Moody’s Investors Service today bumped its utlook on Toronto-Dominion Bank’s financial strength rating to stable from negative.

The rating agency says that the change outlook is based on the view that the asset quality problems which caused Moody’s to maintain a negative outlook on TD have been resolved.

Moody’s said that the change reflects the view that TD has been successful in shifting its strategy towards businesses with more favorable risk-return characteristics — namely, Canadian personal, commercial, and wholesale banking — and away from businesses where the bank lacks franchise strength, such as in U.S. corporate lending. TD now has a much improved credit profile because a greater proportion of its capital is allocated to businesses with better credit fundamentals.

This shift in TD’s strategy has set the stage for a better credit profile, Moody’s adds. In 2003 and 2004, the bank improved its performance considerably on Moody’s favorite ratios for evaluating bank profitability and asset quality. In 2004, earnings before provisions and taxes generated a return on managed risk adjusted assets (risk weighted assets plus securitized assets excluding securitized mortgages) of 3.0%, versus 1.8% in 2003. Asset quality also improved significantly, with nonperforming assets now accounting for 15.6% of the previous four quarters’ core earnings (earnings before taxes and provisions) versus 72.7% at the end of 2002. Of note, TD is now ahead of the Canadian bank median on these two key indicators of creditworthiness, it notes.

Upward earnings pressure would likely follow continued strengthening of TD’s performance on Moody’s key profitability and asset quality ratios, the avoidance of any material strategic or operational setbacks in the U.S. following its soon-to-be completed 51% acquisition of the Banknorth Group Inc., and the continuation of the bank’s decision to retreat from U.S. corporate lending.

Negative rating pressure could emerge if TD reversed its decision on reducing its exposure to the U.S. corporate sector. Moody’s also noted that a weakening of Banknorth’s intrinsic financial strength could result in negative rating pressure for TD. The most likely cause for such a negative rating development would be poor execution of Banknorth’s growth strategy.

TD expects to complete its 51% acquisition of the Banknorth for approximately US$3.8 billion (C$5 billion), this week. In affirming TD’s bond and deposit ratings, Moody’s noted that while this transaction causes some increase in TD’s financial leverage, it expects the bank’s domestic earnings capacity will enable the bank to reduce its leverage in the medium-term. Notwithstanding the lack of a formal support agreement between TD and Banknorth, Moody’s believes that in a period of financial distress, TD would support Banknorth to protect the bank’s own equity investment and to appease U.S. regulators.