OREANDA-NEWS. Regulations to boost SME lending, issued by the Central Bank of Egypt earlier this month, could weaken the quality of loans extended by Egyptian banks in the medium term, says Fitch Ratings. Other measures announced by the central bank on 11 January 2016 are moderately credit positive but are unlikely to significantly affect the banks' overall risk profiles.

The Egyptian government's aim is to increase bank lending to the SME sector over four years to end-2020 by EGP200bn, or USD25bn, equivalent to 26% of end-3Q15 total banking sector loans. In our view, the drive to stimulate the domestic economy is ambitious and could - if implemented - force banks to lend to weaker borrowers to fulfil the lending quotas.

It could encourage banks to restructure existing corporate and SME loans to meet the quotas, which could lead to understated asset quality indicators for the sector. At end-June 2015, non-performing loans (NPLs) for the sector represented 7.6% of total loans, which we think is reasonable considering the operating environment, but the volume of restructured loans not included in NPL figures is significant.

In addition to the SME stimulus package, the central bank cut large exposure limits, but we think this measure will do little to reduce high concentration levels in the corporate loan books because, in our experience, the large privately owned Egyptian banks rarely utilised the maximum available limits. Consumer lending limits were also tightened and local-currency limits for investments in single money market funds were lowered to 2.5% of deposits from 5%.

The impact of the SME stimulus package on overall loan quality will ultimately be determined by how adequately banks price in the incremental risk of lending to smaller, higher-risk customers.

The central bank set a 5% annual maximum lending rate for SME loans, which is well below both the current yield on local treasury bonds (around 13% for a five-year bond) and normal commercial lending rates. Risk weights on SME portfolios will be reduced, but details have not yet been released and any shift away from 0% risk-weighted government bonds, which represented over 40% of sector assets at end-September 2015, will be costly for capital levels.

We think banks may well seek greater incentives to support the SME lending scheme to compensate for low returns, higher capital charges and the higher default rates normally associated with SME lending. We understand that the central bank is considering introducing credit protection guarantees under the scheme but details are not yet public.

New limits on investments in money market funds should encourage banks to prioritise loan growth at the expense of increased investment in government debt. In the longer term, this should shift balance-sheet structures away from government debt. Loans accounted for a mere 32% of total system assets at end-3Q15.

The strong correlation between sovereign and bank risks effectively caps the banks' standalone Viability Ratings (VR) at the level of the sovereign rating. A drastic reduction in government debt exposure, which we do not expect in the short or medium term, could weaken this correlation and lead us to assign VRs above the sovereign rating. Private sector banks such as Commercial International Bank (CIB; B/Stable/b/AA(egy)/Stable) and Credit Agricole Egypt (CAE; NR/NR/NR/AA+(egy)/Stable) are in our view better placed to quickly reduce sovereign debt exposure than public-sector banks such as National Bank of Egypt (NBE; B/Stable/b/AA(egy)/Stable).