Saturday, June 03, 2006

RBC's Strategy vs. TD's Strategy

The Globe and Mail, Sinclair Stewart & Derek DeCloet, 3 June 2006

If you still think Canada's big banks are an indistinguishable lot, lumbering along in more or less the same direction, consider a couple of remarks from the recent earnings season.

First up was Ed Clark, the chief executive officer of Toronto-Dominion Bank, who has been plowing money into U.S. acquisitions about as fast as he can find a bank willing to sell to him.

"We feel that the window of opportunity in the United States is actually fairly short," he told analysts during a conference call late last month, explaining the urgency of his southward push. "The very conditions that are making it tough for Banknorth [TD's U.S. beachhead] are throwing up more opportunities."

The next day, a near identical question was put to Gord Nixon, the head of Royal Bank of Canada, whose U.S. retail expansion plans have essentially been locked in the deep freeze. Here's what he had to say: "I'm not suggesting there's not a window of opportunity right now. I just don't see it closing, and I just don't see a huge amount of consolidation," he said during a call to discuss RBC's quarterly results. "I tend to be a little bit more pessimistic, perhaps, than others, and I think that patience will provide opportunity and that's the way we intend to play it."

Hmmm. Get in while you still can. No. Bide your time on the sidelines until something presents itself. Are these guys looking at the same market?

"The pace of consolidation in the U.S.; the importance of scale; and the ability to compete globally in the capital markets: Their public statements would suggest they disagree on all of these things," said Robert Wessel, an analyst with National Bank Financial Inc.

"They are absolutely different approaches, no question," said another analyst who covers the sector.

Let's put things in perspective for a moment. These are the two most dominant retail banks in Canada. Of all the domestic banks, they have the two most substantial U.S. wealth management platforms, to go along with established U.S. branch networks. Both have investment banks that compete vigorously with one another for underwriting and advisory business.

On the surface, it looks like Canada's two biggest banks are following the same course. Yet when it comes to their vision of the future, when it comes to deciding how to spend that excess capital that has been hanging like a millstone around the industry's collective neck, one could argue their CEOs are blazing starkly different paths that could have long-term implications for investors.

TD, on the one hand, is buying heavily in the U.S. market and exiting some of its derivatives businesses, a bet that the market will reward it for a retail-heavy, and presumably less volatile, earnings stream.

RBC, meanwhile, has forgone another U.S. purchase in favour of using its capital internally, and bulking up its global capital markets business. Banks are complex beasts, but their various businesses can be boiled down to a relatively simple proposition: They are in the game of pricing and managing risk. TD could easily flame out in the United States, either by paying too much for assets, or buying the wrong bank, or fouling up the integration. RBC has been the stock market darling of the two, and recently produced what one analyst called a "mind-boggling" performance from its investment banking unit. Yet these results have been accompanied by whispers that the bank may be assuming more risk to drive its bottom-line growth. For investors, it's a question of which strategy they can stomach.

It is mid-afternoon on a Thursday, and the atmosphere inside the cavernous trading floor at RBC Dominion Securities is relaxed. This is not how trading floors look in the movies. There's no one waving his arms or giving inscrutable hand signals, no yelling or cheering -- not much noise at all, really.

You'd never be able to tell that this room -- 40,000 square feet, about half the size of a Canadian football field -- is the heart of one of the most important profit centres at the country's largest bank. For a lot of investors, it's also a source of mystery. No one is quite sure exactly how they do it; all they know is that Royal Bank of Canada, more than any of the other big domestic banks, is taking full advantage of the prosperity and optimism that has dominated the world's capital markets for the past three years.

RBC's astonishingly good second-quarter results suggest one of two things: It is getting more aggressive, or it got very, very lucky. The bank made $586-million in revenue from trading alone -- easily a record -- including $57-million in a single day. In that 24-hour stretch, RBC's traders earned one-third of what the trading team at archrival CIBC World Markets produced in three months.

"We had a good day," shrugged Mr. Nixon, the bank's chief executive officer, unable to suppress a grin.

Chuck Winograd, the man who heads up RBC's investment banking and trading division, was even more oblique. "I'm not going to talk about just what happened, because we don't talk about trading days. But it was an unbelievable day," he acknowledged. "I was just in China, at the Great Wall. It's a great wall. We had a great day."

That's not the kind of answer that will help analysts with their forecasts, and it's little surprise that there have been questions on Bay Street as to whether RBC, long viewed as Canada's most conservative bank, has a growing appetite for taking risk, especially in trading esoteric financial instruments such as structured products.

"I've got suspicions. In those businesses, you don't see the good rewards without added risk," said Murray Leith, director of investment research at Odlum Brown Ltd., a Vancouver brokerage that invests heavily in financial services stocks. "But is it manageable?" Probably, he said.

Others have their suspicions, too, but say the bank doesn't give enough information to confirm them. Mr. Wessel, at National Bank Financial, argues that RBC's disclosure is lacking, "but based on what they do disclose, it would certainly seem that, more than any other bank, they have substituted market risk for credit risk over the past couple of years."

RBC is certainly no Goldman Sachs, whose whole business is focused on the capital markets. The bank's trading operation is still dwarfed by the size of its consumer businesses, such as personal banking, credit cards and mortgages. Even in the second quarter -- which Mr. Nixon calls "an aberration" -- trading still represented only about a 10th of the bank's revenue. And the CEO emphatically denies he has made a conscious decision to take on more risk.

"Absolutely not. Absolutely not. I couldn't say it more clearly," Mr. Nixon said. "You listen to these analysts too much. They're not always right." He did acknowledge, however, that the trading business at RBC is "the most difficult area for the analysts to get their arms around"

It may sound like these analysts are unduly picking on RBC, especially considering that TD has made some very sizable gambles: after all, the U.S. market has not exactly been a playground for Canadian banks. The difference is the market seems to have a better grip on the risk TD is taking; it's easier to see where the money is going, and one either accepts the risk or doesn't.

To be fair, no one is suggesting RBC is courting catastrophe. There are questions, however, as to whether the bank's stock should reflect some aspect of a heightened risk profile, especially when compared with a rival like TD.

Mr. Clark, a retail evangelist, has been on a mission to strip market and credit risk out of TD ever since taking the helm in 2002, and at the same time make it more reliant on plain old branch banking and wealth management. Little wonder: He inherited a balance sheet that was charred by billions in bad loans to the telecom industry, courtesy of an overly aggressive investment banking culture.

He has spent billions of dollars on three U.S. banks and orchestrated a major discount brokerage merger in hopes of creating a cross-border retail banking juggernaut. The investment bank is still there, but in a streamlined, more focused version of its former self.

As one might expect, the bank's credit risk profile has shrunk dramatically, much as it has for the other Canadian banks, all of which have slashed their corporate lending. TD's capital markets risk, measured as a percentage of the bank's entire risk-weighted assets, has also dropped substantially. It was just 2.6 per cent at the end of the second quarter, down from 8.5 per cent at the end of 2000. RBC's, by contrast, has headed in the opposite direction. It was 6.9 per cent at the end of the second quarter, up from 2.2 per cent at the end of 2000.

"There's no question that investors are buying a different set and character of earnings [with TD and RBC], but who knows over the next 10 years which will turn out to be better or worse," Mr. Clark said in an interview. "You just say 'let's just keep on pounding away and doing what we said we were going to do . . . It may be that the Royal will also just keep pounding away and doing what they're doing, and produce terrific results, and I say well, Godspeed to them, too."

If Mr. Clark's mantra is focus, Mr. Nixon's is diversification. Instead of taking another shot at a U.S. acquisition, Mr. Nixon, a former investment banker, is allocating capital around all of his business lines, and wading into some of the areas that TD's scaled-down capital markets group recently abandoned: exotic derivative instruments such as structured credit and interest rate products.

Call it Gordon Nixon's Third Way. After taking the heat two years ago over the disappointing results from the U.S., it seemed he had two options: To double his bets in that market by buying even more assets, or withdrawing to Canada.

But Mr. Nixon checked the "neither-of-the-above" box and chose a more subtle, gradual approach to building. In U.S. consumer banking, that has meant adding branches to RBC Centura, its North Carolina-based retail bank. In Mr. Winograd's department, it has meant a bunch of things. It's a major player in selling and trading bonds in Europe and Asia, and almost overnight it became the largest dealer of so-called "Maple bonds," debt issued by foreign companies but denominated in Canadian dollars. It pushes around Australian and New Zealand currencies with the same comfort as Canadian dollars.

Yes, Mr. Nixon acknowledges, the traders are placing bigger bets, but not disproportionately to the growth of the bank. RBC has also offset risk by ruthlessly culling its loans to corporate customers, by far the biggest source of trouble for a bank during an economic downturn.

So far, the strategy has worked gloriously. The bank is on pace to shatter the $4-billion annual profit mark for the first time, and investors are getting giddy on the quarterly fix: RBC, despite the furtive musings about risk in some corners, is trading at a clear premium to its peers, including TD.

Suzann Pennington, a portfolio manager with Saxon Mutual Funds, credited RBC's diversification as a primary support for the stock's value. The bank's retail and wealth management business is so powerful, she said, that it's capable of smoothing out a lot of trading mistakes.

"Maybe it's not such a bad thing," she said of Mr. Nixon's strategy. "I don't know the answer to that yet."

Mr. Clark repeatedly insists that he "doesn't get too fussed" that his stock trades at a discount to some of the other banks, such as RBC, although some who know him insist he most definitely is fussed by it. Whatever the case, he seems resigned to the fact that TD won't get a primo price-to-earnings multiple until it can prove its mettle when the credit picture darkens.

"Until there's a [downturn in the] credit cycle, I don't think that our strategy will drive a superior P/E," he said, "because right now the markets are saying there's virtually no risk."

TD's Ed Clark

RBC's Gord Nixon

• On the analysts
'We had a blowout operating quarter, and the fact that a 23-per-cent profit increase didn't satisfy them, you sit there and say you can't get too fussed by that, because you the start to do dumb things in running your institution.' 'You listen to these analysts too much. They're not always right.'
• On risk and valuation
Until there's a credit cycle I don't think that our strategy will drive a superior P/E, because right now the markets are saying there's virtually no risk. And so, in fact, people who extend up the risk curve are getting those earnings without having to pay a big price for those earnings.' 'I think the real question is if your look at those [capital markets] businesses, what are the relative values of those businesses compared to retail banking U.S., retail banking Canada, etc? Because the jury is out on that.'
• On each other's bank
'If someone else has a magic formula that produces even better returns, I say well good for you. But don't think TD could run those strategies. I know we couldn't run those strategies.''They've never had an investment banking franchise like we have in Canada: mergers and acquisitions, new issues, equity trading, equity derivatives, global fixed income, all of these businesses... What I will give you is that we've been more committed to the capital markets, globally, than TD has.'
• On the U.S. retail market
'I'd rather put the energy into figuring out how I can make the retail bank compete with Bank of America successfully, because I don't have to put the energy into that. I can import intellectual capital throughout the organization, because it's the main game that we're in.' 'We also believe that we should be patient in the U.S. If you look at acquisitions in the United States, they're still expensive. We have concerns about the performance of that market relative to Canada and other markets where we've been investing.'
• Capital markets profit

The following graph shows how much of the banks' overall profit is derived from their capital markets units, which include investment banking and trading, among other businesses. TD's reliance on capital markets has decreased dramatically, while RBC's has increased modestly.

2000 - 23% - $508-million      2006* - 33% - $770-million
2000 - 39% - $778-million      2006* - 21% - $339-million       * First 6 months of fiscal 2006

• Market risk

Banks are required to set aside capital according to how risky their assets are. This graph shows what percentage of a bank's total risk-adjusted assets is represented by capital markets risk.

Q4, 2000 - 2.2%      Q2, 2006 - 6.9%
Q4, 2000 - 8.5%      Q2, 2006 - 2.6%;