Canada’s banking regulator, rightly sensing a pickup in loan losses and wanting to avoid a sharp tightening in credit conditions, indicated on Friday a willingness to reduce minimum capital requirements even further to keep lending from contracting during the economic downturn. Dividend yields on Canadian bank stocks reflect a grim outlook, standing at levels not seen since the financial crisis (see chart below). The banks have committed to maintaining dividends in the face of an ever-evolving health and economic crisis, and some have also pledged to avoid job cuts.
While bank earnings face downside risk on increased loan loss reserves, that alone is not a reason for banks to cut dividends since they can increase the payout ratio to compensate. But unlike the financial crisis when Canadian banks had mostly avoided U.S. subprime mortgage exposure and maintained their dividends throughout, there are many domestic sources of risk that bear close attention and that also confirm why dividend yields are as high as they are today.
Energy is often cited as one of the principal concerns. As the severity of the economic impact from the spread of the coronavirus became more apparent, we noted the strong potential for policymakers to deliver needed stimulus but expressed concerns about the outlook for the Canadian energy sector. The past two weeks have seen something of a reprieve on news of a potential output cut among Organization of Petroleum Exporting Countries (OPEC) and non-OPEC members, sparking a 39% increase in oil prices and an equivalent 30% gain in Canadian energy stocks since the mid-March lows. But, in our view, this rebound appears fragile amid declining demand estimates and questions over how to achieve supply reductions outside OPEC+. Moreover, oil prices are still more than half of what they were at the beginning of the year even after last week’s rise, suggesting a still very difficult road ahead for the oil producers, their supply chains, and households and businesses that derive an income from the sector.
But when the energy sector went through a deep contraction in 2015-16, loan loss reserves at Canadian banks barely budged (see chart below). Even during the financial crisis when many of the world’s banks were hemorrhaging over subprime losses, Canadian banks only raised loan loss reserves marginally against a worsening global and domestic economy. We shouldn’t forget, however, that the commodity supercycle was still very much in full swing during the financial crisis thanks to Chinese stimulus to build out infrastructure and promote the domestic economy. That support is no longer there.
Pressure on bank dividends could also arise from stressed household balance sheets where debt service ratios and indebtedness as a share of disposable income have risen to generationally elevated levels (see chart below). Fortunately, government stimulus programs to bridge the economic fallout from the coronavirus lessens the near-term pressure on meeting debt payments. Moreover, banks have shown a steady willingness to permit impaired homeowners to defer mortgage payments for up to six months. According to the Canadian Bankers’ Association, 10% of the Big Six banks’ mortgage portfolio has been deferred, and this number is likely to climb sharply as unemployment rises in the coming weeks. Banks are also working with customers facing difficulties meeting their credit card payments.
With payout ratios sitting in the 40-50% range, banks have flexibility to weather an earnings slowdown without necessarily having to reduce dividend payments. If earnings fell to a degree seen during the financial crisis (by ~20% year over year), the average payout ratio would only rise to 60% – a level that banks have comfortably paid in the past (see chart below). It would require a much sharper 50% earnings decline to reach a payout ratio of 90-100%. Beyond that, banks would be forced to draw down assets or take on additional debt in order to continue paying dividends.
The coordinated Canadian monetary, fiscal and regulatory efforts announced in the weeks since the coronavirus emerged have been nothing short of incredible and will likely lessen the long-term negative impact on the real economy. But the duration of the economic outage is still highly uncertain given the unpredictability of the coronavirus outbreak. If the economic damage can be limited to months, then bank dividends would appear to be secure. However, a more sustained outbreak and economic stoppage would imply a rising risk to bank dividends as policymakers exhaust their available tools and require any available earnings to absorb what are likely to be growing loan losses to ensure the safety and soundness of the financial system.
Kurt Reiman is a Managing Director and BlackRock’s Chief Investment Strategist for Canada. Kurt is a regular contributor to The Blog in Canada.
Daniel Donato is an Associate within BlackRock’s Toronto office.