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

DBRS, Inc. (DBRS) has today confirmed the ratings of The Bank of Nova Scotia (Scotiabank or the Bank) and its related entities, including Scotiabank’s Long-Term Issuer Rating of AA and Short-Term Issuer Rating of R-1 (high). Scotiabank’s Long-Term Issuer Rating is composed of an Intrinsic Assessment (IA) of AA (low) and a Support Assessment (SA) of SA2, reflecting the expectation of timely, systemic support from the Government of Canada (Canada; rated AAA with a Stable trend by DBRS). The SA2 designation results in a one-notch lift to the Long-Term Issuer Rating. The trend on Scotiabank’s short-term ratings as well as the Long-Term Issuer Rating, Long-Term Senior Debt, Long-Term Deposits and older-style subordinated debt ratings remains Negative, while other capital instruments whose ratings are notched down from the Bank’s IA continue to have Stable trends.

Scotiabank’s ratings incorporate its well-developed business model that is diversified both by product and by geography. Indeed, the Bank’s strong Canadian franchise as well as solid presence in a number of faster-growing international banking markets results in a highly diversified franchise and, ultimately, in a highly diversified geographic footprint. DBRS notes that the Bank has focused its international growth on the Pacific Alliance region (Mexico, Peru, Colombia and Chile). In fact, of the large Canadian banks, Scotiabank reports one of the highest percentages of net income derived outside of Canada at around 40% of total net income. The ratings also consider the challenging operating environment that is constrained by sluggish global growth, low interest rates, heightened regulatory and compliance expense burdens and the potential for a housing downturn in Canada. Additionally, the ratings factor in the potential for greater volatility in its international markets.

The continued Negative trend reflects DBRS’s view that changes in Canadian banking legislation and regulation point to declining potential for timely support for Canada’s systemically important banks. Eventually, this decline is expected to result in a change in DBRS’s SA to SA3 from SA2. Currently, for these banks, the SA2 results in an uplift of one notch above their IAs. This regime primarily affects the six big Canadian banks that have been designated as domestic systemically important banks (D-SIBs). While this bail-in regime is expected to come into force in H1 2018, the proposed new “bail-inable” debt will only begin to be issued by D-SIBs at that time and no existing debt will be subject to bail-in retroactively. Thus DBRS believes that there will not be sufficient “bail-inable” debt initially to reduce the likelihood of systemic support from its current level in Canada. DBRS expects to maintain the current notch of support until the D-SIBs build up sufficient new “bail-inable” senior debt such that the likelihood of systemic support has declined to a level at which this uplift is no longer warranted. The timing of such action depends on the finalization of the bail-in regime and the extent to which the D-SIBs build up their “bail-inable” senior debt. Two factors pressuring the D-SIBs to issue new “bail-inable” senior debt are the maturing of their existing senior debt and their need to meet the newly established requirements for total loss-absorbing capacity (TLAC) by November 1, 2021. DBRS continues to evaluate the impact of the proposed regulations and will comment further as the proposals are finalized. For more detail, please see “DBRS Comments on Proposed Implementation of Bail-in Regime in Canada; Bank Negative Trends Unchanged” published on July 11, 2017.

Scotiabank reported H1 2017 net income of $4.1 billion, up 20% year over year. However, after adjusting for the restructuring charge last year, net income increased a still-solid 11%. On an adjusted basis, the improved results reflect higher revenues and a lower provision for credit losses, partially offset by higher non-interest expenses and the negative impact of foreign currency translation. For H1 2017, Scotiabank achieved positive operating leverage, as net income and revenues grew in all business segments. Scotiabank’s results equate to a solid return on equity of 14.6% for H1 2017.

For H1 2017, the provision for credit losses decreased because of lower provisions related to energy exposures and last year’s collective allowance build. Net impaired loans have increased but remain at the fairly stable and manageable level of 49 basis points.

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. Additionally, of Scotiabank’s Canadian residential mortgage portfolio, 54% is insured, while the Loan-to-Value Ratio of the uninsured portion is very conservative at 51%.

Funding and liquidity remain strong with a Liquidity Coverage Ratio of 126% for the quarter ended April 30, 2017. DBRS notes that the Net Stable Funding Ratio will not go into effect until January 1, 2019, which Scotiabank should be able to readily comply with in due course.

Capital remains sound with a Basel III Common Equity Tier 1 (CET1) Ratio of 11.3% as at April 30, 2017. The Bank continues to have strong internal capital generation, offset by the natural organic growth in risk-weighted assets and the Bank’s regular share buybacks. Indeed, Scotiabank’s CET1 Ratio sits on the upper-end of its peer group. Additionally, Scotiabank’s Basel III Leverage Ratio was 4.4%, comfortably above the 3.0% minimum.

Scotiabank is the third-largest Canadian bank with assets of $922 billion as at April 30, 2017.

The Grid Summary Grades for Scotiabank are as follows: Franchise Strength – Very Strong/Strong; Earnings Power – Very Strong/Strong; Risk Profile – Strong; Funding and Liquidity – Strong; and Capitalisation – Very Strong/Strong.

RATING DRIVERS
When support is removed, Scotiabank’s long-term ratings will likely be downgraded by one notch. 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, continued successful execution and building of its diverse international banking franchise without increasing risk could be viewed favorably. Conversely, sustained negative operating leverage, an increased reliance on wholesale funding, a material increase in impaired loans (particularly as result of underwriting weakness) or a severe downturn in the housing market 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 by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (May 2017), which can be found on dbrs.com under Methodologies.

The primary 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.

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

Lead Analyst: John Mackerey
Rating Committee Chair: Lisa Kwasnowski
Initial Rating Date: 31 December 1980
Most Recent Rating Update: 28 July 2016

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.