TEXT-Fitch release on Sri Lanka's HDFC Bank

(The following statement was released by the ratings agency)

Oct 3 - Fitch Ratings has today downgraded the National long-term rating of the Housing Development Finance Corporation (HDFC) Bank of Sri Lanka HDFC.CM to 'BBB+(lka)' from 'A-(lka)'. The rating Outlook remains Negative. Fitch has simultaneously downgraded the rating on the following outstanding senior unsecured debentures issued by HDFC to BBB+(lka) from A-(lka):

2005/2010, 2015, 2020 senior unsecured redeemable debentures of LKR250m

2005/2009 senior unsecured redeemable debentures of LKR125m

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. However, Fitch derives comfort from possible state support, given the government of Sri Lanka's circa.51% stake in HDFC, and the bank's perceived importance to the state's housing policy. The rating also factors in HDFC's sound capital adequacy, and the relatively low ultimate credit risk in its loan portfolio. The Negative Outlook reflects Fitch's view that, while HDFC is currently in the process of implementing measures that could address its weak profitability, the bank could find it challenging to arrive at a sustainable level of profitability over the ensuing 12-18 months, if the present macro economic conditions were to persist.

On a consolidated basis, profitability as measured by return on assets progressively declined from 1.68% at year end 2006 to a negative 0.34% and negative 0.87% at year end 2007 and end-June 2008 respectively. This was largely driven by the deterioration in net interest margin (NIM), due to the bank's inherent interest rate mismatch. 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 increased lending rates on new loans during FY07 in a bid to offset rising borrowing costs, and has maintained a NIM of around 5%-6% on incremental lending since end-2007. However overall NIM reduced to 2.6% at end-June 2008 from 3.3% at FYE07 driven by slower loan growth, while average borrowing costs continued to increase. HDFC's profitability is constrained further by its portfolio of low-yielding directed loans to state employees, which has been limited to LKR1bn (8.4% of gross loans at end-June 2008).

HDFC's statutory liquid assets ratio (SLAR) has been below the regulatory minimum of 20% since May 2008 due to a large repayment of institutional borrowings, while deposit growth slowed considerably. Fitch notes that liquidity could be constrained further by increased operating costs, and weak profitability. However the bank expects the SLAR to return to 20% towards FYE08 based on its decision to reduce loan growth since Q208.

HDFC is a licensed specialised bank whose main shareholder (c.51%) is the government of Sri Lanka. The bank is one of two that specialise in lending to the low and middle income segment. HDFC has a network of 21 outlets, and had an asset base of LKR13.2bn at end-June 2008.