The governance of banks in transition economies Hungary country report

2012

Hungary Country Report – 2012 Page 2 of 26

Table of content

Table of content .................................................................................................................... 2

Foreword .............................................................................................................................. 3

A. Methodology and overview of the banking system in Hungary ......................................... 4

1) Methodology ....................................................................................................................... 4

2) Overview of the banking sector in Hungary ....................................................................... 4

B. Key findings .................................................................................................................... 11

1) The strategic and governance role of the board .............................................................. 11

2) Composition and functioning of the board....................................................................... 13

3) Risk Governance ................................................................................................................ 17

4) Internal Control ................................................................................................................. 19

5) Incentives and Remuneration ........................................................................................... 21

6) Transparency to the market and regulators ..................................................................... 22

7) Overall assessment of bank governance quality in Hungary ............................................ 24

This Report does not constitute legal advice. Readers are advised to seek appropriate legal advice before entering into any transaction, making any determination or taking any action related to matters discussed herein. The content of this Report is copyrighted. The assessments and views expressed in the Report are not necessarily those of the EBRD. All assessments and data in the Report are based on information gathered in the course of 2011.

For information or comments please contact Gian Piero Cigna at cignag@ebrd.com

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The team is grateful for the assistance provided by all parties interviewed. In particular, the team would like to acknowledge the precious assistance offered by the law firms Morley Allen & Overy Iroda (http://www.allenovery.com/locations/europe/hungary/en-gb/Pages/default.aspx) Ormai és Társai CMS Cameron McKenna (http://www.cms-cmck.com/Budapest-Hungary).

Hungary Country Report – 2012 Page 3 of 26

Foreword

1. In July 2010, the Legal Transition Team of the EBRD launched a comparative assessment of the corporate governance of banks in its countries of operations. The overall objective of the assessment is to inform and support the EBRD’s policy dialogue with authorities with a view to generating further commitment to improve the corporate governance of banks in EBRD countries of operations. The assessment aims at providing the EBRD with an overview of the legal and regulatory framework governing the corporate governance of banks and how diligently the various rules and best practice guidelines are implemented.

2. The assessment focuses mostly on internal corporate governance arrangements in banks, particularly the role and composition of boards. It analyses the legal and regulatory framework; its implementation by supervisors; and the practices developed by the systemically important banks in each country. The transparency of governance arrangements to the supervisory authority and the markets is also reviewed. While the assessment analyses banks and their boards, and considers ownership structure and patterns in the banking sector, broader governance issues covered in the OECD Principles such as shareholder and stakeholder rights and responsibilities as well as equity market issues are not dealt with in any detail.

3. To enhance the EBRD’s understanding of the corporate governance of banks in countries of operations, countries reviewed are subjectively rated. For this purpose, the legal framework, supervisory practice and banking practice are given an overall score in the overall assessment section of each Country Report. The rating approach is detailed in the box below.

Rating

“Strong to very strong” - The corporate governance framework / practices of supervisory authorities /

practices of banks are fit for purpose and are close to best practice.

“Moderately strong” - Most parts of the corporate governance framework / practices of supervisory authorities / practices of banks are adequate but further reform is needed “Weak” - The corporate governance framework / practices of supervisory authorities / practices of banks contain some elements of good practice but overall the system is in need of reform “Very weak” - The corporate governance framework / practices of supervisory authorities / practices of banks contain significant risks and are in need of significant reform

4. This Country Report is divided in two Sections: (A) Methodology and overview of the banking system; (B) Key findings – describing the strengths and weaknesses of the corporate governance of banks and policy recommendations where appropriate.

Hungary Country Report – 2012 Page 4 of 26

A. Methodology and overview of the banking system in Hungary

1) Methodology

5. The analysis and recommendations contained in this report are based on desk research carried out by the EBRD and responses to written questionnaires sent to two Hungarian law firms; the Hungarian Financial Supervisory Authority (hereafter the ‘HFSA’); and two among the largest banks in the country (‘the banks reviewed’). Responses to the questionnaires were complemented by a desk research of Hungary's legislative framework, webpages of banks reviewed and other on-line information about the country’s banking sector.

Exhibit 1: The eight largest banks in Hungary by share of total banking assets, and listing

Bank name Total Assets

(HUF million) Share of total assets of banking system (%) *

Listing (BSE - Budapest Stock

Exchange)

1. OTP Bank 6,717,325 21.98 BSE

2. Erste Bank Hungary 3,215,327 10.52 no

3. Kereskedelmi és Hitelbank (K&H) 2,895,685 9.48 no

4. MKB Bank

2,696,991 8.83 no

5. CIB Bank 2,502,221 8.19 no

6. Raiffeisen Bank 2,348,890 7.69 no

7. UniCredit Bank Hungary 1,742,495 5.7 no

8. Budapest Hitel- és Fejlesztési Bank 924,774 3.03 no

Total eights largest banks 23,043,708 75.4

Total banking system 30,560,046.181 100

Based on information in the HFSA Golden Book 2011 (http://www.pszaf.hu/data/cms2369078/Golden_Book_2011_j.xls) *(Total Assets of Bank/Total Asset of sector)*100 ‡ According to OTP Bank's website its GDRs are listed on the Luxemburg Stock Exchange and are traded on SEAQ International in London.

2) Overview of the banking sector in Hungary

6. According to HFSA's statistical data about the financial sector for 20121, the Hungarian banking system includes 35 credit institutions operating as joint-stock companies. Out of which, there are 8 largest banks (See Exhibit 1 above), 21 small and medium sized banks, and 6 specialised credit institutions. See Exhibit 2 for more information about Hungary's banking sector.

1 HFSA Credit institutions data for 2012, see at: http://www.pszaf.hu/en/left_menu/pszafen_publication/creditdata.html

Hungary Country Report – 2012 Page 5 of 26

Exhibit 2: Information about the structure of the Hungarian banking sector

Source: BSCEEE Review 2011 (http://www.bscee.org/bins/BSCEE_Review_2011_tcm23-31967.pdf)

7. There are a number of international financial groups operating via their subsidiaries in Hungary. Most of the largest banks in the country are a part of these groups. Out of these, the OTP Group is a Hungarian registered international financial group primarily supervised by the HFSA. For purposes of supervising the other groups, HFSA participates in 21 specially organised supervisory banking colleges comprising the primary supervisory authority and subsidiary supervisory authorities from countries where the group operates.2 See Exhibit 3.

2 HFSA Annual Report 2011, p. 59, see at: http://www.pszaf.hu/data/cms2371932/annual2011_jav3.pdf

Hungary Country Report – 2012 Page 6 of 26

Exhibit 3: Main banking groups participants in Hungary's financial sector and their primary supervisory authorities

Banking groups Home supervisory authorities

OTP group HFSA (HU)

Erste group FMA (AT)

Raiffeisen group FMA (AT)

KBC group (K&H) CBFA (BE)

BLB group (MKB) BaFin (DE)

Intesa Sanpaolo group (CIB) Banca d'Italia (IT)

UniCredit group Banca d'Italia (IT)

Banco Popolare group Banca d’Italia (IT)

Credit Agricole group (Credigen) ACP (FR)

BNP Paribas group (Cetelem) ACP (FR)

Banque PSA Finance group ACP (FR)

Banque Accord group (Oney) ACP (FR)

RCI Banque group ACP (FR)

Commerzbank group BaFin (DE)

DZ Bank group (Takarékbank, Fundamenta) BaFin (DE)

HSBC group FSA (UK)

Volksbank group FMA (AT)

Bank Burgenland group FMA (AT)

Porsche Bank group FMA (AT)

Branch offices

Deutsche Bank group BaFin (DE)

ING group De Nederlandsche Bank (NL)

Source: HFSA Annual Report 2011, page 61-62

8. Hungarian banks may be organised as joint stock companies, i.e. private or public limited companies (private [Zrt.] or public [Nyrt.])3, and cooperatives. All Hungarian banks are organised as joint stock companies. The vast majority of credit institutions are private limited companies. Out of the 8 largest banks in the country, two are public companies, but only one is listed on the Budapest Stock Exchange. Public limited companies have extensive information disclosure requirements. As regarding governance structure, joint stock companies may choose to adopt a one- or two-tier structure. However, banks are required to have a two-tier governance structure and appoint a supervisory board.

9. According to the BSCEEE Review 2011, in 2011, the Hungarian economy experienced a slight recovery, as real GDP grew by 1.7%, mainly pulled by manufacturing and agriculture on supply side, while particularly pushed by exports on demand side. The unfavourable trends in banking sector continued in 2011. Due to low demand for credit and still tightening credit standards the loan stock contracted by more than 10% in real terms. Banking sector’s total assets slightly increased in nominal terms because of the HUF weakening, but the total assets/-GDP ratio fell from 105.2% to 102.4%. The CHF, in which the 42% of loans were denominated, appreciated 14.9% during 2011. The EUR, which had 28% share in outstanding loan volume appreciated by 11.6%.

3 Based on Section 171 of the Hungarian Companies Act, a company is deemed open if its shareholders have the right to alienate

their shares without the consent of the other shareholders. A company is private if its shares are not offered to the public and may not be traded on the organised stock market. Shares of the public limited company are traded publicly.

Hungary Country Report – 2012 Page 7 of 26

10. The banking sector met notable losses in 2011. The primary reason of this fact was the high proportion of non-performing loans and impairment necessity. The final repayment scheme also caused losses for the sector. The distribution of the losses was unequal, thus banks with massive losses needed capital injections. Owners provided sufficient amount and good quality capital, and this with the supplementary effect of the reduction in risk weighted assets left the sector’s capital adequacy ratio unchanged at 13%.4

Exhibit 4: Capital Adequacy and Asset Portfolio Quality

Source: BSCEEE Review 2011

11. The EBRD country strategy for Hungary approved at the end of 2011, also points to the fact that the global financial crisis in 2008-09 hit the country hard, partly due to its high public debt and a history of private borrowing in foreign currencies. GDP growth was less than 1% in 2008 and the economy contracted sharply by 6.7% in 2009. The post-crisis recovery has been sluggish by regional standards, with a growth in 2010 and early 2011 of about 1.2%, showing little dynamism and fragility. Household consumption and investment remain weak, held back by rising unemployment and a continued contraction of credit. However, recent indicators point to some strength of industrial production and in exports, both of which continue to benefit from the recovery in the core euro zone economies; and subdued domestic demand has contributed to build up of current account surpluses.5

Supervisory framework

12. The financial sector of Hungary is regulated and supervised by the Hungarian Financial Services Authority ('HFSA'). The HFSA reports to the Parliament and is a constitutional body with considerable independence. According to the HFSA Annual Report, the 2010 brought important changes to the HFSA. "The amended legal provisions on the HFSA’s legal status changed the authority’s work, man- date and responsibilities so profoundly that these changes could fairly be described as historic, a

4 BSCEEE Review 2011.

5 Strategy for Hungary, October 2011, see at: http://www.ebrd.com/pages/country/hungary/hungary_strategy.shtml

Hungary Country Report – 2012 Page 8 of 26

veritable rebirth"6 In the second half of 2010, three significant acts imposed changes on the HFSA’s operation. The most significant of these was the amendment to the Constitution, transforming the HFSA into an independent constitutional body empowered with a regulatory mandate. The second was the amendment to the Act on the Hungarian Financial Supervisory Authority (HFSA Act) whereby the HFSA became a more modern, efficient organisation and an active participant in the increasingly unified efforts of European supervisory authorities. The third change was a package of new laws aimed principally at further developing and harmonising the sector specific laws applied by the HFSA.

13. One of the most important achievements of the new HFSA Act is to provide the HFSA with the authority to issue regulations.7 This put an end to a decade long debate, bringing to conclusion all professional disputes regarding the regulatory mandate of the HFSA. Accordingly, the following regulatory tools are available to the President of the HFSA: decrees, recommendation, CEO letters and methodology guidelines. Out of these, decrees are the only binding legal provisions while the others do not have mandatory force. A decree issued by the HFSA president is at the same level as a ministerial decree in the hierarchy of laws. 28 decrees were issued in 2011.

14. The HFSA's primary objectives are to: (i) insure and enforce solid, transparent and effective operation of the financial intermediation system; (ii) provide stability and undisturbed operation of financial markets; (iii) reveal risks of financial organisation and sectors; (iv) consistently and proactively protect the rights and interests of customers of financial institutions; (v) strengthen public confidence in the financial intermediation system and (vi) - as a member of the European System of Financial Supervisors - represent the interests of Hungary and cooperate with European and other supervisory authorities.8

15. The HFSA has the authority to license banks and all other financial institutions, supervise their activities and apply sanctions or demand remedial measures for purposes of achieving the HFSA's objectives and effective law implementation.

16. The Hungarian central bank, the Magyar Nemzeti Bank ('MNB'), has as the primary objective to achieve and maintain price stability. The MNB also supports the economic policy of the Government using its monetary policy instruments. The MNB does not have regulatory or supervisory powers regarding the participants in the financial intermediary system, but it has partial regulatory power with respect to settlement system. However, according to its Annual Report 2011 it actively participates in the regulatory initiatives aimed at the financial sectors and is member of the Financial Stability Board ('FSB').9 The FSB is a consultative body of the Chairman of the HFSA, the Governor of the MNB and the Minister responsible for regulation of money, capital and insurance markets.10 Its task is to assess the stability of different components of the financial system, and to monitor the activities of the HFSA as regards the enforcement of laws and regulations in relation to financial stability.11

6 HFSA Annual Report 2011, see at: http://www.pszaf.hu/en/left_menu/pszafen_publication/pszafen_reports

7 The regulatory power of the HFSA does not cover the prudential regulations of the banking sector. It mainly refers to

reporting and some consumer protection issues. 8Id.

9 In January 2010, the Financial Stability Board (FSB) started its operations. The FSB is a body assisting the work of the Hungarian

Financial Supervisory Authority (HFSA). Its members comprise the Minister of Finance, the Chairman of the HFSA and the Governor of the MNB. See MNB Annual Report 2011, see at: http://english.mnb.hu/Root/Dokumentumtar/ENMNB/Kiadvanyok/mnben_evesjel/eves_jelentes_2011_en.pdf 10

According to the Act on the HFSA (Act 158 of 2010, Chapter III): 32 § (1) The FSB aims to harmonize the microprudential and macroprudential supervision. (2) The FSB is a consultative body of the Chairman of the HFSA, the Governor of the MNB and the Minister responsible for regulation of money, capital and insurance markets which shares information, discusses strategic, regulatory, risk and other questions relevant for the financial intermediation, and if necessary, it takes position in these questions in order to ensure stability of the financial intermediary sector. Any statement should be issued by common consent. … (4) The FSB shall not influence any rights or powers ensured by the original status acts of each participant. 11

See details about the FSB at: http://www.pszaf.hu/en/left_menu/financialstabilityboard

Hungary Country Report – 2012 Page 9 of 26

17. The Budapest Stock Exchange ('BSE') opened in 1990 and since January 2010 the BSE is a subsidiary of the CEESEG AG holding company, which owns 68.8% of the BSE.12 According to BSE 2011 Annual Report, the main indicators of the BSE for years 2005-2011 are as follows.13

18. As mentioned above, only 1 bank out of the 8 largest in the country is listed on the BSE, the OTP Bank.

19. In 2008, the BSE approved the “Corporate Governance Recommendations” applicable to listed companies. The Recommendations are currently of voluntary nature, but if a company chooses to apply them it should file an annual "comply or explain" report, as per the template included in the Recommendations. The Recommendations were lastly amended in November 201214

Laws and regulations relevant for corporate governance of banks

Exhibit 5: Laws and regulations on the corporate governance of banks

Laws

1. Act CXII on Credit Institutions, 1996, as amended - establishes main principles and provisions regarding banking activity and governance of banks.

2. Act CLVIII on the Financial Supervisory Authority, 2010 - sets forth the framework for HFSA's authority and responsibilities.

3. Act IV on Business Associations (Companies Act), 2006, as amended – includes main provisions about joint stock companies and their governance. As mentioned above most banks are organised as joint stock companies.

4. Act CXX on Capital Market, 2001, as amended - sets forth detailed disclosure requirements for listed companies. HFSA acts

15

1. Recommendation 1/2000 on Financial Institutions' Internal Audit Systems,16

2000 – details the financial institutions’ internal audit procedures and reporting lines.

2. Recommendation 7/2006 on increasing the effectiveness of credit risk management,17

2006 - includes guidelines for banks regarding risk management and necessary procedures.

12

The CEE Stock Exchange Group includes the Budapest, Ljubljana, Prague and Vienna Stock Exchanges. See: http://www.ceeseg.com/ 13

BSE Annual Report 2011, see at: http://bse.hu/data/cms166800/2011_annual_report.pdf 14

See more information about the BSE Corporate Governance Recommendations at: http://www.bse.hu/topmenu/issuers/corporategovernance 15

As mentioned above, until recently HFSA did not have the authority to issue regulatory acts. Accordingly, most of its regulatory activity was via soft power recommendations and guidelines. See at: http://www.pszaf.hu/en/left_menu/regulation 16

http://www.pszaf.hu/en/left_menu/regulation/pszafen_recommendations/pszafen_guidelines_20050812_1.html 17

http://www.pszaf.hu/en/left_menu/regulation/pszafen_recommendations/pszafen_recommendations_20061011_1.html

Hungary Country Report – 2012 Page 10 of 26

3. Guidelines on risk-based supervision methodology of the HFSA, 2008 - describes principles and matters reviewed as part of the supervisory process.

4. Recommendation 11/2006 on setting up and using internal safeguards,18

2006 - establishes principles and guidelines for the internal control systems in financial institutions (including banks).

5. Recommendation 4/2007 on the assessment of the fitness and propriety of managers, directors and owners of financial organisations, 2007 - establishes the principles for "fit and proper" assessments by the banks.

6. Recommendation 1/2010 on the application of remuneration policy, 2010 - includes recommendation regarding setting up compensation systems in banks and principles on which these should be based.

7. Recommendation 3/2011 on the application of the remuneration policy, 2011. The recommendation spells out in detail the requirements concerning the payout of remuneration forms applicable by institutions. Further, the recommendation also provides details concerning the theoretical basis of the deferred payment of performance remuneration, the withholding policy and the rules of the subsequent consideration of risks.

Corporate Governance Code:

Corporate Governance Recommendations, 2008, - contains a set of detailed corporate governance rules, which are currently voluntary and applicable to the public companies listed on the BSE should they choose to apply these. Companies that chose to apply the Recommendation should complete a "comply or explain" statement providing an explanation where the company diverges from the provisions of the Code.

Relevant EU Directives:

19

1. Directive 2006/43/EC of the European Parliament and of the Council - on statutory audits of annual accounts and consolidated accounts, amending Council Directives 78/660/EEC and 83/349/EEC and repealing Council Directive 84/253/EEC.

2. Directive 2006/46/EC of the European Parliament and of the Council - amending Council Directives 78/660/EEC on the annual accounts of certain types of companies, 83/349/EEC on consolidated accounts, 86/635/EEC on the annual accounts and consolidated accounts of banks and other financial institutions and 91/674/EEC on the annual accounts and consolidated accounts of insurance undertakings

3. Directive 2006/48/EC of the European Parliament and of the Council - regarding the pursuit of business of credit institutions.

4. Directive 2006/49/EC of the European Parliament and of the Council - on capital adequacy of investment firms and credit institutions.

5. Council Directive 86/635/EEC - on the annual accounts and consolidated accounts of banks and other financial institutions.

6. Directive 2004/109/EC of the European Parliament and of the Council - on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market and amending Directive 2001/34/EC

18

http://www.pszaf.hu/data/cms275880/pszafen_recom_11_2006.pdf 19

See the directives here: http://eur-lex.europa.eu/en/legis/latest/chap06202020.htm and http://eur-lex.europa.eu/en/legis/latest/chap06202025.htm

Hungary Country Report – 2012 Page 11 of 26

B. Key findings

1) The strategic and governance role of the board

Key strengths

20. The banking law and the Company Act establish the basic framework for corporate governance in banks. Banks may be organised as joint stock companies or cooperatives, but they must have a two-tier governance structure. In practice, most banks are organised as joint stock companies, i.e. public limited companies ("Nyrt.") or private limited companies ("Zrt."). Governance bodies of banks include the general meeting of shareholders ('GMS'), the supervisory board ('SB'), board of directors ('BD') and executive management. According to the default rule in the Company Act, the GMS appoints both the SB and the BD; but banks may opt out of this general rule. The general meeting of shareholders or the board of directors, depending on what is established by the bank bylaws, appoints the executive management.

21. The supervisory board must approve the bank internal control and governance systems. The HFSA has access to banks’ governance documents and has the authority to address corporate governance failures and compel appropriate remedial action. These include setting a timetable for compliance and deciding on sanctions for non-compliance. Responses to our questionnaires indicate that such powers have been occasionally used by the HFSA in the last five years.

22. The board of directors has the authority and responsibility to decide the strategy of the bank and its budget (or financial plan). BDs' responsibilities also include the approval of major policies of the bank, including policies on risk management. In line with the law, the BDs in the banks reviewed approve the strategy, discuss and approve the budget. The BDs are regularly informed about the market circumstances and any budget or policy variances that may affect the bank.

23. The Budapest Stock Exchange has approved the Corporate Governance Recommendations ('CGR'), which reflect best international practice for corporate governance in companies. The CGR stresses the importance of internal control checks and balances, effective composition of the bank managing bodies and their adequate discharge of duties. The CGR structure contributes to implementation of the recommendations, as these include suggestions and explanations of the proposed rules. The CGR are not mandatory, but should a listed company elect to apply the recommendations it should publish a "comply or explain" statement. Explanations on practices disclosed by listed banks not in compliance with the Corporate Governance Recommendations are not always comprehensive and there are a number of non compliance issues where no explanation is offered.

24. Seven banks out of the eight largest banks in the country are subsidiary of a foreign banking group.20 The HFSA is active in ensuring that the local boards have sufficient input into the governing of local subsidiaries. The HFSA reports that it meets at least annually with the representatives of the foreign parent and requires policies specifying the role of the parent entity in decision-making process of the subsidiary. The HFSA also reported that it undertakes additional measures aimed at increasing the effective control of subsidiaries of foreign banks by local boards, such as more rigorous watch lists, additional reports, provision allocations. The respondent bank reported that its board approves

20

See Exhibit 1, page 4. Only OTP – the largest bank in Hungary is not. Erste is a subsidiary of Erste Group Austria, K&H is a subsidiary of KBC Belgium, MKB is a subsidiary of Bayerische Landesbank Germany, CIB is a subsidiary of Intesa Sanpaolo Italy, Raiffeisen is a subsidiary of Raiffeisen Group Austria, Unicredit is a subsidiary of Unicredit Group Italy, Budapest Bank is a subsidiary of GE, USA.

Hungary Country Report – 2012 Page 12 of 26

specific decisions for transposing group decisions so that they become policy of the subsidiary. The banking law requires that at least two directors appointed to the board of directors are local residents.

25. Group executives are not prevented from sitting on the board of the subsidiary, thus having an opportunity to share their experience and pass on good practices developed by the parent bank. Overall, tour survey indicated that there is good communication of group policies and codes of ethics to the subsidiaries and adequate transfer of good practices between parent and subsidiary boards.

26. A number if banks have adopted codes of conduct and some trained their staff on the code's implementation. The HFSA also approved a sample code of ethics available on its website.21

Key weaknesses

27. The governance structure in banks seems unclear. Banks are required to set up supervisory boards with the authority to setting up and overseeing the internal control system in the bank, but the strategic responsibilities for approving the strategy and budget for the bank is within the remit of the board of directors, which has also the responsibility to supervise the bank's senior management. Both the supervisory board and the board of directors must be composed of a majority of non-executive directors, and BD members can not sit on the SB. Both bodies are elected by the general meeting of shareholders (which means that none has clear authority over the other). Recommendation 11/2006 on internal safeguards clarifies that SB is responsible for overall overview and operation of the control system while the BD is responsible for strategic and business decisions. In practice however, it seems that the true reigns in the banks reviewed belong to the board of director, whereas the supervisory board seems to have a marginal role. The major risk related to this structure is the possibility that part of the bank’s oversight duties fall within the cracks between the board of directors and supervisory board.

28. The fact that executives can take part in the decisions of the bodies responsible for monitoring their actions is potential for conflicts of interests and is cause of concern, especially in a framework as the Hungarian one, where the practice of “independent” board committees is not well developed (see below). While members of management should act as rapporteurs to these bodies, they should not be their members.

29. According to the banking law, banks must be managed by at least two executive directors who should sit on the board of directors and that are called "internal directors". The banking law delegates their appointment authority to the board of directors. The Company Act instead preserves such authority with the general meeting of shareholders unless bylaws direct otherwise. As a result, bank practice varies as in one respondent bank the senior executives are appointed by the board of directors and in the other by the general meeting of shareholders. In the former case, respect it is fair to believe that when the body empowered with oversight of the management is deprived of the authority to appoint and remove management, its supervisory capacity is greatly weakened.

30. Effective allocation of authority and responsibilities among bank governing bodies is a key element of sound corporate governance. The Basel Committee stresses over the importance of the board oversight among the most important factors to ensure appropriate check and balances. According to best practices the board should have clear overall responsibility for the bank, including approving and overseeing the implementation of the bank's strategic objectives, risk strategy, corporate governance and corporate values. The board should also be responsible for providing oversight of senior

21

See at: http://www.pszaf.hu/en/left_menu/regulation/code

Hungary Country Report – 2012 Page 13 of 26

management.22 Instead, it appears that in Hungarian banks this oversight authority is shared between the SB and the BD, which might not be the most effective solution.

Key recommendations

Legal framework

1. The framework regulating the governance structure of banks provides a good degree of flexibility but seems to have potentials for conflicts of interests, which the regulator should carefully assess.

Bank Practice

2. Given the flexibility offered by the legal framework, banks should clarify their corporate governance structures in policies reflecting the distribution of duties and authority among the governance bodies and bank functions.

2) Composition and functioning of the board

Key strengths

31. The banking law sets general “fit and proper” criteria for all members of bank governing bodies. These require financial soundness, lack of violations of banking and financial laws, no criminal record and good business reputation. Further the law requires that all members of the board of directors must have at least three years experience in banking or business management and must not hold any other positions which could negatively affect their performance and professional duties. The managing directors (CEO and senior executives) have additional requirements towards their education and experience. The HFSA must pre-approve all candidates for the supervisory board and board of directors. The HFSA has the authority to refuse the proposed candidates but this power has been rarely used. The HFSA has approved separate recommendations23 offering guidance to banks on how to insure that directors have sufficient expertise and are able to adequately fulfil their duties. Banks are encouraged to require information from candidates on their education, qualifications, holdings and positions in other businesses. Credit institutions should assess the suitability of the candidates and ensure continuous maintenance of directors' adequacy. According to the HFSA, most board members have banking or financial experience.

32. The banking law establishes that bank supervisory board must comprise between three and nine members. The Company Act sets the limits for the board of directors between three and eleven. It appears that the BDs and SBs of the banks reviewed are within the limits set by law (see Exhibit 6, below). In general, smaller boards are generally better equipped to efficiently discharge their duties and allow adequate participation to all members.24

22

Principles for enhancing corporate governance by the Basel Committee on Banking Supervision, 2010, Principle 1, pages 6 and 7, see at: http://www.bis.org/publ/bcbs176.pdf 23

See in particular, the HFSA Recommendation 4 dated 2007 about assessment of fitness and priority of managers, directors and owners of financial organisations (http://www.pszaf.hu/data/cms275876/pszafen_recom4_2007.pdf). 24

"The board should structure itself in a way, including in terms of size, frequency of meetings and the use of committees, so as to promote efficiency, sufficiently deep review of matters, and robust, critical challenge and discussion of issues." Basel Committee’s Principles for enhancing corporate governance - final document, 2010, § 42, see at: http://www.bis.org/publ/bcbs176.pdf . According to the UK Corporate Governance Code "The board should not be so large as to be unwieldy and should be of sufficient size that the requirements of the business can be met and that changes to the board’s composition and that of its committees can be managed without undue disruption", Section B, B1; see at:

Hungary Country Report – 2012 Page 14 of 26

Exhibit 6: The size of the boards of directors and supervisory boards in the two banks reviewed

Source: Annual Reports 2011 of the banks reviewed, available on their respective websites

33. According to the banking law, members of bank governance bodies ("bank managers") are subject to duties of loyalty and care and are required to act with necessary expertise and diligence in the best

http://www.frc.org.uk/documents/pagemanager/Corporate_Governance/UK%20Corp%20Gov%20Code%20June%202010.pdf. Further, in the Walker Review of corporate governance in banks in UK it is stated that based on most recent research and behavioural studies that "an “ideal” size [for a bank board is] of 10-12 members, not least on the basis that a larger board is less manageable, however talented the chairman, and that larger size inevitably inhibits the ability of individual directors to contribute", § 3.1, see at: http://webarchive.nationalarchives.gov.uk/+/http://www.hm-treasury.gov.uk/d/walker_review_261109.pdf

Hungary Country Report – 2012 Page 15 of 26

interests of the bank and its customers. Bank managers are prohibited from using inside information in their personal interests or otherwise to obtain a benefit for themselves. The Company Act establishes liability of bank managers for any omissions or acts that causes damages to the company due to their intention or negligence. Specifically, the executive officers are required to act with due care and diligence as generally expected from persons in similar positions. However, similar to other countries in the region there is little court practice in enforcing these duties.

34. Both banks reviewed reported that their directors do not sit on more than five external boards, which should contribute to insure that directors dedicate sufficient time to their duties. Directors must also inform the bank and HFSA about any additional appointments and may not undertake senior positions within businesses pursuing similar activity to that of the bank.

35. There is no direct requirement in the law to provide training and induction to the members of the governing bodies, but the Corporate Governance Recommendations encourages companies to have induction programs for newly appointed directors. In practice, both banks reviewed indicated that they have an induction programme and continuous learning/training for directors. This is in line with best practice: the Basel Committee recommends that in order to help board members acquire, maintain and deepen their knowledge and skills and to fulfil their responsibilities, the board should ensure that board members have access to programmes of tailored initial (e.g., induction) and ongoing education on relevant issues.25

Key weaknesses

36. The concept of "independent directors" does not seem to be well developed. This might be primarily due to conflicting legal provisions: the Company Act requires that the majority of members of SB or BD (in one tier structures) in public companies is independent. The definition of "independence" is fairly comprehensive and includes independence criteria from the company's senior executives, as well as from the significant direct or indirect equity holders (significant meaning 30% or more). Instead, the banking law only requires that members of the SB are not in employment with the bank (i.e. non-executive), except for employee representatives on the board.

37. The independence requirement applies only to public companies26 and, as mentioned above, out of eight largest banks in the country only two are public companies. Accordingly, one of the respondent bank that is not a public company indicated that it does not have independent directors sitting in its board. The other respondent bank, which is a public company, indicated that its independent directors sit on the SB. Here, it appears from the available information available online that "independence"27 is sometimes confused with the fact that directors are non-executive.

38. Independent directors find their natural place in board committees, created to allow deeper focus in specific delicate areas, potentials for conflict of interests. Typical board committees are the audit committee,28 nomination committee, remuneration committee and risk committee. The Company Act requires public companies to set up audit committees, made of three members appointed by the

25

See Principles for enhancing corporate governance by the Basel Committee on Banking Supervision, 2010, Principle 2, page 10. 26

Section 172 of the Company Law states that 'Public limited company' shall mean any company whose shares (all or some) are

traded publicly in accordance with the conditions set out in the act governing securities. Any limited company whose shares were not originally offered to the public and are offered for sale to the general public or admitted for trading on a regulated market shall also be considered a public company. 27

For some guidance on the definition of “independent director” in EU, see in particular Annex I of the EC Commission Recommendation dated 15 February 2005 on the role of non-executive or supervisory directors of listed companies and on the committees of the (supervisory) board (http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2005:052:0051:0063:EN:PDF) 28

Art. 41 (1) of Directive 2006/43/EC dated 17 May 2006 on statutory audits of annual accounts and consolidated accounts, amending Council Directives 78/660/EEC and 83/349/EEC and repealing Council Directive 84/253/EEC, states that “At least one member of the audit committee shall be independent and shall have competence in accounting and/or auditing.”

Hungary Country Report – 2012 Page 16 of 26

general shareholders meeting, out of the independent members of the supervisory board or board of directors.29 However, based on the banking law, banks may opt out of such requirement (note that this requirement applies only to public companies). Accordingly, one of the banks reviewed (which is not a public company and has no independent directors) indicated that it has an audit committee. The other bank (which is a public company) has dissolved its audit committee in 2011 arguing that its SB is capable of adequately discharging its duties without the assistance of an audit committee. The law requires banks having a market share by assets of 5% or more to establish remuneration committees. There is no requirement that remuneration committee must include independent directors. Further, Recommendation 1/2010 states that “Members of the remuneration committee can include the members of the management body”. Accordingly, one of the respondent banks reported having set up a remuneration committee also comprising executive directors. This is potentials for conflicts of interest and might jeopardise the independence of committee recommendations.

Exhibit 7: Board committees in the two banks reviewed

Committees Audit Risk Remuneration Nomination

Bank 1 YES (at the SB level) YES (at the BD level only) YES NO

Bank 2 NO YES (at the BD level only) YES (at the BD

level) NO

39. The law and regulator do not require banks to have a nomination policy for the board. The banks

reviewed follow suit and do not have such policies, relying primarily on the general meeting of shareholders to propose candidates. This is not necessarily a big issue, in view of the fact that most large banks are privately held subsidiaries of international banking groups where the parent appoints the board members. However, a nomination policy may assist in keeping a closer look at the necessary mix of skills on the board.

40. Boards in banks reviewed do not seem to perform board evaluations. To support board performance, best practices recommend the board to carry out regular assessments of both the board as a whole and of individual board members.30 Board evaluations help ensure that the board has the necessary mix of skills and members are diligent in their performance.31

41. Banks reviewed do not appear to have created a permanent senior position for company secretary who would assist the activities of the boards (SB and BD) and boards' committees, as well as, who would monitor corporate governance practices of the bank. The company secretaries assist in improving board effectiveness and provide the board with clear information about the corporate governance structure and mechanisms at the bank. 32

29

Art. 311 of the Company Act. 30

Principles for enhancing corporate governance (2010), Basel Committee on Banking Supervision, page 11. 31

Note that self-evaluations do not mean monitoring or evaluation by another governance body (e.g., the general meeting of shareholders or the HFSA). 32

For guidance on the corporate secretary role and responsibilities, see ICSA Guidance on Corporate Governance Role of the Company Secretary: http://www.icsa.org.uk/assets/files/pdfs/081020%20-%20Corp%20Gov%20role%20of%20co%20sec.pdf

Hungary Country Report – 2012 Page 17 of 26

Key recommendations

Legal framework

1. The regulator should assess on whether the current system allows the board and board committees to have the adequate objective judgement over delicate issues potentials for conflicts of interests.

Bank practice

2. Banks’ boards should develop nomination policies for the definition of the required mix of skills that board candidate should possess. Boards should carry out board evaluations, which inter alia may be fed into the nomination process and help improve the work practice of the board.

3. Banks should consider appointing a senior company secretary for improving the effectiveness of boards and board committee activities.

3) Risk Governance

Key strengths

42. The banking law requires banks to have in place sound risk management systems, detailed in written risk policies and procedures. For this purpose, the law requires the BD to approve and periodically review the strategies and policies for managing, monitoring and mitigating the risks of the bank. Additionally, the HFSA Recommendation 11/2006 and other acts33 encourage banks to define the bank’s risk appetite. Accordingly, all banks reviewed reported that their boards approved risk management policies and the bank risk appetite statements34, which include high level quantitative limits for the bank as whole, specific business lines and specific exposures. In both banks the BD reviews the bank risk profiles quarterly. The HFSA reports that it monitors the effectiveness of boards' oversight of their banks' risk management systems, requires from banks forward looking statements on risk appetite and quarterly appraises risk profiles of banks.

43. The HFSA Recommendation 11/2006 on setting up and using internal safeguards encourages large credit institutions to established separate and independent risk management departments reporting to the board of directors. Both respondent banks report to have set up separate risk management functions which identify key risks, measure and monitor risk exposure, participate in determining corresponding capital needs, and participate in setting provisioning levels.35

44. The banking legislation does not expressly require banks to set up a risk committee at the board level. On the other hand, Recommendation 11/2006 provides that “large organizations may set up risk committees or compliance committees in order to increase efficiency”. The banks reviewed reported

33

See the Recommendation 11 dated 2006 by the HFSA on setting up and using internal safeguards and the HFSA Supervisory Review Process and ICAAP Guideline, at: http://www.pszaf.hu/en/left_menu/regulation/supervisory_methodologies/supervisory_guidance_ 34

See EBA Guidelines on Internal Governance, (GL 44), 2011, page 8. 35

"Risk reporting systems should be dynamic, comprehensive and accurate, and should draw on a range of underlying assumptions. Risk monitoring and reporting should occur not only at the disaggregated level (including risk residing in subsidiaries that could be considered significant), but should also be aggregated upward to allow for a firm-wide or consolidated picture of risk exposures. In this regard, organisational “silos” can impede effective sharing of information across a bank and can result in decisions being made in isolation from the rest of the bank. Overcoming information-sharing obstacles posed by silo structures may require the board and senior management to review or rethink established practices in order to encourage greater communication. Some firms have found it useful to create risk management committees - distinct from the board’s risk committee - that draw members from across the firm (e.g., from business lines and the risk management function) to discuss issues related to firm-wide risks.", Basel Committee on Banking Supervision, Principles for enhancing corporate governance (2010), §§ 97-98, see at: http://www.bis.org/publ/bcbs176.pdf

Hungary Country Report – 2012 Page 18 of 26

having established senior executive risk committees, which meet regularly and have an integrated view of all categories of risks and responsibility for the overall risk profile of the bank.36

45. Although the banking law does not require banks to appoint a chief risk officer ('CRO'), the banks reviewed reported that they appoint a chief risk officer. The HFSA indicated that it monitors the presence of a CRO in banks and the remit of its responsibilities.

Key weaknesses

46. The law does not require that the CRO, who should be responsible for the risk management across the entire organisation, has sufficient seniority to enable him to challenge the decision making process in the institution and has direct access to the board and in particular to its non-executive directors.37

47. It is not clear if banks' BD members and in particular non-executive directors are required to have risk management experience. Only one of the banks reviewed discloses the qualifications of its members of the board of directors and of the supervisory board and there does not appear to be any specific risk expertise among its non-executive directors. In view of the fact that boards have the responsibility to decide risk management policies and monitor the risk management function, the supervisory authority should encourage banks to include risk management expertise on the board or have the capacity to seek independent expert opinion where necessary. It is important that the supervisory authority encourages boards to include an adequate “mix of skills” covering all relevant areas of the bank’s activity.38 This would contribute to effective discussions on the board serving as a check on group proposed policies or management decisions.

Key recommendations

Legal framework

1. The banking law should include provisions to insure the independence and seniority of the CRO in banks.

Supervisory/Bank practice

2. The supervisory authority should encourage and banks should strive to include risk management expertise on their boards and be able to access independent expert opinion when necessary.

36

Banks have also established ALCOs and senior credit committees. "Risk reporting systems should be dynamic, comprehensive and accurate, and should draw on a range of underlying assumptions. Risk monitoring and reporting should occur not only at the disaggregated level (including risk residing in subsidiaries that could be considered significant), but should also be aggregated upward to allow for a firm-wide or consolidated picture of risk exposures. In this regard, organisational “silos” can impede effective sharing of information across a bank and can result in decisions being made in isolation from the rest of the bank. Overcoming information-sharing obstacles posed by silo structures may require the board and senior management to review or rethink established practices in order to encourage greater communication. Some firms have found it useful to create risk management committees - distinct from the board’s risk committee - that draw members from across the firm (e.g., from business lines and the risk management function) to discuss issues related to firm-wide risks", Basel Committee on Banking Supervision, Principles for enhancing corporate governance (2010), §§ 97-98, see at: http://www.bis.org/publ/bcbs176.pdf 37

See CEBS High level principles for risk management, February 2010, p. 4-5, at: http://www.eba.europa.eu/documents/Publications/Standards---Guidelines/2010/Risk-management/HighLevelprinciplesonriskmanagement.aspxId . 38

"The management body is responsible for overseeing senior management and also for establishing sound business practices and strategic planning. It is therefore of the utmost importance that the management body in carrying out both its management and supervisory functions has collectively a full understanding of the nature of the business and its associated risks. The members responsible for those functions need a level of understanding commensurate with their responsibilities.", Id. p.3

Hungary Country Report – 2012 Page 19 of 26

4) Internal Control

Key strengths

48. The banking regulation sets forth the requirements for the creation of an internal control system, which include: Internal control functions include the risk control function, the compliance function and the internal audit function. The law further requires that bank's structural organisation must be clearly documented in internal policies. The Recommendation 11 recommends that the internal control framework should include independent risk function, compliance function and internal audit. The Recommendation clarifies that in order to be considered independent these functions must be separate from each other and segregated (i.e. separate from the activities that fall within their control and reporting to different senior executives).39 Both banks reviewed indicated that they regularly review organisational charts and terms of reference for key functions and businesses. Both banks reported having n place segregation of duties between functions responsible for initiating a transaction, making payment and accounting for it.

49. The banking law requires banks to set up internal audit departments. The department must report directly to the supervisory board (or the audit committee, when created). The SB is in charge of setting up the internal control system, including approving internal audit's plan, overseeing the internal audit's work and following up on recommended by the audit measures. The SB appoints the staff for the internal audit department including the head of the department. The direct access of the audit function to the SB should insure its independence from the management (provided the SB is able to exercise an independent and objective judgement over the internal audit activities).

50. There are detailed rules for conflicts of interests and transactions with related parties that include comprehensive definition of related parties and requirement that such transactions are approved by the managing body or general meeting of shareholders. Both banks reviewed indicated that they have specific policies and procedures for managing conflicts of interests. Such policies are reported to the HFSA. The HFSA has the authority to apply sanctions in case of breach of conflict of interests’ rules and reports that there have been only a few significant issues with related parties’ transactions in the three largest banks in recent years.

51. Banks are required to appoint an external auditor to audit banks' financial statements. The banking law and Recommendation 11/2006 include comprehensive rules to preserve the independence of judgement of the external auditor.40 The external auditor must be certified by the HFSA for auditing credit institutions. The auditor and its related parties must have no interest in the bank and vice versa. Further, the auditor must not derive more than 30% of its income from the bank to be audited, or 60% in case of financial groups. The auditor may be appointed for maximum 5 years and may be reengaged only after the expiration of 3 years from the previous appointment. Accordingly, both banks reviewed confirmed that they rotate their external auditors, as well as have policies for managing the provision of non-audit services.

52. The Recommendation 11 encourages banks to set up a compliance department as part of a sound internal control system. The Recommendation describes duties and responsibilities of the compliance

39

Best international practice recommend that as part of procedures to manage conflict of interests, banks should insure "adequate segregation of duties, e.g. entrusting conflicting activities within the chain of transactions or of services to different persons or entrusting supervisory and reporting responsibilities for conflicting activities to different persons". See, EBA Guidelines on Internal Governance (GL 44), page 30 (at: http://www.eba.europa.eu/cebs/media/Publications/Standards%20and%20Guidelines/2011/EBA-BS-2011-116-final-(EBA-Guidelines-on-Internal-Governance)-(2)_1.pdf) and Principles for enhancing corporate governance (2010) by Basel Committee on Banking Supervision, page 24. 40

For further guidance see OECD Corporate Governance Principles (2004), p. 55, at: http://www.oecd.org/dataoecd/32/18/31557724.pdf

Hungary Country Report – 2012 Page 20 of 26

function and defines compliance risk, which apart from identifying the risk from failure to comply with various regulatory instruments, includes management of conflict of interests, separation of financial and investment services activities, prevention of insider trading and exchange rate manipulation, money laundering, fair treatment of clients and other aspects. 41 Banks reviewed reported that they have set up separate compliance functions.

Key weaknesses

53. The Company Act requires public companies to set up audit committees, made of three members appointed by the general shareholders meeting, out of the independent members of the supervisory board or board of directors.42 Recommendation 11/2006 further suggests all large financial organization engaged in complex and substantial international activities even when they are not public companies setting up an audit committee. On the other hand, the banking law allows banks to opt out with a specific provision in their bylaws.43 While this flexibility is welcome as provide banks with the possibility to model their internal governance and control framework as they deem appropriate,44 it misses to identify the requirements that the audit committee (or the supervisory board) should possess to provide the necessary "objective judgement" to ensure the independence of the internal control system, the integrity of the financial reports and the independence and qualification of the external auditor. In fact, under the Hungarian framework, the supervisory board and the audit committee (in non-public companies) are not required to include independent members and can include executives. Moreover, the framework does not require the audit committee or supervisory board to include directors having experience in financial reporting, accounting and auditing, which are key competences for the functions assigned to the audit committee45 Recommendation 4/2007 only generally requires that managers and directors should be suitable for performing governance, risk management and control functions. Here, the effective implementation of this principle is essential for insuring the effectiveness of the role of the supervisory board and audit committee.

Key recommendations

Legal framework

1. The regulator should assess the effectiveness of the governance structure in banks and consider whether the structure (supervisory board or audit committee) is effective in insuring a proper and independent oversight over the “internal control function”.

Supervisory practice

2. The supervisory authority should carefully monitor the composition and qualification of boards and committees to insure that they have sufficient skill to perform their duties.

41

Best practices define compliance risk is as the current or prospective risk to earnings and capital arising from violations or non-compliance with laws, rules, regulations, agreements, prescribed practices or ethical standards) that can lead to fines, damages and/or the voiding of contracts and can diminish a bank’s reputation. See EBA Guidelines on Internal Governance (GL 44), page 43. 42

Art. 311 of the Company Act. 43

Art. 66 (8) of the Act on Credit Institutions. 44

One of the banks reviewed has an audit committee, whereas the other has dissolved such committee as considered being redundant. 45

The Basel Committee recommends that for large banks and internationally active banks, an audit committee or equivalent should be required. The Basel Committee notes that it is advisable that the audit committee consists of a sufficient number of independent non-executive board members. At a minimum, the audit committee as a whole should have recent and relevant experience and should possess a collective balance of skills and expert knowledge commensurate with the complexity of the banking organisation and the duties to be performed - in financial reporting, accounting and auditing. See the Principles for enhancing corporate governance (2010), Basel Committee on Banking Supervision, Principle 3, page 13 and EBA Guidelines on Internal Governance (GL 44), 2011, page 28.

Hungary Country Report – 2012 Page 21 of 26

5) Incentives and Remuneration

Key strengths

54. The banking law was recently amended to include detailed rules on remuneration policies and procedures in banks. Accordingly, banks are required to have remuneration policies in line with their internal structure, nature, scope and complexity of their activities. Recommendation 1/2010 on the application of the remuneration policy details compensation policy principles and requires that these policies take into account long-term interests of banks and banks' risk profile. The general shareholders meeting or supervisory board must approve such policies. The banks reviewed confirmed that their boards adopted bank wide compensation policies and establish the remuneration for the senior executives. Both banks appointed remuneration committees to assist their boards.

55. The banking law and Recommendation 1/201046 draw attention to the fact that the remuneration of members of the management and supervisory bodies and senior executives responsible for risk taking and control function must be in line with the bank’s long-term interest, risk taking and risk management principles. Further the Recommendation points out that the control functions (such as risk control, compliance and internal audit) should be compensated in accordance with their own objectives and not according to the performance of the business unities they oversee.

56. The Recommendation encourages banks to link compensation to individual and bank performance, but it should not encourage excessive risk taking and should not reward individuals for taking risks in excess of the institution's risk appetite. Significant bonus cash payments should not be paid up-front and deferred payments should be linked to certain measures indicating adequate performance over time.

57. At the same time, to preserve the non-executive directors’ objective view on risk, the Recommendation encourages banks not to link their remuneration to the bank's short-term results. Accordingly, banks reviewed pay a fixed fee to their non-executive directors. 47

Key weaknesses

58. As noted above, the law requires banks having a market share by assets of 5% or more to establish remuneration committees. Recommendation 1/2010 further specifies that for the purpose of developing and monitoring the enforcement of the remuneration policy, banks can establish remuneration committee, subordinated to the supervisory board, which can include members of the management body. Both respondent banks have set up remuneration committees comprising all or a majority of non-executive directors. The lack of requirement that remuneration committee must include independent directors and the possible inclusion of executives are potentials for conflicts of interests and should carefully monitored. In order to overcome this problem, Regulation 1/2010 requires that the remuneration policy should be subject to regular (at least annual) and independent internal review, but it is not clear how this review is conducted in practice as the banks reviewed do not seem to entirely adjust their remuneration practices to the principles established by Regulation

46

The Recommendation is available at http://www.pszaf.hu/data/cms2115410/recom_1_2010.pdf 47

Guidelines on Remuneration Policies and Practices (2010), CEBS, page 30, §47, see at: http://www.eba.europa.eu/cebs/media/Publications/Standards%20and%20Guidelines/2010/Remuneration/Guidelines.pdf; see also ICGN Non-Executive Director Remuneration Guidelines and Policies, Revised (2009), consultation paper, page 9, at: http://www.icgn.org/files/icgn_main/pdfs/best_practice/exec_remun/2009_guidelines_and_policies_consultation.pdf

Hungary Country Report – 2012 Page 22 of 26

1/2010. One of the banks reviewed reported paying bonuses higher than 70% of annual salary, and not deferring any payment. 48

59. One bank reported that the CRO is paid based on the same criteria as other senior management. This may jeopardise the objectivity of the CRO in his/her views on risk management. According to best international practice and as adequately directed in the HFSA Recommendation: "for employees in the risk and compliance function, remuneration should be determined independently of other business areas and be adequate to attract qualified and experienced staff; performance measures should be based principally on the achievement of the objectives of their functions."49

Key recommendation

Bank practice

Banks should adjust their practices to the new regulatory requirements established in the banking law and Recommendation 1/2010.

6) Transparency to the market and regulators

Key strengths

60. The banking law requires banks to adopt policies and procedures regarding disclosure of information by the banks. Banks are obliged to publish all information that may have a significant effect on bank's financial situation. The Government Decree No. 234/2007, which transposes the provisions of the EU Directive 2006/48/EC,50 includes reporting requirements for credit institutions. Banks are required to publish, among others: a report on risk along the lines required by Basel II Pillar 3, a director remuneration report, a report on ownership structure and a report on the effectiveness of internal controls.

61. Additionally, the Company Act requires public and listed companies to publish detailed information about company governance, including information about governance bodies, their structure, composition and responsibilities, their remuneration reports. We have reviewed the information available on line by one listed bank and we could find an extensive amount of governance information. This includes: information about bank governance bodies, their remuneration (exact amounts for all members), a corporate governance report, ownership structure, terms of reference for the SB, bylaws and risk report in line with the Basel II Pillar 3 requirements. The bank's corporate governance report includes detailed information about the work and sessions of the bank governance bodies in the reported year and a "comply or explain" statement based on BSE CG Recommendations.

62. The HFSA has full extensive access to bank materials and performs annual on-site inspections. The supervisor feels confident that it can obtain information about the beneficial ownership in banks.

48

For further guidance on best practice regarding remuneration of senior executives see Compensation Principles and Standards Assessment Methodology, by Basel Committee on Banking Supervision, 2010 at: http://www.bis.org/publ/bcbs166.pdf; and FSB Principles for Sound Compensation Practices, 2009, at: http://www.financialstabilityboard.org/publications/r_090925c.pdf 49

Compensation Principles and Standards Assessment Methodology, Basel, 2010, Principle 3 - Standard 2, see at: http://www.bis.org/publ/bcbs166.pdf 50

Directive 2006/43/EC of the European Parliament and of the Council, on statutory audits of annual accounts and consolidated accounts, amending Council Directives 78/660/EEC and 83/349/EEC and repealing Council Directive 84/253/EEC.

Hungary Country Report – 2012 Page 23 of 26

Key weaknesses

63. According to the Accounting Act, listed companies that must prepare a consolidated annual report must prepare such report in accordance with the IFRS. Other companies are not obliged to prepare their reports based on IFRS but may do so. The HFSA confirms that not all banks base their annual financial statements on the IFRS.

64. Large unlisted banks do not appear to disclose comprehensive corporate governance information. The disclosure offered by the unlisted reviewed bank, includes limited information in its annual report but it does not provide any corporate governance report, and does not disclose the qualification of the members of the governance bodies, terms of reference of the governance bodies, director remuneration reports or risk governance structure.

65. The “comply or explain” compliance statements published by listed banks are a good source of information on the bank’s internal governance, but explanations on practices not in compliance with the Corporate Governance Recommendations are not always comprehensive and there are a number of non compliance issues where no explanation is offered.

Key recommendations

Legal framework/Supervisory practice

1. The law should require banks to align their financial statements with the full IFRS.

Bank practice

2. Banks should improve their non financial disclosure on their websites.

Hungary Country Report – 2012 Page 24 of 26

7) Overall assessment of bank governance quality in Hungary

66. The following table provides a preliminary rating of Hungary’s performance in the key governance areas mapped out in the EBRD best practice assessment checklist. Rating in this table is subjective and based on the overall assessment of the strengths and weaknesses of the legal framework, supervisory practice and the practice of banks as discussed above. The rating also reflects our assessment of the legal framework, supervisory practice and the practice of banks compared to international best practice standards.51

Issues Score 52

The strategic and governance role of the board

Strategic role of the board

Do boards have a sufficiently active role in developing and approving the strategic objectives and the budget of their banks?

Weak

Do boards effectively review and evaluate management performance against agreed budgetary targets?

Weak

Governance role of the board

Do boards effectively shape the governance framework and corporate values throughout their organisation?

Weak

Are boards of subsidiaries in a position to effectively control the operation of their banks? Strong

Is there adequate transfer of good practice between parents and subsidiaries? Strong

Board composition and functioning

Size, composition and qualification

Is the size of boards adequate to meet the requirements of their business? Moderately

strong

Are directors qualified for their position? Moderately

strong

Is the board sufficiently independent from management and controlling shareholders? Weak

Are the duties of directors to their banks, shareholders and stakeholders clearly set out? Moderately

Strong

Is there adequate balance of power between individuals within boards and are there adequate checks to maintain the balance?

Weak

51

Best practice standards used in our assessment: Basel Committee on Banking Supervision, Principles for enhancing corporate governance, (2010); Basel Committee on Banking Supervision, Enhancing corporate governance for banking organisations, (2006); EBRD, OECD, Corporate Governance of Banks in Eurasia, (2008); OECD, OECD Principles of Corporate Governance, (2004); European Commission, Corporate governance in financial institutions and remuneration policies, (2010); Institute of International Finance, Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations, (2008); Netherlands Bankers’ Association, Banking Code, (2009) 52

Where: “strong to very strong” - The corporate governance framework / practices of supervisory authorities / practices of banks are fit for purpose and are close to best practice. “moderately strong” - Most parts of the corporate governance framework / practices of supervisory authorities / practices of banks are adequate but further reform is needed “weak” - The corporate governance framework / practices of supervisory authorities / practices of banks contain some elements of good practice but overall the system is in need of reform “very weak” - The corporate governance framework / practices of supervisory authorities / practices of banks contain significant risks and are in need of significant reform.

Hungary Country Report – 2012 Page 25 of 26

Issues Score 52

Do board chairs possess relevant banking and/or financial industry experience and a track record of successful leadership?

Moderately Strong

Do current tenure patterns of board directors suggest a high level of engagement and independence? Moderately

Strong

Do boards provide adequate induction and professional development to their members? Strong

Nomination committees

Is the process for director succession and nomination sufficiently transparent? Very Weak

Functioning and evaluation

Are the responsibilities, authorities, and terms of reference of boards and board committees clearly defined and documented?

Moderately Strong

Do boards function in ways that encourage informed contribution and constructive challenge by all directors?

Moderately Strong

Do boards meet regularly? Moderately

Strong

Are boards and board committees supported by a senior company secretary? Very Weak

Do boards evaluate their performance and discuss the outcome of such evaluation? Weak

Risk governance

Risk governance framework

Are boards and their risk committees sufficiently involved in setting the risk appetite and monitoring the risk profile of banks?

Moderately Strong

Do banks appoint and empower senior chief risk officers? Moderately

Strong

Do senior executives have a sufficiently integrated firm-wide perspective on risk? Moderately

Strong

Risk committees

Are boards in a position to effectively review risk management? Weak

Internal Control

Internal control framework

Does the organisational structure of banks include clearly defined and segregated duties for key officers and effective delegation of authority?

Strong

Are there enough check s and balances to ensure the independence and integrity of financial reporting?

Moderately Strong

Are conflicts of interest including related party transactions effectively managed? Strong

Have banks established effective internal audit departments? Moderately

Strong

Do banks establish effective compliance departments to ensure that they comply with regulatory obligations?

Moderately Strong

Do boards and their audit committees effectively oversee and regularly review the effectiveness of the internal control systems?

Weak

Audit committee

Do boards establish audit committees? Weak

Hungary Country Report – 2012 Page 26 of 26

Issues Score 52

Are audit committees fully independent? Very Weak

Do audit committees include at least one member with substantial auditing or accounting experience?

Weak

Incentives and compensation

Remuneration policy

Do boards and their remuneration committees have a sufficient role in shaping the compensation system of their banks?

Strong

Is remuneration meritocratic and linked to firm and individual performance? Moderately

Strong

Is senior executive compensation aligned with prudent risk management? Moderately

Strong

Remuneration committee

Do boards establish remuneration committees? Moderately

Strong

Are remuneration committees independent from management? Weak

Transparency to the market and regulators

External auditor

Is external auditor independence upheld by boards and their audit committees? Strong

Financial statements

Is IFRS required by law or regulation? Weak

Corporate governance

Do banks report regularly on corporate governance matters? Moderately

Strong

Do banks publish key governance information on their website? Weak

Is disclosure proportionate to size, complexity, ownership structure and risk profile of banks? Weak

Transparency to regulators

Can the supervisory authority obtain information about ultimate ownership and other corporate governance matters?

Moderately Strong