Sri Lanka DFCC Bank Rating Watch Negative Held Amid Soft Peg Collapse: Fitch

ECONOMYNEXT- Fitch Ratings said it was maintaining a negative watch on Sri Lanka’s DFCC bank amid a currency crisis that has triggered dollar shortages and sovereign default as bad debts surge.

The Rating Watch Negative “reflects the potential for the bank’s creditworthiness to deteriorate relative to other entities on our Sri Lankan national rating scale,” Fitch said.

“This is due to increased strains on the bank’s funding and liquidity, and its sovereign exposure through investments in foreign currency instruments which increase risks to its overall credit profile.

“We believe that the sharp rise in inflation, local currency depreciation and other factors may distort the bank’s underlying financial condition in the current operating environment.”

Sri Lanka is in the throes of the worst currency crisis in the history of the island’s intermediate regime central bank. Sri Lankan economists had the ability to trigger balance of payments deficit and currency crises with the establishment of a loosely pegged central bank in 1950.

In 2022, the rupee crashed to 360 against 200 for the US dollar as an attempt was made to float the currency with a surrender rule.

Fitch said the bank’s foreign currency funding and liquidity position was significantly stretched and vulnerable to sudden shocks in a weaker credit environment, although the bank managed to raise $150 million in term funding in 2021, Fitch said.

“We believe additional access to such funding would be difficult, in the same way as its peers, given the sovereign’s weakened credit profile,” the agency said.

As customers’ ability to repay weakens due to economic conditions, Fitch said it expects DFCC’s impaired loan ratio (Stage 3) to increase in the short to medium term.

“Impaired loans at the end of 2021 represented 6.2% of total assets, along with an additional 2.2% of assets in US dollar-denominated sovereign bonds and Sri Lanka development bonds, the share of which would have decreased in 1H22” , the rating agency said. said.

The agency said the sovereign default, coupled with growing economic challenges, poses significant risks to DFCC’s profitability, as the bank could become structurally unprofitable.

“Earnings pressure is already evident in the bank’s operating profit to risk-weighted assets ratio, which fell to 0.6% at the end of 1Q22 (end of 2021: 1.7%) as credit costs eroded 83% of the bank’s earnings before impairment”

The full statement is reproduced below:

Fitch Maintains DFCC Bank’s National Rating of ‘A+(lka)’ Under Watch Negative

Fitch Ratings – Colombo – July 28, 2022: Fitch Ratings has maintained DFCC Bank PLC’s national long-term rating of “A+(lka)” on Rating Watch Negative (RWN). Fitch also maintained DFCC’s senior and subordinated debt ratings of “A+(lka)” and “A-(lka)”, respectively, on RWN.

KEY SCORING FACTORS

RWN maintained: The RWN on DFCC’s long-term national rating reflects the potential for the bank’s creditworthiness to deteriorate relative to other entities on our Sri Lankan national rating scale. This is due to increased strains on the bank’s funding and liquidity, and its sovereign exposure through investments in foreign currency instruments which increase risks to its overall credit profile.

We believe that the sharp rise in inflation, local currency depreciation and other factors may distort the bank’s underlying financial condition in the current operating environment.

Currency liquidity constraints: We believe that DFCC’s foreign currency funding and liquidity position is significantly stretched and vulnerable to sudden shocks in a weaker credit environment. The bank was able to secure $150 million in term funding in 2021, but we believe accessing additional funding would be difficult, like its peers, given the sovereign’s weakened credit profile.

Weakened operating environment: Our assessment of the operating environment (OE) of Sri Lankan banks reflects the pressure on banks’ already stressed credit profile following the sovereign’s default on its foreign currency obligations. It also captures the rapid deterioration of the economy as a whole, including rising interest rates, high inflation and acute currency depreciation. The economic crisis has limited DFCC’s operational flexibility.

Increased pressure on asset quality: Fitch expects DFCC’s impaired loan ratio (Stage 3) to increase in the near to medium term as borrowers’ ability to repay weakens due to rapidly deteriorating economic conditions. The bank’s exposure to government instruments denominated in foreign currencies, although low relative to its peers, adds pressure on asset quality. Impaired loans at the end of 2021 represented 6.2% of total assets, along with an additional 2.2% of assets in US dollar-denominated sovereign bonds and Sri Lanka development bonds, the share of which would have decreased in HY22.

Capital buffers under pressure: Fitch expects higher asset quality risks and lower earnings retention as well as inflated risk-weighted assets due to the continued depreciation of the Sri Lankan rupee, which will put significant pressure on the bank’s capitalization parameters in the short term. This is despite the bank’s lower exposure to government securities denominated in foreign currencies than that of its peers. Raising capital continues to be a challenge for the bank, as evidenced by its recently concluded rights issue which was undersubscribed.

Costs of credit to erode income: We believe that a sovereign default, coupled with growing economic challenges, poses significant risks to DFCC’s profitability, as the bank could become structurally unprofitable. Earnings pressure is already evident in the bank’s operating profit to risk-weighted assets ratio, which fell to 0.6% at the end of 1Q22 (end of 2021: 1.7%), borrowing costs that eroded 83% of the bank’s pre-impairment earnings.

Economic volatility weighs on the business model: We believe that DFCC’s business profile, like most of its domestic counterparts, is highly vulnerable to growing risks in the domestic market, given the heavy focus of its business profile on the weak and unstable Sri Lankan economy. This could limit the bank’s ability to generate and defend its business volume. The rapid deterioration of the OE is likely to derail the bank’s aspiration to reach an asset base of LKR 1 trillion by 2025.

High risk profile: DFCC’s high risk profile, similar to that of its local peers, stems from its primary exposure to high-risk customer segments with low credit quality, as evidenced by negative ‘ccc’/EO.

This is further exacerbated by DFCC’s exposure to government instruments denominated in foreign currency, although lower compared to its peers, which leaves the bank vulnerable to the repayment capacity and liquidity position of the sovereign.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to a negative rating action/downgrade:

The RWN reflects growing risks to the bank’s rating due to funding strains, which could lead to a multi-notch downgrade. We expect to resolve the RWN when the impact on the issuer’s credit profile becomes more apparent, which may take longer than six months.

Developments that could lead to a multi-notch downgrade include:

– funding stress that hampers DFCC’s ability to repay;

– significant intervention by the authorities in the banking sector which limits the bank’s ability to honor its obligations;

– a temporary waiver or standstill agreement negotiated following a payment default on a significant financial obligation;

– Fitch’s belief is that DFCC has entered a period of grace or recovery following the non-payment of a material financial obligation.

A downgrade in the sovereign’s long-term local currency (CCC) issuer default rating could also lead to a downgrade in the bank’s rating.

Factors that could, individually or collectively, lead to positive rating action/improvement:

Opportunity for upside action is limited given RWN

OTHER DEBT AND ISSUER RATINGS: KEY RATING FACTORS

SENIOR DEBT

DFCC’s outstanding senior unsecured debentures are rated at the same level as its national long-term rating according to Fitch criteria. In effect, the debt ranks pari passu with the claims of the bank’s other first-ranking unsecured creditors.

SUBORDINATED DEBTS

DFCC’s Basel II and Basel III compliant Sri Lankan rupee subordinated debt is rated two notches below the national long-term rating anchor. This reflects Fitch’s base loss severity rating for this type of debt and our expectation of low recoveries.

There is no additional notch for non-performance risk, as the ratings do not incorporate going concern loss absorbency features.

OTHER DEBTS AND ISSUER RATINGS: RATING SENSITIVITIES

Senior and subordinated debt ratings will move in parallel with the bank’s long-term domestic rating.