IF BANKS in emerging countries are to be made safer and stronger, their governments, supervisors and managers need to develop a better understanding of why banks get into trouble. But although there is widespread agreement on the effects—that they are hugely expensive, for instance, and horribly difficult to deal with—there is far less of a consensus on their causes.

That may be because the typical banking crisis has no single cause, but is usually the outcome of many factors working in parallel. For an example, look at the current banking mess in Bulgaria, where about a dozen banks have failed and more may follow. The initial mistake was to allow chancers with little experience and even less capital to set up their own banks. These were then ruined by, among other things, weak supervision, inadequate rules governing accounting and bankruptcy, dire economic management and a heavy dose of reckless lending. Counting up all the reasons for Bulgaria's crisis would take more than two hands.

However, among all the potential dangers for banks in emerging markets, four stand out: macroeconomic volatility; “connected” lending (ie, to the bank's employees or owners, or to companies they have links with); political involvement; and financial liberalisation.

Start with macroeconomic volatility. There is an increasingly clear link between the health of emerging banking systems and the health of the economies in which they operate. According to David Carse, deputy head of the Hong Kong Monetary Authority, “{The best way to ensure sound banks is to run a sound economy.” Conversely, no economy can be truly solid if its banks are wobbly. One difficulty is that a fragile banking system limits a central bank's flexibility on monetary policy, making it harder to raise interest rates.

It is no coincidence that some of the most severe banking meltdowns of the past 20 years or so have been preceded by economic shocks, including wild swings in asset prices and exchange-rate fluctuations. This is particularly true of Latin America, a region with a history of economic turbulence. Chile's banking crisis of the early 1980s was the result of an overvalued, fixed exchange rate, followed by a sharp devaluation. The same was true of Mexico's crisis of 1994-95. There is also a clear link between banking crises and severe economic downturns. In Latin America, recent recessions have lasted longer and cut deeper than elsewhere, and inflation and economic output have fluctuated wildly. So have banks' lending and deposit-taking, as chart 4 shows.

This volatility has a powerful impact on the ways banks do business. When growth and inflation rates are constantly on the move, working out borrowers' credit risk becomes extremely difficult. Moreover, a company's credit history in periods of high inflation says little about its creditworthiness in more stable times, as many Brazilian banks are now finding to their cost. And banks that survive by speculating in currency markets during bouts of high inflation often come unstuck when prices fall back to earth and they have to return to more conventional ways of earning a crust.

The second main culprit, connected (or insider) lending, has ravaged banks from Bolivia to Bangladesh. Though not unheard of in rich countries, these days it is a more serious problem in emerging countries, where supervisors are less rigorous about rooting it out. It has recently caused bad headaches in Eastern Europe, especially in Russia, where unscrupulous businessmen have found it easy to set up banks simply to finance their other companies' pet projects. At many Russian banks, the personal ambitions of owners and managers still come before the prudent assessment of lending risks. Loans to related companies are rarely made on an arm's length basis, and tend to be granted at below-market rates, with scant credit vetting. Many bad loans just fester: it takes a brave bank manager to foreclose on a loan to a firm run by a senior colleague or major shareholder.

There is plenty that governments can do to curb the practice, and many are already doing it. All the more advanced emerging countries now have rules in place to limit a bank's exposure to any single borrower to a fraction of its capital base (typically between one-tenth and one-quarter, similar to limits in rich countries). However, in many countries supervisors lack the resources, or the will, to enforce their rules. Since 1990 several Indonesian banks have gone bust partly because of dodgy loans made to families or conglomerates they have connections with, despite rules meant to prevent such calamities. The IMF worries that banks are always finding clever new ways round supervisors' latest attempts to spot and penalise excessive chumminess between commercial banks and their friends. Several recent crises in Latin America and Eastern Europe revealed the widespread use of dummy accounts and borrowers with fictitious names that had escaped regulators' attention in better times.

Mine, all mine

The third offender, government involvement in banking, is even more pernicious. Across the developing world, governments have shamelessly used state banks to plug gaping fiscal holes and to finance dubious projects. Many simply view state banks as instruments for carrying out national industrial or social policies. In the 1980s, for example, Israeli banks were pushed into making big loans of questionable viability to the country's socialist kibbutzim, resulting in a wave of write-offs and much recrimination.

The degree of state ownership of banks varies from country to country (see chart 5). In some, such as Hungary and Argentina, the state's grip is loosening as cash-strapped or crisis-ridden governments sell up; in others, such as India and China, state banks still dominate. Yet such banks are typically neither efficient nor prudent. They often distort financial markets by lending at rates private banks cannot compete with, and their credit-assessment record is usually unimpressive. For instance, around 30% of loans outstanding at Argentina's public-sector banks were in arrears at the end of 1994, compared with 10% at the country's private banks. And in India's state-dominated banking system one-fifth of loans are dud, according to Morgan Stanley, an investment bank.

Nowhere has the political exploitation of banks been more brazen than in sub-Saharan Africa. The World Bank estimates that in the past decade no fewer than 15 countries in the region have experienced systemic crises involving mostly state banks. It is still common for ministers to think of their banks as mere adjuncts to the treasury, making them prop up clapped-out state-controlled industries until the banks themselves collapse. In Zambia, banks are still reeling from a crisis that bears all the hallmarks of political meddling. In the 1980s the government set up a raft of banks for the purpose of funnelling money to loss-making public-sector companies. Some of these banks became insolvent almost overnight, but were forced to limp on until they could no longer stand. In some African countries, the finance ministry can issue banking licences without consulting its central bank.

Regional rackets

But it is not just central governments that banks have to be wary of. The blame for many recent banking troubles lies with fiscally inept local governments. In Latin America, where several countries have a federal structure, regional administrations habitually abuse the banks they own. The sorriest tale of all is that of Banespa, the state development bank for Sao Paulo in Brazil. A few years ago the regional government persuaded the bank to lend it money to cover shortfalls in its annual budget. Before long, this had become an annual ritual. The loans were guaranteed by future tax receipts, but when the administration began to default on its loans these guarantees proved all but worthless. Sao Paulo's debt to Banespa of just under $20 billion has created one of the biggest black holes in banking history.

Banespa is no isolated case. Brazil's 27 regional state banks were set up to finance important infrastructure projects, but more often than not their primary function has been to dispense cheap credit to vote-buying politicians. Only a few are profitable. Most of the remainder sit on billions of dollars-worth of unrecoverable loans, and would have failed long ago if only the politicians had let them. Now that they have become more of a liability than an asset, they are being privatised. Banerj, the state development bank for Rio de Janeiro, is due to be sold in the next few months following a federal-government rescue. Banespa too may be auctioned, if it can be sufficiently cleaned up. But private buyers will take a second look only if the banks' new managers slash costs by shedding unproductive workers and closing unprofitable branches and businesses.

Not that privatisation guarantees an end to political interference. Governments, whether local or national, do not need to own banks to cause them trouble. In South Korea, for instance, politicians think of bankers as agents of industrial policy even though most commercial banks have been in private hands for years. One independent study conducted in the mid-1990s found that policy-related loans still accounted for up to half of all commercial banks' outstanding loans, more than a decade after the banking industry was privatised.

Or take the story of Hanbo, a big Korean steel maker, which collapsed in January after banks had lent it more than $3 billion for an unpromising steel-mill project. Investigations so far have unearthed no proof of political interference, but the scandal cost several cabinet members, including the finance minister, their jobs. The central bank was forced to inject $7 billion into the financial system to avoid a credit crunch and further bankruptcies. Some variation on this interventionist model can be found in much of emerging Asia. As one Hong Kong banker puts it, “Banks, whether public or private, are widely seen by politicians as subsidiaries of Country Inc.”

The fourth on the list of crisis factors, financial liberalisation, at first sight looks the odd one out. Few emerging countries would question its long-term benefits. By exposing banks to market forces, liberalisation should leave them leaner and better managed. It should allocate credit more efficiently and give borrowers a better deal. Since the early 1980s, many developing countries have freed their financial systems by removing restrictions on interest rates, welcoming foreign banks, letting commercial banks move into new businesses or expand their branch networks, and so on.

Yet financial liberalisation and banking mishaps often seem to go together. One study, commissioned by America's Federal Reserve and the IMF, looked at the causes of financial crises in the 1980s and early 1990s in a representative sample of 25 countries. In 18 of those 25, the financial sector had been liberalised at some point during the five years leading up to the crisis.

Damned if you don't, damned if you do

How is it, then, that a measure which so obviously benefits banks in the long term causes them so much short-term pain? The trouble is that liberalisation exposes banks to new risks which, without proper precautions, can make a crisis more likely. The lifting of restrictions often releases pent-up demand for credit which can turn into an uncontrolled lending boom. The most important precaution is improved supervision to monitor these risks.

Opening banking to foreign or new domestic entrants multiplies the risks. As new competitors arrive on the scene, they put pressure on existing banks' earnings, perhaps tempting them to finance ever-riskier ventures to try to match the easier profits of old. The switch from a cosy, state-directed system to one driven by competition also requires commercial bankers to develop a new way of thinking. Banks that have grown fat on a captive market must learn how to analyse credit risks, which takes time and training.

The timing of deregulation is important for other reasons too. Banks do not operate in a social or political vacuum. In a climate of political instability, banking liberalisation can be dangerous or even impossible. In Pakistan, for example, reformers within the government in the early 1990s produced a promising package of wide-ranging financial deregulation to get the lumbering banking industry into shape. But the turnover of administrations since then has been such that the package has still not been passed; and if it had, things might have been even worse. Pakistan's banks would not have been ready to face a newly liberalised market while governments came and went and the economy was in turmoil. That is precisely what happened in Venezuela, with notably awful results, as a later section of this survey will show.

Yet even in countries renowned for economic stability and high growth, poorly designed banking-sector revamps can cause havoc. A prime example is Indonesia, where the economy has been growing at a steady 6-8% a year for a decade. Until the early 1980s, most of its banks were state-owned and lent to whomever the government told them to: mainly the well-connected rather than the deserving. In 1983 interest rates were partially freed and new licences were given out, which led to a fivefold increase in the number of bank branches and a proliferation of new private banks. By the early 1990s bank credit was growing at about 50% a year. But behind the scenes, non-performing loans were ballooning. In 1995, official estimates put them at 11% of total loans outstanding, more than in any of the other Asian tigers. Banking scandals and collapses became commonplace.

Part of the blame lay with liberalisation. The number of banking supervisors had not risen in line with the rise in banking activity; besides, those supervisors first had to learn their new job. The government was also slow to bring in new rules needed to operate the new system. The problems still continue. In a report published late last year, Moody's, a credit-rating agency, said that Indonesia's private banks were still “demonstrating classic symptoms of post-liberalisation frenzy”.

Indonesia's experience may be helpful to others. Shahid Zahid of the Asian Development Bank thinks the problems faced by the Indonesians and others are leading developing countries to think more carefully about freeing their financial systems before taking the plunge. With enough regulatory planning, they should be able to avoid the worst effects of liberalisation. There is nothing wrong with rules for banks: they just have to be the right kind.