A shoot-from-the-hip blogger raised eyebrows recently by casting doubt on Canadian banks. Pointing to a list of global lenders with the smallest tangible-capital ratios – a list on which all of our big banks appear prominently – the blog called Zero Hedge suggested that this country’s banks were in big trouble.
That seems highly unlikely, at least for the reason given. The tangible-common-equity ratio, which the blogger used to draw up his list, compares tangible assets (things such as loans, cash and buildings) to common shareholders’ equity. It’s a way of gauging how much debt a bank is carrying. The more debt, the easier it is to erase the company’s equity. The blogger’s point was that a smallish writeoff of 3 or 4 per cent of assets would wipe out shareholders.
There are many holes in this argument. One is the fact that this is really nothing new. All banks are highly leveraged and always have been. At any point a relatively small writedown of assets could destroy book equity – with an emphasis on “book.”
That points to another hole: Most excellent franchises trade at a big multiple to book value, however calculated. Coca-Cola does, as does Exxon Mobil, Apple, WD-40 (yes, the lubricant maker), and so on. Why? Because they have assets that don’t appear on their balance sheets such as name recognition, public trust and long-standing relations with vendors. If they could count these assets, their book equity or net worth would be substantially higher.
Our banks have off-balance-sheet assets, too. First, they’re an oligopoly. They won’t admit it but it’s true. They’re pretty friendly; they don’t compete too hard, as U.S. banks do. And they’re so big that, given the economies of scale in banking, they’ve built a protective moat around their businesses that exists almost nowhere else in the world.
Second, they enjoy a cozy relationship with the government. Ottawa has allowed the banks to expand into almost every non-lending financial business over the past three decades. The banks also get effective subsidies from Ottawa in the form of Canada Mortgage and Housing Corp., which insures risky mortgages and buys others. CMHC appears to make money but it’s basically backstopped by the taxpayer and it’s quite possible that if the housing market turns really ugly, the taxpayer will be forced to write a cheque.
In return, our banks tend to be more conservative. Why take big risks when you can make such good returns with mortgages? It’s not necessarily a bad system. Canadian banks fared well in the financial crisis, in part because they’re backstopped by assets that don’t appear on the balance sheet, such as 100-plus-year histories and enormous amounts of public trust.
Finally, there are technical issues with the argument, as colleague Boyd Erman pointed out on The Globe and Mail website. CIBC is highest on the Zero Hedge list, and thus the supposed riskiest, with a tangible-common-equity ratio of 2.8 per cent, which is indeed scary, especially given that we’re talking about the accident-prone CIBC. But the bank reports a tangible-common-equity ratio four times higher, which is very healthy. The difference comes down to details of how each calculates the ratio. The blogger treats all assets the same as far as their riskiness goes, while the bank adjusts them for risk.
The adjusted version, which regulators use, is the better way. You wouldn’t treat as equal two banks with the same ratio if one had assets consisting of only cash and the other had assets consisting of loans to Portuguese real estate developers.
Our banks will have some troubles, inevitably. The majority of their assets are connected to real estate and, when the average home in Vancouver costs $1-million and the economy is weak, you know there are defaults coming. No asset class goes up at three times the historic rate, as housing has for a decade, without correcting, usually sharply.
And banks have longer-term growth challenges, given how mature and saturated the marketplace is and also given how good they had it for the past two or three decades. Banks and their investors benefited mightily from a confluence of trends that won’t be repeated. You probably should moderate your expectations.
But it’s highly unlikely that there’s a monster shock lurking in the balance sheet that will wipe out shareholders. Canadians tend to pay their mortgages. If they don’t, the taxpayers will.
Fabrice Taylor publishes The President's Club investment newsletter, focusing on off-the-radar small to mid-cap companies trading at a discount to net asset value. His letter and The Globe and Mail have a distribution agreement. He can be reached at firstname.lastname@example.org.