Canada's Banks: A Model Industry?

They operate in a low-risk, high-return environment, but future growth may be limited

Christian Charest 7 December, 2011 | 10:51AM

When the credit crisis started to get serious in the autumn of 2008, it exposed weaknesses in the banking systems of many developed countries. Banks that were previously thought of as sensibly managed megaliths began to show signs of unsuspected risks as the opacity of their financial statements, which investors were happy to overlook as long as the profits kept flowing in, became more and more troublesome.

This was not the case in Canada, where the banking environment emerged as the model for others to emulate. The banks may have lost some money and stock-market value, but there were no bankruptcies or government bailouts. In fact, in the darkest days of the crisis, a survey by the World Economic Forum named Canadian banks as the soundest in the world--an honour they received again the following year.

Canada's banking system is described by Morningstar's equity analysts as a high-return, low-risk market for investment. Six banks dominate the industry, accounting for almost 90% of the nation's banking deposits. This gives them a scale advantage that makes it unlikely that the market will fragment or that new entrants will pose a meaningful threat. Moreover, the industry is heavily regulated by the federal government, with strict limits on foreign ownership, capital reserves, and mortgage lending, among other things.

These regulations pose limits on risk-taking by the banks. For example, the Bank Act essentially prohibits mortgages or home equity loans with a loan/value ratio in excess of 80% without insurance. Since most insurance is purchased from the federal government via an agency called the Canada Mortgage and Housing Corporation, there is very little credit risk to the banks. This means that a bank's cost structure is generally well-known as Canadian banks do not take significant interest rate risk and mortgages have historically generated very little credit risk.

Canadian banks are much more than just deposit takers and retail lenders; rather, they should be described as financial services supermarkets. Beyond traditional banking activities, they are also major players in the insurance industry, trust services, investment banking and brokerage. The Big Six banks all have asset management subsidiaries that sponsor some of the largest fund companies in the country.

Ownership of the banks is also extremely widespread, owing in part to a rule that precludes any single shareholder from owning more than 10% of any of the big banks. These stocks typically make up the cornerstone of Canadian investors' domestic portfolios, either through direct ownership or via mutual funds. Because of their size, they are also major components of the capitalisation-weighted market benchmarks like the S&P/TSX Composite Index, of which the Big Six banks combined represent nearly 19%. In short, just about anyone in Canada who owns a diversified domestic equity portfolio owns a piece of at least one of the big banks.

Over the last 10 years, the entire Canadian banking industry has averaged returns on equity of over 15%. The banks have also been a high-growth industry during the last few decades. The Bank of Canada, the country's central bank, tamed inflation in the early 1990s and has kept it low ever since, resulting in substantially lower interest rates that have fed a credit boom. Household debt as a percentage of GDP has risen to 91% versus 35% in 1985. Thus, a concentrated sector has benefited from a generous competitive, regulatory, and macroeconomic environment during the last few decades.

However, Morningstar analysts believe the attractiveness of the industry may have passed its peak and that the credit boom is largely over. They believe household debt levels are close to the limit, and that while the market will continue to offer high returns on capital, growth rates will moderate.

With Canada's domestic market approaching saturation, an important source of growth for the banks in recent years has been international expansion, particularly to the United States. This has met with mitigated success, as the U.S. banking sector is still struggling to find its footing after posting severe losses in 2007 and 2008.

Here are highlights from Morningstar's equity analyst reports on the six largest Canadian banks:

Royal Bank of Canada (RY)
Fair value: C$52 | Morningstar Rating: 4 stars | Moat: Wide

The largest bank in the country with C$730 billion in assets, Royal Bank of Canada possesses the most extensive distribution network in Canada and generates the most fee-based income of the large Canadian banks. It has a well-diversified mix of businesses that generate strong financial performance. RBC made a series of acquisitions in the U.S. that have been a significant drag on its operating performance. In 2011, it decided to sell a large portion of its U.S. banking operation, a move that Morningstar analysts viewed favourably.

Toronto-Dominion Bank (TD)
Fair value: C$77 | Morningstar Rating: 3 stars | Moat: Wide

Canada's second-largest bank, TD possesses attractive businesses, including its profitable wealth management unit, and has managed through the recession very well. Although TD's Canadian operations are under pressure, the size and profitability of its U.S. segment continues to grow. That segment's share of overall profitability has increased from 22% for 2009 to 27% as of second-quarter 2011. However, U.S. operations offer lower marginal returns than Canada.

Bank of Nova Scotia (BNS)
Fair value: C$49 | Morningstar Rating: 3 stars | Moat: Wide

With over C$567 billion in assets, Bank of Nova Scotia is the third-largest bank in Canada. Morningstar analysts believe it has been among the better-managed Canadian banks. With a well-diversified income stream from each business segment, its capital generation is very resilient, but it is not immune from the nearer-term headwinds facing the Canadian banks. International banking continues to be a bright spot for Scotiabank; it provides financial services in more than 45 countries with a particular focus on South America, Mexico, Asia, and the Caribbean.

Bank of Montreal (BMO)
Fair value: C$64 | Morningstar Rating: 3 stars | Moat: Wide

Bank of Montreal derives almost 90% of its net income from its high-return Canadian operations, though its lower-return U.S. banking business is growing. Its retail segment has shown revenue growth of more than 10% over the last three years, but we don't expect that level of growth to continue. Moreover, its U.S. expansion has had less than stellar results, posting losses in 2007, 2008, and 2009. Its recent acquisition of M&I Bank, which was plagued by non-performing loans, may add to these troubles in the short term.

Canadian Imperial Bank of Commerce (CM)
Fair value: C$73 | Morningstar Rating: 3 stars | Moat: Wide

The recent past has not been easy for CIBC, especially for its wholesale banking segment. In 2005, CIBC paid US$2.4 billion to settle allegations that it helped hide Enron-related losses. Most recently in 2008, CIBC recorded a loss of C$4.9 billion from its structured credit run-off business, as well as the sale of some U.S. businesses. With its retail and business banking unit, CIBC's exposure to the Canadian consumer is much larger than that of other Canadian banks, so its loan growth is likely to be lower than peers.

National Bank of Canada (NA)
Fair value: C$76 | Morningstar Rating: 3 stars | Moat: Narrow

With C$153 billion in assets, National Bank of Canada is the smallest of the Big Six banks. Unlike its peers, it focuses almost exclusively on the domestic market with a large portion of its business occurring in the province of Quebec. National Bank is more exposed than many other Canadian banks to the cyclical personal and consumer banking business. In order to balance this exposure, and to provide a broader array of financial services, National Bank is trying to expand its wealth management business (now only 11% of its net income) both through acquisitions and organically. Not all of these initiatives have been beneficial, according to Morningstar analysts.

Christian Charest is editor of, the Canadian sister site of

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Christian Charest