The Magyar Nemzeti Bank has today published the November issue of its Report on Financial Stability. The Report states that the liquidity and capital position of the domestic banking sector is strong. The profitability outlook of the financial system is distressed due to the deteriorating portfolio quality of loans and the high tax burden on banks, thus the sector is not supporting economic growth by lending. Restoring the profitability of the domestic banking sector would greatly contribute to lending and economic growth reinforcing one another. This requires a closer cooperation between the banking sector and the State.

The liquidity and capital position of the domestic banking sector has improved significantly since publication of the April issue of the Report. The outflow of foreign funds remains accelerated, but the appreciation of the forint, the drop in CDS premia, the fall in banks’ FX swap exposure and deleveraging of banks altogether offset it, leading to an improvement in the banking sector’s liquidity position. The short and long-term regulatory liquidity rules, introduced in 2012, contributed to an improvement in the funding structure of the sector’s balance sheet. Capital injections by parent banks absorbed losses; moreover recent injections improved the capital adequacy of the domestic banking sector. However, the banking sector’s profitability is low, many banks have been unprofitable for years and the retained earnings capacity of the sector is persistently weak.

Adequate liquidity position and the resilience of bank capital to shocks are necessary but not sufficient conditions for the fit functioning of the banking system. It is also important that the banking sector supports economic growth via lending. The financial system fulfils its lending function to a very limited extent, due to the weak profitability outlook and lurking risks. Although gauges of lending capacity do not indicate problems, contraction in corporate loans outstanding, owing to low willingness of banks to lend, is exacerbating the recession.

There are a number of obstacles to the improvement in willingness to lend. The protracted debt crisis in the euro-area and the deteriorating domestic economic outlook pose significant perils for the banking sector. Uncertainty over economic outlook is impairing companies’ ability to service their debts, to which banks respond by adopting more cautious lending policies. Furthermore, banks face higher losses as more loans default. At the same time, the rising ratio of non-performing loans as a result of the rapid deterioration in portfolio quality and sluggish portfolio cleaning are raising the required loan loss coverage ratio, as fire sales of collateral may induce plummeting market prices. The sector therefore may come under pressure to set aside higher provisioning, not only for newly impaired, but also for outstanding loans. And, last but not least, the bank levy and the financial transaction tax impose a significant burden on banks, which also weighs on profitability.

Subdued profitability and lurking risks are adding to the banking sector’s procyclical behaviour, which affects both new lending and the outstanding amount of loans. New lending is unlikely to recover in the next two years, pointing to further persistent contraction in loans outstanding. The domestic banking sector is able to partially offset rising losses by raising interest margins and, to a smaller degree, by raising fees. However, rising interest margins imply higher debt servicing burdens for bank customers, which feeding back on the portfolio, is likely to lead to a deterioration in portfolio quality as well as to lower consumption and economic growth.

For these reasons, and in order to support economic growth, it is crucial to restore the profitability of the domestic banking sector and to boost lending. This requires a closer cooperation between the banking sector and the State. Legal and technical factors impeding efficient portfolio management should be reviewed with regulators, supervisory authorities and financial sector participants, with particular regard to the existing liquidation rules. Banks should make efforts to clean up non-performing loans from their balance sheets as quickly as possible, efficiently manage debtors’ problems and ease strict credit supply constraints to the corporate sector. The State could support the rebound in lending by reducing the tax burden on banks and by improving the predictability of the regulatory environment. Voluntary commitment by foreign parent banks related to the EU/IMF agreement aimed at slowing the outflow of parent bank funds would also have a positive impact on domestic lending.

Report on Financial Stability (November 2012)