Challenges Facing Canadian Banks (ZEB)

March 30th, 2015

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This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

Disclosure: I have no position on ZEB, but I do own a couple of put options on 2 major Canadian banks.

Ive had the opportunity to talk to many people who manage their own investments, and Ive found that a great number of them favour holding stocks of Canadian banks.

Its easy to understand why. We Canadians feel that our banks will always make money. Unlike the situation in the U.S., we dont have thousands of banks, both large and small, trying to take market share away from one another. We have the Big Five banks, whose smallest member has more assets than the next biggest six banks combined. Because Canadians have limited options, Canadian banks have always had willing customers in both good times and bad.

Canadian banks have proven resilient in times of distress. While U.S. and European banks teetered on the brink of collapse in late 2008, Canadian banks were praised for their stability. If a once in a century financial crisis couldnt topple Canadian banks, what could?

Its also true that many Canadian banks pay a high dividend yield. As of the time of this writing, TD and RBC both pay between 3.5 and 4% per year.

In summary, the big banks have a history of big, stable profits and high dividend yields. No wonder so many Canadians think theyre no-brainer investments.

However, whenever an investment looks like a no-brainer, you should be extra cautious. If you choose to buy Canadian bank stocks today, keep in mind that youre buying from other investors who are happy to sell at the price youre willing to pay. This leads to the question: Why are they happy to sell? What do they know that you dont?

While I cant speak for all those who sell, I do see some challenges facing the Canadian banking industry. In this article, Ill explain those challenges.

How Banks Make Money

To understand the challenges of the banking industry, we should first understand how banks make money. First and foremost, banks are in the business of lending money such as mortgages. If a bank lends you a $200,000 mortgage at 3% per year, that means they will charge roughly $6,000 (i.e. 3% of $200,000) of interest in the first year.

Banks finance their loans using customer deposits. For example, if you have $10,000 in a savings account, the bank will lend that money out to someone else. (If you withdraw that money, theyll find some other depositor to finance the loan.)

Banks generate profit because the interest rates on the loans they make are higher than the interest rates they pay on deposits. For example, TD currently offers 5-year mortgage rates of around 3% per year. On the other hand, they pay out 0.8% per year on high interest savings accounts. By receiving 3% and paying 0.8%, TD will make a profit of 2.2% on the loan. This 2.2% number is called the net interest margin.

The total revenue that a bank generates for its shareholders using loans is the amount of loans times the net interest margin. For example, if a bank has a loan portfolio totalling $1 billion and if the net interest margin is 2%, the bank will generate $20 million ($1 billion times 0.02) in revenue.

Banks can be lucrative businesses because a typical bank can loan out many times the money that shareholders contribute. To illustrate, lets take a hypothetical bank named NewBank as an example. Lets say that shareholders of NewBank contributed $100 million to the bank. Even though it only owns $100 million, the bank may make $1 billion in loans. Let me explain how this can happen.

Whenever a bank lends money, it also creates new depositors. For instance, if you went to NewBank and borrowed $30,000 and spent it, most of that money would end up at NewBank or some other bank as a deposit. If you bought a $30,000 car with the money, the person who sold you the car would take that cash and deposit it into his or her bank account, which may or may not be NewBank.

Now, imagine that all the banks did the same, and made lots and lots of $30,000 loans to different individuals. The money will spread around to the different banks as deposits, and so as banks create more loans, they will also attract almost an equal amount in deposits.

Once they open for business, NewBank will get access to new cash as it attracts depositors. As the bank lends out this new cash, it will also create new depositors. New depositors mean more cash, with which the bank can make new loans, and on and on it goes.

What stops this cycle of loan and deposit creation is the risk of loss, and the regulation that comes with it.

For example, lets say NewBank made $1 billion in loans using $900 million of customer deposits, and $100 million of shareholders money. What happens if the bank loses $150 million as a result of borrowers refusing to pay back? In this case, the bank will only be able to recover $850 million in loans, and theyll still owe the depositors $900 million. Since the bank owes more than they have, they become insolvent and, barring intervention from another bank or the government, the depositors wont be able to get all of their money back.

The bigger their loan portfolio compared to the shareholders money, the bigger the risk that a bank could become insolvent. For example, if NewBank had made $2 billion worth of loans, then only a 5% loss on their loans would have wipeed out $100 million, making the bank insolvent. If, on the other hand, NewBank had just $500 million in loans, the bank would have to lose 20% of its loans before it became insolvent.

Aware of the danger, regulators impose rules that limit the amount of loans banks can make. They may say, for example, that banks cant have more than 12 times as much in loans as shareholders have committed (e.g. if shareholders contributed $100 million, the bank couldnt make more than $1.2 billion in loans). The more stringent the rules, the fewer loans banks can make, and the less profitable they become.

Challenges From Recent Trends

Now that we understand how banks make money, lets look at some recent trends that affect them.

In a recent article, I highlighted the fact that the Bank of Canada lowered short term interest rates. This move will likely lead banks to charge lower interest rates on loans such as mortgages, which means that banks will generate less revenue.

Normally, banks will also lower the interest they pay on customer deposits, such that the net interest margin will stay the same. For example, if mortgage rates go down to 2.5%, banks can lower the interest on savings accounts to 0.5%, and still earn a net interest margin of 2%. Banks' profits are not affected as long as net interest margin stays the same. However, theres a limit to this strategy.

For one, theres a theoretical limit of 0%, beyond which they cant lower interest rates paid to depositors anymore. But even before they reach the 0% limit, depositors will become unsatisfied with earning such low interest rates, and may prefer to withdraw their money and put it elsewhere, such as in stocks.

Recognizing this problem, the banks could be reluctant to lower the amount they pay to depositors. If they lower the interest they charge on loans, but dont lower the interest paid to depositors, their net interest margin shrinks and they make less money.

Another concern is the debt level of the average Canadian. The average Canadian today has more debt than the average American did before their financial crisis. While Im not predicting the same magnitude of crisis that the U.S. banks faced in 2008, a mass default by Canadian borrowers will definitely hurt the bottom line of Canadian banks.

Furthermore, there is reason to believe that such an event could happen sometime soon. Because of the crash in oil prices, many people in Alberta are losing their jobs. Worryingly, Albertans are also the most indebted among the different provinces, with the average Albertan carrying roughly $125,000 in debt.

Recognizing the potential for such losses, the regulators have put pressure on the banks to lower their leverage (i.e. lower their loans relative to shareholders money). While banks have become safer investments as a result, it also means that we can expect them to make less money going forward.

While its easy to imagine how banks could make less money, its hard to imagine how they could make more. The most obvious way for banks to make more money is by growing their loan portfolio. However, its hard to offer more loans when Canadians already have too much debt.

Some banks have looked to the U.S. for growth, and set up subsidiaries and/or bought smaller established banks in the U.S. However, the track record of Canadian banks in the U.S. is dismal. Like an animal outside of its natural habitat, Canadian banks have a tough time competing against more agile competitors.

Finally, Canadian banks, as with many other businesses, have to contend against startups armed with new technology. For example, companies like Grouplend aim to disrupt the traditional banking business. This site, MoneyGeek, also offers an alternative to investment services long provided by the banks.

While startups such as these have a very long way to go before theyll take meaningful market share away from the banks, we should keep such startups in mind. If startups can disrupt the banking industry the same way startups disrupted other industries, the banks will have a hard time fending off the new competition.

In summary, Canadian banks face challenges both in the near term and the long term. If a bank fails to meet one or more of the challenges, their profits may go down, and in more severe cases, they may even have to cut their dividends.

On the other hand, banks could brush off each challenge and continue to grow their profits. I wont claim to know which scenario will turn out. But I would suggest that you consider these points if you choose to hold bank stocks. There are plenty of investors who think that Canadian bank stocks will go down. Youd hate for them to be right.

This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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