Barclays 2014 Global Financial Services Conference

Sep 9, 2014

Well, ladies and gentlemen, thank you again for joining us today. Very pleased to have Tom Flynn, who is Chief Financial Officer of BMO Financial Group. This is not Tom's first time being stuck up on stage with me here. Tom, thank you very much for joining us. Before we start off, I have actually been asked to tell you that Tom's comments today may include forward-looking statements. Actual results could differ materially from forecast projections or conclusions in these statements. Listeners can find additional details in the public filings of BMO Financial Group. With that, we are off. Thank you. It is good to be here. This is a great conference. Happy to be up on the stage with you once again. Thanks, Tom. Well, I guess I have to congratulate you on what was a very strong third quarter and some fantastic results. In my opinion, though, what we saw was actually quite striking in terms of the strength of the quarter, and it was, from my standpoint now, predicated on the diversity of your operations and what BMO has been able to build up. You look at your cross-border retail banking platform, exceptionally strong Capital Markets, and we saw an increase in wealth management with the inclusion of F&C. How does BMO manage the portfolio of businesses in terms of intermingling and capital allocation, and what do you see as the relative outlooks and challenges along each of your segments? Okay, thank you for the question and the comments on the quarter. We did think that we had a good third quarter, and really, a good third quarter in a series of good quarters over the course of the year. Our underlying operating earnings were up at about 12% if you exclude the impact of very low credit losses last year and the interest rate sensitivity that we have got in our insurance business. More importantly, as you said, we had good operating performance in our businesses, and we think we have got good traction in those businesses, and I will roll through them one by one. Overall, from a mix perspective, about 75% of our revenue and income is coming from our retail businesses and around 25% from Capital Markets, and that is a mix that we like. Over time, we've worked to have Capital Markets at about that level of contribution in the overall group. Looking forward, we would expect to continue to have it in that kind of a zone. We're happy with that kind of a mix and do believe in the virtue of diversification. We've got four main business groups, and I'll roll through them here and give you a little flavor on the quarter and the outlook that we see. The largest business is Personal and Commercial Banking in Canada. That business represents around 45% of our total income, and we've had a series of good quarters in that business over the last year. in Q3, our revenues were up 6%, our income was up 8%, and our operating leverage was above 2% for, I think, the fourth quarter in a row. We've had a very good track record of driving revenue growth above industry average balance sheet growth and generating operating leverage in the business, which reflects a lot of good and hard work that we've done over a period of time. Looking forward, we do think that we'll have some slowdown in the personal segment in the industry, which will have some impact on us. But overall, we think the basic momentum that we've seen in the business will continue over the balance of this year and as we head into next year. Second business I'll talk about is U.S. Banking, and this business represents around 15% of our net income. We increased the size of this business significantly in 2011 with the acquisition of M&I. Bit of a different story in the sense that U.S. Banking, as you know well, has been more significantly impacted by the downturn than Canadian banking. The U.S. Banking business had positive revenue growth year-over-year, positive income growth, and positive pre-tax, pre-provision growth, albeit in all cases at a modest level. I would view this business really as troughing after having gone through, with other banks in the industry, a fairly difficult patch, and we expect the business to slowly pull out of the trough heading into next year. We hope helped at some point by higher interest rates, and we've been hoping that for some time, but it feels like the prospect of higher rates is a little closer sitting here today than it has been over time. In the U.S. Banking business, we have really done a great job, I think, growing our commercial business. We've had solidly double-digit loan growth in that business for well over a year. In the last quarter, the growth was 18% year-over-year in the core C&I portfolio. That growth, which is above average, reflects the fact that both M&I Bank and Harris Bank had a strong commercial banking business that was really the strongest part of their business. Together we've got real powerful force in the Midwest market, very good leadership, and we're doing good things to drive the growth, and we expect continued good performance, not necessarily at the same level as Q3, but continued good performance. Over the course of the last year, we've had a reasonable degree of margin pressure in that business. It's being driven by competition in the commercial space and the lingering impact of low rates. The good news is that we do see that margin pressure beginning to moderate. So in Q3, the margin was down by 3 basis points. That was in line with our guidance of down 2 to 4. Heading out into the first part of next year, we are expecting similar pressure on the margin side. As you know, it can move around quarter to quarter. Generally, we think given that the commercial landscape is still pretty competitive, there is some tail to the impact of low interest rates, we will be looking at margin pressure in that business into at least the first part of next year. Third business is Capital Markets. Capital Markets had a strong Q3 with income above CAD 300 million, second quarter in a row at that level of income, benefiting from better corporate confidence, good markets, and in particular in Q3, good equity performance and better M&A revenues. We characterize income in Capital Markets when it is above CAD 300 million as being good. That is a good quarter, probably an above average quarter, and again, reflected favorable market conditions and corporate confidence in the third quarter. Looking forward, August is traditionally a slower month given holidays. It does feel like people have come back in September ready to do business, so we feel good about the environment that we are dealing in now after a typically slowish August season. In our Capital Markets, we have added resources to our U.S. business over a period of time, strengthened people in our firm, strengthened the alignment between different parts of the firm. With that, we have had good growth in the U.S. part of the business, which represents around a third of our Capital Markets business. This is a mouthful, but year to date, year-over-year in U.S. dollars, our Capital Markets business is up 25% in net income. That is good traction in that part of the business. In Canada, the market is well banked. It is competitive, and we do well from a share perspective, but it is harder to drive significantly above average growth given the competitive nature of the market. We do think our U.S. strategy gives us an extra dimension to growth that some of the other banks don't have, and importantly, makes us more relevant to our Canadian investing and corporate clients who do business in the U.S. So there is both an offensive and a defensive element to that part of our strategy. Lastly, Wealth Management, which represents around 23% of revenue, 20% of income, included for the first quarter in Q3 the acquisition of F&C, which is a U.K.-based asset manager, and that acquisition contributed about 10% to the Wealth Management results. We had a bit of noise in the wealth segment year-over-year because we have an insurance business in wealth that has a sensitivity to interest rates, and we basically mark our policy liabilities to market every quarter under IFRS accounting. Year over year, that produced a CAD 64 million negative swing in net income. We had about a CAD 40 million pickup last year, so income was high in Q3 of last year and a CAD 20 million hit this year. That reduced the reported growth in the segment. If you exclude that and look at organic growth, we were up 19% year over year, benefiting from traction in the business and as well, again, pretty good markets and better AUM flows and higher retail activity. Long answer to your first question, but it was a large question and I would sum up by saying we feel good about the operating momentum that we have in the business most importantly, and feel good about the overall earnings level in the third quarter. I am personally quite pleased with your look at Capital Markets in September and October. That is good. Tom, you touched on this in your answer, but BMO has actually made several acquisitions over the last little while, but M&I and F&C have been the most significant recently. Outside of ampersands in the title of the acquisition, what does BMO look for? Has that approach to looking at targets and acquisitions changed as the regulatory environment has changed? A few things. When we talk about how we think about acquisitions, we have been saying for probably a decade that we look at strategic fit, financial fit, and cultural fit. We still think that that is a pretty good way to think at a high level about how we want to grow the business. Each of those dimensions is important. Number one, you want to make sure that you buy a business that you have confidence you can manage, that fits with your existing business, and lines up with where you want to dedicate resources as a firm. Those things speak to strategic fit, and we think we have done a good job of that over time. On the financial fit side, I think for some investors, maybe many investors, acquisitions are a double-edged sword. It helps you grow the business, moves the business forward, but there is risk that you do a transaction where you pay too much or you take on more risks than is advisable. We have tried to be disciplined over time on the financial side. The best example of that I can point out is that for a number of years pre-downturn, we talked about growing our U.S. Banking business more aggressively, including through acquisitions. We did do some smaller transactions, but we passed on some larger transactions that would have passed our strategic and cultural fit screens because we did not like the financial returns that resulted from bank valuations at that point in time. We took some heat for being less aggressive in pursuing our U.S. Banking growth strategy than some other banks. That wasn't necessarily pleasant at the time, but we had conviction that it was the right thing to do. I think we've demonstrated that we have the ability to have a clear strategy and to be disciplined about executing it. Lastly, people need to fit at the acquired firm within the broader organization, and I think we do a good job and have a good reputation as it relates to integrating people. That's at a super high level how we think about it. From a business mix perspective, we have been saying for close to 2 years now that growing in the wealth management space is the main priority for inorganic growth. The acquisition of F&C was consistent with that, and that is a shift from where we would've been years ago, where the focus was more on U.S. Banking. Given the acquisition of M&I, which doubled our U.S. Midwest bank, we think we've got critical mass in the Midwest market that we compete in. We'll look at smaller bolt-on type acquisitions over time, but don't feel the need to do another large acquisition in that market. In fact, want to make sure we've got our people taking advantage of the investments that we've made in the market, given that the market environment is better from a growth perspective. We want people to be focused externally on the market and organic growth at the current time, rather than focused inwardly on an integration. In part with that, and in part given the desire to grow the wealth business, which is higher growth, lower capital, and high return, and at our firm, we think well managed. We've been focused on wealth management, and more specifically, asset management and private banking. Our track record of integrating firms acquired in that space has been good. We've done, I think, a pretty good job of keeping the people at firms that we've acquired and keeping the clients, and then growing off of that base. Gilles Ouellette, who runs our wealth business himself, was at a firm that was acquired by the bank a long time ago now, but he's lived through an acquisition from the other side of the table, and with that is a good ambassador for the broader organization as we talk to people about potential transactions. That would be how we're looking at things currently, and we try to be reasonably clear about our intent and think that we did that with the F&C acquisition over a period of time leading up to it. Before I throw it open to the audience, I think we're going to start off, kick off with our first polling question, please. What is the most attractive feature of Put that down. What is the most attractive feature of the Canadian banks? One, stability to the Canadian banking environment and economy. Two, compelling dividend yield with increasing dividends. Three, rational oligopoly with exposure to global economies. Four, the universal banking model, or five, the strength and consistency of strategies and management teams. You were going to press five, weren't you? Totally objective. The results are 50% for the stability of the Canadian banking environment and economy. Tom, would you mind touching on that in terms of how you feel that the environment or the economy benefits not just your operations, but I guess the group as a whole? Sure. The Canadian economy does feel stable right now, and it's in what I would call a post-downturn new normal kind of a recovery with solid growth, but more modest growth than we've experienced coming out of recessions previously. The economy is certainly benefiting from low rates and over the last year or so, a lower Canadian dollar. We had a change in the governor of the Bank of Canada some time ago, and since that change, we've had the Canadian dollar depreciate by not a huge amount, but a non-trivial amount at the same time. Off the back of that, we've seen a pickup in the commercial part of the economy, an increase in exports. That activity is trying to help shift demand in the economy away from the housing market and towards the business segment. I think there's been success with that part of the policy that has been implemented by the Bank of Canada. Overall, consumer confidence is at a reasonable level, and Canada does have a big export relationship with the U.S. U.S. economy is doing better than it has been doing. In our business, we're seeing better confidence on both the personal side and the business side than we have seen in some time, and we're big believers in the power of that to drive activity. U.S. economy feels like it's in pretty good shape. Consumers are still obviously somewhat cautious and in places in a deleveraging mode, but confidence is higher than it was, and that helps the Canadian economy. The overall economy is pretty stable. The banking system, as you know, has been rated for a number of years as being the most stable in the world. We're, I think, as a country, proud of that. We work hard to maintain that, and we operate with high levels of capital, good liquidity positions, and I think have a constructive relationship that exists between the different participants in our system, be it on the business side or the regulatory side. Being in a position where you can have constructive dialogues, at times disagreeing, but at least good, full, open communication, I think is an asset to the system. Great. Well, I hogged the puck for long enough. Is there any questions out in the audience? Hi, there's frequent chatter certainly about the leveraged consumer in Canada and the overheated housing market. Is that a story which is a concern to you, or has it been overhyped and overplayed in the media? I would say we're mindful of where consumer leverage levels are, and they are high for sure by historical standards, and the housing market has had a good run. We are aware of those facts. We've made changes in the way we're managing the business, given them, but we're not alarmed by the current state of affairs either. I think at times, the media has painted a picture that is gloomier than we see. We have been promoting actively as a bank, mortgages that have a shorter amortization period, and in particular, over the last number of years, a 25-year amortization mortgage product, which is designed to help consumers pay off debt more quickly and also given the impact of a shorter amortization on their monthly payment, lowers their capacity to buy a more expensive house. We think that's a responsible product, and we've been active in promoting that given the concerns that do exist around the Canadian housing market. We do think given the growth that we've seen over the last 5 to 10 years in consumer leverage and the housing market, that growth over the next few years will be lower. We think that's a good thing for the consumer, a good thing for the economy overall. Our expectation is that the market growth rate will revert to something in the order of nominal GDP over the next few years, after having run at much higher rates off the back in part of lower rates. As we think about it, there's a bit of a growth impact as the economy adjusts. We think that's healthy. We're supportive of it. But we're not particularly concerned about things from a credit perspective. I think as most of you well know, the structure of the Canadian mortgage market is really very different than the structure of the U.S. mortgage market. Canadian banks don't have exposure to mortgages above an 80% loan-to-value. We do underwrite some mortgages above that level, but when we do, the mortgage is fully insured, and the insurance is backed by a crown or government corporation. That's a big difference structurally from the U.S. market. We also don't underwrite home equity loans above an 80% loan to value. Structurally, the industry is very meaningfully less at risk to a downturn in the housing market than most other jurisdictions would be. We're happy to have it that way. But we don't expect a significant downturn at the same time. If you look at debt service capacity and house price affordability, we're actually not outside of historical norms given low rates. There is something of a vulnerability, obviously, to meaningfully higher rates, but the prospect of that happening seems pretty remote to us sitting here today. I guess, Tom, if you can, following on to that, touch on your days as Chief Risk Officer in terms of the stress testing on the Canadian P&C portfolios, the commercial as well as retail. I know all the banks run various scenarios. What is the largest critical factor in terms of creating an uptick in credit losses? From my standpoint, the numbers that we've run, it's not interest rates, it's largely unemployment. Yeah. Unemployment is the largest driver of higher losses, and we do extensive stress testing as you would know, and stress the portfolios in a variety of ways. When you shock the economy and have a significant recession, double-digit unemployment and maybe not add on higher interest rates, your losses go up, and they go up very meaningfully. The capacity to withstand loss at our bank and in the industry is pretty high given the ROEs in the business. Our ROE year to date is running just a little below 15%. There's an expression that your best prevention against loss is to have a high level of pre-tax, pre-provision income. With a 15% ROE, we do have that and the capacity to absorb a lot of loss. In the stress testing, the mortgage portfolio doesn't throw up really significant loss given the structure of the industry. When you stress the things I talked about and have housing down meaningfully, losses obviously go up. But the structure of the portfolio means that they are banded by a certain level. None of that is to suggest that we don't have credit risk, and obviously we do have credit risk, and the bigger the stress that you throw onto the balance sheet, the bigger the losses that result. But given high capital levels and the high pre-tax, pre-provision income base, we think there's a good and very strong cushion to absorb the loss that you can produce under different scenarios that you run. Do you all have a target in terms of where you'd like to see U.S. assets get to as a percentage of total assets in, say, five years? We don't have an explicit target, and we talk about being happy with diversification, looking to grow the U.S. business. We've shied away from hard targets because we think they can drive you to do things in the pursuit of a target that might not make as much sense as something you'd rather do because you want to hit a number that you've gone out publicly with. We're expecting the U.S. businesses to grow meaningfully. We've invested in them over the last five years, and we think we've got good organic growth potential in the business, and particularly so with an improving economy. So I'd expect over time, growth at or a little above the rate of growth of the overall company, but we don't have an explicit target. Can you also touch on the regulatory environment in terms of M&A, how you are seeing it today? I think it is pretty clear that the regulatory environment, generally for the industry, is tougher from an M&A perspective than it used to be. There has not been a significant amount of M&A in the banking landscape for a period of time. That is partly because banks have been working on strengthening risk and compliance systems, investing in technology, and looking to grow organically. As we look at our business, the main focus coming off of a very significant acquisition is on being in the market and growing organically, given that we doubled the size of the business in an acquisition just about three years ago. We are happy to be focused on organic growth and do see a lot of opportunity for that in the business. Could you just give us some of your thoughts on the debt proposal that was recently released with your potential 17%-23% of debt capital stack, and your initial thoughts on that? Okay, sure. Just for people in the room who are not as familiar with that, there is a proposal from our Department of Finance to add a layer of what is called bail-in debt to our capital structure. We would have common equity, non-common Tier 1 sub-debt, and those things totaling around 13%, and then a layer of bail-in debt on top of that it was proposed would run to, in total, 17%-23% of risk-weighted assets. The introduction of bail-in debt is intended to bail in a class of senior creditors when an institution ceases to be viable. That is an attractive thing to do from a government perspective because it reduces the risk that taxpayers are in a position where they are putting money into a bank that has failed. From our perspective, it makes sense to introduce bail-in debt. It's one of the reforms that the Financial Stability Board has talked about wanting to see introduced globally. The industry has been in discussions with the official sector for a number of months on the topic of how to structure bail-in debt, and those discussions are continuing. There was a paper that people will be submitting comments on by September 12. We would expect over the next number of months that the structure of the bail-in debt will be finalized, and it will be introduced to the capital structure over time. We're not expecting it to have a significant impact on the business. If there's a cost impact, we don't think it will be significant, and really what we're doing is making explicit what was previously implicit. One of the things I say, and I probably shouldn't say it, but we've been paying a credit spread to senior creditors for a long time, and we pay that because people take risk. Just formalizing the nature of that risk, I think is a reasonable thing to do from a system perspective, given the experience that occurred during the course of the downturn, where different capital providers who were paid for risk didn't experience loss when institutions ceased to be viable. Introducing reforms to address that makes sense to us. Before we go to the next question, can we go to the second polling question, please? How do you view BMO's acquisition of F&C? Don't take this personally. One, very positively, two, modestly positive, three, neutral, four, modestly negative, and five, very negative. Don't press five, please. These things sound better when I'm writing the note as opposed to when I'm actually up here with you. Largely overwhelming neutral, but then the bias is to the positive. I'm not going to ask you to go through the F&C acquisition, though I think that BMO's done very well. I'm actually personally a little surprised that it wasn't a little more positive after what we saw in the quarter. Yeah. We started to see some momentum on that front. Do we have any other questions out on the floor? The debt proposal appeared to have been the cue for the rating agencies to put negative outlooks Yeah or watch lists on your debt ratings. I'm wondering, how do you feel that will shake out? Secondly, will any increased amount of issuance of debt be big significant and possibly cause a widening in your spreads from your perspective? A couple things. On the rating agencies, both Moody's and S&P put the ratings for the Canadian industry on watch given the development. In the ratings methodology that both of those firms use, they assume some level of government support for the institution at the senior level. Government support is baked into the rating under the methodology for senior debt. I would say it's not clear how the ratings at the end of the day will be impacted. When you look at, as we would see it, Canadian bank ratings relative to ratings for banks in other jurisdictions, we think the current ratings, more or less, make a lot of sense. You can come at ratings in a variety of different ways, but we think the income streams that the Canadian banks have are strong. The ROEs are strong. The system has a good design to it. There's a lot of inherent credit strength in the industry, and that's reflected in the ratings today. It doesn't make sense to us that would change in a significant way. The rating agencies, I think, have been clear that they want to take time to look at their methodologies, which are structured and involved, and think about the changes that come with the bail-in structure to decide what the net impact is. My expectation is that they'll take their time doing that so that they are sure that in their minds they get it right. In terms of a change in spreads, we're not expecting a flurry of issuance. The expectation is that we'll build the layer of bail-in capital growth, really bail-in debt, gradually over time. We will be allowed to do that given the phase-in period that comes with the introduction of the rules. There might be initially some higher credit spread, we do not think significant given the more explicit nature of the credit risk, but we are not expecting an abnormal issuance pattern that results just from the introduction of the bail-in debt. Going back to the bail-in. In 2008, when the banks got in a bit of trouble, you were able to issue sub-debt at a very attractive price. Now, with the conversion mechanisms and we see bail-in, if you were to get into some issues going forward, do you think this would prevent you from issuing at attractive prices? I do not think it would prevent us from issuing at reasonable prices in a market environment. To me, we are making explicit what was formerly implicit. Credit risk is not a new thing to credit providers to banks. Banks have paid a credit spread to credit providers over time given that credit risk. I do not think there is a night and day change that will result from the introduction of bail-in. In addition, the Canadian proposal is that debt with an initial term of under 400 days is not subject to the bail-in terms. Allowing for shorter term issuance that is sort of outside of the bail-in stack reduces the risk that there is an access to liquidity issue in the market. I think that was purposely built into the proposal and from the industry's perspective is a good idea. Can we throw up the final polling question? See if we can squeak it in under the wire. Which areas of the business do you think BMO should expand and possibly make an investment or acquisition? Expanding U.S. retail banking footprint beyond its U.S. Midwest, broadening wealth management capabilities in Europe and Asia, strengthen the bank's domestic retail banking footprint, bulking up its Capital Markets platform, or diversification through other avenues such as insurance. They cannot just say no acquisitions. That's- Wealth management capabilities in Europe and Asia. Well, you've got your marching orders. Wow. Interesting. Massively overwhelming. 63%. Very good. We are getting close. Are there any last couple questions in the audience? You are going to leave it up to me? Avoiding the wealth management, the obvious wealth management question. One of the things that differentiates BMO is obviously the U.S. strategy, and you made the acquisition of M&I. How do you plan or how do you continue to plan on competing in terms of the retail segmentation? Because the U.S. market is very competitive. I am not going to say more competitive than Canada, it is just a different marketplace. What differentiates yourself and how are you going to grow? A few things. I will talk about banking and maybe a little bit about wealth as well. Firstly, on the commercial side, we have been doing very well, and we would see that continuing. We talked about that earlier in the session. Some of that good performance comes from sharing best practice. Both M&I and Harris Bank had good capabilities, but not always in the same ways. If M&I was good at a particular thing, we have taken that capability and looked to spread it across the broader footprint, and we have taken ideas from our Canadian business and brought them down to the U.S. business. More specifically as examples, we have a big auto finance business in Canada. It is a good and profitable business for us, and we have taken some of the capability from that business and people from that business down to the U.S. and have grown that part of our portfolio. Similarly, we have an asset-based lending capability in Canada that we have grown over the last 5 years or so. Neither M&I nor Harris Bank was in that market in a meaningful way. We have taken the know-how from Canada down to the U.S. and have got very good traction in that part of the business. Treasury services is an area where M&I had a good capability, and we have been selling it through the Harris part of the footprint. It is a form of cross-selling, taking strengths from one part of the business and bringing them to another, and it has served us well and is contributing to the good growth that we have had. On the personal side of the business, the market generally has been slower, as you know. Showing better activity levels currently than we have seen for a few years. Our client base skews meaningfully to the affluent side. That was true of Harris Bank in Chicago in a very significant way. It was true of M&I as well, although not to as significant a degree. We have been looking to take advantage of that by selling wealth management related services and Premier Services to higher end clients. As part of that, we have introduced what we call Premier Services, which is a private banking kind of a model to our retail customers. We have got 100 Premier Services sales reps in our branch network, and we are doing a good job of basically delivering more services to higher potential clients in the banking network, and through that, driving a larger share of wallet and higher revenues. I would say that activity has good room to run. We have been focused internally for a period of time on the integration that is done. We are focused more on the personal side, given that we are done with the integration and the market is better and growing retail. You will see more things with a wealth flavor around our efforts to grow on the personal side, given the client base that we have got, which again skews to the affluent side. We also have good positions in our market. We are number 2 in Chicago, which is the third largest market in the U.S. We are number 2 in Wisconsin, which was M&I's home base. Depending on how you cut it, we are number 3 or number 4 in the Midwest generally. We have got good positions in our markets to grow from. The Midwest market is a large market for us. In terms of population and GDP, the states that we are in are actually a little bit bigger than Canada. There is a lot of market for us to grow into given the size of the market. The GDP growth rate is basically in line with the U.S. average. It is doing fine from a growth perspective. We are seeing better activity on the commercial side of the business. I would say we feel very comfortable with our ability to compete. We are hoping to get a little bit of help from higher rates next year. We are enjoying the help that we are getting right now from a little better performance on the economic side. That is great, Tom. I think we are going to leave it there. Tom, thank you very much. Thank you very much.