29/03/2023 13:49
Moody’s rating agency retains stable outlook on Cyprus’ banking system.
According to a report issued today, despite elevated inflation and higher interest rates that will dampen both economic activity and loan growth in 2023, bank creditworthiness will remain stable.
As it says, loan quality risks are moderated by low unemployment rates, the tourism sector's recovery to pre-pandemic levels, the banks' tighter underwriting standards, ongoing resolution of legacy problem loans and strengthened loanloss reserve coverage.
“Risks to capital have therefore receded and capital will remain sound, supported by improving internal capital generation. Profitability will strengthen, closing the gap with European peers, as higher interest rates unlock the value of Cypriot banks' large and stable liquid assets, and solid deposit funded profiles. Higher rates and cost-cutting by banks will counter the rise in inflation-linked costs and moderately higher loan-loss provisions”, it adds.
Economic activity will slow, which will weigh on banks’ growth potential. Real GDP growth will decelerate below 3% in 2023, from 5.6% in 2022, as inflationary pressures dampen domestic demand and slower euro-area growth drags down external demand.
Economic growth will accelerate in 2024, towards Cyprus' potential growth rate that we estimate at around 3%, underpinned by the European Union's (EU, Aaa stable) Next Generation EU package of grants and loans1 and the related reforms and investments.
Although economic activity will slow this year, following strong momentum in 2022, the economy has been more resilient than originally expected and growth in the next couple of years will outpace the euro area.
Credit conditions in the banking sector will be supported by sustained low unemployment, the strong rebound in the tourism sector (accounting for the majority of banks' Stage 2 loans, which make up 14% of total loans ) to near pre-pandemic levels and a reduction in the rate of inflation.
Asset quality risks are moderate
A combination of resolution and sales of problem loans has reduced rated Cypriot banks’ nonperforming exposures (NPEs4 ) to less than 5,5% as of December 2022, from over 50% in 2015. However, this is still weaker than the EU average of 1.6% as of the third quarter of 2022.
Residual credit risks include a large stock of foreclosed property, which will take time to resolve, while smaller Cypriot banks continue to be saddled with a higher stock of legacy NPEs. Higher inflation and interest rates reduce loan affordability and will lead to new NPE creation and higher loan-loss provisions. The impact will be reduced by tighter underwriting standards in recent years , a pipeline of legacy problem loans that will continue to be resolved, banks' solid track record in dealing with restructurings, and increased loan-loss reserve coverage.
Structural credit weaknesses include high indebtedness and a legal framework governing foreclosures that remains vulnerable to delays and frequent political interference.
Banks’ capital will remain well above regulatory requirements
Risks to capital have receded as banks have largely completed their balance-sheet derisking and large-scale restructuring initiatives. Improved internal capital generation, amid strengthening profitability, will offset the resumption of dividend distributions from 2023 onwards, subject to regulatory approvals. Excess cash liquidity will also likely be deployed into fixed-income securities, which carry a higher risk-weighting, to benefit from higher rates. A potential upgrade of the sovereign rating to investment grade would indicate a reduced risk for banks and improve Moody’s adjusted capital metric, with the two large rated banks’ tangible common equity equivalent to 14.2% of risk-weighted assets as of September 2022.
Profitability will strengthen, as banks' net interest margins widen following hikes in the European Central Bank (ECB)'s policy rate, closing the profitability gap with European banks. Higher rates will allow banks to unlock the value of their large liquid assets portfolio.
At the same time, their retail deposit bases and excess liquidity, with a very low net loan-to-deposit ratio of 46.3%, will keep the interest rates banks pay on their deposits low. Large banks have also taken action to reduce costs by streamlining their operations, in some cases reducing staff numbers through early retirement schemes. This will counter higher inflation-linked costs, lower new lending volumes, higher funding costs as banks issue market funding to meet regulatory requirements (see below), and moderately higher loan-loss provisions. Banks' cost-to-income ratios will improve and move closer to European peers, largely from 2024 onward.
However, the majority of the improvement will be derived from the revenue side, as their cost base continues to reflect ongoing investment in IT and digitalisation and remains structurally constrained. Intense competition in the country's small, saturated banking sector and high private-sector debt will remain a structural weakness that dampens longer-term loan and earnings growth prospects.
Funding and liquidity will remain strong. Banks rely predominantly on stable domestic deposits for their funding, having significantly reduced their dependence on confidence-sensitive foreign deposits and sold or resolved a large portion of their problematic assets. Market funding will gradually increase as banks issue more loss-absorbing debt to satisfy their minimum requirement for own funds and eligible liabilities (MREL), while strengthening the protection afforded to depositors and other senior obligations across the liability structure. Large banks’ access to the markets, despite challenging market conditions, has improved, although the affordability of such funding is still sensitive to market conditions and investor sentiment. Banks' robust liquidity buffers, the majority of which are in cash and balances with the central bank, will be supported by limited lending growth and stable deposits.