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Canadian Banks: Risks and Exposures
What to worry (and not worry) about
· The risks/exposures you need to know about. We highlight the key risks
and exposures for each name that are most likely to present challenges over the
coming year across investment portfolios, derivatives and off-balance sheet
exposures.
· Further impacts look manageable. Disclosure is limited and visibility is
poor, but in our view, the worst exposures have been materially reduced and
accounting treatment has become more flexible. We expect further writedowns,
but they should be manageable relative to the respective platforms,
improved capital levels and earnings generation.
· Risk of another downturn. That said, we believe that the group is far from
immune and another wave of financial/economic distress could offer
potentially material downside risks in some cases.
· Disclosure still needs more work. Industry disclosure has evolved materially
over the past year. Our work reflects our understanding of the available
disclosure and additional clarification and discussion with the companies.
However, there are still large pools of assets where there is little insight
available and there is always the risk of new or completely unexpected
exposures.
· Avoid higher risk/exposure business models. Against this backdrop, we
continue to avoid those platforms with higher potential for exposure. In our
view, Bank of Montreal appears most susceptible to incremental negative
developments in a downturn. Royal’s business mix could also offer challenges
amid further capital markets distress.
Investment Summary
We believe that 2008 will mark the low point for the Canadian banking
industry with respect to the magnitude of asset write-downs and in terms of their
shock value and disruptive impact on the industry and investor perceptions.
Over the past year, disclosure and understanding has improved materially, while
management teams have made significant strides in reducing exposures and
rebuilding capital.
In the context of expected continued weakness in capital markets and the global
financial system we anticipate further asset write-downs in 2009 across the group.
However, they should be manageable relative to the respective platforms, capital
levels and ongoing earnings generation.
Visibility remains relatively low, but with a number of the most problematic
positions already materially reduced, and the introduction of increased accounting
flexibility (i.e. the shift from Trading to Available for Sale) we do not expect to see
amounts materially above several hundred million (pre-tax) from a given company
in a given quarter.
There are still, however, some significant risks that could develop should we see
another significant leg down for the industry such as the failure of another major
global financial institution or the collapse to commercial paper markets (we view
both examples as remote). As always, there is also a risk of completely unknown or
new exposures.
Given the limited visibility and continued risk of further disruptions, our bias
remains to avoid platforms with relatively large or broad based businesses that
increase the potential for contact with troubled areas or where visibility is limited
such as large trading and investment operations. As we discuss, in our view, Bank
of Montreal has a number of issues to manage. Our review also highlights Royal
Bank as a platform with a relatively outsized exposure to trading and investments.
The last 12-16 months have seen a remarkable deterioration in a number of
significant businesses and exposures across the banking industry globally,
highlighting the need for more thorough and aggressive analysis of the potential
risks in the integrated banking model. While the root cause of many of these
problems was the deterioration in the credit conditions (led by the U.S. housing
market), the worst exposures were generally outside of the sector’s traditional
lending activities (the topic of an upcoming report), and originated in some
unexpected areas of trading and investment activities (the focus of this report).
Disclosure around these potential exposures has improved across the industry over
the past year prompted in part by the request of finance ministers and central bank
governors from the G7 and the Financial Stability Forum which in April of 2008
issued a report that, among other things, encouraged enhanced disclosure related to
financial instruments that markets now consider higher risk.
In our 2008 Canadian Banking Handbook (November 3, 2008), we identified what
we thought were the key Risk Hot Spots going forward. We have updated that
commentary with this report.
1) Securities Trading and Investment Portfolios. Most integrated banking
models have substantial asset portfolios as a result of facilitating various forms of
client activity as well as proprietary investment strategies. Depending on how
management positions the bank, weak capital markets can result in potentially
sizeable losses. The industry has focused on a handful of particularly troublesome
assets that have come to light, but banks have sizeable portfolios with limited
disclosure to assess.
Across the group we note Royal as tending to have among the larger exposures to
trading income as a revenue source, securities portfolios including sizeable
portions of equity and corporate debt and lower quality assets in terms of assessing
Fair Value (i.e. Level I, II or III).
2) Derivative Exposures. Banks have massive derivative portfolios relating to
credit, interest rate and foreign exchange risk. Most of the books are run on a
matched basis, but remain subject to significant counterparty risk. Here too,
disclosure is limited to areas of known problems, specifically the monoline
insurance providers. However, the failure of a significant global financial
institution poses significant risks, as was the case with Lehman.
The aggregate exposures are substantial across the board. However, CIBC
continues to have sizeable exposure to monoline counter-parties, although the
underlying reference assets are believed to be of reasonably high quality.
3) Off-balance Sheet Exposures. In our view, this category holds one of the
potentially largest risks, should we see another leg down in the current downturn.
The ABCP (asset backed commercial paper) market is a significant source of
financing for a wide range of credit financing. Not only do banks use it directly as
a source of funding their own assets, but they also backstop (through liquidity
commitments and forms of loss protection) a wide range of other facilities for
clients and investment purposes. There have been some relatively isolated
problems to date where banks have had to take responsibility for trouble assets or
participate in restructurings. That said, the bulk of the assets are for the most part
relatively plain vanilla and are of relatively high quality. To date the commercial
paper market has continued to function reasonably well, although at materially
wider spreads with less liquidity generally. However, if this industry were to seize
up, banks could find their exposures increasing rapidly as the conduits drawn down
on liquidity facilities that effectively transfer risk to the banks.
BMO, Scotiabank and Royal all have sizeable ABCP conduits, some of which have
experienced some relatively minor difficulties. National was heavily exposed to
the 3rd party ABCP market which was eventually restructured. However, BMO has
additional sizeable exposure to two SIV conduits and a restructured conduit that
present sizeable (although remote) risks.
We have detailed the available disclosure across these broad categories for each
bank in Appendix I. In the following pages we focus on what we consider the
biggest issues across the industry and across each name.
The key risks/exposures you need to know about
Bank of Montreal. We cannot define an impending material risk, but in our view
the bank has a number of potential problem areas under a downturn scenario
including its investment in troubled assets originated in its U.S. ABCP conduits
and ongoing liquidity facilities, efforts to support two SIV conduits and multiple
exposures to a conduit of levered CDS exposure.
Scotiabank. The bank has weathered the downturn reasonably well and has been
among the most proactive in rooting out and isolating exposures. The bank
maintains a sizeable ABCP conduit program, but to date the assets have held up
well. The bank is somewhat unique in its relatively outsized exposure to the auto
sector. Exposure is mainly on the lending side, but the bank has invested in a
structured product that holds consumer auto loans from GMAC. The product is
conservatively structured and to date the bank has seen relatively minor mark-tomarket
losses which it views as temporary.
CIBC. The bank suffered materially in 2008 having found itself with significantly
outsized exposures to extremely toxic assets. However, combined with substantial
write-downs on the worst assets, management looks to be effectively working
down and isolating the situation. From here, additional write-downs are likely to be
modest relative to what the platform has already endured, although the notional
exposure remains substantial. Further, while it may appear remote at this juncture,
we believe the possibility remains for substantial recoveries over the coming years.
National Bank. The bank appears to have avoided a worst case scenario with the
success of restructuring efforts under the Montreal Accord, although there are
ongoing exposures. Otherwise, we see the bank having very limited exposures to
identified problem areas.
Royal Bank. The bank has managed to avoid any dramatic challenges, however it
has suffered from a range of smaller exposures and write-downs. There is no
single issue that alarms us, but across its businesses, we believe that the bank has
accumulated a number of watch items and overall has relatively outsized exposure
to trading/investment activities that offer the opportunity for problems in a
downturn.
A number of lingering
issues at BMO.
Scotia maintains its
conservative stature.
We think CIBC is
managing its troubles
well.
National appears to have
avoided a worst case
scenario.
Royal’s business mix
offers potential risks.
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