Accession Countries Must Learn from Russia’s Mistakes

Over the last decade recurring financial crises have plagued transition and other emerging market countries. The recent experiences of Argentina and Brazil have increased fears that similar crises may take place in the future. A new CEPR Report, written by Enrico Perotti, Lessons from the Russian Meltdown, examines the causes of the Russian crisis of 1998 and suggests that important lessons may be learned from this episode for bank supervision in countries with weak enforcement capacity. These lessons are particularly relevant to some Eastern European countries aiming to join the EU.

The Report identifies the consequences on fiscal and financial behaviour of soft legal constraints, resulting from weak enforcement institutions and opportunistic behaviour. For countries in such circumstances, it suggests that to increase financial stability, they must liberalize their banking sector gradually. Countries with weak legal institutions should start with a narrow, segmented banking sector, and a concentrated commercial banking segment. The Report finds:

• The visible reason for the Russian crisis was an unsustainable fiscal deficit coupled with massive capital flight.  But the real causes were the structure of individual incentives in a context of weak institutions, captured by special interests. 

• The lack of enforcement was further undermined by collective non-compliance and a rouble overvaluation driven by international support. This led to a build-up of non-payment, theft and capital flight leading to the crisis.  By early 1998 the banking sector was insolvent, well before the fiscal default.

• Perotti argues that it is now crucial for Russia to implement measures that create incentives for prudent banking without relying too much on prudential rules that can be easily bypassed or resisted when weak institutions are in place.

• While most Western countries started their financial development with extremely restrictive bank licensing policies, and only gradually liberalized them, Russia made a leap into universal banking. This was not the result of careful policy considerations, but the result of regulatory capture by strong special interests. This attempt to leapfrog the intermediate stages of financial development backfired badly, allowing asset stripping and feeding extreme speculation.

• The Report recommends a shift from conventional prudential supervision of universal banks to a policy of asset restrictions, segmentation and limited competition in a two-tier banking sector.

• A layer of safe banking institutions, subject to asset restrictions, and dedicated to payment and safekeeping services for retail depositors, should be established to create a solid foundation for the financial system. This segment may have limited deposit insurance.

• A second layer of banks, the commercial banks, would have no restrictions on their lending but should not enjoy deposit insurance.  Such banks will need to obtain special operational licences and capital requirements should be keep high to restrict entry.

• A concentrated commercial banking sector will restore profitability, as a low degree of competition will maintain margins in less risky lending.  This creates powerful incentives for banks to remain solvent in order to maintain operating licences.

• The amount of lending by retail banks may progressively increase as the institutional framework for debt collection and prudential supervision improves.

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CEPR Policy Paper 9

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