Stable to positive outlook for Croatian banks – Moody’s

The credit outlook for rated Croatian banks is stable to positive, reflecting the banks’ stable fundamentals as well as the positive outlook on Croatia‘s foreign currency debt and deposit ceilings. Foreign investment in the banking sector and recent years’ positive macroeconomic conditions have underpinned buoyant credit demand, facilitating the evolution of the banking sector, Moody’s Investors Service said in its new Banking System Outlook for Croatia.

Key challenges include the rapid pace of asset growth (raising concerns over asset quality problems in the future), Croatia‘s still challenging operating environment and competitive pressures and regulatory burdens, which, although understandable, are weighing on banks’ performance.

Following the wave of bank privatisation in the late 1990s, foreign ownership of Croatian banks accounts for over 90% of the country’s banking assets.

“Foreign investment has resulted in a stable system that inspires confidence in depositors, as well as increasing the level of competition, raising the quality of products and services offered, and helping improve corporate governance practices and enhance transparency. The strategic investors — most of them investment-grade Western European institutions committed to maintaining a foothold in the region — also provide financial support to their subsidiaries in case of need,” said Stathis Kyriakides, a Moody’s Analyst and author of the report.

Nonetheless, Moody’s cautions that two developments are leading to a degree of under-pricing of risk: on the one hand, the banks’ desire to expand and/or defend their market shares and, on the other hand, the capacity of the foreign-owned banks to undertake higher risks to exploit the higher returns available in Croatia, as an emerging market.

Meanwhile, despite the consolidation that has taken place, Croatia remains somewhat over-banked. Although further consolidation and the exit of weaker players would improve the quality and stability of the system, some smaller specialised players could continue to prosper in the medium term. Currently, the system remains highly concentrated, with the two largest banks controlling around 41% of assets.

Despite marked macroeconomic improvements, the operating environment for Croatian banks remains relatively challenging with high levels of unemployment, a large public sector and a judicial system in need of improvements, while some political risk persists.

“A key driver of Croatian banks’ growth in recent years has been the notable surge in household credit demand. Although this focus enhances banks’ loan book granularity and yields higher profit margins than corporate loans, we are somewhat cautious given the high growth rates and the fact that such lending has yet to be tested in a full economic cycle. Given the system’s high euro-isation, customers’ loan servicing capacity could also be compromised in the event of unforeseen unfavourable exchange rate movements,” Kyriakides explained.

During 2006, banks’ aggregate profitability eased for the third year running, reflecting margin pressure and regulatory burdens. Moody’s expects margins to continue to fall, as local currency interest rates will start to converge with the corresponding euro interest rates as Croatia moves closer to joining the EU. The banking system’s asset quality is understood to be relatively healthy and improving, according to official figures.

However, the speed of the credit expansion and the still developing nature of the economy raises some concerns with regard to the level of credit risk going forward. A longer track record and less favourable economic conditions could prove to be a true test of the robustness of the system’s credit portfolios. Meanwhile, the sector’s liquidity profile remains comfortable and capitalisation levels are adequate, although on a declining trend. The system benefits from an improving regulatory and supervisory framework for financial institutions and Moody’s believes that systemically important banks would be likely to enjoy support if needed as the authorities would wish to contain the potential fallout in the event of them encountering financial distress.