Moody's: Prolonged oil price slump is negative for Canadian banks, limited impact for US banks

A prolonged slump in oil prices will have a negative impact on the profitability of the big Canadian banks and a limited effect on the asset quality of the US regional banks, according to two new reports from Moody's Investors Service: "Canadian Banks' Profitability Vulnerable to Prolonged Oil Price Slump" and "Most US Banks Have Limited Asset Quality Risk from Low Oil Prices."

"For Canada's major banks, the credit costs on energy-sector loans would rise if oil prices were to remain low for too long, which would hurt the banks' profitability," said David Beattie, a Moody's Senior Vice President. "Given the historical relationship between oil prices and the impairment rate for energy-related loans, we expect some mild erosion in these loans' asset quality in the coming quarters."

Furthermore, revenue from both underwriting and capital markets activities for the major banks could decline because of potential spending cuts by the banks' oil and gas clients. Consumer credit costs could also rise, owing to a slowdown in the economies of Alberta, Saskatchewan and Newfoundland, all oil-producing provinces.

Direct loan exposures to the oil and gas sector vary by bank, as does the overall exposure to the energy-rich Prairie and Atlantic regions, the two areas that will suffer the most from any prolonged deterioration in asset quality if oil prices remain low for an extended period. Two banks are particularly vulnerable to both the direct exposures and regional factors: Bank of Nova Scotia and Royal Bank of Canada.

On the positive side, the scale and diversity of Canada's Big Six function as a "shock absorber" against the likely rise in impaired energy loans and the decline in capital markets revenue. Moreover, the banks will also benefit from the depreciation of Canada's currency, which has so far functioned as a natural hedge by reducing costs in Canadian dollars and limiting the impact on the oil producers, whose production is sold based on USD benchmark pricing.

For the US regional banks, direct energy-sector loans generally constitute only a small portion of bank portfolios and thus the credit risk these loans pose to the banks is more than manageable. Moreover, these exposures tend to be diversified across exploration and production, as well as midstream, downstream and field services, and would require only a slight increase in loan loss provisions at some banks.

"Declining energy costs could actually be positive for the US banks' operating environment, with a neutral to positive effect on their overall asset quality," notes Allen Tischler, a Moody's Senior Vice President. "In many cases, the US banks with the highest exposures are also the most experienced in underwriting energy-sector loans."

However, lower oil prices could dampen oil exploration and production, with potential implications for energy loans' asset quality. Furthermore, if oil prices do remain depressed for long, credit risk will rise for even the most conservatively underwritten energy-related loans. For a handful of the smaller, more focused lenders among the Moody's-rated banks with the most direct exposures, a lengthy slump in oil prices could lead to the need for higher loan loss provisions and to lower profitability.