Canada’s banking giants headed for earnings iceberg

By Theresa Tedesco
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Apparently, a great reckoning is fast approaching inside the country’s gleaming bank towers. Canada’s major banks are said to be on the verge of hitting a revenue iceberg that could slice earnings per share growth in half this year.

And it’s all Mark Carney’s fault. The Bank of Canada governor’s obsession with aggressively low interest rate policies and his get-tough message on climbing household debt are really putting a crimp in the historically predictable and reliable sources of income the big banks have enjoyed at home.

The two engines that have fuelled strong earnings momentum during the global economic turmoil— growth in consumer credit and residential mortgages — are stalling.

All six of the majors — Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce and National Bank — are said to be feeling the squeeze.

To pick up the imminent slack, they’re being forced to look outside the country to boost their balance sheets in 2013. Except the problem is that it isn’t a whole lot rosier out there either, which is why the mighty financial institutions will likely see their credit ratings lowered a notch next week by Moody’s Investors Service Inc.

Basically, the rating agency is concerned about the banks’ exposure to record high levels of consumer debt and elevated house prices, which has made them more vulnerable to the downside risks than they have been of late.

The big red flag is that current Canadian household debt resembles rates in the United States before the housing market tanked in 2008. According to Statistics Canada, the ratio of household debt-to-income in this country reached 163.4% in the second quarter of 2012, up from 161.8% in the first three months of last year. The trend continued in the third quarter of 2012, showing Canadian households owed $1.65 on average for every after-tax dollar they earn.

Compare that to the U.S., where household debt-to-income at the height of the housing bubble in 2007 was 170%.

This is causing considerable angst because a shock to the Canadian economy will inevitably reverberate on bank balance sheets.

Already, bank retail margins are under pressure. Consumer lending is falling; 5.1% in November, 2012, from 5.8% during the same month in 2011.

At the same time, a series of initiatives to tighten mortgage requirements has had a cooling effect as the resale of homes in Canada fell 17% in December from 2011. The end of the boom in residential mortgages has a double whammy effect on banks because that revenue stream helped cushion the blow of slimmer margins on loans and shrinking revenues courtesy of persistently low interest rates.

Stalling income growth at home means the banks have to find other ways to shore up their balance sheets. Obviously, that means focusing on their operations outside Canada. Except for Scotia, which has carved a unique presence in Latin America and risky developing markets where the margins are wide, the focus for the rest will likely be in the U.S. For RBC, that means trying to capitalize on the exodus of European players in capital markets and wealth management. TD and BMO will continue to scratch out a presence in the lucrative and hugely competitive U.S. regional banking sector.

Nonetheless, the challenge on the home front will be keeping expenses at, or below, diminishing revenues. In order to maintain a competitive position in Canada, the banks have to make major investments to their retail banking infrastructures, while at the same time, making sure expenses don’t get ahead of income growth.

The bottom line: expect bank earnings to be stunted this year, with predictions of industry revenue growth in personal and commercial banking to be a paltry 1%. That translates into estimated earnings per-share growth to be in the 5% range this year — hardly the end of the world, but still below 10% from 2012.

Even so, the trends may be going in the wrong direction, but much of the balance-sheet consequences will be played out at the margins. It may be harder to make the kinds of heady returns bank shareholders have enjoyed in recent years, but in Canada banking will always be a profitable proposition. So chin up, no matter what Moody’s says.