Banking in the Soviet Union.

    The traditional instrument for intermediated private saving in the former Soviet Union was the ruble deposit in the Gosbank.

    Gosbank then extended credit to public investment and consumption activities.

    The interest rate was positive in real terms, but did not fluctuate to clear the credit market. Rather, the public sector by plan had first claim on goods, and the private sector was able to consume only what remained. In a market economy this would have led to increased commodity prices, but in the command economy the result was rationing of consumption and consequent "forced saving".

Saving in Gosbank was in excess of that desired by the households, but in the absence of goods to purchase the deposits accumulated into the "ruble overhang". Since households in the Soviet Union were not integrated into international capital markets, imports did not serve as an alternative for the scarce domestically produced goods.

n the last years of the Soviet Union, the share of national product represented by saving deposits was steadily rising. This phenomenon became known as the ruble overhang, and represented the forced saving of individuals unable to find goods to purchase at the controlled prices of the economy at that time. The share of currency in circulation to GNP rose from under 10 percent in 1985 to nearly 15 percent in 1990, while the share of household deposits in the banking system rose from 28 percent in 1985 to nearly 40 percent in 1990. This suppressed purchasing power would fuel the burst of inflation observed with independence in the newly independent states. Available indicators suggest that Kazakhstan reacted similarly to the Soviet Union as a whole during this period of overhang.

Saving in Kazakhstan since independence.
Savers were faced with quite different incentives to save once independence was declared and commodity prices were liberalized.  The monopolistic and specialized features of formal financial intermediaries have been carried forward into the financial sectors of the former Soviet republics. They have two implications of importance to savers: low (often negative) real interest rates in formal-sector financial institutions, and an explosion in activity by informal intermediaries. Formal-sector financial institutions have in practice been quite sluggish in raising interest rates on household deposits to rates in excess of inflation. The following table, for example, indicates the nominal rates on deposits in domestic currencies at the Saving Banks of various former Soviet economies in mid-1993.

Since independence the potential saving instruments have proliferated to include deposits denominated in foreign currencies, holdings of foreign currencies, deposits with informal financial institutions and trust companies, and stocks of commodities.

    Saving and inflation.
There was thus an ex ante shortage of saving. The short-term solution to this shortage relied upon a variant of the "inflation tax". The private sector received income in nominal assets (cash or bank deposits). The fiscal deficit was financed through the banking system extension of directed credits refinanced by the central bank. The fiscal purchases were made with these credits; when the private sector spent its income it found the supply of goods limited. Excess demand then bid up the price of goods. In the notation of the previous section this registers as saving, since the real value of income exceeds the real value of consumption. From the household perspective, however, it is a tax because the real value of purchasing power in the present has been decreased by the inflation.
 
The key to the effectiveness of the tax was the private sector's continued holding of nominal assets denominated in the home currency. The private sector quickly recognized this and switched its holdings into assets denominated in other currencies. I denote these other assets as foreign-exchange holdings, either of cash or of deposits in the banking system. The tax became less and less effective as the tax base became less and less, and in the spirit of Cagan (1956) inflation entered an upward spiral.

With the onset of inflation in 1991, the relative attractiveness of banking deposits denominated in domestic currency declined sharply. Those holding wealth in nominal domestic assets (including government entitlement programs) were made poorer by inflation relative to those with the ability to diversify assets into real property and hard-currency instruments.  Inflation eroded the real value of nominal assets.
 

The attraction of foreign exchange in an inflationary environment.

The holding of foreign exchange provides a hedge against the inflation tax on accumulated wealth. This alternative has become quite prevalent in the former Soviet economies, as is evident in the very liquid informal markets in foreign currencies. One hedge is of course to hold the banknotes of the foreign currency, while another is to make foreign-exchange denominated deposits with a financial intermediary. This latter strategy has proved quite lucrative for private savers. Commercial banks have been quite active in offering these deposits, as have "trust companies". The surveys reported above provide the only available consistent evidence on holdings of foreign banknotes or use of non-bank financial intermediaries, but commercial-bank deposits in foreign exchange provide a lower bound on the importance of these deposits in attracting wealth.
 
Banking in Kazakhstan since independence.

The banking system of Kazakhstan had its beginnings in 1987 with the "break-up" of the Gosbank and the passage of a new law on corporations. The Almaty Cooperative Bank in 1988 received the fourth banking license issued in the Soviet Union. By mid-1994 there were over 200 banks in Kazakhstan. 35 of these were private, while the remainder were joint-stock corporations. Four that had begun as specialized state banks -- Turanbank (previously Promstroibank), Agroprombank, Narodnyibank (previously Saving Bank) and Credsotsbank -- were joint stock companies with the government retaining part of the stock. There were also 9 banks with partial foreign ownership.
 
The most successful banks in Kazakhstan are participating in both tenge (national-currency) and foreign-currency markets. In the tenge market, funds were obtained predominantly through sale of capital, founders' deposits and either credit auctions or the refinancing of directed credits with the National Bank of Kazakhstan (NBK). Tenge deposits by citizens were in general an unprofitable way to obtain funds. For small banks (mainly those created since independence) there was an insufficient network of offices to attract deposits. For most there was only one office -- in Almaty -- and for some there were no offices at all. In that situation attraction of deposits from the population became almost impossible. For large banks (mainly the specialized state banks Agroprom, Turan and Kredsots) the deposits of the population were unprofitable and undesirable. Despite their network of offices, the cost of funding through NBK refinancing fell below that of attracting many small depositors. Further, these banks were also aware that the directed credits were extended to many essentially bankrupt producers. If the banks attracted their own deposits, they would be pressed to lend those as well to these corporations, and thus could not protect the funds of the depositors. The NBK was not unhappy with this outcome. Keeping all banks dependent upon them for funds allowed them to supervise and organize the banking system. Only at Narodnyibank were deposits a primary source of tenge funds.

Non-bank financial institutions stepped into the breach and solicited deposits from the population for trading activities. They promised a large return on investment. These activities were popular with investors but poorly monitored. These included trust companies, Lombard companies, pension funds and investment funds. The government was unsure how to handle these new businesses, since legislation did not at that time provide the government with the ability either to regulate the new businesses or to obtain data from those businesses. For example, Smagulov and Company was a private firm offering 600 percent annual interest on tenge "deposits" throughout 1994. The firm delivered as promised in the earlier months, and by August 1994 a "large share of the population" wished to place money with it. In one case, people waited in line 3 days to make their deposits. The people liked the return, and also liked the fact that the agreements were in effect 1-month deposits. Unfortunately, Smagulov and Company closed its doors in late 1994, without repaying principal or interest on current balances. Smagulov was reportedly in Australia at the end of 1994.
 
Kazakhstan is a good example of this process. It was characterized in 1994 by a small volume of private saving. Private investors and commercial banks attract the funds of those who did save, and this saving was made available to private investors and traders. The government budget was not competitive in its efforts to attract saving, and relied upon currency emission for financing. The government is able to "attract" saving in this case only through exploitation of the private sector's need for currency; it has as cost the reduction in the real value of original nominal financial assets known as the inflation tax. The banking system was slow to attract saving from the population or enterprises in domestic currency, as it was able to rely upon National Bank of Kazakhstan (NBK) refinancing credits. In the end, this circuit of financing only enriched the bankers without attracting any real resources -- the NBK was in the end been dependent upon inflation to achieve its financial goals.

The change in the pattern of saving also has implications for resource allocation. Saving in foreign exchange would be beneficial if intermediaries existed to ensure that the funds were allocated to high-return investment activities. In fact, however, the intermediaries in foreign exchange focus upon the financing of trade expeditions to bring back consumer goods to the countries. These goods are imperfect substitutes for those available for domestic currency. Consumption thus rises, inflation hits the domestic economy and the domestic currency depreciates against foreign exchange. The population also made "deposits" with non-banking intermediaries such as Smagulov and Company; these investments were denominated in tenge for one-month maturity and were yielding 600 percent annual interest (50 percent per month). This saving was however financing the purchases of the company.

This financial-market experience in Kazakhstan provides two lessons to the government's economic strategists. First, the real cost of financing the ongoing budget deficit was quite high. The credit auctions coordinated by the NBK and the interest rates offered on dollar deposits at the commercial banks indicated that saving was quite scarce. This scarce saving was being attracted by private actors -- commercial banks and "trust companies" like Smagulov and Company -- through offering higher real interest rates than were available in the Narodnyi Bank or other state commercial banks. Second, there is an opportunity for the government to attract this saving if it is willing to raise the interest rate that it pays on borrowed funds to compete with these private actors.
 
This growth did not in general indicate increased opportunity for or competition to attract depositors. Commercial banks found "origination" of directed credits refinanced by the national bank to be quite profitable. Attraction of deposits was more expensive, given the high costs of establishing branch offices, and required more detailed record-keeping. Finally, that activity involved some risk to the bank if assets and liabilities were not matched as to maturity and interest rate. This risk did not occur in the origination market. Finally, the deposits denominated in the national currency were an inherently poor saving instrument during a period of extreme inflation, but the banks were not in a strong enough financial position to offer inflation-hedging improvements to these instruments (e.g., indexed interest rates).
 
Commercial banks were chartered in great number. A large subset of these also qualified for "general licenses" that permitted the bank to denominate its deposit and lending activity either in national currency or foreign exchange. The competition for depositors in fact surfaced in the foreign-exchange transactions, since the banks had an excess demand for foreign-exchange credits. Interest rates in these markets were bid up to extremely high levels. This reflected in part the profitability of international trading transactions, but also in part the emergence of Ponzi schemes and ill-advised financial transactions in the underregulated markets of these economies.
 

The "trust company" phenomenon.

Commercial banks were not the only financial institutions to thrive in the volatile financial environment after independence; non-bank financial institutions also proliferated. These took a number of forms, from foreign exchange bureaus to Lombard companies (or pawnshops), but the most famous (or infamous) were the "trust companies". These were non-bank institutions that offered deposits or shares with interest rates or capital gains promised to exceed returns available in the banking system. The MMM corporation of Moscow was the best-known of these, but similar institutions grew up in all the countries observed.

These trust companies operated in a standard manner. Each sold monthly certificates. The firm set a buying and selling price each month, and these prices rose from month to month to guarantee a positive return to investors. For example, certificates in the Golden Bowl Corporation of Georgia had risen in value from $.98-$1 in June 1994 to $2.30-$2.50 in October 1994 for a compounded monthly return of about 25 percent. These trust companies were not chartered by the government and were not typically regulated by the national bank or any other government organization.
 
The first wave of trust companies attracted clients with the promise of -- and initial success in returning -- 20 percent return per month on deposits. Some of these may have been pure "Ponzi" schemes, but others were financial intermediaries with ties to corporations able to turn high short-term profits through trading operations. These organizations were able to offer such high returns because of the profits from trading activities and because deposits were loaned out completely -- negligible reserves were held for repurchase of deposit certificates. The success of these corporations attracted competitors, both from newly created trust companies and from more aggressive commercial banks. The cash flow from deposit receipts and repayments of lending was sufficient to cover withdrawals until the failure of the Russian firm MMM. During the time of the MMM crisis in Moscow, depositors in other countries approached their trust companies to redeem their certificates. The trust company was typically unable to meet these demands, and was forced to close. In Georgia there were 15 to 20 such companies during their heyday in the first half of 1994, but few remained after the MMM crisis.
 
These failures were liquidity-driven. Subsequent failures were related to insolvency, and occurred in one of two ways. The first was through theft: for example, the Golden Bowl Corporation failed when the chairman fled the country (reportedly with $60 million). Smagulov and Company in Kazakhstan similarly closed in late 1994 after a year of operation as a "trust company"; Mr. Smagulov was reported to be in Australia. The second was through ineptitude. Here, the case of Innovation Bank in Georgia is instructive. This bank was backed by the Ministry of Internal Affairs and offered high interest rates on deposits. The leaders of the bank made a number of improper loans, including a 400,000 USD loan to a woman friend, while paid-in capital was valued at less than a tenth of that. Most loans were made to the founders of the Bank. Each borrower proposed a productive use for the loan, but these were not well thought out and not well screened by the bank. The bank was warned about its behavior a number of times by the National Bank of Georgia before it finally failed.
 
Much "trust company" activity was fraudulent. There were also reports, however, of companies resorting to formation of trust companies because of the shortage of available credit in the banking system. This is comparable to, though less dramatic than, the formation of a commercial bank by a trading company. In each case the shortage of credit from the banking system encouraged the formation of a "captive" financial intermediary.
 

Specialization and sluggish adjustment of state commercial banks.

With the bifurcation of the financial markets, the former state commercial banks (other than the Saving Bank) found it profitable to act as the originator of directed credits in domestic currency that the national banks refinanced. The return to the bank was in effect indexed to inflation, since the "fee" received was a fixed percent of the value of the directed credit. Given this secure and relatively stable source of funds, these banks did not find it profitable to attract deposits in domestic currency. This proved to be true across countries for the successor banks to Agroprombank (Agro-Industry Bank) and Promstroibank (Industry Bank). The sole exception proved to be during periods of cash shortage; in those circumstances these banks (for example, Promstroibank of Belarus) solicited deposits from households because the deposits would be made in domestic banknotes that could be redistributed to other clients.
 

The successors to the Saving Bank in each country were rather slow to adjust to the new economic environment. The banks remained state banks for some time in all countries, and their management thus remained under the direction of the state bureaucracy. As a result, the Saving Bank was not allowed in most instances to capitalize upon its existing monopoly in the collection of domestic-currency deposits. Interest rates paid on deposits were adjusted infrequently, and by too little to be attractive to depositors; the maturity and other characteristics of deposits were not adjusted to the inflationary post-independence economic climate. As a result, the Saving Bank became progressively less dominant as an intermediary for private saving, although its extensive network of branches made it the sole provider of financial services for much of the population.
 
Chapter V:  The financial system as an example of industrial organization.

Chapter XI:  Saving and the circular flow.
Non-consumption (or deferred consumption)
Desired vs. forced.
Intermediated vs. non-intermediated.

Chapter XII:  The financial system as an intermediary between savers and borrowers.
Role in circular flow.
Role in encouraging saving.
Role in lending resources to best uses.