-- 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 that 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 affirming our ‘AA-/A-1+’ long- and short-term issuer credit ratings on Toronto-Dominion Bank (TD Bank), and revising the outlook to stable from negative.
-- The stable outlook reflects our expectation that TD Bank will maintain its current credit profile in the next 24 months.
On Dec. 13, 2012, Standard & Poor’s Ratings Services affirmed its long- and short-term issuer credit ratings on Toronto-Dominion Bank (TD Bank) at ‘AA-/A-1+’ and revised the outlook to stable from negative. TD’s stand-alone credit profile (SACP) remained unchanged at ‘a+'.
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 continuing pressure on margins particularly in the Canadian retail sector, and areas of continuing weakness in the global economy and financial system.
We believe banks operating in Canada are vulnerable 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 stand-alone credit profile (SACP), which is the starting point for our ratings on financial institutions operating primarily in Canada, to ‘a-’ from ‘a’.
This is reflected in our revision of our Banking Industry Country Risk Assessment (BICRA) for Canada to group ‘2’ from ‘1’ and our revised 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 feel 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, in our view, 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 pickup 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.
The ratings on TD Bank reflect its revised anchor SACP of ‘a-', company-specific factors, and our expectation for extraordinary government support. Company-specific factors include TD Bank’s “strong” (as our criteria define it) business position based on its leading Canadian retail franchise complemented by its increasingly substantial retail banking franchise in the eastern U.S.
The rating is also based on our assessment of TD Bank’s capital and earnings as “adequate” given its forecasted Standard & Poor’s risk-adjusted capital (RAC) ratio in the range of 7.7%-8.2% for fiscal year-end 2014 as well as its resilient earnings capacity. We revised our assessment of the bank’s risk position to “strong” from “adequate”, to reflect TD’s continuing strong asset quality metrics, favorable loss experience, and diverse risk exposures.
The ratings are also based on our assessment of TD Bank’s funding as “average” (revised from “above average”) and of its liquidity position as “adequate”. The revision of our assessment of TD Bank’s funding profile recognizes its favorable deposit position, particularly in the U.S., counterbalanced by notable reliance on wholesale funding, as is the case with other large Canadian banks. The resulting SACP of ‘a+’ is adjusted upward one notch in arriving at the ‘AA-’ issuer credit rating, reflecting our expectation for potential extraordinary government support in a stress scenario.
The stable outlook reflects Standard & Poor’s view that TD Bank’s core retail-oriented franchise spanning both Canadian and U.S. markets incorporates sufficient resilience to weather a range of economic environments, even recognizing the potential for more drawn-out recoveries in both markets.
We could lower the ratings on TD Bank if deterioration in economic conditions were to lead to material erosion in its profitability and capitalization, such that its RAC ratio weakened and remained below 7% over the next 18 to 24 months. The same result could arise if asset growth is disproportionately focused on higher risk categories such that overall asset performance measures would consistently and materially exceed historical levels.
An upgrade would depend on the bank attaining an RAC ratio consistently above 10% while maintaining its current franchise positions in Canada and the U.S.