Canadian Banks to Profit from Rising Rates

With Canada’s inflation at a 30-year high, the Bank of Canada is under pressure to take steps to bring it under control. One of the key levers in a central bank’s inflation-management toolkit is interest rate manipulation. The BoC has hinted it will soon start raising the overnight interest rate from record lows – it currently sits at 0.25% -- to combat inflation.

Rising interest rates push up the cost of borrowing, a concerning development for consumers and borrowers. However, rate hikes create a tailwind for financial institutions by improving profitability and a stable economic environment for the broader financial sector, one of the strongest pillars of the nation’s economy.

Canadian investors looking to readjust their portfolios to align with the higher interest rate environment may want local lenders to buttress their portfolios. Leading Canadian financial institutions enjoy oligopolistic control of banking deposits, which keeps them highly profitable during periods of economic strength and resilient during downturns.

One of Canada's two largest banks, Toronto-Dominion (TD) operates three business segments: Canadian retail banking, U.S. retail banking, and wholesale banking. The bank has a strong U.S. presence where it also owns 42% stake in TD Ameritrade, a discount brokerage. The bank derives approximately 55% of its revenue from Canada and 35% from the U.S., with the rest from other countries. 

“Toronto-Dominion has done an admirable job of focusing on its Canadian retail operations and growing into number-one or -two market share for most key products in this segment,” says a Morningstar equity report.

The bank also boasts a number-two market share for business banking in Canada. With over $400 billion in Canadian assets under management and the largest card issuer in Canada, “Toronto-Dominion should remain one of the dominant Canadian banks for years to come,” the report adds.

The Canadian lending heavyweight has a significant presence in the U.S. with more branches stateside than any other Canadian bank. 

TD’s dominant position in the discount brokerage space bodes well for its growth since “this industry is ripe for growth as investors seek out lower-cost alternatives, and the bank could leverage its knowledge of the industry for future growth in Canada,” says Morningstar equity analyst Eric Compton to recently raise the stock’s fair value from $85 to $97, prompted by strong quarterly results.

The bank’s wide economic moat is underpinned by its solid funding base, leading home market share, moaty nonbank businesses, and the favourable Canadian banking environment.

Bank of Nova Scotia (BNS) is the third-largest Canadian-based bank by assets and one of six Canadian banks that collectively hold almost 90% of the nation's banking deposits. The global financial services provider has five business segments: Canadian banking, international banking, global wealth management, global banking and markets, and other.

The bank's international operations span numerous countries with greater concentration in Central and South America. “It is known as Canada’s most international bank as it derives a little over half of its revenue from Canada, over 40% from international operations (primarily Latin America), and a single-digit percentage from the U.S.,” says a Morningstar equity report. 

The lender’s domestic operations are more concentrated in mortgages and auto lending, with a leading market share in autos. Scotiabank has been expanding its domestic wealth operations significantly. Its acquisitions of MD Financial and Jarislowsky Fraser made it the third-largest active manager in Canada.

The bank has been rejigging its LatAm footprint. It has made strategic acquisitions in markets like Chile and Colombia while lowering exposure to businesses and geographies that are less favourable. “The international exposure gives the bank the potential for higher growth and return opportunities compared with peers, but it also exposes the bank to more risks, as we've seen during the pandemic,” says Compton, who recently raised the stock’s fair value from $83 to $87, after incorporating the latest quarterly results.

The bank’s digital efforts are reflected by spending on technology and communication. “These efforts will ultimately pay off in the form of improved operating efficiency, customer engagement, and internal sales coordination,” says Compton.

One of the two largest Canadian lenders by assets, Royal Bank of Canada (RY) generates two-thirds of its revenue from Canada, with the rest spread primarily across the U.S. and the Caribbean. Its diverse services include personal and commercial banking, wealth management services, insurance, corporate banking, and capital markets services.

Royal Bank has done a commendable job expanding its nonbank lines of business, running efficient banking operations, and generating some of the best returns for shareholders in the industry. “RBC should remain one of the dominant Canadian banks for years to come, even as a more difficult macro backdrop pressures earnings growth in the medium term,” says a Morningstar equity report.

Royal Bank of Canada has the largest amount of assets under management among the Canadian banks and is projected to remain a formidable player in its domestic retail and commercial banking operations.

It is also expected to maintain its dominance in global capital markets, a segment that is expected “to continue to be a strong contributor to net income,” the report adds, pointing out that “if anything, capital markets have been countercyclical for the bank during the pandemic as earnings have soared for the unit.”

The wide-moat bank’s wealth-management segment also boasts strong returns on equity with large inflows lifting it to a top market position. “RBC remains a top asset manager and gatherer in Canada and is also experiencing outsize growth from [U.S banker] City National, where cross-selling and client integration efforts have gone well,” says Compton, who recently upped the stock’s fair value from $132 to $141.