Friday, September 08, 2017

RBC & City National: How Canada’s Biggest Bank Overhauled Its US Strategy

  
The Globe and Mail, James Bradshaw, 8 September 2017

There's no sign of Michael J. Fox, Helen Mirren, Martin Scorsese or any of the other Hollywood stars who have been clients of City National Bank in CEO Russell Goldsmith's office. The closest hint of celebrity in Mr. Goldsmith's eighth-floor, Beverly Hills suite is an autographed picture that shows him shaking hands with Ben Bernanke, formerly the world's most powerful central banker as chairman of the U.S. Federal Reserve.

There are prints by artists David Hockney and Richard Diebenkorn, whose genius captured California's essence, interspersed with more personal mementos such as a photo with his father Bram, who preceded him as chairman and chief executive officer of the financial institution that's known in the United States as a premiere private banker to Hollywood.

And just behind his desk there is a plain white, faintly rumpled golf cap emblazoned with a blue RBC logo.

The cap is an important nod to City National's future – and to its parent, Royal Bank of Canada, which bought the Los Angeles-based bank for $7.1-billion in 2015. But it's also the only visible token of RBC's ownership in Mr Goldsmith's digs, which is emblematic of the Canadian bank's new, lower-profile approach to winning in the fiercely contested United States banking market.

The deal to acquire City National signalled a complete reboot of the Canadian bank's U.S. strategy and is the signature gambit RBC CEO Dave McKay has undertaken in his three years at the helm. It was RBC's largest acquisition in recent memory and the third-largest purchase by a Canadian bank since 2000.

The acquisition has left him with something to prove. Smaller rivals such as Toronto-Dominion Bank and Bank of Montreal built extensive banking networks south of the border – the former has more than 1,200 branches across the U.S. eastern seaboard, while the latter has been growing BMO Harris Bank in the Midwest since the mid-1980s. But for at least two decades – perhaps even longer – Royal Bank's top executives have wrestled with the question of how and where to find international growth.

In the late 1990s and early 2000s, John Cleghorn took a stab at a number of deals, most of which didn't work out and the most significant of which was for a North Carolina bank called Centura Banks Inc. His successor, Gord Nixon, struggled valiantly to turn it into a meaningful foothold in the southeastern states, only to retreat after absorbing losses for 10 straight quarters in the aftermath of the global financial crisis.

Canadian banks have never won success easily in the crowded, cutthroat U.S. banking market. But with the acquisition of City National, Mr. McKay is trying again, driven by the need for new growth to supplement returns from a relatively saturated Canadian banking market. This time, he's charting a different course. The bank's executives have learned lessons from past missteps, he says, and have developed a more effective strategy to thrive in the United States.

Rather than trying to win the hyper-competitive retail market, RBC is staking a claim to a new niche south of the border: high-net-worth wealth management. Instead of slapping the bank's Canadian name on its new acquisition and "RBC-izing" its operations – costly mistakes it made the last time round – it's aiming to let City National be its own brand and largely preserve its own identity and culture as a high-touch relationship-based private bank to the stars. It even installed an executive on the California bank's board whose job has been, in part, to help ensure City National's independence by controlling the flow of demands coming from RBC in Toronto.

Whether RBC's light-touch approach will succeed is a vital question for the bank's long-term plans and could go a long way toward shaping Mr. McKay's legacy.

A new approach

Mr. McKay's courtship of City National began in the summer of 2013, at the Peninsula Hotel in Beverly Hills. When he first reached out to Mr. Goldsmith via a mutual acquaintance, RBC was a mystery to the U.S. CEO. The two executives spoke for the first time over dinner at the hotel. It was clear, though, that they are cut from different cloth. Mr. Goldsmith is the consummate relationship banker, with a warm smile and gregarious nature well-suited to Hollywood deal-making. Mr. McKay comes off as more conservative, a restless intellectual shaped in the more staid mould of Canada's banking culture. Even so, "we really connected," Mr. McKay said.

There was just one problem: City National wasn't for sale. "We saw a bright path ahead for City National as an independent company," Mr. Goldsmith said.

Mr. McKay, on the other hand, saw a promising future, and the lessons learned from the last time the bank tried to plant its flag on U.S. soil were never far from mind.

He was determined to avoid the mistakes that unfolded after RBC bought Centura Banks Inc. in 2001 for $3.3-billion as the centrepiece of an experiment in personal and commercial banking. Applying a piecemeal approach to the U.S. market, the Canadian bank soon took on another acquisition, Alabama National Bancorp., for nearly $1.8-billion, and assembled a loosely knit collection of more than 400 branches across six southeastern states including Georgia, Virginia and Florida.

But the network of outlets never achieved critical mass. Scattered across a string of disparate, smaller markets and heavily dependent on mortgage and construction lending, it struggled when the U.S. financial crisis struck. RBC had tried to establish a clear brand identity, splashing its name across its U.S. properties and eventually dropping the Centura brand altogether, naming its retail network RBC Bank. It even shelled out to name the arena that is home to the NHL's Carolina Hurricanes the RBC Center in an effort to build its brand in the United States. (The rink has since been renamed PNC Arena).

Yet as the financial crisis deepened, the bank was forced to swallow billions of dollars in losses and writedowns. By 2011, RBC had opted out of the U.S. retail banking market, selling its southeastern operations to Pittsburgh-based PNC Financial Services Group for $3.62-billion.

As it regrouped, RBC began looking at economic trends, assessing different parts of banking's profit pool, and looking at where the bank still had U.S. assets that could be built out – and by the time Mr. McKay reached out to Mr. Goldsmith, the executive team was developing a new vision. "We started by narrowing down to a space," said RBC's head of strategy and corporate development, Mike Dobbins.

The bank didn't want another retail network, particularly at a time when digital disruption and the rise of new fintech players is complicating the consumer market, Mr. McKay said in an interview at his Toronto office. Instead, RBC set its sights on three or four lenders occupying a different niche – high-touch, relationship-based private banking catering to high-net-worth and commercial clients. "But none had the breadth of City National," he said.

So at the restaurant table in Beverly Hills, Mr. McKay told Mr. Goldsmith: "I want to be your first call if you change your mind. That's all I want to hear." Then he flew home, determined to be patient but persistent.

Not long after, Mr. Goldsmith came calling. By 2014, the two banks were talking, and Mr. Goldsmith began to see the logic of his Canadian counterpart's vision. RBC wanted to unlock the potential of its undersized U.S. wealth-management business, headquartered in Minneapolis, and to drive its highly competitive New York-based capital markets arm to new heights. And City National saw the potential to grow much faster with access to RBC's larger balance sheet and sterling credit rating.

Mr. McKay and Mr. Goldsmith also grew closer. "I think we've become friends through the process," Mr. Goldsmith said in an interview in Beverly Hills. "We've, on occasion, played golf together and we enjoy each other's company."

The deal was announced in January of 2015 and closed in November the same year.

It's something of a truism that banks are sold and not bought. But in this case, City National wasn't being offloaded, notes Jared Shaw, an analyst at Wells Fargo Securities LLC. "They had everything going for them, at the time, and I think they still do."

Keeping in mind what went wrong last time, Mr. McKay plans to integrate City National with a lighter touch this time around.

After acquiring Centura, for example, RBC sent its own team of managers south to run the operation, and tried to do a full integration of operations and technology systems, none of which meshed properly. And at a deeper level, RBC acknowledges it never found a good cultural fit.

"The mistake we made with Centura [was that] we tried to RBC-ize a southeastern bank in the United States who has their own process and customers," Mr. McKay said. "We tried to make it too much like RBC, and it ended up neither like them nor like us, and in this very bad place in the middle. We learned from that."

With City National, Mr. Goldsmith and his senior management team remain in charge, with three Canadian directors on the bank's board, including Mr. Dobbins, who acted as a gate-keeper of sorts. From the start, RBC has carefully managed the flow of influence and information from one bank to the other.

Senior bankers from both sides would gather to go through client lists, looking for opportunities to refer business back and forth. Finance and risk systems have also been integrated, and the two banks hold quarterly business reviews.

Mr. Dobbins's routine included speaking weekly with business leaders at RBC to make quick decisions about which of their priorities should be brought to City National's attention. "They'd say: I want to do this. We'd debate whether that was light-touch or not, and we'd talk about, is it critical or is it nice to have? And that's how we made decisions," he said.

RBC wants City National to treat its parent like a store, picking and choosing from the menu of products and resources it needs to accelerate its growth.

"I think every company treats an acquisition as a new shiny toy," Mr. McKay said. "We can't have 75 different executives picking up the phone and asking them to do something or getting involved. They don't need it. They've been extremely successful as a standalone company for 60 years."

Maintaining City National's character and reputation will be critical to future success. Founded in 1954 in Los Angeles, the bank has been led by a Goldsmith for more than 40 years: Russell's father Bram from 1975 to 1995, and Russell ever since. And it has deep roots in the entertainment sector – founder Al Hart was a Columbia Pictures board member.

Its clientele, whose identities are closely guarded by industry norms of privacy and discretion, has been known to include Hollywood superstars, including legendary singer Frank Sinatra. In 1963, when the singer's son was kidnapped, City National opened its vault to put up $240,000 to pay the ransom. More recently, it has built a tidy business financing Broadway from its New York offices.

But it is also a successful commercial banker to less glamorous industries, from legal services and biotech to fast-food franchising and wine making. Add to that a low-cost deposit base, a strong reputation in wealth management and a balance sheet that was poised to benefit from expected interest-rate hikes, and it's no wonder the California-based bank looked like an attractive takeover target.

"City National is kind of a crown jewel, a unique business with a very high-end clientele," said Meny Grauman, an analyst at Cormark Securities Inc. "And so it fits in nicely to what Royal Bank already has in the United States and to what Royal Bank's ambitions are."

Yet no integration of two large companies goes totally smoothly, and it takes time to build trust. It's natural for employees to worry about job changes and harbour suspicions about the the new parent's intentions. "We had actually planned for them to be a little bit unfocused as we closed the acquisition," Mr. McKay said. But "they just rocketed right through the close. They just didn't miss a beat."

One thing that helped, according to Mr. Goldsmith, is that no one was laid off or fired because of the merger – "which I think makes it unique among bank mergers of any consequence in the last 30 or 40 years in the United States," he said. Instead, the bank has hired more than 450 new people, luring teams of bankers away from rivals, and now has about 4,400 staff.

But the threat of homogenization remains a key concern. "When you're a small piece in a larger organization, there's a risk that the larger organization changes the magic formula," said Mr. Grauman of Cormark.

Banking on growth

The first of what Mr. McKay calls "critical moments of truth" came about a month after the two banks formally merged, in December of 2015.

Thanks to Mr. Goldsmith's connections, RBC's capital markets arm had a chance to get involved in a $250-million public stock offering out of California. The shares belonged to Santa Monica-based Kite Pharma Inc., a major player in emerging cancer treatments. The deal was tricky and exceeded RBC's built-in risk controls, so it was kicked up to Mr. McKay and the bank's chief financial officer at the time, Janice Fukakusa, for approval.

"We got it done, we made a quick decision, we got comfortable with it," Mr. McKay said, and RBC took part as joint book-running managers.

The deal may seem comparatively small, but Mr. McKay insists "those are seminal moments" because they compel the two banks to work together on a complex problem. "It builds connective tissue," Mr. McKay said. "We're all in this together. This is not us and them, which is a little bit what happened in the old Centura days."

There have been other deals like it since then, though RBC is reticent to name its clients, and there will need to be many more if the bank is to reach its ambitious targets for the coming years.

City National has been growing fast, and "we've accelerated our growth plans as a result of the merger," Mr. Goldsmith said.

At the time RBC acquired it, the bank had about $36-billion (U.S.) in assets and had delivered uninterrupted quarterly profits for 23 straight years. Its assets have now swelled to $47-billion and it contributed $79-million in profit in RBC's fiscal third quarter – a 26-per-cent increase from a year earlier even after accounting for ongoing integration costs.

Looking ahead to 2020, RBC projected that City National could more than double its 2015 pretax profit to $1-billion (Canadian), which would represent a compound annual growth rate of about 22 per cent.

To make the grade, RBC needed interest rates to rise to help its U.S. arm make better margins, and the Fed has so far delivered with three quarter-point rate hikes since December. Each separate hike was expected to be worth about $50-million in profit for RBC's U.S. wealth management franchise, including $35-million from City National.

Growth is also expected to come from expansion into new markets. With RBC's support, City National has opened a third office in New York, and is eyeing a short list of other major cities such as Boston. It has set up shop in Washington, where there's a robust market for legal services, which is one of City National's existing strengths.

And it has opened its first full-service regional banking centre in Minneapolis, in support of RBC's existing wealth management business, which has nearly 2,000 investment advisors. "We had some great assets, but we couldn't unlock the value there," Mr. McKay said. "So how do you unlock that value? … We want to serve a high-net-worth commercial client."

City national has helped RBC reach that client, but McKay is clear that the expansion plan has limits. "We stay to that footprint. That's it," he said. "There's so much opportunity, we're so small within those markets that the last thing you want to do is spread yourself too thin geographically and not cover a market properly."

Another substantial chunk of City National's growth is expected to come from the two banks joining forces to drum up new business. With access to RBC's balance sheet, City National can lend larger sums and finance more jumbo mortgages. And there is also a pipeline to refer business back and forth with RBC.

The earliest benefits were apparent in RBC's New York-based capital markets division, which the bank has continued to build into a top-10 American investment bank with 3.5-per-cent market share. Within two to three years, RBC hopes to grow to its share to 4.5 per cent and move up the rankings.

"Russell introduced us to a number of clients that were thinking of making acquisitions or raising equity," Mr. McKay said. "That's led to business."

But City National's hallmark, its real competitive edge, remains the white glove service it offers.

Nancy Novokmet runs Need Financial, a Los Angeles-based firm that provides back-end accounting and operations to entertainment companies that shoot and produce TV commercials and films.

Her staff has access to a group of dedicated City National representatives who know her firm. And when a foreign production client needed funds released quickly to begin building a set abroad earlier this year, City National got it done within 48 hours.

"They understand the community. In production, there's this sense of urgency that's required," Ms. Novokmet said in an interview. "City National just responds very quickly, and it's not always the case with some of their competitors."

By forging long-standing connections with customers and keeping to major markets where it can compete, City National has built "a defendable moat," Mr. McKay said. "They didn't try to be everybody to everyone. They win on service, they win on speed of turnaround, they win on customization."

But the City National need for speed could still test RBC's appetite for risk.

While Royal of Canada does business in many states across the U.S., the markets it considers a priority for future growth have changed. It once sought to build a network of retail branches for day-to-day banking across a strip of the southeastern U.S. But now it plans to grow its presence in key cities with a concentration of high-net-worth and commercial clients.



Wild cards

Mr. McKay was tapping out an e-mail to Mr. Goldsmith as a reporter entered his office this summer. The two CEOs were debriefing after a television interview Mr. Goldsmith had just given on business network CNBC, in which he suggested it was "time to take a fresh look at Dodd-Frank."

He was referring, of course, to the massive legislative response to Wall Street's 2008 meltdown, which sought to substantially de-risk the shuddering financial system. Like many bankers who feel handcuffed by its strictures, Mr. Goldsmith was arguing for leniency: "For seven years we've piled on a lot of rules and regulations, and it needs to be re-examined," he told the program's viewers.

Back in Toronto, Mr. McKay tuned in from his corner office above Bay Street. Navigating a maze of regulations – and the cost that comes with it – is the thing that worries him most, he said. As a standalone bank, City National used to enjoy the lighter regulatory burden of a mid-sized institution. But combined with RBC and its much larger balance sheet through a holding company, City National gets the large, complex bank treatment, which comes with greater scrutiny from Washington.

That has generated mountains of new work. The combined bank has roughly 300 people involved with just one regulation: The stress-testing exercises known as the Comprehensive Capital Analysis and Review, or CCAR.

"That regulatory change has been difficult for a small bank, and us even, to handle," Mr. McKay said.

At the same time, private banking and wealth management are being reshaped by new regulations and shifting demographics. As the sector "has witnessed a regulatory avalanche over the last few years," banks looking to expand have to navigate a slew of reputational and regulatory risks, according to a 2016 report from Deloitte & Touche LLP.

RBC hasn't been immune to such pressures. The bank has largely pulled out of wealth management in the Caribbean and Latin America, due partly to concerns about anti-money laundering controls. Last year, RBC faced pointed questions about its relationship with the law firm behind the leaked Panama Papers, Mossack Fonseca, through which RBC allegedly registered hundreds of shell companies.

But the regulatory regime in the U.S. is considerably stricter, and City National does its private banking onshore. Mr. Goldsmith notes that City National has succeeded "because our experienced banking colleagues take the time, and dedicate the resources – including the use of state of the art technology – to ensure that we know our clients well."

The other thing that keeps Mr. McKay up at night is "geopolitical instability," and "what could be the contagion effect back to the U.S. economy." Since RBC closed its purchase of City National in late 2015, the world has gone through a series of convulsions, from Brexit and the U.S. election to NAFTA rate hikes and the beginning of a long march back from ultralow interest rates.

The Fed rate hikes are helping ease a prolonged squeeze on banks' profit margins. But the Trump administration's economic agenda, which once produced a surge of confidence among American businesses, is now clouded with uncertainty. Promises of deregulation and tax reform have moved slowly through a chaotic administration, while negotiations to redraw the North American free trade agreement are jarred by periodic threats from the President to withdraw from the pact altogether.

Mr. Goldsmith sees encouraging signs in the U.S. economy, from a surging stock market to strength in housing, industrials and trade. And some of the potential reforms on the table – whether to overhaul Dodd-Frank, or to lower corporate taxes – could provide City National with a major tailwind.

"Even a 5- or 10-per-cent drop in our [corporate tax rate] would be enormously significant, but that's not built into anybody's projections," he said.

But he also knows there are good reasons to be wary. Uncertainty has a habit of making businesses to hold back on investments, which would be bad news for a commercially focused bank with ambitious plans for growth.

"Do I have concerns as to what the policies in Washington may or may not do? Yeah, and we follow it closely," Mr. Goldsmith said. "And I'm obviously particularly concerned to see what happens with any potential renegotiation of NAFTA."

RBC's challenge through it all is to fight the same tendency toward short-term thinking that may afflict some of the businesses it serves, and to continue investing in new business lines and digital capabilities.

And it means not shying away from further, smaller U.S. acquisitions if the price is right. RBC has been putting together a playbook to evaluate potential targets that could accelerate its growth in one of the priority markets. But with U.S. bank valuations at elevated levels, RBC is biding its time, and insists it doesn't need an acquisition in the near term.

"At the end of the day I would say we did this deal and we have a strategy for the next 20 years, which is five [U.S. presidential] administrations," Mr. McKay said. "Honestly, we did not even remotely think about political cycles when we did the deal. Nor should you, right?"
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