DBRS Confirms Bank of Montreal at AA; Trend Remains Negative

DBRS, Inc. (DBRS) has today confirmed the ratings of Bank of Montreal (BMO or the Bank) and related entities, including BMO’s Issuer Rating and Deposits & Senior Debt rating at AA and its Short-Term Instruments rating at R-1 (high). The trends on the senior long-term debt, short-term instruments and older-style subordinated debt remain Negative, while other capital instruments whose ratings are notched down from the Bank’s intrinsic assessment (IA) continue to have a Stable trend. Confirmation of the ratings follows a detailed review of the Bank’s operating results, financial fundamentals and future prospects.

BMO’s ratings reflect its strong North American franchise that is underpinned by a business model that is diversified by both geography as well as by product, with over half of all revenues derived from non-interest income. Despite weakness in energy and other resource-based sectors of the economy, the balance sheet remains strong and supportive of the ratings. The ratings also consider the difficult operating environment highlighted by weak global growth, low interest rates, and evolving regulatory and compliance burdens that are negatively affecting expenses. While BMO still lags behind its regional U.S. bank peers, profitability within its U.S. bank subsidiary has improved, reflecting strong organic growth, as well as the subsidiary’s acquisition of GE’s Transportation Finance (TF) business that closed in December 2015.

BMO’s long-term Deposits & Senior Debt rating of AA is composed of an IA of AA (low) and a support assessment of SA2, reflecting the expectation of timely, systemic support by the Government of Canada (rated AAA, Stable trend, by DBRS). The SA2 designation results in a one-notch benefit to the senior debt and deposits ratings. The maintenance of the Negative trend reflects DBRS’s view that ongoing changes in Canadian legislation and regulation still indicate that the potential for timely support for systemically important institutions is declining, leading to a likely change in DBRS’s support assessment to SA3 from SA2. The legislation enacting the bank recapitalization, or bail-in, regime is moving forward, but DBRS does not yet have sufficient clarity on the details of the implementation to remove the benefit of systemic support from the affected ratings.

BMO continues to report solid results with an adjusted return on equity (ROE) above 12% despite the challenged resource sector. Specifically, BMO reported net income of $973 million, or $1.15 billion on an adjusted basis, in Q2 2016 and net income of $2.04 billion for H1 2016, or $2.33 billion on an adjusted basis. First half results are up 2% on a reported basis and 7% on an adjusted basis. Adjusted results saw improvement in each business segment with the exception of Wealth Management, which was negatively affected by a write-down on an equity investment. On an adjusted basis and excluding the write-down, DBRS notes that BMO has delivered four straight quarters of positive operating leverage, evidencing the strength of the franchise. Overall, BMO’s H1 2016 adjusted ROE was a still healthy 12.1%.

DBRS remains concerned over the significant appreciation seen in housing prices, particularly in and around Vancouver and Toronto. Nonetheless, BMO’s residential mortgage portfolio appears conservatively underwritten or is insured. Specifically, 59% of BMO’s Canadian residential mortgage portfolio is insured, while the loan-to-value of the uninsured portion is a very conservative 57%. Meanwhile, loss rates for the past four quarters have been less than one basis point. Alberta, the province most exposed to the energy sector, represents 16% of the total residential mortgage portfolio and is primarily insured. The resource sector also remains challenged, but overall exposures to oil & gas and mining total less than 3% of the total loan portfolio.

Funding and liquidity remains strong with a Liquidity Coverage Ratio of 123% for the quarter ended April 30, 2016. DBRS notes that the Net Stable Funding Ratio will not go into effect until January 1, 2018, which BMO should be able to adhere to but at likely modestly higher funding costs.

Capital remains sound with a Basel III Common Equity Tier 1 Ratio of 10.0% at April 30, 2016, and is down from 10.7% in October 31, 2015, primarily reflecting the TF acquisition. DBRS notes that this metric is roughly in line with big Canadian banks. Meanwhile, BMO’s Basel III Leverage Ratio was 3.9%.

RATING DRIVERS
If support is removed, BMO’s long-term ratings would likely be downgraded. On an intrinsic basis, upward ratings momentum is unlikely, as DBRS views the Bank as well placed within its rating category. Over the longer term, further improvements within the Bank’s U.S. operations’ financial performance, while maintaining sound balance sheet fundamentals would be viewed favorably. Moreover, safely growing the consumer side of the business would also be viewed favorably. Conversely, sustained negative operating leverage or a material increase in impaired loans could have negative rating implications.

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.

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.

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.

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

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

DBRS will publish a full report shortly that will provide additional analytical detail on this rating action. If you are interested in receiving a copy of this report, contact us at info@dbrs.com.

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

Lead Analyst: John Mackerey
Rating Committee Chair: Roger Lister
Initial Rating Date: December 31, 1980
Most Recent Rating Update: July 16, 2015