DBRS Confirms Bank of Montreal at AA; Trend Remains Negative

DBRS, Inc. (DBRS) has today confirmed its ratings on the Bank of Montreal (BMO or the Bank) and its related entities, including BMO’s Long-Term Issuer Rating of AA and Short-Term Issuer Rating of R-1 (high). BMO’s Long-Term Issuer Rating is composed of an Intrinsic Assessment (IA) of AA (low) 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 lift to the Long-Term Issuer Rating. The trend on BMO’s short-term ratings as well as the 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.

BMO’s ratings reflect its strong North American franchise that is underpinned by a business model that is diversified by geography and by revenue sources. Specifically, over 50% of BMO’s revenues are derived from non-interest income sources while approximately 25% of net income is earned in the United States with both percentages ranking second-highest among the large Canadian banks. The ratings also consider the challenging operating environment that is constrained by sluggish global growth, low interest rates, heightened regulatory and compliance expense burdens as well as the potential for a housing downturn in Canada.

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, press release entitled, “DBRS Comments on Proposed Implementation of Bail-in Regime in Canada; Bank Negative Trends Unchanged.”

For H1 2017, BMO continued to report solid results with revenue growth readily outpacing expense growth resulting in positive operating leverage; however, the Bank’s operating efficiency remains somewhat higher than Canadian bank peers. For H1 2017, BMO reported net income of $2.7 billion, up 34% from H1 2016. First-half results are up 34% on a reported basis and 21% on an adjusted basis. Adjusted results saw improvement in each business segment with the exception of U.S. Personal & Commercial (P&C) results, which were adversely affected by higher provisions for credit losses, and Corporate services. Overall, BMO’s H1 2017 adjusted return on equity was a healthy 14.2%.

Asset-quality metrics remain sound and have been relatively stable over the past year with gross impaired loans (GIL) at 0.63% of gross loans and acceptances while the annualized H1 2017 provision for credit losses as a percentage of average net loans and leases was 0.23%; however, GIL have increased due to an increase in U.S. P&C and the impact of the stronger U.S. dollar. With Canadian consumer loans representing 23% of total assets, BMO is the least exposed large Canadian bank to the Canadian consumer.

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. Nonetheless, BMO’s residential mortgage portfolio, like all large Canadian banks, appears to be conservatively underwritten or is insured. Specifically, 55% of BMO’s Canadian residential mortgage portfolio is insured while the loan-to-value (LTV) ratio of the uninsured portion is a very conservative 54%. Additionally, less than 1% of the uninsured portfolio has a beacon score of 650 or lower and a LTV of greater than 75%. 90-day delinquencies, at just 23 basis points, remain benign. Meanwhile, loss rates over the past year have been less than one basis point.

Augmenting its deposit funding, BMO enjoys ready access to diversified wholesale funding sources. The Bank’s liquidity remains strong with a Liquidity Coverage Ratio of 136% for Q2 2017. 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.

During Q2 2017, BMO’s common equity tier 1 (CET1) ratio further improved by 20 basis points quarter-over-quarter to 11.3%, primarily driven by retained earnings that were partially offset by higher risk-weighted assets. BMO also announced a 2% increase in its common stock dividend. DBRS notes that the Bank has rebuilt regulatory capital ratios following an acquisition-related dip last year.

With $719 billion in assets as of April 30, 2017, BMO is the fourth-largest Canadian bank.

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

RATING DRIVERS
When support is removed, BMO’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, further franchise and financial performance improvements, particularly within its U.S. operations, would be viewed favourably. Conversely, sustained negative operating leverage, a material increase in impaired loans, particularly as result of underwriting weakness, or a severe downturn in the housing market could 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. 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: John Mackerey
Rating Committee Chair: Lisa Kwasnowski
Initial Rating Date: 31 December 1980
Most Recent Rating Update: 28 July 2016

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.

For more information on this credit or on this industry, visit www.dbrs.com.