OREANDA-NEWS. Fitch Ratings has affirmed Santander UK Group Holdings plc's (SGH) and Santander UK's (San UK) Long- and Short-Term Issuer Default Ratings (IDRs) at 'A'/'F1', Viability Ratings (VRs) at 'a', and Support Ratings (SRs) at '2'. The IDRs of San UK's subsidiary, Abbey National Treasury Services plc (ANTS), have also been affirmed at 'A'/'F1'. The Outlooks are Positive. A full list of rating actions is available at the end of this rating action commentary.

SGH's (the holding company) and San UK's (the operating company) ratings are analysed on a consolidated basis. Their VRs are the same as they are driven by substantially the same factors and also because we do not see a significant difference in the likelihood of failure between the two entities.

In both cases, the VRs drive the IDRs. The IDRs of the two entities are equalised because of the lack of holding company double leverage at SGH and as yet insufficient down-streamed senior debt from the holding company to San UK.

Our assessment of the VRs takes into consideration the group's conservative risk appetite, sound and increasingly diversified domestic franchise, healthy asset quality, consistent but still low profitability and sound liquidity and capitalisation. The group has one of the most prudent risk appetites among similarly rated banks. The ratings also reflect the ordinary benefits it obtains in terms of expertise, franchise value and products, of being part of the Santander group (Banco Santander SA, rated A-/Stable), reducing the limitations of its fairly narrow geographic presence.

The Positive Outlooks reflect the potential upgrade of SGH's and San UK's VRs and Long-Term IDRs to 'a+'/'A+' from 'a'/A', should the group's business model continue to diversify through an expansion of the retail, commercial and corporate franchises, while maintaining its conservative risk appetite and healthy asset quality. Greater diversification should reduce its dependence on the UK mortgage market and result in better earnings and profitability without raising its risk profile materially.

As a leading player in the UK's prime residential mortgage market, the group has consistently low loan impairment charges (LICs) although this has been a trend across the market in recent years and has been helped by benign macroeconomic conditions such as low and falling unemployment, low base rates, rising house prices. However, with the increased presence of commercial and corporate exposures as well as consumer and credit cards, LICs are likely to increase slightly and possibly become uneven. However, the quality of corporate borrowers has so far proved to be healthy. The legacy commercial real estate and transportation portfolio has been scaled back and at end-2015 the exposure amounted to just GBP1.7bn.

The bank's reported non-performing loans (NPL) aggregate, which include impaired loans plus all loans which are 90 days past due, is a more conservative classification than that used by other UK banks. NPLs have been falling and now account for just 1.54% of gross loans (equal to an impaired loan ratio at the same date of 0.8%). The bank aims to reduce this ratio to less than 1.5% over the medium term and while some increase can be expected with rising base rates, this target does not appear overly ambitious given its conservative risk controls.

The bank is mainly funded by customer deposits but also makes use of wholesale markets, with a significant portion of funding obtained from secured funding sources such as securitisations and covered bonds. Its liquidity buffer is strong and is managed across the group as under a single unit.

In Fitch's view the group's capitalisation is in line with the risk profile, taking into consideration current and expected regulatory requirements. Current capital levels provide it with an adequate buffer over and above these requirements and for the group's projected growth. Leverage remains fairly high, however, with a reported leverage ratio of 4% at end-2015, despite having been boosted in 2014 and 2015 by the issuance of additional Tier 1 capital securities.

SGH's and Sank UK's SRs reflect Fitch's view that support from their ultimate parent, Banco Santander, should it ever be needed, is highly probable. We believe that due to the strategic importance of the UK business to Banco Santander and the high reputational risk associated with failure to support UK operations, Banco Santander would have a high propensity to provide such support.

The likelihood of providing support, however, is somewhat limited by Banco Santander's ability to provide such support given that the group's UK operations comprise a material portion of the parent's balance sheet. Therefore at the current levels of ratings, the possibility of such support is not reflected in the ratings of either SGH or San UK.

The ratings of SGH's and San UK's subordinated debt and hybrid securities are notched down from the respective banks' VRs, reflecting a combination of Fitch's assessment of their incremental non-performance risk relative to the VR (up to three notches) and assumptions around loss severity (up to two notches). These features vary considerably by instrument.

SGH's fixed rate reset perpetual additional Tier 1 capital securities and San UK's non-cumulative preferred shares are rated five notches below the respective banks' VRs to reflect the higher-than-average loss severity risk of these securities (two notches) and higher risk of non-performance as coupon payments are fully discretionary (three notches).

Tier 1 securities, including those issued by Abbey National Capital Trust 1 and guaranteed by San UK, are rated four notches below San UK's VR to reflect higher loss severity risk (two notches) and higher risk of non-performance due to discretionary coupon payments (two notches).

Legacy upper Tier 2 securities are rated three notches below San UK's VR (one for loss severity and two for non-performance). Dated Tier 2 instruments are notched down once from the VR for loss severity.

The ratings of ANTS, the UK group's main debt issuing vehicle, are equalised with those of SGH and San UK. ANTS's obligations are guaranteed by San UK and all proceeds are up-streamed to the parent. Following an announcement of change of issuer in April 2014, San UK will become direct issuer of the group's senior debt effective from 1 June 2016. ANTS debt rating is affirmed on the expected substitution (see also NRAC: Santander UK's EMTN Ratings Unaffected by Issuer Substitution, dated 27 April 2016).

The Positive Outlooks on San UK's and SGH's Long-Term IDRs reflect our view that as the group's business becomes more diversified through the expansion of the retail, commercial and larger corporate franchises while its risk appetite remains moderate, their VRs and hence their IDRs, could be upgraded. Given the high indebtedness of UK households, the strong focus of the bank on the UK mortgage lending market, and its leading franchise, however, we believe that the potential upgrade is likely to be limited to one notch in the medium-term.

Negative pressure on their VRs, and hence IDRs, would arise if the group increases its risk appetite, for example, through more aggressive expansion into commercial lending, or if its capitalisation or asset quality weakens materially, none of which are expected by Fitch.

Over time, the Long-Term IDR of San UK could be notched up once from its VR, when sufficient senior debt is down-streamed to it from its parent company, SGH, in a manner which is subordinated to other senior creditors of San UK. The uplift would be influenced by Fitch's assessment of the direct and indirect linkages between San UK's and Banco Santander's risk profiles, which typically constrains a subsidiary's VR to no more than three notches above a parent's IDR. An upgrade of San UK's Long-Term IDR could take place once there is sufficient quantum of this down-streamed internal debt to recapitalise the bank to a viable level without having to bail in other senior debt holders at San UK.

SGH's ratings would be downgraded on a material increase in holding company double leverage, which we do not expect.

The group currently expects to keep only the necessary business within its ring-fenced arm and a material part of its operations to fall outside its ring fence under the auspices of ANTS. The VRs of the various group entities could diverge depending on the credit metrics of the various institutions, which have yet to be fully clarified. However, in terms of Long-Term IDRs, the differentiation among the group entities could be significantly smaller given our expectation that the group will be able to support its main subsidiaries to some degree.

The group's VRs and IDRs (and those of group subsidiaries) could be affected by a material change in the operating environment, for example, a material economic and financial market fallout from a decision by the UK to leave the EU.

Fitch believes that San UK's reputation and business flows are to some extent correlated with the overall creditworthiness of the parent Banco Santander S.A and that consequently there should be a difference of maximum two notches between the VR of SGH and the Long-Term IDR of Banco Santander. San UK's ratings are therefore also sensitive to changes to the parent's IDR.

The Support Rating is sensitive to both a change in the strategic importance of the UK banking group to its parent, which is currently not envisaged by Fitch, and in Banco Santander's ability to provide such support.

The ratings are primarily sensitive to changes in SGH's or San UK's VRs. The AT1 securities are also sensitive to a change in Fitch's assessment of the probability of their non-performance relative to the risk captured in SGH's VR. This could reflect a change in capital management or flexibility or an unexpected shift in regulatory buffers, for example.

ANTS's ratings are sensitive to changes in San UK's IDRs.

The full list of rating actions is as follows:

Santander UK Group Holdings plc
Long-Term IDR: affirmed at 'A'; Outlook Positive
Short-Term IDR: affirmed at 'F1'
Viability Rating: affirmed at 'a'
Support Rating: affirmed at '2'
Senior unsecured debt long-term rating, including programme rating: affirmed at 'A'
Senior unsecured debt short-term rating, including programme rating affirmed at 'F1'
Subordinated debt: affirmed at 'A-'
Subordinated notes and fixed rate reset perpetual additional Tier 1 capital securities: affirmed at 'BB+'

Santander UK plc
Long-Term IDR: affirmed at 'A'; Outlook Positive
Short-Term IDR: affirmed at 'F1'
Viability Rating: affirmed at 'a'
Support Rating: affirmed at '2'
Senior unsecured debt long-term rating, including programme rating: affirmed at 'A'
Senior unsecured debt short-term rating, including programme rating and commercial paper: affirmed at 'F1'
Market-linked senior unsecured securities: affirmed at 'Aemr'
Subordinated debt: affirmed at 'A-'
Upper Tier 2 subordinated debt: affirmed at 'BBB'
GBP300m non-cumulative, callable preference shares, XS0502105454: affirmed at 'BB+'
Other preferred stock: affirmed at 'BBB-'

Abbey National Treasury Services plc
Long-Term IDR: affirmed at 'A'; Outlook Positive
Short-Term IDR: affirmed at 'F1'
Senior unsecured debt long-term rating, including programme ratings: affirmed at 'A'
Senior unsecured debt short-term rating: affirmed at 'F1'

Abbey National Capital Trust 1
USD1bn trust preferred securities (ISIN: US002927AA95) (guaranteed by San UK): affirmed at 'BBB-'