The Evolution of Bank Credit Quality in Transition: Theory and Evidence from Romania

The paper develops a simple theoretical framework of financial discipline during the stabilization of a transition economy, from which it derives an empirical measure to assess whether the banking sector has started to act as a source of financial discipline, or just as a temporary buffer for enterprise losses. The model suggests that in the presence of active bank monitoring the correlation between bank lending and arrears should be decreasing over time, while it would increase if banks rolled over bad loans in the expectation of a bailout. We run the test on balance sheet data from a sample of Romanian state-owned enterprises over 1991-1994. We find evidence that, contrary to the findings of Pinto and van Wijnbergen for Poland, credit criteria used by Romanian banks show few signs of improvement. Most worrisome is the stability of the relation between bank credit and financial arrears, which seems to increase in strength over the period and remains very significant both statistically and in terms of economic impact. Bank credit appears negatively correlated with profitability; however, there is evidence that this is the result of better firms reducing their demand for credit as real rates rise. Reassuringly, credit to these firms depend positively on their receivables, while bank arrears have a insignificant impact. However, firm size was a significant determinant till 1993 and trade arrears become a strong determinant of credit in 1994. Banks appear to particularly soft towards the worse performing firms, particularly towards larger and more insolvent enterprises. There is evidence of a structural policy shift in 1993-1994 with banks refinancing trade arrears, perhaps following IMF pressure against further central bank bailouts of such arrears. Overall, the evidence suggests a largely passive attitude of banks towards the worse borrowers and only limited reallocation of credit to better users.