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The TD Centre in Toronto’s Financial District on March 15.Fred Lum/the Globe and Mail

Canadian bank profits are set to drop, with dampening loan demand and capital markets activity expected to lead a trend of sluggish financial results across the lenders’ businesses.

As the Big Six banks prepare to report their third quarter earnings over the next week, analysts have slashed their expectations, citing persistent inflation that has ratcheted interest rates higher, and more stringent capital requirements from increasingly cautious regulators.

Most anticipate that earnings will drop between 4 per cent and 7 per cent year-over-year, dragged down by narrower profit margins, higher reserves for loans that could turn sour, and expenses outpacing revenue.

The results “are unlikely to show any real sign of recession, but they are also unlikely to paint a particularly compelling picture,” Scotiabank BNS-T analyst Meny Grauman said in a note to clients.

On Thursday, Royal Bank of Canada RY-T and Toronto-Dominion Bank TD-N will be the first major banks to report earnings for the three months that ended on July 31. Bank of Nova Scotia and Bank of Montreal BMO-T will release results on Aug. 29. National Bank of Canada NA-T is set to report on Aug. 30, and Canadian Imperial Bank of Commerce CM-T will close out the week on Aug. 31.

Canada’s largest banks operate in several different businesses and markets, including retail banking, wealth management and investment banking, with operations in the United States and other countries. When growth slows in one business, because of poor economic circumstances or a slowdown in a certain industry, typically another banking segment will offset that slump with an uptick.

This quarter, slower growth is expected across the board, with capital markets leading results lower.

Investment bankers and traders have come under pressure over the past year, as volatile markets and the high cost of borrowing have stunted dealmaking. In the U.S., the Top 5 largest capital markets banks experienced an average 10-per-cent year-over-year drop in revenue in their capital markets divisions in the second quarter.

That trend is set to hit Canadian lenders as well, with capital markets revenue expected to sink 9 per cent from the same period a year earlier, according to RBC analyst Darko Mihelic.

Other sources of revenue are also expected to wane, including wealth management, banking and lending fees, CIBC analyst Paul Holden said in a note to clients. While assets that banks manage for wealth clients may grow slightly, customers have been shifting their money into lower fee products, offsetting those gains.

“We also don’t see much of a lift from other sources of fee income,” Mr. Holden said.

In part, the quarter’s revenue pressures stem from central banks’ efforts to tame heated inflation. The Canadian and U.S. economies have continued to post strong growth and employment rates, prompting the Bank of Canada to raise its key interest rate twice since May, when the banks released second quarter results.

The higher cost of borrowing is weighing on loan demand. And customers are now moving money into deposit accounts that are costly for banks to fund, squeezing net interest margins – the difference between the interest banks pay on deposits and what they charge on loans.

Rising borrowing costs also increase the risk that customers could default on their debts. This has prompted banks to increase the funds they set aside for sour loans – known as provisions for credit losses – from low levels in 2021.

When banks set aside provisions for credit losses, they categorize them by how likely the loans are to go bad in the near future. Provisions have been driven higher in recent quarters by loans that, while risky, are still being repaid. But analysts expect banks to start setting aside more money for debt that is not being paid on time.

Even as the banks have increased provisions, defaults have remained low. But in the first two months of the third quarter, consumer and business insolvencies climbed, according to Keefe, Bruyette & Woods analyst Mike Rizvanovic.

Meanwhile, risk is rising for loans in commercial and residential real estate, as demand softens for office space and more mortgages come up for renewal. Borrowers who renewed over the past year have chosen shorter terms than the typical five-year period, meaning a parade of homeowners will have to renew in 2025 under significantly higher interest rates, Mr. Mihelic said.

The banks also have less capital to invest in their businesses or return to shareholders. In June, Canada’s banking regulator, the Office of the Superintendent of Financial Institutions, said it would increase the domestic stability buffer – a capital reserve that banks build to soften the blow of an economic downturn – in November. The change means banks will have to set aside billions of dollars.

Inflation and competition for talent has also hiked expenses in recent quarters – a trend that is expected to continue.

“The Big Six banks have clearly been surprised by the level of expense growth they have faced over the past several quarters, generally missing their guidance on its trajectory,” Mr. Rizvanovic said. “Each of the large banks is focused on cost control in the near-term, particularly with the revenue growth outlook looking less robust.”

In anticipation of a difficult quarter, the banks are unlikely to increase dividends, many analysts said. Bank stocks have limped along this year, and the S&P/TSX Composite Banks Index has dropped 5.4 per cent, lagging behind the broader market.

But the quarter may not be as bad as many expect, according to Barclays analyst John Aiken. Higher interest rates could bolster net interest margins, and loan growth has been positive despite several headwinds, he said in a note to clients.

“With consensus estimates lowered ... we believe the banks could surprise to the upside, posting better than expected third-quarter earnings and continuing to fuel valuations ahead of the long-awaited and but now only potential recession,” Mr. Aiken said.

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