Hungary's banking sector is likely to demonstrate a slow recovery after enduring a severe stress test in 2009, Fitch Ratings said in a report published on Wednesday.

The stress experienced by Hungary's banks would have been more severe had the sector not benefited from a combined International Monetary Fund (IMF) a and European Union support programme, which together with the Hungarian authorities' tightening fiscal policy, helped to stabilize the sector. However, Fitch notes that fiscal tightening has aggravated Hungary's recession in the short term, Fitch said.

The agency believes that without the IMF/EU support programme, the Hungarian banking system would currently have been in a worse situation, given the macro-economic imbalances, its high share of foreign-currency lending, the funding requirements of such lending and years of rapid loan growth. As a result, the support measures have enabled the banking sector to avoid greater challenges, Fitch said.

"The profitability of major Hungarian banks in 2010 is likely to remain under pressure given depressed revenue generation caused by reduced loan growth and sizeable loan impairment charges as asset quality continues to suffer," says Michael Steinbarth, Senior Director in Fitch's Financial Institutions team based in London. "The banks' heavy reliance on the strong performance of investment in domestic government bonds will also not be sustainable in 2010."

New lending in CHF to households has fallen dramatically since October 2008 as banks changed their lending practices amid the new operating environment. The change has been reinforced by recent regulations issued by the Hungarian Ministry of Finance on retail lending. The regulations stipulate more severe lending criteria for loans in foreign currency by capping the available loan volume and also introduced more restricted loan to value ratios on foreign currency denominated loans compared with local currency loans. As a result, Fitch expects that the loan growth rates seen in the past will not be repeated in the short- to medium-term. In

addition, the regulations do not deal with the existing loan stock in foreign currency, which is sizeable in the case of the Hungarian banking system, accounting for roughly 70pc of total lending, Fitch said.

The average loans/deposits ratio fell to around 151pc at end-2009, from 159pc at end-2008 as a result of reduced lending.

activity and greater efforts to gather customer deposits. While this seems relatively high, Fitch notes that the mortgage bonds in issue reduce some of the re-financing risk as they provide a more long-term source of financing. Nevertheless, the loans/deposits ratio highlights a continued reliance on wholesale funding, which is sourced from either foreign parent banks or the institutional market, Fitch said.

Capital adequacy has improved, but remains modest, in Fitch's opinion, when taking into account contingent risks (from lending in foreign currency) and current multi-national discussions on the changes in capital requirements.