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The great Canadian bank stock bonanza is coming to an end

Last year, my bank lost $150,000 of my money. Its automated systems didn't register a four-for-one stock split in my investment account and inadvertently vaporized a six-figure amount. I spent a couple of weeks making increasingly frantic calls before the money reappeared.

I mention this because many people seem to believe Canadian banks are superbly managed world-beaters. I disagree. To my eye, they're glitch-prone institutions that face a growing number of issues. If you're counting on them to produce big returns over the decade ahead, I urge you to think again.

Now, I realize this is a minority opinion. Canadians love bank stocks, and for good reason. In recent decades, the Big Five have delivered an intoxicating blend of stability, growth and lush dividends. They've soared far, far beyond the rest of the Canadian stock market.

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Like everyone else, I'm in awe of the Big Five's great run; I just want to point out it's unlikely to continue at anything like its historic pace. Yes, that's partly because of Canada's frothy housing market. But even if you make the heroic assumption that home prices will never decline, the outlook for Canadian bank stocks over the next decade still looks only so-so.

The reason is simple: Banks have little, if any, expansion room left in this country. The Big Five already dominate every area of financial services, outside of some areas of insurance that will probably continue to be off-limits due to political pressure and regulatory barriers.

But surely there are opportunities for the banks in other countries? Maybe. The problem is that Canadian banks face tough local competition when they venture into foreign lands. Look at Toronto-Dominion Bank, one of the best-run Canadian lenders. It hasn't been able to achieve returns on equity in its U.S. operations that come anywhere close to the results it generates in Canada.

Canadian banks' middling experience outside Canada highlights an often overlooked point: Our domestic banks have grown so strongly over the past half-century not because of best-in-world business acumen, but because Canadian regulators have gone to great lengths to engineer their success in the domestic market. Eager to create national champions, the rules-makers have done everything they can to allow big banks to gobble up smaller competitors as if Canada's financial services sector were a giant game of Pac-Man.

Amazing as it now seems, Canadian banks were once restricted to making business loans. The environment began to shift in 1954, when the banks won Ottawa's approval to inch into mortgage lending and personal lending. A wave of expansion followed.

Then, as regulators knocked down other barriers, the Big Five surged into new areas—securities and investment banking in 1987, followed by the trust industry and large parts of the insurance sector in 1992. Over the past decade and a half, banks have swallowed much of the mutual fund and financial planning business.

Today, whether you look at investment banking, retail banking or wealth management, big banks dominate. But they face largely saturated markets. Household debt stands at record highs in comparison to disposable income. Meanwhile, total credit to Canada's non-financial sector has surged to a dizzying 297.8% of GDP, the second-highest level in the G7, according to the Bank for International Settlements. Canadian banks operate more than 220 ATMs per 100,000 people, roughly five-and-a-half times the global average, according to World Bank estimates.

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Sure, the Big Five will remain profitable, but it's difficult to see how their future growth can match their glorious past. Despite that concern, Canadian bank shares are trading at significantly higher levels than their U.S. or European rivals if you compare price-to-book-value ratios.

Already, the sector is slashing costs and closing branches in an effort to maintain profitability. However, banks must keep investing heavily in technology to fend off competition from more technically advanced rivals and keep customers happy in an increasingly online world. Judging from my recent experience, they still have some distance to go. Expect bumps ahead.

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About the Author

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More

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