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On average, the bank industry’s profits for the quarter that ended April 30 could fall 5 per cent compared with the same period last year.Fred Lum/The Globe and Mail

Investors are expecting Canada’s largest banks to report strong financial results for the second quarter that just ended. What happens next could be cause for greater concern.

Big bank earnings are likely to be robust, easing back from giddy highs a year ago as revenue from trading and investment banking dips and loan loss reserves start to creep up from unusually low levels. But analysts are looking ahead for signs the rate of growth in banks’ lending could be starting to slow as rising interest rates and economic turmoil begin to eat into demand for mortgages and other new loans.

On average, the industry’s profits for the quarter that ended April 30 could fall 5 per cent compared with the same period last year, when banks blew past estimates to report soaring profits, according to estimates in a research note by Sohrab Movahedi, an analyst at BMO Nesbitt Burns Inc.

Bank of Montreal BMO-T and Bank of Nova Scotia BNS-T are first to report earnings on May 25, followed by Royal Bank of Canada RY-T, Toronto-Dominion Bank TD-T and Canadian Imperial Bank of Commerce CM-T the following day. National Bank of Canada NA-T will be the last of the Big Six lenders to release results on May 27.

Mr. Movahedi estimates quarterly revenue will rise by 2 per cent on average, with the rate of growth in loan portfolios remaining strong, supported by strong mortgage demand, while rising interest rates should help boost profit margins on those loans. But some banking analysts are already looking past the second-quarter figures for signals the pace of borrowing could fall by next year, raising the prospect of leaner results to come.

“We expect the banks will post another set of strong results in [the fiscal second quarter], but with an economic slowdown increasingly being priced in, headline results might not matter all that much,” said Paul Holden, an analyst at CIBC World Markets Inc., in a note to clients. “We should not extrapolate strong growth this quarter into future quarters. Rapidly increasing borrowing costs and economic uncertainty will dampen future demand.”

Mr. Holden estimates that banks’ loan books will still expand by an average of 9.6 per cent for their fiscal year, which ends Oct. 31, thanks to a strong start. But he expects that rate of growth will be cut in half for fiscal 2023, falling to 4.7 per cent.

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One key reason analysts expect slower growth is an anticipated cooling of the housing market after a two-year hot streak. Home prices fell nationally from March to April, and some economists are predicting a correction in prices in some regions.

Increases in mortgage balances “have been running at unsustainably strong levels since late 2020,” said Gabriel Dechaine, an analyst at National Bank Financial Inc., with most banks posting consistent double-digit percentage increases year over year. But because mortgages typically generate low profit margins for banks, the hit to revenue from a sharp slowdown should be manageable, he said.

If the current year-over-year rate of mortgage growth of 10 per cent was halved, he estimates banks’ revenue and earnings per share would have been about 0.3 per cent lower. Instead, concerns about a possible recession or a period of stagflation – a combination of rising prices and slow economic growth – “are the most relevant bank stock driver,” Mr. Dechaine said.

In that context, rising interest rates are a “double edged sword,” said John Aiken, an analyst at Barclays Capital Canada Inc. They will help increase profit margins banks earn from loans, which were squeezed during a prolonged period of rock-bottom borrowing costs. But they are also likely to reduce demand for borrowing by making it more expensive, most notably for mortgages and personal loans.

A gradual uptick in provisions for credit losses – the money banks set aside to cover loans that may default – is also likely to dampen bank profits. In the near term, provisions will still be modest, creeping up from historically low levels when COVID-19 support and other fiscal and monetary stimulus drove down defaults.

But lately, bank profits have been padded as they recovered provisions set aside during the pandemic that were no longer deemed necessary because actual losses on loans were much lower than expected.

With the war in Ukraine and rising inflation driving concerns about the potential for a recession, banks are expected to slow or pause those releases of loan loss reserves.

Revenue from fees is also likely to dip as the pace of equity and debt issuance has slowed, and tumbling stock and bond markets will eat into returns from wealth management.

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