joshlaverty
Kim Parlee speaks with Mario Mendonca, Managing Director and Senior Financial Services Analyst at TD Securities, about the Q4 performances for Canadian banks as well as the 2023 outlook for the sector as interests rates continue to rise and the economy slows.
Kim Parlee: December was a big month for Canadian banks. Lots of earnings coming out, lots for investors to digest to understand what has happened and what will be happening. As well, some news from the Canadian Banking Regulator on capital requirements. Here to tell us what this means and what he saw in earnings, we’re joined by Mario Mendonca. He is managing director and senior financial services analyst with TD Securities. Mario, good to see you. I want to start off, if we could, with the news out of the regulator. You published a note that has come out, and with regards to the increased need for capital on Canadian banks. And you said this is wider range and more abrupt changes perhaps than what was expected. Maybe you just start with the basics, what changed, and then your reaction to it.
Mario Mendonca: Sure. The base capital ratio banks are required to hold is 8% of their risk weighted assets. So capital should be about 8% of risk weighted assets. There’s something called a domestic stability buffer. We call it the DSB. Up until recently, that number was 2.5%, which would take you to a total capital ratio of 10.5%. And our banks always operate above the 10.5%. Most are over 11%. Some are well over 11%.
What we learned recently is that that ratio is now going to 3%. So instead of 10.5% being the buffered minimum, it’s now 11%. And that in and of itself wasn’t surprising. And I don’t think that in and of itself would result in any meaningful capital raises from our banks. But OSFI went one step further, and instead said that the upper bound could be as high as 4%.
To be clear, the DSB is now 3%, but it could be 4%, is what they’re saying. And that was a change because previous to that, the upper bound was 2.5%. So that’s a meaningful change. I think the other thing that was meaningful is the regulator is having the banks reach that upper bound by February 1, 2023. That’s only two months away. And that’s also a little bit unusual. Normally OSFI provides a little more time than that.
And then OSFI seemed to make a point that if economic conditions were to deteriorate in the near term, they would abruptly lower the DSB. And what that means to me is our regulator is going to be maybe a little bit faster to react and seems to be inserting itself a little bit more into the capital functions of our banks. I’m not suggesting it’s a bad thing. I’m not passing a value judgment here. I’m just saying it feels different.
Kim Parlee: So tell me. So for banks, then, this means what? This means, in terms of, if they have to increase their capital requirements, that means less capital for other things. Or what do they need to do to that? And what’s going to be the impact?
Mario Mendonca: Yeah. So again, most of our banks will naturally get to 11% on their own, if they’re not already there. There are possibly– possibly could see a capital raise from Bank of Montreal (BMO). We don’t know that they will. They’re closing the Bank of the West deal, I suspect in the next month or so. It is entirely possible that they raise some capital to close that deal previously they said they were.
Now, before anyone takes that as alarming, my best guess is that they would only raise about a billion and a half. And on a nearly $90 billion market cap company, a billion and a half could be easily digested by the market. And to be fair, investors have already taken BMO down somewhat relative to their peers’ 4% or 5% in preparation for this offering. So there’s nothing really new here investors should think about.
Now, as for the other banks, I don’t think we’ll see capital raises. I think instead what we’ll see is they’ll all announce discount reinvestment plans. In fact, we know that Royal (RY) has one in place for their HSBC acquisition, Bank of Montreal for Bank of the West. CIBC (CM) announced a 2% drip this morning. The only one of the big six– the only two of the big six that haven’t announced a drip yet are Scotia and National, but they could very well announce a drip as dividend discount reinvestment plan.
Now, other implications, besides what they do with their capital, like raising equity or announcing a drip– the other thing that you probably could see our banks do, I think it would be logical if they slowed down the pace of loan growth, because loan growth requires capital. Now, I don’t think they’ll slow down their mortgage growth because mortgages don’t require a lot of capital, right?
But maybe the right thing for our banks to do would be to slow down their commercial loan growth. Now, if you slow down commercial loan growth, that’ll save you a little capital, but it has the effect of slowing your earnings growth. I don’t think our banks are going to generate massive earnings growth anyway in 2023. I think at the margin, this takes a little bit of growth of the table.
Kim Parlee: Let’s talk about the earnings, Mario, a whole slew of earnings coming out. And again, just for full disclosure, obviously, you work for TD. We don’t talk about– you don’t rate and do TD. But let’s talk about the others. Royal, not a huge reaction in the stock when the earnings came out. But tell me in terms of what you saw, what caught your eye with them.
Mario Mendonca: Royal delivered a very strong quarter. They beat earnings by about 3%, earnings growth was strong. Pre-tax, pre-provision profit, which is one way we look at things now, was up 10% year over year. I’d say everything about the quarter was good. They had 30% growth in their net interest income, which was driven by solid loan growth and very healthy margins, which are supported by the bank’s– I’d call it industry leading or near industry leading– deposit franchise in Canada, and a good deposit franchise in the US, as well. So everything about the quarter was solid. When you say the reaction was somewhat muted, I think in part that reflects that Royal had already performed very well heading into the quarter. Royal is already trading at a meaningful premium to most banks, particularly, a meaningful premium to both CIBC and Scotia (BNS).
So a very solid quarter across the board. I think we’re going to see further margin improvement in the near term. It would be very hard to poke holes in Royal’s quarter.
Kim Parlee: And I know we’re going to talk a bit more about this, too, but obviously, one of the big deposit-rich banks, too, which benefits disproportionately in this kind of interest rate environment– BMO. The stock, you noted, didn’t do much when it reported, but a slight miss there, too.
Mario Mendonca: Yeah. The company missed earnings by about 1%. 1% is so small that I’m going to call that an inline quarter. It was a good quarter. Their net interest income was up 27% year over year. That’s a great number. But their capital markets were kind of weak. So you saw underwriting income come down a little bit, their securities gains come down a little bit.
In part, what that reflects is that Bank of Montreal had a very strong Q4 ’21. So the year over year comp was difficult. I think activity with financial sponsors is down, and that’s been an important part of BMO’s overall capital markets growth over the last year or so. So as the environment starts to soften for financial sponsors, you’d expect a little bit more weakness out of BMO. But overall, I’d say it was a solid quarter.
The only thing that’s really affecting the stock right now is this outlook about the Bank of the West deal. The market wants to see that close. I think the market would prefer BMO to close it without any capital raise. But again, like I said, a $1.5 billion capital raise, which is my guess, doesn’t matter. We can absorb that. The market can absorb that without much of a hit.
Kim Parlee: What are your thoughts on Bank of Nova Scotia? Obviously, in the news quite a bit with some leadership changes, and lots happening there. How did the earnings look?
Mario Mendonca: Scotia beat numbers by 3%, which was good. The problem is, it came from areas that were not as quick to reward them for. They had very strong securities gains. That’s good. That helped beat the number. But overall, the bigger concern with Scotia is quite in contrast to Royal. They don’t have a strong deposit franchise outside of Canada. It’s just one way to quantify this.
In Royal’s US business, their loan to deposit ratio is about 50%, meaning there are far more deposits than there are loans, which supports the bank in a period of rising rates. In Scotia’s international segment, loans to deposits are 140%, meaning there are far more loans than there are deposits. Now, that relates to the structural differences in Latin America.
The problem Scotia is struggling with right now is they have little exposure to rising rates. In fact, they’ve set up their business to actually benefit as rates go down. So the market right now is behaving in a way like Scotia is going to be in the penalty box forever. I agree with market sentiment, and I downgraded the stock a while back. I agree with market sentiment that Scotia is not in the right place.
I think we can go overboard with this in taking Scotia too low relative to their peers, because Scotia will have their day. They’ll have their day when rates sort of flatten out or even decline. I think investors should be careful how much they trade Scotia down relative to their peers. It’s not that bad.
Kim Parlee: Interesting. OK, let’s talk about national and CIBC, some similarities between the two in terms of net interest margins, higher expenses, PCL. So tell me. Let’s start with National first.
Mario Mendonca: Well, National, they had a reasonably good quarter. Their pre-tax pre-provision was up about 7%, 7.5%. That’s not a bad number. Maybe a little bit lower than the Street, but still a good number. The reason why the stock traded off, though, didn’t have as much to do with margins. I think a lot of it had to do with their Cambodian business, where credit losses look like they’re elevated a little bit. Gross impaired loan formations, their loans that have turned poorly in the quarter, were elevated.
Now, the company is unflappable on this. When you ask management about higher losses in Cambodia, they’ll say, it has everything to do with the end of the Moratorium on payments. They’re very confident that that will trend down in 2023, meaning the losses will trend down in 2023. For their sake, I hope that’s true because Cambodia has become a big part of the overall loan book for National and a big part of why the stock has performed well.
So I think that’s part of the story that Cambodia looked a little bit elevated from a gross impaired loan perspective. The other thing that happened this quarter was there was one particular day in the quarter. It was September 26 when National recorded a fairly meaningful loss. It was about $22, I guess $23 million in their trading book.
It was just one day, and it related to the UK government announcing certain changes in their mini budget, and it caused the pound to move and interest rates to move in peculiar ways. National had some positions in their portfolio that resulted in that meaningful loss in a given quarter. Do I care about national losing $22, $23 million in the quarter? Of course not. That’s manageable in the context of their overall earnings.
But what it does do is it speaks to a different business model at National than their peers. I think National’s capital markets business takes a little bit more inter-quarter risk. And that’s why we saw that charge. And I think National manages this well. It’s very unusual to see these losses. But it’s one of the reasons why it’s hard for me to get behind that stock, because I really do see the business model as different from their peers.
More capital markets exposure. This exposure to Cambodia, in my view, supports having a more muted view on the stock than some of my peers do.
Kim Parlee: Very interesting. Let’s talk about CIBC. It’s the one that caught the headlines in terms of a pretty rapid move down after they reported their earnings and the stock price.
Mario Mendonca: Absolutely. I got very fortunate on this one. A month or so before CIBC reported the results, I downgraded from buy to hold, and the logic I had in this case was that I felt that their margins performance would be a little bit weaker because they don’t have the balance sheet structure that, say, a Royal does. The balance sheet structure, I don’t favor. Some was part of the logic.
The other bit of the logic was that I felt that being a big mortgage player, they’ll experience a little bit more stress as the mortgage market weakens, perhaps later in ’23. What I didn’t count on is what probably really hurt the stock in the quarter, was that their expenses would be so high, that very elevated expenses. I think their year over year expenses or comp expenses might have been up 15%. There were significant severance charges in their capital markets business, which drove this.
So although CIBC missed earnings by 19% relative to consensus, the performance wasn’t 19% worse than we really expected. I kind of feel like CIBC just threw everything into this quarter. Beyond the higher expenses, the other thing we saw was that the bank’s capital ratio, it’s 10.7%. Or, sorry, 11.7%. There’s nothing wrong with that, but it is a little bit lighter relative to peers. So I think people are a little sensitive to the capital ratio.
And then finally, CIBC booked some higher performing loan credit provisions in the quarter. These are loans that haven’t gone poorly, but CIBC is being a little bit cautious here and putting aside performing loan reserves. And that was higher than what the other banks did, and it probably led some industry observers to be a little more careful with CIBC. And I’d note that I think three or four analysts downgraded CIBC after the quarter, in part because of some of these trends.
Kim Parlee: It was a fascinating, actually, set of earnings, I think, coming out from the banks. And there’s a lot going on, a lot of cross-currents. So let me ask you about 2023. And you’ve made note of this, too. Obviously, the ones that are in the penalty box might get a chance to shine a bit more in the upcoming year or so. But what are you looking for, what are going to be the material things we need to watch in the upcoming year in the bank space?
Mario Mendonca: Probably one of the biggest ones I’m sensitive to is, when do short-term rates stop rising? Because when short-term rates stop rising or even come down a little bit, maybe later in the year, the banks like CIBC and Scotia that have underperformed as rates were rising might have their day in the sun. I think banks with very big, strong deposit franchises, like a Royal Bank, could lose a little bit of momentum relative to CIBC and Scotia.
But I see that more as a later 2023 phenomenon. It’s not something that I would imagine happening in the first quarter or two. But that’s, as you say, that’s something to watch. The other big thing to watch is mortgages. We all know that mortgage growth will likely slow in 2023. I think part of OSFI’s concern that was expressed on the recent call was about the Canadian housing market.
And OSFI is also probably going to act on the minimum qualifying rate– really, what you use to qualify a person for a mortgage. I think they’ll make some changes around that, as well. So we all know that mortgage growth is going to slow, or we all suspect that. The bigger question is, what happens to mortgage credit? Could we, for the first time in a long time, actually see losses related to the mortgage portfolio?
I think it’s prudent for the banks to build up some performing loan reserves against their mortgage portfolios. That’s what I’ve done in my estimates, but I’ll say this. When I speak to the banks about it, and when you listen to them speak about their mortgage portfolios on the calls, they are extremely confident in the quality of their mortgage books.
It sounds to me from listening to these banks that they don’t believe they’ll experience anything material in the way of mortgage losses. I feel like, given the debt service ratios, the debt to disposable income, everything that’s gone on in the Canadian housing market, we should prepare for some, at least some, modest losses.
But to be very clear, the banks don’t agree. At least so far, they don’t agree that there’ll be any meaningful losses in the mortgage market. So I’m super interested in how that unfolds throughout 2023.
Be the first to comment