nonperforming loans of only 13.5 billion HUF. Anything higher than that would cause an erosion of the real equity of the banks'<sup>0</sup> .

Thus, the apparent high spreads leave little room for an increased volume of nonperforming loans. Moreover, there are several reasons to suggest that the banks may not be able to sustain their present spreads. First, as inflation slows down, the banks will benefit less from the current high spreads between average lending rates and rates paid on demand deposits. Second, bank overhead costs will rise as the banks develop their branch networks and install expensive computer systems and banking technology. Third, competition for loan and other business is likely to intensify further. Although spreads have not declined so far despite the increased number of competing banks, this may well change in the future.

Thus, action to tackle nonperforming loans and recapitalize the large banks may be required at an early stage. The Hungarian authorities have already approved the issue of NBH guarantees to cover 50% of bad loans inherited by the large banks in 1987 and estimated at about 21 billion HUF. However, this measure would clearly prove inadequate if nonperforming loans turn out to be much higher than allowed under current provisioning policies.

# **Revenues and Costs**

The data provided by NBH do not contain a detailed breakdown of income and expense items. An analysis of operating income ratios and intermediation spreads is not possible for the whole banking sector. The LAS accounts contain data on costs and revenues for the seven banks for which such accounts are available. However, even IAS data suffer from many disaggregation problems and make difficult a meaningful analysis of revenues and costs. For example, very large expense items appear in some of the financial statements under the heading of "other expenses" or "other operating expenses". The result is that assumptions made regarding the treatment of these expenses greatly influence operating cost ratios.

The data on revenues and costs highlight the following points. First, Hungarian banks have high shares of fee-based incomes. This is partly attributed to the tendency of banks to charge for all types of services that in more mature Western European markets tend to be provided free of charge. Second, joint venture banks operate with unusually low cost/income ratios. Third, the gross income margin of the large banks is divided between a direct cost of intermediation of 5.9% and a cost of capital of 1.8%. And, fourth, the large banks incur a heavy burden of taxation that amounts in total to 3.4% of assets.

to In many developing countries undergoing extensive economic restructuring, it is often argued that nonperforming loans may be as **high** as 30% of total loans and may require a 60% average level of provisioning. Applying these proportions to **the** large Hungarian banks would imply nonperforming loans of 150 billion HUF, an increase of 85 billion HUF over those already provided for. Interest suspension on these loans would amount to 24 billion HUF and required new provisions to 51 billion HUF. These would produce a net loss of 53 billion HUF for 1990 against equity capital of 37 billion HUF. Even before additional provisions, the suspension of interest accral would produce **a** net loss of 2 billion HUF.

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