Fitch assigns Asia Securities first-time rating of ‘BBB-(lka)’; Outlook stable

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Fitch Ratings has assigned Asia Securities (Pvt) Ltd (ASPL) a National Long-Term Rating of ‘BBB-(lka)’. The Outlook is Stable. ASPL is a prominent equity brokerage in Sri Lanka.

The company, which was founded in 1990, also offers broker credit services to its clients.

KEY RATING DRIVERS

The rating on ASPL reflects its franchise as one of the leading equity brokerages in Sri Lanka, simple yet generally effective risk management, adequate capitalisation relative to local regulatory requirements, and acceptable liquidity buffers as indicated by liquid assets and contingent liquidity coverage of short-term liabilities.

The rating also incorporates limitations from the weaknesses of the industry’s operating environment, including a small and volatile equity market, stilldeveloping market infrastructure and regulatory framework, as well as ASPL’s narrower funding base and variable profitability due to its dependence on fluctuating stock-market revenues.

We believe ASPL’s lean management team leaves it susceptible to key-person risk, although this is mitigated by the stability of its senior leadership since an ownership change in 2015. ASPL’s revenues are primarily from equity brokerage and margin lending, with little direct investment risk.

Credit risks in margin financing are mitigated by a 50% regulatory loan-to-value limit. ASPL applies an additional valuation discount on securities that it deems to be higher-risk, forming a further buffer against collateral risk. Meanwhile, upcoming sector enhancements to address settlement and other operational risks lag those of many markets in Asia, but should help to strengthen industry operations.

ASPL’s reliance on volatile equity-market revenues weighs on its credit profile. Operating profitability has fluctuated widely over the past few years – although this partly reflected a number of one-off costs in FY19. Nonetheless, average operating profit to average equity was positive at around 41% over FY18-FY21 (calculated using provisional financial statements for FY21).

Earnings have been strong in the past 12-18 months due to robust equity-market activity. Improvements to the cost base over the past few years should also help to support revenue retention and profitability, if sustained. However, we believe profitability is likely to remain unpredictable due to the nature of ASPL’s business. Ongoing challenges to the economy and sovereign credit profile also raise risks to funding conditions and equity-market performance, which could put pressure on ASPL’s profitability and funding over the next few years.

Management is working to build more recurring revenue streams under the Asia Securities brand. These business lines are held separately from ASPL, but could help to strengthen the overall franchise if successful. However, execution of this strategy remains uncertain and the plans are likely to entail further investment, funded by loans from ASPL. This places an additional demand on ASPL’s resources, which Fitch incorporates in our assessment.

We also view ASPL’s funding profile as more confidence-sensitive than larger financial service organisations, such as major banks and finance and leasing companies. The company has raised adequate funding from banks and private investors despite challenging market conditions in the past several years, and expanded funding facilities provide additional flexibility as borrowing needs have risen alongside strong market activity in the past 12-18 months.

Nonetheless, Fitch believes the company’s funding avenues remain relatively narrow, which presents concentration risk in times of stress. We deem ASPL’s capitalisation to be adequate, with net adjusted leverage – defined as (tangible assets – reverse repurchase agreements – securities borrowed) / tangible equity – of 3.0x-5.5x over FY17-FY20. ASPL’s client financing exposure is subject to a prudential limit of 3x regulatory adjusted net capital, and we expect the company to remain within this limit in the near to medium term (FY17-FY21: 0.7×1.9x regulatory adjusted net capital).

In calculating net adjusted leverage, Fitch deducts ASPL’s exposures to related entities from tangible assets and equity. These are mainly investments in emerging business lines held apart from ASPL but under a common influence.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade: A more consistent profitability record would be positive for ASPL’s credit profile. This may be due to a sustained improvement in cost efficiency, a structural improvement in equity turnover leading to dependably higher brokerage and securities lending revenues, or an expanded group product range that generates supplementary cross-sell revenue for ASPL.

This is provided that the company maintains broadly steady net adjusted leverage and liquidity coverage, and it continues to enhance its operational risk defences as planned – although we do not view ASPL’s operational risk management as a weakness relative to local norms. A more diverse funding base would also strengthen ASPL’s rating profile.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

The rating would be downgraded in the event of weak profitability with a likelihood of sustained losses potentially due to prolonged poor market conditions. A deteriorating capital position, significantly enlarged related-party exposure relative to equity, declining liquidity coverage, or more limited funding flexibility would also be negative for the credit profile.

A rapid expansion in margin lending or proprietary trading would indicate a rising risk appetite and also place pressure on ASPL’s rating. This is particularly if leverage were to also rise sharply as a result. Fitch may take negative rating action if the regulatory adjusted net capital buffer were to narrow significantly or if the Fitch net adjusted leverage – which includes the company’s brokerage settlement receivables – remained at or above 6x for an extended period.