TD has a big problem with its U.S. operations. No, not that one

The very public humiliation of Toronto-Dominion Bank TD-T this month should make investors think twice about how they’re investing in banks.
At the very least, the severe problems that U.S. regulators discovered in TD’s retail operations in the United States should blow away any lingering belief that Canadian banks are invariably icons of good management. TD will pay US$3-billion in fines for “significant, systemic breakdowns” in its anti-money-laundering procedures. The breakdowns were so glaring that low-level TD employees joked in internal e-mails that the bank was an easy mark for bad actors.
The question now is whether TD’s troubles will end there. I suspect not, for two reasons.
The first reason can be summed up by Warren Buffett’s decades-old insight: “There is seldom just one cockroach in the kitchen.” His point is that when a company has a highly visible problem, there is a good chance that other less-visible problems are lurking beneath the surface.
Wells Fargo WFC-N provides a cautionary example. The high-flying U.S. bank took an initial stumble in 2016 when it was forced to admit that employees had created fake bank accounts in customers’ names to meet unrealistic profit goals set by management.
A year later, Wells Fargo acknowledged that it had also mistakenly dinged many customers for missing deadlines on mortgage payments. In the years that followed, the bank was hit with a cascade of charges over myriad other aspects of its operations. Between 2016 and 2023, Wells Fargo paid fines totalling nearly US$10-billion.
No one is suggesting that TD’s dysfunction is as extensive as Wells Fargo’s. But TD has already this fall paid US$20-million to resolve a separate investigation by U.S. authorities of fraudulent trading by a former employee. It is fair to observe that problems rarely travel solo. They often come in convoys.
This brings us to a second reason to think TD’s problems might linger: its questionable decision to bet so much on expanding its retail banking operations in the United States.
The problem here is a structural one. U.S. banking – especially the business of making personal and commercial loans – is fiercely competitive. It is capital intensive. And it operates under a regulatory regime that is less friendly to Canadian banks than the regulators back here at home.
“Pursuing U.S. expansion is not a winning strategy long term for any Canadian bank,” says Nigel D’Souza, senior investment analyst at Veritas Investment Research in Toronto. He has long argued that the Canadian banks most aggressively pursuing a U.S. retail presence – TD and Bank of Montreal BMO-T – are likely to disappoint.
Mr. D’Souza says the returns on equity from the U.S. personal and commercial (P&C) banking operations of TD and Bank of Montreal are among the lowest of any major U.S. bank when adjusted to reflect unallocated corporate expenses and taxes. His numbers suggest that these Canadian banks’ P&C operations in the U.S. actually dilute their shareholder value.
Investors may want to take note. The upshot of Mr. D’Souza’s analysis is that U.S. banks typically produce better risk-adjusted returns from their U.S. operations than Canadian banks do from their U.S. banking endeavours. Therefore, Canadian investors who want to bet on U.S. banking should consider investing directly in shares of U.S. banks.
Which U.S. banks? Mr. D’Souza doesn’t research these stocks so he doesn’t have specific recommendations. However, it seems reasonable for Canadian investors to stick to big U.S. banks that have the heft and diversity to weather economic storms. Bank of America Corp., JPMorgan Chase & Co. and Morgan Stanley are some names to consider. Each has generated better total returns over the past 10 years than either TD or Bank of Montreal.
Just to be clear: Buying some U.S. bank shares doesn’t mean Canadian investors should abandon Canadian banks. Our domestic lenders have the same advantages in Canada as U.S. banks do in the United States.
What you may want to keep in mind, though, is that the best-performing Canadian bank of the past 10 years is National Bank of Canada, an institution that has kept its P&C banking tightly focused on the domestic market. The second-best performer is Royal Bank of Canada, another lender that has stayed largely at home when it comes to retail banking.
For now, Canadian investors may want to ride these trends and tilt toward the domestically focused duo of National Bank and Royal Bank, while investing in U.S. bank stocks as well.
Looking further out, investors should be on watch for signs that TD and Bank of Montreal are reconsidering their U.S. expansion strategies. To Mr. D’Souza’s way of thinking, both lenders would be well advised to change course. They could refocus on Canada. Or they could attempt to further build out their wealth-management and capital-markets businesses – two areas where international expansion makes sense.
For now, though, such moves seem unlikely. Judging from Bank of Nova Scotia’s decision this summer to pay a hefty price to acquire a piece of U.S. regional lender KeyCorp, several Canadian banks are still in love with the dream of U.S. expansion.
Investors may want to differ.