Barclays Global Financial Services Conference 2019

Sep 10, 2019

Okay, ladies and gentlemen, to break up the post-lunch stupor, we are going to carry on with the presentations. Very pleased to have Tom Flynn, Chief Financial Officer of Bank of Montreal, who is apparently a veteran at our conference these days. Tom, thank you very much for joining us. Thank you for having us. Always good to be here. So Tom, we were actually talking beforehand about macro, and there is a lot of concern on the macro front these days. Whether it is going to come to fruition or not is up for debate. But I was wondering, at the outset, how does BMO manage for contingencies, eventualities, positive or negative, in terms of how do you try to put the platform in the best shape for what may or may not occur? Yeah. I guess a few things on that front. The first would be, although I totally agree there is lots of concern about the macro picture and uncertainty about the direction of the economy, in part given the trade discussions, we do think that the underlying economy, based on what we see with our customers, is doing, I would say, better than the markets most days think it is doing, or the outlook feels better than the headlines and the markets seem to anticipate. And you saw that in our third quarter results. We had 8% and 9% pre-tax, pre-provision growth in our Canadian and U.S. Personal & Commercial banking businesses, driven by good balance sheet growth. So the underlying economy, we think, is trucking along. One kind of oddball factoid that actually struck me as I was heading down to New York and reading some things, but we actually expect higher GDP growth in Canada next year than we expect this year. It's not higher by much, it's basically a rounding error, but for this year, we're calling for 1.5% GDP growth. Next year, 1.7% growth. In the U.S., we think growth will be about 1.8 points down, roughly half a point. So we do expect lower growth in the U.S. In Canada, the growth, we think will be relatively flat. Although the recovery is long in the tooth by most measures, we don't think recovery is end of old age. So, subject to a reasonable resolution or a reasonable de-escalation of the trade discussions, from our perspective, there's no reason to think that the economy is necessarily heading for materially lower growth. We see reasonable confidence in our consumer business and our commercial business on both sides of the border, and we see people generally carrying on. Then in terms of how we manage, a couple of things. We feel good about our business mix. We have about 65% of our business in Canada, around a third in the U.S. We like the diversification that we get by virtue of that. We're stronger in commercial banking than we are in personal banking, and our growth has been better there, and market growth has generally been better there. So we think we're in a good place from a market potential perspective. We've invested in our U.S. businesses over time and think they've got room to leverage the platforms that we've invested in. So we believe we've got the ability to outperform market growth in our banking business, in our capital market business, in our wealth business in the U.S. So from a revenue perspective, we think we're in a good place for whatever the environment brings. I would say, notwithstanding everything that I've said to date, given the potential for lower growth and the impact of lower rates, we are looking at our expense growth plans as we head into next year. So, one of the levers we have the ability to pull is on the expense side, and we'll be targeting a lower level of expense growth next year than we had this year. We think that's a better starting spot to be in heading into the year, given the potential for revenue growth to be a little bit lower. You touched on a whole myriad of topics. Hopefully, we'll be able to drive down on most of them. BMO actually has a very strong commitment to commercial, like you mentioned, on both sides of the border. One of the very interesting things that I've noticed as the consumer borrowing has slowed a little bit, probably not as strongly as most had anticipated, but we've seen the continued strength of the commercial at multiples of GDP growth. Particularly in Canada, what's underpinning that, and what gives you confidence that this level of growth, plus or minus, may be sustainable over the medium term? Yeah. So we agree with the premise of the question. Commercial loan growth has been running at a high rate relative to GDP growth. We've been running at sort of 14%-15% for the last three quarters. We've gained share over the last year, and the market's growing at a low double-digit rate. We think part of what's been producing the good late cycle growth in Canada is the fact that commercial credit growth was weak in the early part of the recovery. It was a while ago now, but commercial loan growth typically is kind of like, and this is rough, a high beta play on GDP growth. As you bounce out of a recession, commercial loan growth is typically quite strong and 2 or 3x GDP growth. That didn't happen this recovery, because the recovery was weak and low for. People didn't have that confidence to spend, and they held back, and with that commercial loan growth coming out of the recession was modest by historical standards. As time has gone on, we think we've in effect had an extended investment cycle, which has given rise to strong growth over the last few years. We do have a good business. As we've talked about, we're number two in the Canadian market, have a 19% share. It's an area of strength for us. The growth that we've got is well-diversified, and that's a question that we sometimes get. So in the last quarter, growth was about 15%, and we had double-digit growth in nine sectors that we lend into and five regions. So quite broad-based, and we feel good about the diversification that that gives us. For us, we're growing at a rate that's a bit above market, and some of that growth is coming from just having a strong business, good reputation in the market, a desire to lend to our customers through the cycle. As well, we've in effect, created capacity in our commercial banking business through technology that we've deployed in the business. That technology, in a variety of ways, has freed up our client coverage people to spend more time generating business and more time with our customers as opposed to doing administrative things internally. That capital creation or capacity creation is creating some of the growth that we've seen. We've added bankers in some markets where we were underrepresented, and Toronto is the biggest example of that. We have a very strong business nationally. We're actually a little underrepresented in the greater Toronto market. We've added people over the last year or two to that market, and that's helped the growth that we've seen. We feel really good about the business, our ability to outperform the market. We do not believe we've changed our risk appetite. We do not believe we're reaching on credit to deliver the growth that we are delivering. Once again, all of that said, 15% growth in today's environment is a pretty good number. We do expect growth to come down over the next few quarters. We don't have immediate line of sight to that in Canada. The pipelines look pretty good. As we go into next year, it's likely that the growth will move towards the 10% plus or minus level. There we're assuming, again, reasonable growth, but we think we'll have a little bit of moderation from rates that are pretty strong at the moment. Could you touch upon your expectations for the U.S. commercial side? Yep. On the U.S. side, a number of similarities. Strong business as well. U.S. commercial banking is sort of the bedrock of our U.S. Personal & Commercial banking business. Represents around 75% of our loans, so we're a stronger commercial bank in the U.S. as well than personal bank. For I believe it's the last four years, we've guided to commercial loan growth in the upper single digits, and we've done solidly double-digit growth. So we've out-delivered relative to guidance on loan growth on a consistent basis and have done that off the back of what is a really strong business with strong leadership under Dave Casper, who runs that business for us. Really good presence in the upper Midwest market. We've grown some of our businesses from an industry vertical perspective on a national basis, and we've opened offices in some cities as well. A range of things producing good growth. As we look forward, growth in the last quarter was also mid double digit, 15-ish percent. We expect that growth to tail down really for similar reasons. We are very confident in our ability to continue to outperform in U.S. commercial lending. With the rates that we have seen, it is natural to expect a bit of give back and a move that is closer to the high single digits, 10% zone in that business over the next few quarters. Mm-hmm. Tom, we are only a couple of weeks removed from your third quarter earnings being reported. I was honestly quite surprised with the market's reaction to the results because a lot of the headwinds that BMO experienced that generated the miss against, admittedly, our expectations seemed to be, by definition, non-recurring. When you look at the results of the quarter, what do you think about in terms of earnings that are repeatable, run rate, and your expectations to be able to sustain that going forward? Yeah. We had what we thought was a good operating quarter in the third quarter. Again, pre-tax, pre-provision growth in our two Personal & Commercial banking businesses, about 8%. Capital markets had a good quarter with year-over-year growth. I would say clearly very good performance compared to our competitors with that outperformance coming from, in particular, strong investment in corporate banking revenues in the U.S. where we have invested. Again, think we can continue to expand at a higher rate than the market. We had positive all bank operating leverage of 0.5%. So good operating performance. I mentioned the commercial loan share growth. We have also grown share in Personal & Commercial deposits and in credit cards in Canada. We feel very good about the operating performance. Below the pre-tax, pre-provision line, we have credit provisions, and they were elevated in the quarter for a few reasons. We guided to lower losses going forward. The losses in the quarter were higher because of a couple of one-off events in our Canadian business. We put in a new collections system during the quarter. We had a few, I would say, small hiccups as we put that system in. They are resolved, but our collections effort was not as crisp in the quarter as it normally is. With that, our consumer losses were a little bit higher. We had a larger commercial credit, which we do think was a one-off and not a canary of any sort, went tilt in the quarter. So the losses were a little elevated there. We built our general allowance under IFRS 9 and had about a CAD 60 million build there. With that, losses were up. The higher loan losses drove the miss to expectations. And we guided on the call, and our CRO, Pat Cronin, did this to loan losses in the 20-25 bps zone for the next few quarters. In Q3, we were 28 bps with those things. We do think the loss rate will come down. Otherwise, in the business, it was a pretty normal quarter, I would say. The wealth segment earnings were a little bit soft because of insurance, and offsetting that, our corporate segment was a little bit strong. Those two things basically washed at the all bank level. The big outlier item was credit, which we do think was related to specific things this quarter. As Pat guided to, we think the results will be better on that front going forward. Last point is, just as a general matter on credit, as we look at our portfolios, Canada, U.S., commercial, personal, we see credit as being stable. People wonder about where we are in the cycle. None of us know with any high degree of certainty. But the portfolios are not showing significant migration one way or the other, not getting better. They're not getting worse. With rates low, unemployment low and solid, the credit quality picture looks pretty stable at the moment. Fantastic. Don, before I open it up to the audience, can we start with the first polling question, please? How do you view BMO executing a U.S. acquisition to enhance the bank's U.S. P&C platform, and what are the implications for its valuation? We believe likely and it's going to be positive for the valuation. We believe it's likely but negative for the valuation. We have no idea, or it's unlikely but positive or unlikely and negative. We got a neutral, but we also likely and positive valuation. 86% positive valuation. Am I reading that correctly? No, the middle one is neutral. Three is neutral. One is Three is neutral. Okay. Unless you're going to give us a list of targets that you're looking at. Yeah Can you discuss the capital position of the bank and what your expectations are for use of excess capital? Sure. Our capital position is strong. As you know, our CET1 ratio in the quarter was 11.4%, up 10 basis points. Very strong position. We have had strong commercial loan growth over the year to date. With that we have guided people to expecting capital to build at the low end of our normal 10 to 15 basis point build per quarter, which is more or less what we have done. We always say our best use of capital is organic growth. We say that because we believe it, and the returns are good in that space. We are open for business across our platforms and feel good about our ability to generate organic growth as we have talked about. We have grown our business through time periodically through acquisitions. We do not feel compelled to do something, and if there was an opportunity that met our hurdles around strategic fit and cultural fit and financial fit, we would be open to it. We maintain relationships, we talk to people, and we keep our eye open for opportunity. We stick to our disciplined approach and disciplined standards in evaluating opportunities. We feel good about our organic ability to compete, so we do not feel compelled to do something. We will see if there is an opportunity that arises. Your question talked about U.S. P&C banking. That has been our biggest area of growth for acquisition over time, and not unreasonable to expect over time looking forward that would be an area that we would focus on as well. As we go into next year, in Q1 of next year, all of the Canadian banks have two relatively small but noticeable capital changes, one related to a regulatory capital change and the other related to the adoption of a new accounting standard. We have said that those changes will ding our CET1 ratio by 10 to 15 basis points, and so we will take that in stride, but it will be an item that we will have in the first quarter. We do not really see the need to have the ratio build above the 1150-ish level. We would expect to be active with a buyback if the ratio was otherwise going to drift above that level. You have seen us over time be active with the buyback when the ratio has been strong. With the ratio around where it is, we have got enough capital to complete a reasonable size, not too big, not too small acquisition in a highly responsive way to opportunity, and we like having the capital to do that. Equally, we do not want to carry too much capital because that is inefficient for the shareholders. So that is how we think about it. As CFO, what level are you willing to take the capital ratio down to with an acquisition, of course, with a plan to grow it back up to, but what is your minimum? Yeah. I will start with our regulatory minimum and our regulator, OSFI, has introduced what is called a domestic stability buffer. They have added to that a couple of times, and so with that, their minimum expectation is 10%. With that in place, we take the ratio, depending on timing and the opportunity down, likely in the range of 10.5%-10.7%. Look to build it back up above 11% over time from there. Fantastic. Do we have any questions in the audience at this stage? Darryl's mentioned growing earnings in the U.S. to be around a third. You've gone through that around 35% now, what's sort of the upper range of where that could go to? Thanks for the question. It's a good question. We have had the good fortune, I would say, of hitting kind of a mid-ish term target that we put out on U.S. earnings contribution sooner than we thought we would. The U.S. is now contributing about a third of our earnings. We've had very good growth over the last couple of years, partly organic, just through growing our customer business, in particular on the commercial and the deposit side, like we've talked about, and partly benefiting from, on the way up, rates and tax reform. We haven't come out with a new target. We're sort of north of a third, and I would say, we don't see any magic around any particular number. We think about it more from a fundamental perspective, looking at the growth in the business and where that will take us over time, as opposed to having a mix target. We do expect over time, not necessarily in every year, but over time, the growth in the U.S. to be higher than the growth in the Canadian business, given that we've got, in effect, more market to grow into, given the size of our businesses there relative to the Canadian market. M&A is more likely to occur in the U.S. just because the Canadian market is more consolidated. Over time, not necessarily in every period, I'd expect the U.S. growth rate to continue to be at a higher rate than the overall consolidated bank. Tom, in your commentary today and also in the quarter, you used the phrase pre-tax, pre-provision. And now is this just in response to the situation that occurred in the third quarter earnings, or is this a subtle messaging that even though credit is stable at this stage in the game, we are expecting provisions to increase at a higher rate than the Um- Pre-tax, pre-provision earnings? I would say it's really two things. Firstly, we look at it all the time. When we look at our businesses internally, we probably don't look at it quite as much as income, but we look at it close to as much, simply because it's a more pure representation of how the operating business is doing. We think it's an important measure to gauge the success you're having in growing your business. We talk about it pretty regularly. I would say, it's fair to say that we amped it up a little bit in the third quarter because the numbers were so good and reflected what we really did think was good operating performance. We had kind of the inconvenience of the higher credit losses, which we saw as one-off in the quarter. We didn't amp it up a bit in anticipation of future higher losses. We were trying to say the underlying business is doing pretty well and we expect credit to behave in a better fashion over the next quarter or two. We thought it was actually the more relevant number to look at in thinking about the performance of the business. We touched upon the commercial growth, but I mean, the other side for the top line is margins. There was obviously a lot of talk about margins this quarter, but it's also fascinating to see how the environment, at least we look at the environment, is drastically different today than it was at the start of the year. Can you give us a, I guess, a rehash of your summary of expectations on margins in Canada and the U.S.? Yeah. So, I will do just that. I'll give you the rundown on what we're thinking. And it is a bit of a different picture in the two jurisdictions. So starting in Canada, and in Canada, the Bank of Canada just made its interest rate announcement, didn't move, and had a pretty neutral stance. So we think it's likely we'll have one move from the Bank of Canada in the next six months, but a pretty stable situation. And so we think our Canadian margin will be flat-ish for Q4 and into the first bit of next year. And I should caveat all of the margin comments, and you know this, but there are a lot of variables, obviously, on the balance sheet, and then there's customer behavior, and there's a competitive dynamic around that. There is a lot of uncertainty in all of these numbers, and people should take them as directional. Canada, we think stable-ish, given the rate environment that we have got and also the amount of short-term exposure we have got versus longer-term exposure. The longer-term exposure reprices at 15% to 20% a year clip, and so the impacts aren't as immediate. in the U.S., for the fourth quarter, we said there would be pressure from the Fed cut that we have had and a bit of pressure coming from loans likely growing at a higher rate than deposits, which we saw in the last quarter as well. The margin is likely down sort of an upper single-digit number, given those two things. Then into next year, assuming we have additional Fed cuts, there is likely to be some manageable level of margin pressure as well in the U.S. We will see what the tightening or easing cycle looks like in the U.S. But on the way up, we obviously saw banks benefiting more early days and less later in the hiking cycle. We think the impacts from cuts will be most pronounced early, and the impact will be lesser as the number of cuts goes on, if it does. Our hope would be that if there are a series of cuts, the later cuts aren't as impactful as the first few, which is the way it worked when the trend was going up versus down. Yeah. A little more fun when that goes up than down. Do we have any questions from the floor? No? In terms of one of the things you talked about, the sensitivity that you have, the leverage you can pull is on operating expenses, and you are talking about lower growth going forward. How do you balance the need to spend on new initiatives like technology and everything else like that, versus trying to pull back and manage in an environment where your revenue growth may not be as strong as it has been in the past? Yeah. Balance is a good word, and you used it in the question. You try to strike a reasonable balance between delivering good and competitive financial performance and investing in the areas where you see opportunity and you believe you need to invest for the long term. As we think about our business plan for the coming year, we think revenue growth is likely to be a little lower than the current year. With that, we would expect a lower rate of expense growth, and we think we can achieve that while adding to our expenses in certain areas, and we will do that by having lower expense growth in other areas. One of the bigger expense buckets that we have got in the Bank of Montreal and that has increased significantly over the last five years is technology. We have talked about growing our tech budget by a double-digit rate for the last three years. With that, we have delivered a huge amount of utility to our customers on both the retail and the consumer side. We have strengthened the underlying architecture of our platform. We have responded to a significant amount of regulatory change. That is an area where, given the building capability that we have seen, we do not see the need to invest at the same rate. The growth there will continue to be above the overall bank level of expense growth, but at a more moderate rate, given the investments we have made than we have had over the last few years. Do you think that that is going to be system-wide, or is there a risk of the slowdown in the technology spending, even though it is still quite high? Can that put you at a competitive disadvantage? I would say we are not worried about being at a competitive disadvantage. We think we are in a good place from a capability perspective now. Couple examples of that. In the U.S., our online banking platform for consumers has one of the top ratings in the App Store, and our rating in Canada is also high. So we have got, for sure, a competitive capability across capabilities, and you are not at the top everywhere, but we think we have got a good mix. Then there are cycles to things. We have gone through a big cycle around tech investment. It has room to run for sure, and the expenses will continue to grow at a higher rate than the overall expense growth. But our assessment would be although the returns are good, the number of opportunities to invest for great returns are not as high as they once were. It would make sense after a lot of spend by the industry for a number of years that the expense growth comes down a bit again, although still running at a level above the overall level of expense growth. That is just a sign of greater maturity and a bit of a cycle. When you are running a business, and you know this, you manage, to a degree, your expense line based on the cover that you have from your revenue line. When revenue growth is lower, you manage expenses in a tighter way. When the opposite is true, you do have some incremental ability to invest. We are pretty sure we are not unique in that. We would expect the general trend of the industry to be in a similar direction. Tom, I will give you a chance to have another drink. If we can have the second polling question, please. Where can BMO deploy capital to achieve the greatest valuation impact? Expand U.S. retail banking, broaden wealth management, greater diversification through other avenues, aggressive share buybacks, or run at a payout ratio above 50%, build capital levels. Now I know it flies off the handle, but- It would be interesting. Expand U.S. retail banking beyond the footprint. I guess it dovetails in with the- Yeah the first. Yeah. I guess you talked to being open to acquisitions. How willing are you to go further afield and outside of Yeah I know that you have, but are you willing to continue to extend the footprint Yeah or are we looking more in market? Our principal current footprint for the Personal & Commercial banking business is the upper Midwest. Across that footprint, we have a strong business. We are number four in the market from a deposit share perspective, and it is a big market. It is equal in population and GDP to Canada. It is a big market for us to grow in. All that is to say, good market, lots of room to grow, and we would be happy to grow in it organically and inorganically. As well, over time, we do want to expand our footprint from a geographic perspective. Our focus, in the broadest sense when we talk about it, is on the middle-ish of the country. Given our concentration now in the upper Midwest, we think it makes sense to extend that and grow in the adjacent areas in the middle of the country and south. Given that focus, we do not think it makes sense to go to either coast because they are big, competitive markets, and we think we would be spreading ourselves too thin if we were to try to compete on either coast. Expanding beyond the upper Midwest footprint is a possibility over time. Again, we do not feel compelled to do an acquisition. We feel good about our ability to outperform and grow organically given the business that we have got, but we are open to opportunity to expand the business. What about in, because we are discussing mainly the retail banking operations, but is there any desire to inorganically expand in some of your other operations? Wealth management does come up, even though probably not your financial focus in the question. The M&A question typically focuses on U.S. banking as it has here, and that is not uncommon. We do often add that we would look at opportunities in wealth management, and we have done transactions in wealth management from time to time over time. There, the focus would likely mainly be on personal service wealth businesses. We have a big private bank or high-net-worth business in both Canada and the U.S. Depending on the year, we are ranked either number one or number two in private banking, in the Canadian market. Harris Bank, as its legacy, was a big trust custodian bank and commercial lending bank. We have a good private banking business that is actually active across the U.S. We are in, I think it is 12 U.S. cities coast to coast in the private banking business. That is something that we would look at and consider. You need to be careful with business fit when you're looking at acquisitions on the wealth side and make sure that the business model of the acquired entity fits with your vision for how you want to run the company. Less of a focus, we did this year close in our capital market business, the acquisition of a firm that focused on U.S. agency debt securities, and that transaction has gone very well. We feel good about the team that's come on board. They've got a lot of good ideas. They run a very good business. We wouldn't do something larger, but for, in a sense, team acquisitions there, where we could accelerate an existing strategy, we'd be open to looking at opportunities. Coming back into Canada on the wealth management front, BMO actually has a bit of a differentiated strategy in being one of the early movers in terms of the passives. Can you talk about your strategy for wealth management and what you expect to see industry-wide over the next 5 years or so? Yeah. We have what I'd describe as a full-service wealth management business in Canada. We're active in first full-service brokerage, online brokerage, private banking, mutual funds, institutional asset management, and we have a big ETF business, which you're asking about. We were the first bank to introduce a robo product. We've got a good history of innovating. On the ETF side, we're number one in the market on sales, number two in the market on assets, and it's been a great business for us. Obviously, we've ridden the trend to passives. But we were early in the market. We identified that as an opportunity early days. When there's innovation, you always debate moving into the new part of the market, which might have a different value proposition for customers, because early days there can be a risk of cannibalizing your existing revenues. We think that example, together with our robo example, they're good examples of innovating in a way that has resulted in the business growing over time, and we've captured share through that innovation. We feel good about the outlook for growth there. The business in Canada overall, and this is a market comment as much as a Bank of Montreal comment. It's more mature today than it was 10 years ago. The growth rate we expect will be above the growth rate of the bank overall, and lower than it would've been 5 to 10 years ago, just given the greater maturity. There has been fee pressure in parts of the asset management business, which people in this room would be familiar with. For us, we're happy to have, in effect, the ETF hedge that we've got against that pressure. That's helped keep our overall revenue growth going at a good clip. We also think with the baby boom demographic aging and generational turnover, there will be a big ongoing opportunity related to wealth management and helping people manage their wealth. We've got a very strong sort of what I call high net worth business in Canada, both through our private bank and our full-service brokerage business, and do a really good job around estate planning, tax planning, and think those areas of focus will serve us well over the next 5 to 10 years. If you just finish up by touching on the global parts of your asset management business. On the global side, I'd say we have had good investment performance in our business, both the U.S. and in Europe. The business has experienced fee pressure in our business, and that's been true of the industry. We feel good about our ability to deliver investment returns for our customer. We feel good about our ability to distribute. We have worked to sort of cross-fertilize our distribution so that our distribution in Canada is distributing product we manufacture in the U.S. or in Europe. That's something we've worked on for a few years, and we feel good about the traction that we've got. Broadly, we're looking to move our exposure to alternatives and to continue to grow the passive part of the business in the Canadian market. Like others, we've had some impact from the fee compression that has occurred in the industry. That's all I think. Just in closing, my final question for you, we started out with talking about the macro pressures and everything else like that. I'd just like to, from your seat, what's the first thing that you flip to in the business pages in the morning to find out about what's your biggest concern, even if you don't even think it's a high probability of happening. But what's out there on the macro front that most tickles there at the back of your neck? Our base case is for stable, moderate growth and we'll see how that plays out, but that's our base case. Then I'd say the biggest macro concern I have, and it's not one that I'm alone in having, just relates to the ability of the official sector to respond to the next downturn given how low rates already are and where the current budget deficit is and where the debt levels are. The amount of ammunition to fight the next downturn feels like it's lower than it's been in the past, and that might give rise to either a weaker response or a response that involves a higher degree of creativity. And where that will bring us will, by definition, likely, if that's the case, be less certain. But we'll continue to focus on the base case then. All right, that works for me. John, thank you very much. Thanks for having us.