Do bumps in the road lie ahead for Canada's banks?

Canada’s banks had another sound fiscal year in 2018, recording strong profits and continuing to build an international footprint that should ensure growth going into the final year of the decade. Banks were buoyed by a strong economy in Canada and across the border in the US (where many Canadian banks also operate), low domestic unemployment and rate hikes from the Bank of Canada. Personal lending slowed marginally, but was easily compensated by a solid performance in commercial lending.

The largest bank in the country, Royal Bank of Canada, reported a record C$12.4bn ($9.4bn) in net income for the fiscal year that ended October 31, 2018. The second and third banks in the system, Toronto Dominion (TD) and Scotiabank, also saw incomes rise, reaching a respective C$11.3bn and C$8.7bn for the fiscal year.

TD did particularly well thanks in large part to its activity in the US, where it had a 44% increase in earnings in its retail banking segment in the fourth quarter of the fiscal year. This was a result not only of the strong US economy, but also the US government’s tax overhaul implemented in 2018.

Scotiabank CEO Brian Porter says the 2018 fiscal year was strong and he expects 2019 to be more of the same. “We are optimistic about the year ahead. Economies are going to grow at a fairly good clip. We see good growth in terms of corporate, commercial and small business  lending,” he adds. 

Domestic hurdles?

Sector analysts agree with Mr Porter's assessment in broad strokes. They see growth but also point to more obstacles domestically, and they are keeping a close eye on geopolitical trends that could have an impact on Canada’s highly open economy in the coming years.

“The past five years have been strong [for Canadian lenders]. With the exception of the hiccup around oil prices, there really have not been any strong headwinds for the banks,” says Nigel D’Souza, an analyst at Veritas Investment Research in Toronto.

Fitch rates the top seven banks in the country within a small band between AA and A+, saying they are among the highest and most stable ratings for banks it rates worldwide. “The beauty of Canadian banks is that their businesses are diversified; they are not necessarily just depending on mortgage growth or personal loan growth to drive profitability. There are other areas or levers they can pull on,” says Foster Cheng, a Canada-based analyst at Fitch.

The major banks in the system have been growing domestically (largely through acquiring investment firms) and internationally in the past few years and 2018 was no exception. In the domestic market, Canadian Imperial Bank of Commerce, the fifth largest bank in the system, took over Wellington Financial, a specialist financial shop; Scotiabank bought investment firm Jarislowsky Fraser; and TD acquired Greystone Managed Investments.

Mr Cheng says acquisitions such as these highlight continued growth and expansion by banks in the areas of corporate lending, wealth management and capital markets.

Scotiabank's new focus

Expansion of market share abroad remains a tantalising option for Canada's banks. Scotiabank made the most moves overseas in 2018, building its footprint in the Pacific Alliance – a trade and integration group formed by Chile, Colombia, Mexico and Peru – and strengthening its brand in the Dominican Republic. At the same time, it announced in November that it was unloading banking operations in nine countries, and its insurance business in two others.

Scotiabank acquired assets from Spain’s BBVA in Chile and the US's Citibank in Colombia, and also acquired Banco Cencosud in Peru. It is now the third largest bank in Chile and Peru, and fifth largest in Colombia. It is also prominent in Mexico, where it did not make any acquisitions in 2018.

Mr Porter says the bank has focused on its core businesses getting scale in its key markets. “We continue to build our business in the Pacific Alliance countries and we like that region,” he says. The decision to sell banking operations in nine Caribbean countries to Trinidad and Tobago-based Republic Financial Holdings is not a withdrawal from the region, but part of a more focused approach, the bank claims. Earlier in 2018 the bank agreed to buy Banco Dominicano del Progreso, the third largest private bank in the Dominican Republic.

Meny Grauman, managing director at Cormark Securities, says the divestiture of some markets and bulking up in the Dominican Republic is more of “a rationalisation rather than a change in strategy. At the end of the day, Scotiabank is not leaving the Caribbean, but looking to optimise its operations in that region,” he adds.

Mortgage baton

While still upbeat about future prospects, analysts says the climate in Canada in 2019 and onwards will be less benign than it has been recently. Christopher Wolfe, a New York-based analyst at Fitch, says finding new drivers for growth is a challenge for Canada’s large banks. “They have high market shares in their domestic markets, so it is hard to grow. If the economy is growing by 2%, it is going to be hard to outgrow that,” he says.

The International Monetary Fund (IMF), in a June 2018 analysis of Canada’s fundamentals, estimated growth for the year at 2.1%, and 2% in 2019. Veritas and Cormark analysts agree on two key points, stressing that mortgage growth will slow and loan losses will increase. These trends were already starting to show in some balance sheets in the fourth-quarter results of the 2018 financial year.

Mr Grauman also says he expects mortgages to slow, but that commercial loans will “pick up the baton” from mortgages. This is an important change, because Canada's housing market soured in 2018. The number of homes sold in October was down 3.7% from the same period the previous year, while the number of new houses on the market was down 1.1% and the average sale price fell 1.5%, according to the Canadian Real Estates Association.

The IMF cited a correction in the housing market as a “key domestic risk”, saying: “While the banking system is profitable, it is heavily exposed to household and corporate debt. In this context, risks to financial stability and growth could emerge, if the house price correction is accompanied by a rise in unemployment and sharp contraction in private consumption.” 

Part of the change is attributed to new requirements for mortgages that kicked in at the start of 2018. The regulations require banks to review applications from borrowers using a five-year benchmark that is equal to or higher than that used by the Bank of Canada. The idea behind the 'stress test' is to make sure borrowers can cover mortgages at 2 percentage points above the contracted rate.

Fitch director Mark Narron says the banks potentially face more pressures as higher rates kick in for mortgages that were originated when rates were lower, four of five years ago. The Bank of Canada has defended the stress test, saying it was necessary to reduce the number of highly indebted borrowers.

Asset laundering

Two key issues that often go together, and are critical to growth in any banking sector, are compliance with international anti-money laundering (AML) and counter-terrorist financing (CTF), and the application of new technologies to meet demand and improve efficiency.

Changes to Canada’s Proceeds of Crime and Terrorist Financing Act are coming into play in 2019. The proposed changes were floated in the third quarter of 2018 and will be enacted in the third quarter of 2019. The final make-up of the modifications is still unknown but they will affect how banks do due diligence and report to the regulator.

Mr D’Souza says the changes will have an impact, but are more of an operational challenge than a growth restriction. “Banks are constantly onboarding new regulations – it is part of their business model and something that they have been doing efficiently,” he says.

The Fitch analysts have a slightly different take, seeing increasing scrutiny around AML/CTF raising the risk of non-compliance, which would impact banks' bottom lines.

Mr Narron says the inter-governmental Financial Action Task Force (which analyses national AML/CTF policies and makes recommendations) “highlighted holes in [Canada's AML and CTF] frameworks that exposes banks to risk”.

Several key issues include corporate transparency and beneficial ownership, which requires financial institutions to identify the final owner or owners of a corporate entity. Canada currently does not have a unified registry for beneficial ownership. Some sort of registry will be implemented with the new changes, putting Canada on a par with numerous other countries implementing similar rules.

The task force’s 2016 review of Canada’s policies also pointed to weak enforcement. It noted that only one bank had been fined for an AML/CTF violation, at a modest C$1.2m. “The results are commensurate with money-laundering risk and asset recovery is low,” said the task force report.

Mr Porter believes AML programmes are essentially about data, and so technology is helping guarantee better programmes and results. “If you narrow it down, any sophisticated AML/CTF programmes centres around customer data,” he says.

Technology challenges

Technological advances, such as the use of artificial intelligence, not only help detect potential AML/CTF anomalies, but are also improving conditions across the board at banks worldwide. The level of spending on digital transformation indicates its importance. According to research by Fitch, on a global level up to 40% of spending on technology today is on bank transformation, up from 25% in the middle of the decade. 

Technological changes are upending the back-office side, including lending and payments. Artificial intelligence can be used to do credit checks in hours instead of days (or sometimes weeks). This not only expedites loans, but also highlights any red flags that could violate regulations. “Technology is changing banking and banks have to change along with it,” says Fitch’s Mr Wolfe.

Scotiabank’s Mr Porter says that while technology helps with routine clerical functions, makes banks more productive and cuts down on time and errors, the bank is constantly ushering in solutions to “reduce friction points with customers”.

Canada's banks are also creating more extensive links with fintechs, seeing them as an opportunity to reach a wider audiences and deal with complex issues rather than a threat to their very existence. “We partner with different fintechs for solutions for our customers and I have never met a fintech that wants to put us out of business,” says Mr Porter.

Scotiabank’s most recent foray came in October 2018, when it announced a partnership with Canada’s CGI Group and the Netherlands' Conpend to work on solutions to expedite trade finance. The idea is to use robotics to work through the extensive paper trail currently associated with trade financing.

International uncertainty  

As well as domestic pressures and new regulations, banks and sector analysts are closely watching international developments, particularly potential changes in the US involving the renegotiated trade deal between Canada, Mexico and the US (USMCA), and the lingering effects of the trade dispute between the US and China.

Canada is also part of discussions to become an associate member of the Pacific Alliance with Australia, New Zealand and Singapore, and has provisionally implemented the Comprehensive Economic and Trade Agreement with the EU, which eliminates 98% of tariffs.

The next big agreement to come into force is the Comprehensive and Progressive Agreement for the Trans-Pacific Partnership, or CPTPP, an 11-country Pacific Rim agreement. It was originally signed in February 2016 and included the US, but Donald Trump withdrew the country in one of his first acts as president in January 2017. The agreement was resigned in 2018 and as of November had been ratified by seven countries, including Canada, triggering implementation as early January 2019.

The CPTPP will open up seven new countries for Canada, including Japan, which is already one of Canada’s top trading partners. Trade flows in products are expected to increase rapidly from 2019. Canada’s trade with these seven new markets was C$71.3bn in 2016, according to the government’s Global Affairs Office. Trade earnings overall are forecast to increase by 4.2% once the CPTPP is implemented.  

Stuck in the middle

Canada has been stuck in a difficult position in the US-China dispute; while some industries benefit by replacing US products subject to tariffs in China, Canada is generally fearful that a protracted fight would hurt overall trade. 

The US and China reached a truce at the start of December to negotiate a settlement. US tariffs will remain, but not increase in January to 25% from 10% on more than $200bn in goods. China agreed to resume buying US commodities.

“Canada is a very open economy. We are next to the US and only have 36 million people, so trade is very important for the country, and for growth in Canada and throughout the countries where we have a footprint,” says Mr Porter.

Analysts are looking for signals in the US and Mexico concerning the USMCA, which Mr Trump, Canadian prime minister Justin Trudeau and Mexican president Enrique Peña Nieto inked on November 30 (Mr Peña Nieto’s last day in office).

Mexico’s new president, Andrés Manuel López Obrador, backs the agreement as does the Trump administration, but the US Congress will have to approve it in 2019 when the Democrats are in charge of the lower chamber. Democratic lawmakers are not necessarily keen on the agreement and Republicans, who have voted overwhelming for trade agreements in the past, are less sympathetic.

Fitch’s Mr Narron says failure to approve the USMCA is a downside, but “talk of opposition to the agreement is not our base case”.