Introduction
Hungary was a centralized economy during and before early the 1980’s. The economy was highly controlled by the government including sectors within the economy. The Hungarian banking sector was under the control of the government with no private banks in operation during this time.
The country was operating under a mono-bank. The bank was later divided based on specialization with introduction a two-tier banking system. This led to the establishment of three banks that were owned by the state. In 1987, Hungary initiated the transition process of converting its economy from being centralized to become market-oriented economy.
This transition led to the changing of Hungarian banking sector from centralized banking system to a market-oriented system through privatization. Creating an open competitive market for foreign banks to invest was one of the government roles in developing banks in Hungary.
During this time of transition, the economy of Hungary was performing poorly and was nearly collapsing. The state-owned banks during the beginning of transition were faced with the problem of non- performing debts, bad debtors, as well as bad investments. The financial sector, which highly incorporates banking, had thus a great role to play in this transition process. In the late 1980s, Hungary was faced within the problem of bad debts, massive under-capitalization as well as high concentration.
The main reason of developing banks in Hungary through use of market-oriented system was to establish a stable banking system. The government had to solve the existing problems in the banking system before introducing new reforms. This paper discusses the process of consolidating state-owned banks and then privatizing them. The paper also looks into the role of developing banks in Hungary during the beginning of transition.
The transition of banking to a new system
In the late 1940s, the Hungarian banking system was established with formation of the national bank known as National Bank of Hungary (NBH). NBH was established as a monopoly. It was the only bank dealing with money circulation and credit activities within Hungarian economy.
The government further established a centralized banking system with the introduction of specialized banks. For example, the NBH only dealt with allocating credit to enterprises, the National Savings Bank (NSB) only dealt with colleting deposits from savers, and Hungarian Foreign Trade Bank was only involved with foreign trade transactions. All these banks were owned by the state that made them monopolies in their respective areas of specialization.
In the late 1980s, the Hungarian economy was performing poorly. The government initiated the process of transition from use of centralized economy to introduction market oriented economy.
The market-oriented economy meant that foreign investors would invest in Hungary. This made the government permit some foreign banks to invest in Hungary. During this time, these foreign banks faced competition from the state owned banks in foreign exchange and trade transactions. The banking system became more decentralized with introduction of the two-tier banking system.
This system led to NBH becoming the central bank while its commercial functions were delegated to three new commercial banks, which were introduced in the country. The government went further to allowing introduction of new specialized banks, which had very narrow functions. These reforms greatly influenced the post-socialist government to create way for more reforms in the banking sector.
In early 1990s, the new democratic government formed new reforms for the banks. The banks were expected to meet a certain percentage of capital adequacy ratios. Banks were also expected to provide reserves against their bad loans. This issue on bad loans made the banks to suffer huge losses. This is because several major banks had huge negative equity percentage of loans that were considered doubtful loans. These banks suffered huge losses, as the existing accounting laws at this time did not require provision for doubtful loans.
These structural reform initiatives led to a significant drop of the country’s GDP. This drop in GDP led to heavy losses among state-owned enterprises, which made them unable to service their debts to banks. With these losses, the government had to resolve the issue on bad debts. This led to the instruction of loan consolidation program in 1993.
This program enabled banks to exchange their bad debts for government bonds called consolidation bonds. These bonds had a coupon equal to 90-day treasury bills. Although this program removed bad debts from banks, it did not create new capital in the banking sector. The government then went further to recapitalizing its state-owned banks to attain the minimum requirement of 8 percent.
In the mid 1990s, there was a significant progress in establishing a market-oriented banking system. The government still discouraged foreign banks with its preference of keeping a golden share of the venture. To achieve transition in the banking sector the government started negotiations with foreign banks in offering them flexible terms and conditions of bank privatization.
Privatization of large state-owned banks involved two important stages. The first stage of privatization took place in parts with blocks of shares being offered to different foreign investors at different times. This was a significant step for foreign investors whose initial cost and risk of investments was reduced strategically.
Although the government offered block of shares to the foreign investors it still held 20-to-25 percent ownership of these banks. The government instead allowed the foreign partners to take full control on management of these banks.
In the second stage of privatization, the government negotiated with foreign investors. The government came into contract with foreign investors on terms of privatization. These contracts allowed subsequent price adjustments in the purchase price, according to profits to be made by the bank in future.
The contract also provided for acquisitions of share from the government or any other non-private partners. This method of liberal privatization faced criticism politically even if others supported the idea as it meant a strong efficient banking sector foundation.
The role of debt clearance
In developing banks in Hungary, the government wanted to deal with the problem of bad debts, which had even led to collapse of many firms. This had contributed greatly to the poor economy and high rates of unemployment. In trying to overcome this problem on debts, the government had to allow for entry of foreign banks into Hungary.
The government had to restructure the banking system by developing banks to deal with issue on debts as some state-owned banks had even lost their capital. The government had to deal with the issue of debts and debtors in the banking system through bank consolidation. The government wanted to develop banks with no bad loans to pave way for privatization and avoid the problem of bad debts again.
In the initial stages of bank consolidation, the government had to do portfolio cleaning. Here the government gave bonds in exchange for bad debts to those banks with a capital adequacy ratio (CAR) of less than 7percent. The government then sold a part of the non-performing loans bought as bonds at a discount to the Hungarian Development Bank (HDB). Although the government left the other part of bad loans with the banks it gave them a fee of 2 percent to encourage them work out bad loans.
This measure of government exchanging bad debts with bonds solved the problem on debts partially. This is because the government did not include neither doubtful nor substandard loans. The government also failed to solve the problem of banks’ bad investments and contingent liabilities.
In 1993, the bad debts were still increasing and the government had to carry out recapitalization but this time including bad investments and contingent liabilities of the banks. The government here purchased newly issued shares by the recapitalized banks through use of bonds. This increased the government ownership in the banking sector.
The government then recapitalized banks by extending subordinated loans to banks. This form of recapitalization prevented increasing government ownership. The government then left the banks to solve issue on other debtors as it had more information regarding them.
The objective here was to try to separate banks with more debtors from those with few. This paved way for privatization process. The government also introduced consolidation program aimed at putting banks on track. This program required banks to improve their management, internal control and come up with modernized operations. These measures enabled the government to develop banks and solve the issue of debts in the beginning of transition.
Role of privatization
The government had controlled the banking system before transition process began in Hungary. The government had to develop banks to enable their privatization as it had being unable to run them. This is because at the time of transition Hungarian banks were facing large bad debts, and were poorly managed. The government had thus to introduce a market-oriented banking system to enhance economic growth. Therefore, another role of developing banks in Hungary during the beginning of transition was to encourage their privatization.
The government also encouraged privatization of banks through introduction of liberal licensing policy. This policy encouraged many foreign banks to set up subsidiaries in Hungary. This led to a decrease of government ownership in the banking sector with about 20 percent.
This enhanced competition which encouraged better management skills, and provision of services in the banking sector. This left the government with the ownership of just one large commercial bank. The banks from European Union invested in Hungary contributing to the 70 percent of foreign ownership in the country.
Privatization of banks in Hungary has played a great role in its economic growth. This is shown by the stabilization of Hungarian banking system that is evident as shown by the current high level of CAR. The percentage of bad debts has also decreased significantly to a very low percentage of about 3 percent. The increased investment of foreign banks in Hungary has also encouraged direct investment in other sectors with banks from home countries operating in Hungary.
Role of bank regulation and supervision
The centralized banking system applied by Hungarian government before beginning of transition prevented better regulatory measures to apply. The government was unable to impose measures, which would regulate banking system efficiently as it was the one still controlling them. Therefore, another role of developing banks in Hungary during the beginning of transition was to establish a regulatory structure.
The government had experienced high rate of non-performing debts before transition began. These debts had led to high instability in the banking system leading to a deteriorating economy. The government had thus to develop banks to as to introduce measures to regulate and supervise the banking system.
These regulations in the banking sector help to control the stability of an economy. Hungary with the aid of EU has improved its regulation and supervision in the banking sector. The government established a group-based supervision as opposed to the institution-based mode of supervision applied earlier. The group-based supervision was to be introduced through formation of a single agency to supervise all banks.
Management role
The government of Hungary had experience and significant increase of the non-performing debts during the late 1980s. This was due to the poor performance of the state-owned banks during this period. These banks allocated loans on basis of political influence rather than based on profitability that had contributed to the large amount of bad debts.
This was partially the contribution of poor management and unskilled staff in the banks. Another role of developing banks in Hungary during the beginning of transition was to improve their management and human capital.
Privatization process of state-owned banks was also aimed at improving their management. In the first face of privatization though the government only allowed a given percentage of ownership to foreign investors, it left management role to them.
This is because these banks were characterized with poor operations management structure that incorporates many undisguised employees. The government also introduced measures through ministry of finance to supervise these banks on basis of management. These measures led to the decrease on non-performing loans, which were now allocated on basis of profitability.
Conclusion
Hungary transition from a centralized economy to a market-oriented economy started in late 1980s. The government had to change the banking system from a centralized banking system to a market-oriented system. The government had to allow foreign banks to invest in Hungary. Before foreign banks were allowed to invest in Hungary, the government had to solve the problems, which existed within the state-owned banks.
The role of developing banks was thus to pave way for more reforms in the banking sector which would lead to a stable banking system. One role of developing banks in the beginning of transition was first to consolidate them. The government had to deal with the issue existing bad debts and bad debtors that had even led to the closure of some banks due to lack of capital.
The government had to introduce use of bonds to buy these bad debts and those debts debtors were owing to banks. The government went further to recapitalizing the banks including their bad investments and liabilities. This was followed by privatization of these banks to be owned by other foreign banks. The government did this by first selling partial ownership before realizing full ownership in mid 1990s.
The government then introduced a single group-based supervision agency to supervise all banks on standards of management, performance and services offered. This has led to improved banks management, and reduced non-performing loans within the banking sector. Through these developments of banks, the government of Hungary has been able to establish a stable banking system.
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