Should You Be Worried About Your Canadian Bank Stocks’ Dividends?

March created a sharp dip in the stock market after three US banks collapsed in a week. The banks collapsed as rising interest rates reduced the prices of long-term bonds. But Canada’s big five banks are well capitalized to handle the current macro environment. So, should you be worried about Canadian bank stocks’ dividends? 

The current sentiment around Canadian bank stocks 

Looking at the sensitivity of bank stocks to the interest rate hike, the Bank of Canada paused the rate hike. But the US Fed announced another 25 basis point rate hike, increasing the interest rate to 4.75%–5%. However, the Fed gave plenty of assurance that the rate hike is nearing its end, with economists expecting an interest rate peak of 5.1%. 

The scenario of the US Fed is understandable, as US banks have been vulnerable to failures because of loose regulations. 

How are Canadian banks different from US banks? 

Many say the 2008 subprime crisis is different from the 2023 liquidity crunch. In 2007, US banks collapsed as they had too much exposure to high-risk mortgages, and a 5.25% interest rate popped the credit risk bubble. Homeowners defaulted on a mass scale, and credit default swaps could not handle the mass default. 

In 2023, the three US banks collapsed as they had too much exposure to long-term bonds, which lost value as their yield was lower than the current interest rate. These banks had a concentrated customer base, all from the same sector and the same social groups. Panic from one customer created a bank run, and all customers started withdrawing. The banks couldn’t handle the mass withdrawals and collapsed. 

In both scenarios, there is one thing in common, concentration risk. It is where Canadian banks, especially the big five, have an advantage.

• They have a diversified customer base across personal and commercial banking, and wealth management solutions. 
• They have a diversified asset base, with a certain amount of Tier 1 equity capital set aside for credit risk. As the risk of default on loans increases, so does this capital ratio. 
• The big five banks increased their provision for credit losses (PCL) as they feel they might not be able to recover the loan amount. As PCL is an expense, it reduces the bank’s net income. 
• The big five increased their liquidity coverage ratio to be prepared for unexpected withdrawals or liabilities. 

Should you be worried about dividends from the big five? 

Royal Bank of Canada (TSX:RY), Scotiabank (TSX:BNS), TD Bank (TSX:TD), Bank of Montreal (TSX:BMO), and CIBC have been paying regular dividends for more than 20 years, without any dividend cuts. While the other four banks paused dividend growth between 2009 and 2011, Scotiabank continued to grow its dividend even then due to its limited exposure to the United States. But in 2021, all five banks paused their dividend growth. 

When the interest rate is at a record low, these banks pause their dividend growth as interest income is the source that funds dividends. These Canadian banks have a dividend policy to maintain a 40–50% payout ratio. But their reported dividend payout ratio inflated in the first quarter ended January 31, 2023. 

• RY’s reported ratio was 58%, and the adjusted ratio was 43%.
• TD Bank’s reported ratio jumped to 116.5% due to its recent US acquisitions. But after adjusting for the one-off event, the ratio was 42.9%. 
• BMO’s reported ratio surged to 474.5% as it recently completed a major acquisition of the US-based Bank of the West. But after adjusting for the acquisition, the ratio was 44.3%.
• CIBC’s reported ratio was 219.6% as it set aside $1.2 billion in legal provisions to settle ongoing litigation. But after adjusting for the legal cost, the ratio was 43.8%. 

These one-off expenses have impacted all banks’ cash flows. But their cash flows should normalize in the coming quarters unless there is another event. The banks are unlikely to cut dividends. At the most, they might stall dividend growth for a year or two.