Citigroup US Financial Services Conference

Mar 6, 2013

Janice, a quick word for people that have not been familiar with your career. Since joining RBC in 1985, she has held positions in retail and business banking, corporate banking, account management, corporate finance, treasury, strategic development, and corporate functions. Janice serves on a number of professional and charitable organizations, including Wellspring Cancer Support, Princess Margaret Hospital, Ryerson University, and the Schulich School of Business. In 2007, Janice was inducted into Canada's Most Powerful Women Hall of Fame. I will start with my first question. You guys recently reported first quarter 2013 results. For this year, you expect to make more money in the U.S., in the capital markets part of the business, than in Canada. This is, I guess, a bit of a milestone for you in the U.S. You have also moved up the rankings quite significantly in terms of being number 13 last year in global equity underwriting, up from number 21 five years ago. In U.S. debt, you are number 10, and in U.S. syndicated lending, you are already top 10. The question for me and for a lot of our investors is, are we going to see you as a top five player eventually, and what is the timeframe around that? What would it take you to get there? That's a great question, Stefan. Just to set the overall context for our overall strategy, at RBC, I think that the ultimate governor of where our wholesale platform is has to do with the total bank. We've just come off a very strong quarter, where we've earned over $2 billion, had record earnings in some of our retail platforms, our Canadian banking, and our wealth, strong in insurance. When you look at that context, we've always set our strategy in having our overall earnings mix of 75% retail and up to 20% to 25% wholesale or capital markets. When you look at where we've gone, yes, you're right, we have had exceptional performance in the U.S. as we reconfigured our capital markets platform. Some of you who have followed us will recall that during the financial crisis, we did have an outsized trading revenue stream because there was a flight to quality. We were pretty stable, and so we had a lot more trading revenue. As the trading environment shifted, that created volatility for us in our capital markets earnings, and we had, in particular as we built out our European platform, a little bit more volatility on the trading side with fixed income positions. In the meantime, over the past 10 years, we've been building out our corporate investment banking platform by investing in teams in sectors that we're familiar with. It has been a long process, but what we found in the past two to three years is two things. As we reconfigure off trading into corporate investment banking and as our teams mature, we're able to shift and get a lot more origination, so a lot more of lending exposure backed by very good fee income. In the meantime, take volatility out of our trading. We're at the position where 50% of our revenue stream in capital markets is from the U.S. I would say that we're already in the top 10 in a lot of the categories we deal in, and we're not targeting so much moving up the league tables as much as having very strong performance in the sectors we're in. We rank highly in some of the sectors like energy, oil and gas, infrastructure, those areas of the investment banking world. We also are very mindful of the fact that we run an integrated bank that needs to have not just the wholesale firing, but all of our platforms firing on all cylinders, and we're mindful of the mix. I see. As you see how European banks have started exiting some areas within the U.S. capital markets area, what would be certain niches that maybe you can step in and steal market share? When you look at the activity in Europe, what we're finding is that because European banks are pulling capital out of their business, we're able to replace them in the lending platforms and the investment banking flow in the U.S. We see that in particular in the sectors that we cover, like the resource-related sectors, real estate, infrastructure, and even technology. You'll have heard of the recent deal that we did with supporting Dell on their buyout. The flip side of that is in Europe we have spent a lot of time right-sizing our operation there, which did not mean taking down corporate investment banking, but staying in sectors where we need coverage there, but we don't need to build. Our coverage in Europe is across the sectors that we support globally, but maybe there's a little bit more emphasis on, for example, financial services because there's that anticipated view that there could be some issuance, some M&A activity, that sort of thing, as well as supporting some of the clients in manufacturing and in energy that are doing activity outside of Europe, because I think European companies are still on the whole growing. They're just growing outside of Europe. Right. I just wanted to circle back on the volatility of earnings within your U.S. capital markets business. There is a school of thought out there that some of the foreign banks in the U.S. are doing more prop trading compared to some of the domestic U.S. banks. If you have ever disclosed maybe the proportion of profits that you derive from prop trading, and in terms of the path towards less volatility, I would imagine that will be going down over time. So in terms of the Volcker Rule, how much of an impact should we expect over the next 2-3 years, let's say? I think that as we went through the financial crisis, we had disclosed that the "proprietary trading platforms," so global arbitrage trading, those sorts of platforms, comprised about 10% of our overall revenue. I think that when you look at that activity, it wasn't the cause of volatility because it was about high index trading and stuff that was actually fairly stable, and the positions were pretty liquid because they were equities and they were monitored very closely. I think as you look at what's happening in the market, there's a necessary retooling, and as we shifted our focus and deployed more capital at the margin towards traditional corporate investment banking activities, there, while still a focus in some of the deployment of capital through those trading operations, there's not as much focus. With respect to the Volcker Rule, it's very difficult to discern what is meant for foreign banks operating in the U.S. because we're very highly capitalized in the U.S. There's a lot of capital here. We're highly regulated as the other banks are, the domestic banks. I think that when you look at the nexus of what we're doing around Volcker, some of that activity can possibly be shifted out of the U.S. nexus because it is a global platform, and we conduct that business through Toronto and in Asia and London in addition to New York. So from our perspective, while we're monitoring what's happening, we think that there may be higher friction costs, but it shouldn't be a significant earnings event for our platform. Okay. You mentioned you are more than adequately capitalized within the U.S. business. That probably assumes that you continue to transact some of the business out of Toronto rather than out of New York or out of the U.S. offices. The recent Fed proposals which may or may not force you to ring-fence some of that business within the U.S., would that have much of an impact on your current excess capital position within the U.S. business? I think when you look at the capitalization levels, we are more than adequately capitalized here. As we have a first look at the rules, and they're still under comment period, and we aren't making comments on the rules as they pertain to a foreign bank operating. In terms of the ring-fencing, it's around liquidity, and we manage our liquidity on a global basis. So what it would do would be to add some friction cost in that we'd have to keep separate liquidity in our U.S. operations to support the U.S. domestic business that we have. And then there are other reporting rules, and we actually, when we had our U.S. retail bank and we were looking at the holding company structure, explored a lot of the infrastructure and systems changes that we would possibly need to make to comply with the full scope of the rules. That's also an additional operational cost that we'd have to undertake. And we're looking at the impact on liquidity, which would mean at the margin that the cost of liquidity for us overall would go up slightly. So we're currently examining what we need to do and how we are organized, and we think that it is operationally achievable, but it will have some friction costs associated with it. Okay. Thank you. Now just switching gears slightly, still staying in the U.S., but I guess moving a little bit towards the retail side. You've recently mentioned the possibility of re-entering the U.S. market, not necessarily as a retail bank, but more on the payment and wealth side or expanding the wealth side of things or as an internet bank. Why would you do that? And what is the value in doing it? I think that in looking at why we would do that, we look at the overall context of our activity in the U.S., and we have a really robust wholesale bank that's growing. We have a very solid wealth management platform that's growing. It would be in the context of looking at those two platforms, could we supplement and do we need to believe that we need to be in U.S. retail? We have a small internet bank, as you know, that we carved out of our U.S. divestiture, which services snowbirds. We have a nascent internet platform. We believe that the U.S., as Canada's largest trading partner, has relevance in ultimately future growth, but we're not willing to step into U.S. banking on the same basis we did before because we didn't have a great experience with bricks and mortar branch build. We are exploring possibilities of looking at payment strategies, partnering with some maybe nontraditional payments providers to provide the banking backbone or network, looking at things like potentially credit card platforms, that sort of thing. I would say that we are at the design stage, and it's fairly remote at this point in time, given the fact that we are focused on the other growth that we have in the U.S. and also focused on wealth management and more of an international asset management sort of a place. Okay. Now moving a bit north in your domestic market. Your business loan book was the fastest-growing year-over-year as of the first quarter. I believe it grew around 12%, which is substantially faster than your mortgage book, which grew at around 5% or so. What is the potential for corporate lending to actually offset the weakening Canadian mortgage growth? Which industries do you think will see the most demand in 2013? I think that when you look at our mortgage and retail lending, it's about the rate of growth slowing down. You can see that we still have volumes and growth, but it's slowing down. When you look at the activity around business, what we have found with our business clients is that there was, over the past year, a lot of pent-up demand for financing inventories, doing CapEx that was put off because of the economic uncertainty. You saw the growth in Q1 year-over-year, but it has been moving up on a trailing quarter basis throughout the year. We think that that activity will, to some degree, offset some of the reduction in the retail growth. We are targeting the fact that we will have volume growth, and we may have less revenue growth than we had in the past, but we're really focused on still driving the right earnings growth trajectory. That's through being more efficient at what we do, focusing on our cost management programs and focusing on our spend very carefully so that we're not investing without good payback. So it's more about keeping in the business and driving earnings growth and altering some of our other trajectories on the expense side to accommodate slowing revenue growth. Okay. The corporates in Canada have been quite spoiled because they've been able to issue debt at very low levels, and in some cases, significantly below bank loan rates. Will the banks have to become more competitive to attract a bit more of this corporate debt formation? Because Canadian corporates, let's not forget, are some of the least levered in the Yes advanced economies. They have lots of liquidity too. Yeah. I think that what you're talking about is potential pressure on our net interest margins as a result of competition. In fact, while there is that intense pressure now and all of the banks are moving into that space, there is still relatively more discipline there in terms of pricing because of the fact that everyone is using comparable risk weights and return on capital is extremely important. We haven't seen dramatic pricing pressure there on the corporate side. I think that on the flip side of that, I'm not saying that there isn't any pricing pressure, I think that we're seeing a little more pressure on the business deposit side, which syncs up with your view about the overall liquidity of the Canadian corporates in that a lot of the deposit flows, which are basically around current account flows and that, they're traditionally not considered deposits that you pay on, but you see some pressure at the margin to recognize those as pretty good funding sources and perhaps look at potential for having to pay interest on them, and that would involve maybe perhaps fixing a portion of them, that sort of thing. So that's where we see sort of the bit of pressure on corporate spreads, and I think that's something that is new in the market. It's nascent, and it'll take a while to take hold. Okay. So it sounds like it's more of a liability spread issue rather than an asset yield. Right at this point in time. Things can shift around, but that's where we're seeing more of the pressure. Just shifting gears slightly into the retail part of your Canadian business. Toronto's commercial real estate vacancy rate is really low right now. It's around 5%, which is close to the all-time low of 4%, if our data sources are correct. As more supply comes onto the market, vacancy rates should start to go up. Do you see this as a risk within the context of your exposure to the CRE market overall? When we look at the CRE market, we overall have portfolio sector limits that govern our overall lending and exposure to sectors like real estate that are very closely managed. When you look at underwriting of CRE in particular, you're correct that vacancy rates are really low. When we look at underwriting, the vacancy rates we use in modeling and the underwriting analytics are at 5% vacancy or whatever the actual is, the greater of the 5% or the actual. We also look at the equity underpinning the loans. So we look at anywhere between 40%-60% underpinning of the loans, depending on whether you have a straight mortgage versus an unsecured line that is basically secured by the general covenant. Ensuring that there's enough cushion against the actual exposure is also another way to ensure that the lending is viable, and that it makes sense to us. Our CRE exposure has bumped up slightly, but it's not astronomical. I think our exposure is I have a brain cramp, and I'm thinking could it be CAD 16 billion or something like that, I think, and I think the Canadian portion is lower than that. So I think it's not something, given the prudent lending, that we think that we're actually betting the bank on, and it's something we monitor extensively. Okay. What would cause Toronto's real estate prices to follow Vancouver's? Supply and demand, Stefan. I think that the dynamics in Toronto are a little different because what's happening in Toronto is the bulk of the new build is in condos, and it's at various different price points. The market has by and large more net new flow of people coming in. When you look at Canada and population growth, it is through net immigration, and if you look at the Toronto region, I think it's something like 20,000 to 40,000 new households coming into the market all the time. When you look at price appreciation in Vancouver and Toronto, I think that the price points are higher in Vancouver, and the issue is about the underlying, not just loan-to-value ratios, but the debt serviceability of the individuals there. The Toronto market has more, I would call them owner-occupied condos or condos that are actually being occupied by people as opposed to maybe not fully occupied. I think that when you look at what's happening overall at the Toronto real estate market, the condo production is coming off. It's taking longer to build condos because you need to have fully subscribed people that are going to purchase them. So the supply side is diminishing. I think that in Vancouver, of course, it is too. I mean, 24% less housing sales in Toronto. I think that is about a bit of a slower rate of growth. I think the decline is a lot lower than 24%, but the market didn't ramp up as much. So I think that there are different governors around the market in Toronto than Vancouver. If I look at our overall portfolio of mortgages, it's fairly sound. I mean, we're running basis point losses of between zero and one basis point. We stress-tested, and while the stress testing is pretty draconian, we don't see that it'll ratchet up into any range that is beyond a portion of the earnings of a quarter of our retail bank. Sure. Those low losses, as well as your pretty high level of mortgage insurance overall, maybe can be used to justify each other. At the same time, when we look around the world, there is a general movement on the side of regulators to impose minima in terms of mortgage risk weights or just overall residential lending risk weights. Examples are Sweden, Norway. Australia also has something resembling a floor. Do you see this as a risk on the part of OSFI? Do you see this as a sort of overnight risk or more of a gradual movement towards a floor? Well, we haven't had that discussion specifically around risk weightings on mortgages. I think that our regulator expects us to manage to prudent capital levels. Generally speaking, in looking at the overall capital, I think it's more about thinking about the Canadian banks in running buffers and putting in, for example, the national SIFI buffer that we talk about that could be running the ratio 1% higher than the 7%, and having more visibility and clarity into the types of exposures. I think our regulator is very concerned about transparency, about exposure across the Canadian banks. That's why you saw the new B-20 rules. That's what we call them, which are about disclosure, types of underwriting caps, and those sorts of things with the Canadian banks so that there is more insight and transparency into the types of exposures. Capital is managed at the aggregate level with buffers for potential unintended consequences. It's not so much Product view a varied metric that's somewhere that Right it's just hard to imagine. We're hoping that that's the way, because we think that's more prudential. In terms of the other parts of your retail business, you have recently purchased Ally. The Canadian part of Ally Financial. In terms of the overall auto lending sector, that has tripled over the past five years to around CAD 55 billion. There's a lot of growth in there as the banks have realized that actually this is pretty good business given the low losses that have gone into it and the relatively high margins. Obviously, Ally will help you get a large slice of that action, but what are some of the risks that we as analysts and our clients as investors should be thinking about in terms of that type of business? I think when you look at the overall positioning of Ally, when we take that portfolio of clients that they have and added to ours, it makes us number one. So one of the things that's positive from an investor perspective is that we can actually take that business and run it off an existing platform. So that's hugely positive to operating leverage. We can keep the parts of the business that are direct with clients, but leverage our fixed cost infrastructure. The automotive lending sector is pretty interesting because you're right, the loss ratios are pretty low. They're pretty well monitored, and all of the underwriting for the dealers is in accordance with our normal underwriting standards. We have a lot of monitoring around it. So we're not anticipating any ramp-up at all in our loss profiles as a result of this. What we are anticipating is way more efficiency because we have this, and we're able to leverage off of our positions and basically generate strong shareholder value. I think from the risk profile perspective, we've been in the business. We have several clients now in the business. We have a lot of history with underwriting, so we're very comfortable with the position we're in. We did a lot of diligence around the Ally client base, and so we think that we're in a good position. Okay. I think we'll stop here to Okay give our audience the opportunity to ask questions. Any questions? Well, you've been very clear, it seems like. Okay. Well, I do have two more. Okay. Maybe we can just look at those. In terms of acquisitions that you will be considering over the short to medium term, how would you rank the following in terms of attractiveness and in terms of return on investment or IRR, for example? U.S. wealth, Canadian wealth, global asset management, and insurance. I'll start with the one that I like the most. Okay Which is global asset management. I think that with any wealth acquisition, you're paying a lot for goodwill upfront, but there's no balance sheet usage. In asset management, the pre-tax margins are pretty strong, and it's a business that is very shareholder-friendly. So those are a lot of positives, and we are looking at asset management as one of our key sectors where we think it's possible to add to our capacity by way of acquisition. It's tough because the multiples are high, and we're looking probably primarily more towards the equity side because we, through the acquisition of BlueBay, have a pretty good fixed income capability internationally. But it is a business that we're constantly looking at. When you look at any of the wealth distribution businesses, they're not as shareholder friendly because of the high commissions and dealing with all of the financial consultants. While you get a lot of distribution for your asset management product, we feel that we have pretty robust network in Canada and the U.S. and internationally through our private banking network, and that what we need is more of the product capability. Insurance is difficult, and it's a tough one because we built our platform based on acquisition, but we stopped doing that, and a lot of the insurance for us being a financial services company has to be in the context of being capital neutral to positive, and it's tough with insurance companies to be there. So what we're focused on in our own insurance company is more on the distribution side. So get access to the distribution networks and put product out as opposed to the manufacturing side. Okay. We have one question, James. Just on the acquisition of asset managers. Banks don't have a very good history generally of buying and making money out of asset managers. It very often goes horribly wrong. As you said with insurance, there's no need to own the product to sell it. I'm not quite sure why that logic wouldn't apply to asset management as well. I think that with respect to asset management, maybe you're always colored by your own experiences, and with our acquisitions of asset managers, they've been fairly positive. I think that what we're looking at is outside of North America and even outside of Canada, getting that capability and doing what we're doing very well with, for example, BlueBay, bringing that product back into the North American network, especially on the emerging markets. So that's why we're thinking that particularly we need to round out our offering in equity, because it's about getting the product to leverage some of our distribution networks that currently are there. I think the Why do you need to own the product? Still not sure why you need to own the product when you've got 20,000 asset managers to choose from. Right. I think that is the million-dollar question about asset managers, is that once you buy an asset manager, once you work through the retention period, what do we have at that point in time? That is the question for us, and that's why when we're looking at asset manager acquisitions, one of the difficulties is we need to also have a pretty good cultural fit, we feel, so that we reduce the risk of that happening. Janice, could you provide a little color around your Canadian residential mortgage book in terms of insurance? Because if I look at RBC and I contrast it with TD, you have vastly different profiles in terms of the amount that's CMHC-insured versus uninsured. I do realize that you have significantly lower LTVs than we see historically here in the U.S., so there's some obvious buffer if housing prices trended lower and there was a point in time that they have to refinance them. Is there any additional metrics you could point us to in terms of something like an equivalent FICO or any other color in the mortgage book you could kind of point me towards? I think when you look at the overall proportion of mortgages insured at the various Canadian banks, some of it is a function of the actual requirement for credit insurance. A lot of the ramp-up of insurance has to do with making some of the funding of the covered bonds that were issued by some of the other Canadian banks, making the funding more attractive. When we put out the first covered bond offering, we specifically did the covered bonds the way the Europeans and some of the U.S. banks had issued, with no insurance. It wasn't a requirement for us, and the cost of actually paying for that additional portfolio insurance was high vis-a-vis the funding lift that we would get because we were funding at pretty good spreads. When you look at our fundamental mortgage portfolio and what's insured by CMHC, because we've always operated with our own sales force and we don't use mortgage brokers, a lot of the selection of credit that we get presented with, because we have our own people underwriting for our own book, less of that product requires insurance, so less of it is, quote, "subprime product." We don't require the insurance. So that's sort of a bit of the nuance of why the insurance ratios are different across all the Canadian banks. It depends on some of that on debt issuance. If you look going forward, the issuance of insurance to support funding programs like covered bonds, it's not available anymore. CMHC has said it's not available, so the program will be more about insuring because of credit quality. When we look at our own portfolio, LTV is important, but we also look at debt serviceability, which is an extremely important metric for us because when you look at when borrowers get into difficulty, you need to have debt serviceability in order to determine what you're going to do around the margin. Because the last thing you want to do is to repossess a house and have to sell it on the open market. You'd rather work with the borrower. If you look at our loan-to-value ratios, they're trending in the high 20s to low 30s, and I think that depending on when the loans are originated. To us, that's more of a living metric. So we always pair loan-to-values with serviceability. Any more questions? I will wrap up with one question. Okay. You have been returning some capital to shareholders in the form of obviously dividends, but also buybacks. Just one question, Janice. Imagine you're in 10 years from now, there's just no opportunities to grow domestically or organically in a reasonable way. That is, without taking on excessive risks. Would you be happy simply doing buybacks and returning capital to shareholders rather than scouting around for opportunities that may not be there, really? That's a tough strategy for us because we believe that we can add value through the deployment of capital. But we also believe that we need to have things like dividend increases because our investor base needs to have a return on capital. That's why we have a 40%-50% dividend payout ratio. I think that if that was indeed the case, then yes, we would think about doing returning capital to shareholders. I don't think we're in that position now because we still have a large number of organic growth activities and in addition, have leverage points within our franchise and we're always adding to the franchise. For example, investor services is a good area to talk about because it is something where we believe from a revenue perspective, we can leverage our positions in custody to anchor more activity on the relationship side, like FX flows, securities borrowing, lending, all of that other product. And we know, for example, that we need to deal with the fact that the efficiency ratios are too high. So it is acquisitions like that where we believe we can leverage the whole to make a better return than looking at the assets individually. Great. Then we wouldn't have jobs, all of us. We need that. Except for the treasurer, maybe. Yeah, that's true. Great. Thanks, Stefan. Well, Janice, thank you very much for your time and for your insight. And we'll be back in 10 minutes with Tom Flynn, who is the CFO of Bank of Montreal. Thank you. Thank you.