Tuesday, February 9, 2010

Bank Regulation in the Canadian context - Part 1

The fallout of the 2008-09 Great Recession in terms of failed banks, lost jobs, shuttered plants, bankrupt companies, is news to all by now. What started off as a repayment crisis had an amplified impact on the overall economy - driven by reckless risk-taking by big banks, over-leveraging and ultimately pursuing a path that seems to suggest that they believed they were too big to fail. Which turned out to be the case ultimately. Read bailout of AIG, the arranged marriage for Bear, government takeovers of Fannie and Freddie and so on.

The contagion has not been limited to US banks and institutions by any means. European Banks (UBS, Deutsche and Societe Generale), British banks, Irish and Icelandic banks - all showed similar behaviours, similar disdain for any considerations of their long-term health believing themselves to be too big to fail. One glorious exception in all of this has been large Canadian banks. As compared to some of their US and European rivals, these large banks have been the very paragon of well-managed and well-run financial institutions and have hardly suffered a blip to their profitability or needed any government largesse over the Great Recession to survive. In fact, Canada is the only G7 country to survive the financial crisis without a state bail-out for its financial sector.

(The top 5 Canadian banks are Royal Bank of Canada, Scotiabank, Toronto-Dominion Bank, Bank of Montreal and the Canadian Imperial Bank of Commerce. Besides cornering nearly 90% of the Canadian market, these banks are in reality large international banks with operations in 40-50 countries, and stock listings on multiple exchanges. A quick primer on Canadian banks is here.)

What caused the Canadian banks to survive? An immediate reaction (which incidentally would be wrong) is that Canadians are somehow too nice to participate in the kind of no-holds-barred plundering practiced by the American banks. They play a soft form of capitalism, one that protects the downside but also somehow limits the upside. Hmmmm, not entirely true. The net shareholder returns of Canadian banks have exceeded that of UK and US banks in the last 5 years, as evidenced in the graph below.

What about returns over a larger time period? How do the top Canada banks compare to the top US banks in terms of stockprice performance?

Looking at a 7 1/2 year period from mid-2002, the total returns on a basket of large Canadian banks (the ones mentioned above) was 144%. In the same period, US large banks (Citi, Chase, BofA, Wells, Goldman, Morgan Stanley) had a return of a paltry 2%. OK, the US banks returns were decimated because of the recent credit crisis. The market over-reacted maybe. If you look at returns from a period from Jan 1998 to Dec 2005, when we were having a so-called 'Goldilocks' economy, the story isn't too different. US bank stocks rises to a more respectable 69% but the performance of Canadian bank stocks improves even more to 183%.

Table of stock price performance for top Canadian banks - followed by US banks
(Boom and Bust Period)

June 2002 Feb 2010
RBC 16.06 50.44
TD 23.19 59.56
CIBC 32.85 59.135
BofM 21.86 48.86
Scotia 17.41 42.87

June 2002 Feb 2010
Chase 22.25 38.39
Wells 25.2 26.71
BofA 35.18 14.47
Citi 28.68 3.18
Goldman 73.35 152.49
MS 35.62 27.13

Table of stock price performance for top Canadian banks - followed by US banks
(Boom Period only)

Jan 1998 Dec 2005
RBC 12.15 39.27
TD 17.49 52.55
CIBC 24.02 65.8
BofM 20.22 55.94
Scotia 16.6 39.93

Jan 1998 Dec 2005
Chase 51.29 48.3
Wells 18.22 35.56
BofA 29.94 46.15
Citi 24.78 48.53
Goldman 73.72 133.26
MS 29.19 56.74

(Goldman Sachs and Bank of Montreal did not have full information over these periods. But having them in the numbers - or taking them out - doesn't change the story.)

SO what can explain the better performance of Canadian banks? What allows them the ability to not only perform better through the cycle but also do so with mininal government handouts? The answer is superior risk management and that will form part of the next part on this subject.

Christya Freeland of FT.com has a fascinating article on the subject and the link is here.

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