Bank dividends — how safe?

Until recently, all the experts have been telling us that Canadian banks almost certainly will not cut their dividends. It would destroy investor confidence, make it more difficult to float new issues, undermine their credibility — plus it’s just not done. Not in Canada, anyway.

And think of what it would do to our international image! Prime Minister Stephen Harper and Finance Minister Jim Flaherty have been using every opportunity to tell the world how great the Canadian banking system is and how it should be used as a model for the world’s ailing financial structure. Even President Barack Obama has bought into the message. If our banks then turn around and slash their payouts, thereby admitting that they are in worse shape than most people believe, our credibility as a example for the world would be severely damaged.

Despite all this, the market remains sceptical. Despite the recent jump in the price of bank stocks, yields are at unusually high levels. As I write, Bank of Montreal shares still yield a lofty 8.9 per cent. Shares of CIBC yield 7.8 per cent, Scotiabank yields 6.5 per cent, TD Bank pays 5.9 per cent, while Royal Bank is at 5.6 per cent. In normal times, bank stock yields are in the 3 per cent to 4 per cent range.

Now along comes a 67-page report from a bank-owned brokerage firm which calls on the banks not just to cut their dividends but temporarily suspend them entirely. The report from RBC Capital Markets says that such a move would make sense because it would “increase internal capital generation and thereby reduce the need for banks to raise capital” if loan losses and writedowns exceed expectations.

Analyst Andre-Philippe Hardy and associate Dave Mun say that Canadian banks may be in decent shape now but more bad news would place them under severe stress. ” We believe that the Canadian banks have enough capital to handle loss rates in line with those of the early 1990s,” they write. “However, we do not believe that they have enough capital to handle loss rates in the 1.5-2.0x range when compared to the early 1990s and sustain dividends. Given how weak the economic environment is, the prospects of loan losses that exceed the early 1990s is certainly something banks and investors must consider in their investment decisions. It might not be the base case but it is a possibility if the economy does not improve by 2010.”

As a result, they recommend that “the Canadian banks we cover should consider suspending their dividends. They have historically been reticent to do so (the Big 5 banks have not cut dividends since the Second World War) and might maintain their long standing record of paying dividends, so our view may ultimately be nothing but that: an opinion”.

The analysts acknowledge that the initial reaction of the markets would be “negative”. As a result, “income-focused investors might sell their shares and investors who view Canadian banks as ‘bullet-proof’ would likely be disappointed”.

I think that’s a gross underestimation of the effect of such a drastic move. Should the banks follow this misguided suggestion, I believe the result would be a crisis of confidence in our financial system similar to the one that has all but paralyzed the U.S. After all, if our banks are among the safest in the world what kind of a message would be sent if they all suspended their dividends?

We have troubles enough to cope with. Let’s not compound them by inducing mass panic — especially when it is not necessary.

But we’re left to wonder why Royal Bank would allow its brokerage arm to publish such a radical suggestion. Are there problems bubbling beneath the surface that we don’t know about? Just asking!

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, click here.