Big banks review: Tough quarter, but is the worst behind us?

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- Hello, and welcome to the MoneyTalk COVID-19 Daily Bulletin for Thursday, June 4th. I'm Anthony Okolie. In a few minutes, Kim Parlee will be speaking with Mario Mendonca, Managing Director at TD Securities, on last quarter's performance of Canada's big banks. But first, a quick wrap of today's headlines.

More evidence the worst may be over for the US jobs crisis. Another 1.9 million Americans applied for unemployment benefits last week, a sharp drop from a peak of almost 7 million in March.

More bad news from the beaten-up retail sector. The biggest US mall owner, Simon Property, is suing Gap for skipping out on $66 million in rent and other charges due to the coronavirus pandemic.

Meanwhile, Las Vegas casinos are preparing to reopen for business at midnight tonight. That's after closing their doors three months ago due to COVID-19. Disinfected dice, face masks, limits on gamblers at tables, and temperature checks are all part of the new Vegas experience.

Finally, a sign of optimism for air travel. American Airlines said it plans to fly 55% of its domestic schedule in July, up dramatically from May, when the airline flew 20% of its schedule from a year earlier.

And that's a wrap of today's headlines. Next, Kim Parlee's conversation with Mario Mendonca.

- Mario, the last time we spoke was the end of February. And I feel as though, at that time, there was a lot of concern, not a lot of information on what was happening. And I think, at that time, you only had one buy rating on one of the banks. Fast forward to today, it feels as though we're at the end of the beginning. A lot has happened in between, so maybe you could just tell us what you've seen. I know you made a big change to your analysis on March 20th. And then we'll get into the quarter itself.

- Sure. Prior to the COVID issue-- so you're right, around February-- I had one buy rating. That was on Royal Bank. My caution certainly wasn't pandemic-related, it was just concern that credit losses were very low and likely to move higher. I felt that margins could come in somewhat as rates were declining. Once the COVID pandemic hit and the bank stocks dropped substantially-- several of them, in fact most of them, were trading below book value around March 20th-- I upgraded the sector [AUDIO OUT] essentially all the banks, with the exception of Laurentian Bank. That was the one bank I didn't upgrade.

And the logic in doing so was simply that I felt book value was a very fair valuation, particularly if you believed that the banks would exhibit capital strength, not cut their dividends, and that their business models would stay essentially intact. And so it felt like the appropriate thing to do around March 20th. The stocks have performed well, and I think this quarter-- and we'll get into it in a moment-- this quarter lends some support to that thesis.

- Let me ask you, then, so what has this quarter taught us? I mean, I know that people are-- I'd say we're watching earnings. I don't think we're focused too much on earnings. I'd say it seems to be a more a capital story, and trying to understand what's happening there. But let's start with the lessons of the quarter.

- Well, certainly capital and credit were the two big issues that everybody was focused on. But before we even get there, this was a challenging quarter. Earnings were down 51%. EPS was down 51% for the big six banks year over year. It was driven by a variety of things. The most important was credit losses. Credit losses were up approximately 400% year over year. So a very substantial increase in credit losses. And when we get into the credit discussion, I'm going to put some nuances around that. But certainly, credit losses were the big reason why earnings were down.

Beyond that, though, we did see a decline in fee income. Credit card purchases collapsed. Purchases for airline tickets, entertainment and leisure. Activity in the credit card space dropped substantially, and that resulted in much lower fee income. So a combination of lower fee income, much higher credit losses, offset somewhat by stronger capital markets numbers, are what ultimately drove EPS to be down 51%.

- Let's get into the nuance discussion on the credit side. And maybe just take us through, if you could, what you're seeing and what it tells us about maybe where the banks are going, where the economy is going at the same time.

- Sure. Now, this quarter was different. This was the very first quarter where we had a significant amount of stress and we applied new accounting standards. And I won't get into the details too much, but the way to think about credit losses now are real credit losses, what we call impaired losses, where the loan has become truly impaired, the person isn't paying, and what we call expected losses.

The actual impaired losses this quarter were not that significant. They didn't actually increase materially for most banks on a year over year basis, and partly because the payment deferrals that are in place are not treated as delinquent loans. So the actual impairments weren't that big. What was enormous was the expected credit losses.

And expected credit losses are really a function of the bank's outlook for the economy. So the banks appropriately assumed that 2020, and most of 2021, that unemployment will be elevated, economic growth will be muted. And when you build in those long-term expectations about the economy and unemployment, you necessarily have to build in very high expected losses.

So the nuance this quarter is simply that the expected losses are what dominated the story. Over the longer term, the opposite will happen. The actual credit losses will be high, but fortunately, the banks have already booked these credit losses today. They'll be able to release some of the expected credit losses as they book the real credit losses.

- Just for those who don't follow this as closely, Mario, maybe you could explain, quarter by quarter, as things happen and the true impaired loans come in, are we going to see variations quarter by quarter, or is this kind of they booked what they expect over the longer term, and there's other large bookings provisions for future credit losses still on the way?

- That's where it's actually difficult to tell. I think, for many of our banks, the expected credit loss that they book this quarter will, in fact, be the peak level. There's no need to build in materially more expected credit loss. I can't say that's true for everybody. I think, in the case of Scotia, they warned us that there might be some more expected credit losses to emerge. But for the other banks, I don't feel that we're going to see a lot of high expected credit losses.

But what we do have to prepare for is that, at some point, these payment deferrals will end, these payment holidays we're given. Maybe in the next three to six months. When that happens, I would imagine most borrowers will then resume making their payments, but there will be some that have lost their jobs and are incapable of essentially resuming the payments. At that point, we will see what we call the impaired credit losses, the real credit losses. I would expect, at that point, that the impaired credit losses will be very large, but because the banks have built in very significant expected credit losses this quarter, they'll be able to offset the two to some extent.

- Mario, maybe you could give us a little sense of-- a lot of the deferrals you're talking about sound as if they're more in the retail space and personal banking space. So how is the commercial side and how is the investment banking side looking? Where are you seeing the big red flags?

- From a deferral perspective, the vast majority we saw on the personal side. Think mortgages, credit cards, personal loans, auto loans. We did see some deferred payments on the commercial and wholesale side, probably more so commercial than wholesale, but I would think that the majority of the delinquencies and issues we're going to see emerge from the payment deferral will be on the personal side.

In terms of capital markets, not so much thinking of the deferred payments, capital markets are actually very strong this quarter. We saw very strong trading revenue across most of the banks, as bid/offer spreads were wider and activity was strong. I think one of the things we might see from capital markets perspective that will be very positive is significant debt and equity issuances as governments and businesses recapitalize post this pandemic. So there actually is a sort of a bright future here on the capital markets side, at least I hope so, for a lot of our banks.

- Let me ask you, just sticking with the equity issuances, good business for the capital market side. What about the banks themselves? Are you expecting to see something there?

- Yeah, that's important. So credit and capital are the big issues. Let's flip to capital, because that's precisely what we have to think about now. You know, the Canadian banks reported very strong capital levels this quarter. We saw their capital ratios decline somewhat, maybe 70 basis points at the outside, in some cases essentially no decline. Now, we shouldn't assume, however, that because capital looked so solid this quarter that it will always be this way. I think there will be periods throughout 2020 and 2021 when we see more significant declines in their credit-- or sorry, in their capital ratios. And that makes sense because, as these loans deteriorate, we will see what the market calls RWA inflation. It's Risk Weighted Asset inflation we call it.

So the deterioration will cause capital ratios to go down. What I feel very confident in saying, and what supported the March 20 upgrade, is that I don't see capital ratios declining to the point where banks need common equity. And I really think of the minimum capital ratio right now is about 9%, and our banks, most are-- the lowest among the big six is 10.9%. And that's Scotia. That's very, very strong capital ratio. So I really can't see a scenario, at least for now, where our banks really have to raise equity or cut the dividend. I think both are very safe.

- I want to get to the dividend, but just when you say-- and I'm going to ask you to be your own devil's advocate on that capital piece-- what would have you change your mind on that front?

- Yeah, it's not so much the severity, but more the duration of the downturn. Let's envision a scenario where it's fall, and there is the second wave of the pandemic. And society collectively agrees to shut down yet again, putting even further strain on the economy and pushing out the recovery still further. That would be the scenario that would scare me and cause me to question my thesis a little bit.

This is not a political statement, but my view is if, in fact, there is a second wave, I can't see society collectively shutting down all over again and really damaging the economy further. So I'm more of the view that this will be a painful period, capital ratios will deteriorate, but they'll stay well above the 9%.

- OK, fair. Let me ask you, then, dividend, I mean, you touched on it, but give me a bit more color on that. You're not seeing-- your feeling is that the dividends are fairly secure from the banks, most of the banks.

- The only one that I was a little concerned with was Laurentian Bank. And they cut their dividend by 40% this morning. Stock's reacting to that. The large Canadian banks, I really don't see dividends being cut. In part, they went into this with payout ratios that were only about 45%. And what I did learn from this quarter is that the pre-tax pre-provision earnings are incredibly strong for this group. And it's really your pre-tax pre-provision earnings that provide the basis both for your capital and for the dividend. So I really, again, from a profitability and from a capital perspective, it seems highly unlikely to me that our banks will cut the dividend.

We do-- two banks-- TD has a DRIP right now, a 2% discount dividend reinvestment plan. BMO has a DRIP. I wouldn't be surprised if the other banks eventually introduce dividend reinvestment plans. That would be a sort of prudent thing to do over time. But ask for dividend cuts? Highly unlikely.

- Mario, I think one of the more fascinating things that has happened through this-- and I want to just say, you know, a lot of people are going through some incredible hardship. I mean, people have lost loved ones who are sick, their business is not functioning. So I don't want to be Pollyanna-ish about this. It's very tough.

But one thing that has happened we've seen is this rapid move to digital adoption, both on the bank side, in terms of how they operate, and the consumer side, in terms of the speed at which they're able to do things. So when you look at the operating model today, and you look at the operating model for the banks, let's say, in 2021, 2022, does it change? Does the emphasis change? Does where they're putting their resources and where they hope to make money change?

- That's really important because we are headed toward a period here where interest rates will remain very low for a long time. And that could put a lot of strain on bank earnings power, which then immediately has you think a little bit about expenses. And the digitization story really ties in well with the expenses. I've heard several bank executives, and insurance executives, say that what COVID-19 did in terms of pushing people toward online banking and online insurance is would have taken years to get there, but it happened abruptly because of COVID-19.

Now, I think what that does is it really hastens the trends that were already in place. The trends were fewer branches, smaller branches. I think this pandemic will only hasten that. It will go to even fewer branches, smaller branches, online distribution, online bill payment, which is sort of kind of the price of admission. Every bank has to have a good online presence.

But I think the consumer will adopt it, I think, a lot faster. And that's relevant to me because the banks are going to have to look for ways to cut expenses in a very slow growth environment. I strongly suspect we'll emerge from COVID with strong capital ratios, the dividends intact, but we still have to cope with what the long-term implications for earnings are. And I think expense cuts and digitization play a role.

- Mario, always a pleasure. Thanks so much for the insight.

- Thank you.

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