In the race for banking supremacy, Scotiabank taking the lead

The yellow flag has come down and the pacer car has left the track. It’s time for the Canadian banking industry to put the pedal to the metal.

For two long years, the Office of the Superintendent of Financial Institutions (OSFI) had banned the banks from undertaking major capital deployments until there was greater clarity over reserve requirements from global regulators. Then in September, the Basel III rules came out not as harsh as feared and the OSFI gave the green light to dividend hikes, share buybacks and acquisitions.

First out of the gate with dividend hikes were National Bank (NA-T70.01-0.76-1.07%) and Laurentian Bank (LB-T50.390.390.78%).

And the larger banks lost little time laying down rubber on the acquisitions track, highlights of which include Royal Bank of Canada’s (RY-T54.020.020.04%) October takeover of BlueBay Asset Management PLC, Bank of Nova Scotia’s (BNS-T56.14-0.23-0.41%) November purchase of DundeeWealth Inc. (DW-T21.490.050.23%) and Toronto-Dominion Bank’s (TD-T75.90-0.20-0.26%) December bid for Chrysler Financial.

The Canadian banking industry is at an historic juncture. It has emerged from the global financial wreck in better shape than foreign rivals and is now deemed the soundest in the world by the World Economic Forum. Competitors in other countries are still far from having the same capacity for snapping up bargain-priced assets. Their balance sheets are nowhere near as charged up. Nor do most get quite the same mileage in making foreign acquisitions as Canadian banks do from domestic currency strength.

Bank of Nova Scotia, top performer

The strongest of the strong, arguably, is Bank of Nova Scotia – even though it is only third largest by assets in Canada. The two largest, Royal Bank of Canada and Toronto-Dominion Bank, are struggling with large exposures to sluggish capital markets and ailing U.S. housing markets. On the other hand, the Bank of Nova Scotia - also known as Scotiabank - just finished its second-best year on record thanks to a focus on retail banking and expansion into emerging markets.

Fourth-quarter financial results reported in early December were well received. “In an earnings season for the sector that has been particularly messy, [Scotiabank] delivered what we believed to be a very clean quarter in which earnings quality was also high,” noted Macquarie Research Equities’ Sumit Malhotra, a top-ranked banking analyst in the Thomson Reuters StarMine ratings.

For the fiscal year ended Oct. 31, growth in earnings per share came in at 10 per cent, return on equity finished at 18.5 per cent and book value per share climbed 10 per cent. The bank’s Tier 1 capital ratio ended up close to 12 per cent, well above the Basel III requirement of 7 per cent plus a 2.5-per-cent conservation buffer.

Metrics like these prompted Mr. Malhotra to upgrade Scotiabank’s stock from “neutral” to “outperform.” He also hiked his 12-month target for the share price to $62. “At a time at which the outlook for … Royal and TD remains mixed at best,” he wrote in a Dec. 6 research report, “we believe the 4Q/10 print for Scotia’s International Banking franchise indicates that earnings growth for the business is set to accelerate in 2011.”

Growth strategy: International division

Another analyst highly rated in the StarMine survey, Jason Bilodeau at TD Newcrest, has a similar message. “International is starting to come on a bit … we now have for the second quarter in a row, a pretty good bottom-line contribution … we feel more comfortable that International can be a driver of superior growth and returns for Scotia,” he observed in his Dec. 6 note.

Several factors are boosting the contribution from the international division, which currently accounts for one-third of total earnings. First, operations are concentrated in fast-growing regions such as South America that are in the early stages of a cyclical rebound.

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