DBRS Confirms Bank of Montreal at AA with a Stable Trend

DBRS Limited (DBRS) confirmed the ratings of Bank of Montreal (BMO or the Bank) and its related entities, including BMO’s Long-Term Issuer Rating at AA and Short-Term Issuer Rating at R-1 (high). BMO’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 (rated AAA with a Stable trend by DBRS). The SA2 designation results in a one-notch benefit to the Long-Term Issuer Rating. The trend on all ratings is Stable, reflecting the finalization of the Canadian Bank Recapitalization Regime (the Bail-In Regime) and DBRS’s view that a sufficient level of bail-inable senior debt will provide an adequate buffer for non-bail-inable obligations, which will offset the expected removal of systemic support (see “DBRS Takes Rating Actions on Six Canadian Banking Groups after Finalization of Bail-In Regime,” April 19, 2018).

KEY RATING CONSIDERATIONS
The confirmation of the ratings reflects BMO’s strong North American franchise, which is underpinned by its position as one of Canada’s largest banks, with total assets of $743.6 billion at April 30, 2018. In addition, BMO has a strong regional banking presence in the U.S. Midwest, particularly in the states of Illinois, Wisconsin, Indiana, Minnesota, Missouri and Kansas, and the United States continues to be a strategically important and growing market for the Bank. BMO’s ratings are further supported by its conservative risk profile, diverse funding mix, strong liquidity and sound capitalization. DBRS remains concerned with elevated housing prices, particularly in the greater Toronto and Vancouver areas (GTA and GVA, respectively), and the potential for a real estate market correction in Canada. As a result, BMO may be susceptible to any adverse changes in the Canadian real estate market or Canadian consumer behaviour. However, DBRS notes that, while still large, BMO has the lowest exposure among the large Canadian banks to real estate-secured lending in Canada.

RATING DRIVERS
DBRS views BMO as being well placed in its current rating category. Over the longer term, DBRS sees the potential for positive rating pressure if BMO’s U.S. banking operations performance improves to levels similar to highly rated U.S. regional bank peers. In addition, positive rating pressure could arise if BMO outperforms compared with its Canadian bank peers while maintaining sound underwriting standards.

Negative rating pressure could arise if there is an elevated increase in BMO’s risk appetite or a shift toward a more volatile earnings mix, including a material increase in the contribution from BMO Capital Markets. Moreover, a severe downturn in the real estate market that leads to a sustained deterioration in asset quality, especially from deficiencies in risk management or underwriting, could pressure the ratings.

RATING RATIONALE
BMO consistently generates strong earnings and profitability metrics through a diversified business model, which includes a high proportion of fee-based products. Indeed, at 55.4% of total revenue for the six months ended April 30, 2018, which was the second highest of the big six Canadian banks, BMO’s non-interest income contributes to earnings stability and strengthens its ability to withstand stresses. In F2017, earnings were predominately generated in Canada (71%) and the United States (23%). Net income in F2017 was up a strong 16% compared with the previous year, with the efficiency ratio improving 190 basis points (bps). However, BMO’s profitability metrics remain below that of its Canadian bank peers, largely reflecting the weaker performance of its U.S. business, as well as the higher efficiency ratio and relatively lower net interest margins.

Overall, BMO maintains a conservative risk profile through a strong risk culture and prudent underwriting standards, which supports the Bank’s ratings. Asset quality remains sound, with most metrics remaining at relatively low levels, and the U.S. portfolio’s credit risk profile continues to improve, reflecting the continued run-off of riskier loans. In Q2 2018, gross impaired loans as a percentage of gross loans and acceptances and provisions for credit losses (PCL) on impaired loans as a percentage of average net loans and acceptances were just 0.56% and 0.18%, respectively. The adoption of International Financial Reporting Standards 9, effective November 1, 2017, has resulted in BMO recording a recovery of PCL related to non-impaired loans in the first two quarters of 2018.

DBRS remains concerned with elevated housing prices, particularly in the GTA and GVA, which could lead to a real estate market correction in Canada. As a result, BMO may be susceptible to any adverse changes in the Canadian real estate market. As at April 30, 2018, BMO’s exposure to real estate-secured lending in Canada, which is comprised of residential mortgages and home equity lines of credit, represented 35% of total loans and acceptances. This is the lowest among the large Canadian banks, where Canadian real estate-secured lending comprises on average 46% of their respective loan portfolios. In addition, DBRS notes that approximately 48% of residential mortgages as at April 30, 2018, are insured and loan-to-value ratios are low. Loss rates on the residential mortgage portfolio remain at very low levels.

BMO maintains a strong funding and liquidity profile underpinned by a high level of client-sourced deposits. The Bank supplements its funding through a wide range of wholesale funding sources, and DBRS views the use of wholesale funding as adequate and in line with BMO’s Canadian bank peers. In Q2 2018, BMO’s liquidity coverage ratio was 150%, which was well above the regulatory minimum of 100% and at the higher end of its Canadian bank peers.

Capitalization remains sound with continued organic capital generation that supports balance sheet growth and provides a cushion to absorb potential losses. BMO’s Basel III Common Equity Tier 1 Ratio was 11.3% at April 30, 2018, up 20 bps compared with January 31, 2018, largely driven by the elimination of the Basel I floor and higher earnings retention partly offset by higher risk-weighted assets and the repurchase of five million common shares during the quarter. Meanwhile, BMO’s Basel III Leverage Ratio was 4.2% at April 30, 2018, which declined 10 bps over the linked quarter. DBRS notes that both these metrics are largely in line with the other large Canadian bank peers.

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

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

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.

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

Lead Analyst: Robert Colangelo, Senior Vice President, Canadian Banking Financial Institutions – Global Financial Institutions Group
Rating Committee Chair: Michael Driscoll, Managing Director, Head of NA FIG – Global FIG
Initial Rating Date: December 31, 1980

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