Predicting Bank Failures in Transition: Lessons from the Czech Bank Crisis of the mid-Nineties

Abstract

Almost all countries in Central and Eastern Europe have experienced turbulence in their banking and financial sectors. In the early 1990s, for example, Poland’s banks experienced a crisis, followed in 1994–1996 by the failure of several small banks in the Czech Republic, and severe problems in Latvia in 1995 when four of its large banks fell. Bank regulators in transition countries have been searching for early warning signals that could be used to make bank supervision more efficient. Although several papers exist on modeling or predicting bank failure in mature market economies [See Looney, Wansley and Lane (1989), Lane, Looney and Wansley (1990), Barber, Chang and Thurston (1996), Hwang, Lee and Liaw (1997); among others], there are several problems connected with the direct use of these models in transition economies. First, these models depend almost exclusively on economic conditions and balance-sheet data based on accounting standards that are conceptually and significantly different from those in transition economies. For example, most transition economies still use accounting procedures carried over from central planning that reflect production rather than profit. Moreover, unlike stable economies, the transition period is typified by high uncertainty, the lack of standard bank behavior, and other problems carried forward from the communist era that only worsen the situation. Finally, the vast majority of banks in transition economies have a very short history, with balance sheets seldom if ever scrutinized by prudent auditors.