When financial historians come to write about the Czech economy in the 1990s they may pick one of the following clichés to describe it: “the lost decade”, “the invisible revolution”, “the Prague winter”. Any of these would describe how eastern Europe’s most promising economy after the collapse of communism has, by way of incestuous politics and bad management, ended up as an also-ran. A damning report by the European Union, which singled out the Czech Republic as the only applicant among six that needed to make serious economic progress towards accession, fittingly sums up the last 10 years.
The good news is that the message is at last getting through to the government that essential reform is long overdue. Although things need doing on many fronts, the most critical reform and the one that has most held the Czech Republic back – bank privatization – is finally going ahead. Cynics argue that even now this is only being done because the government has no other choice: balance sheets are shot to pieces following years of lending to privatized companies, many of which are now bankrupt. With a budget deficit approaching 3% of GDP – close to the Maastricht ceiling – the option of continually bailing them out has disappeared.
Reluctantly the government will have to give up control of a powerful financing arm that in a country with poorly developed capital markets was the only show in town, and which allowed loans to be made for political rather than economic reasons. Predictably many of these loans turned bad and the state is being forced to retreat from its commanding position in banking. The unanswered question is the economic cost of delaying for 10 years a reform that should have been a priority.
Estimates of the total cost of bail-outs and recapitalizations, which run into double figures as a percentage of GDP, represent only a fraction of the damage. (Simon Nellis, analyst with CAIB in Prague, has come up with a rough figure of $5.9 billion or 11% of GDP.) On top of that must go the reduced sale price of the banks and the failure of much of Czech industry under the bad influence of easy credit. The opportunity costs of getting it so profoundly wrong are incalculable. Meanwhile Poland and Hungary have made good progress in restructuring and privatizing their leading banks.
“The problem here is a political one, it’s not fundamentally an economic problem,” says Zdenek Bakala, chairman of investment bank Patria Finance. “The lack of performance is political in nature and bank privatization, which is being forced on the government, is the only way to start the reform of the system because you bring in someone who is not prepared to play the game.” Patria is advising the government jointly with Merrill Lynch on the sale of Ceska Sporitelna, the biggest Czech retail bank.
Czech bank privatization was given a big push in the summer when Belgian bank KBC paid a high price – 2.3 times book value – for a controlling stake in Ceskoslovenska Obchodni Banka. Among large Czech banks CSOB’s balance sheet is one of the least battered, and it has gone further than most in dealing with what problem loans it has. All the same, some analysts were staggered by the price paid. “It must be one of the most expensive bank acquisitions the world has ever seen,” says Martin Taylor, a fund manager with Baring Asset Management in London. “In central Europe you want to find a bank with retail deposits but CSOB was a trade bank so doesn’t have much of a branch network. KBC said it wanted to build up the branch network which is interesting because everywhere else banks are closing branches down not building them up.”
A fully fledged retail network with more than 1,000 branches, albeit a high-cost one, will come the way of Austria’s Erste Bank if it succeeds in getting its hands on Ceska Sporitelna. Badly run as it is, with non-performing loans of 44.3% of total loans last year, Ceska Sporitelna still maintains a dominant 34% share of the retail market. Erste Bank has been given exclusivity to bid for Ceska Sporitelna following an unusual procedure whereby bidders were asked to give different prices depending on what condition they received the bank in.
The cheapest option for the Czech taxpayer would almost certainly be to let the bank go for a nominal sum and let the buyer clean it up. But most likely Sporitelna will be sold at a higher price either cleaned up or backed by government guarantees as it would be politically difficult for the Czech government to let state assets go for a nominal price. That would mean admitting that under state ownership in a market economy the value of the banks has been sadly reduced. Erste’s chief executive, Andreas Treichi, said in late October that its offer would be based on the group’s receiving guarantees and that it would not bid if it had to worry about credit risks in the portfolio.
This was the case with CSOB. Explaining the high price obtained for CSOB (which had non-performing loans to total loans of 30% in 1998) becomes easier knowing that 37% of the loan portfolio is guaranteed by the state. It also reflects a lack of opportunities for foreign banks to get inside the Czech market which with a per capita income of around $5,000 is still, despite all the bad management, the highest in eastern Europe.
With Investicni a Postovni Banka (IPB) sold to Nomura in March last year, and provided Erste does take Ceska Sporitelna, that leaves only Komercni Banka among the biggest four Czech banks. As one of the largest banks in central Europe by assets but with a loan portfolio that is most exposed to the country’s troubled industrial sector, Komercni Banka will be quite a challenge for even the most experienced buyer.
Salomon Smith Barney analyst Matthew Czepliewicz calculates that at end-1998 Komercni had Kr29 billion ($830 million) of unprovided bad debt exposure but shareholders equity of only Kr20 billion. To make matters worse a rights issue to raise Kr9.5 billion in equity has been delayed because of legal challenges by minority shareholders and the government was forced instead to transfer Kr23.1 billion of non-performing loans to state-owned bail-out vehicle Konsolidacni Banka for Kr13.6 billion. This transfer is almost certainly not the last.
“After the rights issue and the transfer of Kr23 billion of bad loans, our forecasts show Komercni remaining marginally above the minimum capital requirement into 2001,” says Czepliewicz in a report on Czech banks. “We are confident that the Czech government is highly unlikely to let the ratio fall much lower than our forecasts, and therefore would expect further capital increases or bad loan transfer.
“Of the Czech banks, Komercni Banka is most vulnerable to the continued deterioration in the macroeconomic environment [GDP contracted an estimated 2.3% last year and is estimated to shrink 1.8% this year]. Its loan book is heavily weighted towards domestic industrials, representing over 50% of the loan book, which have been hardest hit over the past two years.”
Any takers? The rumours are that only four banks have expressed an interest, less than half the number that did likewise for Sporitelna. With Komercni not slated for privatization until late 2000 it may be too early to read this as a lack of enthusiasm. On the other hand, as one Czech bank watcher notes, “some foreign players express interest only to be polite”, so the true roll call could be even less flattering.
If that’s the case there could be scope for the unexpected. The conventional wisdom in Prague is that Nomura would be prepared to sell its stake in IPB should the right buyer come along and that Deutsche Bank, which was pipped at the post in the race for CSOB, is an interested buyer.
Says Jan Klacek, chairman and CEO of IPB: “From the beginning Nomura declared that their presence here is not a strategic one but a commercial one. They wanted to wait until the assets are properly valued and the bank performing in a way that is attractive and then consider the sale of the bank.”
But Randall Dillard, the Nomura managing director who put the IPB deal together, says there are other possibilities including that Nomura could bid for Komercni and, if successful, merge the two banks. The idea of a Japanese investment bank owning the biggest commercial bank in eastern Europe may appear fanciful to some but in the Czech Republic, where the art of the deal can often count for more than the weightiness of a name, this possibility should not be completely ruled out.
“The long-term plan is to merge [IPB] with other banks,” says Dillard, “and one alternative is to merge with Komercni Banka. We expressed an interest in CSOB but the government took a policy decision that it wanted a new commercial bank to come in rather than somebody already here. We haven’t formally expressed interest in Komercni and I’m not sure the government would entertain the idea but it’s a viable option.”
“There will not be four Czech bank survivors [when the country joins] the European Union. It’s just not possible. In 20 years time there won’t even be two,” says Dillard who explains that there are two ways to consolidate. The other option is to bring strategic partners into IPB such as a bancassurance player or separate bank and insurance investors. That might involve selling control but with Nomura retaining a stake to reap the upside from whatever value-added the new investor could produce.
According to Dillard, IPB is modelled on ING so that might provide hints as to the way it will go in future. The bank offers a wide range of services including insurance, pension funds and mortgage loans and its retail potential was transformed with the merger in January 1994 between Investicni Banka (the wholesale industrial development bank) and Postovni Banka (the post office savings bank), which gives it outlets through the post office network. IPB has been aggressively pursuing Sporitelna for retail market share.
Nomura Europe PLC holds only 8.3% of IPB directly with a special purpose vehicle called Saluka Investments BV holding 35.3% of which Nomura is the beneficiary. Says Czepliewicz in his report: “Our main concern with IPB is the opaque ownership structure and the weak corporate governance that this has led to. The other concern is a legacy of its industrial development role which resulted in the accumulation of a substantial equity portfolio, which management has been slow to dispose of.”
Relations between Czech banks and Czech industry are much too close and this partly explains the levels of bad loans. It’s difficult to deny a loan to a company a bank has an equity stake in. Apart from straight industrial holdings the banks gained corporate equities through the voucher funds they set up at the time of privatization. With the banks remaining state-owned some critics have argued that Czech industry effectively stayed under government control. Right now the government through its revitalization programme is buying the debt of stricken Czech corporates and swapping it into equity, a process that has been dubbed renationalization.
But did the government ever relinquish control in the first place? Bankers whose institutions are struggling under mountains of bad debt argue that they had little choice but to participate in privatization lending. “Foreign banks concentrated on the best companies; there were no capital markets so the commercial banks of the country had to do the dirty work,” says Peter Palecka, deputy chief executive and board member with Komercni. “To a great extent these problems are the normal result of a pioneering period.”
Palecka estimates that of the bank’s bad loans one-third were inherited from the communist era, one-third came as a result of the transformation in the early 1990s and another third spring from later economic troubles. But he says that the introduction of a new scoring system for lending at the beginning of 1998 has greatly reduced loan losses to 0.6% of newly granted loans.
Using an apt metaphor for a state-owned bank, Palecka says: “We are like the Soviet hockey players who used to practise with 80 kilograms on their shoulders. The 80 kilos are the non-performing loans from the past and we hope to get rid of them and realize our full strength.” Palecka, who used to be the Czech representative at the WTO, joined Komercni last year with a brief to assist privatization and investor relations.
Petr Hlavacek, board member and deputy CEO at Sporitelna, says: “Ceska Sporitelna and Komercni Banka represented about half the banking market so it would have been difficult for privatization to take off without us. The banks have also suffered because we have a legal environment that is debtor-friendly making it difficult to recover loans.”
Others are less forgiving of the banks’ role in an economic system that did not bring about widespread gains. “The privatization was mishandled and led to the establishment of [corporate] ownership structures that are not interested in the capital markets by definition because they don’t like transparency,” says Patria’s Bakala. “They prefer the old government-controlled banking relationship because at the end of the day the government will have to pay the bill.”
“It lasted this long because the country was relatively well off at the beginning with significant reserves and no debt to speak of. Many companies had massive assets on their books at unrealistically low values.” One difficulty for the banks was that real estate used as collateral for loans turned out to be almost impossible to seize under Czech law. As a result the central bank ruled that real estate collateral must be phased out. This has added considerably to provisioning problems.
But not every bank succumbed to political pressures to lend, so managements cannot entirely get themselves off the hook with this argument. CSOB is one that bucked the trend and chairman Pavel Kavanek is noted for his opposition to voucher privatization. “From the beginning we didn’t trust the voucher scheme because it doesn’t bring new capital into the country. We were criticized for this but it was proven that we were right,” says bank spokesman Milan Tomanek. “Mr Kavanek used to say ‘we preserve shareholders’ interests even against their will’. This is the reason he didn’t become a senator or a member of parliament. CSOB was heavily criticized by Klaus [former prime minister Vaclav Klaus who declared himself a supporter of Margaret Thatcher and the free market] for not supporting state companies.”
Only CSOB would do
Carl Rossey, a KBC executive who is now on CSOB’s board, says: “KBC wants to be active in eastern Europe and we typically look for partners which have potential on their own. Our style is not to buy badly managed banks and turn them around. So looking at the Czech market in terms of opportunities CSOB was the only candidate we could consider.” KBC’s sister bank, KBL of Luxembourg, has a 55% stake in Patria so there are clear opportunities for cooperation or even a merger between Patria and CSOB. KBC’s aim is to build retail at CSOB whereas Patria is strong in asset management. Putting the product together with the distribution network would appear to make perfect sense.
Says Vladimir Jaros, research director for brokerage Wood & Company: “The banks can’t blame the government for their own mistakes. They lent money because they wanted to.” Now the problem is that the major banks aren’t lending much at all and the Czech economy is faced with trying to recover without credit growth as a driver. While many investors are completely disillusioned with the country, portfolio investors who think that change is really on its way this time have few places to put their money. There are only a handful of liquid shares listed on the stock exchange. It is a sad reflection of the moribund condition of the market that there has never been an IPO in Prague.
Says Dalibor Vavruska, a Czech equities analyst with ING Barings: “Investors are more cautious now than in the early 1990s. This year the stock market has outperformed largely on the basis of the banks [share prices have risen in anticipation of bail-outs and eventual privatization]. But investors’ confidence is only gradually returning.” Vavruska notes that banks have had to sell many of their equity holdings since legal changes forced closed-ended investment funds to open and prevented funds from holding more than 11% of a company. This sell-off has been dubbed the third wave of privatization.
So Czech banks are starting to slim down and concentrate on their core businesses, but a lot of time has been lost. Euromoney‘s sister publication Central Europeanrecently published a ranking of the region’s banks compiled by Standard & Poor’s showing the growing influence of Polish banks and the decline of Czech ones. Ranked by adjusted common equity Komercni Banka fell from first to fifth place between 1997 and year-end 1998. While Komercni and Sporitelna used to be the largest banks in the region, Polish banks such as Bank Pekao and Bank Handlowy w Warszawie (even before taking account of the proposed merger with Bank Rozwoju Eksportu) came first and third respectively. Polish banks have benefited from strong regulation and increasing foreign ownership while Czech banks have stagnated.
Yet there is some positive news on Czech banks. In the ranking, CSOB climbs from fifth to second and IPB is up from 19th to sixth showing that restructuring and privatization, in the case of IPB, bring results. This message has finally got home to Czech politicians and, ironically, it is the governing left-of-centre Social Democratic party that has got on with privatization after years of stalling under right-wing administrations.
Says S&P analyst Walter Pompliano: “If you talked to Czech politicans four years ago they would say ‘we will never sell the banks, they are the country’s jewels’. Now they realize the bills that have to be paid and are changing their thinking.”
The high cost of waiting
But the price for waiting has been high. One of the most gloomy reports on the Czech banking sector has been put out by Nomura’s own equity research department in London. “Even after the eventual clean-up both KB and CS are likely to take a place in the bottom of CEE [central and eastern Europe] banks in terms of profitability, strangled by sticky cost structures and the low-growth nature of the Czech market,” write analysts Andrei Ilyin and Mike Wheelhouse. “Ongoing lending problems, furthermore, would hardly disappear before corporate restructuring accelerates dramatically, and until new banking laws are in force.”
The Nomura team makes comparisons between Czech, other east European banks and some western European banks in terms of asset quality, margins, cost of risk, profitability and efficiency. It discovers that the higher returns offered by east European banks, and particularly the Czech banks, are often insufficient to compensate for the higher risks of investing in an emerging market. Investors would be better off buying equity in west European banks.
Non-performing loans not covered by provisions, as a percentage of shareholders’ equity, exceed 100% for Komercni, Sporitelna and IPB (by contrast pre-privatization Crédit Lyonnais last year still managed 44%). Only CSOB appears to be in line with western ratios on its provisions of non-performing loans, the Nomura report finds, using figures that ignore collateral.
The story is the same for return on equity where Nomura estimates that only CSOB will report a decent – in the region of 10% – return on equity over the next two years and costs – CSOB is the only one of the big four to keep costs below 2.5% of assets.
“Investors with flexible mandates should watch valuation differentials between the EU and CEE banks, and compare them to the differentials in financial performance and risk profiles. In many instances, prospects for financial institutions in developed markets may appear more promising in the age of cheaper delivery channels and consolidation,” says the Nomura report.
For western European investors, who at the start of the decade saw great potential and promise in the Czech Republic, this is a sad outcome.
