Report on Financial Stability

1. Report on Financial Stability November 2013

2. Financial stability heatmap 2

3. Key messages of the Report on Financial Stability • The contraction in corporate lending is expected to halt in the coming years, in which the Funding for Growth Scheme play a dominant role. • Sustained recovery in lending will require further easing of credit conditions on the supply side. • Some of the activities of deleveraging large banks may be taken over by smaller banking market participants. This, however, will require improving the capital position and funding capacity of those institutions • The indebtedness of households in foreign currency poses significant financial stability risks, thus itsmanagement is inthe interests of all parties. • The most important duty is the elimination of exchange rate risk. • The rules of transparent pricing should be mandatory in the case of outstanding mortgage loans. • It should be considered to cap the interest margin above the benchmark rate on mortgage loans in order to limit the interest risk of households. • The domestic banking sector is marked by persistently weak profitability outlook, which may prompt some banks to revise their market strategies. • This may lead to the consolidation of the market, whereby smaller banks and cooperative credit institutions may boost significantly their market share; while the entry of new participants cannot be ruled out either. 3

4. Key risk and their mitigation measures I. Key risk: • Deteriorating investor sentiment undermines the growth outlook 2.Domestic banking sector does not support economic growth through lending 2.1.Credit market problems in lending to the corporate sector, particularly in SME lending 2.2.High interest margins on loans to households Risk mitigation measures: • Maintaining prudent domestic fiscal policy and supporting sustainable economic growth in Hungary remain a priority in order to mitigate the impact of potential adverse shocks from the external environment. 2.1. The second phase of the Funding for Growth Scheme is expected to lead to a further improvement in SMEs’ access to credit at favourable interest conditions. 2.2.1. The rules of transparent pricing should be extended bindingly to cover outstanding mortgage loans. 2.2.2. Maximising the interest margin on mortgage loans, even on outstanding ones. 4

5. Key risk and their mitigation measures II. Key risk: • Households’ unhedged foreign currency exposure may speed up the deterioration in portfolio quality 4. The high share of non-performing loans is leading to profitability problems and impedes bank lending 4.1.Ratio of non-performing corporate loans continues to rise 4.2.In the household sector, the high share of non-performing household mortgage loans poses a risk Risk mitigation measures: • Adjusting the exchange rate cap scheme so that the exchange rate risk is mitigated more than previously or completely for households without a natural hedge. 4.1. Speeding up the process of portfolio cleaning, which could be facilitated by regulatory measures and/or incentives as well. 4.2. Introducing the institution of family bankruptcy as soon as possible would help manage non-performing portfolios,, while ensuring a ‘clean-sheet’ for overindebted customers. 5

6. Key risk and their mitigation measures III. Key risk: 5.Banks’ profitability remains persistently low 5.1.Competitive disadvantage in access to external funding 5.2.Market consolidation accompanied by stronger deleveraging Risk mitigation measures: 5.1.1. The FGS has helped ease financing constraints by providing access to cheap central bank funding. 5.1.2. Foreign currency funding is ensured in large part under Pillar 3 of the FGS without an increase in swap market exposure. 5.2.1. Paying increased attention to banks’ resilience in issues affecting the banking sector. 5.2.2. Strengthening participants (smaller-sized banks, cooperative credit institutions) which could partially replace larger-sized credit institutions even over short run. 6

7. Lending developments

8. The drop in corporate lending occured at large banks, while their role in new lending remains dominant Annual growth rate of and cumulative changes in corporate loans by types of institutions • Quarterly volumes and annual average of loans granted to corporations broken down by lenders • Note: (*) annualisedaverage. Source: MNB. Source: MNB. 8

9. Policy rate cuts translate into more favourableSME lending rate, but only for a narrow range of companies Pricing of new corporate HUF loans in Hungary and the MNB’s policy interest rate Source: MNB. 9

10. Owingtothe FGS the interest burden ofSME-s has eased significantly both for new and refinanced loans Fall in interest rate on loans refinanced in Pillars I and II Source: MNB. 10

11. The FGS has significantly improvedthecredit availability of theSME segment Loans disbursed under the FGS by size of business • (*): Including loans granted to pre-finance EU financial support. • Source: MNB. 11

12. Due to the FGS,corporate loans outstanding have increased substantially for the first time since the onset of the financial crisis Quarterly net changes of loans outstanding and annual growth rate Source: MNB. 12

13. Given the success of the FGS, the Monetary Council decided to continue the programme Comparison of the first and second phases of the Funding for Growth Scheme Source: MNB. 13

14. The contraction in corporate lending willstop, while rebound is alreadyexpected in SME lending this year Forecast for lending to SMEs Forecast for lending to non-financial corporatesegment Source: MNB. Source: MNB. 14

15. Sustained recovery in lending requires further easing of large banks’credit conditions, however part of themarket may be taken over by small- and medium size banks and credit cooperatives • The lending capacity of the small- and medium size banks amounts to HUF 450 bn, which is 7 and 12 per cent of total corporate loans and SME loans outstanding, respectively. • Given that liquidity constraints are binding here, the FGS means additional buffer. • The lending capacity of credit cooperatives amounts to HUF 450 bn, which is 6 and 10 per cent of total corporate loans and SME loans outstanding, respectively. • Given that capital constraints are binding here, the planned capital injection may improve markedly the lending capacity. 15

16. Portfolio quality

17. The corporateNPL-ratio of the banking sector is expectedtopeak Ratio of non-performing loans and cost of provisioning in the corporate segment Source: MNB. 17

18. Due to one off effects the household NPL-ratio of the banking sector has risen substantially Share of non-performing household loans of the banking sector by contracts Source: MNB. 18

19. Indebtedness in foreign currency concerns large part of households, thus a solution is in the interests of all parties Household loans of the banking sector and branches broken down by currencies and products Source: MNB. 19

20. In the rise of debt servicing burdens, besides the appreciation of the CHF, the increase of lending rates exceeding the rise in risk premia play a dominant role as well Average estimated cost of foreign funds and the average interest margin on outstanding of Swiss franc mortgage loans HUF/CHF exchange rate Source: MNB. Source: MNB. 20

21. The debt servicing burden has reached critical levels in the case of low income households Debt service burden of households by denomination in proportion of disposable income • Payment-to-income ratio of indebted households by income deciles Source: MNB. Source: GfK, MNB. 21

22. The participation rate in the exchange rate cap scheme is below our expectations, thus default risk remains elevated Utilisation of the exchange rate cap • Reasons for not entering the exchange rate cap scheme Source: MNB. Source: GfK, MNB. 22

23. In the case of non-performing loans, increased activity of the NET (National Asset Management Agency) and the expeditious introduction of the private bankruptcy may be the solutions Non-performing household loans of the banking sector broken down by currencies and products Source: MNB. 23

24. An improvement is expectedin the household segment over the forecast horizon Ratio of non-performing loans and cost of provisioning in the household segment Source: MNB. 24

25. Profitability

26. The profitability of the Hungarian banking sector remains severelylow in international comparison Pre-tax profit/loss of the banking sector and branches Profit after tax ROE in international comparison • Note: The chart depicts the 46–60, 20–80 percentile value of the member states' banking systems together with the Hungarian banking systems' ROE. • Source: ECB CBD. Source: MNB. 26

27. The persistently subdued profitability may lead to the exit of some major foreign-owned banks Relationship between the invested capital of selected groups of institutions and the present equity capital and dividends disbursed Note: between 1997 and June 2013, amounts calculated not at present value. Invested capital means the initial equity capital and the capital increases carried out in the period under review. 27 Source: MNB.

28. The consolidation may be slowed down by the high ratio of parent bank funding Role of foreign and parent funding in the banking sector Source: MNB. 28

29. Stress test results

30. The liquidity stress test indicates strong resilience, but only in HUF Liquidity Stress Index and banks’ liquidity surplus or deficit relative to the regulatory level in the stress scenario Note: The LSI is the sum of normalised liquidity deficits relative to the 10 per cent regulatory limit, weighted by the balance sheet total. The higher the value of the index, the higher the liquidity risk in the stress scenario. 30 Source: MNB.

31. Increasing, but still manageable capital need in the stress scenario Stress test result with the 8 per cent regulatory capital adequacy ratio Source: MNB. 31

32. There has been only a slight change in the Solvency Stress Index since our last Report Solvency Stress Index, capitalbuffer and needalongthestressscenario 32 Source: MNB.

33. Thank you for your attention!