Fitch affirms Croatia's Zagrebacka Banka at 'BBB-', outlook negative

ZABA's negative outlook reflects that on the parent, Fitch said in a statement late on Wednesday, adding that the viability rating (VR) of the Croatian bank was also affirmed at 'bb+'.

"Fitch believes that UniCredit has a strong propensity to support ZABA as the Croatian subsidiary is based in the CEE region, which is strategically important for UniCredit. This is further underpinned by ZABA's close operational integration with its parent and potential reputational damage for UniCredit from a subsidiary default," the statement reads.

Moreover, a potential support should be immaterial for UniCredit since ZABA represents only 2% of its total consolidated assets, Fitch said.

The rating agency also said:

"ZABA's VR considers Fitch's assessment of the operating environment in Croatia and to a lesser extent, of the weaker operating environment in Bosnia and Herzegovina. The latter is partly balanced by the bank's significant credit exposure to the Croatian sovereign. ZABA's standalone credit profile is underpinned by its strong franchise in the local market, robust capitalisation and comfortable funding and liquidity position. However, it also factors in the bank's still large (albeit substantially reduced) stock of legacy bad debts and noticeable volatility in through-the-cycle profitability.

ZABA is the largest bank in Croatia, holding high market shares in customer loans and deposits (about 25%). The bank's strong and domestically diversified franchise, prudent risk management and sizeable capital buffers have underpinned its business model stability. However, ZABA's performance has suffered from the challenging operating environment in Croatia. Apart from Croatia, ZABA operates in Bosnia through its 99.3%-owned subsidiary Unicredit Bank dd, Mostar. At end-3Q19, the Bosnian subsidiary accounted for a moderate share (around 17%) of ZABA's consolidated assets.

In 2019 the Croatian economy has continued to grow at a moderate pace, accompanied by a revival in the domestic real estate market. However, credit demand remained fairly muted (especially in the corporate segment). Fitch expects real GDP growth for Croatia of 2.8% in 2019 and 2.5% in 2020.

In 9M19 ZABA's asset quality improved markedly due to the continued loan book clean-up. The bank sold large amounts of legacy bad debts, taking advantage of stronger investor demand for distressed debt as a result of better economic prospects for Croatia and a strong recovery in real estate prices. Limited new defaults, an improved operating environment and resumed loan growth should support further asset quality improvement. The Stage3 loans/gross loans ratio decreased to about 6.5% at end-3Q19 from 11.3% at end-2018. The coverage of Stage3 loans by total loan loss allowances also improved to about 75%. Substantial non-loan exposures (about 43% of total assets) are predominantly to the Croatian sovereign (upgraded to BBB-/Positive from BB+ in June 2019) and to the Croatian central bank.

ZABA's pre-impairment operating profitability has been stable and solid (at around 2% of average assets), but overall performance has suffered from volatile impairment charges. A dominant market position enables ZABA to maintain heathy net interest margins through active management of funding cost and gradual changes in the loan mix towards higher yielding products. Profitability is also supported by good cost efficiency. The ratio of operating profit to risk-weighted assets improved to about 3.3% in 9M19, but we believe that the bank's current profitability benefits from cyclically low loan impairments and is unsustainable in the long term.

We believe that there is an increased risk of Croatian banks recognising provisions on legal disputes related to legacy Swiss franc mortgage loans. This is based on a growing number of lawsuits filed by Swiss franc borrowers against banks. Any potential losses would be likely spread over time. In our view, this could have an impact on ZABA's profitability, but should not significantly affect its capital position.

Capitalisation is underpinned by ZABA's high Fitch Core Capital (FCC) ratio, sizeable capital surplus over regulatory minimums, solid ability to generate capital internally and potential capital support from the parent. The CET1 and total capital adequacy ratios were about 11.9pp and 8.4pp, respectively, above the regulatory minimums including buffers (under Pillar 1) at end-3Q19. The tangible common equity/tangible assets ratio (about 12.9%) compared well with similarly rated regional peers. Unreserved Stage3 loans equalled a modest 7.4% of FCC, down from about 18% at end-2018.

ZABA's comfortable funding and liquidity position is underpinned by its strong domestic deposit franchise, low share of wholesale funding, substantial liquidity buffers and potential parent support. Customer deposits accounted for around 92% of total funding at end-3Q19 and were predominantly based on granular retail deposits. Concentration in the corporate deposit base is low. Funding from the parent is low (around 5% of total funding) and is extended directly to ZABA's subsidiaries. The loans/deposits ratio was about 78% at end-3Q19.

RATING SENSITIVITIES

IDRS, SR

ZABA's IDRs and SR are sensitive to our view of the ability and propensity of UniCredit to provide support. A downgrade of the parent would likely result in similar action on the subsidiary. However, given ZABA's VR of 'bb+', a potential downgrade would likely be limited to one notch. We do not expect the parent's support propensity to weaken.

VR

An upgrade of ZABA's VR would require a substantial improvement in the operating environment for banks in Croatia (beyond a sovereign upgrade), which is unlikely in the medium term. A downgrade of the VR could be driven by a significant weakening of the bank's capitalisation due to asset quality or profitability deterioration. A sizeable increase of the size of the Bosnian operations relative to operations in ZABA's home market (not Fitch's assumption) would be negative for Fitch's assessment of its operating environment and could put pressure on the VR."