Why confidence in Canada's banks won’t fade soon

Financial sector specialist says earnings announcements contained few surprises, though headwinds and uncertainties remain

Why confidence in Canada's banks won’t fade soon

Given the historical stability of Canada’s financial sector as well as the outperformance of bank stocks over the course of 2021, there was a lot of expectation preceding last week’s earnings announcements. By and large, investors got what they expected.

“There weren’t many surprises from the big banks during earnings results last week,” Carl De Souza, senior vice president of the Banking, North American Financial Institutions Group at DBRS Morningstar, told Wealth Professional.

As De Souza noted, the continued moderation of capital markets activities from their highs in H1 2021 weighed somewhat on the banks’ results. They also faced margin pressures from increased costs, primarily from higher variable compensation costs; all together, Canada’s six largest lenders set aside nearly $20 billion for performance-based compensation in their 2021 fiscal year. Aside from that, there was the spending on strategic and business growth initiatives, which increased their efficiency ratios by 390 basis points on average during the most recent quarter.

On the positive side, continued reversals on provisions for credit losses due to improving macroeconomic outlooks brought a boost to earnings. The other story of the quarter centred around capital management activities, particularly as the Office of the Superintendent of Financial Institutions (OSFI) lifted restrictions on dividends and share buybacks that were put in place at the onset of the pandemic.

“The banks were very active in this area, as everyone expected,” De Souza said. “They raised dividends by an average of 15%, and announced planned share buybacks ranging from about 2% to 3.5% of their common shares outstanding.”

From a bottom-up perspective, he said Canadian banks’ diversified platforms have been a valuable source of strength. Aside from having strong positions in the domestic market, they tend to have strong businesses internationally, whether in the Caribbean, the U.S., or Latin America. TD and BMO, he noted, have both seen higher yields on their large business presence in the U.S.

With the persistently high and record levels of headline inflation seen in recent months, the impact of rising rates represented a burning question for many bank watchers. Generally, De Souza said banks do well when rates rise as their balance sheets are asset-sensitive.

“However, they’ll want to avoid shocks from large and rapid interest rate increases,” he cautioned. “That’s particularly true in Canada, considering the high household debt levels and elevated housing market.”

A recent trend of consumers piling into variable-rate mortgages has raised the stakes on that front. With the widened spreads on borrowing costs between variable and fixed mortgages, consumers have been taking advantage of much lower rates at the variable level. But as some economists at the big banks themselves have warned, those borrowers may be in for a painful reckoning four to five years down the line when their rates have to be renewed.

The still-evolving situation from COVID represents another risk. The recent emergence of the Omicron variant stirred up considerable volatility in the markets, which has since settled somewhat as the symptoms presenting among the infected appeared to be on the milder side.

“The banks are cautiously optimistic. However, there’s definitely headwinds and uncertainties presented by the emergence of this new variant and others that may come down the pipeline in the future,” De Souza said.

A look at the large lenders’ asset quality shows how they’re navigating between confidence and pessimism going into 2022. While their provisions for credit losses and gross impairments are at a low level following the recent declining trend, they’re still just shy of 30% higher than they were pre-pandemic on aggregate. But given the aforementioned risks from rising interest rates and margin pressures, De Souza would like to see the Big Six take the extra step of diversifying their lending portfolios away from residential mortgages.

“Residential mortgage lending volumes have been strong, so it’s to be expected that those volumes will somewhat moderate,” he said. “We’ve seen a bit of a turn in the most recent Q4 results, but non-residential mortgage lending volumes are still far below pre-pandemic levels.”

One lingering question mark hanging over financial institutions comes from an election pledge by Prime Minister Justin Trudeau to impose a tax on Canada’s large financial institutions, which have weathered the pandemic crisis better than many other economic sectors.

Now on his third term and faced with large deficits from pandemic spending, there’s a chance he’ll follow through on his promise. Still, some have raised concerns over whether it’s fair to target a tax toward one specific sector, as well as its potential ramifications with respect to foreign investment into the country.

“The details and timing of that are still not finalized, so it would be hard to predict its impact on fiscal 2022 earnings at this point,” De Souza said. “If the federal government does end up implementing it in Q2 or Q3 and when all the details come out, I’m sure the banks will look at all the strategies they have available.”