Some Canadian banks could be forced to preserve capital by raising equity or even cutting dividends if oil prices continue to slump, Moody’s warns in a new report.
In a “severe stress” scenario modelled by the ratings agency, and included in the report to be widely circulated Monday, losses in consumer lending portfolios would exceed historic peaks and capital markets activity at the country’s biggest banks would be significantly crimped.
“Under the moderate stress scenario we modeled, the profitability of Canadian banks will decline but their capital would not be impaired,” David Beattie, a senior vice-president at Moody’s, wrote in the report.
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“In our severe stress scenario, however,” he warned, “some of the banks’ CET1 (capital) ratios could fall under 9.5 per cent, in which case we believe they might be required to take capital conservation measures, cut dividends, or raise additional equity.”
In an interview, Beattie characterized the likelihood of the severe stress case as “very remote” and said dividend cuts would be avoided by the big banks “except under extreme duress.”
Still, with oil prices slumping to levels not seen in more than a decade, the ratings agency expects banks will have to absorb the pain of oil producers, drillers, and service companies, as well as consumers in oil-producing provinces.
In the severe stress test scenario outlined by Moody’s, losses in the big banks’ consumer portfolios would rise above the historical peak, and there would be a 20 per cent decline in capital markets’ net income, driving losses to 1.5 times quarterly net income.
In this scenario, unless the banks reduce the payout ratio — the percentage of earnings paid out to shareholders as dividends — or issued shares, “it would take multiple quarters to absorb stress losses through retained earnings,” Beattie wrote.
Among Canada’s biggest banks, Canadian Imperial Bank of Commerce and Bank of Nova Scotia emerge as the “negative outliers” in the Moody’s stress testing.
CIBC’s rank reflects the fact that the bank’s operations are primarily in Canada. The country’s fifth-largest bank also has “considerable oil and gas concentration in its corporate loan book, and a material portion of its earnings comes from capital markets activities,” Beattie wrote.
Scotiabank would face higher stress losses from its corporate loan book and the segment mix of its corporate loans.
In the severe stress scenario, both CIBC and Scotiabank would lose about 100 basis points from CET1, a key measure used to gauge a bank’s capital cushion.
However, Beattie said that doesn’t mean those banks would be the first to have to tap the market for funds through an equity issue, or to reduce dividends.
“Each of the banks is coming from a different starting point in terms of capital,” he said, adding that all Canada’s big banks hold capital well above the regulatory minimum. What’s more, any of the banks could invoke capital conservation measures quickly and pre-emptively if the probability of a severe stress situation were to begin to rise, he said.
Toronto-Dominion Bank is a “positive outlier” in the Moody’s analysis, losing just 53 basis points of CET1 in the severe stress scenario. Beattie said Canada’s second-largest bank by market capitalization has a relatively small oil and gas corporate loan book, despite that book growing considerably over the past year.
TD also has a comparatively low concentration of retail operations in oil-producing provinces, and low reliance on earnings from capital markets, he wrote.
The impact on capital markets activity is difficult to predict, Beattie said, adding that underwriting earnings will be hurt by reduced equity issues in the energy sector, but that could be at least partly offset by mergers and acquisitions activity that tends to take place during a downturn.