A credit cycle refers to a period where borrowing increases due to low interest rates, easy borrowing, and rising asset values. This is followed by a period where asset values fall, interest rates rise, and borrowing decreases. Currently, Canadian households are in a historic period of debt accumulation, and, like all periods of debt accumulation, it will eventually come to an end.

The household debt-to-income ratio recently came in at 165%, which is one of the highest in the developed world, and it has been on a steady upward trajectory for the past 25 years. In 1990 the ratio was 84%. In addition this, private sector non-financial debt to GDP has increased more since 2005 than it did during the prior 40 years.

This means that as the U.S. consumer saw their debt levels fall rapidly after the financial crisis, Canadians continued to add to debt levels, and this was supported by rising home values and the continuation of the massive bubble in commodity prices that began in the early 2000s.

The end of this period of rapid leveraging, however, seems to be in sight. High debt levels among households puts limitations on the ability to accumulate debt, and future interest rate hikes will put stress on borrowers. In addition, rising real estate prices will begin to dampen demand, and an inevitable pullback in real estate prices will both slow credit growth and increase unemployment.

What this means for Toronto-Dominion Bank

This back story is important because previous credit cycles have resulted in major cost increases to Canadian banks. These increases come in the form of provision for credit losses (PCLs), which are a deduction from revenue and therefore reduce a bank’s earnings.

PCLs are reported as a percentage of total loans outstanding, and for Toronto-Dominion Bank (TSX:TD)(NYSE:TD), 2015 PCLs were 0.32%. Historically, these are some of the lowest levels TD (and all Canadian banks) have ever reported.

PCLs have been on a steady decline since the peak of the previous credit cycle in 2009 and are likely to rise from the current historically low levels. How high could they go? For all Canadian banks, PCLs peaked during the previous credit cycle in 2009 at around 0.8%, in the early 2000s, they peaked at around 0.87%, and in the early 90s they peaked at around 1.6%, according to research by Credit Suisse.

TD’s peak PCL since 1990 was a huge 2.41%, and the average historical PCL for all banks since the 1970s is 0.72%. In other words, history says PCLs could rise substantially, and if they do, TD could see a major hit to earnings as more PCLs mean less earnings.

Where will PCLs for TD end up for this credit cycle?

PCLs rising well above 1% for TD would not only result in an earnings declines, but would also see TD’s capital ratios fall. Fortunately, some analysts see this as an unlikely scenario.

This is because over time, TD has gradually reduced its exposure to credit as its business mix has moved away from credit businesses and towards wealth management and capital markets. In addition to this, TD has also grown its U.S. exposure. This diversification means that TD is less exposed to Canadian credit than ever before and is therefore unlikely to see PCLs spike above 1% as they have in the past.

A report by Credit Suisse estimates that in a worst-case situation that involves a recession, TD’s PCLs in 2017 would rise to 0.61%. This is likely low considering the report was published in October 2015, and Credit Suisse estimated at the time 2016 PCLs would be 0.35% (TD recently stated they would likely be 0.45%).

Using the same growth rate from Credit Suisse’s 2016 PCLs to 2017’s recession PCLs and applying that to TD’s estimated 2016 PCLs of 0.45% would lead to a worst-case scenario of 0.7% for 2017.

While this is a major increase from 2015’s PCLs, TD has the earnings power to absorb it with $8.5 billion of operating net income in 2015 (the rise in PCLs would cost about $2 billion). Revenue growth would absorb some of these losses, but TD shares would likely see some downside as the market reacts to reduced earnings growth.

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