Rating Rationale

Strengths
* Comfortable capitalisation
The overall capital adequacy ratio was high at 14.5% under Basel III and the networth adequate at Rs 12,499 crore, as on June 30, 2018. The networth coverage for net non-performing assets (NPAs) was 8 times on that date. The bank raised Rs 2,500 crore of equity capital in the first quarter of fiscal 2018. The comfortable capital position is likely to be maintained over the medium term.

* Healthy resource profile with strong brand equity in Kerala
Strong brand equity among NRIs, especially from Kerala, lends stability to the resource base and fee income. Deposits from NRIs as a proportion of total deposits remains sizeable, at 40% as on March 31, 2018. Moreover, the ratio of current account and savings account deposits to total deposits improved to 33.5% as on June 30, 2018, from 25% as on March 31, 2010. The resource profile is strengthened with retail deposits forming 96.2% of total deposits as on June 30, 2018, and a higher savings account deposits ratio (28% as on March 31, 2018) compared with peers. Cost of deposits for fiscal 2018 was 5.76%.

Weakness
* Average asset quality and profitability
The gross non-performing assets (NPAs) ratio was 3% as on June 30, 2018. There was a sharp rise in gross NPAs in the last quarter of fiscal 2018 owing to accelerated NPA recognition following the revised framework for resolution of stressed assets by the Reserve Bank of India. An increased focus on lending to better-rated corporates over fiscals 2017 and 2018 should support asset quality over the medium term. The bank is also diversifying into the retail and SME (small and medium enterprise) sectors, and strengthening its credit appraisal and risk management systems to improve asset quality. However, increased slippages in Kerala on account of the recent floods are likely to impact asset quality over the near term. Ability to manage the retail and SME loan portfolios in the Kerala region will remain a key rating monitorable.

Return on assets (RoAs) was low, at 0.8% for the first quarter of fiscal 2019 (0.7% for fiscal 2018), mainly due to high credit cost. Provisioning cover for NPAs was 43.5% (excluding technical write-offs) as on June 30, 2018. Earnings should gradually improve over the medium term.

* Modest but growing scale of operations; regional concentration
Federal Bank is a mid-sized bank, with a 1% share each in the system advances and deposits as on June 30, 2018. Nonetheless, with higher-than-industry-average advances growth at around 25% over fiscals 2017 and 2018, the market share has increased.

The business is mainly concentrated in southern states. The top four states in this region account for 75% and 57% of deposits and advances, respectively, while Kerala alone accounts for 66% and 36%, respectively. The bank had 1,252 branches as on June 30, 2018, most of which were in South India, particularly Kerala. However, with higher share of incremental lending coming from outside Kerala, concentration has been declining. Moreover, the southern states are among the economically better performing states in India, thus mitigating the concentration risk. Nonetheless, the financial risk profile remains susceptible to changes in the economic and business environment in the region. Asset quality in the retail and SME portfolio in Kerala will remain a key monitorable.