Union Bank of Colombo

Union Bank of Colombo PLC: Rating reaffirmed; outlook revised to Negative

Instrument Rated Amount (LKR Mn)Rating Action
Issuer RatingNA[SL]BBB reaffirmed; Outlook revised to Negative from rating on watch with Negative Implications

Rating action

ICRA Lanka Limited has reaffirmed the Issuer Rating of Union Bank of Colombo PLC (“UBC”/ “the Bank”) at [SL]BBB (pronounced as S L Triple B); while revising the outlook to Negative from rating on watch with Negative Implications.

Rationale

The outlook revision to Negative from rating on watch with Negative Implications factors in the Bank’s stretched asset quality indicators as compared to its peers and is expected to further deteriorate given the extremely challenging operating environment. UBC’s gross NPA ratio remained high at 5.65% as at Dec-21 as compared to Licensed Commercial Bank (LCB) sector average of 4.27% as at Dec-21. ICRA Lanka expects asset quality indicators to deteriorate in the near to medium term given the envisaged rise in slippages, especially within the SME segment, due to the business disruptions from fuel shortage, power outage and various other macro-challenges from Q2CY2022 as majority of these challenges intensified from April 2022 onwards. ICRA Lanka notes that the SME segment mainly accounts for the gross non-performing facilities of the Bank (82% of the GNPA as at Dec-21), which is likely to remain under pressure. 

The outlook revision also considers the subdued profitability in the near to medium term as ICRA Lanka expects the core margins to be affected due to deposit repricing and weaker loan growth given the challenging macro outlook. The sharp interest rate hike by 700 bps in April 2022 and further by 100 bps in July 2022 resulted in a large number of deposits being repriced. In addition, the banking sector absorbed a significant amount of local currency liquidity. Therefore, ICRA Lanka takes comfort and does not expect much stress in terms of the local currency liquidity. Further, sizeable provisioning due to the elevated market risk given the challenging macro outlook, sharp local currency devaluation along with increased taxation places further downward pressure on the earnings profile.

The rating takes comfort from the strong strategic and financial support received from the leading global investment firm Texas Pacific Group (TPG) through its affiliate, Culture Financial Holdings Ltd (CFHL) which held a 70.84% stake as of March 2022. TPG provides strategic support through its three representatives within UBC’s board which comprises of nine directors. The Bank also receives financial support and is able to maintain a healthy capitalization profile given the backing of TPG. UBC maintains a healthy capital buffer with Tier 1 Capital ratio and total capital ratio of 13.69% and 14.45% as on Mar-22 above the regulatory requirement of 8.00% and 12.00% respectively. The comfortable capital position is also expected to enable UBC to withstand impairment shocks. The rating also takes note of UBC’s core capital of LKR 18 Bn as of Jun-22 compared to the minimum regulatory requirement of LKR 20 Bn to be met by the end of CY2023. However, ICRA Lanka takes comfort from the warrants issued to the major shareholder CFHL amounting to around LKR 3.5 Bn which could be exercised to meet the regulatory requirement, if required. ICRA Lanka expects the strategic and financial support from TPG to continue, going forward.

Outlook: Negative

The outlook revision to Negative from rating on watch with Negative Implications factors in the envisaged deterioration of asset quality indicators from Q2CY2022 on account of the current state of the economy, particularly on the SME segment, while profitability is also likely to remain subdued. The negative outlook also reflects the tight dollar liquidity faced by UBC, along with the rest of the peer banks. The outlook may be revised to “Stable”, if there is a consistent improvement in its asset quality metrics and earnings profile.

Key rating drivers

Credit strengths

Strategic and financial support from the leading global investment firm; TPG – Union Bank PLC (UBC) is a small-sized bank consisting of an asset base of around 1% of the total LCB sector offering its services through a branch network of 67 branches as in Mar-22. The Bank is strongly backed by one of the leading global investment firms, Texas Pacific Group (TPG). TPG acquired 70% of UBC in 2014 for a total consideration of LKR 11.9 Bn through its affiliate company, Culture Financial Holdings (CFHL). Currently, CFHL holds a stake of 70.84% as on Mar-2022. TPG has a long-term interest in the Bank since it has special regulatory permission to hold 75% stake till 2029 as compared to the regulatory cap of 10%. As per the regulation, TPG is required to reduce its stake to 15% by 2029. The firm provides strategic support through its representation within UBC’s board which comprises of nine directors of which three are representatives of TPG. The Bank also receives financial support from TPG and has issued 218,281,250 warrants to TPG in Dec-14 at LKR 16 per warrant. These would be exercised in case of any shortfall in meeting the minimum capital requirement. ICRA Lanka expects the strategic and financial support from TPG to continue, going forward.

Healthy capitalization profile – UBC’s capitalization profile remains comfortable with healthy buffers over the regulatory requirements with the backing of TPG. UBC reported a Core capital adequacy ratio of 13.69% as in Mar-22 as compared to 15.51% as on Dec-21 (regulatory requirement of 8.00%). The Bank also reported a total capital ratio of 14.45% as in Mar-22 as compared to 16.47% as on Dec-21 (regulatory requirement of 12.00%). ICRA Lanka notes that the capital buffers marginally diminished in Q1CY2022 due to the sharp currency devaluation leading to an increase in the risk-weighted assets and the impairment charges in the foreign currency loans and investments, which was seen across the Banking sector. With core capital of LKR 18 Bn as in Jun-22, the Bank is yet to meet its absolute minimum regulatory capital requirement of LKR 20 Bn by Dec-23. ICRA Lanka expects that the Bank could meet the core capital requirement through internal generation and any shortfalls could be covered by exercising the warrants issued to TPG.

Moderate funding profile with marginal improvement in CASA ratio – The CASA ratio of the Bank marginally improved to 30.44% as at Mar-22 from 30.14% in Dec-21 mainly due to UBC’s cash management solution (Union Bank BizDirect). However, the ratio remains below the average of the LCB sector (38.87% as at Dec-21) due to the Bank’s moderate franchise strength. ICRA Lanka also notes that UBC’s dependence on public deposits have increased over the years to around 72% of the total funding profile as at Mar-22 from around 58% as at Dec-17. The deposit concentration remains somewhat moderate with the top 10 depositors accounting for 20% of the total deposits as in Mar-22. 

Comfortable Liquidity profile – UBC reported a positive short-term (within 6-12 months) cumulative mismatch of 18.95% as at Mar-22 in comparison to 24.24% as at Mar-21. The decline in the positive mismatch was mainly due to the Bank’s reduced investments in short-term investments including unit trusts. In terms of liquidity ratios, UBC maintains a comfortable position over the regulatory requirement in both liquid coverage ratio and liquid asset ratio, however, the ratios somewhat declined by Mar-22 due to the Bank’s reduction in investments. UBC maintained an all-currency liquid coverage ratio of 167.37% as on Mar-22 (regulatory requirement 90.00%) as compared to 252.85% as on Dec-21 (regulatory requirement of 100.00%). Additionally, UBC maintained a domestic currency liquid asset ratio of 24.14% as on Mar-22 as compared to 23.50% as on Dec-21 (regulatory requirement of 20.00%).

Credit Challenges

Modest franchise strength – UBC is a relatively small-sized bank, with just over 25 years of establishment, consisting of an asset base of around LKR 129,878 Mn (1% market share as of Dec-21) and 67 branches as at Mar-22. UBC’s portfolio is segmented into corporate, SME, and retail which accounted for 51%, 30%, and 18%, respectively as at Mar-22. The portfolio composition remains fairly constant over the years with the key product classes including term loans, imports and exports, and overdraft facilities accounting for 51%, 16%, and 13% of the total portfolio as at Mar-22, respectively. Going forward, ICRA Lanka expects the challenging economic outlook to further hinder private sector credit growth resulting in portfolio moderation in the short to medium term.

Asset quality is likely to deteriorate in the short to medium term – The asset quality indicators of UBC remain stretched with Stage 3 to total loans ratio at 4.82% as of Mar-22 (4.46% as of Dec-21). ICRA Lanka also factors in the low impairment (Stage 3) to Stage 3 Loans ratio of 32.73% as of Mar-22 as compared to 31.86% as of Dec-21. ICRA Lanka expects the overall asset quality of the Bank to deteriorate in the short to medium term due to the extremely challenging operating environment.

Profitability marginally improved in Q1CY2022; but the same is likely to remain subdued in the short to medium term – UBC reported a marginal improvement in operating profit/ATA of 1.02% in Q1CY2022 in comparison to 1.00% in Q1CY2021 which was largely attributable to the improvement in Net Interest Margins (NIM) due to the growth of the portfolio and improvements in CASA indicators. The Bank’s NIM was 3.51% in Q1CY2022 as compared to 3.11% in Q1CY2021. Furthermore, UBC reported an improvement in the operating cost to operating income ratio of 64.69% for Q1CY2022 as compared to 66.50% for Q1CY2021 as a result of higher other income in Q1CY2022. Credit costs increased to 0.93% in Q1CY2022 as compared to 0.62% in Q1CY2021 due to increased conservative provisioning. As the macro challenges aggravated after April 2022, ICRA Lanka expects the impairment charges to further increase in Q2CY2022. The PAT/ATA declined to 0.64% in Q1CY2022 as compared to 0.89% in Q1CY2021 mainly due to the significant rise in taxes.

Going forward, given the extremely challenging operating environment, ICRA Lanka expects the overall profitability to remain subdued due to compressions in core margins with the sharp increase in systemic interest rates, increased provisioning costs, and higher tax regime.

Analytical approach: For arriving at the ratings, ICRA has applied its rating methodologies as indicated below.

Links to applicable criteria: https://www.icralanka.com/rating-methodology-for-banks/

About the Bank:

UBC, incorporated in 1995, is a small Licensed Commercial Bank (LCB) accounting for about 1% market share of the Sri Lankan banking sector assets as on December 31, 2021. After a Restructuring process in 2003, which included Union Bank transferring LKR 978 Mn of NPAs and LKR 600 Mn of Cash to an SPV in return for low-yielding long-term Deep Discount Bonds (DDB), the Bank has raised capital from various investors. The Bank was listed on the main board of the Colombo Stock Exchange with an IPO offering in March 2011. UBC acquired controlling interest in National Asset Management Limited (NAMAL) and The Finance and Guarantee Company Limited (TF&G), subsequently renamed UB Finance (a licensed finance company). As on December 31, 2021, it holds about 51% of the share capital in NAMAL and 92% share capital in UB Finance. In 2014, UBC received equity infusion of about LKR 11.4 Bn from Culture Financial Holdings Ltd (CFHL), an affiliate of the private equity investor TPG; CHFL presently holds about 70.8% of the equity share capital. CHFL also subscribed to about 218 Mn share warrants, which could result in further equity infusion, if exercised and, increase CHFL’s shareholding to 75%. Given the restrictions on Bank shareholdings in Sri Lanka, special approval was granted by Central Bank of Sri Lanka (CBSL) to CHFL to reduce the holding to 15% by 2029.

UBC reported a PAT of LKR 198 Mn on a total asset base of LKR 129,878 Mn in Q1CY2022 as compared to LKR 282 Mn PAT on a total asset base of LKR 124,796 Mn in Q1CY2021. During the year ended December 31, 2021, UBC reported a PAT of LKR 765 Mn on a total asset base of LKR 118,406 Mn.

Key financial indicators
LKR MnCY2020CY2021Q1CY2021*Q1CY2022*
Net interest income3,8704,2579851,091
Profit after tax577765282198
Networth18,09017,92518,22717,327
Loans and advances (net)67,51867,83571,60975,479
Total assets122,943118,406124,796129,878
Return on Equity3.24%4.25%6.20%4.49%
Return on Assets (Based on PAT)0.47%0.63%0.89%0.64%
Capital adequacy ratio (BASEL III)16.95%16.47%15.88%14.45%
Gearing (times)5.675.475.736.31

*Unaudited financials

Rating history:
Analysts
Sanduni Kankanamalage
+94-777478138
sanduni@icralanka.com

Niraj Jalan
+91-33-71501146
niraj.jalan@icralanka.com

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