This article at The Globe and Mail provides a good reality check on why one shouldn’t rush into Canadian banks. The most interesting part of the article:

• During the second quarter of 2008, the industry took provisions of 0.4 per cent of loans — still below the cycle average of 0.5 per cent.
• Provisions rose to 0.9 per cent of loans in 2002. In 1992, the recession saw provisions up to 1.7 per cent of loans.
• Canadian banks have only a dollar in earnings for every $50 in loans. Even a modest increase in impaired loans could damage their bottom line.
• “In a flat-to-falling property price environment, it’s unlikely that we’ll be seeing much in the way of revenue growth,”

Most investors see banks as a staple in their investment portfolio. Despite what’s happening in the US, they don’t seem to “get” just how leveraged banking — as a business model — really is.

From current levels, provisions would need to increase over 300% to match those 1992 recession levels. This would crush bank earnings. Sound bad? Things can get a lot worse when it comes to banks and bad loans. Norway’s three largest banks collapsed in 1991 and shareholders lost every penny. In the US, 25% of S&Ls were bust by 1991. How many US names will be gone post this crisis?

Provisions — for those of you who do not know — are banks’ best guess of loan losses on the end-date of the reporting period. That’s why I don’t think Canadian banks low provisions are necessarily a good thing.  They’re low simply because the Canadian economy has not turned down in any major way. Taking a provision is kind of like giving a cookie to a dieter who “just wants a taste,” and telling her she can come back later if she really needs another. She may not come back. It’s hard to predict. But deep down you know that if she does come back, she might want more than one.

Are provisions going to rise dramatically? I have no idea. I’m certainly less knowledgeable than those pasty-faced bank analysts who work 12-hour days and fiddle with spreadsheets. The sad thing though is their lack of social life is completely unnecessary. That’s because it doesn’t really matter now accurate their forecasts are. In a deteriorating economy, investors have a tendency to “sell banks now, ask questions later.” Just look at Bear Stearns.

Even if provisons stay low, it’s hard to imagine how Canadian banks can maintain premium valuations in the face of slowing revenue growth. There are two good reasons to be concerned here: Canadian housing is showing price declines for the first time in years; Chinese and Indian stock market indices are down some 40% from their highs. The slump in their stock markets could portend the end of the commodity cycle.