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All six Canadian banks delivered record earnings per share and beat consensus estimates by the greatest margin on record last quarter. Why are Canadian banks finally performing and will they continue to outperform in 2021? Kim Parlee talks to Mario Mendonca, Managing Director at TD Securities.
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- I want to start with the quarter itself. We saw overall earnings up 12% in the quarter on an EPS basis. What's behind that?
- Yeah, very strong results from all the banks. What drove it probably primarily was credit losses. Credit losses were down 44% year over year. What's become clear is that the banks have been sufficiently conservative in building up their credit reserves.
The environment's starting to appear a little better, so several of the banks, in fact I think most of them, released provisions, released credit provisions. And then the actual impaired losses were very low, as well. So the actual losses turned out lower, the reserves were released. So I think that was the biggest reason why earnings looked so good.
But it wasn't just that. The top line looked good, as well. Capital markets revenue was very strong, up 19% year over year. We're starting to see the emergence of other key revenue lines maybe building up some momentum, like retail banking fees and even net interest income, which had been down a fair bit in 2020, looks like it's starting to stabilize. So yeah, a very good quarter for the banks.
Well, we'll talk about the NIM, or the net interest margin, in a bit, because there's some interesting things happening in the market. But do you see that overall great performance being able to keep it up, and to continue to outperform?
- Yeah, if we look at some of the factors that drove it, credit, I would expect that we'll see higher credit losses emerge as we get further and further away from government support. But recall that the banks did set up a significant amount of credit reserves in 2020. So as actual losses rise, the banks will be able to release more of those credit reserves. So I don't see anything emerging on the credit environment, the credit horizon, that's going to derail this momentum.
In terms of the top-line momentum, we might see a bit of a changing of the guard. What's been driving top-line throughout 2020, what's been driving it is very, very strong capital markets revenues. And we'd expect that to continue in Q2. But as the year progresses, as we get further and further into 2021, look for net interest margin to be a bit of a more important story, or net interest income generally. And also certain banking fees, like credit fees, credit card fees, deposit fees, those are the sorts of fees you'd expect to develop some momentum as the lockdowns end.
Again, we'll get to that, but just to stick with what just happened, I mean, any standouts in any particular lanes you saw in the quarter?
- Well, National and Bank of Montreal were very, very strong. They generated pre-tax, pre-provision earnings growth-- so this is excluding the effects of taxes and credit losses-- National was up 20% year over year, Bank of Montreal was up 17% year over year. That was a fair bit better than the rest that were roughly 5% up year over year.
Now, what really drove it for these two banks, part of it is their business mix. Both banks are a little heavier in capital markets than their peers. But on top of that, they were the only two banks that generated growth in net interest income. That really stood out. They are exhibiting far greater stability in their lending and their interest margins than the rest of the group.
Hm. OK, now let's talk about the-- continue the conversation about interest rates and NIM. We have seen a lot of concerns about inflation right now. Those fears have been rocking the markets. We've seen yields start to back up in some of the five-year and 10-years. And of course, that's all based on inflation and, eventually, rates going up when the central banks choose to pull the trigger. So what is going to be the impact on that on banks?
- Well, if you take a step back and look at what happened in 2020 and in Q1 2021, National and Bank of Montreal exhibited far greater stability in their margin than their peers. At the other extreme would be Royal Bank, where we saw far more margin pressure.
The biggest difference between, say, Royal, on one hand, and National and BMO on the other, is that Royal has far more of the low-cost deposits. Think demand and notice deposits. And in a period of declining rates, you'll see a bank like Royal exhibit more margin pressure because of those low-cost deposits because you can't take a zero interest rate deposit below zero, yet the yield you earn on the assets does continue to decline.
Now, the opposite is also true. If, in fact, the five-year moves higher from here-- and we've already seen it in both Canada and the US-- I think what you'll find is that the gap in performance, Royal on one hand, maybe Scotia and CIBC that have a little bit more rate sensitivity than BMO and National, you'll see those banks exhibit better margin performance than BMO and National. And I think that's a theme and a trend we'll see unfold if, in fact, rates do continue to rise.
Hm. Another big theme, of course, that everyone's been asking about is we keep seeing these capital ratios that are just off the charts from all the banks. What happens with all that capital?
- Well, when people ask me about capital, the word that keeps coming to mind for me is gluttonous. Our banks are well above any capital ratio I expected to see them at. They developed those capital ratios despite living through a serious real-life stress test. The pandemic was a real-life stress test, and what's happened to capital ratios? They've gone up, not down.
Now, one could argue that part of the reason they've gone up is because they haven't been raising their dividends and buying back stock, but I think the real reason is they've done a good job of managing risk and their earnings have remained relatively strong. And so we're at a point now where, globally, we're seeing banks start to buy back stock and raise dividends. We're seeing the restrictions come off. That's not the case in Canada. There's still a moratorium on dividend raises and buybacks.
My suspicion, if I had to put my best sort of guess onto this, sometime in around June or July of this year, the regulator, OSFI, will increase what we call the domestic stability buffer. They took it from 200 basis points to 100. I think they'll bring it back up to 200 and say things are looking good again.
And I think at that point, maybe June or July, our banks will be given permission to raise dividends and buy back stock. And I think that's the order you should think about it-- raise dividends for sure, some buy back stock, and then maybe, over time, we'll see some more M&A.
Hm. And the M&A piece is interesting. I mean, if you talk about maybe the Canadian banks have been-- rightfully, wrongfully, and not a judgment here-- forced into have higher capital positions, it puts them in a better place for those acquisitions later on.
- Yeah. So clearly, when you have a very high capital ratio, doing a deal is easier because you can use more of your existing capital. That allows the deal to be more accretive to earnings, or at least less dilutive. You don't have to go to the public market and raise as much equity as you would have in the past. So having capital is a very good thing when you are doing an acquisition.
But the one thing I do think investors should remember is our banks don't make the M&A decision based on their capital position. The M&A decision is based on the opportunity, the right fit, the right strategic, financial merits of the deal, not on the excess capital they're currently holding.
So I know it's become popular lately to ask about M&A risk now that the banks have a lot of capital. I wouldn't look at it that way. Our banks don't function that way. They don't walk around the streets of the US with bags of capital looking for a deal. I think the deal has to be right. It's got to come to them. And then if they've got excess capital, all the better.
Yeah. Nice visual, though, walking around the streets with lots of money. Let me ask you, you know, you reiterated that the outlook is pretty good, it sounds like, for most of the Canadian banks. I know you don't cover TD, but tell me just maybe your specific outlook on the other banks.
- Yeah. In the very near term, like as in the next few quarters, the banks that still rate very high for me would be Scotiabank. And in Scotia's case, it's largely because they had such a rough 2020. The lockdowns in Latin America and the lack of travel to the Caribbean really affected their international business.
And I think we're starting to see that ease somewhat. Latin America's in their summer, so we're seeing more of a reopening trend there. So I would really expect Scotiabank, which trades at a discount to the group, has the benefit of this recovery in Latin America, I rank them very high.
BMO still ranks very high for me, as well. BMO is showing a ton of momentum in their businesses right now. They generated the best operating leverage of the group last quarter, at 7%. That's the difference between their revenue growth and their expense growth. So BMO ranks very high.
There is one sort of nuance I'd like to offer. I think BMO probably, as the year progresses, won't meet all of my themes quite as directly. So while I feel good about BMO today, I would suspect that, as the year progresses, I'll be moving other banks up in my pecking order. A bank that might move up in my pecking order would be a Royal Bank. As we talked about a moment ago, Royal benefits from that reflation trade. As interest rates move a little higher, I think the bank could be one of the beneficiaries.
I think CIBC comes next. In terms of CIBC, they meet a lot of the themes I care about-- strong mortgage growth, not as much exposure to capital markets. The reason I'm a little bit careful with CIBC is largely because the bank has been guiding to growing their expenses more aggressively in the second half of the year as they retool their domestic retail operations. I think in a period where they're growing expenses faster than their peers, they might lose a little bit of investor enthusiasm.
Mario, always a pleasure. Thanks so much.
- Thank you.
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- I want to start with the quarter itself. We saw overall earnings up 12% in the quarter on an EPS basis. What's behind that?
- Yeah, very strong results from all the banks. What drove it probably primarily was credit losses. Credit losses were down 44% year over year. What's become clear is that the banks have been sufficiently conservative in building up their credit reserves.
The environment's starting to appear a little better, so several of the banks, in fact I think most of them, released provisions, released credit provisions. And then the actual impaired losses were very low, as well. So the actual losses turned out lower, the reserves were released. So I think that was the biggest reason why earnings looked so good.
But it wasn't just that. The top line looked good, as well. Capital markets revenue was very strong, up 19% year over year. We're starting to see the emergence of other key revenue lines maybe building up some momentum, like retail banking fees and even net interest income, which had been down a fair bit in 2020, looks like it's starting to stabilize. So yeah, a very good quarter for the banks.
Well, we'll talk about the NIM, or the net interest margin, in a bit, because there's some interesting things happening in the market. But do you see that overall great performance being able to keep it up, and to continue to outperform?
- Yeah, if we look at some of the factors that drove it, credit, I would expect that we'll see higher credit losses emerge as we get further and further away from government support. But recall that the banks did set up a significant amount of credit reserves in 2020. So as actual losses rise, the banks will be able to release more of those credit reserves. So I don't see anything emerging on the credit environment, the credit horizon, that's going to derail this momentum.
In terms of the top-line momentum, we might see a bit of a changing of the guard. What's been driving top-line throughout 2020, what's been driving it is very, very strong capital markets revenues. And we'd expect that to continue in Q2. But as the year progresses, as we get further and further into 2021, look for net interest margin to be a bit of a more important story, or net interest income generally. And also certain banking fees, like credit fees, credit card fees, deposit fees, those are the sorts of fees you'd expect to develop some momentum as the lockdowns end.
Again, we'll get to that, but just to stick with what just happened, I mean, any standouts in any particular lanes you saw in the quarter?
- Well, National and Bank of Montreal were very, very strong. They generated pre-tax, pre-provision earnings growth-- so this is excluding the effects of taxes and credit losses-- National was up 20% year over year, Bank of Montreal was up 17% year over year. That was a fair bit better than the rest that were roughly 5% up year over year.
Now, what really drove it for these two banks, part of it is their business mix. Both banks are a little heavier in capital markets than their peers. But on top of that, they were the only two banks that generated growth in net interest income. That really stood out. They are exhibiting far greater stability in their lending and their interest margins than the rest of the group.
Hm. OK, now let's talk about the-- continue the conversation about interest rates and NIM. We have seen a lot of concerns about inflation right now. Those fears have been rocking the markets. We've seen yields start to back up in some of the five-year and 10-years. And of course, that's all based on inflation and, eventually, rates going up when the central banks choose to pull the trigger. So what is going to be the impact on that on banks?
- Well, if you take a step back and look at what happened in 2020 and in Q1 2021, National and Bank of Montreal exhibited far greater stability in their margin than their peers. At the other extreme would be Royal Bank, where we saw far more margin pressure.
The biggest difference between, say, Royal, on one hand, and National and BMO on the other, is that Royal has far more of the low-cost deposits. Think demand and notice deposits. And in a period of declining rates, you'll see a bank like Royal exhibit more margin pressure because of those low-cost deposits because you can't take a zero interest rate deposit below zero, yet the yield you earn on the assets does continue to decline.
Now, the opposite is also true. If, in fact, the five-year moves higher from here-- and we've already seen it in both Canada and the US-- I think what you'll find is that the gap in performance, Royal on one hand, maybe Scotia and CIBC that have a little bit more rate sensitivity than BMO and National, you'll see those banks exhibit better margin performance than BMO and National. And I think that's a theme and a trend we'll see unfold if, in fact, rates do continue to rise.
Hm. Another big theme, of course, that everyone's been asking about is we keep seeing these capital ratios that are just off the charts from all the banks. What happens with all that capital?
- Well, when people ask me about capital, the word that keeps coming to mind for me is gluttonous. Our banks are well above any capital ratio I expected to see them at. They developed those capital ratios despite living through a serious real-life stress test. The pandemic was a real-life stress test, and what's happened to capital ratios? They've gone up, not down.
Now, one could argue that part of the reason they've gone up is because they haven't been raising their dividends and buying back stock, but I think the real reason is they've done a good job of managing risk and their earnings have remained relatively strong. And so we're at a point now where, globally, we're seeing banks start to buy back stock and raise dividends. We're seeing the restrictions come off. That's not the case in Canada. There's still a moratorium on dividend raises and buybacks.
My suspicion, if I had to put my best sort of guess onto this, sometime in around June or July of this year, the regulator, OSFI, will increase what we call the domestic stability buffer. They took it from 200 basis points to 100. I think they'll bring it back up to 200 and say things are looking good again.
And I think at that point, maybe June or July, our banks will be given permission to raise dividends and buy back stock. And I think that's the order you should think about it-- raise dividends for sure, some buy back stock, and then maybe, over time, we'll see some more M&A.
Hm. And the M&A piece is interesting. I mean, if you talk about maybe the Canadian banks have been-- rightfully, wrongfully, and not a judgment here-- forced into have higher capital positions, it puts them in a better place for those acquisitions later on.
- Yeah. So clearly, when you have a very high capital ratio, doing a deal is easier because you can use more of your existing capital. That allows the deal to be more accretive to earnings, or at least less dilutive. You don't have to go to the public market and raise as much equity as you would have in the past. So having capital is a very good thing when you are doing an acquisition.
But the one thing I do think investors should remember is our banks don't make the M&A decision based on their capital position. The M&A decision is based on the opportunity, the right fit, the right strategic, financial merits of the deal, not on the excess capital they're currently holding.
So I know it's become popular lately to ask about M&A risk now that the banks have a lot of capital. I wouldn't look at it that way. Our banks don't function that way. They don't walk around the streets of the US with bags of capital looking for a deal. I think the deal has to be right. It's got to come to them. And then if they've got excess capital, all the better.
Yeah. Nice visual, though, walking around the streets with lots of money. Let me ask you, you know, you reiterated that the outlook is pretty good, it sounds like, for most of the Canadian banks. I know you don't cover TD, but tell me just maybe your specific outlook on the other banks.
- Yeah. In the very near term, like as in the next few quarters, the banks that still rate very high for me would be Scotiabank. And in Scotia's case, it's largely because they had such a rough 2020. The lockdowns in Latin America and the lack of travel to the Caribbean really affected their international business.
And I think we're starting to see that ease somewhat. Latin America's in their summer, so we're seeing more of a reopening trend there. So I would really expect Scotiabank, which trades at a discount to the group, has the benefit of this recovery in Latin America, I rank them very high.
BMO still ranks very high for me, as well. BMO is showing a ton of momentum in their businesses right now. They generated the best operating leverage of the group last quarter, at 7%. That's the difference between their revenue growth and their expense growth. So BMO ranks very high.
There is one sort of nuance I'd like to offer. I think BMO probably, as the year progresses, won't meet all of my themes quite as directly. So while I feel good about BMO today, I would suspect that, as the year progresses, I'll be moving other banks up in my pecking order. A bank that might move up in my pecking order would be a Royal Bank. As we talked about a moment ago, Royal benefits from that reflation trade. As interest rates move a little higher, I think the bank could be one of the beneficiaries.
I think CIBC comes next. In terms of CIBC, they meet a lot of the themes I care about-- strong mortgage growth, not as much exposure to capital markets. The reason I'm a little bit careful with CIBC is largely because the bank has been guiding to growing their expenses more aggressively in the second half of the year as they retool their domestic retail operations. I think in a period where they're growing expenses faster than their peers, they might lose a little bit of investor enthusiasm.
Mario, always a pleasure. Thanks so much.
- Thank you.
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