Fitch Affirms Bank of Baroda's IDR at 'BBB-'; Outlook Negative

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Fitch Affirms Bank of Baroda's IDR at 'BBB-'; Outlook Negative
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(The following statement was released by the rating agency) Fitch Ratings-Singapore/Mumbai-03 December 2020: Fitch Ratings has affirmed India-based Bank of Baroda's (BOB) and wholly owned subsidiary Bank of Baroda (New Zealand) Limited's (BOB NZ) Long-Term Issuer Default Ratings (IDRs) at 'BBB-'. The Outlook is Negative. The agency simultaneously affirmed BOB's Viability Rating (VR) at 'bb-', Support Rating (SR) at '2' and Support Rating Floor ( SRF (NS: SRFL )) at 'BBB-'. A full list of rating actions is at the end of this commentary. The Negative Outlook on BOB's IDR mirrors the Outlook on India's sovereign rating (BBB-), which was revised to Negative from Stable on 18 June 2020 due to the impact of the escalating coronavirus pandemic on India's economy (for more details, please see "Fitch Revises India's Outlook to Negative, Affirms IDR at 'BBB-'" at www.fitchratings.com/site/pr/10126674). The operating environment for Indian banks remains challenging despite a moderate revival in economic activity due to gradual easing of the lockdown since May 2020. Fitch revised India's fiscal year ending March 2021 (FY21) real GDP to -10.5% from -5% in September 2020, but expects India's real GDP to rebound to 11% in FY22, largely as a result of the low base. The economic contraction is likely to result in protracted weakness in the asset-quality cycle, which could manifest in significantly higher stressed loans and ultimately more write-offs over the next few years, even though Indian banks' latest 2QFY21 earnings present a more benign picture (please see "Indian Banks to Face Tough Times" at www.fitchratings.com/site/re/10137748). Fitch believes a speedy economic recovery is critical for the sector to rebound meaningfully, even though we expect to see a moderately worse landscape for the Indian banking sector in 2021 on weak prospects for new business and revenue generation. Private banks with stronger loss-absorption buffers will be in a better position to benefit from the recovery against state-owned counterparts, which are generally burdened with greater balance sheet challenges and weaker loss-absorption buffers. Key Rating Drivers IDR, SUPPORT RATING AND SUPPORT RATING FLOOR BOB's Long-Term IDR is driven by its SR of '2' and SRF of 'BBB-', which reflects Fitch's expectations of a high probability of extraordinary state support for BOB, if required. This is based on the bank's high systemic importance from large market shares (6.5% of sector assets and 7% of deposits), its pan-India franchise and majority government ownership (71.6% state ownership). Moreover, large state-owned banks such as BOB play an important policy role in furthering the state's social-lending objectives and thus promote financial inclusion. Fitch believes a default by a large bank such as BOB could result in a general loss of confidence in the sector and pose high reputational risk for the state. The Negative Outlook on the IDR mirrors the Outlook on the Indian sovereign IDR of 'BBB-'. BOB NZ is a fully owned subsidiary of BOB and its IDR is driven by a high probability of support from its parent and, ultimately, from the Indian government. There is strong integration between the two entities, and BOB NZ's small size relative to the parent makes potential support manageable. Therefore, we expect government support for BOB to flow to the subsidiary. VIABILITY RATING BOB's intrinsic profile remains largely unchanged since our last VR action on 30 April 2020. It represents a moderate degree of fundamental financial strength as its capitalisation and earnings are vulnerable to even moderate shocks, which we believe is yet to fully manifest for BOB and other Indian banks. The bank's pan-India domestic franchise and state linkage ensures continuity of stable funding and liquidity, but they have less influence on the VR than do other factors. We believe there is further downside risk to BOB's financial profile unless the moderate loss-absorption buffers, in particular capitalisation, are strengthened. The bank's less-than-satisfactory core capital buffer is most at risk from the heightened stress. BOB's reported common equity Tier 1 (CET1) ratio of 9.2% at end-September 2020 (1HFY21) is lower than most comparable peers and offers only 120bp buffer over the regulatory minimum of 8.0% that banks are supposed to meet from April 2021. The bank had notified the stock exchanges earlier this year that it planned to raise INR135 billion in capital, of which INR90 billion was likely to be in fresh equity. The proposed amount - if raised in full - will add about 150bp to the bank's core capital ratio but not enough to fully mitigate the risk to capital (net non-performing loan (NPL)/CET1 ratio: 30%; 25% post-equity adjustment) if asset-quality stress leads to further losses and capital erosion, as we believe is most likely. However, a sharply discounted equity valuation (price/book: 0.13x) poses a significant challenge for fresh equity raising from the markets, although the state could chip in with capital infusions as the majority owner in a similar way to most state-owned banks. The bank reported a profit in 2QFY21 (after a loss in 1QFY21 and FY20) but overall profitability remains weak with operating profit/risk-weighted assets at 0.4%. The available buffer is thin considering that loan and securities impairment charges/pre-provision profits is still around 87%, despite a material decline in credit costs to 1.6% of loans in 1HFY21 from 2.5% in FY20. Overall income levels are likely to remain muted on weak credit growth. As such, we believe that the bank's coronavirus-related provisions of 0.2% of loans will not be sufficient if there are significant fresh slippages in impaired loans (and restructured loans) from the special mention asset pool, which cumulatively amounted to 5.5% of loans (comprising loans overdue 30 days and 60 days). We expect some reprieve on operating costs (cost/income ratio: 47.8%) in the near term, as management plans to complete the merger integration of Vijaya Bank (NS: VJBK ) and Dena Bank (NS: DENA ) by December 2020 (latest March 2021), after which cost-saving strategies will be in focus. However, credit costs are likely to remain the key determinant of near-term profitability. We maintain the negative outlook on asset quality notwithstanding the modest improvement in both impaired loans ratio (1HFY21: 9.1%; FY20: 9.4%) and loan-loss coverage (1HFY21: 74.4%; FY20: 68.9%), with the former benefiting by about 20bp from the judicial stay on recognition of moratorium loans as NPL. Fitch believes the impaired loans ratio is yet to reflect the true nature of the economic stress inflicted by the pandemic, although a rise in special mention loans has been in line with Fitch's expectations. A sharp increase in delinquencies or restructuring would weaken loan-loss coverage and reverse the trend on the net impaired loans/CET1 ratio (1HFY21: 30.1%; FY20: 37.6%). Deposits account for 84% of BOB's total liabilities, while customer deposits account for 93% of total funding. This stems from high depositor confidence on BOB's close government links as well as size and reach. BOB also reported a low-cost deposit ratio of nearly 40% at 1HFY21, up 70bp from FY20. We expect the loan-deposit ratio to remain low (1HFY21: 75.3%) until credit growth materially resumes. The bank is also carrying excess holdings of government securities (nearly 650bp over regulatory minimum), which we believe will continue to support liquidity coverage ratio (FY20: 136%) and asset-liability management. Managing offshore liquidity is critical in the near term, although available buffers seem sufficient. SENIOR DEBT BOB's senior debt rating is at the same level as the IDR, as the debt represents unsecured and unsubordinated obligations. RATING SENSITIVITIES IDRS, SUPPORT RATING, SUPPORT RATING FLOOR AND SENIOR DEBT Factors that could, individually or collectively, lead to negative rating action/downgrade: The SR and SRF are most sensitive to Fitch's assessment of the government's propensity and ability to support BOB, based on the bank's size, systemic importance and linkage to the state. Weakening of the government's ability to provide extraordinary support - reflected by negative action on India's sovereign ratings - would lead to negative action on the IDR. Negative action on the IDR is also likely should Fitch perceive any reduction in the government's propensity to extend timely support, in which case the agency will reassess the SR and SRF, and the bank's IDR and senior debt ratings, although that is not our base case. Any change in BOB's IDR would have a similar impact on BOB NZ, but the latter's IDR could also be downgraded by a weaker propensity for its parent and, ultimately, the government, to support the subsidiary. Factors that could, individually or collectively, lead to positive rating action/upgrade: A revision of the sovereign rating Outlook to Stable would lead to a corresponding revision on the Outlook on BOB's IDR, provided the sovereign's propensity to support remains unchanged. An upgrade to BOB's SRF could occur in the event of a sovereign upgrade if Fitch believes that the sovereign's ability and propensity to support the bank has improved. However, an upgrade of the sovereign rating appears less certain in the near term. Any changes in BOB's IDR would result in equivalent changes to the senior debt rating. It would also have a similar effect on BOB NZ. VIABILITY RATING Factors that could, individually or collectively, lead to negative rating action/downgrade: BOB's limited loss-absorption capacity against heightened stress implies that the VR could be vulnerable if there is a more severe weakening of the loan portfolio (stressed asset ratio of impaired loans + restructured loans approaching 15% from 9.1% impaired-loan ratio at 1HFY21) and impairment charges. This would put further pressure on earnings and, potentially, capitalisation - a key influencing metric on the VR, unless it is sufficiently augmented. A drop in CET1 ratio closer to the regulatory minimum of 8% would most likely be more consistent with a 'b' category score. Fitch believes the bank's measures to help clients through the downturn will become less effective the longer the downturn lasts, which is likely to limit the speed of recovery after the pandemic has been brought under control. Factors that could, individually or collectively, lead to positive rating action/upgrade: There is little prospect of an upgrade in the VR in the near term in light of the risk to the bank's intrinsic profile from rising external pressures. However, downside risk will be lower if the economic downturn is shallower and the recovery is faster than expected in Fitch's base case, as this may result in less deterioration in the bank's asset quality (from 9.1% impaired-loan ratio at 1HFY21), earnings and profitability. Core capitalisation is also an important factor for the VR; the bank's ability to improve core capitalisation to levels near 12% is important before any VR upgrade can be considered. Best/Worst Case Rating Scenario International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit [https://www.fitchratings.com/site/re/10111579] REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria. ESG Considerations BOB has an ESG Relevance Score of '4' for Governance Structure. It reflects our assessment that key governance aspects, in particular board independence and effectiveness, ownership concentration and protection of creditor or stakeholder rights are a moderate influence on the VR. It is a negative influence since Fitch views governance to be less developed for state banks, which is evident from weak underwriting that results in high levels of poorly performing loans and credit losses. The board is dominated by government appointees, and business models often focus on supporting government strategy with lending directed towards promoting socioeconomic and macroeconomic policies, which may include lending to government-owned companies. These factors also drive our view on the bank's state linkages that affect support prospects that drive the long-term ratings. BOB has an ESG Relevance Score of '4' for Financial Transparency. It reflects our assessment that the quality and frequency of financial reporting and the auditing process are a moderate influence on the VR. It is a negative influence however since these factors have become more prominent in the past few years because of the sharp financial deterioration at state banks as well as the widely reported divergences in NPL recognition between the banks and the regulator, although these incidences have narrowed in recent years. Still, financial transparency is pivotal for general business and depositor confidence and can lead to significant reputational risk if not managed well. Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg Bank of Baroda; Long Term Issuer Default Rating; Affirmed; BBB-; Rating Outlook Negative ; Short Term Issuer Default Rating; Affirmed; F3 ; Viability Rating; Affirmed; bb- ; Support Rating; Affirmed; 2 ; Support Rating Floor; Affirmed; BBB- ----senior unsecured; Long Term Rating; Affirmed; BBB- Bank of Baroda (New Zealand) Limited; Long Term Issuer Default Rating; Affirmed; BBB-; Rating Outlook Negative ; Support Rating; Affirmed; 2 Contacts: Primary Rating Analyst Willie Tanoto, Director +65 6796 7219 Fitch Ratings Singapore Pte Ltd. One Raffles Quay #22-11, South Tower Singapore 048583 Secondary Rating Analyst Saswata Guha, Director +91 22 4000 1741 Committee Chairperson Jonathan Cornish, Managing Director +852 2263 9901 Media Relations: Bindu Menon, Mumbai, Tel: +91 22 4000 1727, Email: bindu.menon@fitchratings.com Leslie Tan, Singapore, Tel: +65 6796 7234, Email: leslie.tan@thefitchgroup.com Peter Hoflich, Singapore, Tel: +65 6796 7229, Email: peter.hoflich@thefitchgroup.com Additional information is available on www.fitchratings.com Additional Disclosures Dodd-Frank Rating Information Disclosure Form (https://www.fitchratings.com/site/dodd-frank-disclosure/10144950) Solicitation Status (https://www.fitchratings.com/site/pr/10144950#solicitation) Endorsement Status (https://www.fitchratings.com/site/pr/10144950#endorsement_status) Endorsement Policy (https://www.fitchratings.com/site/pr/10144950#endorsement-policy) ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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