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Merchant Bank of Sri Lanka & Finance hit with lending and deposit caps, outlook cut

ECONOMYNEXT- The Merchant Bank of Sri Lanka & Finance Plc, (MBSL) which is suffering from low capital adequacy, has been slapped with lending and deposit caps by the central bank, ICRA Lanka, a ratings agency, said.

MBSL’s core capital ratio was 4.70 percent at end-June compared to a minimum requirement of 6 percent, while total capital was at 7.89 percent, while needing to maintain 10 percent.

“This has resulted in lending and deposit caps of 35 billion rupees and 23 billion rupees respectively, being imposed by Central Bank of Sri Lanka from Apr-19 and May19 respectively,” ICRA Lanka said.

The finance company will require between 1.4-2.7 billion rupees in capital injections by 2022, the ratings agency said.

Timely capital support from the state-owned parent Bank of Ceylon was lower than expected, ICRA Lanka said.

Four of MBSL’s seven directors, and members of its senior management team are from Bank of Ceylon.

The ratings agency downgraded MBSL’s outlook to [SL] A negative from a previous stable outlook.

The ratings agency said the bank’s weakening capital, poor profitability and weak asset quality warranted the outlook downgrade.

MBSL had 13.82 percent in bad loans at end-June from 11.24 percent six months earlier.

The full ICRA Lanka statement follows:

Rating action
ICRA Lanka Limited, subsidiary of ICRA Limited, a group company of Moody’s Investors Service, has revised the the issuer rating of Merchant Bank of Sri Lanka & Finance PLC (MBSL or the Company) to [SL]A- (Pronounced SL A minus) from [SL]A (Pronounced SL A).

ICRA Lanka has also revised the rating of the LKR 2,000 Mn Subordinated Unsecured Redeemable Debenture to [SL]BBB+ (Pronounced SL triple B plus) from [SL]A- (Pronounced SL A minus). The outlook on the ratings is Negative.

ICRA Lanka has also revised the rating to [SL]A(SO) from [SL]A+(SO) on the LKR 343.5 Mn (reduced from LKR 1,463 Mn) Trust certificates of MBSL Trust-01. The outlook on the rating is Negative. Please refer to our detailed rationale dated December 23, 2019.

ICRA Lanka has revised the rating for the LKR 2,000 Mn Senior Unsecured Redeemable Debentures to [SL]A- (Pronounced SL A minus) with Negative outlook from [SL]A (Pronounced SL A) with Negative outlook and has withdrawn the rating at the request of the Company, as the same have been fully redeemed.

Rationale

The rating revision factors in MBSL’s continued weakening in the capital profile, poor profitability and weak asset quality.

The timely capital support of the parent, Bank of Ceylon (rated [SL]AAA (Negative) by ICRA Lanka, “BOC”/”Parent”) with 81.59% 1stake was lower than expected.

ICRA Lanka notes that MBSL’s capital profile continued to remain below minimum regulatory requirement with core capital and total capital adequacy ratios standing at 4.70% and 7.89% as in Jun-19, as compared to the regulatory requirement of 6.00% and 10.00%.

This has resulted in lending and deposit caps of LKR 35 Bn and LKR 23 Bn, respectively, being imposed by Central Bank of Sri Lanka (“CBSL”/”Regulator”) from Apr-19 and May19 respectively.

Capital profile remained weak driven by poor profitability metrics as the Company reported operating losses (before deducting credit cost) of LKR 16 Mn in 9MCY2019, as the Cost to Income ratio continued to increase from 80.62% in CY2018 (79.60% in CY2017) to 100.67% in 9MCY2019.

ICRA Lanka notes that MBSL’s capital structure is already stretched with gearing at 13.5 times as on Sep-19.

As per ICRA Lanka’s estimates, MBSL will require capital infusion of ~LKR 1.4 – 2.7 Bn (~91%-173% of its market capitalisation), assuming a 10-20% growth in the risk weighted assets (RWAs), during CY2020-22 to report a minimum Tier I capital ratio of 9.50%, including a cushion of 100 bps.

The ratings also factor in the continued weakness in MBSL Insurance Company Limited’s (MBSI) performance post the LKR 1.2 Bn capital infusion in Apr-19.

ICRA Lanka notes that MBSI would require additional capital to meet any contingent liabilities and to improve its overall risk profile going forward, as MSBL is expected to retain MBSI as its subsidiary.

ICRA Lanka also notes that the above along with MBSL’s weak asset quality profile (Gross NPA 13.82% in Jun-19 as compared to 11.24% in Dec-18 and 10.10% in Dec-17) has adversely impacted its solvency (Net NPA/ networth) further, which currently stands subdued at 98.93% in Jun-19.

Outlook: Negative
The Negative outlook reflects the continued moderation in MBSL’s financial risk profile characterized by a weakening in its capital and earnings profile.

The outlook may be revised to ‘Stable’ in case of steady improvement in MBSL’s capital profile, asset quality and earnings profile.

The ratings may be further downgraded if the Company fails to meet the minimum regulatory capital requirements and turnaround the performance of its core operations.

Key rating drivers

Credit strengths

Being a subsidiary of BOC; MBSL is 81.6% subsidiary of Bank of Ceylon (“BoC”, rated [SL]AAA (Negative) by ICRA Lanka).

The Company was incorporated in 1982 as a specialised bank, operated as the leasing and merchant banking arm of BoC.

Subsequently it became a Non-Banking Financial Institution offering leasing, term loans, personal loans, microfinance, and gold loan facilities to its customers.

The Company has its own corporate advisory division which provides transaction advisory services to its clients.

The Company has a network of 49 branches around the country and over 900 employees as in Sep-19.

The rating factors the strategic and financial support derived from its Parent, BOC.

The parent company, BoC continues to provide financial support by providing term loan facilities and contingent funding lines to the Company.

However, the timely capital support was observed to be lower than expected from the parent as the Company is facing regulatory restrictions due to its failure in meeting the regulatory capital adequacy requirements imposed by CBSL.

The parent provides strategic support for operations as MBSL’s board with four directors being BOC representatives out of a total of 7 directors.

The BOC representation includes members from the BOC’s senior management team.

Credit challenges

Stretched capital position; The Tier-1 core capital ratio was 4.70% and the total Capital Adequacy Ratio (CAR) of the Company was 7.89% as in Jun-19 and the same was below the regulatory requirement of 6.00% and 10.00%.

The Company failed to meet the regulatory capital requirements due to IFRS-9 day one adjustment and weak profitability with losses at operating level in 9MCY2019.

As a result, CBSL imposed lending and borrowing caps of LKR 35 Bn (LKR 30.7 Bn as on Sep-19) and LKR 23 Bn (LKR 22.5 Bn as on Sep-19) in Apr-19 and May-19, respectively. The Company adjusted LKR 892 Mn as the day one adjustment to the equity when the Company adopted IFRS-9.

The gearing continues to increase as it was 13.5 times as in Sep-19 as compared to 12.6 times in Dec-18 (9.7 times in Dec-17).

The Company would require ~LKR 1.4 Bn to LKR 2.7 Bn fresh equity over the next three years (CY2020-22) to meet the minimum Tier I capital ratio of 9.50%, with a buffer of 1.00%, given the expected RWA growth of 10-20% during the same period.

ICRA Lanka will continue to monitor MBSL’s capital raising plan from BOC or a new investor in FY2020 and FY2021 and timely capital support from BOC will be a key rating sensitivity.

Weak asset quality; MBSL’s asset quality deteriorated as the Gross NPA ratio increased from 10.10% in Dec-17 to 11.24% in Dec-18, it further increased to 13.82% as in Jun-19.

The GNPA ratio was higher than the system average of 9.18% in Jun-19. The asset quality of the portfolio deteriorated due to poor performance reported in micro, business and personal loans with Gross NPA ratio of 48.81%, 35.96% and 9.01% respectively in Jun-19.

As a result, the Company discontinued the microfinance and unsecured business loan facilities, while curtailing the personal loans by strengthening the credit underwriting for the product.

The Company has discontinued its clean lending portfolio and targets to increase the asset-backed portfolio to 95% by Dec-20.

Furthermore, the Company has centralised the credit operations process to improve quality of the new facilities to control further slippages and strengthened its recovery activities.

MBSL’s provision coverage ratio remained weak at 48.36% in Jun-19 as compared to 47.34% in Dec-18 and remained below the system average of 57.90%.

As a result, the solvency profile deteriorated with Net NPA/ Networth at 98.93% in Jun-19 as compared to 78.17%% in Dec-18.

ICRA Lanka takes note of the actions taken by the Company to control the NPAs and further deterioration in asset quality would have a negative impact on the earnings and capital profiles of the Company.

MBSL’s ability to control the new slippages and recoverability of the long outstanding legacy NPA portfolio would be a key rating sensitivity.

Poor profitability; The Company’s overall earnings profile is characterized by operational inefficiencies and increasing credit costs.

The credit cost continued to increase as it was 0.49% of average total assets for the 9MCY2019 as compared to 0.21% in CY2018 (0.88% in CY2017).

The increase was due to higher slippages witnessed in micro, business and personal loans.

The Company’s operational level viability is hindered by its higher operating expenses to average total assets (9MCY2019 – 6.34%, CY2018 – 6.33%, CY2017 – 6.20%).

The Company reported a PAT of LKR 13 Mn for the 9MCY2019 as compared to PAT of LKR 181 Mn in CY2018 vis-à-vis LKR 101 Mn in the previous year.

The Company reported a profit for the latest nine months ended Sep-19 due to reversal of provisions of LKR 166 Mn made on its insurance subsidiary MBSL Insurance Company Limited (“MBSLI”).

The profitability ratios weakened as the ROA moderated to 0.05% in 9MCY2019 as compared to 0.50% in CY2018 (0.30% in CY2017) and ROE moderated to 0.66% in 9MCY2019 as compared to 6.30% in CY2018 (3.18% in CY2017).

Going forward, the ability to control credit costs and the operating expenses by the way of optimising business growth and rationalizing the operations would be critical for the improvement in the profitability indicators.

Moderate liquidity; The Company reported a short term (less than 1 year) ALM cumulative negative mismatch of 12.57% of total assets in Jun-19 as compared to 9.47% in Mar-19 (18.00% in Mar-18).

However, the Company has close to LKR 1.9 Bn contingent funding lines available from the commercial banks.

The Company’s liquidity profile is supported by its 80% deposit renewal rate and the funding support from BOC including LKR 1.5 Bn contingent funding facility.

Analytical approach: For arriving at the ratings, ICRA Lanka has applied its rating methodologies as indicated below.

The ratings also factor in the capital support from BOC, which uplifted the credit risk profile of MBSL.

Links to applicable criteria: ICRA Lanka’s Credit Rating Methodology for Non-Banking Financial Institutions

About the Company:

MBSL was established in 1982 as a merchant bank. The Company had two subsidiaries, MBSL Savings Bank Ltd (MSB, Licensed Specialised Bank) and MBSL Insurance Company (Composite Insurer) and two associate companies, Lanka Securities (Pvt) Ltd (registered stockbroker) and MCSL Financial Services Ltd (a licensed finance company).

Pursuant to the Master Plan on Consolidation of the Financial Sector proposed by the Central Bank of Sri Lanka (CBSL), in January 2015, MBSL Savings Bank Limited (MSB) and MCSL Financial Services Limited (MCSL) were merged with MBSL.

MBSL offers leasing & HP, long and short-term loans, microfinance and gold loans to its clients. The Company has 49 branches and employs more than 900 staff members as in Sep19.

MBSL Insurance Company Limited (MBSI) is 84% owned subsidiary of MBSL. The Company offers life and general insurance products to its customers. MBSI has close to 50 branches and window offices covering Sri Lanka.

For the CY2018, MBSL reported a PAT of LKR 181 Mn (CY2017: LKR 101 Mn) with a total asset base of LKR 35,864 Mn as at December 31, 2018 (LKR 35,970 Mn as at December 31, 2017).

For the 9MCY2019, MBSL reported a PAT, of LKR 13 Mn with a total asset base of LKR 38,674 Mn.

The Company operated with a net worth of LKR 2,544 Mn and a gearing ratio of 13.5 times as at September 30, 2019.

MBSL group reported a PAT of LKR 472 Mn for the CY2018 (CY2017: LKR 103 Mn) with a total asset base of LKR 37,314 Mn as at December 31, 2018 (LKR 37,242 Mn as at December 31, 2017).

For the 9MCY2019, MBSL group reported a loss of LKR 210 Mn with a total asset base of LKR 40,683 Mn.

The Group operated with a net worth of LKR 3,331 Mn and a gearing ratio of 13.1 times as at September 30, 2019. (Colombo/Dec26/2019)

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