Soon After We Sounded The Alarm, Canada's Regulator Warns Local Banks Are Underreserved To Energy Losses

Back in early February, Zero Hedge laid out what was the biggest crisis facing Canada's banks: a chronic under reserving to potential (and soon, realized) oil and gas loan losses.

As we said nearly two months ago, "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:

 

Two months later, we are happy to announce that Canada's regulator has caught up to our warning, and as the WSJ reported, "Canada’s banking regulator is urging the country’s major banks to review their accounting practices to ensure they have sufficient reserves as the commodity-price collapse takes a toll on the economy."

As we first suggested in early February, Canada's Office of the Superintendent of Financial Institutions is now warning local lenders should scrutinize their collective allowances and reserve funds that act as cushions to absorb potential future loan losses, the regulator’s chief said in an interview.

“We want them to take a good look at their accounting practices,” said Superintendent of Financial Institutions Jeremy Rudin. “They should support loss-absorbing capacity and the ability to manage through difficult times in general,” he added.


Some of the banks laughed at us when we suggested they are purposefully masking their exposure to distressed loans; we wonder if they will also laugh when their regulator tells them to do precisely that. As the WSJ further writes, "Canada's regulator is giving the country’s six biggest banks this guidance on their accounting as they face mounting criticism from some analysts that they haven’t amassed enough reserves to cover soured loans to the energy sector. That criticism was a recurring theme during calls following their fiscal first-quarter results, in which many banks warned of rising provisions for credit losses but assured investors their rainy-day cushions were adequate."

Here is the WSJ chart released today which is oddly identical to the one we showed many weeks ago:

 

Next, the WSJ summarizes the details of what is known about Canadian loan exposure:

Energy loans totaled 49.7 billion Canadian dollars ($38.2 billion) for the country’s six biggest banks during the November-to-January quarter, according to a report by TD Securities Inc.  Bank of Nova Scotia, Canada’s third-largest bank by assets, has the biggest direct oil and gas exposure at 3.6% of total loans.

 

Some analysts are skeptical about the lenders’ reserving practices in part because U.S. banks, including J.P. Morgan Chase & Co. and Wells Fargo & Co., have set aside millions more for their reserves as they brace for bigger energy-related losses.

 

Mr. Rudin declined to say whether Canadian banks are under-reserved compared with their U.S. peers. Nor did he offer an opinion on whether analysts voicing such criticisms were misinformed.

Actually, that is only half the picture: as we explained in "The Next Cockroach Emerges: Including Undrawn Loans, Canadian Banks Exposure To Oil Doubles" if one includes undrawn (but committed) bank exposure, the number doubles. Indeed, when adding "untapped loans in the form of undrawn revolvers and other committed but unused credit facilities, Canadian banks’ exposure to the struggling oil-and-gas industry more than doubles from the current C$50 billion in outstanding loans generally highlighted by Royal Bank of Canada, Toronto-Dominion Bank and the country’s four other large lenders in quarterly earnings calls and presentations, to C$107 billion ($80 billion)."

We expect the WSJ to catch up with this critical angle of the story in the next 4-weeks, one which would imply the all-in loss reserves are about 50% lower than the already alarming estimates. For now, however, what we do know is that most banks declined to comment, including on how they have responded to the regulator’s guidance. “We have no comment on this specifically, but are confident in our current provisioning practices,” said Ali Duncan Martin, a spokeswoman for Toronto-Dominion Bank, Canada’s No. 2 lender by assets, in an email.

For their part, Canad's banks did what they also do: float in a sea of denial. A spokeswoman for an industry group representing the lenders, the Canadian Bankers Association, said that Canadian banks aren’t under-reserved. Well, they clearly are, but admitting as much would unleash the market's realization just how wrong its valuation of Canadian banks has been. 

Not only are Canadian banks under-reserved, they are also purposefully opaque to prevent investors from making a comprehensive health assessment:

Canadian banks tend to disclose their energy exposures as a percentage of total loans, but it is difficult to make a direct comparison with U.S. lenders. For instance, Canadian portfolios include large amounts of insured residential loans that are essentially risk-free because they are backstopped by the federal government.

 

Canada’s banks have also been criticized by analysts for providing varying degrees of detail about their energy lending books—such as the proportion of reserve-based loans and the amount considered “investment grade”—and about their stress-testing of loan portfolios.

 

“I’m concerned about this,” said  James Shanahan, an equity analyst with Edward Jones, in a recent interview. “The banks aren’t really saying a whole lot about the true underlying quality of these [energy] portfolios,” he later added. He’s among the analysts calling on Canadian banks to provide more disclosure on their energy exposure, including how much covenant relief is being provided to distressed borrowers.

He almost certainly won't get it, unless for some reason, the Dallas Fed make it explicit that Canadian banks have to be more transparent in a few weeks when bank borrowing base redeterminations are made in negotiations which will include not only Canadian and US commercial banks, but the Dallas Fed as well as the US OCC.

That could prove to be a key issue in the spring borrowing base redeterminations. Mr. Rudin declined to specify what role, if any, OSFI would play in those upcoming reviews, saying only banks are expected to have a “robust credit assessment process” that is frequently reviewed by the regulator. Issues, such as covenant relief, are “business decisions” best left to the individual banks, he added.

We can tell Mr. Rudin what will happen: the OSFI will play the same role that the US OCC played in recent preliminary, if quite definitive, discussions between US lenders and shale producers, the same discussions which the Dallas Fed denied ever took place even though both Credit Suisse and the WSJ confirmed our story: discussions which made it clear to US banks not to force defaults, but to suspend MTM until the local lenders can force the underlying company to issue debt (just like Weatherford) and use the proceeds to take out the secured lender bank.

Expect precisely the same in Canada over the next few months as Canada's lenders are told to quietly, if aggressively, unwind their exposure to all Canadian oil and gas companies.