Fitch assigns Bank of Ceylon ‘BB-’ IDRs

Fitch Ratings said yesterday it has assigned Sri Lanka’s Bank of Ceylon (BOC) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) of ‘BB-’ with Stable Outlooks. Fitch has also assigned BOC a ‘b+’ Viability Rating (V/R). Simultaneously, BOC’s National Long-Term rating and its outstanding subordinated debentures have been affirmed at ‘AA+(lka)’ with a Stable Outlook and ‘AA(lka)’, respectively.

Fitch has also assigned BOC’s proposed senior unsecured USD-denominated notes an expected rating of ‘BB-(exp)’, same as its Foreign Currency IDR. The size and tenor of the notes are yet to be determined. The final rating is contingent upon receipt of final documents conforming to information already received. A full list of rating actions is provided at the end of this commentary.

BOC’s IDRs and National Long-Term ratings reflect Fitch’s expectation of support from the Government of Sri Lanka (GoSL, ‘BB-’), if required, given its quasi sovereign status, high systemic importance and role as one of the main bankers to the Government. BOC is the largest bank in Sri Lanka and fully owned by GoSL. Any change in Sri Lanka’s sovereign ratings would likely be reflected in the ratings of BOC. Please see Fitch’s special report on Sri Lanka, dated 1 March 2012, for an update of the sovereign’s credit profile.

The V/R reflects BOC’s domestic franchise being underpinned by its sovereign linkages and extensive branch network, as well as its weak capitalisation, improving profitability, increasing loan/deposit ratio and concentration in the state sector (GoSL and state entities).

While BOC’s IDRs and National Long-Term rating are closely correlated with Sri Lanka’s sovereign rating, an upgrade of BOC’s National Long-Term rating could result from a demonstration of preferential support for BOC. The V/R could be upgraded if BOC enhances its capital buffer substantially (including a high loan loss reserve coverage), the loan-deposit ratio is maintained/sustained at 80%-85% and/or supplemented by medium term wholesale funding, and operating performance and asset quality remain stable. The V/R could be downgraded if capital buffer weakens from continued high asset growth, or if a large asset quality downturn from domestic/external macroeconomic shocks leads to capital impairment.

BOC has established a strong domestic deposit franchise, as reflected in a high current and savings accounts deposit ratio (51% at end-2011). Nevertheless, aggressive 45% loan growth in FY11, driven by increased lending to the state and certain private sector business segments, sharply increased its loan/deposit ratio to 95% (FY10: 74%). Management is challenged to reduce this ratio to the target 85%, amid increased competition for deposits and expected continued strong credit growth.

Fitch notes that the high credit growth, alongside high dividend payouts in the last two years and no fresh capital injection since FY07, has weakened BOC’s capitalisation. Tier 1 capital and capital adequacy ratios were reported at 9.3% and 12.8%, respectively, at end-2011, compared with 11.4% and 15.2% at end-2010; although these are well above the local regulatory requirements of 5% and 10%, respectively, but are inflated by the zero-risk weighted exposures to the state sector and gold-backed loans as per local regulatory guidelines. Equity/asset ratio remains low at 5.1% at end-2011, although marginally improved from 4.3% at end-2010.

Fitch notes that BOC’s profitability remains low.; although return on assets improved to 1.45% in 2011 (2010: 1.08%) mainly from reduced effective taxes due to the reduction in tax rates in Sri Lanka and from reduction/reversal of general provision as per the Central Bank of Sri Lanka guidelines. BOC’s large exposure to the state sector and local corporates (that are perceived as lower risk in the local market) has resulted in its net interest margins (2011: 3.70%, 2010: 3.64%) being historically lower than peers, while its operating cost base is also high.

The high credit concentration of BOC in the state sector reflects its sovereign linkages, and as such is unlikely to reduce in the foreseeable future. On balance sheet and off-balance sheet exposure to the state sector accounted for 43% and 18% of assets at end-2011, with the top five exposures accounting for a significant 645% of equity. However, Fitch notes that all these relate to state-owned entities and bulk of these are secured.

Although net non-performing loans (NPLs minus specific loan loss reserves (LLRs)/equity) improved to 11.9% at end-2011 (2010: 19.5%), Fitch considers a high LLR buffer as imperative amid the strong credit growth in the last two years. The requirement of provisioning starting only for NPLs delinquent beyond 180 days, together with the reversal of a part of the general provisions (as per local regulatory guidelines), elevates residual provisioning risks. Fitch also expects some slippages from the seasoning of the non-state sector portfolio, a latent asset quality impact from rising domestic interest rates and possible external shocks from a flare-up in geo-political tensions and economic slow-down in Sri Lanka’s key import/export markets.

BOC is the largest bank in terms of assets in Sri Lanka. Its established domestic franchise is supported by 970 service points (318 branches, 248 extension offices and 404 ATMs) across the country. The bank has maintained a sizeable share of domestic banking system assets, loans and deposits at 22%, 21% and 21%, respectively, at end-2011.