Union Bank’s ratings reaffirmed at BBB/Stable/P3

RAM Ratings Lanka has reaffirmed the respective long- and short-term financial institution ratings of Union Bank of Colombo PLC at BBB and P3; the outlook on the long-term rating is stable. The ratings are supported by the bank’s healthy capitalisation but tempered by its small stature, below average asset quality, performance and funding levels. Incorporated in 1995, Union Bank is one of the smallest licensed commercial banks in Sri Lanka, accounting for only 0.74% of industry assets as at end- September 2012. The bank acquired The Finance and Guarantee Company Limited subsequently renamed UB Finance Company Limited for Rs. 600 million in November 2011. UB Finance had faced financial strain under its previous ownership, resulting in its loan portfolio recording high delinquencies.

The bank together with National Asset Management Limited (“NAMAL”) and UB Finance is referred to as ‘the group’. The bank continued to account for the larger 96.07% of total assets of the Group despite the recent acquisitions. The group concentrates on small and medium enterprises that are more susceptible to economic fluctuations, as reflected it’s in below average asset quality.

Following 87.93% year-on-year growth in credit assets in FYE 31 December 2011 amid a favourable economic climate, the group’s credit assets grew by a slower 20.72% in 9M FY December 2012, as lending was curtailed amid the credit ceiling placed by the Central Bank of Sri Lanka.

The weakening in the bank’s loan quality, coupled with the acquisition of UB Finance (whose loan book almost entirely consisted of non-performing loans), resulted in the group’s asset quality indicators weakening with the gross NPL ratio deteriorating to 10.55% as at end-December 2011 (end-December 2010: 8.26%), comparing weaker than its LCB peers. However as at end-September 2012, due to recovery efforts in UB Finance, the group’s gross NPL ratio improved to 9.16%.

Meanwhile, the bank’s absolute NPLs spiked 70% during 9M FY December 2012, thereby weakening the bank’s NPL ratio to 6.39% from 4.13% as at end-December 2011. Delinquencies stemmed mainly from the construction and trading industries.

The bank’s credit asset portfolio also remained unseasoned following the aggressive credit expansion in fiscal 2011. As such, RAM deems the bank’s asset quality to be below average. Going forward, recovery efforts are expected to bear fruit in tandem with the gradual pick up in the construction and trading segments in the economy albeit at a slower pace.

The group’s relatively weaker than peer net interest margin, held down by its low yielding deep discounted bonds bond together with the higher cost burden results in an overall below average performance. RAM deems that the NIM which is in line with the LCB peers do not commensurate with the higher risk profile of Union Bank’s target market which comprises of SMEs. The group’s interest income ascended 63.91% year-on-year in 9M FY December 2012 following a 20.72% loan growth during the same period.

RAM Ratings Lanka also notes that the bulk of Union Bank’s customer deposits comprise of relatively expensive fixed deposits. This, coupled with its low-yielding DDB (4% yield), had pressured the group’s net interest margin, which remained weaker than its banking peers’ at 4.20% in 9M FY December 2012. The bank’s cost to income ratio also weakened to 73.51% in 9M FY December 2012 owing to the addition of six new branches. Overall pre-tax profits in 9M FY December 2012 compared 6.78% year-on-year lower than Rs. 324.04 million in 9M FY December 2011. The group’s funding structure was dominated by customer deposits as at end- September 2012, with a share of 76.24%. Due to the group’s aggressive loan growth, its loans-to-deposits ratio weakened to 92.63% as at end-September 2012 (end-FY December 2011: 87.45%). At the same time, its statutory liquid-asset ratio weakened to 21.69% as at end-September 2012, (December 2011: 23.38%) amid loan growth. That said, the ratio is currently in line with those of its peers. As such, RAM deems the group’s liquidity position average.

The bank’s capitalisation levels are perceived to be healthy. However, amidst loan growth, its tier-1 and overall Risk Weighted Capital Adequacy Ratios weakened to 19.54% as at end-September 2012 (end-December 2011: 24.45% and 24.22%). RAM also notes with concern that the bank’s net NPLs to shareholders’ funds weakened to 20.41% as at end-September 2012 from 9.74% as at end- December 2011 amid the influx of NPLs.

RAM opines AFL’s capitalisation levels to be better than its LFC peers’, following a capital infusion of LKR 900 million in April 2012. The company’s tier 1 and overall risk-weighted capital adequacy ratios clocked in at 32.32% as at end- September 2012, after having been below regulatory levels for the last four years. Going forward, given planned loan growth, RAM envisages the ratios moderating, albeit remaining better than that of peers. However, persistent losses may weigh down AFL’s capitalisation.