"The downgrade reflects the bank's inability to swiftly re-price its existing housing loan portfolio to avert deterioration in profits as market interest rates started to rise since end-2011," the rating agency said.
"This failure of timely re-pricing has further accentuated the interest rate risk inherent in HDFC's balance sheet due to maturity mismatches between its assets and liabilities."
BBB is still in the investment grade.
The bank's outstanding 195 million rupees of senior unsecured redeemable debentures have also been downgraded to 'BBB(lka)'. The outlook on both ratings is stable.
Fitch said with 51 percent state ownership support was expected if needed. Credit management was also satisfactory, with overdue loans only 1.8 percent of total advances.
The full statement is reproduced below:
Fitch Downgrades Sri Lanka's HDFC Bank to 'BBB(lka)'; Outlook Stable
Fitch Ratings-Colombo/Seoul/Singapore-29 November 2012: Fitch Ratings Lanka has downgraded the Housing Development Finance Corporation Bank of Sri Lanka's (HDFC) National Long-Term Rating to 'BBB(lka)' from 'BBB+(lka)'.
The Outlook is Stable. Its LKR195m outstanding senior unsecured redeemable debentures have also been downgraded to 'BBB(lka)' from 'BBB+(lka)'.
The downgrade reflects the bank's inability to swiftly re-price its existing housing loan portfolio to avert deterioration in profits as market interest rates started to rise since end-2011. This failure of timely re-pricing has further accentuated the interest rate risk inherent in HDFC's balance sheet due to maturity mismatches between its assets and liabilities.
The current rating and Stable Outlook reflect Fitch's expectations that the Government of Sri Lanka, with over 51% ownership of HDFC, is likely to provide support to the bank under extreme circumstances if required. This is based on the bank's linkages with the state, and its quasi-policy role in supporting the government's initiatives towards low- and middle-income housing.
The state's ownership stake in HDFC is almost entirely held via the National Housing Development Authority - a state-owned corporation that is tasked with formulating and implementing the national housing policy. HDFC's board is appointed by the Ministry of Finance, and seven out of a total of nine board members are senior public servants, representing key ministries and state-owned corporations, most of which are related to housing and construction. A majority of HDFC's clientele consists of low and middle-income consumers who have limited access to traditional bank credit.
HDFC's profitability weakened sharply in the nine months to September 2012 (9M12), driven by increasing borrowing costs in line with rising market interest rates. Consequently HDFC's return on assets (ROA) fell to an annualised 0.07% at end-9M12 (end-2011: 1.77%). The bank increased interest rates on its existing housing loans with effect from 1 October 2012 - by up to 200bps or up to a ceiling rate of 18% - which the bank expects will stem the deterioration in profits in the near-term.
HDFC successfully amended its Act of Incorporation in November 2011, in order to be able to disburse short-term lending products such as gold-backed loans, Islamic finance, and leasing. Furthermore the bank expects to introduce variable-rate housing loans starting in 2013 which will be re-priced annually in line with market rates. However, gaining a critical mass in these products is likely to take 24 months or more, and the successful implementation of these strategies will be key in determining the level of HDFC's long-term profitability.
HDFC's credit risk management has been satisfactory, considering the low income nature of its borrowers. Credit quality is supported by the low default risk of housing loans relative to other consumer loans. Loans in arrears of over 18 months have remained broadly below 1.8% of total advances between 2009 and 2012.
HDFC's rating may be downgraded further if its linkages with the state weakens, including a dilution of the state's majority ownership of the bank. Fitch does not expect rating upside for HDFC over the medium-term, given that a successful reduction in the bank's exposure to interest-rate risk will likely take longer to implement.
HDFC is a licensed specialised bank created by an Act of Parliament. At end-September 2012 HDFC's asset base stood at LKR20.4bn, while it had a network of 21 branches and 11 service centers.