Fitch Ratings-Chicago-October 22: Fitch Ratings has affirmed Bank of Montreal's (BMO) Long- and Short-Term Issuer Default Ratings (IDRs) at 'AA-' and 'F1+', respectively.
The Rating Outlook is Stable. A full list of rating actions is at the end of this press release. This rating action follows Fitch's periodic review of the Canadian Banks Peer Group, which includes Bank of Montreal (BMO), Bank of Nova Scotia (BNS), Canadian Imperial Bank of Commerce (CIBC), Desjardins Group (DESJ), National Bank of Canada (NBC), Royal Bank of Canada (RBC) and Toronto-Dominion Bank (TD). Company-specific rating rationales for the other banks are published separately. For further discussion of the Canadian banking sector, please refer to the special report titled '2019 Outlook: Canadian Banks' to be published in the near future.
KEY RATING DRIVERS IDRS, VRS AND SENIOR DEBT
BMO's rating affirmation and its high ratings reflect the company's consistent financial performance over various credit cycles, sizeable franchise and market position, and good revenue diversification relative to its peer banks given its U.S. based operations. BMO's ratings also benefit from Canada's strong regulatory environment as well as a stable domestic banking market. Additionally, Canadian Mortgage and Housing Corporation (CMHC) insurance plays an important role in supporting the balance sheets of all Canadian Banks. In Fitch's view, BMO may currently be better positioned than peers to navigate through recent mortgage market changes, which could have an impact to its balance sheet compared to its Canadian peers. As of 3Q18, BMO has the lowest percentage of mortgage loans to gross loans at 30% compared to a peer average of 46%. The company's Canadian insured book totaled 47% of total Canadian mortgages, which exceeded a peer average of 44% as of the third quarter. Consistent with peers, BMO reported an average LTV of 67% at origination for its uninsured residential mortgage portfolio. Fitch views favorably BMO's geographic revenue diversification through its U.S. based operations. This revenue diversification could provide a buffer should the Canadian operations experience a slowdown in the economy and/or a gradual decline in housing activity. That said, BMO's U.S. operations have to date been somewhat dilutive to the overall enterprise's return on equity (ROE), as they incur some additional regulatory and operating costs relative to more domestically focused banks. As an example, BMO's Canadian P&C segment, the company's largest by revenue, reported an adjusted efficiency ratio year-to-date 2018 of 49.6%, which was approximately 10% lower than its U.S. P&C segment. Further, BMO's U.S. C&I loan growth has accelerated from the pace a year-ago and continues to outpace U.S. large regional peers. Fitch has raised concerns regarding C&I industry loan growth in the U.S. given fierce competition, loosening of underwriting, and growth trajectory that is above the level suggested by macro indicators. Asset quality has improved modestly compared to the same period a year ago with continued improvement in the energy manufacturing portfolios. BMO's ratio of gross impaired loans and loan impairment charges continue to compare well internationally and to be in-line with expectations. However, compared to Canadian bank peers, its gross impaired loans (GIL) and loan impairment charge (LIC) ratios over the past 10 years tends to have a higher standard deviation driven mainly from its U.S. franchise. Notably, in more recent years, these measures have trended better as the U.S. segment has seen a slowdown in the inflow of problem credits. During the first nine months of 2018, the company's earnings performance continues to be solid supported by revenue growth despite a challenging environment. Return on average common equity was 12.3% and return on average assets was 0.67% which rank near the bottom of the Canadian peer group but compare favorably to similarly rated D-SIBs internationally. Had a C$260 million restructuring charge in 2Q18 and acquisition related intangible amortizations year-to-date been excluded, ROE would have been higher. BMO's Canada and U.S. Personal & Commercial (P&C) banking segment has been a strong contributor to earnings accounting for (respectively) roughly 50% and 27% of operating group net income over the last nine months. The company's results were also boosted by strong organic loan growth in the U.S., and higher Wealth Management revenue, the positive effects of which were partially offset by lower Capital Markets revenue and lower net interest margin. BMO's capital position is considered solid and supportive of its ratings. The company's CET1 ratio has continued to trend higher (similarly to its Canadian peers) reaching 11.4% in 3Q18. BMO CET1 capital increased 7% YoY driven by net income and moderate capital payouts which represented about 67% of net income year-to-date. Similar to its Canadian peers, Fitch views BMO's funding profile and liquidity as solid. The company maintains a large portion of assets in cash and liquid securities, which is reflected in its solid LCR ratio of 146% at 3Q18. BMO also benefits from a solid funding base, including a sizeable amount of retail deposits. In addition to its Canadian retail franchise, BMO's expanded U.S. based retail franchise diversifies the funding mix and provides relatively low-cost, sticky deposits.
SUPPORT RATING AND SUPPORT RATING FLOOR
The bank's Support Rating (SR) of '2' and Support Rating Floor (SRF) of 'BBB-' reflect Fitch's view on the continued potential for support for the largest Canadian banks in the near term given their systemic importance. Canadian banking authorities have wide latitude to resolve a troubled bank including re-capitalizing an institution, creating a bridge bank, or imposing losses on creditors. However, recently implemented bail-in rules for the Canadian domestic systemically important financial institutions (D-SIBs) reflect the government's intent to reduce potential sovereign support. In addition, guidelines on total loss absorbing capital require D-SIBs to build up a minimum of 21.5% of total loss absorbing capital (TLAC) by November 2021, which Fitch believes would significantly lower sovereign propensity to provide support. Over time, Fitch will likely lower the SRs and SRFs of these institutions as bail-in eligible debt is issued.
SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
BMO's subordinated debt is rated one notch below its VR to reflect for loss severity in accordance with Fitch's assessment of each instrument's respective non-performance and relative loss severity risk profiles. It has thus been affirmed due to the affirmation of BMO's VR at 'aa-'.
SUBSIDIARY AND AFFILIATED COMPANY
All of the subsidiaries and affiliated companies including BMO Harris Bank National Association reviewed as part of the Canadian Bank peer review factor in a high probability of support from parent institutions to the subsidiaries. This reflects that performing parent banks have very rarely allowed subsidiaries to default. It also considers the high level of integration, brand, management, financial and reputational incentives to avoid subsidiary defaults.
DERIVATIVE COUNTERPARTY RATING, LONG- AND SHORT-TERM DEPOSIT RATINGS
BMO's Derivative Counterparty Rating (DCR), and Long-Term deposit ratings are at the same level as the bank's Long-Term IDR and senior unsecured debt. Short-Term deposit ratings are similarly equalized with the bank's Short-Term IDR. Under recently finalized bail-in rules for Canadian D-SIBs, derivative counterparties and depositors have preferential status over other senior obligations and are excluded from being written down under a bail-in, irrespective of the amount of bail-in eligible debt outstanding.
LONG- AND SHORT-TERM DEPOSIT RATINGS
U.S. Subsidiaries BMO Harris, NA's uninsured long-term deposit ratings are rated one notch higher than the company's IDR and senior unsecured debt because U.S. uninsured deposits benefit from depositor preference. U.S. depositor preference gives deposit liabilities superior recovery prospects in the event of default.
RATING SENSITIVITIES IDRS, VRS AND SENIOR DEBT
Given the already high level of BMO's ratings, Fitch does not expect any upside to ratings. Today's rating action incorporates Fitch's view that uncertainties remain on what the impact of recent mortgage reform announcements will be to the broader mortgage market. Fitch also considers the negative impact of higher interest rates in BMO's primary North American mortgage markets, especially given high levels of consumer debt in Canada. As such, a faster price correction that is prolonged and/or a slowdown in the housing market will likely impact earnings growth for all Canadian banks. This would also affect the broader economy through the link between housing wealth and consumer consumption, and the real estate sector, which are important drivers of GDP growth. The Canadian banks' ratings are sensitive to these changes. BMO's ratings would be sensitive should the company deploy more capital into another large acquisition and/or manage capital more aggressively through increased dividends and/or repurchase activity, such that total payout ratio exceeded 100%. Modest rating pressure could also ensue should BMO's credit performance deteriorate evidenced by impaired loans and loan losses trending to levels above its 10 year average of 1.0% and 0.4%, respectively. This could potentially become more severe should macroeconomic risks such as unexpected increases in interest rates, a severe housing price correction as well as macroeconomic weakness in the overall Canadian economy that leads to a material rise in unemployment. Similarly to peers, BMO has good contribution from capital markets to net income. Should capital markets expand materially or should BMO look to move more from the middle market to larger clients, this could potentially increase the volatility of the company's earnings and result in ratings pressures. In addition, given the Financial Action Task Force's identified weaknesses in Canada's anti-money laundering / anti-terrorism financing (AML/ATF) regime, BMO's ratings would be sensitive to material and systemic conduct risk findings, particularly as they relate to anti-money laundering/terrorism financing or sanctions compliance. While this is not currently expected, material findings that suggest broad-based weaknesses or failings in the risk management infrastructure could pressure BMO's ratings.
SUPPORT RATING AND SUPPORT RATING FLOOR
The SR of '2' incorporates Fitch's expectation that there could be some level of support for the Canadian D-SIBs going forward, although it has been weakened given the implementation of bail-in legislation. Fitch recognizes that Canadian authorities have taken steps to improve resolution powers and tools but intend to maintain a flexible approach to bank resolution. However, SRs and SRFs would likely be lowered further as banks begin to issue bail-in eligible debt. While Fitch had viewed the reduction of support to occur closer to the time of compliance with bail-in requirements in 2021, Fitch may accelerate the lowering of the SR and SRF prior to banks' full compliance with the TLAC requirement.
SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
BMO's subordinated debt and hybrid capital ratings are broadly sensitive to the same considerations that might affect the VR (or bank subsidiaries). BMO Capital Trust II's trust preferred securities are rated five notches from BMO's VR, given management and regulatory authorities' powers to suspend dividends.
SUBSIDIARY AND AFFILIATED COMPANIES
The subsidiary and affiliated company ratings including BMO Harris Bank National Association are primarily sensitive to any change in the VRs of the bank.
DERIVATIVE COUNTERPARTY RATING, LONG- AND SHORT-TERM DEPOSIT RATINGS
BMO's DCR and deposit ratings are sensitive to changes in the bank's IDRs. DCR and deposit ratings may be upgraded by one notch above the bank's respective Long-Term and Short-Term IDRs in the event of the bank's faster-than anticipated issuance of bail-in eligible debt sufficient to effectively recapitalize the bank.
LONG- AND SHORT-TERM DEPOSIT RATINGS U.S. SUBSIDIARIES
The ratings of BMO Harris National Association uninsured long-term deposit ratings are sensitive to any change in the bank level IDR. Fitch has affirmed the following ratings: Bank of Montreal --Long-term IDR at 'AA-'; Outlook Stable; --VR at 'aa-'; --Senior unsecured debt at 'AA-'; --Subordinated debt at 'A+'; --Short-Term IDR at 'F1+'; --Short-term debt at 'F1+'; --Support Rating at '2'; --Support Floor at 'BBB-'. BMO Harris Bank National Association (formerly Harris N.A.) --Long-Term IDR at 'AA-', Outlook Stable; --Long-term deposits at 'AA'; --Short-Term IDR at 'F1+'; --Short-term deposits at 'F1+'; --Support Rating at '1'. BMO Capital Trust II --Preferred stock rating at 'BBB'. Fitch has assigned the following ratings: Bank of Montreal --Derivative Counterparty Rating 'AA-'; --Long-term deposits 'AA-'; --Short-term deposits 'F1+'. Contact: Primary Analyst Christopher Baker, CFA Director +1-312-606-2361 Fitch Ratings, Inc. 70 W. Madison Street Chicago, IL 60602 Secondary Analyst Christopher Wolfe Managing Director +1-212-908-0771 Committee Chairperson Alan Adkins Senior Director +44 20 3530 1702 Media Relations: Sandro Scenga, New York, Tel: +1 212 908 0278, Email: sandro.scenga@fitchratings.com. Additional information is available on www.fitchratings.com Applicable Criteria Bank Rating Criteria (pub. 12 Oct 2018) https://www.fitchratings.com/site/re/10044408 Additional Disclosures Dodd-Frank Rating Information Disclosure Form https://www.fitchratings.com/site/dodd-frank-disclosure/10049294 Solicitation Status https://www.fitchratings.com/site/pr/10049294#solicitation Endorsement Policy https://www.fitchratings.com/regulatory
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