Canadian Banks Should Consider Dividend Cuts - RBC

While Canadian banks enjoy stronger capital positions than many of their global peers, they should still consider suspending their common share dividends, according to Andre-Philippe Hardy at RBC Capital Markets.

In addition to reducing risk, the move might improve the cost of funds as debt investors would have less to worry about, he told clients. It could also stabilize share prices if the risk of having to raise capital at low share prices becomes more remote.

Mr. Hardy said in a research note:

It would materially increase internal capital generation and thereby reduce the need for banks to raise capital if loan losses and write-downs prove greater than in the early 1990s.

While the initial reaction to such a move would likely be negative, particularly because the Big 5 banks have not cut dividends since WW II, income-focused investors might sell their shares and those who consider Canadian banks as “bullet-proof” would also probably be disappointed.

Based on RBC’s earnings forecasts, which include the firm’s best guess on securities writedowns and loan losses close to the peak of the early 1990s, it estimates that the six Canadian banks can maintain their dividends and have tangible common equity (TCE) to risk weighted ratios of 6.4% to 7.8% by the end of 2010. However, a dividend suspension today would add 1.3% to 1.9% to fourth quarter 2010 ratios, which would greatly increase the margin for error against higher-than-forecast loan losses or write-downs, Mr. Hardy said.

He said:

Given how weak the economic environment is, the prospects of loan losses that exceed the early 1990s is certainly something banks and investors must consider in their investment decisions. It might not be the best case but it is a possibility if the economy does not improve by 2010.

With lower exposure to credit in Ontario and the United States, a clear securities book and a relatively low valuation, Mr. Hardy considers National Bank best positioned in the near term.

Bank of Montreal’s credit issues were far worse that its peers in 2008. But while the analyst expects the difference to be less noticeable this year as the credit cycle broadens geographically and by product line, he remains concerned about its dividend.

Mr. Hardy said:

We are concerned, however, that the bank’s dividend is least sustainable and that as long as the risk of a cut is in place, the stock is unlikely to rally. Unlike the situation in the U.S., we would expect dividend cuts to be viewed negatively as they would probably be perceived as a sign of lower confidence in the outlook, whereas in the U.S. most investors have a pessimistic outlook on U.S. banks and dividend cuts are viewed as positive since they reduce a drain on capital.

Comments

[Chezfrederick:]

Analysts, including Mr. Hardy, have substantially underestimated Canadian Banks earning power... Calls to cut dividends are generally misguided and are a reaction to current market price declines. A long term perspective and a turnaround in the markets towardsthe latter part of 2009 is essential when making such calls. Banks don't want to regret a move to cut dividends now if it would undermine investor confidence and lead to further unwarranted price reductions. Headline grabing commentary are typical of analysts, whose reputation has been tarnished of late.

Should Bank of Montreal have deeper financial issues with their balance sheet then be it... but stop second guessing as you are creating a constant fear that will be self fulfilling even if wrong. The market is spooked as it is and you are adding fuel to the fire.

Canadians have an inherent inferiority complex which leads to inappropriate and costly conclusions and behaviour at times. Some Canadian banks felt that in order to grow, they need to invest in the US rather than chart a policy of growth independant of the big boys... that served them well!!! Investors see the drubbing of the US Banks... and follow the course north of the border... BNS has show us that there are other alternatives, while RY and TD have only tiptoed into the mine fields.

Final point, I copy below a comment I made to another blog on that same issue... Let's not all be lemings:

"The reason Canadian Banks are a model of banking for the world, is that they have not adopted the herd mentality and followed blindly the path of most other banks. As such, monkey see, monkey do is not a sufficient rationale for cutting dividends.

I believe the market has punished them harshley in an unwarranted fashion, and will come to realize there is value backed by a strong balance sheet justifying a bounce in their stock prices in the near term. As you may recall, their recently announced results were substantially ahead of analyst concensus, and looks solid going forward. Their reserves have been built up, and can provide a good profit bounce when time comes to reverse such unused portions.

Let's celebrate the difference and success, stop the pessimism, encourage solid market participants, rather than pile up the pressure with no justification.

I would be first in line to dump my holding should dividends get cut, as it would signal to me, that their financial problems run deeper than has been previously indicated.

Let's not just blow away their unique position and long lived tradition every time the winds temporarily change direction. Think long term, think respect, think confidence."

Mar 10 07:06 AM

[karu46:]

Totally agree with Chezfrederick.

Not so long ago this same pundits were whining that the Canadian banks must merge or be taken over by the big guys down south.
Except for the CIBC, others were not much involved with the toxic asset based derivatives game and thus saved the CDN bank investors and the general public.

Hope sanity continue to prevail.

Mar 10 08:57 AM

[tomciver:]

I agree chezfrederick and karu46 and I am not invested in banks either side of the border, but I like what I see to the north much more so than down here. Another reason for not cutting dividends is that only Americans swoon over a 2% divvy! Our Canadian brethren like higher payouts for their risk..........if they don't get it, they don't invest, i.e. canroys, income trusts, etc.

Drunks hate to drink alone, misery loves company, guilt by association, and hate to see others succeed where we have failed, might be phrases to describe the mentality of this article.

Mar 10 09:36 AM

[Bingo 2:]

I will sell my holdings in Canadian banks as fast as possible if they cut dividends. Agree totally with Chezfederick- hopefully the Canadian banks will not be the lemmings to this fiscal mess which the US bankers brought on themselves. The Canadian government is smart enough to stay out of world affairs where it does not see any possible solution and therefore does not spend trillions being the world banker and world police force.

Mar 10 12:21 PM