Office of the Governor of Financial Institutions congratulated Canadian banks on holidays

OSFI gave Canadian banks a bad gift at the end of the year Paul Roberts Visitors: 689 ★★★★★

Canada's largest banks will have to increase their internal stability reserve (DSR) by half a percentage point, to 3% of risk-weighted assets, effective Feb. 1.

The range of future adjustments to the ratio is also to be expanded from zero to 4%, compared with an upper limit of 2.5% since June 2021.

Increasing the RSI would de facto raise the banks' Tier 1 capital ratio by the same amount, to 11% (the so-called CET1).

These decisions, designed to strengthen the soundness of the major banks and public confidence in the financial system, come at a time when constant increases in inflation and interest rates are overshadowing the economic situation and worsening the financial situation of indebted households in particular.

The RBC analyst is referring to the recent increase in federal taxes on banks and the possibility that the Canadian government will regulate transfer fees between financial institutions and merchants for credit card purchases.

Analysts' Reaction

Financial analysts believe this is not a good time for banks, that they are already battered by the many economic uncertainties in the stock market.

The decision to raise the cap on the return on equity range to 4% is negative for investors because it will reduce long-term shareholder returns. They are also concerned that investors will conclude that banks are now operating in a more hostile regulatory and political environment than before.

This refers to the recent increase in federal taxes on banks and the possibility that the Canadian government will regulate transfer fees between financial institutions and merchants for credit card purchases.

The situation is further complicated by the fact that banks have only two months to comply with the new rules, instead of the four-month period when the last adjustment was made in June.

The decision will especially hit BMO Bank, whose purchase of Bank of the West in the U.S. temporarily weakens its reserve ratio, but it will affect all institutions, opening the door to a further 100 percentage point increase in ROI.

While BMO Bank may consider issuing shares to meet the new reserve ratio, the decline in its stock price already reflects that possibility.

Overall, the OSFI decision, and the reasons given for tightening the reserve ratio, are not favorable for Canadian banks' stock market valuations. As an example, the analyst points to the weaker performance of U.S. banks in 2022, where growth slowed significantly as higher capital ratios in the U.S. led to lower borrowing. He predicts the same dynamic could happen in Canada.

More reserves, less lending

Although most banks are well above the new regulatory capital ratio of 11%, many analysts are unhappy with this turn of events.

Such a decision by the regulator, they believe, is primarily aimed at curbing lending growth and does not reflect any new concerns on its part about the level of problem loans. And replenishment of reserves becomes a more positive factor for profitability of the capital in the short term. Additionally, there is the risk that the regulator will raise the ratio again in June 2023 if conditions deteriorate further, as the new 0-4% range for the internal stability reserve allows.

To illustrate the mechanics of reserves, recall that during the pandemic, the RSI was lowered from 2.25 to 1% so that banks could absorb more potential losses and continue lending. This reduction in the reserve cushion provided banks with $300 billion in additional capital to lend. The opposite happens when the RSI increases.

The unexpected effect of the RSFI decision caused the banking sector to fall 2.4% over the past week, less than the 2.6% drop in the S&P/TSX index, which was hurt by the nearly 11% drop in West Texas oil prices.

The deteriorating economic outlook has been a hot topic for months. That's why banks have taken the lead. Since the beginning of 2022, the 9.5% drop in banks is worse than the 5.9% drop in the Toronto Index.

There is a view that it is too early to look too closely at bank stocks, even though their valuations have fallen below 10 times earnings expectations by a factor of 12.

The consensus earnings forecast for 2023 does not yet reflect the slowdown in lending or the increase in loan loss reserves that accompany all recessions, job losses and real estate depreciation. Analysts still expect earnings at the ten financial institutions in the S&P/TSX index, including alternative lenders Home Capital Group and EQB, to grow 6.8% in 2023.

This, not to mention the fact that the banks have yet to cut their own spending patterns.

Paul Roberts
Paul Roberts

Paul Roberts 51 years old Born in Edinburgh. Married. Studied at University of Oxford, Department of Public Policy and Social Work. Graduated in 1997. Works at Standard Life Aberdeen plc.

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