The transformation of the Czech banking system has been a hot topic since the Velvet Revolution and it is very likely to remain topical for a long time to come. While there has been a broad consensus regarding the necessity of banking transformation, there have been major disputes concerning the methods, timing and sequencing of the reforms. The decision to use primarily Czech capital to finance the costly transition from a centrally planned to a market economy has further complicated the complex task of banking reform. The restructuring of the Czech banking system has become a protracted and extremely costly project, which has cost Czech taxpayers hundreds of billions crowns. A striking feature of the Czech banking transformation is the failure of the Czech state to assume its proper regulatory and supervisory functions in the financial and banking industry functions that are crucial for proper functioning of any market economy. We can only speculate what has been behind this magnificent failure, nonetheless, it is against the laws of nature for hundreds billion crowns to simply evaporate from this world. Therefore, it is possible to argue that some nice amount of money "evaporated" illegally ­ another words, it was, at least partly, used for corruption.

Several foreign institutions analyzed the Czech banking transformation. The European Union (EU) has been one of the critical voices:

The failures of the financial sector, combined with deficiencies in the enterprise sector and weaknesses of the legal system, have allowed the development of some inappropriate business practices. This has manifested itself in the stripping of assets from enterprises by managers, known in the Czech Republic as "tunneling", which has affected many of the industrial companies privatized through the coupon privatization scheme of the mid-1990s, in addition to investment funds, and agricultural co- operatives. (European Commission, 2000)

The Czech Republic can be regarded as a functioning market economy. .... However, measures need to be taken in order to ensure fiscal sustainability in the medium term. Progress has been made on further restructuring and privatization of banks. The strengthening of proper supervision in the financial sector is crucial in order to reinforce macro-economic policies and to foster economic activity. The prudential regulations should be implemented without further delay. Moreover, every effort should be made to maintain the momentum in the process of restructuring and privatization of state-owned enterprises and to effectively implement the recent amendment to the bankruptcy laws. Effective action must be taken to strengthen corporate governance and the enforcement of laws. (ibid.)

Almost the entire Czech political elite criticized this EU report as being too pessimistic, too critical, and ignorant of recent positive trends. The objective of this paper is to provide a brief overview of the Czech banking transformation and of its impact on the Czech economy. The hypothesis is that the lack of effective state regulation and supervision has been one of the most serious flaws of the entire Czech banking transformation. Moreover, that this regulatory gap has enabled spread of corruption, reaching even the highest business and most likely also political levels.

Most contemporary economists would concur that a competitive market economy requires effective state regulation and supervision in order to prevent fraud and corruption.¹ The banking and financial sectors in the Czech Republic are not yet effectively regulated and supervised. Because the government delayed necessary reforms, taxpayers are now left with a massive bill. Despite the efforts of the current Social Democratic government, the banking transformation is likely to enter Czech history textbooks as one of the biggest free lunches ever. Because of the six-page limit for this paper, I unfortunately cannot include an in-depth analysis of Czech privatization and banking reforms² but I will attempt to discuss a few most interesting points in some detail instead.

In 1989, the situation in the Czech banking system was critical and demanded immediate reforms. The very nature of the banking system was outdated and unsuited for the planned transformation of the „socialist economic jungle” toward a functioning market economy. Especially the burden of bad (classified) loans, which in the following years proved to be much heavier than originally expected, had to be dealt with quickly and with special care. Moreover, since foreign capital was very scarce at this time, domestic Czech banks³ had to finance both the costly transformation and the privatization of the economy.

There was a wide-spread sentiment that some form of privatization was needed to create a new structure of owners, preferably private ones, who would be profit-motivated and who would force the banks to behave according to the rules of the market. Banking reform was a hot topic on the agenda of the first postcommunist government. In 1990, a modified version of the communist idea of splitting the ineffective monobank was adopted and a number of state-owned banks emerged. All banks⁴ were included in the first of the two waves of mass voucher privatization, which was the Czech solution to the problem of redistributing state-held assets into private ownership. The real, albeit somewhat unexpected winners of voucher privatization were the investments funds (IPFs), which obtained 71,4% of total vouchers (Varho 2000: 45). This outcome has, however, had serious repercussions for the banking sector, which deserve further analysis.

As mentioned above, the banks were to finance the economic reform in Czech Republic.⁵ The effect of voucher privatization, however, was that relatively few big banks became owners of more than 2/3 of all privatized enterprises, either directly or through the investment funds they established. Officially, there was a 20 percent restriction placed on the banks' ownership of an IPF; but in reality, of the approximately 280 IPFs existing in the Czech Republic during privatization, seven of the top ten funds by market capitalization were bank funds (Bonin 1998: 41). The 20% limit was avoided by setting up separate investment companies, which were fully owned by the banks.

This avoidance of the laws, together with unclear regulations and weak enforcement, led to the downfall of the Czech voucher privatization. The banks became owners of the very same enterprises that owed them most of the money in unpaid loans. Instead of demanding re- payment of their loans, as any prudent bank would do, state-owned banks pumped even more money into these inefficient companies. It is still debated to what extent these infusions of funds were driven by concerns about layoffs, by the vain hope that, somehow, these companies would get back to profitability and repay their loans, or by the explicit knowledge by bank management that these funds would never be repaid. Until today, these transactions were not properly investigated, and the more time passes, the less likely we will know to what extent there were illegal transactions involved.

What we know for sure is that the final result of the voucher privatization was an obscure, highly interconnected and non-transparent ownership structure in the Czech economy. Komercni Banka (KB), for example, has business ties with at least half of all Czech companies, which raises concern that the bank holds its client-companies hostage in non- market based transactions by virtue of their ownership stakes (Bonin 1998: 42). Today, the state still controls some significant assets of shares in the major banks, either through the National Property Fund (NPF) or through the Restitution Investment Fund (RIF).⁶ Continued state control had the following repercussions on Czech banks:

• First, the major banks were deemed "politically too big to fail" (ibid.: 9), which could be explained either by social consideration or by the political power lodged in large institutions that are unwilling to be split up, sold, or closed down.
• Second, these banks have not learned to be competitive in the marketplace, simply because they were not forced to be competitive. The state was a constant source of backup and source of bailout. Every Czech government since 1989 has used billions of crowns for bailing out inefficient banks, in the process creating system-wide moral hazard. Bank managers had no strong incentives to perform, as there was always the possibility of future government support or bailout. Equally important or even more important was the fact that the leaders of banks were not punished for bad choices (and some were rewarded for purposeful bad choices).
• Third, these big banks were overly interconnected, creating systemic risk for the entire financial system. The banks not only had the same main shareholder - the state - but they cross-owned each other's shares. For example, the bank- dominated IPFs as group held 32,5 percent of the shares in Ceska Sporitelna, while private investors participating in the voucher privatization (DIKs) owned only 4,75 percent (ibid.:14).

In sum, we may say that despite the original goals of the voucher privatization (i.e., the creation of a new class of responsible non-state owners both in the financial sector and in the „real” economy), the transfer of ownership rights to private citizens and/or privately owned economic subjects remained unresolved.

Apart from the persistence of state ownership, the other major downside of Czech privatization was that the speed of implementation exceeded the pace at which proper legal, regulatory and institutional control mechanisms were put in place. This is not to claim that there were no changes at all but that these changes were unsystematic and far too slow. Thus, the Czech Republic has not only failed in privatizing the banks in the voucher privatization scheme; it has also failed to establish proper regulatory systems.

To give a specific example, one can mention the series of bankruptcies and major existence troubles among the small and medium size banks caused by high number of bad loans. The establishing of many of these banks in the first years of transformation was very spontaneous and their management had often no experience with banking at all. In 1993, a Czech National Bank (CNB) inquiry revealed that out of 46 banks under its supervision, only 5 could be classified as having no problems. The percentage of bad loans often increased to such levels that even in a lax regulatory environment, bankruptcy became the only option. In the case of the first bankrupted bank in Czech Republic, AB Banka, this percentage was as high as 91 percent right before its closure in 1993 (Mervart 1997: 110-111). These percentages of bad loans are not explainable only by lack of experience, but also by the fact that banks were tunneled by management and shareholders who were given cheap loans and did not pay them back. This was exacerbated by the common practice of dishing out huge loans to unprofitable enterprises, as well as loans given to friends and political allies.

Even though such practices became increasingly commonplace and well-known, the Czech state and its police organs have been slow to respond ­ that is, to investigate suspicious loans and losses and to prevent future losses through proper regulation and supervision of banks. The privatization of the "big" banks has also not always been a success story. The Investicni a Postvni Banka (IPB) crisis has been the latest, and so far the biggest, shock for the Czech financial sector. It has, however, only revealed (on a much greater scale) the old flaws of Czech banking reform - the lack of transparency and effective state regulation and the resulting prevalence of semilegal and illegal transactions. This is why, in my view, the Czech privatization can be characterized as the biggest free lunch ever.

Apart from that, it has also made the Czech Republic famous for its long tunnels but. According to new director general of Konsolidacni Banka (KoB) L. Reznicek (Lidove Noviny 2001: 13), the state will have to take over some 100 Kc billion of classified loans from the IPB portfolio alone. In this context, many wonder where all the money went and how it is possible that it took so long before the regulatory and control mechanisms were tightened. The IPB crisis was only the latest indication that there is still a lot of work to be done here. The EU Report (European Commssion 2000) mentioned in the introduction, offers a brief but informative evaluation of the IPB crisis:

"Although intervention by the authorities might have been the only available option under the circumstances, it should have been possible to avoid such actions by strong, independent, supervision of the banking sector."

When comparing the criticism of the EU Report with the above analysis of Czech banking transformation, one has to wonder what exactly caused such an outrage among the Czech politicians. The EU report has merely stated some facts, which are uncomfortable. The true extent of the banking crisis has not been revealed, and can only be speculated upon. To be fair, there has recently been progress in the banking transformation ­ for example, the privatization of major Czech banks has finally been re-launched under the current Social Democratic Government. The problem is, however, that it could (and should) have been executed a long time ago. This paper explained how voucher privatization merely "privatized" most companies back into the hands of the state, which has neither functioned as a responsible majority owner, nor assumed its proper regulatory and supervisory functions in the banking sector.

The banks (through their IPFs) became owners of many privatized companies, which has greatly obscured their proper role on the market. Instead of demanding the repayment of the loans already issued, new loans were granted for reasons that remain to be fully explained. The best interpretation is that these loans were given in the hope that as the economic situation improves, companies will eventually pay back. The worst interpretation is that the money has been stolen. It is clear that the vast majority of these companies are unable to repay the loans for a long time to come, and as a result, all Czech governments had to spend hundreds of billions of crowns bailing out the ineffective banks while continuing to subsidize large loss-making firms. Instead of creating a transparent and enforceable legal framework, the state has created special "debt hospitals" (KoB, Ceska Inkasni, etc.), where not only the pre-1989 but also the post-1990 accumulated classified loans have been transferred whenever the state-owned (and in the case of IPB, partly privately-owned) banks got in trouble.

If we consider that in March 2000 the total amount of known classified loans amounted to 483 Kc billion, and that the IPB crisis and KB privatization are likely to add as much as another 100 Kc billion, we get a total bailout cost of some 600 billion crowns. Considering that only about 110 Kc billion was needed to cover the pre-1989 classified loans, the "Czech way" of banking reform after 1990 has already cost approximately half a trillion crowns. That translates into about 50 000 Kc (1400 EURO) per citizen. When faced with these findings, the average Czech taxpayer would agree with the EU Report when it says that "overall, bad loans in the Czech financial system have reached EURO 13.2 billion, or 26.5% of GDP, which is a serious matter of concern." (European Commission 2000).

The main conclusion of this paper, thus, is that while the main aim of Czech privatization was to transfer the state-owned assets into private hands, this process should have been closely followed by the state assuming its proper regulatory roles in the banking system. Without an early established, transparent relationship between the privatized banks and the state, the privatization was fraught with risk. Several measures should have been taken when (better possibly before) privatization was launched: (i) a responsible and independent bank examiner must be in place, (ii) strict capital adequacy standards should be defined and enforced, (iii) a strategy for dealing with banks that do not satisfy regulatory requirements should be in place (Bonin 1998: 6). In the Czech Republic, many of these measures were not implemented until recently; and recent reforms have remained partial.

Still, it is possible to argue that in the last two years, the Social Democratic government has done more to improve both the speed and quality of Czech banking transformation than the self-proclaimed „pro-free-market” governments since 1990. Ceskoslovenska Obchodni Banka (CSOB) and Ceska Sporitelna (CS) were finally privatized and privatization of KB seems to be on the way. Moreover, there have been some initial efforts to curb semi-legal practices, corruption, tax evasion and other economic crime in the banking and business sectors. Whether these efforts will yield tangible results remains to be seen. The Revitalizing Agency project was launched and there was a laudable effort to make the Agency independent and its actions transparent. The first package of the classified loans managed by KoB has been sold and others are to follow in the coming months.

In light of the number and scale of problems that the current government inherited in the banking sector, the recent developments have to be judged as positive. The problems that remain are, however, daunting and complex, and it will take time and money to establish a functioning banking system in the Czech Republic. Finally, the state is beginning to assume the role it should have assumed right from the beginning in 1989 ­ including regulation, supervision and law enforcement in the banking and financial markets. In the meanwhile, the costs of the delay are amounting to hundreds of billions of crowns. Some 500 Kc billion might have been saved, had the Czech state not opted for a haphazard, „Czech way” of banking transformation. While for a few, the „Czech way” of banking transformation became the „biggest free lunch ever”, the vast majority of Czechs find themselves stuck in a traffic jam in a long and expensive „tunnel”. --- END

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Other sources: (Note: URLs valid as of March 2001)
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