In transforming a planned economy to a market basis, one sphere that requires particularly deep and difficult reforms is the banking sector. The banking systems and skills that had developed under central planning bear little resemblance to those which these countries now need. Banking regulation and supervision was irrelevant in the past, and had to be developed from scratch. The large degree of needed reforms, combined with the severe real and financial shocks faced by these economies, meant that much could go wrong and did go wrong in the banking sphere.
As other reforms progress, the relative importance of banking issues will grow. Commercial banks will still face difficulties and growing pains long after liberalization and privatization have been largely completed. The dominance of banks in the financial systems of economies in transition further increases the importance of these issues.
Reforms of the banking system can be divided into three main elements: planned “top-down” reforms (e.g., better regulation and supervision, legal reform, privatization, etc.); spontaneous “bottom-up” developments (e.g., new entry, mergers, etc.); and the occasional resolution of sudden and often violent banking crises.
All three elements have been particularly visible in the Baltic states of Estonia, Latvia, and Lithuania. As these countries emerged from a minimally reformed Soviet economic system, in which most decisions were made in Moscow, the extent of needed reforms and institution building was particularly large. As in much of the former Soviet Union (FSU), and moreso than in Central and Eastern Europe (CEE), the degree of bottomup development of new banks has been extensive. Most importantly, all three countries have now faced large open-banking crises – Estonia in 1992 and Latvia and Lithuania in 1995.