If a Canada-U.S. trade war materializes this year, the Canadian banks would take a hit, as an economic shock translates into weaker credit quality, Morningstar DBRS Inc. says.
In a new report, the rating agency examined the possible fallout for the Canadian banking sector from a trade war, which would torpedo the generally positive economic growth outlook for North America.
“Were the original tariff plan to be implemented, the North American macroeconomic outlook, particularly Canada’s, would deteriorate materially, with clearly negative repercussions for the Canadian banking sector,” it said.
Notably, a trade war could push Canada into recession this year, driving higher unemployment, and complicating the monetary policy picture — as tariffs would disrupt supply chains and stoke inflation, alongside weaker growth.
Against the weaker economic backdrop, the banks’ asset quality would deteriorate, and lending to sectors hit hardest by tariffs (such as the auto sector, mining, and manufacturing) would likely suffer too.
“While revenue and loan growth would face headwinds in such a scenario, we believe the most significant impact would be on credit quality,” DBRS said, with the banks facing higher delinquencies, loan losses, and credit provisions.
“All the Big Six Canadian banks would be negatively affected by a tariff war scenario. That said, impacts to certain sectors and loan books would affect banks in different ways,” it said. Smaller banks and credit unions are more vulnerable too, it said, given that they are generally less diversified and have significant exposures to riskier assets, such as commercial real estate.
Despite the negative consequences of a possible trade war for the banks, the sector is also generally “well positioned” to weather a downturn, “with adequate liquidity, stable funding, and sound capital levels,” the report said.
Additionally, banking regulators have some capacity to support the banks in times of stress, such as lowering the capital buffer requirements, which would allow the Big Six banks, “to continue lending to households and businesses while absorbing potential losses.”
DBRS noted that the Office of the Superintendent of Financial Institutions (OSFI) cut the domestic stability buffer (DSB) from 2.25% to 1.0% in the face of the onset of the pandemic in early 2020 — and that requirement currently sits at 3.5%.