The Czech financial sector remained stable in 2012 and in the first quarter of 2013 despite the record-long recession the economy is suffering but risks persist, the central bank said in a newly-published report.

The main risk for the Czech economy that shrank for six straight quarters to Q1 is longer and sharper contraction of economic activity that will lead to a decrease in corporate and household income and in turn increase the risk of deteriorating the bank’s loan portfolios as the number of individuals and businesses able to service their credits will decrease.

The central bank’s stress tests showed that the banking sector, the core of the financial sector, will remain stable and highly resilient to external risks. Banks have a large capital buffer which enables them to absorb adverse shocks and maintain the overall capital adequacy sufficiently above the regulatory threshold of 8% even in a very unfavourable scenario. The central bank tested local lenders under two scenarios - a baseline scenario and a stress scenario. The stress scenario assumes a prolonged contraction in economic activity due to a sharp drop in household consumption and investment in the domestic economy and weak external demand. Under this scenario, 13 banks (representing 17% of the sector) would get into a situation of insufficient capital adequacy and will need a capital injection totalling CZK 16bn (EUR 625mn), or 0.4% of the GDP, the bank said.

Insurance companies and pension funds also passed the stress tests thanks to their high level of capital but the credit union segment is still assessed as risky. The still relatively high interest rates on deposits in the current period of law rates is forcing credit unions to grant risker loans, the bank said.

Increased ownership of government bonds by banks, insurance companies and pension funds poses a risk to their profits as bond yields are posed to increase, the bank said.  The share of domestic sovereign debt held by the Czech banking industry reached 17% of balance sheets in 2012 up from 15% in 2011, nearly three times higher than the average for the euro zone.