Morningstar DBRS' Takeaways From Bloomberg Intelligence's "Canada in Transition" Event: Big Six Banks Remain Well Positioned as Headwinds From Macroeconomic and Trade Uncertainty Remain Elevated
Banking OrganizationsAs part of its Takeaways series, Morningstar DBRS is publishing write-ups about "Canada in Transition: Bank Resilience, TSX Strategy, Policy Shifts," a Bloomberg Intelligence event looking at Canada's financial institutions and key economic policies at both the federal and provincial levels to provide a comprehensive outlook for H2 2025.
In the session "Canadian Banks & Financial Stability," Carl De Souza, Senior Vice President and Sector Lead, North American Financial Institution Ratings at Morningstar DBRS, answered a range of questions from Himanshu Bakshi, Senior Credit Research Analyst at Bloomberg Intelligence, on how Canada's large banks are navigating a pivotal moment as profit growth slows and global uncertainty tests the sector's resilience.
Q: We've just come through a mixed Q2 2025 earnings season: revenue declined quarter over quarter (QOQ) for most banks, pre-tax pre-provision earnings were down, performing provisions continued to rise, and net income declined across the board, except for National Bank of Canada, on an adjusted basis. How stable or fragile is the outlook for Canadian banks over the next six to 12 months, especially given softening asset quality, and elevated macro risks driven by tariff uncertainty?
A: "The risks are skewed to the downside and, although things are changing slightly with Canada now at the lower end of the effective tariff rate, there's still a great deal of uncertainty," De Souza said.
Net interest margins will likely stabilize or be up modestly, but interest rate and monetary policy is very uncertain because of the competing factors of inflation versus growth. "When we look at loan growth, Q1 was good but Q2 started to show some cracks," he said. Indeed, aggregate loan growth in Q2 contracted 1% QOQ when excluding the loans that the National Bank of Canada acquired from Canadian Western Bank. "That's big, when you see loan growth contracting QOQ," De Souza said. "But that wasn't a big surprise as business investment has halted in Canada and slowed in the U.S., while consumer spending remains resilient but moderating." Although the banks were fairly optimistic in their Q2 earnings calls with respect to loan growth potential in H2 2025, loan growth remains uncertain and depends on what plays out between Prime Minister Carney and President Trump and the evolving trade uncertainties, along with geopolitical risks.
Non-interest income benefitted greatly from trading volatility in Q1 and Q2, but Q2 came down from the excessive trading volatility highs in Q1, which affected QOQ results. Provisions for credit losses (PCLs) on performing loans really ramped up in Q2, De Souza noted. "The banks have been managing their non-interest expenses very prudently, and that's one way to somewhat manage the uncertainty," he said.
"I would say we can have some optimism based on what's going on right now with effective tariff rates," De Souza said. "But in the end, headwinds are still there, and the risks are to the downside."
Q: If loan growth remains soft and margins plateau, does the earnings cushion against credit losses start to thin?
A: "The earnings cushion to absorb losses may thin if there's pressure on earnings in H2 2025 but the banks have had a really good Q1 and a decent Q2, and this has put them ahead of plan," De Souza said. "The large banks are very resilient with regards to internal capital generation; they also have capital available to absorb losses if necessary and they're all maintaining elevated levels of CET1 capital."
Q: Beyond the usual past-dues, what indicators would you look at for signs of increasing credit stress?
A: Key macroeconomic indicators are important predictors, De Souza noted. Unemployment remains the biggest driver of delinquencies. Certain sectors, like auto and manufacturing, are already under pressure because of tariffs. Other indicators are consumer and business bankruptcy filing trends, along with increasing draws in utilization of credit cards and unsecured lines of credit. "When consumers are really under pressure, they'll draw on their credit cards or lines of credit to make their mortgage payments," he said.
Q: If trade-related risks escalate, are you more concerned about broad macro credit slippage or targeted pain in specific sectors? How are the banks positioned?
A: "I'm concerned about both," De Souza said. "Macroeconomic factors are a big driver." While few people are forecasting a recession that is deep and prolonged, a recession is still possible, depending on how things play out, he noted.
On the other side, targeted tariffs on the steel and auto industries, for example, are important but manageable from the Big Six perspective, De Souza said. These banks performed varying levels of analyses that were discussed at their Q2 earnings calls, showing that direct exposure to sectors subject to tariffs are very manageable, although indirect exposure is much harder to gauge. The Big Six are well diversified across sectors and geographies, so each bank must be reviewed independently to assess its concentration and exposure risks.
Q: We've seen a broad uptick in PCLs across all banks this quarter. Are current reserve levels sufficient, or do you expect a continued ramp-up in the second half of F2025?
A: "The Big Six banks in aggregate increased their PCLs for performing loans to $1.8 billion from just under $500 million," De Souza stated. The banks are building uncertainty into their models along with management overlays to incorporate factors that models don't capture. "If the models are wrong, the Big Six will reverse the PCLs and net income will get a bump in the future," De Souza said. "It's the right and prudent thing to do¿and let's remember that PCLs are not losses but provisions for potential future losses." Impaired loans decreased moderately, but De Souza expects that trend may not continue in H2 2025 with some of the Stage 1 and Stage 2 performing loans taken on in Q2 moving to impaired loans, which will increase PCLs.
Q: CET1 levels look strong on the surface, but with provision trends rising and capital return still elevated, are capital ratios more vulnerable than they appear?
A: Capital ratios are ultimately a buffer against losses, De Souza noted, and capital ratios in Q2 for the Big Six ranged from 13.2% to 14.9%. Above the 4.5% minimum CET1 capital requirement is the 2.5% capital conservation buffer, then the 1% D-SIB surcharge buffer, and the 3.5% domestic stability buffer (DSB), taking the capital threshold to 11.5% from the minimum trigger of 4.5%. "Looking at the stress tests the banks run, their stress scenarios may breach some of those tiers, but don't get close to 4.5%, and breaches of the tiers above 4.5% require mitigating actions," De Souza concluded while indicating that CET1 ratios are sufficient at this time and additional PCL builds would be expected if things change. Additionally, the DSB is currently at 3.5%, near the high end and most conservative point of the DSB range (with 4.0% being the top of the DSB range). The assumption is that the next move for the DSB at some point would be down, which would release capital for the large banks. OSFI also recently indefinitely paused the Basel III phased-in implementation of the output floor with a two-year notice period, effectively eliminating the implementation for the foreseeable future.
Q: Do you agree that indefinitely pausing the Basel III implementation of the output floor was the right decision to maintain competitive balance across jurisdictions? And looking ahead to June 26, do you expect OSFI to keep the DSB at 3.5%, or raise it to front-run further stress?
A: "I do agree with the indefinite pause of the DSB because OSFI was clear that the decision was made for competitive balance reasons," De Souza said. Deregulation is happening in the U.S. and the UK regulator is following the U.S. on Basel III implementation. Canadian banks have global Capital Markets businesses, along with notable operations in the U.S. According to De Souza, OSFI had to react to external forces that could affect the banks' competitive ability and competitive balance.
De Souza expects OSFI to maintain the DSB at 3.5% at its next decision in June. "The DSB operates like a rainy day fund. In good times, you increase it; in bad times, you decrease it," he said. "We're not in good times, but we're not in all-hell-breaks-loose times yet, either." However, lowering the DSB could signal to the market that trouble lies ahead. If OSFI chooses to lower the DSB, it will have to be careful in its messaging and clarify that it is lowering capital requirements to release loan capacity for the Big Six or to maintain competitive balance, so that the market interprets any move in the DSB correctly.
Written by Deirdre Maclean
NOTES:
For more information on this industry, visit https://dbrs.morningstar.com or contact us at info@dbrsmorningstar.com.
DBRS Limited
DBRS Tower, 181 University Avenue, Suite 600
Toronto, ON M5H 3M7 Canada
Tel. +1 416 593-5577