OREANDA-NEWS. Fitch Ratings has affirmed Zagrebacka Banka d.d.'s (ZABA) Long-term foreign currency Issuer Default Rating (IDR) at 'BBB-', Support Rating at '2' and Viability Rating (VR) at 'bb'. The Outlook on the Long-term IDR is Negative. A full list of rating actions is at the end of this rating action commentary.

KEY RATING DRIVERS
IDRS, SUPPORT RATING
ZABA's Long- and Short-term IDRs and Support Rating are based on the potential support available from its ultimate parent, UniCredit S.p.A. (UC; BBB+/Stable/bbb+). Fitch believes that UC continues to have a strong propensity to support its Croatian subsidiary given the importance of the central and eastern Europe (CEE) region to its strategy, as well as the significant operational integration of the subsidiary, and negative implications of its default for the group. The agency would rate ZABA one notch below UC's Long-term IDR, if not for the cap from the Country Ceiling of Croatia (BBB-) reflecting transfer and convertibility risks.

The Negative Outlook on ZABA's Long-term IDR reflects that on the Croatian sovereign (BB/Negative) and therefore the potential for the bank's ratings to be downgraded if the sovereign rating is downgraded and the Country Ceiling is revised downward.

The planned change of ZABA's direct legal owner to UC from UniCredit Bank Austria AG (BBB+/Stable/bbb+) has no impact on Fitch's view of the parental support available to the Croatian subsidiary.

VR
ZABA's VR is constrained by the operating environment and reflects Fitch's view of the high correlation between the sovereign and the bank's credit profile. The VR also reflects the bank's high stock of impaired loans and muted lending activity, which have weighed on its credit risk profile and profitability. The rating continues to be supported by the bank's leading local market franchise, strong funding and liquidity profile and adequate capitalisation.

The high correlation with the sovereign rating stems from ZABA's high direct exposure to the sovereign, the broader operating environment, and its marginal geographical diversification. At end-3Q15 ZABA's (gross) credit exposure to the sovereign (comprising treasury bills and government bonds, accounts with the central bank, loans to state-owned entities) was equal to around 28% of total balance sheet assets and 210% of Fitch core capital (FCC).

Asset quality remains weak, reflected by the share of impaired loans in total gross loans of 16.4% at end-3Q15, compared with a similarly high sector average of 17.1%. Problem loans were concentrated in the commercial real estate and private individual portfolios. The coverage of impaired loans with total reserves was moderate of 60.9% at end-3Q15. However, the bank could absorb additional impairment charges, if needed, through its pre-impairment profits and the sizeable capital buffer.

In Fitch's view, the long period of recession in Croatia has significantly amplified the credit risks faced by the bank, evidenced by substantial borrower defaults and reduced collateral valuations due to lower recovery expectations. Although impaired loans seem to have peaked, we believe that a significant improvement in loan quality would require a marked economy recovery. The conversion of Swiss franc retail loans into euro in 2H15 could help prevent further deterioration of the retail portfolio, but it is unlikely to cure already defaulted borrowers.

ZABA has substantial capital buffers, but these must be viewed against its high stock of unreserved impaired loans (37% of FCC at end-3Q15) and the challenging operating environment. A large one-off loss from the Swiss franc loan conversion had only a moderate negative impact on the bank's capital since it was largely absorbed by operating profit generated in 9M15. At end-3Q15, ZABA's FCC ratio dropped to 20.9% from 25.3% at end-2014, which was mainly due to the dividend paid by the bank and its loan portfolio expansion (mostly reflecting the acquisition of UC's leasing subsidiary in Croatia).

ZABA's pre-impairment operating profitability has been relatively resilient, which can be attributed to its strong market franchise, large overall size (cost efficiencies) and extensive lending to the broader public sector. The annualised 9M15 operating profit, excluding the conversion-related loan impairment cost of net HRK1.56bn, fell by a modest 3.5% yoy. At end-3Q15 the operating return on average assets stood at 1.1% (end-2014: 1.2%).

ZABA's funding profile is its key rating strength. The bank sources most of its funding from customer deposits, while its wholesale funding is obtained largely from the parent bank. The stability of the deposit base is underpinned by the bank's dominant deposit market share (around 26% at end-3Q15), predominantly based on retail customers. The bank's liquidity position is comfortable, but a significant part of the liquidity buffer is held in Croatian government debt and treasury bills and thus is sensitive to sovereign stress.

RATING SENSITIVITIES
IDRS, SUPPORT RATING
ZABA's IDRs could be downgraded if (i) Croatia's Country Ceiling is revised down; or (ii) UC markedly changes its CEE strategy, resulting in a lower expectation of parent support for its subsidiaries in the region in general, and ZABA in particular. An upgrade of ZABA's Long-term IDR is contingent on an upward revision of the Country Ceiling, which is unlikely at present given the Negative Outlook on the sovereign rating.

VR
The bank's VR is mainly sensitive to potential further deterioration in the operating environment, including that evidenced by a potential downgrade of the sovereign.

The rating actions are as follows:
Long-term IDR affirmed at 'BBB-'; Outlook Negative
Short-term IDR affirmed at 'F3'
Viability Rating affirmed at 'bb'
Support Rating affirmed at '2'.