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Canadian banks are releasing their earnings reports this week and so far, the numbers are dismal. However, it is worth stressing that one of Canada’s strengths is the robustness of its banking sector. During the 2008/2009 financial crisis, not one bank needed a bailout. Lending practices in Canada are generally conservative. Subprime lending is limited. Mortgages are recourse loans, where the lender can legally seize assets to make up for any shortfall in the loan value. A high proportion of mortgages are quasi-government insured. Borrowing requirements by commercial firms can be shared between the chartered banks and one of the crown corporations, Business Development Canada (BDC) and Export Development Canada (EDC). Therefore, while the current downturn will be the worst since the Great Depression, Canadian banks likely have more than adequate capital to absorb the expected credit losses. The buffer was further strengthened by the new IFRS9 accounting standards, where the loan loss provisions are allocated gradually over the life of the loans. Having said all that, there will be losses. Moreover, they will be substantial.
Despite the multitude of the government programs to support the economy, there will be business bankruptcies. I expect Canada to lose many small and medium sized enterprises. Some large firms will also be pushed over the brink.
Much of the policy response has been to ensure that there is adequate access to credit to keep businesses afloat. This approach will surely create heavily indebted businesses, some of which will eventually run into difficulty meeting their financial commitments.
On the personal front, the economic contraction has created an employment and income shock. Banks are allowing many to defer their mortgages, but those deferrals will eventually end, at which point the financial burden will return. Canadians were heavily indebted before the pandemic and debt service burdens, as measured by interest and principal payments relative to after-tax income, will be higher in the aftermath due to lower income and/or higher unemployment.
This is why Canadian banks are reporting sharp declines in profits: they are making provisions for larger credit losses. Scotiabank reported their second quarter earnings yesterday, while RBC and BMO had their turn today.
RBC profit fell 54 percent in the second fiscal quarter, as the bank set aside $2.83 billion in credit loss provisions. This represents 1.65 percent of the loan book, and is higher than the previous peak during the 2008/2009 financial crisis. It is also a dramatic increase from the 0.29 percent anticipated a year ago.
BMO also reported a 54 percent drop in profits, as it made provisions for $1.1 billion in potential loan losses.
To be clear, provisions are not the same as defaults or charge-offs. It is money being set aside in anticipation of the default, which now looks more probable.
There will be a debate about whether banks have set aside enough for future losses. A lot will depend on how the reopening of the economy unfolds and what happens as the temporary government income and wage support programs end. Given the high level of household debt, the vulnerability is material and we should not be complacent about the risks.
I will end where I started. Having been involved in many bank financial stress-testing exercises, I believe Canadian banks have adequate capital to absorb even greater loan losses than they are currently provisioning for. The greatest risk of high household debt is not bank failures, or even the associated systemic risk to the financial system, but rather the implications for the economic recovery and, subsequently, our standard of living. If the current bank provisions prove adequate, then the underlying losses suggest significant financial hardship but should not severely hamper the recovery. The same cannot be said if the provisions are blown through by what is sure to be an unprecedented amount of defaults.
On the global front, the International Energy Agency (IEA) reported that worldwide energy investment is expected to plunge by around 20 percent this year – a stark deterioration when compared to the 2 percent increase anticipated heading into this year. Canada’s energy sector will not buck this trend. Domestic energy firms have already slashed investment and reduced production. As they say, the solution to low oil prices is low oil prices. Reduced supply will ultimately lead prices to more economic levels. Crude prices have rebounded in recent weeks, with the WTI benchmark increasing from below US$20 to around US$32 per barrel. It is still below the US$45 level prior to the March OPEC meeting. Although there is much talk about opportunities to use this crisis to foster a shift to a greener economy, it is important to stress than a robust Canadian economic recovery is not possible without fulsome participation of the energy sector.