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Moody's Investors Service – the credit rating arm of Moody's Corp. (MCO - Analyst Report) – has put the long-term ratings of six major Canadian banks on review for a possible one-notch downgrade. The potential rating revision comes in the wake of a flagging economy, record-high consumer debt, soaring housing prices as well as sizeable exposure of banks to capital markets.

Moody’s will be reviewing the ratings of Bank of Montreal (BMO - Snapshot Report), The Bank Of Nova Scotia (BNS - Snapshot Report), Canadian Imperial Bank of Commerce (CM - Snapshot Report), National Bank of Canada (NTIOF), and The Toronto-Dominion Bank (TD - Snapshot Report). The rating of Canada’s largest association of credit unions – Caisse Centrale Desjardins – is also put on review for a likely downgrade. However, the rating agency has affirmed the short-term ratings of all these banks, including Caisse Central.

Moody’s also placed the subordinate debt ratings of Royal Bank of Canada (RY - Snapshot Report) for revisions, keeping all its other ratings affirmed. Earlier, in June this year, Moody’s had downgraded Royal Bank of Canada’s deposit rating to ‘Aa3’ from ‘Aa1’ as part of its strategy to cut the credit ratings of nearly fifteen of the world's largest banks, including Bank of America Corporation (BAC - Analyst Report), JPMorgan Chase & Co. (JPM - Analyst Report) Citigroup, Inc. (C - Analyst Report) and The Goldman Sachs Group, Inc. (GS - Analyst Report)

Downgrade Rationale

As per Moody’s, Canadian banks face a bunch of risks from substantial increases in the nation’s consumer debt over the last few years. The household debt-to-income ratio came in at 163% in the second quarter of 2012, up from 137% in the second quarter of 2007.This reflects the rising disparity between the growth in debt and hike in personal incomes.

Another contributor to the escalating consumer debt is the substantial rise in housing prices. Home sales in September this year dropped nearly 15% from a year ago due to stringent mortgage lending rules and sluggish economy. Though Moody’s estimates Canadian Gross Domestic Product to grow in the range of 2%–3% for 2013, it is of the opinion that the potential downside risks to the economy have increased significantly.

Further, external risks including slow recovery of the U.S., deepening Euro-Zone crisis and moderate growth in the emerging markets will weigh down on the commodity markets with severe ramifications on the overall Canadian economy, which will consequently engulf the nation’s entire banking system.

In addition to the abovementioned macro economic factors, there are certain other bank-specific factors taken into consideration by Moody’s to assess the ratings of these Canadian banking biggies. These include the considerable exposure to volatile capital markets, increased contribution from subsidiaries threatening the creditworthiness and concentrated franchise structure limiting profitability growth.

Rating Action by Standard & Poor's

In July, Standard & Poor's Ratings Services cut its outlook from ‘stable’ to ‘negative’ on seven Canadian banks, over concerns about shakily high housing prices and consumer debt levels. The banks included Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, National Bank, Laurentian Bank of Canada, Home Capital Group Inc. and Central 1 Credit Union.

S&P, on its part, affirmed the ratings of all these banks. However, it maintained stable outlooks and reaffirmed ratings on five other Canadian banks including Canadian Imperial Bank and Bank of Montreal.

Our Take

We believe that Moody’s rationale for the possible downgrade is well justified. Further, removal of the government support from the ratings of the subordinate debt of some institutions will force the debt holders to bear the brunt in case of losses, thereby keeping safe the taxpayers’ money.

However, it must be mentioned that these aforementioned Canadian banks have been performing better than their global peers for the last couple of years. The strong fundamentals and franchise structures of these banks are expected to absorb the ill effects of the rating downgrades.

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