Report on Financial Stability

(November 2012)

5 November 2012

2

Financial stability heat map

Source: MNB.

Procyclicality Shock-absorbing capacity

November 2012

April 2012

November 2012

April 2012

• 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.

Summary I. – Credit contraction may persist longer than anticipated

3

• Risks: Several external and domestic perils

1. The protracted sovereign debt crisis in the euro-area remains a key risk, despite the improvement in investor sentiment.

2. The economic outlook of Hungary is deteriorating further.

3. Outflows of external funds may accelerate, while the reliance of the banking sector on the FX swap market remains high.

4. The ratio of non-performing loans is high in the domestic banking sector and the risk of insufficient loan loss coverage is rising.

5. Given the deteriorating portfolio quality and high tax burdens, banks’ profitability may remain subdued, which may translate into further deterioration in already low willingness to lend.

6. Banks partially offset rising loan losses by increasing interest rate margins, this, however, is not a sustainable income structure over the longer term.

Summary II. – Credit contraction may persist longer than anticipated

4

Credit conditions

5

6

The banking sector is not supporting economic growth

Source: MNB.

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.

Financial Conditions Index (FCI), real GDP growth and the output gap

-8

-6

-4

-2

0

2

4

6

-8

-6

-4

-2

0

2

4

6

2006 Q

1Q

2Q

3Q

42007 Q

1Q

2Q

3Q

42008 Q

1Q

2Q

3Q

42009 Q

1Q

2Q

3Q

42010 Q

1Q

2Q

3Q

42011 Q

1Q

2Q

3Q

42012 Q

1Q

2

per centper cent

Output gap Real GDP FCI

7

Tight credit conditions, particularly in corporate lending, have been causing credit

contraction for a long time

Source: MNB.

Net quarterly changes in corporate loans outstanding

-15

-10

-5

0

5

10

15

20

25

-300

-200

-100

0

100

200

300

400

5002008 Q

1Q

2Q

3Q

42009 Q

1Q

2Q

3Q

42010 Q

1Q

2Q

3Q

42011 Q

1Q

2Q

3Q

42012 Q

1Q

2Q

3Q

42013 Q

1Q

2Q

3Q

42014 Q

1Q

2Q

3Q

4

per centHUF Bn

Forecast Actual Growth rate (RHS)

8

Credit supply constraints are driven primarily by low willingness to lend

Source: MNB.

-20

0

20

40

60

80

100

-20

0

20

40

60

80

1002008 Q

2-3

2009 Q

1

Q2

Q3

Q4

2010 Q

1

Q2

Q3

Q4

2011 Q

1

Q2

Q3

Q4

2012 Q

1

Q2

H2 e

xp.

per cent

Easi

ng

per cent

Tig

hte

nin

g

Capital position (lending capacity)Liquidity position (lending capacity)Cyclical factors (willingness to lend)Competition (willingness to lend)Change in credit conditions

Changes in credit conditions of corporate loans and factors contributing to changes

9

Despite tighter credit conditions, banks lend to corporations with higher default risk as a result

of deteriorating economic conditions

Source: CCIS, MNB estimate.

Distribution of new loans according to probability of default in the given years

0

2

4

6

8

10

12

14

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8 9 10

per centper cent

Probability of default (per cent)

2007 2011 2011 (assuming an unchanged macroeconomic environment)

10

Banks adjusted in terms of quantities and maturities against the deteriorating corporate

credit quality

Source: CCIS, MNB estimate.

Maturity structure of newly issued corporate loans

14

16

18

20

22

24

26

28

30

0

200

400

600

800

1 000

1 200

1 400

1 600

2007

Q1

Q2

Q3

Q4

2008

Q1

Q2

Q3

Q4

2009

Q1

Q2

Q3

Q4

2010

Q1

Q2

Q3

Q4

2011

Q1

Q2

Q3

Q4

MonthHUF Bn

Over 5 years maturity 1-5 years maturityShort-term Average maturity (RHS)

11

In contrast to corporate lending, household lending is driven predominantly by demand

factors

Source: MNB.

Net quarterly changes in household loans outstanding

-21

-14

-7

0

7

14

21

28

35

-300

-200

-100

0

100

200

300

400

5002008 Q

1Q

2Q

3Q

42009 Q

1Q

2Q

3Q

42010 Q

1Q

2Q

3Q

42011 Q

1Q

2Q

3Q

42012 Q

1Q

2Q

3Q

42013 Q

1Q

2Q

3Q

42014 Q

1Q

2Q

3Q

4

per centHUF Bn

Forecast ActualEffect of early repayments scheme Exchange rate fixationGrowth rate (RHS)

HUF 552.6 Bn HUF 468 Bn

12

The state interest rate subsidy scheme reduces the initial interest costs markedly (to 8-9 per

cent), which may boost credit demand

Source: MNB.

45678910111213141516

050

100150200250300350400450500550600

2005 Q

1Q

2Q

3Q

42006 Q

1Q

2Q

3Q

42007 Q

1Q

2Q

3Q

42008 Q

1Q

2Q

3Q

42009 Q

1Q

2Q

3Q

42010 Q

1Q

2Q

3Q

42011 Q

1Q

2Q

3Q

42012 Q

1Q

2

HUF BnHUF Bn

Mortgage loansOther loansRefinancing for early repaymentsAverage APRC of mortgage loans (RHS)

New disbursements of credit institutions in the household segment

Resilience

13

14

System-wide Financial stress Index (SWFSI) is on low level

Source: MNB.

Note: Higher levels denote higher stress.

0,0

0,1

0,2

0,3

0,4

0,5

0,6

0,7

0,8

0,9

1,0

0,0

0,1

0,2

0,3

0,4

0,5

0,6

0,7

0,8

0,9

1,0

2008 2009 2010 2011 2012

The System-wide Financial stress Index

15

The stress scenario of liquidity stress test

Source: MNB.

Note: The liquidity stress test is 30-day forward looking.

Assets Liabilities

ItemDegree (per

cent)

Currencies

affectedItem

Degree (per

cent)

Currencies

affected

Default on interbank

assets20 HUF

Withdrawals in

household deposits10 HUF/ FX

Exchange rate shock on

swaps15 FX

Withdrawals in

corporate deposits15 HUF/ FX

Depreciation of assets

eligible at the central

bank

10 HUF

16

The Liquidity Stress Index (LSI) has improved markedly

Source: MNB.

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.

-125

-100

-75

-50

-25

0

25

50

75

-2,500

-2,000

-1,500

-1,000

-500

0

500

1,000

1,500Ja

n-09

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan-

10

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan-

11

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan-

12

Feb

Mar

Apr

May

Jun

per centHUF Bn

Liquidity buffer above the regulatory requirementLiquidity need to meet the regulatory requirementLiquidity Stress Index (right-hand scale)

Liquidity Stess Index, liqudity surplus of banks above the regulatory limit, and need along baseline scenario

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.

Baseline scenario Stress scenario

Loan losses on corporate and household

portfolio555 971

Loan losses on new non-performing corporate

loans280 411

Loan losses on new non-performing household

loans275 425

Additional loan losses on the already non-

performing loans135

Loan losses on local government portfolio 11 24

Exchange rate risk of open position -64

Interest rate risk 80

Bank levy 205 205

Interest cost of the exchange rate cap scheme 36 65

Main components of losses of banking

system in eight quarter horizon (HUF

Bn)

19

The Solvency Stress Index (SSI) shows one of the lowest value since the onset of the crisis

Source: MNB.

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.

-10

0

10

20

30

40

-300

0

300

600

900

1,2002005 Q

2Q

3Q

42006 Q

1Q

2Q

3Q

42007 Q

1Q

2Q

3Q

42008 Q

1Q

2Q

3Q

42009 Q

1Q

2Q

3Q

42010 Q

1Q

2Q

3Q

42011 Q

1Q

2Q

3Q

42012 Q

1Q

2Q

3

per centHUF Bn

Capital buffer above the regulatory requirementCapital need to meet regulatory requirementSolvency Stress Index (RHS)

Stress test index, capital buffer and need in stress scenario at the end of 8 quarter horizon

20

Foreign-owned banks have injected EUR 2.4 billion capital since 2009

Source: MNB.

20

25

30

35

40

45

50

55

60

-400

-300

-200

-100

0

100

200

300

4001998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Jun-

2012

per centHUF Bn

After tax profit Dividends (with opposite sign)Capital injection Dividend ratio (right-hand scale)

Profit after tax, dividend and capital raise of existing foreign owned banks

Risks

21

• 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.

Risks in the external environment of the financial intermediary system

22

23

Deteriorating domestic economic outlook

Source: Eurostat.

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

0 5 10 15 20 25 30 35

GDP g

row

th 2

012 H

1(c

om

pare

d t

o e

nd

-2011,

per

cent)

Cumulated GDP growth 2005-2011 (per cent)

HU

Euro area

LV

EE

LTRO

BG

PL

SK

CZ

Economic growth in international comparison

24

The recently benign investor sentiment and expectations over the EU/IMF negotiations

reduced markedly the Hungarian CDS premia

Source: MNB.

-100

0

100

200

300

400

500

600

700

800

-50

0

50

100

150

200

250

300

350

400

Jul-1

1

Aug-11

Sep-

11

Oct

-11

Nov-11

Dec-11

Jan-

12

Feb-

12

Mar-1

2

Apr-1

2

May-12

Jun-

12

Jul-1

2

Aug-12

Sep-

12

Oct

-12

basis pointbasis point

International componentIndividual componentHungarian sovereign CDS spread (right-hand scale)

Decomposition of the Hungarian 5–year CDS spread

25

The outflow of external funds continues to be strong, significant drop in loan-to-deposit ratio

Source: MNB.

20

22

24

26

28

30

32

34

36

38

112

116

120

124

128

132

136

140

144

148Dec-09

Jan-

10

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan-

11

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan-

12

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

EUR Bnper cent

Foreign funds - estimated band (RHS)Foreign funds - actual (right-hand scale)Loan-to-deposit ratio - actualLoan-to-deposit - estimated

Estimated and actual change of foreign funds and loan-to-deposit ratio

26

Given the still large FX swap exposure (open on-balance-sheet position), cap is necessary

Source: MNB.

0

5

10

15

20

25

30

35

40

45

50

55

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

5,500Ja

n-08

Mar

May

Jul

Sep

Nov

Jan-

09

Mar

May

Jul

Sep

Nov

Jan-

10

Mar

May

Jul

Sep

Nov

Jan-

11

Mar

May

Jul

Sep

Nov

Jan-

12

Mar

May

Jul

per centHUF Bn

Amount of excessOn-balance-sheet open FX positionOn-balance-sheet open FX position/ Total assets (RHS)Total assets based market share of banks exceeding the 15 per cent limit (RHS)

15percent limit

On-balance-sheet open position of the banking system and the total assets based market share of banks exceeding the 15 per cent limit

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

Source: MNB.

Corporate Household

0

3

6

9

12

15

18

0

1

2

3

4

5

6

2007

Q2

2008

Q2

2009

Q2

2010

Q2

2011

Q2

2012

Q2

2013

Q2

2014

Q2

per centper cent

Loan loss provisioningLoan losses related to the early repayment schemeLoan loss provisioning - forecastNon-performing loan ratio (RHS)

0

5

10

15

20

25

30

0

1

2

3

4

5

6

2007

Q2

2008

Q2

2009

Q2

2010

Q2

2011

Q2

2012

Q2

2013

Q2

2014

Q2

per centper cent

Loan loss provisioningLoan loss provisioning - forecastNon-performing loan ratio (RHS)

28

High NPL ratio may persist amid sluggish portfolio cleaning

Source: MNB.

Cleaning of non performing loans

0

2

4

6

8

10

12

14

16

0

10

20

30

40

50

60

70

802008 Q

2

Q3

Q4

2009 Q

1

Q2

Q3

Q4

2010 Q

1

Q2

Q3

Q4

2011 Q

1

Q2

Q3

Q4

2012 Q

1

Q2

per centHUF Bn

Cleaned loans - households Cleaned loans - corporate

Cleaning ratio - households (RHS) Cleaning ratio - households (RHS)

• 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, particularly in the corporate segment.

• 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)

In evaluating portfolio quality, in addition to the dynamics, the level is also crucial

29

30

Reducing NPL ratio is key

• Reduction of NPL ratio:

1. Through nominator:

• Portfolio cleaning and debtor rescue packages (by reviving loans 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:

a.Higher loan loss coverage may boost portfolio cleaning or

b.Otherwise would make the banking sector safer, though portfolio cleaning would be more sluggish.

31

Loan loss coverage is low in regional comparison

Source: EBCI, MNB.

Note: (1)= 2011Q4, (2)= 2012Q1, (3)= 2012Q2.

Montenegro (1)Albania (1) Serbia (1)

Lithuania (3)

Latvia (2)

Bulgaria (1)Ukraine (3)

Romania (2)

Bosnia and Herzegovina (3)

Hungary (3)

Croatia (3)

Moldova (3)

FYR Macedonia (2)

Poland (1)

Slovakia (2)Czech Republic (2)

Slovenia (2)

Estonia (2)

0

5

10

15

20

20 40 60 80 100

Rati

o o

f non p

erf

orm

ing l

oans

to t

ota

l lo

an

port

folio(%

)

Coverage ratio of non performing loans(%)

NPL ratio and loan loss coverage in international comparison

32

In the case of project loans and restructured foreign currency denominated, insufficient

coverage is plausible

Coverage of non-performing loans - corporate

Coverage of non-performing loans - household

Source: MNB.

0

100

200

300

400

500

600

700

800

0

100

200

300

400

500

600

700

800

NFC Project-finance NFC Project-finance

NPL Restructured (performing)

HUF BnHUF Bn

Value of collaterals Provisions Outstanding amount

0

100

200

300

400

500

600

700

800

0

100

200

300

400

500

600

700

800

HUF EUR CHF HUF EUR CHF

HUF BnHUF Bn

Value of collaterals Provisions Outstanding amount

Non-performing mortgage Restructured mortgage loans passed due less than 90 days

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.

-5

0

5

10

15

20

25

30

-5

0

5

10

15

20

25

30

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

per centper cent

Germany Italy AustriaHungary Bulgaria CroatiaPoland Czech Republic SlovakiaRomania

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Ger

man

y

Belg

ium

Ital

y

Aust

ria

Lith

uani

a

Latv

ia

Slov

enia

Pola

nd

Cze

ch R

epub

lic

Esto

nia

Slov

akia

Bulg

aria

Rom

ania

Hun

gary

per centper cent

34

The interest margin remained high on the performing portfolio

Source: MNB.

Interest margin (based on aggregated individual, non-consolidated data)

2,5

2,6

2,7

2,8

2,9

3,0

3,1

3,2

3,3

3,4

3,5

0

100

200

300

400

500

600

700

800

900

1000

Jan-

09Fe

bM

arAp

rM

ay Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan-

10Fe

bM

arAp

rM

ay Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan-

11Fe

bM

arAp

rM

ay Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan-

12Fe

bM

arAp

rM

ay Jun

per centBn HUF

12-month rolling net interest income

Net interest income as a propotion of the gross interest bearing assets (right-hand scale)

Net interest income as a propotion of the net interest bearing assets (right-hand scale)

• The resilience of the banking sector and thus 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 ….

Credit contraction may persist longer than anticipated

35

36

Financial stability heat map

Source: MNB.

Procyclicality Shock-absorbing capacity

November 2012

April 2012

November 2012

April 2012