BAY STREET-Low rates push Canadian banks to fight for profit

Sun Jul 17, 2011 10:30am EDT

* Net interest margins (NIMs) seen down through 2012

* Earnings growth under pressure until rates rise

* Banks jostle for loans, deposits to buffer NIM pressure

* TD, RBC, Scotiabank positioned to ride out trend

By Andrea Hopkins

TORONTO, July 17 (Reuters) - Frugal Canadian customers, low interest rates and stiff competition are putting a squeeze on the profits from loans made by the country's big banks, a trend that's likely to persist into 2012.

Canada's five major banks all reported a drop in net interest margins in their domestic operations last quarter and the slide isn't expected to reverse any time soon. Banks begin reporting third-quarter results in August.

Net interest margins, or NIMs, are a major component of the billions in profits Canadian banks earn each quarter, so margin trends affect the portfolios of millions of investors.

"What we're going to see is there will be continued pressure this year," Bank of Nova Scotia's (BNS.TO) head of Canadian banking, Anatol von Hahn, said in an interview.

"My guess is the first or second quarter of our bank year -- January to April, that period -- I think we will see some movement on interest rates and that will help us in terms of getting the NIMs up."

The net interest margin is the difference between what a bank charge borrowers for loans and pays out to customers on deposits.

Typically, banks borrow cheaply at the short end of the yield curve -- usually through deposits -- and then lend longer-term loans at a higher rate.

Low interest rates traditionally boost bank profits by making loans affordable to to a wider number of customers. But the ultra-low interest rates brought in by the Bank of Canada after the global financial crisis have skewed the equation.

Bankers say low interest rates are encouraging customers to stick with less profitable variable-rate mortgages rather than higher-margin fixed ones. And rates aren't seen rising soon.

A Reuters survey published on Wednesday found forecasters do not expect the Bank of Canada to raise interest rates until the fourth quarter. [CA/POLL] The central bank's target overnight rate is 1 percent, where it has been since last September. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Starmine data on banks: link.reuters.com/wek62s ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

Many banks are now trying to make up in volume what they are losing on the spread.

"Your revenue is your spread times assets, so you try to get more assets," said Peter Routledge, a bank analyst at National Bank Financial in Toronto.

But growing loans in Canada isn't easy. There are only five major banks in the country, all with coast-to-coast branch networks and deep and stable customer bases. With few people willing to change banks for their existing needs, lenders are left jostling for a dwindling number of new loans and deposits.

"Consumer lending in Canada is a very competitive environment already, and when there are fewer loans out there to be had, the competition is only going to grow to get those loans," said Craig Fehr, an analyst at Edward Jones in St. Louis, Missouri.

Whether the banks will try to win customers by offering lower prices via cheaper loans is hotly debated. Canadian banks avoided much of the global financial crisis because they did not follow their U.S. counterparts down the sub-prime lending black hole, and still sound reluctant to go that way.

"Pricing has not been part of our strategy ... that's a dangerous game," said von Hahn. "You have to be competitive, but we are not ones that compete on price. We also don't think that that is sustainable."

That leaves the banks fighting to differentiate themselves with better service, while accepting that stiff competition means margins will remain under pressure until rates rise.

"We continue to have a very competitive environment in Canada and that can certainly affect margins," Bank of Montreal (BMO.TO) spokesman Ralph Marranca said in an email.

"Going forward we think that margins will continue to have ... stable to downward pressure."

The two largest banks, Royal Bank of Canada (RY.TO) and Toronto-Dominion Bank (TD.TO), declined to comment on the outlook for their net interest margins. The two showed the least compression in the second quarter, leading analysts to speculate they either made good bets on yields ahead of time, or simply delayed their pain until the third quarter.

Given domestic margin pressure, some analysts now favor banks with strong international operations or business lines outside of retail banking to make up the softness at home.

"We've got a 'buy' on TD and RBC -- they are international banking players, as is Scotiabank, no question," said Fehr, noting TD's strong U.S. retail presence and a focus on global wealth management at RBC. Scotiabank is Canada's most international bank, with operations across Latin America.

Longer term, many think rising interest rates are the best hope, as they could quickly drive Canadians into higher-margin loans.

"There will be a herd mentality," said Scotiabank's von Hahn. "If there is a feeling that this is the beginning of the rise, I think we will see it quite quickly. Many of those in variable rates will decide to go into fixed rates and the margins on the fixed rates are a lot more." (Reporting by Andrea Hopkins; Editing by Frank McGurty and Jeffrey Hodgson)

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