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A TD Canada Trust branch is shown in the financial district in Toronto on August 22, 2017.

Nathan Denette/The Canadian Press

Canada’s largest banks are expected to report improved third-quarter earnings thanks in part to deferred payments on troubled loans and easing pressure to build reserves against losses. But with persistent challenges still to come, the rebound could amount to a “head fake,” as one banking analyst put it.

When the country’s Big Six banks release financial results for the fiscal third quarter this week, most are expected to report a sharp decrease in provisions for credit losses – the funds banks set aside to cover bad loans – compared with the prior quarter. Provisions could fall 30 per cent to 40 per cent from the $11-billion total set aside in the second quarter, according to some estimates, though they will still be dramatically higher than they were a year ago, before the coronavirus pandemic hobbled the global economy.

The banks’ capital levels, which are an important measure of their ability to absorb losses while continuing to lend to clients and pay dividends to shareholders, could also stabilize or even improve slightly after taking a second-quarter dip. And surging trading activity, as well as demand to issue new debt, could help capital markets divisions deliver generous returns for the second consecutive quarter.

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Yet some of the scars the pandemic is carving into banks’ balance sheets may be harder to erase.

“For the time being, the damage appears to be limited, but we recognize that the impact is being buffered by an unprecedented amount of government and private-sector support,” said Meny Grauman, an analyst at Scotia Capital Inc., in a note to clients. “The big test will come in the fall and early winter, when many of these programs are reduced or eliminated.”

Bank of Nova Scotia and Bank of Montreal are first to report earnings on Tuesday, followed by Royal Bank of Canada and National Bank of Canada the next day, and Toronto-Dominion Bank and Canadian Imperial Bank of Commerce on Thursday.

The proportion of loans with deferred payments at each bank is sure to attract a good deal of investor attention. Those loans are largely being treated as though they’re performing normally, with the banking regulator’s blessing, but pose a potential risk as deferral periods expire. At the end of April, 11 per cent of the major banks’ loans were in deferral, by dollar value, and as of late July, 16 per cent of all mortgages had payments put on hold at some point, according to the Canadian Bankers Association.

For investors to have confidence that the banks have accounted for the portion of deferrals that may turn into defaults, “we believe the value of loans in forbearance needs to decline by roughly a third,” said Gabriel Dechaine, an analyst at National Bank Financial Inc., in a research note.

The rest of the banks’ loan portfolios are also being squeezed. A succession of cuts to interest rates in March has compressed lending margins, which narrowed last quarter and were expected to tighten even more in the third quarter. And while demand for mortgages is picking up as housing markets roar back to life, demand for other types of new loans has slowed.

Several analysts expect banks’ capital levels as measured by the common equity Tier 1 or CET1 ratio – an important indicator of a bank’s resilience – will mostly hold steady or gain ground as corporations pay down credit balances drawn at the onset of the pandemic. Even so, “we should expect CET1 ratios to trend lower over the next 12 to 18 months,” said Paul Holden, an analyst at CIBC World Markets Inc.

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Combined with an uneven economic recovery, those factors “could lead to slow [earnings per share] growth for the foreseeable future,” said Darko Mihelic, an analyst at RBC Dominion Securities Inc., in a note to clients. “In our view, this quarter is a head fake and any meaningful rally in the [Canadian bank] stocks should be greeted with caution.”

One bank is likely to be an outlier: Scotiabank’s provisions are expected to rise again, even as its peers dial back the size of their new reserves. That’s one reason Mr. Mihelic is forecasting a 39-per-cent drop in Scotiabank’s core earnings per share, year over year, compared with a 14-per-cent decline for the banks on average.

In effect, Scotiabank is playing catch up after booking a relatively modest increase in provisions last quarter. Its international banking operations are heavily concentrated in Latin America, especially in Mexico, Peru, Chile and Colombia. As of April 30, when Canada’s banks closed their fiscal second quarter, those countries had yet to see major spikes in COVID-19 cases. But a surge in infections since then threatens to drive up losses and drag on economic growth.

Capital may also have constrained Scotiabank’s ability to pile on new provisions as a precaution last quarter. It was the only bank to have its CET1 ratio fall below 11 per cent, to 10.9 per cent – still well above a 9-per-cent regulatory minimum, but affording the bank less breathing room than some competitors had.

Mr. Mihelic predicts Scotiabank will need to earmark $2-billion in new provisions in the third quarter, which amounts to 1.26 per cent of all loans – nearly double the average ratio of 0.64 per cent of loans that he is forecasting for all six banks combined.

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