Canadian banks have always displayed great strength even during the world financial crisis of 2008, yet this past year the banking community is facing a new set of challenges as it adapts to rapid changes in the marketplace.

Earlier this month, the Big Six banks 2019 earnings reported lower profits, tighter operating margins, larger loan loss provisions, and layoffs. Moreover, every bank CEO spoke about the difficult environment facing his respective bank, as Canada’s growth slows in response to declines in the commodity sector, record levels of household debt and a ongoing uncertainty in the international trade. While the housing sector continues to expand, these banks now face competition from alternative lenders who are basically unregulated. As a result, mortgage underwriting has been lagging behind prior years’ performance and the mortgage stress regulations have spawned a surge in loans provided by near-bank and private lenders. This shift in mortgage lending has caught the attention of the Bank of Canada because the lending by unregulated lenders.

As consequence, the TSX banking index has taken a hit. Prior to the release of the 2019 earnings banks stocks enjoyed a nice run-up, only to hit a wall as most banks reported weak earnings growth and others outright profit declines. Last the TSX bank index dropped nearly 5%, effectively erasing a year’s worth of dividends.

Figure 1 TSX Bank Index

(Click on image to enlarge)

Now, the regulator, Office of Superintendent of Financial Institutions (OSFI), considers that:

 key vulnerabilities to Canada’s Domestic Systemically Important Banks (D-SIBs) remain elevated, and in some cases show signs of increasing. The key vulnerabilities include Canadian household indebtedness, asset imbalances, and institutional indebtedness. In addition, global vulnerabilities related to ongoing trade tensions and rising leverage are growing, which could increase the chance of a spillover of external risks into the Canadian financial system Against a backdrop of accommodative low-interest rates and stable economic conditions, it is prudent to build additional resilience against potential shocks to the financial system.

The OSFI insists that the risk-adjusted capital be raised for the third successive time by another ¼ point to 2.25%.  In and of itself, the increase in reserve requirements is manageable and this should not disrupt lending activities per se. However, it is a reflection of the extent to which the regulators have become concerned that the banks do not have adequate buffers should there be a credit event. Given a sobering profit outlook and higher reserve requirements, we can expect that the Canadian banks will perform at a lower trajectory in the coming year.