Fitch affirms HDFC Bank at ‘BB+(lka)’; outlook stable

Fitch Ratings has affirmed the National LongTerm Rating on Housing Development Finance Corporation Bank of Sri Lanka (HDFC) at ‘BB+(lka)’. The outlook is stable. Fitch has also affirmed the bank’s senior debt ratings at ‘BB+(lka)’.

Fitch provided the following rating drivers.

Weak intrinsic profile: HDFC’s National Long-Term Rating reflects its own financial standing, which is highly influenced by the bank’s exposure to the sovereign’s weak credit profile (Long-Term Local-Currency Issuer Default Rating: CCC-) through its investments in government securities. The rating also reflects the bank’s limited domestic franchise, high risk profile and its weaker-than-average asset quality, which stems from its large exposure to low- and middle-income customers, who are more susceptible to economic and interest-rate cycles.

Stabilising OE: Sri Lankan banks’ operating environment (OE) continues to show signs of stabilisation, with sustained improvements in reported headline economic indicators, supporting the recovery in banks’ operational flexibility. Further improvement to the banks’ OE remains contingent on successful execution of the sovereign’s external debt restructuring exercise alongside the restoration of Sri Lanka’s creditworthiness, given the strong link between sovereign financial health and banks’ operating conditions.

Retail lending dominates portfolio: We expect HDFC’s ability to generate and defend business volumes – mainly in the retail space – to be supported by the stabilising OE. We also expect the bank’s plans to grow in other retail products, such as gold loans and leases, to diversify its loan book and modestly reduce the concentration on housing loans (68.9% of gross loans at 1H24).

Sovereign risks remain: HDFC’s high risk profile stems from its business focus on the domestic economy, with a concentration in borrower segments highly susceptible to economic cycles, and through its high exposure to local-currency Government securities, which made up around 26% of assets at end-1H24. The bank’s significant product concentrations further weigh on its risk profile.

Asset quality risks linger: We do not expect a meaningful improvement in HDFC’s asset quality metrics over the medium term given the bank’s large exposure to low-tomiddle income borrowers in housing finance. These borrowers tend to take Employee Provident Fund (EPF)-backed loans, where the default risks are significantly higher. The bank’s estimated impaired loan (stage 3) ratio of 44.7% at end-1H24 (2023: 43.6%) remained the highest among peers (peer average: 14%). Excluding the EPF-backed loans, the impaired loan ratio is estimated to be lower by at least 15pp.

Profits to normalising after peak: We expect HDFC’s operating profit/ risk-weighted asset ratio to normalise over the medium term from a peak of 13.2% in 2023 driven by a gain realised from a one-off disposal of treasury bonds. Excluding this, the ratio would have been 0.7%. The ratio moderated to 5.5% in 1H24, but we expect this ratio to converge with the pre-crisis average of 4%, which is still higher than peers’, supported by its large zero risk-weighted EPF-backed loans.

Capital impairment risks linger: The gain on disposal of the treasury bond resulted in a significant improvement in the bank’s CET1 ratio to 35.8% by end-2023 from 25.5% at end-2022, highest among small and mid-sized peers. That said, HDFC’s unprovided impaired loans/ CET 1 ratio of over 200% in 1H24, increased share of available for sale (FVOCI) positions in Government securities and its small capital base weigh on its capitalisation assessment.

Manageable funding and liquidity: HDFC’s increased short-term security investment positions have reduced stresses on funding and liquidity. This is due to narrowing of significant negative asset-liability mismatches that stemmed from a longer duration asset portfolio funded mostly via short-term deposits. The bank’s loans-to-deposit ratio marginally increased to 83.8% in 1H24 from 81.6% at end-2023 but remain below pre-crisis levels of 88%-90%.