DBRS Morningstar Downgrades Laurentian Bank of Canada’s Long-Term Issuer Rating to BBB (high), Trends Negative

DBRS Limited (DBRS Morningstar) downgraded its credit ratings on Laurentian Bank of Canada (LBC or the Bank), including the Bank’s Long-Term Issuer Rating to BBB (high) from A (low). Concurrently, DBRS Morningstar confirmed the Bank’s Short-Term Issuer Rating at R-1 (low). The trend for all credit ratings is Negative. The Bank’s Intrinsic Assessment (IA) is BBB (high) while its Support Assessment (SA) remains SA3. The SA3 designation, which reflects no expectation of timely external support, results in the Bank’s Long-Term Issuer Rating being equivalent to the IA. These credit rating actions resolve the Under Review with Negative Implications status under which LBC was placed on November 3, 2023.

KEY CREDIT RATING CONSIDERATIONS
The credit rating downgrades and Negative trends reflect DBRS Morningstar’s view that LBC’s franchise strength and profitability prospects have significantly weakened with a limited visibility on the Bank’s long-term strategic path. The fundamental challenges faced by the Bank’s Personal Banking franchise in recent years has led to a sustained weakness in financial performance. Further, the Bank's ability to improve earnings and growth prospects in the near to medium term will likely be affected by the adverse series of recent events, including the unexpected and sudden departure of the former President and CEO and the rapid succession of executive leadership departures, while there remains the uncertainty related to the delay in the Bank’s renewed strategic plan. Of note, LBC continues to report the lowest levels of profitability among Canadian medium-size banks rated by the DBRS Morningstar. The Bank is dealing with these fundamental changes and operational issues amid an uncertain economic environment with increasing headwinds. As a result, the challenging operating environment will likely make the timely and successful execution of a new strategic plan more complicated. The credit ratings also consider LBC’s relatively high proportion of brokered deposits and higher cost base.

Supporting its credit ratings, LBC has demonstrated good credit quality with low impairments and loan losses; however, DBRS Morningstar expects that asset quality metrics will deteriorate from current levels in F2024 as a result of the high interest rate environment, which has materially increased debt-servicing costs. Despite recent events, the Bank’s balance sheet fundamentals remain stable with higher levels of liquidity to deal with any potential deposit outflows. LBC’s capital position is adequate with sufficient buffers to absorb stressed levels of loan losses.

CREDIT RATING DRIVERS
Given the Negative trends, credit rating upgrades are unlikely. DBRS Morningstar would change the trends to Stable if LBC’s new leadership demonstrates a sustained improvement in the Bank’s franchise position and financial performance while maintaining a similar risk profile.

Conversely, additional operational missteps and/or a failure to execute on the strategic initiatives leading to further deterioration in franchise strength and earnings generation would result in a credit ratings downgrade. Furthermore, increased pressure on funding and liquidity would also result in a credit ratings downgrade.

CREDIT RATING RATIONALE
Franchise Combined Building Block (BB) Assessment: Good/Moderate
LBC is Canada’s eighth-largest Schedule I bank with assets of $49.9 billion as at October 31, 2023. The Bank offers retail services in Québec through its branch network as well as commercial lending across Canada and in the U.S. LBC also distributes financial products to brokers and financial advisors across Canada through its wholesale arm, B2B Bank. Over the past few years through 2022, LBC’s franchise has been faced with fundamental challenges in its Personal Banking business, which resulted in customer attrition, shrinking loans, and stagnant deposits. Two years into the current strategic plan that was unveiled on December 10, 2021, the Bank has undertaken a digital-first approach and introduced new and enhanced digital capabilities to close gaps in its Personal Banking business, particularly across mortgage, Visa, and deposit products. On October 2, 2023, following the mainframe outage, the Bank announced the sudden and unexpected departure of its president and CEO, Rania Llewellyn, and the resignation of its board chair, Michael Mueller. With Éric Provost only recently being appointed as president and CEO, DBRS Morningstar has limited visibility into LBC’s long-term strategic direction, although the Bank’s current focus is on improving operating efficiency and simplifying the organizational structure.

Earnings Combined Building Block (BB) Assessment: Moderate
Relative to its peers, LBC has demonstrated lower profitability although it has a higher share of noninterest income at about 27% of total revenue as at October 31, 2023. The Bank’s net income decreased by about 20.1% year over year (YOY) to $181.1 million in F2023 as a result of lower noninterest income and higher provision for credit losses and operating expenses. While a decrease in noninterest income was largely driven by reduced capital markets revenue, noninterest expenses increased on higher salaries, employee benefits, and ongoing investments in technology. Noninterest expenses included restructuring charges of $18.2 million resulting from changes in the Bank’s management structure, as well as strategic review-related charges of $5.9 million. As a result, the operating efficiency ratio deteriorated to 71.1% in F2023 from 67.7% in the prior year. Partly offsetting the downward pressure on net earnings, net interest income grew 1.8% YOY to $746.3 million in F2023; however, the net interest margin as calculated by DBRS Morningstar compressed by 6 basis points (bps) to 1.51% on higher funding costs, which outpaced growth in asset yields.

Risk Combined Building Block (BB) Assessment: Good
Amounting to $37.1 billion as at October 31 2023, gross loans contracted by 1.1% YOY in F2023, compared with 11.4% YOY growth in the prior-year period. A reduction in commercial and nonmortgage personal loans was partly offset by an increase in residential mortgages. The bulk of credit risk lies in the commercial book, which accounted for about 48% of total loans as at October 31, 2023 and has concentrations in commercial real estate and inventory financing. Overall, the Bank’s asset quality is good with low impairments and loan losses. The gross impaired loans ratio increased by 19 bps YOY to 62 bps in F2023, largely because of increased impairments in commercial mortgages. As with the rest of the banking sector, DBRS Morningstar expects asset quality metrics to further deteriorate from current levels amid the challenging macroeconomic environment. Furthermore, if not managed prudently, the Bank’s continued realignment of the loan portfolio and geographic expansion, as well as any additional deficiencies in IT capabilities and uncertainties around its new strategic direction, could expose LBC to heightened levels of operational and credit risk.

Funding and Liquidity Combined Building Block (BB) Assessment: Good/Moderate
LBC’s overall funding and liquidity position remains sound. Accounting for about 65% of the funding base, total deposits, including capital markets deposits, declined by 4.1% YOY to $26.0 billion in F2023. Personal deposits, which represented 86% of total deposits, remained broadly stable at $22.3 billion in F2023 on the back of an uptick in direct retail deposits. Broker-sourced deposits marginally declined to $10.7 billion and accounted for about 41% of total deposits. The Bank expects to attract more direct client deposits on a national level in the coming years, which DBRS Morningstar would view favourably over broker deposits. Liquidity levels are strong, with liquid assets forming 23% of total assets as at Q4 2023.

Capitalisation Combined Building Block (BB) Assessment: Good/Moderate
LBC’s capital ratios under the standardized approach are above regulatory minimums and provide adequate buffers to absorb stressed levels of loan losses. DBRS Morningstar would view favourably a larger capital buffer, sufficient to absorb significant losses, especially as the Bank undertakes an “accelerated evolution of its strategic plan” and continues to grow its commercial loan book, which may be more susceptible to weakness in the event of a sustained economic downturn. The CET1 capital ratio increased to 9.9% as at Q4 2023, compared with 9.1% for the same period of F2022, primarily reflecting lower risk-weighted assets as well as internal capital generation.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/425414.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors
The following Social factor(s) had a relevant effect on the credit analysis:
The Social factor is relevant to LBC’s credit ratings but did not affect the credit ratings or trends assigned to the Bank. LBC noted that a mainframe outage occurred during its planned IT maintenance update in late September 2023, which affected retail and business clients, who lost online access to accounts for four days. However, customer data and financial information remained secure. The potential occurrence of such incidents could lead to a failure of the Bank in delivering quality products and services, cause damage to clients, and expose the Bank to financial and legal liability. As a result, this factor is incorporated into LBC’s Risk Profile grid grades.

Governance (G) Factors
The following Governance factor(s) had a significant effect on the credit analysis:
The Governance factor is significant to LBC’s credit ratings and affected the credit ratings and trends assigned to the Bank. Two years into its current strategic plan, LBC announced the sudden and unexpected departure of its president and CEO, along with the resignation of the board chair, on October 2, 2023. Given the macroeconomic headwinds and significant executive turnover, operational challenges have amplified at the Bank, which, if not managed prudently, could result in reputational risk, customer attrition, loss of market share, and impaired financial performance. As a result, this factor is incorporated into LBC’s Franchise Strength grid grades.

There were no Environmental factor(s) that had a relevant or significant 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/416784 (July 4, 2023).

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 (July 4, 2023; 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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