Moody’s Investors Service has downgraded its ratings on Royal Bank of Canada (TSX:RY), due to the bank’s growing exposure to capital markets businesses, the rating service said Monday.

The bank’s deposit rating was lowered to Aa1 from Aaa. RBC’s unsupported bank financial strength rating was lowered to B from B+. The rating outlook is stable.

The rating agency said that the downgrade is largely due to the bank’s “commitment to its sizable and growing capital markets business, which potentially exposes bondholders to increased earnings volatility and poses significant risk management challenges.”

Moody’s notes that RBC is building a global investment banking platform. “Tactically, RBC has been able to exploit the continuing disarray at many of its investment banking competitors to upgrade and build out its banking, sales and trading capabilities outside Canada,” it said.

Moody’s reports that the capital markets segment now represents roughly 45% of the bank’s consolidated balance sheet, and management is attributing roughly 25% of the firm’s $33 billion in common equity to the capital markets segment. Moody’s adds that, in the long run, RBC’s management has signaled that the contribution from capital markets businesses could be as much as 30% of overall revenue and earnings.

“Shareholders and bank managers are attracted to the growth potential of capital markets businesses, but these businesses can expose bank bondholders to hidden tail risks,” said Peter Nerby, a Moody’s senior vice-president, in a release.

Although Moody’s expects RBC’s other businesses will provide a substantial buffer against these risks, the rating agency also believes the opacity and the potential volatility associated RBC’s enlarged and expanding capital markets operations are not consistent with its former rating.

The rating outlook on RBC is stable, which Moody’s says reflects the bank’s commanding Canadian franchises, which have produced high and relatively predictable pre-provision, pre-tax earnings, and should provide a strong defense against asset quality deterioration or potential earnings volatility.

“Even after the downgrade, Royal Bank enjoys one of the highest ratings globally amongst banks with substantial capital markets operations,” Nerby said.

IE