Moody's Investors Service has updated its stress tests on Canadian banks, given that crude-oil prices have fallen considerably lower than they were when Moody's last ran its tests in April, 2015.
Indeed, oil is below $30 (U.S.) a barrel, down from a high of nearly $60 in April, raising concerns about the potential damage inflicted on the big banks if energy companies default on loans and consumers in energy-producing provinces struggle to meet their own debt obligations.
The severe scenario is far more grim today than it was a year ago: Moody's now believes that under this scenario – which isn't pegged to any particular oil price – losses on residential mortgages would rise to 20 basis points (there are 100 basis points in a percentage point), up from just three basis points in last year's stress test.
Losses associated with personal loans and credit cards would also shoot higher, while the probability of default among energy companies would rise as credit ratings fall – inflicting considerable pain on bank capital.
Moody's estimates that the common equity tier 1 (CET1) ratios – a measure of capital levels watched closely by Canadian bank regulators – among some banks could fall below 9.5 per cent. In this case, Moody's said in its report, "we believe they might be required to take capital conservation measures, cut dividends, or raise additional equity."
The good news: Moody's believes that the severe stress scenario has a low probability of becoming reality.
But even a moderate stress-test scenario looks challenging for the banks as profits fall. According to Moody's, energy companies would take a two-notch downgrade to their median credit ratings and profits from the banks' capital markets would fall by 10 per cent.
"In this scenario, the majority of the banks would be able to absorb losses within one quarter of earnings or, assuming the current dividend payout ratio of 45 per cent, two quarters of retained earnings," Moody's said. "Moreover, since the provisioning for the stress losses will not occur in a single quarter, the banks will have longer than this to absorb any losses."
The big banks are set to report their fiscal first-quarter results starting on Tuesday.