DBRS Confirms Bank of Nova Scotia at AA; Trend Remains Negative

DBRS, Inc. (DBRS) has today confirmed the ratings of Bank of Nova Scotia (Scotiabank or the Bank) and its related entities, including Scotiabank’s Issuer Rating and Deposits & Senior Debt rating of AA and its Short-Term Instruments rating of 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.

Scotiabank’s ratings reflect its strong Canadian and select international banking franchise that is underpinned by a business model that is diversified both by product and geography. In fact, of the large Canadian banks, Scotiabank reports the highest percentage of net income derived outside of Canada at around 44% of total net income. Despite weakness in energy and other resource-based sectors of the economy, the balance sheet remains strong and supportive of the ratings. Scotiabank’s exposure to the oil & gas sector is the largest of the large Canadian banks; however, DBRS continues to view this exposure as manageable at less than 4% of total loans. 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.

Scotiabank’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.

Scotiabank continues to report solid results with an adjusted return on equity in the 14% range despite higher loan loss provisioning needs reflecting the challenged resource sector. Specifically, Scotiabank reported net income of $1.6 billion, or $1.9 billion on an adjusted basis (excluding a restructuring charge), in Q2 2016 and net income of $3.4 billion for H1 2016, or $3.7 billion on an adjusted basis. First half results are down 4% on a reported basis and up 4% on an adjusted basis. Adjusted segment results saw year-over-year improvement in each business segment with the exception of the Global Banking and Markets segment, which was negatively affected by higher provision for credit losses and challenging market conditions.

DBRS remains concerned over the significant appreciation seen in housing prices, particularly in the greater Vancouver and Toronto areas. Nonetheless, Scotiabank’s Canadian residential mortgage portfolio appears conservatively underwritten or is insured. Indeed, the Bank purchased bulk insurance on an additional portion of this portfolio during Q2 2016. Following this additional purchase, 62% of Scotiabank’s Canadian residential mortgage portfolio is now insured, while the loan-to-value of the uninsured portion is very conservative at 51%. Alberta, the province most exposed to the energy sector, represents 16% of the total residential mortgage portfolio and is primarily insured.

Funding and liquidity remain strong with a Liquidity Coverage Ratio of 121% 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 Scotiabank 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 10.1% at April 30, 2016. Additionally, Scotiabank’s Basel III Leverage Ratio was 4.1%, comfortably above the 3% minimum.

RATING DRIVERS
If support is removed, Scotiabank’s long-term ratings would likely be downgraded. On an intrinsic basis, continued successful execution of the Bank’s diverse international retail banking strategy without increasing risk could be viewed favorably. Conversely, sustained negative operating leverage, a material increase in impaired loans or an increased reliance on wholesale debt in the Bank’s funding mix 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.

For more information on this credit or on this industry, visit www.dbrs.com.

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