Rising interest rates would slow consumer loan demand and further exacerbate rising consumer delinquencies, S&P says

The major Canadian banks are maintaining strong underlying momentum in their domestic personal and commercial businesses this year, says Standard & Poor’s Ratings Services in research note.

Credit metrics are normalizing, however, putting some pressure on profitability, but the impact is likely to be more pronounced in 2008, it predicts.

S&P says that it believes that the Canadian banks’ domestic retail platforms will be the earnings growth engine for the balance of 2007 on the back of still-strong mortgage and personal loan lending volumes. Bank of Montreal is the exception, “as its domestic P&C bank faces challenges, including the difficult task of fixing its market risk governance infrastructure”.

The Canadian banks continue to show strong growth in personal loans, residential mortgages, and business loans, while mutual fund assets under management keep growing, it says. Capital markets activities in M&A, underwriting, and equity trading have also been buoyant overall, the rating agency adds.

“Although the outlook for the Canadian banks is still fairly positive, the strength in the Canadian economy may be leading the policymakers at the Bank of Canada to think about raising interest rates to ease worries of inflation. This would slow consumer loan demand and further exacerbate rising consumer delinquencies, particularly the unsecured segment,” it notes. “Some banks have larger credit card portfolios and other unsecured consumer lending than others, in particular Canadian Imperial Bank of Commerce. Cracks in these lending segments are traditionally early indicators of a downturn in the credit cycle. We also expect to see weaker corporate credit quality.”

“It’s important to note, though, that the banks’ rising provisions for loan losses still reflect for the most part higher lending volumes and fewer corporate recoveries, while credit losses remain at historically low levels,” S&P says, adding that it believes material credit quality weakness won’t emerge until early 2008.

Even then, it notes, “Canadian banks have significantly de-risked their wholesale loan books in recent years. Furthermore, retail lending remains conservative with little appetite for nonprime lending, and a large component of the retail loan book is made up of high-quality residential mortgages, many of which are government guaranteed. Canadian banks also have improved their credit risk management processes and are better reserved today.”

Standard & Poor’s notes that it recently raised the ratings on Royal Bank to reflect its state-of-the-art enterprise risk management infrastructure, above-peer risk-adjusted profitability, and competitive edge in most core businesses.

Conversely, it lowered the ratings on BMO, “based on weak market risk governance following a thorough review of the bank’s ERM and trading risk management practices propelled by significant commodities trading losses announced recently. BMO also is grappling with an underperforming P&C bank (relative to most peers) and market share pressure with near-term growth prospects under question. We believe that these significant issues will take time to resolve and might distract the bank from pursuing its corporate strategy.”

“The Toronto-Dominion Bank, along with Royal Bank, clearly continues to lead the pack with its domestic powerhouse. While The Bank of Nova Scotia is benefiting from its strong international operations performance, revenue growth picked up in Canada this quarter but the overall growth trend in its domestic retail bank has been lackluster. CIBC is benefiting from its successful cost reduction plan while continuing efforts to reduce the consumer credit risk profile,” S&P adds.

The rating agency notes that the significant commodities trading losses sustained at BMO begged the question of whether other Canadian banks have anything lurking in their closets. Standard & Poor’s is approaching completion of its ERM reviews, including trading risk management, of all five large Canadian banks. “With the exception of BMO, our preliminary views are that the risk governance practices range from standard to strong,” it says.

“This isn’t to say that blowups won’t occur,” it adds. “However, a bank that benefits from a strong score will reflect robust risk stature within the organization and will have an enterprise-wide view of its risk appetite consistent with a corporate strategy with well-defined key risk indicators. Also, it’s clear to us that the reach of the risk management function would be sufficiently wide across the organization; that the established policies of the business lines would be consistent with the group’s stated risk appetite and business strategy; and senior management would be well informed of risk issues.”