Banking in transition economies: Does efficiency require instability?

Efficient banks are essential for capitalist economies, yet bank failures result in costly externalities, lending to a potential conflict between the risk choices of private agents that own banks and socially optimal choices. This conflict is particularly severe in transition economies. Evidence suggests that these economies have banking systems that are both prone to failure and inefficiently small; established banks suffer from an overhang of bad loans, and implicit subsidies often favor continued lending to inefficient state-owned enterprises (SOEs). If a regulator seeks to impose higher capital standards to reduce the odds of bank failure, privately held banks may instead exit the industry, shrinking a system that is already inefficiently small. If loans to SOEs are subsidized so as to mitigate repercussions from their failure to workers and to banks, established banks may prefer such loans over riskier unsubsidized loans to entrepreneurial firms. Encouraging entry into banking may mitigate this problem, but the new banks will be quite risky and prone to failure. The upshot is that, in transition economies, achieving an efficient banking system is likely to require significant instability.