May 25, 2023
What are loan loss provisions and why is it a theme this bank earnings season?
Canadian banks are in a position of strength: Former bank regulator
Canada's leading banks are taking precautions around their credit divisions should consumers fail to pay back their loans.
Five of the leading six Canadian banks who have reported second-quarter earnings have revealed a significant jump in loan loss provisions compared to this time last year. This uptick reveals that Canadian banks see a heightened possibility of loan defaults as Canadians battle with increased expenses ahead of a possible recession, one expert explained.
“This week we’re looking at approximately $3 billion set aside from five Canadian banks and that’s a significant change from last year,” Andrew Pyle, senior investment advisor and portfolio manager at CIBC Wood Gundy, told BNN Bloomberg in an interview on Wednesday.
Pyle explained that Canada’s economic climate has changed drastically in the past 12 months with increased interest rates and a surge in inflation. In these conditions, Canadian banks see a real possibility of businesses and consumers possibly failing to make payments on their loans, he added.
“When it appears that borrowers might not be able to maintain their loans, banks make a forecastable risk by putting aside a certain amount of their earnings should they need that capital to address short falls in lending, this is known as loan loss provisions,” he said.
Here's a look at how much banks have set aside for loan loss provisions:
- TD Bank’s credit loss provision totalled $599 million, an increase from $27 million annually.
- BMO set aside $1.02 billion for credit losses, up from $50 million annually.
- Scotiabank allocated $709 million to provisions for credit losses this quarter, up from $219 million the same time last year.
- CIBC set aside $438 million, an increase from $303 million a year earlier.
- RBC reported $600 million in loan loss provisions compared with a recovery of $342 million a year earlier.
One reason these banks, with the exception of CIBC, posted weaker than expected earnings was due to money being funneled into loan loss provisions, Pyle said.
“Think of loan loss provisions as insurance against bad loans,” he added.
The large amount of money that is being set aside in the event of loan defaults is a testament to the Canadian banking sector’s strong risk management strategy, one portfolio manager told BNN Bloomberg in an interview on Wednesday.
“If something goes wrong, they have the capital to deal with that stuff,” Paul Harris, partner and portfolio manager at Harris Douglas Asset Management, said.
He added that this caution could pay off handsomely to investors in the future, should this capital not be used.
“Don’t forget if everything works out – reserves go into earnings,” he said.
Investors looking to buy banking stocks might want to hold off until the banks reach the bottom of their credit cycle, another expert advised.
“We’ve seen reserves go up, we think they’re going to continue to go up and we think that the time to pounce is going to be when the market is worried that it’s going to take that much more in reserves,” Mike Vinokur, portfolio manager at Aligned Capital Partners, said.
He believes that we are currently in the middle of the credit cycle and foresees late summer as the time when credit loan loss provisions might peak.
“That’s going to be the opportunity,” he said.