Don’t fear the banks

  By Guest Blogger Ryan Lewenza

Canadians have a strong love-hate relationship with their banks. It’s up there with the Toronto Maple Leafs and visits to the proctologist. The hate is particularly acute at the end of the month as we see our monthly bank charges, which only seem to go up, along with their profits. In the last quarter alone, the “Big 6” Canadian banks raked in over $10 billion in profit.

While rising bank fees and huge profits help to reinforce our resentment of the banks, we still deep (deep) down have a sense of nationalistic pride in our banks. And why not? Unlike many of their US and European peers, the Canadian banks did not need to be bailed out by the government during the financial crisis due to bad loans and being overleveraged. Despite this, there is a growing chorus of investors who believe the Canadian banks are heading for trouble. We disagree.

Readers of this blog know well our view of the Canadian housing market, and the significant risk we believe it poses to our economy. Given this view we are increasingly asked by readers and clients whether the Canadian banks are destined to decline like the US banks did following the collapse of their housing market in 2007/08. In fact, some investors are going one step further by shorting the banks in anticipation of steep price declines as the housing market bubble begins to unravel. We believe this view is misguided and misinformed. Here’s why.

First, we believe, like many other organizations, that the Canadian banks are the strongest in the world. According to Global Finance, an organization that ranks the world’s safest banks, five of the “Big 6” (TD, Royal Bank, Bank of Nova Scotia, CIBC and Bank of Montreal) rank in the top 50 of the safest global banks, with TD in the 10th spot and Royal Bank at 16.

The World Bank also sees the Canadian banks as the safest in the world citing: 1) the country’s stringent regulatory regime; 2) their reliance more on deposit funding versus debt or wholesale funding (this was a major factor in what brought down Lehman Brothers); 3) the banks are stable and well capitalized; and 4) as already mentioned, they did not require a government bailout. In our view, it’s hard to debate the strength and resiliency of our banks.

Second, the Canadian banking industry is highly concentrated and faces little competition, especially from foreign competitors. Let’s face it, the Canadian banks are an oligopoly. Sure competition is fierce among the major banks, but unlike in the US which has thousands of banks, the Canadian market is dominated by the “Big 6”. This provides a large moat around their businesses and profitability.

Third, the Canadian banks are well capitalized and conservatively run. Currently, the “Big 6” have Tier 1 capital ratios (a measure of a bank’s equity to its assets) of roughly 11%. By most global standards this is quite high, and is well above the minimum Tier 1 ratio requirements of 9.5%.

Even if they do face headwinds from an unwinding housing market, they have the balance sheet and capital to withstand it.

Fourth, the Canadian banks are very diversified both geographically and across their business units. Often investors just focus on the mortgage lending business, overlooking all the other business units which contribute to the bottom line. For example, all the major banks have multiple business units ranging from institutional (trading and investment banking), to wealth management (what we do), to insurance and credit cards etc. Moreover, following the financial crisis the Canadian banks used their strong capital position to make acquisitions, thus diversifying further into other areas.

For example, TD Bank acquired a few large US banks with BMO, and Royal Bank doing the same. Many are unaware of this, but TD Bank now has more bank branches in the US than they do in Canada. So, it’s important to look at the entire operations of the banks rather than just focusing on the mortgage lending arm.

Lastly, the Canadian banks have a long track record of performing well through challenging times. We’ve already mentioned how they performed during the financial crisis, but let’s look at a comparative period when the Canadian housing market went through a downturn. In the early 1990s the Toronto housing market endured a significant downturn, with prices declining roughly 40% in inflation adjusted terms from 1989 to 1996.

With Toronto being the biggest housing market in Canada, one would think that this would have negatively impacted Canadian bank share prices and earnings. However, over this period the S&P/TSX Bank Index rose 136% or 11% per year with bank earnings rising 75% from 1990 to 1996. Previously having worked for a large Canadian bank, and analyzing them for well over a decade, I have seen first-hand how they can navigate through difficult times and continue to earn incredible profits.

To be sure, Canadian banks could experience some weakness if the Canadian housing market really deteriorates over the next few years. But we believe they will be able to weather any storm and betting against them could prove to be a costly investing mistake. We’re happy to maintain our exposure in them through our ETF holdings, and continue to earn those juicy dividend yields.

Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.

Source: http://www.greaterfool.ca/2016/09/10/dont-fear-the-banks/