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-- We believe that the Canadian banking sector is encountering incremental pressure from headwinds facing the Canadian economy, which is heightening economic risk in the banking system.
-- We also believe industry risk for the Canadian banking sector is increasing. We expect that intensifying competition for loans and deposits will lead to pressure on profitability growth, especially in banks' retail businesses.
-- We are lowering our long- and short-term issuer credit ratings on National Bank of Canada to 'A-/A-2' from 'A/A-1', following our revision of the stand-alone credit profile on the bank to 'a-' from 'a'. The outlook is stable.
-- The stable outlook reflects our expectation that National Bank of Canada's credit fundamentals will remain consistent with current ratings over the next 24 months.
On Dec. 13, 2012, Standard & Poor's Ratings Services downgraded its long- and short-term issuer credit ratings on National Bank of Canada to 'A-/A-2' from 'A/A-1'. The outlook is stable. In addition, Standard & Poor's lowered its issue ratings on National Bank's senior unsecured debt to 'A-' from 'A', nondeferrable subordinated debt to 'BBB+' from 'A-', and preferred shares and hybrid securities to 'BBB' from 'BBB+'.
The rating action follows our review of banking sector industry and economic risks in Canada, taking into account the headwinds facing the Canadian economy, Canadian consumers' high debt levels, expectations of decelerating loan demand and continued pressure on margins, particularly in the Canadian retail sector, and areas of continuing weakness in the global economy and financial system.
We believe banks and credit unions operating in Canada are subject to an expanding set of potential stresses arising from competitive pressure on growth and margins, while asset quality is potentially vulnerable--in light of high consumer indebtedness--to developments that may trigger general economic deterioration in Canada.
Consequently, we lowered our anchor SACP, which is the starting point for our ratings on financial institutions operating primarily in Canada, including National Bank, to 'a-' from 'a'. This is reflected in our revision of Banking Industry Country Risk Assessment (BICRA) for Canada to group '2' from '1' and revised our industry risk score, a component of the BICRA, to '2' from '1' (see "Various Rating Actions Taken On Canadian Financial Institutions Due To Rising Industry and Economic Risks," published Dec. 13, 2012, on RatingsDirect on the Global Credit Portal).
We believe that the banks and credit unions are under incremental pressure from the headwinds facing the Canadian economy. The acceleration of household debt to record levels has increased Canadian households' vulnerability to sudden shocks in incomes, employment, or a spike in interest rates.
Exposure to the consumer sector accounts for nearly three-fifths of total bank loans, and losses on banks' uninsured loan portfolios--although recent performance levels have generally been strong--may be driven higher in the event of a substantial shock to household creditworthiness, though we expect effective regulatory supervision to remain a positive influence on Canadian bank credit quality.
Although we expect ongoing intensification of competitive dynamics in the Canadian banking sector, we note that overall Canada still remains positioned favorably vis-a-vis most of its global peers. However, a slowing economy risks exacerbating the already-intense competition between banks for loan and deposit share and puts further pressure on the margin and profitability of the Canadian financial institutions' retail and commercial lending businesses, the cornerstone of Canadian banking and largest contributor to revenues.
We also believe that Canadian financial institutions' risk tolerances may increase to compensate for lower profitability by reaching for yield through investments, more aggressive lending in higher yielding loans such as personal loans and credit cards, or potentially a pick-up in mergers and acquisitions activity.
Furthermore, we expect that continuing industry conditions will test banks' operational capabilities. Relative performance in areas such as service standards, cost control, operational effectiveness, underwriting discipline, and ability to integrate acquisitions will likely contribute to changes in market position and financial performance, and will have an impact on the relative credit standing among industry participants.
Standard & Poor's ratings on National Bank reflect a combination of factors including the anchor SACP and company-specific factors. For National Bank we start at the anchor of 'a-'. We then adjust for a "moderate" (as our criteria define it) business position given the company's smaller market shares relative to Canadian peers', its regional focus in Quebec, and some degree of potential revenue volatility stemming from its capital market's businesses; "adequate" capital and earnings based on Standard & Poor's forecasted risk-adjusted capital (RAC) ratio in the range of 8% to 8.5%; "strong" risk position reflecting more favorable credit quality metrics than many of its domestic peers' and moderate market risk exposure; and "average" funding and "adequate" liquidity scores, based on the bank's core deposit base and low-risk securities portfolio, while recognizing a material wholesale funding component. The SACP on National Bank is 'a-'.
The stable outlook reflects our expectation that National Bank will maintain its solid franchise position in Quebec, a RAC ratio above 7%, and strong asset quality that continues to compare favorably to that of peers.
The outlook and /or ratings could come under pressure if asset quality were to deteriorate significantly, as evidenced in a significant rise in loan losses, if the forecasted RAC ratio were to fall below 7% over the next 18-24 months, or if capital markets operations' contribution to revenues, as calculated by Standard & Poor's, were to consistently exceed 25% for several consecutive quarters.
An outlook revision to positive would entail a RAC ratio that is sustainably above 10%, improved market share positions that mimic those of its large Canadian bank peers, and better geographic and revenue diversification, but we see positive rating movements as unlikely in the near term.