Bank of Montreal (BMO) Earnings Call Transcript & Summary

Welcome back to our last presenter before the lunch. And last but certainly not least, Tayfun Tuzun. Welcome to the stage, and nice to meet you in person, finally.

Thank you.

Tayfun is the Bank of Montreal's Chief Financial Officer. So we might get a bit more numbers-type questions this session than I have in the past. Lucky you.

One thing I do want to start off with, not specific numbers question but numbers nonetheless. Q1 '24 was a challenging quarter for BMO. And your message was this is going to be the low-water mark for revenue performance or growth and then the high-water mark for expenses. So what gives you the confidence in that, in Q1 being what it is and the rest of the way is going to be better?

Yes. So yes, Q1 was a disappointing quarter relative to our expectations, especially coming out of last year. As we observed a better environment in October -- September and October leading into the end of the year, we had higher expectations, especially for our market-facing businesses, Capital Markets being the most important one. And we had a very weak November and December client activity level. Although things picked up in January, it just didn't quite save the quarter. And we had some idiosyncratic issues in the first quarter, which I don't expect to repeat in coming quarters. One was the transition to IFRS 17 in insurance from IFRS 4. We finished the year under IFRS 4, and then we had to restate our earnings during this transition for '23 and '24, although it's funny because our fourth quarter in insurance under 4 was very similar to our first quarter in insurance under 17. But when you look at the restated numbers, there was a big down impact on revenues, which related to our preparation at the end of last year for this transition and adjusting our hedge ratios. So that created a dip in our performance and reasonable dip over $100 million. And then the third idiosyncratic part in Q1 was in our corporate segment. And the biggest factor that changed our quarter-over-quarter net income there was our fair market value hedges and the mark-to-market impact on that hedge portfolio resulting from the significant rally in rates during the quarter. That's an accounting phenomenon related to those hedges. And by definition, the fair market value moves over the lifetime of those hedges will converge to 0 by definition. So there will be some negative quarters. There will be some positive quarters. Q1 just happened to be a big negative impact. So the cumulative impact of some of these market phenomenon and these idiosyncratic factors ended up impacting our revenues quite negatively during the quarter. What we have observed towards the end of the quarter, especially in Capital Markets, and what we kept observing in February and into March gives us a more positive outlook in our market-facing businesses. So a large part of this shift from Q1 into the latter part of the year relates to not being subject to some of these unique items, but at the same time, also a pickup in our expectations of revenue improvement. We still have positive impact coming from Bank of the West incrementally as that transaction moves on to the next phase, way post conversion, having captured all of the cost synergies. Now we have the full run rate of the expense savings in our base. Our internal legacy BMO efficiency initiative is also still incrementally helping the expense picture. So when you put it all together, we expect Q1 still to be the low point on revenues and the high point on expenses. We still are keeping that message, which also should move us on to positive operating leverage for the remainder of the year. So again, it is a combination of not repeating some of these idiosyncratic events, but more importantly, probably a lift in the revenue performance. We guided -- we provided some guidance to give you a better perspective on this step-up. In Capital Markets, we guided to $625 million to $650 million in PPPT, which is, when you think about it, not too far from where we were in Q4. In Q4, we were a little over $600 million. Then it dipped to $485 million, $490 million in Q1. So now we expect back on that trend that we have been building at the end of last year. We're guiding in corporate to converge back to the net income that we showed in Q4 of last year by the end of this year. So in Q4 of last year, we were right around $185 million in net income in corporate. We think we will be approaching that by the end of this year. So there's a bit of a convergence back to that level. And with continued positive muted, but albeit still a positive environment in our P&C businesses, we think you put it all together should give us better performance for the remainder of the year.

Okay. And then before we get into the P&C business, the Capital Markets had a tough quarter. Embedded in there was like the impact of the dividend taxation and the reduction of the teb -- trading revenues. Wondering how investors should expect that to be, I mean, addressed, for lack of a better term, over the course of time, whether you backfill with new activities and it takes just a while to get back to where you were or is an element of market participants in that particular activity that readjust and higher pricing, presumably, and there'll be some return to -- a partial return of that business, if you will?

Yes. So I don't have a ready solution for the particular reduction on the dividend side. But the strength in our Capital Markets business and the expected uptick in performance does rely on the diversity of the different parts of that business. I think we are showing some very good strength in the securitized products. We were actually #1 in the U.S. in [ CMOs ] in mortgage. We have a very strong mortgage business within Capital Markets. We have a very strong and growing CMBS business in capital markets. This quarter, leverage finance, DCM, Canadian ECM are showing better trends. And we've been investing in our U.S. rates business. That should also provide a good, strong, diversified revenue stream. So I think we will be able to address this particular change in the revenue stream through basically the collective strengthening of other areas.

Now the balance sheet optimization has been an industry theme, but BMO has been the poster child for making some decisions under that umbrella. So credit risk transfers leading up to the Bank of the West closing, the RV and marine business exit, if you will, and the exit of the indirect auto lending in Canada and the U.S. I know you've been asked before. I'll ask it again. Is there more to come from BMO in this regard?

Yes, you are right. We've been active in these transactions for the past 6, 7 years. We actually have built a particular expertise in this. And we view these transactions as tools that help us to both create more room for client growth, for balance sheet growth, for risk management and as well as more efficient use of capital. In some instances, our focus on capital optimization takes the form of getting out of certain businesses. Indirect auto loans were not producing the desired level of returns, and we were not -- we did not expect that in the long term they would revert back to double-digit returns on ROE. So -- and these are not relationship building businesses, single products, and we got out of it in both the U.S. and in Canada. In other businesses, these transactions allow us to continue to grow the client base and with the client base without necessarily taking outsized exposures to certain areas. It certainly helps from a risk perspective in downturns because investors are taking first loss exposures. It does help manage provision builds. And while all of that is happening, we have about 45 basis points of our CET1 ratio coming from these transactions. The notional balance -- the cumulative notional balance is roughly $60 billion.

Credit risk transfers?

Or credit risk transfers. The RV transaction is particularly the large transaction because it came with Bank of the West. It is an asset type that was attractive to investors, and we were able to execute a large size, about USD 7 billion. We will continue to look for opportunities, although I don't expect those opportunities to be of that size. This is part of our tool set. We look for these tools to help us get back to the 15% ROE target that we are still maintaining as our medium-term targets while helping us maintain -- we're at 12.8% CET1 ratio. We're 130 basis points above the minimum regulatory levels. And we intend to maintain a strong balance sheet. As we all know, OSFI still has an option to add another 50 basis points. We have 2 more years of an adjustment in the floor factor related to the Basel III calendar. We want to make sure that we leave ourselves enough room to support our clients and to grow our balance sheet while we manage our risk exposures. We view that these tools will continue to help us along those lines. And as you said, although we were the only ones maybe 5, 6, 7 years ago, now almost all Canadian banks and a good portion of the U.S. banks are using and utilizing these transactions.

So as far as the individual portfolios and not so much the synthetic stuff, but I look at smaller parts of the BMO bank, mortgages in the U.S., and then there's maybe the life insurance business. Maybe talk about those 2 as far as how could they contribute to your portfolio optimization strategy, if at all.

Yes. I mean -- so we don't have any plans to exit the life insurance business. I think incrementally, they are accretive. They're contributing to returns and revenue growth. So at the moment, we have no plans to exit that business. The U.S. mortgage business overall is in a much different place compared to the Canadian mortgage business because a large chunk of mortgage production is not funded on balance sheet. The part of mortgages that we fund on balance sheet is either the jumbo mortgages or more tailored mortgages for our high net worth clients. We want to make sure that we maintain our relationships with these, especially the wealth management clients where we can build a relationship around them. In our personal banking, it's no different than Canada. Our goal is not to have a mortgage business that solely relies on single product relationships but building a bigger relationship. Other than that though, we want to make sure that we maintain a very efficient use of balance sheet space for mortgages, but we have no plans to exit at the moment. I think the U.S. side tends to have more flexibility in utilizing less balance sheet space than Canada because in Canada, we don't have as many options to move mortgages out. So we intend to remain in the mortgage business in both countries in just a little bit of a different way.

And last one on balance sheet optimization. You indicated or stated that it's -- these are ROE accretive transactions. But there is a gap between -- and timing gap between when you execute on a transaction, free up the capital and redeploy it. And what's your expectation of timing before putting it back to work? Is it over the course of a year? Or is it going to take us longer? Because these are smaller transactions, but dispositions are sometimes good. But then there is -- well, how do you put -- how do you get the earnings back that you've just disposed?

I think that issue becomes a bit more challenging when you execute these transactions infrequently. For example, today, we are enjoying the capacity that the previous transactions created in maintaining the growth rates on our balance sheet, loan growth, customer growth. So I understand the question, and I agree with you that sometimes discrete transactions may just sort of create a bit of a hole and then you grow into it. But right now, we have a portfolio of these transactions. As they come due, we will most likely roll them. And as such, it creates a continuity. And I think the disruption becomes less meaningful. In '23, there was a bit of an uptick because '22 was quite a busy year, pre Bank of the West. So that did impact the revenue streams. But going forward, I don't expect a similar type of disruption. For example, in our RV transaction, this was not a transaction where we gave up a chunk of the earnings because we actually provided the leverage to the buyer. So we took off $7 billion of loans, but we put on about $6 billion of the security that will leverage that transaction. So the earnings give up was rather small.

Okay. Then speaking of timing lags, and this is clarify if I misunderstood, but Piyush on the last call made it sound like the timing gap between when rates are cut and when credit risk deflates essentially is very short. So that -- and BMO is not the only bank to indicate this, but Q4, there's an expectation that will be peak losses and it will start to decline in 2025. Is that still -- is that the message? And then how come it could be so short as far as rate cuts leading to a benefit?

Yes. So our guidance, he guided to low 30s for the year. And that guidance relies on a base outlook -- base case outlook for rate cuts in Canada and the U.S., probably 2 to 3 in the calendar year during the second half of 2024. We came in below guidance in Q1, which would suggest that there could be a few quarters where we may show some uptick in impaired losses but still staying within that guidance for the full year in the low 30s. He's the expert. I don't want -- I don't like to counter my CRO's...

Stay in your lane...

But at the same time, I think that the consumer portfolio and the commercial portfolio may show different timing patterns. I think in the consumer portfolio, it's tough to expect a significant abrupt decline in the credit losses as a result of rate changes because you have roll rates, your delinquency buckets. And there is a predictable pattern to consumer losses. I suspect that there is going to be a bit of a gap between the first few rate cuts and when maybe potential credit pressures coming down. On the commercial side, clearly, some of the pressures related to higher rates will ease fairly quickly, which may not necessarily alter the impaired provisions as quickly, but it certainly will help negative credit migrations to plateau faster because negative credit migrations are forward-looking, and they do take into account the impact of the rate pressures. So maybe the variables that impact performing provision may act sooner than the variables that impact impaired provision, which may lag a few quarters. In performing provision, my expectation is that we will continue to see negative credit migration for a few more quarters, normal based on the base case outlook. But we expect them to plateau, which will lessen the pressure on performing build. You may see modest builds for the remainder of the year, but we had a rather large build in Q1, which may not quite repeat during the remainder of the year. But this all depends upon the macro outlook. If there's abrupt change in the macro outlook, this may shift a little bit.

As far as last one on credit, but the impairment formation -- impaired loan formations over the past 2 quarters have been pretty substantial. Is there anything unusual that took place in Q4 and Q1 that...

Yes. I think actually impaired formation, I think, came down in Q1, but I mean I think it's in line with the environment. It really is in line with the macro trends that we are seeing. We are predominantly a collateralized lender. And we continuously focus on the loss content of these movements. And so far, all of that is included in our guidance. As I said, I mean, as I look at the rest of the year, impaired provisions, although they may tick up a little bit very incrementally, I think they are going to stay within the range that we've guided for.

Switching to Bank of the West, and I'm going to draw a line between the M&I experience and then what I may or may not expect to see in the Bank of the West situation. BMO seemed to plug in a strong sales culture system, whatever, and this is post M&I acquisition. And it was generating industry-leading growth almost to a point where people were getting concerned. Didn't turn out to be a problem, thankfully. But I'm wondering if -- when the economy stabilizes or whatever, is there an outlook for reviving my words, Bank of the West sales culture and growth prospects that you're implementing now?

Yes. I certainly hope that we are doing that now. I think we are seeing that in our performance. In our personal banking business, we have seen their branch productivity lifting up. We are aggressively converting their sales personnel to sales personnel -- I'm sorry, their service personnel to sales personnel in the branches, which already is contributing to both client growth, lower attrition and higher revenue growth, higher deposit growth. That's -- we're already seeing that, and we intend to share some of that with you guys, so you can follow with us. In commercial banking, similarly, we are seeing now growth in clients. With conversion behind us, net growth becomes a bit easier to attain. And you are correct that -- I was not here when M&I was acquired, but I have seen now the transition in the way we manage these teams that we manage, the sales targets across the organization, clients, segmentation and wallet share growth between personal banking, wealth management and commercial banking. We are very encouraged. And as you know, we have set for ourselves some ambitious targets for PPPT. We're still keeping those targets despite the fact that macro conditions are weaker today than we anticipated in the early parts of this transaction. We still are expecting a good lift across all 4 businesses. So the level of optimism around this transaction is truly maintained. There's no change there.

And the California part of Bank of the West is obviously the largest, but are you expecting other parts of that footprint to be more -- earlier to respond, I guess, to stimulus?

California is still the biggest. I mean I think that's the economy that drives the U.S. significantly. And that's part of the big strategic purpose behind this transaction, was our entry to California, and that will be the driver for that franchise.

Okay. Last one quickly on margins. You're guiding to modest increases this year. What kind of rate cut activity is underpinning that guidance? And then would you expect loans to reprice faster than deposits or vice versa?

Yes. We're guiding for stability. I think deposit pricing pressures and term migration has continued a bit longer than we expected. But I think looking now into the second part of the year, the base case scenario is that we would see, I think, 3 rate cuts in the calendar year. I think it's 2 within the fiscal year. So it does rely on that rate outlook. But we have a modest exposure to lower short rates, but that modest exposure is balanced by the impact, the benefit of the rolling investments.

The securities.

Yes, the securities. So that gives us a pretty good level of confidence that we will maintain the margins within a very tight range from here.

All right. And that's a wrap. Thank you. Getting hungry. Lunch time, I believe.

Thank you.

Thanks for coming to Montreal.

Thanks for inviting us. Thank you, Gabe. Thank you.