OREANDA-NEWS. Fitch Ratings has upgraded Bank of Cyprus Public Company Ltd's (BoC) Long-Term Issuer Default Rating (IDR) to 'B-' from 'CCC' and Hellenic Bank Public Company Limited's (HB) Long-Term IDR to 'B' from 'B-'. The Outlooks for the two banks' Long-Term IDRs are Stable. A full list of rating actions is at the end of this Rating Action Commentary.

These rating actions reflect Fitch's expectation that some improvement in the economic environment in Cyprus and the implementation of reforms to its insolvency framework will support domestic banks' efforts to manage and reduce very high non-performing loan volumes and enhance recoveries, primarily via forbearance. Investor confidence is also improving following the completion of the international bailout programme in March 2016 and customer deposits in the system have remained broadly stable since capital controls were fully lifted in April 2015.

Nevertheless, these banks' ratings remain deeply sub-investment grade, in particular because their capitalisation is still highly vulnerable to their very weak asset quality. Their internal capital generation capacity is also weak given that modest pre-impairment operating profits are eroded by impairment charges.

KEY RATING DRIVERS
IDRs AND VRs
BoC's and HB's Long-Term IDRs are based on their VRs, which reflect their respective standalone creditworthiness. The very weak asset quality and its capital encumbrance to unreserved problem loans are factors that have a high influence on both banks' VRs.

As a result of the deep recession and restructuring of the banking sector in the past three years both banks are exposed to exceptionally large non-performing exposures (NPEs, as per the EBA's definition) representing 62% of gross loans at BoC and 56% at HB (excluding suspended income) at end-2015. However, we believe that 2015 was an turning point for these banks' asset quality as they experienced a decline in 2H15. At the same time, the composition of NPEs is also improving as a larger proportion of them are being restructured.

The NPE reserve coverages also improved in 2015 as both banks allocated their pre- impairment profits to build additional provisions. However, at end-2015 coverage for NPEs remained low by international standards.

Both banks have reinforced their loss-absorption buffers since September 2014 through equity issuance and as of end-2015 had acceptable Fitch Core Capital (FCC) ratios (12.1% for BoC and 13.4% for HB). However, their capital is tied up with their large unreserved NPEs, which at end-2015 represented around 360% of FCC at BoC and around 246% of FCC at HB.

The stability of customer deposits in Cyprus since the full removal of capital controls in April 2015 has supported the banks' funding profiles. At end-2015 HB had a low gross loans/deposit ratio (excluding suspended income) 66% of which underpins its good liquidity position. At the same date, BoC's gross loan/deposit ratio remained high at 159%. To fund the gap between loans and deposits BoC relies on central bank funds, largely from the Emergency Liquidity Assistance (ELA) facility. However, BoC has been progressively reducing this reliance and we expect this trend to continue in 2016 in the absence of any unforeseen liquidity shocks.

SUPPORT RATING AND SUPPORT RATING FLOOR
BoC's and HB's Support Rating (SR) of '5' and Support Rating Floor (SRF) of 'No Floor' reflect Fitch's expectation that support from the state, while possible, cannot be relied upon despite the two banks' systemic importance to Cyprus, with deposit market shares of around 28% for BoC and 14% for HB at end-2015. This belief is due mainly to the limited resources at the Cypriot authorities' disposal, as demonstrated primarily by the receipt of an international support package of EUR10bn and the March 2013 imposition of losses on BoC's senior creditors.

RATING SENSITIVITIES
IDRs AND VRs
Upside rating potential is limited in the short term, but BoC's and HB's VRs, and hence their IDRs, could be upgraded if they accelerate the recoveries on their exceptionally large problem loan stocks, thus reducing the vulnerability of their capital to further stress in asset quality. We believe that the new insolvency framework and the improvement in the economic prospects for Cyprus could help the banks to make progress in sustainably restructuring larger loan volumes. In the case of BoC, the VR would also benefit from a reduction in the funding imbalances. We expect the bank to continue reducing its reliance on central bank funding progressively in the next 18 months.

A material deterioration in asset quality that jeopardises solvency, or any unforeseen shocks to the stability of the banks' customer deposit bases could result in a downgrade of the VRs. In the latter scenario, Fitch believes that BoC would be more at risk of a VR downgrade than HB.

SUPPORT RATING AND SUPPORT RATING FLOOR
Fitch believes there is little upside potential for BoC's and HB's SR and SRF. This is due to the authorities' limited capacity to provide future support, the presence of a resolution scheme with bail-in tools that have already been implemented, but also in light of a clear intention to reduce implicit state support for financial institutions in the EU, following the implementation of the Bank Recovery and Resolution Directive and Single Resolution Mechanism.

The rating actions are as follows:

Bank of Cyprus
Long-Term IDR: upgraded to 'B-' from 'CCC'; Stable Outlook
Short-Term IDR: upgraded to 'B' from 'C'
Viability Rating: upgraded to 'b-' from 'ccc'
Support Rating: affirmed at '5'
Support Rating Floor: affirmed at 'No Floor'

Hellenic Bank
Long-Term IDR: upgraded to 'B' from 'B-'; Stable Outlook
Short-Term IDR: affirmed at 'B'
Viability Rating: upgraded to 'b' from 'b-'
Support Rating: affirmed at '5'
Support Rating Floor: affirmed at 'No Floor'