Two weeks ago we asked if, in the aftermath of the dramatic selloff suffered by European banks over commodity exposure concerns, whether Canadian banks would not be next in line. The reason was that according to an RBC report, while US banks had already taken significant reserves against future oil and gas loans, roughly amounting to 7% of their exposure, Canadian banks were stuck in denial.
As RBC grudgingly noted, "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." Yes, well, China already advised its media to stick to "positive reporting" - sadly for the energy-rich or rather energy-por province of Alberta it is now too late.
As for ths reason for this surprising reserve complacency, RBC said the following:
Canadian banks like to wait for impairment events to book PCLs rather than build reserves (called sectoral reserves in the past) for problematic industries.
In other words, let's just wait with the reserves until the losses are already on the book: hardly the most prudent approach which may be why today, with its usual several week delay, Moodys opined on which Canadian banks it views as most susceptible to a "severe oil slump."
As quoted by to Bloomberg, Moody's said that "Canadian Imperial Bank of Commerce and Bank of Nova Scotia would be nation’s hardest hit lenders if the oil slump became sharply worse, while Toronto-Dominion Bank would best be able weather a worsening rout."
"The prolonged slump in oil prices will increase the financial stress on oil producers and the drillers and service companies that support them, as well as on consumers in oil-producing provinces," Moody's said. "Correspondingly, the Canadian banks’ losses in related corporate and consumer portfolios will increase, and their capital markets income is likely to decline."
The good news is that if downgrades were contained, Canadian bank profits would fall though capital levels wouldn’t be hurt in a moderate stress scenario, Moody’s said.
Moody’s defines a moderate stress scenario as one in which credit ratings of relevant energy firms are downgraded two levels, banks’ losses from consumer loans, credit cards and residential mortgages reach historic peaks and capital markets net income falls 10 percent.
“There is some moderate expectation that we could see the moderate stress scenario," David Beattie, Moody’s senior vice president, said in a telephone interview. “Even if that happens, it’s pretty addressable in terms of the earnings power of the Canadian banks. They could absorb this over a couple of quarters and move on."
However it was the "severe stress" scenario that was more notable not only because when it comes to worst case scenarios they tend to materialize more frequently than the "best case" but because this is the one where Moody's actually saw significant changes to Canadian bank cash management. According to Moody's the severe stress case "could force lenders to cut dividends, sell shares or take measures to preserve capital. The six biggest banks would see losses of C$5.56 billion ($4 billion) in a moderate scenario, while losses in a severe scenario would reach C$12.9 billion, or about 1.5 times the lenders’ combined quarterly profits."
The severe scenario, which Beattie calls “remote,” would involve energy firms hit by a four-level downgrade, consumer portfolio losses surpassing the historic peak and capital markets profit plunges 20 percent. In that scenario, Canada’s banks would still generate sufficient internal capital to cover stress losses within two quarters, just not at the current payout ratio, Moody’s said.
As a reminder, according to an RBC calculations, merely increasing loss allowances to match the level of their US peers would eat up over C$2.3 billion in capital.
Which is a reason to be skeptical about Moody's take on bank capital needs under the severe scenario, but of course the real answer would not be revealed until such a scenario actually plays out and reveals both how underreserved Canada's banks truly were, and how substantial balance sheet impairments would be.
In any case, focusing on the two most exposed banks, here was Moody's summary:
- CIBC, which has the highest regulatory capital among Canada’s banks, would see its Common Equity Tier 1 capital ratio decline by 46 basis points in a moderate stress scenario and 103 basis points in the severe scenario, reflecting the Toronto-based lender’s primarily domestic focus, Moody’s said. Losses in the severe scenario could reach C$1.57 billion for Canada’s fifth-largest lender by assets, the report said.
- Scotiabank would face a 41 basis point reduction in regulatory capital in the moderate scenario and 100 basis points in a severe situation due to larger losses from its corporate loan book, Moody’s said. The severe scenario would equate to C$3.52 billion of losses for Canada’s third-largest bank, according to the report.
So for those who are worried about the energy rout getting worse, but just must be invested in Canadian banks, which one is safest? According to Moody's, Toronto-Dominion Bank, Canada’s largest lender, would be the least affected under both scenarios, "given its relatively small oil and gas corporate loan portfolio, lack of reliance on capital markets earnings and low concentration of retail operations in oil-producing provinces."
For the sake of Canada, we hope Moody's is right.