Fitch affirms Merchant Bank of Sri Lanka and Finance at ‘BBB+(lka)’; Outlook stable

Fitch Ratings has affirmed Merchant Bank of Sri Lanka & Finance PLC's (MBSL) National Long-Term Rating at 'BBB+(lka)'. The Outlook on Stable.

MBSL is 84.5% owned by Bank of Ceylon (BOC, A(lka)/Stable) and other BOC group entities. BOC is the largest banking group in the country.

KEY RATING DRIVERS

Shareholder Support Drives Ratings: MBSL's rating is driven by our expectation that its parent, Bank of Ceylon PLC, would provide extraordinary support to MBSL, if required.

The rating is anchored by BOC's National Long-Term Rating, which reflects its standalone credit profile and ability to support MBSL. It also takes into account BOC's 84.5% ownership of MBSL, its history of providing equity support, its control over MBSL's policies and strategies through board representation, and known links between BOC and MBSL.

Limited Subsidiary Role: MBSL is rated two notches below BOC due to its limited role in the parent group. MBSL mainly serves high-yielding and under-banked customers that are outside BOC's target market.

BOC aims to bolster its fee-based revenue by expanding merchant banking activities through MBSL, but we expect the impact to be limited in the
short term. MBSL's contribution to BOC's consolidated assets and profitability is minimal (less than 1% of assets and pre-tax earnings), and the parent's prior capital support to remediate regulatory capital shortfalls was with a delay.

Parent's Oversight, Branding Links: MBSL maintains significant management independence in its daily operations, but is subject to BOC's oversight on strategic and policy matters via the control of MBSL's board. BOC executives hold five of MBSL's eight board seats, which should help align MBSL with its parent's priorities.

MBSL also uses the BOC brand for its marketing initiatives, highlighting the reputational links between the two entities.

Weak Standalone Profile: MBSL's standalone credit profile does not directly drive its rating, but we consider it to be weaker than its support-driven rating. This is due to its modest market share with around 2% of sector assets, riskier business mix, variable profitability, and high leverage. MBSL's primary focus on vehicle leasing and gold- and property-backed loans with targeted borrowers who are sensitive to economic fluctuations
contribute to a higher-risk profile.

Above-Average Impairment Ratios: MBSL's stage 3 non-performing loan (NPL) ratio of 34.7% at end-December 2023 was high and above the sector average of 17.8% indicating a strain on asset quality due to its riskier portfolio. Exposure to cyclically- sensitive vehicle classes, like motor lorries, dual-purpose vehicles and motor coaches, contributed to the elevated NPL ratio. We expect asset quality indicators to improve amid the domestic economic recovery.

Improving Profitability: Profitability has been volatile with a history of losses, although MBSL achieved a positive net profit in 1Q24. We expect the ongoing economic recovery to support profitability in the near to medium term.

Moderate Capital Buffers: MBSL's total capital ratio of 16.8% at end December 2023 exceeded the 12.5% regulatory minimum. However, its debt/tangible equity ratio of 6.7x remained high relative to the Fitch-rated peer average and the total capital position had been below regulatory requirements up till a year ago (end-2022: 12.0%).

BOC's capital injections and lower risk-weighted assets helped remediate the capital position, but aggressive growth in non-gold products that outpace the growth in internal capital generation may pressure MBSL's capital ratios.

Primarily Deposit-Funded: MBSL is funded mainly by public deposits raised through its branches. MBSL has also issued Tier 2 debentures in the past, demonstrating its access to local capital market. We believe its affiliation with BOC benefits its deposit mobilisation and access to funds at lower costs.

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