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ECONOMYNEXT – Sri Lanka’s Fitch Ratings has confirmed an ‘A(lka)’ rating of Bank of Ceylon saying the operating environment was improving but the exposure to state was high.
“BOC’s asset-quality metrics remain highly influenced by the sovereign’s credit profile due to the bank’s large sovereign exposure via its loans, off-balance-sheet liabilities and securities holdings,” Fitch said.
About 60 percent of bank assets were exposed to the sovereign risk profile.
The bank had provided 55 percent for defaulted sovereign bonds which were 2 percent of its assets.
The bank’s core asset-quality metric – impaired (stage 3) loan ratio – increased to 13.5 percent by end-1Q24 (end-2023: 12.6 percent, 2021: 10.2 percent) primarily due to a contraction in gross loans.
“We estimate this ratio to be significantly higher if BOC’s foreign-currency loan exposure to the state and state-owned entities is included,” Fitch said.
The full statement is reproduced below:
Fitch Ratings – Singapore/Colombo – 06 Jun 2024: Fitch Ratings has affirmed Bank of Ceylon’s (BOC) Long-Term Foreign-Currency Issuer Default Rating (IDR) at ‘CC’. The rating does not carry an Outlook because of the potential for high volatility at this rating level, in line with Fitch’s rating definitions. At the same time, Fitch has maintained BOC’s Viability Rating (VR) of ‘cc’ on Rating Watch Negative (RWN).
Fitch has also affirmed BOC’s Long-Term Local-Currency IDR at ‘CCC-‘ with a Stable Outlook, the Short-Term IDR at ‘C’, Government Support Rating at ‘ns’ and the National Long-Term Rating at ‘A(lka)’ with a Stable Outlook.
A full list of rating actions is at the end of this commentary.
KEY RATING DRIVERS
Downside Risks to VR: Fitch has maintained BOC’s VR on RWN to reflect risks to the bank’s credit profile from potential capital stress stemming from the restructuring of loans granted to state-owned entities. The government budget unveiled on 13 November 2023 allocated LKR450 billion for the recapitalisation of the state banks, including BOC, to ensure financial system stability. Fitch’s affirmation of BOC’s IDRs continues to reflect a high risk of default from the sovereign’s restructuring of debt.
The recapitalisation plan to address potential capital erosion, should it materialise, may constitute extraordinary support. In accordance with Fitch’s Bank Rating Criteria, extraordinary capital support to restore viability would be viewed by Fitch as a “bank failure” and would lead to the bank’s VR being downgraded to ‘f’ but subsequently, upon recapitalisation, be upgraded to a level commensurate with its standalone credit profile.
Restructuring Delays Hinder Progress: Sri Lankan banks’ operating environment (OE) continues to show signs of stabilisation, supporting the recovery in banks’ operational flexibility. There are sustained improvements in reported economic variables such as GDP growth, inflation and interest rates but we think persistent delays in the completion of the sovereign debt restructuring exercise could impede the progress made thus far.
Capital Impairment Risks: The ongoing restructuring of the loans granted to state-owned enterprises that has been assumed by the government raises significant risks to BOC’s capital, which is reflected in the allocation of LKR450 billion by the government for the recapitalisation of the state banks, including BOC.
This is in addition to the risks to capital stemming from the bank’s holdings of defaulted sovereign bonds for which the bank has already absorbed a provision of around 55%, although the adequacy of the provision is uncertain.
Sovereign Exposures Strain Risk Profile: BOC’s large exposure to the sovereign’s fragile credit profile – which we estimate at around 60% of assets – continues to weigh on the bank’s risk profile assessment. This includes credit extended to a state-owned entity that has been transferred to the government effective end-2022 and its holdings of defaulted sovereign bonds (2% of assets), which are currently under restructuring negotiations. These exposures have made the bank vulnerable to the sovereign’s repayment capacity and liquidity position.
Asset-Quality Pressures Persist: BOC’s asset-quality metrics remain highly influenced by the sovereign’s credit profile due to the bank’s large sovereign exposure via its loans, off-balance-sheet liabilities and securities holdings. The bank’s core asset-quality metric – impaired (stage 3) loan ratio – increased to 13.5% by end-1Q24 (end-2023: 12.6%, 2021: 10.2%) primarily due to a contraction in gross loans. We estimate this ratio to be significantly higher if BOC’s foreign-currency loan exposure to the state and state-owned entities is included.
Risks to Profitability Manageable: The revision in BOC’s earnings and profitability outlook to stable from negative reflects our view that downside risks to earnings have abated despite the potential for a loss following the restructuring of the foreign-currency loans to a state-owned entity, which we expect to be one-off.
BOC’s operating profit/riskweighted asset ratio declined in 1Q24 to 3.0% (end-2023: 3.1%) due to higher impairment charges relative to 2023 when the bank’s profitability benefitted from net impairment reversals.
Funding and Liquidity Risks Persist: Fitch believes BOC’s funding and liquidity profile, especially in foreign currency, is susceptible to the sovereign’s weak credit profile (Long-Term IDR: RD). Stress on foreign-currency liquidity has eased somewhat, reflected in the liquidity coverage ratio, but BOC’s access to foreign-currency wholesale funding remains constrained by the default status of the sovereign. This is evident from the reduction in the share of term borrowings from banks abroad to 0.7% of funding by end-2023 from 3.3% at end-2021.
Economy Supports Business Profile: Fitch revised the outlook on BOC’s business profile to stable from negative, underpinned by our view that the stabilising macroeconomic environment has reduced uncertainties for the bank in generating and defending business volumes. That said, the business profile score continues to reflect the bank’s predominant exposure to the weak domestic economy and OE constraints in the near term.
RATING SENSITIVITIES
Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade
We expect to resolve the RWN on BOC’s VR when the impact to its capital from the sovereign’s debt restructuring becomes more apparent, which may take longer than six months.
If the proposed restructuring of state debt leads to a material capital shortfall that necessitates recapitalisation by the authorities to restore viability or the granting of any regulatory capital forbearance regarding such a shortfall, Fitch would downgrade BOC’s VR to ‘f’ and subsequently, upon any recapitalisation, upgrade it to a level commensurate with its standalone credit profile, likely driven by it risk profile and capitalisation.
A downgrade of the VR may not necessarily lead to a downgrade of the Long-Term Foreign- and Local-Currency IDRs.
Fitch would downgrade BOC’s Long-Term Foreign- and/or Local-Currency IDRs if we perceive there is an increased likelihood that the bank would default on or seek a restructuring of its senior foreign- and/or local-currency obligations to non-government creditors.
A deterioration in the bank’s key credit metrics beyond our base-case expectations relative to peers could trigger a downgrade of BOC’s national rating.
Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade
There is limited scope for upward rating action on the VR given the RWN. Fitch may resolve the Rating Watch with an affirmation if we believe that large capital shortfalls that threaten the bank’s viability are not likely to arise.
An upgrade of BOC’s Long-Term Foreign- and/or Local-Currency IDRs would most likely result from an improvement in the sovereign’s credit profile, which could occur after the successful restructuring of the sovereign’s external debt.
Positive rating action on the sovereign may lead to an upgrade of BOC’s national rating. A sustained improvement in the bank’s key credit quality metrics beyond our base-case expectations, relative to peers, could lead to an upgrade of the bank’s national rating.
OTHER DEBT AND ISSUER RATINGS: KEY RATING DRIVERS
The Basel II and Basel III Sri Lankan rupee-denominated subordinated debt of BOC is rated two notches below its National Long-Term Rating, in line with Fitch’s baseline notching for loss severity for this type of debt and our expectations of poor recovery.
There is no additional notching for non-performance risk, as the notes do not incorporate going-concern loss-absorption features.
The Basel III compliant notes include a clause whereby the notes will be converted to an additional Tier 1 instrument on a permanent basis at the point of non-viability, subject to the occurrence of a trigger event, as determined by the Monetary Board of the Central Bank of Sri Lanka.
The Government Support Rating of ‘ns’ reflects our assessment that there is no reasonable assumption of government support being forthcoming.
OTHER DEBT AND ISSUER RATINGS: RATING SENSITIVITIES
BOC’s subordinated debt rating will move in tandem with the National-Long Term Rating.
VR ADJUSTMENTS
The operating environment score of ‘ccc-‘ is below the ‘b’ category implied score due to the following adjustment reason: sovereign rating (negative).
The business profile score of ‘ccc-‘ is below the ‘b’ category implied score due to the following adjustment reason: business model (negative).
BOC has a 1.78% equity stake in Fitch Ratings Lanka Ltd. No shareholder other than Fitch, Inc. is involved in the day-to-day rating operations of, or credit reviews undertaken by, Fitch Ratings Lanka Ltd.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG CONSIDERATIONS
BOC has an ESG Relevance Score of ‘4’ for Governance Structure due to ownership concentration, with a 100% state shareholding and several related-party transactions with the state and state-owned entities, which has a negative impact on the credit profile and is relevant to the rating in conjunction with other factors.
BOC has an ESG Relevance Score of ‘4’ for Financial Transparency. It reflects our view that the recent regulatory forbearance measures announced by the Central Bank of Sri Lanka could distort the true solvency and liquidity position of the bank, thereby limiting financial transparency. This has a negative impact on the credit profile and is relevant to the rating in conjunction with other factors.
The highest level of ESG credit relevance is a score of ‘3’, unless otherwise disclosed in this section. A score of ‘3’ means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch’s ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision.
For more information on Fitch’s ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores. (Colombo/Jun6/2024)
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