Royal Bank of Canada (TSX:RY) stock fell 7% in March after three U.S. banks collapsed. The U.S. banking system has started feeling the pressure of accelerated interest rate hikes and the delayed response to inflation. In other news, Switzerland’s second-largest bank, Credit Suisse, came under fire after its major investor refused to inject more money.
The news around banks has made investors wary, as the net income of the top six Canadian banks fell due to rising expenses and weakness in the wealth and insurance sector. Should you be worried about your Royal Bank of Canada holdings?
Royal Bank of Canada’s business model
Founded in 1864, Royal Bank of Canada is Canada’s largest bank and holds the first or second rank in most banking and financial products, including mutual funds. The bank has a diversified portfolio of services: personal and commercial banking (53%), capital markets (21%), wealth management (21%), and insurance (5%).
It also has a geographical outreach, with 60% of revenue from Canada, 24% from the United States, and 16% from other countries. RY is the largest Canadian investment bank in the United States, preferred by corporate, institutional, and high-net-worth clients.
Already a market leader, the bank looks to grow organically through cross-selling products. It is acquiring HSBC Canada, with over 130 branches and over 780,000 retail and commercial customers, for $13.5 billion. The U.S. banking crisis has nothing to do with this acquisition. HSBC is selling its profitable Canadian business due to political pressure from the west and China.
In its latest first-quarter earnings ended January 31, 2023, Royal Bank of Canada’s revenue surged 15% due to demand for loans. But its net income fell 22% to $3.2 billion due to weakness in insurance and higher provision for credit losses (PCL). The bank increased the PCL from $105 million a year ago to $532 million. While RY’s U.S. operations are facing the effects of the banking crisis, its strong risk controls can help the bank sustain itself through a recession.
Should you be worried about Royal Bank of Canada’s holdings?
Canada’s regulatory authorities have put several restrictions on banks to maintain the financial system’s stability. And the Big Six banks maintain the liquidity and capital adequacy ratio to manage market, credit, and liquidity risks.
The common equity tier-one ratio (equity capital and disclosed reserves) is the money that is readily available to a bank. Of the total loan book, a bank identifies risky assets and weighs them according to their probability of default. Royal Bank of Canada has a common equity tier-one ratio of 12.7% of risk-weighted assets, above the minimum requirement of 4.5%. This ratio states that RY’s core capital can absorb up to 12.7% of loan defaults from risky assets in a major crisis, without hampering profits.
Another risk is around liquidity, and RY has a liquidity coverage ratio of 130%, which states that it has enough cash to meet liabilities for the next 31 days plus a 30% buffer. This ratio is greater than its peers.
These risk measures show that the Royal Bank of Canada is well capitalized to handle a credit and liquidity event.
Should you invest in this bank stock?
RY stock is down 12% from its high. The weak macro environment could pull the stock down further. In the 2008 Financial crisis, the bank paused its dividend growth and maintained the dividend per share at $2 per annum. History could repeat itself. The next one to two years could see tepid growth. You can use this opportunity to buy the stock in small quantities throughout the bearishness and lock in a higher dividend yield.
A recession eliminates weak companies, and only the strongest survive. Banks tend to emerge more efficient after a crisis and have a stronger potential to harness future growth. Royal Bank of Canada’s stock first saw a recovery rally in 2009 and then a normal growth rally in 2011. RY has completed a recovery rally in 2020. If the 2008 trend continues in the upcoming recession, the next would be a normal growth rally, which is gradual and long lasting. Hence, buy the stock with the intent of long-term investing.
