DBRS Confirms National Bank of Canada at AA (low); Trend Remains Negative

DBRS Limited (DBRS) has today confirmed its ratings on the National Bank of Canada (National or the Bank) and its related entities, including National’s Long-Term Issuer Rating of AA (low) and Short-Term Issuer Rating of R-1 (middle). DBRS has also assigned a new rating of AA (low) to the Bank’s Long-Term Deposits and a new Short-Term Issuer Rating of R-1 (middle). National’s Long-Term Issuer Rating is composed of an Intrinsic Assessment (IA) of A (high) and a Support Assessment (SA) of SA2, reflecting the expectation of timely, systemic support from the Government of Canada (rated AAA with a Stable trend by DBRS). The SA2 designation results in a one-notch benefit to the Long-Term Issuer Rating. The trend on National’s Long-Term Issuer Rating, Long-Term Senior Debt, Long-Term Deposits and older-style subordinated debt remains Negative while other capital instruments whose ratings are notched down from the Bank’s IA continue to have Stable trends.

National’s ratings reflect its super-regional presence with particular strength in its home province of Québec. The Bank’s strong earnings include a high component of fee-based revenues, owing to its Wealth Management and Financial Markets businesses. Moreover, asset quality remains sound while funding and capital profiles are stable. The ratings also consider the Bank’s relative concentration in Canada, especially in Québec, and that National has one of the lowest net interest margins among the large Canadian banks because of competition from its peers and Desjardins Group in its home province. Furthermore, this geographic concentration could have a larger impact on National in the event of a housing downturn in Canada, although housing prices in the Bank’s primary market have been more modest. Lastly, National has a relatively large capital markets business segment whose earnings can be more volatile.

The continued Negative trend reflects DBRS’s view that changes in Canadian banking legislation and regulation point to a declining potential for timely support for Canada’s systemically important banks. Eventually, this decline is expected to result in a change in DBRS’s SA to SA3 from SA2. Currently, for these banks, the SA2 results in a one-notch uplift above their IAs. This regime primarily affects the six big Canadian banks that have been designated as domestic systemically important banks (D-SIBs). While this Bail-in Regime is expected to come into force in H1 2018, the proposed new “bail-inable” debt will only begin to be issued by D-SIBs at that time and no existing debt will be subject to bail-in retroactively. Thus, DBRS considers that there would not be sufficient “bail-inable” debt initially to reduce the likelihood of systemic support from its current level in Canada. DBRS expects to maintain the current notch of support until the D-SIBs build up sufficient new “bail-inable” senior debt such that the likelihood of systemic support has declined to a level at which this uplift is no longer warranted. The timing of such action depends on the finalization of the Bail-in Regime and the extent to which the D-SIBs build up their “bail-inable” senior debt. Two factors pressuring the D-SIBs to issue new “bail-inable” senior debt are the maturing of their existing senior debt and their need to meet the newly established requirements for total loss-absorbing capacity (TLAC) by November 1, 2021. DBRS continues to evaluate the impact of the proposed regulations and will comment further as the proposals are finalized. For more detail, please see the July 11, 2017, DBRS press release entitled, “DBRS Comments on Proposed Implementation of Bail-in Regime in Canada; Bank Negative Trends Unchanged.”

The Bank continues to experience an improvement in earnings as a result of its good revenue mix, modestly improving expense levels and generally low credit costs. For H1 2017, reported net income of $981 million was nearly double H1 2016 levels because of net income growth across all business segments, including the net income contribution of the ABA Bank subsidiary. Furthermore, National’s H1 2016 results had been negatively affected by a sectoral provision on the oil and gas (O&G) portfolio and a write-down of its investment in Maple Financial Group Inc. Adjusting for these items, net income was up 17% year over year to $994 million in H1 2017. Overall, National’s H1 2017 return on common equity, excluding the aforementioned adjustments, was a healthy 18.4%, one of the highest among the Big Six Banks.

Asset quality has improved over the past year, benefiting from improvements in the O&G sector. Indeed, some troubled O&G sector clients for which National had previously taken provisions in H1 2016 were able to make repayments. As a result, gross impaired loans declined to 0.3% of gross loans in H1 2017 compared with 0.4% in H1 2016. Positively, DBRS notes that this ratio is currently one of the lowest among the large Canadian banks. In addition, loan-loss reserves covered 181% of impaired loans in H1 2017 versus 161% in H1 2016; however, in DBRS’s opinion, National is more susceptible to economic weakness in the country, given its concentration in Canada, particularly in Québec. Furthermore, while market risk appears to be well controlled, the growing importance of National’s capital markets business segment also exposes the Bank to increased risk from significant market downturns or other adverse events.

DBRS remains concerned about the significant appreciation in housing prices, particularly in and around Vancouver and Toronto, and the potential impact of a housing downturn on the Canadian economy as well as on other consumer-related loan portfolios. Nevertheless, with its footprint mainly in Québec, National only has 25% of its retail mortgage and home equity line of credit portfolio in Ontario and 7% in British Columbia. In addition, like all large Canadian banks, National’s residential mortgage portfolio appears to be conservatively underwritten or is insured. Specifically, 47% of the Bank’s Canadian retail mortgage portfolio is insured while the loan-to-value ratio of the uninsured portion is a very conservative 59%.

National’s funding profile remains sound and stable with access to diversified wholesale funding sources. Liquidity as measured by the Liquidity Coverage Ratio was 139.0% at April 30, 2017, one of the highest among the large Canadian banks. DBRS notes that the Net Stable Funding Ratio will now not go into effect until January 1, 2019, but expects that the Bank is well positioned to adhere to the rule.

The Bank’s common equity tier 1 (CET1) ratio reached 10.8% in Q2 2017, a 20-basis point improvement over the previous quarter, mainly because of higher earnings retention. Although National’s CET1 ratio is one of the lowest among the large Canadian banks, it is still 280 basis points above the minimum requirement instituted by the Office of the Superintendent of Financial Institutions.

With $239 billion in assets as of April 30, 2017, National is the sixth-largest Canadian bank.

The Grid Summary Grades for National are as follows: Franchise Strength – Strong; Earnings Power –Strong; Risk Profile – Strong/Good; Funding & Liquidity – Strong/Good; Capitalisation –Strong.

RATING DRIVERS
When support is removed, National’s long-term ratings would likely be downgraded by one notch. On an intrinsic basis, upward ratings momentum is unlikely as DBRS views the Bank as well placed within its rating category. Over the longer term, increased geographic diversification within Canada that would lead to an improvement in the franchise strength would be viewed positively. Conversely, a material increase in impaired loans, particularly as result of underwriting weakness or a severe downturn in the housing market, or a significant increase in risk appetite in the capital markets business will likely have negative rating implications.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The principal methodology is the Global Methodology for Rating Banks and Banking Organizations (May 2017), which can be found on dbrs.com under Methodologies.

The primary sources of information used for this rating include company documents and SNL Financial (and other sources such as bank regulators, etc.). DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: Maria-Gabriella Khoury
Rating Committee Chair: Lisa Kwasnowski
Initial Rating Date: March 31, 1981
Last Rating Date: July 27, 2017

The rated entity or its related entities did participate in the rating process. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities.