DBRS Confirms Central 1 Credit Union Rating of A (high) Stable, Following Methodology Change

DBRS Limited (DBRS) has today confirmed the ratings of Central 1 Credit Union (Central 1), including its Issuer Rating and Medium & Long-Term Senior Notes & Deposits rating at A (high), its Subordinated Debt at “A” and its Short-Term Instruments Rating at R-1 (middle). DBRS is now using the “Global Methodology for Rating Banks and Banking Organisations” (June 2015) and the related “DBRS Criteria: Support Assessment for Banks and Banking Organisations” (March 2015) to rate Central 1.

The confirmation of Central 1’s rating considers the fundamental strengths of the credit unions in British Columbia (B.C.) and Ontario, which jointly own Central 1. Central 1 is an integral component of the B.C. and Ontario credit union Systems, and the ratings of Central 1 primarily reflect the intrinsic assessment (IA) of “A” on the B.C. System and BBB (high) on the Ontario System. The B.C. System assessment reflects a satisfactory franchise strength, passable earning power, a satisfactory risk profile and a strong funding, liquidity and capitalization profile. The Ontario System assessment reflects a passable business franchise and earnings power, satisfactory risk profile, funding and liquidity, and capitalization. Central 1 has generally sound fundamentals that do not detract from the assessments of the systems.

Reflecting the importance of the credit unions and the role of Central 1, implicit support from the provincial governments for Central 1 is considered likely and is reflected in the support assessment for Central 1 of SA2. Reinforcing the importance of Central 1’s role, B.C.’s Financial Institutions Commission, the provincial regulator, named Central 1 as a Domestic Systemically Important Financial Institution within the Canadian credit union system, with an enhanced regulatory and supervisory framework for Central 1. With a rating of AA (high) for B.C. and a rating of AA (low) for Ontario, the provinces are considered capable of providing such support. This expectation of systemic and timely external support adds a notch uplift from the IA of the Systems, resulting in the final rating of A (high) for Central 1.

The cohesiveness of both systems is underpinned by ownership, funding and control of Central 1, as well as the critical services offered by Central 1 to the credit unions. This cohesiveness is enhanced by deposit insurance programs, which are administered by the Credit Union Deposit Insurance Corporation (of B.C.) (unlimited amounts for all deposits) for B.C. credit unions, and the Deposit Insurance Corporation of Ontario ($100,000 maximum or unlimited for registered plans) for Ontario credit unions.

Among credit union centrals in Canada covered by DBRS, Central 1 is unique in having members from more than one province. Central 1’s role is providing three types of services to its credit union members: (1) centralized liquidity and funding services, (2) payment and settlement services to the credit unions (operated by Central 1 on behalf of all the centrals west of Québec) and other services to credit unions and (3) government relations and trade services.

The B.C. System consists of 42 independent co-operatively owned credit unions, with assets of $62 billion representing about 63% of the assets of Central 1’s credit unions. DBRS estimates the credit unions operate in the order of 31% of combined bank and credit union branches in the province and account for about 23% of deposits and 17% of residential mortgages. (Branch information is based on credit union branches and branches of the nine largest chartered banks. There may be other deposit-taking branches in the province, including trust companies.) The operating environment in B.C. is good, although some level of caution is warranted as a result of real estate prices in Vancouver and surrounding areas. The B.C. System’s overall franchise is considered strong.

Profitability of the combined credit unions in the B.C. System has been under modest pressure over the last several years, although there has been some improvement to date in 2015. Net interest margin continued to decline in 2014 as a result of competition and the low interest rate environment, although the reduction was comparatively modest compared with 2013. Net interest income increased modestly as a result of higher interest earning assets. Non-interest income declined modestly as a result of lower capital gains partially offset by higher member services revenues and subsidiary earnings. The ratio of non-interest income to operating revenue has remained low but stable at about 20% over the last several years. Operating expenses to operating revenue increased to 77.6% in 2014; expense levels remain higher than those of banks. Loan loss provisions relative to operating profit increased to 12.7% in 2014 following a more than ten-year record low of 8.3% in 2013; provisions are well contained within operating profit. While DBRS recognizes expense levels are higher for credit unions because of the additional costs of the democratic process, the generally smaller size of credit unions, the typically high level of charitable donations and continual efforts to reduce the cost-to-income ratio are still important considerations in remaining competitive over the longer term. The B.C. System’s earnings are considered satisfactory.

While the B.C. System’s level of loss provisions increased in 2014, most of the B.C. System’s asset quality metrics continued to show improvement in 2014 and into 2015. The low level of credit costs is a direct result of the largely real estate-secured nature of the loan book and rising real estate prices for an extended period of time. Gross impaired loans declined relative to gross loans and were 33 basis points (bps) at the end of Q3 2015 compared with 47 bps at the end of 2013; gross impaired loans are defined as 90-day delinquencies. The B.C. loan portfolio primarily comprises low-risk residential mortgages (67%) and real estate secured commercial loans (25%), suggesting recovery rates will be high. The remaining portions of the portfolio include comparatively small amounts of personal lines of credit, other personal loans and other commercial loans and leases and securitizations. The B.C. System’s risk profile is considered satisfactory.

Both systems have material exposure to the Canadian residential mortgage market. Any slowdown in this market may slow earnings generation, while a downturn in the residential mortgage market could hurt asset quality indicators and ultimately have an impact on provisioning levels.

The B.C. System’s overall funding and liquidity profile is considered strong. About 89% of the system’s balance sheet and more than 100% of loans are funded by deposits, which are considered stable. B.C. credit unions have a mandatory deposit requirement, which must be held at Central 1. The credit unions have access to committed facilities with Central 1. A review of the Financial Institutions Act and the related Credit Union Incorporation Act could lead to regulatory requirements closer to OSFI Basel 3 liquidity and capital standards. A discussion of the 100% deposit guarantee is expected as well; while DBRS does not know the outcome of that discussion, an adequate phase-in period would be expected if limits were to be put in place.

The B.C. System’s capital adequacy (based on risk-weighted assets) was 14.9% at the end of 2014, compared with a minimum requirement of 8.0%. Retained earnings, which DBRS views as the strongest form of equity for a system, remain the largest component of equity at 87%. Although down in 2014, internal capital generation has remained in the mid- to high-single digits for several years. The B.C. System’s capitalization is considered strong.

As an important component of the financial sector in Ontario, the credit union system had over 1.3 million individual members and 82 independent credit unions that are cooperative members of Central 1 at year end. DBRS estimates the credit unions operate in the order of 17% of bank and credit union branches in the province but account for just 3% of deposits and 4% of residential mortgages (branch information based on the credit unions and the nine largest banks). The operating environment in Ontario is good given the diversification of the economy. The Ontario System’s franchise is considered passable although not as strong as the B.C. System.

The Ontario System’s return on equity (before dividends and patronage refunds) was 5.4% in 2014, down from 7.4% in 2013, although this has been a modest improvement year to date in 2015. Net interest income increased in 2014 on strong loan growth offset by margin compression; the trend of loan growth offset by margin compression, which has been in place for several years, is the result of the low interest rate environment and competitive conditions in both deposits and lending. Non-interest income declined modestly in 2014 compared with 2013; the proportion of non-interest income to total income continues to hover around 20%. While the contribution of non-interest income remains low for the Ontario System compared with the Canadian banks, it is similar to the B.C. System and most credit union systems in Canada rated by DBRS. The Ontario System’s earnings are considered passable. Ontario member credit unions continue to report high non-interest expenses, with an efficiency ratio at 81%.

The Ontario System’s Gross impaired loans (defined as 90-day delinquencies) declined from 61 bps at the end of 2013 to 47 bps at the end of Q3 2015. Loan loss provisions as a percentage of operating profit crept back up from a 15-year low in 2013 to 17.3% in 2014, which is reasonable given the largely secured nature of the portfolio. Low-risk residential mortgages continue to represent the largest proportion of the on-balance sheet loan portfolio at 60%, while non-mortgage personal loans represent 6% of the portfolio. The proportion of commercial lending has been relatively stable over the last few years at about 28% to 29% of the total portfolio. While commercial loans represent an opportunity for the credit unions to enhance yield, they also result in higher expected loss provisions. The Ontario System’s risk profile is considered satisfactory.

Ontario credit unions are contractually required to keep 6% of assets as deposits with Central 1; they have access to committed facilities with Central 1. A large portion (83%) of the collective balance sheet and 95% of loans are funded by deposits, which are considered stable. The Ontario System’s overall funding and liquidity profile is considered satisfactory.

The Ontario System’s risk-based ratio was 12.8% (compared with a regulatory minimum of 8.0%) and shareholders’ equity-to-total assets was 6.4% at year end. The Ontario System is less capitalized by retained earnings than the B.C. System (only about 64% of equity is in the form of retained earnings). Internal capital generation has been acceptable, averaging about 4.6% over the past five years. The Ontario System’s capitalization is considered satisfactory.

There are no material deficiencies at Central 1 that would affect the rating relative to the assessment of the System. Central’s profitability is limited, but earnings are not a material rating factor for a central. Asset quality and financial risk profile metrics remain acceptable. Central 1’s liquidity is strong, and its capital is generally strong, although a regulatory requirement for a borrowing multiple on the mandatory reserve pool has resulted in regularly scheduled share calls to top up this portion of capital because of System growth.

The Stable trend reflects the resiliency of the two systems’ franchise strength, earnings, liquidity, funding and capitalization, as well as no material deficiencies at the central that would affect the rating. Negative rating pressure could occur with material weakening of asset quality metrics caused by housing market deterioration or other factors, weakness in system earnings or financial risk profiles or a re-assessment of support expectations. One or more large credit unions successfully applying for a federal charter might have negative implications as well. Positive ratings pressure could develop should the different provincial centrals choose to merge, or with strengthened System business franchises or improved System earnings.

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 by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodology is Global Methodology for Rating Banks and Banking Organisations (June 2015) and DBRS Criteria: Support Assessment for Banks and Banking Organisations (March 2015), which can be found on DBRS’s website at www.dbrs.com.

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