OREANDA-NEWS. The Swiss National Bank's surprise decision to abandon the euro/franc ceiling is likely to add to pressure on Swiss banks' profitability, Fitch Ratings says. The full effect will depend on where the exchange rate settles, and the effectiveness of the banks' hedging strategies.

Appreciation of the Swiss franc will probably have a greater effect on profitability than directly on the banks' balance sheets and regulatory capital and leverage ratios. Many banks, including the country's two largest and many larger private ones, generate a high proportion of revenue in foreign currency, whereas a larger proportion of operating costs are in Swiss francs.

Some banks hedge their income statement against foreign-currency moves, but many do so only partly or not at all. This will put pressure on earnings reported in Swiss francs. Private banks, with a typically larger Swiss franc cost base, are likely to be most affected.

The SNB's lowering of interest rates on some sight deposit account balances to -0.75% from -0.25% will put additional pressure on banks' already narrow net interest margins. They are likely to pass the drop in negative deposit rates on to larger corporate or institutional depositors to maintain adequate net interest margins.

Effects on regulatory capital and leverage ratios are likely to be limited and might in some cases even be positive. Most banks typically run limited open-currency positions, with equity investments in foreign subsidiaries typically hedged. But the sharp appreciation of the franc, which rose by 27% against the euro at one point on Thursday before settling around 13% higher, will test the solidity of the banks' hedging strategies, which will probably need adjustment.

Differences in currency composition of accounting equity, risk-weighted assets and leverage exposures have made it difficult for banks to hedge the various regulatory ratios to the same degree. This is likely to result in some divergence in the sensitivity of these ratios.

A sharp appreciation of the franc after the abandonment of the ceiling would be likely to lead to deterioration of the banks' very strong domestic asset quality. Exposures to exporters unable or unwilling to use the period since implementation of the ceiling in 2011 to improve operating margins, and to the wider tourism sector look most vulnerable. But many banks have been cautious in their approach to lending to these sectors or counterparties.

Domestic demand has been the main driver of Swiss growth, but the potential negative impact on exports presents downside risk to our GDP growth forecasts (+2.1% in 2015 and 2016). Growth risks may also emerge as franc appreciation adds to deflationary pressures (average annualised Swiss CPI was flat in 2014, with a greater impact from foreign goods and services (-1.2%) than domestic goods and services (+0.4%).

The direct hit to official reserves from the lower valuation of euro assets (around 44.6% of official SNB's reserves at end-3Q14) should be seen in the context of the accumulation of large official reserves in recent years, partly due to the ceiling. Reserves increased to 77.7% of GDP (or 12.4 months of external payments last year), up from 51.6% of GDP at end-2011, soon after the ceiling was introduced. . Reserves that might have been spent maintaining the ceiling will now be saved, although the SNB said it "will remain active in the foreign exchange market to influence monetary conditions."