NON-RATING ACTION COMMENTARY

Canadian Banks’ 1Q23 Provision and Expense Growth Offset Rate Benefit

Mon 06 Mar, 2023 – 12:31 PM ET

Fitch Ratings-New York/Toronto-06 March 2023: Canadian banks’ recently reported results reflect incremental normalization of performance measures post-pandemic, as incorporated in Fitch’s ratings and outlook. The largest Canadian banks’ January fiscal first quarter earnings were materially down yoy on a reported basis, driven by a one-time windfall tax, litigation-related provisions at Canadian Imperial Bank of Commerce (CIBC) and Toronto-Dominion Bank (TD) and costs related to recently closed or upcoming acquisitions by Bank of Montreal (BMO) and TD. Excluding these, and other adjusting items, results were largely flat yoy. Adjusted return on average assets across the seven largest banks, including Desjardins Group (DESJ) which reported as of December 2022, averaged 0.8%, unchanged from the year-ago quarter.

Loan growth remained strong, at or near double digit levels yoy, particularly in commercial portfolios. However, on a qoq basis, the pace of loan growth slowed significantly, especially in personal lending, as credit demand responded to the 425 bps in cumulative rate hikes since March 2022. A number of banks reported quarterly contractions in credit card balances and consumer loans for the first time since 2021.

With the exception of National Bank of Canada (NBC) and Desjardins Group, yoy loan growth outpaced deposit growth, which together with an unfavourable mix shift in deposits, compressed net interest margin across most institutions. Average firmwide net interest margins declined by approximately 6 bps qoq and 5 bps yoy. More asset sensitive TD was the exception, having progressively expanded its adjusted margin by 25 bps relative to 1Q22.

Average bank provisions for credit losses, as a share of loans, were 22 bps as of quarter end, largely flat versus the prior quarter, after stepping up from single digit levels from mid-2021 to mid-2022. Banks continued to guide to normalization of credit losses over the near term, and are expected to close the gap with pre-COVID provision ratio levels over the coming quarters (approximately 12 bps). Impaired loan ratios also ticked upwards modestly qoq, by roughly 2 bps on average, in line with Fitch’s expectations.

Mortgage quality remained largely benign, notwithstanding a housing market correction and materially higher debt service costs for renewing borrowers. Year-over-year non-interest expense growth outpaced adjusted revenue growth at most institutions, reflecting personnel costs and an elevated pace of technology investment. However, many banks guided to peaking expense growth and recommitted to positive operating leverage for the full fiscal year.

In terms of segment performance, revenue growth was broad based, with strong performance in Canadian personal and commercial banking (growing approximately 12% yoy on aggregate). Capital markets revenues also ticked upward by 2% yoy, as recovering sales and trading helped offset continued weakness in investment banking. Wealth management revenues similarly increased broadly yoy, benefitting from higher net interest income in private banking, which helped offset lower net sales and fee income from the market-driven contractions in assets under management.

Common equity Tier 1 (CET1) levels continued their rapid normalization to pre-COVID levels, as anticipated. Bank of Montreal, which closed its acquisition of Bank of the West after the end of 1Q23, guided to a CET1 ratio of 11.5% by 2Q23, and 12% by fiscal year-end. TD, which reported a pro forma 15% CET1 ratio following its Cowen acquisition on March 1, similarly guided to a CET1 ratio well in excess of 11% after it closes on its expected acquisition of First Horizon Corporation (FHN).

TD disclosed that a delay in regulatory approval had extended closing on FHN beyond the May 27, 2023 horizon of its merger agreement. In terms of Basel III regulatory capital reforms, which will be implemented as of fiscal 2Q23, banks guided to a small or moderately positive benefit to CET1. Royal Bank of Canada’s estimated benefit from the new rules was at the higher end, at 70 to 80 bps.

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After a 17-year court battle, an Ontario judge has ruled in favour of retail investors who suffered losses as two Canadian companies had let big investors make profitable, improper trades in a number of their funds.

Ontario Superior Court Justice Markus Koehnen in February found that both CI Mutual Funds Inc. and AIC Limited, which is now known as AIC Global Holdings Inc., breached their duty of care to prevent market-timing trades in their funds. While the court found both companies did not breach their fiduciary duties, they did act negligently, and the court directed a separate trial to determine damages.

Also known as frequent trading or short-term trading, market timing is a practice where certain sophisticated investors are allowed to move in and out of their funds very quickly. The practice dilutes the returns available to long-term unit holders

The class action includes any investors who held money in AIC funds from Jan. 1, 1999, to Sept. 30, 2003, or CI Mutual funds from Sept. 1, 1998, to Sept. 30, 2003. Counsel for the plaintiffs estimate damages to investors could total as much as $674-million.

“There was ample evidence before me to demonstrate that the standard of care during the class period required the defendants to be aware of the dangers of frequent trading in and out of their funds and take reasonable steps to prevent it,” Justice Koehnen said in the court decision. “The harm that frequent trading causes to long-term unitholders has been known for decades.”

AIC Global Holdings did not respond to requests made by The Globe and Mail. CI Investments spokesperson Murray Oxby said in an e-mail that “this decision is lengthy and deals with many issues. CI is considering the reasons and its legal position.”

The mutual-fund market-timing scandal first exploded into view in 2003 in the United States when then-New York attorney-general Eliot Spitzer announced a settlement with Canary Capital, a small fund company. The Securities and Exchange Commission, the primary regulator of the U.S. fund industry, and various state officials then jumped in.

Ultimately, industry participants – the fund companies and the traders who benefitted – executed settlements amounting to US$4.25-billion in penalties and returned profits, according to academic Jerry W. Markham in a 2006 article in the Hastings Business Law Journal.

At the same time, the Ontario Securities Commission launched its own investigation into similar practices in the province, resulting in five Canadian asset managers – including both defendants – entering into settlement agreements with the provincial regulator. The five companies, which also included IG Investment Management Ltd., Franklin Templeton Investments Corp. and AGF Funds Inc., paid over $200-million to their respective fundholders, according to recent court documents. Mr. Oxby confirmed that CI paid $49.3-million to investors as part of that settlement in 2004.

In 2006, investors launched a class-action lawsuit against all five companies that settled with the OSC, with retail clients alleging that this frequent trading diluted the returns of long-term investors in the funds.

Three of the companies have since settled with plaintiffs, leaving AIC Limited and CI Mutual Funds Inc., now known as CI Investments Inc., to go to trial.

The case took over six years to certify as a class action, including an appeal with the Supreme Court of Canada. The trial was eventually held over the course of three months in 2022, with a decision ruled last month.

“For retail investors this is an important day for accountability, for behavior modification and to really send a signal to the wider investment industry that there will be consequences for conduct that does not meet the appropriate standard of care and where steps are not taken to appropriately protect unit holders,” said Joel Rochon, co- lead counsel for the plaintiff and managing partner at Rochon Genova LLP, in an interview.

Justice Koehnen said in his decision that mutual fund prospectuses – documents that are provided to investors upon purchasing a fund – warned that frequent trading caused harm to funds and could result in fees of up to 2 per cent being charged to participants.

Despite the contents of their prospectuses, the defendants not only failed to take steps to prevent frequent trading or charge the fees set out in their prospectuses when it occurred, they facilitated the practice by entering into “switch agreements” that allowed certain investors to switch in and out of funds for a much lesser fee of only 0.2 per cent.

The court found companies permitted sophisticated investors to execute large volume, short-term trades in their funds, amounting to hundreds of millions of dollars per month, and billions of dollars per year in funds “switched in” and out.

“The 2-per-cent fee would have stopped switching or frequent trading immediately,” Justice Koehnen said.

A hearing date for damages has not yet been determined.

S&P Dow Jones Indices said late Friday that it’s making minor changes to the S&P/TSX Composite Index, the broadest measure of the Canadian market.

The index provider said it will add International Petroleum Corp. IPCO-T +1.55%increase and Lundin Gold Inc., LUG-T +1.95%increase while it will drop Artis REIT AX-UN-T +0.81%increase cannabis seller Cronos Group Inc. CRON-T +1.41%increase and finance company ECN Capital Corp. ECN-T +4.78%increase. No changes are being made to the S&P/TSX 60, a selection of most of the largest companies in the composite.

The changes will be effective at the open of markets on March 20.

With the growth of index funds and other passive investing strategies, whether a stock is part of a major index can have a meaningful effect on share prices. Fund managers who track an index need to hold shares in the companies. Canadian stocks added to the composite – which has about 230 to 250 members, depending on the quarter – can see a price bump before and even after inclusion. Similarly, companies removed from the index lose a source of demand for their shares.

Research by Morningstar Direct for The Globe and Mail found Canadian mutual funds and exchange-traded funds with assets under management amounting to $252-billion had returns that were 95 per cent or more correlated with the S&P/TSX Composite over the 12 months ended Dec. 31. This included funds that explicitly say they track the index.

S&P Dow Jones Indices uses “float” – the value of shares that aren’t held by insiders and therefore trade frequently and are easily available to the public – to judge whether a company should be included in its indexes. The index provider does not release its proprietary float calculations.

To get into the composite, a company’s float-adjusted market capitalization must be 0.04 per cent, or four-hundredths of a percentage point, of the total value of the index. Also, companies must be listed on the TSX for at least six full calendar months as of the month-end prior to the quarterly review, so recent initial public offerings will have to wait a bit longer to be considered for inclusion.

To stay in the composite, a company’s float must not drop below 0.025 per cent, or 2.5 hundredths of a percentage point, of the total value of index.

Monday March 6

China trade surplus and foreign reserves

Euro zone retail sales

(10 a.m. ET) U.S. factory orders for January. The Street is forecasting a month-over-month drop of 1.8 per cent.

Earnings include: Cargojet Inc.; Element Fleet Management Corp.; Wajax Corp.

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Tuesday March 7

Germany factory orders

(10 a.m. ET) U.S. wholesale inventories for January.

(10 a.m. ET) U.S. Fed Chair Jerome Powell testifies to the Senate Banking Committee.

(3 p.m. ET) U.S. consumer credit for January.

Also: Manitoba budget

Earnings include: Ag Growth International Inc.; Ero Copper Corp.; InterRent REIT; Labrador Iron Ore Royalty Corp.; Pet Valu Holdings Ltd.

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Wednesday March 8

China aggregate yuan, financing, new yuan loans and money supply

Japan current account deficit and bank lending

Euro zone real GDP

Germany retail sales and industrial production

(8:15 a.m. ET) U.S. ADP National Employment Report for February. Consensus is an increase of 200,000 jobs from January.

(8:30 a.m. ET) Canada’s merchandise trade balance for January.

(8:30 a.m. ET) U.S. goods and services trade deficit for January.

(10 a.m. ET) Bank of Canada policy announcement

(10 a.m. ET) U.S. Job Openings and Labor Turnover Survey for January.

(10 a.m. ET) U.S. Fed Chair Jerome Powell testifies to the House Financial Services Committee.

(2 p.m. ET) U.S. Beige Book is released.

Earnings include: Granite REIT; Linamar Corp.; Nuvei Corp.; NuVista Energy Ltd.; Parex Resources Inc.; Peyto Exploration & Development Corp.; Spin Master Corp.; Stella-Jones Inc.; Transcontinental Inc.; Vermilion Energy Inc.; WSP Global Inc.

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Thursday March 9

China CPI and PPI

Japan GDP and machine tool orders

Bank of Japan monetary policy meeting (through Friday)

(8:30 a.m. ET) U.S. initial jobless claims for week of March 4. Estimate is 195,000, up 5,000 from the previous week.

(12 p.m. ET) U.S. flow of funds for Q4.

(1:30 p.m. ET) Bank of Canada Senior Deputy Governor Carolyn Rogers presents the Economic Progress Report to Manitoba Chambers in Winnipeg.

Earnings include: Docebo Inc.; Endeavour Mining Corp.; Enghouse Systems Ltd.; Maple Leaf Foods Inc.; Northwest Healthcare Properties REIT; Paramount Resources Ltd.; Spartan Delta Corp.; Wheaton Precious Metals Corp.

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Friday March 10

Japan household spending

Germany CPI

(8:30 a.m. ET) Canadian employment for February. The Street expects an addition of 2,500 jobs from January with the unemployment rate at 5.1 per cent. The January report showed surprising job gains of 150,000 from December. Average hourly wage are expected to be up 5 per cent from a year ago.

(8:30 a.m. ET) Canada’s capacity utilization for Q4.

(8:30 a.m. ET) U.S. nonfarm payrolls for February. The consensus is the addition of 220,000 jobs with the unemployment rate remaining 3.4 per cent.

(2 p.m. ET) U.S. budget balance for February.

Earnings include: Energy Fuels Inc.

• Amid a gradually growing rift between longtime close allies Saudi Arabia and the UAE, the latter is now debating withdrawing from OPEC, the Wall Street Journal reported, citing unnamed Emirati officials.
• This would have a significant impact on the oil producer group’s global clout, as well as allow the UAE to pursue its own oil production plans that suit its interests.

https://www.cnbc.com/2023/03/03/oil-prices-volatile-on-report-uae-is-considering-leaving-opec.html

The Toronto-Dominion Bank (TD) on Thursday reported fiscal first-quarter net income of $1.17 billion.

The company said it had earnings of 61 cents per share. Earnings, adjusted for non-recurring costs, were $1.64 per share.

The results topped Wall Street expectations. The average estimate of three analysts surveyed by Zacks Investment Research was for earnings of $1.61 per share.

The retail and wholesale bank posted revenue of $16.61 billion in the period. Its revenue net of interest expense was $9.01 billion, also exceeding Street forecasts.

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This story was generated by Automated Insights (http://automatedinsights.com/ap) using data from Zacks Investment Research. Access a Zacks stock report on TD at https://www.zacks.com/ap/TD

Canadian Natural Resources Ltd. (CNQ) on Thursday reported fourth-quarter earnings of $1.12 billion.

On a per-share basis, the Calgary Alberta Canada, Alberta-based company said it had net income of $1. Earnings, adjusted for non-recurring costs, came to $1.44 per share.

The results did not meet Wall Street expectations. The average estimate of five analysts surveyed by Zacks Investment Research was for earnings of $1.61 per share.

The oil and natural gas company posted revenue of $8.11 billion in the period. Its adjusted revenue was $7.14 billion, exceeding Street forecasts. Three analysts surveyed by Zacks expected $7.04 billion.

For the year, the company reported profit of $8.41 billion, or $7.32 per share. Revenue was reported as $32.54 billion.

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This story was generated by Automated Insights (http://automatedinsights.com/ap) using data from Zacks Investment Research. Access a Zacks stock report on CNQ at https://www.zacks.com/ap/CNQ