For more than a year, Canadian banks and financial experts have warned that the quarterly profits of the Big Five would take a hit because of an economic slowdown, a real estate downturn and a clampdown on consumer lending.
But so far, they have been wrong: Bank bottom lines have grown by hundreds of millions of dollars each quarter. Scotiabank wrapped up first-quarter earnings season for Canada’s big banks Tuesday by joining its peers in beating analyst expectations and hiking its dividend, underscoring how profit growth persists even as signs point toward an increasingly fragile economic climate.
During the final three months of 2012, the first quarter of the banks’ fiscal year, economic growth ground nearly to a standstill. Banking analysts set expectations low, figuring that an exhausted housing market would reduce mortgage lending, while record levels of consumer debt would lead to more loan defaults. An impact on the domestic banking business was inevitable, they thought.
Instead, Canada’s big banks have posted hefty profits that soared past analysts’ expectations. Many boosted their dividends.
Story continues below slideshow
At Royal Bank of Canada, the largest Canadian bank and one considered a bellwether for the rest of the sector, the personal and commercial banking segment earned a record $1.1 billion, up 11 per cent from the same quarter last year, “with particular strength in personal and business deposits and residential mortgages” – the very segment expected to post declines.
Are industry insiders crying wolf? Are they suffering premature pessimism, perhaps? Or is it, as one analyst suggests, a case of setting the bar low to make results appear more impressive?
Brad Smith, a banking analyst at independent investment firm Stonecap Securities, predicted before earnings came out that his competitors’ projections would turn out to have been extremely low.
So when banks beat those expectations, he wasn’t surprised.
“I think it’s a real mistake to underestimate the ability of large organizations like domestic banks to produce earnings long after most people would think it was possible, because they have a lot of levers to pull in these organizations,” he said.
Predictions of slowing consumer loan growth did come true, but banks were able to make it up in other segments such as business lending and through cost-cutting. In addition, provisions for credit losses – the money needed to cover bad loans – fell as fewer consumers defaulted on loans.
Those were among some of the positive developments that took analysts – and potentially banks themselves – by surprise.
Their gloomy outlook was not unwarranted. For the past several quarters, bank CEOs have been warning investors of challenging times ahead as consumers become tapped out. Credit rating agency Moody’s Investor Services downgraded the ratings of several of the country’s largest banks in January, citing high housing prices and record levels of consumer debt that leave banks vulnerable.
Influential banking analyst John Aiken of Barclays Capital has cut his ratings for five Canadian banks since August over their exposure to a slowing Canadian economy.
Like many analysts, he set expectations low for this quarter.
“How surprised am I that I’m wrong? Not very,” he said after digesting results from four of Canada’s largest banks.
Still, he maintains his outlook for slower growth ahead, though he believes profits this year will be slightly better than he had earlier anticipated.
“This was a bit of a positive blip.”
The Street was caught off guard by the drop in provisions for credit losses, given prevalent challenging economic conditions.
“They were putting up less money for bad loans this quarter, which by and large was a surprise for the Street, because you’d expect in this environment for loan growth to slow – you’d start to see not improving credit, which is what we saw this quarter,” Aiken said.
Low interest rates are helping to keep some at-risk borrowers afloat because it makes the cost of carrying credit cheaper, which means people can carry their debt loads without defaulting longer than expected. But as the government has repeatedly warned, when interest rates inevitably rise, some of the most indebted consumers could find themselves under water.
Analysts still expect a slowdown; they feel they were just premature on the timing.
Since the recession, the banks’ average annual income growth has been about 20 per cent. But this year, consensus estimates peg annual growth at just four per cent. A sluggish Canadian economy is to blame.
There are enough indications that the economy is slowing. Just last week data showed economic growth was only 0.6 per cent in the fourth-quarter, and posted an outright decline in December. That is one of the reasons many analysts were surprised to see growth in lending revenue and domestic banking profits.
At Bank of Montreal, Canadian loans were up nine per cent from last year and CEO Bill Downe noted that the uptick was “against the backdrop of a cooling housing market in Canada, moderate consumer spending and continued government restraint.”
Still, “there is no question that the Canadian banking industry is facing slightly slower growth as a result of slower mortgage demand,” RBC CEO Gord Nixon said on a conference call with investors.
Over the weekend, BMO decided to reintroduce a record low five-year lending rate of 2.99 per cent in an apparent attempt to lure consumers into the mortgage market. That sparked Finance Minister Jim Flaherty — who has made several moves to intentionally cool the housing market — to promptly warn other banks to stay away from mortgage wars.
“My expectation is that banks will engage in prudent lending – not the type of ‘race to the bottom’ practices that led to a mortgage crisis in the United States,” Flaherty said in a statement to The Globe and Mail.
During the most recent quarter, an increase in business borrowing, as companies grew slightly more confident about the state of the U.S. economy, helped to offset the decline in consumer lending. However, that offset would be tough to sustain if consumer lending were to drop off, because it makes up the majority of their loan portfolios.
“Say consumer lending grows by one per cent, you need business lending to grow by 15 per cent to even come close to offsetting that relative slowdown,” Smith said.
TD Bank CEO Ed Clark gave investors a similar warning during a conference call last week.
“With Canadian households deleveraging, consumer lending growth is slowing across the industry. Business lending growth remains strong, but this provides only a partial offset and the tailwind from credit is diminishing,” he said.
Many of the banks chopped expenses to help deliver growth. Smith questioned how much of that cost cutting was really just a deferral of costs to future quarters. That expense trimming will also make it difficult for the banks to replicate their first quarter results, because there’s only so much they can cut, he added.
“If any worries that we have about consumer and credit actually come to fruition, then you’re going to see a real pressure on earnings,” he said, adding that that would mean having to set aside more money to cover bad loans at “exactly the wrong time.”
Economist David Madani of Capital Economics believes the economy has turned toward slower growth, but because it’s just the beginning of a downward slope, some of the negative implications have yet to work their way through the economy, meaning a rise in debt defaults could still be on its way.
He predicts the country is in the first stage of a housing market correction that could see home prices fall by as much as 25 per cent over the next few years, which would lead to a big erosion in household wealth.
“I can understand people looking at the headlines and thinking, what’s the problem? Another record quarter, but the devil, of course, is always in the details,” he said.
“I wouldn’t look at a delinquency rate now and say this is going to tell me something about the future.… People often point to some of these rates and think ‘you know, what's the problem?’ but that’s how you end up getting blindsided.”
That fear of being blindsided may help explain at least part of the reason banks and analysts are being so cautious about the consumer-lending sector and why they are likely to make the same predictions in the coming quarters.
The global economy is still living in the shadow of the U.S. real estate crash that led to bank failures and a worldwide financial meltdown. The banks and analysts know all too well the implications of failing to heed warning signs in the mortgage market.