Financial system stable, but lending activity still low, MNB report reveals

"The resilience of the Hungarian financial system in terms of capital and liquidity is adequate, and has improved markedly since the last report [published in April]," the MNB staff said. "At the same time, the financial system is only performing its function as a financial intermediary to a very limited extent," they added. Banks are expected to behave in a pro-cyclic manner as before, and a noticeable increase in corporate or retail lending stock is not expected until 2015, according to the report. Persistently subdued corporate lending could lead to a contraction in production capacity, weighing on medium- and long-term potential growth, the staff warned in the report.

In spite of a deteriorating lending portfolio, higher risk costs and big fiscal burdens, banks' capital position improved further, the report said. The sector's overall capital adequacy ratio rose to almost 15% at the end of June – nearly double the 8% regulatory minimum –because of the contraction in lending, the firmer forint and big capital injections by parent banks, it explained.

Foreign owners have raised capital by a combined €2.4 billion at their Hungarian units since 2009, including €1.2 billion in 2011 and EUR 800m in 2012, MNB director Márton Nagy said, commenting on the report. Foreign-owned units had paid just 25-30% of profits as dividend before the losses of the past two years.

Nagy said that foreign funds of the Hungarian banking system had dropped from HUF 36 billion in 2009 to €22 billion by August 2012. The outflow, going parallel with the contraction in lending, has accelerated since June, but liquidity risks are still lower, he added, also citing the strong forint, a lower-loan-to-deposit ratio, as well as lower CDS prices and net swap stocks.

Nagy deemed the pace of the adjustment too rapid, citing the resulting cost in terms of growth. He noted that the sector's the loan-to-deposit ratio had dropped to 118% from about 160% in 2008 and could fall to 110% by the end of 2012 and dip under 100% by the end of 2013.

He said net swap stock fell from €12 billion at the end of May to EUR 9 billion by August because of the stronger forint, but was still too high. Stock is at about 10-12% of total assets, with banks with 45% market share still exceeding the 15% of total assets threshold over which systemic risk could increase, he explained, adding that the MNB had started talks with banks on sticking to the 15% threshold.

Outflow of foreign funds from the Hungarian banking sector came to € 4 billion in January-August and could reach more than €6 billion for the full year if as banks' fiscal burden grows, the staff said in the report. The pace of the outflow could slow if Hungary reaches an agreement on a financial backstop with the International Monetary Fund and the European Union, and parent banks agree to slow the pace at which they reduce the financing of their units, it added.

The report noted that corporate lending stock fell by HUF 1,400 billion between January 2010 and the middle of 2012, and the MNB projects stock will be reduced by a further HUF 665 billion by the end of 2014. The staff projects the decline will accelerate for the rest of the year from nearly 6% annually in H1 and slow gradually to about 4% by Q4 2014.

Subdued demand for credit due to the drop in corporate investments and fading business sentiment support the projection, the MNB staff said. As a result of lower corporate profitability, the quality of banks' corporate loan portfolio is expected to deteriorate and risk costs to increase, affecting pricing, they added.

The ratio of non-performing loans (NPLs) rose to 20.9% in corporate segment in Q2 2012, and the MNB projects it will rise to 25.6% in Q2 2014, making additional provisioning necessary.

The staff counted government decisions to postpone a reduction in the bank levy and raise a financial transactions duty among additional negative factors affecting corporate lending. They said a combined 50bp reduction in the central bank base rate in August and September "will probably only be able to offset these factors to a lesser extent".

The report is based on information available until October 10; however, the MNB's Monetary Council decided to reduce the rate by another 25bp to 6.25% at a meeting on October 30.

The staff attributed low levels of retail lending to weak demand stemming from uncertain income outlook and deleveraging of over-indebted households. They added that government-subsidized mortgage loans as well as the reductions in the central bank base rate were expected to "mostly offset" the negative impact of weakening demand for credit and high fiscal burdens on banks.

In the retail segment, the NPL ratio rose to 16.2% in Q2 2012, partly due to steps to clean out portfolios, and is projected to change little until Q2 2014.