Analysts lower profit expectations for banks as pressure grows to increase provisions for loan losses

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Canadian banks are facing a hit to their profits as high borrowing costs and economic uncertainty increase pressure to set aside more money for loan losses, prompting analysts to further lower their earnings expectations.

The Big Six banks are set to release results for the fiscal second quarter this week, with earnings per share expected to drop 8 per cent to 9 per cent year-over-year.

Canadian banks evaded the turmoil in the U.S. sparked by the failure of Silicon Valley Bank, but analysts have nonetheless lowered their profit estimates in recent weeks, pointing to a parade of near-term hurdles that threaten to mute growth.

“We do not believe that we will see clear signs of recession in this set of numbers, but what we will see is rising [provision for credit losses] ratios in anticipation of a recession, as well as slowing mortgage growth, pressure from rising funding costs, and a still challenging environment for wealth management and capital markets revenues,” Scotiabank’s Meny Grauman said in a note to clients.

On May 24, Bank of Nova Scotia and Bank of Montreal will be the first major banks to report earnings for the fiscal second quarter, which ended April 30. Royal Bank of Canada, Toronto-Dominion Bank and Canadian Imperial Bank of Commerce will release their results the next day, and National Bank of Canada the following week.

Investors expect banks to further increase the funds they set aside for sour loans – known as provisions for credit losses – amid concerns about an economic downturn.

As loan risk rises, provisions are expected to be made largely for loans that are still being repaid, driven up by rising stress in commercial real estate portfolios and more credit card delinquencies, as higher interest rates stretch borrowers’ ability to meet their obligations.

“The higher provisions in this upcoming credit cycle, in our view, will largely be from higher provisions in commercial/corporate loans (with a focus on office [commercial real estate]) and unsecured consumer loans,” Bank of Montreal analyst Sohrab Movahedi said in a note.

Meanwhile, the failure of three banks in the U.S. has cast a spotlight on liquidity – a bank’s ability to convert assets into cash to meet sudden obligations – just after Canada’s banking regulator raised the amount of capital lenders must carry.

In December, the Office of the Superintendent of Financial Institutions (OSFI) increased the domestic stability buffer, requiring banks to hold more money as a cushion to soften the blow of an economic downturn. The banks are already sitting on large piles of excess capital, above the 11-per-cent requirement for the common equity tier (CET1) ratio – a measure of a bank’s ability to absorb sour loans. But OSFI increased the potential range of the buffer, opening the door for another increase in June that could reach as high as 12 per cent.

The regulator also cited liquidity as the second-highest risk to the banking sector in its annual outlook, released in April.

“The Canadian banks already have strong liquidity and capital positions, but in the current environment there is incentive to boost ratios higher,” CIBC analyst Paul Holden said in a note.

The requirement to set aside capital – taking a chunk out of profits – comes as key sources of revenue are being squeezed. Customers are increasingly moving cash from deposit accounts, which cost banks very little, to fixed-term products with higher interest rates. Additionally, high borrowing costs are dampening demand for loans and mortgages.

This could squeeze net interest margins – the difference between the interest banks pay on deposits and what they charge on loans. Interest rate hikes typically boost margins, as banks can charge wider spreads, but customers cut back on spending when central banks launched their aggressive rate hiking campaigns to temper heated inflation.

“We continue to expect loan growth to decelerate in the quarters ahead across the entire lending portfolio as higher interest rates adversely impact loan demand, while a challenging macroeconomic outlook adds further downside risk in the near term,” Keefe, Bruyette & Woods analyst Mike Rizvanovic said in a note.

Investors anticipate second-quarter results will do little to revive Canada’s beleaguered bank stocks. The S&P/TSX Composite Banks Index reversed earlier gains, slumping 1.7 per cent this year and underperforming the S&P/TSX Composite Index’s 4.7-per-cent climb.

BMO’s Mr. Movahedi said the current drag on earnings could be short-lived, depending on the severity of a potential recession and liquidity concerns in the U.S.

“While it may take a while for market sentiment to turn positive for bank stocks, we believe the fundamentals of Canadian banking and the Big Six are sound.”