Without their ambitious international expansion plans, Canada's biggest banks would be constrained by their large size in their home market, their dependence on domestic economic activity and the direction of interest rates.
That is, they would look like a Canadian version of U.S.-based Wells Fargo & Co. – which isn't a good thing, according to Hamilton Capital Partners, a Toronto-based investment manager that specializes in financial services companies.
"Wells Fargo represents the Canadian bank counterfactual – i.e., what a Canadian bank would look like without a viable expansion strategy," Hamilton Capital's Robert Wessel, Jennifer Mersereau and Chris Dewey said in a report.
Most notably, the portfolio managers pointed out that the U.S. giant has gone three years without reporting any perceptible profit growth.
Of course, Canadian banks have been expanding abroad, with the size of recent deals underscoring the importance they put in U.S. diversification.
Royal Bank of Canada completed its $5-billion (U.S.) deal for Los Angeles-based City National Corp. last year. Toronto-Dominion Bank struck a $1.3-billion deal for Scottrade Bank last month. And Canadian Imperial Bank of Commerce announced a $4.9-billion (Canadian) deal for Chicago-based PrivateBancorp Inc. in June.
The flurry of deals has been accompanied by glowing growth prospects, but there has been little discussion of what the alternative to international expansion would look like. How would Canadian banks fare if they just stayed put in Canada?
Hamilton Capital holds up Wells Fargo – its market capitalization, based on the value of its outstanding shares, is equal to Canada's three biggest banks, combined – as an illustration. They connect the U.S. bank's focus on the domestic U.S. market to its inability to increase its quarterly profits in recent years.
"In our view, Wells Fargo is arguably the first bank in U.S. history to be strategically challenged based on its immense size," the portfolio managers said.
"To illustrate, with the integration of Wachovia Corp. complete, credit normalized and GDP growth for the United States well below historical trends, Wells Fargo is now entering its fourth year of basically zero earnings growth. And with rising legal/litigation/compliance expenses likely to weigh on future earnings, it would not surprise us if 2017 consensus estimates are revised downwards."
To be fair, Wells Fargo and its peers among U.S. banks have been on a nice rally over the past four trading days, following the results of the U.S. presidential election.
With many observers expecting the Trump administration to relax bank regulations and drive up inflation and bond yields – which can make bank loans more profitable – the KBW bank index has risen more than 12 per cent. Wells Fargo shares have surged 16 per cent.
The rise is likely reflecting the promise of bigger profits ahead if the Federal Reserve raises interest rates. But analysts at Royal Bank of Canada found that some U.S. banks would benefit far more than others in a rising interest rate environment.
Comerica Inc., Bank of America Corp., Regions Financial Corp., M&T Bank Corp., Citizens Financial Group Inc. and JPMorgan Chase & Co. would see their profits rise by double digits if the Fed raised its key rate by a total of 1 or 2 percentage points. Wells Fargo, by comparison, would see its profit rise just 5.2 per cent in a rising interest rate environment.
Needless to say, Hamilton Capital doesn't see a lot of potential in Wells Fargo, and believes that its recent imbroglio involving the creation of unauthorized bank and credit card accounts, simply reflects its growth challenges.
Instead, they prefer mid-cap U.S. banks, such as First Republic Bank, SVB Financial Group and Western Alliance Bancorp, which are showing better profit growth, are more rate-sensitive and come with lower regulatory risk.
As for Canadian banks, which are set to report their year-end financial results starting at the end of November, Hamilton Capital believes they're a better bet than the U.S. giants.
"While earnings-per-share growth of the Canadian banks is clearly slowing to mid-single digits, we would expect the sector to outgrow the U.S. mega-caps in absence of material differences in either GDP growth rates and/or central bank policy," the portfolio managers said.