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Comparing and contrasting large Canadian and U.S. banks

Global financial stocks have surged over 125% since having bottomed out in March. In the U.S., financials have more than doubled and in Canada have rallied over 90%. We believe that while financial stocks across the globe may still have more upside as the economy levels off and deal flow picks back up, discrimination will be instrumental going forward. Consistent with this, our favourite picks, which we feel offer the best risk/reward profile are the large Canadian banks. Indeed, all of the “big five” Canadian banks (Royal Bank (RY), CIBC (CM), TD Canada Trust (TD), ScotiaBank (BNS), and Bank of Montreal (BMO)) are on our “Strong buy” list, and are well-positioned to beat the market over a 3-12 month time horizon. This compares to the wide variety of ratings for U.S. banks, which range from “Strong buys” for Bank of America (BAC), J.P. Morgan (JPM) and Wells Fargo (WFC), to “Strong sells” for Citigroup (C) and Suntrust (STI).

Note 1: Prices are shown adjusted for stock splits and dividends
Note 2: LS = Left Scale; RS = Right Scale
Sources: Yahoo! Finance for ETF prices and Bank of Canada for exchange rates

Quality of capital, not just quantity

As shown in the chart below, both the major Canadian and U.S. banks have strengthened their capital bases in recent months. At first glance, one might conclude that U.S. banks are better capitalized because they have, on average, higher Tier 1 capital ratios. However, it is important to remember that the recapitalization of institutions that are systemically important (read: too big to fail) was spoon-fed by the U.S. government and resulted in substantial dilution to existing shareholders. While the Bank of Canada continues to provide emergency liquidity facilities should credit markets freeze up again, government involvement in the financial crisis has been of a much smaller order of magnitude than in the U.S.

Sources: Company filings with SEDAR (Canadian banks) and SEC (U.S. banks

Looking forward, while capital ratios are important tools in assessing financial institution health, measures such as Tier 1 capital do not capture the potential risk taken by engaging in over-the-counter (OTC) derivatives transactions. According to the most recent report on OTC derivatives published by the U.S. Comptroller of the Currency, $190 trillion, or 95% of all U.S. notional OTC derivative exposure, was held by four U.S. banks (J.P. Morgan, Goldman Sachs, Bank of America, and Citigroup), with potential exposure of over $1 trillion after netting of contracts. In Canada, the large chartered banks do operate trading desks, but the size of the bets taken is dwarfed by trading operations in the U.S. The bottom line is that in the absence of major financial market reforms, U.S. banks have resumed their risk-taking behaviour and will likely profit from trading activities in the interim, before another crisis caused by excessive risk taking erupts. We will likely publish a piece on our outlook for the global economy and financial system in the near future, so stay tuned.

The soundest banking system in the world

On September 8, the World Economic Forum released its Global Competitiveness Report for 2009. For a second consecutive year, Canada was ranked as having the world’s soundest banking system. As noted by the International Monetary Fund in its May report on Canada, regulators such as the Office of the Superintendent of Financial Institutions (OSFI) follow and enforce some of the best practices with respect to the supervision of financial institutions, including minimum capital requirements stricter than Basel II, conservative lending practices, and limits on gearing (leverage).

Also, Canada’s regulatory system is far better organized than in the U.S., where financial institutions are able to “shop” for regulators and select the regime which best suits their business models. While many criticize the oligopoly in the Canadian financial services industry, having a few stable, closely-monitored large firms (at least so far) has proven to have worked better than letting thousands of players duke it out in a competitive, “market-disciplined” environment.

Valuations reasonable

On a price-to-earnings basis, both Canadian and U.S. banks are trading around 20 times earnings. At over 4%, dividend yields for the “big five” Canadian banks are much more attractive than the 2% (give or take) that is being paid out by U.S. banks.

We will pre-empt any stabs at Canadian banks being overvalued on a price-to-book basis (1.6 times vs. 0.7 times for U.S. banks) by noting that the second wave of writedowns in the U.S. (commercial real estate and consumer loans) has yet to hit the books of U.S. banks. Canadian banks, on the other hand, have already aggressively charged off loan losses in recent quarters.

To summarize, Canadian banks should continue to fare better than American counterparts: Canadian bank balance sheets are generally of higher quality (and are easier to understand), barriers to entry are high and regulations are already stricter, and valuations are reasonable on a relative basis. Investors who wish to play this theme without picking stocks may want implement this idea by going long the Canadian financials ETF, XFN, and shorting a U.S. financials ETF such as KBE. Note: This theme also incorporates some net long $C exposure, which can be offset by taking a short $C / long $US position in a currency ETF.

Happy trading,

Jason Moschella
Consulting Editor

Disclosure: No positions at the time of writing.