Canadian banks brace for tougher times as 'Goldilocks' era winds down

By Nichola Saminather

(Reuters) - Canadian banks face challenging times as souring macroeconomic conditions and trade uncertainties increase lending risk and weigh on profit margins, investors and analysts said on Thursday after major lenders wrapped up their quarterly earnings season.

TD Bank Group <TD.TO>, the country's No. 2 lender by market value and the last of Canada's top six banks to report quarterly profits on Thursday, slightly missed analysts' expectations.

The latest earnings season for Canadian banks saw higher loan loss provisions, subdued margin growth and capital markets weakness offsetting retail and wealth management strength, with three of the top six banks missing market expectations for profit growth.

"The last few years have been an absolutely Goldilocks environment for credit for the banks," as low interest rates and unemployment eased consumer burdens while robust profits helped commercial loan books, said Brian Madden, portfolio manager at Goodreid Investment Counsel.

"It's not unreasonable to think we will have a recession within the next couple of years ... so credit provisions could go significantly higher," he said. "And net interest margins could be compressed because central banks are cutting rates."

Banks are raising bad debt provisions as they take a worsening macroeconomic outlook into account in their assumptions about future loan-loss levels at a time when household debt in Canada is near a record high.

"We've been saying for a number of years that credit quality has been exceptionally benign," TD Bank Chief Financial Officer Riaz Ahmed said in an interview. "We're starting to see some normalization of that ... Macro news around trade, Brexit etc. are creating uncertainties."

Loan-loss provisions at TD Bank climbed 17% to C$655 million ($493.4 million) in its third quarter. While that was better than analysts' expectations, the bank reported adjusted net income of C$1.79 per share, missing estimates by 1 cent.

TD Bank shares closed up 0.5% at C$71,87, compared with a 0.7% gain for the Toronto Stock Exchange's S&P/TSE composite index <.GSPTSE>.

BANKS UNDERPERFORM

Canadian banking stocks have underperformed the broader market in 2019, with the sector sub-index <.GSPTXBA> up 5.2% this year, compared with a 14.4% rise in the benchmark Toronto stock index. Canadian banks are trading at an average price-to-book ratio of 1.06, the lowest level since February 2016, according to Refinitiv data.

Amid mixed results, Canada's six top banks, including Royal Bank of Canada <RY.TO> and Bank of Montreal <BMO.TO>, have raised amounts set aside to cover bad loans by 27% to C$2.45 billion in the three months ended July 31 from a year earlier.

Smaller Montreal-based lender Laurentian Bank of Canada <LB.TO> on Thursday said provisions jumped nearly 2.5 times to C$12.1 million in its third quarter from a year earlier.

Some of the commercial credit provisions across the industry are due to persistently low energy prices, said Greg Taylor, chief investment officer at Purpose Investments.

"The energy sector has some concerns broadly across the Canadian economy, so it probably makes sense to increase provisions for credit losses in that sector," Taylor said.

Overall, Canadian banks have done slightly better than expected, Taylor said. "While a lot of people are concerned about the inverted (U.S. Treasury) yield curve, it doesn't seem to be affecting earnings yet."

Even so, Canadian banks have posted subdued, if any, margin growth. A three-basis-point increase in net interest margins in TD's Canadian retail operation was more than offset by a six-basis-point drop in its U.S. retail business from a year earlier.

"We do see some compression in margins that can arise from the overall interest rate environment," TD's Riaz said, adding that this could "be mitigated by volume increases and better credit performance."

TD posted 11% growth in adjusted earnings in U.S. retail and a surprise 9% increase in wholesale banking, which includes capital markets and investment banking, while Canadian retail income rose 3.4%.

Across the sector, growth was driven by increases in domestic retail, U.S. commercial and wealth management businesses, while capital markets units lagged. Bank of Nova Scotia <BNS.TO>, Canada's most international bank with a focus on Latin American markets, shone.

Separately, smaller lender Canada Western Bank <CWB.TO> on Thursday reported earnings of 81 Canadian cents a share, up from 70 cents a year ago, sending its shares soaring to their highest level since November.

(Reporting by Nichola Saminather in Toronto; Editing by Denny Thomas and Paul Simao)