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Pedestrians walk past a Scotiabank branch on Bloor Street West in Toronto on April 16, 2020.

Fred Lum/The Globe and Mail

Bank of Nova Scotia’s profit plunged by 41 per cent in the second quarter as reserves to cover potential losses on loans soared to levels not seen even during the 2009 financial crisis – yet many investors still greeted the results as reassuring news.

Scotiabank was Canada’s first major lender to report earnings for the fiscal quarter that ended April 30, and though the novel coronavirus pandemic has battered its returns, they were better than anticipated. Canadian bank stocks surged higher after the release, rising 7.3 per cent at Scotiabank and 5 to 7 per cent at other major lenders on Tuesday.

The bank’s earnings are an early indicator of what losses Canada’s banks expect to swallow on loans as a result of the havoc wreaked by COVID-19 on the global economy. Scotiabank added nearly $1-billion to loan-loss reserves in the quarter, more than doubling total provisions to $1.85-billion, which was lower than the average estimate of $2.13-billion among Canadian analysts.

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For some investors, that was a welcome sign that banks’ eventual losses on loans could be manageable. Yet for others, the bank’s reserves for covering potential losses raised questions about whether Scotiabank’s forecasts are conservative enough, or whether the current provisions provide a full picture of losses to come.

“The truth is that none of us really knew what to expect," said Jim Shanahan, an analyst at Edward Jones & Co. "I think the market’s breathing a sigh of relief that the bank could absorb that [level of potential losses] and still be profitable.”

Scotiabank’s chief executive officer, Brian Porter, told analysts the bank is “appropriately reserved for potential credit losses," even as he expects the bank to add “very similar” levels of provisions again next quarter. Though Mr. Porter predicts some business activity “will snap back pretty quickly,” there is “structural damage to part of the economy,” especially in energy, hospitality and travel, and the full extent of that damage is not yet clear.

“This is not a garden-variety recession,” he said on a Tuesday conference call. “This is not a one-quarter or two-quarter event. The banking sector will be picking up broken eggshells for a number of quarters."

Scotiabank reported profit of $1.32-billion, or $1 per share, for the fiscal second quarter, which ended April 30. That compared with $2.26-billion, or $1.73 a share, in the same quarter last year.

Adjusting to exclude certain items, Scotiabank said it earned $1.04 per share, ahead of analysts’ average estimate of $1 per share on an adjusted basis, according to Refinitiv. The bank also held its dividend steady at 90 cents per share.

Later Tuesday afternoon, after financial markets closed, National Bank of Canada reported profit of $379-million, or $1.01 per share, down 32 per cent from $558-million, or $1.51 a share, a year earlier. That beat analysts’ estimate of 95 cents per share. But provisions for credit losses of $504-million increased nearly 500 per cent from $84-million a year earlier.

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Those provisions reflect “our most prudent estimate ahead of an uncertain macroeconomic outlook,” said Louis Vachon, National Bank’s CEO, in a statement. “At this point in time, the severity and duration of the COVID-19 pandemic and its impact on the economy are impossible to predict.”

At Scotiabank, provisions set aside to cover potential loan losses make up 1.19 per cent of its total loan book, nearly double the ratio from last quarter, and far exceed the peak loss ratio of 0.82 per cent that the bank recorded at the heights of the financial crisis of 2009.

The bulk of that increase is for performing loans that are still being paid back but could be at risk, which soared by 464 per cent to $976-million based on adjustments to models that predict losses. Those assumptions are growing more pessimistic because of rising unemployment and falling economic growth.

Provisions for loans that are currently impaired increased a comparatively modest 24 per cent to $870-million, eased in part by the deferrals the bank has granted on some loans.

Loan loss provisions will rise over the coming quarters as the bank continues to adjust its risk models, said John Aiken, an analyst at Barclays Capital Canada Inc., in an interview. This gradual approach appears to have been sanctioned by regulators, who are giving banks extra leeway to take allowances over several quarters while the economic outlook is still cloudy.

“There’s going to be large losses coming from this," he said. But if banks book all of that up front, "that is going to significantly erode capital, that is going to spook the markets, and confidence is a very tenuous thing at this stage in the game,” Mr. Aiken said.

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As expected, surging provisions for credit losses and large draws on corporate and commercial credit lines ate into the bank’s capital reserves. Scotiabank’s common equity Tier 1 (CET1) ratio – a key measure of a bank’s resilience – fell to 10.9 per cent from 11.4 per cent in the last quarter. That was lower than most analysts expected, but still well above the current 9-per-cent minimum set by Canada’s banking regulator.

Scotiabank has tested a wide range of recovery scenarios, including a prolonged recession, and “our capital ratio – as far as we can look forward today, and using the most conservative assumptions that we can imagine today – is in excess of 10 per cent in all these scenarios, quite comfortably,” said Raj Viswanathan, the bank’s chief financial officer.

Analysts are still trying to grasp the knock-on effects from payment deferrals on loans that banks have granted to hundreds of thousands of customers for up to six months. Scotiabank has given financial relief to more than 300,000 Canadian households on roughly $40-billion in loans, and processed two million applications for assistance on another $20-billion in loans from international clients, many of whom are in Mexico, Peru, Chile and Colombia.

Rising loan loss provisions also dented profits in Scotiabank’s core Canadian banking division, which fell 42 per cent to $477-million, and its international operations, where earnings fell 73 per cent to $173-million year over year.

With files from Mark Rendell

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