DBRS Morningstar Confirms Bank of Montreal at AA With a Stable Trend

DBRS Limited (DBRS Morningstar) confirmed the ratings of the Bank of Montreal (BMO or the Bank) and its related entities, including BMO’s Long-Term Issuer Rating at AA and Short-Term Issuer Rating at R-1 (high). All ratings have Stable trends. The Bank’s Long-Term Issuer Rating, which is composed of an Intrinsic Assessment of AA (low) and a Support Assessment of SA2, reflects the expectation of timely, systemic support from the Government of Canada (rated AAA with a Stable trend by DBRS Morningstar). This results in a one-notch lift to BMO’s Long-Term Issuer Rating.

KEY RATING CONSIDERATIONS
The rating confirmations and Stable trends reflect BMO’s diversified franchise, ranking as the eighth-largest bank in North America by assets, solid earnings, and strong balance sheet fundamentals. BMO’s footprint spans Canada, while the U.S. franchise, which is currently focused on states in the U.S. Midwest with some national businesses, it will be further enhanced by the announced acquisition of Bank of the West (BOTW; unrated), which will double its branch network and expand its geographic reach. In DBRS Morningstar’s view, the combination does not add to credit risk because both companies have a strong lending track record. However, as with all acquisitions, there are integration risks, especially for an acquisition of this size. BMO’s ratings are further supported by a conservative risk profile, reflecting a strong and prudent underwriting culture. DBRS Morningstar views both the Bank’s funding and liquidity profile—which benefits from a stable deposit base that is sourced in both Canada and the U.S.—and its capitalization as strong.

The ratings also consider that government support measures have largely mitigated the negative economic impacts of the Coronavirus Disease (COVID-19) pandemic. Positively, economic performance has rebounded, and the labour market is essentially at full capacity; however, headwinds persist from a potential aggressive interest rate tightening cycle to combat inflation, geopolitical tensions related to the Russia-Ukraine conflict, supply chain disruptions, and the pandemic. Furthermore, DBRS Morningstar remains concerned about the combination of Canadian household debt levels that have reached an all-time high and elevated home prices (particularly in the greater Toronto and Vancouver areas) that have been driven by housing market imbalances and robust demand during the pandemic. Housing prices remain vulnerable and, as a result, BMO and its Canadian peers remain susceptible to adverse changes in the Canadian real estate market. However, BMO’s loan portfolio is more weighted toward commercial lending, and DBRS Morningstar notes that the Bank has the lowest exposures to residential real estate-secured lending in Canada relative to its Canadian bank peers.

RATING DRIVERS
Over the longer term, sustained outperformance by BMO compared with global bank peers, while maintaining its current risk profile, would lead to an upgrade of the ratings.

Conversely, BMO’s ratings would be downgraded if there were significant operational issues with acquisition integration or an inability to rebuild capital post acquisition. Additionally, a sustained or significant deterioration in asset quality, especially from an increase in risk appetite, or a decline in profitability levels to below that of its peer group, would result in a downgrade of the ratings.

RATING RATIONALE
Franchise Combined Building Block (BB) Assessment: Very Strong/Strong
In Canada, BMO is a full-service universal bank providing all major product lines, including commercial and retail banking, wealth management, and capital markets, to approximately 8 million clients. DBRS Morningstar notes that BMO's loan portfolio is weighted more toward commercial lending than its Canadian bank peers where it has leading market shares. In the U.S., BMO operates under its U.S. holding company, BMO Financial Corp. (BMO Financial), with a focus on states in the U.S. Midwest: Illinois, Wisconsin, Indiana, Minnesota, Missouri, and Kansas. In both Illinois and Wisconsin, BMO Financial ranks second in deposit market share. However, a significant portion of revenue is generated outside of the Midwest states, with all business lines operating nationally.

BMO’s acquisition of BOTW (for approximately USD 16.3 billion in cash) is expected to close during fiscal Q1 2023 pending various approvals. BOTW will add approximately USD 95 billion in total assets (as of March 31, 2022) and more than 500 branches in California and the western half of the U.S. Overall, DBRS Morningstar views the announced acquisition as improving the franchise strength of BMO’s U.S. operation through better scale and an enhanced presence in affluent, although highly competitive, markets.

Earnings Combined Building Block (BB) Assessment: Strong
BMO consistently generates solid earnings and profitability metrics underpinned by its highly diversified business franchise, which contributes to the Bank's ability to absorb credit losses. BMO reported Q2 2022 net income of $4.8 billion, a 62% increase on a quarter-over-quarter (QOQ) basis, and largely reflecting higher revenue from fair value management actions related to the announced acquisition of BOTW. On an adjusted basis, the Bank reported solid net income of $2.2 billion, representing a 15% decline QOQ. The lower linked quarter-adjusted net income reflects a decline in revenue (results were affected by three fewer days in the quarter) and a higher provision for credit losses (PCL; the previous quarter had a recovery), partially offset by lower expenses. Meanwhile, BMO’s efforts over the last few years to improve efficiencies are showing results as the efficiency ratio (as per DBRS Morningstar calculations) reached 45% in H1 2022 versus the 60% level reported in F2020.

Risk Combined Building Block (BB) Assessment: Very Strong/Strong
Overall, DBRS Morningstar views BMO's risk profile as conservative, reflecting a strong risk culture and prudent underwriting standards as the Bank has historically maintained asset quality metrics that are better than the Canadian bank peer average. BMO's credit quality remains strong. In Q2 2022, PCL totalled $50 million, as compared with $99 million recovered in the previous quarter. As a result of the increased provision, the PCL on impaired loans ratio marginally deteriorated by 3 basis points (bps) to 10 bps in the quarter, while the total PCL ratio worsened by 12 bps to 4 bps. However, on a year-over-year basis, both ratios have improved and remain at exceptionally low levels. Gross impaired loans (GIL) decreased marginally QOQ, and this coupled with strong loan portfolio growth allowed the GIL ratio to further improve by 3 bps to 0.41% in Q2 2022. DBRS Morningstar notes that overall the Canadian banking sector is reporting asset quality metrics that are at unsustainably low levels and modest deterioration is expected as credit conditions normalize.

Funding and Liquidity Combined Building Block (BB) Assessment: Strong
BMO has a strong funding and liquidity profile, which is underpinned by a high level of client-sourced deposits garnered in both Canada and the U.S. The Bank supplements this through a wide range of wholesale funding sources, with BMO's usage within an acceptable range and in line with the Canadian bank peer average. Additionally, the BOTW acquisition is expected to add USD 80 billion in deposits (as of March 31, 2022), with approximately 70% of total deposits being sourced from operations in California. In addition, liquidity at BMO remains strong as it reported a Q2 2022 liquidity coverage ratio of 129% and a net stable funding ratio of 116%, both comfortably above the regulatory minimums.

Capitalization Combined Building Block (BB) Assessment: Strong
DBRS Morningstar views the Bank's capitalization as strong, reflecting current capital levels as well as its significant internal capital generation. In Q2 2022, BMO’s CET1 ratio was 16.0%. At this level, the Bank's CET1 ratio was well above the regulatory minimum of 10.5% for Domestic Systemically Important Banks. In March 2022, BMO successfully completed a public offering of 20,843,750 common shares total gross proceeds of $3.1 billion. The Bank intends to use the net proceeds to finance a portion of the purchase price for BOTW. The Bank expects to fund the acquisition primarily with excess capital, reflecting its strong capital position and anticipated capital generation. Capital levels are expected to decline to around 11% at close. In Q2 2022, BMO’s risk-based total loss-absorbing capacity ratio was at 30.7%, well above the regulatory threshold of 24.0%. The Bank reported a leverage ratio of 5.4% in Q2 2022 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.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/397904.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factor(s) that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (July 19, 2021; https://www.dbrsmorningstar.com/research/381742). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (May 17, 2022; https://www.dbrsmorningstar.com/research/396929).

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/principal asset class 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” (July 19, 2021) was used to evaluate the issuer, and “DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings” (May 17, 2022) was used to assess ESG factors.

The last rating action on this issuer took place on December 20, 2021, when DBRS Morningstar confirmed the ratings.

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: https://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, Global FIG
Rating Committee Chair: John Mackerey, Senior Vice President, Global FIG
Initial Rating Date: December 31, 1980

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

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