Loan demand from business borrowers expected to boost Big Six profits in first quarter

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Borrowers are expected to prop up Canada’s biggest banks’ financial results for the first quarter of the fiscal year, even as the threat of a recession weighs on lenders’ bottom lines.

Analysts anticipate that loan growth will boost results, fuelled by aggressive interest-rate hikes by the Bank of Canada and demand from commercial customers. But analysts are also watching for slowing growth in mortgages – which make up a swath of the banks’ overall lending portfolios – and rising reserves for potential sour loans, all while tighter regulatory and government oversight take a notch out of earnings.

On Feb. 24, Canadian Imperial Bank of Commerce CM-T will be the first major bank to report earnings for the fiscal first quarter, which ended Jan. 31. Bank of Montreal BMO-T and Bank of Nova Scotia BNS-T will release results on Feb. 28, followed by Royal Bank of Canada RY-T and National Bank of Canada NA-T the next day. Toronto-Dominion Bank TD-T will be the final Big Six lender to release earnings, on March 2.

On average, profits across the Big Six banks could rise 6 per cent from the previous quarter, but drop 8 per cent from the same period a year earlier, as loan loss provisions climb back up toward prepandemic levels, according to research by Keefe, Bruyette & Woods analyst Mike Rizvanovic.

Banks are expected to raise their reserve funds for bad loans – known as provisions for credit losses, or PCLs – in anticipation of a potential economic downturn. They had previously lowered the amount of money set aside for this purpose, after the pandemic produced fewer loan defaults than expected.

But even as loan losses edge up from their pandemic trough, analysts expect the banks to make relatively minor adjustments to PCLs, because the downturn is expected to be mild.

“While we don’t dismiss the potential downside risk to earnings from rising PCLs as the economy weakens in a higher rate environment, we view a moderate recession (the current consensus view) as very manageable from a loan loss perspective,” Mr. Rizvanovic said in a note to clients.

Interest-rate hikes bode well for the banks’ net interest margins – the difference between the interest that banks pay on deposits and charge on loans. Banks can charge wider spreads and turn out bigger profits as central banks ratchet rates higher. With consumers continuing to reach for their credit cards and businesses opting for loans as employment remains strong, analysts expect loan books overall to continue to grow.

But higher rates also cause customer wallets to tighten, and demand for debt could shrink and squeeze margins. The greatest threat comes from the stunted mortgage market, as borrowing costs rise and fewer homebuyers qualify for loans.

“Fuelled by the BoC’s ongoing rate hiking cycle, we believe that the environment continues to be supportive for net interest margins,” Barclays analyst John Aiken said in a note. “Although Canada’s real estate market continues to moderate, we anticipate mortgage volumes will stay positive, albeit at a more modest growth rate. As such, we anticipate net interest income will continue to trend higher” from levels in the fourth quarter of the previous fiscal year.

The banks are also juggling new regulatory requirements that they carry more capital. In December, after most of the banks boosted dividends, the Office of the Superintendent of Financial Institutions (OSFI) increased the amount of money they must hold in case of an economic downturn, which is known as the domestic stability buffer. The OSFI also increased the potential range of the buffer – a cushion built up in good economic times to soften the blow if conditions worsen – opening the door for another hike in June.

This means that the banks could choose to avoid dividend increases, share buybacks and new deals, and instead build up their capital reserves. Toronto-Dominion Bank, Bank of Montreal and Royal Bank of Canada are already in the throes of some of the biggest acquisitions in the industry’s history.

The banks face rising capital thresholds at a time when the federal government has imposed higher taxes in the sector, with a permanent increase to the corporate income tax rate for banks and insurers, and a temporary tax called the Canada Recovery Dividend that will be imposed over five years.

While investors’ main focus will still be on key net interest margins this quarter, the spotlight will begin to shift to concerns about how banks will sustain higher capital levels, according to Scotiabank analyst Meny Grauman.

“A more challenging capital and regulatory environment for banks ... is something that we are very concerned about,” he said in a note.

Even so, bank stocks have started the year on a tear. The S&P/TSX Composite Banks Index has climbed about 9 per cent this year, outperforming the S&P TSX Composite Index’s 6-per-cent gain. But this is partly a result of the market’s increasingly bullish tone, as central banks signal potential rate-hike pauses and predict a coming economic downturn they say will be less severe than others in recent decades.

As the market cautiously crawls out of last year’s slump, beleaguered wealth management and investment banking divisions that saw activity sink in 2022 could rebound, and benefit bank earnings in the year ahead.

“U.S. banks and some of the Canadian banks have indicated there is a robust pipeline of investment banking activity waiting for better market conditions,” CIBC analyst Paul Holden said in a note.