Have Canadian banks 'cleaned up' enough this quarter?

Broadly weak Q4 earnings from the big six point to trend and potential for some upside next year, says sector expert

Have Canadian banks 'cleaned up' enough this quarter?

Canadian banks reported their Q4 earnings last week, with broadly poor results. Commentaries highlighted a difficult operating environment and while each of the big six raised their dividends, they also reported significant restructuring charges, asset write downs, and credit losses . TD, BMO, National Bank, and Scotiabank all missed earnings expectations. CIBC and RBC beat expectations, but with more money set aside for loan losses than predicted.

At the start of Q4 Rob Wessel, Managing Partner at Hamilton ETFs, predicted this could be a ‘clean-up quarter’ for the banks. A former bank analyst and now the leader of the second-largest Canadian bank ETF manager by AUM, Wessel looked at banking history to show that at the end of a difficult year, banks will often pull forward expenses, accelerating loan loss reserves, writing down or selling assets, and booking restructuring charges to improve forward earnings. 

In Q4 earnings reports and layoffs announced by Scotiabank and TD, as well as RBC earlier in the quarter, Wessel sees an almost textbook example of a clean up quarter and, in that, the potential for better performance next year.

“The key question going forward is did [the banks] set the table or set the stage for an improved 2024?.” Wessel says, “And I think the restructuring charges and large reserve builds, in particular look like a clean-up. Because the sector is so cheap, and the valuations are so low, it's hard to believe that you're not set up for a much better 2024.”

Despite CIBC and RBC coming in over expectation, with the other four big banks missing, Wessel thinks the narrative of a cleanup holds broadly true across these banks. He notes that Scotia and TD have made more efforts to clean up than other banks, highlighting TD’s announcement of another restructuring charge in the first half of next year. However, each of the banks has made some effort to scrub their books of expenses, account for potential future losses, and prepare themselves for a new start in the new year.

Restructuring charges have helped ameliorate what was one of the rising risk factors for banks this year: inflation induced expense growth. Wessel describes the rising costs banks faced over the past few quarters as “ominous,” given their speed and capacity to consume operating leverage. By making such significant cuts, however, many of the banks have brought those risks more in line.

Wessel explains that in their loan loss accounting is very forward looking, bank profitability can decouple from the broader economy, meaning bank profitability can recover before the economy.. Because of now-negative economic growth and worsening overall conditions, the banks are accounting for something close to a worst-case scenario. That means, however, that if their macro assumptions prove to be somewhat better than expected, there should be better overall performance even if the economy continues to struggle or even slides into a recession.

Wessel says it appears like the banks are reserved for a “very challenging economic environment in the coming year”. He believes that with the clean-up efforts they’ve made in Q4 should reduce this risk. 

Looking ahead, Wessel sees an emerging concern for Canadian bank investors coming from increased regulatory risk, including higher minimum capital levels, regulatory charges for anti-money laundering, and taxation.. There are signs, Wessel says, that regulatory risk is creeping higher. 

We still don’t know for certain if the banks have fully cleared their books, but Wessel says that looks to be the case, or in the very least many of these banks have put their problems behind them. Given that outlook, he thinks advisors can look more favourably on Canadian financials in the future and demonstrate to their clients that bad results in Q4 may mean better results next year.

“The banks are priced for a lot of bad news, so if the news is not as bad as what’s priced in, that would be quite positive,” Wessel says. “There is history to suggest that would be the case. The banks are currently down over a rolling two-year period, and it’s very unusual for the banks to be there. When that has happened in the past, the vast majority of the time, returns were positive over the following twelve months.

“We would say: at these low valuations, history is on your side.”