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The country’s largest bank reported fourth-quarter profit of $3.9-billion on Wednesday.Andrew Vaughan/The Canadian Press

Royal Bank of Canada RY-T is adopting a cautious stance after profit levelled off at the end of its fiscal year, taking measures to stockpile capital and rein in expenses as rising credit losses, labour costs and persistent economic uncertainty put pressure on its core operations.

The country’s largest bank reported fourth-quarter profit of $3.9-billion on Wednesday, which was roughly unchanged from a year earlier. Rising interest rates have provided a tailwind for RBC, boosting profit margins on loans. One day earlier, the bank announced a landmark deal to buy HSBC Bank Canada for $13.5-billion that promises to add to its leading share of Canada’s highly concentrated banking industry.

But chief executive officer Dave McKay warned that there are still several warning signs in the economy, such as high housing and energy prices, political instability and strain on manufacturing. With a potential recession on the horizon, and inflation, as well as labour-market pressures, driving costs higher, “there’s a higher level of uncertainty and therefore you have higher tail risk right now,” Mr. McKay said.

To pay the steep price for HSBC Canada, RBC is preparing to reach deep into its capital reserves, which serve as its strongest defence against economic shocks. On Wednesday, the bank announced measures to help rebuild its capital over the next year, while it works to close the deal. The bank implemented a 2-per-cent discount on a dividend reinvestment plan, which should generate $2-billion in capital, and is pausing share buybacks until the deal closes.

The bank expects that will ensure its common equity Tier 1 ratio is still at nearly 12 per cent even when the deal closes. The CET1 ratio is a key measure of the bank’s capital strength, and at almost 12 per cent it would be well above regulatory minimums even after the bank pays cash for the largest transaction in its history.

“We’re just being conservative in building a buffer against the uncertainty out there that we all face,” Mr. McKay said.

RBC earned $3.88-billion or $2.74 a share in the quarter that ended Oct. 31. That compared with $3.89-billion or $2.68 in the same quarter last year. On an adjusted basis, RBC said it earned $2.78 a share, above analysts’ consensus estimate of $2.69, according to Refinitiv.

At Montreal-based rival National Bank of Canada, fourth-quarter profit fell 4 per cent even as its lending margins also benefitted from rising interest rates. CEO Laurent Ferreira told analysts on Wednesday that economic indicators “are moving in the right direction,” but that his bank is nonetheless keeping “a defensive positioning.”

In an interview, he said he is watching central banks’ tone on monetary policy, and keeping an eye on whether commercial banking clients are hiring, tapping credit lines and building inventory. He also pointed to the “payment shock” that homeowners will feel, mostly in the latter half of 2023 and through 2024, as mortgages come up for renewal and monthly payments reset at much higher interest rates.

The impact will be “quite substantial,” he said. “Everyone knows it. … The central bank knows it.”

For now, retail banking operations – including mortgage portfolios – are still a source of strength for the major banks, and improving profit margins on loans are an important buffer against economic headwinds. RBC expects its margins will continue to increase over the next year, but at a more moderate pace as it has started to hedge against an eventual decline in rates to more normal levels.

Quarterly profit from RBC’s personal and commercial banking division increased 5 per cent to $2.14-billion, and revenue was up 17 per cent. The division’s net interest margin – the difference between what it charges on loans and pays on deposits – increased by 10 basis points from the previous quarter, and 28 basis points year-over-year. (One hundred basis points equal one percentage point).

Lending also continued to rise despite a slowing economy. RBC’s personal and commercial loans were up 15 per cent, and mortgage balances increased by 9.8 per cent. But the profitability of those mortgages is being squeezed by intense competition in a slowing housing market.

Losses from defaulting loans are also slowly starting to tick higher. In the fourth quarter, RBC set aside $381-million of provisions for credit losses – the money banks set aside in case loans go bad. A year ago, the bank was still recovering provisions it had built up during the COVID-19 pandemic as it released reserves it no longer deemed necessary.

National Bank set aside $87-million in provisions, after recovering $41-million from its reserves in the same quarter last year. But that was mainly because its economic forecasts became more pessimistic, compelling the bank to set aside more money against loans that are still being repaid to comply with accounting rules.

Loss rates are still below prepandemic levels, and are expected to gradually climb higher over the coming year.

In the fiscal fourth quarter, National Bank earned $738-million or $2.08 a share, compared with $776-million or $2.19 a year earlier. On average, analysts were expecting earnings per share of $2.22.

Both banks raised their quarterly dividends: RBC’s payout rose 4 cents to $1.32 a share, and National Bank’s by 5 cents to 97 cents.