(Bloomberg) -- Canada’s banks are expected to post the biggest profit decline in more than two years as they’re buffeted by rising taxes, higher regulatory capital requirements and the threat of a recession. 

Net income for the country’s six largest banks is expected to fall 15% in the fiscal first quarter, according to data compiled by Bloomberg. That would be the largest drop since the third quarter of 2020. Canadian Imperial Bank of Commerce kicks off the reports Friday. 

Driving the drop is a need to hold more capital — rather than deploy it into interest-earning loans — to absorb the defaults that may result from a downturn in Canada’s economy and meet their regulator’s 50-basis-point increase in required Common Equity Tier 1 capital ratios. On top of that, the banks will be paying higher taxes as measures Prime Minister Justin Trudeau campaigned on before his most recent election take effect.

“Regulatory capital is arguably the most important theme for the sector today,” Paul Holden, an analyst at CIBC, said in a note to clients. “Banks are managing to a 12% CET1 ratio by end of year,” which will damp loan and earnings-per-share growth as well as return on equity. 

The banks are expected to have set aside C$2.48 billion ($1.83 billion) in provisions for credit losses in the three months through January, the highest total since the fourth quarter of 2020, when concerns that the Covid crisis would lead to a wave of defaults still lingered. 

On the positive side, a rebound in equity markets that started late last year, as well as rising expectations for a soft landing in the economy, may bolster the bank’s fee-generating wealth-management and capital-markets divisions, according to analysts.

What Bloomberg Intelligence Says:

“Canadian banks’ median fiscal 1Q EPS may fall 8%, based on consensus, as increased rates drive 4% revenue growth, albeit offset by higher loan-loss provisions. Rates and reserve-build timing may produce more variable results. Economic risks could hurt capital-markets revenue and asset trends may offer some wealth stability. Commercial-loan growth has continued, as mortgage activity slowed.”

— Paul Gulberg, BI senior industry analyst, and Ethan L. Kaye, BI senior associate analyst

The banks also are benefiting from higher interest rates that are making lending more profitable and a Canadian economy that has yet to soften much.

“Amidst steady loan growth, Bank of Canada rate hikes should bode well for margin expansion,” Barclays Plc analyst John Aiken said in a note. “Despite the slowdown in Canada’s housing market, for now, overall loan growth continues to hold steady.”

Still, the question remains whether those pockets of strength will be enough to maintain a rally that has seen Canadian bank stocks outperform the broader market this year. The S&P/TSX Commercial Banks Index has climbed 7% in 2023, compared with a 4.2% gain for the S&P/TSX Composite Index.

The bank stocks have been “hot out of the gate — too hot, in our view,” Gabriel Dechaine, an analyst at National Bank of Canada, said in a note. Even with that strong performance, the Big Six banks are trading at roughly 10 times estimated earnings, a slight discount to historical averages. 

“Despite the shifting landscape, we maintain a defensive stance,” Dechaine wrote. “We will revisit our position if/when valuation levels reflect even more downside risk than they already do, and we are more confident in the direction of the credit cycle.”

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