Canadian banks face the risk of higher credit costs, a trend that may favour more conservative lenders such as Bank of Montreal, according to a report from UBS Securities Canada Inc.

UBS says that credit costs for Canadian banks “have been trending at remarkably low levels, bolstering profit growth”, at a time when margins are under pressure. “With [provisions for credit losses] rates presently running at their lowest levels in our data set spanning nearly 25 years, we believe the risk from here is very clearly one of rising credit costs,” it says.

“Most investors and management teams we’ve spoken to agree that indeed the next move for credit costs is almost certainly up,” it adds. However, UBS notes that there remains a great deal of uncertainty about exactly when credit costs will begin to tick up and to what level.

In the report, UBS estimates what a normalized provisioning rate would be for each major loan category and for each bank. “The impact is potentially significant, as a swift return to normal provisioning levels could wipe out 2006 growth entirely,” it cautions. “However, considering the current environment and more conservative credit management, we do not anticipate such a dramatic move and believe credit costs can remain below average for longer.”

It adds that the senior risk managers from Canada’s largest banks expect costs to rise sooner rather than later, “but it is clear that more robust credit management techniques and a more conservative approach to lending are expected to result in a much gentler cycle”.

“The reality of rising credit costs and decelerating profit expansion should weigh on sentiment for the group in the near term,” it concludes. “Bank of Montreal is likely to benefit from its conservative underwriting track record, while we think CIBC is still viewed as a less disciplined lender and continues to work through issues in its retail portfolio.”

“Over the longer term, we believe a less volatile/risky earnings cycle is supportive of higher sustainable valuations,” it adds. “Ultimately, the credit cycle should be less severe than it has been in the past. Nonetheless, decelerating earnings growth should weigh on near-term sentiment for the group.”