DBRS Limited (DBRS Morningstar) confirmed Central 1 Credit Union’s (Central 1) ratings, including its Long-Term Issuer Rating at A (high) and Short-Term Issuer Rating at R-1 (middle), both with Stable trends.
DBRS Morningstar views support from the Provinces of British Columbia (B.C.; rated AA (high) with a Stable trend by DBRS Morningstar) and Ontario (rated AA (low) with a Stable trend by DBRS Morningstar) for Central 1 as likely, which reflects the importance of credit unions in these provinces as well as the significant role Central 1 plays for its member credit unions. This is particularly evident in B.C. where the provincial regulator, B.C. Financial Services Authority, named Central 1 as a domestic systemically important financial institution within the Canadian credit union system. Accordingly, DBRS Morningstar assigned Central 1 a Support Assessment of SA2. Furthermore, DBRS Morningstar 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 (the Systems).
KEY RATING CONSIDERATIONS
The ratings of Central 1 consider the fundamental strengths of the Systems. Specifically, these 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 ratings confirmation and Stable trends reflect the strong market shares of credit unions in B.C. and growing market shares for residential mortgages and deposits of credit unions in Ontario. DBRS Morningstar also 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 the B.C. and Ontario Systems and their susceptibility to a market downturn. The ratings also reflect sound levels of liquidity and solid funding profiles for both Systems, which are driven by relationship-based member-sourced retail deposits. Both Systems’ capital cushions are sufficient, although the Ontario System has relatively lower capital levels and internal equity generation capacity compared with its peers.
Over the longer term, ratings would be upgraded if the franchises of the two provincial Systems materially strengthen through membership growth, increased revenue per member, and improved financial performance.
Conversely, the ratings would be downgraded if the intrinsic strength of the Systems is reduced. Furthermore, a reduction in DBRS Morningstar’s assessment of the likelihood of provincial support would also result in a downgrade, as would any material operational or market risk management issues at Central 1.
Franchise Combined Building Block (BB) Assessment B.C. System: Good
Franchise Combined BB Assessment Ontario System: Good/Moderate
Franchise Combined BB Assessment Central 1: Good/Moderate
In DBRS Morningstar’s view, the B.C. System continues to have a strong franchise. Nevertheless, the System’s intrinsic strength could be weakened if there is increased momentum from other large credit unions in B.C. and Ontario to pursue a federal charter.
DBRS Morningstar considers the Ontario System franchise to be good, despite modest market shares in the province in key products.
In DBRS Morningstar’s view, Central 1’s financial fundamentals have remained strong. It continues to perform important functions for credit unions, including managing liquidity and providing access to the national payments systems. Effective January 1, 2021, the credit union mandatory liquidity pools (MLP) have been segregated into a bankruptcy-remote structure with Central 1 continuing to manage the funds in the trust. Also, on another positive note, Central 1 has emphasized enhancing its operational capabilities to service credit unions across Canada, specifically for digital banking and market intelligence.
Earnings Combined BB Assessment B.C. System: Good/Moderate
Earnings Combined BB Assessment Ontario System: Moderate
Earnings Combined BB Assessment Central 1: Moderate
The B.C. System generates strong levels of recurring earnings that are sufficient to absorb normal levels of loan losses. Credit unions in B.C. saw a 25.4 % year-over-year (YOY) rise in aggregate net operating income in 2021 to $470.3 million. Net interest income increased 11.3% to $1.39 billion as interest expenses fell more than interest income. The B.C. System’s strong revenue was partially offset by a 9.3% decline in noninterest income associated with a fall in trading financial instruments and other noninterest income.
The Ontario System generates adequate levels of recurring earnings and improving profitability, yet it still has strong competition from the large Canadian banks. The Ontario System’s net operating income totalled $475.2 million in 2021, up $259 million, or 119.8%, from 2020. Net interest income increased $210 million, or 18.5%, as interest income fell less than interest expenses. Noninterest income was relatively stable.
DBRS Morningstar 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, DBRS Morningstar is cautious that a sharp and sustained decline in excess liquidity deposits from credit unions to Central 1 could weaken its financial and operational position.
Risk Combined BB Assessment B.C. System: Strong/Good
Risk Combined BB Assessment Ontario System: Good
Risk Combined BB Assessment Central 1: Strong/Good
With negligible amounts in impaired loans and loan losses, the B.C. System’s asset quality remains solid, given 62% of lending exposures are secured through real estate as of YE2021; however, elevated housing prices remain a risk. Loans to CRE companies, small and medium-size enterprises, and construction projects are sources of wholesale credit risk for the B.C. System. However, 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 loan loss ratio was -0.1 % in 2021, down 19 basis points (bps) YOY. However, DBRS Morningstar 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 be a source of 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 10% of total assets as at Q1 2022, with no loan impairment and write-offs in recent years.
Funding and Liquidity Combined BB Assessment B.C. System: Strong/Good
Funding and Liquidity Combined BB Assessment Ontario System: Good
Funding and Liquidity Combined BB Assessment Central 1: Strong
The B.C. System has solid levels of liquidity and a retail deposit base that benefits from a 100% provincial deposit guarantee.
The Ontario System’s funding source is largely stable retail deposits; however, excessive reliance on market funding for growth would be viewed negatively. While liquidity levels are lower than peers, they remain sufficient.
Central 1 is largely funded through excess liquidity deposits generated from the Systems, which DBRS Morningstar 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 repos. Despite the segregation of MLP assets, Central 1 will continue to provide asset-management services for a substantial portion of the MLP funds. As such, DBRS Morningstar expects the removal of MLP funds from Central 1's balance sheet to have minimal to no impact on Central 1's funding position.
Capitalization Combined BB Assessment B.C. System: Good/Moderate
Capitalization Combined BB Assessment Ontario System: Good/Moderate
Capitalization Combined BB Assessment Central 1: Good/Moderate
DBRS Morningstar views the B.C. System’s capital position as strong, considering the solid capital cushion and good levels of internal equity generation. The System’s total capital ratio (TCR) declined to 15.1% in 2021 from 15.8% in 2020, while its internal equity generation of 7.1% was top tier relative to its Canadian peers.
The Ontario System’s capitalization is weaker than peers, although the capital cushion is sufficient. The Ontario System’s TCR, which is based on Basel II standards, marginally deteriorated to 13.5% in 2021, following an 80-bp YOY improvement in 2020.
The B.C. Financial Services Authority set a consolidated borrowing multiple of 18 times (x) for Central 1 as of January 1, 2021. As of YE2021, Central 1’s consolidated borrowing multiple was 14.3x compared with 17.8x in the prior year, largely following the segregation of mandatory deposits as a result of the MLP segregation.
Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/401844 (B.C. System) and https://www.dbrsmorningstar.com/research/401845 (Ontario System).
ENVIRONMENTAL, SOCIAL, AND GOVERNANCE (ESG) CONSIDERATIONS
DBRS Morningstar finds the social impact of products and services ESG factor is relevant to the credit rating but does not affect the assigned ratings or trends. The credit union Systems play an integral role in providing banking services to local communities and funding to small and medium-size businesses and underbanked areas. The credit union 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, DBRS Morningstar 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 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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.
All figures are in Canadian dollars unless otherwise noted.
The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 23, 2022; https://www.dbrsmorningstar.com/research/398692). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (May 17, 2022; https://www.dbrsmorningstar.com/research/396929).
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 rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.
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 ratings are under regular surveillance.
For more information on this credit or on this industry, visit www.dbrsmorningstar.com.
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