Bank of Nova Scotia (BNS) 2016 Q2 法說會逐字稿

Good morning, everyone, and welcome to Scotiabank's 2016 second-quarter results presentation. My name is Jake Lawrence, and I'm the Senior Vice President of Investor Relations for the Bank. Presenting to you this morning is Brian Porter, Scotiabank's President and Chief Executive Officer; Sean McGuckin, our Chief Financial Officer; and Stephen Hart, the Bank's Chief Risk Officer. Following our comments this morning, we'll be glad to take your questions.

Also in the room with us to join for the Q&A session are Scotiabank's Business Line Group Head, James O'Sullivan from Canadian Banking; Nacho Deschamps from International Banking; and Dieter Jentsch, from Global Banking and Markets. Before we start the call, and on behalf of those speaking today, I'd like to refer you to slide 2 of our presentation, which contains Scotiabank caution regarding forward-looking statements.

And with that, I'll now turn the call over to Brian Porter.

Thank you, Jake, and good morning, everyone.

I'll start on slide 4. We are pleased to report our second-quarter results to our shareholders. For Q2, the Bank delivered another good quarter of operating and financial results. As we announced on May 2, this quarter's results include a restructuring charge. And while the decision to take the charge was not an easy one, it was done in a thoughtful manner. The charge and associated investments will support our strategic objectives, and allow the Bank to provide a better experience for our customers and employees, as well as better results for you, our shareholders. Sean McGuckin, our CFO will provide further details on the charge, and expected benefits in a moment.

Adjusting for the impact of the restructuring charge, the Bank earned CAD1.9 billion in the second quarter, delivering diluted earnings per share of CAD1.46, 3% ahead of the same period a year ago. Earnings growth this quarter was again driven by good performances in our personal and commercial banking businesses, both in Canada and internationally.

Strong results in our retail businesses allowed the Bank to grow earnings despite elevated provisions for credit losses, largely related to energy which contributed to lower results in global banking and markets, and a reduced performance in international banking. As a result of the continued strong performances in Canadian and international banking, these businesses generated more than 80% of our Q2 earnings.

Our adjusted return on equity in Q2 was 14.4%. Looking at our capital position, the Bank remains well-capitalized with a Common Equity Tier 1 ratio of 10.1%. We are well-positioned to continue to invest in and grow the Bank organically, and we have the balance sheet strength to selectively pursue acquisitions.

As an example, this quarter, we closed acquisitions in Panama and Costa Rica which strengthened our existing operations in these markets. As I said, I'm pleased with this quarter's earnings, particularly the performance of our retail businesses, which are executing on our strategies and driving bottom line growth.

Before updating you on the Bank's strategic priorities, I would like to take a moment to speak to the tragic events in Fort McMurray. First and foremost, our thoughts go out to all those impacted by the fires. Secondly, the Bank continues to support our customers in the region, and that would not be possible without the dedication and hard work of many Scotiabankers. And finally, as a Bank, we remain committed to being a part of a stronger Fort McMurray as the area rebuilds.

I'd now like to update you on some important steps we're taking to build an even better bank, which are benefiting our customers, shareholders and employees. Last quarter, I discussed aspects of our digital transformation, and our evolving business mix. This quarter, I'll focus on our efforts to better serve our customers while reducing structural costs.

The restructuring charge we took this quarter reflects a widespread series of initiatives across the Bank to improve our efficiency and become low cost by design. Many of these initiatives are anchored in our digital transformation. At the same time, these initiatives are accelerating our ability to adapt to our customers' shifting behaviors and preferences, and to deliver a better customer experience.

Let me elaborate on a few examples. The utility of our branches continues to evolve. As such, we are digitizing more services and transactions that are delivered through these channels. With more than 80% of transactions being done outside of branches, we are positioning our branches to be even more advice-driven.

Moving to digital sales, our recent efforts to enhance our digital capabilities have resulted in significant improvements in our sales through digital channels. In the past year, digital sales growth in Canada has been very strong. Our progress here is well-recognized. As an example, Retail Banker International has recognized the Bank for having the best digital strategy among global banks.

Now let me comment on a few of our key efficiency initiatives. The increasing importance of technology for our business is obvious, and it is a significant expense category. One area we are becoming more efficient in is our technology spend, particularly by enhancing our operating model to deliver technology services internally.

Another area where we are capturing productivity gains relates to procurement and strategic sourcing. There are several areas here, where we could better leverage our scale and our footprint to achieve meaningful savings. The investments we are making in efficiencies also support our efforts to improve our customer focus, and accelerate our digital transformation. In total, we expect the Bank's productivity ratio to improve meaningfully in the coming years, a win-win for our customers, shareholders and employees.

We appreciate that there is much interest in the Bank's digital transformation, and how it will impact our business and financial performance. We intend to hold an Investor Day later this year to discuss both in more detail, and we'll provide more information on this event later this quarter.

I will now pass the call to Sean to review this quarter's performance.

Thanks, Brian, and good morning, everyone. I will begin on slide 7, which shows our key financial performance metrics for the current quarter and comparative periods.

As Brian mentioned, Q2 diluted earnings per share adjusted for the restructuring charge was CAD1.46, up 3% year-over-year. The quarter had very strong personal and commercial banking results. The elevated provisions for credit losses this quarter related to a small number of accounts primarily in the energy sector, and were largely offset by a gain on sale, and lower employee benefit costs.

Revenue growth was strong, up 10% from Q2 last year with solid asset growth in Canadian banking, international banking, as well as US corporate lending. Revenues are positively impacted by acquisitions, as well as higher banking revenues, net gains on investment securities, and the aforementioned gain on sale of a non-core lease financing business. Partially offsetting was lower wealth management, underwriting and advisory, and trading revenues.

Our core banking margin was 2.38%, down 3 basis points year over year. Higher margins in Canadian banking and international banking were more than offset by the mix impact of higher volumes of lower yielding investment securities and lower interest GAAP profits. Core expenses were up 2% year over year, after adjusting for the impact of the restructuring charge and acquisitions. Overall, a very good expense management performance in Q2. The 2% increase was primarily due to higher technology and professional fees, reflecting the continued investments related to the digitization of the Bank, as well as efficiency initiatives.

Adjusting for the restructuring charge, the productivity ratio was 51.7%, reflecting an improvement of 310 basis points quarter over quarter, and 160 basis points year over year. It is important to note that there were no benefits recorded in the second quarter related to the Q2 restructuring charge. These benefits start to accrue in Q3 and beyond. I will provide more detail in a moment.

Moving to capital on slide 8. As mentioned, the Bank continues to have a strong capital position with a Common Equity Tier 1 ratio of 10.1% unchanged from last quarter. During the quarter, the bank generated net internal capital of CAD0.6 billion. Common Equity Tier 1 risk-weighted assets decreased CAD17 billion to CAD357 billion from CAD374 billion last quarter. The decrease was entirely driven by the impact of a stronger Canadian dollar on foreign currency denominated risk-weighted assets. The Bank's leverage ratio was 4.1%, up 10 basis points quarter over quarter.

Moving on to the next slide, we want to provide some additional detail on the restructuring charge in this quarter's results. The senior management team is committed to the Bank's strategic priorities, which include: ongoing efforts to enhance the customer experience, driving a digital transformation, and improving our productivity ratio through operational efficiencies and structural cost savings. The restructuring charge amounted to CAD278 million after-tax or CAD0.23 per share, and is included in the other segment's results this quarter.

The restructuring charge arises from a structural cost reduction program, and relates primarily to optimizing the branch network in Canadian banking, simplifying and optimizing the Bank's organizational structure, and lastly, reducing costs to deliver our internal corporate services including technology services.

These strategic efforts will help the Bank sustain its strength in the marketplace, and better position the Bank for long-term growth. And as Brian noted, this supports our ability to adapt to an evolving banking environment including changing customer preferences, behaviors and needs.

The charge will be more than self-funded by the expected benefits, will also support further investment in the digitization of the Bank. Combined, these investments will deliver savings and yield efficiency improvements for the Bank. In terms of savings, we expect the program to reduce annual run rate expenses by approximately CAD350 million in 2017, growing to CAD550 million by 2018, and growing to over CAD750 million for 2019 from today's expense levels. For the second half of 2016, the net savings is estimated to be CAD40 million.

The expected savings I just mentioned are a multiple of this quarter's charge, as the cost reduction program has both a near-term saving component, and a second component that plays out over the next 18 to 24 months. This latter component would include some of the distribution changes including to our branch network, those elements that leverage new technology investments, and the streamlining of the delivery of internal corporate services. The investments to deliver on these components is being self-funded with the near-term savings, thereby driving the higher CAD750 million run rate savings in 2019, compared to current expense levels.

The estimated savings of CAD750 million by 2019 reflects roughly 5% of the Bank's current expense base. The majority, approximately 70% of the expected savings will benefit Canadian banking, and the balance primarily in global banking and markets. We expect the actions related to this structural cost reduction program to contribute to a 200 to 255 basis points improvement in the Bank's productivity ratio for 2019.

Turning now to the business line results, beginning on slide 10. Canadian banking produced a strong quarter, with net income of CAD977 million, up 18% year over year. Adjusting for the gain on sale of the lease financing business, net income was CAD877 million, up 6%.

Loan volumes increased 3% year over year, driven by prudently managed double-digit growth in credit cards and auto lending, partly offset by a slight decline in mortgages. Adjusting for the Tangerine mortgage run-off book, mortgages grew slightly, and total loan volumes rose 5% from Q2 last year.

Deposit balances increased 7% year over year, with retail checking and savings deposit balances up a strong 9% and 15%, respectively. Our targeted asset growth and strong deposit growth reflect the execution of our strategy to improve business mix.

The net interest margin rose 12 basis points from Q2 last year, primarily due to margin expansion and deposits, acquisition impact, as well as the run-off of low spread Tangerine mortgages. Wealth management contributed positive earnings growth of 2% year over year, as expense reductions more than offset lower revenues from a moderation in asset volumes. AUM levels were up 2% year over year, while AUA levels were down slightly versus the same period last year, reflecting weaker market conditions.

Provision for credit losses were up CAD35 million year over year, due mainly to higher provisions in the retail portfolio driven by growth in higher spread products. The PCL ratio was up 4 basis points. Notwithstanding, the risk-adjusted margin was up 8 basis points.

Expenses increased 4% year over year, or 2% adjusting for acquisition impacts. The increase was driven by higher technology and project spending and salary increases, partially offset by benefits realized from ongoing cost reduction initiatives. Adjusting for the gain on sale, Canadian banking delivered positive operating leverage of 0.7% year to date.

Turning to the next slide on international banking, net income increased 12% to CAD500 million from the same quarter last year. This is the business line's third consecutive quarter of earnings at or above CAD500 million. These results reflected continued strong operating performance, with strong loan, deposit and fee income growth in the Pacific Alliance region, as well as positive operating leverage. Partly offsetting the very strong operating performance was an elevated level of commercial provisions for credit loss.

International banking continued to deliver strong loan growth, up 13% year over year, or 15% adjusting for the impact of foreign currency translation. Latin America continued its strong loan growth, up 19% on a constant currency basis from Q2 last year.

The strong asset growth was also supported by excellent deposit growth, up 19% versus the same quarter last year on a reported basis, and up 20% when adjusting for the impact of foreign currency translation. The net interest margin increased to 4.69%, up 2 basis points versus the same period last year, primarily due to acquisitions. Looking forward, modest benefit of recent rate increases in some of the countries we operate in will begin to have a positive impact as assets reprice.

Loan losses increased CAD114 million year over year, and the loan loss ratio increased by 31 basis points to 150 basis points. The higher loan losses were driven almost entirely by one energy-related account in Colombia, and to a lesser extent, a small number of accounts in Puerto Rico. Expense growth was up 11% year over year, or up 6% when adjusting for the impact of acquisitions and foreign currency translation. The strong cost management in part reflects benefits from ongoing initiatives to reduce structural costs. On a reported basis, operating leverage was positive 3.1% year to date.

Moving to slide 12, global banking and markets, net income of CAD323 million was down 28% from last year. The lower performance was driven largely by higher provisions for credit losses, as well as lower contributions from equities. Trading revenues on a TEB basis decreased from last year primarily in equities. Total corporate loan volumes were up 18% versus Q2 of last year, or up 13% after adjusting for the impact of foreign currency translation. The growth was across our portfolios in Canada, the US, and Europe.

Volumes were lower in Asia, as a result of our previously disclosed initiatives to reduce certain Asian trade finance businesses, which we have completed during Q2 of this year. Provisions for credit losses increased CAD105 million from last year, due mostly to higher provisions on a small number of energy-related accounts. Provision for credit losses increased to 57 basis points, from a low level of 8 basis points a year ago. Stephen Hart will have more to say on our energy exposures in the risk discussion.

Expenses were up 6% year over year, reflecting in part the negative impact of foreign currency translation. Adjusting for this, expenses were up 3% from higher salaries, technology and regulatory costs, partly offset by lower performance based compensation.

I'll turn now to the other segment on slide 13, which incorporates the results of Group Treasury, smaller operating units, and certain corporate adjustments. The results include the net impact of asset and liability management activities. The other segment reported a net loss of CAD277 million this quarter. Adjusting for the restructuring charge, net income was CAD1 million.

Earnings in this segment were down from CAD32 million in Q2 last year, and reflect lower contributions from asset liability management activities and higher expenses, partly offset by the positive impact of foreign currency translation and higher net gains on investment securities. Lower expenses from post-retirement benefit costs were largely offset by an increase in the collective allowance on performing loans.

This completes my review of our financial results. I'll now turn it over to Stephen who will discuss risk management.

Thanks, Sean. Good morning, everyone.

We remain comfortable with the underlying fundamentals of the Bank's risk portfolios, and we expect that this quarter's higher loan loss ratio to be the peak level for the year. The all bank loss ratio came in at 64 basis points, or 59 basis points after adjusting for the increase in the collective allowance for performing loans. This loss ratio was up 14 basis points quarter over quarter, and up 18 basis points year over year.

Before discussing the current credit metrics, I'd like to give you an update on our retail, corporate and commercial credit portfolios. In Canada, our retail delinquency rates and overall retail credit quality remains stable, albeit we are seeing some continued regional weakness in the prairies. This is being offset by strength in other markets, including Ontario and BC.

As noted by Brian, we've been closely following the tragic events in Fort McMurray, and are working with our customers to assist them. To date, our review of our credit exposures and related mitigants including insurance, would indicate that any related loan losses will not be material.

Turning to international, retail credit performance leading indicators also remain stable in the quarter. We operate a diverse number of portfolios, across different geographies, and some books are performing better than others. We have seen particularly strong credit performance in Mexico and the Caribbean. Overall delinquency rates remain generally stable across the international retail.

Looking at our corporate and commercial loan books, we did see increased provisions related to our energy exposures, and to a lesser extent Puerto Rico. I will have more to say on the energy portfolio in a minute.

Looking at the credit metrics, our gross impaired loans were relatively stable, up 1% quarter over quarter. Similarly, our net impaired loans as a percentage of our portfolio also increased 1% compared to a year ago. Net formations increased to CAD982 million, up from the CAD806 million in the prior quarter. The increase was driven by corporate and commercial lending exposures in the energy sector. Looking at market risk which remains low, our average one-day all-bank VaR was CAD13.9 million, down CAD1.3 million from the prior quarter.

Slide 16 shows the trend in loss rates over the past five quarters for each of our businesses. For context, nearly 80% of our total PCLs relate to our retail business. As I mentioned, we expect the Bank's loss rate of 64 basis points in Q2 to be the peak level of loan losses for the year. The quarter also included a CAD50 million increase in the collective allowance for performing loans.

Adjusting for that collective, the Bank's loss rate is 59 basis points, up 18 basis points from the same quarter last year. The increase in loss rate from the prior periods was almost entirely driven by higher losses in corporate and commercial lending exposures, primarily related to energy and international banking, and the global banking and markets division. And this drove the high PCL ratios in each of these businesses.

In international, our retail risk was stable quarter over quarter, and showed a nice improvement from last year. Canadian banking's PCL ratio was 28 basis points. This was up from prior periods, as the Bank's asset mix into higher yielding products continues to evolve. Overall, we believe our credit portfolios remain in good condition. And as we had been proactive in managing our energy exposures and taking provisions, we expect PCLs to move lower in Q3.

Turning to slide 17. We provide a more detailed update on our energy exposures which continues to be actively managed, and candidly, is playing out as we expected and indicated almost 18 months ago. Our total committed exposures declined CAD4.3 billion from Q1, with drawn corporate energy balances declining CAD1.6 billion to CAD16.3 billion. More importantly, the bulk of this decrease occurred in the E&P and oil fields services sub sectors.

Approximately 50% of our drawn portfolio is investment grade, and that increases to almost 75% for the undrawn commitments. Compared to last quarter, the level of drawn investment grade percentage decreased, as a result of credit migration as well as repayments.

As we expected, we have had some downgrades this quarter, but the watch list component of our energy portfolio remains within our risk appetite. As a reminder, most accounts in the watch list do not necessarily result in the actual losses, but rather garner closer attention as we work with the borrower. The additions to the watch list were driven almost entirely by E&P and oil field services exposures, which remain our key areas of focus.

Looking at the E&P and oil field services in more detail, the accumulated loan losses since Q1 2015 have amounted to CAD277 million. It is worth noting that there have been no net losses associated with our midstream and downstream portfolios. And as discussed last quarter, for the E&P and oil field services accounts that we are focusing much of our attention on, approximately two-thirds of issued debt that ranks below our senior position in the capital structure.

On average, this debt is a multiple of the Bank's financing, and illustrates how risk is distributed away from the senior lenders. In fact, we've had nine accounts undergo bankruptcies or pre-pack restructurings since last quarter. For these accounts, given the Bank's senior position in the capital structure, our provisions were minimal, only single digit-percentage levels, and we would not expect any further provisions from these accounts.

For many of our E&P accounts, we are in the midst, in the process of completing the spring borrowing base redeterminations, which should conclude by mid to late June. With more than 70% of these reviews completed, almost 25% of our upstream accounts have either maintained or increased their credit facility based on increased (inaudible) production. For the remaining 75%, the reduction in credit is averaging approximately 20%. In these instances, clients are continuing to make the necessary and prudent moves, including further reducing expenses and selling assets in order to reduce debt and maintain liquidity.

There continues to be market interest in loan covenant relief, which we believe serves as an indicator of potential credit stress, and facilitates a healthy discussion between the bank and the borrower. In these instances, the Bank works to be constructive with the borrower to improve the situation, but we do not compromise our economic interest. In fact, our lending position with these accounts improved, primarily through loan reductions and/or increased security.

Now turning to the energy-related provisions this quarter, the Bank saw PCLs increase to CAD150 million from CAD79 million last quarter. The new PCLs were in the focus areas that we have discussed, with much of the increase related to a single account in Colombia that quite frankly did not adhere to the quality underwriting standards of good assets, good management, and strong structure that we see in the rest of our portfolio.

Looking forward, assuming the market environment continues to operate around current levels, we believe energy-related PCLs have peaked this quarter. We are encouraged that oil prices are up, which is generating renewed interest in both asset purchases, as well as providing borrowers access to markets for capital.

As such, and this is a very important point, we see cumulative loan losses for the 2015 to 2017 period for the energy portfolio to be between 3% to 3.5%. This is based not just on a portfolio stress test, but also a bottom up, name by name review of each of the Company's asset valuations, liquidity profile, and our debt structure. We remain encouraged by the resilience of our energy portfolio of senior ranking in the capital structure, and we will continue to proactively manage these exposures.

And with that, I'll now turn the call back to Brian.

Thank you, Stephen. Before we open the call for questions, I'd like to comment briefly on each business line's performance over the quarter, and make some brief remarks on our outlook.

As we noted earlier, Canadian banking had another quarter of strong results. James and his entire team are executing on their strategy to improve the customer experience, enhance our business mix and drive efficiency gains.

Their efforts are delivering solid growth in the businesses and products we are targeting. I would like to call out the continued strong growth in deposits, particularly in personal deposits which reflect our increased efforts to focus on both sides of the balance sheet. Our deposit growth, paired with our focus on targeted growth and assets that provide attractive yields will continue to enhance our risk-adjusted margin.

This quarter, we saw solid expense management, with underlying expenses only up slightly from Q2 last year. A continued focus on efficiency, combined with our good revenue growth will support greater operating leverage. As we move into the second half of 2016, despite slower growth in some markets, we expect continued good growth in Canadian banking through the balance of the year.

Turning to international banking. As Sean noted, the division delivered another strong performance. This quarter also marks the third consecutive quarter with at least CAD500 million of earnings, which is consistent with the expectations we have shared with you over the past year.

Similar to recent quarters, the strong results were again driven by the Pacific Alliance region. We saw particularly strong growth in Mexico and Peru. The strong operating results this quarter, allowed us to earn through the higher energy-related loan loss in Colombia that Stephen mentioned. We expect the strong business momentum in international to continue, as provisions move back towards Q1 levels.

Improving results in the Caribbean and Central America continued to contribute to growth in international, and reflect the economic environment, which is as strong as it has been in many years across the region. Our outlook is for continued strong performance from the Pacific Alliance region, which will continue to be a growth engine for international banking.

Finally, in global banking and markets, as we have discussed results this quarter were negatively impacted by elevated loan losses related to energy. We would characterize the recent level of quarterly earnings to reflect the bottom end of expected earnings power from this business.

As we move into the second half of the year and Dieter's first full quarter, we are encouraged by the pipeline in this business and expect better trading conditions. As a result, we expect the business to deliver an improvement in earnings.

In closing, we are encouraged by the results from our P&C businesses here in Canada, and internationally this quarter. Together, they represent more than 80% of our divisional earnings. As Stephen noted, we expect loan losses from the energy sector to peak this quarter. And for the current cycle, cumulative losses will be between 3% to 3.5%, lower than many expect, which reflects the quality of our portfolio and underwriting. We are confident that we are on track to deliver improving financial and operating results for our shareholders over the balance of this year.

I will now turn the call back to Sean for Q&A.

All right. Thanks, Brian. That concludes our prepared remarks.

We will now be pleased to take your questions. Please limit yourself to one question, and then rejoin the queue to allow everyone the opportunity to participate in the call. Operator, can we have the first question on the phone, please?

Your first question will come from the line of Meny Grauman of Cormark Securities. Mr. Grauman, your line is open.

Hi, can you hear me now? Hello?

Yes.

Good morning -- sorry about that. Stephen, you mentioned cumulative losses of 3% to 3.5%. I'm just wondering -- just talk about how that would hold if conditions stayed stable? If you could just comment on the sensitivity to different assumptions is -- are oil prices a big part of that outlook? And how would that change if oil prices went back down, and if you could comment on maybe some other key assumptions that are driving that outlook on the cumulative loan losses?

Sure, Meny. I mean, when we did this analysis, as I said, we did it company by company, reserve base by reserve base. And quite frankly, we used the oil and gas prices that's in our deck that dates back to February. So these are numbers that do not reflect the current uptick.

So any uptick that we get that's sustainable will be an improvement to those numbers. So we were still going off the [$30 to $35] range for oil, and so you can go with that.

Okay. And then, if I could just ask a question just on the restructuring, you talk about three different areas of cost savings, including the branch network. And I'm wondering how would the cost savings basically get divided across those three areas? Is most of the cost savings over the expected term related to savings from the branch network?

I'll take that one, Meny. No, it would be -- as I mentioned, there's the Canadian banking, there's the internal corporate services we're looking at, and also just simplifying and streamlining our operations. When you look at the final allocation benefit, because we do allocate the corporate function cost to the business lines, as I mentioned earlier, Canadian banking will generally get about 70% of the net savings benefit, GBM about 20%, and IB kind of the small balance after that.

When you talk about the branch network, the optimization, do you have any numbers around that, in terms of number of branches or square footage? Can you give us any sense of how dramatic those changes will be, and over what time?

I'll ask James to give some color on that.

Sure. So, Meny, we have just over 1,000 branches as we speak. That would be down from a peak of about 1,040. So we've been opening branches, and we've been consolidating branches, and we are opening branches every quarter as we speak.

I would say it's difficult to forecast on a go-forward basis, as we're right on the cusp now of piloting our new branches of the future. So we're going to have an express format called Scotiabank Express; we're going to have an advice format called Scotiabank Solutions; and we'll continue to have a lot of full service branches as well. My point is that learnings from these pilots are going to shape future openings and future consolidations.

But to your specific question, based on our current knowledge, we might expect a further reduction of 4% to 5% over the next two years. But I do want to be clear, Meny, branch transformation for us -- it's about much more than just openings and consolidations. It's about new branch format, it's about more technology, and it's about new and better roles for our employees that involve less paper.

Thanks for that.

Next question, please?

Your next question will come from Gabriel Dechaine of Canaccord Genuity.

Good morning -- just want to talk about the international business -- actually the credit trend there. First of all, it looks like you had a CAD50 million credit mark release. Where would that show up? Would that be in the commercial portfolio?

Yes, I'll take that one. That comes from some of the recent acquisitions -- the acquisitions of Citibank in Peru, Costa Rica, Panama, and a bit to Cencosud from last year. But even though the credit mark is being released, we're also adding provisions to build up reserves in those as well.

So the net acquisition benefit to the bottom line is the best way to look at that. And that's about CAD20 million or so for international banking, and about CAD15 million or so for Canadian banking.

Oh, so, it wasn't all in international. Sorry, that's how I read it.

Right, not all of that falls --

But would that have been in -- the element that was in international, was that international commercial? What I'm getting at here is that it looks like -- and maybe we can just go at it this way -- the losses in international commercial were very high. You talked about one account in Colombia, and some others in Puerto Rico. I'm just wondering what went on there?

Most of the acquisitions were all on the retail side. And so, the credit mark, to the majority, is on the retail side and not the commercial.

Okay. So, what was going on in the commercial side, as far as -- the type of loss incurred, which is much, much higher than the run rate we've seen there? Is it really a one-off here -- is some special situation that went awry I guess?

Yes, as indicated, Gabriel, there was one loan that we've had that has been non-accrual for the last few quarters, and quite frankly, was a sizeable portion of the CAD150 million that I quoted. So, well over 40% of that CAD150 million related to that one particular loan in Colombia, which, quite frankly, as I indicated, did not reflect our normal standards. And we decided to just take it down to the bare minimum.

So, that truly, in our mind, is a one-off with international. The rest of the portfolio performed well. As indicated, we did pick up -- do some additional increases in Puerto Rico, given the ongoing situation that's going there. But on average, the rest of the portfolio is performing very well.

And it begs the question -- how can I gain comfort that this is truly a unique situation -- this one particularly didn't meet your normal criteria? Whenever we see things like this, you wonder -- was there anything more that didn't meet the normal lending criteria of the Bank?

Gabrielle, it's Dieter. We talked about only one formation at our Investor Day in Mexico, and it was isolated to one problem account, and that one came to fruition.

This is the one, okay.

We were quite clear about our investor, and this is the one.

Okay. I missed that one probably. Okay.

And then, just a quick one on the margin in Canada -- it looks like it was up, but mostly due to Chase I guess. So, excluding Chase, which was around 6 basis points of down 3, is this mostly prime [BA] spread narrowing that's causing the margin to reverse a little bit?

No, we see continued margin pick-up. We're seeing a lot of the value come through the deposits, as we have the stronger deposit growth in checking and savings. That's adding a positive mix to our margin. So, we would, again, continue to see margins generally being flat to slightly up, as we continue to evolve our business mix in Canadian banking.

Okay. All right. Thanks.

Next question, please?

The next question comes from John Aiken of Barclays.

Good morning. With the sale of the Roynat leases that occurred at the end of the quarter, can you give us some sense as to what the anticipated dilution to net interest margins will be, and what potential offset could come through on the PCL ratio for Canadian consumer?

I'm sorry, you want the net interest margin impact on the Roynat sale?

Yes.

Yes, that would -- it's a very small portfolio. I think total assets were CAD1 billion out of our total CAD300 billion in Canadian banking. So it should not have a meaningful impact on our margin.

Sorry, what was your second question --?

Then an offset on -- anticipated on the PCL ratio?

Yes, we had very little losses in that business. So it shouldn't have much impact at all on our PCL ratio.

Okay. Thanks, Sean.

Next question, please?

Next question comes from Robert Sedran of CIBC.

Hi, Sean. I just wanted to come back to the restructuring initiatives, if I can. There's a pretty big ramp into 2019. And so, is this just the delay in branch closings? Is it the size of the initiatives you have under way, that it's just going to take some time? Or are there investments that need to be made in the meantime?

Yes, so, the benefits of CAD750 million are a multiple of the charge you saw in this quarter. And as I'd mentioned, we have some immediate near-term savings, mostly from simplifying the Organization, some near-term benefits on some sourcing procurement initiatives. But some of the other ones -- the branch network transformation -- that plays out over 18 months to 24 months.

As we look to improve the cost to deliver our internal services via finance, HR, risk, some other functions, that takes a bit of time to lean out some of those operations and get some consolidation synergies on that. So, the investments for those ones that take a bit longer are being paid for by the near-term savings.

So, when I mention CAD350 million savings in 2017, and then in 2018 a further CAD200 million to get the cumulative rate to CAD550 million, and then a further CAD250 million is because the second part, these 18 to 24 month pieces, the investments are being paid for by the near-term savings. But once you get through the full cycle, that CAD750 million is our run rate benefit from current levels. And as we mentioned, we'll improve productivity by 200 to 250 basis points from these initiatives by then.

Okay. And just to follow up, I mean, there's -- I guess, there's a perception externally that there has been an awful lot of transformation at Scotiabank over the last few years. And, Brian, I'm curious how you'd characterize the amount of transformation that's been happening? And how much execution risk you put around the latest round, considering, again, externally at least, it feels like there's been a fair bit going on?

Yes, that's a fair question, Rob. Let me go back, is that, if you look back four or five years ago, the Bank was extremely acquisitive. And I think from the start of the crisis through to the 2012, 2013, the Bank did some 25 different acquisitions, most of them internationally. So, we had to go through a period of digestion and integration.

And as I've always said, buying is the easy part; integrating these businesses is the tougher part. So, the charge we took in Q4 of 2014 largely related to the international business branch optimization -- some -- a few factors in the Canadian business.

We have been working on this structural cost initiative for the past 1.5 years. It largely relates to the Canadian operations of the Bank. And it's really focused around the customer, the customer experience, and digitizing the Bank.

In terms of pace of change and the degree of change, I spend a lot of time with the management team here, and we spend a lot of time with the Board, thinking through what we're doing, the pace of change, how much can the Organization absorb at any one time. And we're very comfortable with the pace of change.

And I'm also cognizant of the fact -- people want to tell me what I want to hear from time to time. But as I criss-cross the country and talk to people, our customers and our employees, about what we're doing, overwhelmingly they say this is great. We're glad you're doing it; it's about time. So, I think summing it up, we've been very thoughtful and deliberate about the pace of change and the degree of change here, and we're very pleased as to where we are.

Thank you.

Next question, please?

Next question comes from Peter Routledge of National Bank Financial.

Hi -- a question for Brian, just on the restructuring. On page 9, which is very useful, and I appreciate your quantifying the goals -- I always thought Scotia was really strong on expense management. And the size of this restructuring, and then the goals you intend to achieve are a lot more than I would have thought. And I'm trying to figure out why that might be the case?

And the three reasons I came up with were -- either the Bank wasn't as disciplined on expenses as I had thought. The Bank was under-invested in technology -- that would be another explanation. Or there's something more profound happening in your Business, and your platform is changing more significantly than I expected?

So I wondered if you could talk about what the explanation for the scale of this change? How do you explain the scale of the change to this Business?

Well, I think that most of this, as I said in the last question, pertains to the Canadian operations of the Bank. And if you look at our efficiency ratio compared to our peer group, there's lots of room for us to deliver more efficiencies for our shareholders.

So, we did a deep dive and a diagnostic on the Canadian Bank with James and his team, and efficiency isn't -- it's an ongoing initiative around here. It doesn't -- you just don't do a program and then stop. So, this is a continual program. And part of this is -- I would describe as catch-up, and part of it would be getting to the top of the pack.

And the gains are inclusive of any new investments you make in technology -- the gains you're forecasting?

Yes, we have -- beyond this structural cost program, we've had some other ongoing cost initiatives within the business lines. We have had a higher regulatory spend in terms of our technology. So, when you think of some of those running off, and the other ongoing initiative opportunities we see in the business lines, a lot of that will pay for the ongoing digital transformation that you'll hear more of from the Bank. So, we're fairly confident that a large piece of these benefits will make it to the bottom line, from this most recent structural cost reduction program.

Peter, another way to look at it, to provide some color for you, is if we look at the Bank's ROE, and this is an industry trend, the compression of ROE over the last five years -- if you look at the components, the biggest components of compression on our ROE is, one, is increased capital or less leverage, which is obvious. The other one is just a lower margin environment.

So that one of the ways you're going to offset that is using technology to your advantage and digitizing the Bank. So, productivity gains are going to help offset margin compression and increased amount of capital that we hold as an Organization.

All right. Thanks very much.

Next question, please?

Our next question comes from Mario Mendonca of TD Securities.

Good morning. Sean, if we can go back to the restructuring, and I may ask for a level of precision that you can't offer here, but let me give it a shot anyway. When you talk about using the expense savings to fund all of the necessary investments, is that the same as saying that in 2016, 2017 and 2018 that there will be no net contribution from these restructuring initiatives to the Bank's expenses and earnings, and it all really falls through in 2019?

No, I'm not saying that at all. We're saying that we expect near-term benefits -- so, your question is, the CAD350 million savings we project for 2017, how much of that falls to the bottom line?

Right.

Is your general question?

That's right.

So, again, we continue to work out our digital strategy. And as Brian mentioned, we are going to have an investor session later in the year to lay out for you our digital strategy over the near term. That will require investments. But some of the money where we have been spending recently will not be at the same pace, and that's generally around regulatory investments we've been making to meet some recent regulatory requirements.

And there has also been some other near-term efficiency initiatives within the business lines that are also freeing up capacity to invest. So, again, I'm fairly confident we are going to have a large -- very large portion of that CAD350 million make it to the bottom line in 2017, and a bit more in 2018, and a bit more in 2019, until we get to that run rate savings.

A large portion of the CAD350 million and the CAD550 million then fall to the bottom line?

Yes.

Okay. So, then what we're dealing with then is inflation obviously, which I guess for Scotia runs higher than the sort of 2% or 3% because of your international business. So we should factor in some inflation, some investment spending. And then take off a large portion of this CAD350 million, and that will get us to -- I mean, I'm not asking you to prepare the model for me, but that's the general -- (laughter)

Sounds like we just built it. (laughter)

Yes.

But as you have seen in the past, technology spend is our highest expense category for growth, and we expect that to continue. And we expect it to maybe moderate from the 20%-plus rate we've been seeing the last couple of years; that will moderate. But overall, we expect these savings to offset the inflation and some of the higher technology spend going forward.

Okay. So, real quickly then, just on credit, Stephen, you talked about [300 to 350 basis points] in cumulative losses 2015 to 2017. Where are you right now on that?

Right now we're at CAD277 million -- (multiple speakers)

CAD277 million, [1.7%]. (multiple speakers)

[1.7%].

So, 170 basis points, so you're about halfway through then?

Yes.

Yes, we're in the bottom of the fifth.

Sounds good, thank you.

Next question, please?

The next question comes from Doug Young of Desjardins Capital Markets.

Hi, good morning. Just, I guess most of my questions have been asked and answered. But I did notice that you did do a bulk mortgage reinsurance deal. I think it was in the quarter; correct me if I'm wrong.

But I just wanted to get a little bit of a sense of why, and what regions that related to? So, just a little bit more detail around that? Thank you.

That was really mostly around giving us some flexibility for balance sheet management, provides us more liquid, liquidity, more liquid assets, some flexibility around funding. There's some rule changes that come July 1 about the purchase of insurance, and what period you've got to actually apply that if you want to securitize. So, overall, it was just around balance sheet optimization, small capital benefit, but again, it was really around balance sheet flexibility.

Can you quantify -- ?

And it was across the country.

Yes, it was across the country, and you will see in that our LTV, loan-to-value ratio, for the uninsured portfolio because of that, improved from about 55% down to 51%.

And what was the -- can you quantify the capital benefit? Was it 5 basis points, or much smaller? Just quantify it?

It was around that range, 5 basis points.

Okay. And then just secondly, on the international banking side, I noticed just acquisitions were a big part of the NIM expansion year over year. I guess, excluding acquisitions, it would have been 19 basis points lower. I'm going to guess predominantly that's Cencosud; is that correct?

Yes. On a year-over-year basis, Cencosud was a big driver of that. The more recent ones in Costa Rica and Panama also contributed to that as well. But looking from Q1 to Q2, the margin increase was quite meaningful, about two-thirds was from acquisitions, and one-third was from organic growth in our margin.

Okay, great. Thank you.

Next question, Please?

The next question comes from Darko Mihelic of RBC Capital Markets.

Hi, thank you. Good morning. I just want to make sure I understand the commentary around the problem loan in Colombia, and maybe you can perhaps help me with this? On page 18 of your supplemental, when we look at the commercial classifications in the quarter of CAD222 million, would that include that account that was in Colombia?

No, that was classified, I think, in Q1.

Yes.

Okay. So, then, what is it that's building the big classifications in Q2? There's CAD222 million of classifications. (multiple speakers)

Yes, we would have ongoing energy classifications; that's the bulk of the classifications.

In international?

International commercial -- there were two classifications in Puerto Rico, but the rest of it -- and that would probably pick up some of the delta.

Okay.

But the rest of it was just across the board.

And then going back to the account that was classified in Colombia, that was classified in Q1?

Yes.

Okay. What was it that required an extra quarter to realize you weren't going to collect very much money on that account?

Well, quite, as you know, restructurings and negotiations are an ongoing issue. This was a complicated transaction. In this case, there were not just banks, but there were also bondholders, new equity investors, as well as the existing management group.

So quite frankly, it was a moving target that we had hoped for a better result. And quite frankly, at the end of the day, that result didn't come, so we decided to take the hit, move on.

And just to wrap up then, one could take a view that there could be other similar such circumstances with other loans that are already classified as impaired that would require top-ups to your provisions in future quarters? What would you say to that kind of a thought process?

I would indicate that as I said earlier, we have done a name-by-name analysis. There were one or two other loans that we did top up this quarter, but that was the extent of it. We feel very comfortable where our existing provisions are.

Darko, it's Brian. I think that because this was a one-off, it requires a further explanation, which you're requesting. As this was -- when you go through a cycle like this, there's always one loan you wish you never did, and this would be the one. And I think that if lessons -- under the category of lessons learned on this one was the quality of reserves and the quality of the management's team ability to execute. And it's been a painful experience for us, but this is a one-off situation.

Okay. Thanks very much for the commentary.

Next question, please? This will be the last question.

Your next question comes from Sohrab Movahedi of BMO Capital Markets.

Okay, thank you. Brian, internal capital generation in the quarter, less than 20 basis points, lots of puts and takes. How should we think about Scotia's internal capital generation, given everything you've talked about -- we've seen peak loan losses probably, we see expense benefits coming through, some investments going through. How do you think about your internal capital generation over the next 4 to 6 quarters, let's say?

Yes, we're -- we haven't talked about this, but I alluded to it in my comments. We're proud of what we've done in terms of balance sheet optimization here. I think the Organization has done a very good job on deposit growth, personal deposit growth, both here in Canada and internationally. And we've done a lot of work in terms of risk-weighted assets, and looking at underperforming parts of our portfolio, and you saw the benefit of that this quarter.

We still have some more work to do on -- there's always work to do on cleaning up your risk-weighted assets. But we made very good headway, but there's still more work we can do in subsequent quarters.

So this has been a bit of a messy quarter. There's lots of moving parts in our quarter, but we're optimistic about capital generation in Q3 and Q4, and into 2017.

But above this quarter's levels?

Yes.

Yes, okay. Thank you.

All right. That concludes the call. Thank you all for participating, and we look forward to talking to you next quarter.