Turbulence in global credit and stock markets has negatively impacted the performance of all financial institutions, including those in Canada. After record-breaking earnings in 2006, Canada’s banks experienced slower growth in 2007. How is Canada’s banking industry weathering the global financial storm, and what does the year ahead look like?

While unstable market conditions have definitely affected results, the 2007 combined net income of the six largest Canadian banks was $19.5 billion, representing a 2.2% increase over 2006. These results are a stark contrast from the banks’ 50% increase in 2006 over the previous year. Based on 2008 first quarter results, it’s clear that uncertain market conditions have cast a shadow on 2008, and are testing the leadership of each bank.

To date, much of the fallout has been more severe abroad than in Canada. Between the write-offs and marketplace uncertainty, the question for 2008 is no longer whether events will affect Canadian credit capacity and liquidity demand, but how much and how fast? It also remains to be seen whether the apparent related slowdown in the US economy will have a significant effect on the Canadian economy.

How are Canadian banks weathering the storm?

Historically, Canadian banks have been restricted from bulking up to rival the size of global banks. Ironically, their constrained size may have protected them from some of the excessive levels of exposure experienced by some global banks.

Ten years ago, two Canadian bank merger proposals were unveiled. The two planned unions—Royal Bank (RBC) with Bank of Montreal (BMO), and Canadian Imperial Bank of Commerce (CIBC) with Toronto-Dominion Bank (TD)—were ultimately killed late in 1998. Since then, all of the banks got on with life and pursued different growth strategies. Since 2001, Canada’s six largest banks invested about $38 billion through acquisitions, 95% of which were outside of Canada¹.

Despite being unable to merge domestically, in 2007 Canadian banks were very active in acquisitions outside our borders. The largest of these deals was TD’s announced US$8.5 billion acquisition of Commerce Bank. BMO closed its acquisition of First National Bank & Trust and agreed to purchase two Wisconsin-based banks—Ozaukee Bank and Merchants and Manufacturers Bancorporation Inc., which furthered their expansion in the US Midwest. RBC expanded their Caribbean presence by acquiring RBTT Financial Group and their US presence with the acquisition of the broker-dealer business of Carlin Financial Group in New York, 39 AmSouth branches in Alabama and New Jersey-based J.B. Hanauer & Co. Bank of Nova Scotia (BNS) added to their already significant Caribbean, Central and South American and Asian footprints. They acquired a 10% stake in Puerto Rico’s First BanCorp for approximately US$94 million, a 24.99% stake in Thailand’s Thanachart Bank for approximately US$240 million, and a 99.5% stake in Chile’s Banco del Desarrollo for just over US$1 billion. CIBC obtained control of FirstCaribbean by acquiring a further 47.8% ownership interest from Barclays Bank for US$1.2 billion.

Although Canadian banks are clearly growing internationally, the global marketplace is intensely competitive and becoming more so. As measured by market capitalization, the big six Canadian banks continue to pale in size in comparison with their global counterparts. As an aggregate group, they have failed to make a significant move from 2006 to 2007 in the list of Top World Banks². In fact, today Canada’s largest bank, RBC, is a third of the size of the third largest global bank³.

Global banks, which continue to expand rapidly through acquisitions, are able to bring more significant resources to bear on product development, systems development and acquisitions⁴, making it ever more difficult for Canadian banks to compete.

To ensure their continued success and survival, Canadian banks need to become more focused, invest in a few, carefully chosen areas, execute efficiently, serve their customers better, embrace and manage change, and identify and manage risk better than ever before.

A new look at risk management

As risk managers and business leaders reflect on how risk management performed in the turbulent markets of the past several months, many will wonder whether better risk management practices would have helped some banks avoid some of the pitfalls. Were risk management personnel overwhelmed? Or, did risk managers rely too heavily on the rules, tools, models and credit ratings and therefore have a false sense of security that prevented them from seeing the broader implications of changing market conditions?

The events of the past year have highlighted the need to reconsider whether assumptions about market correlation, stress testing, scenario testing and liquidity modeling were appropriate and whether some risk measurement and management techniques need further development. Many banks have also realized that they need to get back to putting more emphasis on first principles of risk management, simplify their governance and operational solutions and better align their organization to key business objectives and outcomes. It is ironic that the current credit crunch situation arose at the very same time that banks have been focused on regulatory initiatives intended to better manage risk, such as Basel II, Sarbanes-Oxley, Markets in Financial Instruments Directive (MiFID) and Anti-Money Laundering. A year from now, it will be interesting to see how well Basel II, an internal risk-based capital management framework, performed under these stressful market conditions.

Many of the banks have talked about initiatives to improve their customer experience, sustainability efforts, talent management programs and risk management. Will current conditions distract them from these activities or propel them to move more quickly on their commitments? Will refocusing on risk management help banks survive the next cycle and foresee future problems? There are many unanswered questions about the coming year.

At the time of writing, it’s impossible to know which banks will weather the current crisis and turmoil the best. What is certain is that all banks will continue to be challenged by slower growth and instability in the credit markets, as evidenced in 2008 Q1 results. The possible fallout of the credit crunch on global economies will continue to negatively affect markets. As a result, Canadian banks operating in a tightening liquidity environment may adjust their credit granting processes, continue to diversify their funding mix and seek additional capital.

As each bank pursues its own distinctive growth strategy, we are increasingly seeing the emergence of a much more differentiated Canadian banking industry. Over the next year, it will become even more important for each bank to understand the impact of changing conditions on their own operations, respond quickly, and make effective decisions that steer the organization through the rough waters ahead.

This article is an excerpt from Canadian Banks 2008: Perspectives on the Canadian banking industry.