Rob Wessel is managing partner of Hamilton Capital, a Toronto-based fund manager specializing in financial services. An expanded version of this article and HCP Notes can be found at www.hamilton-capital.com.
The golden era for the Canadian banks is over.
This era, which began in the late 1980s with the banks' acquisition of the major broker-dealers and continued for two decades, saw Canadian bank stocks generate a total return of nearly 14 per cent annually. This is an astonishing achievement for a banking sector in a developed economy.
Not surprisingly, since this period overlaps the career of virtually all financial journalists, analysts and stock brokers, this exceptional performance has resulted in a near evangelical-like faith from investors, who have come to view this performance as normal. It is not.
Investors should understand that the outperformance over the past 20 years was driven by three important factors, all of which have largely passed.
First, a large decline in corporate tax rates in the past 20 years gave a lift to bank earnings. In the past decade alone, effective tax rates declined a huge 10 percentage points, providing a large amount of that period's earnings growth.
Given the surge in government deficits, further large tax cuts are unlikely.
Second, the banks have benefited from a highly favourable economic backdrop. Between 1990 and 2010, the Canadian prime rate declined by more than 10 percentage points, while inflation fell significantly. The result was a near-perfect environment for financial assets, pushing values for stocks and bonds ever higher.
Lower financing costs helped fuel growth, spurring consumer borrowing (arguably, to an excessive degree) and driving real estate prices higher, which reduced loan losses. This "virtuous circle" provided an exceptional backdrop for bank earnings.
Unfortunately, while the timing is uncertain, interest rates and inflation will eventually rise. This will not be positive for financial assets, and therefore bank profits.
Third, the banks benefited from regulatory changes that allowed them to acquire the broker-dealers in the late 1980s, and then the largest trust companies in the 1990s. This was arguably the greatest transformation in Canadian bank history: the sector evolved from "just banks" to extremely powerful financial conglomerates. Some investors forget that the banks' large and highly profitable investment banking and wealth management segments did not even exist in 1989. Today, they account for over one-third of earnings.
Empowered by the regulator, the Canadian banks have leveraged their massive size and distribution powers to dominate virtually all the financial services sector.
In investment banking, the banks tied various forms of lending products to their lucrative underwriting and advisory businesses, crowding out a bevy of independent brokers that lacked the ability to offer loans. Their huge branch networks allowed them to gain market share in the areas of financial advice and retail stock trading, as the banks were able to refer their customers to in-house investment advisers. Crucially, the banks also provided capital and low cost funding to their newly-acquired trading operations, allowing them to thrive.
The combined outcome was an explosion in trading and market-sensitive revenues, which grew by more than 15 per cent a year for two decades, and today are approximately 20 per cent of gross revenues. Although the process is not quite complete, the banks are also well on their way to dominating the domestic mutual fund business.
The impact of this consolidation on the Canadian competitive landscape has been dramatic - and not entirely positive.
So, going forward, what should investors expect? In the medium term, a slowdown in earnings growth to a far more "normal" rate of high single-digits.
The most important factor impacting incremental returns will almost certainly be the performance of banks' foreign subsidiaries.
It is not at all clear that investors appreciate the challenges that the shift in emphasis from domestic to foreign expansion will bring.
Foreign operations are, with rare exceptions, significantly less profitable than the domestic operations. Moreover, with each additional foreign acquisition, investors become less exposed to highly profitable domestic franchises.
Investors often ask why the Canadian banks' foreign platforms have not performed as well as their domestic operations. There is one big reason. In Canada, the banks are able to use their huge scale and distribution advantages to dominate the market. Outside Canada, this key success factor is almost always absent. In many instances, Canadian banks do not even hold top 10 market positions in the foreign markets in which they operate. And in markets where they are marginal competitors, performance has suffered.
Without question, the need to achieve scale outside Canada in a bank's chosen market is an important strategic challenge, and explains why the banks will continue to make acquisitions. It also explains the widely divergent strategies of TD and RBC in U.S. commercial banking.
The former has adopted a "go big or stay home" strategy, and has spent $17-billion in its successful quest to become a top 10 bank in the U.S. However, this pursuit of longer-term scale has come at a (hopefully short-term) cost - namely, lower returns on capital, earnings-per-share dilution and lower capital ratios. RBC, on the other hand, appears to have concluded (for now) that the costs and risks outweigh the potential future growth, and has instead preferred to build upon its other non-Canadian operations.
Foreign expansion also introduces meaningful regulatory risk that is new to Canadian bank investors. While the Canadian banks distinguished themselves during the recent crisis, most foreign banks did not, and are suffering an intense political backlash as a result. Regulatory risk is particularly acute in the U.S.
Canada is not immune to this trend. New international rules, known as Basel III, will significantly increase minimum regulatory capital requirements, which will reduce future returns on equity. More equity will also likely be required to finance future deals, increasing the costs of expansion. And, in the near term, investors should expect the Canadian banks to be conservative with respect to buybacks and dividends.
The Canadian banks are excellent companies that will continue to do well. They are well managed, and, as the most recent crisis highlighted, have a very resilient business model. But they will not have the same favourable tailwinds in the next five to 10 years that they had in the previous 20. The golden era has ended, and it will be remembered fondly.