Frontline Perspectives: How Resilient Are Canadian Medium-Size Banks?

As part of its takeaway series, DBRS Morningstar is publishing several write-ups about pertinent topics discussed during its Frontline Perspectives webinar series. In the session titled, “How Resilient Are Canadian Medium-Size Banks?” Shokhrukh Temurov, Vice President, North American Financial Institutions at DBRS Morningstar, discussed the credit characteristics of medium-size banks (MSBs), including their credit profile, market risks, and liquidity and funding, as well as factors supporting the resiliency of these banks in the current environment.

Although significantly smaller than Canada's so-called “Big Six” banks, Temurov said small and medium-size banks provide a viable alternative for Canadian consumers and businesses in the specific regions and products where these banks have expertise. DBRS Morningstar estimates small and medium-size banks held under $650 billion in assets as of December 31, 2022, or slightly above 7% of total bank assets in Canada, while the remainder (approximately 93%) was held by the Big Six banks: Bank of Nova Scotia, Royal Bank of Canada, TD Bank, Bank of Nova Scotia, National Bank, and Canadian Imperial Bank of Commerce.

Temurov said the MSBs offer more specialized banking services than the Big Six. While retail loans—mostly residential mortgages—make up more than 90% of loans at Home Capital and Manulife Bank, Canadian Western Bank (CWB) is predominantly a commercial middle market lender, with commercial loans comprising 81% of its book. Further, Laurentian Bank and ATB Financial have more diversified loan portfolios, evenly split between retail and commercial, while Equitable Bank is more exposed to residential mortgages compared with commercial lending.

Temurov also noted the MSBs are less geographically diversified than the Big Six, both in Canada and internationally, despite the efforts CWB and Laurentian have made in recent years to expand beyond their traditional markets through acquisitions and organic growth. Equitable, Home Capital, and Manulife remain heavily concentrated in Ontario, because of their focus on residential mortgages and the outsized growth in housing prices in the province. ATB exclusively operates within the Province of Alberta.

Most MSBs generate consistent profitability and stable net interest margins (NIMs), Temurov said, although the cost of funding is higher and revenue sources are less diversified from interest-sensitive assets compared with the Big Six. He added that MSBs generally have higher yields on their assets because of their focus on commercial middle market lending and Alt-A mortgages, while the higher share of broker-sourced deposits increases their overall cost of funding.

Over the past five years, the NIM and return on average equity at these banks averaged 2.0% and 10.5%, respectively, compared with 1.6% and 14.3% among the Big Six.

“As with the Big Six, MSBs are likely to benefit from rising interest rates. In the baseline scenario, DBRS Morningstar expects good levels of recurring earnings at MSBs to be sufficient as the first line of defense in absorbing increasing provisions for credit losses given the current economic environment,” Temurov said.

Despite the relative geographic and product concentration of the loan portfolios, Temurov said asset quality at the MSBs is generally very sound.

“However, given the current economic environment we are cautious that MSBs would likely be exposed to higher credit costs compared with the Big Six because they are less diversified and have exposures to riskier asset classes,” he said.

Notably, most of the MSBs boast significant on-balance sheet exposure to commercial real estate, including construction and real estate project loans, compared with large Canadian banks. “We view commercial mortgages among the most sensitive asset classes to credit cycles,” Temurov added.

Turning to liquidity, he estimates retail and commercial deposits, including broker-sourced deposits, formed most of the funding at MSBs, ranging from 22% to 58% of their total funding base. While the proportion varies by bank, broker-sourced deposits made up a material portion of most MSBs' deposits.

“In DBRS Morningstar’s view, broker-sourced deposits tend to be more sensitive to rates and bank-specific events and, despite being term deposits, are less favourable compared with branch-raised deposits,” Temurov said. “DBRS Morningstar views positively that most MSBs are actively seeking to diversify their funding by increasing directly sourced deposits, wholesale funding, and the use of securitizations.”

While capital ratios vary by bank, MSBs maintain sufficient capital cushions above regulatory limits, providing an additional buffer to protect these banks from losses in a stressed environment.

“Except for ATB, regulated by ASFI, the MSBs are OSFI-regulated entities and they follow the Standardized Approach to calculate CET1 ratios. CWB, Equitable, and Laurentian are considering a transition to the advanced internal ratings-based approach for capital and risk management in the coming years. As a result, DBRS Morningstar expects these banks' capital ratios will improve from more accurate reflections of the credit risks of their loan portfolios because of the lower risk weighting,” he said.

Writing by Scott Anderson

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