Royal Bank of Canada's (RY) CEO David McKay on Q2 2016 Results - Earnings Call Transcript

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Royal Bank of Canada (NYSE:RY)

Q2 2016 Results Earnings Conference Call

May 26, 2016 8:30 a.m. ET

Executives

Amy Cairncross - Vice President & Head, Investor Relations

David McKay - President and Chief Executive Officer

Janice Fukakusa - Chief Administrative Officer and Chief Financial Officer

Mark Hughes - Chief Risk Officer

Doug McGregor - Group Head, Capital Markets and Investor & Treasury Services

Jennifer Tory - Group Head, Personal & Commercial Banking

Bruce Ross - Group Head, Technology & Operations

Doug Guzman - Group Head, Wealth Management & Insurance

Analysts

Sumit Malhotra - Scotia Capital

John Aiken - Barclays Capital

Meny Grauman - Cormark Securities

Gabriel Dechaine - Canaccord Genuity

Peter Routledge - National Bank Financial

Sohrab Movahedi - BMO Capital Markets

Robert Sedran - CIBC World Markets

Doug Young - Desjardins Securities

Operator

Good morning, ladies and gentlemen. Welcome to the RBC 2016 Second Quarter Results Conference Call. I would now like to turn your meeting over to Ms. Amy Cairncross, VP and Head of Investor Relations. Please go ahead, Ms. Cairncross.

Amy Cairncross

Good morning and thank you for joining us. Presenting to you this morning are Dave McKay, President and Chief Executive Officer; Janice Fukakusa, Chief Administrative Officer and CFO; and Mark Hughes, Group Chief Risk Officer. Following their comments, we will open the call for questions from analysts. The call is one hour long and will end at 9:30. To give everyone a chance to participate, please keep it to one question and then re-queue. We will be posting management's remarks on our Web site shortly after the call.

Joining us for your questions are Doug Guzman, Group Head, Wealth Management & Insurance; Doug McGregor, Group Head, Capital Markets and Investor & Treasury Services; Jennifer Tory, Group Head, Personal & Commercial Banking; Zabeen Hirji, Chief Human Resources Officer; and Bruce Ross, Group Head, Technology & Operations.

As noted on Slide 2, our comments may contain forward-looking statements, which involve applying assumptions and have inherent risks and uncertainties. Actual results could differ materially from these statements.

I will now turn the call over to Dave McKay.

David McKay

Thank you, Amy and good morning, everyone and thank you for joining us. Before we review our results for the second quarter, I would first like to take a moment to address the situation in Fort McMurray.

We are all shocked by the scenes of the devastating fires. But in the days following, the resilience of Albertans was never more evident and I am proud of the support that we were able to provide to the community. Our immediate priority has been to provide peace of mind to our impacted clients, including through special financial considerations such as short-term payment deferrals. Working with the Canadian Red Cross, we leveraged our leading e-transfer capabilities to facilitate automatic payments to evacuees accounts and our employees were on hand at the evacuation centers to provide further assistance.

Also, RBC Insurance was on the front line and mobilized its catastrophe rapid response team within hours of hearing news of the fires. To help the rebuilding and recovery efforts, we have committed $2 million and our employees from around the world have also raised more than $100,000 and volunteered many, many hours of their time. From a business perspective, we have been reviewing our exposure since the fires began on May 1. While the evacuation order has been partially lifted, it will take time for clients and RBC to assess damages and the potential impact. However, we don’t expect the impact to be material to our results.

Turning to our financial results. RBC delivered solid earnings of $2.57 billion in the second quarter, up 3% from last year or up 7% on an adjusted basis. This is a great result, particularly given pressure from the sustained low oil prices which has driven our PCL up considerably from historical low levels we experienced last year. For the first half of 2016, we earned over $5 billion which is a record for RBC. These results were driven by underlying strength across all of our businesses and a disciplined approach to managing costs and capital.

We closed the quarter with a CET1 ratio of 10.3%, up 40 basis points from the prior quarter, demonstrating the earnings power of RBC. I am especially pleased with our capital position since we just closed the acquisition of City National last quarter, the largest acquisition in RBC's history. Going forward, we have flexibility to deploy capital for long-term growth and continue returning capital to our shareholders including through reinstating our buyback program as was announced this morning. Against the challenging macro environment for both our clients and for us, our results reflect the benefits of diversification across businesses, geographies and client segments.

A sustained low oil price resulted in credit losses in our oil and gas loan book and in the unsecured retail portfolios of oil exposed regions. Overall, these losses are within our expectations and Mark will expand on our credit performance in a few minutes. While we have seen improvements in the price of oil over the last few months, levels are still down meaningfully and we are working closely with our clients to help them manage through this cycle as we have done through previous cycles. Although we saw credit weakness in oil exposed regions this quarter, this was partly offset by relatively benign credit conditions in other Canadian markets, including Ontario and BC, explained in part by the low unemployment rate.

In fact, BC's unemployment rate of 5.8% in April marked the first time the province had the lowest rate nationally. The Canadian consumer continues to be key to our economy and is expected to drive almost two-thirds of GDP growth in 2016. Against this backdrop of solid employment levels and low interest rates, recent consumer spending data was strong with both home and auto sales at record levels in the first calendar quarter and we are focused on strengthening our market share.

This quarter we benefitted again from our diversification outside of Canada. Our strong results in City National with double digit growth in both loans and deposits demonstrates the benefits of our leverage to the U.S. economy. In particular, to the attractive commercial and high net worth client segments. We are looking forward to telling you more about this great franchise at our City National Investor Day which will be held in Toronto on June 17.

Turning to the markets. The challenges we saw at the end of January carried into the start of our second quarter. A number of factors continued to weigh on the markets, including plummeting oil prices which were the lowest in over 30 years in mid-February, reduced growth prospects in China and speculations that the Bank of Canada could cut interest rates even further. In fact, the VIX Index, a measure of market volatility, was at its highest level over the past year in mid-February.

Markets, however, rebounded sharply with oil prices up 75% to over $45 a barrel by the end of the second quarter. This increase coupled with more supportive economic data, drove many investors back into the markets as the TSX and the Dow, both rallied almost 15% over the same timeframe. As signs of stability returned to the markets, client activity increased particularly in Canada and our market leading capital markets franchise managed a significant number of those deals.

For example, we were joint book runner on TransCanada's common equity offering and asset financing deals. These transactions represented the largest equity offering and loan financing in Canadian underwriting history. We also continued to be active in global mergers and acquisitions and advised our clients on over $18 billion of completed transactions in the second quarter alone. As a group, we benefitted from great opportunities to cross-sell and deepen client relationships due to the strength and scale of our businesses. We work as one RBC, collaborating across our businesses to support our clients as their financial needs change.

We saw this theme play out in the second quarter across our Canadian banking and wealth management platforms. This past RSP season, in flows into long-term funds were the lowest since 2009, as our clients stayed on the sidelines and kept higher cash balances. However, as investor sentiment improved in the second half of the quarter, we helped our clients take advantage of the more favorable markets, advising them on the conversion of their cash balances into investment products.

This drove strong net sales of long-term funds in the month of April which were up almost 40% from March. Our size and scale allows us to drive efficiencies and invest to deliver an exceptional client experience. We are pleased to see the continuing benefits of our cost management capabilities, which have evolved over the past decade to form part of our business as usual activity. With a disciplined approach, we have been investing heavily in technology for over past five years with these costs already built into our run rate. These investments are paying off and evident in our results. For example, our efficiency ratio in Canadian banking was at an all time low this quarter.

These investments are also enabling RBC to maintain a market-leading position in payments and mobile technology to meet the evolving needs of our clients. We recently announced free interact e-transfers for personal checking account customers, which was well received by our clients as more than half of RBC e-transfers are sent using a mobile device. This past month we also announced that clients will be able to use their RBC credit and debit cards with Apple Pay.

As another example, in investor and treasury services, over the last few years we have worked hard to improve our cost structure which in turn has freed up capital to invest in technology and in innovation. Using agile framework for interacting with our clients to develop enhanced solutions in our custodial business. As a testament to the success of this approach, we have seen very good early traction in client demand.

To wrap up, I am pleased with our second quarter, marking a record first half in a more challenging operating environment and I am confident that we are well positioned to continue delivering long-term value to shareholders given the strength of our diversified business model, our disciplined approach to risk, cost and capital management, and our leading client franchises that enable cross-selling opportunities, plus our size and scale to deliver an exceptional client experience. And with that, I will now turn the call over to Janice.

Janice Fukakusa

Thanks, Dave, and good morning, everyone. We had a solid second quarter with earnings of over $2.5 billion, up $71 million or 3% from last year. As a reminder, last year we dissolved the U.S. based subsidiary and realized a foreign currency gain of $108 million before and after tax. Excluding this gain, earnings were up 7% from last year reflecting higher earnings in wealth management, record earnings in personal and commercial banking and higher earnings in insurance, offset by lower results in capital markets and investor and treasury services.

This was a strong result, particularly given the significant increase in PCL compared to last year, which Dave highlighted. Compared to last quarter, earnings were up $126 million or 5%, reflecting higher results across most business segments and stable provisions for credit losses on impaired loans. This quarter we increased our collective allowance by $50 million due to volume growth and ongoing economic uncertainty. Overall, we believe we are adequately provisioned.

In our Q2 results, we reflect our ongoing focus on driving efficiencies across all of our business segments as well as our ability to execute more targeted restructuring when business conditions change. This was the case with our Caribbean banking business a few years ago and for the first half of 2016, we have achieved record results in this business. I would point out that our tax rate in Q2 was lower mainly due to the mix of earnings from both a business and geographic perspective.

For example, in capital markets we had a higher proportion of earnings in Canada and growth in our U.S. municipal bond business. In this quarter we also had a modest tax recovery in insurance relating to a prior year. As the result of mix, our tax rate was 21% for the first half of 2016 and we anticipate it will trend at the low-end of our expected range of 22% to 24% on a full year basis.

Turning to capital on Slide 7. As Dave mentioned, our common equity tier one ratio was up 40 basis points from last quarter to 10.3%. This increase was mainly driven by strong internal capital generation and lower risk-weighted assets reflecting continued balance sheet optimization.

Moving to the performance of our business segments on Slide 8. Personal and commercial banking reported record earnings. Canadian banking had earnings of over $1.2 billion, up $50 million or 4% from last year. Results were driven by solid volume of growth of 6% across most businesses. This includes strong deposit growth of 7% and solid loan growth of 5% driven by continued growth in residential mortgages and business loans. Our results include the positive impact of one additional day in February and fee-based revenue growth. These factors were partially offset by higher PCL.

Our net interest margin of 2.64% was flat from last year. Excluding a cumulative accounting adjustment in the prior year, our margin was down 2 basis points. Expenses were well contained and up only 1% from last year, driving very strong operating leverage of 3.6% this quarter. Year-to-date, operating leverage was 1.9% and our efficiency ratio was 43.1%, an all time low as Dave mentioned. We continue to target operating leverage in the 1% to 2% range and an efficiency ratio in the low 40s, as we invest in our business and digital transformation.

Sequentially, Canadian banking earnings were up 1% as lower staff costs and higher spreads were partially offset by seasonal factors including fewer days in the quarter and higher PCL. Our net interest margin was up 2 basis points from last quarter, mainly reflecting higher credit card spreads and product mix. Moving forward, we continue to estimate 1 to 2 basis points of margin compression per quarter as a result of the continued low interest rate environment. Caribbean and U.S. banking had earnings of $56 million, up $47 million from last year, reflecting fee-based revenue growth, lower provisions in our Caribbean portfolio and benefits from our ongoing efficiency management activity.

As you may recall, last year's results included a $23 million loss related to the sale of RBC Suriname. Sequentially, earnings were down $3 million.

Turning to Slide 9. Wealth management had earnings of $386 million, up 42% from last year and 27% from last quarter. City National had strong results with earnings of $66 million or $108 million excluding the amortization of intangibles and integration related costs. City National's year-to-date results are ahead of plan driven by strong core operating performance, the positive impact of foreign exchange translation and benefits from a full quarter of higher interest rates in the U.S. Excluding City National, wealth management earnings were up 18% from last year reflecting our efficiency management activity, lower restructuring charges in international wealth management and lower PCL. These factors were partially offset by the impact of challenging markets.

Global asset management revenue was down 5% from last year mainly due to lower earnings on average fee-based client assets, reflecting unfavorable market conditions. Assets under management were up 1% from last year as the positive impact of foreign exchange in net sales were partially offset by weaker markets. Canadian wealth management revenue was up 3% from last year driven by higher earnings on average fee-based client assets and higher net interest income from loan and deposit growth.

In fact, assets under management were up 12% from last year driven by strong net sales, partially offset by capital depreciation. Moving to insurance on Slide 10. Net income of $177 million was up $54 million or 44% from last year, reflecting the favorable impact of investment related gains in Canadian life and lower net claims cost in both our Canadian and international insurance businesses. Sequentially, net income was up $46 million or 35%, reflecting a tax recovery and lower net claims cost in Canadian insurance.

On the Aviva Canada transaction, we continue to expect it to close in Q3 with a net after-tax gain estimated at $200 million. Turning to Slide 11. Investor and treasury services had earnings of $139 million, down 13% from a strong quarter last year. Results reflect our continued investments in technology and lower earnings from foreign exchange market execution driven by lower client activity. These factors were partially offset by higher earnings from growth in client deposits and foreign exchange translation. Sequentially, earnings were down $4 million or 3%, reflecting lower funding and liquidity revenue from lower market volatility, partially offset by higher custodial fees and higher spread on client deposits.

Turning to Slide 12. Capital markets delivered solid results. Net income of $583 million was down $42 million or 7% from very strong results last year, largely due to lower client activity across our business and higher PCL. These factors were partially offset by lower variable compensation, lower taxes and the impact of foreign exchange. Results reflect less favorable market conditions, primarily in the U.S. We saw lower equity in fixed income trading revenue due to lower client activity as well as lower equity and debt origination. Despite market headwinds, we saw a marked improvement in European fixed income trading as we continue to optimize this business.

M&A activity also increased across most of our regions. Sequentially, earnings were up $13 million or 2% driven by higher client activity, growth in debt and equity origination and higher loan syndication activity. These factors were partially offset by higher litigation and related legal costs, lower foreign exchange translation and lower M&A activity.

Overall, we had a good quarter in a challenging macro environment, reflecting solid results across all of our business segments and disciplined cost management. With that, I will turn it over to Mark.

Mark Hughes

Thank you, Janice, and good morning. Let me address our credit performance starting on Slide 14.

Total provisions for credit losses of $460 million were up $50 million or 12% from last quarter, reflecting an increase of $50 million in the collective allowance as Janice mentioned. Excluding the collective allowance, our provisions on impaired loans of $410 million, were flat from last quarter. Our PCL on impaired loans ratio of 32 basis points was up only 1 basis point from last quarter and remained within our historical average of 30 to 35 basis points.

In personal and commercial banking, provisions of $279 million decreased by $5 million from the last quarter, reflecting lower provisions of $12 million in Caribbean and U.S. banking. This decrease was offset by higher provisions in Canadian banking, up $7 million from the last quarter, mostly due to higher write-offs in our credit cards portfolio, resulted from continued weakness in oil exposed regions as well as seasonal factors and volume growth.

Wealth management provisions of $7 million increased by $2 million from the previous quarter, reflecting slightly higher provisions in City National driven exclusively by the growth in the loan book. Capital markets provisions of $123 million increased by $3 million from the last quarter, reflecting the impact of low oil prices.

Turning to Slide 16. Gross impaired loans of $3.7 billion increased $583 million from the last quarter, reflected increases in capital markets and Canadian banking due to low oil prices. This growth was partially offset by decreases in Caribbean banking and wealth management largely due to the impact of FX translation and repayment. New impaired formations in capital markets reflect a name by name, bottom up analysis of our oil and gas portfolio, external factors, and the impact of strategic management actions, including recent bankruptcy filings.

While some of these management actions have occurred earlier than anticipated, given the seniority of our loans and the value of our collateral, the increase in new formations did not warrant a proportionate increase in PCL.

Turning to Slide 17. Notwithstanding the increase in oil and gas impaired formations this quarter, our drawn and undrawn exposures decreased by 5% and 19% respectively, compared to last quarter, largely due to the impact of FX translation and reductions in borrowing basis. Consistent with our expectations, with 80% of the spring borrowing base redetermination process now completed, borrowing bases in both Canada and the United States have decreased on average 15% to 20% since 2015 fall review. We remain comfortable with our exposure to the sector for the following reasons.

We have a long history of lending to the sector and working with our clients through previous cycles. Our exposure to the sector represents only 1.5% of our overall loan book, down from prior quarters. Most E&P non-investment grade loans are governed by borrowing bases which are sized to proven reserves of the borrower and provide good protection against credit losses. Over 60% of the E&P clients on our watch list of junior debt ranking below our more senior position in the debt stack.

I would note that we did see slightly more productive markets this quarter, leading to some positive capital activity. Equity markets opened up for some issuers and we have seen some asset sales. However, we expect that our clients will continue to be challenged throughout the cycle. Outside of our oil and gas portfolio, commercial loans in Alberta performed well but we continue to monitor the region closely.

Let's turn to our retail exposure on Slide 18. As Dave mentioned, we are reviewing our exposure to the Fort McMurray fires. While it's too early for us to determine the full impact, our early assessment indicates that the impact will not be material as 55% of our $1.3 billion of mortgages are insured. We require property insurance on all mortgages at the time of origination and we reinsure our risk in our insurance portfolio. As discussed last quarter, higher unemployment rates in Alberta and other oil exposed regions are driving higher write-offs in our credit card portfolio. We are also seeing a slight uptick in provisions in our personal and small business loans in these regions. However, I would stress these portfolios are very small relative to the size of our Canadian retail portfolio.

Notwithstanding the challenging environment, we maintain solid credit quality across most of our portfolios, given our strong underwriting practices and enhanced portfolio monitoring. Outside of the oil effected regions, we are not seeing any signs of contagion. Particularly, our national mortgage portfolio continues to perform well as provision of 1 basis point this quarter, reflecting our strong underwriting practices including no second lien mortgages and broad geographic diversification as depicted on Slide 19. Our clients credit profiles are strong and it remains stable over the past year. Also, many clients are committed to accelerated repayment plans and the debt service ratio is low, reinforcing our confidence in our client's ability to repay.

We do continue to see strong house price growth in a few markets, notably Vancouver and Toronto, driven by the short supply of single family homes coupled with strong demand. We are monitoring these markets closely.

Looking ahead, we continue to maintain our PCL guidance of 30 to 35 basis points for 2016, in line with our historical average. We expect PCL could trend to the higher end of our range, reflecting a continuation of the provision levels we saw this quarter. It is conceivable provisions could increase in Canadian banking if there is contagion beyond oil exposed regions. Provisions could also increase in capital markets if more companies take strategic management actions. However, it is also conceivable provisions could decrease if oil prices continue to rise as we have seen recently.

Turning to market risk on Slide 20. VAR decreased by $3 million from last quarter due to FX translation and lower activity in equity derivative markets. We did have two days of trading losses during the first two weeks of the quarter, which as Dave described was characterized by significant market volatility. In February we have seen slightly more constructive markets which are reflected in our improved VAR and stable trading performance.

Operator, with that we will open the lines for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Sumit Malhotra with Scotia Capital. Please go ahead.

Sumit Malhotra

First question is probably for Doug as it relates to the wealth segment. Doug, just looking at the numbers here, pretty good rebound in revenues sequentially and I think you talked about some of the market conditions improving. At least the way I am looking at it on a core basis, your expenses were actually down sequentially, so not usual that you see those two trends going in opposite directions. Could you give me a little bit of detail on some of the restructuring efforts and integration efforts that have been going on and what exactly in your view underpin this level of margin improvement in the business?

Doug Guzman

Sure. There is a couple of -- thanks for the question -- there is a couple of things going on there. One is the quarter-over-quarter comparison because last quarter, if you go back to the disclosure from the year ago quarter we would have articulated, and I don’t have it right in front of me but the amount that was restructuring related. So that’s obviously from a quarter-over-quarter basis gone or reduced. There is $4 million of international restructuring costs in the current quarter and then there is real organic cost take out that we implemented in Q4. So there is a couple of things going on but, yes, costs are down.

Sumit Malhotra

And maybe this is, I will leave it here and re-queue, this is maybe more specifically for Dave. We see the Canadian P&C operating leverage at a very good level this quarter. Royal has, obviously, stood out relative to peers in that restructuring has been a very popular word in the sector and Royal hasn't participated nearly to the, well, not anywhere near the same way that your peers have. Can you maybe give me a little bit of insight into how you've thought about restructuring relative to some of the threats the industry is facing on the technology side? I know that has been a topic of conversation that you were early on. I just wanted to know how that ties in with your thought process on the restructuring the industry seems to be undertaking?

David McKay

Thanks, Sumit. Maybe I will take that now because I am sure it's on everyone else's mind, so a good time to take it. So I think, you talk about our D&A and how we look at cost structure. You have to look it in a couple of ways. One, we have run rates built into our operating cost structure where we take out and adjust our cost base on an ongoing basis, looking for areas we are adding value or not adding value. So as we have talked about over the years, it's part of our D&A. It's built into our cost infrastructure and we have severance that we take every year to reposition the cost structure of our business. In addition to that we take, there's specific instances in the past, Caribbean strategic challenges or investor and treasury services strategic challenges, where we took larger kind of one-time charges within a year, again within our operating cost structure to reposition the overall business entity. And Caribbean was a great example where we took out over 3,000 employees to reposition that business.

So you can see it within our D&A that we do it on an ongoing basis. It's built into our overall operating infrastructure. We have a number of instances in the past where we have taken larger charges, again, built into our operating cost structure. And we would continue to operate the business with the same philosophy going forward that we have a built in adjustment mechanism. We are looking at all our businesses. We are looking at the digitization of our processes and how customers are interacting with us and we will have to reposition our cost base over time. But, again, because we started eight years ago in doing this, it's an evolutionary tale. We don’t have to shock the system maybe the way some other competitors have had to shock the system.

Sumit Malhotra

I get it, I think you may have been the first senior Canadian bank executive to start talking about FinTech in any kind of a regular way to us, it seems like also ten years ago now. But has it, how do I put this, to the extent that the market has dutifully adjusted for what has now been $2 billion of restructuring charges from your peers, have you viewed it as a competitive disadvantage to the way the market has viewed your results relative to the group, or is that not the way you think about this?

David McKay

You look at our operating expense ratio, productivity ratio, of 42%. It's best in class in Canada. It would be one of the best top decile globally. So our competitive advantage comes from our scale, our brand, our distribution network and power. Customers are still using branches. It's not like they have disappeared or not using our branches. They are multichannel customers that are using us in many, many different ways. So you have to evolve your cost structure over time. You can't get too far ahead of your customer base. So, yes, customers are using more mobile. Customers are more digital but they are still living in a physical world at the same time and it's an evolution over time and you can't get too far ahead of your customer, which is why we started ten years ago, as you referenced, why it's an evolution instead of a revolution as I like to say. And why that’s easier on your employees and it's easier on your customer to take them through a more moderate pace over a longer period of time instead of a shock in a short period of time.

So that’s how we have chosen to manage it. It doesn’t mean we won't do something different in the future if customers change more rapidly or competitors change more rapidly. But that’s how we see our customers using us. We watch it every month. We analyze it and we feel we have a very good understanding of customer needs and preferences and usage and we will adapt accordingly.

Operator

Thank you. Our next question is from John Aiken with Barclays. Please go ahead.

John Aiken

In context with your CET1 ratio, I also am duly impressed with the growth that you've been able to achieve. But how do you look at your capital ratios in context with your ROE? Obviously, the share repurchase program announced today is part of that, but how do you balance the dual pressures of the ROE versus the expectations that you're getting from the rating agencies and some of the global fixed income investors that invest in Royal?

David McKay

A great question. So we spend a lot of time talking about our medium term objectives, whether it's our EPS growth objective of 7% plus, our ROE target of 18% plus, which we continue to reaffirm. And we are confident we can continue to grow this business and we have got sufficient capital to grow this business organically and to return capital to shareholders at the same time and achieve those medium-term objectives of ROE and growth. And we sit down and we look at a number of factors. One target is around 10% plus a buffer. We are at 10.3% today. We feel it gives in the near-term a chance to returning capital to shareholders this year. But we don’t see a limitation. We have got very strong internal capital generation ability over the medium-term as we look at those targets.

So there are some tailwinds as we have talked about built into our business, particularly in a higher rate environment, that give us confidence in bridging that 16.2% gap back to 18% plus gap. Synergies with City National in bridging that gap back. There is organic growth in businesses like Doug Guzman's business that require less capital to grow, that can bridge you back. So there is a number of mechanisms that we look at that give us confidence that we have capital to grow, invest in our businesses and our lending book. We have capital to return to shareholders. We can meet our medium-term targets on those key objectives. So we spend a lot of time on it but that’s how we think about it.

Operator

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

Meny Grauman

On the On the FinTech theme, I just wanted to ask about Apple Pay. And a competitor of yours talked about Apple as being, they said that they viewed Apple as a competitor. Would you use that same characterization? Is Apple a competitor to you now in Canada?

Jennifer Tory

It's Jennifer. Thanks for the question. Well, first of all, we are pleased that our Canadian clients with Apple devices will now be able to use their mobile to make payments with their RBC credit and debit cards through an Apple Pay mechanism. And so they are a competitor, but we also think providing convenience and choice to our clients comes first and we want to provide the client experience that our client choose without compromising their safety and security. As mobile payments technology continues to mature, we see significant potential through the innovation of our RBC Wallet to provide the seamless and convenient mobile transactions that our clients expect. But we also know that there are going to be features that come out with different mobile providers that our clients are looking for and we continue to look to add value added features to our Wallet and our mobile banking channel. So that’s how we look at them.

Meny Grauman

And then I know there's sort of a symbiosis or, I don't know, competition between external kind of technology applications and ones that you develop internally. Is the move to Apple Pay sort of an acknowledgment that to some extent your bank or banks in general, just are limited in terms of what they can do in-house? Is that a reflection of any change in your thinking in terms of how you can build technology internally?

Jennifer Tory

Not at all. In fact, I think that Apple Pay has been out for, I don’t know how long, around different countries around the world. And so we knew that at some point it would be in Canada and our customers would expect us to have it so that they could use it on their Apple device. But we have developed our RBC Wallet actually before this and have provided all the way along the option to use credit and debit through our Wallet which has been something that was industry-leading. And so we think that we have the capability and we are developing continuing capability to be able to compete across the whole spectrum of financial services against any of the FinTech.

David McKay

This is Dave. What I would add is that, you are talking about the physical world with the recent Apple Pay launch in many ways. But the future development world is in app payments and as you look at the capabilities we are building and the industry is building in app payments, there are some very exciting new technologies and alternatives that we are working on that creates a very playing field there. So I think you look at the different ways customers are shopping and using ecommerce, you will see different solutions to that and some of them will involve traditional methodologies and some will involve the Apple Pays and the Google Pays of the world and potentially the Amazon Pay of the world and whoever comes up with a digital wallet. But I think we sit back and we say, we look at the ecosystem. And there is nothing preventing us from building a technology but you have to understand the overall ecosystem and where value is created in the ecosystem. And you will see every player in the ecosystem start to vertically and horizontally expand the value equation and how they service customer needs and I think that’s the real key story.

As you expand the definition of what you do, try to create value for our customer, it will bring you into new areas of interaction with your customers and I think that’s the exciting part of the new world that we live in and where we are spending a lot of our time.

Operator

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

Gabriel Dechaine

My first question is either for Janice or Mark and then I've got a quick follow up for Doug. On Slide 7 of your presentation, the waterfall showing the CET1 progression. I don't see anything in there going the other way on the RWAs from credit downgrades. Was that not a factor at all this quarter? And then also, I'm kind of surprised if it wasn't considering the level of impairments that we saw in this quarter and what we also saw from several of your peers where it was a fairly material capital item?

Janice Fukakusa

Thanks, Gabriel. It's Janice. I will start with the answer. If you look at the waterfall, the lower RWA does include all of the downgrades that we have. What you see here is the result of really effective balance sheet optimization. So if you look at both our assets on our balance sheet and RWA, you will see that we are supporting business growth and earnings growth but at the margin taking a very sharp view of where we can take down RWA if it's not yielding in accordance with our return criteria to support all of the business and all of the activity. We started this process on a more granular basis about a year and half ago and we continued on a weekly basis to review our portfolio and take down RWA. So all of the downgrades are accommodated. And so all that’s progression on GIL and all of that, it's all lumped into the RWA balance.

Gabriel Dechaine

So which areas are you optimizing and how much more potential improvement in your capital ratio is there from that initiative?

Doug McGregor

It's Doug McGregor. We have really been focused on a couple of trading portfolios. One of them, the securitized product portfolio in the U.S., where we have been taking a fair amount of balance sheet off. We have also had a lot lower balance sheet in some of our credit books, which was a good thing over the last six to nine months. And finally in the loan book, which has been experiencing pretty significant growth over the last several years, we have been de-marketing some accounts that just aren't providing adequate returns. So we are recycling some capital out there but with the loan book as well.

Gabriel Dechaine

Got you. Is there any way you can quantify what you've done and what there is left to be done?

Janice Fukakusa

I think Gabriel we will continue to be very efficient in our use of RWA. We don’t really quantify it so much as overall looking at our CET1 targets being around the 10% level, as Dave said, and making sure that we don’t have a lot of volatility there and can still, through internal capital generation, support all of the growth and then also look at other things like share buybacks to reward our shareholders.

Gabriel Dechaine

Okay. And then my follow-up for Doug. We've got [indiscernible] at looming, it seems like every year there's a big headline issue that creates a lot of volatility and headlines in the capital markets. How are you positioning yourself for this particular item? Is it affecting your business in the current quarter, specifically in the trading activity?

Doug McGregor

Not in the trading activity. That’s a pretty liquid activity. So actually the results of out of Europe continue to improve. And in FIC trading in particular in Europe, including credit and rates, things are going quite well. Where you see some effect is in the M&A side of the business where people are more reluctant to make large commitments in advance of the vote. So we have seen a bit of that. But overall, our numbers in Europe were up and actually we are happy with the progress there.

Operator

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

Peter Routledge

Just a follow up on the Apple Pay question. Thanks for your candor in talking about Apple as a competitor. So a question that comes to my mind is, given that you are working with them or cooperating with them in this particular application, how do you prevent them -- longer term, how do you prevent them from stealing your customers or usurping your relationship?

Jennifer Tory

We have to make sure that our relationship with our client is as deep and strong as it can possibly be and we think we have a lot to offer across the spectrum of financial services and that’s our goal. And with our industry-leading cross-sell we believe and we continue to work with our customer data to make sure we are creating value for our clients. We think that we have a lot more to offer than what they do.

Peter Routledge

Is there anything in the agreement between the banks and Apple Pay or Apple, that allows you to keep maybe more control over customers than perhaps I might think just reading the headlines on this?

Jennifer Tory

Well, we really can't comment on anything that’s in our agreement.

David McKay

So I would add, when you think about the long-term customer relationship, the key drivers will continue to be brand and trust, which is absolutely critical. And you look at, whether it's Gartner or others, trusted brands in the financial services is critical and we have that and we would lead in that against traditional competitors but also the challengers, the non-traditional challengers. The second one is relevancy to the customer and what type of insights do you have to maintain a relevant capability with a customer. As Jennifer just mentioned, we have great data and we are collecting and using data in a much better way to create a relevancy to that customer. The non-traditional competitors don’t see the customer the same way we do. Therefore data and creating relevancy is absolutely critical and we feel very good about that and we have had some great innovation around our Hadoop Data Lake and working with other partners to create deep understanding of our customers.

And the third thing is reciprocity. Again, it's difficult to fragment the Canadian retail relationship client. You have to offer something much superior and when you use reciprocity across rates, across loyalty programs, across a multi-product relationship, it's more difficult to pull that customer away over time. So those are the three core assets plus incumbency that the industry has. But RBC just idiosyncratically has enormous strength given our scale, given the number of clients we have, given our technology capability, our innovation rate, the patents that we are filing. We feel that we will be able to manage those dimensions and those drivers better than the non-traditional competitors and adapt at the right pace.

Peter Routledge

Pick up on your point about data, I think it's a good one. I just wonder if Apple, will Apple start gathering payments data that might allow them to compete more effectively against RBC?

David McKay

I can't comment on what type of data they are collecting so I really don’t know, but I assume that they will try to play the same game against the same dimensions. But we see a customer across multi-dimensions, not just payment data.

Peter Routledge

Right. You have got credit and everything else.

David McKay

Well, it also determines what partnerships you form with retailers and others to increase your understanding, your relevancy and your value proposition to the customers. So that’s the ecosystem we are playing and we have enormous competitive capabilities in that ecosystem and you have to play the game properly and serve your customer and create value for your customer. We are sitting here today feeling good about our ability to create value across those dimensions.

Peter Routledge

Thanks. And quick one for Mark. Something you said struck a chord with me. You said Toronto and Vancouver, you mentioned their uptick in housing prices and that you are monitoring those markets. So I'd kind of like a little more color on what you mean by monitoring? And down the line is there anything RBC would do to maybe pull back in incremental exposure to consumers in those cities?

Mark Hughes

Well, at the moment we feel quite comfortable with the exposure we have in both places but it does get a lot of press. It's all around as to the size of the price increases. I think we feel in Toronto in particular it's very much a demographic issue, that’s driving that. So we monitor not just housing prices but we also monitor things like the demographics. In Vancouver, I think it's also a location issue in terms of how many houses can you build in the type of space that you have in Vancouver but you overlay those type of geographic issues as well. But we do have policies around how much we would do in terms of LTVs. The scale comes down as we go up with the higher prices and so we try to manage it in that manner. But I think, what I mean really is is that not only are concentrating on monitoring house prices but we monitor all of the external factors that influence house prices.

Operator

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

Sohrab Movahedi

Maybe for Janice or Dave. You've talked about this evolutionary path you've been on for the better part of five or ten years. I wonder if you could quantify for us now that it's part of your run rate everyday business, what percentage of your non-interest expense would you say is broadly allocated towards technology spend?

Janice Fukakusa

Well, I will start with the technology spend. It's approximately, about 5% I think on a gross basis. I don’t know exactly what the capitalization pipelines are in all of that but I think we have a run rate where effectively it is around that level. And that would be all in, so that would be about running the bank as well as building the bank. And we have maintained those trajectories by and large as a whole within a, I would say 10% to 15% envelope despite the overall economic condition. In fact when we talk about reducing cost, it's reducing expense in other areas so that we can continue the technology trajectory. As you know, technology has been, it's not about a one year spend, it's about many years and many improvements. And so as Dave said, we identified that several years ago and had to have consistency around the spend and that’s why we are continuing focusing on cost reduction in other areas.

Sohrab Movahedi

Okay. So, Janice, would you say it's been around that 5%, plus or minus 10% or 15%, for the past four or five years or for longer?

Janice Fukakusa

I think at least the past four or five years. I think that we started at around seven or eight years ago as Dave said. Bruce Ross, our Head of Technology and Operations also can give you some color on the spend.

Bruce Ross

So as Janice said, it is around the 5% range. Related to some of the other questions that you have been asking this morning around transformational activities in terms of where the market is going. We work within a consistent envelope around that 5% bench and we work in driving efficiencies in the run part of our business so that we can move cost into the investment areas around transformation to support the businesses. And we have been doing that for years. Obviously, as the market moves at an accelerated pace, we are moving that even faster. Investing in key areas like data, as Dave said, to support the businesses. So we feel comfortable we can work within that envelope. We have demonstrated that over the years and we continue along that progression to make it non-lumpy, I would say.

Operator

Thank you. Our next question is from Robert Sedran with CIBC. Please go ahead.

Robert Sedran

Just wanted to come back to Doug's answer on the balance sheet optimization. Doug, is it fair to say that there was some earnings impact taking some of these assets off the balance sheet?

Doug McGregor

Yes. I would say in the trading area, no. In fact, we weren't making any money on that book and fortunately we got at it kind of early and it was reasonably small to start out with. And so I would say, no. In the loan book what we are really focusing on is, when we make commitments to customers, we usually have an expectation of doing other business with them and if it doesn’t go according to plan over a period of time of years then we take a look and decide whether or not we want to continue with that relationship. So there is some reduction in run rate but the earnings on those loans were less than our target return on equity. And so it hasn’t been any significant reduction in earnings and in fact it should increase earnings as we recycle the capital into more productive activities and we have been doing that. There are places we have been putting balance sheet on that have a nice return on equity.

Robert Sedran

So we think of this optimization as almost a remedial action to help fund the City National acquisition. But it sounds like this is just normal course business, normal course activity, that you would want to be doing even in the face of leverage ratios and everything else to not have this kind of stuff on the balance sheet if you can at all avoid it.

Doug McGregor

Well, I mean given the changes, the regulatory changes and changes caused by Basel in terms of how you have to capitalize certain trading assets, that means every investment bank in the world is trying to optimize right now and changing its asset mix to try to get a return on equity that’s adequate. So fortunately we are starting from a pretty good place compared to many other investment banks but we are working with that.

Operator

Thank you. Our next question is from Doug Young with Desjardins Capital.

Doug Young

Just, Mark, I wanted to confirm something. You mentioned that your borrowing base redetermination process was partially the way through it and I didn't catch the number, how much you are through. And then on the same vein, I guess, just looking at the development on your watch list, if you can update me in terms of the number of names that have gone in and out on the watch list.

Mark Hughes

Yes. Thanks for the question. The number I quoted in my comments was 80% through the redetermination process with a 15% to 20% reduction in amount. In terms of the watch list, I don’t think we have actually disclosed how many names are on our watch list. I would note that during the period, the names that we have had on our watch list now for a period of time, were the names that we have identified over a number of months now. I think we have got a very good handle on the names that are exposed in our loan book.

Doug Young

Okay. And then just quickly, on the insurance business, maybe, Janice. It looked like it was outsize this quarter. Can you talk -- was there anything one time in terms of gains that came through on that side? And then I think there was a tax rate gain that came through. Can you quantify that as well? Thank you.

Janice Fukakusa

So most of the adjustments except for the tax rate are ongoing. There is some volatility with the claims and that sort of thing. On the tax rate, in insurance over the year we have run at an effective tax rate of about mid-20s. So say 25%. In the current quarter, I think the tax rate is about 14% or 15%. So that differential was caused by or we benefitted from the one time recovery of a prior loss that we could actually reduce our taxes this quarter because we had a gain.

Doug Young

Okay. And that wasn’t backed out when you did your cash EPS, is that right?

Janice Fukakusa

No, we didn’t back it out.

Doug Young

Okay. And is this a -- I mean I can't imagine this is a normal run rate for insurance but I'm just trying to, it's tough to model it. I mean how do we think about this earnings this quarter relative to what we should expect in that business?

Janice Fukakusa

I think if you put the normalized tax rate on the earnings, there is some volatility. As you know, we tend to look at insurance over the course of the year because there are certain contracts that we do that are annual contracts. So there is some lumpiness. But I think if you look at it that way, we are probably at about an average run rate for the quarter although in actual results you will see some volatility.

Doug Guzman

It's Doug Guzman. On the insurance side, Janice is right, quarter-to-quarter things bounce around which must be frustrating to model for the crowd on the phone, because claims and investment activities bounce around. There are a couple of comments though. First half this year is the same as first half last year, ballpark. And so that benefits from the tax adjustments that Janice just mentioned and also accommodates the year-over-year increase in tax from some of the previous tax changes. So that’s a guidepost. The other point to remember is that as we close the Aviva transaction, we will see the gain that was mentioned earlier in the call will also in the near-term cede to them the profitability on the manufacturing portion of the insurance business. That’s not a huge number and we would expect to earn that back over the course of the year as the range of products is broader and you have more distribution profitability. But as you are thinking about the business don’t forget about the Aviva change.

Operator

Thank you. There are no further questions registered at this time, I would like to turn the meeting back over to you, Mr. McKay.

David McKay

Thank you, operator. As noted in my remarks, I am pleased with the quarter demonstrating the strength of RBC's leading client franchises and our ability to execute in a challenging environment. Finally, as many of you will know, this is Amy Cairncross's last quarterly call before she moves on from her role as Head of Investor Relations at the end of the next month. Amy has been core, a real core part of our investor relations team since 2007, has led it for the past five years. On a personal level, I have greatly valued her strategic insight and leadership and would like to sincerely thank her for her significant contribution to our company. I am sure you will all join me in wishing Amy a well-earned break before she rejoins RBC in a new role this fall.

At the same time I would like to welcome back to investor relations, Dave Mun, who will lead the IR team. He will be familiar to many of you as he was previously the Director of Investor Relations and also worked in equity research. Most recently Dave was the Vice President of Finance supporting our wealth management business. Thank you again for joining us this morning and we look forward to presenting to you next quarter.

Operator

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

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