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Moody’s outlook remains negative for the Hungarian banking system

Moody's Investors Service maintains a negative outlook for the Hungarian banking sector, which is being affected by the adverse domestic and global economic conditions weighing on the banks' operating environment.

The outlook also reflects the risks embedded within the system, which can further aggravate these negative pressures. The negative outlook for the Hungarian banks expresses the rating agency's view on the likely future direction of fundamental credit conditions in the industry over the next 12 to 18 months. It does not represent a projection of rating upgrades versus downgrades.

“While Hungarian banks have had only very limited exposure to structured asset classes at risk or to failed financial institutions, the main threats to the banking sector derive from the dramatic downturn of the economy, the large share of foreign currency lending, tight liquidity and the significant volume of foreign currency obligations,” says Gabriel Kádasi, lead analyst for the Hungarian banking system.

The Hungarian banking system is one of the more vulnerable in the Central and Eastern European (CEE) region, partly because the country went into recession already weakened by the 2006 austerity package. Additionally, it regards the country as highly vulnerable to market sentiment, affecting the government's ability to fund itself on the markets and resulting in significant forint weakening between mid-2008 and Q1 2009 as foreign investors sold Hungarian assets. The worsening of the environment and Hungary's ability to cope resulted in the government turning to the IMF for financial assistance and in this period Moody's has twice downgraded the Hungarian government bond rating, in November 2008 and March 2009, to its current level of Baa1 with negative outlook.

With the Hungarian economy in recession, the likelihood of corporate defaults is rising and this will lead to increased losses in banks' corporate loan portfolios. Additionally, the worsening situation on the job market, forint volatility and the potential decline in house prices are also likely to result in increased losses in the retail portfolios. It is expected to significantly weaken the profitability and capital position of most Hungarian banks over the next two years.

The significant forint weakening also highlights the risks linked to the fast growth in lending, which has been driven in recent years by foreign currency loans. With the forint weakening by over 20% against the Euro during Q1 2009, retail clients and smaller companies in particular have started to have difficulties servicing their debts. At the same time, it has become more expensive and difficult for the banks to hedge the open foreign currency positions on their balance sheets or to raise funding.

Although financial fundamentals reported by the banking sector in 2008 were still relatively good - with return on equity declining to approximately 13% from 18% in 2007, rapid deterioration is expected in 2009 and 2010. The weaker economic environment and tight liquidity will affect the banks' ability to sustain revenues at last year's levels, while provisioning is set to increase due to a
worsening of asset quality indicators. “Weaker profitability, and in some cases even potential losses, and increasing risk-weighted asset levels given the rising share of non-performing loans could weigh significantly on the system's capital adequacy,” adds Kádasi.

The Hungarian banking system was only mildly affected by the initial phases of the financial crisis, given the banks' limited exposure to the affected asset classes or failed institutions. However, in the later stages, the credit risk has increased as the crisis has spread into the real economy. In the case of Hungary, these risks are even further inflated, especially in retail lending, by the large share of foreign currency loans that exceeds 60% of the total portfolio, and significant share of asset-based lending due to the large grey economy.

Additionally, the fact that lending growth has in recent years been predominantly funded by wholesale sources, mainly in foreign currency, adds to the system's embedded risks. Nonetheless, despite this pressure on the banking system, Moody's still sees some stabilizing factors. These include the large share of foreign ownership of the Hungarian banking system, the robust and stable franchises of rated banks in their home market and the banks' historically good financial fundamentals, which
could represent a buffer to absorb at least an initial deterioration in asset quality. (Moody's)