* Czech banks continue to show highest profitability in CEE
* Cost-cutting, increased lending mitigate low rate effect
* Sector has highest capital ratio, lowest credit risk in region
By Jason Hovet
PRAGUE, Aug 22 The runaway profitability that made Czech banks the darlings of their Western European owners is set to continue even though record low interest rates make the environment trickier, analysts and investors say.
Czech banks boasted a return on equity of 20 percent in 2013, according to research from Raiffeisen, more than treble the 6.6 percent averaged by Europe's top 30 listed banks, providing a welcome boost to the five European parent banks that make up over two thirds of the market.
Markets with standout profits, like Ireland, have proved false friends to large international banks in the past and triggered massive losses, while other central and eastern European countries like Hungary and Slovenia have thrown up problems of their own in the recent past.
Experts say the situation in the Czech Republic is different and returns - which averaged around 20 percent of equity for the last five years according to Raiffeisen - will endure.
"There are a few markets (including the Czech Republic) in this world where it is possible to earn very good money," said Patrick Lemmens, a fund manager at Netherlands-based Robeco who invests in emerging market banks.
"They all have a relatively high degree of concentration - relatively few banks - banks are generally very efficient, they have good cheap funding and they're able to cross sell (other products like insurance)."
Moody's analyst Arif Bekiroglu said Czech banking profits would likely remain "more or less" unchanged in 2014, even as low interest rates put pressure on profits, since banks are able to increase lending - at a time when many banks in Western Europe are watching their loan books contract as demand fails to keep pace with loan repayment.
The ratings agency predicts Czech economic growth of 1.5 percent for this year and 2.5 percent for 2015.
The main beneficiaries of the continued boom include the market leaders: Austria's Erste Group Bank, Belgium's KBC, France's Societe Generale, Italy's UniCredit, and Raiffeisen Bank International .
Some of those banks face pressure in neighbouring economies. In Hungary, a similar-sized market, banks will have to deal with government measures to help borrowers that could cost the sector 700 billion to 900 billion forints ($3-3.8 billion) this year.
Erste made 35 percent of its 2013 pre-provision income from its Czech unit, the country's second biggest bank by assets, Ceska Sporitelna, which has 18 percent of Erste's assets, Moody's calculated.
Low interest rates have already eaten into Czech bank income, and at the tail end of a record 18-month recession, the banking sector's profits fell 4.5 percent last year, according to central bank data. The central bank has also said it would keep its main rates near zero into 2016, a problem for banks who traditionally make more money when rates are high.
Analysts expect Czech banks to rein in costs to mitigate the impact while waiting for loan growth - buoyed so far by mortgage loans - to quicken as firms look for credit amid the recovery, but some say the situation is challenging.
Komercni Banka, 60 percent owned by Societe Generale and the only listed Czech bank, sees its lending up by around 3 percent this year, having cut earlier forecasts.
"We would probably be negative on Komercni Banka if it wasn't for the fact that they have been pretty successful at offsetting top-line pressure with cost cutting and that it is such a well-capitalised bank that pays out a very attractive dividend," said Citi analyst Simon Nellis.
The sector has the highest Tier 1 capital ratio - a key measure of banks' financial strength - in central Europe, at 16.9 percent, and has more deposits than loans so it's not vulnerable to the whims of interbank lending markets.
Banks are feeling confident enough to return cash to their owners. The biggest Czech bank CSOB sent sole shareholder KBC 8.1 billion Czech crowns ($390 million) in dividends last year, and Ceska Sporitelna paid out 9.1 billion crowns.
KBC's Czech unit is even now a separate reporting group from its four other international markets. It made 554 million euros ($740 million) in adjusted net profit in 2013 while units in Slovakia, Hungary, Bulgaria and Ireland had a combined loss of 853 million euros because of a one-off charge in the latter. KBC's home market contributed 1.57 billion euros.
While Czech banks are unlikely to overtake their parents in performance, they will in many cases remain a strong second.
CSOB's new Chief Executive John Hollows told KBC's investors day in June that the Czech bank had "an enviable return on allocated capital consistent at about 40 percent.
"Significantly higher, dare I say, than business unit Belgium though I must not indulge in competitive talk," he said, "but of course there is an internal competition." (1 US dollar = 0.7506 euro) (1 US dollar = 20.9020 Czech crown) (1 US dollar = 236.4200 Hungarian forint) (Additional reporting by Laura Noonan in London; Editing by Toby Chopra)