A Look At The Big Canadian Banks

Includes: BMO, BNS, CM, RY, TD
by: Alan Longbon


The big Canadian banks have a loan book that is over 220% of GDP and pay a dividend of over 3%.

Credit creation is still growing the loan book at 1.4% of GDP.

Coming central bank rate rises will cause the interest income from the accumulated loan book to cause automatic income increases to banks on outstanding loans.

The central bank and government stand behind the too-big-to-fail banks and stand ready to assist them in a crisis should 2007-09 repeat.

The purpose of this report is to assess if the big Canadian banks are worth investing in.

To answer this question, an assessment of the success to which the banks have enclosed the economy with debt will be used together with an assessment of how this enclosure of the economy can be made into higher profits.

Enclosure of the Private Sector

The chart below shows the level of private credit creation entering the private sector through commercial banks.

The above chart shows that credit creation from private banks has grown in 2017 and added $US20B to the economy or 1.4% of GDP. This is a strong result, and one can see from the chart that lending/borrowing accelerated in the second half of the year.

The chart above shows the money supply is going up, so overall, there is income entering the private sector and a good portion of which is credit money from private banks.

The flow of credit adds to the stock of private debt in the economy, and this debt is shown in the chart below.

(Source: Professor Steve Keen)

The chart above shows that Canada has a high private debt level of 220% of GDP. Private debt levels now are higher than the peak set during the GFC marked on the chart. Both corporate and household debt is exceptionally high and goes hand in hand with Canada's expensive real estate. The bulk of the private household debt is for home mortgages for a place to live.

What this means going forward is that one cannot expect Canada to be able to sustain a bull run fueled by credit money given that it has reached what can be considered a full debt capacity.

Professor Steve Keen's studies show that economies with private debt levels of 150% and over tend not to become more indebted. They hit a natural barrier where no more debt is demanded.

The reason is that such a large percentage of aggregate demand goes to debt servicing that there is a noticeable drop in the demand for real goods and services. Production goes unsold and is cut back; this leads to job losses, income losses and a further cessation of aggregate demand until the debt is repaid or written off and more income can be spent on buying production rather than debt service.

This phenomenon where debt service absorbs so much aggregate demand has been coined "debt deflation" by economist Professor Michael Hudson. This is in the sense that the real economy is deflated by the weight of the debt service.

Bank Strategy

It is the role of the banking industry to create credit and lend it out at interest and make a profit. In a bank utopia, every creditworthy citizen would be "loaned up" and paying interest. The loan book is the bank's asset and provides the bank income from which to pay shareholder dividends. The aim is to make this loan book as large as possible with as little risk as possible. One could simplify the model as follows:

  1. Loan as much money out to creditworthy borrowers as possible.
  2. Seek to create a rising rate environment to maximize profit on the established loan book for as long as possible.
  3. Protect the loan book.

A three-stage process where the economy is first enclosed with loans and then squeezed to extract as much income as possible.

One can assess how successful a bank is by looking at how large its loan book is and how much of the economy's income it has secured as an income stream on that loan book.

Stage 1: Grow the Loan Book

In the case of Canada, the banking sector has been very successful as the charts above show. While one cannot expect the loan book to grow very much more given that it exceeds 220% of GDP and the real limits of the economy to support further loans, it can still provide a rising income for a long time without growing in size. That said, it is still growing at 1.4% of GDP.

Mission accomplished, it is over 220% of GDP. One of the highest in the world. Not much more can be expected, though is.

Stage 2: Maximize Returns on the Loan Book

For Canada, one can model the impact of this private debt on the economy over a range of interest rate levels, and this is shown in the table below. The standard home loan in Canada is a variable rate at three to four percent. Rates are not fixed for 30 years like they are in America. The longest fixed rate loan one might get is for ten years and these are not common. Central bank rate rises will therefore automatically be passed on to customers via their variable rate loan after a relatively short time.

(Source: Author calculation based on Trading Economics dot com GDP data and Prof. Steve Keen private debt data)

One can see at present that over 6.6% of GDP/aggregate demand goes to private commercial banks as debt service cost and not on real goods and services in the real economy.

One can also conclude that this interest payment from loans underpins the strong dividend income one can receive from Canadian banks. The largest bank, the Royal Bank of Canada (RY), shown in the chart below, yields a dividend of better than 3.54% and shows steady five-year growth in the share price.

(Source Google Finance)

Canada has five large banks that monopolize the finance market. The other banks have similar dividend returns and stable share prices and growth trend as RY.

Bank Name Code Dividend Yield Market Capitalization
Toronto Dominion Bank (TD) 3.29% $134B
Scotiabank (BNS) 3.99% $94B
Bank of Montreal (BMO) 3.76% $64B
Canadian Imperial Bank of Commerce (CM) 4.37% $41B

Bank profits and dividends can be expected to rise with central bank (BOC, Bank of Canada) rate rises.

The central bank wants to raise rates, as all central banks do, to give them more room to move in the next recession, and could paradoxically be the cause of the next recession. Rates now are considered too low at only 1.5%-2% and should be "normalized" to at least 3% to 3.5%. Such a scenario would see home loan variable rates increase to 7% to 8%. By this time banks will be earning about $270B of extra income per year. This is about twice the loan book earnings at present. This is based on the loan book remaining static with no extra effort on behalf of the banks to generate more loans. The dividend could potentially more than double given the cost base is the same, and yet the rising rates have brought in more income.

America has started the rate rise and QE unwinding process. Other central banks around the world will follow this lead. Historically, Canada has always been six to twelve months behind the USA with its monetary policy and has already started its tightening process as one can see in the chart below.

From the table above, in the previous section, we can see that each one percent rate rise adds over $US33.65B to loan interest income when passed onto the consumer.

Stage 3: Protect the Loan Book

Two of the big Canadian banks appear in the top ten list of the largest banks in the world by market capitalization as the chart below shows. The other three are not far behind.

This is extraordinary given that Canada has a population of 36.8 million people. California is about the same size and Texas slightly less but state banks do not feature in the top ten list.

American banks feature in the list and they should as America is much larger than Canada in terms of population and GDP firepower. Canada, like Australia, is punching above its weight in banking.

By assets under management (size of loan book), three of the Canadian banks also feature in the top fifty banks in the world as the chart below from Wikipedia shows.

In the event of a crisis, the "too big to fail" card will be played and will work as it did in 2006-2009 where the national governments across the world guaranteed bank liquidity. What this means is that the banks are backstopped by the national government which is sovereign in its currency and therefore has unlimited Canadian dollars.

In the event of a problem, QE will be activated. Bad loans and long-dated bonds will be bought from the private banks by the central bank in exchange for excess reserves. It happened last time, all around the world, and will happen again as well. Profits are privatized, and losses are socialized.

What does this mean for investors? It means that the bank and its accumulated loan book are safe. One can invest in the Canadian big banks with some impunity.

Unlike Australian banks, there is no talk of Canadian banks being the next big short even though they are more extended than Australian banks at 220% of GDP rather than 207%.

Canada’s economic growth has been relatively concrete and better than in most other OECD countries since the start of the recession in 2007. Overall, no Canadian bank was acquired, nationalized, required a government recapitalization or declared bankrupt and there were no government bailouts of insolvent companies during this period. Canada was the only G-7 country able to escape a financial crisis, and its downturn was more moderate than Europe countries and U.S.. Canadian financial institutions are inclined to be more rigorous monitored, with larger capital requirements, greater restrictions and fewer off balance sheet activities. Also, the recent stress tests conducted by International Monetary Fund (IMF) show the resilience of Canada's economy and its major banks for contagion risks. A number of factors played a role in this positive outcome. According to recent economic review, Canada has an economy characterized by some strengths: responsible fiscal policy, strong and resilient financial system, sound monetary policy and institutions that produce reforms to encourage growth.

(Source: Bankpedia.org)

Exchange Rates

No discussion of an overseas investment would be complete without a discussion about the exchange rate and its impact on investment returns.

At present, the US dollar has been weakening against the Loonie and is trading at about 80 cents. This is a simple supply issue. At present, there are a lot of US dollars being created:

  1. The US current account deficit adds $450B per annum to the stock of US dollar overseas.
  2. Increased federal government spending means more dollars come into existence at the rate of about $710B per annum with the promise of additional infrastructure spending still to come.
  3. Credit creation by US banks puts a further $23B per annum of credit money into circulation.
  4. The President’s trade initiatives are often ‘weak dollar’ stories.
  5. Fed rate hikes fundamentally weaken the US dollar via interest income channels. What this means is that the government pays more interest on its Treasuries and this additional income payment puts more dollars into circulation. The table below shows that with every 0.25% rate rise, an additional $50B is put into circulation.
  6. US trade policy is reducing non-resident desires to accumulate US dollar financial assets. Sanctions tied to foreign policy is not popular with users of the world reserve currency who then seek alternatives.

America is leading this expansionary phase, and while it leads, the US dollar will fall as more US dollar come into circulation.

As other countries follow the leader, this process reverses, and the US dollar rises in value. Similarly, the USA will be the first to tighten monetary policy, thus restricting the supply of the US dollar at a faster rate than other currencies, further reducing its supply relative to others. The result is that the US dollar rises even though it will, paradoxically, be going into recession at that time. The safe haven aspect comes into play too.

Summary, Recommendation, and Conclusion

This article has shown:

  1. The Canadian banks have enclosed the economy with a loan book of over 220% of GDP.
  2. The next phase is harvesting interest income from this loan book asset, and this phase has begun with recent rate rises. The 3%+ dividend is safe and will grow automatically with each central bank rate rise.
  3. The big Canadian banks are too big to fail and are backed by a monetary currency sovereign with the unlimited ability to issue Canadian dollars.
  4. The Canadian banking sector is one of the better-regulated ones and avoided the bailouts and bail-ins of the GFC and may do again when the time comes.
  5. Exchange rate movements will enhance the investment prospect and add to the total return over the next years into the tightening cycle and beyond.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.