Will "Operational Risk" Drag Down Royal Bank of Canada in 2013?


Canadian banks had an excellent year in 2012, so it's no surprise that many analysts and investors are wondering if they will be able to stay the course into 2013. For months now, there have been predictions regarding a slowdown in the sector, which has so far failed to materialize. For Royal Bank of Canada , the country's largest bank, however, the headwinds might just be strong enough to push it off of its recent earnings-report high.

Headwinds in housing, and consumer debt
As the once-hot housing sector cools, alarms have been raised as early as last spring , cautioning that the cash-cow mortgage business would soon start to wane. An accompanying problem entails a high level of personal debt being carried by the average Canadian consumer, which might cause them to pay down debt rather than take on more. A recent Moody's downgrade of RBC and its peers, including Toronto-Dominion , Bank of Montreal , and Bank of Nova Scotia noted that household debt has risen to 163%, the highest in the nation's history.

Fitch has called out the same issues as Moody's, but considers the condition of northern banks stable. The ratings agency notes that Canadian banks have plenty of cash to see them through a housing downturn, but points out that any economic decline could impact borrowers' ability to make loan payments.

These issues could adversely affect the fortunes of RBC, which is dependent upon the Canadian lending segment. Fully 80% of the bank's income comes from its Canadian operations, so any slowing of that country's economy would be bad news for the bank.

Tighter U.S. regulations, risk profiling at home
Two other issues may negatively influence RBC over the next year. One is the possibility that regulators in the U.S. will soon demand larger capital cushions for foreign banks doing business here. Analysts estimate that TD Bank, for instance, would have to come up with an additional $5 billion to comply with such a rule. RBC would very likely be affected, although CEO Gordon Nixon has said that he expects no impact at all on the bank's business. Since the bank is currently pumping up its U.S. capital markets section, however, that judgment seems a bit premature.

Last, but not least, is the Canadian government's plan to highlight "operational risk" in the banking system. The Office of the Superintendent of Financial Institutions will be reviewing the nation's banks to see how well prepared they are for risks such as cyber attacks and money laundering.

The banks will be assessed on internal controls, as well -- something that banks worldwide are seen as lacking. It appears that Canadian banks will be first on the global list, as the Basel Committee will soon be looking at this issue as well. It seems fair to expect that RBC, the biggest of the banks, may be first in line.

Can RBC take it all in stride?
So far, despite a slight slowing in the housing market and an attendant reduction in lending, RBC has managed to keep those profits up. However, its 2012 performance would be hard to beat, particularly if European and U.S. economies continue to be sloggy.

Investors should be prepared for a little less glitter from northern banks next year, including RBC. It's good to know that, with a strong and safe banking system like Canada's, any downturn will be more like a breather, rather than cause for alarm.

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