The bad debt crisis and its impact on the banking reform in Poland

The painful process of economic transition has loomed over Poland for the past decade. It was launched by abolishing the mechanism of central planning and by a radical liberalisation both in respect to price setting and market entry. It was soon realised that the success of the reform heavily depended on how the process of widespread institutional change would proceed - a new legal order had to be established in order to protect free contractual agreements; privatisation of the bulk of the economy was needed in order to improve corporate governance; and finally a new mechanism of capital allocation had to be created. The institutional reform encountered serious obstacles, and it turned out that it was the third task, the transformation of the financial system, which was confronted by the greatest challenge. The explosion of bad debts called into question the banks' ability to pursue the task of efficient credit allocation. As a nation-wide crisis it undermined the stability of the whole banking sector. Its collapse not only would have resulted in the destruction of the credit allocation function for the economy, but it might have buried all chances for a successful transition. That is why overcoming the bad debt crisis can be regarded as a key factor in the further economic development of all transition countries. This study focuses on how the Polish horities have addressed the problem. It explores whether the government and the Central Bank have managed to outline an implement a reform programme both comprehensive and capable of combating all sources of potential moral hazard in the banking system.