If the Canadian banks were indeed more virtuous than their international competition going into the recent financial crisis, that virtue may have to suffice as their reward. It doesn’t appear that Canadian banks will be reaping any other great benefit for running superior businesses.

Although the Canadian banks may have sailed through the financial crisis in much better shape than many of their rivals in the U.S. and Europe, our domestic banks are still facing the same sorts of regulatory reforms that will hamper the profitability of their businesses in the future, not to mention pressure to rein in compensation. Unfortunately, for the Canadian banks, the rest of the global industry had gaffed so badly that the entire industry is facing tougher regulation — all big banks are being punished, whether they enjoyed the excesses of the upside or not.

Most important, the Basel Com-mittee on Banking Super-vision is proposing: that banks face higher capital requirements; that their capital be of higher quality (more common equity); and that they adhere to liquidity standards and leverage limits. The Basel Committee’s latest proposals in this area were released in mid-December. The Basel Committee hopes to have the details of the new regulatory framework for global banks decided by the end of this year, with an eye to implementing reforms by the end of 2012.

Although the proposals aren’t yet final, the feeling is that bankers aren’t too pleased with the results so far. “Our initial impression is that the proposals are likely to have prompted considerable uneasiness within the global banking community,” notes a Blackmont Capital Inc. research report released in the wake of the latest proposals. The report added that if the current proposals are adopted, the banks could see their current capital ratios decline and leverage ratios increase.

In this environment of regulatory flux, banks are naturally forced to be cautious. Speaking at a Canadian bank CEO conference hosted by Royal Bank of Canada’s capital markets division in mid-January, RBC CEO Gord Nixon indicated that banks will have to carry high levels of capital until there’s greater certainty about the details of the new capital rules.

He suggests that domestic banks could consume excess capital by increasing dividends or making acquisitions, but that this sort of capital usage probably won’t occur until closer to the end of 2010, when the banks and their regulators will have a better sense of what they are facing from Basel.

For now, says Nixon: “We’re in an environment [in which] conservatism is being pushed to the limit because the regulators don’t want to be caught offside, nor do financial institutions want to be caught offside.”

In the meantime, the uncertainty created by the prospect of these looming reforms has become a dominant concern for bankers and has helped keep the Canadian banks from capitalizing on their status as the strong survivors amid a herd of weakened competitors.

Arguably, Canadian banks’ relatively healthy and flush condition should position them as ideal strategic acquisitors in the current environment. But that hasn’t proven to be the case, as there have been relatively few acquisitions carried out by domestic banks — and none of any major significance in this period.

Nixon observes that there’s been a real dearth of mergers and acquisitions activity in the financial services industry generally in the past couple of years. Apart from the crisis-driven transactions that occurred in the autumn of 2008, there have been no deals of any magnitude, he notes. And he points to the climate of regulatory uncertainty as one reason for the lack of M&A action, explaining: “It’s been very difficult for potential [acquisitors] to do a deal in an environment [in which] you don’t know what the capital rules are, nor do you want to take on balance sheet risk or uncertainty.”

He suggests that it’s “almost irresponsible” to be an aggressive buyer in an environment such as this, which has limited firms’ scope for deals. At the same time, potential sellers don’t have much incentive to deal, either, he notes, as the prices they’d be likely to get would be too low.

The fact that the uncertain regulatory environment (particularly, in terms of capital rules) has limited the banks’ appetite for acquisitions was echoed by the other senior executives at the RBC conference. Nevertheless, they maintain that the window to do deals is not yet closed. Nixon says that he expects the M&A activity to pick up toward the end of 2010, when there’s greater clarity around the capital rules.

@page_break@At that point, Canadian banks will have a clear idea of how much capital they are likely going to have to raise to meet the new standards, and they will have to figure out how they are going to do it — an exercise that may well include divesting assets, which would give well-capitalized banks another opportunity to seize their advantage. That’s when Canadian banks may finally see their more cautious approach pay off.

Of course, a dramatic acquisition isn’t the only way for the Canadian banks to play their advantage. It could also occur in terms of organic growth, as the banks aim to win business from rivals that have to devote themselves to building up their capital ratios as a result of the new rules.

Bank of Montreal CEO Bill Downe suggested at the RBC conference that he expects that some of BMO’s historically strong competition in the U.S. will be sidelined by the need to rebuild capital in the years ahead, notably in the U.S. Midwest region: “That’s where I think the relative weakness of competition is going to create opportunity for us.”

At the same time, he stressed that BMO has also been taking advantage of the current environment to build up its human capital — hiring the sort of bankers that it believes will give the bank a competitive advantage in the field.

These advantages may yet materialize for the Canadian banks. In the meantime, there will undoubtedly be plenty of lobbying by the banking industry for less dramatic changes to the capital rules than the Basel Committee is recommending. Indeed, some market players, including regulators, have publicly questioned the feasibility of some of the Basel Committee’s moves, such as whether the authorities can effectively calibrate countercyclical capital requirements. And bankers are hoping that other authorities, such as central bankers and finance ministers, will restrain the regulators from making the new capital regime too punitive, for fear of choking off the economic recovery.

Although there will undoubtedly be plenty of lobbying and negotiation over the final look of the rules in the year ahead, it seems unlikely that the pressure on Canadian banks’ capital levels will abate.

Nor does it seem likely that compassionate local regulators will be able to provide much relief. It will be up to national banking regulators to implement these changes, which could provide some scope for divergence from the global standards. However, in the wake of the crisis, it is unlikely that the market will tolerate too much deviation. Domestic regulators may find that their hands are tied by the push for uniform global capital rules.

For example, under the latest proposed reforms, Canadian banks would no longer be able to count minority stakes in other firms as part of their Tier 1 common equity. This could hurt a couple of the Canadian banks that have used the strategy of taking minority interests as a way to get into new markets; they may have to put up fresh capital as a result.

Sabi Marwah, chief operating officer of Bank of Nova Scotia, told the RBC conference that Scotiabank has explained to the regulators that such an approach would be quite punitive. And although regulators agree, he says, the reality is that these changes are being driven at the global level, not by Canadian regulators. As a result, Canadian banks may well be forced to consume more capital to support their existing operations or alter strategies in response to the new rules.

Toronto-Dominion Bank is another firm that could be affected by the proposed approach to minority stakes. Speaking at the RBC conference, TD CEO Ed Clark acknowledged that there’s a risk that TD will have to put up more capital against certain businesses, but he stressed: “You don’t change your business strategy because of that.”

Indeed, Clark appears resigned to the fact that the underlying cost of doing business is rising. He notes that regulatory changes have increased overhead costs; and while not all of these changes are adding value, it is the new reality facing banks. He says that TD’s earnings are growing, so the bank can accommodate the added expense.

Still, it’s not clear what the final regulatory bill will be for any bank. It’s expected that the proposed reforms could yet change quite a bit before they are finalized. “The likelihood of the Basel Committee’s proposals being implemented in anything close to the presented initial form is, in our view, remote at best,” says the Blackmont report.

Nevertheless, it appears that bankers’ political currency is at an all-time low, which may limit their ability to secure softer reforms. Case in point: witness the Obama administration’s recent decision to start charging a levy on bank liabilities, designed to cover the US$117-billion cost to U.S. taxpayers of the industry bailout.

As a report from New York-based research firm CreditSights Inc. observes, the fees themselves shouldn’t be too harmful to banks’ bottom lines, although they will certainly have a negative impact on bank profitability. However, the fees are indicative of the fact that banks don’t have any clout with politicians right now.

“We remain concerned that this is more evidence of the cynical view of the banking industry that prevails in Washington,” the CreditSights report says. “We continue to believe that these myriad new rules, fees and legislative proposals represent new major risk factors for U.S. banks.”

Of course, it remains to be seen how this rule-reform process will play out over the coming year. The only certainty now seems to be that banks are going to have to retain more capital and that their returns are likely to be lower as a result. Concludes the Blackmont report: “We remain convinced that, at best, overall capital levels will migrate higher and returns will migrate lower for the global banking industry.”

The banks will undoubtedly try to pass much of the added burden through to clients in the form of higher prices for financial services. Says Nixon: “I think the most underrepresented constituent in the debate right now is the user of financial services — because, ultimately, a large percentage of the cost of increased regulation is going to be passed on to borrowers and consumers.”

It would be one thing if regulatory backlash harmed only the guilty, but it also seems sure to hamper the business of banks that avoided these excesses in the first place. The Canadian banks will have to console themselves with the knowledge that they had a better business model than many of their global rivals going into the crisis — although that may prove to be cold comfort when they find themselves paying for the sins of others and running less lucrative businesses as a result. IE