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Bad Czech Banks
Subject Economic Development
Topic Developing and Transitional Economies
Key Words Economic Growth, Investment, Unemployment
News Story

The Czech Republic's transition from a communist to a capitalist system has not been without problems. Initial attempts at establishing a private banking system and investing resulted in about $8.6 billion in bad loans. To handle this problem Czech banks were purchased by foreign banks or dissolved. In addition, the Czech Republic was forced to create Konsolidacni Banka to handle the bad debts accumulated in those first years of capitalism. The Czech Republic's experience may provide a lesson for other Central European countries.

After the overthrow of Communism in 1989, the Czech government initiated a privatization plan that distributed shares of the major national enterprises to Czech citizens. But a significant share of these citizens had no experience with equity ownership. Speculators were able to fleece individuals of their shares and eventually were able to seize control of major companies. These companies, that had the potential to be profitable, were soon losing millions of dollars and defaulting on loans.

Many of these problems could have been avoided if Czech banks were used to assessing a firm's financial strength and basing their loan decisions on the firm's ability to repay any loans. Under the old system, banks based their lending decisions on the firm's repayment record. Furthermore, Czech law made it difficult for the bank to seize assets that had been used as collateral for these loans. Bad decisions concerning loans cost the banks and the government billions of dollars.

Bad investment decisions were not the only source of problem loans. Czech officials charge that top management had systematically looted other banks, such as Investicni a Potovni Banka. Rumors about this bank's problems caused a panic among the bank's depositors and the Czech government forcibly seized control of the bank and its assets. Sources estimate that it will be another six years before the government's bailout agency is able to clean up the financial mess.

(Updated February 1, 2001)

Questions
1. What are some of the functions that banks perform?
2. Why are these functions so important to a capitalist system?
3. Suppose that Czech citizens and businesses lose confidence in the safety of the Czech banking system. What are the likely consequences in terms of the ability of firms to get loans and to finance economic development?
Source Edmund L. Andrews, "The Yoke of Capitalism" The New York Times, January 16, 2001.

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