DBRS Limited (DBRS Morningstar) upgraded the ratings of EQB Inc. (EQB or the Group), including the Group’s Long-Term Issuer Rating, to BBB from BBB (low). At the same time, DBRS Morningstar upgraded the ratings of EQB’s primary operating subsidiary, Equitable Bank (Equitable or the Bank) and Concentra Bank (Concentra), including their Long-Term Issuer Ratings, to BBB (high) from BBB. The trends on all ratings are now Stable. The Intrinsic Assessment (IA) for the Bank is BBB (high), while its Support Assessment remains SA1. The Group’s Support Assessment remains SA3 and its Long-Term Issuer Rating is positioned one notch below the Bank’s IA.
KEY RATING CONSIDERATIONS
The ratings upgrades reflect the increasing diversification of the Group’s funding sources, along with its consistent profitability and sound credit fundamentals. The Bank has a solid and growing franchise and is Canada’s largest mortgage lender in the Alt-A market niche by portfolio size. The Bank also has a notable prime mortgage portfolio that is fully insured, along with a rapidly growing wealth decumulation business and momentum in its conventional commercial lending portfolio. Additionally, with the closing of the Concentra acquisition on November 1, 2022, Equitable now has more scale and is the seventh-largest Schedule 1 bank in Canada by assets with more than $100 billion in combined pro forma assets under management and administration.
The Stable trends reflect DBRS Morningstar’s expectation that there will be no material missteps in the integration of Concentra. DBRS Morningstar remains concerned about the combination of Canadian household debt levels that remain near an all-time high, still elevated home prices, and rapidly rising interest rates to combat inflation. Equitable and many of its Canadian peers remain susceptible to adverse changes in the Canadian real estate market. Nonetheless, DBRS Morningstar views Equitable’s mortgage lending exposure as manageable given its prudent underwriting, history of low impairments and charge-offs, solid asset quality, and low average loan-to-value (63%) on its Alt-A portfolio that provides additional cushion in a housing market downturn.
Continued progress in diversifying funding sources, particularly through more stable direct-to-consumer channels, and revenue, through higher noninterest income, while maintaining sound asset quality would lead to a ratings upgrade.
Conversely, the ratings would be downgraded if there were material operational issues with the acquisition integration. Additionally, significant losses in the loan portfolio as a result of unforeseen weakness in underwriting and/or risk management, disproportionate growth in commercial originations that weaken the risk profile, or substantive funding pressure caused by deposit outflows would also result in a ratings downgrade.
Franchise Combined Building Block (BB) Assessment: Good/Moderate
Equitable is Canada’s largest Alt-A mortgage provider for borrowers who are generally self-employed, new immigrants, or recovering from bruised credit. While growth in this core portfolio was relatively flat quarter over quarter (QOQ) in Q3 2022, it had strong year-over-year (YOY) growth of 24%. The Concentra acquisition provides increased scale and diversification, with the Bank’s pro forma loans under management increasing 27% to $55.7 billion at September 30, 2022. Reverse mortgages and specialized finance, although still relatively small, are targeted growth opportunities for the Bank. The acquisition provides access to a new and unique distribution network with more than 200 credit union relationships and more than 5 million members. Additionally, the Bank’s new payment card and pending EQ Bank launch into Québec will enhance and continue to build out its successful digital bank offering that continues to attract deposits. These new initiatives should strengthen customer relationships and have a positive impact on customer acquisition. As a fully digital bank, it is well positioned to capitalize on a younger demographic and the accelerated shift to digital banking, open banking, and innovative financial services.
Earnings Combined Building Block (BB) Assessment: Good/Moderate
Equitable generates consistent profitability and produced all-time high earnings in F2021 and year-to-date 2022. Q3 2022 record revenue was driven by record net interest income (NII; up 12% QOQ and 24% YOY) and a net interest margin that increased 13 basis points (bps) QOQ to a new quarterly high point of 1.93%. The Bank’s focus remains on profitability through disciplined pricing on loans while optimizing the cost of funds through selective deposit rate increases at EQ Bank. NII makes up more than 90% of revenue and DBRS Morningstar considers this to be a ratings constraint. Positively, the Concentra acquisition provides new income streams, along with cost benefits. Concentra Trust (i.e., trust, estate administration, and registered accounts) immediately diversifies revenue, expanding Equitable’s pro forma revenue by 24% while increasing the contribution from NII from 7% to 10% of revenue at September 30, 2022. Additionally, the Bank has indicated that it expects to achieve its targeted $30 million annual run-rate cost synergies by the end of 2023. Reported Q3 2022 return on equity of 14.8% is near the top of the peer range while the Bank’s low-cost digital model results in an industry-leading efficiency ratio of 43.0%. DBRS Morningstar notes that the Concentra acquisition will likely result in some near- to medium-term fluctuation in the efficiency ratio.
Risk Combined Building Block (BB) Assessment: Strong/Good
Equitable’s risk profile is considered sound with its loan book essentially 100% secured and 46% insured (excluding Concentra). At Q3 2022, the pro forma loan portfolio mix is 56% from Personal Banking and 44% from Commercial Banking. The residential mortgage lending portfolio and multi-unit mortgages comprise approximately 80% of total loans. Commercial Banking lending, including equipment leasing, is diversified across industries and geographies with asset classes considered more sensitive to economic cycles, such as shopping centres and hotels, representing a manageable 3.7% and 0.2% of commercial loans (1.2% and 0.1% of total loans), respectively. Construction loans represent less than 2% of total loans under management (excluding insured construction loans) and DBRS Morningstar notes the Bank has temporarily stopped lending against land and uninsured construction because of current market conditions. Prudent underwriting has led to a history of low impairments and charge-offs. In Q3 2022, commercial impairments increased 53% QOQ as a result of one loan that went delinquent but has since been discharged. Loan books remain fairly well provisioned with $55.2 million in allowances for credit losses (up 7% QOQ and 6% YOY). After several quarters of provision reversals in F2021 and into F2022, provisions have increased for the last two quarters ($5.2 million in Q2 2022 and $5.4 million in Q3 2022) to account for the deteriorating economic forecasts.
Funding and Liquidity Combined Building Block (BB) Assessment: Good/Moderate
Equitable is gaining increased benefits from its funding diversification strategy, decreasing its reliance on brokered deposits. EQ Bank deposits represented 21% of on balance sheet funding in Q3 2022 (compared with 9% in Q3 2017). Direct-to-consumer deposits are a key source of growth that has reduced the Bank’s reliance on brokered deposits (38% in Q3 2022 compared with 48% in Q3 2017) and funding facilities and securitization (34% in Q3 2022 compared with 43% in Q3 2017). The Bank has also further diversified its funding base by building out its deposit note program with three successful issuances in 2021, while completing three covered bond issuances since launching this program in 2021 (lowest cost and most stable source of wholesale funding). Fixed-term brokered deposits are 95% insured and distributed across tenors and dealers. The Concentra acquisition further diversifies Equitable’s funding sources, adding two additional new funding channels ($2.5 billion of low-cost credit union deposits and $0.6 billion of commercial deposits, along with an additional $0.6 billion in covered bond capacity). Equitable holds adequate levels of liquidity, with $3.2 billion in liquid assets (10% of total assets, excluding securitization, and approximately 55% of demand deposits). The Bank had a liquidity coverage ratio of 339% at Q3 2022.
Capitalisation Combined Building Block (BB) Assessment: Good
Equitable is well capitalized with a CET1 ratio of 13.3% at Q3 2022, providing cushion to withstand adverse scenarios. CET1 was 40 bps lower YOY because of organic deployment of capital to conventional lending and associated growth of risk-weighted assets. The Bank is able to grow CET1 through retained earnings and stable internal capital generation, with a relatively low dividend payout in the 10% range. The CET1 ratio was expected to remain above 13% following the Concentra acquisition.
Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/405816
ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/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 (May 17, 2022).
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). In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022) in its consideration of ESG factors.
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.
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