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ECONOMYNEXT – Sri Lanka’s National Development Bank has been downgraded to ‘A(lka)’ from ‘A(lka)’ amid growing economic stress due to the worst currency crisis in the central bank’s history island, triggering a sovereign default in its wake.

“The downgrade reflects our view that NDB’s credit profile has weakened relative to peers with a similar rating,” the rating agency said.

“This is due to the rate of deterioration of its capital buffers and the limited profitability margin to absorb credit cost shocks given the increasing risks to the bank’s operating environment.”

Sri Lanka defaulted on its external debt in April 2012 after running out of reserves.

“The sovereign’s default on its foreign currency bonds has put significant pressure on the NDB’s foreign currency liquidity position, given its large portfolio of foreign currency government securities, at 6.5% of assets at the end of 2021”, said Fitch.

“Access to foreign currency funding has been severely constrained due to the sovereign’s weakened credit profile, which has caused the bank to depend on limited flows of remittances and export earnings.

Sri Lanka is printing money to keep interest rates low and trigger a currency crisis and a loose peg leading to depreciation and sharply higher rates as corrective pressure is applied. Under a flexible inflation policy, the frequency of monetary crises had increased.

In the current crises, market corrective rates have exceeded 25%, raising concerns about bad loans and also market-to-market losses.

“We expect worsening economic stress to further destabilize corporate and household balance sheets, leading to a marked increase in impaired loans (Stage 3) from the estimated 8.3% in 1Q22 in the short to medium term” , said Fitch.

“Nevertheless, the recently announced concessions for affected borrowers could limit the growth of impaired loans, which we believe could mask true credit quality. The bank’s exposure to government foreign currency instruments also adds to its asset quality issues.

The full statement is reproduced below:

Sri Lanka’s NDB Bank downgraded to “A(lka)” amid currency crisis

Fitch Ratings – Colombo – July 28, 2022: Fitch Ratings has downgraded the national long-term rating of Sri Lanka-based National Development Bank PLC (NDB) to “A(lka)” from “A+(lka)”. Fitch also downgraded NDB’s subordinated debt rating to “BBB+(lka)” from “A-(lka)”. The ratings remain under Rating Watch Negative (RWN).

A full list of rating actions is detailed below.

KEY SCORING FACTORS

Deteriorating capital buffers: The downward revision reflects our view that the NDB’s credit profile has weakened relative to that of its similarly rated peers. This is due to the rate of deterioration of its capital buffers and the limited margin of profitability to absorb shocks in the cost of credit given the increasing risks weighing on the operating environment of the bank.

RWN maintained: the RWN on the NDB’s long-term national rating reflects the potential for the bank’s creditworthiness to deteriorate relative to other entities on the Sri Lankan national rating scale amid heightened stress on the bank’s funding and liquidity and its significant exposure to the sovereign via investment in foreign currency instruments which increase the risks for its overall credit profile. We believe that accelerating inflation, local currency depreciation and other factors may distort the bank’s underlying financial performance in the current operating environment.

Constrained foreign currency liquidity: The sovereign’s default on its foreign currency bonds put significant pressure on the NDB’s foreign currency liquidity position, given its large portfolio of government securities in foreign currency, at 6.5% of assets to be held. end of 2021. Access to foreign currency funding has been severely constrained due to the sovereign’s weakened credit profile, which has caused the bank to depend on limited inflows of remittances and export earnings.

Highly Vulnerable Capitalization: We believe the risks to NDB’s capital have increased significantly since our last rating review, despite a capital injection of LKR 9.5 billion in 2Q21. This stems from the possibility that increased provisioning on loan and other loan exposures could significantly exceed profitability before impairment, potentially eroding its capital and capital buffers.

The bank’s above-average share of unprovided bad loans and the possibility of a haircut on its government securities in foreign currencies greater than the amount already factored into its measures exacerbate the risk to its low capital reserves. Recently announced regulatory forbearance measures could help the bank remain compliant with minimum capital ratios on a reported basis.

Heightened pressure on asset quality: We expect worsening economic stress to further destabilize corporate and household balance sheets, leading to a marked increase in impaired loans (Stage 3) from the 8.3% estimated in 1Q22 in the short and medium term.
Nonetheless, recently announced concessions for affected borrowers may limit the growth of impaired loans, which we believe could mask true credit quality. The bank’s exposure to government foreign currency instruments also adds to its asset quality issues.

Deteriorating Profitability: Fitch expects pressure on NDB’s earnings and profitability to intensify in the short to medium term as economic conditions continue to deteriorate rapidly. Earnings pressure is already evident in the substantial increase in impairment charges (86% of 1Q22 earnings before impairment) on its lending and non-lending exposures, which has led to a decline in the bank’s primary profitability indicator – operating income/risk-weighted assets – at 0.7% at the end of 1Q22 (end of 2021: 2.3%).

Weakening operating environment: Our assessment of the operating environment for Sri Lankan banks reflects pressure on banks’ already stressed credit profile following the government’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, which have limited the operational flexibility of the NDB.

Instability weighs on the business profile: We believe that NDB’s business profile, like that of most of its domestic counterparts, is highly vulnerable to growing risks in the domestic market, as the profile is heavily focused on the Sri Lankan economy. Weak and unstable lankan. This could potentially limit the bank’s ability to generate and defend its volume of business while controlling risk.

High risk profile: NDB’s high risk profile, similar to its local peers, stems from its predominantly domestic exposure with low credit quality, including project finance, which is reflected in the ‘ccc’ score. /negative of the operating environment. This situation is exacerbated by the NDB’s large exposure to foreign currency instruments issued by the government, which makes 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 once the impact on the bank’s credit profiles becomes more apparent, which could take longer than six months. Developments that could lead to a multi-notch downgrade include:

– funding stress that hampers the bank’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 negotiated waiver or a standstill agreement following a default on a material obligation

– Fitch believes the bank has entered a period of grace or recovery following the non-payment of a large 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:

The scope for upside action is limited given the RWN.

OTHER DEBT AND ISSUER RATINGS: KEY RATING FACTORS

SUBORDINATED DEBTS

The NDB’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 benchmark 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.


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Elaine R. Knight