Outlook for Cyprus banking remains negative, says Moody’s

The outlook on Cyprus's banking system remains negative, Moody's Investors Service said in a report Thursday.
The rating agency’s pessimistic view is based on the tough operating environment in the banks' main markets; a continued asset-quality deterioration, driven primarily by the weakening repayment capacity of the Greek private sector; and high exposures to Greek government bonds (GGBs), which will subject the banks to economic losses and reductions in capitalisation levels.
The island’s three main banks – Bank of Cyprus, Marfin Popular and Hellenic – announced first half losses this week, but these were burdened with the cost of swaps of Greek debt, estimated at about 100 mln euros for all three. Excluding the swaps, the two first banks said they would report profits.
“Over the next 12-18 months the operating environment will remain challenging for Cypriot banks in their main markets due to slow economic growth in Cyprus (forecast at 0% and 1% for 2011-12) and the expectation that operating conditions in Greece, where rated banks maintain 38% of their loan books, will continue to deteriorate over the outlook horizon,” the rating agency said.
Moody's said it also expects asset quality to deteriorate, reflecting both the reduced payment capacity of Greek households and corporates and some near-term weakening in the performance of loans to the private sector. Aggregate problematic exposure for rated banks will likely increase to 15% of gross loans by year-end 2011, from 12.1% year-end 2010 and 5.9% at year-end 2008. These developments are likely to lead to higher loan-loss provisions and lower profitability.
“While we expect banks to report losses on their Greek operations, primary operations in Cyprus should continue to benefit from strong franchises and good, albeit reduced, pre-provision profitability, which will help to absorb higher provisioning expenses,” the Moody’s report said.
It added that Bank of Cyprus, Marfin Popular Bank and Hellenic Bank maintain sizable exposures to the Greek sovereign, amounting to around 5 bln euros or 70% of Tier 1 equity on an aggregate basis. Moreover, Greece will face significant solvency challenges over the medium-term; therefore, Moody's cannot rule out that further potential losses might occur on Greek sovereign debt holdings, beyond the losses envisaged under the current debt exchange.
In turn, Moody's notes that impairments will lead to lower capitalisation levels and will weaken the banks' ability to deal with any further deterioration in operating conditions.
Despite experiencing deposit inflows since the Greek crisis began, Cypriot banks' relatively high reliance on deposits from foreign owned corporate entities — accounting for a third of total deposits — exposes the three rated banks to potential negative shifts in market confidence and the risk of deposit outflows.
Although Moody's assesses Cypriot banks' capacity to absorb deposit withdrawals as significant, outflows could trigger a painful deleveraging process, it said.