Fitch Rating update on Nations Trust Bank

Rating Outlook and Key Rating Drivers

• The Outlook for NTB’s rating is Stable. The bank’s ability to maintain asset quality and solvency in an unfavourable economic environment would be a key rating driver, but the rating is constrained by the bank’s comparatively small size and modest profitability.
  Profile
• NTB began operations in 1999 following the acquisition of the Sri Lankan branch of Hong-Kong-based Overseas Trust Bank Ltd. The bank’s promoters, the John Keells group and the Central Finance group, hold 30% and 20% of its equity, respectively.
  Profile
• Promoted by the John Keells group and the Central Finance group
• Has followed a strategy of aggressive but selective acquisition to build its franchise

NTB is an LCB that began operations in 1999, following the acquisition of the Sri Lankan branch of Hong-Kong-based Overseas Trust Bank Ltd. The bank was promoted by leading corporates, John Keells Holdings Ltd (a diversified conglomerate rated ‘AAA(lka)’), and Central Finance Company Ltd (a registered finance company rated ‘A+(lka)’), together with the International Finance Corporation (IFC). The promoters (except the IFC, which disposed of its holding in FY04) jointly hold 50% of NTB’s equity (30% by John Keells group and 20% by the Central Finance group). The bank has been relatively successful compared with other banks formed during the 1990s, largely owing to the backing of and credibility derived from its promotors. NTB, which accounted for 1.9% of banking system assets at end-H107, operates through a network of 31 branches.

To establish its franchise, NTB has pursued a strategy of aggressive but selective acquisition since its inception. The bank acquired Waldock Mackenzie Ltd. (WML), a fixed-income securities trading firm, as a fully owned subsidiary in 2002. During the same year, it acquired the Kandy branch of Standard Chartered Bank, the personal banking portfolio of the Colombo branch of Deutsche Bank and the Colombo branch and foreign exchange services business of American Express Bank.

In 2003, NTB underwent an organizational restructuring following a strategic review carried out by the Boston Consultancy Group. After the review, the bank increased its focus on the consumer segment, and its growing presence in this business evidences its adherence to this strategy.

NTB’s acquisition of the exclusive franchise for American Express (AMEX) credit cards in Sri Lanka in 2003 facilitated its entry into the domestic credit card business. Despite its late entry into a market dominated by foreign banks, the AMEX card has gained considerable acceptance, ranking third in terms of card spend.

To build its card base, the bank approached existing AMEX customers and merchants in Sri Lanka, selectively converted potential customers from its NEXUS affinity card network and offered additional benefits in the form of discounts and extended payment schemes. The credit card business contributed 15% of NTB’s total income before interest expenses in FY06 and accounted for 5% of total assets at FYE06.

On 1 January 2006, NTB merged with MLL, a longe stablished specialised leasing company acquired by the John Keells group in 2004, thereafter rebranded as Nations Leasing (NL). Effected through a share swap, the merger boosted the bank’s capital base by LKR1bn, and enabled it to meet the enhanced regulatory minimum capital requirement of LKR2.5bn imposed on LCBs ahead of the end-2007 deadline, also giving it fast access to a higher yielding product.

Together with MLL,NTB also acquired three fully owned subsidiaries of MLL that provide operating leases, as well as the company that owns the office building that housed MLL and a captive insurance broking service. In addition, the merger presented the bank with an opportunity to enter the factoring business. Leasing contributed 13% to NTB’s total income before interest expenses in FY06. Exposure to the consumer segment formed 33% of the loan book at FYE06. In this segment, NTB has generally sought mid- to high-income customers.

The SME segment accounted for 21% of the total at FYE06, and includes the lease portfolio, which is secured by the leased asset. Consequently, dominant exposure is to the corporate segment, which formed 46% of the bank’s loan book at FYE06.
In January 2007, the CBSL restricted the ownership of shares in banks carrying voting rights to a maximum of 15%. Consequently, it has issued a directive requiring John Keells and Central Finance groups to decrease their material interests in NTB to this level by 2012. The directive also states that failure to do so will result in voting rights being reduced to 10%.

Performance

• Significant increase in profitability NTB reported substantial loan growth of 73% during FY06, although from a low base, which increased its loan book by LKR11.7bn in FY06. However, 33% of the increase stemmed from loans acquired from MLL.

The pace of loan growth remained high during H107, at 30% (annualised).
Net profit increased significantly by 159% during FY06 to LKR323m, supported by strong growth in loans and a healthy NIM derived from both the acquired leasing business and organic growth.

Consequently, profitability, measured by ROA, rose to 0.9% in FY06 from 0.5% in FY05, although this is still just below the level for most peers. Despite a dip to 0.8% (annualised) at end-H107 caused by higher interest costs of mobilising funds[, Fitch expects a moderate increase in profitability.

Net Interest Income
Loans accounted for 58% of NTB’s total assets at FYE06. Most, except for leases and housing loans (25% of the book), are priced on a floating-rate basis, somewhat insulating the NIM. The proportion of government securities held was a high 25% of total assets at FYE06 (10% at the bank’s subsidiary).

Despite increased interest costs, NTB’s NIM rose to 5.6% in FY06 as a result of its increased exposure to higher-yielding consumer assets, underpinning 81% growth in net interest income during the year. The NIM decreased to 4.5% in H107 owing to higher interest costs, as funding shifted to more expensive time deposits. Although these rising costs may make it difficult for the bank to sustain the NIM, Fitch believes, its focus on the consumer segment should keep margins healthy.

Non-Interest Income
The proportion of total income contributed by noninterest income fell to 35% in FY06 owing to the rise in net interest income. Credit-card-related income comprised 39% of non-interest income in FY06 (33% in H107), and is expected by Fitch to remain the primary component of non-interest income.

Commission and foreign exchange income (other than that derived from credit cards) accounted for 29% and 19% of non-interest income, respectively, in FY06.

Operating Expenses
NTB’s cost structure remains high compared with peers as the bank is still new and is in its investment and growth phase. Although operating costs (excluding provisions) increased by 58% in FY06, 40% of this rise related to the merged entities. As a result, the cost/income ratio remained high, at 69% in FY06, despite a decrease from 73% in FY05 as a result of income growth. Personnel costs accounted for 35% and premises and equipment costs for 21% of operating costs in FY06. Depreciation increased by 83% following the acquisition of fixed assets (including a revalued office building) at the time of the merger and the revision of the national accounting standard that required depreciation to commence from the point at which an asset is available for use. The cost/income ratio dipped to 66% in H107, although this is still high.

Prospects
NTB is likely to retain its focus on the consumer segment, and consumer assets should therefore dominate the loan book. The bank intends to maintain its current pace of growth, although this may be dampened by currently high interest rates.

While its assets grew at a CAGR of 36% between FY03 and FY06, NTB is still a small to mid-sized bank. The bank will need to gain considerable mass if it is to achieve economies of scale, diversify its portfolio risk and sustain profitability.

Risk Management
In Fitch’s opinion, NTB’s risk management function is reasonably good. The bank has achieved some diversification of its activities and has also streamlined its support services in response to growth in transaction volumes.

However, some risk could arise from the leasing and credit card businesses, which the bank expects to be major growth areas. The contribution from these businesses was 28% of total income before interest expenses in FY06, from a small asset base of 17% of total assets at FYE06. In addition to the intense competitive pressure in the leasing and credit cards businesses, these loans could be more vulnerable than other types in an economic downturn. Hence, growth in these businesses needs to be carefully managed.

The board audit review committee, comprising nonexecutive directors, examines the activities of the bank and advises management and the board on the management of risk.

Like most other banks, NTB plans to adopt the standardised approach to calculating capital adequacy under Basel II from FY08, and prepares parallel capital adequacy calculations.

Credit Risk
Credit risk management is structured around evaluation, approval, monitoring and recovery processes that are supplemented by procedure manuals, standardised forms and information systems.

Credit approval follows a hierarchical scale of delegated authority according to the risk classification of the customer, based on an internal rating. The final approving authority is the board credit committee, consisting of non-executive directors.

In addition to granting approval, the management credit committee also reviews NPLs, sector exposures and customer classifications. It refers credits that are outside its authority to the board credit committee, which examines all credits approved by management on a monthly basis and large unsecured credits on a quarterly basis.

The credit risk management unit evaluates credit proposals above a certain threshold, reviews excesses and monitors industry and sector exposures.

Credit administration and management is independent of the business units. The credit administration unit manages operational issues related to the granting of credit facilities, such as the control of security, the loading of limits into the system and the provision of reports.

Credit risk management is further facilitated by good management information systems. Comprehensive reports based on data obtained from the system are prepared on a monthly basis for submission to the board.

Customer concentrations fell but remain high: the 10 largest exposures accounted for 13% of total on- and off-balance-sheet exposure and 152% of equity at FYE06. The enhanced capital enabled NTB to raise its absolute exposures, although these are mostly to established corporates. Exposure to the promoters accounted for 2% of total exposure and 23% of equity at FYE06.

Exposure to the leasing industry (other than through NL) i.e. to other finance and leasing companies accounted for 11% of loans at FYE06. Consequently, NTB’s total exposure to the leasing industry (either directly or indirectly) was 30% of loans at FYE06. NPLs increased by 50% during FY06. However, one-third of incremental NPLs in FY06 were those acquired from MLL. NPLs at NL constituted 39% of the total at FYE06.

Nevertheless, the gross NPL/gross loan ratio fell to 3.6% at FYE06 from 4.2% at FYE05 as a result of loan growth, which compares well with peer levels and the system average of 5.7%. The NPL ratios for leases and credit cards were 6.7% and 5.5%, respectively, at FYE06 and compares well against the industry.. The gross NPL/gross loans ratio decreased to 3.5% at end-H107 as a result of further loan growth during this period.
The ageing of NPLs indicates that most fell into the specially mentioned category (three to six months in arrears). Loans are now classified as NPLs at NL once they are three months overdue (as a specialised leasing company, MLL had classified loans as NPLs at six months). In H107, 42% of NTB’s NPLs fell into the overdue or three to six months in arrears category, which does not require specific provisions under CBSL regulations.

NTB’s provisioning policy for NPLs is more stringent than the CBSL stipulates except in the case of leases, where it follows CBSL guidelines. as the bank provides for potential losses early, although it considers collateral values before making a provision.

The CBSL required all banks to make mandatory general provisions of 0.1% per quarter for 10 consecutive quarters on all performing loans and overdue NPLs commencing from Q406 until they had accumulated a general provision of 1%. NTB already maintains a 1% general provision to cover potential losses on all loans except for those that are secured against cash. Consequently, total loan loss provision coverage was good, at 76% at FYE06.

Specific provision coverage increased to 54% at FYE06 from 50% at FYE05, but declined to 46% at H107 as a result of NPL accretion.
Solvency, as measured by net NPLs/equity, improved to 16.3% at FYE06 from 22.8% at FYE05, mainly owing to the increase in equity at the time of the merger; this compares favourably with peer levels. However, net NPLs/equity deteriorated to 23.6% at H107 due to NPL accretion and deductions from equity (See Capital). Fitch notes that, while
NTB’s solvency compares favourably with peer levels, it will nevertheless come under further stress unless NPL accretion is contained and the equity position increased – especially considering the risks posed by the fairly high unsecured portion of the loan book.

Fitch notes the risk profile of the consumer and SME segments targeted by NTB, while observing that most such loans are secured. Given the bank’s high and growing exposure to these segments, they are likely to determine its overall asset quality. The current economic environment may pose a challenge to NTB’s ability to maintain asset quality, calling for intensive screening of potential customers and close follow-up action.

Market Risk
Interest rate and foreign exchange rate risk positions are controlled by board-approved limits. The treasury is responsible for managing market risk and must ensure that exposures remain within the limits. These positions are periodically monitored by the assets and liabilities management committee (ALCO). The bank also uses derivatives such as interest rate swaps (LKR1,056m) and currency swaps (LKR5,169m) to hedge some of its market risk exposure.

Funding and Liquidity

• Deposits and borrowings accounted for an equal share of funding NTB recorded deposit growth of 44% yoy in FY06. The proportion of costlier time deposits to cheaper savings and demand deposits has remained relatively unchanged, accounting for 60% and 31% of total deposits, respectively, at FYE06. The bank had low deposit concentrations at FYE06. the proportion of funding from deposits fell to 43% in FY06 owing to the increase in borrowings, but increased to 53% at H107.

Borrowings rose substantially, accounting for 43% of funding at FYE06, following an increase in money market borrowings as the bank took advantage of a steep yield curve. However, it reverted to 34% of funding at H107, as money market borrowings shifted back into deposits, which accounted for 53% of funding at H107. Borrowings under repos accounted for 59% of NTB’s borrowings at FYE06.

NTB obtained multilateral funds in the form of an LKR-denominated subordinated loan of EUR5m from the Netherlands Development Finance Company (FMO) in FY04 and FY05. The loan contributes to the funding of the bank’s housing loan portfolio and also qualifies as Tier 2 capital.
The bank issued unsecured subordinated redeemable debt of LKR560m during FY06. The issuance also qualifies as Tier 2 capital and was used to fund the leasing portfolio.

NTB’s statutory liquidity position is comfortable at FYE06 and H107.
Mismatches between interestbearing assets and liabilities are present in the underone- year category, as is the case for other banks, due to a higher proportion of short-term deposits and borrowings.
The bank’s leverage, as indicated by loans/customer and short-term funding, fell to 98.2% at FYE06 from 110.4% at FYE05.

Capital

• Satisfies the regulatory minimum capital requirement
  The shares issued at the time of the merger boosted NTB’s capital base to LKR2.8bn at FYE06 from LKR1.4bn at FYE05. Consequently, the bank has satisfied the enhanced regulatory minimum capital requirement of LKR2.5bn imposed on LCBs ahead of the end-2007 deadline.

Equity/assets increased to 6.0% at FYE06 from 5.8% at FYE05. However, core and total capital adequacy ratios (CAR) decreased to 7.9% and 11.9%, respectively, at FYE06 from 8.7% and 13.9%, respectively, at FYE05. CARs were depressed by the increase in regulatory risk weights on “‘Loans secured by a primary mortgage over residential property” to 55% from 50% and “Other loans and advances” to 110% from 100%.

Strong loan growth, sustained during H107, and the payment of a dividend after full provision for goodwill caused NTB’s capital ratios to fall during H107. Consequently, equity/assets decreased to 5.2%, and core and total CARs to 6.9% and 10.7%, respectively, at end-H107.
Fitch expects the bank’s capital ratios to decline further if the current pace of growth is maintained.

Source:Fitch Ratings