Royal Bank of Canada Investor Alert: Do Big Profits Come With Higher Risk?

Here are the risks new investors in Royal Bank of Canada (TSX:RY) (NYSE:RY) should consider before buying the stock.

| More on:
The Motley Fool

Royal Bank of Canada (TSX: RY)(NYSE: RY) came out of the great recession reasonably unscathed because it had little exposure to the high-risk elements that decimated banks in the U.S. and Europe.

Investors who still think the bank is a low-risk investment should take a closer look.

Royal Bank of Canada has truly become a global banking giant with a market capitalization of more than $100 billion. Shares of Royal Bank have risen 44% in the past two years alone, primarily driven by growth in its wealth management and capital markets divisions.

In its Q3 2014 quarterly report, Royal Bank announced record earnings and investors should be asking if the profit party is being financed with high-risk revenue.

Here is a look at Royal Bank of Canada’s fantastic capital markets results as well as an analysis of some risks for investors.

Capital markets

Profits in the capital markets division of a bank’s business come from wholesale banking activities catering to corporate, government and institutional clients. One area of focus is investment banking where companies and institutions pay the bank fees for an array of advisory services including those connected to merger and acquisition activities. Other revenue in the capital markets unit comes from debt and equity underwriting as well as trading.

In the most recent quarter, earnings from Royal Bank’s capital markets group surged 66% to a record $641 million. This represented about 27% of the bank’s total earnings.

Historically, the bank has maintained an internal earnings limit of 25% for the capital markets group as a means of controlling risks.

The reason the capital markets revenues are considered risky is they can be very volatile. When times are good, the banks can earn a lot of money from capital markets services. When economic conditions get ugly, earnings from the capital markets side of the business can fall off a cliff.

David McKay, Royal Bank of Canada’s new CEO, appears to be comfortable with the higher risk profile. During the Q3 2014 conference call he told analysts that the 25% limit is a “strategic guideline”.

Investors should be cautious about the capital markets revenues moving forward.

“Overall it was an outstanding quarter for Capital Markets. Clearly the segment benefitted from a number of factors which are unlikely to be repeated to the same degree, but the success of the repositioning of the business in recent years is undeniable and I remain confident in the long-term strategy,” McKay said on the earnings call.

With shareholders expecting bigger profits and more dividend increases, I think it is unlikely Royal Bank of Canada’s management team will move to restrict the amount of capital-markets business the company takes on.

Canadian mortgage exposure

Royal Bank of Canada also has some risks sitting on the retail side of its balance sheet.

Dan Werner, analyst at Morningstar, wrote in a July report that he expects house prices in Canada to drop by 30% once they finally peak. The decline will be triggered by an increase in interest rates that will force home and condo owners to sell because they will not be unable to afford the higher mortgage payments.

In the analysis he said that Royal Bank and Canadian Imperial Bank of Commerce (CIBC) would be hit the hardest by a housing crash because they have the largest percentage of residential loans to tangible common equity ratios.

Common equity ratio

Royal Bank’s Basel III common equity Tier 1 (CET1) ratio dropped in the second quarter to 9.5% from 9.7%. The ratio is an indication of the bank’s financial strength. Royal Bank of Canada is still well capitalized but its CET1 ratio is lower than the 10.1% reported by CIBC.

The bottom line

Given the current risk environment, I think it is advisable to take a cautious approach with Royal Bank of Canada. The earnings party might continue for another couple of years, but the possibility of a big shock is also increasing.

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.

More on Bank Stocks

analyze data
Bank Stocks

Should You Load Up on TD Bank Stock?

TD Bank (TSX:TD) stock has bounced back a bit since its recent lows, but the best may be on the…

Read more »

Businessperson's Hand Putting Coin In Piggybank
Stocks for Beginners

3 Dividend Stocks Every Investor Should Own

Heading into earnings season, which bank stocks are best for dividend income?

Read more »

stock research, analyze data
Bank Stocks

Should Investors Buy the Correction in TD Stock?

TD stock is down more than 25% from the 2022 high. Is it finally time to buy?

Read more »

Bank Stocks

Could Royal Bank Stock Reach $200?

Growing rate cut hopes and improving analysts’ expectations from Royal Bank’s financial results could help its stock maintain strong upward…

Read more »

edit Business accounting concept, Business man using calculator with computer laptop, budget and loan paper in office.
Bank Stocks

1 of the Best Dividend-Paying Bank Stocks to Buy Now and Hold Forever

Here’s a very reliable, dividend-paying Canadian bank stock you can buy at a bargain right now and hold for the…

Read more »

Prospects for TD Bank stock
Bank Stocks

TD Bank in Hot Water: An ‘Exceptional’ Opportunity

Is TD Bank stock a buy after its money-laundering regulatory problems?

Read more »

woman data analyze
Bank Stocks

Best Stocks to Buy in May 2024: TSX Financials Sector

Wondering which TSX financial stocks could see substantial growth in the future? Here are three stocks with BIG upside from…

Read more »

Bank sign on traditional europe building facade
Bank Stocks

2 Canadian Bank Stocks to Watch in May 2024 (They’re Not the Big 5)

Watch National Bank of Canada (TSX:NA) and another top financial closely in May.

Read more »