Canada’s big six banks appear to be thriving, even in the face of the lingering economic downturn. Strong earnings, high capital ratios, comparatively modest loan-loss provisions and cost efficiencies have the banks on solid footing — particularly when matched up against global peers, according to industry analysts and organizations that assess the viability of financial services institutions.

As of July 31, the end of the third quarter of this fiscal year, the average Tier I capital ratio for the Big Six was 11.6% — well above regulatory requirements and far ahead of global banking competitors.

“Despite the challenging credit and capital markets environment witnessed over the past 18 months, the Canadian banking industry is suitably managing risks,” says a report by Toronto-based bond-rating agency DBRS Ltd. released in early November. “The banks have strong earnings before loan losses and taxes, and capital levels [are] sufficient to absorb potential losses that would result from risk-taking.”

In October, a global competitive-ness report from the World Econo-mic Forum rated the Cana-dian banking system as the world’s soundest.

Although loan-loss provisions at the Big Six continue to climb — an indication that individuals and businesses are still struggling financially — experts are encouraged by the fact that loan-loss provisions appear to be modest compared with those in other downturns.

“Loan losses are not rising at nearly the pace they hit in the early 1990s,” says Robert Sedran, an analyst with National Bank Financial Ltd. in Toronto. “It’s really an indication of [the banks’] conservative nature and evidence of their lower risk profile.”

A significant portion of the losses are coming from the banks’ retail loan portfolios, which include mortgages, home-equity lines of credit and credit cards; the last is an area of particular weakness.

Banks that own significant U.S. retail banking platforms — such as Royal Bank of Canada, Toronto-Dominion Bank and Bank of Montreal — are also directly exposed, to varying degrees, to the ongoing downturn in the U.S. residential and commercial real estate markets, and to the struggling U.S. economy in general.

However, experts say, high loan losses are not unexpected, given the state of the economy.

“Loan losses are something of a lagging indicator,” says Shane Jones, managing director and head of Canadian equities with Scotia Asset Management LP. “Most companies and individuals will try to stay afloat for as long as they can. So, it’s at the end of a recession that you’re going to have higher loan-loss provisions.”

With the banks due to report their fourth-quarter earnings in late November, Jones says, he will be keeping a closer eye on “gross impaired loan formations” — loans that are currently impaired but not yet written off — rather than just loan losses.

“Over the past couple of quarters, we’ve seen a levelling-off in the [growth] trends in impaired loan formations,” Jones says. If growth in impaired loan formations were to pick up pace, he adds, that would indicate continued weakness in the Canadian economy, and might lead the banks to become even more risk-averse.

The banks also have received good reviews for finding cost efficiencies. “During the first nine months of 2009, revenue growth exceeded expense growth for the industry as a whole,” says a DBRS report on bank earnings released at the end of September.

Although the banks’ capital markets units have been generating high trading revenue, significantly contributing to improved earnings overall, most industry observers agree that continued growth in this area can’t be expected.

“With the uncertainty and volatility in the capital markets abating from the highs of the early part of fiscal 2009,” says the DBRS report, “it will be challenging to replicate the levels of trading revenue.”

Sedran says he’ll be watching the earnings reports for increasing “net interest margin” — a ratio comparing what a bank is earning in interest vs what it is paying out — to determine whether that could be the next area for bank growth.

“Trading revenue has been strong, but can’t be expected to continue growing,” Sedran says. “Will net interest margin be that next catalyst [for strong growth]?”

Industry observers suggest that the banks will remain committed to keeping their capital levels high and be reluctant to take on significant risks through either acquisition or increased dividends.

“I don’t see any possibility in the near term of dividend increases,” Jones says. “The banks will wait to do so until they are convinced the economy is growing — and growing in a self-sustaining way; not just as a result of stimulus packages.”

@page_break@Although the Canadian dollar has been rising against its U.S. counterpart and dozens of small U.S. bank players are available, banking industry observers also believe the Canadian banks will continue to exercise extreme caution when it comes to making any acquisitions south of the border.

“The [U.S.] Troubled-Asset Relief Program stabilized a lot of American banks. But, at the same time, there isn’t a lot of visibility in terms of what kinds of assets they hold,” Sedran says. “That decreases the appetite [for an acquisition], given the still volatile nature of the economy.”

Jones also believes that the Canadian banks, which are still struggling with their existing U.S. platforms, are loath to add more unless the banks run into an ideal opportunity.

“I think they’re all well positioned to do an acquisition,” he says, “but only if they find the right target.”

Jones thinks a lack of growth in the U.S. economy is one of the key risks facing all the Canadian banks, whether or not they have a U.S. retail banking platform.

“You see the effect in rising unemployment,” he says, “especially in the manufacturing sector.” IE