Banking on a Break

07/20/2010 12:01 am EST

Focus: GLOBAL

Tom Slee

Retired- Financial Advisor, Money Manager, Gordon Pape Enterprises LTD

Even if the financial industry can’t water down tough new capital requirements, several Canadian lenders should emerge as winners, writes Tom Slee in the Internet Wealth Builder.

Pity the poor politicians. They have just discovered that reforming banks is easier said than done. The finance ministers cannot agree on a bank tax, let alone a ban on hedge funds or ways to clean toxic assets.

This is an incredibly complex sector and has to be carefully handled. If the new rules are too weak, it's going to be business as usual; too tough, and credit dries up. That's why the G20 kicked the problem down the road. Talk about uncertainty! Yet, Canadian banks stand to benefit.

One thing is certain: There are going to be some significant changes in the way Canadian banks do business. Sure, they weathered the worldwide collapse much better than their foreign counterparts, but they are not going to escape unscathed.

The proposals that count are contained in documents issued by the Bank for International Settlements (BIS) in Switzerland. Officials generally agree that these will govern international banking in the future. So, Bay Street analysts are agonizing over the small print, trying to gauge the implications.

The first document deals with new global banking capital requirements, and it is much more severe than expected. Even the Canadian banks, with their huge surpluses, are going to feel the impact. Stricter capital requirements will slow bank earnings growth—in this case, by as much as 5% per annum.

The second document relates to liquidity, and according to many experts, is more demanding than the capital requirements. Banks will [be required to] keep a higher percentage of their assets in liquid but inevitably lower-yielding investments, such as cash and government bonds. That is going to reduce earnings. In fact, it has been estimated the requirements would reduce the Canadian banks' return on equity by as much as 150 basis points. We would be left with six major, extremely safe but less profitable financial fortresses.
 
The betting, therefore, is that both the capital and liquidity requirements are going to be substantially modified.

I still like Bank of Montreal (NYSE, Toronto: BMO), [which is] expected to earn about C$5.00 a share this year, with an increase to C$5.50 in 2011. With a 12x price/earnings multiple, the shares are cheap and pay a C$2.80 dividend to yield 4.67%. Consequently, you earn a well-above-average return even if the economy splutters and capital gains are delayed. I have a C$65 target, slightly less than the $C67 consensus forecast.

I also continue to like TD Bank (NYSE, Toronto: TD) with a conservative target of C$82. Some analysts were disappointed with the second-quarter numbers, but when you scratched the surface, they were solid. Loan losses were far less than expected. We could see earnings of C$5.90 a share in 2010 and an increase to the C$7.00 range next year.
 

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