The banking industry’s ‘calm before the storm’

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For more than a year, the analysts who cover Canadian banks have predicted an earnings slowdown. Household credit is sky high, families can't take on much more debt, and the spreads that the banks earn from lending money over rock-bottom interest rates fell fast.

But the slowdown never came. And so far this quarter, the banks keep pulling rabbits out of their hats.

It's early to make blanket statements because only two of the big banks reported by Wednesday, but Royal Bank of Canada's fourth-quarter figures contributed to a record annual profit of $7.5-billion. Bank of Montreal's $4.2-billion annual profit is up 35 per cent from 2011. Smaller regional banks such as Canadian Western Bank and Laurentian Bank of Canada also posted solid results. The surprises keep coming from different areas. At BMO, trading and insurance revenues soared this past quarter; at RBC, investment banking and advisory fees were hot.

This strength has become a bit of a running joke with the bank heads. In an interview with The Globe and Mail a few months ago, Toronto-Dominion Bank chief executive officer Ed Clark joked that the analysts and the media weren't misleading investors by predicting lower profits. "It's us that's the liars – for saying it was going to slow down," he said.

While no one is quite sure when the surprises will end, there are certainly some warning signs that a slowdown is brewing. Although BMO's total profit was strong, its Canadian personal and commercial earnings, which contributed 53 per cent of total profit last quarter, has barely budged over the past five quarters. The market demands growth.

"We're not watching a slow-motion train wreck in Canada; we don't face a U.S.-style calamity," said National Bank Financial analyst Peter Routledge. "But there is something coming and it will be unpleasant," he said, referring to household deleveraging and the likelihood of a housing slowdown.

Mr. Routledge describes the recent results as "the calm before the storm," adding that figures from the Bank of Canada serve as more warning signs.

Until recently, Canadian household debt grew at about 10 per cent a year. Now it's 5 per cent. And while mortgage credit is still growing between 5 and 6 per cent for most banks, the more profitable debt, such as credit cards and home equity credit lines, is growing at 2 to 3 per cent. That difference matters because mortgages are low-spread products, and there's stiff competition from non-bank lenders in this market, whereas a bank can borrow at 1 to 2 per cent and then lend money out for a credit card at 20 per cent annual interest.

Another thing to keep in mind: The earnings surprises at BMO and RBC came from areas such as capital markets and insurance, which can't always be relied upon. They also don't account for that much of overall profit. In Canada, retail banking is still the bread and butter of the income statement, typically contributing between 40 to 50 per cent of earnings. At RBC, this division comprises 54 per cent of total profit.

Even RBC CEO Gordon Nixon acknowledges that next year is supposed to be tougher, noting in his latest earnings release that the industry "is expected to face headwinds in 2013." That uncertainty is weighing on analysts, yet they also can't keep getting caught off guard by earnings surprises. A few shockers in a row quickly becomes a trend.