DBRS Morningstar Changes Innovation Credit Union’s Trends to Stable from Negative, Confirms Ratings at R-1 (low)

DBRS Limited (DBRS Morningstar) confirmed the ratings of Innovation Credit Union’s (Innovation or the Credit Union) Short-Term Issuer Rating and Short-Term Instruments rating at R-1 (low) and changed the trends to Stable from Negative. 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 (low), with a Stable trend 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
The trend change to Stable from Negative reflects the better than expected performance of the loan portfolio. Moreover, the Credit Union’s loan portfolio holds a higher than average proportion of agricultural loans which have performed well due to strong agriculture prices, while the vast majority of the total loan portfolio is secured by real estate. Moreover, Saskatchewan’s economy is beginning to show some signs of gradual recovery in 2021 following the adverse impact of the Coronavirus Disease (COVID-19) pandemic, including a recovery in oil prices as well as improving consumer and business sentiment.

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 union system. Innovation’s above-average revenue per member underpins its good earnings power, which supports the ratings. Moreover, the Credit Union’s pending move to a federal charter could pose challenges to funding and operational risk.

RATING DRIVERS
Over the longer term, ratings would be upgraded if the Credit Union can sustain membership growth, especially among younger members, as well as increase the member share of wallet leading to a strengthening in the franchise. Additionally, a significant and sustained improvement in earnings through the growth of non-interest income and/or improved efficiency would also lead to a ratings upgrade. Ratings would be downgraded if Innovation is unable to manage funding while moving to a federal charter, especially member-sourced deposits. Significant losses in the loan portfolio or sustained negative operating leverage would lead to a downgrade.

RATING RATIONALE
Innovation is the third-largest credit union in Saskatchewan with $3.0 billion in assets as of December 31, 2020. The Credit Union serves 11.9% of the Province’s credit union system membership base through 28 advice centres in its footprint area, which provide retail and small business commercial offerings as well as an active digital platform. With approximately 58,000 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.

On October 1, 2020, Innovation finalized the sale of its insurance subsidiaries to a property and casualty insurance brokerage company. This business line had been successful for the Credit Union, but would have been considered a nonpermitted activity under a federal charter.

Innovation experienced some headwinds to earnings in 2020 owing to the impact of the pandemic coupled with the sale of the insurance subsidiaries, which reduced the Credit Union’s proportion of noninterest income. Overall, noninterest income comprised 20% of operating revenue in 2020, putting Innovation at the lower end of its peer group. However, Innovation’s revenue per member of $1,425 in 2020 remains one of the highest among all DBRS Morningstar-rated credit unions. The Credit Union continues to enjoy the highest net interest margin amongst its peers despite a decline of 41 basis points (bps) year over year (YOY) to 2.32% in 2020 driven by narrowing spreads and a shift in the balance sheet structure. While credit unions typically have a high cost base because of their business model, Innovation usually maintains good expense control with its emphasis on technology. However, as modest expense growth was met with a greater decline in revenue, the Credit Union experienced a 900 bps deterioration in its efficiency ratio to 76.7% in 2020. Moreover, provisions for credit losses rose by 58% in 2020 to $11.8 million from $7.5 million in the previous year to form 60.8% of income before provisions and taxes on an adjusted basis. This elevated level of provisioning was in line with other financial institutions and is expected to moderate as the Saskatchewan economy recovers from the pandemic.

Net loans declined 4.7% YOY to $2.0 billion in 2020 as higher paydowns were met with lower loan volumes given that the pandemic slowed growth in commercial and nonmortgage consumer lending. As a reflection of its footprint area in Northern and Western Saskatchewan, Innovation’s proportion of agricultural loans at 23% of the loan portfolio is nearly double that of its peers, but has a long track record of strong performance. Overall, impairment levels increased to 1.71% in 2020 from 1.36% in 2019. Some of the increase was attributable to the pandemic, but also as a result of Innovation adding some weaker legacy credits, from the amalgamation of the two smaller credit unions. DBRS Morningstar remains cautious that impaired loans may continue to trend upward due to business shut downs in response to the pandemic, especially given the increased prevalence of coronavirus variants, and the consequent rise in unemployment. 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 impact 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 808% (450% using OSFI’s calculation), well above the regulatory minimum of 100%.

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 14.4% in 2020, up 108 bps from the previous year.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 8, 2020; https://www.dbrsmorningstar.com/research/362170). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021; https://www.dbrsmorningstar.com/research/373262).

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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