For Canada's Banks This Is "The Next Shoe To Drop", And Why It Will Drop This Spring

Roughly around the time the market troughed in early February, we asked "After The European Bank Bloodbath, Is Canada Next?" The reason for this question was simple: we said that "when compared to US banks' (artificially low) reserves for oil and gas exposure, Canadian banks are...not."


Stated otherwise, we warned that the biggest threat facing Canada's banking sector is how woefully underreserved it is to future oil and gas loan losses.

We added that unlike their US peers, "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."

We then cited an RBC analysis according to which a 7% loss reserve would be sufficient to offset loan losses in what is shaping up as the biggest commodity crash in history. We disagreed:

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.

We were, of course, referring to the Globe and Mail's reaction to our post from 2011 that despite the sterling facade, Canadian banks are really woefully undercapitalized.

And while we still await for the G&M to note this ping, here is Canada's Financial Post, confirming everything we said almost a month ago, and explaining what the "next shoe to drop" for Canadian banks will be. The Post's answer: "Relatively low oil loan provisions."

Sounds familiar?

Here are the FP's details which are already well known to our readers.

Canadian banks are taking lower provisions for oil and gas related credit losses than their U.S. counterparts, prompting observers to dig into the reasons behind the trend.


Reserves related to oil and gas loans held by U.S. banks are four to five times higher than those held by the Canadian banks, according to analysts at TD Securities, who believe accounting treatments and interpretations are, at least in part, behind the striking difference.


In a note Tuesday, the TD analysts led by Mario Mendonca said loan quality within the portfolios could also be another reason, with historical loss trends suggesting Canadian banks are more conservative lenders. Still, they said there is more to than that, including how aggressive each country’s regulators are, and interpretations under two different accounting regimes: U.S. Generally Accepted Accounting Principles (GAAP), and IFRS.


A close reading “reveals what we view as a material difference in loss recognition,” the analysts wrote.




It appears Canadian banks are... different.

Under U.S. GAAP, they said, a loan is impaired when it is probable a credit will be unable to collect on all amounts due, based on current information and events. IFRS accounting considers a loan impaired based on “objective evidence” surrounding a financial asset or group of financial assets.


“We believe that either there is a very significant difference in the two accounting regimes or the standards are being interpreted in very different ways,” the TD analysts wrote.


In addition, they said U.S. banks are more likely than their Canadian counterparts to use a special form of provisioning known as a collective allowance because there is a greater acceptance in the United States of releasing these reserves in the future if conditions improve.

Like, in the case of a global financial system bailout. Of course, nothing prevents Canadian banks to release these reserves too. The problem is that one has to take them first, and doing so would soak up so much capital it may expose the bank's balance sheet as a hollow sham.

That said, now that everyone is finally pointing the finger at their gaping reserve holes, Canadian banks have begun to increase provisions for credit losses, reflecting the early impact of low oil prices.

It is too late.

The TD analysts said they expect "the next shoe to drop" in Canada when second-quarter results are posted this spring. “Despite the recent move in oil, futures are flat year-to-date and prices are still down materially since the fall 2015 determinations,” they wrote. “This should result in further pressures on borrowing bases and the potential for covenant breaches.”


Combined with expected “prodding” from the Office of the Superintendent of Financial Institutions (OSFI), Canada’s key bank regulator, “we expect impairments and credit losses to climb,” the analysts said.

All of this could have been avoided if Canada's banks did not try to be just a little "too clever." Instead, now they have a bleak future to look forward to, one where, in just a few months, the European bank bloodbath will shift over, as we first warned nearly two months ago, to Canada, something which both the mainstream media and "respected" analysts now admit.


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