DBRS Confirms Nationwide Building Society at AA (low), Trend revised to Negative

DBRS Ratings Limited (DBRS) has today confirmed the ratings of Nationwide Building Society (Nationwide or the Society) including its AA (low) rating for Long-Term debt and deposits. The Trend on all long-term ratings has been revised to Negative from Stable. The Trend on the R-1 (middle) Commercial Paper rating remains Stable and the Intrinsic Assessment (IA) remains at A (high). Given Nationwide’s position as the UK’s largest mutual and a leading provider of savings products and residential mortgage lending, DBRS views Nationwide as systemically important within the U.K. (categorised as SA-2) and the ratings incorporate one notch of uplift from the IA for systemic support.

The revision of the trend to Negative reflects a number of challenges facing the Society, in particular the need to improve its leverage ratio (as calculated by the Prudential Regulatory Authority, or PRA) to at least 3%, within a relatively short time period. The Society is primarily relying on retained earnings to reach the 3% leverage ratio by end-2015, but despite some recent improvements in the net interest margin, DBRS still considers the Society’s profitability to be constrained by some legacy issues. These include the high provisions on commercial real estate lending that have been required in recent years and the Society’s Base Mortgage Rate (BMR) promise to its members. As a result of these factors, and the Society’s mutual model that inherently generates lower levels of income, DBRS is of the opinion that the Society may be challenged to reach the leverage ratio requirement within the period to end-2015.

As of 4 April 2013 Nationwide had a solid regulatory capital base as evidenced by a core tier 1 capital ratio of 12.3% and an estimated fully-loaded Basel III core tier 1 ratio of 9.1%. However, following the capital shortfall exercise carried out by the PRA, under their definition, Nationwide’s leverage ratio was 2.1% at end-2012, below the 3% minimum required by the PRA. As a result of this Nationwide was required to submit a plan to the PRA detailing how the society would meet the 3% ratio. On 12 July 2013 Nationwide announced its capital plan, which would see the 3% minimum leverage ratio reached by end-2015, had been accepted by the PRA, and that it does not require the issuance of new capital instruments. Given the Society’s mutual status, and that the plan does not include the issuance of new capital instruments, the improvement in the leverage ratio will therefore require improved earnings retention over the period to end-2015. DBRS notes that although the plan approved by the PRA does not include issuance of new capital instruments, if Nationwide were to issue qualifying instruments, this could speed up the process of reaching the 3% leverage ratio requirement.

The Society’s profitability has been subdued in recent years by the challenging operating environment, including the low base rate environment, increased funding costs, provisions for commercial real estate lending, and Nationwide’s own Base Mortgage Rate (BMR) promise that maintains the interest rate on certain mortgage products at 2% above the Bank of England base rate. The Society estimates that, in the financial year to 4 April 2013, maintaining the BMR, compared to other standard variable rates in the market, cost the society GBP 800 million of income reflecting a substantial transfer of value to mortgage customers. However, balances on the BMR are now expected to reduce as they primarily reflect short-term fixed and variable rate products that reverted to the BMR at the end of the incentive period. Since 2009 all new business written will revert on to a more normal standard variable product and this should help to boost profitability in the future. DBRS views positively the 25% increase in the net interest margin to 1.04% in the year to 4 April 2013, a result of the re-pricing of mortgages, the impact of the Funding for Lending Scheme (FLS), the growth in lending balances and lower liquidity holdings. Further improvement in the margin will be important for Nationwide given its high reliance on net interest income.

Provisioning requirements for commercial real estate have also affected the Society’s profitability with these totaling GBP 493 million in the financial year to 4 April 2013. Although DBRS expects the level of provisioning related to the commercial real estate portfolio to moderate in the future, the relatively high level of impaired loans and provisions taken against these suggest that the credit quality of this lending is weaker than previously expected.

The ratings could see further downward rating pressure if, in DBRS’s view, the Society appears unlikely to meet the leverage ratio requirement, if provisioning charges on the commercial real estate portfolio remain elevated suggesting that the quality of this lending is lower than previously anticipated, or if the UK economy fails to continue to recover. Conversely, a stronger than expected recovery in the Society’s profitability could lead to the trend being revised to Stable.

Nationwide’s ratings continue to reflect the strong domestic retail franchise, which is underpinned by its solid positions in residential mortgage lending and saving products, as well as its substantial high street presence. Additionally the society has been successful in further improving its franchise in recent years in current accounts where it now has an estimated market share of 5.7%. The ratings also incorporate the solid credit quality of the society’s mortgage book which has consistently proven to be significantly better than the industry average credit performance and this is reflected in the ability Nationwide continues to evidence in generating sufficient pre-impairment income (IBPT) to absorb the cost of credit. Liquidity and funding remain solid and well-managed, underpinned by the substantial retail deposit base.

Separately, DBRS has also withdrawn the AAA ratings on debt guaranteed by HM Treasury, as this debt has been repaid.

Notes:
All figures in pound sterling (GBP) unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organizations. Other applicable methodologies used include the DBRS Criteria – Intrinsic and Support Assessments and DBRS Criteria: Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments. These can be found at: http://www.dbrs.com/about/methodologies

[Amended on June 23, 2014, to reflect actual methodologies used.]

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

Ratings assigned by DBRS Ratings Limited are subject to EU regulation only.

Lead Analyst: Ross Abercromby
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 9 December 1998
Most Recent Rating Update: 19 March 2012

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/

The conditions that lead to the assignment of a Negative or Positive Trend are generally resolved within a twelve month period. DBRS’s trends and ratings are constantly under surveillance.

For additional information on this rating, please refer to the linking document under Related Research.