Why Canadian Bank Stocks Don't Always Win When Rates Rise

The Bank of Canada raised its policy rate four times in the first half of 2022, and RBC's stock fell 14 percent over the same window. TD dropped 11 percent. BMO lost 9. The problem wasn't that investors misunderstood how banks make money. The problem was that they understood the next part of the cycle.

When rates rise, the spread between what a bank charges for a loan and what it pays to depositors, called the net interest margin, does widen. A borrower with a variable-rate mortgage tied to Prime sees their payment jump immediately. The bank's savings account rate moves slowly or not at all, which means the bank captures more profit on every dollar it lends.

What breaks the thesis is the part that happens 18 to 24 months later. Higher borrowing costs slow the economy. Businesses delay expansion. Consumers pull back on discretionary spending. The housing market cools, which reduces the volume of new mortgages originated. At some threshold, the extra margin per loan stops compensating for the fewer loans being written, and revenue growth stalls.

The provision problem

The second lag is darker. Banks are required by regulation to set aside money, called loan loss provisions, to cover loans that might not be repaid. In a stable economy, these provisions run low. When rates climb fast enough to tip households or businesses into distress, the provisions rise sharply. CIBC set aside C$438 million in provisions in Q2 2023, up C$135 million from a year ago, as economic uncertainty forced the bank to build a larger cushion against potential defaults. The higher the provisions, the more earnings are erased, regardless of how much margin the bank captured on the way up.

Alberta's position adds a twist. Edmonton's housing market has historically been more affordable, which means buyers here entered the hiking cycle with less stretched balance sheets. That should, in theory, make local loan books more resilient. But Alberta's economy is energy-weighted, and oil and gas capital investment is interest-rate sensitive. When the Bank of Canada pushes rates above 4 percent, drilling budgets get revised, which ripples through employment and eventually through consumer credit quality. A bank with heavy exposure to Alberta might see strong mortgage performance offset by weaker commercial and personal lending tied to the energy sector.

What dividend investors actually get

For someone holding bank stocks through a rate cycle, the "win" is not usually share price appreciation. Canadian bank stocks trade on their dividends, which historically yield between 4 and 6 percent. The attraction during a hiking cycle is that banks use the temporary margin expansion to maintain or grow their dividend payouts, even while the stock price drifts sideways or down. RBC held its quarterly dividend at $1.32 through 2022 despite the share price decline. An investor who bought for income collected the same payout whether the stock rose or fell.

The risk is that the dividend becomes unsustainable if provisions climb too high or if loan volume contracts more than expected. In that scenario, the bank cuts the dividend, and the stock reprices lower. That happened to some U.S. regional banks in 2023. Canada's Big Six have higher capital buffers and have never cut dividends during a modern hiking cycle, but avoiding a cut is not the same as posting a gain.

Banks do benefit from higher rates. They benefit until the economy they lend into stops growing, or until the provisions required to cover distressed borrowers erase the margin they gained. The stock market prices in both halves of that trade, which is why the share price often falls even when the bank's quarterly earnings look strong.