RBC has been downgraded by Standard & Poors by assets to ‘negative’ from ‘stable’.  Rating agencies always tend to be reactive, not proactive…a nice change.  Should we be concerned as Royal is Canada’s biggest bank?  I discussed last year that the risks in banks were high due to the oil crash and overextended Canadians.  Could this be the beginning of more pain to come and what should investors do?

Enjoying this article? Receive our Fortrus 4-Minute newsletter for FREE - Sign-up now! Empower your investing today! For a limited time, receive our Precious Metals: Gold and Silver report, a $79 value for free!

What prompted the S&P to downgrade the Royal Bank of Canada?  They state that it reflects the lender’s increased risk appetite and credit-risk exposure relative to other domestic banks.  The S&P also said that the downgrade reflects their concerns over what they see as RBC’s higher risk appetite relative to their peers.  An example they used is its aggressive growth in loans and commitments in the capital markets wholesale loan book, especially in the US.  Rating of the bank’s assets to ‘negative’ is definitely a concern.  They are leaving RBC’s credit ratings untouched at this stage.

Let’s look at how this compares to 8 mega US bank ratings.  In December 2015, the S&P lowered by one notch its ratings on the non-operating holding companies of Bank of America Corp., Bank of New York Mellon Corp., Citigroup Inc., J.P. Morgan Chase& Co., Morgan Stanley, State Street Corp., Goldman Sachs Group and Wells Fargo & Co. The rating outlooks are stable.  The primary reason for the downgrade is the probability that government bailout is much less likely in today’s world given state legislation.  S&P’s downgrades put Bank of America, Citigroup, Goldman and Morgan Stanley at triple-B-plus, which is three notches above junk territory, while J.P. Morgan is one notch higher at A-minus. Bank of New York, State Street and Wells Fargo are rated A.

Royal’s downgrade means that their rating may be lowered.  The way S&P ratings work, is they categorize a bank as positive, stable, developing (rating can be changed either way) or negative.  As you see, negative is the area of most concern.    The bank is currently not a concern, but it is trending the wrong way.  The biggest concern for RBC is its exposure to the oil and gas sector which is valued at about $8 billion dollars on their books.  Over 80% of these loans are lower quality companies.  On top of this, they have about $11 billion in untapped credit for energy borrowers, of which over 40% is with lower grade borrowers.  Alberta represents 16% of the bank’s retail loans which again is a concern given the implosion of the energy sector.

This adds to the list of negative announcements on Canadian banks as in January the Bank of Nova Scotia was downgraded one notch by Moody’s over what it calls a “shift away from the bank’s traditionally low-risk appetite.”  This comes amid Scotia’s growth in credit card and auto finance activities – both of which Moody’s says are especially prone to deterioration when the economy weakness.  The move came just a few hours after Fitch revised its outlook on RBC to negative due to potential earnings volatility.

So what are the biggest areas of concern for Canadian banks:

  1. Energy company loan write-downs
  2. Over-indebted Canadians with huge credit card, auto loan and home line of credits
  3. Mortgages that have been driving their growth since the financial crisis
  4. Exposure to the development and construction sector that has also been a major driver behind the Canadian economy and bank earnings
  5. Investment banking and IPO’s, as they tend to dry up during negative stock market and economic periods
  6. Investment management fees, as customer portfolio performance has been poor, fees are supposed to be disclosed soon, and pressure on fees coming down will be huge

Bottom line, the banks better hope that the Canadian economy only goes through a soft landing.  This will be contingent on the US and how their economy fairs.  Our economy is tightly linked to theirs.  The concern with the US is that their economy is weak, yet their Central Bank, the Federal Reserve is still talking about increasing interest rates.  The last two times that the Federal Reserve pushed up interest rates a recession followed shortly after that.  In current times, it is, even more, concerning given the massive increase in debt across the board and fragile financial system.

It is critical to make sure that you have a robust risk management plan in place to ensure that your investments and trustee of your assets are very safe.

Matt Sammut