A more dovish approach by central banks in the United States and here at home could be bad news for Canada’s major commercial lenders.
Canadian banks rode a wave of interest-rate hikes to higher profits in 2017 and 2018, in part because of gains in net interest income, generated by the spread between the higher rates they charge for loans and the lower rates they pay out on customer deposits.
But with the U.S. Federal Reserve under pressure to cut rates, and the Bank of Canada having backed off its hawkish stance, the banks could have a harder time increasing their net interest margins going forward, analysts say.
Barclays Capital analyst John Aiken wrote recently that the “ability for the banks to grind out mid-single digit earnings growth for the year could prove challenging,” and that a Bank of Canada rate-cut could hurt the outlook of lenders who are more exposed to the Canadian market.
“On the back of five BoC rate hikes, domestic margins were largely positive (for the banks’ second quarter), while lending volumes continued to moderate but remained positive,” Aiken wrote. “However, with the BoC in a holding pattern on future rate hikes and loan growth moderating, the outlook for net interest income remains tempered.”
The holding pattern could persist. The Bank of Canada is set to make another interest-rate announcement on Wednesday, which follows the news last week that the Canadian economy shed around 2,200 jobs in June (although the unemployment rate remained at a near-record low).
Big Canadian banks, however, have to worry about more than just the interest-rate moves of the Bank of Canada. A rate-cut by the U.S. Federal Reserve could affect their earnings as well, as lenders have had weaker earnings growth in their home market of late supplemented by stronger showings from their U.S. and international businesses. Moreover, the U.S. central bank has been pressured by President Donald Trump to cut rates.
A recent report from Citi Research said they were lowering their estimates for the Big Five Canadian banks’ earnings per share by between one and five per cent, partly driven “by a more cautious stance on margins.”
“On the back of stable rate outlook in Canada, we expect the banks to maintain their margins in domestic operations,” the Citi analysts wrote. “For the U.S. divisions, we incorporate moderate NIM (net interest margin) compression in 2019-21E.”
Any rate cut would be another headwind for lenders which have already had to grapple with sometimes-choppy capital markets conditions, new mortgage-underwriting rules that have weighed on loan growth and concerns around credit quality.
Despite those concerns, Canadian banks remain immensely profitable, and could adjust pricing to compensate for any change in interest rates.
A rate cut could also stoke housing market activity, according to Robert Colangelo, senior vice-president of Canadian banking financial institutions at ratings-agency DBRS, something that would work in the banks’ favour.
Colangelo said decisions to hold interest rates steady or to cut them further may not have a huge impact on earnings, even if it does compress net interest margins.
“On the flip side of that, it means that they would pay less on deposits,” Colangelo said. “So I think rather than an expanding net interest margin, we would expect it to remain relatively stable, if not compressed a bit. And I think, at the end of the day, the banks have weathered the low-interest-rate environment since the financial crisis quite well.”
Canadian lenders have offered guidance in the current environment that net interest margins will expand around one to two basis points per quarter, Colangelo said, which would change if there was a rate cut.
Net interest margin for the Canadian personal and commercial operations of Canada’s Big Six banks rose by an average in the second quarter (which ended April 30) of two basis points over the previous quarter, and by five points over a year earlier, according to a recent CIBC World Markets report.
“With peak margin expansion looking like a thing of F2018, loan growth slowing modestly, and loan losses moving higher, Canadian P&C Banking earnings growth was weak for a second consecutive quarter,” wrote analyst Robert Sedran.
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