According to a new report by Equifax Canada, the national 90-day non-mortgage delinquency rate rose to 1.12% in the first quarter of 2019. Further deterioration of loan book quality of Canadian banks can lead to a rise in risk-weighted assets, and consequently a reduction in capital ratios. This will in turn put pressure on dividend payout as banks will need to retain capital to meet regulatory requirements.
We believe that Toronto-Dominion Bank (TD) and VersaBank (OTC: VRRKF) are relatively safe from adverse movements in asset quality compared to peers because of their already high capital ratios. Consequently we recommend dividend seeking investors to buy Toronto-Dominion Bank and VersaBank.
Dividends Under Threat From Credit Losses
Latest data on credit quality in Canada shows that delinquencies are continuing to worsen. Equifax reported that the national 90-day non-mortgage delinquency rate rose 3.5% to 1.12% in the first quarter of 2019. Our outlook on asset quality for Canadian banks is also somewhat bearish as we feel that trade tensions and an expected fall in crude oil price will further increase credit losses.
Rise in credit losses can increase risk weighted assets and thus decrease capital adequacy ratios (see the Canadian regulator's formulas for capital ratios here). The reduction in capital ratios will in turn put pressure on banks to curtail dividends as they will want to retain capital to meet regulatory requirements. Consequently, a worsening of credit quality in Canada can have negative implications for dividend payouts of banks.
Toronto-Dominion and VersaBank to be Relatively Safe
Out of all the nine publicly listed Canadian banks, we feel that Toronto-Dominion Bank's and VersaBank's dividends are the least threatened by our outlook on credit losses in the Canadian economy because of their currently high capital ratios.
The charts below show the three risk-weighted capital ratios of the nine banks in relation with their minimum regulatory requirements. Please note that Toronto-Dominion Bank, National Bank of Canada (OTCPK:NTIOF), Canadian Imperial Bank of Commerce (CM), Bank of Nova Scotia (BNS), Bank of Montreal (BMO), and Royal Bank of Canada (RY) are all Domestic Systemically Important Banks (D-SIBs). As a result of their designation as D-SIB, they have to maintain capital ratios that are higher than non-D-SIB banks. They have to maintain a 1% surcharge as well as a domestic stability buffer, which can range between 0% to 2.5%. As of April 30, 2019 this domestic stability buffer stood at 1.75%. The charts below show the actual minimum regulatory requirement in dark grey, and in light grey they show the minimum regulatory requirement if the highest level (i.e. 2.5%) of the domestic stability buffer had been incorporated.
In all three of the ratios shown above, VersaBank and Toronto-Dominion Bank stand out with capital ratios that are very comfortably above regulatory requirements. National Bank of Canada also stands out, but we have not highlighted that bank in this report because its Leverage ratio is the worst compared to its peers.
Leverage ratio is another capital ratio that banks need to maintain at a minimum level of 3.0% in order to meet regulatory requirements. This ratio is different from the three ratios mentioned above (CET 1 ratio, Tier I ratio, and Total Capital Ratio) in that it does not consider risk weightings of assets. As can be seen from the chart below, VersaBank leads again by its high leverage ratio.
Recommending Toronto-Dominion and VersaBank
Due to their comfortably high capital ratios, we believe that Toronto-Dominion Bank and VersaBank are at lower risk of curtailing their dividends than peers. Consequently, we recommend dividend seeking investors to buy them. We prefer Toronto-Dominion Bank over VersaBank just because the former's stock is more liquid. The table below gives dividend yield, payout ratio and 5-year growth of dividends of the nine Canadian banks for easy reference.
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.
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