A necessary public-service announcement: No matter how horrendous they're made out to be, bad energy loans will not bankrupt Canadian banks. Enough with the hysteria.
Will there be blood? Absolutely. The energy crash has deservedly raised bank executives' collective blood pressure. But so far, it isn't proving to be nearly as troublesome for Big Six lenders as their telecom woes after the tech bubble burst, nor is it the global financial crisis all over again. Hallelujah.
And yet, investors and analysts have been obsessing about energy loan default rates for over a year – with the media admittedly stoking the fire. (Sorry about that!) From the jump, bank executives deployed dulcet tones, stressing the unlikelihood this latest downturn will turn into a train wreck. The implicit messages fired back at them: You must be spinning us.
No matter how much detail the banks provide – and some have been incredibly forthcoming – there always seems to be a new reason not to believe them. Early this year, when the price of Brent crude dropped below $30 (U.S.) a barrel, banks were thought to be too conservative with their loss-ratio assumptions; when the oil price rebounded this spring, National Bank of Canada's surprising $250-million (Canadian) loan-loss provision convinced some people the recovery wouldn't help lenders all that much.
As the energy industry's carnage drags on, there is bound to be more bad news to drown out the banks' promises. Don't ignore it by any means – just don't get too myopic, either. Now that four of Canada's largest lenders have reported second-quarter earnings, we've got pretty good proof they weren't lying when they said they would probably be all right. (Worth noting: The two banks yet to report, Bank of Nova Scotia and National Bank of Canada, have some of the highest exposure to energy, but even bigger losses this quarter shouldn't change the longer-term narrative.)
Provisions for credit losses, or money set aside to cover bad loans, are mostly hovering around 40 basis points, or 0.4 per cent, of all outstanding loans. That figure can seem spooky, because only a few quarters ago, Royal Bank of Canada's provisions were as low as 23 basis points. But RBC long stressed its provisions were at record lows. A few quarters back, chief financial officer Janice Fukakusa went so far as to admit her team went through the books several times to make sure they were calculating things correctly, because they were in that much disbelief.
A reversion to the long-term average of between 30 to 35 basis points was inevitable.
Comparisons with recent crises are also comforting. When telecom loans gave investors angina in 2001, the money banks set aside to cover credit losses spiked to an average of 1.2 per cent, or 120 basis points, of total loans – three times the current levels.
The severity of loan losses was also much worse then, too. Banks today are mostly projecting losses over two-year windows, whereas the telecom crash was so sudden that Toronto-Dominion Bank posted its first-ever full-year loss.
As for the global financial crisis, its pain was also more acute, with provisions for credit losses popping to an average of 90 basis points, or 0.9 per cent of all loans, during that epidemic.
What hurts Canada's banks now more than anything is uncertainty. There's an obvious irony here, because they've been so candid about their energy exposure, but they can't control how they account for loan losses. Big Six lenders are told to use 'just-in-time' reserves, which means they mark down new provisions only when they finally crop up.
Some banks are trying to skirt these rules by announcing expected losses. Canadian Imperial Bank of Commerce, one of the most open of the lenders, has said it expects roughly $650-million in total losses through the energy downturn – 75 per cent of which will come from business loans, the remaining quarter from related consumer bankruptcies and the like. Every percentage point increase in Alberta's unemployment rate is also expected to boost total loan losses by $100-million.
Despite this candour, CIBC and its peers are punished for their complexity. The diversity of their business lines helps them weather storms, because losses are spread over many different units – from trading revenue to wealth management fees. However, it also makes your head spin when digging through their financial information packages because there so many numbers to compute. Energy loans, by contrast, are very tangible things to wrap your head around.
No one should dismiss the threat energy loans pose. They may only make up 2 per cent of total loan books, on average, but they often comprise between 15 per cent and 18 per cent of capital. That's not chump change.
The market can also change in a heartbeat. Who knows what will happen with Iran's oil production hopes, or with Saudi Arabia's pending energy privatization.
It's time we had some real talk, though. The bigger issue for the banks is the likelihood of a slow-growth future. The lending boom is over, and no one can pinpoint where the next revenue wave will come from – though there is a lot riding on wealth management.
Anemic expansion is the real reason energy loans matter. If earnings per share are only growing by 5 per cent annually, losing half of it to provisions starts to hurt.