Fitch Revises Virgin Money's Outlook to Stable; Affirms at 'BBB+'
The revision of the Outlook to Stable reflects our view that pressure on the bank's planned growth and diversification has increased. The outcome of the EU referendum in June 2016 will likely result in a slowdown in economic growth over the next two years, which could result in slowing business volume growth at VM and reduce its ability to diversify its businesses further. 'Lower for longer' base rates may also put further pressure on margins given the bank's business model.
KEY RATING DRIVERS
IDRS, VRS AND SENIOR DEBT
VM's IDRs are driven by its standalone strength, as expressed by its VR and reflect the bank's low risk profile, healthy asset quality, improving profitability, as well as adequate liquidity and capitalisation in relation to its risk profile.
Loan growth has been faster than the market average over the past two years as the bank has concentrated on developing its franchise through gaining market share and growing its residential mortgage portfolio. Its mortgage loans consist of high quality, low-risk, owner-occupied and buy-to-let (BTL) loans, which are generally extended at moderate loan-to-value ratios (LTVs). It has achieved some diversification by growing its credit card portfolio, partly ahead of schedule. However, the bank's diversification remains limited and largely based on retail lending. During 2016, the bank decided to drop its plans to develop its SME banking franchise due to the economic uncertainty ensuing from the UK's vote to leave the EU.
Assets are predominantly made up of mortgages and these continue to perform well, supported by a benign economic environment over the past three years with falling unemployment and prolonged low base rates. Arrears levels and impairment charges are very low, average indexed LTVs have been supported by rising house price inflation and the loan book is highly fragmented with generally low average loan sizes. Asset quality remains vulnerable to the high indebtedness of UK households, but in Fitch's opinion, this risk is somewhat mitigated by the sound performance of the UK's mortgage market with low base rates supporting affordability. The bank's credit card portfolio, although higher risk in nature, is also performing well.
The anticipated economic slowdown ensuing from the vote to leave the EU could result in weakening asset performance if house prices fall. However, the bank's focus on low LTVs, strong underwriting standards as well as the low base rates are all expected to allow the bank to be resilient to such deterioration.
VM's profitability, although improved, relies on net interest revenue generated from its low risk mortgage book and this is likely to come under pressure from lower base rates and from slowing volume growth. In 1H16, business volumes continued to increase strongly, partly compensating the pressure on loan margins generated by the strong supply of credit for better quality mortgage loans. Profitability further benefited from falling funding costs, a changing loan mix, higher margin credit card exposures and also from a lower, but still adequate, on-balance sheet liquidity buffer. Costs continued to be managed effectively with further improvements in the bank's cost-to-income ratio in 1H16 as a result of growth in net interest income.
We expect profitability to remain under pressure, although funding costs are likely to further reduce following the availability of the Term Funding Scheme and as costs remain under control. However, improvements in profitability will largely depend on the bank's ability to continue to grow other the next few years.
Given its exposure to low-risk mortgages, VM reports strong regulatory capital ratios based on risk-weighted assets (RWA), despite these ratios reducing gradually in line with the bank's expansion. The bank's common equity Tier 1 (CET1) ratio was 17.7% at end-1H16, with RWA for the bank's residential mortgage portfolio calculated on an internal ratings-based approach. Leverage was just adequate, with a 3.8% leverage ratio at end-1H16. However, as the focus is now likely to be on mortgages, it is likely that its leverage ratio will be under pressure at least in the short to medium term. We expect regulatory capital ratios to be managed down albeit remaining well within the regulatory minimum.
VM is predominantly funded by retail deposits, particularly in the form of savings. It has achieved some diversification of its funding base through accessing wholesale markets, mostly secured, through its RMBS issuance as well as through the Funding for Lending Scheme. However, management has stated it will manage its wholesale funding appetite conservatively. Balance sheet encumbrance has risen to levels that are higher than generally seen at UK banks. Liquidity is sound and maintained well above European and UK regulatory requirements.
SUPPORT RATING (SR) AND SUPPORT RATING FLOOR (SRF)
VM's SR and SRF reflect Fitch's view that senior creditors cannot rely on extraordinary support from the UK authorities in the event the group becomes non-viable given its low systemic importance. In our opinion, the UK has implemented legislation and regulations that provide a framework that is likely to require senior creditors to participate in losses for resolving the bank.
IDRS, VRs AND SENIOR DEBT
VM's VR and IDRs are primarily sensitive to structural deterioration in profitability, through tighter margins and higher loan impairment charges, and weaker asset quality. This could be caused by a material weakening of the operating environment in the UK if the economic effect of the UK's decision to leave the EU is particularly severe.
VM's IDRs, VR and senior debt ratings are also sensitive to an increase in the bank's risk appetite, which could result in either significantly higher leverage or higher regulatory requirements than at present. They would also be under pressure from lower liquidity buffers or a less stable funding model.
Further diversification of the bank's businesses and continued improvements in its profitability could result in upward pressure on its ratings over the longer term. Any upgrade would be dependent on the bank maintaining its currently moderate risk appetite and sound funding and liquidity.
SUPPORT RATING AND SUPPORT RATING FLOOR
An upgrade of the SR and upward revision of the SRF would be contingent on a positive change in the sovereign's propensity to support its banks. While not impossible, this is highly unlikely, in Fitch's view.
The rating actions are as follows:
Long-Term IDR affirmed at 'BBB+', Outlook revised to Stable from Positive
Short-Term IDR affirmed at 'F2'
Viability Rating affirmed at 'bbb+'
Support Rating affirmed at '5'
Support Rating Floor affirmed at 'No Floor'
GBP3bn senior unsecured GMTN programme: affirmed at 'BBB+'
GBP300m senior unsecured debt, XS1222597731, affirmed at 'BBB+'