"The ratings are, however, constrained by Bank’s short operating history and large risk appetite."

Directed Lending

RAM said Lankaputhra was created as part of President Mahinda Rajapaksa's vision of promoting domestic enterprises to lend of small and medium enterprises overlooked by other banks, by a decision of the cabinet of ministers in 2006.

"LDB is expected to play a pivotal role in the current government's national development agenda," RAM said.

"Given its broad vision to create and enhance entrepreneurial talent in the country, its asset quality is expected to take second place."

So far the bank only had 1.51 percent of the country's licensed specialized bank assets.

Swift Deterioration

Lankaputhra's gross non performing loan ratio had "deteriorated swiftly to 38.9 percent" as at end-August 2009, despite its unseasoned portfolio, RAM said.

LDB was itself created by merging with two other state institutions, a state-run infrastructure fund and SME Bank, another new state bank that collapsed under the weight of bad loans from local entrepreneurial talent.

RAM said about 25 percent of its bad loans at end-August came from legacy assets that came from the merger with SME Bank.

But bank's board is now chaired by Sarath de Silva, a former general manager of state-run Bank of Ceylon with over 30-year's banking experience.

The bank's capital base, boosted by recent mergers was "deemed sturdy at present," RAM said.

Peoples' Capital

Lankaputhra mainly funded by government capital accounting for 61.14 percent of its capital by end December 2008.

"Consequently, its public deposits remained negligible," RAM said. "In the long run, however, public deposits are expected to become a material component in the bank's funding mix."

The bank also had a US dollar denominated loan, coming from its merger with the former Private Sector Infrastructure Development Fund (PSIDF) which accounted for 31 percent of its funding base.

But its exchange risk was mitigated by investing in US dollar denominated deposits and debentures.

All combined, the Bank’s ratio on interest expense to interest-bearing funds were a low 2.91 percent as at end-August 2009.

Financial Flexibility

"Thanks to LDB’s low-cost funding, its financial performance appears respectable despite its weak asset quality," RAM said.

After tax profits were 226.6 million rupees in the year ending December 2008 after the merger (up from 58.04 million in 2007). Return on assets was 4.22 percent (1.84 percent in 2007).

"Over the longer term, however, its profitability indicators are expected to moderate due to the normalisation of its funding costs," RAM said.

"We note that the Bank’s key rating driver is the financial flexibility stemming from its state ownership."

The bank's Tier I risk weighted capital adequacy ratio was 92.39 percent at end of December 2009, and overall risk weighted capital adequacy ratio 93.39 percent.