Unemployment is soaring and doctors are worried the country will face a third wave of COVID-19, but you wouldn’t know it from watching the share prices of Canada’s Big Six banks.
Even though the lenders are deeply linked to the country’s wounded economy, their stocks have roared back to around pre-pandemic levels. Canadian Imperial Bank of Commerce is worth even more than it was before markets tanked last February.
How is that possible? There are many reasons, including unprecedented government stimulus and remarkable scientific breakthroughs on vaccines. But one structural variable often gets overlooked: Canada’s banks were built for this.
Over decades, the Big Six lenders have diversified their businesses, largely by building and acquiring capital-markets divisions and by beefing up their wealth management arms. Today they are something akin to oil tankers on open water – they may not move quickly, but they can make it through rough seas.
So if consumer borrowing slows and falling interest rates hurt loan margins, like last year, they have many other revenue streams to offset the hit.
Such expansion can be troublesome – the 2008 financial crisis proved that chasing growth in exotic businesses, or exotic countries, comes at a cost. But Canada’s banks have been relatively disciplined about their expansions of late. Crucially, they continue to prioritize their domestic personal- and commercial-banking franchises, which contributed an average 45 per cent of their combined $41-billion in profit last year.
This matters because Canadian personal and commercial banking delivers outsized returns on equity – averaging 24 per cent across the five biggest banks last year, more than double the average ROE for their entire operations. These divisions have sticky revenues, such as $15 monthly chequing-account charges and $120 annual credit-card fees, that serve as recurring income, even during an economic catastrophe.
This structural advantage was largely overlooked when stock markets fell off a cliff last February. Investors panicked when a large chunk of the economy ground to a standstill. For example, Toronto-Dominion Bank , the country’s largest lender by profit last year, watched its share price drop 35 per cent in four weeks.
But the free fall only lasted one month because unprecedented government stimulus helped to establish a floor for bank stocks. Then the Bank of Canada stepped in and stabilized credit markets by purchasing bonds. This kept yields low and allowed corporations to issue debt for cheap, instead of relying solely on bank credit lines.
From therem the banks’ diversity started to shine. Highly profitable credit-card lending shrank last year, with card balances dropping over the fiscal year as customers repaid debt, but wealth-management fees remained strong because stock markets soared in the back half of the fiscal year. Banks earn a fixed percentage of their assets under management.
Capital-markets divisions were also extremely busy, with revenues up 23 per cent on average across the Big Six in 2020. “In short, if capital markets hadn’t delivered robust revenue performance last year, there would have been no top-line growth across the industry,” National Bank Financial analyst Gabriel Dechaine wrote in a recent note to clients.
Diversity within capital markets itself played a powerful role. The Big Six investment dealers earn everything from derivatives-trading commissions to mergers-and-acquisitions advisory fees, and last year it was fixed-income trading that did the heavy lifting, with revenues jumping 67 per cent year-over-year to comprise three-quarters of Big Six capital-markets revenues – a proportion not seen since 2010, according to Mr. Dechaine.
Not to be overlooked, Canada’s banks have recalibrated their loan books over the years. Limiting exposure to any single industry, and to any single company, is one of the main reasons Canada’s lenders largely skated through the 2016 energy crisis when oil prices plummeted. There were loan losses, no doubt, but nothing like the telecom bust in 2002 when Toronto-Dominion Bank posted its first-ever – and only – full-year loss.
The same is true for the pandemic – at least so far. Bank of Montreal is known for being a commercial lender, yet at an investor conference in January, chief executive Darryl White stressed that the bank’s exposure to troubled industries such as tourism and airlines is limited to 5 per cent of its total loans.
Much of this prudence can be traced back to Ottawa’s banking watchdog, the Office of the Superintendent of Financial Institutions, which has long demanded conservatism. When many global banks were caught with hardly any capital backstopping their riskiest bets in 2008, Canada’s lenders were already subject to something known as the assets-to-capital multiple (ACM), which stated capital reserves could not be less than 5 per cent of assets.
Regulators have boosted capital requirements since, and Canada’s banks are now swimming in these reserves, at an average of 12.2 per cent of risk-weighted assets.
Because this backstop is so large – and still growing, despite the pandemic – investors aren’t worrying much about the banks absorbing their loan losses. At the same time, the value of residential mortgages with deferred payments has plummeted to a fraction of the amount requested when the pandemic erupted.
Because balance sheets look to be in such good shape, there is already speculation brewing that OSFI could soon let banks raise their dividends again.
This doesn’t mean Canada’s banks are immune to everything. They all continue to suffer from slim lending margins that are expected to persist for a few more years because both the Federal Reserve and the Bank of Canada have pledged to keep interest rates near zero until 2023. And many Canadians continue to carry elevated debt loads.
But the future for Canada’s economic recovery is looking bright, not bleak.
“The last 10 [economic] cycles over the last, what, 30, 40 years, have all been retail-led, consumer-led recoveries,” Royal Bank of Canada CEO Dave McKay told investors at a bank conference in January. During the current recession, Canada’s government stimulus has been so robust that consumers have been paying down debt and accumulating excess savings, which means they will be able to spend as the economy reopens.
“The consumer is in a very good position to lead this recovery,” Mr. McKay said – and much of their expected spending and borrowing will flow through the biggest lenders.
“We are bullish on the outlook for the Canadian banks,” BofA Securities analyst Ebrahim Poonawala wrote in a note to clients this month. “In the near term, economic recovery in North America should serve as a strong tailwind to drive revenue growth, lower credit costs and unlock excess capital.”
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