Scotia Capital, 14 January 2009
• Canadian banks in the past few months have raised $7.6 billion in capital, with 68% being common equity. The banks continue to issue modest amounts of preferred shares and Innovative Tier 1 capital.
• The Tier 1 ratio pro forma for the bank group is 9.8%, with the quality of the capital base relatively high, as preferred shares and Innovative Tier 1 represent 25% of total Tier 1, below the 40% maximum.
• We estimate the banks have capacity to issue a further $27.7 billion in non-equity Tier 1 capital, which would boost Tier 1 ratios by 250 basis points (bp) to 12.0%. The non equity capital component could be all qualified preferred shares or a combination, with Innovative Tier 1 capped at $4.7 billion or 15% of Tier 1. Although the banks have capacity from a regulatory perspective, it is highly unlikely the market would be able to absorb these amounts in the near term, especially preferred shares.
• The magnitude of capital raised since fiscal year-end represents 7.2% of Tier 1 capital, with the equity raised representing slightly less than 5% of the common equity base and 2.8% of market capitalization. The equity issues were readily absorbed by the market, but we believe they caused share prices to pull back approximately 10% as well as stall some positive share price momentum. The equity issues were at discounts to the market and at extremely low valuation levels with the market concluding that all banks would be coming to market at discount prices.
• The equity issues, we believe, were in response to market pressures, not regulatory pressure, as OSFI minimum Tier 1 ratio as stated is 7% with Canadian banks well above this level at 9.8%. It is highly likely that regulatory minimums will go up over the next several years; however, there is usually a phase-in period as there has been with virtually all Basel initiatives. Basel I capital standards were phased in between 1989 and 1992 with banks being given three years to achieve a minimum Tier 1 ratio of 4%. Required minimum total capital ratio was 7.25% in 1990, increasing to 8.00% by 1992, i.e., a 75 bp increase over two years. Canadian banks, we expect, will be able to easily exceed minimum capital requirements in normal course, even capital level requirements that are bound to overshoot prudence.
• The market pressure catalyst appears to be the capital infusions by U.S., U.K., and European countries to bail out their troubled banks and boost capital ratios. Despite the fact that Canadian banks’ capital ratio would still be above a number of the major global capital-assisted banks, with Canadian banks having less toxic assets and strong funding, the market fixated on a 10% Tier 1 as a minimum for Canadian banks. Also, global banks have yet to report their year-end numbers and the level of their capital ratios after potential further earnings, and retained earnings charges are still somewhat uncertain as well as the value of their high-risk assets. The bailout announcements were primarily in the last week of September and during the month of October 2008.
• In addition, OFSI released an advisory in October 2008 stating that “all financial institutions that have normal course issuer bids in place should not be repurchasing shares pursuant to those bids without first consulting OSFI,” which we believe added fuel to the fire and provided further impetus for the market to pressure banks to raise their capital ratios. The intent of the advisory was no doubt prudence but the results, we believe, played to investors’ fear about bank financial strength, especially given the psyche of the market.
• We believe the balance sheet or leverage problems in the global financial system have more to do with the nature and quality of the assets, both on balance sheet and off, as opposed to the amount of capital. There is no substitute for the prudent management of the asset side of the balance sheet, and when that fails dramatically (regulators? rating agencies? bank risk management?), it would seem virtually no amount of capital will be enough to sustain the company. In the earlier stages of a banking crisis, or maybe more appropriately put, brokerage crisis, it’s very easy to focus on the need for more capital versus the real adjustments that need to be made on the asset side. The amount of capital needed is thus proportionate to the magnitude of the problem assets/risk (on and off balance sheet).
• We continue to view Canadian banks as well capitalized even before the rush to raise capital, especially given the relative high quality of the asset side of the balance sheet, retail deposit base, and capital composition. We also believe banks can build their capital ratios up to the 11% range if they need to (we are in overreaction phase) on an orderly basis over the next several years through retained earnings, risk-weighted asset management, and issuance of preferred shares and Innovative at hopefully substantially lower costs. We expect retained earnings to add approximately 80 bp per annum to Tier 1 with earnings in dire straits still adding 40 bp.
• We do not believe banks should feel compelled to raise their Tier 1 ratio, especially in such a short time frame as it seems almost like panic, especially given the pricing. However, the counter argument we suppose is always prudence and perhaps the market will provide a higher valuation for the banks with higher capital ratios, at least in the short term. Clearly, all things being equal, 9% Tier 1 is better than 8% and 10% is better than 9%, etc. However, we simply don’t see the panic for Canadian banks to raise capital, especially equity, at these prices from a holistic perspective.
• All the banks except CIBC recently announced modest preferred share issues with yields creeping up to 6.25% (NA – 6.6%) from the 5%-5.5% level. BMO is the only bank to raise Innovative Tier 1 recently; however, BNS and TD have filed preliminary short form prospectuses. The yield on the 10-year BMO issue was 10.3%, with a possible range for BNS and TD if they decide to issue in the 10%-11% range, which is a hefty 600-700 bp over Canadas. It would seem that reset preferred shares at 6.25% that would likely be called after five years (recent resets: 400 bp over five-year Canadas) are less expensive capital than issuing 10-year Innovative at 10%-11% (6.5%-7.1% after tax – tax deductible) and common equity at 12%. However, we believe the preferred share market does not have the capacity to absorb nearly $28 billion in issuance.
• Interestingly, the major U.S. banks, Bank of America, JP Morgan, and Wells Fargo, each received US$25 billion in capital from the U.S. government with Citi receiving US$45 billion. Compare this to the entire Canadian banking system, which would require $27.7 billion to bring their capital ratios up to 12.0%.
• The U.S. capital infusion to these banks was in the form of non-voting preferred shares at 5% interest callable at par after three years, with the rate increasing to 9% after five years (major incentive to call). Compare this 5% financing in size with Canadian banks chipping away in the preferred share market with issues of $200 million-$300 million with the most recent coupon at 6.2%. However, the cost of government capital for a number of global banks has been extremely high in the 14%-22% range with perhaps some loss of autonomy.
• In our opinion, the fact that Canadian banks do not require government capital infusions and at the same time are maintaining arguably the strongest balance sheets globally is a testament to the strength of the Canadian banking system.
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• Canadian banks in the past few months have raised $7.6 billion in capital, with 68% being common equity. The banks continue to issue modest amounts of preferred shares and Innovative Tier 1 capital.
• The Tier 1 ratio pro forma for the bank group is 9.8%, with the quality of the capital base relatively high, as preferred shares and Innovative Tier 1 represent 25% of total Tier 1, below the 40% maximum.
• We estimate the banks have capacity to issue a further $27.7 billion in non-equity Tier 1 capital, which would boost Tier 1 ratios by 250 basis points (bp) to 12.0%. The non equity capital component could be all qualified preferred shares or a combination, with Innovative Tier 1 capped at $4.7 billion or 15% of Tier 1. Although the banks have capacity from a regulatory perspective, it is highly unlikely the market would be able to absorb these amounts in the near term, especially preferred shares.
• The magnitude of capital raised since fiscal year-end represents 7.2% of Tier 1 capital, with the equity raised representing slightly less than 5% of the common equity base and 2.8% of market capitalization. The equity issues were readily absorbed by the market, but we believe they caused share prices to pull back approximately 10% as well as stall some positive share price momentum. The equity issues were at discounts to the market and at extremely low valuation levels with the market concluding that all banks would be coming to market at discount prices.
• The equity issues, we believe, were in response to market pressures, not regulatory pressure, as OSFI minimum Tier 1 ratio as stated is 7% with Canadian banks well above this level at 9.8%. It is highly likely that regulatory minimums will go up over the next several years; however, there is usually a phase-in period as there has been with virtually all Basel initiatives. Basel I capital standards were phased in between 1989 and 1992 with banks being given three years to achieve a minimum Tier 1 ratio of 4%. Required minimum total capital ratio was 7.25% in 1990, increasing to 8.00% by 1992, i.e., a 75 bp increase over two years. Canadian banks, we expect, will be able to easily exceed minimum capital requirements in normal course, even capital level requirements that are bound to overshoot prudence.
• The market pressure catalyst appears to be the capital infusions by U.S., U.K., and European countries to bail out their troubled banks and boost capital ratios. Despite the fact that Canadian banks’ capital ratio would still be above a number of the major global capital-assisted banks, with Canadian banks having less toxic assets and strong funding, the market fixated on a 10% Tier 1 as a minimum for Canadian banks. Also, global banks have yet to report their year-end numbers and the level of their capital ratios after potential further earnings, and retained earnings charges are still somewhat uncertain as well as the value of their high-risk assets. The bailout announcements were primarily in the last week of September and during the month of October 2008.
• In addition, OFSI released an advisory in October 2008 stating that “all financial institutions that have normal course issuer bids in place should not be repurchasing shares pursuant to those bids without first consulting OSFI,” which we believe added fuel to the fire and provided further impetus for the market to pressure banks to raise their capital ratios. The intent of the advisory was no doubt prudence but the results, we believe, played to investors’ fear about bank financial strength, especially given the psyche of the market.
• We believe the balance sheet or leverage problems in the global financial system have more to do with the nature and quality of the assets, both on balance sheet and off, as opposed to the amount of capital. There is no substitute for the prudent management of the asset side of the balance sheet, and when that fails dramatically (regulators? rating agencies? bank risk management?), it would seem virtually no amount of capital will be enough to sustain the company. In the earlier stages of a banking crisis, or maybe more appropriately put, brokerage crisis, it’s very easy to focus on the need for more capital versus the real adjustments that need to be made on the asset side. The amount of capital needed is thus proportionate to the magnitude of the problem assets/risk (on and off balance sheet).
• We continue to view Canadian banks as well capitalized even before the rush to raise capital, especially given the relative high quality of the asset side of the balance sheet, retail deposit base, and capital composition. We also believe banks can build their capital ratios up to the 11% range if they need to (we are in overreaction phase) on an orderly basis over the next several years through retained earnings, risk-weighted asset management, and issuance of preferred shares and Innovative at hopefully substantially lower costs. We expect retained earnings to add approximately 80 bp per annum to Tier 1 with earnings in dire straits still adding 40 bp.
• We do not believe banks should feel compelled to raise their Tier 1 ratio, especially in such a short time frame as it seems almost like panic, especially given the pricing. However, the counter argument we suppose is always prudence and perhaps the market will provide a higher valuation for the banks with higher capital ratios, at least in the short term. Clearly, all things being equal, 9% Tier 1 is better than 8% and 10% is better than 9%, etc. However, we simply don’t see the panic for Canadian banks to raise capital, especially equity, at these prices from a holistic perspective.
• All the banks except CIBC recently announced modest preferred share issues with yields creeping up to 6.25% (NA – 6.6%) from the 5%-5.5% level. BMO is the only bank to raise Innovative Tier 1 recently; however, BNS and TD have filed preliminary short form prospectuses. The yield on the 10-year BMO issue was 10.3%, with a possible range for BNS and TD if they decide to issue in the 10%-11% range, which is a hefty 600-700 bp over Canadas. It would seem that reset preferred shares at 6.25% that would likely be called after five years (recent resets: 400 bp over five-year Canadas) are less expensive capital than issuing 10-year Innovative at 10%-11% (6.5%-7.1% after tax – tax deductible) and common equity at 12%. However, we believe the preferred share market does not have the capacity to absorb nearly $28 billion in issuance.
• Interestingly, the major U.S. banks, Bank of America, JP Morgan, and Wells Fargo, each received US$25 billion in capital from the U.S. government with Citi receiving US$45 billion. Compare this to the entire Canadian banking system, which would require $27.7 billion to bring their capital ratios up to 12.0%.
• The U.S. capital infusion to these banks was in the form of non-voting preferred shares at 5% interest callable at par after three years, with the rate increasing to 9% after five years (major incentive to call). Compare this 5% financing in size with Canadian banks chipping away in the preferred share market with issues of $200 million-$300 million with the most recent coupon at 6.2%. However, the cost of government capital for a number of global banks has been extremely high in the 14%-22% range with perhaps some loss of autonomy.
• In our opinion, the fact that Canadian banks do not require government capital infusions and at the same time are maintaining arguably the strongest balance sheets globally is a testament to the strength of the Canadian banking system.
