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Report on financial stability Márton Nagy MNB Club 26 April 212

Key risks Deteriorating lending capacity stemming particularly from liquidity side raises the risk of a credit crunch, mainly in the corporate sector Strong outflow of external funds in regional comparison continues or accelerates; the outflow may become the cause of subdued lending, instead of consequence Heavy reliance of the banking sector on the FX swap market results in a significant vulnerability Further deterioration in corporate portfolio quality may significantly worsen banks liquidity

The risk of drastic credit contraction = credit crunch Two considerably different cases need to be distinguished Current situation Credit contraction: production capacities decline due to amortisation, investments aimed at replacing amortisation or new invesments fall behind resulting in small decrease in potential GDP Credit crunch: decaying capital stock due to the bankruptcies of viable companies, as a consequence, marked contraction in potential GDP Risk 3

Oct-8 Nov Dec Jan-9 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan-1 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 Severe contraction compared to regional peer countries 115 Corporate lending in international comparison (October 28=1; exchange rate adjusted) 115 11 15 1 95 9 85 8 75 11 15 1 95 9 85 8 75 Romania Bulgaria Poland Slovakia Czech Republic Hungary Euro area Source: Central banks of the countries, MNB. 4

28 Q1 29 Q1 21 Q1 211 Q1 212 Q1 213 Q1 28 Q1 29 Q1 21 Q1 211 Q1 212 Q1 213 Q1 Turnaround in lending is not expected until end- 213 Lending forecast Corporate Household 5 HUF Bn 25 5 HUF Bn 35 4 2 4 28 3 2 1-1 -2 15 1 5-5 -1 3 2 1-1 -2-3 HUF 552.6 Bn HUF 468 Bn 21 14 7-7 -14-21 -3-15 Forecast Actual Annual growth rate (RHS) Forecast Early repayments Annual growth rate (RHS) Actual Exchange rate fixing Source: MNB. 5

Capital position is strong, it is not an underlying risk for credit contraction

28 29 21 211 Losses from early repayment scheme and deterioration in portfolio quality were offset by capital injections of parent banks Factors affecting the cumulative changes in the capital adequacy ratio of the banking sector 5 4 3 2 1-1 -2 age point (11.2%) (12.3%) (13.1%) (12.5%) (13%) age point (13.8) (13.5%) 5 4 3 2 1-1 -2 Share capital and capital reserve Retained earnings and other capital Deductions (excess on limits, holdings in other FIs) RWA (capital requirements on claims) Other capital requirements (market, operational and settlement risk) Cumulative change Note: capital injections of parent banks to their subsidiaries amounted to HUF 35 bn (~EUR 1.2 bn) in end-211 and early 212. Source: MNB. 7

In the stress test, the escalation of euro are sovereign debt crisis is quantified Macroeconomic scenarios in the stress test 212 213 212 213 GDP*.1 1.5-1.1 -.7 Sovereign CDS spread (bp) 546 475 743 811 Yearly average of HUF/EUR exchange rate Yearly average of HUF/CHF exchange rate Baseline scenario Stress scenario 297 331 247 276 Employment* - public sector -2. -.2-2. -.2 Employment* - private sector -.1.5-1. -2. House prices*.. -1. -1. Assumptions on foreign currency denominated mortgage loan schemes (both in baseline and stress scenarios) Ratio of borrowers opting for the new exchange rate cap 9% Ratio of non-performing FX mortgage loans eligible for conversion 2% into HUF Rate of converted loans regaining performing status 5% * yoy age change Source: MNB. 8

Stress test shows strong resilience of banks Distribution of CAR based on number of banks at the end of 212 24 24 2 2 16 (14.6% (15.6%) 16 12 8 (12.2%) Minimum regulatory capital level (11.4%) 12 8 Results of stress test based on 8 regulatory capital requirement 4 4 Baseline scenario Stress scenario Baseline scenario Stress scenario 212 213 Capital adequacy ratio of banking system Vertical stick refers to the interval of 1-9, while rectangle refers to the interval of 25-75 Baseline scenario Stress scenario 212 213 212 213 Capital need of banks (HUF Bn) -12-27 -83 Capital buffer of banks above 8 CAR (HUF Bn) 1,117 1,294 83 691 Total capital buffer (HUF Bn) 1,117 1,282 776 68 Source: MNB. 9

due to the capital injections, balance-sheet adjustment and exchange rate cap scheme Scenarios and results of previous MNB credit risk stress tests HUF/CHF exchange rate baseline/stress scenario CDS spread baseline/stress scenario (basis point) Average of GDP growth rate in stress scenario (per cent) Capital need in stress scenario (HUF Bn) End of stress test horizon April 29 October 29 April 21 November 21 April 211 November 211 April 212 192/221 18/29 188/22 23/234 212/257 237/275 237/275 54/74 22/42 19/39 32/52 26/5 45/74 45/74-1.5-6.3-1.6.1.9 -.4 -.4 3 17 5 5 83 196 83 End of 29 End of 21 End of 211 End of 211 End of 212 End of 212 End of 213 Source: MNB. 1

Deteriorating lending capacity stemming particularly from liquidity side raises the risk of a credit crunch, mainly in the corporate sector Strong outflow of external funds in regional comparison continues or accelerates; the outflow may become the cause of subdued lending, instead of consequence Heavy reliance of the banking sector on the FX swap market results in a significant vulnerability Further deterioration in corporate portfolio quality may significantly worsen banks liquidity

Jun-1 Jul Aug Sep Oct Nov Dec Jan-11 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan-12 Feb Strong outflow of external funds in regional comparison Changes in external funds in international comparison (June 21 =1, exchange rate adjusted) 13 13 12 11 1 9 8 7 6 12 11 1 9 8 7 6 Bulgaria Czech Republic Hungary Romania Poland Note: The outflow of external funds has amounted to HUF 35 bn (~EUR 12 bn) since June 21. Source: ECB, MNB. 13

Jun-1 Jul Aug Sep Oct Nov Dec Jan-11 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan-12 Feb although still heavy reliance on external funding External funds relative to the total assets in international comparison 35 35 3 3 25 25 2 2 15 15 1 1 5 5 Bulgaria Czech Republic Poland Hungary Romania Source: ECB, MNB. 14

A build-up of FX swap exposure points to an excessive outflow of external funds Starting point Assets Liabilities HUF FX HUF FX FX swap (to hedge on-balance sheet FX position) Sound outflow of external funds Assets HUF FX Liabilities HUF FX Repayment of external funds by maturing foreign currency denominated assets Deleveraging FX swap exposure is unchanged Excessive outflow of external funds Assets HUF FX Liabilities HUF FX Repayment of external funds by HUF liquidity FX swap exposure grows 15

1. reason: Pace of the deleveraging in the European banking sector poses a risk Loan-to-deposit ratios on the basis of crisis experiences 15 15 14 14 13 13 12 12 11 11 1 1 9 9 8 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 t+1 Years Scandinavian crisis (91') USA (27) Empirical findings of past crises Euro area (27) Japan (92') Source: Felcser et al (21), Fed, BoJ, ECB. 8 16

Jan-8 Apr-8 Jul-8 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 Apr-1 Jul-1 Oct-1 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 coupled with deteriorating funding environment 5-year CDS spreads of parent banks 7 basis point basis point 7 6 6 5 5 4 4 3 3 2 2 1 1 UniCredit Bayerische Landesbank (MKB) Erste KBC (K&H) Intesa Sanpaolo (CIB) Raiffeisen Source: Bloomberg. 17

Hungary Slovenia Romania Hungary - corrected Italy Bulgaria Belgium Austria Latvia Germany Poland Slovakia Czech Republic Lithuania Estonia 2. reason: Weak profitability of domestic banks may prove to be a significant disadvantage in the competition for external funds After-tax profitability indicators of the banking sector 3 3. 25 2.5 2 2. 15 1.5 1 1. 5.5. -5 -.5 ROE ROA (right-hand scale) Note: Adjusted figure excludes the impact of early repayment scheme and the bank levy. Source: MNB, ECB CDB database. 18

Germany Belgium Italy Latvia Austria Lithuania Estonia Slovenia Poland Czech Republic Hungary Slovakia Bulgaria Romania however profitability can be restored easily due to high interest margins Net interest margin (net interest income / balance-sheet total) 4.5 4.5 4. 4. 3.5 3.5 3. 3. 2.5 2.5 2. 2. 1.5 1.5 1. 1..5.5.. Source: MNB, ECB CDB database. 19

Proposals for slacking the outflow of external funds Maintaining prudent domestic fiscal policy, further credible reduction of government debt Conclusion of the EU/IMF negotiations as soon as possible and strengthening parent bank commitment in funding domestic subsidiaries Restoration of the banking sector s ability to accumulate capital and generate income, improvement of competitiveness 2

An orderly deleveraging can be underpinned by the EU/IMF agreement Benefits of the EU/IMF agreement 1. Banking stabilization 2. Fiscal sustainability The contingent liabilities of the government decrease The reduced general financing requirement facilitates the acquisition of funding for the banking sector IMF credit facility & continued fiscal consolidation The government faces lower risk premia Improved economic stability 21

Jan-4 May-4 Aug-4 Nov-4 Feb-5 May-5 Aug-5 Nov-5 Mar-6 Jun-6 Sep-6 Dec-6 Mar-7 Jun-7 Sep-7 Dec-7 Mar-8 Jul-8 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 Apr-1 Aug-1 Nov-1 Feb-11 May-11 Aug-11 Nov-11 Feb-12 Changes in the on-balance sheet FX position and the FX swap stock hedging it were influenced by volume, composition and exchange rate effect Decomposition of the on-balance sheet FX position of the banking sector and 4, HUF Bn the branches HUF Bn 4, 3, 3, 2, 2, 1, 1, -1, -1, Composition effect Volume effect Exchange rate effect On-balance sheet FX position Note: on-balance sheet FX position is approximately equivalent to outstanding amount of FX swaps. Source: MNB. 23

Oct-8 Nov-8 Jan-9 Feb-9 Mar-9 May-9 Jun-9 Jul-9 Aug-9 Oct-9 Nov-9 Dec-9 Feb-1 Mar-1 Apr-1 Jun-1 Jul-1 Aug-1 Oct-1 Nov-1 Dec-1 Feb-11 Mar-11 Apr-11 Jun-11 Jul-11 Aug-11 Sep-11 Nov-11 Dec-11 Jan-12 Mar-12 The role of MNB is significant in providing foreign exchange liquidity through swaps Outstanding amount of the central bank EUR/HUF swap instruments 2,2 2, 1,8 1,6 1,4 1,2 1, 8 6 4 2 EUR million 6 55 5 45 4 35 3 25 2 15 1 5 Overnight euro-liquidity providing EUR/HUF swap 3-month EUR/HUF swap facility 6-month EUR/HUF swap facility 1-week EUR/HUF swap facility All central bank FX swaps to the total FX swaps (RHS) Source: MNB. 24

Heavy reliance on swap markets poses a serious risk to financial stability Margin call: the margin requirements make banks more sensitive to exchange rate volatility Shorter maturities: FX swap deals has a shorter maturity than that of external funds, resulting in higher roll-over risk Decrease in foreign currency reserves: In case of FX swap market turmoil, or frozen markets, the MNB would intervene, given the utmost importance of them in the transmission mechanism Introduction of a new regulation should be considered to prevent the evolvement of further swap market risks 25

Jun-1 Sep Dec Mar-11 Jun Sep Dec Mar-12 Jun Sep Dec Mar-13 Jun Sep Dec Outflow of external funds, developments in loanto-deposit ratio and FX swap exposure, that are consistent with the lending forecast Banking sector's loan-to-deposit ratio and external funds in the baseline scenario 15 145 14 135 13 125 12 115 11 15 1 EUR Bn 4 36 32 28 24 2 16 12 8 4 Loan-to-deposit ratio External funds (RHS) Note: at external funds, upper boundary shows when external funds are paid back through maturing FX assets and increasing FX deposits (FX swap exposure is unchanged), while lower boundary shows when repayment from higher HUF liquidity, stemming from inflow of HUF deposits or maturing HUF assets is included (FX swap exposure increases). Source: MNB. 26

28 Q1 29 Q1 21 Q1 211 Q1 212 213 The exchange rate cap scheme may help prevent the build-up of new defaults in the household segment Non-performing household loans to total household loans in the banking sector 16 16 14 12 1 8 6 4 2 14 12 1 8 6 4 2 NPL ratio by customers NPL ratio by contracts Source: MNB. 28

28 29 Q1 21 Q1 211 Q1 Distribution at end-211 via eliminating exchange rate risks The partial breakdown of nonperforming FX housing loans according to the probable reasons of default 1,2 CHF million 1, 8 6 4 2 7% 24% 15% 3% 51% Other Employment FX interest rate Exchange rate Term of interaction Source: MNB. 29

27 Q1 28 Q1 29 Q1 21 Q1 211 Q1 212 213 Further deterioration in corporate loan portfolio Non-performing corporate loans to total corporate loans in the banking sector 25 25 2 2 15 15 1 1 5 5 9+ days delinquency ratio Source: MNB. 3

weakens lending capacity through worsening liquidity Capital position does not worsen lending capacity High loan loss coverage ratio Stress tests show strong resilience of banks However liquidity position weaken lending capacity NPL portfolio diverts a vast amount of funds from new lending; It does not create income, and thus impairs the ability to accumulate capital and attract external funds 31

Proposals for the effective management of non-performing loans Faster insolvency procedures Facilitating the transfer of collaterals Dismantling barriers to efficient corporate restructuring (e.g. tax policies) Improving the efficiency of out-of-court agreements 32

Key risks and potential risk mitigating measures The risk of credit crunch Strong outflow of external funds in regional comparison continues or accelerates Heavy reliance of the banking sector on the FX swap market results in a significant vulnerability Further deterioration in corporate portfolio quality may markedly worsen banks liquidity Maintaining prudent domestic fiscal policy Earliest possible conclusion of the EU/IMF negotiations and strengthening parent bank commitment in funding domestic subsidiaries. Restoration of the banking sector s ability to accumulate capital and generate income, improvement of competitiveness Regulatory intervention may be needed Faster insolvency procedures Facilitating the transfer of collaterals, Dismantling barriers to efficient corporate restructuring (e.g. tax policies) Improving the efficiency of out-of-court agreements