By Vipal Monga
An expected rate increase from the Bank of Canada Wednesday
would give the country's lenders a long-awaited boost in lending
margins, but analysts say it would also trigger concerns about a
rise in defaults down the road.
The expected rate increase by Canada's central bank will be the
first in seven years, and it could help boost lending margins -- a
key profit-driver for banks -- which have been falling steadily
during the postcrisis era of ultralow rates in Canada, the U.S. and
elsewhere.
But the six Canadian banks that dominate the financial system
are also vulnerable to consumers who are borrowing at historically
high rates, say analysts and investors. An extended cycle of rising
rates could cause many to default on their credit cards, car loans
or mortgages, potentially rattling the foundation of the Canadian
financial sector.
Residential mortgages made up 22% of the banks' combined assets
in the second quarter, ending April 30. Personal and credit-card
debt made up about 11%, according to filings. Those levels are down
just slightly from the 23% and 12%, respectively, two years
prior.
At U.S. banks, which tend to securitize more of their loans and
move them off their balance sheets, mortgages make up roughly 13%
of assets, according to the most recent Federal Reserve data.
The expected rate boost comes amid a strong run for Canada's
banks, which have been bolstered by the country's recent pickup in
economic growth and high demand for mortgages in markets like
Toronto and Vancouver. Royal Bank of Canada, Toronto-Dominion Bank,
Bank of Montreal, Canadian Imperial Bank of Commerce, Bank of Nova
Scotia and National Bank of Canada increased earnings by an average
11% during the second quarter, according to a report by Credit
Suisse.
Net interest margins, which measure the difference between their
cost of borrowing and the money they make from lending, averaged
2.46%, down 0.04 percentage point from the end of 2015. A rate rise
should help boost those numbers, helping grow earnings further,
analysts say.
The banks, anticipating a rate increase, have already begun to
raise mortgage lending rates. RBC, TD, Bank of Montreal and CIBC
raised rates early in July by as much as 0.20 point for five-year
mortgages.
Despite their robust earnings, some observers have already sent
up cautionary flares. Moody's Investors Service in May downgraded
the top five banks, citing their vulnerability to debt. Household
debt totaled 175.9% of disposable income at the end of 2016,
according to the Organization for Economic Cooperation and
Development. That compares with 152.3% in the U.K. in 2016 and a
U.S. ratio of 112% in 2015, the most recent year for with the OECD
had data available.
Canadian consumers and the Canadian banking system haven't been
tested at such high levels of leverage," said David Beattie, a
Toronto-based analyst for the ratings service. "We don't know what
the shocks to the system will be, but we do know it's harder for
the system to respond when we get to these levels."
Canadian officials have signaled they are concerned. They have
imposed measures to cool housing markets in Toronto and Vancouver,
including a tax on foreign buyers, and last week said they are
weighing tighter rules for mortgage issuance.
This spring, alternative lender Home Capital Group Inc. unnerved
the financial sector when it suffered an outflow of 95% of its more
than C$2 billion ($1.55 billion) in high-interest savings deposits
following allegations the company misled investors about its
mortgage fraud problem. The company, a large lender to the
self-employed and those with little credit history, was bailed out
last month by an investment from Warren Buffett's Berkshire
Hathaway.
To be sure, the major banks aren't as exposed as Home Capital to
non-prime borrowers. The government's Canada Mortgage and Housing
Corporation also fully insures more than half the mortgages on the
banks' books, according to a report by Citi, reducing their risk to
the firms. But any damage to the banks' balance sheets from rising
interest rates and stressed borrowers likely will begin through
other forms of borrowing, said Brian Klock, an analyst with Keefe,
Bruyette & Woods.
"The fear in Canada is that you have that consumer borrower who
finally turns," said Mr. Klock. "If they are having problems with
their car loans, do they default? Will that cause an issue with
their mortgage?"
Chris Kresic, head of fixed income at Montreal-based investment
management firm Jarislowsky Fraser, said that growth in the housing
sector poses a macroeconomic risk for the Canadian economy as
whole, which exposes the banks. But the banks, who effectively hold
an oligopoly in the country, haven't had to take on as much risk to
remain competitive as U.S. banks did in the run up to the housing
crisis in 2007.
Canadian banks don't have many subprime loans on their balance
sheets, he noted, which could help them avoid the worst of a
default wave.
That conservatism could help avoid a crisis, even if higher
rates lead to a severe housing downturn, he said.
"There's no doubt that the Canadian economy has never been so
leveraged and so leveraged to housing," he said. "There is a
macroeconomic exposure for the banks. Is the risk greater now than
ever before? Probably. Are the banks able to survive such a
downturn? We think they will."
Write to Vipal Monga at vipal.monga@wsj.com
(END) Dow Jones Newswires
July 12, 2017 07:07 ET (11:07 GMT)
Copyright (c) 2017 Dow Jones & Company, Inc.
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