-Discover why bank failures are unlikely to happen in Canada despite periodic market turbulence -Learn about the health of financial sector investments over the long-term -Uncover how Canada might navigate a potential recession in 2023-2024
In a time of global economic uncertainty, concerns about how the US banking crisis might impact Canadian banks and the overall economy, have emerged. But it’s time to put those worries to rest. The Canadian financial system stands on solid ground, compared to its American counterparts.
In this Smart Advice episode, we delve into the state of the Canadian economy, with senior equity research analyst David Andrich. With a keen eye on bank stocks and their implications, Andrich shares his optimism for the Canadian economy despite some potential headwinds.
For those seeking a deeper understanding of how Canada’s well-structured financial system acts as a safeguard against turbulent economic conditions, this episode is for you.
Carissa Lucreziano: Welcome to Smart Advice, a podcast bringing you financial advice, investment strategies and economic trends. I'm CIBC’s financial advice expert, Carissa Lucreziano, and today, we're zeroing in on the big players in the Canadian banking sector. With the top six banks making up over 20% of the TSX composite, bank stocks are a staple in many investment portfolios. Known for their steady long term performance, they're like the trustee compass for many investors navigating the investment landscape.
But with some recent shakeups in the banking world, including takeovers at Silicon Valley Bank, and First Republic Bank in the US, it's a good time to take a closer look at the muscle of our Canadian banks. Whether you're an investor or you want to learn more about how Canada might navigate a recession in 2023, 2024, this episode is for you.
With banks taking up more space in the news recently, we know it's a hot topic for many Canadians. To help us dig in. I've invited my colleague David Andrich, senior equity research analyst with CIBC asset management. David's always busy extracting the latest views and trends in the Canadian financial sector, and the REIT market. And he's just co authored a detailed white paper on the state of Canadian banks.
David, thank you so much for being with me today.
David Andrich: Yeah, no, thank you for having me.
Carissa: Yeah, I think we last caught up in October 2022. When we talked about the rising rate environment in detail, we were in the midst of it, Bank of Canada was at a target rate of 3.25. And we've had another three rate hikes since we last spoke.
But today, I know you're gonna give us the goods on the trends of the Canadian banking sector. So let's get right into it. In Canada, we've got sizeable banks, they’re known for being solid, dependable, lots of structure and rigorous attention to diversification of their businesses, a reputation that was upheld during tough times of 2008, 2009.
Even with this history of such stability, though, some investors have been selling off some of their financial stocks, based on concerns the recent activities in the US will hit home. So should we be concerned in Canada? Is our banking system sheltered from what's going on in the US?
David: So I think in terms of Canadian banks, in particular, Canadian investors, and also Canadian deposit holders, I don't think that we need to be overly concerned about what has been going on with US banks, and particularly us regional banks, and any spillover effects onto Canadian banks. There's a number of reasons for that, why I think the Canadian banking sector is going to be much more resilient and stable.
I'd say first of all, Canada, in general, is a country, we are much more regulated, probably across me and most aspects of our life and financials and our banking system, as well. And so the Canadian regulator is much more intertwined in the Canadian banking operations than in the US. And especially in US regional banks, where we've seen these issues flare up with Silicon Valley Bank and First Republic.
So in the US, there are over 4500 banks, you can contrast that with Canada, where we basically have six major banks and maybe another dozen or so kind of material financial institutions, couple smaller regional banks and credit unions of size. So just the sheer number of US banks, it makes it that much more difficult for us regulators, to apply the same kind of scrutiny to each individual bank, the more Canadian regulators can, and the historic stability of the Canadian banking system reflects that ability to really drill in as regulators.
So I mean, since 2013, over the past 10 years, there have actually been 73 bank failures in the US, and Canada has not had a major bank failure in nearly 100 years. So, most of those US bank failures would have been very small kind of regional banks. But it still gives you some idea that is not an uncommon event in the US. It's just more recently, we've seen some larger regional banks fail. And that's what sparked some concern.
The circumstances surrounding the failure of Silicon Valley Bank and first republic bank were very specific. Both situations were similar, but with a slightly different twist. Both situations essentially revolved around the material asset liability mismatch that resulted in a reduction in liquidity. So when the wider kind of market and deposit holders started to have fears around the liquidity and ability to withdraw funds from those banks, it led to a run on both of those banks, essentially.
To be fair, Silicon Valley Bank apparently saw 42 billion withdrawals in a single day, the largest previous bank failure had seen 11 billion of deposit withdrawals, but over the span of a week, and so gives you some idea of kind of the materiality and you know, the extreme nature of what Silicon Valley Bank went through. And part of that is because Silicon Valley was very concentrated, focused on the tech community, and particularly had a large deposit base from tech in the innovation economy. And that created a large concentration of deposit holders.
So when worries began to spring up about the ability to make withdrawals, it spread very quickly amongst their deposit base. Because they had such a high concentration of uninsured deposit holders, you know, these very large, very chunky accounts, people started to withdraw them en masse.
Some of the accounts I'd heard of that, apparently, people were so desperate to withdraw their corporate funds from Silicon Valley Bank, that they were actually transferring those funds to their CEOs personal bank accounts, because they didn't have a backup bank account to transfer them to, but they just knew they wanted to get them out Silicon Valley Bank. I mean, that's kind of desperation that people were in.
As a side, you know, one of our fixed income team members, he's worked on treasury desk for a number of US regional banks. And one thing that's very different about the US regional banks and how they run, is they’re not active in terms of hedging their interest rate risk, whereas Canadian banks are very active in terms of hedging interest rate risk, and try to prevent that mismatch in terms of assets and liabilities.
And in terms of Silicon Valley Bank and First Republic, as I mentioned, both had very high concentrations of uninsured deposits, these deposits above USD250,000 are not insured by the FDIC, the Federal Deposit Insurance Corporation. And so because they're not insured, they're at greater risk of flight.
If you're a deposit holder with those kind of large deposits, and you're worried about the ability to withdraw them, you're going to just withdraw those funds right away, and you're not going to wait and see what happens. Whereas if you have insurance, then you may not be so quick to kind of withdraw the funds because, you know, essentially the federal government's backing you. And so, Silicon Bank, as I mentioned, was concentrated tech. And FRC was more focused on mass affluence, so very targeted deposit basis.
And then you can contrast that with the Canadian banks that cater to individuals and corporations across Canada. And so they have a very wide and diversified deposit base. And so you just have a lot more diversification benefits and you don't see that kind of, you know, concentration risk in terms of deposits that what Silicon Valley Bank and FRC saw.
The other aspect that's, I think, interesting to flag is just the amount of liquidity that was unleashed in the US economy during COVID. So, I mean, Canada had its own stimulus and its own support programs. But it wasn't nearly to the scale of liquidity that the US economy saw. And because of that liquidity being unleashed into the US economy, US Bank saw massive inflows of deposits.
What they should have done was trade those excess deposits really as kind of temporary, but the mistake that I think Silicon Valley Bank and FRC made was that they traded them as longer term deposits, and they didn't see that there would be a reversal at some point. So basically, what they did is in the case of Silicon Valley Bank, they invested them in long term fixed income instruments, typically kind of nine or 10 years, very high quality instruments. So those you know, very little risk of or any risk of credit default, but it locked them in for these high duration bonds at very low interest rates during COVID. So 2020, and 2021.
So when rates began to rise in 2022, the value of these bonds fell in value and created unrealized losses. They couldn't sell them to get liquidity. With First R of didepublic, they kind something similar.
But instead of taking those excess deposits and putting them into the fixed income market, they basically just issued personal mortgages. But they issued those personal mortgages at below market rates. And so as soon as they issued the mortgage, it essentially had an unrealized loss attached to it if it was marked to market, and again, that created, you know, a lack of liquidity for those assets. Because if they want to sell them, they would have to take losses on them.
So when you combine that with then a reversal of interest rates, interest rates going up, and the US government starting quantitative tightening, they were starting to withdraw funds from the system, and a deposit base is starting to decline. And then on top of that, particularly in the US, you've had a really strong swing from people shifting cashed deposits out of the banks, either into essentially US version of GICs, or also shifting them to money market mutual funds, because now interest rates are at a level where you can actually get some material yield. And that's withdrawing a lot of liquidity, a lot of deposits from the system.
So that's kind of the higher level dynamic that’s going on in the US. But again, it's a matter of the fact that there's been so much excess deposits in the system to date. And then Silicon Valley Bank and First Republic were just on the very extreme end of that, in terms of how they mishandled that asset liability mismatch, and then saw a very extreme withdrawal, or very, like accelerated pace relative to the bank.
So again, all this is kind of to say that in Canada, we just don't see those types of extreme movements either in deposits building up, deposits being withdrawn. It's a much more gradual market, and the banks run a much tighter ship in terms of asset liability management. So really, the only kind of flow through that we've seen to Canadian banks has actually been to kind of some cross ownership.
So TD owns a 12% stake in Schwab. And Schwab has seen, you know, some modest shifting out of deposits into money market mutual funds. And because they have to replace those deposits with, you know, higher cost deposit just going away on their name going forward. And lower name means lower earnings then that lower earnings flows through into TD, creates a little bit of a drag on TDs earnings.
So there's been some flow through from that, but fundamentally, from a US perspective, it's probably benefited a couple banks as well. So BMO and Royal, you know, they both have a pretty significant presence on the west coast in the US and California. So they've probably benefited from some other outflows from Silicon Valley Bank and First Republic as people look for alternative places to put them. That's kind of a nutshell, wy I feel pretty confident that we're not going to see material implications in the Canadian banking system from what's going on in the US and the US should be fairly isolated.
Carissa: Yeah, well, that was a great way to break it down, like, first of all, 100 years is a great track record for Canada. But you know, after you went through all those different components, and connecting all the dots, it truly seems like a different story for Canada, like from the number of banks that you mentioned, to the regulatory parameters, targeted deposit base and the mass movement of deposits.
So yeah, a great recap. Thank you for taking us through that. I read your recent report, “Continued Confidence in Banks Despite Global Market Volatility”. And you summarize some great insights. It's a jam packed piece on the banking center. So thank you for putting that together.
David: Oh, thank you.
Carissa: In your report, you painted a pretty upbeat picture about bank valuations, trending around historical averages. And that, like typically Canadian bank stocks have outperformed the market in a recession. However, there are other views that are a bit more cautious, worrying about the troubles in the US banks having a domino effect the side of the border.
I know you just mentioned all of the reasons why that wouldn't happen. But when do you anticipate Canadian banks being on sale? I know you just mentioned, we should be very confident in our banking system, we should be confident in the banks in general. But when do you think they'll be on sale for investors to feel that confidence to dive back in?
David: I mean, I think generally at the moment, Canadian bank valuations are actually pretty attractive relative to their long term history. So most Canadian banks are trading at a discount to the long term price to book value generally on one standard deviation below. And if you're a longer term holder, that's pretty good entry point. Although I think, you know, in the near term, there could be some further headwinds, as you mentioned.
So the last little year or two, banks have had some pretty significant tailwinds. First of all, coming out of COVID, they had very material provisions for credit losses. PCLs that had been built up in anticipation of a strong downturn in the economy and a lot of defaults and credit losses. And because of government stimulus, we never saw that. And so those PCLs have been being released Oct. 2021, and a little bit over 2022, as well.
So that's provided nice tailwind for earnings. And then you've also had very strong loan growth, both on the retail and the commercial side, because of ultra low interest rates that we've seen. And, you know, we've seen that with mortgages in particular in the Canadian economy. And so that's again, but another very strong tailwind for the cane banks.
Over the past year, despite concerns more recently about recessionary conditions, etc, the increase in interest rates over the past four months or so has helped new banks expand their NIM over that time period. Now, that's probably plateaued and we'll probably see a little bit more expansion, but the pace of that expansion has slowed, serially, and will likely remain fairly muted over the rest of 2023.
So essentially, what you've seen is, a lot of these tailwinds will start to reverse and turn into headwinds for the Canadian banks. And then an additional headwind could be if we start to see recessionary conditions emerge going forward, the PCL bills will start to increase. So PCL will go from being released to being a build up. And that's going to be an additional headwind.
But I guess on the positive side, a lot of that has already been priced into the valuations of these bank stocks, as I mentioned, and typically the trading with maybe one or two exceptions. So trading apps, you know, standard deviation will over the long term price to book value. So you could see a little bit more downside risk over the next six months or so. But as a longer term investor, it'll be a good entry point.
Carissa: So let's go a little bit more macro. Now. We know that the banks are a barometer of the bigger picture of the Canadian economy. After eight rate hikes since March 2022. The Canadian consumer is still spending. Inflation has just creeped up in May. And it looks like our pause on rate hikes could be short lived. I would love your view on the health of Canadian consumers. A lot of questions on this that come from Canadians in general and clients. What's your thoughts of the Canadian consumer and the Canadian economy in general?
David: I think a lot of people, including myself, have actually been pleasantly surprised at how resilient the Canadian economy has been given the massive interest rates that we've seen. So as you mentioned, rates have increased at an historic rate we went from a low of 25 basis points during COVID and starting from March 2022, they've risen another forum 25 basis points to 4.5% by January of this year. so it's up 425 basis points increase in just 10 months. That's a pretty aggressive series of rate increases.
And you have to keep in mind that the Canadian economy is more geared to interest rates than the US economy, particularly because of the structure of our mortgage market. So in the US, the standard mortgage is typically a 30 year fixed rate mortgage, that's probably somewhere like 95% of all mortgages sold in the US.
So rate increases in the US really only impact new homebuyers, because the current owners are already locked in. Whereas in Canada, you know, if you look at our standard mortgage is typically a five year fixed. And so you see about 18% of mortgages renew every year typically. And if you're renewing, and so you know, a higher mortgage rate environment, and you're facing higher payments, then that's going to create a drag on your disposable income essentially.
Now, I think there's been a couple things that have helped kind of buffer or helped cushion this, because we haven't actually seen, despite these pretty historic rate increases, and you're in the Canadian economy, we've seen inflation come down, as we've been hoping it would. Unemployment has made really strong towards record low levels of unemployment, and consumer spending has actually been pretty resilient.
And then in terms of, you know, loan delinquencies and such, they've been steadily normalizing since COVID. But they're still kind of at or even maybe a little bit below pre COVID levels. So we haven't really seen a strong credit cycle emerge yet, despite all this aggressive increasing interest rates.
So and I think the things that are helping buffer this is, it takes typically 12 to 18 months for the rate increases to roll through the economy. And so you know, as of today, we're probably only seeing the impact of the first 75, or maybe 100 basis points start to come through. And so as we go through the rest of the year, we'll see the balance of those rate increases start to flow through and have an impact.
I think the other thing as well is that a lot of mortgage holders early renewed in 2020 and 2021, when interest rates were at record lows, and mortgage rates were at record lows, and so they lock them in. And so you know, over 2023 and 24, instead of seeing like a typical kind of new 18% of mortgage holders roll over to renew the mortgages, that number would probably be closer to kind of like 11 or 12% a year.
So you know, it's running at I would say like a lower lower number than what you would expect. And then that will probably pick up in 2025, and 2026. Because then the people who early renewed that mortgages in 2020, and 2021, will then start to see their mortgage rules come up and then see a larger increase in the cost of their mortgages, mortgage payments.
And then the third thing I think, has really provided the buffer. And this is harder to quantify from the outside. But you know, the average Canadian still has a lot of savings leftover from COVID. So because people can travel during COVID, they are stuck at home. And there's a lot of government stimulus being released, Canadians did build up quite a bit of savings.
People have been drawing that down over time. I think that's helped buffer, you know, the higher inflation that we've seen, as well as the higher mortgage costs for people that that excess savings is getting drawn down. And when I was speaking with the large Canadian banks, you know, earlier this year, they felt that it would get drawn over the next 12 to 18 months. And so that kind of brings us to the second half of 2024.
So I think the second half of those 24 is important because that's where we could start to see higher mortgage payments start to roll through the economy, because then you've had kind of a year and a half, two years of renewals. And then also, with the savings being drawn down at the same time, that's when you could kind of see the two intersect.
That starts to bite on consumer spending. Now, for that reason, I guess my own personal view is I think you'll probably see the Bank of Canada, maybe dial back on the rates a little bit towards maybe mid 2024, or the early half of 2024, because when they see all this data from the large Canadian banks, and so they can kind of see this happening. And I think they'll probably want to just dial back and release a little bit of pressure before things become too much for people.
Carissa:
Yeah, that's what I was gonna ask you like, if we're starting to feel the impact of just the initial rate increases, like you mentioned, it takes you said 12 to 18 months to go through it. Does the Bank of Canada still raise rates? When do they start to give some relief? Because, I mean, there's a lot of pressure out there. But if we haven't started to feel the entire impact of it, it may get a little bit more challenging before it gets better.
David: Yeah, no, absolutely. I mean, it will continue to act as a drag until the bank starts to back off on interest rates for sure. And yeah, I mean, it will probably take another 12 months or so before we see the full effect roll through the economy.
Carissa: So then just lastly, though, have some great insights. So you lightly mentioned recession in your white paper. How do you see the next, call it 12 to 18 months? Do you see a further dip into what we would actually define as a recession? Or do you see the continuation of what we're going through right now?
David: Yeah, so probably expect conditions to continue as they are throughout 2023. I think that tipping point will be kind of around mid-2024, or potentially kind of Q2 2024. That savings will intersect with the higher mortgage costs rolling through the system, and then you know, the other impacts of higher interest rates come through. And that's probably kind of where it really starts to bite in terms of consumer spending. And you know, people pulling back on spending and that having a further widespread impact on the economy. So I feel like you know, for the first half of 2024 is where you really start to see it come through.
Carissa: David, thank you so much for joining me in this conversation today. It was a pleasure to have you on the podcast. You've given us some factual insights to digest and considerations for investors in the Canadian banking sector.
David: Oh, great, thank you.
Carissa: If you're interested in reading “Continued Confidence in Banks Despite Global Market Volatility” by David Andrich, and co-written by Ryan Diamant, you can find it on cibc.com/assetmanagement. And on the investment front, while there's a good long term case to consider holding Canadian banks, staying well diversified across sectors with a broad range of high quality dividend paying companies is always a good strategy.
These are the companies with staying power through the ups and downs of the market. Thank you to our listeners for tuning in to this episode of Smart Advice. To make sure you never miss an episode, subscribe or follow on your favorite podcast platform and visit us for more advice at cibc.com/smartadvice.