Rising likelihood of recession and higher credit loss provisions will put pressure on profitability, says report
While the 2024 outlook for Canadian banks is stable, an uncertain macro outlook, the faltering economy, and material increases in interest rates and debt servicing costs will create challenges for the sector, according to a new report by DBRS Morningstar.
The report noted that financial performance for the fiscal year 2023 has been somewhat mixed, with the Big Six banks seeing their adjusted return on equity dipping 217 basis points year on year to 14% on average.
“[A]djusted aggregate net income decreased by 4.8% YOY, as revenue growth (both net interest income and noninterest income) was more than offset by materially higher PCL and elevated noninterest expenses,” DBRS Morningstar said.
While the big banks saw 6.8% net interest income growth year on year on the back of higher interest rates, that was offset by elevated expenses related to employee and business development costs to support growth. Efforts to control expenses led to layoffs in the second half of the fiscal year 2023.
Canada’s economy is still growing but at a tepid pace, the report said, with Canadian GDP rising by 1.4% in 2023 and a projected 0.8% in 2024. That weak momentum, DBRS Morningstar estimates, is still supportive for bank ratings.
However, the report also cited several economic data points suggesting slight downside risks, including the estimated real GDP contraction of 1.1% in Q3 2023 – which the Bank of Canada cited in its recent third consecutive interest rate hold – along with stalling consumption and rising unemployment.
“While inflation decelerated to 3.1% in October, the November unemployment rate of 5.8% is up notably from 5% in a relatively short seven month timespan,” it said. “Additionally, the Canadian yield curve remains inverted and is showing a steep negative gap between long- and short-term bond yields.”
As high interest rates add to financial pressures for households and businesses, DBRS Morningstar expects banks’ fiscal 2024 earnings to be pressured with potential credit loss (PCL) provisions continuing their upward trajectory.
Lukewarm loan growth and the likelihood of interest rates stabilizing, and even potentially getting cut next year, is likely to put a lid on NII growth, it added.
“With the Big Six targeting positive operating leverage, DBRS Morningstar expects the large Canadian banks to remain especially focused on expense discipline in F2024, reducing discretionary spending while potentially announcing additional layoffs,” the report said.
