U.S. banking crisis casting chill over Canadian banks heading into earnings this week

U.S. bank failures have invited additional scrutiny of banks with operations in the U.S.

By: Stephanie Hughes

Commuters outside the TD Tower in the financial district of Toronto. Canadian banks will report second quarter results this week.Commuters outside the TD Tower in the financial district of Toronto. Canadian banks will report second quarter results this week. PHOTO BY COLE BURSTON/BLOOMBERG

Canada’s banking system avoided taking a direct hit from the U.S. crisis that shook the global financial landscape earlier this year, but the episode is still fresh in market watchers’ minds heading into second quarter bank earnings.

Contagion from the March collapse of California-based Silicon Valley Bank claimed a handful of U.S. regional banks and forced Swiss authorities to engineer a rescue of Credit Suisse. Though the damage stopped short of the Canadian border, the incident has left lingering concerns about potential weaknesses in the financial system and invited additional scrutiny of Canada’s biggest banks, especially those with operations in the U.S.

The chill cast over the sector comes amid fears that a recession could be imminent, with slowing loan growth and potential exposure to a weakened commercial real estate sector among the specific concerns for the banks themselves.

Canadian Imperial Bank of Commerce analyst Paul Holden and his team forecast that loan growth dropped just over one per cent quarter over quarter, as banks have gone on the defensive in the wake of the crisis.

“With recent banking failures in the U.S., the banks are likely to be more cautious on loan growth in the near term,” Holden wrote in a May 15 note.

He added that banks with a CET-1 ratio below 12 per cent would be more inclined to pump the brakes on loan growth.

Toronto-Dominion Bank and National Bank of Canada are expected the have stronger capital positions, with TD in particular sitting on a significant capital cushion after abandoning its pursuit of Memphis-based First Horizon.

Royal Bank of Canada senior economist Josh Nye meanwhile flagged that the crisis was having a ripple effect on U.S. lending.

In a May 17 report, he noted that commercial lending south of the border contracted sharply in March amid a decline in deposits.

Nye also pointed to a recent U.S. Federal Reserve survey showing that banks continued to tighten credit conditions in the first quarter, with higher premiums on riskier loans. The same lenders expected conditions to further tighten over the rest of the year. Those factors could have a direct impact on Canadian banks operating in the U.S., but also could act as headwinds for the North American economy as whole, something that could drag on Canadian financials.

Concerns are also growing about commercial real estate lending, a space in which smaller U.S. banks have been particularly active, RBC noted. While the Canadian banking sector’s exposure to commercial real estate is small in comparison — non-residential mortgages account for about two per cent of their assets’ total value, according to data from BofA Securities Inc. and the Bank of Canada — it was worrisome enough for the central bank to flag in its recent financial system review.

The Bank of Canada argued in its May 18 report that banks with a large amount of exposure to industries already facing challenges would be weighed down by further credit risk.

“A notable example is the commercial real estate sector, where the demand for office space has declined because of the shift to more remote work,” the bank said in the review. “As a result, market valuations of firms in the office space subsector have decreased. If some of these commercial real estate firms were to default on their loans, lenders could face credit losses.”

The review added that though the banks’ exposures were generally small, some were more significant than others and a severe recession could magnify the effect of any credit losses.

Analysts such as John Aiken at Barclays PLC have been wondering if the upcoming quarter could be the “last hurrah” of strong results before a potential recession.

“Consequently, solid results will take a back seat to management commentary on the outlook, particularly for credit and revenue,” Aiken wrote in a May 9 note. “Unfortunately, we see more downside risk than upside.”

Canadian banks will report second quarter results this week starting with the Bank of Nova Scotia and Bank of Montreal on May 24.

Source: Financial Post