Fitch Ratings Lanka Affirms SMIB's 'A(lka)' Rating

Fitch Ratings Lanka has affirmed the National Long-term 'A(lka)' rating of the State Mortgage and Investment Bank (SMIB). The Outlook on the rating is stable.

SMIB's rating is driven by its state ownership, relatively high profitability, and strong capital position.

The rating also factors in its relatively weak competitive position and asset quality, and the inherent limitations in SMIB's business model as a specialised housing finance bank catering to the low-middle income segment.

Overall portfolio growth showed signs of improvement with total loans increasing by 7.4% over the first nine months of 2006 from 5.4% during the financial year '05, albeit still well below that of industry peers. The bank has become increasingly reliant on housing loans secured by the borrower's employee provident fund balances in order to offset the decline in mortgage loans. The credit risk posed by EPF loans was minimal due to the bank's ability to resort to the provident fund for recoveries, and can only be offered by a few selected state banks. However, Fitch notes that over-reliance on EPF loans exposes SMIB to vulnerabilities such as those which would arise if the scheme was to be discontinued or significantly altered.

SMIB's funding is primarily from deposits (54.1% of assets at end-Q306), with equity and borrowings contributing 25.4% and 14.0%, respectively. However deposit concentrations are high, with five public institutions accounting for 31.7% of deposits at end-Q306.

SMIB's Tier 1 and total capital adequacy was high (91.34 and 92.59%, respectively) at end-Q306, due to SMIB's large equity base and the low regulatory risk weights assigned to housing loans. However, Fitch observes that SMIB's internal capital generation is constrained due to its historically high payout ratio. 62.4% and 70.9% of net profits was paid out to the state's consolidated fund during FY04 and FY05, respectively. Although the bank's capital base is adequate to support current levels of loan growth, low internal capital generation could be a key limiting factor over the long term.Profitability remained strong with net interest margins ("NIM") improving to 9.0% (annualised) at end-Q306 from 8.3% at FYE05 despite increasing borrowing costs brought on by rising market interest rates over the period. The high NIM is primarily driven by the increase in penal interest recovered on EPF loans in tandem with the growth in the EPF loan portfolio, along with SMIB's significant capital funding. Return on assets ("ROA") compares well against other banks (3.5% annualised at end-Q306), but is likely to be constrained over the near term due to expected increases in operating costs.

The agency notes that SMIB's monitoring and follow-up procedures were enhanced during H206, resulting in a significant improvement in the asset quality within SMIB's mortgage portfolio as well as the resultant solvency. As such, gross non-performing loans ("NPLs") reduced to 14.7% of gross loans at end-Q306 (from 21.0% at FYE05), with absolute mortgage NPL's reducing by 26% during Q306 alone. Solvency (measured by Fitch as net NPL's/Equity, and excluding EPF loan NPL's) improved to 27.0% from 40.5% during the period. Nevertheless SMIB's asset quality and solvency remain weaker than that of its peers.

SMIB is one of Sri Lanka's oldest banks and traces its origins to the Ceylon State Mortgage Bank of 1931. It was constituted in its present form as state-owned bank in 1979, and operated through its head office in Colombo and through district representatives until 1990. The bank subsequently obtained Licensed Specialised Bank status in 1998 and currently has a network of eight outlets, with the two latest additions being made in December 2006.