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Bank of Montreal (NYSE:BMO)

CIBC 12th Annual Eastern Institutional Investor Conference

September 18, 2013 9:10 AM ET

Executives

Tom Milroy - Chief Executive Officer

Analysts

Robert Sedran - CIBC World Markets

Robert Sedran - CIBC World Markets

Okay. We talk a lot about BMO’s U.S. P&C banking expansion and for good reason, it’s obviously a key part of that bank. But it’s noteworthy that the contribution from – to earnings from the capital market segment which also includes some U.S. exposure by the way, a far bit of U.S. exposure in fact, over the last four quarters has almost doubled that of the U.S. P&C business.

So I’m pleased to welcome Tom Milroy. He is the CEO of BMO Capital Markets, to the conference to help us learn more about his business. Tom began his career with BMO in the Investment Banking Group in 1993, holding progressively more senior roles since that time. Before that he practiced securities law as well as M&A for U.S. investment banking firm. I don’t often get to spar with a lawyer on the stage, so I'm even more over-matched than I normally am.

Tom Milroy

I’m in an advance stage of recovery so.

Robert Sedran - CIBC World Markets

So welcome to Montreal. Before we begin, I have been asked to tell you that Tom’s comments today may include forward-looking statements. Actual results could differ materially from forecast, projections or conclusions in these statements. Listeners can find additional details in the public filings of BMO Financial Group. So again, welcome to Montreal, Tom.

Let’s start with some opening thoughts on what has been a strong year so far for the business, what’s gone right and maybe what hasn’t gone as right so far.

Tom Milroy

So obviously, we had really good results year-to-date and both of our main businesses, both trading products and the investment corporate banking businesses are doing quite a bit better than they did last year.

And as I thought about this I really do think it's due to a couple of things maybe two or three things. The first was the strategy that we started pursuing and focusing on over five years ago. We really came back to who are our clients and what are their needs and how do we grow our business to meet them. And we really focused as we worked our way through thinking about that we really focused on our products and our capabilities and what we could do.

We also focused on what we were doing and how we were doing it. So we got out of certain businesses. We made some organizational changes. We made investments to both increase our productivity and to adapt to the new environment, which is a big theme that I'm sure will come up in some of our other questions.

So today we have this North American platform which serves the needs of our clients in North America and outwards where they need us and where it make sense for us to go with them. So that would be the first fact I think we adapted this strategy that’s turned to be the right strategy.

The second thing is the market environment and the opportunities in the markets are just better. We went through a period of time where every day there was a new challenge but the market environment every time I hesitate to say it but it feels a lot better and it feels more stable than it has been. As soon as you say something like that that obviously is where you are going to wake up tomorrow and you are going to be smote down by some [bull] [ph], but it does feel a lot better. And we continue to position ourselves for the risks that are out there but we feel pretty good about it.

And then lastly, we benefited this year from some major client transactions and that got us off to a really strong start in the first quarter and we see some of that continue and that’s obviously has a what we're on is a little element of luck into it. You work with your clients and you don't know always the timing of what they are going to do or when they are going to do it. So we are there. So we are really pleased with our results year-to-date and we feel pretty good going through Q4. So we are looking forward to the end of the year.

Robert Sedran - CIBC World Markets

When you think about the size of this business in the context of the overall bank, so it’s almost like I’m asking you to step back a little bit from your own business --

Tom Milroy

Right.

Robert Sedran - CIBC World Markets

…and think about the bank generally, like how much is too much, how much is not enough, like what’s the right number in terms of earnings contribution from the capital markets business?

Tom Milroy

So I give you the party line or what I would like?

Robert Sedran - CIBC World Markets

We don't need the party line --

Tom Milroy

I mean all the companies obviously running the business; I would think more is better. But the business today represents about 25% of the revenues of the bank. And I think that somewhere in that area seems like a good place for it to be. We expect the overall bank to grow. So for us, we don’t feel constrained by that. We think that there is a lot of growth opportunities that we have and those opportunities will grow our business as the bank grows our business. So I think you'll see it remain about that proportion. Obviously, if some of the other groups grow more quickly then you will see it decrease but we are not uncomfortable with it at about the 25% level.

Robert Sedran - CIBC World Markets

There's kind of two schools of thought on the capital markets contribution. One is that it’s a very volatile business and it’s low quality earnings. The other is that it’s almost counter cyclical, in other words, when loan losses are rising or when retail is struggling often the market opportunity is larger.

Is it truly -- does it truly make the bank more counter cyclical to have a larger capital markets platform that allows when those loan losses are rising allows you to offset it somewhat or how should you -- how should we think about the quality of earnings that are being generated?

Tim Milroy

I'd like to – there's this presumption that somehow that wholesale earnings and capital market earnings are lesser quality. I don’t actually think that’s the case. I think what we experience with people getting less so on in Canada for sure but that in the industry at large, they were reaching for larger and larger and riskier types of activity.

I think that sort of business that we have that is really well-diversified that has a lot of elements of it that are sustainable, continuing, dependable. These are pretty good quality earnings stream. That being said, we operate in the capital markets which by their nature have variability certainly month-to-month and quarter-to-quarter and some cyclicality. So we experience cyclicality. We have seen in the past where it's offset other things. So my guess is there are instances where it’s actually a plus in terms of offsetting weakness elsewhere in the bank as you suggest.

Robert Sedran - CIBC World Markets

In some of the other businesses we tend to think of a natural organic growth rate just – the average – economic performances actually can figure a revenue run rate and operating leverage and the rest. How should we think about organic growth in the capital markets business? Is it just about the market environment and how much risk you prepared to take on or is there a natural progression that we should see over time in a capital markets franchise?

Tom Milroy

So we look at our business in terms of growth. I mean I guess, if you can raise up to one level and you think about the businesses generally they are tied to economic growth. So that would be the biggest indicator of how they grow. But when we look at the markets that we have a big presence in Canada and United States, we have really two different situations.

Canada, an extremely mature market, we have a very large share of it. We are continuing to win marginal market share year in and out. But I would think that we would look at that growth in that market has being tied to some sort of GDP growth, nominal GDP growth plus something for share and for working a little harder. So, that’s how we see the Canadian market.

In the U.S. market, for us the opportunity is quite a bit different and it’s from a -- growth opportunity is much better. We have in the market that we have positioned ourselves which is the midcap market $200 million to $5 billion of market type companies, that's a market that's growing and we’re growing our market share. And so we see that has being a very attractive opportunity. Secondly, we have built out that platform in the U.S. And so we see that we believe that we have in addition operating leverage and the investments that we’ve made.

Robert Sedran - CIBC World Markets

Let’s talk a little bit about the U.S. investment bank because it’s -- the goal I think clearly and for all of that certainly the bank owned dealers in Canada is to be all things to all people in that business line. In the U.S. is it to be all things to all people in the $200 million to $5 billion market cap range or is there a differentiated strategy that maybe a more niche strategy on either product differentiation or geographic differentiation like, what is the strategy in the U.S.?

Tom Milroy

So and why do we choose the segment we're in I think it goes to.

Robert Sedran - CIBC World Markets

Yeah.

Tom Milroy

And then we did it for exactly that reason. So we think that we are differentiated in the U.S. because our competitors in that midcap space are the sizable boutiques so I'd include in that Jefferies and Baird and Blair and the like.

And then, on the one hand, and there we differentiate ourselves because we have a full product spectrum. We have a balance sheet and so we can really provide that full product offering to them. And we’re there and we tend to be steady in there over the long-term where the experience in the market has been those firms come and go; they have different emphasis. But they are not quiet the long-term provider of the services that companies need.

And then, when we look and say well the other thing that happens is you’ll have the [both record] [ph] players, peek down into the market come down and dabble. And so they go in and out and I think that we just provide a better quality of service than what they’re willing to provide to that part of the market. Their focus is up market they provide an incredible level of service there but we find that we get the kudos on sort of the quality and the level of service.

In that market, we made a very conscious decision that we don't want we're a Chicago headquartered midcap focus thing. Obviously, in our trading businesses, our counterparties can go much broader spectrum but we’re focused, our main attention is focused on the clients where we think we can have long-term relationships and given what we are doing have a sustainable business out of it.

Robert Sedran - CIBC World Markets

How different -- I guess you touched on some of it just in terms of the predictability or the consistency of the competition being perhaps not what it is in Canada, but aside from that is there an intensity of the competition - here every single business line, I mean lemonade stands are competitive in the U.S. Is there an intensity of the competition is different in the U.S. market even if it is in the midmarket space when compared to what you do in Canada?

Tom Milroy

No. I mean in Canada, we have a great position but it’s a heavily banked market and we have the same global people coming in. So both markets are extremely competitive and you can’t sit still. It’s true we’re more of a new guy in the U.S. So we fight harder for our wins. But we’ve had tremendous successes. I mean, we’ve moved our share up. We almost tripled our share in that midcap space over the last four or five years. We see great growth going forward. We’ve crossed in terms of institutional research rankings; our share of [secondary] [ph] commissions across a whole number of the fact that we have just seen big gains, big gains off small numbers. So that’s part of it. But we see an opportunity to continue to grow the business. And so we think it gives us an opportunity to out-compete.

Robert Sedran - CIBC World Markets

At the Investor Day you noted a target for the U.S. of a double-digit ROE, I guess over the medium term. What has to happen to get there? And should we be more focused on just the growth in the contribution or does the ROE - is the ROE an output or the ROE actually matter to you?

Tom Milroy

ROE matters to us a lot. If you recall at Investor Day as well my boss was trying to negotiate next year’s plan. But leaving that aside, what we were able – where we really we care about -- the business has been profitable for a long time. The question has been for us is it, are we earning our cost of capital. So we’re now earnings our cost of capital and if we get the fourth quarter, we expect to get we’ll be earning double-digit ROE and we’re really close.

Robert Sedran - CIBC World Markets

Okay. [Luke] [ph]

Question-and-Answer Session

Unidentified Analyst

[Inaudible]

Tom Milroy

It’s a good question and we are deploying more of our balance sheet in the market but loans with clients and we’re not very aggressive. Where we get knocked out in the U.S. even with people that we think we have a good clients is people that are trying to come in and use the balance sheet on terms that we don’t like. But by and large, that outside of the leverage loan market in that traditional corporate banking market in the U.S., spreads and terms have remained in a pretty good territory I would say.

So we have seen the ability to grow our loan book in ways that really relates to our core strategy. We’ve been pretty disciplined in the leveraged area and we have our good leverage finance business but we’ve been – we’re a laggard not a leader in terms of some of the, what I would view as some of the weakening and some of the structures in that market. The distribution market so far so good, but we’re really careful.

Robert Sedran - CIBC World Markets

And you mentioned that the corporate loan, the spreads are hanging in fairly well. Considering there’s not been a lot of pull or lot of demand for credit and the banks generally have excess liquidity and are desperate to lend, I’m a little surprised to hear it. So why do you think pricing is holding in as well as it’s holding in, and is it fair to say that the corporate loan is a profitable standalone product today like hurdling the [kind of inventory] [ph] you need?

Tom Milroy

Well, I think there's a good -- I guess let’s talk first about why do I think spreads as you know in this business there is a little bit of a pendulum swing. So they were tight, they became extremely wide and now they come back to an area I would say is, they’re good, it’s in a good spot, it’s a place we don’t mind lending.

The factors behind that I think is -- there is a desire to use that capital in combinations with the other capitalized companies believe that the economy is turning and they’re starting to look beyond just kind of hunkering down for the year. So I think that’s being useful for us.

There has been the exit of a number of lenders in the North American environment as well. So that means that the people that are here and that are established we have some further opportunities. I think our franchise has grown so that helps us.

Lending is a profitable business for us. On average we are in double-digit ROE in our loan book. But it’s not a crazy high ROE business, but it’s very often is a foundation for the client relationship and when we bundle and are able to offer them other products on top of that, then we tend to make a really good return.

Robert Sedran - CIBC World Markets

I mean are you finding that it’s easier to get the cross-sell and to get the other products into them because some of their lenders maybe leaving. So the syndicates are getting smaller or I mean is the cross-sell easier to get in this kind of an environment? So is it – so double-digit ROE on the loan by itself means a much better return on the book overall because you’re actually getting the other products in?

Tom Milroy

We make it a priority. We’re not in the business of building a loan book for the sake of the loan book in our part of the business. So we make it a priority. Is it easier? I think what I'm unable to untangle is whether it’s easier because our platform is better and we’re doing a better job and how much of it is the market. So there is probably an element of both, but we’re just a much stronger competitor in the market. So then, therefore, when we ask for some of the other things and want to participate in some of the other places that the companies were playing it’s easier for them to say yes.

Unidentified Analyst

[Inaudible]

Robert Sedran - CIBC World Markets

Sorry, the question is un-regular, so I changed [inaudible] at the back.

Tim Milroy

And it’s a really good question. We see it less on the revenue line. We think that there's lots of trading revenue opportunities but what we have been working really hard and the industry has been working hard how do we deal with the increase in the expenses that are coming from the regulator. Obviously, there is some specific provisions of the Dodd-Frank Act and some of the other legislation that has forced us to change the way we do things like clearing derivatives and other examples like that. But where we've had to work really hard is to make sure that we are investing additional dollars in to making sure that we can comply that we have the systems in place that allow us to get there.

So that shift in cost related to any regulatory environment has hurt as such we go through the P&L. And then you add to that the additional capital that’s coming under the Basel regime and we are fully Basel II complaint at least as the best as we understand Basel III at the beginning of this year. So you've seen those two pressures hit the ROE in the business.

We have done a great job offsetting it. We still think we have a really good and profitable ROE, and I think we are 19-ish percent year-to-date but it's we felt the pinch of those things in the return.

Robert Sedran - CIBC World Markets

Do you think they are in the numbers, I mean, is there more to come? Since we can’t get through a day without a front page story on somebody getting pinched by the regulator or someone or so, is there still more to come on that front or is it just in the run rate now that we can stop thinking about it as much?

Tom Milroy

Well, I think the growth in that expense line has started to flatten but I still think there is – I know that we in our case we still in some of the areas we still need to add some bodies which is expense dollars. We are also at this point go and I guess I don’t have this completely crystallized. But we are investing a lot in the systems and a lot of those investments are one-off and lead to a more productive environment when we get them up and running than where we are today, where we are using a mixture of old systems and a lot of manual support. So there is probably a trade-off. We are getting close to the inflection point where it’s in the run rate I think.

Robert Sedran - CIBC World Markets

Compliance has been the fastest growing part of our business for a while now I guess.

Tom Milroy

Right. And we love all those people. Rob has – he did the thing at the beginning for me, I just wanted to add to that.

Robert Sedran - CIBC World Markets

When you think about non-compliance cost, whether its headcount and I guess it’s – you need to talk about the U.S. and Canada differently because the Canadian business is mature and the U.S. business is being built. So I guess you have to answer it differently?

Tom Milroy

Right.

Robert Sedran - CIBC World Markets

When you think about your expense run rate, is there room to bring it – just to rationalize it more in Canada to offset the growth in the U.S.?

Tom Milroy

We think we've done a really good job – well, I think U.S. will take care of itself. Let me start in the beginning, we really went after expenses over the last two years. And it seemed like every dollar that we saved, we spent on the increased burden that was coming out of the new environment.

So the victory is kind of somewhat pyrrhic one because expenses have remained roughly the same, but they would have gone up a lot if we have done the things that we are doing. And we are continuing to work on it. And we spend a lot of time on all those cost that you ignore, I mean, right down to the very popular ones like how much you can spend when you travel and how you have to travel and where you buy your tickets, to systems investment and clearing costs and data feeds. And so we worked really hard across all that stuff. And we are continuing to grind away at it.

In the U.S., the answer to our productivity ratio which is how we look at it is the top-line not the expense. We have done the same thing there. What we need is to earn more dollars of revenue for the expense that we have in the business. And we have seen that improve year after year after year, so we think we will get it to the right spot. That being said, the U.S. business will never have the same productivity ratio as our Canadian business.

Robert Sedran - CIBC World Markets

Okay.

Unidentified Analyst

[Inaudible] having the right people, do you need more people, you have the right people [inaudible]?

Tim Milroy

Right. So asking -- the question, I think I wanted to hear but just in case, the question was how do we feel about the quality of the people we have there. Are we hiring more people and are we finding the environment for the people competitive including or we losing our own people.

So let me start by saying we’ve had huge, when we embarked on over the last four, five years a lot of upgrade account across all of our U.S. business. So we are very happy with the quality, the people in our U.S. business. When we started out the strategy on a simple way to describe as we want to have a platform in the U.S. that was on par with one we had in Canada. Today, we have it.

So today, we’re no longer investing to kind of get to the spot where we wanted to be. Now we are investing as we would in kind of a normal course fashion to upgrade people where we see opportunities to chase things that come along and so we really feel we’ve got where we needed to be.

It’s a competitive market for people. We have we believe a distinct culture. So we had a really good retention rate. But it’s always competitive. So we have made some changes. Recently in our credit business, we have a great people and then as we did that, we lost one of the research analysts that we cared deeply about. So that happens all the time both sides of the board and that’s just part of the business that we’re in.

We think that the most of the people that are joining our business have choosing us because we go out of our way to describe what we’re about when they are coming in and to make sure the fit is right. And to say, if you’re looking for this, we might not be the right place to do but here is our value proposition. Here is how we think about running the business, here is our culture and we spend longer time than I think other people do on hiring people and bring them in. So we’ve had a really good experience. And the quality of the platform in terms of the people is excellent.

Unidentified Analyst

I think I had a follow up on that one with a question I guess it relates to the culture and it’s also I will be the shareholder advocate instead of the sell-side. When you think of incentive compensation as part of the next, is there a room for shareholders to benefit still further from following compensation levels in the business or have we reached the kind of steady state now where it’s about revenue growth and there is no longer about managing comp levels down?

Tom Milroy

So I’m not sure I understood the question, okay.

Robert Sedran - CIBC World Markets

I wish I could explain it better but I don't either.

Tom Milroy

Obviously that’s an area that we focus a lot. And if you just step back, we never paid the way that the U.S. falls back on the state. And so our employee spends the revenue ratio is down around where they’re driving it to. That being said, we’re being really careful to make sure that we don't leave the market anywhere and we have no interest and we’re quiet explicit about that.

We did not want to pay the most but what we want to do is pay competitive in the marketplaces where we choose to compete. And we don't want to lose good people for dollars that are reasonable but we won’t chase people. So someone bids as was the case.

One of our employees with a number that’s just silly, we did have -- we just walk away. I think -- I don't think that the promise of -- from a shareholder point of view reduced compensation being a big factor in for the Canadian firms is as true as it was for U.S. firm. We've all -- we've really worked hard on it. We worked hard on the make up of the compensation that you would know to try to make sure that people's focuses are long-term that they are aligned with shareholder interest. And so, I don't think there is a lot to get from that front, but clearly if the trend is lower, we will be following right along with it.

Unidentified Analyst

[Inaudible]

Tom Milroy

We have -- I think we’ve got to continue to do what we’re doing. Our strategy is not changing. So it’s really about execution. So in the U.S. it’s about driving the top-line in terms of revenue. And if you look at the year, we had two really good quarters in the U.S. and then we had a weak quarter in the third quarter. We feel really good about the fourth quarter. So we think we’re going to end the year where we had hoped to end it. So we’re comfortable with that. But we didn’t want to drive that top line and to really leverage some of those investments, so that’s a challenge.

The other one is to -- as it always, its coming back to Canada is to defend the position we have to grow the market share. So all of the other things we think of just being blocking and tackling and we’re going to continue to grind away on optimizing our capital, we're going to continue to see where we can reduce cost and make further improvements on how we do things. We are and have been investing in some of the systems technology underneath and a lot of that investment is behind us. So now we want to leverage that. We’ve got a much better platform across all of our trading businesses.

So those are the things we’re going to be focusing on going forward. It’s a little less flashy than some of the things we’ve done in the past because it’s really this year -- this coming year is all about execution.

Robert Sedran - CIBC World Markets

Got a minute or two left. I wanted to ask you about the outlook in Canada, and I’m not asking to call the commodity cycle in a minute and a half. But the business is certainly struggling a little bit, just the Canadian industry generally in terms of a slowdown in activity in some of our key sectors.

Do you position the bank for a slowdown in that area, do you stay staffed up because it’s going to come back like how do you manage a cycle which may not – which maybe a longer term cycle in just a couple of years if it happens to be?

Tom Milroy

Yeah. We're in -- and we watch it closely and what we’ve learnt that is that we have a diversified enough business that if in a particular area and it’s really not commodities broadly its metals and mining. And if the metals and mining activity falls off, we take people out of the group and into other groups and back and forth a little because these are experienced bankers. That’s one of the things we do.

The other thing is that we’ve seen that – and I say it’s not all commodities because the energy market has shown strength especially over the last three or four months has been – we’ve been involved in – led six equity or equity related transactions. So there is a good activity there. But then we also have all these other businesses.

So when metals and mining is down, we find that the consumer and food and some of these other sectors are driving. So and I think the U.S. is for us is a big help there because it’s less reliant than the Canadian. So when we look at the overall business, we have a little bit of a hedge there as well.

Metals and mining for our business -- for the overall business is only about 3% of the top revenue line. I mean it’s big in terms of the activities in the parts of the business where it is but it’s not that big of an impact on the overall business as you might think.

Robert Sedran - CIBC World Markets

We’re out of time. Thanks a lot for your participation Tom. That was great discussion. Thank you.

Tom Milroy

Thank you everyone.

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