A rebound in the investment banking business is providing a big bump to bank bottom lines that will be evident when the country's biggest financial institutions start reporting their quarterly earnings next week.
National Bank Financial analyst Peter Routledge forecast this week that capital markets income for the six biggest Canadian banks rose 12 per cent in aggregate in the quarter ended July 31 from the same quarter last year. And it's likely to keep going.
"We believe market conditions will remain accommodative and forecast a reasonably steady increase in aggregate revenues over the next 18 months," Mr. Routledge wrote, adding that "We believe that this business will become a significant source of revenue and earnings growth over the next 4 to 8 quarters."
Trading is likely to be a bit soft, as illustrated by what is happening in the U.S. But equity underwriting is busy, and debt markets are wide open. This is likely a "cyclical turnaround" after a very slow period for equity. And Royal Bank, the biggest earner in capital markets, has shifted its business mix to lending from trading. And when you lend, you tend to get underwriting business from companies you lend to. Mr. Routledge finds that "empirically, there exists a positive correlation between lending growth and underwriting revenue growth."
(Never let it be said that this is tied selling. It's a relationship business, we all know.)
Rob Sedran, who covers banks for Canadian Imperial Bank of Commerce, has similar expectations for solid growth, but not for as many quarters. He expects the six biggest banks to report capital markets related revenue for fiscal 2014 (which ends Oct. 31) that is up 6.9 per cent, led by gains at Royal Bank of Canada and Toronto-Dominion Bank. But by the end of fiscal 2016, five quarters out, he expects year over year capital markets revenue to be flat.
The real kicker for bank valuations will be if investors start to reward capital markets earnings with bigger multiples. Generally, investors have fretted over the "quality" of capital markets earnings and tended to not give them big multiples. But if that starts to change, you will see multiple expansion and earnings growth. And at that point, you will see banks funnel more capital into capital markets businesses, feeding the loop.
"We would not be surprised if market multiples for the banks rose moderately in the near term to reflect a greater comfort level with capital markets earnings streams," Mr. Routledge wrote.