The Big Read

For Canada’s Big Six banks, strong earnings belie challenges ahead

Bank towers are shown from Bay Street in Toronto's Financial District. The Canadian Press/Adrien Veczan
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When CIBC CEO Victor Dodig premonished in January sweeping layoffs at Canada’s fifth-largest bank, some analysts took the announcement as a sign that Canada’s big financial institutions were entering a period of turbulence.

BMO had already announced a 2,300-person layoff; banks in the U.S. and Europe were grappling with their own employee and spending cuts, as well as branch closures and falling share prices. Dodig’s announcement stoked concerns that efforts to rein in spending at Canadian banks would throttle the industry in its next earnings season, which finished this week.

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Talking Point

Canada’s Big Six banks wrapped up a strong quarterly earnings season this week, beating analysts’ expectations nearly across the board. But financial experts warn the strong start to 2020 could obscure the long-term challenges facing Canada’s financial institutions, including a slowing economy, emerging tech rivals and legislative changes ratcheting up pressure on banks to transform.

Instead, nearly all of Canada’s Big Six banks beat analysts’ first-quarter expectations. After 2019 ended as the industry’s worst year for profits since the global financial crisis, 2020 was expected to start off slow. But RBC saw profits grow to $3.5 billion, from $3.2 billion a year earlier; BMO posted a 22 per cent increase in quarterly earnings from its wealth management division; Scotiabank reported a 35 per cent jump in adjusted capital markets earnings; and National Bank saw its adjusted net income increase 12 per cent. TD, the only bank that missed profit estimates, still posted a 24 per cent rise in earnings, and even CIBC, which ultimately announced plans to lay off about 2,200 workers, reported a nine per cent jump in adjusted net income along with an improving efficiency ratio—a key metric for gauging expenses relative to revenues. Each bank reported upticks in their earnings per share. 

But economists caution against taking solace in the positive quarter, warning the strong start to 2020 could obscure the challenges facing Canada’s financial institutions. Emerging fintech rivals and legislative changes are ratcheting up the pressure on banks to transform themselves. 

“A lot of observers expected a recession last year, and that’s what caused bank share prices to drop,” says Michael King, a finance professor at the University of Victoria’s Gustavson School of Business. “We didn’t get a recession; we got a slowdown—but the outlook doesn’t look positive, either. We think slow growth could be the new normal.” 

Obstructing that growth, says King, is a new requisite to spend money on innovation, but with fewer resources to fund it. 

The dynamics are playing out globally. Banks in Europe and the U.S. laid off 30,000 workers in summer 2019, after revenues at 12 of the top institutions in those markets dropped 11 per cent in the first half of that year. Already in 2020, HSBC has announced plans to cut 35,000 jobs globally and US$4.5 billion in spending over the next three years; banks across the U.K have announced mass layoffs and hundreds of branch closures.

“In general, the banks have entered into a challenging growth environment,” says Nigel D’Souza, a financial analyst with Veritas Investment Research. He points to confounding factors like economic uncertainty from global pressures including trade conflicts, Brexit and now COVID-19; perennially low interest rates dwarfing banks’ earnings; and record-high consumer debt levels raising credit risk. “This quarter is one thing; the other is looking at headwinds over the longer period of time.” 

According to King, the current trouble for Canada’s banks goes back to just after the 2008 financial crisis. While the country had weathered the economic downturn without any bank closures or bailouts, its lenders were still subject to new monetary policy meant to prevent the kind of havoc that crippled the U.S. and European banking systems. The Volcker Rule, part of the landmark financial reform law enacted under President Barack Obama, restricted banks with business in the U.S.—which includes Canada’s Big Six—from making trades for the purpose of earning a profit. 

The rules left banks with fewer revenue sources to leverage, just as an onslaught of new fintech rivals began threatening their market share. 

In 2017, the CEO of Deutsche Bank, Europe’s fourth-largest lender, suggested nearly half his 970,000 workforce could be replaced by automation. The following year, global investment in fintech spiked from US$14.9 billion to US$30.8 billion, up from US$1.8 billion in 2011, according to research firm CB Insights. It isn’t just startups challenging the hulking legacy lenders: tech giants like Apple, Google and Facebook are wading into banking, too. In its latest annual banking report, McKinsey & Company sounded alarm bells for the sector’s incumbents to act: “After a decade of expansion, the banking industry appears to be entering the late phase of the economic cycle.” It suggests about 36 per cent of banks need to “radically rethink their business model. The only other option may be to merge with similar banks or sell to a stronger buyer with a complementary footprint.” For another 19 per cent of banks identified as being vulnerable to a market slowdown, “they should focus on innovating within their core markets,” the authors recommend. “Now is the time for banks to take bold action through universal and archetypal levers—or risk being left behind.”

Other analyses lend credence to the prediction. A recent working paper published by the International Monetary Fund found that banks ranked in the top 25 per cent in terms of IT adoption in 2010—in the wake of the financial crisis—had about half as many bad mortgage loans as the bottom 25 per cent of IT adopters. “Our results suggest that technology adoption in lending can enhance financial stability through better monitoring and screening,” the authors wrote. 

Pressure to improve digital banking is now, perhaps belatedly, resonating with banks, says King. RBC, Canada’s largest bank, launched RBC Ventures in June 2018, a $3.2-billion tech initiative with the aim of attracting 500,000 new customers in five years through services funded or developed through the division. As of December 2019, it’s launched 17 ventures and captured 50,000 new clients. “It’s gotten a disproportionate amount of attention from equity analysts recently,” says King of the initiative. “It’s actually really small relative to their overall business, but it’s almost all that analysts are asking about because they’re so focused on how each bank is doing in terms of adopting technology.” 

That banks are reacting to transformation rather than driving it is in part due to their legacy IT systems, many of which were built in the 1980s and ‘90s and which can’t easily support new technologies like mobile banking apps, says King. One solution is to acquire or partner with fintechs for their technology and customers. Goldman Sachs, for example, has partnered with Apple to launch a credit card; Google has teamed up with Citibank and a credit union in California to build consumer bank accounts; and Facebook has plans to launch a controversial digital currency, Libra, that would be backed by various currencies and government debt. In Canada, for example, National Bank took a minority stake in robo-adviser startup Nest Wealth, which let the bank integrate its technology into its digital services, and TD acquired artificial intelligence startup Layer 6, which uses AI to analyze customer data to help it gauge their needs.

Although more Canadians are banking online and looking for alternative services like the kind that Nest Wealth and robo wealth management Wealthsimple offer, fintechs are still not likely to fully displace legacy institutions anytime soon, says D’Souza. “It would have to be a new entrant they can’t acquire or whose technology they can’t replicate in-house,” he says. “It will be very hard for new entrants to overcome how entrenched Canadian customers are across the Big Six banks.”

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That could start getting easier, though, and it’s something to which banks are paying attention. Ottawa is considering rules for open banking, which would require banks to share customer banking-transaction data with third parties, including competitors. The Big Six have warned the committee reviewing the file that the complexity of open banking presents a threat to Canada’s financial stability. HSBC Canada, however, sided with dozens of fintechs, submitting to the committee a letter of support for the practice. The subsidiary of the U.K. bank, while not a fintech, has managed to pull business away from the Big Six as they grapple with disruption: it slashed its mortgage rate in the country and, at a time when incumbents are closing branches, announced plans to grow its Canadian branch network. It also opened a lab in Toronto to work with fintechs and AI startups. 

“Open banking is just another front in the battle to put a moat around their franchises. But it’s not forward-looking for them all to do this,” says King. “What banks should be asking themselves is ‘What do our customers want and what’s best for our customers?’ rather than asking ‘What do our shareholders want and what’s best for our bottom line?’ Because providing customers with what they want is the best thing for shareholders, ultimately.”

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