Collapsing financial markets involve fear-induced liquidity deficits that squeeze leveraged sectors like real estate and energy. A longer Covid-19 lockdown would make the damage greater. With interest spreads widening to reflect the rush for quality, credit downgrades are inevitable.

Canadian banks have avoided the devastation suffered by other financial institutions during the global financial crisis and have earned a reputation for prudence by adhering to strict capital rules and limiting exposure to excess US mortgages.

By diversifying from capital market activities and their traditional spreading activities (short-term borrowing and long-term lending), banks have developed more stable profitable activities, in particular wealth management and insurance.

Today, predictable margins and profitability are called into question by unprecedented events: the response to Covid-19, but also negative real interest rates and fintech challenges. How will banks deal with the uncertainty of an economic depression induced by a pandemic?

Covid-19

Cash flow is the lifeblood of businesses and individual consumers in any economy. The public health decision to shut down the economy to save lives is tantamount to stopping the heart and hoping that monetary and fiscal defibrillation will revive the patient with minimal organ and brain damage.

Delays are synonymous with risk. Because banks dominate the financial lives of Canadians and the businesses that employ them, responsible for about two-thirds of all business loans, according to the Canadian Bankers Association.

Unlike the financial industry solvency problem of 2008-2009, this crisis started as a liquidity dilemma that is likely to turn into a solvency situation later. The banking system needs to do two things:

1. bridging loan payments and keeping enough money in the system, like a heart bypass machine, so the economy doesn’t come to a complete stop; and
2. facilitate recovery to regenerate employment when “everything is clear” is reported.

Some banks have taken immediate steps to create liquidity by providing secured loans, and others are expected to follow as their customers draw on revolving lines of credit as an insurance policy against a tightening. The Bank of Canada is always ready to add liquidity, but is limited by a lower limit of zero (currently the bank’s overnight rate is 0.25%).

If the economy is frozen for too long, deferred payments will cause prices to drop sharply, which will gradually be informed by more rational risk assessments as the data and flaws become known. The first signs of financial dislocation put the banks in the middle of the storm. Loan losses at the onset of the crisis are expected, but their magnitude is unknown. Five major US banks quintupled loan loss provisions in the current quarter.

Abstention

Tolerance is what the economy needs, and the banks hold the key. Deferring payments and accumulating interest expense is the quick answer, but governments will encourage leniency.

Banks must strike a balance between jeopardizing their profit margins and bankrupting their customers or foreclosing on mortgages. In conventional economic recessions, mortgage portfolios turn into real estate portfolios. No one wants this to happen now.

Portfolio banks

Bank stocks have been the cornerstone of Canadian equity portfolios. They collectively represent 20% of the market capitalization, the largest sector in the country.

Canadian banks are too big to fail, but if they faltered, the country’s problems would become much more serious. Government and central bank bailouts or mergers would follow.

For most investors in a low interest rate environment, the bigger question is, “How safe are bank dividends?” Bank profits traditionally generate dividends with a payment of 40 to 50% of targeted profits.

During the pandemic, personal and business lines of business are most at risk. Even though these are the most profitable, income could be halved in 2020 and dividends would still be covered.

Dividend growth may have to wait for the timing and success of the economy reboot, and some banks may prefer to be more conservative than others. Time will tell us.

Table 1: Canadian banks by market capitalization (in billions of dollars) as of April 3, 2020

Source: Toronto Stock Exchange

AND F

ETFs remain the most effective way to gain diversified exposure to Canada’s largest group: from 20% of the popular iShares S & P / TSX 60 Index to 130% for the Horizons Betapro Capped Financial Bull 2X leveraged ETF, which has 200% exposure to financial stocks (of which 130% represent banks).

The third column of Table 2 below shows the level of bank exposure that the ETF investor gets to banks per basis point of MER. Broad-based ETFs with low MERs (such as XIC and VCE) are very effective. Horizons Total Return ETFs (HXF and HEWB) are also effective ways to gain banking exposure.

Table 2: Banks’ exposure to ETFs traded in Canada as of April 2020

Mark Yamada is President of PÜR Investing Inc., a software development company specializing in risk management and defined contribution retirement strategies.