Canadian Bank Earnings and Valuation Outlook for Q3 2025: Navigating Credit Risk, NIM Expansion, and Capital Dynamics

The Canadian banking sector has long been a cornerstone of the country's financial stability, but Q3 2025 presents a complex landscape shaped by global trade tensions, shifting interest rates, and evolving credit risk profiles. For investors, understanding how these dynamics intersect with net interest margin (NIM) expansion and regulatory capital strength is critical to identifying undervalued opportunities.

Credit Risk: A Controlled but Uneven Picture

Canadian banks have maintained historically low non-performing loan (NPL) ratios and charge-off rates, even as global trade wars and domestic economic headwinds create uncertainty. As of Q3 2025, NPLs remain below 1% of total loans, with large banks reporting a 26% increase in credit loss provisions since 2023. Medium-sized banks, however, have seen sharper rises in impairments, particularly in business and mortgage lending, due to concentrated regional exposures.

The Bank of Canada's stress tests confirm that even under a severe recession scenario—featuring a 5.1% GDP contraction and 9.2% unemployment—large banks would remain solvent. This resilience is underpinned by CET1 capital ratios averaging 13.3%, well above regulatory minimums. For investors, this suggests that while credit risk is not negligible, the sector's buffers are robust enough to absorb shocks without triggering widespread defaults.

NIM Expansion: A Tailwind for Earnings

Net interest margins (NIMs) have emerged as a key driver of earnings growth in Q3 2025. Analysts like Gabriel Dechaine of National Bank Financial highlight a 2 basis point sequential NIM expansion in Q2, driven by higher securities reinvestment yields and a slowdown in low-margin mortgage origination. Favorable deposit inflows have further reduced funding costs, allowing banks to widen margins.

This NIM tailwind has prompted upward revisions to earnings forecasts. For example, Royal Bank of Canada (RBC) and Bank of Montreal (BMO) are benefiting from stronger trading revenue and improved loan mix, while Toronto-Dominion Bank (TD) faces headwinds from U.S. dollar translation losses. Investors should focus on banks with the most favorable NIM trajectories, such as BMO (P/E 12.3, P/B 1.2) and CIBC (P/E 11.7, P/B 1.6), which balance margin expansion with disciplined cost management.

Regulatory Capital: A Buffer Against Volatility

Regulatory capital dynamics remain a critical factor in the sector's valuation. Large banks have built capital conservation buffers exceeding 200% of minimum requirements, ensuring they can sustain dividends and share buybacks even during downturns. For instance, TD's CET1 ratio has stabilized at 12.8%, while Scotiabank's stands at 12.4%, reflecting strong internal capital generation.

The sector's capital strength also supports strategic flexibility. Banks like National Bank of Canada (NA) (P/E 13.0, P/B 2.0) are leveraging excess capital for buybacks, while CIBC is prioritizing organic growth in capital markets. This duality—between capital preservation and growth—creates a spectrum of opportunities for investors seeking either income or appreciation.

Valuation Metrics: Identifying Undervalued Opportunities

The Big 6 banks trade at a range of valuations, offering diverse entry points. Toronto-Dominion Bank (TD) (P/E 9.8, P/B 1.4) and Scotiabank (BNS) (P/E 11.2, P/B 1.4) stand out for their low P/E ratios and high dividend yields (5.2% and 5.3%, respectively), making them attractive to income-focused investors. Meanwhile, BMO (P/E 12.3, P/B 1.2) and CIBC (P/E 11.7, P/B 1.6) offer a balance of growth and stability, with BMO's 4.6% yield and CIBC's 13% ROE underscoring their competitive advantages.

However, investors should exercise caution with RBC (P/E 13.7, P/B 2.2) and National Bank of Canada (NA) (P/E 13.0, P/B 2.0), whose higher valuations reflect strong market confidence but leave less room for error in a downturn.

Strategic Recommendations

1. Income Investors: Prioritize TD and Scotiabank for their high yields and undervalued metrics.
2. Growth-Oriented Investors: Target BMO and CIBC for their NIM expansion and capital efficiency.
3. Conservative Investors: Allocate to RBC and National Bank of Canada for their scale and regulatory resilience, but monitor credit risk trends.

The Canadian banking sector's ability to navigate Q3 2025's challenges hinges on its capital strength, NIM flexibility, and disciplined credit management. While macroeconomic risks persist, the sector's fundamentals remain compelling for long-term investors willing to capitalize on its structural advantages.