Tashkent, Uzbekistan (UzDaily.com) -- S&P Global Ratings lowered its long-term rating on Khalq Bank to ‘B+’ from ‘BB-’ and affirmed the short-term rating at ‘B’. The outlook is stable.

We anticipate Khalq Bank’s asset quality will gradually improve after the dramatic hit earlier this year, but that it will remain materially weaker than that of peers.

As of Aug. 1, 2021, Khalq Bank’s problem loans, which include loans in unsatisfactory, doubtful, and loss categories--under the treatment of the Central Bank of Uzbekistan--increased to 24% of its loan portfolio from 2.8% as of year-end 2020. The share of the problem loans significantly exceeds that of the system average, which we estimate at 6%-7% at the same date. We note that the increase in problem loans occurred primarily in June and July after the bank’s management adopted a more conservative approach to the treatment of the impaired loans to reflect the true picture of the bank’s asset quality. However, compared with other local banks, which have also demonstrated a gradual increase of problem loans in recent months, we also see the following reasons for the dynamics:

• Higher exposure to small and midsize enterprises and retail customers, with a substantial share of clients receiving loans under special social support programs and demonstrating weaker creditworthiness.

• Relaxed underwriting standards and risk controls, and last year’s aggressive lending growth (which reached 62% versus 31% of systemwide growth).

• Management’s stricter approach to restructuring programs, which didn’t allow customers to recover their financial position.

We note that the bank is undertaking several steps to improve its asset quality, including strengthening customers’ payment discipline, various restructuring programs, and collection of the defaulted debt and collateral. Although we expect that the bank’s asset quality will gradually improve in the coming months, not least because of the favorable macroeconomic environment, we expect that the share of problem assets will likely substantially exceed 10% under International Financial Reporting Standards at year-end 2021 and will remain materially higher than that of peers. We also expect deterioration of the provisioning coverage ratios with specific provisions covering nonperforming assets (NPAs) reducing to 25%-30%, versus 42% at year-end 2020.

The bank will likely preserve a solid capital position, thanks to capital support from the government, slow lending growth, and good earnings capacity.

We expect that the bank’s risk-adjusted capital (RAC) ratio will likely remain above 10% in the next 12-18 months. We take into account the bank’s significantly slower lending growth this year (11% versus 62% last year) as Khalq Bank virtually stopped new lending on Aug. 1, 2021. We also take into account Uzbekistani sum (UZS) 200 billion of capital support the bank received earlier this month from the government, as well as UZS80 billion of support through capitalization of earlier paid taxes. We understand that the government might provide the bank with another tranche of capital later this year, although the amount and timing of this potential support is uncertain. Finally, we think that the bank’s improved earnings capacity with a net interest margin closer to 8% may protect the bank against substantial provisions it might need to create this year. We assume that the bank’s cost of risk will increase to 3.5% this year from 2.6% last year and we recognize the high sensitivity of the bank’s capital position to even higher provisioning needs later this year. As of Aug. 1, 2021, the bank’s capital adequacy ratio was 14.1%, versus the regulatory minimum of 13.0%, and we think that there is a low risk Khalq Bank will breach the regulatory minimum, thanks to potential government support and slower business growth.

The bank will likely maintain its stable funding profile and liquidity position.

As of Aug 1, 2021, pension savings and funding from the Ministry of Finance and the Uzbek Fund for Reconstruction and Development represented nearly 50% of the bank’s total liabilities. We think that these resources support the stability of the bank’s funding profile. Although the bank is currently in breach of asset quality covenants on a few credit lines from international financial institutions and foreign banks, we don’t think that these creditors will require immediate repayment. In our view, the bank maintains an adequate liquidity buffer with highly liquid assets (around UZS3.85 trillion) covering 70% of all international funding or 16% of liabilities as of Aug. 1, 2021.

The bank remains an important financial institution for the government.

We think that Khalq Bank will remain important for the government, considering its exclusive status as an agent distributing pensions and other social payments in Uzbekistan. Although the bank will likely start transferring its pension savings starting from 2022, we think that the bank will preserve its distributor status in coming years, given it has the widest branch network in the country. We also do not expect privatization of the bank in the coming two years. We believe that the bank’s credit profile will continue to benefit from ongoing and extraordinary government support in the form of capital, funding, and liquidity.

The stable outlook on Khalq Bank reflects our view that, despite the substantial increase of problem assets and credit losses in 2021, the bank will likely preserve its credit profile from further deterioration thanks to a sufficient capital and liquidity buffer, stable funding, and government support.

We could take a negative rating action in the next 12 months if, contrary to our expectations, the bank’s capital position deteriorates significantly, with its capital adequacy ratio lower than or at risk of breaching the regulatory minimum, or its RAC ratio falling below 10%, while the bank’s asset quality remains weak. This might happen if, for example, the bank’s new loan loss provisions materially exceed our expectations and the government does not provide timely and sufficient support to offset pressure on the bank’s capital position. 

A negative rating action may also follow a significant outflow of depositors’ and foreign creditors’ funds, leading to pressure on the bank’s liquidity. Continuing issues with asset quality that lead to weaker client confidence and inability to grow healthy business resulting in deterioration of the bank’s market footprint might also prod us to take a negative rating action. 

We could consider a positive rating action over the next 12-18 months if management succeeds in reducing problem loans and improving the bank’s risk management with NPAs moving closer to the system average and if the bank maintains its solid capital position with our RAC ratio sustainably above 10%.