Canadian banks’ eventful year

TD’s troubles, Scotiabank’s comeback

The Big Six Canadian chartered banks all reported their fourth-quarter and fiscal year results in the first week of December, bringing an end to what was by any standards one of the most eventful years for Canadian banking since the Great Financial Crisis 15 years ago.

The year included RBC’s takeover of HSBC’s Canadian operations and National Bank’s acquisition of Canadian Western Bank. Scotiabank also expanded with an initial 4.9% stake in Cleveland’s Keycorp.

In addition, the year saw the imposition of a massive US$3.5 billion fine levied by U.S. authorities on TD Bank for failures in its anti-money laundering (AML) controls. TD’s U.S. assets were also frozen at their end-of-September level.

It used to be something of a cliché to remark that with minor exceptions, there was very little to differentiate one Canadian bank from another. But it’s now apparent that the choices made by bank managements have directly impacted the returns investors have received over the last few years.

The best-performing banks over the last five years have been the largest (RBC, up 70% before taking dividends into account) and the two smallest, CIBC (up 72%) and National Bank (up 84%). Bank of Montreal rose 44%, but the two banks with major non-Canadian exposure have been the worst performing by a long way, with Scotiabank up only 7% and TD actually down 1% over the five-year period following its 13% retreat last week after it suspended guidance for 2025.

Scotia and TD the laggards

Scotiabank has underperformed the other major banks as its exposure to Latin America has been regarded as a negative owing to volatility of earnings and over-dependence on commodities. It points specifically to what it describes as the four Pacific Alliance countries (Mexico, Colombia, Peru, and Chile), which have generated around one-third of its earnings over the last decade. This accounts for new CEO Scott Thomson’s decision to reallocate more money to its North American businesses, where it believes there are better prospects for growth than in its Latin American operations.

Apart from the initial US$800 million investment for the 4.9% stake in Keycorp, which is intended to be expanded to 15% eventually, Mr. Thomson has also mentioned he is keen to expand in Quebec, where Scotiabank has historically been under-represented.

For TD, the U.S. expansion strategy has come to a screeching halt, as the cap on assets means there is no prospect of growth in U.S. retail banking, which has been the major driver of growth for TD for the last 15 years. Given the much more fragmented and competitive nature of the U.S. banking landscape, TD’s U.S. operation was always less profitable, even though in recent years it had more branches than Canada, showing once again the enormous benefit of an oligopolistic market.

Investors had rewarded TD for its seemingly successful growth-by-acquisition strategy in the U.S., with TD being the best-performing bank over the previous five years as recently as a couple of years ago. It now appears that the focus on growth had led to neglect of basic infrastructure, such as AML controls, reinforced by over-rigid cost controls.

Now that there can be no growth in U.S. retail assets, TD will have to find other avenues to generate growth. But this will be a difficult task given its suspension last week of its previously set targets of 7%-10% growth in adjusted earnings per share, 16% return on equity (ROE), and positive operating leverage (revenues growing more rapidly than expenses) while it focuses on fixing its risk and controls infrastructure.

Scotiabank and TD were also the only two major Canadian banks that did not raise their dividend when they announced their results. The other four majors all announced increases in quarterly dividends, ranging from 8% for CIBC through 4% for RBC to 3.6% for National and 3% for BMO.

Despite this, their underperformance has left Scotiabank and TD with dividend yields well over 5%, as opposed to BMO at 4.3% and CIBC at 4.1%, while the two best-performing banks understandably have the lowest yields, at 3.4% for National and 3.3% for RBC.

Interest rates continue to fall

November’s weaker-than-expected unemployment rate rose to an eight-year high of 6.8%, giving the Bank of Canada added impetus to cut interest rates by another half a percentage point on Dec. 11, to 3.25%, rather than the previously expected quarter-point cut. Canadian banks should continue to benefit from this current cycle of falling interest rates, making borrowers more willing to take out extra loans while reducing the shock of mortgage rates resetting from the exceptional lows reached during the pandemic.

The Bank of Canada has now cut interest rates this year by a massive 175 basis points (1.75 percentage points), more than twice as much as the U.S. Federal Reserve, and one of the reasons why the Canadian dollar has been so weak. But one sector that is undoubtedly a beneficiary of this is the banking industry, as its net interest margin (NIM) between borrowing and lending rates widens and its bad debt provisions begin to decline.

While Scotiabank and CIBC saw declines of 20% or more from the previous year in the fourth quarter, provisions for credit losses (PCLs) were still higher for the other banks, but bank management expressed confidence that PCLs had peaked. With the exception of TD shares, which are down 10% over the last 12 months, much of this improving situation is already reflected in share performance, with the remaining banks up between 25% (BMO) and 68% (CIBC).

But falling rates and PCLs will continue to help banks do well over the next 12 months, as financials (including insurance companies) outperform in a falling interest rate environment. Thus BMO, National, and CIBC, at the time the three smallest of the banks by market capitalization, doubled from the post-Covid lows in May 2020 to early 2022, when rates started rising. By comparison, the Big Three of RBC, TD, and Scotiabank rose 80%.

Scotiabank’s comeback

The Bank of Nova Scotia (TSX: BNS) was the worst-performing of the Big Six banks until TD’s recent fall from grace. This was due to its exposure to what investors regarded as higher-risk areas, including Latin America, the Caribbean, and Asia. Scotiabank has taken substantial writedowns in recent years in the latter two areas, most recently $379 million on its holding in the Bank of Xian in China in the latest quarter.

For the year ended Oct. 31, Scotiabank reported net income of $7.89 billion ($5.87 per share), up 2.6%. Return on equity was 10.2%, below its long-term target of 14+%. On an adjusted basis after excluding such items as the writeoff on Bank of Xian, net earnings were $8.63 billion, up 3%, but EPS was flat at $6.47 a share, and adjusted ROE was 11.3%.

CEO Scott Thomson said “2024 was a foundational year for Scotiabank as we…made early progress against our new strategy. The bank delivered solid revenue growth and positive full-year operating leverage (i.e., revenues growing faster than expenses) while redeploying capital to our priority markets across the North American corridor.”

Book value per share has risen 4.4%, to $59.14, but more importantly, the shares are now trading at 1.33 times book value, as opposed to less than 1 times book value a year ago after rates had been rising for 18 months.

While Scotiabank did not increase its dividend at all in the last year, it still has the second-highest yield among the banks at 5.4%. There is the possibility of further moves in North America, as Mr. Thomson has mentioned his interest in expanding in Quebec. The stock would be of interest to income-oriented investors looking for reasonable earnings growth, a high and sustainable yield, and a continued rerating after years of underperformance.

Gavin Graham is a veteran financial analyst, money manager, formerly Chief Investment Officer of BMO Financial, and a specialist in international investing, with over 35 years’ experience in global investment management.

Notes and Disclaimer

The commentaries contained herein are provided as a general source of information, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.

The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

Image: iStock.com/standret