There is always an element of unknown for investors when analyzing a company and debt typically acts as a multiplier for that uncertainty. Banks are no exception.
This is because a bank’s business model is predicated on debt. Fundamentally, traditional banking is a process of getting a loan for “x” per cent and then turning around to lend that money to someone else for “x + y” per cent, making “y” as income. Loans can take the form of deposits (where, instead of interest payments, the bank offers safety and accessibility), debt securities issued to the investors, and anything in between.
However, banks do have to put their own skin in the game. Since the Great Financial Crisis, banks have had to comply with required equity minimums so they can absorb losses. The most systemically important banks are required to carry the largest buffers. JP Morgan Chase is considered the most systemically important bank in the world, but a few buckets below them you’ll find TD and Royal Bank. Both banks are required to maintain a minimum CET1 capital ratio of 9%. Capital ratios are like the down payment you need when buying a house. You cannot borrow the whole amount; you need to contribute a certain percentage. The question around dividends directly relates to these capital ratios. There are a few ways a bank could increase their equity buffer to help insulate their business from tail-risk scenarios. The easiest one is to cut the dividend. Income generated in a business is added to the equity capital of that business until it is returned to its owners. Banks typically pay out most of their income in the form of dividends and share repurchases (effectively the same thing) while the remaining amount is used to finance growth. The question around bank dividends then becomes “do banks need to increase their equity buffers (or capital ratios)?” Focusing on Canada, most of the large banks have CET1 ratios above 11.5% (2.5% above minimum). Smaller banks, like Laurentian Bank, who recently cut their dividend, do not have the same level of buffer because they are not seen to be as systemically important.The Office of the Superintendent of Financial Institutions (OSFI) has been pushing large Canadian banks to build more equity for several years now, increasing the D-SIB (Domestic Systemically Important Banks) capital buffer up ~0.25-0.50% a year (meaning these banks had to keep more equity in the business and pay less dividends than they could have). This gave OSFI the room to decrease the D-SIB buffer by 1.25% when the crisis started, giving banks the ability to lend more freely to support the economy and consumers. If banks cannot meet the 9% minimum, OSFI will require them to stop disbursements. The risk is that many more loans than anticipated become “impaired” – meaning banks absorb losses on their loan books, which reduces their equity capital. However, the banks have already tried to account for this by taking provisions on “performing loans”. This means their current capital ratios reflect larger losses than they have actually experienced. Furthermore, Canada’s mortgage debt situation is fairly unique given the need to either put a large down payment up front or pay for CMHC insurance, protecting the banking system from large losses. Mortgages and Home Equity Lines of Credit (HELOCs) are secured (backed by) the house. If the borrower defaults, the lender takes possession of the home and tries to sell it to make themselves whole. The loss, therefore, is only on the difference between the price of the asset and the loan. If housing prices fall in excess of 20%, this could become a larger issue, but at this point, that does not seem to be the case. The large Canadian banks are also quite diverse. Royal Bank, for example, has about half of its earnings coming from traditional Personal & Commercial banking with the rest coming from Wealth Management, Insurance, Capital Markets, and Treasury Services. This creates additional protection as those businesses are somewhat insulated from default risk and their income will help maintain equity. OSFI could change their tune and force banks to stop returning cash to shareholders, but that seems unlikely at this point. Also, losses could be larger than anticipated, but that also seems unlikely given government aid to businesses and consumers. The Canadian Banking system has built reserves over the past several years to handle this type of environment and they are now drawing on those reserves. If anything, this shows good execution on the part of financial regulators – not something many countries can say. This writing is for general information purposes only and is not intended to provide legal, accounting, tax or professional advice. Any opinions expressed are my own and may not necessarily reflect those of Louisbourg Investments. Author:
Robert Currie, CFA is an Associate Portfolio Manager with Louisbourg Investments. Comments or questions may be submitted to Robert.currie@louisbourg.net.