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Canadian Bank Health Update - 2015.Q4

Go to the most recent report: 2016 Q4

Health of Canadian banks: stable (green)

Introduction

In these reports, I apply the same analysis techniques that I used when watching the US financial system through 2005-2009. These metrics should show early warning signs of impending bank losses or even a banking crisis. All data comes from public financial reports.

Summary for 2015.Q4

Capital levels and leverage

Off-balance sheet derivatives

Big Six Banks: Balance Sheet Health

Definitions: GIL = Gross Impaired Loans, CET1 = Common Equity Tier 1

Full data tables can be seen here

Table A. GIL / gross loans (higher = worse loan book)

This is a rough measure of how bad the loan book is, looking at impaired (non-performing) loans. Before 2008, these values were under 1.0%. Presently, the values are quite low but one must also consider the accounting standards change that started excluding non-performing amounts within packaged loans and debt securities: banks switched to IFRS accounting standards in 2012.Q1 which caused a sudden drop in the impaired loans being reported. It's important to note that impaired loans were stable at this time, and the approx 0.25% decline is due to accounting changes and NOT an improvement in loans. A value of 0.75% today is roughly equivalent to a value of 1.00% under the previous GAAP standards in effect during the 2007-2009 crisis.

Therefore, I watch for the 0.75% level as an important threshold.

Currently, only Scotiabank is over this threshold due to high levels of impaired loans from international banking. On average, the banks are below the threshold.

Table B. GIL / CET1 capital (higher = more risk)

Similar to the Texas Ratio, a measure of bad loans versus the bank's capital. Around the 100% mark, a bank's capital cushion is no longer adequate to absorb loan losses. This ratio is believed to be an early warning signal for bank failures, though the ratio has to get very high before solvency is threatened.

Currently, the values are extremely low. There is no threat of failure.

Table C. Leverage multiple (higher = more leverage = more risk)

Higher leverage means a bank is more susceptible to sudden shocks, and is less capable of handling losses. High leverage means a bank has less capital; conversely, low leverage means a bank has more capital. I define Leverage = Assets / CET1 capital. This is sometimes stated as N:1 or N x leverage.

Currently, bank leverage is still very high in absolute terms, but has been declining over the years.

Off Balance Sheet Derivative Exposures

Amounts are in trillions of dollars. All amounts are notional, which is the amount of underlying money represented by a contract. Note that $1 trillion notional exposure does not mean the bank could lose $1 trillion; however, it shows the magnitude of derivative contracts. For instance, RBC certainly has a larger derivatives book than any other bank and likely faces more derivatives risk than others.

OTC exposures are included here because I believe OTC contracts are the most dangerous: they are illiquid, difficult to value, and become worthless if the counterparty (another bank) collapses.

Even the experts have very little idea how to properly account for risk in derivative books. This is new and uncharted territory.

Derivative exposure is hidden off-balance sheet where it can't distress investors and depositors. The standard excuse given by banks is that they are long some derivatives, and short others – and the two (thanks to financial engineering) perfectly balance out risk, resulting in minimal net exposure. But in reality, banks can only maintain such perfect hedging during exceptionally low volatility. A spike in volatility, or a counterparty failure, can suddenly create enormous derivative losses. This happened in 2007-2009 (wiping out several banks), and will probably happen again. More derivative exposure means more risk.

The below data comes from: OSFI, financial data: banks: quarterly derivative components.

Bank 2015.Q3 Notional (trillions) OTC Notional (trillions)
RBC $13.26 $12.96
TD $6.78 $6.22
Scotiabank $5.79 $5.35
BMO $4.76 $4.62
CIBC $2.27 $2.13
National Bank $0.98 $0.74
Total derivatives $33.84 $32.02

Bankruptcy Statistics

These numbers show total Canadian bankruptcies (consumer + business). Bankruptcy rates closely relate to bank loan quality and losses. Note however that banks with significant US/international operations have further credit exposure beyond Canada, which isn't reflected in this graph.

The volatile monthly data is smoothed using a trailing 6 month moving average. Bankruptcy rates have been declining since 2010.

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