Argentine banks' capitalization will serve as a cushion against expected loan losses in 2019 amid adverse market conditions, Moody's said May 21.

The country's worsening economic prospects are taking a toll on lending among banks, in turn increasing funding costs and exacerbating asset risk, Moody's said in a sector report. Local banks' overall loan portfolio narrowed by almost 10% in real terms last year, and local currency loans contracted by nearly 20%.

The rating agency expects contraction in lending to continue this year, with banks most likely extending credit only to lower-risk borrowers and refinancings. Banks' loan books as of March already have contracted by 17% year over year.

Moody's also sees credit cost rising and nonperforming loans hitting 4.5% this year, with all credit segments underperforming given higher interest rates and Argentina's deepening recession.

Still, banks are well prepared for such a scenario and will be able to safeguard their profitability amid potential losses, Moody's said. Although the capitalization ratio of banks declined in 2018 as a result of currency depreciation, they continue to have adequate capital to absorb higher loan losses. Banks will also be supported by reduced capital needs, thanks to the weak loan growth, and high nominal earnings that will aid in replenishing capital, the rating agency said.

Additionally, Moody's believes large Argentine banks with more creditworthy customers and large retail core deposit balances will keep their funding relatively affordable. Highly liquid banks can also afford to invest in Leliqs, or central bank notes to support their earnings.

Securities income, mainly composed of Leliqs, accounted for 54% of banks' total income in December 2018, up 28% year over year. Meanwhile, the share of net fee revenue in total income declined 16% while net interest income fell to 8% from 36% previously.

On the flip side, niche consumer lenders, whose portfolios are limited and are more tied to the business cycle, will observe an erosion in asset quality and greater losses. These banks face higher refinancing risk given their reliance on market funds and have low- and middle-income household borrowers as primary customers, which make their operations riskier.

Moody's expects banks to become more aggressive in lending to both corporate and consumer segments once market conditions improve. "Enhanced economic conditions will likely restore consumption, borrowers' financial needs and lending prospects for banks," Moody's added.