Tashkent, Uzbekistan (UzDaily.uz) -- S&P Global Ratings today assigned its ‘BB-/B’ long- and short-term issuer credit ratings to Uzbekistan-based ` Bank. The outlook is negative.

The rating agency thinks that the substantial capital support provided by the government to date and additional capital to be injected in 2020 will enable the bank to preserve its solid capital buffer, which is Khalq Bank’s key rating strength. In 2019, the bank received Uzbekistani sum (UZS) 2,559 billion of capital from the government, which enabled it to increase its capital base by almost 3.0x. Meanwhile, in 2019 our risk-adjusted capital (RAC) ratio jumped to 15.2% versus 10.2% at year-end 2018. We expect that the government will provide additional capital of about UZS800 billion ($80 million) this year to support the bank’s implementation of the social lending programs and its transformation efforts. We forecast that the bank’s RAC ratio will remain above 10% at mid-year 2021, which would allow it to offset the expected deterioration of its asset quality caused by COVID-19. That said downside risks to this forecast remain acute considering negative trends related to economic risk in Uzbekistan combined with new wave of lockdown measures related to COVID-19.

“In our view, Khalq Bank’s relatively high market share, holding of the country’s largest branch network, and solid franchise in retail and small and midsize enterprise (SME) lending will support the stability and diversity of its business. However, this is balanced by uncertainty with regards to planned transformation of the business model, frequent changes in the management team, and historically poor profitability. With total assets of UZS21.8 trillion as of July 1, 2020, Khalq Bank is the sixth-largest bank in Uzbekistan, with a market share of 6.9% of systemwide assets and 9.6% of total customer deposits. Khalq Bank serves 18.5 million retail customers or about 56% of Uzbekistan’s population through 197 branches. The bank also owns the largest payment system in the country, Uzpaynet, which allows it to access clients’ transaction activity and might improve the product offering and risk management, the agency said.

We think that the bank’s profitability and business sustainability will likely improve in the next three years. In particular, the recently announced government plans to take over the Khalq Bank’s responsibilities of accumulating and managing pension assets might give the bank more flexibility in managing its asset mix and operating costs and therefore improve its profitability. We also note that the bank’s growth in commercial lending with better risk-adjusted return and transformation initiatives may further improve its earning capacity.

We expect that the bank’s asset quality will remain worse than peers’, reflecting the predominance of unsecured retail and SME loans, which might suffer more from COVID-19 than large corporate customers. As of year-end 2019, the bank’s Stage 3 loans represented 6.1% of its gross loans versus the 2.5%-3.0% systemwide average. The bank has restructured UZS2.4 trillion, or 15.5% of its loan portfolio, as of mid-year 2020, including UZS1.4 trillion to corporate customers and UZS1.0 trillion to individuals. The share of total restructured loans is materially higher than that of the largest state-owned banks and is closer to private banks. We assume that roughly half of the restructured loans will become problem by year-end 2020, which translates into expected nonperforming assets (NPAs) to total loans of about 11.6%, versus 4.0%-5.0% expected for the system average.

In our view, aggressive lending growth, which reached 174% in 2019, a significant share of newly acquired unseasoned loans (more than 40% of its loan portfolio), and low provisioning coverage ratios might lead to elevated credit losses in the future. We expect the bank’s lending growth will remain high in 2020 and could reach 50%--supported by corporate lending and implementation of state-driven social programs. At the same time, we assume that the bank’s cost of risk will increase to 3.5%-4.0% this year, reflecting deteriorating asset quality and the need to create additional provisions.

We expect the bank’s funding profile will gradually change since it will transfer some pension assets to the Ministry of Finance. After the transfer, the bank’s funding mix will be more similar to other state-owned banks in the country, although funding from government-related entities (GREs) and the government itself will remain the most important funding source. Credit lines from international financial institutions will gradually become another important source of future business growth and will likely represent 30%-35% of the bank’s funding mix in the next two-to-three years. We expect the transfer of pension savings will be gradual, over two-to-three years, and therefore will not pressure liquidity.

In our view, the bank’s systemic importance will gradually diminish along with the transfer of pension functions to the Ministry of Finance. Although the bank will likely lose its exclusive right to distribute pensions to current retirees, we think that it will remain the key player along with other banks due to its wide geographical footprint and good brand recognition.

We consider the bank to be a GRE with a moderately high likelihood of receiving extraordinary government support, if needed. This, in turn, reflects the bank’s important public policy role for the financial system and close link with the government, since the government directly owns 100% of the bank’s capital. We note that the government recently announced its plans to privatize the bank in 2021. We expect the privatization process will take at least three years and the government will retain control of the bank in the next 12-18 months. Although Khalq Bank will be less involved in managing state pensions, it will remain important for the government to finance a number of social support programs, mainly in the entrepreneurship and SME sectors.

The negative outlook reflects our view that the bank’s capital buffer might come under higher pressure, with our RAC ratio falling below 10%. This might be the result of more aggressive lending growth than we currently expect or higher risks affecting borrowers in Uzbekistan because of an extended lockdown. It also reflects the risk of much more significant deterioration of the bank’s asset quality due to recently aggressive credit growth and a high share of unseasoned loans.

We could take a negative rating action in the next 12 months if the bank’s RAC ratio falls below 10%, due to higher economic risks in Uzbekistan or more aggressive lending growth. A negative rating action may also follow if the recent improvement of the bank’s profitability proves to be unsustainable and it continued being heavily dependent on government capital support. This could happen, for example, due to significantly higher credit losses than we currently expect or if management fails to improve the bank’s operating efficiency and risk governance. A material deterioration of the bank’s asset quality due to COVID-19 and weaker performance of recently provided loans, with problem assets exceeding those of peers with a similar lending mix, would likely lead to a negative rating action as well. In addition, a negative rating action on Uzbekistan would result in similar action on the bank.

A positive rating action is unlikely in the next 12 months. We could consider revising the outlook to stable if macroeconomic and sovereign risks decline, the bank maintains a solid capital buffer and demonstrates sustainable improvement of its core profitability, and there is no sign of asset-quality deterioration beyond our current expectations.