Morningstar equity analysts are lowering their economic moat ratings to narrow from wide for several global banks in our coverage universe. These new moat ratings reflect our general reassessment of the inherent structural advantages at five Canadian banks, and three more from Europe and the U.S. They include Bank of Nova Scotia (BNS), Bank of Montreal (BMO), Canadian Imperial Bank of Commerce (CM), Royal Bank of Canada (RY), Toronto-Dominion (TD), HSBC (HSBA), Westpac Banking Group (WBK), and Svenska Handelsbanken (SHB A).
Central to our moat downgrades is our new scepticism regarding the ability of these institutions to achieve sustainable, excess returns above their cost of capital. In our view, the liabilities of a financial institution are the primary source of competitive advantage. Financial intermediation--the transformation of raw materials in the form of liabilities into profitable assets--is usually a commodity business, in which lenders compete aggressively for both assets and liabilities. In such a business, low costs are key to achieving excess returns. For banks, funding costs are the largest source of sustainable cost advantage, followed by operational efficiency and exceptional underwriting, which depend to a larger extent on management.
In the past, we've assigned wide-moat ratings to banks in some geographies--generally concentrated, strictly regulated markets. Concentration often limits rivalry, and stringent regulation limits management's ability to adversely affect profitability through bad lending decisions, strengthening the competitive position of banks in these markets compared with those in more competitive geographies.
However, even in the best markets--for example, a lender with a monopoly in a small town--a bank cannot tolerate mismanagement. Furthermore, an investor cannot count on regulators to prevent problems created by bad management. The last few years have proven that neither managers nor regulators can eliminate risk completely, as formerly "low-risk" asset classes such as mortgages and sovereign debt have destroyed bank balance sheets.
We therefore do not have a high degree of confidence that competitive advantages at these banks will persist for 20 years--a requirement for a wide moat rating. As a result, we are lowering the moat ratings for the above lenders to narrow.
Click on the afore-mentioned company codes to read the full Morningstar research reports on those banks.
