As the effects of higher interest rates work their way through the economy, the big banks will come under pressure in the year ahead, according to an analysis by DBRS Morningstar.
“The Canadian banking outlook for 2023 is affected by a challenging operating environment featuring muted economic growth and the increasing likelihood of a recession,” the rating agency said in a report on Thursday.
Aggressively tighter monetary policy has been unable to significantly tame high inflation, and has increased borrowing costs, negatively affecting disposable income. In Canada, high household indebtedness and still-elevated housing prices remain two key vulnerabilities in the Canadian financial system, the report noted.
The drop in disposable incomes “is expected to negatively affect [banks’] credit quality in 2023, driving higher delinquencies, [provisions for credit losses], and loan losses,” the report said.
Earlier this month, the Office of the Superintendent of Financial Institutions (OSFI) launched a consultation on potential debt serviceability measures for the residential mortgage market to mitigate the risk from household indebtedness.
The DBRS report also noted that a slowdown in economic activity and a potential recession could dampen banks’ loan growth in 2023. For example, growth in residential real estate secured loans moderated in the fourth quarter of 2022 as a result of reduced sales activity, the report said, noting that house prices have decreased 13% since their February 2022 peak.
In addition to slower loan growth, banks’ rising funding costs, resulting in part from customers’ shift to higher-cost term deposits, will affect their net interest margins.
While DBRS Morningstar expects credit quality metrics to continue normalizing in 2023 from their unsustainable lows, credit deterioration could become more pronounced if additional interest rate hikes or a severe recession occur in the year ahead, the rating agency said.
As things stand, capital levels at the big banks remain strong and “provide sufficient cushion to absorb potential losses,” the report said.
In December, OSFI boosted the big banks’ capital buffer requirements as a way to address rising risks.
However, with the banks expecting to close several large acquisitions in 2023, DBRS said some banks may have to take actions to boost their capital buffers, citing BMO’s recent $3.35-million equity raise. DBRS also said it expects banks to cut the pace of share buybacks and dividend increases after a busy 2022 on those fronts.
Despite macroeconomic conditions amplifying some key vulnerabilities, DBRS Morningstar expects the overall financial impact to be manageable.
“The Big Six are entering 2023 from a position of strength with strong asset quality, ample liquidity buffers, and sound capital levels,” the report said.