Privatization: Czech

Peter Green

Breaking the Bank

In the end it was a question of when, not if. At precisely two minutes before noon, on a sun-drenched Friday, June 16, 2000, a team of heavily armed men, their faces covered in black wool masks, stormed the Prague headquarters of Investicni a Postovni Banka, the country's third largest bank. Within minutes they had corralled the bank's top managers and seized control of the building.

No one called the police, because they were already there. The armed intruders were a police special assault team, escorting forced administrators dispatched by the Czech government to claim back IPB. A three day run on the bank had emptied its coffers, threatening the Czech banking system - and regulators feared, the entire Czech economy - with collapse. IPB's largest owners, a Netherlands-based firm apparently controlled by the Japanese bank Nomura, cried foul. Parliament chairman Vaclav Klaus, whose rightist Civic Democratic Party was closely linked to IPB's top management, called the police raid and the subsequent state takeover "daylight robbery." Within three days, IPB had been sold to KCB Bank of Belgium, the majority owners of IPB's local rival, Ceskoslovenska Obchodni Banka (CSOB), with the government agreeing to swallow most of IPB's bad loans. The final bill is not yet in, but the IPB debacle is expected to cost Czech taxpayers as much as 5 Billion dollars, or about 500 dollars - more than a month's average wage - for every man woman and child in the land.

How IPB went from a state-owned banking giant to an apparently empty shell is a microcosm of the problems the Czechs had privatizing their banking sector.

Privatization's laggards:

When the Czechs privatized their state-owned industry at the end of Communist rule, they distributed shares in over 1700 companies to ordinary citizens. The scheme was so complex that about half of the assets ended up in the hands of investment funds that were managed or owned by banks, and over which the ordinary fund holders had almost no influence. This gave the banks an extraordinary degree of power and control over the development of the country's business and industry. The privatization program's originators had not intended the funds to be so powerful, but since the banks had the cash which the companies needed to pay for and develop their operations, the economic architects argued that it would lead to a beneficial situation for all, along the model then prevalent in Germany, where local banks ensured the financing of local companies. Particularly in the emerging economies of post-Communist Europe, where managers had no track record with which to impress foreign lenders, local control of finances was considered a good thing.

The problem was that the banks themselves had yet to be privatized, and their managers were nearly all appointed by the government of prime minister Vaclav Klaus, who was more interested in talking about a free market than actually building one. Despite his rhetoric that "the invisible hand of the market" would make the most rational economic decisions, politics quickly intruded on banking decisions, as bank managers opened the cash taps to large industrial companies which promised to keep employment high in politically sensitive election districts.

Easy money, inflows from other privatization and asset sales, and vast amounts of hard currency from tourism all kept the economy humming.

But at IPB and other banks, a vicious circle had developed. Banks loaned money to companies which were owned by funds that were controlled by the banks. And since the banks themselves had no shareholders to answer to, the loans kept flowing. Poor regulation made it easy for the banks to fudge their balance sheets and keep lending, as companies borrowed just to cover the interest on outstanding loans.

That made both the banks and the companies appear to be performing well, and that kept share prices high, increasing the commissions for the investment funds that managed the companies. Managers got nice bonuses, and as long as no one looked too closely, the whole house of cards stayed up. These problems - which many would say were outright fraud - were compounded by a virtual absence of regulation of either funds, banks or the stock market itself.

As economists Edward Snyder and Roger Kormendi pointed out in the case of IPB's other state-owned rival Komercni Banka, "The opportunity to privatize a strong bank and harden enterprise-level budget constraints quickly was foregone, or at least postponed, in favor of creating a protected bank that would deal more leniently with [the bank's] politically-vested commercial clients."

By 1997, the problems of bad loans and unclear ownership had put IPB in the spotlight. A series of share issues had diluted the government's control (some said with the collusion of the Klaus cabinet) and bad loans had piled up reaching 2 Billion Koruny ($58 Million), by the year's end. Police investigators had already jailed IPB's top managers in one fraud investigation, but they were released and the probe dropped for lack of evidence. Meanwhile, regulators had watched more than half a dozen banks collapse, and with the fall of the Klaus government in November, 1997, the new cabinet moved swiftly to sell IPB. Rushing to show he was serious about privatization, finance minister Ivan Pilip sold IPB in March 1998 for half of what it had originally hoped to net. Nomura International, which already owned a 10 percent stake in IPB, bought the government's 36 percent share for $80 million in cash, and the promise (later fulfilled) to inject another $160 Million.

That Great Big Whooshing sound

The sale should have introduced the common sense of profit and loss to IPB's operations. Instead, that's when things began to go seriously wrong.

IPB had built a respectable collection of industrial assets in its portfolio, including stakes in the lucrative Czech beer industry, the country's top insurance company, and the bank itself had loans out to the two top private television networks and to both Mr. Klaus' party and the opposition Social Democrats, among others. Nomura had promised to restructure IPB, cleaning up its loan portfolios, rationalizing its shareholdings and reorganizing the bank's commercial, retail and postal banking operations. Then it would sell IPB to a larger, but more cautious commercial bank.

But for Nomura, the biggest profit to be had was in the holdings controlled by the privatization investment funds managed by IPB, not in running a healthy but unglamorous banking business. State regulators exercised almost no oversight of investment funds, and small shareholders in the funds had little power to influence management. In fact, most of the country's privatization investment funds were run largely for the benefit of the managers, who were exceptionally skilled at selling shares cheaply to shell companies which they controlled and then selling the shares on to strategic investors or others at much higher prices.

Throughout the mid to late 1990's the Prague Stock Exchange and the country's RM-System secondary market had many shares whose prices swung radically from day to day, as buyers and sellers manipulated prices, with dealers pocketing vast profits at the expense of minority shareholders.

In this environment, Nomura saw clearly that the fastest way to riches was not to turn IPB into a profitable bank, but to grab control of the IPB investment funds, assemble some attractive share packages and sell the funds' holdings to strategic investors. The clues were all there: under Nomura's ownership, IPB kept the same leadership that had gotten it into trouble in the first place, and began consolidating not its banking operations but the shareholdings of the funds it controlled, moving its shares, funds and profits offshore and out of reach of Czech authorities. With its new owners, Nomura, unconcerned about the bank's balance sheeet and focused solely on share deals, more bad loans were made to more unhealthy Czech companies, as the bank's assets whizzed out its doors. Auditors Ernst & Young initially approved both its loans and all these transfers, but somehow the bank lost track of or sold substantial amounts of its holdings along the way.

The country's justice system, was, after 40 years of communism, simply not up to the task of chasing financial crooks with well-paid lawyers. Despite regular press coverage of IPB's apparent misdeeds, regulators neither would nor could take action to protect minority shareholders.

In one of the key transactions, IPB and Nomura subsidiaries acquired control of the countries largest beer makers, often trading shares between publicly owned funds and private offshore investment vehicles at prices far below market value. In the end, for an estimated $250 Million, Nomura bought control of Plzensky Pivovary, makers of the world famous Pilsner Urquell beer and several smaller breweries. The package was re-sold for more than $650 Million to South African Breweries, a windfall for Nomura, which booked the profits through a series of subsidiaries, but a rotten deal for IPB, its funds, and their minority shareholders, who never received fair market value for their shares, having been forced by the Nomura-backed IPB management to sell the shares cheaply. And it ended up a rotten deal for the Czech taxpayers.

But by early-2000, IPB was beginning to bend under the weight of bad loans. Auditors estimated them at $1.1 billion, nearly a third of IPB's portfolio. After a string of newspaper stories detailing the depth of IPB's troubles, depositors scrambled to empty their accounts. Nearly $1.5 Billion, a fourth of Nomura's deposits, were withdrawn in less than a week. Nomura offered the government several options to refinance the bank but the government was under increasing pressure from the media and public opinion to take strong action and when Nomura stalled in its promises to pump cash into the IPB, Czech regulators finally acted and the police moved in. "Machine guns and taxpayers money were used to expropriate IPB and make CSOB the dominant Czech bank," Randall Dillard, Nomura's point man on the IPB transactions, told Newsweek in 2000. "When the smoke clears and the mirrors no longer dazzle, we will see a familiar tale of corruption, cronyism and politics."

By middle of 2002, the state had yet to calculate the total cost of the IPB bailout. It had pledged to spend at least 1.2 Billion dollars, buying bad loans from IPB's portfolio from its new owner KBC Bankof Belgium. The cost of the bailout did not stop there. In a report last year, the International Monetary Fund said restructuring IPB would cost the government Kc400bn or 21 per cent of GDP, of which only 5 percentage points had been paid by the end of 2000. The price IPB's luckless shareholders will receive for will be set by investment bank J.P. Morgan, but is likely to be zero, according to the Financial Times. Nomura is now suing the Czech government for compensation of at least $100 Million, and the Government says it will pay nothing. The gist of its argument: the smoke and mirrors were all manipulated by Nomura and its political patrons.

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