Fitch Downgrades DFCC Bank to 'AA-(lka)'; Affirms DFCC Vardhana Bank at 'AA-(lka)'; Outlooks Stable

Fitch Downgrades DFCC Bank to 'AA-(lka)'; Affirms DFCC Vardhana Bank at 'AA-(lka)'; Outlooks Stable
28 Aug 2013 6:21 AM (EDT)
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Fitch Ratings-Colombo-28 August 2013: Fitch Ratings has downgraded Sri Lanka-based DFCC Bank's (DFCC) National Long-Term Rating to 'AA-(lka)' from 'AA(lka)', and affirmed its 99.1% subsidiary, DFCC Vardhana Bank (DVB), at National Long-Term 'AA-(lka)'. The Outlooks are Stable. A full list of rating actions is provided at the end of this rating action commentary.
'AA' category National Ratings denote expectations of very low default risk relative to other issuers or obligations in the same country. The default risk inherent differs only slightly from that of the country's highest rated issuers or obligations.
RATING ACTION RATIONALE
The downgrade of DFCC's ratings reflects the weakening composite risk profile of the group in view of the growing significance of DVB, which has a weaker credit profile than DFCC.
Because the two banks are now also highly integrated in operations and management, and also because DVB has become a core subsidiary of DFCC, it is Fitch's view that their credit profiles cannot be meaningfully disentangled. Therefore the agency has equalised the ratings of DFCC and DVB. This approach is outlined in greater detail in Fitch's published criteria for Rating 'FI Subsidiaries and Holding Companies'.
KEY RATING DRIVERS
As a new entrant to the highly competitive domestic LCB space through DVB, DFCC is likely to face headwinds compared with more established peers as it seeks to achieve critical mass in commercial banking products, given its limited reach and an evolving deposit franchise. Fitch believes that with rapid expansion DVB's loan book could rival the size of DFCC's traditional project lending business in the medium-term.
These business risks are counterbalanced by DFCC's low financial risk, in terms of its healthy profitability and above-average capital. Fitch also takes comfort from DFCC's satisfactory track record as a project lender and the potential diversification benefits that could accrue to DFCC's consolidated balance sheet via DVB's commercial banking products.
DFCC's asset quality continues to be somewhat weaker than its domestic peers' due to the inherently risky nature of its project financing book and the weaker credit quality of DVB's loans. The group's non-performing loans (NPL) ratio increased to 5.4% for the financial year to March 2013 (FYE13) from 5% at FYE12. Fitch views that DFCC group's asset quality is likely to deteriorate on the back of weakening economic conditions and expected lower loan growth during FY14, which is broadly in line with the agency's expectations for the domestic banking sector.
DFCC group's capitalisation remained strong with a Fitch core capital of 31.2%, or 25.4% excluding revaluation gains from its 14.9% stake in Commercial Bank of Ceylon PLC (AA(lka)/Stable). Fitch expects capitalisation to reduce in line with the bank's expected growth in commercial banking business, but to remain satisfactory for the current ratings. DFCC expects to maintain regulatory tier 1 capital adequacy ratio (CAR) above 15% or 3pp higher than the banking sector average. Its CAR was 20.8% at FYE13.
DFCC's and DVB's subordinated debt are rated one notch lower than the respective issuer ratings to reflect their gone-concern loss-absorption qualities in the event of a liquidation, in line with Fitch's criteria for rating such securities.

RATING SENSITIVITIES
An upgrade of DFCC's ratings is unlikely over medium-term given Fitch's expectation for the direction of the group's risk profile and potential lower capitalisation. Over the longer-term an upgrade would be contingent on DFCC developing and maintaining a solid commercial banking franchise alongside a stronger financial profile or lower risk appetite than higher-rated peers.
Fitch would expect the bank to maintain (at a consolidated level) above-average capitalisation relative to 'AA-(lka)'-rated peers, due to its higher business risk profile. Therefore, a sustained deterioration of capitalisation towards that of 'AA-(lka)' peers would put pressure on DFCC's rating. However, Fitch does not expect this in the next 12 to 18 months, which is reflected in the Stable Outlook.
Because Fitch views DVB as carrying the same risk as DFCC, DVB's ratings will move in tandem with DFCC's ratings. DVB's ratings are also sensitive to changes in its strategic importance to DFCC.
Any change in the issuer ratings would impact the ratings of subordinated debentures issued by DFCC and DVB.
DFCC is Sri Lanka's only specialised development finance institution and a licensed specialised bank which was established in 1955 by an Act of Parliament. The government of Sri Lanka indirectly holds a 35% stake in DFCC. DVB is a LCB acquired by DFCC in 2003.