Lagging effects of higher interest rates to impact banks’ bottom lines

As the effects of higher interest rates work their way through the economy, the big banks will likely come under increasing pressure in the year ahead, says DBRS Morningstar.

In a new report, the rating agency said the big banks face the prospect of deteriorating financial performance and credit quality in 2023 due to the lagging impact of tighter monetary policy, and declining liquidity.

While rising rates typically benefit banks’ net interest margins, the material increase in debt service costs is expected to drive higher credit losses, it said.

According to the report, in 2022, total net interest income for the Big Six banks and Desjardins rose by 10.2% on average — yet this was largely offset by higher provisions for credit losses and growing operational expenses.

And, while loan loss provisions grew in 2022, the decline in credit conditions “could be more pronounced in 2023,” the report said, “as higher borrowing costs and an economic slowdown and/or recession take their toll on companies and highly leveraged consumers.”

DBRS reported that it’s “seeing signs of weakness in the market, including a slowdown in the housing market and residential and commercial mortgage application pipelines.”

And, as loan growth slumps, competition for new loans is expected to increase, which could pressure asset yields, the report noted.

Additionally, banks’ funding costs are expected to rise as deposits shift from lower-cost demand deposits to term deposits.

The banks’ capital markets revenues may suffer in the weaker operating environment, it noted.

“In DBRS Morningstar’s view, financial and credit pressure on the Canadian banking sector could increase from the current environment,” Shokhrukh Temurov, vice-president, North American financial institutions at DBRS Morningstar, said in a release.

Despite the gloomier conditions, DBRS said the effects are expected to be manageable, given the banks’ strong balance sheets and capital positions.

“[W]ith robust capital and liquidity buffers, the Canadian banks are well positioned to weather upcoming challenges,” Temurov said.

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.