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Canada’s largest banks will look to avoid the same fate when they report results for the fiscal third quarter, which ends July 31.Michelle Siu/The Globe and Mail

Canada’s large banks are under pressure to show that their core lending business is rebounding after investors appeared unimpressed with the latest round of U.S. bank earnings, choosing to overlook rising profits and focus instead on tepid demand for loans.

The bottom line looked good for U.S. banks: The largest American lenders each beat profit expectations for the fifth quarter in a row, aided by large recoveries of funds that had been set aside early in the coronavirus pandemic to cover possible losses on loan defaults that never happened.

Major U.S. banks earnings also benefited from surging fees for advising on mergers and initial public offerings, even as trading revenues fell from record levels a year ago. But the booming results from healthy credit and busy deal-making masked a challenging underlying trend: Although quarterly profits more than doubled at JPMorgan Chase & Co. and Bank of America Corp. year over year, revenues fell 8 per cent and 4 per cent, respectively.

U.S. bank stocks tumbled last week as lenders reported earnings, falling 3.5 per cent on average, while the S&P 500 index declined by only 1.3 per cent over the same span.

Canada’s largest banks will look to avoid the same fate when they report results for the fiscal third quarter, which ends July 31. Reporting season begins on Aug. 24 and although economies have started roaring back to life as vaccination rates rise and public-health restrictions are lifted, consumers and businesses have been slow to start borrowing money again, limiting the income banks can earn from interest on loans.

“From our vantage point, there is one important implication for the Canadian banks [from U.S. bank earnings]: net interest income needs to show better to escape a similar outcome,” said Paul Holden, an analyst at CIBC World Markets Inc., in a note to clients. And there are “reasons to believe this will be the case.”

While U.S. banks reported results for the second quarter that ended in June, Canadian banks have a staggered fiscal year and will release third-quarter earnings for a period that wrapped up July 31. Regulatory data from May – the first month of that fiscal quarter – offers a glimmer of hope that borrowing may be gradually picking up in Canada. On average, loans increased by 0.5 per cent from the previous month, and domestic lending was up 1 per cent, according to data from the Office of the Superintendent of Financial Institutions (OSFI) – a gradual but still modest uptick.

Mortgages led the way, with balances rising 1.1 per cent month over month and 9.6 per cent from a year ago amid hot housing markets. Other consumer loans increased 0.6 per cent on a monthly and annual basis, while business lending rose 0.9 per cent from April, and 2.3 per cent from a year ago. But loan balances abroad declined year over year.

One of the main factors depressing demand for loans is the glut of excess cash that has built up in deposit accounts over the course of the pandemic, as consumers and businesses spent less and stashed away stimulus cheques that governments doled out to help offset the pandemic’s damage to the economy.

“Consumer spending activity has bounced back to prepandemic levels, but excess liquidity means that people are using cash, not borrowing, to fund that spending,” Mr. Holden said. “We expect loan growth to return later this year.”

The dip in borrowing is most evident with credit cards, which are a highly profitable line of business that is producing weaker returns for banks as consumers make fewer purchases that generate interchange fees while paying off interest-bearing balances more often.

“There is no clearer sign of the decline in consumer lending than the 20-per-cent drop in Big-6 credit card balances from pre-COVID levels,” said Gabriel Dechaine, an analyst at National Bank Financial Inc., in a note to clients.

A return to normal levels of profitability from credit cards could raise Canadian banks’ earnings per share by about 2 per cent on average, and as much as 3.6 per cent for Canadian Imperial Bank of Commerce, according to Mr. Dechaine’s analysis.

But shareholders may have to be patient: He predicts a full recovery in credit card use might not happen until 2023.

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