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Canadian bank earnings this quarter should be interesting. The negative balance sheet effects of the recent market decline are squaring off against the higher profits available from a steeper yield curve. The timing – the balance sheet effects will be felt immediately while higher net income will occur in the future – will make the results all the more interesting.
All Canadian banks hold mammoth portfolios of investments, largely fixed income, on their balance sheets as assets. For accounting purposes, these assets are classified in two ways; held for sale and held to maturity.
In the latter case, held to maturity, the holdings do not have to be marked to market – they are held on the balance sheet at book value.
The assets in the held for sale category however must be marked to market – their value changes with market price. And, since global bond markets have taken a major beating since May, the hit to bank balance sheets reported in the next earnings statement is likely to be severe.
To be clear, there is no threat to the solvency of Canadian banks. Their balance sheets remain in many ways the envy of the world. But even a small decrease in the size of bank balance sheets is significant to the overall economy. A smaller bank balance sheet reduces the ability of a bank to lend. Again, none of the Canadian banks is stretched to the point where it will have to call in loans as a result of mark-to-market losses. But, at the margin, they will be less inclined to lend, and this could have a chilling effect on credit expansion.
The positive side of the recent bond market upheaval is that new loans will be far more profitable than they were a year ago. The yield curve has steepened – the difference between short-term money market yields and ten-year bond yields has increased. This means that the banks' basic business of borrowing money at short-term rates and lending funds at long-term rates, will generate more profits.
Watching the banks navigate the more volatile market and economic backdrop will be fascinating, particularly at a time when mortgage rates are rising and Canadian households are already carrying record debt loads. They will be pulled in both directions – encouraged to lend less because of balance sheet issues and motivated to lend more because of higher margins.
They may really start earning their huge paycheques.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights , and follow Scott on Twitter at @SBarlow_ROB .
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Scott Barlow