BANKING SECTOR DEVELOPMENTS: GOV'T AND BANKS ADAPT

UNCLAS SECTION 01 OF 03 BUDAPEST 001214

SENSITIVE
SIPDIS

DEPARTMENT FOR EUR/CE, EB/OMA, INR/EC
TREASURY FOR ERIC MEYER, JEFF BAKER, LARRY NORTON

E.O. 12958: N/A
TAGS: EFIN ECON PREL HU
SUBJECT: BANKING SECTOR DEVELOPMENTS: GOV'T AND BANKS ADAPT
TO NEW REALITY WHILE SME'S STRUGGLE FOR CREDIT

REF: A. BUDAPEST 1108

B. BUDAPEST 1139

C. BUDAPEST 1059


1. (SBU) Summary. The banking industry is undergoing a rapid
transformation as the financial crisis and global credit
crunch impose new realities on the financial sector in
Hungary. Banks find themselves altering their business
models to reduce loan deposit ratios and improve the quality
of their loan portfolios. The government, meanwhile, is
rushing to pump liquidity into the system even as it tightens
its oversight of the industry. Small businesses, a key
political constituency but viewed as riskier and less
profitable than consumer borrowers, are increasingly finding
themselves caught in the middle and without access to credit.
End summary.

PARLIAMENT PASSES REVISED BANKING ASSISTANCE PACKAGE


2. (U) On December 15, the Parliament passed a revised
version of its banking sector support package, part of the
Stand-by Arrangement with the IMF. The package includes a
fund to guarantee the rollover of loans and wholesale
securities (Liquidity Fund),and a fund to increase the
capital of banks (Capital Enhancement Fund) (ref A). The
revised law expands the number of banks eligible to
participate in the program, and addresses a key concern of
banks by limiting the possibility of the government taking
over management and control of participating institutions.


3. (U) Participation eligibility in the HUF 600 billion (USD
3 billion) package has also been expanded. Under the initial
draft proposal, only three banks met the warranty capital
requirements. This has now been expanded to all credit
institutions registered in Hungary.


4. (U) Banks are in the process of studying the new law, and
have not yet indicated whether they will use the support
package. Many observers believe that a number of banks will
likely use the credit guarantee program, if not the Capital
Enhancement Fund.


5. (U) The IMF welcomed legislation implementing the banking
assistance package in its recent review of economic and
fiscal developments in Hungary, noting that with current
global deleveraging and economic downturn, "it is important
that banks in Hungary have access to the same capital
enhancement and borrowing guarantees as other banks in the
EU."

GREATER GOVERNMENT OVERSIGHT


6. (U) Additional support for the financial sector will be
accompanied, however, by additional regulation and oversight.
As noted in its agreement with the IMF, the government is
working on legislation to strengthen financial sector
regulation and supervision, including expanding the role of
the financial supervisory authority to more actively monitor
and analyze risks to the financial sector, and to provide it
with additional tools to intervene if necessary. Other
measures announced in the IMF agreement include the
introduction of a positive credit registry for households,
introduction of maximum loan-to-value ratio requirements for
new mortgage loans, and close monitoring of foreign exchange
exposures.

SME LENDING HURT BY LOWER LOAN DEPOSIT RATIOS, FOCUS ON
PROFITIBILITY


7. (SBU) A number of bankers have told us that the financial
crisis is rapidly transforming the banking sector in Hungary.
Over much of the last decade, banks enjoyed high levels of
profitability, and were focused primarily on growth and
increasing market share. Today the landscape has changed
considerably, as scarce and more expensive credit and greater
oversight from parent banks is causing banks to focus on
improving the quality of their loan portfolios, reducing loan
deposit ratios, and shedding less profitable business lines.
Unfortunately, small and medium sized enterprises (SMEs) will
likely feel the worst effects of these changes.

LOWER LOAN DEPOSIT RATIOS


8. (SBU) Banks in Hungary maintain comparatively high loan
deposit ratios. In June 2008, the loan deposit ratios of
large banks in Hungary averaged nearly 150 percent, with only

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one major bank having a loan deposit ratio below 100 percent.
When loans exceed deposits, banks must rely on parents or
external sources of funding to cover excess liabilities.
Because of continued scarce and expensive credit, and
possibly instructions from parent banks, banks are reducing
their loan deposit ratios to levels more sustainable in the
current environment.


9. (U) To do so, banks are working hard to increase deposits
on one hand, and are limiting new loans and not renewing
certain existing loans on the other. To increase deposits,
banks are offering high interest rates as a lure to
depositors. K&H Bank, for example, is currently offering
interest rates of over 13 percent for certain deposits (the
Central Bank benchmark is currently 10.5 percent). Other
banks are offering similarly high rates.


10. (SBU) Their efforts appear to be taking affect, but
perhaps in unanticipated ways. The Central Bank reports that
deposits from companies into Euro-denominated accounts rose
over 50 percent in June - October, climbing over HUF 1.4
billion. By contrast, HUF-denominated deposits dropped 4
percent to HUF 1.6 billion.


11. (SBU) Banks are also reportedly tightening lending
standards and reducing the number of riskier and less
profitable loans in their portfolios in order to both reduce
loan deposit ratios and to improve the quality of their loan
portfolios. Consumer lending, while experiencing some
decline, has not been severely impacted, as it is generally
favored over corporate lending because of higher profit
margins and more diffuse risk. Unicredit officials tell us
that international institutions find these operations in
Hungary particularly profitable compared to other European
markets. In the corporate sector, banks favor large
corporate customers over smaller businesses, which are often
viewed as riskier and which generally have lower profit
margins.


12. (SBU) As a result, SME's are facing difficult times
securing financing. Gyorgy Barcza of K&H Bank predicts that
unless the government takes action or liquidity returns to
the market at pre-crisis levels, we will see an increasing
number of small businesses fail because they are unable to
obtain new financing or renew existing loans. Indeed, we are
already hearing anecdotal evidence of this from business
contacts (ref B). SzDSz Party President Gabor Fodor, for
example, told a group of Ambassadors yesterday that he found
"most stores empty ... or not open at all" when he tried to
do his Christmas shopping.

PROVIDING CREDIT TO SME'S


13. (SBU) The Hungarian government and international
institutions recognize the problem and are working to
increase liquidity in the banking sector, with a particular
focus on SME's. Central Bank Governor Andras Simor reports
that about HUF 1,000 billion (USD 5 billion) more liquidity
flowed into the Hungarian banking system in the last quarter
than the previous one, as the mandatory reserve requirement
was lowered from 5 to 2 percent, and banks found new funding
sources. Despite increased liquidity, however, Simor notes
that banks remain risk averse, and are "not getting money out
the door," particularly to SME's.


14. (SBU) Simor believes additional measures are needed to
incentivize banks to use resources where they are most
useful. He admits that this is not ordinarily the role of a
central bank, and that banks should make loans based on their
own business decisions, but notes that "these are not normal
times."


15. (U) The government has already undertaken steps to
encourage loans to small businesses (ref C),including
through micro-credit programs, redirecting EU development
funds to SMEs, and providing financial incentives and loan
guarantees to banks. In addition, the EBRD and the EIB are
making more money available to banks for SME's.


16. (SBU) Comment. Despite statements from banks and
government officials that the banking sector in Hungary
"isn't broken", the financial crisis and current economic
situation is transforming several aspects of the Hungarian
banking industry. For banks, the order of the day is to
improve the quality of loan portfolios, reduce
vulnerabilities, and shed less profitable business lines. On

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the government side, the trend is toward greater regulation
and oversight of the financial sector and toward greater
sensitivity to SME's, which represent a large political base
depite their comparatively modest economic impact. At the
end of the day, these trends may result in a healthier, less
vulnerable financial sector. In the short term, however,
there is a risk that it could further delay the financial
sector "returning to normal", and could have increasing
spillover effects on the real economy. End comment.
Foley