Banks Are The Achilles' Heel Of Central Europe

Banks are in such bad shape that they're a drag on progress

Czech Prime Minister Vaclav Klaus, Central Europe's most vocal free-marketer, is learning the hard way that a commitment to capitalism is only the beginning. In August, Kreditni Banka, one of several dozen banks to pop up during the financial free-for-all of the early 1990s, collapsed under a labyrinth of questionable backroom deals, losing $444 million. The 11th bank failure in three years, it is forcing the central bank to fork over millions to prop up another one, the otherwise healthy Agrobanka Praha, because some of its backers are linked to Kreditni. Moody's Investors Service has put a downgrade watch on its Ba1 rating of Agrobanka.

The scandal highlights the Achilles' heel plaguing all of Central Europe. Even as most of the region's formerly communist economies post vibrant growth rates and attract increasing foreign investment, their banks lag woefully behind. Lax regulation and an alarming dearth of expertise have left the sector in the dust. Now, banks have become a roadblock to further progress, starving companies large and small of needed capital.

Countries require financial stability and healthy banking to channel funds to good ideas. Central Europe suffers from a shortage of long-term capital that local banks aren't fit to supply. "The real institutional bottleneck to Eastern Europe is the banking system," says Susanne Gahler, a senior economist at J.P. Morgan & Co. in London.

The problem isn't unique to the region. Historically, when countries convert to a free-market system, banks have tended to remain mired in the past longer than the corporate sector. In China, state-owned banks are still struggling under mountains of bad loans to state enterprises. And Russia's banks, most of them little more than windows for currency speculation, are undergoing a wrenching shakeout. Even Latin America, whose major developing economies are far more mature, has relatively few local banks that meet U.S. standards of profitability and safety.

Many Central European banks, originally set up as cash dispensers for state-owned enterprises, are still wallowing in bad debts. The region is paying a heavy price for letting its banks flounder. Bulgaria is in a crisis, with the government tripling interest rates, to 300%, to stop a run on banks. Even in more developed Poland, notes Krzysztof Bledowski, economist at Pioneer First Polish Trust Fund Co., corporate lending is barely growing, even as consumer financing to buy cars and refrigerators booms at a 30%-to-40% clip.

Some governments are gradually addressing the banks' troubles. Hungary suffered an early crisis in 1991-92, when the government sank more than $2 billion into a bank bailout. The banks have since then streamlined and are investing heavily in new technology. And this month, Poland's Finance Ministry forced a controversial merger of four out of nine state-owned banks, finally getting a bogged-down privatization campaign under way again.

FLY-BY-NIGHT. The Czechs are only now rethinking their laissez-faire policy. The central bank raised minimum-reserve requirements this summer, and most fly-by-night operations have been merged or closed. But loopholes have kept penalties light for banks that still do more speculating than banking. "We should now start to limit somehow the participation of banks in nonbanking areas," admits Martin Svehla, an executive director of the Czech National Bank.

More foreign competition would be a big help. The Czechs have resisted it, believing that permitting foreign access would be tantamount to giving up control of their economy. By contrast, in Hungary, GE Capital has brought its consumerfinance knowhow to Budapest Bank. The government has put out a tender for a majority stake in Magyar Hitel Bank and invited bids from the likes of Citibank and Creditanstalt by next month. Poland is also encouraging foreign investment in existing banks.

Banking laws in the three Central European countries most likely to enter the European Union now conform to Western standards, and a systemwide collapse, like the one in Bulgaria, is not in the cards. But unless regulation is tightened--and vigilantly enforced--another financial scare such as Kreditni's could swiftly tarnish their hard-earned reputation for free-market progress and bog down further reform.

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