Capital markets, rather than credit is the main concern facing Canadian banks at the moment, according to a research report released today by banking analyst Peter Rozenberg of UBS Securities Inc. Canada.

“Credit quality remains good,” wrote Rozenberg in the report on Canadian banks. “While we project higher provisions, this should not significantly undermine earnings per share (EPS).” He added that while EPS could be pushed down by lower-than-projected capital markets revenues, this risk should generally be captured by the second and third quarter. “Given that the market is increasingly discounting peak provisions, we expect bank stocks to ultimately re-rate higher.”

According to the report, UBS thinks that bank stocks have largely bottomed out, but the likelihood of lower than projected EPS in the second half of the year combined with further write downs and slow economic growth could extend the timing of this out by one or two quarters.

“While capital markets revenues could continue to be less than expected, we think that this risk is modest relative to current high valuation discounts,” it said. “And this risk will be largely captured by Q2-Q3. While Canadian banks should continue to outperform US bank stocks, we note a strong correlation of 94% in the last 12 months.”

UBS added that the U.S, backdrop remains negative due to its dependence on housing markets.

The research forecasts moderately negative EPS growth in Q2 and Q3 due to lower capital markets revenues and an increase in loan provisions from 28 bps in the fall of last year to 37 bps for the same period this year and 43 bps for 2009.

UBS said with credit risk under control, it maintains its BUY rating on the Bank of Nova Scotia, TD Bank Financial and the Royal Bank of Canada. “We note that relative stock performance has largely been related to market sensitive exposure, not asset quality or loan mix.”

According to the report, UBS believes the risk of high loan losses has been overly discounted by the market and growth and returns will moderate.

“We expect provisions to increase from cyclically low levels, and earnings growth to moderate to 5-10%,” wrote Rozenberg. “However, we don’t expect a significant increase in loan provisions (or much lower earnings growth), which we think is increasingly being discounted.”

The main risk to provisions, Rozenberg’s research concluded, would be business loans, which represent 38% of total loans and are the most cyclical with recent peak provisions of 159 bps. But, he added that because loan mixes have improved, business loan provisions of 42 basis points would have to quadruple to really have an impact. UBS said it does not expect major loan losses because corporate debt is low, profitability is high and the economic backdrop is satisfactory, albeit moderating.

“To the extent that the market is discounting much higher provisions, which we think are unlikely, we expect bank stocks to ultimately re-rate higher,” Rozenberg concluded.

However, the report added that long term performance will not be sustained about 9.5x-12x EPS until Canada’s big banks work through problems surrounding higher provisions, lower capital market revenues, lower growth, de-leveraging and lower implied returns.

As well, UBS said it expects long rates to increase from 3.6% to 4.2%.