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Nobody wants to say it will happen, because it probably won’t. But given what we’ve seen in the U.S. banking sector and elsewhere in the world, the prospect of dividend cuts for Canadian banks continue to weigh on investors minds as the economic uncertainty persists.

Plunging share prices have pushed dividend yields for Canadian bank stocks to their highest level in 24 years. At 6.8%, the last time they were this high was in June 1984, when yields climbed to 7.0%. However, bond yields were 13.8% back then, versus just 2.9% today.

So while the Big 5 Canadian banks have not made a dividend cut since World War II in 1942 and before that the Great Depression in the 1930s, climbing yields have looking at what might force them to make such reductions.

UBS analyst Peter Rozenberg continues to project surplus capital generation even with peak provisions for credit losses (PCLs). However, he thinks an extended period of very low earnings or unexpected government intervention could have a negative impact on dividends.

A weaker economy could push PCLs higher than expected. Assuming they climb to a similar level to the 1992 peak, which Mr. Rozenberg does not expect, profits could decline an estimated 27% to 33%. This would result in “moderately high” dividend payouts of 76% versus 52% currently. Banks target a range of 40% to 50%.

However, the analyst said historically low corporate leverage, average consumer debt service and lower exposure for both the sector and individual names, make peak PCLs unlikely.

Current dividend payouts combined with a 10.1% Tier 1 capital ratio suggest lower dividends are not on the horizon, Mr. Rozenberg told clients. However, higher potential payouts mean the risk remains.

He suggested that Toronto-Dominion Bank (NYSE:TD) appears to be least vulnerable to a dividend cut and Bank of Montreal (NYSE:BMO) the most at risk. Meanwhile, Mr. Rozenberg does not anticipate any dividend increases in fiscal 2009.

The analyst said:

Concerns regarding higher PCLs and implied equity dilution continue to weigh on global sector valuations. However, we think valuations reflect peak PCLs and we continue to expect Canadian banks to outperform.

Source: Canadian Bank Dividend Cuts Possible but Unlikely - UBS