Economy 12 March 2020, 12:50pm

Hungarian banks await massive storm in great shape

Portfolio

2019 may have been the peak year of the current growth cycle of the Hungarian banking sector as the coronavirus threatens to curb economic growth this year. According to statistics released by the National Bank of Hungary (MNB) on Wednesday, credit institutions had an all-time record profit of HUF 698 billion last year at 13% ROE. OTP contributed 59% to the total, while Erste and K&H added 16% each. However, the golden age of lending losses appears to have ended as banks booked higher impairment losses than any time in the past three years and could be facing worse to come. Meanwhile, credit institutions have not made progress in cost efficiency.

As reported yesterday, banks' profit in nominal terms rose 7.7 year on year to a record high in 2019. The MNB also includes OTP's foreign subsidiaries in the statistics, without which Portfolio's calculations show HUF 476 bn profit last year, with OTP's weight dropping from 59% to 40%.

Three banks have released earnings reports for 2019, with the combined profit of OTP (HUF 413 bn), Erste (HUF 60 bn) and K&H (HUF 51 bn) accounting for 75% of banking profit in Hungary last year (63% excluding OTP subsidiaries), indicating high market concentration.

Relatively speaking, 2019 was well behind compared to earlier peaks as the nearly HUF 700 bn profit is more adequate than excellent, representing a 13.1% return on equity in line with previous years.

It is interesting to see which items changed most compared to 2018. As lending activity was high last year, it is not surprising that interest income rose by HUF 95 bn despite low interest rates and margins, while fee and commission income increased to HUF 142 bn, boosted by a dynamic growth in payment transactions. Meanwhile, operating costs were HUF 143 bn higher than a year earlier, and impairment losses grew by a remarkable HUF 58 bn.

The age of reversal of impairment losses appears to have come to an end as impairment exceeded reversals by HUF 91 bn last year, although this was not due to worse loan portfolios but rather because of lower reversals of prior impairment losses.

The loan portfolio was not worse than a year earlier as the ratio of non-performing loans dropped from HUF 1,735 bn to HUF 1,584 bn, with retail and corporate loans both improving in this regard.

Non-performing loans 90 days past due were at pre-crisis levels in 2019, with 2.6% NPL rate in the entire banking sector, 5.2% for households and 2% for non-financial corporations, according to the central bank.

Returning to profitability factors, cost efficiency also merits a mention. Although 2019 was complicated by many one-off events (preparation for instant payment, customer authentication, PSD2 developments, etc.), the fact that cost-to-income ratio (CIR) dropped to 65% will not make the sector proud. This ratio is between 50 and 60% in efficient banking systems and is below 50% at the best Hungarian banks.

Operating income rose 9.1% and operating costs 10.8% last year, although both figures would probably be a few percentage points lower excluding OTP's six new acquisitions last year.

The major driving force behind revenue growth was an increase in lending, with loans growing 22% while deposits, with their miniscule interest costs, grew 18% according to central bank statistics. However, it is worth looking at the numbers cleaned from OTP's acquisitions. According to the MNB's earlier statistics for domestic credit institutions, domestic lending rose 15.2% last year while deposits grew by 9.7%.

The combined balance sheet total of Hungarian banks increased by 18% in 2019, partly owing to OTP's acquisitions. Within assets, receivables from the central bank and other credit institutions grew even more (23%) than lending, while among the key liabilities equity grew the msot besides deposits, by 15% at an 11% rise in the solvency margin. As in parallel with the growth of loans, risk-weighted assets (RWA) grew even more than the solvency margin, the average total capital adequancy ratio (CAR) of the banking sector dropped to 16.9% by the end of 2019 from 18.1% a year earlier.

The capital position of the banking sector is robust despite the above deterioration, and so is its liquidity status. This is reflected to a certain degree by the loan/deposit ratio. The sector as a whole inched closer to 100%, but it is still has quite a distance to cover. In a low interest rate environment credit institutions are unlikely to start a heavy campaign to collect deposits.

As for 2020, risks are a lot higher than only a few months ago. The escalation of the coronavirus outbreak - which is now officially a pandemic, not that definitions matter too much as the virus has been sweeping across the world for weeks - carries various risks for the financial sector. The big question is whether the pandemic will affect banks' lives and performance a lot or only a little this year. The longer the panic the more likely that the effect will be drastic. The main risks are the following:

A business risk: demand for loans may decline, and as a consequence interest and fee and commission income targets may be missed. Areas other than lending could also be hit, but at the same time business (and possibly operational) risks relating to financial transactions are mitigated by the successful launch of instant payment in Hungary on 2 March, which gives electronic payments a competitve edge over the use of cash.
A credit risk: corporations that are exposed the most heavily to the coronavirus-stricken sectors (e.g. tourism) or which are struggling with the disruption of their supply and marketing chains could become insolvent. This could affect primarily smaller businesses that have low liquidity reserves and are not that capital-strong. As the pandemic escalates, the solvency of households affected by a loss of income could also deteriorate. In the medium and long terms, this could lead to the worsening of the banks' portfolio quality, a rise in impairment losses, and an erosion of profits.
A market risk: the revaluation of banks' security portfolios. A drop in government security yields may lead to an exchange gain on liquid securities kept for trading purpuses, while it can bring about a decline in interest income on papers kept until maturity. So, the impact on bank profits is ambigous and the degree of the effect will also vary greatly.
An operational risk: everything you an image the coronavirus can do to human resources, physical infrastructure, logistics, etc. The responses Portfolio has received to its inquiries show that large banks in Hungary are gearing up for the spread of COVID-19 by coming up with and implementing pandemic plans and business continuity planning (BPC). Most of them have set up specific working groups to put together pandemic-related recommendationns and taking certain business decisions. These measures would be aimed mainly at protecting the health of employees, customers and business partners, and also at prevention and the maintenance of business continuity. These aspects of these could cover day-to-day hygiene routines, as well as social contacts, business trips and attendance at events.

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