Bank of Nova Scotia Should Make a Move for the Rest of CI Financial

Includes: BNS, CIFAF
by: Streetwise Blog

Canada's banks are probably sitting on way more capital than they need under pending new rules that will govern emergency reserves at lenders, but they're unlikely to start using the extra cash for major purchases until regulators lay out exactly how the capital rules will work, Macquarie Capital Markets Canada analyst Sumit Malhotra argues.

"Given the considerable uncertainty that remains evident in both the regulatory and operating environment, we are unlikely to see sizable acquisition activity in the bank space until there is a much-improved level of visibility as to how capital is going to be both generated and monitored," Mr. Malhotra said in a report Wednesday.

That includes any potential bid by Bank of Nova Scotia (NYSE:BNS) for the rest of CI Financial (OTCPK:CIFAF), which faces barriers because of the capital issue, he says.

Scotia bought about 36 per cent of CI a year ago for $2.3-billion, and many in the market now spend a good deal of time speculating on whether the bank might make a move on the rest, since CI is widely held and control can be had at the right price.

There was a strategic rationale in the CI investment for Scotia, which has been a laggard in wealth management. However, so far the bank has treated the investment as a passive stake, with basically no attempt to try to align CI's business with its own. In fact, by some accounts, Scotia's and CI's management teams rarely even communicate. So an acquisition of control may be the only way to make the deal work on a strategic level.

Scotia may be especially hampered in any bid for the rest of CI by its balance sheet. On the surface, Scotia, like all Canadian banks, is swimming in capital. However, should regulators focus on a measure known as tangible common equity in their new capital calculations, Scotia suddenly is in a relatively weak position, said Mr. Malhotra.

That's because Scotia was the only one of the five big Canadian banks not to issue common stock in 2008, and tangible common equity only counts common shares. As a result, something Scotia pointed to as a strength - having no need to sell common shares - may turn into a weakness in the acquistion game.

Mr. Malhotra expects regulators to put more focus on tangible common equity, which will make Scotia loathe to run down its ratio with an acquisition of CI, he contends. An acquisition of CI would be heavy on goodwill, and even using half stock would push Scotia's TCE ratio below 6 per cent, a level rarely seen by Canadian banks even before the blowup in markets, and he questions whether that would be viewed as prudent.

"We do believe that it is reasonable to expect that there will be greater emphasis on tangible common equity," he says, pointing to the statement by the Group of 20 leaders to look at rules to improve "both the quantility and quality of bank capital."

The end result, he says, could be a share issue by Scotia if it's looking to "play offense" with its capital.