Polish Banking Sector Outlook 2014: Brighter Prospects Ahead As Economic and Operating Pressures Recede

Polish Banking Sector Outlook 2014: Brighter Prospects Ahead As Economic And Operating Pressures Recede
Primary Credit Analyst: Francesca Sacchi, Milan (39) 02-72111-272; francesca.sacchi@standardandpoors.com Secondary Contact: Pierre Gautier, Paris (33) 1-4420-6711; pierre.gautier@standardandpoors.com
Table Of Contents
Long-Term Growth Prospects Look Healthy A Cautious Stance Sees Further Falls In Foreign Currency Lending Profitability Should Remain Strong, Despite Declining Net Profit In 2013 Capitalization Will Remain Sound, Thanks To Moderate Asset Growth And Steady Earnings Retention Banks' Asset Quality Continues To Stabilize, But Downside Risks Persist Banking System Remains Exposed To A Negative Shift In Investor Confidence Further Industry Consolidation Is On The Cards Appendix Related Criteria And Research
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Standard & Poor's Ratings Services believes that the Polish banking sector will be able to withstand adverse economic and operating conditions and remain strongly profitable in 2013 and 2014, thanks to the banks' sound financial profiles and balanced business models. A domestic economic slowdown and low interest rates inevitably weigh on the profitability and asset quality of Polish banks, but, in our view, these pressures should ease from 2014 onward. Until then, we believe that the Polish banks will optimize their cost bases to mitigate declining revenues and the high cost of credit risk. We also anticipate that consolidation will continue in 2014, as economies of scale are crucial for profitability. Overall, we believe that the banks' financial profiles will recover once the EU economic outlook improves, thanks to Poland's low financial intermediation and increasing wealth. (Watch the related CreditMatters TV segment titled "Brighter Prospects Ahead For Polish Banks In 2014," dated Jan. 14, 2014.) Overview Polish banks should be able to withstand adverse economic and operating conditions thanks to their sound financial profiles and balanced business models. Low interest rates are reducing Polish banks' net interest margins and squeezing their profitability. We anticipate that the banks will manage their cost bases to mitigate declining revenues and the high cost of credit and remain adequately profitable in the next two years. Although we expect the banks' asset quality to stabilize, it could deteriorate if the Polish economy takes longer to recover than we anticipate.
The Polish banking sector's strong fundamentals have helped it withstand the domestic economic slowdown, high exposure to foreign-currency risk in mortgage portfolios, and heavy reliance on parent funding. Over the past two years, Polish banks have reduced their risk appetite; absorbed increased credit risk through their operating revenues; and improved their capitalization, mainly thanks to more moderate asset growth and steady earnings retention. In our view, Polish banks' creditworthiness should benefit in the longer term from the gradual economic recovery, thanks to an improvement in their earnings generation and stabilization of their asset quality. However, we believe that potential downside risks persist in the economy and could put pressure on the Polish banking sector. In our view, Polish banks' credit risk could worsen if the economic slowdown is more prolonged than we currently anticipate. This could further delay Poland from catching up with more mature economies in terms of wealth. In addition, the banks' high exposure to foreign currency risk through their foreign currency-denominated mortgage portfolios could negatively affect their asset quality if investor confidence dwindles and causes the Polish zloty to depreciate sharply.
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Long-Term Growth Prospects Look Healthy

The Polish economy presents good long-term growth prospects for banks, in our view, with low financial intermediation compared with EU countries, increasing GDP per capita, and a population of about 40 million inhabitants. Poland's growth performance has remained relatively robust over the European debt crisis, and Poland is the only EU country that has escaped recession since 2009. Having said that, real GDP growth slowed over 2012 and 2013, to the lowest rate for a decade. Real GDP growth moderated to 1.9% in 2012, from 4.5% in 2011, as the contribution of domestic demand to growth fell dramatically. We forecast modest growth of just over 1% for 2013 and 2% in 2014 (see chart 1). Reduced external demand and uncertainties over changes to the Polish government's fiscal policy have hampered both consumption and investment. That said, the Polish economy is showing signs of recovery. We anticipate that economic growth will average almost 3% between 2014 and 2016, thanks to Poland's strong manufacturing sector, competitive workforce, and increasingly diversified export markets. Recent data also indicate that domestic demand is recovering, and, in our opinion, will resume as the main contributor to overall growth.
Chart 1
Poland's economic performance has been more resilient than that in the rest of the EU since the onset of the financial crisis. Net exports, zloty flexibility, and the central bank's recent cycle of monetary easing have all contributed to
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economic growth. In addition, Poland has diversified its export partners, increasing trade with Russia and Ukraine in particular. This has helped to mitigate reduced demand from Poland's eurozone (European Economic and Monetary Union) partners. Year-on-year lending growth fell to 3% in the first half of 2013, from 7.5% a year before, as credit demand weakened on the back of the economic slowdown, and banks' lending policies tightened (see chart 2). After a double-digit rise in consumer and corporate lending before the onset of the financial crisis, credit growth has decelerated sharply, partly due to negative consumer lending growth for the past two years. Credit growth has been sustained by housing mortgages, which increased by 4% year on year in the first half of 2013. However, demand for housing loans has softened since the beginning of 2013 as the government phases out its "First Family Home" (Rodzina Na Swoim) program, whereby it subsidizes the interest on zloty-denominated housing loans.
Chart 2
Credit demand from corporate entities, especially small to midsize enterprises (SMEs), has suffered from these entities' worsened creditworthiness and an uncertain economic outlook. These factors have kept investments at low levels. Overall, we anticipate that credit to the private sector will match a trend in GDP and grow at a moderate average rate of about 3%-5% over the next two years.
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A Cautious Stance Sees Further Falls In Foreign Currency Lending

Polish banks' risk appetite has decreased over the past two years. Not only are banks moderating credit growth, but they are also reducing lending in foreign currencies. Lending in foreign currencies was high before the financial crisis, and it continues to expose Polish banks to potentially higher losses in the event of a sharp devaluation of the zloty. However, new lending denominated in foreign currencies has reduced substantially. About 94% of new lending in 2012 was in zloty, compared with 88% in 2009, and we expect this figure to rise further (see chart 3).
Chart 3
Additionally, since 2010, the Polish Financial Supervision Authority (KNF) has been attempting to reduce consumer lending--which mainly generated credit losses during the financial crisis--and to curb foreign-currency lending to households by tightening lending standards for consumer credits and for foreign-currency mortgage lending. We believe that the KNF's recommendations have helped reduce lending growth in the consumer segment and the banks' share of foreign-currency mortgages since mid-2010. For example, in early 2010, the KNF imposed tighter standards on lending to households, including capping the debt-to-income ratio under stressed scenarios. In 2011, the KNF strengthened standards on mortgage lending to households by capping the debt-to-income ratio for foreign-currency loans at 42%. Positively, we note that Polish banks now apply stricter rules and parameters when they lend in foreign
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currency (see chart 4).

Chart 4
According to the most recent guidelines issued in June 2013 on the maximum loan-to-value (LTV) ratio, banks have until the end of 2016 to gradually reduce the LTV ratio of newly granted loans to 80%. Finally, since 2011, risk weights for foreign-currency mortgages have risen to 100% from an already high 75%, and compared to a Basel II requirement of 35% on mortgages.
Profitability Should Remain Strong, Despite Declining Net Profit In 2013

Although we anticipate a double-digit decline in net profit for the Polish banking sector in 2013 compared to 2012, we believe the sector will remain strongly profitable overall, with margins sufficiently high to cover high credit losses. Despite a decrease of 40 basis points (bps) since 2009, Polish banks' loss absorption capacity--measured as pre-provision operating income on customer loans--has remained above 3%. The Polish central bank cut the reference interest rate several times in 2013, by a total of 150 bps. The decrease in net interest income was also caused by a drop in the spreads on government bonds in the banks' securities portfolio, which represented about 20% of total assets as of June 30, 2013. The lower interest rate than before the crisis is reducing net
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interest margins and squeezing banks' profitability, especially those with a retail focus (see chart 5).
Chart 5
In addition, a reduction of interchange fees is weighing on commission income. As a result, net interest income declined by 8.8% and fee income by 2.5%, year on year, as of June 2013. A potential increase in the fees banks pay to the Bank Guarantee Fund to enforce the resolution fund could weaken banks' profitability in 2014. Nevertheless, we anticipate that a stabilization of market interest rates and banks' efforts to improve operating efficiency could help net profits to recover in 2014. We anticipate that the Polish banks will optimize their cost bases to mitigate the effect of declining revenues and the high cost of credit risk and remain adequately profitable in the next two years.
Capitalization Will Remain Sound, Thanks To Moderate Asset Growth And Steady Earnings Retention
In our opinion, Polish banks are well-capitalized. The Standard & Poor's risk-adjusted capital (RAC) ratios of the Polish banks we rate are generally higher than those of Western European banks (see chart 6). In addition, Polish banks' capital ratios have improved over the past year, mainly thanks to more moderate asset growth and steady earnings retention. We note that Polish banks have increased their earnings retention since 2011. This follows the KNF's
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recommendation to local banks to refrain from paying out high dividends and to use the profits generated to strengthen their capital bases. We expect this restriction to prevent Polish subsidiaries of foreign banks in financial distress from supporting their parents to an extent that would impair the subsidiaries' stand-alone creditworthiness.
Chart 6
Consequently, we project that Polish banks' capitalization will remain sound overall. The capital ratio of certain banks could weaken slightly due to ongoing acquisitions. This was the case for Powszechna Kasa Oszczednosci Bank Polski S.A. (PKO), the largest state-owned bank in Poland, which recently announced the acquisition of the Polish businesses of Sweden's Nordea Bank AB. Such mergers and acquisitions activity could affect the acquirer-banks' capital, although the extent of the effect will vary by case. However, we do not expect a material weakening in the level of capitalization for the banking sector overall, due to the size of the target or acquired banks.
Banks' Asset Quality Continues To Stabilize, But Downside Risks Persist

Polish banks' asset quality stabilized after a rapid deterioration between 2008 and 2009, when most nonperforming assets (NPAs) came from consumer loans and the corporate sector, mainly SMEs. NPAs stood at 8.7% of gross customer loans as of June 30, 2013, with SMEs still representing most NPAs (see charts 7 and 8). The NPA ratio was
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8.8% as of end-2012 and 8.3% as of end-2011. The stabilization of the banks' asset quality reflects tightened underwriting standards and sales of impaired consumer loans to third parties. With an economic rebound likely to start in 2014, we believe that asset quality is likely to improve gradually.
Chart 7
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Chart 8
We anticipate that the construction and households sectors will generate most of the credit losses in 2013 and 2014. However, we foresee that the magnitude of credit losses in the consumer loans segment will be significantly lower than in 2009-2010. After peaking at about 190 bps in 2009, credit losses have gradually reduced to 100 bps in 2012, and we expect a reduction to about 80 bps on average in 2013-2014 (see chart 9).
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Chart 9
That said, we believe that trends in NPAs and credit losses could diverge from our base-case scenario if the Polish economy takes longer to recover than we anticipate, difficulties in the labor market persist, and real estate prices decrease materially. In addition, we believe it will take time for Polish banks to reduce the stock of NPAs they have accumulated over the past four years.
Banking System Remains Exposed To A Negative Shift In Investor Confidence

Despite its strong financial fundamentals, we consider that Poland's banking system remains exposed to external shocks. We believe that risks posed by rebalancing and deleveraging in Western European economies and a consequent negative shift in investor confidence toward Polish investments could put pressure on the Polish banking system. Our concerns mainly derive from the banks' high exposure to foreign-currency risk in their mortgage portfolios, and their still-high, albeit reducing, reliance on parent funding. Polish banks' exposure to foreign currency lending accounts for about 30% of their total loan book as of mid-2013. The proportion is particularly high for housing loans. We note that the share of mortgages denominated in foreign currency, mostly Swiss francs (CHF), decreased to about 54% as of mid-2013, from 62% at end-2011, but continues to
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exacerbate households' vulnerability to the depreciation of the zloty (see chart 10). Despite the reduction in new foreign currency lending since the beginning of 2012, we believe that it will take time to unwind this structurally risky portfolio because of the long tenor of the mortgages.
Chart 10
Mitigating the aforementioned risk is the relative stability of the zloty versus the Swiss franc over past few years. This attests to investors' confidence in the Polish economy and the adequate credit quality of Swiss franc-denominated mortgages, since these loans were granted to highly creditworthy clients. However, in our view, if a shift in investor confidence caused the zloty to depreciate sharply, this would rapidly increase household debt repayments, thereby increasing NPAs and, as result, credit losses. In addition, some banks have built large funding imbalances in the past decade. In particular, the subsidiaries of large Western European banking groups have relied heavily on parent funding, notably to obtain long-term funds in foreign currency to grant mortgages in Swiss francs. Parent banks have continued to withdraw such funding over the past 18 months since their liquidity positions have been stretched, although this trend is now starting to ease (see chart 11).
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Chart 11
We believe that Western European banks will remain committed to supporting their Polish affiliates because the Polish banking sector remains a profitable investment. Nevertheless, we anticipate that liquidity transfers will likely be lower and more expensive. We acknowledge that Polish banks have substituted funding from their parent banks with domestic customer deposits and other wholesale funding over the past 18 months. We therefore anticipate that Polish banks will become increasingly self-financed if foreign parent banks continue to withdraw funding. We see the reduction in funding imbalances as positive, but at the same time a direct consequence of currently weak credit demand and households' propensity to save money during uncertain economic times. In addition, the covered bonds market is still not a viable alternative for the majority of Polish banks, which adds to their difficulties in accessing long-term funding. In our base-case scenario, however, we expect foreign parents to continue to support their Polish subsidiaries since they are a source of recurrent revenues and economic prospects in Poland are good. We also anticipate that Polish banks will continue to readjust their business models to lending in Polish zloty rather than in foreign currency, financed by domestic customer deposits in zloty.
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Further Industry Consolidation Is On The Cards

There have been some noteworthy mergers and acquisitions in the Polish banking sector over the past two years, such as the expansion into Poland of financially strong players Banco Santander S.A. and Raiffeisen Bank International AG. We view these moves as positive for the Polish banking industry because financially stronger shareholders provide a number of advantages such as better operational and managerial expertise, risk control culture and systems, and access to capital and funding, if needed. In July 2013, PKO, the largest state-owned bank, announced the acquisition of Nordea Bank's businesses in Poland. More recently, BNP Paribas reached an agreement to acquire BGZ bank, the Polish affiliate of Netherlands-based Rabobank. Despite our belief that the Polish banking sector will remain more fragmented than in other Central and Eastern European countries, we anticipate that consolidation will continue in 2014, as economies of scale are crucial for profitability.
Appendix
Table 1
Solicited And Unsolicited Ratings On Polish Banks

Bank Polska Kasa Opieki S.A. Powszechna Kasa Oszczednosci Bank Polski S.A. mBank (formerly BRE bank S.A.) Bank Millennium Capital Group* Bank Handlowy w Warszawie S.A.* BBB+/Stable/A-2 A-/Negative/A-2 BBB+/Negative/A-2 BBpi BBBpi
*Public information; unsolicited ratings. Source: Standard & Poor's Ratings Services as of Jan. 13, 2014.
Table 2
Largest Financial Institutions By Assets

Parent nationality Powszechna Kasa Oszczednosci Bank Polski S.A.* Bank Polska Kasa Opieki S.A. Bank Zachodni WBK S.A. and Kredyt Bank S.A. mBank (formerly BRE Bank S.A.) ING Bank Slaski S.A. Getin Noble Bank S.A. Raiffeisen Bank Polska Bank Millennium Capital Group Bank Handlowy w Warszawie S.A. Polish Italy Spanish German Dutch Polish Austrian Portugal United States Total assets (Bil. PLN) 226.8 150.9 100.8 102.2 78.3 58.8 54.7 52.7 43.5 Gross customer loans (Bil. PLN) 177.4 99.8 71.1 67.6 50.4 46.5 42.3 41.5 16.4 Systemic importance High High -Moderate ---Moderate Moderate
*Pro forma data, including the acquisition of Nordea. Source: Standard & Poor's Financial Institutions Ratings. Data as of year-end 2012. PLN--Polish zloty.
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Related Criteria And Research

Banking Industry Country Risk Assessment: Poland, Oct. 31, 2013 Banks: Rating Methodology And Assumptions, Nov. 9, 2011 Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011 Bank Capital Methodology And Assumptions, Dec. 6, 2010
Additional Contact: Financial Institutions Ratings Europe; FIG_Europe@standardandpoors.com
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Polish Banking Sector Outlook 2014: Brighter Prospects Ahead As Economic and Operating Pressures Recede

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Polish Banking Sector Outlook 2014: Brighter Prospects Ahead As Economic and Operating Pressures Recede

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Polish Banking Sector Outlook 2014: Brighter Prospects Ahead As Economic And Operating Pressures Recede

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Long-Term Growth Prospects Look Healthy

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A Cautious Stance Sees Further Falls In Foreign Currency Lending

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currency (see chart 4).

Profitability Should Remain Strong, Despite Declining Net Profit In 2013

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Banks' Asset Quality Continues To Stabilize, But Downside Risks Persist

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Banking System Remains Exposed To A Negative Shift In Investor Confidence

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Further Industry Consolidation Is On The Cards

Solicited And Unsolicited Ratings On Polish Banks

Largest Financial Institutions By Assets

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Related Criteria And Research

Additional Contact: Financial Institutions Ratings Europe; FIG_Europe@standardandpoors.com

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