Banks brace for economic headwinds

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Canada's two largest banks earned a combined $3.25-billion in the second quarter, fuelled by strong consumer lending and deposit business. But as Royal Bank of Canada and Toronto-Dominion Bank look ahead, they are casting a wary eye on mounting problems in Europe, the precarious U.S. recovery and a slowing Canadian housing market.

Those three concerns dominated the discussion with investors and analysts Thursday as the banks reported earnings. Amid reports that European Union leaders are formulating contingency plans for a possible exit by Greece from the euro zone, RBC executives told analysts they have been running a "playbook" of scenarios aimed at containing the fallout.

"We, like a lot of other large financial institutions, have had a specific contingency planning effort under way," said Morten Friis, RBC's chief risk officer. Though RBC said it has minimal direct exposure to a potential Greek default, the strategy is to shield the bank from the inevitable ripple effects across Europe. "We have a playbook if you like of all of the various options that we need to work through in the event of a euro zone breakup."

TD chief executive officer Ed Clark said he is confident the European crisis won't derail the U.S. economic recovery, but there is some concern over other problems south of the border. The expiry of tax incentives introduced to boost the U.S. economy in recent years could slow growth in the U.S., where TD has 1300 branches.

"The main risk to the United States outlook is a fiscal shock next year, as a variety of tax incentives expire, injecting a dose of austerity that the [U.S.]economy may not be robust enough to absorb," Mr. Clark said. "[But]the U.S. economy has proven its resilience time and time again, and we're encouraged by that."

And both banks said they have seen a distinct slowing of the Canadian housing market in recent months.

A slowdown will have an impact on TD and RBC alike, since they are among the biggest mortgage lenders. However the banks said efforts by Ottawa to cool the market in recent months through new lending guidelines and the elimination of 30-year mortgage amortizations last year, are better for the sector and the economy in the long run.

"Where the direct costs to the banks of a sharp correction will be quite absorbable, the effects of a large correction on the economy warrant prudence," Mr. Clark said. "At the moment we see signs that the housing market is slowing, and the risk of a sharp correction are diminishing."

Questions have arisen this year about potential overheating of the housing markets in Vancouver and Toronto, particularly involving condo sales. RBC's head of retail banking, David McKay, said the bank is watching those markets carefully.

"There are a couple of hot spots across the market that we are watching closely," Mr. McKay said. "But you can't really generalize across the country. So it's very important that you maintain kind of a regional and at times city-specific strategy."

TD, the country's second largest bank by assets, announced a 21-per-cent increase in second-quarter profit to $1.69-billion. RBC, Canada's largest bank, made $1.56-billion, down 7 per cent from last year due to a $202-million writedown it recorded on the buyout of RBC Dexia Investor Services from its European partner in April. Without the writedown, RBC said its profit rose 5 per cent to $1.77-billion.

While TD's results beat analysts' expectations, RBC's earnings were viewed as a slight disappointment by the market. RBC shares fell almost 3 per cent on Thursday to $51.38, while TD's shares were up marginally to $78.99.

The earnings underscored the two different stages Canada's biggest banks are at. TD, which spent the past five years expanding its retail banking footprint in North America, along with bulking up in the auto lending business, is now reaping higher profits from those deals.

RBC is in the middle of a shift, having jettisoned its money-losing U.S. retail branches last year, while expanding its global wealth management business. That strategy is expected to lead to greater profits in the future, when interest rates begin to rise and market activity picks up.