Canadian banks sailed through the 2008 to 2009 global financial crisis without major problems while enhancing their reputations for being conservative and well managed. Of course, that’s history now, and we have to consider the effects of two major risks Canadian banks currently face.

Before we get to those risks, here’s a brief summary of the situation: Current bank valuations in Canada are at the lower end of historical ranges, reflecting investor concerns about these risks. We are comfortable with our Dividend Champions holding in TD Bank for reasons discussed in a separate article. Royal Bank, on the other hand, may be a candidate to sell at the first sign of trouble in the housing market.

Commodity Producers

The prolonged slump in commodity prices since 2011 has put pressure on mining companies and oil-and-gas producers. The exposures of the main Canadian banks to these sectors vary. Although the absolute numbers are large, the proportion of these loans to overall bank lending is limited. The average exposure of the four main Canadian banks is 2.6%, with Bank of Nova Scotia an outlier at 4.9%.

Apart from the drawn loans, the banks also may have undrawn commitments from untapped lines of credit to the commodity producers. The Bank of Nova Scotia discloses $13.5 billion of undrawn commitments to oil producers, which, if used, will add another 3% to the total exposure.

Also, the banks have other loans, including home loans and credit cards, extended to the Prairie provinces (Alberta and Saskatchewan). When borrowers lose their jobs, these loans are at risk. Of all the major banks, Royal Bank has the most exposure to home loans in these provinces, 9%, and Bank of Montreal the least, 6%.

Recently, the various banks commented on the results of internal stress tests performed to establish the harm of prolonged low energy prices on profitability. Even with oil prices at $30 per barrel, the management teams consider the impact controllable.

Real Estate

The major Canadian banks all have considerable exposure to the country’s real estate market, either through residential mortgage lending, home equity loans or various forms of commercial lending, including development and project finance.

The Canadian real estate market overall is considered by many analysts, including those at the Bank of Canada, to be overvalued. Given the traditional deep links that banks have with real estate, there is nowhere for them to hide when that market goes into a tailspin.

The two largest banks, Royal and TD, have the largest portfolios of Canadian real estate-backed loans—no surprise here. What is surprising is that Royal also has the largest exposure when Canadian real estate loans are measured as a proportion of the total loan portfolio, currently at 63%.

On the other hand, Bank of Montreal has a much smaller real estate portfolio of $134 billion, representing 41% of the total loan portfolio. Should things go wrong, BMO will be less vulnerable.

A further point is the level of diversification of the Royal Bank of Canada. Although a considerable portion of the loan book is Canadian real estate, RBC derives the lowest proportion of total revenue from interest income, mainly as a result of the large contribution of the investment banking operation.

Controls

The banks use various measures to mitigate the risks of their real estate lending. First, loans can be insured by the government-backed CMHC or private entities, reducing the risk to the lenders. Royal has the lowest portion of its residential portfolio insured, while TD Bank has 57% of the residential portfolio insured.

A second risk-management technique is the loan-to-value ratio (LTV), which shows the value of the loans compared with the value of the property-lending book. The point: Property prices can drop a long way before the real estate backing the loans becomes a concern for the banks.

Although the banks seem to be managing their lending risks well, a substantial drop in home prices would lead to higher credit losses because more borrowers will default during a market downturn. The provisions for covering these losses are currently at low levels as a result of the real estate bull market.

Comfort Zone

The Canadian banks have performed well over the past decade, with the core lending growing steadily and wealth management and investment banking activities providing some impetus.

Nevertheless, should the Canadian real estate market go through a deep and extended correction, banks will suffer. RBC will be more exposed and BMO somewhat less exposed than the other major banks. In the end, though, the ways banks mitigate real estate risk boil down to some combination of insured mortgages and relatively low loan-to-value ratios for the uninsured components.