DBRS Morningstar’s Takeaways from Credit Outlook Canada 2024: Solid Fundamentals Position Large Canadian Banks for Growth Opportunities

As part of its takeaways series, DBRS Morningstar is publishing several write-ups about pertinent topics discussed at Credit Outlook Canada 2024. With a focus on “How Economic, Climate, and Tech Pressures Are Affecting Credit Quality,” this conference is a full day of global and Canadian market insights on what we should expect in the coming year.

Carl De Souza, Senior Vice President, North American Financial Institutions at DBRS Morningstar, provided an overview of the large Canadian banks in a global context along with how their solid fundamentals respond to economic pressures while positioning them for growth opportunities.

GLOBAL GROWTH FOR THE BIG SIX
Canada’s Big Six banks—Bank of Nova Scotia (BNS), The Canadian Imperial Bank of Commerce (CIBC), The Bank of Montreal (BMO), Royal Bank of Canada (RBC), Toronto-Dominion Bank (TD), and National Bank of Canada (National)—are among the largest banks globally by assets. Indeed, RBC and TD are designated as global systemically important banks while BNS, BMO, CIBC, and National are designated as domestic systemically important banks.

In a saturated Canadian banking market dominated by the Big Six, these banks must look outside their home market for growth opportunities. The U.S. is the primary growth target for four of the Big Six, with TD, BMO, RBC, and CIBC ranked among the top 45 U.S. banks by assets and within the top 10 largest foreign-owned banks in the U.S.

“The perception that the large Canadian banks are similar is true in the domestic market where they have a stranglehold,” said De Souza, “but the Big Six differ in their international strategies and focus areas. The U.S. banking market is too big for a single-focus strategy, thus TD is more of a retail bank in the U.S., BMO is more of a commercial bank, while RBC has a heavy focus on wealth.”

The solid fundamentals of their franchise strength, earnings power, risk profile, funding and liquidity, and capitalization keep the Big Six well positioned to take advantage of international opportunities.

When it comes to assessing climate-related consequences, large banks are typically balancing a number of different objectives, and they continue to support clients that are seen as having sufficient plans to transition to Net Zero. In terms of the banks’ credit ratings, DBRS Morningstar is monitoring overall climate-related risks along with watching how banks are incorporating this evolving risk into their risk management frameworks. This field is evolving rapidly in March 2023, OSFI published its initial Guideline B-15 on Climate Risk Management. Although this guideline was heavily consulted while in development, we expect further updates as financial institutions weather a potential accelerated and volatile transition pathway in the 2030s. Should the risks not be adequately mitigated, climate-related risk factors could have a negative impact on banks’ credit ratings over time.

STRENGTH AT HOME
The Big Six have a dominant share of both loans and deposits in Canada at 92% and 94%, respectively.

The Canadian banking industry is an oligopoly that provides stability but limits domestic growth opportunities: in short, the market is saturated. The top three Canadian banks represent more than 60% of assets in Canada, in contrast to the U.S. where the top three banks comprise 38% of total U.S. assets. Opportunities to acquire high-quality Canadian banking assets are rare, and are quickly snapped up. “The Canadian market is capped and the Big Six are focused on other areas—as they should be—for growth,” said De Souza.

The Big Six generate solid, diversified earnings with return on equity being among the highest in comparison with global banks. Net interest margins have benefitted from higher interest rates in Canada despite higher funding costs including a notable shift from demand deposits to higher-cost term deposits and other products such as mutual funds. However, the international operations of the Big Six have been a drag on net interest margins in recent quarters as a result of exposure to the U.S. regional banking turmoil and to some Latin American countries that are now in recession. Efficiency ratios, despite elevated noninterest expenses, remain favourable compared with many U.S. and European global peers.

The loan books of the Big Six are broadly diversified by sector and geography, lowering their risk profiles and allowing them to remain resilient in times of uncertainty and to withstand economic shocks and volatility. For monoline banks, a housing shock can ruin a mortgage lender’s business. For the Big Six, although mortgages are a core loan book, their operations extend to many different sectors and loans strategies. “That diversification helps them,” said De Souza. “And it’s proven very valuable in times of distress and economic shock.”

HIGH INTEREST RATE ENVIRONMENT LEAVES CANADIAN HOUSEHOLDS AND BUSINESSES AT RISK
In recent quarters, credit metrics have been normalizing at an accelerated pace from the unsustainably low levels seen during the pandemic, although credit quality remains strong and compares favourably with global U.S. and European banks. Higher interest rates for longer periods, however, will likely amplify deterioration in credit quality in ensuing quarters as borrowing costs materially increase for highly leveraged Canadian borrowers when debt reprices at maturity.

Indeed, aggressive interest rate increases—the Bank of Canada overnight rate of 5% is at a 22-year high—are starting to cause stress to borrowers. Canadian households are highly leveraged with an elevated household debt-to-disposable income ratio, while household debt as a percentage of GDP is the highest of any G7 country, making Canadian borrowers much more susceptible to interest rate hikes and more vulnerable to unemployment shocks.

Higher interest rates are increasing credit risk in the Canadian mortgage books, particularly with variable-rate, fixed-payment mortgages where the percentage of mortgages with an amortization over 30 years has materially increased and borrowers will experience a payment shock at maturity when contractual amortizations are restored. Borrowers have been changing their mortgage rate types in response to interest rate changes. In February 2020, five-year, fixed-rate mortgages represented 42.8% of all uninsured mortgage originations with variable rate mortgages at 8.2%. By January 2022, variable-rate mortgages were the overwhelming favourite at 60.1% as the spread between variable-rate and fixed-rate mortgages widened materially, with five-year, fixed-rate mortgages falling to 18.7%. In July 2023, variable-rate mortgages were out of favour having fallen to 5% as a result of a series of rate hikes made by the Bank of Canada since March 2022, while fixed-rate mortgages of terms from three years to less than five years were the majority at 54.8%. “People don’t know which way interest rates are going, economists keeping making then changing predictions as a result of ongoing uncertainty, and so borrowers are going with shorter-term (i.e., primarily one- to three-year), fixed-rate mortgages for payment certainty,” said De Souza. “Even though at times the five-year rate may be cheaper than the one-, two-, or three-year rates, borrowers are opting for shorter mortgage terms in anticipation of rate cuts at some point.”

Real estate-secured lending and commercial real estate (CRE) are two sectors of concern that DBRS Morningstar is monitoring. The Big Six are essentially prime-based lenders, however, whose mortgage books present very strong credit quality metrics with an average loan-to-value ratio of 53.5% and average credit score of 793. CRE exposure, especially to the office sector, remains manageable as a percentage of total gross loans and acceptances at 10% and 1.3%, respectively. “While we do have concerns there, particularly in the U.S.,” said De Souza, “the Big Six maintain office loan portfolios that are generally well-diversified by geography, location, and class, with many properties backed by strong financial sponsors.”

DIVERSIFIED AND STABLE FUNDING
The Big Six benefit from their diversified and subsequently stable funding with deposit funding from a wide variety of personal, government, and business customers totalling just under 50%. The wholesale funding segment is also diversified, and debt maturities are well laddered. The Big Six are easily able to access the markets to refinance debt as maturities come up. They maintain comfortable cushions above the 100% regulatory thresholds for both the liquidity coverage ratio and the net stable funding ratio.

SOUND CAPITAL LEVELS PROVIDE SUFFICIENT CUSHION TO ABSORB POTENTIAL LOSSES
The large Canadian banks have sufficient cushions to absorb potential losses. It is expected that the Big Six will continue to build up their CET1 ratios in anticipation of heightened capital requirements in both Canada and the U.S. Additionally, they are able to take additional actions to boost capital levels if needed to align with regulatory requirements/changes from Canadian and/or U.S. regulators.

Written by Deirdre Maclean

NOTES:
For more information on Canadian financial institutions, visit www.dbrsmorningstar.com or contact us at info@dbrsmorningstar.com.

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