Report on Financial Stability (November 2012): Banking System Resilience

1. Report on Financial Stability (November 2012) 5 November 2012

2. Financial stability heat map Source: MNB.

3. Summary I. – Credit contraction may persist longer than anticipated • Credit conditions:The banking system is supporting the economy to a limited extent • Owing to the low willingness to lend, the banking system is strongly procyclical in corporate lending. • Resilience:The resilience of the Hungarian financial system has improved markedly • LIQUIDITY: Despite the dynamic outflow of external funds, liquidity risks have abated due to the appreciation of the forint, the drop in CDS spreads, decrease in net FX swap exposure, and the longer maturities of swaps. • CAPITAL: Capital injections by parent banks, steady deleveraging and the apprecation of the forint resulted in higher capital adequacy ratio, despite persistently high risk costs and fiscal burdens on the banking sector.

4. Summary II. – Credit contraction may persist longer than anticipated • Risks:Severalexternal and domesticperils • The protracted sovereign debt crisis intheeuro-area remains a key risk, despite the improvement in investor sentiment. • The economicoutlook of Hungary is deterioratingfurther. • Outflows of external funds may accelerate, while the reliance of the banking sector on the FX swap market remains high. • The ratio of non-performing loans is high in the domestic banking sector and the risk of insufficient loan loss coverage is rising. • Given the deteriorating portfolio quality and high tax burdens, banks’ profitabilitymay remain subdued, which may translate into further deterioration in alreadylow willingness to lend. • Banks partially offset rising loan losses by increasing interest rate margins, this, however, is not a sustainable incomestructureover the longer term.

5. Credit conditions

6. The banking sector is not supporting economic growth Financial Conditions Index (FCI), real GDP growth and the output gap Note: The annual growth in the FCI shows the contribution of the financial intermediary system (banking sector) to the annual growth rate of real GDP. If the sign of the FCI is identical to that of the output gap, then the banking sector behaves procyclically. Source: MNB.

7. Tight credit conditions, particularly in corporate lending, have been causing credit contraction for a long time Net quarterly changes in corporate loans outstanding Source: MNB.

8. Credit supply constraints are driven primarily by low willingness to lend Changes in credit conditions of corporate loans and factors contributing to changes Source: MNB.

9. Despite tighter credit conditions, banks lend to corporations with higher default risk as a result of deteriorating economic conditions Distribution of new loans according to probability of default in the given years Source: CCIS, MNB estimate.

10. Banks adjusted in terms of quantities and maturities against the deteriorating corporate credit quality Maturity structure of newly issued corporate loans Source: CCIS, MNB estimate.

11. In contrast to corporate lending, household lending is driven predominantly by demand factors Net quarterly changes in household loans outstanding Source: MNB.

12. The state interest rate subsidy scheme reduces the initial interest costs markedly (to 8-9 per cent), which may boost credit demand New disbursements of credit institutions in the household segment Source: MNB.

13. Resilience

14. System-wide Financial stress Index (SWFSI) is on low level The System-wide Financial stress Index Note: Higher levels denote higher stress. Source: MNB.

15. The stress scenario of liquidity stress test Note: The liquidity stress test is 30-day forward looking. Source: MNB.

16. The Liquidity Stress Index (LSI) has improved markedly Liquidity Stess Index, liqudity surplus of banks above the regulatory limit, and need along baseline scenario Note: The ratio is the liquidity need to 10 percent of balance sheet total weighted by balance sheet total. Higher ratio is mean higher liquidity risk along baseline scenario. Source: MNB.

17. The scenarios of the solvency stress test • Over the 8 quarter forecast horizon beginning 2012 H2, the shock hits in 2012 Q4. • Our baseline scenario is the forecast of the Report on Inflation 2012 Q2. • Our stress scenario relative to our baseline scenario: • 4.3 percentage points lower GDP growth; • 15 per cent deprecation of HUF; • 300 basis points risk premium shock; • 10 per cent drop in house prices. • Along the stress scenario we accounted for additional loan loss provisioning on outstanding non-performing loans as in a significantly deteriorating economic environment their recovery rate falls. • As regards the exchange rate cap scheme, we assumed 70 per cent participation ratio both along the baseline and the stress scenario. • The postponement of halving the bank levy and the pass-through of the entire financial transaction tax are taken into account.

18. Main components of the losses of the banking sector in the stress test over a two-year horizon Source: MNB.

19. The Solvency Stress Index (SSI) shows one of the lowest value since the onset of the crisis Stress test index, capital buffer and need in stress scenario at the end of 8 quarter horizon Note: The indicator is the sum of normalised capital shortages relative to the 8 per cent level, weighted by the capital requirement. The higher the value of the index, the higher the solvency risk in the stress scenario. Source: MNB.

20. Foreign-owned banks have injected EUR 2.4 billion capital since 2009 Profit after tax, dividend and capital raise of existing foreign owned banks Source: MNB.

21. Risks

22. Risks in the external environment of the financial intermediary system • Protracted sovereign debt crisis in the euro area. • Several periphery countries are compelled to implement stricter fiscal austerity measures. • In some of the core countries, major fiscal consolidation measures will be implemented as well. • Significant deterioration in the economic outlook of the euro area, while investor sentiment might remain volatile . • Weak earning capacity of European banks due to the high funding costs and deteriorating portfolio quality. • Worsening economic outlook weigh on banks’ balance-sheet. • In several peripheral countries banking systems need substantial capital injections. • Steady, or even accelerating deleveraging by parent banks.

23. Deteriorating domestic economic outlook Economic growth in international comparison Source: Eurostat.

24. The recently benign investor sentiment and expectations over the EU/IMF negotiations reduced markedly the Hungarian CDS premia Decomposition of the Hungarian 5–year CDS spread Source: MNB.

25. The outflow of external funds continues to be strong, significant drop in loan-to-deposit ratio Estimated and actual change of foreign funds and loan-to-deposit ratio Source: MNB.

26. Given the still large FX swap exposure (open on-balance-sheet position), cap is necessary On-balance-sheet open position of the banking system and the total assets based market share of banks exceeding the 15 per cent limit Source: MNB.

27. The greatest challenge of the domestic financial intermediary system is managing the deteriorating portfolio quality Ratio of non-performing loans and the cost of provisioning Corporate Household Source: MNB.

28. High NPL ratio may persist amid sluggish portfolio cleaning Cleaning of non performing loans Source: MNB.

29. In evaluating portfolio quality, in addition to the dynamics, the level is also crucial • Flow problem: new defaults weigh on profitability through loan loss provisioning. (moderate risk) • Stock problem: 1. High NPL ratio freeze banks’ balance-sheet (moderate risk) • Reduces itself willingness to lend, particularlyinthecorporatesegment. • Refinance of non-performing loans erodes profitability. • Deteriorates liquidity, increases maturity mismatch, diverts funds from lending. 2. Not just the NPL ratio, but also loan loss coverage matters (high risk) • The higher the NPL ratio, the higher the risk of collateral misvaluation. 3. Despite its flaws in terms of international comparability, analysts pay particular attention to it in their risk perception over the banking sector in the CEE region. (high risk)

30. Reducing NPL ratio is key • Reduction of NPL ratio: 1. Through nominator: • Portfolio cleaning and debtor rescue packages (by revivingloans from defaults) reduce the nominator. 2. Through denominator: • Rebound in lending increases the denominator. • If the NPL ratio cannot be reduced, then the loan loss coverage should be raised: • Higher loan loss coverage may boost portfolio cleaning or • Otherwise wouldmake the banking sector safer, though portfolio cleaning would be more sluggish.

31. Loan loss coverage is low in regional comparison NPL ratio and loan loss coverage in international comparison Note: (1)= 2011Q4, (2)= 2012Q1, (3)= 2012Q2. Source: EBCI, MNB.

32. In the case of project loans and restructured foreign currency denominated, insufficient coverage is plausible Coverage of non-performingloans - corporate Coverage of non-performingloans - household Source: MNB.

33. Banks are attempting to offset higher costs by increasing interest margin Banking sector ROE in international comparison Net interest income to total assets (Dec 2011 – consolidated data) Source: IMF GFSR, EKB CBD database, MNB.

34. The interest margin remained high on the performing portfolio Interest margin (based on aggregated individual, non-consolidated data) Source: MNB.

35. Credit contraction may persist longer than anticipated • The resilience of the banking sector andthus its lending capacity is strong. • Given the deteriorating portfolio quality and high tax burdens, banks’ earnings may remain subdued, which may translate into further deterioration in low willingness to lend. • The procyclical behaviour of banks concerns both new lending and loans outstanding. • No turnaround is expected in new lending, leading to further contraction in loans outstanding. • Banks are attempting to offset rising losses by widening interest margin (pass-through of costs to customers). • Financial intermediation is becoming more expensive, leading to unsustainable state, as feedback loop may emerge: loan losses  interest margin  debt servicing burden  consumption and investment  non-performing loans  interest margin  ….

36. Financial stability heat map Source: MNB.