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Canada’s banks: a world-class industry

Before the crisis, Canada’s banks were derided for being too cautious. Now look at them. Having been ranked the soundest on the planet for the sixth year running, Canada’s banking system is the envy of the financial world. Philip Moore reports.

Canada’s banks could be forgiven for becoming blasé about the accolades they have been given on an apparently uninterrupted basis since the global financial crisis began. The most recent of these, in early September, was the now predictable announcement by the World Economic Forum that Canada’s banks were ranked as the soundest on the planet in 2013 — just as they were in each of the previous five years. 

Banks in the US and the UK, ranked 58th and 105th respectively in this year’s Global Competitiveness Report, will now be casting covetous glances at a banking system once stereotyped as over-cautious. “Pre-crisis the criticism from abroad was that Canadian banks were unnecessarily risk-averse and had too much capital,” says Craig Wright, chief economist at Royal Bank of Canada in Toronto. “Now we’re seeing that that was not such a bad thing after all, and, in fact, many banking systems around the world are looking to copy the Canadian model.”

For at least one bank, maintaining a high capital level that was sneered at by other banks before the crisis directly helped to turbocharge growth after the downturn. “Pre-crisis, Scotiabank was sitting with a high tier one capital ratio under Basel II standards — well beyond regulatory standards,” said Richard E Waugh, chief executive of Scotiabank, in a speech earlier this month. “It was high enough that we were being criticised by some analysts for not undertaking share buybacks or special dividends.

“Because of our high capital levels and a return on equity that remained in the high teens, we were the only Canadian bank that did not have to issue equity during the crisis period — and we were able to deploy capital to take advantage of a number of strategic acquisitions. In fact, since the crisis we’ve made some 40 acquisitions for more than $40bn.”

The envy of the world

Given the intensity of the focus on capital within the global banking system, it is little wonder that Canada’s banks have been increasingly regarded as the envy of many of their US and European competitors. As Mark Carney said in his last speech as governor of the Bank of Canada, in May: “Since the crisis, Canadian banks have become considerably stronger. Their common equity capital has increased by 80%, or $77bn, and they already meet the new Basel III capital requirements six full years ahead of schedule.” 

On a fully implemented basis, the six largest banks reported an average Basel III tier one common equity ratio of 8.4% at the end of 2012. 

Canadian banks’ innate conservatism does not seem to have done any harm to their performance, as their recent results amply illustrate. Fitch noted in its review of 2012 that “the major Canadian banks maintained consistent earnings trends driven by volume growth in retail and commercial banking, still modest provisioning expenses, and a strong rebound in capital markets-related activity.” 

The result was an increase of more than 18% in net income at the Big Six in 2012. And although Fitch’s report cautioned that the backdrop for future earnings performance would become progressively more challenging, there was little sign of any pressure building in the banks’ recently announced third quarter results. Quite the reverse. Operating cash EPS rose by 4% from Q3/2012, according to research published by BMO Capital Markets, which was 6% ahead of expectations. 

Growth in the banking system has underpinned a continued rise in capital market issuance in 2013. In marked contrast to Europe, where new issuance from the deleveraging FIG sector has nosedived over the last year or so, the primary market for Canada’s banks remains very active. According to data published by BMO Capital Markets, by early August total issuance of term debt (defined as deals of $100m or more with a maturity of more than two years) had reached C$61.2bn. The lion’s share of that total is accounted for by deposit notes in the domestic market, which by early August had contributed a record C$27.7bn of Canadian bank funding.

George Lazarevski, research analyst at BMO in Toronto, says that there have been three main drivers of elevated issuance among Canadian banks in 2013. The first is the record volume of maturing issues in 2013, at $54.1bn across all currencies.

A second driver of heavy issuance in 2013, says Lazarevski, has been refinancing by the banks of the remaining $50.1bn of mortgages securitised under the Insured Mortgage Payment Programme (IMPP). This was set up by the government as a temporary measure in 2008 to address the liquidity crunch that restricted access to credit for many corporate customers at the height of the crisis. 

The third explanation for increased FI issuance this year has been stronger than expected loan growth, in spite of more onerous guidelines imposed by the Office of the Superintendent of Financial Institutions (OSFI), says Lazarevski. 

According to the BMO data, the Canadian banks were especially active outside the domestic market in the first seven months of 2013, raising $33.5bn in international markets, of which $26.2bn was in senior debt and Yankees CDs issued in the US. 

For Canada’s leading bank issuers with the largest funding needs, the US market is too deep and too close at hand to overlook as a competitive source of funding diversification. Take the example of an issuer like RBC, Canada’s largest bank by market capitalisation, which raised over $21bn in wholesale markets in the first three quarters of this year, just under $10bn of which was in senior debt.

“While we have significant funding capacity in the Canadian market, we feel it is sensible to diversify into foreign markets,” says Ken Mason, managing director, corporate treasury at RBC in Toronto. “It is also important to preserve some capacity in the domestic market in case market conditions become stressed.

“Additionally, we have a natural mix of US and Canadian dollar requirements, and a very strong brand presence in the US. So there are plenty of good reasons why we are a regular issuer in the US market.” Indeed, as of October 2012, the US accounted for 49% RBC’s wholesale term and covered bond funding, compared with 36% in Canada.

A world beyond North America

Mason adds, however, that the US market is by no means the only alternative source that is open to RBC outside the Canadian dollar space, with other programmes such as the Kangaroo market and the bank’s ¥1tr issuance shelf available if the economics were to make a Samurai issue viable. “Maintaining access to several different funding options generally means we are able to diversify without paying a premium over what we would pay in the Canadian market,” says Mason. “But for some of the other benefits of accessing the US dollar market we would have a modest tolerance for paying up.”

Other borrowers say that the economics of issuing in the dollar market are of course an important determinant of their broader funding strategy. But that does not necessarily mean that arbitrage is always the overriding issue. “Notwithstanding that the domestic market is our cheapest source of funding, there may be capacity constraints in Canadian dollars,” says Wojtek Niebrzydowski, vice president at CIBC treasury in Toronto. “Economics are always important, but there will always be strategic reasons for issuance from various platforms.”

CIBC, says Niebrzydowski, typically issues between one and three senior unsecured benchmarks in the dollar market.

Others are more recent entrants to the US market for term senior unsecured funding. One of these is National Bank, which has a total funding requirement of about $1bn per quarter, most of which is to cover the roll-down of existing facilities, according to the bank’s Montreal-based treasurer, Eric Girard. “Much of our issuance is in the senior unsecured market, although we are also an active participant in the CMHC CMB [Canadian Mortgage Bonds] programme,” he says. 

Last year, says Girard, National Bank issued its first senior unsecured US dollar transaction off its MTN programme in 3(a)2 format. This $1bn three year issue, in June 2012, was priced at 120bp over US Treasuries, and was followed in November 2012 with a $750m five year transaction at a 75bp spread. Both transactions were led by Citi, JP Morgan, National Bank Financial and Wells Fargo, and both were well oversubscribed, according to Girard. 

“Although we issue in short term paper in the US, in the Yankee CD and commercial paper markets, this was the first time we funded in benchmark size in the US dollar term senior unsecured market,” says Girard.

“Most of our funding needs are in Canadian dollars, so we will look at opportunities outside the domestic market when they offer the chance to diversify our investor base and generate cost-effective funding,” he adds. Both objectives, he says, were met by National Bank’s US dollar issues last year. “It’s possible that some of the investors in our 3(a)2 programme also participate in our Yankee CD programme,” he says. “But as all the investors were new to our senior unsecured funding, we are pleased with the diversification the programme has given us.

“We have not used the programme this year, because funding conditions in the Canadian dollar market have been good. But last year the new issue concession in US dollars versus Canadian dollars made it a favourable time for us to issue.”

Covered return

Probably the most striking feature of the leading Canadian banks’ funding programmes over the last year, however, has been their return to the covered bond market. This followed the extensive revision to the legislative framework governing the issuance of covered bonds, outlined in the budget in March 2012, the details of which were announced by the Canada Mortgage and Housing Corporation (CMHC) late in 2012. 

Although covered bonds rapidly became an important funding source for Canadian banks following the launch of the first Canadian issue in 2007, with the outstanding stock of bonds doubling in 2010, these were issued under a contractual framework which was considered by then to have passed its sell-by date. A consultation paper released in 2011 by the Finance Department explained that “this non-legislative, contractual approach provides a high level of disclosure to investors on the cover assets and has been successful in developing a covered bonds market for Canadian issuers.” The problem, said the consultation paper, is that it suffers from “two drawbacks that make the market less robust and reduce the ability of Canadian FIs to diversify their funding sources.”

“First,” the consultation document added, “the issuer’s assurances in the prospectus that the cover assets will be available for the benefit of covered bond investors are not a substitute for statutory protection. Second, some international investors are restricted from purchasing bonds issued under a non-legislative framework, narrowing the investor base.”

The authorities’ response was the establishment of the new framework designed to tighten the eligibility criteria for issuers and broaden the investor base for Canadian covered bonds. “The framework is intended to make the market for Canadian covered bonds more robust and increase financial stability by helping lenders find new sources of funding,” explained a Norton Rose briefing in May 2012.

The response among analysts was mixed. Moody’s commented soon after the release of the CMHC guidelines that credit risk would be higher in new programmes, reflecting one of the main changes in the new framework, which excludes insured mortgages from the collateral pool. 

“Still,” Moody’s added, “the guidelines do have positive features for investors.” These include disclosure of detailed cover pool data, compliance with a comprehensive set of tests to protect against credit risks, and the creation of an independent cover pool monitor to oversee compliance with collateral requirements. “In addition,” Moody’s commented, “as the covered bond regulator, CMHC’s mandate to promote a healthy housing market aligns with the interests of covered bond investors, another positive.”

RBC jumps

Before the publication of the CMHC’s guide on issuance under the new framework, RBC became the first of the Canadian banks to register its covered bond programme with the SEC in September 2012. It has since issued two SEC-registered covered bonds, with a five year $2.5bn transaction issued at 35bp over swaps in September 2012 followed in November with a $1.5bn three year issue at 20bp over.

With European covered bond issuance at an all-time low in the first quarter of this year, RBC capitalised on pent-up investor demand when it re-opened the euro market for Canadian issuers in July, launching the first Canadian covered bond for five years. The €2bn five year issue, led by RBC CM, Barclays, BNP Paribas and Deutsche Bank, generated total demand of €3.5bn from 150 investors, allowing pricing to come in from guidance in the low 20s over swaps to 16bp over. Demand, says Mason, was such that the book was larger than it had been for RBC’s inaugural issue in 2007.

Later the same month, RBC issued the first Australian dollar covered bond benchmark, a A$1.25bn three year floating rate issue led by ANZ, NAB and RBC which was the first from a Canadian borrower in the Aussie market since a A$600m deal from CIBC in July 2011. Around 40 orders were generated for A$1.8bn, with about two-thirds of demand from onshore accounts. The transaction was priced at the tight end of guidance at 53bp over BBSW.  

“The Australian dollar deal was a longstanding project,” says Mason. “We had roadshowed back in 2011 and explored the possibility of issuing Aussie covered bonds. Market conditions did not allow us to issue at the levels we wanted, but we monitored the market on a continuous basis.

“The fact that the Australian banks had been able to get their domestic programmes up and running was helpful for us because it meant there were more investors engaging with the product. We were also able to leverage the positive buzz that was generated by the new legislation and by the success of our dollar and euro deals. But the US dollar, euro and Aussie dollar issues were all independent projects that fell into place because the economics of each transaction lined up.”

CIBC goes east

In the euro market, CIBC followed soon afterwards with its inaugural CMHC-registered covered bond, which was led by CIBC, Commerzbank, HSBC and RBS. Originally expected to have been launched before the RBC transaction, CIBC’s €1bn issue generated demand of €3bn from over 100 accounts at 9bp over mid-swaps, 3bp inside initial price talk. This was reported to have equated to around 48bp over dollar swaps, which was about 5bp tighter than CIBC would have priced in the dollar market.

Demand was led by Germany, which accounted for 38% of placement, with 24% going to the UK and Ireland and 11% to Benelux and France. Banks took 38% of the issue, while central banks and agencies accounted for 30% of distribution.

“We were very pleased with investors’ response to our euro issue,” says Niebrzydowski at CIBC, “but I wouldn’t go so far as to say we were surprised because we believed we had a good story if you look at the four components that the buy-side will typically look for in any covered bond.”

“In no particular order, these are the strength of the issuing bank, the type of the collateral, the credit standing of the sovereign, and in this particular circumstance the issuance framework,” Niebrzydowski adds. “Aside from being Ucits eligible, which by definition we can’t be, all the pieces were there for a successful deal.” 

Those pieces included a week-long roadshow, which contrasted with the RBC transaction, which was launched without having been roadshowed. “We believe investor engagement is important, but since we were issuing against a pre-existing pool of prime residential mortgages we did not feel we needed to roadshow the deal,” says Mason. “Bear in mind that we have been issuing for many years and we visit European investors on a regular basis. Other than the overlay of legislation, we were issuing from the same programme as we had on previous transactions.”

Niebrzydowski says that CIBC’s circumstances were different. “The only time we had previously issued in euros was in September 2008 under a different programme,” he says. “Notwithstanding that we had remained committed to keeping European investors informed on developments in the Canadian market, we believed we would be having a somewhat different conversation with them, given that we were issuing under a new legislative framework and a different cover pool.” 

“So we thought the right thing to do was to spend a week on the road in order to reintroduce investors to our programme,” adds Niebrzydowski. “The one question we had was whether the middle of July would be the right time to visit investors.” Their response both to the roadshow and to the transaction itself, he says, was a clear vindication of CIBC’s decision to take to the road — even at the height of the European holiday season. 

Valuing scarce Canadian paper

Demand for each was such that both approaches to the European investor base were equally productive. “I think European investors are valuing non-European assets from relatively low beta jurisdictions very highly,” says Anthony Tobin, head of financial institutions syndicate at RBC Capital Markets in London. “Canadian issuers in general are benefiting from that dynamic. The proof was in the phenomenal demand we saw for the RBC and CIBC trades, which generated some of the largest order books ever seen in the European covered bond universe.

“The Australian banks have benefited from a similar trend. The difference with the Canadians this year has been that although they’ve been able to come to the market under the new covered bond legislation that has been the driver in terms of supply, issuance has still been relatively low. We’ve seen just the one transaction from RBC and one from CIBC transaction versus multiple issues from Australia.”

The scarcity of Canadian issuance coupled with the fact that European supply has been quite light meant that there was no danger of indigestion arising from two Canadian banks issuing so close to one another. “If anything I think investor appetite for the CIBC deal was enhanced by the success of the RBC issue, which is quite a contrast to other markets where one big transaction can sometimes exhaust demand for the next deal,” says Tobin. 

Analysts are upbeat about the outlook for covered bond issuance from Canadian banks, with Scotiabank having registered its covered bond programme with the CMHC at the end of July. BMO, meanwhile, has filed a preliminary prospectus, but has still to register with the CMHC.

Among other issuers, National Bank is also assessing the potential of re-accessing the covered bond market, although it has not yet determined the currency of issuance. “In the past our preference was to build a yield curve in a single currency, as we have in the US when we issued a $1bn three year issue and a $2bn five year bond out of our CMHC-insured mortgage covered bond programme,” says Girard. “Because we’re not a frequent issuer we would likely adopt the same strategy with a legislative covered bond programme.” 

Tight cap

The issuance capacity of the Canadian banks is, however, capped by the 4% encumbrance limit set by OSFI, which is low by international standards. Australian banks operate with a limit of 8%, while in New Zealand issuance is capped at 10%. Few of the Canadian banks are close to this limit, with BMO’s research calculating that issuance capacity is over $20bn at TD, more than $16bn at Scotiabank, in excess of $15bn at RBC and over $13bn at BMO.

Among the largest issuers, CIBC has brushed up against the 4% issuance limit, with BMO’s research putting its capacity at a little over $3bn. “This is an efficient funding vehicle that allows banks to access a different investor base across a number of jurisdictions,” says CIBC’s Niebrzydowski.  “It is also a way of reaching investors that may not be able to buy your bonds in the senior unsecured market because of ratings restraints. Given these factors, there’s room for the Canadian issuance limit to move higher.” 

With maturing issues to add to the $3bn-plus elbow room that it has for further issuance, Niebrzydowski believes CIBC will be returning to the covered bond market in the foreseeable future. “We anticipate further issuance, but whether this is in euros or dollars will be driven not just by economics,” he says. “It will also be determined by more strategic considerations such as the need to reintroduce the covered bond programme in its new legislative form to investors in markets where we previously issued through the structured vehicle.”

Other banks report that the 4% limit has not yet been a constraint on their issuance. “We regard covered bonds as a global programme which is complementary to what we do on the senior unsecured side,” says Mason. “It gives us certain cost advantages and allows us to reach out to different investor groups, be they agency investors in the US or central banks throughout the world. But we don’t want to over-use the product and we haven’t yet come close to the 4% limit.”

No NVCC yet

If Canadian banks contrast vividly with their European counterparts in terms of their primary market issuance, they also differ very markedly from many European banks in their requirements for — and attitudes towards — capital. 

To date, there has been no issuance by Canadian banks of non-viability contingent capital (NVCC) instruments, which as BMO’s Lazarevski explains are fundamentally different from European-style contingent convertible (Coco) notes. “We view Cocos as high-trigger going concern instruments of the type that was issued by Barclays,” he says. “We don’t think we’ll see anything like that in Canada. Instead, OSFI has been pushing for the concept of late trigger NVCC which converts into common equity at the point of non-viability.”

At RBC, Mason agrees. “There does not seem to be any obvious need in Canada for the high-strike going concern Cocos that we’ve seen in Europe,” he says. 

OSFI issued its advisory on NVCC in August 2011, and as of January 1 2013 all tier one and tier two instruments issued by Canadian deposit-taking institutions (DTIs) are required to comply with a number of provisions set out in the advisory.

These include conversion into equity on the occurrence of a trigger event, defined as an announcement by OSFI of non-viability or the federal or provincial government that the DTI has been offered a capital injection.

Analysts say that the regulator has been very clear in defining point of non-viability. “OSFI has been explicit about the triggers for non-viability, which include loss of confidence making it difficult for banks to roll over short term funding, erosion of regulatory capital, inability to access funding and so on,” says Lazarevski.

He adds that there are a number of reasons explaining why there has yet to be any NVCC issuance in Canada. One of these is that with capital ratios in the Canadian banking sector so strong, there is no urgent need for DTIs to raise new capital.

Another, he says, is that very little detail has yet been given by the government about bail-in in Canada. “Until we have more clarity on the bail-in rules in Canada and the role that senior bondholders would play in the event of restructuring at PONV, it will be very difficult for investors to price NVCC,” he says.

Issuers agree that NVCC instruments are likely to come into the Canadian market gradually. “As we see some of the older instruments roll off over the next few years, NVCCs will be a natural replacement,” says Mason. 

“Bail-in is coming to Canada — no question about it,” Mason adds. “But we have not seen many details yet on how it might be implemented. We’re supportive of it, as it is part of the global regulatory reform effort for banks. We just need to be sure that it is implemented in a similar way in Canada as it is in other markets.”

House price danger

While senior bondholders may not yet need to lose sleep over bail-in, bank treasury teams continue to be grilled by investors about the danger of a collapse in house prices.

“We are often asked about the housing market,” says Girard at National Bank in Montreal. “We argue that the structure of the Canadian mortgage market is very different to the US, because 83% of our households have more than 25% of equity in their homes.

“With measures having been taken in 2011 and 2012 to reduce the growth in household debt and cool the housing market down, our base case is for a soft landing in the housing market.”

At RBC, Mason agrees. “We think that the authorities have some very effective controls over the housing market which they have used several times, and tightening the rules has already had an impact on the trajectory of the market,” he says. 

“We also impress upon investors that we stress test our mortgage portfolio very rigorously for interest rates and unemployment rising at the same time. We’re satisfied that even in this extreme scenario the impact on bank balance sheets would be manageable.”