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Financial Institutions Large Canadian Banks Q2 2017 Earnings Round-Up: Solid Performance Despite a QoQ Decline in Earnings Growth During Q2 2017, while overall earnings remain solid, the large Canadian banks demonstrated a decline in quarter-over-quarter (QoQ) earnings growth, partly reflecting the lower day count this quarter as well as exceptionally strong results in the previous quarter. DBRS notes that year-over-year (YoY) results were up solidly, reflecting positive operating leverage and significantly lower provision for credit losses (PCLs) in the energy sector. Ratings Outlook DBRS Limited (DBRS) views the large Canadian banks’ Q2 2017 results as sound and supportive of current ratings. Overall, balance sheet fundamentals remain solid with sound asset quality and strong risk-weighted capital levels. While rating upgrades are likely to remain limited, banks that continue to improve and diversify their franchises and consistently outperform peers while maintaining sound balance sheet fundamentals could be upgraded. Conversely, a significant deterioration in asset quality caused by a notable increase in provisioning needs or materially diminished earnings capacity could have negative rating implications. At present, DBRS has Negative trends on the senior and subordinated debt ratings of the six Domestic Systemically Important Bank (D-SIB) Canadian banks (Royal Bank of Canada, The Toronto-Dominion Bank, The Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce and National Bank of Canada) and their subsidiaries. The maintenance of the Negative trend reflects DBRS’s view that ongoing changes in Canadian legislation and regulation indicate that the potential for timely systemic support for these six systemically important institutions is declining, leading to a likely change in DBRS’s support assessment of SA2 to SA3 for these banks. To that end, on June 16, 2017, the Canadian Government pre-published regulations to implement the Bank Recapitalization (Bail-in) Regime with a 30-day request for comment until July 17, 2017. Following the review and consideration of stakeholder comments, a final version of the regulations will be published, likely during Q4 2017. Key Trends: • Collectively, the average net income decreased by 8.3% QoQ, a dip compared with last quarter’s 25.4% increase in relation to Q4 2016. On a YoY basis, average earnings improved by a very strong 38.6%. • Asset quality remained solid. This contributed to just slightly higher QoQ provisioning needs largely in line with loan growth. Reflecting last year’s elevated energy-related provisioning requirements, provisioning was significantly lower YoY. • The average Common Equity Tier 1 ratio increased by ten bps QoQ and 110 bps YoY, reflecting strong internal capital generation partially offset by increased risk-weighted assets and ongoing stock repurchase activity. Additionally, on June 16, 2017, the Office of the Superintendent of Financial Institutions (OSFI) requested comments on its draft Total Loss Absorbing Capacity guideline. The guideline establishes the framework for OSFI to assess whether a D-SIB maintains its minimum capacity to absorb losses in conjunction with the Bail-in regime. DBRS anticipates that it will shortly opine on how proposed draft regulations will affect the likelihood of systemic support. If DBRS lowers the support assessment, ratings would likely be downgraded. Overview Overall, the banks performed well for Q2 2017, despite five of the six large Canadian banks reporting a QoQ decrease in net income, reflecting a shorter day count this quarter as well as lower trading results in capital markets. Financial Institutions: Banks & Trusts June 20, 2017 DBRS: Large Canadian Banks Q2 2017 Earnings Round-Up DBRS.COM 2 Exhibit 1: Average % Changes in DBRS-Rated Large Canadian Banks 50% 38.6% 40% 30% 20% 6.2% 10% 7.9% 4.3% 5.6% 3.0% 2.6% 0% -10% -1.6% -1.9% -8.3% -8.7% -20% -30% -28.2% -40% Total Revenue Non-Interest Expense Net Income 2Q17 vs. 1Q17 Sources: SNL Financial and DBRS Analysis. Total Net Loans Loan Loss Provisions Impaired Loans 2Q17 vs. 2Q16 Collectively, average net income decreased by 8.3% sequentially after experiencing a strong increase of 25.4% in the previous quarter. Moreover, net income improved notably YoY with average net income increasing by 38.6%, primarily reflecting elevated PCLs last year as the banks built reserves in the energy sector. Sequentially, a modest drop in revenue, higher expenses and increased PCLs led to the decline in earnings. Capital markets activity, which has been a strong performing segment for the banks in recent periods, continued to put up strong results this quarter despite being affected by lower global fixed-income trading revenues for many of the banks. Exhibit 2: Reported Net Income Trend for Major Canadian Banks (in Millions) 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000 0 2016Q1 2016Q2 BMO 2016Q3 BNS CIBC 2016Q4 NB 2017Q1 RBC 2017Q2 TD Sources: Company Reports, SNL Financial and DBRS Analysis. Expenses increased this quarter, although remaining relatively well managed. Specifically, average aggregate non-interest expenses increased by 4.3% QoQ as well as 5.6% YoY. DBRS notes that, despite the increases, the large Canadian banks reported positive operating leverage on a YoY basis. Most banks have ongoing efficiency initiatives geared toward cutting expenses through cuts in staffing, branch rationalizations, call centre and data warehousing consolidations as well as further digitalization of bank operations and processes. DBRS notes that, while up QoQ, the banks’ average efficiency ratio remained below 60%. Financial Institutions: Banks & Trusts June 20, 2017 DBRS: Large Canadian Banks Q2 2017 Earnings Round-Up DBRS.COM 3 Asset quality remained solid with aggregate impaired loans declining QoQ and more significantly YoY. Four of the six banks reported decreases in gross impaired loans (GILs). Overall, impaired loans decreased by 0.9% QoQ and 5.0% YoY, primarily because of ongoing improvements in commercial loan portfolios, especially those related to energy; however, with unstable oil prices, which have declined since quarter-end, this trend may not continue in future quarters. Nonetheless, DBRS expects provisioning requirements to remain manageable and comfortably absorbed by income before provisions and taxes (IBPT) without invading capital. Exhibit 3: Aggregate Provisions and IBPT for Major Canadian Banks 18,000 30% 25.8% 16,000 14,000 15,597 14,846 12,917 25% 13,956 13,703 12,741 12,000 20% 16.3% 10,000 12.8% 14.1% 8,000 15% 13.2% 11.7% 6,000 10% 4,000 2,000 2,638 2,099 1,990 1,911 1,925 1,883 0 5% 0% 2016Q1 2016Q2 IBPT 2016Q3 Provisions 2016Q4 2017Q1 2017Q2 Provisions/IBPT Sources: SNL Financial and DBRS Analysis. DBRS remains cautious of a potential adverse correction in the Canadian housing market, especially in the Greater Toronto Area (GTA) and Greater Vancouver Area (GVA). Previous actions taken by the federal and provincial government authorities, coupled with higher risk aversion on the part of lenders, appears to have materially slowed down the pace of market acceleration in the GVA; however, while still in the early days of fairly recent provincial steps to slow down the market, the GTA continues to experience unsustainably strong YoY growth in home prices, despite declining sales volume in recent periods. Nevertheless, DBRS expects that, in the event of a housing market correction, the large banks appear to be well positioned to absorb a higher level of provisioning related to home lending, especially given the large level of insured mortgages in their portfolios. Positively, the Canadian economy has remained fairly robust with economic growth expected to continue through 2017 and into 2018. Specifically, an expansionary fiscal policy, gains in household wealth and a resumption of business investment, including in the commodity sector following improved commodity prices, all contribute to the positive economic outlook; however, economic and financial risks associated with the booming housing market remain a concern. The Government of Canada announced that the Canadian economy grew by 3.7% during Q1 2017, largely driven by increased household spending and reduced imports. DBRS continues to view the balance sheets of the six large Canadian banks as strong. Liquidity positions remained ample with all banks reporting liquidity coverage ratios (LCRs) well above requirements. Positively, the banks had strong capital generation this quarter and further strengthened their risk-weighted capital ratios. On average, the six large Canadian banks’ Common Equity Tier 1 (CET1) ratio increased by ten basis points (bps) QoQ and 110 bps YoY, reflecting strong internal capital generation which was partially offset by increased risk-weighted assets (RWAs) and stock buyback activity. DBRS expects a continued modest capital buildup among the large Canadian banks, which would position the banks well for further acquisitions and/or expected future RWA increases. Financial Institutions: Banks & Trusts June 20, 2017 DBRS: Large Canadian Banks Q2 2017 Earnings Round-Up DBRS.COM 4 Ratings Table Financial Institutions: Banks & Trusts June 20, 2017 DBRS: Large Canadian Banks Q2 2017 Earnings Round-Up DBRS.COM 5 Individual DBRS-Rated Bank Earnings Highlights [Please visit http://www.dbrs.com for full detail.] Bank of Montreal (Deposits & Senior Debt Rating at AA, Negative trend) DBRS: BMO Reports Lower Linked Quarter Results for Q2 2017 on Lower Gains, Higher PCLs • Bank of Montreal (BMO or the Bank) reported Q2 2017 net income of $1.25 billion, down $240 million or 16% sequentially, but up 28% YoY. Net income was lower compared with the linked quarter because of the $133 million net gain realized in Q1 2017 that was largely caused by the sale of Moneris Solutions USA (Moneris), lower trading revenues and higher PCLs. • By segment on an adjusted basis, Personal & Commercial (P&C) earnings declined by 22% sequentially, mainly because of the previous quarter’s gain on the sale of Moneris, which contributed approximately 21% to the decline in this quarter’s Canadian portion of P&C net income, higher provisions from credit losses and a lower day count. Similarly, Capital Markets adjusted earnings declined by 14% sequentially because of higher PCLs and higher taxes. Wealth Management reported a modest decline of 3% compared with the linked quarter. • Asset quality deteriorated during the quarter with PCLs increasing by 50% sequentially and 29% YoY, leading to a higher, although still very manageable, ratio of provisions as a percentage of income before provisions and taxes of 14.7%. Provisions were higher sequentially as a result of higher provisioning in Capital Markets and both U.S. and Canadian P&C. Additionally, the GIL ratio increased three bps QoQ and impaired formations were also up this quarter, driven by higher government and business loan formations. • During Q2 2017, BMO’s CET1 ratio further improved by 20 bps QoQ to 11.3%, largely because of retained earnings partially offset by higher RWAs. BMO also announced a 2% increase in its common stock dividend. Liquidity improved during the quarter with the LCR strengthening to 136%. The Bank of Nova Scotia (Deposits & Senior Debt Rating at AA, Negative trend) DBRS: Scotiabank Reports Solid 2Q17 Earnings Boosted by Strong Momentum in International Banking • The Bank of Nova Scotia (Scotiabank or the Bank) reported Q2 2017 net income of $2.06 billion, up 3.0% sequentially and 30.1 % YoY. Compared with the linked quarter, net income was stronger in all business segments except for Canadian Banking, which was affected by the lower day count this quarter. Additionally, during Q2 2016, the Bank recorded a restructuring charge of $278 million after tax ($378 million pre-tax). Adjusting for the impact of last year's restructuring charge, net income rose 11% YoY while reported return on equity was 14.9% compared with 14.4%. • By segment on an adjusted basis, Canadian Banking net income decreased 1% QoQ, mainly because of lower net interest income as there were three fewer days in this quarter. International Banking income was up 3% QoQ, driven by strong asset growth and higher net interest margin. Similarly, on a YoY basis, the earnings momentum in International Banking continued with a 19% increase attributable to higher margins, positive operating leverage and stronger credit performance. DBRS notes that the Pacific Alliance region (Mexico, Peru, Colombia and Chile) had a particularly strong performance in the quarter. Lastly, Global Banking and Markets also reported a 10% increase in earnings over the last quarter as a result of strong client trading activity in equities, which was partially offset by lower fixed-income trading and lower precious metals income. • Asset quality weakened slightly during the quarter with PCLs increasing by $34 million or 6%, QoQ. Specifically, there were higher commercial provisions in International Banking against a few commercial accounts in Puerto Rico and Brazil. Retail provisions were also higher in Canadian Banking and International Banking, driven by portfolio growth as well as the negative impact of foreign-currency translation. Financial Institutions: Banks & Trusts June 20, 2017 DBRS: Large Canadian Banks Q2 2017 Earnings Round-Up • DBRS.COM 6 During Q2 2017, Scotiabank’s CET1 ratio stood flat at 11.3%. The Bank continues to have strong internal capital generation, offset by the natural organic growth in RWAs and the Bank’s regular share buybacks. Indeed, Scotiabank’s CET1 ratio sits on the upper end of its peer group. Canadian Imperial Bank of Commerce (Deposits & Senior Debt Rating at AA, Negative trend) DBRS: CIBC Reports Solid 2Q17 Earnings Boosted by Higher Wealth Management Revenues • Canadian Imperial Bank of Commerce (CIBC or the Bank) reported Q2 2017 net income of $1.05 billion, down 25% sequentially and up 12% YoY. Compared with the linked quarter, results were solid, but not as robust across most business segments, partly because of the lower day count this quarter. Additionally, overall reported net income declined this quarter as Q1 2017 results were favourably affected by a $245 million (after-tax) gain on the sale and leaseback of certain retail properties. Adjusting for this gain, net income this quarter would be down by 10% sequentially. • By segment on an adjusted basis, Retail and Business Banking results decreased 9% QoQ, primarily because of narrower spreads and higher spending on strategic initiatives. Similarly, Capital Markets earnings decreased by 21% QoQ as a result of lower revenue from interest rate and foreign-exchange trading as well as lower equity underwriting. Positively, the Wealth Management segment reported a 15% increase in earnings QoQ as growth in assets under administration drove higher revenues. • Asset quality improved further during the quarter with the PCLs down 16% sequentially. PCLs during this quarter can be primarily attributed to the consumer portfolio with weaknesses observed in residential mortgages, credit cards and personal loans as opposed to losses in the oil and gas (O&G) sector observed during most of 2016. Despite lower provisions this quarter, the provisions as a percentage of income before provisions and taxes ratio still increased modestly to 13% compared with 11% in the linked quarter because of lower overall earnings this quarter. • During Q2 2017, CIBC’s CET1 ratio continued to improve, adding another 30 bps after increasing 60 bps in the last quarter to 12.2%. The Bank’s CET1 ratio sits on the upper end of its peer group, but it is expected to decline by approximately 100 bps when the Bank closes the PrivateBancorp Inc. acquisition. National Bank of Canada (Deposits & Senior Debt Rating at AA (low), Negative trend) DBRS: National Bank Reports Solid 2Q17 Earnings; Marginal Changes from the Last Quarter • National Bank of Canada (National or the Bank) reported Q2 2017 net income of $484 million, down 3% sequentially and up 130% YoY. Compared with the linked quarter, results were solid across all business segments, but not as robust as last quarter because of the lower day count this quarter. Additionally, the large YoY increase in reported net income is mainly a result of the O&G sectoral provision of $183 million taken during Q2 2016. Adjusting for this sectoral provision, net income increased 23.2% YoY. • By segment on an adjusted basis, P&C results increased marginally by 9.4% QoQ, mainly because of the $40 million reversal of the sectoral allowance for the O&G sector. Wealth Management earnings were down 1% QoQ because of lower operating revenues caused by the shorter quarter. Overall, however, the two retail-based segments reported a QoQ increase in earnings of 5.7%. On the commercial side, the Financial Markets segment lost some momentum this quarter with net income down 4.4% QoQ. Lastly, the U.S. Specialty Finance and International segment reported a 5.3% increase in earnings, largely owing to the revenues generated by the Bank’s subsidiaries, Credigy Ltd. and Advanced Bank of Asia Limited. • Asset quality improved with GILs declining $20 million to $422 million in Q2 2017 as O&G impaired loans shed 24% QoQ to reach $109 million while impaired construction loans saw an uptick to $34 million in Q2 2017 from $13 million in Q1 2017. Overall impaired loans to gross loans saw a marginal change to 0.32% in Q2 2017 from 0.35% in Q1 2017. Financial Institutions: Banks & Trusts June 20, 2017 DBRS: Large Canadian Banks Q2 2017 Earnings Round-Up • DBRS.COM 7 At the end of Q2 2017, National Bank’s CET1 capital ratio under Basel III was 10.8% compared with 10.6% at the end of last quarter; the increase was essentially attributable to earnings retention. Additionally, the Bank’s Basel III leverage ratio was 3.8% at the end of Q2 2017, unchanged from the previous quarter. Royal Bank of Canada (Deposits & Senior Debt Rating at AA, Negative trend) DBRS: RBC’s 2Q17 Net Income Flat Adjusting for Last Quarter’s Gain on Sale of Moneris Assets • Royal Bank of Canada (RBC or the Bank) reported Q2 2017 net income of $2.8 billion, down $218 million or 7% sequentially, but up 9% YoY. Net income was lower compared with the linked quarter, primarily because of the $212 million net gain realized from the sale of the U.S. operations of Moneris. Adjusting for this specific item, net income remained relatively flat QoQ as stronger revenue growth was offset by higher expenses and a slightly higher PCL. • On an adjusted basis by segment, P&C results declined modestly QoQ, largely reflecting the lower day count in the quarter and higher PCLs, which were partially offset by volume growth in Canada and lower expenses. Investor and Treasury Services net income declined 10% QoQ because of lower funding and liquidity revenue. Wealth Management reported flat net income QoQ as higher fee-based assets were offset by lower transaction revenue. Capital Markets revenue increased by a modest 1% sequentially as a result of higher U.S. origination activity and higher Canadian mergers and acquisitions activity. The performance of the Bank’s Insurance segment was strong, reporting a 24% increase in net income QoQ, reflecting higher investment-related gains. • Asset quality remained sound. The PCL inched up 3% QoQ, reflecting higher provisions in P&C, which were partially offset by lower provisions in the Capital Markets segment. Positively, GILs declined $310 million or 9% QoQ, mainly because of an improvement in the O&G portfolio. • During Q2 2017, RBC’s CET1 ratio declined by 40 bps QoQ to 10.6%. Although internal capital generation during the quarter was solid, contributing 33 bps to the ratio, a combination of share repurchases, updated risk parameters, the impact of lower rates in determining pension and other benefit obligations as well as higher overall growth in RWAs contributed to the decline. Additionally, the LCR was flat at 123% QoQ. The Toronto-Dominion Bank (Deposits & Senior Debt Rating at AA, Negative trend) DBRS: TD Reports Solid Q2 2017 Results; Lower Revenues Offset by Declining PCLs and Expenses • The Toronto-Dominion Bank (TD or the Bank) reported $2.5 billion in earnings for Q2 2017, down 1% compared with the linked quarter and up 22% YoY. Compared with the linked quarter, lower revenues were largely offset by a lower PCL and lower expenses. • On a segment basis, Canadian Retail, the Bank’s largest segment, was essentially flat compared with the linked quarter as lower revenues, largely caused by the shorter day count in the quarter, were offset by lower insurance claims, expenses and PCL. U.S. Retail earnings increased 6%, reflecting flat revenues and modestly higher expenses offset by a lower PCL. Wholesale Banking, coming off a particularly strong prior quarter, saw a 7% drop in net income, reflecting lower fixedincome trading revenue and a lower net recovery of credit losses, which were partially offset by lower expenses. • Credit quality remains strong and GILs declined approximately 3% QoQ, reflecting ongoing improvement in the O&G sector. Overall, the PCL decreased by $133 million or 21% to $500 million QoQ, driven by lower provisioning in both Canadian and U.S. Retail businesses, partially offset by lower recoveries in the O&G sector. DBRS notes that the lower provisioning in Retail was primarily attributed to seasonality in U.S. auto lending and credit card portfolios, but the Bank also saw lower provisioning in the U.S. commercial loan and Canadian auto portfolios. • The CET1 ratio decreased ten bps QoQ to 10.8% with common stock repurchases and growth in RWAs more than offsetting earnings retention. TD repurchased 15 million common shares during the quarter for a total cost of $880 million. Financial Institutions: Banks & Trusts June 20, 2017 DBRS: Large Canadian Banks Q2 2017 Earnings Round-Up John Mackerey Vice President Global Financial Institutions Group [email protected] Maria-Gabriella Khoury, CFA Vice President Global Financial Institutions Group [email protected] DBRS.COM 8 Michael Driscoll Managing Director, Head of NA FIG [email protected] The DBRS group of companies consists of DBRS, Inc. (Delaware, U.S.)(NRSRO, DRO affiliate); DBRS Limited (Ontario, Canada)(DRO, NRSRO affiliate); DBRS Ratings Limited (England and Wales)(CRA, DRO affiliate); and DBRS Ratings México, Institución Calificadora de Valores S.A. de C.V. (Mexico)(CRA, NRSRO affiliate, DRO affiliate). Please note that DBRS Ratings Limited is not an NRSRO and ratings assigned by it are non-NRSRO ratings. For more information on regulatory registrations, recognitions and approvals, please see: http://www.dbrs.com/research/225752/highlights.pdf. © 2017, DBRS. All rights reserved. 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ADDITIONAL INFORMATION REGARDING DBRS RATINGS, INCLUDING DEFINITIONS, POLICIES AND METHODOLOGIES, ARE AVAILABLE ON http://www.dbrs.com. Financial Institutions: Banks & Trusts June 20, 2017