Paying the Price

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Jan Mladek, deputy finance minister for privatization, readily admits that he had a very different idea about how to sell off the Czech Republic's major banks when his party, the Social Democrats, took power in the summer of 1998. He figured the best course would be a slow and steady one, perhaps keeping one of the four biggest banks in state hands. Two years later, his party is still in power but three of the four banks have been sold and the last one is scheduled for privatization early next year. Mladek's explanation? "This may sound cynical, but Social Democrat governments privatize only when they need money or something doesn't work. Ours is not an exception." For Mladek, reality dawned in December, 1998, when the top management of Ceska sporitelna, the country's third-biggest bank, said it faced insolvency in 14 days if the state didn't prop it up. "They were promptly relieved of their positions," says Mladek. And that's when the party changed its view on privatization and decided to implement a strategy of quick sell-offs to shore up further losses.

The new strategy was too late to spare taxpayers the more than $5.1 billion the state has spent on shoring up the banking sector in the past decade. The red ink, which is still flowing, resulted from both the inexperience of the Czech bankers and a misguided privatization in which shares were sold to a fragmented collection of investors. That approach produced a deadly cocktail of limited accountability and poor lending practices. Sloppy banking also helped postpone for too long the restructuring of large swaths of the Czech economy which survived on soft loans.

The sell-offs have staunched the hemorrhaging, and many hail them as an important step. "This is the end of crony capitalism," says Pavel Kavanek, chairman of the board of directors and chief executive officer of the recently privatized Ceskoslovenska obchodni banka (CSOB). "The name of the game now is impartial lending." A majority stake in CSOB was sold to Belgium's KBC Bank in mid-1999 for roughly $1 billion. And in February, 2000, the government approved the sale of a 52% stake in Ceska sporitelna, the bank Mladek originally intended to hold onto, to Austria's Erste Bank for about $500 million.

The one bank the government didn't expect to have to deal with was Investicni a postovni banka (IPB), which was fully privatized by the time the Social Democrats came to power. But the bank's financial distress due to poor lending in the past set off a massive run in June when it lost $440 million in deposits in just three days. Without a strategic investor in a position to help it pull through, the government was forced to intervene. The Czech National Bank reluctantly concluded that IPB's collapse would have caused the country's gdp to contract by 2% to 4% and was, in the parlance of central bankers around the world, too big to fail.

The CNB was unable to reach a settlement with Nomura International, a subsidiary of the Japan-headquartered investment bank, that represented the largest IPB shareholder, the Dutch Saluka Investments. On June 15 at 11 p.m., the government convened and endorsed a "non-cooperative" scenario. It was enforced the next day when two dozen members of the Czech antiterrorist police wielding submachine guns took over the bank's downtown headquarters and sent management packing. Vaclav Klaus, former Prime Minister and leader of the Civic Democrats, the strongest opposition party, decried the de facto nationalization as a "bank robbery carried out in broad daylight and directly assisted by the state" and a parliamentary commission was set up to investigate. Klaus' outrage seems a bit misplaced, since most economists say that his policies in the '90s led to the banking debacle.

Mladek insists it was the only viable solution. "There would have been public unrest had people been deprived of their savings. It would have turned the Czech economy into shambles." Randall Dillard, head of European emerging markets with Nomura International, disagrees. "It's fine to come in with a few police officers to communicate authority. But the idea that they were going to suddenly pull out revolvers and start to shoot people was crazy," he says. "It was a great hostile takeover, but it didn't need to occur this way." Dillard also cautions against regarding privatization as a cure-all for the sector's ills, which include weak mechanisms for speedy collection of collateral by banks. "We are not finished with it because it's being privatized," he says. "If they don't put better laws in place, then another problem is just around the corner."

He's right about the need for a better legal environment, but it now seems clear that IPB had ventured far beyond the existing legal framework. Three days after the police stormed its headquarters, the government turned IPB over to the Belgian-owned CSOB, which dispatched some 40 interim managers, doubling the number two days later, to assert control and assess the bank's finances.

What the CSOB found was a sprawling conglomerate counting some 600 variously interlinked companies which Kavanek describes as a "nightmare ... You have over-leverage schemes, pyramid schemes and all the tax havens you can imagine, Cayman Islands, Lichtenstein, Netherlands Antilles ..." According to Kavanek, the bank had to act fast to stop assets from being spirited away. "Basically everything was moving out." And he says that of the estimated $4.6 billion in outstanding loans, half were distressed and probably only 20% recoverable."

Similarly bad news awaited the Czech Finance Ministry at the last of the four big banks to be privatized, Komercni banka (KB). It is the country's second biggest after the CSOB/IPB merger, and like IPB, it will be a major money loser for the government even if it sells for the expected $1 billion to $2 billion. The state will have to put up at least that much to clean up KB's balance sheet, which is riddled with questionable loans. The police are currently investigating 11 former employees, including a number of board members, on suspicion of mismanagement of assets in connection with a deal that cost the bank $200 million. They are considering criminal charges in another case that cost the bank over $60 million.

Radovan Vavra, KB's new chairman of the board of directors and general director is strangely forgiving of the old management. "It's not that everybody was a criminal here and wanted to give bad credit. There were a number of very good, educated but naive people who didn't know what modern banking is about," he says.

Perhaps. But the bill for educating the country's rookie bankers has been steep. On top of the billions of dollars pumped into failing and failed banks, the Czech Republic has also wasted almost a decade in the necessary restructuring of the old socialist economy. The taxpayers who are paying the price are unlikely to be as forgiving as Vavra.