May 24, 2011 / 11:48 AM / 7 years ago

RPT-BAY STREET-Canada banks may soon show their vulnerable side

(Repeats column first run May 22 without changes)

* Big Six expected to report another solid quarter

* Looking ahead, slower retail lending expected

* Commercial lending growth won’t make up difference

* Canadian banks have outperformed broader market in 2011

* Bank stocks may rise further, but big gains likely muted

By Euan Rocha

TORONTO, May 22 (Reuters) - Canada’s big banks, after prospering so long from a resilient domestic housing market, may soon start feeling some pressure as mortgage lending begins to cool down across the country.

Backed by earnings growth and rock-solid balance sheets, shares of Royal Bank (RY.TO), Toronto-Dominion Bank (TD.TO), Canadian Imperial Bank of Commerce (CM.TO), Bank of Montreal (BMO.TO), Bank of Nova Scotia (BNS.TO) and National Bank of Canada (NA.TO) have outpaced the broader market this year.

But the stocks may have trouble keeping this momentum in place as retail lending, particularly mortgages, heads for a dry spell.

For now, the banks are sitting pretty. Over the coming two weeks the banks are set to report another quarter of steady earnings growth, as loan loss provisions moderate and profits benefit from the strong retail lending gains booked in 2010.

Given their recent track record, it is understandable why some might take this trajectory for granted. But after some outsized share price gains this year, investors may need to be more cautious, analysts say.

To guard against a U.S.-style housing meltdown, the Canadian government has tightened rules on mortgage lending. The prospects of rising interest rates could also temper growth in mortgage lending and expected gains in commercial lending probably won’t make up the difference.

“The household credit market is about three times larger than the business lending market, so a slowdown in the housing market will have a bigger impact than an improvement in the commercial lending market,” said National Bank analyst Peter Routledge.

"Generally speaking, we think you are going to see slower overall earnings growth from the bread-and-butter business, which is personal and commercial banking in Canada," he said, in reference to the current quarter and beyond. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ For share performance graphic: For StarMine Data on Banks: For graphic on CPI/benchmark rate: ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

U.S. banks this year have struggled with revenue growth and their shares have tumbled. By contrast, shares of Canadian banks are up more than 10 percent on average this year, easily outpacing a roughly 1.5 percent gain in Canada’s bluechip index the S&P TSX 60 .TSE60.

Canadian banks however may now be entering a period of transition, as retail lending loses steam and commercial lending begins to gather pace. [ID:nN15208168] [ID:nN15209406]

“If the Canadian banks are able to maintain modest earnings growth, you’re likely going to see modest valuation increases,” said Barclays Capital analyst John Aiken. But any share price gains are likely to be tepid compared with the beginning of the year, he added.

“Given the dynamics of a slowing revenue environment, the banks that are going to succeed, or surprise positively are going to be those that are able to manage costs better,” he said.


Royal Bank, TD and BMO, all of which have large operations south of the border, could benefit this period from a healthier U.S. credit environment, as loan loss provisions continue to wane. That said, the strength of the Canadian dollar could erode some of these gains, analysts said.

On top of that, volatility in capital markets revenue, which includes gains from trading, underwriting and brokerage services, is expected to persist.

“The fact that the capital markets numbers look to have been softer quarter-on-quarter and the fact that it’s a shorter quarter leads us to expect a pullback in sequential earnings,” said CIBC analyst Robert Sedran, while adding that year-on-year growth will still look healthy.

National Bank, smallest of the Big Six, is often the most sensitive to fluctuations in the capital markets segment, while the CIBC is typically the least exposed to swings in this area, due to its large focus on retail banking.

Bank of Nova Scotia, scheduled to be the last of the six to report, could see revenue and earnings benefit from the recent acquisition of DundeeWealth.

Investors might also see National Bank and Royal Bank raise dividends over the coming week, as the payout ratios of both banks are near the low-end of their respective target ranges, analysts said. (Editing by Frank McGurty and Jeffrey Hodgson)

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