Barclays 2016 Global Financial Services Conference

Sep 12, 2016

Ladies and gentlemen, if we can get started with the next session. Pleased to have Tom Flynn, Chief Financial Officer of BMO Financial Group here. Before we begin, I have been asked to tell you that Tom Flynn's comments may include forward-looking statements. Actual results could differ materially from forecast projections, conclusions in these statements, and obviously, whatever we forecast here at Barclays. Listeners can find additional details in the public filings of BMO Financial Group. Tom, thank you very much for coming. We do really appreciate it. Good to be here. Thank you. I guess I am going to start out with, I was hoping you could let us know what the impact on the Canadian economy has been on BMO's, or sorry, is on BMO's outlook. We are seeing slower growth than out of the U.S. and most of the G7. In particular, how does this affect your planning, your capital allocations in terms of BMO's international strategy? Sure. I will address the question both as it relates to Canada and how it impacts our international view. First, a little context. We sort of buy into the notion that we are in a new normal growth environment. Our growth expectations for Canadian GDP next year are for about 2% growth. In the U.S., our number is a little bit higher, about 2.4%. The economy is growing. It is new normal growth, and we are, in essence, resigned to and recalibrated to new normal growth, and we do not view it as a negative, and we are happy to have the economy growing. There is some noise in the Canadian GDP numbers, as you would know this year because of the fires that we had in the western part of the country. Fundamentally, we would view the activity level in Canada this year as not being that dissimilar from what we're expecting next year when you take out the noise in the numbers. So, reasonable tone and positive growth, and lower growth than we've seen at points over time. With that, from an operating perspective, we're looking to manage expenses in a reasonable and in a diligent way, as you would expect. You saw that in our most recent quarterly numbers where we posted strong operating leverage and year-to-date as a bank, we're at around 2% operating leverage. So we're focused on managing the relationship between revenues and expenses in an environment where in places revenue opportunities are lower. But importantly, we're a diversified business, and the U.S. bank that we've got is an important part of our growth strategy. We do think that being diversified helps us earn through environments that aren't as conducive to growth in different parts of the business. So being diversified, first and foremost, is a core part of our strategy. On the U.S. side, the U.S. represents around 25% of our business. We had good results in our U.S. operations in the third quarter and in the year-to-date. U.S. banking in particular was up strong, in part because of an acquisition that we closed in our first quarter. Our capital markets business had a good quarter in the third quarter. Over time, we have grown our U.S. business through acquisition. We would consider that going forward. As always, we try to balance strategic intent to grow with financial discipline and also ensuring that we have a good cultural fit with any organization that becomes a part of our company. Fantastic. Bank of Montreal earlier in the year took a restructuring charge to obviously flatten your expense base. How do you see the operations changing over the next five years? What do you see in terms of the necessary changes to a structural cost base over that time period? We've been working very hard on managing expenses and investing in technology and our channel strategy. We're focusing on expenses and operating leverage, in part, given the lower growth rate that we've got in the environment. We're very focused on deploying technology in our business in customer-facing areas so that we're relevant to customers and we're doing business in the way they want to do business, and internally to reduce our cost base. I think our numbers this year point to having good success on the cost and operating leverage side. Again, our operating leverage for the year-to-date is about 2 points. If you go back over the last 5 or 6 quarters, our expense growth in constant currency and excluding the impact of both acquisitions and divestitures is a little below 2% in each of the last 5 quarters. We've had good expense containment. Looking out over the next 5 years, which is a long time, I would expect continued deployment of technology, a continual shift to what we call new branch formats, which basically means having smaller branches, so smaller square footage, a lighter touch, and with that, lower cost and something that's more in keeping with the way that our business is being done. Our digital volumes are up quite materially over time. We're now doing about 40% of our transactions in our Canadian retail business digitally, and that's up about 20% year-over-year. Very high growth in digital adoption, which is driving a lower cost to serve. We are investing in technology in order to enable all of that, but I'd say we're doing it in a way that allows us to continue to generate positive operating leverage. Our midterm goal is to have 2% operating leverage as a bank. We'll get there in different ways in different years, but I would expect us to continue to shoot for that number over a 5-year horizon and over time to have increasing transactions done digitally and to reduce the square footage more than the branch count that we have on the physical distribution side. In terms of the transformation of the branch network, I know I framed it in a 5-year time horizon, but I'm assuming that a full transformation of the branch network might take a little bit longer than that. How long, on average, do you think this will take, and how far along in the process is Bank of Montreal? That's a hard question. Five years is a long timeframe to look out, and looking out beyond five is that much harder. But our expectation is that branches will continue to be a core part of our offer. We do believe that individuals and corporations, particularly commercial accounts, want to go into branches for significant transactions. We expect a larger decline in the square footage in our branch footprint than in the number of branches. Our new branches are very materially smaller than the existing legacy branches. They also have a sort of a light, nice, high-energy feel to them, which resonates with our customers. So over, say, a 10-year timeframe, our branch count might come down by something like 25%, and the square footage we would expect to come down by a larger percentage, and it does take time as you've said. Right now we're running at a place where we're well into the game on digital adoption, and not as far into the game on reducing the branch network. That's in part because the truth is right now we have parts of our customer base that really like to do things digitally, and we have parts that like to do things physically in the branches, and we're running both platforms. Over time, we'll have more people doing things in a digital way, and we'll take down the branch square footage. Great. Tom, before we open the questions up on the floor, can we start with the first polling question, please? What's the most undervalued aspect of BMO's operations? One, its U.S. business, two, its domestic retail, three, its capital markets, four, wealth management, and five, the North American commercial banking, which includes the Transportation Finance. The U.S. business is key, but also we have interest in wealth management as well as the North American commercial. Tom, I know you touched upon the U.S. business in terms of my opening question, but can you give us a little bit of drill down in terms of where you expect to see the growth coming from and what you can do to leverage the bottom line? Sure. Our U.S. business has had a very good year, again, aided by the acquisition of the GE Transportation Finance business. With that, growth rates are around 20%. But importantly, in each of the last two quarters, excluding the benefit of the acquisition, we've had good performance. Revenue growth sort of bumping into 5%, and in the most recent quarter, double-digit pre-tax, pre-provision growth, and negative expense growth. So we're focused on growing the business in a variety of ways, acquisitions and organically. The biggest business in our U.S. banking business by far is commercial. Our commercial strength comes from our legacy Harris business, which we've owned since the early 80s. M&I had a very strong commercial banking business in the upper Midwest. Together we've got a real powerhouse commercial business in the upper Midwest. Off of that, we've driven, I think, excellent growth, about 15% year-over-year growth in the commercial loan portfolio for the last two years, excluding the benefit of acquisitions. The business is nicely profitable. We've got strong leadership, and we expect that business to continue to do well. We've guided to growth rates coming down from 15% because that's a very high number, more to in the neighborhood of 10%. That was actually the guidance we gave at the beginning of this year, so we've outperformed that. With that business representing a little over 60% of the loan book, it is the engine of the overall business. We feel very good about the prospects for continued growth there. Pricing is a little tough, but we've managed to earn through that with volumes. On the personal side of the business, which is the smaller of the two, our portfolios have not shown growth in recent times. We are expecting the portfolio to turn to positive growth, excluding a part of the auto portfolio we're winding down in relation to the acquisition of Transportation Finance, sometime in the first bit of next year. So we expect a transition in that portfolio with that coming from growth in our mortgage book and less of a runoff in parts of the portfolio that had higher risk characteristics. Away from growth in the loan portfolio, similar to some of my earlier comments, we're focused on operating leverage. We've had good positive operating leverage in the business this year, and as we look out to next year, we will absolutely be looking to grow the expense line at a lower rate than revenues. Given all of the excitement in the air around what the Fed might or might not do, I would be remiss if I didn't add that we do have a rate sensitivity that would benefit from higher rates. So we're hopeful that we'll have that at some point over the balance of the year. The previous presenter wasn't willing to give her view on when the Fed might raise rates. Are you willing to give us yours? Well, I would say that given the unemployment level that we see in the U.S., given the cumulative level rates are at, and the benefit that would exist in having some incremental firepower for the next downturn, we hope and think it makes sense to have a rate increase later this year. Fantastic. Do we have any questions from the audience at this point? We have one in the middle. With regards to your U.S. business, you mention acquisitions. How do you balance the strategic intent for growth in the U.S. with acquisitions versus organically growing within the business? The way we think about that, the first use of capital that we have in our hierarchy is good organic growth. We allocate capital to our business groups, and they are not constrained for business that is good business. That's a function of the return on equity we've got in the business and the growth in the market. We're looking for, in effect, all of the good from both a return and a risk-return perspective business that we can get organically. We do expect to generate net incremental capital on top of or with that growth. Then in terms of balancing, if this was part of your question, the strategic desire for growth against financial disciplines and capital allocation generally, we have through time tried to keep those two things very much in balance, and we talk about that a lot. To me, the best example of that is we did express a strategic desire to grow our U.S. banking business through a larger acquisition pre-downturn, and talked about that for probably 2 and a half, maybe 3 years prior to the downturn. We talked about a screen that includes strategic fit, financial fit, and cultural fit, which is a screen that we continue to use, and it really does have full meaning. Pre-downturn, we came across opportunities that were good strategic fits, good cultural fits, and we passed on transactions because of the financial fit. We thought value was stretched and came out at the tail end of the downturn with the acquisition of M&I at a price that was quite favorable relative to where it would've been pre-downturn. So that's the best tangible example I can give you of our willingness to both have intent and patience. The sort of relief valve on capital, subject to the capital that's consumed through organic growth and acquisitions, is share buybacks. If the ratio was higher than otherwise made sense, we would activate the share buyback. Over the last three-ish years, we've done two acquisitions, the acquisition of Transportation Finance, which closed in December of last year, and then the acquisition of F&C Asset Management, which closed about two years ago. Prior to both of those acquisitions, the capital ratio was a little above 10.5 and approaching 10.5. We were active with the buyback before each of those acquisitions. Bought back, I think it was 12 million shares in the three or four quarters before announcing the acquisition of F&C and 8 million shares before the acquisition of Transportation Finance. So if the capital structure is at risk of becoming inefficient, we'll use that to relieve the pressure. Tom, in terms of the use of the buyback, how important is the relative valuation of Bank of Montreal in using that? If that is truly the safety valve and you're trying to temper your capital ratio, do you even care what valuation Bank of Montreal is trading at? Well, we care about that for- Well, not closely. We do. We have a view on value when we are active with the buyback. Our pricing tends to be price sensitive, so we run a grid, and at lower prices, we buy more when we are active, and at higher prices, we buy less within a range. It is one of the considerations that factors into it. I would not say it is probably one of the It is not the number one, and I do not think it would be the number two, but it is part of the discussion. Any other questions? Two of the trends that came out of third quarter earnings were, to me, capital markets better than expected and credit costs better than expected. The question is: Is that something you expect to continue, or is it a little bit tougher from here forward? I guess secondarily, if the revenue environment is a little bit tougher, what can you do to kind of defend that 2% operating leverage target? So a few things. Agree with both of the perspectives. On capital markets, we had a very good quarter in the third quarter, best quarter of the year. It was a good environment, and the results reflected the benefits of that. And we had very good expense management. So I think revenue was up 9%, expenses were up about 1%. So fantastic operating leverage, and the net income reflected the benefit of good revenue and good expense management. We do think the number that we had in the third quarter is reflective of the potential of the capital market business in a good environment. And clearly, results can be better or worse in any quarter depending on both the environment and our performance in it. But I wouldn't call that an outlier number. I'd say it's reflective of our potential in a good, constructive environment. Markets have generally continued to be reasonable since our quarter ended. So we'll see what the fourth quarter holds into next year. But we do think that's reflective of our potential. And I think it's significant and interesting that the performance was driven again, both by good revenue and good expense management. And in our capital markets, year-to-date expense growth is de minimis, low single digit, and the revenue growth is pretty good, and that reflects a lot of focus on the part of the capital markets team in driving the operating leverage. On credit, losses came in within our guidance in the quarter. We had guided to 25 to 30 basis points. We came in at about 29. We held that guidance for sort of the near term, next quarter or two. And so we're not expecting with that, a significant move up or really down in credit, and we think we're sort of in the zone of what we'd expect in the near term. Before we go to the next question, can we have the second polling question, please? How big of a threat to growth for the Canadian banking industry does fintech represent over the next 5 years? One, a significant headwind, two, a modest headwind, three, no impact, a modest tailwind, or a significant tailwind. I think we know where my next question's at. I think that's basically neutral. Yeah. Maybe a little bit on the headwind. Tom, what is your personal opinion in terms of fintech and? Well, I would hate to disagree with our audience here. Your audience. It would have been interesting to see the answer to that question a year ago. Yeah. I do think, and we think that views around fintech have evolved and matured a bit over the last year. We're looking to invest in technology like I talked about earlier. We're looking to partner with technology firms that are doing new, interesting, and innovative things and think there's opportunity to do that. We are really vigilant around fintech and technology, are not for a second complacent. But do think that we are in an advantaged competitive position given the large customer base that we've got, the fact that we think we're meeting the demands and the wants and the wishes of our clients, and the high-security networks that we operate, and the very significant technology budgets that we've got. We feel good about our ability to compete. We're open to working with others, and we're looking to innovate so that we stay relevant. The answer there that shows up, which, can people on the web see it, if there's anyone- No, but we will be publishing it. Okay. So pretty neutral. Really as was said, pretty neutral response, and that makes sense to us. The neutral-ish impact number doesn't speak to the level of activity that's going on beneath the surface, and there's a lot of very hard paddling to do lots of good things on the technology side so that we keep the position that we've got in the marketplace. Well, that leads into a follow-on question for me is that, I know that we are still really in early days when it comes to fintech. But what has Bank of Montreal's experience been in terms of the investment, in terms of payback, and what is your expected timeframe for payback before, however you want to categorize it, breakeven or actual contribution to the bottom line? Have you been able to meet that with the evolving, I guess, issues that are coming up with fintech? Yeah, that is a tricky question because there is a range of payback depending on the investment, as you would expect. You can have some product features that have very short in-year paybacks. Then we have done as part of our technology work over the last few years, a lot of work related to rewiring our core infrastructure, and changing the underlying technology architecture so that it is more efficient and will allow us to change at lower cost through time. We have leveraged some of the regulatory changes that we have had over the last few years to basically change our systems in a way that allows us to meet the regulatory requirements and also rewire our system and aggregate our data into large data lakes so that we are better equipped to evolve over time. That activity, which is kind of infrastructure related, has a nice payback, but it is a longer-term payback. So there is a mix in the portfolio, and I would take you back to our consolidated results. We have increased our technology spending quite significantly over the last five years. We have done that at the same time that we have produced pretty good operating leverage, and we have talked about the numbers this year. I would expect us to continue to invest in technology, advance our agenda on that side, manage costs as a general matter, and shoot for the 2% operating leverage number. In the revenue environment that we have got, that speaks to expense growth that is in the lower single digits. Any questions at this stage? We have got one up front here. Could you elaborate a bit more on the asset sensitivity in the U.S. business and whether the recent rise we've seen in one and three-month LIBOR and whether that should have an impact on yields in the commercial portfolio? Furthermore, any impact on credit quality as well, please. Yeah. Okay. Our commentary around rate increases is at 100 basis point parallel shift in both Canada and the U.S. Would be with a lot of assumptions in it, something like CAD 175 million to CAD 200 million of revenue in the first year. The U.S. short sensitivity would be something in the range of 70 to 100 for 100 basis points. Again, lots of assumptions about the competitive market and how it evolves. The number reflects our assumptions. I would say we had very good retention on the one increase that we had from the Fed. In terms of LIBOR, we haven't seen, at the bank level yet, a noticeable impact, I would say, from the higher LIBOR. As CFO, I'm hoping to see it, but it hasn't been visible yet. We manage our interest rate risk so that we basically match fund our book in effect. Given that LIBOR is up and a good portion of our U.S. loan portfolio is funded with customer deposits, intuitively, you would expect some increase, but I've not seen it yet in the numbers that I'm looking at. On the credit side, our view is that rates are just so low. The kind of move that we've seen or even some incremental move on top of that isn't big enough from a cash flow perspective to actually cause pressure from a credit perspective. That's sort of our starting spot. Obviously, there's a point at which that ceases to be the case, but rates are so low, we do think they've got room to move up before we'd see a negative impact on the credit side. Before we go back to the audience, can we have our third polling question, please? Where can BMO deploy capital to achieve the greatest valuation impact? One, expand U.S. retail banking footprint beyond the U.S. Midwest. Two, broaden wealth management capabilities in Europe and Asia. Three, greater diversification through other avenues similar to Transportation Finance. Four, run at a payout ratio above 50%, or five, build capital levels. This is going to go straight to the board. This will be interesting. Expand retail banking. I'm sure that the investment bankers in the room are going to be happy to hear that. Yeah. Then a little bit of a mix with broadened wealth management and greater diversification. Yeah Through Transportation Finance. Go ahead. I've nothing to add. You're not going to give us a target? No, I think we've talked about wanting to continue our strategy of periodically growing the business through acquisition. As we look at deploying capital, our first use of capital is our organic growth, as I was talking about earlier. We would expect some capital build after that is done. As we think about growing through acquisition, we think about U.S. banking. Could be in the form of banks or in the form of something like Transportation Finance. With your questions, question one or question three. We do like the wealth business, and the wealth business represents close to 20% of our overall bank. It's had very good growth through time, growth in excess of the rate of growth of the overall bank. It's a more capital light business, in terms of its capital requirements, and we think our business is very well managed. We've grown that from time to time through acquisition, and we would look at things that made sense there. Those are some of the points that we talk about in the context of thinking about our acquisition strategy. Again, we would view that as being consistent with what we've said through time. Over the last three years, we've done the two acquisitions, and we've managed the capital ratio, as we talked about earlier, in a way that allowed us to build up capital in anticipation of that. If we didn't find opportunities that made sense to activate the buyback to relieve the excess capital that would otherwise be there. Well, it's obvious that because I had full control over the polling questions, that I seeded them with a bit of my bias. But in terms of wealth management, when you look at Bank of Montreal's operations, I think that the North American banking model is fairly well understood, but I think something that gets lost in the observation is the global wealth management strategy that you have in place. As you said, you mentioned you have done some acquisitions in the past to grow that business. Do you think that you're at scale? Do you need more scale on the global side? And what can you do to grow this business Yeah if we're considering it's a very competitive landscape? Yeah. No, it's a competitive business, but a really good business. Again, it represents close to 20% of our revenues as a bank. In Canada, we are basically a universal wealth management firm, I would say. We have institutional asset management, full service brokerage, direct brokerage, private banking, and mutual funds. And we have a robo product. We've innovated, and we've been in traditional businesses. We're the number two ETF family in the Canadian market with about CAD 25 billion of AUM. And so large, mature business that has good share positions across the board. In the U.S. and really outside of Canada, our focus is on asset management and private banking. In the U.S., it's both in about equal measure. And in Europe, with the acquisition of F&C a few years ago, we really significantly strengthened and established, in effect, our European asset management capability. With that acquisition, we moved into a top 50 global AUM position. So we're in the top 50 asset managers in terms of AUM globally with the acquisition of F&C, which we feel good about. We do think we have scale. We don't feel, in a sense, compelled to do a transaction in order to bulk up. But as we look at the business outside of Canada, and particularly in the U.S., we would look at asset management and private banking transactions, again, with a good and pretty strict lens on strategic, financial, and cultural fit. And those two businesses are businesses we've been in in the U.S. for a long time. So they're mature businesses for us, and we think that they will have good performance through time. We'll open it up to questions for anyone. Actually, I have two questions. The first one is a follow-up to your comments about the increase in LIBOR and not yet seeing that impact. I am curious as to why you think that might be, if there is floors in place that is causing that to manifest itself, or what other reasons you might have for not seeing that impact yet. I think the biggest reason is it is relatively early days, and it is a big balance sheet, it is a big book, and it can take a while for things to come through. That is what I think the biggest reason is at this point. My second question is, and this is more on the Canadian retail side of things, is loan growth generally slower than it had been in the past? You have the same number of banks looking for growth. Are you seeing anything on the competitive front, whether it be pricing or structure that you would care to comment on? Short answer would be no. The market is competitive, has been competitive, and is rationally competitive. Margins have held up, and we are not seeing discernible margin erosion given the potential for some people to, quote, "reach for growth." On the risk appetite side, certainly at our bank, we are not looking to shift our risk appetite in order to generate growth. We are trying to stick with the good fundamentals that we have had to date. Anything else in the last couple of minutes that we have? Tom, I think that I am surprised that we actually haven't had any real questions on credit. I am not going to ask you about Canadian housing or the energy side, but I think it's fair to ask you, since BMO has got a historically very strong credit adjudication metrics in place. Is there any reason to be concerned about Canadian consumer household debt level? Well, I would say we are vigilant around Canadian consumer credit. We are underwriting in what we think is a reasonable way. We have tightened our underwriting standards in places over the last few years, given the performance we have seen in the housing market and Canadian consumer leverage levels. So we are not uncomfortable, and we are vigilant given the levels that consumer leverage is at. We do expect, to one of the earlier questions that were asked, in that part of our business, somewhat lower growth over the next 5 to 10 years than we have had over the prior 10 years, and we think that's a good thing given where we are at. Fantastic. Well, Tom, thank you very much. We really do appreciate it. Next up in this room is KCG Holdings. Thank you very much, everyone. Thank you. Thank you.