Analysis-Canadian banks’ outsized reliance on mortgages could slow margin recovery

By Nichola Saminather

TORONTO (Reuters) – Canadian banks may struggle to see an immediate boost to their net interest margins next year even as interest rates tick up due to their outsized reliance on mortgages, particularly if growth in that more profitable business and credit card lending is hindered by supply bottlenecks and surging inflation.

With interest rates near record lows, the average net interest margin (NIM) at the six major lenders’ Canadian banking units fell 10 basis points to 2.34% from a year earlier, with executives attributing the declines largely to loan books dominated by mortgages.

Despite their lower returns, mortgages now account for about 67% of domestic loans, from 64.5% two years ago. The six top banks, which reported their fourth-quarter results last week, posted mortgage growth of 11% in Canada in the period from a year ago, with the pace accelerating in each of the past several quarters. Lending outside of home loans increased 5.9% in the past quarter, which, while improving, still lags the pace of growth before the onset of the coronavirus pandemic.

With money markets expecting the Bank of Canada to hike interest rates five times next year, net interest margins should rise at a pace similar to that of past cycles.

But “an interest rate increase would take a little bit more time to work through the banks’ margins, given the composition” of loans, said Rob Colangelo, vice president and senior credit officer at Moody’s Investors Service.

Banks and investors have been lamenting the pressure on NIMs resulting from the central bank’s pandemic-related rate cuts, which have narrowed the gap between what they paid out in deposits and the interest they earned on loans. That has weighed on interest income, making the banks more reliant on fee income to drive profits.

Cost pressures

Banks are likely to face further cost pressures from higher expenses, driven by surging inflation and planned business investments.

“It’s a significant challenge, and highlights the importance of revenue growth,” said James Shanahan, an analyst at Edward Jones. “They have to generate some loan growth and margin expansion or they’re going to have a difficult time outgrowing their operating expense growth.”

Banks including Royal Bank of Canada and Canadian Imperial Bank of Commerce expect NIMs to stabilize over the next few quarters and rise alongside interest rates. CIBC also hopes to get an additional boost from its acquisition of the Canadian Costco credit card portfolio, which is expected to close early next year.

The recent jump in variable-rate mortgages, which reprice higher when the central bank lifts interest rates, could mitigate some of the weight of home loans in banks’ portfolios, Colangelo said.

But while variable-rate loans accounted for more than 54% of new mortgages in September, they made up only a quarter of all outstanding home loans, according to Bank of Canada data, so the benefits are likely to be limited.

If the central bank were to raise its key interest rate by 100 basis points next year, BMO executives said the bank’s net interest income would increase by C$384 million in fiscal 2022. They added that the figure could double if BMO retains its current deposit levels, and forecast that margins will stabilize, and rise, if rates trend higher.

Mike Clare, portfolio manager at Brompton Group, is hopeful of a margin recovery as interest rates rise, but warned the additional complications from the pandemic could delay a recovery in business lending.

“The biggest uncertainty is around the new variant and what that may do to business activity,” he said, referring to the emergence of the Omicron COVID-19 variant. “We could potentially have an environment where growth isn’t as high as expected but inflation remains elevated.”

(Reporting By Nichola Saminather; Editing by Denny Thomas and Paul Simao)