Royal Bank of Canada CEO Gord Nixon is a master at parrying questions about how quickly earnings are growing and where RBC might make its next acquisition. But the harsh spotlight recently directed at the bank’s outsourcing practices was new and unfamiliar territory, as many observers surmised from his rather confused response, culminating in an unprecedented public apology.
The media scrutiny isn’t just over outsourcing, nor is it just focused on RBC. Once the reigning monarchs of corporate Canada, the big banks have lost their crown, at least in the eyes of the public. Many believe they are at least partly responsible for the country’s overheated housing market, cranking out mortgage loans faster than ever before even as consumers struggle with record debt loads. The banks continue to grow at a pace well ahead of the domestic economy, almost as if they’re immune to the occasional headwinds that afflict the rest of the country.
In the past, the banks enjoyed public tolerance because, despite such negative perceptions, they were dependably profitable, churning out dividends year after year. But after a global financial meltdown and four years of economic uncertainty, that may be about to change. The banks have helped drive a decade-long housing boom and now it’s coming to an end. If another financial crisis were to strike, say, a housing meltdown as some economists predict, will heavily exposed Canadian banks still have the strength to weather the storm?
Mark Carney, the outgoing governor of the Bank of Canada, has warned there is “growing distrust” of the banking system in the wake of the 2008 financial crisis and revelations about the behavior of some of the players that took huge risks and were rescued with taxpayer money. The Canadian banks didn’t need bailouts and Carney was talking about the global industry, but his criticisms apply here as well.
If we get a significant downturn in housing, there would be a large, sharp impact on bank earnings
Remarkably, it was only about four years ago that Canadian banks were declared the world’s strongest banks and put on a pedestal. They were among the few lenders to emerge from the turmoil unscathed, much to the surprise of their international peers, who made pilgrimages to Bay Street to figure out just how they’d managed to do it. The World Economic Forum has ranked the Canadian banking system the world’s strongest five years running. A 2012 survey by Bloomberg Markets rated Canadian banks among the top 20 strongest in the world with Canadian Imperial Bank of Commerce, the highest rated in this country, in third place overall. Mainly, it had to do with prudent Canadian values, according to the pundits.
Banks in this country have always taken a conservative approach to risk and that was reflected when they largely avoided the toxic credit products that caused so much devastation on Wall Street and in London. It’s an approach helped along by the Canadian regulatory system. The federal watchdog, the Office of the Superintendent of Financial Institutions, stays in close dialogue with the industry it oversees. Rather than issuing rules like its counterparts do in other countries, OSFI lays out principles that players are expected to adhere to. The result, according to proponents, is greater clarity: Banks have a better idea about what they can and can’t do. It also helps that OSFI only has to focus on a few dozen banks while the U.S. regulator oversees more than 6,000.
This brings us to another key strength of Canadian banks: Just six big players account for about 80% of the domestic market. That level of concentration turns players into price makers rather than price takers and generally limits the need for competition among themselves. It also ensures every bank is profitable, which they are. Canadian banks often boast return-on-equity ratios above 30% in their domestic markets, levels their foreign counterparts can only dream about. In the U.S., for example, the ROEs of the big banks are currently languishing around 10%. In Europe, many players are still struggling on the verge of profitability, while others are getting bailouts.
Arguably, this is the most important advantage of Canadian banks. Because of their oligopoly and resulting profitability, they didn’t have the incentive of U.S. or European banks to delve into some of the new-fangled products that emerged in the credit bubble, especially those linked to subprime mortgages. They had the luxury of being able to sit back and observe, something their foreign peers didn’t have. “People used to complain that [Canadian banks] were stodgy, too conservative, but that ended up as an advantage,” says Chris Ragan, an economics professor at McGill University in Montreal.
But if it was the Canadian banking system that saved this country from the financial crisis, it’s the same system that appears to be providing the spark for a new and potentially more damaging conflagration.
Like many countries, Canada has policies in place aimed at helping middle-and lower-income people to buy houses. In our case, the main instrument is the Canada Mortgage and Housing Corp., a Crown entity formed in 1946 to provide housing for returning soldiers after the Second World War. Since then, the CMHC has expanded its mandate to a swath of housing-related activities including its controversial mortgage default insurance program. Thanks to CMHC insurance, hundreds of thousands of Canadians who otherwise wouldn’t meet minimum bank criteria are able to get home loans. There are nearly $600-billion worth of outstanding mortgages covered by CMHC, roughly half the total mortgage market.
The fact the insurance is backed by the government makes it attractive to the banks, since it shifts the risk of default onto the shoulders of taxpayers. That makes the mortgage business easy money. Not surprisingly, lenders have been eager to issue mortgages, especially since the financial crisis, as their other businesses such as capital markets and wealth management ran into occasional headwinds. Indeed, over the past two years, the banks’ main profit driver has been their domestic retail operations with home loans being the biggest single asset on their balance sheets.
And that’s the problem. The reason the business is attractive is because of the government guarantee. It was a crucial advantage in the financial crisis — government-backed mortgages were one of the few assets that enjoyed a liquid market. But the guarantee has caused players to relax credit standards, according to critics. After all, what’s the incentive to scrutinize borrowers when you don’t have to worry about whether they might default?
During the credit boom years, lenders lowered their requirements — with the help of government regulation — and began issuing home loans with 40-year terms, a major departure from convention. The rules have been tightened several times since then, but not soon enough to put the brakes on a lending spree that has left consumers saddled with record debt loads. The average household debt-to-income ratio is nearly 165%, the highest ever, and the Bank of Canada says that’s posing a major risk for the Canadian economy. “It was the relaxation in credit standards that happened, this is why we are worried about the housing market today,” says Dave Madani, Canada economist for Capital Economics. That’s not just his opinion, either.
Finance Minister Jim Flaherty and Mark Carney have repeatedly warned that elevated consumer debt represents the biggest risk facing the Canadian economy. OSFI last month revealed in its annual Plan and Priorities that it, too, regards household debt and the risk it poses for the financial system as its top priority. The fear is that a rise in unemployment or interest rates could leave some borrowers unable to meet their obligations, triggering a housing crash and, potentially, a self-reinforcing meltdown.
The real test [of the Canadian banking model] will be to see how well [banks] hold up in a housing bust
It’s legitimate to ask why the banks should be worried, since they’ve offloaded the lion’s share of the risk posed by the massive pile of mortgages they’re sitting on. But they’re only free from the direct risk of mortgage default. So far, such defaults are minimal, less than half of 1%. But if the numbers were to spike significantly, there would be painful repercussions for the banks’ retail lending operations since people who can’t pay their mortgages are likely to cut back on other spending.
That’s a scenario the industry dreads. “If we get a significant downturn in housing there would have to be a large, sharp impact on bank earnings,” McGill’s Ragan says. “Are the Canadian banks going to be exposed? Absolutely, and the Canadian taxpayer will also be exposed.”
Carney has repeatedly warned about the danger of elevated household debt and the kinds of things that might turn it from mere theoretical risk into disaster, such as a rise in unemployment. Right now, it seems that’s exactly what we’re headed for. Slumping energy prices are putting a damper on activity in the oil patch, one of the few economic bright spots in the Canadian economy. Then there’s the cooling housing market. Sales over the past 12 months have fallen and prices are softening. Construction, especially on the condo side, is on the decline. Given the size of the industry, what happens next could have a major impact on employment in cities such as Toronto and Vancouver.
Few economists are predicting a full-fledged housing meltdown, but there’s growing agreement what happens next will be painful. Capital Economics, one of the more pessimistic groups, is forecasting a 25% housing price decline over the next few years, with serious ramifications for the broader economy. Bottom line: We may be about to find out how strong the banks really are.
This is a story about how an advantage — government-guaranteed mortgage insurance — was transformed into a disadvantage by overuse and mismanagement. When the crisis first hit in 2008, Canadian banks’ mortgage businesses saved them; other countries had to pump money into their failing lenders. That didn’t happen here because government support was already in place. Politicians merely had to tweak the program by increasing the supply of CMHC insurance and agreeing to buy back some additional loans as a way to boost liquidity. In the event the crisis reemerges in this country, the solution won’t be so easy.
The clouds are gathering and markets are worried. There are $1.2 trillion worth of home loans outstanding, according to the Bank of Canada, with roughly three-quarters covered either by the CMHC or a handful of private insurers that benefit from government backing. While part of that is securitized, the bulk is sitting on bank balance sheets.
Have the banks created a monster that will ultimately lay waste to their capital along with the economy? We’ve certainly seen what housing busts can do in the U.S., Ireland, Spain, Greece and now, apparently, Slovenia. “This is what happens [in a housing bust],” says Capital Economics’ Madani. “A lot of developed economies have gone through this boom-bust scenario… and the U.S. is not unique. It’s actually a very old story that begins when credit standards are relaxed.”
For their part, the banks insist Canada is not headed for a U.S.-style collapse because lending standards did not deteriorate in this country to the degree that they did south of the border. However, “a soft landing may be difficult to achieve,” says Finn Poschmann, vice-president of research at the C.D. Howe Institute.
The good news is that government and regulators appear to have learned from their mistakes. In March, OSFI declared the six biggest banks “systemically important” or, in other words, too big to fail. The new designation requires players to hold additional capital reserves and submit to greater regulatory scrutiny. In the most recent federal budget, Finance Minister Flaherty signalled he wants the banks to map out a bail-in strategy. In the event one gets into trouble, there would be a series of trigger points where bank liabilities such as senior unsecured debt (but not customer savings) would get converted to bank capital, thereby helping to staunch any damage. “These developments reinforce our perception that Canadian regulators are emphasizing prudential standards, active bank supervision, and the avoidance of a future taxpayer funded bailout of a failing financial institution,” says Tom Connell, an analyst at Standard & Poor’s.
Critics, however, say it’s too little, too late. Consumers have already racked up the debt that the banks now hold and the government has guaranteed. House prices have nearly doubled over the past decade, according to the Teranet-National Bank House Price Index. It was only in 2008 that the government got rid of the 40-year amortizations, and while it’s true that today’s mortgage rules are a world away from what was going on back then, the trouble is that many of those easy-money loans are still outstanding.
“The real test [of the Canadian banking model] will be to see how well [banks] hold up in a housing bust,” Madani says. “They’ve never been fully tested. The government has now come full circle. It’s realized in hindsight that this relaxation in mortgage credit was not a smart idea. I think we all agree that home prices are going to fall, economists are now simply debating about the extent of that fall.” And just how much it’s going to hurt.
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