Bank of Montreal's (BMO) CEO Bill Downe on Q2 2014 Results - Earnings Call Transcript

May.28.14 | About: Bank of (BMO)

Bank of Montreal (NYSE:BMO)

Q2 2014 Earnings Conference Call

May 28, 2014 2:00 p.m. ET

Executives

Bill Downe - Chief Executive Officer

Tom Flynn - Chief Financial Officer

Surjit Rajpal - Chief Risk Officer

Mark Furlong - Group Head, U.S. P&C Banking and Chief Executive Officer, BMO Harris N.A. (Chicago)

Frank Techar - Chief Operating Officer

Cam Fowler - Group Head, Canadian Personal & Commercial Banking

Tom Milroy - Group Head, BMO Capital Markets

Sharon Haward-Laird - Head of Investor Relations

Analysts

Robert Sedran – CIBC World Markets

Sumit Malhotra - Scotia Bank

Steve Theriault - Bank of America Merrill Lynch

Gabriel Dechaine – Canaccord Genuity

Peter Routledge - National Bank Financial

Doug Young – Desjardins Capital Markets

Darko Mihelic – RBC Capital Markets

Meny Grauman – Cormark Securities

Mario Mendonca - TD Securities

Sohrab Movahedi - BMO Capital Markets

Operator

Good afternoon. And welcome to the BMO Financial Group's Q2 2014 Earnings Release and Conference Call for May 28, 2014. Your host for today is Ms. Sharon Haward-Laird, Head Investor Relations. Ms. Haward-Laird, please go ahead.

Sharon Haward-Laird

Thank you. Good afternoon, everyone. 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 our Chief Financial Officer, Tom Flynn; and Surjit Rajpal, our Chief Risk Officer. After those presentations, we’ll have a short Q&A period where we will take questions from prequalified analysts. To give everyone an opportunity to participate, please keep it to one question and then re-queue. Also with us this afternoon are Frank Techar, Chief Operating Officer; Cam Fowler from Canadian P&C; Mark Furlong from U.S. P&C; Tom Milroy from BMO Capital Markets; and Gilles Ouellette from Wealth Management.

On behalf of those speaking today, I note that forward-looking statements may be made during this call. Actual results could differ materially from forecasts, projections or conclusions in these statements. I would also remind listeners that the bank uses non-GAAP financial measures to arrive at adjusted results to assess and measure performance by business and the overall bank. Management assesses performance on a reported and adjusted basis and considers both to be useful in assessing underlying business performance. Bill and Tom will be referring to adjusted results in their remarks, unless otherwise noted. Additional information on adjusting items, the bank’s reported results and factors and assumptions related to forward-looking information can be found in our annual report and in our second quarter report to shareholders.

And now I’ll hand things over to Bill.

Bill Downe

Thank you, Sharon, and welcome to everyone on the call. BMO’s quarter results demonstrate continued momentum and strong performance across the operating groups. Our largest business, personal and commercial banking in Canada did really well, with net income growth of 14% year-over-year. Commercial loan growth remained robust in Canada and the U.S. Our large North American platform provides attractive growth opportunities, especially in the current environment.

Wealth Management and Capital Markets also had strong results, both posting double digit revenue and earnings growth. [in sum], our Business Group performance resulted in positive operating leverage and good balance sheet growth with earnings per share up 13% from last year. today, we announced a dividend increase reflecting the success of our business strategies which are grounded in the work we do for customers; taking deposits, facilitating payments, providing credit, helping them make better decisions with better information and to have confidence in the decisions they make.

A few highlights from our second quarter; both reported and adjusted net income were $1.1 billion. Pre-provision pretax earnings reached $1.5 billion, up 11% from a year ago and earnings per share were $1.63. Revenue grew 9% from last year, contributing to positive operating leverage of 1.2%. Credit was stable in the quarter and Surjit will provide more detail later in the call.

BMO’s common equity Tier 1 ratio was 9.7% at the end of April. With the strengths in our common equity Tier 1 ratio heading into 2014, we had the flexibility to announce the acquisition of F&C in the first quarter which closed on May 7. In an environment where capital expectations from banks have been increasing internationally, we believe as a general principle that moving back to a common equity Tier 1 ratio between 9.5% and 10% is appropriate and provides flexibility.

Turning to the operating groups, Canadian P&C continues to demonstrate momentum, with net income up 14% to $482 million. Strong organic balance sheet growth continued, driving revenue growth up 6%. Combined with disciplined expense management, operating leverage was 3.3%. The business has delivered operating leverage above 2% for three consecutive quarters and is showing solid improvement in the efficiency ratio. US P&C net income was $150 million in source income. Revenue was stable quarter-over-quarter, largely due to robust commercial loan growth, which lifted total loans up 7% from a year ago and 4% sequentially.

Expenses were well controlled while we invest for future growth and absorb increase costs from a higher level regulatory engagement. Our commercial banking team continues to excel with growth across the core C&I portfolio as well as in commercial real estate. BMO Capital Markets reported strong results for net income over $300 million. Revenue growth was 14%, reflecting strength in both investment and corporate banking and trading products and return on equity increased to approximately 21%. These results reflect continued solid contributions from the US business where earnings are up 15% in the first half of this year.

Wealth Management also had a strong quarter with net income up $200 million, up 36% year over year. Assets under management and administration were up 17% to over $600 billion. The acquisition of F&C significantly increased our client assets which will be reflected in our third quarter. F&C is the proud manager of Foreign & Colonial Investment Trust, founded in 1868 as the world’s first publicly listed pool investment vehicle. The addition of F&C advances BMO global asset management strategy and growth trajectory. Today, our asset management business has 24 offices in 14 countries across five continents serving an increasingly global client base. Our multi-disciplined teams are headquartered in Toronto, Chicago, Hong Kong and London with a network of investment specialist boutiques strategically located across the globe. Our strengths span asset classes with a broad range of investment solutions across various geographies including equities, fixed income and multi asset solutions such as target date funds and liability driven investing.

To wrap up, strong operating group performance resulted in another quarter with consistent earnings over $1 billion. For the quarter and year-to-date, continuing business momentum is reflected in positive operating leverages and good balance sheet growth. And with our consistent strategy in areas of operational focus, we are confident that this will continue into the second half.

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

Tom Flynn

Thanks, Bill, and good afternoon. I’ll now take you through our results starting on Slide 8. We delivered EPS of $1.63 this quarter, which was up 13% year-over-year. Net income was $1.1 billion. Year-to-date performance is also good with revenue growth of 9% and EPS growth of 10%. As Bill said, our operating group results were strong. Canadian P&C continued to demonstrate momentum and wealth management and capital markets made strong contributions to our earnings growth. Good loan growth in US P&C contributed to stable quarter over quarter revenue. Similar to last quarter, the only adjusting item in Q2 is the amortization of acquisition related intangibles.

Revenue was $4 billion in the quarter, up 9% from last year. Looking at the components of this growth, net interest income was up 5% year-over-year, driven by volume growth, revenue from the purchased performing loan portfolio and the impact of a stronger U.S dollar, partially offset by lower net interest margin.

Net interest income was down 2% sequentially largely due to fewer days. Non-interest revenue was up 13% from last year, driven by higher non-interest revenue in almost all categories. Non-interest revenue was down 2% from Q1, primarily due to lower underwriting and advisory fees, trading revenue and fewer days.

Q2 expenses were $2.6 billion, up 8% year over year. The increase reflects business growth, the impact of a stronger U.S dollar and higher employee and technology costs related to a change in business and regulatory environment. Expenses were down from Q1, primarily due to costs related to employees eligible to retire in the first quarter, lower severance cost and fewer days.

The efficiency ratio improved 80 basis points from the prior quarter to 63.5%. Some peers calculate the efficiency ratio excluding certain costs including claims related to the insurance business which are outlined on the slide. On a similar basis, our Q2 efficiency ratio is much lower at 58.8%.

The effective tax rate was 16.5% down from last year. The rate was 24.4% on a TEB basis which is relatively in line with prior quarters.

Moving to Slide 9, our common equity tier 1 ratio was 9.7%, up approximately 40 basis points from Q1 due to lower source currency risk weighted assets and increased retained earnings. Risk weighted assets declined $5 billion from Q1 due to reduced market risk exposures and lower credit risk, which was primarily due to improved risk assessments, the favorable FX movement in the quarter, and these were partially offset by updates to calculation methodologies. As a reminder, the F&C acquisition will impact our third quarter of CET one ratio by approximately 75 basis points.

Moving to our operating group performance in the quarter starting on slide 10, Canadian personal and commercial banking demonstrated continued momentum, with revenue growth of 6% and net income of $482 million, up 14% from last year. Organic balance sheet growth was strong, with personal loans up 9% and commercial loans up 10%. Personal and Commercial deposits were up 10% and 9% respectively. NIM was down 3 basis points from last quarter due to changes in mix, including loan balances growing more than deposits. Expenses were up 3% year over year in part reflecting ongoing work to simplify core processes and investment in the business which will continue over the balance of the year.

Expenses were down 4% from Q1, primarily due to lower employee cost, including fewer days. Our execution focus is driving strong operating leverage in the business. It was 3.3% in the current quarter and the efficiency ratio improved 160 basis points from last year to 50.2%.

Moving to U.S P&C on slide 1, net income was US$151 million, down from Q1 which had a low level of PCLs. Pre-provision pretax earnings increased 4% quarter-over-quarter. Revenue of $691 million was down 3% from last year as loan growth driven by sustained double digit growth in core C&I loans was more than offset by lower NIM and mortgage related revenue. Revenue was stable quarter-over-quarter despite the impact of fewer days. The net interest margin declined primarily due to strong commercial loan growth. Loan and deposit spreads remained fairly stable. Expenses are being managed closely and were relatively flat year-over-year and down quarter over quarter.

Turning to Slide 12, BMO capital markets had a good quarter with net income of $306 million, up 17% year over year and 10% in Q1. Revenue growth of 14% reflects the benefits of our diversified business mix, including continued good contribution from the US segment. Expenses were up 14% from last year due to a higher employee related expenses and cost related to a changing business and regulatory environment. Expenses were down 5% sequentially due to lower severance costs and costs related to employees eligible to retiring in Q1. As Bill mentioned here we remain strong at 20.8%

Moving on to Slide 13, Wealth Management net income was $200 million up 36%year over year. Strong performance and traditional wealth continued with net income up 23% and revenue up 11% driven by growth in client assets. The underlying insurance business continued to perform well with income significantly higher than last year. The prior year results were impacted by movement in interest rates. Expenses were up 7% year over year primarily due to higher revenue base costs. Assets under management and administration were up 17%, driven by market appreciation, a stronger U.S dollar and growth in new client assets.

Turning now to Slide 14, the corporate segment had a net loss of $58 million compared to a net loss of $11 million a year ago and $41 million in the prior quarter. But the clients were primarily due to lower credit related recoveries partially offset by lower expenses in the current quarter.

To conclude, we had good results across our operating groups as quarter and for the first half of the year and are heading into the second half of the year with good momentum.

And with that, I will hand it over to Surjit.

Surjit Rajpal

Thank you, Tom and good afternoon everyone. Our credit performance was good this quarter, reflective of continued improvement in the U.S economic environment and stable conditions in Canada.

Starting on Slide 17, excluding recoveries in the purchased credit impaired portfolio, specifically sales improved by $9 million. Recoveries in the purchased credit impaired portfolio were down $72 million from prior quarter as the remaining portfolio is considerably smaller and almost half is performing. In Canada, commercial losses were in line with expectation. Consumer losses increased from the low levels of Q1, but are down 5% year over year and 10% year-to-date. Losses in the U.S consumer portfolio were flat, while US commercial losses increased $31 million. This increase was due to a few large accounts compared to last quarter where recoveries fully offset new reservation.

Moving to the next slide; formations of $509 million down $133 million from the prior quarter. The decrease was broad based, with deductions in commercial and consumer in both Canada and the US. Growth impaired loans also decreased this quarter to approximately $2.3 billion reflecting improvements in the U.S portfolio. In fact over the past year U.S growth impaired loans have decreased by approximately $500 million or 24%.

In conclusion, given the quality of our portfolio and our strong risk management practices, I expect our credit performance to remain good.

I will now turn it over to the operator for the question-and-answer portion of today’s presentation.

Question-and-Answer Session

Operator

(Operator Instructions) The first question is from Rob Sedran from CIBC. Please go ahead.

Robert Sedran – CIBC World Markets

First a quick clarification for you Tom. When you talk about 75 basis points for F&C, is there an operational risk weighted asset component to that or is that all the goodwill that comes with the deal?

Tom Flynn

There would be an operational risk component to the capital number, but the biggest number obviously is the goodwill.

Robert Sedran – CIBC World Markets

Okay. And just the -- my question actually is on trading and Tom Milroy, I guess. There’s been a number of notable moves not just in the overall number, but the components equity and foreign exchange were both quite strong. Can you perhaps comment on what specifically worked well? And then on a related note and maybe this flips back to Tom Flynn, the tax rate seemed a little on the low side on a reported basis, but the TEB tax rate seemed closer to normal. So is the tax issue related to the trading this quarter?

Tom Milroy

Okay, Rob, it’s Tom Milroy, I’ll take the first question and thanks for the question actually because I was hoping I get to talk to this. It was a really strong quarter that’s built on the solid foundation of the first quarter and we feel really good about the business and about how we are benefiting from the diversified business mix that we have. When you look at the trading numbers, let me talk first to the rates and then I’ll get to equity and FX. And you saw the big swing between interest rate and equity. Interest rate trading was really a function of two -- I would say two major factors. One was our own name spread which narrowed which has a negative impact on P&L. And then generally in the space we had much lower issuance, particularly in the government area and less activity. So that’s what happened in that piece.

In terms of equity, we benefited from several large client related transactions combined with strong equity market performance, low equity volatility, and we experienced higher retail note issuances. So they all combined to give us the swing you saw in equity. If you go to the FX trading line which also was strong, it was really a result of higher client activity. In particular the weaker Canadian dollar helped our export clients. And so we saw a lot of activity as they were doing more business and that was a plus. The other thing was we benefited from good performance from our FX business in China where we with the band and the R&B they were able to post some pretty good results.

Tom Flynn

It’s Tom Flynn. I’ll just go to the consolidated bank tax part of the question. And I think you really lead to the answer in your question. The TEB tax rate for the bank was about 24.4%, very much in line with a typical number. The effective tax rate is somewhat low this quarter at 16.5% and that simply reflects the higher level of TEB revenue and capital markets flowing through to the tax rate and the comments that Tom mentioned.

Operator

Thank you. The next question is from Sumit Malhotra from Scotia capital. Please go ahead.

Sumit Malhotra - Scotia Bank

The question relates to Canadian P&C and I wanted to start off first with your outlook on loan growth. BMO obviously had some of the stronger consumer loan growth in the sector over the past couple of years now. And it seems, at least on the consumer side to slow pretty noticeably. Hoping you can give us an update on what you are seeing here and whether or not that relates to perhaps a slowing in some of the third party mortgage activities the bank has been involved with?

Cam Fowler

Thanks Sumit. It’s Cam Fowler speaking here. Thanks for the question. The first thing I’d say is this is clearly a strong quarter for us. We are pleased on the net income, the revenue that’s driving it and the balance sheet growth both sides of the business. I’m also pleased with the operating leverage third quarter straight. The consumer lending piece specifically, while it is true that things are a little bit lighter quarter on quarter, I feel that’s primarily driven by a slower mortgage market in part driven by weather. We ourselves were a little bit later starting this year in the mortgage season, Sumit. That said, activities are back up to the volumes we’d expect and I think we’ll close the season quite well and expect Q3 to be stronger and that we’d finish the year quite well on the personal lending side. We have just to your specific point with respect to third party, the state involved in this to some degree or other over many years. We have dollar is down slightly in recent quarters, but I think primarily this is more the force on activity in the market.

Sumit Malhotra - Scotia Bank

Just to take the temperature a little bit here Cam, obviously BMO has had faster than industry growth on the consumer side and particularly mortgages for two or three years now. Is it your expectation -- I know you don’t have the full picture on what your competitors may or may not be doing on the pricing side, but is your expectation that you will revert back to above industry average growth in the near term or do you feel it’s more aligned now?

Cam Fowler

Pipelines are strong. We think that the home finance strategy that we’ve been undertaking for the past three years which is pretty focused on what’s best for Canadian consumers, shorter M, lower LTV, the fixed rate. The distribution system is pretty efficient at having these types of conversations with our customers and our prospects now. So I expect that we can continue to be a little bit better than the market.

Operator

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. If I can just start with a quick follow up for back to Tom Milroy on the equity trading. You mentioned several large client related transactions. So I guess those are equity derivative transactions I guess and I’m wondering if those are the total return swaps at the bank undertakes and if there’s any seasonality to that line of business?

Tom Milroy

Let me answer it. It is in the equity derivative area, but it’s -- I wouldn’t say it’s seasonal. It’s client driven so you end up, depending on what your clients are doing, that line will go up and down.

Steve Theriault - Bank of America Merrill Lynch

Okay. And if I can ask Tom Flynn, I saw in the notes you mentioned a change in calculation methodology. I apologize if you went through this in your commentary, but that’s partly what offset -- was an offset in the risk weighted asset category. So another bank this quarter flagged updated risk parameter updates. Is that similar to what we are seeing here from you today? And could there be more to come on this front? If you just give us a little more granularity either.

Tom Flynn

I’m not sure what was going on elsewhere, but every quarter as you know you go through processes related to looking at your models and your risk positions. And so this quarter there was a change related to that work. I would say it was nothing out of the ordinary and we wouldn’t expect anything out of the ordinary in this area going forward.

Steve Theriault - Bank of America Merrill Lynch

Okay. So it was more normal course. It wasn’t a review center of retail or commercial or anything specific, it doesn’t sound like?

Tom Flynn

That’s correct.

Operator

Thank you. The next question is from Gabriel Dechaine from Canaccord Genuity. Please go ahead.

Gabriel Dechaine – Canaccord Genuity

Good afternoon. The first question I have is on the purchase performing loans. That’s a $15.5 billion portfolio and it’s performing. So the NII is going through corporate, correct?

Tom Flynn

That is correct.

Gabriel Dechaine – Canaccord Genuity

Okay. And then as far as the U.S goes, I guess a two-pronged question here. Can you quantify the mortgage gain on sale you had this quarter and what it was a year ago and what's kind of a normal number? And then on the U.S NIM trajectory, a little bit weaker than I was expecting, not on a sequential basis, nothing to get all worked up about. But on a year-over-year basis, it doesn’t look like the trend is getting better. And I know Mark you’ve talked in the past about the pace of NIM compression improving over time. And I’m wondering if that’s still on track or if some of the loan growth we’re seeing is actually above average -- the loan growth we’re seeing is -- the offset of that is that NIM is going to stay lower for longer.

Mark Furlong

Okay. So thanks for the questions. I’m going to go to the last one first, the NIM question and see if I can go at both those. So I think one is what's happening with NIM and the other one is what's happening with loan growth. Is that a good way to translate it?

Gabriel Dechaine – Canaccord Genuity

Yeah. You’re about more straightforward than I am.

Mark Furlong

I want to answer your question correctly. So on NIM, my outlook is improving. We previously thought we have about 4 to 8 basis points of NIM compression this quarter. We now think prospectively maybe it's like 2 to 4 basis points. There will be variability in between quarters. Those quarters that have really strong loan growth, that strong loan growth will affect margin by a few basis points would be my right now. But overall, when we look at that loan growth, it’s driving revenue growth and we like the diversity. We like the credit quality and the new relationships we’re adding. In terms of prospectively, loan growth that was part of the question too. I think this was a really strong quarter.

So I don’t know that every quarter will look like this, but we like the pipeline in commercial and in business banking. We have a strong position in our biggest markets. In both of those we feel good long term about those. We’re putting up double digit loan growth in C&I and commercial real estate as well as in our business banking. If we -- you can’t bet on one quarter on its own, but if you looked at prospectively, we expect that we’ll be -- that we’ll have good solid loan growth prospectively when you look across year-over-year numbers. Did I get to where you want to get to on those two questions?

Gabriel Dechaine – Canaccord Genuity

Yeah. And if you can talk, well we can -- maybe I’ll re-queue for the other one, but the mortgage gains would be something I'm interested in.

Frank Techar

Gabriel, it’s Frank. On the mortgage gain question, Q2 ‘13 the gains were $19 million and this quarter $7 million just really specific.

Gabriel Dechaine – Canaccord Genuity

Somewhere in between there normal or how should I look at that?

Frank Techar

As you know, it's volatile quarter to quarter but within this range.

Operator

Thank you. The next question is from Peter Routledge from National Bank Financial. Please go ahead.

Peter Routledge - National Bank Financial

A question for Surjit. Surjit, I think credit is probably as about as good as we’ve seen it. And I suppose in your job you’ve always got to ask yourself how could it get worse. I actually don’t want to ask you that. What I want to ask you is how likely is it in your mind that it stays this good for an extended period of time? What's the argument that this lasts for two or three years?

Surjit Rajpal

I think the argument that this could carry on for a while is that the recovery of this last cycle has been very slow and the economy is still improving. The U.S is improving. Canada is stable and barring something happening that no one can predict, I think this may carry on the way it is for some time. So given our two principal markets, I think we’re very positive on the U.S. In Canada there seems to be no reason to be really concerned about. So I think this can carry on for a bit.

Peter Routledge - National Bank Financial

For you to change your mind on that, what would have to change in the broader environment? What are you looking at?

Surjit Rajpal

I think at this point in time I would say it would have to be a sudden or a shock event. I can’t think of anything that would cause things to get off the rail other than some event on the geopolitical front that I can’t really foresee at this point in time. But you’re right, the question you were planning to ask me and you didn’t ask, at this point in time I think things are good. But at some point in time the cycle will change but it doesn’t seem like it’s on the horizon right now.

Operator

Thank you. The next question is from Doug Young from Desjardins Capital Markets. Please go ahead. Mr. Young, your line is open.

Doug Young – Desjardins Capital Markets

So the first question is just on the US purchase credit impaired block. And I think if I recall back in Q4 you guided to $100 million pretax for 2014. I think we are at $152 million year to date over the first two quarters. I’m just wondering if you have an update in terms of your thoughts on a glide pass for that portfolio.

Surjit Rajpal

Let me give you a little bit of flavor. I think in my remarks I did say the portfolio is small. It’s about $600 million right now and roughly half of it is performing. So that leaves us with small portfolio and the accompanying market $12 million. So the variables you are dealing with are very different from what they were let’s say six or so months back. So I do expect recoveries and the recoveries will exceed the mark because when we bought the portfolio from M&I, M&I had already taken some reservations against that portfolio. So if my guidance not good two quarters back, it was because it’s very difficult to time some of the sales and the workout that happens with these accounts. Now given that the portfolio is small, I think there’s not too much left in it, but I would think in the next quarter we’d have a decent quarter. I think the recoveries will exceed the mark, but then the portfolio will have come down slower. So I would suggest that for the balance of the year it is going to be left in the first part of the year clearly, a lot less.

Doug Young – Desjardins Capital Markets

Is it conceivable by the end of next year that this -- there is not further adjustment from the portfolio? Is that fair to assume?

Surjit Rajpal

Highly likely, but it all depends. Highly likely that we won’t have much of it left by then.

Doug Young – Desjardins Capital Markets

Okay. And then just a quick follow -- or just a second question on the F&C transaction, just wondering if you’ve finalized all the purchase price details. And I would imagine you are going to in your adjusted numbers back out associated amortization. I’m just wondering if you have a sense of what that impact would be on a quarterly basis.

Tom Flynn

Hi, it’s Tom Flynn. Given that the acquisition just closed a couple of weeks ago, we are still working on finalizing the purchase price. So we don’t yet have the amortization number. Our plan is to back it out like we back out the other intangible amortization that we’ve got. And we’ll also have some integration charges. They won’t be that significant in the context of the bank, but we’ll be incurring those over the next few quarters and the plan would be to adjust for those as well.

Operator

Thank you. The next question is from Darko Mihelic from RBC Capital Markets. Please go ahead.

Darko Mihelic – RBC Capital Markets

A couple of questions. The first is, I’m wondering with respect to the expense control in the Canadian P&C -- or maybe perhaps you can speak about this in the context of an operating leverage. Can you just remind me what operating leverage are you looking for, for the balance of this year? What do you think is a more sustainable level? And then I have a follow up question with respect to loan growth please.

Cam Fowler

Darko, it’s Cam Fowler. Thanks for the question. With respect to operating leverage, we expect revenue to continue along a similar trajectory and our expense profile is relatively consistent. So operating leverage in line with an average of what we’ve done in the last few quarters. Perhaps not quite what happened this quarter, but not far off the two before that.

Darko Mihelic – RBC Capital Markets

And so just to be clear, expense growth in the 2% to 3% range is normal. And as I recall if I sit back and think about the previous couple of years, there was an awful lot of initiative spend at Bank of Montreal within Canada P&C and the sense that I’m getting is somehow that slowed or stopped. Am I wrong in that thinking?

Cam Fowler

I think that thinking is not quite right. What I would say is we continue on a similar revenue trajectory. I think expense as you’ve laid out is in the range 2% to 3%, maybe a little more, a little less from time to time. We’ve been on a relatively consistent track with respect to investment doing the business in the last three or four years. Spikes here and there, but the platform renewal continues. We just work very hard to ensure that it pays in such a way that we don’t have any blips. But I think positive operating leverage in the 2ish range is decent guidance.

Darko Mihelic – RBC Capital Markets

Okay. Thanks for that. And then maybe just to follow up on the loan growth questions. Two things; first, with respect to the mortgage promotions and I guess this year you are a little bit late with the promotion, my sense is that the other banks seem more competitive this year than last. They may not have actually copied the product, but they certainly are getting more aggressive with rates and even today I think we saw Scotia with a more aggressive rate offer. Can you speak to whether or not that’s having an impact? And then similarly last year when we looked at your commercial loan growth versus peers, you were clearly ahead. Now it seems as though many of the Canadian banks are also putting up impressive commercial loan growth numbers. Is there more competition now in commercial? And if it is, is that also affecting the overall margin in the Canadian P&C business?

Cam Fowler

Okay, thanks. Let me start with the first one. It’s possible there’s a little more competition in the Home finance market this year than last, but I don’t think to a large degree. I think we are all observing a slightly later start, a slightly slower market for reasons that we’ve all talked about. If I look at where activity went to through the quarter, it’s picked up as I said to the levels that we’d expect and if I look at the pipeline that we are say looking to close, I don’t think that there’s a disproportionate amount of competition hitting that that would affect our outcome. So yes, there’s competition but I think we’ll bear up just fine against it and it wouldn’t affect the results.

Moving to the commercial loan side, I would still characterize the competition out there as healthy. We have a large and strong franchise. We’ve been focused on diversification. Our part funds are really very strong. I can’t comment specifically on what others are doing. I wouldn’t say there’s disproportionate pressure from any one player in any particular region. And we are confident that we’ll keep up our momentum in a meaningful way on the commercial business.

Darko Mihelic - RBC Capital Markets

Thank you for that. That’s good color. And then just lastly, could you speak to credit cards. I mean a lot of noise being made by competitors. We continue to see Bank of Montreal somewhat in a different position on the credit card scene. Is there anything on the horizon or should we just view the credit card portfolio as one that’s not going to be strong growth for Bank of Montreal?

Cam Fowler

I wouldn’t like you to view it that way. I think the cards business is an important one. It’s critical to our growth aspirations. It’s critical to our loyalty aspiration. To be sure, the scenario that we haven’t perhaps done as well and in past years. Past four quarters we’ve had a great deal of emphasis on the business and I think we are starting to see some pretty pleasing results. We’ve focused on renewal of the team there. The platform is new. We’ve had product renewals. We’ve had a very large focus on the premium segment. We are looking right now at some positive metrics. We are originating across all card categories at double digit. We are acquiring in the premium segment at multiples of last year. We acquired more premium cards in the first half of this year than we did all of last year. One fifth of those are new to bank. And then other metrics like balances, active accounts, retail sales, they are all up. So we consider this to be good momentum in a business that’s really critical to us and I expect the back half of the year to be stronger in cards.

Operator

Thank you. The next question is from Meny Grauman from Cormark Securities. Please go ahead.

Meny Grauman – Cormark Securities

First question is on capital and you are targeting CET 1 ratio between 9.5% and 10%. That seems a little bit higher than the thinking before and then some of your peers have mentioned this quarter. I’m wondering what the change is, what’s driving I guess this extra conservatism?

Tom Flynn

Thanks for the question Meny. I would characterize it as pretty consistent as opposed to a change in trajectory for BMO. If you think about the last five years we moved our Capital ratio up ahead of the market. We were very clear going back really all the way to 2010 about where we thought CET numbers would start to pan out. The reason why we were very comfortable entering into a discussion to acquire F&C Asset Management which was really a significant company and is going to be a significant contributor is we finished 2013 with the ratio at 9.9%. And since that time you can just see the level of discussion more broadly in the United States and Europe around where capital levels will finish. I think there are a number of jurisdictions where they are talking about levels above the 10% and I think it has a lot to do with mix of assets in specific geographies and in bank portfolios.

I think at the 9.5% the 10% range the balance is about right between having the flexibility to do things when the opportunity arises and capital levels that are not too high to allow banks to competitively intermediate credit in the market. So what we are talking about I think is just clarity around the range that in the ordinary course provides the maximum flexibility to take advantages of opportunities and at the same time be efficient for shareholders. The way that we can balance that is between dividend share buybacks, acquisitions. And what we are hoping for is a little faster economic growth in the developed world, which probably means that in ‘15 and ‘16 absorption of capital retained from growing the balance sheet.

Meny Grauman - Cormark Securities

And then just to follow up on the discussion of loan growth and margin, I understand that the tradeoff between the two, and the question is why would you prefer to sort of err on the side of loan growth at the expense of margin versus the other way around? How would you explain that trade off?

Bill Downe

I guess, let me answer the question generically. I think you are asking a relative generic question. It’s really a matter of mix and in certain loan categories and I would say the commercial loan business, while the margins in the market have reset, they still represent a very attractive return on capital and that’s the sector the market is growing. So in a single asset class you might -- your question might prevail. Are you trading margin against volume? But when you talk about the business mix what we are talking about is growing the whole balance sheet and optimizing the return to the shareholders on capital. So I think there it isn’t a discrete trade off in a single product in a single market. It’s the overall balance sheet growth. And we are fortunate that with the business mix that we have and the capabilities we have that we can demonstrate performance and commercial banking on both sides of the border.

Operator

Thank you. The next question is from Mario Mendonca from TD Securities. Please go ahead.

Mario Mendonca - TD Securities

First for Tom Flynn, clean up question. To what extent did interest recoveries in the U.S pay the margin? Last quarter was something like 3 basis points.

Tom Flynn

It was a measurable number last quarter. This quarter it really didn’t have an impact on the margin.

Mario Mendonca - TD Securities

Then as a follow up question to this loan growth in the U.S and this is probably best for Mark Furlong. C&I loan growth, commercial real estate loan growth, quarter over quarter and I appreciate we are talking about a base that’s relatively small, but that quarter over a quarter growth is pretty significant. Now, I’m not so much interested in what’s going on with the margin because I followed the explanation you are offering here that the margin has been reset or the rates have been reset, but is there anything going on, on terms that would have driven such a significant growth in a given quarter?

Mark Furlong

So this is Mark again. It’s a good question. In the sector for commercial in the U.S that isn’t the area that’s under structured changes on deals, both in C&I or commercial real estate. There has been different periods of good competition on price, but in cases I can tell you where we have seen structured changes which aren’t a lot and we just don’t participate in it. The growth that we’ve had has really been across all of our sectors and across all of our geographies and if one quarter -- and, I’m talking about the last day rolling three to five quarters. If one quarter, one sector, one geography didn’t grow then it grows the next quarter and something else maybe doesn’t grow for a quarter. So when you look back year-over-year, all of them have had growth. And so it hasn’t been weighed down, the growth hasn’t been weighed down by one sector or one market or one of anything. It really has been broad based across the portfolio.

Then too you have to recall that when we were going through merging and integration, you necessarily get some of that internal distraction and we had some of it too. And then it’s learning new rules and learning the new credit process and the team coming on. And so that causes the slowdown in part of the business, but then of course picks up once everyone gets comfortable. I think what you are really seeing now is the company coming in into its -- the seasoning of a team working together really well. It feels like we’ve been in the same company for years and years now. Everybody understands process and understands what’s acceptable in the credit box and you just have this great chemistry working across the business. And that’s what I think you are seeing in the commercial and the business banking units really in particular.

Mario Mendonca - TD Securities

Now Mark, you’ve characterized the pricing this time round on the new business, the new commercial loans coming on as being lower than what’s on the books now. And that’s one of the explanations why the margin has come down by. I think that’s clear to me. Could you offer a similar comment on covenants in terms of the new business relative to what’s on the books today?

Mark Furlong

We do as you can imagine in an environment where there’s good risk management process, we do period reviews. And we actually just finished the review for the risk teams looking at a couple of the sectors of our portfolio. And we just haven’t been subject to structured changes in this -- in the segment that we go after it in commercial banking or in business banking. The stuff you read about, the stuff I read about in the United States it’s the far higher end largest syndicated loans made in the United States. That is a different group that you read about things like covenant life and things like that. That really hasn’t made it into the commercial sector and not into the business banking sector either. So I would tell you that changes to structure have been very, very modest in the piece of the business that I’m responsible for.

Operator

Thank you. The next question is from Sohrab Movahedi from BMO Capital Markets. Please go ahead.

Sohrab Movahedi - BMO Capital Markets

Just say a couple of questions. Just on that last one with Mark, any so just -- the three or so I think you said commercial accounts in the U.S P&C that drove the PCLs up quarter on quarter, what was the year of origination for those accounts?

Surjit Rajpal

Offhand I do not know, but they were not very recent.

Sohrab Movahedi - BMO Capital Markets

So they are not reflective of more recent lending standards?

Surjit Rajpal

No. And really from two accounts I can’t draw many conclusions. In the commercial area you will generally have a few accounts that contribute to them. And unless you see a pattern with a lot of smaller losses, it’s difficult to make an assessment. This is just the normal variability that you see in commercials. Nothing out of the portfolio characteristics that I can point to and say, look, I should be more concerned about that portfolio. I think Mark makes a good point. The portfolio that he has in commercial is very well diversified with small holes in a very large number of accounts and very well diversified across industry groups and the leverage is not very high in them too. So we’re very comfortable with that portfolio.

Sohrab Movahedi - BMO Capital Markets

Okay. And then Mark, just to clarify maybe coming at the U.S just a little bit differently, if I think of this concept of pretax, pre-provision earnings, Q2 to 2012 the U.S and native currency was 262. Q2 2013 it was 258. Q2 2014 is 240. Where do you think that will trough?

Mark Furlong

Let me go at this a little differently and see if I can help. I think you are going to see year over year earnings growth. I think we’ll have maybe some bounce around a little bit in pretax, pre-provision earnings a little bit, but I think we’re going to see year-over-year net earnings growth. I think as I’ve talked about margin, I gave a little bit of indication of we see some tempering in that in terms of what’s going on with net interest margin, albeit it depends a little bit on the quarters of really strong loan growth. But looking prospectively, we feel pretty good about where net earnings are going on a year-over-year basis. Is that a way to go at answering that?

Sohrab Movahedi – BMO Capital Markets

I think it helps for sure, but it almost feels like the bottom line which has been right around $150 million to $160 million has basically been driven through the credit cost line. So I’m just trying to get a sense of when does the above the line start contributing to the bottom line?

Mark Furlong

Okay, fair question. The sustained earnings growth – sustained I should say loan growth, as you saw the runoff portfolios are becoming relatively immaterial at this point in time. Margin is beginning to stabilize and we feel pretty positive about topline growth looking prospectively from this quarter end.

Sohrab Movahedi – BMO Capital Markets

Okay. So can I just ask one last question then? I promise it will be the last one. When you think about the U.S franchise and if you think about it from a profitability perspective, what will winning look like?

Bill Downe

Maybe Sohrab, since Mark has had the opportunity to answer two of your questions, I’ll for the third. There is no question that the commercial banking business that we have in the United States is demonstrating traction in a way that we’re very satisfied with and we think that, as Mark said, with the runoff disappearing, it’s going to be more clear the value of the business that we have. But the bank is in a fundamentally different position today than we were prior to the recession in that we now have a very large retail branch system. There is no question that we’re in a historically low interest rate environment. The five year treasury rate still reflects a level far below the average. And you can take any period, whether it’s 50 years or 30 years or the last 10 years. So I think everybody gets a lift when administered rates rise, which they inevitably will and some inflation shows up. But we have 700 bank branches and that’s more than twice what we had not too many years ago.

But more importantly, we’ve invested much more heavily in the brand in the last three years than the rate of investment previously and there’s a lot of operating leverage in the retail bank. And I think that the definition of success is that we continue to be market leaders as we have been in commercial banking in Canada in the U.S. There’s no reason why within our concentrated footprint we wouldn’t be the number one or number two commercial lender. And when retail banking, the economics of retail banking improve marginally, you get some reasonable economic growth. The strength of our brand, the value of that core deposit base I think is going to be very evident. And so I think we are relatively patient around the recovery in interest rates and a period of stronger economic growth.

Many of the provisions of Dodd-Frank were very hard on banks that had benefitted from some of the things that Dodd-Frank squeezed out. We weren’t susceptible to. We didn’t have very many areas where we had to make adjustments because we had really built our brands, both in the acquired footprint and the legacy footprint around the best interest of the customer. I think you’re going to see the value of a concentrated footprint in a very healthy market over the next three to five years and some quite surprising operating leverage in the business. And for us I think that would be the definition of success.

Operator

This will conclude today’s question-and-answer session. I would now like to turn the meeting back over to Ms. Haward-Laird.

Sharon Haward-Laird

Thank you, everyone for joining us today. If you have any follow up questions, we’re happy to help you in Investor Relations. Thanks and have a great afternoon.

Operator

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

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