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Fitch Affirms Canadian Banks; Fundamentals Outweigh Persistent Housing Risks.

New York: Fitch Ratings has affirmed the ratings of the seven largest Canadian banking institutions by assets (referred to as Canadian Banks) following a peer review committee. The seven financial institutions included in this peer review are:

--Bank of Montreal (BMO; rated 'AA-/F1+');

--Bank of Nova Scotia (BNS; rated 'AA-/F1+');

--Canadian Imperial Bank of Commerce (CIBC; rated 'AA-/F1+');

--Federation des caisses Desjardins du Quebec (FCDQ; rated 'AA-/F1+');

--National Bank of Canada (NBC; rated 'A+/F1');

--Royal Bank of Canada (RY; rated 'AA/F1+');

--Toronto-Dominion Bank (TD; rated 'AA-/F1+').

The ratings for the major Canadian banks are among the highest in Fitch's global bank universe. In Fitch's view, the ratings reflect the sound fundamentals at these banks, as evidenced by consistent earnings performance through various credit cycles and sound capital and solid liquidity financial profiles. The big six Canadian banks and FCDQ operate in a highly concentrated banking system within a highly developed economy and solid banking regulatory framework. Fitch also believes barriers to entry remain high, which benefits the large banks' performance.

The Rating Outlook is Stable for BMO, BNS, NBC, TD and FCDQ. The Rating Outlook has been revised to Stable from Negative for RBC. The Rating Outlook has been revised to Negative from Stable for CIBC. For detailed ratings and rationale, please refer to individual rating action commentaries released separately on each bank.

RY's Stable Rating Outlook reflects that while its growing capital markets business could increase overall operating performance volatility over a long-term horizon, Fitch does not believe it will have an outsize impact during the Outlook horizon. RY's ratings and Stable Outlook are also supported by the company's solid domestic franchise, geographic diversification and consistent operating performance.

CIBC's Negative Outlook reflects previously highlighted sensitivities to its continued sizeable mortgage growth relative to its peers, which is concerning at this point of the credit cycle. Further, in Fitch's view, CIBC's concentration in Canadian consumer asset classes, particularly at a time of record levels of debt, makes it more vulnerable to downside risks. CIBC's ratings are supported by its solid franchise and sound financial measures.

Fitch believes that all Canadian banks are exposed to credit deterioration in their domestic loan portfolios. Fitch has highlighted asset quality deterioration as a high influence factor for current ratings for all Canadian banks. To date, consumer assets, particularly mortgage, continue to perform well, but the banks' ratings would be sensitive to weakening gross impaired loans, loan impairment charges and delinquency rates above long-run averages. Fitch's ratings and Outlooks incorporate a modest deterioration in asset quality in the context of healthy capital levels and solid earnings power.

Fitch has highlighted the operating environment as a higher influence for the Canadian bank ratings. This reflects the two key risks for the banking system which are the intertwined unsustainable rise in home prices, particularly in Toronto, and the record level of household debt. The combination of these two factors makes borrowers vulnerable to a sharp increase in unemployment or interest rates and could hurt lenders' asset quality. While unemployment is not expected to weaken over the Outlook horizon, Fitch anticipates further increases in interest rates by the Bank of Canada, which are forecasted to reach 2.25% in 2019. This could affect asset quality performance, particularly if monetary policy changes faster or further than expected.

The Canadian economy has bounced back from the slowdown experienced in 2015 and 2016. Fitch revised its forecast for GDP growth up to 3.1% for 2017 and 2.0% for 2018. As such, economic conditions should remain favorable. However, a severe correction in the housing market could impact future growth given the sizeable contribution consumption and residential investments make to GDP over the last several years. Further, Fitch assumes that the renegotiation of the NAFTA treaty does not significantly disadvantage Canada's competitiveness in the U.S. market.

According to Fitch's RMBS group, housing markets in several major metropolitan areas are increasingly vulnerable to a price correction due to a rise in values not fully supported by underlying fundamentals. Home prices in Toronto and Vancouver have increased 45% and 36%, respectively, since the start of 2015. According to Fitch's most recent sustainable home price model, Canadian home prices are overvalued by approximately 25% with major regional variations. If government actions (i.e. tightening in borrower qualification standards) slow home price growth and there is no unexpected shock to the economy, a soft landing or mild correction is likely. However, if home prices continue on the current trajectory, the housing market will become increasingly vulnerable to an unexpected shock and severe correction.

Today's ratings affirmations incorporate a rating case scenario for price correction in the market of about 10%-15% over time. Fitch's base case assumption is not a forecast of home prices but rather a view on the level of home price change that on its own would not likely affect ratings. Should home prices decline at a faster pace and/or more severely, ratings could be pressured.

Fitch's rating affirmations recognize recent macro-prudential policy changes designed to cool the housing market, which include: tighter requirements for mortgage insurance, and tax changes and recent regulation implemented by local authorities in Ontario. Fitch views these policy initiatives as proactive and prudent given the continued increase in home prices. In Toronto and Vancouver, overvaluation has become a significant policy concern.

Although it is too early to assess whether increased housing market regulations will have a long-term impact, early signs suggest that there has been a slowdown in re-sell activity, and listings have increased for Toronto and Vancouver. An orderly slowdown in the pace of home price appreciation or even modest correction may be viewed as supportive to current Canadian bank ratings. However, should the cumulative effect of all these housing and mortgage market initiatives potentially cause more significant disruptions to the mortgage market, this may negatively impact the Canadian banks' ratings and/or Rating Outlooks. However, Fitch would assess the materiality of the impact on each bank individually.

In the event of a severe economic shock, Fitch expects that Canadian Mortgage and Housing Corporation (CMHC) would act as a shock absorber for the insured mortgage exposure. CMHC, a crown corporation, explicitly guarantees a large portion of the mortgages on bank balance sheets (on average 50% of total Canadian residential mortgage portfolios, which supports the Canadian banks ratings.

Fitch also remains cautious given record levels of consumer indebtedness. Consumer debt to disposable income stood at 169.9% at end-June 2017, which is amongst the highest compared to G7 countries. More recently, Bank of Canada has increased its benchmark rate by 50bps in July and September erasing the previous two rate cuts from 2015 following the commodity price decline. Should interest rates rise rapidly, marginal borrowers may be pressured, which could impact asset quality and potentially lead to an overall slowdown in the economy.

On June 16, 2017, the Department of Finance and the Office of the Superintendent of Financial Institutions released a draft of bail-in regulations and TLAC guidelines for Domestic Systemically Important Banks with a compliance date of Nov. 1, 2021. The draft provides clarity for liabilities that will be eligible for bail-in conversion, requirements for qualifying bail-in debt, and compensation regulations.

Given the exclusion of deposits from bail-in, Fitch believes this creates a "de facto" depositor preference regime in a resolution scenario. However, senior debt and uninsured deposits would rank pari passu under a liquidation scenario. The bail-in resolution proposals did not address the pari passu ranking of deposits in liquidation. Fitch may assign deposit ratings, but uplift may be limited as their ranking will depend on the resolution path chosen. Likewise, Fitch may also consider assigning derivative counterparty ratings reflecting the higher ranking of these obligations, given that they are excluded from bail-in dependent on the ranking of these obligations in liquidation.

For now, Fitch equalizes the ratings for senior bail-in debt to the long-term Issuer Default Rating (IDR). A rating distinction could be introduced between the IDR and legacy senior debt in the future if the bail-in debt built over time provides a sufficient qualifying junior debt buffer that structurally benefits senior non-bail-in debt holders.
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Publication:Daily the Pak Banker (Lahore, Pakistan)
Geographic Code:1CONT
Date:Jan 5, 2018
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