Fitch Ratings has affirmed Paragon Banking Group PLC's (Paragon) Long-Term Issuer Default Rating (IDR) at 'BBB+' with a Stable Outlook and Viability Rating (VR) at 'bbb+'.

Key Rating Drivers

Real-Estate Exposure: Paragon's ratings reflect the bank's business model as a lender in the UK buy-to-let (BTL) mortgage market and also its continuing expansion of commercial-lending activities, including real-estate development financing. This exposes the bank to sectors that are potentially more vulnerable in an economic downturn. The ratings also reflect sound profitability and capitalisation. The bank specialises in more complex BTL lending, supplemented by commercial lending and motor finance.

Focus on BTL Lending: Paragon's mainstay is BTL lending, where its market share is modest at about 4%, limiting its pricing power. However, it has a larger share in the specialist professional BTL market, where relationships are important, supporting margins.

The bank's diversification strategy into commercial lending has mitigated margin pressure following its exit from Idem Capital. Underwriting standards are generally sound in commercial lending and the book is well-diversified, but the portfolio has grown rapidly since 2018 and, in Fitch's view, is vulnerable to asset-quality pressures as loans season in a deteriorating environment.

Resilient Asset Quality: Paragon's asset quality has remained healthy, with an improved impaired loans ratio of 0.9% at FYE22 (year ended 30 September 2022; or 1.1% when including purchased originated credit impaired (POCI) loans) from 2.1% at FYE21. The reduction in impaired loans was due to the resolution of non-performing loans and the disposal of POCI loans in Idem Capital.

We expect some deterioration in asset quality with the impaired loans ratio (including POCI loans) to rise to around 1.4% of gross loans by end-2024, mainly due to higher interest rates, an expected recession in 2023, and affordability pressures.

Higher Funding Costs, Impairments Expected: Profitability continued to improve in FY22 with operating profit/risk weighted assets of 3%, supported by rising interest rates and faster growth in higher-yielding commercial lending. However, asset margins remain vulnerable to competitive pressures and slowing growth in a more challenging housing market.

Paragon's low cost base continues to benefit from not having a branch presence, but is facing some inflationary pressure. Fitch expects loan impairment charges (LICs) to increase from low levels, but to remain manageable, given strong loan collateralisation. Rising LICs and funding costs will weigh on earnings in 2023.

Adequate Capitalisation: The bank's common equity Tier 1 (CET1) ratio of 16.3% at FYE22 provides adequate buffers over minimum regulatory requirements, despite policies to return capital to shareholders. Internal capital generation is strong compared with peers' but is offset by payouts and a short track record for some new businesses through the cycle. Paragon's UK leverage ratio of 7.9% at FYE22 is strong relative to peers'.

Adequate Funding and Liquidity: Paragon's funding profile continues to improve as it grows its retail deposit base and its loans/deposits ratio decreased to 130% at FYE22 from 163% at FYE20. However, we believe its deposit base remains price-sensitive. Securitisation funding has remained low relative to deposits and central-bank funding. Liquidity remains sound, with an average monthly liquidity coverage ratio (LCR) of 146% in FY22.

Paragon's Short-Term IDR of 'F2' is the lower of the two options for a 'BBB+' Long-Term IDR as the bank's funding and liquidity score of 'bbb' does not justify a higher rating.

No Support: The bank's Government Support Rating (GSR) of 'no support' reflects Fitch's view that senior creditors cannot rely on extraordinary support from the UK authorities if Paragon becomes non-viable, in light of the legislation in place that is likely to require senior creditors to participate in losses to resolve the bank.

Rating Sensitivities

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Paragon's ratings are primarily sensitive to weakening in capitalisation and operating profitability. They are also sensitive to material deterioriation in asset quality due to significant pressure in the BTL market or from Paragon's expanding commercial-lending portfolio.

The VR could be downgraded if we expec the CET1 ratio to approach 13%, which could be caused by faster-than-expected growth or by larger capital returns to shareholders. The VR could also be downgraded if Paragon's operating profit/RWAs falls sustainably below 2%.

An increase in double leverage at the holding company to above 120%, or reduced fungibility of liquidity or a weakening of liquidity management between group companies, could lead to a downgrade of Paragon's IDRs and VR.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

An upgrade would require material improvements to Paragon's business profile as manifested in further diversification of earnings, a track record of strong and sustainable performance in new business lines through the credit cycle and strengthening financial metrics. An upgrade would also require an improved funding profile that remains stable through a more challenging economic period.

OTHER DEBT AND ISSUER RATINGS: KEY RATING DRIVERS

Paragon's senior unsecured debt rating is one notch below the Long-Term IDR as the bank does not have a Minimum Requirement for Own Funds and Eligible Liabilities (MREL) requirement, and we do not expect the bank to build up a buffer of qualifying junior and senior holdco debt in excess of 10% of RWAs.

Paragon's Tier 2 debt is notched down twice from its VR to reflect poor recovery prospects in a failure given its subordinated status.

OTHER DEBT AND ISSUER RATINGS: RATING SENSITIVITIES

Paragon's senior debt ratings are primarily sensitive to a change in its IDRs.

The subordinated debt ratings are primarily sensitive to changes in the VR.

VR ADJUSTMENTS

The Operating Environment score of 'aa-' is in line with the implied score range but we apply the following adjustment reason: sovereign rating (negative). This is to reflect the score is constrained by the UK sovereign rating (AA-/Negative).

The 'bbb' asset quality score is below the implied 'a' score range due to the following adjustment reason(s): underwriting standards and growth (negative).

The 'bbb+' capitalisation & leverage score is below the implied 'a' score range due to the following adjustment reason(s): risk profile and business model (negative).

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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