Ratings agency Standard & Poor’s may lower HSBC Bank Bermuda’s A/A1 credit ratings by as much as two notches, after it put the bank on “CreditWatch Negative”.

In a report published this week, S&P’s analysts cite concerns over the bank’s loan deterioration and “shrinking capital base”.

The report states that last year HSBC Bank Bermuda (HSBC BB) paid a “large discretionary dividend” to its parent company HSBC Holdings PLC, as well as upstreaming its profits — which totalled $45 million last year — to the global banking giant. This transfer of money to the parent was the main factor in HSBC Bank Bermuda’s total equity falling by about one third, S&P said.

S&P does not give a dollar figure to describe the amount of capital taken from the Bermuda operation by the parent group. But publicly available financial statements show that HSBC BB paid out dividends of $594 million. The bank’s total equity fell by more than $550 million to $1.06 billion, as of December 31, 2013, from $1.61 billion a year earlier.

HSBC BB yesterday declined to comment on the S&P report.

“We expect to resolve the CreditWatch negative within 90 days and anticipate that we could lower the rating by up to two notches,” the ratings agency said.

Nikola Swann, director, financial institution ratings, for S&P and the primary credit analyst for the report, told The Royal Gazette that before the latest assessment, the bank’s outlook had been “negative” which indicates a one in three chance of a credit rating downgrade for the bank over the next three years. “CreditWatch Negative” indicates a 50 percent chance of a downgrade during the 90-day consideration period.

During the next three months, S&P will review the bank’s loan book and study the potential for further losses.

The 2013 financial results showed a 34 percent increase in impaired loans to $689 million at the end of 2013, compared to $515 million a year earlier.

S&P regards HSBC BB as “strategically important” to the HSBC group, something that supports the Bermuda bank’s ratings. Its analysts will also speak with bank bosses at Bermuda operation and group levels to verify that this is still the case, following the hefty transfer of capital to the parent.

“We will also be thinking about what this means for our forward-looking view of the Bermuda economy, given that HSBC Bank Bermuda is such a large component of loans made to Bermudians,” Mr Swann said.

He added that there could be several reasons behind the parent group taking out a large slice of the Bermuda bank’s total equity, including that the local branch simply had more capital than it could deploy gainfully.

“From the perspective of the HSBC Group, they can look at the regulatory capital ratios and see they look quite high,” Mr Swann said. The higher the amount of equity, the more difficult it is to generate an acceptable return on equity, he added.

“However, from our perspective, it’s a warning sign when you have an increase in impaired loans at the same time you have a significant decrease in capital — as the capital is the cushion to absorb those losses.”

In its 2013 financial statements, HSBC BB comments: “The group’s policy is to maintain a strong capital base so as to maintain creditor and market confidence and to sustain future development of the business.”

It goes on to detail that its total regulatory capital — under “The Revised Framework for Regulatory Capital Assessment” by which the internationally accepted Basel II framework is implemented in Bermuda — fell only modestly to $1.06 billion from $1.12 billion at the end of 2012.

In its report, S&P acknowledged the financial strength of HSBC BB, as its risk-adjusted capital ratio of “well above 15 percent” puts the bank in the rating agency’s top category and regulatory capital requirements are comfortably exceeded.

S&P said the increase in impaired loans, combined with a decline in gross loans to $3.3 billion (from $3.8 billion), “resulted in a significant increase in non-performing assets to total loans”.

“Moreover, combined with the decline in equity, non-performing assets to equity plus loan loss reserves also increased meaningfully,” the report continues. “Positively, the company earned $45 million, despite having to take a sizeable loan loss provision of $126 million.

“Still, although reserve coverage improved slightly, we consider the possibility that the company may need to take substantial additional loan loss provisions in 2014, which would hurt profitability.”

The report goes on to note that the Bermuda economy has been struggling since 2008.

“Recent evidence suggests the possibility of an impending inflection point for the Bermudian economy, but in light of HSBC BB’s 2013 loan performance, we are re-evaluating our views on the likely timeframe for recovery in the Bermudian banking system and economy as a whole, given that the bank accounts for about one-third of bank loans made to Bermudians.

“This view has implications for future loan asset quality performance and net charge-offs of impaired loans. This is particularly because HSBC BB’s impaired loans to Bermudian residents increased in several loan categories in 2013, including residential mortgages, non-mortgage consumer debt, and corporate loans.”