REUTERS SUMMIT-Slow reforms hamper banks' profits in Croatia

* For other news from Reuters Eastern Europe Investment Summit, click on http://www.reuters.com/summit/EasternEuropeInvestment14

* Croatia's banking sector well capitalised and liquid

* Profitability suffers due to slow structural reforms

* EU-wide AQR seen prompting minor capital corrections

* Consolidation possible; no new foreign players expected

By Igor Ilic

ZAGREB, Oct 1 (Reuters) - Croatia's banks have enough capital and liquidity but their profits will remain subdued until the government cuts spending and loosens curbs on the private sector, the head of a major local bank told Reuters.

Croatia's banking sector - more than 90 percent of it in foreign hands - posted a pre-tax profit of 695 million kuna ($115 million) in 2013.

That was sharply down from 3.5 billion kuna a year before, largely due to stricter rules on provisions for bad loans, while return on capital fell to just 1.3 percent at the end of last year, reflecting years of economic decline in the European Union's newest member state.

"The key conditions for better profitability are fiscal adjustments and structural reforms that would pave the way for more vibrant private sector activity and less state presence in the economy," Bozo Prka, CEO of the second biggest Croatian bank, Privredna Banka Zagreb (PBZ), said at the Reuters Eastern Europe Investment Summit on Wednesday.

PBZ is majority owned by Italy's banking group Intesa Sanpaolo.

Banks' profitability recovered somewhat in the first six months of this year but Prka said no major progress was possible unless the economy returned to growth. Croatia has had no growth since 2008 and prospects for 2015 are around zero.

"There are some indications, like an increase in exports, that we could see mild growth in 2015, but no major breakthrough is possible without bringing the fiscal gap in line with the European Union rules and boosting the private sector," Prka said.

Rigid labour market rules, expensive and inefficient public administration, a high tax bite and frequently changing regulations are largely blamed for Croatia's economic decline, comparable in duration only to that of Greece.

Brussels wants Zagreb to cut the budget gap to below three percent of gross domestic product by the end of 2016 from the current level of close to five percent.

Prka said Croatia's banking sector had ample funds to finance the economy and did not expect any problems in passing the recent EU-wide stress test and asset quality review (AQR), which included four top Croatian banks.

"I expect only minor corrections in capital requirements for the banking sector following the AQR. The average capital adequacy in Croatian banks is above 20 percent and the banks are well funded to support the recovery, if reforms take place," he said.

He also said the banking sector can still withstand the pressure of the rising level of bad loans, which will begin to taper only with economic growth. The overall level of bad loans is close to 17 percent and close to 30 percent in corporate sector loans.

"Some 35-40 percent of bad loans can turn back into performing loans in a year or two if economic recovery gains pace. That is why it is so important for the banks and the economy as a whole to see fast fiscal and structural changes," Prka said.

PBZ has a three-year plan to handle its bad loan portfolio as part of a wider strategy put forward by its majority owner.

Croatia has 30 banks, but the three biggest lenders, PBZ, Zagrebacka Banka, a unit of Unicredit (Milan: UCG.MI - news) , and Austria's Erste Bank (Other OTC: EBKDY - news) , control almost 60 percent of the market.

Several speakers at the summit have predicted a spate of bank mergers and acquisitions once the current asset quality review of European lenders is complete.

Prka said some small Croatian banks, which account for less than 10 percent of the market, would face growing pressure from bigger local competitors.

"I think consolidation is quite possible but I don't expect new foreign players in the local banking sector," Prka said. (1 US dollar = 6.0624 Croatian kuna)

Follow Reuters Summits on Twitter @Reuters_Summits (Reporting by Igor Ilic; Editing by Ruth Pitchford)