What the Collapse of U.S. Banks Means for Canada’s Big Six

If you are concerned about the U.S. bank contagion, you don’t have much to worry about. The U.S. banking crisis was triggered due to the loss of regulatory controls and too much exposure to long-term bonds that lost value in a rising interest rate environment. The Big Six Canadian banks have diversified asset portfolios and adequate liquidity and capital to meet withdrawal needs.

While Canadian banks don’t have much exposure to the failed banks, their acquisitions of U.S. regional banks could create short-term weakness. The Big Six could also feel the heat of a slowing macro environment, as central banks worldwide dry up liquidity to ease inflation. But they have the potential to ride the recovery rally and grow with the economy. 

The correlation between banks and the macro environment 

Before investing in bank stocks, you need to understand how they are affected by the macroeconomic environment. Banks are the source of supplying money for the economy. The central bank increases interest rates to reduce the money supply by making borrowing expensive. For banks, an increase in interest rates helps them earn higher interest income from loans. 

But when a rate hike accelerates, so does the credit risk. At a time when inflation is high, the purchasing power of people and the investment capacity of businesses slows. Many businesses use internal deposits to fund their operations. Canadian banks saw an uptick in loan books as well as risk-weighted assets. Hence, they increased the provision for credit losses (PCL). 

When the economy weakens due to a dip in the money supply, bank stocks fall. Does this make bank stocks a risky investment? The Canadian banking system has strict regulatory controls and strong risk management that prepare them to withstand an economic crisis. 

The risk management of Canada’s Big Six

Basel III requires Canadian banks to maintain a common equity A tier-one ratio of at least 4.5%. It means for every $100 million in risk-weighted assets that have a probability of default, a bank should maintain $4.5 million of common equity A tier-one equity capital reserve that it can easily access. As of January 31, 2023, the Big Six maintained a ratio of over 11% to withstand a higher amount of credit risk. 

A bank also faces liquidity risk, which means having inadequate cash to meet withdrawals and other liabilities for the next 31 days. Basel III requires banks to have a liquidity coverage ratio of 100%. But the Big Six maintained a higher buffer, as rising interest rates and high inflation is drying liquidity in consumers’ hands. 

The banks are increasing their PCL depending on the market, which is reducing their net income. But it is a small price to pay to manage a macro-level risk. The Silicon Valley Bank collapse shows the impact of weak risk management on the sustainability of a bank. 

Should you invest in TSX bank stocks? 

The Big Six banks overcame the 2008 and the 1980 crises and improved their capital adequacy and risk control with every crisis. While scandals and gaps weakened U.S. and European banks, the Big Six avoided them by focusing on Canadian lending. However, Bank of Montreal, TD Bank, and Royal Bank of Canada’s expansion in tier-two cities of the United States through the acquisition of regional banks increased their U.S. exposure. 

Unfortunately, regional banks are the most vulnerable to the U.S. banking crisis. If you go by the bankruptcy logic, the banking crisis creates an opportunity for Canadian banks. They can buy assets of distressed U.S. regional banks at a cheaper price and bring them under their better-regulated system. 

Amid uncertainty around whether the U.S. banking crisis is a boon or a bane for Canadian banks, you can invest in BMO Equal Weight Banks Index ETF to secure a position in the recovery rally.