RBCPF - Royal Bank of Canada (RY) RBC Capital Markets Global Financial Institutions Conference (Transcript)
2023-03-08 12:59:02 ET
Royal Bank of Canada (RY)
RBC Capital Markets Global Financial Institutions Conference
March 08, 2023 11:55 AM ET
Company Participants
Nadine Ahn - Chief Financial Officer
Conference Call Participants
Darko Mihelic - RBC Capital Markets
Presentation
Darko Mihelic
Can you hear me? All right. Perfect. There we go. Thank you very much. Very happy that everybody could join today. I'm very happy, Nadine Ahn, Chief Financial Officer of Royal Bank.
And as in all of my other sessions, I just want to remind everybody that -- Bank's reported last week in Canada, so we're going to be basically rehashing some stuff from the earnings call and maybe diving into things a little more deeper than what you typically would an earnings call, Nadine.
Nadine Ahn
Sure.
Question-and-Answer Session
Q - Darko Mihelic
One of the things that I've been asked to ask you from some investors is to maybe let's revisit the net interest margin discussion from the quarter. Talk about the one basis point improvement, how that arrived and your forward outlook, please, if you could, just on the margin? That's a start.
Nadine Ahn
Yes. No, for sure. I mean it's obviously a hot topic of conversation, and I think it's probably easy to break it down a bit for you if I focus on kind of what happened quarter-over-quarter, how that changed from what we initially thought was going to happen at the end of last year and then come what our forward-looking is guidance on it.
So, I think part of it, we've talked a lot, and I'm sure you've heard it from others around when you think about NIM, think about index trading because we obviously were down to nine basis points on a quarter-over-quarter. And a lot of that has to do with the way we report from a capital market standpoint, in particular for some of the products there. And so sometimes you've got your NIE representing your funding costs sitting in your NII, so NIE funding cost, and then what you're seeing is the offset coming through other income.
So that was about 10 basis points driving on the negative 9%. And so that was primarily off of our repo business and, in addition, our equities business. So about six basis points and four basis points there. So that takes us to that one-basis-point accretion on a quarter-over-quarter basis, and a lot of that driven off of the Canadian banking margin expansion, three basis points.
We did see in the quarter, the 10-basis-point margin expansion that we were looking for in terms of the structural deposit base, our low-beta core deposit base as we -- where most of our interest rate sensitivity comes from. And as a result of that, you did see that margin expansion we're anticipating, but one of the things that -- and I'll talk a bit more about it later from the guidance standpoint, we saw the rotation a bit stronger than we had anticipated in terms of the GICs.
And while those are a very strong deposit high-margin deposit product versus where we were on the savings product, where a lot of it rotated out from, obviously, that resulted in some of the eating up of the margin expansion we saw in our deposit base. But that is -- overall, we still saw strong revenue generation off of our savings and our GIC deposit, and that is a great source of wholesale funding for us.
And if we look at what we saw, we actually had growth in our deposits year-over-year, $14 billion on the GICs alone, and half of that was actually new money. And it speaks a lot to our client acquisition strategy. I think we've been working through building this deposit franchise over a number of years. It doesn't happen overnight, and a lot of it has to do also with that client connectivity we have.
And so you think about it from the number of clients of ours that hold all four products, that's 18% to 19%. And so we have the ability -- strong ability to cross-sell off of that deposit base. So while we did see rotation for clients looking to see yield, it still speaks to the fact that we had a very strong revenue generation overall from it.
And then when you look at what happens in the US and City National, the five basis point NIM contraction in the quarter, that doesn't translate obviously to five basis points at the top of the house when you look at all bank margin. But a lot of that driven off of the increase we had in FHLB in the quarter, particularly as it related to improving on the liquidity position overall for City National.
That is something, though, that we are looking at from a deposit funding base for the City National Bank. Obviously, they've had very strong asset growth. We do have a low beta deposit product there, but similar to what you've seen elsewhere you've seen some of those deposits start to run off. And I would say with our City National franchise, we've got a very high net worth client base, and there's other opportunities for them where we put the deposit.
We are still very focused on that deposit retention, so they're working back and making sure that they speak to the client base around that. So while we do expect some pressure from City National as it relates to that deposit mix, we expect that to subside a bit going forward.
And then if you think about what other we saw dynamic, our liquidity position improved overall for the bank, and that was really a content of our constructive markets for our wholesale funding. And so that will start to get absorbed really as we move through the year and the loan book starts to accrete.
That was kind of what happened from the margin expansion on a quarter-over-quarter basis. And as I mentioned, as it related to our guidance, it was really that rotation of the GIC book a bit quicker than we had anticipated. But in addition, I mean everyone saw yesterday with Powercom, it's what's been happening with the inversion of the yield curve.
So when we actually set our plan, the five-year swap rate, which is a bit of a benchmark in terms of where we look at some of our margin, it's moved around like to the tune of like 50 basis points over the last few months. And so that inversion of the yield card does make it a bit challenging in terms of estimating out in the near-term and some of the puts and takes around net interest margin, which is why we focused a lot of our guidance on NII, because what we've seen, as I mentioned, around our deposit franchise, the strength we're seeing, really seeing that accretion overall from a revenue standpoint. And that's why we thought it was probably more important given some of the near-term dynamics that you can see in net interest margin to speak to NII growth trajectory.
And so for the retail bank, we're looking at that mid-teens trajectory. And for City National, we are going to continue to benefit from the rate increases, in particular, what we heard yesterday. And as a result of that, we do expect that to be even more significant than for the retail bank in Canada, so about 20% on a year-over-year growth basis.
I talked about the margin. We are focusing more on NII, but we will expect to see more of that pressure happening into Q2 in part for City National because you would have had a full quarter impact of the of the FHLB funding, and we'll see how the deposit performance is overall. And then the retail bank stimulus, there's going to be some pressure in the near-term as it relates to margins, but just really thinking that NII trajectory going forward.
Darko Mihelic
And so with respect to the pressure that you just highlighted, what about the liquidity? I mean shouldn't that sort of help a little bit?
Nadine Ahn
It will start to help a little bit as it absorbed, but that's really dependent upon how the loan book starts to come on and get absorb some of that funding.
Darko Mihelic
And do we dare talk about the rest of the year, the back half of the year, or is the environment just simply too difficult to…?
Nadine Ahn
Well, I think that's why we're really looking at our full year guidance, right? And so I do think that when we speak to what we expect the trajectory to be to the latter half is really where you're going to see that margin expansion start to come.
Darko Mihelic
Okay. And another topic of interest for a lot of people as they related to me was really expense control. Now you spoke about, and you gave a pretty good waterfall, I thought, in the presentation for the earnings. But in particular, a couple of things stood out, and I was talking about hiring and some discretionary spend. So maybe can you just touch on those two topics specifically? How should we think about, especially comm? Because that's -- it's a tough one for banks. We have been hearing that, obviously, there's some inflation and many companies have had a lot of initiatives on the go. So can you touch maybe on the FTE side and what that means for your expense base?
Nadine Ahn
Yeah. Just to start off, I mean you're right, and that’s why we did the breakdown of the waterfall because 17% growth on a year-over-year basis is not a headline number we like to see, either. And you would have heard some of Dave's comments overall. We kind of step that back a bit just to get to your point around FTE. We did have one item related to reversal from prior year. It takes off about 1%. And the way I've been trying to think about it even internally a lot more is really around operating leverage. I mean at the end of the day, that's what everybody should be focused on.
And so when we take out those items, I'd either have offsets in revenue relates to accounting through our wealth accumulation plan and when you think about FX as well. And, obviously, with the addition of Brewin Dolphin, and that's a great thing. But when you look at just from an NIE line, it looks like a significant increase year-over-year.
So when we take that, we get to that piece that's remaining, and that's really where we were about 8% year-over-year. When I break that down, half of it does relate to the salaries, so about 4%. The inflation piece of that is a component of it, but I would say that it's also just around our FTE growth.
And one of the things that we talked about on the call was -- maybe we call towards the end of last year, you couldn't keep up with hiring, right? Like the employee base was really in the driver seat. We had opportunities through the market. So you had a bit of the attrition probably at a higher percentage point. So you had -- you couldn't keep up. Like there was funnel was just emptying before you could actually get sufficient employee base.
But it changed so fast, and this is just another thing that we're seeing overall with the market when I commented on NIM. Things are changing fast. And what we found was that we got our recruiting engine all started up and this was about front office sales-type rules, particularly in the retail bank. So great from a -- we talked about our client acquisition strategy. We talked about our revenue growth. Our volumes, really strong. So we got ahead of ourselves and on the hiring, and then the attrition stopped. And so, they got over their skis in terms of total headcount at the start of the year.
Now when I think about my plan, I'm starting with a higher FTE base. So as a result of that, we're really working through. And you have heard Dave's comments on the call, we are laser-focused on ensuring that we think through about that FTE complement now that we've done a lot of our hiring already on the front office side, it's going to be absorbed through. But because we up-fronted a lot of it, now we have to think about where are we going to hire than maybe we don't need to, right, particularly around things like head office or support roles, right? What do we need to stop doing?
So that's been a big part of what you saw from the overall NIE. When I look at the other buckets, technology is something -- and what you see from an NIE standpoint is obviously a lot of the benefit from past investment coming through. And that has been an area that we've been investing, not just from the client perspective, but also from -- you've heard us talk about our zero-based budgeting and increasing in efficiency, operational efficiency, processing automation. You spend the money to take the time to take the cost out. The costs do come out, but they're not going to come out, because you've got to build on from an infrastructure standpoint. So that's where you see a lot from the NIE standpoint.
And then I think similar to what everybody has been dealing with, one area that inflation is hit just besides our own FTE cost base is in terms of some of our third-party suppliers. So when you look at -- marketing has gone up in terms of costs. You took a business development. We're all here. We're traveling. This is great to be in person. But if you all recall last year, we did this conference virtually, right? And so you're seeing those costs tick-up, especially on a year-over-year basis. But that's where we're going to see it start to moderate going forward.
So I'm really focused on operating leverage. At the end of the day, that is what's driving earnings going forward, and that's why we have a very targeted approach to target for positive operating leverage for the year. You're going to see, obviously, as we saw inter-quarter movements, but that's why we're really focused on.
And you think about -- I talked about Canadian banking. I talked about them getting a bit ahead in terms of some of their hiring. We are still looking at a sub 40% efficiency ratio. And I know, Darko, you look at the number of banks, I think that you consider that as global leading, But that doesn't mean that we stop there, and we're still very focused on it.
Darko Mihelic
And should people think about, well, you hired a lot of front office, so should we start to see some revenue?
Nadine Ahn
Yes, absolutely. Productivity is increasingly important. And I think that's one of the things that the diligence around ensuring that as you add the people, they are delivering on the revenue. And I think that's something that we've been much more focused on the past as part of our zero-based budgeting work that we've been doing is really looking at that productivity.
Darko Mihelic
And – but that should be a back-half phenomenon of the year, do you think?
Nadine Ahn
Yeah. In terms of – I mean, everything you got in constructive markets, but yeah, that's really where you're seeing the drive for the positive operating leverage comes from the revenue, yeah.
Darko Mihelic
Okay. I'll maybe just move on to another topic, and I'll poll for questions after we sort of hit some of the hot button topics that people have been sending me. Capital. So clearly, capital has been topical ever since the regulator changed the DSP. Royal is in an area where they've got a strong capital ratio. And then you've got a big benefit coming next quarter, a little bit outsized relative to everybody else. And so I wanted to just ask, what it is that Royal is getting such a big benefit on the capital? And then maybe also speak to the final reforms as they get implemented in next year?
Nadine Ahn
Sure. Yeah. Well, we are in our final chapter, although I don't know if everybody believes it. But just for background context, right? For Basel III, the reform, this is really looking to set that consistency, that standardization across the industry. And so what you're seeing is more of a movement towards the foundational view of the IRB. So what we're looking at is that is removing then what they call this scaler, right? And this mainly relates to, obviously, credit risk, on the banking book.
So -- well, every bank is going to benefit from removing of the 6% scaler. It was basically just an add-on. And then so when you look at then the actual adoption of what the new parameters are around the financial Foundation IRB that is where you're seeing the standardization. And particularly, the impacts are on the corporate and commercial books. And maybe no surprise to those of you who deal with RBC in terms of our conservative nature, and so what we're actually finding is that the new parameters are less severe than or conservative than our own internal ones.
And so that's where you're seeing a better a significant portion of the improvement. About half of it is relating to the scaler, and then another half of it's relating to that dynamic. And so this is obviously driving what we talked about in terms of our guidance around capital, and that is all included as it relates to the guidance we had for the 12% on the close as it relates to pending HSBC transaction.
Then you get into the next phase, which comes in 2024. In Canada, for those of you in the US that follow it, we are early adopters, if you will, versus the rest of the world. Australia, I think, is also going this year. So FRTB, the trading book changes are coming in 2024. And from our perspective, again, back to – we were primarily on standardized for our trading book.
So this is impacting our equities business, rates business from a repo business. But because primarily for the groups that were being impacted, we were already un-standardized, so it's not like we were on models and now we're going to a more punitive standardized view. So that's why we're not expecting to see as much of an impact under FRTB, but we're all still working through the rest of it. But that's all been factored into the guidance we've been providing on capital overall. But do not expect it to be as significant as maybe for others, just given those dynamics.
Darko Mihelic
Okay. That's really great color on the dynamic there, which brings me to the question on where could things go wrong. And one of the things we haven't seen in Canada, and I haven't seen it for many banks, is RWA inflation. And it's been a bit of a topic. We haven't seen much credit migration. What's your view on RWA inflation? And maybe we'll weave this into a discussion on mortgages at some point because loan to values are falling with house prices in Canada. That might be in the area of RWA migration. Can you give us some initial thoughts on that as a potential headwind?
Nadine Ahn
Yes. We did see a bit of credit migration this quarter, and I think we're still sitting with a bit from where we were back post COVID. I do think that if you look at what's been happening, and you commented on the mortgage book overall, I think that, we are still not -- we're still seeing very healthy balance sheets for a lot of our clients. Particularly on the commercial side, we're not seeing, to the great extent, the clients defaulting on from a credit standpoint. We're seeing a bit more on where you would expect on the unsecured, on the retail side. And that's why you've seen some of the tick-up, particularly in the Stage 3.
We are seeing a bit more on credit card and unsecured RCL. But the delinquencies, we're just not seeing them there as it relates to the commercial book. And I think when we look at one of the advantages around having that strength of client franchise in that deposit base is you get a lot of insights into your clients. And they're still sitting with a significant amount of liquidity over and above where they were pre-pandemic, and so that's been -- it slowed down some of the utilization rates. We're expecting those to tick up again towards the end of the fourth quarter. We're starting to see the -- from a credit card perspective, we're starting to see continued growth there. Revolve rates coming up, maybe expect that to come back to pre-pandemic levels. So you're starting to see some utilization from a credit standpoint.
But from overall health, I would say, of the client base, when you think about credit migration, we are very, I would say, prudent in the way that we will -- we downgrade from aged. We're probably more slower to build them back up, hence why we still have negative credit migration from what we've seen from post COVID. So, we are quite prudent in that regard. But I think that when you look at it, from an overall book perspective, it's not something that you're seeing is going to be significant in the near term.
Darko Mihelic
Which brings me to maybe a discussion on something that's been topical in the news lately with respect to just the overall situation in Canada with respect to housing and mortgages. One, bank had disclosed that they had 20% of their mortgage portfolio effectively negatively amortized. And this is Canada, most of the banks do the same thing. So I got to think structurally, this is probably happening at Royal. So, I wondered if you can comment on that phenomenon. And why or why not that should be a concern for investors?
Nadine Ahn
Yes. I think when -- it really helps to break the book down and kind of understand the worry about around that tail risk, right? And so, when you look at our balance sheet, $355 billion of mortgages, where about two-thirds of it is roughly floating fixed rate story, and about one-third of it is floating rate. And when you look at our variable rate book, it's about $75 billion. 20% is roughly at that -- hit that trigger rate, which means that they're paying interest only, right?
And so, when you look at -- from our client standpoint, when we're looking at what their cash flows are, when we're looking at the insights that we get in terms of their ability to pay, like we're sitting here, they've got their TCLTVs for the book as a whole is at 51%, right? New originations are at 70%. FICO scores at 800. So you're talking about a book that is quite healthy overall. You've got that equity in the home.
When you start to break it down then and look at the cohorts, right? So, most of our book, when you're talking interest only, so that means their payment is going to reset on maturity. And so if you think about both our fixed rate and our floating book, a lot of the volume came in turned into COVID period, and so a lot of that is going to be up for maturity in 2025 and 2026. So 50% of the book is pretty much going to have the maturities at that point in time.
And so when you look at it from what that means from a client payment standpoint, you're seeing about maybe $400 on average increase in payment, so maybe a 30% increase overall. And so what we see from our cash flow standpoint with our clients, it's quite manageable. I mean, you're thinking about 2025 to 2026, you're also talking about the wage inflation that's benefiting the client.
And that from a percentage standpoint, people could argue is it really keeping up with inflation, but one thing when you just look at the absolute dollar amount, if you look at the time horizon since pre-2019, you've had three times more increased appreciation in your salary base versus what you're seeing from the mortgage payment. But the tail risk is there, right? And so you have to look at that and break it down.
And so when we take that cohort of those that are going to be into 2025, 2026, if we look at it from who has LTV greater than 80%, FICO is less than 700, when you look at that piece of the book, that is like low single digits of our total mortgage portfolio. And so you do focus on that, and you do work through with the clients to make sure that they're going to be ready to be able to manage that cash flow.
From a client conversation overall, like we haven't seen actual people rotating into fixed rate mortgages. We've actually seen people looking to try and speed up some of their amortization, just more of the broader book in terms of double up payment, et cetera, just to bring down that overall interest cost.
So it is definitely a risk, but I tried to size it for you in terms of where you have really start to break down the cohorts and see where you've got an area that you have to focus, and that's where you're getting into that smaller -- really small portion of our overall mortgage book. And then you think about our loss rates on something that has so much equity overall in the house, it's not, I would say, significant.
But I see it almost more as a societal impact in Canada, right, at the cost of housing more generally that we still suffer from a supply/demand imbalance. Canada has been recognized for its immigration policies, looking up to take 0.5 million people in. These are people who are producing, they need housing. And so we're actually in a situation where we don't think the housing market is going to go into free fall, because there is that tension around supply/demand. And those of us who live in Toronto, we just found out what the house prices actually went up last month.
So it still means that people have value in the home as well. So it's definitely from this file, it's more of a cost burden price of housing overall, which trying to address, but it's not as easily quick fall either.
Darko Mihelic
So, just some follow-ups on that, with $75 billion in negative AM, I think on the quarterly conference call, correct me if I'm wrong.
Nadine Ahn
Yes.
Darko Mihelic
But I think Graham mentioned that there was $64 million of formations.
Nadine Ahn
Yes, $64 million information off of the…
Darko Mihelic
…related to that that very book there.
Nadine Ahn
Yes.
Darko Mihelic
$64 million on $75 billion.
Nadine Ahn
Yes. Quite de minimis from a $355 billion book overall.
Darko Mihelic
And 12 basis points of overall delinquency, which is still relatively low, I think, for the mortgage book. So I guess what people want to zone in on is you're having these discussions. Very few people are falling by the wayside. Is there any other risk in there, What about the fixed part of the portfolio, the fixed rate?
Nadine Ahn
Yes. The fixed rate is, I would say, similar from the -- while clients have been benefiting from the rate that they receive, the majority of the cohort is going to be maturing similarly in 2025 and 2026. And so when you look at that, again, you're looking at about a 30% increase in payments to that average $350 to $400 range for clients. And similarly, the book overall in terms of the average basis of FICO scores is quite healthy.
Darko Mihelic
Okay. All right. Then maybe turning to the other aspect of credit quality, which is just -- I mean we're seeing Royal build allowance for credit losses again. So maybe you can just touch on that a little bit, give us a little bit of idea as to what kind is going on there. We're seeing a bit of a change in some scenarios and some outlook. We did get a weak GDP print, but it wasn't terrible. So maybe you can just give us an idea on the reserve build. And what -- should we be thinking of more and more builds as we go quarter-after-quarter?
Nadine Ahn
Well, IFRS 9 is an interesting contract. I think everyone has gotten a little bit well versed in it. But so our base case essentially does have the moderate recession hitting in 2023, both for Canada and the US. And to put that in context, we've got GDP, by the end of the calendar year, contracting 0.2%. We've got -- this is the interesting part we can talk a little bit more. Unemployment going to 6.8% by the end of the year. And then from an HPI standpoint, we've got the peak to trough going down by 14%.
So when you build that in, that's what you see from the Stage 1 and Stage 2 as part of our base case, and we did comment that we actually moved some of our waitings from pessimistic into base case. Because as your base case really starts to take into account that economic scenario, that pessimistic economic scenario, then you don't need to have the extra layering on because it's already being built into the base case.
And so as we think about that then going forward, that is why you are seeing the expectation that we're going to start to hit through the normalization of Stage 3 throughout 2023. And so when you think about Stage 1 and Stage 2, that reserve building, that is really because the economic scenario has not materially changed in the last little while, what you're seeing in terms of that reserve build is almost that pull forward or that roll forward into that Stage 3 view.
So as you get to the point, I mean the interesting dynamic around, and I think I've said this before, IFRS 9 is it imagines this lovely, little economic cycle, where we hit the trough and then we come back up. And so I think the challenge with it in the standard now is that the rapidity with which we move through these cycles gets a bit challenging. But that's essentially what you're seeing from the reserve build. So then you would liken the fact that when we actually hit that Stage 3 normalization that you would then start to see the reserves release because the expectation is that you've hit the trough point.
But the kicker on all of this is that people keep waiting. Unemployment, which is the primary driver of the -- for credit, the provisioning increases has not been happening. We continue to see very low levels of unemployment. So there's still a significant amount of jobs. You have inflation there.
And I think in Canada, one of the things that seems to have happened is that, inflation has kind of hit a point of tapering off. I think, with the comments in the US, it just seems like the US economy and the consumer spending power, it's a lot harder to pull back on the growth trajectory there, and so they seem to be wanting to hammer it a little harder.
But the unemployment level is still -- well, people are having jobs, right? And so, that's why that hitting of that -- Graeme throwed the fact that we both give guidance. He seems to be more like the economist and be able to change it. But he keeps waiting for that Stage 3 to happen.
We are starting to see it build in. But I think, as in my comments earlier on commercial, until the unemployment actually starts to tick up and hit, you are -- it's hard to call when exactly you're going to start to see that. But we are -- that's what the reserve build is. The reserve build is legging into that view of when the Stage 3 is going to hit.
Darko Mihelic
And we never saw it during the pandemic, so the Stage 3 never materialized. So it was --
Nadine Ahn
Never materialized. But we don't like to comment on that a lot because. Then the government says, 'see, I gave you all that money, you should pay me back more.'
Darko Mihelic
I promised I would ask -- are there any questions from the audience? So we are running out of time, but we'll gladly take a quick one. No? Fantastic Nadine. Always great to chat. Thank you very much for joining.
Nadine Ahn
No. Thank you so much, Darko, I appreciate it. Thank you all for the attendance.
Darko Mihelic
Cheers.
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Royal Bank of Canada (RY) RBC Capital Markets Global Financial Institutions Conference (Transcript)