The FINANCIAL -- The fundamental credit outlook for the Ukrainian banking sector remains negative, reflecting the vulnerable state of the credit fundamentals of domestic banks in the medium term amid the ongoing financial and economic crisis, says Moody's Investors Service in its new Banking System Outlook on Ukraine .

Particular concerns relate to downward pressure not only on banks' capitalisation and profitability as a result of deteriorating asset quality but also on their liquidity due to weak depositor confidence. Political uncertainty and potential currency volatility is adding to risks in the banks' operating environment.

Moody's negative outlook for the Ukrainian 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.

The Ukrainian economy has been one of the hardest hit during this crisis and GDP contraction is expected to be around 12% for 2009. This has immediate consequences for banks as, under adverse macroeconomic conditions, Ukrainian borrowers are finding it difficult to service their debt. "Moody's estimates that non-performing loans account for about 20% of banks' gross loans and could rise to 25-30% by mid-H1 2010 unless macroeconomic conditions substantially improve," says Yaroslav Sovgyra, a Moody's Vice-President/Senior Credit Officer and co-author of this report.

While the Ukrainian economy is showing some early signs of recovery, any such pickup is likely to affect the banking system with a lag. Banks are currently reducing their balance sheets and Moody's does not expect them to return to growth before the end of 2010.

For now, with a still uncertain macroeconomic outlook, high loan book losses, stronger competition for deposits and reduced foreign funding, Ukrainian banks' loan books are contracting in real terms. Indeed, many banks have largely stopped lending during 2009, which has negative repercussions on growth as the economy's access to new credit is more limited. A reduction in interest-bearing assets will have a direct adverse impact on banks' profitability, which will remain weak in the medium term -- and more than a third of banks were loss-making in Q3 2009.

"With asset quality deteriorating, pressure on Ukrainian banks' capitalisation is high because they have to create provisions for non-performing loans. However, thanks to support from parent banks for those banks with foreign ownership and capital injections by the Ukrainian government for government-owned and nationalised banks, the capitalisation of the banking system is holding up despite an increase in loan loss provisions," explains Katrin Robeck, Associate Analyst and report co-author.

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