A fantasy world

Today most believe that banks should be the bedrock of Canadians’ portfolios.

People assume our banks are much more conservative than their counterparts elsewhere and therefore are the prime investment for all of us. Nevertheless, this reputation should be called into question.

As is the case with other corporations, banks’ accounting principles are far from perfect. To take just one example, a major bank did not subtract $359-million from its profit statement and merely put in a footnote that there was separately "a capital market environment charge," with no further explanation. Could any individual pay a credit card, using that subterfuge? Of course, there should have been a clear deduction from earnings. Banks often engage in this chicanery, so caution is essential in viewing banks’ earnings statements.

One bank analyst with an investment firm argued that in this era of a capital shortage banks should cut or eliminate their dividends on their common stock. That would increase internal capital generation and reduce their need to raise capital. However, banks are reluctant to do that as it would damage their reputation as being immune to business recessions. Again, that is an example of paying more attention to image making, not necessarily following the most sensible course of action.

Banks remain in a fantasy world and shun realism. They still are largely run by the same people responsible for their current troubles, where most common measures, return on equity, cost-income ratios and price-earnings ratios, flatter leveraged firms, and where a culture of giving cheap capital to high-risk units has thrived.

Banks inherently are vulnerable. They can leverage, that is borrow, 20 times their capital. Is that prudent in this business climate? How would we view an investor who borrows 20 times his assets to fund some operations? Too, if banks were properly capitalized, why would they borrow money by means of a preferred share issue nowadays when going to capital markets for funds is so difficult?

Banks in Canada have diverged from their historic role of taking in deposits, and then lending those funds at a slight premium over the interest paid on that money. Instead, they mask their actions, using incomprehensible jargon, such as collaterised debt obligations.

Also, a major Canadian bank has one entire floor where the sole activity is to trade derivatives. Other banks have trillions of dollars in derivatives outstanding, clearly not a judicious course of action at this time. That also explains why many banks have had to report heavy losses in trading ventures.

What should banks do? They should go back to basics, defining their core business, and concentrate on that, ensuring that they have sufficient capital at all times. Their balance sheets should enable them to weather economic downturns, and they should forgo acquisitions because often they do not work out. The difficulties of meshing combinations usually are underestimated. In the past banks thrived by sticking to their historic role and they should do so again.


Bruce Whitestone