Fitch affirms Bank of Sharjah at 'BBB+'/Stable

Dubai :  Fitch Ratings has affirmed UAE-based Bank of Sharjah P.J.S.C.'s Long-Term Issuer Default Rating (IDR) at 'BBB+' with a Stable Outlook. Fitch has also downgraded BOS's Viability Rating (VR) to 'ccc+' from 'b-' and removed it from Rating Watch Negative (RWN). A full list of rating actions is below.

In accordance with Fitch's policies, the issuer appealed and provided additional information to Fitch that resulted in a rating action that is different than the original rating committee outcome.

Fitch placed BOS's VR on RWN in May 2020. The downgrade reflects our view of the bank's still weak asset quality and capitalisation, which have not materially improved since we placed it on RWN. These weaknesses are driven by high impaired loans and foreclosed assets in the UAE and the large exposure to Lebanon through wholly-owned subsidiary Emirates Lebanon Bank (ELB). The downgrade also reflects our view that BOS's capital buffers would be insufficient in the event where the bank needs to recognise additional losses on its Lebanese exposures.

Fitch has withdrawn BOS's Support Rating and Support Rating Floor as they are no longer relevant to the agency's coverage following the publication of its updated Bank Rating Criteria on 12 November 2021. In line with the updated criteria, we have assigned BOS a Government Support Rating (GSR) of 'bbb+'.

Weak loan book quality is evidenced by a very high Stage 3 loans ratio (albeit these exposures are partially provisioned and collateralised) and a Stage 2 loans ratio that is significantly higher than peers. Together with very high levels of foreclosed assets and significant uncertainty from the bank's Lebanon exposure, this results in very high capital encumbrance, while BOS's capital ratios are only marginally above regulatory minimums. Fitch expects some positive developments in relation to the bank's problem assets in the UAE by end-2021, including a reduction in the Stage 3 loans ratio - mostly through migration to Stage 2 -and lower foreclosed assets. The bank also plans to raise additional Tier 1 capital. However, these potential changes are not significant enough to maintain the VR at 'b-'.

KEY RATING DRIVERS

IDRs AND GSR

BOS's IDRs and GSR reflect a high probability of support being available from the UAE authorities, if needed. Fitch's view of support factors in the sovereign's strong ability to support the banking system, reflected in the 'AA-'sovereign rating and sustained by sovereign wealth funds and recurring revenue mostly from hydrocarbon production. Fitch also expects a high propensity of the UAE authorities to support the banking sector, which has been demonstrated by its strong, timely and predictable record of supporting its domestic banks. This view also reflects the state's close ties with and partial ownership of some banks, including BOS (17%-owned by Sharjah Asset Management).

BOS's GSR is two notches below the UAE domestic systemically important banks' GSR of 'A', due to Fitch's view that BOS is of moderate systemic importance based on its approximate 1% market share of total assets in the UAE banking system and the bank's niche corporate focus.

BOS's Short-Term 'F2' IDR is the lower of two options mapping to a 'BBB+' Long-Term IDR, reflecting the fact that a significant proportion of UAE banking sector funding is related to the government and a stress on BOS would be likely to come at a time when the sovereign itself is experiencing some form of stress.

VR

BOS's VR reflects the bank's weak asset quality and capitalisation, which have a high influence on the rating, as well as weak profitability. The VR also considers a higher-than-average risk appetite and concentrations on both sides of the balance sheet, as well as pressures from the operating environment in Lebanon, to which BOS is exposed via its 100% subsidiary ELB. Positively, the VR reflects the bank's stable funding and healthy liquidity. BOS's VR is one notch below the 'b-' implied rating due to the weakest link adjustment, reflecting the capitalisation and leverage key rating driver, assessed by Fitch at 'ccc+'.

BOS's asset quality continued to deteriorate in 1H21. Our assessment of the bank's asset quality and risk appetite considers:

- Above-average Stage 3 loans ratio of 14% at end-1H21 (end-2020: 12.7%) with only moderate coverage of Stage 3 loans by total reserves of 65% (end-2020: 72%), resulting in a high 40% encumbrance of common equity Tier 1 (CET1) capital by uncovered Stage 3 loans (end-2020: 28%).

- High Stage 2 loans ratio of 28% at end-1H21 (end-2020: 27%), equivalent to 2.3x CET1 capital.

- The bank's Lebanese exposure, and the very weak Lebanese operating environment following the default of the Lebanese sovereign in March 2020. BOS's exposure to Lebanon is mainly through ELB, which accounted for about 16% of consolidated assets at end-1H21, or 2.2x BOS's consolidated CET1 capital. ELB's asset at end-1H21 were represented mainly by cash and placements at BdL (57% of the total), corporate lending (27%) and foreclosed assets (4%). The duration of BdL's freeze of Lebanese banks' foreign-currency assets remains uncertain, given that they are being used to finance commodity imports amid the large depletion of foreign-currency reserves.

- Large holdings of foreclosed assets (11% of total assets or 1.5x CET1 at end-1H21), realisation of which is likely to be challenging and lengthy in a soft real estate market, despite the bank taking several remedial actions to dispose of these assets. We expect foreclosed assets to be moderately reduced by end-2021, with the real estate market starting to show some sign of recovery and the management's plans to dispose of some of these holdings.

- Exposure to investment properties (2% of total assets or 31% of CET1), as a result of the acquisition of a local property development company in 2017. We expect these to gradually reduce in the near term but this has a moderate weight in our assessment of the bank's asset quality.

- High exposure to equity investments (1% of total assets or 15% of CET1 at end-1H21), of which half are unquoted. Equity investments have resulted in large losses in other comprehensive income in recent years, affecting BOS's capital.

BOS's profitability remains weak. In 2020 and 1H21, the bank reported a net loss equal to 14% and 28% (annualised) of average equity, respectively, mainly driven by loan impairment charges in Lebanon and in the UAE, and securities impairment charges mainly booked on sovereign debt instruments and assets placed at BdL. BOS's profitability was also hit by a loss of AED577million on its monetary position in relation to the application of hyperinflation accounting at ELB.

BOS's capital ratios have declined significantly in recent years due to a combination of negative internal capital generation and regulatory changes (transition to Basel 3 from Basel 2). BOS's total capital adequacy ratio was a low 10.7% at end-1H21 (end-2020: 10.7%), only 0.2% above the minimum regulatory requirement of 10.5%. The latter excludes the 1% capital conservation buffer requirement (reduced from 2.5% as part of the UAE central bank support measures). The CET1 ratio was 9.5% at the same date, while Fitch estimates net Stage 3 loans together with foreclosed assets, unquoted equities and investment property were equal to 2.3x of CET1 capital. ELB's standalone equity accounted for about 54% of BOS's consolidated CET1.

Fitch views BOS's ability to absorb losses through profits as weak, with core pre-impairment operating profit (excluding the one-off hyper-inflation loss at ELB and non-recurring income from Lebanese-related transactions) equal to only 2% of average loans in 1H21 (annualised).

In our view, BOS's funding profile is reasonable, with a stable and moderately concentrated customer deposit base providing the bulk of funding at the bank. BOS complements its deposit funding with senior unsecured issues, demonstrating sound access to capital markets when required. BOS's liquidity position is healthy, with net liquid assets covering 26% of total customer deposits at end-1H21.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to negative rating action/downgrade:

IDRs AND GSR

BOS's IDRs and GSR are sensitive to a change in Fitch's view of the creditworthiness of the UAE authorities or their propensity to support the banking system or the bank.

Deterioration in our view of the creditworthiness of the UAE authorities or their propensity to support the banking system or BOS could lead to a downgrade of the bank's IDRs. Should the bank recognise large losses, particularly with respect to its Lebanese operations, affecting capital, or experience a liquidity squeeze and funding outflows, without timely support being forthcoming from the UAE authorities, it is likely we would downgrade the IDRs.

VR

A breaching of capital requirements, in particular if the CET1 ratio falls below the 7% minimum regulatory requirement on a sustained basis, or crystallisation of further losses on credit exposures and problem assets could lead to a VR downgrade.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

IDRs AND GSR

An upgrade would reflect a more positive view of the creditworthiness of the UAE authorities or their propensity to support the banking system or the bank. Given our existing view of the UAE authorities' high creditworthiness and high propensity to support the banking system and BOS, positive rating action is unlikely.

VR

The VR could be upgraded if Fitch believes the bank had sustainably increased its capital buffers above the regulatory minimum requirements including buffers, combined with significantly lower capital encumbrance and reduced risks of impairment losses on its Lebanese and domestic high-risk exposures. This is unlikely in the near term.

VR ADJUSTMENTS

The Operating Environment score of 'bbb-' has been assigned below the 'aa' category implied score for the UAE due the following adjustment reasons: Size and Structure of Economy (negative), Financial Market Development (negative), Regulatory and Legal Framework (negative), International Operations (negative)

The Business Profile score of 'b+' has been assigned below the 'bb' category implied score due to the following adjustment reason: Business Model (negative).

The Capitalisation & Leverage score of 'ccc+' has been assigned below the 'bb' category implied score due to the following adjustment reason: Regulatory Capitalisation (negative) and Risk Profile and Business Model (negative)

The Funding and Liquidity score of 'bb+' has been assigned below the 'bbb' category implied score due to the following adjustment reason: Deposit Structure (negative).

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579 

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG CONSIDERATIONS

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg 

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