Recent quarterly earnings (Q2 2011) from the biggest Canadian banks have revealed intense rate competition within the Canadian banking industry, which has eaten away at their net interest margins (NIM). The NIM and other metrics indicate that Canadian banks may not be the superior investment that many investors in Canada tend to believe, and that top U.S. banks deserve some consideration.
Back in 2008 I discussed the NIM (among other metrics) in the Bank Valuation series, as part of evaluating bank stocks. The metrics discussed were particularly useful during the financial crisis when many major financial institutions collapsed, or were taken over by stronger ones in the U.S.
Net Interest Margin (NIM) is the difference between interest income generated, and the amount of interest paid to the lender. It is an indication of the firm’s investment decisions compared to its debt situations. Many investors are still unfamiliar with the term, but investopedia & wikipedia have pretty decent definitions.
During the past few weeks, the largest Canadian banks have released their second quarter earnings for 2011. TD Bank, CIBC, National Bank, Bank of Nova Scotia, and Laurentian Bank of Canada, all saw their quarter-over-quarter net interest margins decline in Q2 2011, while Royal Bank and Bank of Montreal saw their quarterly number increase. In addition to quarter-over-quarter, many also saw their year-over-year NIM decrease as well.
However, they were all in agreement and pointed out the same concerns. Margin compression, was a common theme that was spoken of by all the banking executives during the earnings conference calls. They mentioned lower margins, particularly in personal, secured, and mortgage lending, due to increased competition especially among the large institutions. This aggressive and competitive rate pricing, is a trend that the banking executives expect to continue. Economic uncertainty, combined with very high levels of household debt in Canada and expected interest rate hikes, increase the concern of slower lending growth and volume.
Canadian Banking Executives Warn Of Continued Margin Pressure, Lower Spreads, Lower Growth
Statements from Canadian banking executives illustrate the situation, during Q2 2011 earnings conference calls.
Toronto-Dominion Bank / TD Bank :
Ed Clark (Group President & CEO) summarized the banking situation:
• ” if you look at the other banks as well as ourselves, there is some margin pressure coming on here as I think people respond to the slower growth to try to get the assets in different ways”.
• “in Canada” “growth rates, particularly in the personal lending, secured lending, the mortgage business has slowed down”.
• “there is some slowing down in the retail banking space in Canada, and there is margin pressure”.
Colleen Johnston (CFO & Group Head, Finance) warned of impact to Q3:
• “Slower volume growth and continued margin pressure in personal banking is expected to result in a moderation in the earnings growth rate in Q3”.
Timothy Hockey (Group Head, Canadian Banking & Insurance) reiterated the general trend that is expected to continue:
• “the theme of the day and the theme of the reporting season seems to be that margins are more under pressure than probably the Street expected, and we’re seeing that day to day in fighting over the growth opportunities in Canada”.
• “There is aggressive pricing going on in the marketplace”.
• “I think it’ll continue to be quite competitive because we do like to win, all of us. And as a result, we’ll continue to compete for the Canadian consumer. And so, I think that’s what will continue to put the pressure on the margins over the next few quarters”.
Royal Bank of Canada / RBC :
Gordon Nixon (President & CEO) warns of the low margins, and its heavy dependence on the mortgage market:
• “I think a lot will depend” “on what happens with respect to the mortgage market and because that’s where you’re seeing some pretty unusual activity and is probably having the biggest pressure on margins”.
• “some of the activity we’ve seen in the mortgage market almost imply a very low margins to say the least”.
David McKay (Group Head, Canadian Banking) mentions the competitive pricing tactics. Although they experienced margin expansion rather than decline (did not use pricing tactics), their warnings were consistent with the other banks:
• “the value destroying pricing tactics that are in the market place right now”.
• “the environment in the consumer lending side that is very competitive and you are seeing compressing margins there”.
• “It’s a challenging environment. Our goal is to manage towards flat margins but you may see a slight decline. I think that’s a pretty consistent theme out there. There is some very aggressive pricing on the consumer lining side in the marketplace right now”.
Bank of Montreal / BMO :
Frank Techar (President & CEO, Personal & Commercial Banking Canada) mentions that lower margins were expected from competitive pressures:
• “in the last couple of quarters, we were really expecting to see some softening in margins”.
• “the competitive pressure is heating up a bit more than we would have expected. And we’re seeing that probably play out the most on the commercial business. And my expectation is, going forward, we will continue to see that”.
Tom Flynn (EVP & CFO) comments on lower spreads in loans:
• “[Quarter-over-quarter] lower net interest margin in P&C Canada due to continued low interest rates in a competitive environment and to changing mix”.
• “[Year-over-year] Net interest margin decreased 7 basis points due to continued low interest rates, in a competitive environment, resulting in lower mortgage, commercial loan and term deposits spreads. Margin decline was also attributable to the impact of unfavorable product mix”.
Bank of Nova Scotia / Scotiabank :
Rick Waugh (President & CEO) describes margins in the current environment:
• “In Canadian banking, margin compression from a highly competitive environment”.
Anatol Von Hahn (Group Head, Canadian Banking) expects the trend to continue:
• “[Concerning] retail asset growth, we have seen some moderating of consumer demand and intensifying competition in the first two quarters of 2011, and we expect this environment to persist for the remainder of the year. The effects of an increasingly competitive market as well as consumer preferences for lower yield, variable rate loans has put pressure on our margin and we expect this pressure to be sustained for the rest of fiscal 2011 as well”.
Canadian Imperial Bank of Commerce / CIBC :
Kevin Glass (SEVP & CFO) expects margin pressure to continue:
• “more competitive pricing in mortgages and lending. We expect that near-term margins will continue to be pressured by competitive rates”.
National Bank of Canada / NBC :
Louis Vachon (President & CEO) mentions the competition is widespread but a large portion among the larger institutions:
• “[the competition is] wide spread, concentrated maybe in three or four players”.
Jean Dagenais (SVP, Finance, Taxation, Investor Relations) points to competitive pressures and lower spreads:
• “overall margins were at 2.33%, down 7 basis points sequentially, due in large part to competitive pressure and lower spreads”.
Canadian Bank Stocks Favored By Canadian Investors
Canadian banks are heavily favored by Canadians, particularly dividend investors. Dividend investors, primarily those who choose to do-it-yourself, favor stocks that pay dividends (and increase them), over other investment aspects & characteristics. One large reason for the popularity of Canadian banks in investor portfolios has definitely been their continued dividend payments, as well as dividend increases. Unlike U.S. banks, no Canadian bank has collapsed, and none required a government bailout during the recent financial crisis. Canadian banks far exceed the minimum capital requirements (Canadian & international) needed to cover their loans & investments. As a group, they have also been more conservative, and did not take risks as large as their American counterparts. This may be due to tighter housing market regulations and lending policies in general.
Canadian Banks May Be Good Investments But Not Superior Ones
Over the years, the majority of Canadian investors have ignored the U.S. banking sector. The trend has continued and even strengthened since the financial crisis, where U.S. banks have been avoided en masse. However, if we look back at Canadian banks, not all were guilt free from the crisis. In particular, CIBC and National Bank had significant writedowns (as a percentage) associated with the subprime mess in the U.S. which negatively impacted their earnings for several quarters during the meltdown.
The superiority and profitability of Canada’s banks may not be as strong as Canadians tend to believe. Investor interest may be attributed more to the troubles experienced by banking industries outside Canada (particularly the U.S.), rather than the growth prospects of Canadian banks. They may not be necessarily better, or the best banks to invest in. If Canadian banks were as superior as people believe, would we have seen legendary investor Warren Buffett take a small interest in at least one of them during the past 50 years? Buffett has not taken an interest in Canadian banks, but what qualities would make them superior investments?
There is lots to like about the banks in Canada. They have the capital strength and a constant customer base. They are also more conservative in their risk taking approach (except for a few). But unfortunately those attributes alone do not make them superior. The Canadian banks lack a sustainable and clear competitive advantage over domestic rivals. Advantages that a bank may currently have are prone to being lost. In other words, they lack a wide competitive moat investors should look for. The constant and stable customer base exists, but has difficulty growing. Canadian consumers tend to hop around from bank to bank, much like they do between the small handful of players in Canada’s cell phone, television, and home & auto markets. Statements from the banking executives, shine light at these issues.
The outlook for the Canadian banking sector may not be as rosy as the media and the average investor believes. The housing sector is an area that should be of great concern going forward. Affordability may become a real issue, while prices continue to rise, but income growth remains stagnant. In large urban cities, such as Vancouver and Toronto, a significant portion of the demand is driven by foreign investors. The impact will be significant, if demand from foreign investors retract. With rising interest rates and already high levels of household debt, domestic demand has a real likelihood of dropping. A decline in domestic demand would lower mortgage loan growth, as well as personal lending.
Canadian banks may make decent or good investments, but they may not be superior ones. They might not be the most superior banks to invest in either.
Net Interest Margin (NIM) – Investors Need To Look Closer At Numbers
For net interest margin (NIM), I consider a value close to 4% (or more) to be quite good. The major lenders of financial institutions, consist of other institutions, the federal reserve, their deposits, etc. They all have low interest rates, so we can see why 4% would be considered good.
Taking a look at the largest Canadian banks, we can see that recent NIM numbers are not far off from their historical NIMs. For the second quarter of 2011, RBC and BMO saw improving NIM numbers. But CIBC, National Bank, and even TD saw decreasing numbers.
National Bank of Canada (NBC) [tse:NA]
• Q2 2011 (4/30/2011) = 2.38%
• Q1 2011 (1/31/2011) = 2.45%
Laurentian Bank of Canada (BLC) [tse:LB]
• Q2 2011 (4/30/2011) = 2.01%
• Q1 2011 (1/31/2011) = 2.03%.
We can also see that the Canadian banks have NIM values well below 4.00%, which is consistent with their historical values. Why is the NIM value important? Lets revisit the definition of NIM. The difference between interest income generated and the amount of interest paid to the lender. It is an indication of the firm’s investment decisions compared to its debt situations. The NIM is important because it is the most basic and core fundamental operation of a bank, at any time. We want to see NIM increase, which would indicate the ability to maintain and improve spreads on loans, grow deposits, and control funding costs. These fundamental core operations are the most conservative within a bank. If a bank cannot maintain or improve their net interest margin, they would typically put more effort into other areas to boost earnings (insurance, investment banking, wealth management, etc.). Although not necessarily, it may lead to larger risk taking or riskier assets, in an attempt to increase profitability in the other areas (like we’ve seen with many banks just prior to the crisis). There are other numerical metrics such as ROE and earnings too look at as well, but those numbers can be manipulated. NIM less so.
Do American Banks Deserve Some Attention?
Canadians have customarily defaulted to investing in banks within our own country. There is nothing wrong with that. But perhaps Canadian investors should be taking a look States side, where there is a much larger customer base (one that dwarfs Canada’s). There is also a larger number of banks and financial corporations, with a wider range of markets and niches. As a result, there is a wider range of quality & financial performance among the banks. One can find financial institutions that perform very poorly and is on the brink of collapse, as well as ones that are very profitable and have wide competitive moats.
How does the net interest margin of the biggest Canadian banks compare to their cousins in the United States? Some investors may be surprised to find that the biggest Canadian banks have much lower NIMs than some of the American banks that are performing very well financially (not necessarily the largest nor with best stock price performance).
Wells Fargo & Co [WFC]
• Q1 2011 (3/31/2011) = 4.05%
• Q4 2010 (12/31/2011) = 4.16%
U.S. Bancorp (U.S. Bank) [USB]
• Q1 2011 (3/31/2011) = 3.69%
• Q4 2010 (12/31/2011) = 3.83
Umpqua Bank [UMPQ]
• Q1 2011 (3/31/2011) = 4.23%
• Q4 2010 (12/31/2011) = 4.14%
Texas Capital Bancshares Inc [TCBI]
• Q1 2011 (3/31/2011) = 4.46%
• Q4 2010 (12/31/2011) = 4.12%
JPMorgan Chase & Co [JPM]
• Q1 2011 (3/31/2011) = 2.92%
• Q4 2010 (12/31/2011) = 3.00%
In the Bank Valuation series, I discuss different metrics (quantitative & qualitative) for evaluating the relative strength of banks (in addition to calculating the intrinsic value of a bank stock). Numbers which may flag potential problem areas are also highlighted.
How do the Canadian banks compare by the quantitative metrics? As a group, many Canadian banks have strong capital bases, and are also stronger in certain areas than their American cousins. In other areas, they fall short (such as with Return on Assets). Quantitatively, one concern is that Canadian banks lack a wide competitive moat, with little to keep customers from migrating to any of the other big domestic competitors. Running through the metrics as well as other research & analysis, show that Canadian bank stocks are by no means the “hands down winners” or “sure bets” that the majority of Canadian investors make them out to be.
Investors need to look at, and compare each bank individually to see the real differences. Very few investors perform adequate due diligence (research & analysis, or valuation) prior to purchasing an investment. For bank stocks, most people look only at the P/E, dividend yield, recent price movements, and positive headline phrases (“record earnings”, “beat estimates”). As a consequence, they do not have accurate assessments of the banks in either Canada or the United States. Perhaps some of the top U.S. banks deserve more attention from Canadian investors, while Canadian banks should be looked into more deeply than they typically are.
Canadian Bank Q2 2011 Earnings Conference Calls:
Bank of Montreal:
Bank of Nova Scotia:
I do not own any shares in Canadian banks, nor do I plan on initiating any positions in the foreseeable future. They do not pass my personal investment criteria & metrics. However, I do like TD Bank more than any of the others, for their corporate & strategic initiatives, over their quantitative metrics. I believe that their corporate direction will translate into better quantitative metrics over time.
I own shares of Wells Fargo, US Bancorp, and Umpqua.
The banks mentioned are not meant as recommendations, and are for illustration purposes only. I encourage investors to perform full research & analysis, as well as calculating intrinsic values before considering any investment!
Thanks & Happy Investing! — The Investment Blogger © 2011