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Canadian banks picked up where they left off after the holiday break with Toronto-Dominion Bank (NYSE:TD), National Bank and now Royal Bank (NYSE:RY) raising capital by bringing preferred share issuances to market. Capital ratios are clearly in focus these days, as the group has encountered everything from capital market related writedowns, counterparty risk and disclosure of exposures, to the global economic downturn, deterioration in lending-related credit quality and concerns about the level of regulatory capital since credit and liquidity problems emerged in the summer of 2007.

Merrill Lynch financial services analyst Sumit Malhotra said:

From a capital management perspective the banks have demonstrated that it is possible to raise funds in this environment – be it common equity, preferred shares, or innovative Tier 1 – though the cost is becoming increasing[ly] prohibitive.

He noted that CIBC (NYSE:CM) has outperformed the TSX Bank Index by 15% since Dec. 4 “despite long-standing lackluster revenue trends and a recent up-tick in their credit card loan losses.” That’s when it released fourth quarter results and moved to boost its Tier 1 ratio to 10.5%.

However, the analyst told clients that “all Tier 1 ratios are not created equal” and suggested investors be cautious due to the potential impact of off-balance sheet conduits, backstop liquidity lines, and available-for-sale or held-to-maturity securities. Differences in earnings and loan portfolio composition are also capable of quickly influencing a bank’s capital position, he added.

Mr. Malhotra noted that moves to strengthen balance sheets at TD, National and Royal with its C$200-million worth of reset preferred shares on Tuesday, indicate that the retail-oriented preferred market may be opening somewhat as the RRSP deadline in early March approaches.

While valuations assigned to the Canadian banking sector have fallen sharply, the uncertainty associated with both the economy and financial market, as well as the continued threat of earnings per share dilution, makes valuation even less of a catalyst than usual, Mr. Malhotra said.

“The U.S. led the downturn, and we believe it will be trends in U.S. housing and employment that eventually lead the recovery,” the analyst told clients. At the same time, he expects the broad economic downturn will make credit deterioration more than just a U.S. real estate story in 2009.

“In the interim, and with Canadian fundamentals still worsening, we continue to play defense with the bank space,” the analyst said.

He favours names with less exposure to business lending and capital markets earnings, and a higher proportion of retail deposits. In the large cap space, this means CIBC and TD, along with smaller name Laurentian Bank (OTCPK:LRCDF).

Mr. Malhotra said:

Part of the reason for our muted-to-bearish outlook on the stocks at the current time is our long-held mantra that positive EPS momentum is required to sustain a rally and help in driving valuation higher.

While it may be difficult given how politicized the issue has become, he also expects the banks will probably have to dump some of their commercial and corporate lending clients as 2009 progresses in the interest of both their credit quality and capital management.

Source: Capital Ratios Are the Focus for Canadian Banks