These Canadian banks will profit most from an interest rate hike

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When interest rates rise, bank investors cheer. But the greatest enthusiasm should be reserved for banks with a penchant for domestic lending: Canadian Imperial Bank of Commerce, National Bank of Canada, Canadian Western Bank and Laurentian Bank of Canada – your time has arrived.

On Wednesday, the Bank of Canada is expected to raise its key interest rate for the first time in seven years. Financial markets are currently reflecting a 90-per-cent probability of a quarter-percentage-point hike, according to Bloomberg, which would take the key rate to 0.75 per cent.

The bond market, too, has been pricing in a move by the central bank. The Government of Canada five-year bond yield has surged to 1.48 per cent, up from below 1 per cent last month.

But Canadian bank stocks have hardly moved since bond yields began to take off. They have risen an average of less than 1 per cent since mid-June, which raises the question of whether investors are ignoring a potential boon to bank profits.

Higher rates ultimately slow economic activity, and there are some concerns about what higher interest rates will do to Canada's overheated housing market if mortgage rates also rise. Loan losses could creep higher and bank-loan activity could slow – neither of which is good for bank profits.

But there are significant offsets here. Central-bank rate increases acknowledge a healthy economy. More importantly, banks tend to increase their profit margins on loans when rates rise because they can charge a higher rate of interest while still paying a low rate on deposits.

This spread – in banker jargon, the net interest margin – has narrowed as rates have fallen to ultralow levels. With rates rising, the spread should widen, leading to fatter profits.

Just look to the U.S. experience to see what higher rates, and the anticipation of higher rates, can do to bank stocks.

Bank of America, identified by RBC Dominion Securities as being particularly sensitive to rate hikes, has risen 48 per cent since the start of November, about a month ahead of the U.S. Federal Reserve's first of three rate increases.

In Canada, expectations are modest right now: "We are inclined to see the potential move in the Canadian overnight rate as only an incremental positive for the banks at this time," Robert Sedran, an analyst at CIBC World Markets, said in a note.

The problem, he said, is that it is impossible to know how much of the rate increase the banks will pass along to consumers. If the Bank of Canada raises its rate by a quarter point, will the banks raise their prime lending rates by the same amount or less?

Still, rate hikes are good for bank profits. And banks focused on the Canadian retail market stand to benefit more from rate hikes than those that are diversified internationally or through areas such as capital markets.

There are different ways to size up this domestic exposure. The most appealing: Compare the bank's Canadian net interest income – or the money they generate on domestic loans – to total revenue. This provides a look at which banks are focused on bread-and-butter Canadian lending.

Using this approach, CIBC tops the list: Its Canadian net interest income accounted for 48 per cent of total revenue in 2016, according to Mr. Sedran. National Bank isn't far behind, at 40 per cent.

Smaller banks do even better on this measure because they operate almost entirely within Canada. Laurentian Bank's net interest income is nearly 65 per cent of total revenue, while Canadian Western Bank's (CWB) ratio is 89 per cent.

This higher exposure to Canadian lending could translate into heftier profits. If bank profit margins on their retail loans widen by a modest 10 basis points (there are 100 basis points in a percentage point), Mr. Sedran estimates the Big Six banks will see per-share profits rise by 3.3 per cent, on average, in 2018.

National Bank will exceed the average, with an estimated 3.9-per-cent profit gain, and CIBC will get a 4.5-per-cent gain. But take a look at CWB and Laurentian: Their profits could jump 8.7 per cent and 13 per cent, respectively.

If rising interest rates are a tailwind to bank profits, bring them on.