DBRS Morningstar Changes Trend on National Bank of Canada to Positive; Confirms Long-Term Issuer Rating at AA (low)

DBRS Limited (DBRS Morningstar) changed the trend on all ratings of National Bank of Canada (National or the Bank) and its related entities to Positive from Stable and confirmed all ratings, including the Bank’s Long-Term Issuer Rating at AA (low) and Short-Term Issuer Rating at R-1 (middle). National’s Long-Term Issuer Rating is composed of an Intrinsic Assessment of A (high) and a Support Assessment of SA2, which reflects the expectation of timely systemic support from the Government of Canada (rated AAA with a Stable trend by DBRS Morningstar). As a result of the SA2 designation, the Bank’s Long-Term Issuer Rating benefits from a one-notch uplift.

KEY RATING CONSIDERATIONS
The Positive trends recognize National’s successful expansion of its footprint in targeted markets and niches across Canada, especially in Wealth Management (WM) and Financial Markets (FM). In addition the Bank’s strong performance over the last few years, with Personal and Commercial (P&C) and WM now contributing a larger portion of earnings, has placed National at the top of its peer range in terms of profitability metrics.

The rating confirmations reflect National’s dominance in its home province, the Province of Québec (Québec; rated AA (low) with a Stable trend by DBRS Morningstar), which had experienced strong economic growth prior to the Coronavirus Disease (COVID-19) pandemic. Furthermore, the Bank benefits from strong pre-provision earnings, while transformation efforts in its P&C business and growth of its WM business have driven growth in client deposits. The ratings also consider the small yet growing contribution of the U.S. Specialty Finance and International (USSF&I) segment, which DBRS Morningstar views as having a higher risk profile, as well as potentially more volatile earnings. Lastly, DBRS Morningstar notes that National’s FM business segment is an important contributor to the Bank’s franchise and has benefitted from the market volatility experienced in the last year. Although the majority of transactions are client driven, the segment’s activities could expose the Bank to increased capital markets risk from significant market downturns.

The ratings also consider the challenging economic environment because of the coronavirus pandemic, which has had an adverse impact on profitability and asset quality. Although unprecedented support measures put in place through monetary and fiscal stimuli have largely mitigated the negative impact of the crisis, DBRS Morningstar remains concerned that once these measures expire the economic impact on the already highly leveraged Canadian consumer could adversely affect Canadian banks.

RATING DRIVERS
Continued franchise momentum and improving operating performance while limiting the adverse impact on asset quality from the economic downturn would lead to an upgrade of the ratings.

Conversely, the ratings would be downgraded if there is a sustained deterioration in asset quality, especially from deficiencies in risk management, which would have a significant impact on profitability.

RATING RATIONALE
With its focused franchise and leading position in Québec, National generates strong underlying earnings, which contribute to the Bank's ability to absorb credit losses. In F2020, earnings declined by 10% year over year to $2.1 billion, largely because of the impact of the pandemic as the Bank, like peers, took prudent provisions to manage the potential economic fallout. As a result, return on average common equity declined to 14.9% from 17.9% in F2019 but remains ahead of peers. Unprecedented support measures put in place through monetary and fiscal stimuli have mitigated some of the negative impacts of this crisis; however, near-term challenges remain given the scale of the economic disruption, renewed lockdowns, and ongoing challenges related to vaccine rollout.

In DBRS Morningstar’s view, prudent risk management and a conservative lending culture enable National to maintain strong asset quality metrics. Gross impaired loans remained at a low of 0.45% of gross loans as of Q1 2021—better than some of the Bank’s larger Canadian peers—as the majority of National’s credit exposure is underwritten in Québec, which has experienced a relatively benign credit environment in recent years and has not witnessed the real estate price appreciation seen in other provinces. Furthermore, although credit in the USSF&I segment is in riskier sectors or geographies, DBRS Morningstar notes that the segment’s loans only form 7% of the Bank’s total portfolio and that this credit risk has been historically well managed. DBRS Morningstar will continue to monitor the adverse impact of the coronavirus pandemic on the economies of both Canada and Québec, which may result in asset quality deterioration and higher provisioning needs.

The Bank has a strong funding profile with a growing retail and commercial deposit base. This includes an increase in the client’s share of wallet through various coordinated initiatives among the Bank’s P&C, WM, and FM divisions. As a result, according to DBRS Morningstar’s calculation, retail and commercial deposits make up 55% of total funding, one of the highest levels among large Canadian peers. Additionally, National has ready access to a wide range of wholesale funding sources to supplement deposit funding with a diverse international investor base. At the onset of the pandemic, like peers, National accessed several Government of Canada programs to supplement its funding. Most of these borrowings have been repaid. Meanwhile, the Bank enjoys the highest liquidity level among peers as measured by the Liquidity Coverage Ratio, which was 154% for Q1 2021, well above the regulatory minimum. Effective Q1 2021, the Bank began disclosing its net stable funding ratio (NSFR), which DBSR Morningstar views as a better gauge of funding resilience over the medium to longer term. National’s NSFR was 124%, which was above the regulatory minimum of 100%.

Capitalization is strong as National continues to organically generate sufficient capital to support balance sheet growth. As at January 31, 2021, National’s Common Equity Tier 1 (CET1) ratio stood at 11.9%. At this level, the Bank's CET1 ratio was well above the regulatory minimum of 9% for Domestic Systemically Important Banks (D-SIBs), reflecting the Office of the Superintendent of Financial Institutions’ (OSFI) reduction in the Domestic Stability Buffer to 1.0% at the onset of the pandemic. Moreover, DBRS Morningstar expects National’s capital levels to continue to build over the near term, largely reflecting the restrictions placed by OSFI on capital management activities for D-SIBs. Additionally, the Bank reported a leverage ratio of 4.3% in Q1 2021 that was above the regulatory minimum of 3% and in line with its Canadian bank peers; however, DBRS Morningstar notes that this metric remains somewhat weaker than many global peers.

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.

The Grid Summary Grades for National are as follows: Franchise Strength – Very Strong/Strong; Earnings Power – Strong; Risk Profile – Strong; Funding & Liquidity – Strong; and Capitalization – Strong.

DBRS Morningstar notes that this press release was amended on October 22, 2021, to correct the rating table and remove the Cumulative Preferred Shares, which were discontinued in July 2014.

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.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom, and by DBRS Ratings GmbH for use in the European Union, respectively. The following additional regulatory disclosures apply to endorsed ratings:

Each of the principal methodologies employed in the analysis addressed one or more particular risks or aspects of the rating and were factored into the rating decision. Specifically, the Global Methodology for Rating Banks and Banking Organisations (June 8, 2020) was used to evaluate the issuer, and DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021) was used to assess ESG factors.

The last rating action on this issuer took place on April 30, 2020, when DBRS Morningstar confirmed all ratings and changed the trend to Stable from Positive.

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

For further information on DBRS Morningstar 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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

Lead Analyst: Maria Gabriella-Khoury, Senior Vice President
Rating Committee Chair: Michael Driscoll, Managing Director, Head of NA FIG
Initial Rating Date: February 29, 2000

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

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