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TD's first-quarter profits were down slightly from the same period last yearSHANNON STAPLETON

Canada's two largest banks are seeing profits fall as their capital markets businesses feel the pinch of global economic uncertainty, most notably in Europe.

Both Royal Bank of Canada and Toronto-Dominion Bank reported first-quarter profits Thursday that were down slightly from the same period last year. The banks' earnings both dropped by roughly 5 per cent – to $1.86-billion and $1.48-billion respectively.

Still, the results were a relief for investors. Given the headwinds the banks are facing from low interest rates and volatile markets, analysts had actually expected a worse performance this quarter.

And both banks hiked their dividends, offering a sign they are comfortable their future profits will be resilient. Investors reacted favourably, sending shares of both companies up.

The core Canadian consumer and business lending operations of both banks posted solid growth, but their capital markets divisions reported significant profit declines compared with a year ago, when trading revenue soared amid uncertainty in Europe that ignited a frantic bond market. Since then capital markets revenue has fallen steadily.

"I still don't believe that we're in markets that could be even remotely described as normal," Mark Standish, RBC's co-chief executive officer of capital markets, told analysts on a conference call.

RBC was particularly exposed to the volatility, given its large capital markets business. That operation made $448-million, a drop of 30 per cent. The decline overshadowed record earnings for the Canadian retail banking business, which made $994-million, up 7 per cent.

The bank had previously told analysts what range of profits they could normally expect from activities such as trading, but Mr. Standish refused to give a range this time around. While there have been signs the market is improving, he suggested the environment simply remains too unpredictable.

RBC's $1.86-billion profit was equal to $1.21 a share, down from a profit of $1.95-billion, or $1.27, last year.

TD's earnings of $1.48-billion amounted to $1.55 a share, down from $1.56-billion, or $1.67, a year ago. Though TD's retail banking, wealth and insurance units reported higher earnings, profit at its capital markets division fell 17 per cent.

TD's results were also impacted by a number of one-time items, most significantly a litigation reserve that amounts to $171-million after tax, which TD is setting aside after it was ordered to pay $67-million for its role as a third-party bank in a $1.2-billion Ponzi scheme operated by Scott Rothstein, a disbarred Florida lawyer.

Despite the earnings drops, both TD and RBC kicked more money back to investors in the form of a dividend increase. TD raised its quarterly payout 5.9 per cent to 72 cents, while RBC announced a 6-per-cent hike to 57 cents.

TD CEO Ed Clark and RBC CEO Gord Nixon both said that they are feeling more optimistic about the markets and economy.

However, the banking sector is expected to see some challenges in the next year or two, as Canadians seek fewer loans while low interest rates squeeze profit margins.

"Our message is that the economy does feel a bit better, certainly the U.S. economy feels better and I think Europe has taken out a bit of the tail risk," Mr. Clark told analysts on a conference call.

Given that low interest rates appear to be here to stay for quite some time, Mr. Clark said he is operating on the premise that margins will be pressured. As a result, he's embarking on projects to permanently lower the cost structure of the bank. He added that TD will have to work hard to meet its goal of boosting annual profits by 7 to 10 per cent.

RBC is also seeing growth in consumer lending slow. "In terms of Canada, generally, clearly we are starting to see some slowdown of the consumer side," Mr. Nixon said.

Spurred in part by the low interest rates, Canadian consumers have racked up record high debt levels. There are fears that many borrowers are taking on more debt than they will be able to afford once interest rates rise, and both the federal Finance Minister and central bank governor have been warning consumers to rein in their debt loads.

As a result, bank executives say they are looking elsewhere for growth, and are putting new muscle into areas such as insurance. Mr. Nixon said there is also some momentum in business lending. "We're starting to see a pickup in commercial loan demand, which is a good thing, it's a sign that companies are investing," he said.