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Are Canada's big banks just playing it safe or is there more trouble ahead?

SEND  PJT-ScotiaBank-14.jpg
SEND PJT-ScotiaBank-14.jpg

Are Canada’s big banks just taking their usual conservative approach or are there signs of more trouble ahead in the sector?

That’s a question on which analysts are divided after the five largest banks reported choppy but mostly well-received fourth-quarter financial results that included increased provisions for soured loans as well as cost cuts and staff reductions aimed at weathering any slowdown as consumers and businesses adjust to higher interest rates.

While some are chalking the quarter up to getting bad news out of the way as the economic forecast for 2024 darkens, others warn the increasing provisions point to a softening economy and regulatory landscape that will weigh on bank results in the coming year. 

“We see potential downside risk to 2024 earnings expectations across the banks based on higher credit losses,” Paul Holden, a bank analyst at CIBC Capital Markets, wrote in a Nov. 30 note to clients. 

Based on guidance from Royal Bank of Canada that day, Holden said “risks are skewed to higher PCLs (provisions for credit losses) given soft economic conditions.”

RBC, the country’s largest bank, beat analyst earnings expectations for the fourth quarter ended Oct. 31 due, in part, to its capital markets operations, but total provisions for credit losses rose to $720 million from $339 million a year earlier, even higher than the $699 million forecast by analysts.

RBC’s gross impaired loans of $3.7 billion were also up in the fourth quarter, climbing 13 per cent from the previous quarter and 68 per cent from the year-earlier period. However, the bank noted in its earnings report that the ratio of impaired loans remains below the historical average.

 A pedestrian walks past the Royal Bank of Canada in the financial district of Toronto.
A pedestrian walks past the Royal Bank of Canada in the financial district of Toronto.

Maria-Gabriella Khoury, a senior director at Fitch Ratings Inc., said she views the Canadian banks’ treatment of the loans on their books as conservative, noting that they come at a time when consumer loan defaults in Canada remain below pre-pandemic levels. This is due in part to savings built up as a result of COVID-19 pandemic-related government aid in addition to reined in spending, she said in an interview.

Khoury said it was also noteworthy that a portion of the provisions taken by the banks represents performing rather than impaired loans, meaning borrowers are continuing to pay them back. And provisions can be reversed if the loans perform better than expected in the coming months. 

In the case of Bank of Nova Scotia, which doesn’t have a large presence in the United States like some of its peers, overall provisions for credit losses rose to $1.26 billion in the fourth quarter from $529 million a year earlier, but a large share of those loans were in the performing bucket — $454 million, almost evenly split between retail and commercial loans.

“These loans are technically still performing,” Khoury said “But the macro outlook says that these could potentially in 2024 or 2025 go impaired, so they’re taking the provision (now).”

In the United States, where credit has traditionally been easier to obtain and some U.S. government relief such as a three-year pause for millions of borrowers repaying student loans are coming to an end, there are already signs of strain, she said.

“If you’re looking at the U.S. operations, it’s (provisioning) more on the impaired versus the performing side. Those are loans that have already gone impaired, and that’s in line with our thinking that the U.S. consumers are going to feel the crunch before the Canadian consumer,” Koury said.

Provisioning by banks in their commercial lending portfolios isn’t focused on one particular sector, but signs of stress in commercial real estate in the U.S. were visible in the fourth-quarter report posted by Canadian Imperial Bank of Commerce on Nov. 30. CIBC reported a 14 per cent increase in gross impaired loans in the fourth quarter, with 60 per cent of the new impairments coming from the bank’s commercial real estate portfolio.

National Bank analyst Gabriel Dechaine said the impairments in CIBC’s commercial real estate portfolio were primarily tied to the U.S., where office property has been hit particularly hard, but in a note to clients he said a 40 per cent drop in commercial real estate maturities will improve the picture for CIBC in 2024.

The latest earnings reports from Canadian banks and the accompanying conference calls with executives revealed a continuing focus on cost cutting. This includes reducing employee counts, reflected in severance and restructuring costs, as the banks aim to bring expenses in line with anticipated slower revenue and loan growth.

 A Toronto-Dominion Bank branch in Toronto.
A Toronto-Dominion Bank branch in Toronto.

Toronto-Dominion Bank said Nov. 30 it would cut 3,000 jobs, or three per cent of its workforce, taking a $363-million restructuring charge in the fourth quarter. CIBC has also been cutting this year, reducing staff by as much as five per cent. Royal Bank and Bank of Nova Scotia have also announced cuts. 

“They all went on a hiring spree during the pandemic, so this was expected, and basically they’re all just positioning themselves for a muted 2024,” Khoury said.

As the year comes to a close, there is also regulatory uncertainty for Canadian banks as they await a couple of key decisions from Canada’s top bank regulator that could affect the lenders and homebuyers.

On Dec. 8, the Office of the Superintendent of Financial Institutions could raise the minimum amount of capital Canada’s largest banks must hold as a buffer against hard times. Then, on Dec. 12, OSFI will make an announcement about the minimum qualifying rate, or stress test, which determines whether homebuyers qualify for a mortgage based on their financial ability to handle interest rate increases. Last year, OSFI left the qualifying rate for uninsured mortgages unchanged at the greater of 5.25 per cent or the mortgage contract rate plus two per cent.

As interest rates were quickly ratcheted up by the Bank of Canada to combat inflation over the past year and half, some in the mortgage industry began pushing to lower or scrap the stress test as homeowners struggled to deal with the twin forces of higher rates and inflation.

Arlene Kish, director of Canadian economics at S&P Global Market Intelligence, said households in Canada are heavily indebted, which is a concerning factor as the economy slows even with recent data showing higher savings rates. 

In a Nov. 30 analysis of a decline in Canada’s GDP during the third quarter, Kish noted other concerning trends such as business insolvencies and bankruptcies rising from pandemic lows and the unemployment rate also edging higher.

Against this backdrop, there is general agreement among bank watchers that provisioning for credit losses, whether for loans that are performing or impaired, has not yet peaked.

“It’s not going to be massive increases, but on a quarter-by-quarter basis, we expect the Canadian banks to continue to sort of save for a rainy day,” Khoury said. 

 People make their way past the The Bank of Canada as they travel along Wellington Street in Ottawa.
People make their way past the The Bank of Canada as they travel along Wellington Street in Ottawa.

Whether those provisions will ultimately be released as loans perform will depend on whether the Bank of Canada begins to cut interest rates by spring 2024, as some economists including those at Fitch suggest. 

“We don’t expect there to be significant cracks in the performance of the Canadian consumer,” Koury said. “But we’re not even at pre-pandemic (default) levels, so we expect to see the normalization towards pre-pandemic levels actually shape up in 2024.”

A big factor for the banks will be how mortgage loans perform over the next couple of years. Many were locked in when the Bank of Canada’s overnight interest rate was near zero in the early days of the pandemic in 2020 and 2021. Renewals are likely to be at much higher rates even if the central bank begins to lower rates from five per cent sometime next year.

The Canada Housing and Mortgage Corporation (CMHC) estimates that 2.2 million mortgages will be up for renewal in 2024 and 2025 — with loans totalling $675 billion — or about 45 per cent of all outstanding mortgages in Canada.

Economist and analysts suggest widespread defaults are unlikely as long as employment levels don’t change significantly.

“Barring higher levels of unemployment, I don’t think we’re going to see the needle really move on mortgage defaults,” Khoury said.

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