Changing Hands: Governance and Transformation in Hungary's Financial Sector

Abstract

AbstractThe early 1990s in Hungary saw rapid institutional change and severe economic downturn. Credit relations and the financial system generally suffered from widespread corruption, including the exchange of loans for bribes, self-enrichment schemes, and manipulation of such procedures as bankruptcy, state-initiated debt restructuring programs, and banking supervision processes. The cost of this early rash of corruption and later episodes through the 1990s easily runs into the hundreds of millions of dollars.Many countries in similar circumstances have failed to come to grips with these problems, with disastrous results—the paradigm example being Russia's experience leading up to the crisis of 1998. There, rapid privatization (in the absence of functioning safeguards and market institutions) opened the door to massive self-enrichment by enterprise insiders, and a loosely supervised banking system facilitated the rise of the oligarchs. Hungary saw the beginnings of this in the early 1990s. Its experiments with market socialism had ushered in a complex and murky business environment. Hybrid (state-private) corporate groups, in many cases run by former state managers, linked enterprises, banks, and the state in a collusive mutual embrace.What could be done? Economic restructuring to transform heavily corrupt incentives had to take first priority. Thus, the choices confronting Hungary in the early 1990s were tough and the stakes high. In the event, Hungary escaped the trap of failed transition. The main steps in its reform were the implementation (and adjustment) of a legal reform package known as “legislative shock therapy”, a (highly flawed) debt restructuring process, and robust privatization—especially of state holdings in the banking sector. These reforms revolutionized ownership incentives and imposed transparency on the system. The influx of foreign owners, together with the growing strength of markets and public sector institutions, brought banks and enterprises under the effective discipline of corporate governance and regulation. This helped create one of the strongest financial sectors in the region, a vibrant economy, and a reasonably well-governed and competitive marketplace. Corruption in the financial system, nearly a way of life in 1991, became far more episodic and manageable. The disciplines imposed by the applicable international regimes, especially the EU, have played an important role. There are lessons here for policymakers around the world.