Chapter

VIII Banking and Capital Market Reform

Author(s):
János Somogyi, and Anthony Boote
Published Date:
March 1991
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Although the authorities recognized the need to shift the central guiding force of the financial system from the state budget to a more active credit policy, the New Economic Mechanism blueprint left the banking sector subordinated to financing the national economic plan. The authorities did not significantly alter the highly concentrated and specialized banking system and segmented financial structure of the economy—established in the late 1940s—until the mid-1980s.

The banking sector continued after 1968 to be dominated by the NBH. The NBH performed central banking functions; regulated foreign exchange transactions, with responsibility for conducting almost all external credit operations with the convertible currency area; and, through its credit department and branch offices, acted as the principal banker of the enterprise sector and helped administer government programs in industrial policy and other areas. The volume and allocation of credit by the banking system for investment and working capital purposes was determined by the credit policy guidelines of the NBH, which were approved by the Government in coordination with the national economic plan. The NBH exercised direct control over the allocation of credit, a substantial part of which was funded by foreign borrowing. Interest rates had a small allocative role, and indirect monetary policy instruments were absent.

The other banks in the system continued to be restricted to specialized activities. The State Development Bank’s principal task was to prepare, monitor, and finance state investment projects and allocate equity to enterprises; projects were funded by refinancing credits from the NBH, budget transfers, project loans from the International Investment Bank of the CMEA, and enterprises’ contributions to project financing. The Hungarian Foreign Trade Bank specialized in foreign currency trade financing of enterprises; it funded itself in the international markets under the supervision of the NBH. The National Savings Bank, supplemented by the Postal Savings network and savings cooperatives, acted as the banker of the general population, private concerns, and local authorities. It collected deposits at low interest rates, most of which were relent at even lower rates for housing. Other banking and financial institutions (including the Central European International Bank, Ltd., established in 1979 as an “offshore” bank in a joint venture between the NBH and six foreign banks) played a peripheral role, mainly conducting foreign exchange and real estate transactions. In addition, beginning in 1983, the authorities set up small experimental financial institutions in the form of specialized funds mainly to finance research and development and venture capital for risky projects.

With the institutional structure of the banking sector remaining essentially unchanged, the segmented pattern of financial flows—in particular the separation of household monetary and credit flows from those of the enterprise sector—was preserved. Although a high proportion of national income was allocated to investment by international standards—with the share of gross capital formation to GDP in the range of 30-35 percent in the 1970s and 25-30 percent in the first half of the 1980s—financial intermediation outside the budget remained limited. In the mid-1980s, about three quarters of investment approved by the State was financed by the budget and enterprise contributions, and the same proportion of enterprise investment was financed by internally generated funds. Enterprise investment was financed this way partly because of a bias of enterprise management in favor of fixed asset formation as against financial savings, which was reinforced by repeated confiscations of accumulated financial assets of profitable enterprises, low interest rates, and a scarcity of savings instruments. For the household sector, in addition to currency holdings and bank deposits, available savings instruments were limited to life insurance policies with the State Insurance Company, small amounts of bonds issued since 1983, cooperative share certificates, and real estate. The financial saving propensity of the population was generally low because precautionary saving was discouraged in light of virtually guaranteed lifetime employment, negative real interest rates on savings deposits, and the availability of heavily subsidized housing loans. Real estate was the principal investment outlet for household savings.

The Government also exerted strong influence over investment by disbursing state loans to finance state-initiated projects, and by having branch ministries participate in vetting credit applications from enterprises and in granting selective credit preferences. The latter included preferential credits under a facility inaugurated in 1976 providing longer-than-usual maturities and interest rebates from the budget to finance eligible projects aimed at export promotion, import substitution, energy conservation, raw materials recycling, and (since 1982) to finance projects sponsored by the International Bank for Reconstruction and Development (IBRD). As a result, access to credit for entirely enterprise-initiated projects was limited, which curtailed the expansion of small profitable enterprises in the socialized and private sectors.

Monetary policy accommodated the inflation rates projected under the annual macroeconomic plans, but over most of the period it avoided adding significantly to inflationary pressures. Credit restrictions were applied periodically, mainly to control expansionary investment cycles; liquidity in the enterprise sector was squeezed by tightening credit ceilings, forcing early repayment of outstanding credits, and, at times, confiscating financial assets. These restrictions were imposed mainly on successful companies. Inefficient enterprises—generally conglomerates in dominant positions vis-à-vis suppliers and customers—accumulated payments arrears and were eventually given access to budgetary support, equity allocations, and bank credit. The latter policy, including the nearly automatic provision of working capital credit to guarantee enterprises’ wage payments—which accommodated overstaffing and excessive wage awards—hindered the closure or restructuring of loss-making enterprises and led the NBH and the State Development Bank to acquire a large share of dubious claims on the enterprise sector. Part of such claims was intermittently converted into equity allocations to weak companies.

Reform of the Banking System Since 1985

By the early 1980s, the authorities acknowledged that the existing financial institutions and instruments had blocked their pursuit of both short-term demand management objectives and efficiency gains from long-term structural reforms. They adopted preliminary institutional reforms in 1985; these included separating central banking and commercial banking functions within the NBH, converting the Budapest branch of the NBH into an independent subsidiary, and registering as independent specialized financial institutions several funds earlier established. Various administrative constraints on the flexibility of banking activities were removed: state enterprises were allowed greater freedom to place their time deposits, but not their current account deposits, with the banking institution of their choice; savings cooperatives were authorized to provide similar banking services as the National Savings Bank; and small socialist and private enterprises were permitted to transfer their accounts from the latter bank to both savings cooperatives and the NBH, a move designed to facilitate their transactions with the state enterprise sector. In 1986, a new commercial bank, Citibank Budapest, was established under the joint ownership of Citibank (80 percent) and the NBH (20 percent), authorized in principle to offer all types of banking services to enterprises. Whereas other interest rates continued to be determined administratively, from 1986 on, lending institutions became free to set loan rates to enterprises subject to the constraint that the average rate charged not exceed the refinancing rate of the NBH by more than 1.5 percentage points.

The principal phase of the banking reform, consisting of the establishment of a two-tier banking system, was implemented in January 1987. The domestic commercial banking operations of the NBH and the State Development Bank were taken over by three new commercial banks. The new banks were set up as joint stock companies owned directly by the State and state enterprises. They assumed the deposits and the loan portfolios of their predecessors, with certain banks inheriting a disproportionate share of credits to less creditworthy enterprises and loans at concessional interest rates. Two other banking institutions, including the Foreign Trade Bank, were also authorized to function as full service commercial banks from this date, and new banks, including some with foreign participation, later acceded to the system. In 1987, the authorities lifted the requirement for enterprises to keep their current accounts with a particular commercial bank and authorized the banks to use interest rates to compete for enterprise deposits and loans.

The segmentation between banking services for enterprises and the traditional network of savings institutions for households continued to prevail, however, through 1988. A necessary condition for the integration of banking services between the enterprise and household sectors was reform of the housing finance system, which was introduced on January 1, 1989. The implicit taxation of depositors at the savings institutions as a source of the subsidization of housing loans had already been reduced notably from late 1987 through increases in interest rates on savings deposits. In early 1989, the Government discontinued granting very-low-interest housing loans by the National Savings Bank and transferred the cost of the remaining subsidy elements of new housing credits to the budget. The sizable outstanding stock of concessional loans of the National Savings Bank was transferred to a newly established housing fund in exchange for bonds with market-related yields. The losses of the housing fund from the assumption of the portfolio of low-interest housing loans were covered by budgetary transfers.

These reforms helped free the commercial banks and the savings institutions to compete for the deposit and credit business of customers across the economy. Until the beginning of 1990, strict reserve requirements were imposed on household deposits at commercial banks in order to protect the savings institutions from a drain of funds. Ceilings also remained in place on interest rates on household deposits, although these were generally set high enough to allow positive pre-tax real rates of interest; increasingly, these ceilings were adjusted in line with movements in market rates of interest.

With respect to foreign exchange transactions, banks were authorized to provide foreign-exchange-related services to households beginning in the second half of 1988; from the beginning of 1989, banks could act as agents in foreign exchange purchases of enterprises from the NBH and be involved in forward exchange operations. From September 1989 on, banks were effectively free to take foreign currency deposits of residents. As a further step toward decentralizing foreign exchange operations, certain commercial banks were permitted, beginning in early 1990, to carry out trade-related foreign exchange operations directly with their customers and to maintain correspondent banking relationships with some major international banks. Banks were also permitted to make foreign currency loans for export pre-financing for certain export-related investments.

Along with the institutional reform of the banking sector, the authorities established a system of prudential regulations and banking supervision; at the same time, monetary control shifted gradually from reliance on credit ceilings to indirect instruments affecting the cost of credit. A system of reserve requirements introduced in early 1987 served largely prudential purposes. However, central bank refinancing quotas—including rediscounting of commercial bills—and interest rate policy became the principal instruments of monetary control. Monetary policy instruments were streamlined and rendered more flexible beginning in 1989. A uniform rate was introduced for standard reserve requirements, and interest payments on reserve deposits were discontinued. The role of the rediscount facility and liquidity credits was enhanced and rendered more flexible. The auctioning of treasury bills by the NBH, beginning in December 1988, facilitated a more flexible interest rate policy.

While quantitative refinancing quotas remained proportional to a bank’s equity capital and reserves, interest rates on refinancing were raised substantially in December 1989—by 3 percentage points—to 17 percent for the basic refinancing rate and 21 percent for the more widely used “liquidity rate.” Subsequently, these rates were adjusted in the light of developments in market-based interest rates (Chart 5).

Chart 5.Interest Rates, January 1985–December 1990

(Percent)

Source: IMF, International Financial Statistics.

1Treasury bills of 90-day maturity; sold by auction from December 1988.

2Two-year time deposit rate.

3Twelve monthly percentage change.

The new Government will rely more heavily on market-based instruments of monetary and credit control. From the beginning of 1991, all short-term refinancing loans by the NBH have been at market interest rates, with some of these funds made available through auctions. In January 1991, the authorities abolished ceilings on interest rates on household deposits of more than six months’ maturity. A new Central Bank Law is being prepared; it will establish the autonomy of the NBH and define the primary responsibility of the NBH as preserving the value of the forint.

The Government recognizes that an efficient financial system is necessary to promote the effective mobilization and reallocation of resources toward their most efficient use. It has therefore taken steps to increase competition in the provision of banking services. In October 1990, the authorities granted general banking licenses to two foreign banks, authorizing them to provide retail banking services. A new Banking Law is being drawn up to introduce internationally accepted prudential regulation, including levels of capital adequacy and the treatment of bad loans.

Other Developments in the Financial System

After a hiatus of thirty years, the authorities resumed issuing bonds in 1981. Initially, local councils issued bonds to finance infrastructural projects, and since 1983 state enterprises have also issued bonds. Bonds were initially placed with enterprises, but sales to households have been permitted since 1984, provided the issue is backed by a state guarantee. The State Development Bank initiated secondary trading of bonds in 1984, and the Budapest Bank assumed the role of residual buyer and seller after adoption of the two-tier banking system in 1987. Activity in the nascent primary and secondary markets flagged after the authorities ceased issuing government guarantees for bonds in early 1987. Bonds also became less attractive as the main underwriters refrained from adjusting bond prices despite the rapid rise in interest rates and increasing competition from treasury bills and certificates of deposit. Further new developments in the securities market included an increase in 1988 in the number of enterprises selling shares, and the opening in early 1988 of the first brokerage house. In 1990, a Securities Market Law was adopted that established a State Securities Supervision Board to regulate the public issuance of securities and the rights and obligations of security traders. Following this, the Budapest Stock Exchange formally reopened operations in June 1990.

Although commercial bills could be issued on the basis of legislation originating in 1877 and a decree from 1965, they remained absent from the financial system from the inception of central planning through the mid-1980s because of a general prohibition of interenterprise financial operations. Financial legislation adopted in 1985 created a new basis for issuing and trading bills. The role of bills remained negligible, however, until 1987, when their discounting at the banks—and their rediscounting with the NBH—increased their importance as an instrument of working capital finance for enterprises.

The state insurance monopoly created by the nationalization of insurance companies in 1949 was abolished in July 1986 and succeeded by two major institutions offering a broader selection of policies. These companies have recently begun to act as institutional investors, investing in the bond market, in bank shares, in real estate, and in treasury bills.

The Government wishes to encourage citizen shareholding as a way of promoting the efficient allocation of capital. It recognizes that a genuine market economy cannot come about without the earliest possible development of the infrastructure of financial information and services. Although the volume of transactions on the Budapest Stock Exchange has been light so far, its growth should be aided by the expansion of private property and privatization. The implementation of laws setting international standards in accounting and auditing planned for 1992 should also promote the exchange’s expansion. The Government plans to introduce an Insurance Act in 1991 that will foster the development of the insurance sector to cover the growing economic risks.

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