In Part #1: Why the Global Investment Banking Model is Under Siege, we discussed why the global investment banking model is undergoing a painful restructuring. Hardly a day goes by without bad news of the challenges facing the global investment banks. In this Insight, we address the obvious question: “With their large investment banking operations, how have the Canadian banks largely avoided this painful global restructuring?”.
Part #1: Why the Global Investment Banking Model is Under Siege
Part #2: Why the Canadian Investment Banks Largely Avoided the Painful Global Restructuring
- Canadian Wholesale Divisions are Not “Pure Play” Investment Banks: Canadian investment banking subsidiaries are actually combined corporate and investment banks. As a result, the inclusion of more stable net interest and credit fee income from the corporate lending operations helped dampen revenue volatility from the capital markets divisions.
- Pre-Crisis Canadian Investment Banks Operated at Lower Leverage than their Global Peers: Relative to global investment banks, Canadian investment banks entered the crisis with materially lower leverage than their global investment banking peers. As a subsidiary of a regulated commercial bank, Canadian investment banks were/are required to operate under the parent bank’s total bank capital rules which include a limit for assets-to-capital. This meant the sector’s business model is designed to generate returns on a higher capital base. As a result, these subsidiaries experienced lower dilution to their returns on capital than their global peers (although the Canadian banks did seek to increase capital levels, post crisis).
- Canadian Banks Have More Stable Funding than Global Investment Banks: Canadian banks operate with loan-to-deposit ratios below 100%, meaning they are funded by stable retail core deposits versus less stable uninsured wholesale funding. By contrast, many global investment banks entered the crisis relying heavily on short-term funding, including overnight REPOs, making them highly vulnerable to credit market distress.
- Oligopoly Structure in Canada Enables Strong Market Power: The Canadian investment banking market, now dominated by the Big-6, does not have meaningful competition from the global investment banks or importantly, domestic independents. By integrating corporate and investment banking, and combining the sale/distribution of lending and capital markets products, the Big-6 banks have imposed significant barriers to entry to the Canadian market, allowing them to hold strong pricing power and retention over key staff.
- Canadian Wholesale Segments Less Impacted by Volcker Rule: With less exposure to fixed income and “proprietary” trading as a percent of total gross revenues, the Canadian investment banks were less impacted by the Volcker Rule than their global peers.
For the Canadian banks, their corporate and investment bank segments generally, and investment banking subsidiaries specifically, have largely avoided the painful restructuring of their global peers. This is not to say they don’t face certain challenges (they do), but that, unlike their global peers, their challenges are cyclical and not structural.
First, the Canadian investment banks are not “pure play” investment banks; rather, they are a combined corporate and investment bank (CBIB). The broker-dealer subsidiaries were combined with the corporate lending business nearly two decades ago. As a result, revenues generated by these segments are not exclusively volatile capital markets items, like trading, underwriting fees and commissions, but also include a very large stable component from corporate lending, like net interest income and credit fees (although they also include potential for credit losses). Therefore, Canadian investment banking earnings were significantly more resilient than their global peers entering the crisis, and the areas facing the greatest headwinds (namely fixed income trading), while important, represented a much lower percentage of gross revenues for the total/consolidated bank.
Second, by entering the crisis with higher capital levels, the Canadian investment banks did not experience distress or pose systemic risk to the Canadian economy. The main reason for this is that, before the crisis, Canadian investment banks operated within the regulatory capital rules of their parent bank. This meant that the Canadian wholesale segments did not operate at the same massive leverage ratios as their global peers (which in some instances, reached ~50x assets-to-equity). As a result, the sector was not required to undergo a massive recapitalization, such as that imposed upon the global investment banks which resulted in significant EPS and ROE dilution. Hence, while the Canadian banks did add materially to their capital as a result of post-crisis Basel capital regimes, they did not raise nearly as much as the independent global investment banks, which saw their required capital levels basically double.
Moreover, unlike their global peers, Canadian banks largely avoided multi-billion dollar write-downs of U.S. alternative mortgages and litigation charges from the U.S. government, which together placed additional stress on global investment bank capital levels and caused additional EPS/ROE dilution.
Third, the funding model for Canadian banks and, by extension, their corporate and investment banking subsidiaries, never experienced severe stress. The main reason is that Canadian banks – as an overall business – operate at loan-to-deposit ratios well below 100%, which results in significant funding stability by reducing reliance on uninsured wholesale funding sources in favour of stable core deposits.
This is in stark contrast to the global investment banks which, heading into the downturn, were not only funded almost exclusively by less stable wholesale funding, but even worse, relied heavily on the overnight REPO market. This funding structure meant that the independent global investment banks were highly vulnerable to an institutional “run on the bank” once balance sheet confidence was compromised. In fact, this reliance on highly unstable funding ultimately hastened the downfall of Bear Stearns and Lehman Brothers and, for a period, placed Goldman Sachs and Morgan Stanley in mortal danger as the crisis was peaking.
Fourth, competition within Canada is much lower than in other large/developed economies, and is not meaningfully impacted by competition from the global investment banks. By integrating corporate and investment banking, and combining the sale/distribution of lending and capital markets products, the Canadian banks have imposed significant domestic barriers to entry to the Canadian market. It also provides them with significant market power over their domestic independent competitors. This oligopoly market structure gives the Canadian banks substantial market power, enabling the sector to reprice products and reduce/control compensation ratios after the crisis. The sector also benefited from the near elimination of independent investment banks in Canada in the 15 years preceding the downturn, which further reduced competition for both revenues and key staff.
Fifth, entering the crisis/downturn, Canadian banks’ CBIB segments were less exposed to both fixed income trading and “proprietary trading” relative to most global investment banks. As a result, they were much less impacted by the implementation of the Volcker Rule – which was designed to limit proprietary trading within institutions substantially funded with government-insured deposits.
Canadian CBIB Segments Do Not Face Structural Challenges Domestically (Cyclical Headwinds Only)
For the reasons cited above, the Canadian corporate and investment banks are not facing structural challenges to their business model. That said, these businesses definitely did not completely escape regulatory change. Much higher required capital levels globally have resulted in a ~350 bps decline in Canadian bank ROE since 2011, despite benefiting from a credit tailwind during the period (i.e., declining provision ratios). With the Canadian corporate and investment banks representing close to 25% of total bank earnings, the fact that these important subsidiaries are not facing anything close to the challenges of their global peers is a major positive.
However, the Canadian corporate and investment banks do face a significant challenge in the form of looming credit losses from their large energy portfolios, as the sector enters at least a mild credit cycle. That said, this challenge is cyclical, not structural, and these losses will be absorbed through earnings as they emerge, and are unlikely to result in the need to raise capital.