By Richard Phillips, Chief Investment Officer and Kevin Muir, CFA, Market Strategist, for EastWest Investment Management, and republished here with permission
Try Googling “Canadian banks 2008 crisis”.
What’s the first thing that comes up? In our browser, it’s a publication from the Richmond branch of the Federal Reserve entitled, “Why was Canada Exempt from the Financial Crisis?”
What’s the next article? A National Bureau of Economic Research piece called, “Why Canada Didn’t have a Banking Crisis in 2008.”
Don’t forget we put no positive qualifiers into our search query, but merely stuck those four words (“Canadian banks 2008 crisis”) into the search engine. Instead of delivering up stories of the tumultuous year for Canadian financial markets, most results were centered on how Canadian banks performed so admirably during the global financial crisis.
The Google results should be no surprise as Canadian banks have earned reputations as terrific performers – providing solid, safe growth through good times and bad.
Ask market watchers about the performance of Canadian banks versus U.S. banks over the past two decades, and most would guess the Canadian bank index would be up more than the U.S. equivalent. Yet the extent of the outperformance might surprise.
Since 2000, the U.S. KBW Bank Index is up 46%. During that same period, the Canadian bank index has risen almost 400%.
And the outperformance is not solely a post-GFC (Great Financial Crisis) phenomenon. Going into the market crash, the TSX Bank Index was already up 200% versus the U.S. rise of 50%.
Canadian bank stocks have consistently outperformed their U.S. brethren for the past two decades.
Less Bank Competition in Canada
Ask a Canadian why this might be the case and they will surely answer that the bank oligopoly overcharges their customers. Although Canada has 30 official Schedule I banks, there are six main competitors that dominate most banking. Contrast that to the United States where there are almost 6,800 FDIC insured commercial banks. There is little doubt this dramatic difference in competition is a factor contributing to some of the Canadian bank outperformance.
Examining the return-on-capital of the two countries’ bank sectors shows Canadian banks earning more.
Not only have Canadian banks consistently earned almost 100 basis points more, but during the GFC, they managed to avoid the gut-wrenching negative returns that plagued U.S. banks.
There can be little surprise as to why Canadian bank stocks have outperformed their American neighbours over the past couple of decades. Canadian banks have earned more and lost less.
Canadian Consumer Credit Bubble
Some might say this is due to the large consumer debt bubble that has manifested in Canada. Although both countries’ household-debt-to-GDP ratios were approximately the same in the early 2000s, after the GFC Canadians went on a borrowing binge that took the household-debt-to-GDP ratio to new highs.
During this same period, the American household-debt-to-GDP ratio fell from almost 100% to 75%.
It’s much easier for a bank to make money with a consumer credit expansion tailwind at its back. In this environment clients are buying houses, taking out new credit cards and in general, continually expanding the amount of banking they require.
This credit expansion has helped fuel a striking housing bull market.
The ever-rising Canadian home prices has been a large factor in keeping Canadian bank loan losses low. A bull market hides a lot of lending mistakes.
Tax Rate Surprise
Yet the real secret to the Canadian bank index outperformance is not confined to simply earning a better return from operations.
Although Canada has a reputation as a high-tax nation while America enjoys the opposite moniker, the relative effective tax rates for each country’s banking sector are at odds to their notoriety.
We performed some work to calculate the median effective tax rate for both indexes through this period. In the calculation we chose the median tax rates, as using the average rates results in too much distortion due to large outliers.
The U.S. KBW Bank Index was over 1000 basis points higher than the Canadian big six with a median effective tax rate of 31.3%.
To some extent, this helps explain the higher return-on-capital number for Canadian banks as compared to American banks. The most recent ROC observation for the Canadian index was 4.33% while the U.S. level was 3.45%. If we assume 1000 basis points of tax difference, that would account for almost 0.40% of return-on-capital drag for the U.S. index. On an adjusted basis, Canadian banks still have a better ROC and the tax rate differential further widens the gap.
The past two decades have seen Canadian banks earn a higher (and more consistent) return-on-capital, with major drivers being an unflagging Canadian consumer credit expansion and a substantially lower effective tax rate north of the border.
Looking Ahead: Drastically Slowing Canadian Credit Expansion
We recently had the good fortune to attend an ITG conference where Anthony Scilipoti from Veritas Research was presenting his “single best idea”. Much to the surprise of the guests, Anthony came out with a “sell the Canadian banks” call. This was a gutsy move. Given the decades of wealth generation, Canadian investors have become quite fond of their banks (and as an aside, Anthony was even so bold to highlight it as his “top short” idea at the Vancouver CFA Forecasters dinner where Anthony was featured).
This “sell the Canadian banks” call has been controversial over the last few years. Hedge fund after hedge fund has attempted to make a grandiose statement about the unsustainability of the Canadian banks’ rise, often alleging a “housing bubble” as the culprit. Vast sums of money have been lost trying to time their collapse.
Veritas has put forward a more nuanced, detailed, and (in our view) timely rationale: Canadian credit will be unable able to grow as much going forward.
From the report:
Canadian retail banking has seen credit risk trend lower over the last ten years despite a prolonged period of increasing household leverage. Household Debt to GDP and Debt to Disposable Income have doubled since the 1990s, yet PCLs for the Big Six banks sit near cycle lows, highlighted by the lowest Canadian PCLs for personal and consumer (‘P&C’) lending since 1996.
We think the cycle is about to turn, however… In this report, we highlight three factors that we expect to drive the consumer credit environment for Canadian banks in F18 and F19:
1. The heightened sensitivity of households to rising interest rates;
Households will struggle to absorb the current round of rising interest rates: If we exclude earn-ins related to pension entitlements, Canadian household savings rates are effectively zero. As a result, any increase in monthly debt servicing costs has to be funded from reduced spending or new borrowing. With the recent B-20 rules limiting access to refinancing and high household debt levels, new borrowing may not be an option.
2. The direct relationship between household Debt Service Ratios (‘DSR’) and Provisions for Credit Losses (‘PCLs’);
Rising household Debt Service Ratios (‘DSR’) are a pre-cursor to higher PCLs: Given rising interest rates, we expect household DSRs to rise by as much as 76 bps by 2020. Past experience suggests that a change in DSRs of this magnitude is associated with an increase of ~60% in consolidated PCLs for the Big Six, or an additional 17 bps by 2020. This would mark the highest level for PCLs since 2010. We find that changes in the DSR for Canadian households is a strong leading indicator for turns in the PCL cycle.
3. The acceleration of potential PCL recognition under IFRS 9, if and when consumer credit deteriorates;
When the credit cycle turns, IFRS 9 is likely to accelerate recognition of PCLs: Under prior rules, recognition of credit losses developed slowly and only when indicators of impairment emerged, which explains the two-year historical lag observed between rising DSRs and higher PCLs. This time, however, IFRS 9 is expected to trigger earlier recognition based on an ‘expected loss’ model, such that we expect our predicted increase in PCLs to happen as early as 2019.
There is little doubt that the risks to the Canadian economy have been heightened by the stretched consumer market. It is difficult to time the saturation point, but there are two main catalysts giving credence to Veritas’ argument that the turn may be upon us.
The first is the rise in interest rates. The Federal Reserve has been raising rates somewhat aggressively (at least for the post-GFC world) and the Bank of Canada is forced to tag along. Higher rates will not be kind to an over-indebted consumer.
The second is last year’s change in the mortgage rules by the Canadian Federal Government which tightened credit for mortgages by requiring individuals prove they can afford the same mortgage at a higher interest rate.
These two factors will put a crimp in the rate of Canadian household debt expansion. This will make continued Canadian bank outperformance more difficult.
Bank Friendly Canadian Tax Rates in the Rear-View Mirror
The Canada Revenue Agency (CRA) has become increasingly focused on protecting the Canadian tax base, and corporations, including the banks, have not been immune from this attention. The CRA has become more aggressive in challenging Canadian banks’ approaches to managing down their tax rates. This has included new legislation attacking “dividend rental arrangements” and “synthetic equity arrangements” as well as the offshore booking of revenue from various business lines. In addition to the new legislation, CRA is challenging the banks in court in respect of many prior years’ filing positions on a number of these items, with the quantum in question running into the billions. Bank analysts have written about these matters in detail.
The Bull Case for American Banks
South of the border, on the other hand, the tax environment is becoming more friendly. Last year’s corporate income tax cut in the United States will have a prodigious effect on the earnings power of U.S. banks going forward.
The Harvard Business Review recently had an insightful interview with Mihir Desai, professor of finance at Harvard Business School, that explains the dramatic changes in depth (excerpt):
SARAH GREEN CARMICHAEL: Do you have an opinion on the … biggest changes to the corporate tax code?
MIHIR DESAI: … I think the first place that one has to start is on just the rate, which is, it’s a really significant cut to the rate, from 35 percent to 21 percent. And that I think is just the first piece of the puzzle, and it is an enormously expensive thing to do—probably around more than $1.3 trillion. And in many ways, that is one of the parts of the bill to like, meaning our statutory rate had been out of whack with the rest of the world, and that led to a lot of transfer pricing abuses, bad investment incentives, and so getting it down to 20-plus percent I think is a good idea, at least partly a good idea.
SARAH GREEN CARMICHAEL: So, this corporate tax rate cut. The argument there has been that this lowering of the corporate tax rate will convince more companies to stay inside the United States or to locate their headquarters here, and that will create jobs. Is that an argument that you think holds water?
MIHIR DESAI: I think it’s an argument that holds water, but not to the degree that it’s been emphasized by the administration. So, it’s clear that the corporate tax system was broken. It’s clear that corporations were trying many tricks to try to leave the United States, and that was a sign of just literally how broken it was. And so, corporations were willing to do mergers with U.K. companies solely for the purpose of trying to leave the United States. And that is a symptom of a deep structural problem that we needed to fix with a change in the rate. And so, I think that’s powerful, and that’s helpful, and that will help keep corporations here who are domiciled here and headquartered here. It can also help with investment in the United States.
Almost overnight, the tax rate for the U.S. banks has declined from 30%+ to a level much more even with Canadian banks.
On top of that direct tax reduction, American banks will benefit for a period of time from the general increase in economic activity that will result from the tax cuts. More American jobs and business activity will allow the banks to leverage their earnings to the improving economy.
The years of American banks paying 1000 basis points more in tax than their Canadian counterparts have suddenly disappeared.
Deregulation in America
Although trade rhetoric and geopolitical posturing get all the attention, Trump has passed a number of initiatives that have dramatically reduced regulation.
The Regulatory Reform: Two-for-One and Regulatory Cost Caps directed agencies to eliminate two regulations for each new one and to reduce net regulators’ costs.
In addition, in March of this year, the government passed legislation that rewrote parts of the 2010 Dodd-Frank Act. The bill made it such that banks with assets less than $100 billion would be freed from certain oversight requirements. The bill also offers relief in the mortgage lending space, easing appraisal requirements on certain mortgage loans, and it exempts small banks from certain disclosure rules.
A new business friendly climate has been thrust upon the U.S. economy. It’s more than just lower taxes.
U.S. Banks Are Poised to Outperform Canadian Banks Over the Next Decade
The Canadian banking sector has more than its share of challenges ahead of it. The economy faces a multitude of consumer credit challenges. And barring significant legislative changes, Canadian bank tax rates may be set to edge higher due to the removal of certain tax-saving trading and booking strategies. This comes at a time when Canadian bank valuations are stretched to the upside, with years of outperformance leading investors to believe owning Canadian banks is a sure thing.
Contrast that to America where they are in the midst of de-regulating, cutting taxes and instituting business-friendly policies. Further, the American consumer has much more room to expand credit when compared to the Canadian consumer.
American banks have substantially underperformed their Canadian counterparts for the past two decades, but that trend may be about to change.
And although you would expect the U.S. banks to instantly discount the change in the tax rate, the rise in U.S. bank stocks compared to Canadian bank stocks since the tax cut has been somewhat muted.
U.S. banks sprinted higher in late 2017 and early 2018, but have since had difficulties continuing the rally. And, although the U.S. bank index price-to-book ratio has risen, it is still below the Canadian bank index.
In short, U.S. banks have discounted some of the tax cut good news, but nowhere near as much as one might have assumed.
Long only funds should consider swapping Canadian banks with U.S. banks. Or, for those looking for a way to play the Canadian banks from the short side, a long U.S. / short Canadian bank position may make sense.
The days of relatively lower taxes and an ever-expanding consumer credit cycle for the Canadian banks are most likely in the rear-view mirror. America has lowered corporate taxes, eased regulation and has a consumer much more able to expand their borrowing (especially on a relative basis versus Canadian consumers). The odds favour an end to the two decades long outperformance that Canadian banks have enjoyed versus their American counterparts. Investors should think about adjusting their portfolios accordingly.