Canadian Banks: Perspectives on the Canadian Banking Industry

2008 was the year the credit crunch deteriorated into a full-blown worldwide economic crisis, and yet to date, Canada's six largest banks appear to have avoided the worst of the fallout and earned the envy of their global peers.

Undeniably, Canadian banks were affected by the turmoil in the capital markets; however, in one of the most turbulent times in history, they have been able to maintain solid levels of capitalization and, unlike their counterparts in most G7 countries¹, have not required capital injections from the government. Most of them have also been able to generate positive earnings and all have served their customers without interruption.

The resiliency of the banks during this year of significant upheaval has not gone unnoticed by Canadians. In a recent survey of Canadian consumers conducted by Leger Marketing on behalf of PricewaterhouseCoopers, 85% of Canadians expressed confidence in the Canadian banking system, 92% agreed that the strength of the large Canadian banks is critical to the health of the overall Canadian economy and 91% feel that their deposits are secure. Interestingly, this vote of confidence was achieved despite the fact that fewer than half of Canadians knew their country had recently been rated by the World Economic Forum as having the soundest banking system in the world.

Very few countries can claim that their citizens have this level of confidence in their banks. A recent survey by the Worldwide Independent Network of Market Research showed that respondents in many major countries rated banks at or below 5 out of 10 in terms of their stability and solidity, including UK, Germany, France and Switzerland.

Canadians do not feel, however, that banks are taxed sufficiently. In the Leger survey, only half of Canadians felt the banks pay their fair share of taxes. This is surprising since, another survey by PwC demonstrates that the banks total tax contribution is in fact proportionately higher than many other industries.² As noted by Ontario Finance Minister Dwight Duncan in a recent Toronto Life interview: "We build a lot of schools and hospitals with that money."³

Three years forward, three steps back

Despite their resiliency, Canadian banks were impacted by the financial turmoil. In fiscal 2008, combined annual profits for the Big Six banks sank by $7.5 billion to just over $12 billion from a record $19.5 billion in 2007. This puts 2008 income on par with the results from 2005.

Admittedly, the results could have been far worse. Because of the relative strength of Canada's banking system, the Bank of Canada, which provides liquidity to the banking system in the normal course of business, did not have to increase its provision as much as other central banks. Currently, the Bank of Canada is providing liquidity at a rate equivalent to around 1% of total domestic banking assets. The comparable figures in other countries are 6% in the US, 4% in Europe and 5% in the UK.⁴

Over the past year, the relative ranking of Canadian banks within the global and North American industry has dramatically improved. In fact, at December 31, 2008, four Canadian banks cracked the list of North America's 10 largest by market capitalization (RBC was fifth, TD eighth, BNS ninth and CIBC tenth).⁵ This shift, however, was largely the result of a contraction in US banks and a decline in their market capitalization, rather than the expansion of Canadian banks, which also saw their capitalization drop. Nonetheless, the relative standings of the banks position them to be able to strategically take advantage of potential acquisitions over the coming year. It remains to be seen whether they will look to grow organically, through acquisitions, or simply stay the course, until there are definitive signs that the worst of the recession is over.

What protected Canada's financial system? In short, a number of factors: Canada's relatively conservative lending practices, effective regulation, high-quality capital and lower leverage.

For all banks, the events of the past two years have been a stark illustration of the inadequacy of the transparency and understandability of some of the more complex derivatives, lending and structured products, and of the speed with which systemic risk can impact the banking system and cause liquidity to dry up.

As we noted in last year's edition of this publication, risk managers and business leaders have been duly reminded of the importance of the first principles of risk management, including using common sense to recognize warning signs and becoming cognizant of the broader implications of changing market conditions. Transparency and understanding your product are also key components of these principles.

As the Canadian economy begins to feel the significant impact of continued global economic woes, banks are increasingly getting caught in a tug-of-war between different stakeholders. On the one hand, banks and other lenders face pressure to increase lending to provide stimulus to the economy. On the other hand, banks and other lenders face pressure from shareholders, analysts, rating agencies and regulators to be ever-more prudent by reigning in loans and increasing their store of capital.

As this tug-of-war continues, the relationship between banks and the government is fundamentally changing. While the government often keeps an eye on the activities of banks to ensure they are operating within regulatory boundaries, today the government is encouraging banks to play a stronger role in stimulating the Canadian economy. Notwithstanding this, the government echoes the views of its constituents, understanding that a strong banking system is critical to the overall health of the country.

The year ahead

Even the soundest banking system in the world is not immune to the impact of worldwide events.

In 2009, we expect to see the continuation of the challenging economic trends, which began emerging in the latter half of 2008. The global recession is deepening, potentially triggering further declines in the prices of many commodities. While domestic demand in Canada remains relatively healthy and the depreciation of the Canadian dollar may offset some of the decline in external demand for Canada's products and services, the risks to growth and inflation are escalating. Corporate profits are down and job losses are up, causing household wealth to evaporate.

In fact, according to the December 2008 statistics from the Office of the Superintendent of Bankruptcy, personal bankruptcies soared more than 50% in December from a year earlier.⁶ Continued increases in personal bankruptcies could have a significant impact on loan losses and bank profits, since the household sector represents the largest exposure in the loan portfolios of the Canadian banks.⁷

Despite this dire outlook, it is important to note that we go into this recession in a very different fiscal position than previous recessions and unlike the position of the US. Unemployment and interest rates are at historically low levels. We also have a strong banking system and a history of government surpluses. Furthermore, the high degree of co-operation and communication among central bankers, Bay Street and Ottawa has helped the system continue to respond quickly to rapidly changing conditions.

Clearly, the global banking system has been shaken significantly by aggressive lending and gaps in risk and capital management. Over the coming months and years, these lessons will very likely lead to more stringent regulation, including requirements for higher capital ratios, less leverage and a greater emphasis on stress testing of portfolios. But the Canadian banks are in relatively good shape to weather the storm.

This article is an excerpt from Canadian Banks 2009: Perspectives on the Canadian banking industry.