DBRS Morningstar Confirms Central 1 Credit Union’s Ratings, Including its Long-Term Issuer Rating at A (high) and Short-Term Issuer Rating at R-1 (middle), Stable Trends

DBRS Limited (DBRS Morningstar) confirmed Central 1 Credit Union’s (Central 1) ratings, including its Long-Term Issuer Rating at A (high) and Short-Term Issuer Rating at R-1 (middle), both with Stable trends.

DBRS Morningstar views support from the Provinces of British Columbia (B.C.; rated AA (high) with a Stable trend by DBRS Morningstar) and Ontario (rated AA (low) with a Positive trend by DBRS Morningstar) for Central 1 as likely, which reflects the importance of credit unions in these provinces as well as the significant role Central 1 plays for its member credit unions. This is particularly evident in B.C. where the provincial regulator, B.C. Financial Services Authority, named Central 1 as a domestic systemically important financial institution within the Canadian credit union system. Accordingly, DBRS Morningstar has assigned Central 1 a Support Assessment of SA2. Furthermore, DBRS Morningstar believes the provinces are capable of providing such support, if needed. The level of support results in a one-notch uplift to Central 1’s Long-Term Issuer Rating from the Intrinsic Assessment (IA) of the B.C. and Ontario Credit Union Systems (the Systems).

KEY CREDIT RATING CONSIDERATIONS
The ratings of Central 1 consider the fundamental strengths of the Systems. Specifically, these ratings reflect the IAs of “A” for the B.C System and A (low) for the Ontario System. Central 1 provides liquidity management, payment solutions, and clearing and settlement services to the B.C. System and to most of the Ontario System. These credit unions own Central 1, and the IAs of these two systems incorporate an analysis of the combined financials of the credit unions in each province.

The rating confirmations and Stable trends reflect the strong market shares of credit unions in B.C. and growing market shares for residential mortgages and deposits of credit unions in Ontario. DBRS Morningstar also views the risk profiles of these Systems as generally robust, but it remains cognizant of significant exposures to commercial real estate (CRE) and construction lending in the B.C. and Ontario Systems and their susceptibility to a market downturn. The ratings also reflect solid funding profiles for both Systems, which are driven by relationship-based member-sourced retail deposits. While the B.C. System reflects sound levels of liquidity, the Ontario System has seen a marked decline in liquidity buffers since 2021. Both Systems’ capital cushions are sufficient, although the Ontario System has relatively lower capital levels and internal equity generation capacity compared with its peers.

CREDIT RATING DRIVERS
Over the longer term, DBRS Morningstar would upgrade the ratings if the franchises of the two provincial Systems materially strengthen through membership growth and increased revenue per member, resulting in a sustained improvement in financial performance.

Conversely, DBRS Morningstar would downgrade the ratings if the intrinsic strength of the Systems becomes weaker. Furthermore, a reduction in DBRS Morningstar’s assessment of the likelihood of provincial support would also result in a downgrade, as would any material operational or market risk management issues at Central 1.

CREDIT RATING RATIONALE
Franchise Combined Building Block (BB) Assessment B.C. System: Good
Franchise Combined BB Assessment Ontario System: Good/Moderate

In DBRS Morningstar’s view, the B.C. System continues to have a strong franchise. Nevertheless, the System’s intrinsic strength could weaken if other large credit unions in B.C. pursue a federal charter.

DBRS Morningstar considers the Ontario System’s franchise to be good, despite modest market shares in the province in key products.

In DBRS Morningstar’s view, Central 1’s financial fundamentals are strong. It continues to perform important functions for credit unions, including managing excess liquidity and providing access to the national payments systems, although the credit union mandatory liquidity pools (MLP) were segregated into a bankruptcy-remote structure on January 1, 2021, with Central 1 continuing to manage the funds in the trust. Central 1 has developed a 2023–25 enterprise strategy, which includes priorities such as strengthening Treasury and digital offerings, delivering cost-effective utility payment services, expanding into new product categories enabled by richer data streams, and providing solid and cost-effective service and pricing for members, among others.

Earnings Combined BB Assessment B.C. System: Good/Moderate
Earnings Combined BB Assessment Ontario System: Moderate

The B.C. System generates good levels of recurring earnings that are sufficient to absorb stressed levels of loan losses. Credit unions in B.C. saw aggregate net income decline by approximately 61% year over year (YOY) to $28.2 million in Q1 2023 as a result of lower net interest income and higher operating expenses. Net interest income decreased by 12.0% YOY to $314.2 million driven by rising funding costs. Operating expenses increased by 9.0% YOY to $340.8 million in Q1 2023 on higher salaries and benefits and other noninterest expenses. Partially offsetting downward pressure on net earnings, noninterest income increased by 22.8% YOY during the same period as a result of higher income from trading financial instruments.

The Ontario System generates adequate levels of recurring earnings and improving profitability, yet it still faces strong competition from the large Canadian banks. The Ontario System’s aggregate net income totalled $19.5 million in Q1 2023, down 74.4% YOY because of lower net interest income and higher noninterest expenses. Net interest income reduced by 12.3% YOY to $362.1 million in Q1 2023 driven by rising interest rates, while noninterest expenses increased by 9.9% during the same period on higher salaries and benefits. Partially offsetting downward pressure on net earnings, noninterest income jumped 19.4% YOY in Q1 2023 on higher income from securitization, rent, and other noninterest income.

DBRS Morningstar views Central 1’s earnings power as adequate, given its primary role as a liquidity and service provider for the Systems, although the majority of its net income comes from managing credit unions’ excess liquidity deposits. Consequently, DBRS Morningstar is cautious that a sharp and sustained decline in excess liquidity deposits from credit unions to Central 1 could weaken its financial and operational position. For Q1 2023, Central 1 reported net income of $1.3 million, compared with a loss of $35.4 million for the same quarter in 2022. During 2022, credit spreads widened in reaction to the economic uncertainty around rising inflation and the Russia–Ukraine war, resulting in unrealized and realized losses from the marked-to-market value and disposal of financial instruments during the same period.

Risk Combined BB Assessment B.C. System: Strong/Good
Risk Combined BB Assessment Ontario System: Strong/Good

The B.C. System’s asset quality remains solid, given that about 63% of lending exposures are secured through real estate as of YE2022. With negligible amounts in loan losses, the System’s rate of loan delinquencies over 90 days was 0.12% of total loans at the end of Q1 2023. Nevertheless, elevated housing prices and exposure to CRE, small and medium-size enterprises, and construction projects remain key risks for the System. On the other hand, the B.C. System has a proportionally lower exposure to CRE and construction lending relative to the credit union systems in Alberta and Saskatchewan. Furthermore, the bulk of such exposures are secured through a mortgage on the property.

The Ontario System’s asset quality remains sound as the majority of lending exposures are secured through real estate. The System’s rate of loan delinquencies over 90 days was 0.15% of total loans as at Q1 2023, down 4 basis points (bps) YOY. However, DBRS Morningstar remains cautious of heightened exposure to real estate development and construction lending. As is the case for credit unions across Canada, credit unions in Ontario also have relatively large single-party commercial loan exposures. These can be a source of increased levels of loan impairment, and potentially large losses, in the event of a sustained economic slowdown.

Retail and wholesale credit risks are relatively limited for Central 1 because these are largely in the form of Central 1’s commercial mortgage loans, which are entirely provided on a syndicated basis. Collectively, these represented about 11% of total assets as at Q1 2023, with minimal loan impairment and write-offs in recent years. However, Credit 1 is still exposed to market risk because it manages the Treasury pool. In DBRS Morningstar’s opinion, overall market risk well managed.

Funding and Liquidity Combined BB Assessment B.C. System: Strong/Good
Funding and Liquidity Combined BB Assessment Ontario System: Good/Moderate

The B.C. System’s funding profile is strong with solid levels of liquidity. The System's stable deposit base, comprising member-sourced retail and institutional deposits, represented about 95% of total funding in Q1 2023 and benefits from a 100% provincial deposit guarantee.

The Ontario System’s funding source is largely stable retail deposits; however, excessive reliance on market funding for growth is a credit negative. The System’s liquidity levels have reduced markedly since 2021 and remain the lowest among peers.

Central 1 is largely funded through excess liquidity deposits generated from the Systems, which DBRS Morningstar assesses to be relatively stable. Central 1 maintains good access to capital markets and diversified sources of funding, which include medium-term notes, commercial paper, Canada Mortgage Bonds, subordinated liabilities, and repurchase agreements. Despite the segregation of MLP assets, Central 1 will continue to provide asset-management services for a substantial portion of the MLP funds.

Capitalization Combined BB Assessment B.C. System: Good/Moderate
Capitalization Combined BB Assessment Ontario System: Good/Moderate

DBRS Morningstar views the B.C. System’s capital position as strong, considering the solid capital cushion and good levels of internal equity generation. The System’s total capital ratio (TCR) declined by 29 bps YOY to 14.7% at the end of Q1 2023.

The Ontario System’s capitalization is weaker than peers, although the capital cushion is sufficient. The System’s TCR, which is based on Basel II standards, marginally deteriorated to 13.7% in Q1 2023.

The B.C. Financial Services Authority set a consolidated borrowing multiple of 18 times (x) for Central 1 as of January 1, 2021. As at Q1 2023, Central 1’s consolidated borrowing multiple was 13.9x compared with 14.6x at Q1 2022, largely because of the reduction in total borrowings.

Further details on the Scorecard Indicators and BB Assessments can be found at:
https://www.dbrsmorningstar.com/research/419896 (B.C. System).
https://www.dbrsmorningstar.com/research/419895 (Ontario System).

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
Social Factors
DBRS Morningstar finds the social impact of products and services ESG factor is relevant to the credit ratings but does not affect the assigned ratings or trends. The credit union Systems play an integral role in providing banking services to local communities and funding to small and medium-size businesses and underbanked areas. The credit union Systems operate on a community banking model where the social aspect of their activities strengthens their franchises, without the requirement or need to maximize profitability. As a result, DBRS Morningstar incorporated this factor into Central 1’s Franchise Strength grid grades.

There were no Environmental or Governance factors 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 (July 4, 2023) https://www.dbrsmorningstar.com/research/416784.

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 22, 2023; https://www.dbrsmorningstar.com/research/415978). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (https://www.dbrsmorningstar.com/research/416784) in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

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 credit rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

DBRS Morningstar had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

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 credit ratings are under regular surveillance.

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

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