Moody’s Investors Service affirmed the ratings and outlook of the Bank of Nova Scotia following today’s announcement of the bank’s latest acquisition in Latin America.

However, the rating agency warned that there is concentration risk in Scotiabank’s increased regional exposure.

Scotia announced that it has reached an agreement to acquire 78% of Corporacion Interfin S.A., the parent of Banco Interfin S.A. It will merge Interfin with its Costa Rican subsidiary, Scotiabank de Costa Rica S.A.

In affirming the ratings, Moody’s noted that the Interfin/Scotiabank Costa Rica combination will hold an 8% deposit share, making it the leading private bank in Costa Rica. “This standing indicates that the merged institution will enjoy a level of market presence that more closely resembles that of Scotiabank’s Canadian and Caribbean franchises,” it said. “In the past, Moody’s has expressed concern about the low market presence at Scotiabank’s other Latin American franchises. In Moody’s opinion, small banks with low franchise value in volatile economies are more susceptible to periods of stress.”

Moody’s also indicated that despite its enhanced franchise in Costa Rica, Scotiabank would continue to face important country risk challenges, including the relatively high dollarization of the financial system and the inherent risks associated with the absence of a true lender of last resort. “Like the other private banks in Costa Rica, Interfin/Scotiabank Costa Rica must also contend with competition from the state-owned banks, which not only hold dominant market shares but also benefit from the State’s full guarantee on their deposits,” it added.

The rating agency stated that Scotiabank’s equity investment in Latin America is well above 10% of its tangible common equity, an exposure pinpointed in prior research as being as a source of downward rating pressure. While it views this exposure as a concentration risk, it does not result in immediate negative rating pressure because the correlation between the bank’s largest Latin American subsidiary — Mexico-based Scotiabank Inverlat — and its other South American subsidiaries is declining as Mexico’s integration with the North American economy deepens.

“Nonetheless, additional acquisitions in Latin America or Mexico would increase Scotiabank’s concentration risk in these two regions and could ultimately result in a downgrade of Scotiabank’s bank financial strength rating,” it cautioned. Also, negative rating pressure could emerge if asset quality deteriorates beyond expectations, it says, “The deterioration would need to be of an order such that approximately one year’s earnings would be insufficient to address the asset quality problems.”

Alternatively, Moody’s suggested that upward rating pressure could emerge if Scotiabank improved its
risk-adjusted profitability and asset quality performance and reduced exposure to corporate banking outside Canada where its competitive advantage is low.