An Uncertain Outlook

Bank of Montreal (BMO) reported a mixed quarter in Q3-F20 marked by a rebound in capital ratios, lower deferred loan balances, and a build-up of provisions for credit losses (PCLs). Higher PCLs in Q3-F20 were largely driven by commercial impairments and provisions for performing loans. Loan losses for U.S. P&C banking increased in the quarter on higher impaired and performing PCLs. We remain cautious on BMO’s credit exposures largely due to a higher concentration in commercial lending coupled with headwinds for U.S. P&C banking and an uncertain economic outlook. 

We continue to recommend selling shares of BMO and have increased our valuation to $65.00 per share on a moderately lower run rate for PCLs in subsequent quarters due to a material build-up of performing loan provisions in Q3-F20. BMO’s loan portfolio remains skewed to commercial lending which we expect to face elevated credit risk as businesses navigate challenging economic conditions driven by COVID-19. We expect credit losses and impairments to peak in early FY21 as fiscal support measures are wound down along with loan deferral programs.

Need-to-Knows from Q3-F20

• Deferrals for commercial loans decline in the quarter while retail loan deferrals remain elevated: In Canadian P&C banking, ~12% of loans remain in deferral which marks a slight improvement versus ~14% in deferral for Q2-F20. The decline in deferrals was mainly driven by lower balances of commercial banking deferrals in Canada. However, deferrals for residential mortgages and credit cards increased in the quarter and remain elevated with ~14% of residential mortgages, ~5% of credit cards, and ~7% of other retail loans in Canadian P&C banking in deferral. Deferrals for U.S. P&C banking are more modest with US$1.7 billion of balances in deferral versus $29.4 billion for Canadian P&C banking.
• Performing loan PCLs remain elevated on credit risk driven by COVID-19: PCLs on performing loans remained elevated at $608 million or 51 bps, declining modestly from a performing PCL ratio of 59 bps in Q2-F20. Management attributed higher performing PCLs to several factors including changes in scenario weights with a higher weighting to the adverse scenario, a build-up of provisions to reflect risks related to COVID-19, and management overlay based on an in-depth analysis of credit exposures. Given challenging economic conditions, we remain cautious on credit losses in the near-term as the impending ‘deferral cliff’ is likely to drive elevated provisions from negative credit migration and higher loan impairments.
   
• Capital ratios bounce back on lower risk-weighted assets (RWAs) and higher internal capital generation: BMO’s CET1 ratio increased by 60 bps to 11.6% in Q3-F20. This increase was driven by several factors including internal capital generation (+14 bps), lower RWAs (+14 bps), share issuances (+6 bps), and a transitional addback of expected credit loss (ECL) provisions (+10 bps). RWAs declined on lower commercial loan balances and favourable foreign exchange movements which was partially offset by unfavourable credit migration. Although BMO’s current CET1 ratio is an adequate buffer over regulatory minimums, capital ratios are likely to be pressured in the near-term on higher RWAs and lower internal capital generation due to elevated credit risk.

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Adjusted Earnings Growth for Key
Amounts in millions of Canadian dollars except where noted