Banking on Uncertainty

Executive Summary - May 2008

Russia’s transition from a controlled economy to a market-based system brought about waves of economic chaos. At the firm level, Soviet-era managers struggled to adapt supply chains and quality controls to remain operational. Across every sector of the economy, Russia struggled to build the framework to structure a market economy: contract enforcement and rule of law varied widely, factor markets were unpredictable, and the ruble was far from stable.

During this period, financial institutions also struggled to manage risk. In the relative calm of the early 2000s, Russian banks began to adjust their lending portfolios. They moved away from commercial loans and shifted a counter-intuitively large share of their investments to individual, consumer loans. Why?

This paper explores the banks’ lending decisions at the microeconomic level through the lens of institutional quality. Using oblast level data on the ratio of bank loans to firms versus individuals, I study the connection between portfolio choices and the variability of institutions across regions.

Institutions are the assumptions that govern economic activity: trust that credit will be repaid and the structures of redress when it is not; confidence that property right and contracts will be enforced and that investments will be protected; belief that the government will strengthen the market rather than undermine it.

By focusing on these fundamentals of market functionality, my research explores an understudied aspect of capital market development. During the process of transition, firms, legal structures, and political systems simultaneously rewrite the rules of the game. In the face of corruption, unenforced laws, and a lack of alternatives, banks seem to prefer loans to individuals, which are more administratively costly but easier to recover in the case of default.

Data from the microeconomic level of each bank's lending choices indicate concerning trends for the broader economy. The decision to lend to individuals over firms points to an inefficient use of capital as a conscious strategy. The inefficiency enables banks to combat government capture and unenforceable loan agreements with well-connected firms. The implication at the macroeconomic level is a widespread loss of capital productivity.

Although the data available at the time of this research inadequately captures institutional quality, this paper moves forward the literature on the long process of liberalization.

It begs a new question: when is transition over? 

Full paper available here or download a PDF