DBRS Confirms Ratings of Equitable Bank, Stable Trends

DBRS Limited (DBRS) confirmed Equitable Bank’s (the Bank) long-term ratings, including its Long-Term Issuer Rating, at BBB and confirmed the Bank’s Subordinated Debt rating at BBB (low). In addition, the long-term ratings of the Bank’s parent, Equitable Group Inc. (the Group; together with the Bank, Equitable or the Company), were also confirmed at BBB (low). The Bank’s Intrinsic Assessment of BBB and the Group’s Support Assessment of SA3 are unchanged. All trends are Stable.

KEY RATING CONSIDERATIONS
In confirming the ratings, DBRS recognizes Equitable’s solid and growing franchise, where the Company has now garnered its position as Canada’s largest mortgage lender in the Alt-A market niche. Furthermore, Equitable has successfully built up its online bank, EQ Bank, adding several products and services and thus attracting more direct deposits and further diversifying the Company’s funding sources. The rating confirmations also consider Equitable’s good asset quality and history of low impairments and charge-offs. These positive factors are tempered by the Company’s large exposure to uninsured mortgages and its business model which has been impacted by regulatory changes that took effect in 2018 and have dampened single-family mortgage originations. Concurrently, Equitable has increased its commercial mortgage originations, which in DBRS’s opinion, could face more challenges in the event of an economic downturn.

RATING DRIVERS
Continued progress diversifying funding sources, especially through direct consumer channels, could have positive implications on the ratings. In addition, the ratings could experience upside due to a material and sustainable increase in fee-based income. The ratings could come under pressure should there be significant losses in the loan portfolio as a result of unforeseen weakness in underwriting and/or risk management. Furthermore, disproportionate growth in commercial originations that would weaken the Company’s asset mix and risk profile could also have a negative impact on the ratings, as would substantive funding pressure caused by deposit outflows or insufficient liquidity to meet redemptions.

RATING RATIONALE
Equitable’s mortgages under management (MUMs), which have experienced significant growth over the last few years, were up 9% year over year (YOY) to $23.8 billion in Q1 2018. The Company’s asset mix has now stabilized with uninsured single-family mortgages forming 40% of MUMs, while prime insured mortgages make up 16% of the portfolio. Originations remained strong and the Company has gained market share in Canada’s Alt-A mortgage market, both due to certain strategic initiatives and as one of its main competitors faced an investor confidence crisis during the first half of 2017. Throughout, Equitable has been successful in maintaining and solidifying its relationships with both mortgage brokers and deposit brokers on which it is heavily reliant.

In DBRS’s view, Equitable’s earnings power is good despite the slight increase in interest expense in 2017. In response to market conditions in H1 2017, Equitable had to raise rates on fixed-term deposits and pay standby fees on a backstop funding facility, which caused the net interest margin to slip to 1.57% in Q1 2018, from 1.64% in Q1 2017. Going forward, interest costs are expected to decrease as the Company has reduced the amount of its funding facility and rates on term deposits have reverted to market averages. Additionally, Equitable implemented International Financial Reporting Standards (IFRS) 9 effective January 1, 2018. As a result, provisions increased slightly, with provisions to income before provisions and taxes at 1.39% in Q1 2018, versus 1.24% in Q1 2017; however, provisioning remains within manageable levels. DBRS expects that IFRS 9 may create more volatility in provisioning over the credit cycle.

Asset quality is sound with the Company successfully managing its uninsured Alt-A portfolio, which makes up over half of its on-balance sheet loans. Gross impaired loans remain low at 0.14% of gross loans, as of March 31, 2018. Nevertheless, Equitable could be more susceptible to a real estate market correction than its bank peers that have a more diversified business model, as the bulk of the Company’s retail credit risk lies within the riskier non-prime-mortgage market segment. The changes to the Office of the Superintendent of Financial Institutions’ residential mortgage underwriting B-20 guidelines, which took effect on January 1, 2018, are expected to modestly improve Equitable’s credit risk profile. However, the new guidelines could pressure origination volumes in single-family mortgages thus driving the Company to increase commercial mortgage originations. DBRS is cognizant that a considerable change to Equitable’s asset mix over a short time period could potentially weaken its risk profile and lead to an increase in impairments, especially during an economic downturn.

The Company experienced healthy growth in deposits during the year despite market pressure and disruption in H1 2017, which Equitable was able to weather relatively unscathed. Total deposits grew by 19% to $11.9 billion in Q1 2018, from $10.0 billion in Q1 2017. Although brokered deposits remain Equitable’s primary source of funding, the Company continues to diversify its funding base by adding more products to EQ Bank, which experienced a 42% YOY increase in deposits to $1.7 billion in Q1 2018. In the meantime, Equitable’s liquidity position remains stable, sufficient to cover operations. As such, the Company has reduced the amount of the secured backstop funding facility that it obtained last year to $850 million from $2.0 billion. Equitable did not utilize the facility during the year and has increased the liquid assets it holds on its balance sheet.

With a Common Equity Tier 1 ratio at 14.7% as at Q1 2018, DBRS considers Equitable’s capitalization levels to be good, especially given the relatively high earnings retention rates, which allows for organic capital growth. Meanwhile, DBRS applied its Canadian residential mortgage-backed securities model (including home equity lines of credit) on the Bank’s uninsured residential mortgage portfolio using static loan-level data to gain an understanding of how the portfolio might act in the event of a material market decline. Additionally, the uninsured portion of the commercial portfolio was run through DBRS’s commercial mortgage-backed securities (CMBS) model. The analysis showed that the expected loss in both the residential and commercial mortgage portfolios during a significant real estate market correction is manageable.

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

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 principal methodologies are the Global Methodology for Rating Banks and Banking Organisations (May 2017), Rating Canadian Residential Mortgages, Home Equity Lines of Credit and Reverse Mortgages (November 2017), and North American CMBS Multi-borrower Rating Methodology (April 2018), 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.

Lead Analyst: Maria-Gabriella Khoury, Vice President, Global Financial Institutions Group
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer - Global FIG and Sovereign Ratings

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