The FINANCIAL  -- The credit outlook for the Bulgarian banking system is negative, primarily reflecting the adverse impact of the domestic economic recession on the credit quality and net profits of the country's banks, says Moody's Investors Service in its new Banking System Outlook on Bulgaria.

Moody's negative outlook for the Bulgarian banking system expresses the rating agency's view on the likely future direction of fundamental credit conditions in the industry over the next 12 to 18 months. It does not represent a projection of rating upgrades versus downgrades.

"Following several years of strong economic growth, the Bulgarian economy was significantly affected by the global economic and financial crisis and entered recession in 2009. From the end of 2008, credit activity started to slow down, largely as a result of sluggish credit demand, the more cautious lending practices adopted by credit institutions and tighter financing conditions both domestically and in the international markets," says Elena Panayiotou, a Moody's Analyst and author of the report.

The sharp deterioration in the Bulgarian economy fed through into the banking system in 2009 and Moody's anticipates that the negative trends evidenced in the banks' reported asset quality metrics and bottom-line profitability in 2009 will continue over the next 12 to 18 months.

"We recognise that the banking system remains adequately profitable and has strong capital buffers that were built up during the good macroeconomic conditions in light of the prudent regulation adopted by the Bulgarian National Bank. Hence, the larger and higher-rated banks typically have strong capital levels and a high loss-absorption capacity," Ms Panayiotou explains. Nevertheless, the system's non-performing loans grew at a very rapid pace during 2009, resulting in high provisioning expenses and reduced net profitability for most banks.

The high level of foreign ownership in the banking system has played an important role in recent years in strengthening the service and product quality of the sector and improving the banks' risk management systems and procedures. Moody's cautions, however, that the current downturn will test further the risk management systems that were adopted during a period of economic prosperity and a lending boom.

Although the foreign parent banks are expected to maintain their presence in the Bulgarian market, any incremental funding support they provide is likely to be limited in 2010, given the difficulties faced in their home markets. In cases where support is extended, Moody's believes the costs of provided funds will remain high in view of the higher risks embedded in the Bulgarian market.

"As regards profitability, on the one hand, we expect revenue generation to be constrained by low growth in business volumes, despite good interest rate margins, while net profitability will continue to be affected by elevated provisioning expenses. On the other hand, we expect managements' efforts to rationalise the banks' operations and rein in costs to partly alleviate the pressure on profits," says Ms Panayiotou.

A key rating constraint at present is the significant growth in credit risk assumed by the Bulgarian banks during 2009. Moody's also views the borrower risk concentration in some banks' loan portfolios as giving rise to particular concerns with regard to increased credit losses in case of some corporate defaults. Going forward, the rating agency also cautions that the modest recovery in the economy in 2010 and expectations of a continued rise in unemployment levels suggest that delinquencies will continue to grow, albeit at a slower pace.

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