BANKING SYSTEM OUTLOOK. Summary Opinion

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1 JUNE 19, 2014 BANKING BANKING SYSTEM OUTLOOK Czech Republic Our outlook for the Czech banking system is negative. The outlook expresses our expectation of how bank creditworthiness will evolve in this system over the next months. Table of Contents: SUMMARY OPINION 1 RATING UNIVERSE 3 OPERATING ENVIRONMENT 5 ASSET QUALITY AND CAPITAL 7 FUNDING AND LIQUIDITY 12 PROFITABILITY AND EFFICIENCY 13 SYSTEMIC SUPPORT 17 SOURCES REFERENCED IN THIS REPORT 19 MOODY S RELATED RESEARCH 19 APPENDIX 1: MOODY S SCENARIO ANALYSIS FOR CZECH RATED BANKS 22 APPENDIX 2: EXCERPT FROM SOVEREIGN CREDIT OPINION 23 APPENDIX 3: BANKING SYSTEM OUTLOOK TABLE 26 APPENDIX 4: GLOBAL COMPARISON CHARTS 27 APPENDIX 5: BFSR / BCA MAPPING TABLE 31 Analyst Contacts: LONDON Oscar Heemskerk Vice President - Senior Credit Officer [email protected] Henry MacNevin Associate Managing Director [email protected] Yves Lemay Managing Director - Banking [email protected] Summary Opinion The outlook for the Czech banking system remains negative, as it has been since December However, the main factors driving the negative outlook have changed since the previous Banking System Outlook published in September The current negative outlook is informed by the recent adoption of the Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism (SRM) regulation in the European Union. In particular, this regulation reflects that with the legislation underlying the new resolution framework now in place and the explicit inclusion of burden-sharing with unsecured creditors as a means of reducing the public cost of bank resolutions the balance of risk for banks senior unsecured creditors has shifted to the downside. Although our support assumptions for Czech banks (as for other European banks) are unchanged for now, there is an increased probability that they will be revised downwards to reflect the new framework. 1 The conditions prevalent in the previous outlook report reflected pressures on asset quality and profitability caused by the country s adverse macroeconomic conditions. While the low interest rate environment will continue to negatively affect banks profitability, we expect that the domestic economy and conditions in the euro area will strengthen to support a more stable operating environment over the months outlook horizon. We forecast Czech GDP growth of 1.9% in 2014, accelerating to 2.5% in Downside risks to our central scenario appear somewhat limited, after a coalition government was established in January 2014 by the country s three main political parties. 3 Importantly, our central scenario for the euro area, the country s main export market, is to exit the recession and grow by % and 1-2% in 2014 and 2015, respectively, which will sustain Czech exports. 1 See Reassessing Systemic Support for EU Banks, 29 May Source: Country Statistics: Czech Republic, Government of, May See Czech Republic: Coalition Agreement Signals End to Political Uncertainty That Has Weighed on Economic Sentiment, a Credit Positive, January 2013.

2 We expect the level of banks non-performing loans (NPLs) to stabilise. These accounted for 5.9% of gross loans as of December On the one hand, the improving economic outlook is likely to prompt mild improvements in the asset quality of the manufacturing and trade segments of the loan book, backed by rising exports. On the other hand, the asset quality of the commercial real-estate (CRE) and construction segments continue to face limited downward pressure because of a slower recovery of domestic demand. Czech banks capital buffers are robust with a system-wide 16.8% aggregate Tier 1 ratio at year-end Funding and liquidity profiles are strong and will likely remain stable over the outlook period. The sector s loan-to-deposit ratio of 76.8% at year-end 2013 and the relatively low incidence of parent funding will help Czech banks limit the possible impact of any pressure arising from foreign parents, in the relatively unlikely event of worsening economic prospects in Western Europe. While earnings remain solid, profitability metrics will remain under downward pressure as (1) the lowinterest rate environment continues to affect Czech banks net interest margins (NIMs); and (2) banks fee income will continue to be constrained by the slower increase in corporate loan volumes with or relative to mortgage lending. This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on for the most updated credit rating action information and rating history. The recent EU BRRD endorses our view of diminishing levels of systemic support from the Czech government, suggesting that support in all EU countries for unsecured creditors (including those of systemically important banks), is also now less certain, even where the sovereign has the resources to fund bank bailouts. We believe that a clear expectation now exists that bail-in tools will be used, if needed, as part of bank resolutions. In light of this assessment, the outlooks on the deposit ratings of the three largest rated Czech banks are negative, reflecting the increased uncertainty regarding the probability of systemic support in case of need. The outlook on the A1 Czech government bond rating is stable, reflecting our expectation that the sovereign will continue its path of public finance and debt consolidation, sustained by the expected pick-up in economic growth. EXHIBIT 1 Overview of key drivers for Czech negative banking system outlook Operating environment Asset quality and Capital Stable Stable + We expect the economic recovery to provide a more stable operating environment for Czech banks. Given the export-oriented profile of the Czech economy, its performance is in large part aligned with developments in Western Europe, the country s major trading partner, where we forecast revival in demand. + We expect asset quality to remain relatively stable in 2014, with potential mild improvement in the manufacturing and retail segments. However, construction and real estate are likely to remain under some pressure. High single-client concentrations increase banks vulnerability to a limited number of borrowers in distress + Robust capitalisation, as reflected in an aggregate 16.8% Tier 1 capital ratio in 2013 Funding and liquidity Stable + Stable funding profile, with banks deposits significantly exceeding their loans as evidenced by the loan-todeposit ratio of 76.8% in 2013 Profitability and efficiency Deteriorating The continued low interest rate environment puts downward pressure on profitability + The expected pick-up in economic growth and reduced competition for deposits will be supportive for the profitability of Czech banks in 2014; however, growth in corporate and consumer lending remains low, only compensated by an increase in mortgage lending. Systemic support Deteriorating Recent trends suggest that support in all EU countries for senior creditors, including those of systemically important banks, is now less certain 4 All system-wide aggregate banking ratios presented in this report, unless otherwise cited, are sourced from the Czech National Bank (CNB). 2 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

3 EXHIBIT 2 Key indicators for the Czech rated banks Pre-Provision Income/ Risk-Weighted Assets (%) Net income/ Risk-Weighted Assets (%) (Market Funds - Liquid Assets)/Total Assets (%) Liquid Assets/Total Assets (%) Cost / Income ratio (%) Tier 1 ratio (%) Tangible Common Equity / Risk-Weighted Assets (%) Problem Loans/Gross Loans (%) Problem Loans / (Shareholders Equity + Loan Loss Reserves) (%) Note: All figures include Moody s Standard Adjustments Source: Moody s Banking Financial Metrics, rated banks, asset weighted EXHIBIT 3 Moody s publicly rated banks Ceskoslovenska Obchodni Banka (CSOB), a.s. Total Assets ($ Million, as of YE2013) Rating Universe» This report focuses on four Czech banks, one securities brokerage and one government-related issuer that we rate (see Exhibit 3); nonetheless, the key statements in the report, the identified credit fundamental trends and the stable system outlook apply to the overall Czech banking system.» The Czech banking system is highly concentrated: three out of our four rated lenders - Ceskoslovenska Obchodni Banka (CSOB), Ceska Sporitelna, and Komercni Banka - are market leaders, as each of them has market shares ranging between 18% and 21% of the system s loans and deposits. Together, the four commercial banks we rate accounted for 61% of total system deposits, 58% of loans and 58% of assets as of year-end Domestic Market Share (loans, as of YE2013) Domestic Market Share (deposits, as of YE2013) LT Debt & Deposit rating/outlook Standalone Credit Strength and Outlook 52, % 18.8% A2/Negative C-/Stable/ baa1 Ceska Sporitelna, a.s. 48, % 20.7% A2/Negative C-/Stable/ baa1 Komercni Banka, a.s. 43, % 18.8% A2/Negative C-/Stable/ baa1 J&T Banka, a.s. 5, % 2.5% Ba1.cz*/ Negative Specialised Lender E+/Negative/ b3 Notches of uplift for external support Ultimate Parent/Owner Parent Standalone Credit Strength and Outlook Ownership 2 KBC Bank N.V. C-/Stable/ baa2 100% 2 Erste Group Bank D+/Negative/ baa3 99% 2 Societe Generale C-/Stable/ baa2 60% - J&T Finance Group -/-/- 100% Czech Export Bank, a.s. 4,799 N/A N/A A1**/Stable -/-/baa3 5 Czech government A1***/Stable 100% 5 Moody s estimates based on company reports and system-wide aggregate data reported by the Czech National Bank (CNB). 3 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

4 EXHIBIT 3 Moody s publicly rated banks Total Assets ($ Million, as of YE2013) Domestic Market Share (loans, as of YE2013) Domestic Market Share (deposits, as of YE2013) LT Debt & Deposit rating/outlook Standalone Credit Strength and Outlook Notches of uplift for external support Ultimate Parent/Owner Parent Standalone Credit Strength and Outlook Ownership Securities Firm BH Securities, a.s. 130 N/A N/A Ba1.cz/Stable N/A - PROXY FINANCE, -/-/- 100% a.s. Notes: The Long-Term Bank Deposit Ratings reflect a bank s standalone credit strength and support considerations. A bank s standalone credit strength reflects its creditworthiness without considering support. The table shows banks standalone credit strength as indicated by our Bank Financial Strength Ratings (BFSR) ratings (on a scale from A to E), the corresponding trend, and the standalone BFSR mapped to our baseline credit assessment ( expressed on a lower-case alpha-numeric scale). For further details, see Moody s banking methodology webpage (follow hyperlink). *J&T Banka and BH Securities are assigned a National Scale Rating. **Czech Export Bank is assigned an A1 issuer and long term debt rating, and a baseline credit assessment of baa3. For further details, see Government-Related Issuers: Methodology Update (follow hyperlink). ***Czech government long-term issuer and debt ratings. The domestic market share of total loans and deposits is estimated by Moody s based on company reports and system-wide aggregate data reported by CNB. Source: Moody s Banking Financial Metrics, CNB system-wide aggregate data, Moody s Calculations» The average (asset-weighted) deposit rating for Czech banks is A2 as of June The top three banks ratings each benefit from two notches of rating uplift as a result of systemic support (see Exhibit 4). This uplift reflects our expectations of a high probability of support being provided by the Czech government in the event of need, considering these banks country-wide presence, large market shares of loans and deposits and importance for the payments system. As discussed above, however, the outlooks on the deposit ratings of the three largest rated Czech banks are negative, reflecting the increased uncertainty regarding the probability of systemic support in case of need following the adoption of the BRRD. EXHIBIT 4 Moody s rated banks Rating Universe, Parental and Systemic Support Aaa BCA Parental / Coop Support Systemic Support Aa2 A1 A3 Baa2 Ba1 Investment grade Ba3 B2 Caa1 Caa3 C Czech Republic (A2) Poland (Baa1) Slovak Republic (Baa1) Romania (Ba2) Hungary (Ba3) Slovenia (Caa1) Source: Moody s Banking Financial Metrics, rated banks, asset weighted» The banking system is mainly foreign owned. Foreign held companies represent almost 82% of all Czech credit institutions. 6 Five Western European banks - KBC Bank NV, Erste Group Bank, Societe Generale, UniCredit SpA and Raiffeisen Bank International AG - own approximately 69% 7 of Czech banking system assets. However, the deposit ratings of the three largest banks we rate do not receive rating uplift from their parent banks because the parents baseline credit assessments (BCAs) are lower than their own. Nonetheless, our rated Czech subsidiaries contribute for a material share of their parents consolidated profits (see Exhibit 5). Although they 6 Moody s estimate based on the number of banks reported by CNB, as of end of December Moody s estimates based on company reports and system-wide aggregate data reported by the CNB. 4 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

5 account for a relatively small proportion of the parents group total assets (3% to 18% as of yearend 2013), their pre-provision income (PPI) represents a much higher percentage, between 8% and 35%, of the groups. EXHIBIT 5 Czech subsidiaries generate significant profit for their parents Parent Parent s BCA Ownership Share of Parent s total Assets, as of YE2013 Contribution to the Parents PPI, as of YE2013 CSOB KBC Bank baa % 18% 21% Ceska Sporitelna Erste Group Bank baa3 99.0% 18% 35% Komercni Banka Societe Generale baa2 60.0% 3% 8% Source: Moody s Banking Financial Metrics Operating Environment We expect the Czech Republic (A1 Stable) to benefit from an export-driven economic recovery in the next months.» We expect real GDP in the Czech Republic to pick up in 2014, after a 0.9% contraction in 2013 and a 1% contraction in 2012 (see Exhibit 6). Our forecast of 1.9% GDP growth in 2014, accelerating to 2.5% in 2015, is underpinned by a recovery in domestic demand and a favourable export performance being largely driven by improvements in demand from Western Europe. We believe the economic recovery will allow the Czech Republic s unemployment rate, at 6.7% as of year-end 2013, to stabilise at the lowest level in the Central and Eastern Europe (CEE) region (see Exhibit 7). EXHIBIT 6 Real GDP Growth Expected to Turn Positive in % 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% Czech Republic Slovakia Hungary Poland Romania Slovenia F EXHIBIT 7 Czech unemployment is the lowest among CEE6* countries, although higher than historic levels 16% 14% 12% 10% 8% 6% 4% 2% Czech Republic Slovakia Hungary Poland Romania Slovenia 0% E 2014F Note: *CEE6, or Central and Eastern Europe Six = Czech Republic, Poland, Slovakia, Romania, Hungary, Slovenia. Source: Moody s Country Credit Statistical Handbook (May 2014), Eurostat, Moody s Analytics (DataBuffet) & Moody s Investors Service» We expect the recovery in exports to benefit from the central bank s (Czech National Bank or CNB) exchange rate commitment decided on 7 November The CNB commits to sell the Czech koruna and buy Euros as needed in order to prevent the koruna from appreciating beyond the historically low rate of CZK27 per euro, while the currency floats freely on the weaker side of this threshold. CNB forecasts this intervention to last for the whole of 2014; we expect it will 5 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

6 likely boost inflation and economic activity, by increasing the system s export competitiveness, while also providing Czech corporates with some certainty regarding the koruna exchange rate.» Downside risk to our central scenario is limited. Political uncertainty appears to have been reduced and the central government s fiscal position is also sound: in spite of the worse-thanexpected GDP contraction in 2013, the government improved its deficit to 1.4% of GDP, from 4.2% in 2012, outperforming its 2.9% target. 8 This result allows the centre-left led coalition government to pursue its stated objective of supporting the economic recovery, through increased capital and welfare spending. The stability of the Czech economic environment is reflected in the 10-year local-currency sovereign yields, which are the lowest across the CEE6 countries (see Exhibit 8). EXHIBIT 8 Czech 10-year sovereign yields are the lowest in the CEE6 region Between April 2013 and April % Czech Republic Hungary Poland Romania Slovenia Slovakia Germany 6% 5% 4% 3% 2% 1% 0% Source: Eurostat» In addition, we consider the vulnerability of the Czech economy to external shocks to be limited. The recent start of the tapering of the US Federal Reserve s quantitative easing policy (US Fed Tapering) did not have a significant impact on the Czech sovereign s cost of funding (see Exhibit 9). In addition, our central scenario is for the euro area to exit the recession and grow by % and 1-2% in 2014 and 2015, respectively. We expect Germany, the main market for Czech merchandise with a 32% share of exports, to grow by about 1.5% a year in 2014 and 1.7% in 2015, after a moderate 0.4% growth in See "Czech Republic: General Government Fiscal Outcome in 2013 Strongly Outperforms Targets Despite GDP Decline, a Credit Positive", April JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

7 EXHIBIT 9 Czech local-currency yield curves: no significant impact from Fed tapering 5 15-Apr Apr mo 6mo 9mo 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 25Y 50Y Source: Bloomberg Asset Quality and Capital We expect asset quality to remain fairly stable in the next months on the back of the export driven economic recovery. Czech banks continue to be well capitalised. Stable asset quality across sectors, supported by the improving economic outlook, although with potential mild pressure in the construction and real estate segments» We expect total NPLs to remain relatively stable in the next months, supported by the improving outlook for the Czech economy. Further, we anticipate improvement in the asset quality of export-driven industries, particularly manufacturing and trade 9 (16.4% of total corporate loans and 32% of NPLs as of year-end 2013), which are likely to benefit from pickup in demand from Western Europe, the country s main trading partner. EXHIBIT 10 Czech banks loan book composition shows concentrations in manufacturing, trade, and real estate and construction Residential mortgages 28% Corporate & SMEs 54% Trade 7% Manufacturing 9% Services 5% Utilities 6% Retail (ex mortgages) 16% Government 2% Real Estate & Construction 14% Other 6% Notes: The percentage breakdown of the Corporate & SMEs segment represent the proportion of the total loan book. Source: CNB, Moody s calculations (as of YE2013) Financial & Insurance activities 7%» The construction and real estate sectors are likely to remain under some pressure (1) as a result of a slower recovery in domestic demand; and (2) because the improvement in these segments generally lags behind the rest of the economy. While delinquencies in loans to the construction 9 See Pickup in car exports signals improvement in Czech banks problem loans, January JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

8 sector increased to nearly 22% in 2013 from 18% in 2012, construction accounts only for 2% of the banking sector s loan book (see Exhibit 11). Nevertheless, we recognise that some Czech banks have larger exposure to this segment, making them more vulnerable to further weaknesses.» The asset quality of banks household loan portfolios remained resilient through the recessionary environment in 2012 and 2013 (see Exhibit 11). We anticipate that improved consumer confidence, which we use as a leading indicator for retail loan performance,9f 10 will continue to drive retail lending growth and help support asset quality. EXHIBIT 11 NPLs breakdown by sector of activity and sector presence in the loan book Proportion of Total Loans (RHS) 25.0% 22.5% 20.0% 17.5% 15.0% 12.5% 10.0% 7.5% 5.0% 2.5% 0.0% Manufacturing Construction Wholesale and Trade Real Estate Households Source: CNB, Moody s calculations 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%» System-wide NPLs remained mostly unchanged, at 5.9% at the year-end 2013, and are among the lowest in the CEE6 region (see Exhibit 12). EXHIBIT 12 Czech NPLs remain among the lowest in the CEE6 banking systems Czech Republic Poland Slovakia Romania Hungary Slovenia 24% 22% 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Notes: *NPLs for Slovenia are defined as total loans in arrears. Source: Financial Supervisory Authorities of Poland and Hungary, National Banks of Czech Republic, Slovakia, Romania and Slovenia, Moody s calculations» These relatively contained levels of NPLs, compared to regional peers, reflect (1) the country s relatively strong industrial base; and (2) limited foreign-currency lending (at about 18% of the 10 See Leading Indicators of Asset-Quality for Banks in Eastern Europe and the Middle East, November JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

9 banks total loans as of end of December 2013, limited to corporate lending) compared to some other CEE countries. 11» Loan loss coverage of problem loans remained mostly unchanged, at about 58% as of year-end Our stress scenarios indicate that capital ratios remain strong under mild and more severe stress loss assumptions (see Appendix 1). Leading indicators for asset quality suggest easing pressure across retail and most corporate segments» Year-on year growth in exports of cars (see Exhibit 13), and machinery and transport equipment (see Exhibit 14), bottomed out in Q3 and Q4 2013, and further accelerated during the first quarter of 2014, signalling easing pressure on NPLs relating to manufacturing and trade.» The three-month average growth in industrial new orders (see Exhibit 15) has reached its highest point since May 2010, and is close to pre-crisis levels, suggesting a favourable outlook for asset quality in the manufacturing sector.» The number of issued building permits, however, continues to decline (see Exhibit 16), suggesting continuing pressure in the construction and real estate sectors.» The consumer confidence indicator in the first months of 2014 has climbed to its highest levels since September 2008 (see Exhibit 17).» The house price index, which has been relatively stable throughout 2013 (see Exhibit 18), does not indicate pressure on retail NPLs. EXHIBIT 13 Car Exports, and Trade and Manufacturing NPLs 40% 30% 20% 10% 0% -10% -20% -30% Car Exports (YoY % change) - LHS Manufacturing PLs (%) - RHS Trade PLs (%) - RHS Mar 2005 Sep 2005 Mar 2006 Sep 2006 Mar 2007 Sep 2007 Mar 2008 Sep 2008 Mar 2009 Sep 2009 Mar 2010 Sep 2010 Mar 2011 Sep 2011 Mar 2012 Sep 2012 Mar 2013 Sep 2013 Mar 2014 Source: CNB, Czech Statistical Office 16% 14% 12% 10% 8% 6% 4% 2% 0% EXHIBIT 14 Machinery & Transport Equipment Exports, and Manufacturing and Trade NPLs Machinery & Transport Equipment Exports (YoY % Change) - LHS Manufacturing PLs (%) - RHS Trade PLs (%) - RHS 40% 17% 20% 0% -20% -40% Mar 2005 Sep 2005 Mar 2006 Sep 2006 Mar 2007 Sep 2007 Mar 2008 Sep 2008 Mar 2009 Sep 2009 Mar 2010 Sep 2010 Mar 2011 Sep 2011 Mar 2012 Sep 2012 Mar 2013 Sep 2013 Mar 2014 Source: CNB, Czech Statistical Office 12% 7% 2% 11 Source: CNB. 9 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

10 EXHIBIT 15 Industrial New Orders and Manufacturing NPLs 30% 20% 10% 0% -10% -20% -30% Industrial New Orders (3m Average of YoY % Change) - LHS Manufacturing PLs (%) - RHS Mar 2005 Sep 2005 Mar 2006 Sep 2006 Mar 2007 Sep 2007 Mar 2008 Sep 2008 Mar 2009 Sep 2009 Mar 2010 Sep 2010 Mar 2011 Sep 2011 Mar 2012 Sep 2012 Mar 2013 Sep 2013 Mar % 14% 12% 10% 8% 6% 4% 2% 0% EXHIBIT 16 Building Permits and Construction and Real Estate NPLs 180, , , , ,000 80,000 60,000 40,000 20,000 - Building Permits (12m rolling total) - LHS Construction & Real Estate PLs (%) - RHS 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Mar 2005 Sep 2005 Mar 2006 Sep 2006 Mar 2007 Sep 2007 Mar 2008 Sep 2008 Mar 2009 Sep 2009 Mar 2010 Sep 2010 Mar 2011 Sep 2011 Mar 2012 Sep 2012 Mar 2013 Sep 2013 Mar 2014 Source: CNB, Czech Statistical Office Source: CNB, Czech Statistical Office EXHIBIT 17 Consumer Confidence and Retail NPLs EXHIBIT 18 House Prices and Retail NPLs Consumer Confidence Indicator - LHS Retail PLs (%) -RHS Flat Price Index (Avg of 2008 = 100) - LHS Retail PLs (%) -RHS % 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% % 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Mar 2005 Sep 2005 Mar 2006 Sep 2006 Mar 2007 Sep 2007 Mar 2008 Sep 2008 Mar 2009 Sep 2009 Mar 2010 Sep 2010 Mar 2011 Sep 2011 Mar 2012 Sep 2012 Mar 2013 Sep 2013 Mar 2014 Mar 2008 Jun 2008 Sep 2008 Dec 2008 Mar 2009 Jun 2009 Sep 2009 Dec 2009 Mar 2010 Jun 2010 Sep 2010 Dec 2010 Mar 2011 Jun 2011 Sep 2011 Dec 2011 Mar 2012 Jun 2012 Sep 2012 Dec 2012 Mar 2013 Jun 2013 Sep 2013 Dec 2013 Source: CNB, Czech Statistical Office Source: CNB, Czech Statistical Office High borrower concentration increases single-name vulnerability The Czech banks single-client concentration remains high, reflecting their predominant focus on the domestic economy and the scarcity of lending opportunities. 12 Excluding banks exposure to the Czech sovereign and major Western European banking groups, the top 20 corporate exposures alone amounted to approximately 115% of the banks Tier 1 capital at year-end 2013, a slight improvement from 130% in Exposure to Western European parents has declined after regulatory intervention Following the introduction of tighter regulatory limits on intra-group transfers in 2012, 14 the gross exposure of the five largest Czech banks to their parent groups declined to 49.1% of their regulatory capital in 2012 from 60.4% in While this decline was caused by a one-off intervention and we do not expect further reduction, the adjustment has been credit positive for the foreign-owned Czech banks, because it reduces the risk that those Czech banks foreign owners with weaker credit profiles 12 For further details see CEE4 Banks: Single-Client Concentration Survey Reveals High Credit Concentrations, January Moody s calculations, based on rated banks. 14 For more detail see Czech Banks: Tightening Regulatory Limits on Group Transfers is Credit Positive, February Source: CNB, Financial Stability Report 2012/2013. Gross exposures include claims in the form of loans provided to the parent groups and claims arising from derivatives transactions and other off-balance-sheet items in the investment and trading portfolios. 10 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

11 would take funding from their subsidiaries, to an extent that would be detrimental to the Czech banking system. Czech banks continue to display robust capitalisation» The capital of Czech banks will remain robust, as banks continue to be profitable, enabling them to take advantage of the growth in mortgage lending and those corporate sectors which will be more favourably affected by the recovery in economic activity and external demand. Nevertheless, we expect lending growth to be in the mid-single digits, a much lower rate compared to historical levels, thus reducing the likelihood of a rapid build up of exposures. Under our central scenario, the rated banks with larger assets are able to withstand a moderate increase in risk provisioning without substantial capital erosion.» System-wide, Czech banks Tier 1 capital ratios increased to an average of 16.8% at year-end 2013 (2012:15.9% and 2011: 14.2%), the highest among its Central European peers (see Exhibit 19). The strong capital ratios partly reflect the banks large exposures to the Czech government (A1, stable), which are generally assigned zero- or very low risk weights. If banks exposures to their domestic sovereign were weighted at a 20% risk weight, 16 the average Tier 1 capital ratio for the rated banks would decline to 15.2%, compared to 16.3% as of year-end 2013, 17 a level which is still at the top range of the peer group.» The improved capital ratios were primarily driven by the good profitability of the Czech banking system, despite the recessionary environment during 2013, and, to a lesser extent, by the optimisation of the banks risk weighted assets. Although capital management practices vary across different banking groups, 18 historically, Czech banks have retained a significant portion of their earnings, with the largest three banks paying an average of 66% of their 2012 net profits as dividends in EXHIBIT 19 Czech banks Tier 1 capital ratio remains among the highest in the CEE6 banking systems 18% 16% 14% 12% 10% 8% 6% 4% 2% Czech Republic Slovakia Poland Hungary Romania Slovenia 0% Note: The most recent Tier 1 ratio for Romania is as of H Source: Financial Supervisory Authorities of Poland, National Banks of Hungary, Czech Republic, Slovakia, Romania and Slovenia 16 Based on Basel II guidance for single A rated sovereigns. Sovereign exposures for the rated banks are estimated based on 2013 annual reports. 17 Excluding Czech Export Bank, which we regard as a Government-Related Issuer 18 For further details on the dividend payouts of the three largest banks, see CSOB, Ceska Sporitelna, Komercni Banka: Peer Comparison, June JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

12 Funding and Liquidity Czech banks benefit from a stable funding profile, with large deposit funding base, and strong liquidity Low loan-to-deposit ratios reflect banks stable funding profile» We expect Czech banks funding profiles to remain stable over the next months, with deposits substantially exceeding loans, as indicated by the system-wide loan-to-deposit ratio of 76.8% as of year-end 2013, which remains the best among CEE6 peers (see Exhibit 20). 19» However, given the historically low interest rates in the Czech Republic, we expect customers to seek alternative products that enable them to earn higher return on their savings, resulting in a slowdown of deposit growth in At the same time, we expect sustained growth in mortgage, manufacturing and trade loans, supported by the improving economic fundamentals. As a result, we expect a slight increase in the loan-to-deposit ratio of Czech banks during EXHIBIT 20 Czech loan-to-deposit ratio is the lowest in the CEE6 banking systems % 140% 120% 100% 80% 60% 40% 20% 0% Czech Republic Poland Slovakia Romania Hungary Slovenia Source: Financial Supervisory Authority of Poland, National Banks of Czech Republic, Slovakia, Romania, Hungary and Slovenia» In 2013, customer deposits grew by 6.7%, and remained the primary source of funding for Czech banks, representing 64% of total liabilities (see Exhibit 21). Retail deposits accounted for 54% of total client deposits (up 2.4% year-on-year in Q4 2013), with the remaining 46% split between corporate and general government deposits (up12.4% year-on-year in Q4 2013).» With a substantial deposit funding base, reliance on market-sensitive funding remains and will continue to be limited such sources accounted for only about 20% of total liabilities as of yearend 2013.» In addition, Czech banks remain relatively independent from their parents, with estimated intragroup funding accounting for about 39% of the three largest banks wholesale funding in All data in this section, unless otherwise cited, is provided by the Czech National Bank. 12 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

13 EXHIBIT 21 Czech Banks are largely deposit funded (year-end 2013) Capital and Reserves 12% Other Liabilities 4% Retail Deposits 35% Debt securities 8% Interbank Loans 12% Source: CNB, Moody s calculations Non-Retail Client Deposits 29%» Liquid assets as a share of total assets remain high at about 33.8% at year-end In addition, about 14% of Czech banks total assets are invested in domestic sovereign securities. Further, domestic banks hold around 45% of all outstanding Czech government debt securities; therefore, in the event of a liquidity squeeze, banks might face difficulty monetising on these assets as a result of insufficient marketability outside the domestic market. However, this risk is somewhat mitigated as these securities can be used as collateral for repo transactions with the ECB in case of need. Profitability and Efficiency We expect Czech banks profitability to remain under pressure from the low interest rate environment, though partly offset by reduced competition for deposits and growing loan volumes as the economic recovery picks up Low interest rates will continue to hinder Czech banks profitability, partly compensated by a volume increase in the more profitable loan book segments» Although Czech banks profitability metrics are still very strong compared to regional peers, these metrics decreased in 2013 (see Exhibit 22), with the system-wide Return on Equity dropping by more than 250 bps, to 13.7%. We expect profitability to stabilise at the current levels, as net interest income, which constituted about 63% of the sector s 2013 operating revenues, will continue to be affected by the low interest-rate environment, in turn, affecting new lending and re-pricing. We expect banks weaker interest income to be partially offset by reduced competition for deposits and by the anticipated economic recovery, enabling banks to expand their loan books. 20 Source: CNB, Moody s Calculations. Liquid Assets are defined as all marketable debt securities, cash, deposits and loans with the central banks. 13 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

14 EXHIBIT 22 Czech banks earnings face downwards pressure 3.0% Net Interest Margin (LHS) RoA (RHS) RoE (RHS) 16.5% 2.5% 16.0% 2.0% 15.5% 1.5% 15.0% 1.0% 14.5% 0.5% 14.0% 0.0% Source: Czech National Bank 13.5%» System-wide net interest margins shrank to 2.3% as of year-end 2013 from 2.5% in 2012 and 2.7% in 2011, as loan yields continued to decline at a rapid pace. 21 The average interest rate on outstanding mortgage loans, as measured by local real estate company Hypoindex, has declined every month since October 2013, reaching the historical low of 2.88% in April (see Exhibit 23). EXHIBIT 23 Average mortgage loans interest rates in the Czech Republic are at historically low levels 7% 6% 5% 4% 3% 2% 1% 0% Source: Hypoindex» Czech banks sizeable liquidity buffers (as reflected in 76.8% loan-to-deposit ratios as of year-end 2013) are commonly invested in government securities (Sovereign rating: A1 stable), characterised by a low risk-low yield profile, or deposited with the central bank. In particular, the yield on the five-year Czech Republic government bond decreased to about 75 bps at the end of May 2014 from 1% as of year-end 2013 (2010: 2.9%). As of December 2013, 34% of Czech banks assets were in the form of cash or deposits with the central banks or securities, up from 31% in December 2012, which contributed to the contraction in profitability.» We expect banks to increase the relative size of their loan books and reduce the proportion of liquid assets as the export-driven economic recovery gains momentum. Loan book dynamics 21 For further details see Low Interest Rates Hurt Czech Banks Profitability, May See Historically Low Mortgage Interest Rates Are Credit Negative for Czech Banks, June JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

15 accelerated in the second half of 2013: growth in total loans increased significantly to 6.6% yearon-year as of December 2013, after decelerating to 2.4% in 2012, but still remains substantially below the high double-digit pre-crisis level (see Exhibit 24). The growth in total loans was mostly driven by mortgage lending (up 5.2% year-on-year in 2013), also on the back of the banks balance sheet risk deleveraging, while consumer lending grew by a modest 0.4% during the same period. This performance represents a trend inversion after nine quarters of negative year-on-year growth in consumer lending, and is a first signal of increasing demand for consumer loans. Corporate loans grew by 3.8% year-on-year, up from 0.9% in 2012, but remain well below the pre-crisis peak. EXHIBIT 24 Recent loan growth is driven by lower yielding mortgage loans Loans for house purchase Loans to non-financial corporations Other Consumer Lending CZK (bn) 1, Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Source: Czech National Bank» We consider the Czech banking system s profitability to be supported by developments in deposit and lending rates. Competition for deposits, particularly from smaller banks, has eased, with the average interest rate offered on new household and corporate demand deposits declining for six consecutive quarters (see Exhibit 25), 30 and 17 basis points respectively in March 2014 compared to September At the same time, interest rates on newly issued loans have decreased at a slightly slower pace since the second half of 2013, with rates on newly issued mortgages declining by 10 and 20 basis points in the last quarter of 2013 and the first quarter of 2014, respectively, on a year-on-year basis (see Exhibit 26). We expect this trend to continue in the next months, thus helping the Czech banking sector mitigate the adverse impact of the persistently low interest rate environment. 15 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

16 EXHIBIT 25 Declining interest rates on demand deposits signal decreasing competition 2.0% 1.5% 1.0% 0.5% 0.0% Q Source: CNB Household Demand Deposits Corporate Demand Deposits Q Q Q Q Q Q Q Q Q Q Q EXHIBIT 26 Lending rates Mortgage Loans Corporate Loans Q Q Q Q Q Q Q Q Consumer Loans Q Q Q Q Q Q % 14% 12% 10% 8% 6% 4% 2% 0% Loan loss provisioning increased in 2013, but cost of risk remains relatively low» In 2013, system-wide cost of risk increased by 11% compared to year-end However, based on our calculations the impact of provisioning on operating income for the rated Czech banks remains the lowest in the CEE6 region and is still below pre-crisis levels (see Exhibit 27). Furthermore, we expect the cost of risk to stabilise as pressure on asset quality eases in the next months. EXHIBIT 27 The impact of loan loss provisions on pre-provision income for Czech banks is the lowest in the CEE6* 250.0% Czech Republic Hungary Poland Romania Slovak Republic Slovenia 200.0% 150.0% 100.0% 50.0% 0.0% 2009 YE 2010 YE 2011 YE 2012 YE 2013 YE Note: *The ratio is calculated by dividing the sum of Provisions for Credit Losses, Releases of Provisions and Recoveries, Direct Write-Off of Loans and Advances and other Loan loss Provisions by the Income net of Operating Expense before Loan Loss Provisions and Taxes. In 2013 Slovenia s banking sector experienced a significant increase in loan loss provisions due to restructuring of the three largest banks Source: Moody s Banking Financial Metrics, rated banks 23 Source: CNB, Moody s calculations. 16 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

17 » Overall, in spite of lower net interest margins, Czech banks net profitability and capital generation have remained relatively strong in the past few years and rank above others in the CEE6 banking system, as measured by a return on equity close to 14% (see Exhibit 28). EXHIBIT 28 Czech banks net profitability remain the strongest in the CEE6* (2013) 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% Net Interest Margin (NIM) -LHS Return On Assets (RoA) - LHS Return on Equity (RoE) - RHS 16% 14% 12% 10% 8% 6% 4% 2% 0.0% Czech Republic Poland Slovakia Romania** Hungary 0% Note: *Slovenia is excluded from the chart as it recorded a net loss in 2013 **NIM for Romania as of H Source: Financial Supervisory Authority of Poland and Hungary, National Banks of Czech Republic, Slovakia, Romania, Hungary and Slovenia Systemic support We expect that systemic support for Czech banks will likely diminish, because recent trends and policy statements suggest that support for a broad range of liabilities, including senior creditors, in all EU countries is now less certain. This is the main driver of our overall negative banking system outlook. The recent EU bank recovery and resolution draft directive endorses our view of diminishing systemic support» In April, the European Parliament voted to adopt a new framework for managing troubled banks - the Bank Recovery and Resolution Directive (BRRD, applicable to all EU member states) and the Single Resolution mechanism (SRM, applicable to euro area countries). As we have noted, the new framework has negative credit implications that exceed the benefits of improved stability for senior unsecured creditors of European banks. Indeed, the BRRD/SRM package seeks to alleviate the cost of bank failures for taxpayers at the expense of shareholders and unsecured creditors, with a very clear expectation that bail-in will be utilised, if needed, as part of bank resolutions.» On 29 May 2014, we changed the long-term rating outlook to negative for three Czech banks, in line with 79 other European banks. 24 These outlook changes reflect our assessment that, with the BRRD/SRM now adopted and other aspects of the framework in development, the balance of risk has shifted to the downside for banks senior unsecured creditors. While our support assessments have unchanged, there is an increased probability that we will revise them downwards.» We currently incorporate two notches of systemic support uplift into the long-term deposit ratings of the three largest Czech banks, Ceska Sporitelna, CSOB and Komercni Banka. The uplift reflects our expectation that the Czech government s willingness and capacity to extend support to 24 See Moody s changes outlooks to negative on 82 long-term European bank ratings, 29 May JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

18 its systemically important banks remains high, in case of need. This uplift is similar to the levels of systemic support for banks in Poland and Slovakia (see Exhibit 29). EXHIBIT 29 CEE6 banking system s asset-weighted average ratings* Aaa Aa2 A1 A3 Baa2 Ba1 BCA Parental / Coop Support Systemic Support Investment grade Ba3 B2 Caa1 Caa3 C Czech Republic (A2) Poland (Baa1) Slovak Republic (Baa1) Romania (Ba2) Hungary (Ba3) Slovenia (Caa1) Note: * All ratings are as of publication date of this report Source: Moody s 18 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

19 Sources Referenced in This Report» The source for all ratings information is Moody s Investors Service.» Company-specific financial information has been provided by the respective companies or is sourced from Moody s internal systems, such as Moody s Banking Financial Metrics.» Sources for other information are disclosed throughout the report and include: Financial Stability Report 2012/2013, Czech National Bank MOODY S has provided links or references to third party World Wide Websites or URLs ( Links or References ) solely for your convenience in locating related information and services. The websites reached through these Links or References have not necessarily been reviewed by MOODY S, and are maintained by a third party over which MOODY S exercises no control. Accordingly, MOODY S expressly disclaims any responsibility or liability for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on any third party web site accessed via a Link or Reference. Moreover, a Link or Reference does not imply an endorsement of any third party, any website, or the products or services provided by any third party. Moody s Related Research Rating Methodologies:» Global Banks, May 2013 (154255)» Government-Related Issuers: Methodology Update, July 2010 (126031) Credit Focus:» CSOB, Ceska Sporitelna, Komercni Banka: Peer Comparison, June 2013 (154484) Special Comments:» Reassessing Systemic Support for EU Bank. May 2014 (170460)» Moody s Approach to Estimating Czech Banks Credit Losses, July 2009 (118930)» Leading Indicators of Asset-Quality for Banks in Eastern Europe and the Middle East, November 2013 (148129)» CEE4 Banks: Single-Client Concentration Survey Reveals High Credit Concentrations, January 2013 (147710) Sector Comments:» Historically Low Mortgage Interest Rates Are Credit Negative for Czech Banks, June 2014 (171301)» Pickup in car exports signals improvement in Czech banks problem loans, January 2014 (163734)» Low Interest Rates Hurt Czech Banks Profitability, May 2013 (154287)» Czech Banks: Tightening Regulatory Limits on Group Transfers is Credit Positive, February 2013 (139290) Issuer Comments:» Czech Republic: Coalition Agreement Signals End to Political Uncertainty That Has Weighed on Economic Sentiment, a Credit Positive, January 2014 (162217)» Czech Republic: Ready for Growth in , April 2014 (169682) 19 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

20 Credit Opinion:» Czech Republic, Government of To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients. 20 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

21 Banking System Outlook Definition Banking system outlooks represent our forward-looking assessment of fundamental credit conditions that will affect the creditworthiness of banks in a given system over the next months. As such, banking system outlooks provide our view of how the operating environment for banks, including macroeconomic, competitive and regulatory trends, will affect asset quality, capital, funding, liquidity and profitability. Banking system outlooks also consider our forward-looking view of the systemic support environment for bank creditors. Since banking system outlooks represent our forward-looking view on credit conditions that factor into our bank ratings, a negative (positive) outlook suggests that negative (positive) rating actions are more likely on average. 21 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

22 Appendix 1: Moody s Scenario Analysis for Czech Rated Banks» Our scenario analysis uses our estimated expected loss (EL) rates for different asset classes, based on asset class probability of default (PD) and loss given default (LGD) assumptions, to derive estimated life-time expected loss in our central and adverse scenarios (see Exhibit 30). Exhibit 30 Moody s Summary Scenario Analysis Assumptions Central Scenario Adverse Scenario PD LGD EL PD LGD EL Large Corporates 6.60% 50.00% 3.3% 18.80% 50.00% 9.40% SME and leasing 8.38% 60.00% 5.00% 23.23% 70.00% 16.26% Project finance 11.60% 50.00% 5.80% 28.60% 50.00% 14.30% Mortgages Decline in house price + foreclosure costs of 40% Min. 1.5% Decline in house price + foreclosure costs of 60% Min. 2.5% Unsecured Retail 15.00% 70.00% 10.50% 25.00% 80.00% 20.00% PD: Probability of Default LGD: Loss Given Default EL: Expected Loss Source: Moody s» We offset the expected loss with 75% of a bank s existing loan-loss reserves.» The resulting amount is adjusted for tax. We also allow for four quarters of stressed pre-provision income (tax-affected) to replenish the bank s Tier 1 capital.» The resulting aggregate Tier 1 ratios for our rated banks are strong, amounting to 14.1% in our central scenario, and 8.0% in our adverse scenario (see Exhibit 31). EXHIBIT 31 Czech banks aggregate scenario analysis 300 Expected loss on loan book Tier 1 75% of LLR 4Q of stressed earnings Expected loss on government securities 250 CZK Billion % 8.0% 50 0 Central Scenario Expected Loss Source: Moody s estimates, as of YE Central Scenario Coverage Tier 1 after Central Scenario Adverse Scenario Expected Loss Adverse Scenario Coverage Tier 1 after Adverse Scenario 22 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

23 Appendix 2: Excerpt from Sovereign Credit Opinion Czech Republic, Government of (30 December 2013) Credit Strengths The credit strengths of the Czech Republic include:» Highly affordable interest burden on government debt thanks to a receptive domestic capital market» Proven track record and institutional arrangements that anchor fiscal policy credibility» A healthy, liquid and well capitalised banking system» Floating-exchange rate regime helps absorb external shocks Credit Challenges The credit challenges for the Czech Republic include:» Reducing deficit within the context of a low growth environment» Reversing the deterioration in government debt levels» Increasing potential growth and infusing the economy with greater dynamism Rating Rationale The Czech Republic s A1 sovereign rating with a stable outlook is underpinned by very high fiscal strength, high institutional strength and a low susceptibility to event risk. The Moderate economic strength assessment reflects the country s steady income convergence to the EU average in recent years. In particular, relatively low wages, high educational attainment and close proximity to the core group in the euro area have made the country attractive to foreign investment. High institutional strength is based on the country s advanced economic and financial integration with the EU, which has benefited and helped further develop institutional quality and strengthened the policymaking framework of public-sector entities, as well as the sovereigns very strong track record of fiscal prudence. The sovereign s solid fiscal policy credibility is a key credit strength. The Czech Republic s Very High government financial strength is underpinned by an affordable debt burden and low, albeit rising, debt ratios. Government finances draw strength from the ability to easily tap local-currency financing through its large, though underdeveloped, domestic capital market. Susceptibility to event risk is assessed as Low ; the financial sector remains healthy and vulnerability indicators point to very low risk of shocks that could adversely affect the sovereign s balance sheet. Nevertheless, the economy remains fairly undiversified and its high degree of openness exposes it to external demand fluctuations. Rating Outlook The stable outlook reflects the strength of the government s balance sheet and the inherent buffers built into its credit profile, which are crucial in mitigating the impact of potential shocks emanating from the euro area periphery, thereby preserving the Czech Republic s status as a strong A credit. 23 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

24 What Could Change the Rating Up The government s ratings could be upgraded if there was a significant improvement in the government s balance sheet through a major reduction of its debt levels. Substantial structural reforms that enhance competitiveness and boost potential output growth rates would also be viewed positively. What Could Change the Rating Down A sustained deterioration in fiscal-policy credibility and rising debt following a substantial easing of deficit targets would undermine creditworthiness. Moreover, a reversal of structural reforms and institutional arrangements that seek to entrench fiscal sustainability would be viewed negatively. Recent Developments On 19 December, the lower house of the Czech Parliament approved the 2014 state (central government) budget. The budget projects a deficit of CZK112 billion (2.8% of GDP), a slight increase from the budgeted shortfall of CZK100 billion (2.6% of GDP) for The budget bill was signed into law by President Milos Zeman on 22 December. Although the new budget calls for a larger deficit in 2014, we believe that the economic recovery will benefit from increased government spending and that the sovereign will maintain its solid fiscal policy credibility, as we forecast that the general government deficit will remain below the EU-reference level of 3% of GDP. Compared with the 2013 budget, revenues are projected to increase by CZK18.5 billion to 27.8% of GDP, while expenditure is expected to rise by CZK30.5 billion to 30.6% of GDP. The 2014 state budget was supported by 109 deputies (in the 200-member lower house) from the three parties in negotiations (as at December 2013) to form the new coalition government: the Social Democrats, the newly-emerged Action of Dissatisfied Citizens (known locally as the Akce nespokojených občanů movement), and the Christian Democrats. The distribution of ministries among the future coalition partners is the subject of ongoing negotiations, but we expect that the composition of the new cabinet will be announced by the beginning of 2014, if not sooner. Fiscal performance in 2013 suggests that the authorities are on track to bring the deficit below 3% of GDP for that year, highlighting prudent fiscal management despite economic and political difficulties. The central government s shortfall in the first 10 months of 2013 was CZK47.7 billion (1.2% of GDP), lower than in the same period for 2012 when the deficit reached CZK51.3 billion. Both the one percentage point hike in VAT introduced on 1 January 2013 and increased transfers from the EU have kept government revenues buoyant, despite subdued economic activity throughout that year. The fiscal results through October 2013 indicate an improvement in the central government s deficit on a cash accounting basis. When consolidating the general government accounts under the accrual accounting method in reporting the final 2013 figure to Eurostat, we expect some corrections to EU fund flows that may widen the overall deficit, decreasing the magnitude of the fiscal outperformance and bringing it closer to our 2.7% of GDP forecast. As suggested by the budget, the new centre-left coalition government is likely to boost spending to support the recovering economy, using some of the fiscal space afforded by the significant consolidation effort of recent years. However, fiscal easing is unlikely to jeopardise medium-term fiscal targets given the budgetary outperformance that has been a standard of the Czech framework over the past four years. Moreover, we also note that all three coalition partners have committed to keeping the budget deficit below the EU-suggested limit of 3% of GDP. We expect that the European Commission (EC) will close the Czech Republic s excessive deficit procedure (EDP) following the disclosure of full-year fiscal 24 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

25 data for the general government. The coalition partners commitment to fiscal restraint is a strong signal in the context of keeping the Czech sovereign outside of the EDP and maintaining the fiscal policy credibility that has made it a regional safe haven in Central and Eastern Europe. Although the 2.8% of GDP deficit target envisioned in the new budget corresponds to the central government on a cash accounting basis, we forecast that the 2014 general government imbalance will be closer to the 3% of GDP threshold. Fiscal dynamics will depend to a great extent on the next government s policy priorities and the ability of Social Democrat party and Action of Dissatisfied Citizens movement to achieve political consensus around issues such as taxation and social spending, on which the two parties appear to have opposing views. 25 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

26 Appendix 3: Banking System Outlook Table Banking System Outlook Table As of 2 June 2014 Banking System Positive Stable Negative Banking System Positive Stable Negative Argentina Negative Poland Negative Australia Stable Portugal Negative Austria Negative Qatar Stable Azerbaijan Stable Russia Negative Bahrain Stable Saudi Arabia Stable Baltic Countries Stable Singapore Negative Belarus Negative Slovakia Negative Belgium Negative Slovenia Negative Bolivia Stable South Africa Negative Brazil Stable Spain Negative Bulgaria Negative Sweden Negative Canada Stable Switzerland Stable Chile Stable Taiwan Stable China Stable Thailand Stable Colombia Stable Turkey Negative Cyprus Negative Ukraine Negative Czech Republic Negative United Arab Emirates Stable Denmark Negative United Kingdom Stable Egypt Negative United States Stable Finland Negative Uruguay Stable France Negative Uzbekistan Stable Germany Negative Vietnam Negative Greece Stable Hong Kong Negative Hungary Negative India Negative Indonesia Stable Ireland Negative Israel Stable Italy Negative Japan Stable Kazakhstan Negative Korea Stable Kuwait Stable Lebanon Negative Malaysia Mexico Mongolia Netherlands New Zealand Norway Oman Pakistan Peru Philippines Positive Stable Stable Stable Stable Stable Negative Negative Negative Negative 26 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

27 Appendix 4: Global Comparison Charts Overview of banking system outlooks Asset-Weighted Average Bank Long-Term Ratings (Baseline Credit Assessments with Support Levels) (as of 2 June 2014) C Ca Caa3 Caa2 Caa1 B3 B2 B1 Ba3 Ba2 Ba1 Baa3 Baa2 Baa1 A3 A2 A1 Aa3 Aa2 Aa1 Aaa 27 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

28 Asset-Weighted Average Bank Financial Strength Ratings (as of 2 June 2014) E E+ D- D D+ C- C C+ B- B B+ A- A 28 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

29 Asset-Weighted Average Local Currency Long-Term Bank Deposit Ratings (as of 2 June 2014) C Ca Caa3 Caa2 Caa1 B3 B2 B1 Ba3 Ba2 Ba1 Baa3 Baa2 Baa1 A3 A2 A1 Aa3 Aa2 Aa1 Aaa 29 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

30 Asset-Weighted Average Foreign Currency Long-Term Bank Deposit Ratings C Ca Caa3 Caa2 Caa1 B3 B2 B1 Ba3 Ba2 Ba1 Baa3 Baa2 Baa1 A3 A2 A1 Aa3 Aa2 Aa1 Aaa 30 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

31 Appendix 5: BFSR / BCA Mapping Table BFSR/Baseline Credit Assessment Mapping BFSR Baseline Credit Assessment (BCA) A aaa A- aa1 B+ aa2 B aa3 B- a1 C+ a2 C a3 C- baa1 C- baa2 D+ baa3 D+ ba1 D ba2 D- ba3 E+ b1 E+ b2 E+ b3 E caa1 E caa2 E caa3 31 JUNE 19, 2014 BANKING SYSTEM OUTLOOK: CZECH REPUBLIC

32 Report Number: Authors Oscar Heemskerk Carlo Giovale Aleksandar Hristov Production Specialist Wing Chan 2014 Moody s Corporation, Moody s Investors Service, Inc., Moody s Analytics, Inc. and/or their licensors and affiliates (collectively, MOODY S ). All rights reserved. CREDIT RATINGS ISSUED BY MOODY S INVESTORS SERVICE, INC. ( MIS ) AND ITS AFFILIATES ARE MOODY S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES, AND CREDIT RATINGS AND RESEARCH PUBLICATIONS PUBLISHED BY MOODY S ( MOODY S PUBLICATIONS ) MAY INCLUDE MOODY S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES. MOODY S DEFINES CREDIT RISK AS THE RISK THAT AN ENTITY MAY NOT MEET ITS CONTRACTUAL, FINANCIAL OBLIGATIONS AS THEY COME DUE AND ANY ESTIMATED FINANCIAL LOSS IN THE EVENT OF DEFAULT. 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