Banking models in CEE from a domestically owned bank ’s perspective Tardos Gergely

1. Banking models in CEE from a domestically owned bank’s perspective Tardos Gergely Head of Research OTP Bank

2. Pre-crisis CEE banking model characteristics and sustainability issues A few word about FX lending Basel3 Why do we believe in the region?

3. Pre-crisis CEE banking model characteristics and sustainability issues A few word about FX lending Basel 3 Why do we believe in the region?

4. CEE banking model characteristics before the crisis • Main elements: • Fast, credit driven deepening • Aggressive strategies, cross border, inter-generation financing • FX lending (Debt euroisation, debt „Swiss Francisation”) • Increasing role of mortgage loans • Risks within the balance sheets • Maturity mismatches (mortgage vs. short term financing: deposits, parent banks financing, bonds, FX swaps)

5. CEE banking model characteristics before the crisis Pre-crisis: Aggressive, credit driven deepening: Cross border, inter-generation financing: Debt euroisation Debt „Swiss Francisation”: Increasing role of mortgage loans Risks within the balance sheets Maturity mismatch within the balance sheets Sustainability? Yes, but not in the pre-crisis volumes Yes Our view: Yes No Yes Absolutely To be decreased (Pension funds, 2. pillar) What is happening right now? Sudden stop Reversal of funds Reversed in many countries No No Yes Slight decrease

6. Pre-crisis CEE banking model characteristics and sustainability issues A few word about FX lending Basel3 Why do we believe in the region?

7. Fixed or quasi fixed exchange rate regimes and wrong fiscal policies lead to FX lending • The roots of FX lending: • Trigger: monthly installments • Fixed or quasi fixed exchange rate regimes • Real convergence in fixed ER regimes results in a higher nominal path, with higher inflation, wage growth and interest rates • Not prudent fiscal policy: higher risk premium also contributes to higher interest rates • Underdeveloped or non existing local currency (LC) covered bond market. • Slovakia, Czech Republic: • tight fiscal policy, • floating currency, • no interest rate differential • well functioning LC covered bond market • fx lending has much lower or negligible role

8. When debt euroisation is sustainable? In converging countries, but risks has to be taken into consideration • Convergence results in real appreciation, convergence of price levels and wages expressed in euro • Lessons (to be) learned: • Convergence and overheating has many common symptoms • Convergence can be reversed temporary (negative terms of trade shock, real depreciation, debt deflation in the case of FX loans) • Real convergence can be stopped by wrong fiscal policy • Growth from non-tradable sectors is not convergence („Dutch disease” from non-tradable sectors, especially construction, tourism!) • Debt euroisation significantly decreases the maneuvering room of monetary policy • How to treat risks: if FX lending was not avoided, then converge & adjust fiscal policy • Prudent fiscal policy is a must (donot spend cyclical revenues for structural expenses) • Stricter banking regulation • Lower debt burden to income • Higher loan to value • Higher capital adequacy • CHF? • No convergence driven countries? Ukraine?

9. Pre-crisis CEE banking model characteristics and sustainability issues A few word about FX lending Basel 3 Why do we believe in the region?

10. Introduction of Basel3 is likely to cut back loan generation capacities • Changes in capital adequacy rules: • More rigorous regulation on Capital elements • Introduction of Core tier 1 ratio • Higher capital requirement on the trading book • Introduction of leverage ratio • Introduction of liquidity coverage ratio • Net stable funding ratio • Counter-cyclical measures through • provisioning (IFRS, taxation?) or capital rules A few regional players have: Exotic capital elements Low tier 1 Sizeable trading book Sizeable off-balance sheet items, high leverage

11. Pre-crisis CEE banking model characteristics and sustainability issues A few word about FX lending Basel3 Why do we believe in the region?

12. Global imbalaces have not disappeared, only the sector that accumulates debt in developed countries has changed C/A balance in developed countries (in % GDP) Asian and oil exporter countries are still net savers Developed countries are still net borrowers, just it is not the private but the public sector who raises debt Unsustainable public finances in most of the developed countries while adjustment has only started in the Eurozone Gross debt of main sectors, US (in % GDP) Source: FED, BIS, IMF, OTP 12

13. In CEE adjustment of external position has been carried out in a contrast to developed countries , while public debt is low or expected to decrease C/A balance(in % of GDP) • Regional imbalances have been adjusted: • C/A adjustment was done • External imbalances disappeared or fell back to the level of FDI inflows • Low or sustainable public debt tracks • Overheating in domestic demand disappeared • Drastic, usually double digit fall in domestic demand. Public debt(in % of GDP) Changeindomesticdemand(%, 2009) Source: Eurostat, National Banks, OTP 13

14. Convergence and in international comparison favourable fiscal position makes us optimistic in the middle run Budget deficit 2010-2012 average (in % of GDP) Change in public debt to GDP between 2010-2012 (%-point) Potential growth after the crisis (%) Debt to GDP, 2009 (in % of GDP) Countries facing structural problems due to the crisis Greece 9.9 27.8 1.4 115 Ireland 2.0 12.1 33.3 Portugal 19.6 1.0 7.9 26.9 2.2 Spain 8.8 1.6 Italy 5.0 3.8 10.0 1.8 UK 26.6 USA* 9.9 24.0 2.1 Balanced developed countries Netherland 1.7 12.0 5.1 1.5 4.9 11.4 Denmark 1.7 11.2 4.7 Germany 16.0 1.7 7.4 France Bulgaria Small open economies in CEE 5.4 2.0 3.0 Croatia 2.8 3.0 1.7 Hungary 3.0 -1.6 4.0 Romania 17.4 7.4 4.0 Slovakia 11.5 4.0 5.4 51 Poland 13.7 7.0 3.5 35 Czech Rep. 11.8 5.7 3.8 Commodity exporters Ukraine 4.5 6.0 4.5 5.5 Russia 4.2 3.4 Emerging count-ries with huge domestic markets 2.4 5.0 Brazil -3.0 7.0 5.5 0.4 India -4.0 8.0 3.0 China Source: BIS, IMF, Consenzus Economics, OTP * Gross debt outstanding 14

15. Public debt sustainability is a less critical question in this region Required budgetary adjustment for 60% public debt in 2060* (based on 2009figures no policy change) Main changes after the publication: Bulgaria: C.A, primary deficit worse by 1%-points Italy: announced measures of 1-1.2%-points Germany: announced measures of 1%-points Portugal: announced measures of 2.5%-points Romania: announced measures of 2.5-3%-points Spain: announced measures of 2.5%-points Greece: announced measures of 13%-points Source: Euopean Commission * In the cyclically adjusted primary balance ,in % of GDP, including aging effects

16. 0% Penetration gap in household loans is 50% compared to EMU countries, as a consequence of lower mortgage penetration. After the crisis the forces of convergence will result in faster than Western European Economic growth and closing of penetration gaps on banking markets Main drivers of economic convergence are intact: Relative penetration levels in main market segments EMU = 100% • European Union membership • Free movement of capital • Cheap labour even if we take into account productivity levels (40% advantage) Retail Loans Housing Loans Non-housing Retail Fast Growth in Banking Markets Convergence will result in closing of penetration gaps Corporate Loans • Convergence in productivity and GDP/capita • Convergence in wage levels • Convergence in loan penetration • Convergence in financial asset penetration Private Deposits Insurance Reserves (2007) Total Retail Financial Assets (2007) Penetration level of the EMU in % of GDP Source: Eurostat, National Banks, OTP

17. What do we expect: back to the roots • Much slower than pre-crisis, initially fragile economic growth: • Convergence to return in 2011 • Be prepared of lower, than estimated potential GDP levels (waste capital) • Much lower and more expensive capital absorption • Domestic demand lagging, external demand driven growth • Diverging growth patters: • Economic structure will have stronger effects, than expected (weight and structure of manufacturing, construction and real estate related services) • Exchange rate regime : below 10-15% depreciation can help, even if FX lending is present • Banking markets: • Much slower, less credit driven growth, • No aggressive growth strategies • Negligible cross-border financing in the coming years • Revival of LC loans • Mortgage will be the main driver again, regulation will be in focus • Maturity mismatch: LC mortgage financing from pension funds savings

18. Thank you for your attention!