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This episode, we continue the discussion around quarterly earnings reports with a look at the results of Canada’s top banks. Stu Kedwell, Co-Head, North American Equities, details the three major themes he’s paying attention to affecting the financial sector as a whole, including banks’ capital positions, when their loan deferrals will end, and what their earnings power will be on the other side of this pandemic. Recorded June 2, 2020


Hello, welcome to the Download. I’m your host, Dave Richardson. And it’s Tuesdays with Stu Kedwell from RBC Global Asset Management. And Stu, there’s a whole bunch of things that I’d like to get into with you around the North American markets, both Canada and its economy, and the US certainly. Lots going on there. But we did get through between last week’s podcast and this week’s, the remainder of the big five banks in Canada reporting their earnings. And you’ve got an interesting way at looking at the sector, with the terms of three gates. Maybe you could explain that, and what you saw in the earnings last week, and where the different banks are sitting, and where the sector overall is sitting, relative to the way you’re looking at it.

OK, great. Thanks again for having me. I’m really enjoying this weekly conversation. So when we think about the banking sector, there are three things that have been top of mind. The first has been the banks capital position and their ability to withstand a fair amount of provisions for credit, and what we call risk weighted asset inflation, which will come in the next couple of quarters. The second gate is how will the deferral process, when deferrals end, whether or not it’s not a loan or a mortgage in the next four to six months, how will those loans perform? And the banks have tried to make some assumptions and will continue to make some assumptions about those in the future. And the third is: what will the ultimate earnings power of the bank be, the return on equity and what have you, come the other side of this crisis? And so when the banks reported last week, we were very much focused on that first gate, so to speak. We had Scotia last Tuesday just after or right before our podcast. And the other five banks did come along through the week. And what we can say after looking at the results is that, in all likelihood, each of the six banks will get through this period of elevated provisions for credit and the risk weighted asset inflation with their credit ratios above the regulatory minimums. So that has been welcome news. It was generally what we thought, going into the quarter. It has been endorsed by the different management teams as they’ve taken us through their scenarios about what their credit ratios could look like in certain aspects. Of course, there are always caveats around second waves and all sorts of things, but what we know right now is: that first gate has been passed to some degree. The second is the deferrals and some remnant asset classes that I think are going to take more time. Some pockets of commercial real estate will require a bit of a rethink. And that’ll be the next leg of discussion with the banks around what type of real estate is in their commercial real estate portfolios, what are the loans to values? Those types of discussions. And then on the deferral front, very important: will there be additional government support? Will the CERB be extended? Maybe in a different form? How will unemployment come down as the economy reopens? And for the banks, I think that is also manageable. That will lead to ongoing elevated provisions for credit. Again, in our minds, that will be around for probably three to six quarters. And then the last is on the ultimate earnings power. Banks make money two ways. The first is net interest income and the second is non-interest income. What we’re looking at is: for banks that have more net interest income than non-interest income, it’s going to take longer for their earnings to fully recover, because of the impact of low interest rates, and there may be less asset growth or less loan growth than we would have hoped for. Versus banks that have more non-interest income, those should recover a little bit faster. And when you look at those three gates and you look at how the banks have done, the market has generally been correct in the stance of the Royal and the National Bank being the strongest performers and the closer of all the six to where they were originally. Not surprisingly, those banks have strong capital positions and also have a fair amount of non-interest income. And that really came through in the quarters as well.

And Stu, just one last quick question, because I know a lot of investors rely on Canadian banks for dividends and they have an outstanding track record on dividends. I know we’ve covered it off on a previous podcast, but for those who haven’t listened to every episode — I don’t know who those people would be, but I know some people have missed the odd episode, they are all posted on your provider of podcasts. You never had any concern about the dividends with the banks and you still think they’re in a very solid position dividend wise, correct?

I do think they’re in a solid position. The point we would make there is we did have TD Bank put a dividend reinvestment plan in place, which is just extra cushion to prepare for anything that might come their way. The major question, which is not something that is totally analyzable from a financial standpoint, is will the regulators say to the banks at some point, hey, why don’t you put these things on hiatus for a quarter, or two quarters, just to keep building capital to get us through a more difficult period of time? And we would view it very much in line with that. The banks, as far as we can tell, all expect to continue to pay their dividends. They have the normalized earnings power to continue to pay their dividend. So it would be more of a shorter term angle where the regulators say, for the good of the economy, the good of the country, let’s put them on hiatus for a couple of quarters just to get us through this. Again, nowhere near our base case today, but that is the one caveat.

Very important to state that that’s not your base case. So Stu, always fascinating talking to you about particularly the banks, because of your expertise in this area. Look forward to carrying on the conversation, broadening out a little bit next week. Thanks again for your time Stu.

Great. Thanks, Dave. Have a good day everybody.


Recorded June 2, 2020

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