DBRS Morningstar Confirms The Bank of Nova Scotia at AA with Stable Trends

DBRS Limited (DBRS Morningstar) confirmed the ratings of The Bank of Nova Scotia (Scotiabank or the Bank) and its related entities, including Scotiabank’s Long-Term Issuer Rating at AA and Short-Term Issuer Rating at R-1 (high). The trend on all ratings is Stable. Scotiabank’s Long-Term Issuer Rating is composed of an Intrinsic Assessment (IA) of AA (low) and a Support Assessment (SA) of SA2, which reflects the expectation of timely systemic support from the Government of Canada (rated AAA with a Stable trend by DBRS Morningstar). As a result of the SA2 designation, the Bank’s Long-Term Issuer Rating benefits from a one-notch uplift to the Bank’s IA.

KEY RATING CONSIDERATIONS
Scotiabank’s ratings and Stable trends are underpinned by its highly diversified franchise. The Canadian operations of the third-largest bank in Canada (by assets) is complemented by an International Banking (IB) business segment that represented 25% of F2022 adjusted earnings and focuses on the high-growth, core markets in the Pacific Alliance region (i.e., Mexico, Peru, Chile, and Colombia). Although DBRS Morningstar views the overall risk profile as well managed, the Bank’s exposure to emerging markets is seen as heightening the risk profile and potentially adding earnings volatility. Indeed, the Bank’s return on capital has not been commensurate with the risk taken in certain IB segments. Further, a reliance on higher-cost wholesale funding to support loan growth has compressed net interest margins. Further to the recent appointments of Scott Thomson (President and Chief Executive Officer) and Francisco Aristeguieta (Group Head, International Banking), the Bank also announced a comprehensive strategy refresh to be completed by the end of F2023 that will purposefully allocate capital, focus on long-term core deposit growth, and improve the business mix and profitability.

The ratings also consider the challenging macroeconomic and geopolitical environments, which could lead to an adverse impact on profitability and asset quality. DBRS Morningstar remains concerned about the combination of highly leveraged Canadian consumers; still-elevated home prices, particularly in the greater Toronto and Vancouver areas; and materially higher borrowing costs and elevated inflation levels that are eating into consumers’ disposable income. DBRS Morningstar believes that housing prices remain somewhat vulnerable and, as a result, views Scotiabank, like its Canadian bank peers, as susceptible to any adverse changes in the Canadian real estate market. Positively, DBRS Morningstar views Scotiabank's residential real estate portfolio as conservatively underwritten, reflecting the Bank's strong risk culture.

RATING DRIVERS
Over the longer term, the Bank’s ratings would be upgraded if Scotiabank were to continue to build the depth and scale of its franchise, resulting in a sustained improvement in financial performance without substantially increasing its risk profile.

Conversely, the Bank's ratings would be downgraded if there were material missteps in its strategy refresh. Additionally, a sustained deterioration in earnings or asset quality, especially caused by deficiencies in risk management or an increase in risk profile, or significant operational issues, would also lead to a downgrade of the ratings.

RATING RATIONALE
Franchise Combined Building Block (BB) Assessment: Very Strong
The ratings are underpinned by the Bank’s scale and highly diversified business, product, and geographical mix that provides significant versatility to respond to changing market opportunities. Scotiabank’s strong Canadian franchise, albeit underrepresented in British Columbia and Québec, has maintained its market positions (first in automotive lending, third in real estate secured lending and personal loans, and fifth in credit cards and business loans). Mexico (fifth market position), Peru (third), and Chile (third) provide solid platforms for future growth, with a focus on Mexico in industries that benefit from its export agreements. In the U.S., the Bank is starting a structured collateralized loan obligations business as part of a larger U.S. investment banking expansion strategy to accelerate growth of the corporate client franchise.

Earnings Combined Building Block (BB) Assessment: Strong/Good
Scotiabank generates solid underlying earnings, which contribute to the Bank's ability to absorb credit losses. Adjusted F2022 net income increased 5.7% from the prior year to $10.7 billion, largely because of higher net interest income and lower provisions for credit losses (PCLs), partially offset by lower noninterest income and higher noninterest expenses. Adjusted Q1 2023 earnings were $2.4 billion, down 10% quarter over quarter as a result of higher provisions and noninterest expenses, as well as net interest margin (NIM) pressure. Margin pressure has been more significant in the IB segment where the Pacific Alliance NIM of 3.81% was down 4 basis points (bps) quarter over quarter and 13 bps year over year. Overall, certain profitability metrics are at the lower end of the peer range, and exposure to emerging markets and can lead to earnings volatility.

Risk Combined Building Block (BB) Assessment: Strong
Scotiabank's risk profile is viewed as conservative, exhibited by its strong asset quality with a manageable level of PCLs and impaired loans. However, the Bank exhibits slightly weaker asset-quality metrics compared with its Canadian bank peers, reflecting Scotiabank's exposure to emerging markets. Positively, this credit risk has historically been well managed, reflecting the Bank’s conservative underwriting and knowledge gleaned from its long operating history in emerging markets. The Bank has maintained a favourable business mix, with 73% of its IB loan portfolio secured. However, asset quality metrics are at unsustainably low levels, and modest deterioration is expected as credit conditions normalize. The Bank’s strategy refresh that is to be completed by the end of F2023 will focus on more targeted, slower loan growth to ensure returns are commensurate with risk, including less emphasis on monoline customers.

Funding and Liquidity Combined Building Block (BB) Assessment: Good
Overall, Scotiabank has a solid funding and liquidity profile, which benefits from a substantial retail deposit base. However, the Bank has a heavier reliance on higher-cost wholesale funding (22.8% of total assets compared with 21.3% at Q1 2022) than its peers. A focus of the strategy refresh will be to grow core deposits and reduce its Q1 2023 loan-to-deposit ratio of 116%, which was the highest among the Bank’s peers. Wholesale funding remains well managed and diversified by instrument, currency, program, tenor, and source/market. Scotiabank also ensures that its IB subsidiaries are funded in their local markets. In addition, liquidity at Scotiabank remains strong as it reported a Q1 2023 liquidity coverage ratio of 122% (129% to 176% in Pacific Alliance countries) and a net stable funding ratio of 109%, both comfortably above the regulatory minimums. Unrealized losses of $4.3 billion ($3.3 billion in fair value through other comprehensive income (FVOCI) and $1.0 billion in amortized cost) on its $110 billion investment securities portfolio remain manageable.

Capitalization Combined Building Block (BB) Assessment: Strong
DBRS Morningstar views the Bank's capitalization as strong, reflecting current capital levels as well as its significant internal capital generation. In Q1 2023, Scotiabank's CET1 ratio was 11.5%, 50 bps above the regulatory minimum of 11.0% for Domestic Systemically Important Banks. Internal capital generation supported organic growth across all business lines, with the re-evaluation of FVOCI securities mitigating much of the one-time impact of the Canada Recovery Dividend. The adoption of Basel III reforms in Q2 2023 is estimated to benefit capital by approximately 20 bps to 30 bps. DBRS Morningstar expects the Bank will manage to a 12.0% CET1 ratio over time. In Q1 2023, Scotiabank's risk-based total loss-absorbing capacity ratio was 27.9% at Q1 2023, comfortably above the regulatory threshold of 24.5%. The Bank reported a leverage ratio of 4.2% in Q1 2023 that was above the regulatory minimum of 3%.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/412891.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factor(s) 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).

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (https://www.dbrsmorningstar.com/research/398692/global-methodology-for-rating-banks-and-banking-organisations; June 23, 2022). 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 credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.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 www.dbrsmorningstar.com.

The rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process for this rating action.

DBRS Morningstar had access to the accounts, management and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

This is a solicited credit rating.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom, and by DBRS Ratings GmbH for use in the European Union, respectively. The following additional regulatory disclosures apply to endorsed ratings:

The last rating action on this issuer took place on April 20, 2022, when DBRS Morningstar confirmed the Bank’s ratings.

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 monitored.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

Lead Analyst: Carl De Souza, Senior Vice President, North American Financial Institutions Group
Rating Committee Chair: Michael Driscoll, Managing Director, Head of NA FIG
Initial Rating Date: December 31, 1980

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.

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