Barclays Global Financial Services Conference

Sep 15, 2020

Good morning, ladies and gentlemen. Welcome to the second day of the Barclays Global Financial Services Conference. Very pleased to kick off today's sessions with Bank of Montreal, Tom Flynn, Chief Financial Officer. Tom, thank you very much for joining us. Thank you. Before Tom does some opening commentary, I just wanted to go through a quick administrative issue. If you have any questions for Tom during the presentation, please email them to me, john.aiken, A-I-K-E-N, @barclays.com, and we'll do our best to fit everything in the end. Tom, please, if you want to do an introductory commentary, please go ahead. Okay. Thank you, John, and good morning, everyone. It's great to be here. I hope we are all together again next year in New York City. It's a great conference and one that everyone looks forward to after Labor Day. I'll make a few comments and then I look forward to the discussion that will follow. I just want to highlight a couple of things off the top. The first is that the bank has had very good operating performance over the year to date and the last 12 months compared to our peers, and we think in absolute terms. Looking at our adjusted pre-provision, pre-tax profit growth, we're up 8.4%, number two of the Canadian bank group. Our operating leverage over the last 12 months is 3.1% compared to the group average of 0.5%, and we're number one in that. We have had a significant focus on expense management. That was a focus at the beginning of the year. For the last 12 months, our expenses are up just 0.2% against an average for the Canadian group of 3.8%, so we are number one on that measure. So good operating performance. We feel good about that. We expect that to continue as we go into next year. Second point is we think the balance sheet is very strong. Our capital ratio has actually gone up, not down through COVID. We are sitting at 11.6. We were up in the third quarter that we just reported. In addition, we built loan loss reserves and our liquidity is very strong, so we are feeling good about the balance sheet. Thirdly, we like our business mix. We are about a third in the U.S. Our Canadian banking business is our biggest at about 45% of the total. The other three businesses that we have got are each around 20%, and we think that mix gives us a good diverse revenue stream, which makes our income more resilient through time. Last point I would make is that we are focused on operational resilience. We have done a great job to date. We feel good about our ability to continue to operate in this very strange environment that we are operating in. As we start to look forward to next year, we feel good about our ability to continue to produce value for our shareholders. With that, John, I will hand it over to you. Great. Thanks, Tom. Just wanted to hone in on the commentary on your third point, the resilience. As you pointed out, the bank has performed very well, much better than I think most would have anticipated as we were heading into the pandemic. Can you give us some sense in terms of what the bank's response has been to COVID-19, and how this has changed your strategy and what you may expect moving forward if we assume that there is not going to be a significant second wave? Yep, sure. I guess a few things on that. In terms of our response to COVID-19, I will go back to the beginning, and there is no question that our response varied through time, basically as we and others got a little more accustomed to dealing with the environment. Initial days, we had a very acute focus on operations and like other companies, we went from having the vast majority of our employees working in the office or their regular place of work or employ to working at home. Through the first two or three weeks, we had a lot of work done to ensure that the operational resilience was where it needed to be. I will say I have been hugely impressed, really, at the ability of our bank and really the economy generally to adjust to a new way of working. I think we're all fortunate that we're dealing with this pandemic, if we had to deal with one, at a point where we've got the technology that allows us to keep the economy moving, working remotely in a way that wouldn't have existed 10 or 15 years ago. Secondly, we had a sharp initial focus, and that continues today, on our customers and our community. We're here to help as a large, strong organization, and we've had a premium on workplace safety for our employees, helping people in a variety of ways adjust to the new environment and in our communities, and helping our customers. We're giving back in a variety of ways, and happy to talk about that more later. As well, early days, we had a pretty significant bout of market volatility. Through that, we were focused on managing through the volatility, keeping our balance sheet strong, talking to government officials and regulators about what we were seeing and what the response might be. Happily, we've come through that period of the pandemic and really entered into a completely different world where we are awash in liquidity, markets are strong, and people worry about the disconnect that might exist between markets and the real world. That was a significant issue at a point in time. Just lastly, and maybe briefly, given the time, I wouldn't say that COVID-19 has had a change or has resulted in a change in our fundamental strategy. We like our strategy. It served us well through time. We're going to continue to deliver on it. That said, I would say that it's having a significant impact in terms of how we're going about doing that. One of the common expressions I think that exists around COVID-19 is that it is an accelerant for change. We all have a bigger appreciation of what's possible, given that we're working in ways that we really didn't imagine six months ago. We're focused on accelerating digital change, harnessing the more agile ways that we've been working, looking to deliver performance improvements more quickly, and putting a huge degree of premium around all of that, which goes to pace of execution, while at the same time keeping the fundamentals of our strategy intact. John, you mentioned that even just in the last six months, there's been a lot of, and I'm paraphrasing, but a lot of change, different concerns, different focuses. Is there anything about the pandemic and either the industry's response, the government's response, or customer's response that have particularly surprised you or something that you would not necessarily have expected if this was a theoretical construct heading into it? Yeah. It's an interesting question. We do all sorts of stress testing and scenario planning. We had talked about this in, I would say, a light way, but hadn't gone deep into it. Sitting here six months or so later, I would say that I've been, I don't know if surprised is quite the right word, or impressed by the resilience of the banking sector, our bank, and the economy generally. This is back to some of the comments I made earlier about the ability of people to adapt, organizations to adapt, and people to move on. This conference is one little case in point. You're sitting where you're sitting, I'm sitting here, we're doing this virtually. My bet is your attendance is higher, not lower, than the great attendance you've always had because it's easier for people to participate. We're all adapting and moving on, and I think that's something to take confidence from. It shows that we're resilient. Second point would be, I would say pleasantly surprised by the pace and the size of the official sector support for the economy, for individuals and for markets. Typically in a significant stress, that form of support does exist. This is a pretty unique circumstance, and none of us contributed to it. We're all, in different ways, kind of bystanders or victims of it. Recognizing that we're going to go through a bit of a valley and then come out on the other side. I think governments were very highly responsive in Canada, the U.S., globally, to the stress and looking to put in place a bit of a safety net to help society really get through. I'm not sure I would have anticipated the size of that or the speed with which it was implemented. I think that was the right policy response and it's helped us minimize the downturn. That's not to trivialize the pain that exists in places, but we're clearly overall in a better place as a result of that. The form of support will vary as we go through time and it will be calibrated in different ways and that makes sense. But it was certainly significant early days. One thing I wasn't really surprised by, and this will sound self-serving and maybe it is a little bit, but it's true at the same time, is the resiliency of our business. We talk all the time about the benefits of diversification, and we deeply believe in those benefits. The simple point is that, for us, we've got four businesses that we report on externally. One is about 40% and then we've got three by 20. Then those four businesses we further subdivide as we look at our performance internally into about 30 businesses. The truth is that there's a decent amount of variation underneath the surface across those businesses. So at any point in time, some are doing really well, some aren't doing as well. But the consolidated revenue stream and income stream that results is much more stable because you've got a diversification benefit. It's a diversification benefit, but there are ties that bind. We've got common infrastructure, common customer bases. The collection makes sense, but it produces a far more robust revenue stream than we think maybe we get credit for as an organization. Our pre-tax, pre-provision income is up about 8% over the last 12 months. That is a good number in a pretty crazy world, and it reflects the strength of that diversified business mix, we think. John, just to give you the data point, and thank you for the plug, our attendance is up year-over-year. Okay. That is great. You are quick right on that point. That's great. In terms of I being a sell side analyst, your performance may be absolutely fantastic, but I also do have to be the glass is half full. When you look out to 2021, what do you see as the biggest risk in terms of either, not necessarily because I don't think anyone is subscribing to the theory that there's going to be a hole punched in your balance sheet, but in terms of the momentum that you've built, what could slow that down? What are the things that you're concentrating on? On the flip side, are there any opportunities that you see that could actually help you accelerate or maintain your growth? Okay. There's a lot in that question. On the risk side for 2021, I think it's kind of all of the obvious ones. Maybe we'll have a really big second wave or spike in what are just generally choppy seas, and that possibility exists. We could have disappointment on a vaccine. None of us know. There's inherent uncertainty there. On that, I think we've all learned a lot about how to live with the virus, and so the potential for setbacks is clearly there as we go into the fall and kids are back at school in most places, and so we're likely to see some uptick in the virus. But I think there's lots of evidence that says when that occurs, people, of course, correct from a behaviors perspective and things settle down. So we're not too concerned about that. With interest rates lower, one of, I would say, more of the realities we're looking at as opposed to the risk is just that revenue growth in parts of our businesses will be lower because of the impact of lower rates, and that's true for banks as a general matter. We have a pretty good non-interest revenue to interest income mix in our revenue stream, and so we're probably a little underexposed to that risk compared to the average bank. But low rates will be a bit of a headwind from a revenue perspective. So we're expecting low revenue growth next year given the belief that loan growth is likely to be lower than it's been over the last few years, given a weaker economic environment, and then as well, the impact of lower rates. To offset that, we'll be focused on having a very low rate and likely a negative rate of expense growth next year. For the last 12 months, our expense growth is 0.2% for the year to date in constant currency. So ignoring the strengthening of the U.S. dollar, our expense growth is a little bit negative, so we've been delivering low expense growth. We went into this year with the expectation that that would be an important thing to do, and we have delivered. Into next year, we'll be looking to do more of the same given the uncertain environment and the headwinds that we face. On the upside, two come to mind. One is the capital markets have been great. Recently we've seen a lot of financing, recently an uptick in M&A. Capital market activity can be a bit of a counterbalancing factor to an environment that's got some volatility to it. We've got positive exposure to that in our business. If the environment is rockier, capital markets might have a little bit of chop early days, but then they're likely to do well as businesses. Last point is there's some possibility we're going to come out of this even more quickly and in better shape than people expect. Time will tell how things play out. You look at the response to recovery in different parts of the world. In North America, I would say we're relatively locked down in terms of the percentage of people who are returning to work as opposed to what we're seeing in parts of Europe and parts of Asia. There are some conversations taking place around whether we need to be as locked down as we are. That's not to trivialize the need to practice good hygiene as it relates to containing the risk of the virus. There's reasonable evidence that you can do that in different ways. I do think there's a scenario where people act responsibly. We're wearing masks, we're washing hands, we're social distancing, and more people are in circulation. With that, some of the parts of the economy that are still hard hit are able to recover a little more quickly than they currently are expecting to. Tom, one of the strengths that you've alluded to a couple of times with Bank of Montreal has been on the cost and the efficiency that you've squeezed out. Can you talk about how the drop in discretionary spend because of the pandemic has helped that? Yeah. In the scenario that you are talking about where Yeah we may actually start to see better performance economically than we have been dealing with, how does that impact your decision in terms of expenses and particularly balancing spend on technology? Yeah. We went into this year with a low expense plan, as I talked about earlier. Our guidance, Q4 of last year was to have expense growth of 2% or better. Internally, we were focused on, in particular, the or better part of that. Call it 1%, give or take. We have delivered constant currency negative about 1%, I think it is, for the year to date. We were in a good place relative to, I would say, the need for low expense growth given the environment. Dialing back some discretionary expenses, like travel as the classic example, has been helpful in offsetting COVID-19 expenses, as you mentioned. I will not get these numbers exactly right, but I think our COVID-19-related expenses, so additional cleaning supplies and things like that, and it is more than cleaning, but that is a simple example to bring what I am talking about to mind. In the last quarter were something like CAD 40 million-CAD 45 million. The dial back in discretionary expenses like travel, entertainment, a bit of marketing was CAD 70 million or CAD 75 million. The net number was helpful, but not really the story. The underlying story is that we are managing the expenses pretty actively. Our big expense categories around people, which are our biggest expense, are down. We are continuing to invest in technology, but we think we can do what we need to do with a lower rate of growth than we have had over the last five years. If you go back over the last, I think it is 4 years, our tech expense has been growing at a double-digit rate, very significant spend. We and others were doing similar things, delivering lots of improvements to our foundation and better applications for our customers. With the benefit of a really active spend program over an extended period of time, we think we are now able to deliver what we need to deliver, but with a lower rate of growth in tech spend. That was in our plans for the current year, more of a single-digit rate of growth, and that will be our plan for next year. Just a little tangent maybe on the digital acceleration point. One of the real takeaways from the pandemic is that the digital world is here, so we have all been doing lots of work on that front. We have seen our digital take up from our customer base continue to go up. We have seen our virtual businesses like online brokerage have outstanding performance as people are more active on those platforms. We are investing in things digital, and we do see COVID-19 as a big accelerant of that trend. That is a very positive thing from a cost structure perspective because it is far less expensive for banks to deliver things digitally than in person. We are investing in that trend. We think that continues, and it is a big area of focus for us. Then in the scenario where the world is a better place and revenue growth is higher and expense growth, therefore, has the ability to be higher, we will ramp up spending with frontline people, we will ramp it up a bit on the tech side. Our belief is that you are better off going in with an assumption that you want to run expenses at a somewhat lower rate than maybe you will be able to, on the theory that it is so much easier to ramp up than to ramp down. When you ramp down expenses, you do 2 things. You take money out of budgets and you stop doing things that you were planning on doing. You also sap energy from the organization because you had people who were excited about doing certain things, pumped up about their big new project, and that goes from being a go to not being a go. We think you are better to start with a low rate of expense growth and then let capacity out through the year as the environment permits, and generate momentum off of that. Again, we have done that this year. Our expense growth is number one of the Canadian group. It is negative for the year to date. It is 0.2% for the last 12 months. With that, our pre-provision, pre-tax income is strong at 8% for the last 12 months. Tom, just still on expenses. One of the discussion points pre-COVID-19 was the evolution of the branches and the branch network. Has the pandemic altered your thinking in terms of the transition of the footprint of the layout of a traditional branch? Has it accelerated, or is this just still such a long-term evolution that there is not that much change? Yeah. Here I would say we have not arrived at a definitive conclusion, so we are watching the behavior really closely. Early days, obviously, branch traffic was way down, online was up, exactly as you would expect. More recently, as things have opened up, we have actually seen a pretty significant rebound in branch traffic. That traffic is occurring more where people live as opposed to where they work. I am downtown right now in Toronto. It is pretty quiet down here, and our branch is not as busy as it would have been formerly. Branches in suburbs are quite busy, so we are not significantly accelerating, I would say, plans around branch count reductions at present. Part of the reason for that is we have got a meaningful segment of the population that likes to go to a branch. The infrastructure exists. A lot of it is reasonably well depreciated. There is a cost to operating it, but it is not a huge cost. If you move too quickly on branch closures, our belief is you can turn off a part of your customer base and run the risk there. We think the risk return really around that guides you towards being focused on over time, reducing square footage, reducing the number of branches, but not doing it in a really rapid fashion. We have taken down some FTE capacity within our branches because the volumes are down a bit in places, but we have not redone the strategy. On the commercial real estate side, the story is a bit different there. When you operate for 6 months with 95% of the people who are not in branches not at work, it does not take a genius to figure out that you do not need all the real estate that you have got. Over time, we do think we are going to have less traditional office space and more kind of hoteling shared space. That transition will take time because of the leases that we have got in place. That is an area on the real estate side where the conclusion is clear. It will take a bit of time to work out because of the leases we have got. For a period of time, we are going to need more space for those who do come back because of the need to social distance. That is a trend that looks quite clear from our perspective. Tom, just a quick follow on. Is there any difference in your thinking when you look at Canada versus the U.S. in your branch network? I would say at a high level, not really. We do have the same group of people focusing on our branch distribution system across North America. There is some tailoring that exists to the local markets, but the approach has a lot of similarity. There is not a material difference. That said, in the category of some tailoring differences, we did do a review of our U.S. branch network, I don't know, eight months ago, something like that. Out of that review concluded that it made sense to shut a number of branches, and we did that earlier this year. We have had kind of a gradual decrease in the branch count through time and a bigger decrease in the square footage through time. Moving from old style large branches to smaller, funkier, more retailing oriented locations. In the U.S., earlier in the year, we did close about 30 branches, which is something like 5% of the total. That was a bigger sort of one time shot than we happened to have in Canada and resulted from a review of the system. But bigger picture, fundamentally, we don't see a significant difference between the two markets. Tom, you mentioned the government response to the pandemic and how that was beneficial. One of the key ingredients, though, was the reduction in the interest rates by central banks. Yeah. And as we've seen, the spillover impact, unfortunately for the banks, was margin compression. Can you give us a sense in terms of what you're anticipating for margins on a go forward basis? Are we going to continue to see the significant compression? Yeah. Or is it just going to be more gradual or actually even see expansion at some point down the road? Yeah. So unfortunately, that has been part of the policy response. And so with lower rates, you've seen the impact on margin that you described. Margin is down in the industry generally. And really it's been down over the last quarter or two for a couple of reasons. One, lower rates, and in particular, lower short-term rates, because our margin and the other banks' margins are impacted by short and long-term rates. The impact shows up pretty immediately from short-term rates because we've got assets that are repricing and having yield change in the market basically immediately. And then we've got assets that are more sensitive to a five or a seven-year rate, and those get repriced over time. And so the margin change that you've seen over the last couple of quarters have reflected lower short-term rates, but also a really significant expansion of liquidity on the balance sheet. And the world is awash in liquidity. We're sitting with very significant levels of excess cash, excess liquidity on the balance sheet, and we earn a lower yield on that excess liquidity than we earn on the balance sheet overall. And so when you look at our margin in Q3, a meaningful contributor to the quarter-over-quarter margin decline resulted from simply holding more liquidity at a low yield. And I don't have the numbers in front of me, but I think for our all bank ex-trading margin, about half of the quarter-over-quarter decline was due to that excess liquidity. So as we look out to next year, I'd expect a few things, and there's obviously uncertainty around how things will play out. Firstly, we'll have a negative impact on the margin from the roll in of long-term rates. We will have some money that we have invested with term coming in, being reinvested at term at lower rates. That is a negative on the margin, bit of a negative on revenue. As well, we do think this excess liquidity drains out of the system over a gradual period of time. As we go through next year, we think we will be holding less surplus funds, excess cash. That shift in the balance sheet will have a positive impact on margin because we will have a lower percentage of the balance sheet in low yielding assets. Into next year, the actual margin might not be as negatively impacted as people think because of that offset that we think will occur related to the decline in low yielding liquid assets. Likely to be a bit of pressure on the bank margin and the margins in our operating groups, but with a bit of a cushion coming through from the balance sheet mix that I talked about. Tom, I have tried to ignore credit as long as I could, but I do have to bring it up. Yeah. BMO, once again, strengthened reserves in their third quarter, and largely at 50,000 feet, it really was not a migration of credit, but just basically more of a push towards the adverse scenarios for the non-performing. Can you talk about what could cause another lift in credit or push towards those adverse scenarios in the fourth quarter, given full understanding that your guidance is for not another significant reserves? Yeah. In the third quarter, we had a meaningful increase in our allowance, well above average compared to the Canadian peer group. A good portion of that, as you said, was driven by attaching a higher probability to the non-base case scenario where the economy has more trouble than we expect. The underlying thinking there was related to looking at the spike in virus cases that we have seen in the U.S. as activity picked up. The thinking was it actually might be harder to contain the virus as the economy recovers, and therefore, with that, there's a greater probability of a tougher economic environment, and we reflected that in the allowance. Looking forward on the allowance, yeah, we do a few things every quarter. We obviously update the data on the portfolio. We'll have a degree of growth, likely to be modest given current environment. Likely some migration in the portfolio, which we and others have seen over the last few quarters. We'll update our economic scenario. To date, haven't had big changes in the base case economic outlook. We're expecting a pretty good snapback in the U.S. and the Canadian economy next year, growth in the range of 5%-6%. Then we'll assess sort of the balance of probabilities and upside and downside scenarios around that base case expectation. There, there's obviously judgment that comes into play. But we've got a committee that reviews our allowance level, and we think about the potential for, the likelihood of, either upside or downside scenarios, and it's too early to speculate or guess how that discussion might go. All else equal, the more, I would say, encouraging information related to the ability of the economy to open, the lower the chance that we've got a bigger downside waiting. Obviously, we're all watching developments on the medical side, and we're not medical experts. But there's a huge amount of brainpower and money obviously going into vaccines and treatments. Both of those things the market seems to believe will produce positive news as we go into next year. That's our belief as well, and so developments on that front are part of the picture, as they are generally, as people think about the outlook. Tom, the bank has done a really good job in terms of giving us disclosures around the deferral programs that you've had for both. Yeah First on commercial side of the equation. I guess one of the things that investors are trying to triangulate is there's been a better performance than we would've expected with customers coming off deferrals. What are the risks of those customers that are still on deferrals or have asked for a second deferral in terms of the outlook? Do you really think that those will end up being stage 3 loans? Yeah. To date, the experience, as you said, has been, I would say, very positive related to customers coming off deferrals, both on the commercial side and the consumer side, Canada and the U.S. We're seeing the vast majority of customers returning to a status where they are making payments to us. The existing deferrals will run off largely over the balance of the year. I would say we're not expecting a radically different outcome. We are talking to our clients. We're following up where there's a little more stress. In addition, we've provided in our allowance for the potential that some of the accounts that are currently deferred will go impaired. We've built an allowance to cover the scenario where there is a somewhat higher level of default rate coming out of the deferral. Our base case expectation is that we'll have people returning to paying status in a very strong majority sense of things. That said, clearly, parts of the economy are being negatively impacted. Some individuals are going through extremely difficult times. We will have a level of loss, but we expect it to be in line with the guidance that we've given. Overall, we think the deferrals have worked really successfully. The objective, really, of the deferrals that the industry has granted, together with the government programs that we've seen, is to help individuals and businesses get through a tough patch and get through the valley. We're not all the way out of the valley, but we have a better understanding of where we are in it, and the path is firming up in terms of its clarity. And so we feel good about the ability that the industry had given our strength to help our customers through this difficult patch, and we are expecting the strong majority of them to come out on the other side in good shape. Tom, we are coming down to the home stretch, so I am going to refer to one question that we got from the audience. I am curious to know about the outlook for loan defaults and losses, particularly on the corporate loan side. It looked like U.S. gross impaired loan formations were relatively high in Q3. How do you expect these to evolve in the U.S. and Canada? What ranges are in your scenarios? Yeah. I would say on the commercial and the corporate side, losses are running at, I would say, a pretty contained level. And they are obviously up from pre-COVID times. Hard for that not to be the case. That would be the expectation. We gave our loan loss guidance on our Q3 earnings call, and we are expecting impaired losses to run at a rate that is elevated compared to pre-COVID over the next few quarters but isn't spiking really significantly from levels we have seen in Q2 and Q3. And that reflects basically this 90% recovery world where you have got 90%, give or take, of the world doing reasonably well. And you have got a smaller part of the economy, a smaller part of our customer base experiencing stress because they are more exposed to the difficulties that the virus has produced. And so losses are concentrated in the impacted sectors to a reasonable degree. Our exposure to those sectors isn't out of line with the industry in terms of a percentage of our commercial and corporate portfolio that those industries represent. And we do expect to take some losses in those spaces, but we have built allowance for that as we think makes sense. And we think the guidance that we gave on the Q3 call made sense, and it holds looking or sitting here today. Tom, fantastic. That actually hits us almost right on time. Thank you very much for joining us this morning, and best of luck with the fourth quarter into next year. Okay. Thank you. Appreciate you having us. Have a good day, everyone.