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

DBRS Limited (Morningstar DBRS) changed the trends on all credit ratings of Central 1 Credit Union (Central 1) to Negative from Stable and confirmed all credit ratings, including the Long-Term Issuer Rating at A (high) and the Short-Term Issuer Rating at R-1 (middle). The credit ratings for Central 1 reflect Morningstar DBRS' Intrinsic Assessment (IA) of the British Columbia and Ontario Credit Union Systems (B.C. System and Ontario System, respectively, and together, the Systems) and a Support Assessment of SA2. The level of support results in a one-notch uplift to Central 1's Long-Term Issuer Rating, which is based on the aggregate IAs of the B.C. System ("A") and Ontario System (A (low)). The B.C. System is weighted more heavily in the overall assessment because of its strong competitive market position. The support designation reflects Morningstar DBRS' expectation of timely systemic external support from the Province of British Columbia (B.C.; rated AA (high) with a Stable) and the Province of Ontario (Ontario; rated AA with a Stable trend). Further, Central 1 is designated as a Provincial Systemically Important Financial Institution by the B.C. Financial Services Authority (BCFSA), the B.C. provincial regulator.

KEY CREDIT RATING CONSIDERATIONS
The trend change to Negative from Stable reflects weakened profitability in the Systems (which collectively own Central 1), particularly the B.C. System. In Morningstar DBRS' view, weaker earnings prospects could affect the Systems' ability to absorb potential credit losses and generate sufficient internal capital. Specifically, the B.C. System's earnings remained under pressure in the first nine months of F2024 (9M 2024), following significant deterioration in 2023. Despite a potential earnings rebound in 2025, high funding costs and operating expenses will challenge the earnings recovery in the near to medium term, and margin pressure could continue in 2025. Furthermore, both Systems' limited sources of noninterest income and weak operating efficiency weigh on the credit ratings. While Morningstar DBRS views the Systems' risk profiles as generally robust, it remains cognizant of significant exposures to commercial real estate (CRE) and construction lending in both Systems, making them susceptible to a market downturn.

On the other hand, the credit ratings are supported by the Systems' stable franchise in the deposit and loan markets, as well as good balance sheet fundamentals, including stable funding profiles and sufficient capital cushions. Additionally, Central 1 plays a significant role for its member credit unions, providing liquidity management, payments solutions, and clearing and settlement services to the B.C. System and most of the Ontario System.

The B.C. System's IA range has moved because of the ongoing deterioration in its profitability. As a result, the IA is currently positioned above the range. The Ontario System's IA range moved during our last review in August 2024 following its weakened profitability, resulting in the IA being positioned at the high end of the IA range from the midpoint of the range.

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

Alternatively, Morningstar DBRS would downgrade the credit ratings if the Systems' weak earnings performance aligns with a lower credit rating category, or their asset quality metrics deteriorate substantially. Furthermore, a downgrade would also occur if Central 1's credit fundamentals weakened, or Morningstar DBRS has concerns about provincial support.

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

In Morningstar DBRS' view, the B.C. System continues to have a good franchise. Nevertheless, its intrinsic strength could weaken if large credit unions in the B.C. System 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 franchise position is good. 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. For example, Central 1 manages credit unions' excess liquidity and provides access to the national payments systems. Indeed, the B.C. credit unions that have obtained and/or pursued a federal charter continue 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 services and pricing for members.

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

In the elevated interest rate environment, the B.C. System's earnings have come under pressure since late 2022. Credit unions in B.C. saw aggregate net income decline by approximately 79% year over year (YOY) to $54.8 million in F2023 and reported net aggregate losses of $37.7 million for 9M 2024, as a result of lower revenue and higher operating expenses. Increased funding costs led to the aggregate net interest margin (NIM) dropping 46 basis points (bps) YOY to 1.49% in F2023 and 15 bps YOY to 1.39% in 9M 2024, while operating expenses remained elevated on the back of higher salaries and benefits as well as other noninterest expenses. As a result, the operating efficiency ratio exceeded 100% in 9M 2024. Despite the potential for modest improvement in earnings in ensuing quarters, the B.C. System could report a net loss overall in F2024 before an anticipated rebound starting in F2025, as market conditions gradually improve, loans reprice at higher interest rates, and NIM pressures ease.

The Ontario System has also seen downward pressure on earnings since late 2022. Its aggregate net income totalled $96.0 million in 9M 2024, down 24% YOY, largely because of higher operating expenses and provision for loan losses (PCL), partially offset by a rebound in total revenue. Specifically, noninterest expenses increased by 5.6% YOY in 9M 2024 on higher salaries and benefits, while PCL amounted to $27.2 million (compared with $15.1 million in the same prior-year period). NIM continued to decline 5 bps YOY to 1.68% in 9M 2024, following a 31-bp compression YOY to 1.71% in F2023. The operating efficiency ratio stood at 81% in 9M 2024, relatively stable compared with the prior-year period.

Morningstar DBRS views Central 1's earnings power as adequate, given its primary role as a liquidity and service provider for the Systems. In 9M 2024, Central 1 generated more than 80% of total revenue from noninterest income, including its Treasury operations and fair value changes from financial instruments, while the majority of its net interest income came from managing credit unions' excess liquidity deposits. In 9M 2024, Central 1 reported net income of $47.8 million, compared with $23.6 million in the same period of F2023, supported by a 29% YOY increase in noninterest income.

Risk Combined Building Block Assessment B.C. System: Moderate/Weak
Risk Combined Building Block Assessment Ontario System: Good

The B.C. System's overall risk profile has significantly weakened because lower earnings have affected the credit metric of Provisions for Loan Losses over Income Before Provisions and Taxes. However, asset quality experienced only modest deterioration, as the gross impaired loans (GIL) ratio increased by 15 bps YOY in 9M 2024 to 0.40%, largely because of higher delinquency in commercial loans. In addition, loan losses were negligible as most lending exposures are secured through real estate. Elevated housing prices and exposure to CRE, small and medium-size enterprises, and construction projects remain key risks for the B.C. 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.

Compared with the B.C System, the Ontario System reported somewhat higher impairments in 9M 2024. The Ontario System's GIL ratio increased to 0.53% in 9M 2024 from 0.26% in the same prior-year period, largely because of increased delinquencies in commercial loans and residential mortgages. 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 increased levels of loan impairment, and potentially large losses, in the event of a sustained economic slowdown.

Central 1 is primarily exposed to market/interest rate risk as it manages the Treasury pool. In Morningstar DBRS' opinion, overall market risk is well managed. Retail and wholesale credit risks are relatively limited for Central 1 because these are largely in the form of its commercial mortgage loans, which are entirely provided on a syndicated basis. Collectively, these represented about 14% of total assets as at Q3 2024, with minimal loan impairment and write-offs in recent years.

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

The B.C. System's funding profile is strong with solid levels of liquidity. The B.C. System's stable deposit base, comprising member-sourced retail and institutional deposits, represented about 93% of total funding as at Q3 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 Ontario 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 unions' MLPs into a bankruptcy remote structure, Central 1 continues to provide asset-management services for a substantial portion of the MLP funds.

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

Morningstar DBRS views the B.C. System's capital position as good with a solid capital cushion. The B.C. System's total capital ratio (TCR) remained broadly stable at 14.7% as at Q3 2024 compared with the prior-year period.

The Ontario System's capitalization is somewhat weaker than peers; however, the capital cushion is sufficient. The Ontario System's TCR, which is based on Basel II standards, improved 70 bps YOY to 14.1% in 9M 2024.

The BCFSA set a consolidated borrowing multiple of 18 times (x) for Central 1. As at September 30, 2024, Central 1's consolidated borrowing multiple was 11.8x, down from 12.5x in the same prior-year period, largely because of the reduction in total borrowings.

Further details on the Scorecard Indicators and Building Block Assessments can be found at:
British Columbia Credit Union System --https://www.dbrsmorningstar.com/research/445900
Ontario Credit Union System -- https://www.dbrsmorningstar.com/research/445902

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
Social (S) Factors
Morningstar DBRS finds the Social Impact of Products and Services ESG factor is relevant and a credit positive for 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 or 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, 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 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 these credit rating actions.

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' 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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