After First Republic’s failure, Canadian banks need to come clean on capital

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Consider this a stretch assignment for Canada’s banks.

The regulatory seizure and sale of First Republic Bank FRC-N – the second-largest bank failure in U.S. history – is creating a golden opportunity for Canadian lenders to once again distinguish themselves from their global peers.

But winning the hearts, minds and, let’s face it, money of investors will require our banks to show, and not just tell, the world that they remain well-capitalized during this crisis which has resulted in the failure of four U.S. lenders and the rescue of a Swiss banking behemoth in a matter of months.

That’s why Canadian banks should use their coming second-quarter earnings season to stand out from the crowd by providing improved public disclosures about how they fulfill their capital requirements – and in a way that ordinary people can easily understand.

Here’s the problem: Our banks’ financial disclosures offer insufficient detail about the composition of their capital positions.

Just look at their regulatory disclosures and try to decipher what each financial institution counts as capital. Then, if your eyes haven’t completely glazed over, attempt to compare and contrast the capital management strategies of lenders across the domestic industry.

It’s impossible.

Frankly, Canadian banks are doing themselves a disservice by making it so difficult for investors to separate the wheat from the chaff, especially since their primary growth market is the United States.

The failures of First Republic, Silicon Valley Bank, Signature Bank and Silvergate Bank – along with the rescue of Credit Suisse – are naturally prompting questions about whether Canadian banks are capitalized differently than their American and European peers.

Although the short answer is probably “no,” Canadian banking culture is certainly more conservative than what exists in other markets. Our lenders likely have a good story to tell, but their penchant for corporate bafflegab makes it unnecessarily difficult for investors to follow the plot.

Executives and corporate directors, take note. The old way of doing things – simply telling the market that Canadian banks maintain strong capital ratios – is no longer enough.

Here’s why.

Investors already know that some banks have more latitude on how they meet their capital requirements.

The Big Six, for instance, use what’s known in industry parlance as the “advanced internal ratings-based approach” to calculate credit risk. That means the banks – not the regulators – determine “all variables” for calculating risk weights. (Risk-weighted assets are used to determine how much capital banks must set aside.)

So, to a certain extent, it’s based on an honour system.

Investors are also aware the federal banking regulator, the Office of the Superintendent of Financial Institutions, required banks to phase out the use of some complex securities as part of their Tier 1 capital ratios during the COVID-19 pandemic.

But it’s not clear when looking at the banks’ financial statements whether other lower-quality securities are still being included the mix. Banks must be transparent about this issue.

Not only has OSFI recently identified liquidity and funding as the second-biggest risk to the financial system, but the regulator is also mulling whether to strengthen its liquidity rules. (Liquidity refers to a bank’s ability to convert its assets, such as securities, into cash.)

Moreover, the World Bank Group warned in 2019 that while overall capital levels have increased for large banks in high-income OECD countries, definitions of what constitutes capital have become “less stringent” in the years since the Great Financial Crisis of 2008.

Did Canadian banks buck that trend? Investors deserve to know.

As The Globe and Mail reported in March, analysts have determined (based on the banks’ first-quarter results) that Canada’s Big Six have nearly $30-billion in “unrealized” losses in their securities portfolios. But some of those losses are offset by financial hedging instruments.

Banks should do themselves a favour by providing investors with digestible information about how that process works.

Chief executives should practise by explaining it to their elderly parents or even a fifth grader. I’m being serious.

The reality of so-called fractional reserve banking means that lenders are only required to keep a portion of customer deposits available for potential withdrawals.

They lend out the rest to make more money – which is a good thing because it fuels economic growth. But that also means that no bank, including those in Canada, could sustain a massive run on deposits.

Banking is all about maintaining confidence – and right now, investors and customers alike remain dubious about resilience of U.S. and European banks.

If Canadian banks want to avoid getting caught in the downdraft, they should raise the bar on their public disclosures and require their executives to ditch the industry jargon on investor calls.

It’s time for domestic banks to come clean on their capital positions. Their inclination to say as little as possible is needlessly creating reputational risk.

Our banks have long claimed to be boring. But in this new era of digital bank runs, transparency is the key to maintaining the public’s trust.