The Hungarian Way - Targeted Central Bank Policy by MNB | Magyar Nemzeti Bank

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THE HUNGARIAN WAY – TARGETED CENTRAL BANK POLICY

Magyar Nemzeti Bank

THE HUNGARIAN WAY – TARGETED CENTRAL BANK POLICY

ISBN 978-615-5318-14-6

2017

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The Hungarian Way â&#x20AC;&#x201D; Targeted Central Bank Policy

MAGYAR NEMZETI BANK, 2017

THE HUNGARIAN WAY – Targeted Central Bank Policy Book series of the Magyar Nemzeti Bank © Magyar Nemzeti Bank, 2017 Contributors: Budapest Stock Exchange Executive Directorate Consumer Protection and Market Supervision Directorate Monetary Policy Instruments, Foreign Exchange Reserves and Risk Management Directorate Fiscal and Competitiveness Analysis Directorate Economic Forecast and Analysis Directorate Research Executive Directorate Macroprudential Policy Directorate Monetary Policy and Financial Market Analysis Directorate Financial Infrastructures Directorate Financial System Analysis Executive Directorate Financial Institutions Supervision Directorate Resolution Directorate Capital Markets and Consumer Protection Legal Enforcement Edited by: Kristóf Lehmann, Dániel Palotai, Barnabás Virág The editors would like to express their gratitude to the Governor György Matolcsy, Deputy Governors Ferenc Gerhardt, Márton Nagy and László Windisch for their professional comments during editing. Published by: Magyar Nemzeti Bank 1054 Budapest, Szabadság tér 9. www.mnb.hu All rights reserved. Prepress and printing: Pauker-Prospektus-SPL Consortium ISSN 2416-3503 ISBN 978-615-5318-14-6 2017

Contents

Foreword 9 Introduction 13 Summary of key conclusions

Part I – An unconventional crisis with unconventional consequences – finding new ways in international monetary policy A. Consequences of the global crisis for international monetary policy

1. The 2008—2009 crisis and the new international economic environment 27 2. The impact of new economic approaches on the conduct of monetary policy

B. The new instruments of large central banks – Balance sheets in focus

105

3. The Fed’s monetary policy after the crisis

107

4. The ECB in new territory – “Whatever it takes”?

140

5. The Japanese central bank’s fight against deflation

178

Part II – Challenges and answers in Hungarian Monetary Policy A. Complex challenges for the Hungarian economy and Hungary’s monetary policy

205

6. Macroeconomic conditions in the first decade of the 2000s —5—

207

Contents

7. Interactions between fiscal turnaround and monetary policy

234

8. The way from unsustainable indebtedness and a vulnerable, pro-cyclical banking system to financial stability

257

B. Targeted and innovative answers of Hungarian monetary policy to new challenges

289

9. Easing cycles – significant easing with gradual and cautious steps

291

10. Theoretical background of maintaining the level of the base rate for an extended period – monetary policy in a world of uncertainty

326

11. Towards a more flexible framework of inflation targeting

350

12. Targeted lending incentive instruments: from FGS to GSP

395

13. Monetary policy considerations for the conversion of foreign currency loans: growing stability and central bank leeway

420

14. Self-financing programme – central bank tools to reduce external vulnerability

464

15. Development of BUBOR and the domestic interbank market

497

16. The limitation of the 3-month deposit as unconventional easing and related modifications of other central bank instruments

527

C. Hungarian instruments to improve the functioning of the monetary policy transmission mechanism

573

17. Steps towards a more efficient banking system

575

18. Development and modernisation of payments and financial infrastructures 618 19. Relationships between monetary policy and the stock exchange

667 —6—

Contents

Part III – Changes in the Hungarian regulatory policy A. Macroprudential policy in the foreground

687

20. The theoretical basis of using macroprudential instruments

689

21. Targeted Hungarian macroprudential policy instruments in practice

737

B. The emergence of the resolution function

793

22. The MNB as the resolution authority

795

C. Reforming supervisory policy

825

23. Strengthening synergies with the emergence of central bank supervisory functions – The common directions of supervision 827 24. Overhauling the Hungarian microprudential supervision

861

25. Market surveillance and consumer protection procedures

905

26. Supervision in the 21st century and the challenges of digital progress

925

27. Acknowledgements

936

List of acronyms

938

List of charts and tables

945

—7—

Foreword The complex challenges that emerged in the wake of the global economic crisis necessitated new economic policy responses all over the world; therefore, the targeted measures, sometimes regarded as unconventional, have become crucial in successful crisis management and the preservation of sustainable growth and financial stability on a long-term basis. Hungary has been a trailblazer in overhauling economic policy in recent years. Our book presents the Hungarian way from the perspective of targeted central bank policy. In the approximately one decade before 2010, the Hungarian economy was characterised by an unsustainable growth path. As a result of irresponsible fiscal policy, the budget deficit rose to persistently high levels, while the government debt increased substantially. Excessively loose fiscal policy was coupled with excessively tight monetary policy; however, the central bank was still unable to achieve its price stability objective, i.e. massive inflation persisted. However, 2010 ushered in a change of course in economic policy, as a result of which Hungary first performed a fiscal turnaround. In addition to responsible fiscal management, structural reforms leading to the countryâ&#x20AC;&#x2122;s convergence gained prominence. Within the framework of a comprehensive tax reform, the flat-rate personal income tax was introduced, taxes on labour and small and medium-sized enterprises were cut considerably, and large corporations were involved to make the distribution of the tax burden more equitable. Yet, fiscal balance in itself would not have been sufficient to ensure long-term financial stabilisation and sustainable economic growth; these called for fundamental changes in monetary policy as well, which were implemented only from 2013. Central banks have been traditionally characterised by conservative decision-making and consistency. However, the multifaceted 2008 global financial crisis forced monetary authorities to use new instruments. â&#x20AC;&#x201D;9â&#x20AC;&#x201D;

Foreword

While the central banks of developed countries typically responded to challenges rapidly, the Magyar Nemzeti Bank initially did not change its earlier policy. The central bank management that took office in 2013 encountered analysts with extensive expertise at the Magyar Nemzeti Bank. Under the new management, the central bank, without prejudice to its primary objective, took a new approach to financial stability and supporting economic growth. The list of all the proactive and innovative measures and programmes that were implemented in recent years is too long to spell out here; however, let me just proudly mention a few, without attempting to be exhaustive: rate-cutting cycles, Funding for Growth Scheme, SelfFinancing Programme, Growth Supporting Programme, the integration of financial supervisory activities, macroprudential measures, holding financial institutions to account and the forint conversion, the concept of an ethical banking system, resolution activities, the acquisition of GIRO and the Budapest Stock Exchange, the issuance of new banknotes, the Depository Programme and the MNB’s corporate social responsibility programmes. These measures are significant even by international comparison, and they successfully supported the attainment of price stability, contributing to Hungary’s financial stabilisation, the achievement of sustainable economic growth and the serving of the public good. The Magyar Nemzeti Bank will continue to comply with its statutory obligations and ensure predictability and stability, thereby contributing to Hungary’s sustained economic convergence. The success of the measures entailing the fiscal and monetary policy turnaround has become indisputable: the two main areas of economic policy are characterised by constructive harmony. Although the world’s central banks and governments are still looking for the right way ahead, it has become certain that conventional solutions are not enough, and new approaches are necessary. In this respect, Hungarian economic policy has not only been active, but also successful in recent years. This book of studies, the third volume in the Magyar Nemzeti Bank’s book series, gives a detailed overview of the central bank measures leading to the successful turnaround in growth and their impact. Let — 10 —

Foreword

me hereby recommend it to the Reader, as it makes for interesting and useful reading to not only Hungarian, but also international experts and those interested in the topic. György Matolcsy, Governor of the Magyar Nemzeti Bank Members of the Monetary Council of the Magyar Nemzeti Bank since 2013 GOVERNOR

György Matolcsy 2013— DEPUTY GOVERNORS

Ádám Balog Márton Nagy Ferenc Gerhardt László Windisch 2013—2015 2015— 2013— 2013— MONETARY COUNCIL MEMBERS

György Kocziszky Andrea Bártfai-Mager János Béla Cinkotai Csaba Kandrács 2011— 2011—2016 2011—2017 2013—2015

Gyula Pleschinger Gusztáv Báger Kolos Kardkovács Bianka Parragh 2013— 2015— 2016— 2017 —

— 11 —

Introduction In 2017, almost ten years after the outbreak of the global economic crisis, it has now become clear that the economies of the world have experienced a period that can be considered exceptional from an economic history perspective. The financial crisis that arose in 2007 caused a global shock after starting from one of the most developed financial systems in the world, resulting in persistent and serious real economy and social damage. The crisis, just as all similar earlier periods, provided important economic and economic policy lessons. Partly out of necessity, these new approaches and ideas first emerged in the world of central banks. After the onset of the crisis, central banks abandoned their earlier conservative approach, and sought to intervene in the functioning of the financial system and thus the economy using ever more instruments. In the first phase of the crisis, the measures were motivated by the desire to avoid a rapid escalation of the turmoil; however, in later years new elements gained increasing prominence. In addition to the usual, traditional steps such as the primary objective of stable, low inflation, various so-called unconventional solutions were employed as well, aimed at restoring financial intermediation that was persistently damaged and broken in the wake of the crisis, and at supporting sluggish economic growth. Meanwhile, the ideas laying the theoretical and practical basis for the future’s economic policy concerning more optimal cooperation between monetary policy, microand macroprudential policy and fiscal policy emerged gradually. In the unique economic environment that developed, this meant that a part of the central bank’s innovations concerned previously less explored areas. In addition to primary, direct effects, the side effects of several measures as well as their cross-border consequences in a global economy were less well-known, especially in the case of measures that persisted for a long time. — 13 —

Introduction

Somewhat late, after 2013, the more active engagement of the central bank appeared in Hungary too. Similar to other central banks, the Magyar Nemzeti Bank (MNB) preserved the primacy of the inflation target, while using conventional and unconventional instruments at the same time, seeking to support economic growth and further enhance financial stability in Hungary. Taking into consideration the initial position and the features of the economy, the MNB followed a strategy that was markedly different from international trends by employing its unconventional instruments. Instead of general programmes resulting in the significant expansion of central banks’ balance sheets, new and targeted measures were launched that were feasible even in the context of a contracting central bank balance sheet to reduce the vulnerability of the economy, improve monetary policy transmission, bolster economic growth and enhance competitiveness. Ten years after the outbreak of the global financial crisis and almost five years after the Hungarian monetary policy turnaround, we have much more information and knowledge to assess the engagement of central banks after the crisis. Our latest book attempts to assess and analyse these results. Readers are invited on a journey into the highly complex and sometimes mysterious world of central banks. We strive to provide a complete picture of the events and milestones in the past decade of international and Hungarian central bank policies. Special attention is paid to presenting the MNB’s measures and their macroeconomic effects. We hope that our book will prove a useful read to everyone. From financial and economic experts and analysts engaged in monetary policy on a daily basis, to university and college lecturers, professors and students, and readers interested in today’s economic policy events, everyone can find the answers to their questions in this book. Moreover, we hope that the presentation of the results of the Hungarian central bank turnaround will attract a broader, international audience. We would like to hereby wish you happy reading and an enjoyable time with our latest book. The editors — 14 —

Summary of key conclusions The economic and financial crisis that unfolded in 2007–2008 caused grave and profound problems in the functioning of the global economy, unparalleled for almost a century. The crisis took economic policymakers and analysts by surprise. While in the decades before it economies exhibited stable growth in the context of falling inflation, increasing imbalances and tensions built up in the balances of payments and the global financial system. In addition to its onset, the course and consequences of this new type of crisis also came as major surprises. What is more, the financial crisis exposed the structural deficiencies of economic growth that had previously been concealed. This increasingly directed the attention of economists to the deeper analysis and management of the consequences of low productivity growth, declining investment and deteriorating demographic developments. Considering the complex economic challenges posed by the global economic crisis (macro finance issues and problems pertaining to the financial system and the real economy), its global concurrence and the political instability in its wake, it quickly became obvious that the crisis could only be managed through new, complex economic policy measures. In view of the fact that in several cases a part of the problem was posed precisely by the unsustainable and excessive indebtedness of the state, central banks played a crucial role in addressing the problems from the outset. Their position has been strengthened almost everywhere, their engagement has become broader and they have intervened in the functioning of economies with an ever-growing set of instruments. While preserving the primacy of low and stable inflation, the target has been complemented by the provision of support to economic growth and the more active preservation of the financial system’s stability.

— 15 —

Summary of key conclusions

The instruments employed depended largely on the initial position and structural characteristics of economies as well as on the size and structure of the financial system. So-called traditional common elements were observed everywhere (such as the reduction in policy rates or ensuring the liquidity of the financial system in crisis situations), but the so-called unconventional measures (e.g. asset purchase programmes, lending incentive measures) gained increasing prominence. In the case of the latter, two basic groups could be distinguished: in the economies with larger, more advanced and deeper financial systems general easing measures were widespread, while in less developed and smaller economies (such as Hungary) more targeted solutions were attempted. Hungarian monetary policy responded to the situation late compared to international trends, after 2013, but it did so actively, catching up with a series of measures including several innovative, creative elements. At the outset of the crisis, Hungary and Hungarian economic policy were faced with a highly complex situation. Wasteful fiscal management of the pre-crisis era made financing general government unsustainable. In the absence of adequate internal savings, a large proportion of the country’s financing came from foreign sources, and therefore mounting debts were coupled with substantial external indebtedness. In addition to macro finance issues, the economy’s convergence had stopped well before the crisis, indicating fundamental and serious structural problems. With respect to the most important factors of production, labour market activity, which was very low in international comparison, was coupled with a steadily declining private investment rate. Widespread foreign currency lending threatened with chronic economic and social problems. On top of this, economic problems led to acute political instability from 2009, thereby hindering the solution of the problems. From 2010, the first step towards recovery was fiscal stabilisation. The fiscal turnaround and the structural reforms in the labour market helped restore investor confidence in the Hungarian economy, which — 16 —

Summary of key conclusions

led, inter alia, to the termination of the excessive deficit procedure of the European Commission in 2013. The improving risk perception of the economy and the stabilisation of the inflation outlook enabled cuts in the base rate, which were started in the summer of 2012. The launch of the rate-cutting cycle was followed by a set of comprehensive monetary policy measures from 2013, which included international best practices as well as innovative solutions taking into account the features of the Hungarian economy. The Magyar Nemzeti Bank intervened in the functioning of the economy with a combination of traditional and unconventional instruments. While preserving the primacy of the core objective, i.e. stable and low inflation, it used its measures to support financial stability and the economic policy of the Government. Employing traditional instruments, the Monetary Council reduced the base rate to a historic low level in three cycles and a total of 32 steps, thereby providing a powerful stimulus to the Hungarian economy. Low interest rates facilitated the expansion of investment, consumption and employment on the one hand, and substantially reduced the debt burden on all borrowers indebted in forint on the other hand. Annual interest rate savings in the budget may be over 1.5 per cent of GDP in 2017 as compared to 2012, which is equivalent to around HUF 600 billion. Table 1: Reduction of central bank base rates after the crisis

Start of ratecutting cycle

Average interest rate in the 5 years before the cycle

Current interest rate

Change of rate

18/09/2007

2.9

0.75

2.2

Euro area

08/10/2008

2.9

0.00

2.9

Japan

31/10/2008

0.2

0.00

0.2

Poland

26/11/2008

5.1

1.50

3.6

Czech Republic

08/08/2008

1.4

0.05

1.4

Hungary

28/08/2012

7.2

0.90

6.3

Source: National central banks.

— 17 —

Summary of key conclusions

Taking into account the initial position and features of the Hungarian economy as well as international experience with regard to unconventional instruments, the Magyar Nemzeti Bank clearly opted for well-targeted solutions. General unconventional instruments were typically employed by globally dominant central banks, which entailed a drastic expansion of central banks’ balance sheets. In the acute phase of the crisis, these instruments were effective in preventing the further deepening of the crisis; however, after that, their persistence exerted an ever smaller real economic impact, while it increased the risk of the formation of asset price bubbles, thereby widening inequalities in wealth and distorting the information content of financial prices in general. In contrast to the global trend, the Magyar Nemzeti Bank eased monetary conditions and thus stimulated the economy in the context of a contracting central bank balance sheet. Table 2: The instruments employed by central banks and the change in the size of central banks’ balance sheets Easing through Easing through Programme Use of Substantial Change in the targeted for traditional unconventiomonetary current balance nal instrupromoting instruments easing in the sheet relative to instruments ments SME lending context of GDP as compared the reducti- to the average of on of the 2009–2014 (percentage balance points) sheet Fed

+5.8

ECB

+6.0

BoE

+8.9

BoJ

+51.2

MNB

-8.2

Source: Bloomberg.

The MNB’s measures focused on the enhancement of the broken monetary policy transmission and the reduction of the economy’s vulnerability. The first and most important step in this regard was the Funding for Growth Scheme (FGS) aimed at Hungarian small and medium-sized enterprises (SMEs). The Hungarian corporate credit — 18 —

Summary of key conclusions

crunch mostly hit SMEs, which threatened the longer-term growth capacity of the economy. As part of the Scheme, more than 37,000 enterprises received funding until the end of 2016, in the total amount of HUF 2,600 billion. With this, the FGS has placed corporate lending on a growth trajectory in recent years, while contributing to economic growth by 2 percentage points between 2013 and 2016. After the FGS’s phase-out in March 2017, the Market-Based Lending Scheme (MLS) may ensure sustained and healthy corporate lending. In addition to the restoration of SME lending, the other most acute problem was posed by large-scale foreign currency lending. Due to the substantial social, economic and legal impact and embeddedness, the phase-out required a complex approach. The comprehensive resolution of the issue was achieved with the involvement of the central bank in 2014–2015, at the first point in time when it was both feasible legally and adequately supported economically. Thanks to the innovative solution employed, the phase-out was conducted rapidly, in an organised manner and with the preservation of financial system stability. This step supported economic growth, reduced the economy’s vulnerability and enhanced monetary policy transmission. The MNB’s instruments were gradually transformed with the launch of the Self-Financing Programme. The earlier role of the two-week bill as the main policy instrument was taken over first by the twoweek deposit then the three-month deposit. Due to the change in the main policy instrument’s liquidity profile and the interest rate swap linked to the programme, commercial banks deposited an ever-growing share of the excess liquidity deposited earlier with the central bank in the Hungarian securities market. As a result of the programme, the level of external debt and thus the vulnerability of the economy were considerably reduced, while the financing structure of general government improved, thereby greatly contributing to the subsequent upgrade of the credit rating of Hungary.

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Summary of key conclusions

The central bank measures also included the development and reform of one of the most important financial market segments, the interbank market. Earlier, the Hungarian interbank market did not fulfil its information role, as pricing did not have any connection to the liquidity developments characterising the financial system. After the reform implemented in 2016, supplemented by the unconventional easing measures of the Monetary Council concerning the three-month deposit, the volume of transactions on the interbank market soared, while the interbank rate used as a benchmark for pricing loans dropped by 80Â basis points, yielding substantial savings to corporate and household borrowers. In addition to monetary policy, the Magyar Nemzeti Bank overhauled the functioning of the Hungarian financial system as well through several measures. One of the most important experiences from the crisis that started in 2008 was that the risks and difficulties that arose at financial institutions surprised not only the institutions themselves, but also hit the unprepared financial supervisory authority responsible for financial stability in several European countries. After the crisis, several countries reviewed and bolstered their supervisory framework. This included a rethinking of the placement of the financial supervisory authority responsible for microprudential policy within the regulatory framework, as well as the cooperation with the organisation in charge of macroprudential policy, i.e. the organisation managing systemic risks affecting the whole financial system. In line with international developments, the Hungarian Parliament adopted the draft legislation on the Magyar Nemzeti Bank in the autumn of 2013, thereby integrating the financial supervision function into the central bank. The uniform performance of the monetary policy and financial stability functions (including the macro- and microprudential regulatory and authority functions) integrated into the central bank opened up new horizons for supervisors. The continuous development of the supervisory methodology, the use of advanced technology in inspections and supervision, and the assertive supervisory action focusing more on the identification and management of future risks produced remarkable â&#x20AC;&#x201D; 20 â&#x20AC;&#x201D;

Summary of key conclusions

success in a short time. One good example for the result and success of the renewal in the methodology and the approach is the detection of earlier corrupt practices in the investment services sector that had gone on for almost two decades before the MNB assumed the supervisory tasks that were referred to in the press as the “broker cases”, and the prevention of further damage. Owing to the recent enhancements, the microprudential activities of the MNB have evolved into real supervision, and the earlier, fundamentally inspection-based approach characteristic of the period before 2013 was replaced by a supervisory approach focusing on continuous supervision that is better in terms of quality and safety, too. The stability of the financial system was also strengthened by the fact that Hungary was among the first to implement the European Union’s framework developed in 2014, based on global standards and targeting the resolution of credit institutions and investment firms. The first trial in practice of the European Union’s resolution framework was the resolution of the MKB Bank Zrt. which was successfully coordinated by the MNB as the national resolution authority of Hungary designated in October 2013. The active and proactive use of macroprudential policy was a new, independent element in the central bank’s decision-making. The objective of macroprudential policy is to mitigate excessive systemic financial risks. The MNB has decided to implement a broad array of measures to this end. The steps affect both the demand side of financial intermediation (e.g. the so-called debt cap rules pertaining to borrowers) and its supply side (e.g. the capital and liquidity requirements pertaining to banks). As a result of the measures, the recovery in lending will provide an opportunity for lending with a much healthier structure than earlier, contributing to sustainable economic growth. One of the key elements in the efficiency of monetary policy transmission is the appropriate development and modernisation of financial infrastructures. An advanced payment system supports — 21 —

Summary of key conclusions

the efficient functioning of financial markets as well as the reduction of the shadow economy. In recent years, the MNB has facilitated the modernisation of Hungarian payments and the financial infrastructure with a series of concerted actions. Encouraging the use of electronic payment methods has become a strategic objective. In this field, the most significant step in addition to the establishment of the infrastructure was the development of the rules for instant payments. To summarise, the Magyar Nemzeti Bank has been subject to a major overhaul since 2013. Important results have been achieved in all areas. However, this renewal does not only concern Hungarian monetary policy, as global monetary policy is also currently undergoing change. The Hungarian results can serve as useful lessons to other central banks still searching for the right direction, and the MNB should keep an eye open for the experiences and innovations of other countries. After the 2008â&#x20AC;&#x201C;2009 global crisis, the role of central banks has fundamentally changed almost everywhere; however, the evolution of monetary policies has certainly not come to an end.

Data available on 15 January 2017 were taken into account while preparing the studies.

â&#x20AC;&#x201D; 22 â&#x20AC;&#x201D;

Part I

An unconventional crisis with unconventional consequences â&#x20AC;&#x201D; finding new ways in international monetary policy

Consequences of the global crisis for international monetary policy

The 2008—2009 crisis and the new international economic environment András Kollarik – Zoltán Szalai

The 2007–2008 global financial crisis surprised economic policymakers and analysts. While macroeconomic stability increased around the world, current accounts exhibited unprecedented imbalances. Previously, it was not possible for similar deficits and surpluses to emerge, since countries either made adjustments voluntarily or were forced to do so by crises. The persistence of the imbalances required new explanations, many of which predicted that although current account balances were unusually high, they might last because they were based on the interests of the actors concerned. The eruption and course of the crisis surprised even those who considered the imbalances unsustainable and who expected inevitable adjustments or even a crisis. In contrast to the negative scenarios, the crisis did not emerge in the US current account or the exchange rate of the US dollar. Contrary to expectations, exporting Asian countries and oil exporting investors did not engage in capital flight from the US. These investors were not even present on the US structured mortgage and interbank markets where the crisis originated. Among the foreign investors on these markets, the banks of the euro area, which had a current account balance of close to zero, and of the United Kingdom, which ran a current account deficit, were active. The pre-crisis explanations based on current account imbalances significantly underestimated the actual extent and potential dangers of capital flows, and did not provide a useful analytical framework for understanding and managing the crisis. After the outbreak of the crisis, current accounts experienced a substantial adjustment, but the balances typically did not reverse their sign, i.e. the deficit and surplus positions of the regions were maintained. Nevertheless, — 27 —

Part I: An unconventional crisis with unconventional consequences

the adjustment observed in the current accounts occurred at the expense of deteriorating internal balance indicators, and stocks continue to show significant imbalances, which entails risks. Several theories have been proposed for explaining the protracted recovery, and there is no consensus regarding the future outlook. The Great Recession was not a traditional economic downturn, and therefore managing it calls for an unconventional economic policy. The Great Recession was a balance sheet recession and the recovery takes a long time. According to the balance sheet adjustment theory, slow growth is a temporary phenomenon, while other theories explain the subdued growth with factors independent of the financial crisis. According to the latter, economic growth may be persistently low. These theories include both real economy and financial approaches. The central banks in developed countries responded to the financial and general economic crisis with robust monetary easing. Although during a general balance sheet adjustment monetary easing in itself is not a highly effective tool, the expansive monetary conditions are expected to persist. In addition, even though the widespread inflation targeting monetary regime faced a backlash on account of the crisis, with modifications it can still be considered one of the best practices at the international level.

â&#x20AC;&#x201D; 28 â&#x20AC;&#x201D;

1 The 2008—2009 crisis and the new international economic environment

1.1 Developments before the crisis 1.1.1 The build-up of global imbalances

In the literature, the 15-year period before the crisis is referred to as the era of “Great Moderation”.1 This expression refers to the fact that after the 1970s and 1980s, which were characterised by high and volatile inflation and fluctuating growth, macroeconomic policy – and especially monetary policy – successfully stabilised both variables. It seemed that economic policymakers had found the key to success with inflation targeting, independent central bank policy and a mostly passive fiscal policy aiming for a neutral stance on average in the business cycle. It was assumed that macroeconomic stability coupled with marketfriendly financial regulation guaranteed financial stability as well. Monetary policy was not considered to play a role in long-term growth, which, according to this approach, was influenced exclusively by real economy factors, while the central bank only exerted an impact on nominal variables. The role of the central bank was believed to be to help the economy in returning to its long-term trend itself held to be independent of monetary policy when due to an external shock actual growth exceeds it (overheating) or falls short of it (overcooling). In light of the successes in macroeconomic stabilisation, the global financial crisis surprised both analysts and economic policymakers. This in itself may be remarkable, since in the years leading up to the crisis, many analysts and international institutions pointed out the increasing global imbalances. In fact, several scenarios were developed for the rectification of imbalances, including uncontrolled, spontaneous processes with potentially huge social costs.

See Stock and Watson (2003).

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Part I: An unconventional crisis with unconventional consequences

Chart 1-1: Current account balances 4

In percent of world GDP

United States Japan Other Asia Discrepancy

China Europe surplus Oil exporters

2014

2012

2010

2008

2006

–3

2004

–3

2002

–2 2000

–2 1998

–1

1996

–1

1994

1992

1990

1988

1986

1984

1982

1980

Germany Europe deficit Rest of world

Source: IMF WEO (October 2016).

Before the crisis, current account imbalances garnered the most attention. Chart 1-1 shows that compared to earlier years current account deficits and surpluses had tripled by 2007. In this context, most observers noted that the US current account deficit had reached unprecedented levels, at 5.7 per cent of GDP. Other countries, including several European countries, also recorded unusually large deficits. Many countries had a surplus against the US, compensating for their deficits against other regions, and achieving a lower current account deficit overall (e.g. Mexico) or a balanced current account. As a mirror image of the substantial deficit in the US and a few other countries, net exporter countries accumulated unprecedented surpluses, for example China amassed a surplus amounting to 10 per cent of GDP. Such countries primarily included the Southeast Asian exporters and the oil exporting countries.

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1 The 2008—2009 crisis and the new international economic environment

The extraordinarily large current account deficits and surpluses were unexpected in themselves. The phenomenon was difficult to reconcile with the prevailing economic theory.2 The external and internal product and financial market liberalisation in the developed countries in the 1970s and 1980s, and in less developed countries in the 1990s was expected to facilitate convergence towards global equilibrium. According to the view that became widespread with Milton Friedman and his followers, the gradual elimination of the fixed exchange rate regime – which was previously typical in the Bretton Woods system – and the capital controls coupled with that regime was expected to balance current accounts. According to Friedman, current account deficits, current account crises and macroeconomic imbalances are caused by excessive government3 interventions. The fixed exchange rate does not allow an equilibrium exchange rate to develop, which would automatically ensure a balanced current account. The reason behind exchange rate crises is that – in addition to controlling capital flows and fixing the exchange rate of their currency – governments employ an economic policy that is unsustainable over the long term. Due to the controls, private players do not directly receive signals from the global market. Unsustainable economic policies result in a growing current account deficit, the external financing of which faces more and more hurdles. The end of the process is an inevitable and painful – and more or less controlled – adjustment, or perhaps an exchange rate crisis, as well as an inevitable devaluation when neither foreign exchange reserves, nor external financing – provided by private or

2 3

regel (2006). K Friedman often mentions governments even when talking about central banks or the measures by the central bank and the government. This was widespread at that time, since central banks were not independent in today’s sense. Accordingly, separating the two actors is not justified when talking about the above-mentioned period.

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Part I: An unconventional crisis with unconventional consequences

international institutions, in effect the IMF – are available anymore.4 Friedman believes that floating exchange rates make it unnecessary for governments to accumulate large official foreign exchange reserves, since no key exchange rate has to be defended. It logically follows from this that no international institution such as the IMF is necessary either, which was established to support fixed exchange rates and to help governments with temporary FX loans when they face difficulties with their current accounts so that they can avoid devaluation.

1.1.2 Explanations of imbalances prior to the crisis

In the traditional framework, the unprecedented increase in current account deficits (and official foreign exchange reserves) was difficult to explain. The old foreign trade theory, which considered the liberalisation of foreign trade mutually advantageous based on Ricardo’s comparative advantage approach and its more modern version, the Heckscher–Ohlin model’s relative factor endowment, was unable to explain why free-floating exchange rates do not create external balance (current account) and internal balance (coupled with full capacity utilisation/employment). At the same time, a portion of the analyses showed that in reality not all countries let their exchange rate float freely, attempting to nudge it in the desired direction openly or

he literature has identified several types of exchange rate crisis mechanisms. The one T cited in the text is the earliest, so-called first-generation approach (Krugman 1979). In the light of experiences, later models do not require the complete lack of foreign exchange reserves for a crisis to develop: for triggering a crisis, it is enough if actors anticipate that the government will not wait for the depletion of the reserves but will adjust the exchange rate before that. Such an adjustment can happen even when the “fundamentals” would not necessitate it. As a result, the foreign exchange markets are characterised by multiple equilibrium. Third-generation theories attribute exchange rate crises to the operational problems of the banking and financial system, especially based on the Asian crisis. Krugman basically treats the latter as a crisis caused by distorted incentives (“moral hazard”) where, due to cronyism between the state and large corporate groups, external financers considered overlending to companies risk-free. (Krugman 1988; for a more detailed description, see Árvai and Vincze 2002 or Glick and Hutchinson 2011.)

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1 The 2008—2009 crisis and the new international economic environment

covertly, directly or indirectly.5 The US has often levelled this accusation against China, which risked being deemed a currency manipulator6 and the restriction of foreign trade with the US. This, however, did not prove to be a satisfactory explanation, because if governments can indeed influence the exchange rate, it is unclear why countries accumulating huge deficits do not do so. An even more basic problem was that governments usually intervened because the market forces left to their own did not move exchange rates towards macroeconomic equilibrium; on the contrary, they moved them towards even more pronounced imbalances. This experience led governments with major currencies in an international sense to prod their exchange rates in a sustainable direction through coordinated informal interventions when they substantially and increasingly moved away from the equilibrium.7 In the literature, more and more studies showed that the earlier ambitions had been too optimistic, and that free capital flows and flexible exchange rates do not automatically entail external balance.8 Several hypotheses have been formulated to explain the persistent, rising current account deficit of the US.9 In the 1980s, the “twin deficit” ofinger and Wolmerhauser demonstrated that usually smaller countries’ foreign B exchange markets are small enough for the central bank to be able to influence the exchange rate through foreign exchange market interventions. In the case of large currencies, this one-sided approach is impossible due to the large volume of trading. Bofinger and Wolmerhauser (2003). 6 The US Secretary of the Treasury is required to assess on an annual basis the trade and foreign exchange policy of the country’s key foreign trade partners to establish whether they aim to achieve an undue competitive edge over the US. If it is established that, for example, a foreign country uses the exchange rate to secure advantage in foreign trade, the Secretary of the Treasury must initiate negotiations with the given country bilaterally or with the involvement of the IMF and the WTO to put an end to the exchange rate manipulation. See US Code (Internet). If the dispute is not resolved after the notification, in theory, the US may impose sanctions on the given country, for example by levying import tariffs. 7 These informal agreements are called Plaza (1985) and Louvre (1987) Accords. The former sought to reverse the dollar’s strengthening, while the latter wished to reverse its weakening. 8 For a good summary, see Frankel (2009). 9 For a good summary on this, see Palley (2014). 5

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Part I: An unconventional crisis with unconventional consequences

hypothesis became widespread, which attributed the external deficit to excessive internal consumption due to the overly loose fiscal policy. This was replaced by an approach focusing on the private sector’s low saving rate when the budget deficit basically disappeared during the Clinton presidency. The hypothesis of low private savings was only popular until the bursting of the technology (“dotcom”) bubble. Until then, analysts could claim that households’ savings diminished and their indebtedness rose as they anticipated the rapid progress in technology and productivity, and anticipated quick future increase in income. The bursting of the dotcom bubble shattered the bedrock of the hypothesis of swift income growth, whereas the low savings rate and the current account deficit persisted. Chart 1-2: Explanations for global imbalances before the global financial crisis Hypotheses about the US trade deficit and global imbalances

1980–2000

Twin deficits

Saving shortage

2000–2007

BWII

Dark matter

Saving glut

Asset shortage

Reserve currency

Source: Palley (2014), p. 7.

In addition to the lack of satisfactory theoretical explanations, another disconcerting factor was that the persistence of the imbalances was irreconcilable with earlier experiences. Historically, governments were forced to make adjustments when the current account showed even a minor deficit, at best in a controlled manner, having recognised the necessity of adjustment in time, but often under the pressure of the markets. Several developing countries have experienced attacks on their currencies, which entailed huge social costs. Nevertheless, earlier — 34 —

1 The 2008—2009 crisis and the new international economic environment

neither the US nor other developed countries were characterised by high external deficits or foreign exchange crises.10 The configuration that emerged was called Lucas’ paradox,11 and it was not in line with the usual convergence and growth theories, according to which capital should flow from the developed to the less developed countries and not the other way around, as we can see from the current account deficits. This is because within the established macroeconomic framework, the current account balance shows how much a country uses from the total global output compared to its own contribution. The countries with a surplus use less, while those with a deficit use more than their own contribution. Of course, the difference has to be financed, and in this framework the capital flows are regarded as the passive consequence of foreign trade: capital flows from the countries with a surplus to those running a deficit. These two types of flows are combined in one real economy framework by the current account investments and savings approach: the countries with a current account surplus are net savers and lenders, while those with a deficit are net borrowers who bring forward their future income in the form of excess consumption in the present. Due to the persistence of the imbalances, other explanations also emerged that did not explain the imbalances through the excessive (public or private) consumption in the US, and that responded to the paradox posed by Lucas. They basically provided rational, enduring explanations for the configuration that had earlier been deemed clearly unsustainable, and they sought to reconcile the imbalances f course, there were important exceptions such as the United Kingdom, which was O the first country that required IMF assistance in 1976, or the exchange rate crisis in the European ERM system in 1992–1993. Yet these cases were attributed to fixed exchange rates and unsustainable economic policies. In a similar fashion, the Nordic banking crisis was regarded to have been the consequence of the one-off, careless implementation of external and internal liberalisation. At this time, the prerequisites of macroeconomic stability, i.e. sound macroeconomic policy and responsible social partnership (moderate wage growth), were supplemented by prudent external and internal liberalisation. 11 Lucas (1990). 10

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Part I: An unconventional crisis with unconventional consequences

with the optimal, mutually beneficial nature of openness, which was originally provided by the theory of comparative advantages. These explanations are summarised in Chart 1-2. One such explanation is the so-called Bretton Woods II, which states that the deficit of the US paves the way for the swift convergence of export-oriented, rapidly industrialising countries.12 This may be called the real-side explanation of the mutually advantageous, optimal imbalances. In this approach, the role of the US is to provide the ultimate demand or consumption globally. This explanation recognises that the global economy functions as a closed system, i.e. if a group of countries consistently base their convergence on net exports, then regions are required that are consistently net importers. As long as the two groups consider the imbalance that emerges mutually advantageous, it is sustainable, even for a long time. This is also suggested by the theory’s name, which considers it an unofficial, tacit, mutually advantageous international system. Another related hypothesis was the “dark matter” theory. The developers of the theory identified several channels with this name, as a result of which official statistics underestimate the economic performance of the US, and overestimate the performance of the rest of the world vis-à-vis the US. According to the observations of the theory’s proponents, the large current account, especially the large trade deficit did not pose problems for the US, because a substantial proportion of the foreign (e.g. Chinese) firms exporting to the US were US-owned. From the perspective of residence, which is the basis of the current account statistics, these companies were Chinese. The revenue and profit generated by the products sold in the US flowed to the firms, which did not always transfer it back to the US or pay it in the form of dividends. These profits are recorded as surplus imports of the US, but do not appear in the current account until the Chinese subsidiary pays dividends to the owners in the US (in which case it is recorded as factor income) or it is repatriated to the US headquarters. Another 12

Dooley et al. (2003).

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1 The 2008—2009 crisis and the new international economic environment

channel is intra-company or transfer pricing: the division based in the US provides services to the Chinese division, but for example the value of design or know-how is only reflected in the higher price of the products sold in the US, which is registered in the current account as additional imports, but is not offset as copyright or know-how income. In this case, the activity in the US is only recorded in the profits of the Chinese subsidiary.13 According to Hausmann and Sturzenegger (2005), the dark matter is supplemented by some financial channels as well.14 The expression “dark matter”15 is an umbrella term for the phenomenon that the foreign receivables of the US provide it with a consistently higher income than what has to be paid on the foreign receivables against the US. Official statistics do not reflect this higher yield when assessing foreign investments. If this higher income were used to evaluate the foreign receivables of the US, it would be clear that it provides a steadily high income for the US. It is as if the US had invisibly exported more, and the existence and quantity of these exports could only be deduced from the income provided by them.16 According to the authors’ calculations, the current account balance adjusted for the “dark matter” may have fluctuated around zero in the years before the crisis, while the official cumulative current account deficit rose to USD 5,000 billion.17 The above could be considered compensatory financial flows that enable a persistently large current account deficit. The main lesson from regel (2006). K The authors mention other sources too, such as the seigniorage realised by the Fed on the dollar held by non-residents in cash and other dollar receivables. They also mention what they term the “insurance premium” between the yields of the debt of the US and that of less developed countries. Investors are willing to accept lower interest rates in the case of the US debt and consistently expect higher rates (even adjusted for the expected losses) for financing the debt of developing countries. 15 Hausmann and Sturzenegger (2005). 16 According to the estimates, in 2005 the proportion of foreign, mainly US, ownership in the companies exporting to the US was 50 per cent, joint ownership was 26 per cent, and the rest of the firms were in domestic private or state ownership. Manova and Zhang (2008). 17 Hausmann and Sturzenegger (2005). 13 14

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Part I: An unconventional crisis with unconventional consequences

this approach is that in the context of globalised production chains, the traditional statistical framework created for trade in finished products is less and less able to follow the transactions that are important from an economic perspective, and it inadvertently provides a distorted picture of economic processes if we examine them through the framework of this obsolete model. Hausmann and his co-author estimated the “dark matter” flows for the largest actors (see Table 1-1). Table 1-1. Exporters and importers of “dark matter” Exporters

Importers

559

Russia

United Kingdom

234

Ireland

France

Germany

Singapore

Korea

Saudi Arabia

Note: annual averages in 2000–2004, USD billion. Source: Hausmann and Sturzenegger (2005).

Putting this into perspective, dark matter was estimated to constitute 5.6 per cent of US GDP in the first half of the 2000s, in contrast to half of that in the previous two decades. According to the global savings glut theory linked to Bernanke18 (former chairman of the Fed), the excessive savings of certain countries inevitably lead to excessive deficits in other countries, since the saving– investment balance requirement holds true globally. Excessive savings push down long-term interest rates too much, which play a pivotal role in investment decisions, and this boosts demand for these savings. Bernanke also blamed these savings for the Fed’s inability during Alan Greenspan’s tenure to raise the yield on long-term government securities by increasing the central bank interest rate (Greenspan

Bernanke (2005).

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1 The 2008—2009 crisis and the new international economic environment

called the insensitivity of long-term yields to Fed interest rate hikes a “conundrum”).19 Another rational explanation involves the demand for safe securities investments (asset shortage or safe assets).20 In this approach, less developed countries pursuing an export-driven convergence strategy invest their substantial export revenue on the markets of developed countries. This is because their domestic financial systems are not advanced and credible enough to provide a safe investment instrument. In this theory, the US has a comparative advantage in producing the safe global investment instrument. The reserve currency theory uses a similar reasoning with a slightly different emphasis. In this explanation, converging countries amass dollar reserves in order to avoid the financial crises of the past, especially the 1997 Asian financial meltdown and its grave consequences.21

1.2 The eruption of the global financial crisis and the pre-crisis scenarios based on the current account The theories presented in the previous section suggested that the unprecedented balance sheet deficits are sustainable, since they are in line with the interests of the actors, and therefore no one is interested in change. Those who included the unsustainable nature of the imbalances in their projections devised various scenarios.22 The common element in these scenarios is that investors’ confidence in the stability of their US investments is damaged for some reason. In order to mitigate their potential losses, they start selling their investments and exchange the dollar amounts received during the reduction of their receivables against the US for another currency. The conversion leads to weakening of the dollar, which creates a self-reinforcing cycle among reenspan (2005). G Caballero, R. J. (2006). 21 This strategy is also referred to as self-insurance. 22 For a summary of the possible scenarios and their impact on the Hungarian economy, see Hornok et al. (2006). 19 20

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Part I: An unconventional crisis with unconventional consequences

the foreign investors in the US, as their investments are devalued by the weakening dollar exchange rate. As investors retreat, interest rates rise in the US, which reduces the prices on the financial markets on financial markets. This wealth effect forces both the private sector and the government in the US to cut their spending, which is reflected in the drop in GDP and the diminishing trade deficit, which also hampers global growth. These scenarios differ depending on whether they are based on the decline in US house prices, the US government securities market or the drop in the dollar’s exchange rate, but almost all of them assume a current account adjustment. According to the scenarios, the countries affected the most by this process may be those whose current account surplus vis-à-vis the US is the largest, since the theories assumed that these countries were the largest lenders on the global market, including the US market, and that they should expect the most substantial losses. The same countries should have anticipated the largest decline in their GDP, since their economies’ growth was the most dependent on the US trade deficit and growth. Accordingly, these potential losers included the East Asian, rapidly growing, export-oriented countries, primarily China, but oil exporters also faced dire consequences. By contrast, the countries with a more balanced current account seemed to be only marginally vulnerable to the expected current account and exchange rate adjustment of the US, and for the same reason, i.e. due to their almost balanced current account, they also did not appear to be exposed through their capital investments. However, the crisis diverged from the expected scenarios. It originated directly from the US interbank market: partner risk gradually reached a level on the real estate-backed securities market at which it prompted certain actors to start selling off their assets. This resulted in a panic on the so-called subprime market and the interbank market froze. This is because these securities were among the assets of the banks and constituted an important revenue source for them. On the interbank market, where banks accumulated their investable funds, lenders, that — 40 —

1 The 2008—2009 crisis and the new international economic environment

are also banks, monitor the financial position of their partners, since they assume credit risk against their partners through lending. As more and more concerns emerged in connection with the quality of banks’ assets, banks increasingly decided not to lend on the interbank market and to hold their liquid assets with the central bank at a lower interest rate. Banks lacking funds found it increasingly difficult to roll over their loans, which further reduced their creditworthiness. The interbank market was only saved from collapse by the Fed’s unprecedented adjustment, whereby it practically replaced the interbank market, and undertook the role of the partner for all participants. While in normal times the Fed only provides a framework in interbank trading and accepts the marginal surplus and provides loans for the shortages at the end of the day, as confidence completely evaporated, all lenders considered the Fed to be the only credible partner, and only the Fed was willing to lend to banks. The second surprise in connection with the unfolding of the crisis was that it turned out that the largest foreign actors on the US financial markets were European banks. When the refinancing needs appeared on the interbank market, it emerged that European banks were much more active than the exporters (East Asian or oil exporting countries) that had been considered the chief lenders of the US economy based on the current account balances. As a result, the Fed was forced to provide liquidity to these US subsidiaries of European banks in order to restore the stability of the American financial system. The Fed concluded an extraordinary dollar swap agreement with the most important central banks (European Central Bank, Bank of England, National Bank of Switzerland, Bank of Japan), to enable them to provide dollar funds to the banks under their supervision.

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Part I: An unconventional crisis with unconventional consequences

Box 1-1 Current account balances, capital flows and the global financial crisis

Before the crisis, capital flows were explained by the current account balance: the balance of goods and services in the current account requires capital to flow into the countries with a deficit, which “finances” the shortfall. This can be provided by an exporter country, where a “financing capacity” emerges from the trade surplus. It is easy to see the close analogy with the closed economy analytical framework, where net savers offer S amount to net borrowers for their spending brought forward, and borrowers spend I amount (investments), and where this credit market produces the “financial intermediaries”, and equilibrium is guaranteed by interest rates. This is the purely real approach to financial intermediation, which is also known as the loanable funds (LF) theory. However, as nowadays more and more analysts realise, “financial intermediation” does not happen in line with the real LF theory in a closed economy either, just as capital flows in the global economy cannot be described in the traditional way. In a similar fashion, the saving–investment balance approach to the current account, according to which capital flows depend on savings or investments, is obsolete. Chart 1-3: European banks in the US shadow banking system

European Global Banks

Shadow banking system

USborrowers

Wholesale funding market

US sector

Border

Source: Shin (2012).

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UShouseholds

1 The 2008—2009 crisis and the new international economic environment

In contrast to the analyses based on current accounts, European banks were major lenders on global capital markets, especially the US market, despite the fact that these countries overall were not major net exporters to other parts of the world. Nonetheless, the euro area as a whole transferred capital on the order of USD 360 billion to the US in 2007, while China with its highly significant export surplus “only” transferred USD 260 billion, and the OPEC transferred USD 52 billion (Table 1-2). The capital inflows from the United Kingdom amounting to USD 560 billion refute the traditional view even more clearly, since the country’s current account showed a deficit (Table 1-3). This is obviously explained by London’s role as a financial centre.

Table 1-2: Gross financial flows from and into the US in 2007 (USD Billions) from the US

to the US

Total

1 472.1

2 129.5

Europe

1 014.0

1 015.9

Euro area

477.2

360.3

United Kingdom

422.4

561.0

26.8

450.0

China

—2.0

260.3

Japan

—50.0

65.9

Taiwan

—2.8

5.8

Singapore

14.0

20.9

of which

Asia and Pacific of which

Australia

27.3

—0.2

Canada

67.9

83.5

Middle East

13.6

39.8

OPEC

19.2

52.1

Source: Johnson (2009).

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Part I: An unconventional crisis with unconventional consequences

Table 1-3: Current accounts in 2007 (USD Billions) Deficit

Surplus

USA

—731.2

China

371.8

United Kingdom

—80.7

Japan

211.0

Australia

—57.1

Saudi Arabia

95.8

Turkey

—37.7

Russia

76.2

South Africa

—20.7

Norway

62.2

India

—11.3

Switzerland

43.0

New Zealand

—10.6

Singapore

39.2

Mexico

—8.2

Sweden

39.1

Pakistan

—6.9

Taiwan

33.0

Iceland

—3.1

Euro area

20.4

Thailand

14.0

Canada

12.7

Indonesia

10.5

South Korea

5.9

Argentina

4.3

Brazil

1.6

Source: IMF WEO April 2009.

European banks (or more precisely their non-bank institutions, shadow banks, special purpose vehicles or conduits established in the US) mainly invested the funds acquired on the US financial markets rather than “lending out” the deposits collected in their home country. The role played in the accumulation of funds by large banks is shown on the right side on Chart 1-3. The “funds” acquired in the US were then invested by European banks on the US mortgage market at higher interest rates, realising profits on the difference. Let us see a typical example: the US division of a European bank sells short-term asset-backed commercial papers (ABCP) to a US money market fund. (In the US, these mutual funds are pivotal on the retail deposit market, which is usually banks’ business in Europe.) After this, the European bank invests the funds in collateralised debt obligations (CDOs). These are structured financial products based on real estate-backed loans with varying risks. The whole process is a purely financial transaction with no connection to the trade between European countries and the US.

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1 The 2008—2009 crisis and the new international economic environment

Therefore, the current account balance does not provide any guidance on how much European banks are exposed to the US financial market risks, or on the extent to which Europeans influence financial conditions in the US. These connections are not reflected at all in the items of the current account, while they show up in the financial accounts recording gross capital flows. That is why Shin could say that the crisis was not caused by a savings glut, but rather by a “banking glut”.23 Nonetheless, Asian and OPEC exporter countries were typically not active on the interbank market. They invested their export revenue rather than the funds acquired in the US, and they preferred US government securities in their investments, and therefore they were not exposed to the real estate market shock. The onset of the crisis did not threaten the price of government securities – later it even increased due to the drop in interest rates – and therefore no capital was withdrawn from the US financial system and no pressure was exerted on the exchange rate of the dollar. Thus, the expectations in the pre-crisis scenarios about the exposure and behaviour of exporting countries were not realised at all. In light of the dramatic increase in global capital flows, we should not interpret current accounts in the old way either. The current account balance, or saving–investment balance, shows the allocation of real resources between countries: a country running a deficit uses more than it produces. However, no conclusions can be drawn from this with respect to either the direction or the size of the transactions aimed at financing. Therefore, referring to a current account surplus or deficit as “financing capacity” is a widespread but misleading practice. In our view, the expressions “financing capacity” and “financing requirement” should ideally refer to the international investment positions maturing in the given period (e.g. in the case of a requirement, the maturing external debt, which generates a rollover). These are concepts that can be interpreted in a financial, monetary analytical framework, and they do not correspond to the saving–investment concepts defined on the basis of the national accounts established in the real approach. 23

Shin (2011).

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Part I: An unconventional crisis with unconventional consequences

The third surprise in connection with the crisis scenarios was the development of the US dollar’s exchange rate. Instead of weakening due to the dented confidence of foreign investors, demand for the dollar increased, and its exchange rate strengthened compared to other currencies. This is because the crisis was not a traditional current account crisis but rather a financial or banking crisis, albeit with a pronounced international dimension, which included gross capital flows. The interbank panic provoked a liquidity crisis, which can turn into a solvency crisis or bankruptcy if the actors did not acquire refinancing. Therefore, the demand for liquidity grows immeasurably, since the receivables on the assets side of banks’ balance sheet cannot be suddenly reduced to the level of the diminished financing liquidity. If banks are still forced to cut lending and reduce the amount of credit, then that only passes on the problem to their debtors. After the crisis, it became clear that the global imbalances were indeed unsustainable. In the wake of the crisis, the theories explaining the persistence of the unusually high current account imbalances were relegated to the background. Moreover, the crisis also made those theories irrelevant that only examined the imbalances through the current account, assessing their sustainability based on that. The scenarios of balancing mostly attempted to explain the current account adjustment and its consequences. They did not provide a reliable forecast for the expected effects, and therefore decision-makers had to improvise while being pressured by the crisis, and they could scarcely rely on the usual analytical frameworks of economics.

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1 The 2008—2009 crisis and the new international economic environment

1.3 The global economy after the crisis 1.3.1 The imbalances in flows have decreased

After the eruption of the crisis, current accounts underwent a substantial adjustment, but the balances typically did not reverse their sign, i.e. the deficits and surpluses were maintained. Since 2008, current account deficits have still been mainly run by the US and certain European countries, while China has a surplus, and the balance of oil exporting countries has fallen to negative territory (Chart 1-1). However, the deficits and surpluses relative to GDP have greatly decreased since 2008, and therefore the harmony between the income of individual countries or regions and their domestic demand, or between their savings and investments has increased. Thus, flow imbalances have been mitigated. Both the US (declining deficit) and China (declining surplus) have made significant adjustments, whereas the current account of the euro area, which was balanced before the crisis, now shows a surplus. Real exchange rates moved more or less in harmony with the current account balances (for example the Chinese real effective exchange rate has appreciated, while the German rate has depreciated). Nonetheless, the adjustment in the current accounts happened at the expense of deteriorating internal balance indicators. This is because indebted countries reduced their current account deficit, i.e. they boosted their savings relative to investments – or in other words increased their net financial savings – whereby they contributed to a shrinkage in aggregate demand (MNB 2014). This resulted in the reduction of the output gap and a rise in the unemployment rate. Output still fell short of potential in most countries in 2015, and, at least in the euro area, the official unemployment rate published by the ILO was also relatively high.

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Part I: An unconventional crisis with unconventional consequences

1.3.2 Stock imbalances are still substantial

While flow variables have adjusted, stocks still exhibit considerable imbalances. Since most current account balances did not change their sign, i.e. the deficits and surpluses remained, the international investment position of the countries and regions was unable to adjust. Although the growth trend of global net external liabilities and receivables relative to GDP typical before 2008 has been interrupted, stocks do not decrease substantially but stagnate (Chart 1-4). The net negative position of the US (and the “other countries”) continues to dominate, which is counterbalanced by the net receivables of Asian countries. Chart 1-4: Net international investment positions

United States Japan Other Asia Discrepancy

China Europe positive Oil exporters

35 30 25 20 15 10 5 0 –5 –10 –15 –20 –25 –30 –35 –40 –45

2014

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

In percent of world GDP

1992

1990

1988

1986

1984

1982

In percent of world GDP

1980

35 30 25 20 15 10 5 0 –5 –10 –15 –20 –25 –30 –35 –40 –45

Germany Europe negative Rest of world

Source: IMF IFS, WEO.

In the context of constant net debts relative to GDP, global gross debts (relative to GDP) even rose. The increase in the gross debt relative to GDP can be seen in the non-financial corporate sector and — 48 —

1 The 2008—2009 crisis and the new international economic environment

the government, while the debt ratio of households has remained stable since 2007 (Chart 1-5). The rise in gross debt is characteristic of both developed and emerging countries. Within this, the debt of the government and that of non-financial corporations expanded the most in developed countries and emerging economies, respectively. Overall, the amount of gross global debt is more than double the global GDP. Chart 1-5: Global indebtedness 300

In percent of GDP

USD Trillions

180

2007

2010

All

50 EMEs

AEs

100

All

EMEs

150

AEs

120

All

200

EMEs

150

AEs

250

2015 Non-financial corporates Global total (right-hand scale)

General government Households

Source: BIS (2016) p. 10.

Nevertheless, there was a marked change in the total value of the global, cross-border, dollar-denominated bank receivables and liabilities. Before 2008, this stock expanded ever more rapidly, but after that it has stagnated (Chart 1-6), which is in line with the process of deleveraging. In general, with respect to the cross-border dollar receivables and liabilities, out of the world’s regions, Europe has the largest receivables, and the US has the largest liabilities, with both items making up almost half of the gross global assets in the respective categories (Chart 1-7). With respect to the banks’ cross-border net dollar — 49 —

Part I: An unconventional crisis with unconventional consequences

positions, the largest negative item is also American, while in 2007 the Asia-Pacific region had the largest net receivables, and in 2014 Europe had the highest value. It is also interesting that in the 7-year period under review, the net financial savings calculated from these positions were only positive in Europe, i.e. the rest of the world became indebted to Europe. Chart 1-6: Cross-border, USD-denominated bank claims

USD Trillions

15 10

–5

–10

–15

–15 Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep. Mar. Sep.

2000 2000 2001 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 2015 2015 2016 2016

Euro Area – 5 USA

UK Other

Switzerland

Japan

Note: stocks against all sectors. Euro area – 5: Belgium, Finland, Germany, Ireland, Luxemburg. Source: BIS locational banking statistics, Table A5 (based on residency).

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1 The 2008—2009 crisis and the new international economic environment

Chart 1-7: Geographical distribution of cross-border, USD-denominated bank claims 2007

2014 43

◄1

8► 15

Europe

8► Emerging

19► Emerging

Europe

► 98 1,0 6 7 ,7 ◄1

55 ◄

7►

5 2,0 ◄ ◄7 49

Europe 57 ◄

►

1,5

Europe

,13

◄12

0►

Asia Pacific

Latin America

►

◄26

◄28 30

◄142

◄195

◄82 ◄ 83

3►

◄19

7► 64

◄197 ◄ 99

◄10

Latin America

Africa & Middle East

1►

Asia Pacific

◄44

Africa & Middle East

Note: in USD billion. The thickness of the arrows indicates the size of the outstanding stock of claims. Arrows directed from region A to region B indicate lending from banks located in region A to borrowers located in region B. Source: BIS locational banking statistics. Avdjiev et al. (2016) p. 428.

Receivables and liabilities are still substantial and they entail risks. The net positions mean an exposure to risks with regard to changes in the exchange rate and the interest rate. In addition, the countries and regions with net debt also run risks with respect to economic growth, since a given (nominal) debt service represents a greater burden relative to GDP if output is lower. Finally, gross stocks may also heighten risks, if financial assets and liabilities are not in harmony with each other (e.g. open FX position, liquidity risk), or directly due to the higher credit exposure. These risks increase actors’ financial vulnerability.

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Part I: An unconventional crisis with unconventional consequences

1.3.3 Balance sheet recession

The Great Recession was not a traditional economic downturn, and therefore managing it calls for an unconventional economic policy. In the rising phase of traditional business cycles, excess demand generates inflation and it expands the current account deficit (Csortos–Szalai 2015a). In such a situation, eliminating external imbalances warrants a strict monetary and fiscal policy, which dampens domestic demand. However, the crisis that culminated in 2008 was not a traditional current account crisis. It did not originate from an exchange rate crisis (with the depreciation of the dollar), but rather from the American subprime mortgage market. Second, it did not only affect the countries with current account imbalances, but practically the whole global economy. By contrast, the current crisis could be attributed to stock imbalances, in which flow imbalances accumulate for a long time and economic actors take out larger loans for purchasing valuable financial or real assets. In such a situation, an economic policy reducing incomes is not optimal, since it makes debt servicing more difficult for net debtors, potentially leading to fire sales and thus a substantial negative output gap (Csortos–Szalai, 2015a). The Great Recession was a balance sheet recession, and the recovery takes a long time. A recession in which the indebtedness of economic actors becomes unsustainable and therefore they drastically increase their net financial savings and cut their consumption and investment spending is called a balance sheet recession, a term coined by Richard Koo (Csortos–Szalai 2015a). Deleveraging is a protracted process for two reasons. First, the actors – if they do not reduce their net debt by selling real assets – have to accumulate savings (flow) from their income to cut their net debt (stock), which is obviously time-consuming (similar to the way the stock imbalances were built up). On the other hand, in a balance sheet recession, incomes themselves are low, partly due to the uncertainty and partly to the higher savings rate and thus lower

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1 The 2008—2009 crisis and the new international economic environment

aggregate demand (MNB 2014). In fact, the aversion to borrowing may remain dominant even after deleveraging, and therefore the cycle of a financial bubble may last for decades (Chart 1-8). Chart 1-8: Dynamics of balances sheet recession and readjustment BUBBLE

Overconfident private sector triggers a bubble.

Monetary policy is tightened, leading the bubble to collapse. Collapse in asset prices leaves private sector with excess liabilities, forcing it into debt minimisation mode. The economy falls into a balance sheet recession.

With the economy healthy, the private sector regains its vigour, and confidence returns.

With everybody paying down debt, monetary policy is less effective. Fiscal policy becomes the main economic tool to maintain demand.

Monetary policy becomes the main economic tool, while deficit reduction becomes the top fiscal priority.

Eventually private sector finishes its debt repayments, ending the balance sheet recession. But it still has a phobia about borrowing which keeps interest rates low and the economy less than vibrant.

Private sector fund demand recovers and monetary policy starts working again. Fiscal policy begins to crowd out private investment.

Private sector phobia towards borrowing gradually disappears.

Source: Koo (2008), p. 160.

From an economic policy perspective, balance sheet recessions pose new challenges. A balance sheet recession may be exacerbated if economic policy responds to an incorrect diagnosis (e.g. stock imbalances mistaken for flow imbalances) (Csortos–Szalai 2015a). Traditional adjustment may have the opposite effect of what is intended, and the drive to reduce debt may cancel itself out (Csortos–Szalai 2015a). Instead, preventing over-indebtedness may be appropriate, and if indebtedness has already happened, the role of economic policy may be to facilitate gradual deleveraging (MNB 2014). In such a situation, Koo

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Part I: An unconventional crisis with unconventional consequences

suggests that governments use an expansionary fiscal policy. This can expedite income growth, since in the context of a robust deleveraging in the private sector and near the zero lower bound, fiscal multipliers are high (EC, 2012, pp. 119–137). Furthermore, due to deleveraging, public sector spending does not crowd out private spending and thus it does not increase interest rates, and inflationary risk is also low (Koo 2014). In contrast to Koo, Claudio Borio and his colleagues at BIS, and Kenneth Rogoff propose that in a balance sheet recession the room for fiscal manoeuvre should not be used to increase aggregate demand, but rather to clean the balance sheet of the private sector (Borio 2012; BIS 2014, pp. 65–68; Rogoff 2015).

1.3.4 Persistently ailing global economy

The recovery from the global economic crisis that started in 2007 and entered its intensive phase in 2008 appears to be longer compared to previous downturns. US quarterly real GDP per capita only reached the level measured at the end of 2007 in 2013 (Chart 1-9). Meanwhile, investments declined in developed countries, and subdued aggregate demand entailed a drop in inflation. Finally, in an environment characterised by low growth potential, real interest rates also fell considerably and sometimes even dropped into negative territory (Chart 1-10). It is noteworthy that due to ailing global economy, GDP growth is moderate even in countries that were not characterised by imbalances before the crisis.

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1 The 2008—2009 crisis and the new international economic environment

Chart 1-9: US real GDP during previous downturns and after the present financial crisis 120

GDP per capita, cycle peak = 100

120

115

110

105

100

–3 –2 –1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 Quarters Average of prior cycles

2007Q1–2013Q1

Source: NBER, BEA.

Chart 1-10: Long-term real interest rates of government securities in the most advanced economies of the world 8

Per cent

–2

–4

–6

–8

1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014

–8

G7 long-term real interest rate (equal weights)

Note: the figures for 2014, 2015 and 2016 were estimated based on the yield of 10-year government securities and the 1-year inflation expectations of market participants (Consensus Economics). Source: IMF WEO April 2014, Bloomberg, Thomson Reuters Datastream, Consensus Economics.

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Part I: An unconventional crisis with unconventional consequences

Several theories have been proposed to explain the protracted recovery, and there is no consensus regarding the future outlook. According to the balance sheet adjustment theory, slow growth is a temporary phenomenon, while other theories explain the subdued growth with factors independent from the financial crisis. According to the latter explanations, economic growth may be persistently low. These theories include both real economy and financial approaches. Chart 1-11 summarises the theories in the literature. In this section, we examine the lasting theories; the theory of balance sheet adjustment is presented in Section 1.3.3. Chart 1-11: Explanations for the protracted recovery Temporary or permanent cause? Permanent

Temporary

Real or financial cause?

Balance sheet recession Real

Financial

1. Secular stagnation – Decelerating population growth – Deceleration of investments – Technological innovation and change in relative prices – Increase in income inequality – Aging – Uncertain macro policies 2. Savings glut

– Permanently bad distribution of resources – Shortening of investment horizon – Higher hurdle rate of investments – Dividend payment and share repurchase from credit – High corporate bond real interest rates

According to the secular stagnation theory, real interest rates and economic growth are low due to the persistently subdued investments as compared to savings. The expression is attributed to Alvin H. Hansen, and his theory was revived by Lawrence Summers in 2013 — 56 —

1 The 2008—2009 crisis and the new international economic environment

(Hansen 1939; Summers 2014). Secular stagnation may be explained by the following factors (Csortos–Szalai 2015b): • Slowdown in population growth and a drop in the participation ratio: this boosts capital intensity (the capital stock per employee), which reduces investment needs and real interest rates. • Slowdown in investments: as the weight of the services sector increases, investment needs drop. • Technological innovation and the change in relative prices: capital goods have become cheaper as compared to consumer goods, which also stifles investment demand (Eichengreen 2015). • Growing income inequalities: income distribution shifts towards those with higher income, whose propensity to consume is lower. This leads to excess savings, which pushes down interest rates (Piketty 2013). • Ageing: people increase their savings while preparing for retirement, and older generations’ propensity to consume is lower. Both factors point towards a fall in interest rates. • Uncertain macroeconomic policy and uncertainty due to high government debt: risk aversion also encourages people to pad their savings (MNB 2015). According to Summers, the appropriate economic policy response to secular stagnation is the stimulation of aggregate demand by (temporarily) increasing the budget deficit and maintaining loose monetary conditions (Summers 2014). However, Summers underlines that a monetary policy using low nominal interest rates also entails risks. That is, it can contribute to the emergence of financial bubbles, it can influence wealth and income distribution, and may help keep inefficient companies alive.

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Part I: An unconventional crisis with unconventional consequences

In contrast to Summers, Ben S. Bernanke considers the global savings glut to be the main reason behind the slow recovery instead of the low level of investments. Bernanke believes that a low interest rate environment may encourage investments, and if the excessively high current account surpluses are sorted out, the problem of too low interest rates will also be solved (Bernanke 2015a, 2015b). The potential financial reasons for the slow recovery of the global economy are the following. • The persistently poor distribution of resources: the allocation of resources may consistently diverge from the way that would be appropriate for sustainable economic growth, which may be triggered by financial variables as well (e.g. excessive investments in the real estate sector in times of a credit boom). However, according to this reasoning, the pre-crisis productivity growth can be achieved in theory, since the problem lies in the structure of the resources and not in their quantity (MNB 2015; Csortos–Szalai 2015b). • The shortening of the return horizon (“short-termism”): stock exchanges reward the companies that favour portfolio investors in the short run, not those that invest. In addition, venture capital companies are ever less willing to finance research projects in their early stages (Mazzucato–Wray 2015). • Higher threshold rate of return for investments (“hurdle rate”): the rise in the yield expected by investors also curtails investments (OECD 2015). • Dividend payment, share buyback and the accumulation of liquid assets (from debt): companies are prone to using the loans and their liquid assets for such purposes instead of making investments (Lazonick 2014a; 2014b; Mazzucato–Wray 2015).

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1 The 2008—2009 crisis and the new international economic environment

• High real interest rates on corporate bonds: due to the rise in risk premia, the real interest rates on corporate bonds have stayed relatively high even in the generally low interest rate environment, which also curbs investment activity (Chart 1-12).24 Chart 1-12: Historic development of real interest rates 15

Per cent

Basis point

1 000

750

500

250

–5

1948 1950 1952 1954 1957 1959 1961 1963 1966 1968 1970 1972 1975 1977 1979 1981 1984 1986 1988 1990 1993 1995 1997 1999 2002 2004 2006 2008 2011 2013

US BAA real interest rate Spread (right-hand scale) 10-year US Treasury real interest rate Source: Tily (2015).

1.3.5 Central bank responses to the crisis

The central banks in developed countries responded to the financial and general economic crisis with robust monetary easing. Central bank base rates have reached historic lows near zero (sometimes even below that) (Chart 1-13). In addition – partly on account of reaching the 24

hin (2016) also highlights the rise in funding costs. According to him, on account of S the global risk aversion, gearing diminishes and financial conditions are becoming stricter (e.g. the implied dollar interest rates grow on the FX swap market against the dollar). This may hamper global trade and thus lead to lower productivity growth.

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Part I: An unconventional crisis with unconventional consequences

zero or effective lower bound of the nominal interest rate – large central banks employed various unconventional tools (liquidity measures, direct credit market interventions and asset purchases, Krekó et al. 2012, Chart 1-15). In line with the unconventional measures, central banks’ balance sheet totals have increased several fold (Chart 1-14). Chart 1-13: Key interest rates 6

Per cent

6 5

–1

–1 Jan. 2007 Jun. 2007 Nov. 2007 Apr. 2008 Sep. 2008 Feb. 2009 Jul. 2009 Dec. 2009 May. 2010 Oct. 2010 Mar. 2011 Aug. 2011 Jan. 2012 Jun. 2012 Nov. 2012 Apr. 2013 Sep. 2013 Feb. 2014 Jul. 2014 Dec. 2014 May. 2015 Oct. 2015 Mar. 2016 Aug. 2016

Euro area

Japan

Source: BIS (2016), central banks.

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USA

1 The 2008—2009 crisis and the new international economic environment

Chart 1-14: Central banks’ balance sheet totals relative to GDP 90

Per cent

0 2007

2008

2009

2010

2011

Euro area

2012

2013

Japan

2014

2015

2016

USA

Source: central banks, statistical offices.

Although during a general balance sheet adjustment monetary easing in itself is not a highly effective tool, the loose monetary conditions are expected to persist. At the time of the adjustment after the balance sheet recession, both monetary policy’s interest rate channel and its exchange rate channel weakens (Csortos–Szalai 2015a). On the one hand, the financial system has been damaged, and the private sector reduces its credit demand due to its over-indebtedness, which hampers the interest rate channel in taking hold, and on the other hand the devaluation/depreciation of the exchange rate increases the burden of FX debt, which restricts the exchange rate channel. Still, it is necessary to maintain the loose monetary conditions due to the neutral real interest rate that seems to stabilise at a low level on account of the subdued investments as compared to savings.

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Part I: An unconventional crisis with unconventional consequences

Chart 1-15: Possible solutions to the challenges posed by the near-zero lower bound and the acute problems presented by the crisis Additional monetary easing is needed

Approach of Zero Lower Bound

Reform of monetary policy strategy?

Unconventional tools – expansion of the IT tools • Quantitative and qualitative easing, Q(Q)E • Asset purchases • Direct intervention on the credit market • Liquidity expansion tools • Forward guidance (FwG) • Exchange rate policy (depreciation)

• Rethinking of inflation target • It does not work in acute problem solving • History-dependent monetary policy rules (nGDP/price level targeting) • Merely theoretical option • Difficulties in the practice

It arises in line with achivement of ZLB in developed economies Note: QQE = quantitative and qualitative easing. FwG = forward guidance. nGDP = nominal GDP. ZLB = zero lower bound. Source: Ábel et al. (2014).

Even though the previously widespread inflation targeting monetary regime faced a backlash on account of the crisis, it can still be considered one of the best practices at the international level. Up to now, no central bank has abandoned the inflation targeting regime, and their monetary policy strategy has been transformed and become more flexible instead. Now they take other (e.g. real economy, financial stability) considerations into account as well, but instead of the objectives, the tools employed and the institutional system were transformed and expanded. The flexible inflation targeting strategy may remain an integral part of central bank practices even after the crisis (Ábel et al. 2014).

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1 The 2008—2009 crisis and the new international economic environment

Box 1-2 Interest rate theories

Having mentioned the various explanations for the low interest rates, we now present a few interest rate theories. Classical economics was dominated by the productivity and abstinence theories (Böhm-Bawerk 1884). According to the productivity theory, the real rental rate of capital equals the marginal product of capital, and real interest rate equals the real rental rate less amortisation. The abstinence theory states that the capitalist deserves compensation in the form of interest for forgoing the utility provided by consumption in the present (see also the theory of impatience [Fisher 1907] and the time-preference theory). According to this, the real interest rate depends on the subjective discount rate. The productivity theory gives the investment function, while the abstinence theory gives the savings function. The equilibrium real interest rate ensures that both investors’ and savers’ plans are realised, and therefore investments equal savings. In contrast to the classical theories, Keynes did not deduce the (nominal) interest rate from real variables, but from liquidity preferences. Keynes realised that savings can be in equilibrium with investments in the context of any arbitrary (real) interest rate (he referred to this equilibrium interest rate as the natural interest rate) (Keynes 1936, Chapter 17). This is because the various employment (output) levels require different natural rates (according to Hicks’ (1937) interpretation this is the IS curve in textbooks), therefore full factor utilisation does not necessarily happen. Keynes called the natural rate linked to full employment the neutral (real) interest rate. Accordingly, the interest rate characteristic of the economy cannot be derived exclusively from real factors. Keynes deduced the interest rate from the demand for money (liquidity preference) and its central bank supply. In the Keynesian model, the speculative demand for money is the negative function of the interest rate, however, its position is uncertain. Keynes distinguished between transactions, precautionary and speculative demand for money. In his model of speculative demand for money, investors can hold two types of financial instruments: constant perpetuity government bonds

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Part I: An unconventional crisis with unconventional consequences

or money. Bondholders run market risk (which Keynes called liquidity risk). Assuming a horizontal yield curve, if the discount rate rises, the value of the bond decreases. However, in a higher interest rate environment, the value of investments rises at a greater pace in the future. Therefore, there is clearly a breakeven time when the (future) value of the investment equals the (future) value before the rise in yields.25 When examining a given rise in yields, the higher the initial interest rate, the lower the breakeven time (convex relationship, Chart 1-16, Quadrant I). With a lower beakeven time, holding bonds generates losses for a shorter time, and therefore investors are more likely to hold bonds (Quadrant IV). And when they do hold more bonds, they have less opportunity to hold money (Quadrant III). Therefore, in the context of higher interest rates overall, the demand for money is lower (Quadrant II). The (nominal) interest rate is derived at the intersection of money supply and liquidity preference. In the interpretation of Hicks, the LM curve can be derived from money market conditions, therefore in the IS-LM system, both the (real) interest rate and output are determined. Nevertheless, as actorsâ&#x20AC;&#x2122; yield expectations change, the breakeven times corresponding to the initial yield levels change, and so does the money demand curve. This renders the job of monetary policy more difficult (Kregel 2000). Chart 1-16: Determination of liquidity preference in the Keynesian framework II.

Mmax M

III.

IV.

Note: i = nominal interest rate, t = breakeven time, B = bond portfolio, M = money supply, Md = demand for money, Mmax = maximum potential money supply (equals government debt).

( ) If the discount rate rises from i0 to i1, the breakeven time is: ( ) , where D0 and D1 log

log

1+i1

1+i0

denote the duration in the context of the two discount rates ( D = 1 i i ).

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In the Keynesian–Hicksian framework, the theory of secular stagnation and savings glut means that the IS curve shifts to the left. This shift reduces the equilibrium real interest rate corresponding to potential output, i.e. the neutral interest rate in the Keynesian sense. However, it does not necessarily influence the market interest rate, as that is jointly dependent on the IS and LM curves. The new Keynesian model framework also brings the above-mentioned three theories in line, and provides a microeconomic basis for them (Walsh 2010, Chapter 8). Today’s MIU DSGE (money-in-the-utility function dynamic stochastic general equilibrium) models combine the productivity, the abstinence and a (modified) liquidity preference theory. However, a major difference as compared to the original Keynesian framework is that they provide a microeconomic basis for macroeconomics.

Key terms balance sheet recession Bretton Woods current account deleveraging exchange rate regime financial instability global financial crisis Great Moderation

gross capital flows imbalances interest rate theories savings glut secular stagnation shadow banking system zero lower bound of the nominal interest rate

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Part I: An unconventional crisis with unconventional consequences

References Acharya, V. – Schnabl, P. (2010): “Do Global Banks Spread Global Imbalances? Asset Backed Commercial Paper during the Financial Crisis of 2007–2009”, IMF Economic Review, https://www. imf.org/external/np/res/seminars/2009/arc/pdf/acharya.pdf Avdjiev, S. – McCauley, R.N. – Shin, H.S. (2016): Breaking free of the triple coincidence. Economic Policy 31: 409–45. http://economicpolicy.oxfordjournals.org/content/ economicpolicy/31/87/409.full.pdf Ábel, I. – Csortos, O. – Lehmann, K. – Madarász, A. – Szalai, Z. (2014): Az inflációs célkövetés megújulása a válság után. (Inflation targeting in the light of lessons from the financial crisis). Financial and Economic Review, Volume 13, Issue 4, November 2014, pp. 35–56. http://english. hitelintezetiszemle.hu/letoltes/2-abel-en.pdf Árvai, Zs. – Vincze, J. (1998): Valuták sebezhetősége (The vulnerability of currencies). Közgazdasági Szemle, Vol. XLV, June (509–533. o.), http://epa.oszk.hu/00000/00017/00039/pdf/arvaivincze. pdf Bernanke, B. (2005): “The Global Saving Glut and the U.S. Current Account Deficit,” speech delivered for the Sandridge Lecture at the Virginia Association of Economists, Richmond, 10 March. www. federalreserve.gov/boarddocs/speeches/2005/200503102/default.htm Bernanke, B. (2015a): Why are interest rates so low, Part 2: Secular stagnation, March, http:// www.brookings.edu/blogs/ben-bernanke/posts/2015/03/31-why-interest-rates-lowsecularstagnation Bernanke, B. (2015b): Why are interest rates so low, Part 3: The Global Savings Glut. http://www. brookings.edu/blogs/ben-bernanke/posts/2015/04/01-why-interest-rates-low-globalsavingsglut BIS (2014): 84th Annual Report. http://www.bis.org/publ/arpdf/ar2014e.pdf BIS (2015): 85th Annual Report. http://www.bis.org/publ/arpdf/ar2015e.htm?m=5%7C24 BIS (2016): 86th Annual Report. https://www.bis.org/publ/arpdf/ar2016e.htm Bofinger, P. – Wolmerhauser, T. (2003): Managed Floating as Monetary Policy Strategy, Economics of Planning, June 2003, Volume 36, Issue 2, pp. 81–109, doi:10.1023/B:ECOP.0000012258.15614.d8 Borio, C. (2012): The financial cycle and macroeconomics: What have we learnt? BIS Working Papers No. 395, http://www.bis.org/publ/work395.htm Borio, C. (2013): “On Time, Stocks and Flows: Understanding the Global Macroeconomic Challenges”, in: 2013 225: R3 National Institute Economic Review, http://ner.sagepub.com/content/225/1/R3 Borio, C. (2014): The international monetary and financial system: its Achilles heel and what to do about it, BIS Working Papers No. 456, http://www.bis.org/publ/work456.htm Borio, C. – Disyatat, P. (2011a): Global imbalances and the financial crisis: Link or no link?, BIS Working Papers No. 346, www.bis.org/publ/work346.pdf

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1 The 2008—2009 crisis and the new international economic environment Borio, C. – Disyatat, P. (2011b): Did global imbalances cause the financial crisis?, Vox. EU, July, http://www.voxeu.org/article/did-global-imbalances-causefinancial-crisis Borio, C. – Disyatat, P. (2015): Capital flows and the current account: Taking finance (more) seriously, BIS Working Papers No. 525, http://www.bis.org/publ/work525.htm Borio, C. – James, H. – Shin, H.S. (2014): The international monetary and financial system: a capital account historical perspective, BIS Working Papers No. 457, http://www.bis.org/publ/work457. htm Böhm-Bawerk, E. (1884): Capital and Interest. A Critical History of Economical Theory. (Kapital und Kapitalzins. Geschichte und Kritik der Kapitalzins-Theorien.) Transl. by William A. Smart. Macmillan and Co., London, 1890. http://www.econlib.org/library/BohmBawerk/bbCI.html Broadbent (2012): Deleveraging, Speech at Market News International, London, 15 March, http:// www.bankofengland.co.uk/publications/Documents/speeches/2012/speech553.pdf Caballero, R.J. (2006): „On the Macroeconomics of Asset Shortages”, NBER Working Paper No. http://economics.mit.edu/files/1801 Csortos, O. – Szalai, Z. (2015a): A globális pénzügyi válság kezelésének nehézségei: elméleti és gazdaságpolitikai tanulságok (Difficulties in the management of the global financial crisis: academic and economic policy lessons), Financial and Economic Review, Volume 14, Issue 3, September 2015, pp. 5–38. http://english.hitelintezetiszemle.hu/letoltes/1-csortos-szalai-en.pdf Csortos, O. – Szalai, Z. (2015b): Az alacsony inflációs környezet és a visszafogott beruházási aktivitás lehetséges magyarázatai (Possible explanations of the low inflation environment and restrained investment activity). Financial and Economic Review, Volume 14, Issue 4, December 2015, pp. 29–56. http:// english.hitelintezetiszemle.hu/letoltes/2-csortos-szalai-en.pdf Dooley, M.P. – Folkerts-Landau, D., and Garber, P. (2003): An essay on the revised Bretton Woods system, Working Paper 9971, Cambridge, MA: National Bureau of Economic Research, September EC (2012): Report on Public Finances in EMU. European Economy 2012/4. http://ec.europa.eu/ economy_finance/publications/european_economy/2012/pdf/ee-2012-4.pdf Eichengreen, B. (2014): Requiem for Global Imbalances, Project Syndicate, 24 January, http:// www.project-syndicate.org/print/barry-eichengreennotes-that-a-decade-after-externalimbalancesemerged-as-a-supposed-threat-to-the-globaleconomy--the-problem-has-disappeared Eichengreen, B. (2015): „Secular Stagnation: The Long View”, American Economic Review: Papers & Proceedings 2015, 105 (5): 66–70 http://dx.doi.org/10.1257/aer.p20151104 Fisher, I. (1907): The Rate of Interest. Its Nature, Determination and Relation to Economic Phenomena. The Macmillan Company, New York. Frankel, J.K. (2009): What’s in and out of Global Money. Things are hot, then they are not, in the world of international money, IMF Finance and Development, September, https://www.imf.org/external/ pubs/ft/fandd/2009/09/pdf/frankel.pdf

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Part I: An unconventional crisis with unconventional consequences Glick, R. – Hutchison, M. (2011): Currency Crises , http://www.frbsf.org/economic-research/ files/wp11-22bk.pdf Greenspan, A. (2005): Federal Reserve Board’s semi-annual Monetary Policy Report to the Congress Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate February 16, 2005, https:// www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm Hansen, A.H. (1939): “Economic Progress and Declining Population Growth”, American Economic Review, March 1939, 29 (1), pp. 1–15; http://www.jstor.org/stable/1806983?seq=5#page_scan_ tab_contents. Hausmann, R. – Sturzenegger (2005): U.S. and Global Imbalances: Can Dark Matter Prevent a Big Bang? Hornok, C. – Jakab, M.Z. – Tóth, M. (2006): Globális egyensúlytalanságok korrekciója: illusztratív szcenáriók Magyarországra (Adjustment of global imbalances: Illustrative scenarios for Hungary), MNB Occasional Papers 59. https://www.mnb.hu/letoltes/op-59.pdf Hicks (1937): Mr. Keynes and the “Classics”; A Suggested Interpretation. http://public.econ.duke. edu/~kdh9/Courses/Graduate%20Macro%20History/Readings-1/Hicks_Mr.%20Keynes%20 and%20the%20Classics.pdf Johnson, K.H. (2009): Gross or Net International Financial Flows. Understanding the Financial Crisis, Center for Geoeconomic Studies, Working Papers, Council of Foreign Relations, July, http://www. cfr.org/international-finance/gross-net-internationalfinancial-flows-understanding-financialcrisis/p19726 Keynes, J.M. (1936): A foglalkoztatás, a kamat és a pénz általános elmélete. (The General Theory of Employment, Interest and Money.) Transl. by Péter Erdős. Közgazdasági és Jogi Könyvkiadó, Budapest, 1965. Koo, R. (2008): The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession. John Wiley & Sons, Singapore. Koo, R. (2014): Balance sheet recession is there a reason for secular stagnation, in Secular Stagnation: Facts, Causes and Cures. VOX.EU.org e-book, http://www.voxeu.org/sites/default/files/Vox_ secular_stagnation.pdf Kregel, J.A. (1998): East-Asia is not Mexico: The difference between balance of payment crisis and debt deflation, Jerome Levy Economics Institute of Bard College, working paper no. 235, http://www. levyinstitute.org/pubs/wp235.pdf Kregel, J.A. (2000): Krugman on the Liquidity Trap. Jerome Levy Economics Institute WP No. 298. http://www.levyinstitute.org/publications/krugman-on-the-liquidity-trap Kregel, J.A. (2004): External Financing for Development and International Financial Instability, G-24 Discussion Paper Series, No. 32, October. New York and Geneva: UNCTAD, http://unctad.org/ en/docs/ gdsmdpbg2420048_en.pdf

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1 The 2008—2009 crisis and the new international economic environment Kregel, J.A. (2006): Understanding Imbalances in a Globalised International Economic System, in: Global Imbalances and the US Debt Problem – Should Developing Countries Support the US Dollar? Fondad, The Hague, December 2006. www.fondad.org, http://www.fondad.org/uploaded/ GlobalImbalances/Fondad-Global-Imbalances-Chap09.pdf Kregel, J.A. (2008): Financial Flows and Global Imbalances, The Role of Catching up by Late Industrializing Developing Countries, Jerome Levy Economics Institute of Bard College, working paper no. 528. http://www.levyinstitute.org/pubs/wp_528.pdf Kregel, J.A. (2010): An Alternative Perspective on Global Imbalances and International Reserve Currencies, Jerome Levy Institute of Bard College, Public Policy Brief, http://www.levyinstitute. org/pubs/ppb_116.pdf Krekó, J. – Balogh, Cs. – Lehmann, K. – Mátrai, R. – Pulai, Gy. – Vonnák, B. (2012): Nemkonvencionális jegybanki eszközök alkalmazásának nemzetközi tapasztalatai és hazai lehetőségei (International experiences and domestic opportunities of applying unconventional monetary policy tools). MNB Occasional Papers, 100. https://www.mnb.hu/letoltes/op100.pdf Krugman (1979): “A model of balance-of-payments crises,” Journal of Money, Credit, and Banking 11, 311–25 ., http://EconPapers.repec.org/RePEc:mcb:jmoncb:v:11:y:1979:i:3:p:311-25 Krugman (1998): What happened to Asia?, http://web.mit.edu/krugman/www/DISINTER.html. in: Sato, R. R. Ramachandran, K. Mino (eds) (1999): Global Competition and Integration, http:// link.springer.com/book/10.1007/978-1-4615-5109-6 Landau, J.P. (2016): Capital flows, debt and growth: Dilemmas and tradeoffs in the global agenda, Vox. Eu, November, http://voxeu.org/print/61300 Lane, P. (2013a): Capital Flows in the Euro Area, Economic Papers, 497, April, http://ec.europa. eu/economy_finance/publications/economic_paper/2013/pdf/ecp497_en.pdf Lane, P. (2013b): Credit dynamics and financial globalisation, National Institute Economic Review, No. 225 August 2013, http://ner.sagepub.com/content/225/1/R14.full.pdf+html Lane, P. – Milesi-Ferretti, G.M. (2014): Global Imbalances and External Adjustment after the Crisis, IMF WP/14/151, August, http://www.imf.org/external/pubs/ft/wp/2014/wp14151.pdf Lazonick, W. (2014a): “Profits without prosperity”. Harvard Business Review, September, https:// hbr.org/2014/09/profits-without-prosperity Lazonick, W. (2014b): “What Apple should do with its profit”. Harvard Business Review, October, https://hbr.org/2014/10/what-apple-should-do-with-its-massive-piles-of-money Linder, F. (2015): Did Scarce Global Savings Finance the US Real Estate Bubble? The „Global Saving Glut” thesis from a Stock Flow Consistent Perspective, http://www.boeckler.de/pdf/p_imk_ wp_155_2015.pdf Lucas, R. (1990): “Why doesn’t Capital Flow from Rich to Poor Countries?” American Economic Review 80, 92–96, https://www.econ.nyu.edu/user/debraj/Courses/Readings/LucasParadox. pdf

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Part I: An unconventional crisis with unconventional consequences Manova, K. – Zhang, Z. (2009): China’s exporters and importers: Firms, products, and trade partners, NBER Working Paper No. 15249, http://www.nber.org/papers/w15249 Mazzucato, M. – Wray, R. (2015): Financing the Capital Development of the Economy: A KeynesSchumpeter-Minsky Synthesis. Jerome Levy Institute of the Bard College, Working Paper No. 837, May, http://www.levyinstitute.org/pubs/wp_837.pdf MNB (2014): Növekedési jelentés (Growth Report). Chapter 1 and 5.1 https://www.mnb.hu/ letoltes/novekedesi-jelentes-en.pdf MNB (2015): Növekedési jelentés (Growth Report). Chapter 1 https://www.mnb.hu/letoltes/engnovekedesijel-boritoval.pdf Obstfeld, M. (1986): “Rational and self-fulfilling balance-of-payments crises.” American Economic Review 76 (1), pp. 72–81, http://links.jstor.org/sici?sici=0002-8282%28198603%2976%3A1%3C 72%3ARASBC%3E2.0.CO%3B2-D&origin=repec Obstfeld, M. (2012a): “Financial flows, financial crises, and global imbalances”, Journal of International Money and Finance, Elsevier, Vol. 31(3), pp 469–480, http://www.cepr.org/active/ publications/discussion_papers/dp.php?dpno=8611 Obstfeld, M. (2012b): Does the Current Account Still Matter?, NBER Working Paper No. 17877, http://www.nber.org/papers/w17877 OECD (2015): Business and Finance Outlook 2015, http://www.oecd-ilibrary.org/financeandinvestment/oecd-business-and-finance-outlook-2015_9789264234291-en Palley, T. (2006): The Fallacy of the Revised Bretton Woods Hypothesis: Why Today’s System is Unsustainable and Suggestions for a Replacement, Economics for Democratic and Open Societies, Paper prepared for an international workshop on “Currency Conflicts and Currency Cooperation in the Global Economy” held at the Institute for European Studies, University of British Columbia, Vancouver, Canada, February 9–10, http://www.thomaspalley.com/docs/research/ BrettonWoodsHypothesis.pdf Palley, T. (2014): The theory of global imbalances: mainstream economics vs. structural Keynesianism, Paper presented at the IX International Colloquium titled “Global crisis and the need for paradigm change”, on May 6–7, 2014 Brasilia, Brazil, http://www.thomaspalley.com/docs/ research/theory_of_global_imbalances.pdf Piketty, T. (2013): Le capital au 21e siècle, Editions du Seuil-Septembre, in English: (2014): Capital in the 21st century http://piketty.pse.ens.fr/fr/capital21c, in Hungarian: A tőke a 21. században, Kossuth Kiadó, Budapest Shin, H.S. (2011): Global savings glut or banking glut?, Vox.EU, 20 December 2011, http://voxeu. org/article/global-savings-glut-or-global-banking-glut Shin, H.S. (2012): “Global banking glut and loan risk premium” Mundell-Fleming Lecture, IMF Economic Review, Vol. 60(2), pp. 155–192. (Shin, H. Y. (2011): Global Banking Glut and Loan Risk Premium, Mundell-Fleming Lecture, presented at the 2011 IMF Annual Research Conference, November 10–11, http://www.princeton.edu/~hsshin/www/mundell_fleming_lecture.pdf

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1 The 2008—2009 crisis and the new international economic environment Shin, H.S. (2016): The bank/capital markets nexus goes global. Presentation. BIS. http://www.bis. org/speeches/sp161115.pdf Stock, J.H. – Watson, M. (2003): Has the Business Cycle Changed and Why? in: Monetary Policy and Uncertainty: Adapting to a Changing Economy, A symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August, http://www.kc.frb.org/Publicat/ sympos/2003/pdf/Stock-Watson.0902.2003.pdf Summers, L.H. (2014): “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound”, Business Economics, Vol. 49. No. 2, February http://larrysummers.com/wp-content/ uploads/2014/06/NABE-speech-Lawrence-H.-Summers1.pdf Tily, G. (2015): “US Council of Economic Advisers gets dynamics of long-term interest rate wrong”. Prime Economics, 2 September, http://www.primeeconomics.org/articles/dynamics-of-thelong-term-rate-of-interest-the-us-council-of-economic-advisers-getsit-wrong U. S. Code (Internet): 22 U.S. Code § 5304 – International negotiations on exchange rate and economic policies, https://www.law.cornell.edu/uscode/text/22/5304 Walsh, C.E. (2010): Monetary Theory and Policy. The MIT Press. Third edition. http://www2. um.edu.uy/dtrupkin/walsh.pdf

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The impact of new economic approaches on the conduct of monetary policy Szilárd Benk – Lóránt Kaszab – Kristóf Lehmann

Prior to the 2008–2009 financial crisis, the cornerstone of modern central bank consensus on the conduct of monetary policy was inflation targeting, a system employed by close to 30 central banks. The system hinges on the central bank attempting to achieve a pre-announced inflation target over the medium term, mainly through its interest rate policy. The central bank may take into consideration other objectives as well, such as the facilitation of economic growth and low unemployment, without jeopardising price stability. In order to manage the extreme crisis and to stimulate the economy, central banks lowered interest rates to around zero. When the economy could not be further stimulated through interest rates (typically because interest rates hit the zero lower bound), central banks turned to unconventional methods. Unconventional monetary policy has unique transmission channels. Central bank asset purchases from non-financial corporations (typically long-term instruments such as 10-year government bonds) improve monetary and financial conditions, whereby the interest rates of long-term instruments drop, asset prices increase and the interest rates on interbank loans decrease. Forward guidance on the low level of future interest rates and future asset purchases can also provide an effective stimulus to the economy. In deep recessions, when the nominal interest rate is around zero, fiscal policy may also be especially effective. When the interest rate hits its lower bound, higher government spending can lift inflation and inflation expectations, which – in the context of zero nominal interest rate – reduces real interest rates, which in turn boosts consumption and investments. The effectiveness of fiscal policy — 72 —

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is also bolstered by the fact that in recessions householdsâ&#x20AC;&#x2122; income depends more on their current income, and therefore fiscal easing encourages households to increase their consumption spending, for example by reducing income tax. According to the empirical research cited, the expenditure fiscal multiplier, which measures the extent by which one unit of government spending increases GDP, may be higher than 1 in recessions. During and after the crisis, the objectives and instruments of monetary policy both changed. The experiences of the crisis suggested that interest rate policy was not always sufficient for ensuring financial stability, since the lower interest rate environment necessary for crisis management and the achievement of inflationary and real economy objectives may push economic actors towards riskier investments, which may threaten financial stability. Accordingly, financial stability as a separate goal gained prominence among monetary policy objectives, and guaranteeing it calls for further, macroprudential instruments. Thus, the most efficient way to achieve financial stability is not the classic monetary policy mandate targeting price stability (one target, one instrument), but rather macroprudential policy and the instruments linked to it (loan-tovalue ratio, capital buffers), i.e. the principle of multiple targets, multiple instruments has taken hold. The post-crisis economic environment and unconventional monetary policy face several questions. One such issue is the flattening of the Phillips curve, which arises from the fact that inflation is not only influenced by the cyclical position of the economy, but also by cost shocks to which monetary policy would otherwise not respond as it traditionally takes into account core inflation. Another problem that might surface is that when employing unconventional monetary policy, the central bank and the banking system in general may accumulate too many low-grade (therefore risky) assets, which can endanger financial stability. Finally, it has become clear that in times of recession, coordinating monetary policies at the international level may be important.

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2.1 The principles of monetary policy before the financial crisis Before the crisis, the most important goal of economic policy was usually to ensure stable economic growth sustainable over the long term, which central banks could contribute to by keeping inflation low and pursuing a predictable, credible monetary policy. Around 30 countries use an inflation targeting regime to achieve price stability, and this system was first introduced by New Zealand’s central bank. The system rests on the fact that although the central bank strategies include objectives other than price stability – financial stability, low unemployment, supporting the economic policy of the government – these can only be pursued without prejudice to the primary objective (Felcser et al. 2016). Certain central banks (e.g. the Fed in the US) have a dual mandate: in addition to inflation, they monitor a real economy variable, too (in the US, this variable is unemployment). Within the framework of the dual mandate, the central bank strives to minimise the fluctuations of inflation and unemployment by taking into consideration that less volatility in inflation can only be achieved in the context of stronger variation in unemployment (we can say that there is a trade-off between the two objectives). Due to the trade-offs, an inflation targeting central bank cannot stabilise inflation at the level in line with the inflation target in the short run, but rather it undertakes to achieve the inflation target over the medium term (this is referred to as flexible inflation targeting, a term coined by Swedish economist Svensson, in contrast to strict inflation targeting where the central bank stabilises inflation even in the very short run; the latter is merely a theoretical possibility). In normal times, standard monetary policy instruments comprise the interest rate policy and the communication about the expected level of the interest rate. The central bank aims to achieve price stability by adjusting the interest rate appropriately. The central bank determines the interest rate with the help of the so-called interest rate rule (Taylor rule, Taylor [1993]), taking into account inflationary and real economy — 74 —

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considerations. When expected inflation is above the inflation target and/or the output gap is positive, the central bank, in line with the interest rate rule, raises the key nominal interest rate (short-term interest rate), and vice versa. In his widely cited work, Taylor (1993) examined US data, and estimated that the strength of the responses to the inflationary gap and the output gap was 1.5 and 0.125, respectively. The most recent estimates give a considerably higher coefficient for the output gap (around 1) (see, for example, Coibion et al. [2011]). By way of demonstration, let us see the Taylor rule below:

(

)

(

)

R = R nat + 1,5 ⋅ π − π * + 0,125 ⋅ y − y nat ,

where R is the nominal interest rate (key interest rate), Rnat is the natural interest rate, π ∗shows annual inflation, π ∗ denotes the inflation target, therefore π − π ∗ is the inflationary gap, y is output, ynat is the natural level of output (a theoretical point of reference that the economy is able to produce in the absence of price and wage rigidities and in the context of full capacity utilisation) and y − y nat is the output gap. In Taylor’s (1993) classic study, the responses given to the inflationary gap and the output gap are 1.5 and 0.125, respectively. If the inflationary and the output gap close at the same time π = π ∗;y = y nat , the interest rate settles at its natural rate (R = R nat). The natural interest rate can be estimated similar to the way the natural level of output is predicted.

(

)

According to the Taylor principle (see, for example, Woodford 2003), the nominal interest rate has to rise more than expected inflation so that the real interest rate also increases (we can observe Fisher’s correlation here), which ultimately dampens spending (this is reflected by the 1.5 response strength). The strength of the negative relationship between spending (demand) and the real interest rate (which is the bedrock of every modern macroeconomic model containing rational expectations) is subject to discussions (see, for example, Christiano et al.). However, a higher real interest rate “cools” the economy through other channels as well. One example for this is the lending channel: higher interest rates

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Part I: An unconventional crisis with unconventional consequences

lift the interest on loans, and therefore ultimately less investments are realised and output expands less. Monetary policy influences macroeconomic variables through the multi-stage monetary transmission mechanism. The decisions on the central bank base rate (and the communication about future decisions, see below in more detail) exert e their impact on the money market first, i.e. market rates, asset prices and the exchange rate respond swiftly. This is followed by the commodities market reaction, whereby households and companies adjust to the developments on the money market, and aggregate demand changes. Companies respond to the changes in aggregate demand partly by adjusting their production and partly by changing their prices, and thus in the end aggregate macroeconomic indicators (GDP and inflation) also change. When credible, monetary policy can influence long-term yields, asset prices and inflation expectations through the key interest rate (shortterm interest rate). When the economy is confronted by surprises (“shocks”) on the supply (e.g. poorer crop yields) and/or demand side (e.g. higher taxes), monetary policy is able to stabilise the fluctuations of inflation and the output gap (or, more broadly speaking, the real economy) at the same time. In this case, there is no trade-off between the two (“divine coincidence”, Blanchard and Gali 2007). By contrast, in the case of cost (e.g. the unexpected rise in oil prices) or financial surprises (suddenly the value of capital drops, therefore gearing soars, as after the 2008 Lehman Brothers bankruptcy), the volatility of inflation can only be reduced by allowing higher volatility in the output gap (i.e. there is a so-called trade-off between the two objectives). From the perspective of conducting monetary policy, it is important that the central bank commit itself to its objective credibly, for the long term (price stability and lower unemployment or a narrower output gap), and according to the literature, in such a case it achieves a better trade-off between the volatility of inflation and the output gap, i.e. it can stabilise inflation at the expense of less fluctuations in output — 76 —

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than a central bank using a discretionary (case-by-case) decision-making process. Nevertheless, despite all of this, even in the case of a long-term commitment, the central bank is dynamically time-consistent, i.e. it can utilise the fact that at the onset of the time horizon the expectations of economic actors are given, and therefore it can employ a “surprise” (unexpected) inflation. The next section briefly discusses the reasons behind the financial crisis and then presents the impact mechanisms of unconventional monetary policy during and after the financial crisis.

2.2 monetary and fiscal policy during and after the financial crisis 2.2.1 Brief overview of the reasons behind the financial crisis

The eruption of the global financial crisis was due to a constellation of several factors. The low global interest rate environment led to excessive risk-taking in the absence of appropriate financial regulation and supervision, which was exacerbated by the failure to identify risks and to manage them adequately, thereby undermining financial stability overall. In such an environment, investments typically flowed towards the opportunities offering higher yields, which were therefore more risky. Cheap credit bolstered economic activity, but as a result, asset and real estate prices rose, and bubbles formed. Excessive risk-taking was also influenced by the fact that several institutional investors (e.g. pension funds) were only able to fulfil the yield expectations of their clients through riskier assets. This process was compounded by the phenomenon that in “good times”, i.e. in times of upswings, the risk perception of economic actors diminishes, and therefore they are prone to taking unjustifiably high risks, in the belief that the “good times” will last forever.

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In the European Union, the crisis was also influenced by the substantial differences in the inflation of the countries using the single currency in the years before the crisis, on account of the surplus inflation generated by the convergence processes and the increasing labour costs in certain countries. Inflation was substantially higher in Greece, Ireland and Portugal than, for example, in Germany. In the context of a common monetary policy and a uniformly low-key interest rate, this made the real interest rate negative in the countries concerned, i.e. the countries were able to borrow and become indebted with a negative real interest rate. This was the main driver behind their growth, which ultimately led to the accumulation of significant amounts of debt and a considerable decline in competitiveness due to the lack of structural reforms.

2.2.2 The transmission mechanism of asset purchases

In the year before the eruption of the financial crisis, uncertainties rose on money markets, which was clearly reflected in the increasing interest rate spreads in the US. Due to the high spreads, the number of interbank loans and the borrowing of economic actors nosedived, and in fact with the bankruptcy of Lehman Brothers in September 2008, lending basically ground to a halt in the US. In order to lower lending rates, the Fed had reduced the key interest rate to almost zero by December 2008. After this, it became impossible to employ the standard monetary policy instruments (by further reducing the interest rate), therefore the Fed had to use alternative tools to cut yields and continue to stimulate the economy. The two main tools of this unconventional monetary policy were forward guidance and asset purchases (quantitative easing), which paved the way for reducing long-term interest rates and thus increasing asset prices and boosting inflation expectations. Unconventional monetary policy exerts its impact through several transmission channels such as confidence, monetary policy signalling, â&#x20AC;&#x201D; 78 â&#x20AC;&#x201D;

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portfolio balancing, liquidity premium and monetary channels (Chart 2-17) (Joyce et al., 2011; Felcser et al., 2017). The channel of monetary policy signalling comprises the communication about the future interest rate and the future plans for asset purchases, which can influence long-term inflation expectations and the yields on longer-term government bonds. According to the underlying theory, the current consumption and production decisions of economic actors are affected by the current and future path of interest rates. If the central bank can commit itself credibly to a future low interest rate path, it can use that to boost inflation expectations and current economic activity. Due to the asset purchases of the central bank and the promises about additional asset purchases, economic actors’ assets (securities in varying classes) do not lose their value (see the impact of asset prices on wealth on the chart). Capital loss – a drop in the value of listed companies – is therefore avoidable, and thus the new and planned investments can be realised. The monetary transmission of asset purchases is also helped by the portfolio rebalancing or balance channel, in which the long-term government bond purchases of the central bank (e.g. from investment and pension funds) restructure the portfolios of economic actors, and contribute to the rise in asset prices. If the assets are not perfect substitutes (which is a fair approximation in the short run and in times of financial crises), central bank asset purchases not only lift government bond prices (and push down their yields) but also the prices of the assets that are used by economic actors to balance their portfolios. As a result of the previously described process, asset prices increase, lending rates drop, real economy investments may be realised and economic growth gains pace. Unconventional monetary policy was also successful in lowering the liquidity premium (extra interest rate expected by the lender due to the uncertainties about repayment of the loan) with its loans rapidly disbursed at the onset of the crisis. This enables commercial banks to lend to each other at better interest rate conditions. — 79 —

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The money channel also helped manage the crisis, which suggests that when the central bank purchases less liquid assets from non-bank financial corporations, the amount of money received in exchange increases the balance of non-bank financial corporationsâ&#x20AC;&#x2122; deposit accounts held with commercial banks. This provides additional cheap funds to commercial banks in the form of bank deposits, and therefore these banks can lend more and buy other assets as well, which has a positive impact on asset prices. Unconventional monetary policy may help avoid the appreciation of the real exchange rate, and a relatively weak real exchange rate may assist in growing out of the crisis through exports (on Chart 2-1 this is demonstrated by the fact that the channels of unconventional monetary policy exert a direct impact on the exchange rate). For example, after 2010, the weakening of the Hungarian forint helped maintain the competitiveness of companies producing for export, thereby contributing to the recovery. Chart 2-1: Transmission channels of government securities purchases

Confidence Wealth Signaling Gov. Bond purchases

Portfolio rebalancing

Asset prices and exchange rate

Income and expenditure Cost of loans

Liquidity premium Money

Price stability

Loan provision

Source: Joyce et al. (2011), Felcser et al., (2017).

How are asset purchases conducted in practice? As McLeay et al. (2014) and Felcser et al. (2017) presented, quantitative easing has a direct impact on the amount of both broad and narrow money. â&#x20AC;&#x201D; 80 â&#x20AC;&#x201D;

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During quantitative easing, the central bank purchases longer-term government bonds, chiefly from non-bank financial corporations (e.g. pension funds). The effect of quantitative easing on the balance sheet of pension funds, the central bank and commercial banks is illustrated on Chart 2-2. The left side shows the situation before the asset purchase, while the right side shows the situation after it. The columns display both the assets and the liabilities side. Being a non-financial corporation, the pension fund does not have a reserve account with the central bank, and thus its commercial bank acts as an intermediary in the transaction, creating a commercial bank deposit on the pension fund’s account after selling the government bonds. This can be seen in the first row of Chart 2-2. The central bank finances the asset purchase by increasing the reserves of the commercial bank holding the pension fund’s account, while central bank reserves increase to the same extent on the liabilities side (Chart 2-2, Row 2). This is the step where electronic central bank money is created, which is used as a payment by the central bank in exchange for the government bonds. Of course, this boosts the balance sheet of the commercial bank as well, since, in addition to the reserves, new deposits are created, where the payments of the pension fund are credited after the government bonds are sold. At the end of the transaction, government bonds are replaced by the deposits on the assets side of the pension fund, while its liabilities side remains unchanged. However, on account of the transaction, the fund has more liquid assets, which it strives to invest in assets offering high yields (portfolio restructuring channel). Government bonds have appeared on the assets side of the central bank, while the surplus reserves of commercial banks have increased on its liabilities side.

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Chart 2-2: Impact of quantitative easing on balance sheets Before bond purchases

After bond purchases Pension furnd

Assets

Liabilities

Assets

Liabilities

Government debt

Other liabilities

Deposits

Other liabilities

Assets

Liabilities

Cental bank

Government debt Assets

Liabilities

Other assets

Reserves

Reserves Other assets

Commercial banks

Assets

Reserves

Assets

Liabilities

Reserves

Deposits

Liabilities

Deposits

Source: McLeay et al. 2014, p. 11.

2.2.3 Have asset purchases reached their goal?

According to several studies, central bank bond purchases have successfully reduced the yields of long-term government bonds. In the case of the ECB, Altavilla et al. (2016) showed that the announcement â&#x20AC;&#x201D; 82 â&#x20AC;&#x201D;

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of the OMT programme reduced the yield on longer-term Italian and Spanish government bonds by 2 percentage points on average, whereas it did not have a substantial impact on the French and German government securities with similar maturities. In the case of the US, Gagnon et al. (2010) examined the effect of the Fed’s announcement about asset purchases on the yields of various government and corporate assets. As a result of the US government bond purchases, the yield on 10-year government bonds and mortgage-backed instruments dropped by 90 and 110 basis points, respectively. Based on microeconomic data (at the level of loans), Demirgüc-Kunt et al. (2016) assessed the spillover effects of the Fed and found that monetary easing increased cross-border credit supply and that the companies that received loans were primarily ones which would have found it more difficult to obtain such under normal market conditions. Although empirical studies have mostly shown a positive effect with respect to the US programmes, the views regarding certain ECB programmes are more varied. Since after the financial crisis and the European sovereign crisis European commercial banks were considerably undercapitalised, bank lending faced substantial hurdles (see, for example, IMF 2011). Empirical studies (see, for example, Bruegel 2015) show that in certain Southern European countries, the commercial banks that received additional funds did not lend more, and therefore the real economy did not grow more rapidly, as banks preferred to invest their funds in government securities, and ultimately more and more sovereign debt was held by banks. The unconventional policies of the ECB employed between 2010 and 2014 exerted substantial spillover effects on the EU countries outside the euro area (calculation by Bluwstein and Canova 2016). The strongest effect was measured in countries where the proportion of domesticowned banks was relatively high, and where the financial system was relatively advanced. Falagiarda et al. (2015) found that the ECB’s SMP programme considerably lowered the long-term government bond — 83 —

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yields of certain Central and Eastern European EU countries (Czech Republic, Poland, Hungary, Romania), while the spillover effects of the SMP and the OMT programmes were negligible. Acharya et al. (2015) sought to establish why the ECB’s OMT programme – the announcement of which indirectly recapitalised peripheral countries’ commercial banks due to the increase in the value of the sizeable sovereign bond holdings – was unable to significantly boost the economic growth of the euro area. The authors concluded that the euro area was unable to grow because banks engaged in so-called “zombie lending”, i.e. they extended further loans to existing companies with a poor economic background. These companies did not use the new, preferential loans for investments or increasing their headcount but for replenishing their depleted cash reserves. Overall, the Fed’s programmes successfully reduced the yields on long-term government bonds and helped jumpstart commercial bank lending and economic growth after the crisis, however, the ECB’s programmes show a much more varied picture.

2.3 the relationship between fiscal policy and monetary policy Before the crisis, the prevailing view in both economic policy and economics was that fiscal policy is less effective in mitigating the fluctuations of the economy. It was believed that its macroeconomic impact may be weak, since government spending crowds out private investments. According to another common criticism, fiscal policy exerts its impact with a substantial lag due to the legislative practice, and therefore the recession may be over by the time a given programme becomes effective. The belief that business cycles can be smoothed out more efficiently through monetary policy was also widely held.

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By contrast, the period after the crisis showed that in deep recessions, and especially after hitting the zero lower bound of the nominal interest rate, fiscal policy can be highly effective. Fiscal policy gains significance, especially in the light of the fact that with a zero interest rate, the traditional tools of monetary policy become ineffective. Increased budgetary spending raises current and expected inflation. This is important because at the zero lower bound of the nominal interest rate, only the rise in expected inflation can reduce real interest rates, which stimulates spending. Based on the above principle, fiscal policy is very effective in deep recessions, especially in a zero interest rate environment. In such a situation, the expenditure multiplier – measuring the amount by which one unit of government spending increases GDP – is typically higher than 1. By contrast, in normal times (when there is no recession and the interest rate has not hit its lower bound), fiscal policy is less effective (the expenditure multiplier is below 1). This is also supported by the empirical literature. For example, a study by Blanchard and Leigh (2013) confirmed that in times of crises and recessions, the multiplier may be higher than 1 (this contradicts the IMF’s earlier opinion that the multiplier is below 1). According to their observations, the fiscal multiplier has been in the 0.9–1.7 range since 2007–2008. However, they point out that the value of the multiplier decreases as the crises get further and further away. Thus, empirical results (for example Auerbach and Gorodnichenko 2012) confirm that the fiscal multiplier depends on the cyclical position of the economy. Based on the above, we can formulate the economic policy proposal that in deep and long recessions, the economy should be stimulated through fiscal policy, since in such a scenario monetary policy loses some of its effectiveness due to its lower bound. If fiscal policy is the most effective tool during severe crises, and if severe crises have longterm effects, fiscal policy can not only lift the economy, it can also exert a long-term impact.

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The crisis highlighted the importance of coordinating the two branches of economic policy, i.e. monetary and fiscal policy. The significance of this with regard to Hungary is assessed by Matolcsy and Palotai (2016), who show that in Hungary the desired harmony between fiscal and monetary policy, which paved the way for long-term growth, was only achieved after 2013. Between 2001 and 2012, the absence of the necessary harmony severely damaged the Hungarian economy.

2.4 Rethinking the objectives of monetary policy As a result of the crisis, conventional monetary policy was revisited, and monetary policy objectives were reviewed. Traditionally, the main goal of monetary policy was price stability and more generally “anchoring” inflation expectations in line with the targeted inflation. In the case of a dual mandate, monetary policy monitors not only inflation but also some real economy variable such as unemployment or the output gap. Although the latest crisis has clearly shown that inflation expectations are stable, which helped avoid a more vicious deflationary spiral (albeit inflation stayed below the inflation target for a long time both in the US and the euro area), it has also become evident that price stability in itself is not enough to maintain complete real economy and financial stability. Therefore the “multiple objectives, multiple instruments” principle was formulated, which helps interest rate policy facilitate price stability, while macroprudential policy supports the achievement of financial stability. Now we will examine the arguments claiming that i) financial stability should be a key mandate for monetary policy; ii) the central bank should assign greater weight to real economy objectives (such as low unemployment); and iii) monetary policy should be coordinated at the international level.

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2.4.1 Financial stability as the key mandate for monetary policy

Maintaining financial stability has always been among monetary policy goals in emerging countries, even before the eruption of the latest financial crisis (see, for example, Bayoumi et al.). However, in the case of several developed countries such as the US or the United Kingdom, financial stability fell within the purview of a separate supervisory authority, and it was not clear that financial stability was part of the monetary policy mandate. According to the common practice before the crisis, monetary policy should only respond to changes in asset prices if asset prices exert a direct impact on inflation or the output gap. As it later became obvious, standard interest rate policy was not sufficient to manage the financial imbalances that triggered the latest financial crisis. Interest rate policy affects the functioning of the whole economy, and it is unsuitable for avoiding sector-specific discrepancies, which are possibly the result of speculative behaviour and would thus not respond directly to a change in the base rate anyway. Therefore, employing macroprudential instruments such as limiting the loan-to-value ratio (LTV26) or using a countercyclical capital buffer may be much more appropriate, as they are more effective in addressing the propensity to making risky investments ex ante. Monetary policy must take into account that the chosen interest rate level influences the risk appetite of financial corporations (ChodorowReich 2014). The default of Lehman Brothers in 2008 made it clear that the relationship between capitalisation and risk premiums is not linear. During a sudden capital loss at a given company (and the entailing drop in gearing) the asset prices of other financial institutions plunge as well, which prompts a further reduction in gearing.

he loan-to-value ratio shows the proportion of an asset with a given value that is T covered by loans.

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Based on the arguments above, a consensus has developed that the central bank must play a macroprudential role and have a macroprudential toolset as well. Svensson (2015) argues that financial stability should not be defined as part of classic monetary policy, but as a separate objective of the central bank that can be achieved if the appropriate tools are available. Therefore, macroprudential and monetary policy need to have separate objectives and toolsets. Svensson also points out that monetary policy should be brought in line with macroprudential policy and the fiscal policy determined by the government. All in all, in addition to its classic mandate (price stability), monetary policy should play a role in financial stability as well, which it can mainly achieve through macroprudential policy and the related toolset (multiple objectives, multiple instruments).

2.4.2 Greater weight for real economy objectives

Compared to the pre-crisis trends, inflation during and after the crisis remained stable despite the fact that output dropped and unemployment increased considerably in certain countries (IMF 2013). Based on this, it seems that the Phillips curve, which describes the relationship between the current and future inflation and a given real economy indicator, has relatively flattened. The flattening raises the question of whether it is worth responding to the changes in inflation to the extent similar to earlier times, or more attention should be paid to stabilising real economy fluctuations (e.g. unemployment). Bayoumi et al. (2014) identify four reasons behind the flattening of the Phillips curve: difficulties in measurement, globalisation, low inflation in the past decade and the improving credibility of central banks. We will now take a look at each of these reasons.

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The standard estimates of the cyclical component of unemployment are unable to capture the fact that during the crisis unemployment was cyclical, which was compounded by the rise in its long-term component (hysteresis). In addition to the increased difficulties in measuring the cyclical component of unemployment, due to hysteresis, the downward pressure of higher unemployment on wages and prices became less marked. On account of globalisation, companies face more intense competition, therefore they move their prices less in response to domestic supply and demand surprises, and overall domestic inflation changes less. As a result, the shocks from the international market, such as an oil price shock, play a much more central role in the development of inflation. In the past two decades, inflation has been low in most developed countries, which has entailed downward wage rigidity. Furthermore, in the context of low inflation, the frequency of price changes drops, possibly because of the desire to avoid the related costs. According to Gürkaynak et al., the flattening of the Phillips curve may be due to the establishment of central banks’ credibility and its stability in the recent period. When a central bank is credible, inflation expectations are much more anchored, which may lead to the flattening of the Phillips curve. All in all, due to the flattening of the Phillips curve, the main drivers behind inflation are not the changes in the output gap (and thus business cycles, supply and demand) but rather cost shocks, therefore it is debatable whether monetary policy, which traditionally reacts to core inflation adjusted for the effects of cost shocks, should respond to the changes in inflation, and if so, to what extent. However, all of this suggests that monetary policy should place more emphasis on real economy objectives.

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2.4.3 International coordination of monetary policies

The usual example for the lack of international coordination between monetary policies is the Volcker disinflation period, when the rise in the US base rate precipitated a crisis in many Latin American countries whose USD-denominated debt embarked on an unsustainable path. In a financial crisis, coordination of monetary policies may be beneficial. The data suggest that when in developed countries interest rates are low and financial indices indicate low volatility (financing conditions are loose), more capital flows into emerging countries. However, the monetary policy of a dominant developed country may not necessarily be in line with a given developing country’s business cycle. An interest rate hike in a developed country may entail disinvestment in a developing country. The latter may especially hurt an emerging economy experiencing a recession. With respect to the spillover effects of unconventional monetary policies, Korniyenko and Loukoianova (2015) point out that the quantitative easing (QE) programme of the US had a hugely positive effect on developed countries, but affected financial and liquidity conditions in developing countries negatively. However, in addition to the spillover effects, significant spillback impulses may also emerge. Csontó and Tovar (2015) found that the risk premium in the interest rates of long-term US government bonds did not diminish solely due to the QE policies but also because certain developed and emerging countries amassed US government bonds. Overall, the monetary policy of a large developed country (such as the US) has substantial spillover and spillback effects, and the lack of the international coordination of monetary policies may have significant negative consequences, especially in crises. However, there is no consensus yet on whether the externalities linked to capital flows should be addressed within the framework of the monetary or the macroprudential policy mandate.

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2.5 The reform of monetary policy instruments In the previous section, we discussed the reform of the objectives of monetary policy. Now, we turn to the review of monetary policy instruments. The “one objective, one instrument” rule, which assigns a special role to the interest rate in stabilising inflation over the medium term, ceased functioning during the latest crisis, since the interest rate hit its lower bound. As we have indicated in previous sections of this chapter, in the zero interest rate environment, the central bank sought alternative methods (such as purchasing long-term government securities or corporate securities with various risk ratings) to stimulate the economy and enhance financial stability. However, we have seen that in the Fed’s case the aforementioned asset purchases were fairly successful in stimulating the economy, while the ECB’s programmes had a limited impact. In the light of the latest financial crisis, the question arises in connection with the conduct of monetary policy whether there are considerations that could warrant the use of unconventional instruments in normal times (in the absence of a financial crisis)? Now we will analyse this issue.

2.5.1 Monetary policy in the vicinity of the zero interest rate

The lower the natural interest rate (the interest rate where the output gap closes), the higher the probability that we hit the lower bound of the nominal interest rate (see the Box for information on negative interest rates). However, reaching the zero interest rate level is primarily a concern for developed countries, since in developing countries (with low average income per capita) inflation and the natural interest rate are higher. In deep recessions (and financial crises), the monetary authority probably hits the lower bound of the interest rate.

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As we have seen, after hitting the zero lower bound, monetary policy instruments are modified, and asset purchases replace short-term interest rates as the main tool of the policy, and the purchases are able to lower longer-term government bond yields. Based on the available empirical experiences, we can see that unconventional monetary policy can only be as effective as interest rate policy if it is used in a deeper financial crisis. However, according to our present knowledge, several uncertainties surround unconventional monetary policies, such as the diminishing yields related to their use or the issue of escaping from the zero lower bound. Box 2-1 On negative interest rates

During quantitative easing, the central bank typically purchases longterm assets from commercial banks that invest the liquidity received in exchange in so-called sterilisation instruments. However, due to quantitative easing, longer-term interest rates have also dipped, i.e. the yield curve has become almost horizontal. In order to further ease monetary conditions, most central banks have introduced negative interest rates on the deposits held by them. In theory, a negative lending rate is impossible, since this would encourage economic actors to take out an infinite amount of loans, which would in turn drive up lending rates through arbitrage, and therefore the negative lending rate would be eliminated, as it would equal the yield on cash. Nevertheless, even if holding cash theoretically yields nothing, there are costs of storage (or perhaps loss), therefore its yield is in fact negative. Thus, the effective lower bound of the nominal interest rate may be below zero. However, the cost of holding cash can only result in moderately negative interest rates, and there may even be legal hurdles to lowering interest rates to substantially negative territory. Another problem is that if deposit rates are zero, depositors may demand that they be reimbursed for the negative interest rate as a cost by the deposit insurer.

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If commercial banks deposit assets with the central bank at negative interest rates, and the interest on bank deposits does not follow the drop in the interest rates of central bank instruments, commercial banks suffer a loss and monetary policy transmission is undermined. If commercial banks are unable to lower their deposit rates, two methods are available to them. First, they can increase lending rates and the fees on their services or absorb the loss, thereby achieving poorer capital adequacy and ultimately incurring higher costs for acquiring new funds. Thus, negative interest rates may have unintended negative side effects. Another problem is that negative interest rates do not guarantee that household consumption will pick up (and monetary policy transmission may be undermined). Due to the lower interest rates, households should consume in the present (substitution effect), but the negative interest rate reduces households’ total career income (negative savings and wealth effect), which points towards a decrease in current and future consumption (income effect). If the negative income effect exceeds the positive substitution effect, aggregate demand declines. Another interesting aspect is that in the case of a negative interest rate, today’s money is worth more than tomorrow’s, therefore economic actors may be prone to bringing forward their wages, which boosts the circulation of money and aggregate demand. The criticism linked to cash hoarding was not justified in the majority of the countries, as cash holdings increased only in Denmark, but – according to the Danish government – this was not a result of negative interest rates. As a proportion of the central bank’s balance sheet total, the sterilisation stock with negative interest rates is the largest in Switzerland and Denmark, while it is the smallest in Hungary and Japan. This impacts not only the profitability of commercial banks but also bank lending. Lending rates rose and bank lending contracted in Switzerland and Denmark. The introduction of the negative interest rate weakened exchange rates in the short run, but it bolstered them over the longer term, albeit the latter was

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primarily not related to the introduction of negative interest rates. Banks have not charged negative interest on retail deposits, whereas in the case of firms, the costs are being passed on in the form of negative interest rates on deposits. In the wake of the introduction of negative interest rates, inflation dropped in Switzerland and Denmark, while in Sweden positive macroeconomic effects were observed. Overall, the more negative central bank deposit rates are, and the higher the proportion of the banking systemâ&#x20AC;&#x2122;s balance sheet total affected by the sterilisation stock is, the less monetary easing takes hold. Therefore, the applicability of negative interest rates is quite limited: it can ease monetary conditions temporarily and on certain markets, but no substantial demand-boosting effect should be expected from it.

2.5.2 Unconventional instruments among conventional tools?

According to our earlier arguments, our current consumption and savings decisions are heavily influenced by short-term as well as longterm interest rates. Unconventional monetary policy also impacts longer-term yields through the long-term government bonds purchases. According to the literature, the information on the longer end of the yield curve may forecast our current and future investment and consumption decisions, and therefore the question arises whether the central bank should introduce a long-term interest rate target. Finally, we will discuss how the expansion of the assets eligible for use as collateral was able to manage the latest crisis, and what impact its continued use will have on the stability of the financial system. Long-term interest rate target

Between 1942 and 1951, the Federal Reserve capped long-term interest rates (government bond yields). At the same time, the 90-day and 1-year bond yields were also determined. In the period concerned, interest rates did not fluctuate much and stayed around the target.

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However, in the past 20 years, intervention in the “lowest” band of the yield curve (shorter-term interest rates) has become standard, since the substantial risk premium in the interest rates of longer-term government bonds makes setting longer-term interest rates more difficult (in the US and the United Kingdom, the risk premium [term premium] was 100 basis points [1 per cent] on average in the past 30 years). The risk premium is the component of the long-term interest rate that investors expect in compensation for the real and nominal risks. According to Wright (2011), the risk premium mainly compensates for the uncertainty with regard to inflation, or it emerges due to the varying preferences of economic actors with respect to the different assets (market segmentation). Nonetheless, the risk premium does not always move together with short-term interest rates, which makes providing guidance on longterm interest rates more difficult. One of the most famous examples is the so-called “Greenspan conundrum”, in the course of which the short-term key interest rate was increased by 2 percentage points, but the interest rate on the 10-year government bond dropped by almost 1 percentage point (possibly due to the reduction in the risk premium). On another occasion, in the autumn of 2008, the Fed’s Open Market Committee (FOMC) lowered the interest rate, but long-term bond yields rose. In the case of a longer-term interest rate target, shorter-term interest rates may become more volatile, as speculation would balance the interest rates of the overnight deposit and long-term deposits. If the market suspected the new level of the long-term interest rate before the next meeting, the yield on overnight deposits would fluctuate dramatically until the interest rates were balanced. The Bank of England serves as an example for this, as it used to regard the price of the twoweek repo as the key interest rate, and therefore ultra-short-term interest rates exhibited intense volatility.

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The long-term interest rate target may – in certain cases – raise the suspicion of fiscal dominance. The market may interpret the long-term bond purchases as the direct and at the same time cheap financing of the budget by the central bank. If a country is already massively indebted, the monetary authority may be perceived on the market as an institution providing cheap funding to the general government under political pressure. By contrast, although its operations with short-term interest rates cannot exempt the central bank from the potential fiscal dominance, in such a case, the risk premium emerging in long-term interest rates signals the market’s perception. Overall, the long-term interest rate as part of monetary policy instruments may help appropriately coordinate the decisions of economic actors, but the currently available theoretical and empirical literature suggests that it should be assessed whether the benefits of the long-term interest rate target offset the potential drawbacks. Which assets should the central bank accept as collateral for increasing liquidity?

During and after the crisis, central banks provided liquidity to bank and non-bank financial corporations if they provided adequate collateral in exchange for the rapid loan. The classification (and liquidity) of the assets accepted as collateral was often lower than that of certain government bonds, and therefore the central bank applied a so-called discount when imputing the bonds (haircut). As the central bank expanded the list of bonds and securities acceptable as collateral, there is a risk that the banking system continues to hold lower-quality and thus less liquid assets, since banks can obtain a loan for them from the central bank at any time. The expansion of the list of the assets acceptable as collateral may threaten financial stability. With the rapid progress of financial innovation, increasingly risky assets may be offered as collateral, and therefore it is important that central banks continuously enhance their risk rating system. Due to global banks, regulation should cover the use — 96 —

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of assets available in foreign currency as collateral. The acceptance of the instruments issued by financial enterprises engaged in non-bank activities as collateral may reduce the role and profitability of banks, and their vulnerability may be heightened in a potential financial crisis. Overall, the expansion of the list of assets that can be offered as collateral has made the management of the latest financial crisis more successful, but further relaxing the regulation may undermine financial stability.

2.6 The optimal institutional background to microprudential, macroprudential and monetary policy In the wake of the latest financial crisis, the question arose as to how to reconcile the new macroprudential regulation (Basel III) with the already existing monetary policy and microprudential objectives. For example, the regulation of the leverage ratio, as a macroprudential instrument, exerts an impact on aggregate spending and thus also inflation. As we have already noted, the interest rate policy has an effect on the risk appetite of financial and non-financial corporations. If the macroprudential and monetary policy mandate would take into account their impact on each other, the spillover effects would not be substantial. However, this is not the case in practice, since the objective of one mandate does not necessarily take into consideration the feasibility of the other. When the two mandates fall within the purview of two separate institutions, the individual institutions follow their own mandate. The coordination between the two mandates can theoretically be improved if they are part of the same institution, but it is difficult to establish the credibility of the institution if the two mandates conflict. Furthermore, multiple mandates make the accountability of the institution more difficult and add to uncertainties.

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Governments may designate an institution with a macroprudential role, and the designated institution may change over time due to the changes in leadership. Buiter (2014) mentions the United Kingdom as an example, where the Brown Cabinet deprived the Bank of England of all its regulatory and supervisory roles, and when during the latest financial crisis it turned out that the Financial Services Authority (FSA) did not function efficiently enough, certain powers and regulatory instruments (such as setting the capital-to-loan or the capital-to-income ratios in the case of mortgage loans) were transferred to the Bank of England. In the countries where both the monetary policy and the macroprudential policy mandate are held by the central bank, special decision-making structures have been developed (there are separate committees in the ECB and the Bank of England) to improve transparency, accountability and the communication between the two. There are numerous examples for the variety of institutionsâ&#x20AC;&#x2122; solutions. For example, in Australia and New Zealand, the role of the macroprudential authority is fulfilled jointly by the central bank and the finance ministry. In Brazil, the National Monetary Council and the central bank perform macroprudential supervision together. Chile, Peru and Mexico have similar institutional structures. In Singapore, the bodies in charge of prudential policy and monetary policy are under the aegis of the monetary authority, but in certain issues, such as housing programmes, the Ministry of Finance has decision-making powers. Regulatory policy has been considerably transformed in Hungary as well, and as a result the MNB has obtained strong macroprudential powers for managing systemic risks, and microprudential supervision has also been integrated into the institution. We expound on this in Part III.

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The optimal coordination of monetary, macroeconomic and microeconomic policies is a complex issue and depends largely on the financial and macroeconomic imbalances faced by the given country, and on the institutions the policies have an influence on (Chart 2-3). This chapter has surveyed the change in monetary policyâ&#x20AC;&#x2122;s objectives and instruments during and after the crisis as compared to the situation before the crisis. In order to manage the extreme crisis and to stimulate the economy, central banks lowered interest rates to around zero. When the economy could not be further stimulated through interest rates (typically because interest rates hit the zero lower bound), central banks turned to unconventional methods such as asset purchases that improve monetary and financial conditions, whereby the interest rates on long-term instruments decline, asset prices increase and the interest rates on interbank loans diminish. Financial stability as an economic policy objective has regained prominence after the crisis, especially in light of the fact that lower interest rates may encourage economic actors to make riskier investments, which can jeopardise financial stability. The most efficient way to achieve financial stability is not the classic monetary policy mandate targeting price stability (one target, one instrument), but rather macroprudential policy and the instruments linked to that (loan-to-value ratio, capital buffers), i.e. the principle of multiple targets, multiple instruments is taking hold.

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Chart 2-3: Historical development of monetary policy’s objectives and instruments from the “one objective, one instrument” towards the “multiple objectives, multiple instruments” approach Goals

Instruments

Short- and medium-term stabilisation.

Short-term policy rate

Liquidity provision, refinancing

Low interest rates Size and composition of the balanace of the central bank (asset purchases)

Intervention in financial crises

Forward guidance Macroprudencials tools (eg. LTV)

Macro- and financial stability

Source: MNB.

Key terms balance sheet of the central bank dual mandate financial stability fiscal dominance fiscal multiplier fiscal policy Fisher equation forward guidance inflation targeting inflationary gap interest rate policy liquidity premium loan-to-value ratio (LTV) lower bound of the interest rate

macroprudential policy monetary policy monetary policy transmission natural output negative interest rates one instrument, one objective; multiple instruments, multiple objectives Phillips curve output gap slope of the Phillips curve sterilisation instrument Taylor principle Taylor rule unconventional monetary policy — 100 —

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References Acharya, V.V. – Eisert, T. – Eufinger, C. – Hirsch, C. (2015): “Whatever it takes: The Real Effects of Unconventional Monetary Policy.” mimeo. Altavilla, C. – Giannone, D. – Lenza, M. (2016): “The Financial and Macroeconomic Effects of the OMT Announcements.” International Journal of Central Banking. 12(3): 29–57. Auerbach – Gorodnichenko (2012): “Measuring the Output Responses to Fiscal Policy.” American Economic Journal: Economic Policy. Bayoumi, T. – Dell’Ariccia, G. – Habermeir, K. – Mancini-Griffoli, T. – Valencia, F. (2014): “Monetary Policy in the New Normal.” IMF Staff Notes. Bean, C. – Paustian, M. – Penalver, A. – Taylor, T. (2012): “Monetary Policy After the Fall.” manuscript. Blanchard, O. – Gali, J. (2007): “Real Wage Rigidities and the New Keynesian Model.” Journal of Money, Credit and Banking 39(s1): 35–65. Bluwstein, K. – Canova, F. (2016): “Beggar-Thy-Neighbor? The International Effects of ECB Unconventional Monetary Policy Measures.” International Journal of Central Banking. 12(3): 69–120. Borio, C. – Zhu, H. (2008): “Capital Regulation, Risk-Taking and Monetary Policy: A Missing Link in the Transmission Mechanism.” BIS working paper No. 268. Bruegel, 2015. “Bruegel database on Euro system liquidity.” Buiter, W.H. (2014): “Central Banks: Powerful, Political and Unaccountable?” CEPR discussion paper No. 10223. Bullard, J. – Mitra, K. (2002): “Learning About Monetary Policy Rules.” Journal of Monetary Economics. 49(6): 1105–1129. Chodorow-Reich, G. (2012): “Effects of Unconventional Monetary Policy on Financial Institutions.” manuscript. Coibion, O. – Gorodnichenko, Y. – Kueng, L. – Silvia, J. (2012): “Innocent Bystanders? Monetary Policy and Inequality in the U.S.” IZA and NBER working paper. VoXarticle. Coibion, O. – Gorodnichenko, Y. – Wieland, J. (2012): “The optimal inflation rate in New Keynesian models: should central banks raise their inflation targets in light of the zero lower bound?”, Review of Economic Studies 79, 1371–1406. Csontó, B. – Tovar, C. (2015): “Spillovers and Spillbacks: An Analysis of the Impact of Foreign Official Purchases of U.S. Treasuries on the U.S. Yield Curve.” IMF Working Papers. Demirguc-Kunt, A. – Horváth, B. – Huizinga, H. (2016): “Foreign Banks and International Transmission of Monetary Policy: Evidence from Syndicated Loan Market.” manuscript. Drechsler, I. – Drechsel, T. – Marques-Ilbanez, D. – Schnabl, P. (2014): “Who borrows from the lender of last resort.” Journal of Finance.

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Part I: An unconventional crisis with unconventional consequences Eggertsson, G. – Woodford, M. (2003): “The Zero Lower Bound on Interest Rates and Optimal Monetary Policy. Brooking Papers on Economic Activity.” 1:139–211. Falagiada, M. – McQuade, P. – Tirpák, M. (2015): “Spillovers from the ECB’s non-standard monetary policies on non-euro area EU countries: evidence from an event-study analysis.” ECB Working Papers 1869. Felcser, D. – Komlóssy, L. – Vadkerti, Á. – Váradi, B. (2016): “Inflation targeting.” MNB Handbooks No. 3. Felcser, D. – Lehmann, K. – Vonnák, B. (2017): Transmission mechanism before and after the crisis. in: Vonnak, B. (ed) Modern Central Banking. 2017. (manuscript) Gagnon, J. – Raskin, R. – Remache, J. – Sack, B. (2011): “The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases.” International Journal of Central Banking 7(1): 3–43. Gertler, M. and Karádi, P. (2013): “QE 1 vs. 2 vs. 3: A Framework for Analysing Large-scale Asset Purchases as a Monetary Policy Tool.“ International Journal of Central Banking 9(S1): 5–49. Hatcher, M. and Minford, P. (2014): “Stabilization policy, rational expectations and price-level versus inflation targeting: a survey”, Journal of Economic Surveys. VoxArticle. Ilzetki, E. – Mendoza, E.G. – Végh, C.A. (2011): “How Big (Small?) are Fiscal Multipliers?”, IMF Working Papers. International Monetary Fund (2011): “Global Financial Stability Report”, Washington D.C. Joyce, M. Lasaosa, A. – Stevens, I. – Tong, M. (2011): “The Financial Market Impact of Quantitative Easing in the United Kingdom. International Journal of Central Banking. vol. 7. no. 3. Korniyenko, Y. – Loukoianova, E. (2015): “The Impact of Unconventional Monetary Policy Measures by the Systemic Four on Global Liquidity and Monetary Conditions.” IMF Working Papers. 15/287. Krishnamurthy, A. – Vissing-Jorgensen, A. (2011): “The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy.” Brookings Papers on Economic Activity 2: 215–87. Krusper, B. – Szilágyi, K. (2013): “How Can An Interest Rate Rule Reflect Real Economic Considerations?” MNB Bulletin. Lansing, K.J. (2015): “Asset Pricing with Concentrated Ownership of Capital and Distribution Shocks.” American Economic Journal: Macroeconomics, 7(4): 67–103. Matolcsy, Gy. – Palotai, D. (2016): “The interaction between fiscal and monetary policy in Hungary over the past decade and a half.” Financial and Economic Review 15(2). McLeay, M. – Radia, A. – Thomas R. (2014): “Money Creation in the Modern Economy.” Bank of England Quarterly Bulletin, Q1, 14–27. Meier, A. (2009): “Panacea, Curse, or Non-Event? Unconventional Monetary Policy in the United Kingdom.” IMF Working Paper No. 09/163. Neely, C.J. (2010): “The Large-Scale Asset Purchases Had Large International Effects.” Federal Reserve Bank of St. Louis Working Paper No. 2010-018A.

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2 The impact of new economic approaches on the conduct of monetary policy Svensson, L. (2015): “Monetary Policy after the Crises.” manuscript. Oda, N. – Ueda, K. (2005): “The Effects of the Bank of Japan’s Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach”, Bank of Japan Working Paper No. 05-E-6. Orphanides, A. (2016): “Fiscal Implications of Central Bank Balance Sheet Policies.” CEPR working paper. Rajan, R. (2005): “Has Financial Development Made the World Riskier?” in The Greenspan Era: Lessons for the Future, 313–370. Federal Reserve Bank of Kansas City. Szentmihályi, Sz. – Világi, B. (2015): “The Phillips curve – history of thought and empirical correlations.” Financial and Economic Review. 14(4): 5–28. Taylor, J.B. (1993): “Discretion vs Policy Rules in Practice.” Carnegie Rochester Conference Series on Public Policy. 39: 195–214. Woodford, M. (2003): “Interest and Prices: Foundations of a Theory of Monetary Policy.” Princeton University Press. Wickens, M. (2016): “Avoiding Another Eurozone Crisis while Avoiding the Five Presidents Report: Part I and II.” Voxeu.org.

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The new instruments of large central banks â&#x20AC;&#x201D; Balance sheets in focus

The Fed’s monetary policy after the crisis Noémi Végh

Due to disturbances in the housing market, the crisis started in the United States as early as 2007, and as a response, the Fed eased monetary conditions and cut the policy rate. However, defaulting mortgages launched a landslide, and the Fed had to resort to direct instruments and intervene to ease mortgage market tensions. In order to stabilise the banking system and the financial sector, the Fed responded with a pragmatic monetary policy. Between late 2007 and August 2008, it expanded its liquidity-providing instruments in order to ensure the appropriate financing of capital markets and to avoid a collapse. In addition to liquidity schemes, the Fed provided one-off loans to distressed financial institutions. High unemployment after the financial crisis and below-target inflation called for an accommodative monetary policy. By the end of 2008, the policy rate had decreased to around zero, and the Fed decided to introduce further easing measures to stimulate the economy. The more flexible application of credit instruments and asset purchase programmes started in September 2008, which was supplemented by a longer-term commitment to a low base rate. The liquidity-providing measures targeted lending and the asset purchases affected the asset side of the Fed’s balance sheet, therefore these programmes considerably increased the balance sheet total. The effects of monetary policy instruments employed by the Fed are difficult to assess separately, however, in general they can be said to have lowered term premiums over the whole yield curve, and have entailed a drop in interest rates in other market segments as well. Nonetheless, according to several studies, large-scale asset purchase programmes did not exert the expected real economy effect, and they pointed towards increasing income inequalities through the rise in asset prices.

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The measures enabled the Fed to ease monetary conditions without lowering the base rate to negative territory. After the crisis, the role of communication tools gained prominence in monetary policy. More emphasis has been placed on forward guidance in monetary policy press releases, many of which were employed between 2009 and 2016. However, the commitment to a specific unemployment rate caused difficulties from a communication perspective, since it did not provide an accurate picture concerning the capacity utilisation of the labour market. Following this, the Fed returned to a broader open-ended guidance, which provides adequate flexibility in responding to unexpected events. Yet, it can be misleading if market participants do not draw appropriate conclusions from the economic assessment of decision-makers and the expected course of monetary policy. The gradual improvement of economic prospects encourages Fed decisionmakers to normalise monetary policy. The decision-makers have already suggested that once the economy stabilises, they will start tightening monetary conditions by raising the base rate rather than changing the size or composition of the balance sheet. Similar to the development of the expected interest rate path, the manner in which the accumulated stock of instruments will be reduced and ensuing macroeconomic and financial effects are also key issues. While in the United States expectations revolve around the tightening of monetary conditions, other globally dominant central banks are expected to introduce further easing measures. In such an environment, appropriate communication as a central bank instrument plays a pivotal role in preventing a potential overblown reaction from financial markets.

3.1 Crisis management, responses to the crisis Due to disturbances in the housing market, the crisis started in the United States as early as 2007. The build-up of systemic risk was influenced by the combination of several factors. The United States encouraged home ownership, which was supported by governmentsponsored financial enterprises (GSEs). These institutions, commonly

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known as Fannie Mae, Freddie Mac and Ginnie Mae,27 covered their expenses from issuing mortgage-backed bonds on the capital market. Housing loans in the US were provided by the mortgage securities market, which had become one of the largest capital market segments in the world. From the 1990s, in addition to government-sponsored enterprises, other securitising financial institutions started issuing mortgage bonds as well, which had become quite popular by the 2000s. The rapid spread of financial innovation, especially structured finance, also contributed to the build-up of systemic risk. Complex debt instruments transcending collateralised debt obligations (CDOs) – which structure homogeneous loans – and combining securities embodying different types of debt and often re-securitising these appeared among innovative securities, thus the actual content of securities, the actual underlying collateral and the identification of their risks became substantially more difficult if not impossible. During securitisation, loans with different ratings had typically become jumbled, therefore even papers with the best ratings ran potential risks in subprime loans. In addition to the deterioration of the quality of securities, the rise of the shadow banking system also aggravated the situation. These financial actors (mainly hedge funds and other securitising financial enterprises) mostly rely on market liquidity and do not acquire liquidity directly from the Federal Reserve. The US financial system has a unique feature in that the capital market plays a huge role in corporate finance, therefore its uninterrupted functioning is key in maintaining real economy equilibrium. Thus, the Fed had to intervene to alleviate liquidity strains and stabilise markets. Housing prices stopped rising in 2005, and construction started to diminish in 2006. Debtors were unable to repay their loans, and the proportion of overdue and non-performing loans increased. Defaulting mortgage loans launched a landslide. In April 2007, one of the principal mortgage lenders, New Century Financial, and almost a year later, in March 2008, the Bear Stearns brokerage house filed for bankruptcy. In 27

ederal National Mortgage Association (FNMA), Federal Home Loan Mortgage F Corporation (FHLMC) and Government National Mortgage Association (GNMA).

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July 2008, the state provided extensive support to the Fannie Mae and Freddie Mac mortgage-issuing agencies in response to mortgage market tensions, then on 8 September 2008 the Department of the Treasury took control of them, and provided a credit line of USD 200 billion to cover their losses. On 15 September 2008, Lehman Brothers, the fourth largest investment bank in the United States, also filed for bankruptcy. In the face of souring market sentiment, the Fed decided not to bail out the investment bank, which quickly brought down several smaller banks as well. In the United States, investment banks cannot turn directly to the Fed to acquire liquidity through traditional means, therefore the Fed provided several emergency liquidity programmes to capital market participants, enabling them to acquire funding and preventing a collapse (for more details, see Subchapter 3.2 and Table 3-1). In addition to liquidity schemes, the Fed provided one-off loans to distressed financial institutions, creating independent, special financial corporations for this purpose. Through these so-called Maiden Lane companies, the Fed provided loans to the tune of USD 72.5 billion overall for the acquisition of Bear Stearns and to bail out AIG, an insurer. More than 500 bank failures were recorded in the US after the crisis (until 2016), while between 2000 and 2006 merely 20 unique cases were registered. After the 2008 financial crisis, a comprehensive and extensive regulatory expansion was performed in the United States. Due to the systemic risk arising from the eruption of the financial crisis, the Federal Deposit Insurance Corporation (FDIC) raised the deposit insurance limit from USD 100 thousand to USD 250 thousand in the autumn of 2008. Congress adopted the Dodd–Frank Act on 21 July 2010, which included regulatory tightening measures with respect to financial stability supervision. Furthermore, in December 2011, the Fed announced the introduction of strict capital adequacy and liquidity standards developed by the Basel Committee (Basel III) in regulating the operation of US financial institutions. In addition, the full supervision of financial institutions falls directly within the purview of the Treasury. The highly exacting capital adequacy, liquidity and corporate governance standards, the limitation on devising financial products, — 110 —

3 The Fed’s monetary policy after the crisis

and the new tax burden imposed on financial institutions may entail a structural change for the players in the system and the transformation of financial institutions’ operation to an extent not seen for a long time. Overall, regulation tightened drastically in the United States in the wake of the 2007–2008 financial crisis and regulatory costs soared, which may primarily result in the transformation of business structures and models employed by larger financial institutions due to the considerably increased burden. On 13 February 2008, the Bush administration adopted a significant stimulus package (Economic Stimulus Act) to manage financial market tensions and mitigate the effects of the economic crisis. The fiscal stimulus was supported by the Fed in several ways. First, it sought to improve financial conditions by lowering the policy rate and transforming previously used instruments, i.e. by extending the maturity of traditional short-term financing. Nevertheless, on account of the inadequate functioning of credit markets and later the extremely low federal funds rate, the Fed employed unconventional monetary policy instruments.

3.2 Unconventional monetary policy instruments In response to mortgage market tensions, the Fed started easing monetary conditions in 2007, and cut the federal funds rate by 50 basis points in September. The decision-making body of the Federal Reserve System, the Federal Open Market Committee (FOMC), lowered the policy rate by a total of 325 basis points until the spring of 2008 in response to adverse economic developments. The exceptionally rapid and proactive measures fostered employment and the stability of wages in the early stages of the crisis. However, as a result of financial turbulence in September 2008, the economic outlook became even bleaker, which prompted the FOMC to lower the federal funds rate by another 100 basis points, and by December 2008, the policy rate had sunk to the 0–25 basis point range. — 111 —

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Box 3-1 Central banks as the lenders of last resort

Modern central banks play a crucial role in maintaining the stability of the financial system. If the demand for cash grows due to an unfavourable shock, and financial institutions are unable to satisfy it from other sources, the central bank acts as the lender of last resort and provides liquidity to the illiquid (but solvent) financial institutions (or the whole market). The central bank provides liquidity in exchange for financial instruments, therefore ultimately the size of the financial institution’s balance sheet does not change. According to the literature, central banks need to act as the lenders of last resort when banks are unable to acquire sufficient liquidity from the interbank markets. In healthy interbank markets this indicates that the given banks are insolvent or close to bankruptcy. Nonetheless, due to asymmetric information, the market only has limited information on the given banks, and may incorrectly deem them insolvent, or the market may become more cautious in response to the circumstances. Furthermore, financial institutions may also decline to lend when they fear that they may not acquire liquidity in the future when they would need it. The drying up of interbank markets may pose significant risks to the whole financial system. The bankruptcy of a large bank or several smaller ones threatens the stability of the whole banking system and jeopardises the availability of the payment system, the correct pricing of risks and the appropriate allocation of resources. The bankruptcy of a large bank may lead to a drop in lending to smaller firms and households, because only larger companies can acquire financing outside the banking system. In addition, banks may have substantial credit exposure vis-à-vis each other, therefore the bankruptcy of one bank or the loss of client confidence may create a domino effect and contaminate other banks as well. In such a situation, the central bank exchanges the illiquid instruments for liquid, central bank instruments in order to preserve the stability of the financial system.

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The liquidity, capital support and provision of collateral in any form entails a moral hazard if the behaviour and incentives of the insured party change as a result. Modern central banks may shield themselves from this with “constructive ambiguity”, which means a sort of uncertainty as regards availability. In such an approach, the central bank does not commit itself to a potential “lender of last resort” action plan. From the perspective of corporate finance, the capital market has greater weight in the financial system of the United States, while the banking system is more dominant in the European financial system. Therefore, the central banks of the two systems had to find partly different solutions to the liquidity problems during the crisis. As a result of the features of the US financial system, where non-bank actors do not directly receive liquidity from the Fed despite their significant weight in corporate finance, the Fed intervened during financial tensions not as a lender of “last resort” but as the “primary” lender in order to prevent liquidity issues and avoid systemic risk.

The Fed employed further tools to ease monetary conditions near the zero lower bound. The measures included liquidity-providing programmes briefly presented in the previous chapter. During the crisis, the Fed played its traditional role and acted as the lender of last resort (see Box 3-1), ensuring that financial institutions receive direct short-term liquidity in order to maintain the uninterrupted operation of credit markets. In addition, the Fed approved bilateral currency swap agreements with the central banks of 14 countries to ease international financial conditions. Another part of the measures comprised the targeted facilitation of lending on the key financial markets. These programmes supported the purchasing of investment-grade shortterm securities embodying corporate debt (commercial paper, CP28), mainly in order to avoid capital flight from money market investment 28

he short-term securities embodying corporate debt (commercial paper, CP) have T a maturity of up to 270 days, and they are usually used for financing current assets and short-term liabilities.

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funds and a potential broader financial contagion. The instruments employed by the Federal Reserve are summarised in Table 3-1. The Fed placed a high quantitative limitation on the amount that could be acquired in the individual liquidity programmes, and satisfied all liquidity needs. In early 2009, the demand for the central bank’s liquidity-providing instruments diminished as markets were starting to normalise. Nevertheless, the economic impact of the crisis could be increasingly felt. Inflation was in negative territory during the crisis, only returning to the positive range in late 2009. Unemployment peaked at 10.6 per cent in early 2010, while corporate lending declined between 2009 and 2011. These prompted the Fed to take further steps. Table 3-1: Federal Reserve Credit and Liquidity Facilities Term Auction Facility (TAF) Goal

Easing MBS market pressure by promoting the distribution of liquidity and providing access to term lending.

Details

28-day and 84-day loans were auctioned to depository institutions in generally sound financial conditions. Provided over a total of USD 381 billion in loans.

Duration

December 2007—March 2010 Term Securities Lending Facility (TSLF)

Goal

Supporting the liquidity and foster market activity of primary dealers - the most important players of the bond market.

Details

Primary dealers could exchange their less liquid securities for relatively liquid Treasury securities. Largest amount of stock was over USD 230 billion.

Duration

March 2008—February 2010 Primary Dealer Credit Facility (PDCF)

Goal

Promoting the repurchase agreement market and easing liquidity pressures faced by primary dealers.

Details

A collateralised overnight loan facility for primary dealers. Largest amount of stock reached USD 145 billion.

Duration

March 2008—February 2010

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3 The Fed’s monetary policy after the crisis Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) Goal

Help money market mutual funds (MMMF) that held assetbacked commercial papers* (ABCP) meet investors’ demands for redemptions and foster liquidity in the ABCP market.

Details

Provided nonrecourse loans to financial institutions managing bonds to purchase eligible ABCP from MMMFs. Provided over a total of USD 217 billion in loans.

Duration

September 2008—February 2010 Commercial Paper Funding Facility (CPFF)

Goal

Promoting issuance and purchase of longer-term CPs by stimulating market for shorter-term CPs.

Details

The Fed purchased CPs directly from eligible issuers and faded concerns over the repayment of maturing CPs. Provided loans totalling approximately USD 740 billion.

Duration

October 2008—August 2010 Term Asset-Backed Securities Loan Facility (TALF)

Goal

Stabilising the market for asset-backed securities (ABS).

Details

The Fed issued nonrecourse loans for investors purchasing high quality ABS. Provided over a total of USD 71 billion in loans.

Duration

November 2008—June 2010

Note: *Commercial paper is a maximum 270-day long debt instrument issued by a corporation, typically for the financing of current assets and meeting short-term liabilities. Source: Federal Reserve System.

The third monetary policy instrument employed to supplement the reduction of the federal funds rate comprised the large-scale asset purchases (LSAP). In the literature, the term “quantitative easing” (QE) has become widespread, however, Ben S. Bernanke (2009) underlined at the start of the asset purchases that US asset purchases, i.e. credit easing, differed from the quantitative easing used by the Bank of Japan in that in the former the emphasis was on the assets side of the central bank balance sheet. According to Bernanke, the composition of the assets purchased by the central bank indicates in which market segment the bank wishes to exercise a direct impact. The term expresses that the asset purchases also improve the private sector’s access to credit indirectly, through the drop in long-term yields. On 25 November 2008, the Fed announced a GSE debt instrument and mortgage bond purchase programme of up

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to a sum of USD 600 billion, although the asset purchases only gained momentum in March 2009. The aim of the purchases was to manage the liquidity stress on the market of the targeted segments and to reduce risk premiums in order to enhance the credit conditions of the private sector. The weaker-than-expected economic prospects justified the further easing of monetary conditions, and in November 2010 another round of largescale asset purchases was launched. The goal of the programme was to reduce the yield on long-term government securities, and the purchases mainly covered Treasury securities, but the amount from the maturing mortgage bonds purchased earlier was also invested in Treasury securities purchases, keeping the Fed’s balance sheet steady. Another asset purchase-type programme was maturity extension (MEP) or “Operation Twist”. Within the framework of this, the Fed purchased 6–30-year papers instead of papers with a maturity of up to 3 years, thereby creating the same stifling effect on long-term yields as with asset purchases, however, this did not increase the Fed’s balance sheet. Even though the par value of the short-term papers sold and the long-term papers purchased was essentially equal, the extent of the interest rate risk in the balance sheet increased considerably, and the opposite emerged on the side of market participants. As a result of the programme, the amount of available long-term Treasury securities diminished, which shortened the average maturity of Treasury securities owned by market participants. In September 2012, the Fed announced another large-scale asset purchase programme, supplementing the unconventional instruments already in use. Within the framework of the programme, long-term Treasury securities and mortgage-backed securities were purchased each month to the tune of USD 45 billion. Ben S. Bernanke suggested in a statement in May 2013, that the pace of asset purchases would be reduced, which entailed a surge in government securities yields. The financial market turbulence caused by the communication has since become known as “taper tantrum”. After the stir among investors died down, the pace of asset purchases was gradually reduced from December 2013, then in September 2014 it was indicated that the programme — 116 —

3 The Fed’s monetary policy after the crisis

would be terminated in October, however, the reinvestment of maturing instruments would be continued, thereby maintaining accommodative monetary conditions. The asset purchase programmes of the Federal Reserve are summarised in Table 3-2. Table 3-2: Large-scale asset purchases by the Federal Reserve LSAP1 Announcement

18 March 2009

Details of the asset purchases

Purchasing USD 1.25 trillion agency mortgage-backed securities (MBS), USD 200 billion agency debt, USD 300 billion of longer-term Treasury securities.

Duration

March 2009—March 2010

Impact

Inflation expectations rose, volatility was mitigated, and it reduced the risk premium of long-term securities. LSAP2

Announcement

3 November 2010

Details of the asset purchases

Purchasing USD 600 billion of longer-term Treasury securities, at a pace of about USD 75 billion per month. Replacing maturing mortgage-backed securities with long-term Treasury securities in order to keep the size of the balance sheet.

Duration

November 2010—June 2011

Impact

Reduced the risk premium of long-term securities. Maturity Extension Program (MEP) “Operation Twist”

Announcement

9 August 2011

Details of the programme

Extending the maturity of the securities in the Fed’s portfolio: selling shorter-term (max. 3 years) Treasury securities and purchasing longterm (6-30 years) Treasury securities at the same time.

Duration

August 2011—June 2012

Impact

The balance sheet of the Fed did not increase, and it exerted the same downward pressure on long-term yields as the unsterilised asset purchases. LSAP3

Announcement

13 September 2012

Details of the asset purchases

Purchasing MBS and Treasury securities, totalling USD 790 billion. Reinvesting maturing Treasury securities.

Duration

September 2012—October 2014

Impact

Reduced long-term yields, stimulated the MBS market and eased credit conditions.

Source: Federal Reserve System.

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The measures enabled the Fed to ease monetary conditions without lowering the federal funds rate to negative territory. The role of communication was key in the success of the instruments, since in several cases the announcement itself eased market tensions and panic. The mortgage market crisis management warded off the total collapse of the market through targeted instruments. All in all, the Fed’s programmes successfully lowered term premiums, which exerted a downward effect on ex-ante real interest rates as well. The results of various studies show that the large-scale asset purchases had a great impact on long-term yields (Table 3-3). According to Williams’ (2014) summary analysis, the asset purchases of USD 600 billion lowered the yield on 10-year Treasury notes by 15–25 basis points on average, which is roughly equivalent to an interest rate cut of 75–100 basis points. The studies demonstrate that the estimated real economy effects of the programmes vary widely, and there is great uncertainty as regards their quantifiable effects (Table 3-4). Yet the programmes lowered spreads and boosted securities issues. The asset purchases steered investors towards other markets, which entailed a drop in interest rates and a rise in asset prices in those segments as well (portfolio effect). Overall, several studies suggest that the instruments exerted a significantly positive effect on financial markets. The studies underline that without the programmes, both lending and the drop in GDP would have been greater. Table 3-3: Financial market effect estimates of the Fed’s large-scale asset purchases Authors

Programme

Methodology

Financial market effect

Stroebel– MBS Taylor (2009)

No significant effect.

D’Amico–King LSAP1 (2010)

Regression

Shifted the yield curve down by 50 basis points (bp) on average, with an especially marked effect in the case of 10–15-year maturities. The daily effect was estimated to be 3.5 bps based on the purchases.

Fuster–Willen MBS (2010)

Great dispersion in the change in yields, drop of 0–40 bps.

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3 The Fed’s monetary policy after the crisis Authors

Programme

Methodology

Financial market effect

Hamilton–Wu Operation (2010) Twist, LSAP2

Regression

According to the model, in a zero interest rate environment, swapping short-term bonds for 10-year papers may lower the yield on 10-year bonds by 13 bps without increasing short-term yields.

Gagnon et al. (2011)

LSAP1

Regression, case study

The announced asset purchases of USD 1.725 trillion reduced the term premium of 10-year Treasury Bill yields by 38–82 bps.

Hancock– Passmore (2011)

MBS, LSAP1

Regression

The announcement effect lowered mortgage market yields by 85 bps, to which the asset purchases contributed with an additional 50 bps through term premia.

Ihrig et al. (2012)

LSAP1, LSAP2, Operation Twist

Regression

The first round of asset purchases reduced the long section of the yield curve by 40 bps, while the second announced asset purchase programme lowered it by another 10–15 bps. Maturity extension had cut yields by around 20 bps by the end of 2011, and its continuation in 2012 cut them by a further 11 bps.

Regression, case study

Treasury bills decreased by 107 bps on average, while Aaa–Baa spreads fell by 4–61 bps.

Krishnamurthy– LSAP1 Vissing– Jorgensen (2011) Christensen– Rudebusch (2012)

LSAP1, LSAP2 Case study

The yields on 10-year corporate bonds with an AA rating fell by 89 bps, and those with a BBB rating dropped by 80 bps.

Bauer– Rudebusch (2013)

LSAP1, LSAP2 Case study

5-year Treasury Bill yields decreased by 89 bps, 10-year Treasury securities yields diminished by 97 bps.

Neely (2015) LSAP1

Regression

10-year U.S. Treasury bill yields decreased by 94 bps on average, 10-year Baa yields contracted by 35 bps, yields on foreign government securities shrank by 43 bps on average.

Swanson (2015)

Regression, case study

Asset purchases of USD 600 billion reduced long-term Treasury securities yields by 15 bps. The FOMC’s forward guidance that the policy rate would be 25 bps lower than markets expected, the yields on 5- and 10-year Treasury bills fell by 25.5 and 14.2 bps, respectively.

LSAP, Forward guidance

Note: MBS: the Fed’s mortgage-backed-securities programme (part of LSAP1); LSAP1: the Fed’s first large-scale asset purchase programme; LSAP2: the Fed’s second large-scale asset purchase programme; Operation Twist: maturity extension programme; Forward guidance (see Subchapter 3.4). Source: Author’s compilation based on studies of the authors indicated.

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Table 3-4: Macroeconomic effect estimates of the Fed’s large-scale asset purchases Authors

Programme

Baumeister– LSAP1 Benati (2010)

Method Regression

Macroeconomic effect Without the LSAP1 programme, the Q1 GDP would have been lower by 3 percentage points, while inflation in 2009 would have been higher by 0.2–0.3 percentage points.

Chung et al. (2011)

LSAP1, LSAP2 GARCH-M

Without the LSAP1 programme, GDP would have been lower by approximately 2 percentage points, unemployment would have been higher by 1 percentage point until 2012, and inflation would have been lower by 0.7 percentage points until 2011. The LSAP2 programme resulted in a further 1-percentage point reduction in the drop in terms of GDP, and an 0.5-percentage point improvement with respect to unemployment. Inflation increased by another 0.3 percentage points on account of the LSAP2 programme.

Engen et al. (2015)

LSAP1, LSAP2 FRB/US Model

They did not contribute to either economic growth or the reduction of unemployment for 1–2 years after the crisis. They accelerated the recovery after 2011.

Note: LSAP1: the Fed’s first large-scale asset purchase programme; LSAP2: the Fed’s second large-scale asset purchase programme. Source: Author’s compilation based on studies of the authors indicated.

However, according to several authors, the large-scale asset purchase programmes did not provide the expected real economy stimulus, and many authors have noted the negative side effect of the rise in asset prices. Coibion et al. (2014) examined the income distribution effects of monetary policy and concluded that loose monetary policy exacerbates inequalities through the heterogeneity of income sources, the segmentation of the financial market and the portfolio effect. The marginal utility to consume is typically lower in wealthier households, therefore an increase in their income leads to less GDP growth. In contrast, tight monetary policy exerts a similar effect through the heterogeneity of the response of labour income to the business cycle and the differences between the interests of lenders and savers. When examining the opposing effects, the authors concluded that overall in the period under review, tighter monetary policy increased economic — 120 —

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inequalities, while looser monetary policy mitigated them. Nevertheless, when the policy rate is around zero, central bank measures exert an impact as if the economy was characterised by protracted monetary tightening, therefore they add to economic disparities. Krugman (2014) underlined that asset prices had been rising since 2010, while house prices had remained stable, which meant a substantial shift in income towards the wealthy with capital income, since the majority of securities are held by them. Bivens (2015) claims that without the asset purchase programmes, inequalities would have grown more, and that the programmes mostly exerted an impact through stabilising output. DeLong (2014) stressed that the impact of the programmes on income and wealth was difficult to determine because the macroeconomic effects are not straightforward. The question is whether the state commits itself to a lower nominal interest rate and higher inflation, or it wishes to reduce the risk premium by decreasing the supply of risky assets. According to several leading economists, one of the possible explanations for prolonged economic recovery after the crisis is the exceptionally weak aggregate demand, due to the so-called balance sheet recession (for more details, see Subchapter 1.3.3) and market participants’ simultaneous efforts aimed at deleveraging. This impact may be blunted by a substantial engagement of fiscal policy, which is neither constrained by short-term profit prospects nor liquidity and bankruptcy risks. Although central bank asset purchase programmes reduced risk-free (government securities) interest rates overall, risky (corporate) credit spreads and returns expected from investments (hurdle rate) remained high, therefore the private sector’s propensity for borrowing started to pick up extremely slow. Moreover, the majority of subdued corporate borrowing did not serve the expansion of capacities (this could be realised from own funds by both American and European corporations), but financed further dividend payments and stock purchases (Csortos–Szalai 2015). This showed that interest rates around zero and quantitative measures in themselves could hardly offset the negative effect of weak demand and the steadily slow growth prospects — 121 —

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on investments. In light of the experiences of the crisis, Furman (2016) and others recommend a fiscal policy approach. According to this, in contrast to the pre-crisis consensus, fiscal policy is an important complement to monetary policy in stabilising the economy, especially in a prolonged, slow recovery that followed the global financial crisis. Another important experience is that fiscal multipliers are much more pronounced in such an environment, and the negative impact of fiscal austerity on growth is much more profound than estimates regarding normal times suggest. It must be noted that both Bernanke and Yellen (the former and the current chairs of the Fed) have pointed out several times that fiscal policy does not provide adequate support to monetary policy in achieving the central bank’s objectives (price stability, full employment), therefore recovery is unnecessarily slow. They claimed this, despite the fact that before the crisis they had also shared the consensus view on fiscal policy. Their crisis management experience gained in decision-making positions forced them to revise their views. In summary, from August 2007 the Fed first transformed its existing instruments in order to stabilise the banking system and the financial sector, then it expanded its liquidity-providing instruments between late 2007 and August 2008. The more flexible application of credit instruments and the asset purchase programmes were introduced in September 2008, and they were supplemented by a longer-term commitment to a low base rate. The liquidity-providing facilities targeted lending and the asset purchases affected the assets side of the Fed’s balance sheet, therefore these programmes considerably increased the balance sheet total (Chart 3-1). Overall, the monetary base increased almost fivefold in the United States between 2008 and late 2014. However, the assets side of the Fed’s balance sheet not only expanded on account of the programmes, it was also transformed. The shortterm government securities were replaced by long-term government securities and high-quality mortgage-backed securities.

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Chart 3-1: Federal Reserve assets 5,000

USD Billions

5,000

4,500

4,000

3,500

3,000

2,500

2,000

1,500

1,000

500 0 2007

500 2008

2009

2010

2011

2012

Treasury Securities MBS and Agency Debt Lending and Liquidity Facilities

2013

2014

2015

2016

Repurchase Agreements Liquidity Swaps Other Assets

Source: Federal Reserve Bank of St. Louis.

3.3 The change in the Fed’s strategic framework Since January 2012, the Fed has taken steps towards the practice of inflation targeting central banks. Simultaneously with the interest rate decision, the FOMC announced an explicit 2-per cent inflation target measured in the personal consumption expenditures price index. Pursuant to the 1977 amendment to the Federal Reserve Act, the three goals of the Fed are the achievement of full employment, price stability and moderate long-term interest rates. The latter can be mostly guaranteed by the Fed if the inflation premium expected from longer-term instruments decreases due to low inflation, therefore it is commonly claimed that the Fed shapes its monetary policy based on a so-called dual mandate. The term “dual mandate” refers to the fact that price stability and maximum employment have the same weight, — 123 —

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i.e. neither of the objectives is subordinated to the other. According to economists, earlier, in the Greenspan era (1987–2006), the Fed used an implicit inflation targeting regime, since decision-makers made it clear that they were committed to price stability. Still, there was no consensus about the level of inflation considered consistent with the price stability mandate. Due to substantial quantitative easing, the steadily low interest rate level and the communication emphasising growth after the crisis, it was suggested that the Fed may face an inflation problem in the longer run. This was especially true in 2011, when inflation skyrocketed and 12-month inflation expectations also rose due to global commodity price shock. Longer-term inflation expectations remained stable, however, surveys showed increasing uncertainty, which may have posed a risk for long-term expectations with respect to credibility, which is linked to price stability. This all showed that the Fed needed a more solid nominal anchor for bringing down inflation expectations. Since 2009, the long-term inflation projections of members of the FOMC could indicate the long-term inflation considered consistent by individual decision-makers in the context of an “appropriate” monetary policy, and analysts typically interpreted these indications as a value around 2 per cent. However, as the inflation target became a concrete, explicit value in 2012, it enabled the Fed to provide a more stable nominal anchor for the economy of the United States. This step contributed to more consistent decision-making and enhanced the efficiency of the communication in connection with price stability, while also increasing the accountability of monetary policy decisions. As a result of the above-mentioned measure, the Fed’s current strategic framework has been brought in line with the practice of flexible inflation targeting central banks, although it also has unique features. The 2 per cent point target determined by the Fed is measured in the personal consumption expenditures price index,29 in contrast to the consumer price index30 used in IT regimes. The PCEPI takes into account the changes in consumer habits, and it includes a wider 29 30

PCEPI CPI

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3 The Fed’s monetary policy after the crisis

range of products and services. In contrast to the practice followed by IT central banks, the Federal Reserve does not publish an inflation report, although the regional Feds analyse the economic developments in their own regions in detail. Formally the Fed cannot be considered an inflation targeting central bank, since the employment objective is not subordinated to price stability, therefore there is no commitment to the primacy of price stability. The dual mandate means that the Fed must strive to keep unemployment near its natural rate. This refers to a sustainable level of employment that does not entail inflationary pressure. Since the labour market is shaped by several factors over which the Fed’s monetary policy has no control, monetary policy can only smooth short-term economic fluctuations, with not much impact on the long-term level of unemployment. Therefore, the objective of full employment should be interpreted as the moderation of real economy volatility.

3.4 The Fed’s communication challenges At the same time when the nominal lower bound of the base rate was reached, the role of central bank communication gained importance. First, transparency became a key element in the accountability of independent central banks, just as the realisation that monetary policy can exert an impact on economic developments through influencing expectations. Since 1994, the Fed has published a statement following its decisions, and three weeks after the decisions the minutes of the meeting showing the considerations behind the decisions are disclosed. Since 2007, based on the semi-annual practice of Congressional hearings, Summary of Economic Projections (SEP) have been published quarterly, i.e. after every second rate-setting meeting, simultaneously with the minutes, with the projections of the individual FOMC members with regard to key economic indicators. These communication tools bolster general central bank transparency. Since April 2011, the FOMC has published summary tables of the SEP and has held press conferences.

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Since 2012, in addition to real economy projections, conditional forecasts on the federal funds rate have also been published. Yet the forecasts should not be deemed promises, since they show the path projected based on the information available at the given time. On several occasions, the Fed has announced definite macroeconomic data or dates which were considered thresholds by the market, and their subsequent modification provoked fierce criticism against the FOMC’s communication. After the crisis, the role of forward guidance and commitment-type central bank communication as monetary policy instruments have gained special significance. In December 2008, the FOMC lowered the policy rate to the 0–0.25 target range and indicated that owing to subdued prospects, it would maintain the exceptionally low interest rate level “for some time”. From March 2009, the statements continued to include time-contingent guidance, as it was indicated that the interest rate band around zero will persist “for an extended period”. In August 2011, an open-ended guidance was specified, therefore the statement “for an extended period”, was replaced by “at least through mid2013” with respect to maintaining the interest rate, which in January 2012 was extended to “at least through late 2014” then in September 2012, to “at least through mid-2015”. However, in September 2012, the statement was supplemented with the state-contingent element that monetary conditions would remain loose “for a considerable time after the economic recovery strengthens”. In December 2012, the time-contingent commitment was completely replaced by state-contingent guidance. The FOMC made the maintenance of the extremely low interest rate environment conditional on explicit macroeconomic values. It was claimed that the exceptionally low target range for the federal funds rate would be preserved at least as long as the unemployment rate remained above 6.5 per cent, projected inflation within one to two years would be no more than

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half a percentage point above the 2 per cent target (Evans Rule31) and longer-term inflation expectations would remain anchored. The Fed’s communication faced significant challenges when unemployment indicators dropped by more than predicted by earlier Fed projections – mainly on account of a decrease in the participation rate – thus approaching the 6.5 per cent unemployment rate communicated in the statements did not result in the capacity utilisation and tightness measurable in other labour market indicators that was expected from the decline in the unemployment rate. As a result, in December 2013, while approaching the 6.5 per cent unemployment threshold determined one year earlier, the explicit state-contingent guidance was supplemented with an open-ended element when the statement claimed that the target range for the federal funds rate close to zero can be expected to be maintained “well past the time” that the unemployment rate declines below 6.5 per cent, especially if projected inflation continues to run below the 2 per cent target. In March 2014, the forward guidance message was changed once again. After it became clear that even in the context of an unemployment rate well below 6.5 per cent the realisation of the dual mandate may not be within reach going forward, the quantified threshold was abandoned. Later, it was stated that the Fed will assess the economy based on several indicators and that the federal funds rate will stay low even after asset purchases stop. At the press conference following the decision, Fed Chair Janet Yellen suggested that the interest rate increase was expected to start six months after the tapering of the asset purchases. However, in the weeks after the decision, Yellen in her statements refuted rumours that the Fed would start increasing the interest rates earlier than expected and claimed that the economic upturn in the United States required low interest rates for a long time.

ot long before the interest rate decision, Charles L. Evans, the president of the N Chicago Fed, who at that time was not part of the decision-making body, argued that the FOMC should establish thresholds that can be achieved by the economy, determining the 6.5 per cent unemployment rate and the 2.5 per cent inflation threshold in his speech, and that is why this is referred to as the Evans Rule.

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In January 2015, no guidance on asset purchases was provided, and the only thing that was communicated was that the committee “can be patient” with beginning interest rate hikes. Then at the next meeting in March, the communication was fine-tuned with the information that further improvements were expected on the labour market and that the FOMC would adequately ascertain that inflation returns to the target over the medium term. After the December 2015 interest rate increase, the FOMC continued to suggest that the interest rate path would take into account the fulfilment of the dual mandate and highlighted that, in its view, economic developments would only warrant a gradual increase, therefore the base rate may fall short of the long-term value “for some time”. With this step, the FOMC returned to the communication that provides a less explicit indication about the expected development of the interest rate policy. Chart 3-2 provides an overview of the Fed’s communication over time. Chart 3-2: Communication and the different forms of forward guidance of the Federal Reserve

2011, April — (quarterly): An advance version of the SEP table is released following the meeting. Speeches of Federal Reserve Officials Open Congressional hearings 2011, April — (quarterly): Press conference following the meeting 2012, Jan. — (quarterly): Publication of conditional forecasts on FOMC member's interest rate projection (dot plot)

Open-ended

Statecontingent

Timecontingent

Forward guidence based on commitment

Forward guidence based on forecast

General central bank transparency

1994 — : Publication of press releases, minutes 2007 — (quarterly) Publication of Summary of Economic Projections (SEP) with minutes

Explicit

2008, Dec.: “for some time” 2009, March: “for an extended period” 2015, Dec.: “for some time”

2014, March: “...assessment will take into account a wide range of information”; “for a considerable time after the asset purchase program ends”

2013, Dec.: “…well past the time that the unemployment rate declines below 6-1/2 percent”

Source: Author’s work based on Csortos–Lehmann–Szalai (2014).

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2011, Aug.: “at least through mid-2013"

2012, Dec.: “…at least as long as the unemployment rate remains above 6-1/2 percent”

3 The Fed’s monetary policy after the crisis

It can be seen that the Fed’s communication has become increasingly dominant in recent years, and interest rate statements have included several types of guidance (Chart 3-2). During time-contingent commitment, a modification signals a change in decision-makers’ assessment of the economy, however, it usually does not provide any information on the extent to which the changes in the outlook modify the monetary policy strategy of the decision-makers. Explicit timedependent guidance may undermine credibility if a sudden change in economic developments warrants a modification of monetary strategy. The use of state-contingent commitment only provides guidance on the special values of individual, specific variables. On the one hand, choosing the right indicator (GDP growth, unemployment rate, the various labour market indicators) is a challenge, and on the other hand after the indicator is chosen, the Fed may face the problem that the variable does not appropriately indicate the economy’s capacity utilisation. In this context, it has been repeatedly pointed out that the development of the unemployment rate underestimates the remaining slack on the labour market. While the official unemployment rate (U3) dropped below the level considered natural by decision-makers, the broadest unemployment rate (U632) had not reached the precrisis level by the end of 2016, and it is still above the official rate by almost 5 percentage points. The participation rate is also lower than the pre-crisis level, however, the drop in the rate may be due to natural demographic changes – the retirement of baby boomers and the higher education of the younger generation (16–24-yearolds) – and the sustained effect of negative business cycles. Statecontingent commitment may provide direct feedback about whether the developments in economic prospects are in line with the prognosis of decision-makers. Yet, this may not provide a clear-cut signal to the market, and it may have adverse consequences. Finally, openended guidance may provide substantial flexibility in responding to sudden events, but too broad a guidance may be misleading if market 32

6: Unemployment in the broadest sense including those employed part-time due U to economic reasons, discouraged jobseekers and those who only have partial ties to the labour market.

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participants cannot draw the appropriate conclusions with respect to the monetary policy stance. It can be seen that forward guidance has become an active element of monetary policy instruments, and appropriate communication is key in the Fed’s monetary policy.

3.5 Divergence from the zero base rate: The Fed on the road towards normalisation Since 2015, the economic outlook has gradually become brighter, therefore the FOMC increased the federal funds rate by 25 basis points to the 0.25–0.50 per cent target range at its 15–16 December 2015 ratesetting meeting. In the decision-makers’ view, due to expected gradual increases, monetary policy will stay accommodative, thus the economy will continue to grow, the labour market will continue to strengthen and inflation will return to the 2 per cent target. It was underlined that loose monetary conditions were also supported by the reinvestment of maturing long-term securities. After this, in December 2016, the policy rate was raised by another 25 basis points to the 0.50–0.75 per cent target range, and a slightly stricter interest rate path was forecast. The slope of the interest rate path is also surrounded by considerable uncertainties. According to the quarterly Summary of Economic Projections, the date of rate hikes has gradually shifted: the long-term, natural rate of the federal funds rate was estimated to be at 3.5 per cent by the FOMC members in December 2015, and at 3 per cent in December 2016. It is underscored in the decision statements and the decision-makers’ statements that the pace of the rate hikes will be decided depending on the economic outlook. The developments in productivity growth, financial conditions and the changes in saving habits suggest that the level of the neutral interest rate is lower than before the crisis, therefore interest rate increases are expected to be gradual and the long-term policy rate may be slightly below its pre-crisis level. In the 17 September 2014 Fed statement, it was suggested that tightening will begin with an increase in the base rate, rather than — 130 —

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with a change in the size or composition of the balance sheet. The statement outlined the interest rate increase strategy and the details of the modification of the monetary policy instruments necessary in the context of the remaining excess liquidity. The Fed continues to determine a so-called federal funds target range, employing several monetary policy instruments for efficient interest rate increases. Since the end of 2008, the Fed has paid interest on banks’ overnight deposits held at the Fed, which has played a key role in monetary tightening. The Fed uses the interest rate on excess reserves (IOER) to keep the interest rate in the higher target range, the efficiency of which is supported by the overnight reverse repurchase agreement (O/N RRP). According to the FOMC, these monetary policy instruments are used only temporarily, until the previously usual stability in the development of interest rates is achieved. The IOER is adjusted to the upper band of the central bank policy rate, thus the Fed determines an interest rate floor, and no one accepts an interest rate below this for an overnight loan. Given that in the United States, non-bank actors (such as money market funds or state-owned mortgage credit institutions) cannot deposit reserves, due to arbitrage, the rise in the IOER rate, ceteris paribus, exerts an upward pressure on market interest rates. However, the IOER rate does not always represent a genuine threshold for market interest rates. Being as only financial institutions (banks) can deposit reserves with the central bank, the excess liquidity emerging outside this segment may push money market interest rates below the policy rate (the interest rate paid on central bank reserves), which may cause substantial fluctuations in the interest rate. The downward volatility of interest rates is limited by the overnight reverse repurchase agreement. In an overnight reverse repurchase agreement, the central bank sells securities, and simultaneously concludes a forward transaction for repurchasing the instrument the next day. This represents a riskfree option for bank and non-bank actors. The O/N RRP instrument enables the Fed to tie up liquidity in the non-bank sector as well, where participants cannot directly deposit reserves with the central bank. This “interest rate floor” provides a footing for the higher policy rate, since no market participant concludes a deal below this interest rate. In — 131 —

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December 2015, the Fed determined a limit of USD 30 billion per client per day. Chart 3-3 provides an overview of the Fed’s policy toolkit on interest rate hikes. Chart 3-3: Stylised depiction of the Fed’s policy toolkit on rate hikes Basis points 75 IOER rate

25 bp federal funds target range

O/N RRP rate

5 Until 2015 december

Gradually since the lift off

Note: IOER – interest on excessive reserves, O/N RRP – overnight repurchase repo. Source: Author’s work based on Ihrig et al. (2015).

In recent years, communication tools have considerably gained importance in the Fed’s monetary policy, which plays a pivotal role in the tightening process as well. It is important to prevent an overblown response from the financial market and to avoid disturbances similar to the taper tantrum,33 which may be supported by forward guidance and the appropriate central bank communication. The slope of the interest rate path is surrounded by significant uncertainties, and the communication of decision-makers also varies in this respect. Based on traditional economic correlations such as the Phillips curve (that describes the trade-off between unemployment and inflation) or the Taylor rule (that describes the base rate as a function of the neutral interest rate and the cyclical position of the economy), improving macroeconomic prospects and the fact that monetary policy exerts its effect on the economy with a lag call for an interest rate increase, while 33

I n mid-2013, the communication linked to the slowdown in asset purchases led to a spike in government securities yields.

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the controversial macroeconomic picture and foreign developments may warrant a more gradual interest rate path. The asymmetry of risk management has been repeatedly emphasised, i.e. that it will be harder to respond to downside risks than upside risks due to the lower bound of the nominal interest rate, since if economic developments improve, the pace of the hikes may be increased, but otherwise there is only limited room for further easing. According to this reasoning, temporary overheating of the economy is better than potentially dampening growth through more rapid interest rate increases than justified. One counterargument against current low interest rates is that they may motivate investors into excessive risk-taking, and may drive companies and households to increase their leverage. Many analysts believe that low interest rates may artificially inflate asset prices and thus create a new bubble. According to this reasoning, the costs of loose monetary conditions rise gradually, therefore the proponents of this approach maintain that a steeper interest rate path would be appropriate. It can be seen that due to the unique system of the Federal Reserve,34 several opinions have emerged within the FOMC with regard to the course of monetary policy, which enables a more thorough overview of economic approaches. During quantitative easing, the monetary base in the United States increased from USD 850 billion in 2008 to around USD 4,500 billion until October 2014. Similar to the date of the interest rate increase, the manner in which the accumulated stock of instruments will be reduced and the ensuing macroeconomic and financial effects are also key issues. Based on the statements of decision-makers, the stock of securities is planned to be reduced gradually and predictably by not reinvesting the maturing securities. Both in terms of size and structure, the normalisation of the portfolio may be a long process, since as a result 34

he Federal Reserve System consists of 12 regional Feds. The members of the T FOMC: Up to seven Board of Governors members nominated by the President of the United States and confirmed by the Senate. The Chair is elected from the Board of Governors, they and the president of the New York Fed are permanent decisionmakers, while 4 out of the 11 presidents of the other regional Feds serve as decisionmaking members each year.

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of the asset purchases and the maturity extension program (MEP), the weight of long-term government securities and asset- and mortgagebacked securities (ABS, MBS) has increased. As regards the time profile, the complete reduction of the 30-year MBS stock may be the most prolonged. The purchases may be considerably affected if commercial banks will only be willing to purchase the papers at a price at which the Fed would incur a loss. The rapid marketing and sale of such a largescale portfolio is unprecedented at the international level, although all in all, no matter what strategy the Fed opts for, the potential inflationary risk does not depend on the amount of central bank reserves and the way they are reduced. According to endogenous money theory (see Box 3-2), the propensity to lend is not directly affected by the level of central bank reserves: monetary policy can shape it through influencing the interest rates. The actual inflationary risk may be represented by the unjustified rise in growth expectations and rapid credit growth due to an increase in aggregate demand. Box 3-2 Money creation in the modern economy â&#x20AC;&#x201C; Asset purchase is not lending

The overwhelming majority of money in the economy is in bank deposits, therefore it is important to give an overview concerning their function when describing money creation. The endogenous money theory maintains that banks make lending decisions by taking into account profit considerations, aggregate macroeconomic demand and credit demand in the economy. When a commercial bank grants a loan, its assets increase, and its deposits grow by the same amount on the liabilities side. This creates money in the economy. Commercial banks accumulate required reserves in a pre-determined proportion to their funds and in line with the regulations of the given country, and this is settled with the central bank through reallocating excess reserves to the required reserves. In contrast to the traditional view, banks do not act as intermediaries with respect to savings, but rather allocate purchasing power between the economic actors based on market, business and economic considerations. Money is created through the extension of new loans, and it is eliminated with

â&#x20AC;&#x201D; 134 â&#x20AC;&#x201D;

3 The Fed’s monetary policy after the crisis

the repayment of bank loans. It follows from this that lending decisions determine the amount of bank deposits in the banking system and their volume influences the volume of central bank reserves. Monetary policy can affect lending through influencing interest rates, and the level of central bank reserves has no direct impact on the propensity to lend. In response to the crisis, central banks first lowered the policy rate, then engaged in quantitative easing, i.e. asset purchases, to facilitate monetary easing. The effects of asset purchases depend on the type of securities purchased. During government securities purchases, the central bank exchanges securities with various maturities and yields for central bank money, thus this leads to a change in the assets side of the actors other than the state and the liabilities side of the central bank balance sheet. In such a situation, from the perspective of the banking system, the increasing volume of central bank money is an external factor that does not influence lending activity, since central bank money cannot be considered loanable funds in the traditional sense. Through the government securities purchases, the central bank depresses government securities yields and thus the prices of riskier assets rise. During the asset purchases, the central bank may purchase other, less liquid instruments that are difficult to sell, however, in such a scenario its impact pointing towards an enhancement in lending is exerted not through the increase in the volume of central bank money, but rather through the cleaning up of commercial banks’ balance sheets. With the expansion of the instruments purchased during quantitative easing, the central bank is able to contribute to a change in the liquidity of certain asset classes and a contraction in yields. Overall, the volume of central bank money created through quantitative easing does not influence the lending activity of commercial banks, therefore it cannot be deemed “free money” or “lending”.

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Key terms commercial paper (CP) dual mandate emergency liquidity programme endogenous money theory Federal Open Market Committee (FOMC) government-sponsored enterprise (GSE) large-scale asset purchases (LSAP)

lender of last resort lower bound of the nominal interest rate Maiden Lane maturity extension program (MEP) personal consumption expenditures price index (PCE) structured finance taper tantrum

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REFERENCES Ábel, I. – Lehmann, K. – Tapaszti, A. (2016): A pénz és a bankok ellentmondásos kezelése a makroökonómiában (The controversial treatment of money and banks in macroeconomics). Financial and Economic Review, Vol. XVI. Issue 2, pp. 33–58. Baily, M. N. – Elliott, D. J. (2009): The US Financial and Economic Crisis: Where Does It Stand and Where Do We Go From Here? Brookings Institution, Initiative on Business and Public Policy at Brookings, June 2009. Bank of England (2013): Monetary policy trade-offs and forward guidance – August 2013. Bauer, M. D – Rudebusch, G. D. (2013): The Signaling Channel for Federal Reserve Bond Purchases. Federal Reserve Bank of San Francisco Working Paper 2011-21, April 2013. Baumeister, C. – Benati L. (2010): Unconventional Monetary Policy and the Great Recession. European Central Bank Working Paper, no. 1258. Bernanke, B. S. (2009): The Crisis and the Policy Response. Speech, Stamp Lecture, London School of Economics, London, England, January 13, 2009. Bernanke, B (2012): Testimony The Economic Outlook Before the Joint Economic Committee, U.S. Congress, Washington, D.C., May 22, 2013, https://www.federalreserve.gov/newsevents/ testimony/bernanke20130522a.htm Bivens, J. (2015): Gauging the Impact of the Fed on Inequality during the Great Recession. Hutchins Center on Fiscal and Monetary Policy at Brookings, WP12. June 1, 2015. Christensen, J. H. E. – Rudebusch, G. D. (2012): The Response of Interest Rates to U.S. and U.K. Quantitative Easing. Federal Reserve Bank of San Francisco Working Paper 2012-06, May 2012. Chung, H. – Laforte, J-P. – Reifschneider, D. – Williams, J. C. (2011): Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events? Federal Reserve Bank of San Francisco Working Paper 2011-01. Cohen-Setton, J. (2014): The distributional effect of quantitative easing. Bruegel Blog Post October 29, 2014. http://bruegel.org/2014/10/the-distributional-effect-of-quantitative-easing/ Coibion, O. – Gorodnichenko, Y. – Kueng, L. – Silvia, J. (2014): Innocent bystanders? Monetary policy and inequality in the US. October 25, 2014. http://voxeu.org/article/monetary-policyand-inequality-us Csortos, O. – Lehmann, K. – Szalai, Z. (2014): Az előretekintő iránymutatás elméleti megfontolásai és gyakorlati tapasztalatai (Theoretical considerations and practical experiences of forward guidance). MNB Bulletin, July, Magyar Nemzeti Bank, pp. 45–55. Csortos, O. – Szalai, Z. (2015): Az alacsony inflációs környezet és a visszafogott beruházási aktivitás lehetséges magyarázatai (Possible explanations of the low inflation environment and restrained investment activity). Financial and Economic Review, Volume 14, Issue 4, December 2015, pp. 29–56. D’Amico, S. – King, T. B. (2010): Flow and Stock Effects of Large-Scale Asset Purchases. Finance and Economics Discussion Series 2010-52. Washington: Board of Governors of the Federal System.

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Part I: An unconventional crisis with unconventional consequences DeLong, B. (2014): Over at Equitable Growth: Comment on: Ayako Saiki and Jon Frost: “How Does Unconventional Monetary Policy Affect Inequality? Evidence from Japan” http://delong.typepad. com/sdj/2014/08/over-at-equitable-growth-comment-on-ayako-saiki-and-jon-frost-how-doesunconventional-monetary-polic.html Engen, E. – Laubach, T. – Reifschneider, D. (2015): The Macroeconomic Effects of the Federal Reserve’s Unconventional Monetary Policies. Finance and Economics Discussion Series 2015-005. Washington: Board of Governors of the Federal System, http://dx.doi.org/10.17016/FEDS.2015.005. Evans, C. L. (2012): Monetary Policy in Challenging Times. Speech, C. D. Howe Institute, Toronto, Canada, November 27, 2012. Fed (2013): Usage of Federal Reserve Credit and Liquidity Facilities. https://www.federalreserve. gov/newsevents/reform_transaction.htm Fed (2014): Policy Normalization Principles and Plans, Federal Reserve Press Release, September 17, 2014. Federal Reserve (2015): Press release, December 16, 2015. https://www.federalreserve.gov/ newsevents/press/monetary/20151216a.htm Federal Reserve (2016): Press release, December 14, 2016. https://www.federalreserve.gov/ newsevents/press/monetary/20161214a.htm Federal Deposit Insurance Corporation, Failed Bank List, https://www.fdic.gov/bank/individual/ failed/banklist.html Federal Reserve System Annual Reports (2015): Domestic Open Market Operations During 2014. Felcser, D. – Lehmann, K. (2012): A Fed inflációs célja és a bejelentés háttere (The Fed’s inflation target and the background of the announcement). MNB Bulletin, October, Magyar Nemzeti Bank, pp. 24–37. Freixas, X. – Giannini, C. – Hoggarth, G. – Soussa, F. (1999): Lender of last resort: a review of literature. In: Bank of England: Financial Stability Report, November 1999, pp. 151–167. Furman, J. (2016): The New View of fiscal policy and its application. November 2, 2016. http://voxeu. org/article/new-view-fiscal-policy-and-its-application Fuster, A. – Willen, P. S. (2010): $1.25 Trillion is Still Real Money: Some Facts about the Effects of the Federal Reserve’s Mortgage Market Investments. Public Policy Discussion Paper, Federal Reserve Bank of Boston, vol. 10 no. 4. Gagnon, J. – Raskin, M. – Remache, J. – Sack, B. (2011): The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases. International Journal of Central Banking, March 2011. Hamilton, J. D. – Wu, J. C. (2010): The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment. Working Paper, San Diego, University of California. Hancock, D. – Passmore, W. (2011): Did the Federal Reserve’s MBS Purchase Program Lower Mortgage Rates? Finance and Economics Discussion Series, no. 1, Board of Governors of the Federal Reserve System (U. S.).

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3 The Fed’s monetary policy after the crisis Ihrig, J. E. – Klee, E. – Li, C. – Schulte, B. – Wei, M. (2012): Expectations about the Federal Reserve’s Balance Sheet and the Term Structure of Interest Rates. Finance and Economics Discussion Series 2012-57. Washington: Board of Governors of the Federal Reserve System Ihrig, J. E. – Meade, E. E. – Weinbach, G. C. (2015): Monetary Policy 101: A Primer on the Fed’s Changing Approach to Policy Implementation. Finance and Economics Discussion Series 2015-047. Washington: Board of Governors of the Federal Reserve System, http://dx.doi.org/10.17016/ FEDS.2015.047. Krishnamurthy, A. – Vissing-Jorgensen, A. (2011): The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy. NBER Working Paper, no. 17555. Krugman, P. (2014): Notes on Easy Money and Inequality. New York Times The Opinion Pages October 25, 2014. https://nyti.ms/2kdzmTk Lehmann, K. – Mátrai, R. – Pulai, Gy. (2013): A Federal Reserve System és az Európai Központi Bank válság során alkalmazott intézkedéseinek bemutatása (Measures taken by the Federal Reserve System and the European Central Bank during the crisis). MNB Bulletin, October, Magyar Nemzeti Bank, pp. 100–109. McLeay, M. – A. Radia – R. Thomas (2014b): Money Creation in the Modern Economy. Bank of England Quarterly Bulletin, 54(1), pp. 14–27. Mester, L. J. (2016): The Economy and Monetary Policy. Speech, Global Interdependence Center, Sarasota, FL, February 19, 2016. Meyer, M. (2016): The Fed’s cacophony of sound. Bank of America Merrill Lynch, Liquid Insight, 9 September 2016. Neely, C. J. (2015): Unconventional Monetary Policy Had Large International Effects. Journal of Banking & Finance, Volume 52, March 2015, pp. 101–111, http://dx.doi.org/10.1016/j. jbankfin.2014.11.019. Pál, T. (2014): Jegybankok tűzvonalban (Central banks in the firing line), In: Veress, J. DSc. (ed.) (2014): Gazdaságpolitika, oktatási segédanyag (Economic policy, learning material). Budapesti Műszaki és Gazdaságtudományi Egyetem, Gazdaság- és Társadalomtudományi Kar Üzleti Tudományok Intézet, Budapest, pp. 98–139. Stroebel, J. C. – Taylor, J. B. (2009): Estimated Impact of the Fed’s Mortgage-Backed Securities Purchase program. NBER Working Paper, no. 15626. Swanson, E. T. (2015): Measuring the Effects of Unconventional Monetary Policy on Asset Prices. NBER Working Paper, no. 21816, December 2015. White, L. H. (1999): The Theory of Monetary Institutions. Blackwell Publishers Inc. Williams, J. C. (2014): Monetary Policy at the Zero Lower Bound – Putting Theory into Practice. Hutchins Center on Fiscal and Monetary Policy at Brookings, January 16, 2014. Yellen, J. (2014): Speech at the “Central Banking: The Way Forward?”, International Symposium of the Banque de France, Paris, France, 7 November, https://www.federalreserve.gov/ newsevents/speech/yellen20141107a.htm

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The ECB in new territory — “Whatever it takes”? Judit Csutiné Baranyai – Kristóf Lehmann – Balázs Mérő

During the global financial crisis that started in 2007 and the debt crisis of the euro area in 2010, real economic performance declined and disturbances appeared in the operation of the financial system and money markets. Willingness to lend and risk-taking weakened, a number of sub-markets became non-functional, and the government bond yields of certain euro-area Member States increased significantly. The European Central Bank (ECB), similar to other large central banks, responded with rapid interest rate cuts, but other key elements in the responses to the crisis was the modification of the instruments, and in particular the introduction of unconventional tools, which helped to stabilise the financial markets. In contrast to other large central banks, the regional disparities within the euro area posed significant challenges to the ECB in managing the crisis, and the situation was exacerbated by the limited nature of fiscal policy, due to the deficit ceiling of 3 per cent relative to GDP. The economic situation and structure of northern and southern countries was different even at the time of their accession to the single currency area, and the crisis only deepened the differences. As a result, the crisis posed varying problems for the individual countries, which would have called for different crisis management approaches at the national level, but there was no fiscal room for manoeuvre for that and no country-specific monetary instruments could be used. On the one hand, the ECB responded to the 2007–2008 crisis by modifying its existing instruments. It increased liquidity through various means, providing US dollar liquidity with the help of FX swap tenders. In addition, in May 2009, it launched its first bond purchase programme (CBPP1). Overall, the measures proved to be effective in stabilising the banking system by increasing interbank liquidity, but this merely addressed the symptoms without providing a long-term solution. — 140 —

4 The ECB in new territory — “Whatever it takes”?

During the management of the sovereign debt crisis, the primary objective was to avoid a default of peripheral countries. To this end, the ECB sought to reduce the disruptions on the bond market and to restore transmission through its measures. The measures introduced (the Securities Markets Programme, announcement of the 3-year LTRO tenders, Mario Draghi’s “Whatever it takes” speech and the OMT announcement) contributed to a substantial decline in the government securities yields of the peripheral countries. In mid-2014, the ECB’s Governing Council announced an easing package consisting of several instruments. The goal of this package was to raise inflation to the central bank’s target by boosting the balance sheet total to around EUR 3,000 billion. The programme was expanded with government securities purchases in early 2015 and with corporate bond purchases in the second half of 2016. The ECB modified the parameters of the purchases several times, leading to further easing in all cases, and a new targeted long-term refinancing programme (TLTRO II) was announced. The unconventional instruments helped jumpstart the economy, but not all transmission channels were considerably affected by them. At the end of 2016, the conditions necessary for normalisation are still not yet in sight, the problems with the banking system persist, and regional disparities have not been reduced.

4.1 Introduction During the management of the crisis, the European Central Bank faced more complex issues than other developed-country central banks due to the negative loop between the difficulties of the banking system and the uncertainties of fiscal sustainability as well as the lack of a uniform institutional system after the establishment of the monetary union. The European Central Bank (ECB), similar to other large central banks, responded with rapid interest rate cuts, but other key elements in the responses to the crisis included the modification of the instruments, and in particular the introduction of unconventional instruments, which helped stabilise financial markets (Krekó et al. 2012, Lehmann et al. 2013). Since banks play a pivotal role — 141 —

Part I: An unconventional crisis with unconventional consequences

in the transmission of the key interest rate towards the real economy, the ECB’s unconventional responses to the crisis were principally aimed at resolving the disturbances in the banking system. In the euro area, approximately 70 per cent of financing occurs via the banking sector, while this proportion is reversed in the United States. However, the corporate securities market in the euro area is underdeveloped compared to that of the Anglo-Saxon countries. Similar to the Fed’s approach, crisis management efforts were mainly aimed at solving acute problems, but implementation was difficult because the structural and institutional issues of the euro area became more pronounced during the crises. As the institutional system was not unified after the creation of the monetary union in the euro area, the lion’s share of crisis management had to be performed by monetary policy. Prior to the crisis, the ECB’s monetary policy instruments comprised open-market operations, mainly MRO (main refinancing operations) tenders, longer-term LTRO operations (long-term refinancing operations, typically with a maturity of 3 months), repurchase agreements, the marginal lending facility, the deposit facility and the central bank reserve requirements. However, the shocks to the euro area necessitated the use of new, unconventional tools.

4.2 The steps of the crisis management The impact of the sub-prime crisis that originated in the US hit the euro area, mainly affecting the banking system, but the real economy also experienced a downturn. As a first step, the ECB responded by lowering the key interest rate to 0.25 per cent. As the crisis deepened, in the wake of the Lehman Brothers bankruptcy in September 2008, distrust increased among banks. In this situation, the ECB was faced with the drying-up of interbank markets and a rise in interbank yields. The ECB adapted to the new situation by reforming its existing instruments, considerably increasing liquidity (Lehmann et al. 2013). The instruments employed by the ECB during the crisis are summarised in Table 4-1. — 142 —

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TLTRO I

TLTRO II

FX swap

CBPP1

CBPP2

CBPP3

SMP

ABS

PSPP

CSPP

Targeted longer-term refinancing operations

FX swap tenders

Covered bond purchase programme

Securities market programme

Asset-backed securities

Public sector purchase programme

Corporate sector purchase programme

Source: ECB.

LTRO

Long-term refinancing operations

Short name

MRO tenders

Name

Main refinancing operations

Change in asset type

Bond issue and lender incentive

Term

Purchasing ABS'

Asset purchase in secondary markets

Covered bond purchase

Dollarliquidity for 1 and 3 month terms

Availability depends on lender's activity

Government security purchase not available

Longer availability

Corporate bond purchase

Quantity

512 EUR bil (2) 507 EUR bil (2)

2014—2018 2016—2020

from 2016

from 2015

51 EUR bil

1265 EUR bil

23 EUR bil

200 EUR bil

2010—2012

from 2014

203 EUR bil

16 EUR bil

2011—2012 from 2014

60 EUR bil

2009—2010

from 2008

230 EUR bil (1)

150-200 EUR bil extra liquidity provided

from 2014

Limitless availability, easing the from 2008 eligibility criteria of the underlying assets

Achieving inflation target and Government security purchase boost real economy

Stimulance SME sector

Easing the bond market tensions, repairing transmission mechanism

Achieving inflation target

Lowering spreads on bond markets

Support the covered bond market, lowering spreads, liquidity providing

Dollarliqudity provider

Incentivising bank lending to real economy

Lender incentive

Liquidity providing

Aim

Table 4-1: Unconventional instruments of the ECB

4 The ECB in new territory — “Whatever it takes”?

Part I: An unconventional crisis with unconventional consequences

MRO tenders

As a first step, on 8 October 2008, the Governing Council decided on the full allotment of MRO tenders at the base rate. From that time on, the banks of the Eurosystem could access central bank liquidity in unlimited amounts, as long as they had adequate collateral. In parallel with this, the width of the interest rate corridor was reduced from 200 basis points to 100 basis points to prevent market overnight (O/N) interest rates from moving away from the base rate. As a result of the measures, recourse to the MRO tenders increased by about EUR 150 billion in the initial period and the size of the deposit facility rose by over EUR 200 billion. In parallel with this, the average number of overnight transactions on the uncollateralised interbank market fell by almost 40 per cent, and the EONIA (Euro OverNight Index Average) fell to around the bottom of the interest rate corridor. Seeing this, the ECB widened the interest rate corridor back to 200 basis points in January 2009, but this did not significantly raise the number of overnight transactions on the interbank market, and the EONIA also stayed at the bottom of the widened interest rate corridor (Lehmann et al. 2013). Full allotment only helped those banks that had eligible collateral of sufficient volume and quality to receive collateralised loans from the ECB. In order to enable the banks to refinance the larger part of their assets and not to be dependent on the frozen interbank market, the ECB widened the range of eligible collaterals in several rounds and also reduced the credit rating threshold. The risks of the more lenient criteria were offset by the more thorough analysis of counterparty risks and stricter risk management processes. LTRO tenders

Extending the maturity of the liquidity-providing operations also served to ease banks’ liquidity strains. Prior to the crisis, the ECB only performed 3-month LTRO operations. When financing channels were shrinking for certain banks, the ECB increased the maturity of LTROs. — 144 —

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On 15 October 2008, the full allotment of the 3-month loan tenders, the 6-month tenders introduced in April 2008 and the 1-month tenders used from September 2008 (LTROs) at fixed interest rates was decided. On 7 May 2009, the ECB announced that it would hold three 1-year LTRO tenders between June and December 2009. The first two tenders were allocated at the MRO interest rate, thereby fixing the one-year point of the yield curve, and the last one was announced at the average MRO rate for the period. FX swap tenders: Providing US dollar liquidity

With the help of the mutual swap agreements concluded among developed country central banks, the ECB was also able to fulfil the dollar liquidity demand of euro-area banks. Within the framework of the FX swap tenders, the Fed provided the ECB with dollar liquidity in the form of euro/dollar FX swap transactions, which the ECB passed on to the banks of the Eurosystem for 1-month and 3-month maturities, also in the framework of FX swap operations. The world’s large central banks started regular FX swap tenders on 18 September 2008 in response to the dollar liquidity demands that soared as a result of the bankruptcy of Lehman, in the course of which the central banks (the Canadian, British, Japanese and the Swiss central bank and the ECB) provided banks with dollar liquidity, with the help of Fed, in exchange for local currency. In addition, similar to the Fed, the ECB also concluded swap agreements with the central banks of the more developed European countries, thus with the Swiss, Danish and Swedish central banks. The agreements and the swap transactions ensured the FX liquidity of the European banking system, and therefore commercial banks were able to meet their obligations even during disturbances on the interbank markets. First covered bond purchase programme (CBPP1)

The Governing Council of the ECB decided to launch the covered bond purchase programme (CBPP) at its meeting held on 7 May 2009. The covered bond market is one of the most active bond market segments in the euro area, and it is key from the perspective of financing — 145 —

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the banking system. The ECB assessed that the crisis had hit this submarket more severely than the other segments of the securities market. The purpose of the programme was to mitigate covered bond market disturbances, reduce the spreads, boost liquidity and thus encourage primary issuance. With the primary and secondary market purchases, the ECB wanted to support the liquidity of specifically this submarket, and to ease the financing conditions of credit institutions and corporations, as well as encourage credit institutions to maintain or even expand, if possible, their lending. Within the framework of the CBPP, the ECB purchased covered bonds in the total value of EUR 60 billion between July 2009 and June 2010. The ECB did not separately sterilise the liquidity that flowed out during the programme, and thus the instrument increased the banking system’s euro liquidity. Once the programme was announced, covered bond spreads started narrowing immediately, issuing activity intensified and market liquidity came close to the pre-crisis levels. Later, most spreads returned to the levels seen before the announcement of the programme; presumably by this time the main risk was represented by banks’ peripheral government bond exposures. Based on the research by Beirne et al. (2011), the ECB’s first covered bond purchase programme can be considered successful. The yield spread of covered bonds dropped, money market yields diminished and bond markets became more active at all maturity horizons. The average yield reduction on the covered bond market during the course of the programme was 12 basis points. The programme successfully encouraged the issuance of covered bonds on the primary market, thereby enhancing banks’ financing conditions and boosting bank lending. The main deficiency of the covered bond purchases was that no spillover effects emerged, i.e. it had no impact on the market for normal bonds. Another crucial experience is that in the euro-area countries struggling with the sustainability of government debt, the programme was unable to improve yields on the covered bond market, and it was completely ineffective. — 146 —

4 The ECB in new territory — “Whatever it takes”?

As a result of the above-mentioned measures (that are collectively referred to as “enhanced credit support”), the ECB’s balance sheet total increased considerably, and the liquidity available to the credit institutions of the euro area expanded substantially in the period when the drying up of the interbank markets threatened the stability of the banking system (Lehmann et al. 2013). However, the instruments which were successful in the short run were unable to address the euro area’s long-term problems: they were unsuited to prevent the contagion unfolding in 2011, which originated in peripheral countries and spread to other euro-area economies.

Measures taken in response to the sovereign debt crisis

As the Greek debt crisis surfaced in the spring of 2010, a sovereign debt crisis started in the euro area, which quickly spilled over to the banking system of the periphery. Investors started to worry that there might be difficulties in the case of other government securities as well. The concerns were considerably heightened by the new policy announced by Merkel and Sarkozy in October 2010, namely that the private sector should also take part in debt restructuring. The policy was first applied in the summer and autumn of 2011, during the announcement of the second Greek bailout package, and private investors sustained heavy losses. Since investors were fleeing the government securities market and the contagion also spread to other peripheral government securities, interest rates soared in certain countries to levels that called into doubt these countries’ solvency. This situation did not arise from the sudden deterioration of peripheral countries’ fiscal position, but rather from the change in investors’ expectations that the ECB would be unable or unwilling to intervene in order to restore equilibrium (Micossi 2015). Considering the crucial significance of the government securities market in private sector lending, as well as its role in banks’ balance sheets and in liquidity operations, all this considerably undermined the transmission of the key interest rates to the real economy, and therefore the measures had to focus on this market segment. — 147 —

Part I: An unconventional crisis with unconventional consequences

Securities Markets Programme (SMP)

The ECB announced its Securities Markets Programme (SMP) on 10 May 2010 to mitigate the disruptions of the bond market and restore transmission. Officially, the goal of the programme was to manage the inadequate functioning of securities markets and restore the transmission mechanism without changing the standard instruments. Within the framework of the programme, the ECB made purchases on the secondary market – due to the prohibition of monetary financing – primarily aimed at the bonds of peripheral countries. Furthermore, the liquidity-enhancing impact of these purchases were sterilised by dedicated fine-tuning operations aimed at the reduction of liquidity (one-week deposit tenders). Immediately after the announcement of 10 May 2010, spreads nosedived, but then started rising again the next day, and in a couple of months they were above the level seen before the announcement in May. Until the termination of the programme in September 2012, the ECB purchased government securities and other bonds in a volume of EUR 200 billion. In the short run, the programme had a positive effect on the government bond yields of peripheral countries, but it was unable to successfully lower long-term yields. The results of the SMP include the fact that it gave governments time to implement the necessary fiscal and macroeconomic adjustments, and for a while it prevented the uncontrolled increase of the periphery government bond yields and reduced the spread of contagion to other markets. However, the central bank government securities purchases alone were unable to reinstate market confidence in the peripheral countries of the euro area, and the ECB was unable to reduce long-term yields in peripheral countries. Long-term liquidity provision, 3-year LTRO tenders

The unfolding debt crisis in the euro area necessitated a response that was capable of ensuring the banking system’s liquidity even in the medium term. In December 2011, the 3-year LTROs with full allotment were introduced. After this a major part of the liquidity in the system was provided by the LTROs. With the 3-year LTRO, the — 148 —

4 The ECB in new territory — “Whatever it takes”?

ECB managed to mitigate the negative impact of the sovereign risks on the banking system and prevented a credit crunch; however, it only managed to temporarily reduce the government bond yields of the peripheral countries. Later, with the significant improvement of the situation of financial markets in the euro area, banks started to repay the 3-year LTRO loans faster than expected. Second covered bond purchase programme (CBPP2)

On 6 October 2011, the ECB announced the launch of the second covered bond programme (CBPP2), within the framework of which it planned to purchase covered bonds on the primary and secondary markets in the amount of EUR 40 billion between November 2011 and October 2012. After the announcement of the programme – in contrast to the first one – no immediate, sustained fall in the spreads was observed. Covered bond spreads started to decrease more significantly only in late 2011 and early 2012, which was also affected by the impact of the 3-year LTRO tenders. The decrease in spreads did not prove to be lasting and by June 2012 spreads had reached the levels seen before the announcement of the programme. During the programme, market demand increased, and – due to the lower-than-expected willingness to issue – the ECB purchased covered bonds only for EUR 16 billion, i.e. 40 per cent of the planned amount. Communication bombshell: “Whatever it takes”

In 2012, the main priority for the ECB continued to be the management of the debt crisis. The fears connected to the disintegration of the euro area escalated once again in the summer of 2012. The view that the euro area cannot be sustained in its present form became increasingly widely held among market participants. In the case of certain countries, historically low sovereign spreads emerged, while peripheral countries saw record levels of spreads. The jump in the spreads caused by the fears of the break-up of the monetary union could not be adequately mitigated by the earlier measures (e.g. SMP). The ECB assessed that the solution was not the introduction of another programme, but more robust and clear communication. — 149 —

Part I: An unconventional crisis with unconventional consequences

In the period characterised by the risk of a euro-area break-up, Mario Draghi held a speech on 26 July 2012, in which he stated that on average, the euro area as a whole does not fare worse in terms of economic and social indicators than the US or Japan. He underlined that in the preceding half year huge developments had happened in the currency area: a cap had been put on deficits, structural reforms had been introduced and the convergence between the Member States had gained momentum. And according to his message with political overtones, the ECB considered the euro irreversible, and he said that “within its mandate, the ECB is ready to do whatever it takes to preserve the euro”. Draghi pointed out the segmentation of the euro area’s financial markets as a short-term challenge, especially the excessive spreads of government bond yields. In connection with this, Draghi said that “to the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission channel, they come within our mandate.” This suggested that the ECB was willing to assist in reducing yields through bond purchases as well. Although short-term and long-term euro-area yields did not immediately exhibit a substantial response to the speech, the previous weakening trend of the euro against the US dollar reversed, and the single currency strengthened over a one-month horizon. However, in the longer term, yields started to decline. The debt crisis was to be managed through the outright monetary transactions (OMT) announced on 2 August 2012, at the same time when the SMP was terminated. The significance of the programme lies in the fact that the ECB made it clear with the announcement that it wished to maintain the unity of the euro area by all means available to it under its mandate. As part of the OMT, the ECB committed itself to purchasing unlimited amounts of the government bonds of the given countries with shorter maturities (up to 3 years) on the secondary market, provided that the country participated in an EU/IMF programme and implemented fiscal — 150 —

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adjustment, and the purchases were subject to other criteria as well. These requirements were necessary to show that the instrument was not designed for budget financing. The OMT, as opposed to the SMP, has no upper limit, but it is subject to strict structural conditions. The programme sought to restore the unjustifiably high peripheral country yields and the damaged monetary transmission channel. No actual purchases were made during the programme, and therefore it can be considered a principally verbal intervention. The announcement proved to be successful, since yields started to drop gradually in peripheral countries. By this time, the institutions helping the implementation of the EU/IMF programmes and providing financing to the euro area (EFSF/ESM) had already been set up, and the economic and fiscal reform measures had already yielded partial results in several countries. The programme was challenged on legal grounds: several petitions were submitted in connection with the legality of the OMT from German political and economic circles (see Box 4-1). Box 4-1 Legal proceedings against the ECB

The first open criticisms were levelled against the ECB after the announcement of the OMT by German economists and politicians, questioning the legality of the programme. The German Federal Constitutional Court received several constitutional complaints and an action on the cooperation of the Deutsche Bundesbank (German central bank) in the implementation of the OMT programme and the alleged failure of the federal government and the lower house of the federal parliament (Bundestag) to take steps against the programme. The complainants and the plaintiff argued that the OMT was outside the mandate of the ECB and violated the prohibition of monetary financing of euro area Member States on the one hand, and violated the principle of democracy enshrined in the German Basic Law on the other hand, thereby harming German constitutional identity (EC press release 2015). The German Constitutional Court referred the case to the European Court of Justice.

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No verdict was reached until June 2015. In a preliminary ruling, the European Court of Justice stated that the European Central Bank’s bond purchase programme was legal. As in the euro area the EU and thus the European System of Central Banks headed by the ECB have exclusive powers in the field of monetary policy, and the OMT is a monetary policy instrument, the EU’s central bank did not misuse its power. One year later, the German Constitutional Court also ruled that if the purchases are limited and only carried out when special criteria are satisfied, they do not constitute an intervention in the German budget and do not extend beyond the purview of the ECB (Kahn 2016). The verdict of the European Court of Justice and the 2015 launch of the government securities purchase programme was followed by another wave of lawsuits. In six months, three new disputes were brought to court in connection with the asset purchase programme of the ECB. The petitions were submitted by German politicians who had lost the earlier cases linked to the OMT. One of them was filed by a spokesperson of the Federal Constitutional Court, one by the head of the Alfa party, and the third by Gauweiler, according to whom the ECB acted as a “bad bank” by purchasing bad loans from distressed banks, thereby acting in the interests of only these banks, and that the ECB wished to raise inflation through printing huge amounts of money. Furthermore, Gauweiler also personally criticised Draghi for his alleged partiality. Neither of the lawsuits ended in a ruling condemning the ECB, but the constant attacks threaten the credibility of the central bank.

The ECB’s monetary policy measures were ultimately successful in managing the debt crisis. On account of the Securities Markets Programme, Draghi’s speech, the OMT announcement and the government securities purchase programme announced in January 2015, a substantial decline in government securities yields was observed in peripheral countries, and therefore a negative spiral causing contagion was avoided.

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4.3 Protracted crisis — The goal is to stimulate the economy The fears of persistent stagnation in the euro area and a sustained downturn in emerging markets provoked political “panic” in the euro area (Krugman 2014). In connection with the 2015 budget, Germany came under pressure once again related to the adoption of the national or euro-area fiscal stimulus, but the German finance minister, Wolfgang Schäuble, dismissed this. Schäuble claimed that there was no need for investment programmes in Europe, but he believed that economic reforms were necessary. Neither he, nor Jens Weidmann, president of the Bundesbank, regarded the concerns linked to the global economic outlook as being justified; in fact, Weidmann blamed the IMF for painting a more negative picture of the situation of the global economy than justified. Meanwhile, equity prices experienced a sustained decline, and oil prices also exhibited a considerable drop. Some believed that with respect avoiding persistent stagnation, the appropriate solution was the simultaneous use of fiscal stimulus, structural reforms and comprehensive monetary policy easing. Fiscal stimulus should have amounted to 1–2 per cent of GDP, emerging in a balanced manner between core and peripheral countries, and deregulation would have been necessary in the services market (Moghadam 2014). In the economic environment characterised by deteriorating global economic conditions, flagging global trade and increasing uncertainty, the growth prospects of the euro area shifted downwards, although the growth rate stayed positive all along. By the second half of 2014, inflation had fallen short of the 2-per cent central bank target for a long time. However, low inflation was not caused by a drop in aggregate demand, but rather by the negative price changes in some countries and the low energy and commodity prices. Long-term (5x5) inflation expectations also shifted downwards, and deflationary fears intensified, although the risk of deflation affecting the whole euro area did not emerge (Chart 4-1).

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Chart 4-1: Inflation and 5x5 inflation expectations (2014—2016) 1.0

Per cent

2.4

0.8

2.1

0.6

1.9 1.6

0.4

1.4

0.2

1.1

0.0

0.8

–0.2

0.6

Inflation

Sep. 2016

Jul. 2016

May. 2016

Mar. 2016

Jan. 2016

Nov. 2015

Sep. 2015

Jul. 2015

May. 2015

Mar. 2015

Jan. 2015

Nov. 2014

–0.2

Sep. 2014

–0.8

Jul. 2014

0.1 May. 2014

–0.6 Mar. 2014

0.3

Jan. 2014

–0.4

5x5 forward implied inflation (right-hand scale)

Source: Bloomberg, OECD.

The above-mentioned developments called for further stimulus. Accordingly, the Governing Council announced an easing package consisting of several instruments (interest rate cuts, new liquidityproviding programmes, ABS and covered bond purchases). The goal of these measures was to increase the effectiveness of the previously introduced instruments and to raise inflation to the central bank’s target by boosting the ECB’s balance sheet to around EUR 3,000 billion. ECB decision-makers increasingly pointed out that meeting the inflation target required fiscal policy assistance, in addition to monetary policy. Introduction of the negative policy rate

The possibility of negative deposit rates had been present for years, and the ECB stressed that it was prepared for their introduction in technical terms, but these rates were not introduced until mid2014. With the November 2013 interest rate cut, when the key interest rate was reduced to 0.25 per cent, the lower bound of the interest rate — 154 —

4 The ECB in new territory — “Whatever it takes”?

corridor stayed at 0 per cent, avoiding negative deposit rates. According to the justification, the inflation expectations in line with the central bank target did not warrant the introduction of negative deposit rates, which were introduced only at the June 2014 meeting. Then both the key interest rate and the deposit facility rate were reduced by 10 basis points, and therefore the latter decreased to –10 basis points. The decision was justified by the increasing risks connected to the ECB’s price stability objective. Decision-makers underlined the importance of the steadily intensifying but sluggish growth and the persistently below-target inflation. With a further 10-basis point decrease in September 2014, the ECB reached the zero lower bound of the key interest rate. In March 2016, the ECB decided that further interest rate cuts were necessary in order to avoid the external shocks from emerging economies, high market volatility and second-round effects; therefore, from 16 March 2016, all three elements of the interest rate corridor were reduced (the main refinancing rate was lowered to 0, the marginal lending rate was lowered to 0.25 per cent, while the deposit rate was cut by 10 basis points to –0.4 per cent). The central bank pays (the same) negative interest on overnight deposits and on excess reserves, which affected 2.2 per cent of the euro-area banking system’s balance sheet total in mid-2016. In the ECB’s view, the negative deposit rate proved to be effective in relaxing financial conditions. However, the central bank came under heavy criticism for using a negative policy rate. The criticism was mainly expressed by core countries, especially by German politicians. These concerns were chiefly related to the harmed interests of savers and the reduction of bank profitability, and they also called into question the legality of the measures. Targeted liquidity-provision for lending: TLTRO I and TLTRO II

The ECB’s objective with the targeted long-term refinancing operation (TLTRO) announced on 5 June 2014 was to stimulate private sector lending and the real economy, by ensuring that banks do not use it for purchasing government bonds, in contrast to the 3-year LTROs. (If they — 155 —

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do so, the loans with 4-year maturity must be repaid after 2 years.) This instrument provides the ECB’s counterparty banks with a cheap and stable source of finance, which, under the TLTRO, are eligible for loans amounting to 7 per cent of their total loan portfolio, which they have to lend on to the private sector. The loans include only those granted to the non-financial sector, with the exception of household housing loans. The interest rate of the TLTROs is fixed at the prevailing MRO level for the entire 4-year maturity. Banks must make a commitment with regard to the development of their total loan portfolio, but even if they fail to meet this target, they have to repay the loans only after 2 years. In addition, banks could receive additional refinancing amounting to three times the volume of their net lending in each quarter between June 2015 and June 2016. Initially, the refinancing rate exceeded the key interest rate by 10 basis points, but the spread was then eliminated in January 2015. Of the announced measures, the ECB expected the TLTRO to contribute the most to the expansion of the balance sheet total to EUR 3,000 billion. Although the programme slightly fell short of this objective, Draghi stated on 10 March 2016 that the TLTRO I had been successful: in terms of the total amount of the liquidity operations, a large portion of the earlier 3-year LTROs were replaced by TLTROs, and the whole portfolio stayed at around EUR 500 billion. The ECB launched a new targeted longer-term refinancing programme (TLTRO II) in June 2016, with four credit instruments of 4-year maturity each, the interest rate of which depends on the lending activity and may be as low as the ECB deposit rate (–0.4 per cent). The central bank seeks to make the financing of bank lending even more predictable with this instrument, as it provides a 4-year credit line at very low and fixed interest rates, with some of the details depending on banks’ earlier and future lending activity. The TLTRO II amounts to 30 per cent of the dedicated loan portfolio,35 from which the earlier TLTRO loans have to be deducted. The participating commercial banks 35

edicated loans include loans to non-financial corporations and non-housing loans D disbursed to households.

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receive funding from the ECB at the main refinancing rate; however, a lower interest rate will be charged over the entire term in the case of those banks whose net dedicated lending exceeds the reference period value between 1 February 2016 and 31 January 2018. The lower interest rate is tied to the deposit rate prevailing at the time when the financing source is drawn down. The tenders are announced quarterly, between June 2016 and March 2017. Two issues have been raised in connection with the efficiency of the programme. First, by providing funds at negative interest rates, the ECB automatically increases the profitability of the banking system, and second, in contrast to the first programme where banks were required to repay the amount drawn down if it was not used for real economy financing, this requirement is not included in the rules. The first problem raises the issue that in the context of ample available liquidity, the ECB automatically generates profits by channelling back to the banking system, by way of the TLTRO, a portion or the whole amount of the sum deducted through the negative interest rate on excess reserves and overnight central bank deposits. Therefore, the programme may cancel the effect of the negative interest rate, or, at any rate, it weakens its impact. The second issue may be raised by the lack of the repayment requirement in the case of using the funds for purposes not in line with the intentions, i.e. banks that do not lend to the real economy at all, can avail themselves of this 0-per cent scheme without limitation. This may undermine the original aim of the TLTRO programmes, i.e. the enhancement of monetary transmission by fostering banks’ lending activity to the real economy. The ECB has not provided any concrete explanation for removing this rule; President Draghi stated at the press conference after the announcement that the instrument enables safe financing at a low price in a volatile environment at a time when large amounts of bank bonds are about to mature (Merler 2016). In the first two tenders, net recourse was EUR 37 billion and EUR 34.4 billion, respectively, therefore recourse to the new and the earlier long-term credit instrument (LTRO) amounted to EUR 71.4 billion net in total over the two quarters. Due to conditionality, this may exert a positive — 157 —

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impact on euro-area bank lending, but no significant jump in credit flows should be expected. Expanded asset purchase programme (EAPP)

In June 2014, the ECB launched another wave of monetary easing through unconventional instruments (the SMP sterilisation was suspended, the TLTRO was announced). Although the possibility of securities purchases had already been suggested in executive declarations, the decision in September that the ECB would launch the asset-backed securities purchase programme (ABSPP) and the third covered bond purchase programme (CBPP3) in the autumn of 2014 in order to achieve the inflation target, still surprised the markets. In 2013, the ECB stated several times that it would like to stimulate the securitised loan market (the asset-backed securities or ABS market), thereby promoting the financing of the small and medium-sized enterprise (SME) sector. Nevertheless, the corporate asset-backed securities purchase programme (ABSPP) was only announced in the autumn of 2014. The idea behind the programme was that a wellfunctioning ABS market would facilitate the achievement of the price stability objective by improving the transmission mechanism and creating a link between investors with funds and smaller firms in need of credit but less visible to investors. The securitised market would be beneficial from a financial stability perspective as well, since the simple and transparent assets supported by the ECB would be appropriately standardised. The non-performance rate on ABSs fell well short of the rate observed in the United States, thanks to the fact that there was no secondary (subprime) credit market in Europe. After the announcement, Mario Draghi stated that stimulation of the ABS market could motivate banks to make their lending rates reflect their low funding costs charged by the ECB within the framework of the targeted long-term refinancing operations (TLTRO). On the other hand, the programme may also achieve a portfolio effect, as non-bank investors may be attracted to the ABS market. With this, the SMEs may access more a diversified group of investors and funders. Finally, this package improved the — 158 —

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efficiency of other tools, through which the central bank wished to raise inflation to the target. The purpose of the third programme (CBPP3) was to help achieve the inflation target, rather than to enhance the activity of the sub-market, by encouraging lending via the banking sector and substantially increasing the balance sheet total of the ECB. Analysts believed that this asset class was included in the asset purchase programme to ensure that it can be implemented in all countries, even in those where the size of the originally targeted ABS market would not permit this. Although the covered bond purchase programme lifted inflation expectations somewhat, this did not prove to be persistent. However, the asset-backed bond purchasing programme did not influence the development of inflation expectations. By the end of 2014, inflation expectations had dropped even more, and five-year expectations were below the target. Even within the context of the announced easing measures (interest rate cut, ABS and covered bond purchases), the Governing Council emphasised its commitment to use further unconventional instruments in line with its mandate when the inflation outlook necessitated it. In view of the fact that the European financial system is less securitised than that of the United States, and that the first TLTRO tenders fell short of the expectations and asset purchases got off to a rocky start in late 2014, it was suggested that the EUR 1,000 billion expansion of the balance sheet total may require government securities purchases as well. Real quantitative easing: public sector purchase programme (PSPP)

At its January 2015 meeting, the ECB’s Governing Council expanded its securities purchase programme to include euro-area investmentgrade government securities (or non-investment grade, but issued by the programme countries) in addition to the securities purchase programmes launched in the autumn of 2014. As part of this, the ECB planned to purchase private and public securities in the secondary market in the amount of EUR 60 billion monthly, from March 2015 until September 2016, or until inflation increased permanently close to — 159 —

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the target. The volume of the programme is around EUR 1,000 billion, which includes the papers purchased in the framework of the assetbacked securities (ABS) and covered bond (CB) programmes launched earlier. The proportion of purchases is determined by the share of the central banks in the ECB’s capital. 80 per cent of the risks will appear in the balance sheets of the national central banks, while the remaining 20 per cent will be borne by the ECB. The maturity of the eligible government securities may be between 2 and 30 years. In addition, in order to mitigate the risks and market impacts, issuer and issue limits are applied. Should there be insufficient government securities issued by the countries, substitute securities36 may be purchased as well, a list of which is published by the ECB. The programme may include papers with negative yields, provided that the yields are not lower than the ECB deposit rate. At the end of 2015, the central bank believed that growth was still sluggish and that inflation had increased to around the target slower than expected. Therefore, at its December meeting, it decided to expand the conditions of the asset purchase programmes. It was announced that the monthly EUR 60 billion purchases would be extended until March 2017, or until longer, if necessary, until inflation converges steadily towards the central bank target. The capital value of the maturing securities purchased in the program is reinvested. In addition, the group of eligible papers was expanded: EUR-denominated, marketable papers issued by regional and local governments could now be purchased. The Governing Council once again amended the conditions of the purchases in March 2016: as part of the comprehensive easing package announced at the March meeting, the amount of monthly purchases was increased by EUR 20 billion to EUR 80 billion (Chart 4-2), and the issuer and issue limits were raised from 33 per cent to 50 per cent. At its December 2016 meeting, the central bank changed the conditions again. It was decided that the programme would be extended until the end of December 2017, and purchases were reduced 36

ubstitute papers may be bonds issued by designated international and supranatioS nal institutions registered in the euro area, a list of which is published by the ECB.

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to EUR 60 billion as of April 2017. Nevertheless, eligible papers now included securities with lower yields than the deposit rate and those with a residual maturity of one year or more instead of the previously used 2-year lower limit. The securities purchased in the programme, amounting to EUR 726 billion between the launch of the programme and May 2016, entailed a drop of merely EUR 82 billion in the government securities portfolio of euro area banks’ balance sheets. This means that the Eurosystem purchases were mainly targeting non-bank actors or foreign banks. Therefore, further purchases from the banking system may be necessary to reduce the role played by banks in financing (Hüttl and Merler 2016). Within the framework of the comprehensive programme of March 2016, the ECB extended the securities purchase programme to investment-grade EUR-denominated securities issued by companies registered in the euro area. The purchases were launched in June 2016 and are implemented by six national central banks acting on behalf of the ECB. In the programme, only papers which comply with the ECB’s requirements on collateral and are issued by private firms37 can be purchased on the primary and secondary market. Up to 70 per cent may be purchased per issue (ISIN), and residual maturity may be between six months and 30 years. The securities purchased within the framework of the CSPP are available for securities lending. The list of loanable papers is published each week by the ECB. The programme extension announced in March 2016 did not include any changes to the main parameters. According to Demertzis–Wolff (2016), banks’ profitability has declined due to the shrinking interest 37

he eligibility rules regarding issuers: Only non-bank issues may be purchased, T the institutions supervised by the SSM and their subsidiaries may not take part in the programme. The issuers whose parent company is a bank operating outside the euro area are also excluded, and no issuer may take part in the programme whose activities include bank services (e.g. it provides financial services) and is subject to the MiFID II.

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rate spread, and the bond purchase programme may shrink the spread even further by reducing bond yields. Chart 4-2: Asset purchases between December 2014 and October 2016 1600

EUR Billions

Per cent

800

400

Oct. 2014 Nov. 2014 Dec. 2014 Jan. 2015 Feb. 2015 Mar. 2015 Apr. 2015 May. 2015 Jun. 2015 Jul. 2015 Aug. 2015 Sep. 2015 Oct. 2015 Nov. 2015 Dec. 2015 Jan. 2016 Feb. 2016 Mar. 2016 Apr. 2016 May. 2016 Jun. 2016 Jul. 2016 Aug. 2016 Sep. 2016 Oct. 2016 Nov. 2016 Dec. 2016

1200

Covered bonds ABS

Government bonds Corporate bonds Inflation target (right-hand scale)

Source: Bloomberg.

4.4 Assessing unconventional instruments The success of the monetary policy responses to the 2007–2008 crisis, the measures taken in order to address the sovereign debt crisis of the euro area and the monetary policy steps taken after mid-2014 to stimulate the economy is best indicated by their impact on financial market and macroeconomic indicators (yields, lending, exchange rate, inflation, growth and unemployment). At the end of 2016, the euro-area economy was characterised by slow recovery, but neither growth nor inflation reached the desired level. The — 162 —

4 The ECB in new territory — “Whatever it takes”?

monetary policy steps taken by the ECB were able to tackle the problems of the euro area only partially and temporarily. The vulnerability of the banking system was still an issue: the main concern was the high proportion of non-performing loans. In a portion of the euro-area countries, the steadily high debt, while at the level of the euro area, the widening disparities posed challenges. The ECB’s measures could only have been successful if they had been coupled with an appropriate macroeconomic mix. However, in addition to the lack of support from other policies, the rationale behind the existence of the euro area started to be called into question. Even renowned economists believe that the common currency union did not live up to the expectations. According to Joseph E. Stiglitz (2016), instead of enhancing trade relations, blurring borders and fostering a common mentality, in the 17 years since its introduction, the euro has further widened the disparities within the euro area, leading to new crises and engendering common, increasing distrust. Monetary policy in itself was unable to tackle the euro area’s challenges. Lower-than-desired growth, the rising risks due to geopolitical developments and the increasing global uncertainty would have required a responsible, growth-friendly fiscal policy. In the context of persistently low inflation and low growth, fiscal policy is the key to successful debt reduction. In countries where the fiscal room for manoeuvre is greater, a well-chosen fiscal policy can not only stimulate the growth of the given country, it may even exert a positive influence over smaller regions with less leeway, since every country strives for sustainable growth (Buti and Rodriguez 2016). In Koo’s (2011) approach, the euro area will only be able to completely recover from the crisis if EU institutions declare that all of the countries affected by balance sheet recession employ the appropriate fiscal measures to support the process of the private sector’s debt reduction. In addition, for at least ten years, Member States should be required to purchase only those government securities that are issued by their — 163 —

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own country. The latter could ensure debt financing for countries with high debt. Global debt, which at the end of 2016 reached unprecedented levels, may stymie the vulnerable economic growth. Debt reduction would require a significant fiscal stimulus fostering economic activity, thereby contributing to the restructuring of households’ debt and the reduction of the proportion of non-performing loans (IMF 2016). Box 4-2 Fiscal policy’s role in the euro area

The overall performance of an economy is determined by the macroeconomic mix employed. The implementation of fiscal and structural reforms stimulates growth and thus plays a vital role in achieving monetary policy’s inflation target. In most countries of the euro area, fiscal policy only became slightly more expansive and growth-friendly in 2016. still, the structural reforms fostering investments are progressing at an extremely sluggish pace in the three largest economies of the euro area. It is indisputable that in euro-area monetary policy is not efficiently supported by other policies (Fratzscher et al. 2016). After the 2007–2008 crisis, euro-area governments adopted a substantial fiscal package, the average size of which was around 2 per cent of GDP. The largest package was observed in Spain, while in Italy and Greece, due to the limited room for fiscal manoeuvre, discretionary measures were not taken in order to avoid increasing the budget deficit. After the eruption of the sovereign debt crisis, governments were forced to take further fiscal steps. Access to the euro-area emergency funds created for managing the crisis (ESM, EFSM) was subject to significant fiscal adjustments and the implementation of reforms. Accordingly, substantial fiscal packages were introduced in the programme countries (Greece, Ireland, Portugal, Spain and Cyprus). Other countries, including the core countries, (Afonso et. al. 2010), which did not receive assistance, also underwent a substantial

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adjustment process. The measures mainly focused on the banking system and the protection of deposits. Despite the above-mentioned fiscal steps, in the absence of a euro-area institutional system and economic policy, stabilisation had to be performed almost single-handedly by monetary policy both during the 2007–2008 crisis and during the debt crisis that started in 2010. The flexibility of the EU Treaty is attested by the fact that the ECB was able to perform a wide range of activities, but the instruments and the procedures tested the limits. The ECB’s weight increased among the decision-making institutions of the EU, but this also meant that it extended over other economic policies (Micossi 2015). The most obvious phenomenon is the lack of contribution from fiscal policy. Wren-Lewis (2015) estimated that the lack of fiscal rigour reduced euro-area GDP by 4 per cent in 2013, and some estimates showed a 7.7 per cent impact. This is clearly a loss that monetary policy in itself cannot address. After hitting the zero lower bound, monetary policy may become effective if the negative output gap closes, since after that interest rates could rise. However, this requires an expansive, euro arealevel fiscal policy support. In the euro area, fiscal policy falls within the purview of the Member States. Although there is a common budget, it has limited duties and scope, amounting to merely 1.2 per cent of GNP. Financial integration and stability require the establishment of a common institutional system functioning according to principles similar to those of the ECB. However, in the short run, this is politically impossible, since this would require that Member States amend the existing treaties and constitutions (Tabellini 2016). Another challenge is that the room for fiscal manoeuvre varies widely across the Member States, and the necessary stimulus may also vary. Buti and Carnot (2015) examined the output gap and the budget deficit and concluded that in Germany, fiscal adjustment is excessive but economic activity should be intensified. By contrast, in France and Spain, demand should be stimulated, however, since the budget deficit will not sink to the appropriate level for a long time, this has to be the priority.

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In 2016, the euro area faced several challenges, especially the British referendum, as a result of which United Kingdom left the EU. Brexit had two lessons: uncertainties have risen considerably, which – coupled with the slowdown in emerging economies – may pose considerable challenges to the ECB. If the euro area experiences another recession, the ECB will not have any instruments for a successful recovery. This calls for a proactive fiscal policy in the euro area. On the other hand, it has become obvious that the average European citizens are dissatisfied with their current standard of living and do not see a common European goal. Thus, common European projects have to be created to avoid further political erosion (Boefinger 2016).

4.5 Inflation, growth, unemployment The effect exerted by unconventional instruments on inflation, growth and unemployment is difficult to quantify, since it would have to be established how the indicators would have developed without the measures. According to the ECB’s calculations, the programmes’ impact on inflation and GDP over the whole time horizon may amount to 0.4 per cent and 0.6 per cent, respectively. Demerzis and Wolff (2016) analysed the indicators at the time of the ECB’s announcements. At –0.6 per cent, inflation was the lowest in the month when the government securities purchase programme was announced, i.e. in January 2015. In May 2015, it stood at 0.3 per cent and then fluctuated between –0.2 and 0.3 per cent. The only substantial increase was observed in the autumn of 2016, when the consumer price index reached 0.4 per cent in September, 0.5 per cent in October and stood as high as 0.6 per cent in November, but this still falls well short of the inflation target of around 2 per cent. Core inflation was somewhat higher, but was still below 1 per cent. After the start of government securities purchases, a positive effect was felt for a short while.

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Five-year inflation expectations show a varied picture based on two different sources. Analyst surveys have steadily remained near the target over the whole period, which suggests that the experts believed that if enough time was available, inflation would rise to around the target with the help of the ECB’s measures. However, market-based expectations exhibited a downward trend. The difference may be attributable to the reduced credibility of the ECB. The confidence in the ECB that strengthened during the financial crisis now seems to be on the decline, which is mainly due to the euro-area economic policy mix, i.e. we can say that the loss of credibility was caused by factors outside the ECB’s purview (Demerzis–Wolff 2016). Euro-area GDP showed a downward trend for seven quarters from 2012, followed by a slight increase, with GDP peaking at around 2 per cent after the announcement of the government securities purchase programme. Growth in 2016 was driven by consumption and investments. Faster growth would require a higher growth rate of investments. Investments have exhibited a slight rise since 2014 Q1, peaking at 3.9 per cent in 2015 Q4. The impact of the government securities purchase programme with respect to investment activity cannot be established. After peaking in 2013 Q2 (12.1 per cent), the euro-area unemployment rate gradually decreased to around 10 per cent by the end of 2016. The announcements of the ECB had no significant impact on this indicator and the gradual decline continued. However, within the region, the labour market is not homogeneous, as there are substantial regional differences (see Box 4-3).

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Box 4-3 Differences in the unemployment rate within the euro area

Even before the crisis, regional differences with respect to unemployment indicators could be observed within the euro area, but the crisis strongly exacerbated the process that has entailed negative consequences. On account of this, substantial and persistent differences in capacity utilisation could be observed between certain euro-area Member States. In the southern peripheral countries, unemployment rates in excess of 20 per cent were recorded, and on average the euro-area unemployment rate rose considerably. Overall, there were large disparities in unemployment trends, as shown in Chart 4-3. This posed a challenge in shaping the common monetary policy decisions. Chart 4-3: Unemployment in the PIGS and the core euro-area countries 25

Per cent

0 2006 2007

2008

2009

2010 PIGS

2011 2012

2013 2014

2015

2016

Core countries

Note: PIGS: Greece, Italy, Portugal, Spain; Core countries: Austria, Belgium, France, Netherlands, Germany. Source: Authors’ calculation based on Eurostat data.

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4 The ECB in new territory — “Whatever it takes”?

The prolonged shock caused by the crisis affected the euro area asymmetrically, and therefore the differences clearly increased and deepened. Following a slight decrease, the process continued to intensify after 2011 until around 2013. Since then, the differences seem to have diminished at a very slow pace, but this shift is negligible, as the current level is still higher than the initial value by almost 20 percentage points, which is an enormous change. In terms of regional data, the southern countries are characterised by higher unemployment. The figures in Greece and Spain deserve special mention, since in 2016 the former exhibited an unemployment rate of 24 per cent, while the latter showed 20 per cent. In the case of the core countries, unemployment rates are substantially lower. The comparison of France and Spain clearly shows the asymmetric effect of the crisis on the two countries. While the indicator in France moved from 9.1 per cent in early 2006 to around 10 per cent in 2016, Spain – despite starting from a lower base (8.7 per cent) – is struggling with an unemployment rate close to 20 per cent as mentioned already. This also shows that the crisis had a more marked effect on the labour market of southern countries, and that the subsequent crisis management efforts were less effective in this respect. The differences are partly due to the different initial conditions such as the different structures, and the different economic policy responses. During the management of the sovereign debt crisis, fiscal retrenchment was required, and its real economy costs proved to be critical. As a result of this, the already high unemployment rose considerably in these countries, thereby widening the disparities within the euro area. The surge in the Greek and Portuguese unemployment rate was the most pronounced in this period. Even before the crisis, the different monetary condition requirements arising from the country-specific differences were pointed out by economists analysing the euro area using country-by-country Taylor rule estimates (see, for example, Crowley and Lee 2008). Since monetary policy decisions are made jointly, no such differences could emerge in country-specific conditions.

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In the economies where crisis management entailed less fiscal austerity and the labour market proved to be more flexible, unemployment rose relatively less. These countries had to adapt to smaller and shorter real economy shocks, in many cases with a more flexible labour market. Among core countries, both government debt and the budget deficit were lower in Germany than in peripheral countries, and the labour market reform launched in the early 2000s had provided companies the tools necessary for the adjustment by 2007–2008. Accordingly, the labour market responded to the crisis mainly through price adjustment, which prevented a large reduction in the number of employees. All in all, crisis management affected euro-area countries differently, especially the southern countries where considerably higher capacity underutilisation has become permanently characteristic. Persistently high unemployment makes common monetary policy decision-making more difficult and entails heavy social costs. Yields, lending, exchange rate, portfolio restructuring

Government securities yields reached their peak in the summer of 2012, during the sovereign debt crisis, but then started to decline in response to Draghi’s “whatever it takes” speech. The decline has continued steadily, except in the summer of 2015, i.e. the months of the Greek crisis. Although both core and peripheral country yields fell, the latter dropped much more in response to Draghi’s words. The announcement of the government securities purchase programme and the start of the purchases did not cause a substantial shift in spreads (Chart 4-4).

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Chart 4-4: Yields on Spanish, Italian and German 10-year government securities 8

Per cent

Jul. 2016

Jul. 2015

Jan. 2016

Jan. 2015

Jul. 2014

Jan. 2014

Jul. 2013

Jul. 2012

Spanish

Jan. 2013

Jul. 2011

Jan. 2012

Jan. 2011

Jul. 2010

Jul. 2009

German

Jan. 2010

Jul. 2008

Jan. 2009

Jul. 2007

–2 Jan. 2008

–2 Jan. 2007

–1 Jul. 2006

Jan. 2006

0 –1

Italian

Source: Bloomberg.

The lending channel has special significance for the ECB: the central bank basically expects to boost aggregate demand through this channel, which would ensure the achievement of the primary objective, i.e. price stability. Lending to non-financial corporations showed a gradual decline from 2012 and only stabilised in the second half of 2015, after the launch of the government securities purchase programme (Chart 4-5). The growth rate of loans extended to households was around 2 per cent per year. The majority of new loans were mortgages, which contributed to stabilisation, in fact, it fostered growth through the rise in property prices. Therefore, lending contributed to growth by stimulating consumption and investments. According to the ECB’s communication, lending activity exhibits a steady increase, which boosts aggregate demand. Nonetheless, growth is very slow, falling well short of the ideal pace (Van Lerven 2016).

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Chart 4-5: Corporate and household lending and developments in GDP 4

Per cent

–4

–5

GDP growth

Growth of corporate loans

Jul. 2016

–3

Jan. 2016

–3

Jul. 2015

–2

Jan. 2015

–2

Jul. 2014

–1

Jan. 2014

–1

Jul. 2013

Jan. 2013

Jul. 2012

Jan. 2012

Jul. 2011

Jan. 2011

Jul. 2010

Jan. 2010

Growth of household loans

Source: ECB, OECD.

Quantitative easing triggered a substantial change in the EUR/USD exchange rate, as the euro weakened considerably and steadily against the US dollar. The exchange rate channel is able to exert a positive effect on exports. In the case of the ECB’s programmes, the channel’s effectiveness may be low. First, taking into account the monetary policy of other central banks and their behaviour, which is similar to the ECB’s, the impact has weakened globally during the crisis. Second, 80 per cent of euro-area exports are directed at other euro-area countries. Third, after the announcement of the government securities purchase programme, there was a period (between March and September 2015) when the exchange rate was higher than before the announcement, but exports expanded substantially (Van Lerven 2016). Nonetheless, the exchange rate was influenced not only by the ECB’s monetary policy measures: since 2015, the onset of the Fed’s monetary policy normalisation has increasingly affected it (Chart 4-6).

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4 The ECB in new territory — “Whatever it takes”?

Chart 4-6: EUR/USD exchange rate and quarterly export growth in the euro area 1.7

Per cent

Jul. 2016

Jul. 2015

Jan. 2016

Jul. 2014

Jan. 2015

Jul. 2013

Jan. 2014

Jan. 2013

Jul. 2012

–20

Jul. 2011

1.0

Jan. 2012

–15

Jan. 2011

1.1

Jul. 2010

–10

Jul. 2009

1.2

Jan. 2010

–5

Jan. 2009

1.3

Jul. 2008

Jul. 2007

1.4

Jan. 2008

Jan. 2007

1.5

Jul. 2006

Jan. 2006

1.6

Quarterly export growth (right-hand scale) EUR/USD

Source: Bloomberg, OECD.

One of the intended effects of the asset purchase programme is the rebalancing within financial institutions’ portfolio. Accordingly, we can observe a reduction of government securities holdings in banks’ balance sheets and a shift towards riskier assets. However, since the ECB has purchased only a limited amount of paper owned by banks, the realignment has been moderate.

4.6 The possibility of monetary policy normalisation Monetary policy normalisation in the euro area may be a complex and protracted process. However, sustaining excessively loose monetary conditions for a long time may entail risks. Monetary policy normalisation would mean the raising of the key interest rate into positive territory, the termination of asset purchases and, over the long term, the reduction of the balance sheet that has swollen to three times — 173 —

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its pre-crisis size. It must be noted that the ECB started normalising its monetary policy earlier than the Fed, as it allowed its balance sheet to shrink during the repayment of the 3-year LTRO loans (and it did not offset the balance sheet effect of the repayment with other instruments). However, this is exactly the reason why it might be suggested that this early normalisation attempt may have led to the deterioration of economic prospects and the renewed drop in inflation expectations, which resulted in a considerable easing through the introduction of new instruments and the postponement of normalisation. ECB decision-makers admit that the programmes have to end at some point, but they believe that the exact time for that is difficult to determine, since this is mostly “data-dependent” (Visco 2016). One thing seems certain: in view of the December 2016 decision of the Governing Council, the expanded asset purchase programme is not expected to end before the end of 2017. According to the statement, the unconventional monetary policy measures will persist at least until December 2017 but also beyond that if necessary, at any rate until inflation steadily enters on a path consistent with the central bank’s objective. And the policy rate may “remain at present or lower levels until the end of the asset purchase programme’s horizon”. The balance sheet reduction may take much longer than the previous processes, since the ECB reinvests the capital value of maturing assets. However, the prolonged use of unconventional instruments may have its drawbacks. Claeys, Darvas and Leandro (2015) point out in connection with the asset purchase programmes that they will be less and less effective, and at the same time they may increase inequalities and undermine financial stability, especially if implementation of the programmes takes a long time. In addition, the lack of tests in connection with asset purchases makes it difficult to fine-tune the programmes for efficiently achieving the desired growth in demand, especially if the purchases persist for a long time. With respect to negative interest rates, the strengthening of the adverse side effects impacting the stability of the banking system is especially likely to entail risks. — 174 —

4 The ECB in new territory — “Whatever it takes”?

Key terms core countries ESM, ESFM expanded asset purchase programme fiscal policy liquidity-provision monetary union money market disturbances

peripheral countries sovereign debt crisis quantitative easing Outright Monetary Transactions (OMT) programme Targeted longer-term refinancing operations (TLTRO) verbal intervention

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References Afonso, A. – Checherita, C. – Trabandt M. – Warmedinger, T.: Euro area fiscal policies and the crisis, ECB Occasional papers series No109/ April 2010., editor: van Riet, Ad, http://www.ecb.europa.eu/ pub/pdf/scpops/ecbocp109.pdf?880f9c05e4ff2d0dc8b8cf44357db63e Ahearne, A. – Wolff, G.B. (2012): The debt challenge in Europe, Working Paper 2012/02, Bruegel, 2012, at http://bruegel.org/2012/01/the-debt-challenge-in-europe/ Court of Justice of the European Union, Press Release No, 70/15, Luxembourg, 16 June 2015, Judgment in Case C-62/14, Gauweiler and Others. Beirne, J. – Dalitz, L. – Ejsing, J. – Gothe, M. – Manganelli, S. – Monar, F. – Sahel, B. – Susec, M. – Tapking, J. – Vong, T.: The Impact of the Eurosystem’s Covered Bond Purchase Programme on the Primary and Secondary Markets. ECB Occasional Paper Series No. 122, January. 2011. Bofinger, P.: After Brexit: A Lighthouse Initiative for the Euro Area, November 2016, http://www. progressiveeconomy.eu/content/after-brexit-lighthouse-initiative-euro-area Buti, M. – Carnot, N.: What is a ‘responsible’ fiscal policy today for Europe?, CEPR blog, 24 February 2015, http://voxeu.org/article/defining-responsible-fiscal-policy-europe Buti, M. – Rodríguez, L.: Muñoz Why we need a positive fiscal stance for the Eurozone and what it means, 18 November 2016, http://voxeu.org/article/why-we-need-positive-fiscal-stanceeurozone-and-what-it-means Claeys, G.; Darvas, Zs.: The financial stability risks of ultra-loose monetary policy’, Policy Contribution 2015/03, Bruegel,, http://bruegel.org/2015/03/the-financial-stability-risks-of-ultra-loosemonetary-policy/ IMF: Fiscal monitor, 4 October 2016, http://www.imf.org/en/News/Articles/2016/10/04/AM16NAFISCALMONITOR100416?cmpid=TW&hootPostID=e3e1e8fedf5526859b46e7cb4b8b6c98 Crowley, P.M. – Lee, J.: Do All Fit One Size? An Evaluation of the ECB Policy Response to the Changing Economic Conditions in Euro Area Member States. St Louis Fed research paper, 2008, https:// research.stlouisfed.org/conferences/integration/Crowley-Lee-paper.pdf DeMertzis, M. – Wolff, G.B.: The effectiveness of the European Central Banks asset purchase programme, Bruegel Institute, May, 2016. Draghi, M.: Unemployment in the euro area, 22 August 2014, https://www.ecb.europa.eu/press/ key/date/2014/html/sp140822.en.html Fratzscher, M. – Gropp, R. – Kotz,H. – Krahnen, J. – Odendahl, C. – Weder di Mauro, B. – Wolff, G.B.: ‘Mere criticism of the ECB is no solution’, Bruegel Blog, 10 April, 2016, http://bruegel. org/2016/04/mere-criticism-of-the-ecb-is-no-solution/ Hüttl, P. – Merler, S.: Sovereign bond holdings in the euro area – the impact of QE’, Bruegel Blog, 19 May, 2016., http://bruegel.org/2016/05/sovereign-bond-holdings-in-the-euro-area-the-impactof-qe/

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4 The ECB in new territory — “Whatever it takes”? Krekó, J. – Balogh, Cs. – Lehmann, K. – Mátrai, R. – Pulai, Gy. – Vonnák, B. (2012): Nemkonvencionális jegybanki eszközök alkalmazásának nemzetközi tapasztalatai és hazai lehetőségei (International experiences and domestic opportunities of applying unconventional monetary policy tools). MNB Occasional Papers 100, Magyar Nemzeti Bank. Krugman, P: Europanic 2.0, 11 October 2014, http://krugman.blogs.nytimes.com/2014/10/11/ europanic-2-0/?_php=true&_type=blogs&_r=1 Koo, R.C.: The world in balance sheet recession: causes, cure, and politics, (Nomura Research Institute, 2011. Lehmann, K. – Mátrai, R. – Pulai, Gy. (2013): A Federal Reserve System és az Európai Központi Bank válság során alkalmazott intézkedéseinek bemutatása (Measures taken by the Federal Reserve System and the European Central Bank during the crisis). Merler, S.: ECB TLTRO 2.0 – Lending at negative rates, Bruegel Institute, blog, March 11, 2016, http://bruegel.org/2016/03/ecb-tltro-2-0-lending-at-negative-rates/ Micossi, S.: The Monetary Policy of the European Central Bank (2002-2015), CEPR working paper, No. 109 / May 2015. Moghadam, R.: How to break Europe’s economic taboos without shattering its union, Financial Times, 10 October 2014, https://www.ft.com/content/b08047ae-4fa3-11e4-908e00144feab7de#axzz3FsvmwVzv Stiglitz, J.E. (2016): The Euro: How a Common Currency Threatens the Future of Europe. http://www. nytimes.com/2016/07/28/business/international/how-a-currency-intended-to-unite-europewound-up-dividing-it.html?_r=1 Tabellini, G.: Which fiscal union?, 24 April 2016 http://voxeu.org/article/building-commonfiscal-policy-eurozone van Lerven, F.: QUANTITATIVE EASING IN THE EUROZONE: A ONE-YEAR ASSESSMENT, Briefing Paper, 2016 http://www.qe4people.eu/ Wijffelaars, M. – Loman, H.: The eurozone (debt) crisis – causes and crisis response, Economic Report, 18 December 2015, https://economics.rabobank.com/publications/2015/december/ the-eurozone-debt-crisis--causes-and-crisis-response/ Wren-Lewis, S.: Eurozone fiscal policy – still not getting it, 1 March 2015, Blog, Comment on macroeconomic issues, https://mainlymacro.blogspot.hu/2015/03/eurozone-fiscal-policystill-not.html Visco, I. (2016): ‘Scapegoat’ risk of wider central banking roles. OMFIF City Lecture with Ignazio Visco, Columbia University, New York, 10 October 2016. https://www.omfif.org/media/1556260/ omfif-city-lecture-october-2016-governor-ignazio-visco.pdf

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The Japanese central bank’s fight against deflation Árpád Vadkerti

As we have seen before, the Fed and the ECB faced the vulnerability or rather instability of the financial system, deflation and recession at the eruption and the spillover of the crisis, respectively. However, in Japan periods characterised by recession on the one hand and stagnation and low growth on the other hand have been alternating since the bursting of the so-called bubble economy, i.e. the early 1990s, and the impact of the financial crisis exacerbated the situation. The protracted but subdued deflationary environment characteristic of the economy has persisted for a long enough time for economic actors to form deflation expectations. The Japanese central bank cut its interest rates to zero more than a decade ago, and therefore it has tried several unconventional instruments to provide sufficient stimulus, leading the way among globally dominant central banks. The instruments include asset purchase programmes, negative interest rates, forward guidance, yield curve targeting and targeted programmes fostering lending. Precisely because of the persistence of deflation and the wide range of instruments used, the experiences of the Bank of Japan, the Japanese central bank, stand out among developed-country central banks with respect to the fight against deflation and economic stimulus. Following the 2012 parliamentary elections, the so-called three arrows policy, a coordinated economic policy based on a holistic approach, was announced in Japan, after it was recognised that monetary policy in itself would be unable to address the situation. The three arrows refer to an expansive fiscal policy stimulating the economy, large-scale monetary easing and structural reforms. Despite all of this, the Bank of Japan has not achieved its inflation target yet, and almost 10 years after the eruption of the financial crisis slow growth and inflation still pose problems. The initial dissonance between fiscal and monetary policy played a role in monetary policy’s lack of success as regards meeting the inflation target. During monetary easing, — 178 —

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the expected fiscal loosening did not happen; in fact, the revenue side of the budget was expanded through tax hikes in order to preserve the sustainability of government debt. Furthermore, with respect to the third arrow, i.e. structural reforms, only labour market regulations were introduced. Therefore, the lessons from the monetary policy experiments of the Japanese central bank and the features of economic policy coordination may prove quite useful in exploring and understanding today’s monetary policy dilemmas.

5.1 Introduction Due to reasons of economic history, the Japanese central bank (Bank of Japan, BoJ) was the first among the world’s central banks to employ so-called unconventional measures in order to facilitate the elimination of deflation. By the late 1980s and early 1990s, a bubble economy had emerged in Japan as a result of financial deregulation: the Nikkei stock market index quadrupled in a short time, banks engaged in fairly active property lending and the economy became overheated. When asset prices peaked, the central bank tightened its monetary policy in the light of these developments, raising the key interest rate to 6 per cent in several steps, which ultimately led to the bursting of the bubble in 1992. The earlier period of rapid growth was followed by a period of slow economic growth, stagnation, disinflation and prolonged deflation, the problems of which could not be addressed efficiently enough by the prevailing economic policy. The 1997 Asian financial crisis hit a vulnerable Japanese economy, triggering a recession. By this time, monetary policy had lowered the base rate to 0.5 per cent, close to the lower bound then considered effective (0 per cent). The political will and institutional background necessary for the consolidation of the non-performing loans of the banking system and certain zombie banks only emerged by the end of the 1990s (Hidasi–Papp 2015). Thus, the conditions necessary for another upswing were not in place even without the growth-dampening effects of external shocks. In 2001, in response to the developments in the global economy, the Japanese central bank, having used up all of its traditional instruments, — 179 —

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launched the world’s first quantitative easing programme, aimed at the elimination of deflation and the stimulation of the economy. The 2001– 2006 quantitative easing programme and its results are covered in more detail in Box 5-1. In 2006, after the termination of the central bank’s easing, it seemed that the conditions for growth were in place, inflation returned to positive territory and the proportion of non-performing loans in the banking system diminished substantially. The 2007 financial crisis hit the country in an upswing, in contrast to the 1997 and the 2001 shocks, as the economy expanded by 1.4 per cent on average between 2001 and 2007 (Chart 5-1), and the consumer price index, the main measure of inflation, had been positive since 2006. Although in Japan the crisis exerted its impact through other channels, the period of deflation and low economic growth returned. Since 2013, one of the cornerstones of the new economic policy mix has been drastic monetary easing, within the framework of which the central bank has introduced several unconventional measures. Chart 5-1: Economic growth and the projection 6

Per cent

annual GDP

IMF WEO GDP forecast

Source: OECD, IMF WEO.

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2020

2018

2016

2014

2012

–6

2010

–6

2008

–4

2006

–4

2004

–2

2002

–2

2000

1998

1996

1994

1992

1990

periodic average

5 The Japanese central bank’s fight against deflation

Box 5-1 The first quantitative easing programme

In order to curb deflation that had persisted for years, the Japanese central bank started implementing an active balance sheet policy in 2001. By this time, monetary policy had reached its limits regarding its traditional instruments: in 1999 the central bank introduced the zero interest rate policy (ZIRP), but no significant results were achieved. Inflation was persistently low or even negative, while the economy continued to stagnate. After the bursting of the dotcom bubble, confidence in the sustainability of the global prosperity seemed to have been undermined, and fears of a global recession heightened. The Japanese central bank launched its quantitative easing (QE) programme in this economic environment in March 2001, aimed at more robust economic growth and the elimination of deflation. In the course of the programme, the amount of central bank reserves was targeted, and commercial banks’ deposits held by the central bank increased from JPY 5 trillion to JPY 35 trillion. The rise in excess reserves boosted the liquidity of the banking system, which contributed to the stability of the financial system. The increase in central bank reserves financed the second operational element of the programme, the purchases of long-term (10-year and 20-year) government securities, which served to lower government securities market yields. The central bank attempted to support the real economy indirectly, by pushing down the government securities market yield curve and expanding reserves. According to the logic behind the latter, lending processes are limited by reserves, i.e. lending activity is subdued in the economy because the existing reserves of the banking system do not provide adequate coverage for to boost lending. Therefore increasing reserves sooner or later leads to more lending. As we have already seen, assuming adequate demand, lending is principally determined by profitability considerations, and lending is not limited by reserves (Borio–Disyatat 2009) (see Box 3-2). In January 2002, the monthly volume of asset purchases was tripled and the purchases were expanded to include shorter-term government securities as well.

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The first quantitative easing programme was phased out in 2006, after reaching the target (zero or positive inflation rate). It is interesting to note that although the Japanese central bank was not an inflation targeting (IT) central bank, an important element of its quantitative easing programme was the commitment to achieving a positive annual inflation rate. This was supposed to indicate that the monetary policy stance will not change until the programme achieves its objective, and liquidity-provision will continue all throughout. According to Kuroda (2016a), the current governor of the Japanese central bank, QE was not only the first quantitative easing programme in the world, but the Japanese central bank was also the first in the world to employ forward guidance (FWG) linked to this. Even though easing with unconventional instruments proved to be ground-breaking in several respects, its effectiveness was limited. Although it prevented Japan from entering a persistent deflationary spiral and maintained the stability of the financial system by meeting the reserve target, it was unable to stimulate the economy or eliminate deflation (Krekó et al. 2012). However, the limited impact of the programme on lending may be attributable to the long balance sheet consolidation of the banking system due to the massive amount of non-performing loans accumulated earlier.

5.2 2007—2013: From the onset of the crisis until the appointment of Haruhiko Kuroda The 2007 financial crisis dealt a heavy blow to the Japanese economy as well, although the channel of contagion was fundamentally different than in other countries or earlier crises. As the deleveraging of the Japanese financial system ended at this time, its position was and remained stable during the crisis, and it only had a minor exposure on the derivatives market. This may seem favourable as the global financial crisis was mainly a crisis of confidence among financial market participants. Since market participants were unable to gauge each other’s riskiness – which can be derived from the exposure on — 182 —

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the market for the so-called repackaged, derivative products – they became mistrustful, which led to markets drying up and a real economy downturn. The players in the Japanese financial system did not face such issues, however, as they had just ended a long deleveraging process, which traditionally had an adverse effect on Japanese economic actors due to their dependence on bank funds on account of the closed and underdeveloped capital market (Hidasi–Papp 2015). The traditional convergence channel of the Japanese economy is foreign trade. The global recession entailed a substantial drop in export demand for the products and services produced by Japan, leading to a domestic recession. Japanese export companies, who provide a large share of economic value creation, were forced to curb production by the slump in export demand, and therefore longer-term economic growth was dented. By about this time, it had become clear that neither the cyclical position nor the structural situation were satisfactory. Potential growth had been on the decline since the bursting of the bubble economy due to the drop in productivity, unfavourable demographic developments and diminishing capital accumulation. Inflation had been on the rise since 2006 but dipped to below –2 per cent in 2009 as a result of the crisis, only registering positive values now and then until 2013 Q3 (Chart 5-2). In October 2010, the central bank launched its second asset purchase programme (APP), within the framework of which in addition to Japanese government bonds, exchange-traded funds (ETFs), assets from real estate investment trusts (J-REITs) and corporate securities were purchased for JPY 35 trillion. The central bank sought to use the purchase of the securities – assets considered riskier – to relax monetary conditions perceived by ultimate borrowers (households, companies) by reducing various risk premiums (Shirakawa 2012). During its existence, the programme was expanded several times, and in many cases less than half a year passed between two announcements. With the fourth expansion in February 2012, the amount available for the purchases was raised to JPY 65 trillion, emphasising the commitment to the achievement of the numerical target. In December 2012, the central — 183 —

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bank made further announcements: after raising the limit several times, the APP was expanded once more, thus the final amount allocated for the purchases rose to JPY 101 trillion. In addition to its targeted asset purchase programme, the BoJ regularly purchased government securities, to the amount of JPY 21.6 trillion annually to provide stable demand on the government securities market over the long term (Shirakawa 2012). Chart 5-2: Development of inflation rates in Japan 4

Per cent

Core inflation

Inflation

2016

–3

2014

–3

2012

–2

2010

–2

2008

–1

2006

–1

2004

2002

2000

1998

1996

1994

1992

1990

Periodic average of inflation

Source: OECD.

The Japanese central bank decided to introduce an explicit inflation target in February 2012, although it did not adapt an inflation targeting framework at that time. Upon the introduction of the inflation target, a temporary target of 1 per cent inflation was set, but the central bank targets inflation of or below 2 per cent in the long run. It is interesting to note that the announcement of the explicit inflation target meant a step towards the practice of inflation targeting central banks, yet the — 184 —

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word “target” was avoided, indicating a weaker commitment (Felcser– Lehmann 2012). Another important difference is that the primacy of the inflation target within the target system was not proclaimed, despite its fundamental role in IT regimes per definition (Mishkin 1999).38 Governor Shirakawa claimed that they avoided the word “target” because the population mistakenly regarded inflation targeting as monetary policy being pursued “automatically” to achieve a certain inflation target. Nonetheless, the declaration of the inflation target improved the transparency of the central bank’s communication by making it clear to economic actors what level of inflation was considered to be in line with price stability by the central bank as a whole. Earlier, individual decision-makers determined the value in line with price stability separately, which was of course less suitable for appropriately orienting and anchoring economic actors’ expectations, and made achieving price stability more difficult (Shirakawa 2012). In addition, the BoJ also operated targeted programmes to foster lending: a growth-supporting lending scheme with a value of JPY 5.5 trillion and a standing facility-type programme fostering lending with unlimited recourse. The former supported investments and provided preferential funding to the firms contributing to the establishment of the basis of economic growth. The latter provided funds at preferential interest rates up to the value of the net credit growth achieved by certain financial institutions, thereby encouraging them to boost their lending activity. All in all, the Japanese central bank employed a wide range of available instruments to eliminate the negative impact of the economic crisis on inflation and growth. The emerging real economy situation was familiar to the central bank, as only a couple of years had passed since the last period characterised by slow growth and deflation. However, in addition to the asset purchase programme, the central bank now 38

I n its annual publication assessing monetary and exchange rate regimes, the IMF (2013) identified the Japanese monetary regime as inflation targeting, primarily on account of the long-term inflation target introduced in 2012, and the inflation target being made explicit and constant in 2013.

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attempted to stimulate lending and thus domestic demand through targeted financing, and the introduction of the inflation target was a step towards anchoring expectations more firmly. Nevertheless, these central bank measures were unable to restore growth and increase inflation: both stayed below 0 per cent on average over the whole period. This feebleness threatened the central bank’s credibility, which, in the absence of an explicit numerical inflation target, was unable to appropriately anchor inflation expectations and thus fulfil its mandate. Some believe (Kuroda 2014) that the too low inflation target (1 per cent) also contributed to the unsuccessful attempts at lifting inflation. It was unable to raise expectations and influence economic actors’ way of thinking that had developed over a long time, since the target was too close to zero, and therefore it was not credible enough. It is worth mentioning that in this period, fiscal policy was not exactly stimulating due to government debt being considered high, thus economic policy was unable to persistently boost demand, which strengthened deflation expectations.

5.3 2013—2016: The period of the new economic policy mix and quantitative and qualitative easing The 2012 parliamentary elections ended in a victory for Shinzo Abe, opening up new avenues in economic policy. The prime minister sought to steer the economy onto a growth path and lead it out of deflation, and therefore he announced the so-called three arrows policy. The new economic policy mix consisted of robust monetary easing, fiscal stimulus and structural reforms aimed at fostering investment activity. In a joint declaration with the government in January 2013, the decision-making body of the central bank then headed by Governor Shirakawa determined an explicit, non-temporary, 2-per cent annual inflation target, and decided to introduce an open-ended asset purchase programme (without an end date) from January 2014 (Bank of Japan 2013a).

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A little over two months later, in March 2013, Governor Haruhiko Kuroda was inaugurated, by whom the quantitative and qualitative monetary easing programme (QQE) was introduced. The BoJ reaffirmed its joint commitment with the government to achieve 2-per cent year-onyear growth in the consumer price index (CPI) “at the earliest possible time”, over a time horizon of approximately two years (Bank of Japan 2013a). The clear, explicit, numerical inflation target for both the short and the medium term and the joint commitment to its achievement were important steps in orienting and lifting inflation expectations. As we have seen, the central bank had already hit the zero lower bound, and therefore it could not make adjustments and ease the conditions through its traditional instruments. Accordingly, monetary base targeting was introduced to meet the inflation target. With this, the earlier policy instrument, i.e. the overnight uncollateralised lending rate, lost its key role. According to the central bank’s statement, unconventional easing would continue until the inflation target was achieved. At the operational level, this meant the termination of the earlier asset purchase programme and Japanese government bond purchases in the amount of JPY 50 trillion annually. These measures sought to double the average maturity and reduce short-term and long-term yields on the government securities market. The pace of government securities purchases was quite rapid compared not only to similar earlier Japanese programmes but also in international comparison (at such a pace, the earlier quantitative easing programme would have ended in two years). In October 2014, the central bank expanded the programme, increasing the pace of purchases to JPY 80 trillion per year. Although inflation expectations started to rise and inflationary pressure could be felt in the economy, this was mainly necessary because the government did not abandon its objective, and raised the consumption tax in April 2014. As a result, households engaged in significant consumption realignment, which entailed insufficient domestic demand, and the economy stagnated despite growing by 1.4 per cent in the previous year. Households were able to

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bring forward their consumption at no cost, since the rate of return on their savings was practically zero in the low interest rate environment. The measure had an immediate so-called signalling effect, as the tax increase considerably undermined public confidence in the economic stimulus performed through fiscal easing promised earlier. As stated by several members of the Policy Board, the aim of the Japanese central bank’s quantitative and qualitative easing was to stimulate the Japanese economy by raising inflation expectations and reducing real interest rates, and to create an environment where households and companies maintain the “virtuous cycle from income to spending” (Kuroda 2016b, p. 2). In other words, a natural cycle was sought to be established in which economic actors are forced to raise wages in expectation of renewed price hikes, and increased spending entails stronger domestic demand and rising inflation. As a result of the rapid monetary easing, the central bank’s balance sheet quickly became swollen: while amounting to roughly 30 per cent of annual GDP at the start of the programme, in early 2016 it amounted to over 80 per cent of GDP (Chart 5-3). The balance sheets of the US Fed or the European Central Bank, which employed similar unconventional instruments, were much smaller in comparison before they launched their programmes and did not exceed 30 per cent of GDP. The central bank’s government securities purchases were financed by commercial banks’ reserves held by the central bank,39 i.e. the increase on the assets side of the central bank’s balance sheet was offset by an increase of the reserves deposited on the liabilities side.

hese reserves form the basis for the settlement of the transactions between comT mercial banks, i.e. depending on the direction of payment flows, the distribution of reserves may vary across the banks, but the amount in the whole system stays the same after the settlement transactions.

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Chart 5-3: Size of the central bank balance sheet approaches annual GDP 100

Per cent

100

ECB

Fed

2016

10 2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

BoJ

Source: OECD, central banks.

The programme may have an easing effect on monetary conditions through various channels (Chart 5-4). On the one hand, it exerts downward pressure over the whole yield curve through the massive asset purchases, mainly depressing long-term nominal interest rates. On the other hand, it contributes in two ways to the reduction of (ex-ante) real interest rates, which are crucial from the perspective of economic actors’ activity. As the real interest rate is the nominal interest rate less inflation expectations, in Japan, a high real interest rate emerged in the context of a positive nominal interest rate and negative inflation expectations. This can be lowered by the central bank by reducing nominal interest rates and raising inflation expectations. The falling real interest rates stimulate economic activity and domestic demand, which may close the output gap (the difference between potential and actual GDP), and therefore they boost inflation over time. Since inflation expectations are mostly adaptive (backward-looking), rising inflation entails an increase in inflation expectations as well. In order to make — 189 —

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the central bank measures truly stimulating, the real interest rate has to drop below its long-term neutral rate.40 Chart 5-4: Impact mechanism of Quantitative and Qualitative Easing programme (QQE)

Massive purchases of JGBs

Nominal interest rates Decrease

Strong and clear commitment to achieve the price stability target of 2 percent

Inflation expectations Increase

Economy Actual inflation rates

Real interest rates Decrease

Improve

Lending and capital market

Increase

Source: Kuroda (2016a).

In January 2016, the central bank changed its set of instruments, introducing negative interest rates, while leaving its quantitative easing programme unchanged (Bank of Japan 2016a). The decision divided central bank leaders, who voted 5 to 4 in favour of lowering the interest rate on commercial banks’ excess reserves by 20 basis points from 0.1 to –0.1 per cent. The negative interest rate introduced for commercial banks’ excess reserves held by the central bank is unprecedented among central bank instruments, and therefore its impact may be more difficult to predict. In order to preserve the profitability of financial institutions, reserves were divided into three tiers, with different interest rates in each tier. This was necessary because the introduction of the negative interest rate is practically tantamount to taxing the reserves: the commercial bank pays to deposit them with the central bank. On the other hand, commercial banks’ reserves deposited with the central bank increase constantly, since 40

he real interest rate at which there are no unutilised capacities or overheating in T the given economy.

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5 The Japanese central bank’s fight against deflation

in exchange for asset purchases, the central bank boosts the amount of reserves deposited with it, therefore this is somewhat of a given for the individual players. In the first tier containing most of the reserves, i.e. about JPY 210 trillion, the central bank pays 0.1 per cent interest (Chart 5-5). The second tier contains the reserves that are created as a result of the asset purchases, expanding by approximately JPY 80 trillion annually and bearing no interest (0 per cent). The reserves in addition are considered excess reserves (deep red on the chart), and the central bank introduced a negative interest rate of –0.1 per cent for these. Due to this division of the reserves, about one-tenth of the reserves amounting to JPY 300 trillion at the outset fell within the scope of negative interest rates. Kuroda (2016a) notes that while this way the profitability of financial institutions is not dented, the measure is still effective in lowering money market yields, since it applies for every additional unit deposited. Chart 5-5: Three-Tier reserve system The outstanding balance of current accounts at the Bank ~10 trillion yen ~40 trillion yen

–0.1%

ut line of abo pace rent guide l a u n r n u a c n e a se at der th Increa lion yen un ~10–30 trillion yen il r t 0 8

+0.1%

~40 trillion yen + 80 trillion yen per year

~210 trillion yen

Source: Kuroda (2016a).

The measure was justified by the central bank by claiming that the risk of deteriorating business confidence had increased, which was sought to be enhanced by increasing lending activity through this step. Another reason was the fact that two decades of deflation in Japan had had a significant effect on the thinking of households and companies, the

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transformation of which through QQE and raising inflation expectations was jeopardised. This was the result of low energy and commodity prices, as well as the fears linked to the growth of certain emerging economies, especially China. The central bank introduced the negative interest rate on the excess reserves to prevent this risk. After three quarters, in September 2016, following a comprehensive review of the monetary policy measures taken after 2013, the Japanese central bank changed its operational framework again, while committing itself to temporarily overshooting the inflation target (Bank of Japan 2016b). Therefore now the central bank, in contrast to the earlier framework, does not target the growth of the monetary base but the interest rate on the 10-year maturity of the yield curve. In addition, it modified the commitment to reaching the inflation target at the earliest possible time by stating that asset purchases will continue until the inflation determined by the year-on-year increase of the consumer price index adjusted for food prices exceeds and stays above the 2-per cent inflation target in a sustainable manner. The monetary policy stance did not change, only the framework, while in the future the central bank will strive not only to reach the inflation target but also to temporarily overshoot it. Within the framework of yield curve targeting, asset purchases are adjusted so that the yield on 10-year government bonds is around 0 per cent. Yield curve targeting corresponds more or less to quantitative easing: they are similar in that the central bank wishes to attain a predetermined yield, but they are different in that this is performed indirectly in quantitative easing and directly in yield targeting. This means several things: in the asset purchase programme, the central bank purchases the amount determined by it at market prices,41 while in the case of yield targeting, the central bank purchases or sells bonds at a price consistent with the targeted yield. In practice, the central bank sets the price at which it purchases, but the actually purchased amount depends on market participants’ willingness to sell at such a price. According to Bernanke (2016b), the announcement of a yield target may have a substantial signalling effect, which the 41

here is an inverse relationship between bond prices and yields. Bond prices rise T due to increased demand, and at the same time yields drop.

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5 The Japanese central bank’s fight against deflation

central bank can use to shift yields in the direction preferred by it without considerably inflating its balance sheet.

5.4 Results of the new economic policy mix and the unconventional monetary policy instruments When examining the effectiveness of the measures taken by the Japanese central bank since the start of the crisis in a somewhat simplified manner, it is enough to take a look at the current main inflation measure and growth figure to see clearly that the central bank has little to show for its efforts. In October 2016, the consumer price index was 0.1 per cent, and core inflation adjusted for food and energy prices was 0.2 per cent. Meanwhile, the Japanese economy expanded by 0.3 per cent in 2016 Q3 (and by 0.6 per cent in 2015). Based on this we can conclude that neither a rise in prices nor economic stimulus has been achieved during the easing of the past 3 years, the only change is the sharp increase in the central bank’s balance sheet. Chart 5-6: Development of real interest rates in international comparison 3

Per cent

–1

–2

–3 2007

2008

2009

2010

Euro area

2011

2012 USA

Source: BIS (2016).

— 193 —

2013

2014 Japan

2015

–3 2016

Part I: An unconventional crisis with unconventional consequences

Nevertheless, as can be seen in Chart 5-6, the monetary policy launched in 2013 cannot be considered unsuccessful with respect to lowering real interest rates: in line with the main impact mechanism of QQE, it had reduced real interest rates below –1 per cent by 2016, which was similar to the figure in other developed regions. When analysing the central bank’s fight against deflation from the perspective of the developments in the global economy, it is apparent that not long after the launch of the new monetary policy, robust disinflationary processes took place due to the decline in global oil prices, which caused below-target inflation all over the world. Although inflation and core inflation both started to rise in 2013, imported inflation – which emerges quickly and with great weight in the price index of Japan, as a commodity importer – curbed price rises from 2015. Let us now disregard the consumer price index, and examine Chart 5-7: Japanese economic policy successfully raised the prices of domestic products 4.0

Per cent

4.0

3.0

2.0

1.0

0.0

–1.0

–2.0

–3.0

–3.0 2007

2009 Japan

2011 Euro area

Source: World Bank.

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2013 USA

2015 UK

5 The Japanese central bank’s fight against deflation

the central bank’s performance with the GDP deflator that reflects the price developments of the goods and services produced within the given country, since in theory the central bank, thus also the BoJ, can have the greatest influence over these prices. While the CPI containing imported prices is around 0 per cent, mainly due to external cost shocks, the GDP deflator that captures only the changes in domestic prices has exhibited a rising trend since 2010 (Chart 5-7), which suggests that the central bank was able to generate inflationary pressure within the economy. Although real interest rates increased, this did not provide sufficient stimulus to the economy. The GDP deflator rose to no avail, and the inflation perceived by the public remained persistently low and below the central bank’s inflation target. These contrasts may have been attributable to several factors. First, the additional effects of the central bank’s quantitative easing measures may decrease, and the internal channels of the transmission mechanism may be less effective than other channels (BIS 2016). Still, in addition to cyclical factors, structural, longterm reasons (unfavourable demographic trends, low productivity) may also contribute to the protracted stagnation and low inflation. Nakaso (2016b) suggests this when citing the theory of secular stagnation,42 as he believes that the slowdown in long-term global growth and the ensuing drop in the neutral real interest rate constrains monetary policy’s room for manoeuvre, since in the context of diminishing real interest rates, a given monetary easing is less effective. Accordingly, monetary and fiscal policy measures as well as structural reforms are necessary to avoid secular stagnation. In April 2014, in the spirit of “growth-friendly fiscal consolidation”, i.e. guiding government debt onto a sustainable path, the government of Japan, a country that had only just escaped deflation, raised the consumption tax from 5 to 8 per cent. Just like in 1997, when the tax was raised from 3 to 5 per cent 42

ccording to the line of thinking slipped back into academic debates by Larry A Summers, growth trends decline not only because of cyclical reasons but also due to structural, long-term factors, and this contributes to the emergence of low neutral interest rates.

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pushing the economy into recession for years, the measure once again entailed substantial amounts of consumption being brought forward. Although price indices were lifted by the consumption tax, this effect cannot be considered persistent for two reasons: first, it disappears from the annual price index after a year, and second, it resulted in a long-term rescheduling of consumption (Chart 5-8), which led to the expansion of unutilised capacities and recession through weaker domestic demand. Analysing the economic policy as a whole, we can say that although monetary policy sought to generate inflation with several measures, the other important branch, fiscal policy, did not provide enough support in stimulating the economy, in fact, it was restrictive. In the absence of the necessary economic policy coordination, the Bank of Japan’s commitment to continue the asset purchases until meeting the inflation target cannot be credible (as suggested by Andolfatto 2016 as well). Chart 5-8: Effect of the rise in the turnover tax on final consumption expenditure 104

104

103

102

101

100

t–3

t–2

t–1

t+1

t+2

t+3

2014 (2013q2=100) Source: OECD.

— 196 —

t+4

t+5

t+6

1997 (1996q2=100)

t+7

t+8

5 The Japanese central bank’s fight against deflation

Turning to the implementation of the QQE programme, we can say that several risks emerged during the large-scale asset purchases. First, the central bank’s balance sheet amounted to 90 per cent of annual GDP, which is exceptionally high both historically and in international comparison. Second, since asset purchases mostly mean a government securities market intervention, the Japanese central bank has become the primary and largest player on the government securities market. Approximately 40 per cent of the government bonds issued are in its balance sheet (Chart 5-9), and if market share growth continues at a similar pace, the central bank may face supply constraints, i.e. the assets available for purchase may simply run out. If the BoJ continues the asset purchases at the same pace, it may be forced to slow down in 2017–2018, and the exit may cause a sudden excess supply on the government securities market (Arslanalp–Botman 2015). The programme has depressed yields and the yield curve has flattened, which has indeed Chart 5-9: Share of the BoJ on the government securities market (all maturities) 45

Per cent

0 2010

2011

2012

2013

2014

2015

2016

BoJ market share in JGB, Per cent – All maturity Source: Japan macro advisors.

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reduced the relative cost of capital, but looking forward, it has questioned the sustainability of financial investments among market participants. Overall, these factors may lead to portfolio restructuring, which, after spreading from bank actors to insurers and pension funds as well prompting them to search for other opportunities and invest in foreign assets, may cause a rise in capital outflows (Arslanalp–Botman 2015). With respect to the impact and risks of the programme, there was also no consensus among central bank decision-makers. According to Takahide Kiuchi (2015), due to the declining marginal utility of the programme, i.e. the decreasing pace of the fall in real interest rates, and its side effects, asset purchases should be slowed down. According to Kiuchi, the side effects of the programme may jeopardise the proper functioning of the government securities market, and they are linked to the interest rate risk emerging in the normalisation period of monetary policy and the impact on fiscal policy. Takehiro Sato (2015) believes that there is not enough evidence confirming the lifting effect of the programme on inflation expectations, and its yield-reducing impact is also moderate. Sato demonstrated that the central bank purchases roughly 90 per cent of the newly issued government securities on the secondary market, therefore the programme will only remain sustainable if the demand generated by end investors gradually declines. In 2016, in the footsteps of the ECB and a few other European central banks, the BoJ introduced negative interest rates on commercial banks’ excess reserves deposited with the central bank. The central bank sought to minimise the effects reducing the profitability of financial institutions by introducing the 3-tier system. Nonetheless, negative interest rates also affected profitability adversely in an indirect manner, through the reduction in yields, since a huge amount of these assets were held by market participants. Arteta et al. (2016) show that in contrast to the instrument’s aim, in the case of the central banks employing negative interest rates, inflation expectations declined further as compared to the level before the introduction, and they also entail several risks. — 198 —

5 The Japanese central bank’s fight against deflation

The authors believe that these risks affecting financial stability (the contraction of the interest margin, the deterioration of capital adequacy, excessive risk-taking) heighten if negative interest rates persist or drop well below 0. With respect to the negative rate and the QQE, Kiuchi (2016) points out that the negative rate is lower than the yields realised on government bonds by financial institutions, which may reduce institutions’ willingness to sell these assets. According to Sato (2016), negative interest rates may have the opposite effect to what is intended, since they may be perceived as monetary policy tightening and they entail financial stability risks. Sato claims that due to denting banks’ profitability, negative interest rates may lead to tightening credit terms and a rise in credit spreads. Nakaso (2016a) takes the opposite view and argues that the 3-tier system prevents a significant deterioration in profitability. Bernanke (2016a) outlines a range of potential criticism in connection with the yield curve control introduced in the autumn of 2016. When the BoJ introduced yield curve targeting and determined a 0-per cent yield as an operational objective for 10-year bond maturities, it left the earlier quantitative objective in force as well. In Bernanke’s opinion, this is redundant: the central bank either shapes yields through determining the quantity sought to be purchased, or it sets the price at which it will purchase as much as market participants are willing to sell, thereby influencing yields. Accordingly, a yield curve targeting central bank relinquishes the control over its balance sheet, since if it wishes to remain credible, it has to perform the purchases no matter the available supply. Nonetheless, in the case of a credible commitment, yields shift in the desired direction, therefore this framework may be successful with less government securities purchases than in quantitative easing. Due to the BoJ’s government securities market position and the size of its balance sheet, the balance sheet’s further rapid bloating cannot be considered a genuine risk.

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Key terms adaptive inflation expectations cyclical position derivatives ex-ante real interest rate monetary policy normalisation neutral real interest rate non-performing loans

quantitative and qualitative easing required reserves risk premium secular stagnation signalling effect zero interest rate policy

â&#x20AC;&#x201D; 200 â&#x20AC;&#x201D;

5 The Japanese central bank’s fight against deflation

References Andolfatto, D. (2016): The failure to inflate Japan. 29 November 2016. http://andolfatto.blogspot. hu/2016/11/the-failure-to-inflate-japan.html Arslanalp, S. – Botman, D. (2015): Portfolio Rebalancing in Japan: Constraints and Implications for Quantitative Easing. IMF, WP/15/186.s. Arteta, C. – Kose, M.A. – Stocker, M. – Taskin, T (2016): Negative interest rate policies: Sources and implications. CEPR, Discussion Paper, no. 11433. Bank for International Settlements (2016): Monetary policy: more accommodation, less room. 86th Annual Report 2015/16, pp. 63–82. http://www.bis.org/publ/arpdf/ar2016e4.htm Bank of Japan (2013a): Introduction of the “Price Stability Target” and the “Open-Ended Asset Purchasing Method”. Bank of Japan. 22 January 2013. https://www.boj.or.jp/en/announcements/ release_2013/k130122a.pdf Bank of Japan (2013b): Introduction of the “Quantitative and Qualitative Monetary Easing”. Bank of Japan. 4 April 2013. https://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf Bank of Japan (2016a): Introduction of “Quantitative and Qualitative Monetary Easing with a Negative Interest Rate”. Bank of Japan. 29 January 2016. https://www.boj.or.jp/en/announcements/ release_2016/k160129a.pdf Bank of Japan (2016b): New Framework for Strengthening Monetary Easing: “Quantitative and Qualitative Monetary Easing with Yield Curve Control”. Bank of Japan. 21 September 2016. https:// www.boj.or.jp/en/announcements/release_2016/k160921a.pdf Bernanke, B. (2016a): What tools does the Fed have left? Part 2: Targeting longer-term interest rates. Brookings. https://www.brookings.edu/blog/ben-bernanke/2016/03/24/what-tools-does-thefed-have-left-part-2-targeting-longer-term-interest-rates/ Bernanke, B. (2016b): The latest from the Bank of Japan. Brookings. https://www.brookings.edu/ blog/ben-bernanke/2016/09/21/the-latest-from-the-bank-of-japan/ Bernanke, B. – Laubach, T. – Mishkin, F. – Posen, A. (1999): Inflation Targeting: Lessons from the International Experience. Princeton, NJ: Princeton University Press. 1999. Borio, C. – Disyatat, P. (2009): Unconventional monetary policies: an appraisal. BIS, Working Papers no. 292. Felcser, D. – Lehmann, K. (2012): A Fed inflációs célja és a bejelentés háttere (The Fed’s inflation target and the background of the announcement). MNB Bulletin, October, Magyar Nemzeti Bank, pp. 24–37. Hidasi, B. – Papp, I. (2015): A japán bankrendszer átalakulásának főbb állomásai (The main stages of the transformation of Japan’s banking system). Hitelintézeti Szemle, special edition, November 2015, pp. 116–133.

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IMF (2013): Annual Report on Exchange Arrangements and Exchange Restrictions. International Monetary Fund, Washington, D.C. 2013. http://www.elibrary-areaer.imf.org/Documents/ YearlyReport/AREAER_2013_full_report_Final_12-10.pdf Kiuchi, T. (2015): Revisiting QQE. Speech, Capital Markets Research Institute, Japan. 3 December 2015. https://www.boj.or.jp/en/announcements/press/koen_2015/data/ko151203a.pdf Kiuchi, T. (2016): Recent developments in Economic Activity, Prices and Monetary Policy. Speech, Kagoshima, Japan. 25 February 2016. https://www.boj.or.jp/en/announcements/press/ koen_2016/data/ko160225a.pdf Kuroda, H. (2014): Ensuring Achievement of the Price Stability Target of 2 Percent. Speech, Tokyo, Japan. 5 November 2014. Kuroda, H. (2016a): The battle against deflation – the evolution of monetary policy and Japan’s experience. Speech, New York, USA. 14 April 2016. https://www.boj.or.jp/en/announcements/press/ koen_2016/data/ko160414a1.pdf Kuroda, H. (2016b): Japan’s Economy and Monetary Policy. Speech, Nagoya, Japan. 14 November 2016. https://www.boj.or.jp/en/announcements/press/koen_2016/data/ko161114a1.pdf Krekó, J. – Balogh, Cs. – Lehmann, K. – Mátrai, R. – Pulai, Gy. – Vonnák, B. (2012): Nemkonvencionális jegybanki eszközök alkalmazásának nemzetközi tapasztalatai és hazai lehetőségei (International experiences and domestic opportunities of applying unconventional monetary policy tools). MNB Occasional Papers. No. 100, 2012. Nakaso, H. (2016a): Japan’s economy and the Bank of Japan: Yesterday, Today, and Tomorrow. Speech, Tokyo, Japan. 23 May 2016. https://www.boj.or.jp/en/announcements/press/koen_2016/data/ ko160523a1.pdf Nakaso, H. (2016b): Monetary Policy and Structural Reforms. Speech, New York, USA. 12 February 2016. https://www.boj.or.jp/en/announcements/press/koen_2016/data/ko160213a1.pdf Sato, T. (2015): Recent Economic and Financial Developments and Monetary Policy. Speech, Kofu, Japan. 10 June 2015. http://www.boj.or.jp/en/announcements/press/koen_2015/data/ ko150610b1.pdf Sato, T. (2016): Recent Economic and Financial Developments and Monetary Policy in Japan. Speech, Kushiro, Japan. 2 June 2016. https://www.boj.or.jp/en/announcements/press/koen_2016/ data/ko160602a1.pdf Shirakawa, M. (2012): The Bank of Japan’s efforts toward overcoming deflation. Speech, Tokyo, Japan. 17 February 2012. https://www.boj.or.jp/en/announcements/press/koen_2012/data/ ko120217a1.pdf

Part II

Challenges and answers in Hungarian Monetary Policy

Complex challenges for the Hungarian economy and Hungaryâ&#x20AC;&#x2122;s monetary policy

Macroeconomic conditions in the first decade of the 2000s Gergely Baksay – Dániel Babos – Gábor Dániel Soós

Between 1997–2001, the Hungarian economy was characterised by sustained external and internal balance and strong economic growth. In that period, public debt declined steadily, overall macroeconomic indicators improved, and the economy became less vulnerable. The high levels of inflation decreased as the unemployment rate continued to fall; however, these favourable tendencies came to a halt in 2002. Although strong growth was sustained, it was accompanied by an upset balance. The performance of the real economy and the economic convergence therefore became unsustainable in that period, simultaneously with increasing imbalance and growing indebtedness. As economic growth without external and internal financial balance is not sustainable, problems emerged well before the onset of the crisis. Investment and labour market activity restrained potential growth for the Hungarian economy as early as in 2006. The global economic crisis hit Hungary’s economy at a time when the economy was extremely vulnerable, which therefore led to a deepening recession. By the time of the crisis, a macroeconomic situation had evolved in Hungary that limited the central bank’s conventional instruments, calling for the use of new, targeted and innovative instruments; a solution which was provided by the monetary policy turnaround in 2013. By the time of the economic crisis, Hungary had accumulated a high level of public debt, which increased the country’s risk premiums and, consequently, also the costs of financing the economy. Additionally, the unfavourable structure of households’ indebtedness (with the spread of foreign currency lending) further increased the country’s vulnerability. On the domestic side, in — 207 —

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the years preceding the crisis an irresponsible fiscal policy had contributed to unhealthy and unsustainable economic growth. Hungary’s level of development diverged from that of developed European countries, and to resume economic convergence, Hungary needed both fiscal stability and declining public debt ratio, as well as the monetary policy turnaround in 2013. Since then, the Hungarian economy has been on a sustainable growth path. This chapter examines, primarily from a monetary policy perspective, the macroeconomic and fiscal environment characterising the pre-crisis period, and the role of monetary policy in shaping that environment.

6.1 Economic policy objectives in the early 2000s In 2001, Hungary’s economy was on a balanced growth path. Key macroeconomic indicators signalled a favourable outlook in terms of economic developments. The economy was growing at a steady rate of around 4 per cent, while public debt as a percentage of GDP was following a declining trajectory to approximate the 50 per cent mark. In parallel with the active performance of the economy, the unemployment rate declined progressively to approximately 5 per cent. In that period, economic policy was driven by efforts to join the European Union and to introduce the single currency, the euro. The only missing link could be identified on the nominal side: although the inflation rate had fallen sharply in preceding years, it was still high compared to the rest of Europe. Accordingly, yields were also far higher than the criteria.43 Before 2001, Hungary had in place a monetary regime based on a crawling peg of its currency. Although the regime sufficiently reduced inflation from the high levels (occasionally above 43

aastricht criteria: Public deficit shall not exceed 3% and public debt 60% as a M percentage of GDP, the currency of the Member State shall remain stable within a specific range over a horizon of two years, inflation shall not exceed the average of the three Member States with the lowest levels of inflation by more than 1.5 percentage points, and interest rates shall not exceed the average of the long-term interest rates of the same Member States by more than 2 percentage points.

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6 Macroeconomic conditions in the first decade of the 2000s

30 per cent) seen in the 1990s, disinflation came to a halt by the turn of the millennium, and the inflation rate stabilised at around 10 per cent. That value substantially exceeded both the rate which the central bank could tolerate for price stability purposes, and the criterion for joining the euro area. Apart from a sharp rise in commodity prices in the global market, the stall in disinflation was also attributable to an increase in the general effects of imported inflation. For example, in the space of two years the price of crude oil more than doubled from the annual average of 12 USD a barrel in 1998. Another hazard was posed by persistently high inflation expectations. The crawling peg regime had reached the limits of operability, which called for the introduction of a new monetary regime that would again set the inflation rate on a declining path. It was in this environment that inflation targeting (IT), previously implemented successfully in other countries, was introduced.

6.2 Challenges for monetary policy The question arises why, unlike in other countries, inflation targeting did not become a success story in the first decade of the 2000s. To answer that question, it is appropriate first to overview key macroeconomic indicators, then to examine the role of fiscal policy in that period.

6.2.1 A brief macroeconomic overview

Although inflation was successfully reduced from the levels around 10 per cent seen before the adoption of IT, price stability could not be achieved: measured at monthly intervals, annual inflation continued to fluctuate in a wide range between 2 and 9 per cent. The first 8 to 10 years of inflation targeting can essentially be broken down into two periods. The first of these comprises the years 2002–2006, characterised by a fiscal policy of overspending, followed by a period of necessary adjustment. The cyclically adjusted primary balance and the current account balance were both in deep negative territory, clearly indicating the imbalances — 209 —

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of the era. In both periods, inflation was highly volatile, fluctuating around 5 to 6 per cent. Apart from major regulated price increases, that volatility was also largely attributable to indirect tax changes. In combination, these alone accounted for 2 to 3 percentage points within the inflation rate (Table 6-1). Table 6-1: Developments in specific macroeconomic variables (per cent) Period

2002—2006 2007—2009 2010—2012 2013—2015

GDP-growth

4.3

—1.8

0.3

3.1

Inflation

4.8

6.1

4.8

0.5

Contribution of regulated prices to inflation

1.3

2.1

0.9

—0.7

0.5

0.8

1.4

0.6

Primary ESA balance adjusted for the cyclical componnent

Contribution of indirect taxes to inflation

—4.3

—0.7

1.0

2.6

Current account balance (percentage of GDP)

—7.3

—5.8

0.6

3.0

Note: Each value represents the average of the period indicated. Source: HCSO, MNB, AMECO.

6.2.2 Unfavourable economic policy context

In the favourable cyclical environment prevailing for most of the period, a pro-cyclical fiscal policy was pursued and as a result of a fiscal policy of significant overspending, a persistently high deficit and rising government debt was observable. The fiscal measures responding to the adjustment constraint exerted strong upward pressure on prices (in the form of VAT and excise duty increases), the second-round effects of which prompted the central bank to pursue a tight monetary policy. The unfavourable constellation emerging in the period, i.e. a fiscal policy of overspending, a tight monetary policy and free capital movements, essentially paved the way for imbalances and the spread of foreign exchange-based lending. Additionally, overspending scheduled for the elections also influenced the political direction of the fiscal measures taken at the time. Overall, dependence on external resources, the spread of foreign exchange-based lending, an undisciplined fiscal — 210 —

6 Macroeconomic conditions in the first decade of the 2000s

policy, and rising risk premiums collectively led to the deterioration of the economic situation (Chart 6-1). Chart 6-1: Unfavourable developments in the period under review Increasing risk premium

Irresponsible Fiscal Policy

Spread of FX loans

External financing need Source: Authors.

6.2.3 Developments in public deficit and adjustment attempts

At the turn of the millennium, the main indicators of fiscal policy were favourable, with the deficit as a percentage of GDP remaining below the 3 per cent Maastricht threshold, and the debt ratio below 60 per cent. Following the turn of the millennium, however, the balance of the Hungarian budget was upset, with public deficit increasing and public debt as a percentage of GDP set on an upward trajectory. One of the primary functions of fiscal policy is to mitigate economic cycles by pursuing an anti-cyclical policy. The approach taken by classical economics (Musgrave 1959) recognises three functions of fiscal policy: allocation, redistribution and stabilisation. The stabilisation function of fiscal policy concerns the need to mitigate the cyclical fluctuations of the economy through the budget, mindful of the sustainability of public finances. Fiscal policy is considered to perform its stabilising function by cooling the economy in upturns and â&#x20AC;&#x201D; 211 â&#x20AC;&#x201D;

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stimulating it at times of crisis, which is referred to as anti-cyclical fiscal policy. In a crisis, the state should pursue an economic policy to stimulate demand, i.e. run a deficit to mobilise foreign and domestic savings for the purpose of economic growth. For this, it is essential that in an upturn, the state build up “reserves” for itself through a tight fiscal policy. Between 2002–2009, fiscal policy ran an unsustainably high deficit, while for most of the period, it strengthened rather than mitigated cyclical effects. Fiscal policy thus became the main source of vulnerability and imbalances rather than providing a stabilising function. The deficit soared abruptly in 2002, and remained high (at an average 6.5 per cent) for the entire period despite two adjustment attempts. In the first years, the growth in the deficit can be considered anti-cyclical as demand from the country’s external markets decreased in the period, but the increase in the deficit was not aligned with the fall in demand. Subsequently, the fiscal policy became strongly procyclical. In 2005–2007, given the upturn prevailing in the global market, the budget should have built a reserve to cover the fiscal easing to be implemented in a crisis period. By contrast, the public deficit averaged around 7 per cent in those years, although in 2006 an (unsuccessful) attempt was already made to improve the balance. Apart from the high deficit, the credibility of fiscal policy was also eroded by unimplemented adjustment plans. In the convergence programmes submitted to the European Commission, the budget Chart for each year concerned was also considerably more optimistic than that actually expected, and looking forward, improvements were always foreseen in the programmes, without any meaningful measures being taken (Chart 6-2).

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6 Macroeconomic conditions in the first decade of the 2000s

Chart 6-2: Convergence programmes and meeting the deficit target 0

As a percentage of GDP

−2

−4

−6

−8

−10

−12

2002

2003

2004

2005

2006

2007

2008

2009

2010

−12

Public deficit (actual data) Source: Convergence programmes, AMECO.

While the fiscal adjustment attempt carried out in 2006 involved a major growth sacrifice, it failed to provide a solution to the structural problems, as a result of which it ultimately did not improve the balance to the required extent. In 2006, public deficit continued to rise and exceeded 9 per cent. In the second half of that year, fiscal policy made an attempt to reduce the deficit, but the effect of some of the measures were only felt in 2007. Although tax increases reduced the public deficit, they involved major sacrifices in terms of growth and employment. By 2007, the public deficit was reduced to 5.1 per cent of GDP, but the growth rate of the economy also decelerated in the process. The adjustment failed to provide a solution to the biggest challenges. By further increasing the labour tax burden, it maintained the unfavourable labour market situation, and the review and reform of the social benefits system also did not occur. — 213 —

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Box 6-1 Fiscal adjustment in 2006

By mid-2006, it had become obvious that the fiscal policy was unsustainable, and immediate action was needed to reduce the deficit. The austerity measures announced in September primarily involved measures on the revenue side, and taxes on labour and consumption also increased. Key measures – the preferential VAT rate was increased from 15 to 20 per cent; – the rate of health insurance contributions was increased from 4 per cent to 6 per cent then to 7 per cent, and the rate of employees’ contributions was increased from 1 per cent to 1.5 per cent; – the rate of the simplified business tax was increased from 15 per cent to 25 per cent; – development tax incentives were reduced; – the administrative expenses of ministries were cut. The measures reduced households’ disposable incomes, and curbed employment and the rate of economic growth, as a result of which the programme weakened its own effect. According to OECD data, the increases in social security contributions caused the tax wedge on average incomes to rise to 54.5 per cent by 2007, representing a further increase on the rate that had already been extraordinarily high in a regional comparison. As a result of the adjustment, the public deficit decreased from 9.3 per cent to 5.1 per cent by 2007, but economic growth decelerated significantly, and was below 0.5 per cent in 2007.

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6 Macroeconomic conditions in the first decade of the 2000s

Chart 6-3: Tax wedge in OECD countries (2007) 60

Percent of total labour cost

BE HU DE FR AT IT SE FI SI CZ TY EL DK EE ES NL SK NO PT PL OECD LU UK CA US IS JP AU IL CH IE NZ KR MX Cl

Source: OECD.

The onset of the global financial crisis forced another fiscal adjustment, the unfavourable structure of which only contributed to a deeper recession. Countries with stable fiscal positions pursued anti-cyclical policies by increasing their public deficits to boost internal demand and counterbalance the negative economic effects of the crisis. By contrast, Hungary’s fiscal position was unstable and unsustainable over the long term even before the crisis, which called for fiscal stabilisation in 2008. However, the measures aimed at reducing the deficit contributed to a deeper recession in a pro-cyclical manner. This was because the measures cut fiscal expenditures by about 4 per cent of GDP, which was accompanied by a major fall in internal demand, contributing to an approximately 7 per cent decline in economic growth. The controversial outcome of the adjustment attempt is illustrated by the fact that in 2009, the cyclically adjusted fiscal balance improved, but the ESA deficit increased (Chart 6-4). — 215 —

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Chart 6-4: Developments in the cyclical balance of the budget 6

As a percentage of GDP

6 4

4 Fiscal balance according to 2011 methodology

2015

2014

2013

–12

2012

–12

2011

–10 2010

–10 2009

–8

2008

–8

2007

–6

2006

–6

2005

–4

2004

–4

2003

–2

2002

–2

2001

2000

ESA balance adjusted for the cyclical componnent Cyclical component ESA balance Source: MNB, AMECO.

Box 6-2 Fiscal adjustment in 2009

Following the 2006 adjustment attempt, public deficit remained high and public debt continued to rise. The financial crisis hit Hungary when the country was facing an unstable financial situation, creating the need to implement another fiscal adjustment programme, which was also required under the agreement with international organisations. For the most part, the measures took the form of cuts in fiscal expenditures, but specific tax rates were also increased. Key measures – 13th-month pensions were discontinued, and raising the official retirement age was brought earlier;

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6 Macroeconomic conditions in the first decade of the 2000s

– the 2009 upward pension adjustment was rescheduled, and the 2010 upward adjustment was abandoned; – sickness benefits were reduced by 10 percentage points; – nominal wages were frozen in the public sector, and 13th-month benefits were withdrawn; – the VAT rate was increased from 20 to 25 per cent, and the preferential rate was increased to 18 per cent; – excise duties were increased by an average 5 to 6 per cent.

The austerity measures achieved partial results by cutting expenditures, which in turn significantly moderated economic growth. The 2008–2009 financial crisis highlighted the fact that in a recession, the fiscal multiplier is much stronger than in a favourable economic environment. The negative fiscal impulse caused by cutting expenditures consequently exerted a very strong impact on internal demand and GDP, which declined by approximately 7 per cent in real terms. The recession also led to a decline in fiscal revenues, as a result of which the overall deficit did not decrease in comparison to its 2008 level.

6.2.4 Developments in public debt

Between the turn of the millennium and the trough of the crisis, public debt as a percentage of GDP increased by some 30%. Up to 2001 Hungary’s debt-to-GDP ratio had decreased progressively to 51.7 per cent. Subsequently, between 2001 and 2007, the debt ratio increased by 15 percentage points due to the persistent extremely high level of public deficit, and then the financial assistance programme from the IMF and the European Commission and the decline in GDP both led to an increase in the debt-to-GDP ratio by another 15 percentage points (Chart 6-5).

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Chart 6-5: Structure of public debt and its level as a percentage of GDP 90

As a percentage of GDP

As a percentage of total debt

0 2016

0 2015

10 2014

10 2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Share of foreign investors (right-hand scale) Gross public debt Share of FX-denominated debt (right-hand scale) Source: MNB.

Until 2008, the extremely high deficit played the key role in debt growth. In 2002–2007, the public deficit averaged 7.4 per cent of GDP, about one-half of which was comprised of interest expenditures, with the rest corresponding to the deficit of the primary balance. The persistently high primary deficit was a result of irresponsibly loose fiscal policy until 2006, which aimed to maintain a strong fiscal stimulus for demand on a continuous basis. Over the short term, this contributed to GDP growth, while over the long term it reduced growth potential because, for a major part, it was used for expenditures on consumption rather than on investments, and it also increased the vulnerability of the economy. From 2008, due to an economic downturn and the IMF-EU loans, the debt ratio increased significantly and passed the 80 per cent mark by the end of the decade. The crisis intensified investors’ risk aversion, which led to massive capital outflows from vulnerable markets. Due to — 218 —

6 Macroeconomic conditions in the first decade of the 2000s

the sustained high level of the public deficit, the rising trend of public debt and slow economic growth, Hungary was given an extremely high risk rating by the market. As a result, the government securities market “dried up” in a matter of days, and instead of borrowing from the market, the state was forced to seek loans from international organisations. Subject to specific terms and close monitoring of economic developments, the IMF and the EU granted a EUR 19 billion facility to Hungary, of which EUR 12.9 billion was drawn in 2008–2009 (Table 6-2). These drawings significantly increased government gross debt and created an even more unfavourable debt structure. Table 6-2: Drawings and repayments on IMF and EU loans IMF

drawing

EU repayment

drawing

repayment

2008

5.0

—

2.0

—

2009

2.4

—

3.5

—

2010

—

2011

—

2.0

2012

—

3.5

—

2013

—

4.0

—

2014

—

2.0

2015

—

2016

—

1.5

Total

7.4

7.5

5.5

Note: The IMF provided its loans based on SDR, which results in the difference between the drawn and the repaid sum calculated in euros. The table does not show the loan of EUR 1.4 billion drawn from the IMF by the MNB in 2009. Source: IMF, European Commission.

Within public debt, the share of foreign exchange debt and nonresident holdings increased. Observed throughout the period, this development was primarily attributable to the insufficiency of domestic savings to meet the high financing requirement of the state. As households had a low propensity to save, the general government was increasingly financed by foreign investors, partly in foreign exchange. — 219 —

Part II: Challenges and answers in Hungarian Monetary Policy

Due to the loans from international organisations, the share of debt to non-residents reached 50 per cent within total debt, and the share of foreign exchange debt approximated the same ratio (Chart 6-5).

6.2.5 Structural problems prevailing in the 2000s

The structural problems of Hungary’s economic policy in the 2000s were essentially rooted in fiscal policy. For the purposes of this chapter, three aspects are highlighted: the distortions caused by the tax regime, the misaligned incentives of social benefits, and the high risk premiums resulting from the vulnerability of the economy. The structural problem inherent in Hungary’s tax regime was that an excessively low number of taxpayers paid excessive taxes. The labour tax burden was particularly high, curbing both labour demand and supply. On the one hand, the high average tax wedge (the difference between net wages to the total labour cost) is harmful on the extensive margin of labour supply decisions, due to its failure to stimulate labour market activity. On the other hand, the high marginal tax wedge (the tax burden on a single unit of additional work) poses a problem on the intensive margin of elasticity as it erodes the net income than can be generated by means of the additional work. In the 2000s, average earners were subject to a marginal tax wedge of 60 to 75 per cent, i.e. approximately two-thirds of their additional earnings above the minimum wage was collected by the state in the form of taxes and contributions. Apart from hurting competitiveness, this also led to the growth of the shadow economy by incentivising tax evasion (for more details, see Chapter 7). Apart from the tax regime, the misaligned incentives of social benefits also contributed to the low levels of employment and activity. Compared with the burden-bearing capacity of the national economy and the level of activity, benefits represented a high amount, and were mostly unrelated to labour. Their structure and level acted as a

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6 Macroeconomic conditions in the first decade of the 2000s

disincentive to work, especially given the high overall and marginal tax rates. The period between 2002–2009 saw a steady increase in cash social benefits as a percentage of GDP. By the end of the decade, such benefits accounted for more than 15.5 per cent of GDP, which significantly exceeded both the regional average and that of the European Union (Chart 6-6). As a combined result of the foregoing, Hungary had one of the lowest activity rates in the European Union. Chart 6-6: Social benefits as a percentage of GDP (2008) 20

As a percentage of GDP

20 18

AT FR IT EL DE HU BE LU DK FI PT SI PL SE EU28 UK V3 ES HR CZ MT SK IE LT CY EE RO BG NL LV

Source: AMECO.

The economic vulnerability and inflation caused by the unsustainable fiscal policy led to an increase in financing costs in all sectors of the economy. Despite the high global risk appetite of the 2000s, Hungary developed an environment of rather high interest rates, which was primarily attributable to fiscal policy. The tax increases and regulated price increases undertaken as part of fiscal consolidation attempts both

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led to a major upsurge in inflation and consequently in nominal yields. Furthermore, monetary policy kept the policy rate high in an attempt to counterbalance the inflation generated by fiscal policy and the countryâ&#x20AC;&#x2122;s deteriorating risk perception. The high level of domestic interest rates established this way curbed lending and investments in the private sector. The significant difference emerging between high-interest forint loans and low-interest FX-denominated loans led to the spread of foreign exchange-based loans, giving rise to one of the most severe problems in Hungarian economic policy over the past few decades.

6.2.6 The spread of foreign exchange-based lending

Historically, one of the key negative aspects of the period under review is the spread of foreign exchange-based lending (Chart 6-7), and the increased prevalence of over-indebtedness. In addition to high forint rates and narrowing subsidies on forint-based loans, opportunities for retail borrowing were also reduced by government overspending. Moreover, foreign exchange interest rates were significantly lower than forint rates, making decidedly lower instalments alluring for individuals who applied for credit with banks. Additionally, the retail confidence indicator also pointed to an improving outlook for households. In that period, the foreign exchange risk involved in foreign exchange-based lending may have occupied a minor role in decision making.

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6 Macroeconomic conditions in the first decade of the 2000s

Chart 6-7: Developments in household debt 12,000

HUF Billions

12,000

Household foreign currency debt Household debt

2016

2015

2014

2013

2012

2011

2,000

2010

2,000

2009

4,000

2008

4,000

2007

6,000

2006

6,000

2005

8,000

2004

8,000

2003

10,000

2002

10,000

Household domestic currency debt

Source: MNB.

In the spread of foreign exchange-based lending, a role was played both by factors on the demand and supply side, and by those of economic policy.44 Among the factors on the demand side, the most prominent one concerns the far lower interest rates charged on FX-loans relative to forint rates, and the fact that given the stability of the forint against the Swiss franc over the preceding years, households would not expect major exchange rate movements. Additionally, banks did not warn their customers about the risks involved in foreign exchange-based lending. Among the factors on the supply side, one of the most prominent one concerns the fact that the favourable global market environment prevailing at the time provided an abundance of affordable funds for the spread of foreign exchange-based lending in Hungary.

See Erhardt et al. (2015) for more details.

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The deficient regulatory environment may also have played a meaningful role in the spread of foreign exchange-based lending. Foreign exchange-based loans were granted on a large scale to customers who had no natural foreign exchange collateral, and were therefore, in essence, fully exposed to the risk from exchange rate fluctuations. Additionally, banks were not sufficiently prudent either, the qualitative terms of lending were lax, and a lenient consideration of household incomes and customers’ levels of indebtedness was also not seen as a barrier. Debt rising as a result of a fiscal policy of overspending also caused risk premiums to rise, driving investors to expect higher yields on HUF-denominated assets, which contributed to the shift of households towards foreign exchange-based loans with lower rates of interest. The process was intensified by the strong competition developing among banks seeking to increase their share of the lending market, which resulted in more relaxed qualitative terms of borrowing, and consequently made credit accessible for a larger group. The spread of foreign exchange-based lending was observed as early as from 2001 onwards, but at that time its volume was negligible and was mostly limited to car loans. Subsequently, the tightening of subsidies on housing loans contributed to the fact that such loans were increasingly financed in foreign exchange. The dependence on foreign exchange affected both the household and corporate sectors. However, corporations include a large number of exporters with regular foreign exchange sales, which were therefore subject to a smaller degree of risk from greater indebtedness in foreign exchange. In addition, the need for foreign exchange also increased in the case of the state, as the third large player. As domestic funds were insufficient to finance the fiscal deficit, the external financing requirement increased. Overall, the country’s net external debt increased steadily throughout the period between 2002–2008 (Chart 6-8), which largely contributed to the fact that the global economic crisis emerging hit Hungary in a weakened state. — 224 —

6 Macroeconomic conditions in the first decade of the 2000s

Chart 6-8: External debt ratios as a percentage of GDP 140

Per cent

70 60

120

100

Corporations (right-hand scale) Banking system (right-hand scale) Net external debt (right-hand scale)

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

–10 2000

Government (right-hand scale) Gross external debt (left-hand scale)

Note: Excluding inter-company loans. Source: MNB.

The spread of foreign exchange-based lending was apparent with both housing and consumption loans. The process started to disturb the balance particularly after 2006. The fiscal austerity measures45 substantially narrowed households’ leeway, reducing their real disposable incomes and consequently driving individuals towards cheap foreign exchange-based loans for the progress of their own and their families in an attempt to maintain or further increase their level of consumption. Over-indebtedness therefore resulted in excessive demand along with the build-up of large exposures, which contributed to the fact that after 2006, prices increased at a rate exceeding that of the balance, resulting in additional volatility of the inflation rate. Therefore, the 2006 fiscal measures also played a significant role in the spread of foreign exchange-based lending. Indebtedness in such an unhealthy arrangement was outstanding even by regional standards, and was a major factor in the very protracted recovery from the crisis. 45

For more details, see Box 6-1 of this chapter.

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During the period, as a result of the apparently stable exchange rate and the control of high inflation, high forint interest rates contributed to the build-up of a massive portfolio of foreign exchange-based loans. Subsequently, the efficiency of monetary policy was significantly reduced by the high proportion of such loans. Suffice it to take the following simple example: to facilitate recovery from the crisis, interest rate cuts are required in order to accelerate growth. Interest rate cuts in themselves result in a depreciating exchange rate. In turn, a depreciating exchange rate will rearrange the incomes of households that have taken foreign exchange-based loans. Namely, expressed in forints, the instalments of an outstanding foreign exchange-based loan will increase due to a weaker exchange rate, which will reduce the disposable income of the household, and also its consumption as a result. Consequently, monetary easing cannot produce its effect, or only to a limited extent. This distortion was significantly reduced through the economic policy efforts after 2010, and then eliminated completely by the forint conversion carried out 2015, which contributed to healthy, sustainable and stable growth and, as a consequence, to stable inflation. Therefore, the significant downsizing of the portfolio of foreign exchange-based loans was sufficient in itself to strengthen the effect of monetary policy on the real economy.46

6.3 Summary – Inflation targeting in Hungary in the period under review In the early 2000s, inflation targeting was adopted with the primary objective of resuming disinflation so that the inflation rate, which was then stabilised at around 10 per cent, could again be set on a declining path. Initially, this did happen, but primarily due to the fiscal policy being pursued at the time, inflation tended to remain above the inflation target and showed a relatively high degree of volatility compared to other countries in the region (Figures 6-9 and 6-10). 46

or more details on the spread of foreign exchange-based lending and its phasing F out in Hungary, see Kolozsi–Banai–Vonnák (2015).

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6 Macroeconomic conditions in the first decade of the 2000s

Chart 6-9: Developments in inflation targets and inflation 11

Per cent

Consumer price index

11 9

Inflation target

Tolerance band

–1 –2 2001

–1

Inflation target at the end of the year 2003

2005

2007

–2 2009

2011

2013

2015

Note: A tolerance range of ±1% was also defined for year-end inflation targets. Source: HCSO, MNB.

Chart 6-10: Inflation in Hungary and other countries in the region 20

Per cent

–5 1998

2000 EU28

2002

2004

2006

Czech Republic

2008 Poland

Note: HICP annual change, monthly data. Source: Eurostat.

— 227 —

2010

2012 Slovakia

2014

2016 Hungary

–5

Part II: Challenges and answers in Hungarian Monetary Policy

Before the crisis, the overall philosophy of the IT regime was that it would be sufficient to aim solely at the stabilisation of price increases. In other words, it would be sufficient to remain mindful of smoothing the volatility of inflation around the target, which would in itself provide stability for the real economy. This was a generally accepted view at the time, even by international standards. Consequently, the aspects of financial instability were not given due consideration. However, the crisis underlined the fact that such efforts were insufficient and that monetary policy should focus more on aspects of financial stability. The problem with pre-crisis practices is perhaps best exemplified by the spread of foreign exchange-based lending along with excessive indebtedness, factors of substantial risk to the economy. Therefore, in the period under review, the imbalances of Hungary’s real economy and the protraction of its recovery from the crisis were, to a substantial degree, attributable to the build-up of financial imbalances. Slackening fiscal discipline (with the ESA balance of the government sector at around 8 to 10 per cent for years as a percentage of GDP) contributed to over-indebtedness and unsustainable growth, and also played a part in the significant rise in the inflation rate; consequently, the economic policy pursued at the time exerted major undesirable effects on Hungary. The fiscal policy of the era is well exemplified by developments in public debt. Between 1997–2001, the debt-to-GDP ratio was successfully reduced to about 50 per cent. In a matter of seven to eight years after 2002, the same ratio skyrocketed to exceed 80 per cent. Excessively relaxed fiscal measures later forced the government to implement adjustments (such as VAT rate increases), which in 2006–2007 pushed the inflation rate well over the 3 per cent target to approximately 8 per cent, while also causing inflation expectations to increase substantially, whereby opportunities to reduce the inflation rate were narrowed through second-round effects.

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6 Macroeconomic conditions in the first decade of the 2000s

The 2006 austerity measures reduced the purchasing power of households’ disposable incomes, leading to a strong deceleration in consumption growth. Declining real wages and rising unemployment were accompanied by an increase in households’ indebtedness. At that point, emphasis was increasingly shifted to the spread of foreign exchange-based lending, which “looked good” but essentially weakened the country further as a result of the build-up of exchange rate risk and the consequent higher vulnerability to external shocks. The period was characterised by a vicious circle in which a fiscal policy of overspending resulted in adjustment constraints (tax increases) that led to more moderate consumption, while rising taxes further decelerated consumption growth through the reduction of real wages. As a secondround effect, the inflation rate hike produced by tax increases also raised expectations on wage inflation, which therefore supported the inflation rate in rising further. The nominal anchor, one of the cornerstones of inflation targeting, was prevented from performing its function by the conditions prevailing in Hungary, as a result of which it also failed to exert a positive effect on price stability and general economic stability. Following the 2006 parliamentary elections, VAT rates were increased along with regulated prices, which led to a persistent increase not only in the inflation rate, but also in the inflation perceived by households and inflation expectations (Chart 6-11). The volatility of inflation made the stabilisation of an already unsustainable and imbalanced macroeconomic situation even more difficult due to the higher unpredictability of the business environment. Matters were made even worse by a significant increase in food prices. Hungary was facing such a macroeconomic environment when its economy was hit by the 2007–2008 global economic and financial crisis.

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Chart 6-11: Developments in inflation as perceived and expected by households 12

Per cent

–2 2002

2004

2006

Perceived inflation

2008

2010

2012

Inflation expectations

2014

2016

–2

Inflation

Source: European Commission, HCSO, MNB.

High public debt and its unfavourable structure were a major contribution to the significant rise in Hungary’s risk premium. Before the onset of the financial crisis, investors were characterised by strong risk appetite, and the expected yields on Hungarian government securities remained level, despite Hungary’s rising debt ratio. Measuring the risk of default, the CDS spread also remained low until Q1 2008. However, in 2008 both the CDS spread and the expected yields on public debt skyrocketed (Chart 6-12). Yields of around 10 per cent were not viable for the general government over the long term, which is why it relied on loans from international organisations also in 2009.

— 230 —

6 Macroeconomic conditions in the first decade of the 2000s

Chart 6-12: Yields on Hungarian 3-month and 5-year government securities and the CDS spread for sovereign debt 13

Per cent

Basis points

800

700

600

500

400

300

200

100 0

5 2005

2006 3-month

2007

2008

5-years

2009

2010

CDS (right-hand scale)

Source: Bloomberg.

In terms of their relation to the inflation target, the developments in inflation over the past 15 years can be broken down into two distinct periods. The first comprises the years before 2013, when inflation persistently exceeded the inflation target, and the rate also showed a greater degree of volatility compared to the period that followed. The target was often overshot as a result of the fiscal policy (tax increases, regulated price increases), and as second-round effects of its measures. The government measures adopted after 2006 characterise such a typical period, in which the inflation rate was pushed above 8 per cent. In the second period, from 2013 onwards, the pass-through of international developments in inflation (a generally low import price inflation and major declines in commodity prices) along with â&#x20AC;&#x201D; 231 â&#x20AC;&#x201D;

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regulated price cuts substantially decelerated inflation to rates below the target. On the other hand, the inflation rate has been significantly less volatile in this second period, which facilitates stable economic growth.

Key terms build-up of imbalances cyclical position of the real economy effect of indirect taxes on inflation external debt external vulnerability high public debt increase in risk premiums inflation inflation targeting regime financing requirement fiscal policy of overspending low potential growth

monetary policy primary balance pro-cyclical fiscal policy public deficit regulated price increases spread of foreign exchange-based lending time-inconsistency transparency unemployment unsustainable economic growth

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6 Macroeconomic conditions in the first decade of the 2000s

References Bauer, P. – Endrész, M. – Kiss, R. – Kovalszky, Zs. – Martonosi, Á. – Rácz, O. – Schindler, I. (2013): Túlzott lakossági eladósodás: okok, trendek, következmények (Excessive Household Debt: Causes, Trends and Consequences). MNB Bulletin Special Issue, October 2013, pp. 29–38. Felcser, D. – Soós, G.D. – Váradi, B. (2015): A kamatcsökkentési ciklus hatása a magyar gazdaságra és a pénzügyi piacokra (The Impact of the Easing Cycle on the Hungarian Macroeconomy and Financial Markets). Financial and Economic Review, 14(3). Erhart, Sz. – Kékesi, Zs. – Koroknai, P. – Kóczián, B. – Matolcsy, Gy. – Palotai, D. – Sisak, B. (2015): A devizahitelezés makrogazdasági hatásai és a gazdaságpolitika válasza (Macroeconomic Impacts of Foreign Exchange-based Lending and the Economic Policy Response). In: Prof. Dr. Csaba Lentner (ed.): A devizahitelezés nagy kézikönyve. Kolozsi – Banai – Vonnák (2015): A lakossági deviza-jelzáloghitelek kivezetése: időzítés és keretrendszer (Phasing Out Household Foreign Currency Loans: Schedule and Framework). Financial and Economic Review, 14(3). Hoffmann, M. – Kóczián, B. – Koroknai, P. (2013): A magyar gazdaság külső egyensúlyának alakulása: eladósodás és alkalmazkodás (Developments in the External Balance of the Hungarian Economy: Indebtedness and Adjustment). MNB Bulletin Special Issue, October 2013. Matolcsy, Gy. (2015): Egyensúly és növekedés (Economic Balance and Growth). Kairosz Kiadó. Mishkin, F.S. – Schmidt-Hebbel, K. (2001): One Decade of Inflation Targeting in the World: What Do We Know and What Do We Need To Know? NBER, Working Paper 8397, July 2001. MNB (2016): Félidős jelentés 2013–2016 (Mid-Term Report 2013–2016). Musgrave, R.A. (1959): The Theory of Public Finance, New York: McGraw Hill. Németh, A.O. (2015): Politikai költségvetési ciklusok Kelet-Közép-Európában – elmélet és empíria (Political Budget Cycles in Central and Eastern Europe – Theory and Empirical Evidence). KözGazdaság, 2015/4. Orbán, G. – Szapáry, Gy. (2006): Magyar fiskális politika: quo vadis? (Hungarian Fiscal Policy: Quo Vadis?) Economic Review, Vol. LIII, April 2006 (pp. 293–309). Palotai, D. – Virág, B. (2016): Hogyan érhető el a sikeres gazdasági felzárkózás – Néhány szó az MNB Versenyképesség és növekedés című könyvéről (How to achieve successful economic convergence? A few words about the MNB’s book entitled ‘Competitiveness and Growth’). Magyar Nemzeti Bank.

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Interactions between fiscal turnaround and monetary policy Dávid Berta – Balázs Csomós

The interactions between fiscal and monetary policy, the two major branches of economic policy, are decisive in terms of the success of economic policy. In the years prior to the crisis, Hungary’s budget was characterised by high deficits and a structure that restricted opportunities for economic growth, which led the central bank to pursue a tight monetary policy. Structural problems and the excessive indebtedness of the budget were the main sources of a vulnerable national economy and low potential growth. Consequently, a fiscal turnaround was needed at the outset, as a result of which the fiscal balance has improved, its structure now enhances growth, and the excessive deficit procedure (EDP) against Hungary was abrogated. The fiscal turnaround has provided the opportunity for cooperation between fiscal and monetary policy, which was realised after 2013, following the monetary policy turnaround. Through its activity, the Magyar Nemzeti Bank (MNB) had three main channels through which to support fiscal policy. First, by means of reducing yields in the government securities market following its easing cycles and the Self-financing Programme, the Bank contributed to the decrease in interest expenditures. Second, through GDP growth, the development of businesses and their implementation of investments, the central bank’s programmes to support lending and economic growth generated additional tax revenues for the budget. Third, in each year since 2013, the MNB has made a profit, i.e. it has not required budgetary funds to cover losses. Additionally the record high profit earned in 2015, enabled the disbursement of dividends of HUF 50 billion, which contributed to the reduction of public debt.

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7 Interactions between fiscal turnaround and monetary policy

In this chapter, we present the elements of the fiscal turnaround between 2010-2013 and those of the monetary policy turnaround after 2013, as well as their interactions. Due to the reduced monetary policy space provided by conventional instruments, in the future fiscal policy is expected to take on a more prominent role in smoothing the cyclical fluctuations of the economy.

7.1 Fiscal policy turnaround and fiscal consolidation The first step in the economic policy turnaround consisted of fiscal consolidation carried out after 2010. The fiscal policy that was implemented in the 2000s was characterised by a structure that was harmful in several respects, thus it needed to be improved following the two basic principles of creating balance and stimulating economic growth. However, the basket offered by international organisations and international creditors did not contain any proposed solution that would simultaneously provide balance and economic growth for the Hungarian economy. Consequently, a sovereign and independent economic policy mix needed to be compiled, often requiring unconventional methods. The difficulty laid in the fact that the previous excessively loose fiscal policy had caused persistent damage in terms of both flow indicators (fiscal balances with significant deficits) and stock indicators (debt). “Rising abruptly during the crisis and remaining high ever since, the debt ratios have been reducing the fiscal policy space in the course of countercyclical policies, which in many cases calls for measures that can be implemented without causing the deficit to rise (Palotai–Virág, 2016). Due to high public debt, the EU’s excessive deficit procedure, and the international loan agreements, Hungary’s fiscal space had become considerably limited. The unorthodox measures were expected both to achieve balance and to stimulate growth. In the past decades, the literature of fiscal policy has paid particular attention to the establishment of growth-friendly fiscal structures. Nevertheless, a perfect universal solution that fits every country obviously does not — 235 —

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exist, which required Hungarian economic policymakers to rely on a careful selection of methods for restructuring the country’s fiscal policy. In the literature, there is general consensus about the way to balance the tax regime regarding functional breakdown. In that regard, taxes on capital can be considered particularly harmful, given that the distortion from such taxes influence economic actors’ decisions on savings and investments and consequently decelerate investments, which could ultimately hinder economic growth. A heavy labour tax burden is also a negative factor because taxes distort the appropriate allocation of time between work and leisure, and consequently influence both the formation of human capital and corporate decisions. The heavy tax burdens on labour and capital already warrant consideration for aspects of competitiveness: countries that have high tax wedges or levy significant tax rates on corporate earnings could fall behind competitors that provide a more favourable and more competitive cost environment for businesses. Consumption taxes tend to be the least harmful in terms of potential growth, given their more limited distorting effect on both savings and investment decisions. Such rearrangements in the tax regime represent a prominent development in an international context, and have also occurred in Hungary. Apart from theoretical considerations, lifting the labour tax burden has also become central to economic policy objectives. Incentives to work and supporting labour activity were essential for the achievement of fiscal balance. In the 2000s, the Hungarian tax regime did not provide incentives for either labour market entry or a higher intensity to work. For average earners, the additional tax burden on a single unit of additional work, i.e. the rate of the marginal tax wedge was significantly, almost 30 percentage points, higher in Hungary than the average in Visegrád countries, and the difference was still typically 15 to 20 percentage points for earners of higher wages (Chart 7-1). The high marginal tax wedge penalised income on additional work, while it also significantly diminished potential returns on human capital investments. The heavy tax burden incentivised the concealment of income by both employees as well as employers (Balog, 2014). — 236 —

7 Interactions between fiscal turnaround and monetary policy

Chart 7-1: Marginal tax wedge in V4 countries at 100 and 167 per cent of average earnings 80

100 percent of average earnings Per cent Per cent

167 percent of average earnings Per cent Per cent

Hungary

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Czech Republic

Slovakia

Poland

Source: OECD.

Since 2010, the marginal tax wedge has fallen significantly for virtually all levels of income. The decrease is primarily explained by the flat personal income tax introduced in 2011. At the same time, the system of taxes and contributions on labour became substantially simpler, with the emphasis being shifted from social transfers and across-the-board tax allowances to targeted cuts. In the case of the personal income tax, family tax allowances were introduced and progressively extended to this particular end, while also serving demographic purposes. Economic policy, at all times, has a paramount interest in reversing the unfavourable demographic developments that characterise almost every developed and many emerging economies, including Hungary. For the purpose of decelerating the aging of society, and to ensure the sustainability of the pension system, it is essential to increase the fertility rate, which can be supported in a targeted manner by housing subsidies for families (CSOK) and the first-

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marriage allowance. Other than demographic developments, family tax allowances also affect labour supply. Corporate demand for labour is also supported in a targeted manner by the current tax regime. The targeted cut in social security contributions implemented as part of the Job Protection Action Plan encourages employers to support the economic activity of disadvantaged labour market groups, in exchange for lower employment cost. As a result of the above measures and recovery from the crisis, the number of employed people has increased by over 600,000 since early 2010. By the second half of 2016, employment exceeded 4.4 million, while the unemployment rate fell to a historic low of 4.7 per cent. Favourably, about two-thirds of new employees found jobs in the private sector, which also helped restore the balance of the budget. Chart 7-2: Taxes on consumption, labour and capital as a percentage of total tax revenues in Hungary 55

Percentage point

10 2006

2007

2008

2009

Taxes on consumption

2010

2011

2012

Taxes on labour

2013

2014

Taxes on capital

Note: European Commission data up to 2012, MNB calculations from 2013. Sources: European Commission, MNB.

â&#x20AC;&#x201D; 238 â&#x20AC;&#x201D;

10 2015

7 Interactions between fiscal turnaround and monetary policy

The other pillar of tax regime changes consisted of a shift towards consumption and sales taxes, as well as sector-specific taxes. Unconventional fiscal policies, including crisis-related taxes, primarily concerned markets dominated by multinational companies, such as the financial, retail, telecommunications and energy sectors. Increases in the rates of consumption and sales taxes (VAT, excise duties) were applied to counterbalance revenue lost due to the reduced labour tax burden, allowing a healthier tax regime to emerge that better supported real economic growth (Chart 7-2), which was consistent with trends observed in the global economy. Given the stronger effect of the fiscal multiplier in times of crises, the budget could not be balanced solely by means of tax increases or cuts in expenditures. As the fiscal multiplier (see the next chapter) would have amplified the effect of the economic downturn following the global recession, any further fiscal austerity would only have deepened the crisis. In a prolonged recession, contrary to original efforts, declining tax revenues would have upset the fiscal balance even further, thus leading to even more austerity. For example, Greece was caught in such a downward spiral after the crisis. In Hungary, unconventional measures included a transition to the formal economy, the implementation of a more equal distribution of public burdens, as well as other structural reforms, primarily concerning the expenditure side of the budget. As part of the fiscal turnaround, several measures were also taken for a transition to the formal economy. The introduction of online cash registers and the Electronic Trade and Transport Control System (EKÁER) have also been contributing to the reduction of the shadow economy. Based on an analysis by the European Commission (2016) from 2013-2014, Hungary achieved the greatest reduction in the VAT gap (derived from the difference between the theoretical tax liability and the tax actually collected). According to the MNB’s calculations, the effective VAT rate (the ratio of the tax collected to the theoretical tax base) increased by 2 percentage points between 2013-2015, while the actual tax rates remained unchanged (Chart 7-3), which is explained — 239 —

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by the whitening of the economy. According to research by Schneider (2015), the overall size of the shadow economy in Hungary contracted by 1.5 percentage points of GDP from 2010-2015. The reduction of tax avoidance may also have a meaningful effect on the prospects for economic growth. When tax avoidance is high or is increasing, keeping the level of tax revenues steady requires a higher tax rate to be applied, which will place an excessive burden on law-abiding taxpayers and will consequently increase the size of the shadow economy, leading to a self-perpetuating process (Balog, 2014). Therefore, while facilitating an increase in fiscal revenues, the measures for a transition to the formal economy will also enable a more equal distribution of public burdens and more efficient capital allocation by removing tax avoiders’ unlawful competitive advantage. Chart 7-3: The Hungarian effective VAT rate 20

Per cent

Per cent Whitening effect

19 18

Effect of the January 2012 raise

Effect of the July 2009 raise

Effect of the September 2006 raise

10 2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Source: MNB.

On the expenditure side of the budget, fundamental reforms were undertaken in the implementation of the Széll Kálmán Plans. A review of the social security system became vitally urgent, in view — 240 —

7 Interactions between fiscal turnaround and monetary policy

of the fact that, apart from placing an unreasonably heavy burden on the budget relative to the economic situation of the country, it had also been acting as a disincentive to work. Also, serving to supersede the former system, the public work scheme provides employment for about 200,000 people under the “work instead of transfers” principle. The review of social expenditures has involved structural reforms such as that of the pension system. As part of the most prominent measure, the terms of early retirement were tightened, which significantly contributed to ensuring the sustainability of the pension system over the long term. Additionally, following the return of a vast majority of pension fund members to the public pension system, contribution payments were also credited to general government revenues from 2011 onwards. As a result, the budgets of social security funds reached or approximated a state of balance. However, the cuts on expenditures were partially counterbalanced by the possibility for women to retire after 40 years of employment. In the 2000s, a failed fiscal policy undermined confidence in the budget. For both economic policy and growth purposes, it is an important objective to maintain the stability and confidence towards fiscal policy, which may be guaranteed by an adequate institutional system. Budgetary frameworks anchor expectations for fiscal policy, while they also foresee economic policymakers’ medium- and long-term objectives (Blanchard et al., 2010). Over the past decades, fiscal policy has increasingly been focused on the development of the institutional system, with a sudden increase in the number of national fiscal rules from the early 1990s across European countries (Tóth, 2016). The recognition of the importance of the institutional system has driven several countries to establish institutions for the supervision of fiscal responsibility and sustainable fiscal management, and grant those institutions independence from the government. Hungary belongs to that group, because as of 2011, four different national fiscal rules have entered into force, and the Fiscal Council, which was subject to major changes in 2010, has also been supporting compliance with fiscal — 241 —

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rules. In its assessment of the Budget Act, the Fiscal Council carries out an evaluation on compliance with the budget rule laid down in the Fundamental Law47, and its consent is required for the adoption of the Act. The measures implemented as part of the fiscal turnaround were followed by a meaningful improvement in fiscal discipline and compliance in Hungary. Since 2011, the accrual-based (ESA) deficit of the budget, as a percentage of GDP, has consistently remained below the 3 per cent threshold set out in both the Maastricht criteria and the Hungarian fiscal rules (Chart 7-4). The deficit fell to 2.3 per cent of GDP in 2012, to gradually decline in subsequent years to 1.6 per cent by 2015. Post-2000, the primary balance of the budget first showed a surplus after 12 years, in 2012. As a result of the fiscal turnaround, the European Union’s excessive deficit procedure (EDP) against Hungary was abrogated in 2013. The EDP was initiated on grounds of Hungary’s successive violations of the fiscal rules that lead to an excessive deficit procedure (the rules of deficit and debt), and remained in effect against Hungary for nine years from the country’s accession to the EU in 2004. The European Commission had already announced the date of suspending of EU funds; however, Hungary implemented the Commission’s recommendations before the deadline, in 2012, and the procedure was abrogated in 2013 by pursuing disciplined and responsible fiscal management. The withdrawal of cohesion funding represents the most severe penalty under the EDP for Member States outside the euro area, which Hungary faced as a real threat, being set to have its funding suspended in a matter of months.

rticle 36(5) of the Fundamental Law provides that “[A]s long as state debt exceeds A half of the Gross Domestic Product, the National Assembly may only adopt an Act on the central budget which provides for state debt reduction in proportion to the Gross Domestic Product.”

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7 Interactions between fiscal turnaround and monetary policy

Chart 7-4: Accrual-based balance of the Hungarian budget, 2000–2015 6

As a percentage of GDP

As a percentage of GDP ESA-balance according to 2011 methodology

6 4

Primary balance ESA-balance

2015

2014

2013

–10 2012

–10 2011

–8 2010

–8 2009

–6

2008

–6

2007

–4

2006

–4

2005

–2

2004

–2

2003

2002

2001

2000

Net interest expenditures Maastricht criteria

Source: HCSO.

Although the fiscal policy turnaround eliminated the previous fiscal dominance, monetary policy initially did not support the results of fiscal policy. The Magyar Nemzeti Bank could have provided meaningful assistance for the recovery of the Hungarian economy from the crisis; however, monetary policy in the early 2010s was a rather passive agent in Hungary’s economic policy. The tasks to be resolved included the achievement of price stability, the control of an environment of historically high interest rates and yields, and the promotion of lending to Hungarian micro, small and medium-sized enterprises, while economic policymakers also had to deal with foreign exchange-based loans, which had grown into a problem of immense proportions. “Besides the fact that [the] prevalence of foreign currency loans significantly dampened the efficiency of the Hungarian monetary policy transmission mechanism, it also created an exceptional source of macro-financial vulnerability, salient even by international standards” (Matolcsy–Palotai, 2016). — 243 —

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7.2 Fiscal policy turnaround and its impact on the budget The inauguration of new management of the Magyar Nemzeti Bank in March 2013, marked the beginning of harmonisation between fiscal and monetary policy in Hungary. Within the context of the MNB Act48, the central bank has the primary objective to achieve and maintain price stability, and will, without jeopardising its primary objective, support the stability of the financial intermediary system, and use the instruments at its disposal to support the economic policy of the government. Since 2013, through its activity, the central bank has had three main channels through which to support fiscal policy. First, by means of reducing yields in the government securities market in alignment with its interest rate policy, the bank affects fiscal interest expenditures, i.e. lower interest expenditures reduce deficit and public debt. Second, the central bank’s profit/loss affects the budget (see the box on the subject), i.e. to the extent that its profit is positive, the bank does not require budgetary funds to cover losses; indeed, where applicable, it might even improve the position of fiscal policy through dividend disbursement. Third, through GDP growth, the development of enterprises, and the implementation of new investments, the central bank’s programmes, designed to support lending and economic growth (notably interest rate cuts and the Funding for Growth Scheme), generate additional tax revenues for the budget. Box 7-1 The profit/loss of the Magyar Nemzeti Bank and its effect on the budget

The Magyar Nemzeti Bank does not pursue a profit target. Nevertheless, the central bank’s potential profit, which does affect the budget, is influenced by the monetary policy decisions adopted with a view to the discharge of the Bank’s functions, which result from its mandates given by the MNB Act and are aimed at price stability and financial stability while supporting economic growth. With that in mind, a brief explanation is provided below of the channels through which the central bank’s profit/ 48

Act CXXXIX of 2013 on the Magyar Nemzeti Bank.

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7 Interactions between fiscal turnaround and monetary policy

loss may have an effect on the budget, and of the developments in that profit over the past few years. The central bank’s profit/loss essentially consists of three factors: the MNB’s net interest income, realised exchange rate gains, and operating costs and expenses. For fiscal purposes, the central bank’s profit is relevant because to the extent that profit is negative and is not covered by retained earnings, the budget will be required to cover the loss up to the amount of the central bank’s subscribed capital, which will increase both deficit and debt (Kékesi–Lénárt-Odorán, 2015). Chart 7-5: Profits/losses of the Magyar Nemzeti Bank before dividends, and the amount of dividends disbursed in the years concerned 100

HUF Billions

100

Dividend paid

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

–60 2004

–60 2003

–40

2002

–40

2001

–20

2000

–20

Earnings

Source: MNB.

In each year since 2013, the Magyar Nemzeti Bank has realised a profit, i.e. it has not required budgetary funds to cover losses. The record profit, earned in 2015, enabled the disbursement of dividends for the first time since 2002. Out of its profit of approximately HUF 95 billion generated in

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2015, the central bank disbursed HUF 50 billion as dividends to the budget, and the remaining part was transferred to profit reserves. The resulting reserves exceed HUF 100 billion, enabling adequate compensation for unexpected future events. The dividends disbursed also reduce public debt. In the case of a profit, the ESA-deficit will only be reduced by the distribution of the profit from interest income (less operating costs), however, dividend disbursements will also reduce gross public debt through the lower financing requirement of general government (Hoffman–Kékesi–Koroknai, 2013). The dividend of HUF 50 billion approved by the MNB Board reduced the 2016 debt-toGDP ratio by approximately 0.15 percentage points (Chart 7-5).

Started in 2012 and carried out in successive cycles, cautious and progressive interest rate easing had a meaningful effect on the fiscal position of Hungary. The base rate stood at 7 per cent in August 2012, and was gradually decreased to 0.9 per cent by May 2016 in three easing cycles of a total of 610 basis points. Interest rate easing and the Self-financing Programme made a significant contribution to reducing the yields on government securities and to mitigating the country’s external vulnerability. Between the end of August 2012 and the end of September 2016, yields fell by some 550 basis points on average (Chart 7-6). Although base rate cuts primarily affect yields on shortterm government securities through the operation of the monetary transmission mechanism, over the years the decline of the base rate has also been followed by a decrease of long-term yields.

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Chart 7-6: Developments in the base rate and the benchmark yields on 3-month and 5-year government securities 12

Per cent

Per cent Beginning of the base rate decreasing cycle

New phases of the base rate decreasing cycle

12 10 8

Self-Financing Programme announcement

Central bank base rate 5-year Bond yield

Jul. 2016

Jan. 2016

Jul. 2015

Jan. 2015

Jul. 2014

Jan. 2014

Jul. 2013

Jan. 2013

Jul. 2012

Jan. 2012

Jul. 2011

Jan. 2011

Jul. 2010

Jan. 2010

3-month T-bill yield

Sources: ÁKK, MNB.

The savings on interest expenditures due to declining yields have been increasing steadily for years. Between 2013 and 2016, interest expenditures dropped by 1.3 percentage points of GDP. This phenomenon results in substantial budget savings which in 2016, in nominal terms, corresponded to savings of about HUF 400 billion relative to constant interest expenditures at 4 per cent of GDP (Chart 7-7). Economic policy may use that amount to reduce the deficit and debt for the years concerned, or as appropriate, to stimulate demand in order to support economic growth. According to the European Commission’s forecast, compared to the rest of the European Union, Hungary may record the greatest decrease in general government interest expenditures between 2013 and 2017.

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Chart 7-7: Net interest expenditures of Hungarian general government 4.5

As a percentage of GDP

4.5 4.0

4.0 3.5

HUF 400 billion

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.5 0.0

0.0 2010

2011

2012

2013

2014

2015

2016

2017

2018

Notes: 1. In accordance with the requirements of the ESA2010 methodology, the data do not include the imputed interest expenditures related to the reform of the pension system. 2. Data for 2016–2018 represent the MNB’s forecast produced for the December 2016 Inflation Report. Source: MNB.

The global economic crisis has shown that high debt denominated primarily in foreign exchange is a key source of vulnerability. By 2011, foreign exchange had reached about 50 per cent of Hungary’s total gross public debt, and it was therefore absolutely essential that its ratio be reduced. “High external indebtedness – often accompanied by high FX-denominated debt – may be a problem because in a turbulent market environment the refinancing of external debt may run into difficulties or may become impossible. Therefore, it is a priority of economic policy objectives is to strengthen the financing of government debt from internal sources and thus, in turn to reduce dependency on external sources” (MNB, 2015). With the involvement of domestic economic actors, notably of credit institutions and households, the — 248 —

7 Interactions between fiscal turnaround and monetary policy

cost of refinancing public debt decreased substantially, and the ratio of foreign exchange debt dropped by a significant 25 percentage points to below 25 per cent of total central government debt (Chart 7-8). Chart 7-8: Hungary’s gross public debt and the share of foreign exchange debt 85

As a percentage of GDP

As a percentage of debt

Gross public debt

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Share of FX-denominated debt (right-hand scale)

Note: For 2016, the MNB’s forecast produced for the December 2016 Inflation Report is presented. Source: MNB.

Given that repricing of public debt is a lengthy process, there is still room, over both the medium and long term, for major reduction in interest expenditures. Due to the progressive repricing of debt, general government will have to pay lower yields on an increasing share of gross debt in an environment of permanently and historically low yields. In 1 year, one-third of the debt will be repriced, while after 3 years, the interest rate burden on the budget will be eased for approximately one-half of the debt, and after 10 years, almost all of the total debt will have been repriced (Chart 7-9). The switch auctions and buyback auctions carried out by the Government Debt Management Agency (ÁKK) may further accelerate repricing. — 249 —

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Chart 7-9: Repricing of Hungarian public debt over a 10-year time scale

As a percentage of GDP

10 0

0 2013

2014

2015

2016

2017

2018

Newly issued debt with lower yield

2019

2020

2021

2022

Older issuance of debt

Source: MNB background calculations to the 20-year public debt projection prepared for the August 2016 Public Finance Report.

7.3 The role of countercyclical fiscal policy in the future The global financial crisis has highlighted the increased prominence of countercyclical fiscal policy. Due to the reduced monetary policy space provided by conventional instruments, fiscal policy has taken on a more prominent role in smoothing the cyclical fluctuations of the economy. For that reason, it is particularly important that, as a result of the fiscal turnaround after 2010, the budget has a significant amount of fiscal space, which it can use efficiently going forward. That said, efforts are still required to maintain the balance, because the impact of fiscal policy is greater in crises than in normal times. The following is an overview of why the role of fiscal policy may become more important

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in the future, and how, according to the latest research findings and empirical evidence, fiscal policy may influence the real economy. The environment of low interest rates has significantly reduced the monetary policy space provided by conventional instruments. As a result of cautious and gradual easing cycles, the Hungarian base rate declined by 610 basis points and reached a historical low of 0.9 per cent. This unprecedented low base interest rate is consistent with the achievement of the inflation target, with stimulating macroeconomic performance, and facilitates the strengthening and maintenance of financial stability. By reducing the base rate even further, the MNB would proceed increasingly towards an environment where the fundamental laws of economics and monetary policy may behave differently, i.e. unintended side effects may arise. (Nagy–Virág, 2016). Consequently, in addition to the unconventional instruments used in monetary policy, the role of fiscal policy has also become more prominent. Box 7-2 Definition and determinants of the fiscal multiplier

Used to capture the relationship of fiscal policy and economic growth, the so-called fiscal multiplier can be measured in several ways. According to its general definition, the multiplier shows the effect of a discretional change in government expenditures or revenues (ΔG or ΔT) on the rate of economic growth (ΔY).

()

Fiscal Multiplier i =

( ) ()

Y t+i G t

t could either be quarter or year depending on the data used for the assessment of the effect, whereas i shows the time scale of the assessment. A distinction is made between expenditure and revenue multipliers according to whether the changes occur in fiscal expenditures or revenues.

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The value of the fiscal multiplier is difficult to quantify. This is primarily because, apart from the effect of the budget on the economy, the cyclical position of the economy also influences the budget, which responds to changes in that position through so-called automatic stabilisers. In empirical literature, attempts are therefore made at capturing changes in the balance that are not caused by the macroeconomic environment (exogenous fiscal shocks). The value of the fiscal multiplier varies by country. In their study of 44 countries, Ilzetzki et al. (2010) found that the value of the multiplier was influenced by each country’s level of development, the flexibility of its exchange rate, the openness of its trade, the level of its public debt, and the structure of its government expenditures. In the case of developing countries, growth in government expenditures evidently did not need to have a significant effect on economic growth, while a positive correlation was demonstrated for developed countries. The authors’ results indicate a lower multiplier value for countries with high public debt (exceeding 60 per cent of GDP), floating exchange rate systems, and open economies. The value of the multiplier was found to be higher in times of recession compared to upturns, and fiscal policy also gained prominence where monetary policy had reached its limitations. The value of the multiplier may vary by instrument. Theoretical literature provides a clear ranking of specific instruments: on the expenditure side, the highest short-term multiplier is associated with investments, followed by government expenditures on wages and intermediate consumption, while transfers to households are seen as having the least effect on economic growth. On the revenue side, due to the distorting effect of taxes, capital and labour taxes are seen as the most harmful, and consumption taxes as the least harmful to the GDP (Batini–Eyraud–Forni–Weber, 2014). The multiplier also varies by time scale. Some measures may exert their effects immediately, while others may do so only in the long term, or remain ineffective in the long term. Generally, the decline of a fiscal shock has an inverted U shape. That is, the effect is delayed until about the

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second year, then declines progressively. As regards the multiplier, this means that the highest impact occurs in the second year, and the impacts over shorter and longer time periods are more moderate (Batini–Eyraud– Forni–Weber, 2014).

Measuring the relationship of fiscal policy and economic growth, the so-called fiscal multiplier may have a value exceeding previous estimates. During the crisis, many countries were forced to undertake fiscal austerity measures, which were followed by a sharper economic downturn than expected. This suggests that the value of the fiscal multiplier was underestimated by previous studies, as a result of which the effect of austerities on economic growth was greater than expected. The same conclusion is drawn by the study of Blanchard and Leigh (2013) that examined the extent to which growth forecast errors in a country can be explained by the scale of fiscal consolidation implemented. They found a significant correlation between the GDP growth forecast error and the scale of fiscal consolidation. The greater the fiscal adjustment, the greater the shortfall of growth compared to the forecast. According to Blanchard and Leigh’s assessment, the actual value of the multiplier may actually have been somewhere between 0.9 and 1.7 in that period, which is significantly higher than the value of 0.5 previously applied by the IMF. During the debt crisis of the euro area, the measures proposed by international organisations failed because of underestimated fiscal multipliers. As actual fiscal multipliers were higher than those used in the forecasts, the proposed fiscal consolidation packages led to a sharper economic downturn than expected. This, in part, explains why several countries were unable to reduce their debt-to-GDP ratios despite the fiscal adjustments undertaken. In the case of Greece, for example, GDP growth fell short of the IMF forecast by 7 percentage points in 2010 and 2011, while in the same period the fiscal balance changed as expected (Chart 7-10).

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Chart 7-10: Growth forecast errors and fiscal consolidation plans in 2010—2011 Growth forecast error (percentage point)

SWE

6 DEU

FIN AUT

2 CYP 0 –2 –4

MLT POL

BEL KOR CZE ITA CAN NLD ESP BGR HUN GBR JPN DNK FRA SVK USA AUS SVN PRT ROM

–6 –8

IRL

–4

–3

–2

–1

GRC 3

Forecast of fiscal consolidation (as a percentage of GDP) Note: The vertical axis shows WEO growth forecast error for 2010–2011, while the horizontal axis shows the WEO forecast for the change in the structural balance for 2010–2011 (the forecast was produced in April 2010). Source: IMF (2012).

The effect of fiscal policy on economic growth tends to be more powerful during and after crises than in upturns. As the credit constraints that occur at times of crises prevent economic actors from adequately smoothing their consumption, the effect of a fiscal stimulus may be more profound in such periods. Conversely, during an upturn, when capacities are better utilised, the additional demand from the government may crowd out the demand from the private sector, and consequently have a more moderate effect on total output. This effect is confirmed by several empirical findings. For example, Jorda and Taylor (2013) found that over 4 years, a fiscal consolidation of 1 per cent of GDP had a cumulative GDP effect of 2.5 per cent in a crisis, compared to only 0.9 per cent in an upturn.

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The value of the multiplier is higher when the monetary policy space is limited, e.g. in the case of a zero lower bound environment. The value of the fiscal multiplier is greatly influenced by the response of monetary policy to changes in the budget. In the case of a fiscal expansion, inflation may rise to an extent that forces monetary policy to tighten monetary conditions, which will in turn dampen the effect of fiscal policy. Conversely, when monetary policy is confined to a limited space and is therefore unable to respond to the increased demand generated by fiscal policy, the value of the multiplier may be higher. This is the case in a zero lower bound environment, where any monetary policy response given through conventional instruments will only have a lag effect (Erceg–Lindé, 2010).

Key terms countercyclical fiscal policy excessive deficit procedure (EDP) financing Fiscal Council fiscal multiplier fiscal rules fiscal space

interest expenditures marginal tax wedge shadow economy taxes on capital taxes on consumption taxes on labour the Magyar Nemzeti Bank’s profit/loss

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References Balog, Á. (2014): Adóelkerülés és rejtett gazdaság Magyarországon (Tax Avoidance and Shadow Economy in Hungary). Köz-Gazdaság tudományos füzetek, IX(4). Batini, N. – Eyraud, L. – Forni, L. – Weber, A. (2014): Fiscal Multipliers: Size, Determinants, and Use in Macroeconomic Projections. International Monetary Fund. Blanchard, O. – Dell’Ariccia, G. – Mauro, P. (2010): Rethinking Macroeconomic Policy. International Monetary Fund, Washington. Blanchard, O. – Leigh, D. (2013): Growth Forecast Errors and Fiscal Multipliers. IMF working paper. European Commission (2016): Study and Reports on the VAT Gap in the EU-28 Member States: 2016 Final Report. Center for Social and Economic Research, Warsaw. Erceg, C. J. – Lindé, J. (2010): Is There a Free Lunch in a Liquidity Trap? International Finance Discussion Papers 1003 (Washington: U.S. Federal Reserve System). Hoffmann, M. – Kékesi, Zs. – Koroknai, P. (2013): A jegybanki eredmény alakulása és meghatározó tényezői (Changes in Central Bank Profit/Loss and Their Determinants). MNB Bulletin, October 2013. Ilzetzki, E. – Mendoza, E. G. – Végh, C. A. (2010): How Big (Small?) are Fiscal Multipliers? Journal of Monetary Economics, Elsevier, 60(2). Kékesi, Zs. – Lénárt-Odorán, R. (2015): A jegybanki eredmény alakulása (Changes in Central Bank Profit/Loss). Magyar Nemzeti Bank technical paper. MNB (2015): A Magyar Nemzeti Bank önfinanszírozási programja, 2014. április–2015. március (The Magyar Nemzeti Bank’s Self-financing Programme, April 2014–March 2015). Magyar Nemzeti Bank, Budapest. Matolcsy, Gy., Palotai, D. (2016): A fiskális és a monetáris politika kölcsönhatása Magyarországon az elmúlt másfél évtizedben (The Interaction between Fiscal and Monetary Policy in Hungary over the Past Decade and a Half). Financial and Economic Review, 15(2). Mineshima, A. – Poplawski-Ribeiro, M. – Weber, A. (2014): „Fiscal Multipliers” in: Cottarelli, C. – Gerson, P. – Senhadji, A. (eds.): Post-Crisis Fiscal Policy. MIT Press. Nagy, M. – Virág, B. (2016): Sikeres a jegybank nemkonvencionális lazítása (The Bank’s Unconventional Easing is a Success). Magyar Nemzeti Bank. Palotai, D. – Virág, B. (eds.) (2016): Versenyképesség és növekedés: Út a fenntartható gazdasági felzárkózáshoz (Competitiveness and Growth: the Road to Sustainable Economic Convergence). Magyar Nemzeti Bank. Schneider, F. (2015): Size and Development of the Shadow Economy of 31 European and 5 other OECD Countries from 2003 to 2015: Different Developments. Johannes Kepler Universität, Linz. Tóth, G. Cs. (2016): A nemzeti költségvetési szabályok elterjedése és hatása Európában – Tanulságok Magyarország számára (The Spread and Effect of National Fiscal Rules in Europe – Implications for Hungary). Debreceni Egyetem.

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The way from unsustainable indebtedness and a vulnerable, pro-cyclical banking system to financial stability István Papp – Ádám Zágonyi

After 2002, Hungary’s growth model was built on external borrowing, which carried only latent risk until 2008; however, following the onset of the crisis, the risks previously built up materialised, plunging the country into deep recession. Dependence on external funds was supported as a result of overspending by both the government and households. The general government’s use of external funds was mostly foreign exchange-based, and dependence on external funds was almost entirely due to an overheated mortgage market in the household segment, i.e. dependence on external funds was made even worse by currency mismatch risk. The high proportion of external funds in public indebtedness represented a major macroeconomic risk primarily through rollover risk, while the share of foreign exchange within external funds made the position of the budget worse through currency mismatch risk and the increase in the central bank’s balance sheet. Apart from rollover and currency mismatch risks, the sources of risks resulting from foreign exchange-based lending to households also included interest rate risks, which collectively posed a major stability threat to the banking system, while also representing significant social tensions. In addition to the specific risks from external vulnerability, Hungary’s recovery from the crisis was further prevented by risks that fit into international trends and were associated with the “normal” operations of the banking system. Before the crisis, the pro-cyclical operations of the Hungarian banking system intensified foreign exchange-based lending, a key element of vulnerability, — 257 —

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the consequences of which hindered recovery after the crisis. By nature, the movements of bank lending are aligned with economic developments, i.e. in a favourable economic environment it reinforces the economic progress that is already taking place, while in an unfavourable economic environment, responding to consequences of the crisis, it tends to be more risk averse. However, excessive alignment amplifies both the volatility of economic developments and credit risks. Before the crisis, Hungarian banks had taken excessive risks, which was manifested in an unsustainable rate of credit expansion, and in an unhealthy credit structure (foreign exchange-based lending to households, project loans). The pro-cyclical operations of the Hungarian banking system accelerated Hungarian growth in the years preceding the crisis; however, in post-crisis years the country lost growth potential at a rate exceeding the previous gains. In recent years, external vulnerability has been reduced significantly as foreign exchange-based loans were phased out and changes, stimulated by both the government and the central bank, were made to the financing structure of the general government, while pro-cyclicality has become more moderate on the back of international and domestic macroprudential measures and other central bank programmes. The reduced use of external funds in general government financing is owed primarily to banks’ participation, encouraged as part of the central bank’s Self-financing Programme, and secondly to the household programmes of the Government Debt Management Agency. The phasing out of foreign exchange-based loans to households was made possible as a result of a series of coordinated actions commonly agreed upon between the judicial system, government, central bank and credit institutions. The future build-up of a harmful volume of toxic loans is limited by the macroprudential rules implemented in recent years, while the MNB’s interest rate easing, as well as its lending incentive schemes (FGS, MLS), substantially softened the previously very strong pro-cyclicality in the operations of the Hungarian financial system.

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8.1 The problem to be solved: excessive dependence on external funds When the global financial crisis hit Hungary in 2008, the country was already in an extremely vulnerable state: while its economic indicators were poor, the conditions for adequate stability were also lacking, and its banking system was facing severe risks. After 2002, Hungarian economic growth lagged far behind the regional average, and incentives for consumption were considered by decision makers at the time as a possible option to drive economic growth. However, in the absence of sufficient GDP growth, consumption needed to be financed from another source. In Hungary after 2002, household consumption was strongly supported by transfers from both the government and the banking system. However, given the persistently low economic growth, high government transfers led to a major increase in the public deficit, which was aggravated by the fact that the financing of public debt relied heavily on foreign funds. Banks’ increasingly active participation in household financing is associated with foreign exchange-based loans, a new and innovative type of product, which in turn significantly increased the dependence of the banking system on external funds, and more specifically on foreign exchange. In view of the country’s high external exposure and very high foreignexchange debt ratio, external vulnerability grew to become one of the most imperative challenges of Hungary in the years following the crisis. From 2012 onwards, several international organisations (such as the European Commission and the IMF) and credit rating agencies (e.g. Standard & Poor’s, Moody’s) issued negative opinions on Hungary in view of its high debt ratio, high foreign-exchange debt ratio, and its heavy reliance on foreign funds. The macroeconomic significance of the problem of external vulnerability was also reflected in the fact that Hungary’s convergence programme for 2013 identified the reduction of high external debt – a major factor behind the financial vulnerability of Hungary at the time – as one of the four key economic policy objectives (Kolozsi–Hoffmann, 2016). The grave risk of external vulnerability was — 259 —

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underpinned by the 2015 survey by Moody, which found, that in 2014, only Peru and Indonesia recorded a higher share of non-residents in total debt than Hungary.49 Box 8-1 The Hungarian model in 2002–2008 and the 2008 wake-up call

After 2002, Hungary lived under the spell of external funds, and both the general government and the financial system established financing models that were centred around foreign funds. It is to be noted that as in many areas of life, moderation is also key to foreign funds. In itself, the use of foreign funds is not harmful, indeed, it is concomitant to a small open economy; however, excessive dependence may lead to severe problems. • On the government side, the primary problem with the use of external funds lies in rollover risk, i.e. the fact that it is easier for a foreign investor to withdraw funds. Accordingly, once a country is excessively dependent on external funds, it will make efforts to create favourable conditions for those funds, keep them in the country, and attract even more. A specific case of this is when the country starts issuing debt securities denominated in currencies in which it collects no or only limited revenues, which is known as currency mismatch risk. • Similar to the government, the banking system primarily runs a rollover risk, but, owed to the transfer of exchange rate risk, it will, even if only with a lag, inevitably face a currency mismatch risk as a result of nonperforming loan portfolios. However, in addition to the foregoing, in the course of foreign exchange-based lending the Hungarian banking system was also exposed to maturity risk, and a frequently “concealed” interest rate risk. Maturity imbalance is a characteristic of banking operations, which banks seek to immunise through a variety of long-term liability instruments (mortgage bonds). No such immunisation occurred in the case of foreign exchange-based loans; indeed, banks ran a maturity risk

Gór-Holecz–Kolozsi–Novák–Zágonyi (2016), p. 10.

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over and above normal operations as a result of bank financing that was primarily off-balance sheet and involved shorter terms than the average. Additionally, even floating-rate foreign exchange-based loans carried interest rate risk due to the differences in repricing periods. Chart 8-1: Interactions between non-household participants in the Hungarian model in 2002–2008 Central Bank Central bank's assests

FX reserve

State's central acount Capital P&L

Budget

Banking System

Expenditures

State bond_HUF

Retail

Debt

State bond_FX

Foreign currency

State's incomes

HUF

Extranal liabilities (FX)

Transfers

Hungarain state bond

Capital

CB's assests

P&L

Deposits

Foreign investors Hungarian state bond_HUF

Other liabilities

Hungarian state bond_FX

Capital

Banks_FX

P&L

Source: MNB.

Hungary faced a number of problems simultaneously. It was financing its growing public deficit externally and increasingly in foreign exchange, and due to the rise in public debt, banks financed both themselves and households externally in order to avoid high domestic interest rates. In accordance with the Guidotti rule and other rules on foreign exchange reserves50, the model followed by the government and banks increased the central bank’s dependence on foreign exchange, and due to the liability-side bias characterising the Magyar Nemzeti Bank, its losses were

For more details, see Csávás (2015).

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imminent. Following the depletion of retained earnings, the central bank’s losses would have eroded the balance of the budget, causing additional contagion in the public deficit (Chart 8-1). Before the onset of the crisis, both the Hungarian banking system and households benefited from the model implemented by banks; subsequently, however the rollover, currency and maturity mismatch, and interest rate risks built up in the pre-crisis period simultaneously exerted a multiplier effect. The banking sector already faced rollover risk at the very beginning: as the external funds written to their balance sheets by means of off-balance sheet lending dried up, they needed urgent central bank assistance to avoid failure. Households were faced with an increasing debt burden and incomes contracting due to the recession, which added to banks’ portfolio of non-performing loans after an appropriate spillover time. The banking system managed to keep maturity risk and interest rate risk outside of its accounts right until the Curia decision of 2014, when it was forced to write off a single loss corresponding to the risks previously accumulated and unilaterally transferred to households. Accompanying the poor performance of the Hungarian economy, high public deficit and public debt also limited the funding opportunities of the Hungarian state. Funds dried up to such an extent that in the absence of adequate market funding, the country was saved from insolvency by the IMF’s safety net. The hazards resulting from the inappropriate use of external funds materialised quickly and unsparingly, and their effects remained to be felt for a long time. Finding a final solution to the problem, abandoning the previous practice, and transforming the structure of funding took almost a decade.

Instability was primarily attributable to high public debt, and was aggravated by its structural inadequacy, the presence of currency mismatch risk due to significant foreign exchange exposure. Obviously, it is not entirely unbecoming to borrow foreign funds to finance the public deficit; indeed, the debt diversification effect of such borrowing could even — 262 —

8 The way from unsustainable indebtedness and a vulnerable, pro-cyclical...

be desirable. A problem emerges when non-residents have a persistently dominating share in the financing structure of the economy and reliance on foreign financing carries a severe rollover risk, especially in crisis periods. The situation becomes even more difficult when external debt is also foreign exchange debt, and rollover risk is therefore accompanied by currency mismatch risk, which in combination already carry risks with a multiplier effect. Reliance on external savings and foreign exchange markets intensifies the volatility of exchange rates and interest rate spreads, which may undermine the economy’s ability to raise funds when a crisis materialises. Consequently, it posed a key risk to Hungary’s macroeconomic stability in that the external debt of Hungary at the beginning of the 2010s surpassed most corresponding regional ratios and even approached the GDP-proportionate values that capture the external indebtedness of especially risk-laden Southern European countries (Chart 8-2).51 Chart 8-2: External debt of European Union Member States as a percentage of GDP

Brut external debt (2013 Q3, per cent)

400 UK

350

CY NL

300 BE 250

200 DE

0 –100

SK CZ –50

IT HU SL RO

LT PL

Net external debt (2013 Q3, per cent)

Source: Eurostat, 2014.

LV BG

SE FR

150 100

Gór-Holecz–Kolozsi–Novák–Zágonyi (2016), p. 8.

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150

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In Hungary, the steep rise in indebtedness to foreign countries was partly driven – besides the proliferation of foreign exchangebased lending to households to be described later – by sovereign borrowing starting from the second half of the 2000s. In terms of external vulnerability, Hungary was seen as an endangered country even by international comparison, both at the onset of the crisis and in subsequent years: while only 40 per cent of government gross debt was financed by foreign creditors at the beginning of 2004 and less than 50 per cent in early 2008, by the end of 2011 this value had risen to nearly 70 per cent. The crisis distorted the foreign exchange composition of public debt as well: the share of foreign exchange debt surpassed, by a large margin, the levels seen in most European Union Member States. In 2011, the ratio of foreign exchange denominated debt rose above 50 per cent reflecting, on the one hand, disbursements from the international credit lines provided by the European Union and by the International Monetary Fund (IMF) in 2008, and issues of foreign exchange denominated government securities on the other hand. It was partly due to the high level of external debt and foreign exchange debt that, at levels over 700 basis points by 2012, the Hungarian 5-year CDS spread significantly exceeded the Central and Eastern European average and the risk rating of all neighbouring countries, except Ukraine. Eventually, after a steep decline in CDS spreads from mid2012, by the end of 2013 the risk assessment of Hungary improved both in comparison to the regional average and to Croatia. By the end of 2013, the foreign exchange ratio of the central budget debt was scaled back to around 40 per cent, but this was still extremely high; indeed, in the European Union only four countries recorded higher values at the time (Chart 8-3). Notably, of these four countries Bulgaria maintains a currency board system, which means that, for practical purposes, it does not face any exchange rate risk, while Lithuania’s subsequent accession to the euro area practically eliminated its exposure to exchange rate risk.52

Gór-Holecz–Kolozsi–Novák–Zágonyi (2016), pp. 8–9.

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Chart 8-3: Ratio of foreign exchange debt to total central government debt in European Union Member States 80

Per cent

80 70

Austria Cyprus Estonia Finland Luxembourg France Italy Slovenia Belgium Spain Netherlands Germany Slovakia Denmark Portugal Czech Republic Latvia Poland Sweden Hungary Lithuania Romania Bulgaria Croatia

FX proportion of central government's debt in European countries Source: Eurostat, 2013.

The take-off of foreign exchange-based lending to households “reformed” the liability structure of the Hungarian banking system, leading to a significant increase in dependence on external funds (Chart 8-4). In a country pursuing an open economic policy, the banking system always relies on external funds for reasons including its dependence on parent bank funding and its involvement as an intermediary in exports and imports; accordingly, its external funds are predominantly denominated in foreign exchange.53 Rather than the mere existence of liabilities denominated in foreign exchange, the vulnerability of the banking system is attributable to the predominance of external funds in the structure of financing. As seen during the 2008 crisis, dependence on external funds, partly due to maturity mismatches, subjected the Hungarian banking system first to major 53

The structure of external funds is discussed in more detail in Komáromi (2008).

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rollover risk and then to a crisis, and the system needed the central bank’s assistance to resolve its liquidity issues. Chart 8-4: Composition of foreign exchange-based loans to households and its effect on the structure of external funds 9,000

Billion HUF

Per cent

8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000

May. Nov. May. Nov. May. Nov. May. Nov. May. Nov. May. Nov. May. Nov. May. Nov. May. Nov. May. Nov. May. Nov. May. Nov. May. Nov. May. Nov.

2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 2015 2015

100 90 80 70 60 50 40 30 20 10 0

Other_FX Mortgage_FX Retail_HUF Proportion of external liabilities in the banking sectors's balance sheet Portion of foreign currency in external debt Source: MNB.

From 2010 onwards, as a result of improving macroeconomic figures, a positive balance of payments, and a decline in lending and more specifically in lending to households, the share of on-balance sheet external funds within the financing structure of the banking system was progressively scaled back to the level seen before the take-off of foreign exchange-based lending. Significantly, both on-balance sheet and offbalance sheet ratios dropped in the absence of new lending, despite which a significant degree of dependence on off-balance sheet external foreign exchange remained in the system until the phase-out of foreign exchange-based loans was announced (Chart 8-5). The banking system acquired a major part of the foreign exchange funds underlying foreign — 266 —

8 The way from unsustainable indebtedness and a vulnerable, pro-cyclical...

exchange-based loans through swaps, which it continuously rolled over with various maturities until foreign exchange-based loans were phased out by means of reverse swaps with the MNB.54 On balance, until the end of 2014, even without new lending a major rollover risk remained in the system due to pressures to roll over funding for the existing stock, and, as the crisis has shown, this type of risk particularly affects the market of off-balance sheet swaps. From 2014 onwards, another positive development emerged for external funds as the share of forint denominated external funds increased, reducing the currency mismatch risk to the banking system further. Chart 8-5: Share of external funds in the Hungarian banking system as a percentage of the balance sheet total, and the net volume of forint swaps 60

Per cent

HUF Billions

Dec. 2015

Jun. 2015

Sep. 2015

Mar. 2015

Sep. 2014

Dec. 2014

Jun. 2014

Mar. 2014

Dec. 2013

Jun. 2013

Sep. 2013

Mar. 2013

Dec. 2012

Jun. 2012

1,000

Sep. 2012

Mar. 2012

2,000

Sep. 2011

Dec. 2011

3,000

Jun. 2011

Mar. 2011

4,000

Dec. 2010

Net HUF swap (rigtht scale) External debt and net HUF swap in proportion of the balance sheet

Source: MNB.

5,000

For more details, see Kolozsi–Banai–Vonnák (2015), pp. 80–83.

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Even after the dependence of the banking system on external funds had been reduced, investor analyses and reports on Hungary continued to view external vulnerability as a prominent risk. Although the dependence of the banking system on external funds was eliminated by the phase-out of foreign exchange mortgage loans by the end of 2014, the issue of financing the general government remains open. It also exacerbated the problem in Hungary that the crisis aggravated the situation of an already indebted household sector: annual household savings were unable to cover the budget deficit.55 Besides households, the financial sector was gradually driven off the Hungarian government securities market as well: while domestic financial enterprises held about 40 per cent of total government debt in 2009, by the end of 2011 their share shrank to 30 per cent without any considerable increase in sight until the end of 2013. In 2012 and 2013, the gross nominal value of government debt accounted for more than a quarter of the aggregate (non-consolidated) gross financial instruments of domestic financial enterprises and households, comprising around 70 per cent of the financial instruments of credit institutions.56 In reducing the external vulnerability of the general government, solutions were provided by the ÁKK (Government Debt Management Agency) and the central bank’s Self-financing Programme. While the former primarily mobilised domestic small investors, the latter incentivised the domestic institutional investors to provide liquidity through Hungarian government securities (Chart 8-6). After 2010, the share of households started to rise which only accelerated from 2012, with the easing cycle launched in that year, which, by placing real yields under a downward pressure, drove households mostly towards the haven provided by the government securities market. Credit institutions took on a more prominent role in financing the general government from 2014, the launch of the central bank’s Self-financing Programme. Consistent with the tightening of international liquidity rules, the Programme I n 2012 and 2013, the gross nominal value of government debt accounted for more than a quarter of the aggregate (non-consolidated) gross financial instruments of domestic financial enterprises and households, comprising around 70% of the financial instruments of credit institutions. 56 Gór-Holecz–Kolozsi–Novák–Zágonyi (2016), p. 8. 55

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incentivised the banking system to hold liquid assets which, in addition to being of low risk and highly suitable for liquidation, also contributed to reducing the vulnerability of the national economy. Chart 8-6: Share of various holder sectors in financing Hungarian public debt 45

Per cent

Banks

Abroad

Households

31. Dec. 2016

31. Aug. 2016

30. Apr. 2016

31. Dec. 2015

0 30. Apr. 2015

0 31. Aug. 2015

5 31. Aug. 2014

5 31. Dec. 2014

30. Apr. 2014

31. Aug. 2013

31. Dec. 2013

30. Apr. 2013

31. dec. 2012

30. Apr. 2012

31. Aug. 2012

31. Dec. 2011

30. Apr. 2011

31. Aug. 2011

31. Aug. 2010

31. Dec. 2010

30. Apr. 2010

Other sector

Source: MNB.

8.2 The pro-cyclicality of the Hungarian banking system 8.2.1 The highly pro-cyclical operations of the Hungarian banking system

The financial intermediary system of a country fulfils its functions adequately if it is capable of resisting shocks while providing sustainable support for economic growth through the efficient allocation of resources. The shock-absorbing capacity of the Hungarian banking system is robust from both a liquidity and a capitalisation â&#x20AC;&#x201D; 269 â&#x20AC;&#x201D;

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perspective. The previously very high pro-cyclicality of the financial system has softened substantially in recent years, in which a significant role has been played by the central bank’s interest rate easing, lending incentive schemes (FGS, MLS), and Self-financing Programme. Box 8-2 Pro-cyclicality in bank behaviour

Economic history offers plenty of examples to support the view that the behaviour of financial systems is pro-cyclical, as the movements of bank lending are, by nature, aligned with economic developments. The pro-cyclicality of lending is partly attributable to the demand side, given that demand for credit tends to be closely aligned with agents’ activity in the real economy. In an economic upturn, demand for the products and services offered by companies intensifies, which encourages the expansion of output. The funds required to step up production are typically obtained by economic actors in the form of external funds, which in Hungary means bank loans for the most part. In an economic upturn, banks grant such loans with increasing leverage. However, the pro-cyclical behaviour of banks is not only supported by demand for credit, but also by a major part of regulatory provisions, because capital regulations, accounting rules, the decisions of credit rating agencies, and banks’ highly similar risk management methods all encourage stronger pro-cyclical behaviour. In their studies, Kashyap and Stein (2004), and Jokippi and Milne (2008) point out the possibility that provisions on banks’ capital requirements may induce pro-cyclical behaviour, as a result of which banks will cut lending in a downturn, further aggravating its impact. The extent of risk taking is essentially limited by available capital. Consequently, in a recession, the capital adequacy of financial institutions will be eroded by higher risks, higher capital requirements and larger write-offs, which could lead banks to deleverage (Soczó, 2009). The movement of banks’ risk propensity is also closely aligned with the economic cycle: in an upturn, banks tend to have a higher propensity to

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take risks, while they may become more risk avert in a recession. Banks’ pro-cyclical behaviour may have serious effects on the real economy, because in periods characterised by excessive lending, positions of high leverage are built up, which banks will be forced to deleverage following cyclical turnarounds. However, strong deleveraging may cause aggregate demand to collapse, which may lead to a recession, to be followed by a creditless recovery as illustrated by Hungary. For that reason, any factor that reinforces pro-cyclicality may carry risks in terms of financial stability, which calls for the continuous monitoring of developments in economic and credit cycles. A key characteristic of pro-cyclical behaviour is that risks are not taken into account properly, as a result of which the risks to be expected are underestimated by economic actors in an upturn, and overestimated in a downturn. The former will accelerate growth, while the latter will lead to an even deeper economic downturn and protracted recovery. The lessons learned from economic history are that the strong pro-cyclicality of the banking system has a negative effect on the economy because it may overheat the economy and lead to the formation of asset bubbles in an upturn, while in a downturn banks bear heavier provisioning burdens, which will erode their profitability, and will also affect their capital positions. In an economic downturn, financially unsound banks cannot raise new capital or can only do so at a very high cost. This leads banks to cut back on their lending activity in such cases, also often preventing creditworthy companies from access to credit, although their creditworthiness remains adequate despite the cyclical downturn. Banks’ increased risk aversion may tighten credit supply to sound companies as well, i.e. banks’ pro-cyclical behaviour could deepen the economic downturn and hinder recovery from the recession. Not only is the pro-cyclicality of the financial system unfavourable for lending activity, it also impairs the efficiency of resource allocation, while undermining the stability of the financial system. The closely aligned movements of the banking sector and the economy increase the volatility of economic developments, which is detrimental to the stability of the financial system.

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Seeking to identify the causes of the pro-cyclical operations of banking systems, several studies (Caprio, 2010; Hardouvelis, 2010) conclude that pro-cyclical bank behaviour stems from uncertainty around economic policy, the variability of the economic and financial environment, and regulatory provisions. Goodhart et al. (2004) pointed out the tendency that the more risk sensitive the bank regulation, the more amplified the problems resulting from pro-cyclicality may become. With a view to softening the strongly pro-cyclical behaviour of banks, the regulatory environment should be set up so that it is suitable for the prevention of financial crises, and the mitigation of their effects. For this purpose, when profit is realised by the banking system, the size of capital reserves should be increased where possible, which will enable banks to remain adequately capitalised in a recession even as their losses increase. Apart from eroding the shock-absorbing capacity of the banking system, pro-cyclical operations may also lead to major losses in the real economy. Consequently, one of the key duties of the macroprudential authority is to reduce the pro-cyclicality of the financial system.

In Hungary, as in most countries of continental Europe, bank financing is the typical means of access to funds for companies. For that particular reason, it is important to examine the extent to which the movements of the domestic banking system are aligned with economic cycles. Both before and after the crisis, the operations of the Hungarian banking system were characterised by very strong pro-cyclical behaviour, which had unfavourable consequences: it was detrimental to banksâ&#x20AC;&#x2122; lending activity, undermined the efficient performance of the functions of the banking system, and carried risks to financial stability. Developments in the credit-to-GDP ratio (Chart 8-7) clearly show that for years the ratio was above the trend. In the years preceding the 2008 crisis, the Hungarian economy was characterised by a strong credit boom, which was further intensified by access to cheap foreign funds. In Hungary, the take-off of private sector credit was accompanying strong growth in foreign exchange-based lending. Foreign exchange-based â&#x20AC;&#x201D; 272 â&#x20AC;&#x201D;

8 The way from unsustainable indebtedness and a vulnerable, pro-cyclical...

loans, which had been non-existent in household lending, accounted for over two-thirds of all loans in a matter of a few years. Denominated in foreign exchange and used for the financing of commercial property, high-risk project loans gained increasing prominence in banks’ balance sheet totals. However, following the onset of the crisis, the credit-to-GDP ratio started to decline and fell below the trend line in 2009, and the credit-toGDP gap has been in negative territory ever since.57 While the widening credit-to-GDP gap in the years before the crisis implies excessive credit growth, since the end of 2009 to date, the rate of credit growth has remained below the desired level. Chart 8-7: Developments in Hungary’s credit-to-GDP gap 120

Per cent

−20

−80

−40

2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3 2007 Q1 2007 Q3 2008 Q1 2008 Q3 2009 Q1 2009 Q3 2010 Q1 2010 Q3 2011 Q1 2011 Q3 2012 Q1 2012 Q3 2013 Q1 2013 Q3 2014 Q1 2014 Q3 2015 Q1 2015 Q3 2016 Q1 2016 Q3

−40

Credit-to-GDP gap (right-hand scale) Credit-to-GDP Credit-to-GDP trend

Source: MNB.

ifference, in percentage points, to the credit-to-GDP ratio that is seen as balanced D (sustainable in the long term).

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The Financial Conditions Index (FCI), which summarises lending developments in the corporate and household segments and is regularly published in the MNB’s Lending Surveys, is used to assess the impact of the lending activity of the banking system on the growth of the real economy. The FCI quantifies the banking system’s contribution, through lending, to the annual GDP growth rate. If the FCI takes a value of one, 1 percentage point of the annual growth rate of GDP can be attributed to the lending activity of the banking system. As before the crisis, the Hungarian banking system has behaved pro-cyclically, except for a very short period; after the crisis as well (Chart 8-8), which is indicated by the fact that the indicator of the FCI has been identical to that of the output gap. In the years preceding the crisis, the indicator of the FCI was continuously positive, which means that the activities of the banking system had a positive effect on the GDP, i.e. contributed to higher economic growth in those years. Banks were optimistic in their judgment of developments in lending, and progressively relaxed their terms of lending. Banks’ decision makers were confident that higher economic growth would provide coverage for repayments on the credit taken by economic actors. In the decade following the turn of the millennium, the banking system made a spectacularly increasing contribution to annual GDP growth as foreign exchange-based lending took off (in the form of household mortgage loans and project loans); however, from 2007, the contribution of lending to GDP started to scale back, and in 2009 the FCI entered negative territory. Ever since 2009, the indicator of the FCI has been negative, i.e. the Hungarian banking system has been making a negative contribution to GDP growth. That negative contribution increased progressively until 2012 H2. The contracting lending activity of the banking system and its low propensity to lend made access to funds difficult particularly for the SME sector, which is strongly dependent on bank financing. However, owing to the central bank’s easing cycle launched in August 2012, and to its lending incentive scheme FGS, the banking system’s restraining — 274 —

8 The way from unsustainable indebtedness and a vulnerable, pro-cyclical...

effect on the GDP became significantly less powerful in 2013 and 2014. The softening came to a halt in 2015 H1, and the banking system’s contractionary effect became somewhat stronger. Chart 8-8: Financial Condition Index (FCI), annual growth in real GDP, and the output gap 8

Per cent

2.0 1.5

1.0

0.5

0.0

−2

−0.5

−4

−1.0

−6

−1.5

−8

−2.0

2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 2015 2015 2016 2016

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3

Output gap

GDP growth (year-on-year)

FCI (right-hand scale)

Note: The FCI quantifies the banking system’s contribution, through lending, to the annual GDP growth rate. Sources: MNB, HCSO.

The sub-index of the FCI for corporate lending also indicates the procyclical behaviour of the Hungarian banking system (Chart 8-9). Before the crisis, banks’ lending activity had spectacularly increased the annual level of corporate investments, whereas after the onset of crisis, in 2009, the FCI dipped into negative territory, i.e. banks’ diminishing lending activity led to a decrease in the annual level of corporate investments. This restraining effect continued to intensify up to the end of 2012, then from June 2013, as a result of the FGS, the banking system’s insufficient

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lending activity acted as a progressively less powerful drag on corporate investments. Although the lending activity of the domestic banking system continues to have a moderate contractionary effect, the business confidence index, which captures business expectations, has improved recently, implying a favourable outlook for the future. In 2016, banks’ lending activity picked up in both the household and corporate segments, while the annual growth rate of lending to the SME sector entered the 5 per cent to 10 per cent range that is required for sustainable growth. Growth in lending to SMEs may continue on a market basis following the phase-out of the FGS. Chart 8-9: Sub-index of the Financial Conditions Index (FCI) for corporate lending 40

Per cent

0 −1

−20

−2

−30

−3

−40

−4

−50

−5

2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 2015 2015 2016 2016

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3

−10

Corporate investment annual growth rate GKI Business confidence index FCI – Corporate investment (right-hand scale) Note: The sub-index of the FCI quantifies the banking system’s contribution, through lending, to annual growth in corporate fixed investments. Sources: MNB, HCSO.

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According to the consumption expenditure sub-index of the Financial Conditions Index, the impact of the financial intermediary system is currently almost neutral on the consumption expenditures of households (Chart 8-10). In the years before the crisis, banks’ lending activity had increased the annual level of households’ consumption expenditures, whereas after the onset of the crisis the FCI became negative, i.e. from early 2009 onwards, banks’ subdued lending activity dragged on the level of household consumption. This restraining effect was the strongest in early 2012, and subsequently started to soften. The FCI returned to positive territory in early 2015, to become negative again afterwards. For 2016 Q3, the FCI indicates a neutral impact of financial intermediary system on the consumption expenditures of households. Looking ahead, the improvement of consumer confidence over the past quarters offers a favourable outlook. Chart 8-10: Sub-index of the FCI for household consumption expenditures 15

Per cent

0.6

0.4

0.2

0.0 −0.2

−10

−0.4

−15

−0.6

−20

−0.8

2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 2015 2015 2016 2016

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3

−5

Households' net consumption expenditure (annual growth rate) FCI − Households' net consumption expenditures (right-hand scale) GKI Consumer confidence index (right-hand scale) Note: The FCI quantifies the banking system’s contribution, through lending, to the annual growth rate of household consumption expenditures. For technical reasons, the chart indicates a hundredth of the GKI index. Sources: MNB, GKI.

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Developments in domestic lending accumulated considerable vulnerability in the Hungarian economy in the years preceding the crisis. The vulnerability resulted from an unsustainable rate of credit expansion, and an unhealthy credit structure. In the household sector, the latter was manifested in the prevalence of foreign exchangebased lending, and in the corporate sector, high-risk project finance, predominantly consisting of commercial property-related lending (Fábián–Vonnák, 2014). In the years preceding the crisis, Hungarian households developed a high level of indebtedness that broke away from the balanced level, which was aggravated by the exchange rate risk in foreign exchangebased loans. Following the onset of the crisis, households’ increased debt service burden developed into a financial stability risk, with domestic banks sustaining severe losses due to a spectacular impairment of their portfolio quality. Following the onset of the crisis, foreign exchangebased loans were no longer popular, lending to households came to a halt, the terms of lending were tightened, and inclination toward credit declined dramatically. Project loans also reinforced pro-cyclical bank behaviour. Given that in the years before the crisis, project lending grew at a significantly faster pace than corporate lending as a whole, the active use of project loans also contributed to the increasingly pro-cyclical operations of the banking system. However, following the onset of the crisis, demand for commercial property loans fell drastically (Chart 8-11), while project loans, by significantly inflating the stock of non-performing loans, hindered a turnaround in market-based lending for years, again supporting the pro-cyclical operations of the banking system (Bálint– Horváth, 2016).

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Chart 8-11: Developments in the stock of commercial real estate loans by currency denomination 2,500

HUF Billions

Per cent

2,000

1,500

1,000

500

10 0

HUF

2016

2015

2014

2013

2012

2011

2010

2009

−30

2008

−1,500

2007

−20

2006

−1,000

2005

−10

2004

−500

Growth rate (right-hand scale)

Sources: MNB.

Based on previous research findings of MNB experts, in the December 2016 Growth Report the authors quantify the effect of out-of-balance lending developments on economic growth in the years preceding and following the crisis. The aggregate results are included in the summary table below. Table 8-1: Summary of the GDP impact of sustainable alternative lending paths 2002—2008

2009—2015

Impact on GDP through corporate lending

—0.6% / —0.4%

0.9% / 1.1%

Impact on GDP through household lending

—0.3% / —0.2%

0.3% / 0.3%

Total effect on GDP

—0.8% / —0.4%

1.1% / 1.4%

Source: MNB.

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The above results justify the argument that in terms of the overall GDP effect, excessive credit growth led to major asymmetry in Hungary in the years under review (2002–2015). As a result of excessive lending, the domestic economy grew on average 0.4% to 0.8% faster in 2002– 2008; however, following the onset of the crisis, over a period of equivalent length it lost growth by an annual average of 1.1% to 1.4% due to economic actors’ deleveraging. Strong credit growth accelerated Hungarian growth in the years preceding the crisis (2002–2008); however, in the years following the onset of the crisis (2009–2015) the country lost significant growth potential due to deleveraging. It is also obvious that the asymmetry of growth is significantly stronger for corporate lending than for household lending. The balance of the overall GDP effect is clearly negative. For an accurate interpretation of these findings, it should also be borne in mind that the foregoing has been derived from developments in the private sector’s indebtedness, thus the total impact on the national economy may well be higher when developments in the general government are also taken into account. Hungary’s relative international position in the post-crisis period would also be more favourable on a financially neutral growth path. While in 2007–2015, Hungarian GDP growth at an aggregate rate of 3.3 per cent exceeded the average of EU Member States only by a small margin, in the course of sustainable and sound lending developments Hungarian GDP might have grown by an overall 12 per cent compared to its precrisis level, even outstripping Czech economic growth (Chart 8-12).

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Chart 8-12: Cumulative changes in GDP between 2007-2015 in EU countries and Hungary (at 2005 prices) 30

Per cent

Hungary − adj.

Hungary

Slovakia

Poland

Czech Republic

Euro area

EU28

Sources: Eurostat, MNB.

In the foregoing, this chapter explained the pro-cyclical behaviour of the Hungarian banking system both in the years preceding the crisis and following its onset. Before the crisis, Hungarian banks had taken excessive risks, which manifested in an unsustainable rate of credit expansion and an unhealthy credit structure, and jointly led to the excessive vulnerability of the financial system. In the aftermath of the crisis, as consumers’ confidence in banks was undermined, the financial system lost strength, as a result of which it could only perform its function to a limited extent. Banks accumulated major losses, their lending capacity was reduced, and their curbed lending activity hindered the recovery of the Hungarian economy from the crisis.

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The pro-cyclical operations of the Hungarian banking system accelerated Hungarian growth in the years preceding the crisis; however, in post-crisis years the country lost growth potential at a rate exceeding the previous gains due to the restraining effect of the banking system. In order to moderate the pro-cyclicality of financial intermediation, and to avoid severe shocks of this type going forward, a banking system is needed that is less pro-cyclical, enjoys customer confidence, and meaningfully supports the sustainable growth of the Hungarian economy.

8.2.2 Moderating the pro-cyclical behaviour of the domestic banking system

To soften the excessive pro-cyclicality of the banking system, economic regulators have several instruments at their disposal. The macroprudential toolkit is regulated internationally (at EU level), which is complemented by the Magyar Nemzeti Bank’s lending incentive schemes. Bank lending is essentially influenced by three factors: capital, liquidity and demand for credit. Capital regulations for banks mostly operate with a restrictive toolkit (O-SII buffer58), which is difficult to apply at the bottom of a cycle, especially when allocations for buffers are still being made. Liquidity in the banking system was influenced by the MNB’s lending incentive schemes (FGS, MLS), and demand for credit by a meaningful decline in interest rate spreads. Relative to the average of EU Member States, bank funds carry greater weight in financing the Hungarian economy. The domestic capital market is small and concentrated and, apart from a few large agents, financing from the capital market is not a real option for economic actors in Hungary. The MNB specifically seeks to develop the domestic capital market partly to make corporate borrowing more diversified (Banai et al., 2016), and partly to moderate the pro-cyclical operations 58

Capital buffer for other systemically important credit institutions.

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of the banking sector further. However, Hungary, contrary to countries with developed capital markets, due to its underdeveloped domestic capital market has not been able to achieve a substantial reduction in the negative real economy effects produced by deleveraging Hungarian banks. In reducing the pro-cyclicality of the operations of the financial system, it is also important that in financing loans, an increasing role is given to domestic funds, including deposits. The lessons learned from the crisis are that in an upturn, cheap short-term foreign funds increase risk propensity, whereas in a recession, foreign funds may dry up suddenly, forcing banks to adjust through strong pro-cyclical behaviour. Empirical evidence provided by Ivashina and Scharfstein (2010) confirm that in the case of banks where deposit taking had been less prominent, the decline in lending was sharper following the onset of the crisis. In addition to developing the capital market and increasing the weight of domestic funds, state-owned banks may also play a role in softening the pro-cyclical operations of the banking system, as state-owned banks may also provide financing by incorporating through-the-cycle aspects. Namely, the government owns its banks to achieve macroeconomic objectives or perform community functions, lend to sectors of particular importance, or, as the case may be, soften periods of credit crunch through lending incentive schemes. In recent years, the MNBâ&#x20AC;&#x2122;s interest rate easing, as well as its lending incentive schemes (FGS, MLS), substantially softened the previously very strong pro-cyclicality in the operations of the Hungarian financial system. Through the implementation of macroprudential rules, the pro-cyclicality in the system may be softened further. When carefully selected, macroprudential rules only decelerate in an overheated economy, and in a recession, they will not deepen the downturn as previously allocated buffers are released.

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The macroprudential rules introduced by the MNB to control credit growth59 are designed to prevent bank lending from leading to excessive credit growth. At this point, however, the lending activity of the Hungarian banking system falls short of the level that is seen as desirable, as a result of which the macroprudential rules introduced in recent years have no substantial influence on the operations of Hungarian banks in terms of pro-cyclicality. Both the volume of new loans issued and the findings of the Lending Survey suggest that the so-called “debt cap” regulation effective as of 1 January 2015, did not result in an immediate and drastic restriction of lending. According to its objective, macroprudential regulation does not restrain the dynamics of household lending, but strives to maintain its prudent level over the longer term, i.e. confine the issuance of new debt within sound limits. While debt cap rules produce their effects on the demand side of the credit market, those of the counter-cyclical capital buffer are perceived on the supply side. The MNB introduced the framework of the counter-cyclical capital buffer as of 1 January 2016, as part of which it prescribes a variable additional capital requirement in the event of excessive lending, and releases that requirement in periods of financial stress. The additional capital requirement increases the cost of credit by increasing the ratio of capital – a more expensive source of funding – among banks’ liabilities, which may restrain credit supply. Conversely, the previously allocated capital buffer is released in a period of financial stress, which will support banks’ lending capacity, and thereby accelerate recovery from the crisis.

s a macroprudential authority, the MNB uses the debt cap rules and the counA ter-cyclical capital buffer to cushion excessive fluctuations in the credit cycle. The MNB required banks to apply the debt cap rules (payment-to-income (PTI) and loan-to-value (LTV) ratios) as of 1 January 2015 on a mandatory basis. The counter-cyclical capital buffer was introduced as of 1 January 2016 at 0%, and its rate has not been adjusted as part of quarterly reviews to date.

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In addition to a review of the capital requirements and provisioning principles that amplify pro-cyclical operations, it is also necessary to reduce the pro-cyclical nature of the financial incentives (bonuses) of bank managers, e.g. through the deferred payment of such bonuses. This would incentivise banks to design business policies by also incorporating long-term through-the-cycle considerations and effects instead of focusing only on short-term business aspects. Finally, a less pro-cyclical banking system may also be created through rearrangements between market players, although bank consolidation is a time-consuming process that may have undesired consequences60 in addition to its positive effects. Literature fails to provide a clear indication as to whether foreign banks behave more pro-cyclically than local banks. However, Hungary’s crisis experience obviously demonstrates that the behaviour of foreign banks amplified the procyclicality of the Hungarian banking system. By increasing the share of locally-owned banks (Chart 8-13), Hungary seeks to create a healthier and less vulnerable banking system. In the years preceding the onset of the crisis, it was primarily foreignowned banks that had a high risk appetite, and easier and cheaper access to foreign exchange funds, which gave them prominence in the spread of foreign exchange-based lending in Hungary. The banks that played a leading role in toxic lending incurred massive credit losses following the onset of the crisis, while previous cheap and abundant foreign funds dried up spectacularly. These developments amplified risks to financial stability and significantly hindered Hungary’s recovery from the crisis.

here banks exiting the market (or submarket) abandon their positions faster than W other market players could take up those positions, this could entail negative consequences. Another potential danger is that consolidation is accompanied by increased concentration, which could lead to the emergence of highly concentrated market structures in certain segments, which in turn distort competition and could aggravate the problem of banks that are too big to fail.

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Chart 8-13: Market share of domestic and foreign controlled banks in an international comparison at the end of 2015 100

Per cent

100 90

Greece Germany Spain France Sweden Netherlands Italy Denmark Cyprus Portugal Austria Slovenia UK Hungary Latvia Ireland Belgium Poland Hungary* Malta Finland Bulgaria Slovakia Luxembourg Czech Republic Romania Croatia Lithuania Estonia

Foreign ownership

Domestic ownership

Note: Hungary* = share of domestically-owned banks in 2008. Source: ECB.

Key terms counter-cyclical currency mismatch risk deleveraging demand for credit economic cycle Financial Conditions Index (FCI)

interest rate risk lending activity maturity risk pro-cyclical rollover risk volatility

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References Bálint, M. – Horváth, G. (2016): Present Situation and Outlook for the Banking System in Hungary, in: Palotai, D. – Virág, B. (eds.): Competitiveness and Growth. MNB, pp. 529–569. Banai, Á. – Erhart, Sz. – Vágó, N. – Varga, P. (2016): A tőzsdeképesség vizsgálata a magyar kisés középvállalati szektorban (How to Set Listing Criteria for Small and Medium-sized Enterprises in Hungary?). Financial and Economic Review, 15(3), pp. 79–109. http://english.hitelintezetiszemle. hu/letoltes/adam-banai-szilard-erhart-nikolett-vago-peter-varga.pdf Caprio, G. Jr. (2010): Safe and sound banking: a role for countercyclical regulatory requirements? The World Bank Policy Research Working Paper, No 5198. Csávás, Cs. (2015): A devizatartalék-megfelelés értékelésének nemzetközi trendjei (International Trends of Assessing the Adequacy of Foreign Exchange Reserves). MNB Technical Paper, https://www.mnb. hu/letoltes/csavas-csaba-a-devizatartalek-megfeleles-ertekelesenek-nemzetkozi-trendjei.pdf Fábián, G. – Vonnák, B. (2014): Átalakulóban a magyar bankrendszer – vitaindító a magyar bankrendszerre vonatkozó konszenzusos jövőkép kialakításához (Hungarian Banking System in Transition –A keynote paper for developing a consensus-based vision for the Hungarian banking system). Special issue of MNB studies. Goodhart, Ch. – Hofmann, B. – Segoviano, M. (2004): Bank regulation and macroeconomic fluctuations. Oxford Review of Economic Policy, 20(4), pp. 591–615. Gór-Holecz, F. – Kolozsi, P. P. – Novák, Zs. – Zágonyi, Á. (2016): Az Önfinanszírozási program koncepciója és hatásmechanizmusa (Self-financing Programme – Concept and Impact Mechanism), in: Hoffmann, M. – Kolozsi, P. P. (eds.): Az Önfinanszírozási program első két éve (The First Two Years of the Self-financing Programme). MNB Volume of Studies. https://www.mnb.hu/letoltes/mnbthe-first-two-years-of-the-self-financing-programme.pdf Erhart, Sz. – Kékesi, Zs. – Koroknai, P. – Kóczián, B. – Matolcsy, Gy. – Palotai, D. – Sisak, B. (2015): A devizahitelezés makrogazdasági hatásai és a gazdaságpolitika válasza (Macroeconomic Impacts of Foreign Exchange-based Lending and the Economic Policy Response). In: Prof. Dr. Csaba Lentner (ed.): A devizahitelezés nagy kézikönyve. Nemzeti Közszolgálati Tankönyvkiadó, Budapest, pp. 121–158. Hardouvelis, G. A. (2010): Actions for a less procyclical financial system. Economy Markets, 5(5), Eurobank Research. Ivashina, V. – Scharfstein, D. (2010): Bank lending during the financial crisis of 2008. Journal of Financial Economics 97, pp. 319–338. Jokippi, T. – Milne, A. (2008): The cyclical behaviour of European bank capital buffers. Journal of Banking & Finance, 32(8), pp. 1440–1451. Kashyap, A. – Stein, J. (2004): Cyclical implications of the Basel II capital standards. Federal Reserve Bank of Chicago Economic Perspectives 1st quarter, pp. 18–31.

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Part II: Challenges and answers in Hungarian Monetary Policy Kolozsi, P. P. – Banai, Á. – Vonnák, B. (2015): A lakossági deviza-jelzáloghitelek kivezetése: időzítés és keretrendszer (Phasing Out Household Foreign Currency Loans: Schedule and Framework). Financial and Economic Review 14(3), September 2015, pp. 80–83. http://english.hitelintezetiszemle.hu/ letoltes/3-kolozsi-banai-vonnak-en.pdf Komáromi, A. (2008): A külső forrásbevonás szerkezete: Kell-e félnünk az adóssággal való finanszírozástól? (The structure of external financing: Is there a reason to worry about financing through debt?) MNB Bulletin, April 2008. http://www.mnb.hu/letoltes/mnb-bull-2008-04-andraskomaromi-en.pdf Magyar Nemzeti Bank (2016): Növekedési jelentés (Growth Report), December 2016, http://www. mnb.hu/letoltes/novekedesi-jelentes-2016-en.PDF Magyar Nemzeti Bank (2016): Hitelezési folyamatok (Trends in Lending), November 2016, http:// www.mnb.hu/en/publications/reports/trends-in-lending/trends-in-lending-november-2016 Soczó, Cs. (2009): Törekvések a jogszabályi tőkekövetelmény prociklikusságának mérséklésére (Efforts to Reduce Pro-cyclicality of Regulatory Capital Requirements). Financial and Economic Review 8(5), pp. 367–386.

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Part II

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Easing cycles — significant easing with gradual and cautious steps Laura Komlóssy – Balázs H. Váradi

In Hungary, in the years preceding the crisis of 2008–2009, several factors prevented monetary policy from focusing solely on inflation targeting, which contributed to the failure of the central bank policy pursued during the period. One of the key factors was the outstandingly high public deficit characterising the period, the unfavourable side effects of which spilled over to almost all areas of the economy, and in effect, the dominance of fiscal policy made harmonisation with monetary policy impossible. Following the onset of the crisis, advanced economies initially responded to unfavourable macroeconomic developments by fiscal and monetary easing as well. By mid2012, however, recovery from the crisis stalled in many regions of the world economy. Subdued global growth and a moderate inflation outlook caused central banks to ease monetary conditions further. In 2012, like other countries in the region, the Magyar Nemzeti Bank also launched its easing cycle, which was supported by several factors. On the one hand, the favourable measures of Hungarian fiscal policy led to a significant improvement in the country’s risk perception, while the expansionary monetary policy stance of major global central banks also increased room for manoeuvre for the domestic monetary policy. Subsequently, continued monetary easing was needed due to an environment of strong disinflation and in order to stimulate economic growth. Nevertheless, the uncertainty prevailing in the international financial environment justified a cautious monetary policy, as a result of which from August 2013, the easing cycle continued in smaller steps than the previous 25 basis points.

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The second phase of the easing cycle commenced in March 2015, when increasing downside risks to inflation justified a further easing of monetary conditions. Responding to an environment of persistently low costs, in March 2016 the Monetary Council launched the third phase of its easing cycle. Overall, in the course of the easing cycle, the policy rate fell by 610 basis points from 7 per cent to a historic low of 0.9 per cent. In its decisions during the easing cycle, rather than aiming to reach the lowest interest rate level attainable in the short term, the Monetary Council targeted a sufficiently low interest rate level that would ensure the sustainable fulfilment of its primary mandate, and the stability of the base rate as regards the effectiveness of monetary easing. For that reason, in addition to conventional monetary policy instruments, unconventional instruments also gained increasing prominence in conducting monetary policy in recent years. The easing cycle launched by the Magyar Nemzeti Bank in August 2012, had a major impact on both the interest rates of various bank products and on the yields of government securities, while it also resulted in significant savings on interest for the consolidated general government. By influencing short-term money market yields, base rate cuts resulted in equivalent interest rate decreases in major household and corporate banking products, reducing the interest burden on the private sector by several hundred billion forints. Additionally, the easing cycle substantially supported the pick up in economic growth in recent years, while it also prevented inflation from remaining in negative territory for an extensive period, whereby it eliminated deflationary risks and reduced the extent of missing the inflation target.

9.1 Increased flexibility of the monetary policy framework As explained in earlier chapters, major global central banks initially responded to the crisis by using the conventional monetary policy instrument of cutting their base rates; however, that monetary easing proved to be insufficient. Accordingly, soon afterwards central banks also used unconventional instruments to support recovery from the protracted crisis, which was accompanied by a substantial increase in â&#x20AC;&#x201D; 292 â&#x20AC;&#x201D;

9 Easing cycles — significant easing with gradual and cautious steps

central bank balance sheets. Hungary, however, was hit by the crisis when its economy was in a special condition: the external vulnerability of the country was high due to the high level of foreign exchange debt, while the economy was also characterised by an inadequately functioning banking system due to the high share of foreign exchangebased loans. For these reasons, the solutions implemented by other central banks were not viable in Hungary, which called for the introduction of new, innovative and targeted instruments. The Magyar Nemzeti Bank responded to the challenges faced by the economy by introducing a number of novel solutions (Chart 9-1). Chart 9-1: New monetary policy framework of the Magyar Nemzeti Bank PRIMARY OBJECTIVE: INFLATION MORE FLEXIBLE CENTRAL BANK OBJECTIVES Price stability (3%)

Tolerance band (3 ± 1%)

Sustaining financial stability

Supporting economic growth

Enhancing monetary transmittion

Sound financial intermediation

Mark

Policy rate PRIMARY INSTRUMENT

FGS, FGS+, GSP

Selffinancing

Settelement of the issue of FX loans

Strengthened micro and macro supervision

Positive central bank P&L

BROADENED SET OF CENTRAL BANK INSTRUMENTS

BSE

Source: MNB.

While the base rate remained the primary instrument, a number of new instruments were also added to the central bank’s tools in support of a more flexible system of central bank objectives. After the crisis, besides the primary role of the inflation target, increasing prominence was given worldwide to aspects of financial stability, support for economic growth, and the restoration of monetary transmission, which had been damaged during the crisis. Over the past — 293 —

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years, in Hungary these objectives were served, among other measures, by the Funding for Growth Scheme, followed by the Growth Supporting Programme, the Self-Financing Programme, the conversion of foreign exchange-based loans to HUF loans, the reinforcement of micro- and macroprudential supervision, as well as measures to clean banks’ loan portfolios and to ensure access to funding companies by the widest possible means. This chapter provides a more detailed description of the easing cycles carried out using the base rate, the conventional central bank instrument.

9.2 Economic policy and monetary policy before the crisis In Hungary, in the years preceding the crisis of 2008-2009, several factors prevented monetary policy from focusing solely on inflation targeting, which contributed to the failure of the central bank policy pursued during the period. One of the key factors was the outstandingly high public deficit characterising the period, the unfavourable side effects of which spilled over to almost all areas of the economy as the entire economy drifted to an unsustainable trajectory due to the upset balance of the general government. As a result of the expansionary fiscal policy pursued after 2002, fiscal expenditures were high in a regional comparison, leading to a significantly deteriorated general government balance (Chart 9-2). In relative terms, the government spent more on social transfers and less on productive purposes (P. Kiss–Szemere, 2009), which was detrimental to the performance of the economy and sustainable growth. It also contributed to the upset balance of the economy. Taxes on incomes were outstandingly high compared to the region, which acted as a disincentive to employment, and had already set the Hungarian employment rate on a declining trajectory in the years preceding the crisis. High public deficit also hurt external balance, while the transfers to households led to excessive household consumption, and consequently, lower savings. Soaring public deficit and the decline in savings were accompanied by a rising current account deficit, leading to an increasing — 294 —

9 Easing cycles — significant easing with gradual and cautious steps

level of external indebtedness, and ultimately generating a significant rise in Hungary’s public debt and external debt. Chart 9-2: Balances of the current account and the general government as a percentage of GDP 6

Percentage of GDP

Balance according to statistical rules valid in 2011

Current account balance

2015

2014

2013

2012

2011

2010

2009

2008

–12

2007

–12

2006

–10 2005

–10 2004

–8

2003

–8

2002

–6

2001

–6

2000

–4

1999

–4

1998

–2

1997

–2

1996

1995

General government balance

Note: According to statistical rules valid in 2011, general government surplus was above 4 per cent. Source: Authors’ editing based on Eurostat, MNB and Matolcsy (2015).

Therefore, in the years preceding the crisis of 2008–2009, Hungary had faced a crisis of imbalances, where the balances of the general government, the country’s external financing, and labour market had been upset simultaneously (Matolcsy, 2015). A further problem emerged in the form of Hungary’s increased country risk premium as a result of its expansionary fiscal policy, accompanied by a substantial rise in inflation caused by tax increases; consequently, considerations of inflation, financial stability and financing all justified a tight monetary policy.

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However, tight monetary policy entailed additional negative consequences. The real exchange rate gradually appreciated to the detriment of Hungarian exports, the global market share of which consequently grew at a slower rate compared to the rest of the region. The investment rate had also declined gradually in the years preceding the crisis, reflecting Hungary’s inability to exploit the benefits of its accession to the EU in 2004, and the new investment funds that had become available (Matolcsy, 2008). As a combined result of these developments, perceptions on Hungary’s competitiveness deteriorated steadily. The period leading up to the onset of the crisis saw rapid growth in lending to households. However, a problem emerged in the form of a shift in borrowing towards foreign exchange-based loans due to the high base rate and the strong exchange rate, as a result of which households’ open foreign exchange position grew to vast proportions (Chart 9-3). The stock of foreign exchange-based loans to the corporate sector also increased, although to a lesser extent and with a higher level of coverage compared to households. Foreign exchange indebtedness substantially increased Hungary’s financial vulnerability (Matolcsy, 2015). Chart 9-3: Denomination structure of household loans 11,000

HUF Billions

11,000

2,000

1,000

HUF denominated loans Source: MNB.

— 296 —

FX loans

2014

3,000

2013

3,000

2012

4,000

2011

5,000

4,000

2010

5,000

2009

6,000

2008

7,000

6,000

2007

7,000

2006

8,000

2005

8,000

2004

9,000

2003

10,000

9,000

2002

10,000

9 Easing cycles — significant easing with gradual and cautious steps

Analysing the reasons behind the spread of foreign exchange-based lending, it can be concluded that it was partly attributable to the monetary policy pursued before the crisis, which had limited space due to the expansionary fiscal policy. On the one hand, owing to the relatively high base rate, interest rates on forint loans were significantly higher than those on foreign exchange-denominated loans, which in itself created the illusion that foreign exchange-based loans provided economic actors with cheaper access to funds relative to borrowing on a forint basis. On the other hand, the same illusion was reinforced by the relative stability of the exchange rate, as a result of which households failed to give proper consideration to potential exchange rate risks. The stability of the exchange rate was partly attributable to the system of exchange rate bands in place until February 2008, which had prevented major fluctuations in the forint exchange rate. Additionally, the system of exchange rate bands was also responsible for the failure of monetary policy, because the focus on keeping the exchange rate within the band limited the central bank in the practical implementation of pure inflation targeting. The system of exchange rate bands therefore deprived the central bank of a key transmission channel. The central bank’s room for manoeuvre was also limited by fiscal policy. Due to the expansionary fiscal policy, the central bank was forced to pursue a tight monetary policy under the regime of inflation targeting as adopted in 2001, but had relatively little success in doing so. In effect, the dominance of fiscal policy made harmonisation with monetary policy impossible. Namely, with expansionary fiscal policy in place, the central bank had only two unfavourable choices: either to abandon its inflation target to allow higher inflation keeping the balance of the general government, or insist on its inflation target and consequently allow the long-term balance of the general government to become upset (Matolcsy–Palotai, 2016). The central bank kept its base rate high in an attempt to counterbalance high inflation, but failed in its effort. For most of the period, the Hungarian consumer price index exceeded the inflation target defined by the MNB, initially for the end of each year, and on a continuous basis as of 2007, thus the central bank failed to fulfil its primary mandate despite the high base rate (Chart 9-4). — 297 —

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Chart 9-4: Inflation target and development of inflation Per cent Year-end inflation target

Inflation

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

Continuous inflation target

2001

12 11 10 9 8 7 6 5 4 3 2 1 0 –1 –2

Per cent

12 11 10 9 8 7 6 5 4 3 2 1 0 –1 –2

Inflation target

Source: MNB.

Box 9-1 A brief historical overview of the central bank’s interest rate policy

Since its establishment in 1924, the Magyar Nemzeti Bank has attached particular importance to ensure price stability, however, there have been periods in which it did not give priority to control the growth rate of consumer prices. A number of changes have occurred in Hungarian monetary policy before the current framework and central bank practices were established (Madarász–Novák, 2015b). Initially, exchange rate policy was characterised by controlled foreign currency management, while following the 1929 depression, interest rates prevailing in the economy were relatively low. In the period of hyperinflation following the Second World War, developments in lending were predominantly determined by the government, which confined interest rates to a limited role. However, on 1 August 1946, when the forint was introduced, the central bank also had a major role in stabilising the national currency (MNB, 2002).

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In the era of socialist planned economy, there was no independent monetary policy, as a result of which there was also no central bank reference rate of distinct significance which could have been considered the central bank base rate (Madarász–Novák, 2015a). In the course of economic reforms, however, the MNB’s monetary policy instruments gained more prominence, and due to the foreign trade boom of the ’60s, the central bank’s activity in the domestic FX market also broadened in scope (MNB, 2012). Hungary adopted the two-tier banking system as of 1 January 1987. In the early 1990s, the central bank was frequently forced to devaluate the forint as a result of the high current account deficit, which in turn led to a substantial increase in inflation, and then in the base rate (Chart 9-5). Chart 9-5: Developments in the central bank base rate and inflation 40

Per cent

–5

2015

0 2013

2011

2009

2007

2005

2003

2001

1999

1997

1995

1993

1991

1989

1987

Inflation (y-o-y)

Base rate

Source: Authors’ editing based on MNB, Financial Gazette, HCSO, and Madarász—Novák (2015b).

Subsequently, the instruments of monetary policy changed, and the central bank started to shape monetary conditions through interest rates. Simultaneously, the crawling peg exchange rate regime was introduced,

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which nevertheless continued to limit the monetary policy’s room for manoeuvre (MNB, 2000). In the second half of the 1990s, the policy rate was set on a declining path. Due to fiscal and monetary policy measures, the current account and public deficit both remained at a sustainable level, while inflation decreased (Madarász–Novák, 2015a). In 2001, the central bank introduced the framework of inflation targeting, which was, however, initially prevented from functioning adequately and focusing on its primary objective of price stability due to an excessively expansionary fiscal policy and the exchange rate band in place, then financial stability risks arising after the onset of the crisis. In that regard, a turnaround was achieved in August 2012, when the central bank launched its easing cycle, during which the central bank base rate declined to a historically low level. The framework of inflation targeting also became more flexible: in March 2015, the Monetary Council decided to designate a ±1 percentage point ex ante tolerance band around the 3 per cent inflation target, which could also be considered when making decisions (Felcser et al., 2015a). While maintaining the primary objective of price stability, flexible inflation targeting provides a framework where the central bank not only focuses on inflation in the short run, but it also takes into account other factors pertaining to the real economy and financial stability (MNB, 2016a).

9.3 Central bank reactions following the crisis In the world economy, the period preceding the financial crisis of 2008–2009 was characterised by a stable macroeconomic environment, apparently sustainable growth and relatively low inflation. However, the apparent stability concealed imbalances in the real economy and the money market that were gradually building up on a global scale, while the money market was characterised by an environment of low interest rates and moderate credit spreads, as a result of which an increased number of economic actors were granted credit, generating dynamic growth in lending. This development was supported by the — 300 —

9 Easing cycles â&#x20AC;&#x201D; significant easing with gradual and cautious steps

absence of intervention by regulatory authorities, which ultimately led to the emergence of the subprime crisis in the US (Csortos et al., 2016). Following the failure of Lehman Brothers in September 2008, the US subprime crisis became global. The sharp deterioration in investor sentiment caused interbank dollar liquidity to dry up, which spilled over rapidly to the European interbank market, then to the real economy as well. Following the onset of the crisis, advanced economies initially responded to unfavourable macroeconomic developments by fiscal and monetary easing as well. In response to the economic recession, the major global central banks (European Central Bank, Federal Reserve, Bank of Japan) first cut their policy rates, which, however, relatively quickly reached or approached the level supposed, at the time, as the nominal lower bound. In most cases, these monetary easing measures proved insufficient in themselves to foster recovery, which is why central banks introduced other unconventional monetary policy instruments to complement conventional interest rate policy (Felcser et al., 2015b). Initially, central banks across the region responded to the tensions and financial stability risks emerging at the onset of the crisis by raising their base rates (Chart 6-9). In October 2008, the Magyar Nemzeti Bank raised its policy rate by 300 basis points to 11.5 per cent, and introduced new instruments for crisis management purposes, essentially classified into the following three groups: FX swap instruments to ease tensions in the money and FX markets and to provide FX liquidity, instruments to provide forint liquidity, and instruments to support the functioning of securities markets. The measures proved to be effective, all the more so as the increase in foreign exchange reserves due to the loans from the EU/ IMF also helped ease the money-market panic and liquidity constraints, allowing cautious base rate cuts from November (Csortos et al., 2016). By April 2010, the policy rate was cut to 5.25 per cent, followed by hikes from November due to inflation above the target, to 6 per cent in January 2011, and to 7 per cent at the end of the year. The interest rate policies of central banks in the region showed similar dynamics during â&#x20AC;&#x201D; 301 â&#x20AC;&#x201D;

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the period, except that the central banks of Romania and the Czech Republic did not carry out any interest rate hikes after 2010. Chart 9-6: Policy rates of central banks in the region 18

Per cent

Hungary

Poland

2012

Czech Republic

2016

2015

2014

2013

2011

2010

2009

2008

2007

2006

2005

Romania

Source: Databases of central banks.

By mid-2012, recovery from the crisis stalled in many regions of the world economy. Subdued global growth and moderate inflation outlook caused central banks to ease monetary conditions further. To support easing, central banks started to use additional unconventional instruments. Quantitative easing measures led to a substantial increase in the balance sheet totals of major global central banks following the crisis (Chart 9-7).

â&#x20AC;&#x201D; 302 â&#x20AC;&#x201D;

9 Easing cycles — significant easing with gradual and cautious steps

Chart 9-7: Balance sheet totals of major global central banks (as a percentage of GDP) 100

Per cent

100

10 2010

10 2011

2012

European Central Bank

2013

2014

2015

Federal Reserve

2016 Bank of Japan

Sources: Databases of central banks, IMF, Eurostat.

Like other countries in the region, in 2012 the Magyar Nemzeti Bank started to cut interest rates again. The launch of the easing cycle in August was supported by several factors. On the one hand, the favourable measures of Hungarian fiscal policy led to a significant improvement in the country’s risk perception, which was accompanied by stronger international risk propensity resulting from the ECB’s commitment to the euro (Chart 9-8). The expansionary monetary policy stance of major global central banks also increased the room for manoeuvre for domestic monetary policy. At the beginning of the easing cycle, inflation was still substantially higher than the central bank’s 3 per cent target, but that was primarily attributable to one-off effects (Matolcsy, 2015).

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Based on the projection assuming an endogenous interest rate path, over the monetary policy horizon, inflation was seen as decreasing to the target besides the possibility of monetary conditions being eased substantially, assuming that a sustained improvement would occur in risk perception, and that price-increasing shocks would peter out (MNB, 2012). Once these temporary effects had petered out, a period of strong disinflation commenced from late 2012, prior to which the Hungarian risk spread had also dropped significantly (Felcser et al., 2015b). All these factors enabled the central bank to launch its easing cycle, during the course of which the central bank base rate declined to a historically low level, supporting the achievement of the inflation target, and the stimulation of economic growth. Chart 9-8: Developments in the MNB base rate and risk spreads 800

Per cent

Basis point Start of the easing cycle

700

Fiscal stabilization measures

600

Getting out of EDP

500

400

300

3 2

5-year Hungarian CDS spread

EMBI global

1 Sep. 2014

Jul. 2014

May. 2014

Mar. 2014

0 Jan. 2014

Mar. 2013

Jan. 2013

Nov. 2012

Sep. 2012

Jul. 2012

May. 2012

Mar. 2012

Jan. 2012

Russian-Ukraine conflict

“Tapering talk” Nov. 2013

ECB's commitment to euro

Sep. 2013

100

Jul. 2013

Greek election

May. 2013

200

Base rate (right-hand scale)

Source: Authors’ editing based on Bloomberg and Matolcsy (2015).

Given the rate cuts, in the case of the Magyar Nemzeti Bank there was no need to launch quantitative easing programmes similar to those used by large central banks. On the one hand, there was still sufficient — 304 —

9 Easing cycles — significant easing with gradual and cautious steps

room to cut the base rate further, while on the other the central bank used targeted unconventional instruments to restore the monetary transmission, which were more efficient in addressing disruptions to the various transmission channels. In addition to the launch of the easing cycle, in the renewal of monetary policy a prominent role was occupied by the conversion of foreign exchange-based loans, the launch of the Self-Financing Programme, and the renewal of monetary policy instruments, which collectively provided the foundations for more efficient inflation targeting (Csortos et al., 2016). In April 2013, the central bank also launched the Funding for Growth Scheme in an effort to alleviate the disruptions in lending to small and medium-sized enterprises, invigorate corporate lending and thus foster accelerated economic growth. The programme managed to halt the credit crunch among SMEs and created credit conditions which improved enterprises’ investment appetite and hence, improved monetary policy transmission significantly (MNB, 2016a).

9.4 The first phase of the easing cycle In recent years the Magyar Nemzeti Bank has made a substantial easing cycle and deployed unconventional targeted instruments with a view to fulfilling its primary mandate: to achieve and maintain price stability. The launch of the easing cycle was initially enabled by Hungary’s gradually improving risk perception and the persistently expansionary monetary policy stance of major global central banks, while the actions taken in the field of fiscal policy further increased the monetary policy’s room for manoeuvre. Even as the risk perception of the country improved further, continued monetary easing was needed due to an environment of strong disinflation and in order to stimulate economic growth. Nevertheless, the uncertainty prevailing in the international financial environment justified a cautious monetary policy, as a result of which from August 2013, the easing cycle continued in smaller steps than the previous 25 basis points. The second phase of the easing cycle commenced in March 2015, when increasing downside risks — 305 —

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to inflation justified a further easing of monetary conditions (Felcser et al., 2015b). In March 2016, based on the forecast of the Inflation Report, the date of achieving the inflation target was seen as being postponed due to an environment of costs persistently and considerably falling short of the previous assumptions, in response to which the Monetary Council launched the third phase of its easing cycle (MNB, 2016b). In the course of the easing cycle, the policy rate fell by 610 basis points from the initial 7 per cent to a historic low of 0.9 per cent. In the first half of the easing cycle, the gradual interest rate moves were supported by improving international risk propensity, the persistently expansionary monetary conditions of major global central banks, and country-specific factors as well. The significant improvement in global investor sentiment had largely resulted from the crisis management measures adopted across the euro area. Intensifying international risk appetite was accompanied by a remarkable decrease in the expected premium on emerging market assets. The Hungarian risk spread dropped by a total of 200 basis points from June to late August 2012, and yields on the government securities market also decreased. In additional to international factors, the improvement in the Hungarian CDS spread was also supported by increasing fiscal discipline. Following budgetary adjustments, Hungaryâ&#x20AC;&#x2122;s public deficit according to ESA methodology edged down to 2.3 per cent, which was seen as a sharp decline compared to the high average of previous years. Public debt also embarked on a downward path, accompanied by a decrease in external vulnerability, while growth stimulating structural reforms were also initiated with a primary focus on the labour market and on strengthening economic growth over the long term (MNB, 2016a). In the environment of the supportive global monetary policy stance, in the first half of the easing cycle the Monetary Council of the MNB cut the central bank base rate, in 25 basis point steps, from the initial 7 per cent to 4 per cent between August 2012 and July 2013.

â&#x20AC;&#x201D; 306 â&#x20AC;&#x201D;

9 Easing cycles — significant easing with gradual and cautious steps

At the beginning of the cycle, inflation was substantially higher than the central bank’s 3 per cent target (Chart 9-9), however, this was mostly attributable to temporary one-off effects, and once those effects had petered out, a period of strong disinflation commenced from late 2012, to which both international and domestic factors had contributed (MNB, 2016a). Chart 9-9: Developments in underlying inflation indicators 8

Per cent

–2

2012

2013

2014

2015

2016

–2

Core inflation excluding indirect tax effect Demand sensitive inflation Sticky Price Inflation Inflation Source: MNB.

The drop-out of former indirect tax increases from the base and the steps of cuts in regulated prices significantly reduced the direct inflationary impacts stemming from government measures significantly. In addition, unused capacities that emerged during the crisis and continues to prevail in the economy, subdued domestic demand, and decreasing inflation expectations due to low global inflation in the international environment and to an environment of persistently low inflation further reinforced disinflation in Hungary (Chart 9-10, Felcser et al., 2015). Inflation expectations aligned with the 3 per cent inflation target also

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reduced inflationary pressures on the economy through lower wage dynamics, further increasing the room for monetary policy (MNB, 2016a). Chart 9-10: Developments in inflation expectations 12

Per cent

8 Tolerance band

0 –2

Inflation target

2012

2013

2014

2015

Range of inflation expectations

2016

–2

Actual data

Sources: European Commission, MNB.

In addition to the environment of persistent disinflation, the continued improvement in risk perception also contributed to the continuation of the easing cycle, which was supported by the disciplined fiscal policy, the stoppage of the excessive deficit procedure, Hungary’s favourable net external financing capacity, and the expansionary monetary policy of globally important central banks. In September 2012, the Fed launched another massive asset purchase programme (QE3), while in late 2011, in order to control bond market volatility returning as a consequence of the euro area crisis, the ECB launched Phase 2 of its Covered Bond Purchase Programme (CBPP2), additionally, to control soaring peripheral bond yields,

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9 Easing cycles — significant easing with gradual and cautious steps

in September 2012 it announced its instrument for the conditional purchase of government securities (Outright Monetary Transactions, OMT). As part of its economic policy of Abenomics, in April 2013 the Bank of Japan announced Quantitative and Qualitative Easing (QQE). In July 2012, the Bank of England and the UK Treasury launched their joint Funding for Lending Scheme (FLS). As regards the region, the central banks of Poland and Romania launched their easing cycles in late 2012 and July 2013 respectively, while the Czech central bank technically cut its policy rate to zero, then introduced a currency peg in November 2013 to ease monetary conditions. Overall, an environment of intensifying disinflation, inflation expectations falling below the central bank’s target and, looking forward, the inflation outlook justified further monetary easing (Felcser et al., 2015b). Accordingly, the Monetary Council of the Magyar Nemzeti Bank cut the policy rate by an additional 190 basis points to 2.1 per cent by July 2014, then ended its two-year easing cycle. In consideration of potential external shocks, the easing of the base rate continued in smaller steps compared to the previous 25 basis points, since the uncertainty prevailing in the international environment justified more cautious monetary policy (MNB, 2016a). From August 2013, the previous 25 basis point steps were replaced by 20 basis point steps, then by gradually smaller steps as the cycle progressed towards its end: the rate was cut in steps of 15 basis points from January 2014, and 10 basis points from March 2014. The deceleration of steps was justified by increased uncertainty in the international financial environment. In its forward guidance issued after the end of the easing cycle, the Monetary Council indicated that “the macroeconomic outlook points in the direction of persistently loose monetary conditions” (MNB, 2014a). Subsequently, the base rate remained unchanged at 2.1 per cent until March 2015. In the Monetary Council’s judgment, there remained a degree of unused capacity in the economy and the real economy’s disinflationary impact decreased looking forward, while maintaining current monetary conditions would ensure the medium-

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term achievement of the inflation target (MNB, 2016a). Responding primarily to inflation that continued to decelerate due to falling commodity prices, following up on the Inflation Report, in December 2014 the Monetary Council indicated that downside risks to inflation had increased, but macroeconomic prospects did not warrant base rate cuts (MNB, 2014b).

9.5 The second and third phases of the easing cycle In March 2015, following the comprehensive assessment of the latest Inflation Report, the Monetary Council decided to relaunch the easing cycle and carry out a 15-basis point interest rate cut. Continued monetary easing was justified by increasing downside risks to inflation, i.e. inflation developments that continued to fall short of the inflation target, unanchored inflation expectations, a persistent negative output gap, and the supportive monetary policies of global and regional central banks. To achieve the inflation target, the Monetary Council cut the base rate in 15 basis point steps to 1.35 per cent, then decided in July to end its easing cycle. In its communication ending the cycle, the Monetary Council indicated that the macroeconomic and inflation outlook pointed to the direction of loose monetary conditions for an extended period (MNB, 2015). Additional cost shocks led to intensified communication about the expected path of the base rate, as part of which policymakers considered that the prolonged maintenance of the prevailing level of the base rate and expansionary monetary conditions across the entire forecast horizon would be consistent with the achievement of the inflation target over the medium term and a corresponding degree of stimulus to the real economy. With an emphasis on conditionality and the achievement of the inflation target, the cautious application of forward guidance successfully shaped market and analystsâ&#x20AC;&#x2122; expectations for future monetary policy (Chart 9-11, MNB, 2016a), alleviating the uncertainty around central bank decisions and improving the efficiency of monetary policy.

â&#x20AC;&#x201D; 310 â&#x20AC;&#x201D;

9 Easing cycles — significant easing with gradual and cautious steps

Chart 9-11: Base rate and the implied path of interbank yields 9 8

Per cent

First easing cycle 7 % −> 2.1 %

Upper limit on three-month central bank deposits

9 8

Second easing cycle 2.1 % −> 1.35 %

–610 bp Third easing cycle 1.35 % −> 0.9%

Using forward guidance has successfully guided expectations.

1 0

Jul. 2012 Oct. 2012 Jan. 2013 Apr. 2013 Jul. 2013 Oct. 2013 Jan. 2014 Apr. 2014 Jul. 2014 Oct. 2014 Jan. 2015 Apr. 2015 Jul. 2015 Oct. 2015 Jan. 2016 Apr. 2016 Jul. 2016 Oct. 2016 Jan. 2017 Apr. 2017 Jul. 2017 Oct. 2017 Jan. 2018 Apr. 2018 Jul. 2018 Oct. 2018

3 2

2 1

Sources: Bloomberg, MNB.

In spring 2016, low inflation pressures on the cost side and a historically low level of inflation expectations called for additional policy rate cuts with a view to the sustainable achievement of the inflation target. In three steps between March and May 2016, the Monetary Council cut the policy rate by another 45 basis points to a historic low of 0.9 per cent. However, in this phase of the easing cycle, policymakers considered that a comprehensive easing of monetary conditions was needed for the achievement of the inflation target, and accordingly, adjusted the bounds of the interest rate corridor alongside the base rate (MNB, 2016b). As a result of the staggered asymmetric adjustment, the overnight deposit rate decreased into negative territory to reach –0.05 per cent, and the overnight collateralised lending rate was cut to 1.15 per cent by May 2016 (Spéder et al., 2016). Aligned with the adjusted interest rate corridor, the oneweek collateralised central bank lending rate dropped to 1.05 per cent (Chart 9-12). — 311 —

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Chart 9-12: Schematic illustration of changes in the width of the central bank’s interest rate corridor 2.5

Per cent +100 bps

Per cent

2.5

+75 bps

2 +25 bps

1.5

+25 bps

1.5 +15 bps +0 bps 1

1 0.5

–100 bps –125 bps

0.5 –125 bps

–110 bps –95 bps

–95 bps

–95 bps 0

–0.5

–0.5 Base rate Interest rate on Two/One-week central bank loans*

Interest rate on O/N loans Interest rate on O/N deposits

* Before the interest rate corridor became asymmetric, the central bank announced twoweek central bank loans. Sources: MNB.

In its forward guidance after the end of the easing cycle, the Monetary Council indicated that if the assumptions underlying the Bank’s projections were to hold, the current level of the base rate and maintaining loose monetary conditions for an extended period were consistent with the medium-term achievement of the inflation target and a corresponding degree of support to the economy (MNB, 2016c). The Monetary Council also underlined the possibility that if it was assessed necessary in the future, it might also decide to use unconventional tools (MNB, 2016c). In its decisions during the easing cycle, rather than aiming to reach the lowest interest rate level attainable in the short term, the Monetary Council targeted a sufficiently low interest rate level that ensured — 312 —

9 Easing cycles — significant easing with gradual and cautious steps

the sustainable fulfilment of its primary mandate, and the stability of the base rate as regards the effectiveness of monetary easing. For that reason, in addition to conventional monetary policy instruments, unconventional instruments also gained increasing prominence in conducting monetary policy in recent years (Virág, 2016). Following the end of the easing cycle, in July 2016 the Monetary Council announced the next steps of modifying monetary policy instruments, the decreased frequency of tenders for the 3-month policy instrument, and limitations on the quantities accepted in future tenders. With a view to the targeted easing of monetary conditions, the Monetary Council set a HUF 900 billion upper limit on 2016 yearend stock of 3-month central bank deposits, and indicated that going forward it would set that limit on a quarterly basis, and that the limit on the 3-month deposit stock would be an integral part of monetary policy instruments (MNB, 2016d). In order to reinforce the effect of monetary easing through unconventional instruments related to the quantitative limitations on the 3-month deposit instrument, the Monetary Council continued to increase the asymmetry of the O/N interest rate corridor in both October and November by adjusting the spread on its lending instrument. In its November rate-setting meeting, fully exploiting the space available to narrow the interest rate corridor, the Monetary Council cut the O/N lending rate and the one-week collateralised central bank lending rate to the level of the base rate. The guidance provided in the communication following the interest rate decision indicated that if the achievement of the inflation target were to warrant it, the Monetary Council might use unconventional instruments in imposing stricter quantitative limitations on the 3-month deposit instrument in order to ease monetary conditions further (MNB, 2016e). The modification of monetary policy instruments led to a significant fall in yields in key markets. As a consequence of the modifications, the 3-month BUBOR, of particular importance in terms of lending, — 313 —

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dropped significantly below the base rate, while remarkable decreases have also been recorded recently in yields on discount treasury bills and swaps of various maturities.

9.6 The effect of the easing cycle on the financial market The easing cycle launched by the Magyar Nemzeti Bank in August 2012, had a major impact on both the interest rates of various bank products and the yields on government securities, while it also resulted in significant savings on interest for the consolidated general government. The steps of the easing cycle were incorporated gradually into yields on government securities and banks’ interest rates. By influencing short-term money market yields, base rate cuts resulted in equivalent interest rate decreases in major household and corporate banking products, reducing the interest burden on the private sector by several hundred billion forints, while they also prevented further drastic falls in outstanding borrowing, consumption and investment in the period of deleveraging (Komlóssy–Vadkerti, 2015). It is important to note that developments in various yields may also reflect the effect of other events, however, over a longer period a relatively close correlation is observed between the movements of the policy rate and market rates, which implies the significant role of monetary policy in the decline of various yields to historic low levels (Felcser et al., 2015b). Due to gradual interest rate moves the cuts were implemented without causing any risk to financial stability. Due to reference pricing, cuts in the base rate continuously influenced the interest rates on bank products. Following the launch of the easing cycle in August 2012, housing loans to households recorded a decline of over 800 basis points, and corporate overdrafts over 600 basis points, in their interest rates (Chart 9-13). Yields on both household and corporate fixed deposits dropped by approximately 600 basis points.

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9 Easing cycles — significant easing with gradual and cautious steps

Chart 9-13: The base rate and interest on certain forint loan and deposit products 14

Per cent

Sep. 2016

May. 2016

0 Jan. 2016

0 Sep. 2015

May. 2015

Jan. 2015

Sep. 2014

May. 2014

Jan. 2014

Sep. 2013

May. 2013

Jan. 2013

Sep. 2012

May. 2012

Jan. 2012

MNB base rate Housholds' term deposit Corporate's overdaft credit Corporate's term deposit Households' housing loan (max 1 year fixing) Note: With variable interest rate or with interest rate fixation of at most one year for household mortgage loans. Sources: Authors’ editing based on MNB and Felcser et al. (2015b).

In addition to the interest rates on banking products, the central bank’s easing cycle also involved a meaningful decline in the yields on shortand long-term government securities. However, the decline in yields was also attributable to other factors than the cuts in the policy rate. Such factors include the fiscal policy turnaround occurring in the period, the supporting international environment, and other measures initiated by the Magyar Nemzeti Bank. The decline in yields varied by maturity. By late November 2016, yields dropped by 640 basis points for 3-month government securities, 550 basis points for 3-year and 390 basis points for 10-year securities, despite a slight increase in longer yields having occurred at the end of the period, primarily as a result of international developments (Chart 9-14). — 315 —

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Chart 9-14: Short and long-term government securities’ yields 12

Per cent

Per cent Announcement of Self-financing Programme

12 10

3-month yield

3-year yield

10-year yield

Jul. 2016

0 Jan. 2016

0 Jul. 2015

Jan. 2015

Jul. 2014

Jan. 2014

Jul. 2013

Jan. 2013

Jul. 2012

Jan. 2012

Base rate

Sources: Authors’ editing based on MNB, ÁKK and Felcser et al. (2015b).

The Self-Financing Programme set the objective of changing the structure of government debt financing, and may have also contributed to declining yields through this channel (MNB, 2016a). The various yields had declined by 430, 260 and 190 basis points before the announcement of the Self-Financing Programme, while the central bank had cut the policy rate by 440 basis points. During the easing cycle, the movements of yields on short and medium maturities were closely aligned with the decreasing base rate, and after the announcement of the Self-Financing Programme, short term yields tended to be lower than the policy rate as a consequence of rising demand (Felcser et al., 2015b). The declining trend of long term yields shows that investors see the monetary policy credible, and consider the low central bank base rate to be sustainable over the long term (Matolcsy, 2015).

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In recent years, declining yields on Hungarian government securities have resulted in significant savings on interest for both the general government and the central bank (Table 9-1). Compared to the initial 2012 trajectory, which assumed that the base rate and yields in the government securities market would remain unchanged, public interest expenditures had dropped by approximately 0.9 per cent of GDP by 2015. The amount of savings on interest will increase as debt is repriced. Looking ahead, assuming that the environment of low interest rates is sustained, over the long term the government may achieve savings on interest equivalent to 2 per cent of GDP. Table 9-1: An estimate of interest savings by the state and the MNB Cumulative interest saving 2012

Government's interest saving percentage of GDP 0.04

MNB's interest saving

HUF billion

percentage of GDP

HUF billion

0.02

2013

0.3

100

0.5

153

2014

0.6

200

1.5

471

2015

0.9

300

2.4

804

2016

1.2

450

2.7

926

2017

1.4

550

2018

1.6

600

2019

1.7

650

after 2020

2.0

800

Note: The MNB’s interest savings based on the forint interest expenses on the stock of sterilisation instruments (including O/N and preferential deposits), reserve requirements and government deposits. The 2016 value factors in the MNB’s interest savings until the end of H1. Source: Authors’ editing based on MNB calculations, Kicsák (2015) and Felcser et al. (2015b).

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The easing cycle also resulted in major savings on interest for the Magyar Nemzeti Bank. Policy rate cuts contributed to the MNB’s improving interest income through multiple channels. Rate cuts directly reduce the central bank’s interest expenditures, while they also have indirect effects: demand for cash, representing interest-free central bank funds, increases due to lower opportunity cost, and falling deposit rates may thus lead to substantial portfolio restructuring among households (Kékesi et al., 2015). The MNB’s cumulative interest savings since the launch of the easing cycle exceeds 2.5 per cent of GDP by mid-2016. This will also reduce the financing costs and risks to the consolidated general government (Felcser et al., 2015b). It is important to note that the base rate cuts were implemented with adequate foreign exchange reserves in place throughout the cycle, as a result of which the expansionary monetary policy was of no risk to financial stability. Throughout the easing cycle, Hungary’s foreign exchange reserves remained above the key compliance indicators monitored by investors (Matolcsy, 2015).

9.7 The macroeconomic impacts of the easing cycle This subchapter explains the impact of the central bank’s rate cuts on the growth of the domestic economy and on inflation. For an understanding of these developments, a brief overview is provided first on the mechanism through which monetary policy impacts the real economy and prices, and on how the efficiency of transmission has changed in recent years in Hungary. Generally, a distinction can be made between five channels of monetary policy transmission: the interest rate channel, the exchange rate channel, the asset price channel, the credit channel, and the expectations channel (Chart 9-15).

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Chart 9-15: A schematic illustration of the transmission mechanism 1. Interest rate channel

Capital costs Substitution effect

Real interest rate

Income effect 2. Exchange rate channel Real exchange rate 3. Asset price channel Monetary policy

Net exports, relative prices

Tobin Q

Bond, equity and real estate prices

Wealth

Output and prices

4. Credit channel Bank lending channel: credit supply

Liquidity premium

Balance sheet channel: net enterprise value 5. Expectations and uncertainty (Inflation) expectations

Real interest rate Moral hazard and counter-selection

Uncertainty

Source: Authors’ editing based on MNB and Felcser et al. (2015b).

When the interest rate channel functions properly, a central bank rate cut will cause banks to reduce interest rates of their credit and deposit products. Namely, banks will have access to cheaper credit from the central bank, and they will also receive a lower interest on their deposits with the central bank (Felcser et al., 2015b). This will incentivise households to increase their consumption, and companies to pick up their investments. In Hungary, the interest rate channel functioned properly throughout the easing cycle, with the interest rates on various banking products declining substantially on the back of the central bank’s rate cuts over the period. For Hungary, a small and open economy, the exchange rate channel is also of particular importance, which had nevertheless been prevented from functioning properly by the spread of foreign exchange-based loans in the years preceding the crisis. — 319 —

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Moreover, while it remained an important channel, the effect of the exchange rate channel on prices became less prominent after the crisis for both cyclical and structural reasons. However, the forint conversion of foreign exchange-based loans in 2014–2015 reinforced the positive effect of exchange rate pass-through on economic output. The credit channel was severely damaged in the aftermath of the crisis. Protracted deleveraging caused economic actors to moderate their expenditures on consumption and investment, which also reduced their propensity to borrow. Additionally, a high share of non-performing loans led banks to tighten their lending conditions substantially. The MNB facilitated the cleaning of project loans secured by commercial property through the establishment of MARK Zrt., which may, looking ahead, substantially reduce the ratio of nonperforming corporate loans in the banking system. The expectations channel functioned adequately after the crisis, given the ability of the Magyar Nemzeti Bank to shape economic actors’ inflation expectations effectively through forward guidance. Box 9-2 The MNB’s macroeconomic forecasting model

This box provides a summary of the innovations in the new forecasting model of the Magyar Nemzeti Bank adopted in 2016, in the light of the lessons learned from the crisis compared to the previous model. Namely, in the aftermath of the crisis it became inevitable for economics to review its previous assumptions and the conclusions drawn from them, which also affected macroeconomic modelling (Békési et al., 2016). The Magyar Nemzeti Bank’s new model represents a small and open economy in which households are heterogeneous, and constraints are introduced on the debt and funding of economic actors. The model also incorporates a financial accelerator mechanism, which is important because in its absence models are prevented from capturing the endogenously built-up financial risks that may often lead to the emergence of global crises. It is important to note, however, that at this point no model is capable of fully integrating

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all aspects of financial cycles (Békési et al., 2016). Another methodological innovation of the model is that in certain cases it allows departures from the hypothesis of rational expectations, and assumes adaptive expectations on several points. Compared to the MNB’s previous forecasting model, the main innovations of the new model are therefore as follows: – consideration of the indebtedness and heterogeneity of households on consumption; – integration of a financial accelerator mechanism; – more realistic treatment of expectations. Aggregate demand is determined by the demand generated by the following agents: households, among which we can distinguish wealthy and indebted consumers; corporates; the government sector; and nonresidents. Each economic agent has demand for the products and services of three distinct sectors, which are the core inflation sector, the sector of products outside the core inflation sector, and the export sector. A schematic illustration of the relationships between the various economic actors and sectors is provided in Chart 9-16. Chart 9-16: The structure of aggregate demand in the new model Core inflation sector

Export sector

External demand

Indebted consumers

Wealthy consumers

Non-core inflation sector

Domestic investment

Gorvernment

Source: Authors’ editing based on Békési et al. (2016).

The structure of aggregate supply is shown in Chart 9-17. As the model takes into account the most important transmission channels, it affords to

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estimate the effects of the gradual easing cycle, launched in August 2012, on the real economy and inflation. Chart 9-17: The structure of aggregate supply in the new model Investment products

Consumption products Export products

Regulated price products

Composite input General import product

Physical capital

Non-core inflation products

Core inflation products

Labour

Market energy

Oil

Unprocessed food

Imported food

Source: Authors’ editing based on Békési et al. (2016).

In several respects, the easing cycle has had a positive impact on the Hungarian economy: it has reduced the extent of undershooting the inflation target, while meaningfully supporting economic growth. As monetary policy actions exert their effects in the economy with a lag, the beneficial effects of the easing cycle also remain perceptible looking ahead. Actions of monetary policy easing have been and are making an impact essentially through two channels. First, a depreciating exchange rate improves the country’s competitiveness and supports exports, and second, a pick-up in consumption boosts domestic demand (Felcser et al., 2015b). In the first half of the easing cycle, a greater contribution to GDP may have been made by net exports, and in the second half of the cycle, by domestic demand. This is because before the forint conversion, the interest rate channel had been prevented from functioning efficiently by the high share of foreign exchangebased loans, and therefore exerted a limited impact on economic actors’ decisions on consumption and savings. Accordingly, in that period the effect of interest rate cuts on the economy was more powerful through net exports. However, following the forint conversion the interest rate

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channel became more efficient, as a result of which easing actions also provided a substantial stimulus to domestic demand. Overall, the easing cycle substantially supported the pick-up of economic growth in recent years, while it also prevented inflation from remaining in negative territory for an extended period, whereby it eliminated deflationary risks and reduced the extent of missing the inflation target. The gradually intensifying inflationary effect of interest rate moves may have increased the inflation rate by 1.6 per cent in 2015, and 2.0 per cent in 2016 (Table 9-2). Table 9-2: Impact of the easing cycle on inflation and GDP level Period

Inflation (percentage point)

GDP level (per cent)

2013

0.4

0.5

2014

1.1

2015

1.6

1.4

2016

2.0

1.5

Source: MNB calculation.

Key terms crawling peg exchange rate regime currency peg disinflation flexible inflation targeting forward guidance FX swap instrument hyperinflation Inflation Report inflation targeting interest rate corridor interest rate path

monetary transmission nominal lower bound primary mandate quantitative limitations on the stock of the policy instrument quantitative easing measures risk to deflation risk to inflation system of exchange rate bands targeted unconventional instruments

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References Békési, L. – Köber, Cs. – Kucsera, H. – Várnai, T. – Világi, B. (2016): Az MNB makrogazdasági előrejelző modellje (The Macroeconomic Forecasting Model of the MNB). MNB Working Papers 2016/4, October 2016. Csortos, O. – Lehmann, K. – Vadkerti, Á. (2016): A válság okai, terjedése és hatásai a magyar gazdaságra (Causes, Spread and Impact of the Crisis on the Hungarian Economy). Manuscript. Felcser, D. – Lehmann, K. – Váradi, B. (2015a): Az inflációs cél körüli toleranciasáv bevezetése (Introducing a Tolerance Band around the Inflation Target). Világgazdaság Online, 29 April 2015. Felcser, D. – Soós, G. D. – Váradi, B. (2015): A kamatcsökkentési ciklus hatása a magyar makrogazdaságra és a pénzügyi piacokra (The Impact of the Easing Cycle on the Hungarian Macroeconomy and Financial Markets). Financial and Economic Review 14(3), September 2015, pp. 39–59. Kékesi, Zs. – Kóczián, B. – Sisak, B. (2015): A lakossági portfólióátrendezés szerepe az állam finanszírozásában (The Role of Household Portfolio Restructuring in Financing of the General Government). Financial and Economic Review 14(1), March 2015, pp. 80–110. Kicsák, G. (2015): Az MNB lépései megtakarítást hoztak az államnak (The Steps of the MNB Generated Savings for the Government). Világgazdaság Online, 29 June 2015. Komlóssy, L. – Vadkerti, Á. (2015): Az újraindított kamatcsökkentési ciklus makrogazdasági hatásai (The Macroeconomic Impacts of the Resumed Easing Cycle). Napi.hu, 20 July 2015. Madarász, A. – Novák, Zs. (2015a): Historikus mélyponton a magyar alapkamat (Hungarian Base Rate at Its Historic Low). http://www.mnb.hu/letoltes/madarasz-annamaria-novak-zsuzsannahistorikus-melyponton-a-magyar-alapkamat.pdf, Downloaded: November 2016. Madarász, A. – Novák, Zs. (2015b): Kamatszint a változó kamatpolitika tükrében Magyarországon 1924 és 2015 között – Hogyan jutott el a jegybanki alapkamat a historikusan alacsony kamatszintekig? (Level of Interest Rates in the Light of the Changing Interest Rate Policy in Hungary between 1924 and 2015 – How did the Central Bank Base Rate Get to Its Historic Low Levels?) Financial and Economic Review 14(4), December 2015, pp. 87–107. Matolcsy, Gy. (2008): Éllovasból sereghajtó – Elveszett évek krónikája (The First Shall Be The Last – Chronicle of Lost Years). Éghajlat Könyvkiadó, Budapest. Matolcsy, Gy. (2015): Egyensúly és Növekedés – Konszolidáció és stabilizáció Magyarországon 2010– 2014 (Balance and Growth – Consolidation and Stabilisation in Hungary, 2010–2014). Magyar Nemzeti Bank Book Series, Kairosz Könyvkiadó, Budapest. Matolcsy, Gy. – Palotai, D. (2016): A fiskális és a monetáris politika kölcsönhatása Magyarországon az elmúlt másfél évtizedben (The Interaction between Fiscal and Monetary Policy in Hungary over the Past Decade and a Half). Financial and Economic Review 15(2), June 2016, pp. 5–32.

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9 Easing cycles — significant easing with gradual and cautious steps MNB (2000): Monetáris politika Magyarországon (Monetary Policy in Hungary). May 2000, https:// www.mnb.hu/letoltes/monetaris-politika-magyarorszagon-2000.pdf, Downloaded: November 2016. MNB (2002): Monetáris politika Magyarországon (Monetary Policy in Hungary). May 2002, https:// www.mnb.hu/letoltes/monetarispolitika-hu-2002.pdf, Downloaded: November 2016. MNB (2012): Jelentés az infláció alakulásáról (Quarterly Report on Inflation). Magyar Nemzeti Bank, June 2012. MNB (2014a): Press release on the Monetary Council meeting of 22 July 2014. MNB (2014b): The Monetary Council’s statement included in the December Report on Inflation. MNB (2015): Jegybanki Almanach (Central Bank Almanac). Magyar Nemzeti Bank, December 2015. MNB (2016a): Félidős Jelentés (Mid-term Report 2013–2016). Magyar Nemzeti Bank, March 2016. MNB (2016b): Press release on the Monetary Council meeting of 22 March 2016. MNB (2016c): Press release on the Monetary Council meeting of 21 June 2016. MNB (2016d): Press releases on the Monetary Council meeting of 20 September 2016. MNB (2016e): Press release on the Monetary Council meeting of 22 November 2016. P. Kiss, G. – Szemere, R. (2009): Almát körtével? Mérlegen a visegrádi országok állami kiadása (Apples and Oranges? A Comparison of the Public Expenditure of the Visegrád Countries). MNB Bulletin, May 2009, pp. 33–44. Spéder, B. – Vadkerti, Á. (2016): Monetáris politika és az infláció alakulása az inflációscél-követés bevezetésétől napjainkig (Monetary Policy and Development of Inflation from the Introduction of Inflation Targeting until Today). In: Virág, B. (ed.): A forint 70 éve: Út a hiperinflációtól az árak stabilitásáig (70 Years of the Forint: Road from Hyperinflation to Price Stability), MNB Special Issue, pp. 93–117. Virág, B. (2016): Tudomány és művészet – stabilan alacsony kamatokkal az inflációs cél eléréséért. (Science and Art – With Persistently Low Interest Rates for reaching the Inflation Target). Portfolio.hu, 5 May 2016.

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Theoretical background of maintaining the level of the base rate for an extended period — monetary policy in a world of uncertainty András Balogh – Kristóf Lehmann

“Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape” /Alan Greenspan/ During the crisis, the conventional frameworks of monetary policy changed across the globe. In the context of globally low real interest rates, a global fall in demand and the resulting below-target inflation imposed severe limitations on policy making space. As the crisis forced central banks to abandon the use of the policy rate as a conventional monetary policy instrument, it was superseded by unconventional instruments designed to replace, either in whole or in part, the conventional policies of monetary easing. In the literature, the prominent, most frequently cited reason for this is identified as the policy rate reaching its effective lower bound. Nevertheless, as an integral part of their communication, the central banks of many countries point out that their policy rates have not yet reached the effective lower bound. This is an important message in terms of central bank credibility and transparency, because by providing it, the central bank signals to economic actors that it continues to have sufficient room for manoeuvre despite the crisis, given the space remaining for the implementation of conventional monetary policy actions going forward.

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in 2016, the Monetary Council of the Magyar Nemzeti Bank cut its policy rate to 0.9 per cent, and continued to ease by means of targeted, unconventional instruments. The Monetary Council undertook a commitment to maintain the actual level of the base rate for an extended period. The stability of the base rate is an important value of its own as it helps the central bank to influence the expectations of economic actors, while a predictable interest rate policy also facilitates economic decision making. It is possible as a central bank to change monetary conditions even without adjusting the policy rate. Stability is also of particular importance in the light of uncertainties, for a central bank decision maker. Decision makers are faced with many uncertainties, which may result from the functioning of the economy, future shocks to developments, the set-up and specific features of models, imperfect information, as well as from the changes and fragmentation of monetary transmission. Because of these factors, it is also absolutely essential for central bank policy makers to take into account the constantly changing information base, and to make efforts to manage the uncertainties in a decision-making environment with the greatest possible efficiency.

10.1 The stability of interest rate policy is a value of its own in the conduct of monetary policy. During the crisis, the conventional frameworks of monetary policy changed across the globe. In the context of globally low real interest rates, a global fall in demand and the resulting belowtarget inflation imposed severe limitations on policy making space. As the crisis forced central banks to abandon use of the policy rate as a conventional monetary policy instrument, it was superseded by unconventional instruments designed to replace, either in whole or in part, the conventional policies of monetary easing. In the literature, the prominent, most frequently cited reason for this is identified as the policy rate reaching its effective lower bound. Nevertheless, as an integral part of communication, the central banks of many countries point out that their policy rates have not yet reached the effective lower â&#x20AC;&#x201D; 327 â&#x20AC;&#x201D;

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bound. This is an important message in terms of central bank credibility and transparency, because by providing it, the central bank signals to economic actors that it continues to have sufficient room for manoeuvre despite the crisis, given the space remaining for the implementation of conventional monetary policy actions going forward. Why might a central bank prefer unconventional instruments in a crisis even if it still has space to adjust its policy rate? More generally: in the case of a central bank that has space within the frameworks of both conventional and unconventional monetary policy, what will determine the framework of the instruments for which the central bank will use to meet its target? In general, the conventional policy instrument of monetary policy is the central bank base rate. In central banks’ strategy, the base rate is an instrument for meeting the price stability target, and the target is never set as a specific value of the policy rate. Accordingly, a central bank never seeks to achieve the lowest policy rate level available in the short term, but focusing on the price stability objective it strives to achieve a policy rate level that supports the sustainable achievement of the inflation target over the longer term (Virág, 2016). Moreover, while the stability of the base rate may, through the expectations channel, give economic actors a point of reference for their accommodation to a new environment at times of crisis, keeping the base rate unchanged for an extended period also conveys the message to agents that the central bank has preserved its space even in the face of permanently changed conditions. Anchored expectations may successfully support a pick-up in longer-term investment decisions, propensity to save, and demand for credit in an economy (Virág, 2016). At the same time, in an environment of low inflation, maintaining the conventional space by keeping the base rate on hold over the longer term is arguably not merely a symbolic instrument in the hands of policy makers, vis-à-vis economic actors. In his 1967 article, William Brainard was the first to describe the uncertainty principle, which essentially proposes that when policy makers are faced with increasing uncertainty over the future impact — 328 —

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of a central bank instrument, this will warrant a more cautious use of the instrument concerned (Olsen, 2016). Therefore, in the course of monetary policy decision making, while it is important to anchor the expectations of economic actors by keeping the policy rate on hold permanently, it is also absolutely essential that policy makers consider the existence of a constantly changing information basis, and seek to address the uncertainties of the decision-making environment with the greatest possible efficiency. Keeping the policy rate on hold for an extended period is characteristic of several central banks, and more specifically, it is declared to be an integral part of the strategies of the central banks of Norway and Hungary. As Norwegian central bank governor Øystein Olsen explains, interest rate changes in an environment of low interest rates will have a different effect compared to an equivalent move in the same direction at higher rates. In an environment of low inflation and low interest rates, he attributes uncertainties over the effect to changes in the behaviour of economic actors, identifying the phenomenon as an uncertainty over the functioning of specific transmission channels (Olsen, 2016). The Magyar Nemzeti Bank argues that the current level of the base rate (0.90 per cent) still belongs to the “known world” where the transmission mechanism is less unpredictable and thus value is attached to the stability of the base rate, given that it makes monetary policy more predictable despite the structural changes in the environment (Nagy–Virág, 2016). Therefore, maintaining the level of the base rate for an extended period is primarily supported by the changed behaviour of economic actors. A stable central bank base rate does not imply a deliberate constraint on the monetary policy space subject to the principles of transparency and predictability. The theory does not preclude the fine-tuning of monetary conditions, or its additional easing by means of the unconventional instruments available (Chart 10-1). Nevertheless, cautious use of the policy rate is justified because in a changed environment it could intensify uncertainty as its effects become more unpredictable. — 329 —

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Chart 10-1: Illustration of keeping the interest rate on hold for an extended period

Basis point

Monetary policy horizon

Interest rate path 1

Interest rate path 2

t+16

t+15

t+14

t+13

t+12

t+11

t+10

t+9

t+8

t+7

t+6

t+5

t+4

t+3

t+2

t+1

Targeted monetary policy instruments

Interest rate path 3

Source: VirĂĄg (2016).

The following sections describe the possible types of uncertainty that may substantially limit the effectiveness of monetary policy. In conjunction with that, an explanation is given of model uncertainty, which provides the conceptual foundations of keeping the policy rate on hold for an extended period. Regarding the categories described, recommendations are frequently made in the literature for robust policies, which are also discussed in the following sections. Finally, a trade-off is described that is generated by keeping the base rate unchanged permanently between the effectiveness of monetary policy and the reduction of uncertainty. A conclusion is drawn at the end of the paper.

10.2 The role of uncertainty in monetary policy decision making In the course of decision making, two types of economic agent are faced with uncertainty: policy makers while elaborating a monetary policy action, and, through the expectations channel of the â&#x20AC;&#x201D; 330 â&#x20AC;&#x201D;

10 Theoretical background of maintaining the level of the base rate for an extended period

transmission mechanism, market participants who hold expectations about the future monetary policy actions of the central bank. There is risk in the possibility that policy makers may assess the situation of the economy inadequately, and also in that the action at hand is inconsistent with expectations, impairing the effectiveness of the action over the medium to long term. Yet, a major part of the models seeking to identify optimal monetary policy disregard the role of uncertainty (Schmidt-Hebbel–Walsh, 2009). Brainard argues that in a world of certainty structural changes, which may alter the strength of the response to policy, do not alter the attainable utility level (Brainard, 1967). In literature, monetary policy strategy that ignores uncertainty is referred to as “certainty equivalence” (Blinder, 1998). Essentially, this involves the assumption that in a world of uncertainty, action proposed under a monetary policy rule based on expected value will, provided that certain conditions are met, be equivalent to that determined by a rule ignoring the existence of uncertainty (Theil, 1957). However, “monetary policy decisions are made under uncertainty” (Olsen, 2016). Orphanides and Williams have pointed out that policies proposed under models that ignore uncertainty will produce modest macroeconomic outputs in scenarios of imperfect knowledge (Orphanides–Williams, 2002). In that light, it is appropriate that for decision making purposes, policy makers be aware of the significance of uncertainty and understand its various types.

10.3 Types of uncertainty Various forms of uncertainty are identified by a number of authors, with many overlaps between the substantive characteristics of their taxonomies (Brainard, 1967; Blinder, 1998; Schmidt-Hebbel– Walsh, 2009; Cateau–Murchison, 2010; Olsen, 2016). For the purposes of this paper, a description is appropriate of the model approach to — 331 —

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methodology taken by Schmidt-Hebbel and Walsh, and the narrative categories proposed by Olsen. Olsen argues that an environment of uncertainty arises during a decision-making process concerning the following areas (Olsen, 2016): – the current situation of the economy; – the driving forces in the economy; and – the functioning of the economy. According to Brainard’s uncertainty principle (or conservatism principle as referred to in Blinder (1998)), keeping the policy instrument on hold for an extended period is justified when monetary policy makers are faced with increasing uncertainty as to the effectiveness of the instrument. On that basis, the uncertainty associated with the effect of monetary policy can be identified, according to Olsen, as uncertainty relating to the functioning of the economy, because it calls for a review of the assumptions on the functioning of the transmission mechanism. Apart from the narrative aspect, in literature uncertainty is often construed in a model approach. The approach taken by SchmidtHebbel and Walsh deserves particular attention. The authors assume that the “true” model describing the functioning of the economy can be stated as follows (Schmidt-Hebbel–Walsh, 2009): y t+1 = Ay t + By t|t + Cit + Dut+1 ,

where y t is the vector of macroeconomic variables, y t|t is policy makers’ current estimate for the macroeconomic variables, it is the central bank’s policy instrument, ut+1 indicates the magnitude of the exogenous disturbances affecting the target variable for time t+1, whereas A, B, C and D are matrices containing parameters of the model. Overall, the uncertainty associated with forecasts for the y-vector for time t+1, as stated on the left side of the equation, is determined for time t by the uncertainty levels of the parameters (exogenous and endogenous variables) stated on the right side of the equation. Olsen’s categories, — 332 —

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as referred to earlier, are also identifiable in this approach. The types of uncertainty according to Schmidt-Hebbel and Walsh are as follows (with Olsen’s corresponding categories in brackets): – additive uncertainty (driving forces in the economy): identification of independent variables and the role of omitted variables; – model uncertainty (functioning of the economy): the dynamics of correct model specification and independent variables: coefficients of the model used; – imperfect information (current situation of the economy): the current level of the macroeconomic variables to be explained. There is additive uncertainty surrounding developments in ut+1 given that policy makers have no information about the characteristics of the exogenous effects in time t+1. Model uncertainty is associated with model specification and the estimated parameters in the model. Given that the parameters at hand are estimates, they will contain inherent estimation errors. The third type of uncertainty is imperfect information, which refers to the uncertainty around the current level of the macroeconomic variables to be forecast. At the time of the forecast, policy makers are not able to incorporate all information on the period concerned, as a result of which their estimates for the current value of the macroeconomic variables under review may be inaccurate. In the following, an overview is provided of the three types of uncertainty based on Schmidt-Hebbel and Walsh, and of the competing monetary policy strategies proposed in literature, which are robust in terms of uncertainties.

10.3.1 Additive uncertainty – unidentified driving forces in the economy: the role of exogenous disturbances in decision making

Policy makers are unable to identify all factors affecting the future functioning of the economy. There is no single model calibrated to the functioning of the economy that is capable of taking account of all future effects on the forecast variables. To the largest extent, — 333 —

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additive uncertainty stems from the fact that policy makers are unable to identify shocks hitting the economy in time t+1, and may, at best, formulate assumptions as to their nature. As a result, additive uncertainty will be an inherent part of the forecast. The effect of such exogenous disturbances will be condensed into the error term of the model, which is the term ut+1 in the Schmidt-Hebbel– Walsh equation. Assuming that the parameters of the model have been estimated by policy makers on the basis of the information available in time t, an optimal policy exists where subject to the parameters given, the values in time t+1 of the macroeconomic variables to be forecast are reliably forecast by the expected values of the explanatory variables (Brainard, 1967). In this case, the error term is expected to take the value of 0. Theil asserts that policy action maximising expected utility may, under certain conditions, be considered equivalent to utilitymaximising action that ignores uncertainty (Theil, 1957). In literature, the outcome is referred to as certainty equivalence. Nevertheless, policy makers will still be required to make assumptions on specific characteristics of exogenous changes, e.g. concerning the persistence of future shocks (Schmidt-Hebbel–Walsh, 2009). Managing additive uncertainty

Seeking to identify a robust policy that manages additive uncertainty, a solution is proposed by Giannoni and Woodford, who argue that a robust policy rule should only incorporate the macroeconomic variables which are themselves determinants of the central bank’s objectives (Table 10-1). In their example, if the central bank is concerned about maintaining low and stable inflation, stabilising the output gap, and reducing interest rate volatility, then a monetary policy rule that is robust in terms of additive uncertainty would show how the policy rate should be set solely as a function of inflation, the output gap, and lagged interest rates in order to achieve the objective (Schmidt-Hebbel–Walsh, 2009). The rule, therefore, only shows the role of the three target variables in shaping the policy rate. In such a case, policy makers do not need information on the effects of exogenous — 334 —

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disturbances; consequently, as Schmidt-Hebbel and Walsh argue, the rule may be sufficiently attractive in an environment where the persistence of future shocks is difficult to forecast. However, Giannoni and Woodford’s monetary policy rule is focused on the relationship of target variables and the policy rate, without incorporating the forward-looking character which, mindful of the lagged effectiveness of monetary policy, is required for monetary policy decisions. Monetary policy decision making is built on forecasts, because it takes time before the effects of a decision spill over to the real economy through the transmission channels. Monetary policy rules of the Taylor rule type assume that in shaping the policy rate, policy makers constantly monitor changes in inflation and the output gap. In such cases, in light of the central bank’s objective, optimal levels of the coefficients may be selected. In selecting the coefficients, however, as opposed to the Giannoni–Woodford rule, the relative variances of elementary disturbances affecting the economy are also taken into account. Therefore, in constructing the Taylor-type rule, efforts must be made to develop the broadest possible understanding of information on shocks to the economy (Schmidt-Hebbel–Walsh, 2009). Table 10-1: Strategies managing additive uncertainty, and their literature Additive uncertainty – driving forces in the economy

Optimal model

Management of exogenous variables

Theil (1957)

model based on expected assumptions are required on value (certainty equivalence) the nature (persistence) of exogenous disturbances

Giannoni–Woodford (2002)

a linear combination of target variables only

Taylor (1993): Taylor-type rules

forward-looking model: selection of optimal coefficients also using the estimated relative variance of exogenous effects

— the broadest possible information base on the nature of exogenous effects

Source: Schmidt-Hebbel–Walsh (2009): Monetary Policy under Uncertainty and Learning: An Overview.

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10.3.2 Model uncertainty — Do we understand the functioning of the economy?

Policy makers adopt their decisions by using models that capture, with the greatest possible accuracy, the fundamental characteristics of how the economy functions. However, the development of the models themselves involves a number of uncertainties. Using Olsen’s categories, such issues belong to uncertainties around the functioning of the economy. Despite its favourable features, the structural model used may capture the functioning of the economy less accurately compared to other available and applicable models. Additionally, parameter uncertainties and estimation errors may also occur with relevance to the model. In the equation of Schmidt-Hebbel and Walsh, such uncertainties relate to the parameters A, B, C and D. Policy makers have no knowledge of the true values of the parameters, and are therefore required to estimate them. In this case, an estimation error is assumed to occur. In turn, it may also be assumed that the central bank is misinformed about the relationships between the macroeconomic variables; therefore, parameters may also be considered uncertain from this regard. Moreover, the optimal model itself changes over time, and the direction of that change is unknown to policy makers (Schmidt-Hebbel–Walsh, 2009). As the uncertainties described in the foregoing apply to each of the parameters, the model as a whole is subject to what is referred to as multiplicative uncertainty, which is the most relevant type of uncertainty for the purposes of this paper. Regarding the problems relating to model misspecification, it is important to underline that it is not a prerequisite for the model to be inherently misspecified. The optimal model describing the economy may also have changed, rendering the parameters suboptimal. Managing model uncertainty

Through his result, which later came to be known as the Brainard principle or conservatism principle, Brainard showed that multiplicative uncertainty would make optimal policy less activist (Schmidt-Hebbel– — 336 —

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Walsh, 2009). What that means today is that when policy makers consider that a change has occurred in the mechanism of action of the policy rate, any interest rate move will need particular caution (Table 10-2). This is understandable in light of the foregoing, given the probability that the model used has become less consistent relative to the optimal model, as a result of which an equivalent step with a previous move may produce unexpected responses. Norwegian central bank governor Olsen relies on the Brainard principle in his argument for the Norwegian central bank’s policy of keeping the policy rate unchanged at 0.50 per cent since March 2016 (Olsen, 2016). Following Brainard’s paper, the assumptions on multiplicative uncertainty were refined in literature. Some authors point out that certain forms of multiplicative uncertainty warrant a strong response from the central bank (Craine, 1979; Giannoni, 2002; Söderström, 2002). Where uncertainty arises as to the relationship between current and future inflation, the central bank will be required to respond aggressively to achieve price stability (Schmidt-Hebbel–Walsh, 2009). Table 10-2: Model uncertainty I: Strategies managing multiplicative uncertainty, and their literature Multiplicative uncertainty – parameter uncertainty

Optimal policy

Uncertainties in the model

Brainard (1967): Brainard principle

less activist, more cautious policy

Parameter uncertainty concerning the effect of the monetary policy instrument on the target variable

Craine (1979), Giannoni (2002), Söderström (2002)

aggressive response

Parameter uncertainty concerning the effect of current inflation on future inflation

Source: Schmidt-Hebbel–Walsh (2009): Monetary Policy under Uncertainty and Learning: An Overview.

To address the problem of model misspecification, Hansen and Sargent proposed a solution, a brief description of which will be appropriate here (Table 10-3). In their assessment, policy makers fear the harmful — 337 —

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consequences of misspecified models and the decisions based on those models. In such cases, where the policy maker is uncertain as to the suitability of the model used, a monetary policy strategy needs to be developed that can be considered robust in terms of worst-case scenario (Schmidt-Hebbel–Walsh, 2009). From a monetary policy perspective, before the crisis, in an inflation targeting regime the worst case was a persistent positive inflation shock. In the Hansen–Sargent model, therefore, the policy maker will always assume a persistent inflation shock (Walsh, 2003). As shown previously for additive uncertainty, an assumption on the nature of future shocks was not required under the Giannoni–Woodford rule, as the model did not incorporate any exogenous disturbances. Taylor-type rules required a complex information base on shocks hitting the economy. Conversely, Hansen and Sargent’s strategy again does not require complex information about shocks due to the constant assumption under the model that a shock to the economy will always be an inflation shock, which has a positive direction and is persistent. Levin and Williams assume that a central bank optimises its policy for a specific model. In that sense, policy makers are assumed to consider the model used as a structure that adequately describes the functioning of the economy. The authors find that where the model used assumes a significant degree of stickiness as regards its variables, of backwardlooking character, but the set of rules describing the functioning of the economy are actually much more forward-looking, the model will perform well contrary to intuition. Conversely, where the structural model used is forward-looking in nature, but the functioning of the economy involves a significant degree of inertness, i.e. is predominantly backward-looking in character, the model will prove unsuitable (Schmidt-Hebbel–Walsh, 2009). As a direct consequence of these observations, even if policy makers were to consider that the functioning of the economy is forward-looking in character, the optimal solution would be to incorporate a great degree of inertness into the model. The authors therefore argue for backward-looking monetary policy rules rather than forward-looking rules. — 338 —

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Eliminating decision making that focuses on a single model, policy makers may also rely on the results of several competing models, weighted by the estimated probability of the relevance of each model. However, Cogley, Colacito and Sargent (2007) show that when competing models are used which include conflicting components, this strategy may prevent the appropriate monetary policy action from being taken. Namely, in the case of competing models, there is always a possibility that out of two conflicting models, the correct model will be the one to which policy makers attach a lower degree of probability. In such circumstances, mindful of that possibility and due to the weight of the competing model, policy makers will be forced to act by under- or overestimating the strength of the action recommended by the model considered to have the greater probability. In the authors’ assessment, when multiple models are used, the ultimate monetary policy decision can also be influenced by models which are confirmed by the data as appropriately outlining the functioning of the economy only with a very low probability (Schmidt-Hebbel–Walsh, 2009). Table 10-3: Model uncertainty II: Strategies managing model misspecification, and their literature Model misspecification

Optimal policy

Uncertainties in the model

Hansen–Sargent (2004)

worst-case scenario (optimised for a persistent positive inflation shock)

model choice

Levin–Williams (2003)

backward-looking character (highly inert model)

model choice (forwardlooking vs. backwardlooking)

Competing models (criticism: decision making based on model choice Cogley–Colacito–Sargent multiple models weighted by (2007)) the estimated probability of the correctness of each model Source: Schmidt-Hebbel–Walsh (2009): Monetary Policy under Uncertainty and Learning: An Overview.

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10.3.3 Imperfect information — knowledge of the current situation of the economy

Out of the types of uncertainty identified by Olsen, imperfect information relates to an insufficient knowledge of the current situation of the economy (Table 10-4). In the Schmidt-Hebbel–Walsh classification, the essence of the imperfect information concept is the policy makers’ inability to perfectly observe the current state of the economy or macroeconomic variables that are critical for the design of the decision concerned. In cases of data uncertainty, by way of optimal policy the literature recommends attenuated monetary policy action compared to that implied by the data. Where the action is stronger than required, in the case of a low signal-to-noise ratio this will increase the volatility in the system and thereby also the variance explained by the noise (SchmidtHebbel–Walsh, 2009). Rudebusch uses a Taylor rule to show how the strength of the optimal response is reducing as data uncertainty increases. Table 10-4: Strategies managing imperfect information, and their literature Imperfect information

Optimal policy

Uncertainties in the model

Rudebusch (2001)

Attenuated response

Data uncertainty

McCallum (2001)

Attenuated response

Unobservable output gap

Orphanides–Williams (2002)

Response to the changes rather than the level of the output gap

Unobservable output gap

Source: Schmidt-Hebbel–Walsh (2009): Monetary Policy under Uncertainty and Learning: An Overview.

Another type of imperfect information concerns the observability of model variables. In the literature, Schmidt-Hebbel and Walsh highlight robust policies in respect of the output gap, which are supposed to manage the uncertainties stemming from unobservability. McCallum (2001) proposes that the central bank should give an attenuated response to developments in the output gap due to its unobservability. — 340 —

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Conversely, Orphanides and Williams (2002) argue that when the central bank responds to changes in the output gap rather than to its level, the response will often produce favourable outputs.

10.4 Maintaining the level of the base rate for an extended period in the light of changed transmission — The stability of the central bank’s base rate is a value in its own right As shown in the foregoing, when the decision-making environment of monetary policy involves uncertainty, attenuated response is recommended in a number of cases. A more moderate use of the policy rate is recommended in the case of model uncertainty as to the effect of the base rate and in the context of imperfect information with regard to the limited present observability of the variables. This involves cases where policy makers become uncertain as to the functioning and current state of the economy. In recent years, global demand declining in the aftermath of the crisis has failed to pick up despite an environment of persistently low interest rates, accompanied by an environment of low inflation resulting from that decline. All this leads to changes in transmission, as the concerted expansionary stance of central banks has apparently been ineffective in removing the obstacles to increased demand. Olsen argues that there is no clear evidence of the collapse of historical transmission relationships, but underlines the absence of experience on such low interest rates over such a long period of time (Olsen, 2016). Persistently low inflation accompanying expansionary monetary conditions indicates that agents still do not consider the environment to be optimal for raising their demand. Olsen (2016) and Virág (2016) identify changes in the behaviour of economic actors in the case of persistently low real interest rates. While Olsen compares the environments of higher and low interest rates in his assessment of — 341 —

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responses from economic actors, Virág compares keeping the policy rate on hold for an extended period over the lower bound to the impact of a policy rate reduced to the lower bound. Virág (2016) argues that short-term easing aligned with the prevailing environment maintains the probability of a future rate hike, which will then reduce, or may even offset, the impact of easing also in this regard. Economic actors expect a quick spillover of the base rate to lending rates; consequently, a rate cut, due to the implied probability of a future rate hike, warns agents to be cautious about stepping up their demand for credit. In the banking sector, declining deposit rates increase the probability that banks lose some depositors. If this is not offset by keeping lending rates on hold or through slower cuts in those rates, banks’ profitability may be compromised looking ahead (Olsen, 2016). At the same time, a decelerated response from lending rates will in itself reduce the effect of easing through the base rate on boosting demand for credit compared to the effect of a move of equivalent strength and direction at higher rates. In the household sector, in a zero lower bound environment a change will occur in the relationship between interest rates and the propensity to consume. When deposit rates are lower, rather than raising their demand for credit by focusing on the possibility of increased demand resulting from more favourable terms of lending, households will increase their deposits so that looking ahead they may realise the savings optimised for the previous period even at lower deposit rates (Olsen, 2016). At lower rates, the income effect may dominate the substitution effect. Consequently, in the light of experience with the conventional framework, the easing effect of cutting the policy rate will not be felt completely either in terms of demand for credit, or of credit supply. As regards the behaviour of financial markets, the higher the probability of negative bank profitability in an environment of low or negative rates, the greater the increase in yields on alternative investments (Olsen, 2016). This will drive investors towards investments involving higher risk, which may lead to higher volatility — 342 —

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in financial markets. In this way, a rate cut will further reduce the effect of transmission through the banking system. Consequently, the optimal response to changes in economic actors’ behaviour may be keeping the policy rate on hold at a level above the lower bound that limits the scale of the above novel responses. This will enable the central bank to carry out robust fine-tuning through unconventional instruments so that it can retain its confidence in the effect of an expansionary stance on boosting demand, as opposed to monetary policy in the context of a base rate that has become ineffective.

10.5 The monetary policy dilemma of keeping the base rate on hold permanently — Predictability with a slower achievement of the target, or achievement of the target with significant uncertainty? Norway’s central bank has carried out a simulation, based on Theil’s principle of certainty equivalence, in which there was an estimation of policy rate path modelling developments in inflation and the output gap in the context of a monetary strategy that ignored uncertainty. Additionally, based on Brainard’s conservatism principle, analysts in Norges Bank have also modelled a central bank that pursued a policy incorporating uncertainty over the effectiveness of the policy rate, and consequently was more cautious in its use of the policy rate (Olsen, 2016). In this case, the model also estimated the paths of the target variables. Based on the results, looking ahead monetary policy that incorporated uncertainty and consequently the strategy providing the conceptual foundations of maintaining the level of the base rate for a longer period significantly reduces the range of uncertainty in future paths of the target variables. This enables monetary policy to remain predictable, transparent and credible even in a world of uncertainty. At the same time, the inflation target will be achieved and the output gap will be closed more slowly. While the policy of certainty equivalence indicates — 343 —

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faster target achievement, it involves a much wider range of uncertainty, which ultimately questions the viability of achieving the future target. Arguably, then, keeping the base rate on hold for a longer period provides for the viability of the central bank’s target by managing the increased uncertainty over the effect of the policy rate, and improving the accuracy of forecasts for target variables, which may, indirectly, lead to more effective monetary policy even in a world of uncertainty. By keeping its policy rate unchanged for an extended period, the central bank provides indirect support for target achievement through the interim effort of using a strategy that accommodates to the changed environment. This enables effective inflation targeting through the management of specific circumstances in the new environment.

10.6 Why is it important that the MNB maintains the level of the base rate for an extended period? In 2016, the Monetary Council of the Magyar Nemzeti Bank cut its policy rate to 0.9 per cent, and continued to ease by means of targeted, unconventional instruments. The Monetary Council undertook a commitment to keep its rates on hold for an extended period. In addition to the uncertainties described in the previous sections, there are also several other practical and conceptual reasons for maintaining the level of the base rate for an extended period. The stability of the base rate is an important value of its own as it helps the central bank to influence the expectations of economic actors, while a predictable interest rate policy also facilitates economic decision making. The effectiveness of monetary policy largely depends on the extent to which the central bank is able to anchor the expectations of market participants. When the forward communication of the central bank is credible, market participants will align their expectations with guidance from the central bank. Anchoring expectations may be greatly supported by a central bank’s commitment to a sustainable level rather than implementing — 344 —

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frequent adjustments. A more predictable and more stable interest rate path will simplify decisions on consumption and investments and any associated borrowing calculations. Following a balance sheet recession, when consumption and investments fall short of their dynamics shown in normal periods, predictability may become particularly important in recovery in order to achieve stable economic growth. The build-up of a significant stock of household foreign exchangebased loans before the crisis was supported by frequent adjustments to forint interest rates. The pick-up in foreign exchange-based lending was attributable to several country-specific circumstances. The most important of these include the phase-out of subsidised forint loans, the significant volatility of domestic interest rates, and the resulting relative stability of the forint compared to the volatility of other regional currencies before the crisis. Due to reference pricing, the frequent and in several cases major adjustments to the domestic base rate led to major fluctuations in domestic lending rates, which made it difficult to estimate monthly instalments looking ahead. Owing to the stability of interest on credit, monthly instalments on foreign exchange-based loans appeared more predictable, especially in the case of loans denominated in Swiss francs, given the narrow range in which the Swiss central bank’s base rate had been moving before the crisis. The relative stability of the forint exchange rate reinforced the illusion that the burdens of foreign exchange-based loans were sufficiently predictable (Spéder–Vadkerti, 2016). Exchange rate risk became obvious only later, in the aftermath of the financial crisis. As the crisis became protracted, an international environment of zero lower bound emerged, in which the effectiveness of the conventional instrument was impaired. In an environment of lower zero bound, the declining base rate tends to be less effective. In such a case, it is much more important to ensure the overall consistency of monetary conditions with the message of the low base rate kept on hold permanently, as a result of which forward guidance will take on a more prominent role (Csortos–Lehmann–Szalai, 2014). Forward guidance may be complemented by unconventional instruments, which provide a stimulus to the economy by reducing longer-term yields. — 345 —

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The use of substantially negative central bank rates creates a world of uncertainty for central banks. Before the end of 2016, six central banks had set negative interest rates on some of their instruments in the course of crisis management. The reasons for such rates varied. In an international context, there is no clear evidence on their effectiveness. This environment has not been explored to date, and a sufficient body of assessment experience is still lacking. Hannoun (2015) pointed out the potential build-up of risks in the context of extremely low or negative interest rates. Due to the potential risks and the potentially negative effects on transmission, the Magyar Nemzeti Bank is following the strategy of keeping the policy rate unchanged permanently to avoid setting a negative rate on the policy instrument (the rate of the O/N deposit instrument was cut to –0.05 per cent in 2016). Under its strategy, the Magyar Nemzeti Bank will ease its monetary policy in a cautious manner as required. In early 2016, the MNB cut the base rate to 0.9 per cent, and continued to ease monetary conditions from the second half of the year by using unconventional instruments, more specifically, by imposing quantitative constraints on the instrument of 3-month deposits. Given the possibility of the unexplored environment giving rise to a number of unpredictable factors in the event of reaching or potentially undershooting the effective lower bound61, the MNB has been pursuing a different strategy, and more cautious monetary easing.

10.7 Conclusion The study by the Norwegian central bank has demonstrated at a model level that in a world of uncertainty, the stability of the base rate was in fact valuable, which is capable of providing economic actors with a stable reference point. Olsen argues that there is no evidence for the inevitable breakdown of transmission relationships. Changes in agents’ behaviour reflects their accommodation to the crisis and to increased uncertainty. In 61

I t is the lowest interest rate that, when reached, monetary transmission still works and the interest rate cut has the desired effect.

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the context of low interest rates and maintaining the level of the policy rate for an extended period, monetary policy retains its powers in cushioning the cyclical fluctuation of the economy, given that theory does not contradict the viability of unconventional instruments. Even if the policy rate is held unchanged, a number of opportunities remain for monetary conditions to be fine-tuned and eased further. The level of the base rate is transparent for economic actors and makes the future predictable, removing the inhibitions to increasing demand rooted in economic psychology, while it may also lead to more effective monetary policy, potentially supporting the effectiveness of unconventional instruments as well. It is the responsibility of central banks to provide a sense of stability even in a world of uncertainty, because by anchoring expectations, they may make a significant contribution to restoring the effectiveness of monetary policy in meeting the objective of creating persistent price stability. As part of its strategy, the Magyar Nemzeti Bank continued to pursue cautious monetary policy by approaching the zero lower bound; however, mindful of the risks that might potentially arise in the future, it provided the required amount of easing by means of unconventional instruments.

Key terms additive uncertainty anchored expectations attenuated response backward-looking character base rate stability certainty equivalence data uncertainty effective lower bound forward guidance forward-looking character imperfect information income effect model misspecification

maintaining the level of the base rate for an extended period model uncertainty multiplicative uncertainty parameter uncertainty principle of competing models observability of variables robust monetary policy rule signal-to-noise ratio substitution effect uncertainty principle worst-case scenario

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References Blinder, A. S. (1998): Central Banking in Theory and Practice. The MIT Press Cambridge, Massachusets London, England, Second MIT Press paperback edition, p. 12. http://www.artsrn. ualberta.ca/econweb/landon/1999%20Blinder%20Central%20Banking.pdf Brainard, W. (1967): Uncertainty and the Effectiveness of Policy. American Economic Review 57, pp. 411–425. http://www.bbk.ac.uk/ems/faculty/aksoy/teaching/gradmoney/Brainard%20 (1967).pdf Cateau, G. – Murchison, S. (2010): Monetary Policy Rules in an Uncertain Environment. Bank of Canada, June 2016. http://www.bankofcanada.ca/wp-content/uploads/2010/06/cateau.pdf Cogley, T. – Colacito, R. – Sargent, T.J. (2007): Benefits from U.S. Monetary Policy Experimentation in the Days of Samuelson and Solow and Lucas. Journal of Money, Credit and Banking, supplement to Vol. 39(2), pp. 67–99. Csortos, O. – Lehmann, K. – Szalai, Z. (2014): Theoretical Considerations and Practical Experiences of Forward Guidance. MNB Bulletin, July 2014, pp. 45–55. Craine, R. (1979): Optimal Monetary Policy with Uncertainty. Journal of Economic Dynamics and Control 1(1), pp. 59–83. Giannoni, M. – Woodford, M. (2002): Optimal Interest-Rate Rules: I. General Theory. Princeton University, NBER Working Paper 9419. Greenspan, A. (2004): Risk and Uncertainty in Monetary Policy. American Economic Review 94(2), May 2004, pp. 33–40. http://pubs.aeaweb.org/doi/pdfplus/10.1257/0002828041301551 Hansen, L. P. – Sargent T. J. (2004): Robust Control and Economic Model Uncertainty, Princeton University Press. Hannoun, H. (2015): Ultra-low or negative interest rates: what they mean for financial stability and growth. Remarks by Hervé Hannoun, Deputy General Manager, BIS. http://www.bis.org/ speeches/sp150424.pdf Levin, A. T. – Williams, J.C. (2003): Robust Monetary Policy with Competing Reference Models. Journal of Monetary Economics 50, pp. 945–975. McCallum, B. T. (2001): Should Monetary Policy Respond Strongly to Output Gaps? American Economic Review 91(2), pp. 258–262. Nagy, M. – Virág, B. (2016): Sikeres a jegybank nemkonvencionális lazítása (The Bank’s Unconventional Easing is a Success). Magyar Nemzeti Bank, press releases in 2016. https://www.mnb.hu/sajtoszoba/ sajtokozlemenyek/2016-evi-sajtokozlemenyek/nagy-marton-virag-barnabas-sikeres-a-jegybanknemkonvencionalis-lazitasa Olsen, Ø. (2016): A Flexible Inflation Targeting Regime. Speech at the CME/BI, Norwegian Business School, 11 October 2016. http://www.norges-bank.no/en/Published/Speeches/2016/2015-1011-Olsen-CME/

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10 Theoretical background of maintaining the level of the base rate for an extended period Olsen, Ø. (2016): The Role of Central Banks: A Norwegian Perspective. Speech at the OMFIF, London, 1 November 2016. http://www.norges-bank.no/en/Published/Speeches/2016/2016-11-01London/ Orphanides, A. – Williams, J. C. (2002): Robust Monetary Policy Rules with Unknown Natural Rates. Brookings Papers on Economic Activity, pp. 63–145. Rudebusch, G. D. (2001): Is the Fed Too Timid? Monetary Policy in an Uncertain World. Review of Economics and Statistics 83, pp. 203–217. Schmidt-Hebbel, K. – Walsh, C. E. (2009): Monetary Policy under Uncertainty and Learning: An Overview. In: Monetary Policy under Uncertainty and Learning, Central Bank of Chile, pp. 1–22. http://si2.bcentral.cl/public/pdf/documentos-trabajo/pdf/dtbc527.pdf Söderström, U. (2002): Monetary Policy with Uncertain Parameters. Scandinavian Journal of Economics 104(1), pp. 125–145. Spéder, B. – Vadkerti, Á. (2016): Monetáris politika és az infláció alakulása az inflációs célkövetés bevezetésétől napjainkig (Monetary Policy and Development of Inflation from the Introduction of Inflation Targeting until Today). In: Virág, B. (ed.): A forint 70 éve: Út a hiperinflációtól az árak stabilitásáig (70 Years of the Forint: Road from Hyperinflation to Price Stability), MNB Special Issue, pp. 93–117. https://www.mnb.hu/letoltes/70-eves-a-forint-hun-digitalis.pdf Theil, H. (1957): A Note on Certainty Equivalence in Dynamic Planning. Econometrica 25(2), April 1957, pp. 346–349. https://www.jstor.org/stable/pdf/1910260.pdf Virág, B. (2016): Tudomány és művészet – stabilan alacsony kamatokkal az inflációs cél eléréséért. (Science and Art – With Persistently Low Interest Rates for the Inflation Target). Edited form: Portfolio.hu, 5 May 2016. https://www.mnb.hu/letoltes/virag-barnabas-tudomany-es-muveszet-stabilanalacsony-kamatokkal-az-inflacios-cel-ele-jo.pdf Walsh, C. E. (2003): Implications of a Changing Economic Structure for the Strategy of Monetary Policy. in: Monetary Policy and Uncertainty: Adapting to a Changing Economy, Jackson Hole Symposium, Federal Reserve Bank of Kansas City, pp. 297–348.

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Towards a more flexible framework of inflation targeting Dániel Felcser – Zsófia Horváth

Committed to keeping inflation at a low level, central banks in a number of developed and emerging countries have been following inflation targeting regimes. Inflation targeting provides a flexible framework that links the longerterm objective of monetary policy (providing a nominal anchor) to shorterterm considerations (stabilising the economy). In central bank practices, the flexibility of inflation targeting may turn up in several forms, including a monetary policy that takes into account developments in inflation over the medium term, and where appropriate, may even tolerate the target being missed temporarily. Although the framework has undergone international evolution since it was adopted, the global financial and economic crisis still represented a major challenge. Even inflation-targeting central banks had to cope with high inflation due to soaring commodity prices before the crisis, the effects of the shock to the financial system, and the persistence of subsequent extremely low inflation. These factors have been driving central banks towards more flexibility in monetary policy, which has been supported by anchored inflation expectations. As a result of the lessons learned, central bank objectives and instruments have both become more flexible. In the aftermath of the crisis, real economy considerations became more pronounced as central banks geared their instruments towards growth in addition to the achievement of price stability, and complemented the easing of monetary conditions by measures such as the

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11 Towards a more flexible framework of inflation targeting

launch of lending incentive schemes. Another important lesson learned from the crisis is that the relationship of monetary policy and financial stability has changed, as the latter has become part of central bank practice from several aspects. In response to the challenges, inflation-targeting central banks have been moving towards greater flexibility, reforming their monetary policy tools and introducing unconventional instruments with a view to the achievement of central bank objectives. Apart from the foregoing, in Hungary there were also several other factors that impaired the effectiveness of inflation targeting, and limited monetary policy space. First, persistent fiscal expansion in the years before the crisis made a significant contribution to inflationary pressure on the Hungarian economy, while it also eroded the country’s risk perception. Second, the exchange rate band imposed a major constraint on the effectiveness of the exchange rate channel of monetary transmission in the period before 2008. Finally, the spread of foreign currency lending over time also became a relevant factor in terms of both macroeconomy and monetary policy transmission. The buildup of imbalances increased the vulnerability of the economy, and also limited monetary policy space during the crisis. Similar to other central banks, the practice of inflation targeting in Hungary also shifted towards greater flexibility following the crisis. Considerations of real economy and financial stability became more prominent in the central bank’s decision making and communication. The elimination of the risk from foreign currency loans improved the effectiveness of monetary transmission, while the central bank’s extended and reinforced macroprudential mandate has been contributing to the stabilisation of the financial system. As a further indication of greater flexibility, in March 2015 the Magyar Nemzeti Bank designated a ±1 percentage point tolerance band around the 3 per cent inflation target. The progress enabled monetary policy to be more effective than previously in its primary objective of providing price stability, while as a result of its flexible framework, inflation targeting may, at long last, reach its full potential.

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11.1 A monetary strategy based on inflation targeting Inflation targeting is a monetary policy strategy where the central bank seeks to provide price stability through the achievement of a publicly announced inflation target, using the instruments available. The core component of the framework is a declared and quantified medium-term inflation target. The inflation target also serves as a nominal anchor, stabilising the expectations of economic actors for future inflation. The various characteristics of the inflation target are influenced by macroeconomic fundamentals, international factors as well as institutional features. Central banks generally set their inflation targets as a change in the consumer price index; however, there is a much greater variety in central bank practices in terms of the size and other characteristics of the targets. Another key characteristic of inflation targeting (IT) is the institutional commitment to price stability, which prohibits the central bank from taking into account other objectives which jeopardise its primary objective. An additional important trait is the need to establish the broadest possible information base due to the complex economic impact mechanisms involved. Monetary policy also functions transparently, given that effective influence on expectations is essential in terms of monetary policy. Price stability also means anchored inflation expectations, which in turn are best achieved through transparent functioning, improving the effectiveness of monetary policy. Finally, the accountability of the central bank for achievement of the inflation target also contributes to the credibility of monetary policy.62 Inflation targeting started to spread among central banks in the 1990s. Placing stronger emphasis on the ultimate objective of price stability, the new approach became increasingly popular as opposed to strategies using other economic variables (money supply, exchange rate) as intermediate targets. Although inflation targeting was initially adopted 62

or a more detailed discussion of inflation targeting, see Ábel et al. (2014) and Felcser F et al. (2016).

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11 Towards a more flexible framework of inflation targeting

by developed countries, in the mid-2000s the central banks of emerging and developing countries applying the regime already outnumbered those of developed countries. In the spread of inflation targeting, a role was presumably occupied by its ability, as confirmed by a substantial body of research, to show good performance in controlling inflation and reducing volatility (e.g. Roger, 2010). Committed to keeping inflation at a low level, a number of developed and emerging countries have adopted inflation targeting regimes. Today, monetary policies based on inflation targeting are pursued by the central banks of more than 30 countries (Chart 11-1). In 2012– 2013, leading economic areas took a major step towards inflation targeting by announcing a 2 per cent inflation target. The move may enable the Federal Reserve and the Bank of Japan to benefit from the advantages of a declared inflation target, including the more effective anchoring of inflation expectations, which plays a prominent role in the maintenance of price stability. In the case of the Federal Reserve (and the European Central Bank), the inflation target is not as prominent as with inflation targeting, and therefore the monetary policies pursued in practice by these central banks resemble the characteristics of flexible inflation targeting.63 In early 2015, India joined the group of inflationtargeting countries as another major economy. Overall, in 2015 the countries pursuing inflation-targeting monetary policies accounted for approximately 70 per cent of the global economy, including central banks (European Central Bank, Federal Reserve) which were not targeting inflation officially, but were following strategies that were equivalent to inflation targeting in several relevant aspects. In a study of the outcomes, challenges and development of the framework, consideration should be given to both inflation-targeting central banks and the practices of leading developed countries’ central banks, whose frameworks are highly similar to inflation targeting.

or more details on the announcement of inflation targets by the Federal Reserve and the F Bank of Japan, see Felcser–Lehmann (2012).

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Chart 11-1: Prevalence of monetary policy frameworks (2016)

Inflation targeting (IT) Resembles IT (ECB, Fed) Monetary targeting Exchange rate targeting Other

Source: Based on the IMF Annual Report on Exchange Arrangements and Exchange Restrictions 2016 (Chart: OpenHeatMap).

11.2 Flexible inflation targeting Within the framework of inflation targeting, the central bank primarily seeks to maintain price stability. This is achieved at a low but positive level of inflation, which stems from the fact that apart from high inflation, persistent negative inflation (deflation) also has unfavourable effects on the economy.64 Monetary policy can make the greatest contribution to the long-term welfare of society by providing 64

ther common arguments for a positive inflation target are downward nominal O rigidities in the economy and the statistical measurement errors in the consumer price index (including technological development and the improving quality of services). In emerging economies, convergence to developed countries in terms of prices in parallel with economic convergence also generates additional inflation, assuming a constant nominal exchange rate (Felcser et al., 2016).

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a stable economic environment. This purpose is served by price stability, which is set as a primary objective for inflation-targeting central banks. Price stability allows prices to effectively play a coordinating role in the allocation of resources. High inflation also leads to a loss of efficiency as uncertainty over expected inflation increases and it becomes increasingly difficult to determine whether specific price changes indicate relative or general tendencies. Stable low inflation stimulates investments and reduces uncertainty in the business environment, increasing economic actors’ confidence to enter into longterm arrangements. In an environment of low inflation and sustainable fiscal policy, longer-term interest rates will also decline, which in turn will reduce the interest burden of financing new and rolled-over public debt. A low level of long-term interest rates could steer the borrowing decisions of companies, and in particular those of households, towards the domestic currency, reducing the risk of building up stocks of unsecured foreign currency loans (Felcser et al., 2016). Price stability is an important component of a stable macroeconomy. That said, institutional commitment to price stability does not mean that the central bank would focus exclusively on inflation. “Strict” inflation targeting that only takes inflation into account is primarily seen as a theoretical model, which would not be consistent with the central bank’s mandates, where broader economic policy objectives also emerge subordinated to price stability. Inflation targeting provides a flexible framework where, in addition to its efforts for price stability, the central bank also takes into account considerations of real economy and financial stability. In the course of inflation targeting, the central bank supports the economy by providing price stability in the longer term, while in the shorter term it seeks to mitigate the volatility in inflation, as well as in the real economy and the build-up of financial imbalances. The efficient use of resources in the economy requires price stability, whereas over the shorter term macroeconomic stability is shaped by the trade-off between inflation and output. The flexible approach is justified by several aspects (Felcser et al., 2016). — 355 —

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• Time lags of transmission. Given the time required for monetary transmission, adjustments to the base rate tend to make their intended macroeconomic impact with a lag of several quarters. Due to the length of time between an economic policy move and its impact (external lag), a stronger move would be required for monetary policy to influence inflation developments in the shorter term. This, in turn, would lead to greater volatility in other macroeconomic variables, such as in output. It is because of this lagged impact that monetary policy uses its instruments in a forward-looking manner, taking into account expected developments in the medium-term inflation. • Nature of shocks. The economy, and therefore inflation, is hit by a variety of shocks, which may warrant different monetary policy responses. This may be well illustrated for the following types of shock (Chart 11-2). In the event of a demand shock (e.g. a decrease in consumption), output and inflation move in the same direction, in which case inflation and real economy considerations also warrant interest rate moves in the same direction. Conversely, in the event of a supply shock (e.g. the decrease of oil prices in an oil importing country), output and inflation will move in opposite directions, as a result of which monetary policy will face a trade-off between the stabilisation of inflation and output, which in turn will require interest rate moves in opposite directions. A stronger impact on inflation will come at the price of greater volatility in the real economy, or otherwise, where volatility in output is mitigated, more time will be needed to offset the inflationary effect of the shock. • Minimising social losses. As social costs are not only incurred from inflation, in addition to providing price stability monetary policy also seeks to mitigate other losses, such as output volatility and financial imbalances, in order to minimise social losses. Due to considerations of real economy or financial stability, missing the inflation target temporarily may be tolerable if it helps to avoid significant social losses.

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Chart 11-2: Interest rate responses to demand and supply shocks Demand shock

Supply shock Inflation under the target → loosening

Inflation under the target → loosening

Slow growth → loosening

Fast growth → tightening

Source: Edited by the authors.

The temporary toleration of missing the inflation target, and the deferred achievement of the inflation target is consistent with the spirit of flexible inflation targeting. Flexible inflation targeting links the longer-term objective of monetary policy (nominal anchor) to shorterterm considerations (stabilising the economy). Monetary policy is required to take into account the prevailing economic circumstances and outlook to consider the time horizon on which inflation may be brought back to the target. The excessive speed of decreasing or increasing inflation may lead to higher volatility in the real economy. Conversely, a slower than required response would question the central bank’s commitment to price stability, which would subsequently increase the cost of keeping inflation on target. Each of the inflation-targeting central banks has had shorter or longer episodes of inflation missing the declared target. Inflation targeting therefore includes the possibility of flexible application, despite which strong emphasis had been placed on inflation before the crisis, explained using the idea that price stability not only contributed to, but actually ensured macroeconomic stability.

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In the course of flexible inflation targeting, in the short term monetary policy is faced with a trade-off between inflation and real economy considerations at times when inflation deviates from the target as a result of supply shocks. According to a widely held view, flexible inflation targeting is characterised by the central bank’s efforts to reduce the volatility of inflation around the inflation target, and of output around its potential level. With optimal monetary policy in place, the Taylor frontier accommodates the points that combine the lowest volatility of inflation for a given volatility of output (Chart 113). Moving along the frontier, the variance of one variable can only be reduced at the expense of increasing that of the other. The optimal point derived from the central bank’s preferences determines the relative weights attached by the central bank to mitigating the volatility of inflation and that of the real economy.

Variance of inflation

Chart 11-3: Taylor frontier

Taylor Frontier Central Bank preferences

Variance of output Source: King (2012).

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The trade-off between the volatility of inflation and that of the real economy emerges through an analysis of economic outcomes. Given the monetary policies pursued by inflation-targeting central banks, individual countries had varying levels of relative volatility in inflation and economic growth in terms of the average over a longer term (Chart 11-4). Over time, the Taylor frontier may also be shifted in the event of milder supply shocks to the economy. There is evidence from research that greater credibility of monetary policy will take inflation-targeting central banks closer to the frontier over time (Mishkin–Schmidt-Hebbel, 2007). Chart 11-4: Volatility in inflation and output

Standard deviation of inflation

Indonézia Magyarország

Guatemala

Lengyelország Brazília

Dél-Afrika Chile

Kolumbia 2

Thaiföld

Fülöpszigetek

Mexikó

Albánia 1

Peru

Standard deviation of GDP growth Note: Based on a sample of emerging countries with inflation-targeting central banks. Filtered for outliers. Standard deviations represent averages from the adoption of inflation targeting up to 2015 for GDP (annual frequency) and up to Autumn 2016 for inflation (monthly frequency). Source: IFS.

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In some form, flexible inflation targeting takes into account the tradeoff between the stabilisation of inflation around its target and of output around its potential level. Monetary policy is considered effective if it can stabilise the economy by cushioning the volatility of the variables deemed important. Central banks may tolerate the deviation of inflation from the target where offsetting temporary shocks to inflation could come at the price of a sacrifice in the real economy that is unnecessary from the perspective of maintaining price stability. However, this requires anchored inflation expectations and in connection with that, credible monetary policy. In central bank practices, the flexibility of inflation targeting may take several forms (Felcser et al., 2016). The practice of any individual central bank may incorporate several of the following at the same time. • Tolerance band. There are a number of factors which should not draw a monetary policy response in the short term, but have an inflationary effect. The point target may therefore be associated with a tolerance band, which represents the possibility for inflation to fluctuate around the target. Shocks to the economy will divert inflation from the target and occasionally even push it outside the tolerance band, despite which central banks will maintain their primary objective of meeting the point target. For example, in 2015 the Magyar Nemzeti Bank designated ±1 percentage point tolerance band around the 3 per cent inflation target. (For more details, see the section on representing greater flexibility.) • Horizon of reaching the target. Monetary policy can take into account considerations other than price stability by making moves in response to medium-term developments in inflation rather than to current developments or shocks. The impact of central bank decisions on inflation and growth is the strongest on this 1- to 2-year horizon. In the event of major and persistent shocks, in the spirit of flexibility it is possible to adjust the common horizon. The horizon may become shorter or longer depending on the nature and persistence of the — 360 —

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shock concerned. The effects of financial vulnerability may be felt over the longer term, which may also warrant flexibility in setting the monetary policy horizon, and even allowing for somewhat weaker inflation performance over the common horizon in exchange for macroeconomic and financial stability over the longer term. When the horizon is extended, caution is required to avoid weakening the role of the inflation target as an anchor. For example, while the Canadian central bank normally sets a horizon of 6 to 8 quarters, on a number of occasions it has taken into account shorter or longer horizons of up to 11 quarters (Bank of Canada, 2011). Also in the course of the crisis, it extended the horizon to more than two years so it could reduce volatility in the real economy. • Disregarding volatile inflation components. Another indication of flexibility is when the central bank does not respond to certain volatile components of inflation to avoid additional volatility in the real economy caused by central bank response to short-term effects. In this case, flexibility is manifested in the set of information taken into account by the central bank for the purpose of its monetary policy decisions. Over time, there will be changes in which factors’ price developments should be disregarded (oil, commodities, certain components showing temporarily outlying price dynamics, etc.). However, mere disregard for volatile components is not sufficient; an analysis of the underlying inflation trends is required. The inflation indicators that reflect the cyclical position of the economy (they move together with the output gap) help to capture the economic drivers that also influence monetary policy. For example, before 2015 Thailand had been following an inflation target set in terms of core inflation. Sweden’s central bank pays particular attention to an inflation indicator (CPIF) that is not directly affected by changes in mortgage rates, given the sensitiveness of the Swedish CPI to rate changes.

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• Disregarding the first-round effect of shocks. Central banks may specify circumstances in which missing the inflation target temporarily may be tolerated. This may include shocks, mostly in the supply side, on which monetary policy only has a more indirect effect (such as VAT increases or major changes in commodity prices in the global market). While central banks do not respond to the direct (first-round) and temporary effects of such types of shock on the price level, they pay increased attention to any indirect second-round effects that may emerge through expectations and wages. For example, the Czech central bank at the time of the 2012 VAT increase, and the Bank of England at the time of the 2013 regulated price increase, considered that the risk of second-round effects was not significant, and that the rise in inflation did not threaten the anchoring of expectations, and consequently that missing the target temporarily would not warrant monetary policy action.65 • Direct response. Monetary Policy may also respond directly to developments in a real economy variable either by taking into account considerations relating to capacity utilisation in the economy, or by mitigating the risk of financial imbalances emerging. In the short term, this will inevitably hinder the accomplishment of the inflation target to some extent. Where a central bank intends to take into account real economy (or financial) variables directly, this will also be represented in the models used by that central bank. For example, apart from ensuring that the inflation target is reached, the interest rate path of the Norwegian central bank must also comply with the requirements of flexibility (taking into account real economy considerations) and robustness (mitigating the risks of financial imbalances). Following the crisis, the weight of the output gap was increased in the interest rate rule of the forecasting model, which also incorporates a variable to capture financial 65

he theoretical and practical response options of several central banks to VAT increases T are assessed by Felcser (2013). Adjustments to indirect taxes may be seen as a special supply shock where the source, time and initial size of the shock are all easy to identify.

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stability (the deviation of the interest rate from the neutral level), reducing the central bank’s response in the model to supply shocks (Evjen–Kloster, 2012).

11.3 Inflation targeting in the shadow of the global crisis The period preceding the crisis was characterised by inflation near price stability and stable growth in both developed and emerging countries. The period of the Great Moderation showed low macroeconomic volatility accompanied by a build-up of financial imbalances. The crisis served as a reminder of the possibility of major shocks to increasingly interrelated economies and financial systems. It became clear that macroeconomic stability was not sufficient to ensure macro-level financial stability. Apart from objectives, central banks also ran into constraints in terms of instruments, as their monetary policy instruments built on influencing short-term interest rates became ineffective in the face of the liquidity trap emerging, which called for reforms on the instruments.66 New monetary policy instruments were required to manage the effects of the protracted recession following the crisis and the risk of persistently low inflation to expectations. Before the crisis, the lower bound of nominal interest rates appeared to be more of a theoretical possibility. Taking into account the inflation targets commonly set at 2 to 3 per cent and the pre-crisis level of the natural (or neutral) real interest rate that was consistent with the fully utilised capacities of the economy, the natural rate of the nominal interest rate derived from these two factors allowed sufficient monetary policy space to reduce rates in 66

liquidity trap is a situation where in the context of given inflation expectations, A the central bank is unable to provide the (negative) real interest rate required for the stabilisation of the economy even by reducing the base rate to its lower bound. Accompanied by a decline in the real economy, low inflation may be priced in the expectations of economic actors. As inflation expectations become unanchored from the central bank’s inflation target, the real interest rate will start to rise, aggravating the situation of the real economy, and placing downward pressure on prices. Such a development may plunge the economy into an ever-deepening deflation spiral, and will increase the real burden of economic actors’ debt.

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the event of a negative shock. During the financial crisis, however, the shock to the economy was extremely large, while the natural real interest rate was already lower than its previous reading. This rapidly narrowed central banks’ room for manoeuvre, and policy rates quickly reached their lower bounds (Chart 11-5). Chart 11-5: Lower bound of the nominal interest rate Per cent

Per cent

A Zero lower bound

0 Effective lower bound

Source: Edited by the authors.

Following the initially stable period of the 2000s, central banks needed to tackle inflation that was first persistently and significantly higher, and later lower than the targeted levels. In 2007, food prices and oil prices both spiked. As a result, average inflation rose to 1.5 times, and doubled in developed countries in the sample compared to the previous period (Chart 11-6). During the crisis, the increase in oil prices came to a halt, and by early 2016 prices fell to a third of their 2008 peak. Developments in commodity prices also contributed to the fact that persistently low inflation following the crisis led to intensifying

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deflationary risks despite extraordinary monetary easing by central banks. The difficulty in the accomplishment of the inflation target is illustrated by the increased frequency of open letters from the Bank of England, explaining the failure of meeting the inflation target, during those two periods: in the period following stable and low inflation, the Bank of England was forced to explain inflation that first significantly overshot, then fell significantly short of the target (Chart 11-7). Chart 11-6: Inflation in developed and emerging IT economies 7

Per cent

6 5 4

Inflation target (average)

1 0

0 Developed IT

Emerging IT

Great moderation (2003–07) Crisis period (2009–12)

Commodity price shock (2008) Low inflation (2013–15)

Note: The name of each period characterises the developments in that period without full coverage of the period. Developed economies: Australia, Canada, Iceland, New Zealand, Norway, South Korea, Sweden, UK; emerging economies: Albania, Chile, Colombia, Czech Republic, Guatemala, Hungary, Indonesia, Israel, Mexico, Peru, Philippines, Poland, Romania, South Africa, Thailand. Inflation targets are average annual targets set for 2016 by the central banks of developed and emerging countries. Source: IFS, central bank websites.

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Chart 11-7: Number of open letters from the Bank of England 15

15 3.4%

0.3%

6 Average inflation

3 1.9%

2.2% 0

0 Before the crisis Crisis and inflation (2003–2007) (2008–2012)

Fulfilled target (2012–2014)

Low inflation (2015–2016)

Open letters Note: In the UK, if the 2 per cent target is missed by more than 1 percentage point on either side, central bank accountability requires the Bank of England to write an open letter to the Chancellor explaining the reasons for the difference. Source: Bank of England.

With expectations anchored to the inflation target, monetary policy has more room for manoeuvre in achieving price stability and in taking steps towards its other objectives. Where economic actors have confidence in the central bank’s achievement of the inflation target set, their inflation expectations will be aligned with the central bank’s inflation target. Pricing and wage decisions aligned with the inflation target contribute to ensuring that prices rise at a rate suited to the central bank’s target. In this way, maintaining price stability entails a lower cost to the real economy when inflation deviates from the target as a result of some shock. Temporarily, the central bank may also tolerate inflation deviating from the target. It must be remembered, however, that inflation persistently deviating from the target may cause

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expectations to become less firmly anchored as economic actors start to have doubts about the central bank’s commitment to the inflation target, and its ability to achieve the inflation target even in the long term. Insufficiently anchored expectations will reduce the effectiveness of monetary policy, while increasing the cost to the real economy from monetary policy measures that push inflation towards the target. The more credible a central bank is and the longer it has maintained an environment of inflation close to price stability, the more likely it is able to “look through” the inflationary effect of one-off price-level shocks, or allowing the inflation target to be missed temporarily, to have regard for other central bank objectives so that inflation expectations remain anchored. Therefore, the credibility of the central bank’s commitment to price stability largely influences the extent to which monetary policy can mitigate short-term volatility in output. If missing the inflation target persistently were to question the central bank’s commitment, this would subsequently increase the cost of keeping inflation on target. Previous results have also shown that a credible inflation target is capable of anchoring the inflation expectations of economic actors (Gürkaynak et al., 2010). Despite inflation deviating persistently from the target, longer-term inflation expectations remained anchored in the experience of developed countries under review (Cunningham et al., 2010; Harimohan, 2012). Apart from the foregoing, in Hungary there were also several other factors that impaired the initial performance of inflation targeting. The build-up of imbalances (high public and external debt, significant share of foreign currency loans) increased the vulnerability of the economy, and also limited monetary policy room for manoeuvre during the crisis. Following the adoption of the framework, the three factors of relative importance include fiscal policy, the exchange rate band, and the spread of foreign currency (FX) lending (Chart 11-8).

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Chart 11-8: Main factors constraining Hungarian monetary policy before the crisis Fiscal policy Exchange rate band FX lending 2001

2002

2003

2004

2005

2006

2007

2008

Source: Edited by the authors.

Persistent fiscal expansion in the years before the crisis made a significant contribution to inflationary pressure on the Hungarian economy, while increasing public debt and high public deficit eroded the country’s risk perception. The persistently expansionary fiscal policy that produced a deficit fluctuating between 6 to 10 per cent of GDP67 influenced the supply and demand factors affecting inflation through a variety of channels. On the demand side, in addition to its direct effect on demand, fiscal policy also increased households’ consumption expenditures by raising wages and cutting taxes. On the supply side, the large-scale pay rise for civil servants and the increase in the headcount of public sector employees caused tensions in the labour market. The increase of indirect taxes acted as a one-off price-level shock. As a result of a fiscal policy building up substantial deficit over several years, public debt was also set on a rising path, exceeding 70 per cent of annual GDP before the crisis. For a long time after the introduction of inflation targeting in 2001, fiscal and monetary policy remained out of sync (Matolcsy–Palotai, 2016). The exchange rate band imposed a major constraint on the effectiveness of the exchange rate channel of monetary transmission before 2008. The components of inflation targeting were accompanied by an exchange rate band until late February 2008. Within the ±15 fluctuation band, developments in the exchange rate were determined by FX-market demand and supply, despite which the forint rate tended to move in 67

ESA public deficit between 2002 and 2006, without pension adjustments.

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a narrower range, approximating the stronger edge on several occasions (Chart 11-9). The defence of the exchange rate band restricted the central bank’s room for manoeuvre, and monetary policy was prevented from achieving its full effect by reaching the strong edge of the band. The floating exchange rate system adopted in 2008 eliminated the internal logical contradiction of the regime (Spéder–Vadkerti, 2016). Hungary being a small and open economy, the exchange rate continues to play a key role in the development of inflation, but it has now only an indirect effect on central bank decision making. The floating exchange rate system provides better conditions to the central bank for the achievement of its inflation target. Chart 11-9: Developments in the forint exchange rate 340

EUR/HUF

340

EUR/HUF exchange rate

Band

2016

2015

2014

200

2013

200

2012

220

2011

220

2010

240

2009

240

2008

260

2007

260

2006

280

2005

280

2004

300

2003

300

2002

320

2001

320

Band center

Source: MNB, Spéder–Vadkerti (2016).

In the 2000s, foreign currency lending started to spread in Hungary, and became a relevant macroeconomic factor over time. Perception of the exchange rate risk associated with the spread of such lending may as a result, also have been distorted by a monetary policy that also factored — 369 —

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in the exchange rate, due to the exchange rate band, and by the stable forint exchange rate for an extensive period. Apart from the illusion of exchange rate stability, the pick-up in foreign currency lending was also promoted by forint loans becoming significantly more expensive as a result of the rising interest rate spread relative to external levels, and of government measures (such as the discontinued housing subsidies scheme). Before the onset of the crisis, from household loans the share of foreign currency loans (denominated primarily in Euros and Swiss francs) exceeded 50 per cent. In an international comparison, the share of foreign currency loans was also high in other converging countries across Europe; however, in Hungary it became a factor that monetary policy was forced to reckon with. The stock of foreign currency loans had grown at its fastest rate in the years preceding the crisis (Chart 11-10), reaching a level wherein the FX exposure of the household and corporate sectors had already reduced the effectiveness of the interest rate channel Chart 11-10: Spread of foreign currency lending in Hungary before the crisis 10,000

HUF Billions

10,000

8,000

6,000

4,000

2,000

0 2002

2003

2004

2005

2006

HUF denominated loans Source: MNB.

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2007 FX loans

2008

11 Towards a more flexible framework of inflation targeting

of monetary transmission. Apart from individual indebted economic actors, the significant and persistent depreciation in the exchange rate may also threaten the stability of the banking system. On those grounds, the central bank must take into account both the effect of the exchange rate on inflation and the effects generated through the revaluation of foreign currency debt. Considerations of financial stability may come into conflict with the price stability objective, which in turn will restrict the room for manoeuvre of an inflation-targeting central bank that also takes into account financial stability considerations. Building on the lessons learned from the crisis, central banks have been moving towards greater flexibility in terms of both monetary policy instruments used and the framework. Individual central banks have responded to the above challenges in different ways. Nevertheless, a widespread tendency can be seen in the shift towards more flexible conduct of inflation targeting, and the more prominent role assumed by macroprudential policy. All of this in order to retain the effectiveness of flexible inflation targeting as a system to ensure price stability and more general macroeconomic stability.

11.4 Reforms on instruments In response to challenges posed by the crisis, central banks moved towards greater flexibility within the inflation targeting regime and reformed their monetary policy instruments. The extension of central bank instruments cannot be separated from changes in the framework of inflation targeting. Following the onset of the financial crisis, aggregate demand dropped sharply, leading to an environment of low inflation and a decline in production. In order to manage the real economy and deflationary risks arising in the aftermath of the crisis, firm central bank intervention was needed. The central banks of developed countries rapidly cut their policy rates close to zero, but even this proved insufficient to achieve their inflation targets and to stimulate the economy. Having reached the boundaries of conventional — 371 —

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instruments, further monetary easing was made possible through new and unconventional instruments. The use of unconventional instruments was pioneered by the central banks of developed countries when short-term nominal interest rates could not be cut any further. The magnitude of negative shocks to the economy had proven to be such that cutting policy rates close to zero was no longer a sufficient move. In the presence of an instrument (cash) that will at any time provide a nominal yield of at least zero, nominal rates cannot remain persistently and significantly negative. The lower bound of nominal interest rates put an end to monetary easing through conventional central bank instruments that was required by the economy. For that reason, central banks started to add new unconventional instruments to their tools. Such instruments have become integral parts of extended inflation targeting tools. Unconventional instruments can be classified in the following groups (Chart 11-11). Chart 11-11: The new pillars of monetary policy are unconventional instruments

Monetary policy Negative interest rates

Forward guidance

Lending incentive programmes

Asset puchase programmes

Flexibility of the monetary policy framework Source: Edited by the authors.

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• Negative interest rates. Some central banks have adopted negative interest rates on specific instruments to provide further monetary easing. The cost of cash holdings makes it possible for monetary conditions to be eased temporarily in specific sub-markets. To the extent that the negative interest rate may be transferred to bank funding costs, and that credit spreads are kept level by adequate competition in the credit market, higher consumption will support the achievement of the inflation target by providing a stimulus to the economy. As a result of variations in central bank instruments, negative interest rates have been adopted in different ways. Apart from several European central banks, the Bank of Japan also resorted to a policy of negative interest rates. • Asset purchase programmes. By increasing its balance sheet and purchasing the appropriate assets, the central bank can reduce a wide range of the yields concerned, providing additional monetary stimulus to the economy. Asset purchase programmes may cover government securities, mortgage-backed securities (MBS) and corporate bonds. Additionally, liquidity may need to be provided in some sub-markets to restore their functionality. For the most part, the programmes proved to be effective at times of financial turbulence, as they restored the functioning of markets, significantly reduced the rate of the credit squeeze, cut long-term yields, and stabilised asset prices. Nevertheless, experience shows that the effectiveness of asset purchases diminishes over time. During the crisis, a large-scale asset purchase programme was first introduced by the US Federal Reserve in 2008, followed by another two waves in subsequent years. Of the large central banks, the European Central Bank was the last to introduce quantitative easing, launching its government securities purchasing programme in the euro area in 2015. Other examples include the Bank of England, as well as the central banks of Japan and Sweden. • Forward guidance. Central banks’ conditional commitment to holding expansionary monetary conditions for a sustained period may also — 373 —

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affect long-term interest rates by influencing expectations over short-term rates. Forward guidance is not seen as a new element in monetary policy: central bank statements and executive comments already contained indications of future central bank behaviour in the years preceding the crisis as central bank operations became increasingly transparent over time. However, during the crisis, as central banks reached the boundaries of their conventional instruments, the expectations of economic actors assumed a more prominent role. In order to be effective, forward guidance requires credible commitment and clear communication. This instrument has been used by the central banks of a number of developed and emerging countries, including the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England, the central banks of Canada and the Czech Republic, and the Magyar Nemzeti Bank. • Lending incentive programmes. Among unconventional instruments, mention should also be made of lending incentive schemes, as part of which the central bank provides funds to financial institutions at favourable rates, depending on the lending activity of each participant.68 Intensifying risks during the crisis caused a major decline in lending, due partly to the efforts of economic actors to reduce their debt and to deleverage. The environment of low interest rates also proved to be ineffective to boost lending, which is why central banks tried to provide a stimulus to lending and consequently to recovery as part of various lending incentive schemes. The Funding for Lending Scheme (FLS) was launched in the United Kingdom in July 2012 as a joint programme of the Bank of England and the Treasury, covering both the corporate and household segments. The credit support programme announced by the Bank of Japan in 2012 supplied long-term funds at low interest rates to financial institutions as long as they boosted their lending activity. The ECB sought to boost corporate lending through targeted longer-term refinancing 68

n international overview of lending incentive programmes by central banks is provided A by Komlóssy et al. (2014).

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operations (TLTROs). Launched in April 2013, the Funding for Growth Scheme of the Magyar Nemzeti Bank supported lending to the small and medium-sized enterprises sector under favourable terms. Overall, it may be argued that conventional monetary policy instruments (interest rate policy) have proven insufficient in themselves to give an adequate answer to the challenges of the crisis. With anchored inflation expectations, the flexibility of inflation targeting has allowed spectacular extensions to monetary policy tools, and the use of new instruments to achieve central bank objectives (Chart 11-12). Following the onset of the crisis, large central banks pioneered the use of unconventional instruments, which were gradually integrated into monetary policy instruments. Asset purchases significantly increased central bank balance sheets. Although the central banks of emerging economies were faced with the lower bound of nominal interest rates to a lesser extent, over time they also sought unconventional solutions in order to ease monetary conditions as required. Since early 2013, the Magyar Nemzeti Bank has also been characterised by more active central bank participation, and in addition to base rate cuts, it has been using unconventional instruments to fulfil the mandates set out in the Central Bank Act (Funding for Growth Scheme, Self-financing Programme, forint conversion of foreign currency loans, Growth Supporting Programme, negative interest rate on O/N deposits with the central bank, quantitative restrictions on the main policy instrument). The central bank’s measures have been contributing to making the country less vulnerable, which has also been increasing monetary and fiscal policy space.

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Chart 11-12: Changes in central bank base rates and balance sheets compared to pre-crisis levels 6

Per cent

Percentage of GDP

105

–1

0 Jan. 2007

Nov. 2016

Euro area

Jan. 2007

Nov. 2016

Jan. 2007

USA

Nov. 2016

Japan

Central bank balance sheet (right-hand scale)

Jan. 2007

Sept. 2014

United Kingdom Policy rate

Source: WSJ.

11.5 Shaping a more flexible framework Despite the strong economic policy response, the global financial and economic crisis produced protracted effects. This was partly explained by the size of the shock, but was also attributable to the lengthy process of reducing the debt accumulated before the crisis, the more cautious behaviour of financial institutions and borrowers, and investments declining due to an uncertain economic outlook. The post-crisis environment provided a breeding ground for demands to rethink economic policy, and monetary frameworks, including inflation targeting received plenty of criticism. First a few of the criticisms are mentioned, followed by a description of the direction that central banks took based on the lessons learned from the crisis.

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Criticism 1: Excessive focus on inflation

Inflation targeting received criticism on grounds that its focus on inflation was excessive at the expense of support for the real economy (e.g. Kohn, 2004). A counterexample to the possibility of excessively biased inflation targeting was the strategy of the Federal Reserve, the objectives of which also included full employment (dual mandate). The contrast was reinforced by the fact that in the US the unemployment rate had actually been lower before the crisis. In turn, contrary opinions hold that inflation targeting is a flexible framework that also takes into account real economy considerations. Criticism 2: Too low inflation target

By reasons of lessons learned from the financial crisis, several arguments have been raised for the sustained increase of the 2 per cent inflation target that has been widely used in developed countries (Blanchard et al., 2010; Krugman, 2014). On the one hand, the average level of interest rates may be lower in the future, increasing the probability of episodes where the central bank’s room for manoeuvre is restricted by the lower bound of nominal interest rates. In the context of higher nominal rates associated with the higher inflation target, the central bank would have more space to cut the base rate when required. On the other hand, with inflation expectations anchored to a higher target, the real interest rate may be more negative, which would provide more stimulus, while also reducing the risk of persistently undershooting the inflation target. Opponents of the proposition hold that although the higher target would provide benefits in terms of the macroeconomic effects of monetary policy, the provided gains are no longer convincing once its costs are also taken into account (Bank of Canada, 2016). Sustained higher inflation results in a less efficient allocation of resources, while the potential spread of indexing makes inflation more persistent. Higher inflation is also generally more volatile, which may result in more loosely anchored expectations. This is also supported by the possibility that the new target may initially be seen as less credible. The judgment is made difficult by the scarcity of international experience regarding a rise in the inflation target. The effective – and as the case — 377 —

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may be, negative – lower bound of the nominal interest rate in itself represents greater space than expected before the crisis, and is also accompanied by unconventional instruments. Experience suggests that the effectiveness of monetary policy could be sustained longer. With a higher inflation target, in exchange for the temporary advantage of insurance against a risk of lower probability (a future shock of similar size to the economy), the costs of higher inflation must be paid on a continuous basis. Criticism 3: Insufficient attention to financial vulnerability

The lessons learned from the crisis suggest that informed decisions also need to take into account other indicators than inflation. Critics claim that central banks with a disproportionate focus on the inflation target had pursued excessively loose monetary policies before the crisis in the belief that inflation provided sufficient information on unsustainable developments, more specifically, the danger of overheating. In this way, monetary policy also contributed to the build-up of financial imbalances and asset price bubbles. Proponents of this view hold that regard for imbalance indicators other than inflation would help prevent the developments leading to crises such as the current one (Borio, 2014). Based on the lessons learned from the crisis, financial stability considerations have been integrated into monetary policy thinking (see the following section), with important interactions between monetary and macroprudential policy.

11.6 Integrating the aspect of financial stability The lessons learned from the crisis pointed to the fact that macroeconomic stability in itself was unable to provide for macrolevel financial stability, as a result of which most central banks also incorporated financial stability considerations into their frameworks of inflation targeting. Monetary policy works its effect on the economy through the financial system, which is also why the sound functioning of the financial system is taken into account. Additionally, asset price — 378 —

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bubbles and financial imbalances developing in financial markets warrant attention not only from a financial stability perspective, but also from that of macroeconomic stability. Financial stability is an important precondition for price stability, and while it is also true that macroeconomic stability helps financial stability, the former is not a guarantee for the latter, which may call for both micro- and macroprudential policy. Effective economic policy also requires coordination among the various fields of policy (Chart 11-13). Chart 11-13: Interconnection of different policies Price stability while moderating economic fluctuations

Monetary policy

Macroprudential policy

Microprudential policy

Macro-level financial stability

Institutional-level financial stability

Source: Edited by the authors.

Apart from the achievement and maintenance of price stability, central banks must also pay sufficient attention to the prevention of builtup financial imbalances. Asset price bubbles and financial imbalances produce an effect similar to common overheating that also generates inflationary pressure: they lead to excessive macroeconomic volatility, and ineffective and unsustainable resource allocation. The aim of monetary policy is to maximise social welfare, which, in addition to reducing the volatility of inflation and GDP, also requires that the welfare loss caused by financial imbalances be mitigated as indicated in the foregoing. — 379 —

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To date, no consensus has been achieved as to whether monetary policy should set explicit targets for financial stability. Several approaches have emerged (Smets, 2013), all of which recognise the important interactions between monetary policy and financial stability in terms of providing price stability. • Modified Jackson Hole consensus. The central bank continues to function according to its original mandate, while the task of maintaining financial stability is assigned to a macroprudential authority. Financial stability considerations are incorporated into monetary policy decision making indirectly, i.e. to the extent that they have an effect on the inflation and real economy outlook, or on monetary transmission. • “Leaning against the wind.” This approach is based on the interrelation of financial and business cycles. On the one hand, monetary policy affects the risk tolerance of economic actors, and consequently on financial stability. On the other hand, the fragility of the financial system influences monetary transmission and the achievement of price stability. These ideas lead to the conclusion that financial stability considerations must become the secondary objective of monetary strategy. • Financial stability is price stability. Going beyond the first two, the third approach holds that it is not possible to address price stability and financial stability separately, as the former cannot exist without the latter. Consequently, monetary policy must focus on stabilising the financial system first. The objectives of inflation targeting have become more flexible in the sense that they also include financial stability considerations in addition to the medium-term objective of price stability. On the one hand, financial variables and asset prices (indebtedness, property prices) have gained a role in monetary policy communication of several central banks. For example, in its interest rate decisions the Swedish central bank has regularly invoked the risks in household

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indebtedness.69 On the other hand, while recognising the primacy of price stability, an increasing number of central banks are considering financial stability as an additional objective of monetary policy. For instance, the 2010 statement of the Australian central bank on the inflation target included that the central bank also sought to ensure the stability of Australia’s financial system without compromising price stability. Therefore, the requirement was introduced to preserve financial stability, subordinate to the primary objective of price stability (RBA, 2010). Finally, in addition to the purposeful regulation of commercial and investment banking activities, post-crisis measures also concerned the institutional system. Financial supervision was strengthened, central bank instruments were extended, and in certain countries (United Kingdom, Hungary) the supervisory authority merged into the central bank. The concentration of central bank and supervisory activities in a single institution enables the financial sector to be supervised through the harmonised application of interconnected micro- and macroprudential instruments. Overall, an important lesson learned from the crisis is that the relationship of monetary policy (price stability) and financial stability has changed. The full integration of financial considerations into the monetary strategy also requires a novel modelling approach that incorporates financial cycles into the model frameworks applied. Nevertheless, the preservation of financial stability and the prevention of financial imbalances have already become part of central bank practice from several aspects.

11.7 Increased prominence of real economy variables Apart from the maintenance of price stability, central banks also consider themselves responsible for the mitigation of real economy volatility. This holds true both for flexible inflation targeting, where the price stability objective is given priority, and for central banks 69

“ The monetary policy [...] is expected to stimulate economic developments and contribute to inflation rising towards 2 per cent, at the same time as taking into account the risks linked to households’ high indebtedness” (Riksbank, 2013).

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whose mandate includes some accompanying real economy target variable (e.g. full employment in the case of the Federal Reserve). In practice, notwithstanding the differences in their mandates, such central banks follow similar principles in conducting their monetary policies. Where inflation expectations are anchored, monetary policy decisions that are consistent with the target will generate less volatility in the real economy, which is also why inflation-targeting central banks are successful in cushioning real economy swings (Roger, 2010). In the practical implementation of the central bank framework, real economy considerations became more prominent following the crisis. This is readily apparent in the case of the Bank of England, the approach of which had previously incorporated the possibility that in the event of certain economic shocks holding inflation on target may lead to undesired volatility in output. Nevertheless, the 2013 review of the monetary policy framework placed more emphasis on the shortterm trade-off between the volatility of inflation and that of output (HM Treasury, 2013). This is why the central bank may decide to allow inflation to deviate from the target temporarily, while ensuring price stability over the medium term.70 Additionally, the maintenance of the inflation target may, in certain cases, amplify imbalances that are considered by macroprudential policy to be of potential risk to financial stability. Such circumstances may also warrant missing the target temporarily. The trade-off may be larger than usual in the case of an outstandingly severe or persistent shock that also influences monetary policy decisions. It is an important requirement for central bank communication to highlight the influence of this trade-off on monetary policy. Looking at another central bank, the Magyar Nemzeti Bank has regularly given priority to real economy considerations in its monetary policy decisions, i.e. that persistently loose monetary conditions were consistent with “the medium-term achievement of the inflation target, and a corresponding degree of support to the economy”. 70

he flexibility of the inflation target is indicated by the difference in wording. Previously, T a possible interpretation was that the target had to be “[met] at all times”, while the new version made it clear that although the inflation target “applies at all times”, it shall not be required to be met at all times.

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The years following the crisis also witnessed a change in that previously most central banks had been reluctant to link the conduct of their monetary policies explicitly to labour market variables. The increased prominence of labour market indicators, especially of the unemployment rate, after the crisis was indicated by the fact that forward guidance, serving as a signal of monetary policy, was tied by both the Federal Reserve and the Bank of England to a threshold set in terms of that rate.71 The unemployment rate is an economic variable that is easy to communicate because it directly affects the welfare of economic actors, while its prominent role is attributable to several other benefits (alignment with the cyclical position of the economy, level variable rather than a growth rate, favourable statistical characteristics).72 Specific mention must be made of the fact that the increasing prominence of unemployment in central bank communication may also be a means of placing stronger emphasis on real economy considerations (Dale, 2013). While the credibility gained previously enabled central banks to respond to the crisis flexibly, their communication focusing primarily on inflation prevented them from placing adequate emphasis on the flexibility of monetary policy by representing the trade-off between considerations of inflation and the real economy. Stronger emphasis was placed on certain real economy variables as part of central bank communication rather than on the form of an additional target variable. Communication is simpler when monetary policy is apparently tied to developments in a single variable; however, an accurate judgment of the labour market situation and of unused capacities in the economy requires multiple indicators to be taken into account. Having realised the same, over time the two central banks referred to above removed the unemployment rate threshold from their ccording to guidance from the Bank of England, policy makers will not raise the base A rate from 0.5 per cent and will not reduce the stock of asset purchases at least as long as the unemployment rate remains above the 7 per cent threshold, subject to constraints of price stability and financial stability. In the spirit of its commitment, the Federal Reserve will maintain its extremely expansionary monetary policy at least as long as unemployment is above 6.5 per cent, inflation does not exceed 2.5 per cent, and longterm inflation expectations remain anchored. 72 For more details, see Bank of England (2013). 71

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guidance as the rate had rapidly approximated the threshold for both countries, while the utilisation of economic capacities was inadequately indicated (this was partly attributable to a decline in the activity rate). Monetary policy has no influence on long-term developments in unemployment, which are determined by real factors, and monetary policy may at best seek to reduce short-term volatility. The lessons learned point to the difficulties that would be involved in application as a target variable. Providing the equilibrium value of unemployment in the long-term, the natural or structural rate is an unobservable variable that changes over time. Targeting an unemployment rate that is lower than the natural rate would place aggregate demand under constant supply capacity constraints in the economy, which would lead to perpetually accelerating inflation, thereby threatening price stability. The approach implemented was consistent with both the dual mandate and the framework focusing on price stability, which was also reflected by the conditions related to inflation set out in the forward guidance. The appearance of the unemployment rate does not reduce the importance of price stability, but rather supports its achievement, which illustrates the flexibility of inflation targeting that increased during the crisis. Overall, each inflation-targeting central bank is operating a flexible system, and each has recorded an episode in which the inflation target was temporarily missed. Due to the lagged effect of monetary policy and the trade-off between considerations of inflation and real economy, it is difficult to expect the inflation target to be met continuously or at a given point in time. The volatility of inflation relative to the target is significant both in cross section and over time. This continued to apply also after the crisis (Chart 11-14), which is not surprising given the consequences of the crisis and that apart from the inflation outlook, central banks placed more emphasis on considerations of real economy (or financial stability) in the conduct of their monetary policies.73 Central banks’ room for manoeuvre was significantly increased by anchored inflation expectations. 73

hile in pre-crisis years the target was undershot more frequently, following the crisis W there were a greater number of months in which inflation was substantially higher than the target.

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Chart 11-14: Ratio of missing the target by inflation-targeting central banks before and after the crisis 100

Per cent

100

Before the crisis 75

–25

–50

–75

–75 After the crisis

–100

TR PH IL ID PL MX HU ZA CZ IS NO CO PE RO SE KR CL BR GB CA Undershooting

–100

Overshooting

Note: Ratio of months with inflation outside the tolerance band or target range. Where only a point target is set, it was assigned a tolerance band of ±1 percentage point. Post-crisis readings (bars) are mirrored to the horizontal axis. Sample periods: before the crisis between January 2002 (or start of IT in the case of later adoption) and September 2008; after the crisis between October 2008 and October 2016. The countries are indicated by two-letter country codes. Source: IFS.

11.8 Representing greater flexibility Following international trends, the practice of inflation targeting in Hungary also shifted towards greater flexibility after the crisis. This took the form of a ±1 percentage point tolerance band, which the Magyar Nemzeti Bank designated around the 3 per cent inflation target in March 2015 (MNB, 2015). The tolerance band represents the possibility for inflation to fluctuate around the point target as a result of shocks to the economy. It also expresses the possibility that the MNB may temporarily “look through” an inflationary shock — 385 —

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that is less effectively manageable by monetary policy (such as the impact of a VAT increase), while seeking to provide price stability over the medium term. Since the introduction of inflation targeting, developments in Hungarian inflation have come under the dominant influence of supply shocks (non-core items, tax measures) on a number of occasions. Monetary policy can only offset these by a major sacrifice in the real economy. In the form of the tolerance band, the MNB marked the boundaries of a maximum differential it tolerates in the spirit of the flexibility of the framework. The announcement of the tolerance band came as a result of fine tuning the monetary policy framework and the previous central bank practice (Felcser et al., 2015). During the ex-post evaluation of the achievement of the inflation target, the MNB had already considered fluctuations in inflation due to unexpected effects previously.74 However, the fact that the band applied in such cases had a marked ex-post character occasionally making central bank communication difficult, while looking forward it failed to represent the flexibility of the framework adequately. The ex-ante tolerance band set together with the target limits the tolerable level of the deviation of inflation from the target to ±1 percentage point. Therefore, in cases where a significant cost would be incurred by the real economy from ensuring through monetary policy measures that inflation is at a level corresponding to price stability at the end of the forecast horizon, the central bank may rely on the flexibility of the framework and temporarily tolerate inflation that deviates from the target but remains within the tolerance band. In the event of shocks causing inflation to deviate persistently from the target, decisions on the appropriate monetary policy measures must also consider the risk of more loosely anchored inflation expectations (Chart 11-15).

“ In assessing performance in meeting the inflation target, fluctuations caused by unanticipated shocks should also be taken into account. For this reason, the Bank deems a maximum ±1 percentage point deviation of the consumer price index (tolerance margin) from the 3 per cent target as consistent with price stability.” (MNB, 2009)

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Chart 11-15: Inflation in Hungary under the inflation targeting regime 12

Per cent

–2 2001

2003

2005

2007

2009

Lower/upper bound (–2006) Inflation target (2007–) Tolerance band

2011

2013

2015

–2

Monthly CPI (YoY %) Year-end target (–2006)

Source: MNB, Spéder–Vadkerti (2016).

An international comparison shows that most inflation-targeting central banks set a tolerance band around their point targets (Chart 11-16). Such central banks also focus on their point targets in the course of their monetary policy decisions, which means that their tolerance bands primarily serve communication purposes by representing the potential volatility of inflation. The judgment of that by individual central banks may change over time, while central banks newly adopting inflation targeting also favour setting their targets in this way (see for instance India’s inflation target). To illustrate the change in judgment, a brief account of developments in Sweden’s inflation target appears appropriate. In Sweden, a ±1 per cent tolerance band was set for the target when inflation targeting was adopted in 1993. The band served pedagogical purposes in that the central bank used it to indicate that it would limit the deviations of the inflation from the point target, while a certain amount of deviation from the inflation target had to be tolerated. In 2010, the tolerance band was abandoned on grounds that the inflation target was credible and expectations were anchored; however, — 387 —

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the idea of introducing a tolerance band was reiterated in 2016 (Riksbank, 2016). The advantages and drawbacks of a tolerance band, and its differences compared to a target range are explained in the box below. Chart 11-16: Forms of inflation targets (2016) Target range (e.g. 1–3%)

Point target (e.g. 2%)

Point target with tolerance band (e.g. 2±1%)

Note: Due to the prominent role of the mid-band, the central banks of Canada and New Zealand are classified into the category “point target with tolerance band”. Source: IMF Annual Report on Exchange Arrangements and Exchange Restrictions 2016, central bank websites.

Box 11-1 Tolerance band or target range?

In the majority of cases, central bank targets are set as a combination of a point target and a tolerance band. A point target gives a clear signal to economic actors about the central bank’s inflation target. Due to shocks to the economy, inflation cannot be expected to be continuously on target or meet the target within a very short time. As a result, central banks typically seek to meet their targets over a horizon of several years, or the “medium term”. Inflation may temporarily even abandon the tolerance band set in conjunction with the point target, while central banks seek to ensure the sustainability of price stability over the medium term. The difference to the target range is that in such cases, central banks explicitly seek to meet their point targets. There are, however, also examples for setting only point targets or target ranges. The advantages and drawbacks of setting a tolerance band versus a target range are explained below.

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A tolerance band associated with a point target may support a central bank’s communication by indicating that the central bank seeks to reduce the volatility of inflation. At the same time, it assigns a specific value to that effort, which is easy to remember. The symmetry of the band helps to emphasise the fact that deflation is just as undesirable as inflation that significantly exceeds the target. Its drawback is that volatile inflation requires a broad band so that it is likely to remain within that band in the majority of the cases. Where inflation nevertheless abandons the band, this may receive particular attention. The target range may give the central bank more flexibility by eliminating the need to meet a specific value, allowing the central bank to focus on various targets depending on the prevailing economic circumstances (Chart 11-17). The target range highlights the lack of total central bank control over developments in inflation. At the same time, it has the drawback that without an easily captured target value, its orienting function may be weaker, and the nominal anchor may become more uncertain. A higher level Chart 11-17: Conceptual difference between a tolerance band and a target range

Point target The central bank aims at achieving the point target. Tolerance band

Target range Inflation target is achieved within the range.

Source: Edited by the authors.

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of inflation uncertainty may be generated by economic actors’ perception of the target range as one within which central bank policy makers are indifferent to the rate of inflation.75 The room for manoeuvre within the range may also be narrower than it may appear at first sight. The lessons learned from the crisis suggest that efforts must be made to avoid inflation and expectations being stuck in the lower half of the range (and the resulting lower nominal interest rate), because subsequently that might restrain the monetary policy space in the event of easing, i.e. the achievement of a sufficiently negative interest rate (Riksbank, 2016). This may be remedied by the central bank targeting the middle of the target range, which is practically equivalent to a point target associated with a tolerance band. Central bank practice takes into account the previous experience of individual countries and earlier monetary systems, as a result of which central banks’ inflation targets may take various forms and may also vary over time. In several cases, the advantages of a point target were recognised even when a target range was in place, giving more prominence to the middle of the target range.76 The Canadian central bank did so as early as the 1990s, while in New Zealand the central bank’s range for inflation of 1 to 3 per cent was confirmed in 2012; however, contrary to its previous practice, it added the need to focus on keeping average inflation close to the middle of the range (2 per cent). The central bank expects this to better anchor inflation expectations at 2 per cent (Kendall–Ng, 2013). Also using a target range, in 2012 Israel’s central bank received a recommendation from the IMF that it should start placing more emphasis on the mean of its target range when explaining its interest rate decisions (Batini, 2012).

75 76

or the example of the United Kingdom, see Haldane (2000). F By contrast, in 2013 the Korean central bank replaced its former 3 per cent point target and ±1 percentage point tolerance band for a target range of 2.5 to 3.5 per cent. The abandonment of the mid-point was explained by uncertainty over the appropriate level of inflation, assuming that the new target may anchor expectations even at levels below 3 per cent. A point target of 2 per cent has been in place as of 2016.

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11.9 Conclusion Inflation-targeting central banks have been moving towards greater flexibility within the framework of monetary policy, giving considerations of real economy and financial stability more prominence than previously. While the framework has become more flexible from several aspects, central banks are also trying to respond to the challenges of the crisis with a broader set of instruments. In the optimistic view, inflation targeting is capable of addressing the challenges arising. By contrast, the pessimistic view holds that central banks’ ballooning balance sheets blur the dividing lines between monetary and fiscal policy, which may undermine central bank independence (Reichlin–Baldwin, 2013). However, solutions moving beyond the framework of inflation targeting have not gained prominence to date. Due partly to the practical difficulties involved, history-dependent monetary strategies targeting the level of various economic variables have so far emerged only as theoretical proposals, and no central bank has abandoned inflation targeting to date.77 Indeed, in recent years additional central banks decided to adopt inflation targeting, while the operations of central banks in large economies also reflect the characteristics of this framework in many respects. Since the onset of the financial crisis, Hungary has also taken a number of steps within the framework of inflation targeting that may help monetary policy to function more effectively than what has been observed to date. Improving the effectiveness of monetary transmission supports the achievement of the inflation target. Inflation targeting may reach its full potential owing to the steps taken towards greater 77

ith a history-dependent strategy (price level targeting, nominal GDP targeting) in W place, monetary policy sets as its intermediate target the level of a nominal variable rather than its growth rate. In such a case, the deviation from the targeted path accumulated in the past must be offset in the future and resuming the previous growth rate would be insufficient. Consequently, current monetary policy may also be influenced by past developments in the target variable. Proponents of these strategies argue that in this way, a central bank may successfully commit itself to remaining expansionary even after recovery has begun.

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flexibility, creating and maintaining financial stability in addition to price stability. The steps taken over the past years have been aimed at adapting rather than abandoning inflation targeting. Inflation targeting with a focus on price stability has remained a wide-spread monetary strategy even after the crisis. It is a more flexible and complex form of inflation targeting.

Key terms exchange rate band financial imbalance flexible inflation targeting forward guidance inflation expectations inflation target liquidity trap lower bound of nominal interest rates

macroprudential policy monetary policy nominal anchor price stability supply shock tolerance band unconventional instruments unemployment rate

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References Ábel, I. – Csortos, O. – Lehmann, K. – Madarász, A. – Szalai, Z. (2014): Inflation targeting in the light of lessons from the financial crisis. Financial and Economic Review, XIII(4), pp. 35–56. Bank of Canada (2011): Renewal of the Inflation-Control Target. Background Information – November 2011. Bank of Canada (2016): Renewal of the Inflation-Control Target. Background Information – October 2016. Bank of England (2013): Monetary Policy trade-offs and forward guidance, August. Batini, N. (2012): Inflation Targeting in Israel Twenty Years on. In: IMF: Israel: Selected Issues Paper, IMF Country Report No. 12/71, International Monetary Fund. Blanchard, O. – Dell’Ariccia, G. – Mauro, P. (2010): Rethinking Macroeconomic Policy. Journal of Money, Credit and Banking, September, pp. 199–215. Borio, C. (2014): Monetary policy and financial stability: what role in prevention and recovery? BIS Working Papers No. 440, Bank for International Settlements. Cunningham, R. – Desroches, B. – Santor, E. (2010): Inflation Expectations and the Conduct of Monetary Policy: A Review of Recent Evidence and Experience. Bank of Canada Review, Spring, pp. 13–25. Dale, S. (2013): Inflation targeting and the MPC’s forward guidance. Based on remarks made at the International Journal of Central Banking Annual Conference, Bank of England, 16 October 2013. Evjen, S. – Kloster, T. B. (2012): Norges Bank’s new monetary policy loss function – further discussion. Norges Bank Staff Memo, 11/2012. Felcser, D. (2013): How should the central bank react to the VAT increase? MNB Bulletin, January 2013, pp. 35–41. Felcser, D. – Komlóssy, L. – Vadkerti, Á. – H. Váradi, B. (2016): Inflation targeting. MNB Handbooks 3, Magyar Nemzeti Bank. Felcser, D. – Lehmann, K. (2012): The Fed’s inflation target and the background of its announcement. MNB Bulletin, October 2012, Magyar Nemzeti Bank, pp. 28–37. Felcser, D. – Lehmann, K. – Váradi, B. (2015): Az inflációs cél körüli toleranciasáv bevezetése (Introducing the tolerance band around the inflation target). Edited version: Vg.hu, 29 April 2015. Gürkaynak, R. S. – Levin, A. – Swanson, E. (2010): Does Inflation Targeting Anchor Long-Run Inflation Expectations? Evidence from the U.S., UK, and Sweden. Journal of the European Economic Association, MIT Press, vol. 8(6), pp. 1208–1242. Haldane, A. (2000): Targeting Inflation: The United Kingdom in Retrospect. In: Blejer, M. I. – Ize, A. – Leone, A. M. – Werland, S. (eds.): Inflation Targeting in Practice, International Monetary Fund. Harimohan, R. (2012): How has the risk to inflation from inflation expectations evolved? Quarterly Bulletin 2012 Q2, Bank of England, pp. 114–123. HM Treasury (2013): Review of the monetary policy framework.

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Part II: Challenges and Answers in Hungarian Monetary Policy Kendall, R. – Ng, T. (2013): The 2012 Policy Targets Agreement: an evolution in flexible inflation targeting in New Zealand. Reserve Bank of New Zealand Bulletin, Volume 76 No. 4, pp. 3–12. King, M. (2012): Twenty years of inflation targeting. Governor of the Bank of England, The Stamp Memorial Lecture, London School of Economics, 9 October 2012. Kohn, D. L. (2004): Inflation Targeting. Panel Discussion, Federal Reserve Bank of St. Louis Review, July/August, pp. 179–183. Komlóssy, L. – Lehmann, K. – Vadkerti, Á. (2014): International review of lending incentives of central banks. In: The Funding for Growth Scheme – The first 18 months, Magyar Nemzeti Bank, pp. 9–25. Krugman, P. (2014): Inflation Targets Reconsidered. ECB Forum on Central Banking, Sintra, Portugal. Matolcsy, Gy. – Palotai, D. (2016): The Interaction between fiscal and monetary policy in Hungary over the past decade and a half. Financial and Economic Review 15(2), June 2016, pp. 5–32. Mishkin, F. S. – Schmidt-Hebbel, K. (2007): Does Inflation Targeting Make a Difference? In: Mishkin, F. S. – Schmidt-Hebbel, K. (eds): Monetary Policy under Inflation Targeting. Series on Central Banking, Analysis and Economic Policies Vol. 11, Chapter 9, Central Bank of Chile, pp. 291–372. MNB (2009): Statement by the Monetary Council on the Medium-term Inflation Target. Magyar Nemzeti Bank, 4 May 2009. https://www.mnb.hu/en/monetary-policy/the-monetary-council/ statements/statement-by-the-monetary-council-on-the-medium-term-inflation-target MNB (2015): The Monetary Council’s statement in the March 2015 issue of the inflation report. Magyar Nemzeti Bank, 24 March 2015. https://www.mnb.hu/en/monetary-policy/the-monetarycouncil/press-releases/2015/the-monetary-council-s-statement-in-the-march-2015-issue-ofthe-inflation-report RBA (2010): Statement on the Conduct of Monetary Policy. Reserve Bank of Australia, 30 September 2010. Reichlin, L. – Baldwin, R. (2013): Introduction. In: Reichlin, L. – Baldwin, R. (eds.): Is Inflation Targeting Dead? Central Banking After the Crisis, Centre for Economic Policy Research. Riksbank (2013): Press release: Repo rate unchanged at 1 per cent. Sveriges Riksbank, 24 October 2013. http://www.riksbank.se/en/Press-and-published/Press-Releases/2013/Repo-rateunchanged-at-1-per-cent2/ Riksbank (2016): The Riksbank’s inflation target – target variable and interval. Riksbank Studies, Sveriges Riksbank. Roger, S. (2010): Inflation Targeting Turns 20. Finance & Development, March, International Monetary Fund, pp. 46–49. Smets, F. (2013): Financial Stability and Monetary Policy: How Closely Interlinked? International Journal of Central Banking, vol. 10(2), pp. 263–300. Spéder, B. – Vadkerti, Á. (2016): Monetary policy and development of inflation from the introduction of inflation targeting until today). In: Virág, B. (ed.): 70 years of the forint: Road from hyperinflation to price stability, Magyar Nemzeti Bank, pp. 98–124.

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Targeted lending incentive instruments: from FGS to GSP István Bodnár – Sándor Hegedűs – Ádám Plajner – György Pulai

Following the onset of the crisis, Hungary faced a downturn in corporate lending which was outstanding even in an international comparison and hit the sector of small and medium-sized enterprises (SMEs) the hardest. Complementing the series of base rate cuts, in June 2013 the central bank launched the Funding for Growth Scheme (FGS) as a new, targeted element of its monetary policy instruments designed to mitigate the protracted tensions in lending to SMEs, and consequently to provide stimulus to the economy, and strengthen financial stability. Under the FGS, the central bank provided refinancing forint loans at a 0 per cent interest rate to credit institutions, which could lend on these loans to SMEs with an interest margin capped at 2.5 per cent. Within the framework of the Scheme, by the end of 2016 more than 37,000 enterprises obtained financing in the total amount of HUF 2,600 billion. By making the terms of lending more favourable and facilitating the implementation of a large number of investments, the FGS is estimated by the MNB to have contributed to economic growth between 2013–2016 at a rate of around 2 per cent. The Scheme resulted in a turnaround in SME lending: the persistent decline of an annual 5-7 per cent came to a halt as early as in 2013, and from 2015 onwards significant growth was observable. This moved growth in SME lending into the 5-10 per cent range, which the MNB considers necessary for sustainable economic growth. Introduced as a temporary instrument, the FGS successfully accomplished its objectives; however, as growth in lending should desirably be achieved without central bank participation over the longer term, the MNB — 395 —

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decided to gradually phase out the FGS. In that spirit, in early 2016 the Growth Supporting Programme (GSP) was launched, comprising the third, phase-out stage of the FGS, along with the Market-Based Lending Scheme (MLS). The latter is a set of positive incentives, as part of which the MNB helps banks with the transition to market-based lending primarily through an instrument supporting risk management (interest rate swap conditional on lending activity, Lending IRS, LIRS), and an instrument supporting liquidity management (preferential deposit facility). In order to access these instruments, banks are required to increase their lending to SMEs. Apart from these two instruments, additional instruments to encourage more intensive lending include incentives provided through banks’ capital requirements, and the new corporate credit information system set up by the MNB.

12.1 The central bank’s first lending incentive instrument: the Funding for Growth Scheme Following the onset of the crisis, Hungary faced a downturn in private sector lending that was outstanding even in an international comparison. The downturn affected lending to households and corporations alike, but the strains in the financial intermediary system were primarily reflected in corporate lending. In the period of 2009– 2013, loans outstanding in the corporate segment shrank by 4-5 per cent on an annual basis, and while the contraction in lending typically ended in the fifth year following the crisis in most countries that had experienced a severe financial crisis, the outstanding borrowing of the Hungarian private sector was still declining in 2013 (Chart 12-1). In need of bank financing, Hungarian-owned SMEs were hit particularly hard by the scarce credit supply, banks’ restrained willingness to lend and rising risk premiums. High funding costs and deteriorating profitability forced SMEs to adjust their balance sheet, restrain production and postpone investment projects, which, in turn, affected banks’ credit supply by undermining the creditworthiness of enterprises. This exacerbated the risk of an adverse feedback loop, threatening to freeze up the credit market. These corporates account for around two-thirds of domestic — 396 —

12 Targeted lending incentive instruments: from FGS to GSP

employment, while their average productivity is significantly lower than that of large corporations. Consequently, the investments enabled by the improving conditions for access to credit in the SME sector typically lead to faster growth in productivity and higher employment. Chart 12-1: Changes in private sector loans outstanding in an international comparison (Oct. 2008 = 100%) 140

Per cent

140

120

100

0 2005

2006

BG LT SL GR PT

2007

2008

2009

2010

CZ PL Euro zone IE HU

EE RO DE IT

2011

2012

2013

LV SK FR ES

Source: ECB, MNB.

Although the central bank commenced its easing cycle in the summer of 2012, a substantial improvement in corporate lending conditions was only perceived in a limited segment of the corporate sector. For that reason, in June 2013 the central bank launched the Funding for Growth Scheme (FGS) as a new, targeted element of its monetary policy instruments, designed to mitigate the protracted disturbances in lending to SMEs, and consequently to provide a stimulus to the economy, strengthen financial stability, and reduce Hungary’s external — 397 —

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vulnerability. Within the framework of the FGS, the central bank provided refinancing HUF loans at a 0 per cent interest rate to credit institutions, which could lend on these loans to SMEs with an interest margin capped at 2.5 per cent (Chart 12-2). Chart 12-2: Process of financing in the Funding for Growth Scheme

Refinancing 0% Central Bank

Commercial Bank

SME Loan max 2.5%

Source: MNB.

SMEs benefit from the predictability of long-term loans at a fixed and favourable interest rate without any exchange rate risk, which ensures smoother operations and enables enterprises to expand their business and implement postponed and new investments, potentially improving their competitiveness in the process. By making the terms of lending more favourable and facilitating the implementation of a large number of investments, the FGS is estimated by the MNB to have contributed to economic growth between 2013–2016 at a rate of around 2 per cent, and increased employment by about 20,000 jobs. As part of the FGS, by the end of 2016 more than 37,000 enterprises had obtained financing in the total amount of HUF 2,600 billion. The Scheme brought about a turning point in SME lending. After the launch of the Scheme, the persistent decline in SME lending of an annual 5-7 per cent came to a halt, which was followed by gradual increase — 398 —

12 Targeted lending incentive instruments: from FGS to GSP

from 2015. In 2016, growth in SME lending moved into the 5-10 per cent range, which the MNB considers necessary for sustainable economic growth over the long term. Chart 12-3: Growth rate of loans to the whole corporate sector and the SME sector Per cent

Per cent

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

Launch of the FGS

12 10 8 6 4 2 0 –2 –4 –6 –8 –10

2010 2010 2010 2010 2011 2011 2011 2011 2012 2012 2012 2012 2013 2013 2013 2013 2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 2016

6 5 4 3 2 1 0 –1 –2 –3 –4 –5

Corporate sector (MFI, Quarter-on-quarter) Corporate sector (MFI, Year-on-year, right-hand scale) SME sector (banking sector, Year-on-year, right-hand scale) SME sector with self-employed (banking sector, Year-on-year, right-hand scale) Note: Transaction based, prior to Q4 2015 data for SMEs are estimated based on banking sector data. Source: MNB.

The first phase of the FGS was launched in June 2013 and lasted a mere three months. It accomplished the short-term objectives set at the time of its launch, i.e. to ease credit market constraints and boost competition among banks. Already at the time of its announcement, the Scheme exerted a significant impact on the activity of credit market participants both on the demand and on the supply side. The targeted central bank scheme significantly boosted the credit demand of enterprises, while also directing the attention of credit institutions — 399 —

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to the SME sector; competition for obtaining and retaining customers intensified. In the first phase, the share of loan redemptions was still significant, which undeniably produced a more muted growth effect, but helped a large number of SMEs to either achieve more favourable and more predictable interest rate burdens, or get rid of their foreign currency loans and the exchange rate risk involved (see Box 12-1). In the first phase, banks concluded contracts with around 7,000 enterprises, amounting to HUF 701 billion in total. With a view to achieving a stronger growth effect, in the second phase of the Scheme, which was launched in autumn 2013, the focus shifted to new loans and to investment loans in particular. Loan purposes did not change notably compared to the first phase, but loan redemptions were limited to 10 per cent of the total disbursed amount. While already in the first phase banks granted several hundred billion forints worth of new loans in addition to loan redemptions, in the second phase the share of new loans rose to around 95 per cent, including approximately 60 per cent of investment loans that promote economic growth to the greatest extent. The loan purposes eligible under the FGS were adjusted progressively. The range of funding forms widened: apart from loans, funding was also made available in the form of leases and factoring arrangements. Additionally, in response to feedback from the business and financial sectors, the MNB “fine-tuned” the terms of the Scheme several times (Table 12-1) to ensure access to credit for a broader range of enterprises and investments, while preventing unintended uses. Owing to these adjustments and the extended contracting period, the share of smaller enterprises – those facing the greatest financing difficulties – increased considerably. That is also what the MNB intended to facilitate by launching the FGS+: under the new scheme launched in March 2015 and running in parallel with the FGS, the central bank assumed a part of SMEs’ credit risk from credit institutions to improve the conditions for access to credit by creditworthy corporates that had previously been excluded from the FGS on the basis of risk considerations. In the second phase of the FGS and FGS+ combined, HUF 1,425 billion worth of loan agreements — 400 —

12 Targeted lending incentive instruments: from FGS to GSP

were concluded (including approximately HUF 23 billion under the FGS+) linked to some 46,000 transactions and 27,000 enterprises. Table 12-1: Parameters of individual FGS phases First phase of FGS

Second phase of FGS and FGS+

Third phase of Third phase of FGS (Pillar I.) FGS (Pillar II.)

Total available amount

HUF 750 billion

HUF 1000 billion (+ HUF 500 billion)

HUF 700 billion

Utilisation

HUF 701 billion (94 per cent)

HUF 1 425 billion (95 per cent)

Nearly 100 percent (expected).

Contracting period

01.06.2013. — 29.08.2013.

01.10.2013 — 31.12.2015.

01.01.2016. — 31.03.2017.

Max. loan amount

HUF 3 billion

HUF 10 billion

Investment, working capital, pre-financing EU funds, loan redemption

Investment (including leasing)

Max. 10 years

Max. 3 years

—

SMEs

FGS

Loan purposes

Max. maturity of working capital loans Eligible companies

HUF 1 billion

SMEs

EUR 30 million

SMEs with natural hedge

Source: MNB.

Introduced as a temporary instrument, the FGS successfully accomplished its objectives, but since growth in lending should desirably be achieved without central bank participation over the longer term, in autumn 2015 the MNB decided to gradually phase out the FGS. In that spirit, in early 2016 the Growth Supporting Programme (GSP) was launched, comprising as one of its key components the third, phase-out stage of the FGS. On the one hand, this enabled more targeted forint-based funding for investment purposes only, while SMEs with natural hedges also gained access to foreign currency loans, which had not been available in the previous phases. In the third phase ending in late March 2017, up to the end of 2016 more than 11,000 enterprises obtained financing in the total amount of HUF 473 billion (Chart 12-4).

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Chart 12-4: Main features of individual FGS phases 750 701

1500

700

1425

690 *

1 Jun 2013 to 29 Aug 2013 First Phase

1 Oct 2013 to 31 Dec 2015 Second Phase and Plus

✓ Almost 7,000 SMEs

✓ Nearly 27,000 SMEs

✓ The loan redemptions reduced the interest burden of enterprises

✓ Investment loans are in focus (which primarily support economic growth)

✓ Significantly reduced the foreign currency exposure of the SME sector

✓ The sum of every second investment loan is below HUF 10 million

✓ Favourable foreign currency financing is also available

✓ Greater share of microenterprises

✓ Lower maximum loan amount increases the share of smaller enterprises

✓ Revitalised the competition among banks ✓ Significant volume of new investment loans

✓ The regional concentration continued to decline

Utilisation (HUF Billion)

1 Jan 2016 to 31 Mar 2017 Third Phase ✓ Almost 11,000 SMEs until endDecember 2016 ✓ More targeted, only investment loans

✓ Complements the EU funds

Total available amount (HUF Billion)

Note: expected utilisation based on a survey conducted in December 2016. Source: MNB.

Box 12-1 Role of the FGS in the conversion of corporate foreign currency loans

The period preceding the global economic crisis had seen the accumulation of substantial debt in foreign currency loans in both the household and corporate segments, which was to become one of the most important reasons behind the vulnerability of the Hungarian economy. This is especially true for Swiss franc-based loans, which were extremely widespread due to their significant interest advantage, given that borrowers typically do not draw income in this particular currency. Through the forint conversion of a part of domestic SMEs’ foreign currency loans, the Funding for Growth Scheme made a significant contribution to reducing the stability risks arising from corporate foreign currency loans. In the first phase of the FGS, foreign currency loans worth HUF 230 billion in total were converted in relation to more than 1,700 transactions,

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12 Targeted lending incentive instruments: from FGS to GSP

which implied the redemption of more than 10 per cent of performing foreign currency loans outstanding in the amount of HUF 1,800 billion at the time. Consequently, in Q4 2013 the total amount of foreign currency loans outstanding was reduced by nearly 11 per cent. The FGS had a particularly favourable impact on the operation of micro and small enterprises indebted in Swiss franc which almost entirely lacked any natural foreign currency hedge. Although the redemption of approximately HUF 40 billion worth of foreign currency loans by these enterprises may appear moderate, it represented the conversion of one-third of the performing foreign currency loans outstanding at the time (Table 12-2). Table 12-2: EUR and CHF loans outstanding in Q2 2013 by company size HUF Bn

Micro enterprises Total

Performing

Small enterprises

FGS/ PerforFGS Perfor- Total ming ming

FGS

Medium enterprises FGS/ PerforPerfor- Total ming ming

FGS

Total SME

FGS/ PerforPerfor- Total ming ming

FGS

FGS/ Performing

EUR

488

356

24%

425

399

11%

968

924

1 882 1 680

187

11%

CHF

131

29%

43%

14%

214

152

27%

Total

619

446

111

25%

461

421

13%

1 015

964

2 096 1 832

228

12%

Note: The volumes of performing loans are estimated values based on CCIS data. Source: CCIS, MNB.

Thanks to the low lending rate fixed for the entire term of the loan, the interest burden on the enterprises was reduced, offsetting most of the exchange rate losses realised during the conversion. The interest rate on redeemed Swiss franc-based foreign currency loans fell by 1.5 percentage points on average under the FGS, and the new rate remains fixed for the entire term of the loan, facilitating the predictable financial management of SMEs. The positive impact of the interest rate decline is also reflected in the very low share of non-performing loans in the portfolio of loans converted under the FGS; without the refinancing option offered by the Scheme, even some of the performing debtors may have become non-performing over time. By replacing their loans, SMEs indebted in Swiss franc typically realised a 50-60 per cent exchange rate loss; however, by means of the conversion they avoided further increases in the principal debt resulting from the

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continuous depreciation of the forint against the Swiss franc. In the case of four-fifths of the Swiss franc-based foreign currency loans redeemed during the first phase of the Scheme, by the time of replacement the forint had depreciated by 40-70 per cent compared to the level recorded at the disbursement of the original loan, but without the conversion numerous debtors would have faced further depreciation as high as almost 40 per cent. As regards euro-based foreign currency loans, given that the refinanced euro loans were typically taken out after the crisis at already higher EUR/HUF exchange rates, the conversion typically took place at the same exchange rate as the rate prevailing upon the disbursement of the redeemed loan. Of the 1,400 enterprises affected by conversion, more than 500 enterprises obtained loans in the second phase of the Scheme as well, which amounted to HUF 110 billion and comprised mainly new loans. Subsequent borrowing by the enterprises may have also been encouraged by the fact that the conversion improved and stabilised their financial positions significantly, facilitating the implementation of their investment plans.

In subsequent phases, the Scheme increasingly shifted its focus to new investment loans and smaller businesses as loan purposes were tightened and the opportunities provided by the longer contracting period were exploited. More than 40 per cent of the HUF 701 billion worth of loans granted in the first phase of the Scheme, amounting to some HUF 300 billion, consisted of investment loans. The share of microenterprises in the entire facility was approximately 30 per cent, and about one-quarter of investment loans were taken out by such businesses. Of the HUF 1,425 billion worth of loans granted in the second phase and the FGS+ together, new loans accounted for around 95 per cent, and 60 per cent (HUF 835 billion) were intended to finance new investment directly (Chart 12-5), almost one-half of which were related to microenterprises. In this phase, most loans were obtained by microenterprises both in terms of number and volume, with the vast majority of the loans intended for investment purposes. Credit institutions granted more than HUF 501 billion worth of loans to this segment, which corresponds to a weight of 36 per cent in terms of volume and, given the large number of relatively low-amount loans obtained, almost 60 per cent in terms of transaction numbers. A relatively small number of — 404 —

12 Targeted lending incentive instruments: from FGS to GSP

larger SMEs took out loans, but with higher loan amounts, and the share of working capital loans is higher in this corporate segment. In the third phase, funding was available only in the form of investment loans and financial leases. Loans to microenterprises represented a 70 per cent share within the forint pillar, and in terms of transaction numbers, more than 90 per cent were related to micro and small enterprises (Table 12-3). Chart 12-5: Distribution of loan purposes in the FGS 1600

HUF Billions

HUF Billions HUF 1425 Bn

1400

600 400 200 0

1200

391

1000 800

1400

73 126

1200

1600

1000

HUF 701 Bn

HUF 700 Bn

800 600

411

835

400 473

113

200

177 First Phase

Second Phase and Plus

Third Phase

New working capital financing loans Loan redemptions

New investment loans Loans for pre-financing EU funds

Note: Based on contracted loan amount, until end-December 2016 (FGS3). Source: MNB.

Table 12-3: Distribution of loans provided under the FGS by company size and purpose HUF Bn

Micro enterprises Small enterprises Medium enterprises Total Sum Sum Sum Sum Contracts Contracts Contracts Contracts (HUF Bn) (HUF Bn) (HUF Bn) (HUF Bn) 35,561 699 14,831 387 4,649 399 55,041 1,485

Investment loan Working capital 3,460 loan Pre-finance EU 2,778 funds Loan redemption 1,762 Total 43,561

3,790

208

1,425

227

8,675

504

946

416

4,140

127

134 949

2,003 21,570

150 793

1,200 7,690

199 857

4,965 72,821

484 2,599

Note: Based on data as at end-December 2016 (FGS3). Enterprises were classified by size based on data submitted to the NTCA for 2012-2014. Source: MNB, CCIS.

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Compared to the first phase, the average size of loans granted in subsequent phases of the FGS decreased as smaller businesses gained more prominence. In the first phase, the average loan size was HUF 70 million due to the larger share of loans disbursed to redeem relatively high-amount foreign currency loans. That said, most frequent loan amounts fell in the HUF 10 to 50 million range (median loan size: HUF 25 million), whereas in the overall SME debt portfolio, disbursements were most frequently made in amounts below HUF 10 million. Owing to the long contracting period of the second phase, credit institutions had the possibility to satisfy the credit demand of microenterprises which, typically being smaller, requires relatively higher human resources on the bank side. Accordingly, the average loan size dropped to about HUF 30 million with slightly more than one-quarter of the loans below HUF 5 million, and one-half below HUF 10 million. In the third and final phase of the Scheme, in the forint pillar the average loan size dropped nearly to HUF 20 million (median loan size: HUF 6.4 million), while in the foreign currency pillar it was around HUF 100 million due to larger project-type investments (median loan size: HUF 20.7 million). As part of the Scheme, enterprises obtained financing with maturity periods that were longer than the average. Since the onset of the crisis, the corporate sector has been characterised by free capacities, as the unfavourable cyclical outlook has been driving the segment to postpone investments. However, the FGS has also provided an opportunity for the implementation of such investments, which is partly why loans maturing in more than 3 years have an outstanding share in the Scheme (in terms of their number, more than four-fifths of the loans were contracted for such maturities in the first phase). The second phase was also dominated by longer-term loans: among the new SME loans maturing over one year, maturities of 3 to 5 years were the most typical, and three-quarters of such loans were provided under the FGS. The share of FGS loans is rather high within SME loans provided with even longer maturities, amounting to almost 90 per cent in the 8-10-year segment, although the number of these long-term loans is relatively small. In the third phase, the average maturity weighted by contract amount was approximately 8 years. â&#x20AC;&#x201D; 406 â&#x20AC;&#x201D;

12 Targeted lending incentive instruments: from FGS to GSP

As the FGS did not impose any sectoral restrictions, SMEs in any sector were eligible for funding. The Scheme is dominated by the shares of agriculture, manufacturing, trade & repair, with close to 60 per cent of the loans granted to corporates in these sectors (Chart 12-6). Chart 12-6: Sectoral distribution of FGS loans 0

10 12

Manufacturing Building and 1 construction

1 7

Trade, repair Transport and storage 1

Other sectors 0

First Phase

7 5

Per cent

Professional, scientific 1 and tech. activities

2 7

Real estate activities

Per cent

Agriculture

2 10

Second Phase

Third Phase

Note: Based on the contracted loan amount, until end-December 2016 (FGS3). The sectoral distribution does not include self-employed persons. Source: CCIS, MNB.

In all three phases of the FGS, the regional concentration of SME loans was lower than in the total SME loan stock. Even in the first phase, the FGS loans were granted in a more balanced geographical pattern, and this trend also continued into the next two phases of the Scheme. Although most loans were granted in the region of Central Hungary (Budapest and Pest county) under the FGS as well, the concentration of loans was significantly less pronounced than that of the initial portfolio. While around 54 per cent of the overall SME loan stock was linked to enterprises incorporated in Central Hungary at the start — 407 —

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of the Scheme, only 35 per cent of all loan contracts concluded under the FGS were linked to the region. In line with the high proportion of agricultural enterprises within the FGS, the Great Plain regions had a more substantial weight in the Scheme, with nearly one-third of the loans flowing to these regions (Chart 12-7). Chart 12-7: Regional distribution of SME and FGS loans

6% 7%

7% 6%

6% 11%

54%

9% 9%

10% 10%

Overall SME loans outstanding (Q3 2013)

16%

35% 14%

FGS loans

Note: Based on the contracted loan amount, until end-December 2016 (FGS3). Source: MNB.

Box 12-2 Comparison of the FGS and the lending incentive instrument of the European Central Bank

Compared to the TLTRO (Targeted Longer-Term Refinancing Operations), the lending incentive instrument of the European Central Bank (ECB), the FGS is more targeted in terms of both final borrowers and loan purposes. The aim of TLTRO is to boost the growth of lending across the entire private sector (excluding housing loans), as part of which the ECB is granting loans to banks for a maximum maturity of 4 years, at a refinancing rate (currently -0.4 per cent to 0.05 per cent) depending on the growth rate of lending. Compared to the ECB’s programme, the FGS is more focused, as it is aimed exclusively at the promotion of SME lending, as part of which banks are granted access to favourable funding for a longer term of up to 10 years, at a 0 per cent refinancing rate. While the funds received

— 408 —

12 Targeted lending incentive instruments: from FGS to GSP

under the FGS may be passed on by banks to SMEs with a margin capped at 2.5 per cent, the TLTRO does not have any requirements in that regard. As part of the TLTRO, credit institutions may draw funds from a facility of EUR 1,000 billion (5 per cent of GDP) in quarterly tenders, ending March 2017 (TLTRO II). Compared to the ECB’s lending incentive instrument, the FGS represents a larger volume as a percentage of GDP, with the HUF 2,950 billion facility amounting to 8.7 per cent of GDP. In contrast to the ECB’s programme, credit institutions can draw down FGS loans on an ongoing basis, ending June 2018 (Table 12-4). Table 12-4: Comparison of TLTRO and FGS Programme of the ECB (TLTRO I and II)

Programme of the MNB (Phase 1, 2 and 3 of the FGS)

The aim of the programme

To incentivise lending to the private sector (excluding housing loans)

To incentivise lending to SMEs (new investment loans only in the third phase of FGS)

Total available amount

EUR 400 + 600 billion (4 + 6 per cent of GDP)

HUF 2,950 billion (8.7 percent of GDP in 2015)

Tenor of refinancing loans

4 years*

Up to 10 years

Interest rate of refinancing loans

Fixed, depending on loan growth (currently: -0.4—0.05 percent)

Fixed, 0 per cent

Tenders, quarterly

Continously

Final drawdown

TLTRO I — June 2016 TLTRO II — March 2017

Third phase: June 2018 Second phase: June 2017

Interest rate charged by the banks

not defined

max. 2.5 per cent

Frequency of drawdowns

* TLTRO I – maturity Sept. 2018; TLTRO II – 4 years. Source: ECB, MNB.

In addition to playing a prominent role in breaking the unfavourable trend observed in SME lending, the FGS exerted a tangible impact on economic growth by intensifying credit demand and the expansion of credit supply. MNB research has found that a 1 per cent increment in

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the growth of the corporate loan stock results in a 0.2 per cent increment in GDP growth (Tamási–Világi, 2011). The FGS made the most relevant contribution to economic growth by stimulating investment in the corporate sector. In addition to boosting GDP directly, the increase in investment produces additional real economy effects, while the improving cash-flow position of enterprises also contributes to GDP growth. Investment loans exert their effect through the following major channels. Increasing investment activity – over and above its import need – improves domestic aggregate demand, resulting in GDP growth. On the income side, the growth in GDP generates surplus wage and corporate profit, with the latter increasing the dividend-type incomes paid to households. The effects of the rising cash flows of the enterprises are exerted through the same channels. The increase in households’ income improves household consumption, triggering second-round demand effects. Employment will be higher due to additional capacities resulting from the investments and a rise in demand. The unfolding economic activities expand the tax base linked to wages, consumption and profits, generating surplus budget revenues. According to MNB calculations, between 2013–2016 the FGS may have created up to 20,000 jobs and in addition to the effect of the central bank’s rate cuts on growth, it may have contributed to GDP growth by some 2 percentage points (Chart 12-8).

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12 Targeted lending incentive instruments: from FGS to GSP

Chart 12-8: Impact of the FGS on real GDP growth (2013—2016) 1.4

4.2

4.0

Contribution to GDP growth (Percentage point)

3.2

3.1

1.0

2.7

2.8 2.5

0.8

3.0 2.4

2.1 0.6

1.8

1.7

0.4

1.2

0.2

0.6

0.0

2013

2014

2015

2016

Annual growth (Per cent)

3.6

1.2

0.0

Contribution of FGS to GDP growth GDP growth without FGS (right-hand scale) GDP growth (right-hand scale) Source: HCSO, MNB.

12.2 Objectives and framework of the Market-Based Lending Scheme Complementing the third phase of the FGS, the Market-Based Lending Scheme (MLS) constitutes the other component of the Growth Supporting Programme (GSP). Comprised of positive incentives, this set of instruments aims to re-establish the market basis of SME lending, with progressively decreasing central bank participation. By using a part of the assets, essentially “in exchange” for those assets, banks participating in the MLS undertake a quantified commitment to increase their SME lending. As part of the Market-Based Lending Scheme, the MNB helps banks with the transition to market-based lending primarily through — 411 —

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an instrument supporting risk management, and an instrument supporting liquidity management. These are the following: – To hedge their interest rate risk resulting from lending at fixed rates, banks may use the instrument of interest rate swap conditional on lending activity (Lending IRS; LIRS). – Closely linked and complementary to LIRS, the preferential deposit facility was introduced as an instrument to support banks with liquidity management. In combination, these two instruments can support banks in the transition to market-based lending by avoiding any increase in the MNB’s balance sheet, because in this case, unlike the FGS, the central bank provides banks with risk and liquidity management instruments rather than funding and additional liquidity. The two central bank instruments of the Market-Based Lending Scheme are only available to banks in combination, i.e. access to the preferential deposit facility requires the bank concerned to have an active LIRS transaction. The quantified net SME lending undertaken on access to the LIRS facility enables retrospective control, and may also increase banks’ commitment.

12.2.1 Interest rate swap conditional on lending activity (LIRS)

The 3-year LIRS may stimulate lending activity through the management of interest rate risk. By accessing the LIRS facility, banks undertook a commitment to increase their SME lending. A fixed interest rate makes the cost of credit predictable for corporates and reduces the interest rate risk they face, which is why it is important for financial stability and lending incentive purposes that banks primarily increase their fixed-rate lending. However, at the level of the banking sector, funds are typically lent against short-term and quickly re-priced deposits, as a result of which banks undertake interest rate risk by — 412 —

12 Targeted lending incentive instruments: from FGS to GSP

granting credit at fixed rates. This risk is managed by means of interest rate swaps, which enable variable-rate market funds to be swapped for fixed-rate central bank funds. In such transactions, the MNB collects interest from banks at a fixed rate, in exchange for which it pays interest at a variable rate. In this arrangement, commercial banks can lend to their SME customers at a fixed rate, and will forward the fixed interest collected to the MNB. In this way, the higher interest rate paid by banks on their customer deposits in the event of an increase in yields will be counterbalanced by the higher interest earned on the swap, and banks’ profits will be less sensitive to the volatility of yields (Chart 12-9). Chart 12-9: Corporate lending hedged against a long-term central bank IRS Fixed interest SME

Fixed IRS int. Commercial Bank

MNB variable int.: 6 months BUBOR

opportunity cost: lost base interest rate (3M) Source: MNB.

In order to access the LIRS, banks are required to step up their net lending to SMEs by at least a quarter of the transaction value during the term of the transactions, i.e. over a period of 3 years. A precondition for entry into a LIRS transaction is that the amount of net lending to the SME sector over a period of 12 months should amount to at least a quarter of the value of the transaction in question. Interest rate swaps are made for a term of 3 years, which represents a middle course: on the one hand, longer-term lending should be encouraged, while a too long term may lead to an unreasonable increase in interest rate risk and cost of interest to the central bank. Commercial banks may fully or partially close the transactions at the end of the first and second year. Owing to its lending condition, the central bank’s LIRS-transaction is not a market product, as a result of which it is also priced differently — 413 —

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than market-based interest rate swaps: from the bank’s perspective, the price applied by the MNB is more favourable than the price of an unconditional market IRS, with the difference construed as the price of conditionality (later: “income”). The SME lending increment undertaken by the transactions concluded during LIRS tenders amounts to approximately HUF 200 billion, corresponding to a 5 per cent increase in overall SME credit. The tenders for interest rate swaps conditional on lending activity were administered by the MNB in 2016 Q1 with a facility amount of HUF 1,000 billion. Five LIRS tenders took place between 28 January and 24 March 2016. 17 banks participated, entering into an overall HUF 780 billion worth of LIRS transactions with the MNB.

12.2.2 Preferential deposit facility

The preferential deposit is a one-day deposit that is similar to the O/N instrument, but unlike the latter, it bears interest at the central bank base rate, providing a lending incentive by supporting banks’ liquidity management. The preferential deposit facility is an instrument auxiliary to the LIRS, and is available only in combination with an active LIRS transaction. The preferential deposit account is a deposit account managed separately from the customer’s giro account, and the amounts deposited on it are not part of the reserve requirement system. The preferential deposit facility is capped at 50 per cent of each bank’s LIRS transactions. The HUF 780 billion worth of LIRS transactions concluded correspond to a preferential deposit facility of HUF 390 billion in total. Preferential deposits can be placed from the month following the date of each LIRS transaction, and the option is open throughout the term of each bank’s transactions, i.e. as long as the bank concerned has an active LIRS transaction with the MNB. As the bank is required to increase its lending each year, it may also need liquidity to grant credit more easily in subsequent years. — 414 —

12 Targeted lending incentive instruments: from FGS to GSP

12.2.3 Measurement of underlying lending developments, assessment of bank commitments

With the MLS instruments, the MNB back-tests each year the accomplishment of each bank’s commitment, and applies a sanction where a bank falls short of the lending dynamics undertaken. In assessing the use of the central bank instruments, the MNB takes into account the volume of loans disbursed to micro, small and mediumsized enterprises net of repayments, 25 per cent of FGS disbursements, and the gross book value of performing receivables sold. Compliance with the lending commitment undertaken is assessed ex-post when annual data are available, in February in the year following the year concerned. – Where a bank has generated more than 50 per cent of the lending increment undertaken, the MNB will only recover the income related to the unfulfilled part of the commitment. – Where the bank’s lending Charts show that the actual lending dynamics fall short of the target by more than 50 per cent, the MNB will withdraw the total income, and terminate all of the bank’s LIRS transactions. Lending developments are assessed by the MNB for calendar years. Accordingly, compliance with the 2016 criterion and implied undertaking is due to be assessed in February 2017 (Chart 12-10).

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Chart 12-10: Schematic illustration of bank access to the instruments of the Market-Based Lending Scheme Bank conduct 1 year HIRS deal of HUF 100 bn with MNB

Audit of extra lending undertaken by the bank

• HUF 100 billion HIRS • HUF 50 billion preferential deposit frame • Undertaking of HUF 25 billion extra lending

• Based on 2016 figures • Minimum HUF 25 billion loan extension

January 2016.

December 2016.

February 2017.

Utilisation period Tenor of a HIRS deal Possibility of Preferential deposit placement Fulfillment period: calendar year of 2016 Source: MNB.

The data on the use of preferential deposits for 2016 suggest that banks are fulfilling their lending commitments at high rates. Roughly onethird of eligible banks started to use preferential deposits immediately. The first pick-up was recorded in June 2016, when the average monthly volume climbed to HUF 164 billion. As restrictions on the 3-month deposit took effect, the opportunity to place deposits at the base rate appreciated: while the November average was just under HUF 250 billion, the volume of deposits placed in December already approximated the available maximum at HUF 390 billion (Chart 1211). Given the fact that failure to comply with the lending commitment will entail the central bank’s withdrawal of the bank’s income realised on LIRS transactions and preferential deposits, the placement of such deposits implies the possibility for banks to have achieved relatively high rates of compliance with their commitments. Definitive data will be available at the end of February 2017. — 416 —

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Chart 12-11: Preferential deposits placed by the banking sector in 2016 600

HUF Billions

500

500 390

379

400 300

600

309

400 300

164 200 81

309

247

114

200

101

100

Volume of preferential deposit Monthly avg. preferential deposit

Dec. 2016

Nov. 2016

Oct. 2016

Sep. 2016

Aug. 2016

Jul. 2016

Jun. 2016

May. 2016

Apr. 2016

Mar. 2016

Feb. 2016

Max. Preferential deposit

Source: MNB.

In addition, lending activity will be boosted by the fact that within the MLS framework and in the context of the 2016 SREP review, the MNB is to introduce a number of incentives reflected in banks’ capital requirements that are expected to stimulate the economy efficiently through the improvement of capital adequacy. Similarly, the implementation of a new corporate credit information system will also support the achievement of lending objectives. Owing to the adoption of the legislative amendment proposed by the MNB, the MNB is entitled to examine the credit information and financial statements of enterprises together, which allows for the joint modelling of credit risk, corporate features and macroeconomic developments. The database enables the central bank to provide relevant information to the banking sector, supporting their lending decisions.

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On the one hand, through banks’ explicit lending commitments the instruments of the GSP facilitate predictable and stable growth in SME lending; on the other hand, over the long term these instruments support corporate lending activity and hence, sustainable economic growth.

Key terms cash-flow CCIS credit crunch ECB exchange rate risk foreign currency loans fixed rate GDP investment loan IRS FGS FGS+ GSP

lease LIRS MLS non-performing loans preferential deposit Pre-financing EU funds SME SREP Swiss franc-based loan tender TLTRO turning point working capital finance

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References Balog, Á. – Matolcsy, Gy. – Nagy, M. – Vonnák, B. (2014): Credit crunch Magyarországon 2009–2013 között: egy hiteltelen korszak vége? (Credit crunch in Hungary between 2009 and 2013: Is the Creditless Period Over?) Financial and Economic Review, Vol. 13, No. 4, pp. 11–34. Endrész, M. – Harasztosi, P. – Lieli, R. (2015): The Impact of the Magyar Nemzeti Bank’s Funding for Growth Scheme on Firm Level Investment. MNB Working Papers, 2015/2. Fábián, G. – Vonnák, B. (eds.) (2014): Átalakulóban a magyar bankrendszer (The Hungarian Banking System in Transformation). MNB Occasional Papers No. 112., Special Issue. Lieli, R. – Endrész, M. – Harasztosi, P. (2014): The Impact of the National Bank of Hungary’s Funding for Growth Program on Firm Level Investment. MNB (2014): The Funding for Growth Scheme – The First 18 months – Essays and Studies on the Results of the Funding for Growth Scheme Achieved to Date. MNB (2015): A Piaci Hitelprogram (PHP) alapösszefüggései és eszközei (Basic Correlations and Instruments of the Market-Based Lending Scheme [MLS]). MNB (2016): Tájékoztató a változó kamatot fizető, hitelezési feltételhez kötött, 3 éves forint kamatcsere ügylet feltételeiről (Supervisory guidance on the Terms and Conditions of the Three-year Floating Rate Forint Interest Rate Swaps Conditional on Lending Activity). MNB (2016): Tájékoztató a preferenciális betételhelyezési lehetőség feltételeiről (Supervisory guidance on the Terms and Conditions of the Preferential Deposit Facility). MNB (2016): Félidős Jelentés (Mid-term Report 2013–2016). MNB (2016): Növekedési Hitelprogram – A Magyar Nemzeti Bank Hitelösztönző eszközének tapasztalatai (Funding for Growth Scheme – Experiences of the Magyar Nemzeti Bank’s Lending Incentive Instrument). Sóvágó, S. (2011): Keresleti és kínálati tényezők a vállalati hitelezésben (Identifying Supply and Demand in the Hungarian Corporate Loan Market). MNB Occasional Papers 94.

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Monetary policy considerations for the conversion of foreign currency loans: growing stability and central bank leeway Bálint Dancsik – Pál Péter Kolozsi – Sándor Winkler In light of the financial, economic and social developments of the past decade and a half, there can be hardly any doubt that household foreign currency lending will be treated in finance textbooks as one of the most severe growing pains of the Hungarian financial system. The foreign currency indebtedness of Hungarian households was facilitated by both demand and supply factors: demand for foreign currency loans was primarily boosted by the 2003 phase-out of the regime of interest rate subsidies developed for forint lending, while the supply side was primarily supported by the risk-based competition developing among the banks, and by the favourable global liquidity situation. Meanwhile, the passivity of the regulatory authorities enabled the depth and severity of the problem to increase. The significant social, economic and legal concerns and embeddedness also warrant a complex approach to the assessment of the spread of foreign currency loans in the 2000s, and their phase-out in 2014–2015. With regard to the foregoing, this chapter is particularly concerned with the role of the Magyar Nemzeti Bank in resolving the issue of foreign currency loans, as well as with the effect of the measures on the central bank and monetary policy. From the beginning, foreign currency lending involved several risks. On the one hand, the “distortion” of competition between banks also allowed borrowers whose incomes did not guarantee their repayment capacity over the long term to access foreign currency loans. On the other hand, the situation was aggravated by the fact that the loan agreements were concluded in a legislative environment that enabled banks to make unilateral amendments to the terms and conditions during the term, as a result of which borrowers also ran interest rate risk, in addition to undertaking exchange rate risk. Consequently, foreign currency lending intensified macroeconomic and financial stability risks, while — 420 —

13 Monetary policy considerations for the conversion of foreign currency loans...

the “confusion” of the interest rate and exchange rate channels of monetary transmission substantially reduced the effectiveness of interest rate policy. A comprehensive resolution to the issue of foreign currency loans was provided in 2014–2015, at the first point in time when it was both feasible legally and adequately supported economically. The uniformity decision adopted by the Curia in the summer of 2014 formed the legal background for the phasing out of foreign currency loans, while the economic conditions for forint conversion (sufficiently low forint interest rates and an adequate level of foreign exchange reserves) were provided by the autumn of 2014. The central bank’s participation was indispensable in ensuring that the phase-out of foreign currency loans took place in a quick and orderly manner, preserving the stability of the financial system, and without any material impact on the forint exchange rate. The restructuring of household debt as a result of conversion supported the transition of the economy to a path of growth, significantly reduced the vulnerability of the Hungarian economy, and – by improving the effectiveness of the transmission mechanism –increased the central bank’s leeway, which was of particular importance for crisis management.

13.1 The take-off of household lending and the spread of foreign currency loans An inquiry into the causes and circumstances of the spread of foreign currency lending to households should start as far back as the early 2000s.78 Following the change in the political regime, the institutional system essential for the operation of the housing market and home lending had developed by the turn of the millennium. In the summer of 2001, amendments to the applicable law79 and the progressive easing of terms established the conditions for mortgage rate subsidies (Horváth, 2008), which – in combination with auxiliary interest rate subsidies – allowed a wide range of households to purchase homes on credit. 78 79

For more details see: Lentner (2015) Act XXX of 1997 on Mortgage Banks and Mortgage Bonds.

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Interest rate subsidies, which by 2005 accounted for 65 per cent of public expenditures on housing subsidies according to the calculations of Horváth (2008), had two forms: one on the liability side, and one on the asset side. Interest rate subsidy on the liability side, referred to as mortgage rate subsidy, reduced the rates of interest on home loans indirectly through a subsidy paid by the state to banks on their mortgage bond holdings, allowing them to reduce the margin between their liabilities and assets. Additionally, a subsidy on the asset side directly reduced the interest burden on customers. With both forms of subsidies, a cap was applied on the loan rates that could be charged to customers. This was primarily relevant because of the indirect interest rate subsidy, where the cap ensured that liability-side subsidy effectively passed through into the interest rate burden on customers. The favourable interest rate terms of subsidised loans are aptly illustrated by the fact that while in 2003 the average interest rate charged on home loans disbursed on market terms was just over 12 per cent, the interest rate paid by customers on subsidised loans was around 5-6 per cent. These favourable terms generated significant credit demand among households, which lead to a sudden increase in the volume of new lending. In the first half of 2003, the monthly volume of new housing loans to households reached HUF 80-90 billion, a level to be seen again only in late 2008, towards the end of the era of foreign currency lending to households (Chart 13-1).80 Due to the increased volume of subsidised loans, the fiscal burden of subsidies increased significantly, reaching HUF 180 billion by 2003, after which the terms were progressively tightened.

hat said, it deserves to be noted that in the era of foreign currency lending, the T monthly volume of new mortgage lending was much higher due to rising demand for home equity loans, which started to spread at the time.

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13 Monetary policy considerations for the conversion of foreign currency loans...

Chart 13-1: Volume of new housing loans 100

HUF Billions

100

HUF housing loans total

2016

10 2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

FX housing loans total

Note: Statistics on the volume of new foreign currency-based lending are available from 2005 onwards. Source: MNB.

After the terms of interest rate subsidies were tightened, the monthly volume of new housing loans dropped significantly, but nevertheless households’ demand for credit remained intense. Financial deepening81 in the household sector started in the regime of subsidies, and subsequently continued into the era of foreign currency-based lending. As regards the financial deepening observed in household lending, Hungary was far from being unique. In the Central and Eastern European (CEE) countries, household credit penetration was extremely 81

The term financial deepening refers to the increasing role of the financial system in the economy. Financial deepening is characterised by an increase in access to financial services and in the quantity of financial instruments. Developments in financial depth is most frequently measured by the volume of loans as a percentage of GDP.

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low in the early 2000s, and Hungary’s household debt of approximately 3 per cent of GDP was in line with the average of the CEE countries. Nevertheless, growth in bank lending as a percentage of GDP, and more specifically growth in household lending, was a general trend in these countries (Chart 13-2). However, the role of foreign currency loans in the build-up of debt within the household segment varied from country to country. Csajbók et al. (2010) found that the ratio of foreign currency loans was the highest in countries where the difference between domestic and foreign interest rates was the largest, where fear of floating was more characteristic of monetary policy, and where access to fixed-rate products denominated in the domestic currency was limited. Basso et al. (2007) also point out the prominent role of foreign-owned banks in the spread of foreign currency loans. Chart 13-2: Outstanding household loans in the banking system as a percentage of GDP 40

Per cent

Per cent 46.5%

40 35

2000 Latvia Bulgaria

2003 Poland Lithuania

2006 Czech Republic Romania

Sources: MNB, Eurostat, websites of national central banks.

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2009 Slovakia Hungary

13 Monetary policy considerations for the conversion of foreign currency loans...

After 2003, as financial deepening accelerated, due to rising demand for credit and the unfavourable terms of forint lending (high average market rate of 12-13 per cent), households were driven towards foreign currency and foreign currency-based82 loans, which offered much more favourable interest rate terms. In 2005, 60 per cent of all household loans were already disbursed on a foreign exchange basis, with that rate climbing to 83 per cent by 2008. Due to the low interest rate environment in the countries concerned and in the euro area, the interest rates on Swiss franc, euro and yen-based loans were considerably more favourable compared to the price terms of forint loans. In many cases, the size of the difference was similar to that seen in the early 2000s between subsidised and non-subsidised interest rates. Therefore, judged merely by the short-term interest rate differential, from a household perspective taking out foreign currency-based loans may have appeared to be a rational decision. According to the principle of uncovered interest rate parity, on a theoretical basis the differential between foreign currency and forint interest rates implied a depreciating forint, but market participants did not have strong expectations for that occurring. Owing to the intervention band against the euro and the stable exchange rate against the Swiss franc, participants’ belief in security persisted.83 By taking out foreign currency-based loans, households ran the risk stemming from exchange rate changes, whereas the banking system, while closing its exchange rate position almost completely, undertook higher credit risk. Borrowers’ outstanding principal debt was recorded in the foreign currency concerned, as a result of which a depreciating forint increased the forint value of both instalments and outstanding debt. In the 2000s, the forint was relatively stable against both the euro he difference between the two arrangements was that with foreign currency loans, T disbursement and repayments were both made in the currency of the agreement, whereas in the case of foreign currency-based loans, the foreign currency was only used as a basis of records, while the loan was disbursed in forints and the customer also paid regular debt service in forints. In the rest of the chapter, a distinction will only be made between the two products where this is relevant to the argument. 83 The framework of the theoretical factors that shape foreign currency lending is discussed in detail in Bethlendi et al. (2005). 82

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and the Swiss franc; moreover, the exchange rate tended to move along the stronger edge of the intervention band against the euro, which was in place until February 2008. The stable exchange rate may have given participants the impression that the probability of significant depreciation was low, which may have been the reason why many borrowers underestimated the risk of a depreciating forint. However, in 2008 H2 the forint started to depreciate rapidly against both the euro and the Swiss franc. The depreciation of the forint against the Swiss franc was primarily due to the fact that the euro also started to depreciate against the franc, which functioned as a safe-haven currency in the aftermath of the crisis. As the exchange rate risk was realised, these developments led to a major (in many cases up to 80 per cent) increase in repayment burdens and total debt, and consequently to the non-performing of household foreign currency-based loans on a massive scale. As regards the build-up of financial stability risks, the spread of foreign currency-based loans and the consequent exposure of households to exchange rate risk were not the only problem. Prior to the onset and spread of the 2008–2009 crisis, the banking system had considerably relaxed the non-price terms of lending (such as the minimum required loan-to-value ratio and the allowed payment-to-income ratio), which in practice meant that loans were increasingly granted to riskier, i.e. less creditworthy customers. Nagy and Szabó (2008) found that in the 2000s, risk-based competition intensified between banks in Hungary, i.e. in order to keep abreast with competitors and achieve adequate growth in their respective shares of the credit market, banks were forced to finance an increasingly risky customer base. Eventually, the credit risk of the household portfolio which built up in the balance sheet of the banking system increased significantly because of two key factors: the spread of foreign currency-based loan agreements on the one hand, and the larger share of less creditworthy customers (e.g. with lower or less stable incomes) within the portfolio on the other hand.

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13 Monetary policy considerations for the conversion of foreign currency loans...

Apart from the spread of household foreign currency-based loans and an increasing volume of lending to riskier customers, the problem was further aggravated by the deficiencies in the regulatory environment. Bethlendi (2012) points to the fact that in the period marked by the take-off of foreign currency lending, neither prudential nor consumer protection measures were taken to contain the phenomenon. In terms of consumer protection problems, one of the most prominent was that interest on the products concerned tended to be charged at “adjustable rates”, giving banks considerable room to subsequently make unilateral changes to their customers’ contractual interest rates. Regulatory intervention was also impeded by the possibility of regulatory arbitrage (branching and the transition to direct foreign lending) (Bethlendi et al., 2015). As a result of the foregoing, households’ repayment burdens did not only increase as a result of the depreciating forint: financial institutions’ unilateral changes to interest rates on foreign currencybased agreements also had a major effect. The issue of unilateral interest rate increases was made particularly relevant by the fact that in the aftermath of the crisis, banks counterbalanced their higher losses partly by applying higher interest rates on household debt. The Hungarian practice was not universal, as is well illustrated by the example of Poland, where interest rates on household foreign currency-based loans were tied to CHF-LIBOR movements (Chart 13-3). Consequently, following the crisis the decline in reference rates reduced instalments on Polish foreign currency loans. To a certain extent, this was sufficient to offset the negative effect of the depreciating zloty, as a result of which the overall problem caused by foreign currency lending was more moderate in Poland than in Hungary. Finally, it also deserves to be mentioned that Hungary lacked the broader institutional factors (financial literacy, consumer awareness and financial competence) to ensure that a sophisticated and highly unpredictable product such as foreign currency loans spread without — 427 —

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the build-up of risks (Kolozsi, 2015). Borrowers were not sufficiently informed and competent, which prevented them from assessing the risks involved in this type of product, and consequently from making rational, informed decisions. Chart 13-3: Interest rates on outstanding Swiss franc-based home loans in Hungary and Poland 7

Per cent

Hungary

Poland

2014

2013

2012

2011

2010

2009

2008

2007

CHF LIBOR (3M)

Sources: MNB, NBP, SNB.

As a result of the spread of household foreign currency-based loans, by 2008 the portfolio of such loans had grown to significant proportions within the balance sheet of the banking system. Such transactions accounted for a mere 2.5 per cent of the balance sheet total84 at the end of 2004 and reached 16.5 per cent by the end of 2009, while some 70 per cent of all household loans were already foreign currency or foreign currency-based loans. Due to rapid credit growth, as part of which banks increasingly targeted less creditworthy borrowers, risky portfolios were built quickly, a major part of which subsequently became non84

ombined balance sheet total of the banking system and Hungarian branches of C foreign credit institutions.

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13 Monetary policy considerations for the conversion of foreign currency loans...

performing. The rapid and abrupt build-up of risks is well illustrated by the fact that some 70 per cent of the non-performing mortgage loans outstanding as at June 2016 were disbursed in the space of two years between 2007–2008, and that on average, approximately 40 per cent of the mortgage loans disbursed in those years have since become non-performing (Chart 13-4).85 Chart 13-4: Household mortgage loans outstanding as at the end of 2016 H1 by month of disbursement 180

HUF Billions

Per cent

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

120

2003

2002

150

Non-performing mortgage loans Mortgage loans total Ratio of non-performing-loans (right-hand-scale) Source: CCIS.

or the purposes of this chapter, a non-performing loan is defined according to the F classification used by the Central Credit Information System, where an agreement is classified as non-performing if it has accumulated past due debt exceeding the minimum wage for at least 3 months.

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13.2 What were the Consequences of the spread of foreign currency lending to households? The spread of foreign currency lending to households had significant negative consequences for both the banking system and borrower households, while the phenomenon also affected the effectiveness of the central bank’s monetary policy by weakening transmission. The negative effects of foreign currency lending to households are explained following three distinct threads: (1) the increase in repayment burdens due to a depreciating forint and soaring loan rates, which led to loan defaults on a massive scale; (2) the effect on bank liabilities, which increased banks’ vulnerability and dependence on swap markets via the risky structure of their foreign exchange liabilities; and (3) the effect on the transmission channel, which eroded the effectiveness of the central bank’s interest rate policy, due to the large volume of foreign currency-based loans.

13.2.1 Increased repayment burdens and credit risk

With the spread of foreign currency lending, households built up significant open exchange rate positions as their foreign currencydenominated debt increased significantly, for the most part, without being covered by foreign currency incomes (receivables). By leaving the exchange rate risk of foreign currency loans with households, the banking system significantly increased the credit risk of this portfolio. As a combined result of the depreciation of the forint against the euro, and the depreciation of the euro against the Swiss franc, the regular monthly repayments and overall debt of households indebted in Swiss francs increased significantly, by over 50 per cent in most cases, and by up to 80 per cent in some cases. The burdens on households that — 430 —

13 Monetary policy considerations for the conversion of foreign currency loans...

had taken out euro-based loans increased to a lesser extent, but those loans were of more moderate risk anyway from a financial stability and social perspective due to their lower volume. As the forint depreciated and forint-denominated repayment burdens increased sharply, a large number of borrowers with foreign currencybased loans became insolvent. From 2009 onwards, the proportion of household non-performing loans increased significantly: while at the end of 2008 90+ days past due loans accounted for 3.5 per cent of household loans within the banking system, that ratio subsequently increased steadily to reach 19.2 per cent by the end of 2014. The deterioration of the macroeconomic environment in the aftermath of the crisis also increased the default ratio of household forint loans, but even so this effect was nowhere near the ratio seen in the case of foreign currency loans. By 2014, approximately one in every five household foreign currency-based loans, and one in every four foreign currencybased home equity loans had become non-performing, The default of household foreign currency-based loans on a massive scale gave rise to one of the most severe financial stability problems in the Hungarian banking system. As the ratio of non-performing loans increased, banks were forced to write off major losses. From 2010 onwards, the banking system wrote off 2.5 per cent to 3 per cent of the household loan portfolio as a loss every year,86 which is arguably a high ratio compared to the 1 per cent average seen before the crisis.

riting off a loss comprises the impairment recognised on the loans, the write-off W of the loans themselves, and the losses incurred from the sale of the loans.

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13.2.2 Development of stress on bank liabilities

The large foreign currency-based exposure building up on the asset side of the balance sheet of the banking system created a need for new foreign liabilities.87 At the end of 2008, foreign liabilities accounted for some 34 per cent of the liability side of the banking system in the amount of just over HUF 10,000 billion, about one-third of which were short-term. However, this was accompanied by an open balance sheet position of nearly HUF 3,500 billion in the banking system, and most of that “gap” had to be covered by means of FX swaps. As a consequence of the foregoing, financial institutions became highly dependent on swap market operations. Dependence of foreign funds and particularly on swap markets made the banking system vulnerable, and during the crisis the pressures developing in the swap markets caused major problems for banks (Páles et al., 2010). Due to the increased risk aversion of foreign investors financing it, the banking system could only roll over expiring foreign debt, in the case of both off-balance sheet and on-balance sheet items, at a higher cost and in shorter terms (MNB, 2009). Banks’ large volume of external funds and swaps related to foreign currency lending led to a persistently high level of external and short-term external debt in the overall national economy (Kovács, 2009). Given that one of the most widely used indicators of central bank reserve adequacy, and the most relevant one from a Hungarian perspective, is the Guidotti rule based on short-term external debt, foreign currency lending to households indirectly required the central bank to hold a high level of reserves at its own cost.88 anks had two means to finance their ballooning foreign currency asset holdings: B on the one hand through the direct acquisition of foreign currency liabilities, and on the other hand through FX swaps, which are off-balance sheet items. Banks owned by foreign parent banks had easier access to foreign currency funding, while for banks lacking such a background, hedging via the swap market was more relevant. 88 The cost of holding central bank reserves arises from the need for the MNB to pay a higher interest rate (base rate) on the sterilisation assets than the returns it can earn on its foreign exchange reserves. 87

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13 Monetary policy considerations for the conversion of foreign currency loans...

13.2.3 Transmission mechanism

The wide spread of household foreign currency-based loans also influenced the effectiveness of the central bank’s monetary policy by introducing reverse effects to the monetary transmission mechanism. The ballooning foreign currency debt of households eroded the effectiveness of the interest rate channel. The transmission mechanism of monetary policy exerts its effects partly by means of the central bank’s policy rate, which leads to the re-pricing of financial instruments, including household credit products (interest rate channel of the transmission mechanism). However, as the interest rate on foreign currency-based loans is independent of domestic monetary policy decisions, the central bank was unable to use this channel to influence the consumption and savings decisions of a major part of the household sector. Moreover, the exchange rate channel produced effects contrary to its objective: for example, through a depreciating forint, a measure of expansionary monetary policy reduced the disposable incomes and net assets of households indebted on a foreign currency basis. As a result, households became much more sensitive to movements in the forint exchange rate, which, however, the MNB was only able to influence in the short term and to a lesser extent (MNB, 2014). In addition to the foregoing, the general risks discussed above (defaulting borrowers and banks’ stability problems) further reduce the effectiveness of transmission. When financial institutions face capital and liquidity problems, they may restrict their credit supply to such an extent that prevents them from the smooth transmission of changes in monetary policy.

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13.3 Timing the phase-out of household foreign currency loans89 The above risks became obvious following the onset of the crisis, as a result of which the need for the conversion of foreign currency loans repeatedly emerged (see Balás–Nagy, 2010 for the background to this). Timing the phase-out of household foreign currency loans required the following conditions to be met: – secure legislative environment: the legal environment had to ensure that conversion was implemented in a legally unambiguous situation, i.e. that no legal issues of significance remained unresolved that, when judged differently at a later time, might question the legal grounds for the conversion process; – low forint interest rates: conversion would have the required level of social support when the interest rate and other terms of the forint loans replacing the foreign currency loans were effectively not less favourable than those being replaced, i.e. when conversion did not place borrowers at a disadvantage even in the short term; – s table and consolidated macroeconomic environment: the conversion of a large volume of foreign currency debt might involve a substantial amount of uncertainty when the macroeconomic environment was not stabilised and consolidated; consequently, conversion would require a degree of improvement in the perception of the national economy concerned that enabled the conversion to be implemented without any relevant market risks; – available uncommitted foreign exchange reserves: closing banks’ foreign currency positions which opened as a result of conversion would generate strong demand from banks for foreign currency, the 89

This chapter relies heavily on Kolozsi–Banai–Vonnák (2015).

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13 Monetary policy considerations for the conversion of foreign currency loans...

satisfaction of which required foreign currency liquidity; i.e. to the extent that any single, fundamentally unjustified movements in the exchange rate were to be avoided, conversion would require that central bank reserve adequacy was ample in comparison with the volume of foreign currency debt to be converted. In the following, we argue that in terms of the relevant factors, conversion was implemented at the first point in time when it was both feasible legally and adequately supported economically.

13.3.1 Changes in the legislative environment

In the legal sense, the foundations of conversion were laid by the uniformity decision of the Curia promulgated in June 2014. The uniformity decision of the Curia gave unambiguous guidance on three issues: (1) Passing exchange rate risk onto borrowers cannot fundamentally be considered unfair; however, if the exchange rate risk incorporated into the contract cannot be understood by an average borrower, this could render the respective contract void. In economic terms, this means that the exchange rate risk is essentially incurred by borrowers. (2) Any unilateral increase to interest rates is unfair and unlawful, as far as it is not clear and transparent for the borrower to what extent changes in certain conditions impact payment obligations. The decision of the Curia requires that the principles of proportionality, factuality and symmetry be considered in the course of interest rate increases. (3) Applying exchange rate spreads as fees is unfair and void in all cases and in all circumstances. The decision of the Curia was of special importance due to the fact that in the settlement of household foreign currency loans judicial recourse â&#x20AC;&#x201D; 435 â&#x20AC;&#x201D;

Part II: Challenges and Answers in Hungarian Monetary Policy

was increasingly taken as the macroeconomic situation and households’ incomes deteriorated due to the economic crisis.90 As a result, the comprehensive government measure related to household foreign currency lending had to be preceded by closing the unresolved legal issues arising from litigation. 1. The decision of the Curia implied that a settlement had to be made between the banks and customers with regard to overpayments due to unilateral interest rate and fee increases and to the application of exchange rate spreads. 2. Following the decision of the Curia, the required legal basis and legitimacy were given to carry out the settlement, since the Curia definitively put an end to the disputes. 3. The decision of the Curia was necessary to determine the exchange rate applied for conversion purposes. It was established that borrowers would be required to incur the exchange rate risk, which implied the application of the market rate. Overall, the uniformity decision of the Curia provided the grounds for the general settlement of issues related to household foreign currency and foreign currency-based loans, which the government implemented by law.91 The Act prescribed that banks were required to reimburse borrowers for overpayments resulting from unilateral interest rate increases and the application of exchange rate spread at the time of disbursement and repayments as if borrowers had used such overpayments to make early capital repayments each month. The detailed methodology of the measure was developed by the MNB, and was implemented by the banks within the few months available, in the course of which the central bank provided support and was available for consultation on an ongoing basis. The scale of the measure is indicated by the number of contracts covered by the Act, which 90 91

The Interest Group of Bank Debtors (BAÉSZ) was established in 2009. Acts XXXVIII and XL of 2014.

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13 Monetary policy considerations for the conversion of foreign currency loans...

approximated 2 million even in the case of only foreign currency and foreign currency-based loans. The methodology developed by the MNB ensured that the damage caused to borrowers was converted to its present value using the appropriate interest rates up to the time of its payment upon settlement. The settlement and conversion were closely related economic policy measures, which were implemented at the same time, but for different purposes. While settlement “reimbursed” borrowers under the acts adopted pursuant to the uniformity decision of the Curia for their losses resulting from banks’ inappropriate practices before the crisis, the aim of conversion was, pursuant to the decision of the legislator, to eliminate the exposure of consumers, i.e. households, to exchange rate risk.

13.3.2 Falling interest rates on forint loans

By 2014, forint interest rates had dropped to a level which ensured that conversion would not imply, even in the short term, an interest rate increase for foreign currency borrowers (Chart 13-5). There were two reasons for this: 1. The MNB started its easing cycle in 2012, in the course of which by the summer of 2014 the central bank base rate declined from 7 per cent to 2.1 per cent, accompanied by a similar decline in the level of interest rates in the whole economy. This was important to make sure that the conversion did not entail an increase in interest rates and instalments. 2. The adoption of the Fair Banking Act facilitated households’ transition to forint loans, and kept any subsequent re-pricing operations within the bounds of transparency.

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Chart 13-5: Retrospective comparison of Hungarian household foreign currency loans and forint interest rates calculated on the basis of fair banking rules 16

Per cent

0 2007

2008

2009

2010

2011

2012

2013

2014

Fair banking Fair banking max. interest rate Fair banking min. interest rate Hungary, interest rate of outstanding CHF housing loans BUBOR (3M) CHF LIBOR (3M) Source: MNB.

13.3.3 Stabilising macroeconomic background

Against the backdrop of a vulnerable and exposed national economy, both settlement and conversion would only have been possible in the presence of significant market risks, which would have threatened to compromise financial stability and substantially hurt investors’ perceptions. Owing to the consolidation of economic policy and particularly of public finances,92 and to the improvement of Hungary’s overall risk perception, by 2014 an economic environment had emerged in which household foreign currency loans could be phased out without any substantial market risks. This was confirmed by the significant decline in the country’s risk indicators by 2014, e.g. the 2014 autumn CDS spread of 150 to 170 base points can be considered low even by historical standards. 92

For more details, refer to Baksay–Palotai–Szalai (2015).

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13 Monetary policy considerations for the conversion of foreign currency loans...

13.3.4 Smaller volume of foreign currency debt, increasing central bank leeway

The viability of the programme was aided by the fact that by 2014 the volume of foreign currency mortgage loans yet to be converted had dropped to EUR 9 billion from its previous peak of EUR 19 billion as a result of the ban on foreign currency lending, the early repayment scheme, and the amortisation of loans as part of normal operations. The phase-out of foreign currency loans, i.e. settlement and conversion, influences bank profits on the one hand, while it also significantly reshapes the balance sheets of banks. In terms of balance sheet effects, both settlement and conversion contribute to a reduction in banks’ foreign currency receivables and to the opening of their exchange rate positions, which banks will close for both operational and regulatory reasons,93 for which they need to purchase foreign currency. The foreign currency requirement generated by the need to hedge the settlement and conversion of foreign currency loans could have placed considerable pressure on the forint exchange rate in the case of foreign currency purchases from the market. Thus, an essential condition for orderly conversion was that the MNB should have the amount of foreign currency required for bank hedges and should be able to provide banks with that amount of currency in a way that even after conversion, the volume of foreign currency reserves did not drop below the level expected by the market and international organisations.94 With the reduction in short-term external debt, which has a particular influence on reserve requirements, by 2014 the reserve adequacy of the MNB (based on the Guidotti indicator) reached the level that allowed for safe conversion (Chart 13-6).

lthough not all banks will close their open positions completely, open exchange A rate positions involve an additional capital requirement, which is costly. On the other hand, banks are not willing to undertake excessive risks with regard to exchange rates, which is why most of them seek to achieve almost closed positions. 94 For details on the foreign exchange reserve targets set by modern central banks, refer to Nagy–Palotai (2014). 93

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Chart 13-6: The MNB’s foreign exchange reserves and short-term external debt 45

HUF Billions

45 40

2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011 2011 2011 2012 2012 2012 2012 2013 2013 2013 2013 2014 2014 2014 2014 2015

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1

MNB currency reserves

Short term external debt

Source: MNB.

13.4 The central bank’s foreign currency sale programme to support the phase-out of household foreign currency loans In respect of the central bank programme required for conversion, consideration had to be given to the separation of the legal and economic conversion in the case of the phase-out of foreign currency loans. – Legally, currency is considered converted when a previously foreign currency-denominated loan is recorded in the bank’s books as a forint loan. – Economically, however, a foreign currency loan pegged to a fixed exchange rate may also be considered as a forint loan because debt will subsequently “behave” as a forint loan. — 440 —

13 Monetary policy considerations for the conversion of foreign currency loans...

Conversion in the economic sense, which was relevant to transactions between the central bank and banks, was implemented by signing the agreement between the government and the banks on 9 November 2014 and applying the subsequent hedge, while legally banks were required to apply the conversion in their books by 31 March 2015.

13.4.1 The phase-out of household foreign currency mortgage loans

Due to the wide range of banks’ circumstances and business policies, several models emerged in the Hungarian banking sector for financing and hedging foreign currency positions. Nevertheless, irrespectively of the financing model followed, banks will respond to settlement and conversion by closing the foreign exchange open positions, which – depending on the model of foreign currency lending and the costs incurred – means either repayment of foreign currency funds or the closing of FX swaps. Both solutions will involve a foreign currency requirement. 13.4.1.1 The structure and components of the settlement and conversion programme

Aiming to meet banks’ foreign currency requirements, the central bank’s foreign currency sale programme was based on the following strategic assumptions, and respectively designed with the following considerations in mind. – “Given its duties to ensure financial stability as set out in the Central Bank Act, and due to the responsibility which it understands to have in resolving the issue of foreign currency lending, the MNB is required to occupy a role in the orderly phase-out of foreign currency loans, and in the administration of settlement and conversion.”95 – The objective of the central bank programme is “to ensure that household foreign currency loans were phased out rapidly, in an 95

agyar Nemzeti Bank: The Magyar Nemzeti Bank will supply banks with the M amount of foreign currency required for the phase-out of household foreign currency loans. Communication, 24 September 2014.

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orderly manner, preserving the stability of the financial system, and without any major impact on the exchange rate of the forint”.96 – Conversion and banks’ hedging needs are separated from each other because the latter emerges immediately as conversion exchange rates become known, while actual conversion may also take place at a different time. – Hedging needs may also emerge separately from the related use of foreign currency reserves, because the changes in exchange rate positions and the use of foreign currency, i.e. the repayment of foreign currency funds and the closing of swaps, do not necessarily coincide in time. – The foreign currency requirement related to settlement and conversion emerges gradually and is spaced out over several years, i.e. the use of reserves is not necessarily concentrated either. – The central bank’s reserve adequacy must be ensured continuously throughout the programme. – Although the foreign currency requirement is given, bank adjustment is relevant to the central bank’s foreign exchange reserve requirement, because if their behaviour is cooperative, the reserve requirement might also decline. – It is appropriate that the instruments of foreign currency supply be designed with consideration to banks’ maturity structures, and to the financing models and hedging instruments used. Based on the above considerations and due to the particular importance attached to the foreign exchange reserve requirement, the related central bank instruments had to be designed to ensure banks’ interest in reducing short-term external debt, as a fundamental factor in determining the required level of foreign exchange reserve, or, where 96

Ibid.

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13 Monetary policy considerations for the conversion of foreign currency loans...

no such reduction could be made,97 to ensure that banks’ access to foreign currency was spaced out over time. With that in mind, the MNB introduced two central bank instruments to phase out foreign currency mortgage loans, which accounted for a majority of household foreign currency loans:98 – a foreign currency sale instrument conditional on a reduction in short-term external debt, where the MNB prescribed that banks should reduce their short-term external debt at least by 50 per cent of the foreign currency received; – a longer-term unconditional instrument for the sale of foreign currency, which was a combination of a spot euro sale transaction and a FX swap, and primarily provided a hedging option for banks that could not reduce their short-term external debt due to their financing structures built on long swap transactions or long-term debt. In the settlement phase, under the unconditional facility banks could only access foreign currency liquidity at maturities longer than one year, and later, with the improvement of reserve leeway, the MNB announced three maturities in 2015 for conversion tenders (due to the short maturities, in these cases the central bank concluded FX swap transactions, and bank access was also limited). Both instruments supported the reserve adequacy objective. In the case of the conditional central bank instrument, foreign exchange reserves would decrease over the short term, whereas through the repayment of short-term external debt, the MNB’s need for reserves would also decrease, giving the central bank more leeway. The unconditional he reduction of banks’ short-term external debt may be constrained by the following T factors: (a) the volume of foreign deposits is exogenous to banks; (b) the balances of margin accounts associated with derivative transactions are also exogenous; (c) there may be difficulties in early repayments on short-term external debt; (d) banks may have an interest in maintaining a certain amount of short-term external debt in order to ensure the consistence of maturities and to manage interest rate risk. 98 Magyar Nemzeti Bank (2015). 97

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instrument would not reduce the level of foreign exchange reserves over the short term, but – adjusted to the banks’ needs – the use of the reserves would be spaced out over time. 13.4.1.2 Terms of settlement and conversion tenders

Due to the significant volume involved, the programme was crucially dependent on coordinated execution, which the MNB ensured through consultations and formal agreements with banks. The central bank announced the settlement phase on 23 September 2014, and managed the conversion phase by expanding the settlement programme. Regarding the latter, a decision was adopted by the Monetary Council at its meeting on 4 November 2014. Compared to settlement, conversion tenders featured two new aspects: (1) by nature, forint conversion generated much higher demand for foreign currency than settlement; and (2) the need for hedging was much more concentrated than in the case of settlement. The latter was due to the fact that in the case of settlement, due to legal discrepancies and differences in the interpretation of accounting settlement, the foreign currency requirements of banks emerged at different times, whereas in the case of conversion, banks’ foreign currency positions opened and hedging needs emerged immediately as conversion exchange rates were announced. Taking into consideration the above, the following measures were taken by the MNB. – On 23 September 2014, i.e. two months before the Conversion Act was adopted on 25 November 2014, the MNB decided to supply the banking system with the amount of foreign currency required to phase out household foreign currency loans. The central bank’s decision assured the banks that their foreign currency requirements resulting from settlement and conversion would not need to be hedged in the market. – The maximum amount of funds to be used by banks was already fixed by the MNB in the context of settlement during consultations with banks, — 444 —

13 Monetary policy considerations for the conversion of foreign currency loans...

but on 7 November 2014, the MNB also concluded a formal agreement for participation in conversion tenders with each of the counterparty banks concerned. In that agreement, the MNB undertook to provide its counterparty credit institutions with the full amount of foreign currency required for the hedges related to conversion. Credit institutions entering into specific agreements with the central bank agreed to obtain the amount of foreign currency required for their hedges from the central bank rather than from the foreign currency market. The agreement was signed by all banks with significant portfolios of consumer foreign currency and foreign currency-based mortgage loans. – On 7 November 2014, the MNB and the Hungarian Banking Association entered into an agreement, which contained detailed provisions for the key business terms of conversion-related transactions. – To meet banks’ foreign currency requirements to the greatest possible extent, the MNB adjusted the terms of its instruments for the sale of foreign currency: • conditional instrument: for the conversion phase, the MNB allocated a combined frame amount that was applicable collectively for the two instruments, whereas separate limits were set for settlement; • unconditional instrument: in addition to the maturities in 2016 and 2017, the MNB also marketed a limited amount of the instrument for certain maturities in 2015, which could be more advantageous for banks financing their foreign currency loans through short-term FX swaps.99 With both euro sale instruments, the MNB launched a fixed-price100 tender subject to bank limits. The MNB supplied the banks with euro, 99

Magyar Nemzeti Bank (2015). As regards pricing, reference points may be provided by several approaches. It is appropriate to take into account the arbitrage-free band of FX swaps and that – due to a term premium – long-term liabilities are typically available at higher interest rates, i.e. maintaining long-term liabilities while repaying cheaper shortterm liabilities represents a more costly financing structure for banks compared to the early repayment of long-term liabilities.

100

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and the exchange rate risk between the euro and the Swiss franc had to be hedged by the banks. 13.4.2 Phasing out consumer non-mortgage foreign currency loans

Following the forint conversion of consumer foreign currency and foreign currency-based mortgage loans in the autumn of 2014, households’ balance sheets still included foreign currency debt, and households’ remaining foreign currency debt of HUF 300 billion with some 250,000 contracts, mostly in Swiss franc-based vehicle and personal loans, also carried risk in macroeconomic terms due to its broad social impact and to strong fluctuations in the exchange rate of the Swiss franc. On 4 June 2015, the Monetary Council adopted a decision on the MNB’ participation in the conversion of consumer non-mortgage foreign currency and foreign currency-based loans. The Council allocated a EUR 1.1 billion facility to the conversion of the loans concerned. Consumer non-mortgage foreign currency loans differed from mortgage loans in several respects, which was also of relevance to the development of the related central bank programme: (1) they represented a considerably smaller volume (EUR 1.1 billion as opposed to approximately EUR 9 billion); (2) the smaller volume allowed disbursements to be made in Swiss francs; (3) apart from the banking sector, a substantial volume of such debt was held by financial institutions, which were not central bank counterparties. The MNB designed its instruments accordingly. – To ensure the broadest possible coverage for the MNB’s conversion programme, the institutions concerned outside the conventional — 446 —

13 Monetary policy considerations for the conversion of foreign currency loans...

group of central bank counterparties were allowed to participate in MNB tenders as correspondents through the intermediation of counterparty credit institutions. – Since the vast majority of consumer foreign currency and foreign currency-based loans were denominated in Swiss franc, the MNB supplied credit institutions with Swiss francs for conversion. The first tender was held on 24 August 2014, and was followed by another three tenders until 21 September 2014. – Ample foreign exchange reserve adequacy eliminated the need for a conditional instrument: the MNB’s reserves allowed the central bank to supply banks immediately with the required amount of foreign currency. Given the inability of credit institutions to use the Swiss francs purchased promptly in a single amount due to the fact that their maturities were spaced out over time, in addition to the spot purchase and sale of Swiss francs the central bank also provided access to a one-week reverse FX swap, to be rolled over for up to 52 weeks following the first tender. This allowed Swiss franc disbursements to be made progressively, in alignment with the dates and amounts of banks’ maturities. In the Swiss franc tenders, the MNB made spot Swiss franc sales to credit institutions at the official MNB mid-rate for the day concerned, available to each credit institution up to the volume of its own foreign currency loans. In tenders, the participation of each credit institution was set at the value of its debt holdings concerned, net of impairment, as at 31 March 2015. The exchange rate applied to loans was set in Act CXLV of 2015 on the Settlement of Certain Issues Related to the Conversion of Claims Arising from Certain Consumer Loans to Forint. The exchange rate to be applied for forint conversion was set as the official foreign exchange rate of 19 August 2015. Both participating credit institutions and their correspondents were obliged to use the foreign currency acquired in Swiss franc sale tenders — 447 —

Part II: Challenges and Answers in Hungarian Monetary Policy

exclusively for the forint conversion of consumer non-mortgage foreign currency and foreign currency-based loans. The MNB checked the use of foreign currency with each bank on an itemised basis.

13.4.3 Results of central bank tenders related to phasing out household foreign currency loans 13.4.3.1. Settlement and conversion tenders for mortgage loans

The MNB held the first tender of the settlement phase for mortgage loans on 13 October 2014, whereas tenders of the conversion phase started on 10 November 2014. The MNB held a total of 12 tenders, which involved highly concentrated sales of more than EUR 9.1 billion to banks (Table 13-1). Table 13-1: Results of settlement and conversion tenders Utilization of note bank tools related to settlement and HUF conversion (EUR million) Date of tender 1.23.2015

Tools related to settlement

Tools related to HUF conversion

Conditional

Unconditional

Conditional

Unconditional

—

102

12.22.2014

—

12.8.2014

—

12.1.2014

—

11.24.2014

—

11.17.2014

—

11.11.2014

—

11.10.2014

1627

6207

7834

11.3.2014

—

10.27.2014

—

10.20.2014

—

10.13.2014

230

750

—

980

Sum:

293

788

1655

6391

9127

Source: MNB.

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13 Monetary policy considerations for the conversion of foreign currency loans...

According to the calculations published by the MNB, through conversion, the volume of consumer foreign currency and foreign currency-based mortgage loans in the banking system dropped from EUR 10.8 billion at the end of September 2014 to approximately EUR 9 billion. For conversion purposes, this volume figure needs to be adjusted by the more than EUR 1.5 billion impairment loss accounted for on the loans concerned, and with the part of that impairment loss released due to settlement (EUR 0.4–0.6 billion). Banks’ hedging requirement related to conversion therefore amounted to some EUR 8 billion.101 Thus overall: – the MNB allocated EUR 1 billion to the banking system to hedge bank settlements related to exchange rate margins and unilateral increases of interest rates or interest rate spreads and the settlements were completed without any substantial exchange rate effect; – the EUR 8 billion allocated in the MNB’s conversion tenders means that banks effectively hedged the entire conversion with the MNB, allowing household foreign currency loans to be phased out without any substantial exchange rate effect. 13.4.3.2. Conversion tenders for consumer non-mortgage foreign currency loans

In the four tenders for the conversion of consumer foreign currency loans, the MNB sold a total of CHF 605 million to banks, against approximately HUF 174 billion (Table 13-2). Table 13-2: Results of the conversion tenders for consumer foreign currency loans Tender Date

Swiss franc/HUF Maximum Allotted amount spot exchange offered amount (CHF million) rate (CHF million)

HUF countervalue (HUF billion)

15.09.21

289.32

592

0.3

15.09.27

283.96

597

2.2

0.9

15.08.31

291.5

595

9.9

2.9

15.08.24

287.22

1183

591.9

170

Source: MNB. 101

agyar Nemzeti Bank: The MNB’s foreign currency sale tender is a success: banks M hedged forint conversion almost in full. Communication, 10 November 2014.

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13.4.4 The effect of the central bank’s foreign currency sale programme

The central bank’s foreign currency sale programme enabled household foreign currency loans to be phased out rapidly, in an orderly manner, and without any major impact on the exchange rate of the forint. The following sections address two aspects in more detail: the effect of the programme on liquidity in the banking system, and its effect on central bank reserve adequacy. 13.4.4.1 Liquidity effect

The liquidity conditions for phasing out household foreign currency loans were clearly provided in the autumn of 2014, because the surplus forint liquidity in the Hungarian banking system as a whole significantly exceeded the liquidity requirement of settlement and conversion.102 In the autumn of 2014, banks kept HUF 4,800 to 5,100 billion in the MNB’s main policy instrument, while the forint requirement for phasing out foreign currency loans was approximately HUF 3,000 billion to which, due to the temporal dispersion of foreign currency use, it should be added that liquidity in the banking system tends to increase due to factors outside the scope of central bank programmes (primarily EU funds and the Funding for Growth Scheme). The conditions of the central bank’s foreign currency sale instruments provided for a gradual decline of forint liquidity in the banking system (Chart 13-7). – The net sterilisation holdings of the banking system had been volatile up to April 2015, with monthly averages in the HUF 5,100 to 5,600 billion range. – Between April and October 2015, average monthly holdings decreased gradually from the local maximum of HUF 5,626 billion to HUF 3,769 billion, then fluctuated around HUF 4,000 billion until February 2016. 102

he level of liquidity in the banking system is important because supposing T well-functioning interbank markets, it also allows any individual bank liquidity problems to be handled.

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13 Monetary policy considerations for the conversion of foreign currency loans...

Chart 13-7: Course of the MNB’s conditional and unconditional swaps 3,000

EUR Millions

Closed volumes

2,500

3,000 2,500

698

2,000

1,500

500 180

247 2017 Q4

590

2017 Q3

2016 Q2

2016 Q1

613

2017 Q2

2015 Q4

373

2017 Q1

120

784

2016 Q4

10 259 2015 Q3

1056 2015 Q2

500

1,000

102

2016 Q3

2082

1,000

Unconditional FX-swap and CIRS volumes closed earlier on closing tenders Unconditional FX-swap and CIRS volume normally matured (2nd, 3rd and 4th quarters in 2015 and in 2016) Current CIRS deals' volume of unconditional note bank FX tools Source: MNB.

– The major drop in liquidity seen in March 2016 was largely attributable to the forint conversion swap of more than EUR 2 billion maturing at the time, because on maturity, banks exchange forints for euros with the MNB. The negative liquidity effect in March 2016 was financed by the banking system by borrowing from the central bank, i.e. the process of bank adjustment was functioning smoothly. – Due to additional swap maturities in 2016 (and to restrictions on 3-month deposits and the resulting crowding-out effect, see Chapter 16), net sterilisation holdings dropped to HUF 1,333 billion by the end of September, and to HUF 900 billion by the end of December 2016 (Chart 13-8).

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Chart 13-8: Developments in the holdings of sterilisation assets, 2014—2016 HUF Billions

HUF Billions Currency maturities related to HUF conversion, repayment of EU-loan

Two-week deposit Other deposit Net sterilization volume

Oct. 2016

Jul. 2016

Apr. 2016

Jan. 2016

Oct. 2015

Jul. 2015

Apr. 2015

Jan. 2015

Oct. 2014

Jul. 2014

May. 2014

Limitation of two-week deposit, introduction of three-month deposit

Jan. 2014

6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 –500

Three-month deposit Lending tools

Note: monthly average values. Source: MNB.

The vast majority (CHF 554.7 million) of the CHF 605 million allocated in the Swiss franc tenders held in August and September 2015 was transferred to the banks by the end of October 2015. The rolled-over Swiss franc holdings had been completely removed from the MNB’s balance sheet as of 13 April 2016. Forint liquidity in the banking system had essentially narrowed by the end of October 2016 in connection with Swiss franc swaps (Chart 13-9). Overall, the drop in liquidity, caused by the phase-out of foreign currency and foreign currency-based mortgage loans and other consumer loans, obviously affected the framework of liquidity management, but given the possibility to prepare for and foresee the developments involved, it did not cause any liquidity strains in the banking system. — 452 —

13 Monetary policy considerations for the conversion of foreign currency loans...

Chart 13-9: Developments in Swiss franc holdings allocated in the MNB’s foreign currency tenders 700

CHF Millions

700

600

500

400

300

200

100

100 0 8.26.2015 9.2.2015 9.9.2015 9.16.2015 9.23.2015 9.30.2015 10.7.2015 10.14.2015 10.21.2015 10.28.2015 11.4.2015 11.11.2015 11.18.2015 11.25.2015 12.2.2015 12.9.2015 12.16.2015 12.23.2015 12.30.2015 1.6.2016 1.13.2016 1.20.2016 1.27.2016 2.3.2016 2.10.2016 2.17.2016 2.24.2016 3.2.2016 3.9.2016 3.16.2016 3.23.2016 3.30.2016 4.6.2016 4.13.2016

Rolled-over one-week swap volume Total currency allotted on tenders Currency taken Source: MNB.

13.4.4.2 Effect on reserve adequacy

The first part of this paper explained that by 2014, decreasing shortterm external debt and the increasing size of the MNB’s foreign exchange reserves provided the reserve leeway that enabled the foreign currency sale required for settlement and conversion to be carried out by retaining the adequate size of the foreign exchange reserves. Between 2015 Q1 and 2016 Q3, the central bank had approximately EUR 8 billion worth of FX swaps maturing and reduced its foreign exchange reserves by the same amount. During the period, owing to conversion and also in particular to other central bank programmes designed to reduce external vulnerability, the MNB’s international reserves dropped from EUR 37 billion to less than EUR 24 billion, accompanied by a major decrease in short-term external debt to EUR 19 billion. The following — 453 —

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MNB programmes also contributed to the reduction in short-term external debt. 1. Conversion, partly by reducing short-term external debt by means of the conditional instrument, and partly by reducing external debt as a structural concomitant of phasing out household foreign currency loans. 2. Self-Financing Programme, by reducing the foreign currency and external debt of general government (see Chapter 14 for the Programme). Chart 13-10: Developments in central bank reserves and short-term external debt 40

HUF Billions

EUR –8.5 bn

2016 Q3

2016 Q1

2015 Q3

2015 Q1

2014 Q3

2014 Q1

2013 Q3

2013 Q1

2012 Q3

–21 2012 Q1

15 2011 Q3

–16

2011 Q1

2010 Q3

–11

2010 Q1

2009 Q3

–6

2009 Q1

2008 Q3

–1

2008 Q1

International reserves Maturing conversion-related swaps Short-term external debt Note: The value of end-of-year short-term external debt for 2016 is a preliminary estimation calculated on the basis of incomplete data. Source: MNB.

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13 Monetary policy considerations for the conversion of foreign currency loans...

Overall, settlement and conversion, in combination with other central bank programmes, did not compromise the central bank’s reserve adequacy: both at the end of 2016 and looking forward, foreign exchange reserves are certain to provide a sufficient hedge against short-term external debt, which is the primary factor shaping Hungary’s external vulnerability (Chart 13-10).

13.5 “New” debt: more leeway, lower risk? Conversion and settlement brought about significant changes in agreements for household foreign currency loans. Settlement modified borrowers’ outstanding debt and interest rates,103 whereas conversion changed the currency of their loans and subsequent interest payments. Accordingly, borrowers were faced with lower forint debt, which typically started to accrue interest at or below the initial (foreign currency) interest rate, while the subsequent interest rate was set depending on the 3-month BUBOR and the new “fair banking” rules. Of the contractual elements determining the repayment burden, only residual maturity remained unchanged, although that may also have changed with borrowers participating in the exchange rate cap programme. Below we describe the extent to which the new characteristics of debt resolved the macroeconomic problems identified in the first part of the paper. The assertion made there was that from a central bank perspective, the spread of foreign currency loans generated harmful effects partly by reducing the effectiveness of the transmission mechanism, and partly by inducing financial instability.

103

he issue of interest rates was settled technically in the Conversion Act, while T logically the reversal of unfair interest rate increases is attributable to the Curia decision and settlement. This is also confirmed by the fact that several banks had reset customers’ interest rates to the level applicable at the time of contracting even before the interest rules provided for in the Conversion Act took effect.

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The strength of interest rate transmission was clearly increased by the measures, because the interest payments of debt exceeding HUF 3,000 billion were made dependent on the interbank rate, and ultimately on the base rate set by the MNB. Pursuant to the legislator’s decision, the interest rate became variable, which obviously increases the central bank’s flexibility in that the base rate varying in accordance with Monetary Council decisions will automatically be priced in the interest rates charged on debt within 3 months. Interest rates tied to the BUBOR also give more space to unconventional monetary easing (i.e. carried out by other means than through the base rate), which the MNB exploited in 2016 by imposing quantitative constraints on its main policy instrument. Overall, then, the MNB’s interest rate decisions, whether concerning the base rate or indirectly the BUBOR, arguably have a greater effect on aggregate consumption than in the era of foreign currency loans (MNB, 2014). At the same time, the “self-contradiction” was also removed from the exchange rate channel. In the event of an interest rate cut, the effect on indebted households (increase in disposable income) will be consistent with the expansionary measure of the central bank, as opposed to the counter-effect previously triggered by a depreciating currency. The effect through the balance sheet channel is now also a thing of the past, because changes in forint interest rates will no longer have any effect on the size of outstanding debt. Additionally, the elimination of exchange rate risk also makes instalments more predictable, which may provide additional stimulus for consumption (MNB, 2014). While conversion has obvious benefits in terms of the transmission mechanism, from a financial stability point of view it is more appropriate to speak about better controls of risks. As mentioned previously, the legislator tied the interest rates of loans to the 3-month BUBOR, i.e. converted the products previously exposed to exchange rate risk and unilaterally changeable interest rates into loans exposed to interest rate risk owing to variable interest tied to a reference rate, which are not directly responsive to exchange rate movements. This — 456 —

13 Monetary policy considerations for the conversion of foreign currency loans...

provided transparency in terms of changes in interest rates of loans; nevertheless, future developments in repayment burdens obviously still cannot be foreseen with absolute certainty. Exchange rate risk, a previous characteristic of foreign currency loans, has been replaced by interest rate risk, which, however, is less of a threat in the current monetary and economic environment compared to exchange rate risk in the era of foreign currency lending. This is corroborated by the following.104 (1) With foreign currency loans, through developments in exchange rates, changes in repayment burdens were influenced by a number of factors outside the scope of Hungarian economic policy (e.g. the use of the Swiss franc as a safe-haven currency, or the exchange rate policy of the Swiss central bank). (2) According to current expectations, low interest rates may remain persistent globally. (3) The risks of variable interest (an increase in the base rate) tend to occur when the real economy is overheated, which is characterised by rising incomes and a low level of unemployment. In such cases, however, borrowers are more likely to have sufficient incomes to fence themselves against increasing burdens. (4) With variable-rate loans, an increase in the interest rate will not increase the forint value of the debt, as opposed to a depreciating currency in the case of foreign currency loans. (5) Hungary’s macroeconomic situation is much more stable compared to the pre-crisis period. Given a greater resilience to shocks, the probability of extreme interest rate swings is lower. (6) While banks’ foreign currency positions were almost completely closed (i.e. they did not recognise any direct gains or losses due to 104

Based on Dancsik–Felcser–Kollarik (2016).

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exchange rate movements), this was not necessarily true for their interest rate positions. International experience shows that banks profit from an environment of rising interest rates (Borio et al., 2015). This also means that in case households fall into arrears due to rising interest rates, banks’ increasing profits will give them more options to provide debt relief solutions. (7) New loans are already disbursed subject to strict “debt cap” rules that restrict the repayment burdens that may be undertaken, giving borrowers some degree of inherent protection against changes in their instalments (MNB, 2016a). By contrast, in the era of foreign currency lending, banks were competing on a risk basis, also granting credit to borrowers whose incomes were insufficient to tolerate even moderate changes in exchange rates. (8) With converted foreign currency loans, risk is mitigated by the fact that residual maturities approximate 10 years, making these loans much less sensitive to interest rate changes compared to a newly disbursed foreign currency loan. Another benefit is that the instalments of such loans were reduced by an average 25 per cent during the settlement, which was reinforced by the decline in the base rate and the BUBOR since the conversion. Therefore, the income of most borrowers would probably be sufficient for potentially higher credit burdens, since two years ago borrowers were also capable of paying instalments that were more than 25 per cent higher on average. Box 13-1 The dilemma of variable versus fixed interest rates

The question may arise why the legislator set a variable interest rate on these products when by force of law, it could have fixed the interest rate up to maturity. Fixing the interest rate would have eliminated all uncertainty concerning instalment changes, and consumers would have known the nominal amount of their monthly burdens up to maturity. However, that certainty would come at a price, and fixed interest rates are also not entirely

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13 Monetary policy considerations for the conversion of foreign currency loans...

risk-free. The price of fixed rates, assuming that the legislator applied the economically justified price, would have corresponded to higher interest rates representing the expected interest rate path, which could even have resulted in higher post-conversion instalments for borrowers compared to their previous burdens. If, in turn, Parliament had applied an interest rate below what was economically justified, this would have significantly increased banks’ profitability risks, because a portfolio of considerable size would not have been priced in alignment with the cost of funds. Claiming its victims at the turn of the 1990s in the US, the Savings&Loan crisis serves a reminder of the significance of mispriced portfolios and interest rate risk.105 Additionally, the enactment of a fixed interest rate would have unleashed huge demand on the market of long-term fixed liabilities, as well as on the market of interest rate swaps, which synthetically enable interest rate fixing. Banks only have limited ability to restructure the interest rate structure of their assets and liabilities to such an extent at short notice.106

It is important to establish that the acts on settlement and conversion allowed participants (both consumers and banks) to rearrange the market for home loans according to their preferences at the time. Namely, by law, customers were granted a single and free early repayment period of several months, which enabled them to switch to a transaction that best suited their needs at the time. Simultaneously, he crisis of the S&L institutions operating in the US was triggered by the T disbursement of long-term fixed-rate loans on the asset side, which were financed from shorter-term variable-rate liabilities. Due to the specificities of US regulations, deposit rates were capped until 1986 (under the so-called “Regulation Q”), which limited interest rate risk by keeping banks’ cost of funds below a certain level. When the regulation was repealed and deposit rates started to rise, institutions either had their interest rate margins reduced, or, if they kept deposit rates low, faced a liquidity strain due to the withdrawal of deposits (Kohn, 2007). 106 Naturally, the central bank could also have entered the market similarly to the way it satisfied the demand for foreign currency in the course of forint conversion in order to avoid exchange rate volatility. However, while in the latter case the risks to the national economy were obviously reduced by the elimination of households’ open positions, the economic advantages of transferring the interest rate risk to the MNB are by no means that clear. 105

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banks were allowed to contact customers (both their own and those of other banks) to offer fixed-rate products, provided that they could secure the required funds. Early repayments and loan refinancing amounted to HUF 46 billion up to the end of 2015, accounting for a mere 1-2 per cent of the potential volume (Table 13-3). This may highlight two things. First, on the demand side, over the past decade, consumers may not necessarily have developed their awareness and financial knowledge so much as to use such a unique opportunity. Second, on the supply side, there may also be a problem with the intensity of competition, which is also indicated by the relatively concentrated market of home loans with rates fixed for more than a year (MNB, 2016b), and by high interest rate premiums (Aczél et al., 2016). Table 13-3: Value of refinancing loans taken out during the preferential refinancing period following the conversion of foreign currency-based mortgage loans

31-Mar-15

30-Apr-15

31-May-15

30-Jun-15

31-Jul-15

31-Aug-15

30-Sep-15

31-Oct-15

30-Nov-15

31-Dec-15

Total

Volume of new contracts (in HUF billion)

Refinancing loans to existing customers

0.01

0.04

0.01

0.33

1.44

1.63

2.28

1.54

1.01

0.89

9.18

Refinancing loans to new customers

0.16

0.24

2.33

8.43

6.91

8.36

6.11

2.3

1.52 36.36

0.01

0.2

0.25

2.66

9.87

8.54 10.64 7.65

3.31

2.41 45.54

Total Source: MNB.

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13 Monetary policy considerations for the conversion of foreign currency loans...

13.6 Summary By phasing out foreign currency loans, the Hungarian financial system took a huge step towards a sound balance sheet structure. Owing to the new legislation and participants, one of the greatest risks of the banking system was removed from institutions’ balance sheets. In retrospect, the decision was clearly justified by the abandonment of the Swiss central bank’s exchange rate cap in January 2015, which led to drastic appreciation of the CHF. Without the conversion, there would have been a substantial increase in both households’ repayment burdens and the risks to the banking system, creating a major instability in Hungary’s entire financial and economic system. Phasing out household foreign currency loans allowed Hungary to climb from the depths and, in a certain sense, start with a clean slate in terms of the debt of the household sector. The positive effect of conversion also played a role in that for the first time since the crisis, in the summer of 2016 households’ borrowing exceeded the sector’s loan repayments, i.e. the contraction of debt came to an end. The macroprudential regulations introduced by the MNB, the requirements of the fair banking rules for the protection of consumers, and in particular lending exclusively in the domestic currency adequately guarantee that Hungary will not repeat the errors made in the mid2000s, and consequently, it will not be forced to spend additional valuable years on the correction of previous misguided actions.

Key terms credit risk exchange rate risk financial deepening FX swap Guidotti rule instrument instrument conditional on reducing short-term external debt

interest accrual tied to a reference interest rate interest rate risk interest rate fixed for longer than one year longer-term unconditional foreign currency sale open exchange rate position uncovered interest rate parity

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References Aczél, Á. – Banai, Á. – Borsos, A. – Dancsik, B. (2016): A lakáshitelek felárát meghatározó tényezők azonosítása a magyar bankrendszerben (Identification of the Determinants of Housing Loan Margins within the Hungarian Banking System). Financial and Economic Review, 15(4), December 2016., pp. 5–44. Baksay, G. – Palotai, D. – Szalai, Á. (2015): Az államadósság alakulása nemzetközi összehasonlításban és az alacsony infláció hatása. (Government debt in international comparison and the impact of low inflation). MNB Technical Paper, March 2015. Balás, T. – Nagy, M. (2010): A devizahitelek forinthitelekre történő átváltása (Conversion of Foreign Currency Loans into Forints). MNB Bulletin, October 2010, pp. 7–16. Basso, H.S. – Calvo-Gonzalez, O. – Jurgilas, M. (2007): Financial Dollarization: the Role of Banks and Interest Rates. ECB Working Paper, No. 748. European Central Bank. Bethlendi, A. – Czeti, T. – Krekó, J. – Nagy, M. – Palotai, D. (2005): A magánszektor devizahitelezésének mozgatórugói (Driving Forces behind Private Sector Foreign Currency Lending in Hungary). Magyar Nemzeti Bank, Background Studies, HT 2005/2. Bethlendi, A. (2012): Az elégtelen felügyeleti együttműködés és a devizahiteles válság. (Unsatisfactory Cooperation with the Supervisory Authority and the Foreign Currency Lending Crisis). Public Finance Quarterly Online, 24 January 2012. Bethlendi, A. – Fáykiss, P. – Gyura, G. – Szombati, A. (2015): A Magyar Állam mikroprudenciális és makroprudenciális szabályozásának és ellenőrzésének jellemzői a devizahitelezés területén. A folyamat hiányosságainak bemutatása. Fogyasztóvédelmi anomáliák (Characteristics of the microprudential and macroprudential regulation and supervision by the Hungarian State in the field of FX lending. Presentation of the deficiencies of the procedure. Consumer protection anomalies). In: Lentner, Cs. (ed.): A devizahitelezés nagy kézikönyve. Borio, C. – Gambacorta, L. – Hofmann, B. (2015): The influence of monetary policy on bank profitability. BIS Working Papers, No. 514. Bank for International Settlements. Csajbók, A. – Hudecz, A. – Tamási, B. (2010): Lakossági devizahitelezés az új EU-tagországokban (Foreign Currency Borrowing of Households in new EU Member States). MNB Occasional Papers, OP 87. Dancsik, B. – Felcser, D. – Kollarik, A. (2016): Fix vagy változó? Egy fontos szempont a lakossági hitelkamatoknál (Fixed or Variable? A Key Consideration for Household Loan Interest Rates). MNB Technical Paper, December 2016. Horváth, Á.B. (2008): Az 1995 óta tartó ingatlanár-emelkedés mérése és okai, PhD-értekezés (The Measurement and Causes of the Rise in Property Prices since 1995, PhD Thesis). Corvinus University of Budapest, Doctoral School of Economics, Budapest, February 2008. Kohn, M. (2007): Bank- és pénzügyek, pénzügyi piacok. Osiris kiadó. Budapest.

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13 Monetary policy considerations for the conversion of foreign currency loans... Kolozsi, P.P. (2015): A lakossági devizahitelek elterjedésének és kivezetésének vizsgálata intézményi megközelítésben (Assessment of the Spread and Phase-out of Household Foreign Currency Loans in an Institutional Approach). In: A devizahitelezés nagy kézikönyve, 2015. Kolozsi, P.P. – Banai, Á. – Vonnák, B. (2015): A lakossági deviza-jelzáloghitelek kivezetése: időzítés és keretrendszer (Phasing Out Household Foreign Currency Loans: Schedule and Framework). Financial and Economic Review 14(3), September 2015, pp. 60–87. Kovács, Gy. (2009): A pénzügyi stabilitás és a bankrendszer, avagy a közvetítőrendszer egyensúlytalansága (Financial Stability and the Banking System, or the Imbalance of the Intermediary System). Public Finance Quarterly, 2009/1, pp. 49–67. Lentner, Cs. (ed.) (2015): A devizahitelezés nagy kézikönyve. Budapest: Nemzeti Közszolgálati és Tankönyv Kiadó Zrt. ISBN: 9786155344626.MNB (2009): Report on Financial Stability. April 2009, Magyar Nemzeti Bank. MNB (2014): Inflation Report. Magyar Nemzeti Bank, December 2014. MNB (2015): Product brochures for the central bank’s euro sale tenders. MNB website. MNB (2016a): Makroprudenciális jelentés (Macroprudential Report). Magyar Nemzeti Bank, October 2016. MNB (2016b): Pénzügyi stabilitási jelentés (Financial Stability Report). Magyar Nemzeti Bank, November 2016. Nagy, M. – Szabó, E.V. (2008): Az amerikai másodrendű jelzáloghitel-piaci válság és hatásai a magyar bankrendszerre (The Sub-prime Crisis and its Impact on the Hungarian Banking Sector). Magyar Nemzeti Bank, MNB Bulletin, April 2008. Nagy, M. – Palotai, D. (2014): A devizatartalék óvatosan csökkenthető (The Foreign Exchange Reserves Could Be Reduced Cautiously). MNB Technical Paper, April 2014.

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Self-financing programme — central bank tools to reduce external vulnerability Zsuzsanna Novák – Milán Vas

The global financial crisis which started in 2008 highlighted the risks of external indebtedness and the vulnerability of the Hungarian economy, the mitigation of which was set as the objective for several economic policy programmes after 2010. Launched in spring 2014, the Self-Financing Programme of the Magyar Nemzeti Bank (MNB) contributed to the development of a healthier debt structure, and thereby to mitigating external exposure, by encouraging credit institutions to purchase domestically issued securities, which indirectly reduced the previous dominance of foreign investors in debt financing. In the context of the Self-Financing Programme, the MNB reformed its conventional monetary policy instruments, and introduced additional unconventional instruments. As part of the programme, modifications were made to the MNB’s main policy instrument, the system of reserve requirements, and the interest rate corridor, while new instruments were also added to the toolkit in order to facilitate credit institutions’ liquidity and risk management. The liquidity profile of the main policy instrument became less favourable from a bank perspective, and the terms of the central bank’s interest rate swaps (IRS) linked to the Self-Financing Programme required credit institutions to increase their holdings of securities qualifying as eligible collateral to the same extent as the size of the interest rate swaps entered into in tenders. In this way, the reformed instruments channelled credit institutions’ surplus liquidity from central bank deposits to liquid domestic assets in the securities market. The central bank’s programme resulted in a meaningful improvement in the structure of financing the economy, as well as in the ownership, currency and maturity structure of public debt, while the interest burdens on the general government were also reduced considerably. Gross external government debt dropped from around 90 per cent in early 2014 to below 70 per cent of GDP — 464 —

14 Self-financing programme — central bank tools to reduce external vulnerability

in H2 2016, and over the same period, the ratio of foreign currency to public debt decreased from 43 per cent to approximately 25 per cent. An increased volume of forint issues allowed the Hungarian State to repay some EUR 11 billion worth of foreign currency debt using forint issues between 2014 and 2016, in which, apart from growing household demand, a prominent role was occupied by the Self-Financing Programme. This chapter explains the Self-Financing Programme launched by the Magyar Nemzeti Bank in the spring of 2014. First, there is a description of the basic macroeconomic connections and impact mechanisms of the programme, highlighting the ways in which modifications to the central bank instruments contributed to reducing vulnerability. This is followed by an account of the key measures taken in respect of the central bank instruments as part of the Self-Financing Programme, and the main results achieved over the past period of more than two years.

14.1 Unhealthy debt structure, a vulnerable economy Dependence on foreign and foreign currency funds makes the economy vulnerable, while also hurting its external perception. In an economy characterised by capital shortage, the insufficiency of domestic savings will naturally drive the need to raise foreign funds, especially when such funds are available under more favourable terms compared to domestic loans. While a broader group of investors may put downward pressure on yields, it is also important to consider that a strong foreign presence tends to increase interest rate volatility and the threat of contagion, and that it also carries significant rollover risk (Moody’s, 2015). During times of crisis involving market turbulences, the risks from foreign dependence become particularly strong due to unfavourable developments in the exchange rate and in interest rate spreads, or, as the case may be, to negative rating action taken by credit rating agencies. The concept of external vulnerability is not defined unambiguously in the literature, but it tends to be

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measured in terms of indebtedness indicators (gross107 and net108 external debt, debt service), and in terms of export income, the trade surplus and foreign direct investment, which provide the sources for debt repayment (IMF, 2012; Supriyadi, 2014). The foreign currency debt ratio of the government is also seen as a negative factor due to the increase in debt burdens in the event of a depreciating currency, along with the relatively high ratio of short-term external debt109 to foreign exchange reserves, and the large share of non-residents within public debt (Moody’s, 2015). Increased rollover risk resulting from external dependence may feature prominently in assessments because in extreme cases, a shortage of funds may lead to corporate and bank failures, and even sovereign default. From the mid-2000s onwards, Hungary’s financing structure clearly moved in an unfavourable direction, and one of the main reasons for this deterioration was the increase in external debt. Rising steadily from the early 2000s, gross external debt (net of intercompany loans) already exceeded 100 per cent of GDP in 2009, culminating in 2011 at approximately 120 per cent, or just under 150 per cent with the debt instruments of direct investments taken into account, in the aftermath of the European sovereign debt crisis. Particular concerns emerged over short-term external debt in terms of residual maturity, which in 2010 already accounted for 35 per cent of total external debt110 and close to 40 per cent of GDP, and also exceeded the country’s holdings of foreign exchange reserves. ross external debt is the outstanding amount of liabilities owed to non-residents by G the residents of an economy, which involves principal and/or interest payments at a future date, and its volume is included in balance of payments statistics also net of debt instruments within direct investments, i.e. net of intercompany loans and debt securities. This external debt indicator is hereinafter referred to as gross external debt net of intercompany loans. 108 Net external debt is calculated as the sum of liabilities to non-residents less receivables held in the form of debt instruments. 109 Within indebtedness to non-residents, therefore, risks are primarily carried by shortterm liabilities, because their rollover may be particularly difficult. 110 As regards this indicator, Hungary represented the average of emerging economies, given that in 2010, some 37 per cent of the official consolidated debt of those countries matured within one year. With emerging countries, the average maturity of public debt is shorter compared to that of developed industrial countries (Filardo et al., 2012). 107

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14 Self-financing programme — central bank tools to reduce external vulnerability

In Hungary, apart from the spread of foreign currency lending,111 the surge in indebtedness to non-residents was largely attributable to sovereign borrowing from non-residents. Within total external debt, the share of the external debt of general government fluctuated around 40-50 per cent from the 2000s, which indirectly implies that the financing structure of the general government was becoming distorted simultaneously with the increase in external indebtedness (Chart 14-1). Chart 14-1: Gross external debt and the share of public debt within gross external debt 160

Per cent

160

2015

2014

2013

20 2012

20 2011

2010

2009

2008

2007

2006

2005

100

2004

100

2003

120

2002

120

2001

140

2000

140

Public debt/gross external debt Gross external debt/GDP (excluding intercompany loans) Gross external debt/GDP Source: MNB, based on annual data.

External indebtedness was accompanied by significant growth in the ratio of foreign currency to public debt. Whereas at the end of 2005, nonresidents financed just over 46 per cent of government gross debt, their share climbed to 62 per cent by late 2012, while in the same year within the Central European region, in Croatia (facing similarly high public debt exceeding 60 per cent of GDP) the indicator stood at 35 per cent, and Poland 111

For details, refer to Lentner (2015).

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was the only other country in the region with a reading above 50 per cent. Over the same period, the ratio of foreign currency debt to Hungary’s total public debt rose from 29 per cent to 43 per cent (peaking at 52 per cent in 2011), which entailed increasing exchange rate risk (Chart 14-2). Chart 14-2: Share of non-residents and foreign currency financing within gross consolidated public debt 70

Per cent

2016

2015

2014

2013

0 2012

0 2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Foreign investors’ share in total public debt Share of foreign currency within total public debt Source: Government Debt Management Agency (ÁKK), MNB.

In the new Member States of the European Union and in their peripheral states, it was particularly net external debt that was considered high. In a global comparison, the three continents with the highest ratios of gross external debt to GDP are North America, Australia and Europe, with a distinct dividing line in the latter between Member States that joined after 2004 (including candidates) and those that had joined previously. As a percentage of GDP, the gross external debt of old EU Member States is typically between 100 per cent and 300 per cent (occasionally above 10 times GDP), whereas that of emerging economies in Central Europe tends to be below or just over — 468 —

14 Self-financing programme — central bank tools to reduce external vulnerability

100 per cent.112 As a percentage of GDP, Hungary’s gross external debt between 2010–2013 was between the averages of Central European countries and Western European countries (Chart 14-3). Chart 14-3: Gross and net external debt of EU Member States as a percentage of GDP 400 350 300 250 200 150 100 50 0 –50 –100 –150

Per cent

CZ LT RO PL SK EE BG CR SL HU IT LV DE ES DK AT SE FR FI PT GR BE NL CY UK

400 350 300 250 200 150 100 50 0 –50 –100 –150

Gross external debt (Q3 2013, Per cent) Net external debt (Q3 2013, Per cent)

Note: the above external debt indicators are inclusive of intercompany loans. Source: Eurostat, 2014.

Conversely, as regards net external debt, which also takes into account liabilities to non-residents and therefore provides a more reliable picture of the role of non-residents in financing, when compared to EU Members States, Hungary approximated the peripheral countries of the euro area in 2012–2013. Relative to the benchmark countries of Central and South-Eastern Europe (except for Cyprus), Hungary’s net liabilities reflected particularly high exposure to non-residents.

112

utstandingly high statistics are recorded in Malta and Cyprus among countries joining O in 2004 and afterwards, and in Luxembourg, Ireland and the United Kingdom among the rest of the countries.

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Similarly, investor analyses and reports on Hungary assessed its high external vulnerability as a key risk, the reduction of which had become one of the primary objectives of Hungarian economic policy by 2014. In view of the country’s high external exposure and its unfavourable currency composition, external vulnerability grew to become one of the most urgent challenges for Hungarian economic policy in the years following the crisis. In 2013 and at the beginning of 2014, several international organisations (such as the European Commission and the International Monetary Fund) and credit rating agencies (e.g. Standard & Poor’s, Moody’s) expressed criticism of Hungary in their analyses in view of its high debt ratio, excessive foreign currency debt ratio and its heavy reliance on foreign financing. Responding to the risks to macroeconomic stability, Hungary’s convergence programme for 2013 identified the reduction of external exposure, i.e. high external debt, a major factor behind the financial vulnerability of Hungary at the time, as one of the four key economic policy objectives (Kolozsi–Hoffmann, 2016). External exposure was partly attributable to domestic sectors being crowded out of financing the economy and government in particular, which represented a major rollover risk. By the end of 2008, public debt as a percentage of GDP exceeded 70 per cent. Growth in public debt was accompanied by an increasingly prominent role of foreign investors, a tendency that was reinforced in 2009 by Hungary’s borrowing from the EU and the IMF. Another pointer in that direction was that in Hungary the crisis aggravated the situation of an already indebted household sector, the annual savings of which were insufficient to cover the budget deficit (Baksay et al., 2013), as a result of which the share of households in financing public debt gradually fell to under 5 per cent.113 Apart from households, the financial sector was also gradually crowded out or withdrew from the Hungarian government securities market: while domestic financial 113

I n 2012 and 2013, the gross nominal value of government debt accounted for more than a quarter of the aggregate (non-consolidated) gross financial instruments of domestic financial enterprises and households, comprising around 70 per cent of the financial instruments of credit institutions.

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14 Self-financing programme — central bank tools to reduce external vulnerability

enterprises held about 40 per cent of total government debt in 2009, by the end of 2011 their share shrank to 30 per cent without any considerable increase in sight until the end of 2013.114 In 2012, the investment appetite of domestic sectors and of banks in particular may also have been curbed by the fact that as of mid-2012, reference interest rates dropped close to the level of the base rate even for maturities of more than one year. Box 14-1 Trends in public debt financing in emerging economies

The changes in the structure of financing public debt induced by the crisis varied considerably across the emerging countries, and hit the CEE region severely. While in 2000, the 31 emerging economies surveyed by Moody’s had 61 per cent of their total public debt recorded in their domestic currencies, the ratio increased to 88 per cent by 2014, accompanied by a rise in the average share of domestic holdings over the same period from 57.6 per cent to 67.8 per cent. By contrast, in CEE emerging countries both the currency composition and investor structure of public debt changed unfavourably in the years following the crisis. In that region, the ratio of domestically financed debt dropped from 55.3 per cent in 2000 to 54.7 per cent in 2014, accompanied by a significant increase in public debt as a percentage of GDP. The most unfavourable developments occurred in Hungary, the Czech Republic and Slovakia. Between 2000 and 2014, these three countries saw their ratios of domestically financed debt plunge from a relatively high level. Among them, Hungary recorded the greatest decline, from 75 per cent to 45 per cent. Compared to all emerging countries, in 2014 only Peru and Indonesia recorded a higher share of non-residents in total debt than Hungary, the indicator of which exceeded the Central European average by far. Given that in Hungary, too, for risk sharing purposes it was common for foreign investors to acquire government securities issued in the domestic currency, the growing prominence of foreign ownership did not automatically entail 114

esides the restrained risk appetite of Hungarian investors, participation in the B Hungarian government securities market may have been influenced by the elimination of the mandatory private pension scheme in 2010.

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a proportionate increase in foreign currency debt; nevertheless, the foreign currency ratio of public debt still showed spectacular growth. While between 2002–2004 it was as low as 25 per cent, the ratio of debt financed in foreign currency increased from 36 per cent in 2000 to 47 per cent in 2010. With that development, Hungary took the “lead” in Central and Eastern Europe in terms of the foreign currency financing of public debt. By the end of 2013, the ratio of foreign currency to total central government debt fluctuated around 40 per cent, while in the European Union only four countries recorded higher values at the time: Croatia, Bulgaria, Romania and Lithuania.

14.2 The macroeconomic impact mechanism of the SelfFinancing Programme In the spring of 2014, the MNB announced its Self-Financing Programme, which was designed to reduce dependence on external funds and thereby to strengthen financial stability. A level of external exposure that is striking by regional standards intensifies the volatility of the exchange rate and expectations for interest rate spreads, which may undermine the economy’s ability to raise funds when a crisis materialises. The economic policy measures which after the crisis were aimed at the reduction of external vulnerability and were implemented through the cooperation of the economic actors, may be classified under the umbrella term self-financing concept. One element of that concept was the Self-Financing Programme announced by the MNB on 24 April 2014, which had the declared objective of promoting financing from internal funds, reducing dependence on external funds, and thereby strengthening price and financial stability. As part of its Self-Financing Programme, the MNB transformed and reformed the central bank instruments, channelling domestic banks’ surplus liquidity to collateral securities. The modification of the central bank’s instruments made the parameters of the MNB’s deposit instruments less attractive to banks, which, for the purposes of banks’ liquidity management, has indirectly attached a more prominent role to — 472 —

14 Self-financing programme — central bank tools to reduce external vulnerability

securities which have longer maturities and are eligible as collateral for credit operations. Owing to the specificities of the Hungarian securities market, government securities are predominant among the securities eligible as collateral, as a result of which the vast majority of the surplus liquidity generated by the decrease in sterilisation holdings will end up in the government securities market. In practice, the modification of the central bank’s instruments primarily involved the transformation of the liquidity profile of the main policy instrument, modifications to the interest rate corridor and the system of reserve requirements, and the introduction of the interest rate swap instrument to provide an incentive for participation in the securities market (the specific steps taken for the modification and extension of the central bank’s instruments will be explained later). The increase in banks’ demand for securities eligible as central bank collateral indirectly facilitated the reduction of foreign currency debt owed to non-residents. According to the impact mechanism of the Self-Financing Programme, external vulnerability is reduced by banks swapping their central bank deposits for liquid securities, and foreign currency debt owed to non-residents is transformed into domestic forint debt in the process. Taking account of the fact that a major part of eligible collateral is comprised of government securities, credit institutions’ purchases of securities will arguably also provide the government debt manager with the option to use forint funds to roll over maturing foreign currency debt. Through this impact mechanism,115 the Self-Financing Programme contributes to the use of domestic funds for the rollover of foreign currency debt and debt owed to non-residents, any thereby to the reduction of external vulnerability. In this way, consistently with the 115

he commitment of surplus liquidity for a longer term was also supported by a series of T cuts in the central bank policy rate, which the MNB used to channel credit institutions’ surplus liquidity to longer-term investments involving more risk. This was also supported by the LCR regulation on banks’ liquidity position in assets maturing within 30 days, given that government securities improve both credit institutions’ liquidity and their compliance with the indicator.

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objectives set out in the Central Bank Act, the MNB supports price and financial stability over the longer term. Box 14-2 Government securities programmes for households

The Self-Financing Programme was closely related to other economic policy measures that were also designed to reduce external vulnerability, i.e. supported the self-financing concept. Prior to the modification of the central bank instruments, one such programme was the Government Debt Management Agency’s (ÁKK) retail government securities market programme, which set the objective of strengthening the presence of households in the government securities market. Households’ more active participation in the government securities market was primarily attributable to the ÁKK’s decision to introduce new products that offered more favourable terms to household investors compared to previous products. Such products included the Premium Hungarian Government Bond (PMÁK) launched in 2009, and the Bonus Hungarian Government Bond (BMÁK) first marketed in 2014. Both securities yield indexed returns subject to the payment of a set premium, the former being tied to inflation, and the latter to yields in the government securities market. In November 2016, the PMÁK and the BMÁK collectively accounted for approximately 30 per cent of households’ HUF-denominated government securities. As opposed to the rest of the products targeting households, both securities offered an interest premium only with longer maturities, which significantly contributed to the increase in the average maturity of household portfolios. The increase in both the volume of government securities owned by households and their average maturity significantly supported more stable and predictable debt financing, which is consistent with the objectives of the self-financing concept. Through the programme, households also made a major contribution to the significant increase in the weight of domestic participants in public debt financing. Up to 2012, households typically had a 5-7 per cent share in the

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14 Self-financing programme — central bank tools to reduce external vulnerability

market for HUF-denominated government securities. “Catching up” with non-residents, that ratio exceeded 20 per cent by 2016, which represents a major rearrangement in the ownership structure of public debt.

The success of the self-financing concept largely depended on the extent to which participating institutions, notably the MNB and the ÁKK, were capable of cooperation. Within the self-financing concept, the prominent role of the ÁKK was owing to its use of forint funds to refinance a major part of maturing public foreign currency debt, because in this case, a precondition for the functioning of the impact mechanism of self-financing was that the debt manager should increase forint issues, given that external vulnerability could only be reduced through a simultaneous reduction in the ratio of foreign currency to public debt. When it announced the Self-Financing Programme, the MNB presented a concept that aimed to reduce the volume of the main policy instrument, to be accompanied by an increase in the volume of securities eligible as collateral. The modification of the monetary instruments generated a major flow of liquidity from the main policy instrument to the market of liquid securities and government securities, leading to a decline in interest rates. The downward pressure exerted on yields by higher demand supported the increase in the ÁKK’s forint issues, since the central bank’s measures substantially moderated the difference between foreign currency and forint interest rates. Apart from the central bank and the ÁKK, the success of the programme also required cooperation on the banking sector’s part. It should be noted that banks had other channels and a variety of central bank deposit instruments at their disposal for their accommodation to changes in the monetary framework, because the Self-Financing Programme only modified the parameters of the central bank’s instruments without laying down any binding rules. Nevertheless, at their own discretion, consistently with the objectives of the selffinancing concept and taking into account the central bank’s incentives, most banks committed a major part of their surplus liquidity to the

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domestic securities market, enabling the impact mechanism of selffinancing to work effectively.

14.3 Modification of the central bank’s monetary policy instruments In the context of the Self-Financing Programme, the MNB transformed its monetary policy instruments in order to channel a part of bank liquidity to instruments with longer maturities. In effect, the reform of the central bank’s monetary policy instruments concerned every central bank instrument, and in particular the main deposit instrument, of primary importance in terms of sterilisation,116 the interest rate corridor, the credit instruments, and the system of reserve requirements (Table 14-1). Table 14-1: Modification of the central bank’s conventional instruments in specific phases of the Self-Financing Programme117 Instrument

Prior to selffinancing 2-week bond

Main policy instrument Interest rate corridor Symmetrical Reserve requirement Optional rates: 2-5% Collateralised loans Auxiliary instrument to support forint liquidity management

Self-Financing Self-Financing Programme Phase 1 Programme Phase 2 2-week deposit 3-month deposit Symmetrical Optional rates: 2-5%

2-week and 6-month maturities

Asymmetrical Uniform reserve ratio: 2% 1-week and 3-month maturities Restricted 2-week deposit until April 2016

Source: MNB.

he structural liquidity position of the banking system against the central bank is T derived as the net sum of monetary policy operations. Where the net sum of items on the liability side and the asset side is positive, the banking system has surplus liquidity. This surplus liquidity is typically absorbed by the deposit instruments on the central bank’s liability side, which is why the central bank’s instruments used to hold surplus liquidity are referred to as sterilisation instruments. 117 The first phase of the Self-Financing Programme spans the period from the announcement of the Programme (24 April 2014) to the announcement of its continuation (2 June 2015), which also marks the start of the second phase of the Programme. 116

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14 Self-financing programme — central bank tools to reduce external vulnerability

14.3.1 Modification of the main deposit instrument

As part of the Self-Financing Programme, the main policy instrument was first modified in the first phase of the Programme in August 2014, when the 2-week central bank bond was replaced by the 2-week deposit instrument. The 2-week bond had been issued by the MNB in the form of a dematerialised zero-coupon bond at weekly intervals, without any quantitative limitations. The fixed-price auctions were held weekly and were open to the MNB’s counterparties; however, no restrictions were in place concerning the secondary market, which allowed both domestic institutional investors and non-resident financial undertakings to trade the bonds. The portfolio of central bank bonds acquired by non-residents increased the MNB’s external debt, which contributed to the increase in the short-term external debt of the economy. Additionally, the 2-week bond supplied credit institutions with liquid assets over the short term with low risk, and was available in unlimited quantities, which did not provide any incentives for the banking sector to purchase assets with longer maturities. When the bonds were converted into deposits as of August 2014, foreign investors were crowded out from the market of the main policy instrument, which supported the reduction of dependence on external funds, while thanks to the transformation, domestic banks were also oriented towards instruments that were suitable to the replacement of the previous main policy instrument in terms of liquidity. The introduction of the 2-week deposit triggered bank accommodation due to the fact that it was neither marketable nor eligible as collateral, i.e. it was less liquid than the 2-week bond. Both the 2-week bond and the 2-week deposit replacing it yielded returns corresponding to the base rate with a maturity of two weeks (in the form of implied returns with the 2-week bond due to its issuance as a discount security, and in the form of interest credited to the relevant deposit balance with the 2-week deposit). However, compared to the 2-week bond, the 2-week deposit had less favourable liquidity characteristics for the following reasons: — 477 —

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– subscription was only available to central bank counterparties; – contrary to the previous main policy instrument, it was not eligible as collateral for central bank credit operations; – it was not marketable in the secondary market; – it could not be withdrawn before maturity. Compared to the instrument functioning as a fixed asset, marketable securities were seen as more favourable investments in many respects, which led credit institutions to diversify their liquid assets. The previous 2-week bond had accounted for a significant part of credit institutions’ holdings committed as eligible collateral, which after August 2014 could be replaced for other instruments, primarily liquid securities, government securities, mortgage bonds and corporate bonds. The next modification to the liquidity characteristics of the main policy instrument was made in the second phase of the Programme, launched in June 2015, when the maturity of the deposit was increased from 2 weeks to 3 months. Following the transformation of the 2-week deposit into a 3-month deposit starting from 23 September 2016, for the placement of their surplus liquidity banks had an instrument at their disposal that was less attractive in terms of liquidity and required longer-term commitment. Similarly to the 2-week deposit, the 3-week deposit instrument was also a central bank term deposit, which was not eligible as collateral, and continued to be offered for subscription until August 2016 in weekly fixed-price auctions. However, the liquidity profile of the deposit, which continued to yield returns at the base rate, was less favourable compared to liquid securities; for example, for the purposes of LCR118 calculations, only holdings “shortened to less than 30 days” were eligible as items improving liquidity. Therefore, the longer maturity of the main policy instrument provided an incentive for the banking system to purchase liquid assets available in securities markets. Until its phase-out in April 2016, the 2-week central bank 118

he LCR requirement is set to ensure that within 30 days, banks hold a sufficient quantity T and quality of liquid assets in case a liquidity shock occurred, which, in the case of a deposit fixed for 3 months, was only provided within the month preceding maturity.

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14 Self-financing programme — central bank tools to reduce external vulnerability

deposit remained part of the MNB’s instruments as an auxiliary liquidity management instrument, but was only available for subscription in variable-price tenders for limited quantities, subject to a HUF 1,000 billion limitation until the end of 2015. In addition to the limit on the instrument, interest rate paid on the 2-week deposit tended to be lower than the base rate due to competing bids, which made the instrument less attractive, while it also provided the central bank with interest savings on a part of its sterilisation holdings. With these measures, the central bank also aimed to ensure that credit institutions prefer domestically issued forint securities to the central bank instruments that were designed for the commitment of surplus liquidity.

14.3.2 Asymmetric interest rate corridor, reduced maturities for credit instruments

In connection with the announcement of June 2015 concerning the continuation of the Self-Financing Programme and the modification of the sterilisation instruments, on 22 September 2015 a decision was adopted on making the interest rate corridor asymmetric. On the banks’ side, the Self-Financing Programme had generated additional demand for liquid securities, which, however, on certain days drove the yields of discount treasury bills (DKJ) below that of the O/N central bank deposit. The decrease in the yield differences between the two instruments could have channelled bank funds to the O/N deposit instrument, which would have been contrary to the objective of the Self-Financing Programme. Consequently, in September 2015 the Monetary Council adopted a decision on making the interest rate corridor asymmetric, i.e. defined an interval around the policy rate that was narrower for the O/N credit instrument than for the O/N deposit instrument. While leaving the policy rate unchanged, the Council reduced the interest rates on the central bank’s O/N instruments marking the floor and the ceiling of the interest rate corridor by 25 bps lower each, thereby reducing the probability of bank accommodation through the O/N deposit (Chart 144). The adjustment provided simultaneous support for the Self-Financing — 479 —

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Programme, banks’ liquidity management, and accommodation to the modified instruments. Chart 14-4: Developments in O/N interbank rates and 3-month benchmark DKJ yields in 2015–2016 3.5

Per cent

3.5 3.0

2.5

2.0

1.5

1.0

0.5

0.0

–0.5

Jan. 2015 Feb. 2015 Mar. 2015 Apr. 2015 May. 2015 Jun. 2015 Jul. 2015 Aug. 2015 Sep. 2015 Oct. 2015 Nov. 2015 Dec. 2015 Jan. 2016 Feb. 2016 Mar. 2016 Apr. 2016 May. 2016 Jun. 2016 Jul. 2016 Aug. 2016 Sep. 2016 Oct. 2016 Nov. 2016 Dec. 2016

3.0

Interest rate corridor 3-month benchmark T-bill rate HUFONIA

Base rate HUFONIA monthly average

Source: MNB.

Due to the more favourable terms of O/N central bank borrowing provided by the new asymmetric interest rate corridor, the net holdings of O/N central bank instruments decreased, driving an increase in the HUFONIA to approximate the base rate. Following the introduction of the 3-month deposit as the main policy instrument in September 2015, O/N rates fluctuated above their previous level and often exceeded the base rate, which may also have been attributable to the adjusted liquidity profile of the new main policy instrument, and the decrease in sterilisation holdings. At the same time, from November 2015 onwards, the monthly average of O/N rates fluctuated below the base rate, and until March 2016 the HUFONIA breached the 1.35 per cent policy — 480 —

14 Self-financing programme — central bank tools to reduce external vulnerability

rate applicable at the time only on a few occasions, which indicates that for the most part, the effect driving higher yields was temporary. Additionally, the modification of the interest rate corridor drove DKJ yields back to the approximate level of the base rate, which was consistent with both the effective operations of interest rate transmission and the longer-term objective of the Self-Financing Programme. By making the interest rate corridor asymmetric, the MNB also shortened the maturities of its collateralised credit operations: 6-month collateralised loans were superseded by 3-month loans, and 2-week collateralised loans by 1-week loans. The shortened maturities supported accommodation to the new liquidity environment, with the 1-week loan available to meet any liquidity shortage arising between the weekly tenders for the 3-month instrument. The instrument of 3-month collateralised loans was aligned with the maturities of main policy deposits, discount treasury bills, and credit institutions’ lending operations. Similarly to the previous 6-month instrument, the 3-month instrument was allocated in variable-rate credit tenders subject to a quantitative limitation, while 1-week loans were made available to credit institutions in tenders at fixed rates tied to the base rate, but with more favourable terms than the previous 2-week instrument (at the base rate + 25 bps rather than the base rate + 50 bps as of September 2015). By easing the terms of borrowing, the central bank supported credit institutions’ purchases of longer-term securities consistently with the impact mechanism of the Self-Financing Programme.

14.3.3 Introduction of the uniform reserve ratio

As of December 2015, the MNB discontinued the regime of optional reserve ratios and introduced a standard 2 per cent reserve ratio, whereby it prevented the flow of the forint liquidity in the banking system from sterilisation assets to the central bank required reserves. On 6 October 2015, the MNB announced its decision to introduce a uniform reserve requirement ratio of 2 per cent as of 1 December 2015 to replace the optional — 481 —

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reserve requirement ratios of 2 per cent, 3 per cent, 4 per cent and 5 per cent available at the time. In the same month, the aggregate reserve requirements for the credit institutions subject to reserve requirements amounted to HUF 511 billion, corresponding to an effective reserve ratio of 2.9 per cent based on the size of eligible liabilities. If the MNB had maintained its regime of optional reserve ratios, this would have given credit institutions the opportunity to raise the effective reserve ratio of the banking system to 5 per cent by choosing the highest available reserve ratio. As a result, contrary to the intentions of the MNB, rather than flowing to the market of collateral instruments, some HUF 370 billion worth of liquidity would have been placed by banks in the central bank’s sight deposits, which were more favourable than the main policy instrument in terms of liquidity and accrued interest at the base rate similarly to sterilisation instruments. The cut in the reserve ratio was justified by the fact that in November 2016 several banks exploited the benefits of the regime of optional ratios and switched to the maximum 5 per cent ratio for the remaining one month of the regime, as a result of which the effective reserve ratio of the banking system was raised by some 60 bps to 3.6 per cent. In connection with the adjustments made in 2015 to the system of reserve requirement ratios, no significant change was observed in banks’ behaviour as regards compliance with reserve requirements. The abandonment of optional reserve ratios as of 1 December 2015 did not have any sustained, significant effect either on the generally slight excess reserve in the banking system (over-reserving), or in the reserve deficit periodically incurred by individual banks (underreserving). Expressed as the average of the 26 months between January 2014 and February 2016, the excess reserve amounted to HUF 5.5 billion, accounting for just over 1 per cent of the average reserve requirement of HUF 472 billion over the same period. Banks themselves had incentives for keeping their excess reserve low, because in that period no interest accrued on the balances over the reserve requirement in the accounts of credit institutions subject to reserve requirements with the MNB, whereas banks could expect a positive O/N central bank deposit rate on their surplus liquidity placed in O/N deposits. — 482 —

14 Self-financing programme — central bank tools to reduce external vulnerability

Box 14-3 The regime of optional reserve ratios

The 2010 amendment to the Decree on the Reserve Ratio introduced the regime of optional reserve ratios as of 1 November 2010. Essentially, the regime allowed credit institutions to apply their choice of a 2 per cent, 3 per cent, 4 per cent or 5 per cent reserve ratio according to their liquidity needs. With this regime the MNB primarily benefited credit institutions that had lower balance sheet totals and thus a lower volume of liabilities subject to reserve requirements, accompanied by a relatively significant flow of interbank transactions. Credit institutions had the opportunity to adjust their reserve ratios and were bound by their choices for at least half a year. Chart 14-5: Developments in the average reserve requirement ratios of credit institutions subject to reserve requirements 3.75

Per cent

3.75 3.50

3.25

3.00

2.75

2.50

2.25

2.00

2.00 Nov. 2010 Jan. 2011 Mar. 2011 May. 2011 Jul. 2011 Sep. 2011 Nov. 2011 Jan. 2012 Mar. 2012 May. 2012 Jul. 2012 Sep. 2012 Nov. 2012 Jan. 2013 Mar. 2013 May. 2013 Jul. 2013 Sep. 2013 Nov. 2013 Jan. 2014 Mar. 2014 May. 2014 Jul. 2014 Sep. 2014 Nov. 2014 Jan. 2015 Mar. 2015 May. 2015 Jul. 2015 Sep. 2015 Nov. 2015

3.50

Average reserve ratio Average level of average reserve ratios between November 2010 and November 2015 (2.70%) Source: MNB.

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The option of higher reserve ratios was particularly popular among banks that were active in the money markets, but had a comparatively low volume of liabilities subject to reserve requirements, as well as among smaller participants with more passive liquidity management. Accordingly, savings cooperatives and smaller banks tended to prefer reserve ratios above 2 per cent, while the largest market participants typically did not opt for the highest available reserve ratios of 4 per cent or 5 per cent. Weighted by liabilities subject to reserve requirements, the average reserve ratio of the banking system never breached the 3 per cent mark except in the last month of the regime of optional reserve ratios (Chart 14-5).

14.3.4 Introduction of the central bank’s conditional interest rate swap

Introduced in summer 2014, the central bank’s interest rate swap (IRS) offered banks an opportunity to manage the interest rate risks involved in accommodation by means of securities. During the term of IRS transactions with its customers in the money market, the MNB pays interest at a variable rate in exchange for a fixed interest rate received, which allows for the mitigation of the interest rate risk of credit institutions swapping their central bank deposits for longerterm securities. Subject to a fixed minimum interest rate, the MNB distributed the IRS instrument in variable-price tenders. Access to the central bank’s IRS instrument was conditional, which ensured that demand from the banks using the instrument is generated in the market for collateral securities. The MNB required credit institutions to increase their holdings of eligible collateral to an extent equivalent to the volume of IRSs acquired in tenders. To meet banks’ needs, in the summer of 2015, as part of the second phase of the Self-Financing Programme, the MNB supplemented the initial 3-year and 5-year maturities with a 10-year maturity, and in September of the same year it allowed banks to choose between 2014 Q1 and the period of March to May 2015 in respect of the base portfolio against which adequacy was to be checked. While the two modifications did not entail — 484 —

14 Self-financing programme — central bank tools to reduce external vulnerability

any shift in the MNB’s objectives, they did give banks more flexibility, increasing their participation in the programme, and consequently its effectiveness. In the IRS tenders held every second week, the MNB accepted HUF 1,808 billion worth of offers, which in terms of closed transactions amounted to HUF 1,731 billion in IRSs at the end of 2016. In 52 tenders held between 26 June 2014 and 7 July 2016, the MNB entered into IRSs with counterparty credit institutions in the total amount of HUF 1,808 billion. Three credit institutions closed a part of their IRSs before maturity, which reduced total holdings by HUF 77 billion. The HUF 1,731 billion worth of IRSs held at the end of 2016 means that in addition to the portfolios already held in the base period, each credit institution undertook to maintain a securities portfolio of a size equivalent to its IRSs until maturity. Based on the initial maturity of the IRSs, credit institutions participating in the tenders entered into the highest amount of IRSs for 5-year maturities, and a smaller volume of transactions for the 3-year and 10-year maturities. Although it was not introduced as part of the Self-Financing Programme, the interest rate swap conditional on lending activity (LIRS) was also designed to support banks’ interest rate risk management, and it was offered by the central bank in five tenders in 2016 Q1. Access to the LIRS was conditional on increased lending to SMEs rather than on an increase in the holdings of collateral assets. By July 2016, the portfolio of these two interest rate swap instruments of the MNB exceeded HUF 2,500 billion, representing more than 10 per cent of participating banks’ balance sheet. Of this amount, the 3-year LIRS instrument amounted to HUF 780 billion, while banks’ quotes for the 3-year, 5-year and 10-year IRS instrument amounted to HUF 652 billion, HUF 904 billion and HUF 175 billion, respectively (Chart 14-6).

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Chart 14-6: Aggregate holdings of central bank IRS instruments HUF Billions

HUF Billions LIRS-tenders

Start of self-financing IRS tenders

2,600 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0

12. Jun. 2014 10. Jul. 2014 7. Aug. 2014 4. Sep. 2014 2. Oct. 2014 30. Oct. 2014 27. Nov. 2014 8. Jan. 2015 5. Feb. 2015 5. Mar. 2015 2. Apr. 2015 30. Apr. 2015 28. May. 2015 25. Jun. 2015 23. Jul. 2015 19. Aug. 2015 17. Sep. 2015 15. Oct. 2015 12. Nov. 2015 10. Dec. 2015 21. Jan. 2016 4. Feb. 2016 18. Feb. 2016 3. Mar. 2016 17. Mar. 2016 31. Mar. 2016 28. Apr. 2016 26. May. 2016 23. Jun. 2016

2,600 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0

3-year self-financing IRS stock 5-year self-financing IRS stock Total IRS stock

10-year self-financing IRS stock Stock of IRS conditional on lending (LIRS)

Source: MNB.

14.4 Results of the Self-Financing Programme 14.4.1 Accommodation of domestic credit institutions to the modification of the central bank instruments

As a result of the measures taken as part of the Self-Financing Programme, the banking sector increased the value of its holdings of eligible collateral securities by approximately HUF 3,000 billion between 2014 and the end of 2016. The transformation of 2-week bonds into deposits, and in particular the introduction of 3-month deposits in the second phase of the Programme, required major accommodation efforts from participants in the banking system. Owing to the modification of the instruments and the application of stricter liquidity rules (LCR) in compliance with international standards, a major part of bank liquidity flowed from sterilisation assets to the securities market. Within banks’ — 486 —

14 Self-financing programme — central bank tools to reduce external vulnerability

new securities holdings, government securities accounted for more than 90 per cent, comprised predominantly of fixed-interest forint bonds, accompanied by a decline in the holdings of short-term government securities during the Programme (Chart 14-7). There was also a significant increase in the holdings of other bonds (amounting to approximately HUF 300 billion), which included the bonds of both financial and non-financial corporations. Compared to the base period (3-month average for January to March 2014), the increase in securities holdings substantially exceeds the liabilities arising from IRSs (HUF 1,731 billion). Overall, it can be stated that as the central bank’s deposit instruments were tapered, credit institutions looked for other marketable investment opportunities for the placement of their surplus liquidity, which also enabled the use of forint funds to roll over maturing foreign currency debt. Chart 14-7: Developments in the securities holdings of central bank counterparties by type of security vs. developments in holdings of the central bank’s sterilisation and credit instruments HUF Billions

HUF Billions

Announcement of the reform of the monetary policy toolkit

Until August 2014: 2-week MNB bill

From Sept. 2015: 3-month deposit

August 2014–Sept. 2015: 2-week deposit

Mar. 2014 Apr. 2014 May. 2014 Jun. 2014 Jul. 2014 Aug. 2014 Sep. 2014 Oct. 2014 Nov. 2014 Dec. 2014 Jan. 2015 Feb. 2015 Mar. 2015 Apr. 2015 May. 2015 Jun. 2015 Jul. 2015 Aug. 2015 Sep. 2015 Oct. 2015 Nov. 2015 Dec. 2015 Jan. 2016 Feb. 2016 Mar. 2016 Apr. 2016 May. 2016 Jun. 2016 Jul. 2016 Aug. 2016 Sep. 2016 Oct. 2016 Nov. 2016 Dec. 2016

7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 –500

Government bonds* Mortgage bonds* Sterilisation instruments*

Short-term government securities* Other bonds* Credit facilities*

Note: *monthly average holdings. Source: MNB, securities statistics, nominal values.

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7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 –500

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Following accommodation, compared to other countries in the European Union, Hungarian banks secured an upper-midrange position in terms of their holdings of general government debt securities. Banks’ share in Hungarian debt was in the middle range of the European Union values at the beginning of 2016. Banks’ share in their respective countries’ general government debt securities exceeds the Hungarian Chart in Poland, the Czech Republic, Romania and Bulgaria in the region, and in Malta, Ireland, Cyprus and Portugal in the euro area. In the period between 2014–2016, government securities, accounting for a majority of liquid Hungarian securities, saw a significant rearrangement in their ownership structure, with a major increase in the weight of domestic participants. As a result of the measures taken as part of the Programme, the banking system significantly increased its portfolio of liquid securities, and of government securities in particular. While the share of non-residents in the market for HUF-denominated government securities shrank from 32 per cent to around 22 per cent between 2014–2016, the domestic banking sector increased its share from 30 per cent to 37 per cent, replacing foreign investors as the largest buyers and holders of such securities. Among domestic participants, apart from banks, households also recorded outstanding growth in their holdings of HUF-denominated government securities. In the market for HUF-denominated government securities, in the period concerned the ownership share of the household sector rose from 14 per cent to 21 per cent, primarily due to the ÁKK’s retail government securities programmes. Households’ more active participation in debt financing also made a meaningful contribution to reducing vulnerability.

14.4.2 Decreasing external and foreign currency debt

The Self-Financing Programme played a prominent role in ensuring that the gross external debt of the national economy continued to decrease in the period between 2014–2016. While in the aftermath of the — 488 —

14 Self-financing programme — central bank tools to reduce external vulnerability

crisis it was primarily the deleveraged banking sector that saw its external debt reduced, the launch of the Self-Financing Programme also triggered a major decline in the external debt of the general government. During the Self-Financing Programme, the gross external debt of the economy dropped from around 90 per cent as a percentage of GDP to less than 70 per cent by 2016 H2. Over the same period, gross external government debt dropped from 55 per cent of GDP to the vicinity of 40 per cent. During the central bank’s Self-Financing Programme (2014–2016), forint funds were used to refinance some EUR 11 billion worth of foreign currency debt. The ÁKK repaid foreign currency debt of EUR 2.5 billion in 2014, EUR 3.9 billion in 2015 and EUR 4.6 billion in 2016 without issuing a significant amount of foreign currency bonds in international markets (Hoffmann–Kolozsi, 2017). The larger-thanexpected forint issuance also enabled foreign currency debt maturing in subsequent years to be reduced quicker than planned, and the ÁKK made early repayments on foreign currency loans and foreign currency bonds in both 2015 and 2016. The last instalment of the Hungarian government’s loan from the EU, which was repaid in early April in the amount of EUR 1.5 billion, accounted for a major part of the repayments made in 2016. The reduction in external vulnerability was primarily reflected in the change in the composition of government debt. Accumulated in the aftermath of the 2008 crisis, Hungary’s external debt began to decline in 2012 thanks to the commencement of instalments in relation to the EU/ IMF credit facility. However, non-residents’ contribution to forint financing began to increase; moreover, from 2013 foreign currency issuances resumed. From mid-2014, in net terms, the Hungarian government no longer needed to borrow foreign currency for performing its instalments of international loans and for the refinancing of maturing foreign currency bonds,119 as sufficient forint funds were available to finance the general 119

lthough retail foreign currency government securities were issued both in 2014 and A 2015 (Premium Euro Hungarian Government Bonds, “PEMÁK”), net foreign currency financing was negative nevertheless.

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government. Between 2014 Q2 and the end of 2016, the share of nonresident holders within the consolidated Maastricht general government gross debt120 dropped from 55 per cent to less than 40 per cent. In government debt financing, the share of foreign currency within central government debt dropped from 42 per cent at the end of 2013 to around 25 per cent at the end of 2016 (Chart 14-8). The voluntary bank accommodation triggered by the Self-Financing Programme largely contributed to the significant reduction in the exposure of the general government to exchange rates between 2014 and 2016. As part of the Self-Financing Programme, the foreign currency debt held by non-residents decreased, and the country’s external vulnerability was further reduced accordingly. Throughout the Programme, the ÁKK was able to use forint funds to roll over maturing foreign currency debt in a way that, even with regard to the effects of other MNB Chart 14-8: Foreign currency ratio of central government debt121 55

Per cent

Per cent Start of Selffinancing Programme

55 50

Foreigners buy HUF debt

Domestic entities buy HUF debt

Jan. 2007 Apr. 2007 Jul. 2007 Oct. 2007 Jan. 2008 Apr. 2008 Jul. 2008 Oct. 2008 Jan. 2009 Apr. 2009 Jul. 2009 Oct. 2009 Jan. 2010 Apr. 2010 Jul. 2010 Oct. 2010 Jan. 2011 Apr. 2011 Jul. 2011 Oct. 2011 Jan. 2012 Apr. 2012 Jul. 2012 Oct. 2012 Jan. 2013 Apr. 2013 Jul. 2013 Oct. 2013 Jan. 2014 Apr. 2014 Jul. 2014 Oct. 2014 Jan. 2015 Apr. 2015 Jul. 2015 Oct. 2015 Jan. 2016 Apr. 2016 Jul. 2016 Oct. 2016

35 30 25 20

Foreign currency ratio

Source: ÁKK, 2016.

overnment debt expressed in nominal terms, including every subsystem of the general G government with their mutual assets and liabilities netted against one another. 121 Based on the time series on central government debt published on the ÁKK’s website. 120

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14 Self-financing programme — central bank tools to reduce external vulnerability

programmes122 reducing the foreign exchange reserves, Hungary’s foreign exchange reserve adequacy123 was never compromised.

14.4.3 Declining long-term yields

The reduction in the exchange rate exposure of general government and the rearrangement of the ownership structure of the markets for liquid securities was accompanied by a tangible decline in longterm yields. In that decline, a prominent role was played by the central bank’s easing cycles and the Self-Financing Programme. Base rate cuts

Standing at 7 per cent in mid-2012, by the summer of 2016 the central bank base rate had decreased to 0.9 per cent as a result of three easing cycles. The three easing cycles were carried out between August 2012 and July 2014, March and July 2015, and March and May 2016. While the direct effects of cuts in the central bank base rate are primarily felt in short-term yields, expectations for the base rate were also priced in longer-term yields. Self-Financing Programme

The Self-Financing Programme significantly contributed to the decline in longer-term interest rates. In the period between the first IRS tender and the suspension of the instrument, the reference yields on government securities for 3-year, 5-year and 10-year maturities recorded a decrease of 115 to 135 bps, while for equivalent maturities reference euro-area yields dropped to a similar extent only for the 10year maturity, and in Poland yields dropped by less than 100 bps for all maturities (Chart 14-9). Therefore, in Hungary yields declined at articularly those related to forint conversion of household foreign currency loans, P which involved the sale of the central bank’s foreign currency to banks in the total amount of EUR 9.6 billion. 123 Reserve adequacy was maintained throughout the Self-Financing Programme, with international reserves providing adequate coverage for short-term external debt based on residual maturity. 122

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a rate exceeding that of international developments. Csávás–Kollarik (2016)124 estimate the overall downward pressure exerted by the SelfFinancing Programme on long-term yields to be equivalent to 75-90 basis points. In addition to the direct effect, the reduced sensitiveness of yields to global factors, the EMBI spread and long-term euro yields, as well as reduced external vulnerability and a more stable financing provided by domestic participants also made an indirect contribution to the decline in yields. Chart 14-9: Reference yields in the Hungarian, Polish and German markets for government securities between July 2014 and July 2016 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 –0.5 –1.0

Per cent

Hungary 01.07.2014 Poland 01.07.2014 Germany 01.07.2014

10y

5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 –0.5 –1.0

Hungary 01.07.2016 Poland 01.07.2016 Germany 01.07.2016

Note: Base rate cuts of 100 bps in Poland and 170 bps in Hungary in the period concerned. Source: MNB.

The central bank’s base rate cuts and the measures under the SelfFinancing Programme supported a significant reduction in the interest burdens of public debt. According to Baksay–Kicsák (2015), the general government’s total savings on interest expenditures up to first half of 124

saba, Cs. – András, K. (2016): Effect of the Self-Financing Programme on Monetary C Conditions. In: The First Two Years of the Self-Financing Programme. MNB, 2016.

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14 Self-financing programme — central bank tools to reduce external vulnerability

2015 possibly amounted to more than HUF 460 billion (approximately 1.4 per cent of GDP) compared to interest expenditures that would have been made if the yields of August 2012 had been maintained; however, following complete re-pricing, interest savings could possibly reach an annual 1.7 per cent of GDP over the long-term. As a combined result of the above, long-term yields on government securities dropped below the corresponding Polish yields in 2016. While at the beginning of 2014 the Hungarian 5-year benchmark yield was 100 to 150 bps higher than the corresponding Polish yield, by the end of 2015 the difference diminished despite the fact that Poland’s debt rating in the assessment of international credit rating agencies was still two notches higher at the time (Chart 14-10). Chart 14-10: Polish and Hungarian benchmark yields on government securities 7.00

Per cent

Basis points

700

6.00

600

5.00

500

4.00

400

3.00

300

2.00

200

1.00

100

0.00

–1.00

–100

–2.00

–200

–3.00

–300

–4.00

1-year

3-year

5-year

10-year

15-year

–400

Change compared to March 2014 (Poland, right-hand scale) Change compared to March 2014 (Hungary, right-hand scale) Poland March 2014 Poland December 2016 Hungary March 2014 Hungary December 2016 Note: Base rate cuts of 100 bps in Poland and 170 bps in Hungary in the period concerned. Source: MNB.

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Summary Between 2014 and 2016, the Self-Financing Programme substantially improved Hungary’s debt structure. As a result of the increasing share of domestic investors and the crowding-out of foreign currency financing, by the end of 2016 Q2 the gross external debt of the economy had declined to 73 per cent of GDP and net external debt to approximately 20 per cent of GDP. By mid-2016, this put Hungary in a more favourable position in terms of debt structure than the average of the CEE region. The Self-Financing Programme clearly played a part in convincing the three leading international credit rating agencies to consecutively reclassify Hungarian debt as investment-grade. Each credit rating agency highlighted the importance of the Programme in strengthening the country’s financial stability, while international investors and international financial institutions, notably the European Commission and the International Monetary Fund, also expressed their appreciation of the steps taken towards self-financing (European Commission, 2016; IMF, 2016). Given the long-term effects of the instruments’ modifications to banks’ liquidity management, not only did the Self-Financing Programme facilitate progress in improving the financing structure of the economy and in reducing debt service burdens between 2014–2016, it will also be able to support the sustainable financing of the Hungarian economy and further reductions in its external vulnerability in the long run.

Key terms gross external debt eligible collateral external debt external vulnerability financing plan liquid security

net external debt net foreign currency issue ratio of foreign currency to government debt self-financing short-term external debt — 494 —

14 Self-financing programme — central bank tools to reduce external vulnerability

References The First Two Years of the Self-Financing Programme. MNB, 2016. https://www.mnb.hu/letoltes/ mnb-the-first-two-years-of-the-self-financing-programme.pdf Baksay, G. – Kicsák, G. (2015): A jegybanki programok hatása az államháztartás kamatkiadásaira – Mit mutatnak a tények? (The Effect of Central Bank Programmes on the General Government’s Interest Expenditures – The Facts) MNB. http://www.mnb.hu/letoltes/kicsak-gergely-baksay-gergelya-jegybanki-programok-hatasa-az-allamhaztartas-kamatkiadasaira.pdf (25 November 2015). Baksay, G. – Berki, T. – Csaba, I. – Hudák, E. – Kiss, T. – Lakos, G. – Lovas, Zs. – P. Kiss, G. (2013): Developments in Public Debt in Hungary between 1998 and 2012: Trends, Reasons and Effects. MNB Bulletin, Special Issue, October 2013. pp. 14–22. https://www.mnb.hu/letoltes/baksay-berkicsaba-hudak-kiss-lakos-lovas-pkiss.pdf European Commission (2016): Country Report Hungary. Including an In-Depth Review on the prevention and correction of macroeconomic imbalances. Commission Staff Working Document, SWD (2016) 85 final. http://ec.europa.eu/europe2020/pdf/csr2016/cr2016_hungary_en.pdf Filardo, M. – Mohanty, R. – Moreno, R. (2012): Central Bank and Government Debt Management: Issues for Monetary Policy. BIS Papers No. 67. https://pdfs.semanticscholar. org/7bcd/18752d7fdelbd6bb3a3fbbed5703614a4edf.pdf Hoffmann, M. – Kolozsi, P.P. (2017): Biztonságos szinten az MNB tartalékai (MNB Reserves at a Safe Level). http://www.mnb.hu/letoltes/hoffmann-mihaly-kolozsi-pal-peter-mnb-honlapra.pdf IMF (2012): Pilot External Report. July 2, 2012. http://www.imf.org/external/np/pp/ eng/2012/070212.pdf IMF (2016): Hungary. 2016 Article IV Consultation Press Release; Staff Report; And Statement by the Executive Director for Hungary. IMF Country Report. No. 16/107 April. https://www.imf.org/ external/pubs/cat/longres.aspx?sk=43878.0 Kolozsi, P.P. – Hoffmann, M. (2016): Reduction of External Vulnerability with Monetary Policy Tools. Public Finance Quarterly 2016/1, pp. 7–33. https://www.asz.hu/storage/files/files/publicfinance-quarterly-articles//2016/kolozsi_2016_1_a.pdf Kolozsi, P.P. – Banai, Á. – Vonnák, B. (2015): Phasing Out Household Foreign Currency Loans: Schedule and Framework. Financial and Economic Review 14(3), pp. 60–87. http://english. hitelintezetiszemle.hu/letoltes/3-kolozsi-banai-vonnak-en.pdf Kolozsi, P.P. – Novák, Zs. (2016): A monetáris politika eszközei a XXI. században – az MNB példája (Monetary Policy Instruments in the 21st Century – the Example of the MNB). In: Kálmán János (ed.): A monetáris politika a XXI. században. A volume of studies published by Batthyány Lajos College on the “State – Crisis – Finances” conference. Győr, 2016. pp. 133–163. http://blszk.sze.hu/images/ Dokumentumok/kiadv%C3%A1nyok/%C3%81llam%20-%20v%C3%A1ls%C3%A1g%20-%20 p%C3%A9nz%C3%BCgyek%20konferenciak%C3%B6tet%203.pdf

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Part II: Challenges and Answers in Hungarian Monetary Policy Lentner, Cs. (ed.) (2015): A devizahitelezés nagy kézikönyve. (The Great Handbook on Foreign Currency Lending.) Budapest: Nemzeti Közszolgálati és Tankönyv Kiadó Zrt. ISBN: 9786155344626. MNB (2014): Az ország adósságszerkezete tovább javítható (Hungary’s Debt Profile Can Be Improved Further). https://www.mnb.hu/letoltes/mnb-hatteranyag-az-orszag-adossagszerkezete-tovabbjavithato.pdf MNB (2015): The Magyar Nemzeti Bank’s Self-Financing Programme, April 2014–March 2015 (Analysis). http://www.mnb.hu/letoltes/the-magyar-nemzeti-bank-s-self-financingprogramme-april-2014-march-2015.pdf Moody’s (2015): The Evolution of Emerging Market Sovereign Debt: Dramatic Growth in Local Currency Sovereign Debt Is Reducing Emerging Market Financial Vulnerabilities. Report. Nagy, M. (2016): Szükség van-e még az MNB kamatcsere-eszközére? (Is It Still Necessary to Maintain the MNB’s Interest Rate Swap Instrument?) https://www.mnb.hu/letoltes/nagy-marton-szakmaicikk-finalmnbhonlapra.pdf Nagy, M. – Palotai, D. (2015): The MNB Further Reduces Hungary’s Vulnerability by Reforming its Policy Instruments. https://www.mnb.hu/letoltes/marton-nagy-daniel-palotai-the-mnb-furtherreduces-hungary-s-vulnerability-by-reforming-its-policy-instruments.pdf Supriyadi, A. (2014): External Vulnerability Indicators: The Case of lndonesia. Bank Indonesia. Paper Submitted for the Seventh IFC Biennial Conference on 4-5 September 2014. http://www.bis. org/ifc/events/7ifcconf_supriyadi.pdf

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Development of BUBOR and the domestic interbank market Dániel Horváth – Péter Kálmán – Pál Péter Kolozsi

Interbank benchmarks are the “lighthouses” of the financial system: they are public goods that provide a reference point for market participants, support the efficiency of lending operations and other financial products, and reduce transaction costs. Like its international peers, the Budapest Interbank Offered Rate (BUBOR) is typically used as a benchmark with forint-related products. The domestic importance of the BUBOR is illustrated by the fact that it is used to price debt and interest rate derivatives in a volume that is roughly equivalent to the annual GDP of Hungary. In Hungary, the BUBOR reforms implemented between 2012–2015 primarily concerned the reinforcement of the organisational background, the averaging methodology, the number of maturities, and the terms related to contributing banks. In order to fulfil its functions and to function as a reliable basis for pricing the aforementioned products, the BUBOR must represent all relevant market information. The fact that quotes for the most important maturities were becoming increasingly “stuck” until April 2016 indicated that this requirement was not met despite the reforms, and thus the BUBOR failed to fulfil its role adequately. The problems were exacerbated by the fact that during the crisis trading practically ceased to exist in the longer segments of the unsecured interbank market, while counterparty limits fell close to zero. In addition, due to the LIBOR scandal and the ensuing regulatory tightening, “herding behaviour” became stronger and stronger, i.e. panel banks strived to submit interest rates that were close to the group average or to their earlier quotes. Ultimately, besides the possible reputational advantages, against the background of the — 497 —

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tightening regulation and increasing requirements, there was no incentive that could have made banks interested in quotations. This pointed to the conclusion that there was a lack of harmony between the importance of the BUBOR and the soundness of its information content. In order to increase the soundness of BUBOR fixings, the BUBOR Rules were amended and the quotation system was reshaped at the MNB’s initiative from May 2016, which was preceded by several rounds of discussions with the Quotation Committee and panel banks. As a result of the changes, a quotation system based on transaction obligations was set up, similar to the regional patterns in Poland and Romania. In line with international recommendations, it increased the role of real market transactions related to submissions. Additionally, at the request of the Hungarian Forex Association, from 1 November 2016 the MNB took over the administration of benchmarks, which it carries out through the operations of the Benchmark Quotation Committee (BQC). As a result of the reforms implemented in May 2016, for the 1-month and 3-month maturities in the unsecured interbank market, the volume of business between panel banks reached levels last seen before the crisis. Following the introduction of the new quotation system in May 2016, the volatility of the BUBOR increased, and quotes became unanchored from the base rate. The new quotation system therefore strengthened the information flow between the domestic money markets. Even in periods of low liquidity, the movements of quotes reflected the developments in market conditions. This allowed the MNB to fine-tune its monetary policy while leaving the base rate unchanged. Due to the modification of the central bank toolkit, from mid-2016 BUBOR yields dropped by some 80 bps, which in annual terms generated interest savings amounting to HUF 40-50 billion for domestic household and corporate borrowers. In connection with the launch of the new quotation system, the MNB requested the banks to provide the “reasonable” limit level required for the operation of the system. Responding to that request, over the past months most banks have managed to set (or increase) limits for the rest of the panel banks. The — 498 —

15 Development of BUBOR and the domestic interbank market

aggregate amount of counterparty limits more than tripled at the system level. We consider that the “limit grid” that has emerged provides the space required for the operation of the system. As the size of the central bank’s balance sheet is reduced, the channels through which the increasingly asymmetric interbank excess liquidity can be distributed will be an important question going forward. It was in that context that the possibility emerged for the development of the domestic repo market, a market segment that is also becoming increasingly dominant internationally. The repo market may be a key venue for the distribution of interbank liquidity, while it also provides a viable trading opportunity for longer maturities. Additionally, the capital and limit requirements of repurchase transactions tend to be lower, and a pick-up in the volume of business could also have a beneficial liquidity effect on the government securities market.

15.1 Introduction — Why is the BUBOR important? Interbank benchmarks are the “lighthouses” of the financial system: they are public goods that provide a reference point for market participants, support the efficiency of lending operations and other financial products, and reduce transaction costs. From the 1970s onwards, the primary type of benchmark that spread internationally was the quotation of interest rates for unsecured interbank lending, and mainly the varieties involving quotations for maturities of 3 and 6 months. Globally, the most prominent of these benchmarks is the London Interbank Offered Rate (LIBOR), whereas the Budapest Interbank Offered Rate (BUBOR), which is based on international examples, is typically used with forint-related products. By the 2000s, these interest rates acquired such an importance across the international financial system that made them indispensable and effectively fundamental to the entire system, given their almost exclusive use both in credit agreements and in various financial products (such as swaps, interest rate derivatives, etc.) — 499 —

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The BUBOR fixings with various maturities play a prominent role in Hungarian financial markets in respect of derivative and other financial products, variable-rate credit agreements, and the monitoring of monetary conditions as well. Based on data for 2015, the BUBOR was used to price HUF 29,000 billion worth of debt and interest rate derivatives, a volume roughly equivalent to the annual GDP of Hungary (Table 151). The volume of debt priced over the BUBOR amounted to some HUF 2,700 billion in 2012, and now exceeds HUF 6,000 billion, which is mainly attributable to the conversion of household foreign currency loans. Table 15-1: Holdings priced over the 3-month and 6-month BUBOR Use

Holdings (HUF Billions)

FRA

400

IRS

16,114

CCIRS

6,499

Credit

6,127

Total

29,140

Source: MNB, data for 2015

15.2 Reforms in the period between 2012—2015 Following international practices, BUBOR quotes (submitted for the first time in August 1996 for maturities of 1 and 3 months) were arranged by the Hungarian Forex Association (HFA), the professional organisation of FX market brokers. While no fundamental changes have been made to the quotation methodology over the past two decades, the problems arising in connection with major international benchmarks have underlined the benefits in improvements to the BUBOR methodology, as a result of which several amendments were made to the Rules since 2012. One trend of the model international efforts concerned the practice of benchmark quotations and international reform. Through these efforts, over the past years in several countries the bodies tasked with benchmark administration (quotation committees) have been established or strengthened, codes of conduct have been adopted, — 500 —

15 Development of BUBOR and the domestic interbank market

procedures have become stricter, and supervisory authorities have placed more emphasis on the control of benchmark quotes. In Hungary, the reforms implemented between 2012–2015 primarily concerned the reinforcement of the organisational background, the averaging methodology, the number of maturities, and the terms related to contributing banks. Following up on international examples and feedback from the market, steps have also been made towards transparency in the BUBOR Rules. As part of that, the Quotation Committee was established, and the number of maturities was reduced from 15 to 9. The quotes from which the BUBOR was derived were based on participating banks’ business offers for the interest rates at which they would lend unsecured interbank funds to other contributing banks for specific maturities. The value of the daily fixing is established after trimming125 and averaging the quotes received, and will be available for use to the public. The MNB has played multiple roles in deriving the benchmarks. On the one hand, the MNB was responsible for operative functions, i.e. the daily collection, verification and publication of quotes. On the other hand, the MNB delegated two members to the Quotation Committee, which was set up in 2013 to take over the powers and responsibilities of the HFA’s technical committee regarding the management of market benchmarks. Box 15-1 Adoption of the Code of Conduct

During the financial crisis that started in 2008 and following the subsequent scandals over the manipulation of the LIBOR and EURIBOR, international orientation efforts started for reforms of the system of benchmarks. As part of those efforts, several countries adopted codes of conduct to set out the rules, policies and expectations concerning contributing banks’

125

Ignoring the 1 to 4 extreme values depending on the number of offers received.

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operations, organisational structures and control systems, the procedures in place, and the management of conflicts of interest. As part of the BUBOR reform, based on recommendations by Hungarian and international institutions, and on the international trends referred to above, following consultations with the banking system, in September 2015 the BUBOR Rules were extended to include the Code of Conduct, which comprises the requirements for procedures and internal regulations on the operations of contributing banks. The Code of Conduct for BUBOR submitters was drawn up on the basis of international examples and recommendations (notably the EURIBOR and LIBOR Rules, and the Wheatley Report), also taking into account Hungarian specificities.126 Contributing banks agree to be bound by the provisions of the Code of Conduct, and are required by the end of February in each year to issue statements on compliance with the Code. As a general rule, the Code requires contributing banks to ensure that the internal policies, procedural rules, organisational structures, flows and control procedures related to submissions and to transaction obligations are fully and adequately documented, and are available at any time for independent audits. Additionally, contributing banks are required to cooperate with the responsible supervisory authorities, and to provide the technical conditions for compliance with the transaction obligation set out in the Rules. The Code of Conduct contains detailed provisions on governance and organisation, and requires that contributing banks follow a “submitter and approver” method,127 where the submitter is responsible for proposing a quote in compliance with the required flow, and the approver is responsible for the review of the quote proposed, and for the verification of f the Hungarian specificities considered, mention must be made of the fact that due to O the smaller size of domestic banks, a significantly lower number of people are employed in sales positions in Hungary compared to large global banks, which was relevant to the personal requirements set out in the Code of Conduct. Nevertheless, Hungary’s specific rules do not reduce the control provided by the rules of conduct over the quotation process. 127 The Code provides for each contributing bank to have at least two employees with submitter privileges and two employees with approver privileges, and to develop a sufficient order of substitution. 126

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daily submissions (four-eyes principle). Banks are also required to arrange for the training and education of their submitters, as well as to manage potential conflicts of interest. Apart from the principle requiring submitters to maintain their integrity at all times in the discharge of their duties, the Code also requires bank employees to use the appropriate channels to report any suspected manipulation of quotations. With a view to the prevention of manipulation, the Code requires that efforts be made also as part of the performance appraisal and remuneration policies to avoid incentives that might encourage the manipulation of quotations. Subject to the requirement of using objective and identifiable data and information in determining their quotations, each contributing bank is required to define a documented quotation methodology, to be reviewed at least annually. The Code provides for the protection of confidential data, and requires contributing banks to retain the relevant data for a minimum of five years, and the related voice recordings for two years. Contributing banks must have policies and procedural rules in place for complaints management. In respect of the quotation process, the Code defines three lines of defence: internal audit, risk/compliance, and senior management. The Rules provide for the ongoing control of quotations, requiring the risk/compliance function to prepare quarterly reports for more senior management on the findings of reviews and audits. The contributing bank’s internal audit function is required to review the related procedural rules and flows at least annually.

15.3 Why were further improvements to the BUBOR needed from May 2016? In order to fulfil its functions and to function as a reliable basis for pricing the aforementioned products, the BUBOR must represent all relevant market information. However, the fact that quotes for the most important maturities were becoming increasingly “stuck” until April 2016 indicated that this requirement was not met, and thus the BUBOR failed to fulfil its role adequately. In the case of the 3-month BUBOR, apart from adjustments to the base rate, the ratio of unchanged — 503 —

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days (Chart 15-1) has increased gradually in the past 12 years (2004: 12%; 2008: 35%; 2012: 64%; 2015: 85%; up to May 2016: 95%). Chart 15-1: Frequency of the daily shifts in the 3-month BUBOR (left panel) and 3-month unsecured transactions between BUBOR panel banks before the reform (right panel)

2014

2012

HUF Billions

30 25 20 15 10 5

2013

4 5< 2015

0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan.

Per cent 90 80 70 60 50 40 30 20 10 0 <–5 –4 –3 –2 –1 0 1 2 Basis points

Note: Transaction volume data until April 2016. Source: MNB.

Interbank benchmarks for maturities beyond a few weeks became stuck for a number of reasons. Even before the crisis one could not really consider the market liquid, but during the crisis trading practically ceased to exist in the longer segments of the unsecured interbank market, while counterparty limits fell close to zero. In addition, due to the LIBOR scandal and the ensuing regulatory tightening, “herding behaviour” became stronger and stronger, i.e. panel banks strived to submit interest rates that were close to the group average or to their earlier quotes. Ultimately, besides the possible reputational advantages, against the background of the tightening regulation and increasing requirements, there was no incentive that could make banks interested in quotations, and thus the panel size declined in Hungary and also in the case of the majority of international benchmarks. In relation to that, emphasis should be placed on the public goods character of the BUBOR: it is a product available free of charge to — 504 —

15 Development of BUBOR and the domestic interbank market

all, and its reliable production in a stable quality requires common efforts. This pointed to the overall conclusion that there was a lack of harmony between the importance of the BUBOR and the soundness of its information content. It is important to note that the phenomenon at hand is international, i.e. the diminishing information content of interbank benchmarks is not specific to Hungary. Nevertheless, the fixing being stuck so extensively was unique even in a regional comparison (Chart 15-2). Chart 15-2: Developments in interbank benchmark yields across the region Per cent

Per cent

18 16 14 12 10 8 6 4 2 0

4 3 2 1

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Czech base rate Czech 3-month interbank yield Per cent

Per cent

7 6

0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Romanian base rate Romanian 3-month interbank yield

Hungarian base rate Hungarian 3-month interbank yield Source: Bloomberg.

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Polish base rate Polish 3-month interbank yield

Part II: Challenges and Answers in Hungarian Monetary Policy

In the Czech Republic as well as in the Romanian and Polish markets, which operate quotation systems based on transaction obligations, movements of the 3-month interbank benchmark reflected real market developments much better. Overall, therefore, improvements to the rules and principles related to the BUBOR (trimming methodology, maturities, Code of Conduct, transparency, etc.) and the enlargement of the size of contributing banks’ panel were important steps in improving quotes, but nevertheless failed to substantially strengthen the information content of the BUBOR. A significant underlying reason for the problem is that practically there were effectively no unsecured market transactions in the segment concerned, and thus the price discovery function of the market could not support the quotation system.

15.4 BUBOR reform from May to September 2016 In order to increase the soundness of BUBOR fixings, the BUBOR Rules were amended and the quotation system was reshaped at the MNB’s initiative from May 2016, which was preceded by several rounds of discussions with the Quotation Committee and panel banks. As a result of the changes, a quotation system based on transaction obligations was set up, similar to the regional patterns in Poland and Romania. In line with international recommendations, it increased the role of real market transactions related to quotations. According to the new Rules, panel banks are entitled to trade with each other at the interest rates corresponding to the BUBOR quotes submitted by them for a 15-minute period following the publication of the BUBOR fixing at 11 a.m. The transaction obligation is applicable to the 1-month and 3-month maturities, and it is valid up to HUF 100 million and HUF 50 million per counterparty on the given day, respectively. The interest rate on deposit taking was fixed 15 bps below the BUBOR quote submitted. The system was launched on 2 May 2016 — 506 —

15 Development of BUBOR and the domestic interbank market

with the participation of 9 BUBOR contributor banks, with an additional 3 institutions joining the panel during the summer. Box 15-2 Amendments to the MNB’s Business Regulations

The success of the transformation of the BUBOR quotation system depends on the participation of a sufficient number of contributing banks in the daily quotation process. To that end, following international examples, the MNB decided to make certain elements of the monetary policy instruments conditional on participation in the quotation process in the case of banks requested to submit quotes. Incentives for banks’ participation in quotations are a relevant issue in other countries as well, and there are also international examples for linking access to central bank instruments and participation in benchmark quotations.128 Effective as of May 2016, the Terms of Business regulating access to central bank instruments were amended to ensure that banks qualifying as outstanding and relevant in terms of their balance sheet totals and the volume of their interbank business would in fact contribute to BUBOR quotations, which is a key precondition for the execution of monetary policy, and for the maintenance of effective implementation and monetary transmission. Incentives for contribution to quotations are required because BUBOR fixings are public goods within the financial system, which are accessible by market participants free of charge and are used to determine the terms of loans and financial derivatives, while contributing banks incur expenses from contribution to the quotation process. The Terms of Business provide that as part of its money market operations, the MNB may only trade with resident credit institutions that meet 128

esponding to the reduction in the size of the contributor panel, in March 2013 the R Polish central bank adjusted its system for money market quotations, following which access to quick tenders of less than 7 days was restricted to WIBOR panel banks. For the purpose of restricting access to the reserve account, in determining the quota allocated to each bank Norway’s central bank takes into account whether the bank concerned is a NIBOR contributor.

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the particular eligibility criteria specified for the various instruments, and in addition to such criteria – except for the overnight collateralised loan instrument – with money market counterparties requested to act as contributing banks according to the fixing procedure of the Budapest Interbank Offered Rate which undertake and meet their obligations arising from the BUBOR Rules. Where a contributing bank repeatedly submits quotes in deviation from the provisions of the Rules or fails to meet its contribution or transaction obligations, the MNB will exclude the contributing bank concerned from BUBOR quotations, and will simultaneously prohibit the bank from accessing the following central bank instruments: – transactions in securities; – short-term forint deposits with the central bank (3-month main policy deposit, preferential deposit facility, overnight deposit instrument); – secured one-week central bank loans; – transactions carried out between forint and foreign currencies, and in foreign currencies (FX swaps with the central bank, spot FX market operations between forint and foreign currencies, and foreign currency deposits); – interest rate swaps;129 – the Funding for Growth Scheme. Banks that have been requested to contribute but decline the request or grant the request but fail to honour it or to comply with the BUBOR Rules will not be denied access to O/N credit because without such credit, banks could not borrow during the day, which could also cause disruptions to intraday payments. The banks concerned are granted access to this central bank instrument at 200 bps above the O/N lending rate, which may give banks an adequate incentive on the expense side without any negative effect on payments. Whether or not they agree to the request and comply with the Rules, the banks requested to contribute are under an obligation to meet the reserve requirement, and maintain their payments account with the MNB. 129

s part of its Self-Financing Programme, between summer 2014 and July 2016 the MNB A held IRS tenders every second week, and in 2016 Q1 it held 5 tenders for interest rate swaps conditional on lending activity (LIRS).

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15 Development of BUBOR and the domestic interbank market

15.4.1 Following the adoption of the EU Benchmark Regulation, BUBOR administration was taken over by the MNB

In the aftermath of the crisis, an EU Regulation130 was adopted in June 2016 to address the problems identified concerning benchmark rates and to ensure the reliability of such rates. Although the Regulation contains provisions for all levels and participants in benchmark generation (data providers, administrators, supervisory authorities, users), it primarily regulates entities performing administrator functions. As regards administrators, strict requirements were introduced for governance structure, the assessment and management of conflicts of interest, disclosure obligations, as well as the level of employee training and their involvement in conflicts of interest. Additionally, the Regulation provides for regular annual reviews, a dedicated oversight committee function, the detailed documentation of processes, and stakeholders’ personal financial liability. At the same time, exemptions from the scope of application of the Regulation were granted to central banks and other public authorities, which the explanation considers to have already met the basic conditions for the reliable operation of benchmarks. Once it developed an understanding of the requirements set out in the Regulation, the Quotation Committee of the HFA notified the MNB that the HFA was not prepared to undertake the administrative burdens and expenses involved in compliance with the Regulation, and offered to transfer the administration of the BUBOR, BIRS and HUFONIA Benchmark Indices to the MNB. It was justified for the MNB to take over the benchmarks, because they are of particular importance in terms monetary transmission, financial stability and 130

egulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June R 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014.

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supervisory powers. Also, the takeover of the benchmark arguably did not represent any additional expenses or risks to the MNB, because the daily operational work related to the generation of the indices (collection, verification, calculation, publication) had previously been carried out by the MNB. As part of the transfer, all powers and responsibilities related to the generation and administration of the BUBOR, the BIRS and the HUFONIA Swap Index (such as maintenance of and ensuring compliance with the Rules, communication with panel banks) was assigned to the MNB. There were a number of professional arguments in favour of the takeover of the duties related to the benchmarks. • Of particular significance to the country’s financial system, the benchmarks are public goods, the administration of which warrants the contribution of a public sector participant. In view of its powers and experience in the financial markets, the MNB has primary relevance in this regard. • The transmission of monetary policy actions takes place partly by means of these benchmarks. A major part of corporate loans was already priced over the BUBOR, while in the household segment the share of such loans soared after forint conversion. The BUBOR is also a key index for the settlement of FX swaps. • Due to their role as indicators of interbank financial terms and to the role they play in pricing financial products, the reliability of benchmarks is a matter of importance in terms of financial stability. • The manipulation scandals of recent years have highlighted the critical importance of monitoring benchmark generation, which makes the administrator role closely related also to supervisory responsibilities.

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15 Development of BUBOR and the domestic interbank market

At the request of the Hungarian Forex Association, as of 1 November 2016 the MNB took over the administration of benchmarks, which it carries out through the Benchmark Quotation Committee (BQC). The BQC is a body authorised to define the quotation criteria for the financial benchmarks administered by the central bank, to establish the audit universe regarding the submission of quotes and to impose sanctions in the event of any deviation from the rules. The BQC currently administers the BUBOR, BIRS, and HUFONIA Swap Index benchmarks. The BQC is responsible for the development of the rules concerning these benchmarks, providing the operational conditions for benchmark generation, the continual improvement of domestic interbank benchmarks, and the control of the quotation process. Apart from the representatives of several professional fields within the MNB, the BQC also grants consulting powers to market participants to involve them in its professional work. On the MNB’s website, the BQC publishes information on developments concerning the benchmarks, committee meetings, and the changes of the benchmarks.

15.5 Results — The volume of business has grown substantially, and the BUBOR started to move in line with the market conditions Since the introduction of the new BUBOR quoting system, in the unsecured interbank market panel banks have traded transactions with each other in the amount of HUF 90 billion for the 1-month maturity, and HUF 56 billion for the 3-month maturity (Chart 15-3). This represents a volume of business unseen since the crisis. The majority of the transactions were made for the mandatory minimum amounts of HUF 50 and 100 million, but there have also been significantly larger transactions in trade sizes of HUF 500 to 3,000 million. It should also be noted that every panel bank has made transactions, which indicates the existence of an effectively functioning market. — 511 —

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Chart 15-3: Monthly volume of unsecured interbank transactions traded among BUBOR panel banks in the segment of 1 to 3 months 25

HUF Billions

Starting new system 20

0 Jan. 2015 Feb. 2015 Mar. 2015 Apr. 2015 May. 2015 Jun. 2015 Jul. 2015 Aug. 2015 Sep. 2015 Oct. 2015 Nov. 2015 Dec. 2015 Jan. 2016 Feb. 2016 Mar. 2016 Apr. 2016 May. 2016 Jun. 2016 Jul. 2016 Aug. 2016 Sep. 2016 Oct. 2016 Nov. 2016 Dec. 2016 Jan. 2017

1 month

3 months

Source: MNB.

The turnover was not distributed evenly over time (Chart 15-4), but even in periods of low liquidity, the patterns of quotes reflected the developments in market conditions. This means that although the BUBOR market was not the primary platform for the redistribution of interbank excess liquidity, the movement of BUBOR quotes in accordance with liquidity conditions is an important result in itself. This allowed the MNB the opportunity to fine-tune its monetary policy while leaving the base rate unchanged. The new BUBOR quoting system therefore strengthened the information flow among the domestic money markets; consequently, the declining money market yields are also reflected in BUBOR quotes. The occasionally low volume of BUBOR turnover was mostly attributable to liquidity becoming tighter towards the end of each month, and to increasing market uncertainty. â&#x20AC;&#x201D; 512 â&#x20AC;&#x201D;

15 Development of BUBOR and the domestic interbank market

Chart 15-4: Daily volume of unsecured interbank transactions in the segment of 1 to 3 months 7,000

HUF Millions

7,000

31. Oct.

17. Oct.

3. Oct.

1,000 19. Sep.

1,000 5. Sep.

2,000

22. Aug.

2,000

8. Aug.

3,000

25. Jul.

3,000

11. Jul.

4,000

27. Jun.

4,000

13. Jun.

5,000

30. May

5,000

16. May

6,000

2. May

6,000

Source: MNB.

15.5.1 A significant increase in counterparty limits

During the crisis, interbank counterparty limits effectively dropped to zero and did not increase until 2016 H1, which made market flows impossible in the segment longer than 1 or 2 weeks, contributing to the BUBOR quotes becoming void, while impeding the flow of liquidity in other sub-markets as well. In connection with the launch of the new BUBOR quoting system, MNB requested the banks to provide the “reasonable” limit level required for the operation of the uncovered interbank market. Responding to that request, most banks have managed to set (or increase) limits for the rest of the panel banks. As a result, the aggregate amount of counterparty limits more than tripled at the system level, providing the space required for the operation of the system.

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It should be noted that MNB received positive feedback in several instances concerning limit increases, given the opportunity to increase space in other sub-markets as well, which means that the transformation of the BUBOR made a positive external effect on the liquidity of other interbank markets as well. In respect of restrictions on the main policy instrument, this is also important for the MNB, because it enables and facilitates the efficient flow of excess liquidity in the banking system.

15.5.2 Volatility of the BUBOR has increased and has diverged from the base rate

Following the introduction of the new quoting system in May 2016, the volatility of the BUBOR increased, and quotes diverged from the base rate. Following the transformation of the system, the 3-month BUBOR first increased slightly, and then dropped following the announcement concerning the modification of the monetary policy tools (Chart 15-5). By January 2017, the 3-month BUBOR was quoted at around 0.25 per cent. Chart 15-5: Developments in the base rate, and the 1-month and 3-month BUBOR 1.4

Per cent

Per cent First „cap” auction

1.2 1.0

1.4 1.2 1.0

0.8

System launch

0.6

0.6 Report toolbar conversion

0.4 0.2

0.0

1. Jan. 2016 18. Jan. 2016 2. Feb. 2016 17. Feb. 2016 3. Mar. 2016 18. Mar. 2016 4. Apr. 2016 19. Apr. 2016 4. May 2016 19. May 2016 3. Jun. 2016 20. Jun. 2016 5. Jul. 2016 20. Jul. 2016 4. Aug. 2016 19. Aug. 2016 5. Sep. 2016 20. Sep. 2016 5. Oct. 2016 19. Oct. 2016 1. Nov. 2016 12. Nov. 2016 23. Nov. 2016 4. Dec. 2016 15. Dec. 2016 26. Dec. 2016 6. Jan. 2017 17. Jan. 2017 28. Jan. 2017

0.0

Base rate

BUBOR 1 month

Source: MNB.

— 514 —

BUBOR 3 months

15 Development of BUBOR and the domestic interbank market

15.5.3 Reform has resulted in significant savings for borrowers

In annual terms, the decline in BUBOR yields resulted in interest savings amounting to HUF 40 to 50 billion for domestic household and corporate borrowers. In 2015, price of more than HUF 6,100 billion worth of debt was based on the BUBOR. Accordingly, in annual terms, the approximately 75 to 85 bp decline in interbank rates that has taken place since the MNB’s announcement on 12 July, triggered by the modification of the monetary policy instruments, results in a decrease in interest expenditures of some HUF 40 to 50 billion for domestic household and corporate borrowers. Approximately two-thirds of the debt’s price based on the BUBOR, i.e. HUF 3,800 billion, is related to the household segment. In the household segment, the decline in BUBOR yields decreased instalments by approximately 4 per cent, and interest payments by 15 per cent.

15.6 Looking ahead, development of the repo market may be relevant in Hungary 15.6.1 International examples point towards the development of the secured market and the establishment of secured benchmarks

Based on international research and best practices, some alternatives have emerged to replace or complement unsecured interbank rates as benchmarks over the past 4 to 5 years in the aftermath of scandals over unsecured interbank rates. In building the appropriate benchmark, a number of factors should be taken into account: • Is the current benchmark suitable for product pricing? – Does the benchmark reflect the risks and costs to the banking system (liquidity, capital allocation, default) in respect of a loan? — 515 —

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• Can the same benchmark be used for unsecured interbank transactions and derivatives? • What risks are reflected in the benchmark? (risks to the public sector or to the banking system) • Should the benchmark be filtered for counterparty risk? (whether the level of risk is better reflected in an unsecured or secured transaction) • Is there a market for the benchmark with a meaningful volume of business, and can a market price be established? • Is the benchmark rate aligned to the maturity of the transactions to be benchmarked? The significance of unsecured interbank benchmarks has recently become more differentiated, and a number of reports131 have provided assessments of alternative benchmarks (OIS, base rate, treasury bill yields, repo rates, FX swap rates, hybrid rates, bank funding cost index). In the public consultations carried out in the context of the Wheatley Report, out of the alternatives available most respondents identified the OIS (overnight index swap) market as the segment that may provide an alternative benchmark to replace or complement the LIBOR (Table 15-2) in the longer term. One of the main arguments put forward in the Report was that derivative or secured benchmarks involve a lower level of counterparty risk, regarding which repo is also a good alternative. Following consultations with central banks and participants in the global money market, the BIS also recommended the development of benchmarks of low credit risk, including primarily an OIS benchmark, unsecured overnight transactions, and government debt repo benchmarks.

131

heatley Report (HM Treasury [2012b]), BIS Report (BIS ([2013]), Financial Stability W Board Report (FSB [2014]).

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15 Development of BUBOR and the domestic interbank market

For each currency, the Financial Stability Board (FSB) assessed possible alternative benchmarks in addition to rebuilding interbank benchmarks. The report highlights the unsecured overnight market, repos, and the OIS market. In certain countries, the crisis has increased the popularity of repos, which nevertheless have the disadvantage that yields are also influenced by the counterparty and credit risks of the underlying security. Based on the FSB’s benchmark Report, EONIA and repos are recommended. In the latter case, the RepoFunds Rate published by the ICAP has been available since the end of 2012 as an index calculated from overnight repo rates (secured by German, French and Italian EURdenominated government securities). The US options include repos, reverse repos, the so-called IOER (interest rate on excess reserves, an administrative central bank rate), and government securities. A repo index is also available in the form of the GCF Repo Index, which tracks the average of 3 types of repo benchmark (government securities, agencies and MBS). In Canada, the transaction-based repo benchmark CORRA is available and applicable, while Switzerland and Japan also have repo benchmarks on hand.

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Table 15-2: Assessments of the Wheatley Report and the BIS Working Group based on unweighted scores Wheatley Report

Unsecured Central O/N interbank bank base unsecured market rate lending

CDs/CPs

OIS

Treasury bills

Repo rates

0.25

0.5

Counterparty risk

0.25

Liquidity risk

0.25

0.5

Maturity curve

0.5

Transaction volume

0.5

0.25

0.5

Market resilience

0.25

0.75

0.25

0.75

0.5

0.75

0.5

Level of standardisation

0.5

0.75

Total score

Long data series

5.75

4.25

4.5

5.75

4.25

Score (net of counterparty risk and liquidity risk)

3.75

4.5

3.25

CDs/CPs

OIS

Treasury bills

Repo rates

BIS assessment

Unsecured Central O/N interbank bank base unsecured market rate lending

Credit risk

0.25

Term premium

Influence from the effect of flight to quality

Transaction volume

0.25

0.75

Transparency

0.5

0.25

0.5

Total

2.75

2.5

1.5

2.25

Score (net of credit risk and liquidity risk)

2.5

0.5

1.25

*A higher score indicates better compliance with expectations. In the Wheatley Report, scoring was based on a 5-step scale (0; 0.25; 0.5; 0.75; 1), with equal weights attached to the individual steps. In the conversion of the BIS assessment, yes/no questions were scored 1/0, while the low/limited/high options were mapped to the values of 0.25, 0.5 and 0.75, respectively. Sources: Wheatley Report, BIS.

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15 Development of BUBOR and the domestic interbank market

The euro money market repo benchmarks (daily indices generated by the BrokerTec and MTS platforms based on repo transactions) aptly show that at time of market turbulences, the yields of unsecured and secured transactions and benchmarks may diverge, and that secured yields are less responsive to such situations (Chart 15-6). Chart 15-6: Spreads between 3-month interbank yields and repo rates, and EONIA and repo rates 3.0

Percentage point

3.0

EURIBOR 3M — RepoFunds Rate

3. Jan. 2017

3. Jul. 2016

3. Jul. 2015

3. Jan. 2016

3. Jan. 2015

3. Jul. 2014

3. Jul. 2013

3. Jan. 2014

–1.0 3. Jan. 2013

–1.0 3. Jul. 2012

–0.5 3. Jul. 2011

–0.5 3. Jan. 2012

0.0

3. Jan. 2011

0.0

3. Jul. 2010

0.5

3. Jul. 2009

0.5

3. Jan. 2010

1.0

3. Jul. 2008

1.0

3. Jan. 2009

1.5

3. Jul. 2007

1.5

3. Jan. 2008

2.0

3. Jul. 2006

2.0

3. Jan. 2007

2.5

3. Jan. 2006

2.5

EONIA — RepoFunds Rate

Source: Bloomberg.

In the absence of a repo benchmark, it is difficult to visualise this in the region; nevertheless, due to the difference in the level of risk, the spread between OIS quotes and the unsecured interbank yield may be suitable for the approximation of the spread between the repo rate and unsecured interbank rates (Chart 15-7).

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Chart 15-7: Spreads between 3-month interbank yields and OIS in Hungary and Poland 1.0

Percentage point

1.0 0.8

0.6

0.4

0.2

0.0

–0.2

3. Jan. 2011 3. Apr. 2011 3. Jul. 2011 3. Oct. 2011 3. Jan. 2012 3. Apr. 2012 3. Jul. 2012 3. Oct. 2012 3. Jan. 2013 3. Apr. 2013 3. Jul. 2013 3. Oct. 2013 3. Jan. 2014 3. Apr. 2014 3. Jul. 2014 3. Oct. 2014 3. Jan. 2015 3. Apr. 2015 3. Jul. 2015 3. Oct. 2015 3. Jan. 2016 3. Apr. 2016 3. Jul. 2016 3. Oct. 2016

0.8

HUF

PLN

Source: Bloomberg.

15.6.2 Development of a functional repo market would provide multiple benefits

In the context of the modification of the monetary policy instruments and of the quantitative limitation imposed on 3-month deposits, the redistribution of liquidity in the banking system has recently gained wider significance. To date, a major part of liquidity has been traded in the short-term segments of the interbank market, while there has also been a slight increase in transaction volumes in longer-term segments, and in secured markets for swaps and repos. As the size of the central bank’s balance sheet is reduced, the channels through which liquidity redistribution may take place will also be an important question going forward. — 520 —

15 Development of BUBOR and the domestic interbank market

In Hungary, of the markets discussed in the recommendations of the reports, there is effectively no trading the OIS market, the development of which may require a significant effort without any guarantee for long-term functionality (Table 15-3). By contrast, the repo market is picking up, with meaningful transaction volumes for several maturities. Table 15-3: Volume of specific transaction types in unsecured and secured forint markets Average daily transaction volume (HUF Billions) Year

Repo Net of ÁKK

O/N

Unsecured interbank Longer

O/N

Longer

Other FRA

FX swap

DTB

OIS

2009

531

2010

541

2011

514

2012

113

493

2013

114

384

2014

129

434

2015

149

513

2016

154

449

Source: MNB.

In this context the possibility emerges for the development of the domestic repo market, a market segment that is also becoming increasingly dominant internationally. Development of the repo market may also be supported by the fact that in recent years banks have increased their holdings of government securities, i.e. that the volume of securities required for repurchase transactions is present in the system.

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Box 15-3 Repo transactions

Repo transactions are a class of securities transactions, which legally take the form of purchase and sale agreements for securities with a repurchase obligation. A repo is an agreement under which a security is transferred between the parties, subject to a commitment on the repurchase of the security at the agreed price. Specific types of repo transaction vary as to the rights and obligations that each party has in respect of the security concerned; accordingly, a distinction may be made, for example, between held-in-custody, delivery and sell/buyback repo agreements. In an economic sense, repurchase transactions constitute secured lending, and as such they tend to be made for lower yields compared to unsecured interbank transactions.

In Hungary, the trading volume of the repo market is smaller than that of the unsecured interbank market, but it has been picking up in recent years. Although the transaction volume net of the ÁKK has doubled, it is still only on-third of the volume of unsecured O/N transactions. Importantly, however, the transaction volume of the unsecured interbank market is, for the most part, limited to the O/N maturity, whereas the volume of transactions traded in the secured market is more evenly distributed over specific maturities. Although the central bank’s efforts have generated a viable transaction volume in the 1 to 3-month unsecured interbank market, this segment is still not the place for the distribution of interbank liquidity. As a result, consideration is being given to the choice of a suitable market to facilitate the redistribution of liquidity. There are a number of arguments to assess opportunities for the development of the repo market in Hungary. • Potentially a real venue for the distribution of interbank liquidity. In the near future, as the size of the central bank’s balance sheet decreases, the liquidity position of the banking system will become increasingly — 522 —

15 Development of BUBOR and the domestic interbank market

asymmetric, giving more prominence to the allocation of surplus liquidity among banks. Currently, this role is primarily occupied by the unsecured O/N interbank market, although a well-functioning repo market may provide banks with a more efficient option, which is potentially also more favourable in terms of risk management. • Trades for longer maturities as well. In the repo market, a meaningful transaction volume may also be generated in longer segments other than O/N, i.e. of relevance in terms of benchmarks, which is a matter of importance in terms of the stability and reliability of benchmarks. According to data for 2016, two-thirds of the transaction volume of the repo market was traded in the segment above one week, whereas the same ratio is a mere 16 per cent for the unsecured market. • Lower capital and limit requirements. Compared to unsecured transactions, repurchase transactions have the great advantage that they have a far lower capital requirement (with a 0 per cent risk weight for domestic government securities), which makes them less costly for banks. Another important factor is that interbank limits, which have been low notwithstanding an increase related to the BUBOR reform, have restrained the formation of adequate liquidity in longer segments of the unsecured market, in contrast to the much larger space available for trading secured transactions. • Benefits to the market for government securities. A liquid repo market may also have a positive effect on the market for the government securities used as collateral due to the increase in liquidity generated in such related markets, which may also cause yields to drop through the reduction of liquidity premiums. • Support for market participants. In BUBOR consultations, market participants expressed opinions recommending a shift of emphasis to secured markets. In that context, a comprehensive survey of market opinions is needed, as a viable market can only be established through active bank participation. — 523 —

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Overall, therefore, the establishment of a well-functioning repo market in Hungary would equally benefit monetary policy, households and banks, and would also support the government securities market and the protection of financial stability.

15.7 Conclusion The domestic importance of the BUBOR is supported by the fact that it is used to price debt and interest rate derivatives in a volume that is roughly equivalent to the annual GDP of Hungary. However, the fact that BUBOR quotes were becoming increasingly “stuck” until April 2016 despite the reforms indicates that this requirement was not met, and thus the BUBOR failed to fulfil its role adequately. This pointed to the overall conclusion that there was a lack of harmony between the importance of the BUBOR and the soundness of its information content. In order to increase the soundness of BUBOR fixings, the BUBOR Rules were amended and the quoting system was remodelled at the MNB’s initiative from May 2016. As a result of the changes, a quoting system based on transaction obligations was set up, similar to the regional patterns in Poland and Romania. In line with international recommendations, this increases the role of real market transactions related to quotes. Since the launch of the new quoting system, in the unsecured interbank market panel banks have traded transactions with each other in the amount of HUF 90 billion for the 1-month maturity, and HUF 56 billion for the 3-month maturity, representing a volume unseen since the crisis. Following the introduction of the new quoting system in May 2016, the volatility of the BUBOR increased, and quotes became unanchored from the base rate. The trades were not distributed evenly over time, but even in periods of low liquidity, the movements of quotes reflected the developments in market conditions. The new quoting system strengthened the information flow between the domestic money markets; consequently, the declining money market yields — 524 —

15 Development of BUBOR and the domestic interbank market

are also reflected in BUBOR quotes. This allowed the MNB to fine-tune its monetary policy while leaving the base rate unchanged. Due to the modification of the monetary policy instruments, from mid-2016 BUBOR yields dropped by some 80 bps, which in annual terms generated interest savings amounting to HUF 40-50 billion for domestic household and corporate borrowers. As the size of the central bank’s balance sheet is reduced, the channels through which the increasingly asymmetric interbank excess liquidity may be distributed will be an important question going forward. It was in that context that the possibility emerged for the development of the domestic repo market, a market segment that is also becoming increasingly dominant internationally. The repo market may be a key venue for the distribution of interbank liquidity, while in contrast to the unsecured market, it also provides a real trading opportunity for longer maturities. Additionally, the capital and limit requirements of repurchase transactions tend to be lower, and a pick-up in the volume of business could also have a beneficial liquidity effect on the government securities market.

Key terms administrator Benchmark Submissions Committee BIRS Budapest Interbank Offered Rate (BUBOR) counterparty limits EU Regulation fixing HUFONIA Swap Index

Hungarian Forex Association interbank excess liquidity interest rate derivatives London Interbank Offered Rate (LIBOR) panel bank repo market repurchase transaction unsecured interbank market

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References Angelini, P. – Nobili, A. – Picillo, M.C. (2009): The interbank market after August 2007: what has changed and why? Bainbridge, S.M. (2013): Reforming LIBOR: Wheatley versus the alternatives. BIS (2013): Towards better reference rate practices: a central bank perspective. Duffie, D. – Stein, C.J. (2014): Reforming LIBOR and Other Financial-Market Benchmarks. ECB (2013): Reference Interest Rates: Role, Challenges and Outlook. ECB (2015): Euro money market survey. Erhart, Sz. – Ligeti, I. – Molnár, Z. (2013): A LIBOR-átvilágítás okai és hatásai a nemzetközi bankközi referenciakamat jegyzésekre (Reasons for the LIBOR review and its effects on international interbank reference rate quotations). ESMA (2016): Discussion Paper, Benchmark Regulation. European Commission (2013): Proposal for a Regulation of the European Parliament and of the Council on indices used as benchmarks in financial instruments and financial contracts. FSB (2014): Reforming Major Interest Rate Benchmarks. FSB (2015): Progress in Reforming Major Interest Rate Benchmarks. HM Treasury (2012a): Implementing the Wheatley Review. HM Treasury (2012b): The Wheatley Review of LIBOR: final report. Hou, D. – Skeie, D. (2014): LIBOR: Origins, Economics, Crisis, Scandal, and Reform. ICE (2014): Position paper on the evolution of lCE LIBOR. ICE (2016): Roadmap for ICE LIBOR. IOSCO (2013): Principles for Financial Benchmarks: Final Report. Thorn, T. – Vikstedt, H. (2014): Reforming Financial Benchmarks: An International Perspective.

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The limitation of the 3-month deposit as unconventional easing and related modifications of other central bank instruments Csaba Csávás – Gabriella Csom-Bíró – Rita Lénárt-Odorán – Gábor Sin

In addition to the main policy instrument, a central bank’s conventional monetary policy instruments typically comprise the O/N interest rate corridor and the system of reserve requirements. Traditionally, these instruments have been in place to provide support for effective interest rate transmission, i.e. to facilitate the spill-over of the policy rate to market yields. At the same time, central bank instruments are also suitable for shaping monetary conditions in a targeted manner. One example of that is the new monetary policy instruments introduced by the Magyar Nemzeti Bank in the summer and autumn of 2016, which involved unconventional monetary easing in addition to keeping the base rate on a sustained hold. The stability of the base rate is an important value in itself, as keeping interest rate levels unchanged for a sustained period may provide for greater predictability and preparation opportunities, facilitating the adoption of business decisions for the long term. The main element of the system is a quantitative limitation on the 3-month deposit, which allows the MNB to support lending incentives and self-financing by channelling liquidity, and to reduce relevant market yields. Implementing the measure effectively as of Q4 2016, the MNB supported the quantitative limitation by cutting the O/N lending rate to the base rate, i.e. by making the interest rate corridor completely asymmetric, and by cutting the reserve ratio from 2 per cent to 1 per cent. Initial experiences with the quantitative limitation and related modification of other instruments have been positive. As a result of restricted tenders, the MNB’s holdings of the 3-month deposit decreased from almost HUF 2,000 billion in late September 2016 to approximately HUF 900 billion in November, — 527 —

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and a major part of surplus liquidity in the banking system was channelled to O/N deposits. Perceivable in all relevant markets, crowded out liquidity put a downward pressure on yields: following the announcement in July 2016, by December 2016 the decline in short-term yields amounted to 50-60 basis points. While providing for base rate stability, the quantitative limitation system therefore eased monetary conditions, which, due to its effect on the government securities market, resulted in more favourable terms of funding for the public sector, and, due to the interbank effect, in lower borrowing rates for households and the corporate sector. This paper addresses the MNB’s unconventional monetary policy instruments that are suitable to facilitate the easing of monetary conditions with a constant base rate. This volume of studies includes a separate chapter on the Self-financing Programme, which, besides reducing external vulnerability, eased monetary conditions particularly through the government securities market. Accordingly, this paper discusses the modification to the MNB’s instruments in 2016, namely the quantitative limitation on the 3-month deposit instrument, and related modifications to the interest rate corridor and the system of reserve requirements. A description is provided of the central bank’s new monetary policy framework implemented as of Q4 2016, the motivations behind modifications to the instruments, as well as the theoretical background to and practical experiences with those modifications, and the measures are also assessed from an international perspective.

16.1 Banks’ limited access to the 3-month deposit instrument Since autumn 2015, the MNB’s main policy instrument has been the 3-month central bank deposit. Pursuant to the central bank’s decision of July 2016, since August 2016, tenders for the 3-month deposit have been announced once a month instead of the previous weekly frequency (frequency reduction) and since October 2016, a quantitative limitation — 528 —

16 The limitation of the 3-month deposit as unconventional easing and related...

has been applied to banks’ access to the instrument. In connection with the banks’ limited access to the instrument, in October 2016 fine-tuning instruments were also introduced to provide and absorb forint liquidity.

16.1.1 Theoretical background to restrictions on the main policy instrument, international practice

The MNB has been applying limitations on access to the 3-month deposit since autumn 2016, aiming to support the central bank’s lending incentive and self-financing programmes on the one hand, and to reduce yields in a targeted manner on the other. Among the modification of instruments announced by the MNB in July 2016, the most important element is the limitation on banks’ access to the main policy instrument, which was implemented with the following specific objectives: – lending incentives; – support for the Self-financing Programme; – targeted reduction of market yields without a change in the base rate. By crowding out liquidity, the quantitative limitation drives down interbank rates and may lead to a repricing of loans and an increase in credit demand, whereby it may amplify the effect of the MNB’s lending incentive schemes. The BUBOR is used to price loans and interest rate derivatives in a volume that is roughly equivalent to the annual GDP of Hungary, including over HUF 6,000 billion worth of forint loans, which makes BUBOR developments significant also in terms of the real economy. To the extent that crowded out liquidity is transferred by banks to the government securities market, this supports the MNB’s Self-financing Programme and contributes to a further reduction in the country’s external vulnerability. Additionally, representing an unconventional easing of monetary conditions, the departure of BUBOR yields from the policy rate may boost the volume of trading in the unsecured interbank markets, which may thus also play a market facilitation role. — 529 —

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According to the impact mechanism of the quantitative limitation, liquidity crowded out of the 3-month deposit “looks for its place” in the interbank and government securities markets, and will end up in central bank deposits with an interest rate below the base rate. The liquidity crowded out by the quantitative limitation on the 3-month deposit flows into other instruments (Chart 16-1). As a first step, the liquidity appears in the interbank market, and due to the systemic surplus liquidity in the banking system, participants try to get rid of their excess liquidity, which drives down yields in the interbank and government securities markets. Since total liquidity in the banking system is a given, crowded out liquidity will ultimately end up in a central bank instrument or government securities. The instruments into which liquidity will flow depends on the yields of the instruments, banks’ risk-return preferences, and the liquidity characteristics of the instruments. – The most liquid instrument available to banks is the reserve account, which is a sight deposit, accruing interest at the base rate of balances up to the reserve requirement, however, accruing interest on unfavourable terms exceeding that (since October 2016, the interest rate on excess reserves has been 15 bps below the O/N central bank deposit rate). – Banks may earn a higher but still negative yield by placing their liquidity in an O/N central bank deposit, which in turn requires liquidity to be absorbed for one day (i.e. one night). – Crowded out liquidity may flow into the central bank’s preferential deposit, which has an overnight term and is conditional on lending activity and accrues interest at the base rate. However, the preferential deposit is only available to banks in a limited extent (up to twice their annual lending commitments), and excessive use of the deposit carries the risk that a part of the interest paid on favourable terms will have to be repaid in the event of violating the lending condition (MNB, 2015). – Compared to the O/N deposit, banks may earn higher yields by purchasing government securities, and although the liquidity of government securities is similar to that of a demand deposit (given their eligibility as collateral to central bank loans), the longer the maturity of a participant’s holdings, the higher interest rate risk it undertakes. — 530 —

16 The limitation of the 3-month deposit as unconventional easing and related...

Chart 16-1: Stylised impact mechanism of the limitation of the 3-month deposit instrument Unlimited 3-month deposit Liquidity

Risk

Yield

Government securities

Preferential deposit (limited)

3-month deposit (limited)

O/N deposit, excess reserves

Interbank market (unsecured depo, FX swap)

Source: MNB.

The main parameter of the quantitative limitation on the 3-month deposit is the end-of-quarter limit, which, subject to a given liquidity path, also determines the amount of liquidity that will be crowded out of the instrument. The MNB has imposed the quantitative limitation on its 3-month deposit since October 2016, and the first quantitative limit was set as of the end of Q4 2016. The MNB set the quarterly limit at HUF 900 billion, which, according to the central bank’s forecast, is equivalent to at least HUF 200 to 400 billion being crowded out of the instrument. In tenders held monthly, the quantity accepted is determined by the MNB subject to the quantitative limit of HUF 900 billion, while the amount of liquidity that will be crowded out also depends on liquidity developments (see later for the role of liquidity forecasts). The MNB sells its capped 3-month deposits in tenders for fixed interest rates, which ensures that the system of central bank rates remains transparent. In a tender for fixed interest rates, the 3-month deposit is allocated to each participant at the same interest rate, the base rate. A tender for variable rates would involve the possibility of a new interest rate emerging as the average auction rate, which might differ from both the central bank’s rates and market yields. This ought to be avoided, otherwise the average auction rate might give the — 531 —

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market a misleading signal about the central bank’s monetary policy stance. This is because the yield level established at auction can only be influenced to a limited extent, namely through changing the quantity accepted, whereas the quantity accepted in each tender is determined against the main criterion of the amount of liquidity being crowded out. In the MNB’s tenders for its 3-month deposits, the facility is allocated on the basis of banks’ balance sheet totals, which makes the process predictable for banks. There are two rounds of allocation, in the first of which each bank is allowed to place an amount of 3-month deposits corresponding to the ratio of its balance sheet total to that of the overall banking system. In the second round, the quantity that has not been allocated to banks submitting bids below their limits will also be allocated, based on a card allocation. Allocation based on balance sheet total ratios is seen as relatively predictable because the overall balance sheet total is known, which allows banks to calculate the size of the bid that they are certain to be granted on the basis of their balance sheet totals. A bank may only be allocated more than the share corresponding to its balance sheet total if the other banks do not utilise their limits, which does not provide any incentives for manipulation. This is a major difference to allocation based on the ratios of the bids submitted, where a participant might be granted allocation at the expense of the other participants by submitting a bid that is larger than what is in fact necessary. Box 16-1 Limitation of the main policy instrument in central bank practice

Although international practice is not uniform, several developed central banks limit their main policy instruments (Table 16-1). A part of both developed and emerging countries offer their main policy instruments in unlimited quantities. This may either be a standing facility type instrument where the central bank does not publish a quantity in advance and accepts all bids, or a fixed-rate auction, where each bank may submit bids at the same interest rate, and typically all bids are accepted. By contrast, a number of central banks sell their main policy instruments subject to quantitative

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16 The limitation of the 3-month deposit as unconventional easing and related...

constraints. Some of these countries apply variable-rate auctions, where banks submit competitive bids, the best of which will be accepted. With such central banks, the quantitative limitation is generally applied to ensure that the main policy instrument is sold against competitive bids from banks. There are also examples for fixed rate auction systems but with a quantitative limitation applied by the central bank, which requires the application of some allocation mechanism that is not based on yields. For example, the central banks of Sweden and Iceland use “pro-rata” allocations, where allocations are made in proportion to the submitted quantities in the event of an over-subscription. Table 16-1: Characteristics of the main policy instruments of the central banks of some developed and emerging countries

Denmark United Kingdom Eurozone Norway Switzerland Sweden

Main policy Type of the main instrument/ policy Key policy rate instrument 1-week deposit deposit side reserve deposit side balances 1-week repo loan side reserve deposit side balances 3-month LIBOR loan/deposit side 1-week bill deposit side

Auction/ Standing facility

Cap

standing facility

fix-rate auction standing facility with quota bilateral fix-rate auction standing facility with tier allocation

no yes yes yes

New Zealand

reserve balances

deposit side

USA

reserve balances

deposit side

standing facility

2-week repo

deposit side

floating-rate auction

1-week repo loan side fix-rate auction 1-week deposit deposit side fix-rate auction 1-week bill deposit side floating-rate auction O/N interest loan/deposit side floating-rate auction rate 1-week repo loan side fix-rate auction 1-day repo loan/deposit side fix-rate auction 1-week repo loan side floating-rate auction 3-month deposit deposit side fix-rate auction

no yes yes

Czech Republic South Africa Iceland Poland Mexico Romania Thailand Turkey Hungary

yes

yes no no yes yes

Source: Central bank websites. Data collected in November 2016. As the USA has no formal main policy instrument, for this country the table indicates the reserve account, which is the main instrument in the economic sense.

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Some central banks have declared their objective of crowding liquidity out of their main policy instruments, without expressing any intention to drive down yields. Some central banks apply caps in a way that interest is paid at the policy rate on only a part of the bids based on bank quotas. In Norway’s case, for example, bank quotas were introduced in 2011 with the express objective of preventing growth in bank reserves with the central bank, and of providing incentives for O/N market activity (Bindseil, 2016). Obviously, the system by nature causes liquidity to be crowded out, and as recognised in a study by the central bank, this involves reducing market yields below the base rate; however, that objective is implicit only and is not communicated (Norges Bank, 2014). A further example that is similar to a quantitative limitation is provided by the case of Romania’s central bank, where, although the main policy instrument is officially a 1-week active repo, the central bank has not organised such tenders since autumn 2015, due to a liquidity surplus, as a result of which the instrument that determines market rates has been the O/N deposit, and 3-month yields have also been fluctuating below the policy rate. Although the European Central Bank (ECB), of critical importance for the region of Central and Eastern Europe, does not apply a quantitative limitation, the surplus liquidity created by quantitative easing programmes has driven yields below the policy rate. Announced in March 2016, the ECB’s new asset purchase programmes created a significant amount of excess liquidity in the banking system. In December 2016, the total liquidity held by banks on reserve accounts and in O/N deposits amounted to more than 10 times the reserve requirement. The ECB’s main policy instrument is the main refinancing operation; however, banks tend to use it only for small amounts due to the liquidity surplus. Accordingly, in the final months of 2016, with a 0% policy rate, both O/N and 3-month yields were negative, fluctuating between -0.3% and -0.35%, and approximated the O/N deposit rate marking the floor of the interest rate corridor (-0.4%). As part of its previous asset purchase programmes, the ECB had sterilised surplus liquidity at the base rate, a practice which it abandoned as of 2014 (Blackstone, 2014). Surplus liquidity therefore drove down short-term yields, while the ECB’s communication only referred to reducing long-term yields as a specific objective. In the economic sense, the key policy rate is the negative O/N deposit rate rather than the 0% policy rate (Jordan, 2016).

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While the MNB’s quantitative limitation represents a change in the operating target, it does not qualify as a monetary targeting regime. The central bank’s operating target is an indicator which the central bank can influence directly and immediately, the developments of which in turn influence the intermediate target of monetary policy, as well as its final target, i.e. inflation (MNB, 2002). As an operating target, central banks may select an interest rate target, which is typically a short-term market yield, or a quantitative target such as the monetary base (Bindseil, 2014). For instance, the quantitative easing and asset purchase programmes launched by major central banks in the aftermath of the crisis fall into the category of quantitative operating targets, since they set targets on a single element of the central bank balance sheet, i.e. the quantity to be purchased (see the box on the differences of quantitative easing and the MNB’s quantitative limitation). In the case of Japan, a quantitative target was also set in terms of the monetary base, when in 2013 the Bank of Japan announced its intention to double the monetary base within two years (Bindseil, 2014). However, an important difference between the MNB’s regime and that of money targeting central banks is that although the MNB applies a quantitative limitation on a meaningful part of the liability side of the its balance sheet, it does so in order to drive down yields rather than to achieve a broader monetary target (Chart 16-2). Chart 16-2: The limited 3-month deposit instrument in the MNB’s system of monetary policy targets Instruments − limited 3-month deposit* − fine-tuning instruments* − interest rate corridor − reserve requirements

Operational targets − limit on 3month deposit* − amount of liquidity crowded out* − short-term interest rates

Intermediate objective

Final target

− deviation of inflation forecast and target

− inflation target

Variables denoted by * are those which are new compared to the period of unlimited 3-month deposit. Source: MNB.

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In the system of the limitation of the 3-month deposit, the interest rate target remains present in addition to the introduction of quantitative targets. In the MNB’s practice, before the reform of instruments the operating target consisted in short-term yields for maturities around 3 months (MNB, 2012), whereas the quantitative limitation on the 3-month deposit also introduces the quantity of the 3-month instrument as an operating target. Nevertheless, the operating target on yields also remains as the central bank continues to focus on influencing market yields, which, however, in contrast with the previous regime, involves yields below rather than around the policy rate. Although the MNB’s modified instruments do not include an explicit quantitative yield target, this does not represent a marked abandonment of the previous regime, because the central bank had not set a quantitative yield target previously either.132 The quantitative limitation system introduced by the MNB is suitable to contain the growth in yield volatility that is often associated with quantitative targeting. A major critic in literature on quantitative operating targets is that they could lead to increased volatility in shortterm yields (IMF, 2015). In regimes where some measure of money supply is targeted on a daily basis, the central bank might be unable to neutralise liquidity shocks. For that reason, literature recommends that central banks pursuing quantitative targets adopt “flexible monetary targeting”, which includes recommendations for the pursuit of longerterm quantitative targets, the avoidance of point quantitative targets, liquidity forecasting for the longer term, and the avoidance of point policy rates (Maehle, 2014). Accordingly, the instruments adopted by the MNB have a number of elements to prevent growth in the volatility of short-term yields: 132

I t is worth mentioning the example of the Swiss National Bank, where the operating target is a market rate, but the central bank sets a 100-basis-point wide target band on the 3-month CHF LIBOR rather than a single point target. The MNB’s regime is similar in that O/N market rates are also allowed to move within a wide band between the base rate and the floor of the interest rate corridor, which simultaneously determines the band available to longer-term yields for maturities around 3 months.

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16 The limitation of the 3-month deposit as unconventional easing and related...

• the quantitative target on the 3-month deposit is set for a longer (quarterly) term; • the MNB has published a band rather than a point value for the amount of liquidity to be crowded out; • there are fine-tuning instruments in place to smooth unexpected liquidity shocks; • the MNB has narrowed its O/N interest rate corridor. The benefits of a quantitative limitation on main policy instrument compared to unlimited auctioning are also reported in the literature. In these, reference is made to the auctioning of restricted amounts as having the benefit that the central bank retains control over the determination of volume (Bindseil, 2014). This may be important where the banking system’s liquidity forecasting is less accurate than that of the central bank; in such cases, the restriction of tender volumes is recommended (e.g. in the form of variable-rate tenders). Additionally, unlimited standing facility may make participating banks comfortable, while a limited instrument provides an incentive for more cautious liquidity management. Nevertheless, the auctioning of an instrument in unlimited quantities under a standing facility may also have benefits where the central bank aims to keep yields close to the policy rate (Bindseil, 2014). In this respect, too, central banks are following a variety of practices, with a number of examples both for the limited auctioning of the main policy instrument, and for unlimited auctions (see the box above). Box 16-2 Quantitative easing versus quantitative limitation

Major banks’ quantitative easing and the MNB’s quantitative limitation both rely on the use of the central bank balance sheet, but the latter will not cause the central bank balance sheet to widen. Quantitative easing means that the central bank purchases securities denominated in the national currency, mostly with long maturities, while on the liability side the volume of bank deposits increases (Bank of England, 2009). The MNB’s quantitative

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limitation also involves an increase in the amount of banks’ freely usable liquid assets, with the important difference, however, that the quantitative limitation on the 3-month deposit only rearranges the liability side of the central bank’s balance sheet, without any change to its balance sheet total. On the one hand, this means that interest expenditures will decrease compared to unlimited 3-month deposits. On the other hand, the interest rate risk undertaken by the central bank will remain unchanged, because in the event of a rate hike (assuming an interest rate corridor of constant width), interest expenditures would increase to the same extent as with no rearrangements on the liability side of the central bank’s balance sheet. By contrast, as part of their quantitative easing programmes, major central banks purchase significant amounts of government securities or other securities, whereby they both undertake interest rate risk and, by purchasing securities with poorer ratings, add default risk to their balance sheets. While quantitative easing and the quantitative limitation are both aimed at reducing yields, quantitative easing primarily affects long-term yields. One of the objectives of major central banks’ quantitative easing programmes is to reduce long-term yields (Bindseil, 2014). Central banks directly intervene in the market of long-term securities, and by purchasing government securities, they reduce either risk-free long-term yields, or, the yield spread in the case of securities carrying credit risk. Quantitative easing is normally applied in a zero lower bound environment, as a result of which purchases will only have a limited effect on short-term yields. That said, the ECB’s example shows that quantitative easing may also cause short-term yields to fall. By contrast, the MNB’s quantitative limitation aims primarily to reduce short-term money market yields, but obviously the programme also affects longer-term yields indirectly through reduced short-term yields (particularly when the liquidity crowded out flows into government securities with longer maturities).

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16.1.2 The role of liquidity developments and forecasting in limitation of the 3-month deposit

The concept of limiting the volume of the main policy instrument is founded on the expected path of liquidity in the banking system. In a rational scenario, banks place main policy instruments so as to remain capable of meeting their reserve requirements with regard to expected developments in their liquidity positions (Molnár, 2010). The unlimited amount of the main policy instrument between two deposit tenders is optimal when, during the period, minimum use is made of other central bank instruments accruing interest at rates other than the central bank base rate. This is how banks can ensure that they receive the base rate on the largest possible volume while meeting their reserve requirements. When a bank expects its liquidity to increase in the near future, it should place a greater volume of liquidity in the main policy instrument and borrow from the central bank until its liquidity actually increases, in order to meet its need for liquidity arising in the meantime. Conversely, when a bank expects its liquidity to drop, it should place a smaller amount of liquidity in the main policy instrument, because it will need its liquidity in the near future. In both cases, the optimal strategy is the one that will result in the least possible use of central bank instruments that accrue interest on unfavourable terms compared to the base rate. Assuming, first, that banks perceive their expected liquidity paths similarly to the central bank’s perception, and second, that they behave rationally, expected developments in the main policy instrument are estimated on the basis of liquidity forecast. Liquidity in the Hungarian banking system is essentially determined by developments of cash in circulation, budgetary processes, and the central bank’s liquidity adjustment measures. From a different aspect, liquidity in the banking system will change if any item on the central bank’s balance sheet changes (Balogh, 2009). The main factors with a potential impact on liquidity are the following.

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• An increase (decrease) of cash in circulation lowers (raises) the level of liquidity in the banking system. Upon cash withdrawal, a household or corporate participant will receive cash against its bank deposit. Previously that deposit was part of liquidity in the banking system, which will decrease as deposit holdings are reduced. • Liquidity in the banking system is reduced by payments into the budget, and is increased by payments by the public sector. For example, when taxes are paid into the budget, liquidity is transferred from household or corporate deposit accounts to a public account with the central bank. Liquidity in the banking system will be reduced as a result. Conversely, e. g. the payment of social benefits increases liquidity. • The financing processes of the budget also influence the level of liquidity: liquidity is absorbed by issues of forint-denominated government securities, and increased by maturing securities. • In addition to the above, the central bank’s liquidity providing measures may exert a considerable impact on forint liquidity, as evidenced by the central bank’s recently adopted forint liquidity providing swap instrument discussed below or its Funding for Growth Scheme, which also raise liquidity in the banking system. The expected path of the main policy instrument and the intended crowding out clearly determine the quantitative limitation. The expected path of the main policy instrument is a hypothetical volume that banks would be willing to place in the unlimited main policy deposit. By setting the limit, the central bank can “crowd out” a portion of this volume. In practice – and provided that the liquidity projection materialises –, crowding out means that the crowded-out portion of the liquidity will end up in the central bank’s O/N deposits. In determining the limit, consideration should also be given to the utilisation of instruments other than the overnight (O/N) central bank deposit. For example, strong recourse to the preferential deposit — 540 —

16 The limitation of the 3-month deposit as unconventional easing and related...

instrument may mitigate the crowding-out effect, i.e. the liquidity flowing into overnight deposits may be lower. The Monetary Council set the quantitative limitation at HUF 900 billion for the end of 2016, and at HUF 750 billion for the end of Q1 2017. The liquidity projection marks the path of sterilisation instruments, including that of the main policy instrument. In August 2016, when programme parameters were defined, the sterilisation instruments of the banking sector (the stock of 3-month deposits, preferential deposits and overnight deposits) exceeded HUF 1,700 billion. Based on budgetary processes and developments of cash in circulation, a HUF 200-300 billion decline was foreseen in sterilisation instruments (in terms of the average monthly value of sterilisation holdings). Given the declining liquidity path, and also with regard to the preferential deposit facilities, the Monetary Council considered that the HUF 900 billion quantitative limitation was consistent with the HUF 200-400 billion to be crowded out (Chart 16-3). In respect of Q1 2017, a decision was adopted to cut the quantitative limitation to HUF 750 billion, which was consistent with the central bank’s intention to slightly ease monetary conditions further. Additionally, holdings of the main policy instrument may continue to be reduced gradually, enabling additional volumes to be crowded out compared to the previous quarter. Chart 16-3: Flow chart for setting the quantitative limitation Aimed crowding-out effect Liquidity forecast, use of central bank instruments

Expected path of the main monetary policy instrument (stock to be limited)

Source: Authors’ editing.

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In order to control the uncertainty around liquidity developments, the MNB introduced fine-tuning instruments. These fine-tuning instruments enable the MNB to manage persistent and meaningful movements in the liquidity path in order to ensure the effectiveness of the quantitative limitation. • In the event of a negative liquidity shock, additional liquidity needs to be injected into the banking system, because in such cases the liquidity in the system is insufficient for the achievement of the quantitative target. • Conversely, in the event of a positive liquidity shock, excess liquidity in the system is higher than what is consistent with the quantitative limitation. It is therefore appropriate to sterilise the excess liquidity surpluses. The MNB has assigned dedicated instruments to adjust negative and positive liquidity shocks, respectively introducing an FX swap instrument to address negative shocks by providing forint liquidity, and a deposit instrument to sterilise excess liquidity. In tendering both instruments, the MNB takes into account the deviation of the liquidity path from the original path when determining the volumes offered (for more details on the instruments, see Kolozsi–Hoffmann, 2016).

16.1.3 The limitation of the 3-month deposit and reducing of its frequency

The main policy instrument was transformed in two main phases: by reducing the frequency of tenders for 3-month deposits, and by setting a quantitative limitation on such tenders. A timeline of banks limited access to the main policy instrument in 2016 is provided in Chart 16-4.

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Chart 16-4: Major steps along the modification of the main policy instrument in 2016

21. Dec.

7. Dec.

14. Dec.

30. Nov.

23. Nov.

9. Nov.

16. Nov.

2. Nov.

26. Oct.

19. Oct.

5. Oct.

20 December: MPC decision on the cap of the main policy instrument for Q1 2017

12. Oct.

28. Sep.

21. Sep.

7. Sep.

14. Sep.

31. Aug.

24. Aug.

17. Aug.

3. Aug.

20 September: MPC decision on the cap of the main monetary policy instrument for Q4 2016

10. Aug.

27. Jul.

20. Jul.

6. Jul.

13. Jul.

12 July: MPC decision on the reduced frequency of tenders

Tenders before the reduced frequency Maturities with no tender Tenders after the reduced frequency Tenders with quantitative limitation Source: Authors’ editing.

Most banks accommodated to the period of reduced frequency by “advancing” their maturities of 3-month deposits. Advancing meant that in light of the maturities remaining until the next deposit tender, it appeared reasonable for banks to generate the highest possible demand in the reduced frequency tenders for 3-month deposits, and to borrow from the central bank to finance the high volume of deposits temporarily. In this way, banks continued to receive the base rate for 3 months, while they paid interest on O/N and weekly credit temporarily, for a much shorter period. Advanced maturities were characteristic of the tenders called in August and September, when holdings of the main policy instrument in the banking system soared to exceed HUF 1,800 billion, then approximated HUF 2,000 billion. The advance of maturities in September, which was accompanied by the liquidity restraining effect of the central bank swap maturity linked to conversion of FX loans and the VAT payments due at the time, led to a very high volume of bank borrowing from the central bank. As expected by the MNB, borrowing proved to be temporary, and the intense use of lending instruments discontinued accordingly as — 543 —

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the upcoming maturities of the 3-month deposit expired and liquidity increased at the systemic level at the beginning of the month (payment of wages and social benefits). In terms of allotted amounts, the limitation of 3-month deposit was not distributed evenly, which was explained by banks’ adjustment to the frequency reduction. The HUF 900 billion quantitative limitation set for the end of Q4 2016 corresponds to the total amount that may be allotted in the 3 limited deposit tenders in combination. Nevertheless, the amounts offered and allotted in each tender were distributed unevenly, due in particular to banks’ adjustment to the frequency reduction. With a view to ensuring that the volume of liquidity crowded out of the main policy instrument in each tender is spaced out as evenly as possible, a relatively low volume was accepted in the October tender, and larger volumes were accepted in subsequent tenders (HUF 100400-400 billion). The quantitative effect of the quantitative limitation on the main policy instrument began to be reflected in banks’ O/N deposit placements from November 2016 (Chart 16-5). In October, the liquidity crowded out of the main policy instrument flowed primarily into preferential deposits. Owing to their lending commitments, banks have limited access to the preferential deposit; consequently, by the second half of November, the option to place liquidity in preferential deposits ran out. Simultaneously, from the end of November the stock of new O/N deposits gradually edged up and exceeded HUF 400 billion in the first half of December, reflecting the substantial systemic increase in excess liquidity (wage outflows at the beginning of the month, the reduction of the required reserve ratio in December). The end of 2016 saw a meaningful increase in the amount of liquidity in the banking system, with approximately HUF 800-900 billion placed in O/N deposits. As a result, in the value of net O/N deposits (O/N deposits minus O/N loans), which adequately captures developments in excess liquidity in the banking system, dominance has shifted from lending instruments to O/N deposits. — 544 —

16 The limitation of the 3-month deposit as unconventional easing and related...

Chart 16-5: Developments in the amount of 3-month deposits and the net holding of O/N deposits and central bank lending 2,000

HUF Billions

1,500

2,000 1,500

1,000

Tender in September

500

Tender in August

500

Limited tenders

–500

3-month deposit

30. Dec. 2016

16. Dec. 2016

2. Dec. 2016

18. Nov. 2016

4. Nov. 2016

21. Oct. 2016

7. Oct. 2016

23. Sep. 2016

9. Sep. 2016

26. Aug. 2016

12. Aug. 2016

–1,500 29. Jul. 2016

–1,500 15. Jul. 2016

–1,000

1. Jul. 2016

–1,000

Net O/N deposits*

*Value of central bank lending instruments adjusted for O/N deposits. Source: MNB.

In Q4 2016 the persistent and considerable shift in the liquidity path prompted by budgetary processes called for the use of the fine-tuning swap instrument. Actual data received at the end of September and in early October suggested that the liquidity path of the banking system projected for the whole year was lower than expected. This was primarily attributable to the extremely low public deficit path (lower deficit, lower net expenditures, lower increase in liquidity). Therefore, the MNB needed to inject additional liquidity into the banking system through the use of its fine-tuning swap instrument, which had been introduced earlier specifically for this purpose. In Q4 2016, the MNB held a total of six swap tenders: in each of the October tenders, HUF 200 billion worth of extra — 545 —

Part II: Challenges and Answers in Hungarian Monetary Policy

liquidity was injected into the system, and in the November tenders, this liquidity was renewed fully or partially (in the amounts of HUF 200 and 150 billion, respectively). In December, the MNB held another two tenders, one for a maturity of one month (similarly to the previous tenders), and the other for a maturity of one week (Chart 16-6). The instrument enabled the central bank to adjust the previously unexpected, persistent shift in the liquidity path to its intended quantitative target, i.e. to achieve the HUF 900 billion main policy instrument volume and the desired crowding-out effect at the same time. Chart 16-6: Amounts accepted in the fine-tuning swap tenders 600

HUF Billions

HUF Billions 1 month expiry

500

500 400

400

300

300 1 week expiry

200

200 100

100 0

600

17. Oct. 2016.

24. Oct. 2016.

14. Nov. 2016.

Bid amount

21. Nov. 2016.

19. Dec. 2016.

23. Dec. 2016.

Allotted amount

Source: MNB.

16.2 Narrowing the interest rate corridor as a central bank measure to support the quantitative limitation In Hungary, an asymmetric interest rate corridor was introduced in September 2015 to support the objectives of the Self-financing Programme. Subsequently, simultaneously with the easing cycle — 546 —

16 The limitation of the 3-month deposit as unconventional easing and related...

launched in spring 2016, the interest rate corridor was narrowed in three steps from 200 bps to 120 bps. The Hungarian system had already been asymmetric even before the interest rate corridor adjustments related to the quantitative limitation; however, the asymmetry became complete in November 2016, when the MNB set the O/N lending rate at the base rate, narrowing the interest rate corridor to 95 bps. 16.2.1 Definition of the interest rate corridor, interest rate corridor systems in international practice

A wide interest rate corridor may prevent the proper functioning of the interbank market, and the transmission of monetary policy decisions. The interest rate corridor is the monetary policy instrument by which central banks may reduce the volatility of short-term interbank interest rates, and prevent the spill-over of volatility to interest rates on longer maturities. In the course of short-term liquidity management, as part of standing facilities central banks may employ O/N instruments on both the lending side and the deposit side, the interest rates on which mark the effective limit of volatility in interbank yields, i.e. the floor and ceiling of the interest rate corridor. Setting the width of the interest rate corridor represents the trade-off between controlling the desired market rates and minimising the central bank’s intermediary role, i.e. it should provide banks with adequate incentives to trade transactions with one another in the interbank market (Bindseil, 2016; Maehle, 2014). High volatility in interbank rates may hinder banks’ liquidity management, and may increase the risk of their reliance on the interbank market for fine-tuning their available reserves.133 133

According to the results of Bindseil’s stochastic model, the wider the interest rate corridor (i.e. the higher the “penalty” for trading transactions with the central bank), the greater the volume of interbank market activity, the narrower the central bank’s balance sheet, and the higher the volatility in short-term interest rates (BindseilJablecki, 2011). Regression analysis carried out on data pertaining to interbank turnover has demonstrated a statistically and economically significant effect between narrowing the interest rate corridor and interbank trading. However, following the crisis, it became important for central banks to keep short-term market rates close to the target level, which after 2007 prompted a number of central banks to narrow the interest rate corridors they previously had in place, in order to reduce the volatility in short-term market rates driven up by the crisis (Maehle, 2014).

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Part II: Challenges and Answers in Hungarian Monetary Policy

Within interest rate corridor systems, based on existing practice the following main alternatives may be distinguished (Maehle, 2014; Bindseil, 2014, 2016): – In the case of a symmetric interest rate corridor, the interest rates of the deposit and lending sides of overnight standing facility are positioned symmetrically around the policy rate. Utmost importance is attached to the width of the interest rate corridor, which central banks set with or without a reserve requirement, either narrowly (e.g. ±25 bps) or more widely (e.g. ±100 bps). – In the case of an asymmetric interest rate corridor, the differences between O/N central bank instruments and the policy rate are not equal. For example, when the deposit rate is more distant from the base rate, placing deposits will be more expensive in real terms. In a downward asymmetric regime, when the O/N deposit rate is cut, banks will make less use of the O/N deposit instrument, and when the O/N lending rate is cut, banks may borrow on more favourable terms in the event of temporary liquidity shocks. Contrary to a symmetric regime, the effects of autonomous factors need to be forecast more accurately to prevent deviations from the target interest rate level. – In fully asymmetric systems, the width of the interest rate corridor is less relevant, and prominence is given to the average quantity of the instrument available at an interest rate level equivalent to the operating target. In a floor system, the lower bound of the interest rate corridor is marked by the interest rate on the O/N deposit instrument, which is equivalent to the policy rate. The central bank’s operating target is the floor of the interest rate corridor rather than an interest rate level set between the O/N deposit and lending instruments. In order to keep the O/N market rate close to the policy rate, it is essential that banks place a sufficient amount of liquidity with the central bank. Owing to the specificities of the system, on the one hand, the market rate will be very close or equal to the interest rate on standing facility, which will provide less of an incentive for banks to — 548 —

16 The limitation of the 3-month deposit as unconventional easing and related...

trade, while on the other hand the central bank will also be unable to take short-term rates below the target by increasing supply. In a ceiling system, the interest rate on the O/N lending instrument represents the ceiling of the interest rate corridor, which is identical to the central bank’s policy rate and the central bank’s operating target. – In quota systems, the central bank pays interest at the policy rate on banks’ free reserves held with the central bank, but will charge penalty interest above a certain level (“fulfilment band”), which corresponds to an interest rate level below the policy rate. Box 16-3 Asymmetric interest rate corridors in international central bank practice – a snapshot at the end of 2016

In the Czech Republic, at the end of 2009 the central bank introduced an asymmetric band around the policy rate, which was gradually narrowed on the deposit side in the close to three years following the decision. Since November 2012, the interest rate on O/N deposits has been set at the 0.05% policy rate (discount rate, corresponding to the floor of the interest rate corridor), whereas the interest rate on the O/N lending side standing facility (lombard loan) has been set at 0.25 per cent (Table 16-2). In 2013, the ECB narrowed the interest rate corridor around the interest rate on its main refinancing operations (MRO) from 150 bps to 100 bps, following which it decided to establish a downward asymmetric interest rate corridor. Although between June 2014 and December 2015, the interest rate corridor was narrowed to 50 bps and became symmetric again, the O/N lending margin had remained unchanged at 25 bps since November 2013, while the difference of the deposit side instrument to the base rate rose again in both December 2015 and March 2016, as a result of which the width of the interest rate corridor changed to 60 bps, then to 65 bps as asymmetry increased.

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Part II: Challenges and Answers in Hungarian Monetary Policy

In Turkey, the central bank employs a number of different benchmark rates, and has maintained a downward asymmetric interest rate corridor since the end of 2010. Modification of the interest rate corridor represents an additional instrument for the Turkish central bank, which is not consistent with conventional monetary policy instruments because the parameters of the interest rate corridor are not necessarily adjusted by the central bank in the same direction as the policy rate and to an extent that approximates the changes in the policy rate. In the United Kingdom, the policy rate, which had remained unchanged at 0.50% since March 2009, was cut by the central bank to 0.25% in August 2016. As part of its floor system, the Bank of England pays the policy rate (Bank Rate) on reserve account balances, which eliminates the need for a deposit instrument in the case of banks with reserve accounts. Prompted by the asset purchase programme launched in the aftermath of the global financial crisis, the US Fed started to increase its balance sheet, and has simultaneously been paying interest, also equivalent to the policy rate (federal funds rate), on required reserves from October 2008 onwards. The 0.75% interest is paid not only on reserves, but also on reserve balances above the reserve requirement. Interest on O/N reverse repos is remunerated at the policy rate +0.25%. The interest rate level targeted by the central bank is set within the band between 0.50% and 0.75%. In New Zealand, banks’ reserve balances remunerated at the policy rate, which also marks the floor of the interest rate corridor. As part of its tiering system, however, the central bank only pays settlement account holders the policy rate -100 bps above a certain level. The central bank applies the penalty interest rate to encourage account holders not to keep their funds with the central bank, and therefore to keep market rates around the target. The interest rate on the O/N lending instrument (reverse repo) is the base rate +50 bps. In Norway, the Norges Bank maintains a relatively wide interest rate corridor. Up to October 2011, as part of its floor system the central bank paid the policy rate on all banks’ reserves (sight deposit rate); however, it

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16 The limitation of the 3-month deposit as unconventional easing and related...

subsequently introduced a quota system in order to restrict banks’ demand for the central bank instrument, and to channel a part of their liquidity surplus to the interbank market (Bindseil, 2016). Accordingly, the interest rate paid on the reserve accounts above a specific level (quota) is reduced to the policy rate -100 bps (reserve rate). This could push the O/N interbank rate even below the policy rate, since banks may also place their surplus liquidity above the quota in the interbank market at a rate below the sight deposit rate, in order to avoid the lower rates available with the central bank (Norges Bank, 2014). The interest rate on demand deposits (up to the quota) is currently equivalent to the 0.5% policy rate, whereas the interest rate on O/N lending is the policy rate +100 bps. Table 16-2: Summary of the features of asymmetric interest rate corridor systems Country

Czech Republic

Policy rate (%, end of December 2016)

Floor of interest rate corridor (bp)

Ceiling of interest rate corridor (bp)

0.05%

+20

Type of interest rate corridor Asymmetric / Floor

-40

+25

Asymmetric

5.75%

-150

+50

Asymmetric

8%*

-75*

+50*

Asymmetric

Hungary

0.90%

-95

Ceiling

United Kingdom

0.25%

+25

Floor

ECB Pakistan Turkey

USA

0.75%**

+25

Indonesia

4.75%

-75 / -175***

+75 / +25***

Floor

Canada

0.50%

-25 / 0***

+25

Symmetric / Formerly floor

New-Zealand

1.75%

-100 / 0

+50

Tiering system

Norway

0.50%

-100 / 0

+100

Quota system

Symmetric / Formerly asymmetric

Notes: * the policy rate was considered to be the rate of the one-week repo instrument, and the width of the interest rate corridor was compared to that rate; ** the policy rate is the interest rate paid on reserve accounts, with the Fed target in the 0.5% to 0.75% band; *** width of the interest rate corridor formerly in place. Source: Central bank websites.

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Part II: Challenges and Answers in Hungarian Monetary Policy

16.2.2 Modification of the interest rate corridor as part of the 2016 modification of the monetary policy instruments

In 2016, the interest rate corridor was first narrowed in March, as part of the easing cycle starting at the time. In March 2016, the MNB narrowed the interest rate corridor to offset the risks of unintended monetary tightening potentially resulting from the phase-out of 2-week deposits at the end of April and from the drop of liquidity in the banking system. Namely, a meaningful decrease in sterilisation holdings might have induced developments in short-term interbank rates contrary to the monetary policy stance, causing monetary transmission to deteriorate. The measure involved a 15-bp cut in the policy rate and the interest rate on deposit side standing facility, pushing the floor of the interest rate corridor into negative territory (-0,05%). Additionally, a major cut in the O/N lending rate from base rate +75 bps to base rate +25 bps continued to act as an effective limit on interbank yields, which tended to fluctuate around the base rate. Simultaneously with the easing cycle spanning the period from March to late May 2016, the central bank narrowed the previously 200-bp-wide interest rate corridor to 120 bps in three steps, while holding the O/N deposit rate at -0.05 per cent. The interest rate corridor was narrowed in October and November 2016, and the central bank O/N lending rate was cut to the base rate in order to support the quantitative limitation on the main policy instrument, and the maintenance of loose monetary conditions. The MNB has tendered for the 3-month policy instrument at monthly intervals since August 2016, and subject to a quantitative limitation since late October the same year. To strengthen the effect of targeted monetary easing, in October and again in November the MNB increased the asymmetry of the O/N interest rate corridor by adjusting the spread on the lending-side instrument. In October, as a result of cutting the central bank O/N lending rate to base rate +15 bps, the interest rate corridor was narrowed from 120 bps to 110 bps, and in November, when the O/N lending spread was cut to zero, it was narrowed further

— 552 —

16 The limitation of the 3-month deposit as unconventional easing and related...

to 95 bps.134 Cutting the ceiling of the interest rate corridor to the base rate also means that the banking system’s access to the central bank’s instruments is maximised at the base rate, which strengthens the function of the base rate in influencing base rate expectations, while in combination with quantitative easing, it supports the reduction of the maximum O/N market rate and consequently that of the average O/N rate. Box 16-4 Narrowing the interest rate corridor in 2008 and in 2015–2016: different baselines, different motivations

Before 2015–2016, the MNB had last narrowed the interest rate corridor in 2008; however, the motivations for the two operations were fundamentally different. In Autumn 2008, the interest rate corridor was narrowed temporarily (but kept symmetric) in the aftermath of the financial turbulence, in order for the MNB to support credit institutions’ liquidity management, to reduce the volatility in short-term interbank rates, and to realign O/N interbank yields with the base rate. Between September 2015 and late November 2016, the interest rate corridor was narrowed five times, as a combined result of which at the end of 2016 the O/N lending rate was identical to the base rate (0.9%), and the O/N deposit rate has been 95 bps lower, in negative territory since March 2016 (-0.05%). The interest rate corridor was narrowed on a permanent basis essentially for two reasons: (1) to reduce the volatility in O/N interbank rates; and (2) to neutralise the yield-increasing effect of a permanent and meaningful reduction of the liquidity in the banking system, mainly in connection with the maturity of forint conversion swaps, and with the Self-financing Programme.135 he measures were enabled by the fact that as a result of the cap, counterparty T institutions do not have unlimited access to the main policy instrument, which, in the event of speculations over a rate cut, gives them the possibility to use O/N loans to place 3-month deposits only up to the bank limits, i.e. the opportunity for arbitrage has essentially been eliminated. 135 FX swap maturities related to conversion of FX loans, and the Self-financing Programme reduced liquidity in the banking system, which may have caused yields to rise. This effect was counterbalanced by the modification of the interest rate corridor. 134

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Part II: Challenges and Answers in Hungarian Monetary Policy

16.3 Reducing the reserve requirement ratio as a central bank measure to support the quantitative limitation In connection with the limitation of the 3-month deposit, the MNB cut the reserve requirement ratio from 2 per cent to 1 per cent as of December 2016. The measure supports the quantitative limitation regime by permanently increasing liquidity in the banking system. While the introduction of the low reserve ratio further encourages the crowding-out of liquidity, the system of reserve requirements continues to support banks’ liquidity management, reducing volatility in shortterm market rates through its averaging mechanism.

16.3.1 Conventional objectives in the system of reserve requirements

As part of required reserve regulations, central banks prescribe eligible credit institutions to hold liquid central bank instruments amounting to a certain percentage of specific liabilities. Required central bank reserves must be allocated to eligible credit institutions’ external funds, typically including holdings of deposits, borrowings, debt securities issued, and repos. The reserve requirement ratio is the value between 0 per cent and (in theory) 100 per cent that indicates the percentage of the above-mentioned liabilities for which commercial banks are required to hold liquid central bank instruments, mostly in the form of central bank money, and occasionally cash. The higher the reserve requirement ratio, and consequently the ratio of liquid assets to the bank’s total assets, the more secure banking operations are in terms of liquidity. That said, more liquid assets allow banks to earn lower yields compared to longer-term assets, as a result of which holding liquid assets causes a yield loss to commercial banks. This yield loss may be mitigated by the central bank paying a market interest rate on the reserve requirement imposed by it.

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16 The limitation of the 3-month deposit as unconventional easing and related...

Central banks primarily use reserve requirement systems to support banks’ liquidity management and to stabilise short-term market rates. The floor and the ceiling of the central bank’s interest rate corridor represents an effective limit on the volatility in O/N interbank rates; however, it is also appropriate to reduce the volatility in short-term interbank rates within the interest rate corridor. This is supported by the averaging mechanism of the system of reserve requirements, which eliminates the need for banks to meet their reserve requirements at each daily closing, allowing them to meet their requirements within a reserve period (one calendar month for the MNB), in terms of the average of their holdings at the close of each calendar day in that period. Required reserves serve as liquidity buffers, which enable banks to smooth liquidity shocks by reducing their yield losses. Since the system of reserve requirements and the averaging mechanism is applied equally to all participants of the interbank market, smoothing the positive and negative liquidity shocks to the banking system through bank account balances will reduce the volatility in O/N interbank yields. Reserve requirement systems are used for monetary policy purposes mainly in emerging countries, but there are also examples of such use in developed countries. – In emerging countries, reserve requirement systems are typically used for monetary policy purposes in economies with relatively less developed money markets and inadequate interest rate transmission (e.g. China, cf. BIS, 2008). Additionally, following the outbreak of the 2008 global financial crisis, a number of central banks cut their reserve requirement ratios from the previous 5-15 per cent to under 5 per cent (Gray, 2011). This also served monetary policy purposes: the central banks decided to cut their ratios to mitigate the liquidity contraction emerging. Where a system of reserve requirements prescribes reserves to be allocated in foreign currency for FX-denominated liabilities, by adjusting the reserve ratio the central bank may also influence demand and supply for its own currency, and consequently its exchange rate (Turkey is one example). — 555 —

Part II: Challenges and Answers in Hungarian Monetary Policy

– Among the central banks of developed countries, in 2012 the European Central Bank cut its reserve ratio from 2 per cent to 1 per cent partly for monetary policy reasons: the ECB’s explanations for the move included incentives for market activity, and crowding out liquidity of required reserves accruing interest at the policy rate (ECB, 2012). – Even if not the entire system of reserve requirements, the reserve account has also primary importance in the Fed’s monetary policy: since it has also been paying interest on excess reserves, the US central bank has been making active use of the required reserve account as a monetary policy instrument. The liquidity – which increased as a result of the asset purchase programmes – was placed by banks on reserve accounts; consequently, it is the required reserve account that may be considered as the main instrument in the economic sense. Box 16-5 Rules of allocations for required central bank reserves in Hungary

Allocations for required central bank reserves must be made by every credit institution with an operating license for Hungary, including Hungarian branches of credit institutions domiciled in any country that is not a party to the Agreement on the European Economic Area. Allocations for required central bank reserves must also be made by Hungarian branches of credit institutions that are domiciled in and have an operating license from another Member State of the European Union. The reserve base includes credit institutions’ deposits, borrowings, debt securities and repos, provided they are not from another eligible credit institution or the MNB. Pursuant to the applicable regulations, eligible credit institutions must make allocations for required central bank reserves in respect of a reserve base that includes deposits, borrowings and debt securities with an initial maturity of two years or less. The amount of the required central bank reserve is derived as the product of the holdings recognised in credit institutions’ statistical balance sheets (Supervisory balance sheet prior to 2017) and the reserve ratio (Table 16-3).

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16 The limitation of the 3-month deposit as unconventional easing and related...

Table 16-3: Reserve ratios in Hungary after 1 July 2001

Effective date

Reserve requirement ratio

1 July 2001

6.0%

1 August 2002

5.0%

1 December 2008

2.0%

1 November 2010

2.0%; 3.0%; 4.0%; or 5.0%

1 December 2015

2.0%

1 December 2016

1.0%

Source: MNB.

The MNB’s reserve requirement system is based on a reserve period of one calendar month. Interest payable on fulfilment of the reserve requirement is credited by the MNB to credit institutions’ accounts on the second banking day of the month following the month concerned, and penalties are charged within 30 days following the period concerned. The penalty interest rate applicable in the event of insufficient reserves is equivalent to the central bank base rate as in effect from time to time.

16.3.2 Lessons learned from the transformation of the system of reserve requirements related to the quantitative limitation

The reserve ratio was cut in December 2016 as part of the MNB’s quantitative limitation policy. To complement the cap on the 3-month deposit, on 25 October 2016 the MNB announced that it would cut the reserve requirement ratio from 2 per cent to 1 per cent as of 1 December 2016. The move reduced the banking system’s reserve requirement from HUF 344 billion in November 2016 to HUF 174 billion in December 2016 (Chart 16-7). In addition to a one-off liquidity injection, the measure also supports the cap on the 3-month deposit by limiting the possibility to use reserve accounts to smooth liquidity shocks, which ensures that the liquidity crowded out of the 3-month deposit is transferred to O/N deposits within the shortest possible time, thereby facilitating the reduction of yields. — 557 —

Part II: Challenges and Answers in Hungarian Monetary Policy

Chart 16-7: Changes in the aggregate reserve requirement of eligible credit institutions according to various reserve requirement ratios from January 2014 Dec. 2016 Nov. 2016 Oct. 2016 Sep. 2016 Aug. 2016 Jul. 2016 Jun. 2016 May 2016 Apr. 2016 Mar. 2016 Feb. 2016 Jan. 2016 Dec. 2015 Nov. 2015 Oct. 2015 Sep. 2015 Aug. 2015 Jul. 2015 Jun. 2015 May 2015 Apr. 2015 Mar. 2015 Feb. 2015 Jan. 2015 Dec. 2014 Nov. 2014 Oct. 2014 Sep. 2014 Aug. 2014 Jul. 2014 Jun. 2014 May 2014 Apr. 2014 Mar. 2014 Feb. 2014 Jan. 2014

100

200

300

400

500

600

700

HUF Billions Unified fixed 1 % reserve ratio Unified fixed 2 % reserve ratio

Optional reserve ratios (2, 3, 4 or 5 %)

HUF Billions 0

100

200

300

400

500

600

Reverse requirement Source: MNB.

â&#x20AC;&#x201D; 558 â&#x20AC;&#x201D;

700

16 The limitation of the 3-month deposit as unconventional easing and related...

The transformation of the system of reserve requirements in December 2016 accompanied the harmonisation with the reserve system applied by the European Central Bank (ECB). The MNB also aligned its reserve requirement ratio to that of the euro area by means of its measures in December 2015 and 2016. Introduced as of 1 December 2015, the uniform reserve ratio fixed at 2 per cent was identical to the reserve ratio applied by the MNB between December 2008 and November 2010, which had been prescribed by the ECB before 18 January 2012. Cut to 1 per cent as of 1 December 2016, the MNB’s reserve ratio is equivalent to the 1 per cent reserve ratio introduced by the ECB in 2012. By implementing the cut the MNB was the first among EU, but non-euro area Member States, to harmonise its reserve requirement ratio with the ECB (Table 16-4). Table 16-4: Reserve requirement ratios in EU Member States EU Member State

Is there a reserve requirement system?

Type of reserve requirement ratio (fixed/optional)

Reserve requirement ratio

yes

fixed

yes

fixed

10% (domestic funds), 5% (foreign funds)

Euro area members (ECB) Non-euro area members Bulgaria

Czech Republic

yes

fixed

Denmark

none

United Kingdom

none

Croatia

yes

fixed

12%

Poland

yes

fixed

3.5%

Hungary

yes

fixed

2% ➝ 1%

Romania

yes

fixed

8% (RON), 10% (FX)

Sweden

none

Source: Central bank websites.

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Part II: Challenges and Answers in Hungarian Monetary Policy

Box 16-6 Reduction in the interest rate on excess reserves

To ensure the effectiveness of the quantitative limitation system, as of 1 October 2016 the MNB cut the interest rate on excess reserves below the O/N deposit rate. For a brief period from late March to early April 2016, the zero interest rate on the balances of the bank accounts held with the MNB exceeding the reserve requirement was more favourable than the interest rate on the O/N central bank deposit (-0.05%). The shift of the floor of the interest rate corridor into negative territory was followed by the MNB’s bank account terms as of 7 April 2016, and subsequently excess reserves accrued interest at the same rate as O/N central bank deposits. The level of interest rates, first more favourable and then identical to O/N central bank deposits, created a setting in which eligible credit institutions had no incentive to commit their end-of-day balances exceeding the reserve requirement in O/N central bank deposits. As a result, some participants kept their surplus liquidity on their payment accounts (Chart 16-8). The application of a quantitative limitation on the 3-month deposit led to an appreciation of developments in O/N central bank deposit holdings; therefore, as of 1 October 2016, by adjusting its interest rate terms, the MNB has been incentivising banks to keep their surplus liquidity in O/N central bank deposits rather than on their reserve accounts. Accordingly, an interest rate is charged on the payment account balances exceeding the reserve requirement at 15 bps (0.2% on 2016 year-end) below the O/N deposit rate as applicable from time to time. This ensures the separation of reserve account fluctuations within a month from the part of crowded out liquidity that is transferred to O/N deposits. Following the move, excess reserves in the banking system decreased significantly in line with the MNB’s objective.

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16 The limitation of the 3-month deposit as unconventional easing and related...

Chart 16-8: Over-fulfilment of reserve requirements in the banking system (January 2014 to December 2016) 0

Dec. 2016 Nov. 2016 Oct. 2016 Sep. 2016 Aug. 2016 Jul. 2016 Jun. 2016 May 2016 Apr. 2016 Mar. 2016 Feb. 2016 Jan. 2016 Dec. 2015 Nov. 2015 Oct. 2015 Sep. 2015 Aug. 2015 Jul. 2015 Jun. 2015 May 2015 Apr. 2015 Mar. 2015 Feb. 2015 Jan. 2015 Dec. 2014 Nov. 2014 Oct. 2014 Sep. 2014 Aug. 2014 Jul. 2014 Jun. 2014 May 2014 Apr. 2014 Mar. 2014 Feb. 2014 Jan. 2014

60 HUF Billions

HUF Billions 0

Banking system's overfulfilment Source: MNB.

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16.4 The effect of the quantitative limitation and related measures on yields The limitation of the 3-month deposit instrument has the most direct effect on the shortest (O/N) yields, if liquidity is transferred to O/N central bank deposits. Reduced O/N yields also cause 1- and 3-month interbank yields (on unsecured transactions and FX swaps136) to drop, and as liquidity flows onto the government securities market, the modification of instruments reduces the yields of government securities as well.

16.4.1 Effect on O/N yields

From March 2016, the meaningful decrease in sterilisation holdings was accompanied by an increasingly frequent use of the central bank’s lending instruments, which temporarily exerted upward pressure on O/N interbank yields. Although the volatility of O/N rates was somewhat reduced in the first two months of 2016, additional modification of instruments, the expected developments of liquidity in the banking system, and a potential increase in the volatility of interbank rates justified the narrowing of the interest rate corridor, and stronger asymmetry. Bank liquidity was significantly reduced in particular by the swap maturities related to conversion of FX loans, the net issuance of forint-denominated government securities, and the withdrawal of 2-week deposits, the combined effect of which was an increase in short-term interbank yields. In the period leading up to late May 2016, on several occasions the HUFONIA moved above the base rate in the upper segment of the interest rate corridor; however, its monthly average approximated the level of the policy rate (Chart 16-9).

136

he unsecured interbank market is highly significant because the BUBOR is one T of the most important benchmarks in terms of monetary transmission and bank lending. Owing to its high trading volume, the FX swap market is also important for monetary transmission purposes.

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16 The limitation of the 3-month deposit as unconventional easing and related...

Chart 16-9: Changes in the interest rate corridor and the effect of the central bank’s lending instruments on the HUFONIA movements 1,600

HUF Billions

Per cent

3.5 3.0

1,200

2.5

1,000

2.0

800

1.5

600

1.0

400

0.5

200

1,400

–0.5

Net sum of overnight standing facilities (credit) 2-week/1-week loan 3-month loan HUFONIA (right-hand scale) Interest rate corridor (right-hand scale) Source: MNB.

In the frequency reduction phase of the main policy instrument (right up to the 3-month tender at the end of September), the O/N interbank rate moved in the segment of the interest rate corridor below the base rate. In August 2016, given the temporary abundance in bank liquidity, O/N interest rates dropped significantly. However, the scarcity of free forint liquidity following the August tender drove the O/N rate close to the base rate, because surplus liquidity could still flow into the main policy instrument in unlimited quantities. Banks provided for the liquidity required until the next tender partly in the form of MNB instruments accruing interest at the base rate (required reserves and preferential deposits), and partly through repurchase transactions with the Government Debt Management Agency (ÁKK). September was characterised by yields around the base rate; however, the end of the month saw a spike in the O/N rate as a combined result of several factors — 563 —

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decreasing liquidity137. By the end of the month, in accordance with the MNB’s expectations, liquidity in the banking system increased, with a correction in O/N rates and the HUFONIA realigned with the base rate. As the quantitative limitation became effective and the interest rate corridor was narrowed in October and November, O/N interbank rates dropped significantly. In the first half of October, O/N interbank rates fluctuated around the base rate, whereas the monthly average of the HUFONIA, as in September, remained aligned with the base rate in October as well. Before the first limited tender for the main policy instrument, the Single Treasury Account had a highly negative liquidity effect (particularly due to VAT and personal income tax payments into the budget), which temporarily pushed interbank yields upwards. At the end of October, the MNB decided to increase the asymmetry of the interest rate corridor; accordingly, the interest rate on the O/N central bank lending instrument was reduced by 10 bps. The first limited main policy tender was held by the MNB on the day of which the interest rate conditions became effective. As a combined effect of the two factors, as expected the HUFONIA dropped below the base rate, and remained closely aligned with it until early November. In November, O/N rates decreased progressively, possibly due in part to the build-up of O/N deposit holdings. At the end of November, the ceiling of the interest rate corridor dropped to the level of the base rate, and although the HUFONIA moved near the floor of the corridor, it dropped further by the end of November, approximating zero per cent several times in December. In the period of quantitative limitation, banks did not step up their central bank borrowing despite the cut in the O/N lending rate, which represented an increase in the asymmetry of the interest rate corridor. Although stronger asymmetry in the interest rate corridor reduced borrowing costs for banks that made use of asset-side instruments, increased and permanent reliance was generally not made in November 137

part from the payment of VAT into the budget and a swap maturity related to A conversion of FX loans, such factors also included the fact that the last unlimited tender for 3-month deposits was held by the MNB in late September.

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16 The limitation of the 3-month deposit as unconventional easing and related...

and December on O/N lending instruments despite more favourable pricing, and also due to the abundance of liquidity in the banking system as a result of the quantitative limitation on 3-month deposits. As O/N rates gradually moved towards the floor of the interest rate corridor due to the quantitative limitation on deposits applied as of late October 2016, the effectiveness and relevance of the O/N lending rate decreased accordingly. At the same time, the modifications have contributed to the decline of the O/N rate, and continue to reduce volatility in O/N rates, thereby providing support for a more expansionary monetary policy implemented by means of the quantitative limitation.

16.4.2 Effect on 1- and 3-month interbank yields

The announcement of the reform of the main policy instrument resulted in a sharp fall in yields on all relevant markets. After the July announcement of the modification of the main policy instrument, interbank yields – which are of key importance for the pricing of bank loans – fell below the central bank base rate within the space of a few weeks. The temporary rebound seen in interbank yields in late September was followed by further meaningful decline: by the second half of December, 1- and 3-month interbank yields had dropped below 0.4% (Chart 16-10). In addition to the quantitative limitation, the drop in yields may also have been supported by the transformation of the BUBOR fixing system in May 2016 (MNB 2016). The decline in interbank yields – key determinants of loans and money market products – had begun even before liquidity actually started to flow into the overnight central bank deposit, which can be explained by the expectations of market participants. The MNB held its first limited tender at the end of October, but it was only from the end of November that the stock of new O/N deposits began to increase considerably. Consistent with this, overnight interbank yields started their descent close to the floor of the interest rate corridor around the same time. Longer, 1- and 3-month yields, however, had become persistently diverged from the base rate earlier, from mid-October 2016. The faster response — 565 —

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may be due to the fact that market participants had already expected the accumulation of overnight deposit holdings, and because of these expectations, the descent of 1- and 3-month yields began somewhat earlier. Chart 16-10: Developments in interbank yields 1.4

Per cent

Per cent Announcement of the main instrument modification

1.2

1.4 1.2 1.0

0.8

0.6

0.4

0.2

0.0

0.0 4. Jan. 2016 18. Jan. 2016 1. Feb. 2016 15. Feb. 2016 29. Feb. 2016 14. Mar. 2016 28. Mar. 2016 11. Apr. 2016 25. Apr. 2016 9. May. 2016 23. May. 2016 6. Jun. 2016 20. Jun. 2016 4. Jul. 2016 18. Jul. 2016 1. Aug. 2016 15. Aug. 2016 29. Aug. 2016 12. Sep. 2016 26. Sep. 2016 10. Oct. 2016 24. Oct. 2016 7. Nov. 2016 21. Nov. 2016 5. Dec. 2016 19. Dec. 2016

1.0

1-month BUBOR

3-month BUBOR

Base rate

Source: MNB.

16.4.3 Effect on the yields of government securities

A significant decline also occurred in the yields of treasury bills with shorter maturities both at auction and in the secondary market. From the levels around the base rate prevailing before the summer 2016 announcement on the quantitative limitation, within a short time yields dropped to 0.5-0.6 per cent (Chart 16-11). Yields continued to decline during November: in the December auctions, 3-month average auction yields were as low as 6 bps, and the 12-month average yield dipped below 40 basis points. Apart from the limitation, the decline in yields may also have been supported by the reduction in the quantities sold — 566 —

16 The limitation of the 3-month deposit as unconventional easing and related...

by the Government Debt Management Agency in auctions compared to the quantities characteristic in the first half of 2016. Chart 16-11: Average yields in Treasury bill auctions 160 140

HUF Billions

Per cent Announcement of the main instrument modification

3-month auctions

120

1.6 1.4 1.2 1.0

0.8

0.6

0.4

0.2

0.0

5. Jan. 2016 2. Feb. 2016 16. Feb. 2016 1. Mar. 2016 16. Mar. 2016 29. Mar. 2016 12. Apr. 2016 26. Apr. 2016 10. May. 2016 24. May. 2016 7. Jun. 2016 21. Jun. 2016 5. Jul. 2016 19. Jul. 2016 2. Aug. 2016 16. Aug. 2016 30. Aug. 2016 13. Sep. 2016 27. Sep. 2016 11. Oct. 2016 25. Oct. 2016 8. Nov. 2016 22. Nov. 2016 6. Dec. 2016 20. Dec. 2016

100

Bid amount 160 140

Allotted amount

Average yield (right-hand scale)

HUF Billions

Per cent Announcement of the main instrument modification

12-month auctions

1.6 1.4 1.2

100

1.0

0.8

0.6

0.4

0.2

0.0

14. Jan. 2016 25. Feb. 2016 10. Mar. 2016 24. Mar. 2016 7. Apr. 2016 21. Apr. 2016 5. May. 2016 19. May. 2016 2. Jun. 2016 16. Jun. 2016 30. Jun. 2016 14. Jul. 2016 28. Jul. 2016 11. Aug. 2016 25. Aug. 2016 8. Sep. 2016 22. Sep. 2016 6. Oct. 2016 20. Oct. 2016 3. Nov. 2016 17. Nov. 2016 1. Dec. 2016 15. Dec. 2016 29. Dec. 2016

120

Bid amount

Allotted amount

Average yield (right-hand scale)

Source: Government Debt Management Agency (ÁKK).

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16.4.4 Effect on implied interest rates in the FX swap market

The implied forint yields observed in the FX swap market, which are also important for the purposes of monetary transmission, have descended to levels below the base rate since the quantitative limitation was introduced. In the first half of the year, the swap market yields derived from euro quotes for 1-week, 1-month and 3-month maturities fluctuated around the base rate (Chart 16-12). The effect of the drop in liquidity in late September was also felt in the swap market, causing a temporary rise in yields. At the same time, after the first tender for 3-month deposits in October, a drop in yields occurred, which proved to be persistent. In November, the 1- and 3-month implied forint yields dropped to 0.5 per cent, corresponding to a decrease of 40 to 50 bps relative to the announcement on the modification of the main policy instrument. Chart 16-12: Developments in the implied forint yields derived from HUF/ EUR swap market quotes 3.5

Per cent

3.5

0.0

–0.5

3-month

1-month

Source: Bloomberg.

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1-week

Dec. 2016

0.5

Nov. 2016

0.5

Oct. 2016

1.0

Sep. 2016

1.0

Aug. 2016

1.5

Jul. 2016

1.5

Jun. 2016

2.0

May. 2016

2.0

Apr. 2016

2.5

Mar. 2016

2.5

Feb. 2016

3.0

Jan. 2016

3.0

Base rate

16 The limitation of the 3-month deposit as unconventional easing and related...

16.5 Summary In summer and autumn 2016, the Magyar Nemzeti Bank introduced a new monetary policy framework in order to carry out unconventional monetary easing while keeping the base rate on a sustained hold. The main element of the system is a quantitative limitation of the 3-month deposit, which allows the MNB to support lending incentives and selffinancing by channelling liquidity, and, above all, to reduce relevant market yields. Implementing the measure effectively as of Q4 2016, the MNB supported the limitation by cutting the O/N lending rate to the base rate, i.e. by introducing a completely asymmetric interest rate corridor, and by cutting the reserve ratio from 2 per cent to 1 per cent. The quantitative limitation and related modification of instruments have been successful. As a result of limited tenders, the MNB’s holdings of the 3-month deposit decreased from almost HUF 2,000 billion in late September 2016 to approximately HUF 900 billion in November, and a major part of surplus liquidity in the banking system – temporarily exceeding HUF 400 billion in early December – was channelled to O/N deposits. Perceivable in all relevant markets, crowded out liquidity put a downward pressure on yields: following the announcement in July 2016, by December the decline in short-term yields amounted to 50-60 basis points. The decline in interbank yields was supported by the fact that at the initiative of the MNB, in May 2016 the BUBOR fixing system was reformed, which, due to the imposition of fixing requirements, brought about a major increase in the volume of trading in the unsecured interbank market, as well as a meaningful improvement in the information content of the BUBOR. While providing for base rate stability, the quantitative limitation system therefore eased monetary conditions, which, due to its effect on the government securities market, resulted in cheaper funding for the public sector, and, due to the interbank effect, in cheaper borrowing for households and the corporate sector, particularly for SMEs. — 569 —

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Key terms average auction yield BUBOR crowding out fine-tuning instruments government security HUFONIA interest rate corridor

liquidity liquidity management preferential deposit reserve requirement system sterilisation instruments swap swap market yield derived from euro

â&#x20AC;&#x201D; 570 â&#x20AC;&#x201D;

16 The limitation of the 3-month deposit as unconventional easing and related...

References Balogh, Cs. (2009): Az MNB-kötvény szerepe a hazai pénzügyi piacokon. Mi az összefüggés a magas kötvényállomány, a banki hitelezés és az állampapír-piaci kereslet között? (The role of MNB bills in domestic financial markets. What is the connection between the large volume of MNB bills, bank lending and demand in the government securities markets?), MNB Bulletin, October 2009. https://www. mnb.hu/letoltes/balogh-0910.pdf Bank of England (2009): Quantitative Easing Quantitative easing explained – injecting money into the economy. http://www.bankofengland.co.uk/monetarypolicy/Documents/pdf/qe-pamphlet.pdf Bank Indonesia (2016): Strengthening the Monetary Operations Framework. Appendix of Press Release No. 18/67/DKom. http://www.bi.go.id/en/ruang-media/siaran-pers/Documents/ RDG_August_2016_attachment.pdf Bindseil, U. (2014): Monetary Policy Operations and the Financial System. Oxford University Press. Bindseil, U. (2016): Evaluating monetary policy operational frameworks. Jackson Hole symposium, organized by the Kansas City Federal Reserve, August 2016. Bindseil, U. – Jabłecki, J. (2011): The optimal width of the central bank standing facilities corridor and banks’ day-to-day liquidity management. Working Paper Series 1350, European Central Bank, June 2011. Binici, M. – Kara, H. – Özlü, P. (2016): Unconventional Interest Rate Corridor and the Monetary Transmission: Evidence from Turkey. WORKING PAPER NO: 16/08. Blackstone, B. (2014): What Does the ECB’s ‘Sterilization’ Program Do? The Wall Street Journal, March 4, 2014. DBS Group Research (2016): Indonesia: the new policy rate. https://www.dbs.com/aics/ templatedata/article/generic/data/en/GR/042016/160418_insights_indonesias_new_policy_ rate.xml ECB (2012): ECB Monthly Bulletin. ECB, February 2012. https://www.ecb.europa.eu/pub/pdf/ mobu/mb201202en.pdf Gray, S. T. (2011): Central Bank Balances and Reserve Requirements. IMF Working Papers 11/36, International Monetary Fund. Ho, C. (2008): Implementing Monetary Policy in the 2000s: Operating Procedures in Asia and Beyond. BIS Working Paper No. 253. IMF (2015): Evolving Monetary Policy Frameworks in Low-lncome and Other Developing Countries. IMF Staff Report. Jordan, T. (2016): Monetary policy using negative interest rates – a status report. Speech by Mr Thomas Jordan, Chairman of the Governing Board of the Swiss National Bank, at the Vereinigung Basler Ökonomen, Basel, 24 October 2016. https://www.bis.org/review/rl61025c.htm

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Part II: Challenges and Answers in Hungarian Monetary Policy Kahn, G. A. (2010): Monetary Policy under a Corridor Operating Framework. https://www. kansascityfed.org/publicat/econrev/pdf/10q4Kahn.pdf Kolozsi, P. – Hoffmann, M. (2016): Bevetésre készen állnak az MNB új fegyverei (The MNB’s new weapons are ready to be deployed), MNB Technical Paper, October 2016. https://www.mnb.hu/ letoltes/kolozsi-pal-hoffmann-mihaly-bevetesre-keszek-az-mnb-uj-fegyverei.pdf Maehle, N. (2014): Monetary Policy Implementation: Operational Issues for Countries with Evolving Monetary Policy Regimes. Manuscript, expected to be published in 2017. https://www.imf.org/ external/np/seminars/eng/2014/oapbali/pdf/M3.pdf Molnár Z. (2010): A bankközi forintlikviditásról – mit mutat az MNB új likviditási prognózisa? (About the interbank HUF liquidity – what does the MNB’s new liquidity forecast show?) MNB Bulletin, December 2010. https://www.mnb.hu/letoltes/molnar.pdf MNB (2012): Monetáris politika Magyarországon (Monetary Policy in Hungary). January 2012. https://www.mnb.hu/letoltes/monetaris-politika-magyarorszagon-2012.pdf MNB (2015): A Piaci Hitelprogram (PHP) alapösszefüggései és eszközei (Basic correlations and instruments of the Market-Based Lending Scheme [MLS]). MNB, November 2015. https://www. mnb.hu/letoltes/a-piaci-hitelprogram-php-alaposszefuggesei-es-eszkozei.pdf MNB (2016): Inflációs jelentés (Inflation Report). June 2016. https://www.mnb.hu/letoltes/ boritoval-hun-ir-jun.pdf Natixis (2016): Money, markets and central banks: An Indonesian perspective. Special Report, Economic Research. https://www.research.natixis.com/GlobalResearchWeb/Main/GlobalResearch/ GetDocument/wHKAXugurYg54Esm8JTHzg Norges Bank (2014): Banks’ assessment of Norges Bank’s liquidity management system. Norges Bank Papers 4/2014. Varga, L. (2010): A választható tartalékráta bevezetésének indokai (Introducing optional reserve ratios in Hungary). MNB Bulletin, October 2010.https://www.mnb.hu/letoltes/varga-mnbszemle-1007. pdf

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Hungarian instruments to improve the functioning of the monetary policy transmission mechanism

Part II

Challenges and Answers in Hungarian Monetary Policy

Steps towards a more efficient banking system Gábor Horváth – Štefan Krakovský

Over the past decades, studies on the effectiveness of monetary policy have regularly been underlining the role of a functional, healthy and broadly efficient banking system in interest rate transmission. Particular attention must be given to the bank lending channel, which is required for the proper functioning of interest rate transmission, and needed to be cleaned in several respects in the aftermath of the financial crisis. Possible impediments to the bank lending channel include the freeze on lending, soaring costs as a result of the increasing volume of non-performing loans, and the less competitive banking environment. In that context, two important problems concerning the effective contribution of the domestic banking system to interest rate transmission – the freeze on lending in the corporate segment, and the build-up of exchange rate risk and monetary policy ineffectiveness in household lending – were successfully addressed by the central bank by means of its Funding for Growth Scheme and Market-Based Lending Scheme, and through forint conversion, which have already been described in earlier chapters of this book. Apart from those measures, the central bank has also taken a number of important steps in order to resolve the problem of non-performing loans stuck in bank balance sheets, and to facilitate portfolio cleaning. The management of non-performing loans generates costs and non-returning interest expenditure for banks. Cleaning the portfolio may increase the efficiency of the banking system in two respects: first, the cost of workout activities could be saved, and second, the banking system could shed its assets that generate negative interest income, and would be free to use its funds to disburse new loans priced on competitive market terms. In recent years, the Magyar Nemzeti Bank has taken several decisive steps in both the household — 575 —

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and the corporate segments to clean non-performing holdings, whereby it helped the domestic banking system to become more efficient, and interest rate transmission more effective. First, a detailed and comprehensive study was compiled on non-performing household mortgage borrowers, as part of which the MNB put forward a recommendation for banks on the efficient and sustainable restructuring of non-performing loans. Second, the MNB set up MARK Zrt. to act as a catalyst in the market for commercial property loans, which has been making an active contribution to the transfer of commercial property loans, inherited from project finance and burdening bank balance sheets for years, to collection agencies that are more efficient than bank participants. This is a relief for the banking system on the cost side, while it also facilitates the recovery of the bank lending channel through the normalisation of risk appetite, which will ultimately lead to improvements in interest rate transmission.

17.1 The relationship of monetary transmission and an efficient banking system Attention has been called to the importance of the financial system in monetary transmission by the literature of the past two decades, and in particular by the financial crisis. According to conventional “money view”, a central bank can use the interest rate channel to influence economic actors’ supply and demand of money in a clear and simple way. However, the pricing of loans, be they consumer credit or investment loans, largely depends on the specificities of the banking system of the country concerned. For example, Cecchetti (1999) points out the possibility that Member States’ differing legislative environments could act as a major inhibiting factor in the single monetary policy of the euro area. Over time, the explanatory power of the interest rate channel proved to be insufficient to interpret the inconsistencies observed in the various markets. For the most part, it was in the early ‘90s that the credit channel became popular as an answer to the inconsistencies concerning the extent of monetary transmission. — 576 —

17 Steps towards a more efficient banking system

Through the bank lending channel, tightening in monetary policy by means of raising the policy rate will, as a result of shrinking commercial bank reserves, also lead to accommodation in the form of deposit taking, which would increase the cost of funding for banks, as it would require either higher deposit rates to raise the sufficient amount, or reliance on some other form of more expensive funds (credit or equity). At the same time, this would increase the variable cost on banks’ liability side, which they would offset through credit pricing. The bank lending channel focuses on the composition effect mechanism of liability-side costs, whereas the balance sheet channel is concerned with the endogenously variable funding margins regarding the liability side of a given bank, or more generally, of any given corporation. In this case, risk premiums on bank funds typically increase as a result of a fall in asset prices that tends to follow central bank tightening, and they strengthen transmission through the interest rate channel in the sense that lending rates might increase to a greater extent than the change in the policy rate. The functioning of the credit channel is explained in detail in a summary article by Bernanke and Gertler (1995), which is often referred to in literature as a primary source. A theoretical description of additional transmission channels is given by Mishkin (1996), and the mechanisms listed by him are mapped to the Hungarian banking system by Vonnák (2006). Nevertheless, as regards the role of banks in monetary transmission, extensive attention was attracted in literature to the interest rate and credit channels rather than the exchange rate and asset channels. The presence of a credit channel in transmission was demonstrated by Bernanke and Blinder (1992) using data collected in the US between 1959 and 1978. While their finding was indeed relevant at the aggregate level, a number of subsequent studies highlighted the need for analyses on micro-level data. The heterogeneous bank behaviour prompted by monetary policy actions was pointed out as early as Hannan and Berger (1991). Through an analysis of empirical data, they concluded that products are repriced faster by banks that are larger in terms of their total assets, — 577 —

Part II: Challenges and Answers in Hungarian Monetary Policy

and slower in more concentrated markets (using the Herfindahl– Hirschmann index) and on the deposit side at times of monetary easing. Prompted by deposits shrinking as a result of monetary tightening, a commercial bank may raise funds using the methods referred to above, or collect deposits that cannot be placed with the central bank (e.g. term deposits), whereby it can isolate its lending portfolio from negative effects. Kashyap and Stein (1994) found that such alternative sources of funds tend to increase the interest expenses of smaller banks, which are therefore forced to shed their lending portfolios to a greater extent in the event of tightening. Their assumption is supported by empirical data. Drawing on that analysis, Kashyap and Stein (1997) also find that banks’ sensitivity also depends on their liquidity on the asset side. If instead of gradually shedding its lending portfolio, a bank can dispose of its other liquid assets, it will become immune to monetary policy. The ultimate conclusion of the authors is that small banks with no holdings of liquid assets are the most sensitive, which confirms the presence of a bank lending channel, and does so within the framework of a specifically broad micro-level analysis. Weaker responsiveness is also found by Schmitz (2004) in the banking sectors of new EU Member States. According to an analysis on the Belgian financial system, banks with large market shares compete the least through the pricing of their products, cf. De Graeve et al. (2007). Market power is preferred to size and is defined by Brissimis and Delis (2010) as an effect buffering monetary transmission in the US and the euro area between 1994 and 2007. Studies focusing on the Italian banking sector, such as Gambacorta (2005, 2008), tend to reject the relevance of size to the functioning of transmission. Havránek et al. (2015) found that Czech banks with higher total assets tend to accommodate to changes in monetary policy with a longer lag. Carrying out an analysis using an error correction model, De Bondt (2002) found interest rate transmission within the euro area to be accelerating, which he attributed to an increase in the degree of competition, — 578 —

17 Steps towards a more efficient banking system

a decrease in the market power of participants in the bank market, and the costs of asymmetric information and bank switching. The latter two factors are also classified by Horváth and Podpiera (2012) under effects that decelerate transmission. Sander and Kleimeier (2004) distinguish between internal and external competition. To quantify internal competition, they use HHI and CR5 indicators, and for external competition, an index composed of the market share of foreign bank branches and subsidiaries. Their results show that with less competition, deposit rates adjust faster negatively rather than positively. Another article (Gigineishvili, 2011) identified the presence of bank competition (as measured through moderate RoEs) as a precondition for stronger transmission. In their analysis of interest rate spreads in the euro area, Gropp et al. (2007) take into account competition observed among banks (H-statistics) and in the money market (corporate bonds, non-bank lending, the role of mutual funds, etc.). They observe significantly faster and more complete transmission for lending products against the backdrop of more intensive competition, while on the deposit side the difference is considerable only in the case of term deposits. Non-bank lending may also increase competition, which will again accelerate re-pricing. Van Leuvensteijn et al. (2008) also analyse interest rate spreads in the euro area between 1994 and 2004, comparing them to the degree of competition (as measured by the Boone indicator) using error correction models. They conclude that lending rates are better aligned with market rates in more competitive sectors; however, in the same countries they also observe higher interest rate differentials for deposits. In their interpretation, the impact of fierce competition is stronger in the credit market, which banks counterbalance by low deposit rates. A solution to the problem of slow transmission is identified automatically as increased competition in several studies, including Van Leuvensteijn et al. (2013) and Gambacorta (2008). The presence of competition may also support the emergence of an efficient banking system, given the competitive, cost-sensitive and responsive pricing practices followed by such banking systems. In other words, bank efficiency promotes the adequate functioning of the above channels supporting monetary transmission. — 579 —

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De Graeve et al. (2007) measure the degree of inefficiency in financial intermediaries with a cost-to-income ratio. In accordance with previous Italian studies, they find that efficient banks pass on a part of their cost efficiency to customers in the form of higher deposit rates. In the context of the US banking system, Jonas and King (2008) comment on both monetary tightening and easing. They argue that the more efficient banks have flatter marginal cost functions, which will result in a flatter supply function. Therefore, efficient banks reduce their credit supply in the event of tightening to a greater extent, i.e. accommodate better than their less efficient competitors. Additionally, they face lower costs, because advanced management and monitoring associated with efficiency enable them to reject customers that carry higher default risk. It is also assumed that in the event of easing, they can increase their holdings faster due to their efficient lending processes. The authors carry out a stochastic frontier analysis to support their claims. Gambacorta (2008) defines efficiency as the ratio of total loans and deposits to the number of branches, and also finds that the spreads charged by more efficient banks are lower on both the lending and deposit sides. Using stochastic frontier and data envelopment analyses and error correction models, Havránek et al. (2015) cannot find any significant difference in terms of interest rate transmission between efficient and less efficient banks. They compare their evidence to the analyses of e.g. Schlüter et al. (2012), who, like most studies, indicate efficiency as a benefit to consumers. As far as the default rate is concerned, the literature does not call into question the significant positive effect of this factor on spreads. Implementing investments of higher risk generally requires a higher return. Furthermore, Havránek et al. (2015) find a correlation between the levels of high deposit and lending rates, and assume that banks offering higher deposit rates to customers tend to exploit demand involving higher risk. Starting from the definition of the bank lending channel, banks’ capital adequacy and asset-side liquidity bear relevance. A higher amount of capital and liquidity serves as a buffer for commercial banks in — 580 —

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a changing market environment, giving them more freedom in adjusting their spreads, and the opportunity to remain neutral to monetary transmission. This phenomenon is confirmed by empirical analyses reported in a number of studies, including Kashyap and Stein (1994, 1997) in the US, Gambacorta (2005, 2008) in Italy, De Graeve et al. (2007) in Belgium, Brissimis and Delis (2010) in the US and the euro area, and Havránek et al. (2015) in the Czech Republic. Monetary transmission may be further muted where domestic banks have the opportunity to raise funds in the international capital market (also as members of holding companies); however, this may also involve an exposure to monetary developments in other countries, cf. Gambacorta (2005), and Cetorelli and Goldberg (2012). With regard to monetary transmission in Hungary, Vonnák (2006) finds that the contribution of the credit channel may not be significant in the country because a number of corporations and many subsidiaries of foreign banks have access to such funds. By contrast, Gambacorta and Marques-Ibanez (2011) attach importance to other factors. They assume that banks with the means to dispose of some of their loans through securitisation may also shield themselves against the difficulties of raising alternative funds. The authors also examine the share of deposits and short-term funding on the liability side. They found that a higher share of deposits slows transmission, i.e. re-pricing would involve a major increase in costs. They also demonstrate that the share of short-term liabilities forced to shed a larger part of their loans at times of tightening, i.e. strengthened the transmission process. These effects are more pronounced in a financial crisis. Peek and Rosengreen (2013) highlight the importance of required reserves and capital adequacy. In New England, banks that were limited by capital constraints found it difficult to accommodate to the circumstances provided by monetary easing. A capital shock may also cause banks to shrink their assets and liabilities; consequently, such limits must be taken into account in adopting monetary policy actions. Additionally, Hristov et al. (2015) point out that liquidity in financial markets drops at times of crisis, and the resulting volatility of yields mutes the effect of central bank actions. They also argue that a lower loan-to-value ratio may restrict monetary easing as a result of the lower outflow of mortgage loans. — 581 —

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Capital adequacy is closely correlated with banks’ stability and external risk perception. In connection with the credit channel, Gambacorta (2008) explains that at times of tightening, banks perceived to be riskier can only top up their deposit holdings at a significantly higher cost. In their empirical analysis, Gropp et al. (2007) also conclude that positive ratings (Moody’s KMV) enable banks to set their spreads in alignment with the market. Gambacorta and Marques-Ibanez (2011) use the common equity tier 1 capital and the expected default frequency to express stability, or the lack of it as the case may be, and find that the capacity of riskier banks for providing lending is lower, particularly at times of crisis. Neoclassical thinking holds that market participants always seek to maximise their profits within the confines of their existing opportunities. Hicks (1935) was the first to point out, in the context of the relationship between efficiency and competition, that ever-increasing market power may at times lead to diminishing efficiency. In his view, this is because market monopoly, the absence of competitors posing a challenge, and an acceptable level of profits allow management not to increase their efforts to achieve maximum efficiency. This is the so-called “quiet life” (QL) hypothesis. In some respects, using X-efficiency, Leibenstein (1966) explains the positive effect of competition on efficiency. He finds two main reasons for which the entry of new participants will encourage the management of an existing corporate to seek higher efficiency: (1) a new entry increases the probability that an existing participant will be crowded out of the market; (2) having a better basis for comparison, it becomes easier for shareholders to realise the inefficiency of management, and increase pressure on management accordingly. An alternative to the QL hypothesis is offered by the so-called efficient structure (ES) hypothesis. Demsetz (1973) argues that since efficient participants can earn a unit of profit at lower marginal cost, they will crowd out less efficient competitors, which will increase their market power and concentration. This approach is preferred in a number of empirical studies. The contrast between the conclusions of the QL hypothesis and of “efficient structure” theory also implies — 582 —

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that the economic relationship between competition and efficiency is not determined; indeed, in respect of a given country, both may be identified in different periods. It may occur that banks initially operate efficiently, whereby they gain market power, as a result of which they become “comfortable” and less efficient. At the same time, advanced and consolidated banking systems tend to work with lower interest rate margins, which indicate both a competitive environment and efficient operations, which is why the consolidation of fragmented banking systems may be appropriate, while avoiding a weakening competition due to excessive concentration.

17.2 The relationship between the efficiency of the domestic banking system and monetary policy Interest rate transmission plays an important role in determining the extent to which an economy will respond to monetary policy actions, and the lag with which that response will occur; therefore, it is appropriate to map out the pricing habits of banks, the most prominent intermediaries in the financial system. It should be noted, however, that the strength of interest rate transmission will not afford an unambiguous conclusion regarding the strength of the interest rate channel. Namely, the latter is also influenced by the sensitivity of consumption and capital expenditures to bank rates, as well as by the role that developments in other yields play in market participants’ decisions. These two factors primarily depend on the net financial worth of households and corporates, and on the role of non-bank financial intermediation (Horváth et al., 2004). As regards Hungary, separate mention should be made of the increased prominence of foreign-currency financing before the crisis, which had replaced forint bank loans right up to forint conversion, significantly weakening the possibilities for interest rate pass-through. Before the crisis, due to the global abundance of liquidity and a high risk appetite, the Hungarian banking system, and particularly foreign— 583 —

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owned banks, could raise cheap foreign-currency funds. However, before the crisis there was no authority with a clear responsibility for macroprudential policy, which allowed banks to ease their terms of lending virtually out of control as they competed for customers. Demand for foreign currency loans was boosted by households’ optimistic expectations for income convergence, high interest rate margins on forint loans, and the apparently stable exchange rate of the forint. High interest rates were attributable partly to risks resulting from the high indebtedness of the country and the state, and partly to sticky disinflation. Conversely, the relative stability of the exchange rate was the result of a monetary policy regime characterised by the inconsistent combination of inflation targeting and an exchange rate band (The Hungarian Banking System in Transformation, 2014). The phase-out of foreign currency loans was completed as of 1 January 2015 as part of forint conversion, protecting households and the country against another Swiss franc shock occurring on 15 January 2015, when the Swiss central bank abandoned its CHF/ EUR peg, which it had maintained for years at 1.2, allowing the franc to appreciate by 15 per cent in a matter of days. As a result of conversion, the mostly variable-rate loans, now forint-dominated, are serving the purposes of Hungarian monetary policy again. In Hungary, too, the extent and speed of interest rate transmission is influenced by the depth of bank intermediation, the extent of disintermediation and the capital market’s level of development, as well as the capitalisation and liquidity position of the banking system, and its healthy and efficient functioning. The acceleration of financial deepening was halted by the financial crisis, requiring major deleveraging in both the household and corporate sectors. Prior to the onset of the crisis, the banking sector was characterised by a take-off in lending, particularly corporate project lending and foreign currency lending to households, and the resulting high profitability. Due to an inadequate asset structure and a downturn in the performance of the real economy, the banking system incurred excessively high losses in the years of the crisis, which resulted in a major drop in lending activity, leading to slower economic recovery, and hindering monetary policy. — 584 —

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The role of corporate lending in interest rate pass-through was little changed by the Funding for Growth Scheme due to its fixed spreads, but superseding the FGS, the Market-Based Lending Scheme created space for the pick-up in corporate lending, allowing the positive effects of the low interest rate environment. According to the MNB’s 2014 publication, The Hungarian Banking System in Transformation, following the years of transition, the stabilisation of the economic policy environment, the elimination of disincentives, and the simultaneous promotion of competition and macroprudential regulation were needed to achieve a healthy banking system that supported the real economy in a sustainable way. In recent years, the operations of the Magyar Nemzeti Bank have followed this logic. The key criteria for a banking system which, in the context of these conditions, can be considered ideal and efficient in the broad sense are highlighted in the points below. 1. The domestic banking system must be competitive. The share of the three largest participants must not exceed 50 per cent in any of the important market segments. Competition must focus on pricing rather than risk taking. Accordingly, interest rate spreads must descend to the level of the European average, i.e. 1 per cent to 2 per cent for corporate loans, and 3 per cent to 4 per cent for housing loans. 2. The banking system must generate a fair profit. Over the medium term, profitability must stabilise at a level that ensures shareholders’ sustained interest in the Hungarian market, but is at the same time achieved as a result of adequate competition and prudential lending practice. This could correspond to an annual ROE of 10-12 per cent. 3. Banks must reinvest a larger part of their profits into their operations. Once profitability has been restored, banks must reinvest at least 50 per cent of their profits generated in Hungary into their operations in the country, because this is what best supports the convergence of the banking sector and the deepening of financial intermediation. — 585 —

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4. More self-financing is needed in the banking system. Banks’ loanto-deposit ratios must not deviate permanently and substantially from 100 per cent. This will not necessarily eliminate dependence on non-resident FX funding, but will significantly reduce it. 5. Bank lending to corporates must support growth and must be prudential. Through the gradual elimination of the constraints on lending, the credit institution sector must become capable of satisfying the prevailing demand for credit in the corporate sector. In the short term, constraints on credit supply must be eased. In the longer term, a 6-8 per cent annual growth in corporate lending is considered consistent with the convergence path. 6. Banks must be engaged in healthy household lending. In order to ensure sustainable economic growth and to prevent households from taking on excessive burdens, a healthy structure is needed in lending to households. After the natural reduction in the volume of foreign currency loans to households, over the long term an annual 6-8 per cent growth in lending is seen as desirable. 7. The banking system must be cost-efficient and innovative. Apart from the degree of competition, banks’ pricing is also influenced by the efficiency of their operations. An efficient banking system functions with low operating costs and features a proper risk management framework. Therefore, the efficiency of the domestic banking system must gradually be aligned with the average of European countries. Innovation is essential for improving cost efficiency. 8. The domestic banking system must be transparent and responsible. While seeking to innovate, banks must also ensure that the pricing of their plans and the inherent risks are transparent and clear to customers.

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9. There must be sufficient liquidity in the banking system. Banks must have sufficient liquidity on hand to ensure that their core functions can be performed even under an adverse macroeconomic scenario. 10. The domestic banking system must be adequately capitalised. Banks must have sufficient capital to ensure that their expected losses can be hedged even under an adverse macroeconomic scenario. Therefore, banks’ NPL-ratios must drop below 5 per cent, and their capital adequacy ratios must remain permanently above 10 per cent even in years following recovery from the crisis. As a result of the central bank’s actions taken in recent years, a vast majority of the above points have been implemented. The banking system’s weakened solvency and liquidity positions have improved each year despite settlement, the bank levy, forint conversion and the modification of the central bank instruments: at the end of 2016, the liquidity coverage ratio stood at nearly 200 per cent, and the capital adequacy ratio above 20 per cent. Specific legislation was adopted on transparent and responsible banking: Act LXXVIII of 2014 has become known as the Fair Banks Act, which makes developments in interest rates set on household loans transparent and therefore easy to follow. In 2016, the domestic banking system earned the expected return on a level of equity that can be considered adequate, and the share of its external funds dropped significantly, with a loan-to-deposit ratio below 100 per cent. 2016 saw a turnaround in lending to both the corporate and the household segments. The process of deleveraging halted and reversed, and financial deepening was resumed. The criticism expressed in Vonnák (2006) concerning the insignificance of the credit channel in Hungary has therefore partly been dismissed, because financing through forint loans is becoming an alternative (and often the only one) for an increasingly wide range of participants. At the same time, in terms of both competition among banks and efficiency in the strict sense, cost levels and innovation, shortfalls remain that also affect the adequate functioning of the interest rate channel. — 587 —

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Apart from the degree of competition, banks’ pricing is also influenced by their efficiency. An efficient banking system functions with low operating costs and features a proper risk management framework, which in turn allows for the use of lower margins. Although two approaches have gained prominence in literature for a more accurate estimation of bank efficiency, stochastic frontier analysis (SFA) and data envelopment analysis (DEA), Dong et al. (2014) show that despite the positive correlation between the efficiency estimates obtained using the two approaches, the degree of the correlation is only moderate, as a result of which no unambiguous claim may be made as to which approach is more correct. A detailed explication of the complex approaches is beyond the scope of this study, and international comparison is also more difficult using the above models and processes to measure the intensity of competition (see the Box). For these reasons, we are using simplified efficiency indicators such as costto-income and cost-to-assets, set against return on assets. Box 17-1 Methodological questions in the context of efficiency and competition

Studies on the measurement of the correlation between efficiency and competition often use frontier approaches. Such approaches analyse the cost (profit) per unit of profit (cost). The efficiency of participants is determined with reference to a frontier identified on the basis of the most efficient input (output) production achieved. In the relevant literature, three distinct approaches are prevalent. These are data envelopment analysis (DEA), which is based on linear programming, the stochastic frontier approach (SFA) and the distribution-free approach (DFA), which identify the efficiency frontier using regression models. Approaches resembling the SFA and DFA can already be observed in Aigner et al. (1977), Berger (1995), and Allen and Rai (1996). Inefficiency is expressed in the above SFA and DFA approaches by means of error terms. The marginal cost required for the calculation is estimated through the derivation of the regression equation. The correlation between the efficiency obtained in this way and market power is examined in a separate estimation.

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The key advantage of the SFA is the consideration of unobservable external shocks in specifying the cost surface, whereas the DEA approach does not set parametric criteria. Given the possibility of a significant difference between the results obtained using the two approaches, it may be appropriate to use both as part of the same analysis. Nevertheless, the approaches will only allow a comparison between the efficiencies of the banks (units) the data of which are entered on the model concerned, because the cost surface is specified on the basis of such data. The use of the SFA approach occupies a prominent role, for example, in the study of Molnár and Holló (2011), which provides an international ranking where Hungary has a major shortfall in terms of the cost surface measuring bank efficiency in 25 EU Member States. The results obtained from the indicators used to compare competition are not always unambiguous either. Carbó et al. (2009) demonstrate a low correlation between the results obtained using various indicators and approaches. This is normally attributable to factors that are ignored by individual indicators. On that basis, it is recommended that an analysis of this kind should examine the differences between the units from the greatest possible number of aspects. Chart 17-1: Net interest income to total assets (international comparison)

EU average

CEE average

Source: ECB CBD.

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Hungary

2016 H1

2015 H2

2015 H1

2014 H2

2014 H1

2013 H2

2013 H1

2012 H2

2012 H1

2011 H2

2011 H1

2010 H2

Per cent

2010 H1

2009 H2

Per cent

2008 H2

5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

Part II: Challenges and Answers in Hungarian Monetary Policy

In Hungary, high interest income (Chart 17-1) and high spreads may be symptoms of a low intensity of competition and the quiet life hypothesis described in the foregoing. The same holds for the spreads on new loans, which are high by international standards. A further indicator of weak competition and poor efficiency is that in recent years, periods of free loan replacements provided by the government have regularly disappointed, because compared to initial expectations, a far lower number of customers were willing or able to take the option provided. That said, high interest rates are not simply the heritage of the past: in the household segment and particularly with home loans, the spreads on new loans over money market rates are still significantly higher than the regional average.

Household lending / total assets (per cent, 2016 Q3 n.év)

Chart 17-2: Net interest income to total assets of individual banks based on the percentage of household loans within their balance sheets 70 60 50 40 30 20 10 0

Net interest income to total assets (per cent, 2016 Q3) Note: Based on data for the 16 largest banks. Source: MNB.

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Looking at domestic banks individually, the correlation tends to emerge that in terms of profitability over total assets, a higher interest income is generated by banks that are more active in household lending (Chart 17-2), i.e. the situation that has emerged in Hungary in support of the QL hypothesis could primarily be explained by the environment of household lending. Such income-to-assets ratios, which are high even by international standards, may primarily be attributable to excessive spreads on household loans, given that corporate spreads fit into the euro area average even in respect of small loans to SMEs, which is due partly to the central bank’s Funding for Growth Scheme (see Box 17-2). Box 17-2 Competition in the SME lending market before and after the Funding for Growth Scheme

The major drop in corporate lending in the aftermath of the crisis is attributable to the overall sensitivity of corporates to economic and financial shocks. This applies particularly to domestically owned smaller businesses, which were forced to deleverage by the disadvantages resulting from their increasingly distressed market positions (falling sales and demand) and limited funding opportunities. The reasons underlying limited bank lending included banks’ pro-cyclical behaviour and moderate propensity to lend, and rising risk premiums. The Funding for Growth Scheme (FGS) was launched by the MNB in June 2013, to encourage banks to finance domestic SMEs. With its high financial envelope, the central bank’s targeted instrument increased and broadened banks’ attention within the SME sector, while it also provided a stable opportunity for corporations to borrow at fixed rates with low spreads. Key elements in intensifying competition included the allocation mechanism and the option of bank switching, which also enabled small and medium-sized banks to take a large share in the implementation of the programme.

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Among other things, the success of implementation is indicated by the fact that in terms of the number of transactions, 90 per cent of the loans were granted to micro and small enterprises. In 2015, the decline in SME lending was turned into growth, the dynamics of which reached 6 per cent by September 2016. As the mitigating terms specified as part of the programme gradually passed through into market-based credit products, the effect of this was also felt in the level of interest rates in the overall corporate sector (Chart 17-3), while the positive real economy outlook increased credit demand in general. Despite those achievements, there is still space to increase corporate lending, particularly to smaller and younger corporates. By taking over part of the credit risk, guarantee providers may also play an important role in making finance accessible to this segment. Following the phase-out of the FGS, the increase in the degree of competition continues to be supported by several elements of the central bankâ&#x20AC;&#x2122;s Market-Based Lending Scheme, including the transparent SME credit risk model, which enables even somewhat riskier businesses to borrow on increasingly favourable terms. Chart 17-3: International comparison of interest rate spreads on low-amount corporate loans granted in domestic currency 8

Percentage point

0 2008

0 2009

2010

2011

Hungary Poland Romania

2012

2013

Slovakia Czech Republic

Sources: MNB, national central banks.

â&#x20AC;&#x201D; 592 â&#x20AC;&#x201D;

2014

2015

2016

Slovenia Euro area

17 Steps towards a more efficient banking system

That said, in residential mortgage lending the spreads on Hungarian housing loans still exceed by far the regional average, and have continued to rise recently (Chart 17-4), which may indicate an inadequate intensity of competition in the household segment on the one hand, and inefficiency and the absence of cost adjustment in the domestic banking system on the other. Chart 17-4: International comparison of spreads on housing loans granted in domestic currency 7

Percentage point

7 6

2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011 2011 2011 2012 2012 2012 2012 2013 2013 2013 2013 2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

Hungary Poland Romania

Slovakia Czech Republic

Slovenia Euro area

Sources: MNB, national central banks.

The unit costs of banks operating with more efficiency of scale are lower than those of less scale-efficient competitors, and therefore their profitability may also be higher. Scale-efficient banks gain larger market shares, which will lead to higher concentration. Apart from efficiency of scale, banks may also decrease their unit costs through efficiency of scope, adopting increasingly universal operating models. Another possible form of enhancing efficiency could be for banks to improve the — 593 —

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allocation of their inputs or produce more output per unit of input than before. In such efforts, a key role is occupied by innovation, which increases cost efficiency, and contributes to meeting consumer needs on the widest possible scale. Chart 17-5: Operating costs as a percentage of assets in the banking systems of EU Member States 5.0

Per cent

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

2008

2009

2010 Hungary

2011

2012

2013

2014

2015

0.0

Regional average

Note: Distribution of values for European countries, with boxes representing the 20–40 percentiles and the line marks the 60–80 percentiles. The regional average refers to the average of the Visegrád countries for the period concerned, net of Hungary. Source: ECB.

Cost efficiency is low in Hungary, partly due to the small size of its banking system and also because of a higher cost ratio required for expansion, which gradually improved as total assets ballooned, i.e. as efficiencies of scale improved. By international standards, the operating cost to assets ratio stands above 3 per cent, which is notably higher (Chart 17-5) than the European average of 1 per cent to 2 per cent, and the approximately 2 per cent that is characteristic of Visegrád countries. A prominent role in this is occupied by the significant weight of the — 594 —

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financial institutions of Hungarian banks, which operate in markets of poorer cost efficiency: according to non-consolidated data, the ratio of operating costs to assets is 2.9 per cent, which is still among the highest in the Union. Cost analysis typically relies on the cost-toincome indicator, which expresses operating costs as a percentage of the profit or loss on ordinary activities (net of impairment), which is relatively better for the Hungarian banking system due to the higher interest incomes explained above. We have pointed to the fact that in Hungary, the interest rate margin is extremely high, primarily due to the high interest rate spreads seen in the household segment, even in the period following forint conversion and settlement. Rather than the cost efficiency of the banking system, the cost-to-income indicator therefore shows that banks’ dominance allows them to transfer most of their burdens. Apart from a comfortable banking system and a low degree of competition, there may also be other factors underlying the poor cost efficiency of the Hungarian banking system. In 2015, there were 30 bank branches per 100,000 inhabitants in Hungary, which corresponds to the European average; however, it needs to be added that in a number of European countries, including in the region, banks operate with a considerably lower number of branches. At the same time, banks’ employee headcount is below average in Hungary (Chart 17-6), which may stem from smaller branch sizes and less intensive investment banking activity. That said, it must also be noted that in western countries, the depth of financial intermediation is much greater, and accordingly, a comparison of headcounts or branch numbers to total assets will show much more scale-efficient banking systems across the EU.

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Chart 17-6: Employee headcounts and branch numbers of credit institutions Bank employees

Branches

720

640

560

480

400

320

240

160

50 40 30

Slovakia

Eurozone

Czech Republic

Poland

Hungary

Eurozone

Mediterranean countries

No. branches per capita No. branches/total assets (right-hand scale)

800

Slovakia

Czech Republic

per EUR Bn

Poland

per 1,000 people

Hungary

per EUR Bn

Mediterranean countries

per 100 thou. people

No. bank employees per capita No. bank employees/total assets (right-hand scale)

Note: 2015 year-end data. Source: ECB.

The economy would benefit from both the increased prominence of banks with lower marginal costs, and the improvement in less efficient ones. In higher Hungarian marginal costs, developments in the cost of funds are likely to be predominant, which is consistent with the inadequate functioning of the bank balance sheet and bank lending channels as described in the introduction. One of the most straightforward ways of cleaning the bank lending channel is to shed costly non-performing loans on the balance sheets. In terms of operating costs, the accommodation that has taken place to date appears moderate, particularly in light of the aggressive precrisis expansion, given that only marketing costs dropped substantially, followed by branch network rationalisation in 2016. Further accommodation was seen in the postponement of IT investments to â&#x20AC;&#x201D; 596 â&#x20AC;&#x201D;

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retain capacities, which, however, will lead to deteriorating efficiency over the longer term, and as such cannot be considered a sustainable direction. It should be noted again that the share of problem loans is still excessive by both international and Visegrád standards. The low intensity of cleaning non-performing loans could partly explain why the Hungarian banking system is less efficient compared to other Visegrád countries; accordingly, the central bank’s actions to facilitate efforts will be given particular emphasis in the discussion below. In a broad sense, the efficiency of the domestic banking system improved considerably by 2016: lending freeze in the aftermath of the crisis resumed, solvency and liquidity positions in the banking system were consolidated, while the improvement in the effectiveness of monetary policy was also greatly supported by forint conversion. In a narrower sense, however, the ratio of operating costs to total assets, a measure of the efficiency of the domestic banking system, should gradually be aligned with the average of European countries, targeting the 1.5-2 per cent band for the indicator for 2020. In that process, a prominent role could be played by innovation and digital transformation, which could simultaneously support improvements to service quality and cost cutting, and by a stronger competitive environment, which will drive the domestic banking sector towards the necessary changes, and, over the long term, better efficiency.

17.3 Steps towards better efficiency through cleaning non-performing loans The management of non-performing loans generates costs and nonreturning interest expenditure for banks. The heaviest burden on the efficiency of the domestic banking system is the still significant nonperforming loan portfolio. Non-performing loans fail to play a role in interest rate pass-through, and also set back propensity and opportunities to borrow in the case of new lending (Chart 17-7). Cleaning the portfolio may increase the efficiency of the banking system in several respects: — 597 —

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first, the cost of current workout activities could be saved, and second, the banking system could shed its assets that generate negative interest income, and in their stead, it could focus on new lending to support interest rate transmission. Another factor to drive cost cutting could be the spread of sales channels that do not require personal presence, which could improve the efficiency of the banking system in the broad sense by facilitating bank switching and loan applications. Chart 17-7: Operating cost to assets and NPL ratios of Hungarian banks 4.5

Operational cost to assets (%)

4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 0

NPL ratio (%)

Note: Data for 2015. The chart does not present the data of banks with special product structures (i.e. building societies or banks engaged exclusively in consumer lending). Source: MNB.

In the developments that supported cleaning and better efficiency, the Magyar Nemzeti Bank played an active role in both the household and corporate segments. First, a detailed and comprehensive study was compiled on non-performing household mortgage borrowers, as part of which the MNB put forward a recommendation for banks on the effective and sustainable restructuring of non-performing loans. Second, the MNB set up MARK Zrt. to act as a catalyst in the market for commercial — 598 —

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property loans, which, along with the introduction of the systemic risk buffer (SRB) has been making an active contribution to the transfer of commercial property loans, inherited from project finance and burdening bank balance sheets for years, to collection agencies that are more efficient than bank participants. This is a relief for the banking system on the cost side, while it also facilitates the recovery of the bank lending channel through the normalisation of risk appetite, which will ultimately lead to improvements in interest rate transmission.

17.3.1 Non-performing household mortgage loans and the related MNB recommendation138

The costs of non-performing loans and the ways in which such loans impede the effective contribution of the banking system have been discussed above. This part describes the most important actions taken with a view to cleaning non-performing household loans, and the background to the MNB recommendation, which is based on a granular analysis of borrowers. The high level of non-performing household mortgage loans has long been one of the most serious risks to financial stability and society. Following the beneficial effects of settlement and forint conversion, and the depletion of the capacities of the National Asset Management Agency (Nemzeti Eszközkezelő Zrt.), the situation of nearly 130,000 mortgage borrowers is still unsettled. The situation of borrowers is exacerbated by the fact that the forced sale moratorium ended at the end of 2015, as a result of which, with the expiry of the winter eviction moratorium as of 1 March 2016, lenders may again have recourse to collateral enforcement. It is a key objective of the Magyar Nemzeti Bank (MNB) to restore the repayment capacity of non-performing household mortgage borrowers permanently without mass collateral enforcement and mindful of the need to guarantee borrowers’ housing, which will also ultimately lead to the consolidation 138

his subchapter relies heavily on the background study for MNB Recommendation No. T 1/2016. (III.11.), which is available at http://www.mnb.hu/letoltes/mnb-ajanlas-nplhattertanulmany.pdf

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of such borrowers’ creditworthiness. Additionally, a large number of receivables may be de-recognised in bank balance sheets as the market for incurable non-performing debt becomes active. In summer 2015, relying on a broad information base, the MNB launched a survey to explore the problem to the greatest possible extent.139 According to the data of the mortgage loan database compiled as part of the survey, mortgage debt owed by the approximately 144,000 borrowers with debt over 90 days past due amounted to nearly HUF 1,300 billion (some 3.9 per cent of GNP), with principal debt totalling at HUF 1,100 billion. More than one-half (55 per cent) of the past-due loan transactions had been terminated by the time of the survey, i.e. in such cases borrowers had to consider enforcement as a real threat. For the purposes of profiling non-performing mortgage debt, several aspects were examined, which involved an analysis of the capacity and propensity of non-performing borrowers to repay their debt, as well as an analysis of the location, marketability and value of collateral. While the behaviour of non-performing borrowers is primarily determined by the size of their incomes and the ratio of their instalments to those incomes, particular emphasis should also be placed on the examination of their relationships to their banks and on the presence of moral hazard, given the possibility that the eviction moratorium may have caused a number of borrowers to opt for non-payment regardless of their financial standing. Borrowers with delinquent loans may voluntarily offer their property for sale in order to be relieved from their loans; however, this is only possible in cases where the property is located in an area of adequate number of transactions. Previous research by the MNB suggests that there are significant restructuring reserves in the non-performing mortgage loan portfolio: 139

he publication presenting the results of the survey was released in October 2015 and T is publicly accessible on the central bank’s website: Dancsik, B. – Fábián, G. – Fellner, Z. – Horváth, G. – Lang, P. – Nagy, G. – Oláh, Zs. – Winkler, S. (2015): Comprehensive analysis of the non-performing household mortgage portfolio using micro-level data. MNB Occasional Papers Special Issue, Magyar Nemzeti Bank.

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based on research results, it can be established that two-thirds of borrowers had the income subject to personal income tax required for the full or partial settlement of their debt, and 40 per cent made at least partial repayments in the period surveyed (Chart 17-8). However, the termination of the forced sale moratorium created a new situation, which may meaningfully improve the effectiveness of cooperation aiming to restore borrowers’ repayment capacity. Chart 17-8: Breakdown of the non-performing population by capacity and propensity to repay 42 per cent of borrowers performed at least partially in the examined period

Ability to repay based on admitted income

“Moral hazard” relevant to 10–20 per cent of the portfolio Sufficient income for debt settlement

11%

To great a dept with respect to income

23%

14%

No income

24%

No repayment

Partial repayment

Sufficient repayment

Repayments realized within a year Note: As at 30 April 2015. Sources: MNB, National Tax and Customs Administration.

Based on the criteria examined, non-performing household mortgage borrowers constitute a rather heterogeneous population, but may nevertheless be classified into four large, partially overlapping segments. Borrowers affected by moral hazard, i.e. those with adequate repayment capacity but low propensity to repay, make up 10 per cent to 20 per cent of the portfolio. Borrowers classified in this segment have an average outstanding debt of HUF 5.9 million (with a median of HUF 4.6 million), and a monthly average income of HUF 258,000 (with — 601 —

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a median of HUF 222,000), set against an average monthly instalment of HUF 43,300 (with a median of HUF 36,400). Loan transactions have an average loan-to-value ratio of 82 per cent (with a median of 77 per cent). In our judgment, 45-50 per cent of the non-performing portfolio is composed of transactions that could be restructured in a sustainable way (Chart 17-9). Borrowers classified in this segment have an average outstanding debt of HUF 8.9 million (with a median of HUF 6.2 million), which is similar to the portfolio average, and a somewhat higher average monthly instalment of HUF 89,900 (with a median of HUF 48,500), set against a monthly average net income of HUF 256,000 (with a median of HUF 222,000), which is higher than the average. Loan transactions have an average loan-to-value ratio of 82 per cent (with a median of 78 per cent). Chart 17-9: Segmentation of the non-performing household mortgage loan portfolio

100%

Borrowers with low willingness to repay

Borrowers suitable for restructuring

Borrowers with large families

Borrowers with no income

18 thousand deals

68 thousand deals

33 thousand deals

54 thousand deals

100%

80%

60%

40% 20% 0%

40%

45–50 10–20 per cent

per cent

37 17–20 per cent

per cent

20% 0%

Source: MNB.

However, the options of collateral sale are in general limited. With a part of the transactions, the voluntary sale of collateral items or their enforcement by lenders is limited by the local characteristics of the property market. A significant proportion of collateral property is located in regions and/or municipalities where due to the weaknesses of the property market, there are barriers to sales on market terms. Nearly 70 per cent of collateral property is located in villages and — 602 —

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smaller towns, which are less favourable in terms of the property market, and only less than one-third in cities with county rights or the capital, whereas about 51 per cent of Hungarian homes are located in Budapest and in cities with county rights (Chart 17-10). Chart 17-10: Distribution of non-performing debtors by region and type of municipality 15.4% 7.4

3.0

5.0 3.6

5.0

7.6

27.2%

0.8

4.4

7.2% 3.2

2.4

2.8 4.6

11.8%

16.2%

12.6 9.0 4.8

1.6

9.6% 4.0

12.6%

3.4 3.0 6.2

2.4 3.2

12.6% 32.2%

18.0%

37.2%

Municipality

Other town

Town with county rights

Budapest

Sources: CCIS, MNB.

The current legislative environment does not properly regulate the procedures to be followed by lenders in order to restore the repayment capacity of debtors. The restoration of repayment capacity could be facilitated by the debt settlement procedure (private insolvency law) entered into force in autumn 2015, or by the restructuring of loan transactions based on mutual agreement. Experience from the past period shows that interest in the debt settlement procedure has been moderate, as a result of which the procedure is unlikely to provide borrowers with a sustainable solution within a short time and on a massive scale. In addition, the entry criteria of the procedure also represent significant barriers for a part of non-performing borrowers. — 603 —

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The current regulatory environment does not encourage proactive lender behaviour for restructuring based on mutual agreement. Legislation that codifies regulations on restructuring offers a rather limited solution, which has not been extended on the merits during the domestic implementation of the relevant EU directive. Recognising this, the MNB issued a recommendation to catalyse cooperation and resolution between lenders and borrowers, and to make non-performing loans perform again. The recommendation provides a transparent and uniform framework for joint solution finding, given the MNB’s position that the parties basically have sufficient information, interest and capacity for the elaboration of sustainable solutions. The MNB is interested in creating conditions that provide greater flexibility and more instruments for both lenders and borrowers compared to the more restrictive debt settlement procedure. As the boundary conditions of the recommendation, the MNB provides that borrowers’ housing must be guaranteed and the moral hazard associated with default must be minimised, and that the recommendation should not, even over the short term, hinder the contribution of the banking system to economic growth. The MNB recommendation provides a detailed specification of the solutions that may be offered as part of solution finding. The following qualify as sustainable solutions: • sustainable restructuring (rearrangement, reorganisation) of the loan transaction140, which ensures that the borrower’s repayment obligation remains consistent with their income and essential regular expenditures even over the long term; • sale of the collateral property by mutual agreement, including solutions that allow the borrower to lease back the property for a definite term, then repurchase the property at the end of the term; • sale of the collateral property to the National Asset Management Agency; • entry into a debt settlement procedure. 140

I n the case of receivables from terminated mortgage loan agreements, instead of restructuring any solution will be acceptable that allows the borrower to repay the debt in instalments.

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The MNB recommendation lays down objective requirements for cooperation between lenders and debtors. Such requirements include for the lender to (i) attempt contacting the borrower at least three times within a specified period; (ii) enter into an arrangement with the borrower within 3 months; (iii) during each information collection and solution finding, provide at least two opportunities to supply missing information, and at least one opportunity for personal consultation; and (iv) propose at least two solutions to the borrower, of which at least one should provide for the recovery of repayment capacity by granting the option to retain title to the property. With a view to ensuring constructive cooperation in good faith, the borrower is required (i) not to reject the lender’s attempt to contact the borrower; and (ii) enter into an arrangement with the lender within 3 months. Additionally, the MNB particularly recommends that the lender should implement actions in order to recover compliance with debt service obligations only conditionally, subject to the borrower’s performance. With the recommendation the MNB’s declared aim is to restore the repayment capacity of non-performing household mortgage borrowers permanently, and to encourage sustainable debt settlement. The recommendation allows debt settlement through a sustainable solution for some 60 to 70 thousand debtors. Based on the MNB’s detailed study, in the remaining cases a solution could be provided by collection agencies operating on a market basis, which, as opposed to banks, can carry out their activities with specialised human resources, employing the best international practices, and, given the absence of performing loans, without any moral hazard. The MNB has also been monitoring the restructuring practices of market-based collection agencies in order to screen any extreme solutions that are inconsistent with the spirit of the MNB recommendation. Overall, the steady increase in the dynamics of household lending has been accompanied by a decline in the household NPL ratio, which may remove a major obstacle to a more efficient banking system by 2018.

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17.3.2 Non-performing corporate loans and MARK Zrt.

The MARK project was set up by the MNB in autumn 2014 to address the problem resulting from the volume of large non- and low-performing commercial property loans and foreclosed properties accumulated in the banking system. The objective of the programme, the methodology developed for the management of the systemic problem, and the voluntary buy-out of problem assets associated with property lending at market prices earned recognition among both international and domestic participants. Following its setup in November 2014, MARK established its complete staffing and infrastructural background, developed its methodology for the valuation of property and receivables, and obtained the European Commission decision required for its functioning. Additionally, it also developed and implemented the legal and operational framework for the provision of collection agency services to third parties, and launched its property asset management service to the two subsidiaries of the Resolution Asset Manager. Chart 17-11: Developments in portfolio quality across EU Member States 50

Per cent

CY GR SI PT IE IT RO HU BG HR MT AU PL ES EU LT SK LV FR BE DK DE NL GB EE FI SE

Share of non-performing loans (2008) Share of non-performing loans (2015)

Note: The ratio of gross non-performing debt to total debt. Source: ECB CBD.

â&#x20AC;&#x201D; 606 â&#x20AC;&#x201D;

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Even after the resolution of a large bank in the country, Hungary’s NPL ratio remains high, with the corporate NPL ratio at 18.4 per cent at the end of 2015 (Chart 17-11). Due to a large sale, the corporate NPL ratio continued to improve in Q1 2016, and amounted to 12.3 per cent at the end of September. More specifically, the problem portfolio of commercial property loans remains a considerable risk, accounting for about one-tenth of all corporate debt (including performing and non-performing loans). Apart from the foregoing, also for international organisations (IMF, OECD, ECB, European Commission and EBRD) as given particular emphasis in their publications, the primary risk is the high volume of non-performing debt, and its inhibiting effects on lending and interest rate transmission. The breakdown of non-performing loans by product reveals that a considerable portion, i.e. more than half, of the problematic portfolio is still traceable to project loans in the corporate segment, and a major part of these project loans are related to commercial properties (office building, commercial centre, hotel, industrial properties, plots), where the ratio of non-performing loans remained above 40 per cent even after resolution (Chart 17-12). In the 2015 decline in the NPL ratio, a prominent role was occupied by the resolution actions ordered by the MNB, without which cleaning would have corresponded to the market level seen in previous years. In 2015, large banks with a dominant share in project financing sold loans from their gross project loan portfolio in the total amount of HUF 360 billion, of which some HUF 315 billion was attributable to resolutions, primarily in the form of sales to the Resolution Asset Manager (December 2015) after attracting moderate market demand for such assets. As regards market-based transactions, cleaning by banks arguably remained moderate. Compared to the end of 2014, due to the role of MARK Zrt. as a market catalyst and the introduction of the systemic risk buffer, the volume of problem exposures of almost HUF 1,000 billion dropped by approximately one-half. At the end of September 2016, debt secured by commercial property amounted to HUF 360 billion, of which HUF 290 billion was reported to be project type, with a downward distortion — 607 —

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still remaining in the volume. The problem is exacerbated by the fact that in addition to the receivables, there are also HUF 150 billion worth of properties enforced as collateral, as well as exposures transferred to parent banks amounting to some HUF 150 billion. Chart 17-12: Non-performing and restructured project and other corporate loans in the banking system 50

Per cent

2016 Q3

2016 Q2

2016 Q1

2015 Q4

2015 Q3

2015 Q2

2015 Q1

2014 Q4

2014 Q3

2014 Q2

2014 Q1

2013 Q4

2013 Q3

2013 Q2

2013 Q1

2012 Q4

2012 Q3

2012 Q2

2012 Q1

Share of loans with over 90 days of delinquency within project lending Share of loans with over 90 days of delinquency within other lending Share of corporate loans with over 90 days of delinquency NPL ratio of project lending NPL ratio of other corporate lending NPL ratio of corporate lending

Source: MNB.

Due to the slow rate of portfolio cleaning, non-performing corporate loans include a high proportion of loans that have stuck in bank balance sheets for a long time. In terms of the entire corporate sector the ratio of problem loans that became non-performing earlier than three years ago is over 60 per cent within the NPL portfolio (Chart 17-13). It should also be noted that based on the number of contracts, the ratio of corporate loans that became past due earlier than 5 years ago is significantly higher because banks often seek to restructure loans of larger volume in order to restore borrowers’ repayment capacity.

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Chart 17-13: Distribution of corporate NPL holdings by the length of time since the date of becoming non-performing (December 2015) 40

Per cent

0–6 months

6–12 months

1–2 years

2–3 years

By number of contracts

3–4 years

4–5 years

Above 5 years

By outstanding amount

Sources: CCIS, MNB.

A major improvement took place in the lease market of industrial and logistics properties in the capital, which may support the cleaning of problem commercial property market exposures stuck in banks’ balance sheets. At the end of the first half of 2015, some 63 per cent of major banks’ problem commercial property market receivables and on-balance sheet commercial properties were related to the retail sector, plots of land and the office market. In addition, nearly 62 per cent of problem property market receivables and on-balance sheet properties belonged to Budapest (Chart 17-14). First, improving trends of the property market in the capital may facilitate the cleaning of the property market exposures stuck in banks’ balance sheets, and second, as a result of higher collateral values, they may reduce additional losses potentially arising during the cleaning. It should be noted, however, that a meaningful part of exposures will be affected by the overall improvements in the property market only partially, or hardly at all.

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Chart 17-14: Major banks’ problem receivables on commercial properties and on-balance sheet commercial properties 120

HUF Billions

7 6

100

Retail

Allotment

Office

Total GEX and MV

Hotel

Industry and logistics

Other

Budapest

Other

Budapest

Other

Budapest

Other

Budapest

Other

Budapest

Other

Budapest

Other

Average size (right-hand scale)

Note: Values for June 2015. Source: MNB.

Looking ahead, it is particularly important that investors need local knowledge and local capacities for collection agency services, the inhibiting effect of which has been pointed out in earlier studies. Overall, there is apparent improvement in the market, in which a meaningful part is occupied by the central bank’s actions; nevertheless, portfolio cleaning and, more specifically, regulatory incentives for the secondary collection agency market continue to be needed. In the context of the establishment and relevant experiences of MARK Zrt., mention should be made of pricing, the principles of restructuring, and prudential requirements, which are adequate steps towards a more efficient banking system. a) Validated by Brussels, MARK’s methodology for the valuation of property and receivables can be made acceptable for a wide range of parties and can be controlled by the Supervisory Authority

If, by extending its operations, MARK becomes a permanent institutional participant in the system of financial institutions, it could assume a continuous role in market cleaning and market making. In — 610 —

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addition to the management of the market problem that still existed in 2016, this could also be instrumental in preventing the reproduction of non- and low-performing debt. MARK has set a precedent in the history of public asset managers in the EU by having its – market pricing methodology validated by the European Commission. As a result of the validation process of almost one year, outstanding knowledge has been accumulated on the pricing of non-performing loans and the commercial properties securing such loans. Making that knowledge available and transparent may lead to recognition and accommodation by Hungarian participants, while in accordance with the former, it may catalyse the market, since transparency attracts investments, contributing to the development of an advanced commercial property market that goes beyond premium category property in Budapest. To that end, the input parameters of the property valuation methodology that are based on market information need to be updated at regular intervals. The updated methodology would be communicated to market participants regularly in professional forums. Additionally, in the form of an MNB recommendation, each bank would receive a prescription for a fine-tuned version of the Brussels–Budapest methodology. This would provide for transparency in the valuation of commercial property, which could be controlled by the Supervisory Authority on a quarterly basis, even on site. The parameters for the valuation of receivables may need to be reviewed semi-annually according to the methodology used in the Brussels negotiations (based partly on known market data, and partly on interviews with banks and liquidators), which would be made available to market participants in the form of an MNB publication. Consideration may also be given to the release of an MNB recommendation for banks and auditors on proposed valuation principles and parameters. b) Definition of restructuring principles and improvements to the legislative environment

The cleaning of non-performing corporate loans associated with commercial property that have stuck in the balance sheet of the banking system since the crisis is further supported by the cooperation between — 611 —

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the Magyar Nemzeti Bank and the EBRD on rethinking the principles of corporate restructuring (the “Budapest Principles”), which may provide practical guidance on the resolution of stuck syndicated loans and loans that are associated with several lenders and potentially becoming nonperforming in the future. Released in 2010, the Budapest Principles have not been implemented in practice to date, because they have not been published to a sufficiently wide audience, and only laid down principles for restructuring, as a result of which they have not been suitable as a source of genuine guidance. In early 2016, joint work with the EBRD started on the development of the new Budapest Principles as part of a bottom-up process that takes into account opinions from market experts. The Magyar Nemzeti Bank is foreseen to disclose the new Budapest Principles in the form of a central bank recommendation, which is to be drafted by taking into account opinions from bank participants. It would be important for the guidelines to become widely known among corporates in order to ensure that future restructuring operations may be launched in due time, even at borrowers’ initiative, which may significantly contribute to an increase in the number of successful and sustainable restructuring operations. The Magyar Nemzeti Bank may assume a major role in the wide promotion of the guidelines. The out-of-court proceedings laid down in the Budapest Principles provide an alternative to insolvency proceedings, the success and widest possible application of which would be supported by improvements to the efficiency of court proceedings. Apart from the Budapest Principles, improving the efficiency of the legal environment is also a part of the MNB’s action plan to support banks’ portfolio cleaning. The regulatory framework currently in place renders the solution to the problem posed by non-performing loans cumbersome; the uncertainty and systemic disruptions of certain legal institutions significantly impede market participants in performing their duties in an efficient manner. For the resolution of the situation it is indispensable to modify the legislative environment based on an approach that gives greater priority to the representation of creditors’ interests, promotes the improvement of the professional expertise of — 612 —

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liquidators while providing them with more latitude, supplements the set of tools with innovative solutions, and focuses on a procedure that guarantees fast and high-quality information flow. Reforms on the principles of restructuring and support for improvements to the legislative environment convey a positive message to market participants and international organisations, while it also demonstrates the central bank’s commitment to actions that follow the best practice in order to clean bad portfolios. c) Tighter prudential requirements: systemic risk buffer (SRB)141

The MNB has imposed a systemic risk buffer to be allocated as of 1 July 2017 for problem commercial property exposures. Systemic risk is increased further by the high institutional and geographic concentration of problem holdings. The systemic risk buffer (SRB), to be allocated in proportion to problem holdings, encourages banks to shed their problem exposures, while for participants less active in portfolio cleaning, it will increase their shock absorbing capacity. The MNB announced its intention to apply the systemic risk buffer in November 2014, and in November 2015 it also disclosed the detailed conditions of the instrument. The institutions concerned must allocate the capital buffer by 1 July 2017, based on their Charts for the end of March 2017. From the date of the announcement until mid-2016, the banking system reduced its holdings of problem exposures roughly by HUF 500 billion. An additional cleaning of about HUF 154 billion is necessary in order to ensure that no additional capital requirement is imposed on any of the institutions concerned. International practice shows that EU Member States use the systemic risk buffer primarily for the early substitution of the buffer for other systemically important institutions (O-SIIs) or to supplement its maximum rate of 2 per cent. It was introduced with this declared objective in some of the euro area core countries, in Scandinavian countries and in the majority of Central and Eastern European countries, while 141

he description of the systemic risk buffer relies on the MNB’s autumn 2016 MacroT prudential Report. For more details: https://www.mnb.hu/kiadvanyok/jelentesek/ makroprudencialis-jelentés

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Mediterranean countries do not apply this instrument at all. In addition, a large part of Central and Eastern European countries that introduced SRB also considered the decrease in the Pillar 1 capital requirements, resulting from the EU legislation, as a justification for its application. As a result, in these countries, banks that do not qualify as systematically important institutions are also required to allocate an SRB. Hungary is the only EU Member State that introduces the instrument not in relation to a problem attributable to the systemic importance of a given institution, but to manage, in a targeted manner, another structural systemic risk that cannot be managed with other macroprudential instruments.

Key terms debt settlement Budapest Principles bank lending channel capital adequacy collection agency cost efficiency cost-to-income data envelopment analysis disintermediation EBRD efficiency of scale efficiency of scope efficient structure error correction model forint conversion Funding for Growth Scheme and Market-Based Lending Scheme interest rate transmission liquidity MARK Zrt. monetary policy tightening

moral hazard National Asset Management Agency non-performing loans NPL ratio pro-cyclical propensity to repay of non-performing debtors prudential requirements quiet life repayment capacity of nonperforming households Resolution Asset Management Vehicle (MSZVK) restructuring restructuring principles social aspects stochastic frontier analysis systemic risk capital buffer value and location of collateral securing non-performing loans winter eviction moratorium — 614 —

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References Aigner, D. – Lovell, K. C. A. – Schmidt, P. (1977): Formulation and Estimation of Stochastic Frontier Production Function Models. Journal of Econometrics, Vol. 6., Issue 1, July, pp. 21–37. Allen, L. – Rai, A. (1996): Operational Efficiency in Banking: An International Comparison, Journal of Banking and Finance. Vol. 20., Issue 4, May, pp. 655–672 Berger, A. N. (1995): The Profit-Structure Relationship in Banking-Tests of Market-Power and EfficientStructure Hypotheses. Journal of Money, Credit, and Banking, Vol. 27., No. 2, May, 404–431. Bernanke, B. S. – Blinder, A. S. (1992): The Federal Funds Rate and the Channels of Monetary Transmission. American Economic Review, Vol. 82, Issue 4, September, pp. 901–921. Bernanke, B. S. – Gertler, M. (1995): Inside the Black Box: The Credit Channel of Monetary Policy Transmission. Journal of Economic Perspectives, Vol. 9, Issue 4, pp. 27–48. Brissimis, S. N. – Delis, M. D. (2010): Bank Heterogeneity and Monetary Policy Transmission. European Central Bank, Working Paper Series, August, No. 1233. Carbó, S. – Humphrey, D. – Maugos, J. – Molyneux, P. (2009): Cross-country comparisons of competition and pricing power in European banking. Journal of International Money and Finance, 28, pp. 115–134. Cecchetti, S. G. (1999): Legal Structure, Financial Structure, and the Monetary Policy Transmission Mechanism. Federal Reserve Bank of New York, Economic Policy Review, Vol. 5, No. 2, July, pp. 9–28. Cetorelli, N. – Goldberg, L. S. (2012): Banking Globalization and Monetary Transmission. Journal of Finance, Vol. 67, No. 5, October, pp. 1811–1843. De Bondt, G. (2002): Retail Bank Interest Rate Pass-Through: New Evidence at the Euro Area Level. European Central Bank, Working Paper Series, April, No. 136. De Graeve, F. – De Jonghe, O. – Vander Vennet, R. (2007): Competition, transmission and bank pricing policies – Evidence from Belgian loan and deposit markets. Journal of Banking and Finance, Vol. 31, Issue 1, January, pp. 259–278. Demsetz, H. (1973): Industry Structure, Market Rivalry, and Public Policy. Journal of Law and Economics, Vol. 16., No. 1, April, pp. 1–9. Dong, Y. – Hamilton, R. – Tippett, M. (2014): Cost Efficiency of the Chinese Banking Sector: A Comparison of Stochastic Frontier Analysis and Data Envelopment Analysis. Economic Modelling, Vol. 36., January, pp. 298–308. Gambacorta, L. (2005): Inside the Bank Lending Channel. European Economic Review, Vol. 49, Issue 7, October, pp. 1737–1759. Gambacorta, L. (2008): How do banks set interest rates? European Economic Reviews, Vol. 52, Issue 5, July, pp. 792–819.

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Part II: Challenges and Answers in Hungarian Monetary Policy Gambacorta, L. – Marques-Ibanez, D. (2011): The bank lending channel: Lessons front the crisis. Bank for International Settlements, BIS Working Papers, May, No. 345. Gigineishvili, N. (2011): Determinants of interest rate pass-through: do macroeconomic conditions and financial market structure matter? IMF Working Paper, No. 11/176. Gropp, R. – Sorensen, C. K. – Lichtenberger, J. (2007): The Dynamics of Bank Spreads and Financial Structure. European Central Bank, Working Paper Series, January, No. 714. Hannan, T. H. – Berger, A. N. (1991): The Rigidity of Prices: Evidence from the Banking Industry. The American Economic Review, Vol. 81, No. 4, September, pp. 938–945. Havránek, T. – Irsová, Z. – Lesanovská, J. (2015): Bank Efficiency and Interest Rate Pass-Through: Evidence from Czech Loan Products. Czech National Bank, November, Working Paper Series, 9. Hicks, J. (1935): Annual Survey of Economic Theory: The Theory of Monopoly. Econometrica, Vol. 3., No. 1, January, pp. 1–20. Horváth, Cs. – Krekó, J. – Naszódi, A. (2004): Kamatátgyűrűzés Magyarországon (Interest rate passthrough in Hungary). MNB Working Papers, WP 2004/8. Horváth, R. – Podpiera, A. (2012): Heterogeneity in Bank Pricing Policies: The Czech Evidence. Economic Systems, Vol. 38, Issue 1, March, pp. 87–108. Hristov, N. – Hülsewig, O. – Wollmershäuser, T. (2014): The interest rate pass-through in the Euro area during the global financial crisis. Journal of Banking and Finance, Vol. 48, November, pp. 104–119. Jonas, M. R. – King, S. (2008): Bank Efficiency and the Effectiveness of Monetary Policy. Contemporary Economic Policy, Vol. 26, Issue 4, October, pp. 579–589. Kashyap, A. K – Stein, J. C. (1994): The Impact of Monetary Policy on Bank Balance Sheets. NBER Working Paper Series, 4821. Kashyap, A. K. – Stein, J. C. (1997): What Do a Million Banks Have to Say About the Transmission of Monetary Policy? NBER Working Paper Series, 6056. Leibenstein, H. (1966): Allocative Efficiency vs. X-Efficiency. American Economic Review, Vol. 56., No. 2, June, pp. 392–415. Lensink, R. – Sterken E. (2002): Monetary transmission and bank competition in the EMU. Journal of Banking and Finance, Vol. 26, No. 11, pp. 2065–2075. Li, Jiaqi: The Role of Bank Competition in Monetary Transmission Mechanism, Department of Economics, University of Cambridge – http://www.birmingham.ac.uk/Documents/collegesocial-sciences/business/events/mmf-workshop/plenary/LI-paper.pdf Mishkin, F. S. (1996): The Channels of Monetary Transmission: Lessons for Monetary Policy. NBER Working Paper Series, 5464. Molnár, M. – Holló, D. (2011): How Efficient Are Banks in Hungary? OECD Economics Department Working Papers 848, OECD Publishing.

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17 Steps towards a more efficient banking system Peek, J. – Rosengren, E. S. (2013): The Role of Banks in the Transmission of Monetary Policy. Federal Reserve Bank of Boston, Public Discussion Papers, September, No. 13-5. Sander, H. – Kleimeier, S. (2004): Convergence in euro-zone retail banking? What interest rate pass-through tells us about monetary policy transmission, competition and integration. Journal of International Money and Finance, Vol. 23, No. 3, pp. 461–492. Schlüter, T. – Busch, R. – Hartmann-Wendels, T. – Sievers, S. (2012): Determinants of the interest rate pass-through of banks – evidence front German loan products. Deutsche Bundesbank, Discussion Papers, No 26/2012. Schmitz, B. (2004): What Role do the Banks Play in Monetary Policy Transmission in EU New Member Countries? University of Bonn, mimeo. Sorensen, C. K. – Werner, T. (2006): Bank interest rate pass-through in the euro area: a cross country comparison. ECB Working Paper, No. 580. Van Leuvensteijn, M. – Sørensen, C. K. – Bikker, J. A. – Van Rixtel, A. A. (2008): Impact of bank competition on the interest rate pass-through in the euro area. European Central Bank, Working Paper Series, March 2008, No. 885. Vonnák, B. (2006): A magyarországi monetáris transzmissziós mechanizmus fő jellemzői (The main features of Hungary’s monetary transmission mechanism). Economic Review, Vol. 53., December, pp. 1155–1177.

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Development and modernisation of payments and financial infrastructures Gergely Patrik Balla – László Kajdi – Lóránt Varga

The core objective of the central bank is to achieve and maintain price stability, and in that context to increase the effectiveness of monetary transmission, maintain financial stability, and support economic growth. A developed payment system enables the effective implementation of monetary policy operations, the adequate functioning of financial markets, and the clearing and settlement of payment transactions. At the same time, it also contributes to the transition to the formal economy through an increase in tax revenues, while the increasing use of electronic payment methods enables cost savings at the level of society. In the Hungarian payments market, the MNB has previously identified a number of market failures, the elimination of which requires targeted central bank participation. In recent years, this has prompted the MNB to carry out a series of concerted actions in a variety of roles with a view to the development and modernisation of payments and financial infrastructures in Hungary. To develop payments and to address the prevailing market anomalies, the MNB has set objectives within a dual strategy. First, it seeks to provide opportunities for the use of electronic payment methods in the widest possible range of payment situations; and second, it also seeks to encourage the use of such electronic payment methods. The implementation of these strategic objectives may greatly be facilitated by the central bank’s position as majority shareholder in key national financial infrastructures, because this enables aspects of the public good to be manifested directly in developments.

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18 Development and modernisation of payments and financial infrastructures

In line with the strategic objectives set, in recent years the MNB has actively been encouraging the acceleration of the central infrastructure in the segment of low value payments, first by introducing intraday clearing, then by increasing the number of intraday clearing cycles. Also in this regard, a major achievement has been made through the establishment of rules for the instant payment service, which will enable payments to be processed within seconds, on a continuous 24/7 basis throughout the year. At the same time, not only will the new system represent a dimension change in the history of payments in Hungary, the interoperable central infrastructure based on open standards will provide market participants with a new and continuously available platform that also supports the emergence of future financial innovations. As regards the acquirer infrastructure for payment card purchases, currently the most widely used electronic payment solution, the MNB has also initiated and supported a number of developments, which in recent years have led to considerable growth in the volume of card payments. Both the MNB’s experimental POS deployment programme and regulations capping interchange fees have significantly contributed to the dynamic development that is currently seen in the Hungarian payment card system. In the latter case, the legislation initiated by the MNB was exemplary even by international standards, as it preceded the elaboration of regulations covering the entire European Union, and also provided a model for the process. In the field of interbank securities and foreign exchange transactions, the MNB implemented two targeted programmes to support the development of financial infrastructures, and consequently the effectiveness of monetary transmission. Among regional currencies, the forint was the first to join the international CLS system for the settlement of foreign exchange trades, which allows the foreign exchange settlement risk associated with foreign exchange transactions to be eliminated, and the liquidity required for settlement to be reduced. The accession of KELER to T2S, a single pan-European platform for securities settlement, may increase demand for domestically issued securities, which, through the decline in financing costs, may improve the performance and competitiveness of the Hungarian economy.

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18.1 Factors warranting the MNB’s participation in the development of payments and financial infrastructures 18.1.1 The central bank’s objectives and tasks related to payments and financial infrastructures

Pursuant to legislation, the primary objective of the MNB is to maintain price stability, i.e. to retain the unit of account and store of value functions of the Hungarian currency. At the same time, in a broader sense this also involves the retention of the medium of exchange function of money through the requirement to maintain general trust in the currency, as well as the stability of trust in money, for which an adequately functioning payment infrastructure is indispensable. Stable financial infrastructures enable monetary policy operations to be implemented quickly and efficiently, while they also support improvements to the effectiveness of monetary transmission by securing the functioning of money markets. Another core central bank objective is financial stability, for the achievement and maintenance of which efficiently functioning financial markets are absolutely essential. Financial markets can only function by means of adequately working financial infrastructures, because such infrastructures enable economic actors’ mutual positions to be recorded accurately and reliably, and traded money market transactions to be cleared and settled. The risk-free functioning of payment systems is also important because its absence would pose a fundamental threat to financial markets, and could lead to the emergence of systemic risks by amplifying the problems arising with any participant in the financial markets. Additionally, the infrastructure developments concerning interbank securities and foreign exchange transactions may also increase the effectiveness of the exchange rate channel of monetary transmission by improving the execution of international capital flows. Indeed, adequate foreign exchange payment systems may be helpful in avoiding financial turbulences, and may, therefore, contribute to the maintenance of the interbank money — 620 —

18 Development and modernisation of payments and financial infrastructures

market even in crises of confidence. Consequently, by adequately addressing certain risk elements such as settlement and operational risks, efficient infrastructures may considerably enhance the stability of a financial system. In Hungary, this is particularly important because as highlighted by the events in 2008, the foreign exchange exposure of the Hungarian economy and access to the international foreign exchange market play a crucial role in the stability of the domestic banking system. Adequately functioning payment systems may also strongly and directly support improvements to the productive capacity of the economy, as confirmed by a number of international surveys. The beneficial effect on economic growth is felt in several areas. First, advanced payments and payment systems lead to cost savings at the level of society, and a part of the resources committed to payments may be utilised in other economic processes of higher productivity. Second, the decline in the costs of payment services may contribute to improvements in the efficiency of production and the competitiveness of economic actors. The third key argument for state-of-the-art payments is that as the volume of electronic payment methods increases, the size of the informal economy may be reduced substantially, allowing the state to collect more tax revenues. Box 18-1 Key international empirical evidence on the relationship between payment efficiency and economic growth

Evidence reported in the economic literature leads to the general conclusion that a higher ratio of electronic payment transactions indicates a more developed, more efficient payment system, i.e. contributes to the development of the economy and the increase of competitiveness. Two types of methodology are commonly used for assessing this matter. The first group includes the econometric analyses performed on cross-sectional macroeconomic data, which explore the relationship between the level of development of the payment systems of countries and their level of general

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economic development. The other approach is from a micro aspect, and is based on the assessment and aggregation of individual costs, which makes the social cost of other methods of payment quantifiable, and thereby the amount of savings available through the replacement of methods of payment incurring higher social cost with methods incurring lower costs can be determined. Research taking the cross-sectional, econometric approach provides convincing evidence to demonstrate that a more developed, more efficient payment system has a positive impact on the performance of the economy. Between 1995 and 2009, Hasan et al. (2012) examined the correlation between the choice of payment method by residents and economic development in 27 European countries. In their panel model, they explained the logarithm of per capita GDP by macroeconomic variables and variables that measure the penetration of electronic payment methods (number of payment cards, credit transfers, direct debits, cheques, use of cash). Their findings indicate that the penetration of electronic payment methods has a significantly favourable impact on GDP growth. The most powerful effect can be demonstrated in connection with the use of payment cards. Hasan et al. (2009) used data in the panel of EU Member States to analyse the relationship between the level of development of the payment system and the profitability of the banking sector. Following this method, Hasan et al. (2013) performed a general analysis on the correlation of payments and the performance of the real economy. Based on panel data they demonstrated that the ratio of electronic payments positively correlated with per capita GDP in the EU. According to their calculations, a 1.2 per cent increase in card coverage increased the level of GDP by 0.07 per cent. The most comprehensive international results on this subject are presented by Zandi et al. (2013) through the analysis of the panel data of 57 developed and emerging countries between 2008 and 2012. Their results show a very strong relationship between the penetration of card purchases and economic growth practically in each country under consideration. According to their calculations, in developed countries the increasing use of electronic payments in the period under consideration raised the GDP of these countries by 0.3 per cent, and in the emerging countries this value

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18 Development and modernisation of payments and financial infrastructures

was an even higher 0.8 per cent. The aggregate average annual GDP growth rate of the 57 countries under consideration was 1.8 per cent between 2008 and 2012, which would have been only 1.6 per cent without a rise in the use of electronic payments. Therefore, the increasing penetration of electronic payments registered over recent years has raised the global growth rate of GDP by almost 0.2 percentage points annually on average. In the area of payments, the assessment of social costs started as early as at the beginning of the 2000s. The study of Humphrey et al. (2003) demonstrated that in the United States the decrease in the ratio of cashbased means of payment resulted in a significant saving of resources, which can be estimated at 0.5 per cent of the GDP. The same study also demonstrated that the high penetration of electronic payment methods in 12 European countries led to the significant decrease of banking costs (USD 32 billion, 0.38 per cent of the GDP). This research was followed by several similar social cost surveys in Europe, conducted typically on the basis of a harmonised methodology, which were collected and compared in the study of Schmiedel et al. (2012). The main finding of the study is that in countries where the ratio of electronic payments is higher, the social cost of payments has a lower ratio to the gross domestic product than in countries that use cash and paper-based payments more intensively. Using, inter alia, the data for the Hungarian panel of that study, Ilyés–Varga (2016) showed in a general equilibrium model framework that the substitution of cash payments with debit card transactions had a favourable impact on the performance and competitiveness of the economy, increased real income, real consumption, the level of GDP, as well as the tax revenues of the state.

Internationally, the solutions used for the supervision, regulation and oversight of financial infrastructures vary by country; however, all major central banks, pursuant to the legislation applicable to them, provide for the stability and safe functioning of clearing and settlement systems as part of compliance with their primary objectives. In the United States, Japan or China the central bank provides for the operation of the clearing and settlement system pursuant to powers conferred by law, but there are also a number of examples in Europe; for instance, the — 623 —

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central bank in the UK performs this function through the involvement of two partner authorities (the Financial Conduct Authority and the Prudential Regulation Authority). In the European Union, the Treaty establishing the European Community provides for the establishment of the European Central Bank, and specifies the promotion of the smooth operation of payment systems as one of the ECB’s tasks. In Hungary, the Central Bank Act142 lays down the core tasks of the MNB, which, in accordance with the common international practice specifically include tasks pertaining to the functioning payment systems and payments. Accordingly, the MNB is required to “oversee the payment and clearing systems, and the securities clearing systems [...] in order to ensure the sound and efficient operation of these systems and the smooth execution of payments”, and within the scope of these powers, it “participates in the development of payment, clearing and securities clearing systems”. Additionally, the MNB is required to “supervise the system of financial intermediation”. The three key central bank objectives, therefore, are only viable by means of payments and financial infrastructures that function reliably, safely and efficiently.

18.1.2 Central bank intervention was justified by several characteristics of the Hungarian payments market

In order to measure the efficiency of payments, monitor development in the country and ensure international comparability, in 2012 the MNB specified three indicators which show how widespread electronic payment methods are in the most frequent payment situations. The three indicators that measure the level of development of payments are the ratio of credit transfers to GDP, the share of purchases made with electronic payment methods within household consumption, and the share of bills for utility and other services paid 142

Act CXXXIX of 2013 on the Magyar Nemzeti Bank.

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electronically. Credit transfers, the electronic payment method most frequently used by economic actors and in the largest volume, came closest to the European Union’s average in 2012, in terms of the ratio of its annual total to GDP (table 18-1): in Hungary, the total annual value amounted to 13.6 times the country’s GDP, whereas the same ratio for the EU was 17.8. The ratio of electronically paid purchases primarily includes the volume of card purchases relative to annual household consumption. In this regard, 2012 saw a major shortfall: compared to Hungary’s 11.8 per cent average, in the European Union on average more than 37 per cent of purchases were made using some electronic payment method. In the segment of electronic bill payments, virtually all households are affected through the charges paid at regular intervals for services used on a permanent basis such as utilities, telecommunications, and insurance. In this segment, the difference to the European Union’s average was even greater, which is partly explained by the high prevalence of payments using yellow and white postal money orders, a Hungarian specificity. Compared to the approximately 70 per cent ratio of electronic bill payments in the Union, in Hungary less than one-quarter of bill payments were made using this method. Table 18-1: Indicators describing the level of development of payments in Hungary, as compared to the EU (2012) Hungary

European Union

13.6

17.8

Electronic payment Annual volume of purchases paid using bank cards of purchases and other electronic payment methods / Annual household consumption

11.8%

37.3%

Electronic payment Annual estimated volume of core direct debits of bills for utility and other electronic bill payments / Annual and other services estimated volume of bill payments

23.5%

70%

Indicator Credit transfers

Calculation Annual volume of credit transfers / GDP

Estimated value based on the per capita core direct debit figures reported by individual EU

Member States, and the study by Deutsche Bank (2005). Source: MNB Payment System Report 2016.

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Apart from the design of the indicators, the MNB is also carrying out intensive analytical work to assess the level of development of payments in Hungary, one outcome of which was the study on the social costs of major payment methods (Turján et al., 2011). This provided a detailed description of the costs related to payment methods incurred by specific economic actors, and the calculations showed that more modern payments and the greater use of electronic payment methods could allow cost savings of up to HUF 100 billion at the level of society (Table 18-2). Table 18-2: Social cost of major payment methods used in Hungary and the savings available

Social cost (HUF Billions) Social cost / GDP (%)

Situation in Hungary

Hypothetical situation

Savings*

387.81

284.50

-103.31

1.49

1.09

-0.40

73.66

87.81

14.15

Unit costs per payment method (HUF) Cash transactions Debit card transactions

201.13

45.63

-155.49

Electronic credit transfers

174.15

80.47

-93.68

Core direct debit

100.39

47.66

-52.74

106.01

77.78

-28.23

Total *Note: minus sign indicates cost savings. Source: MNB.

The study compared the costs commonly incurred in Hungarian payments to a scenario calculated on the basis of a more advanced, hypothetical payments structure that is characteristic of Scandinavian states. The results not only show cost savings at the level of society, but also the fact that more advanced payments, i.e. a greater share of electronic payments would also involve a change in the unit cost of specific payment methods, making each electronic payment transaction much cheaper.

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18 Development and modernisation of payments and financial infrastructures

Analyses by the MNB lead to the conclusion that the domestic payment market owing to the developments carried out exclusively by market participants, is not developing at an adequate rate, and that problems are primarily attributable to market failures which, at the level of society, only allow a lower total utility than what would be attainable. Central bank participation must be aimed at the elimination of such market failures in order to optimise the social distribution of resources. One of the key factors leading to the emergence of market failures is the networked nature of the payments market. In this network, economic actors represent the individual nodes of the network, and the payment transactions between the market participants represent the connection between the network nodes. It follows from the networked nature of payments that development by a single participant will be neither sufficient nor necessarily rational for the participant concerned, because it is possible for the two nodes of a network connection, i.e. the originator and beneficiary of a payment transaction, to hold payment accounts with different payment service providers. In terms of the public good, the most appropriate solution is therefore to implement developments that cover the entire payment system, involving all market participants. However, while this would entail a cost to all participants, it would not necessarily provide actual competitive benefits for all of them, precisely because of the development covering all participants, as a result of which market participants have no business interest in the developments in the short term. At the same time, in the situation emerging without external intervention, functioning would be sub-optimal in the long term at the level of society, i.e. the level of developments for investment would fall short of what would be desirable for the public good. The lessons learned from payments in Hungary are also that not a single comprehensive development has been implemented at the initiative of market participants: neither the establishment of the Hungarian clearing house, nor the introduction of intraday clearing or the payment method of direct debit would have been viable without active central participation. In such circumstances, owing to its coordinating and regulatory role, the MNB may act as — 627 —

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a catalyst for developments, i.e. it may, through its action, help bridge the market failures emerging due to the fact that developments are not carried out because of the short-term interest of market participants. The networked nature of payments is also relevant from the point of view that utility for individual participants will increase as the number of participants joining the infrastructure becomes higher. Accordingly, the increasing number of merchants joining, for example, the payment card infrastructure, i.e. increasingly wider acquisition opportunities will enable a growing number of consumers to apply for payment cards and use their existing cards, which will benefit all participants concerned. This also means that it is extremely difficult to enter the payments market, because a given service can only be competitive if it is used widely, i.e. if it provides access for a large number of participants. Therefore, from a social perspective it is important that financial infrastructures are as easily accessible as possible, and that services can be provided to other economic actors with the greatest possible ease; in other words, efforts are needed to prevent the emergence of closed, non-interoperable solutions that would lead to the fragmentation of the market, and consequently to sub-optimal market efficiency. Low barriers to entry and strong competition are, at the same time, detrimental to the participants already in the market, which is why central bank intervention is needed for the elimination of market failures. The proper use of public policy actions must pursue a twofold objective: first, through interoperability and the application of open standards, it should coordinate cooperation among market participants in the course of developments; and second, it should also support innovation, which is best facilitated by free competition. Reducing the barriers to entry and thereby increasing competition is also important because in the payments market, a new entrant will inevitably be faced with relatively high fixed costs, due primarily to the cost of developing the required infrastructure. By contrast, variable costs tend to be negligible, i.e. an increase in the number of transactions will generally not require the implementation of additional costly — 628 —

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developments. This means that the significant initial investment costs can subsequently be offset and dispersed by means of the revenues resulting from high customer and transaction numbers. Due to the high fixed costs and to efficiencies of scale, the payments market tends to be affected by market failures resulting from increasing market concentration, which tends to give rise to oligopolistic and monopolistic market structures. One possible example is the payment cards market, which operates with only a few major participating card companies, but it is also the result of similar processes where in some countries a single clearing house is in charge of clearing electronic payments. Although this market structure may be considered optimal in terms of efficiencies of scale, over the long term it reduces total social utility, leads to pricing anomalies, and also fails to help innovation. High market concentration is also helped by the fact that payment services are like utilities in nature, i.e. they may be considered as essential core services for consumers, because e.g. in Hungary, two-thirds of wages and pensions are paid into payment accounts. Nevertheless, switching between providers is extremely difficult, and is impeded by complex and lengthy processes. This is one of the reasons why competition in the market for payment services is limited, i.e. why there are few new entrants, given the significantly greater challenge in acquiring the number of customers required for profitable operations. For decades, conventional market participants have effectively defended their market positions, as the above factors have impeded genuine market competition. At the same time, newly entering FinTech service providers are increasingly undermining banks’ formerly obvious market dominance and strengthening market competition, which is important for the public good, in a process that is also supported actively by the MNB’s infrastructure development policy. Another obstacle to the spread of using electronic payment methods is that the use of cash typically does not generate direct costs to market participants, and surcharges cannot be applied to such transactions either. By contrast, electronic payment methods are commonly associated with charges in proportion to the number or value of the — 629 —

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transactions, and in some countries the application of surcharge is also allowed, e.g. in the case of payment card purchases. In the case of cash, both fixed and variable costs are considered high, but owing to the extremely high transaction volume, the cost per transaction is lower than electronic payment methods. On that basis, it may be argued that although directing cash transactions to electronic channels involves higher costs to market participants initially, when the ratio of electronic transactions reaches or exceeds a critical threshold where average costs fall below those of cash transactions, the solution that is optimal from a social perspective will also become a rational decision at the level of individual market participants. However, that is against the shortterm interests of market participants, which is where central bank intervention may be instrumental. Chart 18-1: The effect of substitution on the unit cost of payments in the case of debit cards and cash 300

HUF

300

250

200

150

100

Baseline

Small

Medium

Debit card

Significant

Cash

Note: Each degree along the horizontal axis represents a scenario of substitution between payment methods, and indicate the extent to which retail payments are shifted from cash to card payments, i.e. the intensity of the electronic transition from cash transactions compared to the prevailing situation today. Source: Ilyés–Varga (2016).

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18 Development and modernisation of payments and financial infrastructures

In retail payment situations, the use of bank cards is the most widespread electronic solution. Based on the MNB’s calculations, the average unit cost of debit card payments can be reduced to the level of cash at an even lower level of substitution of payment methods (Chart 18-1). Therefore, when the share of payment card transactions within the total share of transactions exceeds this threshold (approximately 40 per cent), the acquisition cost of cash transactions will already be higher than that of the electronic alternative, in this case the payment card. By contrast, payments in Hungary continue to be characterised by an intensive use of cash, as also confirmed by the MNB’s studies on the subject (Ilyés–Varga, 2015). According to the MNB’s assessments, some three-quarters of all payments are made in cash, as opposed to Sweden, where the same ratio is around 40 per cent.143 As a combined result of the low use of electronic payment methods and a market that is otherwise small by international standards, it is extremely difficult to provide convenient, safe and state-of-the-art electronic payment solutions at low prices in scale-efficient industries such as the payments market. Another reason for the intensive use of cash is that current infrastructures are not capable of providing immediate processing times of a few seconds, whereby in time-critical situations, they could become an alternative to the use of cash, which effectively provides a real-time experience. As a result of dated and slow messaging systems, conventional payment infrastructures can only support payment innovation to a limited extent, and the extension of services to additional payment situations is generally possible only by increasing system complexity. Accordingly, at present there are essentially two options to implement developments to the payment infrastructure. On the one hand, market participants often develop solutions that bypass the limitations of the traditional infrastructures, as a result of which the complexity of the already complicated infrastructures further increases, thereby decreasing their functional efficiency. On the other hand, rather than building their new services on traditional infrastructures, certain 143

MasterCard: Measuring progress towards a cashless society, 2013

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service providers develop standalone systems that operate in parallel but are not interoperable with the other systems. Such developments make the market for payment services even more fragmented, and as such they do not necessarily support efforts for increased payment efficiency. As a result of technological progress, the costs of modern IT systems with high computing capacity have considerably decreased, and owing to the advanced messaging solutions, data transmission has also become cheaper. This has brought about significant changes in customers’ service requirements as well. However, to date payment services have followed fast technical progress and changing customer requirements only to a limited degree, primarily due to the absence of modern core infrastructures. However, when messages can be delivered in a matter of seconds to remote points of the world, it may soon become a basic expectation of the consumers to do the same also in the case of financial transactions, and send money anywhere, virtually in real time. Accordingly, similarly to other areas of the economy, it would be justified for customers to also expect banking services to enable them to execute financial transactions on any day of the year, at any time of the day. Although in the case of internal credit transfers, payment service providers in Hungary enable the fast transfer of funds between accounts within seconds, it is precisely this isolated nature of the solution that has prevented it from becoming a widespread payment alternative, for instance, in payment situations related to retail trade. As regards the payment card infrastructure, the 9 million cards in use can be considered sufficiently high. According to studies by the MNB, approximately 72 per cent of the adult population of the country and more than 80 per cent of all households have at least one bankcard. That said, a considerable number of consumers use their cards only for cash withdrawals, and hardly ever for purchases. In part, this is attributable to the underdevelopment of acquirer infrastructure and to uneven coverage by region and type of business, — 632 —

18 Development and modernisation of payments and financial infrastructures

i.e. with a large number of small localities or small shops, consumers have no means to use their bank cards to make purchases. In the case of payment card acceptance, merchants may be discouraged by high charges, which prevents the growth of the network of accepting merchants. However, limiting acquisition charges is clearly not in the interest of market participants in the short term, even if a larger acceptance network and a growing volume of business could generate more revenues. MNB analyses and research studies come to the conclusion that through the development initiatives of market participants only, payments in Hungary do not develop at the required rate due to the market failures identified. As a result, the acceleration of credit transfers and the development of the payment card system both require central bank intervention in order that in certain areas of payments, the shortfall compared to the EU average can be made up, and that an advanced Scandinavian type payment market can be developed over the long term.

18.2 The MNB has elaborated an active payments and infrastructure development strategy Disadvantaged in many respects in an international comparison, the Hungarian payments market has a more relevant need for central bank action than other countries. Compared to countries with more advanced payment systems, existing market failures can only be overcome with increased participation in terms of regulation, coordination, and initiative. To develop payments and to eliminate the prevailing market anomalies, the MNB has set objectives within a dual strategy (Chart 18-2). First, the central bank seeks to ensure that electronic payment is available in the greatest possible number of payment situations in the largest possible area of the country, so that it provides an alternative to cash payments, and offers consumers a free choice between payment methods. Second, the MNB seeks to encourage the use of electronic — 633 —

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payment methods by enabling the emergence of fast, cheap, safe and customer-friendly services in the domestic payments market, which are perceived by consumers as reasonable and easily accessible payment options. Among other benefits, the greater use of electronic payment methods facilitates the reduction of social costs, and the transition to the formal economy. In the case of the first pillar, the technical features of current infrastructures impose relevant limitations, because they would not enable the use of electronic payment methods in all payment situations even if the payers and payees involved in the transaction concerned would like to use such methods. Nevertheless, incentives for the use of electronic payment methods could be provided, among other actions, by reducing the charges on such methods, which could equally be supported by a cheaper central infrastructure and regulatory provisions. Chart 18-2: Objectives in the MNB’s payments strategy

MNB Payment Strategy

To provide electronic payment alternative in the most possible payment situtations

To provide cheap, fast, convenient payment services to customers

Az MNB’s instruments: • Legal actions • Owner role • Initiation, coordination

Source: MNB.

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The goal is the abolition of market failures, thus: • Stronger competition • Easier market entry • Cheap, fast, convenient and secure services • Support of innovation

18 Development and modernisation of payments and financial infrastructures

Therefore, the MNB can achieve the objectives within its dual strategy by using a number of instruments, and acting in a variety of roles: first, as a regulator, through its influence on operational processes and specific charges; second, as an overseer, by ensuring that financial infrastructures function reliably, while also acting as a coordinator and facilitator of developments in payments. In addition to the above, the MNB considered that compared to earlier periods, more intensive and direct shareholder intervention was needed for specific payment infrastructures, as a result of which by 2016, the central bank acquired majority or sole ownership of key infrastructure elements. Since their establishment, the MNB has held a participating interest in the most prominent companies of the Hungarian financial infrastructure, including BÉT Zrt., KELER Zrt., KELER KSZF Zrt., and GIRO Zrt. Initially, the MNB acquired such participating interest to help set the infrastructures in motion, and the subsequent increase of its participation contributed to ensuring that financial infrastructures worked reliably, safely and efficiently in accordance with the core central bank objectives. In addition to the four companies, the central bank owns and operates the Hungarian RTGS (VIBER), which is used primarily for the settlement of large-value and urgent financial operations. The MNB’s presence as the Shareholder enables the companies to pursue objectives other than profitability in the course of their operations and developments, while it also provides safety, e.g. for institutions holding accounts with KELER, which also performs bank functions. Importantly, the MNB’s role as an owner also gives the central bank a better perspective of infrastructural processes, which may therefore support the central bank in performing its tasks as a supervisory authority and an overseer. Due to the networked nature of the payments market, through central participants the central bank can directly influence the specification of the direction and rate of developments, i.e. it is easier for the central bank to participate as a coordinator and developer. Shareholder participation enables the elimination of effects that result from market participants’ short-term — 635 —

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business interests and impede developments, and it also enables support for efforts to grant access to innovations for the widest possible range of participants. Additionally, as a result of the MNB’s shareholder participation, the profit expected by market shareholders has been replaced by the social interest and the public good as the focus of operating and developing payment infrastructures, making it possible to reduce the charges flowing from payments market participants to central infrastructures, and thereby to reduce the prices of payment services. Therefore, the central bank’s participating interest in financial infrastructures carries a number of benefits, particularly the possibility that the operations of such natural monopolies can be determined by objectives that are more useful to society as a whole than the generation of monopoly profits. As a developer, the lessons learned in recent decades have been that strong central bank guidance has always been essential for meaningful improvements to the financial infrastructure. Additionally, in the field of developing the financial infrastructures that are also frequently used by international participants, including the domestic foreign exchange and securities trading systems, objectives are also being set to provide incentives for investment and to stimulate the economy. Since these systems handle the capital investments flowing into and out of the country, they have a direct influence on the efficiency of handling such capital flows. Obviously, the quality of the underlying infrastructure will not necessarily determine the decision of an investor, but may greatly support the positive international perception of a capital market, provided that the safety, legal and technical conditions available are adequate, and are provided by the central bank’s participating interest. Efficient foreign exchange and securities trading infrastructures may also be suitable as safeguards against market failures and to avoid the abuse of market dominance, and as such they may support the mitigation of market distortions that hinder the planned implementation of economic policy. Therefore, the targeted central bank programmes launched for the development of financial infrastructures may help to increase the transmission of economic policy actions such as monetary policy decisions. — 636 —

18 Development and modernisation of payments and financial infrastructures

18.3 Targeted central bank developments in the field of payments and financial infrastructures 18.3.1 Development of the Hungarian payment system 18.3.1.1 Developments in the clearing of payment operations

To eliminate the market failures arising in the field of payments, and in order to give prominence to the public good and to influence developments directly, in 2014 the MNB acquired a majority participating interest in GIRO Zrt., the Hungarian clearing house. Until April 2014, GIRO was owned by 21 banks and the MNB, with an 8.1 per cent participation held by the MNB, and 78.1 per cent by five large shareholders. In February 2014, the MNB submitted a bid to GIRO’s large shareholders, the acceptance of which increased the MNB’s participation to 86.2 per cent as a first step. Subsequently, the MNB also acquired the participation of GIRO’s small shareholders, as a result of which the central bank became the sole Shareholder of both GIRO and BISZ Zrt. The MNB acquired participating interest in order to keep the basic financial infrastructures in national ownership, while additional objectives included the need to improve the efficiency of developments in payments with social interests in mind, and to reduce the clearing fees paid by payment service providers. The MNB’s strategy is to ensure that the financial infrastructures that function as utilities in providing basic services should become nationally owned as far as possible. This strategic objective was pursued when GIRO was acquired by the state, the third key element of the Hungarian payment system apart from the VIBER and KELER. However, the MNB’s acquisition of participating interest was also important in terms of the ability to influence developments directly. In view of the developments in payments over the past 10 to 15 years, implementation has only been successful in the case of plans that received strong central bank support. Such plans included the establishment of GIRO, and the introduction of direct debit and intraday — 637 —

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clearing. The acquisition of GIRO changed the prevailing situation in that as an owner, the MNB can now exercise a much more decisive influence on developments, primarily on household and corporate payments, i.e. it has become easier to implement developments without recourse to the strongest regulatory instrument. Under the control of the previous commercial bank shareholders, the profitability of the company was a major concern, with a ROE of around 20 per cent and virtually the entire amount of the dividend fund was distributed each year. As an additional result of that situation, smaller shareholders with larger volumes of business and the Hungarian State Treasury were worse off compared to large shareholders, i.e. the operations of the clearing house created further anomalies in the payments market. Following the central bank’s acquisition of participating interest, the clearing fees charged by GIRO dropped by an overall 27 per cent. The central bank’s acquisition of GIRO created an opportunity to accelerate all Hungarian payments further. This is also one of the key objectives of GIRO’s strategy, which was adopted in 2014 in consultation with the MNB. Accordingly, the next step following the 2012 introduction of intraday clearing was the increase in the number of clearing cycles in September 2015, as part of which, except for the last clearing cycle, transactions are cleared on an hourly basis in ten cycles as opposed to the previous five. This development increased the number of payments that can be executed within the day out of the credits received, which may support improvements in the efficiency of the financial management of the corporate sector as well as in its competitiveness, while it may also reduce waiting time in the case of transactions where delivery only takes place following payment. Additionally, reduced processing times as short as one hour enable the use of credit transfers in even more payment situations, i.e. going forward credit transfers may also provide an alternative to cash payments in cases where electronic payment has previously not been available. These benefits may also contribute to an increase in the — 638 —

18 Development and modernisation of payments and financial infrastructures

volume of electronic payment methods, improving the efficiency of payments and reducing the social costs associated with payments. In addition to the increase in the number of intraday clearing cycles, the operating hours of clearing were also extended: under the new arrangements, as of September 2015, GIRO clears credit transfers first at 7:30 a.m. and last at 5:00 p.m. The extended operating hours enable both households and the corporate sector to make fast and low-cost credit transfers over a wider time interval, which carries significant benefits for participants in the real economy. In response to market needs, a first cycle starting earlier was created, which could primarily be relevant to household customers, allowing credit transfers initiated after the end of the previous business day (typically after 4 p.m. or at weekends) to reach payees earlier on the next day. Conversely, the last cycle shifted later offers benefits mainly to the corporate sector, allowing economic actors to submit credit transfers before a later closing time to be executed on the same day. Simultaneously with the extension of the operating hours and in accordance with the MNB’s requirements, payment service providers now apply later closing times before which customers may submit payment orders for execution on the same day. With longer operating hours, the processing of credit transfers will be better suited to the payment habits of households and businesses, thereby improving the efficiency of their financial management. In alignment with the extension of operating hours and the accession of the forint to the CLS (see the next section), operating hours of the VIBER, the responsibilities of which include settlement of the net positions established as part of intraday clearing, also became longer, as a result of which from mid-2015 onwards the system opens at 7 a.m. instead of the previous 8 a.m. Designed to measure the ratio of credit transfers to GDP and the share of electronic bill payments, the MNB’s indicators have seen considerable progress due to the developments in payments implemented in recent years at the initiative and under the coordination of the central bank (Chart 18-3). — 639 —

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Chart 18-3: Changes in the ratio of credit transfers to GDP and in the share of electronic bill payments 40

Per cent

2012

2013

2014

2015

Electronic utility bill payments (%) Credit transfers / GDP (right-hand scale) Source: MNB.

In the case of credit transfers, the Hungarian values are approaching the EU reference level; by 2015, due to the increase in turnover, the ratio of total volume to GDP was approximately 15, which does not represent a significant difference to the EU average of 17. In absolute terms, the greatest shortfall compared to the international level was recorded in the segment of electronic bill payments, which is primarily attributable to the extremely wide use of payments using yellow and white postal money orders, a specifically Hungarian payment method. However, thanks to the recent developments of the Post, the turnover of electronic bill payments increased from one-fourth to one-third of all bill payments by 2015. The other main reason for the low value of the indicator is the less widespread use of direct debits, which is partly due to a lack of trust between the parties involved in the transaction.

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18 Development and modernisation of payments and financial infrastructures

18.3.1.2 Introduction of instant payment in Hungary

In order to eliminate the inefficiencies resulting from the technical limits of current infrastructures, to widen the range of payment situations enabling the use of electronic payment methods, and to support future innovations, in December 2016 the MNB’s Financial Stability Board adopted the core operational rules for the instant payment service in Hungary. As the instant payment service is primarily introduced to improve the efficiency of payments through the acceleration of transaction processing, it essentially fits in with the former direction of developments in the domestic payment infrastructure. However, as a major step forward compared to previous developments, apart from faster execution the instant payment system also provides significantly wider opportunities for the use of electronic payment services. The system enables the utilisation of modern IT and communication technologies in payments, and on that basis the development of a wide range of innovative payment solutions (Chart 18-4). This creates the possibility to establish a new range of services, which would be limited using the basic services offered by the electronic payment solutions currently in place. This is because the core functional logic of the latter is built on limited messaging possibilities, and as such it makes, at best, a very limited use of the benefits offered by the modern communication and data transmission services that have become available at low cost to a wide range of users in recent years.

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Chart 18-4: Requirements for an instant payment system Expectation of households and enterprises

Expectation of market participants

Expectation of MNB

Easy access, low prices

Finality of payment transactions

Proper liquidity management

Reliable, continuous operation of the infrastructure

Instant credit of the account

Notifications on transactions

Secure operation and high-level data protection

Continuous availability

Possibility to attach information, remitance data

Possibility to introduce innovative services

Increase the ratio of electronic payments

Secure operation and high-level data protection

Interoperability of services

Clear legal backround

Interoperability, use of common standards

Consumer protection Possibility to introduce innovative services Clear legal backround

Source: MNB.

Under the rules specified by the MNB, the transactions subject to an instant processing obligation must be delivered to the payee’s payment service provider, which must instantly credit the transaction to the payee’s payment account, and confirm completion, or as the case may be, failure to complete the transaction to the payer’s payment service provider. The system will be available on a continuous basis (24/7), that is, as opposed to the infrastructure currently in place, it will enable the execution of transactions at any time. The transactions subject to an instant processing obligation include electronically submitted single credit transfers below HUF 10 million, and batched credit transfers of household customers. In light of the lessons learned from the operation of the system, it will be possible to make subsequent increases to the value limit, i.e. to extend the instant processing obligation to an even wider range of transactions.

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18 Development and modernisation of payments and financial infrastructures

Box 18-2 Central bank participation in the introduction of the instant payment service

The introduction of instant payment systems may significantly widen the range of payment situations that enable consumers to use electronic payment methods in addition to cash. Due to the increased transaction volume resulting from a wider range of payment situations, the processing of electronic payment transactions may also become increasingly cheap at the level of individual market participants, i.e. instant credit transfers may provide a reasonable alternative to cash even in terms of costs. Additionally, building on a standardised and open central core infrastructure, the entry of new market participants becomes simpler, which in turn increases competition, while making it easier for service providers to reach new customers and, as a result, scale-efficient operations. One good example for a high level of market concentration is provided by the oligopolistic payment card market, where concentration may be reduced in the long term by the introduction of instant payment through the possibility for merchants to accept electronic payment methods without additional costs charged by card companies, i.e. the new service may also support the growth of the acquirer infrastructure to a great extent. The development may entail major costs for economic actors, including banks that dominate the payments market, while as a result of the development, they may expect competition to intensify as new participants enter the market, which is why it is not in their interest to implement the investment that is otherwise relevant in terms of total social utility. However, it is important to realise that payment service providers may also count on an increasing transaction volume due to the new service and the resulting wide range of payment situations, that is, over the long term the development may also generate higher revenues. Additionally, it should also be apparent that in order to secure the international competitiveness of Hungarian market participants, no tolerance may be shown for a situation where economic actors in the majority of European countries can receive their money and use it to start new transactions, while in Hungary it remains a matter of hours or

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even days to execute a payment transaction. For that reason, the Hungarian implementation of the development is absolutely essential for the central bank. Nevertheless, central bank participation varies widely across countries. At the European level, the European Central Bank has put forward strong expectations for the introduction of and cross-border access to instant payments. Apart from European countries, the respective central banks have been acting as catalysts in Australia, Brazil, Canada, China, India, Japan, Mexico, Saudi Arabia, Singapore, South Africa, South Korea, Switzerland, Turkey, and the United States. The lowest degree of participation involves the operation of systems for central bank settlement; for instance, in India the responsibilities of the central bank are limited to that activity. Central bank participation may also be moderate in countries like Sweden, where the need for the implementation of the development was articulated by market participants. A higher degree of contribution is made by a central bank that implements developments for the introduction of instant payment, e.g. by enhancing the capacity of settlement systems or by extending the operating hours of the system (such as in Mexico) (Chart 18-5). Chart 18-5: Instant payment systems worldwide

SE FL CA

PT ES

GE PL IT

GR TR

CN IN TH

NG CD

ID BR AU ZA

18 countries “live”

12 countries “exploring” / “planning” / “buliding”

17 additional Eurozone countries “exploring”

Source: SWIFT: The Global Adoption for Real-time Retail Payments Systems (2015).

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18 Development and modernisation of payments and financial infrastructures

As regards Hungary, taking into account local specificities and recognising the fact that no concerted action may be expected on the part of market participants to enable the implementation of this investment of social relevance, the MNB has undertaken to develop the concept of the instant payment system, and to coordinate the development process.

In order to encourage a wider range of payment options, service providers must be enabled to create auxiliary services on the basis of the core infrastructure (Chart 18-6). This is supported by two functions of the core infrastructure: the possibility to handle secondary identifiers, and the processing of payment request messages. Secondary identifiers enable customers to originate payments without knowing account numbers, possibly using telephone numbers or e-mail addresses. A payment request enables the payee to send transaction data to the payer before the transaction is initiated, who can use such data to submit an automatically generated transfer order. Chart 18-6: Relationships of major payment situations and the instant payment service Electronic payment solutions Instant payment Payment card purchases Credit transfer Direct debit Payment infrastructure

Payment situations

Time-critical payments P2P payments

Instant payment system

Online purchases

Payment card system

Payments at physical POSs

Intraday clearing system

Bill payments

Overnight clearing system

Payments related to the state administration Source: MNB.

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Auxiliary services include all services established by market participants that enhance the core functionality of the instant payment system, i.e. real-time credit transfer between accounts. Compared to standard credit transfers, such services enable instant payments on a much wider scale in a number of payment situations, making instant payments a competitor to the use of cash in most payment situations. Household customers will have access to a payment solution that enables them to originate fast payments by utilising the benefits of modern technical solutions, on the devices currently available or even new ones that are easier to use (such as in mobile applications), and in new payment situations. In retail payment situations, new payment opportunities may be created for customers, while merchants may benefit from the low cost and faster processing times of these solutions compared to what is currently available. In this segment, it is an important aspect that the amounts paid may instantly be available for use as opposed to current bank card payments, where a payment may take up to several days from the purchase until it is credited on the merchant’s account. Additionally, payment messages may be linked to other corporate and commercial information such as data from billing and frequent buyer systems. In the services sector and for sole proprietors, it will be possible to implement the option of electronic payments at low cost and with minimal technical requirements, with the possibility to receive electronic payments on the devices currently in use (such as mobile phones). In payments between businesses, the instant system may also facilitate the reduction of cash usage by the possibility to mitigate the problems resulting from the lack of trust between businesses. This is because using the instant payment service economic transactions and their financial settlement will no longer be separated in time, which means that just as with cash, transactions may simultaneously be settled economically and financially.

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18 Development and modernisation of payments and financial infrastructures

The sector of payment service providers may also improve its competitiveness through the ability to establish modern payment services built on the instant payment system. The flexible infrastructure foreseen will enable these innovative payment services to be launched faster and more easily than today. As a result, current service providers will be able to compete with newly emerging innovative providers (FinTech businesses), and this will give them the power to retain their customers and the revenues from their transaction services. At the same time, new service providers can enter the payments market more easily with a low barrier to entry, and may use the same infrastructure for their services as current participants. This may intensify competition in the payments market, giving customers access to services that are more advanced than what is currently available, at lower cost. Box 18-3 European developments in the field of retail payments

The intervention of a central and market-neutral participant in developments in payments is not specific to Hungary. In Europe, while euro cash payments without frontiers were implemented across the euro area as of 1 January 2002, cross-border electronic payment transactions between payment service providers in different Member States continued to be more expensive and, due to the complex infrastructural background, generally also slower than domestic transactions. As a further obstacle, payment service providers in different Member States were subject to different legislative backgrounds, and used different standards and message formats. It was in order to achieve a higher level of integration in payments that work on the development of the Single Euro Payments Area (SEPA) started on payment service providers’ own initiative. In the spirit of integration, the European scheme for euro credit transfers (SEPA Credit Transfer – SCT) was developed in 2008, followed a year later by the development of the scheme for euro direct debits (SEPA Direct Debit – SDD). Despite this, effective integration based on payment

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service providers’ voluntary commitments progressed slowly, due partly to a number of cost items arising in the context of transition, while the solutions in place were also sufficient to provide limited core services. It had become apparent that as transition was not viable through market participants’ voluntary participation, legislative enforcement by an external participant was required to establish the area to work under standardised rules, which was also important because significant costs were incurred from the delayed transition to the new schemes. This had prompted the adoption of the so-called SEPA End Date Regulation144 at the European level, which ultimately set the final deadlines for transition at 1 August 2014 for euro area countries, and 31 October 2016 for EU Member States outside the euro area. The End Date Regulation imposes an obligation to use the SCT and SDD schemes for payment transactions denominated in euros, be they domestic or cross-border transactions within the EU, effectively discontinuing payment solutions specific to individual Member States. In order to standardise the functioning of the payments sector and to provide for system interoperability, a single standard was defined for message formats, which supports an even higher intensity of competition in the payments market. The lessons learned from the SEPA confirm the need, due to the networked nature of payments, for the intervention of a central participant to enable the implementation of developments covering the entire sector. Following the introduction of the SCT and SDD standards, the next step was the development of a scheme for instant credit transfers (SCTinst), the rulebook for which was finalised in November 2016. In addition to the adoption of a single operational model and message standards, another major step forward was the start of implementation work, under the supervision of the ECB and the European Payments Council (EPC), on the cross-border

144

egulation (EU) No 260/2012 of the European Parliament and of the Council of 14 R March 2012, establishing technical and business requirements for credit transfers and direct debits in euro and amending Regulation (EC) No 924/2009

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18 Development and modernisation of payments and financial infrastructures

connection of payment infrastructures, designed to eliminate the difference in the processing times of domestic and international transactions, and to intensify competition among payment service providers. 18.3.1.3 Developments in the field of payment cards

The improving ratios of electronically paid purchases are consistent with the macro-level statistics collected and published by the MNB, which show that in recent years, the volume of payment card purchases has grown by more than 20 per cent in terms of transaction numbers, and possibly by more than 25 per cent in terms of value. The steady evolution of the card market may be attributable to several factors and developments, which have in many cases received major contributions from the MNB. In 2014, the MNB launched an experimental programme for POS terminal deployment in Fejér County in cooperation with payment service providers offering acquirer services, with support from card companies. As part of the programme, more than 5,000 merchants were contacted by payment service providers, and close to three-quarters of the terminals were deployed to merchants with lower sales (below HUF 30 million). Within the framework of the programme, service providers deployed about twice as many terminals in Fejér County as in the normal course of their business. The programme also provided an opportunity to collect an extensive body of valuable information on the practical implementation of terminal deployment programmes and on merchants’ concerns about card acceptance, which may also be utilised in the future. Based on the lessons learned from the programme, the MNB proposed that support for POS deployments be extended to the national level. Appropriately seen as the continuation of the road started in 2014, in December 2016 the Ministry for National Economy announced its nationwide POS deployment programme, which, adhering to the principles of the MNB’s experimental programme

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but with a significantly extended geographical scope, was designed to support the development of acquirer infrastructure in the country. Also with relevance to the acquirer infrastructure, but significantly affecting the MNB’s indicator for the ratio of electronic bill payments as well, the Hungarian Post implemented a development on the payment of yellow and white postal money orders by bankcards. Previously, when using a card to pay a postal money order, the customer legally carried out a cash withdrawal, and used the cash withdrawn to pay the bill concerned. However, owing to the higher fees charged on cash withdrawals, this solution could not become widespread, and the payment of postal money orders continued to be dominated by cash transactions. As of early 2015, amendments to the MNB Decree145 and the Postal Services Act146 enabled postal bill payments using bankcards to effectively qualify as card purchases, i.e. the payment of regular bills at post offices without additional charges. This measure was complemented by additional developments, which, from early 2015, have enabled the payment of postal money orders using a mobile phone application, in transactions qualifying as card purchases, by scanning QR codes. Moreover, the Post has started to deploy bill payment machines, enabling consumers to pay their bills electronically even outside of the opening hours of post offices. Similarly, adopted on the initiative of the MNB and the Hungarian Competition Authority, regulations capping interchange fees on card payments were primarily designed to support the further enhancement of the acquirer infrastructure. Pursuant to amendments to the Payment Services Act147 effective as of 2014, interchange fees were capped at 0.2 per cent of transaction value for debit card purchases, and 0.3 per cent for credit card transactions. Interchange fees are paid between payment service providers rendering acquirer services and payment ecree No. 18/2009 (VIII.6.) MNB by the Governor of the Magyar Nemzeti Bank D on the Execution of Payments. 146 Act CLIX of 2012 on Postal Services. 147 Act LXXXV of 2009 on the Pursuit of the Business of Payment Services. 145

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18 Development and modernisation of payments and financial infrastructures

service providers issuing cards in order to make card issuance cheaper, i.e. to enable a sufficient number of consumers holding payment cards to exploit the benefits offered by card purchases. In turn, acquiring payment service providers commonly recharge interchange fees to merchants, i.e. ultimately such fees add to the costs of merchants enabling card payments, to the detriment of growth in the acquirer infrastructure. By capping the fees, the regulations aimed to reduce the burdens on merchants, allowing card acceptance to become a reasonable business decision even for merchants that have so far been deterred by its high costs. The Hungarian regulations preceded the similar European regulations by two years148, namely, as of December 2015, and the above limits on interchange fees have also been applied in the European Union, along with a number of other rules on business operations. In drafting the European legislation, the European Commission also considered the favourable experiences from the Hungarian regulations. From Q1 2014, the Hungarian regulations caused a major fall in the revenues of acquiring payment service providers from interchange fees, i.e. the fees charged to merchants: while in 2013, 40 per cent of all revenues were collected from such items, from 2014 the ratio dropped to 23-24 per cent, and in absolute terms, the amount of fees collected from merchants was approximately HUF 1.5 billion less in 2014 compared to 2013. Chart 18-7 also shows that the revenues of payment service providers fell relative to the volume of transactions as well, and that a major role was occupied in that fall by the sharp cut on interchange fees in Q1 2014.

148

egulation (EU) 2015/751 of the European Parliament and of the Council of 29 R April 2015, on interchange fees for card-based payment transactions.

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Chart 18-7: Card acceptance revenues of payment service providers rendering acquiring services relative to the volume of card transactions 1.2

Per cent

1.2

Interchange fee

Other revenues

Jun. 2016

Mar. 2016

Dec. 2015

0.0 Sep. 2015

0.0 Jun. 2015

0.2

Mar. 2015

0.2

Dec. 2014

0.4

Sep. 2014

0.4

Jun. 2014

0.6

Mar. 2014

0.6

Dec. 2013

0.8

Sep. 2013

0.8

Jun. 2013

1.0

Mar. 2013

1.0

Total revenue

Source: MNB.

The cut on interchange fees was a major contribution to the development of the acquirer infrastructure; in recent years, both the number of physical merchant outlets and the number of POS terminals operated at such outlets have recorded growth rates of 5-10 per cent. This in turn has enabled the volume of payment card purchases to grow dynamically, with recent growth rates exceeding 15 per cent in terms of both the number and value of purchases.

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18 Development and modernisation of payments and financial infrastructures

Chart 18-8: Development of the Hungarian payment card system year-on-year 130

Per cent

130

125

120

115

110

105

100

2013. 1st half

2013. 2nd half

2014. 1st half

2014. 2nd half

Physical merchant outlets Number of purchases

2015. 1st half

2015. 2nd half

2016. 1st half

POS terminals Value of purchases

Source: MNB.

In the growth of the volume of payment card transactions, a key role is played by the emergence and progressive spread of contactless payments (Chart 18-9). The new payment method provides consumers with a fast and simple way to make purchases below HUF 5,000 without using PIN codes.

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Chart 18-9: The spread of contactless technology in the Hungarian payment card system 70

Per cent

2012. 2012. 2013. 2013. 2014. 2014. 2015. 2015. 2016. 1st half 2st half 1st half 2st half 1st half 2st half 1st half 2st half 1st half Ratio of contactless cards Ratio of contactless POSs

Ratio of the value of contactless payments Ratio of the number of contactless payments

Source: MNB.

On the infrastructure side, i.e. as regards the number of contactless cards and of POS terminals enabling contactless payments, major progress had been made ahead of the growth in transaction volume: in 2015, the number of such cards and terminals both exceeded 50 per cent. Importantly, the technology is also becoming increasingly widespread in card payments, and in Q2 2016, more than one-half of all card purchases were made using this method. Another relevant point is that in the case of contactless transactions, which have been driving current growth in the volume of card purchases, the average transaction value is roughly half that of card purchases executed using conventional methods, which means that the new technology may presumably replace a large number of low-value cash transactions. Due to the significant growth in infrastructure and transaction volume, the value of the MNB’s payments efficiency indicator has also improved — 654 —

18 Development and modernisation of payments and financial infrastructures

considerably. As regards retail purchases, the share of card payments increased from the 2012 reading of 11.8 per cent to 17.5 per cent in 2015 (Chart 18-10). Chart 18-10: Share of electronically paid purchases within household consumption 20

Per cent

2012

2013

2014

2015

Ratio of electronic purchases Source: MNB.

18.3.2 Infrastructure developments concerning the clearing and settlement of interbank securities and foreign exchange transactions

Below is an account of the targeted infrastructure development programmes as part of which the MNB has been able to influence the growth in the efficiency of interbank securities and foreign exchange transactions, and the way these programmes are helping to improve Hungary’s risk perception. Two programmes are addressed in detail: first, a description is given of how the accession of the forint on 16 November 2015, to the Continuous Linked Settlement (CLS) system is helping to eliminate the foreign exchange settlement risk in foreign exchange transactions that involve forints; and second, a summary is provided of — 655 —

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how the accession of KELER Zrt., a majority-owned MNB company, to the TARGET2-Securities (T2S) platform on 6 February 2017, is supporting international access to the Hungarian securities market. Both programmes are particularly important milestones in domestic infrastructure development, and may also support the implementation of the central bank’s monetary policy. Also in the context of the two projects, of particular relevance is the MNB’s ability to enforce shareholder interest and instruments, which supported the implementation processes of developments in both cases. In the case of the CLS project, apart from carrying out its project management tasks, the central bank also acted as the Shareholder and operator of the VIBER, and as such had direct liability for the required system developments. The decision on the launch of the T2S project was adopted by KELER, a majority-owned MNB company, and as in other cases, the central bank has played an active role in monitoring and supporting the process. As in other fields, the MNB seeks to achieve its objectives concerning the development of securities and foreign exchange transactions through specific supporting programmes, the implementation of which may be greatly facilitated by the availability of shareholder instruments. 18.3.2.1 Accession of the forint to the CLS system

The Magyar Nemzeti Bank and CLS launched a joint project in January 2014, with the purpose of making the Hungarian forint the 18th settlement currency of the CLS system (Chart 18-11). Less than two years later, on 16 November 2016, the settlement of foreign exchange transactions that involve forints started in the system, making the forint the first among the autonomous CEE currencies to be granted access to the risk mitigation instrument provided by CLS. With the currencies of Australia, Canada, Denmark, the euro area, Hong Kong, Israel, Japan, the Korean Republic, Mexico, New-Zealand, Norway, Singapore, the South African Republic, Sweden, Switzerland, the United Kingdom, and the United States, the Hungarian currency became part of the international system which, by virtue of its risk and liquidity management solutions, qualifies as the leading infrastructure in the international foreign exchange market. Accession had a favourable — 656 —

18 Development and modernisation of payments and financial infrastructures

impact on the perception of the Hungarian capital market, and as the use of the system becomes increasingly widespread, domestic banks will have a wider range of opportunities in the foreign exchange market, which in turn will support the financial stability of the country. Chart 18-11: CLS settlement currencies (2016)

America

CAD, MXN, USD Africa, Europe

CHF, DKK, EUR, GBP, NOK, SEK, ZAR,

HUF

Australia, Asia, Oceania

AUD, HKD, ILS, JPY, KRW,NZD, SGD

Source: CLS.

The CLS system was created to eliminate foreign exchange settlement risk, i.e. to protect banks entering into foreign exchange transactions against losing previously paid capital amounts in the event of their counterparties defaulting. In cases where the settlement agreement related to the foreign exchange transaction concerned fails to guarantee to participating banks that the final transfer of one currency can take place only when the final transfer of the other currency in the transaction has been completed, in the event of a bank problem the counterparty may not receive consideration for previously paid foreign exchange. In a more fortunate case, the delinquent party will only fall into arrears with its payment, whereas in the event of the delinquent party’s bankruptcy, the innocent bank is likely never to receive the foreign exchange payable to it. This risk is referred to as foreign — 657 —

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exchange settlement risk or Herstatt risk. This latter name is associated with Bankhaus Herstatt, a small bank that had been active in the foreign exchange market, and had its operating license withdrawn by German banking supervision on 26 June 1974. Previously, many of the bank’s counterparties had completed Deutsche mark transfers resulting from the transactions with the bank; however, Herstatt’s liquidation prevented them from receiving the US dollars specified as consideration in the transactions concerned. Highlighting the importance of foreign exchange settlement risk, the case was one of the reasons for the setup of the Basel Committee on Banking Supervision in 1974, and the establishment of the CLS system some decades later, in 2002. CLS has designed globally harmonised operational processes for the settlement of foreign exchange transactions, which reduce liquidity requirements while enabling CLS to verify the completion of foreign exchange payments. The Continuous Linked Settlement (CLS) model eliminates foreign exchange settlement risk by linking the foreign exchange transfers of the two parties to a foreign exchange transaction: each party will only receive the foreign exchange paid to it if it has transferred the consideration. To that end, CLS opens accounts in the large-value payment systems of all participating currencies (VIBER for Hungary), then specifies a time window in which all participating central banks and commercial banks worldwide are required to be available for the settlement of foreign exchange transactions. This time window falls between 7:00 a.m. and 9:00 a.m. CET, which is when all system participants send to CLS their foreign exchange payments due on that day, and following receipt of the amounts, CLS forwards them to payees. The model ensures that in cases where consideration is not received from a counterparty, the innocent party to the transaction is refunded for any previously paid capital amounts, enabling it to avoid at least foreign exchange settlement risk, if not exchange rate risk. Moreover, the system supports participants’ liquidity management, because it calculates multilateral net positions rather than gross positions, i.e. it deducts inbound positions from the value of outbound positions for each system participant. Therefore, resulting primarily from differences in time zones and business hours, foreign exchange — 658 —

18 Development and modernisation of payments and financial infrastructures

settlement risk is managed by CLS through the global standardisation of operational processes, and in the capacity of a central participant, by verifying the completion of transactions. Accession to CLS has provided the Hungarian market with a new instrument that may become extremely significant in the event of a crisis situation similar to that of September 2008. In accordance with the openness of the country, domestic banks process a large volume of foreign exchange transactions, and their operations depend heavily on the foreign exchange liquidity available from foreign counterparty banks. In the event that a country has its risk rating downgraded, foreign counterparties may refuse to deal with the domestic banks of the country concerned, potentially causing a major deterioration in the foreign exchange liquidity positions of those banks. In such cases, a bank using the CLS service will have less or no trouble meeting its foreign exchange demand, because the mitigation of its foreign exchange settlement risk through CLS will enable it to secure a more favourable risk perception. The benefit of using the system will therefore become obvious at times of market turbulence; however, it will also drive efficiency in normal market circumstances, because by calculating net positions, it increases the volume of foreign exchange transactions that can be settled with the given amount of liquidity, i.e. the trading potential. Overall, then, for Hungarian banks CLS enables efficient operations in a normal foreign exchange market environment, and normal operations in a turbulent foreign exchange market environment, the importance of which is unambiguously confirmed by the lessons learned from 2008. The volume of forint transactions settled by CLS showed steady growth in the year following the launch of the system (Chart 18-12), as a result of which by November 2016, over one-third of all forint transactions in the global market were settled through CLS. On 16 November 2015, use of the new service was undertaken by a restricted group of banks, whose initial experiences made it clear that the infrastructural cooperation established was fully compliant with the safety and operational requirements, and was therefore ready to integrate additional market participants. As a result, in the course of one year, the average daily gross volume of — 659 —

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forint transactions settled in CLS increased from HUF 75 billion to HUF 400 billion, whereas the average daily net funds required to handle that volume increased from HUF 25 billion to only HUF 75 billion. This indicates a steady improvement in the netting effect of the system, with an increase from the average 65 per cent seen in the first months to exceed 80 per cent as the use of the service became more widespread, i.e. the same amount of liquidity enabled a higher number of transactions to be settled. Developments in the year following the launch of the service were therefore favourable, despite which close to two-thirds of the global forint market, estimated at a daily USD 3 billion149 remained to be settled outside CLS at the end of 2016. Redirecting that volume could further improve the risk perception of the forint and the efficiency of the foreign exchange market, which may ultimately also improve the response of foreign exchange market participants to monetary policy decisions. Chart 18-12: Gross forint amounts settled in the CLS system, and the related net cash flows in the year following the forint accession (16 November 2015–18 November 2016). 800

HUF Billions

800

700

600

500

400

300

200

100

Gross settled value

Nov. 2016

Oct. 2016

Sep. 2016

Aug. 2016

Jul. 2016

Jun. 2016

May. 2016

Apr. 2016

Mar. 2016

Feb. 2016

Jan. 2016

Dec. 2015

Nov. 2015

Net money flow

Source: CLS. 149

ased on Bank of International Settlements: Triennial Central Bank Survey of B foreign exchange and OTC derivatives markets in 2016.

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18 Development and modernisation of payments and financial infrastructures

18.3.2.2 Accession of KELER to the T2S (TARGET2-Securities) system

Acting as the central securities depository in Hungary, KELER is joining the European Union’s international platform for securities settlements (T2S) on 6 February 2017, which is expected to improve the competitiveness of the Hungarian securities market. In 2001, a report was published under the name of Alexandre Lamfalussy, which sought to highlight the possibility of saving up to an annual EUR 1 billion at system level through the establishment of a more rationally structured and better integrated European infrastructure for the clearing and settlement of cross-border securities trading. The professional work started, pursuant to the Lamfalussy report, pointed to real benefits of up to EUR 4 billion per year, which prompted the European Central Bank and central securities depositories across Europe to launch a project for the development of a new financial infrastructure with a view to achieve those benefits. Named TARGET2-Securities, the new system became operational in June 2015, and will be joined by 21 European securities depositories, including Hungary’s KELER, by the end of 2017, primarily with a view to the efficient processing of cross-border securities transactions. The system has been designed to ensure the cheaper technical implementation of international capital investments within Europe, i.e. to reduce the infrastructural costs of cross-border securities transactions. The project is thereby making a great contribution to the development of a single European capital market, as well as an improvement in the economic competitiveness of the European Union. As regards the Hungarian market, this will reduce the cost of purchasing Hungarian securities for foreign investors, while it will also become cheaper for Hungarian investors to acquire securities issued in other European countries. A more efficient capital market can respond more efficiently to events that shape investor perceptions of a country; for example, where the level of efficiency is higher, market responses to interest rate decisions adopted as part of monetary policy implementation will be less distorted. T2S seeks to provide a single IT platform for the safe and efficient settlement of cross-border securities transactions, and to remove — 661 —

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the legal and technical obstacles to the development of a single capital market. While the degree of European consolidation has been considerable in trading infrastructures, including exchanges and other trading facilities, the post-trade clearing and settlement processes have often remained at the national level. This is why on trading platforms, a transaction for the purchase and sale of securities can be concluded easily between investors from different countries, whereas the settlements resulting from the transaction can typically be completed at high cost due to the long chains of intermediation. T2S resolves this problem by providing an efficient connection and cooperation facility for central institutions involved in post-trade processes, i.e. for central securities depositories, which serve as registries of locally issued securities. At the same time, this legally supported cooperation also creates competition by enabling investors to use a single depository to access any of the other depositories in T2S, i.e. to terminate the securities accounts that they had previously been forced to open with those depositories. Therefore, the launch of the T2S project is primarily based on the conviction that intensifying competition among posttrade securities infrastructures will enable a market cleaning process on the continent that will make the European Community considerably more attractive to financial investors. Accordingly, T2S is not only an IT solution, but also a harmonisation project that seeks to establish a single legal and operational framework for the systems and system participants involved in the settlement of securities transactions. T2S offers a number of advantages, including its effect of boosting competition, as well as the benefits of liquidity savings, enhanced operational efficiency, and improved safety. The use of T2S enables international institutions to transfer their liquidity and collateral management to a single location, i.e. to pool resources that have previously been dedicated to sub-markets, and manage them collectively (Chart 18-13). This enables a bank group that is present in several countries to make more efficient use of its liquidity, and of its securities eligible as collateral, which could improve the profitability of the group as a whole. Simultaneously, international institutions can rationalise — 662 —

18 Development and modernisation of payments and financial infrastructures

their business processes related to the settlement of securities, and can eliminate internal redundancies by merging organisational units dedicated to local markets. Moreover, in terms of safety, it is a huge leap forward that T2S works with delivery versus payment (DVP) transactions in central bank money, i.e. monetary settlement takes place between payment accounts held with European central banks, which eliminates central banks’ settlement risk and counterparty credit risk. Taking into account auxiliary services provided by the system to support operations, such as auto-collateralisation, the automated management of company events, or linking securities transactions, T2S can be validly considered as an infrastructural milestone. And all these benefits will also become available to domestic financial institutions provided that they implement, within their own powers, the development and process reengineering required for the efficient use of the system. Chart 18-13: By linking central securities depositories, T2S organises local capital markets into a single network Market participants

Market participants

Depositories

T2S depositories

Source: MNB.

The accession of KELER to T2S may increase demand for domestically issued securities, which, through a decline in financing costs, may improve the productive capacity of the Hungarian economy. The T2S project will bring about major changes in the entire European securities market, including in Hungary, and the accession of KELER to T2S enables the Hungarian depository to shape and benefit from — 663 —

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these changes. By enhancing its international network and services, KELER may identify business niches in the intensifying depository competition, which could also bring major benefits to domestic issuers through the increased efficiency of the financial intermediation sector and the development of the investor environment. A higher intensity of competition will help to reduce the fees of financial intermediation, while the modernisation of services in the Hungarian capital market is likely to result in the entry of new international investors in the relevant trading facilities, including the Budapest Stock Exchange. Therefore, a Hungarian securities settlement infrastructure, which is deeply embedded into the circulation of the European capital market in terms of its service level and availability, will ultimately enable Hungarian institutional and corporate issuers to generate more demand, that is, to raise cheaper funds. In turn, through a decline in financing costs, that is likely to benefit the overall productive capacity and competitiveness of the Hungarian economy. The T2S project therefore primarily promotes the development of a single European capital market, while the improvement triggered by it in business processes may also have a beneficial effect on the exchange rate channel of monetary policy.

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18 Development and modernisation of payments and financial infrastructures

Key terms acquirer (payment card) batch processing cashless (electronic) payment method central securities depository clearing clearing cycle clearing house CLS (Continuous Linked Settlement) direct debit financial infrastructures GIRO KELER KELER KSZF

interchange fee issuer (payment card) liquidity net clearing oversight payment account payment method payments payment service provider payment system settlement social cost T2S (TARGET2-Securities) VIBER

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References Hasan, I. – Schmiedel, H. – Song, L. (2009): Return to Retail Banking and Payments, ECB Working Paper Series No. 1135, December. Hasan, I. – De Renzis, T. – Schmiedel, H. (2012): Retail payments and economic growth, Bank of Finland Research, Discussion Papers 19. Hasan, I. – De Renzis, T. – Schmiedel, H. (2013): Retail payments and the real economy, ECB Working Paper, Series No. 1572, August. Humphrey, D. – Willesson, M. – Bergendahl, G. – Lindblom, T. (2003): Cost Saving from Electronic Payments and ATMs in Europe, Joint Research Paper. Ilyés, T. – Varga, L. (2015): Mutasd mivel fizetsz, megmondom, ki vagy – A pénzforgalmi szokásokat befolyásoló szociodemográfiai tényezők (Show me how you pay and I will tell you who you are – Sociodemographic determinants of payment habits). Financial and Economic Review, 14(2), June 2015, pp. 26–61. http://www.hitelintezetiszemle.hu/letoltes/2-ilyes-varga.pdf llyés, T. – Varga, L. (2016): Az elektronikus pénzforgalom növekedésének makrogazdasági hatásai – Általános egyensúly-elméleti megközelítés magyar adatok felhasználásával (Macroeconomic effects of the increase of electronic retail payments – A general equilibrium approach using Hungarian data). Financial and Economic Review, 15(2), June 2016, pp. 129–152. http://www.hitelintezetiszemle. hu/letoltes/ilyes-tamas-varga-lorant.pdf KELER Zrt. (2013): White Paper, Migration of KELER Group Services to a T2S Environment; Online: https://www.keler.hu/Strategia/TARGET2-Securities/Altalanos%20info/, 19 July 2016. Lamfalussy, A. et al. (2001): Final Report of the Committee of Wise Men on the Regulation of European Securities Markets; Online: http://ec.europa.eu/finance/securities/lamfalussy/report/index_ en.htm, 7 July 2016. MNB (2016): Fizetés rendszer jelentés 2016 (MNB Payment System Report 2016). http://www.mnb. hu/letoltes/fizetesi-rendszer-jelentes-2016.pdf Schmiedel, H. – Kostova, G – Ruttenberg, W. (2012): The Social and Private Costs of Retail Payment Instruments: A European Perspective. ECB Occasional Papers Series No. 137, September. SWIFT (2015): The Global Adoption for Real-time Retail Payments Systems (2015), https://www. swift.com/your-needs/real-time-payments T2S Special Series, Online: https://www.ecb.europa.eu/paym/t2s/about/multimedia/html/ index.en.html, 14 July 2016. Turján et al (2011): Semmi sincs ingyen: A főbb magyar fizetési módok társadalmi költségének felmérése (Nothing is free: A survey of the social cost of the main payment instruments in Hungary). http://www. mnb.hu/letoltes/mt93.pdf Zandi, M. – Singh, V. – Irving, J. (2013): The Impact of Electronic Payments on Economic Growth. Moody’s Analytics.

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Relationships between monetary policy and the stock exchange150 Márton Teremi151

For central banks, the relevance of capital markets152 is twofold in that their role may be important in terms of both monetary transmission and corporate financing. Central banks must be mindful of the fact that through interest rate policy they also influence the pricing of exchange-traded assets, predominantly equities, the additional indirect effects of which on the real economy may influence the functioning of the transmission mechanism as a whole. Additionally, an active capital market that is free of market failures will contribute to widening the range of the financing options available to corporates, and may also reduce vulnerability at the level of the national economy. This chapter approaches the subject along these two dimensions, and concludes with a description of the situation in Hungary.

19.1 The role of the prices of exchange-traded assets in monetary transmission Asset prices play an important role in monetary policy transmission. Monetary policy influences the prices of a wide range of assets that are suitable for investment (equities, bills and bonds, and property), which in turn affects the decisions that economic actors make on consumption and investments. Apart from the asset price channel of the transmission mechanism, monetary policy also works its effects on participants’ balance sheets and through the credit channel. he author wishes to thank Kristóf Lehmann (MNB) and Dániel Felcser (MNB) for their T contributions. 151 Member of the Budapest Stock Exchange staff 152 For the purposes of this chapter, the terms “exchange”, “capital market” and “equity market” are used interchangeably in reference to any market that enables companies to raise funds, and to have their shares traded. 150

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On the investment side, the potential effects of monetary policy can also be identified through lower cost of capital, and corporate balance sheets. On the one hand, monetary policy stimulus (in the form of interest rate cuts) makes bills and bonds less of an attractive investment target compared to equities, which will increase the demand for equities, and place an upward pressure on their prices. In turn, an increase in equity prices (lower cost of capital) leads to higher investment because of the more favourable returns on enhancements to production capacities. On the other hand, an increase in equity prices will increase the market value of the net worth of the company, making the company more creditworthy, enabling more investments to be made. On the consumption side, in the case of households a distinction may be made between the effects on liquidity and wealth. In the first case, where households have a substantial amount of financial instruments, due to the liquid character of multilateral trading facility they are better protected against negative income shocks. This results in greater propensity to purchase durable consumer goods, because there are no concerns about having to sell them significantly below their price in the event of a negative shock. Where equity prices rise, consumption will also increase due to the more favourable financial situation. In the second case, a rise in equity prices will increase the financial wealth of households with equity holdings, which will, again, lead to higher consumption. Consequently, higher equity prices will boost both investments and consumption, i.e. they will increase aggregate demand. This will enable companies to sell more products, and ask a higher price for their products, as a result of which monetary policy easing will lead to higher output and higher inflation. The paradigm of ruling out asset purchases in the equity market for monetary policy purposes is being questioned. Following the crisis, central banks in advanced markets – with variations in extent and dynamics (see Box 19-1 on central banks’ crisis management in the US and Europe), pursued quantitative easing programmes, covering an increasingly wider range of assets. Although the bond purchase — 668 —

19 Relationships between monetary policy and the stock exchange

programmes had in themselves already placed sufficiently strong upward pressure on equity markets through an increased supply of money, central banks were not making equity purchases for monetary policy purposes until Japan launched its programme in 2016. Having already announced the broadest programme in terms of scale and effect, the island nation was the first to start equity purchases specifically for monetary policy purposes. To exploit the stimulating effect of the transmission channels described above, in summer 2016, the Japanese central bank already held 60 per cent of all domestic ETFs, and had also become the largest shareholder in several listed companies.153 In countries where the capital market plays a relatively minor role, the effects of the above relationships are limited. As explained in the following subchapter, in predominantly bank-based economies (mostly in continental Europe), the role of capital markets is relatively limited. Accordingly, whether for fundraising or investment purposes, the prices of exchange-traded assets tend to remain beyond the horizon of central banks’ policy makers. By contrast, in countries with efficient capital markets, typically in the Anglosphere and Scandinavia, developments in the prices of exchange-traded assets play a more prominent role. Box 19-1 The role of capital markets in central banks’ crisis management

Approaches to crisis management varied according to the structural differences in financial systems. The euro area is dominated by bank financing, whereas in the US the role of the capital market is much more significant. Due to its advanced capital market, in the US a larger set of potential instruments were available to monetary policy, which, as a result, rather than relying on the banking system for the most part, used a wider toolkit to work its effect through multiple channels. In Europe, this was not viable due to the specificities of financial markets. In the US, the decline in the yields of government securities and mortgage bonds was accompanied by a drop in the yields of corporate bonds awarded the same risk ratings, 153

Kitanaka et al. (2016).

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making corporate financing perceivably cheaper, while the rise of exchange indices increased capitalisation through the value of corporate equities. For a long time, the European Central Bank and the Federal Reserve applied different instruments in the course of crisis management. The ECB sought to handle corporate financing predominantly through banks’ liquidity positions (except for the purchase of covered bonds), and primarily used indirect instruments such as unlimited MROs, 3-year LTROs, etc. Major changes in the toolkit were only brought about by the large-volume purchases of government securities from March 2015 onwards. By contrast, the Fed’s quantitative easing also improved the financing of large corporates directly via the equity and capital markets, while it also had a positive influence on the capital positions of large banks by driving up equity prices. Three full quantitative easing programmes had been completed before the ECB launched its instrument. Developments in central bank balance sheets also illustrate the insufficiency of relying exclusively on a single instrument for shaping monetary conditions effectively. In late 2010, the ECB’s balance sheet started to shrink, followed by meaningful growth only in spring 2015. Chart 19-1: Central banks’ total assets as a percentage of GDP 35

Per cent

2011

2012

2013

2014

European Central Bank

Sources: Databases of central banks, IMF, Eurostat.

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2015

Federal Reserve

19 Relationships between monetary policy and the stock exchange

19.2 The role of an efficient capital market ecosystem Although conventional monetary policy responsibilities do not include direct capital market monitoring, central banks have a vested interest in the maximum possible efficiency of both primary and secondary capital markets. Creating a balance between bank-based and (capital) market-based financing for the corporate sector has growth and other implications. In exploring the relationships between the development of the financial system and growth, literature154 points to the fact that countries with advanced capital markets tend to achieve higher growth rates and be less vulnerable than bank-based economies. From a central bank perspective, it is of particular relevance that excessive bank financing may carry macroprudential threats, which calls for the development of the capital market as an alternative financing channel. It is to be noted that in the aftermath of the crisis, the excessive expansion of financial markets was recognised as a risk by the relevant literature, yet this represents a problem in only a relatively low percentage of countries. A thriving primary market helps corporate financing to diversify, the favourable macroeconomic effects of which may also benefit central banks. The development of the primary equity market, and of the capital market in a broader sense, has a positive effect on economic growth through several channels, by (1) reducing the costs of long-term financing; (2) providing a cost-efficient method to reallocate capital among industries; (3) encouraging innovation; and (4) offering stronger incentives for equity investors to obtain information on the company concerned and to verify its decisions, which will trigger improvements in operational efficiency. As a result of the foregoing, market-based financing will increase diversification in the corporate sector’s funding structure, enabling companies to adapt more quickly, and thus possibly reducing the vulnerability of the overall economy in a crisis. 154

For an overview of the literature in Hungarian, see Palotai–Virág (2016), pp. 196–200.

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Although central bank mandates conventionally do not include a requirement to maintain the smooth functioning of the equity market, the threat of contagion to other financial markets under the central bank’s responsibility may easily prompt a central bank to intervene. As the smooth functioning of the secondary market is obviously in the interest of the national economy, the threat of contagion due to excessive volatility may also warrant central bank intervention. In Hong Kong, demand was generated in the equity market by the HKMA during the 1998 Asian financial crisis155, and by the PBoC in China several times during the turbulences of 2015–2016156.

19.3 Capital market development in Hungary The Hungarian capital market has seen a falling trend at least since the financial crisis in terms of trading volumes in both the primary and the secondary markets. Since the global financial crisis, the Hungarian equity market has been unable to recover. Between 2008 and 2014, its trading volume fell by an overall 70 per cent, the greatest rate regionally, with a minimal number of initial public offerings (IPOs). Additionally, in the asset portfolios of Hungarian households and institutional investors, the share of equities listed on the BSE is below 3 per cent, which is extremely low even by international standards. For the most part, the reasons for the downturn are institutional or concern efficiencies of scale, and are primarily attributable to deficiencies on the issuer side. In many cases, domestic companies fail to recognise the benefits of public operations, and are reluctant to operate transparently. New IPOs have become less frequent and their overall quality has also deteriorated, causing a shrinkage in the ecosystem supporting IPOs, and in the number of experts and consultants with the professional knowledge required to enter the capital market. Apart from the absence of economic incentives for going public, financing 155 156

am (1998). Y Bloomberg News (2016).

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19 Relationships between monetary policy and the stock exchange

from the capital market has also become less competitive compared to scale-efficient bank lending. Chart 19-2: Annual number of IPOs on the BSE Pieces

Pieces

1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

16 14 12 10 8 6 4 2 0

Annual number of share issues on BSE Sources: BSE.

The development of the capital market may reduce vulnerability in the essentially bank-based Hungarian economy by increasing the level of diversification in corporate financing. In terms of the dimension of corporate financing referred to above (bank vs. market based), in Hungary the prominence of bank-based financing is obvious (Chart 19-3). In the relevant literature on development economics, a consensus has emerged over the much greater added value of developing the capital market from a low base as opposed to enhancements to already developed capital markets. Additionally, diversification in companies’ funding structure will also increase their resilience to shocks, which may also produce positive macroeconomic effects.

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Chart 19-3: Bank and exchange financing Per cent Anglo-Saxon 200 model 175

Per cent

225

Continental model

CEE countries

225 200 175

Bank Loans / GDP

25 EU

100

125

150

125

150

Stock market shares / GDP

Sources: World Bank.

In order to remove the barriers to the development of the capital market, the MNB has acquired majority ownership in the BSE. Until 2015, the BSE had been owned by the CEESEG Group, and efforts for the resolution of the above problems remained ineffective. Recognising the relevance of capital market development to the national economy as described in the previous subchapter, the MNB acquired direct ownership in the BSE. The MNB is set to develop the exchange both in the primary and secondary markets, and is targeting the following developments for the period of 2016–2020.

19.3.1 Developing the primary market: attracting new issuers

The reinforcement of the capital market channel of corporate financing is also justified by increasingly limited access to funding as part of government schemes and schemes supported at the EU level. As mentioned previously, in the long term the spread of exchange financing will produce a positive diversification effect, because it will significantly reduce companies’ exposure to changes in the credit cycle. Additionally, there is also a short-term and country-specific reason to — 674 —

19 Relationships between monetary policy and the stock exchange

develop the primary market. The MNB’s FGS plans already saw their volume shrink in 2016, and are set to be phased out completely in 2017. The scope and volume of EU subsidies, which provide SMEs with funding either in the form of refundable subsidies or non-refundable grants, is also expected to decrease in the near future. All this points to the fact that markets for alternative financing, particularly the exchange, are important to the national economy, and need to be developed. The promotion of successful IPOs requires that the companies to go public meet the high quality requirements that aim to enhance investor confidence, deliver stable or improving financial performance, have a business strategy to ensure a significant growth potential, and may therefore expect to attract meaningful investor interest. Since the low number of new issuers is attributable to several deficiencies, including the erosion of the consultancy ecosystem assisting IPOs, a general lack of knowledge on company managers’ part, and the difficulty in interpreting regulations, market development requires a complex solution. To develop a diversified issuer structure and increase the trading volume of the exchange further, it is essential that both large private companies and SMEs are identified and put to the test on the exchange. Exchange listing provides issuers with an immediate, continuous and long-term opportunity to raise capital, while for shareholders it guarantees the liquidity of their equity investments, whereby it increases competitiveness, and also provides incentives for management and employees. For investors, listing a company’s shares on an exchange represents tangible monetary value: the literature of company valuation uses the terms “illiquidity discount” and “private company discount” to specify the shortfall in the value of an unlisted company compared to the same company being listed on an exchange. As a rule of thumb, private equity investment companies apply such discounts at 10-20 per cent; however, empirical studies have also found significantly higher discounts of up to 80 per cent in specific industries.

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In order to provide companies that meet the listing criteria with the information required for the development of the market, the BSE proactively approaches the managers of companies that may be eligible to be listed on the exchange. In both the large corporate and SME sectors, there are companies for which the exchange could provide a solution: based on data from the Hungarian Central Statistical Office (HCSO), there are over 900 companies that definitely qualify as large corporates157, but the real Chart is higher than that. The BSE tends to attract private companies that are domestically owned or have their centres of decision making in Hungary; in our estimation, this group includes at least one-fifth of large corporates, i.e. approximately 100 companies. Additionally, as pointed out in a joint study158 by experts of the MNB and the BSE, there are estimated more than 300 mediumsized enterprises for which the exchange may be a reasonable financing option based on their ownership structure, indebtedness and growth. State-owned large corporates comprise perhaps the most important target group of issuers. Presence in the capital market supports these companies in increasing their profitability, provides an opportunity for the capitalisation of undercapitalised state-owned companies, and also generates immediate fiscal revenues. Summarising several relevant research studies, Chart 19-4 shows that following sales, an obvious positive effect can be identified in terms of the most important indicators of corporate competitiveness. The macroeconomic effects of privatising state-owned companies (at least partially) are also quantifiable: the sale of assets worth 1 per cent GDP generated GDP growth of 0.5 per cent and 0.4 per cent in the year of sales and the next year, respectively, and reduced the unemployment rate by 0.2 percentage points and 0.5 percentage points, respectively.159 157

158 159

ccording to the Charts in HCSO statistic No. 3.2.7.2, Number of registered companies by A size class, at the end of November 2016, there were 922 companies with a headcount of at least 250, which definitely qualify as large corporates. Since the large corporate sector also includes all companies with headcounts below 250 employees whose total assets and sales exceed the statutory SME threshold, the group of large corporates is obviously wider.

ource: Banai et al. (2016). S Source: Barnett (2000).

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19 Relationships between monetary policy and the stock exchange

Chart 19-4: Performance of state-owned companies after privatisation160 25

Per cent

100

Dividend

Decrease in leverage

Employment

Income

Investment

Efficiency

Profitability

Average rate of change (%, left-hand scale) Ratio of companies showing improvement (%, right-hand scale) Source: Megginson–Netter (2001).

In Hungary, their sale on the stock exchange as part of the privatisation wave of the 1990s provided major benefits for the companies concerned in terms of competitiveness, innovation, and the buildup of the capacities required for development. The registered offices of the companies privatised on the BSE, and consequently their centres for key business decisions requiring highly qualified management and professional staff, remained in Hungary, which generated further substantial returns at the level of the national economy. Although no empirical data are available on the benefits derived by Hungary from sharing state ownership with exchange investors, the advantages of the 160

ggregating the results of three studies, the average indicator of the three years folA lowing privatisation as compared to privatisation, as follows: “profitability” means the difference in the ratio of profits after tax to sales, in percentage points; “efficiency” means the difference in the ratio of sales to number of employees, in percentage points; “investment” means the difference in the ratio of investments to sales, in percentage points; “sales” means the difference in sales, in percentage points; “employees” means the difference in the number of employees, in percentage points; “leverage” means the difference in the ratio of debt to total assets, in percentage points, and “dividends” means the difference in the ratio of distributed dividends to sales, in percentage points.

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exchange sales channel for the national economy are aptly illustrated by the fact that since their sale on the stock exchange in the mid-1990s, the value of the three largest listed companies currently qualifying as blue chips has multiplied 20 to 80 times. While state-owned companies and large corporates comprise a finite set with a direct and meaningful impact on exchange development, the BSE also seeks to provide a solution tailored to small and medium-sized enterprises. In itself, directing SMEs to the capital market will not resolve the problem of declining capital market trading volumes and market capitalisation, but will provide support for the build-up of the ecosystem, and for laying the foundations of larger transactions in the regulated market. Given that experience to date shows that the regulated market imposes an excessive burden on SMEs, a new SME market to serve their needs is set to be developed in the form of a multilateral trading facility (MTF). A restricted funding platform and a crowd-funding platform are also scheduled to be set up at a later stage. In the SME market, quality assurance is of particular importance, which will be provided through the establishment of a dedicated consultancy structure. Dedicated consultants perform two functions: first, they support the company in its preparation from the very beginning of the IPO process; and second, they provide investors with a certain guarantee that the issuers entering the SME market will be of good quality and adequately prepared. For medium-sized enterprises wishing to become more embedded in the capital market, the BSE offers an attitude-shaping programme jointly with ELITE, which operates as part of the London Stock Exchange. The programme was designed to help mature companies that are still in a strong growth phase to change their attitudes, and to become embedded in the corporate financing ecosystem. In the corporate life cycle, there is a growth problem that is well documented in international literature, referred to as the founder’s trap.161 This 161

he term “founder’s trap” is attributable to Ichak Adizes, but the concept is featured T in all corporate lifecycle models. A summary of corporate lifecycle models is provided e.g. in Zsupanekné (2004).

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19 Relationships between monetary policy and the stock exchange

is the stage at which the company faces the greatest challenge in organisational and strategic terms, because at this point a strong need arises to place the organisational and economic operations of the company on new foundations. What was an advantage at the initial stages of the corporate lifecycle becomes a drawback by this time: centralised decision making, a short-term approach with an exclusive sales focus, the absence of internal rules and standards, and ill-advised corporate financing are all capable of halting or even reversing a strong growth path. In Hungary, the presence of the above set of problems is probably even more marked than in western countries. Namely, in the Hungarian corporate structure there is a painful absence of companies that have passed the “founder’s trap” and have approached the large corporate status in their attitude, and thus have, for instance, independent management, stable operations, internal regulations and standards, and a mature organisational structure. Most situation analyses on the Hungarian SME sector162 give focus to the absence of “strong mediumsized enterprises”, which is also striking in comparison to the EU. The commitment of the Hungarian government to exchange-related objectives is demonstrated by its decision to set up the National Exchange Development Fund with an initial contribution of HUF 20 billion worth of public funds. The equity fund aims to provide effective and efficient support for the capitalisation of Hungarian SMEs, and for enabling them to meet the listing criteria. The fund carries out equity investments with the specific objective of ensuring that portfolio companies use those investments in part to finance their listing preparations. This could include any activity, from financing the consulting fees for internal processes reengineering to the cost of approving the admission document that supports the development of the “investor story”, and consequently a successful IPO.

162

Cf. e.g. Békés–Muraközy (2012).

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19.3.2 The secondary market: the importance of information

A substantial part of the shares of companies listed on the Budapest Stock Exchange is held by international institutional investors. This provides an investor base that is less stable, given that such investors may significantly improve price volatility through their ability to exert, relative to the size of the Hungarian market, immediate and concentrated selling or buying pressure in the event of a sudden change in the market environment. Apart from increasing trading volumes and market capitalisation, it is also appropriate to create a more balanced investor base. This can be achieved primarily by increasing the share of Hungarian exchange-traded equity holdings in the asset portfolios of domestic institutions and households, while sustaining the interest of international investors. In terms of equity holdings by small investors (households), the effect of failing to develop the market has been obvious in the past two decades. Direct holdings of domestically issued equities account for less than 1 per cent of households’ financial instruments, while the same ratio was close to 5 per cent at the end of 1997 (Chart 19-5). Taken together with holdings of foreign equity, the ratio is still below 2 per cent, whereas the EU average is above 10 per cent. Presumably, the low ratio of households’ equity holdings is not a result of deliberate risk aversion, because even small investors may derive benefits from a long-term savings portfolio that is adequately diversified and includes a sufficient amount of exchange-traded assets. The BSE seeks to increase its role in enhancing investor confidence, which is why it finds it particularly important to boost households’ confidence in the money and capital market as a whole, its institutions, and way of operation. In that process, a key role is occupied by the development of financial literacy and financial awareness, supported by the reinforcement of a long-term approach of conscientious selfprovision and portfolio management, and by assistance for households with the acquisition of the ability to choose from various forms — 680 —

19 Relationships between monetary policy and the stock exchange

of savings. Launched in 2016, the BSE Academy initiative gives prominence to the above principles. Chart 19-5: Holdings of domestically issued equities as a percentage of households’ financial instruments 6

Per cent

2004

2003

2002

2001

2000

1999

1998

The proportion of households’ financial assets held in domestic issuance Source: MNB.

Exposure to domestic equity is also low in the portfolios of domestic institutional investors. Based on data from the Association of Hungarian Investment Fund and Asset Management Companies (BAMOSZ), in 2016Q1 domestic fund managers had just over 10 per cent of their managed assets invested in equities. In the case of health funds and insurers, this ratio was somewhat higher at 18 per cent. This fundamentally low amount reflects even more negatively in terms of the amounts invested in domestically issued equity, amounting to a mere 1.8 per cent of all invested assets in the case of investment funds, and 3.8 per cent in the case of health funds and insurers.

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Summary For central banks as institutions responsible for monetary policy and financial stability, the efficiency of capital markets is of particular importance. As part of the transmission mechanism, the asset price channel has several ways to influence the achievement of monetary policy objectives, which warrants that consideration should also be given to the functioning of this channel for decision making purposes as well. Additionally, central banks have a clear vested interest in ensuring that an efficient capital market ecosystem provides for multipolar corporate financing, since this means greater growth potential and more stable operations for companies, and, as a result, ultimately for the national economy as well. In Hungary, the development of capital markets is impeded by institutional and scale-efficiency problems, which the Budapest Stock Exchange, supported by the background of central bank ownership, seeks to resolve through a number of initiatives. The opportunities inherent in the capital market are best exploited through more intensive product development, proactivity, and information. However, with a view to the development of the exchange, it is essential that such efforts are accompanied by additional government participation on both the issuer and the investor side.

Key terms capital market capital market ecosystem equity market exchange

MTF market primary market secondary market

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19 Relationships between monetary policy and the stock exchange

References Banai, Á. – Erhart, Sz. – Vágó, N. – Varga, P. (2016): A tőzsdeképesség vizsgálata a magyar kisés középvállalati szektorban (How to Set Listing Criteria for Small and Medium-sized Enterprises in Hungary?). Financial and Economic Review, 15(3), September 2016, pp. 79–109. Békés, G. – Muraközy, B. (2012): Magyar gazellák (Hungarian Gazelles). Economic Review, vol. LIX., March 2012, pp. 233–262. Barnett, S. A. (2000): Evidence on the fiscal and macroeconomic impact of privatization. IMF Working Paper No. 00/130. Bloomberg News (2016): China Said to intervene in Stocks After $590 Billion Selloff. 5 January 2016. Online: https://www.bloomberg.com/news/articles/2016-01-05/china-said-to-intervene-instock-market-after-590-billion-rout Damodaran, A. (2005): Marketability and value: Measuring the illiquidity discount. Das, S. R. – Jagannathan, M. – Sarin, A. (2003). Private Equity Returns: An Empirical Examination of the Exit of Venture-Backed Companies (Digest Summary). Journal of Investment Management, Vol. 1, No. 1 (2003), pp. 1–26. Kitanaka, A. – Nakamura, Y. – Hasegawa, T. (2016): The Bank of Japan’s Unstoppable Rise to Shareholder No. 1. 14 August 2016. Online: https://www.bloomberg.com/news/ articles/2016-08-14/the-tokyo-whale-s-unstoppable-rise-to-shareholder-no-l-in-japan Koeplin, J. – Sarin, A. – Shapiro, A. C. (2000): The private company discount. Journal of Applied Corporate Finance 12.4, pp. 94–101. Kooli, M. – Kortas, M. – L’her, J. F. (2003). A new examination of the private company discount: The acquisition approach. The Journal of Private Equity, 6(3), pp. 48–55. Megginson, W. L. – Boutchkova, M. K. (2000): The impact of privatisation on capital market development and individual share ownership, pp. 71–93. Palotai, D. – Virág, B. (2016): Versenyképesség és növekedés (Competitiveness and Growth). Magyar Nemzeti Bank. Yam, J. (1998): Why We Intervened. Published in the Asian Wall Street Journal on 20 August 1998. Online: http://www.hkma.gov.hk/eng/key-information/speech-speakers/jckyam/ speech_200898b.shtml Zsupanekné, P. I. (2011): A vállalati növekedés a vállalati életciklus-modellek tükrében (Corporate Growth in the Light of Corporate Lifecycle Models). Online: http://elib.kkf.hu/okt_publ/tek_2007_04.pdf

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Part III

Changes in the Hungarian regulatory policy

Macroprudential policy in the foreground

The theoretical basis of using macroprudential instruments Anikó Szombati

The objective of macroprudential policy is to mitigate excessive systemic financial risks. Thereby, macroprudential policy helps prevent large financial crises and reduce losses in the real economy caused by financial crises that nevertheless happen. According to one of the bitter lessons from the global financial crisis that erupted in 2008, the stability of individual financial institutions in itself does not guarantee that systemic financial risks are mitigated as well. Therefore, currently macroprudential policy with a systemic focus is being strengthened all over the world. Systemic financial risks are caused by specific and inherent features of financial intermediation. The majority of organisations engaged in financial intermediation operate using external funds and perform complex activities. Therefore, the relevant information is distributed unevenly among economic actors engaged in financial intermediation, which constitutes a major impediment to market participants in limiting the excessive risk-taking of financial intermediaries. Usually, the escalation of excessive risk-taking is also prompted by the irrationally reduced general risk perception in the financial system. Furthermore, among financial institutions in the financial network often not formed prudently enough, the crisis phenomena of individual institutions spread too easily to others. The market frictions of financial intermediation intensify business cycles and they themselves can also cause financial crises entailing substantial losses in the real economy. Thus macroprudential policy requires a number of instruments of its own, in view of the targeted mitigation of the various systemic risks caused by various market imperfections. These instruments can — 689 —

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be divided into three groups: (1) additional capital buffers, (2) liquidity buffers and instruments limiting excessive maturity mismatch and (3) debt cap rules. Since the mitigation of financial systemic risks is part of general macroeconomic stabilisation, macroprudential policy has to be adequately coordinated with other policies as well. Due to the variety of instruments and the coordination with other policies, establishing the appropriate institutional system of macroprudential policy is essential. The duties of central banks have already included maintaining financial stability in addition to pursuing monetary policy, therefore they have a wide range of financial data and relevant expertise and experience. Accordingly, they have played a major role in shaping the macroprudential interventions that have intensified since the Financial Crisis.

20.1 Introduction The magnitude of economic losses caused by the global financial crisis163 that erupted in 2008 demonstrated the crucial importance of the stability of the financial system in the proper functioning of a country’s economy. The crisis underscored that microprudential interventions alone are unable to prevent the financial disturbances that inflict heavy losses on the real economy. Therefore, the systemic focus of prudential interventions in the financial system has to be bolstered, i.e. macroprudential policy needs to be strengthened. According to one of the bitter lessons of the crisis, stability of individual financial institutions in itself does not provide an adequate guarantee for the stability of the financial system. In terms of the whole system, the manner in which the riskiness of individual financial institutions affects each other may have special significance. The contagion effects among 163

he reasons behind the emergence of the global financial crisis are discussed in T more detail, for example, in the first part of Acharya and Richardson (2009) the second chapter of Dewatripont et al. (2010) and Rajan (2010). The timeline of the US crisis is presented in detail, for example, by Gorton (2010). Laeven and Valencia (2013) and Reinhart and Rogoff (2009) provide a recent summary of the general lessons learnt from the financial crises.

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financial actors, for example, are able to expand an originally local financial stress to a systemic problem. The state focusing exclusively on the stability of individual institutions may easily overlook the fact that institutions in dire financial straits improve their situation by passing on their problems to other institutions. This may happen for example when individual banks are required to comply with liquidity buffer requirements, because low aggregate liquidity may entail a fire sale of the less liquid assets of certain banks at depressed prices. Macroprudential policy maintains the stability of the whole financial system, and it has to be made more conscious, systematic, thorough, strict and internationally coordinated as compared to the pre-crisis situation. Although this process got under way shortly after the eruption of the crisis, leading to fundamental changes both at the international and the national level, at the time of writing there are still several opportunities for progress. Therefore, this chapter will present systemic financial risks and the market problems triggering them, the potential instruments of a successful macroprudential policy, and the dilemmas of its institutional framework.

20.2 The ultimate objective of macroprudential policy164 Macroprudential policy should strive to prevent severe financial crises and minimise their effects on the real economy, if they nevertheless arise. In more precise economic terms, the ultimate objective of macroprudential policy is to mitigate excessive systemic financial risks (Chart 20-1).165

164 165

his subchapter is based on Subchapter 2.1 of MNB (2016). T T he currently available most recent theoretical and empirical basis of macroprudential policy can be found in Freixas et al. (2015).

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Chart 20-1: The ultimate objective of macroprudential policy Shortcomings of public interventions

Correcting market frictions

Avoiding significant losses on the real economy

Inherent feature of financial intermediation

MITIGATING

EXCESSIVE

SYSTEMIC

FINANCIAL RISKS

U lti ma te obj e cti ve of ma croprud e n t ial po l ic y Se ve ra l ma rk e t fri cti on s

Reg u l ato r y re gi me of “multi ple obj e ctiv e s – m ul t ipl e in s t rum e n t s ” Source: Adapted from Chart 1 of MNB (2016).

All elements of the more precise definition of the ultimate objective are important. Generally, systemic financial risks are risks when disturbances of the financial intermediary system substantially harming the whole economy happen with a significant probability. That is, the fundamental objectives of macroprudential policy do not include the prevention of all minor financial turbulences. However, those that entail substantial losses in the real economy need to be mitigated as much as possible. Financial crises are often preceded by widespread excessive lending or asset price bubbles. Participation in excessive lending or investments based on unjustified price increases entails the risk of losses for the given financial institution. This risk becomes systemic if the losses are large and probable enough for financial intermediation to be significantly disrupted or possibly come to a halt when it is realised. Systemic financial risks would be present even in the context of efficiently functioning financial intermediation. However, due to market — 692 —

20 The theoretical basis of using macroprudential instruments

frictions and market failures that emerge without macroprudential intervention, systemic financial risks may be heightened. Therefore, macroprudential policy should mitigate excessive systemic financial risks, primarily by correcting market frictions and failures. Financial intermediation is affected by three main market problems: the asymmetric information of financial actors, varying risk perception and the negative externalities of financial institutions caused by each other. These market problems and the entailing systemic financial risks are presented in more detail in the next chapter. Consequently, financial systemic risks are not exogenous, they emerge endogenously, triggered by certain incentives, as a result of the decisions taken by financial actors. The task of macroprudential policy is not to manage the financial crises that erupt on account of the systemic risks that have emerged, but to mitigate the extent of systemic risks by influencing the incentives, thereby reducing the probability and severity of financial crises. Crisis management itself has to take into account the way it modifies the incentives driving the emergence of systemic financial risks. Macroprudential policy cannot be used to fully eliminate excessive systemic financial risks, only to mitigate them considerably. This is because public interventions are usually unable to completely identify and offset market problems, since those taking part in the intervention have to struggle with a huge lack of information that is difficult to reduce. Although research gained momentum with the eruption of the great financial crisis, amassing huge amounts of relevant information, the exact transmission mechanisms of the main market problems causing systemic risks are still not known completely. Furthermore, the phenomena that have already been identified cannot always be measured accurately, therefore they are difficult to monitor correctly. Another important difficulty arising out of the lack of information is that the behaviour of economic actors cannot be altered through public intervention as desired. Economic actors know the circumstances determining their behaviour much better than those shaping regulation. The economic actors are expected to use their informational advantage — 693 —

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to pursue their own interests, which does not always foster socially optimal regulation. Thus, it is important that realistic social expectations be formed with respect to macroprudential policy. We should endeavour to achieve a situation where market developments and public interventions complement each other appropriately, i.e. where their combined deficiencies lead to as few social losses as possible. Poorly focused or unjustified needs may lead to some market problems being corrected inadequately or entailing too many unwelcome side effects. Successful and efficient macroprudential policy significantly mitigates the probability and extent of financial crises – thereby contributing to sustained economic growth as well – by improving the situation of many economic actors.

20.3 The types of systemic risks and the market problems causing them166 Systemic financial risks are traditionally divided into two types: cyclical and structural systemic risks (Table 20-1). The presence of market imperfections in financial intermediation and the increasingly low risk perception encourage financial institutions to take on greater and greater risks, which ultimately gives rise to excessive risk-taking. Often as a result of external shocks, negative events are realised in the case of a critical part of these systemic risks. In a financial crisis, the excessive risk-taking of financial intermediaries is replaced by excessive risk aversion. Cyclical systemic risks mean that the risk-taking of financial intermediaries moves together in a direction that is either higher or lower than the optimal level.

166

This subchapter is based on Subchapter 2.2 of MNB (2016).

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Table 20-1: Summary table of systemic financial risks and the underlying market imperfections

Forms of systemic risks

Underlying market frictions

CYCLICAL SYSTEMIC RISKS

STRUCTURAL SYSTEMIC RISKS

Misaligned incentives stemming from asymmetric information ● Limited liability, large leverage, and complexity ● Relative performance evaluation ● State support in financial stress situations Time-varying risk perception ● Wealth and income dependent risk preferences ● Limited memory and attention, selective information processing

Negative externalities between financial organizations ● Information and interests exist only in bilateral relationships in the network of financial organizations

● Excessive lending ● Excessive leverage ● Exacerbation of maturity mismatch ● Exacerbation of currency mismatch ● Asset price bubbles

● Contagion through counterparty risk ● Fire sales ● Aggregate liquidity shortage ● Feedbacks from real economy ● Risks from concentration

Effect They may cause financial crises

They may exacerbate financial crises

In a financial crisis, problems related to the network that links financial actors to one another also surface. As a result, financial crisis phenomena can spread like wildfire between financial entities (“contagion effect”). Structural systemic risks are the crisis amplifier effects stemming from the structure of the interconnections between financial actors and from the riskiness of certain financial actors in the network.

20.3.1 Market problems causing cyclical systemic risks

The cyclical emergence of systemic risks is mainly attributable to the difficulties in providing incentives due to asymmetric information and risk perception that changes over time (Chart 20-2). First, we will present the situations involving asymmetric information that are hard to avoid in financial intermediation, where the decisions of financial intermediaries optimal at the individual level do not create efficient

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financial intermediation.167 The uneven distribution of information among the participants in financial intermediation encourages a portion of the agents to take on excessive risks in normal times, which may lead to the emergence of cyclical systemic risks. • Limited liability, high leverage and complex functioning. Among the funders of every company, owners have the most tools for influencing the management of the company. This is because owners are last in line when it comes to receiving a share of the company’s revenue, therefore the risk of the company’s profitability is mainly borne by them. This is a moral hazard situation, where lenders, who are at an informational disadvantage compared both to owners and to management, are exposed to the consequences of the decisions taken by the owners influencing corporate governance. The depositors and lenders of the companies engaged in financial intermediation may be hurt by this situation due to the combined effect of three important factors. First, in order to prevent the substantial risks accompanying financial intermediation making it impossible to create new companies, the owners’ liability is limited, they can only lose their capital in the company. Second, in financial intermediation it is inevitable that the majority of the activities are financed by deposits and debts instead of capital. Third, banks are often large and perform complex activities, while not only receiving funds from professional investors but also managing many laypeople’s savings. Therefore, asymmetric information between depositors and owners is typically huge, and the many retail depositors face substantial collective choice problems when taking action in their own interest. Accordingly, a large portion of the losses of a financial intermediary that may become insolvent are born by the depositors and lenders who have relatively small influence over business decisions, but the potential profits are due to the owners. Thus the management, mainly 167

For more details, see Chapter 4 of Freixas et al. (2015) and Freixas et al. (2008).

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controlled by the owners, is prone to excessive risk-taking for the benefit of the owners and at the expense of lenders and depositors. Chart 20-2: Market problems underlying cyclical systemic risks Time-varying risk perception

T a x p a y e r s Moral hazard (state support in financial stress situations)

Fin. int. D D

Financial institution stakeholders Owners

Debtors Depositors

Fin. int. D D

Moral hazard (stronger control of owners compared to debtors and depositors)

Management

Herd behaviour (relative performance evaluation)

Adverse selection (screening) Moral hazard (monitoring)

Borrowers

Source: MNB (2016) Chart 2.

• Relative performance. The behaviour of financial intermediaries may speak volumes about the information not directly accessible to outsiders. However, this does not always foster the dissemination of useful information and appropriate decision-making, as in certain cases it may lead to herd behaviour and mutual misleading. The latter has three main types.168 • The first is when all financial intermediaries have information about the currently most profitable business opportunities that is incomplete in itself and only observed by them. If some market participants engage in a similar business strategy, this may easily 168

These are presented in more detail for example in Bikhchandani and Sharma (2001).

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lead to herd behaviour. All financial intermediaries that later start to copy the business strategy could think that enough companies are convinced about the profitability of this business strategy to believe them, rather than its own potentially conflicting information. Therefore, the emerging market practice will only appropriately reflect the information of early joiners in contrast to those joining later. Accordingly, excessive risk-taking may become widespread even if based on information available to the majority of market participants that one should not engage in excessive risk-taking. • The other scenario is based on the fact that the owners of financial institutions cannot completely control the management of the organisation, which is a moral hazard situation, since the owners are at an informational disadvantage compared to the management. The owners are forced to motivate management primarily based on observable performance of the organisation instead of directly influencing managers’ decisions. In this respect, they usually apply relative performance measures comparing their own financial organisation to similar others. Examples for this include the remuneration of managers linked to market share or profitability exceeding the industry average, or when stock market investors invest in the more profitable firms among similar companies. However, relative performance measures may also encourage correlated risk-taking, which may exacerbate excessive risktaking. In such a situation, individual managements are less prone to make decisions running counter to market trends, since if they prove to be misguided in the end, their potential income is reduced by the financial institution led by them falling short of the industry’s average performance. This may be true even if, according to the information of the individual managements, market trends are unjustified, i.e. herd behaviour may emerge. Correlated risktaking is also encouraged by the fact that systemic risks heighten as a result, and thus the possibility of collective insolvency increases.

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This lowers the risk perception of the managements, since due to relative performance assessment, the individual income cuts in these cases are lower compared to the case of individual insolvency. • In the third case, the steps taken by financial experts in order to boost their professional reputation lead to herd behaviour. A typical example for this case is illustrated here. Better informed, more diligent and efficient financial experts are more aware of the better investment opportunities than less effective experts. However, these advantageous characteristics cannot be completely observed by outsiders. Therefore, the employers of financial experts only know that the investments considered good by the better experts vary less than in the case of less effective experts. In such a situation, the lack of success of an investment practice running counter to market trends suggests that the financial experts following that investment practice are poorly qualified, which may considerably undermine the career opportunities of those concerned. Thus financial experts worrying about their professional reputation will be much more wary of such decisions even when their opinion that market trends are misguided is justified. This also leads to correlated risk-taking that can intensify excessive risk-taking. • State support in a financial crisis. The previously mentioned incentive problems are not moderated by deposit insurance, central banks’ role as the lenders of last resort and the potential state capital grants provided to financial institutions during the financial crisis, in fact, they can exacerbate them. Deposit insurance protects banks’ management from one of the most powerful opportunities for depositors for pressuring banks, i.e. from large-scale deposit withdrawals by depositors believing that their money is jeopardised. Central bank liquidity assistance and bank bailouts169 may also The resolution proceedings that were improved in several respects after the great financial crisis may help resolve the dilemma between liquidating banks and bank bailouts, since they provide a middle road for reorganising nearly insolvent banks without using public funds in a way that ensures that the bank can perform its basic functions all throughout the process.

169

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contribute to bank managements’ ex-ante risk appetite, since they reduce ex-post losses. The state that represents the interests of taxpayers also makes these decisions in a moral hazard situation, since it knows less about the details of bank operation than bank managers, while the bank managements are prone to excessive risktaking, the consequences of which may lead to huge amounts of public funds being used. The general lesson from this is that ex-post public interventions and crisis management substantially influence the emergence of cyclical systemic risks. Therefore, ex-ante and expost public interventions need to be adequately coordinated. Box 20-1 The three typical cases of asymmetric information

The types of asymmetric information in economic transactions fall into a few general theoretical categories. The special cases emerging in financial intermediation and described in the body text can be divided into the following three general categories.170 • Adverse selection. This denotes the exchanges where one party knows more about the material features of the subject of the exchange than the others. This is the problem of “hidden information”. The term refers to the threatening consequence of such situations, namely that in the exchange process, only products and services of poorer quality become available to the actors at an informational disadvantage. For example in the case of a loan contract, the bank can observe the factors influencing the creditworthiness of the borrower less accurately than the borrower (the expected returns on the company’s investments, an individual’s unemployment risk etc.). Since all borrowers seek to appear as reliable as possible in order to obtain better contractual terms, the bank is right to suspect that there exists some information suggesting the poor 170

he comprehensive analysis of economic situations characterised by adverse T selection and moral hazard can be found in Laffont and Martimort (2002), Bolton and Dewatripont (2005), and Salanié (2005). Hirschleifer and Teoh (2003) provide a basic overview about the models of herd behaviour.

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creditworthiness of the client unobserved by the bank. If the bank had no tool to differentiate between clients based on their creditworthiness, it would only be willing to lend at unfavourable terms (e.g. high interest rate), which would be taken out only by less reliable clients. • Moral hazard. It emerges in exchanges where one party can alter a material feature of the subject of the exchange in a way that is unobservable by the others. The term refers to the fact that the parties at an informational disadvantage are at the mercy of the good faith of the party at an informational advantage. In short, this is the problem of “hidden action”. In the typical example of the moral hazard in lending, the bank can observe the efforts of the borrower for repaying the loan only to a limited extent. As can be seen from the example of lending, adverse selection and moral hazard often appear together in a contractual relationship. Adverse selection emerges ex-ante, i.e. in the situation before concluding the contract, while moral hazard arises in an interim manner, during the performance of the contract. • Herd behaviour. It can emerge in a situation where the members of a group of economic actors have some information that is unobservable to the other group members with regard to an economic phenomenon important to all of them. Herd behaviour arises if the individual members of the group start to copy the observable behaviour of the others excessively, in the belief that the behaviour of the others is based on information more accurate than their own. This process may lead to the poor use of information dispersed among the individual economic actors if too many agents act contrary to their own private information.

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In addition to the various incentive problems arising out of asymmetric information, the changing risk perception over time of financial actors can also contribute to the heightening of cyclical systemic financial risks. The following forms are typical. • Time-varying risk perception. In the case of a general economic upswing, economic actors may be less risk-averse, since the better financial situation or the higher income give them a sense of security. In addition, economic actors with bounded rationality remember previous crisis events less, which may dampen their sense of fear (“disaster myopia”). Second, they are more likely to disregard events with a very low probability and in the more distant future. Third, they may process information selectively in order to maintain their own beliefs, which may either mitigate or strengthen their risk perception. It has to be noted that time-varying risk perception is often created by time-varying risk preferences. In the context of risk preferences changing over time, it is less clear what counts as excessive risk-taking, since in such a situation more risk-taking may emerge not only as an undesirable side effect of financial intermediation but also as a result of the intentions of the individual decision-makers. One might ask whether macroprudential intervention should be used in such a case to mitigate risk-taking. The answer is usually yes. This is because previously less risk-averse decision-makers may later regret their earlier risk-taking if they become more risk-averse. Therefore, macroprudential policy can represent some kind of average of the individual decision-makers’ preferences varying over time instead of their current preferences.

20.3.2 The types of cyclical systemic risks

Due to their size, expertise and the data available to them, credit institutions are often more efficient in choosing projects with a positive net present value and monitoring borrowers than individual savers. Credit institutions taking on excessive risks perform this task — 702 —

20 The theoretical basis of using macroprudential instruments

suboptimally. They provide loans at conditions that are too loose and also for projects with poor returns, not monitoring them thoroughly enough, i.e. they engage in excessive lending. One special form of this is when funding continues to be provided to bad debtors and projects even after their poor quality has become clear to the bank’s management (“zombie lending”). An excessive risk-taking bank management defers the losses that are expected to become even larger, in the hope of the unlikely event that the quality of the debtor or the project improves considerably over time. Excessive lending by individual credit institutions in itself does not necessarily pose a systemic risk. This requires the aggregate amount of excessive lending exceeding the critical level where debt problems entailing threaten with enormous losses in the real economy. Among the mentioned market frictions, this critical level can be exceeded especially easily as a result of time-varying risk perception and herd behaviour. The former is able to trigger the self-reinforcing process of greater risk-taking, and the latter encourages market participants to mutually reinforce each other’s excessive risk-taking. In line with the previously mentioned factors, it is important to note that excessive lending is mainly the result of the excessive expansion of credit supply. Greater credit demand due to a general economic upswing is not necessarily coupled with credit institutions’ excessive risk-taking, therefore the cyclical systemic financial risks do not necessarily heighten. Thus lending activity changes in tandem with business cycles, but this is not necessarily the case with respect to excessive lending. The example of excessive lending demonstrates that financial and business cycles may diverge. In a similar fashion, growing lending as a result of the development of the financial system does not automatically mean excessive lending, especially in a converging economy. Financial intermediaries taking on excessive risks seek to increase their leverage as well, since in this way owners can pass on a greater portion — 703 —

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of the risk to the depositors and lenders of the financial intermediary, while retaining most of the expected profits for themselves. Funds for excessive lending can often only be acquired by creating an increasing maturity and currency mismatch. As a result, banks can perform their role in transforming maturities and risks and in managing liquidity risk more and more poorly. Excessive lending often fosters the formation of asset price bubbles if excessive lending is concentrated in certain sectors, a typical example for which is the real estate market. Then, excessively appreciating asset prices can further bolster excessive lending through the appreciation of loans’ collateral.

20.3.3 Market problems causing structural systemic risks171

The worsening financial crisis situation is mainly attributable to the negative externalities among individual financial institutions. It is a special feature of the financial system, that even competing organisations conduct various transactions with each other, therefore a network consisting of a wide range of business relationships is formed among them. However, when establishing their business connections, individual organisations do not appropriately consider whether they contribute to or mitigate the spread of the financial crisis in the financial system’s network. They do not have enough information about the role played by their business partners in the network, and they are not interested in taking into consideration the financial stability of the organisations further away from them in the network (“negative externality”). The previously mentioned lack of information can be substantially increased if the mediation and settlement of transactions and the allocation of risk among the counterparties is not standardised and does not happen in a transparent manner.

171

For more details, see Chapter 5 of Freixas et al. (2015).

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20.3.4 The types of structural systemic risks

The following main contagion effects can arise in financial networks. The individual contagion channels do not function independently from each other, they can be interconnected in various ways. • Spreading counterparty risk. The value of the receivables against a bank in financial distress or bankruptcy is reduced. This causes a capital loss and thus increases leverage at the financial institutions holding such assets. Accordingly, the receivables against the organisation that therefore become more vulnerable also lose some of their value. The process may be exacerbated by the rapid deterioration of expectations, since no financial institution knows the exact quality of the assets held by its partners, thus distrust may emerge vis-à-vis the organisations less affected by the contagion (“adverse selection” and “herd behaviour”). • Fire sales. In order to regain their capital adequacy ensuring stability, financial institutions that become vulnerable start to sell their assets prematurely and in large quantities. This generates a prisoner’s dilemma, since at the individual level everyone is interested in the rapid sales that therefore occur at relatively higher prices, but ultimately in the absence of adequate demand, the majority are only able to achieve very low prices. The heavily depreciating asset prices then affect the organisations that were originally not forced to sell (“pecuniary externality”). • The exacerbation of aggregate liquidity shortage. Before a crisis, banks are prone to stretch their maturity structure, i.e. they increasingly finance their longer-term, illiquid assets from funds rolled over in the short term. In the case of financial distress, these organisations cannot be sure whether the frequent fund rollover will be uninterrupted, therefore they strive to accumulate as much liquidity in as short a time as possible. This process exacerbates the aggregate liquidity shortage, which may trigger fire sales in the case — 705 —

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of the organisations left without liquidity, generating the already mentioned negative spillover effects as well. • Real economy feedback. In a crisis situation, banks lend less, which improves their capital and liquidity position at the same time. The greater the pre-crisis excessive risk-taking and the stronger the effects of the financial network amplifying the contagion, the more lending during the crisis diminishes. In a financial crisis, this excessively restrained lending causes the greatest losses in the real economy. Economic activity declines and unemployment rises, which further exacerbates the problems of the financial system through debtors’ deteriorating solvency. Thus, the individual financial institutions can influence each other’s stability through the real economy by means of their lending practices, albeit only indirectly. • The impact of systemically important financial institutions. The structure of the financial network fundamentally influences the path, speed and extent of the contagion’s spread. Organisations more central to the network or those that are larger and more complex threaten financial stability more, and in some cases they are exposed to greater risks. Limiting the excessive risk-taking of these systemically important institutions is key, because if they are in financial distress, they alone can trigger a financial crisis that causes heavy losses to the real economy.

20.4 The instruments of macroprudential policy As can be seen from the previous section, systemic financial risks come in various forms, due to the fact that there are various market frictions and market failures in the financial system at the same time. Accordingly, macroprudential policy, which mitigates systemic risks, can only be successful if it intervenes in the functioning of the financial system with the appropriate number of various tools targeting well

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the given systemic risk. Thus macroprudential policy is characterised by a “multiple objectives, multiple instruments” regulatory regime. In view of the fact that the international regulatory practice develops constantly, no widely accepted and applied set of regulatory instruments have become established yet. Below we will give a brief overview of macroprudential policy’s regulatory instruments considered typical that have already emerged in its international regulatory framework and partly also in international practice.172 There are several such instruments, therefore we will present them in groups. The basis of the categorisation is the direct subject of the instruments. In line with that, we will discuss capital requirements, liquidity and maturity mismatch requirements, and debt cap rules. When presenting the instruments, we focus on their definition, objective and transmission mechanism, mentioning adverse side effects as well.

20.4.1 Additional capital requirements

By increasing the capital requirements of financial institutions, macroprudential policy passes on a larger share of systemic risks’ potential negative consequences to owners. Excessive financial systemic risks are largely caused by the fact that the owners of the organisations performing financial intermediation bear the negative consequences of the risks less than they should. Since the other stakeholders cannot even rely on the help of the market competition between financial institutions in making the owners share the potential losses with them to the appropriate extent, public intervention is necessary to ensure this. One of the main tools for raising owners’ interest is when they have to finance a larger portion of financial

172

or a more detailed discussion of the generally applied or recommended macroF prudential instruments, see Cerutti et al. (2016), CGFS (2012), ESRB (2014), IMF (2013a) and World Bank (2014).

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institutions’ operation, i.e. when the capital requirements for financial institutions are higher. The additional, macroprudential capital requirements can mainly strengthen the resilience of the banking system as a whole (Chart 20-3). In a financial crisis, the volume of non-performing loans rises, and financial assets depreciate. This causes massive losses to the financial institutions. These losses are also covered by the macroprudential capital buffers created in normal times from the owners’ money. According to the current international practice, macroprudential policy only specifies capital requirements in addition to the requirements determined in microprudential regulations for banks and investment firms. In line with the fact that the stability of financial institutions does not guarantee the stability of the whole financial system, microprudential capital requirements in themselves may prove inadequate in providing the necessary resilience to systemic risks. This is why macroprudential, additional capital requirements are necessary. The greater resilience of the banking system to financial shocks prevents taxpayers and other actors in the real economy from heavy losses. The losses affecting banks strengthened with macroprudential capital reserves are less able to disrupt banks’ operation. In the case of minor shocks, banks can comply with regulatory liquidity and capital requirements without excessively restraining their risk appetite and lending activity. They are also not forced to sell their assets in large quantities, rapidly and at depressed prices. In the case of larger shocks, more serious liquidity or solvency problems emerge in fewer banks. Banks that maintain their relatively stable operation do not require liquidity assistance from central banks, payments from the deposit insurance scheme, resolution proceedings or capital injections from the state. This helps to avoid major interruptions in financial intermediation as well, thereby reducing the losses in the real economy caused by

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20 The theoretical basis of using macroprudential instruments

financial stress. Furthermore, the use of large amounts of public funds also becomes unnecessary. Since both the probability and the extent of the financial crisis are determined by the size of systemic financial risks, the amount of macroprudential capital buffers should be required in proportion to systemic risks. The different capital reserves mitigate the consequences of different systemic financial risks. There are four major types. • Countercyclical capital buffer. Capital buffer for mitigating the negative consequences of all kinds of cyclical systemic risks. All banks are required to accumulate it in a fixed ratio of their risk-weighted assets. According to international experience, excessive lending is the main cyclical systemic risk that is also easily measurable. Therefore, in practice, the build-up of the countercyclical capital buffer is determined according to the indicators called credit-to-GDP ratios, i.e. the deviation of ratios of credit aggregates to GDP from their long-term trends. • Direct and indirect sectoral capital requirements. Even a cyclical systemic risk not considered substantial in terms of the financial system as a whole may cause systemic problems if it is concentrated in some sectors of the economy. In such a case, the countercyclical capital buffer does not provide an adequate cushion of capital for the banking system. The sectoral capital buffer is the additional capital requirement determined as a ratio of banks’ risk-weighted exposure to these sectors. It is important to note that sectoral capital requirements may be applied indirectly as well. In such a scenario, establishing a floor to the risk weight of the given assets or the relevant loss given default results in a capital buffer requirement. • Capital buffer of systemically important financial institutions (SIFIs). These capital buffers are only required from systemically

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important banks. This capital buffer is also determined as a ratio of the whole risk exposure, but this ratio varies across banks in line with the systemic importance. In today’s international practice, banks’ systemic importance is usually determined based on their size, their importance in the real economy, substitutability of their services, their complexity, the extent of their cross-border activities and their interconnectedness. The disrupted operation of systemically important banks can launch critical contagion effects in the financial network. In order to prevent this, the state is willing to provide considerable assistance to these banks. However, this creates a substantial moral hazard situation, which encourages excessive risk-taking among systemically important banks in normal times. Therefore, the SIFI capital buffer provides protection from both structural and cyclical financial systemic risks. It is important to note that the moral hazard problem just mentioned can also be effectively mitigated by the resolution tools.173 • Systemic risk buffer. This capital requirement is determined as a ratio of risk-weighted assets, but it can also be prescribed only for a certain group of banks. The systemic risk buffer helps cover the potential losses arising from all kinds of structural financial systemic risks. It should be applied in the case of all banks that are affected by a longlasting development that may destabilise the whole banking system. Examples for such developments include when the vulnerability of certain banks to external economic shocks heightens, certain debtors experience sustained payment issues, the banking system becomes more complex or interconnected as a result of financial innovation, the banking system’s market concentration increases or it exhibits a trend of being too large relative to GDP. Higher capital requirements encourage the raising of the capital buffers that can be expanded through retaining profits or acquiring new equity, and the reduction of the assets linked to capital requirements at the same time. Higher capital requirements also 173

See Chapter 22.

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20 The theoretical basis of using macroprudential instruments

raise banks’ funding costs, which makes lending more expensive and tightens banks’ investment opportunities in general. This also leads to a reduction of certain asset holdings. Funding costs rise because the expected return on capital is larger than that of other liabilities due to its greater riskiness. Better capitalised banks are usually less risky, therefore the expected return on all their liabilities is lower, but this usually does not offset the composition effect. (The Modigliani–Miller theorem does not usually take hold in practice.) Chart 20-3: The transmission mechanism of raising macroprudential capital requirements Increase in capital requirements

Banks

Voluntary capital buffers Relocating activity abroad Clear SIFI-identity*

Loan market Targeted assets (with high risks) Non-targeted assets

Credit supply in non-targ. sector Offered interest rate

Lending spread Dividend New equity

No effect, possibly harmful

Credit supply in targeted sector

Resilience increases

Note: *Only in the case of a SIFI capital buffer. Source: Adapted from CGFS (2012).

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Credit demand in non-bank segment

Financial cycle is mitigated

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According to the above, the four capital requirements can also somewhat limit the emergence of the relevant systemic financial risks. On account of the capital requirements, especially the holdings of riskier assets should be reduced, therefore holding assets that increase systemic risk and excessive lending are counter-incentivised. International experience shows however, that in the upswing phase of financial cycles, the euphoria can easily be great enough to prevent the macroprudential capital requirements from considerably curbing the emergence of cyclical systemic risks. In addition, the SIFI capital buffer has special effects. First, the rising capital buffer passes on a portion of the potential losses from the taxpayers to the owners. This reduces excessive risk-taking by systemically important banks. Second, by selectively raising funding costs, it also mitigates the competitiondistorting effects of the unequal access to state support among systemically important and not important banks. Capital requirements may be partially circumvented in various ways. • Banks present in several countries may transfer a part of their operations or only their accounting statements to countries prescribing lower capital requirements. • Banks using the internal ratings based approach for credit risk may modify the risk weights of their assets to facilitate smoother compliance. • Capital requirements for the banking system are unable to prevent the partial transfer of financial intermediation entailing systemic risks to the non-bank sector. Macroprudential capital requirements may also have additional undesired side effects. • In part, banks may respond to the introduction of macroprudential capital requirements by reducing their voluntarily created capital — 712 —

20 The theoretical basis of using macroprudential instruments

buffers. Already existing microprudential capital requirements should be slightly exceeded in order to be able to smoothly comply with the regulatory limits in the case of unexpected events. • Regulators have a huge responsibility with respect to appropriate timing, since the suboptimal timing of raising, and especially releasing of capital buffers may even exacerbate the problem sought to be mitigated. On the verge of a financial crisis, the utilisation of the capital buffers released too early may further increase the financial systemic risks before the onset of the crisis. The capital buffers released too late are unable to appropriately protect the financial system from the effects of rapid and large losses exacerbating the crisis. • The capital buffers required with respect to special asset groups impact not only these assets. For example, it is possible that the excessive risk-taking related to the given asset group declines, but in parallel with that it emerges in asset groups that could be expanded by accumulating less additional capital. In a somewhat contrary manner, the holdings of certain other assets may even diminish in order to facilitate the reallocation of capital from more general capital reserves. • The application of the SIFI capital buffer makes it clear which banks are systemically important. It becomes obvious which banks are more likely to receive state support in the case of a crisis, which reduces the funding costs of these banks, thereby distorting market competition. However, this side effect can be substantially mitigated by efficient resolution tools that reduce the moral hazard linked to systemically important banks.174 Macroprudential policy has to mitigate the undesired side effects of capital requirements. For example, the risk weights of certain asset 174

See Chapter 22.

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groups can be limited, the holdings of certain asset groups or their changes can be capped, the exposure to a certain client group may be limited, and possibly also the leverage can be directly regulated. The estimated net social benefit of macroprudential capital requirements is positive, but initially their costs dominate. On the basis of the above, the creation of capital buffers slightly hampers financial intermediation, and thus also consumption and investments. Nevertheless, the buffers can mitigate the systemic financial risks, which reduces the probability of future financial crises. The capital requirements bolster banks’ resilience, which reduces the economic losses of the financial crisis. According to the studies reviewing the net social impact of capital requirements (BCBS 2016, Brooke et al. 2015 and Rochet 2014), the greatest uncertainty surrounds the quantification of the cost of the financial crisis. Due to the differences among the countries under review, certain studies find that the financial crisis steadily lowers GDP’s trend, while according to other studies, after a temporary drop, GDP will return to its pre-crisis trend. Despite the uncertainties and differences of the estimates, the consensus of the studies states that the net social effect of the macroprudential capital requirements introduced in addition to the capital requirements before the great financial crisis is positive. Another general lesson the studies draw is that the combined maximum value of these capital buffers determined in the Basel III framework is around the social optimum.

20.4.2 Liquidity buffers and instruments limiting excessive maturity mismatch

Systemic liquidity risk is the risk that a significant portion of financial institutions are unable to fulfil their financial obligations in time. Aggregate liquidity shortage entails interruptions in financial intermediation, for example access to deposits and credit lines deteriorates, which substantially hampers the implementation

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20 The theoretical basis of using macroprudential instruments

of consumption, production and investment plans, causing significant losses in the real economy. As we have already detailed while presenting systemic risks, aggregate liquidity shortage is a financial crisis event that may quickly worsen, causing fire sales, and therefore may entail serious contagion effects. Excessive risk-taking in the upswing phase of the financial cycle can significantly contribute to the increase in systemic liquidity risk. In such a situation, financial institutions finance their increasingly longerterm assets from increasingly shorter-term funds, since shorter-term funds are cheaper, while longer-term assets generate higher revenues. Excessive maturity mismatch increases the amount of funds to be rolled over in the short run, and thus also the demand for market liquidity. One of the main instruments also serving macroprudential purposes that constrains the severity of aggregate liquidity shortage is the liquidity coverage requirement. According to the liquidity coverage ratio (LCR), all banks have to continuously hold at least as many liquid assets as the expected value of net cash outflows from the bank in stress over the next thirty days in total. Thus, this is a requirement that wishes to guarantee the liquidity buffer at the individual bank level necessary for managing short-term stresses. One of the main instruments also serving macroprudential purposes that constrains excessive maturity mismatch is the stable funding requirement. According to the net stable funding ratio (NSFR), which is a bank-level regulatory instrument, each bank has to finance an adequate proportion of its long-term assets from long-term and stable funds. The individual asset and liability categories are taken into account with various weights in line with a detailed methodological manual. Here it should be highlighted that all loans with a maturity of over one year should be fully imputed, but interbank funding and funding from within the financial sector (“wholesale funding”) should not. The latter can considerably heighten liquidity risks, since in order to increase their lending and investments entailing excessive risk-taking, — 715 —

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banks are happy to use the rapidly expandable interbank funding instead of the slow accumulation of deposits. Chart 20-4: The transmission mechanism of tightening the rules on liquidity and maturity mismatch T ig h ter re qui re me n ts for li qui di ty an d m at urit y m is m at c h

Banks

Loan market

Short-term funding Voluntary liquidity buffers

Unsecured funding

Circumventing regulation

Liquid assets

Credit supply

Offered interest rate

Wholesale funding

Maturity mismatch Currency mismatch

No effect, possibly harmful

Lower systemic liquidity risk

Credit demand in non-bank segment

Financial cycle is mitigated

Source: Adapted from CGFS (2012).

Both instruments encourage banks to hold more liquid assets and acquire longer-term funds (Chart 20-4). These reduce banks’ revenue and increase their funding costs, therefore decrease their profitability, as a result of which banks attempt to raise their lending rates, thereby reducing the volume of lending. Nevertheless, the reduced liquidity risk may curb the rise of funding costs and thus also the drop in lending activity. Therefore, LCR and NSFR can be used at the expense of restraining economic growth, but with the reduction of systemic liquidity risks, growth becomes more sustainable at the same time. — 716 —

20 The theoretical basis of using macroprudential instruments

The available empirical results suggest that the combined social effect of the instruments is positive (BCBS 2016). However, there may be undesired side effects limiting the net social benefit of the instruments. • Although banks do not fully internalise the costs of their contribution to systemic liquidity risks, they do partly, therefore they create liquidity buffers even without interventions. Thus, it is possible that banks respond to the use or tightening of the LCR requirement by the partial reduction of these voluntary liquidity buffers, as a result of which less liquidity buffers will be created than intended by the regulator. • The high level of the required liquidity buffers may prompt banks to purchase large amounts from the same securities, which may increase the concentration of the exposures in these assets to a risky level. • Both instruments apply only to the banking system, which poses the risk that as a result of tightening requirements, a portion of the financial intermediation activities entailing excessive risk-taking will shift to the non-bank segment of the financial system. The LCR and NSFR instruments should be used countercyclically, i.e. by prescribing looser requirements in times of financial crises than otherwise. The liquidity buffers created with the LCR may be of great use in financial stress when market liquidity can contract very rapidly. The increasing prominence of excessive risk-taking in the upswing phase of the financial cycle can be prevented by ever stricter LCR and NSFR requirements. Another advantage of countercyclical use is that the two instruments restrain lending precisely at the time when the threat of excessive lending nevertheless looms, i.e. in the upswing phase of the cycle. However, an adverse side effect arises when market participants interpret the announcement of the easing of the requirements as a signal for the emergence of aggregate liquidity shortage, since overall this can make the situation even worse. — 717 —

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In addition to the LCR and the NSFR, similar instruments can be used to create liquidity buffers and maintain prudent maturity transformation. Similar to the LCR and the NSFR, other bank-level quantitative limits may be imposed for example on leverage, loan-todeposit ratio, maturity mismatch, the amount of interbank exposures or the volume of swap portfolio. Since the aggregate liquidity shortage may emerge in the individual currencies separately, the previous instruments should be used separately for each currency, and the currency mismatch should also be limited. In contrast to the previously mentioned quantitative limitations, a levy on short-term debts prevents fund raising that can lead to liquidity problems through price regulation. This levy belongs to the set of so-called Pigouvian taxes used for correcting negative externalities. Systemically important credit institutions are able to contribute more to systemic liquidity risk, i.e. they can exert a greater externality on the whole financial system, therefore the short-term funds of systemically important credit institutions should be taxed more.

20.4.3 Debt cap rules

In contrast to the instruments in the other two groups, debt cap rules can be used to intervene not only at the level of individual institutions, or at the level of the banking system but also at the contract level. There are two basic types of these instruments. One group of instruments determines the contracts that can be concluded as a function of the collateral. In a widespread solution, the amount of the loan is limited in a fixed share of the value of collateral behind the loan at the time of borrowing. This ratio is called loan-to-value ratio (LTV), which in the case of mortgage loans basically prescribes a minimum proportion of the own contribution. The other group of instruments limits the loan contracts based on the stable disposable income of the borrower at the time of borrowing. The loan-to-income ratio (LTI) and the payment-to-income ratio (PTI) cap the amount of the loan and the

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20 The theoretical basis of using macroprudential instruments

amount of the regular debt service that can be undertaken, respectively, as a proportion of income. Debt cap rules principally constrain excessive mortgage lending to households, although the income-based limits cover all household loan types. Construction comprises a significant share of GDP, and a large portion of households’ wealth is in residential properties. Therefore, excessive real estate lending accompanied also with excessive real estate price growth makes financial crises substantially more likely and severe. Yet, debt cap rules are only easy to apply to the household segment. In the case of companies dealing with commercial properties, determining the stable disposable income and the accurate assessment of the collateral are more difficult than in the case of households. The debt cap rules considerably mitigate the cyclicality of real estate prices and real estate lending, and significantly improve the resilience of both debtors and lending banks (Chart 20-5). Filtering out risky debtors from a collateral and solvency perspective may be effective, since it happens at the level of the individual contracts, thus it is welltargeted. As a result of the limitations, the supply and demand of mortgage loans may be significantly dampened, which reduces property prices through reining in the demand for real estate. The latter may also curb the volume of property lending, since it limits the rise in the value of real estate collateral. All of this stifles excessive property lending and encourages banks to compete in prices and the quality of the services linked to lending instead of the riskiness of the loans. Overall, systemic risks decrease and the probability of a financial crisis diminishes. In a financial crisis, property prices tumble due to the deteriorating income prospects. Nevertheless, among the borrowers selected by the debt cap rules, debt issues emerge less often, and the depreciation of real estate collateral raises lending banks’ expected losses less. Therefore in a crisis, there is more opportunity for maintaining the real estate lending activity on the side of both borrowers and lenders. This can restrain the drop in property prices as well. — 719 —

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Chart 20-5: The transmission mechanism of tightening debt cap rules Ti ghte r de bt ca p rul e s

Households

Loan market Credit demand in non-bank segment

Ability to repay loans

Banks Performing loans Stability of collateral values

Down payment Credit demand Morgage loans taken out in parts

Credit supply

Frontloading of loans Discontent of loan applicants crowded out

Relocating activity abroad

Real estate demand

Quality of income and collateral valuation

Real estate price bubbles

Loan maturity

Real estate market

No effect, possibly harmful

Resilience increases

Financial cycle is mitigated

Source: Adapted from CGFS (2012).

Debt cap rules should be applied countercyclically. Incomes fluctuate less than real estate prices, therefore income-based limitations are countercyclical even if they do not change over time. These rules limit the amount of available loans better when real estate prices rise than when they fall. However, the cyclicality of mortgage lending can usually be mitigated even better. If optimism and the euphoria in the upswing phase of the financial cycle raise incomes and real estate prices more than expected, it may be necessary to tighten debt cap rules. In a crisis, when the problem is exactly the opposite, i.e. a credit crunch threatens,

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20 The theoretical basis of using macroprudential instruments

there is usually enough room for manoeuvre to relax the regulatory limits. Debt cap rules also have negative side effects that should be restrained as much as possible. • The strategies circumventing the regulation we saw in connection with the previously mentioned instruments also threaten in the case of debt cap rules. Lending activity may partly shift towards unregulated transactions and financial institutions. Banks present in several countries may transfer a part of their lending or only their accounting statements to countries using looser debt cap rules. • The circumvention of debt cap rules can also have special methods. For example, borrowers can attempt to take out the desired amount of the loan in several parts. Banks may start overvaluing stable income and the collateral. The upper limit of the payment-to-income ratio can also be softened through extending the maturity. • The expectations about the changes in debt cap rules can considerably influence the current credit demand. Expected tightening can encourage immediate borrowing, while an expected loosening can discourage it. Therefore, the expectations about the change of rules undermine the countercyclical impact of the rules, thus the regulatory limits should not be changed often. • The discontent of those that are excluded from home ownership or its preferred forms on account of the debt cap rules may generate political pressure against the appropriate application of the rules.

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20.5 The institutional framework of macroprudential policy175 After describing the objective and potential instruments of macroprudential policy, the discussion now turns to effective and efficient implementation. This part contains the major considerations and dilemmas that are the most important to take into account when developing the optimal operational framework of macroprudential policy. The same questions arise everywhere, but due to the unique features of individual countries, the success of macroprudential policy may be underpinned by different institutional solutions.

20.5.1 Coordination with other policies

Macroprudential policy is in strong interaction with several other policies. Effective and efficient public intervention calls for the coordinated operation of various policies. Below we will summarise the synergies to be harnessed between macroprudential policy and other policies as well as the conflicts to be mitigated (Table 20-2).176 Microprudential policy177

Microprudential supervision focuses on the stable operation of the individual financial institutions. However, at the systemic level, in addition to the riskiness of the individual financial institutions, the connections between these risks are also important (“fallacy of composition”). Macroprudential policy is needed precisely because the emergence of excessive financial risks has to be prevented, not only at the individual level but also at the systemic level.

his subchapter is based on Part 3 of MNB (2016). T For a more detailed overview, see IMF (2013a), ESRB (2014) and World Bank (2014). 177 The interaction between microprudential and macroprudential policy is discussed in more detail by Osinski et al (2013). 175 176

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20 The theoretical basis of using macroprudential instruments

Table 20-2: The major interactions between macroprudential policy and other policies SYNERGIES

POLICY

CONFLICTS

Efficient exchange of information Proven microprudential instruments

Harmful competition Microprudential Conflicting objectives in times of policy financial tensions

Long-term, complementary objectives More efficient monetary policy transmission More differentiated macroprudential instruments

Business and financial cycles may Monetary policy also be smoothed at the expense of each other

Financial crises may be addressed more easily More sustainable economic growth Stronger fiscal discipline

Impact of the tax system on capital structure Economic policy Subsidies and benefits may encourage excessive risk-taking

Reduced frequency and easier management of institutional crisis events Reduced moral hazard in financial institutions

Resolution

Risks posed by systemically important banks decline

Competition policy

Haphazardly promoted competition

The two types of prudential interventions may support the achievement of each other’s objectives by the efficient exchange of information. With the help of targeted, organisation-level microprudential inspections, the developments entailing systemic risks and the level of compliance with macroprudential rules can be identified more accurately. The macroprudential vulnerabilities recognised in time may specify the risks threatening specifically the stability of the individual financial institutions for microprudential supervision. Macroprudential regulation uses several types of instruments that can already be found among microprudential instruments, therefore the earlier experiences with these instruments can also be utilised. However, due to the similar objectives and the partial overlap between the applied instruments, it is often difficult to delineate the two areas, which may cause harmful competition among them. Yet their objectives may even conflict in times of financial strains. If a bank in financial distress sells an asset deemed excessively risky, keeps its — 723 —

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capital buffers high or accumulates liquid assets, the resilience of the given bank may improve but the systemic financial strains may be exacerbated. This is because these steps contribute to the drop in asset prices, the curbing of lending and the contraction of the liquidity available to other banks. Monetary policy178

The primary objective of monetary policy is typically price stability, the maintenance of which requires the stability of the financial system as well, therefore it also interacts with macroprudential policy. Price stability and the mitigation of systemic financial risks are mutually supportive longer-term goals. On the one hand, persistently stable prices create a more predictable environment for investments where financial intermediation can also function in a more stable manner. On the other hand, when systemic financial risks are contained, the financial system amplifies the macroeconomic shocks less, therefore the swings of the business cycle and inflation are lower. In addition, in a stable financial system, monetary policy transmission is also more effective. Finally, macroprudential instruments can be more targeted and differentiated, and they can be used to effectively manage the potential adverse side effects of the monetary policy measures affecting financial stability and taken in order to ensure price stability. Nevertheless, the smoothing of business and financial cycles can also happen at each other’s expense. The development of financial and business cycles varies from each other. Economic output may stay below its potential level for a long time, therefore the central bank interest rates kept persistently low due to the low inflationary pressure encourage the underestimation of financial risks, fuelling an asset price bubble. Rising asset prices heighten speculative investments, a large portion of which are financed from irresponsible loans due to excessive risk-taking. In such a scenario, macroprudential policy has to curb the process in time in order to avoid future debt issues. 178

he interaction between monetary and macroprudential policy is discussed in more T detail in IMF (2013b).

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20 The theoretical basis of using macroprudential instruments

Economic policy

Macroprudential policy can best support fiscal policy by making rarer and mitigating financial crises that use up substantial budgetary resources. In addition, an economic policy targeting the enhancement of competitiveness and sustainable economic growth can more easily succeed in the context of persistently stable and effective financial intermediation. Another synergy is that in a financial system free from excessive risk-taking, it is easier to pursue a disciplined fiscal policy. Thus the state’s debt issues are less likely to spread to the banking system that owns a huge portion of government securities. However, the impact of the tax system on the capital structure may reduce financial intermediaries’ resilience. The tax burden on debt-type funds is usually lower than that on capital, therefore implicitly fiscal policy may encourage the low capital-to-assets ratio of financial intermediaries. Another source of conflict is that public subsidies and allowances may cause excessive risk-taking, since they may encourage excessive consumption and investment decisions with low returns. The additional loans taken out for financing these may even entail systemic financial risks. Resolution

Resolution is a public intervention that requires less public funds than bank bailouts, however, through the assumption of ownership and management rights, it ensures the uninterrupted functioning of the given financial institution’s critical functions, for example access to bank deposits or corporate credit lines.179 Resolution starts when there is a real threat of insolvency and it ends in the sale of the distressed financial institution’s healthy assets to other solvent market participants. When systemic financial risks are kept in check, they trigger fewer and less severe crisis situations for the institutions, therefore the potential resolution proceedings can be performed more successfully. Conversely, if the financial institutions are less likely to expect state bailout packages due to effective resolution and they have 179

See Chapter 22 for more details.

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to pay a regular fee in proportion to their risk to the resolution fund intended to cover the resolution’s costs, owners’ and the managements’ incentives for excessive risk-taking will be lower. Competition policy

Competition policy restrains dominant market positions, which may mitigate the riskiness of systemically important banks and the systemic risk entailed by concentrated exposures. Nonetheless, when market competition heightens in the context of financial frictions, banks strive to increase their market share not only by offering better and cheaper financial services, but also by increasing their leverage, stretching their maturity structure, lending to debtors with poorer ratings and other ways leading to excessive risk-taking. All in all, this process can have more social costs than benefits. The competitive pressure from the non-bank sector – which is less regulated from a microprudential and macroprudential perspective – on the banking system may also be detrimental altogether.

20.5.2 The independence of macroprudential policy

The government has varying degrees of direct influence over the previously mentioned policies. The degree of independence from the government is an important issue also in the case of macroprudential policy. The optimal amount of government control over macroprudential policy should be developed based on the considerations below (Table 20-3).180 More direct government control over macroprudential policy enhances its cooperation with all economic policy areas directly controlled by the government. However, independence from the government provides better incentives to carry out macroprudential interventions necessary for realising the long-term benefits of financial stability. 180

For more information, see Nier et al. (2011).

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Inaction bias threatens because governments are more sensitive to electoral cycles than an independent agency. As a result, governments may underestimate the benefits of the reduction of systemic financial risks that emerge in the long run and are more difficult to perceive. On the other hand, they may overestimate the costs of macroprudential interventions that typically arise in the short run, especially the effect of curbing financial intermediation and thus general economic activity. In addition, macroprudential policy can be relatively readily delegated to an agency independent from the government. This is because the necessity of mitigating systemic financial risks is surrounded by a broad public consensus, since financial crises usually hit several social groups sorely. Therefore, the objectives of macroprudential policy do not necessarily have to be adjusted to the current collective preferences, since they do not change much over time. Thus it is permissible to let macroprudential policy be shaped by some other institution than the government that is created according to the will of the current electoral majority. Table 20-3: The independence of macroprudential policy from the government ARGUMENTS FOR TIGHT GOVERNMENTAL CONTROL

ARGUMENTS FOR INDEPENDENCE FROM THE GOVERNMENT

Better coordination with policies conducted Commitment to an active macroprudential by the government policy Macroprudential policy is easy to delegate

20.5.3 Rules vs. discretion in decision-making

Macroprudential policy can only be successful when it is shaped by the appropriate combination of predetermined rules and the discretionary decisions of the organisation performing the intervention.181 Below we will summarise the advantages of the rule-based and discretionary

181

See Chapter 9 of ESRB (2014) for more details.

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operating methods from the perspective of macroprudential policy (Table 20-4). Table 20-4: Rule-based or discretionary operation ARGUMENTS FOR RULE-BASED OPERATING METHOD

ARGUMENTS FOR DISCRETIONARY OPERATING METHOD

Reduced risk of lobbying and political pressure

Applicability of new information and expert judgements

More predictable and more transparent macroprudential policy

It encourages for continuous revision

Market expectations can be shaped with more precision

More targeted interventions

Stronger accountability

Unexpected events can be addressed with more flexibility

Better international harmonisation

Circumvention of the regulation can be restrained more easily The mitigation of certain systemic risks is hard to automate

The commitment power of rules can make macroprudential policy more active. The inaction bias of macroprudential policy may not arise only because of the government mentioned previously. The financial sector, which bears the direct costs of macroprudential interventions, may lobby for more muted interventions, and some special groups may believe that unique allowances are justified. Excessive risktaking may be characteristic of borrowers as well, therefore certain economic sectors or households’ advocacy groups may strive to lower the macroprudential limitations on access to credit. Another advantage of the rules compared to discretionary decisions is that they are known in advance and they provide some guidance on the responses of the regulator to certain situations. Macroprudential policy that is more predictable and transparent can influence the expectations of economic actors more efficiently, as a result of which the regulation can achieve the desired market adjustment more easily. Another advantage of the more predictable and transparent functioning is that it helps in gauging the quality of macroprudential

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policy, thereby contributing to its accountability as well. Finally, the rules harmonised across countries reduce the transaction costs of the international coordination of macroprudential policies, since in the case of discretionary national decisions, the decisions need to be adjusted to each other repeatedly depending on the current situation. The most important advantage of pursuing macroprudential policy through discretionary decisions is that new knowledge and expert judgements can be used promptly. Currently, macroprudential policy is developing also at the international level, therefore the information base of the regulation improves rapidly. Lack of automatisms in decisions prompt decision-makers in the case of each decision to constantly review and improve the practice of macroprudential policy. In the case of discretionary decision-making, better and more targeted intervention can be implemented in response to unexpected events, since unforeseeable events cannot be taken into consideration when designing rules. The innovative efforts aimed at circumventing macroprudential regulation represent a special case of unforeseeable events. Therefore, in the case of discretionary decisions, regulatory arbitrage can be more easily reduced. The interventions that are difficult to automate should also be carried out in a discretionary manner. With respect to instruments sensitive to the current situation (countercyclical capital buffer, systemic risk buffer etc.), several decisions have to be made that are difficult to accurately review in advance.

20.5.4 The extent of international coordination

Due to the international character of financial intermediation, the systemic financial risks of individual countries are in strong interaction (Table 20-5). Therefore, the national macroprudential policies cannot be successful when isolated from each other, the appropriate international coordination of macroprudential interventions is essential. Generally,

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the mitigation of a country’s systemic financial risks protects the financial stability of other countries as well. However, as a result of the differences in the stringency of macroprudential regulation across countries, the activities entailing systemic financial risks may concentrate in the countries with looser regulations. International organisations are needed that are appropriately interested in monitoring the international intermediary system, and that can utilise the economies of scale in data collection, methodological innovation and formulation of regulatory recommendations. Table 20-5: The extent of international coordination ARGUMENTS FOR A MORE CONSTRAINED NATIONAL DISCRETION

ARGUMENTS FOR A WIDER NATIONAL DISCRETION

More efficient monitoring of cross-border systemic risks

Macroprudential interventions differentiated by countries

More efficient international coordination of interventions

Coordination with decentralised policies Stronger democratic legitimacy

However, the elevation of macroprudential policy to the international level faces huge hurdles. First, macroprudential interventions should be differentiated by countries, since the financial systems and financial cycles of the countries and the policies that interact with macroprudential policy vary widely across countries. Countryspecific information and the experts who are more aware of it are usually available locally. Furthermore, the democratic legitimacy of a macroprudential policy governed at the national level is also stronger. Confidence in the regulation and the compliance with it are greater in general if stakeholders can exercise democratic control over the regulation more easily.

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Box 20-2 The main institutional models for macroprudential policy

The effective and efficient functioning of macroprudential policy is enabled by ensuring the necessary resources (mandate, regulatory instruments, data, experts), and it is enforced by the appropriate system of incentives. These have to be provided by the stable operational framework of macroprudential policy, i.e. the macroprudential institutions. The macroprudential institutions of the individual countries can be divided into two basic groups.182 Macroprudential policy is either pursued by the central bank or it is governed by a board of the representatives of several organisations where the central bank typically plays a key role, and usually it also comprises the microprudential regulatory agency and the ministry of finance. Currently, there is no sufficient information with regard to the different institutional solutions for us to be able to accurately assess their success. However, their potential advantages and disadvantages can be taken into consideration while developing or modifying the operational framework of macroprudential policy (Chart 20-6). The key role of the central bank in both institutional systems is justified by its following characteristics. The pursuance of monetary policy, the oversight of the financial infrastructure and the role of the lender of last resort require a systemic approach and comprehensive knowledge about the financial system. Typically, many types of data and qualified and experienced analysts are available for this, well-versed in both macroeconomic forecasting and the rapid quantification of fiscal effects. The success of macroprudential policy can also be influenced by the fact that central banks already have experience in communicating financial risks to market participants and the broader public. Macroprudential policy integrated into a central bank has the following advantages over one controlled by a board. Macroprudential policy in the hands of one organisation means a clear mandate and responsibility, 182

The possible institutional solutions are discussed in more detail by Nier et al. (2011).

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therefore the collective action problem among the organisations comprising the board does not have to be solved. The independence of the central bank helps to resist the pressure from the government, the financial sector and other actors striving for more lenient regulation, which may be especially important in a general economic upswing, during the mitigation of cyclical systemic risks. The integration of macroprudential policy into the central bank also means that the analysis, decision-making, implementation and communication can happen within one organisation, i.e. in the context of adequate information flow and without interruptions. Finally, in a central bank, macroprudential policy can be shaped by coordinating it with monetary policy and in certain cases also with resolution and microprudential policy. Chart 20-6: The relative advantages of macroprudential policy being integrated into the central bank or being controlled by a board

Microprud. supervision Central bank is the macroprud. authority

Macroprudential policy integrated into the central bank • Unambiguous mandate • Reduced risk of lobbying and political pressure

Ministry of finance

• Better coordination of analysis, decision-making, implementation, and communication • Better coordination with monetary policy

Macropr. council

Macroprudential policy conducted by a council

Microprud. supervision

• Competing assessments and proposals Central bank Ministry of finance

• Easier to achieve legislative changes • Reduced reputational risk

The establishment of a multi-member board also has advantages compared to the sole authorisation of the central bank. If more organisations have a say in macroprudential policy, more assessments and proposals for intervention can compete. Since the Ministry of Finance

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is also a member of the board, the necessary legislative changes may be achieved more easily. It is easier to include independent experts on a board, which may make risk assessment and intervention more justified. If the different policies are pursued by separate organisations, the potential operational deficiencies of the individual organisations do not question the reputation of the other organisations. The transparency and accountability of macroprudential policy are vital in each institutional solution. Transparency requires meaningful, clear, regular, well-timed, well-targeted and coordinated communication. Macroprudential regulation has various stakeholders, requiring communication of varying content, detail and frequency. It is especially important to make the institutional framework and the process of regulation clear to the public in advance. Furthermore, the changes affecting these as well as the corresponding explanations should be understandable in time. Within this, it is of fundamental importance that the regulatory agency publishes the conditions for using the instruments intended to apply. The ex post professional evaluations of the instruments employed should also be publicly available. Finally, it is important to point out that the existing institutional environment is crucial in developing macroprudential policy’s operational framework, just like in the case of any institutional changes. The emergence of best practices takes time, therefore the mechanisms that work well should not be modified too much. Accordingly, the optimal macroprudential institutions may vary across countries.

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Key concepts adverse selection agency problems aggregate liquidity shortage asset price bubble asymmetric information bounded rationality contagion effect coordination of policies correlated risk-taking cyclical systemic financial risk debt cap rules discretionary operation excessive lending excessive leverage excessive risk aversion excessive risk-taking financial crisis financial cycle financial stability fire sale herd behaviour

inaction bias international coordination macroprudential capital requirements macroprudential liquidity buffers macroprudential policy market friction moral hazard negative externalities in the financial network resilience spreading counterparty risk stretched currency structure stretched maturity structure structural systemic financial risk systemically important financial institution state support time-varying risk perception rule-based operation

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References Acharya, V. V. – Richardson, M. (2009): Restoring Financial Stability. John Wiley & Sons. Bikhchandani S. – Sharma, S. (2000): Herd Behavior in Financial Markets. IMF Staff Papers, Vol. 47, No. 3, 279–310. BCBS (2016): Literature Review on Integration of Regulatory Capital and Liquidity Instruments. BCBS Working Papers, No 30. Bolton, P. – Dewatripont, M. (2005): Contract Theory. The MIT Press. Brooke, M. – Bush, O. – Edwards, R. – Ellis, J. – Francis, B. – Harimohan, R. – Neiss, K. – Siegert, C. (2015): Measuring the Macroeconomic Costs and Benefits of Higher UK Bank Capital Requirements. Bank of England Financial Stability Paper, No 35. Cerutti, E. – Correa, R. – Fiorentino, E. – Segalla, E. (2016): Changes in Prudential Policy Instruments–A New Cross-Country Database. IMF Working Paper, No. 16/110. CGFS (2012): Operationalising the selection and application of macroprudential instruments. CGFS Papers, No 48. Dewatripont, M. – Rochet, J.-Ch. – Tirole, J. (2010): Balancing the Banks: Global Lessons from the Financial Crisis. Princeton University Press. ESRB (2014): The ESRB Handbook on Operationalising Macro-prudential Policy in the Banking Sector. Freixas, X. – Laeven, L. – Peydró, J.-L. (2015): Systemic Risk, Crises, and Macroprudential Regulation. The MIT Press. Freixas, X. – Rochet, J.-Ch. (2008): Microeconomics of Banking, Second Edition. The MIT Press. Gorton, G. B. (2010): Slapped by the Invisible Hand: The Panic of 2007. Oxford University Press. Hirshleifer, D. – Hong Teoh, S. (2003): Herd Behaviour and Cascading in Capital Markets: a Review and Synthesis. European Financial Management, Vol. 9, No. 1, 25–66. IMF (2013a): Key Aspects of Macroprudential Policy. IMF Policy Paper. IMF (2013b): The Interaction of Monetary and Macroprudential Policies. IMF Policy Paper. Laeven, L. – Valencia, F. (2013): Systemic Banking Crises Database. IMF Economic Review, Vol. 61, Issue 2, 225–270. Laffont, J.-J. – Martimort, D. (2002): The Theory of Incentives: The Principal-Agent Model. Princeton University Press. MNB (2016): Stabilitás ma – Stabilitás holnap: A Magyar Nemzeti Bank makroprudenciális stratégiája, 2016 (Stability today – Stability tomorrow: The macroprudential strategy of the Magyar Nemzeti Bank, 2016).

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Part III: Changes in the Hungarian regulatory policy Nier E. W. – Osiński, J. – Jácome, L. I. – Madrid, P. (2011): Institutional Models for Macroprudential Policy. IMF Staff Discussion Notes, No. 11/18. Osiński, J. – Seal, K. – Hoogduin, L. (2013): Macroprudential and Microprudential Policies: Toward Cohabitation. IMF Staff Discussion Notes, No. 13/5. Rajan, G. R. (2010): Fault Lines: How Hidden Fractures Still Threaten the World Economy. Princeton University Press. Reinhart, C. M. – Rogoff, K. S. (2009): This Time is Different: Eight Centuries of Financial Folly. Princeton University Press. Rochet, J.-Ch. (2014): The Extra Cost of Swiss Banking Regulation, SFI White Papers. Salanié, B. (2005): The Economics of Contracts: A Primer, Second Edition. The MIT Press. World Bank (2014): Macroprudential Policy Framework: A Practice Guide. A World Bank study.

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Targeted Hungarian macroprudential policy instruments in practice Péter Fáykiss – Dr Attila Rédei – János Szakács

Act CXXXIX of 2013 regarding the Magyar Nemzeti Bank, conferred strong powers on the MNB to prevent and mitigate systemic financial risks. Since the Act’s entry into force, the MNB has formulated its macroprudential strategy, improved its system responsible for identifying and monitoring systemic risks and developed its macroprudential instruments necessary for efficient risk management. This chapter gives a comprehensive overview about the Hungarian macroprudential institutional system and its operation, the macroprudential instruments currently employed by the MNB and the adjustment of market participants to these instruments: 1. Before the expansion in the credit cycle, the MNB introduced debt cap rules to prevent the over-indebtedness of households. 2. Due to the low level of the cyclical systemic risks, the MNB currently prescribes a 0 per cent countercyclical capital buffer rate of for market participants, which helps the pick-up in lending. 3. In order to maintain the high liquidity buffers in the banking system, the MNB employed a fast-track procedure to raise the expected level of the liquidity coverage ratio to 100 per cent as of 1 April 2016. 4. The limits on the foreign exchange funding adequacy ratio (FFAR) and the foreign exchange coverage ratio (FECR) introduced by the MNB may efficiently prevent the future build-up of excessive currency and maturity mismatches in the banking system.

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5. The mortgage funding adequacy ratio prescribed by the MNB is aimed to mitigate the forint maturity mismatch and to develop the Hungarian mortgage bond market. 6. The gradual implementation of the capital buffer for other systemically important institutions over 4 years helps mitigate the risks linked to these institutions without impeding lending that is just about to pick up. 7. Since the announcement of the use of the systemic risk buffer, the volume of problematic project loans in the banking system has nosedived.

21.1 The MNB as macroprudential authority Before and during the crisis, systemic risks of substantial magnitude emerged in the Hungarian financial intermediary system that were often interconnected but nonetheless arose in different areas. As the main driver behind Hungarian systemic risks, foreign currency lending was responsible not only for the heightened credit risks, but also for the excessive use of short-term funds on the financing side. With the use of cheap and abundant external funds, the banking system proved to be too active not only in the household mortgage loan market, but also in project financing. However, with the change in the international environment in 2008, the volume of non-performing loans skyrocketed in both segments. In 2013, the MNB was provided with a clear and strong mandate to manage systemic risks. The primary objective of the MNB is to achieve and maintain price stability; however, without prejudice to this primary objective, the MNB seeks to maintain the stability of the financial intermediary system and assist in enhancing the resilience of the financial system and ensuring its sustainable contribution to economic growth. Being responsible for monetary policy, macroprudential policy and financial supervision, the MNB exemplifies a complex institutional

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model where a clear responsibility, a strong mandate and institutional synergies enable efficient decision-making processes and consistent communication. The efficiency of decision-making and the ability to consider several points of view are fostered by the fact that the internal members of the Monetary Council (MT) are also members of the Financial Stability Board (FSB), i.e. the body responsible for the concrete establishment and achievement of macroprudential policy objectives. The management of the main systemic risks has been mostly completed by now using various government (e.g. forint conversion) and central bank (existing macroprudential instruments) measures. By virtue of its strong macroprudential mandate, the MNB engaged in active risk management, developing efficient regulatory responses to risks emerging before and during the global economic crisis. In addition to national discretional options to derogate within the EU framework, measures introduced within the national scope of competence – especially in the form of requirements for long-term liquidity and the debt cap rules curbing excessive credit flows – also contributed to appropriate risk management. The choice of the instruments was heavily influenced by the fact that in addition to the macroprudential actions taken in response to the risks that had already emerged, appropriate preventive instruments should ward off the renewed emergence of these risks. After the recent intensive risk management period, active monitoring may now become the focus. In harmony with the financial cycle, the institutional and regulatory framework, the cornerstone of risk management has been developed. Most of this does not effectively hinder bank processes; however, it might have a hampering effect as risks develop, i.e. as they become more pronounced. In addition to continuously monitoring systemic risks, the MNB’s macroprudential policy can concentrate on both fine-tuning the existing instruments and their appropriate use.

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21.1.1 The Hungarian institutional framework

The functioning of the Hungarian macroprudential policy is fundamentally determined by the legislative environment of both the European Union and Hungary. The prevailing EU bank regulation system is based on the regulation on prudential requirements for credit institutions and investment firms (Capital Requirements Regulation – CRR), and on the directive on the prudential regulation and supervision of these institutions (Capital Requirements Directive IV – CRDIV). The majority of the common regulatory system is directly applicable to banks and investment firms, therefore domestic market and institutional features can be taken into account only to a very limited extent, by applying national discretions. The actual room for manoeuvre for managing special risks at the level of individual Member States and for the unique responses to the different phases of financial cycles is provided by the macroprudential instruments that remain in national competence. In addition to the CRDIV/CRR regulatory package, the operation of the Hungarian macroprudential authority is also influenced by the delegated acts and implementing measures adopted by the Commission. Last but not least, the recommendations and views published by the various EU bodies also play a major role in forming the Hungarian macroprudential policy, with respect to both drawing attention to risks and the recommended method for managing them. The acts constituting the legal basis of the Hungarian macroprudential regulation are rooted in these European Union foundations. The basis of the Hungarian legislation comprises two pillars: The Act on Credit Institutions and Financial Enterprises (Credit Institutions Act) laying down the prudential and supervisory requirements for the implementation of CRDIV along with the Act on Investment Firms (Investment Firms Act) on the one hand, and the Act on the Magyar Nemzeti Bank (MNB Act) enshrining the macroprudential regulatory mandate and specifying the application methods of the relevant instruments on the other hand. These acts establish a strong and clear

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mandate for the Hungarian macroprudential regulatory authority and define the institutional framework of macroprudential policy. Moreover, they specify the available instruments and the method of their application. It should be emphasised that, despite the strong mandate, the competence of macroprudential policy is limited. On the one hand, the instruments can only influence the already recognized risks. On the other hand, despite entailing significant risks, non-bank financial intermediary institutions can currently be regulated only indirectly with macroprudential instruments. The preservation of the financial system’s stability is the shared responsibility of the authorities performing legislative, supervisory, crisis management and central bank functions. Clear-cut responsibilities and intervention powers are key elements of an efficient macroprudential policy. This cooperative framework should not include unreasonable overlaps and conflicts between responsibilities: the responsibility for identifying and managing systemic risks and preventing the ensuing market failures should be clearly placed, and this should be coupled with adequately strong powers and concrete instruments. In Hungary, the Magyar Nemzeti Bank (MNB) was provided with a clear and strong macroprudential mandate. The primary objective of the MNB is to achieve and maintain price stability, and it uses monetary policy instruments to achieve this goal. However, without prejudice to this primary objective, the MNB maintains the stability of the financial intermediary system, and assists in enhancing the resilience of the financial system and in ensuring its sustainable contribution to economic growth. The macroprudential policy aimed at maintaining stability across the financial intermediary system is shaped by the MNB with a view to achieving these objectives. Within the organisation of the MNB, the Monetary Council establishes the

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strategic framework regarding macroprudential policy, while the body responsible for the concrete formulation and achievement of the macroprudential policy objectives is the Financial Stability Board. In addition to macroprudential analytical and regulatory tasks, the FSB is responsible for tasks related to microprudential policy and consumer protection, and for decisions relating to the duties of the supervisory and resolution authorities. Moreover, the FSB provides, if necessary, the forum composed of the MNB’s organisational units performing the central banking and supervisory duties and the ministry in charge of the regulation of the money, capital and insurance markets, where preparations for and, if necessary, the management of crises is conducted (Chart 21-1). This institutional model with such a broad mandate has several advantages. Obvious synergies arise due to the presence of certain areas within the same institution. The flow of information between the various areas considerably boosts the efficiency of individual areas, both in the phase of risk analysis and identification and in the phase of assessment and follow-up. Furthermore, a macroprudential authority integrated into the central bank can harness all the expertise and experience present in a central bank on account of its basic functions, especially regarding monetary policy, money market and payment systems know-how. Even though differences of opinion might arise between the individual areas, their coordination becomes more efficient due to the mandate being under the aegis of the same organisation.183 The advantages of this model are further enhanced by uniform communication and external control: clear, uniform messages can be conveyed to the market and the public, and the framework, by virtue of its clearly defined responsibilities, ensures highly transparent and efficient functioning.

183

Nier et al. (2011)

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Chart 21-1: The Hungarian financial stability institutional system • Base rate • Communication • Taking part in FSB meetings • Requesting information

• Monetary policy instruments • Main forum of MNB decisions Monetary Council

• Economic policy • Fiscal policy • Financial regulation

Goverment

Financial stability goal

MNB

Strategic framework

Sharing of policy materials

• Communication

Financial Stability Board

• Policy documents, reports

• Macroprudential policy instruments

• Legislative proposal

• Microprudential policy instruments • Supervisory tools • Resolution

Source: MNB.

21.1.2 The process of macroprudential intervention in Hungary — The phases of the macroprudential regulatory cycle

The management of systemic risks essentially consists of three main phases. The first step in the regulatory cycle is risk analysis, during which the MNB identifies existing and potential systemic risks. The analysis is followed by the identification of potential intervention instruments and, if necessary, regulatory steps: a response will be selected from the “preliminary”, “warning” and “intervention” types of possible regulatory responses. The regulatory response is evaluated in the next phase, taking into consideration both internal and external information. The cycle is coupled with a continuous communication process (Chart 21-2).

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Chart 21-2: Phases of the macroprudential regulatory cycle Risk analysis

Intervention

Follow-up

Monitoring („probability”) • Market information • Statistical, analytical information Assessment (“loss given default”)

• Macro-prudential pre-decision paper Report on Financial Stability

• FSB proposition and decision • Cooperation with EU institutions

Follow-up, assessment

• Implementation

• Resilience against shocks • Imbalances

Macroprudential Report

• Financing conditions • Identifying stress situations

Communication: Public, market or specialist

Source: MNB.

How does the MNB identify systemic risks?

In order to proactively step up against risks and to manage them appropriately, the MNB considers it vital that risks be assessed regularly and analysed based on their analysts’ competence. Also, the identified risks are communicated as frequently and to as broad an audience as possible. The MNB continuously monitors the stability of the financial markets and the financial intermediary system as a whole and evaluates systemic risks in the following steps. • Risk identification. Potential risks entailing adverse financial stability consequences are identified based on “early warning” indicators, macroprudential indicators, experts’ forecasts, market intelligence and lending surveys. • Risk assessment. The assessment uses methods based on macroeconomic indicators and cross-sectional analysis methods, macroeconomic stress tests (both capital and liquidity stress tests), — 744 —

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and models identifying the contagion risks between institutions and the risks inherent in institutions’ interconnectedness. To cover the whole range of systemic risks, the FSB relies on several elements when making its decisions on potential intervention measures. • Directly determined indicators. In the case of some instruments, the decision is based on indicators that can be accurately determined in advance (e.g. credit-to-GDP gap), which fosters the efficiency of monitoring and the identification of risks in time. In order to establish the phases of cyclical systemic risks and to provide justification for the intervention, a methodology based on these indicators and signalling the activation and deactivation periods is devised as well. • Expert assessment. Systemic risks often cannot be measured by predetermined indicators, and the thresholds indicating their severity cannot be determined in advance due to the different origins and realisations of potential crises. Therefore, in addition to the existing expert knowledge at the MNB, the efficient identification of the risks and the choice of the appropriate instrument is heavily influenced by the continuous communication and cooperation with market participants and the various regulatory areas. • External risk assessments. The assessments prepared by international organisations or other Member States may highlight potential crossborder contagion channels and the potential risks emerging in the Hungarian financial intermediary system. Professional and appropriately integrated operation is key in risk analysis as well. In order to incorporate the international best practices, the MNB monitors not only direct domestic risks, but also the risk analyses pertaining to European and international markets, the developments on these markets and the emerging systemic risks, too. Owing to the direct communication between the areas, valuable

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information can be channelled into the decision-making process through data as well as expert assessments and experience. As a result of the monitoring and model-based analysis, the following materials facilitate the decision-making in the FSB. • Financial Stability Report. The summary excerpt of risk analyses is communicated to both the public and all other stakeholders. In case of greater risks, the Financial Stability Report may contain possible avenues for intervention. • Macroprudential pre-decision paper (MaDeP). The professional preparatory material for the FSB is based on the Financial Stability Report, discussing the alternatives for the new macroprudential instruments to be introduced if necessary, and making proposals for the potential modification of the existing instruments. • Pre-intervention proposition. Depending on the decision of the FSB based on the risk analysis, a detailed proposition presenting the impact of a concrete macroprudential regulatory measure may be drawn up, and based on that, following the necessary coordination steps, the FSB decision is issued. The departments responsible for analyses continuously inform the FSB about the emerging risks. The FSB usually meets every other week; therefore, it can take sound decisions based on thorough and frequent risk assessments. The framework of using regulatory instruments

In the case of a situation threatening the stability of the financial intermediary system, the FSB evaluates systemic risks based on the information gained during the risk analysis process, and decides the necessary steps to mitigate or eliminate those risks. Timing is key in taking regulatory measures. Thanks to the comprehensive risk analysis and the broad array of intervention instruments available to the FSB — 746 —

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within its own competence, the FSB can take preventive measures in a timely manner in the face of major systemic risks. While making the regulatory decision based on the results of the risk analysis, the FSB takes into account the following factors. • Necessity. Based on the previously identified inputs, it is yet to be decided whether the emerging systemic risks require intervention. If regulatory measures are necessary, the extent and form of the intervention is determined in a way that best facilitates the achievement of the macroprudential objectives. • Efficiency. The chosen instrument should have low costs and above all minimal negative externalities. This calls for an appropriate targeting and calibration of the instrument that helps avoid regulatory arbitrage. The efficiency of the instruments can be enhanced by their complementarity, i.e. by their parallel (complementary) use facilitating the achievement of the objectives. • Proportionality. The instruments should impose obligations on the individual institutions in proportion to their contribution to systemic risks. The use of proportionate measures is an important element of appropriate risk management, and it also forms the basis for appropriately boosting the resilience to shocks and for establishing an efficient risk appetite. • Transparency. The instrument’s objective, the reasons behind its selection and the method for its introduction should be clear and communicated appropriately. Bearing in mind the objectives of transparency and predictability, the MNB makes sure to appropriately manage market expectations during the introduction and the review of regulatory measures. Providing timely information to market participants is an important element in this.

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The intervention options available to the MNB

As a regulatory authority, the MNB can boost the resilience of the financial system and manage or prevent systemic risks not only through introducing concrete regulatory measures. The options available can be divided into three groups based on their direct impact on the financial intermediary system. • “Preliminary” measures. The main task of these is to provide information, on the conclusions of the MNB’s analyses about the developments in the financial intermediary system, to the public, market participants, other policy players and international organisations. They include the indications in various periodicals, reports, workshops and analyses, especially the Financial Stability Report or the Macroprudential Report, highlighting the necessity of addressing certain problems. These publications enhance the transparency of the operation of the regulatory authority and facilitate the appropriate development of expectations. • “Warning” instruments. These instruments warn stakeholders about the emergence of concrete risks that should be managed, as well as about the necessity and possibility of a potential regulatory intervention, albeit merely at a communicational level. This category is dominated by calls, resolutions affecting the financial intermediary system in a more direct manner, and the unique warnings and notices about risk management sent to market participants (especially in the form of ’dear CEO letters’ and face-to-face verbal consultations and information provision). • “Intervention”. The regulatory intervention during which the MNB, as the macroprudential authority, based on its mandate from the Parliament, creates binding provisions for market participants in the form of decrees and decisions. This can mean the development of detailed rules of the instruments that are mandatory for all Member States in the European legislative environment, the stipulation of the introduction of the instruments or their employment within the — 748 —

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national scope of competence. Based on its mandate, the MNB may take further measures at its own discretion in order to achieve interim objectives necessary for achieving financial stability. One portion of the available instruments is determined by the previously mentioned European Union legislative environment. With respect to these instruments, the task of the MNB, as the macroprudential authority, is to fine-tune them based on Hungarian systemic risks and market developments: this may mean tightening the requirements, the early introduction of instruments or the identification of the indicators forming the basis for the introduction. In the case of certain instruments, however, the MNB has broader powers, and it also has to calibrate the appropriate risk-reducing instrument after identifying the risks. With respect to excessive credit flows, systemic liquidity risks and the risks threatening the financial infrastructure, the MNB, as a national authority, has the right to issue decrees mitigating risks, irrespective of the EU legislation. In addition, at its own discretion, the MNB can prohibit certain financial services and suspend the sale of certain financial products for a maximum of 90 days if other risk-reducing instruments are ineffective. Although the MNB has a strong mandate with respect to the management of systemic risks, its legal competence does not cover the management of all unforeseeable risks. In line with its statutory mandate, the MNB informs the government about the necessity for risk management with respect to risks that cannot be managed with the available instruments. The Bank, as the macroprudential authority, makes recommendations to the government for legislation or an amendment in a procedure set forth in the MNB Act (in the so-called “comply-or-explain” process). The government has to inform the Governor of the MNB about the legislative process launched based on the recommendation (publicly if the recommendation was also sent to the government publicly), and the reasons about failing to take action, if appropriate. The instrument can be used effectively in case new

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risks are threatening financial stability, and when the option for public disclosure is used, transparency, a priority for the MNB, is also ensured. Follow-up, assessment

After an intervention, the FSB regularly monitors its impact and may decide to employ a new instrument, modify or phase out existing regulations. In addition to the information from the other areas within the MNB – especially from the monetary policy and money market analysis and microprudential and regulatory areas – the continuous feedback from market participants also plays a crucial role, since the MNB considers it a priority to facilitate the adjustment to the regulations as well as to make the implementation of the regulations as smooth as possible. During the follow-up, the communication tools discussed later and the cooperation with the stakeholders are also important. The MNB prepares an annual summary report based on the follow-up principle as defined in its macroprudential strategy. The Macroprudential Report provides an overview of the applied macroprudential instruments giving details about their calibration and impact mechanism. Furthermore, the banks’ modification to the instruments and the risks managed by these instruments are also of key importance. Cooperation with the authorities concerned

The MNB places special emphasis on the communication between the individual areas and the efficient coordination of the tasks. This means not only the alignment of the areas within the MNB, but also the cooperation with external authorities and foreign institutions. • Cooperation with monetary policy. Establishing cooperation between macroprudential and monetary policy is vital from many perspectives. First, the FSB has to achieve financial stability without prejudice to the price stability objective set by the Monetary Council, within the strategic framework determined by the Monetary Council. Second, whereas mainly macroprudential regulatory instruments are used — 750 —

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for directly managing the risks arising in financial intermediation, monetary policy can also affect financial stability. However, by default, monetary policy exerts too broad an impact for achieving financial stability objectives, and taking into account financial stability objectives can deflect the monetary policy’s contribution to economic growth from its optimal level.184 Nonetheless, as a last line of defence, monetary policy can support both monetary policy and financial stability objectives, when in addition to the interest rate instrument, other monetary policy instruments are used in a crisis.185 Since macroprudential policy exerts an impact on lending and other financial conditions that influence monetary transmission, and monetary policy measures have an effect on financial stability, the two areas need to cooperate fully in order to achieve the two separate objectives at the same time. This is ensured, inter alia, by the considerable personal overlap between the FSB and the Monetary Council, and the fact that the specialised materials about the FSB’s macroprudential decisions are received by the members of the Monetary Council as well, who can also request that a given decision be postponed so that the Monetary Council can first discuss it. Where relevant, the propositions about the use of macroprudential instruments discussed by the FSB should contain the measure’s monetary policy implications as well. This setup enables the free flow of information between the two areas, and efficient coordination between the decisions of the two bodies. Furthermore, when risks arise, the FSB establishes whether the macroprudential instruments are suitable for managing the identified risks. If the risks cannot be addressed appropriately with macroprudential instruments, the FSB informs the Monetary Council about the necessity of using monetary policy instruments for macroprudential purposes.

184 185

ishkin (2013) M Svensson (2011)

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• Cooperation with the microprudential, consumer protection and resolution areas. The cooperation with other areas within the MNB can harness the synergies in analysis and decision-making. Although the areas serve different purposes, the FSB is in charge of the decisions pertaining to them, which ensures the appropriate coordination, clear responsibilities and uniform action and communication towards the actors in the financial intermediary system. • Cooperation with the government. The independence from the government ensures that risk assessment and intervention are independent; however, the cooperation with governmental areas is key in efficient macroprudential policy, since several regulatory and crisis prevention instruments fall within the purview of the government. Therefore, the representative of the minister in charge of regulating money, capital and insurance markets can participate in the FSB’s meetings with negotiating powers when agenda items affecting macroprudential policy are discussed. Moreover, in order to ensure the free flow of information, upon request, the MNB provides information in questions related to financial stability to the government or the members of the government on an ad hoc basis. Another important element of the cooperation with the government is the previously discussed recommendation on legislation submitted to the government by the MNB when necessary. • Cooperation with international organisations and authorities from other countries. The MNB works in close cooperation with European institutions at several levels. One important aspect of this is the communication with the European Commission, the European Central Bank (ECB), the European Systemic Risk Board (ESRB) and the European Banking Authority (EBA) prior to introducing regulatory instruments. The other vital role of European organisations is the preparation of reports monitored by the MNB, the publication of recommendations pertaining to the MNB and the establishment of detailed technical rules as part of the European legislation. A major part of the cooperation with the authorities of other countries is the — 752 —

21 Targeted Hungarian macroprudential policy instruments in practice

domestic implementation of each other’s measures, which is also known as reciprocity, as well as providing information to these authorities if an institution falling within their purview is under Hungarian regulatory competence.

21.2 Macroprudential instruments applied by the MNB 21.2.1 Instruments preventing excessive credit growth and smoothing the credit cycle

The 2008 financial crisis clearly showed that the banking system is highly procyclical in its functioning. Due to changing risk perceptions and market frictions in the banking system, excessive risk-taking becomes widespread among banks and their clients in certain periods; then if a financial crisis emerges as a result, too low risk-taking becomes characteristic. The operation of the banking system strengthens economic and financial cycles, which entails large real economy losses. Therefore, one of the main tasks of the macroprudential authority is to mitigate the procyclicality of the banking system. The potential negative effects of excessive risk-taking are shown plainly by the consequences of pre-crisis lending in Hungary. When lending occurs under looser conditions than justified by the actual risks of repayments, it can be considered excessive. Several signs suggest that in the years before the crisis, substantial over-lending emerged in Hungary. As a result of excessive lending and risk-taking, the number of clients facing repayment issues soared after the eruption of the crisis. Due to the significantly expanding volume of non-performing loans, banks had to recognise substantial impairments, which, between 2008 and 2015, necessitated a capital increase amounting to 85 per cent of their own funds measured in 2008. Due to loan loss provisioning, banks’ free capital diminished, and their risk appetite also declined on account of the economic prospects, which considerably dampened lending. This

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curbed consumption and investments that were already on a downward trend in the crisis. As the macroprudential authority, the MNB uses the so-called debt cap rules and the countercyclical capital buffer (CCB) to mitigate excessive fluctuations in the credit cycle. While debt cap rules can be used to intervene on the demand side, at the time when lending is on the rise, the countercyclical capital buffer affects the supply side, and its release exerts its impact in the declining phase of the credit cycle. Therefore, the two instruments can efficiently complement each other.186 Debt cap rules: In Hungary, the MNB already applies instruments limiting excessive credit flows

The literature and international experience show that during the expansion phase in the credit cycle, debt cap187 rules are the most effective in restraining excessive credit flows.188 Debt cap rules are macroprudential instruments that can limit the systemically overheated household lending, while from a consumer protection perspective, they mitigate debtors’ over-indebtedness at the individual level as well. The payment-to-income ratio (PTI) requirement determines the largest repayment instalment that can be taken on, as a proportion of the net, verified monthly income. The cap on the loan-to-value ratio (LTV) limits the amount of the loan that can be taken out as a proportion of the property or the value of the vehicle serving as collateral.

or a more detailed description of the complementarity of the two instruments, see F Recommendation ESRB/2013/1. 187 Debt cap rules limit the maximum amount of the loan that can be taken out in two ways: (i) by applying a payment-to-income ratio (PTI) limiting the repayment burden that can be taken on in proportion to the consumer’s income, and (ii) by capping the loan-to-value ratio (LTV) limiting the amount of the loan that can be taken out as a proportion of the value of the collateral. 188 The instruments limiting excessive lending can be divided into two large groups: (i) instruments affecting credit supply (e.g. capital add-ons, raised risk weights), and (ii) instruments affecting credit demand (debt cap rules, stressed debt cap rules, amortisation and maturity limits). Among these, the literature considers debt break-type rules to be the most effective. See, for example: Kuttner–Shim (2013) and Claessens et al. (2013). 186

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21 Targeted Hungarian macroprudential policy instruments in practice

The Magyar Nemzeti Bank, as the macroprudential authority, was one of the first in Europe to introduce mandatory and comprehensive debt cap rules. The MNB introduced its binding debt cap rules as of 1 January 2015.189 Thereby, it was one of the first in Europe to create a comprehensive and enforceable framework limiting excessive lending in a forward-looking manner, at the onset of the expansion of the credit cycle (Table 21-1). Table 21-1: The LTV and PTI requirement levels Currency of the loan

HUF

EUR

Other currency

50%

25%

10%

PTI

Net monthly income below HUF 400 thousand Net monthly income of or above HUF 400 thousand

60%

30%

15%

LTV

For mortgage loan

80%

50%

35%

For vehicle loan

75%

45%

30%

Note: In the case of financial lease, LTV limits 5 percentage points above this can be applied. Limits have remained unchanged since the introduction of the rule. Source: MNB.

The MNB has developed the debt cap rules based on a broad array of aspects. The mandatory regulation is a combined system covering all credit products and protecting both debtors and lenders (i). During the calibration phase, the main aspects190 included the application of stricter limits on foreign currency loans, (ii) the income-based differentiation between limits (iii) and for compliance purposes only legal, verifiable income can be taken into account (iv). (i) The debt cap rules can be considered comprehensive with respect to both the credit products covered and the protection of the actors in lending. Hungarian debt cap rules cover all household credit products and their use is mandatory for all lenders, therefore there is only limited possibility for circumventing the regulation. MNB Decree 32/2014 (IX. 10.) on the regulation of the payment-to-income and the loan-to-value ratios. 190 The empirical experiences behind these aspects are discussed in Balás et al. (2015). 189

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The rules protect lenders and borrowers at the same time: in case of the PTI, the primary goal is to mitigate the risks arising from the excessive indebtedness of the clients, while the LTV mainly reduces the potential losses arising from collateralised bank loans. (ii) The risks of foreign currency indebtedness are limited by the MNB through stricter regulatory limits for both regulatory instruments. In the case of an exchange rate depreciation, both repayment instalments and the proportion of principal relative to the collateral may increase significantly, therefore the limits have to contain additional buffers to cover it.191 (iii) The regulation should be calibrated in a differentiated manner based on clients’ disposable income. Since consumption typically increases slower than the income rises,192 a greater proportion of the higher income can be spent on debt service. This justifies enabling relatively greater indebtedness in the case of clients with higher income. (iv) In order to facilitate prudent lending, only legal, verifiable income can be taken into account when applying the debt cap rules. Since legal, verifiable income can be considered more stable than other sources of income, only these income elements can be taken into account when using the PTI. This requirement encourages households that seek to obtain loans to report their income, therefore, in addition to ensuring responsible lending, another positive effect of the MNB decree is that it points towards the reduction of the shadow economy. However, this may exclude from borrowers some segments that previously earned “grey” income without any verification.

he limits differentiated by currencies were determined taking into account exT change rate movements and value-at-risk (VaR) estimation, – a widely used indicator for calculating market risk – and other relevant aspects. 192 See, for example, Hosszú (2011). 191

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21 Targeted Hungarian macroprudential policy instruments in practice

Before the upturn in the financial cycle, the limits should be calibrated so that the proportion of non-performing loans (NPL) in the banking system remains manageable even in a downturn. The PTI levels should be set so that they can keep the probability of default (PD) at an adequately low level even in the longer-run.193 When determining the maximum LTV, mainly the possibility of adverse developments in collateral prices and the risk arising out of the subdued prices of forced sales should be taken into consideration. Debt cap rules shape the credit market effectively through the effective calibration that is in line with the credit cycle as well as through the expectations of the actors. The framework aimed at the prevention of over-indebtedness was set up even before lending gained traction in the credit cycle. Owing to early introduction, both lenders and borrowers have become familiar with the new rules and have incorporated them into their decisions, which contributes to guiding the credit market towards sustainable lending through the actors’ expectations. This contributes to the development of a price competition in the household credit market instead of the problematic risk competition observed before the crisis. In parallel with increasing household lending, borrowers are gradually approaching the regulatory limits, but the present level of household indebtedness cannot be deemed excessive. The MNB property price index bounced back from its 2013 trough to the pre-crisis level by the end of 2015, which was accompanied by the expansion of the housing market turnover and a substantial rise in housing loans, both of which started from a low level. According to the MNB’s estimates, despite the dynamic rise in prices, at present, residential property prices typically still do not exceed the level justified by the macroeconomic fundamentals, thus the increase in property prices does not encourage households’ excessive indebtedness for the time being. 193

uring the calibration, the MNB considered the results of an empirical MNB study D about the relationship between PD and PTI levels. The calculations were performed in 2014, and the study was published in 2015 (Balás et al. (2015)).

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The rising house prices were accompanied by a similar growth in the average loan amounts of new housing loans. Thus, the average LTV related to new loans increased only moderately in the past period (in 2016 Q3 it was still only 58 per cent). Chart 21-3: Quarterly distribution of new loans by PTI 16

Per cent

Per cent Borrowers with higher income

16 14

2015 Q1

2015 Q4

55–60 %

2 50–55 %

2 45–50 %

40–45 %

35–40 %

30–35 %

25–30 %

20–25 %

15–20 %

10–15 %

5–10 %

0–5 %

2016 Q3

Note: Distribution per number of contracts by PTI categories. Source: MNB.

Market processes generally project a slow strengthening in the effectiveness of the LTV limits. In parallel with this, a gradual shift in the PTI values of the newly disbursed household loans towards the regulatory limits may also be observed (Chart 21-3). Although in mid-2016, the average payment-to-income ratio of 28 per cent was still well below the maximum level prescribed by the regulation, the MNB continuously monitors the distribution of the borrowers’ income tightness with a view to providing a timely response with the appropriate macroprudential instrument.

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21 Targeted Hungarian macroprudential policy instruments in practice

The increase in the average maturity of housing loans did not accelerate despite the introduction of the PTI regulation. The limits on the instalments that can be taken on may divert borrowers in a tight income situation wishing to increase the available loan amount with longer-term loans, which facilitates the partial circumvention of the objective of the regulation. This is particularly true for high-value housing loans. However, the average maturity of housing loans in 2013, i.e. even before the introduction of the PTI requirement, started to rise slowly, and it did not accelerate much after the introduction of the regulation either. Thus, the extension of average maturity is attributable to the larger loan amounts linked to the rise in housing prices rather than to the PTI regulation introduced in the meantime. The countercyclical capital buffer mitigates the negative lending impact of a financial crisis during the contraction of the credit cycle

The countercyclical capital buffer194 could principally mitigate the negative lending impact of a potential financial crisis. The countercyclical capital buffer has to be created by banks in addition to the microprudential capital requirements. The main aim of the buffer is to ensure that a capital buffer of adequate size is available to cover for a sizeable portion of banks’ losses incurred during a potential financial crisis (Chart 21-4). This way the capital position of credit institutions would deteriorate less after a crisis, therefore they would not be forced to curb their credit supply significantly in order to comply with the microprudential capital requirements that apply even in a crisis. The credit bust would have been mitigated in Hungary if a countercyclical capital buffer of HUF 320-430 billion, in line with the current regulation and amounting to 2.5 per cent of total risk exposure, had been available at the eruption of the crisis (this represents 20–35 per cent of the banking system’s losses incurred during the crisis).

194

The abbreviation “CCB” is used when referring to the countercyclical capital buffer.

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Part III: Changes in the Hungarian regulatory policy

Position of the financial cycle

Chart 21-4: The financial cycle-smoothing effect of the countercyclical capital buffer

Buid-up of CCB

Financial cycle with CCB

Time

Financial cycle without CCB

Release of CCB

Source: own work based on ESRB (2014).

The countercyclical capital buffer requirement is a key indicator in a framework communicated publicly and quarterly, which shows the assessment of the macroprudential authority about the current position of the financial cycle. In line with its objectives, the macroprudential authority determines the required countercyclical capital buffer by taking into account the current position of the financial cycle. Based on experience, the best way to capture cyclical systemic risks is to examine the divergence of the credit-to-GDP ratio from the long-term trend (this is the so-called credit-to-GDP gap). The buffer requirements are increased in proportion to the widening of the creditto-GDP gap, and calibrated to ensure that an adequate amount of capital is available at the onset of a potential financial crisis to cover the losses. The appropriate setting of the countercyclical capital buffer and its — 760 —

21 Targeted Hungarian macroprudential policy instruments in practice

regular review requires the adequate monitoring of the financial cycle, which should be based on a comprehensive assessment of financial systemic risks changing over time, typically published quarterly. This helps the communication between the macroprudential authority and the financial sector, and it may also shape the expectations of market participants. Based on the comprehensive assessment of the cyclical position, the macroprudential authority may indicate other necessary and sufficient interventions and their extent to stakeholders, which facilitates the efficient adjustment of the banking sector.195 The countercyclical capital buffer may curb excessive lending and the build-up of other cyclical financial systemic risks as well. Since during the operation of banks the expected return on equity is typically higher than on external funds, ceteris paribus, the countercyclical capital buffer requirement increases funding costs. This may also foster the reduction of risk-weighted assets, which may slightly mitigate excessive lending and other forms of excessive risk-taking as well. The MNB has been applying the countercyclical capital buffer framework to credit institutions and investment firms since 1 January 2016. The rate of the countercyclical capital buffer may be between 0 and 2.5 per cent of the total risk exposure to a counterparty located in Hungary, but in justified cases, an even higher capital buffer is possible as well. The MNB quarterly reviews the amount of the countercyclical capital buffer, and by default, in the case of an increase, the new requirement must be met after one year, while a decrease can be enforced immediately. The methodology and procedure supporting the application of the instrument were prepared in line with the ESRB’s relevant methodological recommendation (ESRB/2014/1) and by taking into account the special features of the Hungarian financial system (Chart 21-5). The risk of regulatory arbitrage emerging in connection with the CCB is sought to be managed by reciprocity, a compulsory 195

or example, instead of the countercyclical capital buffer requirement covering the F whole sector, a sector-level or in some other way more targeted instrument may be necessary to mitigate the given risks.

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requirement within the EU: Member States are stipulated by law to recognise the CCB rates prescribed by other authorities up to 2.5 per cent. Chart 21-5: The MNB’s decision-making mechanism for determining the CCB196 Preparation for decision

Standardised credit/GDP gap

Decision

Implementation

Quarterly

12 months after the increase of the rate (by default)

Additional credit/GDP gap

Standardised CCB rate (max. 2.5%)

Capital buffer guide (max. 2.5%)

ESRB additional indicators

Cyclical systemic risk map

FSB guided discretion Applicable CCB rate

Institution specific CCB rates

Foreign CCB rates

Source: MNB.

196

tandardised credit-to-GDP gap: The deviation of the credit-to-GDP ratio S from the long-term trend. This is an indicator used for quantifying overheating harmonised at the EU level, the calculation method of which is regulated by an ESRB recommendation. Its calculation and publication is mandatory for all Member States. Additional credit-to-GDP gap: the EU legislation leaves some leeway for the competent authorities to calibrate a credit-to-GDP gap better aligned with the national features of their country. Hungary has exercised this right, therefore the Hungarian capital buffer is determined based on an additional credit-to-GDP gap. Key CCB rate: the CCB rate calculated based on the ESRB’s methodological recommendation, which, in the MNB’s methodology, is derived from the additional credit-to-GDP gap. Applicable CCB rate: the CCB rate determined by the MNB’s Financial Stability Board uniformly for the actors in the Hungarian banking system based on the additional credit-to-GDP gap, the key CCB rate and the supplementary indicators incorporated into the so-called cyclical systemic risk map. Institution-specific CCB rate: the rate used for determining a bank’s unique capital requirement. It can be calculated using the weighted average of the countercyclical capital buffer rates applied in countries where the bank has substantial credit exposure.

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21 Targeted Hungarian macroprudential policy instruments in practice

The MNB mainly relies on the so-called key countercyclical capital buffer rate when making its decisions on creating the capital buffer. As we have already indicated, based on international experience, cyclical systemic risks are best captured by the credit-to-GDP gap, i.e. the divergence of the credit-to-GDP ratio from its long-term trend (BCBS 2010). Therefore, the MNB calculates the key countercyclical capital buffer rate based on such an indicator called the additional credit-toGDP gap. According to the calibration of the calculation rule performed by the MNB, acting in its capacity as the macroprudential authority, if the countercyclical capital buffer had built up in line with the key rate until 2008, it would have resulted in a capital buffer equalling the maximum of the primary regulation (2.5 per cent) in Hungary immediately before the crisis. During the establishment of the countercyclical capital buffer requirement, the MNB relies on both the cyclical systemic risk map and expert assessments. In order to ensure a more accurate identification of the various cyclical financial systemic risks, the MNB monitors not only the additional credit-to-GDP gap but also the development of 31 other indicators, all on a quarterly basis. These together constitute the cyclical systemic risk map. One portion of the indicators measures the overheating of lending, among which the credit-to-GDP gaps, created using a so-called multivariate HP filter197, are especially useful. Another part of the indicators characterises the financial system’s general resilience to shocks. In line with the so-called “guided discretion” principle, the FSB may also use other relevant information in risk assessment when determining the required countercyclical capital buffer rate.

197

I n their case, the trend–cycle decomposition is based not only on the development of the original time series but also on other macroeconomic variables influencing excessive lending (e.g. the weighted interest rate of household credit, the interbank rate, gearing in the banking system, the loan-to-deposit ratio), which enhances the accuracy and clarity of the gap indicators.

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Part III: Changes in the Hungarian regulatory policy

Chart 21-6: Standardised and additional credit-to-GDP gap, 2000—2016 Percentage point

Per cent 6 5 4 3 2 1

2016 Q1 2016 Q3

2015 Q1

2014 Q1

2013 Q1

2012 Q1

2011 Q1

2010 Q1

2009 Q1

2008 Q1

2007 Q1

2006 Q1

2005 Q1

2004 Q1

2003 Q1

2002 Q1

2001 Q1

0 2000 Q1

30 25 20 15 10 5 0 –5 –10 –15 –20 –25 –30 –35

CCB rate to be recognised (right-hand scale) Additional credit-to-GDP gap Additional credit-to-GDP gap, households Additional credit-to-GDP gap, nonfinancial corporations Standardised credit-to-GDP gap Source: MNB.

During a future contraction in the credit cycle, the MNB will decide on the elimination of the countercyclical capital buffer based on the Factor-Based Financial Stress Index (FSI), introduced in 2017. The daily-frequency FSI is the aggregate of 19 stress indicators in the five subsystems of the financial system (the secondary market for government bonds, equity market, foreign exchange market, interbank money market, the banking system’s lending risk), and it helps identify the onset of a financial crisis. Similar to the build-up of the capital buffer, the FSB may take into account all other relevant information during a guided discretion when eliminating the buffer. This may be especially important during a gradual elimination, i.e. when the CCB is not eliminated on account of a financial crisis but because systemic risks exhibit a steady downward trend, which makes the given level of the CCB rate unjustified. — 764 —

21 Targeted Hungarian macroprudential policy instruments in practice

Box 21-1 Estimating the macroeconomic impact of capital requirements

In the wake of the 2008 financial crisis, macroprudential authorities had the opportunity to considerably boost the capital requirements for credit institutions, therefore it is important to estimate the expected net social benefit of such an intervention. In the European Union, the CRDIV/ CRR regulatory package based on the Basel III framework introduced the countercyclical capital buffer, the additional capital buffer for systemically important financial institutions as well as the systemic risk buffer.198 By default, together they can amount to 7.5 per cent of total risk exposure, and under certain conditions, this figure could even be higher. Table 21-2: The impact of raising the countercyclical capital buffer Individual bank reactions Assets with high risk weight ↓

Effects on loan market Credit supply ↓

Lending spread ↑ Dividend ↓ Issuance of new equity ↑ Voluntary capital buffers ↓ Risk of regulatory arbitrage ↑

Offered interest rates on loans ↑

Effects on financial systemic risks

Macroeconomic effects

Resilience of banking sector ↑

Procyclicality in lending ↓

Procyclicality of banking sector ↓

Procyclicality in consumption ↓

Risk in non-banking sector ↑

Procyclicality in investment ↓ Procyclicality in GDP ↓

There is no effect in the extent of reduction in voluntary buffers and increase in regulatory arbitrage.

Source: The author’s work based on “Operationalising the selection and application of macroprudential instruments”, a 2012 study by the Committee on the Global Financial System.

198

he combined capital buffer requirement also includes the capital conservation T buffer, which gradually rises to 2.5 per cent. However, in Hungary the capital conservation buffer is prescribed at the pace regulated by the Credit Institution Act (annually between 1 January 2016 and 1 January 2019), therefore it cannot be deemed a direct component of macroprudential instruments.

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Part III: Changes in the Hungarian regulatory policy

According to the international empirical literature, the primary social benefit of raising capital requirements from their pre-crisis levels, is the improved resilience to shocks. The most comprehensive overview about the various potential methods can be found in BCBS (2016), Brooke et al. (2015) and Rochet (2014). One widespread method estimates the individual effects of raising capital requirements individually, then combines these effects in the following formula.

The net social benefit of raising capital requirements = (The reduction in the probability of a financial crisis) × × (The present value of the cost of the financial crisis) – – (The drop in GDP due to the larger interest rate spread) According to the estimates, the increasing capital requirements significantly decrease the probability of a financial crisis, albeit to a diminishing extent. The studies summarised by Rochet (2014, Table 2) assert that capitalisation doubled from 7 to 14 per cent of the total risk exposure, which reduces the probability of a banking crisis by 4 percentage points in a given year, which thus declines to around 1 per cent. When estimating the net social benefit, the greatest difficulty is presented by the quantification of the total costs of a financial crisis. Due to the profound differences between the countries under review, with respect to, for example, the success in crisis management, the estimates differ sharply as well. Some studies have found that financial crises persistently dampen the GDP’s trend: the median for reductions expressed as the net present value calculated for the starting point of the crisis was found to be 145 per cent of the annual GDP in the year before the crisis. According to other studies, after a temporary dip, GDP will return to its pre-crisis trend, and the figure corresponding to the previously mentioned median was found to be 19 per cent of GDP (BCBS 2010). The higher capital requirements make lending more expensive and may lead to a fall in credit supply, which reduces real economic activity only slightly based on the consensus of the empirical results. Various studies

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21 Targeted Hungarian macroprudential policy instruments in practice

claim that a 1-percentage point increase in capitalisation relative to total risk exposure entails a rise in lending rates of below 0.2 percentage points, a sustained drop in lending of 1.4–3.5 per cent as well as a rapid and sustained decline in GDP of 0.2 per cent (Rochet 2014, Brooke et al. 2015, BCBS 2016). According to the estimates prepared with the above-mentioned methodology, the net social benefit of raising capital requirements is positive. Yet due to the aforementioned uncertainties, no precise value can be given. Accordingly, for example in the BCBS (2010) summary, the net social benefit of capitalisation doubling from 7 to 14 per cent of total risk exposure is equivalent to a persistent growth of around 0.1–5.8 per cent in potential GDP, depending on whether the financial crises entail only temporary or sustained real economy losses. The international literature also includes more resource-intensive methodologies that are able to monitor the effects of macroprudential interventions more accurately. The most widespread among these is the use of the general equilibrium model containing capital requirements and perhaps even other macroprudential interventions that is calibrated to the unique features of the given country or country group. Although, for example, the ECB (ECB 2016, Clerc et al. 2015, Mendicino et al. 2015) and the Swedish central bank (Chen and Columba 2016) already have a similar model, these are typically under development in other European countries as well. Another approach employs so-called agent-based models. In contrast to the usual general equilibrium models, these models are said to represent economic actors’ decisions in a less well-founded and consistent manner, but in exchange highly complex economic relationships can be analysed. This approach may also be useful for evaluating macroprudential policy that strives to mitigate various systemic financial risks with many different types of instruments (see, for example, Hosszú and Mérő 2016). The net social benefit of capital increases was found to be positive with all the above-mentioned methods.

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Part III: Changes in the Hungarian regulatory policy

21.2.2 Instruments mitigating liquidity and financing risks

As a result of the experience of the 2008 financial crisis, the calls for managing liquidity risks more actively have become stronger. Prior to the crisis, even at the international level, there were no uniform, targeted, quantitative regulatory standards for managing liquidity risks. The financial crisis highlighted the importance of addressing liquidity risks, therefore after 2010, based on the recommendation of the Basel Committee, the establishment of the liquidity regulatory framework got under way in the EU as well. As a result of the new regulation, the liquidity coverage requirement (LCR) was created for mitigating shortterm liquidity risks, and the net stable funding requirement (NSFR) was developed in order to achieve a stable financing structure over the longer-term. In addition to ensuring that individual institutions remain liquid, the management of systemic liquidity risks is also crucial, and the latter is a macroprudential task. Systemic liquidity risk means that several dominant institutions face liquidity or financing issues at the same time. One important characteristic of systemic liquidity risks is that their emergence is to a large extent an endogenous process, in which the financial intermediary system, the interbank markets and the loss of confidence on these markets are key. The three main areas of macroprudential liquidity risks are those that build up periodically (cyclical risks), those that arise out of the interactions between individual actors (cross-sectional risks) and those that are in foreign currency (FX risks). The position of the financial cycle, the shock resistance of the individual institutions and their role in the financial network mainly influence the liquidity necessary in the domestic currency. On the other hand, FX liquidity is first and foremost determined by global financial developments and the vulnerability of the macroeconomy and the banking system.

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21 Targeted Hungarian macroprudential policy instruments in practice

The MNB, in line with its statutory mandate, is able to effectively mitigate systemic liquidity and financing risks through the introduction of several liquidity and financing regulations – in addition to the EU’s liquidity requirements – that can be applied to the Hungarian countryspecific risks in a more targeted manner. Liquidity coverage requirement

The liquidity coverage requirement (LCR) strengthens the systemic shock-absorbing capacity, in addition to mitigating risks at the individual level. The liquidity coverage requirement intends to provide, at the level of individual banks, the liquidity necessary for keeping short-term stress situations under control for 30 days. The fundamentally microprudential requirement when applied to every institution can provide an adequate liquidity buffer to the whole system for maintaining financial stability. Basically, the minimum LCR level may be met through two adjustment channels: by purchasing liquid assets or by reducing net outflows (this may often be realised by extending funds’ maturity). This may reduce banks’ profitability, as liquid assets have lower yields, and longer-term funds come with a liquidity premium. On the other hand, the better liquidity position mitigates banks’ risk level, which may reduce the interest on the acquired funds through the lower risk spreads. The individual liquidity buffers may strengthen the stability of not only the individual institutions, but also that of the entire banking system. The emergence of systemic liquidity risks is significantly influenced by the individual institutions’ shock-absorbing capacity and their role in the financial network. Accordingly, the provision of high liquidity buffers at the individual level also helps maintain the proper level of systemic liquidity by avoiding contagion and a loss of confidence. This also reduces the need for the central bank’s intervention as the lender of last resort in the case of a potential liquidity crisis.

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Part III: Changes in the Hungarian regulatory policy

Chart 21-7: Changes in LCR compliance 600

Per cent

600

100

Mean of LCR of 12 banks analysed

Nov. 2016

150

Oct. 2016

200

150

Sep. 2016

200

Aug. 2016

250

Jul. 2016

300

250

Jun. 2016

300

May. 2016

350

Apr. 2016

350

Mar. 2016

400

Feb. 2016

450

400

Jan. 2016

450

Dec. 2015

500

Nov. 2015

550

500

Oct. 2015

550

Minimum requirement of LCR

Note: The chart shows the first and ninth deciles, and the first and third quartiles. *Average weighted by balance sheet total. Source: MNB.

At present, the banking system has adequate liquidity reserves, thus the LCR functions as a risk prevention instrument. In line with the current position of the credit cycle, banks’ liquidity buffers are high. The LCR, which requires no effective adjustment for the time being, serves the maintenance of the buffers at the present level (Chart 21-7). In the future, the prescribed minimum LCR level is likely to effectively prevent the development of liquidity risks both at the individual bank level and the systemic level.

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21 Targeted Hungarian macroprudential policy instruments in practice

Foreign exchange funding adequacy ratio and foreign currency equilibrium ratio Foreign exchange funding adequacy ratio (FFAR)

Before 2008, substantial currency and maturity mismatches emerged in the banking system as a side effect of foreign currency lending to households. The banking system typically financed the long-term foreign currency mortgages with maturities of 15–20 years from two channels. Some banks acquired parent bank or other external, often short-term foreign currency deposits, while others employed synthetic foreign currency financing by combining Hungarian forint funds and off-balance sheet foreign currency swaps that were often short-term as well. The long-term mortgages denominated in foreign currencies and the related funding structure caused an excessive maturity mismatch and entailed substantial rollover and currency risks. The experience of the crisis showed that excessive currency mismatches entail significant risks if swap markets “freeze”, and the rollover of these transactions causes huge problems due to the increasing external vulnerability or global financial developments. With respect to excessive maturity mismatches, it became clear that in the case of market turbulences, the rollover of short-term, typically interbank foreign currency funds may also be problematic. Also, if the yield curve changes, currency and maturity mismatches may have adverse effects on the profitability of individual banks.199 Therefore, financial buffers seemingly appropriate during the expansion of economic and financial cycles may be inadequate during contraction periods, and in case of financial distress, the existing forint liquidity buffers cannot always be used without problems for to cover foreign currency outflows. These risks called for a macroprudential intervention. In order to establish long-term harmony between foreign currency assets and liabilities, the instrument of choice became the foreign exchange funding adequacy ratio (FFAR). The requirement stipulates The quantification of this can be measured by the so-called duration gap (DGAP) value.

199

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that foreign currency funds be steadily available as a predetermined proportion of the assets requiring stable foreign currency financing. The logic of the FFAR regulation can be compared to the NSFR in the Basel III recommendation200 being applied to foreign currency items. Initially, due to the peculiarities of the functioning of Hungarian banks, the net position in foreign currency swaps of over one year could also be taken into consideration as stable funding. After its introduction on 1 July 2012, the regulation would have become increasingly strict and reached 100 per cent by 1 January 2017, to ensure the appropriately stable foreign currency financing in the Hungarian banking system. The conversion of household mortgages to forint at the beginning of 2015, required the review of the FFAR regulation. Due to the removal of foreign currency-denominated household loans from the indicator, immediate risks decreased, but in order to prevent the repeated buildup of the problem, the MNB decided to maintain and even tighten the FFAR regulation. As a result of the forint conversion, the compliance of most banks improved (Chart 21-8), thus the prescribed 100-per cent level could already enter into force on 1 January 2016. In addition, the foreign currency swap portfolio, which decreased due to the closing of the on-balance sheet foreign-currency position, was also excluded from stable funding, thereby moving the ratio closer to the international NSFR regulation, which is to be introduced in the future. With these measures, the FFAR regulation limits the build-up of excessive currency mismatch and the excessive shortening of foreign currency funds. The regulation encourages banks to raise stable foreign currency funds. One of the most obvious methods for banks’ adjustment is to extend the maturity of short-term foreign currency funds. A similar effect may be achieved by increasing the ratio of foreign currency client deposits, which are deemed stable, in the structure of funding. If banks’ adjustment takes place through the extension of the short-term funds, in addition to the diminishing maturity mismatch, the short-term 200

http://www.bis.org/bcbs/basel3.htm

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21 Targeted Hungarian macroprudential policy instruments in practice

external debt of the banking system, and thus also the vulnerability of the national economy may also decrease. Chart 21-8: The average, distribution and expected level of the FFAR Per cent

Per cent 2nd revision Conversion into HUF

Introduction

1st revision

300 280 260 240 220 200 180 160 140 120 100 80 60 40 20 0

Apr. 2012 Jun. 2012 Aug. 2012 Oct. 2012 Dec. 2012 Feb. 2013 Apr. 2013 Jun. 2013 Aug. 2013 Oct. 2013 Dec. 2013 Feb. 2014 Apr. 2014 Jun. 2014 Aug. 2014 Oct. 2014 Dec. 2014 Feb. 2015 Apr. 2015 Jun. 2015 Aug. 2015 Oct. 2015 Dec. 2015 Feb. 2016 Apr. 2016 Jun. 2016 Aug. 2016 Oct. 2016

300 280 260 240 220 200 180 160 140 120 100 80 60 40 20 0

Note: First and third quartile values. Dots denote the average. Source: MNB.

Due to the forint conversion, compliance with the revised FFAR regulation required no major modification. Since foreign currency household mortgages accounted for a substantial part of the foreign currency assets requiring stable foreign currency funds, after their conversion to forint, the stable foreign currency funding requirement to be maintained in the banking system decreased considerably. In line with the low level of systemic risks, the 100-per cent level does not represent a major adjustment pressure for the vast majority of banks even while maintaining an average surplus of 20 per cent. However, in the case of certain institutions, the lower voluntary buffers held in excess of 100 per cent also show that compliance with the requirement requires a more active liquidity management. In the future, with a view

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to ensuring preparation for the introduction of the NSFR regulation and smooth compliance, it may be justified to review the regulation. Foreign exchange coverage ratio (FECR)

The excessive on-balance sheet currency mismatch of the banking system may result in the emergence of systemic risks. In addition to ensuring currency matching with maturities of more than a year (see the FFAR requirement), limiting the general currency mismatch may be justified in case of certain risks. The difference in the denomination of the assets and liabilities is a natural phenomenon in the operation of banks, however, when it becomes excessive, it may pose liquidity risk. As a result of the excessive on-balance sheet currency mismatch, institutions’ reliance on off-balance sheet instruments, especially foreign currency swaps, grows. With respect to swaps, the main risk is posed by the continuous rollover of the transaction in the case of short maturities, and the surplus margin requirements at times of shocks in the case of longer maturities (“margin call”). In order to prevent the emergence of risks, the MNB introduced the foreign exchange coverage ratio (FECR) as of 1 January 2016. Due to the on-balance sheet currency mismatch, a considerable dependence on the swap market had been present in the Hungarian banking system for a long time. Due to the forint conversion in early 2015, the onbalance sheet exposure diminished, which paved the way for regulating currency matching in a manner that does not constrain normal banking operations but is able to prevent the repeated build-up of an excessive dependence on the swap market. In early 2016, the currency mismatch between banks’ assets and liabilities was capped at 15 per cent of the balance sheet total, limiting excessive dependence on the swap markets both at the individual and the systemic level.

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21 Targeted Hungarian macroprudential policy instruments in practice

Chart 21-9: On-balance sheet foreign currency exposure of the banking system as a percentage of the balance sheet total 20

Per cent

Per cent Announcement of the regulation

Regulation enters into force

20 18 16

Average of the institutions analysed

FECR maximum limit

Note: The chart shows the first and third quartile values of the 16 institutions under review. Source: MNB.

The FECR is a preventive regulation; prior to its implementation, only a few institutions had to adjust significantly (Chart 21-9). As the FECR regulation should be applied irrespective of the direction of the foreign currency position, a few institutions with surplus foreign currency funds had to close their substantial on-balance sheet exposure. They replaced the short-term external foreign currency loans with swaps, which simultaneously reduced the on-balance sheet foreign currency position and the off-balance sheet net swap position. This form of the adjustment had no material impact on profitability. Accordingly, the FECR regulation prevents the future opening of the on-balance sheet exposure, the excessive dependence on the swap markets and thereby the repeated increase in the banking sector’s external vulnerability.

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Part III: Changes in the Hungarian regulatory policy

Mortgage funding adequacy ratio

With the conversion of the long-term foreign currency mortgages to forint – although, as a result of the conversion, the exchange rate risk no longer burdens Hungarian households – the forint maturity mismatch substantially increased in the Hungarian banking system. Due to the fact that the overwhelming majority of the mortgages converted to forint in February 2015 had a maturity substantially longer than 10 years and that short-term forint financing dominated, a significant systemic funding risk emerged in the banking system’s balance sheet due to the increased maturity mismatch. Managing the problem justified the acquisition of long-term, stable funds. The MNB manages the systemic risks by prescribing the acquisition of longer-term forint funds. Since the FFAR only encourages the mitigation of the foreign currency maturity mismatch, a new regulation had to be introduced to establish forint maturity matching. A complex indicator enabling several adjustment channels (e.g. NSFR) or one focusing on a shorter time horizon would not be able to reassuringly address the risks arising out of such a large maturity mismatch. The mortgage funding adequacy ratio (MFAR) developed by the MNB directly affects the funding of long-term household mortgages. According to the requirement, banks are obligated to finance a given portion of the forint mortgages from long-term, mortgage-backed funds, which is possible through mortgage bond issuance or stable, mortgage-backed funding acquired from mortgage credit institutions (refinancing). The prescribed minimum initial compliance level – taking into account the legislative environment, banks’ adjustment needs and the current activity on the mortgage bond market – is 15 per cent as of 1 April 2017. As a result of the requirement, the role of long-term mortgage-backed forint funds is likely to increase in the banking system’s balance sheet. Accordingly, both the number of mortgage banks and the amount of loans extended by them to commercial banks for mortgage-refinancing, are likely to increase. The use of longer-term funds reduce the banking — 776 —

21 Targeted Hungarian macroprudential policy instruments in practice

system’s cyclical vulnerability through the funds’ decreasing rollover risk and the falling interest rate risk, which is particularly important due to the repeated boom in long-term housing loans. At the same time, due to the positive slope of the yield curve, the use of longer-term funds may generate extra costs for banks compared to financing by deposits; however, this extra cost may substantially decrease if the mortgage bond market deepens. Chart 21-10: Impact of mortgage bond-based financing on interest rate spreads on the bank and the client side Deeper mortgage bond market

Mortgage bonds

Repayments

Long-term funding

Facilitates fixed interest rates and lower interest risk

Interest rates can be fixed

Strict legal rules, low level of risk

Lower funding costs at longer maturities

Lower borrower risk

Lower interest rate spread

Effects on the side of banks

More stable instalments, more time to prepare for possible increases

Effects on the side of borrowers

Note: Assuming that most of the issued mortgage bonds are fixed-rate bonds. Source: MNB.

The sounder financing structure of mortgages not only reduces the rollover and interest rate risks arising from the maturity mismatch, but may also result in lower spreads in lending rates. On the one hand, due to the higher credit risk rating, mortgage-backed funds may be

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raised at lower spreads compared to other uncollateralised long-term funds, thus they reduce the funding costs of mortgages compared to other funds with identical maturity. On the other hand, the typically fixed-rate mortgage bonds (and refinancing funds) may encourage banks to extend mortgage loans with longer interest periods with a view to reducing the interest rate risk. As a consequence, fixing interest rates for longer periods may reduce the default risk, which may lead to improved portfolio quality and lower lending rates (Chart 21-10). Chart 21-11: New funds necessary for meeting the new MFAR requirement 700

HUF Billions

Per cent

600

500

400

300

200

100

Banks planning to comply by issuing mortgage bonds

Banks planning to comply by taking refinancing loans

Banking system

New stable funding needed Accepted stable funding Average MFAR (weighted average, right-hand scale) Note: Based on November 2016 figures. Without taking into account maturing liabilities. The MFAR figure is a mortgage-weighted average. Source: MNB.

Compliance by April 2017, necessitates substantial preparation and external financing across the banking system. At the time of the regulation’s announcement, the majority of the institutions had no long-term mortgage-backed funds eligible in terms of the MFAR requirement. Accordingly, the regulation effectively necessitates the

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21 Targeted Hungarian macroprudential policy instruments in practice

acquisition of funds for most banks. In case of the analysed leading banks this entails the issuance of new mortgage bonds of HUF 220-240 billion until April 2017 (Chart 21-11). At the sector level, the portfolio to be issued may amount to HUF 340-380 billion including maturing assets. To ensure compliance, the institutions with the largest mortgage loan portfolio have already established their own mortgage banks, and some of the institutions have already concluded the necessary refinancing agreements.

21.2.3 Instruments limiting excessive concentration

The excessive concentration of financial institutions’ exposures may lead to the emergence of systemic risks through two channels. The concentration of direct exposures emerges when exposures to certain sectors or partners are too large. If the performance of these sectors or partners declines, it may have a substantially negative effect on the whole financial intermediary system. In addition, indirect exposures may entail further risks: due to the interconnectedness between the members of the financial intermediary system, the negative effects may spill over through the market-disruptive effect of contagion and fire sales. The best tool for managing concentration risks should be chosen depending on the type of risk. The emergence of excessive concentration may be prevented by limiting exposures to certain sectors or partners, or by establishing central counterparties (CCP), which reduce the probability of contagion within the financial system. In case of already existing excessively-concentrated exposures, instruments encouraging the reduction of the given exposures need to be introduced. The best instrument for this is the systemic risk buffer (SRB) used for managing structural risks.

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Irresponsible lending could be observed not only in the household segment, but also in the corporate sector. Prior to the crisis, project financing, primarily based on commercial properties, expanded in Hungary at an unsustainable pace similar to that of household loans, in several cases through the financing of projects without any promise of return. The overwhelming majority of the portfolio amounting to HUF 2,500 billion that built up until the 2008 crisis consisted of foreign currency-denominated project loans extended to residents. The commercial property market collapsed in the wake of the crisis, considerably curtailing projects’ ability to generate income, making many of them insolvent. The problematic exposures considerably reduced banks’ profitability and absorbed capital and human resources, which indirectly had a negative effect on banks’ general risk appetite and lending activity. The high proportion and concentration of problematic commercial property exposures in the Hungarian banking system posed a significant macroprudential risk. In late 2014, the MNB deemed the high proportion of non-performing corporate loans, especially the direct and indirect exposures linked to commercial properties, a key risk that had to be addressed.201 The excessively rapid growth in problematic property project loans compared to the other problematic corporate loans as well as their persistence hinders the banking system in fulfilling its role to support economic growth. The high institutional and geographic concentration of the problem loans further exacerbated the systemic risk. The overwhelming majority of the loans, 85 per cent, were held by 10 banks. With respect to geographical distribution, almost two-thirds of the loans was linked to commercial properties in and around Budapest. In the European Union’s regulations, one of the key instruments for managing structural systemic risks is the systemic risk buffer (SRB). The permitted SRB rate essentially moves between 1 and 3 per 201

Financial Stability Report, November 2014

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21 Targeted Hungarian macroprudential policy instruments in practice

cent of the credit institution’s risk-weighted exposure, by increments of 0.5 per cent, but in particularly justified cases, a higher rate may also be prescribed subject to the European Commission’s approval. The MNB determines the individual SRB requirement as a proportion of the individual bank’s contribution to systemic risk, based on its domestic non-performing commercial property exposures relative to the domestic Pillar 1 capital requirement. When the ratio is over 30 per cent, the MNB prescribes an SRB rate of at least 1 per cent, while the highest, i.e. 2-per cent capital buffer must be met when the ratio is over 90 per cent (Table 21-3). The credit institutions with problem portfolios not exceeding HUF 5 billion are exempted from the requirement. Table 21-3: SRB capital requirements by size of the problematic exposure Problematic portfolio as a proportion of the domestic Pillar 1 capital requirement

SRB rate

0.00–29.99%

0.00%

30.00–59.99%

1.00%

60.00–89.99%

1.50%

above 90.00%

2.00%

Source: MNB.

Since the announcement of the measure, banks have substantially cleaned up their balance sheets. As a result, the problem portfolio of almost HUF 823 billion at the end 2014 Q3 shrank by 62 per cent to HUF 311 billion by the end of 2016 Q2. The degree of the clean-up varied by institution, but it was substantial at individual level as well. If further balance sheet clean-up efforts are made, the capital buffer to be created in 2017 could substantially decrease (Chart 21-12).

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Chart 21-12: Development of problematic project loans and commercial property exposures, by the components defined by the SRB 1200

HUF Billions

Per cent Announcement of possible application of the SRB

1000

Decision on the application of the SRB

60 50

Sep. 2016

Jun. 2016

10 Mar. 2016

200 Dec. 2015

Sep. 2015

400

Jun. 2015

Mar. 2015

600

Dec. 2014

Sep. 2014

800

Acquired real estate Project loan, non-performing based on the bank's categorisation Project loan, restructed, pending Project loan, over 90 days, restructured Project loan, over 90 days, based on original contract Ratio of problematic stock in the total stock (right-hand scale) Source: MNB.

21.2.4 Instruments for mitigating the impact of misaligned incentives that increase systemic risk

When certain systemically important banks experience stress or insolvency, it may become a risk threatening the functioning of the financial intermediary system as a whole, and it may also indirectly jeopardise real economic activity. The need for managing losses and contagion effects arising from the potential insolvency or bankruptcy of significant banks had already been present among the tasks of regulators (the “too big to fail” problem). However, the experience of the crisis showed that other unique bank features may become serious factors of systemic risk: the bankruptcy of smaller banks that nonetheless perform critical functions and are difficult to substitute can also cause a bank run, either directly or through the confidence crisis triggered at more significant banks having ties to them. Cross-border — 782 —

21 Targeted Hungarian macroprudential policy instruments in practice

and cross-market activities and the sale of complex products may also be risky for the whole financial system. Based on their special status, systemically important institutions are prone to taking greater risk, which increases the likelihood of a potential future stress for them. Significant banks used to be rescued by states at the expense of the budget (“bailout”) in order to avoid insolvency. However, their expectation about a state rescue may have generally entailed looser risk-taking policies (“moral hazard” problem) and ultimately an increase in the probability of default. Since their lenders factored in implicit state guarantees, these institutions were able to finance themselves more cheaply. This upset the level playing field on the banking market and reduced the incentives for lenders and equity holders for controlling and possibly mitigating risk-taking. The unsustainability of the state’s engagement during the financial crisis gave rise to a new set of bailout-instruments, i.e. resolution. During the crisis, several systemically important institutions came close to bankruptcy, and they could only weather the storm with state assistance. The total amount of direct state assistance provided to banks between 2008 and 2013, in order to preserve the stability of the financial system in the European Union, was EUR 821 billion, out of which recapitalisations accounted for EUR 448 billion.202 From 1 January 2016 onwards, the possibility of a bailout in the bank resolution framework was replaced by the requirement of a bail-in: if banks that are dominant from the perspective of public interest experience financial difficulties, the primary sources of recapitalisation are equity owners and lenders’ contributions. Within the framework of the so-called bail-in, the deposits of large depositors that do not fall under deposit insurance and other external funds are converted into capital. Concentration in the Hungarian banking industry is moderate. In international comparison, Hungary, along with the other Visegrád 202

http://ec.europa.eu/competition/state_aid/scoreboard/amounts_used_2008-2013.xls

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countries, is among the countries with moderate bank concentration with respect to both the market share of the five greatest banks and the Herfindahl–Hirschman Index (HHI) calculated for the whole banking system. This means that based on their size, several institutions may become systemically important merely on account of their position in the banking system. The loss of the critical functions performed by the systemically important credit institutions may hamper the Hungarian financial system as well as the efficient functioning of the macroeconomy. So-called critical functions can be identified in banking operations, the potential loss of which may entail a significant drop in the economic performance of other financial institutions or actors of the economy. Usually, these critical functions can be replaced by other credit institutions only in the longer-run, therefore banks performing critical functions deserve special attention with regard to systemic risk. The existence of the systemic risks in Hungary arising out of replaceability is attested, for example, by the fact that in 2015, 90 per cent of all household loans were managed by 10 banks. Approximately 60 per cent of household current account loans were covered by three banks, and in the case of mortgagebacked household loans, the first three institutions’ share was 50 per cent. The relationships between the financial institutions may exacerbate the shocks to the systemically important institutions. Contagion may spread in the uncollateralised interbank market if due to the insolvency of an institution, the solvency of its partners declines to the extent that at least one of them is unable to repay its interbank loans, which triggers a chain reaction (Eisenberg–Noe 2001). The MNB monitors this contagion potential of the individual institutions. Albeit in the context of substantial noise, the weekly interbank turnover in the 2008–2015 period shows an upward trend, coupled with a similar development in the number of lending relationships forged in the network. Despite the expanding turnover, according to the MNB model’s calculations, the current structure of the interbank network does not transmit significant, multi-round contagion. Therefore, in the MNB’s view, the extent and — 784 —

21 Targeted Hungarian macroprudential policy instruments in practice

probability of causing losses through interbank lending is subdued. However, as turnover picks up and the structure of the network changes, this might change considerably in the future. Financial institutions’ collective behaviour pointed in the same direction may also cause systemic risks. According to international analyses, the probability of the so-called indirect contagion due to similar assets and exposures and the contagion’s expected negative impact are often more pronounced than those of direct contagion (Clerc et al. 2015). The forced sale of assets by several actors at the same time or an attempt at this (fire sale) may pose a substantial systemic risk. The intention to sell may entail a drop in prices, which reduces the value of institutions’ assets, thereby limiting their liquidity, which may induce further forced sales. Ultimately the drop in asset value may lead to insolvency through the reduction of own funds, and this has the potential to trigger direct contagion.203 The MNB has identified the systemically important institutions that are required to accumulate an additional capital buffer (Chart 2113). The MNB, in its capacity as macroprudential authority, prescribes an additional capital buffer for the systemically important institutions in excess of the microprudential capital requirements as of 1 January 2017. The MNB determines the institutions concerned annually, and it performed this for the first time in 2015. As a result of the 2016 review, instead of the former nine other systemically important institutions (O-SII), now only eight such institutions can be identified.204 The institutions concerned are determined by the standardised methodology published by the European Banking Authority (EBA/GL/2014/10). The methodology has two components: the basic methodology laid down in the EBA recommendation and the optional supplementary methodology, tailored to the domestic banking system by the national I n its models, the MNB monitors this potential as well (for further information, see MNB 2016). 204 https://www.mnb.hu/penzugyi-stabilitas/makroprudencialis-politika/a-makroprudencialis-eszkoztar/a-rendszerkockazatot-erosito-rossz-osztonzok-tompitasat-szolgalo-eszkozok 203

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authorities. The basic and the supplementary methodologies together represent the methodology that is applied by the MNB (Table 214). Based on the calculated scores, the MNB determines individual rate of additional capital requirements between 0.5 and 2 per cent of the total risk exposure, in line with the EU regulations, for each institution identified as systemically important. The initial capital buffer requirement was determined in the second half of 2016, based on 2015 balance sheet data. The MNB opted for a gradually increasing, fourstage implementation, thus banks must provide the full, individually identified capital buffers by 2020. Chart 21-13: Banks classified by the MNB as systemically important (O-SII) in 2016 and their capital buffer rates 3,000

Percentage point

Per cent

3.0

500

0.5

0.0

MKB

1.0

CIB

1,000

ERSTE

1.5

Raiffeisen

1,500

Takarékbank

2.0

K&H

2,000

UniCredit

2.5

OTP

2,500

Score obtained Threshold (350 bp) Final capital buffer rate (right-hand scale) Note: Based on audited, consolidated data on 31 December 2015. In line with the EBA guidelines, financial institutions exceeding 350 basis points are qualified as systemically important. Banks are required to reach the maximum solvency capital requirement by 2020. Source: MNB.

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21 Targeted Hungarian macroprudential policy instruments in practice

Table 21-4: Methodology of the MNB to identify systemically important institutions Criterion

Indicator’s name

Size

Total assets

Weight 20%

Basic methodology

Value of domestic payment transactions Replaceability

Private sector deposits from depositors in the EU

20%

Private sector loans to recipients in the EU Value of OTC derivatives Complexity

Cross-jurisdictional liabilities

20%

Cross-jurisdictional receivables Intra-financial system liabilities Interconnectedness Intra-financial system assets

20%

Debt securities outstanding Supplementary methodology

Off-balance-sheet items (credit lines, guarantees) Share in clearing and settlement system Supplementary indicators

Assets under custody Interbank receivables and/or liabilities (network analysis)

20%

Market transaction volumes or values (network analysis)

Source: MNB.

The long-term economic benefits of the additional capital requirement are likely to exceed its costs. A positive expected impact of the measure is that the shock absorbency of the respective banks strengthens, and the probability of these banks’ bankruptcy or the occurrence of a potential systemic problem through the contagion effects substantially decreases. According to studies in the literature, this may prevent a substantial drop in GDP. The prevailing European practice shows that the small, open economies that serve as seats for large international banking groups consider the establishment of this capital protection

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especially important205 (ESRB 2016). The concrete cost of the Hungarian adjustment is not expected to be substantial, since according to end2015 data, the Hungarian banking system is over-capitalised. Based on the consolidated reports for the first half-year of 2016, the aggregate free capital buffer of the institutions identified as O-SII is substantial, amounting to roughly HUF 776 billion. In the case of all institutions concerned, the free capital buffer is multiple times greater than the capital absorbed by the O-SII buffer in 2017. The maximum amount of the expected surplus capital is projected to be HUF 48 billion in 2017.

205

mong EU Member States, similar considerations were taken into account when A determining the additional capital requirements for systemically important institutions in the Netherlands and Sweden, or the EEA country Switzerland can also be mentioned, since there the SIFI capital requirement is 19 per cent.

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21 Targeted Hungarian macroprudential policy instruments in practice

Key terms additional capital buffer for systemically important institutions bail-in bailout basic methodology capital buffer comply-or-explain countercyclical capital buffer (CCB) currency mismatch credit cycle credit-to-GDP gap cyclical systemic risks debt cap rules European Systemic Risk Board (ESRB) excessive credit flows Factor-Based Financial Stress Index (FSI) financial contagion financial infrastructure Financial Stability Board (FSB) fire sales foreign exchange coverage ratio (FECR) foreign exchange funding adequacy ratio (FFAR) global systemically important institution (G-SII)

Herfindahl–Hirschman Index interconnectedness liquidity coverage ratio (LCR) liquidity risks Macroprudential Report maturity mismatch moral hazard mortgage funding adequacy ratio (MFAR) negative externalities net stable funding ratio (NSFR) on-balance sheet exposure other systemically important institution (O-SII) procyclical project loan reciprocity regulatory arbitrage Report on Financial Stability resolution structural risk supplementary methodology systemic risk buffer System-Wide Financial Stress Index (SWFSI) total risk exposure too-big-to-fail

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References Balás, T. – Banai, Á. – Hosszú, Zs. (2015): Modelling probability of default and optimal PTI level by using a household survey. MNB Occasional Papers 117. Budapest: MNB. BCBS (2010): Guidance for national authorities operating the countercyclical capital buffer. BCBS (2016): Literature Review on Integration of Regulatory Capital and Liquidity Instruments. BCBS Working Papers No. 30. Brooke, M. – Bush, O. – Edwards, R. – Ellis, J. – Francis, B. – Harimohan, R. – Neiss, K. – Siegert, K. (2015): Measuring the Macroeconomic Costs and Benefits of Higher UK Bank Capital Requirements. Bank of England Financial Stability Paper, No. 35. CGFS (2012): Operationalising the selection and application of macroprudential instruments. CGFS Papers No. 48. Chen, J. – Columba, F. (2016) Macroprudential and Monetary Policy Interactions in a DSGE Model for Sweden. IMF Working Paper No. WP/16/74. Claessens, S. – Ghosh, S. R. – Mihet, R. (2014): Macroprudential Policies to Mitigate Financial System Vulnerabilities. IMF Working Paper, No. 155. Clerc, L. – Derviz, A. – Mendicino, C. – Moyen, S. – Nikolov, K. – Stracca, L. – Suarez, J. – Vardoulakis, A. P. (2015): Capital Regulation in a Macroeconomic Model with Three Layers of Default. International Journal of Central Banking. Vol 11. No. 3. Eisenberg, L. – Noe, T. H. (2001): Systemic risk in financial systems. Management Science Vol 47. No 2. pp. 236-249. ECB (2016): Macroprudential Bulletin. Issue 1/2016. ESRB (2014): The ESRB Handbook on Operationalising Macro-prudential Policy in the Banking Sector. ESRB (2016): A Review of Macroprudential Policy in the EU in 2015. Hosszú, Zs. (2016): The impact of credit supply shocks and a new FCI based on a FAVAR approach. MNB Working Papers 1/2016. Hosszú, Zs. (2011): Pre-crisis household consumption behaviour and its heterogeneity according to income, on the basis of micro statistics. MNB Bulletin. Kuttner, N. K. – Shim, I. (2013): Can non-interest rate policies stabilise housing markets? Evidence from a panel of 57 economies. BIS Working Paper No. 433. Mendicino, C. – Nikolov, K. – Suarez, J. – Supera, D. (2015): Welfare Analysis of Implementable Macroprudential Policy Rules: Heterogeneity and Trade-offs. Mishkin, F. S. (2013): Macroprudential and Monetary Policies. In Evanoff D. D. – Holthausen C. – Kaufman G.G. – Kremer F. (2014): The Role of Central Banks in Financial Stability: How Has It Changed? Singapore: World Scientific Publishing Co. pp. 409-422.

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21 Targeted Hungarian macroprudential policy instruments in practice MNB (2014): Financial Stability Report November 2014. MNB (2016): Macroprudential Report 2016. Nier, E. W. – Osínski, J. – Jácome, L.I. – Madrid, P. (2011): Towards Effective Macroprudential Policy Frameworks: An Assessment of Stylized Institutional Models. IMF Working Paper No. WP/11/250. Rochet, J. – Ch. (2014): The Extra Cost of Swiss Banking Regulation, SFI White Papers. Svensson, L. E. O. (2011): Monetary Policy after the Crisis. Federal Reserve Bank of San Francisco.

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The emergence of the resolution function

The MNB as the resolution authority András Kómár – Antal Stréda

Hungary was among the first countries to implement the European Union’s framework developed in 2014, based on global standards and targeting the resolution of credit institutions and investment firms. Since October 2013, the Magyar Nemzeti Bank has been the designated national resolution authority in Hungary. This chapter presents the most important tasks related to the resolution authority function of the Magyar Nemzeti Bank, both in peaceful times and in crisis situations. Due to the increasingly intense crossborder activities of credit institutions and investment firms, the key to the success of future resolution proceedings will be the efficient cooperation between the resolution authorities of the various countries. Accordingly, the chapter outlines the Magyar Nemzeti Bank’s existing network with foreign resolution authorities as well as the steps taken in this regard. Several implementation rules of the European Union’s resolution directive are yet to be adopted, therefore we will touch upon the active participation in the work of the European Banking Authority with respect to resolution regulation. Furthermore, the role of the Magyar Nemzeti Bank acting in its capacity as the resolution authority in the functioning of the Hungarian collective funds will be demonstrated as well. One of the first tests in practice of the European Union’s resolution framework was the successful resolution of the MKB Bank Zrt. by the Magyar Nemzeti Bank, and the milestones of this process will also be reviewed in this chapter.

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22.1 The road to resolution The two classic crisis management tools in the financial sector are phaseout from the market (the withdrawal of the licence by the authority and liquidation) and bailout (recapitalisation from public money or state takeover). The 2007–2008 crisis showed that in the case of systemically important financial institutions, the first solution cannot be applied due to protracted liquidation and contagion effects, therefore the state can efficiently and successfully manage such situations only by way of a so-called bailout. On account of the experiences from the crisis and the negative impact of bailouts on state budgets, the global leading powers decided to develop new crisis management toolkit that help to avoid the adverse effects of liquidation proceedings and the use of public money for rescuing financial sector players. One such instrument is resolution. In Europe, the establishment of the resolution authority function can be deemed a novel approach,206 and it was introduced through the regional implementation of global standards207 with the aim of providing public authorities with efficient instruments that can be used in the event of a crisis affecting credit institutions and investment firms in the European Union to ensure financial stability, and that are able to serve as alternatives to liquidation and fend off situations threatening financial stability without the need for a so-called bailout from public money, ensuring, at the same time, the continuity of the basic, critical functions provided by financial institutions. Thus in the case of a resolution, bailouts are not financed from taxpayers’ money, the costs of the resolution and the corresponding reorganisation are primarily borne by the shareholders, creditors and other players in the financial sector.

n other continents, the authorities with resolution functions were established O decades ago, albeit not with the instruments and powers that were expanded in the wake of the 2007–2008 crisis; one such authority is the Federal Deposit Insurance Corporation (FDIC) in the US. 207 See FSB (2011), which was later reviewed: FSB (2014). 206

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22 The MNB as the resolution authority

22.2 The MNB’s resolution function The Magyar Nemzeti Bank was designated as the resolution authority from 1 October 2013, pursuant to Act CXXXIX of 2013 on the Magyar Nemzeti Bank (MNB Act),208 which specified the resolution authority function among the tasks of the MNB. This was merely a designation, and before establishing the resolution authority’s powers, legislators waited for the adoption of the Bank Recovery and Resolution Directive (BRRD or resolution directive for short) in the EU that was already available in the form of a draft.209 Thus the expected content of the EU framework and the basic international standards with respect to resolution were already known, therefore experts could start preparing for the time when the MNB would not be a mere designated authority but one with resolution authority powers. The BRRD was published in the Official Journal of the European Union in June 2014, and its provisions had to be transposed into national law by the Member States by 31 December 2014. The Hungarian Parliament adopted the national resolution regulation based on the BRRD already in the summer of 2014, weeks after the directive entered into force, as the first country in the European Union.210 Therefore, the Hungarian resolution framework has been ready since 2014, to ensure that the crisis situation of a domestic financial institution potentially threatening financial stability not be remedied from taxpayers’ money, but with

ection 4(8) of the MNB Act: “Within the scope of its powers defined in a separate Act, S the MNB shall act as resolution authority.” 209 Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/ EU, 2012/30/EU and 2013/36/EU, and Regulations (EU) No 1093/2010 and (EU) No 648/2012, of the European Parliament and of the Council. Text with EEA relevance, OJ L 173, 12.6.2014, p.190–348,http://eur-lex.europa.eu/legal-content/EN/ ALL/?uri=celex%3A32014L0059 , downloaded: 22 December 2016. 210 Act XXXVII of 2014 on the Further Development of the System of Institutions Strengthening the Security of the Individual Players of the Financial Intermediary System (Resolution Act). 208

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market financing and resolution tools that comply with global standards and best practices, as well as with EU regulations.

22.3 Resolution planning Pursuant to the BRRD, the resolution authorities need to prepare resolution plans for credit institutions and investment firms both at the individual and the group level. In the case of groups that are active at the international level, the group-level resolution plans are developed and adopted in resolution colleges (for more details, see below). The content of the resolution plans is tailored to the given institution or group, although the minimum list of content is stipulated by law.211 Both the individual and the group-level resolution plans have to contain the presentation of the institutions’ or the group’s critical functions and their main business lines, the description of the resolution strategies in various scenarios, the assessment of resolvability and a communication plan. In addition, group-level resolution plans have to include, inter alia, the sharing of financing responsibilities connected to the resolution measures among the financial resources of the European Economic Area (hereinafter: EEA) Member States. During resolution planning, the authorities need to make a decision with respect to the institution or the group about one or more resolution strategies. Alternative strategies may be necessary so that the authority can address the situation even when the primary, preferred resolution strategy’s implementation runs into unexpected obstacles. If significant impediments to resolvability emerge even in the planning stage, the resolution authority needs to act to mitigate or eliminate them in an administrative procedure.

211

See Resolution Act, Annex 1.

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22 The MNB as the resolution authority

22.4 The conditions for ordering resolution The MNB may place a credit institution or investment firm under resolution when all of the following three conditions are met: a) the MNB, acting in its capacity as the supervisory authority (hereinafter: Supervisory Authority), determines that the institution is failing or is likely to fail; b) considering the circumstances, the MNB, acting in its capacity as the resolution authority, finds it unlikely that any action other than resolution would prevent the failing of the institution, including the measures of the Supervisory Authority, the institution, the institutional protection scheme or other market players, and the possibility of writing down or converting the capital elements, which can be performed by the MNB acting in its capacity as the resolution authority; c) in the opinion of the MNB, acting in its capacity as the resolution authority, the resolution is justified by the public interest. Therefore, the MNB does not have to wait for the failing of the financial institution – when crisis management has less options available – to place it under resolution; it may intervene preventively as soon as it expects that failure would happen in the near future, within 12 months at the latest, if the authorities do not intervene. The condition that the resolution should be in the public interest is important, since in the absence of this, the failing financial institution is liquidated as a general rule.

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22.5 Resolution tools Acting in its capacity as resolution authority, the MNB may use the following resolution tools: a) sale of business tool: transferring some or all parts of the institution to market players; b) bridge institution tool: transferring some or all parts of the institution to a bridge institution (to a bridge bank or bridge investment firm); c) asset separation tool: separating and transferring some parts of the institution under resolution or the bridge institution to a resolution asset management vehicle; d) bail-in tool: forcing the creditors to participate in loss absorption and in recapitalisation for the success of resolution. In the course of a resolution process, the MNB is free to combine the various resolution tools, the only restriction being that it may not apply asset separation on its own. During the first BRRD-based Hungarian resolution, i.e. crisis management of the MKB Bank Zrt. (hereinafter: MKB Bank), the MNB used the sale of business and the asset separation resolution tools (see below for more details). In other European Union Member States, the bridge institution and the bail-in tool have also been used, the former in Portugal and Italy, for example, the latter in Denmark and Austria.

22.6 The international activities of the resolution unit The international dimensions of the MNB’s resolution activities include the resolution work performed in the European Banking Authority (hereinafter: EBA), administrative cooperation in the resolution colleges established for internationally active institutions and the ties to foreign resolution authorities. — 800 —

22 The MNB as the resolution authority

22.6.1 The resolution work in the European Banking Authority

The EBA is an independent European Union authority established in order to ensure the efficient and consistent prudential regulation and supervision necessary for the banking system. Its general goals include the preservation of financial stability in the European Union and the protection of the prudent and efficient banking system that abides by the harmonized rules. In addition to its supervision related tasks, the EBA also performs resolution regulation and monitoring duties determined by the BRRD. In line with the BRRD’s authorisation, the EBA is required to issue guidelines for determining the detailed rules, and also in line with the BRRD’s authorisation, to make proposals to the European Commission about creating regulations. The Resolution Committee (hereinafter: ResCo) operates within the organisation of the EBA with the participation of the leaders from EU resolution authorities representing their institutions, and discusses the main EBA documents in connection with resolution. The resolution authorities of the European Free Trade Association (EFTA) countries and the representatives of the European Commission and the Single Resolution Board take part in the ResCo’s work as observers. In certain cases, the implementation of the ResCo’s decisions is subject to the approval of the EBA’s Board of Supervisors (hereinafter: BoS). If the ResCo’s decision only concerns resolution powers, the BoS may only express its objections, but if the proposed decision affects not only resolution but also the EBA’s supervisory function, the final decision is taken by the BoS. The MNB, acting in its capacity as the resolution authority, is also actively involved in the EBA’s work. In the sub-working groups operating under the auspices of the ResCo, the resolution staff have taken part in preparation of several reports and decisions. The MNB contributed to the wording of the European Commission regulations on the operative functioning of resolution colleges, to the preparation of the report on the review of the reference value of the resolution fund target — 801 —

Part III: Changes in the Hungarian regulatory policy

levels and the development of the regulatory technical standard on the regulation of the simplified obligations in line with the BRRD, which is expected to be published in 2017. The MNB, acting in its capacity as the resolution authority, works in close cooperation with MNB acting in its capacity as the supervisory authority in the EBA workflows concerning deposit guarantee schemes.

22.6.2 Resolution colleges

In accordance with the BRRD, resolution colleges have to be established for the internationally active institutional groups with the participation of the resolution and other authorities concerned. The members of the resolution college: • the group-level resolution authority (as the leader of the resolution college); • the resolution authorities of the subsidiaries established in an EEA Member State that are subject to consolidated supervision; • the resolution authority of the financial holding company as the parent company established in an EEA Member State; • the resolution authorities of significant branches in EEA Member States; • the consolidating supervisory authority and the supervisory authorities in the EEA Member States where the resolution authorities are members of the resolution college; • the competent ministries (if they do not qualify as resolution authorities); • the national deposit guarantee schemes if the given EEA Member States’ resolution authority is a member of the resolution college; • the EBA (special membership without voting rights). — 802 —

22 The MNB as the resolution authority

If a banking group with an EEA heaquarters has a subsidiary or a significant branch in a third country, then, if certain legal preconditions are met, the resolution authorities of these countries may be involved into the resolution college’s work with observer status. The resolution college is led by the group-level resolution authority, and its members adopt joint decisions about, inter alia, the resolution plans and the resolvability of the group. The resolution college serves as a forum for discussing the results of assessments focusing on resolvability and for coordinating crisis management measures. In 2015, the MNB, acting in its capacity as the group-level resolution authority, was the first in the European Union to launch the operation of the resolution college for the banking group within its scope of competence. Meanwhile, other resolution colleges have been set up for several other banking groups, and the MNB, acting in its capacity as the resolution authority, actively participates in their work.

22.6.3 Relations with foreign resolution authorities

The efficient resolution of institutions engaged in cross-border activities is only possible through the international cooperation between resolution authorities, therefore in recent years the MNB’s resolution unit has started to forge international relations with the resolution authorities of other countries. This work was performed in two stages: in the first stage, between 2014 and 2015, cooperation was developed with the EU Member States, as in parallel with the transposition of the resolution directive (BRRD) into the national legal systems, the European Union (EU) Member States established their own resolution authorities. In the second stage, from 2016, the focus was broadened in several steps to include the resolution authorities from countries outside the EU, therefore the international network of the MNB acting in its capacity as the resolution authority has become global, spanning all continents (Chart 22-1).

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Chart 22-1: The MNB’s global network in resolution (January 2017)

1st Phase: EU Member States (cooperation based on BRRD) 2nd Phase: Resolution cooperation with non-EU countries Source: MNB.

22.7 The MSZVK, the Magyar Szanálási Vagyonkezelő Zrt. (Hungarian Resolution Asset Management Vehicle) The MSZVK, the Magyar Szanálási Vagyonkezelő (hereinafter: MSZVK) was established on 26 November 2015, with a subscribed capital of HUF 200 million. It is owned exclusively by the Resolution Fund. The MSZVK is a resolution asset management vehicle as defined by the Resolution Act and the BRRD. With the asset separation resolution tool, the MNB, acting in its capacity as resolution authority, may issue an administrative decision to transfer some or all assets, liabilities, rights or obligations of one or more institutions under resolution or bridge institutions to a resolution asset management vehicle. — 804 —

22 The MNB as the resolution authority

The resolution asset management vehicle is an institution established for using the asset separation resolution tool that is owned partly or entirely by the state or the Resolution Fund or operated under their controlling influence, and that is set up with the purpose of taking over some or all of the assets, liabilities, rights and obligations of one or more institutions under resolution or bridge institutions. The resolution asset management vehicle has to manage the assets, liabilities, rights or obligations transferred to it with the purpose of maximising their value through a potential sale or during voluntary winding-up or liquidation. To this end, the non-profit economic entity performing the liquidation of the organisations determined in the MNB Act may provide advisory services to the resolution asset management vehicle. Although the MSZVK was established by the Resolution Fund, in accordance with the Resolution Act, the ownership rights over the resolution asset management vehicle are exercised by the MNB acting in its capacity as the resolution authority. One important aspect taken into consideration by the decision-makers while establishing the resolution asset management vehicle was that it should be able to quickly take over the assets, liabilities, rights and obligations from the institution under resolution – whether credit institution or investment firm – even in multiple, parallel resolution proceedings to ensure rapid and smooth proceedings as part of the Hungarian institutional system for resolution. In view of the above, the MSZVK was established similar to a holding, into which the financial institutions established for the management of the portfolios to be divested from the institutions under resolution in the potentially parallel resolution proceedings can be integrated as subsidiaries. One advantage of this structure is that with the preservation of the holding structure and in line with the above, separate subsidiaries may — 805 —

Part III: Changes in the Hungarian regulatory policy

manage the portfolios taken over from the individual institutions in the various resolution proceedings, which strengthens transparency and enables the measuring of performance of individual portfolios. In addition, this structure is highly cost-effective, as shared services (e.g. accounting, HR, acquisition, operation) may be outsourced to the parent holding company. Currently, the MSZVK manages the portfolio taken over from the MKB Bank Zrt. during its resolution allocated into two subsidiaries.

22.8 The engagement of the resolution unit in the operation of Hungarian collective funds The MNB’s resolution unit participates in the functioning of Hungarian collective funds in several ways: it delegates members to the Board of Directors of the Resolution Fund and the National Deposit Insurance Fund (NDIF) and takes part in decision-making, sets the annual fees to be paid to the Resolution Fund, and in situations threatening financial stability it prepares the disbursement of the MNB’s bridge loan liquidity facility with a maturity of up to 3 months to the National Deposit Insurance Fund, the Investor Protection Fund (IPF) and the Settlement Fund (SF).212 In recent years, these bridge loans have been disbursed on several occasions (Table 22-1). Through the bridge loans, the MNB helped launch the compensation of the clients of all institutions concerned before the stipulated deadline and protect the confidence in the financial stability safety net.

212

ue to the Hungarian legal limitations in effect, the MNB is not entitled to provide D temporary liquidity loans to the Resolution Fund, therefore this is only ensured in the case of the other three collective guarantee funds.

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22 The MNB as the resolution authority

Table 22-1: MNB bridge loans to Hungarian collective funds (2015—2016) IPF

NDIF

Start of commitment

4 March 2015

2 July 2015

Settlement Fund 7 July 2016

9 May 2016

Credit line (HUF) 107,116,000,000210 110,000,000,000211 12,000,000,000212 46,000,000,000213 Repayment date 22 May 2015 (bond (and source) issue)

7 October 2015 (bond issue)

7 October 2016214 17 August 2016215 (tap issue) (bank loan)

Source: MNB.

22.8.1 Participation on the Board of Directors of the National Deposit Insurance Fund

The National Deposit Insurance Fund’s (NDIF) 7-member Board of Directors includes two persons designated by the Governor of the MNB, one responsible for the supervision of the financial intermediary system, and the other the Deputy Governor in charge of the resolution function or a leader performing this task. In line with the above, in addition to the Supervisory Authority, a leader from the resolution unit also takes part in decision-making on the NDIF Board of Directors. This is because the NDIF not only has a compensation function in the case of frozen, unavailable deposits, it can also contribute to the financing of resolution. Pursuant to Section 143(1) of the Resolution Act, the NDIF contributes to the financing of resolution at any one time by up to 0.4 per cent of the deposits covered https://www.mnb.hu/sajtoszoba/hirek-2015-juniusig/az-mnb-likviditasi-kolcsont-nyujt-az-oba-reszere 214 http://www.bva.hu/uploads//tagok/tevekenysegi_jelentes_2015.pdf 215 https://www.mnb.hu/sajtoszoba/sajtokozlemenyek/2016-evi-sajtokozlemenyek/az-mnb-likviditasi-kolcsont-nyujt-a-befekteto-vedelmi-alap-reszere 216 https://www.mnb.hu/sajtoszoba/sajtokozlemenyek/2016-evi-sajtokozlemenyek/az-mnb-likviditasi-kolcsont-nyujt-a-karrendezesi-alap-reszere 217 https://www.mnb.hu/sajtoszoba/sajtokozlemenyek/2016-evi-sajtokozlemenyek/a-befekteto-vedelmi-alap-visszafizette-az-mnb-altal-nyujtott-likviditasi-kolcsont 218 https://www.mnb.hu/sajtoszoba/sajtokozlemenyek/2016-evi-sajtokozlemenyek/a-karrendezesi-alap-visszafizette-az-mnb-altal-nyujtott-likviditasi-kolcsont 213

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by its compensation obligation, if the resolution measures of the MNB acting in its capacity as the resolution authority with respect to the institution concerned ensure depositors’ uninterrupted access to their deposits within the compensation limit. From 2017, one important task of the NDIF is the stress testing of its main functions (compensation and contribution to financing resolution) in line with the EBA’s guidelines. Both the Supervisory Authority and the resolution unit play an active role by delegating external observers on the one hand, and by taking part in the planning of the stress scenario in connection with the testing of the contribution to resolution financing on the other hand. Also based on an EU requirement, the Supervisory Authority, the MNB acting in its capacity as the resolution authority and the NDIF are all members of the resolution colleges established for the cross-border institution groups in both home and host roles, and this also calls for efficient cooperation among the three authorities. From time to time, the resolution unit informs the NDIF Board of Directors about resolution issues.

22.8.2 Participation on the Board of Directors of the Resolution Fund

The Resolution Fund (RF) was established on 29 July 2014, immediately after the Resolution Act entered into force, by virtue of the law. The members of the Board of Directors of the Resolution Fund include:219 • the person designated by the minister in charge of regulating the money, capital and insurance market, • the two persons designated by the Governor of the MNB acting in its capacity as the resolution authority, one of whom is the Deputy

219

Section 132(1) of the Resolution Act.

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22 The MNB as the resolution authority

Governor or leader in charge of resolution, the other in charge of supervision, • the managing director of the NDIF. The RF may play a crucial role in resolution financing depending on the adopted resolution action plan. The RF mainly relies on the payments of financial sector players. The funds of the RF may be used for the following purposes:220 • guaranteeing the assets and liabilities of an institution under resolution, its subsidiaries, a bridge institution or resolution asset management vehicle; • lending to an institution under resolution, its subsidiaries, a bridge institution or resolution asset manager; • purchasing the assets of the institution under resolution; • providing capital contribution to a bridge institution or a resolution asset management vehicle; • providing additional financing to the institution under resolution if liabilities are excluded from the bail-in and they cannot contribute to loss-absorption or recapitalisation; • providing compensation to the NDIF if it had to contribute more to the resolution of an institution than if the institution had been liquidated; • providing compensation to owners or lenders, considering that they may be worse off in the resolution proceedings than if the institution had been liquidated. 220

Section 126(3) of the Resolution Act.

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22.8.3 The limits of using the Resolution Funds’ assets

The funds provided by the state for resolution have to be repaid from the RF within ten years after the funds are provided by the state. The RF cannot be used to directly cover the losses of the institution under resolution or to recapitalise it. And in accordance with Section 127(1) of the Resolution Act, its indirect use is subject to the appropriate contribution of the owners and lenders of the institution under resolution for incurring losses and for recapitalisation. The RF played a vital role in financing the application of asset separation tool regarding those assets of MKB Bank that could not be sold on the market (see later).

22.9 The resolution of the MKB Bank — The first test of using the new resolution framework 22.9.1 Background

As a result of the 2007–2008 financial crisis, the MKB Bank incurred one of the largest losses among Hungarian banks (Chart 22-2) due to the very poor quality of its commercial real estate loan portfolio that was proportionally the largest as compared to other market participants. Its owner at that time, the Bayerische Landesbank, was also in dire straits, and the Bavarian state granted it aid in the amount of EUR 10 billion in 2008,221 therefore, in line with the restructuring agreement concluded with the European Commission, it had to sell its Hungarian subsidiary

221

uropean Commission (2008): State aid: Commission approves state support for E BayernLB http://europa.eu/rapid/press-release_IP-08-2034_en.htm

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22 The MNB as the resolution authority

by the end of 2016, after a one-off postponement222 so that the state aid provided could be considered compatible with the internal market. Chart 22-2: MKB Bank’s after-tax profit (2008–2014) 20

HUF Billions

20 0

–20

–40

–60

–80

–100

–120

2008

2009

2010

2011

2012

2013

2014

–120

Source: MNB.

The Hungarian state, primarily taking into account financial stability considerations, recognised that it could acquire a bank active in lending if it purchased and reorganised the MKB Bank,223 and through this could boost lending activity that had significantly declined on account of the financial crisis.

uropean Commission (2012): State aid: Commission approves restructuring aid E to BayernLB subject to repayment of €5 billion of aid http://europa.eu/rapid/ press-release_IP-12-847_en.htm 223 Márton Nagy (2016) Sikeres banki tisztítókúra (Successful bank detoxification), Figyelő, Issue 2016/28, Budapest: pp. 14–15. 222

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In December 2014, the European asset quality review (AQR) showed a large impairment shortage for the MKB Bank, and without the measures necessary for tackling this, the bank would most likely fail within 12 months. Accordingly, the only possible way for restoring the long-term viability in order to protect Hungarian financial stability was offered by the opportunities in the new resolution framework, since by the end of 2014, all three resolution conditions had been met with regard to the MKB Bank, i.e. the bank • would likely to fail within a year, and • this situation would most probably have been impossible to address with a measure other than resolution, and • resolution was necessary in the public interest. The Resolution Act uses a unique concept of public interest: in accordance with Section 17(5), resolution is in the public interest if the measure is necessary for meeting one or more resolution objectives, it is proportionate to them, and with the winding up of the institution under insolvency proceedings the resolution objectives would not be met at least to the extent possible by the use of the resolution measures. When determining the resolution conditions, the valuation of the MKB Bank’s assets and liabilities to establish the insolvency or expected insolvency was performed by the MNB itself within the framework of a provisional assessment, taking into account that very prompt measures had to be taken in order to restore the viability of the MKB Bank. In view of the provisional valuation, the MNB, acting in its capacity as the resolution authority, determined the necessary resolution measures in the resolution action plan. The adequacy of the provisional valuation was subsequently substantiated by a final

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22 The MNB as the resolution authority

assessment prepared by an independent valuer appointed in an administrative procedure.

22.9.2 The resolution action plan

Pursuant to Section 17(7) of the Resolution Act, the MNB had to prepare an action plan for the implementation of the resolution proceedings containing the resolution and reorganisation measures necessary for achieving the resolution objectives, including the necessity for the application of the sale of business and the asset separation resolution tools (Chart 22-3). The MNB sought to achieve the following equally important resolution objectives in connection with the resolution of the MKB Bank: • the protection of public funds by minimising the necessity and use of extraordinary financial aid from the state in any form; • the continuous provision of critical functions; • the prevention of the emergence of effects that endanger the stability of the financial intermediary system or the elimination of those that have already emerged; • the protection of the depositors and investors insured by the deposit guarantee and investor protection schemes; • the protection of the financial instruments and money of the clients, and the preservation of the confidence of depositors and investors in order to maintain the stability of the financial intermediary system.

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The resolution action plan basically sought to ensure the achievement of the resolution objectives through three successive groups of measures: • rationalising the operation of the bank by reducing the corresponding costs and employing measures boosting efficiency (e.g. by cutting back lines of business); • separating the assets responsible for the likely fail and the loss of sustained viability from the balance sheet through the use of the sale of business and the asset separation resolution tools; • selling the MKB Bank under market conditions (by using the sale of business resolution tool). Chart 22-3: Resolution action plan for the MKB Bank ‘Cleaned’ bank MKB Bank Assets to be divested

Sale of business for market participants

Private purchasers

Sale of business for market participants

Regarding assets which could not be sold on the market: asset separation

Resideal Zrt.

MKB Pénzügyi Zrt.

Funding

Resolution Fund

Establishment MSZVK Zrt. (financial enterprise)

The ownership rights of the above two subsidiaries are transferred to MSZVK Zrt.

MKB Pénzügyi Zrt. was financed by MKB Bank till that point. Az MKB Pénzügyi Zrt. is not financed by MKB Bank anymore. Funding!

Resideal Zrt. MKB Pénzügyi Zrt.

Holding structure under the direction of MNB

Note: Following the transfer of assets, the company name of the MKB Pénzügyi Zrt. was changed to Szanálási Követeléskezelő Zrt. (SZKK Zrt.), in order to emphasize the institutional separation from the MKB. Source: MNB.

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22 The MNB as the resolution authority

Among the first steps, the MKB Bank’s business lines that did not contribute to the commercial banking core functions, generated losses and tied down too much capital were eliminated, a substantial costcutting programme was launched, which included the reduction of the number of branches that ensure operation, several executive positions were terminated, supplier contracts were reviewed and substantial steps were taken in order to enhance risk management.

22.9.3 Sale of business

In line with the resolution action plan, the assets (credit claims) to be separated from the MKB Bank first had to be sold to market participants through the sale of business resolution tool in order to ensure an as transparent transfer process and to achieve as high a price as possible. The potential investors could bid for the purchase of the portfolio to be separated either in a package or in individual deals. In this way, the MNB, acting in its capacity as the resolution authority, was able to sell a stock representing gross exposures of HUF 130 billion at a purchase price of approximately HUF 100 billion.224

22.9.4 Asset separation

The assets that could not be sold on the market were separated from the MKB Bank by using the asset separation resolution tool, and transferred to the resolution asset management vehicle (MSZVK Zrt.), as shown in Chart 22-4.

224

risztina Földényiné Láhm – András Kómár – Antal Stréda – Róbert Szegedi: K Bankszanálás mint az új MNB-funkció (Bank resolution as the new MNB function – Resolution of MKB Bank, Financial and Economic Review, Issue 2016/3, p. 14.

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Chart 22-4: Application of the asset separation tool

Loan

100%

MSZVK Zrt.

Loan

10 100%

100% SZKK Zrt.

TEMP ORA

NT NE MA R PE Exercising ownership rights

Resolution Fund

Loan

Consortium of banks

Fee payments

Banking sector

Resideal Zrt. “Bad bank”

“Good bank”

Source: MNB.

During the use of the asset separation resolution tool, the MNB took into consideration the requirements in Section 54(1) of the Resolution Act. Pursuant to the relevant provisions, due to the situation on the market for the assets concerned, the sale of the assets through the sale of business tool may negatively affect one or more financial markets; and the transfer is necessary for maximising the proceeds from the sale, voluntary winding-up or liquidation. The separation from the MKB Bank of the MKB Bank’s assets that could not be sold through the sale of business resolution tool and whose gross value amounted to HUF 214 billion was conducted as follows: first, they were transferred to the MKB Pénzügyi Zrt. (receivables) and Resideal Zrt. (real estate) owned exclusively by the MKB Bank, then the shares representing the ownership rights in these two subsidiaries and the credit claim of the MKB Bank against the MKB Pénzügyi Zrt. were transferred to MSZVK Zrt. within the framework of the asset separation.

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22 The MNB as the resolution authority

For the transferred assets, the MKB Bank received a price (actual economic value – 45 per cent of the gross book exposure) that was HUF 32 billion higher than its low market value originating from unfavourable market conditions, hence it was able to stabilise its capital position. The difference between the price received for the transferred assets and its market value is considered State aid under EU law, which was deemed compatible with the internal market by the European Commission in December 2015, based on the submitted restructuring plan and the commitments regarding the institution.225 Pursuant to the communication from the European Commission on the application, from 1 August 2013, of State aid rules to support measures in favour of banks in the context of the financial crisis (“Banking Communication”) that is also applicable with respect to State aid in the case of European Union resolutions, the losses incurred by the institution should be primarily borne by the owners, since the State aid may entail moral hazard and undermine market discipline.226 Accordingly, in the case of the MKB Bank, the Hungarian state, as the owner, had to take part in appropriate measures, i.e. in absorbing the losses of the MKB Bank to the greatest possible extent. In practice, the appropriate burden-sharing was ensured by all the shares representing ownership in the MKB Bank and owned exclusively by the Hungarian state being transferred to MSZVK Zrt., which provided the State aid, simultaneously with the disbursement of the State aid for a symbolic price. In addition to ensuring the implementation of the MKB Bank’s restructuring plan, the Hungarian authorities undertook 17 commitments in order to eliminate the reasons behind the likely fail of the MKB Bank, restore its long-term viability and do away with the potential competition-distorting effects arising from the State aid.

225 226

I bid. p. 18. Paragraph 3.1.2.40.

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22.9.5 The market sale of the MKB Bank

The measures presented above helped restore the capital position of the MKB Bank and ensure the preconditions for long term viability. In line with the expectations of the European Commission, the bank was sold in an open and transparent, non-discriminatory process applying competitive terms on aÂ level playing field, and complying with the requirements for State aid under European Union competition laws. The sale was monitored by Monitoring Trustee as the independent advisory firm assessing the European Union requirements and chosen and designated by the European Commission.227 One global investment bank provided expert assistance to the MNB in selling the MKB Bank shares. During negotiations with the investors, the bank was mainly thoroughly examined by capital funds, who also made purchase offers, while banks remained uninterested. In the assessment of the bids, the maximising of the sale price had the greatest importance for the MNB, but it considered financial stability aspects, too, as it expected buyers to meet quality requirements, and demanded significant commitments from them supporting the future capital adequacy and stability of the MKB Bank. The MNB assessed compliance with the EU framework of State aids that regards the maximising of prices based on the Market Economy Investor Principle as the primary factor, and also employed the approach of the resolution authority that includes the interest in financial stability in addition to the price.228 Only capital funds made binding purchase offers, and among the offers, it was clearly the amount of the offered purchase price that had the greatest significance in making the final decision. In the evaluation 227 228

I bid. p. 22. Ibid. p. 22.

â&#x20AC;&#x201D; 818 â&#x20AC;&#x201D;

22 The MNB as the resolution authority

of the purchase price, the MKB Bank was also appraised by an external consultant before the sale, who specified a certain range for the market value. The best offer was higher than the middle of the evaluation range, and exceeded the value of the State aid provided to the MKB Bank earlier.229 The highest purchase price was offered by the Blue Robin Investments S.C.A. – METIS Magántőkealap – Pannónia Nyugdíjpénztár consortium, and upon paying the purchase price of HUF 37 billion, they became the owners of the bank with stakes of 45, 45 and 10 per cent, respectively. In the course of the sale process, the MNB as the supervisory authority examined whether the entities submitting bids satisfied the legal requirements of acquiring influence. The one-and-a-half-year resolution of the MKB Bank was the first test of applying the new framework’s rules not only in Hungary, but it was also one of the first cases in the European Union, and the MNB, as the resolution authority, performed it successfully in line with the European Union’s recovery and resolution directive, with the involvement of advisors highly regarded on the global market.230

22.9.6 The guarantee rule for protecting owners and lenders

One important principle of the resolution framework is that neither owners, nor lenders can be worse off as a result of the resolution proceedings than if the institution had been abolished in liquidation proceedings when the implementation of the resolution was ordered (the so-called no creditors worse off than in liquidation principle – NCWO). In line with the relevant European Union and Hungarian legislation,231 this is to be assessed by a valuer independent from the MNB.

I bid. p. 23. Ibid. p. 23. 231 See Article 74 of the BRRD and Section 97(3) of the Resolution Act. 229 230

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If based on the NCWO assessment, shareholders and creditors would have been better off in a liquidation, the difference has to be paid to them as compensation from the Resolution Fund. The MNB, acting in its capacity as the resolution authority, appointed an independent valuer to perform the above-mentioned assessment after the resolution proceedings were terminated.

22.10 Summary One of the responses to the 2007–2008 global financial crisis by regulators was the establishment of global standards and regional, national regulations regarding the creation of the resolution framework. In Hungary, the MNB was already designated as the resolution authority in 2013, even before the publication of the European Union regulation. Thus the government and the Hungarian legislature were committed to safeguarding Hungarian financial stability as much as possible, establishing the necessary organisational framework before most EU Member States. Hungary was among the first countries to transpose the resolution directive’s provisions into national law, well before the prescribed deadline, weeks after the directive entered into force. The MNB was the first in the EU to commence the establishment of a resolution college, and it was the first to launch a successful BRRDbased resolution in connection with the MKB Bank. Through the preparation of the bridge loans provided to Hungarian collective funds for compensation and settlement purposes, the resolution unit of the MNB helped affected customers receive the amounts they were entitled to as soon as possible. Thereby, the MNB contributed significantly to the preservation of the confidence in the financial intermediary system after the crisis situations in Hungary.

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22 The MNB as the resolution authority

Thus resolution is an unfolding function of the authorities in Hungary too, an integral part of the financial stability safety net, the international network with partner resolution authorities have become global in aÂ few years. In addition to the access to international experiences and best practices, it helps the MNB efficiently and successfully in issues requiring international cooperation between authorities.

Key terms asset separation bail-in bank bailout bridge institution joint decision liquidation proceedings Magyar Nemzeti Bank National Deposit Insurance Fund resolution

resolution action plan resolution asset management vehicle resolution authority resolution college Resolution Fund resolution plan sale of business State aid

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References Financial Stability Board (FSB 2011): Key Attributes of Effective Resolution Regimes for Financial Institutions, 2011 http://www.fsb.org/wp-content/uploads/r_111104cc.pdf?page_moved=1 Financial Stability Board (FSB 2014): Key Attributes of Effective Resolution Regimes for Financial Institutions (revised version):, 2014 http://www.fsb.org/wp-content/uploads/r_141015.pdf Földényiné, Láhm K. – Kómár, A. – Stréda, A. – Szegedi, R.: Bankszanálás mint új MNB-funkció – az MKB Bank szanálása (Bank resolution as a new MNB function - resolution of MKB Bank), Financial and Economic Review, Volume 15, Issue 3, September 2016, pp. 5–25. Magyar Közlöny (Hungarian Official Journal) (2015): 1861/2015. (XII. 2.) Korm.-határozat Az MKB Bank Zrt. szanálása tekintetében felmerülő állami szerepvállalásról (Government Decision No. 1861/2015. [XII. 2.] on the State Engagement with Respect to the Resolution of MKB Bank Zrt.), p. 23185: http://www.kozlonyok.hu/nkonline/MKPDF/hiteles/MK15187.pdf Magyar Nemzeti Bank Annual report 2013 (MNB 2013) https://www.mnb.hu/letoltes/mnbannualreport-2013-eng-final.pdf Magyar Nemzeti Bank Annual report 2014 (MNB 2014) https://www.mnb.hu/letoltes/mnbannual-report-2014.pdf Magyar Nemzeti Bank (2015a): Rendben zajlik az MKB Bank szanálása (The resolution of MKB Bank goes as planned): https://www.mnb.hu/sajtoszoba/sajtokozlemenyek/2015-evisajtokozlemenyek/rendben-zajlik-az-mkb-bank-szanalasa Magyar Nemzeti Bank (2015b): Összefoglaló a Magyar Nemzeti Bank H-SZN-I-6/2015. számú határozatáról, amelynek tárgya a szanálás alatt álló MKB Bank Zrt. vonatkozásában a vagyonértékesítés szanálási eszköz alkalmazása (Summary to the decision No. H-SZN-I-6/2015. of the Central Bank of Hungary on the application of the sale of business tool in the ongoing resolution process in respect of MKB Bank Zrt.): https://www.mnb.hu/letoltes/sale-of-business-resolution-summary.pdf Magyar Nemzeti Bank (2015c): A rossz eszközöktől megtisztított MKB Bank már sikeresen értékesíthető (MKB, cleaned of bad assets, can now be successfully sold): http://www.kozlonyok.hu/nkonline/ MKPDF/hiteles/MK15187.pdf Magyar Nemzeti Bank Annual report, 2015 (2015d): https://www.mnb.hu/letoltes/mnb-annualreport-2015.pdf Magyar Nemzeti Bank (2016a): Az Európai Bizottság szoros felügyelete mellett kiválasztásra kerültek az MKB Bank Zrt. új tulajdonosai (New owners of MKB Bank Zrt. selected under close supervision by the European Commission): https://www.mnb.hu/en/pressroom/press-releases/press-releases-2016/ new-owners-of-mkb-bank-zrt-selected-under-close-supervision-by-the-european-commission

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22 The MNB as the resolution authority Magyar Nemzeti Bank (2016b): Összefoglaló a Magyar Nemzeti Bank H-SZN-I-75/2016. számú határozatáról, amellyel az MKB Bank Zrt. szanálási eljárása megszüntetésre került (Summary of decision No. H-SZN-I-75/2016. of the Magyar Nemzeti Bank to terminate the resolution process of MKB Bank Zrt.): https://www.mnb.hu/letoltes/mkb-szanalas-zarasa-osszefoglalo-eng.pdf Moody’s (2016): Completion of MKB Bank’s Resolution Is Credit Positive (11 July 2016) https:// www.moodys.com/credit-ratings/MKB-Bank-Zrt-credit-rating-600018782 Nagy, M. (2016a): Banki tisztítókúra – Az MKB esete (Banks’ detoxification – The case of MKB), MNB: https://www.mnb.hu/kiadvanyok/szakmai-cikkek/tovabbi-szakmai-cikkek/nagy-martonbanki-tisztitokura-az-mkb-esete, Downloaded: 19 July 2016, the paper also appeared in edited form: Nagy, Márton (2016b): Sikeres banki tisztítókúra (Successful bank detoxification), Figyelő, Issue 2016/28, Budapest: pp. 14–15.

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Reforming supervisory policy

Strengthening synergies with the emergence of central bank supervisory functions — The common directions of supervision Gergő Szeniczey232

Pursuant to its new status law, the Magyar Nemzeti Bank assumed the tasks related to the supervision of financial institutions and financial consumer protection on 1 October 2013, from the Hungarian Financial Supervisory Authority (PSZÁF) that terminated on the same date without legal successor. The uniform performance of the monetary policy and financial stability functions (including the macro and microprudential regulatory and authority functions) integrated into the central bank opened up new horizons for supervisors. The continuous development of the supervisory methodology, the use of advanced technology in inspections and supervision, and the assertive supervisory action focusing more on the identification and management of future risks produced remarkable success in a short time. One good example for the result and success of the renewal in the methodology and the approach is the detection of the earlier corrupt practices in the investment services sector that had gone on for almost two decades before the MNB assumed the supervisory tasks and that were referred to in the press as the “broker cases”, and the prevention of further damage. Owing to the recent enhancements, the microprudential activities of the MNB have evolved into real supervision, and the earlier, fundamentally inspection-based approach characteristic of the period before 2013, was replaced by the supervisory approach focusing on continuous supervision that is better in terms of quality and safety, too. One of the most important experiences from the crisis that erupted in 2008, was that the risks and difficulties that arose at the financial institutions surprised not 232

he following people contributed to this chapter: Dr Eszter Böcskei, Dr Péter T Barnóczki, Dr Gábor Dakó, Dr Csaba Kandrács, Réka Fenyvesi, Nikoletta Kerekes, Eszter Kőhidi, László Seregdi, Veronika Törzsök

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only the institutions themselves, but also unexpectedly hit the financial supervisory authority responsible for financial stability in several European countries. After the crisis, several countries reviewed and strengthened their supervisory framework. This included reconsidering the place of the financial supervisory authority responsible for microprudential policy within the regulatory framework, as well as the cooperation with the organisation in charge of macroprudential policy, i.e. managing the systemic risks affecting the whole financial system. In line with the international developments, the Hungarian Parliament adopted draft legislation on the Magyar Nemzeti Bank in the autumn of 2013, thereby integrating the financial supervisory functions into the central bank. Thanks to the successful and effective supervisory activities (the detection of the broker cases, the elimination of unlicensed service providers from the market etc.) and the more assertive supervisory action, the financial sector started to clean up, whereby the MNB made a huge step towards establishing a stable, competitive, prudent and transparent financial sector enjoying public confidence and effectively supporting the economic rise of Hungary as laid down in the supervisory strategy. In its everyday sense, supervision means safeguarding, protection, oversight, and this has to be achieved in the case of the financial intermediary system as well. Generally, the aim of supervision is constant not only in space but also in time, however, naturally, its instruments and methods develop constantly over time, since the economic and regulatory environment determining the operation of the supervised institutions also changes on a regular basis. The MNB, as the new supervisory authority, basically achieves its objectives as an active participant in the international and Hungarian regulation, and through its licensing and enforcement activities, its continuous supervision, its inspection and market surveillance procedures and consumer protection procedures.

23.1 Introduction The most important global change in supervisory activities, that affected not only supervisory tools and methods but also the approach and the paradigm, occurred after the latest global financial crisis. Increasing — 828 —

23 Strengthening synergies with the emergence of central bank supervisory functions

state intervention can be observed everywhere in the general regulatory environment, which manifests itself in the influencing of the stateâ&#x20AC;&#x2122;s public law (taxation, institutions, narrowing framework) and private law relationships (contractual terms) as well. One of the most important experiences from the crisis that erupted in 2008, was that the risks and difficulties that arose at the financial institutions surprised not only the institutions themselves, but also unexpectedly hit the financial supervisory authority responsible for financial stability in several European countries. In connection with the crisis, the question arose all over Europe to what extent the existing supervisory institutional structure and the corresponding powers ensure the timely identification of the risks at the institution-level and systemic risks, and the possibility and framework for rapid and effective intervention. After the crisis, several countries reviewed and strengthened their supervisory framework. This included reconsidering the place of the financial supervisory authority responsible for microprudential policy within the regulatory framework, as well as the cooperation with the organisation in charge of macroprudential policy, i.e. the organisation managing the systemic risks affecting the whole financial system. In the United Kingdom, the partial integration of the previously separate supervisory authority (Financial Services Authority) into the central bank was completed in 2013, and the same process occurred in Belgium and Ireland. In the Czech Republic, Italy, France and Lithuania, banking supervision had already been part of the central bank as an independent unit, however, in the wake of the crisis, the insurance and the capital market supervision were also placed under the purview of the central bank. This facilitated the coordination between micro and macroprudential policy; the available information, knowledge and instruments systematically support each other in identifying the risks affecting the financial sector and in their consistent and efficient management. Therefore, the central bank is able to address the emerging risks with various instruments both at the level of the whole system and individual market participants, while these dual-level measures are coordinated and complement each other. â&#x20AC;&#x201D; 829 â&#x20AC;&#x201D;

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In Hungary, the supervision of the financial sector has been performed by several authorities over the recent decades. The Állami Pénz- és Tőkepiaci Felügyelet (National Money and Capital Market Supervisory Authority), the Állami Biztosításfelügyelet (National Insurance Supervisory Authority) and the Állami Pénztárfelügyelet (National Actuarial Supervisory Authority) supervised the individual sectors separately, then the Parliament merged these institutions on 1 April 2000, establishing the Hungarian Financial Supervisory Authority (PSZÁF). In line with the international developments, the Hungarian Parliament adopted draft legislation on the Magyar Nemzeti Bank at its session on 16 September 2013, thereby integrating the financial supervision function into the central bank. From 1 October 2013, the central banking and supervisory activities are concentrated into one institution: the Magyar Nemzeti Bank (MNB). With the new MNB Act,233 legislators established a structure in Hungary that guarantees the stability of the entire financial system and the safe operation of individual financial institutions within the framework of a single organisation, and that is able to address more efficiently and rapidly the risks of the financial intermediary system, and prevent the problems that impede the balanced functioning of the real economy or entail financial stability risks. Since its integration in October 2013, the MNB as a supervisory authority, has taken numerous steps to become an authority that is capable of shaping the financial system consciously and effectively and that is recognised and acknowledged in the supervisory community of the European Union. In recent years, the MNB, which has been reformed in terms of both its instruments and its organisational structure, and which supervises the sectors strictly and in a forward-looking manner, continuously taking into account consumer’s best interest, imposing severe sanctions in order to eliminate and avoid infringements, intervening immediately and taking assertive supervisory action if necessary, has demonstrated that integration was the right decision. 233

Act CXXXIX of 2013 on the Magyar Nemzeti Bank.

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23 Strengthening synergies with the emergence of central bank supervisory functions

Thanks to the successful and effective supervisory activities (the detection of the broker cases, the elimination of unlicensed service providers from the market etc.) and the more assertive supervisory action, the financial sector started to clean up, whereby the MNB made a huge step towards establishing a stable, competitive, prudent and transparent financial sector enjoying public confidence and effectively supporting the economic rise of Hungary as laid down in the supervisory strategy.

23.2 The aim of supervision The aim of the bodies in charge of supervising financial institutions is the same all over the world: they seek to ensure and sometimes enforce the stable, reliable, fair and prudent functioning of the financial system and the related institutions. The aim of supervision is constant not only in space but also in time, however, naturally, its instruments and methods develop constantly over time, since the economic and regulatory environment determining the operation of the supervised institutions also changes regularly. In its everyday sense, supervision means safeguarding, protection, oversight, and this has to be achieved in the case of the financial intermediary system as well, therefore during supervision, the MNB: – monitors the activities of certain predetermined market participants (institutions and persons) – safeguards certain predetermined objectives. The ultimate aim of supervision is to preserve the stability of the financial system, furthermore to restore and strengthen the confidence of the members in the system (MNB, financial institutions, consumers, economic actors and authorities) and in each other with the help of the integrated supervisory instruments, while guaranteeing institutional stability.

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23.2.1 Stability of the financial system

The stability of the financial intermediary system is the bedrock of the country’s economic development, since this system maintains close business relations with all the actors in the economy, transferring the free capital generated in the economy to the users of savings, i.e. the institutions of the financial system facilitate this money and capital ties. Owing to the role of the financial sector, in the long run, its weakening entails an economic downturn, and all countries strive to avoid this. The long-term viability and stability of the financial sector needs to be guaranteed in the interest of economic growth. This requires the supervision of the financial system not only at the sectoral level, but also the monitoring of activities of the individual market participants. In certain cases, supervisory action may be taken in order to protect and safeguard the prudent functioning of the financial intermediary system and the individual market participants. The appropriate and effective intervention requires the MNB’s ability to continuously supervise these institutions, monitor their activities and the entailed risks, and to assess and address these if necessary. Chart 23-1: Ensuring the stability of the financial sector through supervisory action Economy

Indirect impact of supervision and measures

Financial system Financial intermediary

Financial intermediary

Source: MNB.

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Direct supervision and action

23 Strengthening synergies with the emergence of central bank supervisory functions

All in all, the MNB’s supervisory arm ensures the stability of the financial system through the following activities: 1. It facilitates the compliant and prudent functioning of the persons and institutions in the financial intermediary system, and supervises owners’ careful observance of the law; 2. eliminates unauthorised actors and intervenes against them; 3. identifies undesirable business and economic risks threatening individual financial institutions or certain financial sectors, addresses specific or sectoral risks which have already emerged, and takes preventive measures to ensure the prudent operation of individual financial institutions. Acting in its role as a gatekeeper, it helps the uninterrupted functioning of the capital market, and in its statutory product-authorisation function, it only allows those products on the market that comply with the regulations. The MNB performs these activities through regulation and with continuous supervision employing licensing, inspection and market surveillance procedures and consumer protection procedures.

23.2.2 Confidence in the financial intermediary system

In addition to ensuring the stability of the financial system, the other basic aim of the MNB’s supervisory activities is the protection of those that use the services provided by financial institutions and the increasing of public confidence in the financial intermediary system. Although economic actors and private individuals maintain close ties, contractual relationships to financial sector participants, these relationships are not on an equal footing from several perspectives: first, the economic health and performance of the financial institution is usually much greater than those of the clients entering into an agreement with it, therefore the former is in a somewhat dominant position. During the development — 833 —

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of the financial system, a general need arose among economic actors and private individuals for a third party with the appropriate instruments for preventing financial institutions from abusing their dominant position to the detriment of their partners. The MNB performs the role of this independent third party with the appropriate powers, i.e. it protects the interests of those using financial services. Second, despite the contractual ties, the relationship is characterised by an asymmetry of information. For example, if private individuals deposit their savings in a bank, they have very little information on the bank’s dealings with their savings (whether the bank lends them out or purchases securities), the result of these dealings and the safety of their investments, since people typically only know the interest on deposits paid by banks. The asymmetry of information usually leads to distrust in the short run. In the financial intermediary sector, confidence is guaranteed by the Supervisory Authority: the clients of the institutions can expect the institutions to use their money appropriately, since the Supervisory Authority controls and inspects them, and sanctions non-compliant operation.

23.3 Supervisory instruments Supervision as an activity can be categorised according to various aspects. Based on the supervised sectors, we can distinguish between the supervision of the money market, the capital market, the insurance and the pension fund sector and the corresponding institutions. Based on the type of supervision, we can distinguish macroprudential supervision dealing with the prevention of the emergence of systemic, cyclical or structural financial risks and their mitigation, and microprudential supervision, which primarily ensures the compliance of the supervised institutions with the laws and regulations, and the elimination and management of the risks that arise when these are not observed. In the market surveillance function, the Supervisory Authority’s tasks include the elimination of unauthorised actors that operate without a licence or registration. In addition to monitoring stock market transactions that are — 834 —

23 Strengthening synergies with the emergence of central bank supervisory functions

conducted with the aim of insider trading or market manipulation, the Supervisory Authority supervises the appropriate application of the rules on reporting and disclosure pertaining to insiders and on acquisition. Based on the type of supervision, we can also distinguish consumer protection, which includes not only the protection of the interests of retail clients, but also the improvement of financial literacy and the publication of information concerning clients in a clear form. The MNB can achieve its supervisory objectives primarily through the following instruments: a) regulation, b) licensing, enforcement activities, c) continuous supervision, d) inspections, e) market surveillance procedure, f) consumer protection procedures.

23.3.1 Regulation — The legislative environment of the financial sector

While exercising its supervisory powers, the MNB treats the country’s EU and Hungarian legislative environment as a given factor on the one hand, and contributes to the establishment of the legal environment with the regulatory instruments available to it on the other hand. Since some European Union legislation is directly applicable in Hungary, the MNB participates actively in its drafting by taking part in European Union institutions.

a) The proactive role in international supervisory legislation and the key EU regulations shaping supervision

International, EU supervisory legislation is mainly linked to the so-called European Supervisory Authorities. With respect to macroprudential — 835 —

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regulation, the cooperation with the European Systemic Risk Board has to be pointed out, while with respect to microprudential regulation, the work with the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA) deserves special mention. The London-based European Banking Authority (EBA) was established on 1 January 2011, as part of the European System of Financial Supervision (ESFS) and is the successor of the Committee of European Banking Supervisors (CEBS). Its general objectives include maintaining financial stability in the EU, and ensuring the integrity, efficiency and orderly functioning of the banking system. The Paris-based European Securities and Markets Authority (ESMA) was established by the European Parliament and the Council with Regulation (EU) No 1095/2010 as part of the European System of Financial Supervision (ESFS) on 1 January 2011. ESMA contributes to the stability of the EU’s financial system by ensuring the integrity, transparency, efficiency and orderly functioning of European capital markets and by enhancing consumer protection. ESMA has independent and direct supervisory powers over credit rating agencies and trade repositories with a seat in the EU. The main responsibility of the European Insurance and Occupational Pensions Authority (EIOPA) is to support the stability of the financial sector and the transparency of markets and financial products, and to protect policyholders, pension scheme members and beneficiaries. The primary task of the three authorities involved in microprudential regulation is to contribute to the stable and prudent functioning of the financial sector in the EU by drafting and adopting harmonised prudential rules (for example binding technical standards, guidelines, recommendations) for financial institutions. These EU authorities also play a vital role in ensuring appropriate and harmonised European supervisory practices as well as in assessing the risks to the EU’s — 836 —

23 Strengthening synergies with the emergence of central bank supervisory functions

financial sector. All the materials prepared by the three authorities are discussed in technical working groups and standing committees, the work of which the MNB participates as an active member. In addition to its participation in the EU authorities described above, the MNB takes part in the work of several other international, EU institutions such as the Basel Committee on Banking Supervision (BCBS), the Group of Banking Supervisors from Central and Eastern Europe (BSCEE), the International Organisation of Securities Commissions (IOSCO), the International Association of Insurance Supervisors (IAIS), the International Organisation of Pension Supervisors (IOPS) as well as the Organisation for Economic Co-operation and Development (OECD). Besides participating in international institutions, the MNB also plays a crucial role in the domestic preparation of implementation and communication of European Union legislation. Among the European Union laws enacted recently, the following were especially important. Prudential requirements for European credit institutions and investment firms — CRD IV,234 CRR235

In recent years, due to the impact of the 2008 global economic crisis, substantial changes could be observed in the regulation of the money market sector as well: prudential requirements were tightened (primarily with respect to capital and liquidity risk), the establishment of the Single Supervisory Mechanism was decided, crisis management procedures and laws were developed, the requirements on corporate governance and remuneration policy were strengthened and the EUlevel deposit insurance was introduced.

irective 2013/36/EU of the European Parliament and of the Council of 26 June D 2013, on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC. 235 Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013, on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012. 234

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The first CRD236 directive regulating the capital requirements of credit institutions and investment firms, which introduced Basel II recommendations in the EU, was adopted in 2006, and it has been binding since 1 January 2008. The most important elements of the CRD and Basel II were forward-looking capital regulation, the assessment of future risks, and the fostering and expansion of institutions’ risk sensitivity and risk consciousness. After it entered into force, several deficiencies of the directive became obvious, therefore it was modified, and the CRD I237 was adopted on 27 July 2009. The CRD II238 sought to implement the experiences from the 2008 crisis in the regulation, especially the contents of the report by the De Larosiére Committee published in early 2009. The amendment harmonises at the European level the regulation on own funds and excessive risk-taking, and lays the foundation for the operation of supervisory colleges that form the cooperative framework of supervisory authorities. The four key topics in the CRD III239 regulation are raising the capital requirements for trading book risks, strengthening the capital requirement of complex securitisation positions, the stipulation of the remuneration policy in the whole EU and the clarification of the supervisory review process. CRD IV transposes the Basel III rules into EU law, and in addition to the directive, which has to be implemented in national law by all EU Member States (in Hungary, this is done in the Credit Institutions Act240 and the Investment Firms Act241), CRR, a regulation directly applicable in the whole EU, contains important detailed rules on capital requirements. In Hungary, similarly to other countries in the EU, the parts of the Credit Institutions Act and the Investment Firms Act implementing apital Requirement Directives 2006/48/EC and 2006/49/EC. C Directives 2009/27/EC and 2009/83/EC. 238 Directive 2009/111/EC. 239 Directive 2010/76/EC. 240 Act CCXXXVII of 2013 on Credit Institutions and Financial Enterprises. 241 Act CXXXVIII of 2007 on Investment Firms and Commodity Dealers, and on the Regulations Governing their Activities. 236 237

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23 Strengthening synergies with the emergence of central bank supervisory functions

CRD IV and the requirements of CRR have been in force since 1 January 2014. In the initial phase of implementing the new capital requirements regulation, the MNB focused on properly providing the institutions with the information and methodological knowledge necessary for applying the rules. The MNB created a page on its website dedicated to the questions related to CRD/CRR,242 containing the materials prepared by the MNB’s experts and the links facilitating the better understanding of the new set of rules constituted by CRD/CRR. The links include contact information that allows institutions to monitor, through the EU Commission’s website, the published Commission regulations related to the implementation of CRD/CRR and those that are being prepared. In several instances, the CRD/CRR framework requires national supervisory authorities to disclose the way certain detailed rules concerning particular issues should be applied in the given Member State. In Hungary, the MNB’s corresponding decisions are published in MNB decrees, in accordance with the sectoral laws. Among the MNB decrees linked to the application of certain rules of CRD/ CRR, the most important ones concern remuneration policies243 and capital requirement calculation.244 In addition, the MNB has published several recommendations that disclose the MNB’s legal interpretation practice with respect to the implementation of CRD/CRR, e.g. internal safeguards,245 recovery plans,246 the interest rate risk of non-trading book exposures247 and the disclosure practice.248 Also in connection with the ttps://www.mnb.hu/felugyelet/szabalyozas/crdiv-crr h MNB Decree 39/2014 (X. 9.) on the rules governing the calculation, recording and disclosure of the discounted value of performance remuneration. 244 MNB Decree 10/2014 (IV. 3.) on capital requirements, profits and losses not realised at real value, the corresponding deductions and the acquired rights to equity instruments. 245 Recommendation 5/2016 (VI. 6.) on setting up and using internal safeguards and on the management and control functions of financial institutions. 246 Recommendation 2/2016 (IV. 25.) on the recovery plan to be prepared by credit institutions and investment firms. 247 Recommendation 23/2015 (XII. 29.) on measuring, managing and controlling the interest rate risk of non-trading book exposures. 248 Recommendation 11/2015 (VII. 22.) on certain issues pertaining to the disclosure practices of credit institutions and investment firms. 242 243

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CRD/CRR requirements, the MNB has published and continuously updates the methodological manual and the annexes on the internal capital adequacy assessment process (ICAAP), the internal liquidity adequacy assessment process (ILAAP) and their regulatory review. The MNB has published supervisory guidance on operational risk, disclosure requirements, own funds, remuneration and liquidity, comprising the relevant EU and Hungarian rules, furthermore EBA and MNB recommendations, methodological materials and responses. Bank Resolution and Recovery Directive of the European Union — BRRD249

The 2008 financial crisis also showed that the inaccurate perception of risks by the banking sector may undermine the financial stability of whole countries if the state has to intervene in order to bail out certain banks. The European Union decided to establish two further institutions, constituting the main elements of the so-called banking union, in order to eliminate major deficiencies in the regulation. One of them is the Single Supervisory Mechanism (SSM), which assigns the role of direct banking supervisory body to the European Central Bank (ECB) with respect to euro area countries, in order to ensure that from November 2014, the largest European banks are supervised on the basis of common rules and in an independent manner. The second element is the creation of the Single Resolution Mechanism (SRM), regulating the preparation for a potential bank default, from the side of supervisory and institutional crisis prevention and crisis management on the one hand, and by creating the Single Resolution Fund (SRF) financed by credit institutions on the other hand. The aim of the new regulation was to make both supervisory authorities and credit institutions more prepared for the effective management of potential capital adequacy or liquidity problems or even crisis situations at an early stage.

249

irective 2014/59/EU of the European Parliament and of the Council establishing D a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU, and Regulations (EU) No 1093/2010 and (EU) No 648/2012, of the European Parliament and of the Council.

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23 Strengthening synergies with the emergence of central bank supervisory functions

Based on the relevant guidelines provided by the Basel-based Financial Stability Board, the directive on the recovery and resolution of credit institutions and investment firms (BRRD), was adopted in the European Union in 2014. The Single Resolution Mechanism has been operating since January 2016, however, the Single Resolution Fund will only reach the targeted financing level in 2023. The directive required market participants, inter alia, to draw up recovery plans, spelling out the way the institutions would be able to restore their capital and liquidity position in the case of crisis events without public assistance. However, the BRRD authorised the supervisory authorities to take action at a much earlier stage than before in the case of institutions that are unable to restore stability on their own. The Hungarian Supervisory Authority had been expecting large banks to prepare recovery plans since 2013, and after 2010 the conditions of the Credit Institutions Act’s supervisory intervention were amended and fine-tuned several times in order to create a legal environment facilitating forward-looking actions. Common EU regulation in the insurance sector — Solvency II250

Solvency II (SII), the new set of comprehensive insurance rules fundamentally different from the earlier (Solvency I) regime with respect to, inter alia, capital and reserve calculation and corporate governance requirements -, entered into force on 1 January 2016. During the establishment of the SII regime,251 regulators focused on the protection of clients’ best interests, risk-based approach and the importance of risk management, harmonisation with the regulation in the other financial sectors (especially the credit institution sector) and the standardisation of the EU’s insurance market and supervision, i.e. the reduction of the differences between Member States’ practices. Out irective 2009/138/EC of the European Parliament and of the Council of 25 NoD vember 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance. 251 The SII regime consists of the directive, Regulation (EU) 2015/35 directly applicable in the Member States and the various implementing regulations and EIOPA guidelines. 250

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of these goals, the results of the harmonisation with the other financial sectors are the most obvious, since the SII regulation, similar to the Basel II system pertaining to credit institutions, consists of three pillars. Pillar 1 contains the quantitative elements (own funds requirement and technical provisions), Pillar 2 covers corporate governance requirements and supervisory actions, while Pillar 3 sets out requirements for supervisory data reporting and disclosure. In Hungary, the directive was transposed through Act LXXXVIII of 2014 on Insurance Activities and Government Decree No. 43/2015 (III. 12.) on the Own Funds and Technical Provisions of Insurers and Reinsurance Companies. The EIOPA guidelines were implemented by the MNB in the form of recommendations, supervisory guidance and internal policies. Similar to the preparation for CRD/CRR, the MNB assisted the preparation of Hungarian insurers with several tools. In addition to market consultations and the Q&A process, the regular quantitative impact studies played a huge role, which provided an opportunity for gaining experience with the calculation methodology and the new reporting tables as well as the identification of the quantitative impact of SII. Besides the communication of the requirements, the Pillar 2 preparation was assisted by a qualitative impact study in 2014, and the processing of insurers’ forward-looking assessment of own risks (“FLAOR reports”) and the feedback on the identified deficiencies in 2015–2016. The rules of the sanctions for market abuse (MAD/MAR252)

Since the entry into force of the EU directive on the sanctions for market abuse, MAD, several legislative, market and technical developments (global financial crisis, LIBOR scandal, the increasingly easy access to financial services through the development of the World Wide Web etc.) highlighted the problems posed by the two-tier regulation (Community and Member State level) of market abuse and the authority measures and sanctioning regimes that vary across Member States. The directive 252

MAD/MAR (Market Abuse Directive and Regulation).

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23 Strengthening synergies with the emergence of central bank supervisory functions

amended in response to the changes: MAD II253 did not fundamentally drop the – formerly detrimental – mixed, public administrative and criminal law approach, and it requires all Member States to deem at least the serious cases of insider trading, market manipulation and the unauthorised disclosure of inside information committed intentionally as ‘sui generis’ crimes. The stipulations of the directive were implemented in October 2016, by Act C of 2012 on the Criminal Code. The market abuse regulation (MAR254) ensures the direct and uniformly solid applicability of the requirements. In addition to the financial instruments introduced to the regulated market, the extended scope of the provisions applicable from July 2016, applies from the submission of the request for marketing authorisation to, inter alia, all financial instruments that are traded in a multilateral trading facility or organised trading facility and to all forms of behaviour and transactions that may influence these financial instruments, regardless of whether they occur at a trading venue. The influencing of the benchmarks (for example the interbank offered rates, the credit default swap benchmarks, even including the method used for calculating the benchmark that is partly or fully algorithmic or judgement-based) in any way is deemed market manipulation under the MAR, and it is categorically prohibited. The MAR’s provisions remedy one of the major deficiencies of earlier rules, and prohibit and strictly sanction even the attempt of insider trading and market manipulation. With the harmonisation of Member States’ rules on insider lists, the MAR provides Member States’ authorities with an important instrument for investigating potential market abuses. The enhanced transparency of the transactions conducted by executives of issuers and, where applicable, the persons closely associated with them, is an effective irective 2014/57/EU of the European Parliament and of the Council on criminal D sanctions for market abuse. 254 Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/ EC, 2003/125/EC and 2004/72/EC. 253

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preventive measure against market abuse, especially insider trading. The new general rule stipulating the prohibition of making transactions before the disclosure of the interim financial report or the annual report for executives is also intended to prevent the opportunity for abusing inside information. The MAR has several substantial achievements compared to the previous regulation. In order to facilitate the efficient functioning of the capital market, it enables the conducting of surveys about the opinion of market participants to gauge the opinion of potential investors in advance (these are the so-called “market soundings”). Although during “market soundings” potential investors may receive inside information, if the requirements regulated in the MAR are adhered to, such acts do not constitute market abuse. In connection with the transposition of the implementing directive, in July 2016, the Capital Market Act was supplemented with provisions regulating the reporting of MAR violations, which guarantee the appropriately effective safety mechanisms for those persons reporting market abuses and which may even ensure complete anonymity. In order to enhance the deterrent effect of the measures, the MAR enables the withdrawal of the profits gained or the losses avoided on account of the violation even if their amount exceeds the ceiling of the specific fine (an equivalent provision has existed in the Hungarian capital market regulations for a long time). The overwhelming majority of the instruments and powers provided by the MAR to the competent authorities for detecting capital market abuses (such as conducting on-site inspections, creating physical mirror images from any data storage, effecting seizures, requesting traffic data on electronic communications, freezing accounts, temporarily prohibiting unlawful activities) have been available in Hungary due to the innovative legal solutions codified on the initiative of the MNB even before MAR, and their use became part of the MNB’s professional routine.

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23 Strengthening synergies with the emergence of central bank supervisory functions

The Markets in Financial Instruments Directive and Regulation (MiFID II/MiFIR)

The directive on investment service activities, regulated markets and multilateral trading facilities (MiFID I) has been in effect since November 2007, however, due to the changes on financial markets and the rapid technological advancement, the directive was recently reviewed (MiFID II) and a regulation (MiFIR) was elaborated. These two laws together form the legal framework for those performing investment service activities, regulated markets and the corresponding reporting agents. Due to its regulatory nature, the MiFIR is directly applicable from 3 January 2018, while the deadline for transposing MiFID II into national law is 3 July 2017.255 The revised directive and regulation contains several new provisions, amendments and clarifications as compared to the earlier regulation. One important principle of the MiFID II/MiFIR is that all organised trading has to take place in regulated venues, while ensuring as much transparency as possible before and after trading. Therefore, the trading venues are supplemented with a new category, the organised trading facility (OTF). Compared to regulated markets and multilateral trading facilities (MTF), one of the main differences is that the operator of the OTF executes the order on a discretionary basis. Another important change is that the MiFID II introduces the concept of independent advice. In recent years, several changes and technological advancements could be observed on financial markets. Market participants increasingly use algorithmic trading and its special form: high-frequency trading (HFT). Trading technology’s progress resulted in greater speed and complexity of trading, which required the review and extension of the related rules in order to ensure transparency and the appropriate investor protection as well as to mitigate risks, which has been implemented in MiFID II. MiFID II introduces new, European-level product management rules for both investment firms developing financial instruments and for 255

The MiFID II will also be applied from 3 January 2018.

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dealers. The former need to have in place a product approval process by meeting organisational requirements, which ensures that investment products are created in line with the needs of the given target market and after the assessment of risks, furthermore they provide adequate information to dealers, making available all the data pertaining to financial instruments and the product approval process. The new rules in MiFID II also include position limits and the position management control mechanism with respect to commodity derivatives. Accordingly, the supervisory authorities need to limit the size of the position that can be held by one investor in a given commodity market derivative during a specific period. The limits are determined in order to prevent market abuse and to facilitate orderly pricing and settlement conditions. The MiFIR also contains new provisions with regard to market monitoring and product intervention. With their product intervention powers, European and national supervisory authorities may restrict or ban financial activities, provided that this is justified by investor protection considerations, the relevant EU legislation does not address the problems appropriately and the measures taken by the competent authority are not sufficient to manage the risks.

b) P articipation in Hungarian legislation and the MNB’s regulatory instruments

The MNB as the supervisory authority is an active participant in legislation not only at the EU-level but also in Hungary. It takes part in preparing, developing and commenting on laws, government and ministry decrees pertaining to supervised institutions and market participants, providing support for the effective work of the legislator through the practical experience of its experts. At the same time, the MNB is empowered to employ different types of regulatory instruments for institutions within its regulatory scope, and the most important of — 846 —

23 Strengthening synergies with the emergence of central bank supervisory functions

these is the so-called MNB Decree. The power for issuing decrees is conferred upon the governor of the MNB by Article 41(5) of Hungary’s Fundamental Law, stating that on the basis of authorisation by an Act and within his or her functions laid down in a cardinal Act, the governor of the MNB shall issue decrees; which shall not conflict with any Act. Practical experience has shown that further supervisory instruments are necessary that help supervised institutions and provide guidance about the supervisory interpretation of the laws and about compliance with them, describing the concrete expectations of the central bank, and informing all market participants and interested parties of certain key issues. Such supervisory regulatory instruments include recommendations, the content of which expresses the requirements of the laws, the principles, methods, market standards and conventions that are recommended to be employed based on the MNB’s application of the law. The MNB also issues recommendations for transposing the guidelines and recommendations of the European Supervisory Authorities. The recommendation is not binding, i.e. adherence to the requirements and guidelines contained in it is at the discretion of the institution, however, compliance by the financial institutions under MNB’s supervision with the recommendation is monitored and evaluated by the MNB during its inspection and monitoring activities, in line with the common European supervisory practice. Nevertheless, since the MNB expounds on a given provision or legal obligation in the recommendations, if an institution diverges from the recommendation, during a potential MNB audit or inspection, the burden of proof concerning the compliance of its own practice diverging from the MNB’s interpretation with legal requirements, is borne by the institution. The MNB may also issue public or partly public ‘Dear CEO Letters’, aimed at raising awareness of the observance of a concrete detailed rule or certain detailed rules addressed to specific executives of the institutions falling under the scope of the MNB Act. Another supervisory regulatory instrument is the supervisory guidance, which is a summary of the key information on a specific issue or set of issues — 847 —

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for stakeholders and those interested in the topic, issued to fulfil the obligations provided by the MNB Act, arising from EU membership or other obligations. The MNB publishes methodological manuals for implementing its licensing, inspection, market surveillance and consumer protection procedures, aimed at, inter alia, the disclosure of the methods used during the individual procedures, thereby communicating its expectations to stakeholders in a transparent manner. The contents of the methodological manuals may be public or partly public. The MNB also discloses model policies, which serve first and foremost supporting purposes but also lay down the minimum requirements for developing institutions’ own policies. However, the model policy has to be supplemented by the institutions with institution-specific details in all cases. All in all, in addition to decrees, the instruments communicating the central bank’s legal interpretation and expectations to the supervised institutions and their executives are: recommendations, Dear CEO letters and methodological manuals. Institutions’ legal compliance is facilitated by model policies and sample supervisory guidance. The supervisory guidance is prepared for those interested in the key topics, providing useful information to market participants including clients.

23.3.2 Licensing and enforcement activities — Personal responsibilities in the focus

Financial sector participants maintain ties with the MNB acting in its capacity as the licensing authority from the outset until the termination of the institutions. One of the basic conditions for market entry is acquiring the supervisory licence for the activity sought to be performed. The sectoral laws provide various requirements in the different financial sectors (for example in the case of credit institutions, — 848 —

23 Strengthening synergies with the emergence of central bank supervisory functions

these include the articles of association, the minimum capital requirement and the requirements for organisational structure provided by the Credit Institutions Act; in the case of insurers, these include the required funds and the statutes), but there are common features as well. Such features include the requirements pertaining to executives, since it can be observed in all segments of the financial intermediary system that the reasons behind the insufficiently conscious and careful, furthermore unprofessional corporate governance that can be attributed to leadership deficiencies at the individual level may trigger grave problems in the operation of financial institutions. Therefore, the MNB pays special attention to checking good business reputation, the required expertise and practical experience when licensing members and heads of executive bodies (board of directors, supervisory board), irrespective of whether they want to take part in the operation of the given institution as heads of bodies or responsible members. One solid measure of the efficiency of supervision is to what extent the MNB as an enforcement authority is able to meet the expectations that arise from the demand for the effective representation of public interest. It always has to perform its duties within the legislative framework while utilising the room for manoeuvre provided by that framework for enforcement authorities to the fullest possible extent, acting carefully, consistently but assertively and in a determined manner, keeping in mind its values. In administrative procedures, the MNB weaves a supervisory net around the members of the financial intermediary system through its measures and penalties that paves the way for shaping market developments while not only supervising but also actively influencing the behaviour of market players. During its enforcement activities, the MNB considers the efficient utilisation of all of its available instruments as a priority. Within this framework, the conditions have to be ensured for employing those measures and special measures that are most appropriate for the type, gravity and the extent of the risk induced by unlawful conduct with respect to sanctioning the infringement identified during continuous — 849 —

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supervision and inspection procedures. This is desirable with regard to both financial institutions and their executives, since one of the declared objectives of the MNB is to implement full market purification at the personal, individual responsibility level as well. The responsibility of executives should be examined in the light of the extent to which the deficiencies identified at the financial institution under their control threaten the stability of the financial institution due to the number, systemic nature and gravity of the deficiencies, the type of the operational risks induced by the deficiencies in governance and control, and the impact the deficiencies exert on the liquidity and solvency of the financial institution and the interests of the clients and consumers (depositors, policyholders, investors, fund members etc.). In addition to the measures taken against the financial institution – and sometimes instead of these measures – the personal responsibility of executives is established in every case where the effective legal tool for restoring the compliant operation of the financial institution and preventing further infringements is taking tailored measures.

23.3.3 Continuous supervision

In practice, the MNB enforces prudential requirements, EU and Hungarian laws and internal policies, and controls institutions’ activities in basically two ways: – Off-site, it continuously monitors and assesses the activities and risks of the institutions and the aggregate data for the sector based on the available information. – It conducts audit procedures and on-site inspections at the supervised institution at least at the intervals stipulated by law or when particular risks are identified or certain events occur.

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23 Strengthening synergies with the emergence of central bank supervisory functions

Chart 23-2: Continuous supervision and on-site inspections over time On-site eximination for different time periods

On-site eximination for different time periods

Continuous supervision

Source: MNB.

The aim of continuous supervision is to identify, measure and analyse an institution’s risks, and to initiate measures and interventions when necessary. Continuous supervision hinges on the MNB having as much quantitative and qualitative information about the given institution as possible. MNB staff acquire such information from the following sources: – mandatory, statutory reporting or regular or extraordinary reporting ordered by the MNB (with daily, monthly, quarterly or annual frequency), – other information from the supervised institution (for example committee minutes, meetings with the management of the institution, reports, disclosures by the institution), – internal materials and information from other MNB areas (Stability Report, Macroprudential Report, lending developments etc.),

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– external information sources (e.g. stock exchange reports, information published in the press). Since the financial sector and its risks are highly complex, huge amounts of data need to be processed for monitoring these risks and the institutions’ performance. Furthermore, as the economy, the regulatory environment and the financial sector and its risk change – nowadays in quite a rapid manner – the information demand of supervision also changes and develops continuously. The utilisation of the large volume of available information is facilitated by the monitoring system based on regular reporting and the so-called “automatic notification system”, which immediately warns supervisors about the divergence of the established indicators from the level expected by the Supervisory Authority. Another integral part of continuous supervision is the multilevel ties and information exchange with the institutions. The MNB follows a risk-based supervisory approach. As a first step, the MNB performs a so-called impact rating for all institutions on an annual basis, assessing the impact of the institutions on the financial sector based on several aspects (for example size, market share, number of clients and depositors). As a result of the rating, supervised institutions are grouped into one of four categories: strong, above medium, below medium and weak impact. In the case of the institutions whose impact on the Hungarian financial sector and economy during their operation is deemed major and substantial, the MNB pays special attention during supervision. Depending on the impact rating of the institutions, we distinguish between single supervision, where one or more supervisors are responsible for one institution – this is used in the case of institutions with above medium or strong impact – and joint supervision, where one supervisor supervises more institutions that usually have a less major impact. In the next step, the intensity and focus of supervision are adjusted to match the riskiness of the institutions. In practice, this means

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that the MNB assesses the main risks in all institutions (for example credit risk, liquidity risk), then focuses on these during supervision. Therefore, risk-based supervision means that the MNB supervises and controls all institutions based on their weight and riskiness; the focus, instruments and intensity of the supervision are determined by the risk profile of the institution. The riskier an institution is, the more detailed analysis and the more frequent inspections are conducted by the MNB. From the perspective of monitoring the risks of the sector and timely intervention, it is key that the MNB pays closer attention to riskier institutions and that those risks are analysed more carefully that impair the performance of the given institution most. This approach is an important step forward, compared to the general and standard supervision and inspections, since specific issues have to be addressed thoroughly at certain institutions, while the same type of risk may not even appear in the case of other institutions. Of course, true risk-based supervision rests on two pillars: the ability of the MNB to continuously monitor risks and the availability of a flexible set of methods and instruments that enable rapid shifts in supervision, its focus and instruments when risks change. Supervisory colleges

In the case of institutional groups with subsidiaries in several countries, a uniform microprudential supervision should be provided at the international level as well. The so-called supervisory colleges were created to ensure efficient coordination of the process. In the structure of the colleges, the so-called home (consolidating) supervisory authority is in charge of supervising the parent institution and its related subsidiaries in the given country as well as coordinating the college. The task of the host supervisory authorities is the supervision of foreign subsidiaries. The MNB is a member of colleges in both roles. The goal of the supervisory college is to improve the efficiency of the group-wide and individual supervision. One of the key elements among the instruments is the risk assessment of the supervised

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institutions, which is shared by the competent authorities with the members of the college. In addition, there is continuous, active information exchange about the operation of the institution and its perception. It is in the interest of all the members that group-level risks are identified in time and assessed jointly, and that the appropriate measures are applied. Although the supervisory colleges have been set up in line with the European Union regulation, in certain cases third countries may also be members with observer status. Confidentiality, technical matters and tasks are regulated in the written coordination and cooperation agreements adopted jointly by the members of the college. Continuous contact plays a vital role in the efficient functioning of the colleges. Within the framework of the cooperation, the supervisory college prepares its 12-month work plan and an emergency plan. The emergency plan covers the identification of the crisis, the preparation and coordination of crisis management, the assessment of the crisis, external communication and the sharing of the information available in the supervisory college among the supervisory authorities. With respect to banking groups, one of the main topics of college meetings is individual and consolidated risk assessment and the related so-called joint decisions about individual (sub-consolidated) and grouplevel Pillar 2 capital adequacy (SREP) ratio, liquidity adequacy and other related supervisory measures. The work of the colleges also includes the assessment of the so-called group-level recovery plan and its adoption with a joint decision. In the insurance sector, the other supervisory authorities in the supervisory college regularly provide information to the group supervisors about the report on the solvency and financial position of the insurer or reinsurance undertaking concerned, the regular supervisory report, and the relevant annual or quarterly tables containing numerical data and the conclusions drawn by the supervisory authority concerned after the supervisory review process at the level of the individual companies.

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23 Strengthening synergies with the emergence of central bank supervisory functions

In addition to banking and insurer groups, central counterparties are also licensed by a so-called supervisory college. Central counterparties are special financial market infrastructures replacing clients in agreements concluded on one or more financial markets, thereby acting as buyer for all sellers and seller for all buyers. The members of the college – operating in a strictly regulated framework – were determined in line with the EMIR requirements, and the composition of the college must be reviewed annually. The representative of ESMA is a permanent member of the college, albeit without voting rights. The college comments and takes decisions on all issues related to the central counterparty that materially influence the functioning and/or risk profile of the central counterparty (for example expansion of activities, substantial modification of risk management models and parameters).

23.3.4 Inspections

In the course of supervision, the MNB conducts various inspections, which may be performed off-site, i.e. based on the data and information available to or requested by the MNB, or on-site, i.e. at the head-, branchor other office of the given institution. During on-site inspections, the MNB may perform comprehensive inspections, targeted inspections, thematic inspections, extraordinary targeted inspections or postinspections. The composition of a comprehensive inspection is not prescribed in law; however, its frequency is determined by the MNB Act: depending on the type of the institution, the MNB is required to carry out comprehensive inspections (including an on-site phase) at predetermined intervals: • at least every 3 years at credit institutions, insurance companies, reinsurance companies, electronic money institutions, payment institutions, investment firms, commodity exchange service providers, investment fund managers, stock exchanges and members of financial groups;

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• one year after the start of operations at credit institutions, insurance companies, reinsurance companies, investment firms, commodity exchange service providers and investment fund managers; • at least annually at the central counterparty and the central securities depository; • at least every 2 years at institutions operating payment systems or engaged in clearing house activities; • at least every 5 years at small insurance companies, venture capital fund managers, private pension funds, voluntary mutual insurance funds and institutions for occupational retirement provision. The frequency specified in the MNB Act is only the minimum; the MNB has the right to conduct comprehensive inspections more often. Depending on the risks of the institution, the comprehensive inspection may cover the main activities and risks of the institution. Targeted inspections may be carried out by the MNB at a given institution in order to verify compliance with specific legal provisions on an ad hoc basis. Targeted inspections may be conducted on the suspicion of a violation of legal provisions or to verify, in a noncomprehensive manner, compliance with certain legal provisions. The MNB conducts ex officio thematic inspections at a number of different institutions for the purpose of coordinated and comparative verification of specific risks or compliance with legal provisions of the same or similar type. The MNB has the right to launch extraordinary targeted inspections on the reasonable suspicion of a serious violation of certain legal provisions, if the violation concerns a large number of clients, entails substantial systemic risk or generally threatens market confidence.

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23 Strengthening synergies with the emergence of central bank supervisory functions

During comprehensive, targeted, thematic and extraordinary targeted inspections, the MNB reports its findings, by describing the violations and insufficiently prudent practices or regulations identified at the given institution. Simultaneously with the reporting of its findings, the MNB provides the deadline by which certain measures are expected from the institution in order to eliminate the identified deficiencies. By requiring the measure, the MNB seeks to reduce the institution’s risks and drive its operation in the right direction. The fact that the institution actually and appropriately implements the prescribed and expected measures is verified by the MNB through post-inspections. The MNB may impose a penalty in the case of all inspection types, depending on the gravity of the findings and the risk profile of the institution. The amount of the penalty may range from HUF 100 thousand to HUF 2 billion.

23.3.5 Market surveillance procedures

By identifying and shutting down unlicensed or unreported financial market participants, the MNB aims to foster an intermediary system offering transparent investment opportunities and a level playing field for economic actors, creating an effective capital market environment in Hungary enjoying public confidence. The MNB’s objective is to ensure that investors only have access to products the market of which is known, supervised and regulated by the MNB, and to minimize the “grey” area, the sale of high risk, cross-border “quasi” investment products. Meanwhile, globalised financial markets carry the risk of giving domestic consumers around-the-clock access to complex products, the understanding of which requires a thorough knowledge of financial markets. The MNB must therefore respond quickly and firmly to any phenomena or abuse jeopardising financial markets. The early identification and elimination of unlicensed operations shields market participants from subsequent losses and strengthens confidence in the financial intermediary system; the MNB pays special attention

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to timely intervention during its market surveillance procedures. Accordingly, the MNB develops and operates a monitoring system and an inspection methodology enabling rapid detection, i.e. the more effective identification of money and capital market abuse committed using online publications, websites, blogs and the social media. The MNB enhances capital market transparency by continuously assessing and interpreting issuer disclosures and by conducting targeted inspections of issuer communications, including the application of international financial reporting standards (IFRS). By conducting stricter assessments of the consolidated accounts drawn up according to IFRS requirements by the issuers of securities introduced to a regulated market, the MNB is improving international comparability.

23.3.6 Consumer protection procedures

From a consumer protection perspective, the ideal financial system functions ethically and at a high standard, which requires ensuring every necessary condition for all market participants. Consumer protection procedures may be launched on request or ex officio, yet in recent years the focus has clearly shifted towards the latter. After reviewing, compiling and categorising all submitted consumer requests, claims and enquiries, the MNB conducts targeted or thematic inspections instead of – the less effective – addressing individual claims, and the consumer protection area uses these inspections to identify and address the issues affecting all the consumers concerned at a systemic level, and apply effective sanctions. During its consumer protection inspections, the MNB prioritises the inspection of the institutions that attract the most complaints and requests, the inspection of risky products and the verification of the implementation of new laws in practice.

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Another advantage of ex officio inspections is that the findings presented and measures taken by the MNB can be efficiently controlled in a post-inspection, and it is possible to consistently enforce compliance. In addition, the MNB’s staff in the consumer protection area also participate in the comprehensive inspections launched by the prudential area in order to firmly represent the consumer protection objectives. Mystery shopping is a special type of consumer protection procedure that enables the MNB to directly experience the contracting and information provision practice of financial institutions, their conduct vis-à-vis clients and to collect evidence about unfair market practices and infringements. Mystery shopping may also be used to build fruitful cooperation with partner authorities.

Key terms algorithmic trading ensuring the stability of the financial system high-frequency algorithmic trading (HFT) insider list insider trading maintaining confidence in the financial system market manipulation

market soundings microprudential supervision multilateral trading facility organised trading facility recovery plan regulated market unauthorised disclosure of inside information

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References Discussion paper: Az MNB pénzügyi felügyeleti funkcióinak megerősítése (Új szabályozói eszközök MNB-hez rendelése és a PSZÁF MNB-be integrálása) (Strengthening the financial supervisory functions of the MNB [Assigning new regulatory instruments to the MNB and the integration of PSZÁF into the MNB]) EBA Guidelines on common procedures and methodologies for the supervisory review and evaluation process MNB – Félidős jelentés 2013–2016 (Half-term Report 2013–2016) https://www.mnb.hu/felugyelet/szabalyozas/nemzetkozi-felugyeleti-intezmenyek https://www.mnb.hu/felugyelet/szabalyozas/crdiv-crr https://www.mnb.hu/felugyelet/szabalyozas/mifid-mifir

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Overhauling the Hungarian microprudential supervision Dr Csaba Kandrács256

In the future, in order to avoid shocks similar to the 2008 global crisis, the development of instruments and methods enabling a new type of supervision has become necessary. One such new method, for example, is the increased focus on the business model or the development of the basic monitoring system and the early warning system that hinges on it. Based on the data regularly reported by the supervised institutions, the early warning system generates hundreds of indicators to signal potential problems and the necessity of supervisory intervention. Overhauling the supervisory and inspection activities is also inevitable, therefore the new Supervisory Authority has shifted towards riskbased inspection planning: between the comprehensive inspections, the targeted and thematic inspections with a narrower focus gained prominence. The precondition for the successful regulatory activities of a more robust MNB acting as the Supervisory Authority is that the Supervisory Authority have a strong and independent opinion of the operating environment of the institutions and the risks inherent in their activities, and that it has a clear vision, methods and models for the most rapid and effective management of the risks. Timely supervisory responses are helped by the so-called operational inspection units established for this purpose and specialising specifically in the rapid on-site inspection of risks. Timely supervisory intervention is also facilitated by the information obtained from the institutions in larger quantities than 256

he following people contributed to this chapter: Zsigmond Atzél, Csaba Bakler, Dr T Péter Barnóczki, Dr Richárd Bense, Dr Gábor Dakó, Dr Éva Fegyver, Dr Mihály Attila Hudák, Dr Péter Pál Szikora, Ákos Farkas, Norbert Holczinger, Nikoletta Kerekes, Eszter Kőhidi, Dávid Kutasi, Róbert Mátrai, József Mohácsi, Judit Pintér, Nóra Sljukic, Katalin Szajkó, András Tomsics, László Török, Zoltán Varga

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previously, as well as the other signals from consumers channelled into the process of supervision. The highest level of data collection is when the MNB creates a physical mirror image or an authentic copy, examining the saved data by utilising these. In response to the crisis, sector-specific developments and new features emerged in supervision. For example, in the credit institution sector the ICAAP257 and ILAAP258 reviews259 and the various stress tests, and in the case of the capital market, the overhaul of issuer supervision and the stronger implementation of the MNB’s gatekeeper role in product licensing. And in addition to controlling the reporting by the supervised institutions, the MNB places more emphasis than ever on the onsite inspection of market participants. The immediate backup (“mirroring”) of the complete IT dataset of market participants, which has already been used successfully in market surveillance procedures, has been introduced. Having regard to the entry into force of the European legal framework in the insurance sector effective since 1 January 2016 (Solvency II), the MNB has revised and supplemented its earlier risk assessment procedures concerning its supervisory activities. In contrast to the rule-based capital requirement (Solvency I) used so far, a complex, risk-based capital requirement and supervisory rules were introduced at the European level, therefore the risk-based approach can be traced in the whole set of requirements. In the MNB’s supervisory activities with respect to funds, the business model approach and a proactive attitude have become central, therefore before a potential crisis unfolds, the MNB endeavours to identify the signs suggesting the heightening of risks, and facilitate the appropriate and early management of the risks. In the case of intermediaries, the MNB performs market clearing during its proactive supervisory work in order to eliminate the identified bad practices (for example by calls, penalties, the revocation of licences), thereby contributing to a clear market and the strengthening of consumer confidence. I CAAP – Internal capital adequacy assessment process ILAAP – Internal liquidity adequacy assessment process 259 The supervisory process whereby the MNB reviews and assesses the corporate governance, internal controls, systems, strategies, business model, procedures and mechanisms of the institution/group (hereinafter: institution), assessing the institution’s risks, risk management and whether its capital adequacy and liquidity are in line with its risk, taking into account its internal processes as well, and intervening in time in order to maintain the appropriate level of capital and liquidity. 257 258

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24.1 General developments and new features 24.1.1 Stronger supervisory regulation

Since the 2008 crisis, the regulatory activities of the Hungarian supervisory authority have become increasingly pronounced. The decrees and recommendations issued by the MNB cover a very wide range of activities and risks with respect to the prudential and consumer protection aspect of credit institutions, capital market institutions, insurers and funds. Of course, the precondition for the issuance of decrees and recommendations is that the Supervisory Authority have a strong and independent opinion about the operating environment of the institutions and the risks inherent in their activities, and that it have a clear vision, methods and models for the most rapid and effective management of the risks. The establishment and communication of the Supervisory Authority’s opinion towards the sector ensures the transparency of the operation and expectations of the Supervisory Authority, which is vital in the forward-looking and preventive regulation of the market. The MNB also communicates to the institutions the practices expected and also recommended by it through benchmark models and methods, and it delineates the areas deemed at most risk. The MNB has formulated a comprehensive concept or idea in connection with several parts of the financial market such as the concept of fair banking or ethical life insurance. (Having learnt from the crisis, the MNB has published several recommendations and “Dear CEO letters”, a few recommendations can be found in the box.) Box 24-1 Recommendation No. 1/2016 (III. 11.) of the Magyar Nemzeti Bank on the recovery of delinquent household mortgage loans

The laws pertaining to consumer mortgage loans and the opportunities for changing contractual terms were transformed considerably in 2015. One of the priorities of the MNB is to facilitate the restoration of debtors’ solvency in the case of delinquent household mortgage loan contracts.

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In the recommendation, the Supervisory Authority presents the forms of conduct and best practices it expects from financial institutions in addition to complying with the legal requirements during the restoration of the solvency of delinquent mortgage loan debtors and debtors of already terminated claims secured by real estate. In order to ensure solvency and protect debtors, the recommendation specifies the minimum requirements that are vital to be fulfilled before the termination of the contract, the sale of the claim arising from the terminated contract or the recovery of the collateral. In addition, the recommendation provides transparent and uniform rules of procedure or a framework to financial institutions for the recovery of this portfolio. “Dear CEO letters”: Supervisory guidance on the MNB guidance issued for the operational risk rating of the losses incurred from compliance with the laws aimed at assisting foreign currency borrowers From a regulatory perspective, one of the key topics in the recent period has been the issue of the appropriate identification of conduct risk. Conduct risk is a type of operational risk, and within this, it is part of legal risks. It includes the risk of all losses incurred from the inadequate provision of financial services, including intentional wrongdoing or inappropriate conduct (e.g. inappropriate sale of products, interest rate or exchange rate manipulation, misinforming a client). In recent years, the supervisory authorities have identified several violations in the day-to-day operation of the individual institutions, and in parallel with that, the penalties imposed by the authorities swelled considerably (one example from recent years is the LIBOR manipulation scandal, in which banks unlawfully influenced the development of London interbank interest rates). In response to the situation, international and Hungarian regulation has laid down several qualitative and quantitative requirements for the risk management framework of the players in the banking system, including the establishment and operation of a comprehensive and integrated operational risk framework. In line with the recommendation’s requirements, the institutions ensure the responsible management of these risks through continuous self-assessment, the monitoring of key risks and scenario analyses.

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Recommendation No. 8/2016 (VI. 30.) of the Magyar Nemzeti Bank on the application of the prudential and consumer protection principles regarding unitlinked life insurance policies The declared objective of the recommendation is the establishment of a range of products that enables the creation of a longterm, stable life insurance portfolio. It provides its principles, namely ethical conduct in establishing product conditions, proportionality and rationality when setting costs, a fair ACR260 value, clarity and comparability when presenting costs, comprehensive client information during sales, responsible conduct on the part of the insurers during investment management, risk management and portfolio management, and simplicity in the establishment of the range of asset bases. The recommendation extended the fair ACR limits from the pension fund recommendation, and introduced further clarifications based on earlier experiences as well as an expanded ACR limit system based on product types. In addition, it expects, inter alia, that cost types be few and clear, and provides the appropriate manner for introducing costs to clients. Furthermore, it outlines proposals about the practices deemed good during investments, and expects institutions in concrete cases to check after the conclusion of the contract whether a contract corresponding to the needs was sold. Recommendation No. 6/2016 (VI. 14.) of the Magyar Nemzeti Bank on holding the volatility capital buffer ensuring continuous capital adequacy The Solvency II regime provides that insurers should have eligible own funds covering the solvency capital requirement and eligible own funds covering the minimum capital requirement. Insurers are required to comply with the solvency capital requirement continuously, however, they only need to provide comprehensive data on this to the MNB once a year. In the SII system, a change in the environment or its development diverging from expectations makes the development of the own funds volatile, which may jeopardise continuous capital adequacy. The MNB requires insurers to hold a volatility capital buffer in order to mitigate this risk.

260

ACR - Annual Cost Rate

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Recommendation No. 5/2015 (V. 05.) of the Magyar Nemzeti Bank on the electronic interfaces serving the presentation and comparison of insurance products and used during insurance mediation Within the framework of forward-looking supervision that markedly influences the market, the MNB published its recommendation on insurance interfaces in the first half of 2015, following a broad market consultation. The Insurance Act261 regulates the general framework of insurance mediation, and does not contain separate rules for electronic intermediary and sales activities. The recommendation provides guidance on the practical application of the legal framework on electronic interfaces. In addition to the provision of thorough and professional advice that matches the features of the intermediated insurance service, the MNB deems it is vital that consumers have access to a comparison of not only the insurance services’ price but also their content, in a clear and readily interpretable manner that helps consumers choose the product best suited to their needs.

24.1.2 Forward-looking approach

The stability of the financial sector depends greatly on the time of intervention as well. Rapid and successful intervention in today’s abruptly changing environment is extremely difficult, as the crisis that started in 2008 also escalated fairly quickly. The lesson from the crisis is that European supervisory authorities should have recognised the signs and firmly intervened earlier, before the eruption and escalation of the crisis. The precondition for this is that supervisory authorities be able to provide a reliable forecast about future risks based on the current performance of the institutions and the sector, and that they prevent the escalation or even the emergence of risks by way of their preventive measures, rather than identifying and mitigating through measures only the current risks based on the thorough analysis and examination of institutions’ activities. This requires instruments and methods enabling the so-called forward-looking supervision such as business model analysis and the early warning system. 261

Act LXXXVIII of 2014 on the Insurance Business

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24.1.3 The development of the basic monitoring system, and the early warning system

The new form of utilising the information obtained from the institutions, which assists the responsible operation of the authorities, is the development of the so-called basic monitoring system and the early warning system based on it. On the basis of the data regularly reported by the supervised institutions, the early warning system generates hundreds of indicators to signal potential problems and the necessity of supervisory intervention. Early intervention is facilitated by the collection of information obtained from the institutions in larger quantities than previously (e.g. by more frequent attendance at meetings of various bodies or requests for reports), and feedback from consumers channelled into the process of supervision. By processing these data, the MNB staff can monitor and keep abreast of the activities and operation of the given company and intervene to eliminate risks and infringements in time, if necessary. The frequency of the monitoring reports, which is determined based on the functionality of the analysis, may be daily, weekly, monthly, quarterly or annually. In response to extraordinary market developments, periodical reports are prepared on an ad hoc basis.

24.1.4 New instruments in supervision: Business model analysis

With respect to the methodology of continuous supervision, the MNB complies with the requirements and recommendations of the European supervisory authorities (EBA, EIOPA, ESMA, ESRB), and follows the work of international partner authorities. In this context, the business model-based approach that enables the supervisory authority to eliminate potential risks by analysing the individual business models of the institutions is gradually gaining ground in the Hungarian supervisory activities. Thanks to the business model analyses, the MNB can glean aÂ more comprehensive insight into the sustainability and vulnerability of the profitability, strategy and business model of the institutions. â&#x20AC;&#x201D; 867 â&#x20AC;&#x201D;

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Chart 24-1: Components of business model analysis Preparation Macro Competitive environment environment

Analysis

Trends

Assessment of business environment (forward-looking)

Profit & Loss

Balance sheet

Risk Off-balance appetite sheet items

Quantitative analysis

Business model analysis

Identification Information Preliminary of peers requirement assessment

Identification of focus

Internal External Competitive dependencies dependencies advantages

Viability of current model

Qualitative analysis

Feasibility, execution capability

Projected financial performance

Sustainability Key of vulnerabilites strategy Supervisory view

Assumptions, success drivers

Analysis of strategy

Refine supervisory plan

Consultation

Direct actions

Supervisory action

Source: Authors’ work based on EBAIGLI2014113.

During business model analysis, the MNB explores the situation of the supervised institutions from several aspects. The inspection starts with a preliminary assessment and the establishment of focus points, during which the institution’s group structure, main lines of business, products and geographical scope is reviewed. The business environment is a key factor influencing the implementation of the institutions’ strategy, and during its assessment, business model analyses primarily focus on the macroeconomic environment, the competitive position and the market trends affecting the institutions’ operation. This is followed by the quantitative analysis of the business model, when the Supervisory Authority assesses the institutions’ main financial and accounting statements as well as their financial performance relative to the announced and observed risk appetite. During the qualitative analysis, the factors impacting the successful operation of the institutions and the main external and internal dependences are examined. In the next phase, during the assessment of institutions’ strategic plan and financial — 868 —

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forecasts, the Supervisory Authority reviews the assumptions used, and forms a comprehensive picture about the feasibility and riskiness of the business model. As a last step in the process, depending on the objective and focus of the inspection and the result of the business model analysis, the MNB determines the supervisory measures best suited for managing the identified risks.

24.1.5 Targeted inspections instead of periodical comprehensive inspections — Operational inspection units

The MNB is legally obligated to conduct comprehensive on-site inspections at the various institutions at predetermined intervals. However, today’s economic and regulatory environments are so fickle that the examination of institutions’ risks in certain concrete topics and in connection with emerging events has become necessary between comprehensive inspections. Therefore, supervisory and inspection activities have shifted towards risk-based inspection planning: between the comprehensive inspections, targeted and thematic inspections with a narrower focus gained prominence. The advantage of the new approach is that risks can be examined shortly after they emerge, and it is possible to intervene before the escalation of negative events, if necessary. The box presents two such thematic inspections conducted in the credit institution sector. Box 24-2 Examples of targeted inspections

Thematic inspection of household non-performing mortgage loans As a result of the 2008 crisis, a substantial amount of non-performing loans (NPLs) were accumulated on the banks’ books, exceeding HUF 1,000 billion at the end of 2015 in the case of mortgage loans at the 10 largest banks. The high proportion of non-performing household mortgage loans represents a severe financial stability and social risk. The government has taken several steps to eliminate these loans. However, based on continuous supervision

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and reporting, the MNB perceived no significant drop in non-performing loans in the wake of these measures (settlement and forint conversion). In order to familiarise itself with market practices, the MNB sought to ascertain in a thematic inspection whether banks have a strategy aimed at the reduction of NPLs as well as the necessary resources and instruments. As a result of the inspection, it was established that certain institutions were careful and proactive, devising NPL reduction strategies (even before the settlement) aimed at coming to an agreement with clients, developing cooperative products for this purpose, and providing the resources necessary for the individual treatment of clients, while other institutions remained passive. In order to facilitate the restoration of debtors’ solvency, after the termination of the inspections, the MNB issued a recommendation262 summarising the forms of conduct and best practices it expects from financial institutions during the restoration of the solvency of delinquent mortgage loan debtors and debtors of already terminated claims secured by residential real estate. Examining the remuneration practices of credit institutions The regulation of credit institutions’ remuneration practices became a priority after the global financial crisis, as in several Western European countries bank executives pocketed large bonuses even after the crisis and state assistance aimed at addressing this. The analyses attempting to establish the causes of the crisis also showed that one of the reasons behind the crisis was that the remuneration systems in banks encouraged executives to target the rapid achievement of profits as high as possible, irrespective of the risks that may accumulate in the bank over the long term as a result. Although in Hungary no negative trends were detected in connection with remuneration as in several other EU Member States, but the stability of the Hungarian financial sector would improve if bank executives’ activities were centred around long-term interests. In order to overhaul banks’ remuneration practices, the European Union adopted rules within the framework of the CRD Directive in 2010 aimed at urging bank executives in charge of major decisions to 262

ecommendation No. 1/2016 (III. 11.) of the Magyar Nemzeti Bank on the recovery R of delinquent household mortgage loans

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perform their duties along long-term interests. The rules also stipulated that if it was subsequently proven that executives did not perform their work appropriately, they should bear the consequences. The remuneration rules in Hungary are prescribed in the Credit Institutions Act, the Investment Firms Act and the Government Decree on the Proportionate Application of the Remuneration Policy supplementing them. The EBA published a guidance in order to promote the uniform practical application of remuneration rules. Recently, the MNB has examined eleven banks to see if their remuneration practices were in line with the laws, they encouraged excessive risk-taking, and group leader banks enforced their remuneration policy on group members subject to consolidated supervision. The main deficiencies identified by the thematic inspection were typically in the identification procedure of the persons exerting substantial influence on institutions’ risk profile, the operation of incentive schemes and the information content of the reporting and disclosure performed.

Timely supervisory responses are helped by the so-called operational inspection units established for this purpose and specialising specifically in the rapid on-site inspection of risks. Operational inspection units are delegated if the MNB obtains information during the continuous supervision that may warrant immediate on-site inspection or intervention. The MNB’s usual inspection procedures and rules also apply to the activities of the operational inspection units, however, there are some differences, for example the inspected institution does not have to be informed in advance about the launch of the inspection. During the inspections, the MNB staff conduct examinations in connection to specific topics, in contrast to the planned inspections in prudential supervision. However, these inspections are much more detailed, and backups are often made from the contents of the media of the inspected institution or its employees (computer, telephone etc.).

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24.1.6 The wider use of data

Supervision is not only aimed at the exploration and analysis of the current situation, i.e. the detection of risks that have already emerged, but also the early identification of potential risks, as well as the mitigation of their probability and escalation. Timely supervisory intervention is facilitated by the information obtained from the institutions in larger quantities than previously, as well as the other signals from consumers channelled into the process of supervision. In addition to the data analyses conducted as part of continuous supervision, the MNB collects and analyses data as part of the inspections and procedures it conducts. This type of data collection can be divided into two groups according to the processing of the information: when the selection of the data is performed by the supervised institution, and when the selection is performed by the MNB at its branch office in order to ensure and control completeness. The highest level of data collection is when the MNB creates a physically mirror image or an authentic copy from the media owned by the inspected institution or its employee, including the data stored by a hosting service, examining the saved data by utilising these. In such a case, the MNB is responsible not only for the recovery and processing of the data, but also for proving the integrity and authenticity of the data, which is currently guaranteed by the MNB through the use of so-called hash codes or hash functions. During the processing of database backups, the first task is the establishment of an IT environment identical to the platform of the backup, then the database is restored in a way identical to the manner accessible at the branch office of the supervised institution. After this, filters, reports and analyses are prepared, which are performed using the same logic as during data requests. Querying from the restored database has several advantages as compared to data requests. First, the risk of data forgery is considerably lower; verifiability is comprehensive; there is an opportunity for sampling based on more precise risk rating — 872 —

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for deeper analyses, and problems arising from the asymmetry of information between the requester and the provider of the data can be eliminated (e.g. the reporting entity does not prepare the report with the expected logic/contents). However, special requirements apply to saving databases, i.e. a higherlevel IT infrastructure is required, IT security risk is greater, it has a large human resources requirement and the Supervisory Authority needs to have more thorough information and expertise with regard to the unique operation of the inspected institutions. The processing of the physically mirror image or the authentic copy differs from the processing of database backups in that in the former case, the content of the backup is unknown to the Supervisory Authority until the start of processing and it is unstructured, therefore, the MNB has to possess the appropriate data analysis infrastructure as well as the necessary expertise.

24.1.7 Stronger sanctioning

The Supervisory Authority explores and addresses risks threatening the financial system resolutely and in an uncompromising manner, and it acts against wrongdoing and unlawful conduct in the financial market determinedly, if necessary. The MNB responds to the deficiencies and infringements detected during the various inspections or the continuous supervision with strong, deterrent measures in all cases. In line with its new and stricter policy on sanctions and penalties as compared to earlier years, the penalties currently applied in various cases might entail the imposition of sanctions on institutions committing infringements amounting to two, five or even ten times more than previously. Nevertheless, the MNB not only sanctions but also verifies the correction or modification of flawed practices and conduct by the deadline. If this fails to happen or happens only partly, the MNB can impose further sanctions on the institution concerned, and, under specific conditions, it may even revoke the operating licence of the given institution. — 873 —

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24.2 Sector-specific developments and new features – Credit institution sector The subjects of credit institution supervision are the institutions that fall under the scope of the Credit Institutions Act,263 including banks, banking groups, co-operative credit institutions, branches and the socalled financial enterprises equivalent to credit institutions. Special attention should be paid to the so-called complex banks whose balance sheet total exceeds HUF 500 billion, and whose portfolio, range of products, and corporate structure are extremely intricate. However, smaller financial institutions with a less complex business model may also pose a serious risk to financial stability. The supervision of the credit institution sector focuses chiefly on institutions and their activities, risks and viability, and in contrast to the practices on the capital market product licensing does not occur here.

24.2.1 Managing capital risks – ICAAP reviews

Pursuant to the CRD’s provisions, all credit institutions and investment firms are required to have an internal procedure for capital requirement calculation enabling institutions to assess the level of the adequate capital requirement. According to lessons from the crisis, forwardlooking preparation for risks and provisioning are crucial. The adequate establishment of the capital requirement is necessary because a given institution needs to have the appropriate amount of own funds to cover its losses incurred in a severe stress. European supervisory authorities expect all institutions to regularly assess whether the available capital covers their losses incurred in a stress. In addition to capital requirement calculation, the motivating effect is also important, as it encourages the institution to apply more conscious and effective risk management techniques and internal procedures 263

Act CCXXXVII of 2013 on Credit Institutions and Financial Enterprises.

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for better detecting, measuring and managing its risks. Therefore, embedded into day-to-day processes, the internal capital adequacy assessment process can greatly contribute to the prudent operation of the institution. The adequacy of this regular assessment at the institutions is examined and, if necessary, corrected by the MNB annually. Yet the methodology of the annual review varies depending on the size and riskiness of the institutions. During the ICAAP, institutions perform calculations regarding their capital requirement by risk types. Credit risks have the greatest weight, and they represent the risk of counterparties’ failure to fulfil their payment obligation affecting the institution’s profitability and of the losses influencing its capital position. During the analysis of credit risks, non-payment, counterparty,264 foreign currency lending and settlement risk,265 share exposures as well as concentration, country and residual266 risks are assessed. In addition to credit risks, the role of operational, market, banking book interest rates, business and strategic risks, as well as the risks arising from the regulatory environment should also be mentioned. Operational risks are composed of inadequately functioning internal processes and systems, employee’s inadequate performance of their tasks, losses arising from external events and legal risks. Market risks entail the risks arising from losses incurred from the change in market prices, while the banking book interest rate risk267 assesses how the income derived from banking book positions and the institution’s market capitalisation change as a result of the variation of interest rates on the market. Business and strategic risk arises from changes in the business environment and from adverse business decisions, the establishment of an inadequate business model or from the overlooking of changes in the business environment. Risks of the regulatory environment arise from the change in the rules

redit risk vis-à-vis professional financial and capital market players. C The defective performance of a settlement through a transfer system. 266 The risk of large-scale depreciation or limited recovery of collateral. 267 In the MNB’s interpretation, this means the general interest rate risk. 264 265

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prescribed by international or national authorities that are applicable to the institution, or from the prescription of new rules. During the ICAAP review, the MNB seeks to ascertain whether the institution assessed its risks correctly and whether it quantified an appropriate capital requirement for covering the risks. Since the assessment of the individual risk types may vary even in the context of predetermined principles, the MNB deems acceptable all methodologically accurate capital requirement calculation approaches that are in line with the regulatory requirements and thus sufficiently conservative. The MNB assesses institutions’ models along uniform, predetermined methodologies, thereby ensuring transparency and equal treatment. If during the ICAAP review the MNB deems some capital calculation element methodologically inadequate or if some element does not reflect a sufficiently conservative approach in the light of the institution’s riskiness, the MNB prescribes a capital add-on for the institution to cover for its potential losses. The Supervisory Authority enhanced both its methodology and procedure in the ICAAP review based on lessons from the crisis. In recent years, the MNB has formulated a transparent and strong opinion about both risk management and the calculation of the capital requirements covering risks. In connection with this, the MNB has prepared benchmark methodologies in order to support the acceptability or rejection of several different calculation methods used by the institutions in their risk models. This ensures transparency towards the institutions on the one hand, and helps in the comparison of the models based on mathematics and statistics on the other hand.

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Out of the benchmark developments, the LGD268 for household mortgage loans, and the TTC269 and PD270 models deserve special mention.

24.2.2 Managing liquidity risks — ILAAP reviews

Liquidity is the institution’s ability to finance the growth of its assets and meet its maturing obligations without incurring significant and unexpected losses. Maturity transformation, i.e. long-term lending from short-term liabilities, carried out for the sake of profitability (maturity risk), mass disinvestment before maturity (drawdown risk), the renewability of funds, changes in funding costs (rollover risk), environmental effects and the uncertainty of the behaviour of other market players are liquidity risks. Within liquidity risks, we distinguish: – the risk that institutions (or groups) are unable to meet their financial obligations by the deadline over an overnight, operative (30 days), short-term (1–3 months) and medium-term (3–12 months) time horizon or, owing to the related market liquidity risks, they can sell their balancing capacities only at substantial losses, due to the inadequate depth of the market or other market disturbances, and – the risk when over the long-term time horizon of over a year, institutions are unable to meet their financial obligations without unacceptably raising their funding costs, therefore institutions are unable to maintain their long-term funding sustainably.

oss given default, the parameter estimating the average loss given a default in L the transactions. 269 Through-the-cycle. 270 Probability of default. 268

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The detailed rules on managing liquidity risks are contained in CRD IV, CRR,271 the Delegated Regulation272 and the Credit Institutions Act. Pursuant to the requirements of the Credit Institutions Act, the credit institution must establish its liquidity risk profile in line with the nature, size and complexity of its activities, and it must have effective, written rules of procedure and policies. In addition to the analysis of the information obtained from the regular reporting, institutions’ liquidity position and the management of liquidity risks is assessed within the framework of on-site inspections, in the so-called ILAAP reviews and comprehensive inspection. During liquidity assessments, the MNB has to ascertain whether the institution has adequate liquidity for covering potential liquidity risks or whether a further special liquidity requirement needs to be specified. In this context, the results from the supervisory liquidity stress test based on a uniform scenario help determine the benchmark values and thus the quantification of the potential special liquidity requirements. Earlier, the MNB used the balance sheet and deposit coverage ratio to monitor the liquidity in the banking system and measure the systemic risks linked to liquidity. The deposit coverage ratio is the quotient of the credit institution’s 30-day, actual available liquidity position and the deposits by households and non-financial corporations, while in the balance sheet coverage ratio, the denominator is the balance sheet total of the institution. The stress test based on the above-mentioned indicators parametrised the shock exerted on the assets and the liabilities side by five different events occurring simultaneously with a low probability. However, lessons from the 2008 global financial crisis showed that institutions were not careful enough in managing their liquidity risks, and they did not adequately assess the probability of the emergence of systemic liquidity risks, therefore the MNB decided to use the so-called egulation (EU) No 575/2013 of the European Parliament and of the Council on R prudential requirements for credit institutions and investment firms. 272 Commission Delegated Regulation (EU) 2015/61. 271

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liquidity coverage ratio (LCR) enabling more segmented and deeper analysis of the items influencing liquidity, instead of the balance sheet and deposit coverage ratios that are reliable from the perspective of their composition, but that provide a less detailed picture about the short-term liquidity position of the credit institution. Pursuant to the liquidity coverage requirement stipulated by the prevailing laws, the combined value of institutions’ liquid assets needs to cover the difference between the liquidity outflows and inflows during a stress, thereby ensuring that the institutions maintain a liquidity buffer that is able to bridge the potential imbalance between the outflows and inflows for thirty days during a severe stress. The necessary amount of liquid assets can be determined through the percentage value of the liquidity coverage ratio. LCR =

Liquid assets Outflows –– Inflows

The use of the LCR is also justified by the fact that it takes into account the off-balance sheet liquidity outflows and inflows (financing, disbursement obligations, derivatives, margin requirements), and the indicator is calculated by taking into account stress parameters. This is because it employs predetermined outflow factors (e.g. household deposits) in its calculations with respect to the individual cash flow elements, and an outflow factor determined separately by the competent authorities or based on the stress scenarios devised by the credit institutions with respect to other elements (e.g. margin requirements, credit line drawdowns). Based on the above, the MNB wishes to ensure the identification and quantification of credit institutions’ liquidity risks by spearheading the use of the revised European regulation and framework and by employing innovative instruments, thereby ensuring the Hungarian banking system’s long-term security.

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24.2.3 Stress tests

From the institutions where it conducts the supervisory review of the ICAAP and the ILAAP on-site every year273 due to their size and the complexity of their activities, the MNB expects comprehensive stress tests during the ICAAP, and it also endeavours to develop its own stress test. In addition, there is the EU-wide, uniform EBA stress test, which compares the largest European banking groups along a stress scenario. The purpose of the stress tests conducted during the ICAAP is to assess all material risks of the institution in a comprehensive, integrated and forward-looking manner. The range of stress tests include the impact of risk factors (whether of a market, economic, institutional or political nature), which may influence the prudent and solvent operation and profitability of the bank. Of course, these factors may vary across banks, since they depend largely on size, the scope of activities, risk appetite and the quality of risk management. With the development of supervisory stress tests, the MNB’s aim is to use them as a sort of benchmark, assessing complex banks in the same framework, under the same assumptions and along the same scenarios. This ensures comparability, and helps highlight institutions’ deficiencies. The EBA’s EU-wide stress test seeks to analyse the resilience and assess the loss-absorbing capacity of the EU’s systemically important banking groups under adverse market conditions. Banking groups need to perform the stress test at the highest level of consolidation, and the entry threshold was determined regarding the group-level aggregate balance sheet total. From Hungary, the largest Hungarian banking group was included among the inspected institutions, and large Hungarian banks were represented in the review at the group level, together with their foreign parent institutions. The test also aimed to create an EU-wide uniform framework and methodology in 273

In the case of other institutions, the review is conducted off-site.

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order to facilitate a more transparent European banking system and restore market confidence. The review is conducted annually by certain national competent authorities in the EBA’s framework, along centrally determined definitions and scenarios. The process itself is performed using a bottom-up approach, i.e. the individual institutions are actively involved, therefore bank-specific features are not overlooked during the review. Thus the Hungarian supervisory authority plays a primarily intermediary and quality assurance role in the EBA stress test, however, as a member of the EBA working group, it takes part in fine-tuning the stress test framework and discussing methodological questions.

24.3 Sector-specific developments and new features — Supervising the capital market sector The market for capital instruments forming the subject of capital market supervision is quite broad, therefore their itemised listing is impossible, since large numbers of assets are in this category from the capital factors and materials produced, through production capacities and components, to energy products. Therefore, if we take its everyday meaning, capital market can be defined as the place for selling and marketing material factors of production and money and securities (defined as funds and financial instruments in the sectoral capital market regulation). Due to this difficulty of definition, the elements of financial and capital markets, the products that can be classified into this category, the places of selling the products and the intermediary elements in sales are all represented together in the concept of the capital market. The operating model is based on a simple design, the objective of which is to ensure the best allocation of capital. The design is independent from the regulatory elements and complexity of the product or the venue, since the capital market, as all markets, is governed by supply and demand. The capital market establishes the desired equilibrium that is crucial in all well-functioning economies based on the shifts — 881 —

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of these two economic interests and the capital market intermediary system facilitating this. The demand side (those seeking capital) is comprised of companies and corporations that need money for realising their business model, while the supply side is made up of all those who have savings and wish to invest (typically institutions and private investors). Those who would like to defer spending their savings, inevitably appear on the financial or capital market in some form. Investors obtain a reward for waiting as a result of appearing on the market, while entrepreneurs are rewarded by realising profits (and they record interest rates as implicit costs). In a narrower sense, the capital market is defined without the elements of the financial markets, i.e. in a simplified model, as a concept without the institutions, activities and products in the field of financial services and supplementary financial services, the central element of which is securities regulation. The logic behind capital market regulation in the narrower sense and the corresponding supervision can only be fully understood using three concepts: products, activities and institutions. Capital market supervision can be defined as the licensing of certain capital market products and the supervision of the activities of capital market participants.

24.3.1 The goal and subjects of capital market institutional supervision, the growing number of supervisory instruments and the harmonised use of the instruments

As a general rule, capital market institutional regulation is activitiesbased in line with the rules of the MiFID regime,274 consequently supervision (including the licensing of activities) is also based on the licensing of certain activities and their review after licensing. Capital market product licensing explicitly focuses on the marketing of the

274

irective 2004/39/EC on investment service activities, regulated markets and mulD tilateral trading facilities.

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product (perhaps even without the institutions’ activities being placed under supervision). In accordance with the activities-based regulation, the institutions established in the corporate form determined in law obtain a licence for one or more investment service activities, therefore the licence determines the investment services (and ancillary supplementary services) for the provision of which the companies are authorised. In the European Union, in line with the principles of the freedom of establishment and the freedom to provide services, the given licence is valid for the whole EU, and it enables the investment firm to perform the activities of the licence in all Member States. This may be realised through establishing a branch or compliance with the notification rules on cross-border services. When taking a closer look at the objectives of the MNB’s revised supervisory methodology, we can see that the supervision of institutions and the supervision of activities are interrelated, and they cannot be interpreted without each other. We can draw the same conclusion if we examine the individual elements of the regulation. The itemised list of products of the capital market subject to supervision is included in the Act on Investment Firms and Commodity Dealers, and on the Rules Governing Their Activities.275 One group in this list of financial instruments, which can be considered a cornerstone of capital market regulation, is the group of transferable securities,276 which leads us through the regulation of securities law to the rules on product licensing and the public issuers marketing the transferable securities as specified in the Capital Markets Act.

275 276

ct CXXXVIII of 2007 (Investment Firms Act). A Section 6a) of the Investment Firms Act.

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24.3.2 The admission of capital market products to the capital market, and the implementation of the MNB’s gatekeeper role in product licensing on the capital market

The essence of the supervisory role linked to the admission of transferable securities to the capital market is realised through the MNB’s gatekeeper role. This is because, from the perspective of the capital market product, admission to the market is a pivotal moment in the product’s life cycle, therefore the MNB’s supervisory activities focus on the conditions and rules of admission to the market. The general rules on the public offering of securities and their admission to a regulated market are regulated in the Prospectus Directive,277 which basically uses an information approach, determining the content of the prospectus necessary for admission to the market. The publication of the prospectus is subject to supervisory authorisation. The MNB’s supervisory role means the exercising of this licensing power in order to ensure that, primarily taking into account investor protection considerations, only those issuers are admitted to the capital market, about whom investors can make sound decisions based on their market, economic, financial and legal position and information about their expected development. However, the gatekeeper role has a positive effect on product licensing activities as on the subsequent institution supervision. In order to perform its supervisory activities efficiently, the MNB seeks to employ the instruments available to the authority in a complex manner during the administrative procedures concerned.

277

irective 2003/71/EC on the prospectus to be published when securities are offeD red to the public or admitted to trading.

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24.3.3 Revising issuer supervision

The Capital Market Act278 provides as a general rule that the issuer of the publicly issued securities is liable for the damage caused by the failure to disclose regulated information or if the information is misleading. According to the logic of capital market rules, the assessment of the impact of the economic events concerning the issuer on the issuer or the securities of the issuer is primarily and basically the task and responsibility of the issuer. The main aim of the MNB is to encourage the appropriate, voluntary fulfilment of the disclosure obligation and to effectively review and, if necessary, enforce it. The supervision of issuers as capital market organisations exercised by the MNB is realised through the verification of the adherence to the disclosure rules, since in addition to the general accounting and company law requirements, no other, specifically prudential rules pertain to the issuers in this capacity. Within the framework of issuer supervision, the MNB has put continuous supervision in the forefront, especially the endeavour to use the available instruments as widely and as much in real time as possible. During issuer supervision, the MNB may prescribe a regular or extraordinary reporting requirement for issuers. When called on by the MNB, issuers are required to provide a very wide range of information regarding their activities, and to prepare and provide the documents requested by the MNB in the stipulated form to facilitate the performance of the MNB’s task. Within the framework of the continuous supervision of the issuers, the MNB may conduct onsite inspections as well. Pursuant to the provisions of the MNB Act in force, the employees of the MNB are entitled, inter alia, to be present at issuers’ board meetings, general meetings and meetings of the executive board or the group exercising the powers of the principal body.

278

Act CXX of 2001 on the Capital Market.

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In 2016, the MNB considerably strengthened its cooperation with the auditors commissioned by the issuers. From January 2016, owing to the legislative amendment initiated by the MNB, the auditor commissioned by the issuer is entitled to consult with the MNB, and the MNB is entitled to request information directly from the auditor. Auditors commissioned by the issuer are required to inform the MNB, together with the issuer, immediately and in writing, if the facts established by them may necessitate, for example, a qualified or adverse audit opinion. The information on which regular reporting is required (especially annual and semi-annual reports) is vital for investors and the analysts potentially monitoring the given issuer. However, to the persons familiar with the cumulative data on the issuer’s economic performance, which the issuer may have failed to disclose, the same information provides an opportunity for insider trading. Precisely due to this, the principle followed by the MNB since 2016 is that the papers of the issuer that fail to fulfil their disclosure obligation by the deadline or fail to do so adequately may not be traded on stock exchanges, and in the case of such an infringement, as a sort of preventive measure, the prompt suspension of trading is justified, which is published by the MNB on its website as a public supervisory guidance. According to this interpretation, the suspension of trading prevents the asymmetry of information, or it serves to freeze such a situation until the asymmetry of information is resolved to prevent all market participants from (ab) using their information monopoly, gained in any manner. In line with the MNB’s practice that it has already employed in 2016, the MNB has abandoned the ultima ratio nature of the suspension of trading, which, in addition to the positive feedback from the market, led to a proliferation of trading suspensions. The achievement of objectives in the new concept for the supervisory activities concerning issuers requires closer cooperation than before between the issuers, the Budapest Stock Exchange, and the MNB in order to create a capital market environment that encourages issuers to fulfil their disclosure obligation at an optimal quality and in a voluntary manner. — 886 —

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24.3.4 The emergence of new market participants in supervision

In the case of market participants engaged in commodity derivatives trading who currently do not have a supervisory licence, the MNB has to assess whether they perform activities subject to licensing that fall under the scope of the future MiFID II. Trading venues and the members of the trading venues and their clients need to examine the impact the introduction of position limits and the reporting requirement linked to positions will have on their operation. The group of those engaged in commodity derivatives trading who do not fall under the scope of MiFID II will shrink. In connection with the EMIR Regulation,279 further players will come under the supervision of the MNB with respect to a certain group of financial instruments. The EMIR treats the OTC derivative financial instruments at the EU level. The requirements of the EMIR pertain to both financial counterparties and non-financial counterparties. Therefore, the Magyar Nemzeti Bank is responsible for compliance with the EMIR requirements of those non-financial counterparties that perform derivatives transactions.

24.3.5 New avenues for the continuously overhauled supervisory instruments with regard to the capital market

In line with the new approach of the MNB, the former comprehensive inspections that encompassed a broad spectrum are replaced in capital market supervision as well by more in-depth, detailed inspections mainly focusing on risks relevant to the activity and operation of individual institutions. It is, however, not enough to detect deficiencies and risks; they also need to be eliminated. To that end, the Supervisory Authority applies a strict, deterrent penalty policy, and monitors the fulfilment of the requirements in a comprehensive 279

egulation 648/2012/EU of the European Parliament and of the Council on OTC R derivatives, central counterparties and trade repositories.

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manner. Nowadays, a new forward-looking approach is employed in the supervision of institutions, focusing, in addition to the maximum stringency in the face of deviations, on the active shaping of the market through statements, recommendations and the methods applied in continuous supervision. In parallel with off-site supervision, the methodology of on-site supervision has changed considerably based on the expansion of the supervisory instruments guaranteed by law on the one hand, and on practical experiences on the other hand. The essence of the methodological transition is that, in addition to verifying the reporting by the supervised institutions, the MNB places more emphasis on the on-site inspection of market participants, querying and generating the records data and analytics on site to prevent the modification and falsification of data. Moreover, the MNB has introduced the immediate backup (“mirror copy”) of the complete IT dataset of market participants in supervisory inspections; an established practice in market surveillance procedures. In addition to the new methods, instruments and procedures of the MNB, the MiFIR280 also has new provisions regarding market monitoring and product-level interventions, introducing a new, harmonised product intervention regime that supplements the instruments currently available to the Member States and the product management provisions determined in MiFID II. Financial instruments and structured deposits marketed, distributed or sold in the EU should be monitored by ESMA and EBA, respectively, while the competent authorities monitor the markets for both financial instruments and structured deposits marketed, distributed or sold in the given Member State. The product intervention powers can be used by the authorities to restrict or prohibit financial activities, should this be justified by investor protection considerations. 280

http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A32014R0600 REGULATION (EU) No 600/2014 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012.

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Box 24-3 The broker cases of 2015

“There must be order in the financial sector as well, without that confidence cannot be restored” – (Dr László Windisch, the Deputy Governor for Financial Institutions Supervision and Consumer Protection at the MNB) In 2015 Q1, following barely 15 months of financial supervision, the MNB detected a series of abuses lasting 10–15 years at three investment service providers, the Buda-Cash, Quaestor and Hungária brokerage firms. The central bank appointed supervisory commissioners to these institutions with immediate effect, and took all necessary and expedient measures in order to enable the investors at these companies to seek redress as soon as possible, in line with the rules of the investor protection and indemnification system provided for by law, after the supervisory commissioners established in the given cases beyond any doubt that the legal conditions existed for initiating the liquidation proceedings. In parallel with this, the MNB continuously helped the investigative authorities and the court with information in exploring the events at the brokerage firms and in clarifying the responsibilities of the executives and owners concerned. As a result of the MNB’s decisive action, the Quaestor victims received compensation from the Investor Protection Fund even after non-existent bonds. Owing also to the professional contribution of the central bank, legislators tightened the safeguards of investment service providers active on the market and the rules of their supervision in statutory provisions, and these rules further broadened the MNB’s revised methodological framework of supervisions that is still constantly revised in order to tackle market challenges. The MNB considered it a priority to continuously provide information to the victims and the public in the relevant menus on the consumer protection subpage of its website about the events at the brokerage firms and about indemnification. With respect to the series of abuses linked to the three brokerage firms, the Quaestor Group and the supervised institution in it, the Quaestor Értékpapír-

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kereskedelmi és Befektetési Zrt. deserve special mention based on the volume of abuse, the number of investors affected and the nature of the offence. It is important to note and emphasise in connection with the abuse linked to this investment service provider that the abuse is not related to legal bond programmes based on a prospectus that have been approved by the Supervisory Authority several times on an ad hoc basis since 2007. According to the investigations, the abuse was committed as follows: the investment service provider produced false certificates to those investing large amounts with the intention of purchasing bonds, without actually creating the bonds, therefore the securities could neither be subscribed to nor obtained through sales. Quaestor created the impression that in exchange for people’s money, it placed securities (Quaestor bonds) on a securities account opened with them. However, it actually only took investors’ money without giving real securities in exchange. It is thus important to clarify that this abuse, i.e. the sale of securities through false certificates and the misleading of investors and the authorities, is not related to the fact that the issuer would have had the opportunity to issue actual bonds in a legal manner approved by the supervisory authority, and the investment service provider would have had the opportunity to sell them. The issuer of the bonds, the Quaestor Financial Hrurira Tanácsadó és Szolgáltató Kft., first obtained supervisory authorisation for the public issuance of bonds in 2007, and the authorised amount was already HUF 50 billion. From 2007, the issuer had had an authorised bond programme for every year. The total volume of bonds issued legally, i.e. based on a supervisory authorisation, by the issuer amounted to HUF 58 billion, which, according to the prospectus, financed the Quaestor Group that had a consolidated balance sheet total of HUF 100 billion. However, the abuse occurred through the “sales” of nonexistent bonds in large volumes rather than through the legal bond programme. In the former case, investors thought that they were purchasing bonds, but actually did not receive any securities for their money. The series of abuses committed by the Cegléd-based Hungária Értékpapír Zrt. showed that the supervisory activities are not limited to the monitoring

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and review of a given investment service provider’s range of activities and processes in the narrow sense, but the responsible corporate governance model should also be inspected in a broader context, in a whole network of companies, focusing on business, financial and economic processes, since in the abuse scheme, the activities of non-supervised institutions established by the same group of executives and owners helped commit and conceal the institutionalised abuses. These activities now form an integral part of the revised supervision’s model. Although in certain respects, there are numerous similarities between the institutionalised series of abuses committed by the Buda-Cash Brókerház Zrt. and those committed by the other two investment service providers (for example similar to the Quaestor Group, the vast corporate group and the diverse interests of the owners as well as the manipulated IT system that played a role in the concealment of the abuses), however, the use of this model highlighted several other issues that arise specifically in the provision of investment services, thereby posing a challenge to the supervisory authority. The response given to these challenges is implemented partly through the tightening of certain sectoral laws and the rules of procedure provided for in the MNB Act itself, and, beyond the criminal law implications of the abuse, partly through the detailed analysis of the level of risks arising from the operation in line with the rules of the profession (including the operation of the institutions performing outsourced activities or the network of intermediaries) and the supervisory model based on it.

24.4 Sector-specific developments and new features — Supervising insurers, funds and intermediaries 24.4.1 Changes in the supervision of insurers with the entry into force of Solvency II

Insurers assume the risk of clients (e.g. private individuals or companies) through the conclusion of an insurance contract and against an insurance premium. Risks can be classified according to the so— 891 —

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called lines of business, thus we traditionally distinguish life and nonlife insurance. Further, classification is based on classes of insurance that enable a much more precise distinction. The life insurance line of business includes, inter alia, traditional life insurances and unit-linked life insurances, while within non-life insurance there are accident, health or general liability insurances. The requirements pertaining to insurance activities are stipulated by law, and the most important piece of legislation is Act LXXXVIII of 2014 on the Insurance Business. Within the scope of its supervisory tasks, the MNB also supervises the organisations, persons and activities subject to the Act on the Insurance Business and Reinsurance Companies. Pursuant to the new European legal framework effective from 1 January 2016, and pertaining to the supervision of insurers and reinsurance companies (Solvency II), the supervisory authorities of the home Member States are responsible for monitoring the financial position of insurers and reinsurance companies. Having regard to the entry into force of Solvency II, the MNB revised and supplemented its earlier risk assessment procedures concerning its supervisory activities. In contrast to the rule-based capital requirement (Solvency I) used so far, a complex, riskbased capital requirement and supervisory rules were introduced at the European level, therefore the risk-based approach can be traced in the whole set of requirements. In addition to the risk-sensitive solvency capital requirement calculation, the risk-based approach is integrated into business planning and the assessment of the financial position as well; within the framework of their own risk and solvency assessment (ORSA), insurers regularly assess their general solvency capital requirement based on business plans, also touching upon risks not covered by Pillar I such as liquidity or long-term risks. The riskbased approach can also be traced in qualitative requirements. These qualitative aspects represent a whole new approach for the executive bodies of the insurers, and new requirements pertain to the insurance technical provision of information and the content of the supervisory report, too (a uniform European table system is introduced), which is based on the Solvency II economic assessment principle, providing — 892 —

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detailed information primarily on investments and insurance technical provisions.

24.4.2 The risk-based methodology revised based on the Solvency II framework

The MNB’s risk menu concerning the institutions subject to Solvency II has been expanded and transformed in connection with the implementation of the Solvency II framework, and it now contains five risk categories instead of the earlier four: Corporate Governance, Financial and Operational Risks, Capital And Reserve Risk, Market Entry Risk, and the new risk category is Business Model. In the Solvency II framework, in addition to the change in the risk categories, the Corporate Governance risk group has been expanded with Risk Management and Compliance areas, which are deemed key functions, and with the own risk and solvency assessment (ORSA). While assessing business model risk, the insurer’s main activities, lines of business and products are considered, as well as the macroeconomic environment, the competitive position and the impact of the expected trends on the operation of the insurer. The key aspects during the assessment are profitability, the risk evaluation of the strategy’s risks, the technical provisions, the rating of the assets and the sustainability of the insurer’s activities. During their activities, insurers need to bear in mind that they have to set their solvency capital requirement so that they can fulfil their obligations vis-à-vis the policyholders and beneficiaries over the following 12 months with appropriate certainty. With regard to the corporate governance risk group, as a temporary regulation, the insurers subject to Solvency II had to employ a compliance officer and a risk management officer from 1 July 2014. The most important activities of the risk management function cover the taking of underwriting risk and reserving, asset-liability management, as well as investment risk management, liquidity risk management, — 893 —

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concentration risk management, operational risk management and reinsurance and other risk-mitigation techniques. Earlier, the inspections were not concentrated on the assessment of the issues falling within the purview of the owners and the executives of the institution, as inspections focused on the assessment of the risk impact of decisions. In the Solvency II framework, with the introduction of business model analysis, this approach changed: if risks are identified with respect to the decisions taken by executives or executive bodies, their impact may modify the capital adequacy requirements of the institution. As aÂ result of the modification of the regulatory environment and the new supervisory expectations and methods, the importance of on-site inspections has risen considerably.

24.4.3 The supervision of funds, with focus on the due care approach

The establishment of the funds sector was an important element in social security reform of the early 1990s. The voluntary mutual insurance funds could be created based on Act XCVI of 1993. The aim of the institutions is to provide to its members and their close relatives services complementing, supplementing or replacing social security or other social services. The funds can be established by natural persons, or by employees at the initiative of the employer. The operation of the fund rests on the principles of independence, mutuality, solidarity and voluntery participation, and pursuant to the legislation, the major principles also include self-governance and non-profit operation. The funds sector also includes the private pension funds established based on Act LXXXII of 1997, and the occupational pension provider institution established based on Act CXVII of 2007. The organisational and functional structure of private pension funds is similar to voluntary funds, i.e. the members are also owners, and the main decision-making body of the fund is the general meeting of all the members or the general meeting of delegates elected by the members. The occupational pension

â&#x20AC;&#x201D; 894 â&#x20AC;&#x201D;

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provider institution operates under different principles, as a limited company. The founder and owner of the limited company may be an employer, several employers together, an insurer operating as a limited company, a bank or an investment firm. Voluntary funds are classified in the legislation according to their services: – Voluntary pension funds provide pension services after retirement age from the member’s individual account in the form of a lump sum payment, an annuity or the combination of these. – The task of health funds is to organise and finance programmes aimed at the protection of health, and to purchase healthcare services. – Mutual benefit funds provide supplementary services based on the social obligations stipulated in the legislation, including the services linked to the birth of a child, schooling benefit, unemployment benefits, allowances linked to health, home care, elderly care, aid to the bereaved, supporting the repayment of home mortgage loans. Subsidies for medication and medical accessories may be included in the services of either health funds or mutual benefit funds. From 1 January 2016, legislators have enabled the operation of health and mutual benefit funds, based on which, in practice, health and mutual benefit funds may expand the products they offer with services of a mutual benefit or healthcare nature. The supervision of the funds can also be divided into two basic parts: on-site inspections and continuous off-site supervision. The MNB conducts comprehensive on-site inspections of the funds at least every five years, covering all the important aspects of the institution’s operation such as the institution’s governance, business model, internal control systems, products and the management of financial and operational risks. The continuous supervision of institutions hinges on

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the information sent by the institutions (regular and ad hoc reporting, documents to be submitted), although signs indicating risks may arrive from anywhere (complaints, press coverage, online information, warnings by other authorities). The overwhelming majority of the information received from institutions is comprised of the regular reporting requirement provided for in the legislation (MNB decree). Similar to banks and insurers, the basis of the MNB’s continuous, offsite supervisory activities is formed by the risk assessments conducted quarterly using the quarterly reports and other information received in the given period. At the institutions with strong and above medium impact assessment all the aspects of the institutions’ operation is performed. In the case of the institutions with below medium or weak impact, the quarterly risk assessment covers the review of the main economic developments and changes. In addition to the quarterly risk assessments, the regular, annual supervisory activities include the processing of annual accounts and the review of financial plans. The change in the regime was not as momentous in the regulation of funds as the CRD/CRR in the case of banks or Solvency II in the case of insurers, however, the new approach of the MNB and the development of the methods and instruments has influenced the supervision of funds as well. The business model approach examining the business and strategic decisions whereby an institution seeks to ensure its longterm, sustainable operation has received more weight in the MNB’s supervisory activities concerning funds. In the MNB’s view, based on the “due care” principle, the management of the institution has to strive to establish an economic and operating model sustainable over the long term that can ensure the provision of services to members at an appropriate standard and the funding of the institution’s operation, even in the face of adverse external effects. The “due care” principle

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is also provided for by law with respect to the executives of the fund, and according to it, executives are required to “act with reasonable care that can be expected from a person in such a function, taking into account the interests of the members and the fund”. In order to verify the implementation of the principle, the MNB examines the contracts concluded by the fund, the justification of the contracts and the fees payable based on the contracts relative to market prices. The management of the fund is expected to assess the success of the fund’s investments, manage the investments’ risks, and request reports from the asset manager and investment officer of the fund to this end. Pursuant to the due care principle, funds are expected to avoid undue extra costs when using any services. During its supervisory and inspection activities, the MNB pays special attention to the justification of the costs arising during investment activities (e.g. in the case of purchasing investment fund units for the fund portfolio). The proactive attitude is also pivotal in the MNB’s supervisory activities with respect to funds as well, therefore before a potential crisis unfolds, the MNB endeavours to identify the signs suggesting the heightening of risks, and to facilitate the appropriate and early management of risks. One of the instruments in forward-looking and preventive supervision is the alarm system based on reporting, which sends a signal to supervisors immediately after a report is received detailing the development of certain data in line with predetermined conditions. When the financing of the operation of a given institution entails risks, the MNB issues a decision requiring the institution concerned to prepare regular liquidity reports. Proactive supervision is also assisted by ad hoc requests for information from institutions about an emerging risk or the measures aimed at addressing it. The funds sector can be considered tightly regulated, we need only to think of the restriction on the proportion of the membership fee that can be deducted for costs or the restriction on the amount of the asset management fee. This tight regulation is also characteristic with respect to investments. Pension fund investments are subject to multiple limits. — 897 —

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The decree on the investments of voluntary pension funds imposes limits on certain asset classes as well (e.g. the proportion of domestic corporate bonds may not exceed 10 per cent), there are limits pertaining to several asset classes combined, and the decree also restricts the share the fund can have from all the securities of an issuer. Based on supervisory experiences, the investment limits were also tightened, for example from 1 January 2016, health and mutual benefit funds may only invest 20 per cent of their total assets at one credit institution group (the earlier limit was 40 per cent). The long horizon of pension fund savings (potentially 40-50 years) means it should be generated real returns over the whole accumulation period, and that the investment risks be assigned the same weight as this. The risk taken should be consistent with the generated return at all times. To this end, the legislation allowed funds to create the optional portfolio system, in which several portfolios with markedly different risks can be established within the fund, and members can choose between them. This system enables members to choose a portfolio matching their situation and risk appetite, with the understanding that their decision has a huge impact on the expected return on their savings. At the intervals determined in the optional portfolio policy, i.e. typically quarterly, members may change their earlier decisions and choose another portfolio. This entails costs, which are, however, limited by law, therefore their amount cannot be deterrent. In the initial phase of saving, members are more likely to choose the highrisk portfolio, then later, when their wealth is larger, they increasingly switch to a lower-risk portfolio that yields lower returns, therefore the initial yield spread may be reduced with the lower return of the greater wealth. In accordance with the new provision of the law, if the fund allows this, members may join two portfolios at the same time, which enables them to keep the larger returns yielded from the earlier greater risks by transferring a larger portion of their savings into a safer portfolio with lower returns, and the smaller part is used for attempting to achieve more substantial returns by taking on more significant risks.

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The existence of the optional portfolio system is justified by the fact that 85 per cent of voluntary pension fund wealth is managed in this system, while this proportion is 100 per cent in the private pension fund sector.

24.4.4 On-site targeted inspections at intermediaries and off-site supervisory measures

Financial intermediation is a business activity aimed at establishing a legal relationship for using a financial organisation’s services. Based on the Insurance Act in effect and the IDD281 to be implemented until February 2018, the definition of insurance mediation is the following: a business activity aimed at the conclusion of an insurance contract, including the facilitation of the conclusion of insurance contracts, the description and recommendation of insurance products, the corresponding provision of information, the conclusion of insurance contracts, the organisation of selling insurance contracts and the participation in the conclusion and performance of insurance contracts, including the provision of information on one or more insurance contracts in line with requirements chosen by the client on a website or other means of information provision, as well as the ranking of insurance products, including the comparison of prices and products, or the discount on the insurance contract’s price if the client can conclude insurance contracts, directly or indirectly, on a website or other means of information provision. Financial market agent activities are defined as the provision of financial services or supplementary financial services based on an agency agreement concluded with a financial institution, or the activities aimed at the facilitation of the conclusion of a contract aimed at such services, whereby no independent commitments are assumed or contracts are concluded for the financial institution’s risk.

281

Insurance Distribution Directive.

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With respect to the supervision of intermediaries, there is no uniform international practice, since the risks inherent in the outsourced sale of products and services of insurers and financial institutions are addressed with various solutions across countries. At the European level, the consumer protection focus dominates. However, the Hungarian regulation is broader than that, as it has consumer protection as well as prudential requirements for intermediaries, since the products and services of the insurers and financial institutions reach a large number of consumers through intermediaries. Earlier in Hungary, the supervision of intermediaries’ activities was performed through the supervision of product owners, as a supplementary, ancillary part. Having regard to the rise in the volume of intermediaries’ sales and the riskiness of their activities, since 2013 a separate organisational unit within the Supervisory Authority has been tasked with the supervision of insurance mediating brokers, multiple agents and independent financial market intermediaries (brokers, multiple agents, multiple special intermediaries). Due to the fact that the regulatory environment varies by sectors and the large number of supervised intermediary institutions (over 1,000), the methodologies developed during the supervision of financial institutions and insurers can be applied only with limitations, therefore in the supervision of intermediaries unique instruments need to be used as well. The MNB’s risk-based supervisory principle is used in the supervision of intermediaries too. The market weight of a given intermediary is determined by the MNB based on the number of contracts intermediated and the amount of commission income. From a supervisory perspective, intermediaries with a strong and above medium impact deserve special mention, as the overwhelming majority of insurance and financial market mediation can be linked to these institutions. The supervision of intermediaries with a strong or above medium impact is performed individually, at the institutional level. The supervision of the large

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number of remaining institutions that nonetheless have scant impact on the supervisory objectives individually is performed jointly, similar to the supervision of co-operative credit institutions, primarily through the analysis of reported data. With respect to the methodology of intermediary supervision, we can once again distinguish between off-site and on-site inspections. On-site inspections are conducted within the framework of the targeted and thematic inspections provided for in the MNB Act and the MNB’s internal policies, while off-site inspections are performed mainly through the analysis of reported data and, in justified cases, requests for reporting and based on the other available information (e.g. company register, Internet, individual reports). Insurance intermediaries are required to report their intermediary activities and other key data to the MNB annually. The analysis of the obtained data is one of the main focuses of supervision, enabling the identification of market developments and the detection of the anomalies and risks using monitoring indicators. As a result of the legislative amendment initiated by the MNB, financial market intermediaries will also be required to report their data regularly, annually, from 2017, whereby accurate data will be available for this segment as well, enabling the use of the analysis and supervisory methods developed for insurance intermediaries and linked to reporting. In the case of dominant, large players on the intermediary market, supervision is performed through planned, targeted inspections, which supplements the supervision of institutions covering a large portion of intermediated contracts with on-site inspections. If risks are detected, the MNB eliminates the undesired and potentially unlawful market practices at the smaller players through unplanned targeted or thematic inspections. Generally, intermediaries do not manage clients’ money, but if they do, the relevant regulation requires that the money be managed on a separate deposit account, therefore the risk to clients’ money is low. — 901 —

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The supervisory authority needs to ensure that clients who are in contact with the intermediaries and use financial services, be treated in line with the relevant regulations (laws, MNB recommendation, ESA recommendations),282 with the necessary professional care, taking into account clients’ interests and providing assistance to them. Furthermore, no substantial risks may emerge in this segment of the market that would jeopardise the safety of the services, therefore the Supervisory Authority also needs to verify legal operation, and, in case there are signs suggesting any deviation from this, take (unique) measures. If risks are identified at multiple companies in the sector, the MNB may take coordinated action. The MNB performs market clearing during its proactive supervisory work in order to eliminate the identified bad practices (for example by calls, penalties, the revocation of licences), thereby contributing to a clear market and the strengthening of consumer confidence.

282

European Supervisory Authorities (EBA, EIOPA, ESMA, ESRB)

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24 Overhauling the Hungarian microprudential supervision

Key terms activity supervision balance sheet coverage ratio business model assessment capital market product licensing capital risk comprehensive, targeted, thematic and extraordinary targeted inspection conduct risk consumer protection focus continuous supervision deposit coverage ratio development of the basic monitoring system, early warning system “due care” principle extraordinary disclosure obligation financial market intermediary forward-looking approach ICAAP review

ILAAP insurance intermediary insurance supervision investment limits liquidity risk liquidity risk profile operational inspection units optional portfolio product intervention power prospectus regular disclosure obligation risk-based methodology Solvency II stress test stronger supervisory regulation and sanctioning supervisory benchmark models wider use of the data

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References Act XCVI of 1993 on Voluntary Mutual Insurance Funds. Act LXXXII of 1997 on Private Pensions and Private Pension Funds. Act CXVII of 2007 on Occupational Pension and the Related Institutions. 2013. Act CCXXXVII of 2013 on Credit Institutions and Financial Enterprises. 2014. Act LXXXVIII of 2014 on the Insurance Business. Government Decree 281/2001 (XII. 26) on the Rules Pertaining to the Investments and Financial Management of Voluntary Mutual Pension Funds. Government Decree 268/1997 (XII. 22.) on Certain Rules Pertaining to the Financial Management of Voluntary Mutual Health and Mutual Benefit Funds. DIRECTIVE 2009/138/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II), Vol. 52, L335, 17 December. DIRECTIVE (EU) 2016/97 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 20 January 2016 on insurance distribution (recast). Recommendation No. 5/2015 (V. 05.) of the Magyar Nemzeti Bank on the electronic interfaces serving the presentation and comparison of insurance products and used during insurance mediation. Recommendation No. 6/2016. (VI. 14.) of the Magyar Nemzeti Bank on holding the volatility capital buffer ensuring continuous capital adequacy. Recommendation No. 8/2016 (VI. 30.) of the Magyar Nemzeti Bank on the application of the prudential and consumer protection principles regarding unit-linked life insurance policies. Recommendation No. 12/2016 (XII.1.) of the Magyar Nemzeti Bank on the setting up and operation of the optional portfolio system of voluntary pension funds. EBA Guidelines on common procedures and methodologies for the supervisory and evaluation review process. MNB (2015): Tőkemegfelelés belső értékelési folyamata (ICAAP), a likviditás megfelelőségének belső értékelési folyamata (ILAAP) és felügyeleti felülvizsgálatuk (The internal capital adequacy assessment process [ICAAP], the internal liquidity adequacy assessment process [ILAAP] and their supervisory review). MNB – Félidős jelentés 2013–2016 (Half-term Report 2013–2016).

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Market surveillance and consumer protection procedures Dr. Tamás Babai-Belánszky – Dr. Péter Barnóczki – Dr. Gyula Kardos

The central element in the integrated consumer protection and market surveillance strategy of the MNB is the maintenance and strengthening of public confidence in the financial intermediary system and the stability of the financial intermediary system. The MNB has surpassed the so-called classic approach of the authorities in respect of these areas as well, so that its strategic principles include effective inspections and sanctioning focusing on problems, proportionate penalties and the enhanced protection of vulnerable social groups. Due to rapid social, technological and market progress, such products emerge and become available to Hungarian consumers which represent unprecedented risks in the financial services. These risks arise in a much more pronounced manner in the case of unauthorised service providers, since confidence in the financial intermediary system may be fundamentally undermined by those who mislead consumers acting in good faith or engage in unauthorised financial activities. Therefore, rapid and firm action on the part of the MNB is vital in this area as well. The aim of the MNB employing a preventive approach is to thwart and manage the emergence of future market surveillance and consumer protection risks rather than to subsequently sanction past infringements. In the context of accelerated market developments, supervision can only be successful if it is forward-looking, responds to changes quickly and focuses on the tight control over developments and immediate intervention. In its communication, the MNB places special emphasis on continuously pointing out the risks of unauthorised activities as well as the supervisory efforts aimed at their mitigation and the cutting back on the market position of market participants committing infringements. Enhanced cooperation — 905 —

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with partner authorities, in particular the investigating authorities, is a key issue in this effort. While fighting against unauthorised activities, the MNB increasingly adopts temporary measures at the onset of its market surveillance procedures. In a similar way, the instruments applied within the framework of consumer protection supervision have been renewed, i.e. continuous supervision has been expanded, consumer protection warnings have been introduced, temporary measures are employed and mystery shopping are conducted in an increasing number. Another cornerstone of modern consumer protection supervision is the introduction of sanctioning instruments which are able to provide real and direct compensation to consumers. In connection with this, the central bank has set for itself the objective of strengthening the “fair” institutional approach towards clients in which market participants put the interests of clients first, developing their products and business processes accordingly. This is why the MNB has started, inter alia, to review the standard terms and conditions of financial institutions from a civil law perspective regarding fairness, during which it wishes to ensure through consultations with the institutions and, as a last resort, the statutory instrument of the action in the public interest, that in the future, no unfair terms and conditions are included in consumer contracts.

25.1 Market surveillance procedures The MNB’s market surveillance activities are manifested in a special administrative procedure, the so-called market surveillance procedure. The new European Union rules against market abuse, applicable from July 2016, have created new instruments similar to continuous supervision (i.e. not linked to conducting formal market surveillance procedures) in the field of detecting and monitoring capital market abuses.

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25 Market surveillance and consumer protection procedures

The MNB’s market surveillance powers are fundamentally activitybased. As we have seen in previous chapters, within the framework of the supervision of the financial intermediary system, the MNB supervises the activities determined in the sectoral laws, in addition to the supervision of certain organisations and persons. The overwhelming majority of these financial services, investment services and intermediary (e.g. agency) activities outlined in the sectoral laws are expressly subject to an (operating) licence being granted by the MNB or a notification to the MNB, due to prudential or investor protection reasons. Obviously, performing such activities without a licence or notification (i.e. in an unauthorised manner) is prohibited, and precisely the detection and sanctioning of these unauthorised activities constitute one of the main aspects of the MNB’s market surveillance activities. The provisions of MAR prohibit all forms of insider trading and market manipulation, and stipulate that these should be sanctioned severely. In Hungary, the administrative tasks linked to the execution of MAR fall within the cognizance of the MNB as the competent national authority. On suspicion of insider trading or market manipulation, the MNB establishes the facts and imposes the necessary sanctions in a market surveillance procedure. Due to investor protection considerations, in accordance with the relevant European Union and Hungarian regulations, acquiring influence in public limited liability companies beyond a certain threshold (in Hungary, this threshold is 25 per cent if no one else other than the shareholder acquiring influence has influence of above 10 per cent of voting rights, while in other cases it is 33 per cent) is only possible by making a prior, or, in certain cases, subsequent, mandatory takeover bid approved by the MNB. The compliance with the rules on acquisition is also monitored by the MNB in market surveillance procedures, although due to the operational features of the capital market, information confirming a suspicion with regard to the violation of takeover rules is typically obtained by the MNB during

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the supervision of issuers or the continuous supervision performed under the MAR regime.

25.1.1 Inspections, means of evidence, inspection instruments

In view of the fact that the market surveillance procedure is basically an administrative procedure, the provisions of the Act on the General Rules of Administrative Procedures and Services (Administrative Procedures Act) shall be applied to it with the derogations specified in the MNB Act, therefore all the means of evidence determined in the Administrative Procedures Act are available to the MNB in a market surveillance procedure. However, by the application of the provisions of the Administrative Procedures Act setting out that its provisions shall be applied inter alia in procedures related to the supervision of financial and capital market activities, unless the MNB Act provides otherwise, the MNB, in response to the development of financial markets and in order to meet the extremely high expectations regarding its effectiveness, has several times successfully initiated amendments to the provisions of the MNB Act on market surveillance procedures, including especially the expansion of the set of market surveillance instruments. In this regard, it has to be noted that although legislators enabled the use of several means of evidence of almost a “criminal law nature” in the market surveillance procedures, especially during the legislative amendments following 2014, their use is coupled with the appropriate guarantees in all cases, primarily the requirement of a prior authorisation of the attorney or the judge, as well as the exceptionally strict confidentiality and conflict of interest requirements applying to the employees of the MNB. The means of evidence available to the MNB include, but are not limited to, the acquiring of data through the TakarNet system at the Land Registry or the requesting of the records of bank account transactions related to the client from all Hungarian credit institutions through the GiroHáló service, which is routinely used in the examination — 908 —

25 Market surveillance and consumer protection procedures

of unauthorised activities, or the requesting of securities account transaction records from investment service providers during the detection of market abuses. The MNB also has the right to access specific electronic communication data (such as call logs) during its market surveillance procedure. The MNB’s employees may carry out mystery shopping while concealing the supervisory nature of their actions, and the MNB may conduct on-site inspections anywhere where evidence necessary for the clarification of the facts can be found (i.e. contrary to popular belief, if, for example, the documents substantiating the infringement are stored in a private residence in order to make the job of the authorities more difficult, that in itself does not hinder the detection of the infringement). Since July 2015, on-site inspections can be conducted even against the wishes of the persons present or through unlocking a locked room (on-site investigation subject to prior judicial approval). Of course, the privilege against self-incrimination familiar from criminal law is also applied in the market surveillance procedure (i.e. the suspected perpetrator is under no obligation to make a confession), however, in spite of that basically every individual and organisation is required to provide information, even concerning personal or proprietary data, and submit the documents related to the infringement to the MNB (which may be seized by the MNB if justified), as requested by the MNB, to clarify the facts. The financial supervisory authority was among the first Hungarian administrative authority that received a statutory authorisation to prepare physical mirror images (in practice, this means the creation of a full backup of any type of computer, smartphone or other media in a closed system in a way that enables the restoration of files deleted by the user), and in July 2016, it was the first to receive authorisation for this with respect to data stored “in the cloud”. In all of its market surveillance procedures, the MNB actively uses the whole range of its available means of evidence in order to efficiently — 909 —

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establish the facts as soon as possible. For any person or organisation obstructing any procedure of the MNB or misleading the MNB, a penalty of up to HUF 10 million may be imposed, an extremely high amount compared to other administrative proceedings. Of course, the available and continuously expanding means of evidence are not used by the MNB for their own sake: in addition to providing as much information as possible to potential investors and minimising the damage caused by the infringement as much as possible, the MNB strives to facilitate transparency as much as possible in all of its market surveillance procedures to ensure that the general prevention considerations are taken into account. In line with these principles, if justified by the protection of the interests of the clients of the person or organisation engaged in unauthorised activities, the MNB orders temporary guarantee measures (most often the blocking of various types of accounts) in its market surveillance procedures. In such cases, especially if other property crimes (typically fraud) are suspected, the MNB cooperates closely with the investigative authorities.

25.1.2 Prevention as the priority of market surveillance

The so-called temporary measure can be characterised as a market surveillance instrument aimed at the prevention of infringements to the greatest possible extent. When applying it, the MNB has the right to temporarily prohibit the continuation of the suspected infringement for an interim period until the termination of the procedure. The MNB publishes the cease and desist order on its website, and informs the public about such measures in a press release in order to reach as many victims as possible and to prevent further damage. Another preventive instrument is the so-called public warning list available to everyone on the MNB’s website. The aim of the warnings on the MNB’s website is to provide up-to-date information to Hungarian – primarily retail – investors effectively at all times about

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the organisations that are suspected to be engaged in activities without prior authorisation or notification, thereby impeding unauthorised activities. Of course, warnings may be issued not only in connection with pending market surveillance procedures, however, in the market surveillance procedures conducted on the suspicion of unauthorised activities, as a general rule, the MNB issues a warning with a short description of the potentially unauthorised activity as soon as this does not jeopardise the success of the planned steps in the procedure any longer. Pursuant to a legislative amendment of July 2015, initiated by the MNB and aimed at the obstruction of infringements by means of offshore companies, in the case of non-natural person clients, a separate market surveillance penalty of up to HUF 100 million may be imposed on the natural persons materially contributing to the client’s activities for which a market surveillance penalty was imposed. The penalty may be imposed on natural persons contributing to the infringement especially if they performed an initiating, controlling or organising function – beyond mere participation – in the development or operation of the infringement, and if the infringement would not have occurred without their violation or only to a lesser extent by orders of magnitude. Although as a general rule, a penalty must be imposed if an infringement is established in the market surveillance procedure, the MNB observed, in some cases in 2016, that on account of its early action, i.e. the radical reduction of the time between the detection of the potentially unlawful activities and the launch of the procedure, no actual income from the activities could be demonstrated (preparatory activities). In such cases, the MNB prohibits the actual commencement of the activities in the lack of a licence or notification without imposing a market surveillance penalty, and informs the public about the “attempted” infringement by means of a decision published due to investor protection considerations and a press release.

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25.2 The expansion of consumer protection supervision instruments, the dynamic development of relevant legislation 25.2.1 Paradigm shift in consumer protection — Expansion of the consumer protection supervision instruments

In modern consumer societies, consumers typically conclude contracts on a daily basis for obtaining various products and using services. They enter into contractual relationships with companies that are able, in the absence of special regulations and protection from the authorities, to tip the delicate balance sought between the parties in their favour through their accumulated expertise in the given field and their economic clout. Although legislators have recognised the necessity of the enhanced protection of consumers against companies, a long time passed before the general consumer protection regulations and the independent and solid financial consumer protection powers separate from the administrative powers were established. The latter has a history of less than a decade, although the powerful financial consumer protection that is truly able to control adverse market developments and shift them in the right direction exists only since the financial supervisory powers were delegated to the central bank. In the earlier supervisory structure, the primary task of the authorities was prudential supervision, and financial consumer protection played a mere secondary role. In the current central bank approach emphasising the equivalence of the various supervisory tasks, consumer protection is an independent role not influenced by prudential or other objectives, which are not necessarily consistent with the objectives of consumer protection. The MNB’s consumer protection supervisory powers encompass all the sectors that make up the financial intermediary system, therefore financial supervision covers all the sectors where the MNB also performs the classic prudential supervision, i.e. the financial and capital markets, the insurance and the pension funds sectors. It is important to note that the person enjoying the administrative protection — 912 —

25 Market surveillance and consumer protection procedures

of the central bank acting in its financial consumer protection capacity is the “consumer” as defined in the MNB Act,283 which means any natural person who is acting for purposes outside his trade, business or profession. The laws in the various financial sectors set out different requirements for the financial service providers operating under authorisation with respect to the expected conduct manner of vis-à-vis consumers, including prohibitive or restrictive norms as well as provisions requiring the provision of complete information to consumers. When examining the rules in the different financial sectors from a broader perspective, we can observe that the goals are the same in all cases: the reduction of consumers’ vulnerability due to the asymmetry of information between them and the companies as much as possible, and the protection of consumers from using services not ensuring the expected benefits. The MNB’s consumer protection approach hinges on the realisation that legislators are not always able to keep up with continuously accelerating social, technological and market progress, therefore nowadays trends of development, products, modes of products and service elements proliferate the way that is undesirable from the consumers’ perspective. These modern trends incorporate new risks into the various retail services provided that have of course not been addressed earlier by legislators. As even in an optimal case, the legislator is able to react to these trends only with delay, during its activity as a consumer protection authority, the MNB puts special emphasis on the prompt, preventive and efficient management of the arising risks in line with consumer protection principles. In practice this entails the transcending of the approach responding to developments with a lag and mainly by imposing repressive sanctions for unlawful conduct, promoting instead the application of tight control over developments,

283

Article 81(2)a) of the MNB Act.

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immediate intervention and the strengthening of an attitude that emphasises reparative sanctions. The new consumer protection supervision approach announced by the central bank and detailed above requires that instruments provided to the MNB by law are applied in a more efficient way than before as well as the introduction of new instruments. The work of the consumer protection area includes the continuous off-site supervision mentioned earlier and several forms of on-site inspections. The method of continuous supervision in prudential supervision became incorporated into supervisory practice even before the integration of the supervisory authority, however, its extension to the field of consumer protection only occurred after the merger with the central bank. The new, modern consumer protection supervision rests on continuous supervision, which is implemented through the establishment of the system of institution supervisors. Institution supervisors should have a thorough knowledge of the product structure of the institution under their supervision, monitor and be up-to-date about the changes in the range of products, be familiar with the share of the institution in the individual market segments and the changes in market share, and immediately evaluate the information appearing in connection with the institution. The information relevant in terms of consumer protection supervision reaches the institution supervisor through various channels. The MNB monitors the changes on the websites of the supervised institutions, the content of the advertisements they publish, and within the framework of general press monitoring, it evaluates the information appearing in connection with each individual institution. The continuous supervision of the institutions is facilitated by the continuous analysis of institutions’ statutory reporting and, if necessary, the assessment of the reporting regarding certain subjects ordered by the MNB in an administrative decision. Summarising and analysing the information contained in consumer complaints received by the MNB’s Financial Consumer Protection Centre is of utmost importance, as customers’ experiences — 914 —

25 Market surveillance and consumer protection procedures

and observations often enable the central bank to identify developments and risks in due time, about which it would be otherwise unaware. As we can see, the basis for efficient and continuous supervision is the acquisition and careful analysis of large amounts of information, through which the MNB gains an authentic picture about market trends, with a special focus on newly emerging risks and on the changes in the degree of the risks identified earlier. The “traditional” way of managing the identified risks, i.e. the possibility of conducting consumer protection procedures, is provided for in the MNB Act, however, the measure of the renewed financial consumer protection’s success is whether the risks threatening consumers are kept as low as possible rather than the increase in number of administrative procedures conducted in a given year. Therefore, the system of continuous supervision has to be able not only to identify risks, but it must also have the means to guarantee, if necessary, the mitigation of rising risks without conducting an administrative procedure and losing time. The mildest, but nonetheless, immediately applicable instrument of consumer protection supervision in the new approach is the consumer protection warning, which is issued by the MNB in a targeted manner to the given institution upon identifying various undesired practices or newly emerging risks, presenting the identified risks to the management of the institution, and at the same time requiring the institution to provide prompt feedback, i.e. detailed information, or a report about the extraordinary measures taken. The issuance of a consumer protection warning does not mean that later the institution does not have to report in an administrative procedure on its earlier practices that were either unlawful or gave cause for concern from a consumer protection perspective. The warning merely provides an opportunity for the institution to rapidly and completely remedy the problem with the MNB’s assistance. Another instrument in the revised consumer protection approach is the issuance of administrative decisions taken during continuous — 915 —

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supervision, whereby the lengthy procedures that do not guarantee the immediate addressing of problems are sought to be replaced. This instrument was already used in prudential supervision, and it has now been extended to the consumer protection field as well. When it is employed, the supervisory objective is partly the same as described in the case of the consumer protection warning, however, the identified problem is typically graver, furthermore, in addition to the rapid addressing of the problem, this provides an opportunity for influencing the developments at the institution through administrative requirements, and even imposing repressive sanctions. The latter is justified especially if the MNB, with a general or special preventive intention, wishes to emphasise to the institution or some other market participant that a specific conduct cannot be tolerated from a consumer protection perspective. There are various forms of administrative consumer protection inspections. The MNB Act enables the MNB to conduct quick targeted inspections.284 These are performed if the given problem cannot be addressed with the instruments of continuous supervision, however, supervisory or consumer protection interests require that the MNB conclude the administrative procedure with a decision as soon as possible. Prior to launching its ex officio inspections, the central bank always evaluates whether this type of inspection is justified, and, if necessary, exercises its right provided by the MNB Act. According to the MNB Act the task of the MNB is to investigate the objections against an institution filed in consumers’ complaints within the framework of a consumer protection procedure. The MNB considers consumer protection procedures requested by consumers as a the main pillar of its new consumer protection strategy, however, it has also realised that conducting inspections based on complaints is not the most efficient way of addressing systemic institutional problems. In the MNB’s view, the best returns on the invested work of the authority are 284

Article 87/A of the MNB Act.

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yielded to both individual consumers and all the consumers in general if the MNB manages the emerging problems in depth and in procedures that are adequate to eliminate them completely. Thereby, MNB assigns greater importance to ex officio consumer protection procedures than to those launched upon a request. This is because the latter mainly concentrate on past infringements and threaten with repressive sanctions, while the former emphasise prevention and aim to eliminate the processes and risks that may lead to repeated infringements in the future. The MNB’s experiences show that the central bank is better able to guide market developments in the right direction through a smaller number of ex officio consumer protection procedures than through procedures launched on the basis of complaints that are able to exert only a limited impact beyond sanctioning the given problem. In connection with guiding the developments in a uniform direction, we have to mention one type of ex officio inspections, thematic inspections, which have a special significance in the central bank’s consumer protection supervision. In this type of inspection, the MNB evaluates legal compliance of several institutions in a few topics with special significance, as it could be observed in the so-called fee raising inspections, or the thematic inspection examining adherence to the legal provisions giving the basis of institutions’ settlement process prescribed in connection with foreign currency loans. Whether the above-mentioned type of inspection or the most typical consumer protection direct inquiry is conducted, similar to consumer protection warnings, the decisions issued within the framework of continuous supervision and rapid direct inquiries, the MNB focuses on eliminating the identified problems with the best delay. To this end, the MNB increasingly uses the so-called temporary measure instrument provided for in the MNB Act. Although the temporary measure does not influence the course of the procedure, it provides an opportunity for the MNB to intervene in the operation of the institution even before it comes to a final decision concluding the administrative procedure. According to the MNB’s experiences, when this instrument is used, most problems — 917 —

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can be managed in the early stages of the administrative procedure, thus the MNB can continue the often lengthy procedure without the pressure to take action, and explore the facts and circumstances necessary for assessing the gravity of the infringement and imposing a proportionate sanction. The MNB seeks to make mystery shopping a basic pillar of its new consumer protection approach, as it believes that this tool is more suitable than any other method for the authority to obtain real information about the characteristics of the sales processes in various sectors. This is because during mystery shopping, the MNB does not have to reconstruct the details of an earlier event based on a consumer’s complaint or other indications. Another advantage of mystery shopping is that by examining the sales process first-hand, the MNB’s experts can draw conclusions concerning the inherent defects or consumer risks in the examined process even from signs that seem to be trivial to the average consumer, giving opportunities for the MNB to detect problems that would otherwise not be possible. Due to these benefits, the number of mystery shopping occurrences is likely to increase in all branches of financial consumer protection. Finally, no solid consumer protection can exist without a system of strong sanctions. Although the primary objective of the MNB in consumer protection is to promptly identify and eliminate adverse developments, it cannot dispense with the imposition of sanctions proportionate to the infringement. The consumer protection penalty policy revised by the MNB is centred on the consumer, i.e. the amount of the penalty imposed on the institution is mainly consistent with the disadvantage suffered by the consumer due to the infringement and the number of consumers affected by the infringement. The imposition of penalties with a real deterrent effect is not considered as a goal but rather as an instrument by the MNB, serving as guidance to those who committed the infringement and as well to the other market participants with regard to the expectations of supervisory authority.

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In addition to the traditional instrument of imposing penalties, the MNB uses the types of measures leaving scope for reparation285 in all justified cases, as these enable not only the thwarting of adverse processes but also the elimination of material damages suffered by consumers as well as the withdrawal of the additional revenue collected unlawfully, thereby providing feedback to not only the supervised institution but also to the consumer about the fact that besides the intervention of the authority, the identified problem was addressed in a manner that satisfies the consumer. Having presented the objectives and instruments of consumer protection, we can conclude that the MNB does not consider consumer protection a mere function assigned to a designated organisational unit, but strives to let the modern consumer protection approach permeate the entire organisation in the whole spectrum of its operation, from the lowest stratum to the highest-level decision-making forums. In the new consumer protection approach, the central bank does not wish to take action solely against the infringements committed to the detriment of consumers; it seeks to eliminate the adverse developments observed during its continuous monitoring activities even before they lead to actual harm to consumers. In this approach, the central bank is not content with full compliance with legal provisions, as it expects a “fair” attitude from all market participants and requires that they regard serving the consumer in a fair manner first and foremost as a value, and make the fair approach that goes beyond serving the client while complying with the regulations as a cornerstone of their business philosophy, avoiding techniques through which they can tip the balance sought between the parties in their favour by putting their interests before those of consumers. Consistent with this approach, the central bank has started reviewing the terms and conditions in the standard contracts of financial institutions. 285

Article 88(1)b) and d) of the MNB Act.

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25.2.2 The right to file an action in the public interest serving the strategic consumer protection objectives — Focusing on the terms and conditions in the standard contracts of financial institutions

The overhaul of financial consumer protection supervision put the legal instrument of the action in the public interest in a different perspective. This legal institution stands as a classic one, however, the paradigm shift in consumer protection has shown that the action in the public interest has much more potential than the means it was exploited earlier by consumer protection supervision. The exercising of the right to prepare actions in the public interest enables systemic action, helps in the timely identification and prevention of the emergence of consumer protection risks, its impact is exerted on the dominant portion of the market concurrently and it affects the contractual practices of financial institutions in depth. Against the unfair terms and conditions of individual contracts, principally the aggrieved party can take action in a civil lawsuit, however, in the overwhelming majority of cases, this cannot be expected. This is because consumers often do not realise that the other party to the contract applies unfair terms, and they are typically not in a situation in which they could bear the costs necessarily entailed by litigation. Therefore, the unfair terms and conditions cannot be curtailed through the promotion of individuals’ interests, yet protecting those in a weaker position in contracts is vital. The solution may be the intervention of the MNB in accordance with the MNB Act,286 pursuant to which the MNB, acting in its capacity as the supervisory authority of the financial intermediary system, may file an action in the public interest in accordance with the provisions in Section 6:105 of the Civil Code for the establishment of the invalidity of unfair terms and conditions incorporated into the standard contract between the consumer and the financial institution. Since the MNB regards the option of a lawsuit in the public interest as an instrument, it considers justified to discuss, out of court, the contractual provisions 286

Article 164 of the MNB Act.

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in question before filing a claim. To this end, it calls on the financial institutions concerned, presenting the terms and conditions one by one that may be deemed unfair in a potential lawsuit in the public interest. The filing of the claim is merely a last resort, used only when the outof-court settlement regarding the initiative aimed at amending the provisions that give cause for concern fails to bring forth any results. During its activities pertaining to filing a claim in the public interest, the MNB comprehensively analyses whether the terms and conditions applied by financial institutions in the consumer contracts fulfil the requirements of good faith and fairness set out in the Civil Code. Thus the focus is on the balance of rights and obligations, and the effort to avoid imbalances. Therefore, the justification and proportionality of the rights or obligations in the individual contractual provisions require special consideration. Both prudential and consumer protection aspects need to be taken into account during weighting. On the one hand, the prudent, reliable and safe operation of financial institutions is of fundamental interest, i.e. the return on credit and the corresponding costs should be ensured. On the other hand, no undue and disproportionate burden may be placed on consumers to this end. The MNB formulates its concerns regarding unfairness with respect to the terms and conditions of the new contracts to be concluded. However, if other policies pertain to the standard contracts concluded earlier, the MNB also expects financial institutions to apply the necessary changes in all their effective policies, i.e. those covering all of the outstanding contracts. Therefore, on account of the changes, the terms and conditions deemed unfair by the MNB are removed from all the consumer contracts of the financial institutions under review, and these terms and conditions cannot be incorporated into any future standard contracts. In view of the above, the MNB requires all financial institutions to review their policies, terms and conditions and standard contracts, removing the terms and conditions that are identical in their

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material content with the provisions objected to by the MNB, as well as those that may otherwise be deemed unfair. As a result of the changes, the content of financial institutions’ policies may be simplified and converge, which may enable consumers to more easily review the terms and conditions applied by the various service providers. Box 25-1 The first experiences of examining the general terms and conditions

In view of the fact that the Curia ruled in a review procedure conducted in a lawsuit in the public interest brought against a financial institution offering vehicle financing that several terms and conditions, typically applied by other service providers in their contracts as well, were unfair, as a first step, the MNB reviewed the relevant policies of the nine financial institutions that concluded similar contracts in the autumn of 2015. During this, the MNB examined not only the existence of provisions identical or similar to those in the Curia’s above-mentioned ruling, it also verified the appropriateness of the further general terms and conditions applied by the individual service providers in the contracts concerned. As a result of the analysis, the MNB raised concerns in connection with several contractual provisions, objecting to them in its call sent to the financial institutions concerned. The general terms and conditions that gave cause for concern included those that entitled the lessor to arbitrarily seize the vehicle, i.e. the leased object, did not ensure the transparent, public nature of the sale of returned vehicles, restricted the consumer’s right to prepayment or made exercising it burdensome, did not stipulate the fees and costs clearly or included provisions with regard to insurance contracts that put the consumer at a disadvantage. The MNB most often faced a lack of clarity, and incomprehensible, contradictory or ambiguous wording or phrases enabling unilateral interpretation by the creditor were identified on several occasions. The MNB found that several terms and conditions gave cause for concern because the provisions regarding the costs and fees, the settlement between

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25 Market surveillance and consumer protection procedures

the parties, the reasons for termination or prepayment were unclear to consumers. As the terms and conditions may be unfair due to the lack of clarity in itself, the MNB repeatedly emphasised that clear, easy-tounderstand wording and a transparent system of the general terms and conditions had to be sought. The financial institutions, accepting the arguments presented to them, amended their general terms and conditions by appropriately eliminating the concerns raised by the MNB. As a result of the MNB’s request, they introduced the changes not only in the policies that serve as a basis for the new contracts to be concluded, but also in all their existing contracts. Consequently, as a result of the MNB’s action, provisions that put consumers at an undue or disproportionate disadvantage and that were unclear were eliminated from 150 thousand contracts. The experience confirmed that a more in-depth analysis of institutions’ general terms and conditions is adequate for strengthening the fair financial system and confidence in it. Moreover, the development was also justified by the fact that the risk posed by the terms and conditions that give cause for concern in consumer mortgage loan contracts heightens in line with the rise in the number of new housing loans. In view of this, since the second half of 2016, the MNB has been analysing the general terms and conditions incorporated into consumer mortgage loan contracts at several banks. The ongoing analysis has already highlighted numerous provisions that the MNB objected to in connection with vehicle lease contracts as well, however, concerns characteristic of the given loan category were also identified. The results of the MNB’s examination can be presented in more detail later. The MNB hopes that the effect of its efforts goes beyond the fact that financial institutions remove from their contracts and policies the individual terms and conditions contested. In the longer run, the MNB seeks to establish the fair approach in the development and enhancement of general terms and conditions. Thus the central bank wishes to achieve a shift in market participants’ attitude, so that the development of their policies is centred around the general intention of applying fair contractual terms.

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Key terms acquisition of influence action in the public interest administrative procedure consumer protection warning continuous consumer protection supervision fair general terms and conditions GiroHáló market surveillance instruments mystery shopping personal penalty

physical mirror image procedural penalty on-site inspection on-site investigation rapid direct inquiries reparation TakarNet temporary guarantee measure temporary measure unauthorised activities warning

References Babai-Belánszky, T.: Tisztességtelen általános szerződési feltételek a gépjármű-finanszírozás körében (Unfair terms and conditions in vehicle finance), Versenytükör Volume XII, 2016. Special Issue III, pp. 5–13. Published by: Hungarian Competition Authority and the Magyar Nemzeti Bank. Magyar Nemzeti Bank: Az MNB felügyeleti stratégiája – összefoglaló (2014-2019) (The MNB’s supervisory strategy – Summary [2014–2019]).https://www.mnb.hu/letoltes/14-07-31-felugyeletistrategia-abra-l.pdf

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Supervision in the 21st century and the challenges of digital progress Tamás Gaidosch – Dávid Kutasi287

Developments in the digital world and data analysis methods pose enormous challenges to the supervisory authorities of the financial sector, since several new risk factors emerge in this field greatly affected by technological progress that were not characteristic in the past decades. The technologies and digital achievements that change the existing financial services call for regulation and new approaches on the part of the supervisory authorities. In parallel with this, due to the development of data analysis methods and the IT infrastructure, more and more instruments are available to the supervisory authorities that can be used to identify systemic and individual institutional risks more deeply, accurately and rapidly. This chapter is intended to give a brief overview about these challenges and instruments.

26.1 Cloud-based technologies One of the most momentous changes in the field of IT in the past twenty years was the advent of cloud-based services. The IT cloud is a solution that enables on-demand network access to shared, configurable IT resources, which can be allocated and terminated quickly with minimal management effort or contribution from the service provider. The main features of cloud-based services are that the services are ondemand, i.e. they can potentially be used in a self-service manner, they are generally accessible over the Internet or a private network, 287

he following people contributed to this chapter: Dr Péter Barnóczki, Dr Richárd T Bense, Imre Domonkosi, András Tomsics.

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the resources are shared, therefore the service provider is able to use its resources to meet the needs of several clients at the same time, the system rapidly adapts to the changing capacity requirements and the service is measurable, therefore fees are in line with the amount of usage. Cloud services continue to grow, and according to expectations, by 2020 a large portion of the data will be stored only in this form. Of course, this development also affects the financial sector, however, the challenges and risks presented by cloud services are also clear. These include the loss of direct control over IT, the dependence on cloud service providers and the lack of transparency in the cloud service providers’ IT security and privacy procedures. Consequently, supervisory authorities need to regulate such uses of cloud-based services accurately and strictly in the interest of clients’ safety. In line with this, the MNB has issued a recommendation to financial institutions aimed at providing practical help in the uniform interpretation of the application of the legal provisions on managing and preventing risks arising from the use of social and public cloud services. The recommendation offers guidance on complying with legal provisions, determines the minimum requirements pertaining to contracts, and presents the risks to be managed, the expected control measures and the main aspects of the supervisory authority’s inspections. Pursuant to the recommendation, the institutions are responsible for identifying risks in all phases of the cloud service’s lifecycle and for implementing proportionate control measures. First, when the need for cloud services arises, the institution has to assess the feasibility of cloud services based on business needs, costs and risks involved, security requirements and legal provisions. If the institution decides to use cloud services, depending on the service model, the institution is then required to implement controls of its own or specify in a contract that they be implemented by the service provider, which has to be verified by the institution. The management of the institution has to prepare risk mitigation plans, provide for implementing the measures and — 926 —

26 Supervision in the 21st century and the challenges of digital progress

verify them. The institution has to manage compliance risks through risk mitigation measures (controls) during the whole lifecycle, until the potential phase-out of the service. The MNB, acting in its supervisory capacity, may inspect the control environment of the cloud services at the institution or at the service provider through the institution. The inspection of cloud services has four focal points. First, the MNB assesses whether the IT solution necessary for the uninterrupted operation of the supervised institution and the achievement of the business objectives, and the conditions necessary for its operation and enhancement are available. Second, the MNB examines whether the management has assessed and adequately evaluated the security risks of the cloud services and their development, whether it has implemented controls proportionate to risks, and whether it has created the contractual, regulatory, management, personal, technical and verification conditions necessary for continuous control operation. Then the operation of the controls stipulated in the contract, the instruments ensuring these and the method of verification are analysed. Finally, the MNB assesses the legal compliance of the institution and the service provider (the entity performing the outsourced tasks).

26.2 E-administration With respect to the licensing, approval, registration and removal procedures and notifications under the laws on the capital market and collective forms of investment and their managers, the communication between the MNB and clients concerned in the cases determined in the annex to the MNB Act is maintained compulsorily and exclusively electronically. In Hungary – and based on Member States’ practices, at the international level as well – these were the first administrative procedures that introduced exclusively electronic communication. Exclusively electronic communication substantially contributes to the

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reduction of the time spent on dealing with the authorities by fully eliminating paper-based documents and traditional postal delivery. Based on feedback from the market and the MNB’s recent experiences, electronic administration significantly reduces the environmental impact of paper-based administration as well as record-keeping tasks (since documents stored electronically can be easily retrieved). Moreover, electronic administration is obviously simpler, faster and more cost-effective, and by putting clients’ interests first, it clearly improves the quality of the MNB’s services (by increasing efficiency). The technical implementation of exclusively electronic communication on the part of clients is performed by filling out an electronic form available at the delivery repository operated by the MNB (the socalled ERA system) and uploading the documents defined in the law as annexes. The request has to include a qualified or advanced electronic signature. Of course, in these cases, the MNB also delivers the documents addressed to the clients electronically, via the ERA system. The rules and technical conditions of electronic communication, the operation and use of the ERA system and the content of the electronic forms are regulated in decrees issued by the governor of the MNB.

26.3 The emergence of new players and the alternative banking system Nowadays, the market of banking and financial services is increasingly changing. The emphasis shifts more and more from dealing with service providers in person to electronic services. Banks make substantial investments in their integrated client-service IT systems, and branches have less and less consequence in administration. PayPal is one of the most successful companies offering e-commerce payment services. Users can handle PayPal very simply, as after the registration, which only takes a few clicks, money can be transferred

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26 Supervision in the 21st century and the challenges of digital progress

to the new PayPal account from a bank card or bank account. After this, we can perform basically all online banking activities, in fact, we can also withdraw cash from an ATM using a PayPal card. The service was able to secure a competitive advantage over the usual payment methods through its simplicity and low costs. The company charges the transfer costs to the seller rather than the party making the transfer, therefore no direct costs arise on the customer’s side during the transfer. Another important factor is that the risk entailed by a financial transfer only affects the amount transferred, since the bank account/bank card details do not have to be disclosed to third parties. TransferWise drastically reduces the costs of international transfers on an online collaborative organisation basis, as it directly connects the transfer needs arising in different currencies and countries, and executes them together while netting the amounts. Due to its price, the service is highly favourable to users, since transaction costs are considerably lower than foreign currency transfers at banks. Lending Club has positioned itself even closer to traditional banking services, launching online peer-to-peer lending activities. As one of the first applications on Facebook, it was able to become successful and provide cheaper loans to its clients by utilising the wealth of information in social media and the huge clientele. Bitcoin is a decentralised digital means of payment. There is no monetary authority behind it, and no third, intermediary party takes part in monetary transactions. The money supply (the amount of bitcoins in circulation) rises at a predetermined rate, until reaching the maximum, 21 million bitcoins. In a nutshell, users’ computers can create bitcoins by performing calculations of a given complexity. The complexity of the calculations is set at all times to ensure that the planned amount of virtual money is created. The number of businesses accepting bitcoin increases constantly, therefore the digital currency gradually performs the functions of modern money.

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These new networks organised on a social media basis and typically emerging as cross-border services also raise several regulatory issues. Due to the new risks inherent in them and the issues raised, supervisory bodies also need to pay close attention to these services. This can include the regulation of the operating framework, the risks linked to secure and smooth monetary transactions, data security and even consumer protection issues. From a regulatory perspective, it is key that the activities of these services providers be regulated as prudently as in the case of traditional players.

26.4 Technological challenges on the capital market Electronic securities trading enabled trading systems to receive and execute transactions very rapidly. Based on this, the so-called algorithmic trading or robo-trading was developed, the essence of which is that trading is conducted based on a predetermined algorithm, i.e. the system can execute deals without human intervention. One type of algorithmic trading is the so-called high-frequency trading (HFT), during which trading is conducted at very short horizons, huge volumes and with typically a large proportion of cancelled orders. These algorithms monitor market mechanisms, analyse news and statistics, determining the trading strategy based on these. The American Flash Crash on 6 May 2010, when a huge meltdown could be observed within seconds, apparently without any special reason, is attributed to HFT. Detailed requirements already exist with respect to automated trading, and these will be tightened further with the new rules of MiFID II. More and more investment service providers experiment with automated investment advisory activities, assessing investors’ goals and risk-taking capacity with the help of pre-programmed parameters, then offering investment instruments or a whole portfolio based on these. In the investment sector, there are also wide-ranging developments aimed at the use of artificial intelligence, for example

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26 Supervision in the 21st century and the challenges of digital progress

the analysis and processing of large amounts of information and news supporting investment decisions (see big data). Bitcoin is presented in more detail in a separate chapter, however, the technological achievement behind bitcoin, blockchain, has to be highlighted. Its comprehensive name is Distributed Ledger Technology (DLT), and it may be a major technological development in the years ahead, since it can be used in several financial sectors (e.g. monitoring and clearing transactions). DLT is a chain-like record containing all the history of transactions/deals that may verifiably demonstrate the completion and history of a transaction/deal to all participants. Crowdfunding, which uses online platforms, has an explicitly investment form in addition to banking and donation models. One such example is when crowdfunders become owners once new companies are launched, similar to holding shares. Although there is no European Union-level regulation pertaining to this activity, more and more countries establish national requirements with regard to crowdfunding.

26.5 The impact of digitalisation on today’s vehicle insurance When insurers were asked about the most important trends in the next five years that will shape the whole sector, they pointed to conscious self-controlling services. As this was deemed the most likely, institutions have responded to it, mainly striving to acquire clients and serve clients more efficiently. This contributes to the enhancement of operational efficiency through mobile or online channels, and a major driving force behind these developments is not least, Generation Y. The other major trends pointed out by institutions include the spread of usagebased insurance, the utilisation of the further advantages of vehicle navigation with an online connection, as well as remote access and data collection. Compared to fintech firms, the number of insurtech firms

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is much lower at the international level, and currently in Hungary the consumer solution is available for only one product, while the process is still in the development phase in a few other cases. Below we give two detailed examples of insurtech. Car manufacturers furnish their cars with ever more driving assistance and comfort functions to provide future owners an increasingly safe means of transport. As a result of this technological progress, car driving habits are monitored in real time with increasingly advanced tools, which is taken into account when tailoring insurance products to individual customers as much as possible. With the rise of smartphones and the corresponding applications, the so-called telematic system emerged, which, when determining MTPL and comprehensive insurance premiums, takes into account, in addition to traditional factors (vehicle and operator), where (volume and controlling of traffic), when (time of day, weather, frequency) and how (compliance with the law, duration of the journey, road conditions) the vehicle is driven. At the international level, the other incentive in addition to the spread of digitalisation is the reduction of high insurance premiums, as well as the prevention of damage manipulation. The fact that insurance premiums are already too low and that they require too many resources and IT developments are disadvantages for the insurers, and consumers’ reaction and the data processing capacity are unclear. From a regulatory and supervisory perspective, the change of the strategy, the continued outsourcing, the developments in profitability, data protection and new entrants all raise concerns. Regulatory instruments are being introduced with respect to the joint protection of personal and processed data. One subsequent avenue for the spread of digitalisation is the rise of selfdriving cars. In the near future, owing to driving assistance systems and communication between cars in traffic, a lower insurance premium can be achieved, speed limits may rise, car sharing may reduce traffic, and overall safer travel can be achieved. Of course, as a drawback, added risks and development requirements arise (cyber risks, road network and software development, expensive vehicles, shifting responsibility). — 932 —

26 Supervision in the 21st century and the challenges of digital progress

According to opinion polls, sceptics do not consider this technology safe enough yet, while proponents may only be deterred by the high price, and of course, there are detractors who would never buy a selfdriving car. However, a large group of respondents believes that the reliability of the technology and the shifting responsibility (and the elimination of the potential for human error) may result in a lower insurance premium. Insurers are concerned about whether premium income can be increased and about retaining clients, and new business models and risks emerge such as the commercial use of personal property or the increasing use of third-party data. On the regulatory side, the EU supports this, there are EC guidelines on using the sharing economy as well as an EC communication on the European agenda for the collaborative economy.

26.6 The development of the efficiency of IT supervision and data analysis The MNB has undertaken substantial changes, modifications and innovations in several areas of the supervisory activities. These include the overhaul of IT supervision in the spirit of strengthening the IT approach in supervision. IT supervision traditionally used a technological IT security approach, focusing on regulatory compliance pertaining to the IT of supervised institutions, especially the technological solutions employed. These were assessed by the supervisory authority in comprehensive inspections held every 3–5 years, supplemented occasionally by targeted and thematic inspections. In recent years, IT has become even more significant in the financial sector, which had already depended heavily on IT. New paradigms have emerged such as cloud-based IT (i.e. outsourcing certain activities to third parties), and the complexity, change rate and IT dependence of business processes has increased. Furthermore, prudential supervision has increasingly experienced that without assistance from IT experts, it — 933 —

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is difficult to assess the adequacy of the business control environment. As a result, new methods had to be introduced in IT supervision by including new areas for inspection, and new weights had to be assigned to several already inspected areas. The methodological changes affect three main points. Procedures providing greater assurance gain prominence, therefore in addition to verifying document-based compliance (the appropriateness of control design), control effectiveness testing procedures play a greater role. In addition to enhancing traditional control testing using sampling, procedures based on the examination of the whole population are used as well, with the support of the appropriate audit/data analysis software. In 2016, new inspection areas emerged, namely the evaluation of the IT support of business processes and the analysis of IT strategies. The evaluation of the IT support of business processes covers the mapping of data flows, the verification of data integrity and confidentiality controls, including application-level controls and interface controls. Based on this, the IT supervision area presents an assessment to the prudential supervision area about the reliability of the data, reports and statements retrieved from the systems supporting the processes under review. The examination of the IT strategy is aimed at establishing how much IT supports (or hinders) the achievement of the business objectives, the types of strategic operational risks entailed by the planned project portfolio and whether the institution’s IT budget is realistic. Among the areas that have already been inspected but now receive more weight, the most important is the assessment of fraud risk, which is primarily done through the examination of access management, logging and change management through more detailed procedures that give higher assurance.

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26 Supervision in the 21st century and the challenges of digital progress

The rise of digitalisation and the newly emerging players are expected to be among the greatest challenges of the near future for financial supervisory authorities in all countries. The MNB pays special attention to address these challenges innovatively and as early as possible. Good examples for this include the continuous development of IT supervision or the increasing prominence of stress tests.

Key terms 21st century supervision algorithmic trading alternative banking system cloud-based technologies crowdfunding

digitalisation electronic administration electronic signature high-frequency algorithmic trading (HFT)

References MNB (2015): Tőkemegfelelés belső értékelési folyamata (ICAAP), a likviditás megfelelőségének belső értékelési folyamata (ILAAP) és felügyeleti felülvizsgálatuk (The internal capital adequacy assessment process [ICAAP], the internal liquidity adequacy assessment process [ILAAP] and their supervisory review) MNB (2017): Recommendation No. 2/2017 (I. 12.) of the Magyar Nemzeti Bank on using social and public cloud services.

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Acknowledgements This book was inspired by the experiences in monetary policy in recent years. The studies in it rely heavily on the decisions of the Monetary Council of the Magyar Nemzeti Bank, the analyses and workshops based on which they were taken, as well as discussions at various professional forums. The editors are indebted to György Matolcsy, Márton Nagy, Ferenc Gerhardt and László Windisch for their stimulating support, and all the members of the Monetary Council for their professional comments on the analyses. We would like to thank Eszter Hergár for assisting in the communication about the book undaunted by challenges, similar to her work on other volumes in the MNB Book Series. Special thanks are due to the authors of the studies in this book, namely: Dániel Babos, Gergely Baksay, Gergely Patrik Balla, András Balogh, Szilárd Benk, Dávid Berta, István Bodnár, Csaba Csávás, Gabriella Csom-Bíró, Balázs Csomós, Judit Csutiné Baranyai, Bálint Dancsik, Dr Tamás Babai-Belánszky, Dr Péter Barnóczki, Dr Csaba Kandrács, Dr Gyula Kardos, Dr Attila Rédei, Péter Fáykiss, Dániel Felcser, Tamás Gaidosch, Balázs H. Váradi, Sándor Hegedűs, Dániel Horváth, Gábor Horváth, Zsófia Horváth, László Kajdi, Péter Kálmán, Lóránt Kaszab, András Kollarik, Pál Péter Kolozsi, András Kómár, Laura Komlóssy, Stefan Krakovsky, Dávid Kutasi, Kristóf Lehmann, Rita Lénárt-Odorán, Balázs Mérő, Zsuzsanna Novák, István Papp, Ádám Plajner, György Pulai, Gábor Sin, Gábor Dániel Soós, Antal Stréda, János Szakács, Zoltán Szalai, Gergő Szeniczey, Anikó Szombati, Márton Teremi, Árpád Vadkerti, Lóránt Varga, Milán Vas, Noémi Végh, Sándor Winkler, Ádám Zágonyi.

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Acknowledgements

The authors and editors are especially grateful to Réka Egervári, Adrián Nagy, István Schindler and Ferenc Tóth for their editing and coordination work. Thanks go to Soma Szabó and Károly Pavela for their work on graphic design and page layout, Krisztina Wéber for the copy-editing, as well as to Bence Gáspár for his contribution to the translation of this book. The authors wish to extend their thanks to Maja Bajcsy, István Csonka, Gábor Meizer, Péter Szűcs, Péter Bencsik and Gergely Wonke and all our colleagues for their tireless work that was vital in publishing this book.

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List of acronyms ABCP Asset-backed commercial paper ABS Asset-backed securities ÁKK Államadósság Kezelő Központ (Government Debt Management Agency) AMECO Annual Macro-Economic Database of the European Commission AMLF Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility APP Asset Purchase Program AQR Asset Quality Review BAMOSZ Association of Hungarian Investment Fund and Asset Management Companies BCBS Basel Committee on Banking Supervision BEA Bureau of Economic Analysis BIRS Budapest Interest Rate Swap BIS Bank for International Settlements BISZ Zrt. Központi Hitelinformációs Zártkörűen Működő Részvénytársaság (Central Credit Information Plc) BMÁK Bónusz Magyar Államkötvény (Bonus Hungarian Government Bond) BoJ Bank of Japan BRRD Bank Recovery and Resolution Directive BSC Benchmark Submissions Committee BSE Budapest Stock Exchange BUBOR Budapest Interbank Offered Rate BWII Bretton Woods II CBPP Covered Bond Purchase Programme CBPP2 Covered Bond Purchase Programme 2 CCB Countercyclical capital buffer CCIS Central Credit Information System CCP Central counterparty

— 938 —

List of acronyms

CDO Collateralised debt obligation CDS Credit default swap CEBS Committee of European Banking Supervisors CEESEG CEE Stock Exchange Group CGFS Committee on the Global Financial System CIRS Cross currency interest rate swap CLS Continuous linked settlement CORRA Canadian Overnight Repo Rate Average CP Commercial paper CPFF Commercial Paper Funding Facility CPI Consumer Price Index CPIF Cost-plus-incentive fee CR5 Concentration ratio (top largest 5 banks’ market share) CRD Capital Requirement Directives CRR Capital Requirements Regulation CSPP Corporate Sector Purchase Programme DEA Data envelopment analysis DFA Distribution-free approach DKJ Discount Treasury Bill DLT Distributed Ledger Technology EBA European Banking Authority EBRD European Bank for Reconstruction and Development EC European Commission ECB European Central Bank EDP Excessive Deficit Procedure EEA European Economic Area EFSF European Financial Stability Facility EIOPA European Insurance and Occupational Pensions Authority EKÁER Elektronikus Közúti Áruforgalom Ellenőrző Rendszer (Electronic Trade and Transport Control System)

— 939 —

List of acronyms

EMBI Emerging Market Bond Index EMIR European Market Infrastructure Regulation EONIA Euro Overnight Index Average EPC European Payments Council ES Efficient structure ESA European System of Accounts ESFM European Financial Stabilisation Mechanism ESFS European System of Financial Supervision ESM European Stability Mechanism ESMA European Securities and Markets Authority ESRB European Systemic Risk Board ETF Exchange-traded fund EU European Union EURIBOR Euro Interbank Offered Rate FCER Foreign currency equilibrium ratio FCI Financial Conditions Index FDIC Federal Deposit Insurance Corporation FECR Foreign exchange coverage ratio FED Federal Reserve Bank FFAR Foreign exchange funding adequacy ratio FGS Funding for Growth Scheme FOMC Federal Open Market Committee FSA Financial Services Authority FSB Financial Stability Board FSI Factor-Based Financial Stress Index FSL Funding for Lending Scheme FWG Forward guidance FX Foreign Exchange, forex GCF Repo Index General Collateral Finance Repo Index GDP Gross Domestic Product GNP Gross National Product GSE Government sponsored enterprises G-SII Global systemically important institutions

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List of acronyms

GSP Growth Supporting Programme HCSO Hungarian Central Statistical Office HFA Hungarian Forex Association HFT High-frequency trading HHI Herfindhal-Hirschman Index HKMA Hong Kong Monetary Authority HUFONIA Hungarian Forint Overnight Index Average IAIS International Association of Insurance Supervisors ICAAP Internal Capital Adequacy Assessment Process IDD Insurance Distribution Directive IFS International Financial Statistics ILAAP Internal Liquidity Adequacy Assessment Process ILO International Labour Organisation IMF International Monetary Fund IMF IFS IMF International Financial Statistics IMF WEO IMF World Economic Outlook IOER Interest of excessive reserve IOPS International Organisation of Pension Supervisors IOSCO International Organization of Securities Commissions IPO Initial Public Offering ISIN International Securities Identification Number IS-LM Investment–Saving, Liquidity preference–Money supply IT Inflation targeting J-REITs Japan’s real estate investment trust LCR Liquidity Coverage Requirement LF Loanable funds LGD Loss Given Default LIBOR London Interbank Offered Rate LIRS Interest rate swap conditional on lending activity LSAP Large-Scale Asset Purchase LTI Loan-to-Income Ratio

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List of acronyms

LTRO Long Tern Refinancing Operations LTV Loan-to-Value Ratio MAD/MAR Market Abuse Directive and Regulation MaDeP Macroprudential Pre-Decision Paper MARK Zrt. Magyar Reorganizációs és Követeléskezelő Zrt. (Hungarian Reorganisation and Collection Agency plc) MBS Mortgage-backed security MC Monetary Council MEP Maturity Extension Program MFAR Mortgage funding adequacy ratio MiFID Markets in Financial Instruments Directive MiFIR Markets in Financial Instruments Regulation MLS Market-Based Lending Scheme MNB Magyar Nemzeti Bank MRO Main Refinancing Operations MSZVK Magyar Szanálási Vagyonkezelő (Hungarian Resolution Asset Management Vehicle) MTF Multilateral Trading Facility NBER National Bureau of Economic Research NCWO No creditors worse off than in liquidation principle NDIF National Deposit Insurance Fund nGDP nominal GDP NPL Non-performing loan NSFR Net Stable Funding Requirement NTCA National Tax and Customs Administration of Hungary O/N RRP Overnight reverse repurchase agreement OECD Organisation for Economic Co-operation and Development OMT Outright Monetary Transactions OPEC Organization of the Petroleum Exporting Countries

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List of acronyms

ORSA Own Risk and Solvency Assessment O-SII Other systemically important institution OTF Organised trading facility PBOC People’s Bank of China PCEPI Personal Consumption Expenditure Price Index PD Probability of default PDCF Primary Dealer Credit Facility PIGS Portugal, Italy, Greece and Spain PMÁK Prémium Magyar Államkötvény (Premium Hungarian Government Bond) POS Point of sale PSPP Public sector purchase programme PSZÁF Pénzügyi Szervezetek Állami Felügyelete (Hungarian Financial Supervisory Authority) PTI Payment-to-income ratio QL “Quiet life” hypothesis QQE Quantitative and Qualitative Easing QR Code Quick Response Code RF Resolution fund SCT SEPA Credit Transfer SDD SEPA Direct Debit SEP Summary of Economic Projections SEPA Single Euro Payments Area SFA Stochastic frontier approach SIFI capital buffer Systemically important financial institution capital buffer SII Solvency II SME Small and medium-sized enterprises SMP Securities Markets Programme SRB Systemic risk buffer SREP Supervisory Review and Evaluation Process SSM Single Supervision Mechanism SWFSI System-Wide Financial Stress Index T2S TARGET2-Securities

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List of acronyms

TALF Term Asset-Backed Securities Loan Facility TCR Total cost ratio TLTRO Targeted Long-Term Refinancing Operations TLTRO II Targeted Longer-Term Refinancing Operations II TSLF Term Securities Lending Facility TtC Through-the-cycle VIBER Valós Idejű Bruttó Elszámolási Rendszer (RealTime Gross Settlement System) WSJ Wall Street Journal ZIRP Zero interest rate policy ZLB Zero lower bound

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List of charts and tables List of charts Members of the Monetary Council of the Magyar Nemzeti Bank since 2013

Chart 1-1: Current account balances

Chart 1-2: Explanations for global imbalances before the global financial crisis

Chart 1-3: European banks in the US shadow banking system

Chart 1-4: Net international investment positions

Chart 1-5: Global indebtedness

Chart 1-6: Cross-border, USD-denominated bank claims

Chart 1-7: Geographical distribution of cross-border, USD-denominated bank claims

Chart 1-8: Dynamics of balances sheet recession and readjustment

Chart 1-9: US real GDP during previous downturns and after the present financial crisis

Chart 1-10: Long-term real interest rates of government securities in the most advanced economies of the world

Chart 1-11: Explanations for the protracted recovery

Chart 1-12: Historic development of real interest rates

Chart 1-13: Key interest rates

Chart 1-14: Central banks’ balance sheet totals relative to GDP

Chart 1-15: Possible solutions to the challenges posed by the near-zero lower bound and the acute problems presented by the crisis

Chart 1-16: Determination of liquidity preference in the Keynesian framework

Chart 2-1: Transmission channels of government securities purchases

Chart 2-2: Impact of quantitative easing on balance sheets

Chart 2-3: Historical development of monetary policy’s objectives and instruments from the “one objective, one instrument” towards the “multiple objectives, multiple instruments” approach

100

Chart 3-1: Federal Reserve assets

123

Chart 3-2: Communication and the different forms of forward guidance of the Federal Reserve

128

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List of charts and tables

List of charts and tables Chart 3-3: Stylised depiction of the Fed’s policy toolkit on rate hikes

132

Chart 4-1: Inflation and 5x5 inflation expectations (2014–2016)

154

Chart 4-2: Asset purchases between December 2014 and October 2016

162

Chart 4-3: Unemployment in the PIGS and the core euro-area countries

168

Chart 4-4: Yields on Spanish, Italian and German 10-year government securities

171

Chart 4-5: Corporate and household lending and developments in GDP

172

Chart 4-6: EUR/USD exchange rate and quarterly export growth in the euro area

173

Chart 5-1: Economic growth and the projection

180

Chart 5-2: Development of inflation rates in Japan

184

Chart 5-3: Size of the central bank balance sheet approaches annual GDP

189

Chart 5-4: Impact mechanism of Quantitative and Qualitative Easing programme (QQE)

190

Chart 5-5: Three-Tier reserve system

191

Chart 5-6: Development of real interest rates in international comparison

193

Chart 5-7: Japanese economic policy successfully raised the prices of domestic products

194

Chart 5-8: Effect of the rise in the turnover tax on final consumption expenditure

196

Chart 5-9: Share of the BoJ on the government securities market (all maturities)

197

Chart 6-1: Unfavourable developments in the period under review

211

Chart 6-2: Convergence programmes and meeting the deficit target

213

Chart 6-3: Tax wedge in OECD countries (2007)

215

Chart 6-4: Developments in the cyclical balance of the budget

216

Chart 6-5: Structure of public debt and its level as a percentage of GDP

218

Chart 6-6: Social benefits as a percentage of GDP (2008)

221

Chart 6-7: Developments in household debt

223

Chart 6-8: External debt ratios as a percentage of GDP

225

Chart 6-9: Developments in inflation targets and inflation

227

Chart 6-10: Inflation in Hungary and other countries in the region

227

Chart 6-11: Developments in inflation as perceived and expected by households

230

Chart 6-12: Yields on Hungarian 3-month and 5-year government securities and the CDS spread for sovereign debt

231

— 946 —

List of charts and tables Chart 7-1: Marginal tax wedge in V4 countries at 100 and 167 per cent of average earnings

237

Chart 7-2: Taxes on consumption, labour and capital as a percentage of total tax revenues in Hungary

238

Chart 7-3: The Hungarian effective VAT rate

240

Chart 7-4: Accrual-based balance of the Hungarian budget, 2000–2015

243

Chart 7-5: Profits/losses of the Magyar Nemzeti Bank before dividends, and the amount of dividends disbursed in the years concerned

245

Chart 7-6: Developments in the base rate and the benchmark yields on 3-month and 5-year government securities

247

Chart 7-7: Net interest expenditures of Hungarian general government

248

Chart 7-8: Hungary’s gross public debt and the share of foreign exchange debt

249

Chart 7-9: Repricing of Hungarian public debt over a 10-year time scale

250

Chart 7-10: Growth forecast errors and fiscal consolidation plans in 2010–2011

254

Chart 8-1: Interactions between non-household participants in the Hungarian model in 2002–2008

261

Chart 8-2: External debt of European Union Member States as a percentage of GDP

263

Chart 8-3: Ratio of foreign exchange debt to total central government debt in European Union Member States

265

Chart 8-4: Composition of foreign exchange-based loans to households and its effect on the structure of external funds

266

Chart 8-5: Share of external funds in the Hungarian banking system as a percentage of the balance sheet total, and the net volume of forint swaps

267

Chart 8-6: Share of various holder sectors in financing Hungarian public debt

269

Chart 8-7: Developments in Hungary’s credit-to-GDP gap

273

Chart 8-8: Financial Condition Index (FCI), annual growth in real GDP, and the output gap

275

Chart 8-9: Sub-index of the Financial Conditions Index (FCI) for corporate lending

276

Chart 8-10: Sub-index of the FCI for household consumption expenditures

277

Chart 8-11: Developments in the stock of commercial real estate loans by currency denomination 279 Chart 8-12: Cumulative changes in GDP between 2007-2015 in EU countries and Hungary (at 2005 prices)

— 947 —

281

List of charts and tables Chart 8-13: Market share of domestic and foreign controlled banks in an international comparison at the end of 2015

286

Chart 9-1: New monetary policy framework of the Magyar Nemzeti Bank

293

Chart 9-2: Balances of the current account and the general government as a percentage of GDP

295

Chart 9-3: Denomination structure of household loans

296

Chart 9-4: Inflation target and development of inflation

298

Chart 9-5: Developments in the central bank base rate and inflation

299

Chart 9-6: Policy rates of central banks in the region

302

Chart 9-7: Balance sheet totals of major global central banks

303

Chart 9-8: Developments in the MNB base rate and risk spreads

304

Chart 9-9: Developments in underlying inflation indicators

307

Chart 9-10: Developments in inflation expectations

308

Chart 9-11: Base rate and the implied path of interbank yields

311

Chart 9-12: Schematic illustration of changes in the width of the central bank’s interest rate corridor

312

Chart 9-13: The base rate and interest on certain forint loan and deposit products

315

Chart 9-14: Short and long-term government securities’ yields

316

Chart 9-15: A schematic illustration of the transmission mechanism

319

Chart 9-16: The structure of aggregate demand in the new model

321

Chart 9-17: The structure of aggregate supply in the new model

322

Chart 10-1: Illustration of keeping the interest rate on hold for an extended period

330

Chart 11-1: Prevalence of monetary policy frameworks (2016)

354

Chart 11-2: Interest rate responses to demand and supply shocks

357

Chart 11-3: Taylor frontier

358

Chart 11-4: Volatility in inflation and output

359

Chart 11-5: Lower bound of the nominal interest rate

364

Chart 11-6: Inflation in developed and emerging IT economies

365

Chart 11-7: Number of open letters from the Bank of England

366

Chart 11-8: Main factors constraining Hungarian monetary policy before the crisis

368

Chart 11-9: Developments in the forint exchange rate

369

— 948 —

List of charts and tables Chart 11-10: Spread of foreign currency lending in Hungary before the crisis

370

Chart 11-11: The new pillars of monetary policy are unconventional instruments

372

Chart 11-12: Changes in central bank base rates and balance sheets compared to pre-crisis levels

376

Chart 11-13: Interconnection of different policies

379

Chart 11-14: Ratio of missing the target by inflation-targeting central banks before and after the crisis

385

Chart 11-15: Inflation in Hungary under the inflation targeting regime

387

Chart 11-16: Forms of inflation targets (2016)

388

Chart 11-17: Conceptual difference between a tolerance band and a target range

389

Chart 12-1: Changes in private sector loans outstanding in an international comparison (Oct. 2008 = 100%)

397

Chart 12-2: Process of financing in the Funding for Growth Scheme

398

Chart 12-3: Growth rate of loans to the whole corporate sector and the SME sector

399

Chart 12-4: Main features of individual FGS phases

402

Chart 12-5: Distribution of loan purposes in the FGS

405

Chart 12-6: Sectoral distribution of FGS loans

407

Chart 12-7: Regional distribution of SME and FGS loans

408

Chart 12-8: Impact of the FGS on real GDP growth (2013–2016)

411

Chart 12-9: Corporate lending hedged against a long-term central bank IRS

413

Chart 12-10: Schematic illustration of bank access to the instruments of the Market-Based Lending Scheme

416

Chart 12-11: Preferential deposits placed by the banking sector in 2016

417

Chart 13-1: Volume of new housing loans

423

Chart 13-2: Outstanding household loans in the banking system as a percentage of GDP

424

Chart 13-3: Interest rates on outstanding Swiss franc-based home loans in Hungary and Poland

428

Chart 13-4: Household mortgage loans outstanding as at the end of 2016 H1 by month of disbursement

429

Chart 13-5: Retrospective comparison of Hungarian household foreign currency loans and forint interest rates calculated on the basis of fair banking rules

438

— 949 —

List of charts and tables Chart 13-6: The MNB’s foreign exchange reserves and short-term external debt

440

Chart 13-7: Course of the MNB’s conditional and unconditional swaps

451

Chart 13-8: Developments in the holdings of sterilisation assets, 2014–2016

452

Chart 13-9: Developments in Swiss franc holdings allocated in the MNB’s foreign currency tenders

453

Chart 13-10: Developments in central bank reserves and short-term external debt

454

Chart 14-1: Gross external debt and the share of public debt within gross external debt

467

Chart 14-2: Share of non-residents and foreign currency financing within gross consolidated public debt

468

Chart 14-3: Gross and net external debt of EU Member States as a percentage of GDP

469

Chart 14-4: Developments in O/N interbank rates and 3-month benchmark DKJ yields in 2015–2016

480

Chart 14-5: Developments in the average reserve requirement ratios of credit institutions subject to reserve requirements

483

Chart 14-6: Aggregate holdings of central bank IRS instruments

486

Chart 14-7: Developments in the securities holdings of central bank counterparties by type of security vs. developments in holdings of the central bank’s sterilisation and credit instruments

487

Chart 14-8: Foreign currency ratio of central government debt

490

Chart 14-9: Reference yields in the Hungarian, Polish and German markets for government securities between July 2014 and July 2016

492

Chart 14-10: Polish and Hungarian benchmark yields on government securities

493

Chart 15-1: Frequency of the daily shifts in the 3-month BUBOR (left panel) and 3-month unsecured transactions between BUBOR panel banks before the reform (right panel)

504

Chart 15-2: Developments in interbank benchmark yields across the region

505

Chart 15-3: Monthly volume of unsecured interbank transactions traded among BUBOR panel banks in the segment of 1 to 3 months

512

Chart 15-4: Daily volume of unsecured interbank transactions in the segment of 1 to 3 months

513

Chart 15-5: Developments in the base rate, and the 1-month and 3-month BUBOR

514

Chart 15-6: Spreads between 3-month interbank yields and repo rates, and EONIA and repo rates

519

Chart 15-7: Spreads between 3-month interbank yields and OIS in Hungary and Poland

520

— 950 —

List of charts and tables Chart 16-1: Stylised impact mechanism of the limitation of the 3-month deposit instrument 531 Chart 16-2: The limited 3-month deposit instrument in the MNB’s system of monetary policy targets

535

Chart 16-3: Flow chart for setting the quantitative limitation

541

Chart 16-4: Major steps along the modification of the main policy instrument in 2016

543

Chart 16-5: Developments in the amount of 3-month deposits and the net holding of O/N deposits and central bank lending

545

Chart 16-6: Amounts accepted in the fine-tuning swap tenders

546

Chart 16-7: Changes in the aggregate reserve requirement of eligible credit institutions according to various reserve requirement ratios from January 2014

558

Chart 16-8: Over-fulfilment of reserve requirements in the banking system (January 2014 to December 2016)

561

Chart 16-9: Changes in the interest rate corridor and the effect of the central bank’s lending instruments on the HUFONIA movements

563

Chart 16-10: Developments in interbank yields

566

Chart 16-11: Average yields in Treasury bill auctions

567

Chart 16-12: Developments in the implied forint yields derived from HUF/EUR swap market quotes

568

Chart 17-1: Net interest income to total assets (international comparison)

589

Chart 17-2: Net interest income to total assets of individual banks based on the percentage of household loans within their balance sheets

590

Chart 17-3: International comparison of interest rate spreads on low-amount corporate loans granted in domestic currency

592

Chart 17-4: International comparison of spreads on housing loans granted in domestic currency

593

Chart 17-5: Operating costs as a percentage of assets in the banking systems of EU Member States

594

Chart 17-6: Employee headcounts and branch numbers of credit institutions

596

Chart 17-7: Operating cost to assets and NPL ratios of Hungarian banks

598

Chart 17-8: Breakdown of the non-performing population by capacity and propensity to repay

601

Chart 17-9: Segmentation of the non-performing household mortgage loan portfolio

602

Chart 17-10: Distribution of non-performing debtors by region and type of municipality

603

— 951 —

List of charts and tables Chart 17-11: Developments in portfolio quality across EU Member States

606

Chart 17-12: Non-performing and restructured project and other corporate loans in the banking system

608

Chart 17-13: Distribution of corporate NPL holdings by the length of time since the date of becoming non-performing (December 2015)

609

Chart 17-14: Major banks’ problem receivables on commercial properties and on-balance sheet commercial properties

610

Chart 18-1: The effect of substitution on the unit cost of payments in the case of debit cards and cash

630

Chart 18-2: Objectives in the MNB’s payments strategy

634

Chart 18-3: Changes in the ratio of credit transfers to GDP and in the share of electronic bill payments

640

Chart 18-4: Requirements for an instant payment system

642

Chart 18-5: Instant payment systems worldwide

644

Chart 18-6: Relationships of major payment situations and the instant payment service

645

Chart 18-7: Card acceptance revenues of payment service providers rendering acquiring services relative to the volume of card transactions

652

Chart 18-8: Development of the Hungarian payment card system year-on-year

653

Chart 18-9: The spread of contactless technology in the Hungarian payment card system

654

Chart 18-10: Share of electronically paid purchases within household consumption

655

Chart 18-11: CLS settlement currencies (2016)

657

Chart 18-12: Gross forint amounts settled in the CLS system, and the related net cash flows in the year following the forint accession (16 November 2015–18 November 2016).

660

Chart 18-13: By linking central securities depositories, T2S organises local capital markets into a single network

663

Chart 19-1: Central banks’ total assets as a percentage of GDP

670

Chart 19-2: Annual number of IPOs on the BSE

673

Chart 19-3: Bank and exchange financing

674

Chart 19-4: Performance of state-owned companies after privatisation

677

Chart 19-5: Holdings of domestically issued equities as a percentage of households’ financial instruments

681

Chart 20-1: The ultimate objective of macroprudential policy

692

— 952 —

List of charts and tables Chart 20-2: Market problems underlying cyclical systemic risks

697

Chart 20-3: The transmission mechanism of raising macroprudential capital requirements 711 Chart 20-4: The transmission mechanism of tightening the rules on liquidity and maturity mismatch

716

Chart 20-5: The transmission mechanism of tightening debt cap rules

720

Chart 20-6: The relative advantages of macroprudential policy being integrated into the central bank or being controlled by a board

732

Chart 21-1: The Hungarian financial stability institutional system

743

Chart 21-2: Phases of the macroprudential regulatory cycle

744

Chart 21-3: Quarterly distribution of new loans by PTI

758

Chart 21-4: The financial cycle-smoothing effect of the countercyclical capital buffer

760

Chart 21-5: The MNB’s decision-making mechanism for determining the CCB

762

Chart 21-6: Standardised and additional credit-to-GDP gap, 2000–2016

764

Chart 21-7: Changes in LCR compliance

770

Chart 21-8: The average, distribution and expected level of the FFAR

773

Chart 21-9: On-balance sheet foreign currency exposure of the banking system as a percentage of the balance sheet total

775

Chart 21-10: Impact of mortgage bond-based financing on interest rate spreads on the bank and the client side

777

Chart 21-11: New funds necessary for meeting the new MFAR requirement

778

Chart 21-12: Development of problematic project loans and commercial property exposures, by the components defined by the SRB

782

Chart 21-13: Banks classified by the MNB as systemically important (O-SII) in 2016 and their capital buffer rates

786

Chart 22-1: The MNB’s global network in resolution (January 2017)

804

Chart 22-2: MKB Bank’s after-tax profit (2008–2014)

811

Chart 22-3: Resolution action plan for the MKB Bank

814

Chart 22-4: Application of the asset separation tool

816

Chart 23-1: Ensuring the stability of the financial sector through supervisory action

832

Chart 23-2: Continuous supervision and on-site inspections over time

851

Chart 24-1: Components of business model analysis

868

— 953 —

List of charts and tables

List of tables 1. Table: R eduction of central bank base rates after the crisis

2. Table: T he instruments employed by central banks and the change in the size of central banks’ balance sheets

Table 1-1. Exporters and importers of ìdark matterî

Table 1-2: G ross financial flows from and into the US in 2007 (USD billion)

Table 1-3: C urrent accounts in 2007 (USD billion)

Table 3-1: F ederal Reserve Credit and Liquidity Facilities

114

Table 3-2: L arge-scale asset purchases by the Federal Reserve

117

Table 3-3: F inancial market effect estimates of the Fed’s large-scale asset purchases

118

Table 3-4: M acroeconomic effect estimates of the Fed’s large-scale asset purchases

120

Table 4-1: U nconventional instruments of the ECB

143

Table 6-1: D evelopments in specific macroeconomic variables

210

Table 6-2: D rawings and repayments on IMF and EU loans

219

Table 8-1: S ummary of the GDP impact of sustainable alternative lending paths

279

Table 9-1: A n estimate of interest savings by the state and the MNB

317

Table 9-2: I mpact of the easing cycle on inflation and GDP level

323

Table 10-1: S trategies managing additive uncertainty, and their literature

335

Table 10-2: M odel uncertainty I: Strategies managing multiplicative uncertainty, and their literature

337

Table 10-3: M odel uncertainty II: Strategies managing model misspecification, and their literature

339

Table 10-4: S trategies managing imperfect information, and their literature

340

Table 12-1: P arameters of individual FGS phases

401

Table 12-2: E UR and CHF loans outstanding in Q2 2013 by company size

403

Table 12-3: D istribution of loans provided under the FGS by company size and purpose

405

Table 12-4: C omparison of TLTRO and FGS

409

Table 13-1: R esults of settlement and conversion tenders

448

Table 13-2: R esults of the conversion tenders for consumer foreign currency loans

449

Table 13-3: V alue of refinancing loans taken out during the preferential refinancing period following the conversion of foreign currency-based mortgage loans

460

— 954 —

List of charts and tables Table 14-1: M odification of the central bank’s conventional instruments in specific phases of the Self-Financing Programme

476

Table 15-1: H oldings priced over the 3-month and 6-month BUBOR

500

Table 15-2: A ssessments of the Wheatley Report and the BIS Working Group based on unweighted scores

518

Table 15-3: V olume of specific transaction types in unsecured and secured forint markets 521 Table 16-1: C haracteristics of the main policy instruments of the central banks of some developed and emerging countries

533

Table 16-2: S ummary of the features of asymmetric interest rate corridor systems

551

Table 16-3: R eserve ratios in Hungary after 1 July 2001

557

Table 16-4: R eserve requirement ratios in EU Member States

559

Table 18-1: I ndicators describing the level of development of payments in Hungary, as compared to the EU (2012)

625

Table 18-2: S ocial cost of major payment methods used in Hungary and the savings available 626 Table 20-1: S ummary table of systemic financial risks and the underlying market imperfections 695 Table 20-2: T he major interactions between macroprudential policy and other policies

723

Table 20-3: T he independence of macroprudential policy from the government

727

Table 20-4: R ule-based or discretionary operation

728

Table 20-5: T he extent of international coordination

730

Table 21-1: T he LTV and PTI requirement levels

755

Table 21-2: T he impact of raising the countercyclical capital buffer

765

Table 21-3: S RB capital requirements by size of the problematic exposure

781

Table 21-4: M ethodology of the MNB to identify systemically important institutions

787

Table 22-1: M NB bridge loans to Hungarian collective funds (2015–2016)

807

— 955 —

THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY Kristóf LehmannTHE is Head HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY of the Monetary Strategy HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY Department of theTHE Magyar Nemzeti Bank. His THEcareer HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY started at the Hungarian HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY Development BankTHE (Magyar Fejlesztési Bank), and from THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY 2008 he prepared macroTHEforHUNGARIA economic analyses the N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY German DZ Bank. He obtaiTHE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY ned his PhD at the Corvinus University of Budapest. He has been working at the Magyar Nemzeti THE Bank HUNGARIA N WAY – TARGETED CENTRAL BANK POLICYobjective THE HUNGARIAofN WAY TARGETED CENTRAL BANK POLICY N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY The primary the–Magyar Nemzeti BankTHEisHUNGARIA to ensure since 2011, and is a member of the International THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY and THE HUNGARIA – TARGETEDtoCENTRAL BANK POLICYobjective THE HUNGARIA WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY N WAYprejudice price stability, without its primary it Nalso Relations Committee of the European Central Bank. 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THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY N WAY – TARGETED CENTRAL Award-winning economist who has been Executive THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY Director and Chief Economist Readers are holding the third volume in the book series published THE HUNGARIA WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANKMagyar POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY N of the Magyar Nemzeti Bank by the Magyar NemzetiN Bank in their hands. “The Hungarian since 2013. From 2010– THE HUNGARIA N WAY – TARGETED CENTRAL POLICY THECentral HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY HUNGARIA N WAY BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY Way –BANK Targeted Bank Policy” presents andTHEanalyses in– TARGETED CENTRAL 2013, he served as Head of Nemzeti Bank HUNGARIA N WAY – TARGETED CENTRAL THE HUNGARIA CENTRAL2013, BANK POLICY THEframework HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY Department at the THE Ministry N WAY – TARGETEDsince detailBANK thePOLICY measures implemented in the for National Economy and THE HUNGARIA N WAY – TARGETED CENTRAL POLICY THE HUNGARIA BANK POLICY THE HUNGARIA N WAY – TARGETED N WAY of theBANK new approach adopted by theCENTRAL Magyar Nemzeti Bank as– TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY coordinated the Széll Kálmán well as effects of those whileBANK surveying the global THE HUNGARIA BANKthe POLICY THE HUNGARIA – TARGETED CENTRAL POLICY THE HUNGARIA Plan structural reform programme. 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CENTRAL BANKWith POLICY this THE HUNGARIA WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY N WAY – TARGETED CENTRAL Nemzeti Bank in charge of sustained results in theNHungarian book,N the monetary policy and lending THE HUNGARIA N WAY – TARGETED CENTRAL BANKNemzeti POLICY THE HUNGARIA WAY – TARGETED CENTRAL POLICY THEobligations HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY Magyar BankN complies with its BANK statutory incentives since 2015. He THEatHUNGARIA BANK POLICY THE HUNGARIA CENTRAL POLICY THEthinking HUNGARIA N WAY and seeks to improve financial literacy andBANK economic in– TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY started his career the N WAY – TARGETED CENTRAL N WAY – TARGETED Monetary Policy Division Hungary, whileTHEproviding reading those interested THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY HUNGARIA N WAYuseful – TARGETED CENTRAL to BANKall POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY of the Economic Policy topic. Department at the Ministry of Finance. He THEjoined HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAYin–the TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY 4900 Ft the Bank as an analyst in 2003. 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THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY THE HUNGARIA N WAY – TARGETED CENTRAL BANK POLICY

THE HUNGARIAN WAY – TARGETED CENTRAL BANK POLICY

Magyar Nemzeti Bank

THE HUNGARIAN WAY – TARGETED CENTRAL BANK POLICY

ISBN 978-615-5318-14-6

2017