Banking Soundness and Monetary Policy

22 Restructuring the Banking Sector: The Case of the Czech Republic

Charles Enoch, and J. Green
Published Date:
September 1997
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In a market-oriented economy, the banking sector plays an essential role in facilitating payments and intermediating between savers and investors and in allocating credits by relative risk and return to efficient economic agents. A sound banking sector thus contributes to the smooth operation of the economy and to economic welfare. According to some authors the maintenance of a sound and properly functioning banking system could be considered in part a public good.1

In the case of the Czech banking sector, economic reforms were put in operation in 1991, and banks have had to cope with a number of shocks since the reform. The first stage of economic transformation comprised simultaneous price liberalization, limited currency convertibility, and a rapid wide-ranging privatization of state-owned companies, including a few existing banks. The underdeveloped banking sector was faced with a dramatic increase in the demand for financial intermediation as the number of new companies grew exponentially, and no stock exchange yet existed. At the same time, the “old banks” had to be cleansed of the bad loans inherited from the former regime, and new private banks were established. The split of Czechoslovakia at the beginning of 1993 implied adjustments both for the central bank and the commercial banks.

In 1994, the central bank launched a consolidation program targeting small banks. Some of them had to be closed, others restructured, and others merged. As a consequence, some erosion of credibility has occurred in the banking sector, and together with the government the banking authorities are striving to reestablish it. Extending and upgrading the supervisory department of the Czech National Bank is just one of the institutional changes that has brought about positive outcomes.

Stages of Development in the Banking Sector

In the course of transition, the Czech banking system passed through three stages of development:

  • An initial period of a rapid growth of banking institutions occurred in the years 1990-93. This development reflected the dramatic increase in the demand for financial services in the initial period of transition, given that the monobank system of the centrally planned economy was maintained in the former Czechoslovakia as late as 1989.
  • A period of consolidation followed, marked by an almost entire cessation in the granting of new licenses for general banking activities, although some were allowed for the start of mortgage banks and building societies. This stage was intended to enhance the stability of the emerging two-tier banking sector, to secure the implementation of prudential rules, and to improve the system of banking supervision. The consolidation, particularly of small banks, was expected to be supported by mergers and takeovers, as well as by the entry of new investors and the injection of fresh capital. In that respect, the process is still under way.
  • The follow-up period overlaps somewhat with the consolidation and is linked to the adjustment to EU standards. This implies a further upgrading of the efficiency and competitiveness of the domestic banking sector, as well as making the prudential rules and legal framework compatible with the conditions in the European Union.

As follows from Table 1, the time pattern of banking sector development in the Czech Republic resembles that in other transition economies. A rapid increase in new entries into the banking business during the first transition period of 1990–93 (53 new banks) was followed by the period of the “closed shop” in 1994–95. As a result, four bank failures in the latter period implied a corresponding decrease in the number of operating banks. Moreover, the lessons learned showed that most small private banks founded in 1990-92 experienced substantial difficulties later.

Table 1.Licensed Banks in the Czech Republic
As of 1/1/90New Entries in the YearAs of 12/31/96
State institutions41-41
Domestic banks1969-9-313
Banks with foreign participation
Entirely foreign owned1531111
Building savings banks426
Branch offices of foreign banks6410
Banks total5131317100-355
Liquidated banks00000134
Source: Czech National Bank.
Source: Czech National Bank.

Although large banks still dominate Czech banking, their share in total assets has been decreasing gradually since 1990. In the first transition years, it was due to the entry of new small private banks; more recently, the intensification of the role and activities of foreign banks and foreign bank branches has been the primary cause.

Whereas at the beginning of 19902 all operating banks in the Czech Republic were state owned, there remained only one bank, Konsolidační banka, that was entirely state owned, apart from the central bank, at the start of 1993. Most banks took the form of joint-stock companies. However, the National Property Fund has retained a significant stake of 30 to 43 percent in the “old” banks (the “big four”) privatized through the voucher scheme. The other banks, newly created ones, are owned either by domestic or foreign capital.

The Law on Banks (No. 21/1992) provided for a liberal regime for the entry of foreign banks, and at mid—1993 half of all licensed banks in the Czech Republic were either partly or wholly foreign owned. In accordance with the law, foreign banks can establish not only joint-venture banks and wholly owned subsidiaries as before, but also branches.

Most banks have developed as universal banks, a trend also seen in the Polish solution. By contrast, the Hungarian legislation encourages a more pronounced separation of commercial and investment banking. Along with universal banks, a number of specialized banking institutions started their activities, including the Czech-Moravian Guarantee and Development Bank (to promote small and medium firms), and savings banks for housing construction and mortgages.

Stabilization of the Banking Sector

In the first phase of economic transformation, the central bank and the government had to address a legacy of the past—nonperforming loans in the portfolios of large banks. Within the adopted stabilization program, they could write off or restructure a part of bad loans. The costs of the clean-up operations were covered by the privatization proceeds; a part was passed over to the banks’ clients via the interest rate spread. This partial stabilization had a positive effect on those banks that could intermediate more efficiently between depositors and debtors and respond to rising demand for banking services. The first tranche of the costs of partial stabilization of the banking sector could be thus viewed as a part of the social cost of economic transformation.

The second tranche of the restructuring costs arose when the stabilization of small private banks was launched by the central bank. Unlike those of large banks, the problems of several small banks were rooted in the economic transformation itself, when the newly established private banks (lacking prior experience and qualified personnel) extended credits to finance privatization and restructuring projects as well as investment projects in the nonfinancial sector. Since the state-owned companies were not restructured before privatization and the new companies had no real credit histories, the banks were exposed to extremely high risks. Indeed, a number of the projects failed to meet high expectations as to their rate of return, and the banks became captives of the nonviable indebted companies facing insolvency, default, and in some cases liquidation.

The second tranche was borne by the central bank, the insurance fund for deposits, and banks’ shareholders, including in the cases of mergers. Again, at least a large part these costs is attributable to and inseparable from the economic reforms taken since 1991.

Excess Demand for Banking Intermediation

The two-tier banking structure was created in 1990 through the transfer of portfolios from a monobank system. Only five banks were operating in the former Czechoslovakia at the start of banking reform. Leaving aside the special case of Živnostenská banka, they all were severely undercapitalized and at the same time burdened with inherited nonperforming loans and credits extended at artificially low interest rates.3

The economic transformation in the real sector implied a rapid expansion of registered business firms (see Table 2). Given the initial low capacity and low level of banking sector development, the demand for banking services after reform, let alone payment transactions, surpassed the capacities of the existing banks. The degree of monetization increased quickly and reached a level comparable with Austria (see Table 3). High demand for bank credits originated in the en masse privatization program, a part of it effected through direct sales to new owners who lacked capital. The underdeveloped banking sector was exposed to a type of intermediation burdened with a high risk usually taken by venture capital.

Table 2.Registered Firms and Employees in the Finance and Insurance Sector
Number of registered units18,837178,993955,6471,118,637
Number of employees in finance and insurance27,69737,40950,93264,621
Source: Czech National Bank.
Source: Czech National Bank.
Table 3.Monetization of Selected Economies
Czech Republic1
(In billions of koruny)
(In billions of deutsche mark)
(In billions of shillings)

For 1990-91, Czechoslovak data; data for M2 aggregate in 1990-91 are based on a constant exchange rate of US$1 = Kč 28, nonresident deposits included.


For 1990-91, Czechoslovak data; data for M2 aggregate in 1990-91 are based on a constant exchange rate of US$1 = Kč 28, nonresident deposits included.


New firms, including privatized state enterprises, did not initially have easy access to banking services, particularly credits. The general public and the government exerted pressure on the banks to increase their exposure in the privatization and restructuring processes in the real economy.

The banks became subject to criticism because of their “uncooperative” approach in extending credits to the corporate sector. When the operating banks were unable to meet the high demand for banking services, entry of new banks to the banking sector became necessary. Another reason to encourage entry was to increase competitiveness and support banking product differentiation. Otherwise banking credits would have been replaced by interenterprise debt—in fact, enforced trade credits. Also of concern were the risks inherent in the transition from transfer to cash payments and finally to barter trade. The threat of demonetization was met with accelerated growth of banking sector capacity, granting banking licenses to new banks including foreign ones.

Consolidation Program I

One legacy of central planning was a substantial volume of bad loans in the portfolios of operating banks and their initial undercapitalization. The Consolidation Program I was implemented in the period 1991–93 to prevent a systemic crisis with potentially serious destabilizing effects on the real economy in the first phase of its transformation. Compared to the international standard of capital adequacy (at least 8 percent capital to asset ratio), the major Czech banks were operating at or below 1 percent. In technical terms, all banks were insolvent.

The conception, consolidation and recapitalization of banks can be carried out either in a centralized or decentralized way. The two approaches can also be combined. The former means that all bad loans are transferred to a special institution. In the Czech Republic, this was Konsolidační banka (KOB). The latter is based on the prerequisite that individual banks “handle” these credits themselves. Both methods require capital injections, particularly if the banks are heavily undercapitalized in the initial period.

The clean-up operation reduced the bad loan burdens of the big banks. Initially Kč 22.2 billion and through recapitalization of the banks Kč 7.8 billion of new capital was injected into the banks’ balance sheets. Both were covered from the privatization proceeds of the National Property Fund (NPF). On top of those operations, KOB purchased from the commercial banks credits worth Kč 15.1 billion at 80 percent of their nominal value. The remaining 20 percent was covered from the reserves of the respective banks.

The most important outcome of the Consolidation Program I was its effect on the real economy. Because of recapitalization and partial consolidation of the major banks during the first phase of economic transformation, these banks could fulfill their intermediating function between depositors and credit recipients more efficiently and service financial transactions during the critical period of privatization and the entry of new firms to the market. Despite some problems, the risk of a systemic crisis in the banking sector and destabilizing effects of such a crisis on the real economy was avoided. Compared to the experience of other transition economies, this effect cannot be overemphasized. Several economies (Bulgaria, Latvia, Hungary, Ukraine, and others) have undergone a full systemic crisis in the banking sector. One of the reasons seems to be hesitation with respect to the major banks’ consolidation.

The consolidation and recapitalization of the banking sector was costly and would not have been possible if the government and the National Property Fund had not shared the costs. During the subsequent transformation, the costs of banks’ consolidation and recapitalization yielded returns to the NPF. Following privatization of the companies whose bad debts were restructured or written off, the NPF could collect higher revenues than would otherwise have been the case.

The prevention of a systemic crisis seems to have its own value, however: “The possibility of contagion means that a single bank failure carries with it larger impact to the extent that it leads to or is associated with other bank failures and a shutting down of the payment system.”4 The costs borne in preventing it—especially in the period of transition from a centrally planned to a market-type economy—are therefore intrinsically social ones.

Consolidation Program II

Consolidation Program II, in contrast with the consolidation of the major banks in the first phase of economic transformation, focused on small and medium-sized banks established as new private banks after 1990 (Table 4). Although the first partial consolidation of some small banks was worked out as early as 1993, a more comprehensive approach was implemented by the Czech National Bank and its banking supervision arm only later. For this reason the central bank prepared a comprehensive program of small-bank consolidation in order to prevent a domino effect, following the default of some of them. This would have led to a loss of confidence in all small banks, a reduction in their access to the interbank market, and a transfer of deposits to major banks.

Table 4.Small Banks Under Liquidation, Conservatorship, and Prepared for Merger
Name of BankMethodTotal Assets (in billions of koruny)Total Assets as a Percent of the Banking Sector
První slezská bankaLicense revocation, liquidation1.310.07
Kreditní banka PlzeňLicense revocation, liquidation22.551.17
Podnikatelská bankaConservatorship5.160.26
Velkomoravská bankaConservatorship4.500.23
Subtotal, conservatorship or license revocation35.221.8
COOP bankaConservatorship, takeover by Foresbanka5.700.29
EkoagrobankaConservatorship, takeover by Union banka15.420.79
Bankovní du˙m SkalaTakeover by Union banka7.040.36
EvrobankaTakeover by Union banka9.970.51
Subtotal, prepared for merger with another bank38.131.95
Source: Czech National Bank.
Source: Czech National Bank.

The small banks differ from the major banks in two basic characteristics: they lack the more substantial base of primary deposits and are disproportionately exposed to risky businesses. Small banks, which at the start of their existence had to build up a branch network and cope with the traditional inclination of depositors to prefer established major banks, first became dependent on central bank refinancing and later on the interbank deposit market. As interest rates in this market were high, the assets of small banks became concentrated in credits and other claims with high risk.

When the first small bank failed, the small banks as a group faced a slowdown and then a decline in the growth of deposits. At the beginning of 1996, several small banks were unable to cope with the diminishing deposits; the composition of their liabilities and the poor quality of credit portfolios created heavy pressure on their liquidity. Despite stabilization efforts made on behalf of these banks, the authorities were largely unsuccessful in stopping this unfavorable development. Banking supervision at the Czech National Bank sometimes even encountered unwillingness on the part of bank owners to attempt radical solutions to the problems.

The culmination of several small-bank failures in 1996 is explained by the identical lifecycle of their portfolios. Credits granted in the 1992-93 period “matured” in 1995-96, and many of them turned out to be loss making. An overview is given in Tables 3 and 4.

The basic and common cause of the problems facing small banks was the rapid credit expansion at the start of their activities. All banks with solvency problems created the major part of their credit portfolios in the period of 1992 to 1993. Yet the highest credit risk exposures also originated in this period.

Identification by banking supervision of the quality of these credits was significantly complicated by the absence of a uniform system for classification of credit portfolios. Only after 1994, when the central bank introduced strict principles of classification of credits and creation of reserves and provisions against classified credits, was it possible to identify poor-quality credits in bank portfolios. This led to a significant, once-and-for-all increase in recorded classified credits, and their share in total credits roughly tripled to reach about one-third of credits in the banks’ portfolios by 1996. It is interesting to note that auditors’ reports did not signal any major problem in these banks until the end of 1994.

The main reason for adopting the measures within Consolidation Program II was to prevent a loss of confidence in banking institutions. Although small banks have only about 10 percent of the bank market, the continuing bankruptcies of small banks might gradually undermine public confidence in the banking sector as a whole.

The basic approach adopted by banking supervisors with respect to the small banks was to make existing shareholders and new investors adequately increase the bank’s capital and actively participate in the process of restructuring the bank. If these measures were successful, the deposits would be safe, and there would be no need for public funds to stabilize and rehabilitate the bank (see Table 5). An example of bank stabilization by means of new capital is Universal banka. A merger with partial participation of public funds also might prove less costly than closing a bank and compensating depositors; the latter was employed in Evrobanka, Bankovní du˙m Skala, Ekoagrobanka, and COOP banka (see Table 4). Liquidation of a bank was initiated only if the above methods failed.

Table 5.Small Banks Recapitalized by Shareholders and New Investors
Name of BankSource of CapitalTotal Assets (in billions of koruny)Total Assets as a Percent of the Banking Sector
Universal bankaNew Investors4.590.23
Moravia bankaExisting shareholders11.80.60
Banka HanáMultiple increase capital under way24.131.23
Zemská bankaBank under restructuring, limited activities1.960.10
Plzeňská bankaExisting shareholders3.370.17
ForesbankaExisting shareholders12.400.63
První městskáCapital increase unnecessary6.180.32
Union bankaBank will increase capital to effect a merger13.890.71
Source: Czech National Bank.
Source: Czech National Bank.

To prevent a subsystem crisis, the Czech National Bank, in individual cases, provided guarantees for deposits above the limit of the deposit insurance fund. Within this context, the issue of moral hazard often arises. The Czech banking system did not face moral hazard in the standard sense. Rather, the failures of small banks, where deposits were insured only in small amounts, caused an erosion of confidence in the whole banking sector, and depositors started to shift deposits to large banks and later to withdraw them altogether. The banking authorities had to provide extra guarantees to the depositors to stem the flight, and consequently the costs of stabilization were higher than if a wider deposit insurance scheme had been introduced from the beginning.

Role of Banking Supervision

The incidence of bank failures highlights the role of banking supervision. The crucial objective of banking supervision is often the mitigation of potential instability in the banking system by minimizing systemic risk. Systemic risk in the banking sector is defined in two ways: a contagion effect as the failure of one commercial bank infects the entire banking system; an informational effect, or the possibility that an economic subject can foresee, on the basis of available information, a failure of other banks displaying the same characteristics as a bank in question.5

Systemic risk can be classified according to the potential causes:6

  • vulnerability of banks to depositor runs;
  • risk to the payment system, as when a large participant fails to meet clearing obligations; and
  • destabilizing trading practices arising from “procyclical” trading practices.

If the role of banking supervision is to reduce or limit systemic risk, then this target can be achieved in part through a high degree of public confidence in banks, since in a climate of uncertainty even a solvent bank could easily lose the confidence of depositors. An important reduction of this risk can be achieved by attempts at controlling banks’ solvency and liquidity. A further step is the imposition of a minimal capital requirement and, at the same time, the limitation of risk exposures to individual borrowers and limits for credit exposure.

Banking supervision as a regulatory body was established as part of the central bank in 1991. Like enterprises in the nonfinancial and the banking sectors, banking supervision has had to deal with rapid changes in the real economy. Those changes, for a time, outpaced the capacities of the institutional and legislative framework; property rights were often enforced de facto rather than de jure; and, last but not least, the pool of qualified personnel for the financial sector was very limited initially. The first phase of banking supervision development was marked by a lack of experience. Regulatory and supervisory activities lagged behind banking sector development.

Banking supervision’s capacity to act effectively increased gradually. New regulatory rules clarifying existing provisions and initiating amendments to legal norms were introduced. When the first serious problems were identified, roughly in 1993, a comprehensive analysis of the situation in the banking sector and in banking supervision was carried out. This evaluation led to two principal provisions, the first of which was a temporary licensing moratorium and the second a substantial strengthening of banking supervision personnel. It is necessary to emphasize that hardly any other central bank activity saw such an expansion as the inspection and analytical activities of banking supervision.

In 1995, banking supervision arrived at a stage where it was able, based on consistent monitoring of banks’ situations, to identify problems in time to find adequate responses, and enforce them. In principle, by the end of 1995, a more sophisticated regulatory system for the Czech banking sector was completed. This system has enabled legal procedures to be taken and radical solutions found for the accumulated problems in the banking sector. More and more a need for broader supervision of the financial sector is surfacing, however.

Banking supervision as regulator of the banking industry will now focus more on competition and efficiency. The Czech banking sector lags considerably behind neighboring Austria and Slovenia (see Table 6). The latter country has experienced similar transition issues to the Czech Republic. Although the interest rate spreads that the Czech banks operate fell dramatically in 1994 and 1995, they were still roughly twice those of foreign banks operating in the domestic market.

Table 6.Profitability and Effectiveness of Czech, Slovenian, and Austrian Banking Sector, 1995
Czech RepublicSloveniaAustria
Return on equity (in percent)
Return on assets (in percent)
Interest rate spread (in percent)4.666.542.77
Inhabitants per branch3,052.003,460.001,350.00
Banking assets (in billions of dollars)65.5118.50233.20
Source: Czech National Bank.
Source: Czech National Bank.

In order to stabilize the segment of small banks further and regain the confidence of the general public, the Czech National Bank launched a new scheme in 1996 within which the banks have been invited to temporarily clean their loan portfolios and use the breathing room to build up reserves and upgrade know-how with the help of the central bank. The aim of the scheme is not only to buy time for addressing the issue of bad loans but also to prevent or minimize new nonperforming credits. The funding is provided by the central bank and guaranteed by the government.

Anticipated Developments

Because of the above measures, the Czech banking sector has been generally cleaned up and stabilized and, in financial terms, is in much better shape now than at any time since the start of economic reforms. Therefore, the future supervision of banks will focus on monitoring changes in the financial “soundness” of banks rather than on solving their bankruptcies. The banking sector is likely to be more influenced now by other phases of ownership restructuring in the area of the real economy and by completing the privatization of major banks. In addition, capital market development will generate greater competition in the banking sector, and the integration of Czech banks into European structures will expose Czech banks more substantially to the influence of strong banks from the EU countries.

Experience shows, however, that banking crises are frequent even in developed market economies. It is thought that the main reason lies in the discrepancy between the speed and scope of financial operations on the one hand and the lesser flexibility and adjustment of the real economy on the other. In the case of the Czech banking sector, the character of the economic transformation—including still inadequate regulation of the environment in which the banks operate—have amplified these factors. I have in mind both the business legislature and the regulation of domestic financial markets, where banks are undoubtedly the most strictly regulated entities. However, banks are affected by the inadequate regulation of other parts of the financial markets, like capital and insurance markets and investment and pension funds. The banking sector still needs to adopt standard principles of business ethics and make other segments of the financial sector follow.

Obviously, the development of the Czech banking sector is proceeding fast and the know-how acquired is currently at an incomparably higher level than several years ago. Nevertheless, the banks still have a way to go before they approach the strength and sophistication of banks in advanced countries.

Final Remarks

An analysis of problems in the Czech banking sector points to many causes that were difficult or impossible to avoid. The banking sector as well as its regulators had to learn by doing, and mistakes inevitably happened. One must dismiss the naive idea that a functional market environment can be created overnight and then the next day be staffed by educated economic agents.

In fact, the same sort of problems can be observed in other segments of the financial sector: capital market institutions, commercial and health insurance companies, and pension funds. One can go even further and point to similar banking and financial sector failures in other central and eastern European countries. From this perspective, the cost of consolidation should be seen as a “transition tax” paid by the whole society.

It would be unfair, however, to blame only objective reasons for the above transition tax. Part of the consolidation cost should be attributed to a misperception of the role of markets in the economy. Proper regard was not paid to the fact that while some reform measures can and should be done quickly, others, like forming market institutions, changing the legislative framework, or cultivating new behavior, are of a gradual nature. This institutional dimension of the transition process seems to lag behind the growth of the financial sector. Therefore, the measures directed toward overcoming the problems should concentrate predominantly on it.


H. J. Blommestein, “Transformation of the Banking Sector in Central and Eastern Europe: Policy Assessment and Next Steps,” paper prepared for the joint OECD/WIIW seminar in Vienna, December 9-10, 1996.


One exception was the Czechoslovak Trade Bank, which was constituted as a joint-stock company, with 51 percent of equity capital owned by the State Bank of Czechoslovakia and the remainder by specialized foreign trade corporations.


According to available sources, after start of the transition in 1991, about one-quarter to one-third of the outstanding loans were evaluated as bad, nonperforming, or high risk.


G. Caprio, and D. Klingebiel, “Bank Insolvency: Bad Luck, Bad Policy, or Bad Banking?” paper prepared for the World Bank’s Annual Bank Conference on Development Economics, Washington, April 25-26, 1996.


M. Dewatripont, and J. Tirole, The Prudential Regulation of Banks (Cambridge, Mass.: MIT Press, 1994).


K. Hviding, “Financial Deregulation,” OECD Observer, No. 14 (1995).

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