Last week, I warned of a potential resurgence in the US regional banking crisis in “KRE: The Banking Crisis Has Slowed, But It Cannot Be Stopped,” triggered by the continued wave lower in bank deposits and the reversal in temporary “discount window” liquidity sources. Since then, the critical regional bank fund (KRE) has fallen by 16% amid the collapse of First Republic (OTCPK:FRCB) and, more recently, PacWest (PACW) and (seemingly) First Horizon (FHN). Of course, these stocks are moving rapidly each hour, so they may continue to decline or reverse as this week progresses.
Overall, my view appears to be proven correct as more US banks continue to find themselves on the chopping block amid a mass exodus in deposits, forcing the sale of securities with significant unrealized losses. This process creates a “negative feedback loop” wherein banks need to sell assets at a loss to raise liquidity; however, almost all banks are looking to sell assets, and virtually none are buying, causing prices to decline and the situation to worsen. There remains widespread hope that the Federal Reserve will further increase liquidity provision levels; however, the institution is reluctant as doing so could exacerbate the inflation issue (see 2020 QE and the subsequent inflation response). The Federal Reserve is still planning more interest rate hikes as its primary aim continues to be price stabilization. It will likely continue to have this focus until there is a material increase in unemployment.
For now, we must wait and see how the ongoing US banking crisis will play out and whether or not it will spread to the larger “systemic banks.” In my view, U.S. Bancorp (USB) and Truist (TFC) are two more prominent US banks investors may want to track due to their higher exposures to the ongoing issue. Of course, another important factor will be the extent to which these issues will spread overseas. The Canadian Banking system is the most obvious factor, as Canadian Banks are pretty extensive, with far fewer “regional banks” and more centralization in a few massive corporations. The Royal Bank of Canada (NYSE:RY) is the most important.
RBC is huge, with around 2.1T CAD in assets, making it the fifth-largest bank in North America. The bank operates at higher overall leverage than most US banks, with a total liabilities-to-assets of ~94.5%, compared to most US banks (of comparative size) being closer to the 90-92% range. RBC has a CET1 ratio of 12.7% liquidity coverage of 130%, slightly higher than most US banks.
Of course, the more considerable discrepancy between the bank’s CET1 ratio and its overall leverage ratio (not adjusted for Basel 3 risk-weighed-asset standards) is not necessarily a good sign as it indicates RBC has a great deal of “low-to-zero risk” securities, which usually pay lower yields and therefore can have higher interest rate duration exposures. For example, Silicon Valley Bank had among the highest CET1 ratios in the industry through excessive Treasury securities exposure, eventually leading to a considerable level of unrealized losses realized as its deposits fled. However, RBC’s main risk is its massive exposure to the Canadian mortgage industry.
Like the largest US banks, RBC’s focus is diversified, with around half of its regular income coming from its lending (at a 1.47% NIM in Q1) and the other half from other businesses. Of its different segments, it earns the most significant income portion from investment management and custodial fees (~30% of non-lending income), insurance premiums (~20%), trading revenue (~10%), and mutual fund revenue (~10%). Overall, this makes RBC highly diversified, with around a quarter of its total income likely to fluctuate dramatically with the business cycle (trading revenues, advisory services, etc.) and the remaining three-quarters likely to remain relatively stable.
Royal Bank of Canada also benefits from what is best described as “oligopolistic pricing power” in deposit interest costs. Canada’s short-term interest rate is essentially the same as the US’s, at around 4.5%. However, Canadian savings account rates are stupendously low at 3.5 bps, compared to the US at a still very low 37 bps. As I’ve noted in many recent articles regarding banks, there is a historically massive gap between short-term interest rates from central banks and interest rates paid out by banks to depositors. In the US, where savers have more options (although fewer than in the past), we’re seeing the gap close as more people move money between banks or toward money market funds. However, in Canada’s more concentrated system, there is very little competition for depositors, allowing banks to borrow at massive discounts, keeping their net interest margins more stable amid the rising interest rate dynamic.
Notably, Canada’s M2 money supply figure is also still rising. This measures all cash and near-cash in the economy and is essentially a measure of total bank deposits. In the US, the M2 has been falling over recent months as the QE money creation program went into reverse, now triggering a broader exit of deposits (note, bank deposits are usually 3-5X above actual cash in the economy). However, we’re not yet seeing this trend play out in Canada’s market. See below:
With Canada’s M2 rising more quickly, I believe there is a much lower risk of depositor runs in Canada’s largest banks. Once again, because Canada has fewer banks, depositors have nowhere to go and therefore have no reason to move their savings. Over time, Canada’s rising rates and QT program may cause its M2 to fall, but this is not a significant risk factor in Canada’s banks.
Around half of RBC’s loan portfolio comprises mortgages, equating to about $355B. Of that, 76% are uninsured, and 24% are insured. The Canadian mortgage market differs from the US market as only higher-risk mortgages are insured, akin to the US “FHA” system; however, unlike the US, most mortgages are not insured from default by a government agency. This situation leaves RBC at greater risk in the case of a more extensive mortgage crisis, although, like Europe, most Canadian mortgages are “recourse” (unlike the US), allowing lenders to target borrowers directly in the case of default. The FICO scores on RBC’s uninsured mortgages are high at an 805 average (69% LTV), meager 90+ default rates (9 bps), and a higher portion of variable rate mortgages (37%).
Problematically, Canadian home prices are incredibly high compared to incomes and, as interest rates rise, are falling quickly. Last year, Canada boasted the second-highest average home price-to-income ratio amongst all 38 OCED countries. Canadian home prices are exceptionally high in its largest cities, particularly Toronto and Vancouver, with price-to-income ratios averaging around 12X. To compare, the “housing bubble peak” US home price-to-income ratio was 6.8X in 2006, although that figure is now higher at 7.6X today (indicating US home values are more overvalued than they were in 2006). This surge was triggered by the decade of ultra-low interest rates in the 2010s that naturally pushed home prices higher (since buyers are mainly focused on payment affordability). See below:
As mortgage costs soar, there is immense negative pressure on home prices as new buyers cannot make higher payments. The country’s home price index is now falling quickly and should continue to decline until the home price index falls to the same level as it was the last time mortgage rates were around 6.5%, indicating a potential 30-40%+ decline. Of course, it may take years for the market to rebalance fully; however, the slight decrease already creates issues in Canada’s financial system. Canada’s mortgage insurers have been facing some difficulties recently as many homeowners in the country face underwater loans. A recent survey showed one-in-six Canadians believe they’re likely to default on a significant loan as interest rates continue to rise.
In my view, the most significant risk facing RBC is a larger-than-expected increase in mortgage and other defaults. Around two-thirds of its total mortgage portfolio is in Ontario and B.C, where home price valuations are typically much higher. Considering home prices are falling more quickly, the LTVs on these loans will rise, and many more borrowers will be underwater. Further, although RBC’s higher variable rate mortgage book (37% of total) reduces its interest rate duration exposure, many variable rate borrowers may not manage to make increased payment costs.
Overall, Canada’s banking system appears to be largely isolated from the most significant risks facing the US banking system. Most notably, falling total deposits and increasing depositor borrowing costs – two issues which, for now, do not exist in Canada’s market. Further, because Canada’s banking system is much more concentrated, its banks are more diversified, with few banks with excessive exposures (as in most niche-oriented US regional banks). Obviously, the issues in the US market could cause some losses for RBC; however, it may also allow the bank to scoop up assets at a discounted price.
That said, from a longer-term standpoint, I am slightly bearish on RY and believe that the stock could decline significantly during a recession. The bank does operate at higher overall leverage and has significant exposure to Canada’s precarious housing and mortgage market. As Canada’s property market has been more stable historically, few investors and analysts seem to notice the drastic potential that could follow from a significant decline in Canada’s home prices and a seemingly large potential increase in defaults.
Further, RY trades at a considerable valuation premium, with most of its valuation multiples 30-80% higher than those typically seen today. From that standpoint, RY is being valued as a highly low-risk stock. I agree that RY is less risky than most US banking stocks, but not so much that such a premium is sensible. The immediate US liquidity risk issue is seemingly a non-issue for RY; however, potential mortgage market issues in the event of a recession could, in my view, impair its equity stability. Considering Canada’s home price declines are accelerating, I believe this risk factor is becoming more immediate. Accordingly, I personally would not buy RY at any price above its tangible book value per share (most US banks trade below their book value today), equating to $45 per share – or around half of its current price.
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