Hungary Recapitalization Scheme

On November 4, 2008, the State reached out to the IMF to request financial support via a Stand-By Arrangement of 17 months of special-drawing rights of 10.5 billion (€12.5 billion) for a large economic assistance package that would facilitate macroeconomic policies and promote financial stability throughout Hungary. The State listed three goals under the program (IMF November 2008):

1. To reduce the government’s financing needs and improve long-term fiscal sustainability
2. To maintain adequate capitalization of the domestic banks and liquidity in domestic financial markets
3. To underpin confidence and secure adequate external financing

The State also reached out to the ECB and World Bank for additional funding. Under the package, the State specifically wanted to sponsor a bank support program aimed at boosting the credibility and ensuring the soundness of all banks operating in Hungary. More specifically, the goal of the Program was to increase domestic parent banks’ ability to provide for their foreign subsidiaries. The Program funded the creation of two schemes, a recapitalization scheme and a guarantee scheme. The purpose of the guarantee scheme was to guarantee interbank loans and wholesale securities issued by major Hungarian banks and increase confidence by their counterparty investors. (EC N664/2009) (To read more about the guarantee scheme, you may refer to Appendix A or Buchholtz 2018a.)

On December 15, 2008, the Hungarian Parliament passed the Financial Stability Act aimed at “strengthening the financial intermediary system” and “limit[ing] the effects of the global financial crisis in Hungary and maintain[ing] its financial stability” (ECB Opinion March 2009).

After two months of analysis and deliberation over the Program, the EC approved the Program in February 2009 under Article 87(3)(b) of the EC Treaty, which “enables the EC to declare aid… if it is necessary to remedy a serious disturbance in the economy of a Member State”a. The EC believed that the Program’s objectives could sufficiently address the issues of the lack of liquidity and confidence in the Hungarian banking sector, as well as the benefit to the overall Hungarian economy (EC N664/2009).

The EC stated that the recapitalization scheme was similar to previously approved capital programs that successfully helped strengthen banks and restore market confidence in the participating country. Moreover, the EC said that because the scheme was temporary and limited in scope and size, it could not be abused by institutions or the State itself (EC N664/2009).

Capital interventions, the EC states in its analysis of the scheme, “must be done at terms that minimize the amount of aid”. It concluded that the annual return on the preference shares, as well as the inclusion of a put option granted to the State after five years of share issuance, and the dividend policy were all contributors to ensuring repayment to the State and incentivizing participating institutions to repay their assistance sooner (EC N664/2009).

33 other banks in Hungary’s system were deemed ineligible for this program by the MNB since they were small in size and posed a low systemic risk to the rest of Hungary’s banking system and abroad. These smaller banks located in Hungary were protected by a Hungarian deposit guarantee scheme announced on October 8, which provided a blanket guarantee by the government over all deposits (IMF November 2008).

When the recapitalization scheme was reintroduced in late-2009, the participation funds minimum condition was removed.

Based on IMF stress-test results, it was found that if the largest Hungarian bank’s CAR was boosted to at least 14%, that bank would be able to maintain the international CAR standard of at least 8% in the event of catastrophic declines across domestic currency loans, foreign currency loans, and foreign subsidiary assets (IMF November 2008).

The ECB required that capital provided to financial institutions be in exchange for Tier 1 capital, with the goal of “protecting the interest of taxpayers and respecting the level playing fields for institutions” (ECB Opinion December 2008).

The terms of the recapitalization scheme required that the preference shares, designated as Tier 1, equal in price to the amount of capital injected by the State into the institution, were to payout dividends so that the State could recoup some of its investment over time (EC N664/2009).

The return of the preference share was calculated based on ECB recommendations, where the return would equate to the average 20-day yield of the benchmark five-year European Monetary Union government bond, which at the time was the German five-year government bond (EC N664/2009).

One requirement from the ECB was that any securities exchanged for capital injections must incentivize financial institutions to repurchase the preference shares sooner rather than prolong their dependence on State support (ECB Opinion December 2008). The add-on fee of 2%, as well as the 1% annual “step-up” clause of the add-on fee, served to incentivize the participating bank to repurchase the preference shares and repay the State as soon as possible, likely when the institution was financially strong enough to sustain itself. The add-on fees were meant to cover operational costs of the transaction, as well as being required of preference shares in general corporate banking law (EC N664/2009).

Given that the State would inject capital of loaned funds from international institutions, the terms of the recapitalization scheme included a provision that the institution must grant a special veto share to the State. The share provided “veto rights” that would allow the State to deter decisions “which would lead to a misuse of funds” or could have threatened financial stability at home and abroad. Some examples of misappropriations of funds might have included issuing large dividend payments, providing large executive compensation and bonus payments, or expropriation of funds by management (EC N664/2009).

Hungarian authorities believed that to ensure that the Program did “not allow the credit institutions to expand their business in an unfair manner,” the government would impose behavioral conditions on any participating institution. Those conditions included requiring any participating institution not to advertise any government assistance they received and imposing restrictions on salary, compensation, and other benefit plans on the top executive officers of the banks (EC N664/2009).

No further details revealed from research for this key design decision.

According to the decision by the EC to approve the Program, one indicator of a bank’s unsoundness might be if the participant received State assistance greater than 2% of its risk-weighted assets. Prior to any injection, the State would assess an institution’s soundness and then report to the EC on their findings. If the EC considered the institution to be unsound, a restructuring plan would have to be submitted, and the capital provided under the scheme could only have been used as a condition for a bank’s windup or towards accomplishing a complex restructuring (EC N664/2009).

While the Hungarian Parliament passed the Financial Stability Act in December 2009, the State did not receive approval from the EC to implement the recapitalization scheme until February 12, 2009 (EC N664/2009), therefore, the scheme was only available originally for just under two months until its expiration on March 31. Since the scheme was open for such a short period and general market conditions had not improved, Hungary sought approval from the EC to extend the deadline for participation by six months (EC N335/2009).

Although only one institution had participated in the recapitalization scheme throughout its existence, the State continued to seek six-month extensions from the EC until 2013 with the goal of maintaining financial stability in Hungary in the midst of ongoing volatility across global financial markets. The State believed that maintaining the existence of the recapitalization scheme boosted market confidence by reassuring banks and foreign investors that funding was available for Hungarian financial institutions in the case of sudden declines in the economy, as well as to buffer banks subject to long-term funding risks. The MNB believed that banks likely did not need additional capital in a baseline scenario, but that under a stress scenario, it was likely that banks would draw upon the recapitalization scheme (EC N335/2009).

No further details revealed from research for this key design decision.