DBRS Morningstar Confirms Bank of Montreal at AA With a Stable Trend

DBRS Limited (DBRS Morningstar) confirmed its ratings on the Bank of Montreal (BMO or the Bank) and its related entities, including BMO’s Long-Term Issuer Rating at AA and Short-Term Issuer Rating at R-1 (high). The trends on all ratings are Stable. BMO’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
The rating confirmations and Stable trends reflect BMO’s diversified franchise, solid earnings, strong balance sheet fundamentals, and ranking as the eighth-largest bank in North America by assets. BMO’s strong position in Canada is complemented by an enhanced U.S. franchise with the closing of the Bank of the West (BOTW) acquisition on February 1, 2023. BOTW adds scale, doubling BMO’s U.S. branch network and expanding its geographic footprint to include California along with other states, further diversifying the Bank’s previously Midwest-focused U.S. franchise. In DBRS Morningstar’s view, the combination does not increase credit risk because both companies have a strong lending track record; however, the BOTW acquisition adds increased operational and integration risk. BMO’s ratings are further supported by a conservative risk profile, reflecting a strong and prudent underwriting culture. Additionally, the Bank benefits from a relatively stable deposit base that is sourced in both Canada and the U.S., with DBRS Morningstar viewing both BMO’s funding and liquidity profile and capitalization as solid.

The ratings also consider the challenging macroeconomic and geopolitical environment, which could lead to an adverse impact on profitability and asset quality. DBRS Morningstar remains concerned about the combination of highly leveraged Canadian consumers; elevated home prices, particularly in the greater Toronto and Vancouver areas; and materially higher borrowing costs and inflation levels that are negatively affecting consumers’ disposable income. DBRS Morningstar believes that housing prices remain somewhat vulnerable and, as a result, views BMO, like its Canadian bank peers, as susceptible to any material adverse changes in the Canadian real estate market. DBRS Morningstar notes, however, that the Bank has the lowest exposures to residential real estate-secured lending (RESL) relative to its Canadian large bank peers.

RATING DRIVERS
Over the longer term, BMO’s ratings would be upgraded if the Bank were to continue to build the depth and scale of its franchise without a commensurate increase in its risk profile, while maintaining strong financial performance.

Conversely, BMO’s ratings would be downgraded if there are significant operational issues with the BOTW acquisition integration. Additionally, material deposit outflows or a sustained deterioration in asset quality, especially caused by deficiencies in risk management or increase in risk appetite, would also lead to a downgrade of the ratings.

RATING RATIONALE
Franchise Combined Building Block (BB) Assessment: Very Strong
In Canada, BMO is the fourth-largest bank by assets and provides all major product lines, including commercial and retail banking, wealth management, and capital markets. DBRS Morningstar notes that BMO's loan portfolio is weighted more toward commercial lending than its Canadian bank peers where it has leading market shares and is a top five commercial lender in North America. In the U.S., BMO operates under its U.S. holding company, BMO Financial Corp. (BFC). The BOTW acquisition added $79 billion in average gross loans and acceptances (GL&A) and $86 billion in average customer deposits. DBRS Morningstar views the BOTW acquisition as improving the Bank’s franchise strength, with increased presence in affluent, albeit highly competitive, markets. BFC is a top 10 U.S. bank by assets and has a footprint in 32 states including three of the top five U.S. markets by population.

Earnings Combined Building Block (BB) Assessment: Strong/Good
BMO generates solid earnings and profitability metrics underpinned by its highly diversified business franchise, which contributes to the Bank's ability to absorb credit losses. BMO reported Q2 2023 adjusted net income of $2.2 billion, a 2% decrease on a quarter-over-quarter (QOQ) basis, as higher revenue was more than offset by higher provisions for credit losses (PCL) and higher expenses. Adjusted net interest margin (NIM), excluding trading, increased 9 basis points (bps) QOQ to 1.88% but decreased 10 bps QOQ to 1.69% excluding the impact from BOTW; however, the Bank expects NIM to remain relatively stable for the remainder of F2023. BMO’s adjusted efficiency ratio was sound at 60.2%.

Risk Combined Building Block (BB) Assessment: Very Strong/Strong
Overall, DBRS Morningstar views BMO's risk profile as conservative, reflecting a strong risk culture and prudent underwriting standards. Credit quality metrics are normalizing from unsustainably low levels in the Canadian banking sector toward pre-pandemic levels. However, BMO's asset quality metrics continue to remain strong and better than the Canadian large bank peer average. In Q2 2023, the gross impaired loans (GIL) ratio increased 5 bps QOQ to 41 bps, primarily driven by higher GILs from the acquired BOTW portfolio. Additionally, adjusted total PCL (excluding the $705 million credit mark on the acquired BOTW performing loan portfolio) was $318 million, including $25 million attributable to BOTW, and the total PCL ratio increased 5 bps QOQ to 20 bps. PCL on impaired loans was $243 million, including $15 million attributable to BOTW, and the PCL on impaired loans ratio increased 2 bps QOQ to 16 bps. Positively, BMO has the lowest RESL exposure as a percentage of GL&A at approximately 34% (peer range between 34% and 54%). The Canadian RESL portfolio has an average loan-to-value ratio of 52% and an average bureau score of 798 for uninsured balances up for renewal in the next 12 months, thereby providing notable mitigants. However, amortization periods greater than 30 years in Canada have materially increased since Q2 2022 (31% of residential mortgages at Q2 2023), illustrating the impact of higher interest rates on variable interest rate mortgages with fixed payments. DBRS Morningstar will continue to monitor the impact rising interest rates will have on variable rate mortgages, including the ability of Canadian consumers to handle higher payments once their mortgages reset. BMO’s loan portfolio is more weighted toward commercial lending, with commercial real estate exposure being well diversified and representing a manageable 10% of GL&A.

Funding and Liquidity Combined Building Block (BB) Assessment: Strong
BMO has a strong funding and liquidity profile, which is underpinned by broad-based client-sourced deposits in both Canada and the U.S. In recent periods, however, the deposit mix has been notably shifting from demand to higher-cost term deposits as clients search for yield. Excluding the $86 billion in customer deposits from BOTW in Q2 2023, average customer deposits were flat QOQ with higher Canadian balances offset by lower balances in the U.S., wealth management, and capital markets. Augmenting its deposit funding, BMO also enjoys ready access to diversified wholesale funding sources, with BMO's usage within an acceptable range and in line with the Canadian bank peer average. BMO's liquidity profile remains strong as at April 30, 2023, with a liquidity coverage ratio of 129% and a net stable funding ratio of 113%, both comfortably above the regulatory minimum thresholds.

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 ability. In Q2 2023, BMO’s CET1 ratio decreased 600 bps QOQ to 12.2% but remains above the regulatory minimum of 11.0%, as the BOTW acquisition had a negative impact of 680 bps. In Q2 2023, BMO’s risk-based total loss-absorbing capacity ratio was at 27.0%, comfortably above the regulatory threshold of 24.5%. Additionally, the Bank reported a leverage ratio of 4.2% in Q2 2023 that was above the regulatory minimum of 3.5% and in line with its Canadian bank peers.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/415276.

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 (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 (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 (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 June 2, 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: William Schwartz, Senior Vice President, Credit Practices Group
Initial Rating Date: December 31, 1980

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

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