Royal Bank of Canada (RY) 2010 Q3 法說會逐字稿

Good morning, ladies and gentlemen. Welcome to the RBC 2010 third quarter results conference call. Please be advised that this call is being recorded.

I would now like to turn the meeting over to Ms. Josie Merenda, Head of Investor Relations. Please go ahead, Ms. Merenda.

Good morning, and thank you for joining us. Presenting to you this morning are Gord Nixon our CEO, Morten Friis, our Chief Risk Officer, and Janice Fukakusa, our Chief Administrative Officer and CFO. Following their comments we will open up the call for questions from analysts. The call will be one hour long, and end at 9 AM.

To give everyone a chance to participate, please keep to one question and then requeue. We will be posting management's remarks on our website shortly after the call. Joining us for your questions are George Lewis, Head of Wealth Management, Doug McGregor, Chairman and co-CEO of Capital Markets, Dave McKay, Head of Canadian Banking, Mark Standish, President and co-CEO of Capital Markets, Barb Stymiest, Head of Strategy, Treasury, and Corporate Services, and Jim Westlake, Head of International Banking and Insurance.

As noted on slide two, our comments may contain forward-looking statements, which involve applying assumptions, and have inherent risks and uncertainties. Actual results could differ materially from these statements.

I'll now turn the call over to Gord Nixon.

Thank you, Josie, and good morning, everybody. Today RBC has reported earnings of CAD1.3 billion, or CAD0.84 per share for the third quarter of 2010, and I'd like to comment on these results. Clearly, very strong performances across most of our businesses, particularly led by banking, wealth management, and insurance, but at the same time challenges, particularly with respect to our capital markets businesses, which I'll discuss in a moment.

On the retail side of the business, which we strategically target to represent approximately 75% of our business mix, results continued to be strong across the board, and underpin our earnings. Net income, however, was down CAD285 million or 18% from the record quarter last year, and that was due to a decline of CAD361 million in our capital markets business.

Business growth, improvement in credit quality, and our ongoing cost management efforts were more than offset by a decline in our trading revenues, which I'll address in a moment. Trading revenue was certainly affected by industry-wide declines in client activity, and lower trading margins, particularly throughout Europe. Trading revenue also declined as a result of mark-to-market accounting impacts, which Janice will cover in her remarks. This quarter we are maintaining our dividend at CAD0.50 per common share.

Now let me start by discussing our retail businesses, which as I said, performed very well throughout the quarter. Canadian Banking continued its momentum, generating earnings of CAD766 million, up 14% from last year. Our truly national presence characterized by our size, scale, and unparalleled distribution network, has allowed us to expand our leadership position, and continue to take share from the competition, while at the same time build efficiencies. We are making strategic investments, and currently have a number of major initiatives under way. We are focused on enhancing sales and service productivity, and improving processes through streamlining and automation.

We also continue to push our innovation to provide our customers with superior service, and advice to help them make smart decisions. For example, we recently launched a new online banking platform that includes My Finance Tracker, a customized financial and expense management tool for customers. Our efforts have not gone unnoticed. Forrester ranked our website as number one among Canadian bank public websites for the second consecutive year. We also introduced a new cash back rewards Visa card, adding to our solid portfolio of products. I'm pleased to see the progress we are making, and the results we are delivering in Canadian Banking.

We are also planning an Investor Day in late October, where Dave McKay and his team will walk you through this business, and take a closer look at some of our major initiatives. Josie will have more information about that event in the weeks ahead.

In Wealth Management, we had earnings of CAD185 million. We had good momentum in our Canadian, US, and international businesses, though the impact of low interest rates continues to be felt in terms of lower spread income, and the offering of fee waivers on money market fund assets. We are pleased to be recognized as the seventh largest global wealth manager in an independent study by Scorpio, reflecting both our comprehensive offering of investment management solutions, and global reach. Also, in an exciting validation of our focus on providing superior service to customers, JD Power & Associates announced that RBC's US Wealth Management has achieved the number two spot in its US full service investor satisfaction list.

Our insurance business continues to make solid contributions to our diversified earnings stream, generating earnings of over CAD150 million. In International Banking, we are making progress towards restructuring our US banking operations, notwithstanding a challenged US banking and credit environment. We remain focused on improving the end-to-end customer client experience by simplifying the way we do business, and improving the productivity in our US branch network.

But the story for this quarter is primarily about the Capital Markets business, which is highlighted on slide six. Earnings of CAD201 million were down CAD361 million from a year ago, reflecting a decline in trading revenue from the record levels of a year ago. Our reported sales and trading revenue was down 65% from last quarter. Now, the impact of mark-to-mark accounting drove roughly half of the sequential quarterly revenue decline, and Janice will provide additional disclosure around that in her remarks. If you exclude the accounting volatility related to these items, our sales and trading revenue was down about 39% from last quarter, in line with most of the global trends.

Our operations span many countries, with well over half of our Capital Markets business now outside of Canada. Sales and trading revenue this quarter was affected by significant industry-wide declines in client activity, and lower trading margins, particularly in Europe. Our European fixed income business was severely impacted by the weak conditions, particularly given its focus on sovereign, super sovereign, and agencies, and the poor performance of this sector throughout the quarter. For the first time, we saw sovereign credit spreads widen beyond corporate levels.

From a client perspective we executed well, and we continued to support both our investing and our issuing clients throughout this difficult time, and we have been recognized for that effort. Our credit trading businesses in Europe received top ranking in several categories by institutional investors. In Credit Magazine's 2010 European Credit Awards, we won number one, best bank for fixed income, e-trading and non-core currency bonds, number two best bank for Sterling bonds, and number three best bank for sovereign bonds.

Our sales and trading businesses in the US performed well on a relative basis this quarter despite the drop in client activity arising from regulatory uncertainty, and general market conditions. We are seeing good momentum throughout our US business.

Looking at trading over the quarter, May was a particularly difficult month, and of course that was the heart of the sovereign debt crisis. We saw improvements over the course of June and July as markets stabilized, confidence improved, and clients returned to the market. Market activity continues to improve, as new issue business in debt markets has been quite active recently, and this provides additional support to the trading environment.

While we certainly don't expect to operate at the levels we did in fiscal 2009 and early this year, we believe this quarter's trading results on an adjusted basis to be significantly lower than our sustainable long-term objective and run rate. Market conditions today appear better than they were over the past quarter.

Recognizing many of your prior questions, I would like to reiterate that the majority of our businesses are driven by client flows. Proprietary trading is not a significant portion of our overall revenue, and generally represents approximately 3% of RBC's total revenue. This quarter, our proprietary trading activity remained profitable in each of the three months.

Moving to our investment banking business, the other main component of RBC Capital Markets, corporate and investment banking revenue was actually up 26% from last quarter, and 56% from last year. Compared to last quarter, we had improvement in equity origination, loan syndication, and M&A activity across all geographies. The pipeline remains strong, and we see good momentum across geographies in several sectors. The strength of this franchise has been recognized in this quarter.

In Canada we won a number of significant mandates, including the CAD900 million Manual Life and CAD800 million Rogers Bond deals, M&A advisory to Potash, and our recent appointment as book runner on the General Motors IPO. European Magazine also named us best investment bank in Canada, a title we have held for three straight years. We continue to expand our corporate investment banking business in the US and the UK, with a focus on growing our debt and equity origination, and lending businesses, to meet our clients' global needs, and support our trading platforms.

Outside of North America, we acted as joint book runner and the hedge manager for the largest ever UK Guild offering at GBP8 billion. This represents our largest deal in any single currency. We also acted for resolution of FTSE 250 Company, on its purchase of Axa UK Life business, one of the biggest M&A deals thus far in Europe. This includes acting as book runner to the second largest equity financing year-to-date in the UK to fund the purchase.

While Canada remains our core market, where we have leading positions in all of our businesses, we have made significant strides to expand our Capital Markets franchise, both inside, but also outside of Canada. Our global expansion, and the building of this franchise over the past several quarters provides us with a foundation to diversify our revenue stream, and grow our earnings base.

While there can be volatility in this business, as we have seen this quarter, this is the first quarter in many years that we have had results on an adjusted basis well below our plans. And we continue to believe the long-term returns in this business will be strong relative to other areas in financial services, and provides us with an important revenue diversification.

Before closing, I have a few comments to make on the recent regulatory developments. With respect to the proposed Basel regulation, we have been voicing our opinions to regulators to ensure changes are balanced, and build on the principles that keep our industry strong, vital and stable. The recent Basel amendments from the July release are encouraging, and the tone has certainly improved. As I have said, I believe our strong capital ratios and low leverage makes RBC well positioned relative to global peers. As shown on slide seven, we ended the quarter with a Tier 1 ratio of approximately 13%, among the strongest globally, and a Tier 1 common ratio of 9.6%.

We expect to have more clarity on the regulations, and how they will impact us following the November G20 meetings in Korea. In the meantime, we remain focused on proactively pursuing opportunities to mitigate any potential impacts, and continue to explore alternatives across our businesses.

I will conclude my formal remarks by saying that we had a solid quarter this earnings, notwithstanding the challenging quarter in some of our Capital Markets business that I've spoken to. RBC's results reflect the continued success of our businesses, and the commitment of our employees and our clients, with expert service and advice they need. As I look ahead, I am confident that our long-standing strategy, diversified business model, strong balance sheet, and leading market positions will continue to drive our performance, as we extend our leadership position, both in Canada and globally.

With that I'll turn it over to Morten.

Thank you, Gord. Overall, credit quality has generally improved from the last quarter. The Canadian and the US economies have continued to show signs of strength in recent months, with solid growth in GDP in the US, and improvement in the labor markets in Canada. As I said last quarter, the level of provision for credit losses for the remainder of 2010 will continue to be dependent upon further improvements in economic conditions, and unemployment levels.

Turning to slides 15 to 17, overall provision for credit losses decreased CAD72 million over last quarter. Specific provision for credit losses was down CAD40 million from last quarter, primarily driven by lower provisions in capital markets and Canadian banking, partially offset by a small increase in provisions in International Banking, related to our US banking operations. Here in the current quarter, the general provision was a credit of CAD5 million, as compared to an addition of CAD27 million in the prior quarter.

Now let's look at credit performance in our business segments. In Canadian banking, provisions were down CAD18 million from last quarter, reflecting lower write-offs in our credit card portfolio, and lower provisions in our unsecured personal and residential mortgage portfolio, partially offset by an increased provision in our business lending portfolio. Credit card specific provisions as a percentage of average loans improved to 407 basis points, down from 494 basis points last quarter, driven by portfolio growth, and improved asset quality.

Our Canadian residential mortgage portfolio, which makes up 56% of total Canadian banking average loans and acceptances, continues to perform well, with specific provisions as a percentage of average loans of less than one basis point. This is consistent with our historical performance.

In Capital Markets, we had a recovery of CAD9 million, comprised of recoveries on a few large accounts that more than offset new specific provisions in the quarter. This compared to specific provisions of CAD21 million last quarter.

Specific PCL and International Banking includes CAD7 million, largely attributable to higher commercial provisions in US banking. Our US banking portfolio remains under pressure, primarily as a result of our historical business mix, which is weighted towards commercial, commercial real estate, and residential builder finance.

Also, our footprint in the US southeast encompasses some of the hardest hit areas in the recent economic downturn, including Georgia and Florida. As I mentioned in the past, we are not a distressed seller of assets, as we believe our strategy of working out problem loans over time will result in a better economic outcome.

Partially offsetting the increase in the US, were lower provisions in our Caribbean portfolio during the quarter. Our commercial and corporate portfolio in the Caribbean will continue to be impacted by the weak economic environment in that region.

Now, turning to market risk, the significant volatility in equity credit in the foreign exchange markets led to 20 days with net trading losses, although only one day exceeded value at risk. And this was primarily due to a month-end credit valuation adjustment on MBIA.

As Gord mentioned, our European fixed income business was negatively impacted, reflecting our greater focus on sovereign, super sovereigns, and agencies, and the poor performance in this sector. May was a particularly challenging month, and contributed to over half of the trading day losses, while we saw improvement over the course of June and July.

I'll now turn the presentation over to Janice.

Thanks, Morten. As Gord mentioned, we reported third quarter net income of CAD1.3 billion, reflecting strong results from Canadian banking, Wealth Management and Insurance. Earnings were down CAD285 million from a record quarter last year, primarily reflecting a CAD361 million decline in our capital markets earnings, as trading revenues were impacted by the challenging global capital markets condition. We saw strong momentum in our retail businesses, with volume growth in Canadian banking and insurance, and continued growth in client assets and wealth management.

Our investment banking businesses performed well, and as Morten mentioned, credit quality continued to improve with provisions down 44% from last year. NIE was down 10% from last year, reflecting lower variable compensation, the favorable impact of the stronger Canadian dollar, and our continued focus on cost management. We continue to drive cost management initiatives, while reinvesting cost savings, and increasing initiative spend to support business growth, and further increase efficiencies by simplifying and automating processes. For example, we've been investing in technology to streamline and automate processes in Canadian banking, and continue to build out financial and risk infrastructure in capital markets to support our expansion efforts.

Let's move to slide 19 for a closer look at the performance of our business segments. Starting with Canadian banking, net income of CAD766 million was up 14% from last year, mainly driven by volume growth across most businesses, and lower provisions for credit losses. Year-to-date, our efficiency ratio stands at 46.9%, which is an improvement of 120 basis points from the same period last year, as we focused on managing costs, and reinvesting for business growth. We continue to target an efficiency ratio in the low 40s over the medium term.

Turning to slide 20, you can see that we continued to experience margin compression over the quarter. The tightening of the prime VA spread, and competitive pricing on credit cards and mortgages, more than offset the benefit that the increase in short-term interest rates had on our deposit balances.

Wealth management net income of CAD185 million, up CAD17 million or 10% from last year, primarily due to favorable accounting impacts of CAD24 million after tax, related to the foreign currency translation on certain AFS securities, and a favorable tax adjustment. The favorable accounting impact this quarter largely reverses the negative year-to-date impact. This was offset by the impact of spread compression on client cash balances, and the impact of the stronger Canadian dollar on foreign earnings. We also continue to benefit from increased fee-based client assets.

Insurance net income was CAD153 million, down CAD14 million from last year, mainly due to unfavorable life policyholder experience, and higher claims costs, which were partially offset by the solid volume growth as I mentioned earlier. Compared to last quarter, earnings were up CAD46 million, primarily driven by higher investment gains, and the new UK annuity reinsurance arrangement.

International Banking net loss of CAD76 million improved from a net loss of CAD95 million last year, mainly due to lower provision for credit losses in US banking. We continue to make progress on restructuring our US franchise, and our cost management initiatives are well under way to reduce complexity, drive efficiencies, and improve productivity.

Capital markets net income of CAD201 million was down CAD361 million from a record quarter last year. As Gord discussed, sales and trading revenue were impacted by significant industry-wide declines in client activity, and lower trading margins, primarily in Europe. Capital markets sales and trading revenue of CAD450 million was also impacted by losses on MBIA and BOLI compared to gains in the prior quarter. The valuation of MBIA is dependent on market spreads, and can fluctuate from quarter to quarter. Year-to-date, we've had a small net gain of CAD38 million. We believe that in a realization scenario, we are more than adequately provisioned.

With respect to BOLI, this quarter's loss represents the mark-to-market changes on the forward contracts. Since restructuring this exposure in the fourth quarter of 2009, the cumulative year-to-date impact is a net gain of CAD9 million. We typically look at items that are impacted by market conditions, and in the past we referred to these as market environment related items, together, in assessing their impact on revenue and earnings. Last quarter, the impact of these items collectively was not significant compared to total trading revenues. This quarter we're highlighting MBIA and BOLI, as they drove roughly half of the sequential quarter difference in trading revenues.

Excluding the impact of the accounting volatility related to MBIA and BOLI, our adjusted Capital Markets sales and trading revenue was CAD588 million. We had a strong quarter in corporate and investment banking on increased revenue from equity originations, loan syndication, and M&A activity across all geographies.

Before we move on to answer your questions, I just wanted to point out some changes to our other income disclosure. We've provided slide 21, the Michael Goldberg slide, which provides a further breakdown of other other income. As you may recall, last quarter we had losses on bonds related to funding activities recorded in trading revenue, which were largely offset in other other income. This quarter, we reclassified losses on the bonds from trading revenue to other other income to provide a clearer view of the balances in these accounts.

At this point, I'll turn the call over to the operator to begin questions and answers. Please limit yourself to one question, then requeue so that everyone has an opportunity to participate. Operator?

Thank you. (Operator Instructions). Thank you for your patience. Our first question is from Rob Sedran of CIBC. Please go ahead.

I hope to some day have a slide named after me. Gord, I know you hate answering this question but I guess somebody has to ask it, and since I'm first, I guess it will be me. Last quarter, after the trading result, you suggested that something in the CAD1 billion range was not an unreasonable number and appreciating that there's a lot of variability in the number. Has your outlook on this business changed at all after this quarter? Trying to get a sense for how we should think about 2011 in terms of a trading outlook?

Certainly, Rob, from a strategic perspective, my outlook hasn't changed. I tried to reflect that in our comments. As I said, from a run rate basis, and we're trying to provide the historical levels, if you go back to 2009, and the early part of 2010, there were exceptional positives with respect to trading revenues and if you look at what happened this past quarter, I think there was some exceptional volatility in the other front, and I think from a run rate perspective, we're quite comfortable that it's not likely to be where we are in 2009, but it certainly feels better and should feel better than where we are this quarter.

From a strategic perspective, absolutely, we remain committed to it. We built a very strong franchise. My view, and I think we collectively share this view, is that the margins and returns in this business, while there is some degree of volatility, and we know that in this business, but as I pointed out, if you actually look at our adjusted trading levels, there have been very few quarters where we've been disappointed relative to our expectations. Clearly, this was one. But it's been quite some time.

But I think if you look at the future of this business, we've got a very strong franchise, we've got very strong market positions. You've got a tremendous amount of debt financing which has to occur across the globe, and of course most of the negatives here were in the fixed income business and the strength of our brand, et cetera, is such that I think that while these businesses tend to be viewed either in favor, out of favor by the Street, and I think over the long term, the margins, the returns in the business will be very attractive relative to many areas of financial services. Now, we want to grow these businesses in line with our strategy of diversification and so forth. But I think the long-term outlook for this business remains extremely positive.

Without trying to pin you down on an actual number per quarter, which I know you'll never report, no matter what number we pick, is CAD3 billion to CAD4 billion in annual trading a reasonable number to think about? And that's a pretty wide spread. Appreciating the volatility.

I'm going to let Mark Standish answer that question. Without providing any guidance.

As Gord was saying, a lot of the strength of the sales and trading business is that we're strong in more than one center. If you look at the breakdown geographically of the performance, we actually had quite strong performance in our US business. We had good performance in our Canadian business. And clearly, the outlier for us was a very weak performance in our European business. Now, we made the strategic decision to -- I won't say be aggressive, but we made the decision to be very active with both our issuing clients and our investing clients, because as Gord said, the pipeline for future new issue in Europe is massive. And that's something that we have every intention of being part of.

So going forward, I can't tell you what markets will look like, but I think geographically, we'll benefit from that sort of CAD0.03 of diversification. First quarter number was around I think a CAD1.3 billion for sales and trading. This quarter when you adjust also for MBIA and BOLI, it's around CAD588 million. Something in that range is appropriate going forward, recognizing that we still are in a difficult market environment right now.

Thank you.

Thank you. Our next question is from John Reucassel. Please go ahead.

Thank you and I guess I just want to understand, Gord, the slide six. I just want to understand, you said that half of the 65% decline, so the CAD415 million versus the CAD1.1 billion in Q2 is mark-to-market. Is that something other than the MBIA or BOLI or is that what you're referring to on the mark-to-market?

John, it's Janice speaking. I'll answer that question. So what we're referring to is that the MBIA and BOLI, we actually pointed these two exposures and the delta on a quarterly basis out, because they account for the majority of the difference. As you know, in the past, we have reported market environment losses on some of our runoff businesses related to accounting volatility. So mark-to-market positions. And last quarter, those were not significant compared to our total revenue volume. This quarter, we reported these items because given where the trading revenue levels were, they are quite significant. So the impacts that Gord referred to are by and large picked up by the impact and difference between the MBIA and BOLI mark-to-markets from Q3 compared to Q2.

Okay. I might have to come back to that. I'm sorry, just -- okay. And then Gord, can you still generate a 20% ROE in capital markets? You had some of the US competitors saying competition's back and pricing's getting tougher. So back to your strategic questions, is 20% still a number you think you can earn?

As I said in my remarks earlier, I think the returns in this business over time will remain very attractive, relative to a lot of areas of financial services. And if you actually look at the returns in this business year-to-date, they are at around that level, notwithstanding a very challenging third quarter. And so from an objective perspective, the answer is yes. The one caveat I would place on that answer isn't so much the earnings power of the business, as much as the -- we live in a regulatory environment where capital rules and capital allocation, et cetera, is shifting and very difficult to predict what the long-term implications of that will be and whether they drive returns down in aggregate across that business, relative to other businesses or the business in general. But I think as we sit today, I think it remains a very realistic objective, and as I said, if you look at where we are today, notwithstanding the third quarter, we're at around that level.

I'll requeue. Thank you.

Our next question is from Steve Theriault of Banc of America-Merrill Lynch. Please go ahead.

Thanks very much. Staying with trading, for Mark or Doug, I think back to calendar Q4 was a quarter where global trading platforms suffered from a pretty major slowdown in client activity and when I think of the US players, they had a pretty massive swing in trading revenues, followed by a pretty sharp recovery in calendar Q1. When I think back to your Q1, which includes that very, very quiet December, you had pretty limited impact on trading, I think trading was down roughly 10% in the quarter. I'm not entirely sure how you tackle this. Is there some way you can talk about or reconcile the sudden what seems like higher correlation with global trends, so Royal versus some of your US competitors I guess.

That's a very different -- very difficult comparison to make, because our businesses are different in each center. One of the things that we're very pleased about is the overall performance, for example, of the US capital markets business and while we're focusing on sales and trading, we can't forget there is a significant origination business that goes hand in hand with that. So year-to-date, the -- sorry, for the quarter, the capital markets business in the US was actually up 6%. It looks much more like our Canadian business, which is a deep sales and trading, corporate and investment banking business.

For us in the quarter, the big swing as I said earlier, was the European business, where we're still in the process of building out the origination side, adding a lot of additional bankers, corporate investment bankers, and we're probably two to three years behind where we've gotten to in the US. So when you try and compare us to other firms, it's very difficult to sort of compare what is right now more of a niche focus, sales and trading business in Europe, to other businesses. Our focus in Europe is very much high grade. It's focused on sovereign, super nationals and agencies, primarily. A fair amount of high grade corporate trading. So in a sovereign debt crisis, that puts us front and center in the eye of the storm.

Part of the additional sort of 39% quarter on quarter decline also includes additional reserves in CVA against the origination of that SSA business. As credit spreads blew out for sovereigns, obviously we had to increase our CVA there. So there is noise around a lot of these numbers, but I think going forward, it's going to be really anchored around the amount of new issue activity, which I think will be very good in Europe on the debt side. In the US and Canada, it will be full-bore sort of investment banking, ECM and DCM.

I would just add that I think that no one gets more frustrated with the volatility as a result of accounting than -- and you know, these accounting rules, than companies do. The analysts might as well, but so do we, and we're trying very hard to reduce that volatility and hopefully the accountants are working very hard to reduce that volatility as well. I think in answering that question, there's a couple of parts. One is, the year-end differences do have a -- can have a big impact on quarter-over-quarter comparisons, because of the -- I mean, if you look at the sovereign debt crisis, for instance, it was a third quarter item for most of the US investment banks. I'm sorry, second quarter. It was a third quarter item from our perspective. But the other part of that question, I think, was the fact that the outlier for us this quarter was clearly what happened with respect to the European business.

I would say it's -- it's Doug. Following on those remarks and Gord's remarks, there are several hundred million dollars difference in terms of the marks in some of the legacy positions between Q4 2009 and Q3 2010. So it is -- it does impact quarter to quarter and I think we are looking at different ways to handle that and maybe more transparency going forward. But it is an issue.

Could you size the CVA adjustment that you spoke to in the quarter?

Size the CVA adjustment. The CVA adjustment in the quarter was in -- and it's hard -- I think that following on the comments that I made with respect to John's question on some of these activities, I can size the CVA adjustment for you in the quarter and the deltas but I think what would be more beneficial is for us to look at total market environment, as we define them in the past quarter, total market environment adjustments from a quarter to quarter basis. It's more helpful. Because it includes everything and some of these net off against each other so I think that what we'll do is we'll pull out some of the disclosure we've provided in prior quarters and update it for this quarter's results. Why don't we take that offline and Josie will get back to you.

That sounds good. One more quick maybe related follow-up. The market risk was up quite a bit this quarter. Was this a function of volatility being higher and we'll see that come down? Can you just give us a quick read on that?

So it's Morten. I'll handle that. What we saw during -- we saw a great deal of volatility. As I said in my comments, we ended up with 20 days of net trading losses and if you look at the slide in our MD&A showing the VAR, you'll see that the VAR has drifted up somewhat on an average basis. I would say the peak to trough numbers this quarter are no different than the previous quarter.

I think you need to keep in mind how the VAR is generated. It is using two years of data. As we continue to have the Lehman bankruptcy event in our VAR calculation, and we got two years of fairly volatile data in there, so that has contributed to a fair amount of the year-over-year increase in VAR. I would say it's remained relatively stable, but given the market conditions, we certainly had early in the quarter a few more days of slightly higher VAR but the businesses have really taken a repositioning of risk during the quarter to reflect the volatility.

So from a range standpoint it's in the normal range. Over time we should see it actually starting to reduce as the data set becomes more containing fewer volatile days.

It's Mark Standish. I think the biggest single increase in VAR actually was due to the impact on a methodology change as we moved in a very liquid FRM portfolio that we have in our Treasury services business that we keep as part of our liquidity pool. So from a trading risk perspective, actually VAR was pretty constant during the period and that was the primary difference.

Thanks very much for the time.

Our next question is from Peter Routledge of National Bank Financial. Please go ahead.

Hi. Well, just one broad question on capital and dividends. First, does your capital position presently, relative to the new rules and implementation plan as you understand them, inhibit in any way your dividend increase planning? And assuming not or assuming no in the near term, how does trading revenue and the volatility of trading revenue impact the evolution or your thinking around sustainable EPS in relation to the payout ratio? Do you look at last quarter's CAD1 billion in trading revenue and take a haircut off that? And I know you can't give me specific numbers but just some thoughts on how you process your trading revenue volatility in the context of your payout ratio.

That's a very difficult question to ask, particularly the first part, given the regulatory uncertainty. The way I would answer that question is as follows. I think that when you look at regulation globally and the new rules, which as you know are going to be phased in over an extended period of time, I think the way that institutions -- and I'm going to talk generally here, as opposed to specifically. The way institutions and regulators will look at it is they will look at current capital levels. They will look at the objectives that banks are to get to over that period of time. They will look at the -- we will look at the earnings power and growth of that bank, the capital accumulation combined with the ability to increase dividends, and I think when the marketplace is comfortable that you've got a line of sight in terms of whatever threshold we have to get to, the ability to continue forward with our existing dividend growth plans will be much easier than the current environment.

But as I've said in previous quarters, it's hard to know, until you know what you ultimately have to get to, it's very difficult to forecast the path to get there. And while we do have much greater clarity today than we did even at our last quarter's meeting, there's still a tremendous amount of uncertainty out there. But I think we are -- I think as we move into next year, sorry, post the November G20 meeting as there's greater clarity around capital rules and timing, et cetera, I think it will be much easier for organizations to move forward with respect to their dividend plan.

When you refer to the marketplace, then that category you would place the regulator as a key stakeholder?

Absolutely.

Okay.

I mean, that's to some degree stating the obvious. They are obviously a key stakeholder and they've been very vocal about where institutions and this is not Canada, this is globally, ultimately have to get there. So they will clearly be a key stakeholder.

Okay. Thank you.

On the trading, I mean, again, we've got -- the way we look at it is we have our business plans with respect to our capital markets business general, because remember, it's not just trading. We've got a lot of other components of our capital markets business and one of the things we're continuing to do is ensure that we've got the right balance. So we've got our corporate and investment banking business, investing and growing and frankly well ahead of our plan as far as where we expect it to be at this year. So you had that business actually outperforming our internal expectations and of course trading because of the third quarter slightly lower. But basically we manage around an annual plan with respect to that business and as I say, we continue to remain very confident in terms of our annual expectations with respect to that business in aggregate and as I say, while there is volatility, if you actually look historically, the volatility within that business has actually not been that significant, certainly relative to our internal expectations so from a planning perspective as I say, I don't think there's a dramatic shift.

Thanks very much.

Our next question is from Darko Mihelic. Please go ahead.

Hi, good morning. Actually, a number of questions, maybe I'll just take them offline with Janice on trading. A quick question, though, Gord, when I look at the balance sheet, it's up almost CAD50 billion quarter-over-quarter. It pushes your tangible common equity ratio around quite a bit, even just intraquarter. Should I care about that?

Certainly from the capital markets business perspective, there were two things that drove increase of balance sheet around our business. The first was an increase of repo activity to support clients. As I said earlier, it was a very active new issue period and repo plays a role in that. And then the other significant item was an increase in the DRA, the derivative related asset side of our business. As markets became illiquid, there was a lot of activity in plain vanilla interest rate type swap trading, about a third of which actually flows -- we transact onto LCH Clearnet. But that really contributed to the other part of the build-up on the capital markets side.

Should we become accustomed to this kind of volatility on the balance sheet or do you think this is just a one-off and not to worry and new capital rules really won't crimp your style, so-to-speak?

No, I think on the repo side we're simply responding and helping clients and it's at attractive spreads. On the DRA side, we did have a very significant movement not just in interest rates but also in currencies that sort of takes a little while to work its way through, netting and compression exercises. So no, I think it's just simply--.

I almost take the opposite view. We continue to have a very liquid balance sheet. One of the things that we would like to continue to do is to -- in a sensible fashion, continue to grow our balance sheet, particularly on the asset side and the lending side of the business, but we are in an environment where utilization rates continue to be very low. So most of that relates to the security side of the balance sheet. If anything, we would love to continue to expand our balance sheet particularly on the sort of lending asset side.

Okay. Fair enough. Thanks. Janice, did you talk about the income tax, the amount of the income tax benefit this quarter from prior period adjustments?

The benefit is mostly by and large reflected in corporate support.

And how much was the benefit?

We don't really talk about the sizing of that but it's really the bulk of what's sitting in corporate support, because as you know, we don't talk about trend analysis in corporate support. We talk about what's in the balances. So some of it is relating to resetting of some of our tax provisioning, and some of it relates to actual tax -- favorable tax audits where we've had statute five years. But it's basically the bulk of what's in corporate support.

Okay. So maybe asked differently, this doesn't do anything for our forward look on an appropriate tax rate for Royal. Would that be a correct assumption?

No, I think that when you look at tax rates, the quarterly volatility in tax rates is sort of masking a longer term. So that adjustment, for example, as we get years that flow in and out of audit, while it's an annual adjustment, it occurs in a quarter. So I think that from a corporate tax rate, our actual tax rate has increased because of our business mix and the amount of taxable income we're earning in the US. But we're still targeting somewhere in the mid-20s for the rate. And that has not changed.

Okay. That's helpful. Thank you.

Thank you. Our next question is from Michael Goldberg of Desjardins Securities. Please go ahead.

Thanks. I'm honored to have a table named after me, but it's been several quarters that I was asking for that information, and it took much too long. You have the opportunity to actually provide clearer information and I think that this is something that you can continue to improve, and let me give you an example. You now show that a major factor in the lower trading revenue was CAD100 million loss related to MBIA this quarter versus CAD182 million gain in the previous quarter. But you never disclosed this gain last quarter. Why not? Don't you realize that it makes you look like you were concealing material information last quarter, and you only disclose it now when it's convenient for you? Also, you were just asked for the amount of the tax--.

Wait a second, Michael. That's not right. I think that we should answer that question first because that's totally incorrect. But Janice, do you want to--?

As I said before, Michael, we typically were disclosing market environment related impacts on a quarterly basis, when they were significant. Last quarter, while there was a difference in MBIA and BOLI exposures relative to this quarter, if you took off of the adjustments into consideration, they were not significant, given our trading revenue base. And that's why -- and the items tend to net down. This quarter, because of where our trading revenue base was, these items were significant and we specifically talked to MBIA and BOLI because the deltas on those two accounted for the bulk of the difference in the sequential trading revenue decline. So I think that -- from that perspective, we're giving you fair disclosure on what's causing the deltas in terms of our trading revenue trajectory. I mean, the big news about our trading revenue trajectory was our trading revenues were down significantly on a trailing quarter and a year-over-year basis.

The net number last quarter was not a significant number.

Not significant.

CAD182 million sounds like a big number to me.

That's not the net number. That's one item.

So it would have been good if you had disclosed all of these items as you have in the past. Now, I have another question. You talked about the return that you assume from the capital markets business over time. What is the return that you actually do return, assume, and what proportion of common equity do you assume to get that return?

From a mix perspective, we use a weighted average cost of capital, which basically drives our capital attribution in that. From a mix perspective, I think the equity proportion is somewhere between 30% and 40%, but it's shifting because of our use of -- and we always talk about capital, not pure common equity. It's shifting because of the new capital rules and the impact of innovative instruments and the impact of refinancing subdebt. So what we do from a return perspective is we attribute economic capital to all of our business units, and when you look at economic profit, we charge on weighted average cost of capital, which includes a bit of a risk premium for equity.

And what is the return that you actually assume over time from this business?

Target or assume?

What do you mean by--?

You mean target?

Yes, that you target.

We're targeting about 20 on the economic capital of the business. So you know the capital that's in the bank, we go through the whole economic capital calculation, we come up with a number and the run rate of the business for the first three quarters is almost exactly 20% on economic capital.

Okay. And I have one last question. Gord, you said revenue from prop trading is about 3% of total revenue, let's say in the neighborhood of CAD200 million. What assets support that revenue and what capital supports that revenue also?

Just to clarify, I think what Gord said was it was about 3% of the bank's revenue.

Right. CAD7 billion for the quarter.

Right. Okay. For the quarter. Right. So sorry, what's the rest of the question?

The capital.

What assets are related to prop trading and what capital do you assume to generate that revenue?

When we go through the economic calculation for the business, we obviously go through the same process with risk for our prop trading books and capitalize them that way. And the assets are shown on the balance sheet as securities held.

But I think what Mike was saying, which -- what are you asking? Which businesses are represented by prop trading?

No, I'm asking what the amount of assets are that generate that notional CAD200 million of revenue and what capital do you assume is supporting that revenue also?

I don't think that we're prepared to go in that much detail on our disclosure. The prop trading is principally in our capital markets segment and what we're -- what we did was size it to show that it is not a significant portion of what we have with respect to capital markets. The bulk of the capital markets business is client flow business.

If that CAD200 million -- and I'm just being notional here -- let's say is for one quarter, now, now that's just a revenue number. What I'm really trying to get at is the amount of capital that you have supporting the prop trading businesses? Maybe we could take it offline.

Offline, Michael.

Yes, I think we have to take it offline. Because it contributes to the overall VAR of capital markets so it's very difficult to break it out separately and look at it separately. The only thing I would stress is that our proprietary trading activity is focused on extremely liquid assets. So the biggest cap stocks and government type securities, so it is a very liquid business.

Michael, it's Josie. I'll get back to you. Given the time, we probably have time for one or two more questions. So can we move forward?

Sure.

Thank you.

Thank you. Our next question is from Sumit Malhotra of Macquarie Capital. Please go ahead.

Good morning. My question is for Gord Nixon. Gord, yourself and other members of the bank have spoken on these calls and in print about your interest in expanding the wealth management business and specifically, Europe has been talked about. When you think about the latest news we've got from BASEL and perhaps the implication on European financials and their need to raise capital very quickly or in the near term isn't going to be as severe as we may have thought six months ago, do you feel that some of the potential divestitures that may have come up on the wealth management side in Europe are not going to be as likely and it's going to be perhaps a delay in you expanding that business?

I think that the -- I think the European systems still have a lot of challenges in terms of over a longer term period, getting to the -- whatever the ultimate BASEL requirements will be. The pressure on Europe to restructure is probably reduced, given, one, the changes of the rules themselves, but also given the long time frame to which they are likely to be implemented. I mean, some of these rules are going to be implemented over a five year, six year, seven year period of time, which obviously gives them more time.

Having said that, we still think that there will be a significant amount of restructuring that will take place across the industry as financial institutions, as they move towards sort of the new normal, if I can describe it that way, I think we'll l be looking at a lot of their businesses and determining which businesses are core, which are priorities, which businesses do they want to deploy capital in. I think today in the current environment, it is a bit of a holding pattern because there's such a high degree of certainty out there. The pressure to do things is to some degree not there because of the uncertainty, and frankly, from a investment and acquisition perspective, it's equally as difficult because it's very difficult for buyers or investors to do things when there's not a clear line of sight on cost of capital and the regulatory rules.

So I think you've got this period of time where given the uncertainty, there are things happening but there's certainly not a lot of pressure from either side of the ledger, buyers or sellers. But I think that ultimately, the pressure to restructure across the industry will continue to be there, notwithstanding the fact that time frames have changed and to some degree the capital rules are being watered down. I don't know whether George, you want to make a specific comment in terms of wealth management and some of the things that have been happening, particularly as it relates to Europe.

Sure, thanks, I would just echo Gord's comment and clarify that your question, in terms of our focus within the wealth management segment, in terms of acquisitions, is primarily in the asset management space. And we're using this period pre-the finalization of the BASEL-III rules if you will, to proactively develop relationships with European-based institutions and their asset management businesses, so there is lots of activity under way, and to some extent I think the clarity, and I would agree with Gord on this point, that will come in November will provide more certainty for European based institutions to make those types of decisions about whether asset management is a core business going forward. So I almost look at it is more as an opportunity in terms of that clarifying event.

Very quickly on past acquisitions, I'll leave it here for Janice, as we think about IFRS and goodwill, I know it's still a bit further away for the banks, but obviously a couple of the lifecos talked recently about goodwill-related charges they would have to take under IFRS. Do you have any comment on your US franchise. Obviously there was a charge a year ago, but any initial comments that you have had as you've gone through the IFRS process on what the goodwill situation is looking like?

Yes, Sumit, we've been working through a dry run because as you know, we're not in IFRS accounting for another year.

Yes.

So at this stage, though we have to gather the comparatives, so we're working through a dry run. We're looking at the goodwill in terms of the individual reporting units and we know that we need to shift some of the reporting units slightly, and make them more granular because it's premised on a more broader based cash flow test. So we're in the process of looking at that right now. And it is likely that we will be looking at more granular reporting units specifically in our International Banking unit where we have aggregated everything. But we're not at the stage now where we've made any definitive conclusions on that and we do have the next year to actually sort that out with our auditors and go through the IFRS standards.

Thanks for your time.

Thank you. Our next question is from Gabriel Dechaine of Credit Suisse. Please go ahead.

Just the last one on the capital markets business and other than the top line volatility, what about the cost base? Because we've been building it out over several years, expanding it. I don't see a headcount per segment number, but I imagine that's one of the areas where you've been adding the most people, plus the infrastructure, the floor space. That all adds up. How should we not expect that to also increase the earnings volatility from capital markets?

I'll give you a couple of kind of benchmarks. One of them is in terms of front office people in the business, it's up probably year-over-year about 5%. A lot of what we've been doing is actually reengineering, that is, let's say hiring people in places that we think they would be more productive or hiring more productive people and letting less productive people go. I would say the real growth is in the functions of our business, the tech and ops side of the business and we are investing in all our jurisdictions in terms of upgrading our risk functions, our finance, tech and ops, and so costs are moving up. We're just going through the planning process right now in the business and I would say that year-over-year they're probably going to be up about 10%. But I would say the real buffer in our business is variable comp, and if we continue at the run rate that we demonstrated this quarter, you'll see a reduction in cost.

Variable comp still represents--.

In our case, it's sort of -- it's less than 40% and more than 35% of our revenues.

And then in Canadian net interest margin, like the competitive factors seem to be one of the bigger things driving that down and Royal's not unique in that regard, but where do you see things going from here? More intensity of competition because loan growth is slowing and therefore NIM contraction could become a bigger issue in the absence of higher rates?

It's Dave here. I would say that there is a very strong competitive environment but prime BA compression is the real driver of the decrease.

Okay.

So where prime BA rates end up has a big impact on our NIMs.

Okay. Thanks a lot.

Thank you. Our next question is from--.

Operator?

Yes?

We're out of time. We'll take one last question.

The next question is from Brian Klock of Keefe, Bruyette & Woods. Please go ahead.

Good morning. Thanks for taking my question. Maybe just a quick follow-up on the net interest margin. I guess it does still look like from your interest sensitivity that you're slightly asset sensitive and with the Bank of Canada increasing its overnight rate, is there -- Janice, do you think there's going to be some sort of a catch-up after the margin compression this quarter or maybe what's kind of our outlook for the short-term for the next one to two quarters on the margin?

I said that the drivers of the margin, I can't really comment on where the market rates are going to go. Certainly we've seen significant compression on the largest mortgage book in the country. The other driver certainly is mix, as we focus -- as the market growth seems to be focused on lower margin GICs and competitive pressure in the mortgage market. So I think those are some of the core drivers of NIM that will determine margins going forward. So market rates have an impact.

We're coming off highs and you see prime BA compression, market mix around growth and lower margin product in the marketplace and that's where consumers are spending their money and where banks are originating their assets and deposits and certainly competition, particularly I would say in the GIC market where you see very, very aggressive price competition. Those are the three variables that drive NIM and they will be the impact and determinants going forward.

Great. Thanks, David. Very helpful. That's all I have. Thank you.

Thank you. There are no further questions registered at this time. And the conference has now ended.

Good. Well, we made it through all the questions. We appreciate your participation and we'll look forward to speaking to you next quarter. Thank you very much.

The conference has now ended. Please disconnect your lines. Thank you for your participation.