Saturday, October 14, 2006

Why Banks Won't Convert to Income Funds: A Lust for Fees

  
The Globe and Mail, Eric Reguly, 14 October 2006

You're a bank shareholder and you're grumpy. When will the bank CEOs hit the income trust button? Telus and BCE did it and saw their shares pop. Dozens of other big companies will follow because the feds apparently don't have the guts to shut down the trust market. Surely, the banks, or juicy parts thereof, will be next. It's the CEOs' fiduciary duty to game the tax system to create instant value. Forget long-term wealth creation -- that's for deluded U.S. and European investors and their backward economies.

Banks seem perfect candidates for trust status. They are big, dominant beasts that pile up more capital than they need and often spend it recklessly. They haul in obscene profits and pay a lot of taxes. With the exception of Bank of Nova Scotia, they are largely confined to the Canadian market. Trusts work best when they're not cluttered with income from countries that, bizarrely, insist on businesses paying tax.

Royal Bank has a market value of almost $62-billion. Turn it into a trust, eliminate the tax bill and a bank worth perhaps 25 per cent more flies out the other end like a cannon ball. Suddenly, you've got an $80-billion bank and a fat smile on Gord Nixon's face. He had been fretting about the bank's slide in the international rankings. A trust would propel the bank in the opposite direction without having to do so much as open a new branch.

Dream on. It's almost surely not going to happen. What certainly won't happen is a trust formed by a bank in its entirety.

An inconvenient bit of legislation called the Bank Act insists that banks, that is, lenders, be structured as banks, that is, not trusts in their various guises, like limited partnerships. Okay, but a bank is hardly a bank in the classic definition of the term. They have become all things to all people. There is asset and wealth management, insurance, capital markets, trading, credit cards and businesses you never heard of, like the interbank settlements system. Theoretically, the non-lending bits -- wealth management is probably the best example -- would make ideal trusts. Mutual funds flogger CI Financial boosted its value considerably when it went from corporation to trust earlier this year.

So let's go lads! Again, it's not that simple. Start with some basic psychology. The banks are genetically programmed to do one thing -- get bigger for the sake of getting bigger. You can spot the future bank CEO contender in any kindergarten class. He's the kid glommed onto the biggest toy truck. The teenage contender is the guy who thinks the oil sands are really neat because they use trucks the size of houses. Every bank CEO is obsessed with penetrating every financial services market and dominating it, obsessed with merging with other banks to create enough bulk to make huge acquisitions.

Turning into a trust would move them up a few shoe sizes on the Toronto Stock Exchange. But it wouldn't actually make the business bigger. On the other hand, turning wealth management or other non-lending divisions into trusts -- their sale, in effect -- would substantially reduce a bank's size and the number of the CEO's playthings. That's no fun.

The threat of political interference has to make the banks wary too. A year ago, the Liberals tossed a bucket of water onto the trust bonfire and arguably lost the election for it. The Tories have given no indication they will soon pronounce on the pluses and minuses of the resurgent trust market, even though they must fear that turning Canada into a nation of coupon clippers might damage long-term competitiveness and tax revenue. The feds had an opportunity to reveal their thoughts when Telus and BCE announced their conversions, and passed.

But converting large parts of the banks might push the feds over the edge. If the Finance Minister reacted, say, by slapping a small tax on trust distributions, the trust market would wither, perhaps die. Then the banks would be in real trouble, for the simple reason that their Bay Street arms have been making fortunes on trust initial public offerings and conversions.

They love the trust business because it is essentially immune from foreign competition. Trusts are a retail product; selling them requires retail distribution networks, which firms like UBS, Citigroup and JPMorgan lack in Canada. And the numbers are huge. Six years ago, the value of the trusts on the TSX was less than $20-billion. Today, it's $200-billion. Next year, with the arrival of BCE and Telus and other biggies, it could easily be $300-billion. When you've all but lost the cross-border business to American investment banks, you don't want to upset what remains. With every trust IPO, Bay Street collects a 5-per-cent underwriting fee. Every time a trust hoses out new units to finance an acquisition or a big capital expenditure program, it collects 4 per cent.

In other words, the value of exposure to the rapidly expanding trust market may offset the value of converting chunks of banks into trusts. Banks don't like paying taxes. But they must know that keeping the taxman happy by avoiding trust status will earn them political brownie points and potentially endless trust underwriting fees.
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