A crumbling cornerstone

For as long as any of us can remember, placing funds in the shares of our banks was considered to be the foundation of all Canadian investment portfolios.

However, the cornerstone is crumbling; events have made that strategy seem obsolete.

It must be recognized that Canada’s banks are very well regarded. Yet the bullish story is yesterday’s news; it was based on the historical record of growing revenues and frequent increases in dividends. Furthermore, generally Canadian banks, in sharp contrast to the lenders south of the border, have not gone overboard in extending credit to risky borrowers.

The shares of Canadian banks are “priced for perfection,” assuming that everything is all right. Their shares are trading 40 per cent above their historical multiples to tangible book value, and even more if the economy slips back into a recession. Banks’ shares are among the most expensive in the world. That already reflects the esteem that most hold for our banking industry.

Our banks above all do not have sufficient, tangible shareholders’ equity, if one subtracted such items as goodwill. That high leverage of their assets can be very rewarding during prosperous time, but quickly reverses itself during economic trouble.

Evidence of this hazardous course can be seen in the recent earnings reports of the Bank of Montreal and the Royal Bank of Canada. The former reported a large decline in earnings. The latter announced a 93 percent drop in trading while profits fell by 18 percent.

These tumbles occurred even though the Canadian economy continued to expand. What would have been the outcome if our nation fell into a deep recession?

The effects were the result, to an important extent, of the sovereign debt crisis, where nations such as Greece were unable to meet their obligations. One has every right to ask why our banks have engaged in such unsafe lending activity, particularly in a country outside of our borders.

Then too banks have been speculating in derivatives. It is rumoured that the Royal Bank has one floor devoted only to trading in derivatives.

If Canadian banks confined their role to their renowned one of taking in deposits and lending them to credit-worthy borrowers, then banks would return to their historic position of being the central investment for us all.

Until then, one should be wary of using banks as the prime investment vehicle.


Bruce Whitestone