Shares of small Canadian lenders have taken a pummelling this year, and one veteran analyst thinks the table could now be set for takeovers in the sector.

And he thinks one combination makes particular sense: a takeover of EQB Inc. by Canadian Western Bank.

The analyst is Gabriel Dechaine of National Bank of Canada Financial Markets. Late Monday, he published a 22-page report on four small-lender stocks, and the potential for consolidation in the months ahead.

He began by making the point that the valuation gap between shares of small lenders and big banks in Canada has rarely been so wide.  In addition to Canadian Western Bank and Equitable Bank parent company EQB, Dechaine includes Laurentian Bank and Home Capital Group Inc. in his report.  And he notes that Home Capital has already received a takeover approach. In mid-August, the company said it had received – and its board rejected – a non-binding expression of interest from a party it did not name.

Shares of the four small lenders have declined an average of 32 per cent so far this year, Dechaine says. That’s versus a 14 per cent drop for the Big Six banks.

More importantly, he says, forward-looking price-to-earnings (PE) multiples on the small lenders’ stocks have collapsed so severely that big bank PE multiples are now 41 per cent higher.

That’s the biggest gap in ten years, and Dechaine states he believes it will not go unnoticed by the larger institutions.

“If this discounted valuation persists,” he wrote, ”we could see consolidation speculation of a different nature emerge: potential takeovers by larger entities.”

When he says “larger entities,” Dechaine includes the Big Six banks, but he believes chances are low that regulators would greenlight a big bank takeover of either Canadian Western or Laurentian.

Home Capital, he says, remains in play after the announcement of August. Here, he believes, private equity groups or “privately owned strategic players” are the most likely buyers.

And he devotes considerable attention to the merits he sees in a combination of Canadian Western Bank and EQB.

A combination of those two would result in a financial institution, he says, with stronger capital levels and lower funding costs. The business mixes are complementary, he argues. EQB’s heavy emphasis on mortgages would be balanced by Canadian Western’s focus on commercial lending and wealth management. And EQB’s work on new financial technology channels would be a plus.

The deal structure that he believes makes sense is one in which Canadian Western Bank issues stock to shareholders of EQB at a 15 per cent premium to the current share price.

A combination of Canadian Western Bank and EQB, Dechaine says, would result in an institution that would emerge “on a more competitive footing versus Big Six lenders.”