Canada vs. U.S. - Whose Banks Are Safer?

With the meltdown of US banks, I'm not surprised that the smaller Canadian banks have now become (relatively) bigger. Among the top 10 North American banks (based on market cap), three of them are Canadians: #3. Royal Bank of Canada (RY), #6. Toronto-Dominion Bank (TD) and # 8. Bank of Nova Scotia (BNS).

US banks suffered tens of billions in "toxic-asset" write-downs, dividend cuts, and the need for huge capital infusions. Are Canadian banks safe? I believe they might have a very good chance to survive and continue to provide secure dividends for the following reasons:

1. Canadian banks have a strong capital base. For example, according to Barron’s, Bank of Nova Scotia’s Tier 1 ratio (shareholders’ equity plus preferred stock as a percentage of total assets) is 9.3%, while US banks are in the low single digits.

These days, balance sheets are much more important than earnings. As you can see from the last column of the chart below, Canadian banks (in red) have much smaller debt to cash ratio. I don’t trust banks’ book value. The only thing I look at is cash.

click to enlarge

2. Canadian banks use leverage more conservatively.

When I was in a Certified Management Accountant (CMA) program, one of my instructors was a former executive of Bank of Nova Scotia. He told us the reason banks make money was because they leverage up to 25 times. According to minyanville.com, on average, Canadian banks leverage up to 18 times. No wonder in 2008, Canada’s banking system was ranked the healthiest in the world by the World Economic Forum.

3. The Canadian banking industry is much more consolidated than in the U.S. In Canada there are only 6 big banks (and a few much smaller ones), while in US there are over 8,000 banks.

4. The Canadian housing market is in far better shape (so far). While the US has around 25% sub-prime mortgage, in Canada the number is in the low single digits.

Will Canadian banks go lower? They could. With global de-leverage going on (Canadian banks are not immune), it will certainly cut their earnings. Though their prices were down around 50% from their peak in mid 2007, based on future earning estimates, today’s price is not necessarily a bargain basement price. This year the consensus SP500’s earning is around $50, so SP could easily go down to 600 (based on a P/E of 12), and Canadian banks might go with the same directory as the market. However, as long as they are safe, and continue to pay a healthy dividend (6%- 8%), it doesn’t hurt to stick with them.

Disclosure: I am long all-Canadian banks mentioned in this article.

Comments

[Jake Berzon:]

I like Canada in general, and loonies (Canadian $) in particular. I am also quite weary of equities right now, but I like your Canadian banks idea and will keep my eye on them. Thank you.

BTW, does anyone know if Canadian bank deposits have an equivalent of FDIC insurance?

Feb 15 04:15 PM

[Montreal:]

Yes Jake, there is a guaranty for 100k.

Feb 15 04:32 PM

[yellowhoard:]

Long Royal Bank Canada/Short JP Morgan

Feb 15 04:50 PM

[naidle:]

Having lived recently in both Vancouver and Toronto I can tell you that there is some major speculative positions still to be unwound.

Canada is in a better position within the financial sector but we're far from safe. Wait til interest rates creep back up into double-digit territory in a few years. That's when we can see a banks true strength dealing with mass foreclosures.

That's the downside of "stimulating" the economy now. Let's hope I'm wrong.

Feb 15 07:10 PM

[NByz:]

It sounds like preferred issues may the way to game the Canadian banks.

Can anyone recommend any Canadian Bank preffered stocks that have taken a big hit lately?

Feb 15 07:45 PM

[Teutonic Kn...:]

Responding to Jake's question, the Canada Deposit Insurance Corporation (CDIC) a Crown Corporation (similar to our now conservatory FNM, FRE), insures deposits up to C$100K per person.

I concur with the author's assessment. However, taking a cue from a recent related SA article, for those who contemplate Canadian bank stocks as a dividend play on a long-term basis, be aware that the Canadian government unilaterally withholds15% tax at the source.

Would the extra paper work with claiming foreign tax credit worth the trouble? Besides, going with the old saying, where there is peril, there lies opportunity. I for one would take a second look at some conservative American banks too.

Feb 15 07:53 PM

[pitaking:]

As a Canadian living in the heart of the real estate and commodity bubble near Calgary, I'm looking at shorting most of our banks. The collapse that's occurred in the US and Europe in the first innings here and housing and commercial real estate are in free fall and our consumers are as over extended as any where in the world. As for commodities, junior miners and drillers are going out of business daily and our tax shortfalls will be massive from the lost revenue, not to mention our quickly growing trade deficit. As far as a technical trade, most canuck banks are sitting on or near their 52 week lows. Anyone considering a long position needs a very big time horizon in my opinion, the trend is lower for 2009.

Feb 15 08:33 PM

[Aristophanes:]

As a Canadian I agree that there is substantial de-leveraging to come in Canada, but nowhere near the scale as has been seen in the U.S. Also, the Canadian social safety net ameliorates much distress, such as the national Employment Insurance program and its flexibility. It provides most Canadians with enough cash flow to keep their mortgages current for the average duration of unemployment. It will be tested, for sure, this time around, but the mechanism is there and can be re-tooled (and should be).

That said, Vancouver, Toronto and Calgary are going to get nailed on the real estate side. How that plays out is

What I want to add is the brilliant strategy of tax-free savings accounts. For our American cousins, the Canadian federal government created as of January 1, 2009 a tax-free savings account of $5,000 per year for every citizen. How does this help?

1) It create a moral incentive for each person to prioritize their personal finances with savings at the top of the list, where it should. When the average earnings is $33,000k per year, $5k of incentive is pretty substantial. Seniors on fixed incomes who do a large redemption (Canada Savings bond, for example) and need to park cash will especially benefit.

2) It creates a social incentive to increase the national rate of savings and feel good about the tax breaks and government in general.

3) It creates an economic incentive to re-capitalize the banks through basic deposits, assisting their balance sheets in a time of capital distress.

Think of it: Banks get fresh capital. Citizens get a tax break. The personal savings rate goes up. Wow! Terrific policy. And it's as simple as opening a bank account. I got on online in 10 minutes.

Contrast that approach with the American solution to re-capitalize the banks with debt borrowed from China or thrown from a helicopter, all while trying to get spending (not savings) up to a bizarre level of GDP again. The policy differences is astounding between these neighbours.

Apparently this idea came from the Finance Ministry wonks back under the previous (Liberal) government. There was considerable concern about the savings rate decline and some bureaucrats thought this idea was better than tax breaks (it is). It speaks to the Canadian system that it was put into place by the Conservatives will all-party acclaim.

Feb 15 09:44 PM

[Moon Kil Woong:]

What happens in the US tends to have grave repercussions in Canada.

I don't believe the Canadian economy is delinked enough from the US to feel Canadian banks are safe from the asset destruction or the mortgage crisis that has hit the US. The scope and the extent may be more muted due to less derivatives and avoidance off off balance sheet shady book keeping that is plaguing the US banking system. But the end result should be the same, a fall in the banks capital reserves and share price.

Feb 15 10:49 PM

[Paulo:]

The Canadian dollar is weak against the American dollar and the Canadian banking sector is strong in global perspective.
NByz -- if you lean towards preferreds, have a look at CA:CPD.
Indexes are probably safer for the bank and financial sector shares themselves (and prices are way down): e.g. XFN, CEW
Things look a lot better than C, RBS, and so on.

Feb 16 12:54 AM

[Roscat:]

Good point but old news. See below from Oct 2008:

www.reuters.com/articl...

Feb 16 05:37 AM

[maz:]

Some excellent points brought up re Canuck banks. One other point to consider is the amount of revenue each bank derives from its US operations

The pecentages are well down from their highs but still range 15 - 20% for most. BNS has least US exposure.

Overall the banks will contract further imo as the Canadian economy is inextricably linked to the US and government coffers have recently been filled by high commodity prices (one example gas tax for cars is a % not a fixed dollar/litre - many other royalties/taxes are % based). So just as the revenues drop the government has a massive increase in spending & will run deficits for several years. This will mean eventual inflation - may be two years off just when the economy starts to show life.

Canuck banks benefited hugely from the recent financial bubble. For example: From 1995 through 2005 Royal Bank's ROE averaged between 14.3% and 17.9% - respectable figures for any bank. Contrast this to 2006 & 2007 where ROE ballooned to an exceptional 22.4% and 23.3% - some 40% above the long run average. No surprise that the trailing twelve months is now 16.4% and as with almost all bubbles we can expect a substantially lower than average figure to follow.

Feb 16 01:39 PM

[Matt Blackman:]

Interesting analysis. But anyone who thinks the Canadian housing market will avoid the global downdraft is deluding themselves. Some very good research has been conducted by BMO Capital Market's Doug Porter who showed a very convincing 2 year lag between Canadian and US housing prices. So although the Canadian housing market appears to be in better shape, their downward cycle just began last year and I expect prices here will drop a minimum 25% if not more. The amount of the final correction will depend on how bad this recession gets...

As long as housing prices fall, Canadian banks will suffer downward earnings pressure which means lower stock prices.

Feb 16 03:13 PM

[Paulo:]

Canadian banks do have a more conservative approach tomortgage lending and:
'Mortgage loan insurance is typically required by lenders when homebuyers make a down payment of less than 20% of the purchase price. Mortgage loan insurance helps protects lenders against mortgage default, and enables consumers to purchase homes with as little as 5% down payment — with interest rates comparable to those with a 20% down payment.'
From the Canadian Mortgage and Housing Corporation website.
Of course, no jobs and no savings and people will walk away.

Feb 16 11:30 PM

[NByz:]

Yes, the Canadian equivalent is the Real Return Bond (RRB).

Thanks for the suggestion Paulo.

Feb 17 04:06 PM

[NByz:]

Ignore the link in parenthesis there.

Feb 17 04:07 PM

[silverfox:]

canadian banks are regulated by the canadian government and are
restricted to a maxiimum leverage much less than the american banks.
put some hobbles on those crazy american banks and control the amount of borrowing to cash its just a thought but i think the cows have long since left the corral and it is probably way to late to save the american banking system.

Feb 20 10:46 AM

[Mad Hedge F...:]

Why don’t we accept the wisdom of crowds and accept the market’s judgment that the big banks are worthless? Let them all go bankrupt. With Bank of America (BAC) and Citigroup (C) down 95% from their peaks, shareholders have already been wiped out. All we are arguing about here is whether they should be allowed to come back in the next economic recovery. The Geithner bailout plan missed a golden opportunity to shock us all to our senses. Whatever happened to creative destruction? Let the weak banks go, and they will be replaced by stronger, better managed ones without any government involvement at all. Let the natural Darwinian survival of the fittest run its course. I watched with chagrin while Japanese banks pretended they were solvent for 15 years. Everyone in the country suffered as a result, and a whole generation’s worth of economic growth was lost.

Feb 21 08:56 AM

[User 361750:]

This is unfolding all so quickly. I really wonder if Canadian banks will fare much better. Yes, it is true that our banks have more conservative lending policies and that has been our strength. I wonder however, how much of the this toxic debt has been purchased by our banks and are sitting timebombs in their books. Last year, the Govenment of Canada purchased $32.4 billion in “other” assets to help contain the problem with ABCp's in Canadian companies.

Is there any way to find out how exposed we Canadians are?

Feb 21 11:08 PM

[LaVern Isely:]

I wonder what excuse the country of free enterprise, which I happen to live in, is going to use when they compare Canada, a Socialist country, which is in BETTER financial shape than ours, to the United States. Could it be that the Bush Administration wasn't REALLY conservative and that they lied? They said DEREGULATION was going to save us money. At the end of President Clinton's term, he took off the GLASS-STEAGALL ACT and President Bush took full advantage of that in his eight years in office. He cut the income tax rate for the wealthy billionaires, while at the same time, he promoted HEDGE FUND DEALERS and TOXIC DERIVATIVES because he thought conservative banks should be run like the stock market. That's why we got Enron, World Com and now Bernard Madoff and R. Allen Stanford and many, many more, if they want to get to the bottom of it. Our country will not win, unless it can correct the image of DEBT FOREVER and eliminating our jobs and the middle class, while the wealthiest billionaires hide their money OFFSHORE.
Yours truly, Disgusted Middleclass Taxpayer, Public Citizen and AARP Member, LaVern Isely

Jun 29 02:12 PM