DBRS Confirms Short-Term Ratings on Innovation Credit Union at R-1 (low), Stable Trends

DBRS Limited (DBRS) confirmed the Short-Term Issuer Rating and Short-Term Instruments rating on Innovation Credit Union (Innovation or the Credit Union) at R-1 (low). The trend for all ratings is Stable.

Innovation’s Support Assessment remains at SA2 based on DBRS’s expectation of timely systemic external support from the Province of Saskatchewan (Saskatchewan or the Province; rated AA with a Stable trend by DBRS) through Credit Union Central of Saskatchewan (SaskCentral; rated R-1 (low) with a Stable trend by DBRS), particularly in the form of liquidity, which is reflected in the Credit Union’s short-term ratings.

KEY RATING CONSIDERATIONS
The ratings reflect Innovation’s solid franchise within its operating area, which is tempered by its moderate size, as well as the benefits of being part of the well-established credit union system in Saskatchewan, which counts over 40% of the provincial population as members. The ratings are supported by the Credit Union’s strong earnings power that is underpinned by its above-average revenue per member and steady base of non-interest income. The ratings also consider Innovation’s higher proportion of commercial loans, especially agricultural loans, relative to peers and its aging membership base. Moreover, the Credit Union’s move to a federal charter could pose challenges in the areas of funding and operational risk.

RATING DRIVERS
Although DBRS views Innovation as well placed within its rating category, over the longer term, ratings could be positively affected by sustained membership growth, especially among younger members, leading to an improvement in franchise strength and earnings. Alternatively, ratings could come under pressure if Innovation is unable to manage funding while moving to a federal charter and deposit insurance coverage is reduced, causing deposit outflows. In addition, significant losses in the loan portfolio as a result of unforeseen weakness in the underwriting and/or risk management process could also have a negative impact on the ratings.

RATING RATIONALE
Innovation is the third-largest credit union in Saskatchewan with $2.7 billion in assets as of December 31, 2018. The Credit Union serves 10.9% of the Province’s credit union system membership base through 26 branches in its footprint area, which provide retail and small business commercial offerings in addition to an active digital platform. With over 52,000 members, Innovation has consistently grown its membership base since 2014 and expanded its market share within the provincial credit union system.

In December 2017, Innovation’s members voted in favour of pursuing federal continuance, which would see the Credit Union fall under the supervision of the Office of the Superintendent of Financial Institutions (OSFI). Innovation began to review its formal application with OSFI in September 2018 and will continue working with all counterparties to finalize its federal charter application by the end of 2020. Ahead of federal continuance, the members of Goodsoil Credit Union and Pierceland Credit Union also voted in favour of amalgamating with Innovation. The amalgamation, which took effect on January 1, 2019, brought approximately 2,600 new members to Innovation and added approximately $78 million in assets.

In DBRS’s opinion, while Innovation has significant strengths in its fundamentals, the proposed conversion to a federal credit union raises significant uncertainties about its prospects, especially with respect to funding. With federal continuance, Innovation’s previously unlimited deposit coverage under Saskatchewan’s Credit Union Deposit Guarantee Corporation (CUDGC) would be replaced by deposit insurance of up to $100,000 per account from the Canada Deposit Insurance Corporation, a federal Crown corporation; thus, the Credit Union could potentially experience deposit outflows from large retail and institutional depositors. Furthermore, although a federal charter would provide Innovation with access to prospective new members or retail customers, especially through online platforms, remote deposit acquisition might come at a higher cost than expected, given the highly competitive dynamics in the space that includes the large banks, other online platforms and local credit unions.

Innovation exhibits some of the better profitability metrics among its peer group, reflecting a loan portfolio mix with a relatively higher proportion of higher-yielding agricultural and commercial loans as well as a steady stream of non-interest income. Overall, non-interest income comprised 24% of operating revenue in 2018, which compares favourably with credit union peers. Net interest margin, which has experienced some pressure in the last several years, reversed course and rose to 2.79% in 2018 from 2.67% in 2017 as the Bank of Canada began to raise interest rates. Additionally, while credit unions typically have a high cost base because of their business model, Innovation maintains good expense control based on its emphasis on technology, resulting in one of the lowest efficiency ratios in the industry at 67.02% in 2018. Furthermore, the current rate of additional costs to prepare for federal continuance has been comfortably absorbed in Innovation’s normal run rate of expenditure.

The Credit Union’s loan book continues to grow, though at a slower pace than in the previous five years as Innovation refines its strategy around asset capture ahead of converting to a federal credit union. Net loans were up by 4% in 2018 to $2.1 billion with the portfolio mix between residential mortgage, business and agricultural loans relatively unchanged. Reflecting its footprint area, Innovation’s proportion of agriculture loans at 24% of the loan portfolio is nearly double that of its peers. Positively, DBRS notes that the Credit Union has a strong track record of managing this asset class over time, with gross impaired loans representing only 0.11% of gross loans, as Saskatchewan benefited from moderate economic growth over the last few years. Nevertheless, a weakening economy or pricing pressure in the agricultural sector could lead to an increase in impairment levels. In the meantime, with the conversion to a federal charter, Innovation is in the process of reviewing its policies and procedures to comply with OSFI’s more robust guidelines. Enhanced risk management frameworks would be viewed positively by DBRS.

Commercial and retail deposits fund 85% of Innovation’s total assets. The stability of credit union deposits is enhanced by the CUDGC guarantee; therefore, federal continuance could see deposit outflows. The Credit Union also has access to wholesale funding in the form of securitized borrowings via the Canada Mortgage Bonds program. Innovation has also sought to diversify its funding channels by introducing broker-sourced deposits in 2017, which now constitute 15% of funding; although the Credit Union has placed limits on this avenue of financing, DBRS is cautious that broker deposits tend to be more rate sensitive and are less sticky than direct-raised deposits. In addition, Innovation has various sources of liquidity, including credit facilities with SaskCentral, and reported a robust liquidity coverage ratio of 350%, well above the regulatory minimum of 80%.

Capitalization levels are good in DBRS’s view as there is a sizable cushion over regulatory minimums to absorb potential losses. Innovation’s Common Equity Tier 1 ratio, which is based on Basel III requirements, stood at 11.98% in 2018 versus the 7.00% regulatory minimum requirement. Unlike most credit unions, Innovation still pays quarterly patronage; however, earnings are generating sufficient capital to pay patronage while still supporting balance-sheet growth.

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

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

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 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.

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

DBRS Limited
DBRS Tower, 181 University Avenue, Suite 700
Toronto, ON M5H 3M7 Canada