Morningstar DBRS Assigns Long-Term Issuer Rating of BBB (high) to Innovation Federal Credit Union and Confirms Short-Term Credit Ratings at R-1 (low); Stable Trends

DBRS Limited (Morningstar DBRS) assigned a Long-Term Issuer Rating of BBB (high) and confirmed the short-term credit ratings of Innovation Federal Credit Union (Innovation or the Credit Union) at R-1 (low). The trend on all credit ratings is Stable. As a federally regulated credit union, Innovation's Support Assessment (SA) is SA3, which reflects no expectation of timely systemic external support. The Credit Union is now regulated by the Office of the Superintendent of Financial Institutions (OSFI) under the Bank Act, and has the potential to access the Bank of Canada's (BoC) Standing Term Liquidity Facility (STLF) and Emergency Lending Assistance (ELA) programs; although, these are subject to the BoC terms and conditions at the time of any application request for funding. Consequently, the Credit Union's short-term credit ratings benefit from the exception granted to deposit-taking institutions on Morningstar DBRS' short-term scale.

KEY CREDIT RATING CONSIDERATIONS
The credit ratings reflect Innovation's solid franchise within its operating area, tempered by its moderate size, and the benefits of its membership in the well-established credit union system. While federal continuance provides a potential future growth engine, the Credit Union is currently heavily reliant on third parties for growth in both loans and deposits, which increases operational risk and also potentially increases credit risk. The credit ratings consider Innovation's strong asset-quality metrics, although credit risk is heightened through an increasing proportion of Alt-A residential mortgages, which are primarily sourced from third parties. The Credit Union also has good earnings power, which supports the credit ratings; however, Innovation is highly reliant on spread income, and expenses have grown materially as it invests in digitalization.

CREDIT RATING DRIVERS
Over the longer term, sustained membership growth resulting in increased scale or a significant improvement in earnings metrics, especially through the growth of noninterest income and/or improved efficiency, would lead to a credit ratings upgrade.

Conversely, a material and sustained weakness in financial performance would lead to a credit ratings downgrade. A substantial deterioration in asset quality, especially from third-party-sourced loans or deficiencies in loan underwriting, would also result in a downgrade.

CREDIT RATING RATIONALE
Franchise Building Block (BB) Assessment: Moderate/Weak
Innovation is the third-largest credit union in the Province of Saskatchewan (Saskatchewan or the Province; rated AA (low) with a Stable trend) with $3.8 billion in assets as of December 31, 2023. The Credit Union provides retail and small business commercial offerings to its membership base through 28 advice centres in Saskatchewan, as well as through a national digital platform. Innovation obtained a federal charter under the supervision of OSFI on June 23, 2023, making it the third federal credit union in Canada and the first in the Province. The Credit Union's membership increased by 4.7% in 2023 to about 62,300 members, its highest growth rate since 2019, largely driven by growth within Saskatchewan as membership remains significantly concentrated in the Province. However, Innovation's proposed merger with ABCU Credit Union, the first-ever interprovincial merger, would provide some geographic diversification through the addition of over 7,000 members in the Province of Alberta (rated AA with a Stable trend).

Earnings Building Block (BB) Assessment: Good/Moderate
Innovation generated good earnings before member distributions in 2023 of $24.5 million, up 41% year over year (YOY), driven by strong revenue growth, partially offset by higher operating expenses and provision for credit losses (PCL) (note all quoted earnings metrics are adjusted to exclude the one-time $30.9 million dividend received in 2022 related to the sale of Concentra Bank). The Credit Union continues to become more reliant on net interest income, as noninterest income formed only 14% of revenue in 2023, putting Innovation at the lower end of its peer group. Net interest margin improved by 41 basis points (bps) YOY to 3.28% in 2023, one of the highest among its peers, driven by improving spreads in a higher interest rate environment as well as higher-yielding mortgages sourced from third parties. Innovation's efficiency ratio improved by 260 bps YOY to a still-elevated 74.2% in 2023. PCL increased by 21% in 2023 to $4.2 million from $3.4 million in the previous year, primarily reflecting loan growth.

Risk Building Block (BB) Assessment: Good/Moderate
Gross loans grew 20% YOY to $3.2 billion in 2023, driven by the Credit Union's strategic partnerships with third parties to source residential and commercial mortgages that fall within its risk appetite in order to offset a continued decline in loans sourced directly from members. Third-party-sourced loans now make up about 45% of the total loan portfolio, and while this strategy has contributed to significant geographic diversification, it also presents material third-party risk. In addition, Alt-A mortgages, which Morningstar DBRS views as higher risk, now make up nearly one third of the residential mortgage portfolio, driven by third-party loan sourcing. While the agricultural and commercial loan portfolios have performed well to date, Morningstar DBRS remains cautious that elevated interest rates and an uncertain economic outlook could lead to deterioration in asset quality metrics. Overall, impairment levels remained largely unchanged YOY at 0.27% of gross loans, and net write-offs were a low 7 bps, down from 38 bps in 2022, which can be attributed to the resolution of a large commercial relationship in the prior year.

Funding and Liquidity Building Block (BB) Assessment: Good
Innovation maintains prudent levels of liquidity, and is largely funded through stable retail and business deposits. However, broker-sourced deposits, which Morningstar DBRS views less favourably than member deposits, have grown significantly in recent years, forming 21% of total deposits as of December 31, 2023, up from just 4% in 2021. The Credit Union also has access to wholesale funding in the form of securitized borrowings via the Canada Mortgage Bonds program. Innovation has various sources of liquidity, including mortgage securitization pools held on-balance sheet as high-quality liquid assets, and credit facilities with Central 1 Credit Union (rated A (high) with Stable trend) and several other large financial institutions. Further funding and liquidity sources added in 2023 include repurchase agreements and access to the BoC's STLF and ELA programs. Innovation reported a liquidity coverage ratio of 239%, well above the regulatory minimum of 100%. Morningstar DBRS notes that the Credit Union has not seen any core deposit runoff related to federal continuance, although pre-existing term deposits are still fully guaranteed until maturity under Canada Deposit Insurance Corporation transitional coverage.

Capitalization Building Block (BB) Assessment: Good
Morningstar DBRS views the Credit Union's capitalization levels as good with a sizable cushion over regulatory and internal minimums to absorb potential losses. Innovation's Common Equity Tier 1 ratio improved 184 bps YOY to 16.43% in 2023, driven by the shift to a federal regulatory environment and changes to risk-weighted asset calculations to align with OSFI's updated guidelines.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://dbrs.morningstar.com/research/431174.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
ESG Considerations had a relevant effect on the credit analysis.

Environmental (E) Factors
There were no Environmental factor(s) that had a relevant or significant effect on the credit analysis.

Social (S) Factors
Morningstar DBRS views the Social Impact of Products and Services ESG subfactor as relevant to the credit rating, but it does not affect the assigned credit ratings or trends. As a credit union, Innovation operates a membership-based community banking model where the social aspect of its activities strengthens its franchise. As a result, this factor is incorporated into the Credit Union's Franchise Strength grid grades.

Governance (G) Factors
There were no Governance factor(s) that had a relevant or significant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (January 23, 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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 (June 22, 2023) https://dbrs.morningstar.com/research/415978. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (January 23, 2024) https://dbrs.morningstar.com/research/427030 in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.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 dbrs.morningstar.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.

Morningstar DBRS 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. Morningstar DBRS's outlooks and credit ratings are under regular surveillance.

For more information on this credit or on this industry, visit dbrs.morningstar.com.

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