How Risky Are Canada’s Banks?

Despite Canada’s banks being heavily exposed to a slowing economy and weak oil prices, Toronto-Dominion Bank (TSX:TD)(NYSE:TD) still stands out as a solid investment.

Matt Smith ❯

Former investment manager and market junkie, Matt has 20 years of experience. He hails from Sydney Australia where he earned a Master of Business Law from the University of Sydney and Master of Arts in International Relations from the University of New South Wales. He has been helping investors achieve their goals for over a decade. When not studying the markets, he can be found relaxing with his dogs and practising Spanish.

Published May 18, 2015 8:09 am EDT

The collapse of oil prices has had a far more profound impact on Canada’s economy than many other industrialized countries because the oil industry is responsible for generating roughly 5% of Canada’s total GDP. With this in mind, weak oil prices will not only affect energy companies, but also have a broader impact on Canada’s economy, and banks are becoming increasingly vulnerable.

Now what?

You see, household debt is now hovering around record levels, leaving Canadian households exceptionally vulnerable to economic shocks like the oil rout. This, along with a frothy housing market, means lending activity and mortgages from Canada’s banks are at record levels. The end result is that Canada’s banks have far greater exposure to weak oil prices. This has firmly ratcheted up the degree of risk associated Canada’s banks.

One bank that is visibly hamstrung by weak oil prices is Canadian Western Bank. It has 42% of its total loan portfolio located in Alberta and $600 million in loans to the energy industry. As a result, its share price has plunged 21% in the last six months and I expect this exposure to act as an overhang on its performance and share price for some time.

Another bank that appears to be vulnerable is the Bank of Nova Scotia, with loans to energy companies totaling $15 billion, or 3% of its total loan portfolio. It also boosted its exposure to unsecured consumer lending through a series of acquisitions in recent years, which has dialed up the degree of risk in its lending portfolio.

The National Bank of Canada also has considerable direct exposure to oil and other faltering commodity prices, having lent over $4 billion to the mining and oil industries. Despite this, with the majority of its loan portfolio located in Quebec and eastern, Canada it should be shielded from the impact of the oil rout on the housing market.

Nonetheless, before panicking investors should consider that given the tough regulatory environment in which they operate, all of Canada’s banks have healthy risk indicators. They are all adequately capitalized with tier one common equity capital ratios, well above the minimum regulatory requirement of 7%. The health of their loan portfolios remains high, with impaired loans as a portion of total loans at about 1% or lower across the industry.

So what?

Of Canada’s banks, it is Toronto-Dominion Bank (TSX:TD)(NYSE:TD) that has one of the lowest direct exposures to oil prices, with only $4.5 billion, or less than 1% of its total loans, being made to the energy industry. It also has a relatively small proportion of its mortgage portfolio located in the energy patch, reducing the indirect impact of the oil rout on its balance sheet earnings.

More importantly, it is its U.S. banking franchise that gives it a key advantage over many of its peers; it minimizes the fallout from the weak oil prices because the rapidly recovering U.S. economy will help to drive earnings higher, while reducing its reliance on a faltering Canadian economy to generate earnings.