Nichola Sainather

TORONTO, (Reuters) – Rising inflation and higher bond yields could give a lift to Canadian banks’ profit margins. However, an aggressive response from the central banks could lead to a stalled lending recovery and increased defaults. Analysts and investors disagreed.

The pandemic saw the Canadian banks lose their loan growth, except for mortgages. Lockdowns and surging deposit rates slowed business and consumer borrowing. Although consumer spending increased following the lifting of lockdowns, it has failed to lead to robust credit growth.

Higher interest rates drive banks’ net interest margins. Uncertainty around the persistence of inflation and how rapidly rates will rise cloud investors’ outlook on lending recovery.

“If the Bank of Canada or U.S. Federal Reserve raise rates too fast, it will stifle growth and lead to a decline in loan demand. … It would be a bad for the banks, and have a detrimental impact on profitability,” Rob Colangelo said.

A rash response to a loan servicer’s request would increase costs and raise the risk of defaults. This would cause banks to increase the bad loan provisions and lower profits, which will lead to slower growth.

A rapid increase in rates, given the increased demand for variable rate mortgages, would leave borrowers vulnerable and potentially lead to loan loss, stated Mike Driscoll of DBRS Morningstar’s North American Financial Institutions.

According to the latest data, inflation rose nearly two decades ago to 4.7% in October. Money markets anticipate a March hike and five more next year. But, the Bank of Canada said this week that an increase is not likely until 2022’s middle quarters.

Driscoll stated that grocery prices and cars are getting more costly. Although wages may have increased, real income is declining. This can lead to problems due to the large amount of debt. Higher credit losses may be possible.

The pandemic is receding and investors hope that banks would see their profit growth again from core lending activities, instead of releasing bad-debt reserves which has driven higher-than-expected earnings the past year and other businesses such as wealth management.

Most investors and analysts don’t believe the central banks will raise interest rates quickly enough to stop the economy from recovering. Some investors suggested that if the Bank of Canada slows down in raising rates and inflation continues to seep into wages, then it might not be able to choose.

Colangelo stated that “if inflation persists well beyond the target range (the central bank could have to act)”.

Brian Madden, Portfolio Manager at Goodreid Investment Counsel, stated that an overnight rate exceeding 3% could halt economic growth, and potentially lead to a recession.

A recession is unambiguously bad news for banks. “You get credit losses and that chokes off the loan demand”, he stated. Although it seems unlikely, the risk of losing your credit is not zero.