The banking sector in Canada is known for its stability and strength. Yet in October (year-end for most domestic lenders) a historic upset occurred when TD Bank Group overtook long-standing leader Royal Bank of Canada (RBC) to become the biggest bank in the country by Tier 1 capital. RBC had held the title for the past 16 years. TD now holds C$94.4bn ($70.8bn) in core capital, compared with RBC’s C$84.2bn.
The former managed to increase its Tier 1 by an impressive 24.7%, versus the latter’s muted growth of 2.4%. But it was Bank of Montreal (BMO) that made the largest jump in core capital, of 34.3%, allowing it to leapfrog Scotiabank to become Canada’s third-largest lender. The last time BMO occupied third place was in 2008.
BMO also saw the greatest increase in pre-tax profits (PTP), of 74.4%, while TD saw a 19.5% uptick. However, both RBC and Canadian Imperial Bank of Commerce (CIBC) recorded declines in PTP, of 2.5% and 4.2%, respectively.
All five banks expanded their total assets by an average of 13% and loan books by an average of 15%. The loan book growth is mainly led by the loans advanced to the corporate sector, with an average of 20% growth, with a peak of 30% for Scotiabank. The retail loans book grew on average by 10%, with a rise of nearly 17% for TD.
Importantly, there has not been an uptick in bad loans. A slight decrease in the allowance for loan losses for credit-impaired loans, i.e. Stage 3, is testament to the general good quality of the loans book. No issues are expected in the short to medium term.
Strong and resilient
Clearly, the Canadian banking sector is in rude health. As the Bank of Canada (BoC) reported in its Financial System Review 2022, published in June: “The Canadian financial system has proved resilient throughout the Covid‑19 pandemic, and the balance sheets of businesses and households are generally in good shape.”
Canadian banks are some of the highest rated in Fitch’s bank universe. Mark Narron, senior director, North American banks at Fitch, puts this down to their market power and diversification, operating in all major business lines: retail banking, commercial banking, credit cards, insurance, wealth management and capital markets. “Their diversified business model gives them a stability of earnings, irrespective of the environment and we saw that quite clearly during the Covid-19 pandemic,” he says.
“And we see it now, actually, where they’re able to absorb the negative impacts from the rate rises, declines in fair value, sluggishness in wealth management and stasis of deal flow in investment banking. They’re now growing their corporate books, and recovering their retail and personal banking books quite nicely.”
The BoC began raising interest rates in October 2021 and has hiked eight times since, cumulating in a 425-basis-point increase to reach the current 4.5%. However, this has not had an impact on loan quality.
“Many Canadian households are still sitting on the savings buffer that they built up during the initial 18 to 24 months of the pandemic. While they may be starting to dip into that now, it has created a cushion for some of the challenging economic circumstances that we’re facing now,” says Geoff Rush, partner, KPMG Canada and author of the report ‘Canadian banking in transition’.
He believes that a tipping point has been reached where the BoC, the major institutions and the broader business community are all waiting to see if this tightening of monetary policy is going to have the desired impact on inflation. He says: “If that turns out to be true, I think we’re going to see our way through this period of uncertainty reasonably well. Therefore, I predict that the major Canadian banks will continue to do well over the course of this year.”
According to Mr Rush, Canadian banks are “very well managed and well capitalised, with a strong customer base, and a robust and rigorous regulatory environment”.
Good regulation and supervision have contributed to the banks’ history of low credit losses, according to Mr Narron. He points to the Office of the Superintendent of Financial Institutions’ retail mortgage underwriting rules and minimum qualifying rate, which meant that even when mortgage rates were below 2%, a customer still had to qualify at a 5.25% rate.
“Were it not for the underwriting rules, we think the banks’ credit quality could be in a worse position today,” says Mr Narron. “That gives us a tremendous amount of comfort now that rates are [moving higher] and, as a result, we’re not expecting significant deterioration in their mortgage books – unless, of course, the BoC is not done with rate hikes.”
Smart acquisitions
For many of the Canadian institutions, diversification has also meant looking outside the country for opportunities, particularly in the US. “The system in Canada is so concentrated that it’s difficult for the incumbents to take meaningful market share from each other and for challenger banks to make headway. The US, which is historically fragmented and regionalised, has presented a nice opportunity for the bigger Canadian banks,” says Mr Narron.
Some noteworthy deals include RBC’s acquisition of City National in 2015; BMO’s purchase of Bank of the West in late 2021 (which received regulatory approval in January); and more recently TD picked up regional bank First Horizon and investment bank Cowen (both announced in 2022).
CIBC has also been expanding its presence in the US, following its acquisitions of PrivateBancorp, wealth management firm Geneva Advisors and investment bank Cleary Gull in 2017. According to Victor Dodig, president and CEO of CIBC: “Any conversation about growth for Canadian banks must include having a strong North American footprint to meet the needs of businesses which have grown across borders, which is very common in our market. Through a combination of organic and inorganic investments, we’ve built a strong cross-border platform in recent years and diversified our earnings.” He reports that 2% of CIBC’s net income came from the US in 2016, but by 2021 that had grown to 21%.
The Canadian banks’ cautious culture has played a role in their international success, according to Mr Narron. He says: “They’ve played conservatively, they’ve played well and they’ve made smart acquisitions. I think they understand these markets and they’ve played to their strengths.”
One potential acquisition in the domestic market is RBC’s C$13.5bn proposed purchase of HSBC Canada, which includes the latter’s commercial banking and wealth and personal banking businesses. Announced at the end of November 2022, it is subject to customary closing conditions including regulatory approval.
Future headwinds
The challenges emerging this year, including an expected economic slowdown, may take some of the shine off the Canadian banks. In its Financial System Review, the BoC identified six key vulnerabilities in the financial system:
- elevated level of household indebtedness;
- elevated house prices;
- reliance of some businesses on high-yield debt markets;
- high potential demand for market liquidity relative to supply;
- cyber threats in an interconnected financial system; and
- mispricing of assets exposed to climate-related risks.
In its 2023 outlook report, published on December 6, Fitch assigned a deteriorating sector outlook for the Canadian banking system. “That doesn’t mean that we think that the ratings could move, but what we’re signalling is that key risk indicators are going to be worse this year than they were in 2022,” explains Mr Narron.
“We’ve already started to see a pivot in the otherwise pristine credit quality across the large banks, in terms of loss absorption capacity and deterioration in capital levels. Reserve levels will go up as banks provision more, and the healthy increase in net interest income that the banks are enjoying, particularly TD, is going to slow down and will probably be mostly eaten up by higher provisions.”
Mr Narron believes that capital levels will start to come down because of the large acquisitions that will be absorbed imminently and profitability will potentially be pressured due to higher provisions. “Plus, it’s still not a great environment for asset management and investment banking,” he adds.
While the economic cycle may evolve this year, our focus on our clients and our strategy is not cyclical
CIBC, for one, has focused on the execution of its strategy against the evolving economic backdrop. “While the economic cycle may evolve this year, our focus on our clients and our strategy is not cyclical,” says Mr Dodig. “We saw clear evidence of the positive impact of our emphasis on long-term relationships as we emerged from the Covid-19 pandemic. We stood by our clients during that time and we deepened many valuable relationships as a result.”
According to Siobhan Byron, executive vice-president, universal banking, Finastra, banks in Canada need to play a role in helping businesses navigate clogged supply chains and an energy crisis, as well as a cost-of-living crisis for consumers. “Agility is the only solution to the volatility we are seeing, not only to counter these challenges but to turbocharge the opportunities that arise from a moving landscape,” she says. “And with the rollout of open banking and real-time payment rails both on the horizon for later this year in Canada, banks need to be prepared.”
Changes afoot
In addition to a more challenging economic environment, there are several regulatory and market infrastructure changes expected this year. According to KPMG’s Mr Rush, these are taking up a lot of “mental bandwidth” in the C-suites of the major banks.
First is Canada’s payment systems modernisation, led by Payments Canada, with the move to Lynx release two, a high-value payment platform, and faster payments platform, the Real-time Rail (RTR), both supporting the ISO 20022 payment messaging standard.
“To support our members and the industry in the migration to ISO 20022, Payments Canada has published ISO 20022 message specifications on payments.ca. We are also developing ISO 20022 market practices, which provide additional context and details on the usage of messages for specific use-cases,” says Tracey Black, president and CEO of Payments Canada.
Both implementations have been delayed, however. Lynx release two was postponed from November 2022 to March this year, to align with the change in Swift timelines. The RTR has also been postponed, but the new launch date has not yet been agreed.
Second is the move to open banking. Mr Rush says: “Open banking is a big change coming but the deadline for implementation is a bit opaque. The last I heard it was the end of this year, but they are still debating the common rules around privacy, security and how the accreditation process will work.”
Ms Byron, for one, believes that open banking will be a game changer in Canada. “But, ultimately, it’s like electricity: banks can simply comply or they can be innovative and do something fantastic with it,” she adds.
To seize the opportunities ahead, she argues that Canadian banks need systems designed to be open that can easily integrate with the outside world. “Key building blocks include cloud-native operations that are easy to scale; component-based architecture to facilitate innovation; open application programming interfaces for third-party connectivity and secure data sharing; and real-time analytics – providing the insights to pivot fast,” she says.
Third is environmental, social and governance (ESG) reporting and disclosure rules. “Again, it’s a bit of a moveable feast because some of the reporting standards and details are still being worked out. But all of the major institutions have made commitments towards being net-zero by 2050, which they’re taking very seriously,” Mr Rush says.
ESG has come into focus for CIBC, its clients and other stakeholders, according to Mr Dodig. “We recognise the unique role we play in society and we’re activating our resources to help create a more resilient and sustainable future, including helping clients achieve their sustainability ambitions,” he says. “As one example, we are working closely with clients in the energy sector to fund the innovations that will enable the transition to a lower-carbon economy in the years to come.”
