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

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

Morningstar DBRS views support from the Province of British Columbia (B.C.; rated AA (high) with a Stable trend by Morningstar DBRS) and the Province of Ontario (Ontario; rated AA with a Stable trend by Morningstar DBRS) for Central 1 as likely. This support reflects the importance of credit unions in these provinces, particularly B.C., as well as the significant role Central 1 plays for its member credit unions. Indeed, the B.C. Financial Services Authority (BCFSA), the B.C. provincial regulator, has designated Central 1 as a domestic systemically important financial institution within the Canadian credit union system. Accordingly, Morningstar DBRS has assigned Central 1 a Support Assessment of SA2. Furthermore, Morningstar DBRS 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 (B.C. System and Ontario System, respectively, and together, the Systems).

KEY CREDIT RATING CONSIDERATIONS
The credit ratings of Central 1 consider the fundamental strengths of the Systems. Specifically, these credit 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 credit rating confirmations and Stable trends reflect the strong market shares of credit unions in B.C. and growing market shares for residential and commercial mortgages, and deposits of credit unions in Ontario. The Systems' profitability metrics deteriorated in 2023, driven by lower net interest margin (NIM) and higher operating expenses. Morningstar DBRS 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 both Systems, making them susceptible to a market downturn. The credit 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, Morningstar DBRS would upgrade the credit ratings if the franchises of the two provincial Systems materially strengthen, resulting in a sustained improvement in financial performance.

Conversely, Morningstar DBRS would downgrade the credit ratings if the intrinsic strength of the Systems notably weakens. Furthermore, a reduction in Morningstar DBRS' assessment of the likelihood of provincial support would also result in a downgrade, as would a weakening in the franchise strength and 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 Morningstar DBRS' view, the B.C. System continues to have a good franchise. Nevertheless, the System's intrinsic strength could weaken if other large credit unions in B.C. pursue a federal charter.

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

In Morningstar DBRS' view, Central 1's financial fundamentals are strong. Although the credit union mandatory liquidity pools (MLPs) are now managed on the credit union members' respective balance sheets and Central 1 only manages the funds in trust, it continues to perform important functions for credit unions, including managing excess liquidity and providing access to the national payments systems. Indeed, the B.C. credit union that has recently gone federal continues to use some of Central 1's core services. Central 1's 2023-25 enterprise strategy 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. Additionally, Central 1 is focused on rolling out an enterprise fraud management solution, advancing technical debt and cyber maturity programs, and implementing the client experience model to optimize performance.

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

The B.C. System historically generated good levels of recurring earnings sufficient to absorb stressed levels of loan losses. However, credit unions in B.C. saw aggregate net income decline by approximately 79% year over year (YOY) to $54.8 million in F2023 as a result of lower net interest income and higher operating expenses. NIM compressed nearly 50 basis points (bps) YOY to 1.49% in F2023 on the back of higher funding costs, while elevated operating expenses were associated with higher salaries and benefits, and other noninterest expense. Partially offsetting downward pressure on net earnings, noninterest income increased by 14.7% YOY during the same period.

The Ontario System generates adequate levels of recurring earnings, yet it still faces strong competition from the large Canadian banks. The Ontario System's aggregate net income totalled $145.7 million in F2023, down 55% YOY largely because of lower net interest income and higher operating expenses. Net interest income reduced by 7.9% YOY to $1.4 billion in F2023, driven by rising funding costs despite strong loan growth, while noninterest expenses increased by 7.7% YOY on higher salaries and benefits. Noninterest income was also down 1.8% YOY in F2023 on lower income from securitization & rent.

Morningstar DBRS 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, Morningstar DBRS is cautious that a sharp and sustained decline in liquidity deposits from credit unions to Central 1 could weaken its financial and operational position. In F2023, Central 1 reported net income of $25.4 million, compared with a net loss of $69.6 million in F2022. Prior year results were negatively affected by unrealized and realized losses from the marked-to-market value and disposal of financial instruments because of widened credit spreads in reaction to the economic uncertainty.

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

The B.C. System's asset quality remains good with negligible amounts in loan losses; although, the System's loan delinquencies of more than 90 days increased by 21 bps YOY to 0.33% of total loans as at Q1 2024. 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 of more than 90 days was 0.46% of total loans as at Q1 2024, up 31 bps YOY. Morningstar DBRS 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 result in lumpy and 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 12% of total assets as at Q1 2024, with minimal loan impairment and write-offs in recent years. However, Central 1 is still exposed to market risk because it manages the Treasury pool. In Morningstar DBRS' 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 94% of total funding in Q1 2024 and benefits from a 100% provincial deposit guarantee.

The Ontario System's funding source is largely stable member-sourced deposits (86%); 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 Morningstar DBRS 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 the credit union MLPs into a bankruptcy remote structure, Central 1 continues 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

Morningstar DBRS views the B.C. System's capital position as good, considering the solid capital cushion and good levels of internal equity generation. The System's total capital ratio (TCR) remained flat at 14.7% at the end of Q1 2024 compared with the prior year period.

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 improved YOY to 13.8% in Q1 2024.

The BCFSA set a consolidated borrowing multiple of 18 times (x) for Central 1. At March 31, 2024, Central 1's consolidated borrowing multiple was 11.8x compared with 13.9x at March 31, 2023, largely because of the reduction in total borrowings.

Further details on the Scorecard Indicators and Building Block Assessments can be found at:
https://dbrs.morningstar.com/research/438308 (B.C. System).
https://dbrs.morningstar.com/research/438291 (Ontario System).

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
Social (S) Factors
The following Social factor had a relevant effect on the credit analysis: Morningstar DBRS finds the Social Impact of Products and Services ESG factor is relevant to the credit ratings but does not affect the assigned credit ratings or trends. The Systems play an integral role in providing banking services to local communities and funding to small- and medium-size businesses and underbanked areas. The 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, Morningstar DBRS incorporated this factor into Central 1's Franchise Strength grid grades.

There were no Environmental/Governance factors that had a significant or relevant 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 Factors in Credit Ratings (August 13, 2024), https://dbrs.morningstar.com/research/437781/.

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 4, 2024), https://dbrs.morningstar.com/research/433881. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (August 13, 2024), https://dbrs.morningstar.com/research/437781 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 https://dbrs.morningstar.com.

The credit ratings were initiated at the request of the rated entity.

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

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

These are solicited credit ratings.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS' outlooks and credit ratings are under regular surveillance.

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

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