Banks stand to gain from hike
Bank of Canada expected to start raising interest rates
It wasn’t that long ago that the market was pricing in an interest rate cut from the Bank of Canada, leaving some to forget that rates can actually go up. But they can, and they will, at least if the market is right about Wednesday’s policy announcement.
Futures are indicating a more than 90 per cent chance of a 25 basis point (bps) increase, which would bring the overnight rate to 0.75 per cent and mark the first hike in seven years. The market is also pricing in a more than 70 per cent probability of a second rate hike by the end of 2017.
While even a small rate bump sends a positive message about the health of the Canadian economy and earnings prospects in general, investors also want to know what it means for their much-loved and widely-held bank stocks.
No, we’re not talking about the over-hyped fear of a correction in the housing market, which would undoubtedly hurt the big Canadian banks. Rather, there is good reason to consider how a rate hike will provide some much-needed relief for the group’s net interest income — a crucial driver of earnings.
Robert Sedran at CIBC World Markets reminds us that the previous two decreases in the overnight rate were met with only a partial decline in the bank prime rate. While it’s possible that some banks will opt for only a partial move in prime, the analyst admits it’s difficult to make a call on what exactly they’ll do.
In response to an anticipated pickup in rate hikes by the Federal Reserve, earlier this year Canada’s Big Six banks provided an update on their interest rate sensitivities.
Bank of Montreal, for example, indicated that a 100 bps move higher in the yield curve would add approximately $200 million in earnings, three-quarters of that coming from its U.S. operations.
These figures may have changed in the six months since, and Sedran believes disclosures such as this are somewhat meaningless, partly because they are required to provide them by accounting rules. But the analyst does have a better way to measure rate sensitivity: Look at retail deposits as a percentage of total deposits and total assets.
“Much of the margin pressure of recent years has come from here since these comparatively low-cost deposits have become less valuable as all money carried a low cost,” he said in a report.
Toronto-Dominion Bank tops the list when retail deposits are compared to total deposits at 57 per cent in fiscal 2016, as well as when they are lined up against total assets at 37 per cent.
When it comes to retail deposits as a percentage of total deposits CIBC ranks second at 42 per cent, followed by National Bank of Canada at 36 per cent, BMO at 34 per cent, and then both Royal Bank of Canada and Scotiabank at 33 per cent.
As for retail deposits as a percentage of total assets, behind TD is CIBC at 30 per cent, BMO at 24 per cent, Scotiabank at 22 per cent, and National Bank and RBC at 21 per cent.
Sedran also considered where banks get their revenues, since more net interest income (NII) means more exposure to lending and borrowing.
TD tops the list again, with 59 per cent of total revenue coming from lending NII, followed by Scotiabank, CIBC, BMO, RBC and National Bank.
And since the Canadian banks with significant exposure to the U.S. generate nearly half of their rate sensitivity from climbing rates south of the border, Sedran also thinks it’s worthwhile to look at those exposures.
National Bank, for example, saw lending NII in Canada contribute 40 per cent of its total revenue in fiscal 2016, and CIBC was even higher at 48 per cent. However, neither had any contribution from the U.S., while BMO had a 20 per cent contribution and TD was at 22 per cent.
All things considered, Sedran expects a five bps increase in Canadian personal and commercial banking net interest margins will boost earnings for the Big Six banks by an average of two per cent.