John Greenwood, Financial Post · Wednesday, Feb. 23, 2011

Canada's banks enjoyed a remarkably smooth ride in the two years since the financial crisis, with profits climbing to near-record levels, a tribute to their resourcefulness and diverse operations.

The impressive performance was partly a factor of opportunities created by the crisis, especially in currency and fixed-income trading, where players were able to exploit lack of competition. They were also held aloft by profits from plain vanilla domestic lending as consumers packed on debt to buy real estate.

But now that the financial industry is back on its feet, trading profits have fallen to more normal levels. Meanwhile, income from lending is expected to take a hit as Canadian consumers begin to pay down huge debts racked up over the past few years as they took advantage of low interest rates and soaring real estate.

Other headwinds are emerging in the form of new regulations covering everything from capital (banks need more of it) and activities in financial markets (increased scrutiny, potentially lower profit margins) to how much banks pay their executives.

Surprisingly, analysts are mostly optimistic about the coming first quarter, calling for higher earnings and possible dividend hikes.

"We believe bank fundamentals are strong and valuations are attractive," said Kevin Choquette, an analyst at Bank of Nova Scotia who is calling for profit growth of 3% compared to the previous year on the back of "solid" investment banking revenue and rising wealth management performance.

In investment banking, the results will be driven by strong underwriting and advisory revenue, partly offsetting lower trading activity, he said.

Mr. Choquette's top pick is Toronto-Dominion Bank and he has "outperform" ratings on Canadian Imperial Bank of Commerce and National Bank of Canada as well.

At the same time, retail banking is expected to moderate but will remain resilient.

CIBC World Markets analyst Rob Sedran is slightly more positive, pegging average first-quarter earnings growth at 4.3% as lenders benefit from continuing economic recovery.

The main catalysts: Lower losses from bad loans and reduced fixed expenses.

National Bank of Canada, the smallest of the big six, became the first to hike its dividend since the onset of the meltdown in 2008 at the end of the most recent quarter and many analysts predict others will follow suit, at some point, with much of the focus on Toronto Dominion Bank and Bank of Nova Scotia.

Among the most illuminating commentators is UBS analyst Peter Rozenberg.

In a note to clients earlier this month Mr. Rozenberg called attention to challenges facing the sector such as more stringent capital rules which "has really hurt returns." Nevertheless, banks will maintain their historic average return on equity of 16% -17% over the long term, based on continued strong performance from personal and commercial domestic banking.

Return on equity for domestic banking traditionally around 36% has always been a key driver and competitive advantage over foreign rivals.

According to Mr. Rozenberg, the business has helped players in this country outperform U.S. competitors and the S&P 500 over most of the last 20 years.

The business is as profitable as it is because of the lack of competition. Just six banks dominate the industry in this country compared to more than 5,000 players south of the border, with average return on equity of just 5%.

Based on projected return on equity, Mr. Rozenberg's top-rated banks are Royal Bank of Canada, CIBC and Scotia.