Fitch Ratings has maintained Nations Trust Bank PLC's (NTB) National Long-Term Rating of 'A(lka)' on Rating Watch Negative (RWN).

Fitch has also maintained NTB's subordinated debt rating of 'BBB+(lka)' on RWN.

Key Rating Drivers

Risks Remain Significant: The RWN on NTB's National Long-Term Rating reflects the potential for the bank's creditworthiness to deteriorate relative to other entities on the Sri Lankan national ratings scale, given the heightened stress on the bank's funding and liquidity, and its exposure to the sovereign via investment in foreign- and domestic-currency-denominated instruments raising the risk to its overall credit profile.

We believe 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.

Weakening Operating Environment: Our assessment of the operating environment of Sri Lankan banks 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. These economic stresses have limited NTB's operational flexibility.

Volatility Weighs on Business Model: We believe that NTB's business profile, like most of its domestic peers, is highly vulnerable to intensifying risks in the domestic market, considering its high concentration on the weak and unstable Sri Lankan economy. This could limit the bank's ability to generate and defend business volume while controlling risks.

Elevated Risk Profile: NTB's elevated risk profile, similar to local peers, stems from the challenging operating environment in Sri Lanka - its main exposure is to high-risk customer segments with weak credit quality in the domestic market. This risk is further heightened as the bank holds government foreign-currency-denominated instruments that are now in default, and it thus is affected by the sovereign's repayment capacity and liquidity position.

Rising Asset Quality Pressure: Fitch expects NTB's impaired (stage 3) loans ratio to increase in the near to medium term as borrower repayment capacity weakens amid rapidly deteriorating economic conditions. The bank's exposure to foreign-currency-denominated instruments of the sovereign, albeit small relative to larger peers, adds to asset-quality pressure. At end-1H22, impaired loans accounted for 5.4% of total assets, with another 3.4% of assets in sovereign bonds and Sri Lanka Development Bonds. The latter's share has moderated after June 2022.

Credit Costs to Erode Earnings: We believe that the sovereign's default, together with increasing economic headwinds, poses significant downside risks to NTB's profitability. Earnings pressure is already evident in the bank's operating profit/risk-weighted-asset ratio, which declined to 3.3% by end-1H22 (end-2021: 4.3%) as credit costs eroded 59% of the bank's pre-impairment profits.

Capital Buffers Under Pressure: Fitch expects increased asset-quality risks, weaker earnings retention and bloated risk-weighted assets from the severe rupee depreciation to exert significant pressure on the bank's capitalisation metrics in the near term. This is despite the bank's modest exposure to foreign-currency-denominated government securities, in contrast to its peers.

Stretched Foreign Currency Liquidity: We believe NTB's foreign currency funding and liquidity position is significantly challenged and vulnerable to sudden shocks amid weaker credit sentiment, similar to its peers. Access to foreign-currency funding has been severely hampered given the sovereign's weak credit profile, and the sovereign's default on foreign-currency debt has weakened the bank's foreign-currency liquidity position.

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 issuer'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 NTB'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 NTB 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 (CCC, under criteria observation) 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

NTB's Basel III-compliant, Sri Lankan rupee subordinated debt is rated two notches below the National Long-Term Rating anchor. This reflects Fitch's baseline notching for loss severity for this type of debt and our expectation of poor recovery. There is no additional notching for non-performance risk, as the notes do not incorporate going-concern loss-absorption features.

OTHER DEBT AND ISSUER RATINGS: RATING SENSITIVITIES

The subordinated debt rating will move in tandem with the 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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