Research Update: Bank of Cyprus Assigned 'B/B' Ratings; Outlook Positive Primary Credit Analyst: Regina Argenio, Milan (39) 02-72111-208; regina.argenio@spglobal.com Secondary Contact: Miriam Fernandez, CFA, Madrid (34) 91-788-7232; Miriam.Fernandez@spglobal.com Table Of Contents Overview Rating Action Rationale Outlook Ratings Score Snapshot Related Criteria Ratings List WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 23, 2017 1
Research Update: Bank of Cyprus Assigned 'B/B' Ratings; Outlook Positive Overview Bank of Cyprus' (BoC) leading domestic franchise, combined with the challenges of turning around its asset quality and returning to profitability, are reflected in our assessment of its creditworthiness. We are assigning our 'B/B' issuer credit ratings to BoC. The positive outlook reflects our view that the bank will benefit from an improving economic environment and progress in the workout of its nonperforming assets. Rating Action On Oct. 23, 2017, S&P Global Ratings assigned its 'B/B' long- and short-term issuer credit ratings to Bank of Cyprus Public Co. Ltd. (BoC). The outlook is positive. Rationale Our ratings on Bank of Cyprus are supported by its prominent domestic franchise, with about a 40% market share in loans, and its satisfactory funding and liquidity position. At the same time, the ratings are constrained by the challenges the bank continues to face in reducing the sizable stock of problematic assets and returning to sustained profitability. The starting point for our ratings on BoC is the 'b+' anchor, which is based on our view of the Cypriot banking system. The Cypriot banking system remains one of the most fragile in Europe. Nonperforming exposures (NPEs) still represented over half of the loan book at June 2017 and cash reserves only covered about 45% of NPEs. However, the trend in economic risk is positive, in our view, as we think that asset quality problems have bottomed out. In 2017, banks are accelerating the pace of NPE reduction to double digits thanks to ongoing economic recovery and newly adopted legal reforms that are facilitating banks' loan restructurings. The decline is also supported by banks' increased use of debt-to-asset swaps, however, which increases the stock of foreclosed assets on their balance sheets and does not eliminate the risk until banks sell the properties. Given the recent stabilization in real estate prices, we expect banks to sell assets gradually. Therefore, despite some improvements, we expect local banks' asset quality to remain weak in the next two-to-three years. We anticipate that provisions will remain elevated between 7%-8% of loans between 2017-2019 to adequately cover current NPEs. Our view of economic risk also reflects banks' concentration to the real estate WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 23, 2017 2
and construction sector (over 20% of loan book) and extremely high private sector indebtedness, which we estimate will stand at about 250% of GDP at end-2017. Industry risk is stable. We expect Cypriot banks' operating profitability to be substantially absorbed by provisioning needs in the next two years and to start to recover only in 2019. Operating revenues will likely suffer from further deleveraging and compressed margins as banks continue to recover deposits, but we note that the top line of Cypriot banks has fared well during the crisis. We expect funding to remain unbalanced and the portion of nonresident deposits to be higher than peers', while we anticipate limited access to wholesale markets in the next two years as pricing remains high. Our view of industry risk also reflects the weak regulatory track record that preceded the banking crisis in 2013, whereby about 48% of deposits above 100,000 were bailed-in. Nevertheless, we view positively the substantial banking sector consolidation achieved in the past four years and the low reliance on European Central Bank funding compared with other southern European countries. BoC is the largest bank in Cyprus, with total assets of 22.1 billion as of June 2017. It benefits from its leading domestic position, where about 91% of total lending and 95% of operating revenues are based. The bank offers a wide range of banking services across all customer types, focusing particularly on corporates (47% of loan book) and small and midsize enterprises (21%). BoC is currently focused on turning around its financial and business profiles, after the major crisis experienced in 2012-2013. We expect management to continue prioritizing the reduction of the stock of problematic assets, increasing the coverage and strengthening its profitability. So far, BoC has achieved several improvements, but the bank's very high level of uncovered NPEs--accounting for 3.1x of its total adjusted capital (TAC) at end-june 2017--still represents a tail risk, in our view. We consider new business generation to be limited, although gradually progressing over the next two years. New lending will be primarily focused on recovering sectors in Cyprus (i.e. tourism, health, energy, trade, transport) and steadily developing the U.K. franchise. The latter only accounted for about 7% of the loan book at end-june 2017. We see the bank's target to reduce NPEs to below 30% as ambitious. This is mainly because of the severe correction experienced by the real estate prices over the crisis--30% reduction from the peak--recent still untested regulatory reforms on the foreclosure and insolvency law, and the still-high leverage of the private sector. However, we consider that the improving economic environment in Cyprus will support management's tailored actions to reduce the stock of NPEs, contributing to a gradual improvement of the bank's creditworthiness. We anticipate a reduction in NPEs of about 40% in the next two-and-a-half years, bringing the NPE ratio down to below 40% at end-2019. We expect this reduction to be driven by a combination of restructuring, recoveries, sales, structured trades, write offs, and debt-for-property swaps. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 23, 2017 3
We expect BoC's capitalization to gradually benefit from an improvement in asset quality and continuous deleveraging but, in our view, the bank's still-high loan-loss provisions will reduce our measure of TAC and thereby reduce BoC's risk-adjusted capital (RAC) ratio from the calculated 4.5% at end-2016. Specifically, we estimate that the bank will accumulate an additional 5.5%-6.0%% of loan loss provisions between the second half of 2017 and end-2019, including the impact of the new accounting rule IFRS9, and we do not expect the bank's organic capital generation to be sufficient to fully absorb such high provisioning needs. We expect operating revenues to continue to decline during 2017-2019 on the back of lower net interest income. This will be largely driven by the repricing of the loan book at lower rates, the limited possibility of lower deposits funding, and ongoing deleverage. We anticipate that operating expenses will moderately decline as the bank continues to execute targeted staff reduction and introduces some technology and process improvements. Provisioning needs will normalize in 2019, when we expect the bank's TAC to start progressing. As such, we expect our RAC ratio to bottom out between 4.0%-4.5% during the next 12-18 months. We estimate that the bank's RAC ratio would improve by about 80 basis points if we lowered our view of domestic economic risk. In our opinion, our measure of capital doesn't fully capture the bank's higher-than-peers concentration. Specifically, we consider its single-name and sectorial concentration to be material, with its top 20 clients accounting for 12.9% of the total loan book, about 1.2x of its TAC at end-2016, and about 30% of the loans granted to real estate and construction counterparties. In addition, more than 40% of its top 20 clients are nonperforming. This is mainly due to BoC's corporate profile; although we acknowledge that single-name concentration has gradually declined by 39% over the past two-and-a-half years. We have therefore adjusted our assessment of the bank's risk position to properly reflect this weakness. BoC's liquidity position has improved materially over the past two years after the full repayment of the emergency liquidity assistance in early January, achieving a reduction of 11.4 billion since its peak in April 2013. BoC shows a satisfactory buffer of liquid assets, amounting to more than 3 billion at September 2017, mainly in the form of cash and interbank placements. Liquid assets covered short-term wholesale funding maturities by 3.4x as of December 2016. The bank is mostly retail-funded, with customer deposits accounting for about 90% of total funding as of June 2017. Following management's efforts to increase the deposit base, customer deposits rose by about 4 billion or by 30% since end-2014. Most of the recovery was driven by domestic clients. The ratio of loan to deposits stood at 89.8% as of June 2017, down from 145.3% at end-2013. We expect this ratio to continue to improve over the next 12-18 months, as we anticipate a moderate increase in deposits while the loan book will continue to decline. At the end of 2016, our measure of the bank's stable WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 23, 2017 4
funding ratio stood at about 107%, which compares favorably with most of its peers. Moreover, BoC was the first Cypriot bank to regain access to capital markets since the 2013 crisis, with the issuance of a 250 million Tier 2 note in January 2017. Our ratings on the bank do not include uplift for additional loss-absorbing capacity (ALAC). This is because we consider that its ALAC buffer is unlikely to exceed our required 3% threshold for one notch of uplift over a projected two-year period. In particular, we forecast that BoC's ALAC buffer will stand at about 2.5% of S&P Global Ratings' risk-weighted assets at end-2019. Outlook The positive outlook reflects our view that we could raise the long-term rating over the next 12 months if the economic environment in Cyprus becomes more supportive, ultimately resulting in a strengthening of the banks' overall creditworthiness and capitalization. This could happen if we observe that the country is gradually absorbing the credit cost of the bursting of the credit bubble and subsequent deep economic recession, and the bank's RAC ratio improves above 5%. Our outlook also reflects our expectation that BoC remains focused on continuing to reduce its large stock of NPEs, while keeping its coverage ratio similar to current levels. Specifically we expect a decline in its net NPE ratio to about 2.0x-2.3x and its TAC from the current 3.1x, and that its capital ratio will gradually strengthen. We could revise the outlook back to stable if we anticipate that the economic environment in Cyprus is not becoming more supportive for banks, if the bank fails to strengthen its capital position, or if it doesn't maintain an ample liquidity buffer. Ratings Score Snapshot Issuer Credit Rating B/Positive/B SACP b Anchor b+ Business Position Adequate (0) Capital and Earnings Weak (0) Risk Position Moderate (-1) Funding and Average and (0) Liquidity Adequate (0) Support (0) ALAC Support (0) GRE Support (0) WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 23, 2017 5
Group Support (0) Sovereign Support (0) Additional Factors (0) Related Criteria Criteria - Financial Institutions - General: Risk-Adjusted Capital Framework Methodology, July 20, 2017 General Criteria: Methodology For Linking Long-Term And Short-Term Ratings, April 7, 2017 Criteria - Financial Institutions - Banks: Bank Rating Methodology And Assumptions: Additional Loss-Absorbing Capacity, April 27, 2015 General Criteria: Group Rating Methodology, Nov. 19, 2013 Criteria - Financial Institutions - Banks: Quantitative Metrics For Rating Banks Globally: Methodology And Assumptions, July 17, 2013 Criteria - Financial Institutions - Banks: Banks: Rating Methodology And Assumptions, Nov. 9, 2011 Criteria - Financial Institutions - Banks: Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011 General Criteria: Use Of CreditWatch And Outlooks, Sept. 14, 2009 Ratings List New Rating Bank of Cyprus Public Co. Ltd. Counterparty Credit Rating B/Positive/B Additional Contact: Financial Institutions Ratings Europe; FIG_Europe@spglobal.com Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at www.capitaliq.com. All ratings affected by this rating action can be found on the S&P Global Ratings' public website at www.standardandpoors.com. Use the Ratings search box located in the left column. Alternatively, call one of the following S&P Global Ratings numbers: Client Support Europe (44) 20-7176-7176; London Press Office (44) 20-7176-3605; Paris (33) 1-4420-6708; Frankfurt (49) 69-33-999-225; Stockholm (46) 8-440-5914; or Moscow 7 (495) 783-4009. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 23, 2017 6
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