The Decibel - A warning sign from the Big Banks of a possible recession

Episode Date: June 2, 2023

The six biggest banks in Canada – RBC, Scotiabank, BMO, CIBC, TD, and National Bank recently reported their second-quarter earnings. The majority did not hit target expectations. While banks don’t always meet analyst forecasts, the fact that so many of them had disappointing results in the same period is surprising.Stefanie Marotta reports on banking for The Globe. She’s on the show to explain what’s behind these lower-than-expected profit numbers and what it means for the economy – and Canadians.Questions? Comments? Ideas? E-mail us at [e-mail]

Canada's six biggest banks recently reported their second quarter profits, and the numbers are disappointing. You might be thinking, so what? Banks lose money all the time. Well, they do, but when almost all of them make less than they thought they would, it can mean some bad economic news is on the horizon. Stephanie Marotta reports on banking for the globe. She's here to explain why these numbers are surprising, the reasons behind them, and why the murmurs of a recession are starting to get louder. I'm Mainika Raman-Wilms, and this is The Decibel from The Globe and Mail.

Stephanie, thank you so much for being here. Thank you for having me. So the six biggest banks in Canada have reported their earnings for the second quarter, and only one of them, CIBC, actually topped analyst estimates. Four of them, TD, RBC, Scotiabank, and BMO, they posted lower than expected profits. And the last one, the smallest one, National Bank, either just hit or just missed its target, depending on how you measure it. But Stephanie, banks don't always do what analysts expect, right? So what makes this so surprising? So that's what's interesting. You know, it's not rare, to your point, for a bank or for any company for that matter to miss analyst expectations. What is rare is for most of the banks to miss expectations and to miss them in the way that they did.

So largely profits were down across the board. And that in and of itself is an interesting trend that we haven't seen in a couple of years. But what makes this particularly interesting is that when you look into the different lines of business within the banks, there are a lot of different segments that are showing signs of stress. The reality is that Canada's banks are so well diversified that typically when one area of the business is down, another one steps in to prop it up. But in this case, we're seeing that a number of different lines of business are showing elements of weakness. So that's in retail banking, capital markets, wealth management. It's not just isolated to one point. So it's the beginning of what could be a longer-term trend, depending on how things shake out in the economy.

Okay, okay. And you said something there about how targets were down across the board as well. What do you mean by that? This is what was particularly interesting, because in the weeks leading up to earnings, analysts lowered their earnings expectations. So the bar was already lowered before we went into this. Can we get a sense of numbers here? I mean, I assume we're talking about a lot of money when we're talking about bank earnings, but how much money are we talking about here? Well, the Canadian banks are huge. They make billions and billions and billions

and billions of dollars in sales. And in this case, we saw some of the largest banks report lower profit. So in the case of RBC, RBC's profits were down 14% compared to last year. In the case of TD, it was down 12%. That's hundreds of millions of dollars. So it's a lot of money. But what really makes this interesting is when we look at how and why those profits dropped. And we're going to get into all of this. I just want to ask you, because CIBC was the only bank that hit its target. What are they doing differently? Like, why were they actually able to do that?

It's a great question. And it's something that really surprised analysts. And when you look at analysts' commentary after the earnings, there were quite a few of them that went, wow, this is a complete outlier and we're not totally understanding why this happened. So in one case, expenses have been a big topic across the industry. And CABC managed to manage its expenses better than analysts had expected and better than some of its peers are doing so right now. On the other hand, there's this very technical term, Fort in banking. But in a nutshell, CABC managed to pay a little less on deposits and charge a little bit more on loans than some of its peers. And that

completely bucks an industry trend that we've been seeing across the other banks. So the question here is, was this a short term win for CABC? Or is it something that they can continue to perform at that level in the year ahead? And we'll have to wait and see, basically, to see how that shakes out. Okay, so these banks have lots and lots of money in assets. I guess, Stephanie, why does they're making a profit or them not making a profit? Why does that actually matter to regular Canadians? So I know that banking isn't as exciting to most people as it is to me, but I promise it's really interesting and it's also really important. So the reality is in Canada, the banks are one of the best indicators and best representations of the financial health of every person and every business in the country.

And why is that? So the big banks dominate the banking market in Canada. They have more than 90% of the market share. So every person in this country has a checking account, every business has a line of credit, and the likelihood of you having it with the big six banks is very, very strong. Now the other component to this is the big banks are such a big part of Canada's economy. So let's look at the Canadian stock market as an example. If you look at the Toronto Stock Exchange, the big six bank stocks alone make up about a quarter of the stock market. Wow. That's more than every publicly traded energy company combined. The big six bank stocks alone make up about a quarter of the stock market. Wow.

That's more than every publicly traded energy company combined. So the big Canadian banks are behemoths. And what their earnings tell us is where the state of the financial health of Canada is going. Okay, so this is kind of our pulse for the bigger picture of the economy, essentially, then. Exactly. So does this signal that the economy is in trouble? Like, we've, of course, been hearing talk of a recession for the last year. Is this a sign that things are not going well? I don't mean to sound like an investment manager here, but it's too soon to tell. People have been watching the banks for sign of stress for quite a

while now. And what this is, is the first significant way that that is showing up in their earnings. Okay. Stephanie, you're a banking reporter. You used to work on Bay Street and you used to work at a bank branch. So you're a good person to ask some basic questions here when it comes to banking for those of us who are not as well-versed. So when we talk about bank earnings, what are we talking about exactly? Like how exactly do banks make money? You know, it's funny that question on how banks make money, because even when I was a teller in a branch, I don't totally know that I could have answered that question, because I don't think it's as clear as, you know, people in the banking industry expect. So there's two main ways that the banks make money. One is through the fees that they charge customers. And that's the most

obvious and apparent way. You pay a monthly fee on a checking account, you pay management fees on trading products, and that is one line of revenue. The other side of this, which is a little less understood, is what the banks call their net interest margins. Now, I don't mean to get deep into the financial weeds here, but I'll explain it because it's a really interesting component of some of the trends that we're seeing now. So in a nutshell, the banks make money off of the interest that they charge on loans. But then they also have to pay interest on the deposits that customers keep at the banks. So the difference between what the banks charge on loans and pay on deposits is the net interest margin. Okay. All right.

And what's happening now, and we'll talk about this trend a little bit more, is that margin is getting squeezed. It's getting narrower. And that's eating into the profits at the big six banks. Can you just expand on that a little bit, Stephanie? Like what, you're talking about their profits being squeezed. What's happening there? And this is the really interesting thing that's happening right now.

And it's sort of a result of the economy that we're in at the moment. So typically, higher interest rates are a good thing for banks because it means that they can charge more on loans. But with all of these competing factors we have in the economy right now, high inflation, the threat of a recession, everyone's just coming out of a pandemic where there were huge amounts of money injected into the economy and people are sitting on a lot of cash. That has muddled this typical theory of higher rates, more money for banks. So what we're seeing on the loan side is higher rates to the level that they've gotten are actually cooling demand for loans.

People are less likely to draw on their line of credit or their credit card because you have to pay so much more in interest than you did a couple of years ago. That's one end of the equation. The other side to this is this interesting shift in deposits that we're seeing. So banks have a variety of different deposit products and have to pay different amounts on each of those. So checking accounts are cheap. They don't have to pay anybody anything in interest

on checking accounts. But the longer term savings and fixed term products like GICs, banks have to pay a higher level of interest to their customers. So it costs more to maintain those deposits. And what we've seen over the last couple of quarters is customers are taking their cash out of checking accounts and moving them into fixed-term deposits like GICs because you can get a higher interest rate, you'll benefit more on your savings, and also with the state of the economy, maybe now is the time to lock in some of that cash to help you ride out a potential storm that's coming.

But that shift costs the banks more money and presses on that margin that we discussed earlier. Yeah, I can't believe I'm saying this, but this is actually really interesting. This is like consumer habits because of what's going on in the world right now, actually affecting these profits then. I want to ask you about another aspect of the economy here. So on Wednesday, the latest GDP report was released. And that gives us an idea of how the economy is doing. And the economy actually grew at an annualized rate of 3.1 percent, which blew away. Like that was higher than analysts' expectations for it.

So, I mean, that sounds like good economic news, right? Does that not contradict in a way the bad news signals from the banks? Well, first of all, thank you for saying this is interesting. That makes me very happy because I think it's fascinating. And the more people understand it, the more interesting it gets. So coming out of that GDP announcement where it sounds like things are performing well, if you look over at the Bank of Canada, that's not really what the Bank of Canada wants. And that's a little counterintuitive. What's happened over the last little while is inflation has come so high that the Bank of Canada had to increase interest

rates to help bring inflation down. And one of the ways that you do that is by people getting laid off from their jobs because then people don't have as much money to spend on things. But we're seeing Canada's job market and the consumer spending trends completely buck what the Bank of Canada wants to happen. And earlier in this year, the Bank of Canada paused interest rate hikes and said, we're at a level where we're just kind of waiting to see where this goes. Will there be job losses? We don't want to keep raising interest rates at the risk of accelerating this even faster than we thought we would. But given the numbers that we saw come out of the GDP data, it increases the potential that the Bank of Canada is going to increase rates again. And what's interesting from bank earnings

is that when the CEOs go onto the conference calls, they give a little bit of a state of the economy. And what we heard from them, in a way, was if things keep going the way they are, and if rates stay where they are, then we can maintain this level of growth going throughout the rest of the year. What that implies is if rates go higher, putting more stress on loan demand, putting more stress on how consumers spend, that could change the outlook for bank earnings for the rest of the year. We'll be back after this message. Let's talk more in depth about some of the things that are cutting into the bank's profits. One of the reasons cited by all the banks is something called provisions for credit losses, or PCLs. So Stephanie, I'm going to need you to help me understand what this is. What exactly does that mean? I feel like I've

been talking about provisions for credit losses for years now. It's funny how such a standard element of bank earnings has now come to the forefront in such a big way. So provisions for credit losses is the money that banks set aside just in case loans default. And what we're seeing with that amount of money that they're setting aside is it's increasing at a faster rate than what analysts had expected. And how much money have banks set aside for these bad loans? And I guess, how does that compare to previous years? So here's where things get a little complicated. And we have to peel back to when the pandemic set in. So when the pandemic roiled markets, the banks started setting aside more provisions because people were expecting a recession, massive job losses. The banks were expecting a lot of loans to default.

Of course. That didn't end up happening. Jobs were fairly stable. And even then, the government had so much cash in the system that people didn't really default on their loans. So this is kind of like the pandemic benefits you're talking about that went out to people and to businesses, too. Yes.

All of that stabilized things at the banks. So much so that last year, the banks were able to take those provisions that they set aside and release them in very big ways. Now, what happens when you set aside money is you have less money to spend. So the higher provisions for credit losses were eating into banks' profits. But then when they released them last year, because they didn't see those defaults they expected, it boosted profits. So in the case of RBC, this quarter, they set aside $600 million for loans that could potentially go bad. And that's a stark contrast to the same quarter last year. So in the same

quarter last year, RBC had a recovery of $342 million in provisions. So things were looking much better last year. And Let's look at another example. With TD, TD this quarter set aside $599 million for potentially bad loans. The same quarter last year, they set aside $27 million. Okay, that's a big difference there too, wow. Way less than what they set aside this year. And again, that's some normalization, but it just goes to show you how quickly those PCL levels are climbing again in such a short period of time. Yeah. And we kind of said, you know, bad loans is a general thing for what they're saving for. But

what, I guess, what specifically are they setting aside this money for? The main reason that they cite is the state of the economy and whether or not it continues to worsen. But the big theme that we saw come out of this quarter was commercial real estate. And here comes back in another pandemic theme about returning to work. And people aren't returning to the office as quickly as people thought that they would.

And that means that all the office buildings across the country are much emptier than they otherwise were. So there's a big question around, will there be the continued demand for offices that there was in the past? And what happens if a lot of this office space continues to sit empty and doesn't have tenants paying for those leases? Okay, so they're going to be losing money essentially on that if people don't come back to work. Exactly. So those loans could end

up defaulting. It's not all doom and gloom out there because the banks say that offices make up 10% of their commercial real estate loan books and 1% of all the loans that they offer. Okay. This is very interesting. And I guess I have to think about the psychology of this a little bit because when we talk about PCLs, this is money set aside because they're concerned that things might happen. But when banks set that money aside, that in turn cuts into profits because they can't make any money on that. And that's being pulled out of their profits, which then feeds into the cycle of a shrinking economy. So, I mean, this seems like in a way, isn't putting aside money into PCLs, isn't that kind of causing the problems? Like our emotions

and concerns about what could happen is actually driving this to happen, isn't it? It's a funny question because I'm sure we've all been sitting around the dinner table with our friends and family and someone says, are we not just speaking this recession into existence? Like, we're just going to talk about it so much that it finally happens. The thing with PCLs and with the way that the banks manage these funds is there's a little bit more science behind it than just being worried. So they use this very sophisticated financial modeling that takes into account three main factors. One is the job market, the other is GDP, and the other is the state of the housing market. And they take all that data

and they say, based off of what we're seeing in the economy, here's how much we think we need to set aside. So it is a little bit more scientific than basing it off of an economic pulse or being concerned about the state of the economy, which is why it's a metric that's so closely watched. Okay. So I think when we're talking about banks, the thing that's probably on a lot of people's mind is the fact that three banks recently failed in the U.S., right? Canada, of course, is not seeing anything nearly that dramatic. But Stephanie, how has what's happened in the U.S. affected what banks do here? So ultimately, Canada's banking system is already so much more conservative than the one that its U.S. peers operate in. And a few months

ago, the Canadian banking regulator released a report where it listed the biggest risks facing the banking sector right now. And liquidity was listed as the second biggest risk. And can you just remind us, people who are not so well versed in this, what exactly is liquidity again? So liquidity is a bank's ability to access cash to meet sudden obligations. So given that in today's economy, in the case of a run on deposits, customers are able to very quickly go online and pull those deposits. And that causes a bank reaction to have to pull its investment in certain assets to be able to pay those deposits out to people. Like what we saw with Silicon Valley Bank, the regulator is saying, given this very digital economy we have where this can happen at a much faster rate than it ever could in history, we're keeping a very close eye on liquidity. Now, that doesn't mean that the Canadian banks have a liquidity issue. The Canadian banks already have very strong liquidity ratios, which means that they'd be able to react fairly well if this were to ever happen. The regulator is just saying this is something

that we're watching for. They're just being extra careful, essentially. Yes. Okay. Your typical Canadian bank story. So, I mean, I guess this is kind of a good place to ask you the question then, because I've heard that Canadian banks are often viewed as, you know, the safest in the world. Is what's going on right now, Stephanie, is this, I guess, a shot against that reputation? Is this a change that we're seeing at all? It's a good question. And it's the Canadian banks have withstood so much over the last 15 years, the recession in 2008 being one of them. And it's true across the world, Canada's banking system is considered very, very stable. And there's no signs that suggest that that's deteriorating. If anything, I've heard people suggest that this is an example of why maybe the

U.S. should be a little bit more like Canada, be a little bit more consolidated, be more highly regulated. I mean, that comes with a host of other negatives as well. But the way that Canada has come out of the banking turmoil that we saw in the U.S. and has come out of the pandemic, it's actually a boost to their reputation. So I wouldn't say that we're seeing signals that the Canadian banks are losing that reputation. It's more so an economic indicator that things are getting a little bit rougher for people. Stephanie, that was very interesting. Thank you so much for being here today.

Thank you for having me. This was a lot of fun. That's being here today. Thank you for having me. This was a lot of fun. That's it for today. I'm Mainika Raman-Wilms. Our producers are Madeline White, Cheryl Sutherland, and Rachel Levy-McLaughlin. David Crosby edits the show. Adrian Chung is our senior producer, and Angela Pachenza is our executive editor. Thanks so much for listening, and I'll talk to you next week.