29 March 2006

Cdn Banks Will Have to Deal with Significant Challenges in 2006

The Globe and Mail, Paul Waldie, 29 March 2006

Canada's big banks enjoyed stellar financial results in 2005, but they face several challenges in 2006 that could hurt profits, according to a report released yesterday by PricewaterhouseCoopers.

The big six banks chalked up more than $12-billion in combined profit last year, thanks largely to a strong Canadian economy, high commodity prices and low interest rates. Excluding one-time charges related to litigation costs at a couple of banks, the results were up 18.5 per cent from 2004, the report said.

However, rising interest rates, slower growth in lending and problems in the automobile industry are a few of the issues that could affect earnings this year, said the report entitled "Canadian Banks 2006."

"What we're saying is, we expect 2006 to be challenging for the banks," said Diana Chant, a partner in the consulting firm's Canadian financial services practice. "Lending absolutely does go in cycles, and things are not going to stay high forever."

The report noted that interest rates have been creeping up in Canada and the United States. Rising rates are usually not beneficial to banks because their interest-earning assets are long term and are typically funded by short-term liabilities. "Most economists are calling for continued increases in Canadian and U.S. interest rates throughout 2006 and sustained pressure on interest rate margins [at the banks] is anticipated by most, if not all, analysts," the report said.

The report also said household debt is at unprecedented highs, leaving little room for more consumer borrowing.

Canada's banks have enjoyed a stable credit environment in recent years but there are concerns about rising loan defaults, the report said. Problems at General Motors Corp. and Ford Motor Co., and the fallout to their suppliers, is already being felt in parts of Central Canada.

Soaring pension costs is another major issue for corporations and ultimately banks, Ms. Chant said.

"Some people have said that that is one of the biggest looming problems that we have in the business environment that will kind of hamper corporations," she said. "And when corporations are hampered, then lending and banks get implicated."

On the plus side, Canada's banks are seen likely to continue to benefit from strong commodity prices, which are expected to remain high this year.

As for possible bank mergers, the report said there were signs in 2005 that political opposition to mergers has softened. The election of a Conservative minority government could also hasten the release of merger guidelines, which have been delayed for months. The report noted that the largest Canadian bank, Royal Bank of Canada, ranked 32nd in the world in terms of market capitalization.

Ms. Chant said the merger issues have gone on for so long that most banks have reconciled themselves to looking elsewhere for growth.

"I think the banks themselves are coming out and getting beyond the question of mergers. They are sort of saying, 'Well, you know if it happens it happens, if it doesn't it doesn't. We've got our strategies we've got to keep going.' "

Savings plan

Canada's big banks have enjoyed a stable credit environment in recent years, but concerns about loan defaults are rising. As a result, many banks set aside more money last year to cover problem loans.
Total provisions (millions)Provisions as a % of loans
Scotiabank 8933902300.490.210.11
National 17786330.380.170.06
Combined 3,5759611,6580.400.100.16

Source: PricewaterhouseCoopers

Investment Executive, 28 March 2006

Although Canada’s top six banks enjoyed another record-breaking year in 2005, they will need to embrace change more than ever to meet the challenges of the coming year, according to the Canadian Banks 2006, PricewaterhouseCoopers’ (PwC) annual survey of the banking industry.

“The banks are certain to find 2006 challenging. The year likely holds continued margin pressure, slower growth in lending volumes and increases in credit provisions.” says Diana Chant, partner and leader of the PwC financial services practice in Canada. “It will be a challenge for banks to continue the record-breaking profits of the past few years.”

The Big Six earned a combined net income of over $12 billion and thrived in the strong Canadian economy. If not for litigation losses, aggregate results would have been over $16 billion, an increase of 18.5% over 2004.

“2005 was a banner year for Canadian banks. The economy provided a solid foundation for generating strong profits and the banks responded, delivering another year of outstanding results,” says Chant. “But behind this performance are governance, risk and compliance projects impacting the operations of all banks.”

These projects include the implementation of Sarbanes-Oxley 404 in 2006 for all but one of the Big Six. All banks are leading up to the implementation of the Basel Capital Accord and are also developing systems to manage the new accounting requirements for financial instruments. Added to this is the challenge of an uncertain U.S. economy and the negative consequences a slowdown south of the border would bring.

“Canadian banks and the rest of the world need a robust and growing U.S. economy,” says Chant. “Spending is already trending down in the U.S. With high consumer debt, large fiscal deficits and a weak North American auto industry, it is likely there will be a slowdown south of the border in 2006. 2005 was a great year for Canadian banks. The question now is: Where do they go from here?”

Change is the focus of Canadian Banks 2006, and the survey addressed several emerging trends and hot topics in the banking industry, including:

- sharpening client focus and progressive practices in segmentation;
- aligning governance, risk and compliance with the business agenda;
- operational tax risk;
- re-engineering processes;
- the outlook for economic capital in financial services;
- the new Canadian Financial Instruments Standards;
- 2005 accounting and reporting developments.