How banks can help the move from dictatorship to democracy

Tunisia has its dangers, but it should be safe from financial collapse. archer10

Tunisia has been hailed as a lone success story among the Arab Spring nations. A relatively peaceful transition with a recent agreement on a new constitution has enabled the country to avoid the bloodshed of others in the region and has prevented further economic damage. As usual in political transition processes, this has also affected the financial sector, in both good and bad ways.

Long-ruling authoritarian regimes use the financial system as a way to dominate the economy through easy access to credit, for example, while preventing competitors from gaining the same access. Lobbying by politically connected elites can lead to lower protection for investors, which in turn limits access to finance by non-connected enterprises.

It is a common theme in authoritarian regimes around the world; all leading entrepreneurs are linked to the ruling elite via family or financial ties. Indonesia is a great example. Economist Ray Fisman has shown how political connections to former president Suharto translated directly into lower stock return towards the end of his reign, as investors expected lower returns on these connections in the future.

As such, “connected lending” and political interference in banks and the regulatory process becomes the norm, undermining both stability and efficiency of the financial system. This is certainly not limited to state-owned banks; it is wide-spread throughout the financial system.

Tunisia was no exception. Even after the departure of the ancien regime, the country had a financial system with a legacy of non-performing assets and doubtful solvency positions as well as weakened regulatory and supervisory authorities. Since 2006, for example, regulators have not carried out a single on-site inspection of banks, relying completely on unverified data and information provided by the institutions themselves.

A transitional economy like Tunisia thus faces several challenges as it tries to develop a financial services sector fit for a functioning democracy. First, losses from previous connected lending have to be recognised and written off. This then leaves banks dangerously short of funds. Not recognising the losses would effectively imply evergreen, or standing, loans with no time limit. Thus fresh lending to other more promising borrowers would be limited. At the same time, recognising the losses means recapitalising banks or, in other words, sending a lot more money their way.

Second, lending to new entrepreneurs must be encouraged, and this isn’t easy in an economy where nepotism and central planning has dominated. Rather than relying on “good names” (or connections) or purely on collateral, banks need to acquire skills in financial and business assessment. Building relationship with new borrowers or developing transaction-based lending techniques such as credit scoring or leasing requires a build-up of expertise and technical capacity.

Third, regulators must make provisions for legacy losses stemming from the old regime. Banks will have lent too much, to the wrong people; firms will have made bad investments. Regulators will have to come up with a solution for banks that are weakened by these losses. At the same time, it is in the interest of the same regulators to see a thriving banking sector. A successful socio-economic transition needs one, after all. It is thus a fine line for regulators, to aim for the Goldilocks rate of financial service provision: not too hot and not too cold.

While no transition process is alike and each country is different, some lessons might be learned from the successes in Central and Eastern Europe after the fall of the USSR. There, broad-based institutional reform underpinned the transition process. However it was not painless, with most countries suffering systemic banking distress in the first decade of transition.

In almost all countries, banks initially kept lending to incumbent (formerly) state-owned firms, even in countries where they were privatised. They did this irrespective of the economic prospects of these enterprises; money was thrown at large manufacturing companies with outdated products and production processes.

This had severe macroeconomic repercussions. When these firms were unable to pay back their loans, banks made big losses. The consequent need for funds to recapitalise the banks resulted in rising fiscal deficits and thus inflation. Eventually, this resulted in bank runs and/or solvency crises for banks and governments.

Ultimately, the arrival of foreign banks in Central Europe turned out to be part of the solution. These new banks cut entrenched links between borrowers and lenders, bringing new competition into the economy. Foreign banks contributed to the rise of new enterprises and the reduction of connected lending, as shown by Mariassunta Giannetti and Steven Ongena. They also provided macroeconomic stability by eliminating the need for bank recapitalisation.

It is important to stress that “foreign banks” does not necessarily imply majority foreign ownership. It could also refer to foreign management. The emphasis is on new leadership, new skills and new clientele. Anything to break the old connections holding back financial systems from Indonesia to Tunisia.

For a nation in transition from authoritarian regime to flourishing democracy, banks are crucial. The recent history of banking crises suggests that the faster losses are recognised and dealt with, the faster the turn-around. For the financial system to play its role in the socio-economic transition process in Tunisia, this resolution cannot come fast enough.