DBRS Changes Trend on Equitable Bank to Positive, Confirms Ratings at BBB

DBRS Limited (DBRS) changed the trend on the Long-Term Issuer Rating, Long-Term Deposits and Long-Term Senior Debt ratings of Equitable Bank (the Bank) to Positive from Stable and confirmed each rating at BBB. DBRS also changed the trend on the Bank’s Subordinated Debt to Positive from Stable and confirmed the rating at BBB (low). In addition, DBRS changed the trend on the Long-Term Issuer Rating and the Long-Term Senior Debt of the Bank’s parent, Equitable Group Inc. (the Group; together with the Bank, Equitable or the Company) and confirmed the ratings at BBB (low). The Bank’s Intrinsic Assessment was confirmed at BBB and the Group’s Support Assessment remains SA3.

KEY RATING CONSIDERATIONS
The Positive trend and ratings confirmation recognize Equitable’s solid and growing franchise, where the Company is Canada’s largest mortgage lender in the Alt-A market niche. Equitable has also successfully launched new lending products that complement its mortgage offering in addition to expanding into adjacent verticals through acquisition. Furthermore, the Company continues to attract direct deposits through its digital bank, EQ Bank, while enhancing its wholesale funding channels. While the ratings reflect Equitable’s good asset quality and history of low impairments and charge-offs, the ratings also consider an eventual shift in the current credit cycle and the potential for a housing downturn in Canada.

RATING DRIVERS
Continued progress in diversifying funding sources, especially through more stable direct-to-consumer channels, as well as an improvement in earnings generation while maintaining sound asset quality would likely result in a ratings upgrade. Conversely, significant losses in the loan portfolio as a result of unforeseen weakness in risk management or substantive funding pressure caused by deposit outflows or insufficient liquidity to meet redemptions could result in a negative ratings action. Additionally, a weakening of Equitable’s capitalization levels due to low earnings retention or a material increase in risk-weighted assets could also pressure the ratings.

RATING RATIONALE
Equitable continues its growth trajectory with mortgages under management (MUMs) increasing by 21% year over year (YOY) to $28.9 billion in Q1 2019. Much of the growth was organic, with the Company’s asset mix stable as commercial loans, including insured multifamily loans, form 42% of MUMs, while prime insured mortgages make up 20% of the portfolio. Equitable is persistently gaining market share in the Canadian Alt-A mortgage space while solidifying its relationships with both mortgage brokers and deposit brokers on which it is reliant. Furthermore, the Company launched a reverse mortgage product to serve the aging Canadian population in 2018 and launched Cash Surrender Value lines of credit in partnership with a few life insurance companies. In addition, Equitable acquired Bennington Financial Corp (Bennington), a privately owned brokered equipment lessor with a portfolio of $440 million in assets on January 1, 2019. The $46 million all-cash transaction allows Equitable to diversify into adjacent verticals as Bennington has a strong position in the non-prime equipment leasing space across Canada.

Equitable generates relatively stable recurring earnings, mainly driven by spread income. In Q1 2019, loan growth translated into strong revenue generation as Equitable’s interest income climbed 37% YOY to $265 million. Meanwhile, despite an increase in funding costs due to a rising interest rate environment, Equitable was able to contain its interest expense as it reduced the size of a backstop funding facility it had obtained in 2017 in response to adverse market conditions caused by one of its competitors. Consequently, the net interest margin increased to 1.65% in Q1 2019 from 1.57% in Q1 2018. On the other hand, expenditure on strategic initiatives, including enhancements to technology platforms and investment in migration to the advanced internal rating-based approach to capital, have led the efficiency ratio to deteriorate to 41.1% in Q1 2019 from 37.9% in Q1 2018. Nonetheless, given its branchless model, Equitable remains one of the most efficient banks in Canada.

Asset quality remains sound with the Company successfully managing its uninsured Alt-A portfolio, which makes up the largest proportion of its loan portfolio. However, gross impaired loans rose to 0.50% of gross loans in Q1 2019 from 0.14% of gross loans in Q1 2018 as the Group consolidated the impaired loans it acquired from Bennington in addition to recognizing an impaired commercial mortgage in Vancouver, British Columbia. Although Equitable benefits from the revenue generated by growth in its less-granular commercial portfolio, a small number of impairments could have a relatively larger impact on the Company’s asset quality. Furthermore, while Equitable is expected to achieve higher returns to compensate for the higher risk of the lease assets, 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’s total deposits were up by 23% YOY to $14.8 billion as of March 31, 2019. Although broker-sourced term deposits remain Equitable’s primary source of funding, directly sourced deposits through EQ Bank have kept up pace forming 15% of total deposits for the last couple of years. Additionally, Equitable registered a new subsidiary, Equitable Trust, to capture more insured deposits. Furthermore, the Company is looking at enhancing and further diversifying its wholesale funding sources to complement its future growth. In the meantime, Equitable’s liquidity position remains stable, sufficient to cover operations. As such, the Company reduced the amount of the secured backstop funding facility that it obtained in 2017 from the original amount of $2.0 billion to $850 million in June 2018 and then down to $400 million in May 2019, all while renewing the term until 2021 with a more favourable fee structure. DBRS notes that Equitable has not utilized the facility.

Equitable’s Common Equity Tier 1 ratio stood at 12.9% as of March 31, 2019, versus 14.7% in the previous year. The decrease was primarily due to the acquisition of Bennington. Although the Company’s capitalization levels tend to be ahead of peers given the relatively high earnings retention rates, DBRS is cautious that it would be appropriate for Equitable to maintain a healthy capital cushion as it implements it future growth plans. 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. The analysis showed that the expected loss in the residential mortgage portfolio during a significant real estate market correction is manageable.

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

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodologies are the Global Methodology for Rating Banks and Banking Organisations (June 2019) and Rating Canadian Residential Mortgages, Home Equity Lines of Credit and Reverse Mortgages (November 2018), 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.

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

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