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Credit-rating agencies are keeping a watchful eye on Canadian banks' commercial-loan books after eight straight years of rapid growth.

Commercial lending has been an increasingly important source of new revenue for the banks as rising interest rates and stricter mortgage rules have led to slower growth in consumer borrowing. Last year, commercial lending by the Big Six banks rose by an average of 10.7 per cent, the largest increase since 2012, according to data from Scotia Capital Inc.

When DRBS Ltd. published its 2019 outlook for the banking sector this week, the agency highlighted fast growth in those portfolios as a potential vulnerability for banks down the road. As the current economic cycle enters its later stages, and fears of a looming downturn linger, some analysts worry newer loans could be crafted with looser standards, making them more prone to turn sour should employment and economic growth falter.

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“We’re keeping a close eye on it,” said Robert Colangelo, senior vice-president covering financial institutions at DBRS. So far, the commercial loan books at Canada’s largest banks appear healthy, he said. But as competition intensifies – from large U.S. institutions and non-bank lenders as well as domestic peers – Mr. Colangelo worries that banks could start taking on less creditworthy borrowers or relaxing debt covenants.

“That would obviously be a concern for us,” he said. Although over-leveraged consumers are most often cited as posing a threat to economic stability, a sharp rise in corporate borrowing can also be risky, Mr. Colangelo said. “We shouldn’t dismiss the fact that corporate borrowers are borrowing more, because we are seeing some risks to the economic outlook."

At Moody’s Investors Service Inc., senior vice-president David Beattie is similarly wary. “The obvious concern is that high growth masks underlying problems, particularly in benign periods in the credit cycle,” he said. “We’re 10 years into the credit cycle, it’s long in the tooth, we know things are going to turn at some point.”

Spotting that inflection point can be challenging. Although credit-rating agencies are privy to some privileged information, they still rely heavily on public disclosures and comments made by executives for signals about the health of loan portfolios. And bankers are prone to saying that they have seen peers in the sector loosening standards on pricing and covenants for new loans, without naming names, while insisting that their own parameters remain sacrosanct. Late last year, Teri Currie, the head of Canadian personal banking at Toronto-Dominion Bank, said TD has been walking away from some loans as competitors offered “a pricing dynamic in some cases that we aren’t willing to match from an economic standpoint and some covenants that don’t meet our risk appetite."

When the heads of Canada’s big banks gathered at a Toronto conference in early January, watched closely by credit analysts, most of the chief executives said they expect commercial lending to keep growing at a rapid clip through 2019. “A lot will depend on confidence,” said TD CEO Bharat Masrani, citing continuing uncertainty over oil prices and trade negotiations. “But based on what we see today, we’re still positive on the commercial bank volumes."

There are mitigating factors that give comfort to lenders and investors alike, however. Commercial loans tend to be better secured – by a company’s inventory, equipment or other assets – than most personal loans, aside from mortgages, giving banks some recourse in case of defaults. And commercial-banking customers often need other services ranging from cash management and foreign exchange to personal wealth management, which helps bolster the profitability of those relationships for banks.

“So long as those [commercial] deals are priced right and structured right, they’re not going to be the sources of big incremental losses in a downturn,” Mr. Beattie said. “But if everybody’s piling into the sector because they feel that that’s their best source of earnings growth, given the mortgage growth slowdown, then you get deterioration in terms, security, [and] pricing. And then the loss [resulting from] default starts getting higher.”

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