Tunisian banks' higher profitability in 1H23 hides mounting liquidity and solvency risks, Fitch Ratings said on Monday.

The delay in Tunisia reaching an agreement with the IMF on a USD1.9 billion support package is making the government increasingly reliant on banks to fund its large financing needs, which could weaken the latter's liquidity and increase solvency risks.

The average annualised return on equity for Tunisia's 10 largest banks increased to 13.6% in 1H23 (2022: 11.9%).

The increase was driven by stronger net interest income, which increased by 16% yoy as banks benefitted from positive jaws amid rising interest rates.

The sector's improved performance in 1H23 is overshadowed by banks' high exposure to the very weak sovereign (Fitch downgraded Tunisia to ‘CCC-' in June 2023) and the uncertain operating conditions. The banking sector's claims on the state were TND20 billion at end-May 2023 (12% of GDP; 13% of sector assets; 73% of sector equity), according to the Central Bank of Tunisia, including local-currency (LC) T-bills and government bonds of about TND14 billion, direct loans to the ministry of finance of TND3 billion, and others of TND2 billion

The banking sector's claims on the state were TND20 billion at end-May 2023, i.e. 12% of GDP.

In a hypothetical sovereign default scenario, Fitch Ratings said, local-currency (LC) sovereign debt restructuring could significantly weaken banks' capitalisation.

"A 50% haircut to banks' LC sovereign debt holdings would result in some banks breaching their minimum regulatory capital adequacy requirements."

In such a scenario, Fitch said, authorities would take steps to limit the net present value losses incurred by banks to safeguard financial stability.

Banks' direct loans to the Ministry of Finance are in foreign currency (FC) and also pose a risk. These have increased significantly and were 11% of sector equity at end-May 2023 (end-2020: 1%).

"A full write-down of FC sovereign exposures in the event of an FC-only sovereign default would materially weaken the sector's total capital ratio (end-1H23: 14.6%) but would not in itself make banks insolvent," the agency said.

Fitch forecasts government financing needs to be about 17% of GDP (about USD7.7 billion) in 2024, which is "high."Banks' capacity to absorb the funding gap is limited by the weak inflow of deposits.

This also leads to increased reliance on central bank funding through open-market operations, which accounted for 8.8% of sector non-equity funding at end-May 2023.

"In addition, we expect banks' funding costs to increase due to competition for scarce liquidity. Consistently high state financing is also crowding out private sector lending," Fitch Ratings said.

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