DBRS Confirms Equitable Bank Rating at BBB, Stable Trends

DBRS Limited (DBRS) has today confirmed the Issuer Rating and Deposits and Senior Debt rating of Equitable Bank (the Bank) at BBB and confirmed its Subordinated Debt rating at BBB (low). The BBB (low) Senior Debt rating of the Bank’s parent, Equitable Group Inc. (the Holding Company or, collectively with the Bank, Equitable or the Company), has also been confirmed. All trends are Stable. The rating action follows a detailed review of the Company’s operating results, financial fundamentals and future prospects.

The ratings of debt obligations of the Holding Company take into account its structural subordination to those of the operating Bank subsidiary; therefore, it is rated one notch below the comparable instruments issued by the Bank. This notching practice recognizes that almost all assets and revenues of the organization are held or received by the Bank subsidiary. As a result, the Holding Company is dependent on its own limited resources and on dividends from the Bank subsidiary, which may be curtailed or restricted by the regulators during times of stress to safeguard the viability of the Bank under their supervisory control, if needed.

Under DBRS’s “Global Methodology for Rating Banks and Banking Organisations,” the Bank’s long-term Deposits and Senior Debt rating of BBB has an intrinsic assessment of BBB and a support assessment of SA3. The SA3 rating, which reflects the expectation of no timely external support, results in the final rating being equivalent to the intrinsic assessment.

In confirming the rating, DBRS recognizes Equitable’s franchise strength, operating as the second-largest mortgage lender in the niche Alt-A market, as well as being the ninth-largest independent Schedule I bank by assets in Canada. Furthermore, its branchless business model lends to better efficiency. The rating action also considers Equitable’s satisfactory asset quality and history of low impairments and charge-offs. These positive factors are offset by the Company’s large exposure to single-family uninsured mortgages, which could be challenged in a down cycle, and retention of the bulk of the securitization portfolio on balance sheet. In addition, the Company is heavily reliant on interest income and lacks earnings diversification.

The Company is heavily reliant on external brokers for the origination of both mortgages and deposits. Specifically, the Company has some concentration risk in its exposure to the broker network, with one major brokerage firm accounting for a portion of total mortgage originations in 2015 and a material number of prime single-family originations being sourced from one third-party distribution agent.

To improve its funding profile, the Company launched a digital banking platform, EQ Bank, in Q1 2016, to directly source deposits. Although higher cost compared to traditional bank deposits, these deposits already account for 9% of total deposits. With a limited buffer of unencumbered assets, DBRS will view further growth in directly sourced deposits as further enhancing liquidity and funding.

DBRS considers Equitable’s stable profitability as a positive contributor to the rating. However, the Company’s dependence on interest income is proving challenging because margins have come under pressure in the last year due to the low interest rate environment and Equitable’s business mix. Pre-provision income is sufficient to absorb loan losses at current loss rates, which are relatively low.

Equitable’s risk profile is satisfactory in DBRS’s view, as the Company has been successfully managing its uninsured Alt-A portfolio, which makes up over a third of Equitable’s mortgages under management. In addition, the Company has historically had low loan impairments and implements prudent risk-management practices.

Equitable maintains a passable level of capital in DBRS’s view given the Bank’s uninsured core lending portfolio, which does include more risky asset classes such as land and construction, as well as its growth targets. Capital quality is strong with relatively high earnings retention; however, there is a limited buffer to absorb potential losses.

DBRS ran its Canadian residential mortgage-backed securities model (including home equity line of credit) on the uninsured residential mortgage portfolio using static loan-level data to gain an understanding of how the portfolio might act in the event of material market declines. Additionally, the uninsured portion of the commercial portfolio was run through DBRS’s commercial mortgage-backed securities (CMBS) model. DBRS notes that over a third of the commercial portfolio — such as mortgages that include construction loans and land — could not be run through the CMBS model. Construction loans, which totalled $565 million in Q1 2016, made up 6% of the core lending portfolio and are equivalent to 76% of the Company’s common equity. On a positive note, the analysis showed that the expected loss in the mortgage portfolio during a significant real estate market correction is manageable.

RATING DRIVERS
The ratings could come under pressure should there be a material increase in impaired loans and charge-offs as a result of a serious real estate market correction. Furthermore, losses in the core lending portfolio because of faults in the underwriting and/or risk-management process would also have a negative impact on the rating. Although unlikely given the current environment, ratings could be positively impacted over the medium term by increased diversification through the introduction of more fee-based products, in addition to the removal of a larger portion of securitizations off balance sheet. An improvement in the funding and liquidity profile could also drive the rating upward.

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 or by contacting us at info@dbrs.com.

The applicable methodologies are the Global Methodology for Rating Banks and Banking Organisations (December 2015), Rating Bank Capital Securities – Subordinated, Hybrid, Preferred & Contingent Capital Securities (February 2016) and DBRS Criteria: Support Assessments for Banks and Banking Organisations (March 2016), which can be found on our website under Methodologies.

Lead Analyst: Maria-Gabriella Khoury
Rating Committee Chair: Roger Lister

The rated entity or its related entities did participate in the rating process. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities.

For more information on this credit or on this industry, visit www.dbrs.com or contact us at info@dbrs.com.