1. Vice President International Centre for Bankers Kiev 28 th May 2010 The impact and consequences of the financial crisis on Hungary Erika Marsi INTERNATIONAL TRAINING CENTRE FOR BANKERS

2. Macroeconomic situation: vulnerability First phase: Pre-crisis banking system Lending in FX Second phase: Liquidity crisis Third phase: strong orientation What’s next? AGENDA

3. INTERNATIONAL TRAINING CENTRE FOR BANKERS Macroeconomic situation: vulnerability First phase: Pre-crisis banking system Lending in FX Second phase: Liquidity crisis Third phase: strong orientation What’s next?

4. INTERNATIONAL TRAINING CENTRE FOR BANKERS The Hungarian economic growth was already on a downslide trend before 2008 – the crisis hit an already weakened economy. Annual and quarterly changes in GDP (seasonally adjusted data, per cent) Annual GDP growth rate: stable 4-6% until 2006 Growth is fueled by retail consumption, financed from loans – retail lending is booming Constantly increasing budget deficit EU accession on 1. May 2004 – Governmental adoption of a non-structural reform program in 2006, aiming to decrease budget deficit As a result of the program, GDP growth fell back Source: MNB

5. INTERNATIONAL TRAINING CENTRE FOR BANKERS The weak spot of the Hungarian economy: high external financing need. Net external debt as a percentage of GDP Source: MNB Ratio of external financing is very high 30% of the outstanding government bond stock was financed from foreign sources The foreign indebtedness of the banking system increased even more than that of the governmental, which is basically due to foreign banks financing their Hungarian subsidiaries

6. INTERNATIONAL TRAINING CENTRE FOR BANKERS Hungary is the 5 th worst state in Europe regarding net external debt to GDP. Net external debt as a proportion of GDP, 2008 Source: IFS, Eurostat

7. INTERNATIONAL TRAINING CENTRE FOR BANKERS Hungary’s financial stability could only be maintained as long as external financing was available. High budget deficit and external financing need decreased the efficiency of the monetary policy Monetary policy was restrictive – leading to relatively high HUF interest rates Therefore, FX loans were more popular – further decreasing the room of monetary policy Loose fiscal policy was paired with restrictive monetary policy – the worst combination

8. INTERNATIONAL TRAINING CENTRE FOR BANKERS Macroeconomic situation: vulnerability First phase: Pre-crisis banking system Lending in FX Second phase: Liquidity crisis Third phase: strong orientation What’s next?

9. INTERNATIONAL TRAINING CENTRE FOR BANKERS The Hungarian banking system consists of a big, listed bank and a number of mid-sized banks, subsidiaries of banking groups. The structure of the Hungarian banking system is practically unchanged since 2000: – one big, listed Bank with over 20% market share, – 6 banks with about 6-10% Hungarian market share, subsidiaries of banking groups of the European Union, – The remaining market share is divided between small- and mid sized banks, also subsidiaries of foreign banks, specialising in a segment – Most banks are universal banks, but the market size of Capital market is not significant in Hungary – There are also special credit institutions: mortgage credit institutions, building societies and savings banks – Mainly Austrian, Italian and German bank groups

10. INTERNATIONAL TRAINING CENTRE FOR BANKERS FX lending was becoming more popular in the pre-crisis period Until 2000 the financial penetration to GDP ratio was even below 70%, mainly the retail sector’s financial penetration was low: – Only one bank had a retail portfolio of significant size – Subsidiaries of foreign banks focused on the corporate sector Governmental adoption of interest rate subsidy of housing loans, which did not only boost retail lending, but also the real estate market 2004-2005: interest rate subsidy system is found to be unsustainable – but at that time, banks found out, that retail lending is more profitable than corporate lending Accession to the EU, „obligatory” convergence course higher growth potential expected – financial penetration increased to 100% Interest rate subsidy was decreased, higher HUF interest rates Parent banks gave unlimited access to FX financing FX loans were getting more and more popular

11. INTERNATIONAL TRAINING CENTRE FOR BANKERS Increased competition evolved, leading to higher risk taking and lower expected returns. Equity mortgage loans were also becoming more popular Strong competition, turning into a risk-taking competition: – Increase of loan to deposit ratio – Higher LTV ratios – Lower expected income No classic subprime loans – but some financial products poses similarity (for example loans disbursed without income proof)

12. INTERNATIONAL TRAINING CENTRE FOR BANKERS Increased competition evolved, leading to higher risk taking and lower expected returns. Loan-to-deposit ratios in international comparison Source: ECB, MNB

13. INTERNATIONAL TRAINING CENTRE FOR BANKERS The Hungarian banking system was very profitable before 2008, inciting parent banks to support their subsidiaries. Profitability of the Hungarian bankings system was high between 2000 and 2008: – Improved cost-efficiency – High interest margin – Good credit portfolio quality Risk premia is highly above the margin of the countries of the parent companies

14. INTERNATIONAL TRAINING CENTRE FOR BANKERS The Hungarian banking system was very profitable before 2008, inciting parent banks to support their subsidiaries. Changes in the net interest margin Source: SMNB, ECB EU Banking Sector Stability (Augustus 2009)

15. INTERNATIONAL TRAINING CENTRE FOR BANKERS Macroeconomic situation: vulnerability First phase: Pre-crisis banking system Lending in FX Second phase: Liquidity crisis Third phase: strong orientation What’s next?

16. INTERNATIONAL TRAINING CENTRE FOR BANKERS Although FX loan risk was clear, no regulation was adopted to limit the lending: many, in some cases demagogic explanations were present. The risk of the FX loans was clear for the authorities – although no decision was made to limit FX lending Major „arguments” against the regulation: – FX lending contributed to the growth of housing – Growth of economy, growth of taxes – Borrowers not eligible for HUF loans may get FX loans – Supporters of the regulation want to cause “bad for the people” – Hungary will be part of the Monetary Union – HUF loans bear even more FX risk (!) due to uncertain exchange rate at the adoption of the euro – CHF loans: Switzerland is highly integrated to the EU (carry trade?) Only obligations for risk assessment aimed at consumer protection got into the regulations, which only resulted in customers having to sign one more paper Luckily, JPY loans were successfully regulated

17. INTERNATIONAL TRAINING CENTRE FOR BANKERS Macroeconomic situation: vulnerability First phase: Pre-crisis banking system Lending in FX Second phase: Liquidity crisis Third phase: strong orientation What’s next?

18. INTERNATIONAL TRAINING CENTRE FOR BANKERS The crisis caused a serious liquidity shock in October 2008, Hungary had to turn to IMF to regain the market’s confidence. The crisis shocked Hungary on 8 th October 2008 The Hungarian banks had no access to the swap markets – The FX loans are hedged with FX swaps Even worse: the Hungarian State had no access to foreign funds Meanwhile the foreigners sold the Hungarian government bonds The HUF weakened significantly Result: requesting for IMF (and EU) loan The market confidence was regained at the mid 2009

19. INTERNATIONAL TRAINING CENTRE FOR BANKERS 5-year CDS spreads of selected countries of the region Source: Thomson Reuters The crisis caused a serious liquidity shock in October 2008, Hungary had to turn to IMF to regain the market’s confidence.

20. INTERNATIONAL TRAINING CENTRE FOR BANKERS Although the liquidity crisis has been solved at the end of 2008, the portfolios started to deteriorate due to recession and the weakening HUF rate. The banks’ focus was on liquidity: no new disbursements – No financing for SME-s – further deepening the crisis Strong efforts in deposit collection: the former credit competition has been transformed to a deposit competition The weakening of the HUF Higher risk premia Many high debtor with high LTV The deterioration of the portfolio quality has started at the end of 2008 Parent banks ’ financing CHF and euro swap facilities by the National Bank The liquidity situation consolidated at the end of 2008 repriced loans (major consumer protection concerns)

21. INTERNATIONAL TRAINING CENTRE FOR BANKERS Macroeconomic situation: vulnerability First phase: Pre-crisis banking system Lending in FX Second phase: Liquidity crisis Third phase: strong orientation What’s next?

22. INTERNATIONAL TRAINING CENTRE FOR BANKERS As the liquidity crisis ended, the banks started to stabilize their portfolios by increasing loan / deposit ratio and decreasing costs and RWA. The liquidity situation has been normalised The new focus on: – Stability of the balance sheet structure – Stability of the activities Improvement of the loan/deposit ratio Decreasing the costs and the RWA Active management of the problematic portfolios The dynamic of the lending has slowed down – Demand problems – Stricter lending norms Risks have been decreased in every area (with the exception of lending activity and credit portfolio quality)

23. INTERNATIONAL TRAINING CENTRE FOR BANKERS As the liquidity crisis ended, the banks started to stabilize their portfolios by increasing loan / deposit ratio and decreasing costs and RWA. Changes in main risk indicators between December 2008 and December 2009 Source: Hungarian National Bank

24. INTERNATIONAL TRAINING CENTRE FOR BANKERS The stricter credit conditions caused a decrease in the corporate loans, which was not stimulated by the state, only by a guarantee program. Decreasing risk exposures: high economic price Corporate loans: - 6.2% (2009) Constrained lending deepened the recession Companies: „there is no credit” – Banks: „there is no credit demand” Hungary: no room for anticyclical fiscal policy But: the state owned guarantee program’s importance raised 2009: 13% of the SME bank loans were covered with state guarantee

25. INTERNATIONAL TRAINING CENTRE FOR BANKERS Composition of the net borrowing of corporations from domestic banks The stricter credit conditions caused a decrease in the corporate loans, which was not stimulated by the state, only by a guarantee program. Source: Hungarian National Bank

26. INTERNATIONAL TRAINING CENTRE FOR BANKERS Factors contributing to changes in corporate credit standards and conditions The stricter credit conditions caused a decrease in the corporate loans, which was not stimulated by the state, only by a guarantee program. Source: Hungarian National Bank

27. INTERNATIONAL TRAINING CENTRE FOR BANKERS The structure of new retail loans has changed: no more CHF, only EUR loans with the even more competitive HUF loans together. The retail loans (largely in FX) did not decrease during 2009 But the structure of the newly exposed loans has changed essentially The dominating CHF loans disappeared Euro loans took over the FX loans Stabilization of the budget deficit Low inflation rate The accumulated amount of FX loans is still very high, it can only be changed on long term. cuts in the base rate HUF loans appeared again and are more competitive

28. INTERNATIONAL TRAINING CENTRE FOR BANKERS New loan agreements and total loans by denomination in the banking sector The structure of new retail loans has changed: no more CHF, only EUR loans with the even more competitive HUF loans together. Source: Hungarian National Bank

29. INTERNATIONAL TRAINING CENTRE FOR BANKERS Due to the recession the non performing loans’ proportion increased essentially by the corporate and retail loans as well. The recession of the economy The increase of the unemployment rate Weakening of the HUF rate in early 2009 Even riskier credits before the crisis The main task in 2009 : active portfolio management – Restructuring of credits NPL ratio (loans with more than 90 days delinquency) – corporate loans: 10 % – retail loans: 7% significant increase of the non performing loans

30. INTERNATIONAL TRAINING CENTRE FOR BANKERS Major quality indicators of banks’ corporate portfolio and their distribution Due to the recession the non performing loans’ proportion increased essentially by the corporate and retail loans as well. Source: Hungarian National Bank

31. INTERNATIONAL TRAINING CENTRE FOR BANKERS Major quality indicators of the credit institutions’ household portfolio and their distribution Due to the recession the non performing loans’ proportion increased essentially by the corporate and retail loans as well. Source: Hungarian National Bank

32. INTERNATIONAL TRAINING CENTRE FOR BANKERS The banks focus was on the credit restructuring and cost cutting in 2009. The increasing GDP might be a good sign for the portfolios. Very active credit restructuring - 4% of the retail loans got restructured Government’s measure: interim loan construction for customers getting unemployed or suffering income decrease due to the crisis The corporate loan portfolios are still deteriorating - NPL ratio may reach 15% Positive sign: the GDP is increasing again: 2010 Q1 0,2% growth year/year Important trend: cost cutting OTP’s cost/income ratio decreased from 42% to 34% in 2009 Almost every bank’s cost income is below 50%. Loan/deposit ratio : decreased from 160% to 143% – Due to the strong deposit collection – Still pretty high

33. INTERNATIONAL TRAINING CENTRE FOR BANKERS The profitability of the banks remained high in the international comparison although loan provisions are increasing. The profitability: really good in international comparison too Negative effect: Loan loss provision has been doubled Positive side: Increase of the interest margin Cost cutting Profitability position of the domestic banking sector in regional comparison Source: National central banks

34. INTERNATIONAL TRAINING CENTRE FOR BANKERS The capital adequacy ratio increased due to the less risk weighted assets. Capital adequacy ratio 2008: 11.2% - 2009: 12.8% The capital basis has been also increased (because of the higher profit reserves and issued capital) More important: less risk weighted assets (RWA) Capital adequacy ratio of the banking sector in 2008-2009 and decomposition of its change Source: MNB

35. INTERNATIONAL TRAINING CENTRE FOR BANKERS It’s almost over Macroeconomic situation: vulnerability First phase: Pre-crisis banking system Lending in FX Second phase: Liquidity crisis Third phase: strong orientation What’s next?

36. INTERNATIONAL TRAINING CENTRE FOR BANKERS The bad macroeconomic situation was caused by the irresponsible fiscal and restrictive monetary policy – they must go hand by hand. It was proved: pairing a high net external debt with fiscal “alcoholism” highly increases the vulnerability of the banking sector Even worse: restrictive monetary policy leads to useage of assets outside the scope of the National Bank – The monetary transmission mechanism weakens Example: FX lending - rational for creditors and debtors. The most important safeguard is joint responsibility of the National Bank, the Government and the Financial Services Authority If necessary, this must be guaranteed by legislation, as in Hungary

37. INTERNATIONAL TRAINING CENTRE FOR BANKERS Currently the Basel II regulation is in force in Hungary, which is strongly procyclical and works restrictively during crisis. Basel II Capital Regulation is in effect in Hungary (Capital Requirement Directive, CRD) The regulation is strongly procyclical - in case of a crisis the capital requirement increases significantly Therefore banks restricts lending instead of supporting the recovery The capital requirement under second pillar (stress tests) was not appropriately established.

38. INTERNATIONAL TRAINING CENTRE FOR BANKERS The parent banks behaved really well during the liquidity crisis: no Hungarian bank got in trouble. The FX lending and the liquidity shall be regulated – but it can not be procyclical – not with the current circumstances Positive experiences: parent banks will stand for the subsidiaries with financing and capital – they will review the regional strategy – The region was worth to finance: due its convergence and developing potential of the financial intermediary – They were right in that, but perhaps not that right

39. INTERNATIONAL TRAINING CENTRE FOR BANKERS The regulation’s focus will be on the locally stable operation – but it shall not be too strict to limit growth opportunities. Financing and lending shall be stable even more locally – for international groups too Globalised financial system - safe local operation Currently: restrictions everywhere (ideas or suggestions) Banking will be much more regulated and boring Danger : the regulation shall not limit the banks’ basic functions – financing the economy, – financing the extra needs of the developing countries

40. INTERNATIONAL TRAINING CENTRE FOR BANKERS Thank you for your kind attention! emarsi@bankarkepzo.hu