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Bank towers are shown from Bay Street in Toronto's financial district, on Wednesday, June 16, 2010. Despite concerns that the sluggish economy, tapped out borrowers and low interest rates could dampen the profitability of Canadian banks, the country's six biggest lenders earned a combined $34.88 billion in profits over the past year. THE CANADIAN PRESS/Adrien VeczanThe Canadian Press

Moody's Investors Service is sticking with its "negative" outlook for Canadian banks in 2016, pointing to challenges emanating from the struggling Canadian economy and a changing regulatory framework in the financial sector – even as the big banks continue to diversify abroad.

In its outlook, the credit rating agency pointed to Canada's high household debt, the vulnerability of consumers with credit card balances and auto loans in a deteriorating economy, and the possibility that the federal government will create a so-called bail-in regime to protect taxpayers if banks fail.

Although this marks the third consecutive year that Moody's has issued a negative outlook for the banks, this one stands out for its focus on asset risk, as the economy feels the impact of continuing low commodity prices. Moody's expects the Canadian economy will expand by just 1.8 per cent in 2016, up from an estimate of 1 per cent growth this year.

"It's not a huge thing. If it were only [asset risk], it would probably not be enough to tip the entire outlook into negative," said David Beattie, senior vice-president of the financial institutions group at Moody's. "But combined with the probable reduction in government support, that certainly does leave it firmly in negative."

Even with the negative outlook, Moody's has awarded the big banks some of its top credit ratings. The baseline credit assumption for Toronto-Dominion Bank is just three notches from the highest-quality debt. Bank of Nova Scotia is a notch below TD, followed another notch down by Canadian Imperial Bank of Commerce, Bank of Montreal and Royal Bank of Canada.

In other words, the negative outlook is applied to a relatively high level for the sector over all – and at a time when many of the banks have been making efforts to diversify beyond the Canadian economy.

Scotiabank has been adding financial assets in Latin America, Bank of Montreal recently acquired GE Capital's transportation finance unit, which is focused on the U.S. commercial truck and trailer segment, and RBC completed its $5-billion (U.S.) acquisition of Los Angeles-based City National Corp. in November, which is seen as a springboard for additional expansion into the United States.

But Mr. Beattie noted that diversification is not necessarily a good move for bondholders, and therefore credit ratings, because it risks diluting the banks' strong Canadian-based personal and commercial operations that generate the bulk of their profits.

"Being a Canadian bank, it's an oligopoly, it's very positive," he said. "It's very hard to improve your credit profile by diversifying away from your strength."

He added that the U.S. regional markets in which RBC, Bank of Montreal and TD now operate are very competitive, with profitability ratios trailing domestic personal and commercial operations by a considerable margin.

"There could be scenarios under which being strictly Canadian would be detrimental relative to other banks if their offshore markets are performing well and Canada is not," Mr. Beattie said. "But if I had to choose international diversification versus concentration in Canada, I think most of the time I'd be happier focusing on Canada."

Follow David Berman on Twitter: @dberman_ROBOpens in a new window

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