Big Six Banks ‘Cautiously Optimistic’ Following Solid Earnings Season

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Craig Jerusalim, senior portfolio manager at CIBC Asset Management.

The Canadian banks all navigated through another quarterly earnings season quite successfully, with a few key themes emerging for the group. Overall, most banks struck a cautiously optimistic tone on the economy. Except for Royal Bank who began raising the yellow flags on growth and cautioned on an economic slowdown sometime in 2023. Four overarching themes that we will flush out included credit for provision releases, higher expenses, expanding margins and strong capital levels.

Let’s start with provision for credit losses or PCLs. One of the main reasons why the banks exceeded earnings expectations this quarter was due to the group collectively shrinking their provisions for credit loss reserved. Due to the realization that they were overly conservative at the height of the COVID scare and that there was a better understanding of the expected loan losses following the omicron wave, as well as a better handle on the fall-outs from the Russia-Ukraine war, hence the release of reserves.

The immediate benefit of PCL releases is that it boosts earnings per share, but it also reduces the cushion for future bad debt as a result of future economic risks and fallouts. On this topic, CIBC and Scotia were the most conservative, each building reserves quarter over quarter, while TD and Royal were on the relative aggressive side of their assumptions. The second theme was higher expenses, which are being seen in the war for talent and the overall higher labour costs. TD announced a 3% increase in frontline staff across North America, but there was also a general increase in overall expenses due to inflationary pressures in all aspects of the expense line, including technology and travel. While business travel is nowhere close to pre-COVID levels, the banks are seeing a normalization in those expense lines following the economic reopening. CIBC also called out one-time expense increases from their Costco MasterCard program, which should eventually translate into higher future growth once those problems are ironed out.

The next theme is the flip side of higher expenses, namely higher growth. Specifically higher loan growth. Any cooling in residential mortgage growth is being more than offset with other types of unsecured consumer borrowing, such as higher credit card balances, but more importantly, very strong commercial loan growth. As a reminder, residential mortgages, while helpful to bank return on equity given the relatively lower levels of risks, are in fact dilutive to margins. On the contrary commercial and unsecured personal loans are margin accretive, which should provide a tailwind to net interest income.

In addition, we saw margins expand, helped by higher interest rates, which are generally positive for banks. NIMs, or net interest margins, expanded by six basis points on average this quarter, a key sign post investors have been waiting for to say the least. The net impact of higher expenses, but even higher pre-tax pre-provision earnings growth, is positive operating leverage, which we saw from most banks this quarter. With especially strong growth at TD, who is most rate sensitive amongst the peers.

The final theme is still strong capital levels. Despite CET1 declining 20 basis points for the group on a quarter over quarter basis, levels remain quite healthy and well above any regulatory minimums, leaving plenty of ammunition for further dividend increases. National Bank was the only bank that saw an increase in their CET1 this quarter, while Royal Bank continues to have the most normalized excess capital of the group at 13.2%. As for those dividends, we did get five out of six large banks raising their dividends this quarter, with TD being the lone exemption as they try to build capital to fund their purchase of First Horizon.

There was a clear delineation between the winners and losers this quarter with National, Scotia and BMO delivering the best overall Q2 results. TD Bank with their strong operating leverage and NIM expansion was probably next in line, followed by CIBC and Royal at the rear. However, looking forward, CIBC and Royal offer two of the most defensive bank positions in these volatile markets. CIBC due to their cheap multiple and high exposure to domestic Canadian economy, and Royal Bank due to their fortress capital and scale advantage. But overall, with the group trading at around 10 times earnings, offering dividend yields close to 4%, and a long history of being able to control expenses and outperform the market, the bank group remains a rewarding place to be for long-term focused equity investors.