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A Bay Street sign in the heart of the financial district in Toronto.

Mark Blinch/Reuters

As concerns mount about the debt crisis in Europe and the United States, a significant downgrade in profit expectations for the major banks is becoming more and more likely.

Although the banking system has spent the past three years stockpiling capital and stripping out risk, the ongoing selloff in financial stocks points to potential hidden problems in the months ahead.

Should the U.S. economy falter, or Europe's debt problems grow worse, bank profits would be hit in the next year, with the impact affecting everything from mortgage lending to capital markets.

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Standard & Poor's, the debt rating agency, said Tuesday that it is growing "more concerned" about depressed profits in the U.S. banking sector, since a slower economy would lead to less lending and more troubled loans, sapping banks of their income. In Canada, similar concerns about the sector are emerging, with expectations that a slower economy would depress capital markets earnings and lending.

The Bank of Canada contacted Canadian bank executives this week to discuss the impact of the upheaval in the markets on the banks, and to monitor liquidity, including concerns about sovereign debt in Europe.

"There could be some downward revisions tied to people saying the economy is going to slow down," said analyst Peter Routledge at National Bank Financial. "If we go into a full-bore recession and unemployment goes up and you get more delinquencies and loan losses, then in that case estimates will come down."

Bank stocks are in the midst of a month-long selloff around the world. Though the markets rebounded slightly on Tuesday, with Canada's major banks gaining back some of their declines from earlier this week, it was not enough to make up for the bigger slide in the sector.

Canada's banks are down roughly 11 per cent in the past month, mostly due to worries over Europe. By comparison, Australia's banks are down nearly 15 per cent and Latin American banks are down 19 per cent. The worst-hit stocks have been U.S. regional banks, which are down 22 per cent in that time, with large U.S. banks off 24 per cent and European banks down a similar amount.

Canadian banks had escaped much of the volatility that has hung over the U.S. sector for most of this year. But, "with the group off significantly in the last few weeks, this is clearly no longer the case," Canaccord Genuity analyst Mario Mendonca said.

As bank shares fell in the U.S. on Monday, Bank of America Corp. chief executive officer Brian Moynihan took the uncharacteristic step of penning a staff memo, urging employees to remain calm in the face of a massive selloff in bank shares. U.S. banks registered their biggest one-day drop this week since 2009.

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"Financial markets around the world are going through a period of great uncertainty. We are seeing volatility in the equity markets, including our own stock price," Mr. Moynihan wrote in a memo addressed "to my teammates."

"Turbulence in the global economy will affect us as well. But we have weathered challenging times before and we will now."

Bank of America, the largest retail bank in the country which serves one out of every two U.S. households, has been hit in the selloff by more than just concerns over the economy and the U.S. and European debt crisis. A $10-billion lawsuit launched this week by American International Group Inc. over money lost on mortgage-backed securities, and Bank of America's overall exposure to the U.S. mortgage market, are also a drag on the bank.

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Senior Writer

Grant Robertson is an award-winning journalist who has been recognized for investigative journalism, sports writing and business reporting. More

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