The Bank of Nova Scotia (NYSE:BNS) Canadian Bank CEO Conference Call January 9, 2023 9:20 AM ET
Company Participants
Scott Thomson – President
Conference Call Participants
Darko Mihelic – RBC Capital Markets
Darko Mihelic
Our next speaker is going to be Scott Thompson. Maybe we can have him come up to the stage, please. Hi.
Scott Thomson
Hey, there.
Darko Mihelic
Good morning.
Scott Thomson
How you doing?
Darko Mihelic
Good to see you.
Scott Thomson
Good to see you, too.
Darko Mihelic
Okay. So, why don’t we start right away, because we’re trying to keep track — kind of keep on time here. So, thanks Scott for joining me this morning.
Before we begin — and I should have said this with Royals, but this does apply for the entire conference. Scott, your comments today may include forward-looking statements. Actual results could differ materially from forecast, projections or conditions in the statements –conclusions in the statements. Listeners can find additional details on public filings of Scotiabank and Royal.
So, with that out of the way, Scott, thanks again for joining us today.
Question-and-Answer Session
Q – Darko Mihelic
You took over as President at Scotiabank on December 1. You’ve been on the Board for six years. And we know there’s still about a month or so before you’re officially the CEO. You are known to a lot of investors that are in this room. You’ve had time at BCE, Thalesman and Finning, of course. But why don’t we take this opportunity — because this is actually only the second time I’ve ever seen Scott, so why don’t you take this opportunity here to maybe let us get to know you a bit better, maybe focus on your experiences and sort of how it’s shaped you and prepared you for this new role.
Scott Thomson
Great. Thanks, Darko, and welcome, everyone. And I feel very honored and privileged to be here today, and humbled to the ability to step into this role and build on the great work that Brian has done and the legacy that he’s left. So, look forward to working with all of you going forward.
As you mentioned, Darko, I’ve varied experience set across a large number of industries. And I think there’s two themes across those experiences set. One is the ability to step into complex organizations at a senior level and build teams, lead teams, motivate teams, with success. So, that would be one theme.
The second theme across those experiences would be customer. As you think about my financial industry’s experience, I learned the importance of relationships, importance of advice, and then, most recently, in a customer-facing organization, with Finning, we spent a lot of time on that — over that nine years thinking about the customer, developing solutions and insights for that customer to get, obviously, a great outcome for the customer, but also a great outcome for the company and for the shareholders.
And then, lastly, from the customer lens, I’ve also been a customer. So, I have a good sense of what my expectations are from a customer perspective.
Why do I think I’m the right person for this job at the right time? I guess a couple of things. One is, I’ve got a track record of success leading teams, building, retaining, developing, attracting talent in a collaborative fashion and in inclusive fashion to deliver a great outcome.
Two, capital allocation. It’s been a forefront of how I think about running businesses. And I think we have an opportunity here from a capital allocation perspective to really make a difference.
Three would be operational excellence. I’ve seen the power of operational excellence around execution, and building good businesses and seeing the returns that come with building those businesses.
And then, lastly, I’ve been a CEO of a global organization, with an emphasis in Latin America, and, obviously, not only through my Finning experience, but also with the Talisman experience. I’ve been in these markets for 15 years and I know them well.
Darko Mihelic
Okay. It’s a lot to — that’s a lot for me to work with. You’ve been there for a month. What have you seen?
Scott Thomson
So, I guess, first, it’s been a little bit more than a month. So, the announcement was in September, and I’ve spent a lot of time around the banks since then. So, the focus has primarily been internal and primarily been with employees. And what I would say is I’ve been really impressed with the passion, the enthusiasm, and the openness with which the employee base, 90,000 Scotiabankers have accepted me. So, that would be the first and foremost.
Two, I think, there is a lot of competitive strengths with this platform, and Brian deserves a lot of credit for it. But the strengthening of the earnings quality across the platform has been very successful. The strengthening of the core, the functions that allow the business to be successful has been a real achievement. Addressing the technology deficit has been an achievement as well and places us well for success going forward. And then, I do believe we’re a leader in ESG, and I think that will become increasingly important going forward. So, I think there’s a lot of checks along the way that Brian should be really pleased with.
As I look at two areas — I guess three areas that I’m digging into and I think there’s opportunities for. One is on this deposit and funding franchise. And I do think we have an opportunity — our loan to deposit ratio is high. We have an opportunity to continue to build out the deposit franchise for this business. And I think that helps from two perspectives. One, obviously, funding, less reliant on high-cost wholesale funding, and that helps in the short term, obviously. But I think if you take a longer-term North Star view, that importance of the deposit, importance of that customer relationship is extremely important as you move from a product orientation to a relationship orientation. So, that would be one first impression.
The second first impression will be around business mix. And business mix would be both at the enterprise level in terms of geographies and then within the business lines. So, from an enterprise perspective, we spent a lot of — deployed a lot of capital into the international markets over the last 10 years, and that — the returns on that capital have not been commensurate with the risk that we’ve taken. And there’s a lot of reasons for that, and we’ll come back. I know you’re going to want to talk about the international business. Lot of geopolitical reasons, a lot of macro reasons, a lot of execution reasons, but that’s something that we need to be really thoughtful about going forward.
And then, within the business lines, I think there’s a business mix opportunity as well. I think, we’re evolving from a product to a customer orientation. So, we’ve got a heavy emphasis, for example, in our Canadian business on mortgages and autos relative to our peers. And then, even in the corporate business, heavy orientation to loans rather than ancillary businesses.
So, as I think forward, the great opportunity here is the team that’s around me gets it. As I think about what Dan Rees is doing in Canada, and he’s been in that role now for two years, building out the SCENE platform, which thinks about getting a more holistic relationship with the customer; thinking about cross-sell wealth in our Canadian core franchise; thinking about the under penetration we have in commercial and small business, which comes with great deposits; and then, also thinking about the under penetration we have in Quebec and BC. That’s all leading us to a better business mix outcome with a less focus on the product and more focus on the customer.
Similarly, as I think about Jake and what he’s doing in the GBM business, we’re making great progress not just leading with the loan, but also tying up that ancillary revenue around that loan, so moving less from the product and more to the customer focus.
Those evolutions were early in stage, right? I mean, both of those leaders, as an example, have been in the roles for two years. So, we’re early in that evolution and there’s a lot more to go. But the great thing is the team is on it and understands the opportunity.
Darko Mihelic
Okay. More stuff to work with there. Thank you for that answer. In your previous answer, you mentioned that one of the things — one of your strengths is really about capital allocation. And here we are today in a world where the regulator has increased the domestic stability buffer, widened the range. When I look at Scotiabank, your capital ratio relative to the other companies that I cover is on the low end.
So, maybe a three-part question. First, as I think about it, at 11.5%, how do you see your capital evolve — maybe what Dave McKay gave is a bit of a waterfall. I’m not necessarily saying — pinning you to a waterfall, but how do you see it sort of evolving this year? Are you at risk of potentially raising equity? And what levers are available to you to prevent an equity raise?
Scott Thomson
So, obviously, capital is very important topic of the day. And as I think about our capital and how I want to run this business, optionality is important, right? You want to have enough buffer, so that you can execute on not only organic, but if anything outside of the organic came up, you’d be able to have that optionality. And that’s not going to be the focus necessarily, but it is trying to give you a sense that I do believe optionality on capital is important.
We ended the year at 11.5%. And as I look forward, we’re going to build to 12% by the end of the year. And we feel comfortable that we’re going to get there through a combination of slowing RWA growth, internal capital generation, and then, we have the same Basel reform benefit that all the other financial institutions, I assume, will have into the second quarter, and that’s going to be meaningful. So, we feel very comfortable on internally getting to that 12%-type level by the end of the year. So, I don’t see the need to issue equity.
And as I think right now, there’s two banks out there that don’t have a drip in place. We’re one of them. From what I see today, we don’t — that’s always available to us, but that’s not a tool that we need to use right now, from what I see today. So, I mean, Darko, I feel pretty comfortable of getting that 12%-type level by the end of the year, and I think that’s appropriate for the environment we find ourselves in.
Darko Mihelic
What if the regulator increases the DSP all the way up to 4%?
Scott Thomson
Yes. So, then you start to think about higher buffers and whether you need higher buffer or lower buffer. My expectation is that will take some time, but that will result in getting to that kind of 12%-plus range, which I feel comfortable in us getting to.
I also share the view that Dave had highlighted before is that if you are in a scenario where we have a recession that’s a little bit more problematic than, I think, we’re all forecasting right now, then I think what you’ll hear from Peter today at lunch is that he’ll be open to actually reducing the capital requirements, because that’s actually makes sense, right, in terms of how you want to run the economy.
So, the 12%, slightly higher, is the right place to be from our perspective and that’s what we’re going to shoot for by the end of the year.
Darko Mihelic
And then, so, maybe just switching from capital to credit, but sort of building on it, I guess, in a way, I mean, one of the things that we can worry about is, what if there’s a mistake along the way? What kind of — what if credit costs spike on you? How do you think about the balance sheet? And similar for me, when I look at Scotiabank’s reserves, you’re Stage 2 — Stage 1 and 2 performing allowances, they look about the same to pre-pandemic. So, it doesn’t look as though the balance sheet is actually positioned for a worse environment. Maybe you can talk a little bit about some of these trends?
Scott Thomson
Sure. And I should have mentioned this in my opening impressions. I’ve sat on the Risk Management Committee of the Board. I have watched Brian manage the company over the last nine years through a risk lens and now in the guts of the business. That’s been one of the areas I’ve gone to first, given some of the risks on the horizon, and the credit quality of this bank is strong. Full stop. And I think it’s a great credit to Brian on what have he’s run this bank, but we do have great credit quality.
If you think about the Canadian book, 95% of the book is secured. If you think about the international book, we had some challenges in the unsecured international portion through COVID, and that has been adjusted. And so, the security of that book has now gone up 70%, 72%, 73%. A lot of the dispositions along the way have been Brian’s view of de-risking that area of the bank. And as you look at the corporate side and the PD bands where we play, we play at a very high corporate investment-grade credit. So, I do think the credit quality of the bank is strong.
Now that being said, there’s different views on where we’re heading from a recessionary perspective. And we’re going to be very thoughtful about our pessimistic scenario, the options and the emphasis that we put into that. I think what you’ll see is — or what the guidance was, it was kind of mid-30s basis points PCLs for next year. That seems to make sense, a normalization of the PCLs, and probably more emphasis on performing as opposed to non-performing loans. So that’s the type of framework that we’re thinking about for next year, Darko.
Darko Mihelic
And so…
Scott Thomson
And by the way, ACLs have gone up. As you think relative to pre-pandemic to where we are today, ACLs have gone up. So, I think there’s been a business mix issue, less secured to more secured, plus an ACL build, which gives us comfortable about our provisions.
Darko Mihelic
So, what about the vulnerabilities that are facing — I mean, the Canadian consumer, your mortgage book, how should we think about that if we enter recessionary scenario? And what comfort can you give us that your mortgage book is well positioned?
Scott Thomson
It was interesting because I listened to Dave’s, I mean, I would share the same view on that Dave has around the vulnerability of the consumer. I mean right now, we have a lot of liquidity in the system with our consumers. 40% of our book is variable, and I think they have about 30% more deposits than they did going into the pandemic. And as you know, our variable book resets. So, unlike the deferred amortization of some of our peers, ours is continually resetting, which I think is helpful to continue along the journey with your customers.
And then, 60% of our book is fixed, with 8% renewing in next year and another 8% in 2024. So, we’re really looking at the 2025 issue, where a lot of our customers see the impact of that. We also look at the vulnerable customers, so those customers that have higher LTV, lower FICO, lower deposits in their checking accounts, and then also house prices that are seen vulnerable, and we have about 20,000 of those. So, as you think about the tail risk, we have about 20,000 vulnerable customers, which would be 2.5%. So, I think Dave had mentioned low single digits, we’d be about the same. 2.5% of our mortgage book would be vulnerable. And so, that is a manageable-type situation for us on mortgages.
I think the first place this is going to go, if it does go, is areas like credit cards, right? And that is — again, we’re not seeing signs of that yet. We’re seeing actually people not reduce their — sorry, not build their revolver level, they’re actually starting to reduce it. So, you could argue that that’s a kind of a leading indicator. But again, from a Bank of Nova Scotia perspective, we’re underway in credit cards. So, for us, I think that’s competitive advantage, if you are looking at it solely through a credit lens.
And then, lastly, on the auto book, you’re starting to see used prices come down a bit in the US. I think that’s a precursor of potentially being very careful about used, and we have a very small $3 billion Near-Prime book that we’re watching very closely. So that’s the areas that I think you’re going to see at first before the mortgages.
Darko Mihelic
And so, when I sit back and I think about 2023 for Scotiabank, we’ve got a situation where PCLs are normalizing, earnings per share is declining, and part of that is also a non-expansion of the NIM. So, maybe we can talk a little bit about: a, where you see if there’s any potential areas where net interest margin, net interest income can grow your current positioning on net interest income? And think about — is it just simply in the cards that you’re going to have negative EPS growth this year just because PCLs are normalizing? Or is there somewhere something that help offset and at least create some EPS growth this year? And can it be through the net interest margin or net interest income line item?
Scott Thomson
Yes. So, when I think of 2022, we benefited from abnormally low PCLs, and we benefited from a very low IB, International Banking, tax rate, and we benefited from strong loan growth. So, as we think about 2023, you’re going to see a normalization on all of those accounts; so higher taxes, higher PCLs, and slowing loan growth, as well you’re going to see the full year impact of inflation come through in 2023, which we had part of that in 2022.
And then, I look at the NIM commentary that you’ve highlighted. We are — as I’ve mentioned, we’re very dependent on wholesale funding. The cost of that funding has increased significantly. And so that is also going to be a headwind in 2023. So, as I think about 2023 earnings, I am very cautious on the outlook for 2023.
As I think a little bit longer term into when rates stabilize, and I think that’s an important kind of pivot, rate stabilization, I think we look relatively better in that environment. So, the combination of rate stabilization with asset repricing, which starts to accelerate in the back half of 2023 and 2024, then I do think we get into a better situation. But 2023, I’m cautious until those rates stabilize from an earnings perspective.
Darko Mihelic
What if rates fall?
Scott Thomson
Well, I think rate is falling, and that’s — probably based on what we’re seeing, we’re going to be in a little bit of longer term of kind of rates lower, higher or stable for as longer, and then falling, but that’s a great place for us to be relative. I mean, it doesn’t take our focus off the North Star vision of the deposits and the importance of getting that from a funding perspective and a customer intimacy perspective. But I think given our liability-sensitive balance sheet right now, in rates falling, we will perform relatively better than some of the other banks that are positioned for the rate rise scenario.
Darko Mihelic
Is there anything you’d change with respect to that? I mean, the one thing that we’ve noticed with Scotia is maybe a slightly more active treasury department, maybe actively positioning the balance sheet for rising or falling interest rates. Is that something that might change now under…
Scott Thomson
Yes. Listen, I think there has been an approach to extend duration. You heard Dave talking about it from a Royal Bank perspective. I think we did some of that as well, maybe a quarter or two early. From my perspective, I think we need to be really careful on hedging. I think hedging to protect downside risk, that’s important part of overall Banking 101. But I do think going forward, focusing on the fundamentals, how you run a bank with strong deposits, great customer relationships, which then leads to profitable NII and NIR growth, that’s going to be an important facet of what we’re going to do going forward.
Darko Mihelic
Okay. I may have messed up in the last, so apologies to the audience, because there may have been questions to Royal and I was just staring at the wrong screen. So, apologies to everybody if you had asked the question on Royal. I’ll see what I can do. But I do have some questions here from the audience at Scotia.
So, first question is, does the opportunity to build the deposit franchise require upfront investment?
Scott Thomson
Listen, I think the — as you think about building out the deposit franchise, in my view, this doesn’t happen in a quarter or in a year, it happens with the North Star view, if this is really important, and pivoting the organization to doing that, and it’s again this move from a product orientation to customer orientation. And what I like so much about what Dan Rees and his team are doing in Canada is trying to do that organically, right?
I mean, the SCENE program, which you’ve heard the team talk about, is an attempt to actually create a deeper relationship with our customer and get multi-product relationships. So, more relationships with more of our customers which builds a very healthy customer interaction. We can do more for our customers. We can create value for our customers. And as a result, we’ll actually create value for our shareholders as well.
So that work is in process, but it takes time. And you definitely don’t want to shift the pendulum too far too quickly, because then you actually have too high deposits. You want it this to be sustainable. You want it to be really creating value for your customers, and also that will ultimately create value for your shareholders. So, there’s ultimately a way to do this, but it’s not quarter-by-quarter, it’s year-by-year.
Darko Mihelic
And it elicits some few questions of my own on the deposit franchise. First, are there any targets you can share with us? I mean, is there some level of deposit growth that you’re looking for deposit mix? Is there some sort of target that you got on your mind?
Scott Thomson
Yes. I mean, one of the things I think a lot about is matching loans to deposits, thinking of how did you grow your loan book? You should be growing your deposit book in conjunction with that. Loan to deposit ratio for us right now is too high, and we’re an outlier relative to the other banks. And so that’s something that you can fix both by really focusing on profitable growth, profitable sustainable growth on the loan side, not just growth for growth sake, and then also focusing on that customer relationship — that intimate customer relationship with the deposits, which will ultimately result in a great outcome.
Darko Mihelic
And you mentioned a couple times the work that Dan Rees is doing. What about International Banking? And what about the work — what do you see there first, in your first impression there? And secondarily, does this also extend this discussion of deposits into the IB?
Scott Thomson
Absolutely. So, international, one, start with I’m really supportive and pleased to see what Brian, Nacho and the team have done over the last nine years, strengthening that portfolio, narrowing that portfolio, and building up the earnings quality. And it has been a rough 10-year period from a macro perspective, from a geopolitical perspective. And right now, we have strong platforms, with 95% of the earnings in those CCAU countries, or CCAU.
However, I’ll come back to, the returns there have not been commensurate with the risk. And therefore, there’s an opportunity to improve the ROE in those businesses. I take Mexico as a shining example of where we should try to get to. You’ve got a great franchise there; 8% market share; loan to deposit ratio of 100, so loans matching deposits; ROE of greater than 20%; scale 8% of the market; great cross sell with GBM and our retail franchise; and great cross sell with wealth and our franchise there. So, there is an example of a great platform that we should aspiring to have, and then great connectivity back to the Americas, right, when you think about Canada and the U.S. So that’s an example of what we’re trying to do.
I think Nacho and the team have done a great job coming out of COVID. If you take at — look at the ROE improvement in that business over the last two years, it has been fantastic, but there’s more to do. There’s a gap relative to best in class, and there’s also not enough — big enough of a gap relative to our other businesses here where we can allocate capital, too. So, work in process, but great work to date.
Darko Mihelic
So, you mentioned Mexico as an example of what you’d aspire to do. Give us an example of what needs work in the International Banking business?
Scott Thomson
So, one of the things that we need to make sure we’re clear on is international — I’ll give one example, international unsecured retail. So, now to put this in perspective, 25% of the bank is International Banking, 40% of that — or 35% of that 25% is retail. So, now we’re down to 10% of the overall bank’s NIAT is retail. And of that, the only really unsecured exposure is in Peru and Colombia.
And so, what I’m really talking about here, and it’s really important that people focus on this, because our International Business gets so much attention for sometimes the wrong reason. 2.5% of the bank’s NIAT is in unsecured retail in Peru. But given what we’ve gone through, through COVID, given the secured to — the unsecured to secured mix, we’re selling one of the businesses there to reduce the unsecured mix further. We really need to align on how we’re going to run that unsecured retail business.
And I do think there’s an opportunity to make that important in the context of it only being 2.5%, but you can get higher rounds in that business if it’s done right, if it’s focused on the affluent, if it’s focused on the cross sell, if you bring the deposits with it. Our loan to deposit ratio in South America is actually higher, meaningfully higher than our Canadian business. And so, again, opportunity to make sure you have the deposits along with the loans in that International Business.
Darko Mihelic
Okay. I think we have more time for maybe one more question. Please — so, this is the upvoted. Please describe your credit quality bias? So, we do not think you have had much experience underwriting or managing through credit losses. Should we expect — and I apologize, the rest of this question is not visible to me, it’s really — should we expect you to be conservative and tell your team to build reserves? Or will you sit back and let your team manage reserves underwriting and so on? So, it’s more like a tone from the top kind of question.
Scott Thomson
Yeah, tone from the top. So, one I think, as I mentioned, the credit quality of the bank is good. And if you look at the bias, we’ve had a really strong focus on investment grade, I’m talking about the corporate book now, probably the commercial books as well, but strong focus on investment grade corporates. And I think if the top two PD bands were at 90% of our books there, where the average for the rest of the banks would be about 70%. So, the credit quality is strong. Similarly, in our Canadian business, 95% of the book is secured. When you look at 90% of the business is either mortgages or autos, so it’s 95% of the business is secured.
What Dan and the team are doing is trying to sell more of our products to more of our customers, right? That’s what we’re doing in the Canadian business. And what Jake and the team are doing in GBM is trying to wrap around that loan ancillary businesses, right? And if we can do that, we know those customers well. We know those credits well. If we can sell more products to those customers and create a real customer orientation, I think that’s a great way to impact the business mix over time, not impacting credit quality or exposure, and getting to a better outcome on returns for our shareholders, and a better outcome, frankly, for our customers in terms of the value we add to our customers. And if you can combine that, creating more value for your customers and better returns for your shareholders, that’s a great opportunity for us.
Darko Mihelic
So, Scott, I really appreciate you coming to our conference, being on the job for just a little over a month. And maybe to get us back on track for time, this is a great opportunity for you to sort of lay out I think for everybody here, in the last few minutes here, what your key messages are for investors and what it is that you want them to take away under what your stewardship will be for Scotiabank for the years to come? So, over to you to give us a sort of a key break down.
Scott Thomson
Yeah. Thanks, Darko. So, I’m going to start where I started. I’m really feel honored and privileged to take on this role, and I feel like Brian has left a great legacy on which we can build. And so that’s important comment to start off with.
Second, for me, if I could leave you with three messages, it’s around culture, capital, and execution. And on the culture front, it’s about building teams where we’re collaborative and inclusive. And if we can improve the employee engagement, drive the employee engagement, I’m a big believer, and that actually results in a better customer engagement as well.
And then, from a customer culture perspective, moving from this product orientation to the full customer orientation, which allows us, again, to build more value for our customers and also build more value for our shareholders. So, that would be under the culture bucket.
Under the capital budget — bucket, we have a great opportunity in front of us around capital allocation. We’ve done a lot of geographical repositioning. We’ve had a lot of transactions in and out. We’ve got good platforms. But now we have an opportunity to take an enterprise-wide view and prioritize where we allocate that capital. Our returns have been lagging relative to our peers on almost every return metric. And that has translated into lower TSR over one, three, five and ten years. And we’re committed to change that. And we can do that through very disciplined capital allocation to address the business mix issues that I just talked about earlier today.
And then, third, from an execution perspective, execution, operational excellence, I’ve seen the power of what we can do with operational excellence at Finning. Nine years of operational excellence where you set us next North Star, you’re disciplined, you’re relentless, you focus on building out the platforms that we can, and you focus on profitable, sustainable growth, not growth for growth sake.
So, those three buckets are what I’m focused on right now. As I think about my management style and what you can expect from me, one, I’m going to be very transparent. I’m going to listen. I’m going to listen to all stakeholders, listen to everyone in this room. We’re going to be decisive, but we’re not going to be impulsive. We’re going to base our decision on facts and data, and we’re going to be accountable. And we recognize that our results will be judged by the success we have. But I can guarantee you the team around me understands the challenge in front of us, and we’re going to get after it.
So, thank you very much for having me today and look forward to working with you going forward.
Darko Mihelic
Okay, great. Thank you so much, Scott. We’ll end the session there.
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