Royal Bank of Canada (RY) Earnings Call Transcript & Summary

All right. I'd like to welcome our last speaker before lunch to the stage. And before I forget, lunch is on the other side of this wall, correct? So we have a lunch speaker. Neil McLaughlin, Group Head of Royal Bank's Canadian Personal & Commercial Banking Unit. And I'd like to thank you for coming to Montreal and taking the time to sit down with us and go over a bunch of questions.

One place I'd like to start is on the -- the Royal has been pretty transparent and is talking about low interest rate environment, and mix shifts on the balance sheet has been a $2 billion revenue erosion -- source of erosion.

Yes.

And I think that's a consolidated figure, but the lion's share of it would be in your business. And if you could talk maybe a bit more about where that's coming from?

Sure. About half that over the pandemic would be in our business. It's coming from a couple of places. I mean we have a really strong deposit franchise. Obviously, deposits just as rates have come down, haven't been worth anywhere near what they used to be. And unlike the Europeans, we've floored our rates, we haven't gotten negative. So there's only so much you cannot pay a customer to hold their deposits. So that has been part of the NIM decline. The other side would be we have the leading credit card franchise in the country. We've seen a deleveraging of the consumer. A big part of that in terms of a very high-margin credit card portfolio is a contribution to NIM. And the other thing is just things like utilization on revolvers, whether that's from a commercial client, from a consumer, you're seeing this deleveraging effect as just more liquidity is built up, both in terms of entrepreneurs and consumer. So you bring that all together, and you end up with kind of the impact that you talked about. And the reverse of that is obviously, as we looked at it, finally, we started to see rate movement and we led up by 25 as you would expect, and the government would expect and starting to see that, that rate impact started to come back. And unless there's a real curveball, we expect many more between now and the end of the year. So that's kind of the rate environment. And it's been -- I mean it's been punitive. So we're just glad that we think Bank of Canada is now at a place that's the right thing to do is to start the march back up.

The credit card business, which you mentioned is one of the -- that's an obvious one and one where a lot of questions around what's the direction of revolver rates, when are they going to normalize or whatever. Do you think that with inflation with higher rates, that can actually accelerate the return to normal if it pushes consumers to have to carry balances?

I think the main drivers there are going to be consumer spending and then burning away the liquidity that consumers have on their balance sheet. So our -- the revolve rates we've got in our credit card business are still down about 500 basis points from where they were. We're down -- we peaked our portfolio. It was about $20 billion. We got to a low of $16 billion, and we bounced off the bottom. We're now just about 4% growth year-over-year. So you've seen, I think, the bottom of the trough, and I would think that's us. My expectation is everybody will start to see that trend. And it's because the consumers are getting out, the economies are starting to open up, people can consume and there's a lot of, I'd say, pent-up energy for people to get out and enjoy life. We've not been able to do that. A lot of that gets paid for on your credit card, and a portion of those customers find that the most convenient way to finance that is to pay out on your credit card. And we would look at this from -- it's the first place we're seeing the revolve rates come back. We're still not seeing it as much on the consumer and secured lines of credit. And the only place we're seeing it on revolve rates on the commercial business is at the upper end of the market. So I think this idea of deleveraging, you're starting to see it come to an end and credit cards would be the first place it bounces back, and the rest of them will start to come back. But we're still looking at getting back to probably a normal revolve or payment rates to normalize, still quarters away. And in terms of the -- for the most part, the largest portfolios in the country, our expectation would be second half of '23 to get back to the peak of where those books are performing.

So one thing that I think people underestimated was the amount of revenue contribution that carrying balances on the credit card actually represents for a bank. And I think of it in a couple of ways. One, we hear from banks, not just yours, where our credit card customers are high net worth, ultra-high net worth. But how do you square that against, well, these ones that are individuals, consumers that are carrying monthly balances that doesn't exactly line up to that description? Does that mean we have an underappreciated sense of maybe the lower end of the market as well?

I mean there's -- if you look at the different -- I almost kind of look at it product by product. So there are some products that are meant to revolve on it. So like we've -- there's us and most of our competitors will have something in the sort of 11% -- 10%, 11%, 12% category. It's meant to carry a balance, and the revolve rates would be over 95%. On other things where you're getting a really rich value proposition in terms of points in our program -- our Avion product is the largest product in terms of spend and balances in the country, you have a much lower -- because they are more affluent to your point, I'm there for the points. And so the revolve rates would be a lot lower, but you're making it up on the spending in the interchange line. So it would almost go product by product, Gabriel. But if you look at in terms of where is the risk in there, yes, you're getting the losses are coming from -- for the most part, they're coming from higher-risk credit customers, think about it as sort of sub-680 FICO scores usually combined with a disruption of employment or some sort of loss of income. That's where credit losses are coming. But these 3% loss rate in that business isn't something to get thrust about. We've never got there because we disproportionately have a transactor portfolio. But yes, there is a portion of that business that's always meant to revolve, and it's a convenience. It's really a convenience play to revolve on the same product you spent on.

Another card-related risk or substitution that might be -- I don't know, I don't want to say flash in the pan, but everyone is talking about buy now, pay later. And now we're seeing some of the bigger players in that industry experience some difficulties. Do you think that, a, that risk has been overstated? And b, how do you see that competitive threat evolving over time?

Yes. I mean, I think everybody's had a different point of view. Mine has been consistently that it's this -- it got a lot of ink. I think there is genuine demand from a client there to say, "Yes, this just helps me even though my cash flow. Maybe I don't want to pay my credit card. This helps me normalize that. I don't have to save up to get whatever that product was." But at the end of the day, do I think it's a macro disruption to our credit card business or the industry? I don't. I think we have launched a buy now, pay later product to merchants. We're actually out there live right now. We have about 13,000 customers that we've already brought on to that platform. It's called RBC PayPlan. But we don't think about it as -- like in my mind, it's a service to the merchant. It's not a growth platform for our credit business. And so yes, that's how it manifests itself, and it needs to earn a return there. But the strategic reason we invested in it was to make sure we're competing at the point of sale and offering the types of value proposition that merchants want to convert what's in that digital checkout basket. And buy now, pay later has proven it's got a place to play. Some places, I think the stories of some of these players have gotten overblown. There will be some consolidation. Regulation is going to rein some of them in. But I would look at like is that pay in for value proposition probably here to stay, I would say, yes, I think it's going to be table stakes.

Auto lending, you're top 3 in that industry. I'll ask the question I ask everyone. The mix of origination, how does that compare to pre-COVID you got like 60%-40% used/new, and it was 50%-50% before something like that or...

I don't think that's -- the story in auto has been about just inventory not getting the lots. And so the -- if I look at the retail side, we're just seeing a lot lower originations in terms of our sub-vented programs, working with manufacturers are the bulk of what we finance there. They're prime customers. Used kind of like 1/3 or 25% of our book there. But it's really been a story of having been in the market. You just -- if you wait 5 months for a car, you're lucky, you've even got a car. And so they're just fewer units to finance. On the other side of our business, we do a lot of floor plan financing in our commercial business, and there hasn't been inventory to finance. And so that's really -- it's when we talk about supply chain disruption. I think the auto business is a prime example. And I was saying at dinner, my wife's car came and it's supposed to have a iPhone charger pad, and the sales representative said, "Oh, they just -- they ran out of chips that week, so they decided that's where we're going to take your chip out of and no discount, you're lucky to get your unit at full MSRP." And we said okay and drove away. So it's kind of -- it's -- we're living a supply chain disruption in auto probably as much as anywhere.

Another -- something that I think about that there is a threat -- that's overstating it, but substitution might be more accurate, risk to auto lending is people instead of taking out a car loan, which is higher spread to the bank, they say, "Well, my house has gone up, and I'm buying these combined HELOC mortgage products. I'll just use that. It's much, much cheaper. I mean if I have to buy a truck tomorrow, that's what I'd do or a tractor." Is that a big thing that the substitution effect is...

I mean it's way up about my car for the exact reason that you talk about, but by and large, the everyday consumer goes in, and it's about a point-of-sale experience. And like, listen, we support an awful lot of auto lenders. Point-of-sale or indirect finance is one of the offerings we have. But if you look at that, I think the -- strategically, we look at that and say, there's an example where somebody got between us and the consumer and we now have to pay rent to who owns a customer. The dealer owns a customer. And so if you want to participate, you play by their rules. I think it's more of a lesson for other categories. So if this happens in mortgage, if this happens in other categories from not an auto dealer, but a Google, a fintech, et cetera, there's a lesson there. But it's not -- we don't see a lot of it. You have a more affluent consumer who says, I'm just going to write a check, transfer from my HELOC product in a way I go, and I have the discipline to stick because the other part of it is having the discipline to make the payment, and that's where a lot of what the dealer will sell, dealer sells payment. You can afford this, it's only this much every 2 weeks.

Yes. Okay. Now home equity lines, the combined mortgage HELOC product is drawing some regulatory scrutiny. Like how -- the stuff that OSFI's talking about or focusing on, how much of a business is that for Royal?

Yes. I mean, maybe just a little color. The combined loan product or the HELOC product that we have is their concern is that you have consumers who are essentially like revolving their lifestyle on using their home as a piggy bank. So I make some payments on my conventional mortgage segment, my fixed term conventional mortgage, and then I'm just levering myself up and withdrawing that money on my -- open to buy on my home equity line of credit. And so like we get where they're coming from. We've done the analysis. And I'd say, so that's a scenario of risk. But we kind of put in the same category. So the perpetual revolver, not creating any equity as a scenario, along with someone who's like, "I'm into my mid-50s, and I'm not making -- I still have a lot of mortgage debt." At some point, whereas retirement, how do you get to pay this down. We look at those types of scenarios when we do our portfolio management, neither are a big -- I mean, like less than -- if it was 1%, I think it's less than 1% of customers, we would even red circle and have any type of that risk. So it's -- at the end of the day, it's not a concern, and we're providing OSFI all that information to kind of get their comfort level.

Like 1% of the ones that have this product are like perpetually levered kind of thing? Is that the...

Yes, like less than 1%. And so it's -- our first take on it was we don't see it we've done the analysis, and it's become really an insignificant and nonissue. And so it's -- I can't remember what side of 1% it was on, but it was exceptionally small.

And how do you -- is it just you have this one small bucket of customers that equity just doesn't -- it's staying flat or...

Well, what happens is even if you look at file by file, you can do a file review and you say, "Okay, so what would be your reason for it?" And there's some good advice. I mean if somebody goes in and says, "Okay, so I've created equity, but now I want to renovate my home. Okay, I'm going to take out a -- I don't want to get another mortgage because I'm going to come in to have a liquidity event. I'm going to get a big bonus, sell my business. Hey, I don't want to be locked into a term product. So I'll take out $50,000 or $100,000 and do my renovation." That's not bad advice, and that's good flexibility. And there's a lot of that, that also falls in the same bucket. So it doesn't necessarily signal credit risk. And if you look at from the portfolio side, we still have the LTV. We still have cushion in the deal. And OSFI is appropriately sort of saying, "Are you giving good advice? Are we setting up consumers to be -- continue this leverage path that we're on?" We're just not seeing that as a problem in our book.

Switching gears a bit to the -- what I think has been underappreciated in your business' growth over the last year or 2, let's call it, is that you're at or above -- in the ballpark anyway, on mortgage growth and above on deposit growth and certainly not from a small base effect. So we're seeing big growth rates off of a big base already. And how do you quantify the future growth potential that what you've just delivered adds to the business. I mean that's a wordful, but after 3 years, the mortgage customer will do this and that type of thing.

Yes. It's not lost on me that kind of the growth on growth on growth isn't like the most comfortable position to have to continually chin the bar from. But I think the way we approach it is we just -- we say there's a lot of -- we have a lot of, for example, mortgage customers. Half of our deposit customers have their mortgage elsewhere. That doesn't make any sense. That's a path for growth. We believe we built the most lucrative credit card program. There's a bunch of customers we haven't convinced there. We've launched our new deposit program that provides more reciprocity than -- so we know we've got the value propositions is what we'd say is like where do you have confidence you'll continue to grow. In terms of forecasting what we've already done, the best example we'd probably say is the core of the cross-sell comes on the deposit -- the core deposit account. And you've heard us talk about this for a number of years, which is we've set a target of how many new consumers we're going to add to the business. And COVID put a dent in that as everybody -- we had other things that we had to take care of, but we're back on the path to meet that. And we just had our best Q1 in terms of new client acquisition we've ever had. And we are seeing the kind of the cross-sell and attach rates of those other products that we would hope for. So I don't think we've gone through and said, "Here, the earnings that these vintages are going to provide." But we do monitor, are we getting -- and I'll give you an example. With our new vintage program, we are seeing a substantially elevated cross-sell rate of the credit card and the savings account. And that's because that's the way we've constructed the value proposition. So that kind of builds off of previous pre-COVID 2 exceptional years of new client origination. And it's core to the strategy. We obviously had to pause things. We're going to throw good money out the window when we were going to have low response rates and low returns, but we're back on plan full offense and it's core to the strategy.

And if I -- just on the deposit, the numbers have been astronomical as far as absolute growth. I think last time I checked was on the personal side, an extra $100 billion in the industry. If you look at your slice of that, how much of that has been core to I'm getting a paycheck deposited there?

It's been a really large part of it. I mean, I think we did -- in the pandemic, we did 5 deposit forecasts and got 5 wrong. So we just couldn't have anticipated the type of accumulation we'd see. So every day, the core deposit has been a real focus. Term deposits, just the yields haven't been there. You're starting to see them come back a little bit. So but you saw a real switch out of that into mutual funds at the beginning of the pandemic. We did 13 months of $1 billion or more in net mutual fund sales. So taking it from that quarter. And we had -- you mentioned sort of the industry growth. We were over 20% growth in the everyday savings accounts. And so a lot of lazy deposits. And our strategy was reach out to the client, give them good advice, what they don't need, get into the market and get it working for them. And if you go through the pandemic, we have a lot of happy customers who did really well with high teens type returns on those funds. So a big portion has been there. Savings accounts have been swollen. There hasn't been a real -- the rate is so low, we're trying to get it out of there and get into mutual funds. It's good for the client. But our margin on the trailer fee for mutual funds is many times what it is on the -- either the GIC or the deposit product. So...

On the last earnings call, something that stuck out to me was Dave talking about the economic outlook and picture -- he talked about a couple of good things, but he mentioned labor shortages probably 3 or 4 times during the call. Broad question, how is it affecting your customers? Probably more on the commercial side. And is it -- it's as simple as it's just restricting our growth potential right now and that's it?

Yes. I mean you've nailed it, which is, when we talk to commercial customers, the 2 things on their mind are supply chain disruption and labor shortages. Labor surge is, I think, sort of mid-pandemic, there's a lot of entrepreneurs who we've been saying this government stimulus is we've kind of swung the pendulum too far. A lot of lesser skilled folks are just staying home and rather, hey, I'd rather collect the government benefit than go out and commute to my job -- and a lot of entrepreneurs, I think we're very frustrated on that. You're still seeing that labor storage. I think you're seeing GDP start to really pick up. And a lot of people are saying, "I'm just -- I'm willing to move. And I'm willing to move for convenience. I'm wanting to just try something different." But I would say wage inflation, labor shortage and the second is supply chain disruption. And a great example. We had a call with a number of clients from the Montreal area, and they were saying 2 things stuck out for me. The price of a container coming into the Montreal Port went from $2,500 to $25,000 during the pandemic, that these freight companies are making more money by shipping ships, full ships back to China empty than they are by taking the time to fill them up and sail them anywhere else. And so if you're importing things, that's a huge extra cost, how much can you pass along? And then the other part of it, just was manufacturers and a quote from a client was I've gone from having what I didn't know at the time was the most optimized supply chain just-in-time inventory. Every single part I knew came in 3 days before I need it. And now it's just in case. And they're essentially hoarding inventory, so they don't have work in progress sitting on the shelf, earning them nothing, which is not -- we're going to finance that inventory. But the problem for the economy is that if I'm sitting on all the inputs and you're my competitor, and I've hoarded them all, I'll produce my 100 units and you'll produce none. And that inventory is actually not turning into finished product and getting out the door. So that supply chain disruption is real.

I asked, I think, most of the presenters today about the private equity business in the commercial banking book. What's Royal's approach? What's the exposure as far as the amount of leverage volumes? And then how much co-investing or whatever term you line -- 2 separate things, right?

Yes. So maybe I'll start on the co-investing piece first. We have a couple of different pools we put capital into. We don't it's not a strategy in terms of just an investment strategy on itself. We do this to support other parts of the franchise, and we have a legacy portfolio to support some of our larger corporate clients. In my business, a couple of them would be in our corporate banking group, sort of mid-market corporate where we go out and we'd say, investing with sponsors into a few different funds, really make sure, hey, we're at the table. We can bank those companies coming from the sponsors. And then the other one, more recently, which has been very successful is our launch of what we call RBCx, which is our tech banking vertical. And we've gone from -- that's a business we didn't feel we were at our best, and we've brought in, completely rebuilt the team. We've launched a venture debt product, but co-investing there has been with the right VCs to make sure we're in the ecosystem. We're demonstrating support for their strategies, and we're getting the business back. And I would say it's -- the equity appreciation is one thing, but it's in support of the core franchise.

Okay. So you are -- and then as far as the lending exposure to the private equity investments, not the funds that you're investing in, but the lending exposure?

We don't have a lot. No.

Okay. Operating leverage target, 1% to 2%. With inflation the way it is, is that still achievable? And I guess the revenue picture is supportive of that still?

Yes, absolutely. I mean I think one of the things you would have seen over time is that obviously, with the -- we started the conversation with NIMs. We just put a real focus on saying, "Hey, when NIMs are coming down, and we don't have the headroom, we're going to be really disciplined on expenses." We feel quite good about what we've done there in terms of really bending that curve to get expenses down to low single digits. We do expect to be at the top end of the range. I think we might have referenced that in the last call. So we'll be closer to the 2%, hopefully above that for this year. And then as we move forward, I think with NIMs moving up, we should have the headroom to be able to maintain that type of zone. So you will see our operating leverage target range we've traditionally given move up a notch.

Another question I've been asking others and I've asked you this before, one day, I'll get a surprising answer, but the future of the branch, digitization going up and -- but there's no real business case to take a more aggressive stance on branch count?

We have a lot of the bankers here today. Maybe we get together and we'll all do it at the same time. But the issue there, frankly, is about first mover. There's risk in being the first mover. And it comes down to -- the Canadian consumer has been spoiled with choice. So I can go into a branch when I want, and I can get online when I want, I got my phone and I call it the end-value proposition. It was -- first, it was branches, then it was branches and ATMs and the online and the phone, and we'll come to your house. And so pulling those away, there is some risk in it. I do think the scale players do have an advantage here where we have the most amount of convenience. We have the most ability to pay for the branch network. Our approach to it has been less about the number of branches, and we're taking them down about 25 a year, 25 to 35 a year. But it's more about the productivity of the people in the branches. And how do you set up the roles, how do you connect them with technology, how do you get data about your clients to the people so that their 35, 45-minute appointment is the most productive appointment they could have because at the end of the day, I spend 3x as much on salaries and benefits for frontline people as I spend on the real estate. So to me, it's not a real estate story. If it is, if others believe that, that's their prerogative. Ours is about, we think about it as market coverage. So if you were to take -- you were to take Gatineau or you were to take Sherbrooke. We look at it as a market, and we think, okay, how many people do we need to cover the market, how many commercial account managers, mortgage specialists and then we look at where should they sit. And if we're not in a community location, we move them to a convenient location. If we have too many square feet, we may get rid of an old branch shrink down to a new one. So it's less about just flicking branches off the network as it is making sure you're there to compete in the marketplace.

Question from the crowd?

I have a few follow-up questions. You said you had more deposits and I wanted to ask where they're coming from? Is this property sales? Business sales legacy? Or just the deposits, if you could give us some idea.

I have -- the question is...

Obviously, not spending. Spending is one of them but I mean obviously a age situation where we have demographics, people are getting older in this legacy and so on. The first question. The second one is blockchain. Obviously, blockchain is creating a lot of disruption, faster than the Bitcoin. And so as self-regulated organizations apply regulated growth, self-regulated. But what is the bank doing about pushing the agenda of getting Bitcoin under the blockchain formula, either out, in or something done because there seems to be no regulation. I'm trying to figure this out.

Yes. Well, you've read it. You've read the second situation...

I've got to put the questions down for the -- the first question was on -- the second question is blockchain and the regulation thereof and the sources of deposit growth, which has been phenomenal.

Yes. So I'll start with deposit growth. I mean disproportionately deposit growth, it's not from selling property, it's not from inheritance, these sorts of things. It's from maintaining employment and just not having any place to really put that liquidity to use. So it's disproportionately because of the lockdown, decreased spending and then this was precipitous. I mean, on consumer spending as an example, we used to be able to monitor consumer spending within like 50 basis -- it would roll 50 basis points per month would be fairly good variation. It dropped 500 basis points in like weeks. So I mean I can't overemphasize when the economy shut down, this was like it wasn't tapping on the brakes. It was like the whole thing just came to a stop. We've never seen anything like it before. And then on the other side, the liquidity coming in, this is a really interesting stat. We monitor every single consumer who had been collecting any type of government benefit. The deposit accounts of consumers who were either on or started to collect government benefits actually grew during the pandemic versus pre-pandemic. They had more liquidity than they had ever had as a group, not as an individual. And so you bring those 2 sources together and you saw the deposit account. And the same thing on entrepreneurs. Entrepreneurs just said, I'm not going to deploy this, I'm generating revenue. I'm not putting it out into CapEx. I'm really shrinking to my core, and Canada's entrepreneurs deserve a huge amount of kudos for how they steered through that, but it was shrink to the core, looming deposits. On the question of blockchain to your point, it is unregulated it is -- even if you're seeing right now, so you can separate blockchain from the underlying technology of distributed ledger and then what are the uses of it. One of the uses is Bitcoin, you're seeing cryptocurrencies, the fundamental problem that the regulated institutions are grappling with, and they were not getting a lot of, I think, progress, which is we have -- we play a role in terms of anti-money laundering and terrorist financing. It's not a small responsibility. We have a very high bar with FINTRAC. There's no -- there's apparently some technologies that are coming that will give you transparency to do that work, but they haven't been really, I think, at enterprise grade. Until they get there, I don't think you're going to see a lot of progress, but if I would -- I mean our view over the last while, it's not like these currencies are going away, right? Like it's not like this is a fringe thing, and this will all be shut down. You're starting to see Central Banks start to look at the topic. There was a press release earlier this week about Bank of Canada, the U.S. Fed starting to look at central bank digital currencies. We've had the conversations, but they need to start with some of the fundamentals. Okay, how is this going to be governed? And so it's moving and it's moving fast. But you're getting a lot of this activity in gray markets, and you're getting a lot of -- still a lot of speculative activity in cryptocurrency. So we're monitoring it. We're not participating other than there are crypto securities that we will allow our customers to invest. And other than that, we don't participate.

Can I just piggyback. Why has this been allowed to continue for 2, 3, 4 years, Bitcoin, crypto, Blockchain, all these without regulation at all? In comparison to being alone. I don't know, but I can only imagine.

It's a great question. And if I was a regulator, I might be able to give you a better answer, but we would ask the same question.

Thanks, Neil.