How Risky Is Bank of Nova Scotia After Moody’s Downgrade?

The perceived degree of risk in this bank’s growth strategy is overblown and it now offers considerable upside for investors.

| More on:
The Motley Fool

Global ratings agency Moody’s recently affirmed its ratings of Canada’s seven largest banks and downgraded its outlook from stable to negative on the back of Ottawa’s proposed “bail in regime” for Canadian banks. One of the banks hardest hit was Bank of Nova Scotia (TSX: BNS)(NYSE: BNS), because Moody’s not only downgraded its outlook to negative along with the other top seven banks, but also downgraded its financial strength to negative.

This was on the back of the bank increasing the level of risk in its credit portfolio, with the bank increasing its exposure to higher-risk unsecured consumer credit at a time of peak consumer debt domestically. Most of this came about through the bank’s plan to accelerate growth in its higher-risk auto finance and credit card portfolios, which has already seen the bank acquire a 20% stake in Canadian Tire’s (TSX: CTC.A) financial services division. As part of this acquisition, the bank has agreed to provide up to $2.25 billion in credit card receivables financing to the business in an effort to boost credit growth.

Another concern of Moody’s was the bank’s decision to sell the majority of its stake in mutual fund manager CI Financial (TSX: CIX) in order to fund further growth across its higher-risk international operations.

According to Moody’s, these things represent a fundamental shift in the bank’s historically conservative approach to risk management. However, there is a logical reason for this shift in the bank’s risk appetite.

Why is Bank of Nova Scotia increasing its risk appetite?

Each of those actions is a key plank in driving further earnings growth in a financial services market that is oversaturated and has little room for additional growth in traditional growth markets such as secured mortgage lending. The lack of growth opportunities in the Canadian financial services market has already spurred the major banks to invest significantly in wealth management, but growth opportunities here are diminishing rapidly.

As a result, Toronto Dominion Bank (TSX: TD)(NYSE: TD) and the Bank of Montreal (TSX: BMO)(NYSE: BMO) have aggressively expanded their U.S. operations as a means of driving growth, while Bank of Nova Scotia has typically looked to emerging markets.

Is there a tangible benefit for Bank of Nova Scotia and its investors?

These are all relatively high-risk growth strategies, each with their own unique set of risks. However, if managed effectively within the right risk management framework, they have the potential to be significant drivers of growth for the bank.

The acquisition of a 20% stake in Canadian Tire’s financial services business gives the bank access to the eighth-largest credit card portfolio in Canada and the ability to cross-sell a range of products, including insurances and mortgages.

The bank’s international strategy is also not as risky as it first appears, and is well positioned to pay dividends for the bank. This strategy is primarily focused on building the bank’s Latin American exposure in Colombia, Peru, Mexico, and Chile; all four countries have investment-grade sovereign debt ratings. These four countries also have some of the highest forecast GDP growth rates in the region, and as a whole, an average forecast GDP growth rate of almost 4% for 2014 and 2015.

This is almost double the 2% forecast for Canada over the same period. Unlike Canada, there is also a growing demand for credit, savings, and wealth management products in the region, with the middle class continuing to grow strongly. The OECD has estimated the middle class in Latin America will grow by two-thirds over the next 16 years.

The region is also heavily under-banked, with only around a quarter of Colombians and a fifth of Peruvians holding a debit card or some form of transactional bank account. This is further evidenced by domestic credit provided to the private sector by banks representing only 41% of GDP, whereas it totals 130% in Canada.

These facts highlight the growth opportunities that exist for Bank of Nova Scotia in Latin America, where it has already established a strong presence as the third-largest bank in Peru and the fifth-largest in Colombia. International banking contributes around 23% of the bank’s net income and generates a superior profit margin with a net interest margin of 4% compared to Canadian banking’s 2%. As these operations grow, international banking will contribute a greater portion of the bank’s net income.

Just what do the key risk indicators tell us?

Upon closer inspection, the bank’s key risk indicators are particularly conservative, indicating it has a low degree of risk and that there is some room to boost the bank’s risk appetite as a means of growing earnings.

It has a Tier 1 capital ratio of 9.8%, well above the required minimum of 5.5% and higher than Toronto Dominion’s 9.2% or Bank of Montreal’s 9.7%. Bank of Nova Scotia, like the majority of Canadian banks, has a particularly low non-performing loan ratio of 0.45%, which is a key measure of credit risk. This ratio is lower than Toronto Dominion’s 0.48%, but double Bank of Montreal’s 0.22%.

These indicators highlight that there is significant room for the bank to increase its risk appetite as a means of growing earnings. Therefore the increased consumer lending exposure, as well as the bank’s exposure to expected solid long-term growth in emerging markets, will see its earnings grow significantly. This means that it’s a must-have investment for growth-oriented investors seeking exposure to Canada’s banks.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Matt Smith does not own shares of any companies mentioned.

More on Investing

Oil pumps against sunset

Oil or Tech? Why Choose When You Can Get Both in a Single Stock?

Tech stock Pason Systems (TSX:PSI) is exposed to the energy market boom.

Read more »

A red umbrella stands higher than a crowd of black umbrellas.

Protect Against Inflation With 2 Top TSX Stocks

Here are two top TSX stocks that long-term investors concerned about inflation may want to consider in this time of…

Read more »

Woman has an idea
Tech Stocks

The Smartest Stocks to Buy With $20 Right Now and Hold Forever

These under-$20 stocks have the potential to grow further with time and deliver solid capital gains.

Read more »

A close up image of Canadian $20 Dollar bills
Dividend Stocks

TFSA Investors: Put $45,000 in These Top TSX Stocks and Watch Your Passive Income Roll In

Are you looking to retire early? Here are a few ideas about how your TFSA could earn a passive-income stream…

Read more »

Human Hand Placing A Coin On Increasing Coin Stacks In Front Of House
Dividend Stocks

Love Passive Income? Here’s How to Make Plenty of it as a Real Estate Investor

You could definitely create passive income by investing in pure real estate, but you could make just as much, if…

Read more »

Make a choice, path to success, sign
Dividend Stocks

2 High-Yielding Dividend Stocks You Can Buy and Hold for Years

These two high-yielding dividend stocks can be the perfect addition to your portfolio, as the bear market causes payout yields…

Read more »

A worker uses a laptop inside a restaurant.
Tech Stocks

Why Investors Shouldn’t Give Up on Shopify Just Yet

Here's why long-term investors may not want to throw in the towel just yet on e-commerce juggernaut Shopify (TSX:SHOP).

Read more »

Retirees sip their morning coffee outside.
Dividend Stocks

TFSA Wealth: How to Turn $88,000 Into $1 Million for Retirement

Canadians can use the TFSA to hold a basket of diversified equity investments, allowing you to turn a $88,000 investment…

Read more »