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East: Bad Debts Raise Doubts About Bank Privatizations

One of the main illnesses of banks in Eastern and Central Europe can be summarized in two words -- "bad debts." RFE/RL's Ron Synovitz examines how weak regulations and dubious accounting have allowed the problem to fester across the region, and how the problem in turn complicates privatization efforts.

Prague, 13 August 1999 (RFE/RL) -- Questionable loans and accounting practices have compromised the financial health and future of many banks across Central and Eastern Europe.

Eastern and western financial analysts and international organizations say loan officers have been digging many banks into a hole for years by giving cheap credit to economic allies of their institutions. They say inexperienced loan officers also have been authorizing too many risky loans.

In both cases, borrowers may have neither the ability nor the intention to pay off the debts or the interest. Such loans should be listed on bank balance sheets as "bad debts" or "non-performing loans." But many banks are disguising the extent of their problems and failing to put aside enough reserves to cover losses from an eventual cleanup.

Charles Randolph, a managing partner at the Prague offices of the international accounting firm KPMG, says a large enough bad debt portfolio can mean the difference between profitability and insolvency.

"Whenever a bank accumulates sizeable non-performing loans, it's obviously a drain on earnings because you have no interest revenues coming from the troubled debt."

In Ukraine, the Economist Intelligence Unit says evidence suggests more than 40 percent of all bank loans are bad debts, despite government claims that the figure is only 19 percent.

Romania's central bank appointed a state administrator at Bancorex earlier this year after bad debts reached an estimated 70 percent of its loan portfolio. Bad debt ratios of more than 30 percent also are reported at major banks in the Czech Republic, Slovakia, Bulgaria and the Baltics.

The Economist offers one explanation for the trend. It says state firms and secretive financial groups across the region often set up their own banks to capitalize on weak regulations and to gain access to cheap credit.

Ukraine's banking sector, for example, is dominated by five Soviet-era banks that are still owned by the state. But many of the country's other 170 banks were created by regional business groups to serve their own interests.

In Bulgaria, several private banks were launched in the mid-1990s by a businessman who only had the minimum funds to start one bank. The businessman discovered a legal loophole that allowed him to loan the same money to himself again and again, starting a new bank with each loan. But when bad debts left one bank insolvent in 1996, the financial chain soon brought the other banks down like a house of cards. The incident was the precursor to Bulgarias financial crisis of 1996 and early 1997.

Even in the Baltics and the Czech Republic, where bank reform has been faster than further to the east, the bad debt problem is raising concerns about key mergers and privatizations. Randolph, KPMG's managing partner in Prague, says the problem can ultimately effect national budgets -- particularly when unplanned bailouts become necessary.

"Prospective investors in banks that are soon to be privatized don't want to have to face dealing with problems that have come from the past. This puts the governments [who are] in the selling position under severe pressure to clean up and resolve the [bad debt] situation as best they can."

The Czech government is funding a $287 million bailout of the country's largest and most troubled bank -- Komercni Banka. More than a quarter of Komercni's loans have been classified as non-performing -- nearly $2 billion in lending that is unlikely to be recovered.

The Czech bailout is needed to attract serious investors to the privatization of a 49 percent stake in Komercni next year. Finance Minister Pavel Mertlik says the government also will stick to its schedule of selling off remaining stakes in the state savings bank Ceska sporitelna by next year. But there is still no plan for restructuring Ceska sporitelna's bad debts.

The major banking story in Lithuania this summer has been a proposed merger of Bankas Hermis and its rival Vilniaus Bankas. Backed by Sweden's SEB, Vilniaus has been trying to obtain Hermis through a leveraged buyout for more than a year.

Hermis chief Nadiezda Novickiene recently agreed to the merger. Central European magazine reports that the Russian crisis last year caused Hermis' financial situation to deteriorate to the point where a merger became more attractive to its managers.

If that merger goes ahead, it will allow Sweden's SEB to expand its Baltic network. It also would create a Lithuanian bank large enough to compete in other Baltic states -- the second largest bank in the Baltics after Estonia's Hanaspank.

But a spokesman (unnamed) for the international accounting firm Pricewaterhouse Coopers has warned that the balance sheets for Hermis do not appear to be in order. The bank reported a profit of $125,000 last year. But the Pricewaterhouse Coopers spokesman said losses would have been posted if international accounting standards had been followed.

Latvia, struck by its own banking crisis in 1994 and 1995, has tightened banking supervision in recent years. Riga has instigated international audits for all banks and brought regulations in line with international standards. The central bank also is clamping down on money laundering and other illegal activities involving money from Russia's shadow economy.

Nevertheless, private institutions like Riga Commerce Bank appear to be in trouble because of heavy investments in Russian state bonds. Latvia's new government has not yet decided whether to bail out Riga Commerce.

Indeed, the impact of last year's Russian crisis is still being felt across much of Eastern and Central Europe -- especially by banks that were heavily involved in Russian state bonds and corporate securities. Analysts say Ukraine's banking system lost about $1 billion last year when foreign firms withdrew their investments because of uncertainties over emerging markets following the Russian crisis.