Skyline of the financial district

Last week’s rate cut by the Bank of Canada is set to slow the deterioration in banks’ credit quality over the past year and may reignite demand for loans, the rating agencies say.

In a new report, Moody’s Investors Service said the start of an easing cycle by Canada’s central bank will likely serve as a catalyst to slow the decline in credit quality that the big banks have been facing for several quarters, and that has driven them to boost their provisions for credit losses.

In a separate report, Morningstar DBRS said higher credit loss provisions and weaker net interest income weighed on the banks’ second-quarter results.

Aggregate provisions rose 1.3% in the quarter to $4.2 billion, and provisions on impaired loans increased for the seventh straight quarter, rising 3.1% to $3.7 billion, it said. Gross impaired loans were up 10.5% in the quarter to $25.3 billion.

“The higher-for-longer interest rate environment is weighing on borrowers, with [credit loss provisions] and [gross impaired loans] now beyond pre-pandemic levels by six basis points and 11 [basis points], respectively,” DBRS reported.

Nevertheless, the Big Six saw earnings rise 1.9% from the previous quarter on the strength of “higher underwriting and advisory fees, wealth management revenues, and a modest reduction in non-interest expenses,” it said.

Overall, revenue growth was flat in the second quarter, loan growth was weak, and margins were stable, DBRS said.

However, the start of monetary easing is expected to rejuvenate credit trends.

In response to the rate cut, the big banks all immediately lowered the prime rates charged on variable-rate loans, such as home equity lines of credit, variable-rate mortgages and commercial loans, Moody’s noted.

This reduction in prime rates “will have an immediate effect on [variable-rate] borrowers, whose interest rates have risen since the [Bank of Canada] began its monetary policy tightening cycle in March 2022,” it said.

DBRS echoed Moody’s, saying it expects the start of monetary easing to slow the decline in credit quality and boost demand for loans.

“Easing inflation, the first overnight interest rate cut in four years, and the expectation of further interest rate cuts may stimulate loan demand, particularly residential mortgage growth, which remains muted from a lack of housing demand despite a recent spike in home listings,” DBRS said.

These improvements in credit quality should, in turn, support the banks’ profitability into 2025, Moody’s said.

If the Bank of Canada cuts rates again this year, Moody’s said, “we expect these banks will likely recover previously taken provisions for credit losses on performing loans later in the year, which is earlier than anticipated.”

“We expect margins at the six large banks to be relatively stable through the year, keeping them well positioned should the [Bank of Canada] or the U.S. Federal Reserve cuts rates later this year,” it said.

DBRS added that, while “the operating environment remains challenging,” the big banks have “ample” liquidity and solid capital that’s well above the regulatory minimum requirements.

And it noted that the Office of the Superintendent of Financial Institutions is set to make its next semiannual announcement on the domestic stability buffer on June 18.