Fitch explains its latest rating decisions on nine Sri Lankan banks

Fitch Ratings has revised the Outlook on DFCC Bank PLC (DFCC) to Stable from Negative and has affirmed the Long-Term Issuer Default Ratings (IDR) of the following Sri Lanka-based banks:

National Savings Bank (NSB) at ‘B+’; Outlook Stable

Bank of Ceylon (BOC) at ‘B+’; Outlook Stable

DFCC at ‘B+’; Outlook revised to Stable from Negative

Fitch has also affirmed the National Long-Term Ratings of the following banks:

NSB at ‘AAA(lka)’; Outlook Stable

BOC at ‘AA+(lka)’; Outlook Stable

DFCC at ‘AA-(lka)’; Outlook revised to Stable from Negative

People’s Bank (Sri Lanka) (People’s Bank) at ‘AA+(lka)’; Outlook Stable

Commercial Bank of Ceylon PLC (CB) at ‘AA(lka)’; Outlook Stable

Hatton National Bank PLC (HNB) at ‘AA-(lka)’; Outlook Stable

National Development Bank PLC (NDB) at ‘A+(lka); Outlook Stable

Sampath Bank PLC (Sampath) at ‘A+(lka)’; Outlook Negative

Seylan Bank PLC (Seylan) at ‘A-(lka)’; Outlook Stable

The rating action follows Fitch’s periodic review of the large bank peer group. A full list of rating actions is at the end of this commentary.

KEY RATING DRIVERS

IDRS, NATIONAL RATINGS AND SENIOR DEBT

Fitch has maintained the negative outlook on Sri Lanka’s banking sector, as we expect challenging operating conditions to persist into 2018. The sector outlook is sensitive to trends in the operating environment. Bank credit profiles should broadly remain intact, but there could be modest pressure on the ratings of some banks if sufficient loss-absorption buffers are not maintained.

Capitalisation remains a key issue facing the sector. There was some capital raising among banks in 2017 and Fitch expects this to continue into 2018. Sri Lankan banks are required to phase in higher capital buffers to meet Basel III regulations that come into effect on 1 January 2019. In addition, Fitch believes there could be a significant impact on banks’ capitalisation through the adoption of Sri Lanka Financial Reporting Standards (SLFRS) 9 in 2018, although the effect of this on regulatory capital ratios could be spread out.

Banks with Long-Term Ratings Driven by Sovereign Support

The IDRs and National Long-Term Ratings of NSB and BOC and the National Long-Term Rating of People’s Bank reflect Fitch’s expectation of extraordinary support from the sovereign (B+/Stable).

Fitch believes state support for NSB stems from its policy mandate of mobilising retail savings and investing them in government securities. The NSB Act contains an explicit deposit guarantee and Fitch is of the view that the authorities would support, in case of need, the bank’s depositors and its senior unsecured creditors to maintain confidence and systemic stability. Fitch has not assigned a Viability Rating to NSB as it is a policy bank.

Fitch expects support for BOC and People’s Bank to stem from their high systemic importance, quasi-sovereign status, role as key lenders to the government and full state-ownership.

BOC’s Viability Rating reflects its thin capitalisation that is counterbalanced by a strong domestic funding franchise. Fitch considers state support as BOC’s primary rating driver, even though its Viability Rating is at the same level as its Support Rating Floor.

The US dollar senior unsecured notes issued by NSB and BOC are rated at the same level as the banks’ Long-Term Foreign-Currency IDRs, as the notes rank equally with other senior unsecured obligations. The notes have a Recovery Rating of ‘RR4’.

Banks with Long-Term Ratings Driven by Intrinsic Strength

The National Long-Term Rating of CB reflects its modest risk appetite, strong funding profile, solid franchise and stable performance.

CB raised equity of LKR10 billion that has bolstered its capitalisation ahead of the full implementation of Basel III. Loan expansion increased in 2016 and 2015, but Fitch does not expect the bank to sustain a similar increase in loans despite the increase in capital. CB has maintained a high share of current and savings deposits, which is a funding strength. Loan/ deposits has increased alongside the increase in lending, but is below that of peers.

The bank has expanded its international presence in the Maldives and Myanmar in addition to its operations in Bangladesh. The ratings reflect Fitch’s expectation that these non-domestic operations should remain small and that CB’s broader credit profile remains primarily linked to the domestic market.

The National Long-Term Rating of HNB reflects its strong domestic franchise as Sri Lanka’s fourth-largest commercial bank, its stronger capitalisation following a LKR14 billion equity infusion and its healthy financial performance albeit asset quality deterioration. This is counterbalanced by a higher risk appetite relative to better-rated peers.

HNB’s high risk appetite stems from rapid balance sheet expansion in the past into segments that are more susceptible to deteriorating economic conditions. This has pressured its funding, liquidity and asset quality metrics. Fitch believes that HNB’s liquidity and funding pressure could ease in the medium term alongside the expected moderation in loan growth and increased focus on deposit growth. HNB’s loan/deposit ratio improved to 91% at end 3Q17, from 96% at end-2016.

HNB’s asset quality metrics deteriorated at end-3Q17 due to a sharp increase in non-performing loans (NPL). Its reported NPL ratio increased to 2.6%, from 1.8% at end 2016, having improved from 2.4% at end-2015. Fitch expects asset quality pressures to persist in 2018 as operating conditions remain challenging.

The Outlook revision on DFCC’s IDR to Stable from Negative reflects our view that adverse effects on the bank’s credit profile from increasing risks in the domestic operating environment have reduced. The Outlook revision on DFCC’s National Long-Term Rating to Stable from Negative reflects our expectation that DFCC should maintain higher capital ratios against similarly rated peers despite medium-term moderation alongside the bank’s expansion.

DFCC’s Viability Rating and National Long-Term Rating capture its developing commercial banking franchise and still-high capitalisation relative to the peers.

DFCC’s US dollar notes are rated at the same level as its Long-Term Foreign-Currency IDR. The notes have a Recovery Rating of ‘RR4’.

NDB’s ratings reflect its sustained satisfactory asset quality but lower capitalisation relative to better-rated peers.

NDB’s reported gross NPL ratio of 1.96% compares well against that of peers at end-3Q17. The corporate customer segment continues to dominate its loan book, but the bank has been focusing on increasing its exposure to the SME and retail customer segments. Fitch believes that although this could help correct structural imbalances that result in a thin net-interest margin (NIM), increasing exposure to customer segments that Fitch sees as being riskier and loan book seasoning could pressure asset quality if not managed well.

Fitch expects NDB to sustain a strong growth trajectory to expand its franchise. This, alongside higher minimum capital requirements upon the full implementation of Basel III and possible impact of SLFRS 9, could pressure capitalisation in the absence of a capital injection.

Sampath’s National Long-Term Rating reflects its lower capitalisation and higher risk appetite relative to peers, which counterbalances its expanding franchise, improving profitability and satisfactory asset quality.

The affirmation of the National Long-Term Rating factors in Fitch’s expectation that the bank is in the process of shoring up capitalisation to meet the tighter requirements of 10.0% Tier 1 and 14.0% total capital ratios by 1 January 2019. The bank’s regulatory Tier 1 and total capital ratios were 8.5% and 11.9%, respectively, at end-September 2017. Sampath raised LKR7.6 billion via a rights issue in December 2017, which should allow the bank to meet the intermediate regulatory minimum Tier 1 requirement of 8.875% by end-2017. The bank announced a further LKR12.5 billion rights issue for 2018 as part of its medium-term capital plan

However, the Negative Outlook reflects Fitch’s view that Sampath could find it challenging to improve its capitalisation if it fails to successfully execute its medium-term capital plan while maintaining high loan growth of over 20.0% which we expect for 2018 to 2020. Sampath’s gross loan growth of 18.2% in 9M17 continues to outpace the industry’s 11.9% growth (Sampath 2016: 22.1%, industry 2016: 17.5%) and Fitch expects this trend to continue alongside the bank’s pursuit of market share.

Fitch assesses Seylan’s National Long-Term Rating as driven by intrinsic financial strength, although this is at the same level as its support-driven rating. Fitch believes the bank’s standalone profile has improved in the past few years and is stable, as reflected by its modest franchise, improving profitability and satisfactory capital level. However, these strengths are counterbalanced by the bank’s still-weak but improving asset quality.

Fitch sees downside risk to Seylan’s rating to be limited by the expectation of state support. We believe state support would be forthcoming due to the state shareholding that came about in the aftermath of the crisis the bank faced in December 2008 and higher share of banking-sector deposits relative to some peers. Seylan has a lower support-driven rating relative to larger systemically important banks due to its smaller market share.

HNB’s, DFCC’s and Seylan’s Sri Lanka rupee-denominated senior debt is rated at the same level as their National Long-Term Ratings, as the debentures rank equally with other senior unsecured obligations.

SUPPORT RATING AND SUPPORT RATING FLOOR

The Support Ratings and Support Rating Floors of NSB and BOC reflect the state’s ability and propensity to provide support to the banks given their high importance to the state and high systemic importance.

The Support Rating and Support Rating Floor of privately-owned DFCC reflect its relative lower systemic importance, in Fitch’s view.

SUBORDINATED DEBT

The old-style Basel II Sri Lanka rupee-denominated subordinated debt of BOC, CB, HNB, DFCC, NDB, Sampath and Seylan and the Basel III compliant Tier II Sri Lanka rupee-denominated subordinated debt of BOC, Sampath and Seylan are rated one notch below their National Long-Term Ratings to reflect the subordination to senior unsecured creditors. The Basel III compliant debentures include a non-viability trigger upon the occurrence of a trigger event, as determined by the Monetary Board of Sri Lanka

RATING SENSITIVITIES

IDRS, NATIONAL RATINGS AND SENIOR DEBT

Banks with Long-Term Ratings Driven by Sovereign Support

Any change in Sri Lanka’s sovereign rating or the perception of state support to NSB, BOC, and People’s Bank could result in a change in their IDRs and National Ratings.

A reduced expectation of state support through, for instance, the removal of preferential support extended to NSB or a substantial change in its policy role or deviation from mandated core activities, indicating its reduced importance to the government, could result in a downgrade of NSB’s ratings.

A downgrade of BOC’s IDR would most likely result from the sovereign’s weakened ability to support the bank, manifested through a lower sovereign rating. Visible demonstration of preferential support for BOC and People’s Bank in the form of an explicit guarantee may be instrumental to an upgrade of their National Long-Term Ratings.

BOC’s Viability Rating may come under pressure if there is a continued decline in capitalisation through a surge in lending or high dividends. Further deterioration in the operating environment, reflected in a deterioration of BOC’s key credit metrics, could negatively affect its Viability Rating.

NSB’s and BOC’s senior debt ratings are sensitive to changes in the banks’ Long-Term IDRs. The Recovery Ratings on the two banks’ notes are sensitive to Fitch’s assessment of potential recoveries for creditors in case of default or non-performance.

Banks with Long-Term Ratings Driven by Intrinsic Strength

Enhanced loss absorption buffers against operating environment-related risks could be positive for CB’s National Long-Term Rating. The bank’s ratings could be downgraded if its ability to withstand cyclical asset quality deterioration declines due to lower earnings and capitalisation. In addition, deterioration in its deposit franchise and deviation from its moderate risk appetite, both viewed by Fitch as key factors that differentiate CB from its lower-rated peers, would be negative.

An upgrade of HNB’s National Long-Term Rating is contingent on the bank achieving sustained improvements in its financial profile, particularly in its funding, and a moderation of its risk appetite. A rating downgrade could result from a significant increase in risk-taking and operating environment-related risks that could materially weaken capital buffers.

DFCC’s IDRs and National Long-Term Rating could be downgraded if there is a significant deterioration in its capitalisation, particularly if its asset quality were to considerably weaken. Fitch sees limited upside for the bank’s ratings due to its weaker franchise relative to better-rated peers. The Recovery Rating on DFCC’s notes is sensitive to Fitch’s assessment of potential recoveries for creditors in case of default or non-performance.

NDB’s National Long-Term Rating may be downgraded if the bank cannot sustain its capitalisation at a level commensurate with its risk profile. Conversely, a notable improvement in its capital buffer would be positive for its ratings.

Fitch would downgrade Sampath’s rating if the bank is unable to maintain capital buffers commensurate with its risk profile and operating environment-related risks over the medium term. We would revise the Outlook to Stable if the bank successfully implements its capital-enhancement plan to improve its capital profile.

A downgrade of Seylan’s rating could result from a reassessment of state support and large reversal in recent asset quality improvements, together with a weakening financial profile. An upgrade of Seylan’s rating would be contingent on further improvements in its standalone profile through better asset quality and a financial profile similar to higher-rated peers.

The assigned senior debt ratings will move in tandem with the banks’ National Long-Term Rating.

SUPPORT RATING AND SUPPORT RATING FLOOR

Lower propensity of the state to support systemically important banks could result in a downgrade in the assigned Support Ratings and Support Rating Floors, but Fitch sees this to be unlikely in the medium-term. A change in the sovereign’s ratings could also lead to a change in the banks’ Support Ratings and Support Rating Floors.

SUBORDINATED DEBT

The banks’ subordinated debt ratings will move in tandem with the banks’ National Long-Term Ratings.

The rating actions are as follows:

National Savings Bank:

Long-Term Foreign-Currency IDR affirmed at ‘B+’; Stable Outlook

Long-Term Local Currency IDR affirmed at ‘B+’; Stable Outlook

Short-Term Foreign-Currency IDR affirmed at ‘B’

National Long-Term Rating affirmed at ‘AAA(lka)’; Stable Outlook

Support Rating affirmed at ‘4’

Support Rating Floor affirmed at ‘B+’

US dollar senior unsecured notes affirmed at ‘B+’; Recovery Rating at ‘RR4’

Bank of Ceylon:

Long-Term Foreign-Currency IDR affirmed at ‘B+’; Stable Outlook

Long-Term Local-Currency IDR affirmed at ‘B+’; Stable Outlook

Short-Term Foreign-Currency IDR affirmed at ‘B’

National Long-Term Rating affirmed at ‘AA+(lka)’; Stable Outlook

Viability Rating affirmed at ‘b+’

Support Rating affirmed at ‘4’

Support Rating Floor affirmed at ‘B+’

US dollar senior unsecured notes affirmed at ‘B+’; Recovery Rating at ‘RR4’

Basel II compliant Sri Lanka rupee-denominated subordinated debentures affirmed at ‘AA(lka)’

Proposed Basel III compliant Sri Lanka rupee-denominated subordinated debentures affirmed at ‘AA(lka)’

DFCC Bank PLC:

Long-Term Foreign-Currency IDR affirmed at ‘B+’; Outlook revised to Stable from Negative

Long-Term Local-Currency IDR affirmed at ‘B+’; Outlook revised to Stable from Negative

Short-Term Foreign-Currency IDR affirmed at ‘B’

National Long-Term Rating affirmed at ‘AA-(lka)’; Outlook revised to Stable from Negative

Viability Rating affirmed at ‘b+’

Support Rating affirmed at ‘5’

Support Rating Floor affirmed at ‘B-’

US dollar senior unsecured notes affirmed at ‘B+’; Recovery Rating at ‘RR4’

Sri Lanka rupee-denominated senior unsecured debentures affirmed at ‘AA-(lka)’

Basel II compliant Sri Lanka rupee-denominated subordinated debentures affirmed at ‘A+(lka)’

People’s Bank (Sri Lanka):

National Long-Term Rating affirmed at ‘AA+(lka)’; Outlook Stable

Commercial Bank of Ceylon PLC:

National Long-Term Rating affirmed at ‘AA(lka)’; Stable Outlook

Basel II compliant outstanding subordinated debentures affirmed at ‘AA-(lka)’

Hatton National Bank PLC:

National Long-Term Rating affirmed at ‘AA-(lka)’; Stable Outlook

Sri Lanka rupee-denominated senior unsecured debentures affirmed at ‘AA-(lka)’

Basel II compliant outstanding subordinated debentures affirmed at ‘A+(lka)’

National Development Bank PLC:

National Long-Term Rating affirmed at ‘A+(lka)’; Stable Outlook

Basel II compliant subordinated debentures affirmed at ‘A(lka)’

Sampath Bank PLC:

National Long-Term Rating affirmed at ‘A+(lka)’; Negative Outlook

Basel II compliant outstanding subordinated debentures affirmed at ‘A(lka)’

Basel III compliant Sri Lanka rupee-denominated subordinated debentures affirmed at ‘A(lka)’

Seylan Bank PLC:

National Long-Term Rating affirmed at ‘A-(lka)’; Stable Outlook

Sri Lanka rupee-denominated senior unsecured debentures affirmed at ‘A-(lka)’

Basel II compliant subordinated debentures affirmed at ‘BBB+(lka)’

Proposed Basel III compliant Sri Lanka rupee-denominated subordinated debentures affirmed at ‘BBB+(EXP)(lka)’