Canadian banks need to be more transparent about their exposure to the oil patch

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During a conference call back in February, 2016, there was a terse exchange between a long-time analyst and executives at National Bank of Canada that typified how this country’s banking industry bungled investor relations during the last oil price rout.

Mario Mendonca, who covers banks for TD Securities, asked National Bank CEO Louis Vachon whether the Montreal-based bank was providing energy companies with covenant relief to avoid setting aside bigger provisions for impaired loans. At the time, there was rampant speculation that Canadian banks were under-reserved compared with their U.S. peers because executives were too sanguine about the outlook for loan losses. But instead of providing a straightforward answer, Mr. Vachon suggested Mr. Mendonca was getting his information from American short-sellers.

“It’s a simple question,” Mr. Mendonca retorted. “International investors have made that claim and I’m trying to test whether it’s a sensible claim or not.”

Four years later, crude oil prices are on another nosedive – this time amid a market meltdown fuelled by a Saudi-Russian production feud and worries about how the coronavirus pandemic will hurt the global economy. And once again, Canadian banks have been caught in the downdraft. With annual-meeting season just around the corner, you can bet investors will pepper bank executives with questions about energy loans, which collectively totalled $60.1-billion for the Big Six at the end of January.

This time around, however, executives would be wise to offer straight talk about the prospect for soured loans, because transparency is the only way to prevent more panic selling of Canadian bank stocks like we saw earlier this week. They can start by providing specifics about how they’ve stripped risk from their loan books in recent years and how they’re approaching their current borrowing-base redeterminations for energy companies.

During those biannual reviews (they take place each spring and fall), bankers sit down with energy company executives to assess the health of current loans and to decide how much credit to extend or cut going forward. Banks use what’s known in industry jargon as “price decks,” or oil-and-gas price forecasts, to determine the value of an energy company’s reserves, which act as collateral for loans.

When those commodity prices tumble, reserves are worth a heck of a lot less, and energy companies have a harder time repaying their debts. For those reasons, banks owe it to investors to provide consistent and comparable disclosures about their energy loans.

At present, banks provide varying degrees of detail about their oil price assumptions; their proportion of reserve-based loans; how much of their energy portfolios are investment grade; or if they plan to boost or reduce credit on an aggregate basis.

It’s largely a guessing game, which is why banking and securities regulators should create new standards so such disclosures are uniform across banks. After all, how can investors make informed decisions if there’s no way to make an apples-to-apples comparison?

Reserve-based lending was a sore spot during the last oil price swoon. Here in Canada, the Office of the Superintendent of Financial Institutions asked major banks to review their accounting practices to ensure they had set aside sufficient financial reserves, The Wall Street Journal reported in 2016.

Since that time, however, Canadian banks have adopted new accounting rules that force them to be more pro-active about setting aside money to cover expected loan losses. While that change ostensibly makes our financial system safer, it also makes bank earnings more volatile – which is exactly why executives need to be frank about how much red ink could spill over the coming months.

During the last oil price crash, some banks were better than others about keeping investors informed. CIBC CEO Victor Dodig, in particular, deserves kudos for being clear about the bank’s stress-testing assumptions in January, 2016. He made it a point to share that information even though the vast majority of CIBC’s energy loans were considered investment grade at the time. (As a reminder, he said that if West Texas Intermediate oil stayed at US$30 a barrel for three years, CIBC could lose as much as $650-million on a pretax basis.)

To put it differently, Mr. Dodig had the foresight and decency to be direct about CIBC’s worst-case scenario so investors could be confident the problem was entirely manageable for the bank.

With that in mind, banks need to be more pro-active with their communications from now on if they have any hope of calming nervous investors. Spin tactics that inadvertently provoke mistrust need to go. For instance, enough investors have caught on that when banks report energy loans as a percentage of their total loans, they’re trying to minimize their energy exposures because their loan books include large amounts of insured mortgages that are essentially risk-free, since they’re backstopped by Ottawa.

Similarly, executives should do away with the bafflegab on conference calls. Telling investors your bank is “staying close to your customers” is meaningless. Shareholders want specifics: Are you providing covenant relief to distressed energy borrowers? Are you converting their revolving credit lines into term loans?

Surely there’s a way to improve bank disclosures without sharing proprietary information. Canada needs strong banks and strong energy companies. Given the challenges facing both sectors, perpetuating an information vacuum this time around will only destroy credibility.