After record breaking profits over the past few years, Canada’s big banks are facing an increasingly uncertain and stressful lending environment. Interest rate increases by Canada’s central bank in 2017 and 2018 allowed Canada’s banks to charge more on their loans, leading to a wave of higher revenues. Combine that with lower interest rates paid on deposits that customers make, means a higher net interest margin, which the difference between the rate the bank borrows at, or pays you, and the rate they charge to those who borrow from the bank. A higher net interest margin means more profit for banks, a lower net interest rate margin means lower profits. Since banks earn most of their profits from lending, they want to keep their interest rate margin as high as they can, but that’s easier said than done.
The rate that banks lend at is determined by the Bank of Canada, when the Bank of Canada lowers its rate, banks follow. In 2017 and 2018 the Bank of Canada raised rates, but a dismal outlook for the Canadian economy has led to the Bank of Canada to stop increasing interest rates, which is worrisome for Canada’s banks. If the Bank of Canada doesn’t increase rates, Canadian banks can’t increase their net interest margins, add to that slower growth in lending, means lower profits than the years before.
Since the big banks can’t increase interest rates, theoretically, they could increase their net interest margin by lowering the rate they pay to customers on deposits. While that is an option, competitiveness between banks and other lenders makes it tougher to do.
It seems simple, but there are a lot more factors at play. Canadian banks aren’t only affected by what the Bank of Canada does, but also their counterparts down south, the U.S. Federal Reserve. The U.S. Federal Reserve cut rates for the first time since 2008 to support the U.S. economy. The rate cut in the U.S. has a detrimental impact on Canadian banks’ lending activities in the U.S. As described above, when the net interest margin shrinks, due to a reduction in interest rates, their profits are reduced as well. The interest rate cut doesn’t affect their interest rate margin or earnings generated in Canada but it does reduce their profits generated in the U.S. through a reduction in the net interest margin.
While there is a changing landscape for Canadian banks, they are much stronger than they were before the 2008 financial crisis. Like they say, what goes up, must come down. Interest rates were rising for so long which allowed banks to ride the wave bouncing between the islands of increasing profits, but as always that had to end.