Standard & Poor’s Ratings Services notes that a favourable credit environment and continued strong domestic retail market helped the Canadian banks weather a slowdown in the capital markets during the second quarter. However, higher interest rates and ongoing market weakness pose a challenge, as do several of the banks’ strategies.

“Despite very competitive pricing on deposit liabilities and loans in a low interest rate environment, the stable retail banking performance is still supported by strong growth volumes in loans and core and business deposits, higher credit card fees, and strong revenues from insurance operations,” the rating agency notes in a new report.

However, it says the possibility of an interest-rate increase in Canada means the banks might face a slower growth environment during the second half of 2005. “Although the rise in rates is expected to be very gradual, this would lead to a reduction of retail mortgage and consumer lending volumes but provide some relief on pricing deposit liabilities and improve the net interest margin to an extent and retail banking profitability, although consumer loan losses would rise,” says Standard & Poor’s credit analyst Lidia Parfeniuk.

The banks did face a slowing in the capital markets segment in the latest quarter. “Underwriting fees and trading revenues in particular and, to an extent, wealth management businesses were affected by a slowdown in capital and equity markets activity coming off a really strong first quarter,” it notes.

S&P adds that capital markets-related revenues are expected to weaken further, “and the banks with significant exposure to market risk will see their performance affected the most”.

Demand for corporate loans remained muted, it notes, although corporate lending continues to benefit from fewer problem loans. “The banks’ bottom lines are still benefiting from the release of credit reserves and reversal of loan loss provisions, and recoveries in large corporate lending this year, although not to the same degree as in 2004. Asset quality is unlikely to get any better, which means provision expenses could start turning up at the end of 2005 or early 2006,” it suggests. “Having said that, credit quality is expected to remain relatively benign, and along with the lower risk profile helped by significantly reduced corporate lending books of some Canadian banks, particularly TD Bank and CIBC.”

It maintains a negative outlook on two of the banks: Royal Bank and Laurentian Bank. “Laurentian’s franchise continues to be under competitive pressure, reflected in its weak operating performance,” it notes. “Royal Bank, on the other hand, has reported better performance at Centura since year-end 2004; however, it is not yet apparent when the company will be able to improve returns to peer group levels. Helping future profitability is the recent disposition of RBC Mortgage, which will eliminate the drag on Royal Bank’s earnings.”

“TD Bank, by contrast, is outperforming its peers in retail banking profits. The bank’s vulnerability, however, lies in the execution risk and the successful expansion into the U.S. retail and commercial banking industry through the Banknorth platform,” S&P cautions. “At first glance, the strategy appears to be the most sensible for further expansion in the U.S. among the Canadian banks, although there are challenges associated with this strategy including managing a large minority shareholder position in Banknorth, the difficulty of generating a decent return on invested capital, and limited knowledge of retailnbanking in the U.S. northeast. Reliance on the local management team of Banknorth provides some comfort.”

“Canadian banks have been redeploying built-up capital more actively through increases in dividends, more aggressive share buybacks, and expanding their presence outside Canada, or through shifting to less capital-intensive business such as retail banking. For the time being, the higher capital levels do provide downside protection for the overhang of litigation risk as it relates to the banks’ broker-dealer operations (for example, Enron) and other unforeseeable events,” the report concludes.