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Union Bank of Colombo PLC: Rating Reaffirmed September 12, 2019

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Union Bank of Colombo PLC: Rating Reaffirmed September 12, 2019 Union Bank of Colombo PLC: Rating reaffirmed September 12, 2019 Instrument Rated Amount (LKR Mn) Rating Action Issuer rating N/A [SL]BBB (Stable); Reaffirmed Rating action ICRA Lanka Limited, subsidiary of ICRA Limited, a group company of Moody‟s Investors Service, has reaffirmed the issuer rating of Union Bank of Colombo (UBC or the Bank) at [SL]BBB (pronounced SL triple B). The outlook on the rating is Stable. Rationale The rating reaffirmation takes into account the promoter holding of 70% stake by Culture Finance Holdings Ltd (CFHL), an affiliate of the private equity investor Texas Pacific Group (TPG). TPG has five representatives on the 11-member Board of UBC, and provides managerial support to the senior management team. The rating takes note of the experienced senior management team and adequate risk management systems. Further, the rating factors in the Bank‟s comfortable capital profile with common equity Tier-I (CET-1) of 17.23% as on June 30, 2019 and remains above the minimum regulatory level of 12.50%. Nevertheless, the rating takes note of the regulatory minimum core capital requirement of LKR 20 Bn to be complied by Dec-20. ICRA Lanka envisages that the Bank would need fresh external capital to meet the regulatory minimum core capital requirement of LKR 20 Bn by Dec-20 and expects timely support from TPG by way of exercising the warrants, and infusing capital, when required, to meet the same. The rating factors in the Bank‟s modest size with an asset base of LKR 122 Bn as on June 30, 2019. The Bank reported subdued profitability indicators with RoA1 of 0.39% and RoE2 of 2.74% for CY2018 as compared to industry average of 1.14% and 13.15% for the same period. Further, the rating considers its moderate resource profile (CASA3 27% on June 30, 2019). ICRA Lanka notes that the Bank‟s corporate exposures are quite concentrated. The Bank‟s target segments (SME and retail) is expected to be highly competitive and the SME segment is highly vulnerable to slippages during unfavourable macroeconomic conditions. As a result, the Bank‟s ability to generate adequate returns going forward, would be crucial from a profitability perspective. Further, improvement in operating efficiency and deposit profile would be crucial from a rating perspective. Outlook: Stable ICRA Lanka believes that UBC will continue to benefit from the support from TPG. The outlook may be revised to „Positive‟ in case of a steady improvement in the resource, earnings and liquidity profile as portfolio expands, while keeping the asset quality under control. The outlook may be revised to „Negative‟ in case of weakening in the asset quality, profitability or capital profile. 1 Return on Asset (post tax) 2 Return on Equity 3 Current Accounts and Savings Accounts 1 Key rating drivers Credit strengths Strong financial and managerial support from TPG: Union Bank of Colombo was incorporated in 1995. Presently the Bank offers its services through 67 branches. Texas Pacific Group (“TPG”) acquired 70% stake of UBC in 2014 through its affiliate Culture Financial Holdings Limited (CFHL). TPG has a long- term interest in the Bank, since it has special regulatory permission to hold 75% stake till 2029 as compared to regulatory cap of 10%. UBC‟s board comprises of 11 directors including 5 independent directors and 5 representatives from TPG. TPG‟s representatives provide managerial support to the senior management team and are active at the sub-committee levels as well. TPG has demonstrated its financial support by investing LKR 11.4 Bn in 2014 for a stake of 70%. Further, it has invested LKR 3.5 Bn in UBC‟s share warrants, which would mature in Sep-20. Commensurate risk management system and controls: The Bank implemented a new risk-based pricing module for its corporate and SME clientele in Jun-18. The purpose of this module is to rationalise the portfolio, strengthen the quality of the portfolio and to maximise the return of the individual customers. The Bank has setup a comprehensive internal audit mechanism. The internal audit department conducts planned audits at branches and prepares a risk scorecard for each branch by assigning a rating. Based on the risk rating, the audit division conducts random audits. The audit committee actively attends to audit findings and closely follow-up post implementation. Comfortable capital profile: UBC has a comfortable capital structure based on BASEL III regulatory requirements with CAR of 17.23% in Jun-19 as compared to the minimum regulatory requirement of 12.5% as on January 1, 2019. The Bank reported LKR 17.8 Bn core capital in Jun-19 as compared to CBSL‟s minimum core capital requirement of LKR 20 Bn by December 31, 2020. ICRA Lanka estimates that the Bank would require external capital infusion by Dec-20 to meet the regulatory minimum core capital requirement of LKR 20 Bn. Any shortfall in the Bank‟s capital requirement is likely to be met through the warrants worth LKR 3.5 Bn issued to TPG which are maturing in Sep-20. Credit challenges Modest asset quality indicators mainly driven by the SME segment: UBC‟s Gross NPA (GNPA) increased to 5.40% in Jun-19 as compared to 3.68% reported in Dec-18 (2.69% in Dec-17). The Bank‟s gross NPA ratio remained marginally above the system average of 3.42% in Dec-18. The rise in GNPA was mainly due to poor performance of the SME portfolio coupled with muted growth in the total advances by 6.9% as on December 31, 2018 from 25.5% as on December 31, 2017. At a standalone level SME portfolio reported higher GNPA ratio due to adverse effects of the political and security events at the macroeconomic level and the poor quality of the legacy portfolio (before 2015). The Bank is closely monitoring the recovery of existing NPA‟s and has strengthened the credit underwriting norms and risk management systems. The rating continues to take note of the high NPAs in the subsidiary, UB Finance (GNPA at about 18.60% on December 31, 2018). Going forward, the Bank‟s ability to keep the group level NPAs under control by restricting incremental slippages and, improving the Bank‟s own provision coverage4, which is presently moderate at about 52% on June 30, 2019, would be crucial. Sharp increase in 4 Provision coverage = Provisions based on IFRS/Gross NPA portfolio excluding IIS 2 NPAs during the last six months ended Jun-19 pressured the solvency5 profile which deteriorated to 17% in Jun-19 as compared to 9% in Jun-18. Modest scale and franchise: UBC has segmented its market to corporate, SME and retail and offers term loans, personal loans, import/export loans, mortgage loans, asset backed loans and credit cards to its customers. The Bank has a modest scale of operations with total asset base of LKR 122 Bn and a franchise of 67 branches as at Jun-19. The corporate banking segment accounts for 46% of the portfolio followed by SME 34% and Retail 20% in Jun-19. The loan portfolio growth moderated to 6.9% in CY2018 as compared to 25.5% reported in CY2017 and it has further moderated to 4.8% in H1CY2019. The portfolio growth slowed as a result of tightening credit underwriting norms and adverse macro level events. The Bank envisages its future growth through SME and retail products which are backed by assets. Subdued earnings profile compared to the banking industry: The Bank‟s Net Interest Margin (NIM) improved to 2.98% in CY2018 as compared to 2.87% in CY2017, and it further improved to 3.44% in H1CY2019. The NIM has been strengthened by improved gross interest spread as a result of moderation in overall funding cost to 8.22% in CY2018 as compared to 8.60% in CY2017, although the same has increased to 8.53% in H1CY2019. The measures taken to rationalise the portfolio and maximise the returns on the portfolio has contributed to interest spread improvements. The Bank was able to improve its lending spread to 1.98% in CY2018 as compared to 1.62% reported in CY2017 (1.71% in CY2016). The Bank‟s cost to income ratio remains high but improved to 84% in CY2018 as compared to 95% in CY2017, it further improved to 82% in H1CY2019. UBC‟s cost to income ratio remains high as compared to the systemic average of 50% in CY2018. The overall profitability of the Bank improved at PBT level with a RoA of 0.82% in H1CY2019 as compared to 0.63% in CY2018 (0.50% in CY2017). At PAT level, RoA declined to 0.39% in CY2018 as compared to 0.43% in CY2017 as a result of increased effective tax rates. The Bank‟s return ratios were relatively subdued as compared to the systemic6 average RoA and RoE of 1.14% and 13.15%, respectively in CY2018. Moderate funding profile: The Bank‟s funding is largely in the form of deposits, which accounted for 71% of the total debt as on June 30, 2019. UBC improved the share of CASA to 26.75% in Dec-18 from 23.19% in Dec-17. However, the CASA ratio remains below the systemic average of 31.67% in Jun-19. The credit to deposit ratio improved to 95% in Dec-18 as compared to 100% in Dec-17, although same was high at about 101% as on June 30, 2019, as the advances growth moderated to 4.8% during H1CY2019 vis a vis the deposit de-growth of about 12% (annualised).
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