"The rating action reflects Fitch's view that the continued escalation of HDFC's inherent interest rate risk has weakened its financial profile to a level that cannot sustain a higher rating over the medium term," the rating agency said.
"However, Fitch derives comfort from possible state support, given the government of Sri Lanka's circa 51 percent stake in HDFC, and the bank's perceived importance to the state's housing policy."
Fitch said in took into account HDFC's sound capital adequacy, and the relatively low ultimate credit risk in its loan portfolio.
The Negative Outlook reflected Fitch's view that, while HDFC is currently in the process of implementing measures that could improve profits, the bank could find it tough to maintain profits in the next 12-18 months, if current economic conditions remained.
Sri Lanka's interest rates and inflation are high.HDFC Bank's consolidated return on assets (ROA) had fallen from 1.68 percent at end-2006 to a negative 0.34 percent at end 2007 and negative 0.87 percent at end-June 2008.
"This was largely driven by the deterioration in net interest margin (NIM), due to the bank's inherent interest rate mismatch," Fitch said.
"The bank intends to increase lending rates on its existing loan portfolio commencing in October 2008, in order to improve profitability.
"However, such increases are somewhat constrained by the nature of the bank's clientele, who are largely fixed income earners from the low and middle income segments of the population."
HDFC had increased lending rates on new loans during the 2007 financial year to offset rising borrowing costs, and has maintained a NIM of around 5 to 6 percent on incremental lending since end-2007.
But overall NIM reduced to 2.6 percent at end-June 2008 from 3.3 percent at the end of the 2007 financial year driven by slower loan growth, while average borrowing costs continued to increase, Fitch said.
HDFC's profitability is further constrained by its portfolio of low-yielding directed loans to state employees, which has been limited to one billion rupees or 8.4 percent of gross loans as at end 2008.
HDFC's statutory liquid assets ratio (SLAR) has been below the regulatory minimum of 20 percent since May 2008 due to a large repayment of institutional borrowings, while deposit growth slowed considerably.
Fitch says that liquidity could be constrained further by increased operating costs, and weak profitability.
But the bank expects the statutory liquidity to return to 20 percent towards the of the 2008 financial year based on its decision to reduce loan growth since the second quarter of 2008.
HDFC is a licensed specialised bank with a 51 percent state shareholding.
The bank is one of two that specialises in lending to the low and middle income segment.
HDFC has a network of 21 outlets, and had an asset base of 13.2 billion rupees at the end of June 2008.