Ratings agency DBRS says that the banks’ trading revenue is growing, and risk has been growing alongside it, too.

DBRS reports that the big five banks saw their trading revenue grow by an aggregate 13% in 2006 to $5.7 billion. Royal Bank saw the biggest growth, with revenues up 26%. CIBC was the only bank that saw revenues decline, down 9% in the year, it notes.

RBC also had the highest revenue contribution from trading-related activities at 11.2%, whereas Bank of Montreal had the lowest at 6.6%, it reported. “RBC has had exceptional growth as a result of its platform, which is the most diversified, by product, client and geography, of all the five Canadian banks,” it adds.

“Ongoing strength in the North American capital markets, volatility in both commodities and interest rates and investor confidence have been major contributors to the continued robustness of the Canadian banks’ proprietary and agency trading businesses,” DBRS explains.

“It has taken five years to build trading revenues to amounts that are equal to the peak levels in 2001, which was the height of the technology bubble. DBRS believes the growth in trading revenue is due in part to the increased diversification of the banks trading businesses relative to five years ago,” it says. However, it notes that the contribution of trading revenue to total revenue was just 8.7% in 2006, compared with 10.3% in 2001. “This is primarily due to revenue growth for the Canadian banks in all non-trading business segments, such as retail banking and wealth management, which are typically more reliable sources of revenue.”

DBRS says that it is difficult to predict how long the strength in these trading markets will endure, “but as long as investor confidence remains intact, DBRS does not expect a substantial deterioration in trading environments. DBRS believes trading-related revenue will increase in the medium term given the high return on capital in certain trading businesses (such as equity underwriting, mergers and acquisitions and structured products).” It also expects the contribution from trading-related revenues to increase in the mid to high single digit range over the near term.

The rating agency also notes that the rise in trading revenue in 2006 has been accompanied by higher risk, as measured by average aggregate global trading value at risk (VaR). “Within VaR, the interest-rate and credit-spread risk and the commodity risk components have increased the most, followed by equity risk,” it says. “The growth was partially offset with a slight decline in foreign exchange risk and a higher diversification factor compared with three years ago.”

“VaR as a percentage of average common equity has remained relatively steady over the last three years as growth in average common equity has kept pace with the increase in VaR,” DBRS says, but it expects this risk to increase over the near term. “Nonetheless, as long as the trading businesses are diversified and there is no dramatic decline in common equity, the effect on VaR and VaR as a percentage of average common equity should remain stable,” it says.

For now, DBRS does not consider trading-related revenue to affect the ratings of the banks by itself. “DBRS also takes into account the impact of trading revenues on the earnings, credit fundamentals and financial risk profiles of each bank. DBRS’s outlook for the Canadian banking industry as a whole remains fairly strong and is supported by a strong national banking system, earnings diversification, strong levels of capital and reasonable credit quality relative to the last economic downturn,” it says.