By Tom Bradley

It’s confirmed. We have the healthiest banks in the world. They’ve all reported their second quarter earnings and the numbers are spectacular. Industry leader RBC had a return on equity of 19%, while CIBC and National Bank were over 20%. Yes, 20% in a 2% inflation world.

These results are important because Canadian investors are highly dependent on their banks. Bank stocks account for 21% of the S&P/TSX Composite Index and play an even larger role in most investment portfolios (especially when preferred shares and bonds are taken into account).

In contrast to other countries, Canadians have made a potful of money on bank stocks. It’s been a great twenty-five year run in which the Big Six saw their profits grow from $2 billion a year to almost $8 billion a quarter. Before I take a peek into the next twenty-five, it’s informative to look at what’s fueled the growth.

Interest rates have been a significant factor. Rate declines have meant a steady diet of capital gains and trading profits on the banks’ bonds and other security holdings. They also led to rising house prices, which has made the consumer lending business truly hum (in the second quarter, the return on equity of Scotiabank’s Canadian consumer business was 35%).

Indeed, favourable real estate markets, along with the banks’ marketing and product innovation, have helped facilitate the indebtification of their customers. Since the late 1980’s, Canadians’ debt to income ratio has doubled to a world beating 160%.

As for corporate lending, Canadian banks have shown superb discipline after learning from a series of crippling losses on third world and energy loans in the 1980’s (remember the LDC crisis and Dome Pete?).

They’ve also been savvy in buying and developing new businesses that fit their client base – products and services that can be promoted through the branch network. Brokerage and investment banking came in the late 1980’s, followed by the trust companies a few years later. Wealth management started to get traction after the millennium. Each new initiative helped the banks transition from being service providers to where they are today, sophisticated sales organizations.

Like I said, it’s been a good run, which begs the question - What will the next five and twenty-five years look like? Certainly, some of the tail winds I’ve outlined are going to shift, or already have.

The banks’ biggest and most stable money maker, the Canadian retail business, is getting tougher. In aggregate, Canadians have little room to add debt and may indeed be forced to de-leverage if house prices and/or the economy weaken. Competition is sure to intensify because loans, mortgages and credit cards are just too profitable to risk losing ground.

In wealth management, the banks have become dominant players, so market share gains will be harder to come by. Also, profit margins may have seen their peak due to lower fixed income returns and higher regulatory standards for reporting fees and performance.

Other changes are in the wind, including increased capital requirements, but they’re not all bad. At home, the Federal Government continues to be accommodative. It’s put up barriers to foreign competition and hasn’t pressed too hard on conflicts of interest between the banks’ business units. In other words, the oligopoly will be maintained.

Beyond our borders, Canadian banks now have greater opportunities in international and corporate banking, areas where the competition is in full-on, ‘post crisis’ retreat. RBC is building a world scale capital markets and asset management business. TD is already a prominent player on the eastern seaboard and Scotia has a stake in the ground in almost every country with warm weather and a beach.

When all the gusts and swirls are taken into account, it’s hard to bet against these inherently profitable companies. The banks’ ability to generate sales, make acquisitions, pay dividends and buy back stock is unparalleled. And they still have lots of room to reduce expenses, something they haven’t yet fully embraced.

We’ll continue to have healthy banks (thank goodness), but it’s going to be tougher for them to maintain their torrid pace, especially if their most profitable, reliable businesses hit the wall.