Bank on it: the state of Canadian financial institutions in the wake of bank failures abroad

The financial community was rocked by a string of bank failures in March. The failures of Silicon Valley Bank and Signature Bank in the United States could have been seen as isolated events, given their significant ties to the tech community that had seen a major downturn in recent months. But investors were rattled even further when Credit Suisse, one of the 30 global systemically important banks, was acquired by rival UBS to prevent the former’s collapse, followed weeks later by the collapse of First Republic Bank, which became the second-largest bank failure in U.S. history. The banking community was put on notice, including in Canada, where banks play a huge role in the economy.

Given the interconnectedness of the banking system, are Canadian banks at risk? What differentiates them from their peers abroad? We explore the state of Canadian banks. 

Canadian banks have strength in numbers

Canadian banks started the year off on very strong financial footing and only strengthened heading into the aforementioned banking volatility. Citing “systemic vulnerabilities [which] remain elevated,” Canada’s bank regulator, the Office of the Superintendent of Financial Institutions, increased capital requirements for the country’s six largest banks in December 2022. Banks seem well positioned to deal with any such “vulnerabilities”: As of the fourth quarter of 2022, capital ratios for all banks in the country stood at 17.32%, the highest ratio since well before the Global Financial Crisis (GFC).

Not only are capital ratios much higher than where they were pre-GFC, but the quality of capital has also improved dramatically, being more focused on common equity capital than hybrid securities and debt. Moreover, the hybrid securities now have specific clauses that convert them into equity if a bank is deemed to have failed (which wasn’t the case before the GFC), providing a clearer path to orderly resolution if the bank fails.

Beyond having healthy capital ratios, one of the most attractive characteristics of Canadian banks is their reputation—both domestically and internationally—and the trust of the financial community. Banking is a unique sector due to its interconnectedness; in other words, each bank is somewhat dependent on its competitors, making the viability of the banks dependent on the system as a whole—a system that we believe is one of the most sound in the world. No Canadian bank has failed since 1996, which is in stark contrast to the more than 500 banks that have failed in the United States since the GFC.

Canadian banks, however, can’t rest on their laurels: They’re expected to deliver financial results, even through tough economic times. Financially speaking, Canadian banks are above their international peers, with a return on equity of 14.12% that’s well above their peers abroad.

Source: Bloomberg, Manulife Investment Management, as of April 26, 2023. It is not possible to invest directly in an index.

A case of contagion

Unfortunately, contagion is a very real thing, particularly in the banking world. As we saw with Silicon Valley Bank (SVB) and Signature Bank, investor and depositor panic can quickly spill over to other banks. This was so in the case of Credit Suisse (CS), particularly as it concerns who was—and, more importantly, who wasn’t—bailed out.

In the case of CS, shareholders were somewhat compensated, receiving 1 UBS share for every 22.48 CS shares. This is despite the fact that holders of CS’s 16 billion Swiss francs’ worth of Additional Tier 1 (AT1) bonds—in other words, creditors—got wiped out entirely. This goes against the classic hierarchy of restitution, in which creditors would be paid out before equity holders, and it came as a shock to investors. British, European, and Canadian bank regulators (among others) were quick to issue statements saying that in the case of bank failures in their respective regions, they would respect the creditor hierarchy and that shareholders would be the first to absorb losses.  

Despite the reassurance, AT1 bonds sold off and spreads widened as the market considered them to be a riskier investment in the wake of the Swiss bank regulator’s decision to write down the entire value of CS’s AT1 bonds. On the surface, this could be a financial threat to banks: Regulators require them to hold a certain amount of AT1 capital and, therefore, issuing at higher spreads could hurt bottom lines.

But we believe the rise in AT1 spreads will be a nonissue for Canadian banks for two reasons. First, since this AT1 spread increase was a result of market panic, we think it will be short-lived, as nothing fundamental from a risk perspective has changed for Canadian banks that would justify a sustained increase in yields; in fact, we’re already seeing spreads come back in from their recent highs. Second, with the comfortable capitalization position they’re in—well above regulatory minimums—we don’t foresee the need to issue much debt in the near term, so even if spreads were to remain elevated, they wouldn’t affect funding costs. 

Major differences between Canadian banks and failed U.S. banks

Although contagion is a very real risk, we believe that those who follow Canadian banks know that they’re very different from Silicon Valley Bank for several reasons.

• Asset portfolio—The failing banks had a very large portfolio of fixed-income securities relative to their balance sheet, while Canadian banks are much more tilted to loans, making the latter’s balance sheets less susceptible to market movements.
• Balance sheet regulations—SVB benefited from a regulatory loophole that enabled it to conceal unrealized losses on available-for-sale (AFS) securities. This loophole—which the U.S. Federal Reserve is reportedly considering ending—meant SVB had an artificially inflated amount of capital for regulatory purposes. Canadian banks mark their AFS securities to market for purposes of calculating their capital ratios, so any unrealized losses that become realized shouldn’t affect capital ratios.
• Concentration risk—SVB’s deposits were significantly more concentrated in terms of geography and industry (namely, California and the tech sector), whereas major Canadian banks generally have operations nationwide (and abroad) and with a much more diverse client base.
• Deposit insurance—SVB and Signature Bank relied on significant amounts of uninsured deposits (about 94% and 90%, respectively) so when concerns around their solvency began to grow, clients were incentivized to withdraw their funds, creating a bank run. Major Canadian banks have significantly smaller proportions of uninsured deposits—about 65%¹—so there’s less risk of a bank run as more funds are insured.  

Given these differences, we’re made even more confident by the fact that Canadian banks saw stable to slightly rising deposits during the first quarter of 2023, confirming that the market understands that they’re a very different beast than the failed banks in the United States.  

Rate rise risks

One thing that’s on our banking radar is the significant rise in interest rates, from both a cost and revenue point of view.

Regarding the former, as rates rise, banks would be expected to increase rates offered on deposits and money market instruments such as guaranteed investment certificates (GICs)—one of the largest sources of funding for banks. Yet we’re hearing that while their American counterparts are competing for deposits by raising the rates offered to clients, Canadian banks—in the enviable position of not necessarily needing the liquidity—may have the benefit of a lower deposit beta and are therefore not feeling the need to raise deposit rates to the same degree.

That’s not to say that funding costs from deposits haven’t gone up: One-year GIC rates have increased by about 275 basis points (bps) since their lows of 2020. But in that same time span, the Bank of Canada (BoC) policy rate has increased by 425bps, demonstrating that banks haven’t had to pass off the full policy rate increase to consumers in the form of higher deposit rates. Although we’ve likely hit the peak of interest rates in the near term, as investors in certain Canadian banks, it’s comforting to know that they’re not pressured to follow the exact path of the BoC. 

Source: Statistics Canada, Manulife Investment Management, as of April 26, 2023. GIC refers to a guaranteed investment certificate. BoC refers to the Bank of Canada.

From a revenue perspective, higher rates should be a boon as interest on loans should increase. Indeed, net interest income among Canada’s six largest banks grew by 11.3% (CAD$102 billion) in 2022 over 2021.² But while higher rates are clearly a tailwind for banks, we also caution that this tailwind could easily change direction: Rising rates can create credit and liquidity problems for consumers and mortgage holders, leading them to remove more cash from their deposit accounts to pay for everyday necessities (particularly as costs for these necessities have risen significantly in recent times). If this happens, banks might turn to competing on rates to lure back deposits, which could hurt their bottom line. We’re therefore keeping a close watch on bank deposit rates.

Banks are resilient in the face of the housing market

Speaking of rising rates, we should mention the national elephant in the room: the Canadian housing market. With one of the hottest real estate markets in the world over the last decade, there have been plenty of predictions of a housing crash and the subsequent negative effects it would have on banks. That rhetoric has increased even more over the last year as higher interest rates have hurt the pockets of those with variable rate mortgages and those having to renew their mortgages at higher levels.  

We aren’t in the camp of those who foresee a major housing crash or major detrimental effects on Canadian banks in the near term. While we’ve seen softening in housing prices across the country (to the tune of about 15.5% in March 2023 from a year earlier), we haven’t seen those translate into mortgage delinquencies (which are a leading indicator for nonperforming loans on bank balance sheets). In fact, mortgages in arrears are near their lowest levels in decades, while even credit card delinquencies are well below prepandemic levels.

Beyond the indicators, regulatory changes to mortgages give us increased confidence in Canadian banks’ balance sheets. While rising rates have inflicted pain on homeowners, most of those homeowners have been subject to mortgage qualification stress tests introduced in 2016 and strengthened several times over the years. This means that the average Canadian mortgagor should be able to weather further house price downturns, reducing the potential losses on Canadian banks. In addition, most of the pain of rate hikes is likely behind us, as the BoC has telegraphed its intention to keep rates on pause barring any major economic developments.   

Finally, even if mortgage delinquencies do begin to rise, the effect on most banks’ performance should be muted—or, at least, more muted than it would have been a few years ago—thanks to the rise in non-bank lenders over the years. So-called alternative lenders have taken an increasing share of mortgages of late, particularly as rates began to rise. The big six banks have a market share of about 73% of outstanding mortgages, while non-bank lenders have about 2%. However, non-bank lenders extended their share of new mortgages to 7% in the second quarter of 2022, suggesting that more and more borrowers are flocking to non-bank lenders.³ And while fewer mortgages might sound bad for banks, the reality is that these mortgages are also higher risk: According to the Canada Mortgage and Housing Corporation, alternative lenders attract “a higher number of borrowers that were not able to get qualified with a traditional lender in the context of rapidly rising interest rates.”³ In other words, this may not be the type of mortgage customer that a risk-averse bank would want.

In short, considering the low leading indicators of nonperforming loans, the strengthened regulations around borrowers, and the fact that riskier borrowers are turning more toward non-bank lenders, we believe that Canadian banks are well positioned to face any further housing market deterioration.

Canadian banks are uniquely positioned to succeed

The Canadian banking system isn’t an island, as its big six lenders certainly have ties and vulnerabilities to financial institutions outside of the country. But their financial prowess, healthy capitalization, strong regulatory framework, and reputation as stalwarts of the global financial community do somewhat insulate them from events that happen to their peers abroad. Come what may in the Canadian and global economy, we believe Canadian banks are well positioned to continue performing.

1 www.reuters.com/markets/canadas-deposit-insurer-reviewing-insurance-deposit-limits-trade-group-2023-03-21/ 2 Banking in transition: Fiscal year 2022 results analysis,” KPMG, January 2023. 3 Residential Mortgage Industry Report, Fall 2022 Edition, Canada Mortgage and Housing Corporation.