TORONTO (Reuters) - For Canadian banks, slowing domestic loan growth and narrowing lending margins threaten the double-digit profit gains that have become routine in recent quarters, adding to the generalized pressure being exerted on the sector by Europe's debt crisis.
The slowdown has arrived at a particularly inopportune time for the Canadian banks as the euro crisis threatens to roil bank stocks around the globe. Rather than flocking to Canada's conservative banking sector - often described as the world's soundest - some equity investors may instead gravitate to U.S. lenders, which may have a higher upside when markets eventually recover.
"What we're seeing here is the early indications of the domestic consumer lending slowdown that everyone has been watching for," said Barclays Capital analyst John Aiken, pointing to earnings figures for the most recent quarter.
While few are predicting a marked drop in profits for the sector, the prospect of flattening growth is a significant shift for a bank industry that has long enjoyed robust loan expansion at home, allowing it to churn out billions in quarterly profits.
"Canadian loan growth simply will not be the tailwind for the core domestic banking business as it has for the Big Six (banks) in the last decade," said Todd Johnson, a portfolio manager at BCV Asset Management in Winnipeg, Manitoba.
Canada's banks emerged from the 2008 financial crisis without having to take U.S.-style bailouts, and have taken advantage of the decline of several U.S. and European rivals, buying up bargain-priced assets and poaching investment bankers.
But their domestic consumer-banking franchises have long been the core of their profit engines.
Protected from foreign takeovers by law, the top six Canadian banks dominate the domestic loan market, generating rich profits to fund acquisitions, thanks to the country's steady economy and decade-long housing market boom.
That boom is now showing signs of petering out with year-over-year price gains slowing, while Canadians appear to be starting to heed government warnings about debt levels that are at a record high as a multiple of average income.
Retail banking revenue fell on a quarterly basis in the second quarter at every bank but one.
Lines of credit and credit card balances at some banks are already declining, while personal loans and mortgages are showing increasingly anemic growth, up only slightly from the first quarter.
Margins on the loans are being pinched by low interest rates, which could continue to slide as loans entered into when rates were higher are renewed at lower rates.
Meanwhile, funding costs could rise following a government move to restrict the issue of covered bonds, which the banks use to fund mortgages at low rates.
"Without the benefit of the cheaper cost of funding out there, it seems like the market pressure's going to come back and really show up more for all the banks in the second half of the year," said Brian Klock, a San Francisco-based analyst at Keefe, Bruyette & Woods.
With the domestic picture cloudy, investors say the banks with substantial foreign operations - Toronto-Dominion Bank and Bank of Nova Scotia, in particular - have the brightest growth outlooks.
Despite the overall growth concerns, investors and analysts remain generally positive on the sector, although some wonder if the murky outlook could eat into some share price support.
While Canadian investors, who largely hold the banks in pensions or retirement funds, are unlikely to leave in droves, foreign investors who have embraced the banks as a safe-haven investment over the last four years may be tempted to shift to U.S. financials, market players say.
"If you believe the U.S. economy is stabilizing and growing and if you believe the housing market and employment is growing, then it's probably better to be in the U.S. financials," said Paul Gardner, a portfolio manager at Avenue Investment Management.
The six Canadian banks are trading at price-to-book value ratio of around 1.8, a level that some argue may be unwarranted by the growth outlook, but one that is nonetheless far above the U.S. bank sector, which is trading well below book value.
Recent trading performance shows that the U.S. stocks, while more volatile than their Canadian counterparts, may already be gaining ground.
Among top U.S. lenders, the shares of Bank of America and JP Morgan are up about 40 percent and 5 percent respectively in 2012, despite selling off sharply since March amid rising euro zone tensions. Wells Fargo is up 16 percent in 2012.
Canadian banks Royal Bank of Canada, TD, and Bank of Nova Scotia have had a milder selloff since March, but have a more modest performance year-to-date. RBC is down 2 percent, while TD and Scotiabank have risen 3 percent.
"It doesn't mean that the banks aren't a good investment long term, just that right now there isn't a lot of strong earnings coming through," said Pat McHugh, a senior portfolio manager at Manulife Asset Management. (Reporting by Cameron French; Editing by Frank McGurty)