Good morning. Thanks for joining us again. Our next presentation comes from Bank of Montreal. Joining us today from Bank of Montreal is Tayfun Tuzun, the Chief Financial Officer.
Thank you. Thank you for inviting us, Brian. I think this is my, if I'm not mistaken, 12th in a row. So it's always good to-
Ah.
Come to this conference as a back-to-school conference for us. So, appreciate the invitation.
Excellent. Thanks, Tayfun. Okay, so we're going to start off. I think our first question is gonna be on credit. I'm not sure if you're surprised by that, but the last two quarters, kind of impaired PCLs are higher than expected, and you've primarily attributed it to a handful of specific credits in the commercial segment. So your guidance for impaired PCLs is to remain elevated in the near term. Kinda as you comb through these credits, are you finding any common factors among them? And what other steps are you taking to proactively engage with these clients? And would you consider selling or exiting solutions which are showing signs of weakness?
An appropriate topic to start the conversation with no doubt. You know, we released earnings two weeks ago and increased our expectations of you know, impaired PCLs. Not only we came in at a higher level in Q3, but we also you know, elevated our expectations for the next couple of quarters. But it pains the CFO to actually not be talking about our operating performance, which has been truly very good in Q3 and most of the year. But nevertheless, this is obviously an important topic, so any other comments that I will make here, you should understand that we're taking this very seriously. We own this. It goes contrary to our long history at BMO.
We have actually data that we update and share with our investors every quarter. For the last 33 years, when you look at our impaired PCL performance, in 29 of those 33 years, we have outperformed our peers. There were four years in our three decades, and now we're adding a fifth year. So this is unusual for BMO, and we are clearly spending, and we've spent, and we clearly are spending a significant amount of time. So coming into this year, just to summarize where we are in connection to what we expected, our guidance for the year was an impaired PCL ratio in the low 30s.
Mm-hmm.
Today, year to date, we are at about 40 basis points. In both Q2 and Q3, the levels had exceeded that expected range. When we look at the portfolio of loans that went into our impaired PCLs, about 15 loans actually constitute half of those impairments. So when you think about it, you know, we have, you know, 50,000, 55,000 clients in our corporate portfolio, but these credits have caused a significant blip relative to our past history. And there are a couple of topics under this discussion. One is, why were you surprised?
Mm-hmm.
And then, why this elevated level of impairments? You know, our business model is heavily weighted towards commercial banking. In retail banking, you know, we have a larger retail lending portfolio in Canada. It's easier to follow the trail of delinquency back to charge-off rates into impairments, and the predictions tend to be within a tighter range. When it comes to commercial banking, because of sometimes size differences and sometimes the unexpected events that occur during the lifetime of a certain credit, there may be, you know, quarters that are a bit lumpier than others. That doesn't answer the question about, you know, multiple quarters in a row having higher PCLs, but that probably answers some of the questions about the unexpected or surprise nature of what happened in Q2 and Q3.
In Q3, for example, you know, at the end of Q2, we said we expect our PCLs, impaired PCLs in Q3 to be in the 40-41 basis point range.
Mm-hmm.
-the same as Q2. We came out at 50 basis points. The difference was really two credits. One credit is public, and I can talk about this here, was SunPower. It was a company owned by private equity. We've been following that credit for a while, because, you know, they were showing signs of stress. But all the way to the end of Q2, private equity support had continued to support that credit. And, but then, you know, the auditor resigned. It was a public event, and as such, it no longer was maintained, and so we moved that into impaired PCL. That was one of the two credits. But that doesn't explain again, why we are guiding to elevated PCL.
So when our trends started deviating from our historical levels in Q2 and Q3, we took a step back and went deeper into the portfolio in order to identify like-kind credits. And when we looked at that, the typical describers did not apply. There were no industry concentrations. There were no real geography concentrations. It was not Bank of the West, per se. You know, I think in general in the U.S., Bank of the West's legacy portfolio did not show a different pattern than our own legacy BMO portfolio. When we took that analysis down one more level, we did note a few connecting points. One is the vintages of these problem credits were more the 2021, 2022 vintages.
Right after the worst of the COVID environment was over, with liquidity rising in the markets, with business models trying to match and address the benefits of those liquidities, cash flow lending, and lending that probably was more dependent upon enterprise values. And as long as those business models remain intact, enterprise values remain intact, but when business models come under pressure, then, you know, there's pressure on enterprise values. And they also probably were larger bite sizes than our traditional profile of lending. And also about 70% or so of those loans were Shared National Credits. That's not our typical mode of operation. You know, in close to 90% of our commercial relationships, we are, you know, the direct counter-bank counterpart.
So, as the circle within the portfolio widened by those connections, that gave us a perspective on the next few quarters, next couple of quarters. Our CRO guided to, you know, about another six months or so, of elevated, impaired PCLs. You know, he said, we probably will reach high fifties, low sixties. It will peak. It could peak in Q4, it could peak in Q1. Sometimes, working through these credits, can take a bit longer, so that's the reason why we can't yet call the peak period, with, you know, real precision.
But I think, once we go through the next six months, this episode will be behind us, and we're guiding the second half of next year to come back, to converge back to our normal historical levels, which is in the mid-30s. So, we have refrained from using the word idiosyncratic-
Okay.
Because idiosyncratic would look to a more limited period. Clearly, three or four periods above normal ranges in our minds is more than just idiosyncratic. You know, we're taking a look at the underwriting standards, as you know, you've asked. And there will be tweaks. I mean, you can't go through a period like this and continue to proceed with no changes, and we will make those changes. You know, we're in the process of finalizing that work. But we are pretty confident that even with those changes our potential growth opportunities remain intact.
Because when you go down to these credits and look at the type of loans they are, where they were originated, those are not the areas where we actually have done pretty well against our peers. So although there will be tweaks, and there will probably be some change in growth patterns in certain segments, I think our overall growth potential remains intact. So again, you know, we are very disappointed, just as our investors are, given this break from our normal historic patterns. But, we're quite optimistic that we will put this behind us, and, hopefully, by the time we meet next year here, we will look back and see a different pattern at that time.
Excellent. You know, you made a couple of very interesting points. One thing, you're talking about the 21 and 22 vintage, vintages. Are you seeing a substantial, like, difference in quality between, say, 22 and 23?
I think, you know, if you step back for a moment, and maybe this is not a surprise, but in that time period, given the nature of the economy, within sort of like a four to six or seven quarter period, as there was a flood of liquidity in the market, right? Business models were put together that took the clues from that market. They were suited to that environment, whether it's, you know, varying in consumer preferences, trading preferences, consumption patterns, et cetera. That, once that cycle was over, those business models came under pressure. Those are the types of credits that are giving us a bit of a more headaches today than the normal pattern of lending that we would have experienced during that period of time.
Let me turn to the other question. When you kind of talk about the shape of the peak in losses, you're talking there'll be a peak sometime in the next six months, maybe it's Q4 or Q1 2025, and then go converge. Would it be possible if these losses kind of clear out through the system, you could be actually even performing better than the average sometime in the future?
You know, my expectation is that there is no reason for BMO's credit performance to not go back to the relative levels that we have seen in the past, and relative levels means outperforming the peers. I don't see any reason because the large, predominantly traditional lending pieces of our portfolio have been underwritten in the same way we have underwritten loans for the past 30, 40 years, and with the experience of, you know, three, four decades. So as such, there's no reason why we shouldn't expect that to happen again.
Okay, one final one. You, you mentioned on the call, a number of these credits are in participations or syndications, or today you said, shared national credits. Generally speaking, do you try to be like the lead on these shared national credits? Or, and maybe would you becoming more risk averse in terms of participation in these syndications, like reducing your participation levels?
Our model is based on direct lending relationships. As I said, I think in general, when you look at our North American commercial lending model, it is based on close to 90% of those relationships are direct relationships, where we actually have the full breadth of the customer and the ability to engage with them deeply. Shared national credits are not a mainstay of our business plan. Shared national credits have their place in lending, and I think they will always be a source for new client relationships. I don't want to paint a picture that puts the blame solely on the fact that they were shared national credits. I think we're using that to show you that these relationships were also, at the same time, attractive to other banks.
Mm-hmm.
I don't think that we will take a more conservative approach to shared national lending per se, but more what's the credit like? And there, as I said, there will be some tweaks in that. But in general, shared national credits participations will remain a minority of our new client generation going forward, just as they have been in the past.
Great. Maybe like kind of big picture, can you kind of walk us through how you expect to get from, like, the current ROE levels back to the 15% target? Canadian P&C business seems to be where it needs to be already. The U.S. business seems to be lagging, and capital markets business costs will need a little help, optimization. How much of a headwind is declining rates in the U.S. and Canada on your ROE?
So our medium-term target with respect to ROE remains 15%. And there have been some, you know, important changes over the past couple of years that put pressure on our ROEs. One is the 100 basis point increase in the capital buffer in Canada. That's worth about a point of ROE. We clearly are carrying goodwill from the Bank of the West transaction. And then obviously, the current credit uptick probably is worth another point, you know, between where it is now and where our normal credit performance is. So those are discrete items, some that are not going to change, some, you know, when credit normalizes we should be able to capture that back.
But we do focus significantly today in our company, across all businesses and in the way we manage the balance sheet. We are very focused on achieving that 15% target with speed. Part of it is the U.S. We have, we've had high expectations about our ability to achieve $2 billion in additional PPPT from our Bank of the West acquisition when we announced the transaction. Unfortunately, given the environment in the U.S., that's delayed. You know, we were expecting to get there, on a run rate at the end of 2025. We've delayed it by about a year, given the last two years of rather slow business activity in the U.S., but we are still confident that we will get there. So that's one item.
The second one is, our efficiency ratio that is paired with that medium-term 15% ROE target is 55% or below. And we're quite confident that we will achieve that because we have a very strong commitment to positive operating leverage. We had 5% positive operating leverage this quarter, and we expect to operate the company with positive operating leverage. So ultimately, that should be a contributor to the ROE increase towards the 15% target. But in addition to those more natural steps on the path, we are very closely looking at two areas. One, on sort of the asset side, business generation side, where optimization of where we allocate the capital, either at the portfolio level or at the client level, is a high priority today.
We don't want to waste time with below-target ROE returns in any of our businesses, whether it's personal or retail, and then the second one is we're operating a scale company. You know, we're at CAD 1.3 trillion. We have $450 billion of assets in the U.S.. We need to achieve a cost basis commensurate with that size. So those are the ingredients we believe, and you know, we will be executing towards to achieve the targeted ROE.
Okay, maybe a little bit more, you mentioned on the Bank of the West, kind of hitting its targets. You kind of got the cost synergies from the Bank of the West already been realized. Can you talk about more how you're going to possibilities for generating, you know, incremental revenues for the-
Yeah. We actually more than kind of got the cost synergies. We overachieved the cost synergies.
Mm-hmm.
Compared to what we announced at the time we acquired the company, and they are in our run rate now, so we're very confident about that. On the revenue side, as I said before, we targeted a $2 billion PPPT, and that's across all business lines, and the progress, despite the rather muted market environment, is continued quite well. We are seeing a significant uplift in branch productivity in the old legacy Bank of the West branch system. We operate the branches a bit differently because we also brought significant digital capabilities that they didn't have prior to the acquisition.
And the combination of better digital tools and different sales management approach is showing very strong signs of an uplift in branch productivity, and we are actually getting closer to the legacy BMO branch at the branch levels today in California. The other encouraging sign is in our commercial business. You know, clearly, that's the largest business that we operate in the U.S. There is significant growth in new client acquisition. Our third quarter showed us the highest new client acquisition since closing the transaction in February of 2023 . We are introducing some of the legacy BMO commercial businesses into California. Media Finance is the most recent one. So one of the specialty areas where we actually have market-leading power is wine and spirits.
We purchased an M&A advisory firm to support that business. We do have strong rights to capture market share there because we're already leading provider of to those clients. We continue to operate a number two, number three, market-leading RV Marine originator. That continues with strength. And then, you know, equipment finance overall in the U.S. is a strength for us. All of those are hitting the California markets.
Mm-hmm.
And also, at the same time, one of the cornerstones of hitting the PPPT level was the partnership between wealth management, with both commercial and retail, and those are going very strong as well. So the referral levels are picking up. With all the HR decisions made, with all the management streams in place, I think we're primed to really hit the ground as soon as we see a recovery in sort of the markets overall, which we're hoping that will come soon. You know, the combination of both getting over the election date as well as you know, the expected rate moves hopefully will provide some input as well.
You know, that kind of feeds right into my next question, and you've talked about the business activity in the U.S., and we're seeing the U.S. loan and deposit growth both seem somewhat muted. Do you think the lower rates could help spark a resurgence in loan and deposit growth?
We hope so. Coming into this year, we thought that the US markets were going to outperform the Canadian markets in loan growth, but quite the opposite happened. Despite the fact that the macro output for 2024 was weaker in Canada, all year long, we've seen modest, not like huge increases, but modest but steady increases in loans, both in our personal business and commercial business. In the U.S., we were expecting quite the opposite, but the U.S. continued to be very muted. We have done slightly better than our peers, more so in deposit growth. And our current expectation, based on discussions that we've had with our clients, is the elections appear to be an important an event. It is an important event.
Regardless of the outcome, I think some certainty as to what the next four years will look like should clear some of the uncertainties. The rate cuts are important, not only, I mean, they have multiple impacts, right? One is, in general, it will be helpful to our capital markets business in terms of spurring, hopefully, a bit more M&A activity. In lending, that clearly could be, should be, an important factor in changing the environment from 2024 into 2025. And deposits, you know, it's been strong for us. It might be even more than what we expected. But rate cuts do seem to provide an ease of stress in deposit markets. Liquidity flows from this out of the system have changed.
And so I think, in general, as we make our plans for next year, we have a more positive set of expectations compared to our experience so far in the year.
Okay, and maybe one last more in the US. I just wanna mention or just talk about office for a little bit. Office is just under 16% of the CRE portfolio, but just 2% of the overall US portfolio. Kind of with loss frequencies and severity is increasing that segment, do you have any concerns about that portfolio?
So one, I know we spent a decent amount of time on credit to begin the conversation, but one positive aspect of all this has so far been commercial real estate, and both in Canada and the U.S. You know, we don't have a large exposure to commercial real estate. It's, you know, we have CAD 75 billion in exposure. It's about 10%-11% of our loans. The office exposure is more heavily weighted to the U.S., mostly because of the Bank of the West acquisition. I think we had about $ 5.9 billion or so in the U.S. in office, but it's very well diversified. The urban exposure is just about 30%-31%. The rest is suburban, medical, and REITs.
There clearly will be some downgrades, some probably credit events and some losses. But in general, so far, the portfolio is behaving just as we expected. There was one credit that, you know, we discussed in our second quarter earnings call, with the impairment, and we said we expect some recoveries, and we've actually captured that recovery in Q3. So, so far, that portfolio has not posed, and we don't expect it to pose additional credit pressures for us.
Great, thanks. Let's switch over to the Canadian banking market. We talked about too, early at the start of the year, kind of a weaker economic outlook for Canada compared to the U.S. You know, but still, the consumers held up pretty well in 2024 in Canada. As you sit here today, are you seeing any signs in the payments or delinquencies that kind of on consumer mortgage, Canadian consumer mortgage, that are giving you reasons to think that this might change?
Yeah, I think two years ago, when we sat here and when we sat through all of our investor meetings, the big concern in Canada was mortgage. Rightly so, I think, you know, it's a very hot mortgage market. There are some fundamental differences between Canada, and the U.S. in housing, and with immigration and the large impact on housing inflation, which then caused a significant increase in household leverage and exposure to higher interest rates. There was a lot of concern about defaults and losses in mortgages, and that hasn't happened. We were not expecting it, and that mortgage portfolio has continued to behave according to expectations. Our year-to-date impairment in mortgage is under two basis points.
And with easing interest rates after three cuts and probably the expectation of more cuts coming, the pressure that was coming through negative amortization, et cetera, that's all easing. So, delinquencies may sort of normalize, but, all of the activities that we have seen in mortgage so far, the refis, the expected wave of refis, et cetera, I think, given the nature of bank mortgage portfolios and the LTVs, you know, in the fifties, this is not gonna be a loss issue. So now, the Canadian economy overall, this year and next year, is going through a weaker period in employment.
Mm-hmm.
We expect the unemployment rate next year to probably cross the 7% threshold in Canada. Productivity levels are down. We're seeing mostly the impact of immigration levels and population growth on unemployment, but it is what it is, and as such, delinquency levels in unsecured consumer lending are going up, and we expect that to continue for a few more quarters, and accordingly, we expect charge-offs impairments to also rise, but the Canadian households are significantly more leveraged to rates, and as such, the three rate cuts that we have seen so far, and probably a handful more over the next number of quarters, should provide a decent amount of relief to Canadian consumers.
So despite this, continued increase unemployment rates, there will probably be a point in 2025 where we will see normalization plateauing, in delinquency, roll rates and buckets, which then at one point probably will slow down, the impairments. But so far, in the foreseeable future, there's probably, an expectation that, we will see, increases over the next few quarters in retail lending, on unsecured lending.
Great, thanks. And a little more detail on the mortgage portfolio. You've seen kind of growth in the mortgage balances in Canada over 2023, 2024. I think your peers have been a little bit more flattish. Kind of besides pricing, what strategies have you been employing to kind of increase market share? And, are there any other ways you might be able to increase margins on this portfolio?
Yeah, so, it's, like, unlike in the United States, and this has been a learning experience for me over the last four years, the mortgage product in Canada still is the anchor product in our retail business, and so as much as we are focused, we don't price compete, and we can actually track that because we get to see spreads. Two years ago, at the end of 2022 and early 2023, were probably the worst times in terms of price competition in mortgages, where origination spreads have gone all the way down to teens, if not below. Today, we are significantly above that. The first two quarters actually were, you know, there was a bit of a contraction in Q3, maybe ten basis points, but we're still in the, you know, far from those low levels.
When we look at mortgage, we don't necessarily look at mortgage alone. We look at all the business that comes with mortgage deposits, other lending products, and importantly, fee-producing products and wealth management. So Canada is different, right? There's insurance products that goes along with that. So the return overall, client return related to mortgage is very high. Having said that, there are two reasons why, you know, our mortgage growth has been in the mid single digits. I expect that to be the case still going forward. And I really expect as we look into 2025, I don't think that our mortgage growth will deviate from the overall market growth. The reason why, maybe in 2023 and in some periods in 2024, we may have shown quarters with higher growth rates were two reasons.
One is, we actually have added more to our mortgage sales force-
Mm-hmm.
Relative to our peers, and then, too, as significantly, we had a market-leading digital banking platform in Canada, and that has contributed to our growth rates in mortgage originations because that has a sales aspect to it, and that has a service aspect to it. In both instances, we have actually been able to create digital capabilities that are currently being viewed very favorably by our clients, so those are the two more visible factors that have contributed, but I am not expecting, as I look forward, really an outpacing performance in mortgage growth relative to our peers, you know, the next number of quarters.
All right. And then you did mention the importance, kind of, of wealth management, particularly in Canada. Can you provide more color on the One Client initiative, and how is that differentiating the customer experience?
Yeah, look, I mean, I think, that's the One Client initiatives, which is basically bringing all of our business lines to relationships and addressing their needs wherever applicable. That's a big part of our U.S. expansion today, especially in California, with wealth, but that's always been a big part of our business model in Canada. There's a very strong partnership between our personal business and our wealth management business. About 50% of the new investments that are flowing into wealth come from our retail business through the premier banker relationships that we have been able to generate in our retail banking business. So a very important tuning model. When I mentioned mortgage, for example, mortgage profitability, in that profitability-
Mm-hmm.
Just like we include deposits, we also include all the wealth management products that are being sold in our branch system, and then there is a big partnership between commercial and wealth. You know, having a very large market share in Canada in commercial gives us the ability to hit a large swath of potential wealth customers, and we're seeing referrals from both ends. I think, like there's, I believe year to date, the number of referrals from commercial to wealth is over seven hundred and then over five hundred from wealth to commercial, so there is an ongoing flow of business that is a big, big piece of our business plan.
Great, and then maybe the last question from me. The return to positive operating leverage in Q2 2024 was a welcome development. Kind of looking forward, how are you balancing efficiency goals versus the need for continued investments? And what kind of areas are you targeting to achieve improvements in efficiency?
Yes, we are very proud with our performance in managing expenses. It's been a bright part of our overall performance this year. The reason why we were in negative operating leverage last year was really related to the acquisition. We've never changed our commitment to positive operating leverage, and it's been great to see us coming back once we lap the acquisition. We are still committed to positive operating leverage, especially as long as our efficiency ratio continues to be above the peer average. We're committing to Q4 and as well as full year. Expenses in the fourth quarter will go up. They always go up in the fourth quarter, but I think we're still gonna achieve positive operating leverage.
I don't think that we are sacrificing investments in our business because, you know, we've had this positive operating leverage for a number of years, and in all of those years, we've been able to provide support to all of our businesses in line with their revenue and return opportunities. You know, we have a significant technology investment budget that we commit to every year. There are some real signs of those technologies actually providing both efficiencies as well as returns in revenues, so we're not feeling that this strong commitment to positive operating leverage is creating any limitations in our ability to support growth.
Is that commitment to a positive operating leverage dependent on any way on interest rates?
No, it is not. Mathematically, it always is, but we can get a chance to talk about interest rates, views on our NIM. We manage our NIM. It's been a long-standing principle, with stability in mind. We don't take positions based on certain rate views. So I don't think, as I look into next year, interest rates are going to significantly impact our NIM. It should still behave within a tight range. It's gonna be a really matter of function of earning asset growth, and I don't believe that unless there is something drastic happens in the markets, that the interest rate environment will have a huge impact on our positive operating leverage.
To be honest with you, because of the strong commitment, we are maintaining a flexibility to change our expense outlook based on the revenue outlook so if there's a drastic change in the revenue outlook, we maintain the flexibility to also change the expense guidance.
Great. That brings us right to the end of our session. Please join me in thanking Tayfun for his presentation.
Thank you.