It may not look like a financial hot zone, but Canada could spread economic contagion to the U.S. if its downturn deepens.
Troubles in China and the emerging markets have drawn far more attention than the economic slowdown in our wealthy northern neighbor. But U.S. banks — and the broader U.S. economy — have far closer ties to Canada than to the volatile emerging markets, which raises the specter of collateral damage from Canada's economic problems.
Canada's statistics bureau declared this week that a recession has officially begun, after the country's gross domestic product contracted in the first two quarters of the year. Low oil prices have hurt the heavily energy-dependent nation's economy and caused businesses to reduce their investment.
For now, however, the problems look like they are confined to the energy sector, and the ripple effects have not even reached Canadian banks, much less banks in the U.S.
But the longer the recession lasts the greater the risk of contagion, said Fitch Ratings analyst Justin Fuller.
"We haven't seen low energy prices flow through to [Canadian] bank earnings yet," Fuller said. "But eventually you'd have to see some credit deterioration if there is a major asset-price depreciation as well as an economy slowing."
The notion of contagion from Canada may seem far-fetched, especially because Canadian banks, famously, were barely hurt by the 2008 financial crisis. Bond analysts rate Canada's banking sector among the safest in the world, alongside Australia's and Singapore's. Moreover, Canada's six largest banks control 93% of the sector's total assets, which would appear to leave very little of the market — and very little risk — for American banks.
But a sound banking sector cannot prevent recession, and a slowdown up north could leave U.S. banks open to significant counterparty exposure. Along with being America's largest trading partner — buying almost 19% of our exports — Canada is far more tightly woven into the U.S. financial system than China, Greece, Brazil or other often-cited financial threats from abroad.
U.S. banks' exposure to Canada — direct credit claims on the country's public and private sectors — totaled more than $120 billion at the end of March, or about 4% of U.S. banks' total foreign exposure, according to data from the Bank for International Settlements. That's compared to $97 billion in exposure to China, and just $1.5 billion to Greece.
The Canadian risk is also concentrated with the largest and most systemically important U.S. banks. The four biggest domestic lenders — JPMorgan Chase, Bank of America, Citigroup and Wells Fargo — collectively have about 61% of that $120 billion in exposure, according to data from each company's most recent public filings. Citi had the most exposure, $24.4 billion, as of the end of last year.
And along with their exposure via loans, U.S. banks also had about $150 billion in off-balance-sheet exposure to Canada, including derivatives exposure, guarantees and untapped credit lines, compared to just $43 billion for China, the BIS said. The majority of that Canadian risk is through derivatives, including energy-sector swaps, which could prove risky if the oil-price slide continues.
For now, however, the possibility that U.S. banks could take losses from Canada is just speculation — losses have not even started to hit Canadian banks.
In earnings reports over the past weeks, the six largest Canadian lenders each beat analysts' estimates and collectively showed 8% growth in quarterly profit, mostly from strong domestic lending. Loan-loss rates, even on energy loans, remained below historic norms.
Some analysts think these third-quarter numbers are superficial results that masks fundamental weakness, while others think the banking sector is healthy and the recession is a minor hiccup. Analysts for Standard & Poor's wrote Thursday that the recession is likely to be short and that apart from its energy sector, Canada is poised for growth.
But there are potential storm clouds over the financial system. Over the past decade the Canadian economy and banking system have shed some of their traditional conservatism and, spurred by low interest rates, have come to look more like America's. Home prices have shot up and consumer debt is at an all-time high.
David Beattie, who analyzes Canadian banks for Moody's, sees potential trouble in these trends, though overall he is sanguine on the Canadian financial sector.
"Elevated housing prices and a high household debt-to-income ratio are two key concerns we've had for years," he said. "Now low oil and gas prices are a third emerging problem."
He expects loan losses, if they come, to hit consumer portfolios rather than commercial loans, and to be concentrated in regions that are heavily dependent on the energy industry, like Alberta.
That would be good news for American banks, which generally focus on corporate lending in Canada and have not been able to muscle their way into consumer lending.
Canada's downturn could also hamper Canadian banks' efforts to break into the American banking market. Investor pressure has spurred Canadian banks to push into higher-growth markets over the past decade or so, and some — like Toronto-Dominion Bank and Bank of Montreal — have targeted the U.S. for expansion, though a deep recession could force them to alter course.
"To the extent there are problems in their domestic market in Canada, it may slow their growth strategy here," said Fuller, the Fitch analyst. "That said, for Canadian banks with significant international operations, a more diverse earnings stream may help shelter their results."
Beattie thinks that Canadian banks have invested too much in the U.S to shift strategies lightly.
"Banks have seen this movie before and they know how to manage their portfolios very, very well," he said. "We're not predicting any major credit deterioration in Canadian banks — we're just cautious."