Fitch revises HDFC Bank outlook to Negative

Fitch Ratings Lanka said it has downgraded the National Long-term rating of The Housing Development Finance Corporation Bank of Sri Lanka (HDFC) to 'A-(lka)' (A minus (lka)) from 'A(lka)'. The outlook on the ratings has been revised to Negative from Stable.

The rating downgrades reflect HDFC's deteriorating profitability brought on by its inherent interest rate risk, and the escalation of such risk in the current interest rate environment.

The rating also factors in HDFC's significant state ownership, comfortable capital position, and the manageable and relatively low ultimate credit risk inherent in residential housing finance. The revision of the outlook to Negative reflects Fitch's views on the continuing challenges that will be faced by the bank in arresting its deteriorating profitability over the ensuing 12-18 months, in the prevailing weak macroeconomic environment, the rating agency said in a press release.

HDFC is exposed to a significant level of interest rate risk due to the inherent maturity mismatch between its funding avenues and interest earning assets.

While the bank's earning assets consist almost entirely of housing loans with tenures of 10-15 years at fixed interest rates, its funding comprises of local institutional borrowings and term deposits which are predominantly re-priced in cycles of one year or less. The bank's funding has gradually shifted away from concessionary fixed rate refinance loans from donor agencies and the government of Sri Lanka, the latter on account of the state's fiscal limitations. The rising interest rate environment in 2007 (where 1 year Treasury Bills rose by over 700 basis points) exacerbated HDFC's pricing mismatch.

Although the bank has increased its lending rates on its new loans in a bid to preserve margins, its ability to re-price loans originated in the past is limited due to the nature of the bank's clientele, who are largely fixed income earners from the low and middle income segments. Furthermore, profitability is constrained somewhat by low yielding directed loan schemes to state employees to the tune of Rs 900 million at 30 September 2007 (end-Q307).

Fitch said it remains concerned over the bank's ability to build adequate volume in the near term, in the prevailing high inflation/high interest rate environment.