Moody’s Investors Service has downgraded the long-term ratings of the Bank of Montreal (TSX:BMO) and its subsidiaries on concerns about earnings volatility on the wholesale side of the bank.

As a result of the move, BMO’s deposit rating drops to Aa2 from Aa1 and its bank financial strength rating falls to B- from B. The rating action also includes downgrades of BMO’s subsidiaries, including its’ primary U.S. holding company, Harris Financial Corp. It affirmed BMO’s and Harris’ short-term ratings.

Moody’s senior vice president, Peter Routledge, said “the downgrade of BMO reflects our view that the bank’s wholesale investment bank exposes the bank to greater earnings volatility than previously incorporated in its ratings and the fact that BMO allocates substantial capital to this business.”

The rating agency says that the credit crisis exposed vulnerabilities in the wholesale investment banking business model — including risk management weaknesses, high leverage, confidence-sensitivity, excessive concentrations, and opacity of risk — and intensified Moody’s view of the riskiness of this business.

“Moody’s estimates BMO has taken $2.7 billion in pre-tax charges related to its wholesale investment banking activities. Moody’s also believes the bank’s risk-adjusted profitability will remain constrained due to weak earnings from its U.S. retail and wholesale banking businesses for the foreseeable future. These two factors, taken together, prompted the downgrade of the bank’s BFSR to B- from B and its long-term deposit rating to Aa2 from Aa1,” he explains.

The rating agency returned BMO’s rating outlook to stable and left the rating outlook for Harris NA’s bank financial strength rating at negative. “The return of BMO’s outlook to stable reflects the strength of the bank’s Canadian retail financial services franchise and its strong capitalization,” Routledge said.

The bank’s Canadian retail and commercial financial services franchise has improved its core profitability in recent years and BMO has a very healthy level of capital in relation to Moody’s anticipated credit losses through the recession and recovery, it noted.

However, Moody’s also believes that BMO faces a major strategic challenge: building a reliably profitable franchise in the US. “BMO’s U.S. business entered the credit downturn with low pre-provision profitability – relative to peers and its own Canadian franchise – and has since suffered elevated retail and commercial loan losses and capital markets charges,” it says.

“Therefore, although one-quarter of BMO’s assets were originated in the US, the bank has not generated profits from this geography since 2006. A return to profitability is difficult to foresee given that Moody’s expects U.S. loan losses, industry-wide and at BMO, will remain elevated in 2010,” it says, adding that it views this performance as evidence of greater weakness in BMO’s US franchise than it had previously incorporated in its BFSR.

BMO reaction

In response to Moody’s actio, BMO vice president government & public relations, Paul Deegan, stated, “BMO has a strong capital position and our performance grew steadily stronger throughout 2009, with solid revenue growth and expense discipline, resulting in a sequential increase of quarterly earnings. We have positive momentum across all of our businesses, including Harris, which is a strong competitor in the U.S. Midwest. We continue to expect that we will perform better than our peers across our different portfolios in this credit cycle.”

“Obligations rated Aa are judged to be of high quality and subject to very low credit risk,” he added. “As Moody’s has stated, the return of BMO’s outlook to stable reflects the strength of our Canadian retail franchise and our strong capitalization.”

IE