The second quarter was tough for Canadian banks, with higher provisions for potential credit losses and escalating costs for employees and technology eating into earnings. But the extent to which the trouble spills over into third-quarter results, which the banks will report beginning Aug. 24, has sector watchers divided.

We apologize, but this video has failed to load.

Try refreshing your browser, or
tap here to see other videos from our team.

Canadian banks seen delivering upside surprise amid low expectations Back to video

We apologize, but this video has failed to load.

Try refreshing your browser, or
tap here to see other videos from our team.

Play Video

John Aiken, a bank analyst at Barclays, believes the pessimism, which led many to rein in forecasts for the three-month period ended July 31, may have gone too far.

“With consensus estimates lowered coming out of Q2 (and heading into Q3), we believe the banks could surprise to the upside, posting better than expected third-quarter earnings and continuing to fuel valuations ahead of the long-awaited … but now only potential recession,” the analyst wrote in an Aug. 21 note to clients.

Aiken said Canada’s largest banks will fight hard to keep costs in line in order to maintain margins, and he noted signs of improvement in capital markets activity during the quarter, despite it being a seasonally slow period for deals.

Loan growth, while moderating, likely continued in the third quarter, he said, with higher interest rates buoying net interest income — a measure of revenue generated from a bank’s interest-bearing assets such as mortgages and commercial loans against the expenses associated with paying interest, such as to depositors.

His reasoning is based in part on the Bank of Canada’s decision to pause its rate tightening cycle during a portion of the third quarter before resuming in June, which lent some stability to commercial bank deposit rates and funding costs while asset portfolios continued to reprice at higher rates.

“Further, with a stronger spring selling season spurring the recovery in Canada’s housing market, we believe mortgage volumes and overall loan growth will stay positive,” Aiken wrote. “And, buoyed further by the longer Q3, we anticipate net interest income will likely strengthen from Q2 levels.”

Capital markets activity has been slow in the first half of 2023 amid concerns about recession, tightening credit, labour shortages, inflation and a continuation of elevated or even rising interest rates. But Aiken said the banks’ capital markets divisions could prove to be the quarter’s “X-factor.”

While there is lingering potential for a recession, the domestic economy and employment landscape remains resilient, he wrote, adding that credit is still not likely be a material headwind.

Gabriel Dechaine, who tracks the sector for National Bank of Canada, said the third quarter will invariably be an improvement over the second quarter, but is less enthusiastic about the potential for a rebound.

In an Aug. 10 note to clients, he said improvements to net interest margins seen in the U.S. banking sector are unlikely to translate to Canadian banks due to differences in the markets. For one thing, there are few smaller banks in Canada to shed deposits in favour of the larger ones. Furthermore, he says data from the Office of the Superintendent of Financial Institutions points to continued pressure on bank funding costs.

Meanwhile, Dechaine expects banks to continue to set aside provisions for losses across both consumer and commercial real estate books.  

“We expect a steady grind of new impairments, particularly for banks with relatively larger U.S. portfolios,” the analyst wrote.

Dechaine also expects another expensive quarter after the surprise cost growth in the low teens in the second quarter, noting that Canadian banks as a group have been logging higher expenses than their U.S. counterparts, which have seen outlays rise at a rate of approximately five per cent.

The analyst said he’s firmly in the “it’s too early” camp when it comes to expecting Canadian bank shares to take off, noting that his estimates for third-quarter earnings per share are below analyst consensus.

What’s more, Dechaine wrote that higher rates are likely to put upward pressure on performing loans due to higher debt service ratios  — “not to mention the cloud of 2025 mortgage refinancing risk.”

CIBC Capital Markets analyst Paul Holden, meanwhile, has revised his core earnings estimates down across the banks by an average of five per cent. He’s expecting to see the results of “funding cost pressures, slowing loan growth, soft conditions for fee income and still high expense growth.”

Holden expects the funding pressures to drive net interest margins lower, hitting Bank of Nova Scotia and Bank of Montreal hardest. In addition, while the sector may be avoiding a material increase in credit losses for now, the analyst expects higher losses to materialize in future quarters. In an Aug. 21 note to clients, Holden suggested bank share valuations have not pulled back sufficiently to compensate for reductions in consensus earnings estimates.

“We remain cautious on the banks,” he wrote.

• Email: bshecter@postmedia.com