Earnings Call: Q1 2015

Feb 25, 2015

Good morning, ladies and gentlemen. Welcome to RBC's conference call for the first quarter of 2015. Please be advised that this call is being recorded. I would now like to turn the meeting over to Ms. Amy Cairncross, VP and Head of Investor Relations. Please go ahead. Good morning, and thank you for joining us. Presenting to you this morning are Dave McKay, President and Chief Executive Officer, Janice Fukakusa, Chief Administrative Officer and CFO, and Mark Hughes, Chief Risk Officer. Following their comments, we will open the call for questions from analysts. The call is one hour long and will end at 9:00 A.M. To give everyone a chance to participate, please keep it to one question and then re-queue. We will be posting management's remarks on our website shortly after the call. Joining us for your questions are George Lewis, Group Head, Wealth Management and Insurance; Doug McGregor, Group Head, Capital Markets and Investor & Treasury Services; Jennifer Tory, Group Head, Personal and Commercial Banking; Zabeen Hirji, Chief Human Resources Officer; and Bruce Ross, Group Head, Technology and Operations. As noted on slide 2, our comments may contain forward-looking statements, which involve applying assumptions and have inherent risks and uncertainties. Actual results could differ materially from these statements. I will now turn the call over to Dave McKay. Thank you, Amy, and good morning, everyone, and thank you for joining us today. RBC had a record first quarter with earnings of over $2.4 billion, up 17% from last year or up 12% excluding items in the prior year related to our Caribbean operations. Our results were driven by record earnings in Personal and Commercial Banking and a very strong quarter in Capital Markets. Our performance also reflects record earnings in Investor & Treasury Services, continued strength in Insurance, and solid underlying earnings in Wealth Management. Our capital position remains strong, and I am pleased to report that this morning we announced a $0.02 or 3% increase to our dividend, bringing our quarterly dividend to $0.77 a share. Overall, RBC had a great start to the year, and I'd like to highlight three key strengths of our quarter. First is our record earnings in Canadian Banking. We have the number 1 or number 2 market position in all retail and business product categories, and we continue to gain market share across all of our core businesses while maintaining strong margins. We continue to innovate and enrich our customer value proposition, and we've executed strategic marketing programs, which helped drive solid volume growth of 5% over last year. This growth includes continued momentum in deposits, reflecting our focus on growing core checking accounts, a key anchor product for us. As I've explained before, clients typically start their relationship with us through a checking account, and we can typically sell an additional 2 or 3 products within the following 3 months. We also had strong fee-based revenue, which was up 13% from last year, largely reflecting the power of our branch network to distribute mutual funds to our clients, who achieved double-digit growth every quarter for more than 2 years. A second key highlight is Caribbean banking, which was profitable this quarter following 2 years of restructuring, during which we repositioned the business and took out significant costs. While there are ongoing economic headwinds, we believe our Caribbean business can continue to deliver strong performance. A third highlight is the strength of our global businesses. Capital Markets generated particularly strong trading results, especially in the U.S., as client activity increased on improved market conditions and increased volatility. We also had higher M&A activity and solid growth in our U.S. and European investment banking and lending activities. Investor & Treasury Services also had an outstanding quarter, driven by high levels of client activity in the foreign exchange markets and higher custodial fees. In addition, global asset management performed well with strong growth in client assets, and we continue to extend our reach to institutional investors in the U.S. and select global markets through several new mandate wins this quarter. While we are pleased with our first quarter results, recent changes in the macro environment have created some headwinds, and let me provide you with some insight into how we are navigating through the environment ahead. The price of oil declined 40% in Q1. While we've seen some stabilization and recovery over the past few weeks, the price of oil remains at levels that challenge the profitability of the sector. To date, we haven't seen any significant weakness in our oil and gas credit portfolio or in our retail portfolios in the prairies. Within this environment, we're conducting extensive stress testing to help us understand the potential impacts of persistently low oil prices on our business. We're actively monitoring on an ongoing basis, which provides us significant visibility into early warning signals. I would highlight the potential for some positive effects from lower oil and gas prices. For example, lower energy prices are expected to lead to increased consumer spending, which will help support GDP growth. Additionally, a weaker Canadian dollar and an improving U.S. economy benefit our manufacturing sector. For example, in Ontario, exports in Q4 are up 17% year-over-year. On a national level, we saw wholesale volumes rise nearly 9% from a year ago in December, the strongest annual rate of growth since April 2010. The impact of a lower oil price has also contributed to the depreciation of the Canadian dollar relative to the U.S. dollar. We expect our dollar will remain under pressure in the U.S. as the U.S. economy is projected to outperform the Canadian economy. This quarter, we benefited from translating our strong U.S. earnings into Canadian dollars. As Janice will touch on in a moment, there was a negative impact on our capital ratios from foreign exchange. However, we hedged our balance sheet outside of Canada to offset much of this impact. As you saw at the end of January, the Bank of Canada unexpectedly cut the overnight rate, partly in response to the macro headwinds I've just discussed. It's possible we may see another rate cut as early as March. We've demonstrated very strong margin performance in Canadian banking, though another rate cut would add incremental margin pressure. Within a low-rate environment, we will have to be even more diligent about managing costs and driving efficiencies. From the significant investments we've made in recent years, we believe there's more we can do, particularly through the use of technology and digitization. Notwithstanding these headwinds, I am confident that RBC's diversified and agile business model positions us well to continue to capitalize on opportunities created by the changing market environment. I believe RBC geographic diversification is a key strength. As we demonstrated this quarter, our global businesses in Capital Markets, I&TS, and Global Asset Management have strong momentum and complement our Canadian franchise. In fact, in Q1, we generated approximately 34% of revenue and 26% of earnings from our U.S. and international businesses, and City National will only increase our diversification. We have a strong track record of driving efficiencies while also investing in our business for the long term. We also have a strong capital position, which gives us the flexibility to deploy capital to grow our business and return capital to shareholders, as we did with today's announcements of a 3% dividend increase. Our strong capital position enabled the recently announced City National acquisition, which we believe will create a powerful platform for long-term growth in the U.S. I will now turn it over to Janice to provide more details on our first quarter results. Thanks, Dave, and good morning, everyone. As Dave mentioned, we had a record quarter with earnings of over $2.4 billion, up $364 million or 17% from last year, or up $272 million or 12%, excluding last year's loss on the sale of RBC Jamaica and other charges in the Caribbean. Sequentially, earnings were up $123 million or 5%. We delivered a strong return on equity of 19.3%, driven by record earnings in Personal and Commercial Banking and Investor and Treasury Services, strong performance in Capital Markets, and solid underlying results in Wealth Management and Insurance. As Dave noted, a significant portion of our revenue is generated outside of Canada. Given that the Canadian dollar declined 7% on average relative to the U.S. dollar just this quarter, our earnings benefited from foreign exchange translation of $34 million compared to last quarter, and this was predominantly in Capital Markets. I would also point out that approximately half of our balance sheet is denominated in US dollars, so the weaker Canadian dollar had a significant impact. In fact, approximately half of the growth in our balance sheet this quarter was related to FX. Turning to capital on slide 8, our common equity Tier 1 ratio was 9.6%, down 30 basis points from the prior quarter as strong internal capital generation was more than offset by higher risk-weighted assets reflecting FX and business growth, mainly in Capital Markets. Of the total increase in risk-weighted assets this quarter, over half was due to FX and the balance was volume growth. Through our hedging program, we offset approximately three-quarters of the impact of FX on our capital ratios. I would note that this quarter our capital ratio was also impacted by a lower discount rate, which increased our pension obligation. Looking forward, we continue to target a CET1 ratio of 9.5% with a buffer of 20 to 30 basis points. We expect that through internal capital generation, our CET1 ratio will increase in the coming quarters as we work towards closing the previously announced acquisition of City National, which is targeted for the fourth calendar quarter of 2015. During this time, we expect to maintain our ongoing capital management program, which includes funding all organic growth and returning capital to shareholders through dividends and also share buybacks at the margin. Overall, we are comfortable with our capital position and our solid financial performance supports our announced dividend increase. I would also point out that this quarter we began disclosing our Basel III leverage ratio, which was 3.8%, above the Basel III minimum of 3%. Let me now turn to the quarterly performance of our business segments starting on slide 9. Personal and Commercial Banking reported record earnings of over CAD 1.2 billion, up CAD 184 million or 17% from last year on a reported basis. Excluding last year's losses and provisions in Caribbean banking, net income was up CAD 92 million or 8%. On a sequential basis, earnings were up CAD 104 million or 9%. Canadian Banking reported record earnings of over CAD 1.2 billion, up CAD 83 million or 7% from last year. Our performance reflects strong growth in fee-based revenue of 13%, mainly from higher mutual fund distribution and credit card fees, as well as solid volume growth of 5%. Sequentially, Canadian Banking earnings were up CAD 10 million or 1%. I would remind you that our results last quarter included favorable net cumulative accounting adjustments of CAD 40 million after tax. This quarter, our net interest margin was 2.68%, up 2 basis points sequentially. Excluding certain accounting adjustments last quarter, which lowered our margins by 3 basis points, our net interest margin was down 1 basis point sequentially as a result of ongoing competitive pressures. Turning to expenses this quarter, Canadian Banking's expense growth was in line with revenue growth. Expenses increased from last year due to higher staff costs, which included higher share-based compensation, reflecting the annual accrual for employees eligible to retire. We also continue to invest in infrastructure and marketing strategies to grow our business. Going forward, we continue to target operating leverage for Canadian Banking in the 1%-2% range, and we believe our operating leverage should continue to improve throughout the year. Turning to Caribbean Banking and U.S. Banking, our results reflect a strong quarter of positive earnings in the Caribbean, where we've done a lot of work to restructure our operations, including taking costs out and improving our pricing model. Turning to slide 10, Wealth Management had earnings of CAD 230 million, down CAD 5 million or 2% from last quarter, and down CAD 55 million or 19% from last quarter. We had an after-tax restructuring cost of CAD 27 million related to the repositioning of our U.S. and international wealth management businesses, which we believe we are now halfway through. We also had PCL of CAD 13 million on a couple of international accounts. Excluding the restructuring charges, earnings in wealth management were up CAD 22 million or 9% over last year and reflect solid growth in our global asset management and Canadian wealth management businesses. Assets under management and assets under administration were up 17% and 14% respectively over last year due to FX, capital appreciation and net sales. This growth was partially offset by lower transactions revenue, reflecting lower client activity and fewer new issuances due to the volatile market conditions this quarter. Wealth management expenses were elevated this quarter, largely reflecting the restructuring costs I just mentioned, as well as foreign exchange translation. Our expenses also reflect higher staff costs, mainly in global asset management, where we're continuing to invest for the long term as this business is a key growth platform for RBC. Moving to Insurance on slide 11, net income of CAD 185 million was up CAD 28 million or 18% from last year, largely due to higher earnings from two new U.K. annuity contracts, improved claims and policy experience, as well as net investment gains. Sequentially, net income was down CAD 71 million or 28%, as last quarter we benefited from both favorable actuarial adjustments reflecting management actions and assumption changes, as well as a cumulative adjustment related to outstanding retrocession claims. I would also note that our insurance results now include the negative impact of a change in Canadian tax legislation, which began impacting our foreign affiliates in November 2014. The tax law change will continue to impact the insurance segment's tax rate going forward. Investor and Treasury Services had a record quarter with earnings of CAD 142 million, up CAD 36 million or 34% from last year and up CAD 29 million or 26% sequentially. This quarter, we benefited from exceptionally high levels of client activity in the foreign exchange forwards market and higher foreign exchange transaction volume. This was largely driven by favorable market conditions, including increased market volatility, which we don't believe will continue to the same degree going forward. Turning to Capital Markets, we had a strong quarter. Net income of CAD 594 million was up CAD 89 million or 18% over last year. As I mentioned, the earnings in capital markets benefited from foreign exchange translation. FX and market volatility were also large components of business growth, particularly in our secured funding business where activity was very strong this quarter. Our equity and fixed income results improved, reflecting higher client activity from favorable trading conditions, including increased market volatility. I'd like to highlight that our European fixed income results have improved substantially as we've refocused the business. We also had higher M&A activity in Canada and the U.S. and solid growth in our U.S. and European investment banking and lending activities. Compared to last quarter, net income was up CAD 192 million or 48%, driven by revenue growth across most of our businesses, which was offset in part by higher variable compensation. I would remind you that last quarter's earnings were unfavorably impacted by funding valuation adjustments and our exit of certain proprietary trading strategies, which together totaled nearly CAD 100 million. Overall, it was a very strong first quarter for Capital Markets. Our pipelines look strong, and heading into the second quarter, we feel good about how our businesses are performing. With that, I'll turn the call over to Mark. Thank you, Janice, and good morning. Turning to slide 15. Our credit quality remains strong and in fact improved from last quarter. Provisions for credit losses on impaired loans this quarter were CAD 270 million or 24 basis points, down CAD 75 million or 7 basis points from last quarter, mainly reflecting lower provisions in Caribbean banking and Capital Markets. Caribbean and U.S. banking PCL was CAD 18 million, down CAD 60 million sequentially, as last quarter included increased provisions on our impaired residential mortgage portfolio in the Caribbean. This quarter, as Janice mentioned, Wealth Management had provisions of CAD 13 million related to a couple of international accounts. With respect to Capital Markets, this quarter we had provisions of CAD 5 million, largely related to a single account in the utilities sector. Let's turn to slide 16, which focuses on our Canadian Banking retail portfolio. Provisions in Canadian Banking were CAD 234 million, or 26 basis points, down CAD 2 million or 1 basis point from last quarter. Our credit card provisions remained near historical lows at 245 basis points, up 14 basis points sequentially due to seasonality. Provisions in our small business portfolio decreased 15 basis points from last quarter, and our residential mortgage portfolio, which is well diversified across Canada, as highlighted on slide 17, makes up 65% of our retail portfolio. It continues to perform well with provisions this quarter of 2 basis points, consistent with our historical performance. Given the decline in oil prices, I will make a few comments about our exposure to this sector and how we're managing our portfolio. As you can see on slide 19, we've enhanced our disclosure this quarter to provide more transparency on our wholesale oil and gas exposure, which was previously reported as part of the energy sector along with utilities. Our drawn loan book exposure to the oil and gas sector represents around 1.5% of RBC's total loan book. Over 60% of our loan book is to exploration and production companies, while around 20% is to drilling services companies, with the remaining balance to integrated companies, refiners and distributors. We have not yet seen any stress in our portfolio. As expected, we are seeing some clients drawing on their lines given the environment. We have identified names that could be under pressure if oil prices remain at current levels for a further sustained period, and we're closely monitoring those companies for any early warning signs. We are also monitoring retail portfolios, and this allows us to proactively reach out to clients and engage in a discussion if we see early signs of financial stress. Beyond active monitoring, we have stress-tested both our wholesale and retail portfolios, giving a CAD 45 oil price for a sustained period of time, a significant increase in Canadian unemployment and interest rates, and a national downturn in the real estate market, as well as a recession in Alberta. Under this very extreme scenario, we have determined that the potential losses would still be manageable and within our risk appetite. Turning to slide 20, gross impaired loans and new impaired loan formations increased this quarter, largely due to the two international wealth management accounts I mentioned earlier, as well as foreign exchange. Turning to slide 21. In the first quarter, average market risk value at risk increased to $33 million due to the implementation of funding valuation adjustments, or FVA, at the end of the prior quarter and the impact of the depreciating Canadian dollar. Our first quarter average market risk stress VAR was $107 million, up $29 million from the prior quarter, largely due to the implementation of FVA. While stress VAR was elevated in the first quarter compared to recent historical levels, it has since returned to a more normalized level. We had three days of trading losses in the quarter, with none of the losses exceeding VAR. Overall, I am pleased with our credit performance this quarter and am comfortable with how we're managing our businesses from a risk perspective given the macroeconomic headwinds. With that operator, we are ready for Q&A. Thank you. We will now take questions from the telephone lines. If you have a question and are using a speakerphone, please pick up your handset before making your selection. If you have a question, please press star one on your telephone keypad. You may, at all times, cancel your question by pressing the pound key. Please press star one now if you have a question. There will be a brief pause while participants register. Thank you for your patience. Our first question is from John Aiken from Barclays. Please go ahead. Good morning, Mark. Quick question for you. Well, actually, first off, thank you very much for the expanded disclosure on oil and gas, but of course, it leads to other questions. Can you let us know what the undrawn commitments were as at the end of Q4 for oil and gas? Yes. There are about CAD 12 billion for oil and gas, plus an incremental of about CAD 1.5 billion for trading lines. Great. Thank you very much. In terms of wealth management, we talked about the expenses and growing the business, impeding some of the profitability, but we have seen revenues lagging the AUM and AUA growth. Can you give us some sense of outlook through the remainder of the year, what we should be seeing on revenues, and whether or not we can expect to see heightened expenses coming through on these lines as you do try to grow the business? Thanks very much, John. I will take it. It is George Lewis. A couple of points. I think, first of all, in terms of our quarterly results, as Dave and Janice mentioned, we did have very solid underlying growth, and particularly in our global asset management business, where we are seeing year-over-year increases in earnings in line with our AUM growth of 17% in that business. So that is not only a future growth business for us, but a very solid contributor to the segment. Secondly, we did have elevated expenses. I would say that overall from a wealth management segment point of view, we had strong client asset growth, but we were disappointed that we were not able to deliver more of that to the bottom line. That had two components to it. One was the restructuring charge for our U.S. international wealth business. I would say, you will recall that that program will take some time. We incurred a charge in Q4. I would say we are about 50% of the way through that program. We expect to be largely complete in 2015. But even excluding that restructuring charge, we only generated modest positive operating leverage this quarter. So we are very focused on aligning our expense structure, particularly as we narrow our international footprint to bring that rate of expense growth down and to generate higher operating leverage for our core earnings going forward. Thanks, Rich. In terms of the restructuring that you're doing on the international side, what can we expect in terms of the headwind to AUA coming out of that? John, I think that will be a matter that you're already seeing a bit of an impact from that this quarter as we exit some locations. I think the important thing to note there is that I would say the revenue per AUA that we're exiting would be below our segment average. This is a good move on our part. It's reducing our risk profile, it's reducing our cost structure, and when we get through this program, we'll actually have a much stronger segment with positive operating leverage. You'll see actually more of the earnings power of our large high-performing businesses coming through in the overall segment. Great. Thanks for the color, George. Over to you. Thank you. The following question is from Robert Sedran from CIBC. Please go ahead. Hi, good morning. I just want to ask about the Canadian margin. Dave, I think you touched on it a little bit, but specifically the partial cut in prime that followed the Bank of Canada move earlier this year. Everyone else can say they followed you, I guess, but you guys went first. Why was 15 basis points the right number? Should we assume that if the bank moves again, that it will be a similar partial response on prime? Thanks for the question. We took a number of factors into consideration, obviously, when we moved prime down, our rate down by 15 basis points a few months ago. When we looked at our funding costs, we looked at the environment, we looked at the structure of our business, and that was the appropriate decision at the time. We take the same variables into consideration for any future prime decrease. The probability of that decrease seems to be less than it was maybe a week ago or a month ago as you read the current economic environment and some of the signaling that is coming from the Bank of Canada. The same variables will go into that, and funding costs is a big part of that in understanding how the market is reacting and how we fund our lending positions. We look at it all. It is hard for me to predict how we will react, obviously. As far as understanding our margins, a number of variables go into our margins, including the shape of the yield curve and beyond the Bank of Canada rate cuts. Take all that into consideration. I think our overall view is that with the competitive environment, the shape of the yield curve, the greater shorter-term pressure on rates, that we will continue to see a very slow margin declines over time that you have seen one to two basis points here and there. Nothing drastic, but that continues to be our call. That probably would have been your outlook even before the move. I guess it is fair to say that the partial cut in prime was able to offset some of the other pressure that might have come as you have moved prime in line with the Bank of Canada. Is that fair? Right. We are looking at our historic margins in our variable rate mortgage book, and we are looking at our funding costs and all those go into it, and we are able to manage it somewhat, not offset completely the impact, but certainly manage it. If it does stimulate demand, you have increased volumes and demand to offset that from a revenue perspective. We are very happy with our volume growth and our revenue growth and our margins in a difficult operating environment around competition and low rates. I think it is good performance by the business. Okay. Thank you. Thank you. The following question is from Gabriel Dechaine from Canaccord Genuity. Please go ahead. Good morning. Firstly, on the capital situation, the big FX hit was more than I expected to see this quarter. Are you still on track to be at around 10% quarter one ratio post the City National acquisition? If you can, what is the kind of wiggle room around that figure you think you have? Hi, Gabriel, it is Janice. Good question. We are managing our CET1 ratio at 9.5 plus a range of 20-30 basis points, a buffer above the 9.5. We had very large FX movements, and when we look to the balance of the year, we are managing it in accordance with what City National will do to our ratio. So we expect to be back at the 9.8, 9.9 range, and then up a little bit higher leading up to the acquisition. All of that has to do with pretty solid earnings accretion if we look at what we will be building. We are right on plan to fund City National as we spoke about when we announced the transaction. Organic capital generation, what number should I use? 20, 25? It was 40 this quarter. That seems a little bit high. I think that if you look at our medium-term objectives, what we are saying is that we see the trajectories in line with our medium-term objectives in terms of our earnings growth. We are also looking more actively at hedging some of the potential downside on the US dollar strengthening. With those two activities, you will see a pretty strong organic capital build leading up to the City National acquisition. Okay. But the likelihood of you having to top up, to stick strictly to that 10% to top up your capital ratios in another manner, like an equity raise, that is very low probability, I imagine. At this point, I think it is low probability given our trajectory. Okay, and just a quick one on the tax rate. We are at 24% effective tax rate because of that FAPI stuff, I guess. Is that the run rate we should be using from now on as the international insurance business tax rate increases higher now? I think that it is not a real driver in our overall tax rate. At the margin, it would be maybe a couple of basis points. I think we should still look at a rate in the 23%-25% range. The more important driver for us is earnings mix, and as you know that we are earning on a geographic basis, a higher rate of growth of earnings in the U.S. versus in other jurisdictions, and that is more of a driver of our combined rate. Okay. Thank you. Appreciate the answers. Okay. Thank you. The following question is from Peter Routledge from National Bank Financial. Please go ahead. Hi. Thanks very much. Just wanted to ask about your, Mark, just get your thoughts on unsecured household credit Canada, generally, and then how you think Royal is positioned. I guess the main question is Royal's relative or proportionate exposure to unsecured household credit is a bit higher than peers, and why shouldn't we be worried about that? Thank you for the question. Obviously with the economic conditions, macro conditions, it is obviously something we focus on a lot. The headline household debt number of the 163% or 164% across the country is one that gets a lot of attention. We do have a lot of focus on this. We try to consider more around the debt service of our clients as opposed to the household debt. And debt service ratios continue to be very low. We do have a fair amount of our portfolio is on a fixed rate as well. Yes, we do have lower insured numbers than some of our competitors, although our LTVs continue to be in a very good range. So when you add all of the metrics together, LTVs, debt service ratios, fixed rate, we remain extremely comfortable with our portfolio. Thanks. Just in terms of unsecured- Yeah. Is the underlying credit quality of Royal's customers higher or better than your peers, do you think? Is that why we shouldn't really be worried about unsecured debt? I wouldn't necessarily comment on our competitors, but certainly our FICO scores, our credit scores are very strong, well over 700 FICO score. We do have good customers, certainly. Peter, what I would add is if you look at the last recession that we went through in 2008 and 2009, and how our unsecured book performed, it's performed very consistently over the last two or three recessions. The unsecured book we're referring to is roughly half credit cards, half revolving credit lines that are unsecured, 50/50. They've performed very consistently with around a 50% volatility factor to 60% volatility factor through a cycle. I think that points to a consistent credit profile, the fact that we lend through a cycle on that portfolio, and we certainly stress and think through that full cycle when we make an origination decision. It's the predictability and stability of that performance. When you look at the margins we earn at unsecured credits, they're some of the healthiest margins we have, particularly on the credit card side, obviously. When you factor in margins, expected loss, volatility, this is good business for us, and one that we monitor through a number of cycles. In terms of mitigating a deterioration, one behavior probably will occur, people will start to draw on their unsecured lines as they get worried about the future. Yeah, certainly if you look at the last recession, the first portfolio that showed signs of stress was actually the auto secured portfolio, then the credit card portfolio. Auto secured could show stress in a three to six-month timeframe. Your card book could start to show stress in a six to 12. It was actually the mortgage book was more in the 12 to 24-month lag stress to economic deterioration. So you're right, but it's not necessarily the unsecured that always goes first. Some of the secured higher risk portfolios go first. I think there's a mix there that we watch very carefully, and as we've talked about a number of times, we've got proprietary lending systems that allowed us perform the way we did through the last cycle. We continue to use very advanced monitoring capability with our customers to watch for signs of stress and deterioration and act proactively to manage that account. You'll have the knowledge and flexibility to cut lines that you might get worried about based on behavior? We do. Okay. Thank you. Thank you. The following question is from Doug Young, from Desjardins Capital Markets. Please go ahead. Hi, good morning. I guess the one area, it is small, but I wanted to get a little more detail was on the PCL and wealth. I guess I was surprised by that, and it sounds like there are two accounts, but there was a sizable increase in impaired loan formations, I guess, related to those two accounts. So I was just wondering, can you give a little more detail and how should we be thinking? Is there more noise to come from this through 2015? Hi, it is Mark here. Certainly, wealth management does have a loan book and a credit book. It is a secured loan book, but as with any credit decisions that you make, there will be times when there will be PCL. Individual customers will have unfortunate sort of situations. I think within wealth management, it is very much more on an individual, very selective type of basis that we would expect to see it. But you cannot rule it out once you have credit decisions. What type of accounts are these? Can you give a little more detail on that? Sure, Doug. It's George here. I would also note, as we did in Mark's remarks, that these relate to our U.S. and international business. They are two clients. I would say they're somewhat related to our restructuring efforts as we exit certain businesses in that area. I agree with Mark. We extend loans. We're quite comfortable with our overall credit strategies within the wealth business. We do see PCL from time to time. This would be at a level that's somewhat elevated compared to our average, but consistent with our risk appetite. It doesn't sound like you're concerned that you're going to see much noise. Is that the proper way to think of it? Certainly, I don't expect to see much noise, but I think it would be wrong for me to suggest we will never see any more ongoing PCL. There will be when you have credit decisions every now and then it will go up and down. We believe this is a secured lending business, and it would be on a very selective basis. Then just if I could follow up. The Canadian operating leverage was, I guess, zero. It sounds like from your comments and remarks that you're comfortable you can get some operating leverage the remainder of this year. Can you talk a bit about what you expect from an operating leverage through this year, and what levers do you think you can pull on the expense side, if there are levers? Can you talk a bit about that? Thanks. Sure. Thanks. It's Jennifer, Doug. We remain committed to managing the trajectory of our expense growth against revenue growth as we did this quarter to continue to target operating leverage in the 1%-2% range and continuing to drive our efficiency ratio lower as well. As Janice said, our outlook is that our operating leverage should continue to improve throughout the year. We have a number of levers that we employ, including carefully managing attrition, combining roles, focusing, as Dave mentioned, on digitizing our processes and improving overall operational effectiveness. An example is we've grown our business by over 40% since 2009, but our headcount is down over the same period. In fact, over the past 12 months, our headcount is down over 600. We're quite comfortable that we have the levers that we can pull, but we're continuing to look for other opportunities to make sure that we adjust as margins continue to be under pressure. Great. Thank you. Thank you. The following question is from Steve Theriault from Bank of America Merrill Lynch. Please go ahead. Thanks very much. First, just a quick follow-up to Doug's question. The two clients, are they in the same geography? I ask because last time we saw any credit issues in the division, I think it was a stop loss or an absence of stop loss issue in Asia. Is it something similar? Or as you suggested, does it have more to do with exiting certain areas? They're not in Asia. They're both related to the Caribbean business because we're exiting down there. Okay. That's helpful. Then for Janice, I just want to ask on the hedging side the CAD 41 million that you mentioned in your roadmap as the year-on-year lift in from FX. I just want to confirm that's after hedging and wondering if the Canadian dollar remains unchanged if that impact increases next quarter. I guess I just want to be clear on whether the hedging comes into the P&L all at once or more slowly. If you could elaborate if you're suggesting that you might undertake some hedging to protect versus the downside, what's the implication there? Steve, all of the hedging comes in through other comprehensive income, so it doesn't hit the P&L. We actually hedge some of our U.S. dollar investments so that they are investments in subsidiaries. That would be all coming in through foreign currency translation. The actual underlying would convert, and the mark to market on the hedge also goes through other comprehensive income. That's where all the activity is. If you look at the roadmap and you see the impact on capital and basis points, that's why we're sizing it that way because none of that hedging is going through income. But in the roadmap, did you not point out CAD 41 million that does drop to the bottom line from the- Oh, you mean Oh, I'm sorry. You were talking about the CAD 41 million in earnings. That's strictly foreign currency translation on earnings. So there's no hedging offset to that number? No. So that won't necessarily rise next quarter. There's no sort of smoothing in on that number. Right. Because we do not hedge our future earnings. That is strictly translation as we earn it, then translate it to CAD. We only hedge our equity. Okay. Just while I have you then, your 23% to 25% tax rate that you mentioned, is it fair that that is a couple of hundred basis points higher at either end on a TEB basis, or were you speaking to a TEB basis? That would be as reported, so it is on a TEB basis because it is at the enterprise level. With TEB, it is in the capital market segment, but then it comes out in corporate support. So I am talking about the enterprise effective tax rate. Okay. Thanks for that. Okay. Thank you. The following question is from Meny Grauman from Cormark Securities. Please go ahead. Hi, good morning. Question about the Caribbean. Saw an improvement there, and I'm wondering how much of it is related to changes on the ground. Are you seeing the actual economies improve or stabilize, or is it really just a function of your company specific initiatives coming to fruition? Hi, Manny. It's Jennifer. I would say we're very pleased with the results this quarter. I'd say that there is still a challenging economic environment, but we're hoping that with the improvement in the U.S. economy, they'll benefit from an increase in tourism. Our results clearly are demonstrating that our focus on strengthening our overall business performance over the past several years through quality asset growth, pricing strategies, and obviously, dramatic efficiency management initiatives have really translated into our improved performance. Just another question going to the Capital Markets business. Definitely noticing the growth in U.S. revenue being much stronger than Canada. I'm wondering, as you look out into the future, into the rest of 2015, how do you contrast the different growth expectations in Capital Markets, specifically between Canada and the United States? The Canadian business is actually holding up pretty well. We recently led a large deal for Cenovus, and I think there'll be probably reasonable activity in Alberta, which has a big impact on the Canadian investment banking business. The loan book in Canada has been growing at a much slower rate than in the U.S. because it was largely built out several years ago. I think that you'll continue to see more growth in revenue and earnings, certainly through this year and in the foreseeable future because we are continuing to acquire new clients and get better leverage with clients we've recently acquired. We have significantly more revenue in the U.S. than we do in Canada now, and we have a loan book that's 50% bigger in the U.S. than in Canada. I would expect we're going to see continued growth in the U.S. and probably at a greater pace than Canada. Thank you. Thank you. The following question is from Sohrab Movahedi from BMO Capital Markets. Please go ahead. Okay. Thank you. Just a couple of questions. Mark, when you do the stress testing on the portfolio, what sort of unemployment rate do you assume in Canada? Thank you. When we do stress testing, of course, we do multiple stress tests. It's not individual. It's not just one stress test. Some of our stress tests have unemployment actually as staying where it is. Others do have it going up. One that comes to mind has it going up by close to 2%. Another one has it going up by close to 3%, and another has it staying flat. Our job is to do multiple stress trying to understand how the combination of various economic effects would have on our portfolio. Okay. When you think about your internal risk ratings of corporate borrowers in particular, are you seeing any negative migration? At this point in time, no, we have not. As I think I might have reported on the previous call, we have done stress tests, and we have put some of our onto our watch list. But in terms of actual risk ratings, we have not seen that impact. We're really, I think, being at this point cautious. Needless to say there are companies that we're working with because we foresee the next coming months could be a challenge for them if oil prices don't go up. But at this point, the portfolio is very stable. The watch list is stable? We have not added anything since we did the last stress test. Okay. Thank you. And maybe just quickly for Janice. Janice, I know you said about 50% of the balance sheet is in USD. There has been some increases in the asset levels. The one that kind of stood out was the derivatives balances are quite a bit higher. Any color around that? You will notice that both the DRA and DRL blew out, and half of that is related to FX, and the other half would be the market volatility, so spreads widening on the same contracts. Okay. It's both of those aspects, both market-driven. Okay. Thank you very much. Okay. Thank you. The following question is from Mario Mendonca from TD Securities. Please go ahead. Good morning. A question from our queue. You use the adjective manageable, and you described that the losses based on your stress tests are within the risk appetite, but those adjectives aren't as meaningful as they need to be for the purposes of our analysis. Can you help me think through what does manageable mean? I suspect it means that Royal's capital certainly doesn't become impaired. That would be an obvious statement, correct? Yes. Does the bank stay profitable? Yes. What does manageable mean? Just like a 20%-30% decline in earnings, or does it mean that the bank's earnings growth just becomes very modest? The way I think of it anyway, which is why I put manageable and risk appetite in the same sentence, is, as we previously said, our over the cycle risk appetite for PCL would be 40-50 basis points. Currently, we're at 24. So in any of the stress scenarios, we would stay within that outlook. That's very helpful. The unemployment scenarios you gave us the 0-300 basis points, and you stay within that 40-50. And then on real estate, you also said that your stress tests include something to do with real estate. What are we referring to there? A 20% decline in home values? Is that a reasonable thing to put into the stress test? We have some at 10, we have some at 20, we have some at 25. That's very helpful. If we could just move on to Capital Markets, the equity trading numbers were very strong, and certainly I know this isn't the cash equities because that's the business I'm in. And we saw this at BMO as well. What's going on in equity trading? Presumably it's derivatives. Could you add some color there? Yeah, I can. It's Doug. The equity numbers benefited from a number of things. First, there's some FX because we're bigger in the U.S. than we are in Canada. The second thing is you're correct that the equity volatility trading and trading around convertibles and call spread trading was profitable as well. As a business, we've just gotten better at and more active in as we lead more convertible transactions in the U.S. But I would say overall as well, that has cash equities in it. And the cash equities business has been good with the volatility both here and in the U.S., and we're growing our business in Europe. So it's a combination of all those things. While I've got you, there have been periods in the past when interest rate volatility, like the interest rate volatility we saw this quarter, caused client activity to really just go away and caused Royal to report weak trading quarters. What was different about this quarter that would have led to more client activity from all this interest rate volatility? I think the period you are referring to most recently is the credit spread blowout and a drop in rates in the last quarter of last year. I think this quarter, the moves weren't as violent, frankly, and they were persistent, and it really as the quarter migrated, we saw a tightening of credit and just an improvement in trading conditions. I do not know that I can put it in any other way. That's helpful. Thank you. Thank you. The following question is from Sumit Malhotra from Scotia Capital. Please go ahead. Thank you. Good morning. My first question is for Jennifer Tory, and it relates to fee income in Canadian banking. Even if I adjust for the, I will term it the back and forth that you had between the net interest income and fee income line in Q4, it still seemed like you had a decent sequential increase in the fee income line, which obviously helped the result this quarter. There was some mention in the report to shareholders about mutual fund distribution fees and then specifically card revenues. We have heard some different comments on that line thus far this quarter, and I was just hoping you could give me some more color on what drove a relatively strong card service revenue trend for you in Q1. Thank you for the question, Sumit. We're continuing to have a strong performance in our card business, strong client activity, and strong new card acquisition. The strong fee-based revenue does continue to come from our credit card business and the client activity as well as continued strong performance in our mutual fund business. It is still those two that are the major contributors to the performance and frankly, our cross-sell that we're continuing to drive through those products and services to continue to drive our fee-based income. Jennifer, if I stay with you or maybe to tag in Dave here. Dave, you've certainly been vocal about some of the offsets that the bank has available to it in advance of the interchange implementation or fee reduction implementation that's due to come in in April. Can you talk to us about whether some of those offsets have already been put in place, or is that something that you're holding off on until we get closer to that time? It's Jennifer, Sumit. We have a playbook that we put together of various options that we can employ, and at this point, we're still looking at which ones, if any, we want to move forward with. The changes don't take place until later in April, and so at that time, we'll look at the situation around our interchange revenue and make our decision. The strong results you're seeing in cards don't reflect changes that we've made to offset the potential impact from reduced interchange. I shouldn't necessarily look at the aggregate revenue growth in the segment this quarter and say there's definitely a decline because of interchange since there may be offsets that you can bring forth. Yeah. Well, I think what we're saying is there's nothing we've employed at this point that has driven that improved revenue growth. Yes. All right. Going forward. Some of our competitors appear to have moved on. Already interest rates and punitive pricing and things like that. But we've not moved on any front at this stage. That's helpful. Then one very quick one for Janice, hopefully a quick one, a numbers question. In regards to City National, I know I have my estimate, and you can probably back into some of the statements you've given, but have you provided, and I don't think you have you provided a pro forma estimate of what the acquisition's impact is on CET1? Just to get the ball rolling, if I say in the ballpark of 90 basis points, is that a reasonable estimate? Well, we haven't provided a pro forma estimate, but when you look at the purchase price, I think a good way to look at it is half of the price is paid with shares, and that will underpin our investments in goodwill. Then we bring their balance sheet on. If you look at their balance sheet, I think it's about 2 billion-3 billion of RWA, just a rough estimate. That's what we're building towards in terms of the internal capital generation to be able to accommodate that. All right. I think we're going about it the same way, but I might follow up with you offline. Thanks for your time. Okay. Thanks. Thank you. The following question is from Gabriel Dechaine from Canaccord Genuity. Please go ahead. Oh, just had a quick follow-up on the trading, kind of similar to Mario's, I guess. But in the past, you've flagged some outsized trades that benefited your trading results in any given quarter. Were there any of those this time around, or is that just simply volume? I would say that there's no trades like the one we flagged previously. As I said earlier, we did have some good results trading some convertible call spreads. But I'm reluctant to tell you it won't persist. Given the volatility in the markets around equities, that part of the business is just performing quite well. Yeah. There was one of your big U.S. peers that made some positive comments on February. Is that consistent with what you're seeing, then? The business continues to be good. Okay. Thank you. Thank you. That is all the time we have for questions today. I would like to return the meeting to Mr. McKay. Thank you. Before we end the call, I'd like to reiterate how pleased we are with our record first quarter results. While the industry faces some headwinds, as I noted in my earlier remarks, there are a number of reasons why I'm confident that the RBC franchise is strong and well-positioned to manage through this environment and continue delivering long-term value to our shareholders. Thank you, everyone, for joining us, and have a nice day. Thank you. That concludes today's conference call. Please disconnect your lines at this time, and we thank you for your participation.