Is Royal Bank of Canada the Riskiest Canadian Bank?

Recently, a slew of articles have challenged the status of Canadian banks as low-risk, rock-solid investments thanks to threats such as the Canadian housing market, energy weakness, new FinTech competitors, and an overleveraged consumer.

It is important to note that not all banks are created equal in this regard, and when it comes to risk, Royal Bank of Canada (TSX:RY)(NYSE:RY) is often considered on the higher range of its peers. This is evident by looking at the past performance of the share price.

Over the past three years, RBC shares have posted a beta of one. Beta is one way to measure risk, and it measures how volatile (or much shares move around) relative to the market as a whole. A beta of one means a stock is equally as volatile as the market, where over one means more volatile and under one means less volatile.

RBC is roughly equal to the overall market, but this compares poorly to most its peers. Toronto-Dominion Bank, for example, has a beta of 0.75, and Bank of Montreal has a beta of 0.87. Only Bank of Nova Scotia was more volatile than RBC with a beta of 1.39.

RBC’s volatility can be partially attributed to the fact that the bank has a relatively large Capital Markets segment (which can be volatile), but also because of the size and nature of its energy lending book.

Looking at RBC’s energy book

While oil prices may be recovering, that does not mean risk from energy loans is disappearing, and RBC will likely be processing the ongoing effects from the oil crash and subsequent re-adjustment of the Canadian economy into 2017.

Currently, with energy loans being 1.6% of total loans, RBC actually has less direct energy exposure than all of its Big Six peers (with the exception of TD Bank). This is a change from the beginning of 2015, where RBC had energy exposure of about 2.25%, behind only BNS and CIBC.

This reduction in exposure is positive and is partially a result of reductions in borrowing bases. The concerning part of RBC’s exposure is the composition of it: 62% is to exploration & production companies (higher than all of its peers except for National Bank) and only 20% of its current exposure is to investment-grade borrowers (much less than all of its peers).

This may be starting to show in RBC’s previous quarter results. Gross impaired loans in the energy portfolio grew by 235% from the previous quarter from $310 million to $1.039 billion. This drove overall gross impaired loans for the bank up by a net $539 million.

Interestingly, despite the large growth in impaired loans, RBC barely grew its overall provisions for loan losses from the previous quarter, increasing it by only $50 million (thanks the strong collateral the bank has). Despite this, with the bank’s overall impaired loans now at a very high 13% of the overall loan book, RBC will likely need to increase its provisions going forward, which means less earnings for RBC.

Should shareholders be worried?

RBC’s energy book is one of the biggest sources of risk for RBC shareholders. How much could this hurt earnings as RBC continues to increase its provisions? Since the beginning of 2015, RBC has had provision for loan losses equal to about 3.35% of its total oil and gas loan book.

This quarter, RBC booked $115 million in oil and gas provisions, which would equal about 5.2% of its overall oil and gas loan book if annualized. Analysts at BNS see this growing to 7% by the end of 2017, marking a slight increase from current levels. This is in line with what RBC sees (a continuation of current levels), and the bank does not see this pushing provisions above historical ranges.

While this may be a greater source of risk for RBC than its peers, it should be well within RBC’s earnings power to absorb, and the bank has been successful at containing costs, which should assist with this.

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