Current situation

41. After having accumulated large amounts of underperforming loans, the Czech banking system is nearing the completion of a comprehensive restructuring and privatization program. The main features of this process are: carve-out of a significant part of the large nonperforming loan portfolio and its consolidation in KOB; the sale of the four large state banks to strategic foreign investors, and the merger of the business of two of these; and a reduction in the number of smaller banks. Reflecting in part the need to digest the new acquisitions and the lingering difficulties in part of the enterprise sector, bank managers are taking a cautious approach to credit policy; bank credit has declined slightly over the last three years in spite of the ongoing economic expansion, and is not likely to evidence rapid growth in the near future. While capital adequacy ratios appear comfortable, competition for creditworthy clients is intense, and profit margins are thin. Further consolidation may therefore be expected over the medium term.

42. The resolution of the banking crisis has accelerated the ongoing change in the structure of the Czech banking system. The share of banking system assets accounted for by the large banks has declined from over 80 percent in 1994 to about 60 percent now, while the share accounted for by the subsidiaries and branches of foreign banks has risen from 13 percent to over 30 percent. The number of small Czech-owned banks operating has been greatly reduced. Following the planned privatization of the last of the large banks in the near future, the Czech banking system will be about 90 percent foreign-controlled.

Origin of the large stock of nonperforming loans

43. Nonperforming loans stem from a variety of reasons. These include: inheritance of structural problems and inefficiencies from the pre-transition period; careless lending to privatized enterprises in the early 1990s; weak governance; political interference in lending decisions; weak creditors rights; and inadequate supervision. A determined effort to address all the weakness only was made in the second half of the 1990s.

44. The earlier relatively strong growth and poor classification policies initially masked the problem. It first became apparent among the smaller banks, several of which experienced difficulties in the mid-1990s. The 1997-99 recession and tightening of prudential policies, exposed the portfolio problems of the large banks as well. As the magnitude of the difficulties of the large state banks became evident, the authorities rightly adopted the strategy of privatization.

Restructuring of the banks

45. In the resolution of the banking crisis the authorities have relied on transformation agencies—KOB and its affiliates¹—to acquire bad loans from the banks to improve their balance sheet. For the small banks, these asset transfers were a prelude to closure as the resolution of the banking crisis among the small Czech banks resulted in the liquidation or consolidation of virtually all of those institutions that had experienced difficulties. For the larger banks the asset transfer has been in preparation for their privatization.

46. The first privatization proved to become a distinct failure. A controlling interest in IPB was sold to a foreign investor in 1998. However, the investor treated its acquisition as a portfolio investment, selling off part of its assets and leaving the existing management and management procedures in place. The sale had not involved any balance sheet clean up, and the bank’s situation continued to deteriorate although for a while the extent of this deterioration was not apparent. In June 2000, the CNB intervened, appointing a temporary administration of the bank, who immediately resold the business of the bank.

47. Subsequent privatizations appear to have been successful. Another large state bank (Československá obchodní banka—CSOB), had meanwhile been sold to a strategic foreign investor in 1999. In early 2000 a third state bank (Česká spořitelna—CS) was sold to a foreign investor. The last of the four large banks (Komerční banka—KB) is expected to be privatized later this year, and four strategic investors have reportedly placed bids on the bank.

48. The later privatizations have all involved carve out of non-performing loans, and have led to a sharp increase in current and prospective holdings of nonperforming loans by KOB. The holding of nonperforming loans by KOB and subsidiaries at end 2000 stood at CZK 186.6 billion (equivalent to 9.6 percent of GDP (Table 2). In addition to the outright transfer, KOB guaranteed (“ring fenced”) a nominal value of CZK 25 billion of assets that remained on the books of CSOB. The total carve out associated with the recent resale of IPB is not yet fully known. It is likely that CZK 100 billion will be transferred outright to KOB. But in addition there are uncertainties about the quality of an additional CZK 150 billion, and it is possible that some CZK 100 billion of that will be ring fenced on the books of CSOB. Finally, for KB, the authorities have announced that in addition to earlier carve-outs they will only guarantee up to CZK 20 billion. On these assumptions, the KOB group’s portfolio of nonperforming loans plus the ring fenced portfolio (for which it carries the credit risk) could increase to CZK 431.6 billion, equivalent to 21.2 percent of 2001 GDP.

Table 2.

Czech Republic: Projected Loan Portfolio and Contingent Risk Exposure of KOB Group

(In billions of korunas)

Source: CNB, KOB, and staff estimates.

^1/Data for CF and Konpo up to end-September.

^2/Loans only. KOB loans of CZK 14.9 million to CF and CZK 31.8 billion to Konpo have been netted out.

^3/The increase in the amount of bad loans as a percentage of GDP reflects in large part the misclassification of IPB’s loans.

Table 2.

Czech Republic: Projected Loan Portfolio and Contingent Risk Exposure of KOB Group

(In billions of korunas)

		Estimates December 2000 1/	Projected Exposure June 2001
		Total	Ring fencing	Transfer	Total 3/
Gross loans 2/		205.3	145	100	450
Standard		18.7			18.7
Nonperforming		186.6			431.6
	(In percent of GDP)	(9.8)			(21.2)
Memorandum items:
Left with banking system		171.5			80.5
	(In percent of GDP)	(9.0)			(4.0)

Source: CNB, KOB, and staff estimates.

^1/Data for CF and Konpo up to end-September.

^2/Loans only. KOB loans of CZK 14.9 million to CF and CZK 31.8 billion to Konpo have been netted out.

^3/The increase in the amount of bad loans as a percentage of GDP reflects in large part the misclassification of IPB’s loans.

View Table

Table 2.

Czech Republic: Projected Loan Portfolio and Contingent Risk Exposure of KOB Group

(In billions of korunas)

		Estimates December 2000 1/	Projected Exposure June 2001
		Total	Ring fencing	Transfer	Total 3/
Gross loans 2/		205.3	145	100	450
Standard		18.7			18.7
Nonperforming		186.6			431.6
	(In percent of GDP)	(9.8)			(21.2)
Memorandum items:
Left with banking system		171.5			80.5
	(In percent of GDP)	(9.0)			(4.0)

Source: CNB, KOB, and staff estimates.

^1/Data for CF and Konpo up to end-September.

^2/Loans only. KOB loans of CZK 14.9 million to CF and CZK 31.8 billion to Konpo have been netted out.

^3/The increase in the amount of bad loans as a percentage of GDP reflects in large part the misclassification of IPB’s loans.

49. As a result of the above carve-outs, the remaining classified loans (categories 2 to 5) on the balance sheet of the banks will be reduced to a more manageable, but still significant level. Banks will be left with an estimated CZK 75 billion in watch loans (category 2), the equivalent of 10 percent of their loan portfolio, and with CZK 80.5 billion in nonperforming loans (NPLs) (categories 3 to 5), excluding the ring-fenced loans, the equivalent of 11 percent of their portfolio. The risk of watch loans migrating to the NPL category seems low, given the stringent classification criteria, although some risk cannot be excluded. The collateral on the NPLs amounts to CZK 68.3 billion, and provisions and reserves amount to CZK 58.9 billion. The sum of collateral, provisions and reserves seem sufficient to cover future losses associated with the NPLs. However, collateral is probably overvalued, given the problems that creditors have experienced in foreclosing on collateral.

50. The residual vulnerability of the banking sector will be further contained by privatization of the restructured banks to strong strategic investors. Improvements in the legal framework and the tax treatment of provisions would reduce the degree of vulnerability further. The upturn of the economy and the introduction of stronger lending policies by the new strategic investors should support a better loan performance going forward. The banking system seems well-capitalized, with an average capital to risk assets of 17 percent, and the growing presence of financially strong strategic investors. However, the importance of collateral for the coverage of loan losses indicates the need to keep improving the collateral and insolvency regimes, in order to enhance the realizable value of collateral in the banks’ books. The fact that provisions are only partially tax deductible is also a matter of concern, as it provides an incentive for the banks to misclassify their loans and/or under provision them. The lack of full tax deductibility for loan write off also provides an incentive for banks to keep such loans on their balance sheet, and discourages loan work outs. This points to the need of introducing full tax deductibility of mandatory provisions.

Cost to the government

51. The restructuring and privatization of banks has come at a significant cost to the government. The costs already incurred have amounted to CZK 100 billion. Recent estimates indicate that the additional costs will probably be around CZK 300 billion resulting in a total cost of CZK 400 billion or 21 percent of 2000 GDP.² The preliminary estimates of the MoF assume that the additional costs would amount to only CZK 200 billion. However, these estimates assume that the losses associated with the carve-outs from IPB would amount to only CZK 50 billion, an assumption is likely to prove too optimistic, given more recent information on the poor quality of IPB’s assets and the very low provisions on these assets. More realistic assumptions for the final carve-outs and ring-fenced loans, combined with a reasonable recovery rate of 15 percent, would result in future losses of CZK 300 billion. Assuming the same funding costs as for the recently placed ten-year bonds, the annual interest cost to the budget would be equivalent to CZK 25 billion, or 1.3 percent of GDP.

52. Significant challenges are facing KOB in recovering maximum asset value to help reduce the ultimate cost to the budget. I this context the recent pool sale of a portfolio of nonperforming loans held by KOB was an important test case for the disposal of assets. Although the realized value at about 11 percent of the value at which it was valued on the KOB balance sheet may appear disappointing, it was to be expected given the poor quality of the loans. A continuation of the pool sales would appear to be the best way to proceed to ensure that assets are resolved in a transparent and efficient manner.

Performance, stress testing, and future stability

53. Credit risk remains the dominant vulnerability, based on the stress test results. On the basis of the potential macroeconomic vulnerabilities identified above (Section II.B.), stress tests were conducted for credit risk and market risk (interest and exchange rate changes). A shock meant to replicate the worsening of the NPL ratio that occurred during the period of the Czech recession (a 62 percent increase in nonperforming loans) produces significant negative effects on bank capital positions, with three banks falling well below the Basel minimum capital ratio of 8 percent (Table 3).³ This test, however, is relatively severe because the companies getting new loans are more profitable and less debt-burdened—and, therefore, more capable of withstanding an economic shock—than the borrowers that defaulted in the earlier recession.

Table 3.

Czech Republic: First-Round Results of Stress Tests of Macroprudential Indicators

Source: CNB, IMF staff.

Table 3.

Czech Republic: First-Round Results of Stress Tests of Macroprudential Indicators

Scenarios	Baseline	Credit risk	Foreign exchange risk	Interest rate risk
	(In percent)
NPL/gross loans	9.8	15.9
Foreign exchange rate	37.8		44.0
Short-term interest rate	5.30			6.80
Long-term interest rate	7.00			8.50
Capital ratio (system)	16.9	12.8	16.9	15.9
	(Number of banks in range indicated)
>20%	5	3	5	4
15%-20%	3	2	3	3
10%-15%	8	7	8	7
5%-10%	0	1	0	2
0%-5%	0	3	0	0
<0%	0	0	0	0

Source: CNB, IMF staff.

View Table

Table 3.

Czech Republic: First-Round Results of Stress Tests of Macroprudential Indicators

Scenarios	Baseline	Credit risk	Foreign exchange risk	Interest rate risk
	(In percent)
NPL/gross loans	9.8	15.9
Foreign exchange rate	37.8		44.0
Short-term interest rate	5.30			6.80
Long-term interest rate	7.00			8.50
Capital ratio (system)	16.9	12.8	16.9	15.9
	(Number of banks in range indicated)
>20%	5	3	5	4
15%-20%	3	2	3	3
10%-15%	8	7	8	7
5%-10%	0	1	0	2
0%-5%	0	3	0	0
<0%	0	0	0	0

Source: CNB, IMF staff.

54. At present, bank exposure to market risk does not pose a systemic problem. Stress tests show that banks can absorb both a significant upward yield curve shift (1.5 percentage points) and a sharp monetary tightening (a 4.5 percentage point increase in short-term rates). In this case, only two banks dip below a 10 percent capital ratio and none below 8 percent. It should be noted, however, that the impact on interest rates of the fiscal vulnerabilities could potentially be more severe and that they might give rise to secondary effects on the quality of the loan portfolio. For foreign exchange risk, banks across the board show negligible net exposures and are unaffected in a stress test by even large changes in exchange rates. Again, it should of course be borne in mind that such static stress tests do not take into account any secondary effect on the quality of the loan portfolio through a higher debt service burden for borrowing companies. Such an impact, however, appears, to be manageable. Analysis of the financial conditions of the corporate sector (see below) suggests that the debt of the most leveraged companies has been or is in the process of being transferred to workout institutions.

55. A consequence of the banking crisis and its resolution has been a marked change in the behavior of banks in the Czech system with regard to business lending. The crisis revealed a paucity of creditworthy borrowers among Czech companies, weak creditor rights and poor corporate governance and incentives. Foreign banks continue to lend profitably to their traditional customer base of international companies operating in the country but they remain reluctant to make commitments on commercial and industrial loans in the domestic market. They have been joined now in that reluctance by the large banks, operating under the stricter credit standards of their new ownership and management. The outcome of these changes is general stagnation in loan availabilities and intensified competition for the few good name borrowers.

56. At the same time, deposit growth has continued, putting banks across the system into a highly liquid state. As a result, banks have acquired a large amount and wide array of low-yielding liquid assets at a time when higher yield assets are needed to hit ROE targets. Banks, therefore, are in an environment of pressure on profits. The aggregate ROA for the system—measured as operating profit before provisions, taxes, and extraordinary items—averaged 1.22 percent over 1995-97 and -0.08 percent over 1998-2000. Interest rate margins and gross earnings measures have declined as banks compete for a small pool of good borrowers, while the rate of operating costs has not seen big economies so far (Tables 4 and 5). Profitability improved in 2000 although this was overstated by the taking into profits of some provisions in connection with the transfer of loans to KOB. Adjusting for this, banks registered only minor profits.

Table 4.

Czech Republic: Profitability Indicators of Czech Banks

(In percent)

Sources: CNB and staff calculations.

Table 4.

Czech Republic: Profitability Indicators of Czech Banks

(In percent)

	1997	1998	1999	2000
				Mar.	June	Sep.	Nov.
Interest rate spread/assets	3.76	3.52	2.63	2.40	2.44	2.54	…
Profits from banking activities/assets	4.55	4.53	3.90	3.43	3.30	3.31	…
Operating expenses/assets	2.21	2.25	2.21	1.96	2.12	2.11	…
Rate on new credits (short-term)	15.91	11.64	6.74	6.89	6.85	6.54	6.41
Rate on deposits (short-term)	11.20	9.16	4.82	4.56	4.37	4.26	4.09
Spread: new credits - deposits	4.71	2.48	1.92	2.33	2.48	2.28	2.32

Sources: CNB and staff calculations.

View Table

Table 4.

Czech Republic: Profitability Indicators of Czech Banks

(In percent)

	1997	1998	1999	2000
				Mar.	June	Sep.	Nov.
Interest rate spread/assets	3.76	3.52	2.63	2.40	2.44	2.54	…
Profits from banking activities/assets	4.55	4.53	3.90	3.43	3.30	3.31	…
Operating expenses/assets	2.21	2.25	2.21	1.96	2.12	2.11	…
Rate on new credits (short-term)	15.91	11.64	6.74	6.89	6.85	6.54	6.41
Rate on deposits (short-term)	11.20	9.16	4.82	4.56	4.37	4.26	4.09
Spread: new credits - deposits	4.71	2.48	1.92	2.33	2.48	2.28	2.32

Sources: CNB and staff calculations.

Table 5.

Macroprudential Indicators

(In percent; year-end data)

Source: CNB

Table 5.

Macroprudential Indicators

(In percent; year-end data)

			1996	1997	1998	1999	2000
CAPITAL ADEQUACY
Tier-1 capital / risk-weighted assets			9.23	8.56	9.46	10.85	13.71
Total capital / risk-weighted assets			9.95	9.49	12.06	13.64	17.23	(Nov)
Total capital / total assets			5.68	5.10	5.70	5.77	5.07	(Nov)
ASSETS
Share of loans (exposures)		RW = 0%	23.2	25.1	32.0	35.1	39.9
per risk weight (RW) category:		RW = 20%	22.5	24.9	23.1	23.9	25.5
		RW = 50%	1.5	1.8	2.0	1.9	2.5
		RW = 100%	52.8	48.2	42.9	39.1	32.2
Total exposures/Total assets			105.9	106.2	106.5	106.8	110.6
Loan (or exposure) concentration
Sectoral concentration:
	individuals		…	5.12	6.41	8.47	10.75	(Nov)
	government		…	0.87	1.28	1.27	1.44	(Nov)
	agricultural sector		…	2.32	2.35	2.31	2.17	(Nov)
	mining		…	2.00	1.81	1.70	1.46	(Nov)
	manufacturing		…	30.36	28.68	25.76	24.39	(Nov)
	transportation		…	3.12	2.58	2.50	2.79	(Nov)
	financial services		…	6.47	7.31	6.90	7.51	(Nov)
	other services		…	49.74	49.57	51.08	49.49	(Nov)
Foreign currency lending
Foreign exchange loans / total loans			18.8	24.8	25.1	26.0	25.2
Nonperforming loans (or exposures)
NPLs / total gross loans (or exposures)			21.6	20.5	20.3	21.5	19.5
NPLs net of provisions / total capital			104.1	99.0	72.8	71.1	60.2
MANAGEMENT
Expenses/revenues			80.6	79.5	82.9	83.0	70.4	(Nov)
Earnings/employee (in thousands of korunas)			1,300	1,702	1,865	1,845	1,725
EARNINGS
Return on (average) assets			…	−0.02	−0.20	−0.20	1.57	(Dec)
Return on (average) equity			…	−0.25	−3.30	−3.48	10.23	(Dec)
Interest margin / gross income			47.9	45.8	73.0	58.2	66.9	(Dec)
Noninterest expenses / gross income			80.7	68.6	92.8	107.9	99.6	(Dec)
LIQUIDITY
Liquid assets / total assets			16.2	17.0	23.1	26.4	26.8	(Dec)
Liquid assets / short-term liabilities			…	…	54.9	63.9	62.1

Source: CNB

View Table

Table 5.

Macroprudential Indicators

(In percent; year-end data)

			1996	1997	1998	1999	2000
CAPITAL ADEQUACY
Tier-1 capital / risk-weighted assets			9.23	8.56	9.46	10.85	13.71
Total capital / risk-weighted assets			9.95	9.49	12.06	13.64	17.23	(Nov)
Total capital / total assets			5.68	5.10	5.70	5.77	5.07	(Nov)
ASSETS
Share of loans (exposures)		RW = 0%	23.2	25.1	32.0	35.1	39.9
per risk weight (RW) category:		RW = 20%	22.5	24.9	23.1	23.9	25.5
		RW = 50%	1.5	1.8	2.0	1.9	2.5
		RW = 100%	52.8	48.2	42.9	39.1	32.2
Total exposures/Total assets			105.9	106.2	106.5	106.8	110.6
Loan (or exposure) concentration
Sectoral concentration:
	individuals		…	5.12	6.41	8.47	10.75	(Nov)
	government		…	0.87	1.28	1.27	1.44	(Nov)
	agricultural sector		…	2.32	2.35	2.31	2.17	(Nov)
	mining		…	2.00	1.81	1.70	1.46	(Nov)
	manufacturing		…	30.36	28.68	25.76	24.39	(Nov)
	transportation		…	3.12	2.58	2.50	2.79	(Nov)
	financial services		…	6.47	7.31	6.90	7.51	(Nov)
	other services		…	49.74	49.57	51.08	49.49	(Nov)
Foreign currency lending
Foreign exchange loans / total loans			18.8	24.8	25.1	26.0	25.2
Nonperforming loans (or exposures)
NPLs / total gross loans (or exposures)			21.6	20.5	20.3	21.5	19.5
NPLs net of provisions / total capital			104.1	99.0	72.8	71.1	60.2
MANAGEMENT
Expenses/revenues			80.6	79.5	82.9	83.0	70.4	(Nov)
Earnings/employee (in thousands of korunas)			1,300	1,702	1,865	1,845	1,725
EARNINGS
Return on (average) assets			…	−0.02	−0.20	−0.20	1.57	(Dec)
Return on (average) equity			…	−0.25	−3.30	−3.48	10.23	(Dec)
Interest margin / gross income			47.9	45.8	73.0	58.2	66.9	(Dec)
Noninterest expenses / gross income			80.7	68.6	92.8	107.9	99.6	(Dec)
LIQUIDITY
Liquid assets / total assets			16.2	17.0	23.1	26.4	26.8	(Dec)
Liquid assets / short-term liabilities			…	…	54.9	63.9	62.1

Source: CNB

57. Bank managements have indicated their general reluctance to make any strong commitment at present to commercial lending until evidence of improved creditworthiness in borrowers is established, and the legal framework for debt enforcement is improved. Recent reforms, such as the Public Auction Law, and other prospective changes that promise to improve creditor rights and collateral quality may reanimate growth of collateralized credits. However, these reforms still need to be tested (Box 1).

58. Under the current conditions of excess liquidity and continued concern over the credit worthiness of enterprises, a principal vulnerability facing the Czech system is that banks may take risks in nontraditional business lines in order to generate higher returns. Many banks have expressed their interest in pursuing the retail banking market—credit cards, consumer loans, household mortgages. While these kinds of loans have a track record of superior performance compared to business loans, vigilance is required to avoid that intense competition in these rather limited markets may lead to a slippage of credit standards.

Banking supervisory vulnerabilities

59. Czech banking supervision has improved in recent years although vulnerabilities remain. In preparation for EU accession, the legal framework covering the regulation of the banking sector is being gradually harmonized with EU minimum standards and international best practice. Overall, the CNB was found compliant/largely compliant with 20 of the 25 Basel Core Principles. A recent amendment to the Act of Banks, that would have, inter alia, extended the scope of consolidated supervision, was rejected by parliament but is expected to be re-submitted during 2001. Amendments to the Bankruptcy Act and the enactment of a new Public Auction Law have strengthened the rights of banks in the enforcement of security. However, the operation of the courts remains slow and the banks continue to report a lack of willingness on the part of court officials to support creditor action. Further legislative and judicial reform in this area is essential.

60. The quality of supervisory staff has improved although current skills amongst the supervisors to assess market risk, audit computer-based systems and evaluate risk management systems remain low. Moreover, heavy staff turnover, particularly among the inspection teams, has led to resource pressures within the CNB, both in terms of staff numbers and experience levels. Remaining weaknesses include:

• banks not yet required to allocate capital to cover market risk on a consolidated basis;

• consolidated supervision yet to be extended to nonbank financial holding companies or mixed holding companies;

• insufficient attention provided to corporate governance and internal control functions;

• a lack of clarity with respect to the role and responsibilities shared by the CNB (banking supervision), the MoF (insurance supervision), and the CSC (securities supervision) for the supervision of firms operating in all three financial sectors; and

• although anti-money laundering is covered by separate legislation, key reporting requirements should also be set out explicitly in CNB banking regulations.

61. With the large inflow of foreign investment into the Czech banking sector, a number of banks have imported credit systems from their parent operations. While this will encourage an improvement in the practice of credit management, there remains a lack of a formal requirement for banks to set out their policies, practices and procedures relating to the credit process. The predominant foreign control of the Czech banking system highlights the urgent need for strengthened supervision of foreign banks’ establishments. Most importantly, it will require an efficient system of information sharing and formal Memoranda of Understanding (MOUs) with supervisory counterparts. So far, only a few MOUs have been signed.

Safety net arrangements

62. The Czech deposit insurance scheme, which is operated by the Deposit Insurance Fund (DIF), was introduced in 1994. Although nominally limited to CZK 400,000, of the 10 banks that have failed during the life of the DIF, depositors of seven banks received a full reimbursement of their funds up to a maximum value of CZK 4 million. An amendment to the Act on Banks which is currently under consideration would require the DIF to equalize the position for depositors of the remaining three failed banks by also offering a compensation up to CZK 4 million. The decision to reimburse depositors in excess of the notional deposit guarantee ceiling was taken to ensure the stability of the banking sector as a whole. However, it is likely to have created an expectation among depositors that their deposits will be fully guaranteed by the authorities in the event of any future bank failures. This raises the threat of moral hazard and potentially reduces the motivation for banks and depositors to exercise discipline in terms of risk-based decision making.

63. More generally the capacity of the DIF carry out its narrow “pay box” role remains limited. DIF reserves, which have been drained as a result of previous pay outs, are equivalent to less than 1 percent of the total of insured deposits. This would be insufficient to deal with a failure of a medium- or large-sized bank or a number of small bank failures. Furthermore, proposals to raise the ceiling on deposit insurance to € 25,000 and to broaden the coverage to include foreign currency deposits, while at the same time reducing the percentage of insured deposits that the banks are required to pay to the DIF, will further limit the DIF’s ability to meet any obligations that may arise in the short-term.

64. Although previously the DIF has been able to rely on automatic access to funding from the government and the CNB, proposals now being considered by parliament would remove the obligation of the authorities to lend to the DIF. Instead, the DIF would be required to seek market funding. The appetite in the market for DIF-issued debt remains untested. The changes in the funding structure will present new challenges for the DIF. It will require the DIF to anticipate more precisely future demands on its reserves so that it can discharge its payout function on a timely basis. Greater effort is also required to better inform the public of its roles and responsibilities and improve operating systems relating to setting and collecting premiums.

Credit unions

83. The credit unions are not systemically important. Although losses due to poor lending controls and fraud have been significant in relation to the size of the credit union sector as a whole, there is nothing to indicate any contagion to the rest of the financial sector. Although the legislation covering credit unions was amended in May 2000 giving the regulator, the CUSA, increased powers, the problems that emerged as a result of the original weaknesses in supervision continue to adversely affect the sector. On the basis of current estimates credit union members have lost as much as 90 percent of their aggregate deposits.

84. In the short run, the problem facing the CUSA and the MoF relates to the claims resting with the Credit Union Insurance Fund, and the resolution of the credit unions that are under conservatorship. In addition, a licensing, regulatory framework needs to be put in place that will permit only the financial and managerially sound credit unions to function. However, the continuing viability of the credit union sector remains unclear. Competition from banks, after their restructuring phase is completed, will pose asset side pressures on the credit unions. The challenge will be to ensure that credit unions make prudent investment and lending decisions within a revamped regulatory framework. Consideration also needs to be given to bring the regulation and supervision of all types of deposit-taking financial institutions under a unified supervisory framework.

Leasing companies

85. In the absence of significant amounts of bank credits being made available to the SME sector, leasing has emerged as an important intermediator for small- and medium-sized enterprises. This development also reflects the weak legal environment to support creditor rights and debt enforcement. During the 1990s there has been a sharp growth in the size of the Czech leasing industry. As of January 2000 there were 122 leasing companies that were members of the Czech Association of Leasing Companies (CALC). The CALC accounts for 95 percent of the domestic leasing market. Most leasing business is undertaken by bank subsidiaries or captive companies of the major automobile companies.

86. Between 1995 and 1999 the value of new leasing contracts written during the year increased from CZK 29 billion to CZK 81 billion. The total value of outstanding leasing contracts had reached around CZK 150 billion at end-1999, or about 5 percent of total bank assets. This level of business is high by regional standards. The value of new contracts written in 1999 accounted for more than 1.5 percent of the European volume, with the Czech Republic ranked twelfth among European countries by volume. There is no regulatory oversight of the leasing sector, other than of bank subsidiaries that has yet to be fully integrated within the consolidated supervision framework of the CNB.

Clarity of roles, responsibilities and objectives of the central bank

10. The different formulations of the primary objective of CNB in the Constitution and the recently amended CNB Act can potentially convey confusing signals to the public. Transparency relating to the institutional relationship between monetary and fiscal operations carries several gaps. The terms of government deposits at the central bank are not adequately disclosed. CNB responsibilities for the management of domestic and external public debt and foreign exchange reserves are not detailed or explained in CNB publications. The CNB and the MoF are in the process of preparing a formal agreement on the priorities of public debt management. At this stage, it is not clear whether this document will be made public.

Open process for formulating and reporting monetary policy decisions

11. The conduct of monetary policy and the principles on which it is based are open and transparent. The rules and procedures for the CNB’s relationships and transactions with counterparties in the foreign exchange market and the market of government securities, however, are not publicly disclosed. Also, major shortcoming relates to the lack of consultations with market participants and other interested parties at the time of substantive technical changes in the structure of monetary regulations and monetary policy operations. Apart from the fact that practice of such a system would help the market to adequately prepare for operating and regulatory changes, it would also contribute to good governance on the part of the CNB and provide inputs for better and well understood policies.

Public availability of information on monetary policy

12. The CNB provides a wide range of information and publications and is Special Data Dissemination Standard (SDDS) compliant. The use of the automatic deposit and credit facilities, however, is not adequately disclosed, as their amounts do not appear as separate items in the CNB’s balance sheet.

13. The amounts and terms of emergency financial support by the central bank are not publicly disclosed.

14. The categories in the annual CNB balance sheet and profit-and-loss account change every year, which makes it difficult to conduct consistent comparisons of monetary developments over time.

Accountability and assurances of integrity by the central bank

15. A high degree of transparency exists with respect to the CNB’s public accountability, including preparation of annual report, audited accounts, half yearly report to the legislature on monetary developments and periodic appearances before various committees of the legislature. The Freedom of Information Act requires the CNB to respond in writing to individual requests for information within 15 days. However, the CNB’s internal governance procedures are not publicly disclosed.

Institutional and macroprudential setting, market structure—overview

20. The commercial banking sector has been undergoing fundamental structural changes during the 1990s. The second half of the 1990s, particularly the period after 1996, has been a critical period for the Czech banking system, marked by deterioration in the loan portfolio, placement of banks under conservatorship, revocation of as many as 16 banking licenses, tightening of provisioning norms, mergers, continuing transfer of bad debts to KOB, privatization of large state-owned commercial banks, the problem of the IPB sale, and mounting fiscal cost of the bank restructuring and privatization effort. Apart from the resources required to manage such an operation, the complex legal, institutional, and administrative processes have made it a demanding task.

21. The banking system presently consists of 40 licensed institutions—KOB, 13 Czech-owned banks and 26 foreign banks—dominated by the three largest banks (CSOB, KB, and CS). The three banks have a combined market share of 60 percent. Subsidiaries and branches of foreign banks account for 31.3 percent of the total assets, while the small- and medium-sized domestic banks have a market share of 1.6 percent In addition there are six building societies, and three specialized financial institutions (licensed as banks).

22. The bank privatization process gained momentum during 1999 and 2000 with the sale of CSOB in July 1999 and sale of majority ownership in CS in March 2000. KB is being prepared for sale in 2001. The failure of IPB that was sold to Nomura in 1998 has however provided a setback to the restructuring process and raised several questions relating to early detection of problems in banks, internal control systems, and the role of external auditors. To deal with the problem loans, the government, with the active involvement of the CNB, has set up a variety of workout modalities to acquire the bad loans and clean up the bank balance sheets to promote privatization.

23. The Czech banking system continues to face significant challenges and opportunities in the future. The evolving banking structure, emergence of financial conglomerates, changing ownership structure of the banks, growth in the nonbank sector, has led to a fundamental change in the competitive character of the banking industry. The earnings environment remains weak, as do the avenues for high margin investments. The banking system as it stands today, is highly liquid, marginally profitable, and is making strategic shifts in its business orientation in order to maintain its operating profitability.

Preconditions for effective banking supervision⁹

24. While the Basle Core Principle assessment was not undertaken to evaluate the supervisory performance during the restructuring phase, the assessment has shown that the CNB has responded to these challenges by strengthening the supervisory framework, including enlarging the requirements for licensing, tightening provisioning rules, enhanced disclosure requirements, strengthening supervisory resources, stricter requirements relating to bank auditors, and automatic revocation of license in cases where the capital adequacy drops below a minimum stipulated ratio.

25. The supporting legal system, however, is in transition, and the legislative changes made during 2000 remain largely untested in terms of the way they relate to the banking system. The overall objective is to adapt laws and regulations to conform to EU directives. In addition, the approach is to remedy the current imbalance favoring the debtor vis-à-vis the creditor in the existing laws. The legal reform has included the overall recodification of the commercial law, a reconstruction of the bankruptcy law, and changes in the legal regime of pledges and possessionary lien. Amendments to the CNB Act have been adopted while a new Public Auction Law is in place.

26. The supervisory staff is gaining in professionalism, and its awareness and understanding of international supervisory standards, policies, and practices are very high. However, the current skills to assess market risk, audit computer based systems and evaluate risk management systems are low. This is coupled with a thin complement of supervisors who mainly conduct traditional full-scope inspections and have yet to begin a systematic process to carry out risk-based inspections. The CNB is planning to strengthen training and building of special skills in these new areas.

27. The CNB operates with a relative high degree of independence on supervisory policies. However, on bank restructuring and problem banks, the CNB’s supervisory practices require it to work closely with the government and agencies responsible for implementing laws that directly affect banking operations.¹⁰ Furthermore, the CNB is required to consult with the MoF prior to licensing a new bank, although the final decision of whether to grant a new license is taken by the CNB. In practice, the large array of laws, inefficiencies in the judicial processes and cumbersome administrative requirements impedes effective and timely supervisory enforcement and intervention in the case of problem banks. Supervision is also subject to strict secrecy requirements that restrict information sharing among domestic and foreign supervisors. The laws and administrative procedures on money laundering lag behind those in other countries and need strengthening. The CNB is fully cognizant of these limitations and has been taking up the subject of legal and administrative reforms with the government. The amendments to the AoB that were recently rejected by Parliament would have considerably strengthened the supervisory powers and supported the effective implementation of supervisory policies and regulations.

28. Regarding accounting practices, Czech banks are required to follow Czech accounting standards. While close to International Accounting Standards (IAS), differences remain in two areas, namely in the areas of consolidation and accounting for fair value of financial instruments. By law, banks must appoint an external auditor and notify the CNB of the selection. Auditors’ unqualified opinions state that a bank’s financial statements are audited in accordance with the Act on Auditors and the Chamber of Auditors that they present fairly, in all material respects, the condition and the results of the bank in accordance with the Act on Accounting, and that they are prepared from accounting records which are in accordance with the Act on Accounting. In the case of most major banks, accounts are also audited in accordance with International Standards on Auditing and their statements prepared in accordance with IAS.

Main findings

29. The Czech banking system practices universal banking. Banking sector involvement in the insurance and securities sectors is growing. Ownership structures within the banking sector are changing and the market share of branches and subsidiaries of foreign banks is expanding. There is increasing need to ensure that banks systematically measure and monitor the growing market risks. Banks are also facing competitive pressures in a difficult earnings environment. This may lead to aggressive and risky lending behavior in some banks and the exploitation of cross-sectoral business opportunities as banks seek to maintain profit levels and will require enhanced credit administration and internal control systems.

30. At an operational level it is worth noting that the general quality of CNB supervisors appears to have improved in the recent period. Extensive training programs and technical assistance have deepened the supervisors’ understanding of the business and control risks faced by Czech banks. However, the availability of supervisory resources remains a key issue and staff turnover rates among CNB supervisors are already at very high levels. Should the attrition rate remain at the current level, or increase further, it would almost certainly weaken the CNB’s ability to regulate the banking sector.

31. Steps are underway to strengthen the legal framework and prudential requirements. The AoB has been amended 11 times since 1992, although the recent round of amendments, mainly in preparation for EU accession and to improve the CNB’s oversight of the banking system, failed to receive Parliamentary approval and will need to be resubmitted. This will delay the required legal reforms in key supervisory areas such as consolidated supervision. The prudential framework was strengthened in April 2000 with the introduction of the modified capital adequacy requirement based on market risk on a solo basis. Reporting of capital and large exposures on a consolidated basis was introduced in January 2000 covering only credit risk.

32. A number of other supervisory issues came up during the Core Principle (CP) assessment that require attention Although the CNB has implemented a capital adequacy (CP 6) requirement for credit and market risk, it is on a solo basis only. At the consolidated level banks are only required to calculate a capital adequacy ratio for credit risk. The CNB plans to expand the coverage of the consolidated capital ratio to include market risk in early 2002.¹¹

33. Credit risk (CP 7) remains the key risk facing the Czech banking sector, as evidenced by the scale of nonperforming loans within the country. With the large inflow of foreign investment into the Czech banking sector, a number of banks have imported credit systems from their parent operations. While this is likely to encourage an improvement in the practice of credit management, there are no formal requirements within the Czech banking regulations for banks to set out their policies, practices and procedures relating to the credit process (origination, ongoing management, etc). The position is similar for other risks (CP 13) where, apart from market risk in the trading book, there are no formal requirements for banks to put in place comprehensive procedures for risk management.

34. In terms of anti-money laundering (CP 15) controls, “know-your-customer” requirements are not explicitly set out within the banking regulations. The banks are presently not required to report to the supervisor any suspicious activities and incidents of fraud which might threaten the safety, soundness or reputation of the bank. At present the scope of consolidated supervision (CP 20) in the Czech Republic only relates to groups headed by a bank. A planned amendment to the Act on Banks should allow the CNB to require consolidated reporting from financial holding companies and greater access to information from mixed holding companies where there is a bank presence. Similarly, the CNB currently has limited powers in respect of global consolidated supervision (CP 23). While the CNB can supervise overseas branches and foreign subsidiaries of Czech banks (subject to local laws), it only has very limited powers to restrict the activities of those operations or to require their closure should they pose a threat to the bank as a whole. There is also a need for strengthening, on a priority basis, mechanisms for coordinated supervisory information sharing and action, wherever required, among the CNB, the MoF (insurance), and the CSC (securities).

35. In addition, efforts are needed to improve the implementation and compliance with the following core principles where shortcomings were assessed. Specific recommended actions have been indicated in Table 9 against the respective principles: CP 1 (objectives); CP 2 (permissible activities); CP 3 (licensing criteria); CP 4 (ownership); CP 6 (capital adequacy); CP 8 (loan evaluation); CP 9 (large exposures limits); CP 10 (connected lending); CP 11 (country risk); CP 12 (market risk); CP 14 (internal control and audit); CP 16 (on-site and off-site supervision); CP 17 (bank management); CP 18 (off-site supervision); CP 19 (validation of information); CP 21 (accounting standards); CP 22 (remedial measures); CP 24 (host country supervision); and CP 25 (supervision of foreign establishments).

Table 9.

Summary of Main Findings and Recommendations

Table 9.

Summary of Main Findings and Recommendations

CPs Main Categories	Main Findings and Recommendations
Objectives, Autonomy, Powers, and Resources	The supervisory objectives are set out in general terms in the AoB and detailed in a Board note Conception for the further development of banking supervision. A formal system of appraising the supervisory performance is lacking. CNB should continue to enjoy full financial independence in terms of budgetary resources required for effective and timely supervision. Supervisory decision making should allow for the inclusion of qualitative judgments. Legal protection for supervisors is weak. Movement towards risk based supervision should continue.
Licensing and Structure	Licensing procedures are generally adequate although they do require strengthening in parts such as identification of beneficial owners of banks and in terms of the powers of the CNB to enforce the law against unauthorized use of the term “bank.” Fit-and-proper criteria should be considered in respect of senior management below Board level.
Prudential Regulations and Requirements	While many of these requirements are met in practice, the prudential framework relating to credit risk, in particular, and other risks in general need to be strengthened. In particular, a formal requirement for banks to formulate adequate credit risk management procedures needs to be put in place. Use of differential capital ratios based on an individual bank’s business and control risks should be considered. There is a need to develop understanding of market risk and VaR methodologies. “Know-your-customer” requirements should be explicitly set out in the banking regulations.
Methods of Ongoing Supervision	Ongoing supervision is generally adequate but action required to extend consolidated supervision to financial holding companies and mixed holding companies.
Information Requirements	Further harmonization of Czech accounting standards with internationally accepted accounting principles and procedures is required, such as those relating to leasing and fair value accounting in relation to financial instruments.
Formal Powers of Supervisors	Supervisory powers for prompt corrective action need to be made explicit and strengthened.
Cross-border Banking	Cross-border supervision is weak. In particular the CNB has no powers over foreign subsidiaries of Czech banks. Nevertheless the accounts of foreign subsidiaries of Czech banks are consolidated.

View Table

Table 9.

Summary of Main Findings and Recommendations

CPs Main Categories	Main Findings and Recommendations
Objectives, Autonomy, Powers, and Resources	The supervisory objectives are set out in general terms in the AoB and detailed in a Board note Conception for the further development of banking supervision. A formal system of appraising the supervisory performance is lacking. CNB should continue to enjoy full financial independence in terms of budgetary resources required for effective and timely supervision. Supervisory decision making should allow for the inclusion of qualitative judgments. Legal protection for supervisors is weak. Movement towards risk based supervision should continue.
Licensing and Structure	Licensing procedures are generally adequate although they do require strengthening in parts such as identification of beneficial owners of banks and in terms of the powers of the CNB to enforce the law against unauthorized use of the term “bank.” Fit-and-proper criteria should be considered in respect of senior management below Board level.
Prudential Regulations and Requirements	While many of these requirements are met in practice, the prudential framework relating to credit risk, in particular, and other risks in general need to be strengthened. In particular, a formal requirement for banks to formulate adequate credit risk management procedures needs to be put in place. Use of differential capital ratios based on an individual bank’s business and control risks should be considered. There is a need to develop understanding of market risk and VaR methodologies. “Know-your-customer” requirements should be explicitly set out in the banking regulations.
Methods of Ongoing Supervision	Ongoing supervision is generally adequate but action required to extend consolidated supervision to financial holding companies and mixed holding companies.
Information Requirements	Further harmonization of Czech accounting standards with internationally accepted accounting principles and procedures is required, such as those relating to leasing and fair value accounting in relation to financial instruments.
Formal Powers of Supervisors	Supervisory powers for prompt corrective action need to be made explicit and strengthened.
Cross-border Banking	Cross-border supervision is weak. In particular the CNB has no powers over foreign subsidiaries of Czech banks. Nevertheless the accounts of foreign subsidiaries of Czech banks are consolidated.

Recommended action plan and authorities’ response

36. The CNB commented that they were generally in agreement with the overall assessment. On the CP relating to money laundering, the CNB was of the view that the existing legislative and institutional arrangements were adequate. In particular, they noted that according to the law of anti-money laundering procedures banks are required to report suspicious activities to the Financial Analytical Section at the MoF, which is responsible for implementing and supervising observance of the anti-money laundering law. The CNB in on-site examinations does verify that banks comply with this requirement. The introduction of separate CNB regulations on this matter would, therefore, only lead to duplication of efforts.

Institutional and market structure—overview

38. The CNB is the primary agency responsible for banking supervision in the Czech Republic. It derives it authority from the CNB Act and the Banks Act. The CNB has full operational and financial independence on supervisory matters, although on matters relating to licensing, revocation of licenses and resolution of problem banks, the CNB works in close coordination with the MoF. Similar to the proactive approach towards disclosure and transparency in its conduct of monetary policy, the CNB pursues an open policy on supervisory policies and regulations. The public is acquainted with banking sector developments and supervisory matters through multiple means of disclosure, including an annual report on banking supervision, a dedicated chapter in the CNB Annual Report, the data bulletin “Basic Indicators of the Banking Sector,” and regularly updated web pages on the CNB website.

Main findings

39. Banking supervisory policies, regulations and developments are provided to the market and public in a comprehensible, accessible and timely manner. The CNB provides a basic overview of the regulatory framework within which the banks operate, informs the market of the changes in the regulations, makes public its review of the supervisory activities, informs banking consumers of the products and services offered by banks, discloses basic data on the state and performance of the banking sector in terms of its structure of assets and liabilities, off-balance sheet activities, foreign exchange operations and detailed aggregate data on the banking system that can be used for independent evaluations and public monitoring of bank’s compliance with the prudential requirements.

40. The CNB uses a variety of means and methods of communicating with the public on its supervisory role, polices and operations. It goes beyond relying only on regulation and legislation, which by their nature are public documents. Active use is made of the CNB website to disclose information to a wider group. Also used are less formal and more flexible disclosure forms such as press releases and appearances by officials before public audiences and legislature, and publications such as the annual report on banking supervision.

41. The quality of information disclosed has been improving in terms of content and clarity. In the area of data disclosure, the Czech Republic meets the SDDS specifications for the coverage, periodicity, and timeliness of banking sector data and for dissemination of advance release calendars. In the second half of 2000, the CNB began publishing aggregate banking sector indicators on a quarterly basis.

Recommended action plan and authorities’ response

Table 10.

Banking Supervision Transparency: Assessment Recommendations

Table 10.

Banking Supervision Transparency: Assessment Recommendations

Subject	Recommendations
V. Clarity of roles, responsibilities and objectives of banking supervision agencies	The scope and procedures for cooperation and information sharing, laid down in the 1998 MOU between the CNB, the MOF, and the CSC should be explained to the public.
VI. Open process for formulating and reporting of banking supervision policies	The internal procedures for the conduct of the banking supervision should be publicly disclosed. The provisions of MOUs with foreign banking supervisory authorities should be publicly disclosed.
VII. Public availability of information on [banking] supervision policies	Consistent with confidentiality and privacy of information on individual banks, aggregate information on emergency financial support by the central bank should be publicly disclosed.
VIII. Accountability and assurance of integrity by banking supervision agencies	The CNB’s internal governance procedures should be publicly disclosed. Internal rules to prevent exploitation of conflicts of interest should be publicly disclosed.

View Table

Table 10.

Banking Supervision Transparency: Assessment Recommendations

Subject	Recommendations
V. Clarity of roles, responsibilities and objectives of banking supervision agencies	The scope and procedures for cooperation and information sharing, laid down in the 1998 MOU between the CNB, the MOF, and the CSC should be explained to the public.
VI. Open process for formulating and reporting of banking supervision policies	The internal procedures for the conduct of the banking supervision should be publicly disclosed. The provisions of MOUs with foreign banking supervisory authorities should be publicly disclosed.
VII. Public availability of information on [banking] supervision policies	Consistent with confidentiality and privacy of information on individual banks, aggregate information on emergency financial support by the central bank should be publicly disclosed.
VIII. Accountability and assurance of integrity by banking supervision agencies	The CNB’s internal governance procedures should be publicly disclosed. Internal rules to prevent exploitation of conflicts of interest should be publicly disclosed.

46. The CNB was in agreement with the assessment’s findings and recommendations.

Institutional and market structure—overview

50. There are 41 licensed insurance companies operating in the Czech Republic, of which 7 are branches of foreign insurance companies and the others are incorporated locally. Fifteen of the local companies are controlled by foreign capital and four are subsidiaries of Czech banks. Three of the companies do only life insurance business, 20 do only non-life insurance business, and the other 18 are composites.

51. Total premiums received by Czech insurance companies during 1999 amounted to CZK 62.8 billion, of which CZK 19.8 billion (32 percent) was for life insurance and CZK 43.0 billion for non-life insurance. Total premium income is estimated to represent 3.4 percent of GDP. An insurance penetration of these proportions ranks the Czech Republic as a leader among transition economies in the region, although it would still be far below the situation prevailing in the EU. Total assets for Czech insurance companies as of the end of 1999 amounted to CZK 156.6 billion, or approximately 8.5 percent of GDP.

52. The Czech Republic has adopted the EU formula for minimum solvency of insurance companies. As of the end of 1999, most companies had solvency positions that exceeded minimum requirements by a comfortable margin. For example, the average solvency margin for non-life companies was four times average requirements. The Office reports that only two companies, with market shares of 0.16 percent and 0.18 percent, respectively, failed to meet the minimum margin as at the end of 1999.

53. The year 2000 is a key transition year for the industry and particularly for the regulatory and supervisory framework. With the adoption of the new legislation, a major change has been effected in the manner of supervising companies. In line with practices in the EU, prior formal approval of product and premium rates has been abandoned. Emphasis must now be placed on the monitoring of company financial strength, or solvency, on a permanent basis. This modern approach to supervision demands a higher level of professionalism from supervisory personnel. Analysis and inspection must now be focused on key risk areas if they are to be effective. Under the new law, both life and non-life insurance companies will be expected to appoint an actuary to provide an annual report on the adequacy of technical provisions and other key factors. The supervisory personnel will be expected to work with the actuaries, and indeed the auditors, as joint participants in the work of prudential oversight of the industry. The reclassification of the supervision function from a department of the MoF into an Office is seen as the first step in the institutional restructuring of insurance supervision.

General preconditions for effective insurance supervision

54. The legal system in the Czech Republic is similar to that which prevails in Germany. Companies are incorporated according to the Commercial Code, while relationships with consumers are governed by the Civil Law. Unfortunately, these laws have not been kept up to date. For example, the Civil Law does not contain all the provisions that are needed to protect consumers of insurance policies. There have been discussions to create a special Insurance Contract Law as many countries have recently done (e.g., Argentina). A draft of the proposed Insurance Contract Law has been submitted to the Czech Government and is expected to be passed to Parliament in the near future. The legal framework for insurance is also weak in the area of corporate governance. Recent amendments to the Commercial Code strengthening corporate governance became effective in January 2001, and also apply to insurance companies. This is a positive step, but the provisions in the Commercial Code are general and do not go far enough in protecting the interests of policyholders and account-holders in financial institutions. The new Insurance Law, which became effective in April 2000, should have included special provisions outlining the responsibilities of directors and identifying certain key roles they must play.

55. In general, however, the new Insurance Law represents a significant improvement over the previous law and constitutes a good and modern piece of legislation. In particular, the new Law provides the supervisors with several important tools for dealing with distressed insurance companies. For example, the law prescribes certain actions that must be taken when a company’s solvency margin falls below a specified level (the “guarantee” fund). In addition, there are special powers to be applied at the discretion of the supervisor when other less threatening situations are presented.

56. Accounting and auditing legislation are also relevant for the performance of the insurance sector. Accounting for insurance companies is governed by the general Law on Accounting. The MoF has authority to issue special accounting rules for insurance companies and this was done through a special regulation issued by the MoF. Recent amendments to the Auditing Law that will become effective in January 2001 may have important impact on the way the sector operates. These amendments include, inter alia, the legal obligation for the auditor to inform the supervisor of any breaching of the law, or of a situation is developing that could impair the ability of the company to meet its obligations. Enforcement of this new provision remains to be tested, however.

57. The Czech Insurance Association has adopted a code of ethics for its members. In addition, through its monitoring activities, it is well-placed to give advance warning of companies that are headed for financial difficulties. The association is prepared to expel a member company that gives cause for concern. While it is not strictly speaking an SRO, it behaves in a similar manner.

Main findings

58. The regulation and supervision of the Czech insurance sector has improved in recent years, with the adoption of a more modern insurance law that is more harmonized with EU legislation, and that, inter alia, introduces EU solvency criteria. The Supervision Office is also obtaining technical assistance from EU members and strengthening its supervisory staff.

59. The legislation needs to be further strengthened in some important areas, however. Corporate governance of insurance companies relies on general provisions of the Commercial Code. Although these provisions have been recently strengthened, they are still insufficient to ensure sound governance of insurance companies. Explicit requirements for the boards of insurance companies, particularly in the area of internal controls, are not adequate. There is also a need to strengthen legislation in specific areas, such as licensing, change in control, use of derivatives, reinsurance, and market conduct.

60. The supervisory authorities also lack sufficient legal and operational independence, being located in a department inside the MoF. The lack of sufficient resources for more effective supervision is particularly reflected in the low frequency of on-site inspections, and the absence of sufficient supervisory skills in the areas of risk management and internal controls. The development of an adequate supervisory function will require more legal and operational independence and more adequate resources for staffing and training.

61. Table 11 provides a summary of the main findings of the detailed assessment and related recommendations.

Table 11.

Summary of Main Findings of Assessment of Observance of the IAIS Insurance Supervisory Principles

Table 11.

Summary of Main Findings of Assessment of Observance of the IAIS Insurance Supervisory Principles

Subject	Main Findings
Organization of an Insurance Supervisor	The Supervision Office lacks independence. There is need for additional resources and training
Licensing and Changes in Control	Need to strengthen licensing procedures to include explicit reference to the financial soundness of owners and fit and proper tests for management. There is a need for more explicit conditions regarding the acquirer when changes in control are proposed
Corporate Governance	Corporate governance rules need to be introduced in the Insurance Act. Rules in the Commercial Code do not offer sufficient protection for insurance policyholders
Internal Controls	New provisions in the Insurance Act addressing internal controls need to be introduced. New inspection procedures need to be introduced to encompass risk management and internal controls.
Prudential Rules	Supervisory procedures should be developed for dealing with issues not specified in legislation, such as matching. Office must develop new procedures for review of reinsurance arrangements, including the assessment of receivables. A system of controls and disclosure requirements for derivatives and off-balance sheet items should be prescribed
Market Conduct	Office of Supervision must establish a consumer protection program
Monitoring, Inspection and Sanctions	Minimum frequency of inspections is required. There is also a need to enhanced training program of on-site inspections
Cross-border Business Operations	This principle will become applicable as the country approaches EU membership.

View Table

Table 11.

Summary of Main Findings of Assessment of Observance of the IAIS Insurance Supervisory Principles

Subject	Main Findings
Organization of an Insurance Supervisor	The Supervision Office lacks independence. There is need for additional resources and training
Licensing and Changes in Control	Need to strengthen licensing procedures to include explicit reference to the financial soundness of owners and fit and proper tests for management. There is a need for more explicit conditions regarding the acquirer when changes in control are proposed
Corporate Governance	Corporate governance rules need to be introduced in the Insurance Act. Rules in the Commercial Code do not offer sufficient protection for insurance policyholders
Internal Controls	New provisions in the Insurance Act addressing internal controls need to be introduced. New inspection procedures need to be introduced to encompass risk management and internal controls.
Prudential Rules	Supervisory procedures should be developed for dealing with issues not specified in legislation, such as matching. Office must develop new procedures for review of reinsurance arrangements, including the assessment of receivables. A system of controls and disclosure requirements for derivatives and off-balance sheet items should be prescribed
Market Conduct	Office of Supervision must establish a consumer protection program
Monitoring, Inspection and Sanctions	Minimum frequency of inspections is required. There is also a need to enhanced training program of on-site inspections
Cross-border Business Operations	This principle will become applicable as the country approaches EU membership.

Recommended action plan and supervisory response to the assessment

Institutional and market structure—overview

69. The Insurance Act delegates the state insurance supervision in the Czech Republic to the MoF. Within the MoF, the Office is assigned the supervisory responsibilities over the insurance industry and the handling of consumer complaints. The Director of the Office reports to a Deputy Minister, who in turn reports to the Minister of Finance. The Minister of Finance acts upon recommendations made by the Office in issuing regulations, issuing and revoking licenses, etc. Accountability to Parliament lies with the Minister and not the Director of the Office.

Main findings

70. The responsibility for insurance supervision is fairly well-defined in the legislation. However, from the viewpoint of transparency and disclosure there are several factors that impede the process, making the overall observance with transparency and disclosure less than desirable. The Office is constrained by confidentiality requirements with respect to sharing and disclosing institution specific information. This hampers availability and access to data and information directly from the insurance supervisor. The Office also does not undertake onsite inspection and consequently the market and the general public has low confidence in the ability of the Office to supervise and disclose information that could provide signals on the effectiveness of the insurance regulatory polices in ensuring sound financial health of the insurance firms. In practice, the Czech Insurance Association, although not a legal SRO, collects data, monitors the financial health of its member firms and discloses information on a systematic basis to the market and general public. The Association also provides information relating to the regulatory framework and explains the technical changes with respect to insurance policies.

71. A factor seriously constraining the transparency of the Office is the lack of sufficient resources to discharge its primary objectives. It is however hoped that with the full implementation of the new Insurance Act that became effective in April 2000, the Office will adopt a more systematic approach towards public disclosure of insurance policies and initiate steps to improve its observance with the MFP Transparency Code.

Recommended action plan and authorities’ response

Table 12.

Insurance Regulation Transparency: Assessment Recommendations

Table 12.

Insurance Regulation Transparency: Assessment Recommendations

Subject	Recommendations
V. Clarity of roles, responsibilities and objectives of insurance supervision agencies	The internal distribution of responsibilities for the conduct of financial policies in the area of insurance within the MoF should be publicly disclosed. Government Decree 150/1958, on which the formal responsibility of the Office for settlement of disputes between consumers and insurance companies is based, is outdated. It should be brought up-to-date with the political and economic changes in the Czech Republic since then, and the general public should be actively informed about its implications for the insurance industry. The broad objective of the MoF in the area of insurance supervision should be publicly disclosed and explained through other channels in addition to legislation. The responsibilities and the authority of the MoF to conduct financial policies in the area of insurance should be publicly disclosed through other channels in addition to legislation and regulation.
VI. Open process for formulating and reporting of insurance supervision policies	Specific operating procedures for the conduct of insurance supervision by the Office should be publicly disclosed. The procedures and scope of cooperation and information sharing between the MoF, the CSC, and the CNB, specified in the 1998 MOU, should be explained to the public.
VII. Public availability of information on insurance supervision policies	The MoF should publish aggregate data on the insurance and reinsurance industry. The website of the MoF should provide information on its insurance supervisory policies. The maximum delay between the end of the budget year and the publication of the Annual Report, specified in the latest amendments of the Act on Insurance, should be significantly shortened. Information on the Office’s responsibility for settlement of disputes between consumers and insurance companies should be widely disclosed to the general public. The staffing of the Office should be increased to be capable of handling the potential large amount of complaints.
VIII. Accountability and assurance of integrity by insurance supervision agencies	Internal governance procedures in the MoF should be explained to the public.

View Table

Table 12.

Insurance Regulation Transparency: Assessment Recommendations

Subject	Recommendations
V. Clarity of roles, responsibilities and objectives of insurance supervision agencies	The internal distribution of responsibilities for the conduct of financial policies in the area of insurance within the MoF should be publicly disclosed. Government Decree 150/1958, on which the formal responsibility of the Office for settlement of disputes between consumers and insurance companies is based, is outdated. It should be brought up-to-date with the political and economic changes in the Czech Republic since then, and the general public should be actively informed about its implications for the insurance industry. The broad objective of the MoF in the area of insurance supervision should be publicly disclosed and explained through other channels in addition to legislation. The responsibilities and the authority of the MoF to conduct financial policies in the area of insurance should be publicly disclosed through other channels in addition to legislation and regulation.
VI. Open process for formulating and reporting of insurance supervision policies	Specific operating procedures for the conduct of insurance supervision by the Office should be publicly disclosed. The procedures and scope of cooperation and information sharing between the MoF, the CSC, and the CNB, specified in the 1998 MOU, should be explained to the public.
VII. Public availability of information on insurance supervision policies	The MoF should publish aggregate data on the insurance and reinsurance industry. The website of the MoF should provide information on its insurance supervisory policies. The maximum delay between the end of the budget year and the publication of the Annual Report, specified in the latest amendments of the Act on Insurance, should be significantly shortened. Information on the Office’s responsibility for settlement of disputes between consumers and insurance companies should be widely disclosed to the general public. The staffing of the Office should be increased to be capable of handling the potential large amount of complaints.
VIII. Accountability and assurance of integrity by insurance supervision agencies	Internal governance procedures in the MoF should be explained to the public.

78. In its response, the Office expressed the following reservations regarding the assessment:

• While agreeing that Government Decree No. 150/1958 is somewhat out-of-date, the Office felt that the decree satisfies the present needs.

• The Office questioned the practicality of publishing the Internal Organization Rules of the MoF given their extensive coverage and frequent changes. In a follow-up discussion, the assessors explained that the assessment does not ask for this but rather for disclosing the general distribution of responsibilities between the Office and the other departments in the MoF. As a result of the discussion this objection was dropped.

• The Office objected to the recommended public disclosure of the procedures and scope of cooperation and information sharing between the MoF, the CSC, and the CNB, specified in the 1998 MOU, further noting that this will require the consent of all parties involved.

• The Office noted that as long as its staff receive the audited financial statements of supervised companies by June 30, the maximum delay between the end of the calendar year and the publication of its planned annual report (until September 30) is not so long.

Supervisory framework

80. The primary regulator of the securities markets of the Czech Republic is the CSC. The capital markets of the Czech Republic are young and the CSC is also a very young organization, having been established in April 1998. The CSC’s functions and powers are to be found in the Securities Commission Act and various pieces of legislation governing the capital markets. The CSC is an independent statutory body, with limited obligations to report to both the Minister of Finance and the Chamber of Deputies of the Parliament of the Czech Republic. The CSC’s responsibilities extend to the securities dealing of banks and, to that extent, banks in the Czech Republic that are subject to dual supervision by the CSC and the CNB. The supervision of pension funds is still shared with the Office of Insurance Supervision in the MoF, but there are plans to shift entirely the supervision of pension funds to the CSC during 2001.

81. Primary responsibility for policy formulation lies with the MoF. The MoF also prepares secondary legislation. The PSE performs a limited supervisory role, by monitoring trading on the Exchange and supervising the conduct of its members. From January 2001, the operator of the second securities trading system, RM-SYSTEM (RMS), is obliged to monitor trading on its electronic exchange also.

Market structure

82. The Czech Securities Market was created in the early 1990s, as part of a mass coupon privatization scheme that involved the introduction of around 1,800 publicly traded companies in the capital market, together with hundreds of newly created investment funds. The trading of the shares of companies and investment funds was conducted in two newly created exchanges, the PSE and the RMS. Both the PSE and RMS are authorized by the CSC. The PSE is authorized as an exchange, whereas the RMS has a special authorization under the Securities Act not unlike that of a broker. However, from January 1, 2001, RMS will be regulated in the same manner as the PSE, and will assume responsibility for some regulatory matters, including surveillance of trading on the RMS.

83. The PSE is an intermediated exchange with 54 members and approximately 140 listed securities. The PSE is an electronic exchange with an automated trading system. Its most important trading system is the SPAD system, which is used for the seven most active stocks and which accounts for more than 90 percent of all trades. Trading can also take place through two other channels: automatic trades at fixed or variable prices, or block trades effected off-market between PSE members and subsequently recorded on the PSE’s trading system. Clearing and settlement of trades on the PSE is effected through a system operated by a subsidiary of the PSE, called UNIVYC.

84. The RMS is an electronic trading system accessible by the general public as well as by more sophisticated investors such as brokers or institutional investors. Approximately 2,100 publicly tradable securities can be traded in the RMS, but many of these securities are rarely traded. The regulatory authorities have introduced stricter requirements for publicly tradable securities that are expected to halve the number of securities tradable in the RMS. Access to the RMS is via a number of “share shop” locations (more than 100) throughout the country. Professional and institutional clients may also access the RMS through on-line terminals installed at their premises.

85. The TKD system is used for the issuance, registration and settlement of trades in short term instruments (maturity up to 1 year), including treasury bills and CNB bills. The TDK system operates on a gross and continuous basis. It runs in real time and provides for delivery versus payment. Cash settlement is in the clearing and settlement system of the CNB.

86. The Securities Center (SCP) is responsible for the registration of securities and debt instruments with maturity of longer than one year. The SCP was established under the Securities Act by the MoF. The Czech Republic is liable for the actions of the SCP. The SCP maintains registers of dematerialized and immobilized securities. Registration is presently to the level of the individual beneficial owner. Reforms to come into effect in 2001 will allow for registration in the name of a nominee.

Main findings

87. Broadly speaking, the laws and regulations of the Czech Republic give sufficient functions and powers to the CSC to permit effective regulation of the securities markets. However, there are practical limitations on the capacity of the CSC to discharge its responsibilities. In many areas in which the law appears adequate and the functions and powers available to the CSC appropriate, the CSC lacks the resources to effectively discharge its responsibilities.

88. Table 13 provides a summary of the main findings of the assessment and related recommendations. The summary of the findings focuses mainly on shortcomings in terms of implementation of the IOSCO Objectives and Principles. It should be recognized from the outset that the focus of the summary table does not reflect the real and valuable progress made in terms of securities markets law in the Czech Republic in recent years. Neither does it reflect the major progress in regulation, supervision and enforcement achieved since the inauguration of the CSC in April 1998. Much has been achieved in a short period of time. It should, furthermore, be said that the CSC recognizes many of the shortcomings identified below and appears determined to overcome them. Some of those shortcomings are, however, of a type that may not be able to be addressed by the CSC alone.

Table 13.

Summary of Main Findings and Recommendations

Table 13.

Summary of Main Findings and Recommendations

Subject	Main Findings and Recommendations
Principles relating to the regulator	Broadly speaking, the laws and regulations of the Czech Republic give sufficient functions and powers to the CSC to permit effective regulation of the securities markets. However, the CSC lacks the resources to effectively discharge its responsibilities. Policy and rule-making functions reside in the MoF. Consideration should be given to whether this unduly limits the CSC’s independence and ability to quickly respond to market or regulatory needs. The CSC in certain areas only exercises its powers to a limited extent, and only through the adoption of a formal approach to some of its regulatory responsibilities. The practice might be understandable given the lack of supervisory resources, but has had a damaging affect on the credibility of the Commission. —There should be a review of the resources available to the CSC. —Staffing and salary policies should be evaluated. —There should be a review of arrangements for the promulgation of secondary legislation. —Efforts should be made to ensure a move away from reliance on a formal approach to supervision.
Principles of self-regulation	The use of self regulatory organizations in the securities markets has until now been limited to the PSE. Starting in January 2001, the RMS will also have some SRO duties. Although the Stock Exchange Commissioner appears to monitor the day-to-day activities of the PSE, periodic detailed reviews of the performance of the PSE and RMS SROs are not conducted.
	The increased use of SROs will require more effective oversight of SROs by the CSC. —The CSC should consider the need for periodic reviews of the PSE and the RMS through inspections. —The CSC should consider encouraging SRO functions of market bodies in, e.g., the areas of market conventions and standards of behavior.
Principles for the enforcement of securities regulation	The statutory rules of procedure provide the CSC with sufficient instruments and authority to exercise its powers, impose effective sanctions and enforce its decisions. The difficulty lies in the CSCs limited capacity to exercise its powers. The CSC has few staff with, in general, limited supervisory experience. The CSC relies to some extent on the PSE to carry out inspections. However, the effectiveness of these inspections is questionable, being long and without a clear risk focus. Effective enforcement will depend on the build-up of supervisory capacity at the CSC. —The CSC should carefully prioritize the use of its scarce resources until the acute resource issues have been addressed.
Principles for cooperation in regulation	Exchange of information of non-public character with other domestic regulators is guaranteed by law. International exchange of information is also enabled under the law upon condition of mutuality. MOUs have been concluded with the CNB, the MoF, and the Chamber of Auditors, and with a number of international supervisors.
Principles for issuers	The principle of full and fair disclosure to investors is set out in the Securities Act, and the prospectuses for public offering must be approved by the CSC. The CSC has adequate powers to delay or stop an offering and request corrections. The CSC has undertaken a great effort to ensure compliance with recurrent disclosure requirement, but seems to lack the capacity to examine the risk disclosure in offering documents. —Steps are required to specify the content of disclosure to shareholders, and for increased monitoring by CSC of compliance with rules. —Actions are required to ensure that boards are aware of and comply with their responsibility for ensuring participation by shareholders in general meetings.
Principles for collective investment schemes (CPs 17-20)	The regulatory and supervisory framework for collective investment schemes is generally adequate. However, the CSC does not, seem to undertake a detailed review of the documents associated with the public offering of collective investments, including issues related to risk disclosure. Also, depositories do not seem to perform their legal obligation to scrutinize the activities of collective schemes effectively. —Detailed assessment of the content of statues governing collective investment schemes should be undertaken. —Proper risk disclosure by issuers should be emphasized in review of offering documents.
	—The role of the depository should be reviewed and the legal responsibilities of depositories should be better enforced. —The CSC should mandate and require use the forward pricing principle.
Principles for market intermediaries	The CSC has recently completed a major re-licensing exercise, that has resulted in a dramatic reduction in the number of investment firms, from approximately 400 at the start of 1999 to 120 today. This exercise has cleaned the brokerage sector and has greatly reduced the scope for misconduct. However, ongoing requirements to hold liquid assets against risk are still lacking. —Risk-based liquid asset requirements should be introduced. —The CSC should consider the need to issue licenses to brokers with different endorsements depending on company activities. —The CSC should consider issuing different securities dealers licenses to differentiate between brokers active in different markets.
Principles for the secondary market	Transparency in the stock market has improved drastically after the introduction of the SPAD trading system on the PSE and the requirement for PSE members to report all trades to the PSE for subsequent disclosure. Market manipulation and other unfair trading practices are generally prohibited. However, the large number of very small tradable stocks and the low public float in many of the larger companies, limits the CSC’s ability to prevent market manipulation and unfair trading practices. Therefore, the most important initiative to ensure market integrity is the ongoing effort to encourage meaningful standards for public companies.
	—The efforts to ensure the integrity of the equity market through implementation of minimum listing standards should be continued, although the effects of delisting must be considered as the process moves forward. —There should be a review of the work of the CSCs surveillance department to ensure that it is properly integrated with the surveillance unit of the PSE and the new surveillance function at RMS. —To promote transparency focus needs to be put on compliance with reporting requirements in market surveillance and broker dealer inspections.

View Table

Table 13.

Summary of Main Findings and Recommendations

Subject	Main Findings and Recommendations
Principles relating to the regulator	Broadly speaking, the laws and regulations of the Czech Republic give sufficient functions and powers to the CSC to permit effective regulation of the securities markets. However, the CSC lacks the resources to effectively discharge its responsibilities. Policy and rule-making functions reside in the MoF. Consideration should be given to whether this unduly limits the CSC’s independence and ability to quickly respond to market or regulatory needs. The CSC in certain areas only exercises its powers to a limited extent, and only through the adoption of a formal approach to some of its regulatory responsibilities. The practice might be understandable given the lack of supervisory resources, but has had a damaging affect on the credibility of the Commission. —There should be a review of the resources available to the CSC. —Staffing and salary policies should be evaluated. —There should be a review of arrangements for the promulgation of secondary legislation. —Efforts should be made to ensure a move away from reliance on a formal approach to supervision.
Principles of self-regulation	The use of self regulatory organizations in the securities markets has until now been limited to the PSE. Starting in January 2001, the RMS will also have some SRO duties. Although the Stock Exchange Commissioner appears to monitor the day-to-day activities of the PSE, periodic detailed reviews of the performance of the PSE and RMS SROs are not conducted.
	The increased use of SROs will require more effective oversight of SROs by the CSC. —The CSC should consider the need for periodic reviews of the PSE and the RMS through inspections. —The CSC should consider encouraging SRO functions of market bodies in, e.g., the areas of market conventions and standards of behavior.
Principles for the enforcement of securities regulation	The statutory rules of procedure provide the CSC with sufficient instruments and authority to exercise its powers, impose effective sanctions and enforce its decisions. The difficulty lies in the CSCs limited capacity to exercise its powers. The CSC has few staff with, in general, limited supervisory experience. The CSC relies to some extent on the PSE to carry out inspections. However, the effectiveness of these inspections is questionable, being long and without a clear risk focus. Effective enforcement will depend on the build-up of supervisory capacity at the CSC. —The CSC should carefully prioritize the use of its scarce resources until the acute resource issues have been addressed.
Principles for cooperation in regulation	Exchange of information of non-public character with other domestic regulators is guaranteed by law. International exchange of information is also enabled under the law upon condition of mutuality. MOUs have been concluded with the CNB, the MoF, and the Chamber of Auditors, and with a number of international supervisors.
Principles for issuers	The principle of full and fair disclosure to investors is set out in the Securities Act, and the prospectuses for public offering must be approved by the CSC. The CSC has adequate powers to delay or stop an offering and request corrections. The CSC has undertaken a great effort to ensure compliance with recurrent disclosure requirement, but seems to lack the capacity to examine the risk disclosure in offering documents. —Steps are required to specify the content of disclosure to shareholders, and for increased monitoring by CSC of compliance with rules. —Actions are required to ensure that boards are aware of and comply with their responsibility for ensuring participation by shareholders in general meetings.
Principles for collective investment schemes (CPs 17-20)	The regulatory and supervisory framework for collective investment schemes is generally adequate. However, the CSC does not, seem to undertake a detailed review of the documents associated with the public offering of collective investments, including issues related to risk disclosure. Also, depositories do not seem to perform their legal obligation to scrutinize the activities of collective schemes effectively. —Detailed assessment of the content of statues governing collective investment schemes should be undertaken. —Proper risk disclosure by issuers should be emphasized in review of offering documents.
	—The role of the depository should be reviewed and the legal responsibilities of depositories should be better enforced. —The CSC should mandate and require use the forward pricing principle.
Principles for market intermediaries	The CSC has recently completed a major re-licensing exercise, that has resulted in a dramatic reduction in the number of investment firms, from approximately 400 at the start of 1999 to 120 today. This exercise has cleaned the brokerage sector and has greatly reduced the scope for misconduct. However, ongoing requirements to hold liquid assets against risk are still lacking. —Risk-based liquid asset requirements should be introduced. —The CSC should consider the need to issue licenses to brokers with different endorsements depending on company activities. —The CSC should consider issuing different securities dealers licenses to differentiate between brokers active in different markets.
Principles for the secondary market	Transparency in the stock market has improved drastically after the introduction of the SPAD trading system on the PSE and the requirement for PSE members to report all trades to the PSE for subsequent disclosure. Market manipulation and other unfair trading practices are generally prohibited. However, the large number of very small tradable stocks and the low public float in many of the larger companies, limits the CSC’s ability to prevent market manipulation and unfair trading practices. Therefore, the most important initiative to ensure market integrity is the ongoing effort to encourage meaningful standards for public companies.
	—The efforts to ensure the integrity of the equity market through implementation of minimum listing standards should be continued, although the effects of delisting must be considered as the process moves forward. —There should be a review of the work of the CSCs surveillance department to ensure that it is properly integrated with the surveillance unit of the PSE and the new surveillance function at RMS. —To promote transparency focus needs to be put on compliance with reporting requirements in market surveillance and broker dealer inspections.

Recommended action plan and authorities’ response to the assessment

Institutional and market structure—overview

95. The primary responsibility for formulating and issuing regulations relating to the securities market, including the prudential framework and policy issues are vested with the MoF. The CSC is the independent statutory body responsible for the supervision of the capital markets, including responsibility for ensuring that the laws and regulations are being implemented. Wherever legal or regulatory changes are required, the CSC recommends and drafts the relevant regulation for the consideration of the MoF. It also has the responsibility to inform the public and capital market participants about the policies, practices and performance of the capital market. Thus, while the CSC is primarily a licensing, supervisory, and enforcement financial agency, it works closely with the MoF on the regulatory side as well. This assessment thus focuses on the transparency practices as they relate to the CSC as the primary agency responsible for supervising the capital market activities in the Czech Republic. Where applicable, the assessment also addresses the public disclosure and transparency practices as they relate to the MoF.

Main findings

96. The supervisory responsibilities¹⁹ of the CSC are defined in numerous legislative acts and are not stated in their entirety in the Securities Commission Act (CSC Act). The government has set up a working group of experts from the CSC and the MoF, and visiting EBRD technical advisors, which has prepared a report on the regulatory framework of the capital market supervision. One of the main recommendations of this working group is that the CSC Act, the Stock Exchange Act and other relevant legislation with the exception of the CSC Act should be consolidated in one law on the capital market. If this initiative materializes, it would be advisable to amend the CSC Act to state explicitly all supervisory responsibilities of the Commission as stipulated in the new consolidated law.

97. The CSC uses multiple disclosure channels to inform capital market participants and the general public on regulatory developments and its supervisory actions. Operating guidelines on how the CSC’s discretion is exercised on issues such as licensing and imposition of penalties are made public. The CSC, however, clearly recognizes that a lot more needs to be done to improve transparency of the regulatory and supervisory system.

Recommended action plan and authorities’ response

Table 14.

Securities Regulation Transparency: Assessment Recommendations

Table 14.

Securities Regulation Transparency: Assessment Recommendations

Subject	Recommendations
V. Clarity of roles, responsibilities and objectives of securities supervision agencies	The scope and nature of the MOU between the CNB, the MoF, and the CSC on cooperation and information sharing in the area of capital markets should be publicly disclosed.
VI. Open process for formulating and reporting of securities supervision policies	Specific operating procedures for the conduct of capital market supervision by the CSC should be publicly disclosed. The CSC should ensure the timeliness of its published reports.
VII. Public availability of information on securities supervision policies	The CSC should publish information and aggregate data on capital market developments in its annual, semi-annual, and quarterly reports. One of the main objectives of the CSC—investor rights protection—should be explicitly specified in relevant legislation and more actively disclosed through the CSC’s publications.
VIII. Accountability and assurance of integrity by securities supervision agencies	The internal audit procedures of the CSC should be explained to the public.

View Table

Table 14.

Securities Regulation Transparency: Assessment Recommendations

Subject	Recommendations
V. Clarity of roles, responsibilities and objectives of securities supervision agencies	The scope and nature of the MOU between the CNB, the MoF, and the CSC on cooperation and information sharing in the area of capital markets should be publicly disclosed.
VI. Open process for formulating and reporting of securities supervision policies	Specific operating procedures for the conduct of capital market supervision by the CSC should be publicly disclosed. The CSC should ensure the timeliness of its published reports.
VII. Public availability of information on securities supervision policies	The CSC should publish information and aggregate data on capital market developments in its annual, semi-annual, and quarterly reports. One of the main objectives of the CSC—investor rights protection—should be explicitly specified in relevant legislation and more actively disclosed through the CSC’s publications.
VIII. Accountability and assurance of integrity by securities supervision agencies	The internal audit procedures of the CSC should be explained to the public.

103. The CSC was in agreement with the assessment’s findings and recommendations.

Institutional setting and market structure

115. The CNB and the licensed banks form the backbone of the Czech payments system. While the banks provide most of the payment services to the general public, the CNB plays the principal role in developing and operating the interbank clearing system, the CC. The CNB provides the operating accounts for the government, and the deposit accounts that banks must open at the CNB are used for the settlement of all payment transactions between these institutions. The rules governing the use of these accounts are found in the 1992 Regulation promulgated by the CNB.

116. As in many other countries, there are close links in the Czech Republic between the securities markets, the foreign exchange market, and the payments system. There are three securities clearing mechanisms, each of which uses the CC system in order to effect the necessary settlements each day. The koruna leg of foreign exchange transactions involves payments moving between pairs of banks, via the CC system, two business days after the purchase and sale contracts are negotiated.

117. The CNB has explicit legal responsibility for the Czech payment system. Section 2 of the new National Bank Act states the primary objective of the Czech central bank shall be to maintain price stability. In accordance with this objective, the CNB shall “administer payments and clearing between banks, promote their smooth and efficient operation, and contribute to ensuring sound and efficient payment systems and to their development.” This citation indicates that such smooth and efficient operations are viewed as necessary conditions for the effective conduct of monetary policy. The CNB’s basic approach to payment system policy is that it should develop and run the CC at the heart of the system, marshalling the cooperation of the private banks when necessary.

General preconditions—overview

118. There is not as yet a specific law regulating the payment system in the Czech Republic. Payments involving private individuals and legal entities are considered to occur in a civil law relationship and hence they are subject to the Civil Code (1964) and the Commercial Code (1992). These codes also contain the basic principles on which banking contracts are based. Interbank payment and settlement arrangements are shaped by the 1992 Regulation that is binding on all banks in the Republic. In the same year, the State Bank of Czechoslovakia issued the General Terms and Conditions (amended in 1994 and 1997 by the CNB) that serve, on the basis of a “gentleman’s agreement” with the banks, as the model for these institutions when they create their own terms and conditions for opening accounts and providing payment services to customers. The principles of a uniform interbank payment system, as well as the rules for handling misdirected payments, are stipulated in the 1998 amendment of the 1992 Banking Act. A law providing the rules on bankruptcy was passed in 1992 and amended in 1998. At the present time, a bank ceases to function legally only when the appropriate statements are physically posted by officials of the relevant court. The CNB would immediately thereafter block all further CC transactions involving that institution; it would not unwind earlier transactions.

119. The CNB has drafted the principles for the Payment System Act that is expected to become effective in 2001. Upon its passage, this Act of the Czech Parliament should achieve full compliance with the relevant EU Directives, including those concerned with cross-border payments and finality, as well as with the EU recommendation concerning transactions made using electronic payment instruments.

Main findings

120. The CC system observes all but two of the applicable CPSIPS. With respect to Principle 1, the system largely observes the requirement for a well-founded legal basis at the present time. Moreover the planned Payment Systems Act should bring the legal basis into harmony with the requirements of the EU (and this Principle) in the course of 2001. With respect to Principle 10, the system’s transparency could be improved by the publication of aggregate information on emergency support by the central bank, as applicable. Accountability could be strengthened by an amendment to the CNB Act that provides adequate legal protection for central bank officials while they are performing payment-related duties. The CNB should enhance the transparency of its actions in the payments field by publishing a well-designed booklet that would provide a description of the CC system for an international readership.

Table 15.

Summary of Main Findings of the Core Principles for Systemically Important Payment Systems

Table 15.

Summary of Main Findings of the Core Principles for Systemically Important Payment Systems

Subject	Main Findings and Recommendations
Well-founded legal basis in all relevant jurisdictions	The planned Payment System Act represents an important component of the necessary legal basis for the future of the Czech Republic in the EU.
Governance of the system should be effective, transparent and accountable	Recommendations are made with respect to the publication of aggregate information on emergency support by the central bank, and concerning adequate legal protection for officials while performing payment-related duties. See also the assessment according to the Code of Good Practices on Transparency in Monetary and Financial Policy.
Responsibilities of the central bank in applying the Core Principles	While these responsibilities are met by the CNB, there would be a social benefit from a well-designed booklet on the CC system edited for a broad readership.

View Table

Table 15.

Summary of Main Findings of the Core Principles for Systemically Important Payment Systems

Subject	Main Findings and Recommendations
Well-founded legal basis in all relevant jurisdictions	The planned Payment System Act represents an important component of the necessary legal basis for the future of the Czech Republic in the EU.
Governance of the system should be effective, transparent and accountable	Recommendations are made with respect to the publication of aggregate information on emergency support by the central bank, and concerning adequate legal protection for officials while performing payment-related duties. See also the assessment according to the Code of Good Practices on Transparency in Monetary and Financial Policy.
Responsibilities of the central bank in applying the Core Principles	While these responsibilities are met by the CNB, there would be a social benefit from a well-designed booklet on the CC system edited for a broad readership.

121. The CNB was in agreement with the assessment findings.

Institutional and market structure—overview

123. The CNB is the sole supervisor of payment systems in the Czech Republic. Under the current provisions of the Banks Act, the CNB also has a monopoly over the establishment and management of the interbank payment systems. This is expected to change in the near future, even though amendments in the Banks Act to that effect were recently rejected by Parliament. Currently, there is only one interbank payment system, namely the CC, which the CNB has operated since 1992.

124. Within the CNB, the Payment Systems Department is responsible for managing the non-cash payment system, for developing and running the automated accounting and payment system at the CNB and the interbank settlement system (the CC). A member of the CNB’s Bank Board oversees the activities of this department and submits for Board approval proposals for changes in secondary legislation on payment systems’ operation and oversight. In carrying out its supervisory responsibilities over the payment systems in the Czech Republic, the CNB is guided by the objective, stated in the CNB Act, to promote the smooth and efficient operation of the payments and clearing between banks, and contribute to ensuring sound and efficient payment systems and to their development.

Main findings

125. The institutional framework, responsibilities and objectives of payment systems oversight in the Czech republic are clearly defined in relevant legislation. The central bank, however, should be more proactive in explaining them to the general public in its regular publications.

126. The regulatory framework and operating procedures are readily available to the participants in the interbank payment system in the form of relevant legislation and regulations, and bilateral agreement between them and the central bank. Substantive changes in regulations and procedures are discussed with the Committee on Payments and Payment Instruments of the Bankers’ Association. More remains to be done in increasing the awareness of the general public on these issues. In particular, the chapter on the payment system in the annual report of the CNB is limited to general discussion of trends in the volume and value of transactions. It lacks a detailed description of the working of the payment system, explanation of its operating procedures (such as risk management policies) and a more detailed analysis of the transactions carried out through it (foreign exchange versus domestic currency settlements, counterparties, etc.).

127. In terms of public availability of information, the central bank presents the developments in the payment system in its annual report. Senior officers of the Payment System Department of the CNB participate in seminars and conferences both in the Czech Republic and abroad, on which they present the objectives of state oversight over the payment system and its performance. The CNB’s internal governance procedures are not publicly explained.

Recommended action plan and authorities’ response

Table 16.

Payment Systems Transparency: Assessment Recommendations

Table 16.

Payment Systems Transparency: Assessment Recommendations

Subject	Recommendations
V. Clarity of roles, responsibilities and objectives of the financial agency responsible for payment systems
VI. Open process for formulating and reporting of payment system policies	The chapter on the payment system in the Annual Report of CNB should be expanded to include a more detailed analysis of the transactions carried out through the payment system (foreign exchange versus domestic currency settlements, counterparties, etc.), beside general trends. It should, furthermore, explain the CNB’s policy objectives as a supervisor of the payment system and how the changes in operating procedures contribute to the achievement of these goals.
VII. Public availability of information on payment systems policies	Thought might be given to disseminate information about the operation of the payment system, its structure and safeguard mechanisms in the form of a pamphlet written in non-technical language. In this regard, the translation of the descriptions of the payment system in the Czech Republic, that have been produced in the form of a “Blue Book” and “Red Book,” might be considered. More detailed quantitative information on the nature of transactions carried out through the payment system should be made available to the public on a regular basis, possibly on the CNB website.
VIII. Accountability and assurance of integrity by the financial agency responsible for payment systems	The nature of CNB’s internal governance procedures should be explained to the public.

View Table

Table 16.

Payment Systems Transparency: Assessment Recommendations

Subject	Recommendations
V. Clarity of roles, responsibilities and objectives of the financial agency responsible for payment systems
VI. Open process for formulating and reporting of payment system policies	The chapter on the payment system in the Annual Report of CNB should be expanded to include a more detailed analysis of the transactions carried out through the payment system (foreign exchange versus domestic currency settlements, counterparties, etc.), beside general trends. It should, furthermore, explain the CNB’s policy objectives as a supervisor of the payment system and how the changes in operating procedures contribute to the achievement of these goals.
VII. Public availability of information on payment systems policies	Thought might be given to disseminate information about the operation of the payment system, its structure and safeguard mechanisms in the form of a pamphlet written in non-technical language. In this regard, the translation of the descriptions of the payment system in the Czech Republic, that have been produced in the form of a “Blue Book” and “Red Book,” might be considered. More detailed quantitative information on the nature of transactions carried out through the payment system should be made available to the public on a regular basis, possibly on the CNB website.
VIII. Accountability and assurance of integrity by the financial agency responsible for payment systems	The nature of CNB’s internal governance procedures should be explained to the public.

128. The CNB was in agreement with the assessment’s findings and recommendations.