Barclays Global Financial Services Conference 2018

Sep 13, 2018

Gentlemen, very pleased to have Tom Flynn, I guess again. You are a grizzled veteran of the conference, Bank of Montreal's Chief Financial Officer. Tom, thank you very much for joining us. Thank you for having us. It is a great conference, and we are always happy to be here. That is great. Tom, I am going to kick it off because your longevity, not just with the bank but on the executive team as well, you have actually seen the change of the evolution of BMO's business model. I was wondering if you would give us an overview of what has changed over the past few years, and where do you see the bank heading over the next three to five years in terms of strategy and what you are trying to accomplish in your role? Okay. Happy to do that. Thank you for the question. I will start just with a brief description of the business mix that we have got. In Canada, where we have just under 70% of our business, we are a universal bank active in all parts of banking, personal banking, commercial banking, wealth management across a spectrum of products and client segments and capital markets. Our market share positions range from about 10% to about 20%. So big universal bank, very good profitable market, and we are happy to operate in it. Outside of Canada, most of our business is in the U.S., as you know. There, our biggest business is personal and commercial banking. We have a business headquartered in Chicago, which we have grown through time. But we are also in capital markets and wealth management in the U.S., and we have invested in our capital markets business. Looking forward, we do think the U.S. business will grow at a higher rate than the Canadian business, in part because the Canadian market is mature. It is well banked. We do fight for market share every day. We expect to gain market share, but there is, in effect, more white space to grow into in the U.S. market. Sitting here today, the U.S. business represents 28% of our income. That is the number for our year to date. Last year was 24%, so the U.S. business is growing at a higher rate than the whole. We would expect that to continue both in the current environment from an organic perspective, and over time, we have grown the U.S. business through acquisitions, and it is likely that that will continue although we are disciplined in how we go about executing on that as we look forward. In addition to that mix, I would highlight our commercial business. We have always been a bank that is strong in commercial lending, and that is true in Canada, where we have a number 2 and 19% share in the market, and in the U.S. Our U.S. banking business is very much dominated by a really strong commercial lending business, which is run by Dave Casper, who is the CEO of our U.S. bank. That business has grown organically from a loan growth perspective at a double-digit rate for I think this is our fifth year. If not fifth, it is the fourth year. So four to five years of double-digit organic loan growth I think is a great testament to the strength of our business. This year we will repeat at that level we expect, and we expect that business to continue to grow and to do well. We are driving that growth by expanding into new markets, adding capability in different industries. We have got a really great management team, so we expect the commercial business in the U.S. in particular to grow as the U.S. grows as a larger share of our mix overall. If you roll the tape back 5 to 10 years ago, wealth management has grown as well at a higher rate than the overall bank. The inherent growth rate of the business is somewhat higher. We have had growth in the upper single digits in the wealth business. The numbers move around year to year depending on what markets are doing. But we would expect our wealth management business looking forward three to five years to grow at a higher rate than the bank overall as well. We have got a great business in Canada active across the full suite of products. In the U.S. we are more focused on private banking and asset management we do on a global basis. So we like the wealth business, well-run, good growth, and we expect it to continue to grow going forward. Fantastic. I think one of the interesting factors for the Canadian banks and BMO in particular is the revenue headwinds have actually not been nearly as dramatic as the market and myself in particular had been anticipating. But even in that context, BMO has actually done a very good job in terms of managing expenses. Now, it does look like you are on track to meet your operating leverage guidance for the year. Can you discuss the challenges that you face, though, in terms of maintaining cost discipline while still trying to invest in other factors like technology? Regulatory is easing, but it is still a high inflationary issue, topic. It is a great question, and all of that is one of the biggest management challenges for the management group. Thankfully, revenues have been growing at a higher rate than some had feared they would grow at. We do think the diversified nature of our business is a real positive from a revenue growth and revenue resiliency perspective. We have got a good capital market business. It is active in different products, different geographies, different industry segments. Wealth management is active in the way that we have talked about in Canada and the U.S. That diversification produces, without doubt to us, just a more resilient revenue stream and helps sustain better growth rates. Then one interesting factoid given in part our focus on commercial Canadian retail lending is actually a smaller business than people intuitively think it would be for a big Canadian bank. For us, Canadian consumer lending represents under 15% of our revenue. Our share position in Canadian retail ranges from about 10% to about 12%. That, to me, is a great stat just to reinforce the notion that we have really got a very diversified business mix, and strong share positions. We are happy to have some help on the top line as we manage operating leverage and efficiency. Our target is to achieve 2% operating leverage per year, so revenue growth minus expense growth of 2% or better. We have done that in each of the last 2 years. We are aiming to do that again this year. We have got a bit of work to do, but it is within our grasp to achieve the target, and we are focused on doing that. In hitting the 2% operating leverage, we are growing expenses at about 4% a year, constant currency, excluding M&A. We have got 6-ish percent revenue growth. Within the 4% expense growth, we have a really significant dichotomy, and we are growing technology expenses at a double-digit rate. That is true this year, it was true last year as well. We are growing other expenses at about 2%. There is, across the organization, a lot of very hard paddling that goes on beneath the surface and above the surface to contain non-tech expense growth to give or take 2% while you have got revenues growing at about 6%. And that takes a lot of work and a lot of focus and we've got teams across the company focused on executing initiatives related to driving productivity, managing expenses, digitizing operations wherever we can, thinning out management layers where we don't see the value add, and looking at how we've got resources allocated across the company. Market opportunities change through time, and we look to be quick to adapt to that. If the market opportunity in a particular area isn't as great as we thought it would be or it once was, we'll allocate the resources elsewhere and look to do that in a pretty focused and action-oriented way so that we're getting the returns that we want to get on our expense base. The technology spend is significant. We have no shortage of good initiatives on the technology side. Many of the initiatives are client-facing and drive to apps that customers interact with. But there's lots of opportunity as well to continue to, what we call, digitize our processes and replace paper with technology, which is a very virtuous thing because you increase turnaround times for ourself from an efficiency perspective. For clients, you reduce error rates because people can't miss a blank in a form because the form won't process electronically. So you reduce error rates, reduce costs, increase turnaround time, and we've invested a lot in that, and we think there's more to do. And there's obviously a lot of discussion around technology, and it's not just with banks, it is really on the whole financial service spectrum. But from your standpoint, are the investment in technology, is it just table stakes, or can you actually have a sustainable competitive advantage by the investments that you're making in technology? That's a hard question and- That is why you are here and I am here. Yeah. So it is a good question to ask. I think you would get different answers to that question when you asked different people. So there is no question it is table stakes. You need to invest in technology in every business. You need to be doing so actively, and you need to find ways to fund that within your capacity by managing other expenses. On the question of whether you can create sustainable competitive advantage, I would say the jury is out from my perspective. That is because the world is a very transparent place. We all, in all industries, banking and others, watch our competitors. If someone has a really cool new mousetrap, others look to follow that. Typically, you have an ability to be a fast follower in areas if you are not leading in a particular area. So I actually think it is difficult to create a truly sustained competitive advantage coming out of a traditional banking model, which is not to say that you are not adding lots of value, enhancing customer relationships, enhancing customer loyalty. I think you do all of those things with technology. But it is competitive, and competitors are doing the same thing. So we feel very good about the suite of customer-related apps that we have got. Notwithstanding the comments I just made around what I would consider to be sort of the front end of the technology side, we have invested very significantly over the last five years in our underlying technology architecture. to basically reconfigure it so that we have got data much more aggregated. And the design of the technology system is more elegant and harmonized so that it is easier to make changes in the system and to drop new applications into it. And our head of technology has said that he believes we have one of the best technology architecture platforms of any bank on the planet. And so we do think we have got an advantage there given the architecture and the data aggregation that we have done in part as a result of regulatory change. And that advantage kind of manifests itself in an ability to introduce new functionality into the system at lower cost and higher speed because the design is more elegant from a new capability introduction perspective. So, that is a place where we actually think we do have an advantage. Oh, that is great, Tom. Thank you. Before I open it up to the audience, can we start off with our first polling question? How do you think Bank of Montreal will perform against its Canadian bank peers over the next 12 months? Significantly outperform, modestly outperform, in line, modestly underperform, and significantly underperform. We know what your answer's response is going to be. There are three up there. That is interesting. Definitely weighted towards the outperform. Outperform, yep. We will take that. Yeah. I guess, Tom, you talked about it in your preamble, but what differentiates BMO against the Canadian peer group really is the U.S. franchise with a focus on commercial. Can you talk about, I know you touched on it, but can you talk about what you expect in terms of growth on both sides of the balance sheet for commercial? Yeah. So I think the answers to the questions that you asked does, to a degree, reflect our business mix. We're overweight relative to the average Canadian bank, the U.S. market at 28% of earnings. And we've had success. And we've been there for a long time, so it's not a new undertaking. We've been in the U.S. for like 190 years, and we acquired Harris Bank, which is our main platform in Chicago, in the early '80s. So we've been at it for a long time. We've had good success. And in Canada and the U.S., the commercial focus we think is an advantage from a growth perspective, given consumer leverage in both countries. So we feel good about that. From an outlook perspective, this year our commercial loan growth year-to-date is about 13% year over year in the U.S. In Canada, commercial loans were up 11% in the last quarter. And we expect continued good growth, and the growth can move around quarter to quarter, but we would expect high single digit, low double digit kind of growth rates off the back of an environment that we think will continue to be conducive to good performance. And in Canada and the U.S., the environment feels fairly good. So we're optimistic, and we think the current performance will carry through into next year. On the deposit side of the business in commercial, we split the business in the U.S. into two parts. And we do have a portion of the deposits in our commercial business in the U.S. that come from counterparties who are more price sensitive. And I say counterparties, really customers. But some of those deposits have flown into market products that have higher yields as the Fed has raised rates. So our growth rate in commercial deposits over the last couple of quarters has been modest because that flow has been putting a dampener on our growth. We did not use those deposits to fund our loans. We basically held that cash at the Fed because we expected that this would happen. And those deposits have basically run their course and exited off the balance sheet, and they were not that significant to begin with, but they impacted the growth rate. And in terms of core growth on commercial deposits, we have a big focus on that in Canada and the U.S. We have a very good what we call treasury management capability, which connects our payment capability to our clients electronically. We're expecting good, solid commercial deposit growth in the U.S. in the mid-ish single digit zone in the U.S. In Canada, in the last quarter, I think we were 8%. 8% deposit growth in commercial in Canada is very good and reflects a lot of focus on growing both the deposit side of the business and the loan side of the business. In the U.S., although our lending business is commercially dominated, we do have a very good retail deposit base. That deposit base funds the majority of the commercial loans that we've got. Just before I pass along, on the commercial side, given the success that you've had and the strong growth, what are you seeing on a competitive front? Because particularly in Canada, we hear your competitors, everybody is talking about commercial, and that's where the growth is going to come from. Are you seeing heightened competition? Is it business as usual? Are you seeing anything that might actually be a little bit less than economical choices starting? I would say there's robust competition. There always is. With the expectation that growth might be a little lower on the personal side, there's probably some incremental competition on commercial as people have naturally gravitated there to some degree. We aren't seeing that manifest itself in a significantly tougher pricing environment or in an environment that is changing credit or underwriting terms in a meaningful way. We have seen some increase in the number of people focused on the sector. We have added a significant number of commercial bankers to some of the markets that we serve. Although we're number two in the market in Canada overall, there are some markets where we're under that share and below where we'd like to be. The Greater Toronto market is actually one of those markets for us. In Toronto, we've added, I think it's 30-odd bankers over the last year, and that's giving us more feet on the street and helping to fuel good growth. I'd say bigger picture, it's certainly competitive. It doesn't feel, I would say, consequentially more competitive. But you need to go out there every day and earn the business. Fantastic. Pause here, see if there's any questions in the audience. Wonder if you could expand a bit on the retail business, specifically in the U.S. The areas that you serve, do you have the density and the scale to compete with the larger players, even in a market like Chicago that's still fairly fragmented? If one were to be looking for acquisitions, historically, it's been a pretty darn expensive market to buy in. What are you seeing in terms of seller expectations for what their banks are worth versus what you think they're worth? Okay. On the first question, we have a strong retail or personal business in the U.S. We've got good share positions. We're number two in the Chicago market from a share perspective. We're number four from a deposit share perspective in the upper Midwest states that we compete in overall. We don't feel compelled to do a transaction to add scale given the scale that we've currently got. We've got a good branch network, good brand in the market, good loyalty scores. We're confident in our ability to continue to compete on the retail side. We're obviously not as big as the big money center banks. But we've got a strong enough presence in those markets to compete in a very effective way, and we've done that through time, and we expect to continue doing that. On the second part of your question, we've grown our U.S. business organically through time. We've grown it from time to time through acquisitions. We take a disciplined approach to acquisition and run transactions in a meaningful way through three screens. Does it fit strategically? Does it fit from a financial perspective? Does it fit culturally? That sounds really simple and kind of trite, but those are the key things that we look at when we think about things we might do from a transaction perspective. They guide us in thinking about what makes sense for us. On the value side, a year, a year and a half ago, there was a greater divergence in multiples between Canadian banks and U.S. banks. That was because the U.S. was anticipating tax reform and higher Fed rates, and those things were baked in to some degree into the multiples. The gap was at a point where we didn't think you could make the math work in effect. We talked about not looking to rush into doing anything while that gap existed. Sitting here today, from a relative value perspective, the relationship between Canadian bank multiples and U.S. bank multiples isn't far off the normal historical relationship. With that, if there was an opportunity that hit our screen and subject to all the due diligence you would do around a transaction, we would consider adding to the business. But again, we'd do it in a disciplined way, looking to make sure we were creating value for our shareholders. One. Just to follow up on the M&A discussion. Would the bank be more inclined to, within the U.S. franchise to expand contiguous to its existing footprint? I mean, you had made the comment that you have the scale you need within the Chicago market. There have been many sources that have indicated BMO was one of the finalists in the MB Financial transaction. It just seemed to fit in with your comments about being comfortable with the scale that you already have. In the Chicago market, we've got a very strong position. We're number 2 in the market from a deposit perspective, which is where the data is best. The data on the commercial side isn't as clear, but we would be in the top 2 or 3 on the commercial side. We've got a very good, very strong business. And we are focused in the main on continuing to grow the business organically. We've done a good job of that through time. I mentioned the double-digit commercial loan growth being something that we've run for 4 to 5 years. We expect to continue growing at a very good rate. At the same time, if there are opportunities to advance our agenda, add to our capabilities, and create value, we'd consider that. I'd go back to the 3 dimensions I talked about earlier, strategic, cultural, and financial fit. Those things could potentially take us to a transaction in our footprint, and potentially around our footprint. Either could be possible, but we'd be grounded in the fundamentals of what we think makes sense for the business. If we can actually go with the second polling question, please. We'll transition in. What's the most undervalued aspect of BMO's operations? One, its U.S. business, two, its domestic retail, three, capital markets, four, wealth management, and five, the overall North American commercial and banking. Anybody guess where I'm headed after this? Give me a hint. I haven't answered the question. The U.S. business Okay one in capital markets is Wow. I believe that's Wow. Actually, it was not capital markets where I was heading. This is actually quite interesting because Bank of Montreal, when clients talk about capital markets exposure, Bank of Montreal is not typically listed in the top. But when you look at by revenue, capital market sources actually is fairly high for Bank of Montreal. What is the strategy in capital markets? Because it is truly a North American franchise, but I don't think you get very much credit on the U.S. side. Yeah. No, we think we have a lot of upside in our capital market business coming from the U.S. Capital markets represents, depending on the time period, 20%-25% of our net income. We like it at that kind of a level where it's a significant contributor, but not the dominant business or our dominant business. The business now exists at a super high level in three parts. We have a strong Canadian business, which is obviously the anchor. It's active in all parts of capital markets. I would describe it as a Canadian bulge bracket firm. In the U.S., we've invested significantly over the last five or so years in creating a strong mid-market focus or mid-cap focused capability. We focus on a set of industry verticals. We cover the waterfront in those verticals, so investment banking, sales and trading, corporate lending. The way I think of it from a financial perspective is we've invested in a platform that's capable of driving more revenue. We expect to continue to have success with growth in the U.S. capital markets business. Given the investments we've made and the platform that we've got, we think that growth will produce very good operating leverage through time because you need to be competitive in how you're set up at a point in time, and there's no question that the platform we've got can drive more revenue. From a growth perspective, we're quite bullish on the U.S. capital market business through time given the infrastructure we've got in place. As well, the U.S. presence, which represents around a third of our capital markets business, is important to the Canadian business because any Canadian corporate client or investing client of size does business in the U.S. Our U.S. capital markets capability makes us more relevant to our Canadian clients because we're able to talk to them in an informed way about what's going on in the U.S. and opportunities for them in the U.S. The strategy is both offense from a growth perspective and defense in terms of making sure we continue to be highly relevant to our Canadian clients. The capital market business, as everyone in the room knows, goes up and down in any quarter. But we have had good success over the last few years in growing the U.S. This year it's been a little slower, mainly because of market dynamics, but we do think into next year we'll continue to do well. Just so I don't miss it, I talked about our capital market business at the beginning as having three parts, mainly Canada, the U.S. is about a third, and then we also have capability in Europe and a smaller capability in Asia. Those businesses really focus on the distribution of North American securities and cross-border M&A, and they're a good complement to the North American business. It's interesting. That's great. The one actually that I did want to touch on was wealth management. You did in your opening remarks, you did touch on that briefly. I'd love you to expand upon the strategy because as you said, U.S. is different from Canada. But one thing in particular I'd like to ask you is, BMO has done a very different strategy within Canada, leading on ETF manufacturing and distribution. I was wondering, what are you seeing on the ETF marketplace in Canada relative to the U.S. where we're now seeing a race to zero in terms of fees? Do you see that pressure in Canada? What do you think is likely to happen? Yeah. Also, I know that your products are a little bit differentiated between that. Is that going to be enough to defend pricing pressures? Yeah. I'm happy to talk about wealth. I don't know if wealth is the most undervalued aspect of our operations, but I personally don't think it gets the focus that it deserves, in the sense that it's been a business that has really grown at a nice clip through time. We expect that to continue. We used to say that we targeted low double-digit growth rates from a revenue perspective in the business. As the business has grown and the markets have matured, we've moved that down to mid-single digit number, somewhere between 5 and 10. The income growth we'd expect is closer to 10. It's been a business that has grown at a very nice rate. We think that will continue in Canada. It's a really strong business across literally the full suite of wealth management products. In the U.S., it's focused in the way that I described earlier. We do think we've got a really good record of innovating in the wealth business. The mindset is that we want to serve the wealth management market in Canada in the way that different client segments want to be served. We do have a big mutual fund business. We have a big full-service brokerage business, big private banking business. But when ETFs started to emerge a decade ago, give or take, even though the fees were lower, we made the decision to get into the business in a big way because it was clear that the product was a good product for a segment of the market. Our underlying philosophy was to serve the market. We wanted to participate in the growth of that segment. We're now the number 2 player in ETFs in Canada, number 1 from a sales perspective. It's been a great growth story. We also, by the way, were the first Canadian bank to introduce a robo product capability. There again, that functionality is a good one for a certain segment of the market. We want to cover the market, so we innovated to move into the space before other competitors so that we could be a leader there in an evolving part of the market. We feel good about our ability to reinvent, innovate, and keep up with the market. Margins don't necessarily vary as fees change. Typically, where you've got fee structures that are lower, the cost to create the product is meaningfully lower as well. In the robo space, that's certainly true, and the underlying products in our robo product are our ETFs. The manufacturing cost of that product is very low. Our net margins between the robo business and the full-service brokerage business are about the same, even though the proposition to the client, it's a different value proposition. Both are good value and make sense for the respective parts of the market. But the price points are quite different. Financially, the consequences aren't necessarily as different as you might think given the top line. On the question related to fees, I would say to date, the Canadian market hasn't been in the race that you described. A lot of our products are differentiated in some way, so they're not simple index products. They've got added dimensions related to various factors or yield enhancement alternatives. That value-add dimension helps maintain margins at a higher level. I would say we'll go where the market goes, but the hope would be and the expectation would be that we don't end up in a situation where products that have value are priced in a way that runs counter to that. You're not paid for your work. No. Any questions from the audience? I guess I'll carry on. Tom Flynn, I know that we've had three full quarters now of IFRS 9, and I'm sure we've all settled down as to figure what's going on. But in terms of the change in accounting, have you seen or has this had any impact in terms of how BMO manages its risk or its business? If we look further afield, I've said many times, this is probably the perfect time to implement accounting change because credit costs are so low on a historic basis. From your standpoint, do you actually believe that this is going to increase the volatility of provisioning? Do you think that this is highly pro-cyclical? Not pinning down for BMO, but for the sector- Yeah as a whole, what is the outlook that IFRS 9 is going to have on the reporting? Okay. Good question, interesting topic. For those who aren't as close to it, the Canadian banks adopted IFRS 9 in the current fiscal year. Under IFRS 9, your credit provision reflects your incurred loss in the period and your expected future losses. The old model was an incurred loss model where your provision reflected losses that you had actually incurred as opposed to those that you expected. The introduction was much anticipated. There was a lot of hype, a lot of excitement about the accounting change. As you said, it's been pretty low-key in its introduction to date, and that is for sure in part due to the environment. We're living in a benign environment from a credit perspective. Economic outlooks haven't really changed that much. With that, there hasn't been a lot of IFRS 9 consequence to the P&L. I agree with you that it's good for everyone to get used to the new accounting method in a pretty stable, benign environment, so that when that changes, we've got a decent foundation of understanding. It is likely, and probably more than likely, that IFRS 9 will make credit provisioning more cyclical. That's because, again, you book expected credit losses. We will book credit losses earlier in the cycle. The key thing to watch would be forecasts around economic growth. We're currently expecting economic growth in Canada to be about 2%, in the U.S., the high 2s. If those numbers went to 4% and 4%, then we would expect to have lower credit losses over the next one, two, three, four years, and we would reduce our allowance accordingly. If the reverse was true, and the growth expectation came down meaningfully, then our modeled expected loss would go up, and we would record that provision. As economic outlooks change, you will see provisions go up or down. In time, I think to state the obvious, you lose what you lose. The economic loss does not change. The total provisions booked through a cycle will not change. But the provisions will come earlier. We will get used to that. I do not think it will be something that will be problematic or highly volatile, but the PCL line for sure will be more variable. To me, Canadian bank provisioning might look a little bit more like U.S. bank provisioning. U.S. banks, I think it is fair to say, have had a more variable PCL line through time than Canadian banks. My expectation is we will look directionally more like the U.S. banks as we live with IFRS 9. Hopefully that also means the multiples will start going up like U.S. banks. That is a good I like the thinking. Well, Tom, we're out of time to keep everyone on schedule. I appreciate it. Thank you very much. Thank you very much.