Moody’s says banking system outlook still ‘negative’

As the government struggles to cope with fiscal woes, labour unrest and a stalemate in talks with the Troika of international lenders, Moody’s issued a report saying that the outlook on the island’s banking system remains ‘negative’, due mainly to a persistently high rate of non-performing loans that could rise to beyond 50%.

One of the biggest problems is the high rate of NPLs, estimated at about 46% of all banks’ loan portfolios, and their inability to recover payments or assets, primarily because of a stubborn parliament’s refusal to pass a law regulating foreclosures, an issue Moody’s does not reflect upon in its report.

A continued rise in problem loans over the next 12-18 months will exacerbate losses and erode banks’ capital, the rating agency said, adding that “the outlook also captures the vulnerability of the banks’ funding bases, owing to fragile depositor confidence after the resolution of the two largest banks in March 2013, leading to depositor losses and continued controls on cross-border transfers.”

“Asset quality deterioration will be driven by lower corporate earnings, reduced net worth of households, a high unemployment rate and falling real estate prices,” said analyst Melina Skouridou.

“Following a cumulative GDP contraction of 7.8% over the past two years, we expect contractions of 4.1% in 2014 and 2.0% in 2015,” she said, adding that “fiscal austerity and reduced business prospects have led to significant reductions in salaries, while declining property prices and the bail-in of depositors have also eroded household and corporate net worth.”

The Moody’s report said that lending growth will remain negative as the principal domestic banks and Co-ops continue to downsize close to the EU average of around 250% of GDP (from around 320% at March 2014) and as households and businesses continue to deleverage. However, bank regulation and supervision are being enhanced, which Moody’s says is “a positive development.”

MAIN CHALLENGE

The acute asset quality deterioration is the main challenge Cypriot banks face. As a result of the disruption from the bailin, the subsequent controls and the economic contraction, problem loan formation accelerated significantly with NPLs rising to 45.6% as of May 2014, from 24.7% in March 2013, representing over 1.5x the country’s GDP, the rating agency said.

“While we expect NPLs to exceed 50% over our outlook period, owing to the high domestic indebtedness, further declines in real-estate prices and high unemployment (15.2% in June 2014), we expect the pace of NPL formation to decelerate as the depth of the GDP contraction eases. At the same time, we consider that the banks’ loan loss reserves (LLRs) against credit losses from these exposures remain low at 35% of NPLs as of March 2014 – particularly given our expectations of further declines in real estate collateral values,” Skouridou said in the report.

Despite the sizeable recapitalisation in 2013, which raised Common Equity Tier 1 (CET 1) ratio to an estimated 12.5% as of March 2014, Moody’s expects that elevated credit costs will lead to additional capital needs for the system. Following the EUR 1 bln capital increase of the Bank of Cyprus in August, the rating agency estimates the sector’s capital needs caused by losses on loans and Cyprus government bonds to be around EUR 700 mln and anticipate that the banks will be able to raise any additional capital through private resources.

“However, we expect the cooperatives will tap the EUR 1 bln programme funds earmarked for the banking system, given their government ownership.”

FUNDING VULNERABILITY

Although the banking system has made progress in terms of eliminating the domestic controls without experiencing large outflows, cross-border controls are still in place and depositor confidence remains fragile following last year’s bail-in. Aggregate deposit balances are stabilising but this is mainly the result of modest growth in the more volatile non-resident deposits.

“We expect a sustained decline in the volume of domestic deposits as households continue to deplete their savings in order to maintain living standards or pay off debt. Although declining, the system’s reliance on Euro-system funding will remain significant, even beyond the 12-18 month outlook horizon,” the Moody’s report said.

The rating agency acknowledges that Cypriot banks face further net losses in 2014, albeit not of the same magnitude as 2012 and 2013, when the banking system reported losses of EUR 4.5 bln and EUR 2.2 bln, respectively.

“High loan-loss charges and very little new business will generate further losses over the next 12-18 months, which we expect to be broadly similar to last year’s EUR 687 mln loss from continuing operations. We expect pre-provision profitability to stabilise to last year’s levels, as pressure on net interest margins (NIMs) will be broadly offset by higher fees and commissions generated by the banks’ international units,” Moody’s said. The rating agency added that while banks have made considerable efficiency gains by reducing headcount and cutting expenses, additional cost-cutting will be difficult to achieve.

NO SUPPORT UPLIFT

“We do not incorporate any rating uplift from systemic support in the banks’ ratings. This takes into account the recent bail-in implemented in Cyprus and the EU Parliament’s vote to adopt the Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism (SRM) Regulation,” the Moody’s report said.

The new framework establishes a region-wide resolution tool with a clear expectation that unsecured creditors will participate in the recapitalisation of banks if needed. Accordingly, even if the government’s capacity (which is currently limited, as indicated by its Caa3 rating) to support banks improves, potential uplift could be constrained by the reduced willingness to support signalled by the adoption of the BRRD and SRM.

Analyst Melina Skouridou concluded that “our negative outlook on the banking system focuses on the underlying credit conditions and the weak operating environment. We maintain stable outlooks on the ratings of two banks and on September 2 we initiated a review for upgrade on the ratings of the Bank of Cyprus, following its recent capital raising. The difference between the system outlook and those of the banks reflect the very low ratings currently assigned to the three rated banks (Bank of Cyprus, Hellenic Bank, Russian Commercial Bank), which are near to the bottom of Moody’s rating scale.”