Canada’s big banks expect to earn billions of dollars in added income from interest charges over the next year as central banks drive up interest rates, but the rapid pace of rate hikes could dampen the boost to profits if higher borrowing costs reduce demand for new loans.
The Bank of Canada announced its second consecutive oversized increase to its policy rate on Wednesday, hiking its benchmark rate by 0.5 percentage points to 1.5 per cent, as central bankers act aggressively to tame high inflation. That is good news for chartered banks: It promises to boost the profit margins they earn from lending money at higher rates than they pay for deposits.
For the past two years, banks’ net interest margins have been squeezed as central banks cut policy rates to rock-bottom levels in an effort to stimulate economies and help them rebound from COVID-19. But after the Bank of Canada hiked rates by 50 basis points for the second time since April, Canadian banks are expecting a surge in net interest income (NII) – as much as $3.5-billion combined over the coming 12 months, according to one set of estimates.
Toronto-Dominion Bank TD-T and Royal Bank of Canada RY-T have the most to gain: In theory, each could reap well in excess of $1-billion in added interest income over the next year.
With the Bank of Canada predicting there are more rate hikes to come, and saying on Wednesday it is “prepared to act more forcefully” if needed to cool inflation, banks’ NII could keep rising for at least the next two years. Net interest income is key to bank performance, as it typically makes up about half of a major bank’s revenue, according to data from RBC.
On Wednesday, all five of Canada’s largest banks raised their prime lending rates by 50 basis points, from 3.2 per cent to 3.7 per cent.
Banks tend to earn higher interest income when interest rates rise. That is partly because they are able to charge wider spreads between deposits and loans, but also because they earn a better rate of return on financial assets they purchase with the deposits and other funds they hold.
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The effect of fast-rising interest rates isn’t all upside for banks, however. As the cost to borrow increases, it can cool demand from clients for new loans, making it harder for banks to grow their loan books. And as more clients become financially stretched by the cost of servicing debt, loan defaults can rise and drive up losses.
The impact could be most obvious for banks’ mortgage balances, which have been rising at a furious pace over the last year, but are expected to grow more slowly in the coming quarters. Banks are also on the cusp of an early rebound in credit card balances, which generate higher profit margins for lenders, as customers travel and dine out more with pandemic restrictions easing.
Each of Canada’s Big Five banks estimates the change to its NII from a sudden increase in interest rates of 100 basis points, or one percentage point, that is consistent across the yield curve of rates for all time durations. That scenario is artificial, assuming that rates across the curve move in lockstep and banks’ balance sheets stay the same, with executives taking no action to adjust to changing rates.
At TD, a 100-basis-point spike in rates across the curve would generate nearly $1.6-billion in extra NII over 12 months. Over the past year, TD earned nearly $25-billion in net interest income, and $44.2-billion in total revenue.
“If the forward rates play out as expected, then we would see our margin expand, and it depends on how fast the rates are rising,” said Kelvin Tran, TD’s chief financial officer, in an interview last week. “When short rates increase we see that benefit fairly quickly.”
In the same scenario, RBC estimates its net interest income would rise by $1.1-billion, over and above the $20.7-billion in NII the bank earned in the past four quarters. Chief executive officer Dave McKay said late last year that rock-bottom rates reduced the bank’s revenue by about $1-billion in each of the past two years.
Bank of Montreal BMO-T estimates that a 100-basis-point rate shock would increase its NII by $635-million in the next 12 months, and CIBC predicts a $428-million increase over the same span.
Only Bank of Nova Scotia BNS-T predicts a decline in NII in the first year, of $126-million. Scotiabank has a large international banking operation in Latin America, where interest rates started rising sooner than elsewhere, allowing it to capture benefits to income earlier than some peers.
In the second year after a 100-basis-point rate hike, Scotiabank would expect net interest income to increase by $191-million.
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James Bradshaw