Sri Lankan banks are likely to significantly boost issuance of Basel III-compliant Tier 2 instruments in 2018, says Fitch Ratings. Most banks will need to raise capital to meet higher Basel III requirements that take full effect in January 2019, and to support balance-sheet expansion. Banks will also need to undertake significant Basel III Tier 2 issuance, as a result of the phasing out of legacy instruments – and ongoing redemptions. Around LKR119 billion in qualifying legacy Basel II Tier 2 instruments that are subject to a 20% discount per year were outstanding at end-3Q17.
Fitch has rated Basel III instruments of four Sri Lankan banks since the framework was introduced in July 2017. Only Sampath Bank has so far undertaken public issuance in the domestic market. Our approach to rating Basel III instruments is to notch down from an issuer’s anchor rating based on non-performance and loss severity risk, as per our global criteria.
The anchor rating is usually based on the bank’s standalone strength, because in most cases sovereign support cannot be relied upon to extend to a bank’s junior debt. We have followed this approach for Sampath Bank’s Basel III-compliant Tier 2 issuance and in our expected ratings of proposed issuance by Seylan Bank and Nations Trust Bank.
That said, there is a case to factor extraordinary sovereign support into the anchor ratings of Basel III Tier 2 instruments for banks that have strong state linkages and are also systemically important, as the state is likely to have a strong interest in supporting the instruments of these banks before loss-absorption features are triggered. The anchor rating for instruments of such banks is their support-driven IDR or support-driven National Long-Term Rating. We took this approach in our rating of Bank of Ceylon’s proposed issuance.
Fitch does not generally apply any incremental notching to Basel III Tier 2 instruments for non-performance risk, which is judged to be broadly similar to that of senior debt. These instruments usually specify that losses are triggered only at a bank’s point of non-viability, and do not include any going-concern loss absorption. In Sri Lanka, the loss-absorption trigger point for Basel III Tier 2 instruments is defined as a decision by the Monetary Board that a write-down or public-sector support is necessary to avoid a bank becoming non-viable.
Loss-severity risk is higher for Basel III Tier 2 instruments than for senior debt. Our usual approach is therefore to rate the instrument one notch below the anchor rating in cases of below-average recoveries, and by two notches in the case of poor recoveries – such as when there is a significant risk of full contractual write-down. In Sri Lanka, triggered instruments are required to absorb losses either through conversion to ordinary shares or a write-down mechanism. We rated the Basel III Tier 2 issuance of Sampath Bank, Seylan Bank, Nations Trust Bank and Bank of Ceylon one notch below their respective anchor ratings to reflect below-average recovery prospects.
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