TEXT-S&P summary: Zagrebacka banka dd

Rationale

Standard & Poor's bases its ratings on a 'bb+' anchor, as well as on the bank's "adequate" business position, "adequate" capital and earnings, "adequate" risk position, "average" funding, and "adequate" liquidity, as our criteria define these terms.

We assess ZB's SACP at 'bb+'.

The long-term rating on ZB is one notch above its SACP, reflecting our view of the "strategically important" status of the bank to UniCredit Bank Austria AG, its parent. We believe that ZB's parent would provide extraordinary support in case of need. In addition, we believe that the potential extraordinary support from the Austrian government, which we factor into the ratings on UniCredit Bank Austria, could be extended to its subsidiaries in Central and Eastern Europe (CEE), including ZB.

Our ratings on ZB are capped at the sovereign ratings on Croatia, as we do not believe that ZB has sufficient capital or liquidity to cover the stress that Standard & Poor's associates with a sovereign default scenario, nor that its parent would provide ZB with sufficient support to withstand such stress.

Anchor: 'bb+'

Our bank criteria use our Banking Industry Country Risk Assessment (BICRA) methodology to determine a bank's SACP, the starting point in assigning an issuer credit rating (ICR). Our anchor SACP for a commercial bank operating in Croatia is 'bb+'. We view Croatia's economic growth prospects as constrained by depressed domestic demand and moderate credit growth. That said, EU accession, scheduled for July 2013, should improve Croatia's prosperity and growth potential, if key structural reforms are implemented. Credit risk in the economy is high, in our view; the private sector has moderate levels of debt and a very high proportion of lending is in foreign currencies. Our assessment of the industry in Croatia benefits from the high stability of the banking sector, the benefits and support of foreign players, and an adequate funding structure. Banks have stable core deposits and foreign parents are expected to provide support to their subsidiaries in case of need. Banking regulation and supervision is of adequate quality, though regulators failed to limit bank lending in foreign currencies during the economic boom.

Business position: Leading market position in Croatia ZB's business position is "adequate" in our view. The bank has a long-standing presence in its home market and enjoys a market share of about 25% on loans and deposits. Despite stiff competition, ZB has successfully used its dominant brand and franchise to build up a sound customer base, as demonstrated by stable market shares over recent years. Most of the bank's revenues come from retail and commercial banking activities, while the contribution from trading and other volatile sources is marginal.

The limited geographic diversification is a weakness in our assessment of the bank's business position. Apart from a small subsidiary in Bosnia-Herzegovina, which represents slightly more than 10% of ZB's consolidated risk-weighted assets (RWA), ZB's business is concentrated in Croatia, a relatively small market with only 4.4 million inhabitants. ZB's risk appetite and policies are in line with UniCredit group's guidelines. Management has successfully kept a strong grasp on cost control which has resulted in comparatively good efficiency.

Capital and earnings: Adequate capital level supported by expected good earnings capacity

Our assessment of "adequate" capital and earnings reflects our view that the bank has an adequate capitalization and good efficiency. We anticipate that ZB's risk-adjusted capital (RAC) ratio before adjustments will remain in the 9%-10% range in the next 18-24 months, benefiting from a good earning-generating capacity. We assumed a 60%-70% dividend payout. We anticipate that ZB's operating revenues will likely continue to represent a good cushion against high credit losses. We also anticipate that the pressure on net interest income driven by the increasing funding cost would be somewhat offset by increasing volumes. However, we believe the bank's good efficiency, reflected in a cost-to-income ratio of about 47% in the first quarter of 2012, would continue to support its profitability under current challenging market conditions.

Risk position: Fast lending growth with limited credit risks Our risk position assessment for ZB is "adequate". It balances relatively favorable asset quality metrics when compared to peers in countries with an economic risk score of '7' with the concentrations in the loan book, given the small size of the economy. Loan portfolio structure is well balanced between households and corporate. The share of riskier segments, like consumer loans or construction and the real estate sector, is in line with domestic peers and not increasing. Our view of ZB's relatively simple business model and better-than-peer historical loss experience--with a peak in loan loss provisions in 2010 of 1.15% compared to 1.4% for the industry average--are also supportive of our risk position assessment. Cost of risk fell in the first quarter of 2012 and remained lower than peers. This was mainly driven by loan book growth, while there was some increase in the absolute amount of provisions during this period relating to the continued recession conditions in Croatia. Nonperforming assets grew mainly in the corporate sector in 2011 and relate mostly to the construction and real estate sectors. However, the bank's credit quality still outperforms the domestic banking system. We consider the bank's provisioning coverage ratios of 50%-60% as relatively low, although they may be attributable to the high collateral levels (mainly residential real estate assets).

We expect cost of credit risk to remain below the system average due to the high, and still increasing, portion of state-guaranteed exposure (total credit exposure guaranteed by the government represented about 15% of total loans as of Dec. 31, 2011) and lower-than-system exposure to the consumer finance segment. We note, however, that single-name exposure exists, in line with what we see in small countries with a limited number of large corporations; ZB's top 20 single-name exposures constituted about 116% of ATE (adjusted total equity) as of March 31, 2012. Additionally, loans in foreign currency, mainly in euros or euro-linked, represented a high 77% of the bank's total loan portfolio at year end 2011. Swiss-franc-indexed loans, which we consider most risky due to the high volatility of the Swiss franc-Croatian kuna exchange rate, represented only 10% of the total.

Funding and liquidity: Increasing reliance on parental funding for asset growth put pressure on funding profile and liquidity position ZB's funding is "average" and liquidity "adequate", in our opinion. Its funding profile is underpinned by its large deposit base. However, we believe ZB's fast lending growth is putting pressure on its funding profile, though it still adequately compares with local peers. Its loan-to-deposit ratio has gradually weakened to 120% as of March 31, 2012, from 107% at year-end 2010. Funding gaps are reduced by parental funding (which increased by about EUR400 million over the past 15 months), and short-term local currency funding from domestic banks. (A small part is in foreign currency). The maturity schedule of these deposits is below one month. However, the bank is a net creditor in the local money market.

The total funding from the parent increased to about 22% of total funding (including equity) as of March 31, 2012 (compared to an average 17% in the domestic banking system) from 14% at the end of 2010 (which was in line with the system average).

Total wholesale funding of the group was equal to about 25% of ZB's balance sheet, while its total liquid assets (cash and local government debt) comprised about 17% of total assets, as of Dec. 31, 2011.

External support: One notch of uplift to the SACP for potential group support The long-term rating on the bank is one notch higher than its SACP because of the bank's "strategically important" status to its parent, UniCredit Bank Austria AG (84.2%). We believe ZB fits well with UniCredit group's objective to be a major player in commercial banking in the CEE.

We believe that ZB's parent, UniCredit Bank Austria, would provide extraordinary support in case of need to its Croatian subsidiary. In addition, we think that the extraordinary support from the Austrian government, which we factor into the ratings on UniCredit Bank Austria, could be extended to some extent to its subsidiaries in the CEE, including ZB.

Additional rating factors:

Our ratings on ZB are capped at the sovereign credit ratings on Croatia, as we do not believe that ZB has sufficient capital and liquidity to cover the stress that Standard & Poor's associates with a sovereign default scenario, nor that UniCredit group would provide ZB with sufficient support to withstand such stress, given that the bank is directly exposed to Croatia's declining creditworthiness through its portfolio of government bonds, which, when combined with the loans to the government and public sector, represented about 25% of ZB's total assets as of Dec. 31, 2011, compared to 22% in 2010.

Related Criteria And Research

All articles listed below are available on RatingsDirect on the Global Credit Portal, unless otherwise stated.

-- Banks: Rating Methodology And Assumptions, Nov. 9, 2011

-- Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011

-- BICRA On Croatia Maintained At Group '6', Nov. 9, 2011

-- Bank Hybrid Capital Methodology And Assumptions, Nov. 1, 2011

-- Bank Capital Methodology And Assumptions, Dec. 6, 2010