Fitch places Sri Lanka’s HDFC Bank on rating watch Negative

Fitch Ratings has placed Housing Development Finance Corporation Bank of Sri Lanka's (HDFC Bank) National Long-Term Rating of 'BBB(lka)'on Rating Watch Negative (RWN). The agency also placed HDFC Bank's senior secured and senior unsecured debentures, rated at 'BBB(lka)', on RWN. KEY RATING DRIVERS The RWN reflects the risk that the state (B+/Stable), as major shareholder, will not raise the bank's capital to meet the minimum LKR5 billion capital requirement by 1 January 2018, in which case Fitch will downgrade the rating to reflect the bank's weaker intrinsic strength. The requirement has been in force since 2016 and Fitch would see a further delay as an indication that creditors may no longer be able to rely on sovereign support in a timely manner, notwithstanding HDFC Bank's unchanged linkages with the state. HDFC's rating reflects Fitch's expectation that the bank would receive extraordinary support from the sovereign, if required. Our assessment captures the state's 51% effective holding, of which the National Housing Development Authority directly owns 49%; the bank's quasi-policy role in supporting housing-development initiatives; as well as HDFC Bank's low systemic importance. Fitch estimates that it would take HDFC Bank more than four years to generate the required capital from retained earnings. Its profitability, in terms of return on assets, has been declining because net-interest margins have been contracting due to higher funding costs stemming from the bank's short-tenor deposit base, which reprices regularly, and its high-cost business model. The bank's profitability, funding and liquidity could also be affected by business restrictions imposed by the Central Bank of Sri Lanka (CBSL). Fitch expects HDFC Bank's asset and liability mismatches to persist due to its longer-tenor loan book and short-tenor deposit base. Its deposit base is also highly concentrated. Housing loans, mainly to low- and middle-income customers, continue to dominate the bank's loan book, accounting for 81% at end-1Q17 (2014: 91%). Housing loans to members of the Employee Provident Fund (EPF), which are secured against members' EPF balances, accounted for 24% of the bank's total loans. Non-performing loans (NPL) to EPF members are higher than for the rest of the bank's portfolio, but the CBSL annually reimburses HDFC Bank for EPF-backed loans in arrears for more than three months. The reported gross NPL ratio remained high 18.8%, or 8.9% excluding EPF-backed loans, at end-1Q17. The bank's outstanding debentures are rated in line with its National Long-Term Rating and rank equally with the claims of other senior unsecured creditors. Fitch has not provided any rating uplift for the collateralisation on the senior secured debentures as their recovery prospects are considered to be average and comparable with those of the unsecured notes in a developing legal system. RATING SENSITIVITIES HDFC Bank's rating will be affirmed and removed from RWN if the state demonstrates its commitment to supporting the bank, such as by providing the LKR0.9 billion in additional capital required on or before 1 January 2018. Fitch will downgrade the bank's rating if the sovereign does not raise HDFC Bank's capital by the deadline or if the deadline is extended, as Fitch would question the sovereign's willingness to provide timely support. This is likely to see the bank downgraded to the 'BB' category, the extent of which would depend on whether the bank's profile remained on a negative trajectory. Fitch may also downgrade HDFC Bank's ratings if there is a change in our expectation of state support due to a weakening of the bank's linkages with the state, through a dilution of the state's majority ownership or a revision of Fitch's view of the bank's policy role. The ratings of the senior secured and senior unsecured debentures will move in tandem with HDFC Bank's National Long-Term Ratings. (Media Release)