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Royal Bank of Canada (NYSE:RY)

June 12, 2013 8:35 am ET

Executives

Janice R. Fukakusa - Chief Administrative Officer and Chief Financial Officer

Analysts

Cheryl M. Pate - Morgan Stanley, Research Division

Cheryl M. Pate - Morgan Stanley, Research Division

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. And with me today is Janice Fukakusa, RBC's Chief Financial Officer and Chief Administrative officer. As a member of RBC's group executives, she's 1 of 9 executives responsible for setting the overall strategic direction for RBC. And 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 function. Prior to her current role, Janice was Executive Vice President of Finance. And we're going to kick it off with a polling question today. And 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? And I will leave the polling open for a few -- we have 10 more seconds here.

[Voting]

Cheryl M. Pate - Morgan Stanley, Research Division

And we'll pull up the results. Well, overwhelmingly, the state of the economy and the housing market in Canada is top of mind. So with that, I think we'll start off focusing on Canadian Banking.

Janice R. Fukakusa

That's a good idea.

Cheryl M. Pate - Morgan Stanley, Research Division

Great. So 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 in the housing market maybe on the industry level and then we can talk about RBC specifically.

Janice R. Fukakusa

Great. Okay, great. Thanks, Cheryl, and thanks for having me today. I think that we're all -- the Canadian economies are topical for all of us. And when you look at the Canadian economy, there -- the Canadian economy is still growing, but, of course, the GDP estimates are coming up. We just had some fabulous employment figures reported last week, which indicated that we were -- actually, we had employment growth that was higher than expectations and mostly in the manufacturing and service sectors. So when you look at where the Canadian economy is, there is just 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 markets, it's pretty relevant to financial services. So 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 mortgage, and all that is designed to moderate. And I think that if you look at what's happening in Canada, there is some moderation. So things like mortgages and housing starts are still slowing but at a slower pace. We see on the business side that our business -- for us, our business clients are pretty -- 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 in and their -- the influence of it over Canada, the fact that the U.S. economy is showing some greens shoots, it will have a positive impact. So if we translate that into the topic of concern, which would be looking at leverage of the consumers and the mortgages in 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. And if you look at debt serviceability in our current portfolio, our debt serviceability is about 20% to 25%, which is pretty good. The 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 in being in the lower interest or lower wage earning category, like earning $50,000, $60,000 a year because any sort of systemic shock in terms of interest rates increasing will have an impact on that. So that's a category that we monitor extensively. For us, that category of client would be less than 5% in our mortgage portfolio. And 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 on overall lending environment. So I think these are the areas we watch very closely.

Cheryl M. Pate - Morgan Stanley, Research Division

Okay. And 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?

Janice R. Fukakusa

So we -- our uninsured ratio is lower than our peers' for 2 reasons. First of all, we have our own proprietary sales force for mortgages. We don't rely on the broker model. And through the broker model, you typically get more higher-risk insured mortgages. The second aspect of why we don't have as much insured has to do with our funding programs, and we were first off the market in setting up our covered bonds programs. And we were able to set up our covered bond program and put uninsured product in there that is actually pretty representative of our portfolio across Canada. And we didn't see any extreme funding benefit by putting the mortgage insurance RAP, or the government Canadian guarantee, on our corporate covered bonds programs because we still -- we're funding at pretty favorable rates and we still are. So if you take those 2 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.

Cheryl M. Pate - Morgan Stanley, Research Division

Okay. And going forward, given that, that's not really going to be available, that should sort of change over time?

Janice R. Fukakusa

The -- yes, I think that, that's the case. And with respect to markets like the covered bond market, because it's now a legislated program, which gave our fixed-income investors more assurances that the program was here to stay and it's being -- it's just being administered by the Canadian Government and specifically the mortgage insurance is not available, the Canadian Government RAP, 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 growth [ph].

Cheryl M. Pate - Morgan Stanley, Research Division

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 commitment?

Janice R. Fukakusa

Sure. So our condo exposure on the builder side is pretty small. It's just over $1 billion of exposure because we're generally not a condo lender. And 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, the -- a lot of the development is stacking up, particularly the Toronto market. The other sort of exposure, I think, that you're looking at is in terms of mortgages and mortgageability and then the developing of the condo. We've seen definitely a slowdown in the Toronto condo market by the builders in terms of putting new production onto market. And 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 1 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 region, a lot of the growth in new households is through net integration. And the flip side of the condo construction is there are -- it's very little single-family home construction. All of the expansion in terms of housing is in the condo markets. 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 to -- on condos to the person who has purchased it and has 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 there is -- 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.

Cheryl M. Pate - Morgan Stanley, Research Division

Okay. Maybe shifting gears a little bit and we can spend some time talking about credit card. And are there any opportunities that are coming with the -- particularly in the travel card market given the uncertainty about one of the major renewals at one of your peers?

Janice R. Fukakusa

Right. I think that the card for us in terms of the card market, it is about the loyalty programs. And we've invested quite a bit in our loyalty program, which has -- it has less restrictions or hardly any vis-à-vis the -- it's the Aeroplan and the Aerogold card in terms of being able to buy travel instantly and with different carriers and that sort of thing. And I think that for us, that we look at the opportunities of the uncertain markets to really push our own card and our own offering and try to gain even more market share with the uncertainty that's in the market. So that would be our posturing on the whole card. And you've seen for -- with respect to our cards and our extendings [ph] that we have grown the business. We've grown balances and we've grown a lot of the transactional revenues. So I think that our strategy is working.

Cheryl M. Pate - Morgan Stanley, Research Division

Great. And in the most recent quarter, we closed the Ally Canada acquisition. Maybe a little bit of an update on how the integration is going and the competitive landscape on the auto business.

Janice R. Fukakusa

The Ally Canada acquisition was for us the acquisition of the dealer to our planned financing and a lot of the dealer business that took us from a distant third into the top position in that market. So 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. We have -- I think when we discussed the acquisition, we had said that we thought that we could get to a run rate of $120 million on an annual basis, and we're headed in that direction. You saw a lot of onetime costs this quarter. 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 we -- early days. We're seeing that we've -- we're really achieving the objectives of vaulting into the first position in market share and leveraging our efficiency.

Cheryl M. Pate - Morgan Stanley, Research Division

Great. And on the deposit side, that -- have those all been repriced at this point?

Janice R. Fukakusa

The -- we -- 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 of our -- on our entire deposit base or actually to paying back the deposits. So what -- the surprise for us was that we have been able to see [ph] through a pretty good client retention and marketing, get about 70% of that base into RBC deposits at our high interest savings account rate. So I think that we're seeing the best of both worlds where we've been able to retain the deposits and also maintaining our margins on the deposits.

Cheryl M. Pate - Morgan Stanley, Research Division

Okay. Maybe we'll touch on the net interest margin here. And 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.

Janice R. Fukakusa

I think that when you look at net interest margin, there are 2 factors, competitive pressures and the overall level of interest rates. When you look at the overall level of interest rates, they seemed pretty low for 2 years. So some of the 1 to 2 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 2- to 3-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 with -- and we also, of course, given where interest rates are today, our balance sheet is positioned for gains if interest rates rise. So I think that, that's like a little bit of a no-brainer, well, given where rates are. The curve is pretty flat. But we actively manage that side. With respect to competitive pressures, we have -- 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. And so 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 in the -- within the next year some rising interest rate environment, which will be beneficial not just for our Canadian Banking profit [ph] but for a number of our other businesses.

Cheryl M. Pate - Morgan Stanley, Research Division

Great. And I guess as mortgage is slowing and other parts of the portfolio with perhaps better margins increase, you have a little bit of a mix shift?

Janice R. Fukakusa

Yes. I think that you do see some of that mix shift today with respect to the -- a higher proportion of the growth being in business lending. So there is a little bit of that mix shift, and we're constant monitoring the competitive pressures there.

Cheryl M. Pate - Morgan Stanley, Research Division

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?

Janice R. Fukakusa

I think that in the short to mid term, 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 investments 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've said before, they're pretty liquid, and so they have a lot of capacity now in terms of even their bank lines on the outstanding sources of the authorized credit to draw down very quickly if they get that confidence. So that's another area we're watching.

Cheryl M. Pate - Morgan Stanley, Research Division

Okay, great. And 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 under way and how -- sort of a road map on how we get there.

Janice R. Fukakusa

The -- that's a great question, Cheryl. And I think a lot of the efficiencies in the retail bank have to do with building for scale. And they require investments. It's not just turning off the cap on expenses. And so, if you look at some of the programs we've had, we're 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. So we started investing in this program that we call the retail credit transformation about 3 years ago. So some of the efficiencies you see are a net-net result. It takes a couple of years to do the investment and then gain the efficiencies. So some of the efficiencies you see are related to this redesign of how we deliver the product and administer the retail credits. Other initiatives are on productivity. So we have pretty good metrics around productivity across our network. And because it this so evenly dispersed across Canada, we can -- and we're at scale. We're able to move productivity very quickly through the markets where we see some growth and actually move it from markets where we don't see as much growth. So there are those initiatives, and that requires a pretty good database infrastructure and daily monitoring in order to make those moves. And so it's those sorts of productivity initiatives that are changing the way we do things and also improving the efficiency at which we can get clients that we think are really making the difference.

Cheryl M. Pate - Morgan Stanley, Research Division

Okay, great. Maybe let's switch gears a little bit and talk about the Capital Markets business. Maybe we can start with how you're thinking about obviously a global business with different capital and regulatory environments in the different areas in which you operate. So how you're sort of thinking about the business on the whole and in particular, reinvesting [ph] of capital in markets like the U.S. and Europe.

Janice R. Fukakusa

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. And 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 it comes from the more traditional corporate investment banking. And when we look at the potential for reinvesting of funding and liquidity, what it represents to us is really an extra cost of 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. We trap liquidity. We would have to hold more liquidity. For example, if it is the case here in the U.S., an additional -- 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 sales 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. And so where -- the other part of the efficiency side would be that we're setting up a lot more infrastructure and reporting, reporting of metrics and that. And I think it's -- the same holds true for an environment like lending in Europe.

Cheryl M. Pate - Morgan Stanley, Research Division

Okay. Okay. May be I'll open it up for questions in the room. And just as a reminder, RBC will not be doing a separate breakout session. Any questions?

That's fine. 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.

Janice R. Fukakusa

I think -- and you're right, we did see weaker results on trading. And I think that one of the things you we also saw was with respect to our Capital Markets platform, not a lot of earnings volatility. So I think that was all about our -- how we said we wanted to strategically position. The -- when you look at our trading platforms, they're there to support clients' vote [ph]. So some of the volatility has to do with our fixed-income platforms. And we have a -- platforms, of course, in Canada, the U.S. and in Europe. We -- and so we did not have a lot of trading volumes, 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 platforms. So we're hopeful that, that environment is improving, but it all depends on what's happening with interest rates and then their macroeconomic environments. 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 product and client relationships as opposed to maybe just queuing [ph] us being more fixed-income and trading focused.

Cheryl M. Pate - Morgan Stanley, Research Division

Right. And corporate lending has obviously been a big area of focus and growth that's helped reduce the volatility of the Capital Markets business.

Janice R. Fukakusa

Yes.

Cheryl M. Pate - Morgan Stanley, Research Division

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 a Basel III Common Tier 1 basis? And maybe we can talk about sort of how you think about the buyback in conjunction with the dividend and organic and -- or any potential acquisition opportunities.

Janice R. Fukakusa

Right. And it's really great to be in a position to look at capital management again like that. And so 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's very high ROE business and it just makes sense for us. So you'll see a lot of the growth we're reinvesting in the markets. And then we believe that we need just pay back our shareholders. And if you look at dividends, being a Canadian bank, dividends were sacrosanct. And we used to have a regular environment of increasing our dividend every year. We stopped that during the financial crisis and we've had, I think, 4 dividend increases since then. We believe we should be growing our dividends at the same or same rate of growth as our earnings per share. And so when you look at that and look at our trajectories on EPS, we -- and the fact that we're sitting pretty much in the middle of our dividend payout ratio of 40 to 50, that's where we hope our long-term strategy will be with respect to the dividend. Then with -- 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. The -- 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 '09, '10 time frame. And we also look at funding acquisitions, mostly the bite-size acquisition mostly on our Wealth Management side or even like Ally, the one you saw on Canadian Banking. But none -- no acquisitions at the bank. So we're constantly looking at our capital allocation with that lens.

Cheryl M. Pate - Morgan Stanley, Research Division

Right. And I think it was 2.1 million shares you bought back starting late in the quarter, and it's the $30 million authorization. So is it fair to assume that, that would ramp up over the rest of the year?

Janice R. Fukakusa

I think the -- of course, as we grow earnings, then we will have more excess capital to deploy. So we are actively looking at the share buyback. And remember the programs are annual, so we always have to review at the end and renew them at end of the year.

Cheryl M. Pate - Morgan Stanley, Research Division

Right, right. Maybe I'll pause for a moment and see if there are any questions in the audience.

Unknown Analyst

Just as a follow-up to the Capital Markets question. So it's about 1/4 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?

Janice R. Fukakusa

That's a great question. And one of the things that we believe is that we need diversification across our business platform. So the governor on our Capital Markets business is no more than about 25%, 20% to 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. So the -- and the growth in Capital Markets is organic growth. We would -- we have not have contemplated an acquisition of a Capital Markets platform or a company. It's more along the lines of getting teams and having that governor about 75% of our company being retail focused and 25% wholesale.

Cheryl M. Pate - Morgan Stanley, Research Division

Great. Any other questions?

Unknown Analyst

If you could please develop a little bit more on your -- on acquisitions. What's -- I mean, what would be the kind of businesses and the size of those businesses that you would be looking to acquire if the opportunity presents it?

Janice R. Fukakusa

That -- what we're looking at is more on the Wealth Management side in terms of asset management. And we're looking at expanding some of our product capability and our distribution capability in markets that we're not or that we have a lower presence in. So you would assume 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're specifically looking more on the asset management side on equity capability given where the fixed-income cycle is. And in -- and that would be in markets where we have some other distribution or product capability, just -- or capital markets are welcome, then we're trying to enhance that capability. And the size of the acquisitions are -- we're not getting the banks. So they would be bite-size. I Would say that maybe it's $1 billion to $3 billion to $5 billion depending on the size. It's difficult to say, but the size that we've been doing is anywhere from the $500 million range up to $2 billion. So they're pretty manageable acquisitions.

Cheryl M. Pate - Morgan Stanley, Research Division

Great. So I think we're out of time. But Janice, I'd like to thank you for speaking with us today. Thank you.

Janice R. Fukakusa

Thank you.

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Source: Royal Bank of Canada Presents at Morgan Stanley Financials Conference 2013, Jun-12-2013 08:35 AM
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