Thursday, December 04, 2008

Banks' Tier 1 Capital Ratios

Scotia Capital, 4 December 2008

• Canadian banks and other financial services companies are being pressured to raise capital as we re-enter the "capital/arms race" to have the most and highest capital ratios regardless of what is the appropriate amount of financial leverage. We believe regulators and markets are destined to overreact.

• We expect some banks and managements will resist the "panic," others will "capitulate." We believe the mismanagement of global leverage came from the asset side of the balance sheet (primarily unregulated and misregulated), not the capital side. The risk weighting of AAA securities as prescribed by Basel, in our opinion, was not the problem; rather it was the ratings placed on these securities.

• In terms of Canadian bank capital levels we are seeing modest declines in Tier 1 ratios in the fiscal fourth quarter (Exhibit 1), although they remain very solid, generally above the 9% level. The fourth quarter was particularly difficult on Tier 1 ratios given the spike in risk weighted assets due primarily to the C$ depreciating 19% against the US$, as well as charges to OCI (Other Comprehensive Income) from mark-to-market on the Available for Sale Securities (AFS) portfolio due to major widening in corporate spreads (temporary impairment, holding to maturity).

• Canadian banks have excess capital capacity to issue Preferred Shares and Innovative Tier 1 capital that would increase Tier 1 ratios a further 140 bp. We believe the preferred share market is somewhat full at this time and Innovative Tier 1 is relatively expensive. However, over the next year we would expect issuance in these markets to bolster capital. We expect further Tier 1 capital build from internally generated capital in the 75-100 bp range. Thus we believe Tier 1 capital can be increased to over 10%, and perhaps to 11% over the next few years with some patience. Canadian banks' capital ratios have absorbed the October meltdown whereas international banks with a December 31 year end have not.

• Canadian banks' capital positions (without government assistance) remain very solid. However, if banks feel compelled to "battle for capital" at this stage, whether they need it or not, we have attached exhibits indicating what equity would be required to boost capital immediately via equity only in three scenarios: (1) 50 bp increase (Exhibit 2); (2) Tier 1 9.5% (Exhibit 3); (3) Tier 1 10.0% (Exhibit 3).