August 27, 2012 / 12:06 PM / 5 years ago

BAY STREET-Sluggish lending finally catches up to Canadian banks

* Banks expected to post slim profit gains

* Scotiabank, BMO kick off earnings season on Tuesday

* Slowing loan growth has pinched profits as housing cools

* Wholesale banking weak but higher year-over-year

* Dividend increases are likely from TD Bank, CIBC

By Cameron French

TORONTO, Aug 26 (Reuters) - Canadian banks will post sluggish third-quarter profit growth on the back of slowing domestic loan growth and weak capital markets revenue, leaving little motivation to buy their shares except for some likely dividend increases.

Considered the world’s soundest banking sector, Canada’s big lenders have produced steady profits through the 2008-09 U.S. financial crisis and the more recent European debt crisis, underpinned by a domestic lending business that has benefited from Canada’s roaring housing market.

With house prices and sales activity now showing signs of peaking and Canada’s highly indebted population borrowing less, banking’s core profits are now becoming a point of weakness.

Fitch Ratings Agency said in a note last week it expects a weak lending environment to hurt the second-half results of the top banks.

Canada’s top five banks are Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Bank of Montreal and Canadian Imperial Bank of Commerce .

Analysts say the picture has gotten progressively bleaker in recent months as home purchases have slowed and credit card balances have shrunk.

“What we’re looking at is slower loan growth domestically, margin compression, and volatile but weaker capital markets this quarter,” said John Aiken, an analyst at Barclays Capital. “This is the theme of household deleveraging.”

For the fiscal third quarter recently ended, analysts expect core profits at the five big banks to rise in the mid-single digits in percentage terms. Such a rate pales next to the double-digit profit growth the banks had been churning out with regularity until recently.

The third-quarter reporting period begins Tuesday, when Scotiabank and BMO - Canada’s No. 3 and 4 banks - release their results.

Scotiabank is expected to report a core profit of C$1.19 a share, up from C$1.12 a year earlier, while BMO is seen posting a profit of C$1.39 a share, up from C$1.36, according to Thomson Reuters I/B/E/S.

HOUSING PEAK?

While housing prices have continued to rise and mortgage balances are still on an upswing, the pace of Canada’s property boom appears to have slowed, prompted in part by government measures meant to prevent a U.S.-style housing crash.

Finance Minister Jim Flaherty tightened mortgage lending standards in June, his fourth such move in four years, but said he does not expect to do so again as it appears the measures in place are having the desired effect.

“I expect lending to continue to slow down, especially on the mortgage side, as we move into the latter half of 2012 and into 2013,” said Tom Lewandowski, an analyst at Edward Jones.

“That just creates more of a focus on expenses, given the interest rate environment that we’re operating in currently.”

Interest margins, or the gap between what the banks pay to borrow and the rates they lend at, are still narrowing, as old mortgages entered at higher rates are replaced by lower-rate loans entered under current conditions.

Concerns about margins prompted CIBC to announce earlier this year it would wind down its FirstLine Mortgage unit, which sells lower-rate mortgages through brokers.

Doing so means the bank will realize higher profits per mortgage, but it will depress mortgage volumes in the near-term and likely weigh on profits, analysts said.

WHOLESALE WEAK, BUT DIVIDEND HIKES LIKELY

While lending growth is seen as tepid, wholesale banking profits - derived from investment banking, trading, and advising - are also expected to be down from the first half of the year.

U.S. banks saw markets-related revenue fall in the second quarter - which overlaps with the Canadian banks’ May-July third quarter - suggesting a similar slump in Canada.

“For capital markets, the summer doldrums are always slow for underwriting and trading,” said John Kinsey, a portfolio manager at Toronto’s Caldwell Securities.

Even so, as trading profits were abnormally weak in the third quarter a year ago, the banks as a group are likely to actually show a year-on-year improvement in wholesale profits.

Dividend increases from some of the lenders are likely to turn out to be the high point of the quarter, Kinsey said.

TD Bank and CIBC are both seen raising their quarterly payout, while Scotiabank and BMO are outside candidates.

SHARES MAY STAGNATE

Even with the expected dividend hikes, analysts have generally dim views on the banks’ shares.

The S&P/TSX financial index, largely made up of the banks, has risen about 4 percent so far this year, outpacing the broad S&P/TSX composite index’s 1 percent gain.

“With the run-up that the banks have had over the last couple of weeks, it does look like the expectations have been pricing in not nearly as aggressive a slowdown in earnings growth as what consensus is forecasting for 2013,” said Aiken.

“So I think you need positive earnings surprises to buoy or support the valuations.”

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