The global investment banking business represents an attractive growth opportunity for Canadian banks, but it also poses a risk to their credit quality, suggests Moody’s Investors Service in a new report.

The rating agency said Wednesday that while the Canadian banking system has proven among the most resilient throughout the financial crisis, the banks’ efforts to expand their capital markets platforms, particularly outside Canada, is not without risk. Moody’s views these efforts as a negative for the credit quality of the banks.

Moody’s says that with the banks facing the challenge of finding growth amid a mature domestic market, some are seeking to expand their wholesale businesses to take advantage of the void left by the retrenchment of many global investment banks. It notes that the banks have hired significant personnel over the past year, with an emphasis on investment banking and trading activities, including leveraged loans. “While all the banks have been active, the level of hiring has varied, and RBC has been the most aggressive in this regard,” it says.

This strategy poses its share of risks, the firm cautions. “For bank bondholders, this growth in capital markets activity creates a significant amount of incremental risk,” says Peter Nerby, senior vice president and co-author of the report. “Global capital markets businesses require the periodic assumption of risk concentrations, and this has produced outsized losses for at least some Canadian banks during both the current and previous credit cycles.”

Moody’s estimates that the losses associated with Canadian banks’ wholesale investment banking activities amounted to $22 billion, or approximately 22% of aggregate core earnings, during the three-year period beginning in the first quarter of 2007 through the end of 2009, and that strategic risk failures were evident almost every time sizable losses were incurred.

“The sub-prime mortgage and structured credit crisis illustrated the opacity of many risks to bank bondholders and the challenges facing Canadian bank managers of accurately capturing and measuring capital markets risks,” says Ali Mozaffari, analyst and co-author of the report.

Moody’s noted that even the most well-managed wholesale banks can suffer from unusual earnings volatility, and when serious risk-management failures occur, significant credit rating impacts are possible.

IE