Canadian banks are preparing for a possible wave of defaults. Why it matters – National

Earnings week for Canada’s biggest banks saw the country’s major lenders move forward in unison ahead of an expected economic downturn, each putting more money aside for possible rising loan losses.

Experts say Canada’s higher cost of borrowing and the possibility of job losses could catch up with households and push more and more into default, although some believe the worst of the debt pain is likely in at least a year.

The six big Canadian banks – TD Bank, RBC, BMO, Scotiabank, CIBC and National Bank – all reported profits for their fiscal first quarter this week, with similar results. All reported lower profits as they set aside more money to manage credit losses.

Digging into the banks’ financial records reveals a disturbing economic picture at the heart of these movements.

Documents filed by BMO show that the rise in provisions for credit losses in the last quarter “reflects a deterioration in the economic outlook”, although it noted that the continued improvement in the business environment after the peak of the pandemic. compensated for some of these concerns.

The Montreal-based lender also pointed to a rapid rise in interest rates — the Bank of Canada has raised rates by 425 basis points over the past year, with its next decision coming Wednesday — as putting its strained customers.

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“The high rate environment could directly impact our customers through higher borrowing (eg, mortgage rates) and debt servicing costs,” BMO wrote in filings Tuesday.

But just because banks are preparing for higher credit losses doesn’t mean they’ll happen, says Angelo Melino, an economics professor at the University of Toronto.

When banks increased their provisions in 2020 because they expected large losses during the pandemic, a healthy dose of government assistance offset the rate of business and consumer defaults, Melino told Global News.

But some of those fears of three years ago are coming true today.

In January, the total number of business and consumer insolvency filings increased 13.5% from the previous month and 33.7% from the previous year, according to the Office of the Superintendent of Bankruptcy. . Business bankruptcies rose 55.4% year over year, the data showed.

Melino says banks are noticing the rise in bankruptcies as pandemic-era stimulus measures dry up and businesses are forced to heed the new operating environment.

“A lot of companies that got hooked on it can’t anymore,” says Melino. “So on top of everything that’s been happening in the economy, there’s a surplus of stuff that’s been happening since the pandemic.”

Melino says the banks’ increases in their provisions for credit losses essentially confirm the bleak economic outlook that has led to calls for recession from forecasters on Bay Street and outside.

As provisions for credit losses rise amid higher interest rates and economic uncertainty, Veritas Investment Research analyst Nigel D’Souza says these numbers are still below pre-existing levels. the pandemic and are currently being “normalized”.

Nonetheless, D’Souza tells Global News that he sees indications that the credit situation is set to deteriorate significantly for many Canadians in the months ahead.

Higher interest rates are expected to push up debt-servicing costs for many Canadians with outstanding loans, he says, adding that he expects those numbers could “potentially hit an all-time high.” later this year.

Disposable income is included in the calculation of these costs, which means that an increase in unemployment – ​​and therefore a fall in income – can also push this figure up.

The Canadian labor market has yet to show significant signs of weakness, adding 150,000 jobs in January as the unemployment rate held steady at a near-record low of 5.0%.

But Bank of Canada Governor Tiff Macklem has warned that low unemployment is not sustainable to bring inflation back to the central bank’s 2% target. The Parliamentary Budget Office predicted this week in its economic outlook that the unemployment rate would reach 5.8% before the end of 2023.

Melino says if job losses start to increase, it will mean more losses for banks to absorb on consumer debt.

“What happens to the labor market this year is going to be very important for these consumer loans,” he says.

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When debt servicing costs rise, credit losses historically follow within two years, D’Souza says. This implies that a spike in debt service costs this year will lead to a wave of credit losses at the end of 2023 and into 2024, he says.

“I think this will be an important level to pay attention to in determining the risk of increasing credit losses over the next couple of years,” D’Souza says.

A major source of debt on the books of Canadian banks is in their mortgage portfolios.

While there has already been some stress in this segment, D’Souza notes that the main pain of rising mortgage rates primarily affects the roughly 12% of mortgages that need to be renewed in any given year.

Even when Canadians end up defaulting on their mortgages, those losses don’t tend to make a huge dent in banks’ credit losses, D’Souza adds. Since these loans are secured by the properties themselves, they are usually well secured in the event of default, he says.

“When you look at losses from past cycles, the bulk of credit losses are not due to the (mortgage) portfolio. It’s driven by everything else: auto loans, unsecured lines of credit, credit cards, business loans,” he says.

Melino says the bulk of bank mortgages are also guaranteed by Canada Mortgage and Housing Corporation (CMHC), which means that if there are losses here, it will affect taxpayers more than the banks themselves. same.

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While banks may be bracing their balances to cover a possible increase in credit losses, D’Souza cautions that these impacts don’t happen suddenly — they take time to build.

While he says there are “emerging signs of stress,” such as rising credit card delinquency rates and pressure on variable rate mortgage holders, D’Souza says the blow raised to bank balances – and to the economy in general – could be a way off yet.

“That doesn’t mean there are no signs of stress. I would point out that credit risk takes time to build up,” he says. “It doesn’t happen overnight.”