Soft Budget Constraints and banking Regulation in Transition Economies

Soft budget constraint phenomenons may arise in all vertical relationships in which superior organizations provide monetary support to subordinate ones. In this paper I focus on soft budget constraint problems in government-bank relationship in transition economies. Since 1992 all eastern countries have tightened bank regulation,specifically new capital standards have been introduced. However, it seems widely recognised that the major problem of the new bank regulation is its credibility. In this paper I argue that the importance of the soft budget constraint problems depends on the "reputation" of the regulator : a reputation acquisition model is built to highlight the conditions under which a regulator can devolop a "tough" reputation hardening the banks' budget constraints.