OREANDA-NEWS. Following the Commonwealth of Puerto Rico's default, ratings for the island's two main banks, Popular (BPOP) and First BanCorp (FBP), will not be immediately affected, according to Fitch Ratings.

The long-term IDR of BPOP of 'BB-' and FBP of 'B-' reflect the persistently weak and difficult operating environment. Fitch believes the banks will be able to weather losses related to Commonwealth exposures. Overall, capital positions and expected profitability at both banks remain adequate to support current rating levels in light of the Commonwealth's recent default.

With that said, despite the ongoing fiscal challenges and economic malaise in Puerto Rico, BPOP's and FBP's ratings remain sensitive to the operating environment, particularly regarding the fiscal situation and its impact to the broader local economy. Unemployment rates have remained high (11.7% as of May 2016) and have not dropped significantly. However, Fitch has a cautious view on long-term economic trends given the structural issues in Puerto Rico that need to be addressed, such as net out migration. Should the Commonwealth's fiscal situation worsen further and lead to a material change in economic trends, BPOP and FBP's ratings may be pressured.

Both Puerto Rican banks have various exposures to the Commonwealth and its instrumentalities. At March 31, 2016, BPOP's direct and indirect exposure totaled $982m, while FBP's direct and indirect exposure totaled $757m. Although these exposures are sizable, they have been reduced over time, and the majority is directly tied to municipalities with some exposures collateralized by tax revenues.

Capital positions support the current rating levels. Our view is that the banks will be able to manage through a period of stress. In a scenario assuming a 40% write-down to direct and indirect exposures, Fitch estimates a pro forma TCE/TA ratio of 12.05% for BPOP and a pro forma TCE/TA ratio of 12.22% for FBP, which would still be relatively high versus similarly sized US mainland banks. Fitch's mid-tier peer group has a median TCE/TA ratio of about 9%.

Fitch also notes that both BPOP and FBP also showed solid capital positions in their 2015 Dodd-Frank Act Stress Test (DFAST) results, which use specifically prescribed macro conditions unique to Puerto Rico's circumstances and worse than those prescribed under the Fed's standard "severely adverse" scenario. The DFAST results reflect a GDP contraction of 3.2%-3.3% (versus a 1.1% contraction for the standard test) and an unemployment rate of 18%-19% (versus 9.2% under the standard test). Both banks passed the tests by comfortable margins over "well-capitalized" minimums.

In Fitch's view, earnings performance for both banks is sustainable, although loan growth will be a challenge. Both banks have returned to profitability, albeit at modest levels. Fitch notes that BPOP and FBP have also worked to stabilize NPAs over the past several quarters; nonetheless, nonperformers remain very elevated compared with US banks. Given the low rate environment and consolidation in the local banking sector, as well as weak loan demand, BPOP's and FBP's liquidity positions have also improved. Funding costs have declined as both banks have reduced their reliance on wholesale borrowings.

Fitch also highlights many of Puerto Rico's 100+ cooperative banks (also known as cooperativas; not rated by Fitch) in its banking sector, which account for about $8.5bn in total assets, have outsized exposures to the Commonwealth and Government Development Bank. As a result, some cooperatives' capital positions are likely weak. In December 2015, the Legislature passed "Proyecto del Senado 1454," which allowed cooperativas to amortize a loss on defaulted Commonwealth bonds over 15 years rather than immediately. Under the final Puerto Rico restructuring bill, cooperativas will likely be handled by the independent oversight committee.