ECONOMYNEXT – Fitch Ratings has confirmed a ‘CCC’ rating on Sri Lanka’s state-run Bank of Ceylon with a negative outlook amid concerns over sovereign credit and the possibility of further weakness in the operating environment.
“The outlook on the operating environment assessment remains negative due to the potential for further risk from the deterioration of the sovereign credit profile or pressure on domestic operating conditions beyond our expectation independent of changes in the sovereign rating,” Fitch said in a statement.
“The operating environment for Sri Lankan banks has a high influence on banks’ ratings, as it is likely to constrain their intrinsic credit profiles through its effect on financial and non-financial key rating factors.”
The Bank of Ceylon has seen steep loan growth from lending to government and state enterprises.
“The bank’s increased lending to the state and state-owned enterprises (SOEs) resulted in loan expansion of 27.7 percent in 2020 and 8.6 percent 1Q21, which far exceeded that for the sector, and increased its loan book concentration to the state and SOEs,” Fitch said.
“BOC’s risk appetite is more susceptible to pressure, as its status as a large state bank has led to an increased policy role in intermediating relief to businesses and individuals affected by the pandemic.”
Bad loans had fell to 9.7 percent by the end of the first quarter from 10.3 percent at the end of 2020. Though provisions had also increased, there could be more impaired assets ahead.
“Pressure on impaired loans could manifest across an extended period of time due to relief measures that halted the recognition of credit impairments and ongoing discretionary restructuring,” Fitch said.
“Despite an increase in loan loss allowances/ impaired loans to 59 percent by end-2020 from 56.6 percetn at end-2019, net impaired loans/common equity Tier 1 capital deteriorated to 65%, underscoring the pressure on BOC’s capitalisation.”
The Bank’s loan to deposit ratio had also risen. Banks generally see a rise in the loan to deposit ratio in Sri Lanka amid monetary instability as liquidity injections drive credit, analysts say.
The full statement is reproduced below:
Fitch Ratings – Colombo – 16 Jul 2021: Fitch Ratings has affirmed Bank of Ceylon’s (BOC) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDR) at ‘CCC’. The ratings do not carry an Outlook because of the potentially high volatility at this rating level, in line with Fitch’s rating definitions.
BOC’s National Long-Term Rating has also been affirmed at ‘AA -(lka)’. The Outlook is Stable. At the same time, Fitch has affirmed BOC’s Viability Rating at ‘ccc’, Support Rating at ‘5’ and Support Rating Floor at ‘NF’ (No Floor).
A full list of rating actions is at the end of this commentary.
KEY RATING DRIVERS
IDRS, VIABILITY RATING and NATIONAL LONG-TERM RATING
BOC’s Long-Term IDRs are driven by the bank’s intrinsic credit profile, as reflected in its VR. There are no changes to our assessment of the bank’s intrinsic credit profile since our last review in December 2020. The ratings are constrained by the sovereign IDR (CCC). BOC’s VR remains highly influenced by the operating environment and asset quality.
Our assessment of the operating environment for Sri Lankan banks reflects the risk of doing banking business due to the sovereign’s credit profile and the impact of the coronavirus pandemic. Sri Lanka’s economy contracted by 3.6% in 2020 as a result of the pandemic, and our expectation is for an expansion of 3.8% in 2021. Our forecasts are subject to a high degree of uncertainty depending on the evolution of the pandemic.
The outlook on the operating environment assessment remains negative due to the potential for further risk from the deterioration of the sovereign credit profile or pressure on domestic operating conditions beyond our expectation independent of changes in the sovereign rating. The operating environment for Sri Lankan banks has a high influence on banks’ ratings, as it is likely to constrain their intrinsic credit profiles through its effect on financial and non-financial key rating factors. The negative outlook on risk appetite and most of the financial profile factors reflect the pressure from the operating environment.
BOC’s risk appetite score of ‘ccc’/negative reflects heightened risk from its significant exposure to the sovereign and also from non-state exposures that could be susceptible to deteriorating operating conditions.
The bank’s increased lending to the state and state-owned enterprises (SOEs) resulted in loan expansion of 27.7% in 2020 and 8.6% 1Q21, which far exceeded that for the sector, and increased its loan book concentration to the state and SOEs. BOC’s risk appetite is more susceptible to pressure, as its status as a large state bank has led to an increased policy role in intermediating relief to businesses and individuals affected by the pandemic.
BOC’s asset quality score of ‘ccc’/negative is aligned with its risk appetite score and reflects our expectation of persisting risks to asset quality. Its impaired loans/ gross loans ratio fell to 9.7% by end-1Q21 from 10.3% at end-2020 due to the rapid increase in loans. Pressure on impaired loans could manifest across an extended period of time due to relief measures that halted the recognition of credit impairments and ongoing discretionary restructuring. Despite an increase in loan loss allowances/ impaired loans to 59% by end-2020 from 56.6% at end-2019, net impaired loans/common equity Tier 1 capital deteriorated to 65%, underscoring the pressure on BOC’s capitalisation.
BOC’s capitalisation and leverage score of ‘b-‘/negative factors in the heightened constraints on accessing capital from the state due to its credit profile, although capital deficiencies are not envisaged. In the absence of a capital infusion from the state, the bank has continued to retain more profit since 2019, and has raised additional Tier 1 capital through perpetual unlisted bonds. BOC’s exposure to the state bolsters its reported capitalisation ratios, as the exposure is mostly risk-weighted at 0%. Still, the bank’s capital buffers remain thin, relative to its exposure to risks from the operating environment and sovereign credit profile.
BOC’s earnings and profitability score remains at ‘b-‘/negative to reflect our expectation of sustained pressure in this area through high credit costs, despite the potential for improved pre-provision profit buffers. Its operating profit/risk-weighted assets ratio recovered in 1Q21 to 5.3% after dropping to 2.0% in 2020, alongside a sharp increase in impairment charges that consumed 54% of pre-impairment profits in 2020.
BOC’s funding and liquidity score of ‘b-‘/negative reflects the challenges in accessing foreign-currency funding due to the sovereign credit profile, despite the benefit from its state linkages, which support its entrenched domestic deposit franchise and perception of safety. BOC has the largest foreign-currency deposit base in Sri Lanka, supported by its leading position in channelling inward worker remittances. In addition, the bank also relies on foreign-currency non-deposit funding, although its share in non-deposit funding has declined since end-2019. BOC’s loan/deposit ratio rose sharply to 91% in 1Q21 from 84% across 2017-2020 driven by rapid loan growth in 2020 and 1Q21.
BOC’s National Rating is also driven by its standalone strength and reflects its entrenched domestic franchise, but higher risk appetite and smaller capital buffers relative to private-bank peers that have the same national rating. The ratings are constrained by our assessment of Sri Lanka’s sovereign rating and the operating environment.
SUPPORT RATING AND SUPPORT RATING FLOOR
The Support Rating Floor of ‘NF’ and Support Rating of ‘5’ reflect our opinion that extraordinary sovereign support for the bank cannot be relied upon in our ratings. We believe the sovereign’s ability to provide extraordinary support is severely constrained by its weakened financial flexibility, the size of the banking sector relative to the economy and the banking system’s high vulnerability to large losses in a downturn, despite a high propensity for the sovereign to extend support to the bank.
The Basel II Sri Lanka rupee-denominated subordinated debt of BOC is rated two notches below its National Long-Term Rating, in line with Fitch’s baseline notching for loss severity for this type of debt and our expectations of poor recovery.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
IDRS, VIABILITY RATING and NATIONAL RATING
Upside to BOC’s IDR, VR and National Rating is constrained by our assessment of the sovereign’s credit profile and the operating environment. We do not anticipate developments that might lead to positive rating action in the near-term given the pressure on the sovereign rating and the challenging operating environment.
SUPPORT RATING and SUPPORT RATING FLOOR
BOC’s Support Rating and Support Rating Floor are constrained by the sovereign rating. An upward revision of the ratings is possible provided the sovereign’s ability to provide support improves materially. However, we do not expect this in the near to medium term.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
IDRS, VIABILITY RATING and NATIONAL RATING
Pressure on BOC’s IDR, VR and National Rating is most likely to stem from a deterioration in Sri Lanka’s sovereign rating, constraining BOC’s standalone credit profile, including the operating environment. Operating conditions are likely to deteriorate significantly in such a scenario, resulting in heightened risk for BOC’s financial profile, such as through a lack of access to foreign-currency funding that restricts operations or a significant deterioration in loan quality that erodes its capital. Weaker assessment of the operating environment independent of changes in the sovereign rating, or a deterioration in credit metrics past our base-case expectations relative to peers, would also lead to increased pressure BOC ‘s National Rating.
SUPPORT RATING and SUPPORT RATING FLOOR
The ratings are already at their lowest level and thus have no downside risk.
BOC’s subordinated debt rating will move in tandem with the National-Long Term Rating
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Financial Institutions and Covered Bond 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.
Bank of Ceylon has an ESG Relevance Score of ‘4’ for Governance Structure due to ownership concentration. The state owns 100% of the bank and BOC has several related-party transactions with the state and state-owned entities. This has a negative impact on the credit profile, and is relevant to the ratings in conjunction with other factors.
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of ‘3’. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch’s ESG Relevance Scores, visit www.fitchratings.com/esg