February 15, 2016 – Royal Bank

I have been thinking about adding Royal Bank to our list because so many Canadian investors own it and because I don’t have  any of the large Canadian banks on the list.

However, just to read its 215 page annual report is no small task. And it’s probably not feasible to really understand the risks that it faces. At the end of the day it has a very attractive P/E of 10.1 times trailing earnings and 9.4 times forecast 2017 earnings. (Although that implies only about 4% earnings per share growth in each of the next two years, possibly because the 2015 earnings were boosted by some unusual items.) The price to book value is reasonable at 1.64. The dividend yield is very attractive at 4.65%. The ROE is very attractive at almost 17% according to Yahoo and 18.6% according to the bank itself.

The above ratios would indicate a very attractive investment. And it’s unlikely that my analysis methods would change those ratios very much at all (such as by finding some earnings items to adjust for).

A possible concern however is that banks are by nature heavily leveraged. And Royal Bank appears to me to be more leveraged than some other banks.

The bank reports a regulated common tier 1 equity ratio of 10.6%. That is, by bank standards, a relatively strong ratio. It would imply leverage of “only” 9.4 times.

It can be calculated as regulated tier 1 common equity of $43.715 billion divided by total capital risk-weighted assets of $413.957 billion.

But notice the words risk-weighted. What does that mean? Royal Bank’s actual balance sheet assets are not $413.7 billion but are FAR larger at $1074.2 billion. Common equity is actually a bit larger than $43.7 billion and is $58.8 billion. But that is $49.6 billion tangible common equity after deducting $9.3 billion in goodwill.

The straight-up common equity ratio of Royal Bank is $58.8/1074.2 = 5.5%. That’s a leverage of 18.3 times!

And that straight-up common equity ratio compares to a much stronger looking 9.5% for Wells Fargo and 10.9% for Bank of America.

On a tangible common equity ratio basis (after deducting goodwill) Royal Bank is at $49.6/1074.2= 4.6%. That compares to ostensibly much stronger figures of 8.1% for Wells Fargo and 7.7% for Bank of America.

So, on a simple common equity or tangible common equity versus assets basis, Royal Bank looks far weaker than Wells Fargo and even Bank of America. BUT, on a risk-weighted basis Royal Bank is considered well-capitalised with a regulated tangible common equity to risk-weighted assets of 10.6%.

According to page 96 of Royal Bank’s 2015 annual report its (tiny) investments in stocks are weighted at 99% (so basically 100%). In comparison to that its substantial residential mortgage loans are weighted at 6% (low mostly due to CMHC insurance). Its business loans are weighted at 54%, its investments in government bonds are weighted at an average of 12%. Its very large investment in “repo-style transactions” are weighted at just 2%.

The result of these weighting is that Royal Bank is considered to have far less assets on a risk-weighted basis than it actually has.

The bottom line of all of this is that when it comes to the risk of Royal Bank, investors are basically forced to trust that these risk-weightings are appropriate. And they may well be. But the nature of “risk” is that it is hard to measure.  We also have the bond-rating agencies rating Royal bank’s debt very highly at AA or AA minus. (BUT they may be largely relying on the risk-weightings.)

These experts have gotten things wrong in the past. The bonds issued by Greece were once considered to be basically risk-free. Mortgage-backed securities in the U.S. were similarly thought to be basically risk free.

At the end of the day, Royal Bank probably is a very good investment. But it is probably impossible to truly understand its risks. Therefore, it might be wise to limit the exposure to this bank to some figure like 5 or 10% of a portfolio. And in the probably unlikely event that Royal Bank ran into very heavy losses the other Canadian banks might well be facing the very same. So, it might be wise to limit the exposure to Canadian Banks in total to some figure like say 20% of a portfolio.

I am not saying that Royal Bank is likely to be risky. My view is that anything leveraged about 20 times could be risky and in the case of Banks it’s probably impossible for investors to judge the risks or to be 100% sure that the banking regulators are correct in their view of the risks.