Bank of Montreal (BMO) Q3 2022 Earnings Call Transcript

Operator

Thank you. We will now take questions from the telephone lines. [Operator Instructions] Our first question is from John Aiken from Barclays. Please go ahead.

John Aiken

Good morning. Dave, I wanted to discuss the US deposits. Can you speak to what you saw in terms of customer behavior in the quarter? And what this leads you to believe in terms of growth moving forward?

Dave Casper

Good morning, John. I think actually, I would say, both in Canada and the US, the deposit profile matches exactly the way we modeled the deposits in this rate environment. In the US, we have seen a small decline quarter-over-quarter. We are not quite aggressive in terms of matching some of the competitors’ rate offers. We have not moved, for example, our digital deposit offers to an active state yet. And therefore, the betas actually have been below where we have modeled them.

We do expect the betas to go up with each additional rate increase. And at one point, obviously, we will switch our digital offering on. But at this point, the slow outflow matches exactly the way we thought about how the deposits would behave. And the margin expansion that you have seen, the 21 basis point margin expansion in the US, reflects that effect.

Q – John Aiken

Thank you

Operator

Thank you. Following question is from Ebrahim Poonawala from Bank of America. Please go ahead.

Ebrahim Poonawala

Hi, good morning. I guess I just wanted to follow up. I heard you loud and clear in terms of the outlook for positive operating leverage in 4Q. But when we look beyond and we look at your year-to-date adjusted efficiency ratio of around 55.4%. Give us a sense of should we expect incrementally more improvement over the next year or two years in a backdrop that doesn’t get materially better either for capital markets and just overall for the economy? And if so, what are the drivers that would lead that efficiency ratio from the 55.4% into the low 50s?

Darryl White

Hi, Ebrahim, it’s Darryl. Maybe I’ll try to help you with that. Thanks for the question. So as I think about the future and how we travel on our PPPT performance and our operating leverage. Look, we’ll fall short here of giving 2023 outlook. We do that at the end of the year, but I can give you some of the considerations as we look at our business planning, we think we’ve got a lot of good momentum in our businesses, both on the revenue and the cost side.

You’re right, we’re at 55.4% year-to-date. That compares to a peer set that I think averages only 100 basis points on that. So on the one hand, I would say that number used to be several hundred basis points the gap and now it’s pretty narrow. And at the same time, it’s a little higher than the average. So I think we continue to have a little bit of opportunity there. And as we build our plan as we go into 2023, we continue to think about operating leverage, we do have levers that we can continue to push on. And we’ll update you more on that as we get into the beginning of 2023.

Ebrahim Poonawala

Got it. And if I can just quickly follow up in terms of Tayfun, on your comments on the margin. I guess one near term, is it possible that we see a similar level of expansion through consolidated in the segments in the fourth as we did in 3Q? And beyond that, as we think about the deposit pricing and some of the comments you made earlier. Give us a sense of does Bank of the West and when you look at their deposit betas, not very different from US regional bank deposit betas last cycle? How does that inform your deposit strategy in the US as you move towards deal close?

Tayfun Tuzun

Yes. Look, I mean, I think our NIM performance continues to be very strong. — Now to be honest with you, it looks even better when you take into account how well we have protected the downside since the start of the COVID environment. We do expect margin expansion going into next year, as I said. I try not to give quarterly updates because it really depends on the frequency and the magnitude of the rate increases. But yes, we expect NIM expansion next quarter and we expect NIM expansion into next year.

In terms of the contribution from Bank of the West, they clearly have a very good core deposit portfolio, and core deposit portfolios tend to actually be very beneficial in terms of maintaining margins on — depending upon what part of the rate cycle you’re in. So once we actually absorb that balance sheet and start planning for the future, helped with our now national digital deposit gathering program. I do believe that we will have a better NIM profile even compared to the strongest today post Bank of the West.

Ebrahim Poonawala

Got it. Thanks for taking my questions.

Operator

Thank you. The following question is from Doug Young from Desjardin Capital Markets. Please go ahead.

Doug Young

Hi. Good morning. Just wanted to start. Can you size out the book in which you took a mark, I guess, the leverage lending book which took the mark this quarter? And maybe if you can provide any more details on sector-wise or any more details on it? And just provide some color as to — or quantification as to why you feel comfortable with the marks. It sounds like you’re feeling comfortable and things are improving as you move through Q4. Just hoping to get a little more detail on that.

Pat Cronin

Sure. Doug, its Pat Cronin. Thanks for the question. Maybe I’ll do two things. First, I’ll separate out the loan book, which is quite a bit of a different thing altogether from where the underwriting markdowns came from. So the loan book, then the size of that is what we disclosed in the annual report.

So you would have seen that number in last year’s annual report, it was just over — slightly over $20 billion under our definition. I want to be clear, our definition is sub-investment-grade loans to portfolio companies of financial sponsors. So that’s what’s under that definition. And you can apply wholesale loan growth rates that you’ve seen since that report was published and get a sense of what the current portfolio would look like.

Now, of that total, we make a very clear distinction into two segments. The first is things — parts of that portfolio that are highly secured. So these would be ABL, RBL, real estate secured loans, there are some capital call loans in there. So we treat those quite differently. And in fact, the leverage lending limit that we apply to this business, we don’t actually even include those into that limit, because we view them as a very different risk profile, and that’s supported by years of data around gross impaired loan rates and PCL experience.

So the real portion of the loan book that we limit with our internal limit is traditional cash flow deals to those financial sponsors that I just talked about. That is roughly about 55% of that total that I just talked about. And we’re very comfortable with that whole book. The current — first of all, the current condition is very strong, notwithstanding what you might be reading about in the environment.

Our gross impaired loan rates continue to come down. And, in fact, we’re about 100 basis points lower on the gross impaired loan rate than where we were a year ago. The PCL experience has been very low. I mean, we don’t give out detail on the PCL for the segment. But if you look at our overall wholesale PCL this quarter, you can make a pretty good assumption that we saw almost no PCL from that segment this quarter.

And once you size it down to that number, you realize it’s actually a relatively small part of the overall portfolio. It’s, on any given quarter, just a little over 4% of our business and government loans. And that doesn’t even include some portion of that portfolio that we actually risk transfer to third parties.

It’s really well diversified to your sector question and it’s also diversified by hold size. We, on average, have hold sizes in that business of less than $20 million. So we’re actually quite comfortable with the book. We’ve seen very good performance from our sponsor clients, including during stress where they committed lots of additional capital to support those. And as you know, they’re sitting on a lot of dry powder right now. So we would expect under stress that, that to be the same.

Now separate that completely from the underwriting book. So these are positions that we do not intend to hold. We are intending to distribute to investor clients. That’s been a very good business for us over time. When I look at the fee revenue that we generate relative to the risk inherent in that business, as a risk professional, I think we’re very well compensated for the risk that we take.

We are going to find quarters like this where the market dislocation is profound and we’re not going to be immune to it. But in terms of sizing, as we don’t — typically don’t give that, but as of the end of the quarter, that book would have been in Canadian dollar terms, just slightly north of $4 billion in terms of total underwritings.

But I would note for you, though, that the markdowns that we did take were primarily concentrated in deals that were originated prior to Russia’s invasion of Ukraine. So it was quite concentrated. The markdowns that we took were quite consistent with broader base declines in the leverage lending market.

Now if you look at the broader leverage lending indices, that’s roughly about, on average, the markdowns that we took on those specific positions. Deals that we’ve originated since the invasion largely been with better terms and pricing. And in fact, we see virtually none of those with valuation issues that would cause us concern.

Specific to your question about valuation, we subject all of those marks to regular review and then a rigorous and independent review of valuation by the second line at quarter end. And so I would say, we’re quite comfortable with the marks that we took for Q3.

And I would note that, about 90% of that markdown was unrealized. We have seen a little bit of modest improvement in that market in Q4. So I’m certainly not calling for a recovery, but at least we’re heading in the right direction with a fair bit of unrealized.

To the extent those market windows open up for distribution, we’ll continue to whittle that book down. But at the same time, we’re originating new deals, as I said, at better terms that we’re quite comfortable with. So maybe, hopefully, that answers your question.

Doug Young

Very fulsome, I appreciate it. If I can sneak one more in just on corporate. It seems like you had positive earnings in corporate in the quarter. I think — and you can — correct me I’m wrong, I think in the past, it was guided to $50 million to $75 million quarterly loss.

But again, I could be probably I’m wrong on that. Just wanted to unpack some of the drivers, like was there anything around fund transfer pricing or gains on interest rate hedging or anything unusual that came to corporate?

Tayfun Tuzun

Yeah. I think the corporate segment tends to move around a little bit. This quarter just happened to be — there were some good mark-to-market valuations in our CRA investments in the U.S. So that had a positive impact.

And then compared to last quarter, last quarter, we recorded the underwriting fees for our equity issuance in corporate. So those two items basically move to Q-over-Q numbers, but there’s nothing that is unique this quarter that would impact the number.

Doug Young

Thank you.

Operator

Thank you. The following question is from Scott Chan from Canaccord Genuity. Please go ahead.

Scott Chan

Good morning. My question is for Darryl on Walter or Asset Management. You talked in the opening remarks having 50 investment people on the equity and fixed income team, and just wondering kind of the strategy there because obviously, it’s a pretty big investment. Is there like internalized asset opportunities, or is it mostly opportunities to gather assets over the medium-term?

Darryl White

No, no, great question, Scott, and thank you. And you’re actually right on both accounts. When we sold the EMEA business that took away a lot of the expertise we had in managing a lot of international portfolios, growth portfolios.

And so we took this opportunity to restack that. And it allows us to internalize a bunch of mandates that we have and then also expand the mandates to our distribution within our branches. So really it’s going to solve both issues for us.

Scott Chan

Is the focus on all segments, like in particular, retail or institutional or both?

Darryl White

Actually, so it’s going to allow us to do both. So we have very good institutional capability with the EMEA team. And with that gone, that reduced the amount that we could do, especially with international portfolios, equity and fixed income. So it’s going to solve both retail and institutional for us.

Scott Chan

Okay. Thank you.

Operator

Thank you. A following question is from Gabriel Dechaine from National Bank Financial. Please go ahead.

Gabriel Dechaine

Hi there. A couple of questions here. One, on the — for Pat on the credit side. When I look at the migration and the performing portfolio, we saw Stage 2 classified loans going up 18%, about $7 billion worth of loans. And I’m just — there’s a lot of moving pieces in the performing provision, but I see that increase in almost $26 million of pro forma to $22 million of pro forma in sales this quarter, but the number maybe could have been higher than that?

And then on a margin related question, and this pertains to the US business specifically. Deposit margins are increasing or it’s really driving the demand expansion. I see deposits down 2% sequentially flat year-over-year and was soft versus some of your peers. I’m wondering how the outlook for deposit growth was, if you’re seeing any commercial clients taking money of invested or whatever? And how that could trend over the next few quarters if the deposit base traits, how much of the NIM dampened, I guess?

Pat Cronin

Hi Gabe, it’s Pat. I’ll try and answer your first question. The audio quality was not great. But I think you were asking about the increase in Stage 2 balances quarter-over-quarter. And the answer there is quite simple. That’s really almost entirely a function of the deterioration in the economic outlook that we use to calculate the provision. So as you probably know, that affects staging. That really isn’t really migration in the traditional sense, because you would have seen in some — in the — particularly in the regulatory capital supplement, that credit risk RWA actually went down this quarter, and we had positive, actual positive risk rating migration in both consumer and wholesale. So, that’s really just purely a function of that worsening economic outlook.

I think the second part of your question maybe was you didn’t see that maybe show up in an increase or more of an increase in the provision, if that’s the question? That’s really…

Gabriel Dechaine

Yeah.

Pat Cronin

Okay. That’s really a function of the fact that, that economic deterioration would have all else being equal, increased the size of the provision. But as I said in my prepared remarks, that was largely offset by a reduction in the overlays this quarter. As you can imagine, as we get farther out of COVID, some of those specific COVID related uncertainty overlays are starting to come down. And that’s why you didn’t see the provision itself go up as much as you might have expected.

Gabriel Dechaine

Okay.

Tayfun Tuzun

On the NIM question, Gabriel, again, if I heard your question correctly. In the US, as I said, deposit betas have been slower than we expected. And you did refer to the 2% decline, which again, we expected that type of decline. We continue to protect our turf. We’re just not actively pricing up to attract for deposit growth, because we still have excess deposits in the US.

The 20 basis point margin expansion was very strong this quarter. We shouldn’t expect 20 basis points every quarter for the next three, four quarters. That’s not going to happen. But, nevertheless, we still expect expansion going forward, especially in our Personal and Business Banking business. We are benefiting from this more so than commercial.

In terms of — I think you were asking about client behavior on deposits. Dave, would you want to comment on what you see from the client side?

Dave Casper

Sure. So on the commercial side, we’ve had very modest decline, but very consistent with our peers on the commercial side. We had surge deposits. We maintain a large portion of those surge deposits larger than actually we thought, but our core deposits, which is really our bread and butter, where our clients are using us for their operating – continues to grow, and we feel real good about that. So the LDRs really are still stronger today than they were pre-pandemic. So we feel very good and expect to be able to manage this quite well. I hope that helps.

Operator

Thank you. Following question is from Paul Holden from CIBC. Please go ahead.

Paul Holden

Thank you. Good morning. A real quick one to start. Just to clarify, the loan markdowns. Was that purely mark-to-market or did include some realized losses as well?

Pat Cronin

Hi, Paul, it’s Pat. About 90% is unrealized. These are rough numbers. Then about 10% unrealized – realized, excuse me.

Paul Holden

Perfect. Thank you. And then I want to ask you a question on competitive dynamics in the commercial loan segment, both US and Canada. We’ve heard some comments from Canadian competitors that the markets awfully competitive right now and risk-adjusted margins are not particularly attractive in certain pockets. And then some data points in the US almost point to the opposite sort of conclusion that that the banks are tightening up underwriting criteria in commercial loans. So, just wondering, what your perspective is on both of those markets?

Dave Casper

This is Dave. I would say, for our business, both in Canada and the US, we see actually similar dynamics. Most of our clients, particularly the larger clients do business on both sides of the border, compete in similar industries. It is more competitive. And yet, if you go back over time, that’s almost always said.

And from my perspective, and I go back a long way in time, I actually don’t think it’s much more competitive for us. We really – and you’ll always hear this too. We never compete on price. You hear that all the time. The reality is, in our business, price is an important part, but the clients that we’re actually attracting and maintaining are looking at who can do the best job for them, helping them grow over the long term.

So yeah, price is important. But having a long-term perspective and being in the business as long as we have is actually more important. So is it competitive? Yeah. Is it more competitive in the US or Canada? I actually don’t think it is. And I think we just particularly, I can’t really talk about other banks. But for BMO, I actually see really strong continued momentum on new client acquisition for clients that are really looking for long-term supporters.

So I wouldn’t get overly exercised over what’s happening today. And I actually think the bank – our bank will do very well through the cycle and not substantially, certainly not change our risk appetite, but not change our risk reward to any extent as well. Hopefully, that helps. Might not be what you wanted to hear, but that’s what’s going on.

Paul Holden

It does help. Thank you.

Operator

Thank you. Following question is from Meny Grauman from Scotiabank. Please go ahead.

Meny Grauman

Hi. Good morning. Just two questions on the US P&C business. Two aspects of the results that I was hoping to get a little bit more color on. One is the sequential decline in non-interest revenue. And the other one, if I look at expenses in US dollars, up I think about 6% quarter-over-quarter. So wondering if you could provide more detail on that expense jump. Is there anything unusual going on in the quarter in the US P&C business from an expense point of view?

Dave Casper

So this is Dave again. Let me take the expense question first. We had a little bit higher expense this quarter, but nothing unusual. And if you look at it over the year, we continue to have positive operating leverage. And I’m really quite proud of the fact that our efficiency ratio is now well below 50 for the last several quarters, and I think that’s very strong. And I would expect it will continue to remain positive operating leverage in the US going forward.

The NIR question, there’s a couple of things there. It’s not overly complicated, but there’s one aspect. We have — I think we went down about $14 million in NIR quarter-over-quarter. And there was a $14 million decline in what we call our lease revenue. So let me just explain that very quickly. When clients buy equipment, they have a choice. They can either buy equipment directly and we make a loan. And if we do that, that’s all NII. That’s all interest. If they decide to lease it, they — actually, we get that revenue as NIR because they’re going to actually take the risk at the end on the residual. So the difference is, over time, more of our clients have actually decided to buy the equipment as opposed to lease it. And so we move it from NIR. Income goes from NIR to NII.

So that’s the substantial portion of the decline. But there are some other things we had some — we had a record first quarter in terms of some syndication fees, M&A fees, those have declined a little bit in the market as we’d expect. And lastly, while we — it’s not a big deal, it does have some impact in earnings business. We have gotten rid of all of our overdraft fees. And so that has a decline as well. And I think that’s the right thing to do for our business. And that should explain most of it. Does that help?

Meny Grauman

Yeah. That’s good detail. Just on the overdraft, would you be able to size that in terms of the impact?

Dave Casper

This quarter, I think it’s relatively modest. I couldn’t give you the exact number, but we can get back to you with some further detail. But it’s a portion of the NIR decline.

Meny Grauman

Got it. Appreciate it.

Operator

Thank you. Following question is from Mario Mendonca from TD Securities. Please go ahead.

Mario Mendonca

Good morning. Tayfun, your comments about BMO being able to protect the margin on the way down, but still benefiting on the way up. That’s an important one. Could you help me understand like breaking out the NIM, help me understand what’s happening with asset yields over the last, say, the last couple of quarters relative to the positive cost and funding costs generally? Is there a way to break that out, or do you provide that in your report to shareholders that I just haven’t seen yet?

Tayfun Tuzun

Yeah. We can provide you with more details on that, Mario. In general, I think, there are two factors that typically are important to note. One is the mix change as we look into our loan portfolio. That helps, as well as spread changes. But I’m happy to sort of follow that up with a more detailed discussion around both the commercial business as well as the retail business and give you directional comments on that.

Mario Mendonca

Okay. Sort of a follow-up to there. I’d like to look at the margins in various parts like your domestic retail, US retail and then everything else, which I’ll just call non-retail. And that non-retail margin, which, of course, incorporates wealth, capital markets, that sort of thing, but not the trading. The margin there has been really strong. Can you talk a little bit about what’s happening to the bank in the, say, the treasury function or just everything non-retail that’s supporting the net interest income?

Tayfun Tuzun

Yes. Look, I mean on the treasury side, as we shared with all of you in the past, our focus has been to manage our NIM to a stable direction. And we have done an excellent job in protecting the NIM. And that clearly has helped us to maintain support as rates have moved up. But at the same time, we also left room for more asset sensitivity.

I think the strength of the deposit franchise, you mentioned the loan side and the asset side, has helped us tremendously in that sense. And that comes true very much so in the US, Canada has been more stable. And also, in general, I think, when I look at the composition of our loan portfolios in our P&C businesses, I believe that to a certain extent, our smaller mortgage portfolio is helping us to also have a bit of an outperformance and the way the margin is behaving as well.

Mario Mendonca

If I could just quickly follow up then. BMO is the only bank where the all bank margin today is above where it was in Q1 2020. Every other bank would be slightly below to meaningfully below where it was in Q1 2020. And — would I be correct in suggesting that, that is very much can be explained by the different loan composition, BMO’s heavier commercial exposure? Is that the sort of structural advantages that you referred to or one of the advantages you referred to when you open up these comments about BMO’s business mix? Is that part of the story?

Tayfun Tuzun

I actually think that period-to-period, our hedging strategy and our very close focus in maintaining stability in our NIM is a big factor in that. But in addition to that, I think in general, our more commercial heavy exposure in our loan portfolio would also provide some help.

Mario Mendonca

Thank you.

Darryl White

Mario, I’m going to add to that, it’s Daryl. We talk about this a lot around here in terms of being margin managers as a core competency. The mix does matter. You’re on to an important point. And whether it’s in the wealth business, the capital markets business, the commercial business. When you think about them as high-touch relationship businesses, I mean we’ve been fond of reminding most of you that, for example, in our commercial business, 90% of our relationships are sole or lead relationships.

And Dave talked about how we manage those relationships over time. And you heard earlier how we talk about managing deposits. I think the way we approach the relationship manager is a significant input to the question that you’re asking.

Mario Mendonca

Appreciate your help. Thank you.

Darryl White

We think it’s an advantage.

Mario Mendonca

Okay.

Darryl White

We got time for one more.

Operator

Thank you. Our following question is from Lemar Persaud from Cormark Securities. Please go ahead.

Lemar Persaud

Thanks for taking my question. I appreciate the update on the status of the Bank of the West acquisition. And I noticed you guys still think it’s going to close by the end of the year. What are the greatest risks to that getting pushed out? And then given the big move in interest rates from when the deal was announced today, how should we think about the impact on the accretion estimates? Thanks.

Darryl White

Yes. Maybe I’ll take the first part and I’m going to ask Tayfun if he wants to chime in on the second. Look, we don’t have — I’m going to bore you a little bit with the answer. We don’t have much more to say in terms of timing. Our best estimate at the time that we announced the acquisition back on the 20th of December that was — that it would take approximately a year. And based on what we see and based on what we are involved in today, we stand by that prediction. And we’ll update you as and if that changes. But as of now, that’s our current view.

Tayfun Tuzun

And in terms of the impact of the rates on accretion, I just want to remind you that the way we’ve hedged the exposure to higher rate mark and higher goodwill, basically, neutralized the impact from the moment we closed the transaction. So, I would say, the accretion estimates, with respect to rates is the same as we have assumed. Now, going forward, depending upon the rate environment once we close the transaction, we may get more strength if interest rates continue to go up and they bring asset sensitivity to us. But at this point, our accretion estimates stay the same as we announced.

Lemar Persaud

Okay. Thanks for that. And then for Pat, I think you mentioned, you saw some of those COVID-related overlays in PCL. Can you put some numbers around that? And then, can you help us think about what the performing PCL would have been, if you didn’t release some of those COVID overlays?

Pat Cronin

Sure. The two factors that would have otherwise contributed to a build, as I mentioned, were a deterioration in the macroeconomic variables and loan growth. Those two things together would have been roughly about $185 million. And so, that was offset by positive credit migration and the reduction in the overlays. I probably don’t want to get into the size of the overlay.

I would tell you, going into COVID, we were pretty close to zero on that, plus or minus 5% of our total provision made up of judgment. That would have hit a high back in Q4 of 2021 as we came out of COVID, and it’s been reducing for three quarters in a row now. We are heading into an environment. While it’s uncertain, we expect that our loss estimation models can understand the difficult recession. So, all I can tell you is, I would expect it to continue to come down, all else being equal, but I think I’m going to stop short of giving out specific numbers.

Lemar Persaud

That’s fair. Appreciate the time. Thanks, guys.

Operator

Thank you. That’s for the time we have for questions. I would now like to turn the meeting back over to Darryl White.

Darryl White

I’m just — operator, I’m just being advised that we do have time for one more, if you’ve got somebody in the queue.

Operator

Certainly. We do have Darko Mihelic from RBC Capital Markets. Please go ahead.

Darko Mihelic

Hey, thanks for squeezing me in. My main questions have been asked and answered, so I’m going to be very quick, especially in the interest of time. Just wanted to pin down on a couple of things though, that I heard this morning. First, Tayfun, in your answer to the question regarding corporate, one thing you left out was the expected earnings per quarter, if you can just give us a hand with that? And then on the question with respect to the marks that we’re taking in capital markets. If I heard correctly, it sounds like the levered lending loan book was around $4 billion. Can you just confirm, when I look at those marks versus those indices that are out there, do your marks include fees accrued or not? Thank you.

Pat Cronin

Hi Darko, it’s Pat. First, on the leverage lending loan book, the sizing that I gave is for the loan book in particular. And on that loa0n book, we only take provision for credit losses.

Now the markdowns that you’re talking about, the $88 million apply to the underwriting book. So that’s a very separate book, and that is where I sized that at just over $4 billion. So think of those as two very separate things. One takes PCL and the other one takes mark-to-market losses that flow through Dan’s business. And I think that was your question or no. Did I answer it?

Darko Mihelic

Sorry, I went on mute. Are there fees accrued in that mark or not?

Pat Cronin

Apologies. The answer to that is yes. That’s inclusive of fees.

Darko Mihelic

Okay. Thanks. And then just over to Tayfun on the corporate.

Tayfun Tuzun

Yes. On the corporate side, Darko, this quarter clearly was a little bit of an aberration. So, we probably will go back to the average of the prior two quarters in the near term, and then we’ll give you guidance for 2023 when we get to year-end.

Darko Mihelic

Okay, great. Thanks very much for squeezing me in just.

End of Q&A