Eastern Europe
Financial Reform

At a Brussels lunchtime meeting on 2 October with the Institut d'Etudes Européennes of the Université Libre de Bruxelles, Colin Mayer presented the results of recent research on financial reform in Eastern Europe. Mayer is Price Waterhouse Professor of Corporate Finance at the City University Business School, London, and Co-Director of the Centre's Applied Microeconomics programme. His talk was based on his CEPR Discussion Paper No. 603, `Financial Reform in Eastern Europe: Progress with the Wrong Model' , written jointly with Jenny Corbett. The meeting took place as part of CEPR's research project on Economic Transformation in Eastern Europe, which is supported by the Commission of the European Communities under its SPES and ACE programmes and by the Ford Foundation. The views expressed by Professor Mayer were his own, however, and not those of the above organizations nor of CEPR, which takes no institutional policy positions.
Mayer noted that Eastern Europe has made major progress in the reform of its financial sector and its integration with the Western banking system, but the East European banking sectors are still dominated by the state, and rigidly segmented both by sector and geographic region. They are characterized by too much separation between savings and lending activities and above all by inadequate competition. Progress at times seems frustratingly slow, but the necessary reforms will almost certainly be achieved, and in a few years' time East European banks will offer new and existing services at lower cost and trade on international financial markets, hence becoming part of the modern financial order.
Mayer argued, however, that much more fundamental questions remain unaddressed concerning the future relationship between the financial and non-financial enterprise sectors. Marked differences across Western industrialized nations affect not only the financing but also the control of industry, and the reform and restructuring of East European industry may be better served by `insider' methods of corporate control, as found in Germany and Japan, than by `outsider' methods based on the threat of take-over, as found in the UK and the US. The latter are costly in terms of managerial time and effort, they take no account of the interests of stakeholders other than shareholders, and they weaken investors' commitment to long-term corporate goals. In contrast, in Germany and Japan banks play an important role in monitoring firms' performance; and enterprises also own and control one another through cross-shareholdings, which encourage insiders actively to monitor one another. Such `insider' systems provide greater commitment to long-term policies and effective means of penalizing poor management.
Mayer noted that in the rush to reform their financial systems, East European governments are promoting the development of stock markets of the UK/US type and seeking popular participation in their privatization programmes for three reasons: they receive most of their economic advice from the UK and US; many East Europeans view capitalism and stock markets as virtually synonymous; and privatization and wide share ownership are viewed as the most effective and quickest means of breaking with the past. The UK and US styles of capitalism are exceptions rather than the rule, however, since in most capitalist countries stock markets are of very limited significance, banks are the main source of finance for industry, and there is little direct participation by individuals in the enterprise sector.
Mayer stressed that the substantial restructuring that East European enterprises now require is unlikely to be achieved by a large group of dispersed shareholders and that the (pre-Communist) traditions of most East European nations are more consistent with banking systems of the Continental European type than with the wholesale import of less familiar institutions and banking practices from the UK or US. The markets in corporate control that these require are unlikely to emerge soon in Eastern Europe, and even if they do, their desirability is questionable.
Mayer proposed instead that East European governments promote the development of `control groups' of enterprises and banks. These will stand a better chance of transforming their enterprises than widely dispersed shareholders, and banks will be better able than equity-issuing institutions to raise substantial finance from the public. This entails risks of inadequate incentives to corporate efficiency and an over-concentration of power within small groups, however, which public policy should be directed to avoid. Industrial policy must be directed towards creating competition in product markets, antitrust policy to maintaining it, and bank regulation to protecting the East European financial systems' stability.
In conclusion, Mayer noted that without a conscious policy to promote internal control groups, East European financial markets may develop in three directions: ownership may become more highly concentrated, transferred overseas by foreign purchases of domestic enterprises, or retained in the public sector. The concentration of ownership is already increasing in some countries most notably in mutual funds in Poland although the behaviour of such non-bank financial institutions is still dictated by their own dispersed owners. Reliance on overseas ownership is a denial of responsibility for corporate control, since true economic development requires the indigenous creation of enterprises and institutions that can retain control at the highest level in domestic hands; while retaining a large public sector is no reform at all. Mayer concluded that Eastern Europe has no effective alternative to insider systems of corporate control of the type found in Germany and Japan; and the sooner that public policy is devoted to their development the better.