Health of the Big Five Canadian banks

This is an old analysis (2009). I post quarterly reports on the Big Five Banks; see the Canadian Credit Health Reports on the main page

There has been a lot of excitement lately about the “green shoots” recovery in banking and the economy. The media celebrates strong Canadian financial sector earnings, and makes a point of how we didn't suffer American-style insolvencies. Unfortunately, I think Canadians need a reality check about the health of our Big Five banks. In this article I will summarize some risk-related data for Canadian banks: leverage, loan losses, and off-balance sheet derivative exposure.

1. Bank leverage

Most experts agree that excess financial system leverage was a major cause of the meltdown. Kansas City Federal Reserve President Thomas Hoenig, in remarks recently released, said that top American banks are still too highly leveraged as of August. According to Hoenig, the largest 20 banks in the USA have only 3.5% equity capital supporting their assets, versus 6% for the next 20 largest firms (Reuters article).

He seems to be using an equity figure known as Tier 1 capital which is a regulatory figure similar to, but not the same as, shareholder's equity. Hoenig's figure is a “Tier 1 Leverage Ratio” calculated as: Tier 1 capital / Total assets. A smaller % means less equity capital supports more assets, meaning greater leverage.

Using these recent Federal Reserve comments as a benchmark, let's take a look at the Tier 1 Leverage Ratio for the Big Five Canadian banks.

Name of bank

Tier 1 Leverage Ratio (July 31, 2009)

Bank of Montreal (BMO)


Scotiabank (BNS)




TD Canada Trust


Royal Bank of Canada (RBC)


As you can see, the Big Five Canadian banks are highly leveraged and nowhere near the 6% capital target suggested by Hoenig. Not only that, but Royal Bank in particular at 3.3% is more highly leveraged than the average large American banks! TD and CIBC are close behind. Clearly, our Canadian banks are too highly leveraged, according to the metric suggested by this Federal Reserve president.

In good times, leverage magnifies profits. In bad times, leverage magnifies losses (or swiftly leads to a bank's collapse).

Different countries have slight regulatory differences in what qualifies as Tier 1 capital, but I believe that within American/Canadian financial systems the figures are going to be close enough (most Canadian banks operate in the USA too). Discovering how leveraged our banks are should shatter any notion that our Canadian banks are somehow more conservative or cautious than their American counter-parties.

2. Impaired (non-performing) loans

It's interesting that bank profits in 2009 have not come from banking (traditional business of borrowing and lending money). The profits have instead come from trading operations, as described in Part 2 of this article. There are no profits being made in traditional banking because loans continue to deteriorate, as consumers and businesses are increasingly failing to make payments or even declaring bankruptcy.

The table below shows gross impaired (non-performing) loans as a percent of total loans. This shows what percent of the bank's loans have gone sour. All of the banks show more impaired loans than one year ago. These figures used to be around 0.7% before the downturn.

Name of bank

Gross impaired loans % (July 31, 2009)

TD Canada Trust




Royal Bank of Canada (RBC)


Scotiabank (BNS)


Bank of Montreal (BMO)


While watching the American catastrophe progress, I tracked this same statistic for US banks and noted that warning signs appeared at 1.5%, and some rather critical things (capital infusions and rescues) began to happen as the number crossed 2.0%. Those thresholds are rough of course, but some of the banks are getting close to that dangerous zone. We must keep a very close eye on these numbers and also the Canada-wide bankruptcy statistics, which are a good indicator of whether people will repay loans.

3. Off-balance sheet derivative exposure

Measures like leverage and risk are largely calculated from a bank's visible balance sheet. Most investors are not aware that the modern financial system allows banks to hold significant amounts off-balance sheet, mostly in the form of over-the-counter traded derivatives. These OTC derivatives are leveraged, new financial instruments which banks hold both for internal use (hedging) and trading.

Derivatives are complex and fraught with risks, which is largely why investors don't hear much about them. Even though some of the great losses of 2008 were attributable to OTC derivatives, the media did a poor job reporting the story that banks can suffer tremendous losses due to instruments not even showing on the balance sheet.

It is my opinion that off-balance sheet derivatives also represent hidden leverage and the potential for large sudden losses. Most derivatives are highly leveraged instruments, and huge gains (or losses) can be realized on instruments as market or model prices fluctuate. Because larger derivative exposures mean more credit/counter-party risk and more hidden leverage, I will generalize and say that greater derivative exposures generally mean greater risk for the bank.

The off-balance sheet numbers are not easy to find. The OSFI (bank regulator) does not show any data since 2007. I phoned the regulator but they did not know where the data went, so instead I pulled the information form annual and quarterly financial reports.

Here are the off-balance sheet derivative exposures of the banks. Notional values are not the amount of money at risk, but they do indicate the magnitude of the underlying contracts. For an explanation of what notional values mean and how they differ from market values, see this previous article.

Name of bank

Total notional derivatives

Source / reference


$1.10 trillion

2009 Q3 Supplementary info (p. 28)

Scotiabank (BNS)

$1.62 trillion

2009 Q3 Supplementary info (p. 33)

TD Canada Trust

$2.48 trillion

2009 Q3 Supplemental info (p. 29)

Bank of Montreal (BMO)

$3.20 trillion

2009 Q3 Supplementary info (p. 38)

Royal Bank of Canada (RBC)

$5.42 trillion

2008 Annual Report: Note 7 (p. 151)

Royal Bank (RBC) has an impressive $5.4 trillion (notional) in off-balance sheet derivatives, clearly standing out amount the big banks as the derivatives giant. All of these banks have large exposures. Remember from Part 1 that RBC and TD are the most highly leveraged banks, and large derivative exposures (hidden leverage) only adds to the risk.

Canadians need a reality check on the health of their banks

Most Canadians assume that the nation's banks are in good shape, since they are still profitable. But as shown here, there are many warning signs to keep an eye on:

Although these comparisons are somewhat crude and should be taken with a grain of salt, the data suggests:


I am short the Canadian financial sector, which includes all of these banks. If I have made any errors pulling these numbers from the financial statements, please feel free to contact me at

- Perpetual Bull