Which of Canada’s Big 2 Banks Is Best Prepared for an Economic Crisis?

Royal Bank of Canada (TSX:RY)(NYSE:RY) and Toronto-Dominion Bank (TSX:TD)(NYSE:TD) are some of Canada’s most owned names. Which is best prepared for an economic crisis?

| More on:

Canada’s big two banks are some of the most popular names in the country, and Canadian investors almost certainly have some exposure to them whether they own the names directly or not.

Royal Bank of Canada (TSX:RY)(NYSE:RY) estimates that 40-50% of the big two’s shareholder base are retail investors, and investors who don’t own bank shares are exposed indirectly through the fact that the banks are the top two largest constituents of the S&P/TSX index (making up a huge 12.6% of the index); the movement of the index affects the performance of other stocks.

This means that in a recession situation, the performance of the big two banks matters. Currently, there are a few major sources of risk to Canada’s banks (weak commodity prices, overvalued housing prices, and an over-leveraged consumer), and exposure to these areas would affect performance.

The banks are typically limited in how much information they release in the case of a country-wide recession event with rising unemployment and falling GDP, but they have released information about a prolonged oil crash and how this would affect performance. This can give investors a good sense of how these banks would perform under a stress situation caused by low oil.

While a stress situation can also be caused by other factors (like a housing crash), energy will be an ongoing headwind, and exposure to this sector will affect the ability of banks to respond to another type of crisis.

Royal Bank of Canada

While oil prices may be improving, the days of regular oil prices above $80 per barrel are likely over, and this means Canada’s energy sector will steadily shrink going forward. This in turn means higher unemployment in Alberta and general weakness in Canada as the economy rebalances.

How exposed is Royal Bank to this? Currently, 1.6% of RBC’s total loans are to the oil and gas sector, and about 9.5% are to commodities in total. About 62% of energy loans are to exploration and production companies and, as a result, Royal Bank’s loan book has been under slightly more stress than its peers. The bank’s impaired loans ratio (the percent of impaired oil and gas loans as a percentage of the total) has risen from 0.07% in Q1 2015 to 3.7% in Q1 2016.

While Royal Bank may have a higher exposure to oil and gas loans, its retail loans are also fairly vulnerable compared with its peers; it has 23% of loans in Alberta (compared to 18% for its peer group).

What does this mean for Royal Bank’s earnings? The bank ran a stress test with oil prices averaging US$25 in 2016 (growing slowly afterwards), and the bank found that its provision-for-credit loss ratio (how much of its earnings as a percentage of total loans they put aside to cover bad loans) would grow from 0.3% currently to 0.5%.

While this would put some pressure on earnings, it is within the bank’s historical average range.

Toronto-Dominion Bank

Compared with RBC, Toronto-Dominion Bank (TSX:TD)(NYSE:TD) is lower risk in almost every regard. Only 1% of the bank’s loans are to oil and gas, with 7.8% of loans to commodities as a whole. TD has a lower amount of its loans to E&P companies than RBC (57% vs. 62%) and a much higher percentage to safer midstream companies.

As a result, TD’s impaired loans have only grown from 0.13% to 1.41% over the past year—less than half of the growth RBC saw. TD only has 17% of its loans to Alberta—much less than RBC—and TD also has more U.S. exposure, which provides diversification.

According to TD’s stress tests, which sees oil at US$35 and recovering to $50 over four years, TD’s 2016 provision-for-credit loss ratio would rise from 0.33% in 2015 to about 0.45%. While this is a similar build to RBC, only 5-10% of that build is oil related with the majority being related to normalizing loan losses in the U.S. and recent credit card acquisitions.

TD’s lower exposure to both Alberta and oil companies as well as greater U.S. earnings means that in the event of an economic slowdown, the bank would likely fare better than RBC due to fewer headwinds from oil and gas, which would translate into better earnings power.

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 Adam Mancini has no position in any stocks mentioned.

More on Bank Stocks