01 April 2006

Cdn Banks and $20 Billion Excess Capital

Financial Post, Duncan Mavin ,1 April 2006

Canada's big banks have a ton of cash. So much so that their investors and the analysts who cover the industry want the banks to do something with all that liquid wealth. Merge with someone. Buy something else. Just don't let all that cash sit there.

It's a hell of a problem to have.

Mergers have been top of the must-do list for bank executives for much of the past decade. And casual observers could be forgiven for thinking that the mighty banking sector would crumble without a merger or two. How many times were we told that bulk was the only thing that mattered? As for the near future, no minority government is going to open up the politically contentious issue of bank mergers.

Yet here we are in 2006 and the banks look stronger than ever, delivering record earnings and enlarging returns with the help of a runaway Canadian economy and favourable demographics -- ageing Baby Boomers and a lot of enthusiastic immigrants.

"There's a good steady wind in the sails of the industry," says Robert Pearce, president and chief executive of personal and commercial clients at Bank of Montreal. That steady wind will only get stronger with favourable demographics, he adds.

The market capitalization of the six biggest banks is $200-billion, up from $167-billion at the end of 2004. The entire Canadian income trust sector, 235 trusts in all, has a market cap of $199-billion.

In 2005, the big banks earned a combined net income of more than $16-billion, finding 18.5% growth in what is supposed to be a mature market. In the first quarter of 2006, the banks continued to break earnings records, with an aggregate performance 11.6% better than the previous year. Even after such a stellar performance, analysts estimate the banks will increase earnings between 8% and 10% for the rest of 2006.

And it's all been achieved without much dipping into the banks' swollen war chests.

The banks have stashed away excess capital of more than $20-billion, according to a recent report from financial services firm PricewaterhouseCoopers LLP.

The funds available for acquisitions could more than double in the next three or four years thanks to continued earnings growth and a new set of global banking regulations that should shrink the amount the banks are required to set aside for a rainy day.

Certainly, the big banks aren't afraid to share the joy -- their shareholders received aggregate dividends of more than $6-billion last year, up 151% since 2000.

"They are becoming dividend rich -- which is not horrible," said Basil Kalymon, an expert on the financial services industry at Ivey Business School's executive MBA program. "They are part of the more stable side of the economy, so paying out dividends is not inappropriate."

They've enjoyed an outstanding run, admits Diana Chant, head of PricewaterhouseCoopers financial services group in Canada. But she asks one burning question: "Where do they go from here?"

The answer may be the banks don't have to go anywhere.

There's plenty of growth at home simply because the domestic economy is so strong, says HSBC Canada chief executive officer Lindsay Gordon. "At the end of the day, how a bank does is a reflection of how the economy does."

Mr. Gordon says Canada represents only 2% of the global economy yet it accounts for 4% of HSBC's international profits.

Indeed, HSBC Canada has delivered growth of about 15% a year on average over the past few years. And Mr. Gordon remains bullish about the future of the Canadian banking sector.

The numbers support his optimism. The country's record-low unemployment is putting cash in consumer's pockets, while 14 years without a recession ensures businesses can repay their loans. Even the much-feared downturn in the credit cycle is looking less fearsome and less likely than it did a few months ago. The banks almost unanimously left untouched their provisions for bad debts in the first quarter of 2006.

"These aren't boom times, but they are damn good," said the Bank of Montreal's Mr. Pearce. The consumer mortgage market is "huge and growing" -- by as much as 10% a year -- while car loans and personal debt are projected to grow by 8% to 9% a year.

The ageing of Canada's population is well documented, and in the banking sector, the trend is driving growth in wealth management as Canadians plan for retirement. In the first quarter of 2006, wealth-management earnings at Toronto-Dominion Bank grew 35% compared to the previous year, and at Bank of Montreal it was 27%.

Meanwhile, hundreds of thousands of immigrants are expected to arrive in Canada in the next few years -- about 250,000 in 2006 alone -- contributing to "amazing retail growth" beyond expectations, said Harry Ort, head of financial services at accountants KPMG LLP in Toronto.

Although performance varies from bank to bank, year-over-year retail and wealth-management growth at the big banks in the first quarter of 2006 was about 13% on aggregate -- it was more like 16% to 22% at the best performers, Canadian Imperial Bank of Commerce, TD and RBC.

While retail growth is expected to stay as high as 10% for the rest of this year, there's even more impressive growth available in niche markets, such as the sub- or near-prime lending business. Canada's banks have usually steered clear of the segment, which is riskier than traditional consumer lending because it involves providing loans to customers whose credit history would otherwise prevent them from obtaining funding.

But following the lead of global giants Citibank and HSBC, a couple of the Canadians have dipped their toes in the market -- notably, TD recently bought sub-prime auto-lender VFC Inc., while Scotiabank acquired near-prime home-loans business Maple Mortgage. The sub-prime vehicle loans market is expected to grow at about 35% a year, and the growth in non-traditional mortgages is estimated to be as high as 30% a year.

But there's also a spin-off benefit because banks that acquire sub-prime lenders get access to thousands of new customers.

Scotiabank's Maple Mortgage acquisition brought 40,000 new customers into the fold, says Barb Mason, executive vice-president of marketing and sales and services at Scotiabank.

For each one of those new relationships, the bank estimates it can "cross-sell" two new products, such as credit cards or a bank account. Despite the sub-prime tag, many of the new customers will be responsible borrowers with legitimate reasons for weak Canadian credit ratings.

And then there's the whole insurance market. Banks are not currently allowed to sell or market insurance from their bank branches. But RBC and TD are leading the charge for changes to the Bank Act -- up for review in the fall -- to open up the insurance business.

"We see it as a growth business for us," said Jim Westlake, head of personal and business clients for RBC in Canada. "In every market around the world where banks have been allowed to sell insurance, the market has grown." Mr. Westlake also says having insurance customers walk into RBC branches will provide more of those potentially lucrative cross-selling opportunities.

Nevertheless, in Mr. Kalymon's view, the banks will still have to look abroad for the sort of growth that can fundamentally change the bottom line.

"Canada is a relatively small market when it comes to financial products compared to the global market," he said. "The banks certainly have the potential to expand."

Canadian banks may be successful at home, but they are dwarfed by such global giants as HSBC, Citigroup or UBS, for instance. Citigroup alone has a market capitalization more than US$30-billion bigger than the combined Canadian figure.

Yet although domestic performance is still the main driver for the Canadian banks, they are already doing better than you might think in foreign markets and they are trying to do even more.

The Bank of Nova Scotia, which rightly claims to be Canada's most international bank, with particularly strong operations in Central and Latin America, has seen earnings growth from its foreign subsidiaries of between 15% and 20% a year recently. Now Scotiabank is making announcements about growing its consumer lending and credit business in Mexico, probably through an acquisition.

At TD, more than 50% of net income originated from the bank's expanded U.S. and international operations last year, up from less than 40% the year before, for example. Earlier this week, TD's chief executive, Ed Clark, said the bank would look to get on the acquisition trail in the United States this year.

RBC's U.S. and international operations produced net income of $101-million in the first quarter of 2006, an increase of 3% from the prior year, despite the rising strength of the Canadian dollar. The bank has also announced plans to expand the branch network of its RBC Centura subsidiary in the United States by 10% a year from 2008 -- RBC Centura already provides 9% of the bank's profit

As well, net income at BMO's Chicagoland operations grew by 13% in 2005 to $125-million. And in mid-March, CIBC announced it will pay US$1.1-billion to double its existing stake in FirstCaribbean International Bank this year.

In fact, while traditional domestic banking is providing steady growth even in a mature market, it's clear analysts want more and bank executives are open to further deals. Indeed, the surplus cash must be burning a hole in their pockets.

There's persistent speculation about one or more of the banks hooking up with a fund manager, and the Bay Street rumour mill suggests the big banks are already wrestling to pin down the best corporate lawyers in town in anticipation of a potential surge of spending activity.

"In today's dynamic environment, if you stay nailed to the spot, you are in trouble," Mr. Kalymon said. "Yes, maybe the banks are doing very well focused on mortgages and retail, but I don't think that's a way to succeed into the future. They have to maintain creativity. Obviously they shouldn't commit funds just to commit funds. But staying put is a dangerous position."