Fitch Affirms Bank of Montreal Ratings at 'AA-/F1+'; Outlook Stable

NEW YORK--()--Fitch Ratings has affirmed Bank of Montreal (BMO) Long- and Short-Term Issuer Default Ratings (IDRs) at 'AA-' and 'F1+', respectively. The Rating Outlook remains Stable.

This rating action follows Fitch's periodic review of the Canadian Banks Peer Group, which includes Bank of Montreal (BMO), Bank of Nova Scotia (BNS), Canadian Imperial Bank of Commerce (CIBC), Caisse Centrale DesJardins (CCD), National Bank of Canada (NBC), Royal Bank of Canada (RBC) and Toronto-Dominion Bank (TD).

Company-specific rating rationales for the other banks are published separately. For further discussion of the Canadian Banks sector, please refer to the special report titled 'Canadian Bank Peer Review' to be published shortly.

Recently, the Ministry of Finance announced important changes to the housing finance system in Canada. These entail the introduction of a lender risk sharing policy, tighter requirements for mortgage insurance, and tax changes targeted at speculative and foreign buyers. The most impactful for Canadian banks, and non-bank mortgage lenders, is the introduction of the lender risk sharing policy. This, coupled with other measures being introduced by governmental entities, such as the introduction of mortgage risk-weight floors for Canadian banks, are meant to temper a further run-up in housing prices. To the extent that this creates an orderly slowdown in the pace of home price appreciation, this may be viewed as supportive to current Canadian bank ratings. Alternatively, should the cumulative effects of these initiatives cause potentially more significant disruptions to the Canadian mortgage market, this may negatively impact Canadian Bank ratings and/or Rating Outlooks, though Fitch would assess the materiality of the impact on each bank individually.

KEY RATING DRIVERS

BMO's rating affirmation and its high ratings reflects the company's consistent financial performance over various credit cycles, sizeable franchise and market position, good revenue diversification relative to its peer banks given its U.S. based operations. BMO's ratings also benefit from Canada's strong regulatory environment as well as a stable domestic banking market.

Fitch believes that all Canadian Banks, including BMO, are vulnerable to credit deterioration in their domestic loan portfolios given high levels of consumer indebtedness in Canada, combined with Fitch's view of some overvaluation in the Canadian housing market. This makes consumers particularly susceptible to negative shocks to their income levels, unemployment and, although not expected, rising interest rates. Additionally, the low levels of global oil prices will continue to pressure the Canadian economy. To date, unemployment levels have remained relatively stable on a national level; however, a sharp rise in unemployment could hasten potential credit deterioration.

In Fitch's view, BMO may be better positioned to navigate through the recent mortgage market changes that may have less of an impact to its balance sheet when compared to its Canadian peers. BMO has the lowest percentage of mortgage loans to gross loans at 31% compared to a peer average of 46%. The company's insured book totaled 57% of total mortgages.

BMO recently announced the restatement of its regulatory CET1 ratio that led to a decline in the reported figure of 50 basis points (bps) to 10% from 10.5% for the third quarter of 2016 (3Q16). The company has stated that the ratios were restated given its internal models finding an inconsistency with the calculation of its risk-weighted assets for its Basel I modeling. The decline in capital is modest and Fitch recognizes BMO's solid ability to generate capital given its strong earnings profile. Nonetheless, the issue highlights weakness within its internal controls, which Fitch views negatively. Should this error lead to material regulatory action or signal further issues, Fitch could review the rating for possible negative action.

During the first nine months of 2016 (9M16), the company's earnings performance continues to be solid supported by revenue growth despite a challenging environment and the negative impact of a 32% increase in provision for credit losses (PCL) from the same period a year-ago. BMO's Canada and U.S. Personal & Commercial (P&C) banking segment has been a strong contributor to earnings accounting for roughly 42% and 20% of net income. The company's results were also boosted by strong organic loan growth in the U.S., the positive impact from the BMO Transportation and Finance business, and a jump in capital markets revenue.

BMO's geographic revenue diversification through its U.S. based operations is viewed favorably given it could provide a buffer should the Canadian operations experience a slowdown in the economy from prolonged lower oil prices and/or a gradual decline housing activity. That said, Fitch notes that BMO's U.S. operations have to date been somewhat dilutive to the overall enterprise's return on equity (ROE), as it incurs some additional regulatory and operating costs relative to more domestically focused banks. Further, BMO's C&I loan growth in the U.S. segment has outpaced U.S. large regional peers. Fitch has raised concerns regarding C&I industry loan growth in the U.S. given fierce competition, loosening of underwriting and growth trajectory that is above the level suggested by macro-indicators.

While BMO's ratio of gross impaired loans and PCL has increased, it continues to compare well internationally and in-line with expectations. As expected, given pressures in the energy sector, BMO's credit measures have been impacted, however, stable performance in other areas of its loan book have also provided an offset to overall metrics. Further, BMO's direct exposure to oil & gas lending appears to be on the lower side compared to other Canadian banks.

Similar to its Canadian peers, Fitch views BMO's funding profile and liquidity as solid. The company maintains a large portion of assets in cash and liquid securities. BMO also benefits from a solid funding base, including a sizeable amount of retail deposits. In addition to its Canadian retail franchise, BMO's expanded U.S. based retail franchise diversifies the funding mix and provides relatively low-cost, sticky deposits.

Fitch has also affirmed and withdrawn BMO Harris Bank's Viability Rating (VR) at 'a' as it is no longer considered by Fitch to be relevant to the agency's coverage.

SUBORDINATED DEBT AND OTHER HYBRID SECURITIES

Subordinated debt and other hybrid capital issued by BMO and its subsidiaries are all notched down from the common VR in accordance with Fitch's assessment of each instrument's respective non-performance and relative loss severity risk profiles, which vary considerably.

BMO's subordinated debt is notched one level below its VR of 'aa-' for loss severity in accordance with Fitch's assessment of each instrument's respective non-performance and relative loss severity risk profiles.

BMO's preferred stock is five notches below the VR, made up of two notches down for non-performance and three notches down for loss severity.

These ratings are in accordance with Fitch's criteria and assessment of the instruments non-performance and loss severity risk profiles and have thus been affirmed due to the affirmation of the VR.

LONG- AND SHORT-TERM DEPOSIT RATINGS

BMO Harris, NA's uninsured long-term deposit ratings are rated one notch higher than the company's IDR and senior unsecured debt because U.S. uninsured deposits benefit from depositor preference. U.S. depositor preference gives deposit liabilities superior recovery prospects in the event of default.

M&I Marshall & Ilsley Bank and M&I Bank FSB uninsured long-term deposit ratings are also rated one notch higher than the company's IDR and senior unsecured debt because U.S. uninsured deposits benefit from depositor preference. U.S. depositor preference gives deposit liabilities superior recovery prospects in the event of default.

SUBSIDIARY AND AFFILIATED COMPANY

All of the subsidiaries and affiliated companies including BMO Harris Bank National Association reviewed as part of the Canadian Bank peer review factor in a high probability of support from parent institutions to the subsidiaries. This reflects that performing parent banks have very rarely allowed subsidiaries to default. It also considers the high level of integration, brand, management, financial and reputational incentives to avoid subsidiary defaults.

SUPPORT RATING AND SUPPORT RATING FLOOR

The affirmation of the BMO's SR of '2' and SRF of 'BBB-' reflect Fitch's view that the likelihood of support remains high for Canadian Banks due to their systemic importance in the country, significant concentration overall in of Canadian banking assets amongst the institutions noted above, which account for over 90% of total banking assets, the large size of the banking sector with banking assets at 2.1 times Canada's GDP, and the Canadian Banks' position as key providers of financial services to its local economy. In Fitch's view, Canadian banking authorities through the CDIC Act, have wide latitude to resolve a troubled bank including re-capitalizing an institution, creating a bridge bank, or imposing losses on creditors.

Fitch recognizes that the government's willingness to provide support for D-SIFI's in Canada has been reduced demonstrated by Department of Finance consultation paper which outlines the proposed bail-in regime as banking regulators seek to protect tax payers from the risk of a large financial institution failing. This is evidenced by the proposed issuance of non-voting contingent capital (NVCC) instruments, resolution powers given regulatory authorities under the CDIC Act, and other initiatives that demonstrate the Canadian government's progress to reduce the propensity of state support for banks going forward.

RATING SENSITIVITIES

VR, IDRs, AND SENIOR DEBT

Given the already high level of BMO's ratings, Fitch does not expect any upside to ratings.

Today's rating action also incorporates the view that Fitch believes uncertainties remain on what the impact of recent mortgage reform announcements will be to the broader mortgage market, particularly as lenders (including nonbanks) and even borrowers pull back on mortgage lending activity while they evaluate the potential impact. As such, a faster price correction that is prolonged and/or a slowdown in the housing market will likely impact earnings growth for all the banks. This would also affect the broader economy through the link between housing wealth and consumer consumption, and the real estate sector, which are important drivers of GDP growth. Fitch notes that the Canadian banks ratings are sensitive to these changes.

Fitch also notes that the recent restatement of its CET1 calculation is considered a negative given it signals some weakness within its internal controls. Should this error lead to material regulatory action or signal further issues, Fitch could review the rating for possible negative action.

Further supporting today's rating action is the company's adequate Basel III Common Equity Tier 1 (CET1) ratio. Fitch believes the company's capital should provide a buffer to the balance sheet in the event of economic stress. That said, should the company deploy more capital into another large acquisition and/or manage capital more aggressively through dividends and/or repurchase activity, Fitch would review the impact to determine if the resultant capital ratios had an impact on ratings.

Modest rating pressure could also ensue should BMO's credit performance deteriorate evidenced by impaired loans and loan losses trending to levels above its 10 year average of 1.10% and 0.44%, respectively. Fitch notes that this could be potentially become more severe should macroeconomic risks continue such as further pressure in the global oil and gas markets, unexpected increases in interest rates, a severe housing price correction as well as macroeconomic weakness in the overall Canadian economy that leads to a material rise in unemployment.

Fitch would note that BMO has sizable contribution from capital markets to earnings, which is above its peer averages. Should capital markets expand materially or should BMO look to move more from the middle market to larger clients, this could potentially increase the volatility of the company's earnings.

SUBORDINATED DEBT AND OTHER HYBRID SECURITIES

The subordinated debt and hybrid capital ratings are primarily sensitive to any change in the VRs of the banks (or bank subsidiaries).

The preferred securities of BMO Capital Trust II are preferred securities, which Fitch gives five notches from BMO's VR given management and regulatory authorities' powers to suspend dividends.

LONG- AND SHORT-TERM DEPOSIT RATINGS

The ratings of long- and short-term deposits issued by BMO Harris National Association and its subsidiaries are primarily sensitive to any change in BMO's IDR.

The ratings of long-term and short-term deposits issued by M&I Marshall & Ilsley Bank and M&I Bank are primarily sensitive to any change in BMO's IDR.

SUBSIDIARY AND AFFILIATED COMPANY

The subsidiary and affiliated company ratings including BMO Harris Bank National Association are primarily sensitive to any change in the VRs of the banks.

SUPPORT RATING AND SUPPORT RATING FLOOR

SR of '2' incorporates Fitch's expectation that there could be some level of support for the Canadian Banks going forward although it has been weakened given bail-in legislation. Although Canadian authorities have taken steps to improve resolution powers and tools, they intend to maintain a flexible approach to bank resolution.

Fitch's assessment of continuing support for Canadian D-SIFI's has to some extent relied upon resolution powers granted regulators under the CDIC ACT as well as the potential size, structure, and feasibility of NVCC implementation. Further, continued regulatory action to ensure sufficient contingent capital has been implemented for all Canadian banks.

Fitch has affirmed the following ratings:

Bank of Montreal

--Long-Term IDR at 'AA-', Outlook Stable;

--VR at 'aa-';

--Short-Term IDR at 'F1+';

--Senior unsecured debt at 'AA-';

--Subordinated debt at 'A+';

--Short-term debt at 'F1+';

--Support Rating at '2';

--Support Floor at 'BBB-'.

BMO Harris Bank National Association (formerly Harris N.A.)

--Long-Term IDR at 'AA-', Outlook Stable;

--Long-term deposits at 'AA';

--Short-Term IDR at 'F1+';

--Short-term deposits at 'F1+';

--Support Rating at '1'.

BMO Subordinated Notes Trust

--Subordinated debt at 'A+'.

BMO Capital Trust II

--Preferred stock rating at 'BBB'.

Marshall & Ilsley Corporation

--Senior debt at 'AA-'.

M&I Marshall & Ilsley Bank

--Subordinated debt at 'A+';

Fitch has affirmed and withdrawn the following ratings:

BMO Harris Bank National Association (formerly Harris N.A.)

--VR at 'bbb+'.

Additional information is available on www.fitchratings.com

Applicable Criteria

Global Bank Rating Criteria (pub. 15 Jul 2016)

https://www.fitchratings.com/site/re/884135

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Contacts

Fitch Ratings
Primary Analyst
Doriana Gamboa
Senior Director
+1-212-908-0865
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Justin Fuller, CFA (Secondary Analyst)
Senior Director
+1-312-368-2057
or
Committee Chairperson
Christopher Wolfe
Managing Director
+1-212-908-0771
or
Media Relations
Hannah James, +1 646-582-4947
hannah.james@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Doriana Gamboa
Senior Director
+1-212-908-0865
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Justin Fuller, CFA (Secondary Analyst)
Senior Director
+1-312-368-2057
or
Committee Chairperson
Christopher Wolfe
Managing Director
+1-212-908-0771
or
Media Relations
Hannah James, +1 646-582-4947
hannah.james@fitchratings.com