DBRS Confirms Laurentian Bank of Canada’s Ratings; Revises Trends to Negative

DBRS Limited (DBRS) confirmed the ratings of Laurentian Bank of Canada (LBC or the Bank). The trends on all long-term ratings have been revised to Negative from Stable, while the trends on all short-term ratings remain Stable. The Bank’s Intrinsic Assessment (IA) of A (low) and Support Assessment of SA3 are unchanged. The SA3 designation, which reflects no expectation of timely external support, results in the final rating being equivalent to the IA.

In revising the trends to Negative, DBRS reflects its concern with the quality of LBC’s control functions and underwriting procedures at a sensitive time in the housing cycle and the potential impact of recent events on the Bank’s reputation and funding. These rating actions follow the Bank’s disclosure that residential prime mortgages the Bank had sold to third parties had documentation and client misrepresentation issues. LBC also disclosed that it identified some mortgage loans in these portfolios that were insured, but were not eligible for insurance as a result of their low loan-to-value ratio. These issues will result in LBC repurchasing $180 million of mortgage loans in Q1 2018, with the potential for more repurchases once the rest of the loans in the portfolio are audited. Problems were identified both in the B2B Bank originated mortgages and in the mortgages originated in the Bank’s branches. LBC noted that repurchases may be in the range of $304 million, including the previously mentioned $180 million, once the branch-originated mortgage audit is complete. This estimate is based on extrapolating across these portfolios from a small sample that had already been audited. In addition, LBC identified $76 million in mortgages that were sold to another third party that was insured without being eligible for insurance. Positively, the affected mortgages are all performing in line with the rest of the portfolio and no significant concentration of mortgages with misrepresentations were found for any single mortgage broker. DBRS notes that, while the issues discovered to date do not appear to be significant and LBC has announced that is has strengthened its underwriting procedures as of November 1, 2017, the full audit has not yet been completed.

In confirming the ratings at A (low), DBRS considers LBC’s well-established retail-based franchise in Québec, its improving profitability and its history of low loan losses. The ratings also take into consideration the Bank’s high reliance on brokered deposits and other wholesale funding sources, as well as its weaker capital position relative to peers. Given this reliance, the Bank’s funding profile poses a greater risk of stress in the event of any significant weakening of its reputation or market confidence. DBRS sees LBC as being placed at the lower end of the rating range, implying limited tolerance for any deterioration of its credit fundamentals.

The Bank is well positioned in Québec with the third-largest branch network with 104 branches, offering retail services in the province together with commercial lending across Canada and in the United States. LBC is Canada’s seventh-largest Schedule I bank, with assets of $46.7 billion as at the end of YE2017. The Bank also owns an integrated full-service institutional securities and investment banking firm, Laurentian Bank Securities & Capital Markets. Over the last few years, LBC has actively grown its B2B Bank, which distributes financial products through brokers and financial advisors across Canada, adding some diversification to LBC’s businesses. Building on its commercial lending portfolio, in May 2017, LBC acquired Northpoint Commercial Finance (NCF), based in the United States, through which it added $1.3 billion in assets. This acquisition supports LBC’s development of its equipment financing business and diversification of its businesses.

The Bank’s earnings have been on an upward trend, driven by growth in the higher margin commercial lending segment. DBRS notes that LBC’s efficiency ratio, although improving, is still one of the weakest among peers, as the Bank continues to consolidate its branch network, update its information technology systems and streamline its product offerings. LBC reported $206 million of net income for YE2017, up 36% year over year (YOY) as a result of higher revenues because of the change in the loan portfolio mix which now has a larger portion of commercial lending. Excluding the NCF acquisition which added $3.9 million to the bottom line in Q4 2017, net income increased by 33% YOY. Organic loan growth too was strong, particularly in the commercial lending segment, while provisioning remained manageable at 12% of income before provisions and taxes.

LBC continues to demonstrate a solid track record of strong asset quality resulting in low levels of impairments and loan losses. Residential mortgages make up just over half of the Bank’s loan portfolio. Out of the $18.5 billion mortgages in 2017, 50% were in Québec, where housing prices have kept pace with inflation over the last few years. Nevertheless, in DBRS’s opinion, the Bank’s more recent geographic expansion through its B2B Bank and its Commercial segments does expose LBC to heightened levels of operational risk and credit risk. Given recent events, DBRS is also concerned that risk management processes and policies have not evolved at a pace commensurate with the Bank’s growth.

While LBC has had a strong deposit funding base, thanks to its retail franchise, DBRS notes that the Bank is also reliant on broker sourced deposits that could be a more volatile source of funds should issues related to its mortgage underwriting practices persist. If the current issues persist and foster market uncertainty, LBC could face difficulty in attracting broker-sourced deposits which, in conjunction with any potential restrictions on accessing mortgage securitization conduits, could pressure the Bank’s funding and weaken its liquidity.

The Bank’s capital ratios are close to regulatory minimums and leave only a very limited buffer to absorb any significant losses. LBC’s CET1 ratio stood at 7.9% at the end of 2017, which was a slight deterioration from 8.0% at YE2016.

RATING DRIVERS
If the ongoing audits of the mortgage portfolio remain in line with current management expectations and the costs and sources of funding are not materially impacted, the ratings could be revised back to Stable. However, if further issues are discovered beyond the scope currently disclosed, or if funding costs were to materially increase, or if funding sources were to be significantly curtailed, the ratings could be downgraded. Furthermore, if DBRS were to see a material deterioration in liquidity, or a reduction in capitalization to levels closer to regulatory minimums, there could also be negative rating implications.

The Grid Summary Grades for LBC are as follows: Franchise Strength – Good; Earnings Power – Strong/Good; Risk Profile – Good; Funding & Liquidity – Good; Capitalisation – Good/Moderate.

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 methodology is Global Methodology for Rating Banks and Banking Organisations (May 2017), which can be found on our website under Methodologies.

Lead Analyst: Maria-Gabriella Khoury, Vice President, Global Financial Institutions Group
Rating Committee Chair: Lisa Kwasnowski, Senior Vice President, Global Financial Institutions Group

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

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