Fitch Ratings has affirmed Croatia-based Zagrebacka Banka d.d.'s (ZABA) Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'BBB' with a Stable Outlook and Viability Rating (VR) at 'bb+'.

A full list of rating actions is below.

Key Rating Drivers

ZABA's IDRs reflect the high likelihood of support from its parent, Unicredit S.p.A (BBB/Stable/bbb), as also reflected in its Shareholder Support Rating (SSR) of 'bbb'. We equalise ZABA's IDRs with those of its parent, as in our view, a default of the subsidiary would entail considerable reputational risk for UniCredit, given their common regulation and inclusion in UniCredit's single point of entry resolution group. In our view, any required support for ZABA would be immaterial relative to the parent's ability to provide it. The Stable Outlook reflects that on UniCredit.

The affirmation of the VR considers the bank's improving asset quality and profitability metrics in the post-pandemic recovery. The VR is also underpinned by the bank's strong sector positioning, prudent risk management framework, strong capitalisation and stable funding and liquidity profiles.

We have revised up our assessment of the operating environment for Croatian banks to 'bbb-' with stable outlook. This factors in the sovereign's stronger credit profile and its better capacity to support market stability, the country's expected resilience to external shocks, reasonable growth opportunities for banks following the country's entry to the eurozone and the expected inflow of sizeable EU funds. Banks' asset quality and profitability have improved post-pandemic, while solvency and liquidity metrics were consistently strong.

Dominant Market Position: ZABA is the largest bank in Croatia's small and highly concentrated banking sector, with about a 26% market share in sector assets. It is equally present in both corporate and retail segments, but has a particularly strong positioning in government financing and residential mortgage lending. It also operates a subsidiary bank, which is the largest lender in Bosnia and Herzegovina.

Stabilising Asset Quality: ZABA's impaired loans decreased to 3.5% of loans at end-3Q22 from 5.0% at end-2021, with coverage by specific loan loss allowances at around 70%. Economic challenges, inflationary and energy price pressures will weigh on borrowers' performance over 2023 and we expect moderate increase in impairments, but this comes from the lower levels as asset quality metrics continued to improve in 2H22.

Solid Profitability: Operating profit to risk-weighted assets (RWA) improved further to 3.4% 1H22 from 2.9% in 2021, thanks to the stronger credit growth and lower risk and funding costs as operating conditions remained favourable for Croatian banks. We expect this core profitability metric to moderate to closer to 3% in the next two years, following deceleration in lending in a slowing economy and normalisation of risk costs at around 40-50bp.

Robust Capitalisation: ZABA's capital position is a rating strength. At end-1H22, its common equity Tier 1 (CET1) ratio remained high at 27.6% (end-2021: 32.1%), after cash payout at 100% of ZABA's standalone 2021 profit. It is highly likely that the bank will reinstate its policy to pay out a very high share of current year profits in dividends. We also think that fungibility of capital within the group has increased following Croatia's entry to the Banking Union and actions to optimise capital level might be considered. However, we expect that ZABA will maintain a sizeable capital cushion.

Strong Deposit Franchise: Deposit funding is core (95% of liabilities at end-3Q22), with a sizable share of granular and sticky retail depositors (51% of the total). Strong deposit inflows in 2020-1H22 underpin ZABA's solid market positioning and support robust liquidity profile. ZABA is part of UniCredit's SPE resolution group and any required MREL will be placed internally.

Rating Sensitivities

Factors that could, individually or collectively, lead to negative rating action/downgrade:

ZABA's IDRs and SSRs would be downgraded in case of any of the following: (i) a downgrade of Unicredit's Long-Term IDR; (ii) a change in the resolution strategy of the group with respect to ZABA; (iii) a material rise in sale risk of the subsidiary; or (iv) a change in our view of the parent's propensity to support ZABA for other reasons.

The bank's VR could be downgraded in case of material and sustained deterioration in the bank's core financial metrics. This would be triggered, for example, by a combination of a weakening in asset quality, in particular if the Stage 3 loans ratio was above 8% on a sustained basis, operating profitability (operating profit/RWA ratio is below 1% on a sustained basis) and capital position (CET1 ratio below 13%).

Factors that could, individually or collectively, lead to positive rating action/upgrade:

ZABA's IDRs and SSR would be upgraded in case of an upgrade of Unicredit's Long-Term IDR.

An upgrade of ZABA's VR would require a record of stabilised asset quality metrics, evidenced by low generation of impaired loans and moderation of risks in other credit exposures, while maintaining strong profitability levels and reasonable capital cushion.

VR ADJUSTMENTS

The business profile score has been assigned above the implied score of 'bb' due to the following adjustment reason(s): business model (positive).

The earnings & profitability score has been assigned below the implied category score of 'bbb' due to the following adjustment reason(s): earnings stability (negative)

The capitalisation & leverage score has been assigned below the implied category score of 'a' due to the following adjustment reason(s): risk profile and business model (negative).

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

Public Ratings with Credit Linkage to other ratings

ZABA's IDRs and SSR are linked to UniCredit's IDRs.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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