handshaking and exchanging contract documents

Canada’s smaller banks face larger credit risks than the Big Six as economic growth slows and financing conditions tighten, according to a new report from DBRS Morningstar.

The rating agency said small and mid-sized banks are generally less diversified, both operationally and geographically, than their counterparts in the Big Six, leaving them more exposed to rising credit risks.

According to the report, the smaller banks — which include Laurentian Bank of Canada, Canadian Western Bank, Manulife Bank of Canada, Home Trust Co., ATB Financial, and Equitable Bank — account for an estimated 7.4% of total bank assets, with the Big Six holding the rest (92.6%).

Their much smaller footprints are more concentrated in specific niches, such as residential mortgages (Home Trust and Manulife) or commercial lending (CWB), it noted.

This lower degree of diversification leaves the firms facing higher credit risks, the report said, as does the fact that they are more highly exposed to riskier asset classes such as subprime residential mortgages and commercial real estate loans.

As a result, DBRS said credit pressure on the mid-size banks “will likely increase further from the current environment.”

In particular, the rating agency said it views Home Trust and Equitable “to be more susceptible to a real estate market correction than their peers.”

Alongside the higher credit risks, the smaller banks also face higher funding risks, with broker-sourced deposits representing a greater share of their funding.

DBRS noted that broker deposits are generally more rate-sensitive than branch deposits.

That said, the report also indicated the smaller banks are actively seeking to diversify their funding sources and that they currently boast adequate liquidity. Despite their costlier, riskier approach to funding, it said, the smaller banks generally have stable net interest margins and consistent earnings.

Additionally, credit quality is strong at the smaller banks, DBRS said: the two-year average of impaired loans ranges between 0.2% and 1.3% of gross loans, with minimal write-offs.

“This has been supported by good underwriting standards with most loans being secured,” it said.

Their capital ratios also exceed their regulatory minimums, “providing an additional buffer to protect these banks from losses in a stressed environment,” the report noted.