DBRS Confirms National Bank of Canada at AA (low), Stable Trend

DBRS Limited (DBRS) confirmed the ratings of National Bank of Canada (National or the Bank) and its related entities, including the Bank’s Long-Term Issuer Rating at AA (low) and Short-Term Issuer Rating at R-1 (middle). The trends on all ratings are Stable. National’s Intrinsic Assessment (IA) is A (high) and Support Assessment is 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 one notch of uplift from the IA to the Long-Term Issuer Rating. However, following the finalization of the Canadian Bank Recapitalization Regime (the Bail-In Regime), DBRS eventually expects to remove the uplift from systemic support. This will be actioned once a sufficient level of Bail-inable Senior Debt is issued, thereby providing an adequate buffer for non-bail-inable obligations, which is expected to offset the removal of systemic support (see the press release “DBRS Takes Rating Actions on Six Canadian Banking Groups after Finalization of Bail-In Regime,” April 19, 2018).

KEY RATING CONSIDERATIONS
National’s ratings reflect its super-regional presence with particular strength in its home province of Québec, which has experienced strong economic growth over the last couple of years. The Bank benefits from strong earnings that include a high component of fee-based revenues, owing to its Wealth Management and Financial Markets businesses. Moreover, asset quality remains sound, while the funding and capital profiles are stable.

The ratings also consider the Bank’s position in the rest of Canada where it primarily competes for market share with the large Canadian banks, in addition to competing with Desjardins Group (rated AA with a Negative trend by DBRS) in its home province, especially for retail deposits. Furthermore, National is reliant on a relatively larger proportion of wholesale funding relative to the other large Canadian banks. Lastly, DBRS notes that National’s Financial Markets business segment is an important contributor to the Bank’s franchise. Although the majority of transactions are client driven, which DBRS views positively, the segment’s activities do expose the Bank to increased capital markets risk from significant market downturns or other adverse events.

RATING DRIVERS
In DBRS’s view, ratings could be positively affected by an increase in client deposit capture, indicating an improvement in market position. Furthermore, a decrease in the reliance on wholesale funding could also lead to positive rating pressure.

Conversely, a material deterioration in asset quality, particularly as a result of a perceived weakness in underwriting, could lead to negative rating actions, as would a significant increase in risk appetite in capital markets.

RATING RATIONALE
National continues to benefit from the positive performance of the Québec economy and the growth of the Bank’s footprint in targeted markets across the rest of Canada, especially in wealth management and capital markets. Earnings remain strong, with net income, excluding specified items, growing by 11% year over year (YOY) to $1.1 billion in H1 2018. Positively, the improved results were broad-based, with growth in each of the business segments. While a smaller business within National’s portfolio, the U.S. Specialty Finance and International division saw strong growth, posting a 45% YOY increase in net income to $113 million in H1 2018. Non-interest-income levels continue to be strong, representing over half of total revenues, while return on common equity, excluding the aforementioned adjustments, was a healthy 18.8%, among the highest of the Big Six Banks.

Both prudent risk management and a conservative lending culture have enabled National to exhibit some of the best asset-quality metrics among peers. In addition, the continued strong growth in Québec has contributed to a favourable credit environment over the last few years. As such, gross impaired loans are manageable at 0.40% of gross loans as of H1 2018, while the annualized provisions for credit losses (PCL) as a percentage of average net loans and leases was 0.26%. DBRS notes that the Bank adopted International Financial Reporting Standard 9 starting in F2018, which may lead to more volatility in the PCL. While current asset-quality metrics reflect the benign credit environment in Canada, DBRS views these levels as being near cyclical lows and likely not sustainable over the longer term.

DBRS remains concerned over 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, especially given the level of Canadian household indebtedness. Nonetheless, National only has 26% of its retail mortgage and home equity line of credit portfolio in Ontario and 7% in British Columbia. National’s footprint is predominantly in Québec, and the bulk of the residential real estate exposure is in Montréal, a market that has not experienced significant rises in house prices. Furthermore, the Bank’s residential-secured portfolio, like all the large Canadian banks, appears conservatively underwritten or is insured. Specifically, 41% of National’s Canadian residential-secured portfolio is insured, while the average loan-to-value ratio of the uninsured portion is a conservative 59%.

The Bank enjoys a strong funding profile with a growing deposit base. Nevertheless, given its large capital markets business, National has a larger proportion of wholesale funding versus its large bank peers. As such, an increase in the client’s share of wallet-through-retail and wealth-management deposits, which would increase deposit funding relative to wholesale funding, would be beneficial to the ratings. Meanwhile, the Bank’s liquidity levels are strong with a Liquidity Coverage Ratio of 137% for Q2 2018, near the top of the peer range.

National’s Common Equity Tier 1 (CET1) ratio reached 11.3% in Q2 2018, a 10-basis-point (bp) improvement from the previous quarter and well above Office of the Superintendent of Financial Institutions (OSFI) requirements. On a YOY basis, the CET1 ratio improved by 70 bps, as internal capital generation outpaced growth in risk-weighted assets. Consequently, National’s CET1 ratio is now in the mid-range of large Canadian bank peers. Meanwhile, OSFI published its guidelines related to the amount of total loss-absorbing capacity (TLAC) that domestic systemically important banks are required to issue. DBRS expects National to be comfortably above these TLAC requirements well in advance of the required compliance date of November 1, 2021.

With $256 billion in assets as of April 30, 2018, National is the sixth-largest bank in Canada.

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

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 on the issuer page at www.dbrs.com.

The applicable methodology is the Global Methodology for Rating Banks and Banking Organisations (July 2018), which can be found on our website under Methodologies.

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

Lead Analyst: Maria-Gabriella Khoury, Vice President, Global FIG
Rating Committee Chair: Michael Driscoll, Managing Director, Head of NA FIG

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.

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