1988 to 3.8% in 1989 and 3.6% in 1990. There was a general increase in nominal ROAs in 1989, but not in 1990 despite the acceleration of inflation from 17% to 29% (Figure 4).

The large nominal spread of small and medium-size banks is primarily explained by the high rate of inflation and their low leverage. The nominal ROAs are translated into nominal ROEs of between 30% and 35%. For 1990 when consumer prices rose by 29%, the real ROE was just 3.8%, adequate but far from impressive. However, the real ROE was much higher at 11 % in 1988 and 1989 when inflation was around 17%.

Applying the ROE analysis set out in Annex 2 shows that with a leverage of 4.3 and inflation of 17% in 1989, the required nominal ROA for small ana z'edium-size banks for a 10% targeted real ROE would be 6.7%. With leverage rising to 5.5 but inflation accelerating to 29% in 1990, the required nominal ROA for the same targeted real ROE would rise to 7.6%. As already noted, nominal ROAs for small and medium-sized banks fell from 7% in 1989 to 6.4% in 1990.

As the large banks operate with much higher leverage, their lower nominal ROA is translated into a much higher nominal ROE of over 50%. Before allowing for the possible need for increased provisions against loan losses, this produced in 1990 a real ROE of 18% and as high as 28% or more in earlier years'. With a leverage of 11 and inflation of 17%, the required nominal ROA for a 10% targeted real ROE was 2.6% in 1989 instead of the realized 4.4%. In 1990, the leverage of the large banks increased slightly to 12 but with inflation accelerating to 29%, the required nominal ROA rose to 3.5% against a realized one of 4.3% (always assuming a targeted real ROE of 10%).

These levels of real profitability would be very high by intemational standards. However, the true level of real profitability would be much lower if current levels of provisioning were inadequate for covering loan losses from nonperforming loans. Nevertheless, a preliminary conclusion that emerges from this analysis of the NBH data is that the large Hungarian banks either have larger volumes of nonperforming loans than provided for or earn unusually high profits. The argument that the high level of nominal spreads is fully explained by the high leve! of inflation and low degree of leverage is not supported by these data.

To help refine the assessment of bank profitability, financial data were compiled for a subset of Hungarian banks for which IAS data were available. These cover seven banks (the four large commercial banks, two joint venture banks and the NSB) and largely corroborate the above results, although they also underscore some important differences. The [AS data for the four large commercial banks give a (pre-tax) nominal ROA in 1990 of 3.2%. This is 110 basis points lower than the corresponding figure based on NBH data. Among other things, this reflects larger provisioning charges and deduction of some accrued interest.

8 The relationship between spreads, leverage and inflation is discussed in Annex 2.

9 NBH data do not offer any indication of gains resulting from the revaluation of assets. With inflation running at nearly 30 %, revaluation gains on fixed assets, trade investments and equity holdings could cover anything between a quarter and a half, if not more, of the erosion of the real value of book equity.

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