Scotia Capital, 27 January 2010
• The following are excerpts from our full report titled "Canada's Dividend Culture".
• The main risk currently, in our opinion, to the Canadian banking industry and bank valuation is “regulatory” in terms of over-regulation and mis-regulation. The major uncertainty is what operating and financial constraints will be placed on banks by the regulator. We believe that the regulator will likely require excessive deleveraging in the near to medium term before adopting a more balanced approach to capital.
• Our concern about regulatory risk has been heightened with the recent release of the Basel consultative documents. We are particularly concerned about the potential impact to Canada's dividend culture, where Canadian bank dividend levels may increase in volatility, reducing predictability, or banks may have to lower dividend payout ratios longer term, freezing or reducing dividend increases in the near term in order to manage prudently under the Basel rules. This report focuses on Tier 1 common, potential capital buffers, and the maximum distributions, particularly dividends, to be prescribed by the regulators. Basel has not calibrated its capital conservation rules, but the tone and nature of the document has potential risk particularly for Canada given the bank group's dividend history and culture, not to mention the maintenance of healthy dividends through the recent financial crisis.
• If Canadian banks' dividend policies change, valuations will likely be impacted, and the risk is to the downside. We remain market weight as, in our opinion, we need regulatory clarity, especially on capital and bank dividend policy, before bank valuations can expand further. In fact, bank valuation may contract modestly in the near term under the uncertainty.
• The Bank for International Settlements (BIS) recently released (December 17, 2009) two consultative documents: (1) Strengthening the Resilience of the Banking Sector; (2) International Framework for Liquidity Risk Measurement, Standards and Monitoring. These documents were issued for comment by April 16, 2010.
• “As requested by the G20, the standards will be phased in as financial conditions improve and the economy recovery is assured, with an aim of implementation by end-2012. As part of this phase in process, the Committee will consider appropriate transitional and grandfathering arrangements.” (Strengthening the Resilience of the Banking Sector)
• It is generally believed that a number of proposals will be modified and others subject to country-by-country consideration. We expect that local regulators will have some discretion, with blanket global adoption unlikely.
• The two Basel documents are very detailed, technical, and are consultative, with no minimum capital levels indicated. It seems that Basel’s main focus in terms of capital ratios is on Tier 1 Common. The status of hybrid capital is questionable, especially Innovative Tier 1. We have fine-tuned our pro forma Tier 1 common ratios from our preliminary calculations published December 18 and December 21, 2009 (Canadian Banks Quarterly Overview, Daily Edge, “Banks – Fourth Quarter Overview,” respectively), extending the pro forma ratios to 2012.
• “The fully calibrated set of standards will be developed by the end of 2010 (calendar) to be phased in with implementation by end 2012 (calendar).” (Strengthening the Resilience of the Banking Sector)
• We expect Canadian banks’ capital levels to remain among the highest on a global basis. S&P calculated risk-adjusted capital (RAC) ratios for 40 global banks using detailed information provided by the banks (some non-public). S&P’s RAC ratios were released on November 23, 2009, as at June 30, 2009. S&P RAC ratios are relatively conservative, using stricter definitions of capital and higher risk weights. For the 40 global banks S&P calculated an average 6.7% RAC ratio, with Canadian banks in the high end of the range at 7.8%-8.3%. Thus, it is reasonable to expect Canadian banks to maintain their relative strength under the new Basel proposals.
• We expect that Canadian banks would be able to comfortably meet the Tier 1 common capital ratios stemming from these Basel proposals. However, the single biggest concern for Canadian banks from the Basel proposal, we believe, is the potential impact on dividends from the section titled “Capital conservation best practice” (Strengthening the Resilience of the Banking Sector). In our opinion, capital conservation best practices, depending on calibration, could unfairly threaten Canada’s dividend culture. In essence, Canadian banks are caught in the crossfire of regulators, central bankers, and politicians (populist agenda), mainly from the United States and the U.K. Thus, in our view, Canadian banks may have to maintain inefficient and uneconomical capital levels to be able to sustain dividends near their historical payout ratios or significantly change their dividend payout policy or be prepared to issue equity at likely a very inopportune time in the market. Global banks, at the same time, that have cut or eliminated their dividends would be able to operate with lower Tier 1 common ratios as they have lower capital buffer requirements given their low level of
dividend distribution.
Caught in the Crossfire
• The Basel proposal to place banks in a straight jacket with respect to dividends and regulate dividend payments based on capital cushions we believe is very harsh. This particular proposal could be very disruptive to Canada’s dividend culture. This proposal could result in significant changes to Canadian banks’ dividend payout targets and significantly impact dividend growth, certainly in the near to medium term, and/or result in equity issues, with Canadian banks forced to carry much lower leverage to sustain their healthy dividend payouts, or cause dividend cuts and lower dividend predictability. The Basel proposal in essence favours stock buybacks (likely at market peaks) over dividend increases.
• Canada’s major banks have a long history of superior dividend growth (Exhibit 10), as well as maintaining dividend levels even through severe economic downturns, setting Canada apart from many countries. Canadian bank shares are widely held in Canada by institutions including pension funds and individuals including pensioners who have come to rely on the stability and predictability of bank dividends. Many Canadians rely on bank dividends as a source of income. Canadian banks have the enviable track record of increasing their dividends at a CAGR of 10% over the past 42 years, with none of the large five Canadian banks ever cutting their dividend.
• A major attraction for investors to Canadian bank stocks has been their dividends. So the BIS proposal may put Canada’s dividend history/culture in jeopardy. We believe the BIS proposals in essence attack Canada’s bank culture of reliable steady dividend growth or at least may cause a major reset in the banks dividend payout ratio. Most of the major global banks have significantly reduced or eliminated their common dividend (Exhibit 9), so for them they can operate with much higher leverage with no impact to the current dividend situation. However, for Canadian banks they will have to operate with significantly lower leverage. Thus the BIS proposal in essence penalizes banks that have weathered the financial crisis with solid earnings, capital, and their dividends intact.
• Canadian banks may ultimately be forced to reduce their payout ratios over time so they can be more leveraged and/or provide more capital management flexibility. Canadian banks would have to maintain significant capital buffers to maintain their dividends at historical payout ratios with even moderate earnings cyclicality or issue equity at likely depressed prices or reduce dividends. So in every down cycle, in the absence of huge capital buffers, we believe banks must slash dividends and/or employee compensation, or issue common equity (to restore capital buffers).
• The unintended consequences may be increased volatility in bank share prices and perhaps lower valuations, thus reducing investor confidence and increasing bank cost of capital. In addition, overall confidence in the financial system may be lowered due to increased volatility, which is what the rules are intended to guard against. Major acquisitions that the banks may contemplate de facto must be done primarily with equity or with a reduction to the dividend to maintain the buffer.
• Also, a bank supervisor in charge of a bank’s capital plan (which seems intrusive in itself) may allow the bank to make an aggressive acquisition issuing equity, diluting shareholders, and/or reducing the dividend versus returning funds to shareholders through higher dividends. So the importance of the maintenance of dividends diminishes and substantially reduces the predictability of equity issuances. Thus the ideology of the current and future bank supervisor becomes important, introducing another layer of uncertainty for capital providers to the banking industry. Uncertainty generally pushes up costs and lowers valuation. We understand that the primary goal is to protect the depositor, but we don’t believe you have to disregard the interests of the capital providers in this pursuit.
• The four elements of distribution are common dividends, discretionary bonuses, discretionary payments on Tier 1 (non cumulative preferred dividends), and share buybacks. The two material elements subject to restriction that we are most concerned about are dividends and discretionary bonuses, which we believe could impact the valuation of the common shares and the operating businesses. Non-cumulative preferred dividends are modest and share buybacks are very discretionary with no real expectations, thus this constraint is not expected to be significant.
• The distribution constraint on discretionary bonuses may result in banks increasing base salaries and reducing bonuses, which has already occurred to some degree with a number of global banks. Thus an unintended consequence may be a cost mix shift for the banks towards fixed costs versus variable costs.
• We expect bank dividend payout ratio targets (Exhibit 5) to be reviewed, with payout ratios likely reduced or reset certainly in the near-to-medium term. In determining potential dividend increases between now and the end of 2012, we use the midpoint of the banks’ dividend payout target range. At the very least, the banks may start targeting the low end of the range as opposed to the high end.
• Dividend increase potential (Exhibit 5) in our view favours NA, RY, TD, and BMO, as we estimate they could increase their dividends by 40%, 36%, 17%, and 8%, respectively, using the midpoint of their targets while remaining below the maximum common dividend distribution, including a cushion for earnings cyclicality. On the other hand, CM and BNS have no dividend increase potential at the midpoint of their target payout range and would theoretically have to cut their dividends 21% and 9% to remain below the maximum common distribution including the cushion for earnings cyclicality. However, this is theoretical as they could easily issue common equity to allow a higher distribution, and the earnings cyclicality cushion does not apply until needed in perhaps 2020, which gives them plenty of time to build up this cushion through internally generated capital.
• The conclusion is NA and RY should have the highest dividend growth or flexibility to increase dividends over the next two or three years.
• It would seem from a distribution flexibility point of view a Tier 1 common ratio of 7% and 8% is very important, certainly under both Basel illustration and Scotia Capital calibration. Our pro forma Tier 1 calculations indicate that only BNS and CM fall below the 7% Tier 1 common level and would have to issue $2.8 billion and $1.0 billion in equity (Exhibit 6), respectively, to achieve these levels. To achieve an 8% minimum, Canadian banks would have to issue $11.3 billion in equity (Exhibit 6, row 12). RY is the only Canadian bank that would not have to issue equity as its pro forma Tier 1 common is 8.2%.
• Canadian banks’ pro forma return on equity would decline to 17.3% with a minimum Tier 1 common of 8% led by RY at 19.8%, with TD and BMO a low of 13.9% and 15.4%, respectively.
Investment Returns & Dividends
• Historically dividends have been the most significant contributor to total equity returns. According to Research Affiliates, LLC, dividends represented 53% of total equity returns from 1817 to 2009 (Exhibit 8). However, through the 1990s bull market (1989-2000), dividends declined to 18% of total return, recovering modestly to 32% of total returns from 2001 to 2009. Dividend growth has been a very solid predictor of share price performance historically. Dividends have also been more stable and predictable than earnings, EBITDA, or sales. The recent Basel documents are expected to increase dividend risk in terms of predictability and magnitude, thus potentially hurting long-term value and raising the cost of capital.
• We believe that banks will continue to generate superior profitability versus the market, but clarity on dividends is needed to expand valuation. A period of reset where dividend payout ratios decline in the near-to-medium term will likely mute growth through this period and thus mute valuation and performance. However, once dividend resets occur, we believe growth should return to more normal long-term rates.
Recommendation
• We downgraded the Canadian banks to market weight from overweight (December 11, 2009) due to their strong absolute and relative share price performance in 2009 and increased regulatory/political risk. Bank stocks doubled off their 2009 lows and were up 59% in 2009, outperforming the TSX by 26% in 2009.
• Canadian bank stocks are expected to remain long-term outperformers, with some consolidation expected in the first half of 2010. We believe we are in a consolidation phase, with a stalled bank rally in the near term. Thus rapid appreciation from these levels is difficult to see given the magnitude of the 2009 rally and the fact that banks appear to have been placed on hold with respect to capital management pending clarity from the regulator. In addition, a sharp acceleration in earnings is not expected until the later part of 2010.
• We have 1-Sector Outperform ratings on RY and BMO, with 2-Sector Perform ratings on BNS, CWB, LB, TD, and NA, and a 3-Sector Underperform rating on CM. Our order of preference is RY, BMO, NA, CWB, LB, TD, BNS, and CM.
;
• The following are excerpts from our full report titled "Canada's Dividend Culture".
• The main risk currently, in our opinion, to the Canadian banking industry and bank valuation is “regulatory” in terms of over-regulation and mis-regulation. The major uncertainty is what operating and financial constraints will be placed on banks by the regulator. We believe that the regulator will likely require excessive deleveraging in the near to medium term before adopting a more balanced approach to capital.
• Our concern about regulatory risk has been heightened with the recent release of the Basel consultative documents. We are particularly concerned about the potential impact to Canada's dividend culture, where Canadian bank dividend levels may increase in volatility, reducing predictability, or banks may have to lower dividend payout ratios longer term, freezing or reducing dividend increases in the near term in order to manage prudently under the Basel rules. This report focuses on Tier 1 common, potential capital buffers, and the maximum distributions, particularly dividends, to be prescribed by the regulators. Basel has not calibrated its capital conservation rules, but the tone and nature of the document has potential risk particularly for Canada given the bank group's dividend history and culture, not to mention the maintenance of healthy dividends through the recent financial crisis.
• If Canadian banks' dividend policies change, valuations will likely be impacted, and the risk is to the downside. We remain market weight as, in our opinion, we need regulatory clarity, especially on capital and bank dividend policy, before bank valuations can expand further. In fact, bank valuation may contract modestly in the near term under the uncertainty.
• The Bank for International Settlements (BIS) recently released (December 17, 2009) two consultative documents: (1) Strengthening the Resilience of the Banking Sector; (2) International Framework for Liquidity Risk Measurement, Standards and Monitoring. These documents were issued for comment by April 16, 2010.
• “As requested by the G20, the standards will be phased in as financial conditions improve and the economy recovery is assured, with an aim of implementation by end-2012. As part of this phase in process, the Committee will consider appropriate transitional and grandfathering arrangements.” (Strengthening the Resilience of the Banking Sector)
• It is generally believed that a number of proposals will be modified and others subject to country-by-country consideration. We expect that local regulators will have some discretion, with blanket global adoption unlikely.
• The two Basel documents are very detailed, technical, and are consultative, with no minimum capital levels indicated. It seems that Basel’s main focus in terms of capital ratios is on Tier 1 Common. The status of hybrid capital is questionable, especially Innovative Tier 1. We have fine-tuned our pro forma Tier 1 common ratios from our preliminary calculations published December 18 and December 21, 2009 (Canadian Banks Quarterly Overview, Daily Edge, “Banks – Fourth Quarter Overview,” respectively), extending the pro forma ratios to 2012.
• “The fully calibrated set of standards will be developed by the end of 2010 (calendar) to be phased in with implementation by end 2012 (calendar).” (Strengthening the Resilience of the Banking Sector)
• We expect Canadian banks’ capital levels to remain among the highest on a global basis. S&P calculated risk-adjusted capital (RAC) ratios for 40 global banks using detailed information provided by the banks (some non-public). S&P’s RAC ratios were released on November 23, 2009, as at June 30, 2009. S&P RAC ratios are relatively conservative, using stricter definitions of capital and higher risk weights. For the 40 global banks S&P calculated an average 6.7% RAC ratio, with Canadian banks in the high end of the range at 7.8%-8.3%. Thus, it is reasonable to expect Canadian banks to maintain their relative strength under the new Basel proposals.
• We expect that Canadian banks would be able to comfortably meet the Tier 1 common capital ratios stemming from these Basel proposals. However, the single biggest concern for Canadian banks from the Basel proposal, we believe, is the potential impact on dividends from the section titled “Capital conservation best practice” (Strengthening the Resilience of the Banking Sector). In our opinion, capital conservation best practices, depending on calibration, could unfairly threaten Canada’s dividend culture. In essence, Canadian banks are caught in the crossfire of regulators, central bankers, and politicians (populist agenda), mainly from the United States and the U.K. Thus, in our view, Canadian banks may have to maintain inefficient and uneconomical capital levels to be able to sustain dividends near their historical payout ratios or significantly change their dividend payout policy or be prepared to issue equity at likely a very inopportune time in the market. Global banks, at the same time, that have cut or eliminated their dividends would be able to operate with lower Tier 1 common ratios as they have lower capital buffer requirements given their low level of
dividend distribution.
Caught in the Crossfire
• The Basel proposal to place banks in a straight jacket with respect to dividends and regulate dividend payments based on capital cushions we believe is very harsh. This particular proposal could be very disruptive to Canada’s dividend culture. This proposal could result in significant changes to Canadian banks’ dividend payout targets and significantly impact dividend growth, certainly in the near to medium term, and/or result in equity issues, with Canadian banks forced to carry much lower leverage to sustain their healthy dividend payouts, or cause dividend cuts and lower dividend predictability. The Basel proposal in essence favours stock buybacks (likely at market peaks) over dividend increases.
• Canada’s major banks have a long history of superior dividend growth (Exhibit 10), as well as maintaining dividend levels even through severe economic downturns, setting Canada apart from many countries. Canadian bank shares are widely held in Canada by institutions including pension funds and individuals including pensioners who have come to rely on the stability and predictability of bank dividends. Many Canadians rely on bank dividends as a source of income. Canadian banks have the enviable track record of increasing their dividends at a CAGR of 10% over the past 42 years, with none of the large five Canadian banks ever cutting their dividend.
• A major attraction for investors to Canadian bank stocks has been their dividends. So the BIS proposal may put Canada’s dividend history/culture in jeopardy. We believe the BIS proposals in essence attack Canada’s bank culture of reliable steady dividend growth or at least may cause a major reset in the banks dividend payout ratio. Most of the major global banks have significantly reduced or eliminated their common dividend (Exhibit 9), so for them they can operate with much higher leverage with no impact to the current dividend situation. However, for Canadian banks they will have to operate with significantly lower leverage. Thus the BIS proposal in essence penalizes banks that have weathered the financial crisis with solid earnings, capital, and their dividends intact.
• Canadian banks may ultimately be forced to reduce their payout ratios over time so they can be more leveraged and/or provide more capital management flexibility. Canadian banks would have to maintain significant capital buffers to maintain their dividends at historical payout ratios with even moderate earnings cyclicality or issue equity at likely depressed prices or reduce dividends. So in every down cycle, in the absence of huge capital buffers, we believe banks must slash dividends and/or employee compensation, or issue common equity (to restore capital buffers).
• The unintended consequences may be increased volatility in bank share prices and perhaps lower valuations, thus reducing investor confidence and increasing bank cost of capital. In addition, overall confidence in the financial system may be lowered due to increased volatility, which is what the rules are intended to guard against. Major acquisitions that the banks may contemplate de facto must be done primarily with equity or with a reduction to the dividend to maintain the buffer.
• Also, a bank supervisor in charge of a bank’s capital plan (which seems intrusive in itself) may allow the bank to make an aggressive acquisition issuing equity, diluting shareholders, and/or reducing the dividend versus returning funds to shareholders through higher dividends. So the importance of the maintenance of dividends diminishes and substantially reduces the predictability of equity issuances. Thus the ideology of the current and future bank supervisor becomes important, introducing another layer of uncertainty for capital providers to the banking industry. Uncertainty generally pushes up costs and lowers valuation. We understand that the primary goal is to protect the depositor, but we don’t believe you have to disregard the interests of the capital providers in this pursuit.
• The four elements of distribution are common dividends, discretionary bonuses, discretionary payments on Tier 1 (non cumulative preferred dividends), and share buybacks. The two material elements subject to restriction that we are most concerned about are dividends and discretionary bonuses, which we believe could impact the valuation of the common shares and the operating businesses. Non-cumulative preferred dividends are modest and share buybacks are very discretionary with no real expectations, thus this constraint is not expected to be significant.
• The distribution constraint on discretionary bonuses may result in banks increasing base salaries and reducing bonuses, which has already occurred to some degree with a number of global banks. Thus an unintended consequence may be a cost mix shift for the banks towards fixed costs versus variable costs.
• We expect bank dividend payout ratio targets (Exhibit 5) to be reviewed, with payout ratios likely reduced or reset certainly in the near-to-medium term. In determining potential dividend increases between now and the end of 2012, we use the midpoint of the banks’ dividend payout target range. At the very least, the banks may start targeting the low end of the range as opposed to the high end.
• Dividend increase potential (Exhibit 5) in our view favours NA, RY, TD, and BMO, as we estimate they could increase their dividends by 40%, 36%, 17%, and 8%, respectively, using the midpoint of their targets while remaining below the maximum common dividend distribution, including a cushion for earnings cyclicality. On the other hand, CM and BNS have no dividend increase potential at the midpoint of their target payout range and would theoretically have to cut their dividends 21% and 9% to remain below the maximum common distribution including the cushion for earnings cyclicality. However, this is theoretical as they could easily issue common equity to allow a higher distribution, and the earnings cyclicality cushion does not apply until needed in perhaps 2020, which gives them plenty of time to build up this cushion through internally generated capital.
• The conclusion is NA and RY should have the highest dividend growth or flexibility to increase dividends over the next two or three years.
• It would seem from a distribution flexibility point of view a Tier 1 common ratio of 7% and 8% is very important, certainly under both Basel illustration and Scotia Capital calibration. Our pro forma Tier 1 calculations indicate that only BNS and CM fall below the 7% Tier 1 common level and would have to issue $2.8 billion and $1.0 billion in equity (Exhibit 6), respectively, to achieve these levels. To achieve an 8% minimum, Canadian banks would have to issue $11.3 billion in equity (Exhibit 6, row 12). RY is the only Canadian bank that would not have to issue equity as its pro forma Tier 1 common is 8.2%.
• Canadian banks’ pro forma return on equity would decline to 17.3% with a minimum Tier 1 common of 8% led by RY at 19.8%, with TD and BMO a low of 13.9% and 15.4%, respectively.
Investment Returns & Dividends
• Historically dividends have been the most significant contributor to total equity returns. According to Research Affiliates, LLC, dividends represented 53% of total equity returns from 1817 to 2009 (Exhibit 8). However, through the 1990s bull market (1989-2000), dividends declined to 18% of total return, recovering modestly to 32% of total returns from 2001 to 2009. Dividend growth has been a very solid predictor of share price performance historically. Dividends have also been more stable and predictable than earnings, EBITDA, or sales. The recent Basel documents are expected to increase dividend risk in terms of predictability and magnitude, thus potentially hurting long-term value and raising the cost of capital.
• We believe that banks will continue to generate superior profitability versus the market, but clarity on dividends is needed to expand valuation. A period of reset where dividend payout ratios decline in the near-to-medium term will likely mute growth through this period and thus mute valuation and performance. However, once dividend resets occur, we believe growth should return to more normal long-term rates.
Recommendation
• We downgraded the Canadian banks to market weight from overweight (December 11, 2009) due to their strong absolute and relative share price performance in 2009 and increased regulatory/political risk. Bank stocks doubled off their 2009 lows and were up 59% in 2009, outperforming the TSX by 26% in 2009.
• Canadian bank stocks are expected to remain long-term outperformers, with some consolidation expected in the first half of 2010. We believe we are in a consolidation phase, with a stalled bank rally in the near term. Thus rapid appreciation from these levels is difficult to see given the magnitude of the 2009 rally and the fact that banks appear to have been placed on hold with respect to capital management pending clarity from the regulator. In addition, a sharp acceleration in earnings is not expected until the later part of 2010.
• We have 1-Sector Outperform ratings on RY and BMO, with 2-Sector Perform ratings on BNS, CWB, LB, TD, and NA, and a 3-Sector Underperform rating on CM. Our order of preference is RY, BMO, NA, CWB, LB, TD, BNS, and CM.
