Scotiabank says high interest rates are increasingly weighing on consumers, resulting in a credit deterioration among its variable-rate mortgage customers.

“Specifically, variable rate mortgage customers originated in 2022 have shown signs of stress,” Chief Risk Officer Phil Thomas said during the bank’s second-quarter earnings call, adding that most of those clients are located in the Greater Toronto Area and Vancouver where mortgage amounts are higher.

“This resulted in an increase of vulnerable customers from 2,700 in Q1 to 3,300 in Q2,” Thomas noted, adding that the delinquency rate in the bank’s variable-rate mortgage portfolio increased to 0.28%, up two basis points from the previous quarter.

Scotiabank is the largest mortgage lender to offer adjustable-rate mortgages, where payments fluctuate as prime rate rises or falls.

Unlike fixed-payment variable-rate clients at some of the other big banks, Scotiabank’s floating-rate clients don’t have to worry about hitting their “trigger rate” or experiencing negative amortization given that their payments automatically increase to cover the higher interest costs.

However, this has meant that Scotia’s variable-rate clients—which comprise a third of the bank’s $289-billion mortgage portfolio—have already been impacted by the Bank of Canada’s 475 basis points worth of rate hikes since March 2022.

Despite pockets of stress, Thomas noted that the portfolio has an average loan-to-value of roughly 50%, which he said is “quite low.” He said the average FICO score at origination was also high at 800.

In response to higher rates, the bank said consumers have been making choices in terms of how they’re managing their savings. “We still see our variable rate-customers holding on to about a two-payment buffer within their deposit accounts,” Thomas said. “And on the fixed rate, it’s about three and a half to four.”

The bank said its fixed-rate mortgage balances are showing “stable” delinquency performance.

Higher-for-longer interest rates pose upside risk for loan losses

Scotiabank increased its provisions for credit losses—funds reserved for potential credit losses—in the quarter to $1.01 billion, up from $709 million a year ago.

“Although we believe the monetary tightening phase of the rate cycle in Canada is now complete, our prior expectation for multiple rate cuts in the back half of the calendar year feels less certain,” Thomson said.

“The reality of a higher-for-longer rate scenario will naturally result in a continuation of elevated credit provision in our retail portfolios, keeping us at the higher end of our 2024 PCL outlook of 55 basis points,” he added. “We will continue to work through our mortgage and auto clients and have launched several proactive measures across our collections function, including pre-delinquency solutions and new loss mitigation tools.”

BoC rate cuts to help, but will take time

While the Bank of Canada is widely expected to begin cutting interest rates in the coming months, forecast for the total number of rate cuts by the end of the year have been reduced, increasing the likelihood that interest rates could stay higher for longer.

Should the BoC deliver a quarter-point rate cut in either June or July, Scotiabank’s Thomas said it will still take time before cumulative rate decreases have a meaningful impact on today’s borrowers.

“Even with those decreases…it’ll take a few quarters. Maybe one, two, three quarters for it to start to really support the Canadian consumer,” he said.

Thomas explained that a 25-basis-point reduction to the prime rate would result in an average payment decrease of roughly $100 for the bank’s typical variable-rate mortgage clients in Toronto and Vancouver.

“As you think about how quickly rate decreases happen, that will provide good relief for the average consumer, [who can then] start making payments on other products,” he added.

Scotiabank earnings highlights

Q2 net income: $2.1 billion (+3% Y/Y)
Earnings per share: $1.58

	Q2 2023	Q1 2024	Q2 2024
Residential mortgage portfolio	$300B	$288B	$289B
Percentage of mortgage portfolio uninsured	73%	74%	75%
Avg. loan-to-value (LTV) of portfolio	53%	50%	51%
Portfolio mix: percentage with variable rates	37%	33%	33%
90+ days past due	0.12%	0.20%	0.19%
Canadian banking net interest margin (NIM)	2.30%	2.56%	2.56%
Total provisions for credit losses	$709M	$962M	$1B
CET1 Ratio	12.3%	12.9%	13.2%

Conference Call

On the bank’s mortgage portfolio:

• “Balances have stabilized in the Canadian residential mortgage portfolio, while we have seen moderate growth in other personal and commercial portfolios,” said President and CEO Scott Thomson. “We continue to reposition our business banking portfolios with a view to optimize risk-weighted assets and profitability by client.”
• “On a spot basis in the quarter, we grew our mortgage book by around $2 billion…we’re slowly seeing now the pipeline for mortgages will continue to go up. We’re trying to stay extremely focused on…value versus volume,” said Aris Bogdaneris, Group Head, Canadian Banking.
• “We’re hitting a very high level of [retention] now…over 80% of renewals for the second quarter for our mortgages,” Bogdaneris added. “We’re going to see continued mortgage growth in the second half of the year, obviously predicated on how rates go. But even if rates come down. We will continue to stay disciplined on getting multi-product mortgage customers at origination and again, focusing on renewal.”
• “We haven’t been seeing a big volume of fixed rate renewals so far…it’s interesting to note that 70% of the renewals that are coming through right now are opting for a fixed three-year fixed term,” Thomas said.

On the impact of higher-for-longer interest rates:

• “Given the higher-for-longer rate [scenario], [clients are] making tradeoffs in terms of their payments. And maybe they got a little bit over their skis at the point of origination. But these are good customers that are just facing a little bit of tightness in terms of their cash flow. We’ve been really focused on the collections efforts, and we’ve been doing a lot of proactive outreach to these individuals,” said Chief Risk Officer Phil Thomas.
• “As we look in this year 2025 and 2026, obviously there’s some payment shock anticipated. But we’re taking some comfort in terms of how our variable-rate mortgage customers are absorbing the shock,” Thomas said. “We have seen discretionary spending decrease. As an example, on our VRM portfolio, those customers’ discretionary spend has decreased by about 10% on retail expenditures year-over-year.”

On growing and deepening Scotiabank’s client base:

• “Our focus on relationships and more deliberate new client selection is driving an increase in the percentage of clients that we consider to be primary,” said Thomson. “Our retail bank has added over 95,000 net new primary clients year-to-date and importantly, saw the lowest client attrition in three years as a result of more selective client acquisition and cross-sell initiatives. We are closely tracking client relationship depth and have seen meaningful progress with over 45% of all retail clients currently holding 3-plus products in the Canadian bank, a 230 basis point increase from a year ago.”
• “70% of our new mortgage originations are coming with three or more products,” said Bogdaneris. “And actually, in April, that number was approaching 80% across all channels.”

On deposit growth:

• “Our focus on building primacy through deeper relationships has resulted in continued growth with P&C deposits up 7% year-to-date,” Thomson said.
• “Deposit growth has now outpaced loan growth in Canadian and International Banking in each of the past five quarters,” he added. “The bank’s wholesale funding has been reduced by $34 billion year-over-year, resulting in a wholesale funding ratio below 20% down from approximately 23% in Q2 of 2023.”

On growth at Scotia’s subsidiary Tangerine Bank:

• “At Tangerine, we continue to add new clients and see lower attrition rates with existing clients,” said Thomson. “Year-to-date, we’re tracking well ahead of plan to add new clients in fiscal 2024. Importantly, primary client growth at Tangerine is up 15% year-to-date, with 35% of all clients now having three or more products with Tangerine. Tangerine continues to set the industry pace in terms of mobile penetration with 64% of new client sign-ups happening exclusively through the mobile channel, up 11% year-to-date versus last year.”

Source: Q2 Conference Call

Featured image by Pavlo Gonchar/SOPA Images/LightRocket via Getty Images

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Last modified: August 29, 2024