DBRS Limited (DBRS Morningstar) confirmed the credit ratings of EQB Inc. (EQB or the Group), including the Group's Long-Term Issuer Rating at BBB. DBRS Morningstar also confirmed the credit ratings of EQB's primary operating subsidiary, Equitable Bank (Equitable or the Bank), including its Long-Term Issuer Rating at BBB (high).
The trend on all credit ratings is Stable. The Bank's Intrinsic Assessment (IA) of BBB (high) and Support Assessment (SA) of SA1 remain unchanged. The Group's SA remains at SA3 with its Long-Term Issuer Rating positioned one notch below the Bank's IA.
KEY CREDIT RATING CONSIDERATIONS
The credit rating confirmations and Stable trends reflect Equitable's increased scale and growing franchise as the seventh-largest Schedule I bank in Canada by assets following its acquisition of Concentra, which closed November 1, 2022. The Bank has $108 billion in assets under management and administration and is one of the largest mortgage providers in the self-employed and/or new immigrants space in Canada. Equitable maintains sound credit fundamentals with consistent profitability, producing top-tier return on equity and efficiency metrics. Although the acquisition of Concentra Trust is expected to increase noninterest income, the high proportion of net interest income (NII) remains a credit ratings constraint. The Bank maintains solid capitalization and adequate liquidity levels, albeit still concentrated in broker deposits.
The Stable trends reflect that there have been no material missteps thus far in the integration of Concentra, and that the Bank has already realized its initial target of $30 million in annual run-rate cost synergies. DBRS Morningstar remains concerned about the combination of a potential recession and high Canadian household debt levels, along with persistent inflation and high interest rates, which have materially increased debt servicing costs. DBRS Morningstar considers the Bank to be more susceptible than its large bank peers to significant adverse changes in the Canadian real estate market, particularly with respect to its uninsured mortgage which have more of a nonprime component. Nonetheless, Equitable's mortgage lending exposure is manageable given its history of low impairments and charge-offs. Further, the Bank's uninsured residential mortgage portfolio at Q2 2023 had a solid weighted-average beacon score of 714, along with a low average loan-to-value of 63%, which provides additional cushion.
CREDIT RATING DRIVERS
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 credit ratings upgrade.
Conversely, 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 credit ratings downgrade.
CREDIT RATING RATIONALE
Franchise Combined Building Block (BB) Assessment: Good/Moderate
Equitable is a fully digital bank, providing customers with an alternative to the large banks, particularly through EQ Bank. Equitable's uninsured residential mortgage portfolio has a primary focus on borrowers that are self-employed and/or new immigrants. The Bank also has a notable prime insured mortgage portfolio, along with a growing wealth decumulation business, particularly reverse mortgages, and momentum in its conventional commercial lending portfolio. The Bank's acquisition of Concentra expanded its scale and reach, including access to a new and unique distribution network with more than 200 credit union relationships and at least 5 million members, providing growth opportunities for the Bank and its broader product suite. EQ Bank's launch into Quebec (December 2022) and the EQ Bank payment card (January 2023), along with the new small business bank account that is expected to launch in F2024, should strengthen customer relationships and have a positive impact on customer acquisition. Of note, EQB's noninterest income is expected to increase with its planned acquisition of ACM Advisors, a pooled commercial mortgage funds manager, scheduled to close in calendar 2023 (subject to regulatory approvals).
Earnings Combined Building Block (BB) Assessment: Good/Moderate
Equitable generates consistent profitability. The Concentra acquisition provides revenue diversification through Concentra Trust (i.e., trust, estate administration, and registered accounts); however, NII still represented the majority of adjusted revenue at 89% in the first half of 2023 (H1 2023) (versus 93.5% in H1 2022) and is a credit ratings constraint. Adjusted H1 2023 net income as reported by Equitable, including Concentra, increased 41% year over year (YOY) to $217.2 million, as higher revenue was only partly offset by higher noninterest expenses and increased provisions for credit losses (PCL). Adjusted H1 2023 NII as reported increased 48% YOY to $488.3 million on contributions from Concentra, asset growth across the Bank's conventional loan portfolios, and higher net interest margin (NIM), which expanded 11 basis points (bps) YOY to 1.95%. The NIM benefited from growing asset yields and a shift toward higher spread conventional loans which outpaced funding costs. NIM expansion is expected to moderate, however, in the remainder of F2023 and into early F2024 as interest rate hikes stabilize. Equitable's H1 2023 adjusted return on equity of 17.5% and an efficiency ratio of 44.1% remains at or near the top of the peer range.
Risk Combined Building Block (BB) Assessment: Strong/Good
DBRS Morningstar considers Equitable's risk profile to be sound, with its loan book 98% secured by assets and 51% insured. At Q2 2023, Personal and commercial multi-unit residential mortgages comprise approximately 80% of loans under management (LUM). Commercial Banking lending (46% of LUM), including equipment leasing, is diversified with shopping centres and hotels representing a manageable 3.3% and 0.3% of commercial loans (1.1% and 0.1% of total loans), respectively. Similarly, less than 1% of the Bank's LUM are offices with an average LTV of 60%, and construction loans represent 3% of LUM (excluding insured construction loans). However, credit metrics have been normalizing from unsustainably low levels and are now back to the pre-pandemic range with Q2 2023 reported net impaired loans at 47 bps and PCL at 11 bps. DBRS Morningstar expects credit quality metrics to continue deteriorating for the remainder of F2023 and into F2024 as a result of persistent inflation and materially higher debt servicing costs, with a potential recession amplifying the negative impact on credit quality.
Funding and Liquidity Combined Building Block (BB) Assessment: Moderate
Equitable is gaining increased benefits from its funding diversification strategy, although it still has a heavy reliance on brokered deposits. EQ Bank and credit union deposits acquired through the Concentra acquisition represented 22% of on balance sheet funding in Q2 2023 (compared with 21% in Q3 2022 and 9% in Q3 2017) and have somewhat reduced the Bank's reliance on brokered deposits and funding facilities and securitization. The Bank has also further diversified its funding base by building out its covered bond program (its lowest cost and most stable source of wholesale funding), with covered bonds outstanding up 32% quarter over quarter (QOQ) and 94% YOY at Q2 2023. Equitable's total deposits as reported were $31.8 billion at Q2 2023 and were primarily comprised of brokered deposits at 51%. At Q2 2023, Equitable held adequate levels of liquidity, with $4.1 billion in liquid assets (8% of total assets and approximately 69% of demand deposits).
Capitalisation Combined Building Block (BB) Assessment: Good
Equitable is well capitalized with a CET1 ratio of 14.1% at Q2 2023, providing cushion to withstand adverse scenarios. CET1 increased 10 bps QOQ as internal capital generation outpaced growth in risk weighted assets and increased 60 bps YOY because of increased capital related to the acquisition of Concentra. The Bank is able to grow CET1 through stable internal capital generation combined with a relatively low dividend payout in the 10% range. Equitable remains committed to maintaining a CET1 target ratio of 13%+.
Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/424273.
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 (July 4, 2023) https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings
Notes:
All figures are in Canadian dollars unless otherwise noted.
The principal methodology is the Global Methodology for Rating Banks and Banking Organisations ( June 22, 2023) https://www.dbrsmorningstar.com/research/415978/global-methodology-for-rating-banks-and-banking-organisations. In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (July 4, 2023) https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings 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 credit rating was initiated at the request of the rated entity.
The rated entity or its related entities did participate in the credit rating process for this credit 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 credit rating action.
This is a solicited credit rating.
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 credit ratings are under regular surveillance.
For more information on this credit or on this industry, visit www.dbrsmorningstar.com.
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