Podcast Transcript: Q3 2024 Canadian Bank Earnings

Daniel Stanley

Welcome to the 16^th episode of our deep dive series on Canadian bank earnings. Today, we’re covering the third quarter 2024 bank earnings announcements, and we will return each quarter on this channel to update you on the latest financial results. My name is Daniel Stanley. I’m an ETF specialist and Co-Head of BMO Global Asset Management’s Institutional Distribution team. I’m joined today by a new voice for this podcast, Bipan Rai, Head of ETF Strategy at BMO Global Asset Management, who’s a fantastic addition to our team and to this podcast. And of course, Sohrab Movahedi, Managing Director, Financials Research at BMO Capital Markets. Today, we’re going to cover the recent bank earnings announcements and what they mean for investors and the Canadian economy, as well as looking at different ETF strategies that give you exposure to the Canadian banks. So, without further ado, Bipan and Sohrab, thank you very much for taking the time to join me. And Sohrab, I want to start off with you and just ask how did the banks do this quarter, and hoping you can touch on TDs announcements of that rare quarterly loss, and possibly Scotiabank’s acquisition announcement of that minority stake in KeyCorp.

Sohrab Movahedi

Thanks, Dan, welcome Bipan. Let’s see how did the banks do in Q3? If we kind of stand back and look at it, the six largest banks delivered something like $15 billion in after tax earnings to common shareholders. That was about 8% higher year-over-year. And, I don’t think we’ve had that sort of growth in a few years now, so that was nice to see. They did that with double-digit pre-tax, pre-provision earnings growth. So, think of that as you know, basically the EBITDA equivalent, I suppose, in a bank. They did it good pre-tax, pre-provision, but of course, as we are in the cycle, it was a little bit offset by higher credit provisions, although stable quarter-over-quarter. I think the commentary that we heard from bank management teams were rightfully cautious given the current environment, but probably a bit more improving in tone, in light of both rate-cut expectations and the prospects of maybe an upward-sloping yield curve, and honestly, the resiliency of the Canadian consumer. Okay, so the ability to have so far been able to absorb the higher rates and, you know, avoid, basically the terrible, sort of, mishaps that people would have feared. And what we got out of, for example CIBC, was an announcement of a buyback. What we have had out of Royal Bank a quarter ago was talk of buyback and, and the capital ratios remain very healthy. 

And so, you know, you raised the question of TD? And the reality is, we have been basically anticipating some amount of penalties or charges relating to what has been a bit of a lingering issue for TD, and it’s not behind them completely, just yet. They have had some, obviously, very important issues. They’re dealing with U.S. regulators around the Bank Secrecy Act, and anti-money laundering, and the like and they’re working through three or four different regulatory bodies. The outcome involves both a financial penalty, and what we saw in the quarter was an indication of that financial penalty, and it will almost certainly involve some additional criteria or restrictions that are non-financial in nature. And so, in the quarter TD basically told us that now they have set aside in legal provisions, so they haven’t actually reached an official settlement, if you will. They expect they will do that by the end of the calendar year, but they have now set aside in total, about US$3 billion in the legal provisions, and that will allow them to deal with basically the financial penalty associated with this. But of course, throughout, you know, over the last year and a half or so, they’ve also been trying to improve their compliance and risk management and financial controls, and what have you, so there is ongoing expenditure, aside from the penalty that they took this quarter, that’s being kind of reflected in their underlying earnings power, if you will. 

But you know, I mentioned some banks have started buybacks. Scotia’s was interesting because, obviously, they had the capital flexibility to you know, pursue a minority investment in KeyCorp, which is a U.S. regional bank. I would interpret that as a positive signal that probably regulatory capital inflation that we’ve talked about here that has been an impediment, I’ll say to ROEs for the Canadian banks, is probably behind this, for this, for this cycle, anyway, and that we’re seeing some banks now pursue deferring strategies, but certainly deployment of some of the capital that they have accumulated. So, remember, we would have talked over the last number of quarters banks like Scotia, CIBC, Royal, BMO, they would have had discounts on their dividend reinvestment programs in place, so they essentially would have enticed shareholders to take dividends in shares, as opposed to regular cash dividends. So, they’ve de facto, increased their share count. And you know, for example, a bank like Scotia, over the last six quarters, probably has increased its share count by close to 4% through these discounts. So that equity issue, which would have been spread obviously over a period of time, was primarily used to invest in KeyCorp. That minority investment is not completely done. It’s a commitment. They will have to go through some regulatory approval process, but at a minimum, it allows Scotiabank to pick up some earnings out of a U.S. regional bank, as they are thinking about remixing their earnings composition away from developing countries like Chile or Colombia or Peru, towards developed countries, which is, in their case, Canada, but also the United States.

Daniel Stanley

Thanks for that, Sohrab. So, it basically sounds like where there were issues with TD. For example, it was, it was expected, and in general, as you pointed out, after-tax earnings were 8% higher year-over-year, which we haven’t seen in a while, which is good segue into my next question, Bipan for you, because, we do hear a lot about the sort of the indebted private sector in Canada, but Sohrab just pointed out after-tax income, looks better than expected. How would you frame this from your perspective?

Bipan Rai

Yeah, thanks, Dan. I mean, it’s interesting. I mean, we did see some solid round of earnings from banks, and really, they suggest or imply that, you know, the consumer’s in reasonable shape. But I try, you know, putting my macro hat on, and, of course, that’s my area of expertise, and really try to square that with the data that we’re seeing released by StatsCan on a quarterly basis when it comes to GDP and activity, and we’re seeing something a little bit different. 

I mean, you know, the last quarter of growth in the Canadian economy was actually quite strong on, you know, by most accounts, and far above even the Bank of Canada’s own projection for what Q3 activity would, or Q2 rather activity would look like. But there’s something interesting there. A lot of the activity for the last quarter was front loaded, and it wasn’t necessarily driven by strong Canadian household spending. And, you know, that tells me that, you know, perhaps we did see some reasonably, you know, strong, robust spending activity, borrowing activity on the part of Canadian households, maybe earlier in the quarter. But if we look at, say, the June data and also the flash estimate for July activity, both of those suggest that momentum is slowing down when it comes to Canadian consumption. That’s one way I would frame it. So maybe there should be a little bit more concern with respect to the health of the Canadian consumer on a go-forward basis. 

And the other thing that I would look at, and of course, I’m looking over my notes from Sohrab’s research as well, is that, you know, if we look at the key themes from this recent round of earnings, I think there are two really interesting ones. One of them was the fact that we’ve got solid beats on net income, you know, those primarily demonstrating that credit losses were better than expected for most banks. The other interesting angle was that capital markets there, at least the segment of income reported by capital markets, was firmer than expected, as well. So again, both of those aren’t necessarily tied to Canadian consumer spending habits, but certainly, on a go forward basis, if we’re looking ahead, yes, there is some relief coming via Bank of Canada interest rate cuts going forward that could cushion some of the pain being felt on the debt-servicing front for households, but certainly, it does look like weighing that against other factors that or other indicators that suggest that the labor market is potentially cooling at a faster clip that you know that there are some warning signs being raised here.

Daniel Stanley

That’s great, Bipan. I appreciate that that macro view. It’s great to have you on that podcast for that, and it’s a great segue, sort of into the next question for you Sohrab. I love doing this once in a while. We don’t do it every time, but it’s sort of the if we wanted to be an armchair economist and get a sense of how the Canadian economy is doing, you know, we can do that kind of by looking at the Canadian banks, and we drilled it down, or you’ve talked about these four key variables to look at — commercial loan growth, dividend growth, credit reserve building and capital ratios, and excuse me, the fifth one that the slope of the three-month and ten-year yield curve. So, a great time to get to give us a little bit of an update on those different variables, and it’s where we stand there today.

Sohrab Movahedi

The cheeky answer in the first instance would be, hey, the three banks amongst the large six that have the highest proportion of their overall loan portfolio in Canadian mortgages and home equity lines of credit are the three banks that have had off-the-charts stock outperformance on a total return basis over the last 12 months. I don’t know what you’re talking about. What’s wrong with the Canadian economy? That’s the cheeky answer. I think what ends up happening is we are all, just to varying degrees, probably scratching our heads a little bit, because the U.S. economy, by most metrics, at least, so far, seems to have been stronger than the Canadian economy, but we actually have had pretty decent loan growth in Canada. Whether it’s commercial loan growth, whether it’s mortgage activity, and I think, certainly in Canada, the commercial long growth tends to be fairly pro-cyclical. We had come off fairly strong growth numbers. I think we are starting to see the bottom. Okay, I mean, I’m not an economist, for sure, that’s but the charts that we look at would suggest that there might be a little bit further downside. But from here, we should be seeing more growth from current levels. 

When we look at the banks and as we would expect, they have strong balance sheets, they have strong capital ratios, and they also have, I’ll call it, capital in disguise, as far as their allowances and reserves that they put on the balance sheet. And in in a testament to, I suppose, their conservatism and a bit more of a cautious outlook. We’re not really seeing them release those reserves. They’re still adding to that a little bit for sure, and I think the indications are that there might still be another few quarters of tweaking those higher. So, I don’t want to make anyone kind of either overly excited or overly nervous, because, for a variety of reasons, and Bipan was basically touching on some of it, we may still see higher unemployment rate in Canada. Right? So, the question is not, you know, we look at the banks, one of the things we want to, I think, it’s important to get across is not so much that they are for banks, credit is a bit of a lagging indicator. So, if everything has been managed proactively, like we would have expected to, they’re not going to be able to avoid, for example, unemployment rate going higher. They should have prepared for the impact of higher unemployment rate, whether it’s through their underwriting practices and whether it’s through their reserve levels. And so, we feel comfortable that not necessarily for the tail risk of outcomes, but for the belly of the curve of outcomes, the banks are, broadly speaking, well reserved. 

I’m going to turn it around here a little bit and say that if I look at the Canadian banks — and I want to be careful that we don’t extrapolate one quarter and, you know, get overly excited about it — but the Canadian banks generally target earnings growth at 7%-plus. This would be some sort of a medium-term earnings growth. Well, we got an eight percenter for the first time. It’s one quarter, but we got an eight percenter for the first time in a couple of years. It’s probably been a couple of years that we have been faced with a downward-sloping yield curve or a negative sloping yield curve, and quite candidly, we’re not talking enough about the prospects of an upward-sloping yield curve. And I’m not declaring that we’re there, but indications are that we should be getting closer to a upward-sloping yield curve, which would be helpful to their net-interest margins, because banks, you know, borrow short, lend long. Basically, it should be helpful to capital markets activity, whether it’s trading because there is maybe greater confidence as far as the outlook for the economy, maybe there is a pick-up in transaction activity, which may be helpful in the investment and corporate banking. Certainly, when the markets are doing better, the wealth management arms of these banks, you know, these, remember, these are big, diversified banks, they start doing better. So, I do think there are reasons to be excited, you know, careful, but still see the glass half full, so to speak, as opposed to half empty, as we as we think about the Canadian economy, but also as we think about some of these drivers, if you will. 

And I would say if the banks are looking to do buybacks, at a minimum, we could interpret that as a signal that they have some favourable outlook on their earnings trajectory. So, if they thought they would probably look to buy something or do something in organic with that excess capital if they didn’t have some degree of comfort in the outlook of their own bank. So, you know, take a Royal Bank. They’ve done the HSBC acquisition. Presumably, the synergies are coming through. The benefits of the asset are going to accrue to Royal Bank shareholders. You know, you didn’t mention this, but we also this quarter had National Bank, which is the smallest of the big six banks, agree to acquire Canadian Western Bank, and that has been basically approved by Canadian Western Bank shareholders. So, I interpret these as signs of optimism and being a bit more front-footed, as opposed to reserved and downside-focused. That doesn’t mean to say the pendulum is completely swung, but I feel like if we’ve been a little bit cautious and conservative, the path to being a little bit more front-footed and aggressive is kind of through what we’re going right now. So, we’re a bit more optimistic, as we’ve talked about here on prior podcasts, as well.

Daniel Stanley

Thanks, Sohrab. You ask, we deliver. Your comment about we’re not talking about the return to a steeper yield curve. Hey, we’ve got the man on the podcast here: Bipan. Which is exactly what my next question is going to be for you. This is actually a bit of a two-part question too. I want to start with that that issue, because as the yield curve does begin to normalize, how do you see this impacting net interest margins on the banks? And then the second part of that question is just Bank of Canada expecting to cut rates. How does that impact loan growth? And then, broadly speaking, bank stocks going forward. I would love your input there.

Bipan Rai

Yeah, for sure. I mean, when we talk start with the second half of that question, because I do think it’s important for the first part that you mentioned. I mean, you know, we’re talking about heading into this environment where the Bank of Canada is potentially going to cut rates further. And of course, you know, we have every reason to believe, based on recent Bank of Canada statements and speeches from Governor Macklem, that we’re still headed for another at least on balance, for the rest of this year, we expect the Bank of Canada to continue cutting rates in 25-basis-point increments. At least that’s the base case for now. But that’s very much contingent on incoming data and what it tells us about the about the Canadian economy. Now, you know, so far, the way the market is pricing the Bank of Canada, there doesn’t seem to be that much concern. If we look at forward OIS, and that’s a primary gauge that we like to use in order to really extract where the Bank of Canada is going to end its easing cycle. It’s pricing the Bank of Canada to end its easing cycle close to 2.5%, maybe just a little bit below there. That’s pretty close to the lower end of the Bank of Canada’s neutral range, or where they expect interest rates, or at least the overnight interest rate that use to target the repo market. That’s what they kind of look at, and sort of say that that’s an interest rate that is neither too expansionary, nor too contractionary. 

But, you know, given the degree of leverage held in the private sector, in the Canadian economy, the risks are still tilted towards the downside. And there is, you know, if we get weaker than expected data, and certainly it looks like Q3 is not going to be as strong as what the Bank of Canada anticipates, there’s a good chance the Bank of Canada may need to cut by more than expected, and we should see that reflected in four OIS rates. And potentially, what that could mean is that, you know, we end up in this environment, they’ll cut by more than expected. And then, the question, at least for our purposes here on this on this podcast, is what that means in terms of loan growth. At the margin, lower interest rates, should be conducive to stimulate demand for loans, especially, if you’re at a point in the economic cycle where things are on the uptick, and we’re expanding, expecting the economy to expand, businesses to start borrowing and investing again. But here’s the kicker. I mean, when we look at the Canadian household sector right now. It’s incredibly over leveraged. And if we’re in this sort of environment, and I’m not saying this is the base case scenario, sort of guarded against the risks that you know, where Canadian households have to be worried about a rising unemployment rate. You know, the key offset there potentially could be a deleveraging cycle, and that is, you know, I don’t want to say nightmarish, but it’s a scenario that the Bank of Canada is especially guarded against, and it could propagate into even more interest rate cuts going forward as well. So, I mean, yes, Bank of Canada rate cuts at the margin, to answer your question, Dan, should be beneficial towards loan growth, but it still depends on where we are in the economic cycle. It also depends on whether or not households are going to kick off and start up a deleveraging cycle in general as well. 

Moving on to the other part of your question, what do rate cuts mean? They mean steeper yield curves at this point of the cycle. And you know, touching on what Sohrab said earlier, we all know from, you know, our economics classes, and we also know from our time spent in this business, that steeper yield curve is actually good for a bank business model if you’re borrowing short and lending long. And you know, a higher net interest margin, you know, potentially pretends to higher revenue streams coming out of the of the PNC or the personal and commercial banking segment of Canadian banks. And also, of course, beneficial towards capital market revenue streams as well. But again, you know for that, I defer to Sohrab. I think, you know, the steeper yield curve environment, or more normalized yield curve environment should, at the margin, be beneficial towards bank stocks.

Daniel Stanley

Well, thanks, Bipan. I learn something new every day. For those on the listening to podcasts who didn’t understand, OIS stands for ​“overnight index swap,” but great to hear, you know again. So, the general theme is the Bank of Canada rates look like they’re going to go down with, potentially down toward that 2.5% range, which is a good segue into sort of our last question. Sohrab, for you, it’s interesting. I just happened to pull up the five-year returns on stock prices for the components of the BMO Equal Weight Bank Index ETF and RBC, was up 60%, CIBC is up 50%, BMO is up 19%, TD is up 11%, Scotia was down 6%, and the runaway winner is National Bank, whose stock price is up almost 100% over five years. Talk to us a little bit about why has National done so well? And you know, what should investors take away from these performance differentials over that five-year period?

Sohrab Movahedi

If I knew the answer to that question, I wouldn’t be on this podcast with you. When I look at National, I would say National Bank and the stock price performance, two things stand out to me, more capital and fewer mistakes are a potent combination in banking. If I think about National over time, and I’m going to think a little bit further than the five-year term you had, you know, if you think through like in 2016 National probably had its worst year. They had a surprise charge they took, based on an investment they held in Germany that they had to write off. They were last into the energy cycle of 2016, as far as lending to some borrowers that were a little bit more susceptible to declining energy prices and had to take larger provisions on that portfolio. And they did this at a time that they were selling down essentially their investment in a wealth manager and deploying some of that capital in places like the Ivory Coast and Cambodia, and to get all of this done, they actually did an equity issue. And a few months later, after the equity issue, they actually increased the dividend, like there was a lot of stuff that you would have thought, wow, this is and if you look a little bit further into the history, there’s been instances that it would have, if banking is around, is about driving around the ditches. They may have actually hit some ditches. 

I actually think, knock on wood, they’ve done a reasonably good job since 2016, where they would have probably insisted that, hey, they’re a smaller bank and they’re less risky, why do they have to have the same capital level as Royal Bank or some of these larger banks. They have been at the right capital level, or at the similar capital level to the other domestically, systemically important banks. They have focused on making fewer mistakes, and maybe the third point, so fewer mistakes, more capital. And what’s the challenge for any company? I want to grow without diluting my profitability. What’s the challenge for Canadian banks? Well, there’s a profitable domestic market, but every time I make extra capital, I have to deploy it. Every dollar deployed away from Canada tends to be additive to my growth, but probably dilutive to my ROE. But, I think, in Cambodia, they’ve found an opportunity that’s both accretive to ROE and to growth, which I think has also helped in this regard. And then, of course, they remain the most Canadian-centric, if you will, of the big six banks. So, maybe all this pursuit of growth is interesting, but at the end of the day, being Canadian-centric is more profitable. I don’t know. Those would be a few observations I’d share as to what national has managed to do differently. Maybe.

Daniel Stanley

Well, for the tennis players and golfers listening, they will understand the concept of fewer mistakes and driving around ditches. Unforced errors will do in banks, just like they’ll do tennis players and golfers, right? Bipan, Sohrab, thank you. Bipan, welcome onboard. Thanks very much for joining us this first time. And Sohrab, thank you as always. 

As a reminder to the audience, you can get exposure to the Canadian banks via ZEB the BMO Equal Weight Banks Index ETF. If you have any questions, please visit the ETF Centre at bmoetfs.com. That’s all for today, folks, thank you for tuning in. Please join us in mid-December for the next update on Canadian banks.