Wednesday, January 07, 2009

Banks Respond to Rising Capital Demands

TD Securities, 7 January 2009

Group responds to rising capital demands. There has been a flurry of capital raising activities across a number of the Canadian banks over the past few weeks. We thought it would be useful to see where the industry stands pro-forma these events. We have included our Capital Table for the eight companies in our coverage universe (Exhibit 1).

More than one metric. We do not subscribe to a single hard and fast measure of capital adequacy and we prefer a more holistic approach. Regulators are focused on issues of solvency, equity investors pay close attention to measures of book value and equity returns while management must strive to balance both. We have provided six of the more common metrics that include both risk based and nominal balance sheet measures.

Not all banks are equal. Likewise, bank platforms differ in material respects and we do not believe in applying a single universal target level for any metric. Certainly risk based approaches attempt to reflect variances in business mix/risk, however, they are at best imperfect measures and are limited in so far as they are largely point estimates focused on the balance sheet. In our mind, a platform's ability to generate significant and steady earnings over time that can replenish capital is an important consideration in assessing what level of capital may be deemed appropriate.

Credit and Capital are linked. Finally, we believe the capital discussion is incomplete without taking into account a bank's credit position; particularly as we enter a significant downturn in the credit cycle. A bank with a rapidly deteriorating credit book and thin reserve levels could find that it has effectively overstated its capital strength. We have supplemented our capital table with some key credit metrics across the Large-Cap Canadian banks (Exhibits 2 and 3).

Capital to remain a key focus. Overall, in our view the group is comfortably positioned by most capital measures, particularly given the outlook for still sizable earnings generation in 2009 and a fairly clean slate of risks/exposures. The group is amply ahead of regulatory requirements although market expectations appear to have risen in recent weeks. A recent release from the country's regulator, OSFI (December 19, 2008), was in our view an effort to talk down expectations regarding the need for higher capital levels. The regulator said explicitly that it had not pushed for higher capital levels across the board and underscored that capital levels are not intended to be pro-cyclical and are expected to provide a measure of cushion through down turns.

That said, we believe the reality is that investors, rating agencies and regulators will remain biased in favor of more, not less, capital in the near-term. Therefore we expect the group to conserve capital by holding the line on existing dividends (although not cutting), managing asset growth, raising regulatory capital where possible and potentially adding additional common equity in select cases, namely Scotiabank and National Bank which have resisted coming to market under pressure.
The Globe and Mail, Tara Perkins, 27 December 2008

Many executives will remember 2008 as among the most stressful years in their career, but none more so than banking executives.

The world's banking system was brought to its knees this fall. For Gordon Nixon, CEO of the country's biggest bank, that meant being on constant guard for the next potential crisis and taking action to reduce the bank's exposure to it.

This month, Mr. Nixon decided to bolster the bank's protective defences by raising $2.3-billion in common equity to boost its capital levels. Moves by Canada's big banks to increase capital have been criticized by Bank of Canada Governor Mark Carney, who along with Finance Minister Jim Flaherty is urging the banks to step up lending. But the banks are facing pressure to do the opposite. Like its counterparts around the world, the bank is increasing its provisions for bad debts because it appears consumers and businesses will struggle in 2009. But Mr. Nixon says Canada heads into this period in a much better position than previous downturns.

What is happening in Canada's credit markets?

There is no question that, statistically, Canadian banks are continuing to lend and you are seeing very strong loan growth basically across all sectors. Having said that, there is also the reality that credit has tightened up globally and we've had many providers of credit withdrawing or disappearing from the marketplace.

How does 2008 compare to previous downturns you have been through?

I don't think any of us have lived through a downturn like this. It's been very different, and probably more so for those of us in the financial services industry because the first half of 2008 was a banking crisis, while the second half of 2008 has become a much more widespread economic crisis.

What was the biggest surprise?

I think that the biggest surprise was the systemic impact on the financial services sector and the credit markets as a result of the decline in U.S. residential real estate. A lot of people were expecting a correction, ultimately, in the residential real estate market in the U.S. given the performance in the last couple of years, but I don't think anybody - or very few - suspected the systemic impact that that would have across the financial system. It was just staggering to see the complete withdrawal of confidence and liquidity from the marketplace.

Was there one moment that stands out as the scariest?

One of the toughest things this year was that it was just so unrelenting. Weekend after weekend there would be a crisis, day after day there would be another issue in the marketplace. I think the most important period was the weekend of the IMF meetings, when the G8 members and really the broader G20 came together and came out of that weekend with a plan to provide stability to the banking system. I think it will be looked back on as the turning point with respect to the financial crisis.

What is the wisest move that policy makers have made?

The co-ordinated efforts that occurred across the system. Here in Canada there was a high degree of communication, which I think served the system quite well, and I think it was very important to see the central bankers and finance ministers and governments pull together. The other thing which has been quite remarkable has been the speed and decisiveness with which the American government, the Federal Reserve and the Treasury have been able to institute policy and programs in the marketplace.

What mistakes have they made?

This has been a new process for all policy makers and to some degree part of it is experimental. Sometimes it works, sometimes things don't work as well.

There is no question that the collapse of Lehman Brothers was instrumental in terms of amplifying the systemic nature of the problems. ... Whether Lehman should or shouldn't have been allowed to file for Chapter 11 will be something that I think economists will be debating for 100 years.

What should the system learn as it comes out of 2008?

There's no question that bubbles were created in various markets. ... We had a world where financial assets were growing at a much faster rate than either financial earnings or the economy in general, and it created a situation where there was way too much leverage in the system. And, like every other bubble, it reached a point where it burst; it's just that, with this one, the implications were much more dramatic. Over the next five years, hopefully longer, there will be a much higher priority placed on risks-to-rewards and it will have significant implications on compensation, risk standards, regulatory measurement, regulatory reform.

What is the biggest issue you are watching going into 2009?

One of the things we'll be watching and that the marketplace will be watching very carefully is general credit. As opposed to accounting volatility as a result of securities going up and down, which was clearly a theme for 2008, in 2009 there will be much more focus on credit - what's happening in credit card portfolios and personal loans and the manufacturing sector.

How is Canada positioned for 2009?

We go into this recession fiscally in a very different position than we went into previous recessions over the last 40 or 50 years. Unemployment is at historically low levels, interest rates are much lower, you've got a strong banking system. There are a whole bunch of factors that I do think put Canada in a much stronger relative position to weather this storm than we have been historically.

Looking Ahead

The threat

Royal Bank of Canada is coming out of an unprecedented banking crisis, and the withering economy promises to have an impact on the banking sector in the year to come. The impact

Losses from bad loans are expected to rise across the sector next year as borrowers struggle with their debt loads.

The reaction

Executives at the country's biggest bank are carefully watching its loan portfolios for signs of trouble, but have not cut back on lending