Despite the improvement Canada’s seven major banks have shown in operating revenues and earnings in the first-quarter, Standard & Poor’s expects that 2003 will be a challenging operating year for Canadian banks due to continued weak capital markets activity and a precarious credit environment.

According to the industry report card released by S&P on Wednesday, the strength of the big Canadian banks is their solid retail and commercial franchises, which remain strong in earnings performance and asset quality.

The report card notes that Canadian banks reported lower provisions for loan losses in first-quarter 2003 with the exception of CIBC. However, S&P says impaired energy loans are expected to increase in 2003.

Banks that are less well reserved and have significant energy exposure might find themselves having to increase their provisions for loan losses in 2003. Overall however, 2003 provisions for the major Canadian banks should be slightly lighter than in 2002 because the energy marketers do not have the loss content in loans that the telcommunications companies did, as the value of the collateral and available revenue streams is greater.

S&P says the Canadian banks’ aggregate exposure to the energy sector is 13.7 billion, or about 20% less than the total telecommunications exposure reported of $16.7 billion.

Other potential credit problems could surface in the auto parts sector, and the airline industry, to which the large Canadian banks have relatively minor exposure.

S&P notes that loan growth in residential mortgages and consumer loans has been flat to slightly up in first-quarter 2003 as the volume of these lending segments begins to slow after a prolonged low interest rate environment. Despite the low interest rates, the positive consumer deposit growth trend continued from the previous quarter as investors maintained their aversion to equities markets.

S&P observes that the banks continued to cut costs quite aggressively in the first quarter, as revenue growth remained a challenge. It says the reduction in wholesale lending will mean less international and product diversification for the Canadian banks and increased wholesale concentration in Canada. It also could mean lower future investment banking revenues.

The corporate finance lending environment remains extremely difficult given the dearth of potential mergers and acquisitions and underwriting deals in the pipeline, which will show up again in lower revenues for the Canadian banks in their second-quarter 2003 performance.

S&P notes that the possibility of bank mergers resurfaced this quarter in anticipation of the House of Commons finance committee’s imminent report on bank merger guidelines. As a result, it says banks have put a temporary hold on any aggressive international expansion plans.

As for interest rates, S&P says a steady but limited increase in interest rates would alleviate some of the compression on net interest margins.

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