Key Takeaways
- The big banks’ capital markets and investment banking businesses have been a source of strength in the third quarter, a Morningstar analyst says.
- The financial services sector has become overvalued, by Morningstar’s measure.
- Banks with relatively larger US investment banking exposure benefit from strong IPO activity.
Canadian banks head into their third-quarter earnings this week against a sharply altered backdrop. US-Canada trade negotiations broke down on Friday, and the threat of new tariffs has escalated.
Morningstar analyst Maoyuan Chen says the impact of this will depend on the length and extent of tariffs. “A prolonged and severe tariff will create credit cost headwinds and growth headwinds for the Canadian banks,” she says, adding that leading banks’ balance sheets are strong enough to absorb potential higher credit costs. Meanwhile, she cautions that despite a strong earnings picture (especially for the banks with the most exposure to US markets), investors may be expecting too much from the sector.
Amid geopolitical turmoil and macroeconomic uncertainty, banking and financial services have been a primary engine driving the broader Canadian stock market rally in 2026. The Morningstar Canada Financial Services Target Market Exposure Index has gained 20% this year through Aug. 19, outperforming the broader Morningstar Canada Index’s nearly 15% advance.
Canada’s biggest banks—Royal Bank of Canada RY, Toronto-Dominion Bank TD, Bank of Montreal BMO, Canadian Imperial Bank of Commerce CM, National Bank of Canada NA, and Bank of Nova Scotia BNS—collectively hold more than 90% of the nation’s banking deposits. TD, Royal Bank, and CIBC are more retail-focused, while BMO holds a strong position in domestic commercial lending. Scotiabank is Canada’s most international bank, with over 40% of its revenue derived from operations outside the country. With 81% of its revenue generated domestically, National Bank is the most Canadian-focused of the Big Six.
A Bank of Canada report says the six are well-positioned to continue supporting the economy. Still, Chen takes a cautious view of the sector, particularly concerning whether recent strength in the wealth management and capital markets businesses is sustainable.
Capital Markets Could Provide a Lift
Capital markets services will be a major area to watch, owing to moves in stock, currency, and derivatives markets. Trading income—what a bank earns from its capital markets trading desks—is typically weaker in the May-to-July quarter. But Chen says, “US large banks reported strong earnings in their second quarter [April to June], so I would not be surprised if Canadian banks deliver a strong third quarter.”
In particular, Chen says investment banking fees should be healthy for Canadian banks with US operations, citing strong initial public offerings and merger and acquisition activity that boosted US banks in the second quarter. “Canadian banks with material US exposure like RBC, TD, BMO, and CIBC should do well relative to their Canadian peers,” she says.
Chen notes that RBC was the only Canadian bank with exposure to the high-profile SpaceX SPCX IPO underwriting. RBC Capital Markets was a joint bookrunner on SpaceX’s USD 75 billion IPO on June 12. Meanwhile, all six banks participated in the high-profile June IPO of Apotex Health APTX, valued at C$1.3 billion.
Chen says the Canadian IPO market is strong but relatively modest and heavily concentrated. Meanwhile, the US IPO market is fueled by artificial intelligence businesses and is poised to see 2026 become its second-strongest calendar year after 2021. “I expect RBC, TD, and BMO to benefit more from the strong US IPO market in 2026, as these three have relatively larger US investment banking exposure,” she says.
Credit Performance to Shed Light on Consumers
Chen will also focus on credit performance, especially around the overall health of Canadian consumers. She will look for “any new pockets of weakness in the unsecured consumer lending portfolio.”
Chen expects Canadian banks’ credit costs (the capital banks lose from loan defaults) to peak in financial year 2026. She forecasts the net write-off ratio (the percentage of total loans a bank gives up on collecting when borrowers can’t repay) to increase by 6 basis points to 0.41% before improving in 2027.
Bank-Specific Catalysts to Watch
Chen is also observing how each of the big banks deals with specific headwinds. She is interested in how RBC and BMO plan to allocate the proceeds from the C$2 billion sale of their joint venture Moneris, a Canadian merchant processing business. “I would watch for the two banks’ plan for capital deployment and their overall strategy update for the domestic payment business,” she says.
For TD, the focus will include an update on its US retail banking business’s anti-money laundering regulatory issue and any potential 2027 expense guidance. And Scotiabank’s international turnaround progress will be of particular interest, since “the bank’s international banking segment’s loan balances have been declining amid its optimization efforts,” Chen says. Segment loan balances were down 12% compared with two years ago in the second quarter.
Strong Rally Raises Valuation Questions
After the recent runup in bank stocks, valuations have become stretched. Chen cautions: “I view the sector as overvalued, with the Big Six trading around 22% above their fair value estimates on average.”
At its current market price of C$240.23, BMO stock is trading at a 21% premium to its fair value estimate of C$197.00 per share, as of Aug. 21. Similarly, TD Bank is trading at a 19% premium to its fair value estimate, while Canada’s largest lender, RBC, is trading at a 21% premium.
“While the capital markets and wealth management businesses have been doing really well in the past several quarters, I still think the market is over-extrapolating the short-term strength,” Chen says. She adds that the market’s implied forward price/earnings multiple is exaggerated. Her valuation forecast for the Big Six banks implies an average 2027 price/earnings multiple of 13.1 times—7% lower than the market’s implied earnings multiple of 14.2 times.
Scotiabank and BMO will kick off the banks’ third-quarter earnings week on Tuesday. National Bank will post its earnings report on Wednesday. RBC, TD, and CIBC will wrap up the week with their results on Thursday.
