In the Board’s judgement, the stability of the domestic financial intermediary system is strong. The sector’s capital adequacy ratio rose to 17.4 per cent by the end of the 2013. The results of stress tests conducted by the MNB suggest that, even under a severe but plausible negative scenario, the banking sector’s capital needs to comply with regulatory requirements would amount to HUF 16-18 billion in the period to the end of 2015, which represents a very low risk compared with the capital injections received by banks in the recent period. Based on the results of the liquidity stress test, the banking sector has an adequate liquidity buffer to absorb significant shocks. The sector’s reliance on external funding continues to decrease, with the loan-to-deposit ratio expected to stabilise around 100 per cent in the coming years, after falling to 107 per cent by the end of 2013.

The decline in lending by the domestic banking sector slowed significantly in the second half of 2013, mainly driven by policy rate cuts and the Funding for Growth Scheme; however, the banking sector still does not adequately support sustainable growth. The main reasons lie in the unsound structure of the banking sector’s asset side.

The size and composition of outstanding lending still do not meet the long-term requirements for economic growth. As a positive development, the annual rate of decline in corporate lending has slowed to around 1 per cent from 4-5 per cent in previous years, and the stock of lending to SMEs started to increase from the depressed levels at the beginning of 2013. The Funding for Growth Scheme led to a significant improvement in the structure of outstanding lending to SMEs, resulting in an increase in long-term forint-denominated loans. The role of the Bank and the Government in promoting lending to the corporate sector is important at the current stage of the economic cycle. Nevertheless, robust economic growth would require a rebound in market-based corporate lending and a further easing in credit supply constraints.

Strong precautionary motives by households and the excessive indebtedness of borrowers continue to weigh on forint lending to the household sector. In the future, a prudent recovery in lending will contribute to economic growth. For that, regulatory action is now required in order to prevent excessive, unsound growth in lending to households and to avoid a recurrence of the situation that prevailed prior to the crisis. This can be achieved mainly by imposing a limit on the payment-to-income ratio and the loan-to-value ratio.

Another problem associated with the asset side of the banking sector is the high ratio of non-performing loans. In the corporate segment, the ratio of non-performing loans was 18 per cent at the end of 2013, with commercial real estate accounting for nearly 40 per cent of the distressed portfolio. Although portfolio cleaning accelerated in the final quarter of 2013, this can be considered one-off phenomena attributable to the ECB’s Asset Quality Review. Regulatory action is required to accelerate cleaning of the high stock of non-performing loans from banks’ books. The National Asset Management Agency has made progress in managing non-performing household loans recently, but market-based portfolio cleaning essentially does not work for mortgage loans. The stock of non-performing loans, particularly foreign currency denominated loans, has been rising steadily, while utilisation of the exchange rate cap is only increasingly slowly.

The current structure of the banking sector’s liquid assets appears inadequate in relation to the country’s vulnerability, and through this, the banking sector’s ability to raise funding. The reform of the Bank’s instruments, announced in April 2014, is aimed at encouraging banks to purchase long-term government securities, instead of the main policy instrument. This is expected to contribute to a reduction in the Government’s external debt. Greater involvement of the domestic banking sector, in addition to households, in financing government debt is expected to lead to a reduction in the country’s financial vulnerability and risk premium. Market reactions and developments following the announcement of the self-financing programme suggest that the necessary adjustment has already started.

The banking sector’s low profitability is impeding the development of a sounder asset structure supporting economic growth, although weak profitability is also a consequence of asset-side problems. Furthermore, persistently low profitability may lead to consolidation in the banking sector. This process may be amplified by the fact that, as interest rates are falling and the stock of household loans is contracting, no room remains for improving profitability on the revenue side, and, as a result, cost efficiency may come to the forefront. If this leads to increased concentration, then it may distort competition and exacerbate the risk of systemically important banks.

22 May 2014                                                                                Financial Stability Board