The ease with which the financial sector of formerly centrally planned economies manages the transition to the free market is a crucial determinant of the overall chances of success for the economy. Aimee Cullen takes the example of Hungary and how it dealt with this transformation to demonstrate the challenges faced by other transition countries.
Introduction
It is my opinion that financial sector reform is at the crux of successful transition. It is only logical that an efficient market system will require the efficient allocation of capital. In going from a centrally planned economy to a market economy, there will be a need for the creation of a set of new instruments, institutions, and regulations.
This paper outlines briefly the features of a financial sector under central planning, focusing on the case of Hungary as a means of highlighting the problems faced by an economy undergoing transition and the available measures to overcome these problems. The difficulty and complexity of such a process should be obvious to all from this case study.
The Financial Sector under Central Planning
As participants in a market economy, we are familiar with a two-tier banking system. On one level, the Central Bank functions as the governments bank; sole issuer of currency; lender of last resort; and regulator of the commercial banks. On a second level are the independent commercial banks that serve the needs of households and firms on a day to day basis.
Under central planning, the banking sector was essentially weak. It was an instrument of the central planning authority. A single bank performed both central and commercial banking functions. This Monobank carried out the necessary functions of a western style central bank, as well as making loans and some investments. Branches of the Monobank carried out the functions of commercial banks. Some systems may have included development banks or investment banks that were sector specific.
Households could not deal with the commercial banks, with the only exception of the State Savings Bank. If the system permitted the ownership of property, citizens could arrange a mortgage with this bank. Loans for other reasons, such as the purchase of durable goods did not exist. The lack of banking facilities such as checking accounts was of no real inconvenience to the citizens of centrally planned economies as most transactions conducted were in cash.
The commercial banks held deposits for enterprises only. Banks in the planned system carried out transfers, and in this respect, were often merely accounting agencies. As a result, there was no need for a separate tax collection mechanism.
Balances held by enterprises on their accounts with the State Bank were available only for planned transactions, and as a result there was no real incentive for enterprises to accumulate financial assets.
This credit system gave the government an additional means of controlling enterprise activity. An enterprise requiring working capital would only receive it if the purpose was in accordance with the plan.
It is clear from the above discussion, that the commercial banks did not have any real input into the lending process. Lending decisions were based not on profitability but on government guidelines geared towards implementing the economic five-year plan. In their paper, Catte and Mastropasqua list five formal conditions on which banks based their lending: accordance with the plan, a specific purpose, adequate collateral, repayability, and fixed maturity. The existence of the plan meant that the banks were not required to assess the riskiness of any project or the creditworthiness of the applicants. This clearly laid the foundations for banking problems when bad loans emerged.
The commercial banks, especially in Hungary, did not face any liquidity restraints, and so were able to lend to a virtually unlimited extent. This resulted in a system whereby, loss-making enterprises were rewarded with unlimited credit facilities, even though the likelihood of those loans ever being repaid was minute. The main reason for the unlikely repayment was the existence of soft-budget constraints, which did not require them to keep their costs under control. Smaller, more profitable firms in the non-state sector facing cost constraints were denied access to credit facilities. This is obviously inefficient and would be unacceptable in most market economies.
Present in most centrally planned system is bargaining. Enterprises can bargain for everything from subsidies to the level of taxation they should pay. Each enterprise's position in the plan results in what has become known as ‘Investment Hunger'- the allocation of funds on the basis of size. In particular, enterprises benefit from the absence of any cost constraints or bankruptcy because the central planning authorities can always be relied upon to bail out loss making firms in the state sector. Provision of extra funds can also be arranged with much ease, as long as the project is covered by the plan. Therefore, firms' actual demand for investment funds is interest inelastic, because it depends on other factors, most notably the decision of central planners.
In brief, the problems inherent in a centrally planned system were an absence of cost constraints, an absence of liquidity restraints, an absence of bankruptcy and no assessment of creditworthiness. The economies after transition inherited these problems as well as the resulting effects.
The Case of Hungary:
Hungary was not a big-bang liberaliser; instead, it implemented reforms on a gradual basis. It is believed that origins of the financial distress of the banking system in Hungary lie in the legacies of the old centralised system. The fiscal budget provided the necessary inter-mediation by transferring liquidity from households or the external sector to the production sector. The state withdrew from capital markets leaving a significant void. The banks inherited bad loans as well as bad customers. The government did not do too much to wind up loss-making state owned companies and the banks did not have enough reserve capital to write off bad loans and to initiate foreclosure in the early stages of transition. Abel et al observes that the governments did not grant the newly created commercial banks sufficient autonomy nor did they provide them with a strong enough capital base to carry out the inter-mediation efficiently. Bonin also recognises the problems that arise after state withdrawal: "bank failure is a crucial part of the general problem of withdrawal from the banking sector, since misguided policies may generate mechanisms which in fact reverse rather than promote reforms".
The basis of reforming the financial sector was the decentralisation of the banking system, as well as implementation of regulation.
Financial Institutions:
Prior to the economic reforms of the mid to late 1980s, the financial institutions of Hungary included, the Ministry of Finance, the Hungarian National Bank, five major and several smaller commercial banks. The Ministry of Finance oversaw the financial and banking system.
In 1987, a new two-tier banking system was unveiled. This system was likened to the German-Austrian universal banking model. It consisted of several banks supposed to function as genuine, profit-making credit institutions. Under these reforms, the Hungarian National Bank was stripped of its commercial bank function, but remained the country's bank of issue and its central bank. The National Bank then established the national payment and accounting system, announced rules on money circulation and co-ordinated relations with international financial institutions. As regulator of the money supply, the National Bank used instruments such as credit policy, interest rates and, most important to strengthening the banking system, obligatory reserve requirements.
The president, rather controversially, however heads the National bank.
Five commercial banks were created in the process of reform. These were:
The Act on Financial Institutions defines banking activities, the types of banks, rules for establishment of banks, capital adequacy and liquidity requirements and the creation of reserves. All of the banks were Hungarian-owned companies and were licensed to perform a full range of commercial banking services and provide short term credits. The banks were established as joint stock companies, the state was a majority shareholder, represented by the Ministry of Finance. The banks were not initially permitted to carry out banking operations for households or foreign exchange operations. The Foreign Trade Bank handled foreign-currency exchange and countertrade. It also provided short-term import and export credits and loans geared toward expanding exports.
Since 1989, the commercial banks have carried out services for households, but because of the lack of a widespread branch network, their main activity is issuing Certificates of Deposit.
Since the reforms, joint ventures with a foreign share have played a complimentary role in the domestic system. There are three major players in this field:
Despite provision of credit, many believe that the foreign partners have created very few spillover effects in the Hungarian market. This is a pity, given how risk averse most foreign banks have shown themselves to be.
Profit-oriented management was to be the main feature of the new commercial banking system. They therefore must consider their borrowers more carefully.
Credit Criteria:
Despite the many rounds of reform to the financial system undertaken in Hungary, bank lending decisions still remained unrelated to the past profitability or creditworthiness of the potential borrower, and the government often used the credit system to bail out enterprises operating at a loss. The credit appraisal methods were rudimentary and therefore did not create a sound basis for credit decisions. In the reforms of the late 1980's, the Hungarian National Bank issued "Guiding Principles on Credit Policy" as part of the state five-year plan.
Particularly, high spreads and an inefficient system had driven many good commercial customers to other sources of credit, such as internal funding and foreign sources. The banks did not have the option of credit worthy small risk clients with which to improve their portfolios.
The Issue of Bankruptcy:
In 1986, Hungary became the first communist country to enact a bankruptcy law. This legislation sought to encourage enterprises to become profitable, and less reliant on state subsidies, which in 1987 consumed about 23% of the national budget. Creditors, unpaid suppliers and other enterprises could initiate bankruptcy proceedings against any insolvent enterprise with the exception of agricultural collectives. The National Reorganisation and Liquidation Board oversaw the process and attempted arbitration and reorganisation before final liquidation.
Unfortunately, the government did not enforce this law vigorously. Government intervention remained so widespread that in bankruptcy proceedings unprofitable enterprises could justifiably argue that their losses were only marginally related to efficiency or managerial decisions. The government continued to compensate firms operating at a loss with subsidies, tax breaks, credits, preferential treatment in price-setting, and other means. The earnings of profit making enterprises were extracted to fund these measures. Despite the option for creditors to initiate liquidation proceedings against debtors, relatively few procedures took place. There was a deep-seated problem of ‘creditor passivity'.
As a result of general dissatisfaction with the 1986 legislation, it was amended in 1991 and came into effect in 1992. Bonin and Schaffer discuss the impact of this act in their 1995 paper. They note that its intention was to create ‘financial discipline' and counter the perceived credit passivity. Another particular worry was the problem of inter-enterprise credit and nonpayment. The legislation allowed for three types of procedure: bankruptcy proceedings affording the debtor firm temporary protection from its creditors; liquidation (or "winding-up") procedures, and "final accounting" – the cessation of activity of an economic entity without a legal successor in cases not covered by liquidation. The main innovation of the 1992 Act was the introduction of bankruptcy proceedings; it outlined a procedure whereby a debtor firm renegotiates its debts with its creditors while temporarily protected from them. The protection allowed to debtors is to give them time to formulate a restructuring plan.
Another innovation of the Act was to include an "automatic trigger" which requires that a firm with a payable of any size, that is owed to anybody and overdue by 90 days or more, must file for bankruptcy within 8 days. If the firm does not comply, the managing director is held responsible. This was the main mechanism for inaugurating ‘payment discipline'.
Liquidation arises when an insolvent firm is unable to meet the claims of its creditors and is "wound-up" under court supervision. The prioritisation of settlement is: liquidation costs; secured creditors; social security and tax debts; claims of other creditors and interest, late penalties on taxes, etc.
The inter-enterprise credit is usually represented by the value of payables in the queue, that is, payables of firms sent to the firms' banks and are waiting to be paid because the firms have insufficient funds in their accounts to cover the payables. This was perceived as a real problem and bankruptcy legislation was intended to solve it. Prior to transition, banks were obliged to operate queues, but in the early 1990's it became optional. Between the end of 1989 and the end of 1991, the queue increased from about 4% of GDP to about 7%, or from 15% of bank credit to 21%. Three main kinds of payables appear in the queue: payables to other enterprises; payables to banks; and other tax-like payables. Bonin & Schaffer conclude that this increase is less evidence of deteriorating payments discipline, rather a deterioration of tax discipline.
The banks and the enterprises applied market discipline as early as 1992 in Hungary; the government is the only possible remaining culprit supporting on-going non-economic activity, such as queuing.
The impact of the Bankruptcy Legislation:
The 90 day automatic trigger started to bite in April 1992, and the courts were inundated with bankruptcy petitions. Most cases were as a result of overdue trade credits. Between April '92 and September '93, there were about 4,300 filings. About 80% of these were believed to be as a result of the ‘automatic trigger'.
The scale of queuing did actually fall with the implementation of the Bankruptcy Act. According to a study by the National Bank of Hungary, this was due to the debtor protection afforded by the act, which meant the payables were automatically removed from the queue. In September 1993, after mounting dissatisfaction with the bankruptcy legislation, the ‘automatic trigger' was removed. This is believed to have contributed towards the fall in liquidations in late 1993.
Clearly, the banks' cash flows were hurt by the bankruptcy proceedings in that firms did not service or repay their bank debt during the 90 day protection. Also company loans that went into liquidation were non-performing for the length of the proceedings.
However, the main cost it is believed was in the enterprise sector, as firms were cut off from access to all kinds of credit. The automatic trigger had the effect of causing many firms to try and repay overdue trade credit in early 1992 so as to avoid bankruptcy proceedings. As a result both bank and trade credit fell in real terms in 1992. Unfortunately, the Bankruptcy Act did not do anything to ease the bad loan problem, if anything, it aggravated it.
Problems of Bad Loans
These loans were inherited from the system which evolved under central planning. Indeed, of the structural weaknesses of the new banking system, the concentration of loan portfolios of the three newly established commercial banks was by far the most damaging. It was a direct consequence of the lending procedures of the National Bank of Hungary which subordinated to the national economic plan before 1987.
The New Banking Act (officially Act no. LXIX of the 1991 act on Financial Institutions and Financial Institutional Activities) was promulgated on December 1 1991. This act introduced three categories of ‘problematic' loans for rating the portfolios of banks. It also called for the accumulation of loan-loss reserves against such loans. A schedule for meeting capital adequacy targets was also specified.
The State Banking Supervision in 1992 required that banks classify assets in their portfolios as ‘bad' if the borrower is in default for a year, or if the company against which the claims are held is in the midst of liquidation proceedings. Provisions equal to 100% of total ‘bad' debt had to be accumulated by the end of a three-year period. The act also legislates for two other standards of loan – ‘substandard' and ‘doubtful' with provisions of 20% and 50% to be accumulated within the same time period.
At the end of 1991, total problematic loans amounted to Ft88 bn., about 10% of total enterprise sector credit. By the end of 1992, total problematic loans had ballooned to Ft 289 bn., almost two-thirds of which was classified as ‘bad'. 1993 saw yet another ballooning of the figure.
Estimates of Bad Loans as a percentage of total bank loans
|
1987 |
1988 |
1990 |
1991 |
1992 |
|
0.3% |
0.6% |
2.6% |
4.7% |
12.9% |
Clearly, there was a steady deterioration in the share of bank loans defined as bad. Indeed, many believe a credit market failure was imminent.
To deal with the problem of continuing bad loans, the government in 1992 introduced, rather hastily some believe, a bank consolidation scheme. In this way, the government hoped to put in place the foundations for a quick recovery to the transition- induced recession and to nurture strong sustainable growth. The policies focused on reforming a malfunctioning credit market and weaning viable large enterprises from public support through financial and operational restructuring. It focused on removing the bad-debt burden from the balance sheets of the commercial banks, and replacing it with 20 year maturity government bonds. The debts were bought by a newly created special institution, the ‘Hungary Investment Corporation'. Loans that were declared bad in 1991 sold for 50%, assets turned bad in 1992 traded at 80%. The Ministry of Finance determined eligibility for inclusion in the scheme based on a loan being classified as ‘bad' as of October 31st 1992. The institution was to issue the state consolidation bonds to cover the loans after making a minimal symbolic payment and to sell the bad loans with the proceeds returning to the state budget. There was confusion about whether the bank or the state was liable for payment at maturity. Two different financial instruments were created to replace the calculated values of removed ‘bad' loans. Series A bonds replaced the principal of the ‘bad' loans and paid interest twice annually at the average T-Bill rate of the previous six months. Interest arrears were replaced by series B bonds that paid only 50% of this return.
This scheme resulted in very little loan consolidation and workout and turned out to be "too little too late" from the perspective of recapitalisation. Despite the assertions of this scheme being a once off occurrence, the government announced plans for a second scheme the following year.
In 1993, a different system was introduced. This was an integrated Bank Recapitalisation and Loan Consolidation Program, that initially included 10 banks. Its intention was to resolve the solvency and liquidity problems of the state owned commercial banks. The major objective was to provide positive cash flows to the 3 largest commercial banks, all of which had negative projected capital adequacy ratios. The first strand was applied to the banks' balance sheets at the end of 1993, with the intention of raising the CAR of each bank to a minimum of zero. The second strand, instituted in 1994 was designed to bring each participating banks' CAR to 4% or higher by the end of May 1994.
Finally, at the end of 1994, the participating banks with CARs below 8% issued subordinated debt, which according to BIS standards is counted as Tier 2 capital, to bring their CARs (both Tier 1&2 capital) to 8%. Adherence to this 8% risk weighted capital adequacy ratio prescribed by the BIS is contained in the Act on Financial Institutions.
Loans eligible to be included in this scheme were those classified as ‘doubtful' or ‘bad' by the end of 1993. This scheme has been described as a more integrated approach than the 1992 scheme, because it specified conditions for bank participation in enterprise restructuring.
Distribution of outstanding debts of the banking system in a breakdown by risk 31/12/92
|
|
Debt rating (HUF Billion) |
Stock in Percentage |
|
Standard |
888.43 |
74.4 |
|
Substandard |
41.1 |
3.4 |
|
Doubtful |
98.1 |
8.2 |
|
Bad |
166.6 |
14.0 |
|
Total Outstanding Debt |
1194.1 |
100.0 |
Under the supervision of the Ministry of Finance, the involved commercial banks took the lead in organising and convening a creditors' committee. Debtors having loans classified as ‘doubtful' or ‘bad' by a participating bank received a letter from the bank by 28 February 1994, indicating to them their eligibility to participate. The debtor was then required to prepare a reorganisation plan and submit it to the bank, which then began the above procedure. Agreement was generally reached within 60 days. The tax law was also modified to allow for forgiveness of accumulated arrears.
In the first strand, total recapitalisation amounted to Ft. 114.4 bn. and was provided by a new issue of long term government securities. The second strand amounted to Ft17.2 bn.
There are many conceptual problems with the scheme. Bonin and Schaffer equate its role in restructuring enterprises as "frenzied feeding at the public trough". Once lists are started, companies seem to find reasons for putting themselves on it. Once on the list the companies have little incentive to get themselves off it.
They assert that the policies of the scheme are misguided. They believe, given that tax arrears are a major problem, better tax collection and discipline should have been a primary focus of the government's policy regarding enterprises. Moreover, tax forgiveness sends a very dangerous signal regarding tax discipline.
The necessary establishment of an efficient banking system justifies state intervention. However, it is important the government's actions are seen as a once-for-all occurrence, or a final operation. There is a moral hazard problem otherwise. The consolidation was intended to clean up the banks' portfolios and encourage the preparation of the banks for privatisation. The point of the scheme was to reduce the burden on financial institutions resulting from the bad debts, and perhaps stimulate lending activities and contribute to the reduction of interest rates. This reduction in interest rates would attract a better class of customer.
Accounting Procedures
Hungarian balance sheet figures and ratios derived from them do not provide an adequate picture of the operation of the banks. If international standards had been applied, seemingly large profits would have turned into operating losses at the three banks. The Act on Accountancy terminated the total confusion in asset valuation. The incompatibility of Hungarian practices with international standards, and the non-existence of markets for various types of assets made project evaluation almost completely arbitrary, and could result in wildly differing figures on assets values.
The Act introduced Western-type accounting practices and will make Hungarian financial statements economically meaningful. However, it does not define clearly the proper correspondence between the new and old balance sheet items. As a result conversion of historical data may still yield differing results, complicating the analysis of trends.
The Hungarian Stock Exchange:
Passage of the Securities act in January 1990 made possible the opening of the Budapest Stock Exchange within a regulated framework. Investors' warm feeling towards Hungary at the time created intensive buying fever. The country had held elections bringing a new government and the economy, on the verge of privatisation, was a promising target for investment, which was reinforced by the opening of the stock exchange. Initially members totalled only 42, most of which were joint ventures with Hungarian firms, including Citibank Budapest. The rules of the stock exchange do not prohibit any firm from being wholly founded with foreign ownership. Firms must be registered in Hungary.
Hungary created a stock market believing that an under-developed market was better than none at all, and would help in the process of development towards a market economy. Another reason was to encourage foreign investment. This investment, it was hoped, would bring expertise in market techniques, efficiency and competition. The stock market would act as an incentive to be profitable, to force competition on firms and eventually list these privatised firms on the exchange.
The first company to attempt privatisation on the stock exchange was the country's largest travel agency IBUSZ, and was largely successful. The majority of listed companies were weak and small, some having since gone bankrupt. From the summer of 1991, the BSE found itself in an unstable environment of neighbouring countries. The August coup against Gorbachev in Moscow was the first warning, as foreign investors were overcome by panic to get rid of Hungarian securities. Later, the Yugoslavian conflict projected a multi-directional and permanent view of instability in the region. By the end of 1991 shares were no competition for safe bank deposits offering high interest rates. In 1992, no new shares were listed and for almost a year turnover shrank significantly. The stock exchange pursued intensive lobbying activity for tax havens to stimulate investment. Consequently, regulations appeared according to which the first buyers of shares from an initial public offering could reduce their tax base by the value of their share investment by up to 30% of income, and if they held shares for three years the benefit became permanent. The Budapest stock exchange reacted in these circumstances as most established market economy exchanges would, with the exception that there was even more structural instability.
Conclusion
As stated, banking regulation in Hungary enacted in 1991 did a lot to aggravate the problem of bad debts, the more serious of the weaknesses in the financial system. It seems the instruments available in most market economies are in evidence in Hungary. However, it will take some time before they are used in the same manner as they would be in a market economy. A change in sentiment regarding such measures and enforcement of regulation by the government will be required. Hungary, of all the former centrally planned economies, is the one where reforms are most advanced. Indeed, The Economist praises the actions taken by Hungary for making wise decisions, forcing banks to confront their bad loans, and selling banks to foreign strategic investors. This attracted the capital and professional skills the country needed. As a result, almost half the banks are in foreign hands; and bad loans have fallen.
For transition economies in general, bank solvency and privatisation should be a priority, so that bad credit allocation does not spoil the chances of recovery after stabilisation. It is also true that the problem of regulatory framework does not seem to be the regulations themselves but their enforcement, partly due to the unresolved questions of responsibility for supervision. Most of the economies undertaking transition did so under extreme international pressure. Policy makers in the process were also ‘blind' in their endeavour, and so the effects of any given action were not known until it was actually implemented, usually creating yet more problems.
The complexity of the problem faced should therefore be obvious. As there is no template for any such economy, it will probably continue to be a process of trial and error. I believe the priority should be given to nurturing creditworthy customers, it is just a matter of how.
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