Canada’s biggest banks returned to their winning ways as they reported earnings this quarter that beat expectations. Kim Parlee speaks with Mario Mendonca, Managing Director, TD Securities, about the outlook for Canadian banks as interest rates rise.
Originally published March 17, 2022
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- Canada's biggest banks have all just reported earnings all beat expectations. And this is all the while the Bank of Canada is getting ready to raise more rates in the next little while after they've done it once. Mario Mendonca joins us now. He's Managing Director at TD Securities to take us through what happened and what he's watching as he moves ahead.
Mario, good to have you with us. I'm going to launch right in. Last quarter, if I'm not mistaken, I think three of the Big Six missed estimates. This quarter, they all beat estimates. What's changed?
- Well, Q4s are often a little sloppy, as I say in my note. Generally speaking, the end of the year, results just generally aren't very good. Very often what you'll see is banks will book a lot of expenses in a Q4. You'll see some true up of expenses. It leads to what I call sloppy quarters.
Q1s are generally very strong. It's the beginning of the year. Capital markets revenue is usually very good in Q1. And that's what we saw this quarter. Every bank's trading revenue came in a fair bit stronger than what we were looking for, what the Street was looking for. And I think that was the key determinant of the very strong results. And absolutely right, the banks, all six beat estimates. And they beat by an average of 10%, which is a meaningful number.
- Mario, you say in your note this time that just came out that the banks are shifting lanes. What do you mean by that?
- Now, over many years of watching these banks, they've generally stuck to their lane, as I say. And what I mean by that is-- Royal, for example, National Bank, very strong capital markets banks. They stick to their lane. Scotia and International banks, CIBC, generally more of a retail bank. What I've noticed in the last 12 months or so is we're seeing some changes.
In CIBC's case, they have grown their commercial and wholesale loans at a pace far and away higher than the average bank. In fact, I observe in my note that CIBC has added $31 billion of nonconsumer loans in the last 12 months. That's greater than the $17 billion Royal has added. And Royal is about 60% larger than the CIBC. So that's one bank that's clearly shifting lanes and is becoming much more of a wholesale and commercial lender.
In Bank of Montreal's case, you can see that in their capital markets business 24% of their revenue now comes from capital markets. That's ahead of where Royal used to be, or ahead of where Royal is now. So BMO-- and I label it as such in the note-- is the new capital markets bank in Canada. Those two lane shifts, if you will, for CIBC and BMO have been instrumental in having them grow their pretax, preprovision profits at a pace well ahead of some of the larger banks like Scotia and Royal Bank. And in fact, what we're seeing is the other banks are also shifting lanes in some respects.
Scotia's exited some of the businesses in their Latin American business over the last few years. They're switching to secured lending from unsecured lending. And in Royal's case, what we've observed is the bank's lost market share in the last 12 months. It's not normal to see that out of Royal Bank. That's what I meant by we're seeing some lane shifting among our large Canadian banks.
- Is there a risk in that? I mean, obviously, banks are trying new things and trying a different lane, as you put it. What's the maybe executional risk, or anything else that could come out of that?
- Yeah, you know the saying nothing's free in this world. And for CIBC and BMO to build this kind of pretax, preprovision profit at the momentum that they're delivering-- and you can see it in their share prices. They're the best performing banks of the group this year. To build that kind of momentum in pretax, preprovision comes with a risk. And the risk in CIBC's cases, they're lending a lot more to what we call financial sponsors, or essentially the private equity firms. That does carry a little more risk.
BMO, for example, they recently disclosed that 50% of their share of wallet in the underwriting revenue, about 50% of their underwriting revenue is coming from these financial sponsors. So yeah, there's risk here. But one thing I want to be careful about-- and I was careful on this in my note.
I don't think that this newfound growth in these two banks is going to result in significant charges, similar to what we saw from CIBC in 2008 when they took a big charge on their RMBS exposure, or National when they took a charge on their oil and gas exposure. I don't think these banks are going to take big charges. I just think at some point they'll revisit their growth strategy and we could go through a period where their growth slows. That's what I suggested in my note.
- Interesting. Let me ask you, if we just run through-- you talked a bit about CIBC in the quarter itself, just to run through each one, what you're noticing, anything more to add with CIBC in terms of new growth in terms of where they're going. But anything else?
- No. CIBC, they're clearly not afraid to grow. They are willing to step out of their lane a little bit and grow more aggressively in nonconsumer lending. And they're making investments in that. And so you'd expect them to grow there. But yeah, that's the main point I wanted to make on CIBC.
- BMO.
- Bank of Montreal, we talked a little bit about that one as well. The bank has been a very strong performer in the last couple of years. They've got this deal with Bank of the West that will close later this year. It could be very accretive to the company's earnings in 2024, as much as 10% accretion, maybe even more than 10% accretion in 2024. So BMO is in a pretty good spot here. Very good momentum in their business today. Plus they have the benefit of the acquisition that could play out meaningfully in 2024.
- What about Bank of Nova Scotia? And correct me if I'm wrong, but it looks as though that you have downgraded them to a hold.
- Yeah. Let's take a step back. Back in March 2020, I upgraded everything. And the call was these were all too cheap. It was time to buy them. The logic there was I didn't think they would cut their dividends or have to raise equity.
Scotia participated in the upside like everybody else. Now, their stock did, but their performance has been lagging. And in downgrading Scotia this morning, downgrading them to a hold from a buy, I observed a few things. One is that they're no longer at a discount to the group on a forward PE basis.
In fact, they're trading through both CIBC and BMO, two banks that I think have better earnings momentum than Scotia. But I was observing a couple of other things. I don't think their margins are going to expand as much in their international banking business as we're seeing for the Canadian banks in their US operations. And that could be a big difference as we look out to 2022 and '23.
If we don't see that margin expansion in International business and we do in the US businesses of their peers, that could lead to much better earnings momentum for their peers over Scotia. And then the final thing I think is worth highlighting is Scotia doesn't quite have the excess capital of banks like Royal and BMO, for example. And I think that the lack of excess capital will work negatively against them in the out years like 2024, 2025. That excess capital is going to play a big role in driving earnings growth for BMO and Royal. And that may not play out in the same way for Scotia. That was the call I was making in downgrading the stock.
- Interesting. We can't talk about TD for obvious reasons. But Royal, you did mention they are losing some market share in some loan categories. What about the rest of the business? And is that a concern for you?
- So, clearly, Royal has lost share, 50 to 100 basis points in personal lending and commercial over the last 12 months. A little bit of lost share in mortgages. And that does not look like the Royal that I grew up watching over the years. I will say this. In the past, when Royal appears to have lost a step or lost some market share, we've seen this in prior years, they usually come back very, very strong. This bank doesn't take losing market share very well. So I would expect Royal to come back very strong and regain that market share as they retool their product offerings.
But beyond loan growth, you do have to acknowledge that Royal is doing extremely well in gathering deposits. Their wealth business is very strong. And I will say this, when interest rates move up, Royal's sensitivity to higher rates could really play out in terms of better net interest income growth and pretax, preprovision profit growth. Royal is in a very good position going into the second half of this year in my view.
- Well, that was the next question, is with rates going up, who disproportionately benefits Royal? Who else?
- Royal-- I think BMO to some extent in their US business. I put those two at maybe the upper end. We're not going to comment on TD, obviously. But Royal and BMO would be up there. I think Scotia with National might be closer to the end in terms of less sensitivity to rising rates, and CIBC somewhere in the middle.
- What are you watching-- I mean, when you think about all the growth drivers. We're seeing acquisitions in the space right now with some of that capital being deployed. But other headwinds, tailwinds, I mean, it's a complicated world right there right now, Mario, so what's happening?
- Well, I'm going to still-- I'm going to assume that, notwithstanding what's happening in Europe, I'm going to assume that rates continue to rise and that central banks around the world continue to raise rates. And if that's the case, then rising rates to the improvement in margin will be the dominant theme for 2022 as will accelerating commercial loan growth, eventually card growth should get-- credit card growth, that is. That should matter.
But when we think beyond 2022, we should start to prepare for a slowdown here. In 2023 it is very conceivable that credit losses return to normal. Credit losses are unbelievably low right now because of all the government support that's been added in consumers and corporates. By 2023, we'd expect credit to normalize, maybe even start to deteriorate.
That could play a role in slowing down earnings growth in '23 and '24, which then means that the acquisitions the banks are making now will play a very big role in driving earnings growth because a normalization in credit will take some growth out of our Canadian banks. That's my strong view for '23 or '24.
- Yeah. It takes a bite out of growth for everybody. Mario, thanks so much, appreciate your time today.
- Thanks, Kim.
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