Bank on It

May 28, 2021 | Matt Barasch


COVID-19 Update

For the first time in several months, we have only good news to report. Daily new cases worldwide are at 2-month lows and are declining by ~700k/week with India, the epicenter of the virus over the past few months now in steep decline:

Further, when we focus on our “core 4” regions, we continue to see significant progress:

Canada specifically is about to see its case count fall below the levels of early February when the latest spike in cases began. Further, when adjusted for population, Canada is once again set to eclipse the U.S. on the downside as it relates to new COVID cases:

Market Update

After a poor start to the month, stocks have bounced back nicely over the past couple of weeks. In Canada, the banks reported second quarter earnings with most of the results quite strong. We have described the dynamics of bank earnings before, but it never hurts to come back to it. Banks have several ways of earning money with the largest being net interest margins (the difference between what a bank pays on deposits vs. the interest rate it can charge on loans), capital markets (trading and advisory revenue) and credit.

  • Net interest margins have widened as short-term interest rates remain near zero (what banks pay on deposits), while long-term interest rates have risen (what banks can charge on loans). They are still narrow by historic norms, but with inflation fears quite high (we will discuss this in a later missive), there is some anticipation that long-term rates will continue to rise.
  • Capital markets have been very strong as there has been a significant amount of M&A (mergers and acquisitions), new issuance (lots of bonds and preferred shares have been called early and replaced with new issues) and trading volume.
  • Credit has been the biggest driver, however, for a variety of reasons. When banks have a loan outstanding and there arises a risk that that loan may not be paid back, the bank must take a provision for a loss against that loan (called a “provision for credit loss” or “PCL”). These PCLs lower the earnings of a bank as they are directly subtracted from revenue on the income statement. As you might imagine, last spring the banks took a massive amount of PCLs as the uncertainty over COVID raised the risk that a lot of loans might not get paid back. What is important to note here, however, is that a PCL does not mean that the loan is actually in default, it simply means that the bank thinks there is a risk that the loan will not be paid back. Should the loan actually go into default, the bank would move it from a PCL to an actual loan loss, which does not impact earnings (it was already accounted for with the PCL), but does lower the overall value of the bank. But for a variety of reasons – government stimulus and rescue efforts, vaccines in record time, etc. – loan losses have not been nearly as bad as feared a year ago. Thus, the banks have become over-reserved for losses (PCLs are higher than they should be), which has allowed the banks to reverse some of the PCLs that they took last year. And just as we deduct PCLs from earnings when we take them, we add them back to earnings when we reverse them, which has helped to give a very nice lift to earnings.

The one thing we would add with the banks is that regulators have restricted the banks from increasing dividends or buying back stock over the past year. This has caused all the banks to become over-capitalized and makes it likely that when regulators reverse this decision (which we expect to happen soon), the banks should be well-positioned to raise dividends once again.


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