Sri Lanka’s Union Bank rated ‘BBB’ by RAM

Mar 30, 2013 (LBO) – A ‘BBB’ long term rating of Sri Lanka’s Union Bank has been confirmed by RAM Ratings Lanka Plc, with a stable outlook. A ‘P3’ short term rating was also confirmed.

“The ratings are supported by the Bank’s healthy capitalisation but tempered by its small stature, below average asset quality, performance and funding levels,” RAM said in a statement.

In 2011, credit had grown 87.9 percent followed by a slower 20.7 percent growth in 2012 after the Central Bank imposed a credit ceiling.

Following the acquisition of a finance company group gross NPL’s had deteriorated to 10.55 percent by end December 2011 from 8.26 percent in 2010. But by end September 2012, group gross NPLs had improved to 9.16 percent.

The absolute NPLs spiked 70 percent in the nine months, with the NPL ration rising to 6.39 percent from 4.13 percent.

“Delinquencies stemmed mainly from the construction and trading industries,” RAM said.

“The Bank’s credit asset portfolio also remained unseasoned following the aggressive
credit expansion in fiscal 2011.

“As such we deem the Bank’s asset quality to be below average. Going forward, recovery efforts are expected to bear fruit in tandem with the gradual pick up in the construction and trading segments in the economy albeit at a slower pace.” The full statement is reproduced below:

Union Bank’s ratings reaffirmed at BBB/Stable/P3

RAM Ratings Lanka has reaffirmed the respective long- and short-term financial
institution ratings of Union Bank of Colombo PLC (“Union Bank” or “the Bank”) at
BBB and P3; the outlook on the long-term rating is stable.

The ratings are supported by the Bank’s healthy capitalisation but tempered by its small stature, below average asset quality, performance and funding levels.

Incorporated in 1995, Union Bank is one of the smallest licensed commercial banks
(“LCB”) in Sri Lanka, accounting for only 0.74% of industry assets as at end-
September 2012.

The Bank acquired The Finance and Guarantee Company Limited
subsequently renamed UB Finance Company Limited (“UB Finance”) for LKR 600
million in November 2011. UB Finance had faced financial strain under its previous
ownership, resulting in its loan portfolio recording high delinquencies.

The Bank
together with National Asset Management Limited (“NAMAL”) and UB Finance is
referred to as “the Group”. The Bank continued to account for the larger 96.07% of
total assets of the Group despite the recent acquisitions. The Group concentrates on
small and medium enterprises (“SMEs”) that are more susceptible to economic
fluctuations, as reflected it’s in below average asset quality.

Following 87.93% year-on-year (“y-o-y”) growth in credit assets in FYE 31
December 2011 (“FY Dec 2011”) amid a favourable economic climate, the Group’s
credit assets grew by a slower 20.72% in 9M FY Dec 2012, as lending was curtailed
amid the credit ceiling placed by the Central Bank of Sri Lanka (“CBSL”).

The
weakening in the Bank’s loan quality, coupled with the acquisition of UB Finance
(whose loan book almost entirely consisted of non-performing loans (“NPL’”)),
resulted in the Group’s asset quality indicators weakening with the gross NPL ratio
deteriorating to 10.55% as at end-December 2011 (end-December 2010: 8.26%),
comparing weaker than its LCB peers. However as at end-September 2012, due to
recovery efforts in UB Finance the Group’s gross NPL ratio improved to 9.16%.

Meanwhile, the Bank’s absolute NPLs spiked 70% during 9M FY December 2012,
thereby weakening the Bank’s NPL ratio to 6.39% from 4.13% as at end-December
2011. Delinquencies stemmed mainly from the construction and trading industries.

The Bank’s credit asset portfolio also remained unseasoned following the aggressive
credit expansion in fiscal 2011. As such we deem the Bank’s asset quality to be
below average. Going forward, recovery efforts are expected to bear fruit in tandem
with the gradual pick up in the construction and trading segments in the economy
albeit at a slower pace.

The Group’s relatively weaker than peer net interest margin (“NIM”), held down by
its low yielding deep discounted bonds (“DDB”) bond together with the higher cost
burden results in an overall below average performance.

We deem that the NIM
which is in line with the LCB peers do not commensurate with the higher risk profile
of Union Bank’s target market which comprises of SMEs. The Group’s interest
income ascended 63.91% y-o-y in 9M FY Dec 2012 following a 20.72% loan growth
during the same period. Meanwhile, RAM Ratings Lanka notes that the bulk of Union
Bank’s customer deposits comprise of relatively expensive fixed deposits.

This, coupled with its low-yielding DDB (4% yield), had pressured the Group’s net
interest margin (“NIM”), which remained weaker than its banking peers’ at 4.20%
in 9M FY Dec 2012. The Bank’s cost to income ratio also weakened to 73.51% in 9M
FY Dec 2012 owing to the addition of 6 new branches. Overall pre-tax profits in 9M
FY Dec 2012 compared 6.78% y-o-y lower than LKR 324.04 million in 9M FY Dec
2011.

The Group’s funding structure was dominated by customer deposits as at end-
September 2012, with a share of 76.24%. Due to the Group’s aggressive loan
growth, its loans-to-deposits (“LD”) ratio weakened to 92.63% as at end-
September 2012 (end-FY Dec 2011: 87.45%). At the same time, its statutory
liquid-asset ratio weakened to 21.69% as at end-September 2012, (December
2011: 23.38%) amid loan growth. That said, the ratio is currently in line with those
of its peers. As such we deem the Groups liquidity position average.

The Bank’s capitalisation levels are perceived to be healthy. However, amidst loan
growth, its tier-1 and overall Risk Weighted Capital Adequacy Ratios (“RWCARs”)
weakened to 19.54% as at end-September 2012 (end-December 2011: 24.45%
and 24.22%). We also note with concern that the Bank’s net NPLs to shareholders’
funds weakened to 20.41% as at end-September 2012 from 9.74% as at end-
December 2011 amid the influx of NPLs.

We opine AFL’s capitalisation levels to be better than its LFC peers’, following a
capital infusion of LKR 900 million in April 2012. The Company’s tier 1 and overall
risk-weighted capital adequacy ratios (“RWCAR”) clocked in at 32.32% as at end-
September 2012, after having been below regulatory levels for the last 4 years.

Going forward, given planned loan growth, we envisage the ratios moderating,
albeit remaining better than that of peers. However, persistent losses may weigh
down AFL’s capitalisation