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Photographer: Brent Lewin/Bloomberg Photographer: Brent Lewin/Bloomberg

Some of those shorting Canadian banks contend that the firms aren’t preparing adequately for higher loan losses if credit conditions worsen.

The argument by investors including money manager Steve Eisman and PAA Research LLC’s Bradley Safalow has to do with accounting changes Canadian banks made after adopting global rules known as International Financial Reporting Standard 9 in late 2017. Previously, banks set aside money for bad loans -- also known as a provision for credit losses -- when recognizing a loss.

Under IFRS 9 rules, banks provision for expected losses and divide loan books into three buckets: Stage 1 is for most performing loans, with provisions based on default expectations over the next 12 months; Stage 2 for performing loans with a significant increase in credit risk, and expectations of default based on the remaining life of the loan; and Stage 3 for impaired loans effectively written off. The change is similar to the Current Expected Credit Loss, or CECL, rules that U.S. banks are facing.

“You’re starting to hear noises from the CEOs of the Canadian banks that things are certainly not better in Canada, they’re getting more sluggish,” Eisman said in an April 5 interview. Banks aren’t setting aside enough money to prepare for changing credit conditions, which raises the risk that “all the Canadian banks will miss earnings by a lot.”

Changing Assumptions

Safalow, whose research firm recommends investors short companies including Canadian Imperial Bank of Commerce and Royal Bank of Canada, said lenders kept changing their risk assumptions last year on those performing Stage 1 loans through “re-measurements,” which equated to a C$4.4 billion ($3.3 billion) earnings benefit for the six biggest banks.

The banks won’t be able to repeat that benefit this year given how difficult it is to argue that economic conditions will improve in Canada in the next 12 months, Safalow said. Such reversals can’t continue because overall allowances on Stage 1 loans are now so “irresponsibly” low on an absolute basis, he contends, they have nowhere to go but up.

CIBC provisions “appropriately for the risk that we see in our business,” Chief Executive Officer Victor Dodig said in an interview last week with BNN Bloomberg Television.

Banks’ Judgment

Bank analysts do expect rising loan losses at Canadian banks -- just not the surge anticipated by some contrarians.

“Under IFRS 9, the calculation of expected credit loss that drives provisioning depends significantly on banks’ estimate of probability of default, loss given default and exposure at default,” Bloomberg Intelligence analyst Himanshu Bakshi said in an email. “These three inputs are modeled based on banks’ projections of macroeconomic variables like unemployment, GDP growth and house-price growth over the forecast period.”

Such calculations, he said, require significant judgment by the banks.

“While the provisions are low, we are also in a benign credit environment,” Bakshi said. “The provisions will likely go up from current levels, but not drastically, we think.”

The market may be misreading bank actions with the expanded accounting disclosures, according to CIBC Capital Markets analyst Robert Sedran. There are so many moving parts that simplistically comparing the banks can lead to misconceptions about relative risk positioning, he said.

“Are banks that are regularly adding to Stage 1 and Stage 2 reserves every quarter behaving conservatively or catching up after being too aggressive on transition to the new standard? Impossible to answer and likely a little of both, in our view,” Sedran said in an April 15 note to clients.

Sedran said he believes “the market is getting carried away with noise” and suggests sticking to monitoring economic signals and Stage 3 impaired loan losses, while considering prior performance, geographic and asset mixes, and growth trajectories to assess relative positioning. “And then, when the economic cycle turns, hold on tight.”