Morningstar DBRS Changes Trends on First West Credit Union's Credit Ratings to Negative from Stable, Confirms Long-Term Issuer Rating at BBB (high) and Short-Term Issuer Rating at R-1 (low)

DBRS Limited (Morningstar DBRS) changed the trends on all credit ratings of First West Credit Union (First West or the Credit Union) to Negative from Stable and confirmed all credit ratings, including the Credit Union's Long-Term Issuer Rating at BBB (high) and the Short-Term Issuer Rating at R-1 (low). The Support Assessment (SA) for First West is SA2, which reflects Morningstar DBRS' expectation of timely systemic external support from the Province of British Columbia (BC or the Province; rated AA (high) with a Stable trend by Morningstar DBRS) through Central 1 Credit Union (Central 1; rated A (high) with a Stable trend by Morningstar DBRS), particularly in the form of liquidity. The SA2 designation does not result in an uplift to First West's credit ratings.

KEY CREDIT RATING CONSIDERATIONS
The trend change to Negative from Stable reflects First West's weakened profitability amid the challenging economic environment, which could affect the Credit Union's ability to absorb potential credit losses and generate internal capital. The earnings remained under pressure in the first six months of 2024 and in Morningstar DBRS' baseline expectations, the Credit Union will likely incur net operating losses in 2024. Despite a potential earnings rebound in 2025, elevated funding costs could challenge First West's earnings recovery in the near to medium term and 2025 could likely continue to exhibit margin pressure. The credit ratings incorporate First West's larger exposures (relative to its credit union peers) to commercial mortgages and construction and development loans. Morningstar DBRS considers these exposures, along with residential mortgages (albeit not focused on the City of Vancouver proper), to be susceptible to a potential housing downturn.

First West's credit ratings are supported by its position as the third-largest credit union in the Province and the fifth-largest credit union in Canada. Positively, the Credit Union has a higher contribution from noninterest income relative to its credit union peers, as well as stable operating expenses. Furthermore, the Credit Union maintains sound asset quality and balance sheet fundamentals, including stable funding sources, and solid liquidity and capital positions.

CREDIT RATING DRIVERS
Given the Negative trends, credit rating upgrades are unlikely. Morningstar DBRS would change the trends to Stable if the Credit Union demonstrates a sustained improvement in financial performance while maintaining a similar risk profile.

Alternatively, Morningstar DBRS would downgrade the credit ratings in the event of continued weakness in earnings performance, resulting in a sustained reduction in loss-absorbing and internal capital generation capacity. In addition, Morningstar DBRS would downgrade the credit ratings if there were to be a significant deterioration in asset quality.

CREDIT RATING RATIONALE
Franchise Combined Building Block (BB) Assessment: Moderate
With about $18.6 billion in total assets and assets under administration as at December 31, 2023, First West has a well-established position, with strong market shares in deposits and loans in BC's Lower Mainland, Okanagan, and Vancouver Island regions. First West operates through four community-based brand identities, which also contributes to its product diversification. The Credit Union's membership grew steadily by 2% year over year (YOY) in 2023 to over 270,000 members, driven by growth in both retail and business members. Meanwhile, First West continues to work toward becoming a federal credit union.

Earnings Combined BB Assessment: Weak
Amid the challenging economic environment, First West's profitability has come under increased pressure since 2022. It reported a net loss from continuing operations of $1.8 million in 2023, driven largely by a 28% YOY decline in net interest income as a result of increased deposit funding costs. This led to a net interest margin (NIM) compression of 62 basis points (bps) YOY to 1.3% for the same period, as calculated by Morningstar DBRS. Partially offsetting this downward pressure on earnings, noninterest income increased by 23% YOY in 2023, driven by stable fee sources, while noninterest expenses were flat YOY despite incurring costs related to federal continuance. Nevertheless, the operating efficiency ratio deteriorated to nearly 100% in 2023 from 85% in the prior year on the back of lower earnings. In the first six months of 2024, First West's profitability remained weak. Despite the expectation of modest improvement in revenue and NIM in the last two quarters of 2024, Morningstar DBRS expects a net loss in 2024 before a rebound starting in 2025 as market conditions improve, loans reprice at higher interest rates, and NIM pressures ease.

Risk Combined BB Assessment: Moderate/Weak
Overall, First West has had a solid track record of credit performance, reflecting the Credit Union's conservative risk culture. Gross impaired loans as a percentage of gross loans increased to 0.25% in 2023 from 0.11% in the prior year but remained below the pre-pandemic levels. Net write-offs as a percentage of average gross loans, as calculated by Morningstar DBRS, was stable at 2 bps in 2023. Nevertheless, weakened profitability could affect the Credit Union's ability to absorb potential credit losses. Additionally, First West has a large commercial mortgage and construction and development lending portfolio when compared with its credit union peers, which Morningstar DBRS views as higher risk, particularly in the event of a real estate market downturn. As with other credit unions, Morningstar DBRS expects First West's credit quality metrics to modestly deteriorate in 2024 amid a challenging economic backdrop with still elevated interest rates.

Funding and Liquidity Combined BB Assessment: Strong/Good
The majority of First West's funding is sourced through branch-raised deposits, with member deposits representing nearly 93% of total funding in 2023. While First West's deposit base remains stable, Morningstar DBRS remains cautious that the Credit Union could face some outflows as the existing 100% deposit guarantee reduces with the move to a federal charter. Additionally, First West participates in securitizations through the Canada Mortgage Bonds Program. The Credit Union's liquidity position is strong, benefitting from access to liquidity through its lines of credit with Central 1, as well as from the major Canadian banks. As calculated by Morningstar DBRS, the liquidity ratio of 14.0% in 2023 normalized toward historical levels from an all-time high of 19.6% in 2020.

Capitalisation Combined BB Assessment: Good/Moderate
Morningstar DBRS views First West's capitalisation as good, with the Credit Union holding capital buffers above regulatory minimums. In 2023, the capital adequacy ratio was 15.4%, a 160-bp YOY increase and well above the minimum and supervisory limits of 8.0% and 10.0%, respectively. In addition, capital is largely composed of members' equity and retained earnings.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://dbrs.morningstar.com/research/439715.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

Social (S) Factors
Morningstar DBRS finds the Social Impact of Products and Services ESG subfactor is relevant to the credit ratings of First West but did not affect the assigned credit ratings or trends. First West operates on a community banking model, whereby it provides financial services in geographic areas underserved by large banks and has a common bond and commitment to the people and communities it serves. Therefore, the social aspect of its activities strengthens its franchise, albeit at the expense of profit maximization. As a result, this factor is incorporated into the Credit Union'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 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 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.

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'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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