Buried in Royal Bank of Canada's quarterly results last month was a sense of the new normal at Canadian banks.
Royal Bank, proud owner of a retail profit machine, routinely set high performance standards, then beat those benchmarks.
Canada's largest bank targeted a 20 per cent return on equity - lofty by any measure - and far exceeded that goal by hitting a 24.6 per cent REO in 2007. Profit was to rise by between 7 and 10 per cent - again, stunning growth for a mature business. Royal Bank's earnings rose 17 per cent in 2007, and CEO Gord Nixon and his team made it look easy.
Obviously, it all came crashing down last year, which brings us to the new normal.
With credit markets in disarray and the economy topsy turvy, Royal Bank set out what it called "medium term objectives," performance standards for the next three to five years. The new ROE target is 18 per cent, while the benchmark for earnings growth is 7 per cent.
Mr. Nixon is, quite properly, managing down expectations.
And Royal Bank is simply being singled out here because it's the biggest of the bunch. Every Canadian bank CEO should be doing the same reality check at this year's annual meeting. The message for the bankers will be that the good times aren't coming back any time soon, if ever.
Clearly, what worked before for banks won't work any more. Consider just how crazy things got on Wall Street, where cheap credit and go-for-broke attitudes meant ever-increasing amounts of capital were deployed, with little regard for risk.
In 2003, coming out of a sobering tech wreck, Merrill Lynch had $18 of assets - investments in the market - for each $1 of shareholder equity. The ratio doubled by 2007, when Merill Lynch had $37 of assets for every $1 of equity. Unwinding all these positions has a lot to do with the woes of Merrill's new parent, Bank of America.
So leverage has to come down. That's all well and good. But leverage, in a bull market, translated into stellar profits for both Wall Streert investment dealers and Canadian banks.
The question going forward is just how to replace those profits. It's quite possible that Canadian bankers simply can't do it; that profit margins will contract, that earnings growth will slow from double to single digits, and the ROE will fall to something in the mid-teens.
It's that sense of a permanent downturn in the profitability of Canadian banks that weighs heavy on these stocks.