Canadian banks too inefficient to compete: S&P

(February 15, 2005) Canadian banks looking for inroads into the U.S. market should probably just stay home, according to a recent report from analyst agency Standard & Poors.

“The better bet for Canadian banks is to concentrate on their home turf,” reads the report, based on research by Tanya Azarchs, managing director in financial institutions ratings at Standard & Poors’ Ratings Services. “Here they have room to boost their profits through efficiency improvements in areas such as branch configuration and back-office processes.”

Foreign banks have long struggles to gain a foothold in the U.S., where the banking industry is far more fragmented than in other markets. A handful of national banking behemoths enjoy the advantages of their economies of scale and Canadian banks simply lack the size to compete head-on with a firm like Citibank.

So Canadian banks tend to focus on the lower end of the market, where they compete with smaller regional banks for higher-risk lines of business. Most foreign banks have been fairly intolerant of risk, focusing on less profitable residential mortgages, while the U.S. regionals take more risk, participating in the commercial real estate loan market.

As a result of their lower risk tolerance, Canadian banks have struggled to keep up with the U.S. regionals in terms of fee revenues.

“Strengthening their pricing power with wider spreads on mortgage products and higher account fees would bring benefits, but it is unlikely to happen,” says Azarchs. While Canadian banks pay lower interest than their U.S. counterparts on deposits, this advantage is wiped out by the higher service fees American bankers charge.

The staple of the banking sector shared by Canadian and U.S. regional banks is the mortgage industry, in which Canadian banks are again at a disadvantage. The Canadian market is far more competitive, driving mortgage rates lower to just 0.65% above the benchmark one-year Treasury yield. The standard 30-year U.S. mortgage rate stands 1.52% higher than the benchmark 10-year Treasury yield.

So far, forays into the U.S. market have met with mixed results. The most successful venture to date has been BMO Financial’s Harris Bank division, which has focused on wealth management products and small business services. These services can command much higher fees.

“Efficiency has also been a challenge for Canadian-owned banks,” says Azarchs, pointing to higher expense-to-revenue ratios than their American competitors. “Harris was a big bank when BMO acquired it in 1985, but it hasn’t progressed as much as it could have.”

Canadian-owned banks have even voluntarily taken a disadvantage to mitigate risk, according to the report. While their U.S. and even other foreign competitors underfund their operations, Canadian-owned U.S. banks have kept their holding companies well capitalized.

“While expanding into the U.S. is not the best move for Canadian banks, those intent on taking this route will do better if they focus on the opportunities available to foreign-based institutions,” the report advises. “These include acting as consolidators, bringing a greater scope of products to any acquisitions they may make, and using their managerial expertise. Canadian banks could optimize one of their greatest strengths — their electronic infrastructure — whose sophistication rivals that of much larger institutions.”

But even on their home turf, Azarchs says Canadian banks’ consumer operations are much less profitable than those of their U.S. peers.

“Canadian banks still have a lot of work to do at home,” says Azarchs. “ROAs are substantially lower and so is net income to revenue. In the personal and commercial segment, which is comparable to the retail sector in the U.S., the Canadian banks don’t have the efficiency ratio enjoyed by U.S. banks.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com