European banks face strain in Hungary Already feeling the stress of the eurozone debt crisis, European banks now face further strain in Hungary, where deteriorating public finances and hostile government policies are testing their appetite for a once-lucrative market. Western European lenders control about 80 per cent of the Hungarian banking sector. Austrian banks, in particular, have charged in, looking for emerging market-style returns right on their doorstep. Austria's Raiffeisen Bank International and Erste Group have built up large presences, alongside Belgium's KBC, and Italy's Intesa Sanpaolo and UniCredit. After years of growth, their gamble looks like it may be a losing one. The nationalist-tinted government of Viktor Orbán has targeted banks since it took office in May 2010, blaming them for prompting the financial crisis. Lenders are now enduring new political and economic uncertainty prompted by a fight pitting Mr Orbán against Hungary's central bank - and causing concerns in the European Union and International Monetary Fund, from which it is seeking a financial backstop. In some ways, banks" recent Hungarian troubles resemble their eurozone travails: plunging market confidence has caused the value of Hungarian sovereign debt to tumble, potentially leaving a hole on balance sheets of banks with large bond holdings. Junk-rated 10-year government paper now yields about 10 per cent, up from 7 per cent in September. The fall in bond prices, which have an inverse relationship to yields, also makes it harder for local lenders to raise funds: their credit rating is implicitly tied to the sovereign's. It also hits Hungary's medium-term growth prospects, which attracted banks in the first place. Ewald Nowotny, Austria's central bank governor, acknowledged on Wednesday that Hungary was a "challenge" for the country's banks, but insisted they could withstand it. "Austrian banks have adequate capital coverage, which means they are not in any danger," he said. The political turmoil has also caused the Hungarian forint to tumble from Ft270 to the euro last summer to around Ft310 now. That lowers banks" euro-denominated profitability. But the impact of currency swings is far greater in Hungary. From about 2005, banks aggressively issued loans denominated in foreign currencies, particularly Swiss francs. These came with lower interest rates, but a sizeable currency risk, which has now blown up. Nearly two-thirds of outstanding loans are priced in foreign currency, according to the central bank. The forint's fall has caused the loans" value in forints to spike. As a result, non-performing loans have exceeded 20 per cent, double the figure in other central and eastern European countries. Temporary measures passed by the government in September moved much of the burden of tidying up the mess onto banks. Lenders were forced to allow loans to be paid off at exchange rates near the levels at which they were originally issued, in spite of the ensuing devaluation. As much as €18bn of mortgages were potentially involved and now municipalities that borrowed a further €4bn-€5bn are angling for preferential repayment rates, bankers say. The scheme resulted in big losses for the banks. Erste last year booked a €762m shortfall because of the measure, plus a special banking tax introduced in 2010. A new agreement last month between banks and the government to deal with foreign exchange mortgages will create losses for banks of as much as €2bn over the next five years, according to Gyorgy Matolcsy, Hungary's economy minister. "The impact of these programmes isn't fully known, and won't be for some time," says Magdalena Stoklosa, analyst at Morgan Stanley. The losses come as many eurozone banks are retrenching. Faced with requests from regulators to bolster balance sheets, they are looking to sell overseas units or simply cut back lending, particularly in non-core markets. "You cannot go to your headquarters asking for the same level of funding as before," says Radovan Jelasity, head of Erste's Hungarian unit. Home supervisors are putting more and more pressure for us to reduce exposure. Another bank boss is blunter: "Banks have limited capital right now. Why should they invest it in Hungary, which has poor growth prospects and a government that comes up with new policies to punish banks every weekend? Many lenders have already indicated they are scaling back, including Erste and Intesa. Raiffeisen's chief executive recently described Hungary as "our problem case" as he discussed market exits in central Europe. European banks are having to make difficult decisions about where to stay invested in the region. Hungary is giving them an excuse to reduce exposure," says Timothy Ash, head of emerging markets research at RBS. Other factors may give banks reasons to pause on pulling out. There are currently few buyers for their Hungarian assets. Looking further out, Hungary's export-oriented economy is far from a basket case. It remains underbanked and in the EU. But while Mr Orbán remains in power, few bankers in Budapest expect a smooth ride. Additional reporting by Neil Buckley in London