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.
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.