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Two major Canadian banks are once again building reserves to guard against loan defaults as uncertainty mounts about the prospects of an economic downturn, with Royal Bank of Canada CEO Dave McKay warning that “the end of an economic cycle” is getting nearer.

RBC’s RY-T third-quarter profit fell 17 per cent, hampered by rising loan loss provisions and unusually weak results from capital markets. Those headwinds undercut otherwise encouraging growth in personal and commercial loan balances and expanding profit margins.

National Bank of Canada fared better in the fiscal third quarter, with profit dipping just 2 per cent year over year as resilient results from retail banking and financial markets helped the bank match analysts’ expectations.

With inflation persistently high, strained supply chains, global tensions stemming from the war in Ukraine and tight labour markets, the headwinds threatening economic growth are getting more menacing. And though Mr. McKay told analysts on a Wednesday conference call that inflationary pressures “appear to be peaking,” he said he expects central banks will continue to be aggressive in raising interest rates.

“This pushes us even closer towards the end of an economic cycle,” Mr. McKay said, though he played down the chances of a severe downturn, as most clients appear to be in relatively good financial shape.

For the foreseeable future, “the operating word is uncertainty,” he added. “I can’t honestly sit here and predict how things are going to play out. No one can. Markets can’t, that’s why markets are volatile right now. This is new territory that we’re treading.”

That is a key reason why both banks increased their provisions for credit losses – the funds banks set aside to cover loans that may go sour in future. The buildup in provisions took a bite out of quarterly profits. But it was driven mostly by weakening economic forecasts, which suggest that more of the banks’ loans that are currently being repaid could turn sour in future. Actual delinquent loans remained very low by historical standards, with no clear signs of stress apparent in mortgages, commercial or personal lending.

RBC set aside $340-million of provisions, of which $177-million was earmarked against performing loans. And National Bank took $57-million of new provisions, including $33-million for loans currently in good standing. That signals the end of a year-long period in which banks mostly recovered loan loss reserves stockpiled early in the COVID-19 pandemic, which temporarily inflated profits.

National Bank chief executive officer Laurent Ferreira said the bank’s base assumptions do not include a recession or a severe spike in loan defaults, given low levels of unemployment and high rates of savings held by clients. “My best guess or expectation at this point is that we just go back to regular [levels of] provisions that we had prepandemic,” he said in an interview.

In the three months that ended July 31, RBC earned $3.58-billion, or $2.51 per share, compared with $4.3-billion, or $2.97 per share, in the same quarter last year. On an adjusted basis, RBC said it earned $2.55 per share, while analysts expected $2.66 per share, according to Refinitiv.

In the same period, National Bank earned $826-million, or $2.35 per share – equal to analysts’ consensus estimate – compared with $839-million, or $2.36 per share, a year earlier.

Investors punished banks that missed the mark. Shares in RBC fell 2.6 per cent to $123.20 on Wednesday, while National Bank stock lost 0.9 per cent after meeting expectations, closing at $91.46 on the Toronto Stock Exchange. Bank of Nova Scotia BNS-T shares dipped 2 per cent lower the same day after falling 5.3 per cent on Tuesday, when the bank reported mixed results.

Capital markets earnings were a weak point at RBC, which was expected after a quiet quarter for equity and debt issuance and a downturn in markets. Profit of $479-million was down 58 per cent, made worse by $385-million in loan underwriting markdowns related to the bank’s participation in leveraged loan syndicates. Even excluding those markdowns, RBC’s corporate and investment banking revenue fell 49 per cent, as equity and debt origination as well as loan syndication activity slowed dramatically.

National Bank’s NA-T financial markets division, which doesn’t have the same exposure to U.S. capital markets as its peers, fared better, with earnings of $280-million, up 12 per cent year over year.

Stronger results from the bank’s core retail banking operations, which focus on personal and commercial customers, have been a silver lining for third-quarter earnings. Profit from RBC’s personal and commercial division fell 4 per cent to $2-billion, but the drop was driven mostly by rising loan loss provisions. Core metrics looked more impressive: Revenue rose 11 per cent from a year earlier, average loan balances increased 10 per cent, and profit margins on lending expanded rapidly with help from rising interest rates.

At National Bank, retail banking profit increased 11 per cent to $335-million, with revenue up 13 per cent.

Both banks expect margins will continue to improve, though demand for new loans may cool as borrowing costs go up.

“That’s what the central banks are hoping to achieve, to slow that demand, so we do expect that the loan growth will taper as a result of that,” Nadine Ahn, RBC’s chief financial officer, said in an interview.

Executives at RBC and National Bank are also watching trends in mortgages closely as housing prices cool and borrowing costs jump higher. But neither is expecting significant losses unless unemployment rates spike.

For most mortgages – even those with variable rates – monthly payments don’t change until they come up for renewal. At RBC, more than two-thirds of its clients’ mortgage terms aren’t due to renew until 2025 or later, while at National Bank, fewer than a third of mortgages carry a variable rate.

Over the next couple of years, “we don’t see much risk at all,” said Neil McLaughlin, RBC’s head of personal and commercial banking. With financial models, “we can see [our clients’] capacity, their ability to absorb those incremental interest costs.”

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