Canada's Housing Bubble

Feb 03, 2011 Barbara Shecter Financial Post

Despite coming through the global financial meltdown relatively unscathed, Canadian banks may not be as well-capitalized to meet new regulatory requirements as their U.S. peers, according to Canaccord Genuity analyst Mario Mendonca.

Further, the analyst says in a contrarian take on the situation, Canada's six largest banks can be clearly divided into "have" and "have not" categories in terms of their preparedness for new regulatory capital requirements commencing in 2012.

For Toronto-Dominion Bank, Royal Bank of Canada and Bank of Nova Scotia, reaching the Tier 1 common equity ratio of 7% under Basel III rules "is not an easy task unless the banks have very effective market risk and counterparty risk ... mitigation strategies," Mr. Mendonca wrote in a note to clients on Monday.

He said it could be argued that Canada's other large banks -- National Bank, Bank of Montreal, and Canadian Imperial Bank of Commerce -- are trading at "massive discounts" to the three "have not" banks that are poised to "limp into 2013 just barely meeting the 7% threshold."

Meanwhile, Mr. Mendonca says commentary from U.S. bank executives -- where fourth-quarter results have already been reported -- suggests it is not appropriate to make a claim that Canada's banks are better capitalized.

"In fact, under Basel III it would appear that Canadian bank common equity Tier 1 ratios are, on average, 160 basis points lower" than the U.S. banks that disclosed their information, says the analyst. However, he qualifies his remarks by pointing out that banks with the best news to report are likely the ones to provide information on their capital ratios under Basel III Rules, and large U.S. banks such as Citi and Bank of America declined to provide the information.

Mr. Mendonca's report relies on various assumptions, and the analyst acknowledges the challenges of making investment decisions based on number that will become truly relevant two years from now.

The number crunching can lead to "perverse" suggestions, he says, such as favouring TD over BMO simply because TD does not have the capital to gamble on a large U.S. acquisition.

"We think that's going too far," Mr. Mendonca concludes. "At this juncture our outlook on the banks does not reflect the differences in capital strength outlined in this report."

As for the market, Mr. Mendonca says investors do not seem to have taken much notice of the differences he sees between the financial institutions. In his note, the analyst put forward two theories for why this might be the case. Either the market "is not fully aware of the major differences in capital strength on a Basel III basis or investors simply do not care as long as the banks can get to 7% by the end of 2012 without raising capital or impacting earnings power."

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