Fitch affirms DFCC Bank at ‘AA’; Outlook Stable

Fitch Ratings Lanka has affirmed DFCC Bank’s (DFCC) National Long-term rating at ‘AA(lka)’. The agency has also affirmed DFCC’s senior debentures at ‘AA(lka)’ and subordinated debentures at ‘AA-(lka)’. The Outlook remains Stable.

DFCC’s ratings are driven by its strong capitalisation supported by ongoing high profitability. However, the ratings also take into account DFCC’s relatively high exposure to riskier project finance and the challenges in securing long-term funding for its longer tenure project loans.

The affirmation of DFCC’s ratings comes on the back of the ongoing, albeit gradual economic recovery, which together with increased recovery efforts helped ease non-performing loan (NPL) pressures faced by the bank in 2008-2010.

Absolute NPLs which peaked in June 2009 fell by 19% at FYE10; and a sudden spike at end- June 2010 - driven by a few large customers - also eased by end-August 2010. However, the continued loan contraction resulted in DFCC’s NPL ratios remaining high in relation to the sector.

Nevertheless, DFCC’s conservative provisioning policies combined with its large capital cushion resulted in unprovided NPLs accounting for just 15% of equity at FYE10 (rating category peers: 25%). DFCC’s consolidated loan book contracted by 14% over March 2009-June 2010, due to weak credit demand (particularly project loans) and an increased focus on managing NPLs.

Although disbursements at DFCC increased in Q211, its loan growth is likely to remain low in the year ending 31 March 2011 (FY11). Growth at its subsidiary, DFCC Vardhana Bank (‘AA-(lka)’/Stable) - accounting for 28% of group loans - picked up faster, due to the working capital nature of its loans.

Project loans and leases accounted for 57% and 8% of group advances, respectively, at FYE10, and are largely matched with long-term borrowings from bilateral and multilateral funding partners.

DFCC’s profitability as measured by return on assets (ROA) increased to 3% in FY10 (FY09: 2.5%), driven mainly by wider net interest margins. Higher provisioning costs in Q111 resulted in a lower ROA of 1.8% (after adjusting for the one-off LKR2,921m gain on the sale of a 10.7% voting stake in its associate - Commercial Bank of Ceylon PLC (CB; ‘AA(lka)’/Stable)).

DFCC’s margins continued to benefit from its high proportion of equity-funded assets and a high investment in treasury bonds in H209, when interest rates were at their highest. The contribution from associate companies to the group’s pre-tax profit was 24% in FY10 and would be considerably lower in the coming year due to the sale of part of its stake in CB.

DFCC’s ratings are sustained by its high levels of capitalisation - equity/assets of 26.5% and Tier 1 capital adequacy ratio of 26.2% at end-June 2010 (versus 7.6% and 11.6% respectively for rating category peers).

However, Fitch notes that as DFCC diversifies into commercial banking, its strong capital position could come under pressure. Also, any sustained deterioration in its asset quality or profitability, which is likely to erode its strong equity base, could place downward pressure on its ratings.

DFCC bank was established in 1955 under the Development Finance Corporation of Ceylon, Act No. 35, on the recommendation of the World Bank to foster economic growth in Sri Lanka through the provision of long-term project finance. It was listed on the Colombo Stock Exchange in 1956 and is now 29.9%-owned by government-related entities.

Fitch affirms DFCC Vardhana Bank at ‘AA-’; Outlook stable

Fitch Ratings Lanka has affirmed DFCC Vardhana Bank Limited’s (DVB) National Long-term rating at ‘AA-(lka)’. The Outlook remains Stable.

DVB’s rating reflects Fitch’s expectation that support would be forthcoming from its parent, DFCC Bank (DFCC; ‘AA(lka)’/Stable), should it be required. DVB is 95.58% owned by DFCC. It accounts for 35% of DFCC group’s assets and plays an important role in expanding the latter’s product offering.

In addition to the common franchise shared by both the banks, the operations of the two are closely linked with the integration of key back-office and treasury functions, as well as shared personnel and input on key decision-making committees.

DVB’s asset quality continued to remain stressed in 2010, with the recovery of its customer base lagging that of the macro economy. Recovery of the banking sector has been slower than expected, with improvements in macro indicators taking time to feed into the real economy.

DVB’s gross NPLs fell to 10.6% of loans at end-August 2010 (end-June 2009: 12.3%) with NPL recovery and increased credit growth. While higher loan loss coverage and capital accretion resulted in DVB’s net NPLs/equity improving to 39.2% at end-June 2010 (end-June 2009: 42.6%), this still remains high in relation to the sector (end-June 2010: 26.5%).

DVB made a number structural changes to its credit and recovery processes during the year, and Fitch expects the bank’s asset quality to improve in 2010-2011 as it realises collateral recovered, cash flows of its customers gradually improve and improved credit processes feed into better credit quality.

DVB’s loan book, which contracted 5% in 2009, grew 12% in H110 driven by increased demand for working capital from corporate clients. The bank is expecting further loan growth with increased demand across all its customer segments. Its retail product offering has grown during the year with the introduction of credit cards, personal and housing loans and the bank is also expanding its pawning portfolio.

In 2009, DVB partnered with a local commercial bank to expand its ATM network and increased its postal units in a bid to expand outreach and grow its retail deposit base. This together with the attractive savings rates offered by the bank enabled it to change its deposits mix, increasing lower cost demand and savings deposits to 25.6% of deposits at end-H110 (FYE08: 16.2%).

The bank’s total deposits grew by 16% in 2009 (2008: 57%) and should continue to expand at this pace with the increased outreach and marketing efforts of the bank.

DVB’s profitability as measured by return on assets (ROA) improved to 1.0% in 2009 (2008: 0.5%) despite narrowing interest margins on account of lower provisioning costs due to slower NPL accretion. The drop in the bank’s net interest margins (6.3% in H110 vs 7.2% in 2008) was mainly due to falling market interest rates and higher investments in government securities, which resulted in lower yields. DVB’s rating is linked to that of DFCC and is contingent on the support assumed to be available from DFCC.

Therefore, any changes to the implied support from DFCC or in the strategic importance of DVB to its parent could trigger a rating action.

DVB is a licensed commercial bank, almost fully owned by DFCC bank - a licensed specialised bank and Sri Lanka’s only development finance institution.