14 August 2009

Gordon Nixon: Legacy at a Crossroads

The Globe and Mail, Tara Perkins, 14 August 2009

The good news: Royal Bank of Canada escaped the Big Red Blush. Canada's largest bank never fell head over heels for subprime mortgages, nor was it seduced into any of the other risky trysts that have been coming back to haunt banks around the world since the financial crisis began.

So why did RBC's latest quarter produce the bank's first loss in 15 years?

That would be the bad news. The loss reflects a $1-billion writedown in the value of Royal Bank's U.S. banking operations. It's an acknowledgment that the bank's stateside strategy is, as ever, stuck in neutral.

Unlike writedowns relating to toxic exposures, this charge didn't mar the bank's precious capital levels. But that doesn't make it any more palatable to chief executive officer Gordon Nixon, who has been sweating over the States since his first day on the job.

It was eight years ago that Mr. Nixon, then a wunderkind investment banker, took charge at Canada's biggest bank. His predecessor had just bought a U.S. bank, and it fell to Mr. Nixon to make the purchase work.

Less than two months after Mr. Nixon's ascension, 9/11 walloped the economy. The U.S. bank has been a headache for him ever since.

At 52, Mr. Nixon is one of the longest-serving chief executives among the world's top banks. He was named Canada's Outstanding CEO of the Year in 2007, and he has since cemented his reputation by keeping his company grounded while the financial crisis shook the foundation of world's banking system. Investors have rewarded him: By market value, Royal Bank is now the world's 12th-biggest bank. (The distinction, it must be said, is partly owed to the shrinking value of many major banks.)

But its U.S. bank, now called RBC Bank, could still make or break Mr. Nixon's legacy.

The U.S. market has always proven problematic for foreign banks, his included. But now, thanks to a crisis that has cast more than 300 institutions onto regulators' watch list of “problem banks,” a buyer's market beckons – and, arguably, a once-in-a-generation opportunity to build a major presence in U.S. banking.

Mr. Nixon has always been cautious – too cautious, many have said – about beefing up RBC Bank. When he has taken action, the record has been mixed. Royal Bank's most recent expansion attempt, a $1.6-billion (U.S.) takeover of Alabama National Bancorporation, has turned out to be what one analyst calls “a disaster.” Redeeming the U.S. banking strategy won't be easy.

“Up until now, it is the only strategy that everyone, even Royal probably, would admit has failed for the company,” says Darko Mihelic, an analyst at CIBC World Markets. “Other strategies within wealth management and capital markets have proven successful over time, and this one has failed.”

Mr. Nixon confronts a choice between exiting the U.S. consumer lending business, or growing it. “You're either admitting you made a mistake and you're exiting, or you are stubbornly refusing to admit that you made a mistake and you're going to plow more money into it,” Mr. Mihelic says. “Either way, it's not a great outcome.”

Mr. Nixon dismisses the exit option as “very unlikely.” He sees a third alternative: “Also very much on the table is that we continue to just build a smallish but very strong regional bank.”

But that's the strategy, observers point out, that got Royal Bank into its quandary in the first place.

“Focusing on [improving] returns is a good short-term strategy but not necessarily a good long-term strategy,” says Edward Jones analyst Craig Fehr. “I think growth is an important part of this puzzle, and I think that's largely going to come through acquisitions.”

Sumit Malhotra, an analyst at Macquarie Capital Markets, is skeptical. “Given the historically low rates of return associated with regional banking in the U.S., perhaps the bigger issue is whether [Royal Bank's] management wants to get bigger in this business,” he says.

Growth by necessity

While industry executives are loath to admit it, the Canadian banking market is so mature it's sprouting hair in its ears. With room for growth limited, market share changes among the big five are often just give-and-take skirmishes fought with fierce pricing incentives. Royal Bank is so tapped out in Canada that it's muscling up against the legal lines that prevent it from selling insurance, in some locations offering that service and banking in adjacent storefronts.

So RBC wants to increase the proportion of its business that's coming from abroad. Immediately to the south lies the world's biggest banking market, an elusive pot of gold that's led many banks over the rainbow.

As the financial crisis has illustrated, banking is a different game in the U.S. In contrast to the concentrated, orderly Canadian industry, more than 8,000 institutions are battling for customers in a market that is still tinted with cowboy capitalism: Mortgage rules are looser, capital requirements are lower, and many regional banks thrive simply by arbitraging the difference between short-term and long-term interest rates.

Canadian banks have pulled through the global crisis with high marks precisely because they didn't take many of the risks that were once so profitable for their counterparts in other countries. With regulators around the world moving to tighten and harmonize banking rules, Canadian banks might now find it easier to go head-to-head with incumbents in the American market.

Royal Bank made its first real foray into U.S. consumer and small-business banking (known as “retail” banking) just months before Mr. Nixon stepped into the CEO role in 2001. His predecessor, John Cleghorn, had just paid $2.3-billion (U.S.) for Centura Banks Inc. At that price, the mid-sized lender, with 241 branches and 3,600 employees in the Carolinas and Virginia, was the largest foreign acquisition that a Canadian bank had ever made.

But Centura's results disappointed right out of the gate, and Mr. Nixon inherited the challenge of making the gamble pay off. Mr. Nixon was careful – or timid, in critics' view – from the start. In the first year he took a look at, but passed up, batches of branches that were put up for sale by Wachovia Corp. and Huntington Bancshares Inc.

In 2005, Mr. Nixon presciently sold off Royal Bank's U.S. mortgage origination business, RBC Mortgage Co., which it had acquired (as Prism Mortgage Co.) in 2000. It was the type of operation that helped trigger the financial crisis with overaggressive mortgage sales tactics. Indeed, late last year, the U.S. government alleged that between 2001 and 2005, RBC Mortgage Co. falsified documentation in support of mortgage loan applications, leading to a $10.71-million settlement.

The decision to abandon RBC Mortgage likely saved Royal Bank's U.S. banking business from a much grimmer fate. Most of the mortgage company's assets were sold to New Century Mortgage Corp., the subprime mortgage lender whose 2007 bankruptcy was one of the pivotal events of the crisis.

Rather than play hot potato with risky mortgages, RBC decided to focus on bread-and-butter lending, the type of business it thrives on in Canada. With Centura's network limited largely to rural areas and small towns, RBC Bank aimed to add strength in cities.

During 2006 and 2007, the bank made three more modest acquisitions that expanded its southeastern footprint. First was the takeover of an Atlanta-based bank with 26 branches and offices. That was followed by a move into Alabama with the purchase of 39 AmSouth branches for roughly $400-millionUS or Canadian?. And then, also in Alabama, came a bigger role of the dice.

Alabama beckons

On a damp September day two years ago, Mr. Nixon met with John Holcomb III, the CEO of Alabama National Bancorporation. The encounter was the culmination of a dance that had begun the prior December, when Scott Custer, head of RBC's U.S. bank, phoned Mr. Holcomb and broached the idea of buying his company.

In the interim, Alabama National had become a more eager seller, as mortgage defaults and home foreclosures rose, and credit quality deteriorated in some of its key markets, such as Florida and Alabama itself. For its part, Royal Bank had become a more eager buyer as the prospective price of the acquisition dropped.

So, on a day when U.S. regulators put out an unusual notice urging financial institutions to cut some slack for borrowers who couldn't afford their mortgages any more, Mr. Nixon, Mr. Custer and Peter Armenio, then in charge of RBC's U.S. and international strategy, sat down with Alabama National's executive team in Toronto, and agreed to the final terms of a $1.6-billion (U.S.) takeover.

Thirty-six per cent of Alabama National's loan portfolio was in real estate construction, with a further 28 per cent in commercial mortgages – the very stuff that has since caused so much destruction on the balance sheets of some U.S. regional banks.

Since the deal, the value of U.S. banks have plummeted.

“Regret is a difficult word,” Mr. Nixon says when asked about the timing of the purchase. “If we had acquired Alabama National today, it would have been just as strategic, but we would have acquired it at a very different valuation. If you look at any investment that has been made in the last 15 years in the United States, there have been few dollars that have been good investments.”

About seven months after Royal Bank announced the purchase, Mr. Nixon unveiled a management shakeup, his second in four years. This one saw Mr. Armenio retire and Jim Westlake, who had previously run RBC's Canadian retail banking operation, named head of international banking and insurance.

“Our short-term financial performance has not been pleasant,” Mr. Westlake acknowledged in a July interview from Atlanta.

With its street strength now standing at 430 branches in six southeastern states, RBC Bank last year ranked 31st by deposits among U.S. banks, according to data from SNL Securities. (Larger rivals that compete in the region include SunTrust Banks Inc., Regions Financial Corp. and BB&T Corp., which ranked seventh, ninth and 10th nationally.)

The Southeast has been disproportionately hit by real estate pain, but Mr. Westlake says the region is still the country's strongest growth market for banks in the long term, thanks to favourable demographic trends. What's more, the U.S. “is still the largest banking market in the world, and one where we intend to do well in the future.”

This spring, Royal Bank drafted a three-phase turnaround plan for RBC Bank that it hopes to complete within two years.

A better record on lending is a key part of the fix. RBC Bank represents a mere $30-billion (Canadian) of Royal Bank's $680-billion in assets and, roughly in keeping with those numbers, its U.S. loans are only 15 per cent of the total. But in the latest quarter, the U.S. caused more than half of Royal Bank's loan losses.

U.S. acquisitions

If its stateside salvation is to be realized through acquisitions, RBC must figure out how to capitalize on the fire sale expected in the industry – and how to not get burned by it.

It won't be easy, as the record shows. While Mr. Nixon has been accused of thinking too small, buying big is no guarantee of success, either. Toronto-Dominion Bank has spent roughly $20-billion (U.S.) in recent years to build up a U.S. bank with roughly $73-billion in deposits – but its most recent major acquisition was done at near the top of the market and it's still unclear whether the strategy will pay off.

Canadian Imperial Bank of Commerce, which is now in early stage discussions about taking a stake in a troubled Irish bank, may be looking overseas in part because its own U.S. forays have been disastrous. A decade ago, the bank tried to build a U.S. retail bank by putting branches in grocery stores, but pulled the plug on the experiment after hundreds of millions of dollars in losses. And Bank of Montreal has had its own struggles with Harris Bank, despite the latter's well-established market position in the U.S. Midwest.

Still, there's no denying that the price of expansion is far more reasonable now than when RBC and TD made their earlier deals. For example, SunTrust Banks Inc., the regional rival that is a favourite of the analysts who are pushing Royal Bank to make an acquisition, has $116-billion of deposits and a market value of roughly $10.5-billion; not long ago, it was worth $30-billion.

Mr. Nixon subscribes to estimates that as many as 1,000 banks will fail as customers buckle under the weight of their debts.

“We think we can position our bank in the United States very well as the U.S. evolves and restructures,” he says during a July interview in his office in Toronto. “The $64,000 question is, what does that mean strategically?”

He figures he's got some time to answer the question. The U.S. government's capital infusions into the nation's 19 largest banks has alleviated the pressure to consolidate. Banks that have been bailed out by the government or refinanced have bought themselves some time, and “it's very unlikely you're going to see a significant amount of acquisition activity in the near future,” Mr. Nixon says.

When the opportunities do ripen, Mr. Nixon says it might result in an acquisition or a merger – or perhaps selling RBC Bank to a U.S. bank that Royal Bank takes a stake in. “We want to have the flexibility to have lots of options available to us,” Mr. Nixon says.

No sooner does he make that declaration than Mr. Nixon acknowledges that his position sounds a bit “wishy washy.” But he doesn't mind the rap. In his view, his patience and caution has served the bank well so far. Many Royal watchers agree.

“They faced a lot of pressure prior to the crunch to make a big splash in the U.S., and they chose not to,” says Peter Routledge, senior vice-president of financial institutions at Moody's. “Sometimes a good strategic decision is what you decide not to do.”

“If I were Gord, I would feel vindicated that I resisted pressure from analysts and investors to make an acquisition at what turned out to be the peak of the market,” says Rob Wessel, a former bank analyst and industry expert.

But the peak is ancient history now. And Royal Bank is well positioned to be an acquirer. Its capital ratio sits at 11.4 per cent, having risen from 9 per cent in just six months. (The regulatory minimum is 7 per cent.) “We are significantly overcapitalized,” Mr. Nixon says. “We can grow our businesses and our balance sheet over the next number of years. A lot of our international competitors are going to have to either raise a tremendous amount of equity or shrink their balance sheets.”

The majority of analysts who follow RBC say Mr. Nixon is wise to take a bit of time to see how U.S. prospects shake out. But, they add, he can't wait too long.

“My view is that, if your stock is performing this well anyways, take your time and make the right decision,” says Mr. Mihelic, the CIBC analyst. But if the recovery occurs more quickly than expected, opportunities will start to dry up, he adds. In this scenario, the bank's window of opportunity could be as short as six to 12 months.

Mr. Nixon believes that the financial crisis will be followed by a golden age for banks. It's a relatively rare view, and one that might make him inclined toward having a larger U.S. presence. But he will not be rushed.

“I'm not sure that everyone will see that," he says (of the coming golden era). “We want to make sure we participate in a very smart way.”