V. Banking Sector Issues55
97. The Czech banking system, which is large in relation to the size of the economy, continues to be burdened by poor loan quality. It has, nevertheless, improved considerably since the beginning of the transition in 1990, introducing new information technologies and expanding services. Bank lending amounted to ¾ of GDP in 1997, exceeding the combined market value of stocks (31 percent of GDP), bonds (9 percent of GDP) and outstanding enterprise borrowing from abroad (20 percent of GDP). The role of banks is even more pervasive if one takes into account their partnerships with enterprises, both directly (through lending and equity holdings) and indirectly (through investment funds under their control).56
98. The banking system is dominated by the four largest banks (Komercni, Ceska Sporitelna, IPB, and CSOB) which have a combined market share of 63 percent in total assets, rank among the six largest banks in Central and Eastern Europe, and enjoy investment grade ratings (Table 11). All four banks were state controlled as of end-1997; Komercni is the largest in terms of lending, and Ceska Sporitelna (Czech Savings Bank) is the second largest and the prime institution in terms of mobilizing household deposits. Subsidiaries and branches of foreign banks account for 19 percent of total assets; they have been catalytic in improving the scope and quality of the banking services and promoting financial innovation; and by rapidly increasing their market share, especially among prime (creditworthy) clients, they have been exerting pressure on domestic banks to improve their efficiency. Small and medium-sized domestic banks have a market share of 10 percent and have been involved mainly with the new private enterprises. The three specialized banks (Consolidation Bank, Export Bank, and Czech and Moravian Guarantee and Development Bank) and the building societies have limited deposit-taking activities.
|Large banks 2/||Savings Bank||Small banks||Foreign banks 3/||Special banks 4/||Consolidation bank 5/||Banks under conservatorship 6/||Total excluding KOB||Total|
|(End-of-year balances in billion koruny)|
|Claims on banks||…||77||…||…||…||7||…||…||…|
|Deposits of non-banks||463||300||62||90||38||9||45||999||1,008|
|Deposits of banks (incl. foreign)||153||26||11||224||9||26||16||439||465|
|Sources from CNB||29||3||0||0||37||3||35||71|
|Reserves and capital funds||58||13||3||5||2||38||3||85||123|
|Market shares:||(In percent)|
|Deposits of non-banks||46.0||29.8||6.2||8.9||3.8||0.8||4.5||…||100.0|
|Credits to non-banks||50.6||16.1||5.3||14.3||0.7||7.8||5.2||…||100.0|
|Ratios to total credits:|
|Deposits of non-banks||90.3||184.6||115.0||62.0||522.1||10.8||86.5||106.9||99.5|
|Deposits of banks (incl. foreign)||29.9||16.0||21.0||154.3||124.4||32.6||29.7||47.0||45.9|
|Sources from CNB||5.6||-||5.4||0.3||-||46.7||5.1||3.7||7.0|
|Capital and reserves||15.2||12.7||25.7||11.3||116.0||56.5||16.1||15.6||18.8|
|(Liquid assets + securities)/deposits||57.6||31.9||34.0||70.2||45.3||265.9||29.5||47.8||49.6|
|Own funds / classified credits||45.6||50.4||53.0||266.5||568.5||69.0||35.4||54.1||57.0|
|Ratios to total assets:|
|Liquid assets + securities||30.4||25.5||20.3||16.7||27.8||17.4||16.6||25.4||24.9|
|Claims on banks||…||20.4||…||…||…||5.3||…||…||…|
|Deposits of banks (incl. foreign)||17.5||6.9||10.9||59.2||14.6||19.7||19.3||23.4||23.2|
99. Poor loan quality is the main problem affecting the net worth and profitability of banks. However, banks appear to have limited exposure to foreign exchange, interest rate, and liquidity risks, and have weathered relatively well the effects of the koruna depreciation and the high interest rates in 1997. The poor loan quality problem is most acute in the smaller domestic banks, and the CNB has accelerated their restructuring to prevent contagion to other banks. Privatization of the large, state-controlled banks, which had stalled until end-1997, has recently gained momentum in preparation for the country’s membership of the EU. In addition, steps were taken to strengthen the legal and regulatory framework for banks and the capital market as well as to improve the transparency of the financial system. These steps included the limitation of banks relations with enterprises and investment funds and the establishment of a Securities Commission. These reforms constituted the key structural element of the policy package announced in April 1997.
100. This chapter is organized in three sections. The first examines the financial position of banks, their exposure to risks, provisioning, bank profitability, and the determinants of the spread between lending and deposit interest rates; the second section reviews the legal and regulatory framework for banks and other financial institutions; and the last section examines progress toward restructuring and privatizing banks.
A. Financial Position of Banks and their Vulnerability to Risks
Quality of the Loan Portfolios of Banks
101. The ex post exposure of banks to credit risk is captured by the share of classified credits in their loan portfolios.57 Despite a 3 percentage point decline in the past two years, the share of classified loans remains high, 29 percent in June 1997.58 Classified credits vary considerably across banks and across industries: They stood at 33 percent in the three largest banks (which have generally been reluctant to call in loans and seize collateral), about 45 percent in small banks and banks under conservatorship (reflecting risky lending practices at the early stages of transition),59 but only 4 percent in foreign banks and branches of foreign banks (Table 11). The considerable difference in the incidence of classified credits across sectors (Figure 25) suggests that larger financial institutions, which have a greater capacity to diversify their portfolios, should have better chances of weathering the vagaries of transition.
Figure 25.CZECH REPUBLIC: DISTRIBUTION OF CLASSIFIED CREDITS BY SECTOR
102. Loss-loans account for almost ⅔ of classified credits. They are dominant in all maturities and types of loans but less so in foreign-controlled enterprises (Figures 26 and 27). The large share of classified credits exerts pressure on bank profitability by reducing income earning assets and raising the need for provisions; and also accounts for the fragility of several small banks. In aggregate, however, banks are reported to be adequately provisioned; moreover, the CNB has been actively involved in restructuring smaller banks and is encouraging banks to further strengthen their reserves by minimizing dividend payments. The main factors behind the large share of classified credits and its slow decline are:
Moderate inflation, which did not permit Czech banks to “inflate away” these loans through rapid credit expansion.
The reluctance of the authorities, out of moral hazard considerations, to undertake an extensive cleaning up of the banks’ portfolios from loans extended since the transition to a market economy.60
Unsound lending practices of banks, namely, emphasis on collateral rather than on financial prospects, and a tendency to continue financing loss-making enterprises rather than catalyzing enterprise restructuring.
Application of the association principle, whereby all loans to an entity are classified according to the worst claim that a bank has on it.
Accounting and tax regulations that restrict the writing-off of loss loans against provisions.
Low rate of seizing collateral, owing to a legal system that favors debtors and requires lengthy court procedures;61 reluctance on the part of banks to foreclose delinquent loans out of concerns about glutting the real estate market (this would reduce the value of their collateral and necessitate additional provisions);62 and, to some extent, social policy considerations.
Figure 26.CZECH REPUBLIC: DISTRIBUTION OF CLASSIFIED CREDITS BY MATURITY
Figure 27.CZECH REPUBLIC: DISTRIBUTION OF CLASSIFIED CREDITS BY TYPE OF BORROWER
103. The current stock of classified credits reflects the inherited stock of classified credits net of write-offs, plus accrued interest and the incidence of new classified credits. This is captured by the accounting identity:
where B, W, A, and N denote, respectively, outstanding classified credits, write-offs, accrued interest on classified credits, and new classified credits. Dividing both sides of the identity by current period outstanding credit and rearranging terms gives:
where lower case letters denote ratios to end-of-period bank credit and g stands for the growth rate of nominal bank credit from t-1 to t. Equation (1) decomposes the change in classified credits, bt - bt-1, into four components: The first term on the right hand side of the equation, -[g/(1+g)]bt-1, measures the extent to which the share of classified loans can be “inflated” away by new loans; if classified credits were 30 percent of outstanding credits (bt-1 = 0.3), and total credits increased by, say, 10 percent, then the share of classified credits would be reduced by roughly 3 percentage points.63 The second term measures the impact of write-offs and cleaning of bank portfolios (e.g., transfers to the budget or “bank hospitals” such as the Consolidation Bank and Ceska Financni). The third term measures the contribution of interest capitalization on classified loans, which should be distinguished from the accumulation of new classified loans that is captured by the last term of equation (1).
104. Credit growth, write-offs, and portfolio cleaning-up operations in troubled small banks contributed 5.9 percentage points to the decline in the share of classified credits in 1996 and 5.5 percentage points in the first nine months of 1997 (Table 13). However, their effect was largely offset by the combined effect of interest accrual on classified credits and, not least, the incidence of new classified credits, especially in 1997. The 1997 increase relates to the slowdown of economic activity and the extensive floods; the more accurate recording of the problem at smaller banks undergoing restructuring; and the weak profit performance of banks in 1997, which slowed down write-offs.
|(End-of-period balances in billion koruny)||(In percent of total assets)|
|Deposits and credits with CNB||68.9||164.3||142.1||4.7||8.9||7.0|
|of which: minimum reserve requirement||51.5||75.9||113.7||3.5||4.1||5.6|
|Deposits and credits with banks||300.7||316.4||391.3||20.3||17.1||19.2|
|of which in foreign currency||…||97.0||129.0||…||5.2||6.3|
|Tangible and intangible assets||47.8||58.1||65.5||3.2||3.1||3.2|
|Resources from CNB||77.2||74.4||79.9||5.2||4.0||3.9|
|Deposits and credits from banks||277.5||386.1||469.9||18.7||20.8||23.1|
|of which in foreign currency||…||60.0||71.0||…||3.2||3.5|
|Current year profit||7.2||12.1||18.2||0.5||0.7||0.9|
|Net interest income||46.5||44.1||41.5||3.1||2.4||2.0|
|Net income from fees and commissions||8.5||9.1||11.4||0.6||0.5||0.6|
|Revenue from fees and commissions||9.3||10.1||12.9||0.6||0.5||0.6|
|Expenditure on fees and commissions||0.8||1.1||1.5||0.1||0.1||0.1|
|Revenue from securities||4.3||6.2||11.3||0.3||0.3||0.6|
|Revenue from foreign exchange operations||5.4||7.2||6.7||0.4||0.4||0.3|
|Other operating revenues||0.4||1.5||1.4||0.0||0.1||0.1|
|Gross income from banking activity||65.0||68.0||72.1||4.4||3.7||3.5|
|General operating costs||25.8||32.8||39.7||1.7||1.8||2.0|
|Revenue and provision creation (net)||26.7||25.6||7.3||1.8||1.4||0.4|
|Other operating costs||3.4||7.0||19.6||0.2||0.4||1.0|
|Gross operating profit minus provisions||9.1||2.7||5.6||0.6||0.1||0.3|
(In percent of outstanding credit at end of previous year) 1/
|Outstanding classified credits||32.2||30.0||29.1|
|Change in classified credits||-2.0||-2.1||-1.0|
|Of which due to:|
|Cleaning up of small banks’ portfolios 2/||--||--||-2.6|
|Accrual of interest||0.5||0.4||0.3|
|New classified credits (residual)||3.3||3.4||4.2|
105. The banking system has some exposure to interest rate risk, owing to the reliance of several banks (including major ones) on very short-term interbank borrowing. On the other hand, exposure to market and exchange rate risks has been limited, owing to the small share of marketable securities in banks’ portfolios and prudential limits on open foreign exchange positions. Although banks do not seem to have lent significant amounts for real estate purposes, recent declines in real estate values have affected the financial position of banks via their impact on the value of collateral. The vulnerability of banks to interest and market rate risk became evident during the May 1997 crisis when the discount window of the CNB was closed, three-month interest rates reached 30 percent (entailing a redistribution of profits toward Sporitelna, the prime lender in the interbank market), and bond prices tumbled.
The exposure to interest rate risk relates to the maturity mismatch between assets and liabilities. In particular, the reliance of several banks on interbank borrowing exacerbates the maturity mismatch, owing to the typical maturity transformation undertaken by banks. Although Czech banks have kept their medium- and long-term credits at 25 percent of short-term deposits, their liabilities with a residual maturity of up to one week exceeded 30 percent of total liabilities in 1997 and were double the corresponding assets (Figure 28). As part of their risk management, banks try to contain their exposure to interest rate risk by having about half of their domestic lending at adjustable interest rates.
Exposure to market risk is limited, as securities (government securities and CNB bills) did not exceed 10 percent of banks’ portfolios (Table 12). The high interest rates after the May depreciation reduced bond prices, creating valuation losses for banks and worsening bank profitability.64
Despite increased reliance on foreign borrowing for the financing of domestic lending activities, foreign exchange exposure of banks is limited, as banks broadly cover their net foreign currency liabilities to nonresidents with net foreign currency claims on residents. Moreover, off-balance-sheet positions (which are monitored on a daily basis by the CNB) are reported to be small, owing to prudential regulations that impose limits on the sum of on- and off-balance-sheet positions.65 Banks’ external positions are fairly liquid, as their short-term foreign assets are almost double their short-term foreign liabilities.
Figure 28.CZECH REPUBLIC: DISTRIBUTION OF ASSETS AND LIABILITIES BY RESIDUAL MATURITY
Provisions and Capital Adequacy
106. The current regulatory framework requires provisions against credit risk only, while all other risks are to be covered by general reserves (Table 14). According to external auditors’ reports, major banks have provisioned and/or collateralized their classified loans: risk-weighted classified loans, essentially a proxy for expected losses from lending operations,66 stood at 20 percent of total credit in September 1997. Against this, banks have accumulated loan loss provisions of 10½ percent of total credits while the remaining 9½ percent is collateralized with (state/bank) guarantees, traded securities, or real estate. There is concern, however, that auditors’ reports may not fully reflect the incidence of classified credits and the poor quality of some of the collateral. Indeed, the reluctance of banks to seize collateral suggests that the insurance value of collateral may be overstated. Moreover, the insurance value of collateral deteriorated in 1997 in line with the deterioration of commercial and industrial real estate values.67 Credit rating agencies have expressed concern about the adequacy of provisions but have not downgraded major banks (besides IBCA’s downgrading of Komercni’s long-term rating from A- to BBB+ in November 1997)68 on the presumption that, if they experience difficulties, banks would receive state support.69 Because of moral hazard considerations, the authorities are not contemplating any cleaning up of portfolios of large banks beyond the one in 1991-92 and the restructuring of small banks in 1996-97.
|Loan classification||Delay in servicing||Required total provisions||Annual tax-deductible provisions/reserves 1/||Share in total loans (June 97)|
|Standard||Up to 30 days||0||1||67|
|Watch||31 to 90 days||5||1||5|
|Substandard||91 to 180 days||20||5||3|
|Doubtful||181 to 360 days||50||10||3|
|Loss||More than 360 days||100||20||22|
|Claims on entities declared bankrupt by a court||100|
107. The capital adequacy ratio (capital over risk-weighted assets) of the banking sector was 10.3 percent at end-1996.70 It has declined by 2 percentage points since end-1995 as a result of the transfer of general reserves to loan loss provisions and a change in the methodology, whereby since 1996 participations in nonbanks have been subtracted from own funds. In 18 of the banks the capital adequacy ratio exceeded 15 percent, and in 11 small banks the ratio was below the required 8 percent. Of the latter, 5 were under conservatorship, 3 were merging with other stronger banks, while the rest were participating in the restructuring program for small banks; excluding these banks, the average capital adequacy ratio was 12.4 percent.
108. The minimum capital adequacy requirement has induced banks to improve both their soundness and liquidity by increasing in their portfolio the share of items that have less than 100 percent risk weight and especially government bonds and CNB bills. However, the existing capital adequacy regulation does not address market, interest rate, exchange rate, and trading risk, which are becoming increasingly important with the internationalization of the Czech economy and the development of new financial instruments; moreover, it does not prevent banks that want to hold risky loan portfolios from making the riskiest loans within each risk-weighting class. As a cushion against these risks, the BIS recommended in 1997 that the capital adequacy ratio in emerging and developing countries be held above 12 percent. Ideally, banks need a comprehensive approach that would manage the riskiness of the entire portfolio of banks, including off-balance-sheet items, and allow for interaction among the various types of risk.
109. Core profitability (i.e., pre-provision profits) has been weakening since 1994 as a result of increasing operating costs and shrinking net interest income.71 Profitability is reported to have weakened further in 1997, as (i) several major banks that relied on the interbank market for funds were able to pass on to borrowers only part of the higher interest rates in the aftermath of the May crisis;72 (ii) bond prices fell, owing to the rise in interest rates; and (iii) interest revenue declined as loan quality deteriorated with the slowdown of economic activity and damage from the floods. The decline in core profitability resulted in a smaller buildup of reserves and provisions.
110. The main source of revenue has been net interest income, which declined to 2 percent of total assets, owing to a shrinking differential between lending and deposit interest rates (Table 15, Figure 29). Noninterest income moderated the decline in gross income from general banking activity. The rapid increase of general operating costs (excluding provisions), which reached the level in industrial countries in relation to total assets,73 reflects the rapid expansion of the branch network and employment as well as high wage increases (partly owing to shortages of qualified personnel). In response to higher costs, banks started in 1996 to consolidate their branch networks and eliminate redundancies. The process is expected to intensify further with the privatization of large banks. Foreign partners are likely to introduce more income-generating services (to reduce dependence on interest rates) such as credit cards, mortgages, and consumer loans, and improve credit-analysis skills, thereby reducing the incidence of classified credits in new credits.
|Net interest income||3.1||2.4||2.0|
|Net non-interest income||1.2||1.3||1.5|
|Gross income from banking activity||4.4||3.7||3.5|
|General operating costs||2.0||2.1||2.9|
|After tax profit||0.4||0.1||0.3|Figure 29.CZECH REPUBLIC: ALLOCATION OF GROSS INCOME FROM BANKING ACTIVITY
111. Differences in loan quality account for differences in core profitability across banks. Large banks, with a share of classified credits above average (Table 11), keep the spread between lending and deposit interest rates wide so as to accommodate the buildup of provisions. This boosts the profitability of banks with a below-average share of classified loans, especially foreign-controlled banks, which are able to expand their market share and put downward pressure on the spread; in turn, this exerts pressure to reduce costs but also makes it more difficult for bad-loan-ridden banks to beef up their provisions.
112. Bank profitability, the share of classified credits, and the spread between lending and deposit interest rates are intimately related: classified credits reduce profitability (via provisioning) and raise the interest rate spread; meanwhile, higher profitability (by enabling better provisioning and faster write-offs) reduces the share of classified credits and allows banks to operate at a lower interest rate spread. The approach of the CNB to the bad loan problem has been to press banks with positive net worth and core profitability (essentially the large banks and several medium-sized banks) to use their profits to write off classified credits; and restructure banks with small or negative net worth (essentially several smaller banks).
113. The intermediation spread, i.e., the difference between the average lending and average deposit interest rate, declined from 6 percentage points in 1994 to 5.4 percentage points in 1997 and is about the same as the spreads in Hungary and Poland, and lower than those in several EU countries (Greece: 7 percent; Ireland: 5.7 percent), but it exceeds the EU average. Intrayear gyrations have been considerable, owing to changes in the required reserves ratio and temporary increases in the interbank rate that banks passed on to borrowers (Figure 30).
Figure 30.CZECH REPUBLIC: INTERMEDIATION SPREAD
114. The declining intermediation spread is presumably the result of intensifying competition in the industry (it occurred despite increasing administrative costs) and cross-subsidization of lending/deposit taking from other activities (net fee-income increased steadily). On the other hand, the contribution of required reserves rose to ¾ of 1 percent; and the cost of deposit insurance added ½ percent to the spread.
115. The decomposition of the intermediation spread is subject to several caveats:
Given the high incidence of impaired loans, credit risk should be an important component of the intermediation spread. However, provisions in the income statement are likely to understate credit risk when banks are slow in acknowledging problems in their loan portfolios.
The relevance of the spread between deposit and lending interest rates for analyzing bank profitability declines with the expansion of fee-based services, nonlending activities, and nondeposit liabilities (e.g., certificates of deposit and bank bonds).
The average lending and deposit rates reflect the overall quality of banks’ portfolios and encompass past as well as current asset and liability management decisions. They are likely to differ from interest rates on new loans and deposits, which are related to current market conditions, and guide the behavior of profit-maximizing banks: lending decisions are taken at the margin, whereas overall profitability depends on average interest rates.
The contribution of required reserves to the intermediation spread in Table 16 was calculated from the average deposit interest rate and the share of deposits in the funding of lending operations. A greater reliance of banks on nondeposit liabilities (which are not subject to reserve requirements) would reduce the contribution of required reserves. On the other hand, when pricing new loans, the contribution of required reserves should be evaluated at the marginal cost of raising funds (approximated by PRIBOR); this would almost double the contribution of required reserves.74
|(Average lending minus average deposit rate, in percent)|
|(In percent of bank lending)|
|Provisions and other operating costs||3.4||3.0||0.8||…|
|Cost of required reserves||0.4||0.6||0.7||0.8|
|Cost of deposit insurance||--||0.5||0.5||0.5|
|Net fee income||-2.3||-3.2||-3.1||…|
B. Legal and Regulatory Framework
116. As part of the response to the economic policy and other transformational measures announced in April 1997, the Banking Act of 1992 is being revised in two stages (“small” and “large” amendments). The small amendment was approved by Parliament in January 1998. It was focused on addressing the problems of banks’ close relations with nonbanks, especially in the business sphere, and the consequent risks of interest conflicts; related to this, it was to tackle the problem of overlapping of personnel in the statutory bodies of banks and enterprises; and finally, it was to resolve the problem of interconnections between credit and investment decisions. These amendments will retain the existing concept of a universal banking system as implemented in most of Europe and accepted by the regulations of the EU. In addition, the revisions included measures to aid the process of forced administration and liquidation of banks and to secure the exercise of professional care in trading of stocks and securities and avoid past problems of insider trading and asset stripping. More specifically, the amendments included:
The prohibition of banks from acquiring direct or indirect majority control (at least 50 percent of shares) over nonfinancial institutions and limitations on qualified participation (10 percent or more) in these to 15 percent of capital in a single institution and 60 percent in total;
The prohibition of members of a bank’s board and bank employees from participating in the statutory body or inspection board of another legal entity;
The stipulation of requirements for professional care in trading securities in order to prevent the withdrawal of liquidity and asset stripping (also known as “tunneling”); and the separation within each bank of commercial banking from investment activities to prevent insider trading;
Authorization for the central bank to decrease the value of a bank’s stock, even during a period of forced administration;
In addition, provisions were included to increase the deposit insurance limit from CZK 100,000 to CZK 300,000 per depositor and to oblige the CNB to compensate clients in Ceska Bank (which was closed in December 1995 and is now in the process of liquidation) in an amount up to CZK 4 million, corresponding to the coverage extended to banks under the subsequent consolidation program.
Banks have been granted six months to comply with the new rules on composition of and participation in statutory boards and professional care in securities trading, while the new rules regarding ownership participation are to be phased in over three years.
117. In the second stage, a more fundamental revision of the Banking Act aimed at restoring general confidence in the banking system was approved by the Cabinet in November 1997 and is currently under consideration in Parliament (large amendment). This revision is inspired by failures and irregularities among smaller banks and investment funds which the authorities have linked to agents acting against the interests of the banking and financial system and the absence of effective controls. The amendment would enhance transparency and also legal safeguards in banking, while harmonizing Czech legislation more closely with EU legislation. More specifically, the proposed amendment includes:
A strengthening of the central bank’s control over shareholders of a bank through the requirements that voting stock be issued only in registered form; that acquisitions of voting rights exceeding 5 percent be approved first by the CNB; that new shareholders satisfy the same “fit and proper” criterion as the founders of the bank; and by making it possible for stockholders to be stripped of their voting rights if they undermine the proper and prudential operation of the bank;
Abolition of the economic need criterion as a condition for licencing banks;
Improved accountability of a bank’s management and board by requiring that a bank’s board of directors be composed of the top management of the bank; that the board of trustees be chosen by a general meeting rather than by the employees of the bank; and that directors share responsibility for claims against themselves or the bank;
Expanded notification and disclosure requirements through mandatory prior notification to the CNB of, inter alia, amendments to statutes or personnel changes in statutory bodies or bank director positions; and quarterly rather than annual as well more comprehensive reports;
Enhanced flexibility of the central bank in dealing with problem banks through authorization for an administrator to liquidate a bank; provision for mandatory removal of a banks’ license if capital falls below one-third of the required rate; and requirement that courts decide on liquidation of a bank and appointment of receiver within 24 hours from the submission from the CNB;
An extension of deposit insurance to legal persons, and exclusion from insurance coverage of natural persons related to the bank (management, board members, etc.) and persons convicted for money laundering.
These amendments are proposed to take effect from April 1, 1998. Following the introduction of a money laundering act in July 1996, an amendment to the Criminal Law is also currently being prepared in collaboration with the banking supervision authorities.
118. As described in detail in the 1996 Recent Economic Developments, prudential regulation of banks in the Czech Republic is modeled on international standards as incorporated in EU directives or recommended by the Basle Committee on Banking Supervision. These include rules on minimum capital, capital adequacy, large exposures, liquidity, foreign exchange exposure, investment requirements, required reserves, limits on bank lending and equity participation, and classification and provisioning of credits. These regulations are continuously being amended to harmonize them more closely with international and EU standards, while addressing issues specific to the Czech Republic. However, changes to regulations were relatively minor during 1996-97 and focused on improving the accounting for securities operations and valuation of securities holdings. Specifically, the changes to regulations provided for:
Further specifications and more detailed accounting procedures with respect to off-balance-sheet items and securities operations to reflect the rapid changes in these areas;
Stipulation of principles for creating securities portfolios and ownership interests (including separation of investment and trading portfolios), and requirement that provisions be made for individual securities and ownership interests corresponding to any shortfalls of the market price compared with the purchase price (marking to market);
Revisions to risk weights for the calculation of the capital adequacy ratio (assignment of 50 percent and 100 percent risk weights to claims on banks under conservatorship and liquidation, respectively, compared with 20 percent for standard banks) and to specification and conversion factors for off-balance-sheet items;
A broadening of the definition of credit exposure to single customers;
Better monitoring of liquidity through focus on the structure and risk concentration of liabilities, notably deposits;
Classification of foreign exchange loans which are not fully hedged against exchange rate risk as watch loans (requiring 5 percent provisioning) with effect from January 1998, with a view to encouraging enterprises to hedge their exchange rate exposure.
Classification of foreign exchange loans as substandard (requiring 5 percent provisioning) with effect from January 1998, with a view to discouraging foreign exchange lending;
Periodic (quarterly) reassessment of loan portfolio and other assets.
Banks were given a six-month period to create sufficient provisions for marking to market.
119. As discussed in Section A, banks are somewhat exposed to liquidity and interest rate risk, owing to the reliance of several banks on the very short-term interbank market, while their exposure to market and foreign exchange risk is limited due to a relatively small share of marketable securities in the banks’ portfolios and prudential limits on open foreign exchange positions. This may be the reason why the development of regulations to control market risk (including that related to off-balance-sheet items such as derivatives) is still in its infancy, but it will reportedly be given increased attention. Likewise, the capital adequacy ratio continues to focus on credit risk with no adjustments for market risk.75 Further, certain banking practices and tax regulations restrict banks’ ability to strengthen their capital position. This includes notably the requirement that interest be accrued on classified and even lost loans for income tax purposes, while there is a limit on tax-deductible provisioning of 3 percent of average credits outstanding during the taxation period. There are also restrictions on bank’s ability to write off loss loans from provisions.76 Improved conditions for foreclosure and for writing off loss loans, as well as a more generous tax treatment of provisioning, is required to help banks strengthen their balance sheets.
120. With the banking system under increased pressure and ongoing efforts to rehabilitate problem banks, the Czech National Bank continued to take measures to strengthen its supervisory functions in 1996-97, including an increase in the quantity and quality of staff.77 With the scarcity of resources, the central bank’s supervision has been forced to rely excessively on auditors’ reports. While auditors have generally been internationally acknowledged firms, experience from the Czech Republic as well as many other countries has demonstrated that in many instances, these firms have been led or pressured to underestimate the size of bad assets or risks. The CNB has been able to conduct only one on-site inspection in each of the four large, state-controlled banks during the last four years. The improved resources should allow for a much-needed intensification of the inspection process, including greater scrutiny of off-site inspection reports and more frequent on-site inspections.
121. Moreover, the supervision of banks in the Czech Republic is currently not done on a consolidated basis.78 This is a source of concern, given the universal nature of Czech banks and their close involvement and crossholdings with other financial institutions and the enterprise sector. However, individual banks are not owned by holding companies and generally do not own companies themselves, thus reducing the risk of contagion from related companies or forced manipulation of credit.
122. A number of measures were taken in 1997 to restore investors’ confidence and increase the attractiveness of Czech capital market:
several mismanaged investment firms, including some established and operated by banks, were placed under conservatorship or had their license restricted or suspended;
more than 1,300 inactive shares were delisted from the Prague Stock Exchange; and investment funds have been asked to channel their transactions through the Stock Exchange;
an amendment in the Law on Investment Funds limited the stakes of investment funds in individual enterprises to 11 percent (currently 20 percent); and envisages the conversion into open-ended mutual funds those closed-end investment funds whose shares have been trading at a discount to their net asset value of more than 40 percent over a three-month period;
a Securities Commission will be established in 1998 to regulate and supervise capital markets.
C. Bank Restructuring and Privatization
123. A key element of the policy package announced in April 1997 was the decision to accelerate the privatization of state-controlled banks. The main motivation for this was the desire to improve governance and practices in the banking system while preparing the banks for the increased competition in the EU. In addition, divestment of the banks would assist in adding pressures on the enterprise sector to improve corporate governance and speed up restructuring by hardening the budget constraints that enterprises face. Simultaneously, the authorities have continued their efforts to consolidate and restructure the banking system, most recently through support to the troubled small- and medium-sized banks. This section reviews progress to date in consolidating and stabilizing the banking system and the strategy for privatizing the state-controlled banks.
Overview of the Consolidation Program
124. The rehabilitation of the banking sector in the Czech Republic has gone through three phases: First with the consolidation of large banks in the early 1990s; second with the consolidation of small and medium-sized banks in the mid-1990s; and third with a further “stabilization” program for small banks starting in 1997. The first phase of the banking sector consolidation was implemented in 1991-93 (Consolidation Program I) and involved strengthening the position of the large state-owned banks through purchase of bad assets by the Consolidation Bank and recapitalization.79 The cost of these operations amounted to CZK 30 billion, of which CZK 22 billion related to the takeover of bad loans and CZK 8 billion to new capital. The cost of these operations was covered from the privatization proceeds of the NPF.80 In addition, the Consolidation Bank purchased other credits at 80 percent of face value in an amount of CZK 15 billion. The total support and cost in this first phase of the consolidation effort was thus CZK 45 billion (about 6 percent of 1992 GDP).
125. The second phase of the consolidation program (Consolidation Program II) was initiated at the end of 1995 following the failure of two smaller private banks (Ceska and AB Banka). This program focused on the small- and medium-sized banks established as new private banks after the beginning of the transition. Eighteen banks were selected for the program (covering nine percent of banking sector assets), of which nine were dealt with through capital increases by existing shareholders and new investors, two were taken over by Union Banka, five were placed under forced administration,81 and two were liquidated (including Kreditni Banka) (Table 17). Of the banks placed under conservatorship, one was subsequently taken over by Union Banka and one was liquidated, while solutions are still being sought for the remaining three banks. Deposit insurance was raised from the official limit of CZK 100,000 to CZK 4 million in the banks covered by Consolidation Program II, whereby 99 percent of all deposits were protected fully and 66 percent of total deposits were covered. The total resources committed and the implicit cost of this second phase of the consolidation program amounted to some CZK 30 billion (about 2 percent of 1996 GDP). This cost was borne by the CNB.
|Number of banks||Share of Total Banking Sector Assets (6/30/96)|
|No solution required||3||1.1|
|Of which after conservatorship||1||0.8|
126. The liquidation of Kreditni Banka in August 1996 led to a run on the closely associated Agrobanka, a medium-sized bank covering about 5 percent of deposits, and the bank was placed under forced administration, bringing the total number of banks currently managed this way to four. Outstanding liquidity support from the CNB to Agrobanka amounted to around CZK 16 billion, of which the authorities estimated that more than half would not be recovered. Attempts are ongoing to sell the bank to a foreign investor. There was also a small outstanding amount of liquidity support to other banks (about CZK 4 billion).
The Stabilization Program for Small Banks
127. The problems in Agrobanka led to the announcement in October 1996 of a program to further stabilize and strengthen the position of the small banks. The objective of this program is to restore the remaining problem banks to viability over the medium term through injection of additional private capital and recapitalization through profit generation. The government will provide cash-flow relief through the temporary purchase of bad assets at face value and will indirectly support the banks by forgoing interest. Banks are required to buy back the bad assets within a period of 5-7 years—in effect it is thus a long-term, interest-free repurchase agreement. Thirteen banks initially qualified for the program, but only six were interested in participating. These were approved by the central bank by October 1997 and will share the CZK 14 billion committed to the program. The authorities expect that the nominal value of the support will be fully recovered.
128. The key condition for participating in the program was the approval by the central bank of medium-term workout plans that would restore the banks to a viable position and allow them to repurchase the bad assets. These plans include improvements to, and the potential replacement of, management, reduction of high-risk activities (including limits on securities trading on own account), compliance with prudential regulations (capital, liquidity, lending, etc.), reductions in wage and operating costs, and accumulation of sufficient reserves, if needed through restrictions on profit distribution. Indications from shareholders to provide additional capital were generally an important element of the plans. Banks participating in the scheme would be subject to closer monitoring, although the authorities did not insist on representation on the respective bank boards. The central bank reserves the option to close a bank that is not complying with its plan, and such a procedure was initiated in one case (but subsequently aborted as the program was brought back on track).
129. The program was initially financed through the extension of short-term credit from the central bank to Ceska Financni (CF), a special purpose vehicle set up as a subsidiary of the CNB. CF was to be refinanced at market cost through the Consolidation Bank that would issue bonds for this purpose. The CNB also extended credit to CF in connection with the transfer of bad assets acquired directly by the central bank during the second phase of the consolidation program. At the end of September 1997, CF’s bad assets amounted to about CZK 24 billion, of which about CZK 17 billion represented loans and the rest, equities. Of this amount, about CZK 11 billion related to the stabilization program, CZK 9 billion to the second phase of the consolidation program, and CZK 4 billion to liquidity support extended by the central bank to smaller banks. CF can dispose of assets at a discount with the consent of the bank from which the assets were purchased. The bank will then be liable for the difference between the book value and the discounted sale price.
130. In summary, support amounting to some CZK 64 billion (3½ percent of GDP) was extended to the small and medium-sized banks in 1996-97 in connection with the second phase of the consolidation program (CZK 30 billion), the stabilization program (CZK 14 billion), and liquidity support to Agrobanka (CZK 16 billion) and other banks (CZK 4 billion). Of this amount, the authorities expect to recover about CZK 25 billion (1½ percent of GDP), somewhat less in present value terms. These are capital costs only, with no imputation of interest. The Government has issued a guarantee for CZK 22 billion to the CNB to cover potential losses from the support to the small and medium-sized banks. This guarantee, however, can only be called after 10 years.
Privatization of Large Banks
131. As mentioned, a key element of the April 1997 policy package was the announcement of the intention to accelerate the privatization of the four large, state-controlled banks (Komercni Banka, CSOB, Ceska Sporitelna, and IPB).82 The State has retained a controlling stake in each of these banks, amounting to 65 percent in CSOB, 49 percent in KB, 45 percent in CS, and 36 percent in IPB (Table 18).
132. In July 1997, the government reached an agreement in principle on the sale to Nomura of the State’s shareholding in IPB, in which Nomura had already acquired a significant stake. This weakened the government’s bargaining position and negotiations were protracted, partly because of the need to complete separate audits commissioned by the two parties.83 A final agreement was reached in late January 1998 under which Nomura would pay just under CZK 3 billion and inject additional capital as well as raise long-term funds for a total of CZK 12 billion.
133. In November 1997, the Klaus cabinet approved a strategy for privatizing the three other banks, according to which the divestment process would be carried out simultaneously for all banks with an initial sale of a strategic share in each of the banks to a single foreign investor.84 The government intended to sell at least 34 percent (and up to 51 percent) of the total shares in CSOB and 34 percent each of the shares in Komercni and Sporitelna. The sales would be conducted through a competitive bidding process in which each bidder could only obtain information in the due diligence process on one of the banks. The aim was to complete at least one of the sales by the end of 1998.
134. These divestment plans were very ambitious and indicative of the authorities’ confidence in the financial health of the banks, but the process is likely to be slowed down with the change in the political situation in late 1997 and early 1998. While the caretaker cabinet of Mr. Tosovsky appointed in January 1998 is proceeding with the technical preparation of the sales (advisors are being selected), a final decision is not likely to be taken until after the elections currently slated for mid-1998. Other factors may also complicate the process, notably certain bilateral disputes with Slovakia. An agreement has been reached in principle regarding Slovakia’s shares in Komercni, but an outstanding dispute concerning the CSOB has not yet been resolved. Specifically, the CSOB has a sizable nonperforming loan outstanding to the Slovak Collection Unit (a subsidiary of the Slovak Ministry of Finance), which is currently undergoing international arbitration.
Prepared by Anastassios Gagales and Thomas Laursen.
Three factors have contributed to the dominance of banks in the financial system: the legacy from central planning under which banks acted as enterprises’ accountants while enterprises lacked financial independence; the under-development of capital markets; and the high risks in the early stages of transition to a market economy, which made it difficult for enterprises to raise funds directly in capital markets.
Classified loans include watch, substandard, doubtful, and loss loans. The classification takes into account the delay in servicing, the debtor’s financial situation, and his previous payments record. For each category banks are required to build up provisions and reserves according to notional risk coefficients and may earmark part of their pre-tax income for this purpose. The annual rates of tax deductible allowances have been set so as to enable banks to reach the required level of provisions in five years. Annual additions to provisions and general reserves may not exceed 3 percent of total credits.
This figure excludes the Consolidation Bank (KOB); including it would have raised the share of classified credits to 33.5 percent (Table A28, SM/98/30, Sup. 1 (1/30/98). Notwithstanding a universal banking license, the KOB is a wholly state-owned bank established mainly for managing impaired loans taken over from large banks in 1991-92; it has also been actively involved in enterprise restructuring in its capacity as a major shareholder in a number of enterprises or on the basis of government resolutions. Classified credits exceeded 80 percent of its loan portfolio at end-1996, mostly loans taken over from the large banks in 1991-92 (by end-1996, about 20 percent of these loans had been recovered). Eventual loan losses would be covered by the state and the bank’s reserves were already strengthened in 1995 with a CZK 15 billion transfer by the National Property Fund in the form of a long-term nontradable bond. The authorities are considering converting KOB into a credit institution and merging it with Ceska Financni, a subsidiary of CNB performing a similar function in the restructuring of small banks, and Ceska Incasni, a state agency that took over nonperforming credits of CSOB to developing countries stemming from the pre-transition era.
A major difference between these two groups of banks is that the large banks lent primarily to state-controlled enterprises which have had a relatively low bankruptcy rate, but the clientele of smaller banks was mostly newly created enterprises, which subsequently experienced a high failure rate.
Hungarian and Polish banks have a far smaller share of classified credits, but benefited from cleaning-up operations in 1993, which removed impaired loans of about 15 percent of their loan portfolios. Prior to these operations, the share of classified credits in these countries was similar to the current one in the Czech Republic. However, cross-country comparisons should be viewed with some caution, given differences in criteria and enforcement rules.
For example, banks require the debtor’s approval to sell property, and if he refuses, a lengthy court process is needed for getting permission to sell the property.
For similar reasons they have been hesitant to securitize loans and sell them in the secondary market.
To capture the full effect of the new credits, namely, the generation of income that can be used to write off loss-loans, equation (1) needs to be supplemented with a profit equation (as in Annex V) and an estimate of the incidence of classified credits among new credits.
These were valuation adjustments. They translated to actual losses only to the extent that bonds were sold prior to maturity.
The risk coefficients should capture, in principle, the likelihood of default (credit risk) and the financial consequences of the default (default risk), namely, the extent of default, value of collateral, cost of collecting collateral, and legal costs.
After reassessing the market value of collateral on its classified credits (20 percent of outstanding credits), Komercni Banka announced in January 1998 that it would reduce the value of its collateral and raise correspondingly the provisions against loan losses by CZK 10.5 billion. The buildup of provisions was to be financed from profits and from general reserves. Nonetheless, the bank expected to meet the capital adequacy requirement.
In its press release IBCA noted that, despite write-offs, the share of classified loans in Komercni had increased to 34 percent (loss-loans: 21 percent) and cautioned that the downturn of economic activity and extensive floods in 1997 could lead to a further deterioration of asset quality. Komercni’s short-term rating was affirmed at A-; its overall rating remained the highest among Central and East European banks.
Standard & Poor’s changed its outlook concerning the three largest banks (Komercni, Ceska Sporitelna, and CSOB) from stable to negative and cautioned that their grades would be reduced if further if their sell-off became protracted.
By definition, the capital adequacy ratio exceeds the ratio of own funds to (unweighted) total bank assets reported in Table 11.
The accounting practice of considering as income interest accruals on loss loans does not affect overall profitability because banks are required to increase their provisions by the amount of interest accruals. Besides, the interest rate in the majority of loss-loans has been reduced to very low rates.
However, the sector as a whole managed to raise temporarily net interest income, as evidenced by the widening of the lending deposit spread by ½ percent despite the reduction in the required reserves ratio. The Savings bank, the prime lender in the interbank market, was the main beneficiary.
IMF, International Capital Markets, November 1997, page 147.
The marginal impact of the required reserves ratio on the spread is given by ρ. R.(1-ρ)-1 where ρ and R represent, respectively, the required reserves ratio and the marginal cost of funds.
In January 1996 the Basle Committee issued guidelines regarding capital adequacy for market risks.
These include notably the requirement that court proceedings be initiated against the debtor.
As an indication of the improved quality of supervision, the central bank in its capacity as chairman of the Eastern European Group of Bank Inspectors was invited to participate in the Basle Committee on Banking Supervision’s preparation of “Core Principles for Effective Banking Supervision”. These were issued in September 1997.
The 1992 EU Directive on Consolidated Supervision requires holding companies of banks or other companies within a banking group to provide information to the supervisory authorities.
See the 1996 Recent Economic Developments for further details.
A further CZK 5 billion was transferred to the Consolidation Bank at the end of 1997.
Banks placed under forced administration are kept open with the central bank acting as lender of last resort.
Significant divestment have already occurred as part of the voucher privatization with the sale of 53 percent of the shares in Kormercni, 52 percent of the shares in IPB, and 37 percent of the shares in CS. However, diffuse ownership and a restriction on foreign participation has effectively ensured that these remain state-controlled. 34 percent constitutes a blocking minority share.
Price Waterhouse conducted the audit for Nomura and Ernst&Young the audit for the government. The 1996 accounts of the bank were initially audited by Coopers & Lybrand who pointed to a substantial shortfall of reserves (around CZK 10 billion), but this report was not accepted by the bank and a subsequent audit by Ernst & Young did not reach this conclusion.
EBRD and IFC have expressed interest in participating in the privatization of the three banks.