Fitch affirms Bank of Ceylon at ‘CCC’ and ‘AA- (lka)/stable

Fitch Ratings has affirmed Bank of Ceylon’s (BOC) Long-term Foreign and Local Currency Issuer Default Ratings (IDR) at ‘CCC’.

The ratings do not carry an Outlook because of the potentially high volatility at this rating level, in line with Fitch’s rating definitions.

BOC’S National Long-term Rating has also been affirmed at ‘AA -(lka)’. The Outlook is Stable. At the same time, Fitch has affirmed BOC’S Viability Rating at ‘ccc’, Support Rating at ‘5’ and Support Rating Floor at ‘NF’ (No Floor).

BOC’S Long-term IDRS are driven by the bank’s intrinsic credit profile, as reflected in its VR. There are no changes to Fitch’s assessment of the bank’s intrinsic credit profile since Fitch’s last review in December 2020. The ratings are constrained by the sovereign IDR (CCC). BOC’S VR remains highly influenced by the operating environment and asset quality.

Fitch Rating’s assessment of the operating environment for Sri Lankan banks reflects the risk of doing banking business due to the sovereign’s credit profile and the impact of the coronavirus pandemic. Sri Lanka’s economy contracted by 3.6 percent in 2020 as a result of the pandemic and Fitch’s expectation is for an expansion of 3.8 percent in 2021. Fitch’s forecasts are subject to a high degree of uncertainty depending on the evolution of the pandemic.

The outlook on the operating environment assessment remains negative due to the potential for further risk from the deterioration of the sovereign credit profile or pressure on domestic operating conditions beyond Fitch’s expectation independent of changes in the sovereign rating. The operating environment for Sri Lankan banks has a high influence on banks’ ratings, as it is likely to constrain their intrinsic credit profiles through its effect on financial and non-financial key rating factors. The negative outlook on risk appetite and most of the financial profile factors reflect the pressure from the operating environment.

BOC’S risk appetite score of ‘ccc’/ negative reflects heightened risk from its significant exposure to the sovereign and also from non-state exposures that could be susceptible to deteriorating operating conditions. The bank’s increased lending to the state and state-owned enterprises (SOES) resulted in loan expansion of 27.7 percent in 2020 and 8.6 percent 1Q21, which far exceeded that for the sector and increased its loan book concentration to the state and SOES. BOC’S risk appetite is more susceptible to pressure, as its status as a large state bank has led to an increased policy role in intermediating relief to businesses and individuals affected by the pandemic.

BOC’S asset quality score of ‘ccc’/ negative is aligned with its risk appetite score and reflects Fitch’s expectation of persisting risks to asset quality. Its impaired loans/gross loans ratio fell to 9.7 percent by end-1q21, from 10.3 percent at end2020, due to the rapid increase in loans. Pressure on impaired loans could manifest across an extended period of time, due to relief measures that halted the recognition of credit impairments and ongoing discretionary restructuring. Despite an increase in loan loss allowances/impaired loans to 59 percent by end-2020, from 56.6 percent at end-2019, net impaired loans/ common equity Tier 1 capital deteriorated to 65 percent, underscoring the pressure on BOC’S capitalisation.

BOC’S capitalisation and leverage score of ‘b-’/negative factors in the heightened constraints on accessing capital from the state, due to its credit profile, although capital deficiencies are not envisaged. In the absence of a capital infusion from the state, the bank has continued to retain more profit since 2019 and has raised additional Tier 1 capital through perpetual unlisted bonds.

BOC’S exposure to the state bolsters its reported capitalisation ratios, as the exposure is mostly risk-weighted at zero percent. Still, the bank’s capital buffers remain thin, relative to its exposure to risks from the operating environment and sovereign credit profile.

BOC’S earnings and profitability score remains at ‘b-’/negative to reflect Fitch’s expectation of sustained pressure in this area through high credit costs, despite the potential for improved pre-provision profit buffers. Its operating profit/risk-weighted assets ratio recovered in 1Q21 to 5.3 percent after dropping to 2.0 percent in 2020, alongside a sharp increase in impairment charges that consumed 54 percent of preimpairment profits in 2020.

BOC’S funding and liquidity score of ‘b-’/negative reflects the challenges in accessing foreign-currency funding due to the sovereign credit profile, despite the benefit from its state linkages, which support its entrenched domestic deposit franchise and perception of safety. BOC has the largest foreign-currency deposit base in Sri Lanka, supported by its leading position in channelling inward worker remittances. In addition, the bank also relies on foreigncurrency non-deposit funding, although its share in non-deposit funding has declined since end-2019. BOC’S loan/deposit ratio rose sharply to 91 percent in 1Q21, from 84 percent across 2017-2020, driven by rapid loan growth in 2020 and 1Q21.

BOC’S National Rating is also driven by its standalone strength and reflects its entrenched domestic franchise but higher risk appetite and smaller capital buffers relative to private bank peers that have the same national rating. The ratings are constrained by Fitch’s assessment of Sri Lanka’s sovereign rating and the operating environment.

Support Rating and Support Rating Floor

The Support Rating Floor of ‘NF’ and Support Rating of ‘5’ reflect Fitch’s opinion that extraordinary sovereign support for the bank cannot be relied upon in Fitch’s ratings. Fitch believes the sovereign’s ability to provide extraordinary support is severely constrained by its weakened financial flexibility, the size of the banking sector relative to the economy and the banking system’s high vulnerability to large losses in a downturn, despite a high propensity for the sovereign to extend support to the bank.

Subordinated debt

The Basel II Sri Lanka 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 Fitch’s expectations of poor recovery.