Tashkent, Uzbekistan (UzDaily.com) -- Fitch Ratings has assigned Uzbekistan-based Joint-Stock Commercial Khalq Bank of the Republic of Uzbekistan (Khalq) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) of ‘BB-’. The Outlook on the IDRs is Stable. A full list of rating actions is at the end of this rating action commentary.

Khalq’s ‘BB-’ Long-Term IDRs reflect Fitch’s view of a moderate probability of support from the Uzbekistan sovereign (BB-/Stable) in case of need, as reflected in the bank’s Support Rating (SR) of ‘3’ and Support Rating Floor (SRF) of ‘BB-’. This view is based on (i) the bank’s exclusive policy role where Khalq acts as a pension and social distribution agent of the government, and accumulates and manages pension savings for the working population of Uzbekistan and (ii) the bank’s long-term strategic state ownership with no plans for privatisation, both of which considerations have a high influence on our assessment of potential support for the bank. The low cost of potential support relative to the sovereign’s foreign currency reserves, and a track record of support for the country’s public sector banks that dominate the banking sector are also important considerations in our assessment of support.

Khalq is a successor of Uzbekistan’s branch of Sberbank of USSR and has the widest branch network with over 1,100 offices. However, at end-1H19, it ranked as the sixth-largest bank in Uzbekistan with 5% of system assets, 4% of loans and 7% of deposits.

In Fitch’s view, Khalq has a stronger policy role than other Fitch-rated Uzbekistan’s policy banks due to its exclusive role in accumulating and managing individual pension savings accounts (from 2004) as well as distribution of pension and social payments (from 2017). In carrying out its social functions, Khalq has a significant exposure to interest rate risk, stemming from the required minimum interest rate being accrued on outstanding pension savings, which is determined by the government and is typically not lower than annual inflation. As a result of faster inflation in 2017 and 2018, funding cost for Khalq increased sharply and exceeded the yield of related assets, most of which were fixed-rate, long-term customer loans and bank placements extended in 2016 and earlier.

Net losses reported by Khalq in 2017 and 2018 were UZS131 billion and UZS334 billion respectively, driven mostly by a tightened net interest margin (1.5% in 2017 and 3.3% in 2018 versus over 6% in 2015 and 2016), coupled with weak operating efficiency (operating expenses at over 9% of average assets in 2018) and high credit costs (3.7% of average loans in 2017 and 3.3% in 2018). Net of pension-related income and expenses, the bank’s results were positive on a pre-impairment basis, with an adjusted return on average equity of about 5% in 2018.

Khalq is heavily reliant on state capital and funding support to maintain high growth and offset losses reported in 2017 and 2018. Since the start of 2017, the bank has received about UZS1.5 trillion (about USD180 million equivalent) of common equity from the state, including a capital gain from tax relief. By end-2019, the bank will receive a further UZS0.7 trillion. Additionally, at end-1H19, about 40% of the bank’s liabilities comprised state-related funds or borrowings from international financial institutions guaranteed by the Ministry of Finance (MoF).

The sovereign’s ability to provide support is solid, in our view, given the moderate size of the banking sector relative to the economy (total banking sector assets of USD25 billion with a loans/GDP ratio of 41% at end-2018), while Uzbekistan’s foreign currency reserves are relatively large at around USD27 billion. However, support considerations also factor in the high concentration of the banking sector, where state-owned banks represent around 80% of sector assets, and where sector loan dollarisation is close to 60%. The sector is vulnerable to external shocks, given a commodities-based economy whose external finances rely on remittances.

The bank’s loan quality is weak, with impaired (Stage 3) loans making up sizable 8.1% of gross loans at end-2018, which is significantly above the sector average. Stage 3 loans were just 22% covered by specific loan loss allowances, which is also weak coverage compared with other banks’ (40%-60%).

Positively, loan book concentration by single borrowers is low, with the 25-largest exposures making up just 13% of gross loans at end-2018, while the three-largest exposures (6% of loans) were represented by low-risk state-owned entities. The remaining loans are quite granular and comprise loans to SMEs, mostly in the agriculture (dairy farming and greenhouses) and residential construction industries. Additionally, Khalq has lower dollarisation of its loan book (20% at end-2018) than other state-owned banks, which is credit-positive.

Capitalisation levels are determined by the state, as is the case for other state banks, and regular capital injections ensure that regulatory capital adequacy ratios are maintained above minimum requirements. Our assessment is that capitalisation is tight for Khalq’s risks. At end-2018, the bank’s Fitch Core Capital (FCC) amounted to 16% of regulatory risk-weighted assets, while its Tier 1 regulatory capital ratio was 17.7% and its total capital ratio was 18%. However, after rapid 90% loan growth in 1H19, Khalq’s Tier 1 regulatory capital ratio fell 4pp to just 14% . Anticipated loan growth in 2H19 will be underpinned by an expected capital injection of UZS700 billion.

At end-2017, Khalq was funded mostly by pension savings, which made up 60% of total liabilities at that date. However, the most recent growth was mainly funded by state funding in the form of direct loans and deposits from the MoF and state development funds, along with international borrowings ultimately guaranteed by the MoF. Their total share increased to 40% of total liabilities at end-1H19 from 6% at end-2017. Liquidity risk is lower than at peers due to a substantial proportion of long-term pension savings (36% of liabilities at end-1H19), the early withdrawal of which is constrained by law, and due to sizable cash and bank placements, which were equal to 36% of total liabilities, including 10% being available within three months.

Fitch does not assign a Viability Rating (VR) to Khalq as its pension-related business model is not sustainable on a standalone basis and is entirely dependent on state support. In our view, Khalq’s unique pension-related policy role cannot be carried out on a commercial basis or transferred easily to another state-owned bank or public entity.

Rating actions on Khalq’s support-driven IDRs, SR and SRF will likely result from strengthening or weakening of the sovereign’s credit profile, mirroring changes to Uzbekistan’s sovereign ratings.

These ratings could be downgraded in the event that the state’s propensity to support Khalq weakens, for example should its policy role function in the distribution and accumulation of pensions be transferred to another entity. However, we view this as unlikely, which is reflected in the Stable Outlook.