Are you worried that the fate of the banks on the south of the border could affect you? You need not worry, as Canada’s banking system is poles apart. It doesn’t mean that the Big Six Canadian banks won’t feel the tremors. The U.S. arm of these banks might take a hit, but it could be an opportunity in disguise if you think like a value investor. Let’s see what the U.S. bank collapse could mean to Canada’s Big Six.
Why did some U.S. banks collapse?
The main cause of bank failures is interest rates risk and concentration risk. The U.S. Fed started increasing interest rates in March 2022. In 12 months, the Fed increased rates from 0.25% to 4.5%. The rate hike pulled down tech stocks, as investors shifted their money from growth stocks to short-term bonds.
Interest rate risk
Let’s understand how the bond market works. In a bond, the principal is safe, and the yield is fixed, but the price at which you buy and sell that bond changes according to the interest rate. Bond price rises if the current interest rate is lower than the bond yield and falls if the interest rate is greater than the bond yield.
The Silicon Valley Bank (SVB) has significant exposure to tech startups. In 2021, the interest rate was 0.25%, and it received huge deposits from tech customers amid the tech bubble. It invested a significant number of these deposits in long-term bonds while maintaining a small cash reserve to meet withdrawal requests. At that time, long-term bonds were attractive.
In 2022, tech stocks fell, reducing the price of SVB’s assets. Moreover, the rising interest rates pulled down long-term bond prices, resulting in unrealized losses for SVB’s assets. The problem came when its customers started withdrawing deposits, as capital dried up for startups. SVB’s cash reserves fell short of meeting the withdrawals, and it was forced to sell $21 billion of its security portfolio at a loss of $1.8 billion.
The SVB announced plans to raise $2 billion in capital, which created a bank run, as customers started withdrawing in panic. The situation went out of control, and the regulator had to shut down the bank. The Federal Deposit Insurance Corp (FDIC) withdrew $40 billion from the Treasury General Account to create liquidity for withdrawals.
One incident created panic, and depositors started withdrawing money from other banks, pushing Signature bank and Silvergate capital to a similar fate as SVB.
How will the collapse of these U.S. banks impact Canadian banks?
The FDIC is looking for buyers for the assets of collapsed banks. Royal Bank of Canada was a suitor for SVB assets, but it backed away. Like RBC, other Canadian banks could also be potential suitors for the assets of distressed U.S. banks. These assets would be available at dirt-cheap prices if Canadian banks are interested. While this is an opportunity, Canadian banks that made recent U.S. acquisitions could feel the heat of SVB collapse.
Bank of Montreal acquired Bank of the West for US$16.3 billion in February. The U.S. bank collapse could force BMO to reduce its guidance from the acquisition, as the loans and deposits balance of the Bank of the West declines. However, Toronto-Dominion Bank is probably saved from a costly acquisition of First Horizon for US$25/share (US$13.4 billion) thanks to delays in regulatory approvals. After the bank crisis, First Horizon’s stock is trading at US$15, which is down 37.7% from the acquisition price. TD Bank is unlikely to pursue this acquisition now.
Is now a good time to buy Canadian bank stocks?
Even though Bank of Montreal might reduce its guidance, its BMO Equal Weight Banks Index (TSX:ZEB) is a value investment in the current crisis. The exchange-traded fund has equal exposure to the Big Six Canadian banks. These banks have a diversified customer base across verticals. Moreover, their assets are diversified across different securities.
While Canadian banks’ profits have been falling, their balance sheets and liquidity have been stable so far. The TSX bank stocks might fall in the short term, but they are well capitalized and can sustain a recession, as they did in 2007.