Banks face more debt threats

In contrast, Bank of Montreal’s GILs increased just 7% in the same period, while Royal Bank of Canada’s were up only 3%. National Bank of Canada’s were down 31% as a result of selling off its U.S. asset-based lending portfolio after it was unable to exploit cross-selling opportunities.

Analysts expect the next set of hits to affect TD Canada Trust, vis-à-vis Adelphia and Tyco, and Scotiabank and BMO because of Brazil, although the other big banks will also be affected.

At April 30, TD was best positioned to withstand further losses. Its GILs as a percentage of loans and BAs was 1.29%. GILs as a percentage of loan loss reserves and common equity was 12% and its reserves as a percentage of GILs was 102.4%. Only for GILs as a percentage of reserves were any of the other banks in better shape — CIBC at 115% and National at 114.1%.

Royal Bank, which may face a loss of US$517 million related to Enron, was also in good shape, second to TD in both GILS as a percentage of loans and BAs and GILS as a percentage of reserves and common equity, although its reserves were just 92.6% of GILs.

All the banks have been raising their reserves at the behest of the Office of the Superintendent of Financial Institutions. (In the early 1990s, the weighted average for the seven largest banks for reserves/GILs was around 50%, while GILs/reserves and common equity was more than 60%.)

Despite the high-profile problems, GILs as a percentage of loans and BAs have been relatively low during this economic slowdown, at a weighted average of 1.78% on April 30 vs 5.4%-5.6% in 1992-93. As a result, the impact of the collapse of Adelphia and Tyco will be limited, even at TD. Its exposure — at an estimated $1 billion — is by far the greatest. In that eventuality, GILs at TD would increase by 60% but the bank’s ratio of GILs to loans and BAs would be only slightly more than 2% and its ratio of GILs to reserves and common equity would be less than 20%.

Scotia’s Brazilian exposure is $772 million. If all that became impaired, GILs would rise only 14% but its ratios are already high and that would boost its GILS as a percentage of loans and BAs to 3.4 and its GILS as a percentage of reserves and common equity to 31%.

BMO’s Brazilian exposure is $370 million. If all that became impaired, its GILs as a percentage of loans and BAs would rise to 1.9% and its GILs as a percentage of reserves and common equity to 20%.

Analysts say Scotia, BMO and CIBC have exposure to Adelphia and Tyco, while Royal Bank is exposed to Tyco and Enron.
These high-profile exposures underline a weakness of Canadian banks. U.S.-based Standard & Poor’s warns in a recent report: “The Canadian banks’ financial flexibility for dealing with credit cycles is considered only moderate compared to mature-economy peers as their reserve levels, although improved, are not as robust as their U.S. counterparts.” S&P notes that although loss rates on residential mortgages and consumer loans remain lower in Canada, debt per capita has been rising rapidly for the past couple of years.

At the same time, Canadian commercial lending is as risky as in the U.S. and, within wholesale lending, customer concentration is more pronounced. This is “becoming a greater concern as single-name exposures have proven to be quite risky in a down cycle,” writes S&P.

Because many Canadian industries are dominated by a few very large players, it is difficult for Canadian banks to avoid “excessive loan concentrations for their sizes.” Attempts to overcome this by diversifying internationally has resulted in other risks, such as exposure to emerging markets and to U.S. syndicated loan markets, in which leveraged loans continue to experience some distress. S&P says Canadian banks generally have about 15% of their corporate and commercial portfolios in the U.S., where they participate in the syndicated loan markets.

S&P calls the banks’ attempts to diversify internationally modestly successful so far. CIBC’s acquisition of U.S.-based Oppenheimer & Co. “has not met all of the bank’s expectations and is, in any case, a niche acquisition. And it’s electronic bank, Amicus, “has yet to prove its profitability and is very expensive.”

Nor, says S&P, has BMO’s Harris Bank become “a dynamic entity,” although it has been a stable performer. With its acquisition of U.S.-based CSFBDirect, BMO will be increasing the size of its discount brokerage operations fivefold. As Toronto-based Dominion Bond Rating Service Ltd. says, it is yet to be seen whether it will be able to cross-sell banking, mutual funds and investment products.

Scotia has been successful in the Caribbean, but South American investments — and particularly Argentina — have caused it grief. President Peter Godsoe has been quoted as saying the bank won’t be shying away from international expansion. He has indicated interest in buying a mid-sized regional U.S. bank and acquiring the 45% of Mexican bank Inverlat that it doesn’t already own. Nevertheless, its most recent move has been on the home front, announcing in June that it was acquiring Altamira Investment Services Inc.

TD’s discount brokerage strategy has also been successful, but S&P says its significance pales in comparison with its domestic expansion through the acquisition of Canada Trust.

Royal Bank’s U.S. strategy of retail banking, wealth management and insurance “is starting to make more sense and is, albeit slowly, leading to a decent U.S. platform and product scope,” says S&P.

S&P gives the Canadian banks good marks for shifting their business mix to more retail and less wholesale or corporate components. It notes that they are able to provide and sell products and services “in an efficient way at a lower cost, while at the same time turning in profits that are comparable with the industry average (looking primarily at mature banking systems).”

CIBC has been the most explicit on this, saying that it plans to continue to reduce the size of its corporate loan portfolio “to mitigate the impact of the credit cycle on future earnings” and will also decrease the size of its merchant banking portfolio. In the meantime, it is bolstering its retail business with the acquisition of Merrill Lynch Canada Inc.

Canadian bank efficiency ratios (non-interest expenses as a percentage of revenues) are in the mid-60% range, “equal to those of the world’s more efficient systems and comparable with the 55% level of some large U.S. banks (adjusted for the lower interest margin in Canada).”

Nevertheless, S&P believes Canadian banks “to be only moderately capitalized” given large loan concentrations and sizable commercial and corporate loan books, including a high proportion of non-investment-grade loans and less international diversification than some global banks. It will “scrutinize” any decreases in capital levels resulting from the adoption of the new international guidelines on capital required to back up loans (the Basel II proposals). IE