DBRS Confirms Laurentian Bank of Canada at A (low); Changes Trend to Stable from Negative

DBRS Limited (DBRS) confirmed the ratings of Laurentian Bank of Canada (LBC or the Bank), including the Bank’s Long-Term Issuer Rating at A (low) and its Short-Term Issuer Rating at R-1 (low). DBRS changed the trend on all long-term ratings to Stable from Negative and maintained the Stable trend on all short-term ratings. The Bank’s Intrinsic Assessment (IA) of A (low) and Support Assessment of SA3 are unchanged. The SA3 designation, which reflects no expectation of timely external support, results in the final rating being equivalent to the IA.

KEY RATING CONSIDERATIONS
The trend change to Stable from Negative reflects the resolution of the mortgage loan portfolio review, which followed LBC’s disclosure in Q4 2017 that residential prime mortgages it had sold to third parties had documentation and client misrepresentation issues. The Bank also disclosed that it identified some mortgage loans in these portfolios that were insured, but not eligible for insurance as a result of their product type. The audit of the portfolios resulted in total loan repurchases of $518 million or 1.5% of gross loans in FY2018. Furthermore, there was no marked pressure on funding or liquidity as the Bank awaited the resolution of the portfolio review, which was completed in Q2 2018. As such, DBRS positively views the measures undertaken by LBC to contain and resolve the underlying issues, including enhancements to the Bank’s operational risk management and quality-control functions.

In confirming the long-term ratings at A (low), DBRS considers LBC’s well-established retail-based franchise in Québec, its solid earnings capacity and history of low loan losses. Furthermore, the Bank is on target in implementing its strategy of changing its asset mix to concentrate on key sectors, including commercial lending, while maintaining its risk appetite framework. The ratings also consider LBC’s high reliance on brokered deposits as well as its weaker capital position relative to peers.

RATING DRIVERS
Over the longer term, improved earnings and enhanced efficiency through the successful implementation of the Bank’s transformation plan could positively impact ratings.

Conversely, material losses caused by operational difficulties as the Bank implements the various organizational, risk management and systems projects, or as a result of a perceived weakness in underwriting, could lead to negative rating actions. In addition, a material deterioration in liquidity or a reduction in capitalization to levels closer to regulatory minimums could pressure the ratings.

RATING RATIONALE
LBC is Canada’s seventh-largest Schedule I bank with assets of $45.9 billion as at October 31, 2018. The Bank is well positioned in Québec with the third-largest branch network, offering retail services in the province together with commercial lending across Canada and in the United States. LBC also distributes financial products to brokers and financial advisors across Canada through its wholesale arm, B2B Bank, which has been one of the main engines for growth over the last few years. In addition, the Bank has been refining its commercial portfolio mix to concentrate more on certain sectors, including commercial real estate and equipment finance, with organic growth and acquisitions including the 2017 purchase of U.S.-based, Northpoint Commercial Finance LLC. In 2018, the Bank sold $708 million of loans in sectors it deemed non-strategic, including agriculture, renewable energy and infrastructure. LBC also owns an integrated full-service institutional securities and investment banking firm, Laurentian Bank Securities, Inc.

Changes in the Bank’s portfolio mix and growth in the higher-margin commercial-lending segment have had a positive effect on LBC’s earnings, which rose by 11% in 2018 to $211 million. Non-interest income, on the other hand, declined by 6% year over year (YOY) to $337 million. Although LBC has reliable sources of fee income, the YOY decline can be attributed partly to consolidating branches, converting some branches to advice only, streamlining products and changing customer behaviour, all of which led to eliminating certain fee-based services. DBRS notes that, as a result of the Bank’s various transformation initiatives, its efficiency ratio of 68.7% remains one of the weakest among peers. Provisioning continues to be adequate to cover loan losses at current levels; however, with the realignment of the loan portfolio in favour of commercial loans and the adoption of International Financial Reporting Standard 9 during FY2019, provisions could trend upward.

The Bank continues to demonstrate a solid track record of strong asset quality, resulting in low impairments and loan losses. At $17 billion in FY2018, residential mortgages make up around half of LBC’s loan portfolio with 36% of these loans underwritten in Québec, where housing prices have kept pace with inflation over the last few years. Nevertheless, in DBRS’s opinion, the Bank’s more recent geographic expansion through its B2B Bank and its commercial segments exposes LBC to heightened levels of operational and credit risk. Given events in 2017, the Bank has invested significantly to upgrade its risk management policies and procedures, better aligning them with its vision for growth, which DBRS will continue to monitor.

LBC has maintained its strong branch-raised deposit base, despite branch rationalization over the last few years, which was partly responsible for the 3% decrease in deposits to $28 billion in FY2018. As the Bank continues to move forward with its digital initiatives, management expects to attract more direct deposits to counter any potential loss of funding caused by the ongoing transformation of branches to advice only. DBRS notes that LBC also relies on broker-sourced deposits, especially through B2B Bank, which could be a more volatile source of funds; however, the Bank is looking at various programs to enhance its funding profile to balance out its reliance on broker deposits. Liquidity levels are good with sufficient unencumbered assets to cover LBC’s needs.

Although the Bank’s Common Equity Tier 1 ratio improved by 110 basis points to 9.0% in FY2018, capital ratios remain close to regulatory minimums. This leaves a limited buffer to absorb any significant losses, which DBRS views as a rating constraint; however, capitalization ratios are expected to improve as LBC switches to an advanced internal rating-based model in FY2020.

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

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.

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 for this rating action. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

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