1. The Hungarian financial system can make only a limited contribution to the economic recovery Report on Financial Stability November 2010

2. Main messages The recent deterioration in the operational environment of the Hungarian banking sector does not endanger financial stability, due to the adequate capital position of domestic banks and the financial strength of their foreign owners. The strong Swiss franc, bank levy and the upholding of moratorium on foreclosures and evictions have had a negative effect on banks’ income-generating capacity. Due to the loss of regional competitive advantage, the Hungarian banking sector might experience disadvantages in banking-groups’ funding allocation All this adds to the risk that credit supply and, consequently, financial system’s contribution to economic growth might decline further. BUT

3. Main messages along the baseline scenario Following the economic growth, outstanding loans to corporations and households may increase next year, however downside risks may delay the turning- point Portfolio quality has been deteriorating due to the weak performance of project financing in corporate segment, while in household segment due to the pass- through of the strong Swiss franc The loan-loss coverage ratio of non-performing mortgage loans appears to be low Ratio of non-performing loans may slightly exceed 15 per cent next year for both corporations and households at the end of 2011, the cost of provisioning as a percentage of total outstanding loans may peak at around 3 per cent The banking sector’s profitability is deteriorating sharply due to high provisions for loan losses and bank levy, it is low not only in regional comparison but also compared to the performance of parent banks At the systemic level, banks capital position is adequate, the banking sector’s need for capital injection is minimal along the baseline scenario Reliance on external refinancing remains high, while the shortening in maturities emerges as an additional vulnerability

4. Corporate lending contracted, Q3 may suggest a proximity to the turning point (Net quarterly credit flow of corporate loans by the domestic banking sector and other financial intermediaries ) Source: MNB.

5. Non-price credit conditions are not tightened further, however in the last four years credit supply constraints were strengthened Source: MNB.

6. In a regional comparison, Hungary experienced the largest contraction in corporate lending by banks Note: Quarter-on-quarter percentage changes of real GDP; seasonally adjusted data. New loan volumes to non-financial corporations as a percentage of quarterly nominal GDP. Source: Eurostat, national central banks.

7. Net credit flow to households has been declining Source: MNB. (Net quarterly credit flow of corporate loans by the domestic banking sector and other financial intermediaries )

8. Foreign currency lending has virtually disappeared, although due to exchange rate effect the outstanding amount of FX-denominated loans peaked Source: MNB.

9. The decline in banks’ household lending is also the largest in regional comparison Note: Quarter-on-quarter percentage changes in consumption; seasonally adjusted data. Consumer loans from banks to households as a percentage of quarterly nominal GDP. Source: Eurostat, national central banks.

10. Demand for loans may increase next year, but there are marked downside risks regarding the turning point Source: MNB. (Forecast for domestic lending (net flows adjusted for exchange rate effects))

11. Rising NPL ratio in the corporate segment, rising loan losses at project financing Source: MNB.

12. Debt servicing burdens increased significantly for households having Swiss franc denominated mortgage loans Source: MNB.

13. High debt service burden, but the new personal income tax system could help Source: GfK. Note: The income position of 43 per cent of the respondents with bank loan would improve, for 39 per cent of them would worsen, while for 18 per cent of them it would remain unchanged. Hence, on average high income respondents have larger debts, and they will be better off with the tax amendments. Since 50 per cent of the bank loan portfolio is concentrated in wealthy households, the amendments to the taxation system will have a positive effect on portfolio quality on the whole.. (Debt-service-burden to income ratio by households having loan)

14. Rising NPL ratio in each product segment of household lending Source: MNB. (90+ delinquency ratio for certain retail product types)

15. Rising NPL and LTV ratios lead to increasing cost of provisioning Source: MNB.

16. The loan-loss coverage ratio of non-performing mortgage loans is low Source: MNB.

17. Decreasing residential property prices may increase expected loss on mortgage loans (FHB House Price Index) Source: FHB.

18. Cost of provisoning may reach its peak in the baseline scenario at the end of this year Source: MNB. (Projected cost of provisioning in the baseline scenario by sectors)

19. Decreasing profitability, increasing asymmetry Source: MNB.

20. Adequate capital position along the baseline scenario Source: MNB.

21. There is a slowdown in loan-to-deposit ratio adjustment Source: MNB.

22. The reliance of the domestic banking sector on external funding remains high Note: The chart indicates the share of short-term external liabilities by original maturity. The size of the bubbles indicates the ratio of short-term external liabilities to total assets (June 2010). Source: IMF, World Bank, ECB, websites of the central banks.

23. Shortening maturity of external funds is a risk factor Source: MNB.

24. Risks surrounding economic growth and lending Exchange rate of CHF Strong CHF endanger domestic economic growth as well (solvency -RWA, liquidity effect, repayment ability of customers) Regulatory risks The upholding of bank levy has a negative effect on Hungarian banks’ competitiveness (weakened income-generating capacity – issues regarding banking-group funding allocation, higher interest rates on loans in case of pass- through) Foreclosure and eviction moratorium („moral hazard” - ↑ PD, uncertainties about collaterals - ↑ LGD, impairing mortgage covered bond market) External economic outlook remains fragile Increase in sovereign risks Sizeable government debt issuance, raising fears about potential crowding out of the private sector

25. Low profitability not only in regional comparison but also compared to the performance of parent banks Source: MNB.

26. Without easing of credit supply constraints there will be no sustained credit growth Risks Source: MNB. (Forecast for domestic lending (net flows adjusted for exchange rate effects))

27. Due to high capital buffer strong shock-absorbing capacity Comparison of previous and current stress scenarios: In the stress scenario, the ratio of household NPLs will increase in 2011 Along the stress scenario, the additional need for capital injection (~HUF 40 billion) is manageable, however capital buffer decrease significantly Additional capital need indicated in April was also HUF 40-50 billion, since then the Swiss franc has became stronger, bank levy has been introduced, but capital adequacy has became higher Baseline scenario does not, but stress scenario imply need for balance sheet adjustment of the banking system

28. In the stress scenario the cost of provisioning may start to decrease only in 2012 Source: MNB. (Projected cost of provisioning in the baseline and stress scenarios by sectors)

29. The capital adequacy of the banking sector is adequate in both the baseline and the stress scenarios, but... Source: MNB. (The aggregate capital adequacy ratio of the banking system in the baseline and stress scenarios)

30. … along the stress scenario manageable capital need could emerge at individual level Source: MNB. (Capital buffer and additional capital need in the baseline and stress scenarios)

31. Main messages The recent deterioration in the operational environment of the Hungarian banking sector does not endanger financial stability, due to the adequate capital position of domestic banks and the financial strength of their foreign owners. The strong Swiss franc, bank levy and the upholding of moratorium on foreclosures and evictions have had a negative effect on banks’ income-generating capacity. Due to the loss of regional competitive advantage, the Hungarian banking sector might experience disadvantages in banking-groups’ funding allocation All this adds to the risk that credit supply and, consequently, financial system’s contribution to economic growth might decline further. BUT