DBRS Morningstar Changes Trend on Innovation Credit Union to Negative, Confirms Ratings at R-1 (low)

DBRS Limited (DBRS Morningstar) changed the trends on Innovation Credit Union’s (Innovation or the Credit Union) Short-Term Issuer Rating and Short-Term Instruments rating to Negative from Stable and confirmed the ratings at R-1 (low). Innovation’s Support Assessment is SA2, which reflects DBRS Morningstar’s expectation of timely systemic external support from the Province of Saskatchewan (Saskatchewan or the Province; rated AA, Under Review with Negative Implications, by DBRS Morningstar) through Credit Union Central of Saskatchewan (SaskCentral; rated R-1 (low) with a Stable trend by DBRS Morningstar), particularly in the form of liquidity. At present, the SA2 designation does not result in any uplift for Innovation’s Short-Term Instruments rating.

KEY RATING CONSIDERATIONS
DBRS Morningstar changed the trend on the ratings to Negative from Stable to reflect the abrupt and severe economic disruption caused by the Coronavirus Disease (COVID-19) pandemic and the oil price shock, both of which will likely weaken credit fundamentals. DBRS Morningstar notes that the Credit Union has a large exposure to commercial loans (28% gross loans) and nonmortgage-related consumer loans (12% gross loans).

The ratings confirmation reflects Innovation’s solid franchise within its operating area, which is tempered by its moderate size and the benefits of its membership in the well-established credit union system in Saskatchewan. Over 40% of the Province’s population are members of its credit unit system. Innovation’s above-average revenue per member and steady base of noninterest income underpin its strong earnings power, which supports the ratings. The ratings also consider Innovation’s higher proportion of commercial loans, especially agricultural loans, relative to peers and its aging membership base. Moreover, the Credit Union’s pending move to a federal charter could pose challenges to funding and operational risk.

RATING DRIVERS
Given the Negative trend, a ratings upgrade is unlikely at this time. DBRS Morningstar could change the trend back to Stable when Saskatchewan’s economic potential approaches pre-crisis levels and the Credit Union maintains sound credit fundamentals. Material and sustained weakness in loan performance, which results in a significant increase in loan losses because of longer-than-expected adverse coronavirus-related impact and the oil price shocks, could lead to a ratings downgrade.

RATING RATIONALE
Innovation is the third-largest credit union in Saskatchewan with $2.8 billion in assets as of December 31, 2019. The Credit Union serves 11.6% of the Province’s credit union system membership base through 24 advice centres in its footprint area, which provide retail and small business commercial offerings as well as an active digital platform. With approximately 56,000 members, Innovation has consistently grown its membership base since 2014 and expanded its market share within Saskatchewan’s credit union system, including the amalgamation of Goodsoil Credit Union and Pierceland Credit Union in 2019, adding approximately $98 million in assets.

In December 2017, Innovation’s members voted to pursue federal continuance, which would place the Credit Union under the Office of the Superintendent of Financial Institutions’ (OSFI) supervision. Innovation submitted its formal application to OSFI in July 2018 and continues to work with all counterparties to finalize its federal charter application in 2021. In DBRS Morningstar’s opinion, while Innovation has strong fundamentals, the proposed conversion to a federal credit union raises significant uncertainties about its prospects, especially with respect to funding. With federal continuance, deposit insurance of up to $100,000 per account from the Canada Deposit Insurance Corporation, a federal Crown corporation, would replace Innovation’s previously unlimited deposit coverage under Saskatchewan’s Credit Union Deposit Guarantee Corporation (CUDGC); thus, the Credit Union could potentially experience deposit outflows from large retail and institutional depositors. Furthermore, although a federal charter would provide Innovation with access to prospective new members or retail customers, especially through online platforms, remote deposit acquisition might come at a higher cost than expected, given the highly competitive dynamics in a space that includes the large banks, other online platforms, and local credit unions.

Innovation exhibits some of the better profitability metrics among its peer group, reflecting a loan portfolio mix with a relatively larger proportion of higher-yielding agricultural and commercial loans as well as a steady stream of noninterest income. Overall, noninterest income comprised 21% of operating revenue in 2019, which compares favourably with credit union peers. Moreover, Innovation’s revenue per member of $1,719 in 2019 leads all DBRS Morningstar-rated credit unions. The net interest margin declined by 6 basis points (bps) year over year (YOY) to 2.73% in 2019 driven by a shift in the balance sheet structure. While credit unions typically have a high cost base because of their business model, Innovation maintains good expense control with its emphasis on technology, resulting in one of the lowest efficiency ratios in the industry at 68.7% in 2019. Nevertheless, DBRS Morningstar expects the Credit Union’s earnings to face some headwinds from coronavirus-related economic deterioration as well as the sharp decline in oil prices, both of which will affect many industries in Saskatchewan.

Net loans were flat YOY in 2019 at $2.1 billion. As a reflection of its footprint area in Northern and Western Saskatchewan, Innovation’s proportion of agriculture loans at 24% of the loan portfolio is nearly double that of its peers. DBRS Morningstar notes that the Credit Union has a strong track record of managing this asset class over time; however, the weakening economy and pricing pressure in the agricultural sector have increased impairment levels to 1.36% in 2019 from 0.49% in 2018. The increase in impairment levels is also the result of Innovation’s absorption of some weaker legacy credits, which were added to its books when two smaller credit unions were amalgamated. Furthermore, DBRS Morningstar expects impaired loans to continue to trend upward as businesses remain closed and unemployment levels rise. Although the Credit Union’s agricultural loans might outperform the rest of the portfolio in the near term because of the sector’s importance, the continued uncertainty about the duration of business closures will likely affect Innovation’s commercial portfolio that caters mainly to small and medium-size enterprises, some of which are in the most affected sectors like retail and hospitality.

Commercial and retail deposits are the main source of Innovation’s funding. The stability of credit union deposits is enhanced by the CUDGC guarantee; therefore, federal continuance could lead to some deposit outflows. The Credit Union also has access to wholesale funding in the form of securitized borrowings via the Canada Mortgage Bonds program and broker deposits, which constitute 12% of funding. In addition, Innovation has various sources of liquidity, including credit facilities with SaskCentral, and reported a robust liquidity coverage ratio of 870% (276% using OSFI’s calculation), well above the regulatory minimum of 80%.

DBRS Morningstar views the Credit Union’s capitalization levels as good with a sizable cushion over regulatory minimums to absorb potential losses in an economic downturn. Innovation’s Common Equity Tier 1 ratio, which is based on Basel III requirements, stood at 13.3% in 2019, up 136 bps from the previous year.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 11, 2019).

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

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.dbrsmorningstar.com.

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

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

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

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