## _cr05212

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### Executive summary: key findings
- Financial intermediation deepened since the 2000 FSAP: assets of all financial institutions were 83.1 percent of GDP in 2000 and 106.4 percent of GDP in 2004.
- Financial system more diversified but small by developed-country standards.
- Banks dominant: banks held 69 percent of financial system assets as of end-December 2004; commercial banks accounted for 62.2 percent of financial institutions’ assets in 2004.
- Bank profitability rose sharply; average ROE (after tax) rose from 13.5 percent in 2000 to 25.2 percent in 2004.
- Rapid loan growth raises risk of future increases in non-performing loans.
- Foreign currency denominated loans to unhedged borrowers—primarily households—increased rapidly from a low base, increasing exchange rate-related credit risk.
- Some banks’ interest rate exposures increased due to mortgage growth and introduction of relatively long-duration mortgage bonds after mortgage subsidies.
- Nonbank financial sector grew (financial enterprises: 3 percent of GDP in 2000 to 8 percent of GDP in 2004) but not currently systemic.
- Private pension system shows significant efficiency and transparency issues; payout-phase framework may create future vulnerabilities.
- Supervisory and regulatory reforms since 2000 made good progress; HFSA capacity advanced toward consolidated and risk-based supervision, but further steps and clarification of MOF role vis-à-vis HFSA autonomy are needed.
- Collateral regime seems to work reasonably well; insolvency regime requires reform.
- Gaps remain in the legislative framework for AML/CFT despite strengthening.

### Macroeconomic and external vulnerabilities
- Real GDP growth: 4 percent in 2004, up from 3 percent in 2003.
- Current account deficits estimated at 9 percent of GDP in 2003 and 2004, financed chiefly by borrowing.
- Fiscal deficits and wage rises contributed to the large current account deficit.
- Narrowing interest rate differentials with the euro encouraged unhedged foreign currency borrowing by households and SMEs.
- Slower EU (especially German) growth could present additional vulnerability.
- Policy implication: delays in reducing the budget deficit would pose a risk to financial stability.

### Structure and selected financial sector statistics
- Selected asset levels (in billions of forints):
  - All financial institutions: 10,949.0 (2000), 12,544.0 (2001), 14,677.0 (2002), 18,439.5 (2003), 21,519.1 (2004).
  - Commercial banks: 7,910.4 (2000), 8,290.3 (2001), 8,936.6 (2002), 11,694.3 (2003), 13,392.8 (2004).
  - Financial enterprises: 430.0 (2000), 564.2 (2001), 841.2 (2002), 1,260.8 (2003), 1,637.2 (2004).
- Assets (percent of total financial institutions) in 2004:
  - Commercial banks: 62.2 percent.
  - Financial enterprises: 7.6 percent.
  - Pension & health funds: 6.2 percent (mandatory 3.7 percent; voluntary 2.5 percent).
  - Insurance companies: 6.6 percent.
  - Investment funds: 5.0 percent.

### Risks identified for banks and markets
- Credit risk: potential rise in NPLs from rapid loan expansion, notably household and SME lending.
- Currency risk: rising foreign currency lending to unhedged borrowers increases banks’ exchange rate-related credit risk.
- Interest rate risk: mortgage lending growth and mortgage bond issuance increased duration mismatches for some banks.
- Concentration and cross-border exposure: majority of large financial institutions are subsidiaries of major foreign financial groups; future consolidation may be influenced by parent-group developments.

### Household sector — trends and policy implications
- Household loans expanded from 10 percent to 27 percent of total bank loans between 2000 and 2004; estimated 37 percent when consolidating household loans extended through banks’ financial enterprise subsidiaries.
- Drivers of household lending growth: take-off in mortgage loans in 2002–03 stimulated by mortgage interest subsidy program; more recent rapid expansion in both mortgage and consumer loans.
- Foreign currency lending to households:
  - Share of FX loans to households: less than 15 percent of total household loans as of December 2004, but growing rapidly.
  - Household FX loans recorded in Table 2: n.a. (2000), 0.4 (2001), 0.8 (2002), 1.2 (2003), 3.9 (2004) (percent of total household loans in FX).
- Regulatory changes from January 2005:
  - Banks required to specify risks in contracts for mortgage loans in foreign currency.
  - Banks required to disclose their annual percentage rate charges (APRC) on foreign currency loans.
  - Information on FX risks included on the HFSA’s web page.
- Policy recommendation: continue close monitoring of FX household lending; consider requiring loan applicants be provided information on scale of possible increases in mortgage payments under unfavorable exchange rate scenarios; HFSA should review banks’ assessment and provisioning for FX loans.

### Housing subsidies and mortgage market (Box 2)
- Stock of housing loans: equivalent of 2 percent of GDP in 2001 to 9 percent in 2004.
- Fiscal cost of housing subsidies by 2003: 1 percent of GDP.
- Mortgage bond market: stock of mortgage bonds issued by the three mortgage banks around 6 percent of GDP by end-2004.
- Mortgage loan characteristics and mitigants:
  - More than half of mortgage loans are below HUF 5 million (EUR 20,000).
  - Initial loan-to-value ratios: between 40 and 50 percent.
  - Mortgage foreclosure efficiency: currently effective.
  - Share of non-performing mortgage loans: less than 1 percent.
- Interest rate risk exposures:
  - Commercial banks: asset duration > liability duration → vulnerable to interest rate increases.
  - Mortgage banks: liability duration > asset duration → vulnerable to interest rate declines.

### Corporate sector and FX exposure
- Debt-to-equity ratio of Hungarian non-financial enterprises remained stable.
- Corporate lending shifted toward SMEs; loans by Hungarian banks to corporates grew more slowly than household loans.
- FX corporate loans composition (percent of FX corporate loans): EUR 61.9 (2000), 69.5 (2001), 77.6 (2002), 84.8 (2003), 80.4 (2004); USD 35.6 (2000), 27.8 (2001), 19.3 (2002), 9.8 (2003), 8.3 (2004); CHF 1.7 (2000), 2.6 (2001), 2.8 (2002), 5.3 (2003), 11.2 (2004).
- CHF loans pose higher credit risk given transactions in CHF account for less than 1 percent of total Hungarian exports or imports in 2003.

### Banks — performance, indicators, and operational issues
- Capital adequacy:
  - Regulatory capital to risk-weighted assets: 13.7 (2000), 13.9 (2001), 13.0 (2002), 11.8 (2003), 11.2 (2004).
  - Capital (net worth) to assets: 8.3 (2000), 8.5 (2001), 8.7 (2002), 8.3 (2003), 8.9 (2004).
- Profitability and income structure:
  - ROA (after tax): 1.1 (2000), 1.4 (2001), 1.4 (2002), 1.5 (2003), 2.0 (2004).
  - ROE (after tax): 13.5 (2000), 17.7 (2001), 16.2 (2002), 19.5 (2003), 25.2 (2004).
  - Net interest income to gross income: 68.6 (2000), 67.9 (2001), 68.1 (2002), 65.5 (2003), 85.8 (2004).
  - Noninterest expenses to gross income: 65.2 (2000), 61.8 (2001), 60.4 (2002), 56.4 (2003), 50.2 (2004).
  - Operating costs to assets: around 3 percent (about twice the EU average).
- Asset quality:
  - NPLs to gross loans: 3.0 (2000), 2.7 (2001), 2.9 (2002), 2.6 (2003), 2.7 (2004).
  - Provisions to NPLs: 57.0 (2000), 42.6 (2001), 50.8 (2002), 47.3 (2003), 51.1 (2004).
  - NPLs net of provisions to capital: n.a. (2000), 7.3 (2001), 10.0 (2002), 10.7 (2003), 9.5 (2004).
- Liquidity and funding:
  - Liquid assets to total assets: 31.3 (2000), 29.9 (2001), 24.3 (2002), 19.5 (2003), 21.1 (2004).
  - Loans to deposits: 74.7 (2000), 77.0 (2001), 84.6 (2002), 99.7 (2003), 103.7 (2004).
  - FX liabilities to total liabilities: n.a. (2000), 32.5 (2001), 26.6 (2002), 31.5 (2003), 31.3 (2004).
- Net open position in FX to capital: -0.4 (2000), 6.9 (2001), 2.0 (2002), 2.1 (2003), 5.7 (2004).
- Profit drivers: lending to households and SMEs at wide margins increased net interest income share; new 2005 bank income tax regime: banks may choose either an 8 percentage point higher corporate tax rate—24 percent as compared with 16 percent for other businesses—or a 6 percent tax on net interest income.

### Stress tests — methodology, scenarios, and key quantitative outcomes
- Coverage and method:
  - Tests performed for thirty-two commercial and specialized banks accounting for around 95 percent of total banking assets; conducted by MNB staff using MNB methodology.
  - Tests included sensitivity analyses to interest rate, exchange rate, and credit risks separately, plus two macroeconomic scenarios combining shocks.
- Macroeconomic scenarios:
  - Scenario 1 assumes a simultaneous depreciation of the forint by 30 percent, a parallel upward shift in the forint yield curve by 200 basis points, and a deterioration in the quality of 30 percent of unhedged foreign currency loans (LGD is 50 percent).
  - Scenario 2 assumes a simultaneous depreciation of the forint by 10 percent, a parallel downward shift in the forint yield curve by 100 basis points, and a deterioration in the quality of 5 percent of all loans (LGD is 50 percent).
- Selected stress test results (impact on Tier I Capital; size of shock reported as percent of Tier I Capital; aggregate / best / worst):
  - Interest rate risk — HUF: Parallel upward shift by 500 bp: -5.6 / 228.8 / -58.3.
  - Interest rate risk — HUF: Parallel downward shift by 500 bp: 5.6 / 58.3 / -228.8.
  - Exchange rate risk — HUF: Appreciation by 40 percent: -2.6 / 9.7 / -14.3.
  - Exchange rate risk — HUF: Depreciation by 40 percent: 2.7 / 14.3 / -9.7.
  - Credit risk — Increase in NPAs by 2 standard deviations: -15.2 / 0.0 / -98.5.
  - Credit risk — Increase in NPAs by 100 percent: -14.5 / 0.0 / -42.6.
  - Macroeconomic Scenario 1: -14.5 / 88.5 / -103.1.
  - Macroeconomic Scenario 2: -14.5 / 10.4 / -104.3.
- Distributional outcomes (selected):
  - Baseline CAR distribution (number of banks by CAR buckets): 0 (<6%), 0 (6-7%), 0 (7-8%), 4 (8-9%), 2 (9-10%), 6 (10-11%), 2 (11-12%), 18 (>12%).
  - Under HUF interest rate risk — parallel upward shift by 500 bp: number of banks by CAR buckets: 1, 0, 1, 3, 2, 3, 2, 20; market shares (percent): 20.5, 0.0, 9.8, 18.3, 7.9, 12.3, 4.1, 27.1.
  - Under credit risk — increase in NPAs by 2 standard deviations: number of banks by CAR buckets: 2, 1, 6, 1, 4, 2, 2, 14; market shares (percent): 1.7, 10.8, 30.3, 6.0, 35.0, 3.2, 2.8, 10.2.
- Evolution of selected stress test results, 2000–04 (losses as percent of Tier I Capital for parallel upward shift in forint yield curve by 500 bp): 2000: 4.7; 2001: 5.4; 2002: 9.6; 2003: 10.8; 2004: 24.3.
- Broad finding: majority of banks could withstand substantial shocks, though several banks—including a few large ones—appear vulnerable to interest rate and/or credit risks; credit risk from a substantial forint depreciation is the most significant risk.

### Credit risk, limitations, and stress-test caveats
- Credit risk is the major factor behind relatively high simulated losses; some small banks would suffer losses over 100 percent of Tier I capital under assumed shocks.
- Stress tests based on assumed risk magnitudes and limited time-series data; tests ignore buffering effect of current high profitability and should be viewed as indicative only.
- MNB developments: designing new methodology to assess bank exposure to credit risk via macroeconomic stress tests linking macro variables, borrowers’ solvency, and banking credit losses; plans to combine top-down and bottom-up approaches and rely more on banks’ internal models in future.

### Insolvency and collateral regimes
- Collateral regime: non-court seizure methods developed; collateral regime now seems to work reasonably well; court seizure still time consuming.
- Insolvency regime weaknesses:
  - Reorganization track dysfunctional; no court-led reorganizations recorded in recent years.
  - Creditor rights under liquidation weak; liquidation time consuming and recovery rates low.
  - Deficiencies inhibit corporate lending.
  - Ministry of Justice drafted a concept paper; timetable for reform being established.
  - Recommendation: consider requesting a World Bank assessment of the insolvency framework to refine proposals.

### Nonbank financial institutions, insurance, and pensions
- Nonbank financial institutions:
  - Growing steadily but relatively small; not currently a source of systemic vulnerability.
  - Financial enterprises often act as bank subsidiaries lending (often in Euros) for car purchases and leasing.
- Insurance sector:
  - Total premium reached 3 percent of GDP in 2003.
  - Non-life sector real annual average growth since 2000: 4.4 percent.
  - Sound reserving practices, adequate capital levels, profitability increasing: 6.4 percent of premium in 2003.
  - Portfolio composition conservative and fixed-income heavy; insurers weighted toward government securities.
- Pension funds:
  - Private pension system small but expected to grow; does not constitute a source of vulnerability in accumulation phase.
  - Annual average net rate of return over 1998–2003: about 10.7 percent.
  - Average inflation 1998–2003: 8.6 percent.
  - Average wage growth 1998–2003: 12.7 percent.
  - Pension funds’ portfolio share of government bonds in 1998–2003: about 75 percent.
  - Key issues and recommendations (Box 3):
    - Promote a single revenue collection agency for pension contributions, regulated like a utility monopoly.
    - Consider changing default choice for new members to favor lowest-cost funds or provide standardized fee and return comparisons.
    - Strengthen governance: address conflicts of interest and related-party transactions; enhance board independence.
    - Improve transparency and comparability of fee structures and rates of return.
    - Expand payout-phase menu: allow phased withdrawals and other annuities; share longevity and investment risks; restrict fixed annuities to insurance companies subject to proper regulation.

### Capital markets, payments, and market infrastructure
- Capital markets:
  - Traded government debt: 30 percent of GDP in 2000 to 44 percent of GDP at end-2004.
  - Duration of traded government debt: 1.1 years to 2.2 years with 12- and 15-year issues introduced.
  - BSE market capitalization recovered to 26 percent of GDP after a drop to 18 percent in 2002.
  - Mortgage bonds outstanding: 6 percent of GDP.
  - Corporate and municipal debt nearly nonexistent: 0.1 percent of GDP.
  - Turnover on BSE in 2004: turnover to market capitalization ratio of 50 percent.
  - Recommended legal developments: facilitate instruments for public-private partnerships and municipal finance; make regulatory framework for venture capital fund managers more flexible.
- Payments and settlement systems:
  - Systemically important systems: VIBER, IGS, and KELER.
  - Improvements: extended VIBER opening hours; settlement finality act effective May 1, 2004; MNB oversight competence for securities clearing and settlement systems established.
  - KELER: three-level guarantee system; automated securities lending; RTGS settlement for multiple functions; settlement cycle improvements (SC-T+2 and shortening of other securities to T+3).
  - Emergency and backup arrangements in place; KELER transformed into specialized credit institution as of January 1, 2004; plan to separate CSD and clearing functions.

### Regulatory, supervisory, and crisis-management framework
- Progress since 2000:
  - Substantial reform and harmonization with EU legislation; HFSA operational with expanded risk-based supervisory capacity.
  - Memorandum of understanding for information exchange between HFSA, MOF, and MNB.
- Remaining issues and recommended actions:
  - Further extend risk-based supervision to consolidated banking groups.
  - Clarify extent of MOF oversight of HFSA to strengthen perceptions of HFSA autonomy.
  - HFSA lacks power to issue binding regulations; required regulations issued by MOF.
  - Revise HFSA governance to clarify division between supervisory board and executive management.
  - Strengthen insolvency regime and address AML/CFT legislative gaps.
- Safety nets and crisis management:
  - Deposit insurance: coverage limit raised to HUF 6.5 million with EU entry in May 2004; amounts in excess of HUF 1 million covered only to 90 percent.
  - Financial Stability Committee (FSC) established September 2004 (HFSA, MNB, Ministry of Finance) to promote stability and coordinate crisis management; DIF not a member but governing-body representation exists.

### Key FSAP recommendations (selected)
- Short-term — Banking sector:
  - Increase awareness of risks in unhedged FX borrowing.
  - Ensure credit risks from unhedged FX loans are accurately assessed and provisioned.
- Short-term — Legal and Regulatory framework:
  - Proceed with plans to strengthen the bankruptcy regime.
- Medium-term — Banking sector:
  - Continue development of macroprudential surveillance and macroeconomic stress testing model.
- Medium-term — Legal and Regulatory framework:
  - Extend risk-based supervision to consolidated banking groups.
  - Provide clarity on MOF oversight of HFSA.
- Medium-term — Insurance companies:
  - Conduct in-depth assessment of internal controls as part of move to risk-based on-site supervision.
- Medium-term — Pension funds:
  - Encourage single provider of pension contribution collection services.
  - Ensure fee structures and rates of return are transparent and comparable.
  - Review payout-phase framework to expand pension benefit options.
- Medium-term — Capital markets:
  - Develop legal framework for financial instruments used in public-private partnerships and municipal finance.
  - Make Venture Capital Act requirements more flexible while preserving governance and consumer protection.

*Source: IMF staff—Executive Summary (cr05212) of the Hungary FSAP update.*

### Executive Summary ......................................................................................................

### _cr05212 - Executive Summary ......................................................................................................

### Executive summary: key findings
- Financial intermediation has deepened since the 2000 FSAP: total assets of financial institutions rose from about 80 percent of GDP in 2000 to more than 100 percent of GDP in 2004; assets of all financial institutions were 83.1 percent of GDP in 2000 and 106.4 percent of GDP in 2004.
- The financial system is more diversified but remains small by developed-country standards.
- Banks remain dominant: banks held 69 percent of financial system assets as of end-December 2004; commercial banks accounted for 62.2 percent of financial institutions’ assets in 2004.
- Bank profitability has risen sharply, driven by high-margin lending to households and SMEs, but rapid loan growth raises the risk of future increases in non-performing loans.
- Foreign currency denominated loans to unhedged borrowers—primarily households—have increased rapidly (from a low base), increasing banks’ exposure to borrowers’ exchange rate risk.
- Some banks’ interest rate exposures have increased due to strong growth in mortgage loans and the introduction of relatively long-duration mortgage bonds following generous mortgage subsidies.
- The nonbank financial sector has grown rapidly (financial enterprises rose from 3 percent of GDP in 2000 to 8 percent of GDP in 2004) but remains relatively small and not currently a source of systemic vulnerability.
- The private pension system shows significant efficiency issues: current pension contribution collection arrangements result in high costs for employers and pension funds; the fee structure and rates of return are not transparent and readily comparable; the payout-phase framework may create future vulnerabilities.
- Supervisory and regulatory reforms since 2000 have made good progress; HFSA supervisory capacity has developed toward consolidated and risk-based supervision, but further steps are needed and the MOF’s role in overseeing the HFSA could be clarified to remove doubts about HFSA autonomy.
- The collateral regime seems to work reasonably well, but the insolvency regime requires reform.
- Gaps remain in the legislative framework for AML/CFT despite strengthening.

### Macroeconomic and external vulnerabilities
- Real GDP: increased by 4 percent in 2004, up from 3 percent in 2003.
- Large current account deficits (estimated at 9 percent of GDP in 2003 and 2004) have been financed chiefly by borrowing, raising exposure to global interest rate increases or shifts in foreign investor risk appetite that could cause forint exchange rate or interest rate volatility.
- Fiscal deficits and wage rises have contributed to the large current account deficit; delays in reducing the budget deficit would pose a risk to financial stability.
- Narrowing interest rate differentials with the euro encouraged unhedged foreign currency borrowing by households and SMEs.
- Slower EU (especially German) growth could present an additional vulnerability.

### Structure and recent developments in the financial sector (selected statistics)
- Table 1 highlights selected asset levels (in billions of forints):
  - All financial institutions: 10,949.0 (2000), 12,544.0 (2001), 14,677.0 (2002), 18,439.5 (2003), 21,519.1 (2004).
  - Commercial banks: 7,910.4 (2000), 8,290.3 (2001), 8,936.6 (2002), 11,694.3 (2003), 13,392.8 (2004).
  - Financial enterprises: 430.0 (2000), 564.2 (2001), 841.2 (2002), 1,260.8 (2003), 1,637.2 (2004).
- Assets (in percent of total financial institutions) for selected sectors in 2004:
  - Commercial banks: 62.2 percent.
  - Financial enterprises: 7.6 percent.
  - Pension & health funds: 6.2 percent (mandatory 3.7 percent; voluntary 2.5 percent).
  - Insurance companies: 6.6 percent.
  - Investment funds: 5.0 percent.

### Risks identified for banks and markets
- Credit risk: potential rise in NPLs from rapid loan expansion, notably from loans to households and SMEs.
- Currency risk: rising foreign currency lending to unhedged borrowers increases exchange rate-related credit risk for banks.
- Interest rate risk: growth in mortgage lending and introduction of long-duration mortgage bonds increased some banks’ exposure to interest rate movements.
- Concentration and cross-border exposure: the majority of large financial institutions are subsidiaries of major foreign financial groups; future consolidation of Hungarian subsidiaries may be driven by parent-group international developments as well as domestic developments.

### Nonbank financial institutions and pensions
- Despite rapid growth, NBFIs are not currently systemic; financial enterprises largely act as bank subsidiaries lending (often in Euros) for car purchases and leasing.
- Pension system recommendations focus on improving cost-efficiency and transparency and on reviewing payout-phase arrangements to broaden pension benefit options.

### Regulatory, supervisory, and financial stability framework
- Progress since 2000: substantial reform and harmonization with EU legislation; creation of integrated supervisory agency; expanded risk-based supervisory capacity at HFSA.
- Remaining issues:
  - Further extension of risk-based supervision to consolidated banking groups is needed.
  - Clarify the extent of MOF oversight of the HFSA to strengthen perceptions of HFSA autonomy.
  - Continue to strengthen the insolvency regime.
  - Address important gaps in AML/CFT legislation.

### Key FSAP recommendations (Box 1)
- Short-term — Banking sector:
  - Pursue efforts to increase the awareness of consumers and other bank borrowers of the risks inherent in unhedged foreign currency borrowing.
  - Ensure that the credit risks arising from unhedged foreign currency denominated loans are accurately assessed by banks and appropriately provisioned.
- Short-term — Legal and Regulatory framework:
  - Proceed with the plans to strengthen the bankruptcy regime.
- Medium-term — Banking sector:
  - Continue to develop macroprudential surveillance processes and outputs, including a macroeconomic stress testing model.
- Medium-term — Legal and Regulatory framework:
  - Further extend the risk-based supervision of banks to include supervision of consolidated banking groups.
  - Provide additional clarity regarding the extent of oversight of the HFSA by the Ministry of Finance.
- Medium-term — Insurance companies:
  - Conduct an in-depth assessment of internal controls of insurance companies as a step in the move to risk-based on-site supervision.
- Medium-term — Pension funds:
  - Encourage the establishment of a single provider of pension contribution collection services.
  - Ensure that the fee structure and the rates of return of pension funds are transparent and comparable.
  - Review the framework for the payout phase with a view to expanding the menu of pension benefits.
- Medium-term — Capital markets:
  - Develop the legal framework to facilitate financial market instruments commonly used in public-private partnerships and municipal finance.
  - Make the regulatory framework for venture capital fund managers more flexible.

*Source: IMF staff—Executive Summary (cr05212) of the Hungary FSAP update.*

### 7.      Since 2000, there have been significant changes in the relative importance of

### 7.      Since 2000, there have been significant changes in the relative importance of

### Household sector — trends and risks
- Household loans expanded from 10 percent to 27 percent of the total stock of bank loans between 2000 and 2004, and to an estimated 37 percent of total banking sector loans when consolidating household loans extended through banks’ financial enterprise subsidiaries.
- In 2002–03 the increase in bank lending to households was largely driven by a take-off in mortgage loans, stimulated by the mortgage interest subsidy program.
- More recently both mortgage and consumer loans have expanded rapidly.
- MNB reports higher income households have until now been the main borrowers; competitive pressures are likely to lead to more lending to lower income households.
- Foreign currency lending to households:
  - Share of foreign currency loans to households was less than 15 percent of total household loans as of December 2004, but growing very rapidly.
  - Drivers: winding back of subsidies on forint mortgages, increased spread between effective nominal interest rates on forint loans and interest rates on foreign currency loans, and availability of foreign currency funds from foreign parent banks.
  - Concern: some lack of borrower awareness of exchange rate risks despite steps to publicize these risks.
  - Regulatory changes from January 2005: banks required to specify risks to which borrowers are exposed in contracts for mortgage loans in foreign currency; banks required to disclose their annual percentage rate charges (APRC) on foreign currency loans; information on foreign currency risks included on the HFSA’s web page.
- Policy implication: continued close monitoring of foreign currency household lending warranted; authorities could require loan applicants be provided information on the scale of possible increases in mortgage payments under an unfavorable exchange rate scenario; HFSA may wish to review banks’ assessment of credit risks and provisioning for these loans.

### Household sector — Box 2: Housing subsidies, mortgage developments, stability implications
- Stock of housing loans increased from an equivalent of 2 percent of GDP in 2001 to 9 percent in 2004.
- By 2003, the fiscal cost of housing subsidies had increased to 1 percent of GDP.
- Despite mortgage lending growth, no evidence of a housing price bubble; inflation-adjusted house prices reportedly stable during the past two years.
- Mortgage market features and risks:
  - Subsidies contributed to fragmentation and concentration in credit markets (three mortgage banks channel subsidies and tend to work with specific commercial banks).
  - Subsidies contributed to wider interest margins and solid profitability for banks.
  - Reduced subsidies increased competition in mortgage lending, lowered margins, prompted higher loan-to-value ceilings, and commercialization of broader mortgage products.
  - Banks competing to distribute foreign exchange denominated mortgage loans.
- Mortgage bond market: by end-2004, stock of mortgage bonds issued by the three mortgage banks was around 6 percent of GDP.
- Interest rate risk exposures:
  - Commercial banks: larger holdings of mortgage bonds or direct mortgage lending increased duration of assets relative to liabilities → exposure to interest rate increases.
  - Mortgage banks: asset duration lower than liability duration (higher duration of mortgage bonds versus mortgage loans) → exposure to interest rate declines.
- Credit risk mitigants:
  - Typical mortgage loan amounts: more than half of loans are below HUF 5 million, or EUR 20,000.
  - Initial loan-to-value ratios: between 40 and 50 percent.
  - Mortgage foreclosure efficiency: currently effective.
  - Share of non-performing mortgage loans: less than 1 percent.

### Corporate sector
- Debt-to-equity ratio of Hungarian non-financial enterprises has remained stable in recent years.
- Large Hungarian corporates often have multinational owners and use FDI or loans from banks abroad; loans by Hungarian banks to corporates have grown more slowly than household loans.
- Corporate lending has been shifting towards SMEs.
- Foreign currency lending to corporates:
  - Overall share remained stable, but Swiss franc-based loans increased substantially.
  - Composition of FX corporate loans in December 2004: CHF accounted for 11.2 percent of the total stock of corporate loans in foreign currency, up from 1.7 percent in 2000 (see Table 2).
  - Majority of FX corporate loans still denominated in EUR; Swiss franc loans pose higher credit risk given transactions in CHF account for less than 1 percent of total Hungarian exports or imports in 2003 (limited natural hedges).

### International exposures and funding
- Banks increasingly rely on foreign funding as the share of deposits on liabilities has fallen and the share of foreign currency borrowings from nonresidents has grown.
- Mitigant: much of the foreign funding comes from foreign parent banks and is expected to be relatively stable.

### Banks — performance, strengths, and vulnerabilities
- Banking system indicators:
  - Average capital adequacy ratio (CAR) remains above 11 percent despite some decline in recent years.
  - Profitability improved: average return on equity rose from 13.5 percent in 2000 to 25.2 percent in 2004 (Table 2 shows ROE (after tax): 13.5 (2000), 17.7 (2001), 16.2 (2002), 19.5 (2003), 25.2 (2004)).
  - ROA (after tax): 1.1 (2000), 1.4 (2001), 1.4 (2002), 1.5 (2003), 2.0 (2004).
  - NPLs to gross loans: 3.0 (2000), 2.7 (2001), 2.9 (2002), 2.6 (2003), 2.7 (2004).
  - Provisions to NPLs: 57.0 (2000), 42.6 (2001), 50.8 (2002), 47.3 (2003), 51.1 (2004).
  - NPLs net of provisions to capital: n.a. (2000), 7.3 (2001), 10.0 (2002), 10.7 (2003), 9.5 (2004).
- Profit drivers and fiscal measures:
  - Sharp increase in profits resulted from growth in lending to households and SMEs at wide margins, increasing the share of net interest income in gross income.
  - A new income tax regime for banks from 2005: banks may choose either an 8 percentage point higher corporate tax rate—24 percent as compared with 16 percent for other businesses—or a 6 percent tax on net interest income.
- Operational challenges:
  - High operating costs: average ratio of operating costs to assets in Hungary is around 3 percent (about twice the EU average).
  - Competitive pressures expected to reduce interest margins as inflation and interest rates converge to EU levels, putting pressure to reduce operating costs.
- Credit quality outlook:
  - Rapid lending expansion has not yet raised NPLs significantly, but NPLs may be expected to rise over time as average credit quality could fall.

### Stress tests and scenario vulnerabilities
- Broad finding: majority of Hungarian banks could withstand substantial market or credit shocks, though several banks—including a few large ones—appear vulnerable to interest rate and/or credit risks.
- Most significant risk: credit risk implications of a substantial depreciation in the forint (e.g., from a worsening fiscal situation or an external shock).
  - Banks’ direct FX positions are matched, so direct effects of exchange rate shock would be negligible.
  - However, large depreciation would increase debt servicing costs for unhedged FX borrowers, reducing repayment capacity and household disposable incomes.
  - Loan-to-value ratios for many unhedged FX mortgage loans generally around 40-50 percent.
- Interest rate risk:
  - Large interest rate movements could significantly impact banks heavily involved in mortgage financing.
  - For majority of banks, asset duration > liability duration → vulnerable to interest rate increases.
  - For some (mortgage banks), liability duration > asset duration → vulnerable to interest rate declines.
  - Reportedly banks can partly insulate themselves by delaying interest rate adjustments on assets or liabilities; actual interest rate risks likely smaller than stress tests suggest.
- Recommendation: authorities focusing attention on evolving risks; steps taken to strengthen consumer awareness; further measures could be applied to highlight FX risks to borrowers and to review banks’ provisioning and credit risk assessment.

### Insolvency and collateral regimes
- Collateral regime:
  - Seizure of collateral via courts still time consuming.
  - Non-court seizure methods (clauses detailing lender rights) have been developed and collateral regime now seems to work reasonably well.
- Insolvency regime weaknesses:
  - Reorganization track dysfunctional; no court-led reorganizations recorded in recent years.
  - Creditor rights under liquidation remain weak; liquidation process time consuming and recovery rates low.
  - Deficiencies inhibit corporate lending.
  - Ministry of Justice drafted a concept paper addressing weaknesses; timetable for reform being established.
  - Recommendation: authorities could consider requesting an assessment of the insolvency framework by the World Bank to refine proposals.

### Nonbank financial institutions and insurance
- Nonbank sector:
  - Growing steadily but remains relatively small and not currently a source of systemic vulnerability.
  - Further development encouraged, especially in the private pension system; domestic capital market development would support insurance and pension sectors prior to Euro accession.
- Insurance sector:
  - Total premium reached 3 percent of GDP in 2003.
  - Since 2000, the insurance sector grew modestly, averaging 0.6 percent per annum in real terms.
  - Non-life sector real annual average growth since 2000: 4.4 percent (driven in part by growth in consumer and housing loans and accompanied insurances).
  - Life insurance sector grew much more slowly overall, suffered mild contraction in 2001 due to adverse investment returns for unit-linked life insurance business, but experienced recovery since 2001.

### Key statistics from Table 2 (selected, end of period)
- Capital adequacy:
  - Regulatory capital to risk-weighted assets: 13.7 (2000), 13.9 (2001), 13.0 (2002), 11.8 (2003), 11.2 (2004).
  - Capital (net worth) to assets: 8.3 (2000), 8.5 (2001), 8.7 (2002), 8.3 (2003), 8.9 (2004).
- Asset composition and quality:
  - Annual growth of bank loans: 31.5 (2000), 17.3 (2001), 23.7 (2002), 33.2 (2003), 16.9 (2004).
  - Sectoral distribution of bank loans (in % of total) — Corporates: 70.6 (2000), 65.3 (2001), 53.7 (2002), 49.5 (2003), 48.4 (2004).
  - Sectoral distribution — Households: 10.0 (2000), 14.1 (2001), 19.3 (2002), 24.3 (2003), 27.0 (2004).
  - Sectoral distribution — Other loans: 19.4 (2000), 20.7 (2001), 27.0 (2002), 26.2 (2003), 24.6 (2004).
  - Corporates o/w in foreign currency: n.a. (2000), 22.3 (2001), 18.9 (2002), 20.2 (2003), 21.6 (2004).
  - Households o/w in foreign currency: n.a. (2000), 0.4 (2001), 0.8 (2002), 1.2 (2003), 3.9 (2004).
  - Other loans o/w in foreign currency: n.a. (2000), 14.3 (2001), 16.9 (2002), 18.3 (2003), 17.4 (2004).
  - Denomination of FX loans to corporates (percent of FX corporate loans): EUR 61.9 (2000), 69.5 (2001), 77.6 (2002), 84.8 (2003), 80.4 (2004); USD 35.6 (2000), 27.8 (2001), 19.3 (2002), 9.8 (2003), 8.3 (2004); CHF 1.7 (2000), 2.6 (2001), 2.8 (2002), 5.3 (2003), 11.2 (2004); Other 0.7 (2000), 0.2 (2001), 0.3 (2002), 0.1 (2003), 0.1 (2004).
- Earnings and profitability:
  - ROA (after tax): 1.1 (2000), 1.4 (2001), 1.4 (2002), 1.5 (2003), 2.0 (2004).
  - ROE (after tax): 13.5 (2000), 17.7 (2001), 16.2 (2002), 19.5 (2003), 25.2 (2004).
  - Net interest income to gross income: 68.6 (2000), 67.9 (2001), 68.1 (2002), 65.5 (2003), 85.8 (2004).
  - Noninterest expenses to gross income: 65.2 (2000), 61.8 (2001), 60.4 (2002), 56.4 (2003), 50.2 (2004).
  - Personnel expenses to noninterest expenses: 39.6 (2000), 41.2 (2001), 42.9 (2002), 43.4 (2003), 45.7 (2004).
  - Trading and fee income to total income: 30.0 (2000), 31.2 (2001), 30.4 (2002), 31.4 (2003), 32.8 (2004).
  - Spread between loan and deposit rates: 3.8 (2000), 4.0 (2001), 4.0 (2002), 3.7 (2003), 3.6 (2004).
- Liquidity:
  - Liquid assets to total assets: 31.3 (2000), 29.9 (2001), 24.3 (2002), 19.5 (2003), 21.1 (2004).
  - Loans to deposits: 74.7 (2000), 77.0 (2001), 84.6 (2002), 99.7 (2003), 103.7 (2004).
  - FX liabilities to total liabilities: n.a. (2000), 32.5 (2001), 26.6 (2002), 31.5 (2003), 31.3 (2004).
- Sensitivity to market risk:
  - Net open position in FX to capital: -0.4 (2000), 6.9 (2001), 2.0 (2002), 2.1 (2003), 5.7 (2004).

*Source: IMF staff summary based on the provided IMF document and MNB data.*

### 21.      The performance of the industry has been reasonable overall, as indicated by

### 21.      The performance of the industry has been reasonable overall, as indicated by

### Insurance industry performance
- Sound reserving practices, adequate capital levels, and profitability at satisfactory and steadily increasing levels: 6.4 percent of premium in 2003.
- Portfolio composition of insurers is conservative compared with OECD and EU counterparts, being weighted heavily toward fixed income assets, especially government securities.
- Causes of conservative portfolios include investment policies imposed by foreign parents of local companies and the lack of a wider supply of alternative instruments.

### Pension funds: size, performance, and risks
- The private pension system is still small but is expected to grow more rapidly in the coming years.
- Sector does not constitute a source of financial vulnerability at present because pension funds do not have fixed liabilities and capital at risk in the accumulation phase.
- Potential imbalances could emerge in the payout phase; efficiency issues need examination and addressing.
- Return performance:
  - Annual average net rate of return over 1998–2003: about 10.7 percent.
  - Average inflation over 1998–2003: 8.6 percent.
  - Average wage growth over 1998–2003: 12.7 percent.
  - Pension funds’ portfolio share of government bonds in 1998–2003: about 75 percent.
- Long-run returns expected to be higher, conditional on development of alternative domestic financial instruments.
- Note: Very conservative portfolio composition is attributed to macroeconomic environment, conservative investment culture of asset managers, and lack of alternative instruments; only a few restrictions appear to be binding or close to binding (e.g., the 10 percent limit on mortgage bonds).

### Box 3 — Further development of the pension system (key issues and recommendations)
- Absence of a single provider of pension contribution collection services:
  - Recommend promoting a single revenue collection agency to reduce costs borne by employers, increase transparency, reduce reconciliation costs, and eliminate incentives to register employees with specific associations.
  - Single provider should be regulated like a utility monopoly to avoid monopoly pricing and ensure safety and continuity.
- Default choice for new members:
  - Current default favors regional (higher cost) funds.
  - Changing default to the lowest cost funds could increase competition and efficiency.
  - Alternative: provide new entrants with standardized fee and return comparisons (less effective).
- Inadequate governance framework:
  - Weak rules on conflict of interest and related-party transactions; boards typically dominated by sponsors.
  - When sponsors are related to financial groups, pension associations are typically charged higher management fees.
- Nontransparent and noncomparable fee structure:
  - Fee structure not transparent; asset management fees charged on assets and operating fees on contributions, complicating comparisons.
  - Members lack easy access to standardized, easy-to-interpret industry indicators; annual reports provide fund-level but not industry-level comparable information.
- Nontransparent and noncomparable rates of return:
  - Rates of return not readily comparable: member contributions divided into three reserves and rates calculated only on one reserve.
  - Custodians evaluate assets daily but this information is not used for return calculations.
  - Lack of rules on rebalancing benchmarks impairs performance comparison across asset managers.
- Deficiencies in the payout phase framework:
  - Menu limited to fixed annuities indexed to wages and prices, restricting choice for retirees.
  - Longevity and investment risk currently borne entirely by pension provider; indexation formula compounds investment risk.
  - Recommendations: expand menu to include phased withdrawals and other annuities; share longevity and investment risks between pension funds and annuitant pool; fixed annuities should only be provided by insurance companies subject to proper investment and capital regulations.

### Capital markets: development and remaining gaps
- Growth and diversification since 2000, but some markets remain relatively thin:
  - Traded government debt: grew from 30 percent of GDP in 2000 to 44 percent at end-2004.
  - Duration of traded government debt: increased from 1.1 years to 2.2 years with 12- and 15-year issues introduced.
  - Budapest Stock Exchange (BSE) market capitalization recovered to 26 percent of GDP, after a drop to 18 percent in 2002.
  - Mortgage bonds outstanding stock reached 6 percent of GDP.
  - Derivatives trading expanded, chiefly in futures.
  - Market liquidity for government securities generally decreased.
  - Turnover on the BSE in 2004: turnover to market capitalization ratio of 50 percent.
  - Corporate and municipal debt nearly nonexistent: outstanding stock of only 0.1 percent of GDP.
- Regulatory and institutional improvements:
  - Secondary government securities market has limited daily information disclosure through the Government Debt Management Agency (AKK) website.
  - Financial statement disclosure for publicly traded companies increased from yearly to twice-yearly.
  - Capital Market Act expected to be further changed in July 2005 to harmonize with EU standards.
- Recommended regulatory modifications:
  - Develop legal framework for financial market instruments used in public-private partnerships and municipal finance.
  - Modify Venture Capital Act requirements that force fund investors to pay in capital before investments are identified and that strictly limit fund manager flexibility—adjust to provide more flexibility while preserving governance and consumer protection.

### Regulatory and supervisory framework: strengths and gaps
- Actions since the 2000 FSAP:
  - HFSA issued a range of regulations and recommendations; memorandum of understanding signed between HFSA, MOF, and MNB for information exchange subject to confidentiality.
- Progress toward risk-based supervision:
  - HFSA has made considerable progress, with greatest advances in supervision of banks and securities companies.
  - Risk assessment system for banks could be improved by relying less on historic financial data and more on risks to banks’ future earnings and capital levels.
- Observance of international standards:
  - Regulatory and supervisory framework compares well with relevant international standards.
  - Assessment of insurance supervision against IAIS Insurance Core Principles shows a high level of observance.
  - Factual updates of BCP and IOSCO point to improvements in supervisory capacity.
  - Transparency of regulatory and supervisory framework has improved.
- Remaining gaps and suggested actions:
  - HFSA still has no power to issue binding regulations.
  - Risk assessments of consolidated banking groups should be strengthened.
  - Clarify the role of the MOF in overseeing the HFSA to remove doubts about HFSA autonomy.
  - Revise HFSA governance to produce a more efficient division of responsibilities between supervisory board and executive management consistent with a two-tier corporate governance model.

### Systemic liquidity management
- Improvements since 2000 FSAP:
  - Extended opening hours of the large-value payment system (VIBER) improved daily liquidity management.
  - Legal framework strengthened by removing legal uncertainties regarding pledges, mitigating repo contract risk and aiding money market deepening.
- Interbank market developments:
  - Interbank market continued to deepen and grow; share of repos has yet to increase materially but is expected to rise as banks become more familiar with repos.
  - Day-to-day liquidity forecasting and government debt management could be improved via strengthened information exchange between AKK and the Treasury on primary revenues and expenditures.
- Market liquidity and rates:
  - Growth in turnover in the unsecured interbank market has led to less frequent use of the MNB overnight deposit facility.
  - Market rates generally remained within the band set by the MNB’s overnight lending and deposit rates.
  - Recent trends in lending and deposits reduced banking system liquidity somewhat, but it remains comfortable.
  - Average loan to deposit ratio has risen sharply, reflecting in part an increase in foreign currency denominated loans, but is still not excessive.

### Safety nets and crisis management framework
- Deposit insurance scheme:
  - Well designed and managed; transparency strengthened via an upgraded interactive deposit insurance calculator and claim-tracking on the DIF website.
  - With EU entry in May 2004, DIF coverage limit raised to HUF 6.5 million (slightly higher than the €20,000 equivalent minimum requirement in the EU).
  - Amounts in excess of HUF 1 million are covered only to 90 percent.
- Financial Stability Committee (FSC):
  - Established by HFSA, MNB, and Ministry of Finance in September 2004 to promote financial system stability and coordinate crisis management.
  - DIF is not a member, but the three FSC members have representation in the governing body of the DIF.

### AML/CFT issues
- AML regime significantly strengthened in recent years; most significant step: passage of the revised AML Act in 2003.
- Legislative framework extended to nonfinancial businesses and professions.
- Financial institutions’ compliance with AML requirements is well-supervised and institutions are aware of legal obligations.
- Remaining work: address implementation issues and align with the 3rd E.U. anti-money laundering directive, which authorities intend to follow (directive in final stages of preparation in Brussels).

### Annex — assessments and factual updates
- IAIS Insurance Core Principles assessment undertaken; factual updates of BCP, IOSCO, and CPSIPS were conducted.
- Assessments based on self-assessment by HFSA, reviews of legislation and documentation, interviews with supervisory authorities, meetings with other authorities and independent bodies, and meetings with financial sector firms and associations.

*Source: IMF staff report excerpt (FSAP update).*

### 37.      There is a high level of observance of the Insurance Core Principles (ICP) in

### _cr05212 - 37.      There is a high level of observance of the Insurance Core Principles (ICP) in

### Observance, institutional developments, and engagement
- High level of observance of the Insurance Core Principles (ICP) in Hungary.
- Complete rewrite of the law and regulation since the 2000 FSAP and the operational establishment of the HFSA have contributed substantially to this situation.
- Authorities are significantly engaged in EU and broader international associations in the insurance sector and are well informed and represented in deliberations at this level.

### Supervisory framework: progress and remaining enhancements
- HFSA has made good early progress in the introduction of risk based supervision.
- Areas for enhancement:
  - Strengthening assessment of internal controls and corporate governance at insurers.
  - Progressive (not radical) move to risk based on-site work given varying market participant sophistication in risk management and internal controls.
  - Further development of off-site analysis through deepening market analysis and ongoing refinement of the risk rating system.
  - Empower HFSA to place conditions on licenses and on approvals given under the Insurance Law.
  - Enhance fit and proper oversight as recommended by the Core Principles assessment.

### Conditions for effective insurance supervision — key findings
- Hungary meets the conditions necessary for effective insurance supervision.
- The supervisory system:
  - Principal objectives of insurance supervision clearly defined.
  - HFSA conducts functions in a transparent and accountable manner.
  - HFSA lacks power to issue binding regulations as it is a public administrative body below the level of a government ministry; it issues resolutions and guidelines.
  - Courts have ruled in favor of the HFSA in disputes regarding resolutions, enhancing their role.
- The supervised entity:
  - HFSA should have possibility to set additional prudential requirements when assessing license applicants.
  - Corporate governance framework needs strengthening to cover all types of insurers, clarify roles/responsibilities between governing bodies, and align with international standards.
  - Bicameral governance structure presents interpretation challenges; other jurisdictions have reformed supervisory board roles, not yet fully reflected in Hungary.
  - Establishing a regulation on internal control for insurers would standardize control systems.
- Ongoing supervision:
  - Hungary meets most ongoing supervision requirements.
  - Market analyses could be enhanced by considering wider environmental, forward-looking elements.
- Prudential requirements:
  - Implementation and enforcement of risk-based supervisory methodology will require further developments in risk management procedures in insurers and the HFSA.
  - Current firm control structures not yet at a level to allow solely risk-based, on-site supervision.
  - HFSA could develop guidance on risk management and internal control in investments.
  - Increased supervisory attention needed if insurers start using derivatives.
  - Hungarian capital adequacy requirements based on EU directives; insurers aware of Solvency II developments.
  - HFSA must ensure sufficient supply of necessary skills to cope with Solvency II developments.
- Markets and consumers:
  - Insurance supervision meets requirements for information disclosure to market, intermediaries, and consumer protection.
  - HFSA requires measures to prevent, detect, and remedy insurance fraud.
- Anti-money laundering and combating financing of terrorism:
  - 2003 Act on the Prevention of Money Laundering covers insurance and provides rules for preventing money laundering and combating financing of terrorism.
  - HFSA issued a recommendation to promote prevention of terrorism financing and money laundering.
  - Further efforts needed to improve financial institutions’ capabilities to detect transactions related to money laundering and terrorism financing.

### Table 3 — Recommended Actions (summarized by theme and CP references)
- The supervisory system (CP 2–5)
  - Consider rectifying lack of full regulatory powers for HFSA within Hungarian constitutional framework.
  - Public resolutions could include reasoning (within confidentiality constraints).
  - Agree on a protocol for exchange of information with relevant non-EU insurance supervisors.
- The supervisory system (CP 6–10)
  - HFSA should be able to set additional prudential requirements or other conditions related to authorization when assessing license applicants.
  - Strengthen legislation on fitness and propriety to include obligation to report changes for owners, supervisory/management board members, executive officers, and other senior managers; apply fit and proper requirements equally to all executive officers, including external auditors.
  - Further develop corporate governance framework to cover all insurer types and clarify governing bodies’ roles and responsibilities.
  - Establish a regulation on internal control for insurers to strengthen, standardize, and clarify control requirements.
- Ongoing supervision (CP 11–17)
  - Deepen market analyses to consider wider environmental elements in a forward-looking way.
  - Elaborate off-site monitoring methodology to include indicators for detecting deteriorating conditions relative to prudential benchmarks.
  - Continue developing on-site supervisory methodology toward more risk based supervision, considering insurers’ levels of risk management and internal controls.
- Prudential requirements (CP 18–23)
  - Implementing risk based supervision requires further development of risk management procedures and practices in insurers and the supervisory authority, including review of underwriting and reinsurance strategies and policies.
  - HFSA could develop guidance on risk management and internal control for investments to strengthen key functionaries’ responsibilities and supervision in this area.
  - Monitor derivatives use; supervisory attention needed if insurers start using derivatives.
  - Solvency II developments likely to allow internal models for capital buffer setting, affecting liability valuation, asset-liability matching, and buffer calculation; HFSA must ensure sufficient skilled staff.
- Markets and consumers (CP 24–27)
  - Consider establishing a specialized body to resolve disputes on financial contracts with the power to make binding resolutions.
- Anti-money laundering & combating financing of terrorism (CP 28)
  - Improve capabilities of financial institutions to detect transactions related to money laundering and terrorism financing.
  - Establish a clear legal basis for the obligation to report suspicious transactions relating to the financing of terrorism.

### Authorities’ responses and follow-up
- Authorities broadly agreed with FSAP findings; many areas identified in HFSA self-assessment.
- HFSA has development projects underway and has advanced risk-based supervision methods and on-site inspection approaches.
- Main findings from Authorities:
  - Setting additional license requirements or issuing conditional licenses inconsistent with fundamental principles of Hungarian law; HFSA can arrange requirements during licensing or refuse applications.
  - Comprehensive qualitative standards (corporate governance, internal controls) are still being developed at EU level; fundamental changes expected after Solvency II implementation.
  - Extending corporate governance requirements to small non-profit mutuals is infeasible due to limited human and financial resources.
  - Further development of risk management procedures is contingent on Solvency II outcomes.
- Recommended Actions responses:
  - CP 6–10: see Authorities’ remarks under Main findings and The supervised entity.
  - CP 18–23: see Authorities’ remarks regarding the Solvency II project.

### Factual updates related to Basel Core Principles for Effective Banking Supervision (contextual link)
- Earlier BCP assessments (2000, 2002 update) found banking regulatory framework largely compliant; identified areas needing improvement including regulatory powers, comprehensive risk management requirements, board governance, and remedial action discretion.
- Actions taken since BCP assessment:
  - Issuance of regulations and recommendations; increased flexibility for HFSA remedial actions.
  - Amendments to HFSA Act in April 2004 aimed to strengthen HFSA accountability.
  - HFSA still does not have power to issue binding regulations.
- HFSA reporting and governance changes:
  - MOF responsible for monitoring HFSA; quarterly report to MOF supplementing annual report.
  - HFSA publishes resolutions relating to individual cases with reasoning (confidential data deleted).
  - Since January 2005, HFSA has increased budgetary independence; President can allocate resources within budgetary rules; unbudgeted surpluses can create reserves; certain revenues retained for specified uses.
  - Structural changes in HFSA: creation of five member Board of Supervision with President as Chairman; creation of Director General reporting to the Board with day-to-day management responsibility.
  - Appointment and dismissal procedures described; salary of HFSA President capped at 60 percent of the salary of the President of the MNB.
- HFSA continues to lack power to issue binding regulations; required regulations issued by MOF, which can be time consuming.

*Source: IMF FSAP chapter text provided in content unit _cr05212 - 37.*

### 62.      The 2000 BCP assessment noted the need for a greater focus on the nature and quality

### _cr05212 - 62.      The 2000 BCP assessment noted the need for a greater focus on the nature and quality

### Banking governance, risk management, and supervisory powers
- The banking law required a bank’s board to nominate one director responsible for ensuring the bank’s compliance with reporting requirements for consolidated supervision; precise responsibilities were not clearly specified in law or regulation and have now been specified.
- Since 2000 the HFSA issued a substantial number of clarifying guidelines, including on market risk and internal controls.
- The 2000 BCP assessment recommended:
  - more comprehensive requirements for risk management;
  - more rigorous rules on connected lending and on large exposures.
- Authorities agreed in 2000 on the need to strengthen risk management and took steps in that direction; authorities did not agree that rules on connected lending and large exposures needed strengthening and made no changes to these regulations, noting consistency with EU requirements. The HFSA issued guidelines on credit risk management.
- Information exchange:
  - A memorandum of understanding has been signed between the HFSA, the MOF and the MNB to ensure exchange of necessary information, subject to confidentiality requirements.
  - A tri-partite Financial Stability Committee (HFSA, MOF, MNB) was created to coordinate joint activities (e.g., assessing changes to the insolvency framework).
- Formal supervisory powers:
  - Changes to the HFSA Act increased discretion for remedial actions, allowing more flexible use.
  - The Act previously required certain actions only if regulatory capital fell below prescribed norms for either 60 or 90 days; these time periods were deleted as excessive.

### Securities regulation — IOSCO assessment and developments
- FSAP/Iosco assessment timeline:
  - An initial assessment carried out in 2000 and updated in the FSSA update in February 2002 found Hungary’s securities regulatory regime conformed in most material respects with IOSCO principles.
  - Areas noted for improvement included adequacy of staff resources, coordination of HFSA and Self Regulatory Organizations (SROs) in sanctioning, implementation and enforcement of international principles, and suggested stricter reporting standards for Investment service providers (ISPs).
- HFSA supervisory remit and legislative framework:
  - HFSA has supervisory authority over the Budapest Stock Exchange (BSE), the Budapest Commodities Exchange (BCE), securities intermediaries, and investment fund managers.
  - Following the new Capital Markets Act of December 2001 the HFSA has full responsibility—alongside the BSE and the BCE—with regard to market conduct and sanctioning powers over market participants.
  - HFSA responsibilities guided by Act CXXIV of 1999 and amendments via the 2001 Capital Markets Act (Act CXX) replacing earlier acts (Act CXI of 1996; Act XXXIX of 1994; Act LXIII of 1991).
- Market structure developments:
  - In 2003 BSE became a shareholder company; majority shareholders are the Vienna Stock Exchange and the HVB Bank Hungary.
  - In 2003 the BCE was also transformed into a shareholder company.
  - A merger of BSE and BCE is planned by the end of 2005.
- Progress and outstanding issues by IOSCO principle groups:
  - (CPs 1–5) Regulator: HFSA increased staff and completed a Comprehensive Information Technology System; lack of ability to issue binding regulation remains; ability to retain budgetary surpluses ensured.
  - (CPs 6–7) Self-regulation: Coordination between HFSA and SROs in sanctioning appears workable; HFSA must approve SRO internal rules; on-site operational inspections of SROs remain every two years rather than the recommended not less than once per year.
  - (CPs 8–10) Enforcement: 2003 legislative changes enabled HFSA to conduct reviews per its own inspection plan based on risk; frequency of mandatory comprehensive inspections remains two years; obligation to conduct on-site inspections was removed from the act.
  - (CPs 11–13) Cooperation: ISP reporting requirements are updated annually; HFSA concluded bilateral MOUs with Belgium, Bulgaria, Cyprus, Greece, the Netherlands, and the Slovak Republic; HFSA joined the IOSCO multilateral MOU in 2003.
  - (CPs 14–16) Issuers: No evidence of problems with compliance with accounting and auditing standards; implementation of the Directive on Prospectuses will be effective from July 2005, subject to parliamentary approval.
  - (CPs 25–30) Secondary market: Market Conduct Oversight Department now monitors and investigates market abuse and insider trading; HFSA can impose fines and, where appropriate, transfer cases to the police.

### Payments and settlement systems — CPSIPS assessment and updates
- Systems identified as systemically important: VIBER (large-value payment system), IGS (Interbank Giro System, retail payment system), and KELER (securities settlement system).
- Key findings from 2000 assessment:
  - Need to improve legal underpinning for multilateral netting and the collateral regime.
  - Possible inefficiencies from interdependence of opening hours of VIBER and IGS.
- Operational and legal developments:
  - Distribution of payments between VIBER and IGS depends on functions and user choice; systems are closely linked.
  - Bulk payments processed overnight in IGS on a batch-by-batch basis using daily initial liquidity information; settlement in MNB’s accounting system before VIBER opens.
  - No optimization features to minimize rejected batches existed; since 2003 late payments are allowed to be settled in a special second run during the next day to mitigate IGS operating risk.
  - VIBER opening hours extended by 2 hours; VIBER and TARGET not yet synchronized due to lack of current business need and potential operational burden on banks; plans exist to reorganize the Hungarian retail payment system but details not available.
  - Capital Market Act amended effective beginning of 2003 to establish MNB oversight competence for securities clearing and settlement systems.
  - MNB Act effective May 1, 2004 provides legal basis and explicit competence for MNB oversight of securities clearing and settlement systems.
  - MNB concluded an MOU with HFSA for cooperation on oversight.
  - In 2004 MNB reduced its share in GIRO Rt. (operator of IGS) from 15 percent to 7.5 percent; long-term objective to sell remaining shares as retail payment system will likely become subject to competition following EU Accession.
  - Settlement finality act adopted in 2003 and effective May 1, 2004 removed legal uncertainty around multilateral netting.
  - In 2001 the Act on the MNB removed credit risks for the MNB due to legal uncertainties surrounding pledges; from May 1, 2004 similar conditions apply to interbank money market transactions.
- KELER specifics:
  - KELER acts as central counterparty for spot market transactions on the BSE and derivatives transactions on BSE and BCE.
  - A three-level guarantee system: individual collateral (initial and variation margins), collective guarantee funds, and KELER’s own capital.
  - Automated securities lending system combined with buy-in procedures.
  - Credit facility granted against liquid securities posted as collateral (repos).
  - KELER is the sole provider of inter-institutional clearing and settlement services in Hungary and operates three settlement systems for securities.
  - RTGS-system settles OTC market trades, MNB monetary policy operations, issuing of government papers, and block trades on the BSE.
  - Settlement system for government securities has rolling settlement cycle of two days (SC-T+2).
  - Project for shortening settlement cycle of other listed securities from T+5 to T+3 completed in 2003.
  - Onsite backup facilities in place; emergency plan tested and implemented in Q3 2003; remote disaster recovery facility put into operation in H2 2004.
  - As of January 1, 2004 KELER transformed into a specialized credit institution subject to HFSA supervision.
  - Capital Market Act entrusts MNB with oversight responsibilities for business rules, risk management, and operational reliability of securities clearing and settlement systems.
  - Following an ECB recommendation, authorities plan to separate the central securities depository and clearing house functions of KELER in the near future.

### Status of main 2000 FSAP recommendations (selected)
- I. Regulatory and Supervisory Framework:
  - Enhance autonomy of unified supervisory agency, strengthen supervision of securities markets, and enforce supervisory actions:
    - Changes to legal framework in 2004 improved HFSA accountability but oversight role of the Ministry of Finance could be better clarified.
    - HFSA increasingly focused on risk-based supervision and supervision of conglomerates; legal framework harmonized with EU Directives (status: On-going).
  - Ensure proper entry and exit policies for financial consolidation: Entry and exit policies seem to work reasonably well.
- II. Financial Sector Infrastructure:
  - Improve legal infrastructure for bank lending: Insolvency regime remains weak and creates risks for creditors.
  - Facilitate access of SMEs to financial services: SMEs rapidly gaining access; overall bank lending shifting towards SMEs.
  - Accelerate development of housing finance market: Housing finance boosted by subsidy scheme introduction in 2001; 2003 amendments reduced attractiveness but housing loans, especially in foreign currency, continue to grow rapidly.
  - Stimulate municipal finance market: On-going.
- III. Macroeconomic Policies:
  - Continue cautious macroeconomic policies: Despite solid growth and strong fundamentals, fiscal under-performance in recent years creates some uncertainty in the macroeconomic outlook.
  - Consider faster liberalization of capital outflows: Capital account largely liberalized in mid-2001.

### Stress tests: methodology, scenarios, and results (end-December 2004 data)
- Coverage and methodology:
  - Stress tests designed jointly by MNB and FSAP team; performed by MNB staff using MNB methodology developed after 2000 FSAP.
  - Tests conducted individually for thirty-two commercial and specialized banks, which together account for around 95 percent of the total banking assets in Hungary.
  - Due to legal bank secrecy, results shared with FSAP team in consolidated form.
  - Tests included sensitivity analysis to interest rate, exchange rate, and credit risks separately, plus two macroeconomic scenarios combining shocks.
  - One macro scenario: worsening fiscal situation leading to increase in interest rate, exchange rate depreciation, and indirect effects of depreciation on credit quality.
  - Another macro scenario: external shock (e.g., slowdown in EU GDP growth) leading to depreciation of the forint, a decrease in interest rates, and deterioration in quality of all banking loans.
  - No stress tests for equity price risk because exposure negligible (as of end-December 2004, private sector securities accounted on average for less than 3 percent of the banking sector assets).
- Key quantitative outcomes:
  - Credit risk shock:
    - An increase in nonperforming assets by 2 standard deviations (slightly stronger than doubling current NPAs) would lead to aggregate losses amounting to 15.2 percent of Tier I capital.
    - Under this shock the CAR of nine banks would fall below 8 percent; these banks account for around 40 percent of the banking system; CARs for the large majority of them would still remain above 7 percent.
  - Interest rate risk:
    - Exposure to foreign interest rate risk is low for all Hungarian banks, but a few banks are increasingly vulnerable to a large forint interest rate shock due to duration mismatches related to household mortgage lending.
    - A parallel upward shift in the forint yield curve by 500 basis points could result in CARs for two banks, accounting for around 30 percent of the banking system, falling below 8 percent.
    - A parallel downward shift of the same magnitude could result in CARs for 5 banks, accounting for around 24 percent, falling below 8 percent.
    - Authorities’ research indicates banks can delay interest rate adjustments to some degree on household loans and deposits, insulating them from interest rate risk to a degree.
    - Current very high profit levels provide a buffer to absorb shocks, though increasing competition may reduce this buffer over time.
  - Exchange rate risk:
    - Direct losses from exchange rate shocks are negligible for all banks: a 40 percent shift in the forint exchange rate would lead to direct losses equal to only 2.6 percent of Tier I capital on average for the banking system.

*Italic: IMF FSAP/FSSA update content as presented in the supplied PDF excerpt.*

### 81.      Credit risk is also the major factor in the relatively high losses that banks would

### _cr05212 - 81.      Credit risk is also the major factor in the relatively high losses that banks would

### Credit risk and limitations of the stress tests
- Credit risk is the major factor in the relatively high losses that banks would register under the macroeconomic stress tests.
- Some small banks would suffer losses of over 100 percent of their Tier I capital.
- The assumed shocks for credit risk—including a depreciation in the forint on the performance of unhedged foreign currency loans—represent only a rough approximation of possible deterioration in credit quality.
- The ongoing evolution of the financial system means there is a lack of adequate time-series data, preventing construction of a robust model capturing the relationship between macroeconomic variables, borrowers’ solvency, and banking losses.
- The stress tests reported here are therefore based on assumed risk magnitudes and ignore the buffer that the current high profitability of the banks provides to absorb shocks.
- Conclusion: the tests should be viewed only as indicative of how the banking sector might be affected by adverse credit shocks.

### MNB stress testing framework (Box 5)
- 2000: MNB instituted a stress testing framework based on the 2000 FSAP team approach; first published February 2001 in the MNB’s Report on Financial Stability.
- Key refinements to the MNB framework:
  - (i) Use of a broader variety of stress testing scenarios, including hypothetical scenarios and assessment of effects of market risk changes in opposite directions.
  - (ii) Inclusion of the banking book in the stress test for interest rate shock.
  - (iii) Calculation of exposure to foreign currency risk by major currencies instead of aggregate exposure.
  - (iv) Abandonment of sensitivity stress tests for credit risk when assumptions lost relevance (e.g., assumption of a 50 percent shift of risk-weighted assets into loans) or due to simplicity/ad hoc nature (e.g., assumed increase in NPLs by 100 percent or by two standard deviations).
  - (v) Abandonment of correlated stress tests using Monte Carlo simulations due to unreliability related to lack of sufficient time-series data.
- Current MNB developments:
  - Designing a new methodology to assess bank exposure to credit risk via macroeconomic stress tests capturing relationships between macroeconomic variables, borrowers’ solvency, and banking credit losses.
  - Plans to combine approaches: direct modeling of relationships between macro variables and banking credit losses; modeling default probabilities of non-financial companies relying on individual accounting information or market data.
  - Data constraints: time-series short, full business cycle not covered, ratings of large enterprises absent, few companies listed on stock exchange.
  - Dialogue underway to use a “bottom-up” approach complementing the current “top-down” approach; MNB intends to rely more on banks’ internal models in future.

### Summary of stress test results (selected figures from Table 4)
- Impact on Tier I Capital (Size of shock reported as percent of Tier I Capital; aggregate / best / worst):
  - Interest rate risk — HUF: Parallel upward shift in the yield curve by 500 bp: -5.6 / 228.8 / -58.3
  - Interest rate risk — HUF: Parallel downward shift in the yield curve by 500 bp: 5.6 / 58.3 / -228.8
  - Interest rate risk — EUR: Parallel upward shift in the yield curve by 200 bp: -0.3 / 3.3 / -7.8
  - Interest rate risk — EUR: Parallel downward shift in the yield curve by 200 bp: 0.3 / 7.8 / -3.3
  - Interest rate risk — USD: Parallel upward shift in the yield curve by 200 bp: -0.1 / 0.7 / -0.7
  - Interest rate risk — USD: Parallel downward shift in the yield curve by 200 bp: 0.1 / 0.7 / -0.7
  - Interest rate risk — CHF: Parallel upward shift in the yield curve by 200 bp: -0.1 / 0.1 / -1.6
  - Interest rate risk — CHF: Parallel downward shift in the yield curve by 200 bp: 0.1 / 1.6 / -0.1
  - Exchange rate risk 1/ — HUF: Appreciation by 40 percent: -2.6 / 9.7 / -14.3
  - Exchange rate risk 1/ — HUF: Depreciation by 40 percent: 2.7 / 14.3 / -9.7
  - Exchange rate risk 1/ — EUR: Appreciation by 15 percent: -0.2 / 3.6 / -2.9
  - Exchange rate risk 1/ — EUR: Depreciation by 15 percent: 0.3 / 2.9 / -3.6
  - Exchange rate risk 1/ — USD: Appreciation by 15 percent: 0.0 / 2.4 / -3.2
  - Exchange rate risk 1/ — USD: Depreciation by 15 percent: 0.0 / 3.2 / -2.4
  - Exchange rate risk 1/ — CHF: Appreciation by 15 percent: 0.0 / 2.4 / -0.2
  - Exchange rate risk 1/ — CHF: Depreciation by 15 percent: 0.0 / 0.2 / -2.4
  - Credit risk — Increase in NPAs by 2 standard deviations 2/: -15.2 / 0.0 / -98.5
  - Credit risk — Increase in NPAs by 100 percent: -14.5 / 0.0 / -42.6
  - Macroeconomic scenarios — Scenario 1 3/: -14.5 / 88.5 / -103.1
  - Macroeconomic scenarios — Scenario 2 4/: -14.5 / 10.4 / -104.3
- Memorandum item:
  - Baseline Tier I Capital ratio (in percent of RWA): 11.5 / 72.6 / 6.0
- Notes (as in source):
  - 1/ For each exchange rate shock simulation, other currency cross rates were held constant.
  - 2/ Standard deviation is calculated using the data for the last seven years.
  - 3/ Scenario 1 assumes a simultaneous depreciation of the forint by 30 percent, a parallel upward shift in the forint yield curve by 200 basis points, and a deterioration in the quality of 30 percent of unhedged foreign currency loans (LGD is 50 percent).
  - 4/ Scenario 2 assumes a simultaneous depreciation of the forint by 10 percent, a parallel downward shift in the forint yield curve by 100 basis points, and a deterioration in the quality of 5 percent of all loans (LGD is 50 percent).

### Distributional outcomes (selected findings from Table 5)
- Baseline (before shocks): number of banks by CAR buckets: 0 (<6%), 0 (6-7%), 0 (7-8%), 4 (8-9%), 2 (9-10%), 6 (10-11%), 2 (11-12%), 18 (>12%).
- HUF interest rate risk — Parallel upward shift by 500 bp: number of banks by CAR buckets: 1, 0, 1, 3, 2, 3, 2, 20; market shares (in percent): 20.5, 0.0, 9.8, 18.3, 7.9, 12.3, 4.1, 27.1.
- Credit risk — Increase in NPAs by 2 standard deviations 2/: number of banks by CAR buckets: 2, 1, 6, 1, 4, 2, 2, 14; market shares (in percent): 1.7, 10.8, 30.3, 6.0, 35.0, 3.2, 2.8, 10.2.
- Macroeconomic Scenario 1 3/: number of banks by CAR buckets: 2, 2, 3, 2, 2, 1, 1, 19; market shares (in percent): 1.7, 17.3, 37.4, 15.3, 2.8, 2.9, 0.4, 22.2.
- Macroeconomic Scenario 2 4/: number of banks by CAR buckets: 3, 1, 3, 2, 4, 2, 1, 16; market shares (in percent): 16.0, 7.5, 11.5, 17.0, 13.7, 20.9, 0.6, 12.8.

### Evolution of selected stress test results, 2000–04 (Table 6)
- Parallel upward shift in the forint yield curve by 500 bp 1/: 2000: 4.7; 2001: 5.4; 2002: 9.6; 2003: 10.8; 2004: 24.3
- Depreciation of the forint by 40 percent 1/: 2000: 4.3; 2001: 10.2; 2002: 7.3; 2003: 2.8; 2004: 3.8
- Increase in NPAs by 2 standard deviations 2/: 2000: 31.1; 2001: 19.2; 2002: 13.9; 2003: 14.6; 2004: 15.2
- Notes (as in source):
  - 1/ Losses are defined as gross losses (gains that some banks may incur as a result of interest rate or exchange rate shocks are not included in the calculation).
  - 2/ Standard deviation is calculated using the data for the seven years preceding the year of the shock.

*Source: IMF staff summary of the stress testing results and MNB Box 5 as contained in the provided content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05212.pdf_