After The European Bank Bloodbath, Is Canada Next?

Back in the summer of 2011, when we reported that Canadian banks appear dangerously undercapitalized on a tangible common equity basis...

... the highest Canadian media instance, the Globe and Mail decided to take us to task. To wit:

Were the folks at looking at the best numbers when they argued that Canadian banks were just as levered as troubled European banks?


In a simple analysis that generated a great deal of commentary, a blogger at, an oddball but widely followed financial site, suggested that Canadian banks were as leveraged as European banks because they have low ratios of tangible common equity to total assets.


But there's an argument that looking at that ratio is the wrong way to judge a bank's strength because it ignores the composition of the assets.

Sadly, the folks at were looking at the best numbers, and even more sadly, in the interim nearly 5 years, Canada's banks took absolutely no action to bolster their capital ratios; in fact, these have only deteriorated.

The Globe and Mail, however, was right about one thing: the TC ratio did not capture the full risk embedded in Canadian bank balance sheets: it was merely a shorthand as to how much capital said banks have in case of a rainy day.

Sadly for Canada, it's not only raining, it's pouring for the country's energy industry, a downpour which is about to migrate into its banking sector. Which is why it is indeed time to take a somewhat deeper dive into the Canadian banks' balance sheets, where we find something very troubling, and something which prompts us to wonder if the time of freaking out about European banks is about to be replaced with comparable panic about Canadian banks.

The following chart from an analysis by RBC shows that when compared to US banks' (artificially low) reserves for oil and gas exposure, Canadian banks are...not.

Here is the one chart showing why the time to panic about Canadian banks may have finally arrived:


To be sure, last week we presented a full breakdown of the public U.S. bank energy and commodity exposure courtesy of Janney: which woefully lacking in many aspects, most notably in the credibility of the presentation as a result of the recently noted discussions between the Dallas Fed and US banks, at least it provides a relative benchmark of who is exposed to what per management disclosures.


We would do the same for Canada's banks only... we can't. So where does that leave us? Here are some though from RBC, ironically a Canadian bank itself, on bank balance sheets:

Early small cracks – timing is uncertain – preparing for volatility

The small negative moves in credit would normally not even “register” were it not for plenty of evidence of issues surround the oil and gas sector and the impact it could have on the oil producing provinces in Canada. The timing of loan impairments and PCLs has been volatile on a quarterly basis during previous credit cycles for the Canadian banks (see Exhibit 7 and Exhibit 8). We forecast rising provisions over the next four quarters, but have low confidence of when these losses will materialize for the banks (see Exhibit 9). In other words, while we increased EPS estimates for three banks on account of lower loan losses in Q1/16, this change was due to the perceived timing of losses (e.g., we may still be “early” in the cycle) rather than a shift in our outlook for overall credit quality of the Canadian banks. As we touch upon in the next session – Canadian banks like to wait for impairment events to book PCLs rather than build reserves (called sectoral reserves in the past) for problematic industries.

The problem with that last bolded sentence, is that as it says, "Canadian banks like to wait for impairment events to book PCLs rather than build reserves", in effect throwing the entire process of reserving for future losses out of the window.

However, with oil prices now suffering from a worse crash than the one seen in 2008, waiting is no longer an option, which means approximating the magnitude of potential losses on Canadian oil and gas loans is of utmost importance, especially since as Exhibit 10 shown above demonstrates, no loss reserves have been built whatsoever.

RBC has done this exercise, and here is what it finds (for other banks, if not for itself):

Some large U.S. banks currently have or guided to loss reserves in the 5-9% range against oil and gas loan exposures (see Exhibit 10).


Small diversion…We note there are some differences between the recognition and reserving for loan losses between U.S. and Canadian banks that do not make for a perfect comparison between countries, nor can we control for underwriting discipline. Nevertheless, we believe loan loss accounting is similar in both countries with oversight from the regulator and from auditing firms.


In practice, however, it appears as though U.S. banks build collective (or “general”) loan loss reserves early and later release these reserves into earnings. In Canada, when we speak with management teams, they seem to stress that the event of impairment is what will trigger PCLs rather than a build of reserves before impairments. We show a summary of Canadian and U.S. bank allowances relative to total loans over time and note that U.S. bank allowances are still higher than Canadian banks, but have been trending down (see Exhibit 11). In fact, US banks have more than double the level of allowances against loans versus the Canadian banks. However, we should also point out that the US banks also have approximately double the level of impaired loans that the Canadian banks have and loan mixes are quite different.


Oddly, we often hear that US banks are applauded for “recognizing” the problem “early” and this too may play a role in their volatile reserve behavior and may be why US reserves for the oil and gas loan books are as high as they are. Conversely, we have had many past conversations with Chief Risk Officers in Canada about recovery methods and proactive management of loans that may be criticized or struggling and we found that a “through the cycle” best result is not necessarily tied to recording losses “early” through the income statement. In fact, one might argue that “arming” your recovery teams with large “reserves” ahead of the restructuring/loan workout phase may lead to sub-optimal recoveries…

So... it is preferential to not arm your recovery team to handle the truth, because it leads to sub-optimal recoveries. This is also known as the... well, in this case a picture is certainly worth a $1000 in loss reserves:


RBC continues with its attempt to show how much more pleasant having one's head stuck in the sand is:

We would note that Exhibit 10 only shows specific allowances for Canadian banks while the U.S. bank reserve levels in Exhibit 10 includes both specific and general allowances. In other words, the Canadian banks may have general allowances against oil and gas loans which are not captured in the below analysis. In Canada, general allowances are not explicitly disclosed by industry and hence we cannot quantify how much general allowance the Canadian banks may already set aside for oil and gas loans (so we exclude them from our analysis).

In other words, even more balance sheet obfuscation which means that nobody actually knows the full exposure of Canadian banks, something which has led Europe's largest bank to crash 10% today, seen its CDS more than double in the past month, and trade at levels not seen since the Lehman failure. But for Canadian banks, this is somehow... different.

Which brings us to the punchline:

Back to our loan loss calculation methodology in Exhibit 13… This method essentially holds all loan losses from 2015 as constant and then adds direct loan losses from the drawn oil and gas loan books. Effectively, we are assuming the US banks reserve levels are a “correct” estimation of loan losses from the direct oil and gas loans and the Canadian banks need to “catch up” to have similar levels of reserves. We like this method as it helps us determine a sort of “consensus” loss on oil and gas loans – but we admit this is very general and does not control for the investment grade ratings, geography, future drawdowns and/or specific industry exposures (like E&P lending versus mid-stream lending, etc.).

And here is what "panic" means in purely monetary terms:

To summarize:

  • Canadian banks' (ex RBC) current loss allowance: $170MM
  • Canadian banks' (ex RBC) pro-forma loss allowance assuming U.S. banks reserve levels are accurate: $2,529MM

The difference: $2,359MM, or an increase of 1,288%.

Clearly, the above RBC analysis assumes that 7% loss reserves are sufficient to offset loan losses in what is shaping up as the biggest commodity crash in history.

We wish we could be as confident as RBC that this is sufficient, however we are clearly concerned that if and when Canada's banks finally begin to write down their assets and flow the impariments though the income statement, that things could go from bad to worse very quickly, and not necessarily because Canada's banks are under or over provisioned, but for a far simpler reason - once the market focuses on Canadian energy exposure, it will realize just how little information is freely available, and if European banks are any indication, it will sell first and ask questions much later if at all.

However, indeed assuming a worst case scenario, one in which the banks will have to "eat" the losses and suffer impairments, then the question emerges just how much capital do these banks truly have, which in turn goes back full circle to our post from the summer of 2011 which led to much gnashing of teeth at the Globe and Mail.

We wonder what its reaction will be this time, and even more so, what its reaction will be if the market decides that when it comes to "the next domino to fall", it was indeed Canada which courtesy of a generous global central bank regime which flooded the world with excess liquidity, and which China is now actively soaking up, allowed Canada's banks to quietly skirt under the radar for many years; a radar that has finally registered a ping.