“Our system is better,” Mark Carney said four years ago as the global economy convulsed. We declared our banks to be the envy of the world. We spoke endlessly of the restraint of Canadian financial institutions. But the time for self-congratulation could soon come to an end. Thanks to impending new regulations and a projected slowdown in consumer borrowing, Canada’s Big Six banks are about to encounter the abrupt end of a very profitable run.
Through the recession and its aftermath, Canada’s banks have defied gravity. Earnings have been virtually immune to global economic disorder. Credit the Canadian consumer. “Canada’s ability to outperform has relied on the strength of household demand, as consumers have held fast to the credit-financed spending patterns abandoned by their peers in the U.S. and Europe,” Moody’s said in a September report.
For several months now, industry analysts, ratings agencies and the banks themselves have been warning of risks to bank profitability. Yet 2012 was a blockbuster year. Royal Bank posted record profits of $7.5 billion. Bank of Nova Scotia’s earnings rose more than 20%. “Great year to be a bank shareholder,” says Peter Routledge, an analyst at National Bank Financial.
The Big Six banks largely beat analyst expectations last year through the willingness of Canadians to take on debt. “Borrowing to buy property has helped make Canadians some of the most leveraged consumers in the world,” The Wall Street Journal reported in November. In the third quarter, the ratio of household debt to disposable income rose to another record high of 165%, nearing the peak of U.S. borrowing prior to the financial crisis. “There are a growing number of households that are vulnerable,” Routledge says.
They will be much more vulnerable if the housing market contracts materially. Recent experience in the U.S. demonstrates that amid a substantial real estate correction, consumers borrow and spend less, and save more. That would not bode well for retail banking in Canada.
Even absent a housing crash, a moderate abatement of prices could provoke a phase of household deleveraging. Although Mark Carney has been unable to compel Canadians to stop borrowing as long as his interest rate policy encourages the opposite, credit growth has at least begun to slow. “It will be unpleasant,” Routledge says. “What comes next is either soft deleveraging, which would be great news. Or, it’s something more severe.” Even his preferred option would result in retail banking earnings growth at the Big Six to slow to 3.2% over the next two years, compared to 8.4% over the past two, he says. The banks with the greatest reliance on Canadian retail banking will fare the worst.
Over the past 15 years, Canadians have increased debt loads without interruption. “Things were so good for so long at home, a lot of (the banks) didn’t prepare for the growth problem in advance,” says Brad Smith, an analyst at Stonecap Securities.
CIBC and Royal Bank are particularly focused on Canada. Scotia, having expanded into Latin America, and TD and BMO, with operations in the United States, are somewhat insulated against a period of consumer debt reduction.
They are all, however, likely to get pinched by the next phase of Basel III regulatory reform. This year, all of the Big Six banks are likely to be designated systemically important to the domestic economy and face higher capital requirements as a result.
The changes will squeeze dividends, in addition to the emerging earnings pressure. “It will make dividend increases smaller, and some banks might space them out more,” Routledge says. This year, there doesn’t appear to be much to brag about.
Illustrations by Eva Vázquez.