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A person walks by the Royal Bank of Canada building on Bay Street in Toronto on May 27, 2020.

Nathan Denette/The Canadian Press

Royal Bank of Canada and Bank of Montreal are bracing to absorb a spike in loan losses by earmarking reserves that are six to seven times larger than a year ago, driving a 54-per-cent drop in second-quarter profits at both lenders.

RBC set aside $2.83-billion in provisions for credit losses, an increase of $2.4-billion from last year, as the country’s largest bank adopted a cautious position in the midst of uncertainty about the scope of the economic damage the novel coronavirus will cause in Canada and abroad. And at BMO, provisions swelled to $1.12-billion, from $176-million in the same quarter of 2019, swinging from historically low loss levels to unusually high ones.

In both cases, the massive increases are based largely on models that forecast potential losses on loans that are still being paid back, but considered to be at risk as COVID-19 causes both a dramatic spike in unemployment and a severe contraction in economic activity. With plans to reopen parts of the economy still in flux, banks have been running ever more gloomy stress tests to gauge where losses might peak before returning to more normal levels.

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“The exact arc of that is difficult to predict. It will depend on all sorts of things, including how the economy performs, how the economy restarts, how much support governments provide to help bridge individuals and business through the difficult time,” Tom Flynn, BMO’s chief financial officer, said in an interview.

Provisions increased especially sharply on loans to oil and gas companies, amid low oil prices and weak demand for fuel, and to companies that rely on discretionary consumer spending such as retailers, restaurants and hotels.

RBC expects the fiscal second-quarter, which ended April 30, will be the “high-water mark” for provisions for credit losses, which should be lower next quarter, according to chief financial officer Rod Bolger. And BMO currently expects its provisions “would not be at the same level" next quarter, chief risk officer Pat Cronin said.

Both banks have deferred payments on loans to hundreds of thousands of clients for up to six months, while governments have provided direct subsidies to cover lost wages. Yet as those relief measures expire, banks are expecting actual losses on loans – which have so far increased modestly – to start climbing higher.

“Given our client-support programs, we would expect impaired loans and the associated losses on those loans to be muted in the short term,” Mr. Bolger said in an interview. “Once the [deferral] programs run their course ... we are expecting an increase of losses and we are being prudent and conservative in our reserving."

On Tuesday, Bank of Nova Scotia and National Bank of Canada both reported huge surges in provisions for loan losses, totalling $1.8-billion and $500-million respectively, leading to steep declines in profits. Unlike RBC and BMO, however, Scotiabank suggested its provisions could be similarly high again next quarter.

For the fiscal second quarter, RBC reported profit of $1.48-billion, or $1 a share, compared with $3.23-billion, or $2.20 a share, a year ago. Adjusting for special items, RBC said it earned $1.03 a share, far shy of the consensus estimate by analysts of $1.53, according to Refinitiv.

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In the same three months, BMO earned $689-million, or $1 a share, compared with $1.5-billion, or $2.26 a share, last year. On an adjusted basis, BMO said it earned $1.04 a share, well short of analysts’ expectations, partly due to weak trading results in its capital markets arm.

Both banks kept their quarterly dividend payments unchanged.

Even though both banks missed most analysts’ widely varied profit estimates, investors appear to be relieved by the banks’ ability to absorb steep rises in loan loss provisions and still maintain comfortable capital buffers.

The common equity Tier 1 (CET1) ratio – an important measure of a bank’s resilience – was a robust 11.7 per cent at RBC, and a healthy 11 per cent at BMO, both well above the 9-per-cent minimum set by Canada’s banking regulator. Some of the most severe stress tests run by RBC imagine Canadian stock prices falling by more than half in the next year, Canadian and U.S. GDP plunging 18 per cent to 20 per cent, and unemployment of 14 per cent for several quarters. Even then, RBC expects its capital levels would exceed current regulatory minimums.

After the Big Six banks’ share prices surged 5 per cent to 7 per cent higher on Tuesday, those stocks rose again on Wednesday on the Toronto Stock Exchange, by 4.8 per cent at RBC but only 0.8 per cent at BMO.

“Typically the higher your loan losses are, the less excited the market is about your stock. But in this scenario, it turns out that the bigger the provision you can line up for this quarter, the more pleased the market seems to be,” Meny Grauman, an analyst at Cormark Securities Inc., said in an interview. “It’s not illogical, but it’s definitely unusual.”

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The fate of loans with deferred payments is still a major wild card as banks assess the potential damage to their loan books. RBC has approved deferrals for more than 490,000 clients on loans adding up to more than $76-billion. And BMO has given deferrals in Canada and the United States to nearly 210,000 retail banking clients on $22.8-billion in loans, and another 8,500 commercial businesses worth a further $18.7-billion.

At both banks, most of the value of the deferred loans is in mortgages, which typically cause very low losses for banks. At RBC, about half of customers who took initial one-month deferrals on mortgages have resumed payments so far. And at BMO, Mr. Flynn expects “a majority” of deferred loans will return to good standing.

“We’re confident that the relief program will serve its purpose, which was really to allow individuals who are going through a temporary challenge as a result of the impacts COVID is having on the economy to get through that and to come out on the other side more or less in the position that they were in going into the downturn," Mr. Flynn said. "And with that, we would expect a resumption in the normal payment pattern.”

For other categories of loans, especially those that aren’t secured by assets such as credit cards, the proportion of clients who can’t repay what they owe is expected to be higher, “and our reserves mirror that,” Mr. Bolger said.

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