OREANDA-NEWS. Fitch Ratings has upgraded Skipton Building Society's (Skipton) Long-term Issuer Default Ratings (IDR) to 'BBB+' from 'BBB' and affirmed its Short-term Issuer Default Ratings (IDR) at 'F2'. Fitch has also affirmed Yorkshire Building Society's (Yorkshire) Long-term and Short-term IDRs at 'A-'/'F1' and Principality Building Society's (Principality) Long-term and Short-term IDRs at 'BBB+'/'F2'. The Outlooks of all societies are Stable.

The Support Ratings (SR) and Support Rating Floors (SRF) of all three building societies have been affirmed at '5' and 'No Floor', respectively.

A full list of rating actions is at the end of this comment.

The rating actions follow a periodic review of the three UK building societies (see "UK Building Societies - 2014 Results" and "Peer Review: 2015 Outlook: UK Building Societies", at www.fitchratings.com). Fitch concludes that although the UK building society sector posted a robust performance for 2014, evidenced by higher margins, stronger balance sheets, improving asset quality, reinforced capital and sound funding and liquidity; increasing competitive pressure on mortgage rates and likely increased funding costs will put new pressure on the societies' future performance. Nevertheless, Fitch believes that 2015 should still be a strongly profitable year, while 2016 may bring increasing challenges.

KEY RATING DRIVERS
IDRs, VRs AND SENIOR DEBT
YORKSHIRE BUILDING SOCIETY
Yorkshire's ratings reflect Fitch's view of its low risk profile, which takes into consideration the ongoing integration and consolidation of the various acquisitions it has made since the crisis.

The society's business focus is on low risk prime residential mortgage lending. Its exposure to commercial real estate and specialist loans, which was a legacy from its merger with Chelsea Building Society, and is now in run-off, is negligible. Commercial loans are advanced through the Norwich & Peterborough brand, which represented less than 3% of the total loan book in 2014 and is well diversified across the UK.

Yorkshire has stated its greater appetite for higher loan-to-value (LTV) ratio loans than some of its higher rated peers. Although mortgages with an LTV of over 90% accounted for only 4.2% of the loan book at end-2014. Fitch expects that Yorkshire's high LTV exposure risk will increase, given the society's intentions to maintain its offering to first-time buyers, but such exposure should remain manageable due Yorkshire's risk policy limits of lending above 90%.

Profitability has proved sustainable despite a low interest rate environment. However, margins are expected to have reached unsustainably high levels, with mortgage loan yields suffering from increased competitive pressures and funding costs likely to have bottomed out. Earnings are undiversified.

Fitch considers capital adequate for the society's rating, with sound levels on both a risk weighted and a non-risk weighted basis. The CET1 ratio was 13.8% at end-2014 while the leverage ratio increased by 2bps to 4.8% at end-2014. Capital has been generated through retained earnings.

Fitch considers the society's funding and liquidity profile as solid and stable. Yorkshire is mainly deposit funded, but has also accessed wholesale funding through the government Funding for Lending Scheme (FLS) and through debt instruments during 2014. Its liquidity levels remain sound including high quality assets placed at the Bank of England and encumbrance levels are moderate at around 24% of total assets at end-2014.

SKIPTON BUILDING SOCIETY
The upgrade of Skipton's IDRs, VR and debt ratings reflects the society's strengthened credit profile following the change of its business mix back towards its core mortgage and savings activities. Asset quality has improved, capital ratios have strengthened, non-core investments have been disposed of and earnings have stabilised. The Stable Outlook reflects that its financial performance should be sustainable due to structural changes in the composition of its loan book coupled with its reduced risk appetite for specialist and commercial real estate loans and a continued benign UK economic environment.

Fitch has revised its assessment of Skipton's asset quality upwards due to the significant improvement during 2014 as a result of tightened lending criteria, reduced risk appetite and improving economic conditions. While the society continues to be exposed to legacy specialist portfolios, these have been progressively running down, and impairment levels have been decreasing, thus reducing the society's tail risk. Skipton has some exposure to buy-to-let loans, which represented 18% of its mortgage lending at end-2014. Its new lending is capped to a moderate 75% LTV for this segment.

The legacy specialised lending (self-certified, sub-prime or near prime sectors) from Amber Homeloans and North Yorkshire Mortgage has been in run-off since 2008 and accounted for 12% of gross loans at end-2014. The society has also some exposure to interest-only residential loans through its legacy portfolio. However, Fitch considers that the risks arising from a potential deterioration of this book are manageable since the loans are now relatively seasoned.

Fitch views Skipton's reinforced capital levels, which are the result of retained earnings and the sale of non-core investments in 2014, as strong, on both a risk weighted and non-risk weighted basis. The CET1 ratio was 16.2% and the leverage ratio 6% at end-2014. Fitch believes that capital will be generated mainly through organic growth and expects it to remain at high levels.

The society's profitability significantly improved in 2014 with the net interest margin (NIM) increasing to 1.54% at end-2014 as a result of lower funding costs and higher interest margins. Skipton benefits from income diversification through its earnings generative estate agency subsidiary, Connells, whose business has proved complementary to the society's mortgage and savings activities. This business does not have any debt on its balance sheet and although it is currently considered as strategic for the group, it is a potential source of capital in case of need. Skipton's overall higher cost to income base is mainly the result of the consolidation of Connells as the mortgages and savings businesses' efficiency ratios are in line with the sector average.

Skipton's liquidity has remained strong and its liquidity buffers are mostly composed of UK government bonds, treasury bills and cash. Its encumbered assets ratio at 15.4% remains moderate at end-2014. Skipton is predominately deposit funded but has also some wholesale funding through the FLS and other debt instruments. Fitch does not expect a significant change to this funding mix although some debt issuance is expected through its recently updated EMTN programme.

PRINCIPALITY BUILDING SOCIETY
Principality's ratings reflect its moderate overall risk profile, dominated by its core residential mortgage loans and savings business. The society also has some appetite for second-charge and commercial real estate loans, which while relatively contained, are considered by Fitch to be of higher risk. Nonetheless, Fitch believes that the society is able to adequately price and manage these risks. While second charge lending has been profitable throughout the crisis, the commercial lending division has only recently become profitable again after a number of loss-making years. The society has stated its intentions to reduce its exposure to these higher risk assets as a proportion of the overall loan book, as the core business expands.

Asset quality has been improving in line with that of the sector. Arrears in the residential mortgage loan book were low at 0.75% of gross loans at end-2014. Nemo, the second charge loan book has also seen improvements in its levels of arrears, which fell to 5.9% of total second charge lending at end-2014.

Arrears past due and impaired in the commercial real estate book were GBP67.7m at end-March 2015, albeit reducing. CRE includes loans to the Welsh housing association sector, in which Principality has participated to reflect its role in providing finance for housing in Wales. These loans are performing well but are very low yielding. Concentrations in the legacy commercial loan book have further reduced with the top-20 loans accounting for just over 80% of Fitch core capital at end-2014.

Principality's profitability is higher than the sector average, reflecting its presence in higher yielding sectors. In 2014, underlying profitability was boosted by wider NIMs, the result of lower funding costs, greater volumes of business and lower impairment charges. However, costs suffered from greater investments in operational infrastructure and IT systems. One-off items (a gain on the sale of its estate agency business, Peter Alan and a change in pension accounting) significantly boosted bottom line earnings in 2014. Fitch expects the society's profitability to normalise in 2015, with greater competition resulting in tighter margins on core mortgages and on second-charge lending. NIMs are also likely to be affected in the medium term by higher funding costs and a greater bias towards prime residential mortgage loans.

Capitalisation is considered to be adequate for the risks it assumes, with a CET1 ratio of 18.2% at end-2014, calculated partly on an Internal Ratings Based approach. However, Nemo's exposure is still calculated using the standardised approach: moving the risk weighting of these loans to the IRB method could have a negative impact on regulatory CET1 ratios in the region of 400bps. The Leverage ratio was strong at 5.02% at end-2014.

Funding and liquidity are sound. Funding is obtained largely from customers as the society has a large and stable customer base in Wales, although some diversification is also provided by accessing the wholesale markets, mostly secured (RMBS and FLS). While these have raised asset encumbrance somewhat, it remains modest at 19% of total assets. Fitch expects some additional debt issuance in the medium term to replace FLS maturities, which may take the form of unsecured debt. Liquidity is healthy and of good quality.

KEY RATING DRIVERS - SUPPORT RATING AND SUPPORT RATING FLOOR
ALL SOCIETIES
The SRs and SRFs of all three building societies have been affirmed at '5' and 'No Floor', indicating that Fitch believes senior creditors cannot rely on receiving full extraordinary support from the UK in the event that these societies fail. In Fitch's view, the EU's Bank Recovery and Resolution Directive (BRRD) and legislation and regulation in the UK are now sufficiently progressed to provide a framework for resolving building societies that is likely to require senior creditors participating in losses, if necessary, instead of or ahead of a society receiving sovereign support. The Long-term IDRs of these societies are therefore driven by their standalone performance, as indicated by their VRs.

KEY RATING DRIVERS - SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
ALL SOCIETIES
The ratings of all building societies' subordinated debt and hybrid securities are notched down from their respective VRs, reflecting a combination of Fitch's assessment of their incremental non-performance risk relative to their VRs (up to three notches) and assumptions around loss severity (one or two notches).

All the UK societies' Permanent Interest Bearing Securities (PIBS) are rated four notches below their respective VRs, comprising two notches for their deep subordination and two notches for incremental non-performance.

Dated subordinated notes are rated one notch below their VRs, reflecting their subordination. Yorkshire's convertible debt is notched down twice from its VR as its conversion trigger is considered to be low (5% regulatory core Tier 1 capital) compared with the bank's current core Tier 1 ratio (13.8% at end-2014), Fitch therefore views the non-performance risk of the instrument to be 'minimal'.

RATING SENSITIVITIES
IDRs, VRs AND SENIOR DEBT
YORKSHIRE BUILDING SOCIETY
Yorkshire's ratings are sensitive to it maintaining a low risk appetite. Should there be a material increase in higher LTV lending or significantly higher commercial lending, the ratings could be downgraded. Yorkshire's Short-term IDRs would likely be downgraded if the currently high liquidity buffers decrease Although an upgrade is unlikely in the medium term, the society's ratings could benefit from higher and sustainable profitability, while improving its asset quality and maintaining high capital ratios and without deteriorating its risk appetite.

SKIPTON BUILDING SOCIETY
Skipton's ratings are sensitive to an increased risk appetite in terms of higher LTV lending or increasing commercial exposure, or a significant deterioration in its mortgages and saving business which Fitch does not anticipate in the medium term. A further upgrade is unlikely in the near future.

PRINCIPALITY BUILDING SOCIETY
Principality's ratings could be negatively affected by weaker capitalisation, increased risk appetite, which may be reflected by a significant increase in LTVs, expansion of the commercial and second-charge books or weakening asset quality. Upside potential is limited given the society's small size and relatively undiversified business model.

SUPPORT RATING AND SUPPORT RATING FLOOR
ALL SOCIETIES
Any upgrade to the building societies' SRs and upward revisions of their SRF would be contingent on a positive change in the sovereign's propensity to support its building societies. This is highly unlikely in Fitch's view.

SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
ALL SOCIETIES
The ratings are broadly sensitive to the same considerations that might affect their VRs.

The rating actions are as follows:

Yorkshire Building Society:
Long-term IDR affirmed at 'A-'; Outlook Stable
Short-term IDR affirmed at 'F1'
Viability Rating affirmed at 'a-'
Support Rating affirmed at '5'
Support Rating Floor affirmed at 'No Floor'
Senior unsecured debt and programme rating affirmed at 'A-'/'F1'
Subordinated dated debt affirmed at 'BBB+'
PIBS: affirmed at 'BB+'
Convertible notes affirmed at 'BBB'

Skipton Building Society:
Long-term IDR: upgraded to 'BBB+' from 'BBB'; Outlook Stable
Short-term IDR: affirmed at 'F2'
Viability Rating: upgraded to 'bbb+' from 'bbb'
Support Rating affirmed at '5'
Support Rating Floor affirmed at 'No Floor'
Subordinated dated debt: upgraded to 'BBB' from 'BBB-'
PIBS: upgraded to 'BB' from 'BB-'

Principality Building Society:
Long-term IDR affirmed at 'BBB+'; Outlook Stable
Short-term IDR affirmed at 'F2'
Viability Rating affirmed at 'bbb+'
Support Rating affirmed at '5'
Support Rating Floor affirmed at 'No Floor'
Senior unsecured debt and programme rating affirmed at 'BBB+/F2'
Subordinated dated debt: affirmed at 'BBB'
PIBS: affirmed at 'BB'