Canada's economy finds itself in a sudden stop. An unrelenting sequence of hits, from plummeting oil prices to the outbreak of COVID-19, and the onset of the resulting global recession, will cause the Canadian economy to contract in the first half of this year. Although S&P Global Economics generally expects a recovery in the second half of the year, it expects GDP will decline for the year as a whole.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in our current assessment of COVID-19's economic fallout (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we shall update our economic assumptions and resulting ratings implications and estimates for the banking system accordingly.

S&P Global Ratings believes the pandemic will lead to meaningful deterioration in asset quality across loan portfolios and lower earnings for the Canadian banking sector. That said, Canadian domestic systemically important banks (DSIBs, which together account for 92% of the country's commercial banking assets) are entering this recession from a position of strength. These banks have shown stable and solid operating performance over several decades and benefit from good on-balance-sheet liquidity, strong regulatory capital levels, and credit quality metrics that are stronger than those of similarly rated peers. That strength has been an important factor in our Banking Industry Country Risk Assessment for Canada, our methodology for assessing the economic and industry risks of a country's banking system.

Proactive Regulatory, Fiscal, And Monetary Policy Response Is Broadly Supportive Of Banks

From a fiscal, monetary, and regulatory point of view, the Canadian policy response to the shock from COVID-19 has been swift. We believe the measures enacted have the potential to ease the impact of sharply lower economic and business activity, and act as a bridge to support Canadian banks' retail and commercial clients. That said, the immediate negative effects of extensive "social distancing" and sharply declining oil prices will constrain some of the benefits from increased liquidity in the system, lower interest rates, and government stimulus.

Table 1

We believe the Bank of Canada's (BoC) measures have bolstered liquidity and already provided a boost to confidence, particularly in the short-term funding markets. The raft of supervisory relief measures undertaken by the Canadian bank regulators have helped maintain access to markets for all Canadian banks (for short- and long-term funding) and have ensured consistent guidance in dealing with distressed borrowers.

How And Where Stresses Could Occur

We see a few pockets of potential vulnerability where credit stress could manifest. These include banks' exposures to certain sectors that we surmise could record a high impact from COVID-19 related disruptions, such as consumer discretionary (including media, entertainment, and leisure), tourism and hospitality, retail and restaurants, and transportation (including aviation). (See "Credit Conditions North America: Unprecedented Uncertainty Slams Credit," published March 31, 2020, on RatingsDirect.) Canadian banks' commercial exposures tend to be secured by collateral, and are highly diversified, with no outsize industry concentration (chart 1). This has helped keep loss rates low, with average annual business and government provisions for credit losses (PCLs) of 0.6% since 2003.

Chart 1

One of the most vulnerable corporate segments is the oil and gas industry, which has undergone parallel damage, with prices plummeting due to reduced demand and excess supply. S&P Global Ratings revised down its projection for West Texas Intermediate (WTI) prices to US$25 for 2020. (See "S&P Global Ratings Cuts WTI And Brent Crude Oil Price Assumptions Amid Continued Near-Term Pressure," March 19, 2020.) We believe Canadian DSIBs' direct exposures to oil and gas are manageable, at a modest 2% of total loans, with 57% of the DSIBs' oil and gas exposure to the exploration and production segment on average (chart 2). These loans are fully secured by a borrowing base, which can be flexed down during the ongoing redetermination process. Exposure to the more vulnerable oilfield services segment is 11% on average.

Chart 2

Monthly debt repayments on nonmortgage products contribute more than two-thirds of total household debt servicing costs in Canada. Rising unemployment is likely to erode credit quality in these portfolios.

As a result, we expect defaults on unsecured consumer lending to trend higher than those on mortgages (because more than a third of Canadian mortgages are insured). However, DSIBs have modest exposure to unsecured consumer loan portfolios in general. We estimate that credit card loans, combined with other consumer loans (including autos and other personal unsecured lines), account for 12% of total loans, on average.

Chart 3

The impact of COVID-19 on the housing market remains the biggest wild card. We expect real estate sales and lending will slow due to the economic shutdown, and rental demand to decline as quarantine measures and travel restrictions dampen inflows of immigration. Still, we do not expect a severe correction in housing prices, as we believe demand- and supply-side factors will likely balance (that is, both buyers and new listings hold back). Strapped Canadian households are likely to benefit from the government's fiscal support efforts, while ultra-low interest rates keep servicing mortgages manageable.

Furthermore, government-provided mortgage insurance has historically kept mortgage loss rates very low for Canadian banks (chart 3), and successive rounds of macroprudential regulation for several years have generally led banks to consciously tighten underwriting standards for residential mortgages (charts 4 and 5).

Chart 4

Chart 5

Canadian Banks' Resilience To Stress Under Significant Credit Shock Scenarios

To gauge the impact on Canadian DSIBs from pandemic-related macroeconomic uncertainty, S&P Global Ratings devised stress scenarios to determine the potential impact on DSIBs' capital and liquidity buffers.

We prepared adverse and severely adverse scenarios (see table 2) and applied an entire year of stress to the rated banks DSIBs. These are hypothetical stresses that do not reflect what we are incorporating in our baseline projections for the Canadian economy and banking sector. These simplistic stress test scenarios are intended to help us gauge Canadian DSIBs' ability to withstand a more significant credit shock, if the downturn is prolonged, the recovery is slow, and economic activity normalizes at a much lower level.

We front-loaded a full year of stressed losses (although first-quarter 2020 will be better than the rest of the year), and did not give credit to existing loan loss reserves, applying the full impact of write-offs on capital ratios. Each scenario includes broad-based assumptions for net interest margin compression, loan loss provision, dividend payout, and earning asset growth (see table 2). For simplicity, we did not factor in potential market risk, operational losses, markdown of securities, or unrealized gains or losses from the securities portfolio that would affect capital or any individual bank's loan book. We assumed the banks' funding and liquidity profiles remain stable. We also assumed that the banks' loan composition and risk-weighted assets (RWA) density (total regulatory RWA/total assets) remain the same as at year-end 2019. We believe these scenarios would be especially hard hitting for banks heavily reliant on net interest income or those with a predominant commercial or unsecured consumer loan orientation (given our very punitive loss rate assumptions for these asset exposures).

Stress Scenario Outcomes

Our sensitivity analysis indicates that the Canadian DSIBs' capital and liquidity levels have enough strength to endure adverse downside scenarios, characterized by credit losses of up to 1.8% (this is our adverse stress scenario, which is 5x the average 2019 loss rate for the Canadian DSIBs). We could take widespread rating actions if loss rates surpass this level, under our severely adverse loss scenario. In both our stress scenarios, we estimate most of these losses come from the corporate sectors that are most vulnerable to the effect of COVID-19), followed by increased losses in unsecured consumer loans (we believe the credit cards segment is the most at risk, because cards are typically the lowest in the payment hierarchy for consumers under stress).

Adverse stress scenario

Our adverse stress loss rate is 5x the 0.35% PCL ratio that Canadian DSIBs actually recorded in 2019, and along with lower revenues (given margin compression) and flat expenses (banks are not laying off their workforce), this stress scenario almost entirely wipes out all the net income that the system earned cumulatively in 2019. Under such a scenario, we estimate the Canadian DSIBs' average Common Equity Tier 1 (CET1) ratio declined 130 bps to 10.4%--still well above OSFI's minimum regulatory requirement of 9% (chart 6).

Chart 6

Severely adverse stress scenario

Under our severely adverse scenario, we apply meaningfully higher loss rates on each loan category (see table 2) for a blended loss rate of 2.9% (just over 8x the actual 2019 PCLs of 0.35%). In this scenario, we envisage the stress from the coronavirus impact would spread materially and affect credit quality outside of the industries currently experiencing the most stress, and would also affect the consumer sector more meaningfully. Of particular interest, the 2.9% blended loss rate mirrors the all-time peak loss rate that the Canadian banking system reported during the period of corporate stress in 1986. However, back then, banks were less diversified, with business lending forming about 62% (2019: 39%) of total loans and residential mortgages contributing 15% (2019: 49%). We assign a low probability to this scenario materializing. We estimate that under such a stress scenario, the median CET1 ratio would decline 300 bps to 8.7% (chart 7). In this case, we would also expect the S&P Global Ratings risk-adjusted capital ratios of most Canadian DSIBs to decline below 7%, likely necessitating negative rating actions on most of them.

Chart 7

In conclusion, even if our adverse scenario were to materialize, we likely would not envisage taking widespread rating actions on Canadian DSIBs. In our severely adverse scenario, however, negative ratings implications for the DSIBs could emerge, given the potential for significant credit losses and sizable capital declines.

Liquidity Is Unlikely To Become A Risk To Ratings

We believe liquidity in the Canadian banking system is very good and Canadian DSIBs' high-quality liquid assets (HQLA) will remain sufficient to handle heightened levels of cash outflows. Nevertheless, given the heightened uncertainty, we stressed it. We surmise that drawdowns from credit and liquidity facilities at Canadian DSIBs would need to increase dramatically beyond 2008-2009 levels to drain HQLA and reduce the liquidity coverage ratio (LCR) to dangerously low for the group in aggregate. (This assumes that banks are not experiencing other drains on liquidity apart from the revolver draws, of which there is no evidence yet.)

As of January 2020 (first-quarter 2020), Canadian DSIBs cumulatively held C$986 billion in HQLA, compared with C$808 billion of total undrawn exposure on credit and liquidity facilities disclosed in LCR. Under LCR assumptions, banks estimated that C$130 billion, or 16% of the C$808 billion of undrawn commitments and 13% of the C$986 billion in HQLA, would flow out under a stress scenario. Even if the LCR outflows in the form of line drawdowns increased by 2.5x (which is highly punitive, given that LCR is already a stressed assumption calibrated on the experiences of the 2008-2009 crisis), we estimate the median stressed LCR would still be very good at 96% (albeit down from 132%) (chart 8).

Chart 8

Key Variables Of Our Credit Stress Scenarios

Table 2 outlines the assumptions we applied in our stress scenarios.

Table 2

Canadian Banks Should Weather The Storm

COVID-19's impacts are hitting all, from businesses to consumers, and will definitely dampen Canadian banks' operating performance this year meaningfully. We expect higher credit losses and significant margin compression. The degree to which these happen depends on the length of the downturn and the pace of the economic recovery. However, on a positive note, Canadian DSIBs entered this downturn with diversified revenue streams, extremely low loss rates, and good liquidity profiles, and the government of Canada has the fiscal wherewithal to provide necessary support to the economy. Therefore, we believe Canadian DSIB ratings are resilient to the adverse credit impacts that we see emerging from this pandemic; however, we could lower them if the stress inches toward our severely adverse scenario.