DBRS Confirms Central 1 Credit Union at A (high) and R-1 (middle), Stable Trend

DBRS Limited (DBRS) confirmed all ratings for Central 1 Credit Union (Central 1), including its Long-Term Issuer Rating at A (high) and Short-Term Issuer Rating at R-1 (middle). The trends on all ratings remain Stable.

The ratings and Stable trend of Central 1 consider the fundamental strengths of British Columbia and Ontario Systems (B.C. System and Ontario System, respectively). Specifically, the ratings reflect the Intrinsic Assessment (IA) of “A” for the B.C. System and the IA of A (low) for the Ontario System. Central 1 provides services to the B.C. System and to almost all of the Ontario System, particularly liquidity management, payments solutions, clearing and settlement. These credit unions own Central 1 and account for it on a cost basis. Analysis of the IAs of these two systems uses the combined financials of the individual credit unions in each province.

DBRS views the B.C. System franchise as strong, given its solid market positions in key products, although by DBRS’s estimates, market shares over a five-year period have been trending down, and membership growth has slowed. Earnings power is seen as generally good, although competitive pressures and a low rate environment have weakened profitability. With respect to Central 1’s risk profile, DBRS views it as strong with a track record of low credit costs and the majority of its exposures being backed by mortgages and other assets. Nonetheless, a major correction in housing prices accompanied by a significant downturn in the provincial economy represents an important risk. System funding and liquidity are strong, reflecting a sticky retail deposit base and an improving liquidity position. Capitalization is viewed as good, given a solid capital cushion and sufficient levels of internal equity generation.

DBRS considers the Ontario System franchise to be good, although market shares in key products remain modest, and differentiating service offerings is challenging in this market. Earnings power is considered good, although profitability metrics are below peers, reflecting the intense levels of competition, especially from the larger Canadian banks. The Ontario System’s risk profile is seen as strong, given exposures that are mostly backed by mortgages and other assets. Exposures to real estate development would likely be most problematic if a steep correction in housing prices were to be combined with a significant downturn in the provincial economy. Funding and liquidity is also seen as strong based on the fact that a majority of the Ontario System’s funding is drawn from a sticky retail deposit franchise, though DBRS recognizes its increased use of market funding, primarily securitization. Capitalization is considered to be good, with solid capital cushions and satisfactory internal equity generation.

DBRS views support from the provincial governments for Central 1 as likely, which reflects the importance of the credit unions in these provinces, especially in British Columbia where the provincial regulator, B.C. Financial Institutions Commission (FICOM), named Central 1 as a Domestic Systemically Important Financial Institution within the Canadian credit union system, as well as the key role of Central 1 supporting these credit unions, DBRS views support from the provincial governments for Central 1 as likely. As a result, Central 1’s Support Assessment is designated as SA2. Moreover, given DBRS’s long-term ratings of AA (high) for British Columbia and AA (low) for Ontario, the provinces are considered capable of providing such support, if needed. This expectation of systemic and timely external support provides an uplift of one-notch from the IA of the Systems, resulting in a final rating of A (high) for Central 1.

The cohesiveness of both systems is underpinned by the credit unions’ ownership, funding and control of Central 1, as well as the critical services offered by Central 1 to the credit unions. This cohesiveness is enhanced by deposit insurance programs, which are administered by the Credit Union Deposit Insurance Corporation (unlimited amounts for all deposits) for British Columbia. In Ontario, the deposit insurance scheme has been updated and will go into effect from January 1, 2018. Under the updated scheme, the deposit insurance coverage has been increased to $250,000 (from $100,000), while unlimited coverage for registered amounts will remain in place. DBRS considers that individual credit unions are dependent on the reputation of the credit union system more broadly, and therefore, individual credit unions will likely support the credit union system to the extent that their fiduciary and other responsibilities allow.

DBRS views Central 1’s earnings power as good considering its primary role as liquidity and service provider for the two systems, with upward of 75% of its revenues derived from non-interest income. In Q2 2017, Central 1’s net income declined by 28% quarter over quarter (QoQ) from the impact of narrowing credit spreads on the investment book together with increased expenditures in the Digital & Payments business. For the six-month period ending June 2017, net income increased by 15% on a year-over-year basis driven by higher operating revenues and gains on the sale of financial assets. The decline in QoQ net income was a result of a loss resulting from fair value adjustments in financial assets versus a significant gain recorded in Q1 2017.

At Q2 2017, Central 1’s total assets stood at $17.7 billion. Its balance sheet is considered low risk, given that the majority is held in high-quality, government-issued liquid securities. In recognition of this low risk, on August 24, 2017, FICOM reduced Central 1’s borrowing multiples, thereby easing Central 1’s regulatory capital requirements. Central 1’s loan portfolio is small relative to the size of its balance sheet at 12.4% of total assets as at Q2 2017. This portfolio has been performing well with small loan loss provisions, net of recoveries, over the past three years with negligible impaired loans. Internal equity generation and capitalization is viewed as strong relative to Central 1’s low risk balance sheet and given that Central 1 can require credit unions to provide capital, if required, through a capital call.

RATING DRIVERS
While there is limited potential upside for the ratings, ratings could benefit positively from a material strengthening of the two provincial systems’ franchises, ideally with growth in both the number of members and revenue per member, as well as improved system earnings, either through revenue diversification into non-interest income or expense reduction. Conversely, a sharp correction in real estate prices accompanied by a material deterioration in employment levels resulting in substantial loan losses, a reduction in the assessment of likelihood of provincial support, or a sustained reduction in system internal capital generation could put downward pressure on the ratings.

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 applicable methodology is the Global Methodology for Rating Banks and Banking Organisations (May 2017), which can be found on our website under Methodologies.

The primary sources of information used for this rating include company documents. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: Sohail Ahmer, Vice President - Global FIG
Rating Committee Chair: Michael Driscoll, Managing Director, Head of NA FIG

Initial Rating Date: 31 July 1978
Most Recent Rating Update: 2 August 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.