Morgan Stanley Financials Conference 2013

Jun 12, 2013

Hi, good morning. I'm Cheryl Pate. I cover the Canadian banks here at Morgan Stanley, and it's my pleasure to welcome Royal Bank of Canada to our conference today. We're going to be doing a fireside chat for our presentation here. With me today is Janice Fukakusa, RBC's Chief Financial Officer and Chief Administrative Officer. As a member of RBC's group executive, she is one of nine executives responsible for setting the overall strategic direction for RBC. Janice joined RBC in 1985 and has held various positions in retail and business banking, corporate banking, account management, corporate finance, treasury, strategic development, and other corporate functions. Prior to her current role, Janice was Executive Vice President of Finance. We're going to kick it off with a polling question today. The question is: what do you think the key driver to RBC's stock in the current environment is in your view? Is it more dependent on the Canadian housing and economy, capital markets, execution on efficiency initiatives, or other? We'll leave the polling open for about 10 more seconds here. We'll pull up the results. Overwhelmingly, the state of the economy and housing market in Canada is top of mind. With that, I think we'll start off focusing on Canadian banking. That's a good idea. Great. Janice, thank you for joining me today. Why don't we go ahead and kick it off with a topic that's on everybody's mind, and maybe you can help us think about how you're thinking about consumer leverage and the housing market, maybe on the industry level, and then we can talk about RBC specifically. Right. Okay, great. Thanks, Cheryl, and thanks for having me today. I think that the Canadian economy is very topical for all of us. When you look at the Canadian economy, the Canadian economy is still growing, but of course, the GDP estimates are coming off. We just had some fabulous employment figures reported last week, which indicated that we had employment growth that was higher than expectations, and mostly in the manufacturing and service sectors. When you look at where the Canadian economy is, there is still fundamental underlying growth there. The growth is slowing, and I think that when you translate that into a lot of what you've heard about the Canadian consumer and what's happening in the housing market, it's pretty relevant to financial services. Definitely there are a lot the Canadian consumer is leveraging up. The levels of leverage have gone up over the past couple of years, and we've had government action in terms of trying to talk the leverage down. We've had heightened scrutiny on underwriting criteria for mortgages, and that is designed to moderate. I think that if you look at what's happening in Canada, there is some moderation. Things like mortgages and housing starts are still growing, but at a slower pace. We see on the business side that for us, our business clients are very liquid. They are not highly leveraged, and they're stepping slowly into the market in terms of investing in productivity and in growth because they absolutely have to do that. There's a lot of pent-up demand, so you see some of our loan balances going up, but a very cautious look. I think that overall, when you look at the Canadian economy vis-à-vis other economies, because of where the U.S. economy is and the influence of it over Canada, the fact that the U.S. economy is showing some green shoots will have a positive impact. If we translate that into the topic of concern, which would be looking at leverage of the consumers and the mortgages and that, I just want to say a few words on that in our particular portfolio. While the consumer leverage is going up, for us, the more relevant metric to look at is debt serviceability. If you look at debt serviceability in our current portfolio, our debt serviceability is about 20%-25%, which is pretty good. Issue, if there is any on any portfolio, would be at the tail risk. The tail risk associated with the borrowers that would have very high debt serviceability, meaning that it could be up to 40%, and then being in the lower wage-earning categories- Right like earning CAD 50,000, CAD 60,000 a year because any sort of systemic shock in terms of interest rates increasing will have an impact on that. That is a category that we monitor extensively. For us, that category of client would be less than 5% in our mortgage portfolio. We also support the underwriting guidelines that have been brought forward in terms of 25-year amortizations and watching the leverage because in those particular categories, there could be some risk. It would not be disruptive to our portfolio, but it would create a dampening impact overall on the environment. I think these are the areas we watch very closely. Right. In terms of your mortgage portfolio, your strategy has been a little bit different than your peers in terms of uninsured mortgages versus insured mortgages. Can you speak to the rationale and how you think about that? Our uninsured ratio is lower than our peers for two reasons. First of all, we have our own proprietary sales force for mortgages. We do not rely on the broker model, and through the brokerage model, you typically get more higher-risk insured mortgages. The second aspect of why we do not have as much insurance has to do with our funding programs. We were first off the mark in setting up our covered bond programs, and we were able to set up our covered bond programs and put uninsured product in there that is actually pretty representative of our portfolio across Canada. We did not see any funding benefit by putting the mortgage insurance wrap or the Canadian government guarantee on our covered bond programs, because we are funding at pretty favorable rates, and we still are. If you take those two factors in, our insured portfolio is generally lower because a lot of the other, or all the other big Canadian banks have used insured mortgages for their covered bond program. Right. And going forward, given that that is not really going to be available, that should sort of change over time. Yes. Yeah. I think that is the case, and with respect to markets like the covered bond market, because it is now a legislative program, which gave our fixed income investors more assurances that the program was there to stay, and it is being administered by the Canadian government, and specifically the mortgage insurance is not available, the Canadian government wrap. The market will become more standalone in terms of the funding. And for us, that is a bit of a funding advantage because we never had insured mortgage. Right. Okay. One question that comes up quite often is in terms of condo exposure and particularly within Toronto and Vancouver. Can you just walk us through your portfolio in terms of exposure and then undrawn commitments? Sure. So our condo exposure on the builder side is pretty small. It's just over CAD 1 billion of exposure because we're generally not a condo lender. If you look at the markets that have always been questioned, it's really the Toronto market. I think if you look at the Vancouver and Lower Mainland, a lot of the development is backing off. So taking the Toronto market, the other sort of exposure I think that you're looking at is in terms of mortgages and mortgage ability, and then the building of the condos. We've seen definitely a slowdown in the Toronto condo market by the builders in terms of putting new production onto market. If you talk to some of them, they are constantly looking at the environment and seeing how many condos are going on and scaling back their programs so that they'll add a year on to the completion date, so that the inventory will be absorbed at a moderate pace. If you look at new households in the Greater Toronto Area, a lot of the growth in new households is through net immigration. The flip side of the condo construction is very little single-family home construction. All of the expansion in terms of housing is in the condo market. So when we look at our own mortgage exposure, because we don't do a lot of condo lending to builders, we don't have a lot of lending on condos to the person who has purchased it and have that commitment. Our focus would be on waiting for the person to develop more of a sustainable payment history and then going in for the renewal, and going in more aggressively at the renewal when the valuation issues are set there, and you have payment history and that sort of thing. So we're pretty comfortable with where we sit and where the condo exposure sits vis-à-vis our mortgage portfolio. Okay. Maybe shifting gears a little bit, we can spend some time talking about credit card. Are there any opportunities that are coming, particularly in the travel card market, given the uncertainty about one of the major renewals at one of your peers? Right. I think that for us, in terms of the card market, it is about the loyalty programs. We have invested quite a bit in our own loyalty program, which has less restrictions or hardly any vis-à-vis the Aeroplan and the Aerogold card in terms of being able to buy travel instantly and with different carriers and that sort of thing. I think that for us, that we look at the opportunities of the uncertain market to really push our own card and our own offering and try to gain even more market share with the uncertainty that is in the market. That would be our posturing on the whole card. Right. We have seen with respect to our cards and our spend that we have grown the business, we have grown balances, and we have grown a lot of the transactional revenue. I think that our strategy is working. Great. In the most recent quarter, we closed the Ally Canada acquisition. Right. Maybe a little bit of an update on how the integration is going, and the competitive landscape on the auto business. The Ally Canada acquisition was, for us, the acquisition of the dealer floor plan financing, and a lot of the dealer's business that took us from a distant third into the top position in that market. We have gained a lot of market share. We have our own back and middle office, so we were able to take the business and run it off our own infrastructure. So there was an efficiency play that's happening on that, and the integration is going well in terms of us looking at our own targets. I think when we discussed the acquisition, we had said that we thought that we could get to a run rate of CAD 120 million on an annual basis, and we're headed in that direction. You saw a lot of one-time costs this quarter. Right. I would say that the competitive environment is fierce because you would expect our competitors to actually respond. We have retained more dealers than originally planned in the original business case that we looked at for the acquisition of Ally, and we are continuing to compete on the basis that the rest of the market is competing, and we're seeing some really good client retention and in fact expansion. So it is a tough competitive market. I would say that because of the fierce competition, we will still deliver our business case, and it may be skewed more towards efficiencies in the short term as the market turmoil settles and as the competitive landscape settles. But I think that early days we're saying that we're really achieving the objectives of vaulting into the first position in market share and leveraging our efficiencies. Great. On the deposit side, have those all been repriced at this point? Actually our strategy was to get all of the depositors to either take on RBC deposits, which were generally, of course, at a lower pricing than the Ally pricing because there was a risk of the impact on our entire deposit base. Right. Or actually paying back the deposits. The surprise for us was that we have been able to, through pretty good client retention and marketing, get about 70% of that base into RBC deposits at our high-interest savings account rate. I think that we're seeing the best of both worlds, where we've been able to retain the deposits and also maintaining our margin on the deposits. Okay, great. Maybe we'll touch on the net interest margin. Okay here. There were a couple one-timers in the margin last quarter, and some of it to do with Ally, obviously. But generally, you've done a very good job of holding the margin compression to pretty minimal levels given the rate environment. So maybe if we think about what are some of the levers still available to you as we continue in this rate environment, and how should we be thinking about that going forward? I think that when you look at net interest margin, there are two factors, competitive pressures and the overall level of interest rates. When you look at the overall level of interest rates, they've been pretty low for two years. So some of the one to two basis points of spread compression you see has to do with the fact that as our mortgage portfolios, for example, are running off because they have a two- to three-year duration, the new product is coming in at a lower spread. So we think that as long as the low interest rate environment is sustained, we'll see some of that activity still happening over the balance of the year. And we also, of course, given where interest rates are today, our balance sheet is positioned for gains if interest rates rise. I think that that's a little bit of a no-brainer given where rates are and that the curve is pretty flat. Yeah. But we actively manage that side. With respect to competitive pressures, we do compete, and if our competitors come out with very aggressive offerings at the margin, we don't generally change our posted rates, but we'll match for our best clients. We've seen a little more discipline in the market in terms of everyone recognizing where interest rates are today. I think that on a net-net basis, when you look at NIM, while there is still some pressure on the downside, I think that as the economic environment stabilizes and as inflation picks up in Canada, it's running at about 2%, that we are seeing some hopes of potentially within the next year, some rising interest rate environment, which will be beneficial not just for our Canadian banking platform, but for a number of our other businesses. Right. And I guess as mortgage is slowing in other parts of the portfolio with perhaps better margins- Yes increase, you have a little bit of a mix shift that- Yeah. I think that you do see some of that mix shift today with respect to the higher proportion of the growth being in business lending. Right. So there is a little bit of that mix shift, and we're constantly monitoring the competitive pressures there. Great. And just touching on the commercial lending, obviously that's been an area where we've seen some good growth. How sustainable is the current level of growth in the commercial portfolio, and how should we think about commercial lending? I think that in the short to midterm, it is sustainable to the extent that a lot of the drawdowns that you saw and a lot of the additional balances, they were going on to really invest in pent-up demand on CapEx. Some of the investment is in productivity. As the economy picks up and we gain more confidence in the economy, you'll have more spending with respect to efficiencies and investments in inventories and that. So I think that we're in a good position because we're showing some good economic figures in terms of getting the confidence levels of the businesses to the point where they're able to invest on a larger scale. And as I said before, they're pretty liquid. Yeah. They have a lot of capacity now in terms of even their bank lines on the outstandings versus the authorized credit to draw down very quickly if they get that confidence. That is another area we are watching. Okay, great. Then let's just touch on efficiency and productivity for a moment. Looking at a low 40% target over the medium term, maybe you can talk about some of the current initiatives underway, and a roadmap on how we get there. That is a great question, Cheryl, and I think a lot of the efficiencies in the retail bank have to do with building for scale. They require investments. It is not just turning off the tap on expenses. If you look at some of the programs we have had, we are redesigning the way that we deliver retail credit by automating a lot of the processes and also making it easier for our salespeople to do less administration. We started investing in this program that we call the Retail Credit Transformation about three years ago. Some of the efficiencies you see are a net-net result of us. It takes a couple of years to do the investment and then gain the efficiency. Some of the efficiencies you see are related to this redesign of how we deliver the product and administer retail credit. Other initiatives are on productivity. We have pretty good metrics around productivity across our network, and because it is so evenly dispersed across Canada, and we are at scale, we are able to move productivity very quickly to the markets where we see some growth and actually move it from markets where we do not see as much growth. There are those initiatives, and that requires a pretty good database infrastructure and daily monitoring in order to make those moves. It is those sorts of productivity initiatives that are changing the way we do things and also improving the efficiency at which we can get at clients that we think are really making the difference. Okay, great. Maybe let us switch gears a little bit and talk about the capital markets business. Maybe we can start with how you are thinking about, obviously, a global business with different capital and regulatory environments in the different areas in which you operate. How are you sort of thinking about the business on the whole, and in particular, ring-fencing of capital in markets like the U.S. and Europe? That's also a good question because I think that when you look at our capital markets business, one of the key risks we manage is regulatory risk. When we look at, for example, here in the U.S., we've had a lot of growth in capital markets. Now 50% of our revenue base comes from the U.S. and comes from the more traditional corporate investment banking. When we look at the potential for ring-fencing of funding and liquidity, what it represents to us is really an extra cost to doing business. So an extra cost of creating liquidity that's not optimized. We run all of our funding and liquidity on a global basis through one program and then allocate it down through the units. With trapped liquidity, we would have to hold more liquidity. For example, if it is the case here in the U.S., that would be an additional cost to doing business. From a capital perspective, we have a lot of capital in the U.S. because all of the proceeds from the sale of our U.S. bank, we never repatriated any of that capital, so that's not a concern for us. But again, it's another friction cost. We think that we are, of course, committed to managing within the new regulatory guidelines as they happen. I think like everyone else, we're watching with interest and trying to influence. The other part of the efficiency play would be that we're setting up a lot more infrastructure around reporting. Okay. Reporting of metrics and that. I think the same holds true for an environment like London and Europe. Got it. Okay. Maybe I'll open it up for questions in the room. Just as a reminder, RBC will not be doing a separate breakout session. Any questions? All right, I'll keep going. Maybe keeping on the capital markets theme, we can spend a little time on trading, which obviously we saw some weaker results out of the U.S. and Europe in the last quarter. Maybe you can give us a sense on sort of how those businesses are trending currently. I think, and you're right, we did see weaker results on trading. I think that one of the things you also saw was with respect to our capital markets platform, not a lot of earnings volatility. Right That was all about how we said we wanted to strategically position. When you look at our trading platforms, they're there to support client flows. Some of the volatility has to do with our fixed income platforms, and we have platforms, of course, in Canada, the U.S., and in Europe. We did not have a lot of trading volume, particularly on the European side, but in other markets. We saw in May that the trading environments were improving, so that was hopeful to us. We continue to retool our fixed income platforms to be more client-centric in terms of looking at the flows there and making sure we're monitoring the risk on the platform. We're hopeful that that environment is improving, but it all depends on what's happening with interest rates. Right Then the macroeconomic environment. But we're also pretty happy about the fact that the strategy is working in terms of retooling around corporate investment banking and more traditional investment banking. Yeah Product and client relationships. Right as opposed to maybe the skewing of being more fixed income and trading focused. Right. Corporate lending has obviously been a big area of focus Yeah and growth. Yeah That has helped. Yeah reduce the volatility of the capital markets business. Yeah. Maybe if we talk about capital management for a minute. Obviously, we saw the resumption of the share buyback this quarter. How should we think about buybacks sort of in the context that you're over 9% on on a Basel III Common Equity Tier 1 basis? And maybe we can talk about sort of how you think about the buyback in conjunction with the dividend and Right organic and Right potential acquisition opportunities. It is really great to be in a position to look at capital management again like that. When we look at our capital position, first and foremost, we fund organic growth. Absolutely, at the margin, we fund all the organic growth that we can get because it is very high ROE business. Right. It just makes sense for us. So you will see a lot of the growth we are reinvesting in the market. Then we believe that we need to pay back our shareholders. If you look at dividends, being a Canadian bank, dividends were sacrosanct, and we used to have a regular environment of increasing our dividends every year. We stopped that during the financial crisis, and we have had, I think, four dividend increases since then. We believe we should be growing our dividends at the same rate of growth as our EPS. So when you look at that and look at our trajectories on EPS, and the fact that we are sitting pretty much in the middle of our dividend payout ratio of 40%-50%, that is where we hope our long-term strategy will be with respect to the dividend. Then because we do generate a lot of capital, with respect to the excess capital, we look at maintaining Common Equity Tier 1 ratio of 9%, 20 to 30 basis points around the 9% to account for exchange fluctuations on our balance sheet. After we get to the 9%, we look at the efficacy of doing buybacks. We think that we need to get more efficient on our capital side through buybacks, given some of the shareholder dilution that we had in the 2009, 2010 timeframe. We also look at funding acquisitions. They are bite-sized acquisitions, mostly on our wealth management side, or even like Ally, the one you saw in Canadian banking. But no acquisitions that bet the bank. So we are constantly looking at our capital allocation with that lens. Right. I think it was 2.1 million shares you bought back. starting late in the quarter. Yeah a set of 30 million. Yeah authorization. Is it fair to assume that that would ramp up over the rest of the year? Of course, as we grow our earnings, then we will have more excess capital to deploy. We are actively looking at the share buyback. Remember the programs are annual. Yep. We always have to review them at the end of the year. Right. Maybe I'll pause for a moment and see if there are any questions in the audience. Yeah. Over in the back. Just as a follow-up to the capital markets questions. It's about a fourth of the bank's overall revenue stream, and it sounds like management wants to grow this business. But are the other business lines going to grow faster such that its overall revenue contribution comes down over time? That's a great question. One of the things that we believe is that we need diversification across our business platforms. The governor on our capital markets business is no more than about 20%-25% in terms of revenue and earnings. What we're seeing in our other businesses is that the revenue trajectories and earnings are growing, and that's allowing our capital markets platform to grow. The growth in capital markets is organic growth. We have not contemplated an acquisition of a capital markets platform or company. It's more along the lines of getting teams in and having that governor about 75% of our company being retail and focus and 25% wholesale. Great. Any other questions? Hi. If you could please develop a little bit more on acquisitions. What would be the kind of businesses and the size of those businesses that you would be looking to acquire if the opportunity presented? Thank you. What we are looking at is more on the wealth management side in terms of asset management. We are looking at expanding some of our product capability and our distribution capability in markets that we have a lower presence in. You would have seen BlueBay Asset Management, which is a fixed income shop that we bought a couple of years ago, which aided to our distribution in institutional in London and Europe. We are specifically looking more on the asset management side on equity capability given where the fixed income cycle is, and that would be in markets where we have some other distribution or product capability, either through capital markets or wealth, and we are trying to enhance that capability. The size of the acquisitions are we are not bet the bank, so they would be bite-sized. I would say that maybe it is 1 billion-3 billion to 5 billion, depending on the size. It is difficult to say, but the size that we have been doing is anywhere from the CAD 500 million range up to CAD 2 billion, so they are pretty manageable acquisitions. Great. Well, I think we are out of time. Janice, I would like to thank you.