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Canada’s largest banks just earmarked an unparalleled $11-billion in new reserves to cover losses on loans as the novel coronavirus pandemic batters the global economy. If all goes according to plan, they won’t have to take such massive provisions again, but no one can be sure whether another wave of potential losses awaits as the crisis unfolds.

When the Big Six lenders reported earnings last week, investors zeroed in on provisions for credit losses, which are the funds banks set aside to cover loans that may not be repaid. Typically, markets punish lenders that report outsized provisions, which can be an indicator of undue risk in a loan portfolio.

Yet, the current health crisis has turned that logic on its head: Investors now seem keen to reward banks for taking sky-high provisions as a sign of conservatism and prudence, as bank executives peer into a murky economic future and prepare for the worst.

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“We knew that the banks were going to move aggressively to try to get ahead of underlying credit deterioration," said Sumit Malhotra, an analyst at Scotiabank. “To some degree, it was almost like an arms race: You wanted to take as much as you can on the provision without spooking the market on capital.”

Actual losses and loans in arrears were still modest in the banks’ fiscal second quarter, which ended April 30, as they deferred payments on hundreds of thousands of loans, and governments rolled out an array of relief measures.

But banks are projecting a massive spike in losses to come. The loans most at risk are unsecured types of personal debt, such as credit cards and credit lines, as well as corporate and commercial loans to oil and gas companies, and to sectors that rely on discretionary spending, such as restaurants, retailers and hotels.

“So much of what happens from here depends on our collective success, with the governments and others, to reopen the economy, and the speed with which that can be done in a safe way," said Riaz Ahmed, chief financial officer at Toronto-Dominion Bank.

Banks take provisions to plan ahead for future write-offs. In good economic times, those provisions only need to cover a small fraction of all loans – from 0.25 per cent to 0.5 per cent at most of Canada’s largest banks.

Since the novel coronavirus forced Canada into a wide-ranging economic shutdown in mid-March, ratios of provisions to total loans have surged as high as 1.65 per cent at Royal Bank of Canada and 1.76 per cent at TD – the country’s two largest lenders. On balance sheets with hundreds of billions of dollars in loans, that translates to billions in potential losses.

How banks are bracing

for loan losses

The coronavirus pandemic forced banks

to dramatically increase the reserves they keep

to cover potential future losses in the quarter

that ended April 30. Provisions for credit losses

(PCL) are the funds banks set aside to cover

loans that may go sour. The PCL ratio measures

those reserves relative to a bank’s total

loan portfolio.

Bank

Provisions for credit losses ($bn)

PCL ratio

$0.43

0.29%

RBC

2.83

1.65

0.63

0.39

TD

3.22

1.76

0.87

0.61

Scotia

1.85

1.19

0.18

0.16

BMO

1.12

0.94

Q2 2019

0.26

0.27

CIBC

Q2 2020

1.41

1.39

0.08

0.23

National

0.50

1.28

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: the banks

How banks are bracing for loan losses

The coronavirus pandemic forced banks to dramatically

increase the reserves they keep to cover potential future

losses in the quarter that ended April 30. Provisions for

credit losses (PCL) are the funds banks set aside to cover

loans that may go sour. The PCL ratio measures those

reserves relative to a bank’s total loan portfolio.

Bank

Provisions for credit losses (billions)

PCL ratio

$0.43

0.29%

RBC

2.83

1.65

0.63

0.39

TD

3.22

1.76

0.87

0.61

Scotiabank

1.85

1.19

0.18

0.16

BMO

1.12

0.94

Q2 2019

0.26

0.27

CIBC

Q2 2020

1.41

1.39

0.08

0.23

National

0.50

1.28

JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: the banks

How banks are bracing for loan losses

The coronavirus pandemic forced banks to dramatically increase the reserves they keep

to cover potential future losses in the quarter that ended April 30. Provisions for credit

losses (PCL) are the funds banks set aside to cover loans that may go sour. The PCL ratio

measures those reserves relative to a bank’s total loan portfolio.

Bank

Provisions for credit losses (billions)

PCL ratio

$0.43

0.29%

RBC

2.83

1.65

0.63

0.39

TD

3.22

1.76

0.87

0.61

Scotiabank

1.85

1.19

0.18

0.16

BMO

1.12

0.94

Q2 2019

0.26

0.27

CIBC

Q2 2020

1.41

1.39

0.08

0.23

National

0.50

1.28

JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: the banks

By that measure, and comparing allowances for losses to gross impaired loans, TD and RBC appear to be the most cautiously provisioned among the large banks. Relative to the size of their loan books, Bank of Montreal and Bank of Nova Scotia have built the smallest reserves.

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Yet even in the best of times, comparing provisions among the banks is not easy, because each bank has a different mixture of loans in its portfolios. And in late 2017, a new accounting standard called IFRS 9 made forecasting losses more complicated, requiring banks to divide provisions into two broad categories.

One is for impaired loans, which are in arrears but haven’t yet been written off as losses. The other is for performing loans, which are still being paid back but are deemed at risk of becoming impaired, based on economic forecasts and financial models.

Each quarter, banks add those provisions – performing and impaired – to a larger, running tab known as the allowance for credit losses (ACL), which includes provisions from past quarters, minus any that were written off or recovered. Allowances at Canada’s six largest banks now add up to $27.4-billion, a substantial cushion for absorbing losses.

A large majority of the new provisions banks booked in the quarter – about $7.6-billion out of $11-billion – were for performing loans. But the way those are calculated is far from straightforward, based on an opaque mixture of economic forecasts, financial models and old fashioned human judgment used to generate estimates.

“These models that are being used are effectively a black box," said Rob Colangelo, a banking analyst at DBRS Ltd., in an interview. “There’s lots of assumptions, lots of numbers that go into this.”

On Thursday, TD’s chief risk officer, Ajai Bambawale, gave analysts a peek at that process. The bank’s risk experts chose a range of economic scenarios, from optimistic to severely adverse, weighted each one by its perceived likelihood, then ran those scenarios through the bank’s sophisticated models.

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Next, they assessed the health of loan portfolios across the bank, looked at how macroeconomic data had changed since they first chose the scenarios, and estimated the positive impact of government-led relief programs. For each factor, “we added an overlay,” he said, which changes the final output.

Most Canadian bank executives said they expect to book fewer new provisions next quarter, but may need to keep on adding to reserves as the crisis unfolds. As payment deferrals expire, government turns off the stimulus taps and the economy starts to recover, some performing provisions banks have amassed will gradually become impaired and, eventually, be written off as losses.

Only then will it be clear which banks have done enough to immunize themselves against the economic harm from the virus.

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