OREANDA-NEWS. September 21, 2015. Croatia's plan to convert Swiss franc retail loans into euro-denominated ones will impose significant one-off losses on the banking sector, but capitalisation will remain robust, Fitch Ratings says. The switch should also help stabilise non-performing loans, which have grown rapidly in recent years.

The conversion process is complex and has a very short timetable, creating operational challenges. The banks will have to recalculate all past and future repayments and the principal owed as though the loan had originally been made in euros. We expect customer take-up to be high, as the entire cost of the conversion is borne by the banks, although the actual benefit to customers will depend on when they took out the loan.

The Croatian National Bank has estimated that converting the entire stock of Swiss franc household loans (HRK23.5bn or USD3.5bn at end-1H15) would cost the banking sector HRK8bn (pre-tax) and result in a 3.8 percentage point fall in the total regulatory capital adequacy ratio (CAR).

This would be the equivalent of 2.7x annualised 1H15 pre-tax profit for the sector and, as the costs must be recognised immediately, will result in the sector being significantly loss-making in 2015. But capital adequacy will remain robust at 19.7% and banks should be able to replenish the lost capital by 2017. In addition, the scale of Swiss-franc lending to households among Croatian banks was lower than in some other central and eastern European countries, accounting for around 9% of total outstanding loans compared to around 15% in Poland, for example.

The decision to convert loans to euros, rather than the local currency, means exchange-rate risks will not be eliminated, but the central bank's policy of maintaining the kuna within a trading range against the euro will at least reduce FX-related credit risk. The conversion will also lead to a material reduction in loan principal, which we estimate could be 25% on average. The conversion could help prevent a further deterioration in banks' loan portfolios, where sector total non-performing loans have risen rapidly following a prolonged recession to 17.3% of total gross loans at end-1H15. But we believe the most troubled borrowers will not be cured without marked economic recovery.

Based on publicly available information, we estimate that Fitch-rated Zagrebacka Banka (ZABA), the largest Croatian bank by market share, would face a total cost of conversion of around HRK1.8bn (pre-tax) based on its 23% share of sector Swiss franc housing loans at end-2014 and assuming costs are evenly distributed. The costs should be largely covered by 2015 earnings (1H15 annualised pre-tax profit was HRK1.3bn) and we therefore expect only a moderate impact on the bank's capital ratios (consolidated CAR was 22.8% at end-1H15). ZABA's 'BBB-'/Negative rating is driven by potential support from its parent Unicredit S.p.A. (BBB+/Stable), but is constrained by Croatia's Country Ceiling.

The Croatian parliament approved the conversion plans on Friday and the law is likely to be in force by the end of the month, despite a legal challenge from the banks.