As Moody's contemplates a possible debt-rating downgrade on Canada's banks, it's comforting to know that it's not the banks themselves that the credit-rating agency has a big problem with. It's less comforting to realize that the problem is, largely, with Canada itself.
Last Friday Moody's placed most of Canada's big banks under review for downgrade. The one exception was Royal Bank of Canada, which Moody's already downgraded in June.
But there's a key difference between the latest review and RBC's earlier downgrade. When RBC's ratings were cut, along with 14 other international banking firms, it was all about their sizable exposure to global capital markets, replete with their volatility and risks.
By contrast, last week's decision to review the entire Canadian banking sector wasn't, for the most part, a symptom of continued global economic and financial uncertainties. It was largely about Canada's home-grown risks – namely, from dangerously bloated household debts, an overheated housing market and a deteriorating economy.
First, let's put Moody's opinion in some context. Canada's banks have among the highest credit ratings of any national banking system in the world. At such high levels, wrote Moody's senior credit officer David Beattie, author of the report, "even a small increase in the probabilities of downside scenarios can affect a bank's creditworthiness."
Moody's added that, at worst, the Canadian banks could face a small ratings downgrade – at which level they would still be the envy of most of the world.
Still, the review of the banks' ratings is yet another signal that Canadians' debt levels are a major threat to the country's economic stability – just as the Bank of Canada has been saying, louder and louder, for months.
For the banks themselves, the threat lies in an eventual collapse of Canada's increasingly precarious consumer-debt house of cards, accompanied by a housing-market slump. The decaying Canadian economy has elevated the danger of both. Toss in an unstable and slowing global economy, weakening commodity prices and the U.S. fiscal cliff, and the pile of risks looks too big to ignore.
In general terms, a consumer-led economic downturn could deal a substantial blow to the banks' profitability, which is a concern to credit raters. But the banks are massively profitable; they could withstand a slowdown in consumer and mortgage lending without threatening their financial health.
More specifically, though, the double-whammy of a housing slump and a consumer debt crunch could elevate the banks' loan losses. While Moody's doesn't consider the loan-loss danger to be a huge one, it did note recently that the threat may be bigger than the banks' misleadingly rosy numbers have suggested.
Last month, Moody's Capital Markets Research arm noted that Canadian banks' ratios of loan delinquencies as a proportion of total loans over the past three years have remained "low across all stages of delinquency." But the ratios have stayed subdued not so much because delinquencies are improving, but because the "denominator" in the equation – total loans outstanding – has kept growing.
In short, the banks, reflecting the Canadian economy as a whole, have become overexposed to household debt. The risks to the banking sector may not be too daunting yet, but Moody's action signals that they're palpably rising.
David Parkinson