| There are no bad banks, only bad supervisors. That is a broad-brush view. But without bad banks, central and eastern Europe would not have turned capitalist quite so fast. Now it's time for these Financial entities, prompted by their supervisors, to shape up or they could endanger more than themselves and their national economies. Bad banks are the rule, not the exception. Not many countries have the benefit of centuries of regulation and supervision behind them. Even where they do, bad banks can turn up out of nowhere, like the landmark disaster of the 1990s, Crédit Lyonnais. Most characteristics of badness are the same: bad management, poor credit control, poor record-keeping, shoddy risk analysis. But those factors are exacerbated, incubated even, by bad supervision, an incomplete legal framework, unstable politics and a shaky economy. All these elements conspired to come together in central and eastern Europe in the 1990s. Regulators, law-makers, accountants - not all necessarily angels themselves - fought against corrupt politicians, business barons and the mafia to create a hodgepodge of western-style banking systems out of the communist mess of barter, funny money and convertible rouble accounts. Considering the obstacles, some banks, even some banking systems, have achieved marvels thanks to a handful of far-ighted technocrats and entrepreneurs. But these systems were also rich ground for sharp practices, abuse of depositors' and shareholders' rights, theft of state assets, hijacking of management control and whisking proceeds overseas. There was bound to be some slippage. The great example, US Financier John Pierpont Morgan, did not get where he did and his bank perhaps would not have reached the peak of prominence and respectability without the vicious exploitation of unfortunates and legal loopholes during America's wild and lawless growth-spurt But central Europe's baby boom is over. It is time for its banks and banking systems to become respectable. There are some horrible examples of malpractice and ineficiency still at large. This is not only a threat to the national economies concerned, it's a threat to us all. No Financial system of any medium-size country is an island. A problem of security, insolvency, even liquidity spreads like wildfire across national borders and through cyberspace. The tools deployed to help these reforming banking systems are pitifully weak. There is the IMF/World Bank Financial sector assessment programme (FSAP) initiated in May 1999 and designed to help strengthen countries' Financial sectors. That Fits into the IMF's existing Article Four Financial sector surveillance and the World Bank's activities to strengthen banking systems and their resilience to shocks. There are bank twinning arrangements which so often drift into neglect, there is the Financial institutions development programme of the World Bank and the European Bank for Reconstruction&Development (EBRD). There are the shareholdings in local banks held by the World Bank's International Finance Corporation and the EBRD. But the Russian experience showed how little a 15% shareholding can do against determined corporate robbery. The EBRD has invested in 65 banks in the region; nine of those shareholdings have either been sold or, in two cases, gone bust. "The portfolio is successful commercially with almost 20% internal rate of return in euro terms," says Kurt Geiger, head of the EBRD's banking development programme, But that commercial success tells a story. The EBRD's philosophy has been "to work only with the best. We have to be convinced that the management is open and cooperative, not only with us." So all those sinful banks which suffer from lack of transparency and un-cooperative management won't get a look-in - a rather Pharisee approach to bank reform. The twinning programme has some success stories, notably Allied Irish Banks' romance with WBK in Poland. There is the Group of 10's Financial Stability Institute (FSI) in Basel gamely trying to spread the word but with no executive power. The FSI runs programmes, workshops, seminars for senior banking supervisors in emerging markets, explaining the 25 core principles for effective banking supervision as drawn up by the Basel Committee in 1997. But each country is different, says Elizabeth Roberts, director of the FSI. "If a handful of families control 70% of the economy how can a bank avoid concentrations of risk?" Supervisors too "may not have the respect or backing of their own government", she says. Central and eastern European banking systems now rely on strategic shareholdings by better-regulated western banks. But is that enough to ensure these systems won't be hit by bank runs and other crises? In extremis a western bank may still let its emerging-market subsidiary go down. Letters of comfort aren't legally binding and wouldn't faze a western bank with problems at home. KBC, Unicredito or Allied Irish Banks might not be First choice as lenders of last resort for a national banking system but that is the implication if its major banks have them as parents. Standard&Poor's, in a study published in August, identified three central European Financial systems as being under particular stress: the Czech Republic, Romania and Slovakia. "Large-scale corporate privatizations failed to result in proper restructuring while large banks remained in government hands. There have been delays in reforming the legal structure, especially creditor rights." The plight of Czech bank IPB is a classic example of what can go wrong when shareholders' rights, credit control, supervision and the economy are all weak. Clever men turn these weaknesses into a means of self-aggrandisement and self-enrichment, Finally dashing the expectations of those who thought the bank was providing a public good. IPB isn't the only example. Its peculiar history made it more vulnerable. But most Czech banks were barely any better and were all used as punch-bags for the shocks caused by the government's reluctance to reform. Bank runs and manipulations have terrorized the Romanian banking system but it now has a tough new supervisor with a mission. Short-sighted nationalism has stunted bank growth in Slovenia though that is set for a gradual change. We look at the vulnerability of the more open Hungarian banking sector. Meanwhile Poland is currently the darling of the bank reform lobby. Despite the collapse of Bank Staropolski the sector looks robust, bolstered by strategic shareholders from the west. But there are some endemic problems which run right across the region. Most countries are experiencing either macroeconomic volatility or lack of diversification in a one-product economy, explains Sophie Childs, regional bank analyst at Fitch IBCA. "There is a lack of tested legal structure, which includes corporate, criminal and tax law. There is little moral responsibility either collectively or individually to comply with the spirit, let alone the letter, of the law." Most west European countries have the advantage of a social, political and Financial structure dating back to the 17th century, she says. But that does not include the Spanish and the Italians, she cautions. Corporate governance in banks is enhanced by better management information systems because "a larger number of people will know about the quality of the business". On the other hand technical advancements can lead to leveraged losses, as in the case of Barings in 1995. Mostly, catastrophe is caused by a combination of failures. Childs cites another non-regional example, Crédit Lyonnais, where things went wrong in many areas at once: "poor controls, poor internal reporting, recession in the economy". The bad internal reporting allowed the bank "to accommodate so many problems in so many adverse areas". This reminds us that poor supervision "is not exclusive to the wild east", Childs says. It is another weak link in these Financial systems, says bank-supervisor-turned-bank-analyst Paul Jennings at Thomson Financial Bankwatch. "A lot of supervisors have made a fair stab at the Basel 1988 Accord (which deals with capital charges on credit risk) but nowhere yet has mastered consolidated supervision, which would capture banking exposures that have been parked in affiliates." Poland, Hungary and the Czech Republic have it, but they are new to it. "With consolidated supervision you need to be pragmatic, not legalistic," says Jennings. "It's easy for a bank to say that the unconsolidated affiliate's purpose 'is not Financial business'." The Basel committee on banking supervision is working on proposals for a new framework which will put even heavier demands on supervisors. If the region's supervisors are just getting a handle on the 1988 accord and haven't started to look at the market-risk standards agreed in 1997, how many years will it take them to catch up, even in the more advanced countries? The safe solution may be to make the new Basel framework far simpler than its ambitious First draft, so that it is truly a minimum standard achievable by all.
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