After major efforts since 1990 to lay the foundations for a market-based financial system in the countries that have abandoned socialist planning, many would like to believe that financial transition has been accomplished. But the emergence in mid-1996 of a full-scale banking crisis in the Czech Republic is a sobering reminder that much remains to be done.

A new Report by the Economic Policy Initiative (EPI), a joint venture by CEPR, the Institute for EastWest Studies and seven local partner institutes in the Associated Countries, provides essential background information for understanding recent developments in the region. It assesses how far banking sector reforms have gone towards enhancing corporate governance, promoting market liquidity and facilitating the retreat of the state.

The last objective is what makes transition economics distinctive. It is the area of policy-making where it is most difficult to strike the right balance. In mature capitalist economies, the state plays an important role as regulator and rule-maker. But it exercises its influence at a distance from the private sector. Given the heritage of socialist planning, when state intervention was pervasive and direct, the challenge of transition is to reduce the presence of the state while preserving its capacity to intervene occasionally when needed.

These issues are at the heart of banking policy. Transition economies still face serious risks associated with trade patterns, relative prices and the institutional environment. All are in a state of flux. Consequently, maintaining the stability of the banking system must be a major concern.

Despite some significant crises in recent years, mature capitalist economies have been remarkably successful in assuring stable banking through a routine regulatory apparatus based on three institutions: risk-adjusted capital standards, which make banks diligent in screening and monitoring their debtors; exposure limits towards a single debtor; and deposit insurance, which maintains public confidence in banks and reduces the chance of banking panics.

These are all backed up by lending of last resort, which generally takes the form of central bank provisions of liquidity on a selective basis. Only rarely does state intervention get to the point of active participation in restructuring banks’ assets and liabilities. The effectiveness of routine prudential regulation has meant that banking sectors could become competitive without threatening safety.

The EPI report argues that in order to understand banking policy in the first five years of transition, the mature capitalist scheme described above must be inverted. The overwhelming preoccupation of transition banking policy has been to restructure the large state-owned commercial banks that were spun-off from the national bank.

Restructuring the bad loans made by state-owned banks to state-owned enterprises seems simple in theory, but the clean-ups have been time-consuming. Hence it has been impossible to draw the line between ‘old socialist’ bad loans and ‘new transition’ bad loans.

In some countries, these problems were exacerbated by a series of poorly-planned and half-hearted reform measures, which made bad loan clean-up a constant theme in political debate. Even in countries where actions have been more decisive, the state’s habitual claims that the banks have been recapitalized ‘once and for all’ are probably not credible.

The EPI Report argues that policy-makers must recognise that the state may be called upon to help the banking sector deal with system-wide shocks, against which private banks are unable to hedge. The state should disengage from special relationships with the national bank spin-offs and exercise its responsibilities for banking safety through arm’s length policies applied fairly throughout the banking sector. Crisis management must be replaced by serious reinforcement of routine protections.

In the cases where public intervention is required to deal with large-scale distress, the state should seek to preserve financial discipline in the future: in cases of complete failure, large depositors should make a major loss, shareholders should lose all, and managers should lose their jobs and face full legal scrutiny in cases of possible fraud.

While some people are pushing for such policies, big obstacles remain. The state’s presence in banking generally remains high: even privatized banks often have the state as their largest shareholder. And many support the notion that in order to prepare for international competition, the banking sector should be consolidated into a few large banks. The EPI Report argues that such banks would become ‘too big to fail’, cementing their privileged relationship with the state.

It has also proved difficult to move financial policy away from crisis management and into routine prudential regulation. Bulgaria is a good example: throughout 1996, banks with ballooning bad loan portfolios were kept alive through easy refinancing credits from the central bank. In the face of rising inflation and IMF pressure, the government put a halt to this in the autumn, shutting down 14 insolvent banks and pushing to replace the central bank with a currency board.

More surprising is the crisis in the Czech Republic, where in theory the private sector has responsibility for further economic restructuring now that large-scale privatization is finished. But the state still has big stakes in the largest banks, and this influence is leveraged in the privatized sector through the banks’ investment funds, which control a large fraction of the population’s privatization vouchers.

In 1994–5, the failure of three medium-sized banks plus some smaller banks effectively depleted the deposit insurance funds and left the banking sector vulnerable. In 1996, some additional small banks failed, but the big shock to the system came in August with the failure of Kreditni Banka, the sixth largest commercial bank.

The public sector moved rapidly to stabilize the banking sector by assuring that Kreditni’s depositors would make only limited losses. But confidence was clearly shaken. In September, Agrobanka, the fifth largest bank, began to experience massive withdrawals. Even though it was argued that the bank’s loan portfolio was sound, the state intervened directly by placing it under central bank administration and announcing that all its deposits were guaranteed.

The Kreditni Banka bailout demonstrates how difficult it is to establish arm’s length regulation in transition economies. It is also a lesson in the workings of the new Czech financial system. Official deposit insurance funds covered only 80% of individual deposits up to 100,000 crowns. But Ceska Pojistovna, the largest Czech insurance company and Kreditni’s largest single shareholder, said it would cover losses on other deposits up to 4 million crowns.

Why would a shareholder do this? Perhaps because Pojistovna intended to finance the operation through an exceptional share issue to its own largest shareholders: Investicni a Postovni Banka and Komercni Banka (both large privatized commercial banks in which the state retains a large share), Ceskoslovenska Obchodni Banka (which has not been privatized), and the National Property Fund.

This is not the first time that the new institutions of the Czech Republic have worked together to find ad hoc solutions to the unforeseen problems that emerge in a transition economy. In some ways, it reveals one of the strengths of the Czech system. But it also suggests that a stable and competitive private banking sector that can deal routinely with credit risk is yet to be achieved.