Fitch says challenging operating environment for small and mid-sized banks

A recent periodic review by Fitch Ratings forecasted challenging times ahead for the country’s small and mid-sized banks, largely stemming from capitalisation issues. 
Accordingly, the rating agency downgraded Pan Asia Banking Corporation PLC’s (PABC) national long-term rating to ‘BBB-(lka)’ from ‘BBB(lka)’. The outlook was revised to stable from negative. 
The agency has also revised the outlook on the national long-term rating of Union Bank of Colombo PLC (UB) to positive from stable and affirmed its rating at ‘BB+(lka)’. 
The national long-term ratings on Nations Trust Bank PLC (NTB), Sanasa Development Bank PLC (SDB) and Amana Bank PLC (Amana) have been affirmed with a stable outlook. 
The banks’ operating environment has become more challenging - as signalled by the downgrade of the sovereign long-term issuer default rating to ‘B+’ from ‘BB-’ on February 29, 2016. Fitch expects increased volatility in operating conditions to add pressure on the banks’ credit metrics. Fitch believes capitalisation is the main problem for the banks, due to weakening capital buffers from rapid loan-book growth and high exposure to retail and small and medium enterprise (SME) segments, which are more susceptible to deteriorating economic conditions. PABC and Amana are yet to meet the Rs.10 billion minimum capital requirement set by the regulator. Fitch believes capital-raising may also be a challenge amid increased country risk.
The downgrade of PABC’s national long-term rating reflects the continued deterioration in its capitalisation following above-industry loan growth (2015: 37 percent versus 21 percent for the industry, 2014: 27.2 percent versus 13.7 percent). The rating factors in Fitch’s expectation of an equity infusion, as PABC is required to increase its minimum regulatory capital to Rs.7.5 billion by January 1, 2017 and Rs.10 billion by January 1, 2018. Fitch believes that the bank’s earnings retention alone is not likely to be sufficient to achieve the capital standards, despite improved profitability. PABC’s regulatory NPL ratio improved to 4.4 percent at end-June 2016, from 5.7 percent at end-2014, mostly due to high loan growth, although the stock of NPLs also decreased marginally. ROA improved to 1.1 percent, from 0.6 percent, due to better revenue generation stemming from higher business volumes.
The positive outlook on UB’s rating reflects the structural changes taking place through a shift in the risk profile of the bank’s loan book. This stems from a higher exposure to corporates as opposed to SMEs in the past, which could support better asset quality. However, UB continued to sustain rapid loan growth of 51.5 percent in 2015 and 20.5 percent in 1H16. This could put pressure on asset-quality if not managed.
UB’s rating reflects its still-small franchise, weak profitability and higher capitalisation compared with that of its peers. The bank accounted for just one percent of sector assets in 1H16 and is among the smallest licensed commercial banks in the sector. UB’s profitability in terms of ROA has been gradually increasing (1H16: 0.67 percent, 2015: 0.41 percent), but remains low relative to peers.  Fitch expects capitalisation to decline to levels more comparable with that of its peers in the medium-term, alongside rapid loan growth. Its Fitch Core Capital ratio decreased to 19.8 percent in 1H16, after being boosted to 35.8 percent at end-2014 following an Rs.11.4 billion capital injection from an affiliate of Texas Pacific Group (TPG). However, Fitch expects the bank to sustain stronger capitalisation in the medium-term than in the past. UB reported a sharp decline in its gross NPL ratio to 2.90 percent in 1H16, from 3.55 percent at end-2015 and 8.25 percent at end-2014. This figure excludes NPLs at its subsidiary, UB Finance Company Ltd (UBF), formerly a distressed company. UBF accounted for 31.3 percent of the groups’ total NPLs at 1H16. UBF’s asset quality remains a significant drag on the group’s asset quality, even though it has been improving. NTB’s ratings reflect its moderate franchise, high product concentration and declining capitalisation. The bank’s product concentration relative to peers remain high, with leasing accounting for 23 percent of gross loans at end-June 2016 and credit cards accounting for 11 percent. Fitch believes these exposures could put pressure on NTB’s asset quality. The bank’s reported gross NPL ratio improved to 2.8 percent at end-June 2016, from 4.2 percent at end-2014, due mainly to recoveries and write-offs in the leasing portfolio. The ratio of the bank’s reserves for impaired loans/gross loans stood at 1.7 percent, which was lower than that of its peers. 
The bank’s capitalisation, as measured by the Tier I regulatory capital ratio, decreased to 10.7 percent by end-June 2016, from 13.2 percent at end-2015 (end-2014: 14.2 percent). Fitch believes capitalisation could deteriorate further amid loan growth and the absence of capital-raising activity. A sustained decline in capitalisation could put pressure on NTB’s ratings. Fitch expects NTB’s net interest margin (NIM) to moderate in the near-term due to the rising interest-rate environment and planned increase in exposure to lower-yielding customer segments. The bank’s cost structure remains high compared with peers due to branch expansion, but we expect this to moderate with process improvements the bank has undertaken. NTB’s low-cost current account savings account (CASA) improved to 31 percent of overall deposits by end-June 2016, from 25 percent at end-2013, but lags behind that of higher-rated peers.
SDB’s rating captures the bank’s high-risk appetite in terms of its substantial exposure and rapid loan growth to the retail and lower-end SME segments. Fitch believes a capital injection would support SDB’s rating, as internal capital generation is not likely to be sufficient to cushion the decline in capitalisation as a result of rapid loan book expansion. SDB’s reported gross NPL ratio decreased to 2.34 percent in 1H16, from 3.76 percent at end-2014, largely due to rapid loan growth as the stock of NPLs remained flat. Fitch expects asset quality to deteriorate as the loans season. The bank continues to benefit from above-average NIM stemming from its loan book exposures, although the contraction in its NIM has lowered SDB’s profitability. The affirmation of Amana’s national long-term rating reflects our expectation that the bank will increase its capital to meet the minimum level as directed by the Central Bank of Sri Lanka. In July 2015, the regulator granted approval for an extended timeline to comply with the minimum capital requirement which requires a minimum of Rs.7.5 billion and Rs.10 billion to be achieved by January 1, 2017 and January 1, 2018, respectively.
Amana’s rating reflects its small and developing domestic franchise and limited operating history. It also captures Amana’s relatively high-risk appetite, primarily indicated through rapid growth in the retail and SME segments. This could put pressure on the bank’s asset quality if economic conditions deteriorate. Amana’s NPL ratio has remained at less than one percent since end-December 2015, supported by rapid loan book growth, while absolute NPLs have moved up moderately. Fitch deems the placement of Amana’s excess funds in overseas financial institutions to be less liquid than domestic government securities although tenors on these placements have been shortened. The bank has maintained a stable CASA base relative to peers, with a CASA of over 50 percent.