UNION BANK OF COLOMBO PLC
Fitch Ratings has maintained
Key Rating Drivers
Risks Remain Significant: The RWN reflects the potential for creditworthiness to deteriorate relative to other entities on our Sri Lankan national ratings scale, given the heightened stress on UB's funding and liquidity as well as its exposure to the sovereign, via investment in foreign-currency instruments, such as Sri Lanka Development Bonds, that raises risks to its overall credit profile. We believe that the sharp rise in inflation, depreciation of the local currency and other macroeconomic stresses can distort the bank's underlying financial position in the current operating environment.
Weak Foreign-Currency Funding: System foreign-currency liquidity remains stretched, putting pressure on Sri Lankan banks' liquidity positions. Access to foreign-currency funding is also challenging, due to the weakened sovereign credit profile. We believe that UB is not immune to these funding and liquidity risks, despite a moderate foreign-currency loans/foreign-currency deposit ratio of 72% at end-1H22.
UB continued to maintain an all-currency liquidity coverage ratio (162% at end-1H22) and net-stable funding ratio (121%) above the regulatory minimum ratios. We expect UB to bolster overall liquidity by increasing deposits and reducing credit growth.
Weakening Operating Environment: Our assessment of Sri Lankan banks' operating environment (OE) reflects the pressure on the banks' already-stressed credit profiles following the sovereign's default on its foreign-currency obligations. It also captures the rapid deterioration in the broader economy, including increased interest rates, very high inflation and acute currency depreciation. The macroeconomic stress has limited UB's operational flexibility.
Asset Quality Under Increased Pressure: We expect a sharp deterioration of UB's impaired loans ratio in 2022, similar to peers. This is likely to extend into 2023 because of the weakened OE. Runaway inflation, a sharp increase in interest rates and weak economic activity may erode the repayment capacity of borrowers, intensifying the asset quality risk.
We estimate that UB's stage 3 impaired loans/gross loans ratio at the bank level was around 11.5% at end-1H22, up from 7.8% at end-2021. This ratio for the group should be higher, by at least another 150 bp, reflecting the pressure on asset quality at UB's finance and leasing subsidiary, in our view.
Higher Capitalisation than Peers: We expect UB's capital position - reflected in its reported common equity Tier 1 (CET1) ratio of 16.4% at end-1H22 - to remain stronger than that of similarly rated peers. However, pressure on capital buffers through encumbrance from unprovisioned impaired loans was high at end-1H22, albeit improved, as reflected in its unprovided impaired loans/CET1 ratio of 27.2% at end-2021 (end-2020: 53.2%). We expect this pressure to increase further for the rest of 2022 with the faster accumulation of impaired loans.
Pressure on Profitability: UB's operating profit/risk-weighted asset (RWA) ratio fell to 1.4% by end-1H22 (peer median: 1.6%), from 1.8% at end-2021, due mainly to increased credit costs. We expect further stress on the bank's profitability, similar to peers, in 2022 and 2023 on further increasing loan impairment charges and potential pressure on net interest income amid rising interest rates alongside the slow loan-book growth. Inflation is likely to raise the bank's already-high operating costs, while increased taxes will affect the bank's bottom line in the medium term.
Economic Volatility Weighs on Business Model: We believe that UB's business profile, like most domestic peers, is highly vulnerable to the intensifying risks in the domestic market, similar to peers, given the high concentration of its business profile on the weak and unstable Sri Lankan economy. This, in turn, could limit the bank's ability to generate and defend business volume while controlling risks.
High Risk Profile: Our view of UB's high risk profile, which is at a similar level to local peers, stems from its main exposure to high-risk customer segments with weak credit quality. This is further exacerbated by the bank's holding of government's foreign currency-denominated instruments, which are in distress, thus making the bank vulnerable to the sovereign's repayment capacity and liquidity position.
Rating Sensitivities
Factors that could, individually or collectively, lead to negative rating action/downgrade:
The RWN reflects rising risks to the bank's rating from funding stresses, which could lead to a multiple-notch downgrade. We expect to resolve the RWN when the impact on the credit profile becomes more apparent, which may take more than six months. Developments that could lead to a multiple-notch downgrade include:
funding stress that impedes UB's repayment ability;
significant banking-sector intervention by the authorities that constrains the bank's ability to service its obligations;
a temporary negotiated waiver or standstill agreement following a payment default on a material financial obligation;
Fitch's belief that UB will have entered into a grace or cure period following non-payment of a material financial obligation.
A downgrade of the sovereign's Long-Term Local-Currency Issuer Default Rating (CCC) could also lead to a downgrade of the bank's rating.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
There is limited scope for upward rating action, given the RWN.
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