Changes in the institutional framework and regulation of Hungarian banking have proved insufficient to improve the sector's efficiency. The commercial banks' outstanding non-performing loans largely reflect credits inherited from the old regime, while the sector's market structure remains heavily concentrated. Extensive ownership by the state (including the state-owned enterprises which remain among its largest clients) impedes the rational allocation of credit and objective classification of debtors. The largest banks' irresponsible credit policies and widespread insolvency have seriously reduced both the quality of their portfolios and their profitability. In Discussion Paper No. 826, Éva Várhegyi notes the danger of a downward spiral: forming reserve funds to cope with earlier loans requires rising profits, which they can only obtain by financing high-risk ventures that yield high returns. Loan consolidation is now a precondition for recovery, since the weakness of the banks is hindering privatization, the underdeveloped capital markets cannot finance new business effectively, and the banks' capital base and accumulated provisions fall short of those required to cover loan losses.

Várhegyi discusses possible ways of distributing the costs of cleaning bank portfolios and the most effective forms of state assistance to clean their balance sheets while averting both the breakdown of the financial system and the creation of new bad loans. She argues that privatization of the large commercial banks is essential to modernization, both to improve their ownership structure and to initiate the restructuring they require. Finally, she relates the reform of the banking sector to enterprise restructuring and privatization: the latter are needed to enhance economic efficiency and increase sources of long-term savings, which are in turn required to hasten the restructuring and privatization of inefficient state industries. Várhegyi proposes to resolve this dilemma by recapitalizing the financial institutions and relaxing the legal restrictions on their investment in enterprise equity.

Key Elements of the Reform of the Hungarian Banking System: Privatization and Portfolio Cleaning
Éva Várhegyi

Discussion Paper No. 826, September 1993 (AM)