Bad loans, soft budget constraints and the political economy of financial market reform in transition economies

Abstract

Financial market imperfections and especially the bad debt problem are among the most important factors impeding economic restructuring in transition economies. This paper analyses the implications of non-performing loans for the lending policy of banks and for the ensuing allocation of credit. It is shown that a lending bias exists in favour of old debtors, which not only impedes structural change but may also counteract policies intended to harden budget constraints and to promote restructuring. The paper also discusses from a political economy perspective, why despite these negative implications financial market reforms were not pursued more forcefully in most countries.