The form of financial institutions that prevails in the Central and East European countries (CEECs) may prove to be a key factor determining the quality of restructuring and adjustment in the industrial sector. In Discussion Paper No. 1062, Research Associate Irena Grosfeld looks at empirical evidence and recent economic theory to find some guidelines for building the institutions of the financial system. Empirical evidence is rather ambiguous, while economic theory, at best, provides clues to the trade-offs that might exist between the information and control functions that any financial system should perform. The relative advantages of various institutional arrangements (their costs and benefits) can be examined by distinguishing between two factors: their capacity to generate information about the value of firms, reducing adverse selection; and their capacity to collect information about managers' behaviour, alleviating moral hazard. Bank monitoring and relational investing may be more appropriate for dealing with the latter; open contests, extensive evaluations by third-party bidders and stock exchange listings may have an advantage in the former case.

The author argues that for the CEECs, where large amounts of resources should be liberated from their entrenched uses and moved to their highest value use, the priority should be given to stimulating information generation about various investment opportunities. After years without contestability and given the necessity for a very profound redeployment of assets, it is important to ensure some external evaluation of companies' potential. The actual evolution of financial systems in the CEECs shows that banks are playing an increasingly important role, and that very close links are developing between the banking and industrial sectors. If banks are to become not only privileged creditors, but also shareholders of firms, the information needed for efficient restructuring may become the victim of excessive commitment.

Financial Systems in Transition: Is there a Case for a Bank Based System?
Irena Grosfeld

Discussion Paper No. 1062, November 1994 (FE)