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Executives

Viki Lazaris – SVP, IR

Bill Downe – President and CEO, BMO Financial Group

Russ Robertson – CFO, BMO Financial Group

Tom Flynn – EVP and Chief Risk Officer, BMO Financial Group

Frank Techar – President and CEO, Personal and Commercial Banking Canada, BMO Bank of Montreal

Tom Milroy – CEO, BMO Capital Markets

Ellen Costello – President and CEO, Personal and Commercial Banking US and Harris Financial Corp.

Analysts

Darko Mihelic – Cormark Securities

Sumit Malhotra – Macquarie Capital

Rob Sedran – CIBC

Mario Mendonca – Canaccord Genuity

John Aiken – Barclays Capital

John Reucassel – BMO Capital Markets

Michael Goldberg – Desjardins

André Hardy – RBC Capital Markets

Steve Theriault – Bank of America/Merrill Lynch

Brian Klock – KBW

Cheryl Pate – Morgan Stanley

Gabriel Dechaine – Credit Suisse

Brad Smith – Stonecap Securities

Bank of Montreal (BMO) F3Q2010 Earnings Call Transcript August 24, 2010 2:00 PM ET

Operator

Good afternoon and welcome to the BMO Financial Group’s third quarter 2010 conference call for August 24, 2010. Your host for today is Viki Lazaris, Senior Vice President of Investor Relations. Ms. Lazaris, please go ahead.

Viki Lazaris

Thank you. Good afternoon, everyone, and thanks for joining us today. Our agenda for today’s investor presentation is as follows. We will begin the call with remarks from Bill Downe, BMO’s CEO, followed by presentations from Russ Robertson, the Bank’s Chief Financial Officer, and Tom Flynn, our Chief Risk Officer.

After their presentations, we will have a short question-and-answer period where we will take questions from pre-qualified analysts. To give everyone an opportunity to participate, please keep it to one or two questions and then re-queue. We will wrap up the call at 3 PM. Also with us this afternoon to take the questions are BMO’s business unit heads; Tom Milroy from BMO Capital Markets, Gilles Ouellette from the Private Client Group, Frank Techar, Head of P&C Canada, and Ellen Costello from P&C US.

At this time, I would like to caution our listeners by stating the following on behalf of those speaking today. Forward-looking statements may be made during this call, and there are risks that actual results could differ materially from forecasts, projections, or conclusions in the forward-looking statements. Certain material factors and assumptions were applied in drawing the conclusions or making the forecasts or projections in these forward-looking statements.

You can find additional information about such material factors and assumptions and the material factors that could cause actual results to differ in the Caution Regarding Forward-looking Statements set forth in our news release or on the Investor Relations website.

With that said, I’ll hand things over to Bill.

Bill Downe

Thank you, Viki. And good afternoon, everyone. As noted, my comments may include forward-looking statements. BMO’s third quarter results were solid, underlying the benefit of the Bank’s diversified business mix. Three factors were particularly significant in these results. P&C Canada maintained its strong performance, including market share gains, with results up 17% from last year and 8% from the robust Q2.

Second, our capital market results reflect lower trading revenues, particularly relevant to recent quarters where we had good spreads and capitalized on some unique market opportunities. And finally, we experienced a continued significant reduction in loan loss provisions, better than we had anticipated.

Net income was $669 million, 20% above last year. Cash EPS came in at $1.14 a share. Our ROE for the quarter was 13.7% and we posted 14.8% year-to-date. A $214 million, our third quarter provisions for credit losses reflect a continuation of a positive trend. PCLs were $203 million better than last year and $35 million better than last quarter. Gross impaired loans and formations declined sequentially.

There is a credit recovery underway, and we have confidence in an overall continued positive trend, and Tom Flynn will provide more color later in the call. Russ is going to take you through our group results in more detail, but let me touch on the quarterly highlights.

P&C Canada continues to set the pace for the company. We are deepening customer relationships across all of our businesses, highlighted by year-over-year increases in the average number of product categories used by both personal and commercial customers; strength in commercial banking with increases in market share and growth in loans and deposits and growth in personal banking, notably in our mortgage portfolio; and good market share gains in consumer loans.

Our commitment to delivering for our customers is yielding dividends for our shareholders, marked by the eighth consecutive quarter of strong revenue growth. P&C US results reflect the economic environment in which we are operating. At this time, our objective continues to be to effectively position P&C US for growth as business conditions improve.

To this end, we are executing on the integration of the FDI assisted transaction in Rockford, Illinois. We have completed the branch rationalization and headcount reduction plan. The next milestones will be the replacement of all signage and the technology conversion in September. We are seeing good climb in deposit retention as well as growth in deposits and checking accounts.

We are replicating strong offers across the company. In June, we introduced Harris Helpful Steps to the US market. It’s an extension of a program that has worked remarkably well in Canada. And as expected, we are seeing early and positive response.

And in commercial banking, we have built a business model that focuses on specialized coverage of seven business segments where we have expertise that sets the stage for faster growth in key markets, broadening our footprint and establishing brand leadership. We are going into the economic recovery with an energized US management team and enhanced business structure and ramped up visibility of the strong Harris brand, all good positions to be in.

Net income in the Private Client Group was $108 million, with growth across most of our businesses. Assets under management and administration improved 11% year-over-year after adjusting to exclude the impact of the weaker US dollar. We continue to strategically invest in the business, increasing our sales force and enhancing our product offers. We continue to pioneer in the ETF sector. We launched eight more ETFs in the quarter, expanding our product line now to a total of 30 funds.

As mentioned earlier, BMO Capital Markets Q3 results were down from recent levels with net income of $130 million. The trading environment was considerably weaker and economic conditions negatively affected results. Our Q3 results also reflect a negative impact of widening credit spreads.

Year-to-date, Capital Markets has performed well, delivering net income of $604 million. We are continuing to build our capabilities, including key hires where we have taken advantage of the current conditions to build our team for the long-term. This is positioning us for growth across key sectors as the market environment improves.

I’d like to spend a few minutes updating you on capital and regulatory reform and their impact on BMO. A number of open items are expected to be resolved as we move towards calendar year end. These include the final calibration of regulatory targets and the rule, if any, of contingent capital or a counter cyclical buffer.

We understand that the global framework will provide an appropriate transition period to ensure that the new rules, once implemented, don’t jeopardize the recovery. Based on what we know and the work we’ve done to date, we are well positioned on both an absolute and relative business basis to adopt the new rules.

Our prudent strategy of maintaining elevated capital and liquidity levels now positions us well to execute our growth strategy and take advantage of opportunities going forward. To that end, our Tier 1 capital ratio at the end of the quarter was 13.55% and our tangible common equity to risk-weighted asset ratio was 10.4%.

We continue to assess the impact of the Dodd-Frank Act, which is complex and broad in scope with many aspects subject to rule-making and implementation over several years. We anticipate increased regulatory costs, but think reform will be to the advantage of well-capitalized banks. As you know, BMO have used the current environment as an opportunity to strategically expand our US footprint. We are carefully monitoring all capital and regulatory changes that would impact that strategy in any way.

Before wrapping up, I want to note that BMO is now carbon neutral with respect to energy and transportation worldwide. This fulfills the commitment we made two years ago. I’d like to give special thanks to our employees who made sustainability a priority at BMO. They have made meaningful contributions to reduce carbon emissions by changing work day habits in their teams. Those efforts combined with the purchase of renewable energy and our investment in high-quality carbon offsets got us to today’s announcement. We are proud to be doing our part for a sustainable future for everyone.

In summary, BMO will continue to benefit from our strong diversified business mix. In fact, we are well positioned to increase the pace of growth. The regulatory environment is manageable. Recent economic news suggests lower business activity. However, GDP is still expected to remain positive, supporting our planned business growth. P&C Canada and PCG are producing very good results.

Management at P&C US and BMO Capital Markets are positioning our businesses to benefit as the US economy gradually improves. We expect credit performance to continue to improve with some quarterly variability. And our balance sheet is strong. And we are committed to grow.

And with that, I’ll turn it over to Russ.

Russ Robertson

Thanks, Bill. And good afternoon. As some of my comments may be forward-looking, please note the caution regarding forward-looking statements at the beginning of the presentation.

On slide nine, you can see the third quarter earnings were $669 million or $1.13 per share. Return on equity was 13.7%, and our Tier 1 capital ratio remains very strong at 13.55%. On a year-to-date basis, net income was $2.1 billion and return on equity was 14.8%. Credit continued to show improvement in the quarter with quarterly provisions of $214 million, which Tom will speak to shortly.

Turning to slide 10, revenues were down year-over-year and quarter-over-quarter mainly due to significantly lower trading revenues and Capital Markets more than offsetting growth in our other businesses. Net interest income was $1.6 billion in the quarter, up $105 million or 7% from a year ago, driven by strong growth in P&C Canada and improvement in corporate services, offset in part by a reduction in Capital Markets. Quarter-over-quarter net income increased $49 million or 3% due to additional days in the current quarter and increased margins in our P&C businesses.

The total bank net interest margin was up 14 basis points year-over-year due to increases in our P&C businesses. P&C Canada benefited from higher spreads and deposit products while improved loan spreads and deposit balance growth helped P&C US margins. Better net interest income in corporate services also contributed to the improvement. Quarter-over-quarter margins were unchanged, as increases in our P&C businesses were offset by reduced net interest income in corporate services and decreased spreads on trading assets in Capital Markets.

Turning to slide 11, year-over-year expenses increased $25 million or 1%. The main drivers of the increase are from our recent P&C US transaction, increased initiative spending, and higher provincial sales tax. These increases were partly offset by a weaker US dollar and lower employee cost due to reduced performance-based compensation.

Quarter-over-quarter expenses increased $68 million or 4%, driven by additional calendar days in the current quarter as well as an increase in our investments in technology, high professional fees, provincial sales taxes, capital taxes and costs of the acquired business. These were offset by slightly lower performance-based cost and severance. We remain focused on managing our expenses, and this is a priority across all of our businesses. That said, we will continue to invest in our business to advance our strategic agenda.

On slide 12, you will see that our risk-weighted assets were $157 billion at the end of Q3. While our risk-weighted assets increased in P&C Canada, they were down $2.5 billion over last quarter at a total bank level. The decrease can be attributed to lower corporate and commercial risk-weighted assets and lower other credit risk assets.

Our Tier 1 capital ratio was now 13.55% in the quarter and is expected to remain strong going into fiscal 2011. The tangible common equity to risk-weighted assets ratio also increased to 10.39%. Our strong capital position provides flexibility in the execution of our business growth strategies and positions us well for the pending regulatory changes.

Moving to slide 15, P&C Canada had another strong quarter. Revenue increased over the prior year driven by volume growth across most products, the inclusion of Diners Club revenues and improved net interest margin. Volume growth across most products, improved margins, and additional days benefited comparisons for the second quarter. Cash operating leverage was a strong 5.5%, and the cash productivity ratio remained at 51%.

Turning to slide 17, P&C US results continued to be impacted by the elevated levels of impaired loans and the cost to manage them. In addition, to increase loan spreads benefiting revenues, the inclusion of AMCORE increased revenues and expenses including integration cost each by US $18 million. We expect the integration cost to be higher in the fourth quarter.

Turning to slide 18, our Private Client Group results were down $5 million from a year ago. Last year’s results include a $23 million recovery in prior period’s income taxes. There was solid growth across most businesses driven by an improvement in client assets under management and administration. Revenue from the insurance business was down overall, as growth from net premiums was more than offset by the effects of unfavorable market movements on policyholder liabilities. Expenses remained essentially flat, as higher revenue base costs were offset by active expense management.

BMO Capital Markets results were lower this quarter due to lower trading revenues compared to very good trading performance in the past four quarters. Trading revenues in the second quarter benefited from tightening credit spreads, whereas credit spreads widening in Q3 negatively impacting trading revenues. In addition, trading margins were lower. This was partially offset by higher revenues from our interest rate sensitive businesses and increased debt underwriting fees. The weaker economic conditions for corporate banking also contributed the lower revenues year-over-year.

On a year-to-date basis, revenues in Capital Markets have increased $170 million or 7.4%, largely due to improved M&A activities and debt underwriting fees and investment securities gains versus losses in the prior year, partly offset by decreases in our interest rate sensitive businesses, corporate banking net interest income, and trading revenue. ROE is strong at 18.4% on a year-to-date basis.

Finally, on slide 22, corporate services results continued to benefit from lower provisions for credit losses under BMO’s expected loss methodology. In conclusion, our results reflect a quarter of solid earnings driven by continued good results from Canadian retail and improved credit performance.

With that, I’ll turn things over to Tom.

Tom Flynn

Thanks, Russ. And good afternoon. Before I begin, I draw your attention to the caution regarding forward-looking statements. I will start with slide 25 where we provide a breakdown of our loan portfolio. The portfolio was well diversified both geographically and by segments. 75% of loans are in Canada and 20% in the US. Consumer loans represent 60% of the Canadian portfolio and 86% of these are secured. Our US portfolio mix is 43% consumer and 57% commercial and corporate.

Slide 26 provides details on our US loan portfolio. As we have discussed in previous quarters, losses on this portfolio are higher than those in Canada. The portfolio represents 20% of total loans is well diversified and our underwriting practices were more conservative than the industry overall, resulting in lower provisions. The US consumer portfolios are relatively evenly spread across risk mortgages, home equity, and auto loans. These portfolios have been impacted by weak labor and real estate markets, but all three segments have continued to perform better than the industry.

The C&I portfolio is well diversified and is performing reasonably. As you know, the US commercial real estate continues to experience weakness. Based on current trends, we are not expecting this market to improve in the near term. This sector represents $3.5 billion or 2% of total loans. The portfolio was $3.1 billion, excluding loans acquired in the second quarter and covered by the FDIC loss share.

Investor-owned mortgages represent approximately 5% of the US portfolio, and the developer portfolio is approximately 2%. The investor-owned mortgages are mostly confined to our Midwest footprint, are well diversified by property type, and were underwritten prudently. This portfolio continues to experience negative migration given the market conditions. The developer portfolio has continued to reduce and is under $1 billion in size. This portfolio was impacted early in the downturn, and we believe that migration here has peaked.

Turning now to slide 27, the chart shows information on impaired loan formations for the quarter. Formations were better than expected at $242 million, down from $366 million in Q2. The US portfolio continues to account for the majority of formations at $185 million and were diversified across sectors with the commercial real estate related making up the largest portion at 39%.

Within Canada, formations were diversified across a number of sectors. Gross impaired loans were down to $3.1 billion from $3.4 billion last quarter, excluding impaired loans associated with our Q2 acquisition, which benefit from the 80/20 FDIC loss share. The impaired loans declined to $2.8 billion from $3.0 billion in Q2.

Slide 28 provides details on the provision for credit loss. The consolidated specific provision was better than expected at $214 million, down from Q2 which was $249 million. While the big picture downward trend in both provisions and impaired formations is clear and positive, performance quarter-to-quarter still clearly has the potential for variability, given the weak recovery and the extent to which provisions in the last two quarters have benefited from low capital market provisions and recoveries.

Moving now to the business segment details that are shown in the table, the P&C Canada provision improved this quarter largely due to lower commercial provisions, which were down as expected from a high level in Q2. P&C US provisions were relatively flat quarter-over-quarter, with the increase in commercial provisions largely offset by a decrease in consumer. Provisions in this segment are expected to continue to be impacted by weak real estate markets and higher employment.

Lastly, Capital Market provisions again this quarter were in a negative position or a recovery position, benefiting from low new gross provisions and recoveries. In general, Capital Market portfolios continued to stabilize as larger companies take advantage of better markets to strengthen their balance sheets and they are generally more resilient.

Turning to slide 29, you can see a segmentation of the provision by geography and sector. The Canadian provision was $110 million, down from $139 million in Q2. The consumer and credit card segments continued to be the largest drivers of the Canadian provisions. The US provision was $104 million, down $19 million from Q2 due to lower consumer and corporate provisions. The consumer segment continues to represent the largest segment of the US provisions.

That concludes my presentation, and we can now move to the Q&A.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question is from Darko Mihelic from Cormark Securities. Please go ahead.

Darko Mihelic – Cormark Securities

Hi, good afternoon. Just a question for Frank Techar. Frank, when I look at the result that you are posting, it seems like you’ve had a real positive improvement in the margin for some time now. And even in this last quarter you caught me a bit off guard. Can you talk to where the improvements coming from and why we should think of the margin as at least stable? Or maybe perhaps another way of thinking about this is, do you think you can improve any further?

Frank Techar

Yes. Thanks, Darko. We were happy with the margin improvement this quarter in support of our 9% revenue growth. And it was a contributing factor. I think when you think about the performance of our net interest margin, the biggest reason that we are seeing the continued strength has to do with the mix in the portfolio. If you look at the balance sheet growth in Q3, we had very strong growth in our high spread loan products. We had faster growth in our consumer loans. We had faster growth in our commercial loans than we had seen in previous quarters. And so that contributed to the margin improvement as well.

On top of that, we have not seen our deposit growth decline as much as we had expected as we’ve gone through the year. We thought consumer preferences were going to change as the economy improved. And our deposit growth, both on the commercial side and the retail side, our core operating deposits have both been in excess of 10% for the last couple of quarters. So the combination of faster growth in higher spread loans plus continuing strong growth in our core low interest rate deposit products are resulting in the margin just staying as strong as it has been. In the quarter, we also had a little bit of help from some mortgage refinancing fee business as well. So that helped us out.

But my expectation going forward for margin is that we should be able to hold our margins in and around the 290 level, which we saw. I suspect there will be a little bit of volatility depending upon some of the non-core things. But we are expecting our high spread product growth to continue. And if you look at the balance sheet growth this quarter, the sequential growth in loans and deposits, and you annualize both of those, the loan growth is over 9% and our deposit growth is over 6%. So we think that the balance sheet mix, the change in mix, as we continue to move forward is going to continue to benefit the margins.

Darko Mihelic – Cormark Securities

Okay. Thank you. And maybe just one more question, it’d be remiss to not touch upon trading. So the question is for Tom, with respect to trading, can you talk to the weakness that we saw in the quarter, particularly in fixed income side and talk to us about what kind of run rate we should be using or thinking about for your business?

Tom Milroy

Okay, Darko. Thank you. Obviously, the third quarter was a discipline that it didn’t meet our expectations after two quarters that we’re particularly strong. In the quarter, we experienced more volatility, increased client uncertainty and fewer opportunities. So if you look at page 12 of the sub-pack, you will see that the greatest decline came in the interest rate trading area, and there was – what I would group as sort of two broad factors; one was credit spreads and the other was our fixed income business.

In terms of credit spreads, widening spreads negatively impact the number of the positions we had in some of our non-core businesses. And those were the same positions that we had seen positive marks in Q2. We saw negative in Q3, and it’s obviously – the delta is larger. It amplifies the impact when you have a gain followed by a loss. The other thing that happened in terms of credit spreads was we had increased CVA charges resulting from the fact that in general the spread between our credit spread and our counterparty’s widened. So those two factors were significant and probably accounted for almost 60% of that decline you see. The last major piece of it, which was the fixed income business, the fixed income business just had a poor routing [ph] in the quarter. We saw both narrowing margins and client trading activity, and frankly, fewer trading opportunities.

Darko Mihelic – Cormark Securities

And so on a go-forward basis, how should we think at both of those as that spread impact abated already in Q4 or what can you offer us on that?

Tom Milroy

We saw – I mean, the question came another way, which was May was a particularly weak month, with both June and July were better. And so we’ve seen some improvement in that already. And I can’t forecast for you the exact amount you should put in there. But I think if you look backwards and you look at some of the historical results, clearly we wouldn’t expect to see a repeat of Q3 in Q4.

Darko Mihelic – Cormark Securities

Okay. Thank you.

Operator

Thank you. The next question is from Sumit Malhotra from Macquarie Capital. Please go ahead.

Sumit Malhotra – Macquarie Capital

Good afternoon. Two net interest income related questions. Let’s stay with Frank for the first one. The one area you didn’t mention in answering the last question was the impact of the increases in prime rate and not for the full quarter, but you did get 50 basis points of hikes in Q3 from the Bank of Canada. Can you talk about how that impacted the 5 basis point increase? And specifically, Frank, I think you are one of the first executives to mention that while rate hikes in theory should help, some of that will be eaten away by competition. So just want to know how that impacted the quarter and how you see that going forward.

Frank Techar

Yes, I think – Sumit, I think the rate hikes were not a big factor in the improvement in margins for this particular quarter. I think, as I described, the change in mix and the mortgage refi fees were the two biggest reasons. So I think what I’ve said in previous quarters were net-net, all those things being equal, if rates go up, it should help. But that we were anticipating also some competitive pressure in the marketplace relative to price and doing business, and I think the increase in the prime rate basically got absorbed through the competitive dynamic. So the two reasons I’ve described are the real two reasons we saw improvement this quarter.

Sumit Malhotra – Macquarie Capital

All right. And if the second part of my question is probably best answered by Bill Downe, Bill, you’ve mentioned a few times on these calls that in your view the economic recovery would be driven on the business side and specifically you talked about that in relation to your US commercial lending mandate. When you – when I reconcile that with your comments about the step-back in economic growth over the last few months, how are you feeling about that business-led recovery or the corporate commercial opportunity for BMO on the business side in 2011?

Bill Downe

Thanks, Sumit. I think to some extent, the slightly slower rate of growth in the latter half of 2009 doesn’t really interfere with 2011. 1.5% GDP quote is positive growth. I think that we have to look to export expansion from the US market as a driver, and that’s why it is a business-led recovery. And we still have confidence in that. I think that it probably will be first – it will first show up simply in credit utilization. There is a lot of committed credit available. Balance sheets are very clean. There is a lot of cash in the hands of corporate America, the numbers in the trillions of dollars that of cash and cash availability. So I think that when you start to see a pickup in capital investment, which I think is inevitable because it has been installed, we will see first greater utilization.

The one thing that our push in commercial banking in the last six months in the US has shown is that we can open new relationships. We haven’t seen much utilization from that activity. In fact, many of those lines aren’t being used yet, but we do believe that they will be. So I think it’s a little bit of timing. If you back a year ago, we all accepted the fact that it was liable to a slow recovery. And while I think everyone is prepared to put a probability on the so-called double-dip, I think it’s still a low number. So maybe a delay of a quarter or two in terms of credit utilization, but we still think that this is where we are going to see a very concrete signs of growth. And then I think it will follow into the consumer sector after that.

Obviously, on the consumer side, the overhang in the housing market is going to, for some period of time, keep consumers somewhat conservative. But even there, they are repairing their balance sheets. The positive savings rate is having a very salutary [ph] effect on consumer balance sheets. So the quality of consumer credit will be better going forward. And if you look at what’s going on in the credit card market, transaction volumes in July and August seem to be pretty steady. So I don’t think the consumer has gone on strike, but we’ll be waiting for the business-led recovery to signal that better times are coming.

Sumit Malhotra – Macquarie Capital

Thanks for your time.

Bill Downe

Yes, happy to.

Operator

Thank you. The next question is from Rob Sedran from CIBC. Please go ahead.

Rob Sedran – CIBC

Good afternoon. Viki, I’ll be good. I’m just going to ask one question. Russ, you mentioned expenses. And I know that they were pretty meaningfully higher quarter-over-quarter. And I couldn’t tell from your comments if it was unusually high or if it was at sort of sustainably high. I know you mentioned the impact of acquisitions and business investment. But is that a line where we can expect some relief next quarter or should we assume that the Bank of Montreal continues to invest and so that number is going to stay elevated for a while?

Russ Robertson

I think – Rob, thanks. I’m just looking at page 13 of the sub-pack. I guess the first comment I’d make is that when you look back over the past two years, the expenses, I would suggest, are not that elevated. We did bring expenses down a little bit towards the end of ’09, but the $1.898 billion is not that different from what you’ve seen in prior quarters. So I wouldn’t call it elevated per se. But we are very focused on managing our expenses, as we’ve said in prior quarters. And so we are very focused on the FTE count. I would say in that area we did add quite a number of people this past quarter, but – I think it’s around 800 or so. But 80% of those are frontline revenue-producing individuals, and that’s certainly an investment, intentional that we would do that.

In the supplier spend, we continue to really focus on that cost. But again, having said that, we are making a number of technology investments in our client experience. And so that will continue. And then in the area of just managing our travel and business development and personnel expenses, again, we are pretty hard-nosed about that, but we are out there doing business and we are traveling. So I wouldn’t call it elevated, but I would think this level of expense you will see probably going forward because of the investment spend which is very intentional to drive higher revenues.

Rob Sedran – CIBC

And – fair enough. I guess I was looking at an excluding performance-based compensation, which was down this quarter even as the total expense was up. And I guess that’s the reason why I would have said they were elevated because they didn’t come down as performance-based numbers came down. Should we expect that the performance-based numbers are – have got a downward bias to them as well, or will they be bouncing back? I mean, are we kind of comfortable with the accrual that you had so far this year, or is there anything else that we should be looking for there?

Russ Robertson

We are quite comfortable. We’ve accrued on an appropriate basis. And if revenues move back up, you will see that incentive compensation move back up as well.

Rob Sedran – CIBC

Okay. Thank you.

Operator

Thank you. The next question is from Mario Mendonca from Canaccord Genuity. Please go ahead.

Mario Mendonca – Canaccord Genuity

Good afternoon. Probably for Bill, there have been a number of articles recently, essentially speculation on where BIS will come down on a – where they will come down in terms of the calibration on a particular capital ratio, whether it’s 4% to 6% with 2% capital conversion buffer. Is there anything you can provide – any insight you can provide on where you think the calibration will come down and anything along the lines of what a phase-in period might look like?

Bill Downe

I think the – Mario, thanks for the question. I think that we are getting pretty good transparency from both the BIS and from the regulators. And coming out and talking about where the consensus is forming, the trend since last December, I think, has been a moderation of what I would have thought were some unrealistically hawkish positions. And so I think as the refinements work through and we’re really looking at three or four months, I think those refinements are going to be made with one eye on how much capital is necessary fully through the cycle and it may moderate a little bit more, because the other eye is going to be on economic growth and the importance of maintaining economic growth. And without giving two much credit to the process, I think it’s working reasonably well.

So from our starting point, it looks to us as though we are very well capitalized. And I think that the run-in period – I think actually the guidance has been relatively general. But I think if you look at European banks in particular, they are going to need an extended time period. I think that extended time period will apply to North American institutions as well. So I do think that we’d probably see a little bit of further moderation. There is clearly some yet-to-be-had discussions about the notion of contingent capital and how some of those structures might work. And I think that’s really somewhat open-ended. But you might want to think about Tier 1 versus total capital, and I think it’s the difference between Tier 1 and total capital where there may be some advancement, some new thinking that has yet to emerge. But I think right now the best capitalized banks are being very cautious about saying they have surplus capital. I think in the resolution of the final talks. I think we’ll probably be able to look at a higher degree of confidence that we have growth capital, both for organic growth and for some acquisitions.

Mario Mendonca – Canaccord Genuity

And is it your just talk or is it your feeling then – because I think most people would agree that BMO is one of those banks being at strong capital position. Is it your view that (inaudible) be able to relax any kind of restrictions on dividend increases in 2011?

Bill Downe

I wouldn’t put that at the feet of any supervisor. I think that recognizing that there is going to be a global framework, it’s prudent in any jurisdiction to conserve capital and so you know what the rules are. But the earning power – we look at the earning power of the bank. And if you look at our payout ratio, it has moved back towards our range. And we were outside the range for some period of time. Once you get back into the middle of the range, I don’t think, from a timing perspective – and you’re talking about over two to four quarters, I don’t think that there will be restrictions that will get in the way of dividend increases at that point.

Mario Mendonca – Canaccord Genuity

So you said you don’t think there would be restrictions?

Bill Downe

No, I think this time next year it will be very clear what the capital structures are, and the earnings power of the bank will have put us in a different place.

Mario Mendonca – Canaccord Genuity

That’s helpful. Thank you.

Bill Downe

You’re welcome.

Operator

Thank you. The next question is from John Aiken from Barclays Capital. Please go ahead.

John Aiken – Barclays Capital

Good afternoon. Bill, carrying on with the deployment of capital fee, we’ve seen the most risk-weighted assets decline for six straight quarters. And when do you become comfortable with, I guess, reinvestment of capital on the business? Is it Basel III? Are you looking at IFRS? And as a follow-on to that, are you happy with how the FDIC deal has gone? And would you look towards that as a way of expanding your footprint or would you look to a more normal M&A acquisitions?

Bill Downe

Thanks, John. I have to compliment you. You managed to make a –

John Aiken – Barclays Capital

That was three, wasn’t it?

Bill Downe

A large list of questions into one very neatly packaged question, and Viki will put a little star next to your category on that one.

John Aiken – Barclays Capital

Bill, you can choose which ones you want to answer then.

Bill Downe

I’m happy to – I'm happy to give you an ombudsman answer. The – you are right about the decline in assets. And a lot of that has to do simply with credit utilization. As I said earlier, I think you’re going to see a natural pickup in asset growth as existing commitments start to be used in a more normal way. So I do think we will see organic growth there. The acquisition of the bank in Rockford and Madison, I think, is a good example of how infill expansion really can be beneficial. We essentially opened ourselves up to a much larger group of potential personal and commercial customers. We didn’t just buy assets. It is access to those customer base. And we’ve been able to rationalize branches and people in that process. So it should clearly be more profitable than what a legacy business would like. So I think it’s very attractive.

One thing you’ve seen is that the FDIC has gone a little bit quiet for the last 60 or 90 days. I don’t think that’s because of lack of supply. I just think there is some absorption that has taken place. And it’s just a question of people capacity. You can’t resolve these banks without having people free to do it, and they have come through quite a period actually of resolution of banks. So I think there should be some opportunity there. Those are very attractive transactions. And it’s not just the notion of buying something cheap. It’s access to high quality markets. So I think that does provide an opportunity to stimulate growth. I think I got three of the – the three parts, and I don’t know if I missed something in the middle –

John Aiken – Barclays Capital

No, no. You’ve covered them all. Thanks, Bill. That’s helpful.

Bill Downe

You’re welcome.

Operator

Thank you. The next question is from John Reucassel from BMO Capital Markets. Please go ahead.

John Reucassel – BMO Capital Markets

Thanks. Bill, just wanted to clarify your answer to Mario’s question on dividend. Did you say that it would become clear on BMO’s ability to raise the divi in two to four quarters? Is that what you said?

Bill Downe

John, we are getting into a level of precision here that – I'd prefer not to because I don’t want to make you uncomfortable or me uncomfortable. What I said or what I intended to say was that the dividend payout has come back close to the target range that until there is clarity around capital standards, having – maintaining higher levels of capital makes a great deal of sense. But that we look to the increase in the earning power of the bank to bring the dividend well within the payout range. And when it’s well within the payout range consistent with what we’ve said, our objective is which is to grow our net income and to grow our dividend. I think that’s the timeframe when we would start to talk more about that.

John Reucassel – BMO Capital Markets

Okay. And so I think your previous range was around 50% – 45% to 55%. Correct me if I’m wrong. And so, does that with the new kind of regulatory backdrop? Does that payout ratio range have to come down? It seems like there are some disincentives on high payout ratios coming out of these Basel documents. Is that interpretation fair? And could you talk about your longer term payout ratio?

Bill Downe

I think, John, it’s the relationship between growth opportunities in the business and dividend growth because it really does swing on the amount of capital that you want to maintain. And as you know, it’s arithmetic. It drives rate out of the earnings of the Bank. So at the time that we increased our payout range from 40% to 50%, where it was, to 45% to 55%, the acquisition opportunities were very constrained because basically the market was pricing acquisitions at three times book. And we thought that a higher distribution at that time made sense.

So I think when you have to roll forward a year and say, where do you think you will be able to find organic growth that’s profitable and will there be good opportunities for reinvestment? And that’s the time at which you’d say that you might amend the objective around payout. But if I was a shareholder or if I was an analyst, I would be focused more on growth in the dividend itself and not too bound by what the payout ratio might have been in the past or what our previously declared range relative to the other banks would be. I don’t think it’s that significant a boundary, personally.

John Reucassel – BMO Capital Markets

Okay. To Frank Techar – just, Frank, the outlook for consumer loan growth in Canada, has it changed – your view changed in the last quarter or so, given the slower economic growth and housing stats? Could you give us a sense of what you expect from BMO or from the industry as you look forward?

Frank Techar

Yes. John, we have had really strong growth in the last couple of quarters, stronger this quarter again. The primary reason for the growth is two products; one is Homeowner ReadiLine line product and the other is our auto loan. Both of them obviously secured. Both of them we’re really happy with. And the HRLC product is – I mean, the way we look at is really a substitute for the mortgage – for other mortgage products. And so to the extent we see a tail-off in the mortgage business, it’s likely we might see a bit of a decline in our HRLC business going forward.

Having said that, our objective is to continue to grow share in this product category. It’s obviously important product to us. And our investment agenda is focused on continuing to grow. So through – as Russ mentioned earlier, through putting more people into our branches, focusing more, being more competitive in our distribution network, we are going hard at the marketplace. So I think our strategic agenda is positioned well to us at any decline that we might see in the market itself.

John Reucassel – BMO Capital Markets

Okay. Thank you.

Operator

Thank you. The next question is from Michael Goldberg from Desjardins. Please go ahead.

Michael Goldberg – Desjardins

Thanks. I have two questions. First of all, for Bill, if the contingent capital proposal from the Basel Committee that just came out recently as implemented, what do you think the impact will be and how would you adapt?

Bill Downe

Michael, I think consistent with what I said a minute or so ago, I think that it really is going to be a discussion about the value of the difference between Tier 1 and total capital. And so contingent capital will fit into that zone. And the issue around contingent capital will be how to structure in a way that’s both cost effective and has appeal to investors. And I think you have to look like innovative Tier 1 at sub-debt and perhaps [ph] shares and think your way through where the market would be. My own view is that there is a place in the market where you will be able to issue capital in this category and don’t know where it will price. And the pricing will determine how much you do. One way you might want to think about it is the idea of a total capital ratio, which might allow a portion of the capital to be contingent. And if the market wasn’t there, then I guess we’d have to all be common.

Michael Goldberg – Desjardins

Great.

Bill Downe

The way you could think about it.

Michael Goldberg – Desjardins

Right. Okay. And my second question is if you could give us your view of how you expect reform of the US home finance process to develop. I guess an issue that seems to be at least getting started if not in process now.

Bill Downe

I think there is a commitment on the part of the President to get started in January. I’m sure that at this point he wished he had said he was going to get underway by January 2012, because I think allowing a little bit of time will make it easier for that adjustment. And I think it all relates to the structure of the housing market, and you can make all kinds of comparisons, Michael, between the Canadian housing market and the US housing market and whether tax deductibility of mortgage interest makes sense, the degree to which Fannie and Freddie have to be direct participants in the market or whether they could be guarantors. And I think it will take some time for that today to take place. So I would look for all of 2011 for there to be a discussion around the resolution of the market. And it will only be eased as the housing market stabilizes and you start to see a firmer floor under house prices.

Michael Goldberg – Desjardins

So you think it’s going to take an extended period of time before there actually is even some clear idea of how it is going to go or do you think that, in January, there is a proposal that emerges that could be the basis of how it is going to go?

Bill Downe

Well, this could go on past the end of this call, but the mid-term elections will determine the temperature of those discussions. But I suspect that the President said he was going to get started on it in January. He will start forming the committee in January. So I think you’d see an extended period of time, and I don’t know what rush there would be. The objective, I think, is to get something done, but I don’t think there is a red-hot hurry

Michael Goldberg – Desjardins

Thank you.

Operator

Thank you. The next question is from André Hardy from RBC Capital Markets. Please go ahead.

André Hardy – RBC Capital Markets

Can you please talk about your view of a normalized tax rate and also talk about what took the tax rate from the 20% range to the 13.5% range in the quarter?

Russ Robertson

It’s Russ. Well, certainly the – as you know, our effective tax rate benefits from income earned in low tax rate jurisdictions and also benefits from transactions we do facilitate on a tax efficient basis with our clients. In Q3, those tax efficient transactions probably improved with the delta of 5% or so from the 18 down to 13. But I would also add that our lower pretax income in Q3 does make our income earned from low tax jurisdictions more of a factor in the effective rate, which does bring it down as well. So, André, essentially it is the tax efficient client transactions that took it from 18 down to 13.

André Hardy – RBC Capital Markets

But these transactions are helping or hurting your revenues?

Russ Robertson

Helping.

André Hardy – RBC Capital Markets

So you have a plus on the revenue front and a low tax rate?

Russ Robertson

Yes.

André Hardy – RBC Capital Markets

So –

Russ Robertson

I reflect [ph], as you know, on a tax equivalent basis, you can see that in the groups. The TEB – you can see it in corporate. You can see the TEB growths up in corporate. So – and the offset would be in the group. So you see –

André Hardy – RBC Capital Markets

Sorry, Russ. I guess I was looking at it on the 2.9 billion of revenues, not doing tax affecting.

Russ Robertson

Okay. Well, you would not – no. We reversed that at a total bank level.

André Hardy – RBC Capital Markets

So at that level, that would have hurt or helped revenues?

Russ Robertson

At total bank level, it would be neutral. It doesn’t affect revenue. You just see it in the tax line.

André Hardy – RBC Capital Markets

Okay. So if I’m normalizing your numbers for tax, all I’m doing is taking that 13% to 20% and there is no revenue impact?

Russ Robertson

Right.

André Hardy – RBC Capital Markets

Thank you.

Operator

Thank you. The next question is from Steve Theriault from Bank of America/Merrill Lynch. Please go ahead.

Steve Theriault – Bank of America/Merrill Lynch

Thanks very much. Couple questions. Bill, we’ve talked a lot about dividend increases. Can you refresh us on your thoughts on the potential for buybacks once the regulatory air clears? Would you entertain a buyback before increasing the dividend?

Bill Downe

We have an ordinary course issuer bid in place. It’s a helpful tool to offset small amount of dilution. To me, it’s a business as usual capability in barring the current situation where you’re really waiting for regulatory clarity. There is no reason why once you had regulatory clarity you wouldn’t be incorporated. I think it’s a little different than a dividend increase just because it tends to be small amounts and at really an opportunistic moment in time. So I don’t see buybacks as a big factor in total capital, but I’m putting a little bit of a fine point on it and I think that was really your question.

Steve Theriault – Bank of America/Merrill Lynch

Yes. So just offset small amounts of dilution really?

Bill Downe

Yes.

Steve Theriault – Bank of America/Merrill Lynch

Okay. And just a quick one for Ellen. With the AMCORE acquisition, the productivity ratio jumped to over 70% this quarter. Is that going to be a fact of life for a little while or are there things you can do in the near-term to get back down below the 70% level?

Ellen Costello

Actually, we have announced the headcount cuts that we’ve planned to execute between now and the end of the year. And that’s about half of the workforce. So that will bring our expenses down quite a bit as we head into Q1. And also as I think that Russ touched on this, we do expect a fairly significant acquisition integration cost in Q4, but you will see a normal run rate for the business at the start of the fiscal year. I don’t know if that answers your question completely.

Steve Theriault – Bank of America/Merrill Lynch

And the normal run rate closer to what it was a couple of quarters ago?

Ellen Costello

Yes, that’s right. Because if you factor out AMCORE as well as the MSR adjustment, you would find our expenses are flat over the last year.

Steve Theriault – Bank of America/Merrill Lynch

That’s helpful. Thank you.

Operator

Thank you. The next question is from Brian Klock from KBW. Please go ahead.

Brian Klock – KBW

Good afternoon and thanks for taking my questions. I guess, Tom, this question is for you. The credit trends continue to improve. And actually when I look at the gross impaired loan formations, they were very positive, especially in the US when we look at construction in the commercial real estate portfolio. Just want to make sure – it sounded like from your comments that you are kind of hedging your bets a little bit saying it seemed like there may be some lumpiness. Was there anything that you are seeing maybe post end of the quarter that makes you kind of think that the gross impaired loan trends and formation trends may be a little lumpy going into the fourth quarter?

Tom Flynn

There is really nothing happening post quarter-end that’s influencing our view. And to me, the comments that I made this quarter related to just noting an air of caution related to the potential for variability are similar to the comments that I made a quarter ago. And provisions that are down this quarter are down more than we thought they would have been a quarter ago. And like last quarter, this time around we benefited from very low provisions on the capital market side and an elevated level of recoveries. And so given where we are in the cycle, the fact that there are still challenges in the US and there is the potential for one or two larger credits to jump up on the capital market side, I would just want to caution people that the steep downward trend that we’ve seen may not repeat quarter after quarter.

That said, the general trend backing away from a quarter-over-quarter performance, we think, is clearly positive. And delinquencies are trending down. The Canadian portfolios are performing well. Capital Market portfolios are performing well. And the weakness that we’ve got in the US is reflective of the environment, and we need a little more time for the employment rate, hopefully, in the US to come down and have things stabilized. And with that, we will be more confident about a lower run rate on the credit side.

Brian Klock – KBW

Okay, great. And actually, Viki, you will be happy. Most of my other questions have been answered, so I’m going to do one question and get back in the queue. Thanks, guys.

Operator

Thank you. The next question is from Cheryl Pate from Morgan Stanley. Please go ahead.

Cheryl Pate – Morgan Stanley

Hi, good afternoon. I have a question for Ellen on the net interest margin in the US. And trying to think about how much of the margin improvement this quarter driven by higher loan spreads, how much was due to loan repricing versus new loans going on at higher spreads and how much we can expect that to continue? Another way to say it is, how much of your loan book still has to reprice? And thinking about the margin on a normalized basis going forward, there has been a couple acquisitions, some movement of corporate loans into the portfolio. How should we think about the margin going forward and eventually moving into a rising rate environment down the road in the US as well?

Ellen Costello

Thanks for the question, Cheryl. I would say that there are three drivers of the margin improvement. One is the loan spreads that you touched on. And that’s a function of both renewal credits and new originations that are coming at higher spreads and improving the overall spread on our books. Also, our deposit growth has been very much centered in core deposits, which are more attractive from a spread perspective, even though we have depressed margins in deposits. That growth is outpacing some of the margin impact. And then lastly, we do have a smaller loan book that the margin is reflective of. So that is a factor. As the loan book normalizes, you will see some normalization of that spread probably coming down a bit. And then I think it – I don’t think we’re going to see increased interest rates for a while, but certainly when we do, we hope that we will see some improvement in that depressed margin from a deposit perspective.

Cheryl Pate – Morgan Stanley

Okay. And just as a quick second question, any update you can offer on potential impact from some of the regulations coming in in the US, particularly Reg E, and any mitigation opportunities that you could implement as well?

Ellen Costello

That’s another great question. Reg E doesn’t have as much impact on us as other banks. We have about 5% of our households that are active over-drawers of their accounts. And I would put a number on it of about 25 million. So that’s how small it really is on a relative basis compared to some others you’ve – numbers you’ve heard in the market. We are looking to recover some of that by restructuring some of our checking products much like the industry are currently doing as well as offering options to our customers like savings accounts, overdraft facilities, that type of thing. And some ability to opt in should they choose. So we think we should be able to partially recover, similar to the industry, 50% to 60% of the loss.

Cheryl Pate – Morgan Stanley

Thanks. That’s very helpful.

Operator

Thank you. The next question is from Gabriel Dechaine from Credit Suisse. Please go ahead.

Gabriel Dechaine – Credit Suisse

Hi, good afternoon. Just want to ask about your interest rate sensitivity. It looks like you are hurt more by a decrease than you are by – than you benefit from an increase, and that’s switched around for the first time in the last few quarters. Could you talk a bit about your positioning, what you’ve kind of modeled as far as rate increases, and what happens if rates stay flat in the US and in Canada possibly over the next – throughout 2011? And then, Tom, you mentioned something along the lines of non-core positions not benefiting from the spread widening up that took place this quarter as opposed to spread tightening last quarter. Is that a referral to the proper book? And if so, could you expand on that?

Tom Flynn

It’s Tom Flynn. I’ll start on that. In terms of gentle movement in spread, I don’t think I’d have a lot to add to the comments that Frank and Ellen have made, where they have talked about where the spread was going in the business. In terms of the sensitivity, the sensitivity of earnings to a 100-point decrease in rates increased in the quarter, as you pointed out. That’s in the sub-pack. And the larger negative number there really reflects the consequences of primary increases in Canada. And with a 50-basis point increase in the Bank of Canada rate over the quarter, there is basically more room for rates to move down than there was before. And that creates more exposure when you shock the rates down 100. So it wasn’t a positioning thing. It was just a result of the move by the Bank of Canada and how the model works.

Gabriel Dechaine – Credit Suisse

Are you anticipating rates to – are you modeling rates to, say, go up at the midpoint next year or –?

Tom Flynn

We think, in Canada, rates are going to continue to move up, assuming obviously that the economy continues to do well. And our expectation for US rates is that they won’t start to move up until well into next year.

Gabriel Dechaine – Credit Suisse

Okay. And my question to Tom?

Tom Milroy

At this time [ph], Gabriel, is – I think just to be clear, we had a number of positions in non-core – these are non-core business that we hold. And yes, we hold them for our own account. So I think you could consider them prop. What happened was that as spreads tightened in Q2, we marked those positions to market and it resulted in gains. And in Q3, it swung the other way and there were losses. And the point I made was, when you have a gain followed by a loss, the quarter-over-quarter delta is the sum of the two.

Gabriel Dechaine – Credit Suisse

I think, by way of clarification, Tom, you are talking about legacy assets?

Tom Milroy

Legacy assets, and the perfect example – I wouldn’t be telling you anything that’s not in the market is, the position we hold, as an example, in the Montreal Accord business.

Gabriel Dechaine – Credit Suisse

Okay. Thank you.

Operator

Thank you. The next question is from Brad Smith from Stonecap Securities. Please go ahead.

Brad Smith – Stonecap Securities

Yes. Thanks very much. Just a question for Bill. Bill, looking forward and anticipating that there would be some investment opportunities in the US, I was just wondering if you could describe to me a little bit the formula or the approach that you take to evaluating prospects when they are brought to you by your operators? And specifically I’d like to talk a little bit about profit thresholds, your cost of capital, which I believe has been held pretty steady at 10.5%. Would that be the same cost as in the US or is that blended number different when you look there? And just talk a little bit about the return on assets in the US, which runs about 70% of your ROA in Canada, where do you see that potentially going through scale increase and things like that?

Bill Downe

I’ll try to give you a brief answer on that one. We have a framework around acquisitions that has worked pretty consistently for us. It still looks at a hurdle rate – IRR hurdle rate of 15% and accretion in a relatively short period of time, three years or less. I think in this environment, we are looking for opportunities that are accretive immediately. I don’t think that’s going to be something that prevails for a long period of time. But we are much more driven by the relevance of the property to our business model, the way we serve customers and our existing footprint and anything else.

So if someone brings once in a lifetime transaction in a business that doesn’t look like an existing business, it’s far away from where we do business or is an area where we don’t have experience in or knowledge, it’s not really that relevant. We’re not interested in. So I think that we’re looking for contiguous similar acquisitions and mostly in the personal and commercial and wealth areas. And we have an active group who is very busy and maintaining relationships in hopes of something emerging.

On the Capital Markets side, less inclination to acquire businesses. We have been very fortunate in being able to attract high quality people. And that has led to business expansions. And a good example is municipal bond business where long heritage in the municipal bond business, but have really been able to increase our presence in that segment of the market by adding talents. And so – there is really no change in the sense of the standards that we have or the discipline we have, and the discipline served us well.

Brad Smith – Stonecap Securities

Great. The one thing that I'm just trying to wrap my head around is when I look at the return on the assets in your US P&C Bank, I know at their peak they were doing 70 basis points on an annualized basis. In the latest quarter, it was less than 50. And I’m trying to understand how, in that environment, any potential opportunity that came your way could be jammed into your 15% IRR. Is it just through your leverage assumption or how do you do that?

Bill Downe

Well, the calculation that made, of course, has a burden of a very large impaired loan portfolio. So if you take an acquisition that was with government assistance, the vast portion of the impaired loan portfolio, you’d be able to mitigate at the time you did transaction. So I don’t think they are comparable.

Brad Smith – Stonecap Securities

Right. But back in 2007 and 2006 when you were generating 70 basis points on your invested assets in the US, there was no big impaired loan portfolio. And I’m still not sure how you can jam that into a 15% IRR. How do you make that happen?

Bill Downe

I think that’s a question that we probably have to take offline and sit down with a pad and paper and work through it.

Brad Smith – Stonecap Securities

Okay. That would be helpful. Thank you very much.

Bill Downe

There is no mystery to it, but I don’t want to prolong the conversion. We’ve gotten to, I think, the limit that Viki allocated to us as management. And I’m going to turn it back to her.

Brad Smith – Stonecap Securities

Okay. Thanks.

Operator

Thank you. This ends today’s question-and-answer session. I would now like to turn the meeting back over to Ms. Lazaris.

Viki Lazaris

Great. Thanks, everyone, for joining us today. And as always, please feel free to call the Investor Relations team and we can follow up on some of the questions. Thanks. Have a great day.

Operator

Thank you. The conference has now ended. Please disconnect your lines at this time. We thank you for your participation.

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