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Industry Analysis: Bank (Canadian)
Although there are a number of smaller domestic banking organizations located across Canada, our Canadian Bank industry is comprised of the “Big Six” financial institutions. The original focus of these banks was primarily on the business of lending, receiving and holding money for customers. Over the years, however, these institutions have expanded their business platforms to include a diverse range of products and services, such as wealth management, brokerage, credit cards and insurance.
In addition, the Big Six have extended their reach well beyond Canada’s borders, and international operations have become significant contributors to overall results. Federal legislation prohibits mergers between sizable financial institutions. This has heightened competitive pressures within the domestic market and forced banks to broaden the client base globally.
The Prime Asset
One measure of a bank’s size is “Total Assets” under management. Although acquisitions can substantially impact this measure, it still offers a fairly reliable indication as to the rate and scale at which a bank is expanding. Total Assets include marketable securities, cash and other liquid instruments. But it is “Loans” that make up the bulk of assets, as lending is the main business of these banks.
Loan portfolios are somewhat diversified, typically including residential mortgages, credit cards, and personal, commercial and government lending. Diversification helps to limit the impact of any single sector on overall performance. Canadian banks have also reduced their risk exposure by offering loans immediately south of the border (in the U.S.) and elsewhere. The weighting of a bank’s business among developed and developing nations is an important risk/reward consideration for investors.
One will also find on an institution’s balance sheet the line item “Allowance for Credit Losses”, which is an allotment of funds set aside to cover potential unpaid loans. Should this reserve prove insufficient, a charge for impaired loans might well be reported. The most conservatively managed of banks, however, may, at times, record gains on their income statements due to loan loss reversals and recoveries. Lending is the core operation of these financial institutions and, thus, loan growth is a key indicator of business health. And loan quality is an important determining factor in the stability of a portfolio’s performance.
Canadian banks are in business to lend and borrow at a profit. That is, they generate “Net Interest Income”, according to the spread between rates earned on assets and paid on liabilities. More specific: Loans yield the bulk of interest income, supplemented by earnings on short-term securities. Bank customer savings and time deposits help to balance the overall capital structure and provide a low-cost source of funding for these loans. Other liabilities, including short-term borrowings and long-term debt, facilitate the day-to-day running of operations. Net Interest Income is sensitive to prevailing lending and borrowing rates, which are dependent upon the macroeconomic environment and re-pricing of assets and liabilities. The Net Interest Margin, or Net Interest Income as a percentage of average earning assets, is a gauge to management’s prowess in making strategic operating decisions and optimizing bank performance in a given period of time.
A notable item on a bank’s income-and-loss statement is “Loan Loss Provision” (LLP). LLPs are charged to current earnings and are based on anticipated lending losses, stemming from defaults, restructurings, or other negative circumstances. Under normal circumstances, LLPs amount to less than one percent of total loans outstanding and increase in line with the growth of the overall portfolio. Provisions taken by banks can be affected by changes in broader market conditions and credit quality. A rising LLP ratio may signal a looming macroeconomic event, such as a recession, or an alteration to a bank’s operating strategy, for example, aggressively targeting a riskier class of borrowers.
Another source of “Net Profit” is “Noninterest Income”. As Canadian banks expand their array of products and services, Noninterest Income is becoming a more important contributor. Noninterest Income includes fees and revenue derived from a variety of operations outside a bank’s core portfolio of loans and securities. Checking, credit card, lending, brokerage, trading, and mutual fund accounts generate such fees and revenue. This income is more volatile and, depending on a bank’s reliance here, can affect the stability of the total Net Profit stream. (Trading and capital markets business can be quite difficult to predict.)
As LLPs are an offset to Net Interest Income, “Noninterest Expense” is an offset to Noninterest Income. It is comprised of salary, benefit, occupancy, advertising, and other general expenses. The ratio of Noninterest Expense to Noninterest Income is an effective means to determining how well a bank controls its operating costs.
When evaluating a member of the Canadian Bank Industry for investment, one ought to consider the pace of asset and loan growth, quality of the overall portfolio and dependability of the Net Profit stream. Historically, these banks have had reasonably solid Financial Strength ratings and their stocks have sported low betas and high Price Stability scores. Dividend payout ratios and yields have typically surpassed the Value Line averages. Canadian Bank issues are best suited to conservative income-oriented investors.