Canadian investors have been anticipating a lot over the past several months, especially the day when banks would be unshackled from the emergency regulations that were put in place at the start of the pandemic. That day came on Thursday, when the Office of the Superintendent of Financial Institutions (OFSI) announced that starting immediately, banks would be able to increase their dividends and buy back shares. Expectations of this development had been brewing throughout the summer and analysts figured that the timing for a shift would be either October or November. Given that this is the start of the new fiscal year for Canada’s banks, the timing seemed perfect and comes just a few weeks before we get fourth quarter earnings.

 

Before looking at how the market might deal with the news, let’s first take a step back and examine the reasons for the restrictions in the first place. Following the financial crisis of 2007-09, central banks and federal regulators around the globe realized that banks needed to maintain higher than historical capital ratios given the increasing financial cross threading of the world and to protect against the mistakes before the crisis. At the end of the day, the strength of the banking system stems from its ability to absorb losses that are unexpected. Prior the crisis, many institutions outside of Canada had capital levels that were too thin, lending practices that were too loose and a risk-taking appetite that was insatiable. Following the crisis, the Basel Committee on Banking Supervision agreed on what was termed, Basel III – which aimed at increasing capital requirements, lowering the amount of leverage that banks could have and increasing the level of quality of assets held by banks. A long-winded way of saying that banks now needed to keep more and higher quality capital in reserve against potential storms.

 

 

As the above chart shows, the storm in the great financial crisis/recession was pretty severe. The TSX banking sub-group had lost close to 60% from its peak in 2007 to the first quarter of 2009 and the S&P500 bank group was down almost 90%. No major Canadian financial institution folded in that period (unlike a couple of key ones in the US) and none cut their dividends. The main reason was that Canada didn’t suffer a housing shock and mortgage crisis as the US did. When the COVID-19 pandemic hit in 2020, this was arguably less visible that the factors that created the great financial crisis. There were no textbooks on orchestrated economic shutdowns and no on knew what policy responses would arise, nor how effective they may be. In hindsight the responses were explosive and their effects took place quicker than most expected. Still, at the start, regulators were blindsided and imposed emergency capital restrictions on the fear that Basel III was not going to be enough.

 

If the world was truly going off a cliff, the last thing regulators needed was for the banking system to fail. Capital was viewed as potentially becoming as scarce as semiconductors or contractors for your next home renovation. Therefore, it was not the time for banks to follow their annual tradition of boosting dividends and it was definitely not time to waste capital on buying back shares from investors. It’s easy to look back and say that these restrictions were perhaps a little restrictive, but everyone’s crystal ball was broken then and there are still some cracks and smudges today.

 

Now that the shackles are off, what does mean for investors? Well, at this point we don’t really know. The market believes that the upcoming earnings announcements will contain news of dividend increases and Bloomberg consensus estimates suggest increases in the neighbourhood of 5-10%. Before you say “big deal”, consider that after the financial crisis it was four years from the last dividend hikes before we got the first and that was in 2011. We aren’t even at the two-year anniversary of the pandemic-led restrictions, so I consider this an important historic development.

 

 

Investors have definitely been patient throughout this process. Dividends haven’t budged since the start of the pandemic, but the TSX bank sub-group has rallied 97% from the trough in March 2020 to this week. There’s a lot of reopening optimism in there, don’t get me wrong, but there is a sizable amount of dividend growth faith in there as well. Since the financial crisis, the estimated dividend yield for the overall TSX bank sub-group has never moved much below 3.5%. Ignoring the distortion in the yield, created by the plunge in stock prices in 2020, the yield will typically moved between 3.5% and 4.5%. Today, the yield is around 3.7% so there is plenty of room for upside. The compression in dividend yield since 2020 is part lack of dividend increases and big part heavy demand for bank stocks which has driven share prices higher. A drop in prices would send the yield higher, but I know investors want this to happen from dividend hikes.

 

Once again, the post-crisis era gives up some perspective on how fast dividends can be hiked and by how much. Keep in mind that not all of the banks stopped raising dividends during the crisis at the same time and there were some differences in lift-offs too. Generally speaking, dividends started to increase again in 2011. Over a five year period, however, the percentage growth rates ranged from 20% at the bottom to 67% at the top. When I was reading some of the business media stories after Thursday, I can see how investors might be mislead. There is talk that dividends might be increased by 50% or more. True, that would be similar to what we saw after the financial crisis, but this could also take five years to play out.

 

 

Don’t get me wrong. Dividends are great or, as someone that I used to appear on the panel would say, “you need to be paid to play”. But if share prices have already built in dividend growth, you have to figure out your upside. After the trough of the financial crisis in 2009, the TSX bank sub-group rallied almost 150% in a year – better than what we have just seen. Roughly a year later, dividends would start to grow again and in that year, the sub-group advanced a little more. Five years after those first dividend hikes, bank stocks weren’t exactly rocking it. In fact, the sub-group was down about 8%. There were some cyclical factors impacting the overall market and banks into 2016, but we might be facing similar headwinds 3-5 years from now too.

 

So, here’s the bottom line. Canadian banks have been and will always be, in my opinion, solid components of a portfolio. Long-term growth may not be comparable to innovative stocks and they aren’t invincible in a general market downdraft, but they have been fairly steady income providers. That said, we have seen a strong appreciation in share prices prior to this week’s OFSI announcement and the next leg of portfolio performance from banks might be more income than capital appreciation, at least for the near-term.