OREANDA-NEWS. Fitch Ratings has upgraded Cyprus-based Bank of Cyprus Public Company Ltd's (BoC) Long-term Issuer Default Rating (IDR) to 'CCC' from 'CC' and Hellenic Bank Public Company Limited's (HB) Long-term IDR to 'B-', with a Stable Outlook, from 'CCC'. At the same time, Fitch has upgraded BoC's Viability Rating (VR) to 'ccc' from 'cc' and HB's VR to 'b-' from 'ccc'. HB's Short-term IDR has also been upgraded to 'B' from 'C'. A full list of rating actions is at the end of this rating action commentary.

These upgrades mainly reflect improved capital buffers following the completion of equity issuances and evidence of better deposit dynamics amid the gradual relaxation of capital controls, which were fully lifted by the authorities in early April 2015. BoC's rating actions also highlight progress made in asset de-leveraging, enabling a reduction of its reliance on central bank funding.

However, these banks' ratings remain deeply sub-investment grade to reflect material failure risk, mainly because of weak loan quality performance and, in the case of BoC, still-high funding imbalances.

KEY RATING DRIVERS - IDRS AND VRS
BoC's and HB's Long-term IDRs are based on their VRs, which reflect their respective stand-alone credit profiles.

Capitalisation and asset quality are important VR drivers for these banks. Our assessment of capital has improved due primarily to the completion of equity issuances of EUR1bn at BoC in September 2014 and EUR0.2bn at HB in January 2015. However, the banks' reinforced loss-absorption capacity remains highly vulnerable to exceptionally high problem loans and to challenging operating conditions, including a weak property market and a recession that will continue in 2015. BoC's VR, at one notch below that of HB, also reflects its weaker funding and liquidity profile.

At end-2014, group problem loans, taking into account impaired and unimpaired 90 days past due loans, were close to a very high 53% for BoC and 54% for HB of gross loans (excluding suspended interest). Reserves held for these loans, at 41% for BoC and 42% for HB, remained in Fitch's opinion low in a scenario of collateral stress. Fitch notes that BoC also has a large performing forborn loan portfolio that is subject to a two-year probation period. The non-performing exposure ratio amounts to 62.9% when including these forborn loans. Both banks have large loan concentrations in the Cypriot real estate sector, which may suffer from further downward asset price corrections.

Loan quality pressures will continue in 2015 as the economy contracts further, but the pace of deterioration may slow. Positively, the debt insolvency framework has recently been passed and its forthcoming implementation, combined with foreclosure laws, should help arrears recovery via, for example, restructuring and/or asset repossessions within a shorter timeframe.

At end-2014, the Fitch core capital/weighted risks ratio was 12.3% for BoC and 12.1% for HB. In addition, HB has contingent convertible debt with strong conversion triggers (8% regulatory common equity tier 1 ratio) that feed into its Fitch eligible capital/weighted risks ratio, standing at a better 15.4% at the same date. While these ratios compare well by international standards, they remain highly sensitive to unreserved problem loans, which represent a multiple of their capital base.

The funding and liquidity profile of the two banks has also improved, supported by better deposit dynamics, especially in 2H14. This was achieved despite a gradual relaxation of remaining capital controls and the release of deposits that were blocked at BoC as part of its recapitalisation process. BoC's customer deposit flows began to stabilise in 2014, whereas HB's grew substantially (up 15% yoy). However, the banks' deposit franchises remain, in Fitch's view, sensitive mainly to Cyprus' recession as well as to risks relating to the recent removal of all capital controls.

At end-2014, BoC's gross loan/deposit (LTD) ratio remained very high at 181%. The gap between loans and deposits is bridged with central bank funds, largely from the Emergency Liquidity Assistance (ELA) facility. BoC has nonetheless been able to reduce funding from central banks by a third since its peak in mid-2013, mainly by de-leveraging. At the same time, highly liquid reserves have grown, although they remain comparatively small at 9% of total assets. Fitch expects BoC to continue to carefully manage down central bank funding absent any unforeseen liquidity shocks.

HB's LTD ratio (excluding suspended interest) was a comfortable 66%, but almost half of its deposits are from non-residents and hence potentially more sensitive. To mitigate this risk, HB holds around half of its assets in the form of high-quality liquid investments.

The Outlook on HB's Long-term IDR is Stable, highlighting Fitch's view that its credit profile is expected to stabilise further.

RATING SENSITIVITIES - IDRS AND VRS
Absent of extraordinary circumstances, BoC's and HB's IDRs are sensitive to the same factors that might drive changes to their VRs.

Any further upgrade of the two banks' VRs is primarily contingent upon a substantial reduction in their exceptionally high stocks of unreserved problem loans, coupled with a sustained capital base. We believe that the foreclosure and insolvency laws could help to ease asset quality challenges over the medium term, although implementation risks are still present. BoC's VR would also benefit from further material reductions in its reliance on central bank funding.

Conversely, BoC's and HB's VRs (and hence IDRs) would be negatively affected by a material deterioration in asset quality that puts solvency at risk, and/or by any unforeseen risks to the stability of their deposit franchises related, for example, to the recent removal of capital restrictions. In the latter scenario, Fitch believes that BoC would be more at risk of a VR downgrade than HB.

KEY RATING DRIVERS - SUPPORT RATING AND SUPPORT RATING FLOOR
BoC's and HB's Support Rating (SR) of '5' and Support Rating Floor (SRF) of 'No Floor' reflect Fitch's expectation that support from the state, while possible, cannot be relied upon despite the two banks' systemic importance to Cyprus, with deposit market shares of around 25% for BoC and 14% for HB. This belief is due mainly to the limited resources at the Cypriot authorities' disposal, as demonstrated primarily by the receipt of an international support package of EUR10bn and the March 2013 imposition of losses on BoC's senior creditors.

RATING SENSITIVITIES - SUPPORT RATING AND SUPPORT RATING FLOOR
Fitch believes there is little upside potential for BoC's and HB's SR and SRF. This is due to the authorities' limited capacity to provide future support, the presence of a resolution scheme with bail-in tools that have already been implemented, but also in light of a clear intention to reduce implicit state support for financial institutions in the EU, following the implementation of the Bank Recovery and Resolution Directive and Single Resolution Mechanism.

The rating actions are as follows:

Bank of Cyprus
Long-term IDR: upgraded to 'CCC' from 'CC'
Short-term IDR: affirmed at 'C'
Viability Rating: upgraded to 'ccc' from 'cc'
Support Rating: affirmed at '5'
Support Rating Floor: affirmed at 'No Floor'

Hellenic Bank
Long-term IDR: upgraded to 'B-' from 'CCC'; Stable Outlook
Short-term IDR: upgraded to 'B' from 'C'
Viability Rating: upgraded to 'b-' from 'ccc'
Support Rating: affirmed at '5'
Support Rating Floor: affirmed at 'No Floor'.