Source: The Canadian Press

Canada’s big banks are expected to benefit from lower provisions for bad loans when they begin to release their financial results this week, but weak capital markets revenue is expected to weigh on profits.

CIBC World Markets analyst Robert Sedran expects the banks to report an average of 2.1% growth in earnings in their third quarter, compared to a year earlier.

The primary driver of this growth will be shrinking loan-loss provisions, which Sedran predicted will fall a hefty 27% from the third quarter of 2009.

Loan-loss provisions protect banks against bad loans, such as when customers default on their mortgages. These soared during the recession as fewer consumers were able to make their payments on time. However, the impact on Canadian banks was minimal compared with the U.S., where the recession and the sub-prime mortgage crisis had a devastating impact on many lending institutions.

Shrinking provisions for bad loans indicate the economy has improved dramatically from the same period of 2009, when it was just beginning to bounce back.

Barclays Capital analyst John Aiken described the shrinking loan-loss provisions as “the key driver to earnings for the third quarter.”

“Although economic indicators suggest that the recovery in the U.S., and by extension Canada, has slowed, credit quality continues to improve as economic conditions, though challenged, have largely stabilized,” Aiken wrote in a note to clients.

“As the environment continues to recover, these improving credit conditions should bolster the retail segments, with domestic markets likely showing greater strength.”

However, strength in the banks’ lending divisions is expected to be partially offset by lower capital markets revenue, which the banks earn by providing capital to businesses through such activities as underwriting share offerings or financing merger and acquisition activity.

Sedran said he expects gross capital markets related revenue to decline 21% from last year.

“While we still expected gross (capital markets related revenue) to stabilize ahead of pre-crisis run rates, uncertainty in capital markets over the past several months coupled with very weak performance by large U.S. financials in the most recent quarter… forces us to consider whether sustainable run rates will in fact be lower than we had originally assumed,” he noted.

Higher interest rates on mortgage products following two rate hikes by the Bank of Canada during the May to July quarter should begin to show in the banks’ net interest revenue, but this will largely be offset by slower lending growth and increased competition.

“With lending growth slowing, competitive pressures have intensified as the same lenders chase fewer borrowers,” Sedran wrote. “This in turn has led to more competitive pricing that can weigh on margins.”

Investors who are hoping for higher dividends from the banks may have to wait a little longer, Aiken said. In fact, the downturn seems to have prompted the banks to ease and maybe even lower their ratios of payouts to earnings.

“Should the banks begin to lower their payout ratios, investors could have to wait several more quarters before they see material dividend increases,” Aiken said.

Forecasts compiled by Thomson Reuters predict Bank of Montreal (TSX:BMO), which on Tuesday will be the first major bank to report its results, to earn $1.22 per share, up from $1.05 a year earlier.

CIBC (TSX:CM) will report on Wednesday. Analysts expect the bank to report EPS of $1.54 compared to $1.36 in the third quarter of 2009.

Royal Bank (TSX:RY) will report Thursday, and is expected to earn $1.03 per share, down from $1.21 a year ago. Bank of Nova Scotia (TSX:BNS) will report Aug. 31, and analysts are forecasting a profit of 98 cents per share, up from 94 cents in the same period last year.

TD Bank (TSX:TD) will be the last major bank to report on Sept. 2. It’s expected to report a profit of $1.45 a share, down slightly from $1.47 a year ago.