Global rating agency Moody's has decided to maintain the "negative" outlook on the Bulgarian banking system due to the country's slow economic recovery and tough business environment.

The move is also based on Moody's expectations for an increase in non-performing loans and on local banks' high reliance on financial back-up from their foreign parents, the agency said in its latest report on Bulgaria's banking sector.

The outlook reflects Moody's projections for the credit conditions in the sector over the next 12 to 18 months.

"The operating environment continues to be challenging, with low credit growth, high unemployment and an economic recovery that we expect will remain modest, following the sluggish real GDP growth of 0.2 per cent during 2010," Elena Panayiotou, a Moody's analyst and author of the report, said.

"In addition, the real-estate sector remains under stress, as Western European investors have largely withdrawn; in our view, it was the demand from these investors that was the key driver of the pre-crisis real-estate boom in Bulgaria," said Panayiotou.

On a long-term scale, Moody's projects that local banks will be favoured by the country's gradual economic recovery and future growth prospects following Bulgaria's adoption of the European Exchange-Rate Mechanism (ERM II) in the coming 12 to 18 months.

However, the analysts consider that high levels of overdue loans will continue to result in high provisioning requirements and to weigh on bank's profits.

"Despite subdued net profits, system-wide solid capitalisation and robust pre-provision earnings generating capabilities allow the banks to absorb unexpected credit losses under our stress-case scenario. These are positive offsetting factors considered in our system outlook and are important drivers supporting the standalone credit strength of the four rated Bulgarian banks," Panayiotou said.

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