01 September 2006

How Canada's Banks Make Their Money

CBC News Online, 1 September 2006

The words "record," "bank," and "profits" spend a lot of time together these days. The three have been seen cavorting together so often that their ménage-a-trois is becoming common knowledge.

The public tut-tuts. Billions in profits. Almost $12 billion in 2005 from the Big Six alone. That's about $40 for every man, woman, and little bank customer in Canada. "It's an outrage," people say. The accusations fly. Charges, counter charges, and service charges fill the air.

Suffice it to say that few Canadians admit to having love affairs with their banks, even though most of us park our money with them, or borrow from them, or buy their mutual funds, or use their ABMs, or debit cards, or credit cards, or brokerage divisions.

Behold the modern Canadian bank. These days, they're worldwide profit machines, spitting out earnings from sources of revenue that didn't exist 30 years ago.

And yes, that includes service fees. But for those who think that it's all those $1.50 ABM convenience fees that are the main driver of the big banks' big bottom lines, it's time for a reality check. Banks nowadays have other, more lucrative ways of generating income.

There's money in money-lending

Canadian banks make buckets from what is termed "interest-based revenue." That's the difference between what they pay you in interest and what the banks charge someone else to borrow. That's why a five-year closed mortgage may cost 5.75 per cent, but a five-year GIC would pay only 3.25 per cent. That two-and-a-half percentage point spread is known as … "the spread."

Spreads can be a lot wider, of course. Credit card interest rates can range up to 19 per cent, leaving the spread in double-digits.

When you consider that the chartered banks have about a trillion dollars in loans outstanding (roughly half in mortgages, half in other loans), you can see that even a "small" spread can be a formidable cash-generating tool.

Add in the interest income from bonds and treasury bills the banks hold and before you can count to 12 billion, the banks are awash in money.

Canadian banks make almost half of their revenues (47 per cent) from interest income, according to the most recent figures from the Canadian Bankers Association.

The rest of the revenue comes from juicy underwriting fees for new stock issues, commissions from securities, wealth management and other sources of income — including those service fees that so many of us love to hate. But the bankers say only five per cent of their revenues come from personal service fees.

All the world's a banking stage

Canadian banks are wringing profits like never before from their operations outside Canada. Bank of Montreal has bought Harris Bank of Chicago; TD has bought New England-based Banknorth; Royal Bank has bought Centura Banks of North Carolina.

Scotiabank (the most "international" of Canada's big banks) has such an extensive presence in Mexico, the Caribbean and Latin America that, in a recent quarter, it earned almost as much profit from those foreign markets as it generated from its banking operations in Canada.

Taken as a whole, chartered banks got 28 per cent of their 2004 revenues from outside the country. And with a freeze since 1998 on big banks merging with each other, the Big Six are increasingly looking beyond Canada's borders for profits they can bring back home.

Who benefits from bank profits?

"Canadians do." At least, that's the line from the bankers.

But what actually happens to those billions in profits? It's tempting to think of Daddy Warbucks-like bank CEOs gleefully counting out their bonuses and stock options. But CEOs don't make billions. Only millions.

Of the $13.3 billion in profit made by all of Canada's chartered banks in 2004, they paid out $4.5 billion in dividends to their stockholders. You're probably thinking about Daddy Warbucks again. But some of the biggest shareholders in Canadian banks are the big public and private pension funds and the big mutual funds — in other words, most Canadians.

Let's take the Canada Pension Plan, as an example. It owned $2.6 billion in stock of the Big Six banks as of March 31, 2006. That's about $150 in bank stock for every one of its members.

At the $41-billion Ontario Municipal Employees Retirement System pension plan, banks occupy four of its top 10 equity holdings.

Bank stocks are popular holds in hundreds of equity mutual funds too, because banks are such a big part of the Canadian economy, and because the market performance of the financial sector has been nothing short of sizzling over the last few years.

For example, the giant Investors Dividend fund — with $11.8 billion in assets — lists five banks as its top holdings.

After paying out their dividends, banks use the leftovers to invest in their own operations. And they like to point out that they paid $7.6 billion in taxes in 2004.

So, if you're so inclined, criticize the big banks for branch closures, or for not paying more interest, or for their service charges, or because you think they're too big and impersonal.

But if you're a holder of bank stock (and directly or indirectly, we all are), rising profits have also meant rising dividends and stock prices that have, on average, doubled in the last four years.

Money we can take to the bank.