An increase in nonperforming exposures at Bank of Cyprus Public Co. Ltd. in the fourth quarter of 2017 was attributable to the European Central Bank's toughening of rules around the labeling of loans, executives from the island's largest lender said Feb. 27, adding that they continue to expect a return to profitability in 2018.

Bank of Cyprus reduced overall NPEs — the category includes bad loans as well as some restructured loans — by €2.2 billion in 2017, lowering its ratio of NPEs to total loans to 47% from 55% at the end of 2016. But NPE inflows in the bank's Cypriot operations rose to roughly €360 million in the fourth quarter from €130 million in the third quarter, largely as a result of the technical redefault of a handful of loans that the bank had previously labeled as performing.

The reclassification of €209 million of loans was a one-off that is unlikely to occur again, said the bank's head of loan restructuring, Nick Smith.

"The adjustment was made to a small number of restructured corporate exposures, one single exposure accounting for around 70% of the total," he said. "All of the borrowers impacted by this adjustment have no arrears and are performing in line with or ahead of expectations. We expect the majority, including the largest exposure, to exit NPE status in 2018."

He added that the "pace of underlying redefaults and new flows into NPE remains modest. This is reflected from continuing positive macro conditions, sustainable restructurings and low default rates on new lending."

The ECB issued final guidance on bad-loan definitions in April 2017.

Bank of Cyprus had gross NPEs of €8.8 billion at the end of 2017, and it is aiming to reduce its NPE ratio to below 40% in 2018, when it is also targeting a return to profitability after booking a full-year loss of €551.9 million for 2017. It had a profit of €63.7 million in the previous year, but returned to the red in 2017 after making €942 million in total provisions and impairments, including €500 million in the second quarter.

Banks continue to feel pressure from the ECB in its supervisory capacity to accelerate the reduction of bad loans, Smith said. "With the regulatory environment continuing to tighten around the subject of NPEs, the picture in terms of understanding real risk is becoming increasingly complex."

Banks in countries with high rates of bad loans such as Cyprus, Italy, Greece, Portugal and Ireland have been increasingly at odds with watchdogs over how they should go about cutting defaulted assets. Whereas the regulator favors a quick and aggressive method that involves sales and securitization, often at a steep discount to face value and high cost to the banks' capital base, lenders prefer to gradually work out bad loans through restructurings and collateral repossession.

Smith said Bank of Cyprus will double down on foreclosures as it seeks to continue reducing bad loans, instead of selling toxic portfolios.

Bank of Cyprus had a transitional common equity Tier 1 ratio of 12.7% at the end of 2017, and it told investors to expect this level to rise to 13% in 2018. On a fully loaded basis, the CET1 ratio was 12.2%.

Bank of Cyprus is a unit of Bank of Cyprus Holdings Plc.