Big Six banks are bracing for a negative credit cycle

Q3 earnings show banks in strong position, but expect earnings pressure ahead, says analyst

Big Six banks are bracing for a negative credit cycle

Last week, five of Canada’s Big Six banks fulfilled market expectations as their Q3 earnings announcements showed a defensive and conservative trend. And with macroeconomic indicators pointing to a slowdown at best and a recession at worst, the results haven’t exactly been surprising to one analyst.

“The banks have started taking increased reserves on their performing loans as a result of the deterioration in their macroeconomic forecasts,” says Carl De Souza, senior vice president of the Banking, North American Financial Institutions Group at DBRS Morningstar. “The banks have also started factoring in the possibility of a recession.”

The increases in loan provisions, which De Souza says are forward-looking, are prudent and necessary given the current climate of high inflation and rapid interest rate increases. From his perspective, the banks’ actions signal the start of a negative cycle in credit performance, with banks preparing for higher impairments and loan losses at the cost of reflecting reduced earnings on their income statements.

“The timing and amount of provisions taken are not necessarily consistent across the banks, as it depends on their business mixes, their individual macroeconomic forecasts, and any management adjustments made,” De Souza says.

On the aggregate, he says the Q3 earnings releases from the five banks that have reported earnings so far show increased provisions on their performing loans after several quarters of provision reversals going back to early fiscal 2021. CIBC was an outlier from that trend, he says, as it took provisions on performing loans in the prior quarter Q2 as the other banks halted provision reversals, making it the only bank among the five to report a reduction in total provisions this quarter.

Another overall trend that’s materialized, he says, are lower results in the banks’ capital markets businesses, which has been generally driven by lower underwriting and other advisory fees alongside lower trading revenue. The larger size of RBC’s capital markets business, he says, meant its earnings were more depressed relative to other banks in Q3.

“RBC will experience a little more volatility in its capital markets business, which could be positive or negative,” De Souza says. “In a positive time, when trading revenues are up and underwriting and advisory fees are hot, RBC would be an outlier to the positive relative to its Canadian peers.”

With the current macroeconomic uncertainty around inflation, interest rate increases, and potential recession, earnings could come under pressure in upcoming quarters. But as it stands, De Souza says Canadian banks are coming from a strong credit quality position to weather a looming negative credit cycle that includes risks from an economic downturn, decreasing home prices, and rising debt-servicing costs for individuals.

“The end effects of these headwinds are expected to impact banks’ credit quality in 2023,” he says. “They're starting from a position of strength in their balance sheet with very strong capital positions, with generally higher allowance for credit losses compared to pre-pandemic.

The last bank standing, BMO, will unveil its results tomorrow. De Souza will be closely listening for its disclosures on provisions on performing loans, and how its capital markets business has performed – will it be on trend relative to other banks, or will it be an outlier?

Beyond that, he’s keeping an ear out for news on the bank’s planned acquisition of Bank of the West, which was first announced in December last year. The Big Six bank reportedly expects the deal to bring 1.8 million new customers upon closing.

“BMO continues to work towards closing their planned acquisition,” De Souza says. “We’ll see if there are any expenses recorded related to the integration of that acquisition.”