Rate Rise Could Stoke Worries Over Canada's Banks -- Update

A rate increase from the Bank of Canada Wednesday will give the country's lenders a long-awaited boost in lending margins, but analysts say it could also trigger concerns about a rise in defaults down the road.

The rate increase by Canada's central bank is the first in seven years, and it is likely to boost lending margins -- a key profit-driver for banks -- which have been falling steadily during the postcrisis era of ultralow rates in Canada, the U.S. and elsewhere.

But the six Canadian banks that dominate the financial system are also vulnerable to consumers who are piling on historic amounts of debt, say analysts and investors. An extended cycle of rising rates could cause many to default on their credit cards, car loans or mortgages, potentially rattling the foundation of the Canadian financial sector.

Residential mortgages made up 22% of the banks' combined assets in the second quarter, ending April 30. Personal and credit-card debt made up about 11%, according to filings. Those levels are down just slightly from the 23% and 12%, respectively, two years prior.

At U.S. banks, which tend to securitize more of their loans and move them off their balance sheets, mortgages make up roughly 13% of assets, according to the most recent Federal Reserve data.

The rate increase comes amid a strong run for Canada's banks, which have been bolstered by the country's recent pickup in economic growth and high demand for mortgages in markets like Toronto and Vancouver. Royal Bank of Canada, Toronto-Dominion Bank, Bank of Montreal, Canadian Imperial Bank of Commerce, Bank of Nova Scotia and National Bank of Canada increased earnings by an average 11% during the second quarter, according to a report by Credit Suisse.

Net interest margins, which measure the difference between their cost of borrowing and the money they make from lending, averaged 2.46%, down 0.04 percentage point from the end of 2015. A rate rise should help boost those numbers, helping grow earnings further, analysts say.

The banks have already begun to raise mortgage lending rates. RBC, TD, Bank of Montreal and CIBC raised rates early in July by as much as 0.20 point for five-year mortgages.

Despite their robust earnings, some observers have already sent up cautionary flares. Moody's Investors Service in May downgraded the top five banks, citing their vulnerability to debt. Household debt totaled 175.9% of disposable income at the end of 2016, according to the Organization for Economic Cooperation and Development. That compares with 152.3% in the U.K. in 2016 and a U.S. ratio of 112% in 2015, the most recent year for with the OECD had data available.

Canadian consumers and the Canadian banking system haven't been tested at such high levels of leverage," said David Beattie, a Toronto-based analyst for the ratings service. "We don't know what the shocks to the system will be, but we do know it's harder for the system to respond when we get to these levels."

Canadian officials have signaled they are concerned. They have imposed measures to cool housing markets in Toronto and Vancouver, including a tax on foreign buyers, and last week said they are weighing tighter rules for mortgage issuance.

This spring, alternative lender Home Capital Group Inc. unnerved the financial sector when it suffered an outflow of 95% of its more than C$2 billion ($1.55 billion) in high-interest savings deposits following allegations the company misled investors about its mortgage fraud problem. The company, a large lender to the self-employed and those with little credit history, was bailed out last month by an investment from Warren Buffett's Berkshire Hathaway.

To be sure, the major banks aren't as exposed as Home Capital to non-prime borrowers. The government's Canada Mortgage and Housing Corporation also fully insures more than half the mortgages on the banks' books, according to a report by Citi, reducing their risk to the firms. But any damage to the banks' balance sheets from rising interest rates and stressed borrowers likely will begin through other forms of borrowing, said Brian Klock, an analyst with Keefe, Bruyette & Woods.

"The fear in Canada is that you have that consumer borrower who finally turns," said Mr. Klock. "If they are having problems with their car loans, do they default? Will that cause an issue with their mortgage?"

Chris Kresic, head of fixed income at Montreal-based investment management firm Jarislowsky Fraser, said that growth in the housing sector poses a macroeconomic risk for the Canadian economy as a whole, which exposes the banks. But the banks, which effectively hold an oligopoly in the country, haven't had to take on as much risk to remain competitive as U.S. banks did in the run up to the housing crisis in 2007.

Canadian banks don't have many subprime loans on their balance sheets, he noted, which could help them avoid the worst of a default wave.

That conservatism could help avoid a crisis, even if higher rates lead to a severe housing downturn, he said.

"There's no doubt that the Canadian economy has never been so leveraged and so leveraged to housing," he said. "There is a macroeconomic exposure for the banks. Is the risk greater now than ever before? Probably. Are the banks able to survive such a downturn? We think they will."

Write to Vipal Monga at vipal.monga@wsj.com

(END) Dow Jones Newswires

July 12, 2017 11:52 ET (15:52 GMT)