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Canadian bank stocks have already been hammered by the current wave of credit and liquidity fears, and one analyst is warning investors to brace for further pain and more volatility.

Of the Big Six banks, Bank of Montreal and Royal Bank of Canada are raising the biggest red flags when it comes to risk, said Citigroup Inc. analyst Shannon Cowherd.

“Both banks have a significant asset base with many potential points of exposure. Neither bank has recorded significant writedowns to reflect the potential exposures,” she wrote in a research note.

Ms. Cowherd raised her risk rating on both banks to “high” from “medium” and slashed her price target on BMO from $54 a share to $43, and on RBC from $58 to $47. She maintained her “hold” rating on both banks, citing their size, the lower valuations and the likely resolution to some of the credit concerns by the second half of this year.

The S&P/TSX capped financials sub-index has dropped 14.2 per cent since the start of the year, as investors have sold bank stocks on the continued unravelling of U.S. credit markets, as well as the restructurings of the markets for structured investment vehicles (SIV) and third-party asset-backed commercial paper (ABCP) in Canada.

Shares of BMO have taken the brunt of the selling, tumbling 26 per cent since the start of the year and are trading at $43.62. RBC stock, down 8.3 per cent in 2008, is trading at $47.12.

Canadian Imperial Bank of Commerce stock, which has taken a hit from its large exposure to the U.S. subprime mortgage market, has tumbled 14 per cent. Shares of Toronto-Dominion Bank are down 9.4 per cent this year, Bank of Nova Scotia has fallen 12.2 per cent, while National Bank has dropped 10.2 per cent.

Canada's benchmark equity gauge, the S&P/TSX composite index, has fallen 11 per cent from its Oct. 31 high and 5 per cent since the start of 2008 as investors fret, in part, about widening losses in the banking sector on the back of the collapse of the U.S. subprime mortgage market and a U.S. recession.

In the case of BMO, its first-quarter provision for credit losses surged 300 per cent on new impaired loan formations, Ms. Cowherd said. “We expect increased provision for credit losses ratio to cover impairments in current portfolio and any assets brought onto the balance sheet as a result of the SIV and Canadian ABCP restructuring efforts.”

Although the market has priced in an estimated $14-billion in writedowns, BMO has to date announced less than $1-billion, she said.

RBC, Canada's largest bank, has so far unveiled less than $1-billion in writedowns from disruptions in the credit markets. Based on Ms. Cowherd's calculations, the bank has disclosed at least $8-billion of exposure, or around $2.68 a share loss to either earnings or book value, depending on how it is calculated.

RBC's provisions for credit losses jumped 81 per cent in the first quarter on higher impaired loans in the U.S. residential builder finance business, and with the U.S. housing market still weak, Ms. Cowherd expects to see continued loan losses.

Given that the bank's asset to capital ratio is high, RBC will likely need to sell assets or raise capital, Ms. Cowherd said. “Given reduced value of certain assets, either action will likely be an offset to earnings.”

Ms. Cowherd is not the only one issuing bearish reports on the banking sector.

Peter Rozenberg, an analyst with UBS Securities Canada Inc., said this weekend's spectacular bailout of U.S. investment bank Bear Stearns Cos. underscores the increasing systemic risk surrounding all global banks.

“The banking outlook continues to worsen due to a U.S. recession, increasing credit spreads, declining asset values, and a worsening and more protracted decline in capital markets,” he said.

Until earnings visibility clears up and there is a permanent U.S. policy solution focused on insolvency, capital adequacy and home equity prices, Mr. Rozenberg remain cautious on all global banks.

Among the Canadian banks, Mr. Rozenberg still expects to see credit provisions rise in fiscal 2008 and 2009 from cyclically low levels. However, capital markets – not credit risk – are his main concern when looking at Bay Street.

“While it could be argued that credit deterioration could occur later in Canada following continued U.S. economic weakness, we don't think the structural underpinnings are there for a significant deterioration in Canadian credit quality outside of a prolonged U.S. downturn,” he said.

Mr. Rozenberg noted that Canadian bank valuations have become increasingly attractive. He upgraded RBC from “neutral” to “buy” on Tuesday, citing its valuation.

“While risks including lower capital markets growth, higher provisions, and writedowns remain, we believe Canadian credit risk remains good and valuation is attractive” at 10.6 times our fiscal 2008 per share earnings forecasts, he said.