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 the Bank’s Long-Term Issuer Rating at AA and Short-Term Issuer Rating at R-1 (high). The trends on all ratings are Stable. BMO’s Long-Term Issuer Rating is composed of an Intrinsic Assessment of AA (low) and a Support Assessment 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 uplift to the Long-Term Issuer Rating. Under the new Canadian Bank Recapitalization Regime, DBRS expects to eventually remove the uplift from systemic support once the Bank has issued a sufficient level of bail-inable senior debt, which would provide an adequate buffer for non-bail-inable obligations and is expected to offset the removal of systemic support.

KEY RATING CONSIDERATIONS
The rating confirmation and Stable trend reflect BMO’s strong North American franchise, which is underpinned by a business model that is diversified by both geography and product. The United States continues to be a strategically important and growing market for the Bank, with BMO’s regional banking presence focused on eight core states predominately in the U.S. Midwest. BMO’s ratings are further supported by its conservative risk profile with sound asset quality, strong funding and liquidity as well as sound capitalization. The ratings also consider the challenging operating environment that is constrained by moderating global growth, low interest rates, weakness in energy prices and the potential for a housing downturn in Canada. However, DBRS notes that BMO has the lowest exposures to residential real estate-secured lending in Canada as compared with the other large Canadian banks. Moreover, the ratings also reflect BMO’s somewhat less diversified loan portfolio with a higher proportion of commercial lending relative to its Canadian bank peers. In addition, while the performance of the Bank’s U.S. businesses has improved, it continues to underperform compared with other highly rated U.S. regional banks.

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

Negative ratings pressure could arise if there is an increase in BMO’s risk appetite or a shift toward a potentially more volatile earnings mix, including a material increase in the contribution from BMO Capital Markets. Moreover, a sustained deterioration in asset quality, particularly from deficiencies in risk management, could pressure the ratings.

RATING RATIONALE
DBRS views BMO’s earnings as highly diversified with the Bank consistently generating strong earnings and solid profitability metrics. The Bank generates a higher proportion of fee-based revenue compared with its Canadian bank peers. In this regard, over half of BMO’s total revenue for H1 2019 was derived from non-interest income. This contributes to earnings stability, reduces the reliance on spread income and strengthens BMO’s ability to withstand stresses. In H1 2019, BMO reported net income of $3.0 billion, an increase of 35% compared with the same period last year. The prior year included a charge related to a U.S. net deferred tax asset revaluation and a restructuring charge. On an adjusted basis, earnings increased 6% compared with the prior year, reflecting higher earnings in the personal and commercial (P&C) banking businesses, with good performance in U.S. P&C. Overall, BMO’s profitability metrics remain slightly below those of its Canadian bank peers, but improved performance from the Bank’s U.S. businesses are narrowing the gap.

Asset quality remains strong, benefiting from both the benign credit environment in both Canada and the United States, as well as a conservative risk profile. Most of BMO’s asset quality metrics remain strong, with gross impaired loans (GIL) 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 in Q2 2019 of just 0.53% and 0.14%, respectively. As a result of the run-off of riskier loans in the United States over the last few years, the credit risk profile BMO’s U.S. loan portfolio has improved. DBRS views these low levels of GIL and PCL as likely unsustainable and expects both to revert to a higher, more normalized level over time. DBRS notes that the implementation last year of the new expected credit loss model required under International Financial Reporting Standards 9 will likely result in an increase in quarterly PCL volatility.

DBRS remains concerned about the combination of highly leveraged consumers and elevated home prices in the Greater Toronto Area and the Greater Vancouver Area. While more stringent underwriting requirements and higher interest rates are having a manageable impact in both these markets, DBRS views BMO, like its Canadian bank peers, as susceptible to any adverse changes in the Canadian housing market. Nonetheless, DBRS views BMO’s Canadian real estate-secured lending portfolio, which includes residential mortgages and home equity lines of credit, as conservatively underwritten, with a significant proportion (44%) of insured residential mortgages. Moreover, the Bank’s uninsured portfolio has a loan-to-value ratio of 55%, providing a substantial buffer for a decline in housing prices.

BMO’s strong funding and liquidity profile is underpinned by a high level of client-sourced deposits, with over 93% of these sourced from Canada and the United States reflecting its North American franchise. In addition, BMO has demonstrated access to a wide range of wholesale funding sources to supplement deposit funding. DBRS views the Bank’s use of wholesale funding as reasonable given its business mix. BMO’s liquidity coverage ratio was 132% in Q2 2019, which was well above the regulatory minimum and in line with the average of its Canadian bank peers.

Capitalization remains sound as BMO continues to organically generate significant levels of capital that supports balance sheet growth and provides a cushion to absorb potential losses. As at April 30, 2019, BMO’s Basel III Common Equity Tier 1 Ratio was 11.3%, which was well above regulatory minimums although it was below the average of 11.5% for the large Canadian banks. In addition, BMO’s Q2 2019 Leverage Ratio was 4.2%, which was above the regulatory minimum of 3%. Since the Canadian Bail-In Regime came into effect, BMO has issued over $9 billion of Bail-inable Senior Debt building toward the Office of the Superintendent of Financial Institutions’ new total loss absorbing capacity (TLAC) requirements. DBRS expects BMO to be above TLAC requirements in advance of the required compliance date, as the Bank replaces its maturing senior debt with issuances of Bail-inable Senior Debt.

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 applicable methodology is the Global Methodology for Rating Banks and Banking Organisations (June 2019), which can be found on our website under Methodologies & Criteria.

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 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. The following additional regulatory disclosures apply to endorsed ratings:

The last rating action on this issuer took place on June 22, 2018, when DBRS confirmed the Bank’s ratings.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

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 Financial Institutions Group
Initial Rating Date: December 31, 1980

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

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