A see through piggy bank with money coins

Canadian bank stocks have been riding a wave of investor optimism so far this year, but analysts say the first-quarter results that start arriving later this week will be a reminder of the mixed economic picture ahead.

On the positive side are the signs of easing inflation and job reports that keep surprising to the upside; on the other side is the growing amount of money banks are having to set aside for the expected slowdown ahead.

Investor concerns about capital requirements are starting to edge into the question of how well banks are profiting off higher interest rates, said Scotiabank analyst Meny Grauman, which has been the main focus in recent quarters.

“There is no doubt that the market’s almost singular focus on margins has already begun to weaken as capital concerns have taken some of that spotlight away,” he said in a note.

“A more challenging capital and regulatory environment for banks … is something that we are very concerned about.”

The higher capital requirements come after the banking regulator increased the amount of capital that banks have to set aside, while the two taxation measures the federal government introduced in last year’s budget will also be reflected in the results.

Banks had until Feb. 1 to get their capital ratio to the new level of 11.5% set by the Office of the Superintendent of Financial Institutions, which raised it by half a percentage point over concerns of higher risk from high household debt and rising interest rates.

With the economy looking strong despite a wave of interest rate hikes, concerns the Bank of Canada won’t be able to lower rates any time soon could add to the risks. The regulator could also raise the rate further, leading all of Canada’s big banks to target a capital ratio of 12%, said Grauman, which is putting strains on the amount of capital available for other uses such as share buybacks.

“Given the upward pressure on (bank capital) ratios, share buybacks are about as fashionable as top hats,” said Grauman.

Along with higher capital requirements, banks are having to increase provisions for credit losses, though they are still rising to more historic norms from unusually low levels.

“With the possibility of a recession still likely on the horizon, we anticipate the credit normalization will continue, underscored by higher non-performing loan provisions,” said Barclays analyst John Aiken in a note.

While banks are having to prepare for the potential fallout from higher central bank interest rates, they also still stand to benefit as their net interest margins improve as overall loan activity is still going strong, noted Aiken.

“Despite the slowdown in Canada’s housing market, for now, overall loan growth continues to hold steady. On the capital markets front, investment banking league table data is showcasing a relatively positive quarter.”

The positive indicators, and easing fears, have helped push up shares of the Big Six banks by 10.7% as of Feb. 16, compared with 7.2% for the TSX Composite Index as a whole, noted Canaccord Genuity analyst Scott Chan.

The share growth however came after banks relatively underperformed in 2022, while he said that soft capital markets and lowering credit expectations led him to decrease his earnings expectations for the quarter.

The potential need for elevated rates to stick around longer to get the inflation job done is also a rising concern, he said.

“Recent discussion of ‘higher rates for longer’ in Canada and the U.S. adds to potential credit concerns,” he said in a note.

CIBC kicks off the earnings season Friday, while BMO and Scotiabank report Feb. 28 and RBC, TD and National Bank release results March 1.