Should higher buffer requirements bother Canadian bank investors?

Banking sector analyst says capital requirement is important to earnings – but it's not the only factor

Should higher buffer requirements bother Canadian bank investors?

The most recent decision to raise capital buffer requirements by Canada’s banking regulator might raise concerns some investors mindful of its impact on earnings. And while one analyst agrees it’s important to consider, he isn’t too worried.

“Whenever the environment is challenged, the [Office of the Superintendent of Financial Institutions] gets very focused on bank strength. And capital is an extremely important element to that,” says Robert Wessel, managing partner and co-founder at Hamilton Capital (pictured above).

In January, Hamilton published a commentary outlining four opportunities and four risks for Canadian investors in 2023. Among the risks highlighted was regulation, which included capital requirements.

Last month, OSFI announced it was increasing its Domestic Stability Buffer requirement by 50 basis points to 3.5% of total risk-weighted assets. As a result of the increase, the new regulatory minimum CET1 ratio will be bumped up to 11.5% effective November 1.

In a research report published on the heels of the announcement, BMO highlighted several vulnerabilities underscored by OSFI including Canadian household indebtedness; Canadian asset imbalances; Canadian institutional indebtedness; and external systemic vulnerabilities.

“[OSFI] believes a higher DSB is required under the current circumstance as it allows the ‘Big 6’ to have more capacity to respond to potential vulnerabilities and absorb losses during periods with stress,” BMO said.

The announcement from the banking regulator came several weeks after Canada’s Big Six banks revealed earnings misses in their Q2 reports. Those downside surprises, Wessel says, were driven largely by a $1.2-billion buildup of reserves; over the past four quarters, they’ve systematically built up reserves of over $2.5 billion against performing loans.

“Collectively, the Big Six banks have allowances against performing loans – loans that are still current in interest and principal – of $20 billion,” he notes. “The extent to which banks beat or miss in the next quarters is probably going to be determined by whether or not they have to keep building up these reserves.”

For its part, BMO viewed OSFI’s announcement as marginally negative news for bank investors as it expected higher capital levels to present a near-term headwind to ROE. Martin Pelletier, senior portfolio manager at Wellington-Altus Private Counsel, agrees, adding that some banks have greater exposure to the systemic vulnerabilities OSFI is mindful of.

“I would encourage investors to do their homework on the individual banks within Canada, and how exposed they are to higher rates and mortgages,” Pelletier says. “Generally, the sector’s done a pretty good job of maintaining the appropriate capital ratios.”

Because the reserve requirement is a non-cash accounting metric, Wessel says there’s not much transparency around how it’s calculated. As for the wider question of earnings estimates, he says the forecast for Canada’s economy will be a major factor.

Inflation appears to be moderating; Statistics Canada reported Canadian CPI decelerated from 4.4% in April to 3.4% in May. With GDP growth remaining outside recessionary range and unemployment still relatively low, Wessel anticipates banks will continue to report ROEs in the mid-teens.

“If this new cycle of reserve builds is over or moderating, then I think you'll probably see them begin to recover,” he says.