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DFCC downgraded to ‘B-‘ on Sri Lanka sovereign rating cut, Coronavirus risks

ECONOMYNEXT – Fitch Ratings has downgraded Colombo-based DFCC Bank to ‘B-‘ from ‘B’ after Sri Lanka’s sovereign rating was downgraded a notch and the country is in the grip of a Coronavirus pandemic.

The outlook is negative at the lower level.

“The rating actions follow the downgrade of Sri Lanka’s sovereign rating to ‘B-‘ on 24 April 2020, which reflects the impact of the escalating coronavirus pandemic on Sri Lanka’s economy,” Fitch Ratings said.

“Correspondingly the outlook for the operating environment assessment is maintained at negative to reflect the possibility of further downside should the potential impact of the economic fallout from the coronavirus pandemic become more pronounced or linger.”

The full statement is reproduced below:

Tue 05 May, 2020 – 19:45 ET

Fitch Ratings – Singapore – 05 May 2020: Fitch Ratings has downgraded Sri Lanka-based DFCC Bank PLC’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to ‘B-‘ from ‘B’ and its Viability Rating (VR) to ‘b-‘ from ‘b’. The Outlook on the Long-Term IDR is Negative. The Short-Term IDR has been affirmed at ‘B’. The Support Rating and Support Rating Floor have been affirmed at ‘5’ and ‘No Floor’, respectively.

The rating actions follow the downgrade of Sri Lanka’s sovereign rating to ‘B-‘ on 24 April 2020, which reflects the impact of the escalating coronavirus pandemic on Sri Lanka’s economy. For more details on the sovereign rating action, please see “Fitch Downgrades Sri Lanka to ‘B-‘; Outlook Negative” at www.fitchratings.com.

We have revised our assessment of Sri Lankan bank’s operating environment to ‘b-‘/negative, from ‘b’/negative, primarily to reflect the heightened risk of doing business in the jurisdiction.

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Under Fitch’s base case scenario, we forecast the world economy and the Sri Lankan economy to contract by 3.9% and 1.0%, respectively, in 2020.

We expect the banks’ financial profiles to come under stress from the more challenging operating environment, and their key credit metrics are likely to be weaker than our previous expectations, despite regulatory reliefs.

We expect GDP growth of 4% for Sri Lanka in 2021 as tourism receipts gradually recover from late 2020, but this forecast is subject to an unusually high degree of uncertainty and downside risk, as it depends on the evolution of the pandemic within Sri Lanka and globally.

Correspondingly the outlook for the operating environment assessment is maintained at negative to reflect the possibility of further downside should the potential impact of the economic fallout from the coronavirus pandemic become more pronounced or linger.

KEY RATING DRIVERS

IDRS AND VR

DFCC’s IDRs are driven by its VR, the downgrade of which is driven by our assessment of the operating environment, which we believe continues to have a high influence on bank ratings through its impact on financial and non- financial rating factors. Downside risks to DFCC’s financial metrics include weaker asset quality and earnings, as well as pressure on capital and funding and liquidity amid the Covid-19 pandemic.

The Negative Outlook on DFCC’s IDR reflects the outlook for the operating environment assessment, which is maintained at negative to reflect the possibility of further downside.

We believe that extension of the impact of the virus could intensify the asset quality pressures the bank already faces, and as such we have revised the outlook on DFCC’s asset quality rating factor to negative from stable.

DFCC’s impaired loans (stage 3) ratio increased to 8.4% by end-2019 from 5.8% at end-2018, driven by loans to government institutions where the facilities carry a full Treasury guarantee (56% of the incremental stage 3 loans in 2019). The bank’s stressed regulatory non-performing loans ratio (including rescheduled and restructured loans) continues to be high.

DFCC has one of the weakest earnings and profitability profiles among Fitch-rated large private banks in Sri Lanka and its earnings were under stress in 2019 due to slower loan growth, heavy trading losses on its equity stake in Commercial Bank of Ceylon PLC (COMB: AA(lka)/Negative), and higher credit costs.

We expect margin pressure through lower interest rates amid subdued credit demand and higher provisioning and credit losses stemming from the pandemic to worsen DFCC’s profitability metrics.

We have therefore lowered the mid-point of the earnings and profitability assessment to ‘b-‘ and revised the outlook to negative to reflect further downside to earnings should the downturn prove to be significantly worse than our base case.

DFCC’s common equity Tier 1 ratio stood at 11.3% at end-2019, lower than that of similarly rated peers. While we believe that access to capital is greater for DFCC via its 13.5% stake in COMB, the realizable gains from this could remain low in the medium term given the weak performance of Sri Lanka’s stock market. We have lowered the mid-point of the capitalisation and leverage rating factor to ‘b’ and revised the outlook to negative to reflect our view that there is further risk to capital buffers should the downturn prove to be significantly worse than our base case.

DFCC is funded mainly by deposits, but its deposit franchise lags behind that of larger and more-established peers. The bank also has a significant amount of foreign-currency funding, which accounted for 20% of total funding at end-2019 (13% in deposits and 7% in wholesale funding).

We believe that accessing such foreign-currency funding could become more challenging, both in terms of accessibility and pricing, to due increasing country risks.

As such, we have revised the outlook on the funding and liquidity mid-point score of ‘b-‘ to negative.

SUPPORT RATING AND SUPPORT RATING FLOOR

Fitch’s assessment is that state support may be possible for DFCC, but timely sovereign support cannot be relied upon in light of the sovereign’s weakened financial ability. Furthermore, the bank’s franchise is small with market share of around 3% of system assets against 8%-11% for the larger private banks.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:
IDRS AND VR
DFCC’s ratings are constrained by the sovereign rating. Fitch does not currently anticipate developments with a high likelihood of leading to an upgrade given the pressure on the sovereign rating and deteriorating operating environment.

The Outlook on DFCC’s IDR could be revised to Stable if our assessment of the operating environment improves.

SUPPORT RATING AND SUPPORT RATING FLOOR

An upgrade of DFCC’s Support Rating and upward revision of the bank’s Support Rating Floor would be contingent on a positive change in the sovereign’s ability to provide support, which we do not expect in the near to medium term.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

IDRS AND VR

DFCC’s IDRs and VR could be downgraded if the operating environment deteriorates
significantly beyond our base case scenario, likely triggered by a downgrade of the sovereign rating or caused by a larger GDP contraction or slower economic recovery than we expect, which would also result in a lowering of our assessment of most of the bank’s financial profile factors.

In particular, such an environment would see greater and more prolonged asset-quality deterioration with an increase in its impaired loans/ gross loans to over 14%, which would put further pressure on DFCC’s earnings and capitalisation.

SUPPORT RATING AND SUPPORT RATING FLOOR

DFCC’s Support Rating and Support Rating Floors are already at their lowest level and no downside is possible.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Financial Institutions issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years.

The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG CONSIDERATIONS

The highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies), either due to their nature or to the way in which they are being managed by the entity(ies).