Fitch revises Outlook on Sampath Bank ‘AA−(lka)’ rating to Positive

Rating rationale

Fitch Ratings has revised the Outlook on Sampath Bank PLC’s (SB) ‘AA−(lka)’ National Long‐Term Rating to Positive from Stable, indicating that there is potential for an upgrade over the coming 12‐24 months.

This is based on structural improvements that have occurred within the bank since early 2009, across most spheres of risk management, which, in Fitch’s view, are helping to improve SB’s credit profile faster than that of its peers.

The agency notes that SB has managed the recovery of its NPL stock better than most of its peers. NPLs reduced by 23% on an absolute basis in the 12 months to end‐June 2010, due to concerted recovery efforts. The bank expects further reductions in absolute NPLs, owing to its continued efforts and an improving macroeconomic environment. Strong recoveries, along with an increased share of pawning advances (gold‐backed lending, which has 0% NPLs), helped reduce gross NPLs to 6.91% of loans at end‐Q210 (end‐2008: 7.60%). However, the gross NPL ratio excluding pawning was higher at 8.71% at end‐Q210.

In a prudent move in H110, the bank provided for 18% of its NPLs ignoring the value of collateral held (26% of pre‐provision profits). Most such NPLs are in the regulatory “loss” category. Consequently, SB’s specific provision reserves/NPLs ratio improved to 65.13% at end‐H110 from 54.83% at end‐2009 (‘AA(lka)’ category peer average: 37.66% at end‐H110). As a result, net unprovided‐for NPLs/equity reduced to 17.67% (‘AA(lka)’ peer average: 19.65%). SB has indicated its commitment to improving reserve coverage of NPLs further over the medium term.

Pawning increased to 21% of loans at end‐H110 (end‐2007: 11%). Consequent to SB’s expansion drive, the bank’s assets funded by low‐cost deposits have also increased, benefiting its cost of funds. This, along with greater margins on pawning, NPL recoveries and operating cost containment, helped improve ROA to an annualised 1.66% at end‐Q210 from 1.09% at end‐2008.

Fitch notes that the increased proportion of pawning advances exposes SB to a heightened level of market risk. However, this is somewhat mitigated by the fact that SB’s average loan‐to‐value ratio on pawning was a moderate 76% at 15 August 2010, and that historically an average of only 2%‐3% of its pawning portfolio has had to be auctioned off due to repayment delays.

Support

Given that SB is one of six systemically important licensed commercial banks (LCBs) as identified by the Central Bank of Sri Lanka, state support cannot be ruled out. However, support could be constrained by the state’s own fiscal limitations.

What could trigger an upgrade?

An upgrade will be contingent upon the bank’s ability to develop its franchise and achieve greater economies of scale, while maintaining its ROA, asset quality and capital structure at levels commensurate with a higher rating.

Profile

SB commenced operations in 1986, and at end‐H110, operated via 149 outlets,

employing 2,670 staff. The bank accounted for 6% of LCB sector assets at end‐2009.

Company overview

SB commenced operations in 1986, and is currently the fifth‐largest LCB in terms of assets, out of six systemically important banks specified by the Central Bank of Sri Lanka (CBSL, the regulator). The bank accounted for 6% of LCB sector assets at end‐ 2009.

SB’s current board consists of 13 members including a non‐executive Chairman. The bank’s CEO, CFO and COO function as the only Executive Directors. The present CEO and CFO were appointed in October 2008 and June 2008, respectively. They are both senior bankers, who for most of their careers served at Commercial Bank of Ceylon PLC (CB; ‘AA(lka)’/Stable). They have been credited with bringing about much of the subsequent structural improvement to SB’s credit profile. Fitch notes that succession planning of its senior management personnel is a key risk for the bank over the medium term.

SB’s single largest shareholder is Mr KDD Perera (14.99% ownership), a local entrepreneur with diverse holdings in local corporates, including several banks and non‐bank financial institutions. Mr Perera is a Non‐Executive Director of the bank and sits on its strategic planning and risk management committees.

Like most of its peers within the ‘AA(lka) rating category’ (rating peers), SB has disclosed its compliance with the latest local corporate governance regulations, including mandatory requirements for LCBs issued by CBSL, rules for listed companies issued by the Colombo Stock Exchange, and best practices issued by the Institute of Chartered Accountants of Sri Lanka.

At end‐2009, 65% of SB’s loan book comprised retail and consumer advances, with a further 29% and 6% consisting of advances to large and midsize corporates, respectively. Of the retail segment, pawning advances stood at 18% of loans at end‐ 2009 (21% at end‐Q210), in contrast to 11% at end‐2007. Most of the expansion into pawning occurred over the 18 months to end‐June 2010, amid weak credit demand from other segments of the economy. SB and Hatton National Bank PLC (HNB; ‘AA−(lka)’/Stable) broadly have the second‐largest pawning portfolios among domestic LCBs, but are well behind the market leader in this segment — the stateowned People’s Bank (Sri Lanka) (PB; ‘A(lka)’/Stable). In addition to pawning, the bank expects to focus on credit cards (2007‐2009 average: 1.8% of loans) and other retail and mid‐ticket lending over the medium term.

Fitch notes that competition within the local banking industry is heavy, given the sector’s heightened levels of liquidity at present. At end‐2009, Sri Lanka’s LCB sector comprised 22 banks, of which 11 were foreign bank branches and 11 domestic. The two state‐owned banks — Bank of Ceylon (BOC; ‘AA(lka)’/Stable) and PB — accounted for approximately 40.5% of sector assets at end‐2009, and commanded the lion’s share of state lending, leaving the remaining 20 LCBs to battle it out for mostly private‐sector credit. The largest private‐sector LCB, CB, accounted for 12.9% of sector assets at end‐2009.

Furthermore, local credit card issuance is dominated by foreign bank branches such as HSBC Sri Lanka (‘AAA(lka)’/Stable), Standard Chartered Bank, Sri Lanka Branch (‘AAA(lka)’/Stable) and Nations Trust Bank PLC (‘A(lka)’/Stable) — the sole local franchisee for American Express. Competition for large corporate business has traditionally been the forte of local branches of foreign banks, given their relatively low cost of funds and advanced cash management products. Given the rapid expansion of some foreign banks locally, competition within this segment is expected to increase further as credit demand improves. However, notably, SB has managed to improve its low‐cost deposit mix (see Funding and Liquidity) and thereby funding costs relative to domestic peers, strengthening its competitive position within the sector.

The SB group has four subsidiaries, which are engaged in leasing and factoring (100% ownership), stock brokering (51%), information technology development (100%) and real‐estate renting (97%, which holds SB’s head‐office building). In addition, the bank holds an 11.3% stake in Lanka Bangla Finance (LBF), a company involved in leasing and credit card issuance in Bangladesh. Total assets of subsidiaries accounted for 1% of group assets at end‐2009, and subsidiaries recorded a post‐tax loss of LKR14.55m. The loss stemmed from SB’s leasing subsidiary, Sampath Leasing and Factoring Ltd (SLFL). Subsequently, SB infused LKR300m equity into SLFL in order to reduce leverage, viewing this as a potential growth area over the longer term. The bank states that the subsidiary had made an accumulated profit of LKR64m as at end‐Q210, and is on track to recover losses accumulated historically.

Prospects

The bank is in the process of a fairly aggressive expansion and optimisation of its branch network, with soft targets of 175 and 200 branches by end‐2010 and end‐ 2011, respectively. Most additions are expected to be implemented outside the capital city of Colombo, in relatively under‐banked areas. In tandem with this growth, SB has been streamlining its risk management systems and controls (see Risk Management), which includes the centralisation of the credit approvals process since early 2009 and developing a centralised framework with an enterprise‐wide view of risk.

Performance and Outlook

SB’s policy for the recognition of interest income on loans (other than on overdrafts), whereby income is recognised on a cash basis once a facility is in arrears for over one month, is more prudent than that of most of its peers, which allow accruals until a facility is in arrears for up to three months. As such, Fitch notes that SB’s profitability ratios are of better quality than its peers’. Loans excluding overdrafts amounted to 57% of SB’s interest‐earning assets at end‐Q210. Consequently, interest in suspense (IIS) on delinquent advances at SB averaged 0.93% of its gross loans (including IIS) between end‐2008 and end‐H110, compared with an average of 2.10% for its rating peers during the same period.

Amid falling interest rates and weak credit demand in 2009, a fair number of local LCBs relied on capital gains on their treasury securities portfolios held for trading in order to prop up ROA. Such capital gains among SB’s rating peers ranged between 7% and 26% of operating profit before associate company contributions. In contrast, SB focused on revamping its lending product profile in order to improve profitability in 2009, focusing on strengthening its competitive position in products such as pawning advances and, more recently, credit cards. Consequent to SB’s fairly rapid expansion, its proportion of assets funded by low‐cost savings and demand deposits has gradually improved, to 38% at end‐Q210 from 29% at end‐2008, benefiting its cost of funds. In comparison, the average for the domestic private‐sector LCBs that Fitch rates (the sector) was 32.4% at end‐Q210.

Consequent to the improvement in SB’s NPL ratio driven by its concerted recoveries, provisioning costs reduced to an annualised 0.60% of average assets at end‐Q110 from a high 0.90% at end‐2008. Due to most of the bank’s extra‐prudent provisioning occurring in Q210 (see Loan book development and asset quality), provisions/average assets increased to an annualised 0.82% during the period. Management indicates that SB is committed to improving the bank’s specific provision reserves/NPLs ratio over the medium term. Consequently, Fitch believes that provision costs could continue to weigh on ROA over the short term, despite a further expected recovery of NPLs.

SB’s ROA compares well with that of similar‐sized LCBs, despite its more prudent revenue recognition and provisioning policies. Helped by a widening NIM — which in turn is due to the structural increase in pawning as a proportion of loans (end‐Q210:21%, end‐2007: 11%), the higher proportion of low‐cost deposits, and good NPL recoveries — combined with operating cost containment, SB’s ROA improved to an annualised 1.66% at end‐Q210, from 1.39% at end‐2009 and 1.09% at end‐2008.

While Fitch expects the NIM to come under some pressure over the medium term from an annualised 5.79% at end‐Q210, it is likely to remain healthy and above the bank’s recorded historical average of 4.71% (2003–2007). This expectation is fuelled by the fact that high‐yielding loan products such as pawning and credit cards will constitute a larger share of the bank’s portfolio than in the past. This, in tandem with the potential for better economies of scale over the longer term as SB expands its branch network together with a newly centralised credit function, could help sustain SB’s ROA at healthy levels. At end‐Q210, SB’s cost/income stood at 48.41%, compared with 53.66% for its rating peers.

In 2009, SB fully provided for a non‐performing foreign‐currency bond investment of LKR1.07bn, which was purchased in 2004. However, this charge was offset by a capital gain of LKR1.4bn due to the sale of a bonus share issue of its former associate company LBF during the period. Management maintains that the bank’s newly created executive investment committee — which comprises the three executive directors and other senior personnel — will be involved in all investment decisions in future, thereby reducing the likelihood of a recurrence of the weak investment decisions made in the past.

(Analysts Hasira De Silva +941 1254 1900 [email protected] and Ramali Perera +941 1254 1900 [email protected])