Trading strategy losses hurt banks’ capital markets profit

The capital markets divisions at the Bank of Montreal and the Royal Bank of Canada did little to prop up earnings this quarter, as losses due to market volatility overshadowed strong fixed income trading activity and debt underwriting.

Coming into the quarter, analysts were expecting high trading volumes to drive solid results. The hope was that capital markets could bolster earnings during an otherwise dismal quarter, as was the case last month at the large U.S. banks.

BMO came up short on Wednesday, reporting a $74-million net loss for its capital markets division for the three months ending April 30. RBC also reported worse-than-expected capital markets results on Wednesday, with net income from capital markets coming in at $105-million, down 86 per cent year-over-year.

The most significant factor putting pressure on capital markets earnings was a rise in provisions for credit losses related to corporate loans. However, both banks also faced significant headwinds due to wild market swings in March.

BMO in particular suffered significant losses related to certain trading strategies it uses to hedge structured products, such as equity-linked notes. As market volatility spiked and stocks dropped, the cost of hedging for these products skyrocketed.

Over the course of two weeks in mid-March, BMO saw six days of sizable trading losses, including a $180-million hit to trading revenue on March 20. These losses, combined with those related to other derivatives hedging strategies, led to a 22-per-cent drop in BMO’s Global Markets revenue in the quarter.

"These days coincided with [a] period of extreme volatility, historic price declines in equity markets,” Patrick Cronin, BMO’s chief risk officer, said on an analyst call on Wednesday.

“Although many parts of our trading businesses performed exceptionally well this quarter, a small number of specific segments saw elevated losses. These segments have been closely evaluated, and where appropriate, material risk-reduction actions have already been taken,” Mr. Cronin said.

The results at both banks compare negatively with the Bank of Nova Scotia and National Bank of Canada, which reported on Tuesday. Scotiabank’s global banking and markets division saw profits jump 25 per cent, while National managed to have flat net income for its capital markets, despite significant provisions, due to top line growth.

BMO’s results were “much worse than I would have expected, given what we saw from U.S. banks ... and given our view on what markets did during the quarter,” said Scott Chan, an analyst with Canaccord Genuity Group. RBC’s results were also “weaker than expected," he added.

BMO and RBC also suffered losses in their leveraged loan books. Both banks have an active leveraged loan business in the United States, where they originate loans for the purposes of leveraged buyouts, “warehouse” them, and sell them on later. While the loans are warehoused, the banks have to account for them on their own books, marking the value of the loans to market on a regular basis.

With fear roiling markets in March and early April, credit spreads on corporate debt widened significantly, and the value of the leveraged loans dropped. Both banks had to record losses when they marked the books to market in April.

“We are required ... to book a mark-to-market for the fact that the pricing range that we had indicated in the underwriting is now better than what the market will absorb, and so then we have to mark that to market for what we expect the market to absorb,” RBC chief financial officer Rod Bolger said in an interview.

These losses are not permanent, and because credit spreads have come in significantly over the past month, the value of the loan books will likely be marked up again in the coming quarters.

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