The outlook on Egypt's banking system remains negative, reflecting the country's challenging operating environment, says Moody's Investors Service in a new Banking System Outlook.

It also notes the banks' high and rising exposure to Egyptian government debt and their weak capital and asset-quality metrics in the report.

Egypt's operating environment will remain challenging over the next 12-18 months, underpinned by weak economic growth prospects and a negative investment climate. In view of government financing needs stemming from its large budget deficit (equivalent to 10 per cent of GDP in fiscal year 2012), Moody's expects the banks to further increase their already significant sovereign exposures. During 2011, Egyptian banks' government debt holdings increased to 550 per cent of equity, from 430 per cent in December 2010, linking banks' credit profiles directly to the credit risk of the sovereign, it said.

The rating agency also notes that capital levels are weak and that reported capital ratios overstate the extent of banks' current buffers, as high exposures to government securities are zero-risk-weighted. Moody's also expects that the banks' asset-quality metrics will deteriorate over the outlook period, with the ratio of non-performing loans (NPLs) to gross loans reaching 15 per cent-18 per cent by the end of 2013.

Egypt's banking sector faces increasing liquidity challenges, evidenced by a reduction in the banking system's core liquid assets to 17 per cent of total assets at December 2011, from 23 per cent a year earlier. However, Moody's also notes that despite the system's liquidity challenges, Egyptian banks continue to benefit from sound funding profiles due to high levels of deposits, which amounted to 75 per cent of total assets at the end of December 2011.

Moody's expects profitability to be negatively affected by the challenging macro conditions. Specifically, Moody's forecasts that higher provisioning levels will affect bottom-line profits, whilst subdued business growth will affect both interest and non-interest revenue, despite expectations of rising interest margins.

In April 2012, Moody's extended its review for downgrade (initiated in December 2011) of the five rated Egyptian banks, following the extension of the review for possible downgrade of Egypt's sovereign ratings. Given the banking system's high exposure to government bonds, the banks' ratings are on review for downgrade to assess the correlation between their credit risk profiles and the credit risk of the sovereign. - TradeArabia News Service