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

Fitch has also assigned Paragon's main operating entity, Paragon Bank PLC, a Long-Term IDR of 'BBB+' and VR of 'bbb+'.

Key Rating Drivers

Holdco, Opco Ratings Aligned: Paragon acts as the holding company for the banking group. Its VR is based on our assessment of the group's consolidated credit profile, which reflects the credit profile of Paragon Bank PLC, the principal operating subsidiary. The equalisation of the operating and holding companies' ratings reflects the absence of holding company double leverage and prudent liquidity management, which minimises cash flow mismatches at the holding company level.

Specialist Mortgage Lender: Paragon's ratings primarily reflect the bank's business model as a lender in the UK buy-to-let (BTL) mortgage market and also its continued expansion of commercial-lending activities, including real-estate development finance. This exposes the bank to sectors that are potentially more vulnerable in an environment of higher interest rates and weak economic growth, but Paragon's mortgage lending is focused on specialist BTL, which has been more resilient, supplemented by commercial lending and motor finance. The ratings also reflect strong earnings and sound capitalisation.

Robust BTL; Commercial-Concentrated: Paragon's BTL book has a long record of low arrears, which has been supported by strong underwriting standards, rising rents and conservative loan-to-value (LTVs). Underwriting standards in commercial lending are also sound and the book is diverse. The bank intends to continue growing in this segment and, in Fitch's view, the portfolio is more vulnerable to asset-quality pressures in a challenging operating environment, particularly in the more concentrated development finance portfolio.

Deterioration in Development Finance: The Fitch calculated impaired loans ratio of 1.6% at FYE23 (year-end September; including purchased originated credit impaired (POCI) loans) has increased from 1.1% at FYE22, reflecting rising arrears in mortgage loans and growth in development finance watchlist exposures.

However, the book remains well-collateralised with appropriate haircuts to realisable values, which is reflected in a fairly low 13% coverage at FYE23. We expect the impaired loans ratio (including POCI loans) to rise to just over 2% of gross loans by FYE25, mainly due to affordability pressures from high interest rates.

Strong Profitability, Low Impairments: Operating profit improved to 3.7% of risk-weighted assets at FYE23 (RWAs; net of hedging gains) from 3% at FYE22, due to rising interest rates and a controlled cost base. Loan impairment charges (LICs) remained low in FY23, but we expect a moderate increase in FY24 and to remain modest, given strong loan collateralisation.

We forecast operating profit to fall to 2.7% of RWAs in FY25 due to pressure on net interest margin (NIM) from mortgage lending competition and rising funding costs as the Term Funding Scheme Small and Medium-sized Enterprises (TFSME) is repaid. The bank's equity structural hedge will provide modest support for NIM in a falling rate environment, but it does not have a structural hedge on non-interest rate-sensitive deposits that provide support to larger peers.

Strong Profit but High Pay-Outs: Paragon's common equity Tier 1 (CET1) ratio of 14.7% at end-1QFY24 provides adequate buffers over its regulatory minimum requirement (including buffers) of 13.3%. Profitability is strong compared with peers', but this is partly offset by pay-outs and expanding new businesses that are yet to be tested through the cycle. Paragon is not formally subject to UK leverage ratio requirements, but its leverage is sound at 7.6% at FYE23 (FYE22: 7.9%) and well above the minimum guidance for UK banks.

Improving Funding Profile: Paragon's funding profile continues to improve as it grows its retail deposit base, and its loans/deposits ratio decreased to 110% at FYE23 (FYE22: 130%). However, we believe its deposit base remains fairly price-sensitive and, in our view, deposit resilience has yet to be tested through a period of deposit-market pressure. Securitisation funding has remained low relative to deposits and central-bank funding. Liquidity has been strengthened further through the year, with a 12-month average liquidity coverage of 194% at FYE23 (FYE22: 146%), but we expect this to normalise as TFSME is repaid.

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

Rating Sensitivities

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

Paragon's ratings are sensitive to material deterioration in asset quality, which could arise from pressures in the BTL market or from higher-risk commercial lending. The VR could be downgraded if the CET1 ratio approaches 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 falls below 2% of RWAs on a sustained basis.

An increase in double leverage at the holding company to above 120%, 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 improvements to Paragon's business profile, as manifested in further diversification of earnings, a record of strong and sustainable performance in commercial business lines through the credit cycle, and strengthening financial metrics. An upgrade would also be supported by a 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 its 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 its VR.

VR ADJUSTMENTS

The operating environment score of 'aa-' is in line with the category implied score and we apply the following adjustment reason: sovereign rating (negative). This is to reflect that the score is constrained by the UK sovereign rating (AA-/Negative).

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

The 'bbb+' capitalisation & leverage score is below the category implied 'a' score due to the following adjustment reason: internal capital generation and growth (negative).

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. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation of the materiality and relevance of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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