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Bank towers in Toronto's financial districtMark Blinch

Canadian banks may be on track for higher earnings and valuations thanks to reduced provisions for troubled loans.

In a report titled "The New Golden Age of Canadian Banking," analyst Peter Rozenberg, of UBS Securities Canada Inc., says a dividend boost could be on the horizon, led by National Bank of Canada and Royal Bank of Canada .

"Are Canadian banks smarter? Perhaps, but the main point is that the economic backdrop is better, the competitive environment is better, bank regulation is stronger, and asset mix has significantly improved over time resulting in lower average [provisions for credit losses]" he wrote in a report published Wednesday.

Canada's six major banks will continue to be very cautious about raising their payouts to shareholders in light of continued economic concerns and worries over liquidity and regulation. But the combination of strong capital and lower than average growth could produce dividend hikes by the second half of fiscal 2010, he speculated. The last round of increases occurred in 2007 and 2008.

Earlier this week, the head of the Canadian Imperial Bank of Commerce also indicated that bad loans could be in decline. The bank, which is considered to have the industry's biggest exposure to credit card loans, said Canada's credit card industry could see losses slow in the coming months.

"If Canadian unemployment peaks shortly, and starts to decline - and at the same time the economy performs reasonably - the probability these portfolios will continue to grow and [we]will see a drop off in loss rates is significant," Gerry McCaughey, chief executive officer of CIBC, told investors in Montreal on Tuesday.

Regulations stipulate that the banks set aside a certain amount of money to cover their risks. The Tier 1 ratio must be above 7 per cent, a figure that Canada's top banks have now exceeded.

Mr. Rozenberg estimates that the banks will hold $15.7-billion in excess capital next year, at a Tier 1 of 10 per cent. That figure will likely grow to 13.6 per cent in fiscal 2012, with excess capital of $40-billion, or 15 per cent of market capitalization.

While all of the big banks have raised capital to boost their ratios well above the minimum level, too much capital can depress profitability. That means once the economy is clearly on the mend, they will need to find ways to put the money to work.

Mr. Rozenberg expects the banks will eventually use that money to increase dividend payments and share buybacks as well as to acquire other companies.

The analyst has "buy" recommendations on Bank of Nova Scotia and CIBC and "neutral" ratings on the other four leading banks. Bank of Nova Scotia ranks as one of UBS's most preferred global bank stocks, in part because of its long-term growth potential in emerging markets.

CIBC is a pick because of its low valuation, high returns, strong capital and leverage to declining provisions for credit losses, particularly for high-value credit card loans, Mr. Rozenberg said.

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