DBRS Morningstar Changes Equitable Group Inc. and Equitable Bank’s Trends to Stable from Negative; Confirms Ratings

DBRS Limited (DBRS Morningstar) confirmed Equitable Bank’s (the Bank) long-term ratings, including its Long-Term Issuer Rating, at BBB and confirmed the Bank’s Subordinated Debt rating at BBB (low). DBRS Morningstar also confirmed the long-term ratings of the Bank’s parent company, Equitable Group Inc. (together with the Bank, Equitable or the Group), at BBB (low). Additionally, DBRS Morningstar changed the trends on all ratings to Stable from Negative. The Bank’s Intrinsic Assessment (IA) is BBB, while its Support Assessment (SA) is SA1. The Group’s SA is SA3, and its Long-Term Issuer Rating is positioned one notch below the Bank’s IA.

KEY RATING CONSIDERATIONS
The trend change to Stable reflects DBRS Morningstar’s view that the considerable uncertainties facing financial institutions, particularly those with more limited business models, because of the Coronavirus Disease (COVID-19) pandemic have begun to abate. At the onset, DBRS Morningstar expected the economic impact of the various lockdowns on businesses across Canada, particularly for smaller firms and entrepreneurs, many of whom represent Equitable’s core Alternative-A (Alt-A) borrowers, to disrupt the Group. However, unprecedented support measures put in place through monetary and fiscal stimuli have largely mitigated the negative impact of the crisis.

The rating confirmations reflect Equitable’s solid and growing franchise as Canada’s largest mortgage lender in the Alt-A market niche. Equitable has also successfully introduced new lending products and expanded into adjacent verticals through acquisitions. Furthermore, the Group continues to attract direct deposits through its digital bank, EQ Bank, while enhancing its wholesale funding channels. While the ratings reflect Equitable’s good asset quality and history of low impairments and charge-offs, the ratings also consider the combination of highly leveraged consumers and elevated home prices, particularly in the Greater Toronto and Vancouver areas. As a result, DBRS Morningstar views Equitable as susceptible to any adverse changes in the Canadian real estate market.

RATING DRIVERS
Continued progress in diversifying funding sources, especially through more stable direct-to-consumer channels, while maintaining sound asset quality would lead to a ratings upgrade.

Conversely, a ratings downgrade would occur should there be significant losses in the loan portfolio as a result of unforeseen weakness in underwriting and/or risk management. Furthermore, disproportionate growth in commercial originations that weaken Equitable’s risk profile or substantive funding pressure caused by deposit outflows would also lead to a ratings downgrade.

RATING RATIONALE
Equitable is Canada’s largest Alt-A mortgage provider for borrowers who are generally self-employed, new immigrants, or recovering from bruised credit. Although the Group has been diversifying and expanding its franchise, residential Alt-A mortgages still formed around 38% of the Company’s $28.8 billion loan portfolio as of March 31, 2021. At the onset of the coronavirus pandemic, DBRS Morningstar was concerned that the various lockdowns would have a disproportionately negative impact on small businesses and those who are self-employed, and as a result, the demand for Alt-A mortgages and the performance of those mortgages would be materially affected. However, government aid programs and an easing of restrictions during the summer and autumn of 2020 helped cushion most of the adverse economic impact. Meanwhile the Group has continued to introduce new products on both the lending and deposit sides of the business, including reverse mortgages and U.S. dollar deposits, that are helping drive both growth and diversification.

The Group posted good earnings throughout 2020 and in Q1 2021 as the Bank managed to maintain healthy revenues. Despite a tactical shift to increase prime mortgage securitization during the pandemic, net interest income increased by 8% year over year to $497 million in 2020. In Q1 2021, improving market and economic conditions led Equitable to incorporate more high-yielding conventional mortgages in its business mix. This led to an improvement in the net interest margin, which had fallen to a low of 1.62% in Q2 2020 but now sits at 1.74% in Q1 2021. Meanwhile, the Office of the Superintendent of Financial Institutions (OSFI) instructed Canadian banks to take proactive provisions for performing loans that could turn delinquent because of the economic uncertainty from the pandemic. Consequently, Equitable recorded provision for credit losses of $35.7 million in Q1 2020, which later started being released as the economic outlook improved. Meanwhile, given its branchless model, Equitable remains one of the most efficient banks in Canada with an efficiency ratio of 38% as at Q1 2021.

Equitable entered the current downturn with a solid track record of strong asset quality, resulting in low impairments and loan losses. Gross impaired loans remain manageable, forming 0.38% of gross loans as at March 31, 2021, while loan losses have been negligible as government stimulus and aid has provided substantial mitigation throughout 2020. Nevertheless, DBRS Morningstar remains cautious that impaired loans may continue to trend upward as a result of prolonged business shutdowns in response to the pandemic, especially given the increased prevalence of coronavirus variants.

DBRS Morningstar views Equitable’s funding and liquidity positions as stable, especially given the Bank’s access to some of the Canadian federal government’s liquidity programs. The Group has been successfully reducing its dependence on broker-sourced deposits, which now comprise 61% of its $17.4 billion total deposits in Q1 2021, versus 80% in Q1 2020. Moreover, the Group is growing its directly raised deposits through EQ Bank, which has more than doubled its deposits over the last year to $5.8 billion, by introducing attractive new deposit products that are driving both client growth and retention. Additionally, the Group is growing wholesale funding sources through the use of institutional deposit notes and securitizations.

OSFI’s moratorium on dividend increases have translated into strong earnings retention bolstering Equitable’s Common Equity Tier 1 ratio to 14.52% in Q1 2021, an increase of 102 basis points from the previous year. This implies a capital cushion of $820 million, which is more than adequate to cover loan losses in a moderately stressed economic environment, in DBRS Morningstar’s opinion.

ESG CONSIDERATIONS
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/373262.

The Grid Summary Grades for Equitable are as follows: Franchise Strength – Good; Earnings Power – Good; Risk Profile – Good/Moderate; Funding and Liquidity – Good/Moderate; and Capitalization – Good.

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 8, 2020; https://www.dbrsmorningstar.com/research/362170). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021; https://www.dbrsmorningstar.com/research/373262).

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

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.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are 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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