Home Banking Canadian banks shrink future bad debt cushion even as economic risks mount

Canadian banks shrink future bad debt cushion even as economic risks mount

Canadian banks wrapped up second-quarter earnings season, with most reporting better-than-expected profits, in large part by reducing the amounts of funds they set aside for future loan losses, raising questions among investors and analysts about whether they are too sanguine about looming risks. Rising prices and the central bank’s rapid interest rate hikes are squeezing Canadians, and concerns are rising about the extent to which rates must further increase to skirt an inflationary spiral. 

Brian Madden, chief investment officer at First Avenue Investment Counsel said that recessions start when the economy is at maximum awesome. Canadian banks are likely releasing provisions on performing loans on over-confidence in their positive base case economic scenario and underweighting the likelihood of adverse scenarios. Total allowances for credit losses at Canada’s Big Six banks fell 20% in the second quarter from a year ago to about C$23 billion. This is according to the banks’ financial statements.

There is some evidence that consumers and companies are feeling the pinch, with insolvencies up 24% in March from February. Many of the banks also predict mortgage growth will slow from pandemic levels. Royal Bank of Canada reported the biggest drop in allowances, down 30% from a year ago. Chief Risk Officer Graeme Hepworth told analysts that the bank has adjusted provisions to reflect increased economic headwinds.

Canadian Imperial Bank of Commerce, which missed estimates partly on higher provisions, and Toronto-Dominion Bank had the smallest year-on-year declines in ACLs. Despite the downward trend of recent quarters, ACLs remain about 21% above pre-pandemic levels. Moody’s Investors Service Senior Credit Officer Rob Colangelo said that they are building provisions it is maybe not being built up as fast as one would have expected.

The Canadian banks share index has gained 2.3%, compared with a 1.8% gain in the broader Toronto stocks benchmark, shrinking their underperformance since the March peak. They remain below their historical average trading price relative to forward earnings, while offering higher dividend yields than U.S. peers. While acknowledging that some conditions have worsened, many banks pointed to a firm economy and employment, and ongoing investment by businesses as drivers of earnings growth and high credit quality.

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