07 April 2009

Basel II Disclosures Provide Greater Insight on Banks' Exposure to Credit Deterioration

RBC Capital Markets, 7 April 2009

Credit quality deterioration accelerated in 2008 and Q1/09, and we think provisions for credit losses will continue to grow and will likely be the biggest swing factor in bank earnings results in 2009 and 2010. In this report we look at the enhanced disclosure on credit risk exposures that the banks started providing in the last several quarters as a result of Basel II disclosure requirements.

Things that can be learned from Basel II disclosures include:

• Which banks have more exposure to unsecured retail loans. Of the four banks that provided disclosure, CIBC and TD have higher exposures to unsecured retail loans subject to the Advanced Internal Ratings Based (AIRB) approach for credit risk. Banks had previously disclosed total retail and credit card loans only, so the new disclosure helps isolate retail loans that are unsecured, which is the area that most concerns us in retail lending given the pace of job losses in Canada and the U.S.

• More stratified risk disclosures on business loan exposures. CIBC has the most exposure to wholesale loans subject to AIRB treatment that are non-investment grade, while TD Bank has the least exposure. We expect non-investment grade credits to default on loans quicker in an environment in which the economy is weak, credit spreads are wide and access to funding/liquidity can be difficult for lower quality borrowers.

• The higher relative retail and business loan exposures, in our view, would be related to product mix and, in the case of CIBC, having more of its loans subject to AIRB.

• Most banks that provided Q1/08 data saw faster year-over-year growth in exposures to higher risk borrowers in both retail and wholesale portfolios (largely driven by migration of existing customers, in our view).

• Banks are seeing growth in loans past due but not classified as impaired, which is new disclosure provided by some banks and is a good short-term indicator of impairment trends in our view.

• Some banks have yet to realize the full benefits of the Basel II implementation. National Bank will likely receive approval for AIRB in Q1/10, and we expect its Tier 1 ratio will rise by about 60–70 basis points at that time). Other banks such as TD and Scotiabank that still use the Standardized approach for large loan portfolios (mostly U.S. and international) may also see some benefit to capital ratios upon eventual adoption of the AIRB approach.

Bank disclosures under Basel II are still a work in progress and comparing bank exposures can be challenging in some areas because disclosures are different. We are monitoring the disclosures but believe that more time is needed before they become more consistent and can be relied on with full comfort.
Financial Post, Alia McMullen, 6 April 2009

The Canadian banking system is entering a period where two "mega trends" of remediation and deglobalization will pose significant challenges, the head of TD Bank Financial Group said Monday.

Ed Clark, president and chief executive of TD Bank said the global financial crisis, while now out of the panic phase, would take on a new dimension because of the large amount of government intervention in the world's banking system, namely in the United States, the United Kingdom and in parts of Europe.

He said the period the banking system was entering now would be defined by remediation within the industry, whereby Canadian banks would need to fund loans that would have previously been financed through securitization, and deglobalization, where banks retreat from foreign markets.

"The major foreign banks that used to play a role in Canada have all withdrawn from the marketplace, so Canadian banks have had to step in and replace that lending," Mr. Clark said. He said as the banking system deglobalizes, Prime Minister Stephen Harper appeared to be one of the few leaders in the world encouraging their country's banks to expand overseas.

Remediation is also starting to increase the pressure on Canadian banks to fund loans that were previously financed through securitization.

"The banks are having to fund industry where they used to be able to go out and use securitization vehicles to fund themselves, the auto industry would be the clearest example of that," he said.

Mr. Clark said government, particularly in the United States, had implemented partial solutions to the financial crisis. This has got the markets through the panic phase, but now left them "mystified" in their ability to respond to market conditions.

Mr. Clark said he did not agree with the U.S. government's two-prongued approach of addressing the financial crisis and the recession.

"They have the view that you can't have the economy work if the banks don't; I would say the banks won't work if the economy doesn't work," he said. He added this period of remediation, which was fuelled by a "false boom" in credit markets, would hurt Canada, and he did not believe the country could lead the world in recovery.

"Just because our banks didn't collapse, Canadians are running around saying, wow, aren't we terrific. But the reality is this economy is going to get whacked just as hard as economies around the world," Mr. Clark said.
Financial Post, Janet Whitman, 3 April 2009

Royal Bank of Canada is seeking to cash in south of the border on Canada's new cachet as the soundest financial system in the world.

The bank, which has about 450 RBC Bank branches in the southern United States as well as wealth management and investment banking services, launched an advertising campaign a few weeks ago that, for the first time, clearly plays up its Canadian ties.

"What we're doing now is taking advantage of the privileged position that Canadian banks are in," said Jim Little, chief brand officer with Royal Bank of Canada in Toronto. "Are we the new Swiss? I don't think so. We think there's a window. It may not last forever."

With more than 7,000 different banks to choose from around the country, most Americans have no idea or interest in whether theirs is Canadian-owned. But that is changing for a growing number of consumers and businesses who are concerned about the health of their banks as the U.S. financial system continues to teeter.

Whether it's because of their "Canadianness" or simply their strong financial shape, Royal Bank's RBC Bank, Bank of Montreal's Harris Bank and Toronto Dominion's TD Bank are seeing a surge in bank deposits, demand for loans and other business in the United States as their American rivals both big and small try to dig themselves out from years of reckless lending that has led to the massive U.S. government bailout of the industry.

With ailing U.S. banks clamping down on lines of credit and other loans, consumers and business customers are literally walking across the street and taking their business to Canadian-owned banks.

Worried about the safety of his account with a big American bank, Mark Stevens, a Bedford, N.Y.-based marketing consultant, is thinking about putting some of his money with a rival branch one town away owned by Canada's Toronto Dominion.

Yet, TD, like other Canadian banks historically, doesn't mention Canada anywhere in its advertising or at its branches in the United States.

Mr. Stevens, owner of marketing and P.R. firm MSCO and author of "Your Marketing Sucks," thinks that's a mistake.

"Canadian banks are like the equivalent of Swiss watches right now," he said. "It absolutely should be played up. Anyone who's shown Americans they can get higher quality elsewhere, they do. There was resistance to buying Japanese cars at first, but now Americans do."

TD Bank markets itself here as "America's Most Convenient Bank" and sees no need to tout its Canadian roots.

"The brand that we're trying to build is focused on convenience and service," said Neil Parmenter, a spokesman for TD's U.S. operations headquartered in New Jersey. "The mere fact that we're opening stores when our rivals are closing shows our strength."

Royal Bank's last-minute decision to add "Canada" to its new ad blitz came after its marketing research showed - in a surprise to the bank's executives - that Canada has a new appeal with Americans.

"It was an a-ha moment for us," said RBC's Mr. Little. "Canada is cool and relevant in the banking sector."

Even so, the Canada mention isn't being included at retail bank branches nor in ads directed at consumers, where being "local" is more important.

Instead, RBC is playing up its Canadian roots in ads appearing in places like the Wall Street Journal, BusinessWeek, The Economist and CNBC to appeal to investment bankers and wealthy individuals.

Yet, even without direct advertising, Canada is coming on the radar screens of U.S. consumers. The troubled U.S. banking system has sparked a lot more interest from its customers on the issues of strength and stability – two buzzwords with an increasingly strong association to the Canadian banking sector.

Recent media coverage in the U.S. and around the globe touting Canada's healthy financial system has caught the attention of a lot of customers, said Chris Nardella, a spokeswoman for BMO's Harris Bank in Chicago.

Still, no one is expecting "Bank Brand Canada" to sweep America. The average American customer is likely to remain preoccupied with the level of convenience and service a bank offers.

"The Canadian banks with their strong balance sheets have a great opportunity to grow their business at the expense of weaker American banks," said Gerard Cassidy, bank industry analyst with RBC Capital Markets in Maine. "The new business generated in this kind of environment is oftentimes quite good because the lender is going to be ultraconservative in its underwriting."
Financial Post, Theresa Tedesco and John Turley-Ewart, 3 April 2009

Mark Carney, governor of the Bank of Canada, neatly summed up this week what a growing number of financial leaders are saying about Canada's banks: "Our system is better."

From the World Economic Forum, which ranked it the soundest in the world, to U.S. President Barack Obama's reverent musings and Prime Minister Stephen Harper's gloating on the eve of the G20 meetings in London this week, the Canadian banking system is being feted for its resilience amid the economic mayhem.

Now, a study by a highly respected U.S. economist provides further grist for the adoring throng.

The research paper, Global Banking Rubble: Analyzing the Decade of Western Bank Value Destruction, for a Washington non-profit organization, reveals that conservatively managed, risk-averse and government-coddled Canadian financial institutions have made significant gains for the past 10 years, while their swashbuckling U.S. and British counterparts have steadily declined in value.

According to the study, led by Jan Vanous, a Yale University-trained economist and former senior economist and research director at Wharton Econometric Forecasting Associates, the market value of Canada's major chartered banks increased about 85% since 1999, at a time when the aggregate market capitalization of the top 50 international banks declined by 26%.

"Canadian banking is in great shape in relative terms," Prof. Vanous said in an interview with the Financial Post. "Canadian banks have shown significant value creation over the last decade."

The top five Canadian chartered banks, for example, have experienced a 99% increase in their market capitalization since 1999, despite being "more restrained" by strict government regulation and a prohibition on domestic mergers that forced them to grow organically. Major Canadian banks now account for 6.68% of the value of the world's 50 top banks, up from 2.48% in 1999.

More significantly, the top "value-destructing" global banks in the United States, the United Kingdom, Switzerland and Japan wiped out "a staggering 56%" of market value during the past decade. In fact, the study estimates the top 20 "destroyers" eliminated US$1.06-trillion in market capitalization between May, 1999, and mid-March, 2009.

Consider that in 1999, U.S. banks accounted for 42.93% of the total market value of the 50 most valuable financial institutions in the world.

Today, the study says, that figure has been slashed in half, to 21%. Ditto for the once-mighty British banks, which accounted for 14.87% of the world's most valuable banks a decade ago, and now represent 8.04% of that value.

"The destruction of value among the U.S. and British banks is mind-boggling," declared Prof. Vanous, whose research is part of a non-profit project to develop a warning system about asset-price bubbles and market distortions for the University of Michigan.

"There is little doubt the rest of the world could learn a good deal from how banking is done in Canada," Prof. Vanous told the Financial Post, "especially U.S. bankers who normally tend to look down on their Canadian counterparts as pedestrian."

Over the years, Canada's banking system has been much maligned for its notoriously conservative culture and government oversight. But that caution developed out of necessity, after its own eerily similar Wall-Street-style collapse nearly a century ago.

The five major Canadian banks that survive today -- from the 52 that existed in 1891 -- are the descendants of institutions that adopted prudential policies as the best defence against Canada's boom-bust economic cycles.

During its first 56 years -- 1867 to 1923 -- this country's banking system saw the collapse of about one-quarter of all Canadian banks. Stakeholders in failed banks lost an average 47 cents on the dollar, and generated political fallout for MPs and governments.

The banks were not audited by government and most bank boards paid too little heed to what management was doing. The outrage Canadians expressed after bank collapses roused the curiosity of U.S. business leaders, who were baffled by such uproars. Writing anonymously in New York City's Bradstreet's in March, 1888, one Canadian bank executive explained to Americans that the "unusual stability required by the Canadian people in their institutions" meant that bank failures caused "much sensation and distrust" in Canada.

That "unusual stability required by the Canadian people" was felt keenly by Canada's first government in 1867, which promised to create a safe banking system.

Instead, Ottawa gave Canadians the 1871 Bank Act, which amounted to a collection of banking pointers rather than enforced regulations. Soon after the First World War, the cracks in Canada's unregulated banking system grew too big to ignore.

In 1914, Canada had been a debtor nation. Four years later it was lending what today would amount to billions of dollars to the British to finance the purchase of war supplies and agricultural produce from Canada.

The number of Prairie farmers grew by 114%; acres under cultivation in Canada climbed from 48.3 million in 1911 to 70.8 million by 1921. Between 1913 and 1919, Canada's national income soared from $2.4-billion to $4.2-billion and inflation was running at more than 20% a year when the war ended.

Armed conflict had created an economic bubble.

Between the Armistice in November, 1918, and January, 1919, 200 new bank branches opened across Canada. There was approximately one bank branch for every 3,500 people -- today that number is closer to one branch for every 5,000.

Consumer financing took off: Loans for cars were granted, driving up the demand for autos; people borrowed money to invest and speculate on land -- and the leverage grew.

Canada's financial reckoning began in the summer of 1920, when the bubble finally burst. Peace-time could not generate war-time demand for Canadian produce and manufactured goods.

Banks began to falter led by feckless executives. Among the first was the Merchants Bank of Canada, the fourth largest bank in the country at the time.

D.C. Macarow, a suave banker well-known in Montreal's gilded social circles, became the Merchant's chief executive in 1916. Competition between the banks was fierce and Macarow risked large loans to unproven enterprises.

In 1920, he approved loans to two questionable firms from $800,000 to $6-million. It soon became apparent the loans would not be repaid. This, plus heavy losses incurred at other branches in 1920 and early 1921, moved the bank's president, Sir Montagu Allan, to have an independent audit undertaken.

The inspection revealed that Macarow and a small number of other senior managers had gambled with the bank's future and lost. Millions were written off, leaving little provision for coming losses that would surely hit as the economy spiralled downwards. Behind closed doors, a deal to merge the Merchants with the larger Bank of Montreal began with the minister of finance's approval.

When the merger was announced on December 16, 1921, Merchant bank shareholders were shocked to learn they were much poorer than they thought. More importantly, the heated public reaction meant the old political rules -- leaving banking to bankers -- were now untenable.

The Financial Post at the time editorialized that the Merchant Bank fiasco demanded a thorough investigation and that the Bank Act was "defective." Calls for an investigation turned to public outrage when criminal prosecutions against Macarow and Allan were dismissed in court.

Ottawa's response inadvertently culled the weak and insolvent banks that continued to operate after the Merchants demise.

The Bank Act was to be revised with new standards and enforceable regulations. Assets had to be marked-to-market and all Canadian banks were expected to operate according to conservative principles -- that is, to ensure they fulfilled their primary duty to remain solvent. Independent audits were to be standard, performed by firms prohibited from taking retainers or any extra work from banks they were reporting on.

The revised Bank Act was passed by Parliament and went into force on Oct. 1, 1923.

But before it did, the law unleashed a wave of panic in many bank boardrooms.

The Winnipeg-based Union Bank of Canada announced it was writing off millions in losses that just months before it had characterized as valuable assets. Similarly, Toronto-based Standard Bank of Canada wrote off millions that it too had previously classified as valuable assets.

The Bank of Hamilton chose a different path. Rather than admit it had been massaging the books, its management sought a quick merger with the larger Canadian Bank of Commerce.

Similar scenarios involving other banks played out in Montreal.

However, one bank was beyond help -- the Home Bank of Canada. Based in Toronto with most of its 72 branches located in Ontario and western Canada, the relatively small Home Bank had been a fraud since it was chartered in 1903, and catered largely to working-class families. Their savings were used to finance ludicrous ventures such as Casa Loma, the castle-like home that the eccentric land-speculator, hydro-developer Henry Pellatt erected in Toronto. Pellatt couldn't repay his loans; neither could a large number of the firms and individuals to whom the Home Bank had lent working people's money.

With the revised Bank Act in hand, the Home Bank's management shuttered the bank in August, 1923, ensuring they would avoid criminal conviction under the new federal rules.

Canadians were enraged. A Royal Commission was eventually struck as compensation was demanded for depositors, who in the end lost 68 cents on the dollar.

The Home Bank failure led to Ottawa's imposition of government bank inspection on all banks in 1924, laying the foundation for the regulatory system now being celebrated around the world.

Canada's major five banks are reaping the rewards of that conservative culture nurtured so long ago.

Few would have predicted that Canadian banks, long derided as among the least autonomous because of strict government oversight, would emerge from the global mayhem as the most independent international players.

"One could say we were over-regulated, but our solution is going to lead to us having the most free-enterprise financial sector in the world," beamed Prime Minister Harper to the British press at the G20 summit in London this week.

Today, Canada's major banks remain profitable and are still paying dividends to shareholders, while their global competitors are being bailed out with taxpayers' money. While their American peers were loading up their books with toxic mortgages, Canadian banks appeared leery of the housing market risks.

Although Ottawa has committed to buying $125-billion worth of insured mortgages, increasing banks' capacity to lend, but has only spent $40-billion of that so far. The move is not expected to cost taxpayers a penny. In fact, most analysts predict Ottawa will eventually make money on those assets.

Another sign of their growing strength: All five major Canadian chartered banks currently rank among the top 50 in the world; all five are listed in North America's top 12 and two Canadian banks -- Toronto-Dominion Bank and Royal Bank of Canada -- are among the seven major global financial institutions that currently enjoy a coveted triple-A credit rating from Moody's.