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Greek banks should take precautionary measures ahead of next stress tests round, BoG says

The central bank noted that in order to strengthen financial stability an holistic solution to deal with the non-performing loans problem was needed and warned that "unless there is a turnaround of the existing situation, banks’ profits will not be easily changed given the limited room of cutting operating cost."

Greek banks should take precautionary measures to cover, among others, possible capital requirements resulting from a forthcoming stress tests round, the Bank of Greece (BoG) said in its Financial Stability Review released on Thursday.

The central bank noted that in order to strengthen financial stability an holistic solution to deal with the non-performing loans problem was needed and warned that "unless there is a turnaround of the existing situation, banks’ profits will not be easily changed given the limited room of cutting operating cost."

In its report, the Bank of Greece said that the macroeconomic fundamentals and prospects of the Greek economy have been improving throughout 2019, positively affecting the economic climate. This has been reflected in the operating environment of the banking sector, thus helping to enhance financial stability. As a result, the last remaining capital controls, in force since June 2015 were lifted in September. This should act as a catalyst for attracting investment and bolstering economic activity.

Against the background of the lifting of capital controls and improving fiscal position, Standard and Poor's (S&P) upgraded Greece’s sovereign credit rating once again in October 2019, to BB- from B+, with a positive outlook, signaling a further upgrade in the immediate future. However, Greece still has a non-investment grade rating.

The above developments have contributed to the improvement of banking sector financing conditions and liquidity, enhancing the potential to perform its intermediating function. The environment of very low or even negative interest rates in the euro area exerts a downward pressure on banks' funding costs. Yet, access to money markets is still restricted for Greek banks, which can secure long-term financing only by providing collateral.

At the same time, the Greek banking sector is faced with important challenges relating to: On the rating scales of Standard & Poor’s, Fitch and DBRS, Greek sovereign debt falls short of the investment grade rating by three notches, whereas on Moody’s rating scale, it falls short by four notches.

In order to address these interrelated challenges effectively, either individually or collectively, account must be taken of the interplay of the results of each individual approach. Within this framework, banks’ operating profitability is inextricably linked with the structure of their assets. The particularly large stock of non-performing loans (NPLs) is a determinant of profitability, resulting in a persistently high cost of credit risk (June 2019: 1.8 pct). This cost consequently restricts the net profit margin of banks. Efforts to effectively tackle the large NPL stock have indeed borne fruit. NPL balances have further declined by 7.9 pct or 6.4 billion euros, to 75.4 billion in June 2019, from 81.8 billion in December 2018 (on-balance sheet figures).

It should be pointed out that the cumulative reduction of NPLs from their peak in March 2016 has amounted to 30 pct or 31.8 billion, bearing witness to the successful efforts of all stakeholders. Still, Greece has the highest NPL ratio (43.6 pct) among EU member states, far exceeding the weighted European average of 3 pct. The negative correlation between asset quality and high NPL levels, coupled with the current credit contraction, impacts profitability by leaving little room for its improvement.

The Financial Stability Report looks into the negative correlation between banks’ profitability and asset quality and, more specifically, the large legacy NPL stock on their balance sheets. The capital adequacy of credit institutions remained satisfactory with the Common Equity Tier 1 (CET1) ratio at 15.6 pct as of June 2019. However, the quality of regulatory own funds is worthy of caution, given that the deferred tax credits (DTCs) at sector level exceeded 60 pct of CET1 capital in June 2019.5

It should be pointed out that the high DTC share in the regulatory own funds of banks restricts their ability to accelerate the reduction of the NPL stock, as they are unwilling to use this portion of regulatory own funds to absorb losses. In this context, any additional regulatory capital requirements resulting from the phasing in of IFRS 9, the 2020 stress test, and the introduction of the prudential backstop will act as further aggravating factors. As a result, proactive measures aimed at improving the conditions in the above areas are a key priority to bolster financial stability.

Credit risk at sector level has been reduced compared with previous years, but further rapid reduction of the existing NPL stock is now of utmost importance. Adopting a holistic approach is an imperative in order for banks to proceed with the necessary transformation of their business models. Without factoring in deferred tax assets (DTAs), DTCs account for 54 pct of the total capital base in the reference period. Under Law 4172/2013, this stock shall, in the case of profits, be offset against the amounts of income tax payable by credit institutions and, in the case of losses, determine the amount of banks’ capital increases in favour of the Greek state, resulting in equity dilution. their efficiency and thus ensure the necessary conditions for internal capital generation.

This Financial Stability Report covers the entire financial system, albeit placing an emphasis on the analysis of banking developments, given that the banking sector is of particular relevance. The Report is complemented by special features highlighting topical issues of broader interest.

The resilience of Greek banking groups was strengthened in the first half of 2019 as a result of improvements in capital adequacy and most efficiency indicators. Key drivers behind this are the elevated regulatory own funds and a 390-million-euro profit after tax and discontinued operations, compared with losses in the corresponding period of 2018. In more detail, operating income fell marginally on an annual basis, as the decline in net interest income was largely offset by the increase in non-interest income. As regards the former, the decline in interest income exceeded in absolute terms the corresponding decline in interest expense. Operating expenses were further reduced, mainly as a result of banks’ ongoing restructuring, i.e. staff and branch network reduction.

Against this background, Greek banks' operating profits picked up in the first half of 2019 and their cost-to-income ratio improved. The return to profitability was positively affected by profits from discontinued operations, mainly related to profits from the sale of subsidiaries and affiliated companies of Greek banks.

Banking groups recorded profits after tax and discontinued operations, compared with losses in the corresponding periods of previous years. Greek banks' leveraging also improved vis-à-vis 2018. Liquidity conditions for credit institutions have been continuously improving on the back of an expanding deposit base and broadening funding sources, such as subordinated debt, covered bonds, interbank and repo transactions on more favourable terms, as well as securitisations in the domestic and international markets.

At the same time, bank deposits – a solid source of funding – continued to rise. It is worth pointing out that the upward trend in total deposits was sustained despite persistently low deposit rates. Furthermore, corporations used part of their time deposits to purchase capital goods.

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