CM - Navigating Risks: Earnings Round-Up For Canadian Banks
2023-06-20 08:52:00 ET
Summary
- How concerns about economic downturns are impacting Canadian banks.
- Why Canadian banks could face difficult quarters ahead.
- The potential risk from commercial property for Canadian banks.
Originally posted on June 15, 2023
Most Canadian banks reported quarterly results that missed analysts’ expectations. Mario Mendonca, Managing Director at TD Cowen, speaks with Kim Parlee about the challenges and opportunities for Canadian lenders and the outlook going forward.
Transcript
Kim Parlee: Mario, I want to jump right in and maybe if you could just give us an overview of what you saw thematically from all the banks in the second quarter. What caught your eye?
Mario Mendonca: Sure. Four of the big six missed earnings this quarter. That's unusual for our Canadian banks. Our estimates were a little lower than consensus going into the quarter, so we weren't terribly surprised by the miss. Some of the big themes that emerged that investors are all talking about, expenses were very elevated across several of our banks.
I really think that's something they can get under control. It's not something you can fix quickly unless you take a meaningful restructuring charge, which I don't think our banks will do. I think by 2024, the year-over-year comparisons on expenses will be a little more flattering for our Canadian banks. But it was definitely notable that expenses were quite elevated.
Another theme that I think was somewhat predictable was that balance sheet growth would slow. We're definitely seeing mortgage growth slow, personal loans, commercial loans, wholesale loans. Across all domestic loan categories loan growth has slowed, and that makes sense also. Quantitative easing brought in a period of significant balance sheet expansion. With money supply now contracting under quantitative tightening, it makes perfect sense that bank balance sheets would slow.
I think our banks also want to be cautious on balance sheet growth. It's probably appropriate to conserve capital, especially if OSFI raises the domestic stability buffer later on this month. So loan growth was clearly modest. That was an important theme.
The other one that was, I think, very predictable was that margin expansion would abate. The banks have enjoyed significant margin expansion or most of them have for some time now. We saw margins contract for the first time in, say, since Q2 '21, around that period. We saw margins contract and it made sense there too. Banks were holding more liquidity in response to the US banking crisis.
There's been a significant shift to high-cost deposits from low-cost deposits. Deposit betas, which are just the change in deposit rates relative to the change in interest rates, deposit betas are rising, so margins have stopped expanding as well. I think that's a very fluid situation. We could see margins start to stabilize and expand by as early as Q4 '23, but those were the big, broad themes that I think affected bank earnings this quarter and resulted in, in some cases, some meaningful misses relative to where the street was.
Kim Parlee: Well, let's get into some of those earnings announcements, although I have to say, it's quite interesting you think you could see some meaningful margin expansion in Q4 '23, and I want to come back to that as well. Let's talk about BMO ( BMO ). You talked a bit about that you saw a slowdown in capital markets activity, but you still see some interesting positives with BMO.
Mario Mendonca: Well, there's no doubt that BMO led the street in 2021, 2022. I think most of '22 they delivered very strong pre-tax, pre-provision earnings growth. In fact, in some quarters it was industry leading. And as I observed back then, so much of it was being driven by their very strong capital markets results, specifically their inroads with financial sponsors.
That market has really slowed. It's dried up, so not surprisingly BMO's reporting weaker pre-tax, pre-provision profit growth. In fact, if you take out the benefits of the Bank of the West deal, which closed in Q2 '23, if you take out those benefits, the bank's pre-tax, pre-provision profits are actually down 6% year-over-year as opposed to being up call it 5%, including Bank of the West.
So capital markets clearly played a role there, but also, Bank of the West is a smaller bank than what BMO envisioned when the deal was announced. There's been meaningful deposit runoff. That also has affected the contribution from Bank of the West and BMO's overall pre-tax, pre-provision profit growth.
Kim Parlee: What about Bank of Nova Scotia ( BNS )? You highlight that their capital ratio is something to watch and that it doesn't give them as many options as others.
Mario Mendonca: Yeah, from a capital perspective, all of our banks have to be careful on capital. That's fairly clear. There are changes to the capital rules. As I said, the domestic stability buffer may be raised, although I think that's unlikely. All of our banks want to be cautious on capital.
I think in Scotia's case, and probably the case with CIBC, they're going to be a little bit more cautious on loan formation because of a little bit of pressure on capital, but Scotia's also got a special sort of special situation, if you will. In their domestic business, their loans exceed their deposits, what we call the funding gap, by about $111 billion. That is a funding gap that I think the new CEO, Scott Thompson, wants to address over time.
Now, that could mean that Scotia competes more for deposits. That certainly would make sense that they try to grow the deposit base. But it also means that they could slow the pace of loan formation or loan growth, particularly in brokered mortgages, where margins are pretty thin. So I think Scotia is one of those banks where, if you believe as I do that overall balance sheet growth, the slowdown in balance sheet growth will be a meaningful theme that investors are talking about in 2024, I think Scotia could be one of those banks that were especially sensitive to insofar as declining balance sheet growth is concerned.
Kim Parlee: You make a comment in your report too that you say that Scotia's struggle to redefine the bank will not happen in a vacuum. Tell me a bit more about that.
Mario Mendonca: Well, if in fact Scotia is -- if their goal is to shrink that deposit gap by growing their deposits, well, in the period while they're trying to grow their deposits, the other banks aren't going to cede market share. Their peers will also be competing to maintain their market share of deposits. So that's one thing.
The other thing to consider is that in a period when Scotia is trying to redefine itself, their peers may be benefiting from the acquisitions, like Bank of Montreal's acquisition of Bank of the West or Royal's ( RY ) acquisition of HSBC ( HSBC ). What I'm getting at there is their peers may in fact be delivering balance sheet growth, if only because of the acquisitions, in the context of Scotia perhaps shrinking their balance sheet as they refocus their efforts. So that's what I meant by saying it won't happen in a vacuum.
Kim Parlee: Yeah, no, OK. What about CIBC ( CM )? I mean you mentioned them earlier, but you also highlight some exposure to US real estate as something that CIBC has that perhaps the others don't in the same way.
Mario Mendonca: Well, I think everybody has US commercial real estate exposure. You can see that across the groups. I'd say National ( NTIOF ) would be light in that respect, but everybody else has a lot of commercial real estate, and so does CIBC. What I was observing there is that CIBC's growth in US commercial real estate was especially strong I think it was 2021, 2022.
That means something to me, because often the loans you put in-- the most recent loans you put in could-- that you originate could be the ones that caused you the most heartburn down the road. So I was really observing there that CIBC may have some US commercial real estate exposure that will lead to charges.
In fact, this quarter they did take some charges in the US commercial real estate. I think they were manageable or modest, but they did take some charges. I did do a stress test in my last research report where I assumed some fairly high cumulative loss rates in commercial real estate in Canada and the US, particularly in the office space. What I conclude from that is that every bank could see a bit of a hit to their capital.
But I also believe that that hit to the capital would be manageable, especially because the banks are always producing capital every quarter anyway. So US commercial real estate or commercial real estate generally could lead to some charges and some pressure on capital, but I think our banks have the capacity to absorb it.
Kim Parlee: I want to make sure I get in National and Royal. So National, what are you seeing there?
Mario Mendonca: National's performed extremely well over the last few years. They've really defied gravity in my view. What I'm getting at there is their very strong Cambodian business has been growing the top or growing loans at 30% to 40% a year. It's become a very big part of this bank. What I did notice this quarter, and I've kind of started to see this over the last few quarters, that the margins on that business are compressing. 60, 70 basis points sequential decline in their overall net interest margin in Cambodia. That's because deposit costs are getting higher and I believe perhaps even competition is kicking in.
What I find especially interesting about National and their Cambodian business is while they're growing their loans at that pace, we're not seeing any meaningful increase in credit losses. So either Cambodia is just the best place to be a bank, where you can grow your loans at 40% without credit losses, or that's something we'll see down the road. And I'm taking the view that, at some point, National is going to have to slow the pace of growth in Cambodia.
Kim Parlee: Last one is Royal, and you also alluded to earlier that expense growth was something that you were watching with the banks, and you highlighted it again with Royal specifically.
Mario Mendonca: Yeah, bar none, no bank is growing expenses faster than Royal. And near the end of the call, the conference call, CEO Dave McKay did acknowledge that the bank overhired, particularly in the tech space, on the presumption that there would be significant attrition of employees as the big tech companies in the US competed for employees. The big tech companies in fact started letting people go and that's led to much lower attrition for Royal, for their employees than they expected, and as a result, their expense base is really elevated.
My view is really that our banks never budget out expenses without also taking into account what the revenue picture is like, and I think what happened is the revenue picture slowed down perhaps more abruptly for our banks than they anticipated, and that's what led to this very high expense growth relative to the revenue growth, which is what we refer to as operating leverage. And I think that's what really, ultimately, resulted in Royal's operating leverage looking so weak. They may have underestimated the abrupt decline in margins.
Kim Parlee: Mario, it's always a pleasure. Thanks so much for joining us.
Mario Mendonca: Thanks, Kim.
Kim Parlee: That's Mario Mendonca, and for full disclosure and all the companies that Mario was speaking of and covered by TD Securities, please see a link to TD Securities' website at the end of the video.
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Navigating Risks: Earnings Round-Up For Canadian Banks