For investors in Canadian banks, volatility has arrived.
Monthly returns for Canadian bank shares have surged or fallen by more than 5 per cent, six times in the past 15 months. That’s an unusually high frequency of large swings – and some say it’s because their earnings are now less predictable, due to new international accounting rules that have changed how banks must record loan losses.
Economic factors such as trade tensions, interest rates and high consumer debt loads all have an impact on banks and their outlook for credit. The introduction of the new accounting standard, called IFRS 9, requires banks to focus on “expected” losses over the life of any loan. That means they must set aside provisions to cover potential future losses on loans that are still performing – in other words, loans on which payments are still being made.
How do the banks try to predict future losses on good loans? By using a complex set of forward-looking financial models and economic assumptions that each bank treats differently, making provisions taken against these loan portfolios virtually impossible for investors to predict.
Amid that uncertainty, investors and analysts have often been surprised by the provisions for credit losses that banks have reported. While bank stocks react to a wide array of factors, there are signs the volatility in credit losses is affecting how the stocks behave, according to Robert Wessel, managing partner at Hamilton Capital Partners, a Toronto firm that manages financial-sector exchange-traded funds.
“We believe because this new accounting treatment requires provisions to include estimated losses on performing loans, the market has struggled to estimate earnings, resulting in routine misses and (often downward) revisions to annual estimates,” Mr. Wessel said in a research note.
Canadian banks started reporting results under IFRS 9 in early 2018. In the three years before that, only five times did their shares swing by more than 5 per cent in a month. The frequency of those large swings is roughly double what it had been over the past 10 years, he said in the note.
Several of Canada’s largest banks reported large year-over-year increases in expected loan losses in the fiscal fourth quarter, which ended Oct. 31. Provisions rose 41 per cent to $499-million at Royal Bank of Canada, 33 per cent at Toronto-Dominion Bank and 52 per cent at Canadian Imperial Bank of Commerce, compared with the fourth quarter of fiscal 2018. And bank executives are anticipating a more challenging year in 2020.
A portion of the recent surge in loan losses could be seen as idiosyncratic: CIBC recorded a $52-million provision related to fraud involving a single commercial banking client, for example. But the lion’s share of those increases for all banks came from provisions for loans that are still performing, owing to revised estimates.
“It’s formulaic in that every quarter, we have an economic outlook that gets updated,” Laura Dottori-Attanasio, CIBC’s chief risk officer, explained on a conference call with analysts in early December.
In the fourth quarter, the bank tweaked its forecasts for unemployment and oil prices, and "we increased the probability weight of the downside scenario … to reflect increased uncertainty in the macro environment,” she said. As a result, the bank increased its provisions on performing loans to $72-million, from $5-million a year earlier.
Fourth-quarter provisions on performing loans soared by a collective 165 per cent at the country’s eight largest banks, according to data from Scotia Capital Inc. analyst Sumit Malhotra. Provisions on loans that are impaired, on the other hand, rose only 8 per cent.
“Credit quality is clearly the fundamental factor that acts as the greatest inflection point when it comes to the earnings power and investor sentiment accorded to banks,” Mr. Malhotra said in a research note. “Accordingly, the stocks are quite sensitive to even the perception of a deterioration in credit trends.”