Standard & Poor’s has issued a gloomy review of the credit situation for Canadian banks.

In “Report Card: Canadian Banks” S&P says “impaired loans continued to rise in fourth-quarter 2002 as deteriorating energy sector loans replaced the telecommunications loans that previously were in the forefront of credit problems. Heavy provisioning dragged bank earnings down for the year. Also, the global capital markets’ woes are not showing any signs of subsiding in the near term”.

“As a result of the difficult operating environment, most Canadian banks experienced significantly higher provisions for loan losses and weaker profitability measurements. Canada’s six dominant banks reported $2.7 billion less in earnings in fiscal 2002, a 28% reduction from 2001,” says S&P.

The credit problems follow in the aftermath of a spate of corporate overinvestment and overleveraging a few years ago, rather than of a broad-based North American economic slowdown, the rating agency says. “Canadian banks had been significant players in the U.S. syndicated loan markets, so that a wave of large corporate defaults there had a major impact, causing all of the banks to reconsider their U.S. lending strategies.”

Standard & Poor’s says that it remains concerned about further credit deterioration and capital markets weakness as the global operating environments for the telecommunications and energy sectors and investment banking continue to deteriorate and could add to the Canadian banks’ problem loans and weigh on their operating performance further in 2003.

It estimates the Canadian banks’ (excluding Laurentian Bank) total energy loans exposure at $14.8 billion, with telecoms exposure of $18.6 billion. It also suggests that problems could surface in the auto parts sector, “which would be vulnerable if there is a deeper recession in the U.S., although this is not Standard & Poor’s base case, and also in the airline industry, to which the large Canadian banks have relatively minor exposure.”

“Barring any dramatic change in the capital markets, we can expect the investment-banking environment to remain depressed for at least the near future,” it says. “The impact of revenue declines on after-tax profit margins has been quite pronounced on the Canadians banks, whose after-tax profit margins have been thin to begin with. In general, Standard & Poor’s is not expecting a return to the supernormal business volumes of 1999 and 2000 and thus future revenues are expected to register at more modest levels.”

The agency notes that the Canadian banks have been exiting unprofitable corporate relationships for some time now, and that the last couple of quarters have spelled out a definitive retrenchment from the U.S. and other foreign countries in large syndicated corporate lending.

“The reduction in wholesale lending will mean less international and product diversification for the Canadian banks and increased wholesale concentration in Canada. It also would mean lower future investment banking revenues. Although servicing large corporate clients has been a risky and volatile activity, should that change in the future, the Canadian banks will be less well positioned to benefit. On the other hand, the Canadian banks’ retrenchments in the U.S. should result in greater stability of earnings in the longer term.”

Excluding capital markets activities and the U.S. syndicated lending business, S&P says the traditional banking business of major Canadian banks remains strong in earnings performance and asset quality as the Canadian economy continued to perform well throughout 2002.