Eyeing the Canadian banking system

The Toronto Stock Exchange was heavy with investors. On June 2, shares of Toronto-Dominion Bank (TD Bank) rose 1% to C$57.26, while Royal Bank of Canada (RBC) shares were up 0.6% at C$44.92.

Similarly, financial shares in the Standard & Poor’s/TSX Banks Index rose 2.6% after the results were announced. The index has gained 23% this year. By contrast, US banks and institutions in the capitalization-weighted KBW Bank Index (BKX) dropped 17%.

Bank of Montreal posted an increase in market cap from 1Q09 to 2Q09, from C$17.9 billion to C$21.5 billion, respectively. Despite the increase from quarter to quarter, the bank’s overall market cap decreased by roughly C$4 billion from April 30, 2008 reports.

Royal Bank of Canada (RBC) was the last major Canadian bank to report. While the results were not as bad as some of its US counterparts, the financial institution did exhibit some signs of mortality, posting its first loss since 1993 on a C$1-billion goodwill writedown. The goodwill impairment was announced on April 16. Speaking on the charge at the 2Q09 results conference call, Gordon M. Nixon, RBC’s president and CEO, said, “The charge is a non-cash item and does not affect our cash net income, our ongoing business operations or our capital ratios. Our cash net income was approximately $1 billion this quarter, which is up 4% from last year.”

Largely thanks to the company’s Capital Markets segment, overall operating profit was up 25% quarter-over-quarter. The company took large losses from its US bank subsidiary, RBC Bank, yet still posted an increase in market cap from 1Q09 to 2Q09 from C$42.8 billion to C$59.6 billion.

Bumps like these have yet to deter those looking to Canada for opportunities. Industrial & Commercial Bank of China Ltd. (ICBC), the world’s largest by market value, recently agreed to buy a 70% stake in Bank of East Asia Ltd.’s Canadian unit for C$80.3 million (US$72 million).

Chairman Jiang Jianqing said the purchase “will enable ICBC to establish its banking business and customer base in Canada, which will provide a strong platform to further expand our businesses and network across North America.” Bank of East Asia Canada held assets of roughly C$556 million and deposits nearing C$482 million at the end of 2008. The bank offers consumer and business banking with branches in Vancouver and Toronto.

Building blocks of Canadian banking

So what is it that has offered Canadian banks such a cushion in these tumultuous times? It seems the differences lie in the nation’s historically conservative nature. While the nation itself still faces a recession and a four-year high jobless rate, practices long described as ‘stodgy’ appear to have saved its banking industry from some of the hardships facing the rest of the world.

Conservative lending practices

Canada has a long history of conservative lending practices. Canada’s banking regulator says institutions can lend as much as 20 times their capital base. According to Bank of Canada data released in December, European bank non-risk weighted assets were more than 30 times capital, while that ratio for UK banks and US investment banks was above 25.

The lending approach of Canadian banks as a whole can safely be compared to comments made by TD Bank Financial Group’s president and CEO, Ed Clark. “On lending we have a simple approach – don’t make bad loans in good times, but continue to make good loans in bad times. So while we are expecting to have an increase in loan losses, we will continue to be a positive outlier and gain market share. We have the capacity to do this because we didn’t make the kind of bad loans others did during the good times.”

It’s no secret that the economic meltdown started with banks lending money to homebuyers with low credit scores. While Canada was not immune to the practice – derivatives trading was packaged and marketed throughout the world – a recent look showed subprime loans accounted for just 5% of loans. In the US, independent mortgage brokers and lenders were in direct competition for business with commercial banks. The call to high-risk borrowers resulted in subprime loans of roughly 20%.

“Canadian banks have largely avoided the US subprime mortgage market and highly leveraged (LBO) market. Consequently, the Canadian banks have had comparatively modest loan losses compared to their US peers,” noted Adam Waterous, head of investment banking for Scotia Capital.

High Tier 1 capital ratios

Another tell-tale factor in the health of banking institutions is the level of capital reserves. Tier 1 capital (common shares, retained earnings and non-cumulative preferred shares) to risk-adjusted assets is a Canadian measure comparable to a stress testing measure used by the US Federal Reserve for US banks in determining capital adequacy.

Average Tier 1 capital for Canadian banks sits at roughly 9.8%. That number is almost 3% higher than the 7% required by Canada’s federal bank regulator. In the US, the average capital ratio of commercial banks is 6%. US investment banks are, on average, significantly lower at roughly 4%. Even lower on the scale are European commercial banks with an average capital ratio of 3.3%.

RBC ended the second quarter with a Tier 1 ratio of 11.4%, up from 10.6% from the first quarter, with a tangible common equity ratio of 7.9%. “Over the past two quarters, we have grown our Tier 1 ratio from 9%, which was among the lowest of our Canadian peers, to its current level, which places us among the highest of our peers,” said RBC’s Nixon.

TD Bank ended the quarter with a Tier 1 ratio of 10.9%, up from 10.1% at Q1. The bank estimates about 75% of which is in tangible common equity - a measure it says illustrates the high quality of its capital base. Colleen Johnston, TD Bank Financial Group’s CFO noted the bank’s risk-weighted assets fell by $12 billion in the second quarter. “Our risk-weighted assets as a percentage of total assets is 35%, better than the peer average in Canada and much better than the US banks,” she said.

Bank of Montreal’s Tier 1 capital ratio is up to 10.7% in 2Q09 from 10.21% in 1Q09. A year ago, the bank’s Tier 1 capital ratio stood at 9.42%.

Strict banking regulations

Another factor that comes into play is the stock market crash of 1987. Following the fall, Ottawa began to allow commercials banks to acquire investment dealers. The Big 5 Canadian commercial banks all own investment banks. “Consequently, the major Canadian investment banks fall under the tight Canadian bank regulations,” explained Waterous. Historically, in the US, investment dealers have only been subject to supervision from the Securities and Exchange Commission.

Some of that is changing, at least in the short-term, as more US companies have become subject to US Federal Reserve supervision.

Since the economic crisis started, American taxpayers have provided hundreds of billions of dollars to bail out hundreds of companies. According to the Treasury Department, more than 600 banks took TARP money. Bank of America took $45 billion, Bank of New York Mellon $3 billion, BB&T $3.1 billion, Goldman Sachs $10 billion, JP Morgan $25 billion, KeyCorp $2.5 billion, Morgan Stanley $10 billion, SunTrust $4.9 billion, and US Bancorp $6.6 billion, among others.

In contrast, no Canadian banks have been bailed out by the Canadian government. The only government support has come in the form of a pledge to purchase up to C$125 billion in mortgages, if needed, to allow the banks to continue to lend. Again, the subprime mess did leave a thumbprint in Canada and the nation did make bad investment decisions like so many others.

Toronto-based CIBC charged $3.5 billion against the US subprime ordeal. As a result, federal regulators looked into the matter. The bank quickly sold shares to the tune of $2.94 billion in to improve its capital reserves. What appears to be a differentiating factor between Canada and the US is the relationship between government and banks.

Not long after TARP money was disseminated, US banks grew increasingly uncomfortable with the additional rules and regulations that were tied in. Treasury Department data cites roughly 20 companies that have raised enough capital to pay back the government – and many others are following suit.

Lenders are poised to show Washington they can function without government support. But first, they’ll have to adhere to a few more stipulations. Banks hoping to repay TARP money must show an ability to access public equity markets, sell long-term debt without government backing, lend sufficiently, meet their funding obligations, and support their subsidiaries.

JPMorgan Chase & Co., Morgan Stanley, and American Express Co. have each sold stock to shore up capital; $5 billion, $2.2 billion, and $500 million, respectively. The US’ largest bank, Bank of America, has reportedly raised $33 billion since early May.

Canadian expansion

Despite mostly positive 2Q09 results for the Canadian banks, there is still speculation that the bottom hasn’t hit Canada - the country was hit with the recession after the US. However, the “slow and steady” pace of the Canadian banking system seems sufficient to continue its expansion into the US market.

TD Bank’s expansion began years ago. Two major acquisitions in the northeastern US, that of Banknorth and Commerce Bancorp Inc. have occurred since 2004. Gaining market share by acquiring troubled banks in areas where they’ve already set up shop just seems to make sense, hence the speculation that the banking giant has been eyeing Coral Gables, Fla.-based BankUnited Financial Corp.

The bank has been tight lipped about specific deals, noting that asset values are too clouded to buy a bank outright at this stage. When asked about further expansion in the US during the Q&A session of the 2Q09 results call, TD Bank’s Clark commented on the ‘productive and open’ discussions with US regulatory authorities, and stated that if a potential deal “fits our strategic map and we are confident that it’s shareholder friendly, then we would definitely look at something. But it’s really dependent on events that are outside our control.”

Conclusion

While these steady advancements place Canadian banks in a now-envied position, there are always two sides to every coin. Some in Canada say the system results in high interest rates, a failure to provide sufficient credit, less innovation, and makes Canadian banks less competitive than American banks. Not long ago, when the price of oil soared above $100 a barrel and the economy was on cloud nine, regulatory controls prevented Canadian banks from merging into international players. In hindsight, the conservative Canadian way may have just saved them.