Fitch Downgrades Bermuda Commercial Bank

May 27, 2016

Fitch Ratings has downgraded the Long- and Short-Term Issuer Default Ratings [IDRs] of Bermuda Commercial Bank [BCB] to ‘BB+/B’ from ‘BBB-/F3′. The Rating Outlook is Stable.

A statement from the ratings agency said, “The downgrade of BCB’s IDRs and Viability Rating [VR] reflects the company’s increased risk profile and weakened capital position. Prior to the downgrade, Fitch saw BCB’s liquid balance sheet and strong capital position as a buffer in support of the relatively high risk tolerance of BCB’s investment portfolio.

“BCB’s IDRs and VR have been downgraded following a shift in the business mix and risk profile of the bank, along with a reduction in risk-based capital [RBC] ratios.

“In September 2015, BCB obtained a majority shareholding [75.5%] in Private and Commercial Finance Group Plc [PCFG], a U.K.-based and AIM-listed finance house that specializes in providing auto and other asset-based financing to consumers and small businesses within the U.K. Fitch views the diversification of BCB’s business model and the relatively stable income stream provided by PCFG as positive. However, these factors are more than offset by the capital dilution [as a percentage of risk-weighted assets] and the riskier overall BCB asset mix that resulted from the acquisition.

“PCFG has a solid operating history of over 20 years and specializes in the near-prime and prime customer segments, focused primarily on used vehicle finance and with an average loan size of approximately GBP12,500 as at Sept. 30, 2015. At around the same time that it acquired PCFG, BCB divested its holding in West Hamilton Holdings Ltd [WHH], a Bermuda-based property investment company.

“While the WHH divestment reduced illiquid property holdings by US$19.4 million, the PCFG acquisition added US$163 million of consumer and business finance loans to the balance sheet that comprised 21% of the BCB’s total assets at FYE2015. Fitch views the addition of these loans as an increase in BCB’s overall risk profile and risk tolerance.

“Fitch considers BCB’s RBC levels to have fallen below a level adequate to support its prior rating within the context of the relatively unconventional and high risk investment portfolio. As at FYE September 2015, BCB had a Tier 1 Capital Ratio of 21% calculated according to the Basel III regulatory rules set forth by the Bermudan Monetary Authority [BMA].

“This compares to a 25% ratio a year prior. Fitch calculates a Core Capital [FCC] ratio of 19.8% for FYE 2015 relative to 27.4% a year prior. The FCC ratio incorporates the impact of an unrealized loss in the investment portfolio which amounted to US$6.6 million at FYE 2015. However, management has indicated plans to reduce some of the higher risk-weighted security positions in the investment portfolio, which is expected to bode well for the Basel III RBC ratios.

“Fitch notes that BCB’s RBC ratios remain comparatively high relative to other equally rated institutions in our rated universe. Nevertheless, Fitch views it as a necessary buffer to offset BCB’s relatively high risk appetite.

“Liquidity remains a rating strength for BCB. More than half of BCB’s deposits are maintained in cash and high quality liquid assets [HQLA] and this ratio has remained stable notwithstanding the PCFG acquisition. However, Fitch expects limited deployment of BCB liquidity into the PCFG business.

“Over recent years, Fitch has noted an upward trend in the proportion of BCB’s non-HQLA securities classified as Level 1 in the fair value hierarchy, which adds another source of liquidity. BCB reported a Liquidity Coverage Ratio of 111% for December 2015, which is above the fully phased-in Basel 3 minimums. In the absence of a lender of last resort, Fitch expects Bermudan banks to maintain conservative liquidity profiles.

“Fitch anticipates earnings headwinds for BCB as a result of volatility within its investment portfolio. While BCB continued to perform well in 2015, reporting net income of $8 million [7.2% return on equity [ROE]], Fitch notes that over the last few years BCB’s earnings profile has relied on capital gains from the investment portfolio to bolster earnings. Recent market volatility and a slump in the oil price are expected to strain the values of some of the securities in the BCB investment portfolio.

“While the overall quality of management remains good, Fitch notes that BCB has experienced significant turnover of the CEO role in recent years that also constrains the rating. Despite management’s efforts to restore profitability of the core banking, trust and corporate services segments, performance remains lackluster. Notably, the PCFG acquisition should be a positive contributor to earnings.

“PCFG is currently reliant on a wholesale funding model, which Fitch views as a relatively costly source of funds. Furthermore, the acquisition weakens BCB’s overall liquidity position in the near term.

“Nonetheless, Fitch notes that PCFG is in the process of pursuing a banking license that, if granted, will diversify its funding sources and provide the company access to relatively inexpensive deposit funding. However, the impact of a PCFG banking license is not factored into the rating, since Fitch believes it to be unlikely that the benefits from such approval would be realized within our rating horizon.

“Asset quality at PCFG continues to improve in a benign credit environment with impaired loans as a percentage of gross loans dropping to below 10% of total loans in FY2015. Fitch notes that these impaired loans are well-reserved. BCB’s securities portfolio remains relatively high risk and is concentrated in short-duration high yield corporate bonds.

“Although the credit ratings of these bonds are, on average, investment grade, many of the bonds are not rated or are rated below investment grade. Nevertheless, about a third of the balance consists of cash and HQLA that still provides some offset to the higher overall risk profile.

“BCB’s Support Rating of ’5′ and Support Rating Floor of ‘NF’ reflect our view that BCB is not systemically important in the local Bermuda market and, therefore, Fitch believes the probability of support is unlikely. IDRs and VRs do not incorporate any support for BCB.

“Fitch believes the rating is comfortably situated at current levels. However, downward ratings momentum could develop if average on-balance-sheet liquidity, defined as cash-to-total assets were to be managed to below 20%, either as a result of deposit outflow or deployment of liquidity into risky assets. If Fitch Core Capital were to fall to below 15%, Fitch would consider a downgrade. Additionally, a material increase in market or credit risk from current levels could further strain the rating.

“Conversely, positive ratings momentum could develop if BCB were to increase and maintain its capital to historical levels while maintaining a stable deposit base and on-balance-sheet liquidity of above 35%. However, Fitch would also expect BCB to demonstrate effective governance, risk management and integration of PCFG into the broader BCB group operations.

“The rating incorporates the possibility of short-term deterioration in earnings as a result of volatility in the investment portfolio. However, should capital losses in the securities portfolio drive BCB into an overall loss position, negative ratings pressure could develop. While Fitch anticipates modest improvement to PCFG’s asset quality metrics over the near term, the rating incorporates the potential for some credit deterioration to normalized levels over the long term. However, should the credit performance of this portfolio significantly underperform our expectations negative ratings momentum could develop.

“The impact of a banking license approval is not currently factored into the rating. However, a significant improvement in the funding and liquidity position of PCFG such that it substantially eliminates the potential dependence on BCB as a secondary source of liquidity could be viewed as positive for the rating. However, an upgrade would only be considered if there is a reduction in the credit risk profile of the loan portfolio without a significant earnings impact on a risk-adjusted basis.”

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