ECONOMYNEXT – Sri Lanka’s Fitch Ratings has affirmed an ‘A(lka)’ rating on Bank of Ceylon saying the operating environment was improving but sovereign exposure was high.
“The BOC’s asset quality metrics remain heavily influenced by the sovereign’s credit profile due to the bank’s large sovereign exposure through loans, off-balance sheet liabilities and securities holdings,” Fitch said.
About 60 percent of the bank’s assets were exposed to the sovereign risk profile.
The bank had secured 55 percent of defaulted sovereign bonds that accounted for 2 percent of its assets.
The bank’s core asset quality metric – impaired loan ratio (stage 3) – rose to 13.5 percent at the end of Q1 24 (year-end 2023: 12.6 percent, 2021: 10.2 percent) mainly due to the contraction of gross loans.
“We estimate that this ratio will be significantly higher if the BOC’s foreign currency credit exposure to the state and state entities is included,” Fitch said.
The full statement is reproduced below:
Fitch Ratings – Singapore/Colombo – 06 June 2024: Fitch Ratings has affirmed Bank of Ceylon’s (BOC) long-term default foreign currency issuer rating at ‘CC’. The rating does not have an Outlook due to the potential for high volatility at this rating level, consistent with Fitch’s rating definitions. At the same time, Fitch has maintained BOC’s Viability Rating (VR) of ‘cc’ on Rating Watch Negative (RWN).
Fitch has also affirmed BOC’s long-term local currency IDR at ‘CCC-‘ with a stable outlook, short-term IDR at ‘C’, government support rating at ‘ns’ and long-term national rating at ‘A( lka)’ with a stable Outlook.
A full list of rating actions is at the end of this comment.
KEY DRIVERS OF ASSESSMENT
Downside Risks for VR: Fitch has maintained BOC’s VR at RWN to reflect risks to the bank’s credit profile from potential capital stress stemming from the restructuring of loans to state entities. The government budget unveiled on November 13, 2023 allocated LKR 450 billion for the recapitalization of state-owned banks, including the BOC, to ensure the stability of the financial system. Fitch’s affirmation of BOC’s IDRs continues to reflect a high default risk from sovereign debt restructuring.
The recapitalization plan to address potential capital erosion, if realized, could provide tremendous support. In line with Fitch’s Bank Rating Criteria, extraordinary capital support to restore viability would be viewed by Fitch as a “bank failure” and lead to the bank’s VR being downgraded to ‘f’, but then, after the recapitalization, it would improve to a proportional level. with its own credit profile.
Restructuring delays hinder progress: Sri Lanka’s banking (EO) operating environment continues to show signs of stabilization, supporting the recovery of banks’ operational flexibility. There are steady improvements in reported economic variables such as GDP growth, inflation and interest rates, but we believe that continued delays in completing the sovereign debt restructuring exercise may hamper the progress made so far.
Capital depreciation risks: The ongoing restructuring of loans to state-owned enterprises that have been taken over by the government poses significant risks to BOC’s capital, which is reflected in the government’s allocation of LKR 450 billion to recapitalize state-owned banks, including BOC.
This is in addition to risks to capital arising from the bank’s holdings of defaulted sovereign bonds, for which the bank has already absorbed a provision of around 55%, although the adequacy of the provision is uncertain.
Stress risk profile of sovereign exposures: The BOC’s large exposure to the sovereign’s fragile credit profile – which we estimate at around 60% of assets – continues to weigh on the bank’s risk profile assessment. This includes the loan granted to a state-owned entity that was transferred to the government at the end of 2022 and its holdings of defaulted sovereign bonds (2% of assets), which are currently in restructuring negotiations. These exposures have made the bank vulnerable to the repayment capacity and liquidity position of the sovereign.
Asset quality pressures continue: The BOC’s asset quality metrics remain heavily influenced by the sovereign’s credit profile due to the bank’s large exposure to the sovereign through loans, off-balance sheet liabilities and securities holdings. The bank’s core asset quality metric – the impaired loan ratio (stage 3) – rose to 13.5% at the end of Q1 24 (year-end 2023: 12.6%, 2021: 10.2%) mainly due to the contraction of gross loans. We estimate that this ratio will be significantly higher if the BOC’s foreign currency loan exposure to the state and state entities is also included.
Risks to manageable profitability: The revision of BOC’s earnings and profitability outlook to stable from negative reflects our view that downside risks to earnings have diminished despite the potential for a post-restructuring loss on foreign currency loans to a state-owned entity, which we expect to be a such. -off.
BOC’s operating profit/risk-weighted asset ratio fell in 1Q24 to 3.0% (end-2023: 3.1%) due to higher impairment charges compared to 2023, when the profitability of the bank benefited from net impairment reversals.
Funding and liquidity risks continue: Fitch believes that BOC’s funding and liquidity profile, particularly in foreign currency, is sensitive to the sovereign’s weak credit profile (Long-Term IDR: RD). The stress on foreign currency liquidity has eased somewhat, reflected in the liquidity coverage ratio, but the BOC’s access to bulk foreign currency funding remains limited by the sovereign’s default status. This can be seen from the decrease in the share of term borrowings from foreign banks to 0.7% of financing by the end of 2023 from 3.3% at the end of 2021.
The economy supports the business profile: Fitch revised the outlook for BOC’s business profile to stable from negative, supported by our view that the stabilizing macroeconomic environment has reduced uncertainties for the bank in generating and protecting business volumes. That said, the business profile score continues to reflect the bank’s prevailing exposure to the weak domestic economy and EO constraints in the near term.
Assessment sensitivities
Factors that, individually or collectively, may lead to action/reduction of the negative rating
We expect to resolve RWN on BOC’s VR when the impact on its capital from sovereign debt restructuring becomes more apparent, which could take more than six months.
If the proposed sovereign debt restructuring leads to a material capital shortfall that requires recapitalization by the authorities to restore viability or the granting of any regulatory capital restrictions related to such a shortfall, Fitch would downgrade BOC’s VR to ‘ f’ and thereafter, with each recapitalization. , upgrade it to a level commensurate with its standalone credit profile, likely driven by its risk profile and capitalization.
A decrease in VR may not necessarily lead to a decrease in long-term foreign and local currency IDRs.
Fitch would downgrade BOC’s long-term foreign and/or local currency IDRs if we perceive that there is an increased likelihood that the bank will default on or seek a restructuring of its high foreign and/or local currency liabilities to non-governmental. creditors.
A deterioration in the bank’s key credit metrics beyond our base-case expectations relative to peers could cause a downgrade of BOC’s national rating.
Factors that, individually or collectively, can lead to positive evaluation action/improvement
There is limited room for incremental rating action in VR given RWN. Fitch may resolve Rating Watch to an affirmative if we believe that large capital shortfalls that threaten the bank’s viability are unlikely to arise.
An upgrade in the BOC’s long-term foreign and/or local currency IDRs will most likely result from an improvement in the sovereign’s credit profile, which may occur following the successful restructuring of the sovereign’s external debt.
The positive rating action on the sovereign could lead to an improvement in the BOC’s national rating. A sustained improvement in the bank’s key measures of credit quality beyond our baseline expectations, relative to peers, could lead to an upgrade in the bank’s national rating.
OTHER DEBT AND ISSUER RATINGS: KEY RATING DRIVERS
Sri Lanka’s BOC’s Basel II and Basel III subordinated debt is rated two notches below its National Long-Term Rating, consistent with Fitch’s baseline level of loss severity for this type of debt and our weak recovery expectations.
There are no additional tiers for non-performance risk, as the notes do not include ongoing loss-absorbing features.
The Basel III Compliant Notes include a clause whereby the notes will be converted into an additional Tier 1 instrument on a permanent basis at the point of non-applicability, subject to the occurrence of a trigger event, as determined by the Central Monetary Board Bank of Sri Lanka Lanka.
The ‘ns’ estimate of government support reflects our assessment that there is no reasonable assumption of government support.
OTHER DEBT AND ISSUE RATINGS: RATING SENSITIVITIES
The BOC’s subordinated debt rating will move along with the long-term National Rating.
VR REGULATIONS
The operating environment score of ‘ccc-‘ is below the implied score of category ‘b’ due to the following adjustment reason: sovereign (negative) rating.
The business profile score of ‘ccc-‘ is below the implied category score of ‘b’ due to the following adjustment reason: business model (negative).
BOC has a 1.78% equity stake in Fitch Ratings Lanka Ltd. No shareholder other than Fitch, Inc. is involved in the day-to-day rating operations or credit reviews undertaken by Fitch Ratings Lanka Ltd.
SOURCE REFERENCES WITH MATERIALS CITED AS PRIMARY STATES OF EVALUATION
The main sources of information used in the analysis are described in the Applicable Criteria.
ESG CONSIDERATIONS
BOC has an ESG relevance score of ‘4’ for Governance Structure due to the concentration of ownership, with a 100% state share and some related party transactions with the state and state entities, which has a negative impact on the profile of credit and is relevant to the assessment in relation to other factors.
BOC has an ESG relevance score of ‘4’ for Financial Transparency. It reflects our view that the recent regulatory forbearance measures announced by the Central Bank of Sri Lanka may distort the true solvency and liquidity position of the bank, thereby limiting financial transparency. This has a negative impact on the credit profile and is important for evaluation in relation to other factors.
The highest level of ESG credit significance is a score of ‘3’, unless otherwise disclosed in this section. A score of ‘3’ means that the ESG issues are credit neutral or have only a minimal credit impact on the entity, either because of their nature or the way in which they are managed by the entity. Fitch’s ESG Relevance scores are not input into the rating process; they are an observation on the importance and materiality of ESG factors in the valuation decision.
For more information on Fitch’s ESG relevance scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores. (Colombo/6/6/2024)
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