It's not a bad idea to test the common wisdom that Canadian banks are solid, but the result of the test is that yes, they are, National Bank Financial analyst Peter Routledge said in a note Monday.
The brouhaha that erupted Friday over a financial blogger's contention that the Canadian banks aren't as strong as they are portrayed prompted Mr. Routledge to have a look at the analysis done by zerohedge.com. Mr. Routledge concluded that the metric that Zero Hedge used -- the ratio of tangible common equity to total assets -- is flawed and that Zero Hedge also overlooked some other important factors.
"We find ourselves in the rather boring analytical position of having to defend the conventional wisdom that Canada's banking remains quite solvent and liquid," said Mr. Routledge." Yet, if the financial crisis taught us anything, it is to question critically and constantly conventional wisdom."
Zero Hedge set off the storm by generating a list of the big global banks with the lowest tangible common equity to total assets ratios. Canadian banks had some of the lowest ratios, along with European banks, meaning that small reductions in their asset bases could wipe out their equity.
The debate really boils down to a question of what's the best way to measure assets: Is it better to count all assets as Zero Hedge does or to try to adjust the asset number to reflect the riskiness of the assets.
The argument from proponents of total assets is that it takes out judgement calls that banks and regulators make on the riskiness of assets.
The argument for adjusting for asset risk is that a European bank's assets and Canadian bank's assets might be very different. A Canadian bank's biggest asset base is mortgages, many of which are backed by Canadian government underwritten insurance, while European banks are swimming in European sovereign debt that is facing potential writedowns.
In light of different risks on the asset side, Mr. Routledge says using total assets is wrong.
"While we consider it reasonable and intelligent to question assumptions about the stability of banking systems, particularly during periods of market uncertainty, we reject the use of the aforementioned capital ratio as a useful tool for assessing a bank's solvency. As with all simple ratios, the devil is in the details," Mr. Routledge wrote Monday.
"We reject TCE to total assets as a useful indicator of bank solvency because it uses total assets in the denominator. We consider total assets a misleading measure of an institution's risk of credit loss. For example, $100 of cash has a markedly different potential loss profile than does a commercial loan to a below-investment-grade company."
While weighting assets by risk wasn't perfect in the last financial crisis, as it understated the risks of some exotic investments, risk-weighted assets is still superior, Mr. Routledge argues.
In the case of Canadian banks, the biggest asset class is mortgages. And while there's a constant debate about the health of the Canadian housing market, the banks are insulated from declines in housing because the highest-risk mortgages are insured and backed by the federal government.
"The domestic residential mortgage asset comprises 16% of Big Six bank assets. Thus, including the gross dollar value of Canadian residential mortgages in the denominator of a bank capital ratio vastly overstates the institution's asset risk."
Mr. Routledge also argues that different accounting rules in Canada and the U.S. mean that banks in Canada show bigger derivatives positions in their assets. He points to Royal Bank of Canada, which if it reported under U.S. accounting rules, would show a smaller asset base because its derivatives assets would drop by about $86-billion.
Mr. Routledge also pointed to other subtleties that the one-metric Zero Hedge analysis didn't look at, including the fact that under the new Basel III rules, Canadian banks have among the highest TCE-RWA ratios. "We know of no banking system that is further ahead on this requirement, though some are on the same trajectory as Canada's."
Mr. Routledge's final argument is the strength of the market position of Canadian banks, which allowed them to raise equity in the financial crisis.
"Ultimately, the most valuable asset these players own is not on their balance sheets. That asset is their privileged and protected position in the Canadian financial services oligopoly."