Canadian banks face a conundrum: how to use a $ 55.5 billion spare

As of October 31, Canada's six largest banks had C $ 70.4 billion ($ 55.5 billion) more Tier 1 equity capital than regulators required. Capital CET1 is a pantry of securities designed to serve as the bank's first line of defense in a financial crisis.

While excess capital may be reassuring during a global pandemic, it also threatens to become a drag on banks' return on equity, a key indicator for investors as the Covid-19 vaccines spread and the economy recovers. The challenge banks face is to make a compelling case that they have a better plan to make that money work - and get a better appreciation for it.

"Investors are now looking for where they will grow - revenue and net profit?" This was stated in an interview by Barclays Plc analyst John Aiken. "Investing in capital can definitely help this and also improve the disincentive effect that this higher level of capital has on the return on equity."

Investors may get some answers about how companies plan to use that capital on Monday when their CEOs are due to speak at Royal Bank of Canada's annual CEO conference.

One of the more exciting opportunities for investors is that banks will use this dry powder for shopping, especially south of the border. Toronto-Dominion Bank CEO Bharat Masrani said last month that he is "very open to acquisitions" and sees them as a way to accelerate the growth of his US business. Likewise, Royal Bank CEO Dave McKay said last month that his bank is "looking to expand" in the US and "will continue to seek opportunities."

'Do something'While Toronto-Dominion is "under the most pressure to 'do something'" on the acquisition front, now is the time for Canadian banks to take over smaller US banks, National Bank of Canada analyst Gabriel Deshane wrote on December 16. clients. Banks have surplus capital, low interest rates and weak organic growth prospects, he said.

“The current situation is probably just as good as others for a deal,” Deshane said.

The capital was created last year to guard against a possible wave of defaults resulting from economic shutdowns to combat the spread of Covid-19. In March, Canadian regulators ordered banks to stop share buybacks and increase dividends.

Initially, Aiken said, investors welcomed the capital increase because it made it less likely that banks would be forced to raise more money, resulting in equity dilution. It also ensured the safety of their dividends, a major concern for Canadian investors, he said, as banks in the country tend to have higher returns than their American counterparts.

Extra capitalAs a result, as of October 31, Canada's six largest banks reported a combined CET1 capital of C $ 262 billion, representing 12.3% of their risk-weighted assets. Regulators require this ratio to be only 9%, which means that banks have C $ 70.4 billion more than envisaged.

Many banks are targeting ratios of around 11% internally, and the Big Six still have CET1 additional capital of C $ 27.8 billion above that level.

Beyond acquisitions, share buybacks can be a quick way to mobilize capital once they are allowed again. However, it will take some time for Canadian regulators to see how serious the credit losses are, Aiken said. They will allow foreclosures to resume early this summer, he said, although a fall is more likely.

According to a Bloomberg Intelligence study, Canadian banks could buy back 2% to 5% of their shares year-on-year this year if regulators allow share buybacks in a manner similar to the way the US Federal Reserve did late last year for US banks.

Raising dividends could be an equally quick way to make money work if regulators allow it. So far, Canadian officials have only opened the door for special dividends under "exceptional circumstances."