Canadian banks under fire

Most Canadians have mixed feelings about our banks. Emotions typically range from frustration, to a sliver of pride that none of our banks failed during the recent financial crisis. But soon sympathy may be thrown into that mix. That’s because something unfair is about to happen to our paragons of financial prudence: they’ll have to pay for the reckless behaviour of banks in the United States and Europe.

The Big Six performed admirably during the recession, and survived without the need for massive publicly funded bailouts. All churned out substantial profits in that time (with the lone exception of the Canadian Imperial Bank of Commerce in 2008). While banks around the globe drowned in red ink, the World Economic Forum named ours the soundest in the world four years in a row.

In comparison, U.S. banks were largely a disaster. First up was the biggest corporate bankruptcy in American history in 2008 when Lehman Bros. collapsed, thanks to massive exposure to worthless sub-prime mortgages. Soon after, concerns about liquidity and asset quality put many other institutions at risk, including Bank of America and Citigroup, which took billions in loans from the government to weather the chaos. An incredible 400 U.S. banks and thrifts failed between 2008 and 2011. European banks fared little better. Age-old institutions such as the Royal Bank of Scotland and Northern Rock in the United Kingdom were so badly mismanaged that they became wards of the state. And now the irony: the U.S. and the international banking community, which could learn a few lessons from us, are developing stringent new banking regulations to which our banks have to adhere, and that will make it much harder for them to remain as profitable. [More: How strong as Western banks?]

The main culprit is the so-called Volcker rule. This American legislation, which takes effect in July, is supposed to prevent insured deposit-taking institutions in the U.S. from engaging in certain risky activities. But as written, the rule could have severe implications for Canadian banks, forcing them to make radical modifications to some of their business activities, or implement costly new compliance regimes. Changes are happening at the international level, too. Next year, significant components of a set of global regulations known as Basel III take effect. While not nearly as sweeping as the Volcker rule, the regulations nevertheless force Canadian banks to make changes that could impact their performance.

The scope and pace at which these regulations are being implemented is staggering. “This is the biggest regulatory exercise that banks in this country have ever undergone, and it’s not done yet,” says Terry Campbell, president of the Canadian Bankers Association. “Resources and compliance functions are being stretched to their limit.” At a conference for the International Institute of Finance last month in Mexico City, former Bank of Canada governor David Dodge similarly worried that the effort and resources required to understand and implement these regulations are reducing the banks’ ability to fulfill their primary role of lending to consumers and businesses. (The banks themselves either declined comment for this article or deferred to the CBA.)

The worst part is that these new regulations will have to be implemented at a time when the outlook for Canadian banks is dimmer than in recent years. A mature domestic business and a potential drop in consumer lending will slow bank growth in the months ahead. The banks’ recent first-quarter earnings were generally strong, but their capital-markets divisions, which provide services such as advising other companies on mergers and acquisitions, are already suffering. Royal Bank of Canada, Toronto-Dominion Bank and Bank of Montreal all recently posted double-digit income declines in this area, as there is little demand for these services in a lousy global economy. Analysts generally don’t expect demand to improve any time soon.[More: The main reason MF Global failed]

Restrictive regulations won’t make it any easier for the banks to grow in this climate, and that’s bad news for almost all Canadians. After all, bank stocks are widely held by investors across the country. In fact, if you own a balanced mutual fund, you almost certainly hold bank stocks. Due to a variety of factors, the double-digit returns that investors have grown used to may dry up, and we may all have to adjust to bank share prices that grow more modestly. “There doesn’t seem to be an easy way out,” says Brad Smith, a financial services analyst at Stonecap Securities in Toronto. Our institutions have been nothing but responsible. So why should they have to pay for the failings of others?

The most damaging new piece of legislation on the horizon is the Volcker rule, named for economist and former Federal Reserve chair Paul Volcker, who first proposed a less complex version of the law. The rule is designed to prevent insured depository institutions from engaging in proprietary trading—essentially, making risky short-term bets for their own benefit, not their clients’, and potentially putting the broader financial system in peril. Proprietary trading was by no means the cause of the financial crisis, but it did worsen a dire situation. A report by the U.S. Government Accountability Office last year found the six largest financial companies, including Bank of America, Citigroup and Wells Fargo, lost nearly $16 billion in their proprietary trading units in just over 12 months during the crisis. The government eventually pumped billions into these institutions to keep them afloat in late 2008. But with the Volcker rule, the banks wouldn’t be able to dabble in certain trading activities for their own bottom lines, which lawmakers hope will help reduce losses in the event of another calamity.

Unfortunately, the rule has been written so broadly that it affects the activities of foreign institutions, leading to outcry not only from Canada but from the U.K. and Japan as well. Under Volcker, U.S. banks are generally forbidden from owning stakes in hedge funds and private equity funds, since ownership interests could allow them to indirectly participate in proprietary trading. The problem is, the legislation never really defines what constitutes a private equity or a hedge fund. Canadian bank-sponsored mutual funds could even fall under the definition, meaning U.S. banks wouldn’t be permitted to own them. The rule is so restrictive that Canadian banks fear they would be unable to even process mutual fund transactions for Canadian clients even temporarily residing in the U.S., such as snowbirds. In a letter to U.S. authorities last month, the Big Six Canadian banks claim it would be “impossible...to determine whether a unitholder is communicating from a location within Canada, the United States or some other country.” As a result, the banks argue they would be forced to divest themselves of any ownership interests or sponsorships of Canadian mutual funds, lest they risk running afoul of the Volcker rule.

Finance Minister Jim Flaherty criticized the Volcker rule’s “unprecedented extraterritorial reach” in a letter to Treasury Secretary Timothy Geithner. Bank of Canada governor Mark Carney warned in a letter to Federal Reserve chairman Ben Bernanke the rule could actually “reduce global financial resilience rather than increase it.” The banks, along with Flaherty, are pushing to have Canadian mutual funds exempted from the legislation. Because mutual funds pose no risk to the U.S. financial system, it’s not unreasonable to assume the U.S. government will accommodate. [More: Banks, image problems and the ethics of lobbying]

But other changes could be trickier. Though eliminating proprietary trading is the goal, U.S. banks are still permitted to trade in U.S. government debt. The exemption is justified because the activity is defined as “market-making.” That means U.S. banks play an important role in ensuring a market for U.S. Treasuries, allowing the government to finance itself. Foreign government debt, however, is not exempted. U.S. banks would therefore not be able to trade or hold Canadian federal and provincial government bonds. Carney, Flaherty and the banks themselves have all argued U.S. banks provide the same market-making function for Canadian debt that they do for the American variety, and an exemption should be granted. Around 20% of Canadian government bonds are held by foreign institutions or individuals, and U.S. firms serve as counterparties to two-thirds of the transactions in these securities with other non-Canadian buyers and sellers. Without the presence of U.S. banks, the market for sovereign debt could become less liquid, and borrowing costs for governments could rise.

There are serious implications for our banks, too. The Big Six typically use government debt as part of their risk-management strategies. The bonds are secure and liquid, making them ideal to hold in the event of emergency funding needs. But if liquidity dries up, the banks wouldn’t be able to buy or sell as easily. “A major tool has been taken away from the banks,” says Campbell at the CBA.

The Office of the Superintendent of Financial Institutions, the country’s banking regulator, is just as worried. In a letter to U.S. authorities in late December, it pointed out that liquidity requirements are becoming more important under the Basel III regulations. If the U.S. doesn’t exempt Canadian government debt under Volcker, then it would “significantly impede” how the banks handle their liquidity and funding requirements. In short, at a time when managing risk is becoming more important than ever, the ability of Canadian banks to do so will be undermined.

Whether the U.S. will eventually grant such exemptions is unclear; the intense pressure on the U.S. from Canada, the U.K., and Japan will ensure the government is at least paying attention. The problem is, Paul Volcker is an influential figure in the U.S. (he chaired the Economic Recovery Advisory Board under President Barack Obama, after all), and he has fought back hard against the criticism of his namesake bill. In an opinion piece in the Financial Times in February, he dismissed a lot of the problems raised by foreign governments, arguing the effects on debt markets would be minimal. “Can it really be of concern that some of the largest banks in Europe, in Japan, in China and indeed in Canada cannot maintain effective markets in their own sovereign debt?” he wrote. “Let’s get serious.” [More: Wall Street needs to be fixed, not occupied]

Simon Johnson, an economics professor at the Massachusetts Institute of Technology, told Bloomberg that U.S. officials may be reluctant to accommodate the foreign governments’ demands simply for political reasons. “It would look bad before elections to cave in to foreign demands when your public wants you to be tough on banks,” he said. Granting exceptions can quickly become messy, too. After all, if U.S. banks are permitted to trade in Canadian government debt, why not Spanish debt? Or Greek debt?

One of the questions on the minds of Canadian officials and policy-makers is whether the overreaching aspects of the Volcker rule were intentional or just merely an oversight. Ian Lee, a professor at the Sprott School of Business, is inclined to believe the latter. “There’s a casual carelessness from American government officials about the impact of their decisions on people outside of their country,” he says. “They just shrug their shoulders.” But the two senators who pushed the Volcker rule through Congress did specifically argue that only U.S. debt should be exempted because other forms of sovereign debt could be too risky.

Canada? Too risky? The suggestion strains credulity. Government bonds are a straightforward security, unlike, say, synthetic collateralized debt obligations stuffed with sub-prime mortgages. And the chances that the Canadian government would ever default on payments are incredibly slim. “I’m dumbfounded by this,” says Louis Gagnon, a professor of finance at Queen’s University. “It’s a knee-jerk reaction to a financial calamity.”

The Volker rule is bad enough, but then there’s Basel III. These complex regulations have been crafted by the Basel Committee on Banking Supervision, comprised of central bankers and regulators from around the world, including Canada, in an attempt to make financial institutions safer. (The first round of Basel accords were set in 1988, followed by another in 2004.) Designed to limit risk in the finance sector, they don’t carry the same risk of unintended consequences as the Volcker rule, but they could still cause a drag on our banks’ earnings. Canadian authorities participated in the crafting of Basel III, and the banks are preparing to implement them with comparatively little fuss. It is nevertheless ironic that even though our banks set an example for the world throughout the financial crisis, they still have to take steps to make themselves safer at the request of the global community. A major component of Basel III, in effect starting next year, is a requirement for financial institutions to hold more capital. The details of the capital requirements under Basel III are complicated, but generally speaking, deposit-taking institutions such as Canada’s banks will have to maintain tangible common equity, which includes things like cash, equal to 4.5% of their assets plus an additional buffer of 2.5%, for a total of 7%. All that means is, the banks are required to hold more high-quality capital to backstop against losses in the event of a crisis. That gives creditors more confidence a bank will be able to pay them back, and so they’ll continue to finance a bank’s operations. What happened during the crisis is that even though some banks appeared well-capitalized, they quickly exhausted their capital buffers as losses mounted. Both Washington Mutual in the U.S. and Northern Rock in the U.K. were seized by their respective governments when private lenders, under the belief they were unlikely to be paid back, refused to provide the banks with funding to continue their day-to-day operations.

OSFI has said it expects the banks will meet or exceed the 7% requirement by next year. CIBC currently boasts the biggest capital ratio at 8%. Bank of Montreal and TD Bank recently announced they just squeaked over the threshold in their first-quarter earnings results, making the Bank of Nova Scotia the only one that may still be under 7%—the bank has yet to say where it stands. Meeting the capital requirement is why many analysts believe Scotiabank is looking to sell its headquarters in downtown Toronto, and the bank could raise as much as $1.65 billion by issuing new shares this year.

Generally speaking, the banks aren’t thrilled about having to hold more capital, since it could impact profitability. More capital lowers the return on equity, a measure of how efficient a company is at generating profit for every dollar shareholders invest. Simply put, if a company has a pile of cash just sitting there that it can’t use to make bigger profits, that will lower the return to shareholders. Banks have been an attractive investment in part because the return on equity has historically been very high—more than 20%—but that level will be much harder to maintain. “We’re at risk of seeing shareholder value destruction,” says analyst Brad Smith at Stonecap Securities. “It’s not reflected in the market yet, but I believe it will be.”

Capital rules also complicate how the banks make acquisitions. Because the market for banking services in Canada is relatively mature, the banks have increasingly turned to acquisitions abroad. When purchasing a company, the acquirer will usually end up paying a premium over the other firm’s market value for things like the value of its brand name, or the intellectual capacity of its employees. Such assets are referred to as goodwill. But in the complex accounting of Basel III, goodwill is actually subtracted from other forms of equity to determine how much common equity a bank has. Every dollar of goodwill therefore weighs on the capital ratio. (The theory is that if a bank has to shed assets during a crisis, potential buyers aren’t going to pay a premium, making goodwill worthless.) For Canadian banks, the pace of acquisitions could slow, Smith says, in order to maintain minimum capital requirements.

The banks may eventually have to maintain even larger buffers than the 7% requirement. The Basel Committee is still figuring out how to determine which domestic banks in any given country are systemically important—meaning if a bank were to collapse, could it severely destabilize the country’s financial system? These banks would be required to exceed the 7% minimum. The committee has already named 29 global systemically important banks (none are Canadian) that have to hold an extra 1% to 3.5% more capital. A framework for dealing with domestic “too big too fail” institutions is expected toward the end of the year. Given the concentration in Canada’s banking sector, it’s likely that at least some of the banks will be designated as such, requiring higher capital levels and putting even more pressure on their return on equity.

Rick Waugh, CEO at Scotiabank, is already subtly laying out a case for why the company should be exempted. “We have to be very careful on that, because the business models are different,” he told Reuters last month. “We’re one of the smaller Canada banks,” he insisted, adding that half of the company’s earnings are outside of the nation. Waugh has probably been the most outspoken bank CEO in Canada when it comes to the new regulatory regime. In his speech at the company’s annual meeting last year, he criticized Basel III for being “overly prescriptive,” and pointed out that prudent risk management and consistent profitability will keep “banks from ever having to use capital as a buffer.” Compared to their peers, Canada’s banks are already well-versed in managing risks and churning out profits.

All of these new regulatory requirements worsen what is already a tough period for the banks. At the start of the year, Barclays Capital analyst John Aiken downgraded his view on the entire Canadian financial sector from positive to neutral. “The revenue environment is very challenging for the Canadian banks. This is largely predicated on the fact that consumer borrowing cannot be as strong as it has been over the past three years,” he says. Low interest rates have enticed Canadians to go on a borrowing binge, to the benefit of the banks’ consumer lending businesses. But households are straining under debt, and rates will eventually rise, putting an end to the borrowing frenzy. “There’s very few mitigants that can offset that slowing growth,” Aiken says.

Certainly no one is predicting large declines in profits or share prices, but rather a period of much more modest growth. Rob Wessel, managing partner at investment firm Hamilton Capital Partners in Toronto, was on to this trend last year when he published a note for clients titled “The Canadian Banks—The End of an Era.” His thesis is that the primary drivers of the banks’ growth over the past two decades (lower corporate taxes, a favourable regulatory environment allowing consolidation in the sector) will no longer be as significant, and a number of challenges—including new regulations—will slow their growth. Instead of the double-digit returns investors have grown accustomed to, Wessel predicts high single-digit returns will be the norm. “The Canadian banks are not on the cusp of another golden era, a period which has definitely ended,” he wrote.

In today’s lousy investment climate, high single-digit returns aren’t bad at all. But it’s hard not to wonder why Canada’s banks, which have performed admirably, should be subject to more regulation in the first place. With the Volcker rule, the response from Canadian officials clearly indicates they think the legislation’s reach into Canada is unwarranted. It is virtually guaranteed that they will continue to seek exemptions. Basel III is different, however, something the banks have to begrudgingly accept. The aim of the Basel regulations is to create a safer financial system for the world as a whole. For any one country to refuse to play along would add more risk to the system. “Canada is a good corporate citizen on the world stage, and we are adhering to those standards as well,” says Campbell, “even if we were not the cause of the problems.”

No one is so naive as to think Basel III or any other set of regulations will prevent financial disasters. “New and better rules are necessary, but not sufficient. People will always try to find ways around them,” governor Carney said in a speech last September. But he also challenged that view in the same speech. “Such fatalism should be rejected,” he said. “The sad experience of the past few years shows that there is ample scope to improve the efficiency and resilience of the global financial system.” And if Canada’s banks have to suffer as a result? Too bad. Sometimes there are no rewards for virtue.