Public and Financial Institutions in Transition
Economies: An Overview and Recent Evidences
from Central and Eastern Europe
Cristian Dragos
Daniela Beju
Simona Dragos
This article is a survey of economic literature about the public and
financial institutions in countries with transition economies. It also
presents some particularities within the countries from Central and
Eastern Europe. We investigate the factors that influence a certain in-
stitutional architecture and the impact of those institutions on sev-
eral economic aspects such as growth, trade, corruption, stock mar-
kets, inflation, unemployment, etc. For the financial sector we investi-
gate some specific problems: stock markets, deposit insurance, central
bank and credit market, consolidation, globalization and international
investment in financial services.
Key Words: institutions, transition, economic reform,
Central and Eastern Europe
jEL Classification: P33, P34
Introduction
In the 1990's the countries from Central and Eastern Europe embraced
democracy and capitalism, which led to numerous radical socioeco-
nomic transformations over a short period of time. However, the degree
to which each country has changed is extremely variable. Obviously,
these changes have affected the institutional framework as well, which
in turn had a significant impact on the development of the society in
general and on the economic development in particular. The aim of this
article is to overview the literature on the institutions, especially financial
institutions, with specific reference to the transition countries.
Dr Cristian Dragos is an Assistant Professor at the Faculty
of Economics and Business, Babes-Bolyai University, Romania.
Dr Daniela Beju is an Assistant Professor at the Faculty of Economics
and Business, Babes-Bolyai University, Romania.
Dr Simona Dragos is an Assistant Professor at the Faculty
ofEconomics and Business, Babes-Bolyai University, Romania.
Managing Global Transitions 7 (2): 147-170
In the first part of the article we survey the economic literature, which
describes the institutions in transitions with case studies regarding the
countries from Central and Eastern Europe. We make a succinct descrip-
tion and a comparison of the main results of the empirical and theoreti-
cal studies concerning this subject. We consider (a) the factors that influ-
ence a certain institutional architecture; (b) the impact of institutions on
several economic aspects, such as growth, trade, stock markets, inflation,
unemployment, etc.
In the second part of the article, we analyze some of the main as-
pects that characterize the current financial systems in the transition
economies. We discuss the most important issues related to the creation
of a financial system similar to the ones in the developed economies.
More precisely, we have studied some aspects about the functioning of
the financial system in general and of the banking systems in particular,
namely the role of the stock market in the economic development, the
introduction of deposit insurance, the degree of bank intermediation,
nonperforming loans, the use of collateralization in offering credits, and
the soft budget constraints. We have also shown the position of the cen-
tral bank within the financial system, particularly in connection with its
independence and the monetary policy strategy based on inflation tar-
geting. Concerning the global economy, in the last two decades we have
witnessed a rapid consolidation of the financial system due to mergers
and acquisitions, as well as to globalization and foreign investment in
the financial system. Taking into account that this trend will occur in
the transition countries, we consider the causes that led to consolida-
tion and its multiple effects and the factors that influence foreign direct
investment.
Public Institutions
Starting with the 1990s, after the fall of the communist regimes, the
Central and East European countries had to establish new institutional
regimes. The transition towards a democratic system was made in differ-
ent ways and at different speeds from one country to another. It is impor-
tant to understand which of the social or economical factors have deter-
mined the different behaviour of the nations in the process of adopting
the new structures. Some authors consider that the economical factors
predominate in the building of new regimes; others imply that the social
factors, especially the social capital, decide the sustainment degree of the
institutional reforms by the citizens.
Public and Financial Institutions in Transition Economies 149
NATURAL RESOURCES AND SOCIAL VALUES
The traditional economic reasoning and common sense suggests that a
country's increasing resources promotes the economic growth. But this
reasoning is contradicted by a substantial amount of empirical evidence
that demonstrates that the abundance of resources breaks the economic
growth.
Leite and Weidmann (2002) showed that resource abundance is a ma-
jor factor which influences the role of institutional variables in the eco-
nomic growth. They demonstrated an important indirect effect of re-
source wealth on economic performance: resources affect the level of
corruption, which in turn determines growth. Isham et al. (2003) find
a negative relation between resource abundance and economic growth
when the control of the institutional quality is not appropriate. The anal-
ysis of Bulte, Damania, and Deacon (2005) indicates a significant asso-
ciation between development and resource intensity. They found that
the resources have a robust negative impact on institutions, an idea that
may lead to the conclusion that for countries rich on resources, but with
poorer institutions, the policy improvements are less effective.
Based on empirical regional studies (in Italy), Putnam (1993) considers
the social capital the most important aspect of the economical modern-
ization. The social capital is a very general notion. In order to be able
to quantify its development degree in a community we have to study
its components. Putnam (1993) considers that the social capital of a so-
ciety is described by: (a) involvement in the public field; (b) political
equality based on cooperation not on dependency (addiction) regard-
ing the relationships with the public authorities; (c) solidarity, trust and
tolerance; (d) extensive participation in voluntary associations. Kunioka
and Woller (1999) consider Central and Eastern Europe a favourable
context for correlating the social capital with the democratically con-
trolled procedures. The main motivation is the total extinction, during
the communist period, of the institutions of civil society: private busi-
ness, churches, press, voluntary associations. Using a logit model on a
set of 8 countries (Belarus, Bulgaria, Czech Republic, Hungary, Poland,
Romania, Slovakia, and Ukraine) Kunioka and Woller (1999) try to de-
termine which of the aspects of the social structure influence the cit-
izens' preferences for a parliamentary or for an authoritarian govern-
ment. They use exogenous variables regarding the social capital: insti-
tutional trust, ethnic groups and minorities as a threat, immigrants and
refugees as a threat, patience vs. quick results, order vs. freedom, town
size; and also economic exogenous variables: current/future macro econ-
omy, current/ future household economic conditions, evaluations of the
communist regime. The results show that the variables linked with the
social capital are more representative than the economical ones. The
control variables: education, age and gender have also significance. The
author concludes that the probability that the citizens of the countries
from the sample prefer a parliamentary regime over an authoritarian
one is great, 'given higher levels of institutional trust, higher levels of
political patience, and lower levels of intolerance for ethnic groups, mi-
norities, immigrants and refugees. These findings are consistent with our
hypotheses that each constitutes a statistically significant stock of social
capital in support of parliamentary government' (Kunioka and Woller
1999, 593). Also, the parliamentary regime is preferred to the authoritar-
ian one by the more educated, more aged and male persons.
DEMOCRACY AND ECONOMIC REFORM
In the countries from Central and Eastern Europe (cee) the transition
after the falling of the communist regime is characterized by the simul-
taneous evolution of the economic reform and of democracy. This be-
haviour was not similar to that of certain countries from the Southern
America and Asia where the political liberalization followed the success
of the economic transformations.
A government's ability to accomplish radical economic reforms is
placed in difficulty by the development of the democratic regime (Roland
2000). In a democratic system the citizens can refuse some economical
reforms, which would not happen in the case of a benevolent dictator
(eg. China). Cheung (1998) considers that the introduction of democracy
in an unstable stage of transition may lead to a decline of the national
output.
Fidrmuc (2003) believes that in the cee the 'democracy reinforces
progress in economic liberalization, which in turn, improves growth'
(p. 583). He investigates this connection using a sample of 25 transition
countries. The results show that the impact of liberalization on growth
is positive and strongly significant. The outside environment also has an
effect on the development for the transition period. The variable 'gov-
ernment expenditure' is not statistically significant even if the sign is the
expected (positive) one. For the initial gdp per capita Fidrmuc (2003)
obtains a negative and significant coefficient. The economical growth of
a country is more rapid when the initial gdp per capita is lower.
In some cee countries the political transformations have gone be-
fore the economic reforms. But in some other countries a regress of the
democracy was seen even though initially there have been taken mea-
sures in a good direction - especially in countries of the former Soviet
Union. Even if the relationship between the creation of a democratic
regime and the economic development is often discussed in the eco-
nomic literature, this effect has hardly ever been clearly estimated. De-
thier, Ghanem, and Zoli (1999) remark a positive correlation between
the degree of democratization and the evolution in economic liberaliza-
tion. Nonetheless, they do not consider the direct effect of democracy
on growth. Fidrmuc (2003) estimates this direct effect. He concludes (p.
602) that 'democratization alone is not the key to growth; it is through its
positive impact on economic liberalization that it improves growth per-
formance. A centrally planned democracy would be even less conducive
to growth than an autocratic market economy.'
PRIVATISATION
In the 1990's, the former communist countries considered the privatiza-
tion of public enterprises an instrument for economic development by
increasing its efficiency. The privatization process was very different from
country to country and from one period to another.
Fisher and Sahay (2000) consider that the velocity and the level of
privatization have essential economic repercussions for competition and
development. Generally, it is considered that privatization depends on
three groups of factors: economic conditions, government policies and
exogenous factors (Goel and Budak 2006; Parker and Saal 2003; Djankov
and Murrell 2002).
Goel and Budak (2006) examine the determinants of privatization
in 25 transition countries and also the differences between large scale
and small scale privatization between 1997 and 2001. They consider (p.
99) that the 'large-scale privatization involves privatization of major in-
dustries, including those involved in providing infrastructure services.
Small-scale privatization deals with private ownership of small enter-
prises like shops and service units.' Goel and Budak (2006) use the fol-
lowing variables: index of large-scale/small-scale privatisation, a human
development index, unemployment rate, inflation rate, general govern-
ment expenditure, the index of foreign exchange and trade liberalization,
general government balance, population, population density, land area
(p. 103). The results show that a high level of economic success (gdp, ed-
ucation, longevity), influence positively the privatisation. Greater unem-
ployment and lower inflation stimulates small scale privatisation but the
influence on large scale privatization is not statistically significant. For-
eign exchange liberalization encourages both types of privatisation but
bigger government deficits stimulate only the large-scale privatisation.
The country size and the population have an important positive effect,
especially in the last years of transition. Strangely, a greater population
density appears to slow down the process.
CORRUPTION
Due to massive privatization in the 1990s there were disproportionate
opportunities for corruption in the Central and East European coun-
tries, with a negative impact on society and the economy. Corruption in
this European area has turned out to be more brutal as these countries
amplify their openness and participation in international communities
and organizations.
Based on empirical evidence (in Czech Republic), Lizal and Kocenda
(2001) consider that a significant transform of approach to the institu-
tional structure is required in order to prevent and battle against corrup-
tion effectively. They think that the best way to avoid corruption is not
only to make all procedures completely transparent but also to create
such a background that minimizes the incentives to go around the rules
even in the absence of penalty.
Another aspect of corruption is the negative impact on foreign direct
investment (fdi). Even if transition economies show high levels of cor-
ruption and high levels of fdi, Cuervo-Cazurra (2008) believes that it
is not the level but rather the type of corruption that influences fdi in
transition economies. There are two main types of corruption: (a) per-
sistent corruption, or corruption that is generally present and acts as a
limit to fdi because it increases the known costs of investing; (b) arbi-
trary corruption, or corruption that is unsure and does not have such a
limiting influence because it becomes part of the ambiguity of operating
in such economies. The second type is preferred by the foreign investors
because they prefer to deal with an unknown evil.
Several empirical studies support the main hypothesis that competi-
tion and corruption are connected (Mauro 1995; Bliss and Di Tella 1997;
Ades and Di Tella 1999; Treisman 2000). Emerson (2006) has built a
model of the interaction between corrupt government officials and in-
dustrial firms to prove that corruption is adverse to competition. He
suggests that the quantity of industrial competition is a function of the
quantity of corruption (the level of the bribe). The level of competitive-
ness (or economic freedom) in a country is explained by the following
variables: the degree of corruption, the gross national product, gnp per
capita, the amount of foreign direct investment and the size of the coun-
try. A second regression explains the degree of corruption by the level
of civil liberties, the amount of expenditures on education and the net
enrollment ratios for primary and secondary schools. The estimations
show that competition and corruption are negatively correlated. Higher
education and democracy have a depressing effect on corruption in a
country.
INFLUENCE OF INSTITUTIONS ON ECONOMIC DEVELOPMENT
In recent time, in the economic literature, there has been a revitalization
of interest concerning the influence of institutions on economic develop-
ment. Nelson and Sampat (2001) argue what are the factors which merge
the diverse definitions of institutions and expand a concept of institu-
tions in order to analyse the economic performance and growth. Knack
and Keefer (1995) create a measure of property rights security and con-
firm a positive and statistically significant correlation between this mea-
sure, investment and growth. In another study Knack and Keefer (1997)
conclude that better institutions stimulate the level of investment. A par-
ticularity for the transition countries is the existence of an institutional
vacuum. Schmieding (1993) explains this emptiness by the destruction
of the old institutions without an adequate replacement by new ones.
Brunetti, Kisunko, and Weder (1997b) and Havrylyshyn and van Rooden
(2000) were focused to transition countries in growth empirics with in-
stitutional measures. On a sample formed by 18 transition countries,
Brunetti, Kisunko, and Weder (1997a) found a positive relationship be-
tween institutional credibility and growth.
Using a sample of 25 countries from Central and Eastern Europe (cee)
over the 1990-1998 period, Grogan and Moers (2001) explore the connec-
tion between institutions, foreign direct investment (fdi) and growth.
They establish some new institutional measures and make extensive sen-
sitivity tests. The endogenous variables are: gdp growth per person and
net FDI inflow share. To explain the investment and growth the authors
use two groups of exogenous variables: (a) concerning the institutions:
rule of law, investment law, property rights, civil society; (b) control
variables: gnp per person, share of value added in industry, gross sec-
ondary/tertiary school enrolment rate, export share, import share, liber-
alization index, private sector share, government consumption share and
inflation rate. The results of the estimations for the transition countries
show a strong mutual connection between the quality of institutions and
foreign direct investments (fdi). The institutional quality is more prob-
able to be a source of growth, because the correlation is less mutually rel-
evant. The significant statistical results obtained by Grogan and Moers
(2001) show that an adequate institutional frame is more important than
some 'classical' economic variables when explaining the growth and in-
vestment. Amongst the control variables, only the inflation rate and the
liberalization index are robust and influence the growth rate in the ex-
pected direction. Multicollinearity problems complicate the estimation
of the relative importance of macroeconomic stabilization and liberal-
ization on institutions.
Another point of interest regarding the institutional frame of the tran-
sition countries is represented by its effect on the economic development
throughout trade. Some studies explore the regression of gdp per capita
on measures of institutional quality and market dimension by using the
historical and geographical component of institutions and trade. In long
term, these regressions can quantify the effects of trade and institutions
on growth. The effect of property rights and rule of law on the invest-
ment and innovation predilection was explained by Frankel and Romer
(1999). This predilection and implicitly the economic growth are also af-
fected by the market size, which can be evaluated either by population or
by access to foreign trade.
The partial effects of the institutions on trade and growth have been
studied by Dollar and Kraay (2003), using cross-country regressions.
They measure the institutional quality using an index of rule of law and
protection of property rights created by Kaufmann, Kraay, and Zoido-
Lobation (2002), covering 168 countries. The market size was quantified
by the logarithm of population and the logarithm of trade as a fraction of
gdp. The results obtained by Dollar and Kraay (2003) from the sample
of the countries show that in the long run high-quality institutions and
a higher trade share (% in gdp) determine a rapid economic growth.
Because the quality of institutions and the participation in international
trade are coming from historical and geographical factors, it is difficult
to differentiate the effect of each one of them. The sample of countries
used does not offer a sufficient variation for appreciating the relative im-
portance of trade and institutional quality. In the short run the influence
of trade on growth has a significant role, but the influence of the institu-
tions is not confirmed. Table 1 provides several studies regarding subjects
related to public institutions, mainly for the cee countries.
table 1 Overview on topics related to public institutions
Problem topics/authors
Related problem issues
Natural resources and social values
Leite and Weidmann (2002) • Connection between resource abundance - institu-
Isham et al. (2003)
Bulte, Damania,
and Deacon (2005)
Putnam (1993)
Kunioka and Woller (1999)
tional variables - economic growth
•	Negative relation between resource abundance and
economic growth
•	The resources - a robust negative impact on institu-
tions
•	The social capital is the most important aspect of the
economical modernization
•	The social structure influences the citizens' preferen-
ces for a parliamentary or authoritarian government
Democracy and economic reform
Roland (2000)
Cheung (1998)
Fidrmuc (2003)
Dethier, Ghanem,
and Zoli (1999)
•	Negative correlation between radical economic re-
forms vs. the development of the democratic regime
•	The introduction of democracy in an unstable stage
of transition involves decline of the national output
•	Democracy reinforces progress in economic liberal-
ization, which in turn improves growth
•	Positive correlation between democratization and the
evolution of economic liberalization
Continued on the next page
Financial Institutions
significant issues regarding the financial systems
in transition
When transition countries began the process of political and economic
liberalization at the beginning of the 1990s, they had to conceive their na-
tional financial systems. Several studies, such as those by King and Levine
(1993a; 1993b), and Pagano (1993), show the existence of a strong positive
relation between the characteristics of the financial system and economic
growth. That is why the development of the financial system has become
a top priority issue of the reforms that have taken place in transition
economies.
The process of economic development depends on how the financial
system is constructed. Generally, there are two main alternatives for the
creation of the financial system: the market-oriented financial system
and the bank-oriented system. Most transition economies from Central
Continued from the previous page
Privatisation
Fisher and Sahay (2000)
Goel and Budak (2006)
Parker and Saal (2003)
Djankov and Murrell (2002)
•	Velocity and level of privatization: economic reper-
cussions for competition and development
•	The differences between large scale and small scale
privatization between 1997 and 2001
•	The factors of the level of privatization: economic
conditions, government policies, exogenous factors
•	A quantitative approach to enterprise restructuring
in transition
Corruption
Lizal and Kocenda (2001)
Cuervo-Cazurra (2008)
Emerson (2006)
Mauro (1995), Ades and Di
•	A survey of the corruption problems in the Czech
Republic
•	Correlation between the type of corruption and fdi
in transition economies
•	Models the quantity of industrial competition as a
function of the quantity of corruption
•	Empirical studies which support the main hypothe-
Tella (1999), Treisman (2000) sis that competition and corruption are connected
Influence of institutions on economic development
Nelson and Sampat (2001)
Knack and Keefer (1995)
Knack and Keefer (1997)
Brunetti, Kisunko,
and Weder (1997a)
Grogan and Moers (2001)
Frankel and Romer (1999)
Dollar and Kraay (2003)
Kaufmann, Kraay, and
Zoido-Lobation (2002)
•	Expand the concept of institutions in order to anal-
yse the economic performance and growth
•	Positive correlation between the measure of prop-
erty security rights, investment and growth
•	Better institutions stimulate the level of investment
•	Positive connection between institutional credibility
and growth (sample of 18 transition countries)
•	Relation between institutions, foreign direct invest-
ment and growth (sample of 25 cee countries)
•	The effect of property rights and rule of law on the
investment and innovation predilection
•	Long run high-quality institutions and higher trade
share determine rapid economic growth
•	Measure the institutional quality using an index of
rule of law and protection of property rights
table 1
and Eastern Europe opted for a bank-based system. Regarding the de-
velopment of the financial system in transition countries, some specific
issues must be taken into account, such as the role of stock markets in
the financial system, the importance of deposit insurance in securing fi-
nancial system stability and the position of the central bank within the
financial system (Hermes and Lensink 2000).
Stock Markets
A significant factor in the development of the financial system in tran-
sition economies is the regulation of stock markets, which can increase
its efficiency. Some empirical studies (Levine and Zervos 1998a), proved
that a strong financial system, with well performing stock markets, has
a positive effect on economic development. The role of stock markets in
promoting economic growth consists in the allocation of funds to invest-
ment projects that offer the maximum profit. Since stock markets supply
liquidity insurance, they may help out more profitable long-term invest-
ments (Hermes and Lensink 2000).
The liberalization of capital control is significantly related to the stock
markets issue in transition economies. Many transition countries main-
tained control over capital movements for a long time. Levine and Zer-
vos (1998b) argue that the liberalization of capital flows may contribute
to the expansion of stock markets, facilitating more liquid, more volatile
and bigger stock markets. Their study indicates a positive relationship
between liquid and bigger stock markets and durable economic develop-
ment. The transition economies from Central and Eastern Europe have
proceeded to a gradual liberalization of capital flows, and as of today
they have managed to abolish capital control. As a consequence, the
stock markets in these countries have expanded considerably and be-
come more efficient.
Deposit Insurance
The role of the deposit insurance system consists in securing the pro-
tection of deposit holders against the risk of losing their financial sav-
ings and the protection of banks against the negative effect of runs on
their liabilities. When depositors have some doubts regarding the safety
of their bank, they may withdraw their deposits. The failure of a bank can
be interpreted by the public as a signal of the weak financial situation
of other banks and this may cause liquidity problems even for solvent
banks. Deposit insurance aims to diminish the risk of strong banks be-
ing affected by the bad reputation of weak banks. When contagious bank
runs becomes serious, it results in incredibly unsound financial markets
and financial crises. The confidence of the public in banks can increase
through this mechanism because the entire or limited value of the de-
posit held at banks is guaranteed in the situation where the bank could
not respect its payment obligations. Thus, deposit insurance may make
a positive contribution to the safety of the financial system (Hermes and
Lensink 2000).
The deposit insurance was not introduced in transition economies in
Central and Eastern Europe from the beginning of the reform process.
Given the fact that in the first years of transition some banks recorded
financial crises and became insolvent, a lot of deposit holders lost their
savings partially or entirely. Therefore, the public lost its confidence in
the bank system in particular and in the financial system, in general. It
became therefore necessary to implement the deposit insurance mech-
anism, although this was not an easy process. At the initial stage of the
deposit insurance functioning, the guarantee value of deposits remained
at a low level. At present, the extent of depositors' protection in these
transition countries is similar to that of the countries of the eu.
Central Bank
Essentially, the main task of the central bank is to implement monetary
policy. Moshirian and Szego (2003) consider that price stability repre-
sents the vital issue for an effective monetary policy. Price stability can be
achieved by central banks through two different strategies: monetary tar-
geting and inflation targeting. Recently, some transition countries from
Central and Eastern Europe have adopted inflation targeting, namely the
Czech Republic (1997), Hungary (2001), Poland (1998), Romania (2005)
and Bulgaria (2006). Several studies have found that inflation targeting
has a positive impact on the performance of inflation and output by re-
ducing the anticipated level of inflation. Other studies argue that there
is no clear proof to sustain the benefits of inflation targeting, despite
the fact that their results do not offer arguments against inflation tar-
geting either (Yifan 2003). Still, in all these countries, the inflation rate
decreased after the implementation of this new strategy.
Central bank independence is another very important issue for tran-
sition countries, since an independent central bank can reduce inflation-
ary pressures. Granting real independence to central banks in transition
countries represents a complex process and requires the existence of a
consistent legal and political infrastructure (Hermes and Lensink 2000).
Concerning the meaning of central bank independence, we can distin-
guish different components. Grilli, Masciandaro, and Tabellini (1991)
make a basic distinction between political independence (central bank's
ability to pursue price stability free from government's influence), and
economic independence (central bank's ability to determine its policies
towards the achievement of its objectives). Debelle and Fischer (1994)
highlight the distinction between goal independence (central bank's abil-
ity to determine freely the goal of monetary policy), and instrument in-
dependence (central bank's freedom of choice and adjustment of instru-
ments to achieve the goals set). Cukierman, Miller, and Neyapti (1992)
distinguish between legal independence (various stipulations in the law
of central bank), and actual independence (annual turnover rate of cen-
tral bank's governor).
Another essential aspect is the role of central bank independence in
reducing inflation. Some empirical research has provided evidence for
the negative relation between central bank independence and inflation
in developed countries. Other studies could not find evidence for such
a relationship in the case of developing countries. Yet, there are some
studies that reveal a negative correlation between central bank indepen-
dence and inflation both in developing countries (Jacome and Vaszquez
2005) and in transition countries (Cukierman, Miller, and Neyapti 2000;
Maliszewski 2000).
credit market
In the process of the development of the market economy, transition
countries have chosen to create a bank-based financial system. Their
bank system has been confronted with several problems, among which
we notice a substantial utilization of collateralization in granting cred-
its and a low degree of bank intermediation, measured as the share of
domestic enterprise credit to gdp.
The bank intermediation recorded a low degree because of two im-
portant factors: banking sector concentration (Rother 1999) and defi-
cient legal system (McNulty and Harper 2001). In the case of a flawed
legal environment in transition economies, banks utilize collateral not
only to resolve the issue of moral hazard but also to take out rents based
on their market share. Collateralization may solve the problem of moral
hazard since it diminishes the payoff in the situation of collapse and,
consequently, determines the company to make effort (Bester 1994).
Empirical studies reveal that the likelihood of obtaining credit rises
depending on the quantity of collateral offered by the company that re-
quires a loan. The perfection of institutional environment may have as
effect the decrease of collateral requisite, and, thus, the increase of bank
intermediation. A perfection of the legal environment implies that more
credits are mortgaged than collateralized. Thus, the banks have less pos-
sibility to take out rents as the liquidation values of houses and flats are
higher than those of other types of assets and vary much less. Therefore,
the general requisite of collateral is reducing (Hainz 2003).
Even if almost all contract credits are collateralized, in transition coun-
tries banks have a large part of nonperforming loan in their portfolio,
because of some problems, such as the difficulty of the collateralized as-
sets evaluation, the possible disappearance of movable assets, and the
imperfect functioning of secondary markets in the situation where the
liquidation of collateral is necessary. Hainz (2003) finds some solutions
to solve these problems. First, the accumulation of information provided
by the balance sheet can simplify the assessment of collateralized assets.
Furthermore, all people involved in the collateralization process need to
be well qualified and the property rights to be clearly set. Second, the
existence of collateral registers should supply information concerning
the collateral assets and set priority of claims. Third, the formalities for
seizing the collateral should be simpler and the laws related to collateral
should be set clearly.
The high bank concentration in transition countries determines a
lower bank intermediation, not because of a lower demand for credit
due to the high interest rate, but rather because of the credit rationing
(Rother (1999)). Banks apply credit rationing to avoid the adverse se-
lection arising from asymmetric information concerning the company's
assets attributable to the incomplete information provided by the com-
panies' balance sheets. Therefore, the companies may hide assets by an-
nouncing less collateralized assets than they own in order to keep more
rent. Thus, a low degree of a bank competition has two effects: (1) a large
quantity of collateral required by banks, which leads to a considerable
loss in the case of liquidation; (2) an increase in credit rationing, which
has imposed in transition economies a constraint on successful corporate
restructuring. This constraint can be reduced by the stimulation of com-
petition between banks and the improvement of the institutional and
legal environment (Hainz 2003).
consolidation and international investment
in financial services
In the last two decades, at the global level, some important progress has
been made in the development of the financial system, e. g. the consol-
idation of the financial system due to the mergers and acquisitions, the
expansion of foreign investments in the financial system, and the glob-
alization of the financial system. Despite the fact that these phenomena
are just recent manifestations in the transition countries, they will affect
the future development of the financial system in these economies.
Mergers and Acquisitions in the Financial System
Recently, there is a worldwide tendency for the consolidation of the fi-
nancial system. In the developed countries, mergers and acquisitions
have developed at a sustained pace, which may constitute an answer to
the financial crises in other countries, including the transition countries.
Berger, Demsetz, and Strahan (1999) think that consolidation has as a
major incentive the maximization of shareholder value through mergers
and acquisitions mainly by increasing the participating company's mar-
ket power in establishing prices or by becoming more efficient. In some
cases, the institutions implied in mergers and acquisitions may be inter-
ested in heightening their possibility to benefit from the government's fi-
nancial safety network (deposit insurance, discount window access, pay-
ments system guarantees).
The stakeholders other than shareholders, particularly managers and
governments, may also be motivated in the consolidation. First, man-
agers can be concerned about their own financial advantages in consoli-
dation decisions since executive compensation is proportional to the size
of the financial organization. Nevertheless, Hadlock, Houston, and Ryn-
gaert (1999) indicate that management with large ownership stakes could
obstruct exterior acquisitions, especially when managers of the banks
quit following an acquisition. Secondly, the position of a government
in consolidated decisions consists in its possibility to restrict the type
of mergers and acquisitions allowed (by imposing different limits and
by approving or rejecting decisions for individual mergers and acqui-
sitions) or to support mergers and acquisitions (especially in times of
financial crisis, when it may offer financial support in the consolidation
of financial institutions threatened by bankruptcy (Berger, Demsetz, and
Strahan 1999).
The pace of consolidation is influenced by the changes in economic
environments that modify the constraints, which the financial institu-
tions must deal with. A study by Berger, Demsetz, and Strahan (1999)
provides five relevant issues, which explain the current pace of mergers
and acquisitions:
1. Technological progress can facilitate the appearance of innovative
instruments of financial engineering, new delivery modalities for
depositor services or development in payments technology, which
small financial institutions can benefit from at a low cost.
2.	Improvements in financial conditions may increase the activity of
mergers and acquisitions in the banking sector through low interest
rate and high stock price environment.
3.	Excess capacity or financial distress in the industry or market can
be solved with the support of consolidation more efficiently than
by bankruptcy or other means.
4.	International consolidation of markets can generate demands for
currency, credit, deposit and other services by international finan-
cial services providers, and therefore may favour the creation of
cross-border mergers and acquisitions.
5.	Deregulation of geographical or product restrictions can lead to a
rise in the number of mergers and acquisitions after the countries
permit interstate branching in most states.
Consolidation has several effects on multiple planes. As direct effects
of consolidation we notice the increase in market power or the improve-
ment of institution efficiency implied in mergers and acquisitions. As
a potential indirect effect of mergers and acquisitions we mention the
decrease in the accessibility of financial services to small clients, as the
powerful institutions created by consolidation are able to offer wholesale
financial services or they might close some of their branch offices.
Berger, Demsetz, and Strahan (1999) consider that mergers and ac-
quisitions may determine as potential systemic consequences an increase
in the payment system efficiency, due to the decrease in the quantity of
payment information and instruments, which must be processed and
transferred among the financial services providers, since the payments
are internal and do not need inter-bank transfers. Moreover, the financial
service industry could accelerate the implementation of electronic pay-
ments technologies. Countries with a more consolidated banking sector
utilize the electronic payment system to a larger extent, given the greater
easiness in agreeing on payment standards and common technology and
the utilization of centralized account information (Humphrey, Pulley,
and Vesala 1996).
Consolidation may also affect the safety and soundness of the finan-
cial system owing to the decrease of costs demanded by a heightened sys-
temic risk (through risks diversification and the supervision of a smaller
number of financial institutions) or by an improved financial safety net-
work. Finally, external effects of mergers and acquisitions are likely to
appear, given the reaction of other rival institutions that may be tempted
to develop their activities in the sectors abandoned by the consolidating
institutions (Berger, Demsetz, and Strahan 1999).
Similar benefits and costs could be forthcoming from mergers and ac-
quisitions that will occur in transition economies, especially those from
Central and Eastern Europe. The enlargement of the European Union
and, in future, of the Monetary Union with the transition countries can
stimulate more cross-border mergers and acquisitions to appear, given
the expansion of trade, the reduction of currency exchange costs sup-
ported by the financial institutions which activate in multiple states, and
the reduction of costs paid by customers for the services of foreign-
owned institutions.
Foreign Investments in the Financial System
Another global tendency manifested even in transition countries is rep-
resented by international investment in financial services in general
and in the banking sector in particular. The worldwide movements to-
wards financial deregulation, the progress in information technology
and telecommunications, and the capital market globalization have stim-
ulated foreign direct investment (fdi) in the banking system. Moshirian
(2001) divides foreign investors in overseas banking, including transition
countries, into at least three important groups:
1.	Banks that set their branches, agencies, and subsidiaries in a foreign
country.
2.	Banks that do not open any physical office in a foreign country but
are shareholders of foreign banks.
3.	Non-bank corporations, institutions, and individuals who invest in
foreign banks.
Some studies (Lizondo 1990; Moshirian 2001) show that fdi in bank-
ing is influenced by several factors, such as:
1. Bank's foreign assets. Empirical results of Moshirian (2001) indicate
a positive relationship between the bank's foreign assets and foreign
direct investment in banking. It is supposed that fdi in banking
grows with the expansion of the international lending activities of
banks.
2.	fdi in non-finance industry. Gray and Gray (1981) suggest that fdi
in banking is positively related to fdi in other industries. So, there
is complementarity between fdi in banking and fdi in other man-
ufacturing sectors.
3.	Bilateral trade. Agarwal (1980) reveals a positive relationship be-
tween fdi in banking and bilateral trade. This means that fdi in
banking increases with the expansion of bilateral trade.
4.	The size of the market in the host country. O'Sullivan (1985) claims
that the size of the host country's market represents one of the ma-
jor factors of fdi. This implies that the number of potential new
customers increases with the enlargement of the foreign banking
market.
5.	Relative economic growth. Sabi (1988) finds a positive relationship
between economic growth and fdi in banking. The strong eco-
nomic development in a host country is contributing to the expan-
sion of fdi in banking in that country.
6.	Cost of capital differential. Moshirian (2001) demonstrates that the
cost of capital differential for banks between investors' countries
and host countries is negatively correlated with the fdi in bank-
ing abroad. A bank with an effective and competitive cost of capital
structure may be more successful when it enters into the foreign
banking markets.
7.	Exchange rates. Froot and Stein (1991) show a negative correlation
between the value of host countries' currency and fdi in banking in
these countries. The host countries' currency depreciation relative
to foreign investors' currencies is likely to amplify the fdi since it
becomes cheaper for foreign investors to invest in host countries.
8.	Tax regime. Moshirian (2001) argues that the tax regime applied in
a country may or may not attract foreign investors. To attract more
fdi in banking, the host countries' governments can take initiative
for deregulating the domestic financial market.
Taking into consideration the more facile access of foreign investors
to the transition countries' market and its big potential, the relative eco-
nomic growth, the low cost of capital, the fast expansion of the domestic
banking market and the deregulation of the financial market recorded
recently in transition economies, we can expect that foreign investors
may increase their investments in the financial system in these countries,
especially in banking.
Globalization in the Financial System
The government-led system design after the second war was replaced by a
much more powerful system - the market-led system - due to the growth
in the movement of private capital in the developed countries and to the
emerging markets, the gradual deregulation of the financial markets, the
increased importance of the private sector and multinational corpora-
tions in development of the economy. The innovations in the financial
instruments and the deregulation of the financial system that have oc-
curred in the latest decades have stimulated the process of globalization
and the integration of the financial markets. The globalization of finan-
cial markets has resulted in the expansion of multinational banks abroad,
which compete with the source countries' banks and therefore promote
the process of financial markets integration (Moshirian and Szego 2003).
Even in the transition countries we can notice the expansion of multina-
tional banks that have managed to gain an important position in these
countries' markets.
Since the bank system cannot be fully globalized, given the fact that
national banks could basically offer some services to host companies all
the time, an important question that arises with respect to globaliza-
tion in the financial system is to what extent the banking sector will be
globalized. An empirical study (Berger, Demsetz, and Strahan 1999) on
this issue makes a distinction between two dimensions of globalization
- bank nationality and bank reach. This study shows that the affiliates
of multinational companies prefer host nations' banks for cash manage-
ment services more frequently than home nation or third country banks.
It also indicates that bank nationality and bank reach are considerably
correlated and both differ to a large extent depending on the legal and
financial development of the respective country. The conclusion is that
globalization of the banking system may be limited in the future since a
lot of companies would rather resort to local or regional banks for some
of their services.
Conclusions
The topic of institutions in transition countries has become a significant
research domain within economics. Over the last two decades, numer-
ous academic studies have been dedicated to this theme particularly for
Central and Eastern Europe.
The conversion towards a democratic system and an efficient economy
was made in different ways and with different speeds from one country to
another. Several studies have revealed that the social and economic fac-
tors jointly have determined the behaviour of the nations in this process.
There is negative relation between resource abundance and economic
growth especially when the control of the institutional quality is not ap-
propriate. The policy improvements are less effective within the coun-
tries with poorer institutions but rich on resources. Some authors con-
sider the social capital the most significant aspect of the economic recon-
struction. The results based on empirical studies show that the variables
linked with the social capital are more representative than the economic
ones.
In the countries from Central and Eastern Europe the transition is
characterized by the synchronized evolution of democracy and the eco-
nomic reform. Using a sample of transition countries it was proved that
there is a robust positive relationship between democracy, economic lib-
eralization and growth. The velocity and the level of privatization have
essential economic consequences for competition and economic devel-
opment. In the economic literature, there has been in the last decade a
renaissance of interest regarding the influence of institutions on growth.
From a sample of countries it was shown that in the long run, high-class
institutions and a higher trade share decide a rapid economic growth.
The transition countries represent an attractive market for foreign direct
investments. In order to take advantage of this situation the governments
must create a better institutional framework by trying to reduce the cor-
ruption, because of its negative impact to fdis and economic growth.
The bank-oriented system adopted by the transition economies must
be completed by the liberalization of the stock markets, due to their pos-
itive influence on durable economic development. The ex-communist
European countries had gradually liberalized the capital flows and now
the capital control was eliminated. The liberalization led to significantly
larger, more efficient and liquid stock markets.
The deposit insurance was not introduced in transition economies
from the beginning of the reform process. At present, the extent of de-
positors' protection in these countries is similar to that of the old mem-
bers of the European Union.
In transition countries, there is a high degree of bank concentration,
which determines a lower degree of bank intermediation. A low degree of
bank competition has two effects: a large quantity of collateral required
by banks and an increase in credit rationing which imposes a constraint
on successful corporate restructuring. This constraint can be reduced by
the encouragement of competition on the banking market and the up-
grading of the institutional environment.
The supporting of mergers and acquisitions may represent for the
governments the answer to the financial crisis, bringing benefits such
as: consolidation of financial institutions threatened by bankruptcy, in-
crease in the efficiency of the payment system and expansion of trade.
The international investment in financial services in general and in the
banking sector in particular is a global tendency manifested even in tran-
sition countries. We can expect that foreign investors may increase their
investments in the financial system, especially in banking, in countries
from Central and Eastern Europe.
Future researches may be focused on the theoretical modelling and
estimation of the relations between: (a) the costs implied by better in-
stitutions, lower levels of corruption, better social values, on one side,
and (b) the amount of foreign direct investments, the rhythm of the eco-
nomic growth, on the other side.
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