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Banking in Transition Economies:

A description of Hungary’s attempts at modernizing its Banking Industry


by Alexander
Itskovich

 

It has been over a decade since Hungary has transitioned into the market economy. Its banking system has gone through numerous changes in order to accommodate an ever competitive world of financial innovation. Today, we see a Hungary that has adopted much of financial structure seen in Western Europe and whose banking sector is finally starting to see profits. Early transitional privatization saw an assortment of problems for state-owned banks including inadequate regulation and an agglomeration of non-performing loans. Reforms made through legislation in the last decade have helped alleviate the pressures on previously state held banks and lead the industry further through privatization. According to the latest findings by the IMF,

Hungary’s banking industry is nearly through the transitional process and well on its way to tightening the gap between itself and its Western European counterparts. In 1987, Hungary undertook its first major reform, separating the Hungarian National Bank and its commercial banking sector. Clearly, the goal was too proceed toward privatization. At the time, the state owned banks were flooded with a large volume of non-performing loans. Because foreign funded banks did not face the burden of bad loans, they had a competitive advantage against state-owned banks. This resulted in the “skimming off the more profitable clients” from the state owned banks and caused the legislation reforms of 1992-1994(1).

The government of Hungary subsidized many state owned “bad loans” in order to proceed with privatization. Not surprisingly, and encouraged by the government, foreign investors bought significant stakes in Hungarian banks. In fact, according to the latest numbers provided by the IMF, “2001 saw foreign intermediaries control 70 percent of the equity capital held by Hungarian banks” (2). Hungary saw further steps toward market modernization with the 1996 State Money and Capital Supervision Act which formed the Bank Supervisory Board. This commission regulated securities companies, general credit institutions and other similar financial service companies. Further, the act brought about stricter regulations on management, recapitalization and directed a plan of action to sell the rest of the governments shares in commercial banking.

In 1998, a new amendment allowed foreign banks to freely establish branches in Hungary. All the mentioned legislation culminated in the formation of the Hungarian Financial Supervisory Agency (HFSA). The HFSA is made up of the banking supervisory board and supervisory agencies responsible for overseeing insurance and pension funds. Funded through fees from the financial institutions it oversees, the HSFA is an independent agency that reports to the ministry of finance as well as the Parliament. Although not capable of setting binding regulations, the agency can impose corrective sanctions and its determinations can influence the withdrawal of banking licenses by the Ministry of Finance and the president of the Hungarian National Bank. The HSFA Act clearly defines the functions of a “bank” and restricts the actions of other financial service agencies accordingly. Although a broad step for Hungary’s economy, the agency has been criticized for not properly addressing many of the risks taken by banks. This led to further legislation in 2001 under the Capital Markets Act which further clarified the role of the institution.

Hungary also set up financial safety nets for its institutions with the creation of an equivalent to the American FDIC that insures all assets to 1 million ft. This number is likely to rise as Hungary is attempting to join the EU and is expected to be approximately 6 million forint by 2006. Additionally, failing banks can also be granted an exemption from reserve requirements for a period of three months in order to revitalize there firm. Other more sophisticated risk management techniques have also been adopted that comply with international standards.

A vital element in the success of Hungary’s banking industry has been foreign investment. In the period from 1993 through 1997, foreign ownership in banking grew from 12 to 70 percent. This is true even more so in the insurance sector where foreign ownership is 90 percent. According to Rachel Van Elken, these increases can be attributed to several factors. They include the privatization of state owned banks, foreign banks being able to raise capital faster then state owned ones (no longer primarily state owned, although they were so till 1995) and newly created foreign financial institutions created throughout the country (4).The primary reason foreign banks were entering the region seems to be “untapped retail banking” as well as the demand created by foreign companies establishing themselves in the region (5). Once the state began selling off shares of its commercial banks in 1994-95, foreign investment further skyrocketed as indicated by previously mentioned figures. This greatly benefited Hungary because of the expertise and efficiency foreign investors and managers brought to the table. Further, Stefan Ingves of the IMF points out that “ownership by reputable foreign banks reduces the risk of a systemic distress and contagion in the event of a cyclical downturn or in the event of an external shock”(6).

  This can partially explain why Hungarian banking has been mildly hit by the economic slow down experienced throughout the world. In fact, the country as a whole has experienced 3.8 percent growth over 2001. Although the government still controls approximately 25 percent of banking through minority ownership, plans are already underway to divest its stakes and further privatize the industry (7). Some of these plans have been slowed down due to political pressure to put some of the industry in Hungarian hands. In early 2002, Hungary had 41 commercial banks, 7 credit cooperatives and 187 savings cooperatives (3). IMF figures show that concentration is high among banks indicated by OTP banks 40 percent stake in retail banking and the “five largest banks controlling over 70 percent of bank liabilities to households”. Nevertheless, the competition in the industry has grown significantly, especially in the corporate lending sector. As a result, the sector has seen steady increased in both corporate and private lending over the last decade.

 A major issue early in the transitions was bank portfolios. As Hungarian companies were reintroduced into the global economy, a great deal of bad loans resulted. In the December of 1993, IMF figures show that 28.5 percent of all issued loans were problematic of which 13.2 percent were bad and 6 percent were significantly substandard. Clearly, a new framework had to be adopted in order to eliminate this problem. As foreign investment began to pour into the country, with it came the experience of the market through managers and large financial institutions such as Citibank, now the tenth largest bank in Hungary. By 1996, problematic loans made up only 11 percent of the total only 3 percent of which were bad. This improvement can be attributed to other factors as well including the Capital Markets Act which tightened supervision on the amounts banks can expose themselves to specific risks. The act complies with most standards set by the international organization of security commissions and with the international association of Insurance Supervisors in both banking regulation and “set controls for derivative positions”. Primary criticisms to the act however suggest that supervision and legal oversight of financial firms should be further increased and the laws regarding the HFSA power’s strengthened. Throughout the last decade, Hungary Banking Industry has taken broad steps forward and is well on its way to full modernization.

 Hungary currently possesses one of the most advanced financial systems among central European Countries and is well on its way to reaching its goal of entering the European Union. IMF officials concluded that according to current macroscopic data, Hungary financial system has “systematic stability” and is likely to perform well in the medium term. Further reforms are on the Hungarian parliament’s objective including increasing firm supervision and divesting its remaining stakes in banks. Although the country is still largely based on cash businesses, reliance on credit cards and other banking related items continues to grow. With the Hungarian people ever more dependent on banking services, perspective for the industry’s growth is substantial. The progress made in the last ten years has been tremendous and the perspectives for the future look good. Hungary is now well on its way to reaching western economic development.

Biblography:

1.Shader,Susan and Ingves, Stefan Financial System Stability Assesment, IMF MAY 3, 2002 (4)- P86 (5)- P86-88 (8)P26,P8-P16 Note: When paper references the IMF, statistics can be found between p25-60

2.Van Elken, Rachel Hungary: Economic Policies for Sustainable Growth IMF Washington D.C. 1998 (1)p37 (2)P37-45 3.http://www.buyusa.gov/Hungary/en/page170.html (3),(6)

 

 

 

 

 

 

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