Fitch Ratings has upgraded Hua Xia Bank Co., Limited's (HXB) Viability Rating (VR) to 'b+' from 'b'.

At the same time, Fitch has affirmed HXB's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'BB+', Short-Term IDR at 'B' and Government Support Rating (GSR) at 'bb+'. The Outlook on the Long-Term IDR is Stable. The assigned VR is in line with the implied VR but does not drive its IDRs.

The upgrade of HXB's VR is driven by our assessment that, like other similarly sized banks in China, its intrinsic credit profile has benefitted from regulatory developments in recent years, resulting in a reduction in its off-balance-sheet activity as well as a moderating risk appetite. These were factors we had identified as potential outcomes at the time we upgraded our operating environment (OE) assessment to 'bbb-' from 'bb+' in 2021.

Key Rating Drivers

Government Support-Driven IDR: HXB's Long-Term IDR is driven by Fitch's assessment of a 'Moderate' likelihood of government support in the event of stress. This considers its limited market share and regional significance. There is no direct state ownership or history of government support for HXB. HXB's 'B' Short-Term IDR is mapped to its Long-Term IDR.

Differentiated in D-SIB Status: Chinese authorities designated HXB a domestic systemically important bank (D-SIB) in 2021. However, we do not think formal D-SIB designation alone will influence support propensity for HXB to the same extent as peers with a higher systemic importance or closer government linkages. This is because the government is likely to prioritise its support for larger D-SIBs in the event China's banking system experiences systemic stress.

Stable OE: We expect China's economic growth to recover in 2023 as Covid-19 restrictions have been lifted, which will support consumption. Our 'bbb-'/stable OE score is above the 'bb' category implied score, as we believe China's robust external finances and a record of stable economic performance, which are incorporated in the Chinese sovereign rating, will provide greater financial and economic stability than the implied OE score indicates.

Modest Improvement in Retail Franchise: The revision of HXB's business profile score to 'bb' from 'bb-' reflects its improving retail franchise as it has increased its focus on the retail business in recent years. That said, HXB's business profile score of 'bb' is below the 'bbb' implied category score to reflect management and governance limitations, similar to most Chinese banks rated by Fitch. Management and governance limitations are not uncommon in China due to pressure from the authorities to support segments of borrowers during challenging times.

In addition, HXB's reliance on interest income and exposure to shadow-banking activity also make its business model susceptible to market volatility and regulatory changes.

Reduction in Shadow-Banking Activity: The revision of HXB's risk profile score to 'b+' from 'b' takes into consideration the reduction in its shadow-banking activity amid the tightening in regulations over the past five years. Its off-balance-sheet wealth-management products declined to around 25% of deposits and 13% of assets by end-2022 from 31% of deposits and 18% of assets at end-2018.

Continuous NPL resolution: The revision of HXB's asset-quality score to 'b+' from 'b' considers its non-performing loan (NPL) resolution in recent years, which should reduce the negative impact from economic volatility and property weakness on its asset quality. However, its asset-quality score is still below the 'bbb' category implied score to reflect HXB's large non-loan exposure and our perception of weak underwriting standards relative to state banks and large mid-tier banks.

Modest Profitability: The earnings and profitability score of 'b' is still below the 'bb' category implied score to reflect the potential understatement of risk-weighted assets (RWAs) due to HXB's high non-loan exposure. Its operating profit/RWA ratio remained modest at 1.2% in 2022, and we expect its earnings and profitability will remain constrained by its modest funding profile and the high operating cost associated with its limited scale.

Limited Capital Buffer: The capitalisation and leverage score of 'b' is unchanged and below the 'bb' category implied score to reflect the bank's high non-loan exposure. We expect HXB's modest profitability will continue to pressure its core capitalisation. Its common equity Tier 1 (CET1) ratio declined to 8.9% by end-1Q23 from 9.2% at end-2022, although still higher than the minimum requirement of 7.75%.

Modest Improvement in Funding Profile: The revision of HXB's funding and liquidity score to 'b+' from 'b' reflects its improving retail deposit contributions to total deposit funding. However, its funding profile remains weaker than peers', as reflected in its loan/deposit ratio, which was the highest among Fitch-rated Chinese banks at 108% by end-1Q23. The funding and liquidity score has been assigned below the 'bbb' category implied score because of the bank's reliance on non-deposit funding, similar to most other Chinese banks, and modest retail deposit franchise relative to higher-rated peers.

Rating Sensitivities

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

The Long-Term IDR and GSR will come under pressure if we believe the central government's propensity or ability to provide timely extraordinary support to HXB has diminished. This could be indicated by a sovereign rating downgrade or through an enhanced resolution framework and strong intention by the authorities to permit losses on senior debt obligations as a means of resolving banks, but we do not expect either scenario to occur in the near term.

The Short-Term IDR will not be downgraded unless the Long-Term IDR is downgraded to or below 'CCC+'. We think this is highly unlikely in the short-to-medium term.

The VR could be downgraded if the OE score is downgraded or if we assess the bank to have materially increased its risk appetite, especially in manufacturing, wholesale and retail trade loans, as well as rising exposure to shadow-banking activity, which would be a further drag on asset quality and capital buffers.

A sustained deterioration in the bank's financial metrics could also lead to a VR downgrade, including a combination of the following reported core metrics without having largely addressed perceived risks around transparency of exposures, including off-balance-sheet and non-loan exposures:

The four-year average impaired loan/gross loan ratio increasing to and remaining at around 8% (2019-2022 average: 1.8%). Our assessment of asset quality also takes into consideration other indicators, such as 'special-mention' loans, loan-loss provisioning and whether (and to what extent) we believe reported metrics understate any deterioration in asset quality; and

The CET1 ratio falling to below 8% (1Q23: 8.9%) without a credible path to return to existing levels.

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade

An upgrade of China's sovereign ratings could lead to positive rating action on HXB's GSR and support-driven IDRs if that were to indicate greater ability to support the bank, with no less propensity to provide support.

The Short-Term IDR will be upgraded if the Long-Term IDR is upgraded.

An improvement in HXB's capitalisation such that its CET1 ratio is sustained at around 10% in conjunction with a further reduction in risk appetite and greater transparency in its financial statements - particularly on risks from shadow-banking activity, including our assessment of its asset-quality metrics - would be positive for its VR assessment.

OTHER DEBT AND ISSUER RATINGS: KEY RATING DRIVERS

HXB's IDRs (xgs) are driven by its VR. The Long-Term IDR (xgs) has been upgraded to 'B+(xgs)' from 'B(xgs)' following the upgrade of the VR, while the Short-Term IDR (xgs) has been affirmed at 'B(xgs)'.

OTHER DEBT AND ISSUER RATINGS: RATING SENSITIVITIES

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

The bank's Long-Term IDR (xgs) could be downgraded if the VR is downgraded. The bank's Short-Term IDR (xgs) could be downgraded if the VR is downgraded below 'b-'.

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

The bank's Long-Term IDR (xgs) could be upgraded if the VR is upgraded. The bank's Short-Term IDR (xgs) could be upgraded if the VR is upgraded above 'bb+'.

VR ADJUSTMENTS

The OE score of 'bbb-' has been assigned above the 'bb' category implied score for the following adjustment reason: sovereign rating (positive).

The business profile score of 'bb' has been assigned below the 'bbb' category implied score for the following adjustment reason: management and governance (negative) and business model (negative).

The asset quality score of 'b+' has been assigned below the 'bbb' category implied score for the following adjustment reason: non-loan exposure (negative) and underwriting standard and growth (negative).

The earnings and profitability score of 'b' has been assigned below the 'bb' category implied score for the following adjustment reason: risk-weight calculation (negative).

The capitalisation and leverage score of 'b' has been assigned below the 'bb' category implied score for the following adjustment reason: leverage and risk-weight calculation (negative).

The funding and liquidity score of 'b+' has been assigned below the 'bbb' category implied score for the following adjustment reason: non-deposit funding (negative) and 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.

Public Ratings with Credit Linkage to other ratings

HXB's IDRs are directly linked to China's sovereign ratings.

ESG Considerations

HXB has an ESG Relevance Score of '4' for Financial Transparency due to structural issues around financial transparency and disclosure. These are not captured in headline performance metrics in China and affect our OE and financial profile assessment. HXB, like other mid-tier banks, is more exposed to such risks relative to state banks due to a greater exposure to WMPs and entrusted investments. This stems from the use of off-balance-sheet transactions. This has a negative impact on the credit profile, and is relevant to the ratings in conjunction with other factors.

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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