The regional banking and asset management industry is based almost entirely on the confidence of intermediaries and counterparties that make up the building blocks of the financial system. An investment in a bank or asset management firm must come with the acknowledgement of the distinct possibility that another financial crisis may occur at an unknown time in the future. Though we don't expect one anytime soon given the recent favorable stress-test results of the largest U.S. banks, it's worth noting that there have been three significant banking crises during the past three decades alone: The savings and loan crisis of the late 1980s/early 1990s; the fall of Long-Term Capital Management and the Russian/Asian financial crisis of the late 1990s; and the Great Recession of the last decade that not only toppled Lehman Brothers, Bear Stearns, Washington Mutual, and Wachovia but also caused the seizure of Indy Mac, Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC).
Though regional banks may avoid risky international lending, they are not shielded from potentially prohibitive funding costs and liquidity issues that plague certain investment securities during a crisis. Investors must pay particularly close attention to a bank's capital position (Tier I capital), leverage (total assets divided by total equity, loans/deposits ratio) lending standards (loan loss provisions, non-performing loans), its growth plans (as this could lead to reckless risk taking), the general economic outlook for residential and commercial activity (especially housing and the mortgage markets), the interest rate environment, and the structure of the yield curve (net interest margins).
We generally prefer the oligopolistic structure of the Canadian banking system relative to the highly fragmented and extremely competitive U.S. landscape. For example, Bank of Nova Scotia (BNS), Canadian Imperial (CM), Royal Bank of Canada (RY), and Toronto-Dominion (TD) boast impressive returns on equity thanks in part to this more favorable operating environment. Still, given increasing global regulation and higher capital adequacy requirements as a result of the recent financial crisis, we don't expect the group to ever achieve the return performance of years ago. It's also worth noting that the elevated dividend yields of some industry constituents are more indicative of a higher risk profile than their attractiveness as an investment opportunity.