(Although the Canadian banks have significant international operations, my focus is on their Canadian operations in this blog).

Although banks now have diversified their sources of income to include major areas such as wealth management and trading, they still largely succeed or fail based on the performance of the loans they make to consumers and companies.  COVID-19 shutdowns were a big risk to the Canadian banks. People who lose their jobs cannot pay their rent, mortgages and credit card debt, and Canadian household debt was already at historically high levels. On the commercial side, low energy prices were impacting the oil & gas sector and businesses in the restaurants, entertainment, and travel & leisure space were shut down, leading to direct loan losses which would also flow through to the commercial real estate market. Weak financial markets also impact fees from the Wealth Management and Investment Banking/Capital Markets businesses. All the ingredients were ready for a rough time for the Canadian banks: low net interest margins from the low interest rates, and large losses due to the collapsing economy.

Fortunately, the Canadian government acted decisively to bridge the economy with stimulus programs such as CERB for workers who lost their jobs and CEWS and CERS for small businesses. The Canadian banks also helped by facilitating stimulus payments and by allowing borrowers to defer payments on their mortgage and credit cards.  When the federal banking regulator told the banks not to assume that deferrals were evidence that the borrower might be unable to pay their loans, this was a very strong hint that the government would take aggressive action to protect the banks. In hindsight, this was a great buying opportunity for Canadian bank stocks since the banks remained comfortably profitable with the bridge.

The bank results through April 2021 confirm that the actions by the government have worked. The vast majority of Canadians who obtained a deferral have resumed making normal payments on their loans, and the improved economic situation has led to large reversals of prior loan loss provisions. The high-level narrative is that having survived COVID, the conditions are ripe for a “Goldilocks” situation for the banks: a recovering economy leads to loan growth, capital markets activity, and strong consumer spending. Loan losses would also remain low, as is common in a strong economy.

Going forward, there are several questions that are important to performance.

1) To what extent will deposits runoff?

The significant stimulus spending combined with consumers and businesses shoring up their finances has led to significant deposit growth at the banks. Over the last twelve months through April 2021, the Big 6 have added about $267 billion in personal and corporate deposits:


Normally, deposit growth is great since it is a cheap source of funding that also builds a new relationship with the customer for future cross-sales, but in this case, the strong deposit growth was more reflective of the economic uncertainty: nervous people and businesses are preferring to hold cash rather than travel, spend money, or invest and it makes sense that as prospects improve, people will start spending and investing again. The more run-off there is, the more banks will have to rely on more expensive wholesale funding to fund loan growth in the economic recovery, making the potential upside highly dependent on what happens to deposits:

If we assume that we retain all of the balances, then the sensitivity (of NII) could be 70%-80% higher than what we are showing up here” – BMO Q2 earnings call

There are a few offsets: the Canadian banks are highly diversified businesses with large wealth management, capital markets, and trading operations, and will therefore be able to re-capture some of the growth in investment or consumer spending through credit card interchange fees or investment banking fees. The banks will be able to shift a portion of the deposits to their large wealth management operations (“I notice you have a large balance that’s earning basically nothing, would you like to speak to our wealth advisor?”).

2) Is Canadian housing a risk?

Apart from the impact of runoffs, the upside from rising interest rates could also be hampered by its impact to the housing market. This is important to the Canadian banks because the majority of their loan portfolios are tied to residential real estate including mortgages and HELOCs.

Generally, an improving economy is positive for housing prices as rising income and employment levels and new government programs will also help prospective homebuyers qualify for mortgages. Furthermore, immigration was halted during COVID and should pick up after restrictions are lifted driving even more loan growth. However, Canadian housing prices and values are already historically high on any valuation metric making prices more vulnerable to rising interest rates. There will be homebuyers that borrowed at record low mortgage rates last year who will struggle to refinance their mortgages at higher rates.

Nonetheless, I am not too concerned about possible lower housing prices on the Big 6 banks. Although the media coverage often focuses on the recent sharp housing price increases particularly in Toronto and Vancouver, it’s also worth noting that a very small percentage of the housing stock turns over every year and therefore, the vast majority of borrowers had qualified for their mortgages at higher, pre-COVID mortgage rates. A decline in housing prices from higher rates would also make down payments more affordable, and increase the potential pool of potential homebuyers.

Secondly, the Canadian banks have been extremely prudent in their lending with a large percentage being insured mortgages, and the uninsured books focusing on high credit quality borrowers at low LTVs (where the low-quality borrowers are going is another question!). As such, the major Canadian banks seem well protected even under a scenario where housing prices drop 20% or 30%.


3) How much capital will the banks be allowed to return post-COVID?

At the onset of the pandemic, OSFI banned dividend increases and share buybacks to protect the balance sheets and safety of the banking system. To-date, the restrictions have not yet been lifted. Since the banks have remained profitable through the pandemic, the banks are over-capitalized with CET1 ratios over 12% relative to the required CET1 ratio of 9% and 10% before COVID.

In theory, bank stocks would trade at significantly higher multiples if the Bank of Canada and the government was going to do everything in their power to prevent major loan losses in any crisis. Nonetheless, this kind of assurance could come with guardrails to protect the system such as stricter lending criteria or higher capital requirements, particularly given the current elevated housing prices. Prior to COVID, OSFI had already been planning to raise the domestic stability buffer to 2.25%. As a result, Returns on Equity going forward might be lower than pre-COVID levels with less dividend hikes and buybacks than investors are expecting.


Notwithstanding the three factors above, the economic tailwinds overall should still provide strong results with low loan losses for banks and valuations are not expensive with the Big 6 trading at around 11x earnings vs 14x for major US banks despite having extremely strong balance sheets. We remain long-term investors.