TEXT-S&P Lowers Rtgs On The Bank of Nova Scotia To 'A+/A-1'

Thu Dec 13, 2012 7:59pm EST

Overview

-- 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 Bank of Nova Scotia to 'A+/A-1' from 'AA-/A-1+', following our revision of the stand-alone credit profile on the bank to 'a' from 'a+', and assigning a stable outlook.

-- The stable outlook reflects our expectation that Bank of Nova Scotia's credit fundamentals will remain consistent with current ratings over the next 24 months.

Rating Action

On Dec. 13, 2012, Standard & Poor's Ratings Services lowered its long- and short-term issuer credit ratings on Bank of Nova Scotia (BNS) to 'A+/A-1' from 'AA-/A-1+' and assigned a stable outlook. In addition, Standard & Poor's lowered its issue ratings on Bank of Nova Scotia's senior unsecured debt to 'A+/A-1', nondeferrable subordinated debt to 'A-' from 'A', and preferred shares and hybrid securities to 'BBB+' from 'A-'.

Rationale

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, to 'a-' from 'a' But the anchor for BNS was lowered to 'bbb+' from 'a-', reflecting its operating footprint in countries that are weaker than Canada, in our view.

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. Our ratings on BNS reflect a combination of factors including the anchor SACP, company-specific factors, and our expectation for extraordinary government support.

For BNS we start at the anchor of 'bbb+'. We then adjust for a "strong" (as our criteria define it) business position to reflect the bank's solid banking market position in Canada and largely stable revenue base; an "adequate" capital and earnings position primarily based on our forecasted risk-adjusted capital (RAC) ratio in the rage of 8.2% to 8.7% by fiscal year end 2014 and consistent earnings growth, outperforming some domestic peers in recent years; a "strong" risk position, which reflects loan loss experience that is more favorable than that of financial institutions operating in similar industry risk countries, and the reasonable size of its capital markets operations; and "average" funding and "adequate" liquidity based on the bank's substantial base of core deposits and a low-risk securities portfolio, while recognizing a material wholesale funding component.

The resulting SACP of 'a' is adjusted upward one notch in arriving at the 'A+' issuer credit rating to reflect our expectation for extraordinary government support in a crisis. Outlook The stable outlook reflects our expectations that BNS will continue to generate consistent earnings and to grow without adding outsize risk to the balance sheet.

We could revise the outlook to negative or lower the ratings if the higher-than-peer average (particularly in the international loan portfolio) consumer loan growth of the past few years becomes a disproportionate asset quality issue, such that net charge-offs are consistently and materially higher than the peer average or if the forecasted RAC ratio falls below 7% for a sustained period.

Alternatively, we could revise the outlook to positive or raise the ratings if the RAC ratio is consistently above 10% all else being equal. We see this as unlikely at this time.