Smaller banks worth a look after Home Capital woes sideswipe shares

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The crisis at Home Capital Group Inc. has affected other Canadian lenders in at least one way: Some smaller banks are offering higher rates on deposits, which could weigh on the banks' profits as they prepare to report their second-quarter results this week.

For investors who thrive on uncertainty, though, this Home Capital spectre offers a good reason to give some of the less obvious names in the financial sector a closer look than they might usually demand.

Laurentian Bank of Canada will report its results on Tuesday, followed by Canadian Western Bank on Thursday.

Both lenders have seen their share prices decline by double-digits since the end of April. Laurentian's share price is down about 13 per cent, and Canadian Western's is down nearly 15 per cent – making these two bank stocks stand out as relatively cheap next to the heftier valuations of the bigger financial institutions.

Blame Home Capital for the discounts.

The lender, which specializes in alternative mortgages to home buyers who don't qualify for loans from major lenders, announced last month that it required a financial lifeline to offset fleeing deposits. Its share price plummeted 65 per cent on April 26, reflecting a crisis of confidence.

Concerns about Home Capital's future have reverberated throughout Canada's financial sector, weighing on the share price of any lender with a stake in the country's housing market.

But the smaller, regional banks have been hit harder than the more diversified bigger banks, and any discussion about their second-quarter results this week should explain why: Home Capital's liquidity crisis has raised questions about the funding costs for a number of other lenders, CWB in particular.

Just look at the rising rates attached to guaranteed investment certificates (GICs).

Home Capital's Oaken Financial division is now offering one-year GICs with a rate of 2.6 per cent, up from 1.75 per cent in April, according to RateHub.ca. Oaken's five-year GICs now pay a rate of 3.1 per cent, up from 2.5 per cent last month.

These enticing rates are forcing some other lenders to respond with higher rates on their own GICs to compete for investor attention. As a result, the spread between what these lenders earn on loans and pay on deposits – the net interest margin – may contract.

Equitable Bank, a division of Equitable Group Inc., raised the rate on its five-year GIC to 2.27 per cent from 2 per cent, according to RateHub.

CWB has also responded. According to Darko Mihelic, an analyst at RBC Dominion Securities, the broker GIC deposit rates for Canadian Western Bank have risen about 50 basis points (or half a percentage point) since the end of April, even as larger banks have left their rates relatively unchanged.

This presents a substantial headwind. Mr. Mihelic said that broker-raised deposits account for about 36 per cent of CWB's total deposits – and the majority of these deposits will mature within the next year.

The analyst's damage assessment: He estimates that a sustained 50 basis point increase in funding costs would reduce CWB's 2018 core profit by 9 per cent, or 23 cents a share.

"We are expecting second quarter results to be overshadowed by concerns over broker deposit funding costs," Mr. Mihelic said in a note.

At Laurentian Bank, the rate it is offering on a five-year GIC is comparable to the bigger banks. Yet it, too, has been tainted by Home Capital over concerns that it is vulnerable to financial contagion.

John Aiken, an analyst at Barclays Capital, said the market may be extending Home Capital's contentious broker relationships to Laurentian's own broker network.

However, he rejects this comparison, arguing that Home Capital's challenges are likely contained: "We maintain any parallels from Home Capital to the Canadian regional banks [are] unfair and inaccurate, and would view the sell-off in CWB and Laurentian share prices as excessive," he said.

Mr. Aiken points out that Laurentian shares trade at just nine times estimated profit, down from a valuation of 10.3 in mid-February. CWB trades at 10 times estimated profit, below its historical average and a full multiple below the average valuation for the Big Six banks.

Home Capital Group, it seems, is opening up some intriguing opportunities.