The Possible Economic Impact From Prolonged Tariffs

S&P Global Ratings Economics believes that broad-based 25% tariffs that persist through the end of the year could lead to stagflation for the Canadian economy. In such a scenario, 2025 GDP growth would be materially lower than the previous baseline forecast (we expect GDP to deviate by 1.3% in 2025 compared with our previous baseline), due to a hit to exports, purchasing power of Canadian households, and erosion of investment outlays (see "Growth Prospects Strained After The U.S. Takes The Tariff Plunge," published March 5, 2025, on RatingsDirect).

Although the U.S. economy also would be affected by tariffs, the impact would likely be much smaller than in Canada. S&P Global Ratings Economics estimates that 2025 GDP growth will deviate by negative 0.3% relative to current expectations. We view the resulting slowdown to the Canadian economy as a key risk to the Canadian banking industry as stagnant GDP growth, rising unemployment, and higher inflation could result in a difficult operating environment with deteriorating credit conditions. However, we note that there is a high degree of unpredictability around policy implementation by the U.S. administration and possible responses--specifically with regard to tariffs--and the potential effect on economies, supply chains, and credit conditions around the world. As a result, our baseline forecasts carry a significant amount of uncertainty. Case in point: Just two days after the U.S. administration implemented tariffs on Canadian goods, it exempted auto parts and goods that are compliant with the United States-Mexico-Canada Agreement and subsequently provided another reprieve.

Chart 1

Canadian Banks' Revenue And Loan Diversity And Earnings Power Provide Buffers

Diversified loan books

The large Canadian banks enter this period of high uncertainty holding well-diversified loan books, by sector and type (chart 2), which should help them withstand pressure from tariffs. At first-quarter 2025, commercial and corporate loans accounted for about 32% of total loans and are further diversified by sector, many of which are not directly affected by the tariffs. In our view, this diversification should support credit quality. However, in a prolonged scenario where the Canadian economy slows meaningfully and unemployment rises, secondary effects likely will hit other commercial sectors, as well as retail lending, in particular unsecured consumer lending.

Chart 2

D-SIBs with the highest domestic exposure to Canada are likely to face greater stress than those with sizable diversification outside Canada (chart 3). Canadian loans as a percentage of total loans, consolidated for the six large banks, is high at above 70%. Nevertheless, while we expect that Canada will be hit harder, the U.S. economy is not immune to the fallout from tariffs.

Chart 3

Diversified revenue

Canadian banks benefit from meaningful revenue diversity generated by various business segments: personal banking, commercial banking, wealth management, corporate banking, and capital markets. Revenues are well balanced between net interest income and fee revenue sources (chart 4), but reliance on Canadian revenues remains high (chart 5).

Chart 4

Chart 5

We expect at least some variability in how each business segment will be hit by tariffs. Net interest income is likely to be constrained by lower loan volumes and a change in the rate trajectory assuming inflationary trends materialize, while possibly weaker equity markets could weigh on wealth management and investment banking fee income revenues generated in Canada. That said, we believe that banks with larger capital markets business should have an advantage. That's because greater volatility from the unsettled economic conditions could result in more trading activity, which would be a tailwind to trading revenues, and also because some of D-SIBs' investment banking activity is based on business outside of Canada.

We think some of the revenue headwinds from D-SIBs' business in Canada could be offset by increasing loans in the U.S., provided the U.S. economy maintains momentum.

Healthy coverage ratios

In the past year, coverage ratios have risen modestly and are higher than pre-pandemic levels (chart 6). This should help offset the likely decline in credit quality, although we think large Canadian banks will need to resume building their allowance.

Chart 6

Overall, We Expect Tariffs Will Constrain D-SIBs' Profits

So far in 2025, the threat of tariffs has already weighed on domestic business sentiment amid economic uncertainty. In a longer duration tariff scenario, we expect that banks' profits could be dampened/reduced through lower net interest income from shrinking loan growth, lower fee revenues, and higher provisions for credit losses (PCL). However, in our revised base case, the stress should be manageable.

Revised Base-Case Canadian Banking Sector Forecast For 2025

To reflect S&P Global Ratings Economics' new transitional baseline for the Canadian economy, we have revised our base-case forecast on the D-SIBs for 2025. We now incorporate the impact of tariffs in the second half of 2025 (given that tariffs were paused for goods compliant with the United States-Mexico-Canada Agreement until April 2, approximately two quarters of economic growth without tariffs will already be booked), and, of particular importance, our forecast doesn't include any possible offsets from the Canadian government. That said, given policy uncertainty, at this juncture our baseline forecast carries a significant amount of uncertainty.

In our new base case, we expect flat revenue growth year-over-year in 2025 as loan volumes increase only modestly compared with our previous projection of 6% growth, while net interest margins could be stressed from lower-than-expected Bank of Canada (BoC) policy rates. Our new base case also assumes strain on fee income from the banks' wealth management and investment banking businesses due to market pressure; however, we believe this could be partially offset by higher trading revenues.

In an extended tariff scenario, we expect that large banks will rein in expense growth, helping to offset some of the revenue pressures. Provisions for loan losses are the biggest wild card and we believe Canadian banks will likely increase the probability of a recession in their projections, but it's difficult to tell to what extent. Thus, there's a wide range of variability that depends on the duration of tariffs and the subsequent response from the Canadian government, and we provide scenario analysis given the variability of this key input item (see chart 9). In our revised base-case forecast, we project that in 2025, D-SIBs will raise provisions for loan losses, as a percentage of average gross loans, to modestly above 50 basis points (bps) (versus mid-40 bps in our previous forecast), with the bulk of the increase coming from higher-performing provisions, while nonperforming provisions could rise into 2026.

Overall, we expect that net income could fall from 2024 levels, with a return on equity between 8%-11% in our revised 2025 base case, versus 12% in 2024. That said, the high degree of uncertainty could lead to a variety of outcomes, and we'll continue to revise our forecast as the situation evolves.

Chart 7

As of first-quarter 2025, the average Common Equity Tier 1 (CET1) ratio for D-SIBs was 13.3%, well above the 11.5% regulatory minimum set by the Office of the Superintendent of Financial Institutions (OSFI). A period of extended tariffs could generate some headwinds, although we continue to expect D-SIBs' capital ratios would remain well above regulatory minimum requirements, particularly if banks pare back share repurchases given the uncertainty of the Canadian economy. Of note during the pandemic, bank capital levels were hurt by credit migrations early on, yet even under such stress, banks maintained a cushion well above the regulatory minimum (chart 8) and average CET1 increased for much of the shutdown, helped by the economic support of the Canadian government.

Chart 8

Stress Testing Canadian Banks' Profits Through Scenario Analysis

Given that the duration of tariffs and their impact on the Canadian economy remain unknown, we ran a simple scenario analysis in which we applied various levels of provisioning to the forecast 2025 pre-provision net revenue (PPNR) of the six large Canadian banks. For example, using our new lower PPNR base for 2025 and higher provision assumptions, in our scenario analysis we raised our forecast provisions in increments of 25% up to a level 100%, to see their associated impact on profitability (chart 9).

A 100% increase to provisions for loan losses from the base-case scenario implies provisioning above 100 bps. Were it to materialize, the PCL ratio for the six large Canadian banks would exceed the 74 bps of provisions recorded on average in 2020 in response to the pandemic-related shutdown.

But even if provisions were to rise by a conservative estimate of 100% above our base case, D-SIBs remain profitable, with the increase in provisions affecting just above 50% of PPNR.

We expect the outcome would differ by bank due to variations in their business mix. Nor does our scenario incorporate any likely offset the Canadian government and regulators may consider in such circumstances.

Chart 9

Potential Countermeasures From The Federal Government And Prudential Regulator

Our stress scenario does not incorporate any potential benefit from the Canadian government, which we believe could step in to provide targeted relief to businesses hit by tariffs (for example, through a remission process that provides relief from the payment of tariffs on U.S. goods). Although there's historical precedent that may suggest such actions could be forthcoming, the precise playbook under a prolonged tariff scenario would be differentiated from previous periods of stress.

For example, during the pandemic, the Canadian government moved quickly to provide relief to households and small businesses through the Canada Emergency Response Benefit and Canada Emergency Business Account programs. It worked with the BoC to enact lending facility enhancements to ensure liquidity, in addition to the BoC implementing quantitative easing.

OSFI could also act to buttress the economy, allowing the banks more space to lend to households and businesses. In March 2020, OSFI reduced the domestic stability buffer (DSB) in response to the difficulties brought on by the pandemic. The DSB currently sits at 3.5% and so there remains room to maneuver with the banks having built sufficient levels of capital.

Our Outlooks On The D-SIBs Remain Stable

Our outlooks on the D-SIBs, and the trends on our Banking Industry Country Risk Assessment on Canada, which provides the anchor for our bank ratings, remain stable. We believe Canadian banks are entering this uncertain economic environment from a position of strength, with relatively high levels of capital and robust earnings. We'll continue to monitor the situation as new details emerge and could take rating actions if individual banks are affected more than others, based on peer relativities.

Related Research

• Growth Prospects Strained After The U.S. Takes The Tariff Plunge, March, 5, 2025
• Macro Effects Of Proposed U.S. Tariffs Are Negative All-Around, Feb. 6, 2025
• Which Sectors Would Be Most Vulnerable To U.S. Tariffs On Canada And Mexico?, Jan. 30, 2025
• Canadian D-SIBs’ Outlook 2025, Jan. 22, 2025
• Banking Industry Country Risk Assessment: Canada, Dec. 13, 2024