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Canadian Banks Q1 2020 earnings: good start, before coronavirus hits

The six banks reported solid year over year growth of 10.5% and 7.7% quarter over qusrter growth, however DBRS Morningstar sees headwinds from the COVID-19 outbreak

Robert Colangelo, CPA, CA 9 March, 2020 | 12:04AM
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This strong start to F2020 Canadian banking was largely driven by record results in the capital markets businesses of these banks. The Canadian personal and commercial banking businesses of these banks saw more modest growth in aggregate compared to the linked quarter, while earnings in their U.S. and International businesses declined 10% in aggregate, primarily due to net interest margin compression. Operating expenses remain well managed and flat compared with the link quarter; however, expenses increased 3.5% compared with last year primarily reflecting the $339 million ($250 million after tax) restructuring charge recorded by CIBC in Q1 2020.

Exhibit 1

Aggregate loan growth was a healthy 6.3% compared with the same quarter last year and 2.8% sequentially. Commercial loan growth, while still strong, slowed to 9.0% YOY, which is below the double-digit growth rates the large Canadian banks saw through F2019. Q1 2020 also saw the return of solid growth in residential real estate-secured lending (RESL; includes mortgages and home equity lines of credit), which was up 5% on average compared with the prior year. In particular, RBC and BNS saw strong growth of 7% and 6% YOY, respectively. Several other banks indicated their desire to increase their market share in RESL through F2020. Credit quality remains sound as aggregate PCL was up a modest 3% sequentially, although we expected PCL to build in F2020 as credit trends normalize.

Despite the strong earnings growth the large Canadian banks experienced in Q1 2020, given increasing economic uncertainty, particularly due to the impact of the coronavirus, we expect earnings growth to moderate in F2020. Indeed, net interest margin (NIM) pressure and higher PCL are likely headwinds. Nonetheless, the large Canadian banks are well positioned to navigate these uncertainties, given their highly diversified core earnings power and demonstrated abilities to manage expenses. Overall, the large Canadian banks remain committed to improving efficiency during a period of constrained revenue growth. Additionally, lower mortgage rates may boost residential lending in both Canada and the U.S.

COVID-19 impacts being determined, but banks well-positioned
While the large banks indicated that it was too early to tell what the impacts may be from the coronavirus outbreak, we expect that it will present a challenge to global economic growth, most immediately in China (see DBRS Morningstar's Coronavirus: Growing Policy Efforts But No Respite Yet commentary published on February 21, 2020). The longer this outbreak lasts, the deeper the impact it will have on economic activity, Already global supply chains are being disrupted and sectors such as manufacturing, oil and gas, agriculture, mining, and forestry appear vulnerable. The six large Canadian banks have relatively modest direct exposures to the various industry sectors that we believe could be impacted by the virus outbreak (see Exhibit 2). Overall, these exposures represent approximately 12% of aggregate total loans and acceptances. An additional sector that is likely to be adversely affected is hospitality and leisure; however, only BMO and BNS provide their exposures to this sector, which are very manageable at 2.4% and 0.7%, respectively, of total loans and acceptances. 

Exhibit 2

The coronavirus outbreak has also prompted the U.S. Federal Reserve (U.S. Fed) and the Bank of Canada (BoC) to cut their benchmark rates in emergency moves aimed to offset some of these impacts. On March 3, 2020, the U.S. Fed cut rates by 50 basis points (bps), while the BoC followed up with a 50 bps rate cut of its own on March 4, 2020. Both central banks cited material negative shocks that could be felt by Canada and the U.S. given a weakening global outlook as a result of the coronavirus impact. Business activity in some regions impacted by the outbreak has fallen sharply and the central banks believe that business and consumer confidence will deteriorate, which will thereby further depress global economic activity. 

Record capital markets performance lifts overall earnings
In Q1 2020, most of the large Canadian banks saw their capital markets businesses post record earnings, with RBC posting a record $882 million in this business segment, which was up 51% compared to the linked quarter (see Exhibit 3). Aggregate capital markets-related revenue (CMRR) was up 23.5% QOQ to $6.5 billion largely due to strong trading revenue, and higher debt and equity underwriting and mergers and acquisitions (M&A) activities.

Exhibit 3

Despite the pick-up in CMRR, DBRS Morningstar expects the capital markets businesses of these banks to face headwinds given economic uncertainty. Additionally, markets have been volatile since the large Canadian banks reported earnings, which has resulted in a decline in primary market origination activity and M&A due to the uncertainty and disruption in the markets. Conversely, this market volatility could be beneficial for the banks' trading revenue.

NIM remains compressed, latest rate cuts to compound issues
The large Canadian banks NIMs continued to remain under pressure with the NIM declining by an average of 2 bps compared with the linked quarter (see Exhibit 4). The U.S. and International retail business of these banks saw further compression, with NIMs decreasing by 6 bps sequentially, while the Canadian retail businesses saw compression of 2 basis points. Overall, the compression experienced in Q1 2020 was in line with guidance the large Canadian banks had provided at the end of 2019 for compression of between 1 bp to 2 bps.

Exhibit 4

The latest U.S. Fed and BoC cuts will continue to pressure NIMs at these banks and is likely to negatively impact net interest income earned by these banks. Given the challenging environment, DBRS Morningstar expects NIMs to remain pressured for the balance of F2020.

PCL was mixed, but overall credit quality remains sound
In Q1 2020, aggregate PCL was up a modest 3% compared with the linked quarter, which is in stark contrast to the 17% rise reported by these banks in Q4 2019 (see Exhibit 5). This quarter, PCL on performing loans decreased 36% QOQ and represented 7.6% of total PCL, which is lower than the 11.6% in Q4 2019 as most of the banks had made unfavourable changes to certain economic indicators in Q4 2019. Conversely, PCL on impaired loans increased a modest 1.5% sequentially. BNS also added an additional, more severe pessimistic scenario to its allowance for credit losses methodology, resulting in an additional $155 million of PCL. Overall, aggregate PCL as a percentage of total loans and acceptances was flat QOQ at 0.37%.

On an individual bank basis, PCL was mixed (see Exhibit 6). RBC and CIBC saw their PCL ratios on impaired loans decline by 6 bps and 9 bps, respectively, compared with the linked quarter. This contrasts with BMO where the PCL ratio on impaired loans rose 8 bps QOQ, while the PCL ratios at the other banks remained relatively flat. Moreover, while most banks recorded PCL on performing loans, BNS was the only bank to report recoveries in this category during the quarter.

Gross impaired loans (GIL) were flat at $16.3 billion compared with the linked quarter, while they were up a modest 1.8% compared with the same quarter in the prior year (see Exhibit 5). BMO and TD saw the largest increases sequentially in GIL at 7.3% and 5.8%, respectively. These increases were largely driven by higher impairments in their commercial loan portfolios, with new formations experienced particularly in the oil and gas, media, and manufacturing sectors. CIBC experienced modest growth in GIL of 1.8% while the other three large banks saw GIL decline compared with the linked quarter. Overall, the aggregate GIL ratio at 0.55% remains relatively stable compared with the linked quarter and within the tight range experienced over the last eight quarters (see Exhibit 5).

Exhibit 5

 

Exhibit 6
We expect any impact related to the coronavirus to manifest itself through the economic variables the large Canadian banks include in their IFRS 9 models. This will likely result in the banks recording higher PCL on performing loans. In addition, the large banks may also experience higher impairments particularly in those sectors we believe may be more susceptible to the coronavirus outbreak, which will result in higher PCLs on impaired loans. While we expect PCL to increase in F2020, we view the large Canadian banks as well positioned to absorb higher provisions as aggregate total PCL as a percentage of income before provisions and taxes (IBPT) was a manageable16.4% in Q1 2020, which was down from 17.0% in Q4 2019 (see Exhibit 7). 

Exhibit 7

Banks remain on track to meet TLAC

During the quarter, the large Canadian banks issued in aggregate $97 billion in bail-inable senior debt, as they work toward compliance with their total loss-absorbing capacity (TLAC) requirements. As a result, the aggregate TLAC risk-based ratio climbed 70 bps QOQ to 19.7% (see Exhibit 8), while the TLAC leverage-based ratio increased 20 bps sequentially to 6.3%. These compare favourably against the Office of the Superintendent of Financial Institutions minimums of 23.75% (including the increase to the Domestic Stability Buffer that becomes effective on April 30, 2020) and 6.75%, respectively. We note that National Bank's TLAC risk-based ratio rose this quarter to 23.1%, putting them just below the required minimum. We anticipate that the large Canadian banks will be TLAC-compliant well in advance of the November 1, 2021, date and estimate that the banks will need to issue an additional $83.5 billion in bail-inable senior debt in order to achieve this goal. 

Exhibit 8

Ratings on large Canadian banks
Our ratings and trends on the large Canadian banks are summarized in Exhibit 9 below. Currently, we have a Positive trend on National Bank’s Long-Term Issuer Rating based on its strong franchise momentum and consistent earnings growth, which signal an improving Intrinsic Assessment. 

Exhibit 9

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Robert Colangelo, CPA, CA  Robert Colangelo is Senior Vice President at Morningstar DBRS

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