greatlyinfluence securities market, as commonly takes place in thesocial acceptability, efficiency, welfare, quality of U.S. It is a challenging task to identify the mostlife and survival rules within society. Additional appropriate economic system for each of the TSEs,determining factors for an economic system are: in light of the many differences in managementthe mode of the budget structure (both on revenue styles in these examples alone.and expenditure sides), tax collection system and Arguably, TSEs may prefer the European systemrates and, in particular, the weight of social welfare over that of the U.S., just as, for instance, Hungaryvis-a-vis public investment. If Internetional Finan- moved toward universal banking in lieu of com-cial Institutions (IFIs) choose to ignore these fac- mercial banking. The Poles, in contrast, appear totors in their implementation ofeconomic assistance, focus on the conflict of interest usually associatednot only will economic efficiency be eroded (in terms with a bank's equity underwriting, and may guideof cost, resources, allocation and time), but morale their banks toward engaging in the securities busi-and social justice systems may be severely affected. ness only through subsidiary securities companies,

If we contrast the management styles of each as is the case in the U.S. or Japan. More generally,zone with respect to major areas of operation, some TSEs might recognize similarities and merits in theinteresting areas of common ground emerge. For development of the Japanese system during theexample, corporate strategy in Japan is character- postwar recovery period (see Table 2). This isized by long-term relationships rather than short- especially true if TSE governments choose to pur-term return on investment. Management in TSEs sue growth rather than stability, and consider bankmay place more importance on maintenance of credits as more realistic, accountable methods ofemployment rather than on higher profit-seeking. scarce capital allocation than new securities issues,American and Japanese managements generally which are volatile and slow in reflecting corporatetarget growth and enlargement in market share creditability in equitable capital market ratings.rather than stability or preservation of the status It may be argued that socialist economies col-quo. Japanese managements may give priority to lapsed due to excessive expenditures in support ofgroup welfare rather than individual wealth. Com- military complexes, or investment spending dis-petition in Japan is based more on service and proportionate to GDP. Undoubtedly, TSEs arequality than on wages and prices. Investment funds characterized by undiversified production and ne-in the development process are raised through the glect of public needs for consumption. Yet the old

Table 2: TSEs: Similarities and Differences with Postwar Japan

Similarities Differences

Hyper-inflation and reduction in production Less serious food supply conditions

Credit allocation required Production capacity remains (though obsolete)

Military complex must be converted to Rich in natural resourcescivil manufacturing

Decayed infrastructure No enforcement power regarding decentralizationand restructuring of monopolistic entities

No capital markets, with bank credit as the Little market experiencemain funding source

Priority given to long-term relationships, Interest and exchange rates totally liberalizedcommunity and connections in society

Corporate management is responsible foremployee welfare

Government guidelines effective, essentialand helpful in transition

The Role of the Banking System in Transitional Socialist Economies 29

industrialcomplexesstilltendtorelyonbudgetand welfare nor economic well-being may can be ex-debt subsidies from state banks, since they cannot pected. Agriculture provides essential food for peo-expect to generate enough revenue from the tradi- ple to survive, banking plays the role of the bloodtional production systems. Conditions and pres- system in an economy, and cultural exchange al-sures of the new market environment create lows for trade and investment relationships withadditional constraints leading to their inability to other countries, which provides foreign currencyretain their existing employees. Any sovereign gov- and technical assistance. Neither agriculture norernment must establish a firm and equitable tax cultural exchange can be ignored in policy debatecollection system, one with progressive rates based regarding the transforming economy, but bankingon the source of income. may work more effectively under confined rules ofthe

InTSEs,asocialsafetynetmaybeestablishedby game, specificallywhen an economy is in transition.interim socio-capitalistic means, rather than through Where aristocracy, autocracy, monopoly or cor-the purely socialist method of general subsidy. Cuts ruption dictate any aspect of agriculture, banking,in wage rates and adoption of part time or flexible or cultural exchange, further economic develop-time employment, combined with the provision of ment and living standard improvements will bebasic food supplies at relatively low prices, may be severely hampered. Moreover, corruption in agri-necessary adjustments. While economic bottle- culture, banking, or cultural exchange greatly im-necks--such as those in infrastructure-may be pairs the transition to a global, market-orientedovercome by some ODA, it is essential to split up system. Efforts to maintain accountable systems orlargeindustrialcomplexesandtoresolvebankdebt. to improve productivity in agriculture, foodstuffOnly when this takes place can TSEs transform distribution, banking (deposit and credit approv-traditional budget structures into sustainable ones, al), or overseas capital transaction controls, there-and provide their economic systems with a new fore, should not be eroded by the discretion of amarket orientation. minority interest group. Particular care must be

It is obvious by now that the existing monopo- taken of the agricultural, banking, and culturallistic system must be dissolved. The quicker this exchange systems if public welfare and equity is tooccurs the better, since the system is not only be maintained. Without reasonable control overburdensome for the budget, but is also delaying the these, as well as over the competitive pricing mech-decision-making necessary for economic reform. anism in the commercial banking and foreignAny large individual complex producing more than exchange markets, effective policy dialogue cannot25 percent of similar products should be split into take place. In fact, the key to macro-economicseveral manageable units which can cornpete in issues such as wage rates, subsidies, investment,terms of quality and price within a new market inflation, the budget deficit, exports, and industrialenvironment. Incompetent, incumbent manage- development is commercial (not universal) bank-ment should be replaced with professionals by ing during the economic transition.shareholders and labor unions. This includes gov- The speed and effectiveness of governments inernment, local authorities, private firms, banks, resolvingeconomicbottlenecksandprovidinghardand the like. These are absolute conditions for and soft infrastructure determines the rate andeconomic reform and democratization, as is the amount of new investments-including foreignprivatization of production means in transitional direct investment- and speculation. Telecommu-economies. nications, electricity, and pipelines or transport

An adequate supply of basic foodstuffs, money facilities, for example, are essential to new industri-and foreign exchange are fundamental to any econ- al development. Investment bankers and consult-omy. Each economy-whether it is in transition, ants point to the lack of property law and localrequires transformation, or is pursuing specific capital (securities) markets as impediments to theirdevelopment courses or faster growth-must first professional services and new investment.consider three fundamental factors.5 While the latter may be resolved by an effective

The first key factor is the agricultural industry, banking system, the former may need to be legislat-the second is the banking system, and the third is ed-as rapidly as possible. One caveat, however, isthe cultural exchange system, including tourismearning foreign exchange, and an understanding of 5 This should be done before applying any aspect ofthe country's values and diplomatic ability. Until orthodox economic theory prevailing in developedthese factors are firmly established, neither public countries.


that private ownership of property should be per- imports, and speculation on overseas capital trans-mitted to proceed phase by phase. Quick and harsh actions. These will be affected more seriously in theoverall liberalization will only encourage excessive medium term.6

speculation over office buildings in major cities and Obviously, foreign exchange policy will not onlyselected sites in the regions, specificallywhere inter- affect industrial structures in the medium-term,est rates are negative and nominal prices low. but will also determine the pace of inflation andSupport for this observation can be found in the allowances for income policy. Various countryhyperinflation and devaluation takingplace in coun- experiences support the effectiveness of the adjust-tries such as Poland and Russia. able peg system-perhaps combined with the crawl-

Three points should be taken into account in the ing peg for some emergency measures-to dealinterim period. First, individual households should with imminent macroeconomic issues in terms ofbe given priority to purchase pieces of land or real medium-term guidance. This includes industrial asestate up to certain sizes for residential purposes. well as wage policy in transition, if intended by theSecond, firms with new investment programs should government and supported by TSEs. The key cur-be allowed to purchase real estate for corporate use, rency to which the exchange rate should be peggedand to use it as collateral for bank borrowing or may be a matter of argument for developmentbond issues. Specifically, large industrial complexes economists, but the practical solution is to peg it tothat have prepared restructuring programs may be a basket of three or four major currencies in thegiven priority to select appropriate sites, on condi- world capital markets, possibly to those of majortion that they split existing production lines into trading partners.7

several management units and privatize them with-in perhaps three years' time. Third, foreign inves- 6 Interesting comparisons can be made between the nego-tors should initially be encouraged to invest in tiation styles, implementation procedures, and manage-specified industrial estate zones to achieve reason- ment modes of Brazil or Russia vis-a-vis China, India orable regional development or to restructure bank- Indonesia.rupt companies. 7 It would have been wiser, for example, if the trouble

The status of international relationships with zones (or some payment or clearing union among theFormer Soviet Union) could have been maintained at

ODA agents, IFls and commercial creditors will the outset. This would have minimized overall foreigncertainly affect the speed of reform, types of initial exchange costs and residents' capital flight, while foster-investment, laws and regulations, allowances for ing prospective private enterprises in transition.

* Section //

Institutional Systems For HandlingMacro and Micro Issues

Whatever the economic system preferred, all terprise restructuring and management assistance)TSEs must undertake daunting tasks during the and labor market issues (employment and wagetransition period. These tasks occur at the level of policy). All of these issues were previously inter-macro-economic policy, system building, and mi- locked with each other at all levels by centralcro management. planning agencies. They must be separated, to

Issues to be tackled range from fiscal and mon- make each of them more responsive to marketetary policy (in terms of budget deficit and control forces. This is possible through proper deregulationover money supply), capital market development and transformation into assessable business forms.(in dealing with inherited debt and equity hold- The interlocking situation in TSEs moving towarding), privatization program mobilization (state en- the market system is illustrated in Figure 2 below.

Figure 2: Transforming Socialist Economies

i. Budget ,\2. Money Supply

(MACRO)

3. SOE _ _ _ _4. Equity/Bond

~~~ ~Pr\udent_,,

(SYSTEM) tX

| / ~~Bariking5. Debt _ _ _ 6. Privatization

(MICRO)

7. Employment Xl 8. Wages


Ex-Socialisteconomiesweredoomedtocollapse The disintegration of rigid TSEs is relativelydue to rigidities firmly entrenched in macro-eco- controllable, and can be facilitated through thenomic policy, system workability and micro man- bankingsystem without political intervention. Dis-agement capabilities. The following numbers integration should be based upon prudent com-correspond to Figure 2: (1) Budget policy is not mercial banking regulations which are universallydisciplined, the deficit is enlarged, and society still accepted.pays social costs or wages for (3) State enterprises While more technical measures are discussed inwhich rely on (1) Subsidy and (5) Debt due to state Section II above, four additional factors have beenbanks to keep their (7) Employment. (1), (3), (5) shown to facilitate shifts to the market mechanism.(7) are closely interlocked in TSEs. In order to shift These factors tend to eliminate the rigidity, distor-to a market system, financial discipline and market tion or corruption often inherent in TSEs. Thesevaluation are essential at all three levels. This may include:be reflected in appropriate market instruments, * Ar the macro policy level, efficient andmanagement quality or labor productivity. accountable channels of dialogue are essen-

Ongoing macro-economic assistance is not suf- tial for policy makers and central banks andficient; instead, effective system advice must be allow for an equitable credit system, alloca-given on how financial discipline can be introduced tion or control of total credit, delivery ofto fit into each circumstance, how effective market policy guidelines, and transparency of offi-valuation should be organized, how management cial information;quality can be enhanced or enforced, and how * Established rules of business and imple-wages and employment should be maintained. mentation of the market mechanism through

Money supply (2) must be kept under control, an effective banking system, specificallywith flexible but stern discipline. State enterprises during periods of capital shortage, eco-must be gradually cut off from subsidy, outstand- nomic uncertainty, and lack of informa-ing debt restructured with new equity or bonds (4), tion;or with temporary government recapitalized bonds. Transparency, accountability, and an infor-Perhaps a certain amount of outstanding debtcould be effectively converted into equity. This mation orientation tend to sidestep any

principal agJent problems. State banks mayequity can then be disposed of or sold privately or beithepai ank for State ent ses.publicly in the market, facilitating the pace of A e tri in formati f nber easimarket-based privatization (6). Employment (7) in Asymmetrhc uformation flow can be easdlyTSEs may be reasonably maintained by wage con- throughout k r siation.trol (8) vis-a-vis productivity and quality undernew ownership structure and able management. v Once prudent banking regulation is estab-The direction toward (2), (4), (6), and (8) should lished, agency costs will be minimized. Ifbe objectively and mechanically encouraged and corruption is equal to monopoly plus direc-consistently pursued. tion minus accountability, then these fac-

Under this basic design and structure, a prudent tors can be largely eliminated through thebanking system constitutes a core function in all accountable banking system; andrespects. First, it works as a cushion for financial * Availability of information is crucial, in-discipline (though it may delay processing the shift cluding individual corporate credit ratings,or erode public savings). Second, it facilitates re- investment information; market surveys,structuring and privatization of state enterprises, industry and technology updates, seminars,and serves as economic and business lever for consulting work, and audits or accountingrejecting political intervention (while ousting in- functions. Banking is an information in-competent, incumbent managements). Third, it dustry, and these information flows effec-fosters local capital market development through tively foster growth of small and medium-bank portfolio clean-ups and securitization (while sized firms in periods of economic transi-this may reveal the actual net worth of enterprises tion.as lower than formerly perceived, it may stimulate At any level of macro-economic policy, institu-private investment). And fourth, it facilitates mobi- tional setting or micro organizational manage-lization of monetary and human resources (which ment, strategic design and policy implementationmaycontaincostsbyreducingeffectivewagerates). should be approached with short, medium, and


long-term concerns in mind. Figure 3 illustrates intermediaries. Once standard prudent bankinghow the banking system (established over two regulation is introduced, those banks would becenturies) can be effective in dealing with the social obliged to comply with the rules of the gameissues inherent in the transitional period. Specifi- prescribed for them; that is, either to operate undercally, it is illuminating in terms of resource alloca- commercial banking license or as finance compa-tion, subsidization, and speculation (see Figure 3). nies or securities brokers. Then, many of the allow-

If one denotes the TSE banking system, either in ances under the old loose rules in dealing withterms of TB (i.e. treasury banks for state enterpris- special entities may be taken away, hence reducinges, which only transfer subsidy as instructed by the subsidization, speculation and waste. Figure 3 sym-government and lend as requested by their enter- bolizes the degree to which the commercial bank-prises), or as UB (i.e. universal banks, engaging ing system (CB) will improve effective resourcesimply in speculation in foreign exchanges, com- allocationoverthatachievedwithTBorUB, undermodities or real estate and not acting as proper the standard rules of banking license.financial intermediaries in the true sense), then The banking system holds the key in facilitatingtraditional banks licensed by governments as com- TSE shifts to true market-oriented economies. Anymercial banks under prudent banking regulation effective, efficient and equitable commercial bank-may be expressed as CB in Figure 3. TSE banking, ing system provides an accountable and diversifiednot operating under the normal prudent banking basis for transformation. It plays the role of societalregulation or rules of the game, may either transfer buffer in terms of management systems, socialthe rigidity from the previous regime into its new welfare, and employment and wages; it acts aseconomic environment, or engage purely in specu- societal anchor in maintaining credit order, effi-lation. cient settlements and the market mechanism. The

Neither TB nor UB are transparent in opera- banking system also serves as a stimulus for flexibletion, nor do they serve as traditional financial inflation adjustment, investment and production.

Figure 3: Illustrative Difference In Effectiveness in Banking System

CB

EffectiveAllocation

TB UB

/\Standard License/\

Subsidy Waste

A Level of RulesRigid Use Speculative Use

TSE Banking Resources

* Section 111

An Accountable, Effective Banking SystemThe banking system can facilitate effective han- dates, or sellers issue bills of exchange (BEs) ad-

dling of many macro-economic issues inherent in dressed to buyers to pay on agreed dates. ForTSEs. If enforced in a competitive manner, it can example, ifthe bank's client buys some materials onallocate resources with little political intervention, 30 days' usance and sell its products on 90 days'based upon well-defined rules of the game. Com- usance, this client usually requires trade financingmercial banking forms the basis for all accountable for 60 days (unless the client has sufficient fundingand effective business within both developing and of its own). The bank generallyprovides the financ-transformingeconomies. Startingwith the primary ing for such underlying trade transactions, or dis-functions of commercial banks, this section de- counts the buyer's PN or client's BE (accepted orscribes specific aspects of prudent banking regula- endorsed by the buyer or his banker at relativelytion, the functions of a central bank, the need for lower short-term interest rates). The bank has noclean up of bank portfolios, and local market fi- problem with providing trade or bridge financingnancing of new investments. for underlying payables or receivables. To facilitate

such normal trade financing, the Central Bank's re-discount facility is usually available at a favorable

The primary function of commercial banks as rate for licensed banks and their qualified PNs andfinancial intermediaries is the acceptance of depos- BEs.its from the general public and the lending of those Business transactions, however, may be moredeposits to specific clients (borrowers). The clients diversified in their payment terms and conditions.are those appraised as creditworthy in terms oftheir Bank financing instruments vary according to creditability to pay interest and principal on due dates as risk involved, information or knowledge of com-contracted. The bank's management will readily modities as well as market trends, length of pay-provide trade credits to those clients whose primary ment period and complexity of handling suchlines of business and credit history are familiar to transactions:them and confirmed in advance. Examples here are * Cash finance or discount facilities aresuppliers of raw materials and usual buyers of their readily available for routine (confirmed)products. Some borrowers may be able to provide business transactions for established clients;certain kinds of security as collateral, or guarantees 0 Documentary letters of credit issued byfrom some creditworthy third parties or licensed creditworthy banks may normally be re-banks to supplement their creditworthiness. In quired for discounting the bills of exchangecases of TB or UB, these functions and principles for parties whose credit information is notare neglected and financial viabilities are lost. altogether established or reliable (especially

In normal trade transactions, buyers request in overseas business);their suppliers to allow a certain period of time for * Some banks or trading companies may becash payments (usance for sales). For confirmation willing to purchase (in lump sum) com-of sales of raw materials or products, buyers either modities or products in packages with rel-issue promissory notes (PNs) to pay on agreed evant documents (BL, invoices, BE)


appraised as salable on their own assess- porting regulations and legislation) should be in-ment and risk. These can be purchased at troduced to implement, inter alia, GAAP, BISreasonably profitable levels, if the banks are (capital) ratios, liquidity requirements, ALM, pro-equipped with market knowledge and trad- visions of reserve for bad assets, ceilings on lendinging capacities on their own accounts; to one borrower and equity holding relative to

* Some durable or capital goods may require capital base. Banking license is normally given onlypayment in installments. Hire purchase can to those reputable institutions who can complybe conceived (for cars and durables) if the with such rules of the game.mode of transaction and conditions of SomeexistingTSElocal banks, however, arenotinstallment payments are dearly defined really qualified for banking licenses. But, so as notand contracted between sellers and buyers, to discourage their strong desire to run privateand all PNs are submitted together with a banks, the Central Bank should perhaps be pre-certain amount of down payment (usually pared to open the door for re application once these10 to 25%). Banks may be able to discount banks fulfill the necessary requirements. More im-such PNs provided by sellers (banks' cli- portant guidance is normally prescribed by theents) under appropriate agreement (often Central Bank or by presidential decrees in thewith some kind of comfort letter, guarantee following areas, in order to rectify inherent prob-or with recourse conditionalities); and lems, eliminate the speculative climate prevailing

* Leasing is financing in-kind. It is generally among banks, or to reduce national resource waste:the provision of equipment or plant (capi- * The foreign exchange positions of licensedtal goods, large in sum, usable for long banks (long or short, as well as the maxi-term) for which fees composed of interest, mum ratio of assets in foreign currency)amortization and handling charges are may be defined relative to the bank's realincluded. A main difference between this capital base. Residents' capital flight over-and a hire purchase is that the ownership of seas could be legally contained, say atleasing goods rests in the hands of providers $50,000, with the remainder of investment(lessors) and not with users (lessees). Leas- allowed only with domestic banks or na-ing may look a bit expensive, but still be tional bonds;attractive for the lessee in terms of require- T .oments for funding, collateral and coping extend ofcbanks'smvovement In bewith technological changes. estate and securities investment may bewith technological changes. prescribed, subject to capital base and valu-

Any financing instrument backed by real, un- paibed, subject to craps 60 vlderlying transactions are normally bankable. The anon of collateral, to perhaps 60%;question is whether the obligors (borrowers, buy- * Off-balance transactions or contingenters, or lessees) are creditworthy from the banker's liabilities (including derivatives and guaran-point ofview, and engage in substantially profitable tees) may be required to be specified inbusiness. Normally, cash flow and management annual reports, and should be restrictedcapabilities are the points in question. While any of relative to either capital base or correspond-above financing should be possible in transitional ing assets;economic systems where uncertainty prevails, dis- Equity underwriting should be permittedcounting facilities, letters of credit, or leasing may only through authorized securities compa-be more widely used. Creditworthy and established nies (including subsidiaries) independentcompanies dealing with sound bankers should not from the banks' own accounts, to avoid anyhave the problem of arrears currently facing some insider trading, market manipulations, orTSEs in the inter-company market. All credits conflict of interest, and also to protect de-should reflect normal trade transactions, and in-vestments or remittances should be carried through positors;efficient settlement systems of qualified banks to * The establishment of banks' new subsidiar-creditworthy business counterparts. ies (including overseas) should be screened

by the Central Bank in advance throughPrudent Banking Regulation approval, consultation, registration or re-

If a creditable and accountable system is to be porting. This should take place in relationestablished, the standard Banking Act (with sup- to principal lines of business, ratio of equity

36 The Role of the Banking Systemt in Transitional Socialist Economies

holding, relationship with other partners, Experience in postwar Japan provides severalmanagement structure and corporate gover- parallels to the challenges facing TSE policy-mak-nance in order to identify the extent of the ers. In the 1 950s Japan had high inflation, a highlybank's other commitments, and to keep concentrated industrial sector, capital shortagestrack of all activities of the banking group and high budget deficits.(and preempt any mismanagement); and The government wanted to diversify the indus-Board members and directors of licensed trial base, as well as to encourage savings and privatebanks should not be allowed to borrow investment. After the stringent budget-balancingfrom their own banks or associated compa- measures recommended by Mr. Dodge, as well asnies, or to deal in the securities of their the introduction of a single exchange rate policy,clients on their own accounts. the policy which emerged (through consultation

and consensus) had the following characteristics:Functions of the Central Bank * Effective use of commercial banks and the

The Central Bank should aim at: price stability, postal system to encourage savings;facilitating financing wherever and whenever re- * Reliance on the banking system for scarcequired; and maintaining the order of the credit savings allocation and credit provision forsystem. This should be done through issuance of funding priority investment, as opposed tonotes; as a banker of banks (lender of last resort); using universal banks or capital markets;and as an agent for the government. * Maintenance of tight monetary policies to

Therefore, the central bank and supervisory reduce inflation, mainly through the bank-authorities will need to guard against the bankrupt- ing system, by credit allocation of the Cen-cy of individual banks, which could quickly desta- tral Bank;bilize the financial system during the transitionalphase. Bankruptcy can be envisioned through four * Targeting credit to strategic industries,

scenarios: ~~~~~~~~~~such as steel and coal; andscenarios:• Large defaults by major clients mainly due . Taxing income at the source, thereby re-^~~~~~~~~~~~~~~ui theg otential for taxo evasion.y ae

to poor credit appraisal or undiversified ducing the potential for tax evasion.portfolio lending; While some may recommend that the TSEs

• Liquidity or cashshortagestrigcreate universal banks, such a move is premature inbrLiq o short,age trigg ero b terms of soundness, efficiency and future growth.borowngs hot and l endgelong or At their current stages ofdevelopment, TSEs should

focus on developing a simple but competitive com-* Speculative dealing in foreign exchange, or mercial banking system. Developing efficient pay-

investment in concentrated ranges of ment systems, competitive services for depositors,stocks, shares, or real estate relative to the and effective corporate lending and trade facilitiesbank's management or capital base; and should be primary goals. Since nearly all TSEs face

* Cases specific to certain clients, particularly severe capital shortages, high priority should bethose overseas. given to deposit mobilization at this stage.

These are the classic cases that lead to banking Competition should be encouraged within con-failure. They are often observed at times of credit fined rules of the game in order to minimize over-squeezes, or during rapid changes in the financial head costs and improve the services rendered.system. Normally, however, experienced bankers Financial maturity is gradually achieved throughare accustomed to organizing and controlling their active competition in deposit-taking, a competitiveoperations. The best course of action during the inter-bank market, competitive margins on lend-transitional period discussed here is to exercise ing and foreign exchange deals, quality in creditcontrol and supervision over the bank's range of appraisal, as well as a steady stream of privateactivities. investment and export growth.

The goal is to discourage the bank from engag- Many existing state banks will need technicaling in excessive equity or real estate investment, assistance to establish a sound and competitiveexpanding contingent liabilities, or setting up over- banking base. This could be accomplished throughseas subsidiaries until it has established a solid track the use of management contracts for periods of, say,record in domestic commercial banking. 5 years. Further diversification ofoperations should


only occur after success has been achieved in the State banks can deal with non-performing loansprovision of "plain vanilla" banking services. Banks through five different channels:in transition should refrain from underwriting eq- * Reduction of loan asset value through infla-uity and investing excessively into real estate on tion;their own accounts, so as to avoid overburdening Writing off bad loans, transferring them totheir capital base and contaminating of otherwise a liquidation trust fund, or selling loans orsound portfolios. equity;

At the same time, policy-makers should ensure epladhthat the banks have an appropriate regulatory and Replacement of bad loans with governmentlegal framework for their operations. A strong (thus effectively reducing the portfolio riskfoundation-theuseofgenerallyacceptedaccount- (th t);ing principles, the development of a regulatory and weight);supervisory body, and a strong legal basis for the Restructuring enterprises and introducingbanking system-will facilitate the move toward a new management to improve productivity;more competitive system. Ultimately, it will reduce * Conversion of major loan portions intothe need for direction from the central bank or equity (despite possible adverse tax conse-government. Since bank managers in TSEs are quences).largely inexperienced and the banks' capital bases While inflation is not recommended as a viableinadequate, regulators will need to exercise greater channel for reducing debt in TSEs, banks may usecaution than would be necessary in more sophisti- varying combinations of the above. As a first step,cated environments. large state enterprises must be divided into several

manageable units such as product base, factory orNeed to Clean-up Bank Portfolios enterprisedivision; then theymustbecorporatized.

State banks in TSEs face enormous challenges. Only after this occurs can state banks (similar toUnder prudent banking regulation they must re- their main bank counterparts in Japan) begin tostructure and diversify their existing or inherited design restructuring programs for potentially via-portfolios, and learn to survive in a market-based ble units and liquidate those which are not viable.economy. They must help restructure state enter- Main banks in Japan have played a pivotal roleprises inways that fostergrowth, while maintaining in providing financing, advice and restructuringthe health of the banking system. Moreover, they know-how in response to corporate developmentare expected to conform broadly to their govern- needs. During the post-war period, these banksment's social, economic and industrial policies, provided long-term investment financing to strate-Because of the large overhang of inherited portfo- gic industries and promoted the growth of smalllios, it will be difficult for state banks to play and medium-scale enterprises through equity hold-meaningful roles in promoting new investments ings, provision ofmarket information and manage-until the issues of state enterprise debts are resolved. ment assistance.Thus, the restructuring of inherited debt and re- The major qualifications for determining "mainstructuring of state enterprises are high priority bank" status in Japan can be described in terms oftasks for state banks. six dimensions:

Some TSEs have adopted mass privatization * The ability to hold equity in firms;programs using vouchers or coupons to transfer * The presence of board representation withownership from state to individuals. These schemes key clients;may be significant in building wealth but may not * The provision of last resort facilities;be the most appropriate method of ownership * The maintenance of historical relationshipstransfer. Voucher or coupon systems ignore the with certain groups of enterprises;viability of enterprises, and lack the means to * The development of long term fund raisingevaluate performance in the marketplace. The sys- or trustee roles; andtems have the potential to disappoint individual - The offering of specific intelligence ser-investors and undermine any existing government vices.industrial policy. Also, such methods do not take After World War II, the enterprises involved ininto consideration the need for skilled manage- military production were obliged to convert theirment and effective banking systems in most cases, production systems to civilian operations, such as

38 The Role of the Banking System in Transitional Socialist lconomiei

the manufacture of capital goods, transport, ship- Good enterprises are firms which can be readilybuildingandmachinery.Mainbanksguidedenter- corporatized and sold (either whole or divided).prises through this transformation. Figure 4 Often, splitting firms into smaller, more manage-illustrates the various functions carried out by the able units will enhance overall return to the share-main banks. holders, government or banks.

In tackling their portfolios, state banks should Prospective enterprises are those needing bothclassify their loan portfolios broadly into four cat- subdivision and "financial engineering." That is,egories, using performance (increasing revenue or they require debt clean-up, conversion of debt todeclining income) and net worth (assets versus equity, and replacement with government bonds orliabilities) as primary benchmarks (see Figure 5). recapitalization. These firms can generate reason-Sectoral analysis, showing per capita productivity, able revenue levels, but lack adequate capital. Theyrevenues, overheads and profitability will aid in need continuous support from banks to be sustain-splitting large enterprises into manageable units. able. In deciding which entities to support orExperienced consultants or accountants can assist restructure in this category, the government shouldthe banks in classifying enterprises into four catego- weigh the trade-offs between industrial policy ob-ries, described below: jectives and potential return on investment. Some

Figure 4: Major Qualifications of Main Banks

~~~~~~~~~~~n or

Monitoring I Relationshi

1.Equity Explct Implicit 2. Last ReHLoldng,terrn | RestructuringLong-trm Fclte

5. Sniain .ItliecDealing, Services,Main A/C F X > Credit

Truse Rol Apria

Figure 5: Performance versus Net WorthNet Worth

3. Partially viable 1. Good

Divide and improve Divide and sell

Performance

4. Doubfful 2. Prospective

Liquidate or write.off Debt to equity or(Sell any residuals Divide and improveunder RTC)


industries of comparative advantages or utilities conversion of debt into equity. The major questionand other public services may fall into this category. may be how to replace the incumbent managementFigure 6 illustrates the general criteria for govern- with an able one, or with an effective contractments in making these considerations. While gov- supported by the ministries in charge.ernments in TSEs presumably want to sell as much Partially viable enterprises must be subdividedas possible, some consideration of social welfare and given management assistance in order to im-policy is appropriate. Units may be sold, for exam- prove their performance. These firms should haveple, through regulatory arrangement or specific positive net worth, but accumulating debt andleasing contracts (see Figure 7). In many cases, declining revenues are cutting into their viability.enterprises in this category may be restructured Government bonds or guarantees maybe necessaryinto viable form by a split into several entities and to preserve their viability in the short-term.

Figure 6: Industrial Policy versus Return on Investment (ROI)

l\ROI

Private business Private business

Telecom

Investment Electricity

(Level or Duration) (Regulatory arrangement)

Transport

Mining(Utilities)

Water supply

Figure 7: Social Welfare versus Productivity

High Social Welfare Policy Objectives

* Sell or JV

owned * Regulatory Sell or SellManagement arrangement Jv orcontract * Management Regulatory MBOcoTariff contract Arrangements

*Tariff changeLow High

Productivity Productivity

Sell or splitwith Split

Liquidation/sell Management andContract or sell

Lease

Lower Policy Objectives


Bad enterprises are those firms must be liquidat- - Some high yield bank assets may beed and written off. Assets to be liquidated can be securitized (backed by underlying transac-transferred to a liquidation trust fund (see Section tions), to be sold in the secondary market.IV) to facilitate the recovery effort. - Foreign borrowing may be the major

Credit evaluations and restructuring can best be source of long-term financing for exportinitiated by state banks (main banks) as part of their related projects.portfolio clean ups under prudent banking regula- These steps will prove helpful for regional devel-tion, inter abla, provisions for bad assets, lending opment, investment, or long-term credit banks inlimits and capital requirements. This can take place their pursuit of positive industrial investment fi-with the support of the Central Bank, Ministry of nancing (including domestic resources and foreignFinance and Ministry of Industry, and should be direct investment).strictly enforced (see Section V). Assuming a principal agent problem exists in

Financing Long-term Industrial and Corporate TSEs, four major principles are applicable to theInvestmoent development bank:

The joint venture bank, owned by domes-Under current TSE inflation levels, interest rate tictparners, banon majority shaesavoatliy an unetit in ecnmcprset tic partners, can own a majority share (sayvolatility, and uncertainry in economic prospects 60%). Governmental sources should not

and legislation, it is extremely difficult for any new own a majority but could maintain a 30%investor to appraise and undertake projects or raise to a majri butic maintainuai30%long term funds in the market at a reasonable cost to ow% sr dom priate is

* r * * * ~~~~could own up to, perhaps, 20%. Thisin the medium term. With every financial institu- , , 1 c .m.o.tion engaged in short-term speculation, there is tant in light of current creditability andvirtually no market for funding industrial financ- prevailing practices. It ensures transparencying at the moment. Even the monopolistic Russian . . .Saig Ban is bus wit hosn loan an in,, governance and decision making, asSavings BanK IS bUSy with housing loans and maintains the check-and-balance system ofinter bank market operations. .

Long-term financing under such uncertain con- management responsibility.ditions, however, may be mobilized if reasonable * The single largest government shareholderinterest rate structures can be established (perhaps (owning approximately 25-30%) should befollowing the example of postwar Japan). The available to act as a sponsor of last resort forfollowing channels apply: a joint venture. Regional authorities are

following Treasuryeor locapply: authoritybessential partners in identification, imple-• Treasury or local authoriry bond issues mentation and supervision of projects, with

(initially in short-term) can be underwrit- shares of between 10 and 30%. Still, allten by savings banks or licensed commer- government shareholders together shouldcial banks. Longer term government bonds not exceed the majority of between 30 andmay be undertaken by a pension fund. 49%n

* Main banks for state enterprises could ar- Foreign institutions are indispensable part-range syndicated loans (say, from 2-7 years) ners for bringing in management know-on a roll-over basis (perhaps 3-6 months in how, widespread human resources andstep-up rates) through commercial banks to long-term funds. Both semi official agentsfinance revenue-generating projects. and private institutions may be invited to

* Equity investment funds, venture funds, trust participate to diversify the operation. Per-funds, reconstruction corporations, or privati- haps some type of option clause should bezation funds, may be managed after state required for partners to review total perfor-enterprises' restructuring, corporatization, mances after 5-7 years.and establishment of ownership rights. * A channel for consultation with indepen-

* Some creditworthy banks or enterprises dent experts, such as independent invest-may issue debentures of medium-term ment management boards, may be necessarymaturities (2-5 years), with appropriate depending upon management structure orcollateral (such as guarantees or real estate) available expertise (see Section IV).provided to trustees.

* Section IV

Privatization Programs through the Bank-ing System

TSEs have been deluged with Western advice on * Restructuring should be enforced throughreform and privatization of state enterprises. Addi- portfolio clean-up held by state or maintionally, it has been difficult for merchant bankers banks in the prudent commercial bankingto implement their usual approach of undertaking system (see Section III).privatization programs, due to the absence of prop- * The centralized production systems of en-erty law and the undeveloped condition of local terprises should be broken into severalcapital markets. manageable units and allowed to compete

Because of these facts, IFIs or IFCs should be for new markets.able to assist TSEs as well as investment bankers. i Inherited debt should be handled throughThe ongoing mass privatization programs (includ- securitized instruments and replaced withing voucher schemes) appear equitable in promot-

in *rvt oweshi for sml hp n government recapitalized bonds, equity oring private ownershipforsmallshopsaconvertible bonds. The market should be

restaurants. ,restaurants. ~~~~~~~~~allowed to determine the value of thoseYet what is really required is promotion ofsound debts.

corporate development and new industrial invest-ment. Large enterprises which have technology or d Enterprises should contract with indepen-market share advantages may have already been dent consultants to agree on restructuringpartially sold to Western European investors. and privatization programs with their state

The general difficulty may lie with large indus- or main banks.trial or military complexes, or with state enterprises Governments may set broad guidelines onstill practicing some form of subsidy. Problems lie industrial development in the mediumin: producing salable products in the new world term.environment, financing new investment, shedding These implementation programs should be en-inherited debt, and perhaps replacing old manage- forceable under the new constitution and antimo-ment. nopoly laws, as well as under prudent banking

Privatization programs should be commensu- regulations.rate with the viability of enterprises, since potential Banks should first classify their existing loansinvestors or entrepreneurs may be discouraged by broadly into four categories (see Section III). Duenominal privatization or corporatization. While to capital base constraints, insufficient provisionsome aspects of privatization may be controversial, for bad loans can be made, and some of the loansgovernments and state banks can take several non- may exceed the lending limit under regulation. Badcontroversial steps that will help pave the way for loans must either be written off, replaced withthe ultimate state enterprise privatization. government recapitalized bonds, or transferred to a

Comprehensive restructuring and privatization liquidation trust fund. The rest of the loans may beshould be based on five principles: substantially converted into straight or convertible


bonds or equity. Selling convertibles or equity in markets can deal in both instruments. Variousthe market is virtually the process ofprivatizing the terms may be conceivable for convertible bonds,enterprises. but bond and equity will be their form. CBs may be

Two alternatives may be considered. One is to convertible into equity either when the price of thechange the loans into some preferential form of equity reaches a certain level, or after a certainconvertible bond (CB), possibly collateralized with amount of time has elapsed (say 5 years). The life ofenterprise fixed assets. The other means is to trans- a CB may be up to 12 years, and carry a coupon ratefer excessive equity (that beyond net worth) to the of perhaps 5 to 18 % per annum (as local circum-management of an independent equity holding stances permit). CBs can be issued at two tiers:company. Here, associated banks keep minority * Issues by state banks to government (anshares on their own undertaking, together with equity holding corporation) or the Centralgovernments and/or interested group funds or com- Bank; orpanies (see Table 3 and Figure 8). * Issues by enterprises to their main banks.

Thus, large debt may be divided into smaller The terms and conditions of both CBs mayunits in terms of either bonds or equity, so that basically be the same, but flexible consider-

Table 3: Ownership/ManagementA Case for Mixed Economy

Ownership

Management Fully Government-Owned PartvemmentOwnd Privately Owned

Direct Government Control Public sector cr' Guarantee (Tariff)(State enterprises) (t'^ ttal sals) under regulatory

2 § § 7t -X a> 2 arrangement

lar ekt.ci ntrol. Puiblic corporarion. (Special JV enterpri&ees) Semi-guarantees:

. js;j . * . .. t.u conwace .. Under regulatory under regulatory. i > jj. ..-.. . .;arrangeincnt arrang tmntr,

Private Control Management contract a Private enterprise(Fee) me..

Figure 8: Roles of Banks in Restructuring Enterprises

Government Equity/CB

Management BoEai

Banks (Loans) EquitB E Equity

Enterprises (Debt) Bad BLquidation Trust Fund

Partially Viable <u quity Holding Co

Prospective Equity EiCB \ Fquity

( ~ CB > ManCB

The Role of the Banking Systemt in Transitional Socialist Economies 43

ation may be given to certain prospective guidance for each enterprise. The boards shouldenterprises on applying progressive rates of have the power to authorize, guide or facilitateinterest, starting at perhaps 5 to 7% per viable investments. They should be constitutedannum, and ending at 12 to 18%, unless even prior to the enactment ofthe legislative frame-converted into equity in the meantime. Time work for investment (investment code, contractof conversion should rest on the judgment of law, company law). The boards should not onlybond holders depending on market interest provide individual investors with micro manage-rates, prospective performances of enter- ment assistance in making their investment pro-prises or their own ALM positions. grams workable, but should also play macro strategic

Indeed, CBs can be considered the best market roles. They could aid, for example, in establishinginstruments (both as bonds oras equity), since their appropriate industrial zones, in conceiving invest-prices are quoted to reflect relative asset values, ment incentive schemes in export industries, or inmarket interest rates and performance. While pric- providing intelligence services to diversify treasurying may occasionally induce arbitrage, on the whole operations. They could assist in marketing or init indicates a fairly appropriate measure of local introducing technology or equity partners, as wellmarket values, despite the potential technical diffi- as in assisting with mergers and acquisitions. Inculty of enterprises involved. short, the boards could minimize all dimensions of

By converting debt into equity or CBs, cost on business infrastructure constraints on TSEs.enterprises may be minimized, while restructuring Such draft schemes of restructuring programstime is gained. Debt of a special nature (such as forallenterprisesmayinitiallybeproducedbybankexternal debt or seniorclaims) mayeither be swapped management as main banks or representative cred-into property or replaced with short-term IOUs itors. First, they should be discussed with thefrom the Central Bank, if this is considered appro- management of enterprises to identiif the unitspriate from a monetary point of view. It would be divisible in the existing production systems. Basedeffective if some ODA or IFIs could extend credits upon feedback from enterprise management, banksof say, 10 to 15 years to TSE governments (or the should then submit the plans with feasible balanceCentral Bank), in order to facilitate conversion of sheets for each unit to the government (or somedebt into equity at a two-tiered level, form of independent restructuring authority com-

For reasons of social justice, the national burden posed of members of the ministries in charge) foror social cost inherited from the previous regime broad and general agreement. Such balance sheets

must be borne widely by the economy as a whole. will be worked out objectively by independentDe facto inflation or devaluation is obviously one qualified accountants.means for doing this, and allowing markets, poten- Consolidation of such balance sheets shouldtial entrepreneurs, or foreigners to undertake it may reconcile with the audited balance sheets of thebe another. Still further, devices for enhancing the total complex. The government or restructuringvalue of existing productive capacity (perhaps un- committee is expected, in point of principle, not toder new, professional management) is definitely modify the proposed plans agreed upon by thethe right course of action; this should be quickly concerned parties, except in cases where a specificimplemented. Any of these channels or devices can industrial policy consideration is affected.be organized so as to produce a cost minimizing Based upon state banks'restructuring proposals,effect in tackling inherited debt, but this is only governmentscan obtainastrongpsenseeofethenstatuspossible through market functioning, as well as an quo of each state enterprise. Governments shouldeffective, efficient and equitable banking system. establish and state their positions clearly. The:

In view of the lack of managerial capacity and should be committed to:corporate governance faced by TSEs, these econo- * Adopting a broad view of industrial andmies should consider creating investment manage- welfare policy, and publicly specifying thement advisory boards composed ofexpert financiers, degree to which the government may re-industrialists, consultants, accountants and entre- main as stockholder;preneurs. Many multilateral and/or foreign advi- * Dividing complex enterprises into as manysors should be included to provide outside expertise economically-viable units as possible, thenand objective perspectives. The board could advise privatizing (or selling) them with the aimon macro as well as on micro issues, providing of enhancing competition and efficiency


(not purely for the sake of maximizing (ALM) point of view. On the asset side,revenue). This is the key step toward a some long-term loans may be changed tomarket oriented system; short term loans, if necessary, on a roll-over

• Resolving the actual allocation of work basis. Some loans may be securitized, say toforces to each of the salable units prior to convertible bonds or collateralized straighteach unit's sale. This should be based upon bonds. Fairly large portions of banks' eq-practical judgment, and conducted under uity holdings may be shifted to indepen-the advice of an independent professional dent management companies, possibly viateam (such as the investment board); joint ventures with other pension funds, or

• Concentrating on enhancing the efficiency to foreign partners.and profitability of production units Additional sell down of assets may be pos-through leasing, management contracts, or sible in securitized forms. On the liabilityrecapitalization, in view of the overall lack side, recapitalization of enterprises may beof domestic capital stock. This should take possible through issuing convertible bonds.place unti' potential investors emerge, per- Medium term swap arrangements may behaps in the form of corporations (joint conceivable through foreign financial insti-stock companies), or as other salable instru- tutions, which potentially wish to makements such as convertible bonds; local investments without incurring ex-

* Supporting the public sector through the change risk.social safety net (services). This will be More attractions can be attached to depositmaintained through stockholding, recapi- taking or networking of cheap fund-raisingtalization, bonding, guarantees or regula- in money markets. Opportunities exist fortory arrangements; enhancing stability and balancing assets

• Relegating bad enterprises or doubtful and liabilities. This leads to improved prof-

assets to a special independent liquidation itability for banks.trust fund. It is more transparent and less * Conflict may arise between creditors re-costly if such doubtful assets are concen- garding the seniority of claims. Thesetrated under the same umbrella, rather than should be irrespective of the nature of thesplit between several entities; claims (working capital, bridging finance,

• Streamlining shareholdings in enterprises accounts payable) by replacing them with,for example, convertible bonds of different

(since debt overhang is so substantial), via maturities.either state banks or public equity holding aturites.companies (see Figure 8). This will facili- * For asset sales, the following points shouldtate moves away from an interlocked sys- be given priority consideration:tem, and maintain the option of selling - It is appropriate to set floor prices andbanking equity in the market when appro- guide the market to bid higher.priate opportunities arise. - Since governments ideally should handle

A few additional technical points: the reallocation of work forces to each

* Dividing huge production complexes of unit, and given that employees normallystate enterprises into many independent work harder if sharing in company own-corporatized units not only helps promote ership, shareholding (albeit minor) shouldthe sale of assets and privatization at better be offered to employees at preferentialprices, but also assists in the diversification fixed prices (slightly below the floor price).of portfolios as state banks themselves are - Potential entrepreneurs or managementdivided into smaller units. This enhances candidates normally feel more confidentthe banks' ability to convert long-term investing in or running companies ifloans into equity, and enables them to gain core portions of shareholdings are in thenew equity. hands of reputable groups or specific

* Banks should take this opportunity to di- private parties. Hence, sales to core pri-versify their portfolios more broadly, from vate parties by auction stimulates bid-the Asset and Liability Management ding and often results in success.


- If wider ownership or public holdings cus should be the rationalization of each unit, inare preferred, fixed price offerings are order to enhance efficiency and profitability. Inmore desirable than conventional or many cases, this can be achieved through lease orDutch auctions. management contracts, or by some regulatory ar-

- To stimulate interest or turnover in sec- rangements including tariffs and fees. As in anyondary markets and enhance the conscious- capitalist country, the TSE will face a variety ofness of management over performance, ownership and management forms. While somevarious marketable instruments should be are unique, most fall into nine basic categories (seeemployed to reflect wider evaluation in the Table 3 above). These categories depend on themarket (see Section III). degree of government ownership and control that

* It is essential that every independent unit must be exercised, either from a public welfare orItaisressential thebard) every co ainpendet uindustrial policy point of view. Indeed, there is a(across the board) be corporatized. good case for the mixed economy. However, con-

The amounts which will be privatized thereafter stant review is encouraged to examine performanc-depend on prospective profitability, pricing, viabil- es within those categories, specifically in cases ofity, and market conditions, and should not be of partial ownership and indirectcontrol. Theseshouldprimary concern. The immediate government fo- be sold into private hands in 3-5 year programs.

* Section V

Industrial Policy Considerations

In order to facilitate the shift to market orienta- haps under professional management contracts.

tion, some form of industrial policy is effective in Enterprises still endowed with positive net worth

guiding new long term private investment. Under but with accumulating debt should be divided into

the transitional period of hyper inflation, no inves- viable units and unprofitable units.tor can venture to undertake new investment. Viable units may be put under professional

Three major motivations may promote new invest- management contract for further performance im-

ment: first, increasing the supply of foodstuffs and provement. For partially viable enterprises, some

consumer goods to combat inflation and maintain social welfare policy considerations may be re-

the social safety net; second, overcoming economic quired vis-a-vis productivity.bottlenecks in infrastructure elements such as tele- Government bonds or guarantees may also be

communications, electricity and transportation, required to make them sustainable. Figure 7 (above)

and; third, channelling scarce resources into pro- may provide a general guideline. Units with high

spective industries rather than into foreign ex- productivity should be sold, while those with low

change or real estate speculation. productivity and lower policy significance should

Specifically, industrial policy for transitional be liquidated and written off.economies should address issues of: It may be interesting to compare the differences

i Return on investment vis-a-vis private busi- between prospective new investment, productivityness prospects; and coverage in military state enterprises, centrally

* Social welfare factors vis-a-vis productivity supported enterprises, guided multi-enterprises,

in the public sector; and and free enterprises within a centrally planned unit.The most likely result is that ranges of invest-

Maintainingna creditworing dess, since this ment in military state enterprises would be con-wit exomoter fou ign drebt, inesthist fined to the traditional areas of steel, chemical, oil

may pm frniand gas. Investment in centrally supported enter-Some state enterprises will require screening in prises would center around shops, finance and food

light of the government's industrial policy versus processing; in free enterprises within a centrally

return on investment (ROI). Figure 6 (above) may planned unit, the applicable industries would be

clarify this point. Utility enterprises may be sup- real estate, foreign exchange, and commodities.ported by regulatory arrangements and/or govern- Either may be lower in productivity.ment bonds which allow them to run as going In contrast, in guided multi-enterprise with

concerns. diversified investment one would expect a wider

Those units of enterprises with high ROIs or ranges of industries, where competition would

ROAs may be divided and sold, and units with enforce efficiency and raise productivity. Such dif-

lower returns required to improve efficiency, per- ferences in growth rates and competitiveness would


provide strong incentives to potential private inves- * The timing of refinancing and reschedulingtors. See Figure 9 for a comparison of the prospects arrangements must be reviewed continu-of military state enterprises, centrally supported ously in consultation with major key insti-enterprises, guided multi-enterprises, and free en- tutions;terprises within a centrally planned unit. * Arrears or delayed payments should be

External debt may receive somewhat different avoided, as these will endanger thetreatment, as it involves relationships with many country's sovereign credit standing in inter-important overseas creditors. In terms of scarce national markets;foreign exchange and the creditworthiness of the Rescheduling negotiations should gocountry in capital markets, TSEs should adhere to through one window, such as the Paristhe following guidelines when resolving external Club or bank advisory committees;debts:

dearly a d * If debt and debt service reduction opera-*Early and decisive action IS necessary beforetinarnesay,hecuryhol, ,, ~~~~~tions are necessary, the country should

a crisis occurs. Countries should maintain make all efforts to maintain and restore itsclose relationships with reliable institutions creditworthiness in international markets;which may offer last resort facilities, such asstand-by facilities or note issuance facilities * All possible options should be made avail-(NIFs)i able in dealing with the different positions

of various creditors;

Figure 9: Illustrative Prospects on Productivity/Production

Productivity_ - ~~~~~~~~~~~~~~Guided

Multi-Enterprises

A

/ / \ Free/ \ Enterprises

Centrally / vPlanned Centrally / \

Unit Supported / \\ Mili ary Enteprises /

Enterpies /

6 9 n Mm--O M c a't'et9""~ -

sg~ ~~~~: pa CDs =rTmig3ig 3e 5 litfit


* In a worst case scenario, it may be necessary issues (under professional assistance). These banksto convert external debt to equity; can initiate the classification of outstanding loans

* Avoid using secondary market prices for based upon objective credit appraisal, corporatesequestering and discounting one's own performance, and net worth. They can furtherdebt. These markets are marginal, and use propose methods for restructuring industrial com-multiple counting by using the same debt plexes into economically viable units. They canto bid down the price of the debt. Offi- adopt specific measures to replace debt overhang,cially accepting these prices could lower the mostly with equity. Governments must indicatedebtor's level of creditworthiness, and put broad guidelines, and announce their willingness"friendly" creditors in awkward positions; to promote such restructuring and privatizationInterest capitalization should also be under broad industrial and social welfare policy.

avoided, as it implies a,. inability toconBanks should take this opportunity to improve

one's monetary affairs; meanwhile, debt their own asset and liability management, and tocone'stmonetarysaffairs; meanwhile, debtbecome efficient and competitive in their role ascontinues to accumulate. If this option financial intermediaries facilitating private invest-becomes unavoidable, the interest capital-ized could be converted into short-term ment m the new environment.convertible bonds, perhaps due to state Conclusion

enterprises or state banks. From a historical or cultural point of view, TSEs* Most importantly, any sovereign borrower may prefer the European or Japanese style of eco-

should be able to repay its debts in its own nomic system over the American brand of liberalcurrency. Some creditors may be willing to capitalism. Moreover, TSEs may find the Japaneseconvert their loans into local equity or model of enterprises, guided industrial policy,property if appropriate incentives are at- medium term planning, and socialistic welfare intached. Payment in local currency is desir- net income distribution more palatable than theable at face value to preserve the sovereign American system.integrity of the government. In addition, it Following the adoption of a new constitution,may be possible to link repayments in local antimonopoly, private ownership and property lawscurrency with the provision of new money should be enacted as quickly as possible to discour-by the same creditors. This debt-to-equity age any form of political intervention.conversion could be quite attractive to Pure commercial banking systems may be morefriendly creditors, and to investors (who advantageous than universal banking at the initial,anticipate strong prospects in these econo- 5 to 10 year stage. The former discourages resourcemies once debt overhang is reduced). Debt waste, as well as excessive speculation. Lower inter-equity conversions may be limited, how- est rate policy, equitable taxation systems. Andever, by the government's fiscal and mon- sensible foreign exchange control (such as thatetary position. practiced in postwar Japan) are recommended .

The core problem for TSEs is the substantial This will establish a business system characterizedstate enterprise debt due to their state banks. This by accountability, competition, and fairness.debt was inherited under the central planning The banking system can serve as the core ofpolicy of the previous regime. A centralized ap- information and competition within corporateproach is essential to rectifying such systemic prob- business development. For this to succeed, bankslems as policy guidelines, managerial capacity and must properly train management, obtain the equitythe market mechanism. The distribution ofvouch- of venture capital, arrange for cofinancing anders to private citizens, or the use of mutual funds, facilitate efficient computerization programs.may be useful in promoting small private owner- The protection of depositors and the enhance-ship. However, the main objective is to tackle large ment of employee welfare is essential, as is thestate enterprises by making them viable units, to development of managerial capacity.enhance market competition, and to foster the Foreign banking licenses may be dispersed intomanagerial capacity which lays the groundwork for the region and utilized to promote joint ventures,the move to the market system. perhaps using the conversion of debt into equity.

State banks, as financial intermediaries acting as Certain well-structured regional investmentmain banks, are in key positions to resolve these banks may hold the key to promoting new invest-


ment under industrial policy guided by the central any movement toward a market-oriented system.government. Its efficiency, effectiveness, and equitability will

Corporate governance will be effectively en- vary country by country, reflecting the manage-hanced through banks, auditing arrangements, ment and cultural influences organized at the mac-structuring of boards and creation of independent ro policy level.investment advisory groups. In fact, the banking system may be rendered

IFIs and ODA agents have many avenues for ineffective, inefficient or unacceptable to the soci-assisting developing or transforming economies. ety within which it operated if these macro andMacro policy, institutional setting and micro man- management issues are ignored in the pursuit ofagement provide the foundation for strong and economic development.steady growth (see Table 4). While this paper has A market-oriented system within transitionaloffered much advice on common denominators, it socialist economies can be facilitated by recogniz-is important to emphasize again the importance of ing the role of commercial banking, organizing aninstitutional settings on the economic environment. effective accountability system, and restructuring

The banking system plays a key role in economic state enterprises. The time has come to movedevelopment worldwide, and is instrumental to beyond simple liberalization policy.

Table 4: Major Factors Affecting the Economic System

Common Deminators Focus Culture

Macro policy Macroeconomic Comparative Social safety netadjustment, advantage Value concept

Foreign exchange Economic planning MentalityInvestment Technology

Institutional setting Banking system, Coordination Laws & RegulationsMarket mechanism Competition Market maturity

Information Incentives Workers' welfare

Management Style GAAP Profitability OwnershipEfficiency Quality skill Motivation

Experiences Training Practices

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