With the Canadian financial sector representing roughly 33 percent of the TSX’s overall weighting, bank sector performance is a key driver of Canadian equity market returns. After materially outperforming global peers during the financial crisis, the Canadian banking industry is now facing several headwinds, including a potentially softer housing market and consumers who are holding record high debt levels. Another major potential headwind is an ever-changing Canadian regulatory environment that is both reactively and proactively trying to ensure stability and soundness across the industry. New regulations, such as the Office of the Superintendent of Financial Institutions Canada’s (OSFI) capital adequacy guidelines, aim to limit shortfall risk at the banks. But could limiting the amount of risk that Canadian financial institutions can assume curb growth in the financial sector? The answer is a resounding yes, according to four top banking analysts at major Canadian brokerages who shared their perspectives on the potential impact of the new rules. Here’s what they told us:

Mario Mendonca, CA, CFA
Canaccord Genuity

Conclusion: Slower mortgage growth plus higher costs equal pressure on bank earnings.

Cites: Increased internal bank controls combined with increased standards result in the above.

In his words: “Unfortunately, the banks don’t specifically break down the direct impact of OSFI’s changes, but we do know for a fact that OSFI’s B20 standards, the 65% HELO C limit, and changes proposed by Finance Minister Flaherty (amortization period reduced to 25yrs, refinancing ratio lowered to 80%, and mortgage insurance limitation of $1 million) are contributing to slower mortgage growth for the banks.”

Robert Sedran, CFA
CIBC

Conclusion: Changes made by regulators have decreased both the supply of and the demand for credit, which will slow revenue and earnings growth for the banks. But they also create a healthier economy and operating environment for banks over the long term.

Cites: Tighter rules that govern the business combined with quantity and quality of capital needed to support the business.

In his words: “The decline in Canadian bank profitability during the downturn proved to be cyclical rather than structural, and so, with solid return on equity, capital levels that are already fully in compliance with the newly established Basel III standards are growing swiftly. These strong balance sheets now carry more opportunity than risk for the sector.”

André-Philippe Hardy, CFA
RBC Capital Markets

Conclusion: Slower retail revenue growth for the industry as a whole.

Cites: Although banks are starting from a position of strength, stricter capital and liquidity risks combined with direct regulation limiting consumer credit growth, especially in the housing market, will put pressure on returns on equity.

In his words: “The impact of these rules, in our view, will be slower revenue growth in Canadian retail banking than in the past.”

Darko Mihelic, CFA
Cormark

Conclusion: It is unclear if Canadian banks will be on a level playing field with those in the U.S. and Europe, given the ultimate watered-down implementation of Basel III in the two latter regions. Depositors and taxpayers are better off, but shareholders might not be, as the added quantity and quality of capital comes at a price, implying potentially lower valuations than in the past.

Cites: The higher cost of capital for banks that issue instruments containing contractual clauses of conversion versus debt or preferred issues that do not have contractual clauses. During periods of “stress,” new measures could lead to increasing equity issuance. That translates into higher volatility and a higher cost of capital. Those institutions deemed “systemically important” might have to carry even more capital than others, and there is already a lot more capital in the system.

In his words: “We believe Canada’s tough adoption of Basel III, while in the interests of depositors and taxpayers, is not in the best interests of bank shareholders for now. Time will tell if in the future the playing field will be level. We could conclude that over time, through a full credit cycle, the result will be that Canadian bank stocks will trade at lower valuations versus the valuations of the past under the less strict Basel I and Basel II regimes.”