Banks strong, despite ratings

In late January, Toronto-based Moody’s Canada Inc. downgraded the credit ratings for five of the Big Six banks – Toronto-Dominion Bank, Bank of Nova Scotia, Bank of Montreal (BMO), Canadian Imperial Bank of Commerce and National Bank of Canada – as well as for Montreal-based Caisse Centrale Desjardins. Each firm’s rating was lowered by one notch on Moody’s rating system.

The downgrade decision was the result of a review the credit-rating agency initiated on the banks last autumn.

Royal Bank of Canada, which was not subject to the recent review, already had received a two-notch downgrade from Moody’s last summer, as part of its review of 15 global banks over concerns about those banks’ capital-markets businesses.

The recent Moody’s review identified a number of key risk factors in deciding to make the downgrades, the most notable of which is the Canadian banks’ exposure to an overleveraged consumer market and to a possible drop in housing prices; both risks have risen significantly over the past several years.

“[The aforementioned factors] leave [the banks] more vulnerable to unpredictable downside risks facing the Canadian economy than in the past,” says David Beattie, a vice president with Moody’s Canadian division in Toronto.

Banking analysts say that the credit-rating agency’s announcement, in citing these risks, is essentially echoing remarks that already had been made by the Department of Finance Canada and the Bank of Canada regarding concerns over elevated and potentially unsustainable real estate values and the generally overleveraged consumer.

“Rating agencies tend to move slowly,” says Michael King, an assistant professor with the Richard Ivey School of Business at the University of Western Ontario in London, Ont. “Often, their decisions come after the market already has priced in the news.”

Adds Sedran: “These are risks that investors should have been considering even before they were flagged [by Moody’s].”

Banking analysts and Moody’s both note that – even factoring in the downgrades – Canada’s Big Six remain among the most highly rated banks in the world.

“Canadian banks are very well capitalized,” says King, adding that the Big Six are well ahead of their global peers in terms of meeting their Basel III capital requirements. “And despite having very high capital ratios, they are still very profitable when judged by their return-on-equity figures, which are at significantly higher levels compared with [those of] U.S. or European banks.”

Despite the strong fundamentals, banking analysts agree Canadian banks do face some challenges and may be hard pressed, in both the short and medium term, to achieve the strong earnings they posted over the past several years.

“I don’t think the rate of growth that we’ve seen in the consumer market is likely to continue at the same pace,” Sedran says. “We’re expecting profit growth [for the Big Six] to slow, but we’re not forecasting a significant increase in loan losses.”

The recent Moody’s announcement cites some other risk factors as well, including the possibility of a downturn in the global economy, which would have a negative effect on Canada’s commodity-driven domestic economy.

The announcement also notes that a few of the banks – Scotiabank, BMO, and National Bank – have significant exposure to the capital markets, which has a higher risk profile than other business units. The announcement also cites the Big Six’s reliance on wholesale funding as a factor that “[increases] their vulnerability to financial markets turmoil.”

A rise in interest rates, especially a sharp one, would increase the banks’ cost of funding and have a host of other, potentially negative consequences for the banks. That could include raising the cost of mortgages and lowering the value of real estate, King says: “All of which will work toward reducing the profitability of the banks.”

The Moody’s downgrade announcement also indicates that the agency has removed “system support” from the ratings of the Canadian banks’ subordinated debt – a move, the report says, that was in line with recent actions Moody’s had taken regarding the subordinated debt of many global banks. This indicates that Moody’s believes it unlikely that in the event of a bailout of one of the big Canadian banks, the government would step in to support holders of subordinated debt.

“It’s new that Moody’s is now distinguishing between the degree of government support it believes might be available for different types of bondholders [in the event of a bailout of a Canadian bank],” says King. “[Moody’s is] trying to get at the problem of moral hazard.”

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