Fitch Ratings-Colombo/Mumbai/Singapore-24 December 2009: Fitch Ratings Lanka has today affirmed Union Bank of Colombo Ltd's (UB) National Long-term rating at 'BB+(lka)'. The Outlook is Positive.

The rating reflects UB's moderate asset quality and lack of a broad deposit base. Also, the rating remains constrained by the bank's low profitability given the low-yielding deep-discount bond, (DDB) and challenges to the scalability of its operations. The positive outlook reflects the bank's plans to raise equity in 2010 and the expansion plan underway that is expected to improve its profitability.

UB was restructured after posting negative equity in 2002, after the bank transferred LKR600m in cash and LKR978m of NPLs to a special-purpose vehicle (SPV), in return for a 20-year DDB guaranteed by Sampath Bank PLC (SB, 'AA-(lka)'/Stable Outlook); SB was involved in UB's restructuring process and also made equity infusions.

Thereafter, Central Bank of Sri Lanka (CBSL) in 2006 increased the minimum capital requirement (MCR) for licensed commercial banks to LKR2.5bn (from LKR0.5bn), to be met by H110 (extended from the previous FYE09 deadline). Several equity infusions occurred from FY03-FY07, from both existing and new shareholders, which increased equity to LKR1.5bn at Q309. Given UB's low profitability due to the low yielding DDB (17% of interest earning assets at Q309 and yield of 4%) and the resulting constraints in generating internal capital, Fitch notes that achieving the LKR2.5bn MCR by H110 would require a further equity infusion of approximately LKR1bn. UB's management has informed Fitch that investors are committed to infusing this balance equity by the stipulated deadline.

NPLs deteriorated in Q309, while its loan book remained flat amid challenging macroeconomic conditions (loan growth in FY08: 28%); consequently UB's NPL/gross loans increased to 11.6% at Q309 (FYE08: 4.8%); focused recoveries in the period ensured that "advances in arrears more than 12 months" remained static in nominal terms throughout the period.

UB obtained CBSL approval to open five new branches (predominantly in the Northern Province) in Q309. UB has already extended three of these branches. Increased branch expansion will provide UB opportunities to increase its scale of operations significantly both on its lending portfolio and deposit base, and thereby reduce the overall drag on yields from the DDB on UB's financial profile. UB is currently ramping up credit controls and personnel to create capacity to handle increased lending volume both in the newly extended branches as well as the existing network.

Established in 1995, UB is a small commercial bank (0.4% of system assets) with 14 branches and an asset base of LKR13.3bn at Q309. SB was the single largest shareholder in UB with 17.7% of the latter's issued capital at Q309.

A credit update report will be made available shortly on Fitch's websites, www.fitchratings.com and www.fitchratings.lk.