Fitch Ratings Lanka has upgraded Sri Lanka-based Union Bank of Colombo PLC's (UB) National Long-Term Rating to 'BB+(lka)' from 'BB(lka)'. The Outlook is Stable.

KEY RATING DRIVERS - NATIONAL RATING

The upgrade of UB's rating reflects the sharp increase in its capitalisation and ongoing structural improvements in the bank's credit profile.

UB's Fitch core capital ratio rose to 46% at end-3Q14 from 14% at end-2013 after an LKR11.4bn (USD87m) private placement of shares to Culture Financial Holdings Ltd., an affiliate of Texas Pacific Group (TPG) in August 2014. The placement gave TPG a 68% stake in the Sri Lankan bank, which could increase if TPG exercises warrants to invest a further LKR3.4bn within six years. TPG has approval from the Central Bank of Sri Lanka to increase its holding in UB to 75% and reduce it to 15% in 15 years.

UB is in the process of putting in place a new management team, which is likely to focus on improving the performance of the bank under the direction of TPG's representatives on the bank's board. Fitch will monitor the bank's execution and management of its revised strategy.

Fitch believes that ongoing improvements to the bank's risk management processes and systems, and its plan to move to extend its customer base beyond its previous focus on SMEs could help support better asset quality. Consequently, Fitch expects UB's capitalisation to decline alongside its expected expansion, but believes that the bank could sustain stronger capitalisation than in the past in the medium term.

UB's asset quality remained weaker than that of the sector and deteriorated in the nine months to September 2014 and in 2013. The bank's reported gross NPL ratio (excluding UB Finance Limited) increased to 11.6% at end-3Q14 and 8.2% at end-2013 from 5.4% at end-2012. This reflected in part the increase in NPLs from pawning (gold-backed) advances, which was seen across the banking sector in the aftermath of the decline in gold prices. In addition, NPLs at its subsidiary UB Finance Limited remained significant and accounted for 22% and 34% of the group's total NPLs at end-3Q14 and end-2013.

UB has addressed some of its operational weaknesses by the implementation of systems in 2Q14 to support core banking transactions. Its risk management capabilities have also been enhanced through the implementation of more sophisticated systems.

RATING SENSITIVITIES - NATIONAL RATING

An upgrade of UB's rating is contingent upon UB having achieved a fundamental improvement in its asset quality, moderation of its risk appetite and a strengthened franchise.

Aggressive growth that could increase capital impairment risks or a further deterioration in asset quality could lead to a downgrade of UB's ratings.

Established in 1995, UB is a small licensed commercial bank accounting for less than 1% of the Sri Lankan banking sector's assets at end-2013. The bank had a network of 61 branches at 3Q14.