The ratings are driven by DFCC's strong capitalisation - consolidated Tier 1 capital adequacy ratio of 24.2% as of end-June 11, supported by its sustained solid profitability on the back of an improving economic and operating environment. The ratings also factor in DFCC's high exposure to risky long-term project finance, reliance on long-term bilateral and multilateral funding sources and the consequent need for higher capitalisation, relative to peers.
A sustained weakening in credit quality or profitability could stress DFCC's capital base and may place downward rating pressure. In addition, Fitch expects that as DFCC's commercial banking subsidiary - DFCC Vardhana Bank Limited (DVB, a 99.1% stake) - grows to account for a larger share of group assets, there could be a shift in the group's risk profile which could place pressure on DFCC's ratings. DVB accounted for 36% of DFCC group assets at end-June 2011 (March 2010: 35%, March 2009: 29%). Taking into account the inherent risks in DFCC's business model, Fitch sees limited scope for an upgrade.
Project finance accounted for 72% of DFCC's advances (55% of group advances) at end-March 2011. Project lending is long-term in nature and largely funded by long-term borrowings from institutional lenders. Institutional borrowings accounted for 40% of total bank funding (group: 27%) with DFCC also having a high proportion of equity funded assets (25%). Group concentration to project finance has decreased due to growth at DVB.
Consolidated non-performing advances (NPA) fell 23% from March 2010-June 2011, supported by greater recovery efforts at DFCC and DVB, and as DFCC borrowers' credit profiles benefited from an improving economic environment. Lower NPAs, together with the bank's prudent provisioning policy and a higher capital base, resulted in net NPAs falling to 6.4% of equity at end-June 2011 (end-March 2010: 14.6%) which compares well with local peers.
Total advances at the group level expanded 14.6% in the financial year ended March 2011 (FY11), driven largely by loan growth at DVB. Credit growth was slower to pick up pace at DFCC as project finance lending tends to lag improvements in the economy. However, as increased volumes of facility approvals in FY11 are being converted into disbursements Fitch expects growth to accelerate in FY12. Loans expanded 3.3% in the quarter ended June 2011.
Consolidated profits were boosted by a one-off gain of LKR3bn (post tax) from the sale of DFCC's stake in an associate in FY11. Of the gain, LKR1.8bn was paid out in dividends and another LKR1.1bn invested in DVB. Part of the income was also used to shore up loan loss reserves. Return on assets (adjusted for the gain) fell to 2.3% in FY11 (FY10: 3%) as associate contribution to profits fell and operating costs increased. Nevertheless, profitability remained strong compared to local peers'. Fitch expects core profitability to improve as net interest margins widen with loan growth and incremental provisioning costs reduce with improving asset quality.
DFCC is a licensed specialised bank and Sri Lanka's only development finance institution.