Canadian banks can post billions in profit while their regulator spends an entire report worrying about what might go wrong next.
Both can be right.
The Office of the Superintendent of Financial Institutions’ (OSFI) latest risk outlook continues to focus on real estate lending, liquidity and the growing connections between banks and non-bank financial institutions. Those risks don’t necessarily show up in one quarter’s earnings. A bank can still report strong loan growth, healthy fees and rising profits while vulnerabilities quietly build underneath.
That means investors shouldn’t judge resilience by the size of last quarter’s profit alone. I’d want to know how much high-quality capital sits behind the balance sheet, how much liquidity is available if funding conditions tighten, and whether credit losses are beginning to rise.
The real question isn’t whether the bank looks profitable today. It’s how much shock absorber it has if housing, borrowers or financial markets become less cooperative tomorrow.
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Capital before comfort
Banks need capital to absorb losses. One important measure is the Common Equity Tier 1 ratio, or CET1. It compares a bank’s highest-quality regulatory capital with its risk-weighted assets.
Liquidity is slightly different. It measures whether the bank has enough readily available resources to survive heavy short-term cash outflows. Neither number makes a bank indestructible. Both tell investors considerably more about resilience than a dividend yield alone.
Royal Bank of Canada (TSX: RY) currently enters that test from a strong position.
RBC has room
RBC’s third-quarter adjusted diluted earnings per share (EPS) increased 11% to $4.28. Its CET1 ratio remained 13.5%. That ratio held steady even though RBC returned roughly $4 billion to shareholders during the quarter, including $1.6 billion through share repurchases.
That’s useful evidence. Earnings were replenishing capital while management continued returning money to investors. RBC also pays a $1.76 quarterly dividend. Against $4.28 of quarterly adjusted EPS, that uses about 41% of earnings.
Those are illustrations, not stress-test results. They simply show the cushion between current earnings and the payment. That makes RBC particularly interesting among Canadian bank stocks.
Considerations
RBC recently traded around $278.83, or roughly 18 times trailing earnings, so that’s not exactly crisis pricing. Investors are paying a premium for a dominant Canadian franchise, strong wealth operations and significant capital-markets businesses.
The risk is that a weaker labour market and housing slowdown increase credit losses while capital-markets revenue cools. Several diversified businesses can soften a downturn without making RBC immune to one.
The roughly 2.5% yield also means future returns need more than the dividend. That’s why I’d treat RBC as one of the stronger Canadian dividend stocks without assuming strength makes every entry price attractive.
Bottom line
OSFI is paid to worry about the next problem before investors can see it in earnings. RBC currently gives it fewer obvious things to worry about. Earnings are growing, CET1 remains strong and the dividend consumes a manageable portion of adjusted earnings.
I’d still buy gradually at today’s valuation. A bank can be well prepared for economic stress and still become a better investment after the market gives shareholders a little stress of their own.
