Profits shrink as banks face regulation, slow growth

The latest round of earnings reports by Canada’s Big Banks may have investors feeling as though Santa came early this year — but only to leave a lump of coal in their stocking.

Canada’s biggest financial institutions reported billions in revenues and profits in the fiscal fourth-quarter, but their results fell short of Bay Street analyst forecasts.

Banking industry analysts and observers say that overall, Canadian banks are still on solid financial footing.

However, the earnings reports brought into focus some of the medium and long-term challenges that they are facing — slowing growth at home, uneven economic recovery around the world and, in particular, myriad new banking regulations.

These new rules, being imposed by Canadian and international regulators, are designed to protect shareholders and taxpayers in the event of a financial meltdown. For banks, the regulations are also driving up expenses and making it more difficult to squeeze profits out of their capital markets business units.

“I believe these regulations are important but they’re going to reduce profitability and increase costs for the Canadian banks,” Michael King, assistant finance professor at Ivey Business School at the University of Western Ontario, said in an interview.

“That’s something they’re going to have to manage.”

Royal Bank of Canada was the outlier for this earnings season, delivering results that exceeded analysts’ estimates. Bank of Montreal and CIBC posted results for the three months ended Oct. 31 that were just shy of the forecasts.

Toronto-Dominion Bank, however, issued a report that touched on many negative themes in the banking industry. Growth in its Canadian and U.S. retail businesses were flat and expenses rose sharply.

Scotiabank saw a 14 per cent drop in fourth-quarter profits — as opposed to the increase that analysts expected. The bank was hit by a slowdown in its international banking business, as well as expenses related to severance. Scotiabank announced in early November that it planned to cut 1,500 jobs worldwide as it moves to improve efficiency.

“You wonder where the growth is going to come from, domestically and internationally,” Dan Werner, banking industry analyst at Morningstar, said in an interview.

“Given the debt levels that Canadians already have, how much more debt can they take on from the banks? Worldwide, there still are some struggles in terms of where we are economically.”

The latest quarterly reports and recent job cuts may give the impression that Canada’s Big Banks are struggling, but they are “doing extremely well particularly when it comes to their peers in the U.S. and Europe,” King said.

“When you look at the ROE numbers of Canadian banks, they’re off the chart compared to their foreign peers.”

ROE, or return on equity, is a key metric that shows how much profit a company is able to generate with the money its shareholders have invested.

Canadian banks have a strong return on equity of 17.4 per cent, according to a February, 2014, report by consulting firm PwC. That compares to 12 per cent for the U.S. banking industry.

The Canadian banks also managed to achieve this level of profitability in spite of new international rules that require them to have higher reserves of capital, or equity, on hand in the event of sudden shocks to the financial systems.

“Canadian banks seem to be defying the conventional wisdom that more equity is bad for business. Instead it seems to be helping them win business because they’re seen as strong and stable,” King said.

Along with the new capital rules, put in place after the 2008 global financial meltdown, are regulations that restrict risky trading practices.

The so-called Volcker Rule, named for former U.S. Federal Reserve chair Paul Volcker, bans banks from almost all proprietary trading, or trading for their own profit, and limits banks’ investments in hedge funds. Banks are expected to comply by 2016.

Proponents of the regulation say this type of speculation has no place in financial institutions that gets bailed out using taxpayer funds in the event of a global meltdown.

“Basically, shareholders’ money is being used to speculate to make money,” King said. “The problem is that taking large bets can generate gains in good times but very large losses in bad times. Those losses are what cause banks to fail and need to be supported, which is what happened in the U.S. and in Europe.”

As result, many banks have been spinning off or sharply reducing the size of their proprietary trading books.

RBC, for instance, sold about half of its proprietary portfolio this year, a move that resulted in $75 million of one-time charges and lost revenue, the bank said this week.

The increased regulation means banks are also facing rising costs to implement more IT and risk management systems in their capital markets or investment banking units, particularly when it comes to trading fixed income, commodities, and currencies.

“It used to get away with very little capital so it was quite profitable. Now it’s getting hit with different charges or they have to hold more capital against it,” King said. “It’s making the business much more expensive.’

Increasingly, banks are turning to the other side of the capital markets unit. Advisory services profits are made from fees related to services provided for mergers and acquisitions and underwriting.

“The fee-based businesses have been doing extremely well,” King said. “Banks are basically trying to move more into these fee-based businesses because they can make money without taking risk.’


Source: The Star

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