Morgan Stanley Financials Conference

Jun 12, 2012

I think we'll go ahead and get started. I'm Cheryl Pate, the Canadian banks analyst here at Morgan Stanley. With me here today is Janice Fukakusa from Royal Bank of Canada. RBC is Canada's largest bank as measured by both assets and market capitalization, and is among the largest banks in the world. RBC has assets of CAD 800 billion and over 1,300 retail branches. RBC is also a leader in capital markets and wealth management. In 2011, RBC earned net income of CAD 6.97 billion on revenues of CAD 27.6 billion. As I said, with us here today to present for RBC is Janice Fukakusa, RBC's Chief Financial Officer and Chief Administrative Officer. She's also 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 corporate functions. Prior to her current role, Janice was Executive Vice President for Finance. Janice, thanks for joining us here today. We're going to be doing a fireside chat format. We'll be doing some Q&A between the two of us, and then we'll open it up for questions from the room at large. All right. I thought we'd start off by going through the various segments and sort of key topical issues. Obviously, you guys recently reported earnings. Maybe we'll start with Canadian banking, which has been obviously a very key focus, particularly considering consumer leverage and the debate over the housing market overall. Maybe we could start with getting your thoughts on a macro level in terms of expectations for housing, particularly in Vancouver and Toronto, which seem a little bit more overheated. Then obviously, you guys have given great disclosure on your exposures to the various regions as well. Okay. Thanks, Cheryl. I think when we look at the macroeconomic environment, we're hopeful that the GDP growth will continue. I know just as recently as yesterday and today, the forecasts have come up a bit, so we're looking at GDP growth of around 3%. When we look at our portfolio of loans and assets, and when we look at our production across the board, last quarter we had volume growth of around 7% on our retail side, which translated into revenue growth of about 3%-4%. So when we're looking further down the road, we think that the growth will moderate, and that's what's happening is the growth on the retail side is moderating. We think mid-single digits is where it'll be. When we look at our earnings growth trajectory, what we're seeing is that on the business side, we're seeing a lot better trajectories there because we're seeing companies investing in the economy, investing in the inventories, a lot of pent-up demand there. For example, on the commercial market side, we saw loan growth and volume growth of around 9%, 10%, and we saw on the deposit side, on core deposits growth of about 11%. When you look at that across the board, we are looking at maintaining our earnings trajectory through the focus on the business and commercial side, continuing to focus on getting a disproportionate share of the volume growth across all of the Canadian environments. You mentioned some of the press around the overheating of prices in the condo market in Toronto, and looking in Vancouver. Because of our actual production in our sales force, it's very evenly placed across Canada. We are equally exposed to every area and not too exposed to one area. When we look at condos in Toronto, we do not do a lot of condo lending to developers. I think that we have under CAD 1 billion of actual developer loans. One of the reasons we don't do that is because we're not willing to give two-year interest rate commitments. We don't do a lot of takeout mortgages Right on the retail side on condos. When we look at condo exposure in our portfolio, I think it's about 3% to 4% of the mortgage book. Generally speaking, we don't get in on that first mortgage as a condo buyer buys a new condo. We actually focus on the refinancing. We have a more stable client base, and because we don't do the initial financing of the developer, naturally we don't get that flow, but we find that we get a more mature borrower at that point in time Right as they're refinancing. If you look at our portfolio health, we stress test the portfolio extensively, and we stress tested it for house price declines of 20% on average. Some markets like Vancouver, we would've done 40%, and Toronto condo market, but on average, 20%, interest rates rising 3% on the five-year scale in one year, which is dramatic. Yeah. We hope that never happens, and we don't think it will. Unemployment rates of 13%. When we look at the nature of that sort of stress test, our PCL, our provisions, which are 1-3 basis points, Yeah may climb to somewhere in the high 20s, which to us it's manageable. It's maybe a quarterly earnings event for the retail platform, but it's not a debilitating thing. Right. I think that those are the sorts of things we do as we're watching the economic data. Right. One of the targets that you guys have had for the retail bank is this 25% premium to volume growth for the peer group. Right. Obviously, execution on that front has been very good. Maybe you can talk a little bit more about how you're winning the business and exceeding market growth in those areas, whether it be things like the innovative relationship with Shoppers Drug Mart, and other initiatives that you use both on the deposit and lending side. Right. I think that it is about the initiatives and about the multiple sales channels we have. For example, for the mortgages, we have our own mortgage specialists. We don't use mortgage brokers. I think you can see by the quality of the portfolio and the duration of it, what happens in terms of good lending when you're not reliant on mortgage specialists. Because we have our own mortgage sales force, the cross-sell is way easier, and we try to penetrate three key products, which would be the mortgage, credit card, and the current account. The checking account is invaluable for us because not only does it allow us to monitor the risk on a proactive basis, it also allows us to monitor opportunities and send out pretty proactive individual opportunities if we see changes in deposits and increases, those sorts of things. When you look at our sales channels, we're switching over our branches to be more of a place to actually do significant event things like mortgages or setting up Registered Education Savings Plans and that, and we're trying to migrate a lot of our customer base to electronic channels. So if you look at the whole impetus, it is around our advice and solutions. Then you pair that with also the fact that we are very focused on our efficiency. Our point is that, yes, we need to obtain the higher market growth than the participants, but we also need to drive earnings growth. We drive earnings growth in soft revenue environments by also focusing on our costs. I think one example that sort of matches this whole transactional movement into e-channels with our cost base is that, for example, on electronic statements- over 53% of the volume is electronic now as opposed to paper-based, which is good from a number of different- Right aspects. So those would be some of the initiatives that we focus on to both drive costs and improve the client experience. Right. Maybe let us drill down a little bit more on the efficiency side, medium-term target of reaching the low 40% range. Obviously, we have seen some good progress in terms of bringing down the number or the CAD dollar amount of expenses over the last couple of quarters as well as some of these initiatives are underway. Maybe we can speak to some other initiatives or how we balance sort of investment spend, obviously, to support the business growth versus moving that efficiency ratio down in what is a slower growth environment. Right. I think that when you look at the cost-cutting, we started about in 2004 with basic headcount reductions. In 2009, we looked at end-to-end. A lot of the efficiency gains that we see today are a result of investment in 2009, and it's that whole trajectory of investment. One of the critical things we did last year when we thought that there was going to be a bit of revenue softness given the global economic overhang- is that we retooled a lot of the programs to put the cost reduction programs first. A lot of the automation that I spoke about would come first, which would allow us to either free up productivity for sales or actually manage the attrition. You'll see manage attrition and take our FTE down- Right while still being able to serve our clients. There are initiatives like, for example, we're in midstream of building a whole new retail credit platform. We're starting with the mortgages, of course, because it's the most cumbersome part of that, and part of that has to do with freeing up time for the mortgage reps to sell. Part of it has to do with freeing up time in the contact centers- Right by getting more efficient. We would focus on how we deal with the back office first now, as opposed to putting more productivity in the front office. Right. It's that retooling. One of the things we learned over the last five years is that when you embark on large technology projects, they have to be a series of smaller events. You can't say, "I'm going to spend CAD 200 million to retool my platform." You have to say, "I'm going to have 10 projects that could be CAD 10 million-CAD 20 million each, or 10-15 projects," and be able to turn it off or move it out if you have to respond to the uncertain environment. Right. Increasing sort of a nimbleness around. Yes. Yeah. Then, maybe we'll spend a little bit of time on the commercial lending small business side. which has been one of the areas of accelerating growth to counteract some of the slowdown on the consumer side. Obviously, strong growth that we're seeing out of the commercial side, and maybe we can talk a little bit about your competitive advantage in terms of winning share relative to the peer group. Obviously, it's an area that all the banks are focused on given the better growth dynamics coming out of the segment. We've always had very good market shares in the business and commercial lending arena, over 20%, I think, both in deposits and loans. And that has allowed us over the years to focus our sales force on industry specialization. So all of our account management network in that segment is industry specialized. So we have teams that handle technology, manufacturing, retail. And what that allows us to do is, first of all, get the calls right in terms of our loan exposure, and also to provide advice and look at designing structures and covenant structures, those sorts of things that are very responsive to the industry needs. I would say that over the past five years, we haven't grown the sales force a lot. Over the past year or two, we've actually invested in more productivity and capability there. We're also doing the same thing that I spoke about on the retail platform in terms of retail lending, where we put a business administration platform, where we've taken a lot of administration off the desk of the account managers and centralized it in administrative hubs. We have more specialized credit, not just the adjudication, but the preparation. We've taken some of that off the desk in order to get more face time with clients. And we are seeing that really pay off in terms of some of the trajectories I spoke about. All right. Great. Maybe we'll turn to capital markets, which, always an area of focus for you guys. And you've recently had your investor day. On the capital market segment as well. Maybe we can talk a little bit about the ROE target under a Basel III basis, sort of mid to low teens, and then sort of the actions in terms of business growth, management actions and some of the shrinking of the legacy portfolio that get to that sort of mid to high teen ROE over time. I think that the capital markets is the one business that is taking the brunt of all of the new Basel III and the liquidity rules. When we look at the ROE, we used to have ROEs in the high teens, but we know that there's a marked step down that you saw into the low teens. That being said, I think the ROEs are still higher than a standalone capital markets company or bank or platform because of the leverage that our capital markets group has on the joint infrastructure of the universal bank. When you look at the activities at the margin and what areas they would be in, fixed income is a big one. Moving to exchange traded derivatives and stuff like that will actually lessen the capital impact. In addition to that, you heard Jonathan Hunter talk about in terms of the flows, making sure that at the margin we have 70%-80% that are linked to actual client flows and really making the flow through a lot quicker because we're not really wanting to hold inventory. The legacy portfolio has a lot of capital, and so the decisions have been made at the margin as some of the when you look at market opportunities, should we go in and take their mark-to-market portfolio? Should we take it out, or should we hope that some of the legacy assets will actually pull to par as you go out? Right. But to us, it's an area that we can constantly manage our capital. When Bank of Stan talk about the ROE dilution, I would say that they are looking at a fully overlaid capital plan, which incorporates a lot of the additional cost for even the Basel III liquidity. Okay. So at a very conservative basis. So it would involve even raising term funding, that sort of thing. The reality of a lot of that is that we would MBS securities. There would be some business growth, and we would change the asset mix. But I think that what is thoughtful about what we're doing in capital markets today is we're saying, "Don't grow the front office. Manage with what you have to pick up talent, but constantly upgrade." But that would mean at the margin also taking out talent- Right and figure out which businesses that we need to take down or shrink in order to get to a reasonable return on equity, which we think for capital markets, all our businesses should strive for 18% plus, which is our medium-term goal. But we think 15% is probably a reasonable target given the uncertainty that we have in dealing with the environment. Right. One of the major league uncertainties is the asymmetric implementation of Basel rules for Canadian banks vis-à-vis the other banks. Right. we would like to make sure that as we're planning activity, we have some options if things don't happen the way that we think they're going to happen. Right. And that includes Canadian banks moving to Basel III in 2013- Yes. Right. Just at the end of- versus the 2019. Yeah. I think one of the other initiatives within the capital markets is focusing more on the building out the lending side of the business as well- Yeah rather than the trading side, which is an area you had a lot of opportunity to upgrade. on the talent side over the last- Yeah. No, very much that. few years. And then maybe just to continue sort of the efficiency focus that is sort of bank-wide within the Capital Markets business, obviously focusing on efficiencies is another one of the key initiatives, and how do we balance that versus what is going to likely be more cost associated with things like Basel III and increased regulation? I think that when we started this journey around more investment in our back and middle office about three years ago. So we would have had capital spend in the platform of just over CAD 100 million. We actually more than doubled that over the last three years, so the trajectory has been way higher and mostly technology enablement, plus adding people in finance, risk, and operations. So we're at the stage where we think that we're more business as usual in terms of having a leverageable platform where we can satisfy really enhanced reporting requirements of all the regulatory bodies that we have, and in addition, have more consistency around things like, especially in our trading platforms, daily P&L, capital attribution, all of that, so that we can actually price and have our traders see pricing that's real-time based on the Basel III metrics so that we can make more effective decisions at the margin. When we talk about the expense base going into the low 60% range, the efficiency ratios, keeping in mind that comp is a big part of our capital markets platform, that is about the more normalized capital expenditures that we're seeing the flow on, and being towards the end of our automation program, so it'll still be two to three years out before we get all of the benefits. And also controlling discretionary spend. It's always the one lever that we have in terms of constantly monitoring everything from travel and entertainment to that we've done quite a bit of spend on things like advertising, especially outside of Canada Right through the last few years of looking at sponsorships, things like that. Great. Maybe just a couple last ones for me, and then I'll open it up to the room. Let's touch about wealth management, which has been obviously an area of growth, particularly in recent years. And within Canada, maybe we could talk a little bit about your leadership position in the high net worth market. And one of the things that was highlighted back at the last investment day for wealth management was sort of growing that share within Canada. Maybe we can get sort of an update on your thoughts and sort of how that's progressing. In Canada, we do have the preeminent position. Our asset manager, because of the addition of PH&N, which is really having some traction. We bought it when the markets were pretty soft, but we are seeing some traction there. Also BlueBay Asset Management, our London-based asset manager, where we can leverage the distribution in Canada for some of the emerging markets product. Right and provide a lot of our high net worth with access to that window. We are seeing a lot of flows there. I think that when you look on the wealth management side, in particular in Canada, but globally, part of the equation also is around providing more lending products within our constraint of how we lend, and all the lending, of course, is collateralized by securities. But providing that option, because I think that when we looked at our product mix, George talked about this, we do not actually have a lending platform or lending penetration to the same degree that other global. Right wealth managers have. We see lots of capability there. In addition, with the distribution across Canada that we have in the retail networks, there is excellent cross-sell. Absolutely. For example, on the deposit side, we can make the deposit side work for us both from a liquidity perspective as well as getting more business from our clients when we talk about how we are distributing products, sort of manufacturing specific maturities and that to get the flows that way. Right. It is mostly around all the cross-platform collaboration. Great. Then last one for me before I open it up. Wealth management has obviously been sort of the focus area for acquisitions. Maybe you could talk a little bit about the acquisition appetite, and particular focus, I think, has been on the asset management- Yes side within the wealth management business. I think our wealth management acquisitions are all about future growth because when we look at our criteria for acquisitions, the acquisitions need to be accretive within one to two years. We will suffer some return on equity dilution because we are paying for people and goodwill. Yeah. But for us, wealth management business on an ongoing basis is good because it doesn't use any balance sheet on the other hand. So when we look at our wealth management acquisitions, they are focused on asset management because it provides us with an entry into new markets and some institutional distribution. It's a high-margin business. And we have a great scale that we can leverage off in going into new markets. That being said, we focus on bite-size acquisitions. So PH&N and BlueBay are handleable within the context of the overall bank, and I think we're looking at adding capability to some degree in emerging markets. I think to add any more capability in Canada would be nice, but the opportunities are more in emerging markets or outside of Canada. Right. And so sort of speaking to the size of the acquisitions we'd be looking at is something that would be funded from existing resources. Yes Particularly given capital freed up from the sale. Yes Of the U.S. bank. Yes, exactly. Great. Let's go to the audience and see if there's any questions. Okay, I'll keep going. Maybe one area we can touch upon is the Dexia transaction. which is expected to close next quarter. But sort of any update you can offer to the extent it hasn't closed yet. Right. And obviously, a little bit dilutive to capital in the near term, but quite manageable. Yes at sort of the 20-30 basis points. We think we're committed to the investor services business, and we're working towards a close this quarter. It's regulatory intensive because they operate in so many different jurisdictions, and especially in Europe, it's difficult with the European environment where it is, but we are progressing. We think we're going to be able to close in Q3. The investor services business for us, what we've noticed right away in terms of the client base is there's way more stability now because of our announcement to Right purchase the other 50%. So we're seeing more at-the-margin flows from a lot of the fund managers where the business was, we weren't losing business, but we weren't gaining any business because of the difficulty in terms of looking at the future. We think that there's lots of leverage on the institutional side in foreign exchange, securities borrowing/lending, even in common clients that we deal with on the institutional side with our capital markets platform. So there's a lot of room there to leverage a lot of the capability that we have into investor services. We also think that there are opportunities to grow outside. We don't have any activity in the U.S., and I don't think we're planning to go there, but there's opportunities outside of here in the U.S. to grow the business, in particular, as a lot of the other banks are shedding capability in the investor services. While it's a niche business, it's very highly rated by its customers. We think that given that core custody business, in addition to that, the synergies that we can gain, and also on the expense side, the synergies, we think it will be a large contributor, or larger than it has been to RBC. We are very focused on very good acquisition integration. Great. Any questions from the audience? No? I will keep going. Maybe we could get your thoughts on the OSFI proposal in terms of tightening up some of the mortgage and home equity reporting and how we are thinking about the business there. I think the actual reporting and the transparency around the portfolios is a good thing. I think we always have to complain a little bit about our regulators, so the way they are asking for it, we think it is not in keeping with the flow. They have said that they are not, in terms of the re-adjudication of loans. Right We think that that is an onerous administrative thing to do, and you do it anyway if you think the borrower is, the credit quality is off you, and you monitor it all the time. I know when we renew mortgages, we look at appraisals and those sorts of things, or have appraisals, maybe they are drive-by, but look at valuations. Yeah. I think that they're going in the right direction, and their whole focus is on increasing disclosure so that people can make their own views about exposure to housing markets, that sort of thing. So I think that we need to really marry that intent on expanding disclosure with the reality of how you go about doing that and not slow the business down Right to a crawl because it's not one size fits all. But I think that generally speaking, it's a good thing. Great. Then maybe one last one to round it up. Obviously, the net interest margin within the retail business has been under pressure given the low rate environment, competition, and not looking for that to change over the near term as rates are expected to remain low in the near future. You've done a good job of managing through the NIM pressure. Maybe you can speak a little bit to some of the growth on the deposit growth side and how you're managing that. Yeah. I think that the pressure that we've had on our NIMs has been totally or a lot of it driven by the fact that we have such a high core deposit base that became Right less valuable to us. We are looking for rates to rise, and we will see some benefit there. When we look on the deposit side, we are doing things like on the core deposit base, looking at the longer-term rates and lessening the. We are putting in place things like the structuring of funding to make it easy for us when rates start to move to take advantage Right of that move. If that means because the yield curve is flat after three years to actually take back five-year deposit funding and move it into lower terms, those are the things we are doing at the margin. There will be some movement on the basis points in NIMs, but most of our activity today is how do we get ready for when rates move up and hit the ground running there. Great. Okay. Great. Well, I would like you to join me in thanking Janice. Unfortunately, we are out of time. Thank you, Sarah.