Owning Canadian banks in 2020

Editor’s note: This is an updated version of articles published September 2012 and May 2017.

There will be defaults, deferrals and downgrades from the coronavirus pandemic. Banks will not go unscathed, but their position at the top of the credit structure will position them better than most.

Capital market meltdowns involve fear-induced liquidity gaps squeezing leveraged sectors like real estate and energy. A longer lockdown from Covid-19 would make the damage more extensive. With interest spreads widening to reflect the rush to quality, credit downgrades are inevitable.

Canadian banks avoided the devastation experienced by other financial institutions during the global financial crisis and earned a reputation for prudence by adhering to strict capital rules and limiting exposure to U.S. mortgage lending excesses.

Diversifying away from capital market activities and their traditional spread business — borrowing short and lending long — banks developed more stable fee-based activities including wealth management and insurance.

Today, predictable margins and profitability are being challenged by unprecedented events: the response to Covid-19, but also negative real interest rates and fintech challenges. How will banks negotiate the uncertainty of a pandemic-induced economic depression?

Covid-19

Cash flow is the life blood of corporations and individual consumers in any economy. The public health decision to suspend the economy to save lives is like stopping the heart and hoping monetary and fiscal defibrillation will revive the patient with minimal organ and brain damage.

Delays mean risk. Because banks dominate the financial lives of Canadians and the businesses that employ them, originating  roughly two-thirds of all business loans, according to the Canadian Bankers Association.

Unlike the financial industry’s solvency problem of 2008-2009, this crisis started as a liquidity dilemma that’s likely to develop into a solvency predicament later. The banking system must do two things:

• bridge loan payments and keep enough cash running through the system, like a heart bypass machine, so the economy doesn’t completely shut down; and
• facilitate stimulus to regenerate employment when the “all clear” is signalled.

Some banks have taken immediate steps to build liquidity by extending covered loans, and others are likely to follow as their clients draw down revolving credit lines as an insurance policy against a squeeze. The Bank of Canada always stands ready to add liquidity but is limited by a zero lower bound (currently the bank’s overnight rate is 0.25%).

If the economy is frozen too long, deferred payments will lead to sharply lower prices that will gradually be informed by more rational risk assessments as data and defaults become known. Early indications of financial dislocation put banks in the middle of the storm. Loan losses early in the crisis are anticipated but their magnitude is unknown. Five large U.S. banks have quintupled loan loss provisions in the current quarter.

Forbearance

Forbearance is what the economy needs, and banks hold the key. Deferring payments and accruing interest expense is the quick response but governments will encourage leniency.

Banks must find the balance between compromising profit margins and putting their clients into bankruptcy or foreclosing on mortgages. In conventional economic recessions, mortgage portfolios turn into real estate portfolios. Nobody wants this to happen now.

Banks in portfolios

Bank stocks have been the cornerstone of Canadian equity portfolios. They collectively account for 20% of the market’s capitalization, the country’s largest sector.

Canadian banks are too big to fail, but if they falter, the country’s problems would become far more severe. Government and central bank bailouts or mergers would ensue.

For most investors in a low-rate environment, the biggest question is: “How safe are bank dividends?” Bank earnings traditionally drive dividends with a payout of 40% to 50% of earnings targeted.

During the pandemic, personal and commercial lines of business are most at risk. Even though these  are the most profitable, income could be halved in 2020 and dividends would still be covered.

Dividend growth may have to wait on the timing and success of the economy’s restart and some banks may prefer to be more conservative than others. Time will tell.

Table 1: Canadian banks by market capitalization ($billions) as at April 3, 2020

Source: Toronto Stock Exchange

ETFs

ETFs are still the most efficient way to get diversified exposure to Canada’s largest group: from 20% of the popular iShares S&P/TSX 60 Index to 130% for the Horizons Betapro Capped Financial Bull 2X leveraged ETF, which has 200% exposure to financials (of which 130% represent banks).

The third column in Table 2, below, shows how much bank exposure the ETF investor gets to banks per basis point of MER. Broad-based ETFs with low MERs (such as XIC and VCE) are very efficient. Horizons’ total return ETFs (HXF and HEWB) are also effective ways to get bank exposure.

Table 2: Bank exposure for Canadian-traded ETFs as at April 2020

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.