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A Sobering Outlook for the Canadian Banks

Canadian investors love their bank stocks, and for good reason given the long-term returns generated by holding these names through thick and thin.

At least one U.S. based investor however has a less-than-rosy outlook for these bluest of the Canadian blue chip names.

Saturday’s Globe and Mail featured an article about a small San Francisco based hedge fund that has staked 95% of his investor’s assets on a wager that will pay off if this country’s banking sector stumbles.

Unlike others who argue an eventual slowdown in our housing market will take a bite out of the banks, the argument presented related to the “risk-weight” of 9.9% that the Canadian banks put on mortgages.  And more specifically, how out of line this weighting is with much of the world.

According to the article, U.S. banks apply a risk-weight of 35 to 75% to mortgages, banks in Australia use 15 to 20%, and Europe averages 20%.

So What?

In the homogeneity seeking world that we live, there is a risk that at some point OSFI, the Canadian financial regulator, will be asked to bring this figure more in line with other jurisdictions.  The implementation of a “risk-weight floor” of 15% by OSFI is suggested.

If this change occurred overnight, an infinitely small probability in my mind, several banks could fall below the minimum capital requirements (currently 4.5% but expected to level off at 6.0% by 2015), forcing them to issue equity or cut their dividends.  Tabled below is the current Tier 1 Capital ratio (Tier 1 Capital/Risk-Weighted Assets) for each.

Company Name

Tier 1 Capital Ratio

CIBC (TSX:CM,NYSE:CM)

12.0%

Royal Bank of Canada   (TSX:RY,NYSE:RY)

11.5%

Bank of Montreal   (TSX:BMO,NYSE:BMO)

11.1%

TD Bank (TSX:TD,NYSE:TD)

10.9%

Bank of Nova Scotia (TSX:BNS,NYSE:BNS)

10.3%

Source:  Capital IQ

While these figures don’t take into account the percentage of risk-weighted assets that is comprised of mortgage loans, you can at least see that if mortgages were to require a risk-weight of say 15% vs. 9.9%, the denominator in this ratio (RWA) would go up, bringing the Tier 1 ratio down.  With mortgage loan exposure factored in, Citigroup expects a higher risk-weight would have the biggest impact on CIBC, Royal, and Scotia.

The Foolish Bottom Line

To bolster the argument against Canadian banks, a negative view on emerging markets and therefore commodities is also expressed by the fund’s manager.  I’m not sure betting 95% of a fund’s assets on what a country’s regulator and commodity prices might do is overly prudent, but if these views come to fruition, the fund’s investors are likely to be a happy bunch.

Canadian banks are a favourite for this country’s dividend investors.  If you’re looking to diversify your dividend exposure simply click here to receive our special FREE report “13 High Yielding Stocks to Buy Today“.  This report will have you rolling in dividend cheques before you know it!

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Fool contributor Iain Butler does not own shares in any of the companies mentioned at this time.  The Motley Fool does not own shares in any of the companies mentioned.     

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