Justifications for Macroprudential Analysis

and its application to the

current situation in Hungary

Money and Banking

EC5505 (Spring Term)
Prof. E Philip Davis

Group G

Introduction
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 Macroprudential analysis is defined as evaluating the strengths and
vulnerabilities of a financial system in order to monitor and maintain financial system
stability of economies. Financial instability has been seen as the major reason for
financial crisis and during recent decades financial stability has become significantly
important objective in economic policymaking.

Since 1980s with the strong growth of the financial systems, many instances
of financial distress with substantial macroeconomic costs have been observed
globally (Gjedrem 2005).

The aim of the Macroprudential analysis is to give warning of any factor

leading to financial instability. In another words, Macroprudential analysis examines
the health of the financial system as a whole and performs stress tests and scenario
analysis to determine the system's sensitivity to shocks in economy and risks to
financial stability. In order to get data on the health of the system and its sensitivity to
economic shocks, Macroprudential analysis employs prudential indicators.

In the next part the definition and theories of financial instability will be
discussed. Subsequently the current situation of Hungarian economy will be examined
by Macroprudential indicators in the analysis part.

Financial Instability

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 Broadly, financial instability or systemic risk can be defined as inability of
financial systems to firstly set up an efficient allotment of economic resources;
secondly manage financial risks (Schinasi 2004); and finally continue to perform
these key functions, even when external shocks or imbalances threaten the system.

A well functioning financial system plays a number of vital roles in an

economy such as intermediating financial activity, making credit available to
borrowers, and facilitating payments between parties. Therefore when these roles are
accomplished with a well functioning financial system perfectly, the economy can
perform smoothly at its potential. (Hawkesby 2000)

Cost of financial instability

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 Table 1 indicates the size of some of the recent financial crises cost by
estimates of the fiscal cost to the government to restore the financial system to an
adequate level of capitalisation. (Hawkesby 2000)
Financial instability has also indirect cost on economy such as the costs arising
from interruptions to business activities, decreased investors confidence, and
disruption in credit availability. Hence, financial crises can result in the economy
failing sharply from a period of boom to a harsh economic contraction.

Table 1: Fiscal costs of financial instability

Factors causing financial instability

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 There is a theoretical framework of main factors, for analysing and predicting
financial instability. These factors that typically contribute to financial instability and
are used to the discussion of macro-prudential indicators are shown in table2.

Factors Explanations
Financial crises are followed by a credit cycle. An initial positive
Debt and financial fragility shock and risk mispricing by lenders, provokes rising debt.
However the expected asset bobble will be affected by a negative
shock, leading to a banking crisis. (Davis 2003)
An excessive monetary policy causes rapid increase in asset
Monetarist
prices due to easy access to credit and also encourages
speculation in asset market. Conversely a tightened monetary
policy such as increasing interest rates reduces assets prices
resulting substantial loan losses for banks. (Hawkesby 2000)
When a crisis has not taken placed for some time, adequate
Disaster Myopia attention may not be taken by those responsible for managing the
risk in financial institutions. (Hawkesby 2000)
Information asymmetry between banks and investors means that
Asymmetric information and depositors do not have sufficient information to select safe
agency costs financial institution. Therefore there is a possibility of sudden
falls in public confidence, so depositors will decide to withdraw
their funds quickly. (Hawkesby 2000)
Investors and institution follow dominant strategies regardless of
Herding underlying fundamentals in the markets, resulting sharply
increase in asset price. (Davis 2003, Hawkesby 2000)
Banks might face a liquidity mismatch between their illiquid
Liquidity mismatch assets (long-term mortgages) and liquid liabilities (deposits),
which makes them exposed to liquidity problem if the risk of
default on credits is not suitably managed. (Hawkesby 2000)
Poor corporate government and regulations on financial
Inadequacies in regulation institutions, decrease incentives and capacity of directors and
management to assess and monitor risks. (Davis 2003, Hawkesby
2000)
Choosing exchange rate policy by which the value of domestic
currency is pegged to the value of a foreign currency, threaten
Exchange rate pressure
banks and corporation who borrow in foreign currency with large
losses on foreign borrowings. (Hawkesby 2000)
Table 2: Theoretical framework of financial instability

Table 3 demonstrate the features of some experienced financial instability.

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 USA
Sub-
prime

Table 3: Features of selected financial instability (1933-85)

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Macroprudential indicators and analysing current situation of Hungary

A set of Macroprudential indicators has been identified by IMF that includes

Microprudential Indicators and Macroeconomic indicators. In this section we use both
group of indicators to analyse the current situation of Hungary.
1) Macroeconomic indicators, which include:

 Economic Growth
It’s important to consider economic growth for the past few years to understand
their trends. The following graph explains the countries economic growth rate levels.

Chart 1: GDP projection

Chart2: Hungary GDP growth rate

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 The GDP has decreased from a percentage of 4% of 2005 to -2.3% in 2009.
Hungarian central bank explains the countries growth rates are depreciating due to
unfavourable international environment in Hungaria. Due to the high incorporation in
the financial and foreign trade impact the Hungarian central bank explains that these
shocks cannot be eliminated easily.

Further the bank explains that Hungary’s economic growth rate accelerated in
the second quarter of 2008 as a result of strong agricultural sales, positive correction
of public services and health services. Further the significant drop in the growth rates
of the other euro countries in the year 2008 has affected Hungary as the rest of the
shown euro countries determine Hungary’s export performance.

 Balance of Payment

In 2008 as the central bank of Hungaria explains current account deficit in the 3 rd
quarter to an amount to 2157 million Euros which is 304 million Euros higher
compared with the deficit in the 2nd quarter. The following table explains the above
properly.

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 Table 4: Balance of payment and financing

 Net Foreign Debt

Chart 3: Net foreign debt of Hungary 2002-2008

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 The above chart explains the private and the general government net foreign
debts for Hungaria till the 3rd quarter of 2008. As we can see clearly the foreign debt
has increased drastically for the private sector. As the Central bank of Hungaria
explains at the end of September 2008 the country’s net debt excluding other capital
recorded under direct investment amounted to 51.9 Billion Euros which is 48.9% as a
percentage of the GDP.

After a careful research it was noted that central government lending has gone
down dramatically over the last few years. This could be possible reasons for the
private sector to borrow from the foreign countries. The chart below shows the net
lending by the central government over the past few years.

Chart 4: General government net lending (%of GDP)

Furthermore as the central bank indicates 80% of the Hungary’s output is

produced by the private sector which indicates that the country in general survives
upon the private sector and ultimately as visible from the charts above the private
sector depends mainly on the foreign countries which indicates that the country in
general depends on other economies.

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  Inflation
As the Hungarian central bank explains for the year ended 2008 the average
inflation rate was at 6.1% and the rate has increased to around 7% in the 1 st quarter of
2008. Further around August/September we can see a slight fall in the inflation rate in
Hungaria and as the central bank dictates this is mainly due to the falling food and
commodity prices in the 3rd quarter. However dramatic falls in the prices are seen by
the end of the year. This can be further shown by the following chart,

Chart 5: Inflation developments

As the statistics explains food and oil prices played an important role in the
end of year disinflationary effects as the falling oil prices reduced the domestic prices
to a significant level. However the above chart shows the reduction of the
disinflationary trend by the beginning of the first quarter of 2009.

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  Exchange Rates and Interest Rates

Exchange rates and the interest rates are two important components for a country
as they affect its financial stability up to a greater extend. After a careful research on
the Hungarian credit crisis over the last decade or so we can see that all currencies in
the region has suffered a enormous devaluation in last few months plus by the end of
January it reached to an all time low.

Chart 6: changes in the exchange rate of the currencies in the region

Chart 7: Hungary central bank monetary policy rate (%)

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 Central bank raised the interest rate dramatically in October to defend the forint.
However it was not a viable decision as the government expects the economy to
shrink by 3.5% in 2009 so as inflation falls, real interest rates rise, which means the
central bank is tightening monetary policy into the crisis.
(http://hungaryeconomywatch.blogspot.com)

 Volatility in asset prices

As the following charts indicate there is a dramatic fall in house prices after 2007 due
to dwindling demand and oversupply (chart 9). In the global property guide is stated
that average price was also decreased around 10% between June 2007 and 2008.

Chart 8: outstanding mortgage debt Chart 9: House price changes, annual (%)

2) Microprudential Indicators, which can be considered as:

 Ownership Structure of the credit institutions

Over the last decade Hungary has experienced more foreign bank entries than any
other European countries. Currently about two thirds of all banking assets in Hungary
are foreign owned. This can be clearly seen from the table below.

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 Table 5: ownership of the credit institutions

As the table indicates out of the total 454.9 HUF billions 393.2 HUF billions
which is 86% of the total are direct foreign ownerships. This clearly shows the lack
of dominance the state owned banks have in the banking sector in Hungary in a period
where the economy has ended in a deep-end recession. Further it’s important to note
that the most basic argument for foreign owners’ (FDI) goal is to extract the most
profit possible from the host country regardless the hosts’ economy.

Emphasis should be provided to the amount of domestic deposits the foreign

banks are holding in Hungaria. Significant amounts of the retail and the corporate
deposits for the year ended 2008 are held by foreign banks as shown by the table
below.

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 (HUF million)

Dec 2005 Dec 2006 Dec 2007 Dec 2008

Description
Audited Audited Audited Unaudited
Total domestic deposits 8,489.000 152,267.000 158,280.000 281,302.927
Corporate deposits 6,995.000 137,251.000 135,364.000 225,525.013
Retail deposits 947.000 11,784.000 14,868.000 22,591.917
Other enterprises 389.000 766.000 305.000 448.515

Other domestic customers 158.000 2,466.000 7,743.000 32,737.482

Table 6: Total domestic deposits of branches of foreign credit institutions

 Profitability of Credit Institutions

Table 7: Operating statement for credit institutions

The above income statement indicates a decrease in the net interest income
and the profitability of the credit institutions in Hungaria. As can be seen the net
interest income has decresed from 17% [02-03] to just 1% in 2008. Further the
country shows a loss for their non-interest income for 08 and consequnetly it shows a
after tax loss pecentage of (-7%)

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 Chart 10: ROE and ROA of the banking sector

As can be seen above the ROE has decreased from December 2007 which
indicates the reduction of the profitability of the Hungarian banks.

 Liquidity
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 %2001- %2002- %2003- %2004- %2005- %2006-
Description %2007-08
02 03 04 05 06 07
Deposits 10% 9% 9% 13% 13% 7% 14%
Of which: Corporate deposits 19% 12% 5% 12% 24% 1% 2%
Retail deposits 7% 14% 11% 9% 4% 6% 16%
Interbank deposits -3% 71% 17% 45% 27% 50% 20%
Loans taken 14% 74% 29% 19% 13% 30% 34%
Debt securities 190% 139% 35% 19% 15% 20% 24%
Interest accruals 25% 98% 57% -13% 8% 38% 75%
Other accrued settlements 6% -6% 48% 26% 50% 0% 39%
Non-priority liabilities 4% 34% 3% 49% 100% 11% 6%
Provisions 20% 28% -5% 6% 30% 11% 11%
Own capital 16% 21% 18% 14% 20% 17% 15%
Total liabilities 13% 26% 16% 18% 18% 17% 20%
Table 10: Total liabilities of
credit institutions

%2001- %2002- %2003- %2004- %2005- %2006-

Description %2007-08
02 03 04 05 06 07
Cash and settlement accounts -24% -8% 60% -4% -1% 18% -26%
Securities for trading -6% 47% -4% -3% 48% 77% 15%
Securities for investment 6% 40% -2% 7% 0% 12% 59%
Total securities 2% 42% -3% 4% 14% 36% 38%
Central bank and interbank deposits -2% -11% 25% 35% 9% -31% -12%
Of which: central bank deposits 31% -34% 28% 139% -7% -63% 12%
interbank deposits -19% 8% 24% -17% 32% 1% -21%
Loans (net portfolio) 24% 33% 17% 20% 18% 22% 21%
Of which: corporate loans (net
portfolio) 1% 23% 14% 14% 11% 12% 8%
retail loans (net portfolio) 74% 67% 30% 30% 28% 26% 33%
Participations 26% 29% -5% 19% 71% 11% 16%
Interest prepayments 4% 50% 35% -3% -4% 25% 68%
Other prepayments 61% 25% 29% 11% 98% 29% 40%
Own assets 13% 24% 21% 25% 50% 18% 1%
Total assets 13% 26% 16% 18% 18% 17% 20%
Table 11: total assets of credit institutions

From the above table we can conclude that the percentage growth of loans
provided by banks are more than the deposits they have gained over the time period.

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Further central and interbank deposited have decreased substantially from 2006 to
2008 which results in liquidity crisis.

Following two tables show division of bank’s assets and liabilities in

Hungarian currency and foreign currency .We observe that they have large exposure
in foreign currency which makes bank vulnerable to exchange rate fluctuations.

Table12: Banks’ assets

Table 13: Banks’ liabilities

The following are the reductions in the reserve ratios which government
implemented for improving the liquidity position of the banking sector in Hungaria.

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 Table 14: Reserve ratio

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Conclusion

We observe that country is facing severe economic slowdown since mid 2006
and as expected they are suffering from deep-end recession. After a careful
investigation we can clearly see that the country has a weak fiscal as well as a
monetary policy and also the country is suffering from a high current account deficit.

Furthermore the country has a high amount of foreign debts and most of the
activities are financed by foreign borrowings. The Foreign Direct Investments have
played a significant role in the country’s economy but this has slowed down in the
past few years.

Hungary’s exports income can be affected as their exporting partners (EU)

economies are in the verge of economic slowdown so this has affected Hungaria in a
significant level. Banking system is facing problems with foreign exchange rate
fluctuations and lack of liquidity which have resulted in financial and banking crisis
in Hungaria.

However the IMF against the worsening economic condition in Hungaria has
provided an amount of £7.05 Billion to maintain the stability of the economy.

After considering all the above mentioned factors we can conclude that
Hungaria is facing severe financial crisis and needs solid measures by the
governments as well as banks to bring the economy back into its stable conditions.

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References

Gjedrem, S. (2005), “The macroprudential approach to financial stability”,

33rd Economics Conference of the Oesterreichische Nationalbank

Hawkesby, C. (….), “Maintaining financial system stability: the role of macro-

prudential indicators” Economics Department

Garry J. S. (2004) “Defining Financial Stability”, IMF Working Paper,

International Capital Markets Department

Devenow, A. and Welch, I. (1996), “Rational herding in financial economics”

European economic review

Davis, E.P. (2002), “Macroprudential analysis and financial soundness indicators”,

Brunel University

Moorhouse. A. (2004), “An introduction to Financial Soundness Indicators”

Monetary & Financial Statistics

Evans, O.M., Leone, A., Gill,M. & Hilbers, P. (2000), “Macroprudential indicators of
financial system soundness”,
International Monetary Fund

Davis, E.P. (2003), “Towards a typology for systemic financial instability”,

Brunel University and NIESR

http://hungaryeconomywatch.blogspot.com/2009/02/hungarys-central-bank-puts-
interest.html

http://www.globalpropertyguide.com/Europe/Hungary/Price-History

Magyar Nemzeti Bank, 2009. Annual report 2009. [Online] Available at:
http://english.mnb.hu/engine.aspx?page=mnben_infrep_en&ContentID=12136
[Accessed 16 March 2009]

Magyar Nemzeti Bank. (2009). Hungary’s balance of payments.

Magyar Nemzeti Bank, 2009. Annual report 2009. [Online] Available at:
http://english.mnb.hu/engine.aspx?page=mnben_infrep_en&ContentID=12136
[Accessed 20 March 2009]

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Hungary Economy Watch. 2009. Of Raising Rates and Stakes. [Online] (Updated 27
March 2009) Available at: http://hungaryeconomywatch.blogspot.com/ [Accessed 27
March 2009]

Magyar Nemzeti Bank, Aggregated Balance Sheet of Credit Institutions 2009.

Available at:
http://english.mnb.hu/Engine.aspx?page=mnben_mfi&ContentID=12271.

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