Bank of Nova Scotia F3Q07 Earnings Call Transcript

Sep.17.07 | About: The Bank (BNS)

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Bank of Nova Scotia (NYSE:BNS)
F3Q07 Earnings Call
August 28, 2007, 3:30 PM ET

Executives

Luc A. Vanneste - Executive Vice-President and CFO
Rick Waugh - President and CEO
Christopher J. Hodgson - Executive Vice-President, Head of Domestic Personal Banking
Robert H. Pitfield - Executive Vice-President, International Banking
Stephen D. McDonald - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Corporate and Investment Banking
Brian J. Porter - Executive Vice-President and Chief Risk Officer
C. John Schumacher - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Capital Markets

Analysts

Brad Smith - Blackmont Capital
Sumit Malhotra - Merrill Lynch
Jim Bantis - First Boston Securities
Andre-Philippe Hardy - RBC Capital Markets

Presentation

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Good afternoon and welcome to the presentation of our third quarter results. I am Luc Vanneste, CFO. Rick Waugh, our CEO will lead off with the highlights of our results. I will follow with the review of the all bank financials and each of our business line heads will review performance. Chris Hodgson, Head of Domestic Personal Banking is out of the country and he is joining us by phone today. Brian Porter, our Chief Risk Officer, will then discuss credit quality and market risk. And finally Rick will provide some closing comments. We'll then be glad to take your questions. We also have our two Vice-Chairmen present today to participate in the Q&A along with John Schumacher, Co-Head of Scotia Capital and Dieter Jentsch, EVP and Head of Domestic Commercial Banking.

Before we start, I would like to refer you to slide number 2 of our presentation which contains Scotiabank's caution regarding forward-looking statements. Rick over to you.

Rick Waugh - President and Chief Executive Officer

Okay. Thank you, Luc. Well I'm pleased to report our strong results this quarter. This is our third consecutive quarter of earning more than $1 billion. In fact, our net income was a near record, second only to our strong performance last quarter. Earnings per share was a $1.02. That's up 10% from a year ago. But excluding the recovery of a value-added tax we had in international, earnings per share growth was a strong 15%. Our return on capital remained a strong 22.7% and our productivity came in at 53%. And that's an 80 basis point improvement year-over-year.

Now taking a closer look at our financial performance for each of our businesses. Domestic Banking had a great quarter with 22% increase in earnings, and we are especially pleased with the increasing contributions from wealth management, from our retail branches and our commercial banking in Canada. This is the third quarter now in a row [ph] of excellent results for domestic. And I think you are now seeing the solid results of those many initiatives that we outlined in all our previous initiatives... presentations. We are developing a very strong retail and commercial franchise here in Canada, one that is growing and the one that is increasing in profitability.

Our international bank had positive results and this was despite the sharp rising Canadian dollar as well as the mark-to-mark losses that took place in the quarter... mark-to-market.

We again benefited from our geographical diversification with organic growth in most of our countries and of course helped by the acquisitions in the Caribbean and Central America, all of this contributing to a good performance.

Taking a look at each of our regions, first of all Mexico, here retail loan growth remains very strong and this Mexican market continues to provide us with excellent growth potential. The Caribbean and Central America results were driven by both organic growth and acquisition. This region is delivering excellent double-digit revenue growth. And Latin America, Asia also delivered good loan growth this quarter.

Scotia Capital also had a strong quarter, led by excellent trading results and strong loan demand. We also continue to benefit from very stable credit quality with excellent risk metrics in our credit and our market portfolios.

So overall, we continue to benefit from having three diversified growth platforms. Each has their unique opportunities and this all allows us to achieve consistent earnings growth.

Some of the highlights for the quarter, on Domestic Banking, we continue to expand our distribution capability. We have opened 16 branches this year-to-date and we remain on track to open 35 by the end of the year. We are also on track to achieve the hiring of more than 200 sales staff this year with about 180 of them on board so far.

As I said, we are pleased with our growing wealth management franchise, assets under administration up 13% this year, assets under management up 10%. And as well, our mutual funds rank number five across the entire industry, the whole industry for net sales of the profitable long-term funds. And of course, we continue to gain market share in several key products. For example, mortgage share is up 18 basis points again year-over-year. Our share and term deposits up 21 basis points and we gained 8 basis points share in mutual funds.

In international, we are moving forward with our strategy of both growing organically and by acquisitions. Again, we are here expanding our distribution. This quarter we opened 40 net new branches and offices with 36 of them in Mexico. We are on track to open another 85 in Mexico by the end of this year. And we've added 450 sales staff in our international division over the past year. We have implemented several new product initiatives in the area of credit cards and small business. For example, in Jamaica and the Bahamas, we have launched two new MasterCard programs aimed at the business segment which will make credit facilities more available, especially for small and medium-sized companies. And we also continue to pursue accretive investments in these high potential markets.

In Scotia Capital, we continue to grow and yet we maintain our credit and our market risk discipline. Our focus has been on investment grade lending with a very diversified portfolio and all of VAT [ph] position us very well in this current environment. The current volatility in the financial market and tightened liquidity are already provided us with significant opportunities which we can leverage thanks to our strong historical relationships and corporate relationships in Canada, U.S., Europe and Mexico.

That leads me to my final point before we go into business line presentation. The market volatility is focusing us and particularly Scotia Capital on three short... key short term deliverables. First, avoiding or mitigating any problems in our portfolio and Brian will show you in a few minutes that we are in very good shape here. Secondly, working with our customers to help get them through this storm. And thirdly, pursuing the many opportunities that this volatility presents to a strong bank such as Scotia. We have a strong balance sheet, excellent liquidity and longstanding well known customer relationships. We will be, in fact, we are benefiting from the re-pricing of risks and the re-pricing of liquidity that is now taking place.

With all that, we'll now pass over to Luc who will go through the numbers.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Thanks very much Rick. Turning to our results on slide 8, net income was $1.03 billion, up 17% year-over-year excluding the $51 million of VAT recovery in Mexico last year. This growth was driven by a strong increase in assets across all of our businesses.

Total revenues grew 11% year-over-year as higher asset levels produced good increases in net interest income. We also benefited from higher trading revenues and securities gains. These increases were partly offset by a higher tax rate.

quarter-over-quarter net income declined very slightly. Higher trading revenues and securities gains were offset by a lower interest and loan loss recoveries and the impact of foreign exchange translation.

As you can see on the next slide, the strengthening of the Canadian dollar in the third quarter, particularly against the U.S. dollar had a significant impact on our results hurting us by $0.05 per share compared to last quarter.

Turning to slide 10, you can see that average assets rose 12% year-over-year as all of the major balance sheet categories showed excellent growth. Residential mortgages and business and government loans were particularly strong, up 16% and 21% respectively. The majority of this growth was organic with some contribution from acquisitions in the Caribbean and Central America.

Looking at revenues in more detail on slide 11. Total revenues rose 11% year-over-year with net interest income up 5% and other income up 18%. The increase in net interest income was driven primarily by strong asset growth. The increase in other income resulted from very strong trading revenues along with higher retail brokerage fees and broad-based increases in other customer-driven transaction revenues. These increases were partly offset by mark-to-market losses on certain securities as a result of widening credit spreads caused by liquidity disruptions in several markets.

quarter-over-quarter, total revenues were up 3% as higher trading revenues and securities were partly offset by the impact of foreign currency translation as well as lower securitization revenues.

Now turning to non-interest expenses on slide 12. Expenses increased 9% from last year or 6% excluding the VAT recovery. The increase reflected spending on growth initiatives as well as higher performance-based compensation in line with our strong results.

quarter-over-quarter, expenses were up 2% reflecting the longer quarter, higher performance-based compensation and business expansion. These increases were partly offset by the impact of foreign currency translation, plus lower stock-based compensation.

On the next slide, we continue to see positive operating leverage resulting from good revenue growth and our ongoing control of expenses. As you can see on the slide, year-to-date all bank operating leverage was 4% excluding the VAT recovery in 2006. While operating leverage may vary from quarter-to-quarter as we have said before our goal is to maintain a positive ratio for the year and one that we anticipate achieving in 2007.

Finally, let me say a few words on capital management. We continue to generate significant amounts of capital, nearly $2 billion after dividends over the first three quarters, thanks to the strong performance of our diversified businesses. And we continue to invest this capital to grow our businesses both organically and by acquisition.

Risk-weighted assets are up a strong 12% year-over-year. At the same time, we are returning capital to our shareholders. We have increased share buyback activities somewhat this year, as we have bought back 12 million shares at the cost of $629 million to largely offset dilution. We also continue to increase our dividends which have risen almost 15% over last year. Our dividend payout ratio to date this year is 42% comfortably within our target range.

In summary, we continue to maintain a balanced approach to capital management. Our strong capital base allows us to continue to invest in organic revenue growth initiatives, be opportunistic and take advantage of acquisition opportunities and weather any credit or market stresses, while at the same time providing a very strong return to our shareholders.

I will now turn it over to Chris Hodgson to discuss Domestic Banking's results.

Christopher J. Hodgson - Executive Vice-President, Head of Domestic Personal Banking

Thanks Luc. I will be starting on slide 16. Domestic banking had another very strong quarter with excellent earnings growth. year-over-year net income rose 22% and ROE was very high at 32%. Revenues increased 9% reflecting continued strong volume growth in both assets and deposits. Expenses were up 1% due primarily to business growth including additions to our branch network that Rick referred to earlier and increase in our sales forces as well as normal salary increases. These were partly offset by lower pension and employee benefit costs.

Loan losses rose in line with strong volume and asset volume or strong growth in asset volumes. quarter-over-quarter, net income was up 7% driven by strong volume growth and the benefit of the longer quarter.

Turning to the next slide and looking at revenues in more detail, total revenues rose 9% from last year. In retail and small business, revenues grew 7% as we continued to benefit from strong mortgage and loan growth as well as higher personal and business deposits. As Rick mentioned, we continue to gain market share in mortgages and retail deposits. Higher volume growth has resulted in some margin compression due in part to a rising proportion of lower spread mortgages.

In wealth management, we had another record quarter, as revenues increased 19%. There were increases in all areas, retail brokerage, mutual funds and our Private Client group. We also had a strong quarter in commercial, as revenues rose 7% on strong asset and deposit growth. Compared to the previous quarter, domestic revenues were up 5% reflecting volume growth and the longer quarter.

Overall, we had another strong quarter. We're seeing good progress in a number of growth areas such mutual funds and the expansion of our branch network. We are on track to achieve our two primary goals: good earnings momentum and positive operating leverage.

I'll now turn it over to Rob Pitfield to talk about International Banking.

Robert H. Pitfield - Executive Vice-President, International Banking

Thanks Chris. International Banking's net income was $270 million for the quarter, an increase of 15% from last year excluding the $51 million for VAT in Mexico in Q3 '06. Although... while this quarter's results were affected by some mark-to-market losses and the impact of ForEx, the overall core operating trends are good.

Total revenues rose 13% primarily on the strength of robust volume growth in all regions. Average assets were up $8 billion, 14% from last year, card volumes 26%, mortgages 0.4%, commercial loans 19%. Expenses were 6% excluding the VAT recovery reflecting spending on business growth initiatives as well as normal salary increases.

The tax rate rose to 18% from 8% primarily reflecting higher taxes in Mexico, Asia and the Caribbean. Compared with Q2, International Banking's net income was 8% lower. Higher retail volumes in most regions were offset by the impact of the strong Canadian dollar as well as the higher tax rate in the mark-to-market write-downs on securities.

Excluding these factors, our core operating results were strong. Looking at the revenues in more detail, revenues in the Caribbean, Central America up 19% year-over-year; strong asset growth, deposit growth across a number of countries including particularly the DR, Trinidad and the Bahamas. The benefit of Interteam [ph] in Costa Rica, the acquisition of the Citibank's portfolio in the DR also helped.

In Mexico, revenues grew 6% with strong retail loan growth of 30% on widening spreads and the volume growth, credit cards and mutual fund fees also rose. This was offset somewhat by trading revenues... this quarter lower trading revenues.

Our revenues in Latin America, Asia and other increased 14%, primarily from higher loan growth in Peru and Chile partly offset by mark-to-market losses. Compared to last quarter, revenues were down 3% as growth from higher loan volumes while [ph] quarter were offset by the mark-to-market losses and the foreign currency translation.

In summary, we have had a stronger underlying growth, good contribution from our recent acquisitions. We'll continue to drive revenue and act on our initiatives and we think we'll have a good quarter coming.

I'll turn it over to Steve McDonald.

Stephen D. McDonald - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Corporate and Investment Banking

Thanks Rob. Scotia Capital had a strong third quarter with net income of $276 million, unchanged from last year but down from last quarter's record results which included very significant interest and loan loss recoveries.

ROE for the quarter was 28%. Revenues rose 5% year-over-year. We benefited from strong trading results, good lending growth and solid M&A advisory fees. The strong business growth was partly offset by lower levels of interest recoveries and securities gains compared to the same quarter last year.

Expenses were up 15%, due mainly to higher performance-based compensation in line with stronger trading results and higher technology costs. The quarter-over-quarter results also reflected good core operating trends offset by lower recoveries and the impact of foreign currency translations.

Looking more closely at revenues on slide 23, year-over-year revenue growth of 5% was driven mainly by higher revenues in the global capital market. We had a record quarter in derivatives from higher client activities, favorable market conditions. We also had solid results in fixed income and foreign exchange. These increases were partly offset by lower results in equity trading.

Corporate investment banking revenues declined compared to last year as strong growth in M&A advisory fees and good lending growth more than offset by lower interest recoveries and securities gains. The growth in lending volume continues to be primarily investment grade. Compared to last quarter, total revenues were down slightly due to lower interest recoveries this quarter. Underlying revenues were up on higher trading revenues, higher M&A advisory fees and wider loan spread. Overall we had a strong quarter with good underlying performance in most of our businesses.

I'll now pass over to Brian Porter to talk about the risk [ph].

Brian J. Porter - Executive Vice-President and Chief Risk Officer

Thanks Steve I'll be starting on slide 25. Credit quality was stable again this quarter. Credit losses returned to a more normal level as last quarter benefited from higher reversals and recoveries as well as a $25 million reduction in the general allowance.

Net impaired loans were flat as increases in international were offset by declines in the Scotia Capital and domestic portfolios. There was an increase in VaR this quarter. This reflected some increase in risk and recent market volatility. Market risk remains well controlled and within acceptable limits.

With respect to asset classes of current focus, our exposures are not significant in relationship to our overall portfolio and I'll have more to say on this shortly which we feel that our portfolios are well positioned at this point in the cycle.

Looking at the provision for credit losses in more detail, the specific provision was $92 million this quarter, an increase of $47 million from Q2 '07. This was due almost entirely to lower levels of reversals and recoveries in Scotia Capital and provision reversals in the domestic commercial portfolio last quarter.

The next slide shows that the level of net impaired loans has remained flat over the past four quarters. Increases in international were offset by declines in the Scotia Capital and domestic portfolios.

The next slide shows the VaR in our trading portfolios. The average one day VaR of $15.6 million has increased over the past year, primarily in interest rates and equities. The increase in interest rate VaR was due to larger interest rate risk positions while the increase in equities reflected increased M&A risk arbitrage positions as well as increased market volatility.

In terms of trading results, we had another good quarter with only six loss days compared to three last quarter. The losses were all within the range predicted by VaR. As I commented earlier, a number of asset classes have come under considerable focus during the past few weeks. Let me provide some color on our exposures in these areas.

With respect to Canadian non-Scotia Bank asset-backed commercial paper conduits, we have no holdings in our money market funds. Liquidity-backup exposure is not significant and holdings in the bank are not significant. We have no direct exposure to U.S. sub-prime mortgages. Our indirect exposure again is not significant.

Our LBO underwriting commitments are approximately 0.2% of total assets. Finally with respect to hedge fund counterparties, our exposure is not large relative to our total portfolio. We have strong controls in place. Limits in counterparties are carefully monitored.

I will just spend a moment now on commercial paper. At the end of Q3 we had approximately Canadian $24 billion in backup liquidity facilities or asset-backed commercial paper programs. Of this, 88% was committed facilities for Scotia-sponsored conduits. These conduits contained largely traditional asset classes, such as auto receivables, credit card receivables and so on. It is important to note that liquidity facilities we provide to Scotiabank-sponsored conduits are always available. They are not contingent on market disruption. This type of liquidity arrangement has been in place for a long time as these conduits were set up many years ago.

Turning to slide 31, as I mentioned earlier, we are comfortable with the positioning of our portfolios at this point in the credit cycle. Last quarter we discussed how we control and manage market risk. Let me provide some comments on credit risk.

Since the 2001-2002 downturn we have made many significant changes in the way we manage credit risk. We have instituted stricter underwriting and execution standards. We now have lower hold limits on single name exposures and greater diversification. Our mix of assets has changed. We now have 60% of the portfolios in residential mortgages and personal lending versus 48% five years ago. Also, 71% of the loan portfolio is Canadian base versus 62% in 2002. This shift in mix was partly due to the significant growth in retail assets but it was also a function of reducing systematically the Scotia Capital corporate loan book.

We are proactive in terms of managing our portfolios. We use loan portfolio management to optimize pricing and returns. And we also use loan sales and credit protection to manage our portfolio exposures. These measures and procedures have helped us significantly in improving our credit quality over the past five years. Today, 77% of our corporate and commercial portfolios are investment grade, much higher than in the past. I refer you to slide 40 and 41 in the appendix where you can see our much improved position from 1999.

I'll now turn it back to Rick.

Rick Waugh - President and Chief Executive Officer

Okay. Thank you very much Brian. As you heard we had another strong quarter and our outlook remains positive, and our confidence is based on a number of factors: our proven track record of profitability and capital generation; multiple sources of liquidity; a proven confidence in risk management as Brian has just demonstrated; our significant diversification of operations and revenues streams; our longstanding customer relationships and of course, our strong capital provides us with the opportunities to continue to invest to future sustainable revenue growth both organically and through acquisition. And finally with our record performance over the first nine months of the year, we are on track to achieve our key financial objectives for 2007. And we are well positioned for continued growth in 2008.

With that, I'll now pass back to Luc and open it up to questions from everyone.

Question And Answer

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Thanks very much Rick. We'll take the first question in the room. Jim?

Unidentified Analyst

The additional exposure on the liquidity backup, the $24 billion, I thought that number was $10 billion with asset-backed commercial paper. Is it a terminology thing Brian?

Brian J. Porter - Executive Vice-President and Chief Risk Officer

No, our total exposure on liquidity lines is $24 billion Canadian. $21.4 billion of that is for bank sponsored conduits and the balance is for third-party conduits.

Unidentified Analyst

So the $10 billion that was down on the press release on October 15... on August 15, the $10 billion backup liquidity.

Brian J. Porter - Executive Vice-President and Chief Risk Officer

That was Canada, yes.

Unidentified Company Representative

That was just updating the number that we had in the notebook [ph] financial statements. It was updating the position from October 31 to what's happened to subsequent to that date. And that's why we drew your attention as well to the fact that we had a de-consolidation of the one of the conduits. The number now is updating us totally through July to the one reflecting that de-consolidation.

Unidentified Analyst

So the $24 billion in U.S... sorry the 14 billion US conduits but what sort of things in that... we are all pretty comfortable with the Canadian conduits. We see less visibility into the U.S. conduits?

Brian J. Porter - Executive Vice-President and Chief Risk Officer

WellI'll deal with the third-party conduits, which totaled approximately $1.5 billion U.S., and 75% of that is auto related, and I would describe it as plain vanilla, it's loans, basically auto loans, and it's car loans the business that obviously we're extremely comfortable with. Sorry.

Unidentified Analyst

And the remainder is [multiple speakers] the other half [ph] that one may not dictate. It would be, you've got... you have built up over time great relationships with GM, Ford etcetera, that's the kind of name that you are associated with [multiple speakers]

Brian J. Porter - Executive Vice-President and Chief Risk Officer

Exactly. It's very straightforward, as I would describe a plain vanilla asset backed Corporate America.

Rick Waugh - President and Chief Executive Officer

Corporate America really.

Unidentified Analyst

Thank you.

Rick Waugh - President and Chief Executive Officer

No structured products.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Next question, Darko.

Unidentified Analyst

Excuse me, thank you. A couple of questions. First of all, with respect to Scotia Capital and the trading revenue that we saw in the quarter, private client [ph] area. Can you give us a little bit of a discussion or color on what that is? How should we view that from the standpoint of... point of view especially given that the elevated levels are?

Stephen D. McDonald - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Corporate and Investment Banking

I think that it's actually quite a nice story. We have a very client-driven business that we also happen to have ourselves pretty well positioned in a couple of areas. So about half of that results was clients, a little bit more than half. The other half was from being well positioned in interest rates and more particularly credit markets. The VaR increase that you saw, this is something that we have signaled to you I think for at least a few quarters. It was our intention... it's no secret that we have been at the bottom of our peer group in terms of trading VaR and we intended to change that relationship a bit and slowly prudently over time move our VaR up. And that is exactly what you are seeing. It's a result of an increase in interest rate VaR and I believe the other component was an increase in VaR related to merger activity. We've had... now that's a little bit more opportunistic. You can't just choose to put on a merger our position. There has to be one of the markets. So we've in Q3 had the opportunity to put on a couple of reasonably large positions. But I hope that answers the P&L. The revenue question, revenue increased about 50-50 clients and positioning and the risk of VaR question interest rate in merger-related primarily.

Unidentified Analyst

And to the sustainability of keeping that VaR at that elevated level you're suggesting fiscal [ph] revenues.

Stephen D. McDonald - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Corporate and Investment Banking

Yes for revenues of similar magnitude going forward. And in spite of the current market conditions that we are not having trouble in our trading books and managing our risk. And I... we are intending to slowly increase our VaR level. We don't have a particular end target number in mind but we are continuing in that path.

Unidentified Analyst

And maybe just one last question for certain risk, didn't hear you mention of the watchlist and you're also one of the bigger lenders to financial institutions amongst Canadian banks. I wondered if you can give us any insight there.

Stephen D. McDonald - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Corporate and Investment Banking

Sure. Actually we included that in the presentation of our Board this morning. Our watchlist which we would classify is, we used to classify it as the waiting room. IG 30 to 65 is the lowest that we've ever had in the bank and it has not grown. We don't have any new additions to the watchlist. So the portfolio continues on all basis whether it is commercial or a corporate continues to perform very well.

Unidentified Analyst

Your exposure [ph] to financial institutions.

Brian J. Porter - Executive Vice-President and Chief Risk Officer

Again, our exposure into financial institutions is in terms of the bank broker area. It's limited to 364 days facilities. And again it's a large portfolio for us, as it is for all financial institutions. But we are very comfortable with our exposure there.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Michael, you had a question.

Unidentified Analyst

Yes, a couple of questions. Rob, you referred a number of times to mark-to-markets in your segment and I just wondered if you could give us some color on those?

Robert H. Pitfield - Executive Vice-President, International Banking

Michael I will take that question. We had to take a mark-to-market writedown effectively pursuant to the financial instruments accounting standard for the negative fair value component of the instruments.

Unidentified Analyst

Is it credit, widening credit spreads, I think? Also, I know this that your gross formations this quarter aggregate for the bank are down quite significantly from last quarter. You know there had been increasing previously. Is there anything unusual? I think it was about 300 some odd million dollars last quarter?

Robert H. Pitfield - Executive Vice-President, International Banking

Yes,gross formations are about $1.7 billion Michael, as looking at the exact number. The interesting mix of those is that its formation [multiple speakers], net new formations.

Unidentified Analyst

Do you want to repeat which...

Robert H. Pitfield - Executive Vice-President, International Banking

You are asking formations?

Unidentified Analyst

Yes.

Stephen D. McDonald - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Corporate and Investment Banking

Gross formations or net.

Unidentified Analyst

The gross, the 147 that you have this quarter is down quite a bit from last quarter.

Robert H. Pitfield - Executive Vice-President, International Banking

I think that that is a function of write-offs we've had in the domestic retail portfolio and in terms of business generally we have had formations rise in the international retail business. We've had reversals in international commercial business. So it's a function of the retail business in both Canada and international.

Unidentified Analyst

Okay. And one other question that I have, your average risk-weighted assets are up about 17% year-over-year. Your margins though your net interest margins continues to narrow though, is it lower margin business or what is it that accounts for the margin compression?

Robert H. Pitfield - Executive Vice-President, International Banking

A good part of the increase there Michael is in securities that we put on the books to hedge the client activity that John is talking about. So you've got lower yielding assets but you've got the other income that comes with that.

Stephen D. McDonald - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Corporate and Investment Banking

And also in Canadian book with those residential mortgages which we have been aggressively pursuing and of course those are still yielding mortgages high quality, low risk but also low margin spreads in which brings that margin down.

Unidentified Analyst

Okay.

Stephen D. McDonald - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Corporate and Investment Banking

Proactively [ph].

Rick Waugh - President and Chief Executive Officer

In the corporate business margins has been modestly improving in both Canada and U.S. So from a Scotia Capital perspective it's a mix issue with that increase in concentration of trading assets, high quality trading assets that is affecting the overall margins but the underlying margin in the corporate business Canada and U.S. is showing some improvements.

Unidentified Analyst

Thank you.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

We will have our first question on the phone, please.

Brian J. Porter - Executive Vice-President and Chief Risk Officer

If I just want to clarify Michael's question for you. Michael, gross impaired loans decreased by $77 million. You are quite correct. The decrease was attributable to net new formations of $147 million and write-offs of $179 million and a foreign exchange impact of $45 million.

Unidentified Analyst

What I was getting at though is the $147 million this quarter is down quite materially from last quarter. That number doesn't show up on here but I think it is around $350 million last quarter.

Brian J. Porter - Executive Vice-President and Chief Risk Officer

I'll take it offline and I'll get the answer for you Michael.

Unidentified Analyst

Sure. Sure.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Thank you. First question on the phone please.

Operator

First question comes from Brad Smith of Blackmont Capital. Please go ahead.

Brad Smith - Blackmont Capital

Sure. Thanks so much. I have two quick questions. One is for Luc, just wondering looking at your risk-weighted assets schedule in your sub pack on page 15. The market... the asset equivalents allocated to the market risk seem to have gone up fairly steadily and then jumps quite a bit in the third quarter. I was just wondering if you could provide us with any insights into what's going on there. I don't believe the trading asset book itself changed with the change in the business mix. And for Rob Pitfield, the quick question with respect to your divisional ROE has been trending downward coming in just over 16%. I suspect that that relates to the fact that you've been investing heavily in the number of your regions. Just wondering if you can give any sense for how you would expect that ROE to change if you were to simply go to a maintenance investment position now. And any sense for what timeframe you would expect that ROE to adjust to?

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Well it's... the ROE, the trend down is related to allocation issues in goodwill. Overall, with respect to the expenses, our expenses... once we work through this period of brand builds and the initiatives that we are going on, that will trend up again. So, it will improve.

Brad Smith - Blackmont Capital

Yes, do you have a sense for where it would trend to though? I mean if you were... if you were just to stop making any incremental investments today, maintain your platforms the way they are, would it trend back up in your opinion to 18 and would it take two years or a year to do that?

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Brad, it's Luc. Let me comment on a couple of things there. In Q3 we had an unusually low ROE in part because of the mark-to-market hit which impacted income and corresponding increase in tax rate. If we didn't do anything else today, we still have those acquisitions that we've done in the last 12, 24, 36 months that are still coming to full fruition as we go through the integration and we will see increasing impact on our bottom line from those acquisitions. So I think it's fair to say that a combination of those would increase ROE on a go forward basis.

Brad Smith - Blackmont Capital

Okay, terrific. Thank so much. And just on the risk weighted asset market risks?

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

I --

C. John Schumacher - Co-Chairman and Co-Chief Executive Officer, Scotia Capital and Head, Global Capital Markets

Let me get that. This is John Schumacher speaking. That really represents... almost all of that represents growth in my derivatives business and our total returns to our portfolio. Now that's very high quality risk assets and that plan is something that has been in place for quite a while. We are just getting some traction. It's not... looks like a very high growth rate, but that's a very steady business that we will continue to grow.

Brad Smith - Blackmont Capital

Okay. So that's not... I mean I guess, in a sense that is reflective of the change in the business mix towards that business. I mean that's additional capital being allocated to that business?

C. John Schumacher - Co-Chairman and Co-Chief Executive Officer, Scotia Capital and Head, Global Capital Markets

Yes, these are... these transactions attract very low... relatively low capital, a very high return. They actually getting back to the earlier question from Michael, they are in part the reason why our margins appear to be narrowing, those... additionally those assets, obviously changes the denominator in that equation. But they are very high quality, very low capital, very high return.

Brad Smith - Blackmont Capital

Okay. Thank you.

C. John Schumacher - Co-Chairman and Co-Chief Executive Officer, Scotia Capital and Head, Global Capital Markets

Yes, just while I have a second I wanted to clarify something. With respect to the increase... our plans to increasing our warrant, I should tell you I may... I didn't want to leave the wrong impression, we don't... we aren't planning on moving to the top of our peer group. I think over time if we saw our guide level move to the middle of our peer group, we would be quite happy with that, but again that would be overtime.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Next question on the phone please?

Operator

Your next question comes from Sumit Malhotra of Merrill Lynch. Please go ahead.

Sumit Malhotra - Merrill Lynch

Hi, good afternoon. First question is for Rob Pitfield. Rob, when I look at the loan growth and what you call business loans and acceptances, down about 11% quarter-over-quarter. We saw the same kind of trend when we got the Mexico numbers earlier this month. Just wanted to ask you, it looks like... you talked about this before, more of a shift to retail. But the loans coming off the book in the international business, is this voluntary, is this a market share issue? Is it something where you feel the risk award is better in retail? Just wanted to get your thoughts on that for what we see both on the total international and Mexico specifically as well.

Robert H. Pitfield - Executive Vice-President, International Banking

Well, I know the Scotia Capital side and Steve can jump in here. I know Scotia Capital has been refocusing its efforts on the corporate growth for high returns type of investments and when they don't have that, they've been... well judicious in the way that they manage those companies. As far as the retail side, you are absolutely right. It is a refocus to retail and you've seen the there's foreign growth there with the 40% in credit cards and 40% in mortgages. So I don't know if you want to talk about how you're positioning that book Steve?

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Another comment that I would make Sumit as it relates to Rob's business and certainly to Steve's as well to the extent that it's not in Canada, it's the impact of foreign currency translation on a spot basis at the end of the quarter, quarter-over-quarter spot was quite significant. So that will bring those assets down by a considerable amount

Sumit Malhotra - Merrill Lynch

It seems like Luc even in the Mexico numbers when we get those and pace those in early August, it looked like we saw the same kind of trend for business loans. But you have talked in the past about shifting this.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Right, the one thing that I want to say you on the foreign currency translation, they are relative to that Sumit is that the greatest impact was on the Canadian U.S. dollar comparison not on the other currencies this quarter.

Sumit Malhotra - Merrill Lynch

Okay.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

The impact for the Canadian dollar pesos Mexico situation, which is not as great.

Sumit Malhotra - Merrill Lynch

Okay. Next one is a shift over to domestic for Chris Hodgson. If I got these numbers right, you want to open 35 branches before the year is done. 16 of them are done to the first nine months. So, looks like there is 19 that are going to open in Q4 and the expenses, operating leverage all the stuff you talked about the end of 2006 has been a very good story so far. It sounds like, here we've got a period of time where expenses in this business as we continue to grow it out are going to trend back some of the higher levels, maybe not with all the initiatives you had going in 2006, but is some of your peers have talked about a revenue expense paradigm when they think about the domestic retail businesses. Is that a better way for us to think about what Scotia is going to do in domestic banking.

Christopher J. Hodgson - Executive Vice-President, Head of Domestic Personal Banking

Sumit, the... we made it very clear at the beginning of the year that we had two objectives in our domestic business. One was to improve our operating leverage and the other was to show earnings momentum and up to this point, I think we have been able to achieve that. In terms of the operating leverage side, clearly this is a very, very strong quarter for us. We have been clear in the past that we have been making some significant investments in the business particularly on the technology side and the platform side and I have been through some of those numbers. And also, last year we opened up a number of branches. We opened 15 branches. This year, we will open up 35 and yes, the balance Rick had indicated about 16 to 20 or so will come in this last quarter. But we are going to keep a very strong eye on operating leverage to assume or to think that we would generate operating leverage similar to what we've done this quarter. While we continue to invest in the business, it's something that we watch very, very closely.

So, we are going to continue to build out our branch system, but we are not going to just throw expense to the wind. We are going to continue to grow our sales force side of things and we've made significant growth in our mutual fund business and we are seeing the benefits of that now. In terms of what we have done on the advisory side and on that front, our mutual fund fees and the welfare contributed about 35% of that revenue growth for our domestic business overall. So we are going to continue... to answer your question, we are going to continue to invest in our business, but one of our key goals is to have a positive operating leverage. And that has been clear I think in the past that the operating leverage will fluctuate from quarter-to-quarter. This particular quarter has been very, very strong, but we still expect reasonable numbers going into the fourth quarter, and into 2008.

Sumit Malhotra - Merrill Lynch

That's great, thanks Chris. Last one for me is quickly for Luc. Luc, just to be clear on this international, Puerto Rico and Thailand, those businesses will be included in earnings for the first time in Q4. Is that correct?

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

That is correct.

Sumit Malhotra - Merrill Lynch

And you own minority stakes in both. So it's just your piece of those businesses that you are booked through international, only the net income component. Is that accurate?

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Where we have significant influence and we account for it on an equity basis, we will bring this through a net income; otherwise, it's just a dividend for that comes in.

Sumit Malhotra - Merrill Lynch

Okay, thanks very much.

Operator

And your next question comes from Jim Bantis of Credit Suisse First Boston. Please go ahead.

Jim Bantis - First Boston Securities

Hi good afternoon. Just to continue on the international aspect, we saw that the effective tax rate has gone from 8% to 12%, now to 18%. May be Luc or Rob Pitfield, you can give us a sense on where that's going to level off over the next couple of quarters? And secondly, there was a lot of noise regarding or discussion regarding the mark-to-market in the security in that segment. Can you just quantify the amount in terms of what the write-down was?

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Sure. Jim, its Luc. The mark-to-market write-down was approximately $20 million after tax. And the tax rate increase this quarter over last quarter was impacted by that write-down, so we've had lower income in lower tax jurisdictions, so if you put that around the other way, the income that you did have was subject to higher tax rate than the combined or consolidated international rate was in the past. But we have told you in the past that we will be increasing our tax rate in international; as we have now recognized the previously unrecognized tax loss carry-forward relating to Mexico. That is starting to come into the equation as well, that was in part the increase from 12 to 18 this quarter. Looking towards the Q4, it all depends what happens, I would not expect to see an increase like we saw in the... from Q2 to Q3.

Jim Bantis - First Boston Securities

Thank you, Luc. And just the last question maybe this is for Rob. It sounds like you are coming fairly close to completing your transaction, a very large transaction in Chile. Maybe you can give us an update in terms of how that's proceeding and why Chile?

Robert H. Pitfield - Executive Vice-President, International Banking

Well, Chile is a strong investment grade country, we have a franchise that both the strong franchise, that's the smallest franchise. You know our target is to achieve 10% of critical mass, so we are looking to do that in that country. It will establish us in Chile and would establish us and strengthen us in Latin America and we are continuing and we hope that we can lend this deal.

Jim Bantis - First Boston Securities

Thanks very much.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Next question?

Operator

Your next question comes from Andre Hardy from RBC Capital Markets. Please go ahead.

Andre-Philippe Hardy - RBC Capital Markets

Hey Rob, just following up on Jim's question, historically in Chile your returns have been well below the industry average. How much was scale, the biggest factor there? Are there other issues, said differently, would this transaction allow you to bring up profitability more in line with the rest of the industry?

Robert H. Pitfield - Executive Vice-President, International Banking

All of that. We think it is the scale issues, we think that with another franchise, its strong and commercial and it's strong on near prime, two areas that we need to strengthen quarter for our franchise down there. So we think that we'll get the scale, we think they will get higher ROE. We think we'll get higher income and it will position us to do further things in Chile perhaps.

Stephen D. McDonald - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Corporate and Investment Banking

We have nothing pronounced yet.

Robert H. Pitfield - Executive Vice-President, International Banking

And we have nothing to announce.

Andre-Philippe Hardy - RBC Capital Markets

Thank you.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Next question?

Operator

There are no further questions from the phone line at this time.

Unidentified Analyst

I guess, just taking the opportunity, looking up the group of individuals here, up until here, and from here [ph] as well. As we think of the environment we are in here, where we've had incredible volatility and we've had, what's going on in commercial fields play which really for a while looked as if it was going to spread beyond this, beyond that conduit market. How given the experience, Bob or Rick whoever wants to volunteer, what... I mean how do you think this thing plays out. I mean are you surprised that it's been localized and hasn't gone beyond where it is or do you think its way modern, just localized so far? Tough question, I know.

Rick Waugh - President and Chief Executive Officer

We've had some great debate amongst the guys [ph] right on that question and there is fantastic debates and we have contradictory views and no body's got the crystal ball. But you are right, a lot of us have been through this. Many of us have been through it, not quite the same as we are in today. I mean every issue is quite... from land loans in Alberta to LDC loans international, what have you. So, there is already something. So, there has been a lot of us, a lot of people saying that something is going to happen. We just don't know where, we just don't know when.

But, from my perspective... and Bob and others can join in, because it's an interesting time. First of all, we have reassessment of re-pricing and reallocation of liquidity, and following that, credit. There is lots of liquidity right now globally, I mean if you look at the Asia and the Asian banks and all the petrol dollars around, but it has to be reallocated because it's really... if that process is going on, and so there is a re-price in liquidity which in one respect as long as there is not a systematic problem from our perspective, that's a good thing, because we've been giving liquidity away for nothing for five to six years. And there is only... the only resources of liquidity are obviously the central banks. But through that your peers and your commercial bank, and I think that's something always has to be understood.

And I think the global commercial banks, and certainly the Canadian commercial banks are in good shape. So, that's our message and I think you are probably hearing that elsewhere in calls. So, the financial sector in Canada is in strong shape. There are parts of it that aren't. But there are majority of that are. We are just talking again and already our dollar as you know is pretty strong. The dollar is really what the real things of your economy and your financial sector. So we just got to stand back and look at what's really happened and so there is this fear of the known that is going on as this liquidity gets reallocated and what have you. Macro economics on the global basis again having been through many crisis, this is so unlike the Asian crisis, the Russian default when you had liquidity issues, you had natural economic issues in all these countries, in emerging markets, none of that is different. But there is obviously a initiative going so from our perspective as shown from our credit portfolio, shown from our market portfolios and this is what we showed, trying to show independence that where we are today versus where we were in that crisis back in 99, 2000, 2001 we are in pretty good shape and I think a lot of others are. And so we will see this version of risk liquidity works out, but it plays quite frankly to a commercial bank strength. If you've got strong capital, you've got assets, multiple sources of liquidity and you understand how to underwrite and price and distribute credit risk. So I am a little bit more optimistic. Bob, you want to say?

Robert H. Pitfield - Executive Vice-President, International Banking

I am not really going to do that much more better, I'll just make a couple of comments. I'm paid to worry along with Brian. We are the two guys who are paid to worry around here. But couple of things, first of all, as Rick said, we don't know how this is going to play. But clearly it does favor strong financial institutions in which we are, so in the long run I don't think we are terribly concerned at all. But what I would describe what is going on in the context of the history here, the past several years there has been a tremendous expansion of credit globally, whether it was mortgage-backed securities, asset-backed commercial papers, CDOs, CLOs whatever.

These were all vehicles that provide credit through the capital markets, through structured vehicles of one form or another, it was source of capital markets. And that allows tremendous credit expansion to take place, and that whole marketplace relied essentially on credit rating agencies to tell people what it was they were buying because these things are opaque. It's very difficult for even very sophisticated investors to really understand what's in these various structures, and so forth. So the credit rating agencies became type of the kings here at that time and that has allowed all of the trenching, and so forth that went on that people bought.

Now we've had a crisis in confidence in the credit rating agencies manifested in Canada particularly in the commercial paper market, but more broadly globally in other markets as well. And so people... investors are rethinking what kinds of paper they ought to want to hold, given that they are not quite sure how to evaluate the underlying risk. So it's coming back to the people who can evaluate credit risk, people like ourselves, and whether that... all of it comes back, or only some of it comes back, or content [ph] we don't know. But we are prepared for it.

Stephen D. McDonald - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Corporate and Investment Banking

Making a comment from the trading management side. I don't know how much value there is in grey hair in a way that... because it seems the market... the market finds a new way to screw up every time. In 87, the ones I have been, in 84 and 87 but exclusively the primarily your job as the training floor manager stand was to stand over the equity desk, typical to the credit fees since '98 long term capital. That was really a fixed income issue. They had some of the products, Italian, France and some other fixed income positions. And that's... so that was largely of a bond desk issue and as credited [ph] trading floor manager they were standing over the debt desk. Good problems elsewhere but that's largely the way to focus. I never thought in my entire career I'd be standing at the commercial paper desk. They don't even coupons over there. So I guess by that I mean to say every time in different. And sometimes that's an over having cliptos [ph]. Every crisis is different and this one is no exception. So we will have to wait to and see. That is craze.

This one is tough because commercial paper into cash management, that's about balancing the till. This isn't the both fraud or mis-valuation of long-term securities or funding derivative structures or anything. This is like people are able to balance their checkbook at the end of each day. That's a very tough question to worry about. So getting back to Rick's comment all of the money that used to be around is still around. There has been some deleveraging. So I think some money has been taken off the table but largely it's hiding. It's the buyer strength of sorts and that's based on confidence and somehow our view... my view is that of course confidence will return to the market and will start to function and six months from now we wonder what happened. We will probably know, because it is... does have to do with the issues that the rating agencies in my opinion start reading credit exclusively and forgot about liquidity. And I was a part of the opinion that maybe it was missing and that maybe investors didn't understand and, this is 20-20 hindsight [ph]. But in the future I am imagining that ratings will include a lot of talk about liquidity. And that's why liquidity was zero. People forgot about it but liquidity your ultimate cost.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

One last question, Michael.

Unidentified Analyst

Thanks. It's actually sort of two interrelated and it goes back to Bob's comments. First of all, is it too early to ask what risk-weighted assets would be under Basel II right now? And we are not that far from the... presumably from Basel II coming into force and given recent events the implications you are saying for rating agencies is credibility. Do you think that there is any possibility that the adoption of Basel II with its heavy reliance on ratings might be delayed or changed?

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Wellin a sense, Bob I hesitate to comment on what the risk-weighted assets are under Basel II because we are waiting to see what the regulator is actually going to do. We are in that processes that the other banks are submitting information to them and getting accepted to. [multiple speakers] and as you know we have got a new superintendent. So it's too early at this stage of the game Michael. And then with respect to the second question.

Rick Waugh - President and Chief Executive Officer

We could certainly make the comment I think safely that our ratios will not be hurt by Basel II.

Robert H. Pitfield - Executive Vice-President, International Banking

I mean certainly as it correlates to asset classes which were partaking in i.e. $100 billion residential mortgage book, the risk-weighted component of that is certainly going to be very currently.

C. John Schumacher - Co-Chairman and Co-Chief Executive Officer, Scotia Capital and Head, Global Capital Markets

It's fair to say, Michael that in all the modeling we have done on Basel II everyone of those risk-weighted asset is coming down.

Stephen D. McDonald - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Corporate and Investment Banking

As far as trying to guess whether regulators might change their views on something they have invested all this time and effort.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

We're not going there.

Stephen D. McDonald - Co-Chairman and Co-CEO, Scotia Capital and Head, Global Corporate and Investment Banking

And who the hell in this. It's a very legitimate question to ask but you better ask them.

Luc A. Vanneste - Executive Vice-President and Chief Financial Officer

Okay. Well thank you for participating in today's call. We'll see you soon.

Operator

Ladies and gentlemen this concludes our conference call for today. Thank you for participating. You may now disconnect your lines.

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