of the previous ―monobank‖ structure was not able to meet the demand. Besides natural capacity constraints, they were burdened with a legacy of loans that were to a large extent nonperforming. In addition, their balance sheets were poisoned by the so-called ―loans for financing of inventory needs of firms,‖ which represented quasi-loans from the socialist period. To address the banking sector’s insufficient capacity, a couple of new, private banking institutions were allowed to operate. These institutions began extending credit to new private firms and tradesmen, and at the same time they played an important part in providing funding for the privatization of state-owned enterprises. With a loose monetary policy conducted under a regime combining money supply targeting and fixed exchange rate, the economy became overheated and the quality of the assets of the banking system weakened. Authorities initially resorted to partial solutions. Various forms of government assistance were used to cope with inherited as well as newly created deficiencies. (For details, see Bárta and Singer 2006.) The full extent of problem came to light only in the recession of 1997–1999. Decisive restructuring and (re)privatization of banks followed, paving the way to the current structure, in which the sector is controlled almost exclusively by foreign banking groups. In addition, deep changes in the regulation and supervision of banks, on the one hand, and in monetary policy making, on the other, had to be implemented. The approach was based not on more detailed regulation and tighter monetary control but on better and tougher supervision and smarter monetary policy.

**Chart 1. Credit and its quality in the Czech Republic (1993–2010, in %)**

**Chart 2. Sectoral structure of credit in the Czech Republic (1993–2011, in %)**

<!-- Start of picture text --> 35 70 100<br>30<br>65<br>25 80<br>60<br>20<br>55 60<br>15<br>10 50<br>40<br>5<br>45<br>0 20<br>40<br>-5<br>-10 35 0<br>01/93 01/96 01/99 01/02 01/05 01/08 01/11<br>-15 30<br>I/93 I/96 I/99 I/02 I/05 I/08 Non-financial corporates Households<br>Tradesmen Other financials<br>Credit growth %NPL Credit-to-GDP (rhs)<br>Government<br>Source: CNB<br>Note: Credit growth is year-over-year increase in total bank credit, Source: CNB<br>% NPL is the share of nonperforming loans on total bank credit.<br>Data from the beginning of 1990s are based on authors' estimates.<br><!-- End of picture text --> Given the relatively high exposure of the banking sector to the corporate sector associated with legacy loans, loans for financing inventory needs, and new loans associated with privatization, the credit-to-GDP ratio of the Czech banking sector was rather high at the early stage of transition—roughly 65 percent in 1993 (see Chart 1). In addition, nearly 90 percent of loans in credit portfolios were to the nonfinancial corporate sector. The share of households in the overall credit system stayed below 10 percent throughout the 1990s (Chart 2).

The deep banking crisis that hit the Czech economy from 1997 to 1999 was caused by a mix of flaws in the financial system and suboptimal steps in macroeconomic policies. (See, for example, Frait and Tamarappoo 1998.) The share of nonperforming loans exceeded 30 percent, 3