The fortunes and credit conditions of Canada’s smaller banks are more closely tied to the rate cycle than those of the Big Six, but these institutions are still poised to see earnings rise in the year ahead, Morningstar DBRS said in a report on Tuesday.
The rating agency, which has a stable outlook for the so-called medium-sized banks — including Equitable Bank, Home Trust Co. and Laurentian Bank of Canada — said that the rosier economic outlook and declining interest rates should support higher earnings in fiscal 2025, following “mixed” results for this segment last year.
“The Bank of Canada’s monetary policy easing cycle should help lower debt-servicing costs for heavily indebted consumers and businesses; however, we expect the [medium-sized banks’] asset quality metrics to experience some residual deterioration heading into 2025 before provisions for credit losses begin to moderate,” DBRS said.
On average, in fiscal 2024, the mid-sized banks only generated 17% of their revenues from non-interest sources, such as capital markets and wealth management — compared with 49% at the Big Six banks, DBRS said.
As well, while the mid-sized banks only saw non-interest income rise by 1% on average in 2024, most saw higher net interest income and stronger net interest margins, “which benefited from increased yields on fixed-term loans that more than offset higher deposit costs,” the report said.
In the year ahead, the medium-sized banks are expected to see continued growth in net interest income, “driven by higher loan originations and stable to moderate expansion in [margins],” DBRS said.
“In our view, the overall impact of loan repricing should still be positive for [net interest margins] despite falling interest rates, further supported by lower deposit funding costs,” the rating agency said. “The current monetary policy easing cycle may spur increased loan activity, particularly in residential mortgages and commercial real estate.”
While the mid-sized banks saw asset quality deteriorate in 2024, the rating agency said they have capacity to absorb added loan losses.
“On average, the gross impaired loans ratio increased 82 [basis points] to 1.53% in fiscal 2024,” DBRS said. “On the positive side, the average net write-offs ratio was manageable at 14 bps in the same period.”
In fiscal 2024, the banks increased their credit loss provisions, which rose to 22 bps of average net loans in fiscal 2024, compared with 8 bps in 2023, it reported.
In the year ahead, DBRS said it expects “additional credit deterioration … particularly in non-mortgage retail lending products,” along with ongoing strains in certain commercial loan exposures.
The medium-sized banks also have a much larger exposure to the troubled commercial real estate sector than the Big Six banks — representing 25% and 30% of total loans, compared with around 10% at the Big Six, DBRS reported.
However, the banks’ build up of credit provisions is expected to slow in 2025, as lower rates ease the pressure on borrowers, DBRS said, noting that this should, in turn, boost the banks’ earnings.
“[A]sset quality metrics will likely moderate in the second half of fiscal 2025 as interest rate cuts are fully absorbed. Furthermore, the Canadian economy is expected to accelerate in the medium term and the anticipated increase in unemployment should be modest,” the rating agency said.
Additionally, the report noted that the medium-sized banks have adequate capital cushions, which are above regulatory requirements, and provide “buffers to absorb much higher loan losses.”