OREANDA-NEWS. Fitch Ratings has affirmed Zuercher Kantonalbank's (ZKB) Long-term Issuer Default Rating (IDR) at 'AAA' with a Stable Outlook and its Viability Rating (VR) at 'a+'. A full list of rating actions is provided at the end of this rating action commentary.

KEY RATING DRIVERS - IDRS, SUPPORT RATING
ZKB's IDRs are equalised with those of the bank's guarantor and sole owner, the Canton of Zurich (AAA/Stable). The Canton guarantees all of ZKB's non-subordinated liabilities according to a specific cantonal law (ZKB Law). This represents the canton's largest contingent liability, far exceeding its own direct debt. However, in light of the current legal framework, Fitch believes that this does not constraint the canton's ability to recapitalise the bank, should the need arise. In view of the bank's strong financial profile and resilient business model as reflected in its VR of 'a+', we consider the risk of large capital injections as remote.

The guarantee does not explicitly ensure timely support, but Fitch believes that support, if necessary, would be provided in a timely fashion, given ZKB's high importance for the canton and the potential repercussions of a failure for the Swiss financial sector. The bank's strategic importance for the canton is emphasised by its mandate (Leistungsauftrag) detailed in guidelines governed by the ZKB Law, which prescribes a regional focus of its activities on the Canton of Zurich, with limited nationwide or international activities. The Canton of Zurich is also required to maintain a cantonal bank according to the cantonal constitution.

KEY RATING DRIVERS - VR
The VR reflects ZKB's stable and diversified business model, sound profitability, strong asset quality, low risk appetite and strong funding and capitalisation.

The VR also reflects the bank's leading deposit and residential mortgage lending franchises in the Canton of Zurich, with market shares of 28% and 35% at end-2014, respectively. Its focus on Switzerland's largest regional economy mitigates its limited geographic diversification. ZKB is Switzerland's fourth-largest bank by total assets and Zurich is the largest canton, accounting for over a fifth of the country's GDP and just under a fifth of its population.

ZKB's adequate profitability has faced rising pressure since the Swiss central bank introduced negative interest rates and removed the Swiss franc's floor against the euro in 1Q15. Similar to domestic competitors, ZKB has since partly offset the pressure from negative interest rates through higher margins on new mortgages. However, its performance suffers from its decision not to charge negative rates on deposits, except for large short-term corporate balances. Its large liquidity buffer (about CHF30bn held as central bank deposits) further dilutes its return on average assets (RoAA).

In 1Q15, ZKB acquired from the other cantonal banks the 81.9% it did not already own in Swisscanto Holding AG, Switzerland's leading investment fund provider. This will improve revenue diversification and net fee and commission income's contribution to total revenues, which stood at 29% at end-1H15. As the geographic constraint remains in place, we expect the bank to maintain its efforts to diversify revenues, notably by increasing the share of more profitable discretionary asset management mandates. We also expect the bank to gradually adjust the remuneration model of its asset management business to accommodate regulatory changes within the next three years.

Increased client investment activity on the back of market volatility improved ZKB's trading income in 1H15, which accounted for 20% of total operating income (up from 15% in 2014). Combined with solid fee income, this relieved the pressure on interest income, thus increasing operating income to CHF1.1bn, which was partly offset by integration and staff costs related to Swisscanto. Despite likely synergies as the integration nears completion, we expect ZKB's cost base to exceed those of international peers as its cantonal mandate limits flexibility.

On balance, ZKB has consistently released loan loss reserves since 2011 and we expect low loan impairment charges (LICs) in the near term, helped by the borrower-friendly interest rate environment and a resilient Swiss economy as Fitch expects GDP to grow slightly in the next two years. In the medium term, we expect LICs to increase moderately but remain manageable.

In our view, ZKB's cautious risk management adequately mitigates its large exposure to the property market's inherent volatility, and particularly to valuation risk in Zurich's property market. Its sound underwriting standards are evidenced by moderate loan-to-value ratios and below-average loan growth since 2013 in the residential and commercial property segments (83% and 16% of property loans at end-1H15, respectively, ensuring high granularity). Consequently, ZKB could comfortably absorb LICs from a moderate fall in property prices.

Net income for 1H15 improved 17% yoy to CHF393m. Internal capital generation is adequate, even though typically about half of net income is distributed to the canton and municipalities. Capitalisation is strong in absolute terms and compared with international peers, driven by stringent regulatory requirements on Swiss domestically systemically important banks (D-SIB). ZKB strengthened its capitalisation in 2015 by issuing two Tier 2 instruments, freeing up common equity Tier 1 that was previously used to fulfil the progressive component of regulatory requirements. Undrawn CHF575m endowment capital committed by the Canton of Zurich benefits the VR as we would consider a drawdown as ordinary institutional support.

Deposits dominate the funding mix. Wholesale funding needs are moderate and funding costs are low, benefiting from the canton's guarantee and the Swiss public sector's perception as safe haven.

RATING SENSITIVITIES - IDRS, SUPPORT RATING
ZKB's IDRs are subject to the same sensitivities as the canton's IDRs. An increase in the canton's contingent liabilities, which are dominated by ZKB, could pressure the canton's and, thus, ZKB's IDRs. For instance, sustained growth of the bank's balance sheet in excess of the canton's GDP growth or a multi-notch downgrade of ZKB's VR could signal a higher likelihood of support requirements for the canton.

ZKB's IDRs are also sensitive to changes to ZKB's relationship with the canton, especially if the ZKB Law is amended in a way that would weaken the guarantee's effectiveness or cast doubt on the timeliness of support. However, we view this scenario as unlikely in the foreseeable future.

RATING SENSITIVITIES - VR
The VR is primarily vulnerable to large property-related losses potentially arising from a sharp correction of residential property prices in Zurich. We view such losses as the main potential trigger of a significant weakening of ZKB's capitalisation that could threaten its adherence to the D-SIB requirements. However, Fitch does not expect significant house price correction in Zurich in the near term.

ZKB's sound capitalisation and profits could absorb a material settlement potentially resulting from the US tax authorities' ongoing investigations over the bank's legacy US off-shore private banking clients. However, a settlement amount materially above our expectations could reduce ZKB's financial flexibility and damage its reputation, and thus put pressure on its VR.

The rating actions are as follows:

Long-term IDR: affirmed at 'AAA'; Outlook Stable
Short-term IDR: affirmed at 'F1+'
Support Rating: affirmed at '1'
Viability Rating: affirmed at 'a+'