Nicholas Watson in Prague -

With Central European bank stocks having more than doubled from their nadir hit in February, investors are clearly betting the worst is over for many of the region's lenders. But the sector isn't out of the woods yet.

Banks in the wider emerging European region had virtually no exposure to the toxic sub-prime loans that afflicted so many western banks, yet because they were dependent to a greater or lesser degree on foreign funding - UniCredit Group estimates the stock of external liabilities of the region's banks accounted for more than 20% of total banking liabilities - the crisis hurt them through the drying-up of capital inflows and the deteriorating global economic conditions.

Therefore, banks that were less dependent on external funding, like those in the Czech Republic, Slovakia and Poland, suffered least, while those more heavily reliant on funding from international markets or from their parent companies, like those in the Baltic states, were hit hard.

With the four "Visegrad" economies either never having been in recession (Poland) or are working their way out of recession (Czech, Hungary and Slovakia), investors are betting on a quick return to the good old days of double-digit lending growth. Banking stocks in the region have more than doubled since their lows back in February and now trade at an average price/book value of 1.8x. The bulls would argue there is still some juice left in the rally, given that the banks still trade 30-50% off their all-time highs, the region remains under-banked compared to Western Europe and the economies are clearly structurally sound as evidenced by the resilient third-quarter GDP growth figures.

That may be so, but analysts are warning the road ahead could be bumpier and the recovery slower than many hope, and the relief rally in bank stocks is increasingly clashing with reality, as if demand in the post-crisis world will be just as strong as in the pre-crisis world.

Going bad

After the big slowdown this year, analysts expect bank lending in Central Europe to revive only slowly in 2010, with low demand and credit quality concerns keeping a lid on it. Loan growth will be mostly driven by the recovery of corporate lending, though the Czech Republic and Slovakia could show some respectable growth in retail lending in 2010, as both countries weren't part of the retail lending credit boom of the last few years.

UniCredit sees deposit growth slowing in 2010 from the only modest economic recovery and fading effects of state support. Corporate deposits should return to positive growth (to 5.7% from -2.2 % in 2009), though retail deposits will suffer from households' low savings rate from rising unemployment and falling (or flat) salaries, as well as some people pulling money out of bank accounts to put in the recovering stock markets.

Despite increasing signs of an economic recovery in the various countries, the deterioration in asset quality remains a big concern and poses a key risk to the banks' bottom line. "Provisioning for the surge in non-performing loans (NPLs) could quite easily erase the entire profit of the CEE banking system - something we already witnessed at many Czech and Polish banks at the end of the 1990s," warns the Czech brokerage Wood & Company.

In terms of timing, given that NPLs typically lag behind the leading macroeconomic indicators by roughly six to eight months, the fact Central Europe's economies began improving in the second half of this year would point to NPL growth peaking in the middle to end of 2010. UniCredit expects the NPL ratios to peak at more than double the level observed at the end of 2008 (see table). It notes that the deterioration in credit quality has so far been worse in the corporate sector than in the retail segment, with the exception of Hungary, where, however, the NPL ratio for the corporate sector remains higher in absolute terms. Wood says that while 2009 should be a year of corporate loan book deterioration, 2010 is shaping up to be the year of consumer debt deterioration.

The worrying issue for investors, more than the actual levels of NPLs, is that the provisioning by banks to cover these bad loans has dropped to as low as 40-50% of NPLs at some banks, which is way below the historical averages. Wood says that nearly half of all banks in its Central European universe showed an NPL increase that outpaced operating profit growth in the first half of 2009. Assuming 100% provision coverage of the new NPLs, half of the banks would have therefore been loss-making in the period. "If we were to assume banks maintaining NPL coverage at around 70%, a number of CEE banks would be loss-making in 2009," says Wood.

As it was, with banks either not being able to afford or willing to make provisions for these new NPLs, bad loan coverage declined across the board in the first half of the year, which was why the banks posted better-than-expected bottom lines. "While managements of most banks state 'sufficient and high quality' loan collateral as the main reason for the falling provision coverage, the lack of data in this area makes these statements nearly impossible to prove," says Wood.

The bank regulators may prove more intrusive, leading some to warn that the banks could use the fourth quarter of this year, like they did in the fourth quarter of last year, as a kitchen sink to dump in bad news. "As a seasonal hike in costs will decrease profitability anyway, the banks might have to come up with more provisions or collateral to satisfy their auditors," says Wood.

The upshot is that the start of 2010 could see a significant correction in the share prices of the over-heated banking stocks.