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A Bank of Montreal location in Toronto.

Deborah Baic/The Globe and Mail

Canada's banks are feeling the sting of historic low interest rates more than ever.

Bank of Montreal reported a 41-per-cent increase in profit in the fourth quarter on Tuesday, which looked like a blockbuster finish to the year for Canada's fourth-largest bank. But as investors looked closer at the numbers, it became evident just how much of a toll low interest rates are taking on the bank.

BMO, which has been the most aggressive of the major banks in trying to bulk up its mortgage book in the past year, reported only marginal earnings growth from its Canadian banking operations, which are traditionally the profit-generating engine of the bank. Meanwhile profit fell at its U.S. retail banking operations.

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Fierce competition for mortgages and low interest rates has squeezed the margins for the banks, forcing them to scramble for ways to keep the profits growing at the high rate that investors have become accustomed to from Canadian banks.

"It's pretty simple, we need faster balance sheet growth," Frank Techar, BMO's president of the personal and commercial banking in Canada, told analysts on a conference call.

BMO reported a profit of $1.1-billion or $1.59 a share in the quarter. That compared with $768-million or $1.12 a year ago. But amid slimming retail bank margins, the bank had to rely heavily upon a sharp increase in capital markets earnings and significantly lower loan losses to drive its profit. Revenue rose 9 per cent to $4.18-billion.

To prevent margins from eroding further, BMO executives said the bank plans to work more aggressively to build the deposit side of its balance sheet. After competing fiercely over the past year to increase its loan book – including introducing record low rates on five-year fixed-rate mortgages this spring – BMO now needs more deposits on its books. For banks, deposits are crucial since they are the cheapest way to fund lending operations, and to increase profit margins.

BMO is now faced with loan growth rising at a faster rate than deposits. In the fourth quarter, mortgage growth was 9.4 per cent, while commercial loans grew 8.1 per cent. Commercial deposits grew just 6.2 per cent, the banks said.

To increase deposits, BMO may be forced to pay out more, which will eat into delicate margins in the short term.

"We are turning our attention to deposit growth," Mr. Techar said. "The single biggest opportunity we have to mitigate the pressure on margins at this point in time is to increase our retail deposit growth, and that's what we're going to be turning our attention to."

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"We're not expecting interest rates to change in the near term. We're going to continue to see pressure on deposit spreads going through 2013. And our biggest opportunity is to [get] the deposit side of the balance sheet growing faster."

The drop in margins in BMO's retail bank was a blemish on the quarter, analyst John Aiken of Barclays Capital said in a research note. "Margins were down sizably on both sides of the border, with positive loan growth in Canada, but continued declines in the U.S.," he wrote.

BMO's quarterly profit beat the market's expectations. Adjusted to exclude one-time items, BMO made $1.65 a share. On average, analysts were expecting earnings of $1.42 a share.

A major driver of the profit increase was a reduction in loan losses. Provisions for credit losses, or the money banks set aside to cover bad loans, dropped to $192-million in the quarter from $362-million a year ago.

For fiscal 2012, BMO made $4.2-billion, which was up 35 per cent from last year.

BMO's capital markets business made $293-million in the fourth quarter, more than doubling the $143-million it reported a year ago, as the bank saw higher trading revenues from a year ago, when that sector was in a slump.

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BMO's U.S. personal and commercial bank made $141-million, down from $171-million a year ago. The bank reported a number of one-time items associated with its purchase of U.S. bank Marshall & Ilsley last year, including $153-million worth of costs to integrate the business.

The Canadian retail banking operations made $446-million, up only slightly from the $439-million its branch operations reported a year ago. The bank was squeezed by smaller net interest margins, as competition for loans and deposits ate into profits.

BMO's private client group, which caters to wealthy customers, made $171-million, up from $143-million a year ago. The corporate services, technology and operations segment of the bank reported a $74-million profit, compared to a loss of $67-million last year. The bank said it laid off 700 full-time staff during the year to save costs.

BMO also announced plans to buy back up to 15 million common shares. After doubling the size of its U.S. operations last year with the purchase of M&I, the Canadian bank is planning a marketing blitz south of the border, BMO chief executive officer Bill Downe said. The strategy is part of the bank's plans to bring more deposits in the door.

"This month we're blanketing our U.S. footprint with some of the strongest advertising and promotion the bank has ever developed," Mr. Downe told analysts. BMO has more than 600 branches in the U.S. Midwest.

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