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

Welcome back to the room, and I'd like to welcome to the podium our next presenter here at Derek Neldner, Head of Capital Markets and Royal Bank and also Board and Chair of the U.S. Bank, which will maybe jump into that one right away.

What does that involve the new responsibility. And I guess there have been a lot of, let's say, changes at CNB taking place over the past year plus. What are the key strategic directions you're heading in with City National. So what does the role evolve? And then where are you going with it?

Sure. Thanks, Gabe. And obviously, thanks for hosting this event. So in September of this year, I took on the role of Chair and CEO of our U.S. holding company that we have in the U.S. We have 5 businesses in the U.S., 3 sizable businesses, being capital markets, wealth management. and City National. And the real focus of that role has been to increasingly bring an overall U.S. regional lens to our strategy. So over time, we built up our businesses. They were all at different levels of maturation. We obviously acquired City National in 2015. We grew capital markets over the last 25 years, similar with wealth. And so to date, they were all basically being run and managed under their individual line of business strategies. And when we step back and we look at the size and scale of the opportunity for RBC over the longer term in the U.S., we just felt it was very important to bring more of a holistic review of the U.S. market and how our businesses are working together. So our focus and priorities down there right now. First and foremost is just continuing to drive good execution of our individual line of business strategy. So capital markets, which we'll speak more to. We're fortunate to have the 10th largest capital markets franchise in the U.S. now are seeing lots of good growth opportunities and more we're doing to execute on the strategy that I think people are familiar with. Our wealth management business is probably one we maybe haven't talked enough about. Today, we have the sixth largest wealth management franchise in the U.S. based on AUA, about 2,200 financial advisers, over $500 billion of assets. And so quite a sizable business, obviously, a very nice growth business and a very high ROE business for us. We see lots of opportunity ahead there. And then City National, obviously, a terrific franchise and client franchise that we acquired a number of years ago, as people would have seen, that business has gone through a really significant period of growth over the last number of years, which has been great. But as we step back, there's some operational infrastructure and control infrastructure that we really need to uplift to set the business up for long-term sustainable growth. And so within CNB, I think as you've heard, very focused on getting that it placed and there's a lot we put in place over the last 1.5 years, both in terms of some additions to the management team and a lot of investments in the core infrastructure of that business. And then an increasing focus on really optimization of the capital footprint to boost returns and a focus on our cost base to drive more efficiency and again, bring our efficiency ratio down and earnings and ROE up. Away from those 3 individual business strategies then, the big focus of my new role is, how do we better connect the dots across those franchises. And you can think about that pretty simplistically, there's a lot of areas for client overlap and referrals and different flywheels between the businesses as they interact together that we can be more organized around. There's cost efficiencies we can drive by sharing functional infrastructure, branding, marketing, location strategies, again, all in the spirit of trying to improve our underlying profitability in the U.S. And then importantly, in investments. In each of these businesses, there are significant technology investments in the normal course. That hasn't all been done in the most coordinated way. So we're spending in certain businesses and duplicating in others. And so we think there's just a lot of investment efficiencies and better ROI we can drive by bringing a coordinated lens to all of that.

Just a quick one because of -- you talked about the 3 pillars of the U.S. business. In City National, I don't -- I'm probably the description I'm probably going to but you here, but there's some extra attention from the compliance and regulation and all that stuff. That -- those -- that extra attention doesn't apply to the rest of the capital markets or the wealth operation, like RBC Bank U.S.A., whatever the holding company would be. It's just isolated to CNB?

Yes, I'd answer that in 2 ways. I mean, obviously, people would have seen consent order at CNB and some of the things we need to do to, again, boost our overall risk and control framework there, which is well underway. That really is specific to CNB. But if you do step back post the regional banking crisis last year, the regulatory bar is going higher for all banks and across all areas. And so while those issues are unique to CNB, a rising regulatory bar is something we're very focused on. We want to make sure our business is set up well for long-term sustainable growth in the U.S. And so while that is specific to CNB, again, I think every bank right now in the U.S. is very focused on how do you make sure you're just continuously strengthening your oversight governance controls to what is a rising bar.

And in that vein, when you're thinking about how you're managing your enterprise, I think you were Schedule 3 in the U.S.? Do you pretend like your Schedule 1 just to make sure that your standards are the highest in the industry, so to speak?

Yes. I wouldn't say we're necessarily looking to manage to the absolute highest highest level. But obviously, we're not looking just to meet the mark to be well above where the bar is and also be anticipating where is the borrower moving to over time.

Question on the Capital Markets business because we did have a lot of disruption in the market last year and it's, I guess, calmed down a bit. But if I go back, way back to the financial crisis, one of the big moves that RBC Capital Markets did was take advantage of these opportunities. European banks were in severe stress and you're able to hire away teams and build the franchise out organically. Has anything similar taking place over the past year? Or is it just steady as she goes pretty much?

I'd say it's -- there's similarities and then there are some important differences. And so what is similar is we certainly have seen disruption in the competitive landscape over the last -- really over the last 4 or 5 years. And against that backdrop of disruption, we certainly think that's created an opportunity for us. It's created an opportunity to add good people and continually invest in talent. That's allowing us to add additional capabilities to better serve the needs of our clients. As some of our competitors have run into more challenges. That obviously has created market share opportunities where clients are looking to pivot to other partners. And the theme against all of that, that we tend to hear from our clients is they're looking for scale players that have a track record of stability that bring a holistic full capability service offering, all of which plays -- we think well to our strength. So certainly, that has created an opportunity. The one difference I would highlight, Gabe, just back to the global financial crisis and for those that followed our capital markets growth, we did invest heavily in the U.S. post 2008, 2009. That really started with growth in our loan book. So because we were smaller in the U.S., we really led that growth with our corporate loan book, in particular, to build those lending relationships and then position us to do ancillary business with clients over time. Given where we are today, we have a very big footprint in the U.S. We have a sizable loan book. We have a very strong client franchise. So the disruption in this period -- the way we're capitalizing on it isn't through the balance sheet, but more consistent with the strategy we embarked on 4 years ago, which is talent, growing our nonlending business, growing our fee-based businesses to hopefully drive very good earnings growth, but importantly, continue to boost our ROE that if you look over the last 4 years, one thing I think I'm very proud of that our teams accomplished that I'm not sure it gets enough attention, as we've driven very good earnings growth, but we've also managed to increase our ROE by over 300 basis points, which is clearly important in terms of the RBC investment thesis.

Right. And then you did touch upon the corporate lending business and another page of RBC Capital Markets history was subsequent to your expansion hiring teams, the corporate loan book did indeed grow, but you hit a point where, well, you have to debank customers because they weren't paying off as much as you anticipated, that's behind us. I'm wondering, is there a balance sheet to optimization as a buzzword that we're hearing from many banks these days. It doesn't seem like there's a big change in the corporate loan book, not at RBC. I'm wondering if there's other aspects of this broader theme that might be applicable in your business or evident?

Yes, sure. Yes, I mean, I think you highlighted it well, Gabe, that we went through different phases in the capital markets growth post the GFC, up until about 2015, we are growing the loan book at double digits as we expanded our footprint in the U.S. We then went through following that period of rapid growth and optimization phase where we did really dig in on the profitability and the underlying returns of those relationships, when you grow quickly, there is just a healthy review you need to go through. Starting in 2019, and it's been reasonably consistent over the last 4 years, we're really focused on a moderate growth strategy in the balance sheet. And we've articulated that as roughly 4% to 5%. It won't quite be linear, but we think that we can grow our balance sheet by 4% to 5%, that should continue to then support the client relationships and the fee-based business. Over the last few years, as we've tried to stick with that moderate balance sheet growth and have been very focused on optimizing returns to get our ROE up, a lot of different initiatives. So I would say that ongoing optimization is pretty deeply ingrained in the organization, and we'll just continue to do that daily. That really starts with client-by-client ROEs and really assessing, are we getting the right returns we need off the capital and resources we're deploying. We've gone through, obviously, some regulatory changes with Basel IV and FRTB. In both cases, those were net beneficial to capital markets. I think we've had some conservatism in some of our parameters and data. And as we've gone to a more standardized approach, that's actually provided some capital relief for us. So that will all be sort of ongoing, but I think we feel quite good about just -- nothing dramatic, but just day-to-day management, solid optimization of capital deployment, a real focus on client by client returns and how that translates into hopefully a very strong ROE for the capital markets business.

And let's maybe dive into more of a specific business. It's topical from time to time, the high yield, and I'll use my term, high yield, you might use a different term, but there's the origination to distribute part of it, and then there's the actual lending balance sheet business that's levered finance, I believe you call it. What's -- anything to update there? I know the market has been fairly [indiscernible] the past couple of years?

Yes. The last few years has obviously been a volatile period, and we saw a lot of activity through -- up to the pandemic. We then had a correction during the pandemic as we saw in all markets. And then with the interest rate environment, pivoting a lot last year, we saw leverage finance slow down dramatically. I'd say in the last 6 months, as credit markets have recovered, you've seen a little more stability in the rate environment and spreads have actually tightened in the last 6 months, we've really seen an uptick in activity in broadly the leveraged finance and high-yield markets. And I would actually say there's sort of 3 pieces to that business. There's -- what we would refer to as really the flow refinancing activity. And so that's activity where we're not taking underwriting risk, but you're just getting refinancings of existing term loans or high yield, dividend recaps being done. That has really picked up a lot over the last few months. The second piece then is the sort of underwrite to distribute piece. That has started to pick up, but that's really driven by M&A activity, leverage buyouts and otherwise. That has started to increase. I think it will accelerate more through the year as we see more M&A activity generally as confidence returns in both markets and the economic outlook, but that has certainly started to improve. And then the third piece, as you mentioned, Gabe, is really the risk that we continue to hold. So whenever we originate a new financing and we underwrite and we go place that with institutional investors, there's usually a core revolver piece or term loan A piece that the bank market continues to hold. So as activity picks up, we'll see more lending activity there, but that tends to be very small. We tend to focus on sort of $35 million or less hold position. So it's quite a small piece. But overall, that's a -- it's a very, very good return business. It's one we like, and it slowed down a lot last year. It's nice to see activity returning.

And then, I mean, that brings up the famous pipeline type of question here. Converting the pipeline to actual revenue growth, what do we need to see in the market?

I'd say there's a few things. And you sort of have to break the pipeline down into a few different areas. When we look at our pipeline, we can start by looking at actual client engagements. And so that's when the work of the dialogue begins. There can be an extended period of time from being engaged by a client on an M&A deal or other strategic transaction to when that ultimately translates into a transaction. And in many cases, they won't. Even then once you have a deal announced because of regulatory approvals or otherwise, there's often a gap between announcement and closing. If you're in a regulated business as an example, that could be a 12-month period. So when we talk about the pipeline, we're often looking at what's our engaged pipeline look like? What's our announced pending closing pipeline look like? And then just what's our backlog of overall financing activity, IPOs, otherwise that might be worked on, but are waiting for the market. Overall, our pipeline has been growing nicely. On the investment banking side of the business, it's very linked to C-suite confidence. And so as people have gotten better visibility on the path of the economy, rates have probably peaked, inflation seems under control. Markets -- financing is more conducive. We're definitely starting to see activity pick up and our pipeline has been improving. What do we need? Time, largely for engagements to result in announced deals to then result in closed transactions and booked revenue. I think we continue to need just stability in financing markets that give companies confidence they can finance strategic activity. And there still is some closure of buyer/seller expectation gaps. And any time you get into a dislocated market, not surprisingly, sellers still have old pricing in mind, buyers are looking at new fundamentals. As markets stabilize and improve, you're seeing that bid/ask spread, if you will, converge, which then is conducive to more deals getting done.

A little twist, I don't know, in terms of the growth outlook. Private credit is getting a whole lot more attention lately. Lots of dry powder in that marketplace. I'm wondering is this, I'd say, threat or opportunity. But how are you approaching this -- these players and trying to take advantage of potentially some new opportunities presenting them to themselves.

Yes. No, it's a great question. We get asked a lot of the threat or opportunity friend or foe question. The answer is it's both. But overall, for us, we think it continues to be a large opportunity. So private credit has grown dramatically. We continue to think it will be a very, very active part of the market. The challenge or headwind of it is, in some cases, particularly over the last year, you've seen private credit or direct lending displacing banks in either the underwriting leverage finance market or in some of the lending markets. We're starting to see that pivot. That was natural when leverage finance markets were depressed and very inactive and clients wanted certainty on financing. It was much easier to go to the direct lending market. as capital markets have recovered, we're seeing that shift. And we're actually seeing now some transactions that were done with direct lenders now being refinanced in the conventional institutional market. Direct lending probably represents 1/4 of the market today, so it's meaningful. But for us, when we look at our growth opportunity, and we also assessed it against our risk appetite because we're not looking to stretch on risk or grow dramatically in the leveraged finance business. We think there's lots of opportunity there. Importantly, when you then look at the entire private credit ecosystem away from just direct lending, these are very large clients for us. They're very active in lending and financing they need themselves. They're very active in risk management, hedging strategies. It impacts obviously our sales and trading desk in terms of high-yield secondary trading. So net-net, we see a little bit of reduction in the leverage finance fee pool as direct lenders have become a bigger part of that market, but I think more than offset by the overall growth of the asset and the client base and the other places we support them across our business.

I want to talk about another hot button issue here at commercial real estate. I know it's kind of spread all over the bank. But what's the exposure in the capital markets business. And I haven't really seen any charts, I guess, that illustrate how many of the maturities have already are in the rearview mirror. Like what's the refinancing outlook for what's in your business?

Sure. It's obviously, as we've gone through both an economic correction and a significant shift in the interest rate environment, which has impacted real estate valuations, it's obviously been a place where for capital markets, we've taken a few provisions over the last year, and it's an area we're watching. But I wouldn't say it's an area we're particularly concerned about. And so to your question, Gabe, if you step back, we disclosed in Q1, we had about $28 billion of commercial real estate exposure across the bank. That was about 3% of loans and allowances for the bank, so quite manageable overall for the bank. Capital markets represents a little over 40% of that, so $11 billion to $12 billion spread across different markets, different transactions, different asset classes within real estate. Obviously, the area that's been impacted the most has been the office market. varies a lot by geography and city and the nature of the building. Our office exposure is a relatively small part of that $11 billion. It's something we've continued to monitor. We've had a few provisions we've had to take there, but I don't think we're seeing anything overly concerning. Importantly, we are well provisioned already. I think you've seen our overall ACL increase 3 to 4x depending on the market from sort of precorrection levels. So while we've had provisions, we think that we're well provisioned on what we see today. Obviously, we'll see the path the economy and rates take, but it feels like the worst is behind us. And with rates coming down and hopefully some rate cuts a little further out, we start to see valuations improve, and we continue to move ahead. Overall, when we step back, it's a little bit like what we went through with leveraged lending a few years ago, through a cycle, you're going to run it to losses. We always want to make sure those are commensurate with our risk appetite, commensurate with what we would have expected in a downturn, which, to date, our CRE losses are. And we look at our overall real estate business in capital markets, very profitable business, very high return business. You're always going to go through some tougher points in the cycle, but over the cycle, it's a business we feel very comfortable with and like.

Another business I wanted to talk about and maybe wrap up on that one is energy banking. Historically, a very important one and still is today. A couple questions about it. Is the traditional client base still a growth driver for the bank. The transition economy, that was the buzzword that was thrown around a lot in the past few years. Is it meeting your expectations as far as delivering revenues to the bank? And then how often is it playing to your decision-making that some investors, and I'm not signaling Royal out in this sense, but since you're here, I'll ask you, they won't invest in a Canadian bank because they have some green mandates, particularly European investors. How does that play into your decision making that challenge?

Sure. So if you step back and you look at climate broadly our energy transition as we look to get to net 0, I mean it's obviously one of the most critical issues we face today as a society. And all you have to look at is the weather changes and otherwise to see the risks are very real and very pervasive. So it's something that we're very focused on and our clients are very focused on. And we have what we think is a very well-thought-out strategy around climate broadly, ESG and transition. And the starting point of that of our 4 pillars is really how do we work with clients on their transition. And so to your question, Gabe, when you look at our clients -- and you look frankly at just what's required through the transition, which, in my view, is going to touch every sector, -- we need to work with all clients, and that includes green clients, clients focused on renewables and 0 carbon sources of energy. But equally, one of the biggest impacts we can have is working with clients in higher-emitting sectors and help them with their transition plans on how do they decarbonize. So we're trying to do both. And hopefully, you would have seen in some of our recent climate disclosures, we came out with a lot more detail on our strategy, which is anchored on both. A lot of commitments to growing our renewable financing. We're $5 billion today. We want to take that to $15 billion. How do we grow low emitting sources of energy, I would like to get our lending up to $35 billion in that sector. But then how do we continue to work at decarbonization initiatives. And we've developed a taxonomy, if you will, on what we define as decarbonization. So this gave me things like carbon capture and sequestration and how do we work with our clients and high emitting sectors to advance their strategies on that. Overall, we think it creates an enormous opportunity, but also an area where we have a responsibility and opportunity as a leading Canadian company to do our part by working with our clients. The capital is enormous. I mean for Canada alone, we've estimated $2 trillion of capital investment to achieve net 0 by 2050. That creates enormous business opportunities, how do we advise clients, how do we help them finance the transition and how do we work with them to execute on that kind of capital investment opportunity. So I think the opportunity is very large. We certainly don't think it's abated. We think it probably just grows from here, and we feel we're well positioned to capitalize on it. In terms of your question on different stakeholders, appropriately, we get lots of questions from clients, from employees, from regulators, from our shareholders. We feel we have a very principled approach to the importance of climate and how energy transition needs to be done in a very thoughtful and orderly manner. We're taking steps to support our clients as we've talked about. Equally, we're bringing a lot more transparency to what we're doing. So we've added some new disclosures this year around our authorized lending to oil and gas and higher emitting sectors. We're going to track that and disclose it over time so that all of our stakeholders can see the progress we're making. It's going to be a multiyear journey for sure. But it's one we're very committed to, and we feel we have a thoughtful strategy to address. And for, I would say, the vast majority of our stakeholders, the feedback we get is they see it as a very thoughtful strategy and are encouraging us to move faster if we can. But importantly, just keep demonstrating year-over-year progress on, I think, what's going to be a very important journey.

Well, and that's a nice way to wrap things up. Derek, enjoy the rest of your day. Thank you for coming to Montreal.

Appreciate it.