Fitch Ratings has maintained the Rating Watch Negative (RWN) on Housing Development Finance Corporation Bank of Sri Lanka's (HDFC) National Long-Term Rating of 'BB+(lka)'.

Key Rating Drivers

Risks Remain Significant: The RWN on HDFC's National Long-Term Rating reflects potential for deterioration in the bank's creditworthiness relative to other entities on the Sri Lankan national ratings scale, given the heightened stress on the bank's funding and liquidity. The risk is exacerbated by the sovereign's credit profile (Long-Term Foreign-Currency Issuer Default Rating (IDR): RD, Long-Term Local-Currency IDR: CCC (UCO)) and the ensuing risks to the stability of the financial system.

We also believe that the sharp rise in inflation, depreciation of the local currency and other economic stresses can distort the bank's underlying financial position in the current operating environment.

Elevated Liquidity Risk: We expect HDFC funding and liquidity profile to be exposed to dislocations in funding markets and highly volatility in local-currency markets as a result of the weakened sovereign profile. The bank's liquidity was stretched, as reflected in its loan/customer deposit ratio, which increased to 93.6% by end-1H22 from 87.5% at end-2021 due to high deposit withdrawals. Additionally, HDFC's high asset and liability mismatches, reflecting its longer-tenor loan book and short-tenor deposit base, could also intensify the bank's liquidity risk.

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 economic stress has limited HDFC's operational flexibility.

Heightened Asset-Quality Risk: We expect HDFC's asset quality metrics to deteriorate in 2022 given the bank's exposure to more vulnerable low-to-middle income earners amid the weakening OE. Rising interest rates, high inflation and the contracting economy will likely rapidly undermine the repayment capacity of corporates and household. HDFC's stage 3 loan ratio, excluding loans backed by Employee Provident Fund (EPF) contributions, climbed to 19% by end-1H22 from 15% at end-2021.

Capital Vulnerable to Moderate Shocks: Our assessment of HDFC's capitalisation captures its relatively small capital base (LKR6.7 billion at end-1H22), and its limited access to capital due to the state's weakened ability to participate in the bank's capital through rights issues. This has exposed HDFC's capitalisation to profitability and asset-quality shocks more than its peers.

We estimate that additional capital of around LKR800 million would be needed for HDFC to meet the enhanced regulatory capital threshold of LKR7.5 billion by the extended deadline of end-2023, and internal capital generation may not be adequate to address this shortfall. Notwithstanding that, HDFC's reported common equity tier 1 (CET1) ratio of 24.3% at end-1H22 remains significantly higher than the peer median of 14.7%.

Increased Pressure on Profitability: We expect HDFC's profitability to come under increased pressure in 2022 due to rising credit costs, high inflation and muted loan growth. The bank's operating profits/risk-weighted assets ratio fell to 4.0% by end-1H22 from 4.2% at end-2021due to increased credit and operational costs. However, HDFC's profitability continued to be higher than peers' (peer average for 1H22: 1.2%), benefiting from lower risk density due to EPF-backed loans and mortgage-backed housing loans, which are risk-weighted at 0% and 50%, respectively.

Economic Volatility Weighs on Business Model: We believe that HDFC's business profile, like most domestic peers, is highly vulnerable to the intensifying risks in the domestic market given its high exposure to 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.

Elevated Risk Profile: HDFC's elevated risk profile, similar to local peers, stems from its exposure to Sri Lanka's stressed economy. In addition, its main exposure is to high-risk customer segments with weak credit quality, although HDFC has no exposure to defaulted foreign-currency government securities. However, the bank is still exposed to the risk of market dislocation or tighter local-currency markets as a result of measures to improve government's debt sustainability. HDFC's exposure to local-currency government bonds was around 11% of total assets at end-2021.

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 once the impact on the bank's 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 HDFC'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 HDFC has 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 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.

OTHER DEBT AND ISSUER RATINGS: KEY RATING DRIVERS

HDFC's outstanding senior unsecured debentures are rated at the same level as its National Long-Term Rating in accordance with Fitch's criteria. This is because the issue ranks equally with the claims of the bank's other senior unsecured creditors.

OTHER DEBT AND ISSUER RATINGS: RATING SENSITIVITIES

The ratings of the senior unsecured debentures will move in tandem with HDFC Bank's National Long-Term Rating.

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.

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