Strong body armour enhances dividend sustainability for Canadian banks

Heading into a pivotal earnings week, the Canadian bank subsector of the S&P/TSX Composite Index had declined 24% since the beginning of the year, vastly underperforming the overall Canadian stock market’s year-to-date decline of 11% (to May 22). Lower net interest margins, higher expected loan losses, and deep recessionary conditions were the primary drivers of the poor sentiment. While we shared these concerns, we viewed valuation of Canadian banks as attractive from a medium-term perspective and added banks to our managed portfolios over the past two months.

Unsurprisingly, Canadian banks reported large profit declines as they reported Q2 results this week (for the quarter ended April 30). Despite much lower quarterly profitability bank stocks rallied 12% during the first four days of the week as investors let out a collective sigh of relief. As with most businesses navigating difficult short-term conditions, the market is understandably focused more on balance sheet health rather than current profitability. For banks, where dividend sustainability is highly correlated to balance sheet health, we think the Big-6 came through this earnings season with flying colours. Specifically, the level of regulatory capital that banks are required to maintain was not significantly eroded by higher loan loss provisions taken and remained well above mandated minimums.

A healthy quarter is helpful in supporting our constructive thesis on the banks, but we fully appreciate that the duration and severity of the current crisis remains uncertain. Anticipating this concern, some of the banks addressed the uncertainty head-on by sharing results of their stress tests on the conference calls they hold with the investment community. The stress tests revealed that banks could continue to maintain capital ratios well above regulatory minimums, suggesting that current dividends are not as vulnerable as the market had feared. Indeed, even under severe scenarios it appears that bank capital ratios would sustain current dividends. Included below are pertinent excerpts from two of these calls held in recent days.

“We ran a lot of scenarios. A U-scenario recovery, a V-recovery scenario, an L-scenario, a W-scenario, all kinds of stuff we have done in this quarter and the limited time that we have. But what I can tell you, based on all those results, in all these scenarios, our capital ratio, as far as we can look forward today and using the most conservative assumptions that we can imagine today, is in excess of 10% in all these scenarios quite comfortably. And that’s based on obviously declining or lower earnings that we expect to see, in line with being conservative when you do some of these stress tests and also supporting the dividend payout that we expect to continue to make.”

Raj Viswanathan, Chief Financial Officer, Bank of Nova Scotia (Q2 2020 earnings call, May 26, 2020)

“We have also run more severe stress test scenarios, including Canadian equity prices falling more than 50% over the next 12 months and Canadian and US GDP falling 18% to 20%. We also consider unemployment staying over 14% for a number of quarters and not returning to 2019 levels for a number of years. While we believe these scenarios are unlikely, they do represent the inherent uncertainty still surrounding the health care and economic outcomes. In our severe scenario, we believe our CET1 ratio will remain well above our regulatory minimum.” [Rosedale Family Office: Common Equity Tier 1 is an international regulatory standard for capital requirements in the banking industry]

Rod Bolger, Chief Financial Officer, Royal Bank of Canada (Q2 2020 earnings call, May 27, 2020)

Knowing that the Canadian banks are wearing a reasonably thick layer of armour enhances our view of the group’s dividend sustainability, particularly as other companies in other industries have moved to reduce or suspend dividends. In addition to incremental steps being taken toward reopening economies, greater comfort about banks’ financial health has contributed to their stock price outperformance so far this week. Our intention is to continue holding banks in our managed portfolios over the medium-term, and we may add to existing positions as opportunities permit.

With summer around the corner and prospects of gradual lifting of restrictions we hope you and your loved ones remain safe and healthy. Please contact our team with any questions or concerns.

Rosedale Family Office