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

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

Last week, Canadian banks completed their second-quarter earnings season, with the majority reporting higher-than-expected profits, largely due to lower reserves for future loan losses, prompting concerns among investors and experts about whether they are overly optimistic about looming dangers.

Canadians, who are already among the most indebted in the industrialized world, are being squeezed by rising prices and the central bank’s quick interest rate hikes, and concerns are growing about the amount to which rates must rise further to avoid an inflationary spiral.

“When the economy is at its most fantastic, recessions begin,” said Brian Madden, a chief investment officer of First Avenue Investment Counsel.

“Overconfidence in their (good) base case economic picture and underweighting the likelihood of adverse scenarios, which is, in my opinion, no longer a tail risk,” Canadian banks are likely “releasing provisions on performing loans.”

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According to the banks’ financial filings, total allowances for credit losses at Canada’s Big Six banks declined 20% year over year in the second quarter to around C$23 billion ($18.1 billion), the lowest level in the past two years.

Insolvencies increased by 24% in March compared to February, indicating that consumers and businesses are feeling the pinch.

Mortgage growth is projected to decline from epidemic levels, according to several banks, however additional business and credit card loan recovery is expected to help counterbalance this.

The highest decline in allowances was reported by the Royal Bank of Canada, which saw a 30 percent drop from a year ago. The bank has altered provisions to reflect greater economic headwinds, but this has been mitigated by pandemic-related reserve releases, according to Chief Risk Officer Graeme Hepworth.

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The smallest year-over-year drops in ACLs were at Canadian Imperial Bank of Commerce and Toronto-Dominion Bank, which both missed projections due to greater provisions.

CIBC Capital Markets Analyst Paul Holden wrote in a note on Thursday that “we appreciate the signal we heard” from TD, which held back “a significant bit” of provisions on macroeconomic concerns. “While credit trends are improving, TD continues to take a cautious approach to the future.”

Despite a recent declining trend, ACLs are still roughly 21% higher than pre-pandemic levels.

“They are creating provisions,” said Moody’s Investors Service Senior Credit Officer Rob Colangelo. “It is perhaps not being built up as quickly as one would have expected.”

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Since the lenders began reporting earnings this week, the Canadian banks share index has risen 2.3 percent, compared to 1.8 percent for the broader Toronto equities benchmark, narrowing their underperformance since the March peak.

They continue to trade at a discount to their historical average trading price in relation to anticipated earnings while paying larger dividend yields than their American counterparts.

While conceding that some conditions have deteriorated, several banks cited a strong economy and job market, as well as continuous company investment, as drivers of earnings growth and high credit quality.

“Isn’t this a bizarre world?” On Friday’s analyst call, Laurent Ferreira, the CEO of the National Bank of Canada, remarked. “You’ve got a great economic backdrop… but a lot of pessimism about a possible recession.”

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