Canadian banks have been consistently ranked as some of the best in the world due to their large tier one capital ratios (cash reserves and common stock, which serve to keep the bank solvent in a financial crisis), years of strong earnings, and excellent shareholder returns.
With the global economy and especially the American economy showing signs of improvement, and with interest rates speculated to rise, the question investors are asking is: Which bank is set to benefit most? Toronto-Dominion Bank (TSX: TD)(NYSE: TD) is the answer for these two major reasons.
TD Bank is best positioned to profit from rising rates
Banks primarily make money through their net interest rate spread — that is to say, the difference between their interest income from lending activities and their interest expenses on borrowings and deposits. This net interest rate spread is influenced by interest rates rising, and how much it is influenced depends on the size and composition of the bank’s deposit book.
For example, a bank with a large proportion of no-cost or very low-cost deposits such as chequing or savings accounts will quickly benefit from rising rates. These types of accounts pay little or no interest compared to longer-term deposits and when interest rates rise, banks will gradually see increasing interest income from lending activities, and greater spreads on these deposits since they involve little or no cost.
These banks will do better in a rising rate environment since they are earning greater spreads on a greater proportion of their deposits. In Canada, TD Bank has the highest percentage of demand and notice deposits (chequing and savings accounts) to loans. As a result, it is best prepared to profit when rates rise. This is due to the fact that TD Bank is primarily a retail bank, as opposed to Royal Bank of Canada (TSX: RY)(NYSE: RY), for example, which is focused more heavily on its wealth management and capital markets divisions.
TD Bank estimates that an increase of 25 basis points in interest rates would result in a $300 million jump in pretax annual income over time, whereas competitor Bank of Montreal (TSX: BMO)(NYSE: BMO), for example, would notice only a $190 million rise in earnings over time due to the same increase.
TD Bank has broad exposure to the American market
TD Bank differs from its peers in that it has chosen to drive future growth through aggressive expansion into the United States. Currently, it has 1,306 branches in the U.S., compared to 1,164 in Canada. In addition, it has a 40% interest in TD-Ameritrade, the largest online trading firm the U.S.
The U.S. is currently the world’s largest national economy, and has the largest financial services marketplace, which gives TD Bank a very significant arena to grow into. It has executed its American growth strategy carefully, and rather than attempting to expand countrywide, it has chosen to concentrate its operations in seven of the 10 wealthiest states and focus on convenient and fast retail banking while leveraging its well-regarded brand name.
This American position gives TD Bank an advantage over its more domestically focused peers since its earnings are not overly dependent on a growing Canadian economy and housing market, and it is prepared to benefit from an American economy that is performing well and is predicted to grow according to a range of indicators.
Purchasing TD Bank is a bet on improving Canadian and American economic environments as well as rising interest rates. With American GDP growth expected to exceed 3% into 2015, consumer confidence reaching its highest point since pre-recession, and disposable income growing 4.3% since December 2013, it would be a wise bet to make.
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Fool contributor Adam Mancini has no position in any stocks mentioned.