Scotiabank Financials Summit

Sep 9, 2020

My next guest is Mr. Dave McKay, President and Chief Executive Officer of the Royal Bank of Canada. Good morning, Dave. Morning, Meny. How you doing? Good. Thanks for being here. Our first virtual conference. I haven't worn a jacket in six months, so special occasion. It feels good. It does. I thought I would start with a strategy question. In Q3, we saw the diversified business model of Royal Bank really deliver, and deliver in spades, I would argue. Can you just remind us on what drives that and the strategy specifically for your three largest divisions? Yeah. No, we are very proud of our core growth and our franchise. Notwithstanding we are in a low rate environment and margins have been impacted, I think what is most important is our customer acquisition and our organic growth across all our platforms, capital markets, retail Canada, and wealth management globally. So very strong momentum. It is the result of years of investment in technology and capabilities that are transforming our ability to serve clients and acquire clients for investment and ventures. Our strategy has played out quite well, and we will continue to invest in the strategy of creating more value for customers. That value creation comes across two key dimensions in a matrix, I like to call it. We are creating more value horizontally across our customer base, across mortgages, across investments, across lending products, cash management. The reciprocity and the scale that we can bring in the value creation across the horizontal has really driven an outperformance on cross-sell, which drives an outperformance on ROEs. Recently, you've heard me talk many times on not every investor call and investor meeting about vertical value we're creating within each of our core franchises, whether it's extending the value proposition within the mortgage business vertically and getting into Home Search, into facilitating home moves, and facilitating the home ownership experience, and creating an elongated value chain to acquire more customers. That's working very well for us. We do the same thing in small business, in auto, and in our core everyday banking franchise. We've invested in value, we've invested in technology, we've invested in ventures across both of those dimensions. I think as you look going forward, we've continued to create more capabilities that will deliver future value. We feel very good about our coming launches in our core banking area, which will provide more value to customers and continue to, we think, accelerate our core organic growth performance. So very, very happy with where we are today, how we've come through the first six months, the amount of activity we've seen at the customer level, our core service levels, our customer satisfaction numbers are very strong through the cycle, strongest in the industry, and we just received those a week ago. Therefore, we feel we're very well positioned to continue and accelerate the organic growth that we see. In terms of that vertical strategy that you're talking about, is that just RBC Ventures or are there other aspects to that sort of vertical value chain that you talked to? No, certainly it's throughout all our partnerships and all our businesses, whether it's the credit card business, the ventures supporting mortgages and small business, our activity levels within our product groups. We are looking to create more value for our customers horizontally and vertically. Therefore, ventures has been a big part of that story, and it's really starting to click. We have over 4 million new venture relationships now. We targeted 5 million in our investor day a couple of years ago, so we're well on our way to proving that we can attract a new connection and create value for those customers. Now we're integrating those ventures into our end-to-end processes. We revamped those processes. I think from that perspective, we are well on the program that we set about. I think, with the disruption that you are seeing in the industry, the strategy becomes ever more critical to create more value across both of those dimensions. It requires scale and innovation in technology and investment in partnerships to create that value. I think from that perspective on the retail bank, you are certainly seeing it. I think through the pandemic crisis, we have seen our wealth management platform continue to connect with customers, use technology, use the expertise of our asset management team, of our advisors, whether it is in the U.S. or Canada, to create value. We acquired a significant number of new clients in the U.S. through our execution of the PPP program. In the U.S., over 1,500 core commercial high-net-worth customers came into the franchise just on our ability to execute around PPP and meet customer needs where our competitors couldn't. I think that was a secular moment in the crisis that allowed us to accelerate our organic growth. We are seeing strong traction in the investments in our geographic expansion into new markets like New York and Washington, expansion in California. The investments we have made in capacity and in capability, whether it is digital or physical, have all played into that core franchise growth that was really on display in the last 2 quarters in particular. I want to talk more about that and kind of make it into a discussion of expenses and also technology. You mentioned technology a few times. But maybe first starting on the expense side and maybe first talking about the US wealth management business. Pardon me. Clearly, there are a lot of reports, and you are talking about it as well in terms of hiring teams of wealth managers and private bankers, and I assume that doesn't come cheap in the U.S. The question is, first of all, is this just a spending game? When you win these teams and when you win these people, are you just outbidding your peers in the U.S. or is there more to it than that, more to the strategy than that? There are different strategies depending on the franchise. When you look at City National Bank and lifting out core teams on the commercial banking side or on the private banking side, they are attracted by the holistic ability to build one team without divisional barriers around the customer. That is our core value proposition to talent coming into the platform. That they are coming from large organizations that have very strict divisional lines between commercial banking, private banking. Even within commercial banking, asset teams are all built on pretty stringent hierarchies that the people that are joining us, the experts and the professionals feel it inhibits their ability to really serve a customer. What we are offering them through City National is a holistic ability to bring a team around a customer segment or a customer group. To operate, they feel, and we feel, and proven at customer satisfaction level, in a much more customer-friendly, quick to respond, less hierarchical way. On the City National side, that is the value proposition to a core commercial banker and/or a core private banker, wealth manager coming onto the platform. It has worked exceptionally well and has helped us accelerate our growth in our current markets and new markets. When you are talking about our wealth management advisory platform, our broker platform, US wealth management out of Minneapolis and the advisors we have there, yes, we are bringing advisors in from larger teams, again, from larger franchises. The top 2 or 3 or 4 franchises. There has been some publicity around some of the larger banks as well. Again, it is their view of our investment in core technology to the smaller, kind of familiar organization ability to be more responsive to the customer with less bureaucracy. For all the reasons there is a standard kind of market compensation model for acquiring an advisor. When we look at the grids in the U.S., we do pay a little bit at the higher end of the grid in the United States on the compensation per trade revenue stream. So we have to do that as a smaller player. We are seventh largest in the U.S. market on the advisory side. So we pay a little bit higher on the grid there, but we have been paying higher on the grid for well over a decade or more, and smaller players have to do that. You see the reverse in Canada. We pay lower on the grid in Canada because of the franchise strength that we bring, and others have to pay higher. So it is expected, and that has been consistent. So that is the value proposition, a little bit higher pay in the grid, smaller, quicker organization, more familiar ability to partner with City National. That is the value prop, and it is working, and we watch ROEs very carefully and return to the shareholder when we are bringing these teams in. In terms of the Canadian banking business, you talked about the strategy there at a high level. Clearly, it is working. If you look at above peer growth, loan growth, above peer growth, or really at the top end in terms of loan growth and in terms of deposit growth. The question, first of all, is just how do you have confidence that you can continue to basically perform at that level? At the scale that you are at, it seems really remarkable that something like that can continue, and to what do you ascribe that to? Then on the expense side, in Q3, we saw some higher expenses coming out of the Canadian banking business. Is what we are seeing in terms of the top line partly being driven by higher expenses? Do you need higher expenses in order to get those kinds of results? Are you happy with that trade-off? We think there's two things going on. One, there's absolutely a higher activity level in our organization. We're seeing significant mortgage growth and market share gain. We're seeing significant deposit activity and core banking activity. We're seeing significant commercial deposit gains where these are businesses we focused on. They're high ROE businesses. They're core to the relationship in the long term, and we put our effort there. Our expense levels are running higher because of those activity levels. We're also seeing temporary higher cost levels because of the adjustments we've had to make to the pandemic. Whether it's work from home, maintaining two work premises, the safety and precautions we have to take at the branch level for our employees. There are COVID, the relief we've given to consumers around their payments. All that has led to a short-term increase, we believe, in our cost levels. There is a third component that we will reduce, and we will have to manage down. So we're very conscious of the low rate environment that we're operating in, trying to manage our expenses very carefully, focus on expenses that are supporting expenses that are driving core growth. Whether it's bringing a new advisor in that you have hiring a new manager or some of our expense growth is just compensation in our direct drive businesses that have done very well, whether it's capital markets or our wealth franchise. So that is positive and that we're driving revenue and compensation generally follows that. So we're very conscious of managing costs. We have a number of programs to offset some of the cost increases in a low rate environment, still supporting that growth. We expect to continue, back to your core question, we're continuing to invest in that growth, bringing more leaders onto the franchise as far as Investment associates, advisors here in Canada continue to plan for that, continue to upskill and hire in our investment banking space, which has performed exceptionally well for us now through this cycle, continuing to bring in more private bankers in the U.S. So we will invest in core growth there, and we expect that to continue to drive. It's our technology investments that have really helped us perform really well, simplifying our business, allowing customers to transact with us with greater ease, being able to fulfill and change requests. Building the support network for all the government programs, all the technology investment allowed it to make it easier for our customers to access the government programs both in the U.S. and Canada. Led to high customer satisfaction levels that we have and gave us the right to cross-sell and the right to acquire more. It all comes together in that holistic service and that technology platform. Investment and capacity has really driven the performance we have. We continue to invest in that. We expect that to continue to grow. In addition to that, we are investing in more value for our customers. As I said horizontally across that relationship, we expect to increase that customer quotient with our partners and therefore that will help our cross-sell and help our ROEs. That will come this fall, a major redesign and relaunch. We have more customer value, more opportunities for customers to join us, greater integration of our ventures. We have more coming to the customer because of our scale that we think will continue the growth trajectory, enhance the growth trajectory. We have earned that right because of how well we perform with the customer over the crisis. David, I want to talk more about technology. You mentioned it a lot and not by coincidence. First something more high level. Earlier in the year when Shopify passed RBC as the largest market cap company in Canada, and we will see how long that lasts, but in your response, you wrote, "We are rooting for them," and you went on to say, "I am always proud when a Canadian company becomes a category hero." Why are you rooting for them, and can you explain why you are happy when another company surpasses your company in terms of market cap? Yeah. It is good for Canada. It does not hurt RBC. It does not hurt the RBC shareholder in any sense that someone in another sector is successful. Our country needs category heroes. We have seen the benefit of a RIM and the offshoots and innovation and new company formations and wealth creation within our country. We need more Shopifys and more RIMS. We are incredibly proud of what Shopify has done as Canadians. Second, it comes from the confidence in our own business model and our own position and how we are going to fend against disruptive platforms that are coming at us who do want to participate in the payments business in particular. So it's a reflection of our own inner confidence in that value creation for customers and our strategy and our scale and our brand and the trust in our organization to be successful not only against traditional competitors, which we've been very successful against, but against the new competitive group coming out of the platform space. And our strategy is very clear. Yeah, sorry, go ahead. No, that's really what I wanted to get at, that Shopify is not just another company, but clearly a company that could pose a threat to RBC down the line. They've already started a loan program, sort of a merchant account program. So how do you view that particular threat? And then more broadly, across the landscape of tech companies and fintech companies, how does RBC compete effectively against these upstarts? Right. I think that we put fintechs into a couple of categories. One, the category where you're a monoline and you're relying on price discounts to acquire customers, and you're losing money, and the promise of future cross-sell to make money. Those competitors are diminishing in their threat level. And you're seeing a number get into trouble in Europe, where investors aren't willing to continue to fund losses against that business model. Now, where the competitive set we're mostly focused on is where a platform is able to create the space for a value exchange in the economy. And the banks have always invested a significant amount of capital and have curated the platforms, whether it's moving cash in society or making credit card payments or online payments. We've created the infrastructure to enable a buyer and seller to exchange value and financial value to go with it. And in the future, you're looking at platforms who are now creating capabilities for value exchange, and we're going to have to plug into that. So how does a bank build a strategy for this new era of platform effects, Shopify included? It comes back to that grid I talked about. You have to lever your scale. I think scale becomes the most important. Operating scale and data scale become incredibly important. And that scale allows you to build reciprocal value and relationship scale. So as you bundle value, as you create capabilities for customers horizontally, as I talked about across mortgages, credit cards, deposits, investments, secured and unsecured lending, as you create reciprocal value for the greater the relationship, it becomes harder to pull that apart and there's a different value proposition for your customer. Horizontal breadth of relationship becomes a play, operating scale to create and absorb margin impacts as you price differently against a new competitor set becomes really important, which is our core strength. The second thing you have to do is you have to compete head-on in creating that vertical scale I talked about before. Within a mortgage segment, within a core deposit and payments product segment, how are you creating value upstream to compete with the incumbents? In the small business spaces you talked about, and if we look at Shopify specifically, some of our ventures that we have launched, whether it is helping businesses register and create their companies, create their brand, manage their books through Wave, use our data to help them understand their customer set and the marketplace through our ventures. We have built a whole series of ventures that create a very similar model to Shopify in the retail sector and to Lightspeed that create ancillary value upstream and downstream that allow us to be a more expansive player in that value creation space and defends our financial franchise from potential disruptive play. It is the vertical and the horizontal play with scale, with brand, with technology, with ventures, makes us feel confident that we will have a role to play in that new ecosystem. A point-of-sale play, the way they are being constructed, will be hard to pull our customer away from those horizontal and vertical attachments that they have. It is very important to continue to evolve that and build that, which is why we are enhancing both the horizontal and vertical value creation for each of our customer groups. That is the core strategy that allows us to maintain a relevancy. We use our margin to do that, our technology scale and business scale, and our brand, and the trust in our organization to compete in the long term. I think for us, we feel really good about where we are. The road that we are on, the strategies that we are pursuing maintains a relevancy and a competitive business model going forward. That is really fascinating. I wanted to talk about that strategy in the context of capital deployment specifically. If I was listening to you and I was a banker, I would want to give you a call right away. The question is, are you in the business of, or are you thinking about deploying a large amount of capital or large amounts of capital in pushing this strategy forward, in buying a fintech and buying some capability? It strikes me that the venture strategy is a good one, but it is relatively, especially for the scale of your bank, very relatively small investments. Are you getting closer to the point where you would consider pulling the trigger on something much larger? I do not know if you would call it transformational, but a significant amount of capital in one of these tech platforms or one of these kinds of strategies. The learnings that we've had over the last three years running our venture are incredibly important and a core part of our, we call our secret sauce. What we've learned is it's fairly easy to scale a venture into their core space of acquiring relationships and acquiring users. What is more difficult is embedding that venture into the overall value chain of your financial services company. It's how we take Ownr, and we build Ownr into the overall value chain of a small business. How we take Home Search and OJO into the overall value chain of our mortgage. How we take the mortgage concierge business and embed it into the mortgage. So where the secret sauce really comes in is how you embed it and how you get cross-sell and financial relationships and banking relationships from your ventures. Therefore, we've tended to make, whether it's FilmTrack in the U.S. or OJO and others, we've tended to make smaller ventures investments because we have to prove the hypothesis of conversion first. Therefore, if you are about to make a large acquisition and significant capital of a venture that has not proven the cross-sell, you're taking on a significant amount of risk. Therefore, we would have to be more sure-footed around the conversion opportunity and what role it's going to play in the overall ecosystem. We've shown already that we can take a small venture and scale it to 4 million pretty quickly. That's not the hard part. So the hard part is the integration and conversion. I would say we are on the lookout for all types of opportunities. I wouldn't preclude it, but I say it's lower probability because of the risks you take on and overall monetization of the opportunity into a core banking relationship. We've already shown that we can do the first part that they've done quite well ourselves. It's the overall integration that becomes more important. Therefore, we think we have the right strategy right now of self-curation and acquisition of smaller ventures, scaling them and integrating them into our overall value chain is probably the faster and smarter and has a much higher financial return. But if a platform comes along where we have significant confidence in the integration and conversion and it can really accelerate a North American strategy, we would consider it. Have you seen a platform like that? Obviously, you're not going to name any names, but have you seen anything out there that sort of matches that description in any shape or form? We've seen a couple, and they traded recently. They've merged and integrated as challengers versus being acquired by a traditional bank at exorbitant prices at the end of the day. The price points would have scared us off initially, but they chose to partner with another non-traditional competitor versus with a traditional competitor. Yes, there are models out there that have proven that they can integrate. A few, not many, and they continue to grow through merger. I wanted to go back maybe not quite to expenses, but it's related. I think we came through Q3 a lot more comfortable about credit. Certainly capital as well, and that was already a process that we saw in Q2. I think the reason expenses have come to the forefront so much is because when we look out into 2021 and frankly even 2022, it's hard to make a case for a very robust revenue growth environment, either in Canada or in the U.S. I'm wondering whether you would agree with that assessment. How cloudy is the future in order to even be able to make such a statement? Your view on the outlook for revenue growth next year and the year after. Certainly, the interest rate environment provides the largest year-over-year headwind in revenue growth. Having said that, quarter-over-quarter now, we think we've absorbed the biggest part of the margin compression in the U.S., which was quite significant as you saw in our City National franchise, which is growing organically very well. The Canadian Bank will see some small margin compression. We've seen, I think, the majority of that margin compression, quarter-over-quarter. Still the year-over-year impacts in the first part of next year are still to happen from the significant decrease in central bank rates. Yes, we are facing kind of the shorter term headwinds to absorb that. That's offset by the significant volume growth and market share that we've seen. We're quite happy with some of the margins we're seeing in the new business coming on. We're repricing our back book as it renews. I think we're absorbing all of that, and that, as I said, will have the type of margin impact slow in the U.S. a little bit, more in Canada, but not nearly what we've seen before. Revenue growth will be compressed as far and impacted by the activity of clients in capital markets on the trading side and on the advisory side. We expect to see some renewed activity in advisory M&A and on the equity side. Certainly, maybe not what we've seen historically. Markets are very important to our non-interest income and our fee-based business and wealth management, and we'll see how markets perform over time. These are all kind of external drivers of overall revenue growth on non-interest income and interest income that we're building scenarios around. Net-net, I think you have to expect a challenging environment. Therefore, we are very conscious of managing our costs, focusing on those opportunities that drive the growth that you're seeing, continue the organic growth, and focusing on those activities that are critical to the long-term franchise value and building a franchise that competes with traditional and non-traditional competitors. I think all investors would encourage us to continue to invest in that, which we have, and that's what we're focused on. We will have to cut costs in areas that aren't core to our regulatory long-term competitiveness, short-term growth aspirations, and prudence of managing the platform. I'm curious, taking that a little bit further in terms of sitting at the top of a very large organization with so much uncertainty, how do you make investment decisions right now? How do you make a go, no-go decision when you don't really know what the outlook is, but you know that belt-tightening is probably reasonable? What kind of metrics do you look at? How do you trade off short-term versus long-term considerations? Yeah. We've constituted some new forums now that I chair, that I'm getting more involved in the overall trade-off decisions as I have to be, both between businesses and functions. It certainly requires my involvement to make some final decisions on that. So we've got new committees, so I'm spending more time on that myself personally because it's so important to the organization. So we have processes where we're all around the table. We agree on our mission and where we're going. We agree on our objectives, and we're trying to find balance. I think we've got a really strong team. It's a lot of talking at the end of the day, and the metrics are clear. What's the trajectory of benefits? Does this enhance the long-term franchise value? What are the risks of execution? All the same things that you think you would expect to hear in trying to find that value. It's really challenging. Does this really move the needle? Maybe we would have liked to do this in the past, we just can't afford to do this right now. We've invested in so much technology, and that we have a lead there that we have some flexibility, I think, to pause on certain things and slow things down that maybe others don't. We have the scale to absorb regulatory change within our spending envelope of 5+ billion CAD a year that others may not. So I think this is where scale really comes into play and helps us meet all the objectives of regulatory change, risk management of the organization, growth objectives, long-term enhancement of the franchise, adjusting to COVID. All that we have to balance, and scale really helps us. We are coming close to the end. I just thought I would throw in one more question on credit because how could we not? I think you will maybe appreciate that I am not going to ask you about deferrals, but I wanted to ask actually a bigger. I am ready to talk about them. A bigger picture question really about public policy, and I think you are in an important position to be able to opine on that, and that is really how do we balance support, which we see is clearly working. Government support clearly is working in this situation. How do we balance that with the need to get back to normal to get the economy on track? What is your perspective on that in terms of finding that balance, especially at this stage when we have come through the lockdown and we are opening up the economy, we are opening up schools? There's a couple dimensions at play. I think the size and the speed of the programs that we saw from the federal government were needed back in March and April, and they were well played. I think they really helped Canada perform so far quite well through this crisis. What we've seen, though, is that some of that taxpayer support program, whether it's CERB or wage subsidy, has ended up in the accounts and hasn't circulated through the economy, just because of two things. One, consumers are concerned about their financial situation and their jobs and therefore are more conservative and therefore have built actually some liquidity and absorption of future potential scenarios. So they're sitting on cash, and those cash resides, and you've seen it in the growth in our deposit balances. Two, they can't spend it because the sectors that they would've spent it on are closed or have restricted capacity. Restaurants, travel, gyms, spas, whatever it happens to be, those services that require proximity of contact and are COVID impacted haven't come back, and therefore, the ability to spend and the desire to spend are impacted by everything. I think when you're crafting the next generation of policy, to your question, you have to recognize that there's still stimulus embedded in the savings accounts that can get circulated through the economy that hasn't been spent yet. So that's good news. There's dry powder on the balance sheets of businesses and of consumers to absorb credit shock and to act as a buffer for us, but also to stimulate the economy. The second round of stimulus has to really focus on those sectors and those individuals that have a prolonged impact, I think from the crisis and the uncertainty. Again, it's those service industries that require proximity, that have capacity restrictions or are closed, that will have volatility to them. You know all the sectors. A wage subsidy program and a derivative of wage subsidy is really important. I talked to a number of restaurant owners over the last month that aren't at capacity, and wage subsidy helps keep them going, helps keep their employees engaged, helps them meet their operating costs, or they would have to close. I think whether it's a gym, a dry cleaner, a restaurant, those sort of travel-oriented services that could take some time to come back, we have to bridge that for the health of the economy, and we have to bridge those individuals to some extent, and therefore, we need a more focused policy, maybe not of the same magnitude, recognizing that we have some stimulus still to be spent and some more targeted approaches. I think that would be my recommendation. The third thing we need is we need incentives on taxes. We can't raise taxes. That would affect capital investment and growth. In the long term, I would expect something like the HST, GST to go up, PST, to recoup some of that. But in the short term, we need to stimulate that spend and to continue to encourage capital investment in our economy. It's a tricky balance as we continue to bridge this for time, but those are some of the policies that I would expect to hear more about from the government as we move forward into the throne speech and into the new year. Great. With that, Dave, I want to thank you very much for speaking to me today, and have a good day. Thank you very much. I appreciate the invitation. Good luck with the conference. Thank you. Bye.