As Canadian banks get set to announce their latest round of multibillion-dollar annual profits, their reputation around the world for health and stability has reached new heights. In a four-part series, we look at different views on how Canada's banks can turn domestic strength into international success.
Canada's banks have no need to worry that proposed regulatory changes will put them at a competitive disadvantage to their global peers, said the head of the country's banking regulator.
As Group of 20 nations move forward with proposed international rules for financial institutions, there is growing concern in this country that banks here could end up being unfairly hindered even though they mostly avoided becoming entangled in the financial crisis.
In comments to the media following an address, Julie Dickson, the Superintendent of Financial Institutions, said banks should not be concerned about that.
"When you talk about regulation you recognize it's a global industry and you are competing with banks in Spain, Europe, the U.S., where ever. From that perspective there should be some comfort that the playing field will be level," Ms. Dickson said. "I think we have to be more vigilant there because we thought the playing field was level going into this crisis and then we learned that actually the Canadian banks were more robust than others... partly due to regulation."
Ms. Dickson was speaking at a Women in Capital Markets luncheon.
Over the past year G20 countries have been working together to map out new rules for the international financial system to ensure the crisis is not repeated. However, many of the proposals such as those around executive compensation are highly contentious and the debate has opened up rifts between countries.
In Canada many industry insiders worry that institutions here could get saddled with a lot of costly new rules in the name of international solidarity, limiting their movement at their greatest moment of opportunity to grow internationally.
"Many, many regulatory changes are being discussed," Ms. Dickson said in her speech, adding that countries typically work together on regulations around issues such as capital levels and leverage ratios, leaving it up to each one individually to figure out how supervision will be done.
She said regulators in the United Kingdom have recently begun interviewing all proposed senior banking employees to determine whether the candidates are suitable.
Ms. Dickson said Canada would likely not be following suit with such an intrusive practice but she added that OSFI is re-evaluating its supervisory methods.
During the crisis it became clear that many institutions lacked the ability at the board level to understand some of the risks they were taking. Ms. Dickson said it is "an issue" that many bank boards lack experienced bankers.
Show us the money
Analysts say strong capital-markets profits, rising net interest margins and even some domestic loan growth will likely more than offset any damage from expected defaults.
Starting next week, Canada's big banks will report multibillion-dollar annual profits that are among their best ever.
It comes against the backdrop of a Canadian economy that has just experienced one of the worst 12-month stretches in its history. But while credit quality has been under stress from the aftermath of the global credit crisis, the banks are expected to add only modest growth in provisions for bad loans.
According to analysts' estimates, the big six Canadian banks will report net earnings for fiscal 2009 of about $15-billion, slightly behind the record haul they reported in fiscal 2007.
The biggest of them all, Royal Bank of Canada, could report net earnings for the year of more than $4-billion -- not bad when the rest of the economy is in the deep-freeze.
UBS analyst Peter Rozenberg predicts the main issue for the banks over the next few years will be what to do with the heap of excess capital they are sitting on, predicting it will grow to $40-billion by 2012.
The money will likely be used to "drive acquisitions, dividends and buy backs, however, we expect banks to remain cautions in the short term due to continued economic and regulatory risk," he said in a note to clients on Thursday.
RBC Capital Markets analyst Andre Hardy is calling for net earnings growth for the fourth quarter ranging from 15% for CIBC to 29% for National Bank of Canada.
Mr. Hardy's top picks are National Bank, owing to its almost complete lack of exposure to the U.S. and limited exposure to Ontario's struggling manufacturing sector.
Despite its focus in Ontario, TD "should continue to outperform its peers in both domestic and U.S. banking," he said, pointing to recent data is showing that the bank's U.S. loan losses are better than its competitors.
Of all the players, TD has the biggest retail operation in the U.S.
"Asset and revenue growth in both the Canadian and U.S. banking platforms have been solid and better than peers in recent quarters," Mr. Hardy said in a research note.
In the wake of the financial crisis the Big Six have benefitted from surprisingly strong trading revenues, but one of the biggest question marks going into the fourth quarter is whether that will continue.
Trading results are "difficult to predict at the best of times, and even more so now following three quarters of very strong performance," Mr. Hardy said.
With credit markets continuing to normalize after the crisis the big six are benefitting, especially as they move into the space left by the so called shadow banks that disappeared in the credit crunch.
According to Barclays Capital analyst John Aiken, CIBC is the "dark horse" of the fourth quarter after surprising the market with negative credit experience in the third quarter. Mr. Aiken suggested the poor results may have been a blip rather than the start of a new trend, providing "a reasonably solid likelihood that [CIBC] could report lower [credit losses], generating the possibility of a positive surprise."
In the coming year Mr. Aiken said U.S. exposure will continue to hamper Canadian banks as businesses and consumers struggle through an economy that is significantly more challenged than Canada's.
"We will be keeping a close eye on Bank of Montreal's credit trends as well as those of Bank of Nova Scotia, TD and Royal Bank," he said
Where to next?
Over the next three weeks, Canada’s major banks will post some of the biggest annual profits in their history.
And that comes on the heels of the worst financial crisis since the Great Depression; it’s as if the crisis never happened.
By almost every measure, the banks are at the top their game.
Their trading operations are spitting out eye-popping profit; their capital markets business is getting a major lift from the flood of bond issuance; even consumer loan growth is cranking ahead, albeit at a slower pace than before.
And it seems that not a month goes by that the Big Six aren’t singled out by some venerable institution for their robust risk management.
They are praised for not getting tangled up in risky credit derivatives or other subprime-linked investments that caused so much damage to their peers in New York and London.
First to sing their praise was the International Monetary Fund, which in 2008 declared Canadian banks the best in the world. Moody’s followed suit last month with a report naming Canadian banks as the world’s soundest, landing them at the top of the global ranking for the second year running.
So here’s the question:
Why don’t the banks take advantage of this once in a generation opportunity and go out and strut their stuff on the international scene and acquire some foreign banks?
After all, with so many former banking behemoths still struggling to recover from losses suffered during the crisis, the market is awash in cheap assets looking for new owners.
For years, industry insiders have complained about the lack of domestic growth opportunities and the declining size of Canadian banks relative to fast-growing players in the United States, Europe and Japan.
As an oligopoly, they have built a solid -- and clearly profitable -- business in Canada, but the market is saturated. Apart from a few remaining sectors that they don’t already control -- notably insurance there is nowhere for them to go.
“They’ve pretty much milked the cow dry. What else can they offer Canadians that they aren’t already offering?” said John Stephenson, a portfolio manager at First Asset Management in Toronto. “They’ve got great franchises, but very slow growth.”
Theoretically, the whole country could benefit if the banks went abroad. If these Canadian institutions were stronger globally, there would be less need for Ottawa to maintain laws that limit foreign competition.
Of course, with more competition, bank customers would get a better deal and everyone would be better off.
Larger domestic banks would also be able to offer a more comprehensive range of services to their corporate clients looking to establish internationally.
According to UBS analyst Peter Rozenberg, the Big Six -- Bank of Montreal, Royal Bank of Canada, Canadian Imperial Bank of Commerce, Bank of Nova Scotia, Toronto-Dominion Bank, National Bank of Canada -- are more than capable of doing some deals.
Thanks to huge issuance of new shares and various cost-cutting programs launched in the teeth of the crisis, they’re sitting on a massive pile of “excess capital.”
Mr. Rozenberg predicts their hoard will climb to a whopping $40-billion by 2012.
Even Steven Harper has taken up the rally cry, urging the banks to make good use of their comparative strength and expand abroad. “I hope our banks will see this as an opportunity to build the brand -- the country’s brand, their own brand -- and to expand their scope and profitability over time,” the Prime Minister told the Financial Times earlier this year.
But why should they go on risky ventures?
Sticking close to home certainly hasn’t hurt profitability. Despite the fact that virtually every inch of the domestic market has been claimed, it continues to be highly productive real estate, owing primarily to the lack of competition and the ability of banks to set their own fees.
Faced with growing public outrage over sky-high service fees and credit card rates, Jim Flaherty, the federal Finance Minister, has threatened to introduce new regulations to protect consumers from alleged gouging.
And one reason the capital markets business is so flush is because their biggest clients are in dire need of cash. Hammered by the freeze in credit markets, corporations across the country have been flooding the market with new debt issues -- and the banks are collecting the fees.
Still, they are waking up to the opportunities that have opened up outside of Canada.
Players such as RBC have been aggressively cherry picking from the ranks of struggling competitors. Back in January, BMO acquired AIG’s Canadian life insurance business for about $375-million, and CIBC is rumoured to be mulling over a stake in a troubled Irish bank.
TD reportedly kicked the tires at Washington Mutual, a large U.S. west coast bank that was eventually acquired by JPMorgan, while the other banks have also done some sniffing around.
One reason for not moving is they haven’t found anything with a price they are willing to pay.
“The question is, what are you buying? Because it’s easy to buy something that looks cheap but because so many of the liabilities are off-balance sheet no one knows what it’s really worth,” said Mr. Stephenson. “That’s the hard part. Are you taking a bunch of liabilities that are beyond your comprehension?”
The banks have their own explanations. “Significant opportunities” exist outside Canada, RBC chief executive Gord Nixon told an investor conference in September, emphasizing the bank’s expansionist ambitions.
But at the same time, he cautioned that any big acquisitions will likely take place after the recession has ended, when the bank has a better idea about the direction of the economy.
Mr. Nixon’s fellow bank CEOs have adopted much the same tone, insisting they are waiting for a chance to jump. But they know it won’t come until there is more certainty about the direction of the economy. Simply put, they don’t want to fork out billions of dollars of capital just as the business environment is cratering.
Then there are the proposed new financial regulations being mapped out by Canada and its G20 partners. While the timing is still up in the air, it is almost certain they will require banks to hold a lot more capital against potential losses and generally behave in a much more cautious way.
Given their already robust capital levels, Canada’s banks are unlikely to be penalized by the new system. But the future is far from certain, as the head of the federal banking regulator reminded us recently when she warned the banks to hang onto their capital until there is more clarity.
At the heart of the issue is how much the banks can afford to spend. If the new rules end up requiring the Big Six to hold more capital, it would mean they have less to spend on potential acquisitions.
RBC Capital Markets analyst Andre Hardy said in a research note last week he doesn’t anticipate there will be any clarity on the new rules until at least early 2010.
“While we believe that Canadian banks will likely remain in an excess regulatory capital position, even after OSFI revises capital rules, we struggle to quantify how much excess regulatory capital there might be,” he said.
Once all the questions around price and affordability have been resolved, there is the matter of risk. Despite all the bold pronouncements about “opportunities,” the banks are very wary of failure.
All have experimented with foreign acquisitions in the past but the majority of their experiences have been far from positive.
Bank of Montreal bought U.S.-based Harris Bankcorp nearly 30 years ago but it has struggled to build critical mass around its home base in Chicago and the operation remains only marginally successful.
Royal Bank started building its U.S. branch network around the start of the decade, focusing on the southeastern states such as North Carolina, Georgia, Alabama and Florida. But it’s been hammered by the real estate meltdown and the losses continue to pile up.
Toronto Dominion is the only one to make a go of its U.S. business, thanks largely to years of patience and focus, according to Mr. Stephenson.
“U.S. customers want service and they want value for money and TD has been able to deliver that,” he said. “There is a possibility that BMO might be able to do the same, but Harris has been losing money for years. Royal is doing its own thing with [its U.S. subsidiary] but I don’t think its a success.”
The main challenge south of the border is that the environment is completely different from Canada, with several thousand banks instead of a handful, and a much more political landscape where banks with the right connections are able to access government money while others can’t.
Perhaps the most successful international player is Scotiabank, which skipped the U.S. entirely in order to focus on South America and the Caribbean, where it has had operations going back more than 100 years.
In fact, there are very few banks in the world that are true global players, partly because each country has its own set of rules that tend to favour domestic players.
The right acquisition must be followed by decades of effort and patient investment, and that’s something Canadian banks have had a hard time doing, said Mr. Stephenson.
The Canadian banks are justifiably cautious about embarking on foreign adventures, but now is the time to get over their risk aversion and make a bet on the future. The domestic market is saturated and despite being highly profitable, there’s limited room for growth.
In the past, the Big Six have blamed their reluctance to expand internationally on a lack of resources, but the crisis has changed the game completely.
And the window of opportunity won’t stay open indefinitely.
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