Royal Bank of Canada
TSX:RY
Earnings Call Analysis
Q3-2023 Analysis
Royal Bank of Canada
The strength of the company's diverse business model underpinned performance this quarter, delivering an earnings per share (EPS) of $2.73, and an adjusted diluted earnings per share ($2.84) that was up 11% from last year. This highlights the company's resilience in a muted industry fee pool, facilitated by strategic cross-platform teamwork and global market share gains across various core products.
The company reported a robust capital position, with the CET1 ratio increasing to 14.1%, indicating a solid net internal capital generation and a healthy buffer above the regulatory requirements. The all-bank net interest income rose by 7% year-over-year, thanks to the sensitivity to the higher interest rates and growth in volumes, especially in Canadian Banking.
Non-interest expenses escalated by 23% from last year, majorly influenced by acquisition costs, macro-driven factors, and investments in technology and employees. However, the company is actively working on reducing the employee base and managing discretionary expenditures. A significant FTE reduction is anticipated, which will result in additional severance costs in the short term but is expected to yield cost-saving benefits in the future.
The company is witnessing increased credit delinquencies and provisions, with predictions of credit trends weakening as labor markets soften and mortgage payments climb. Nonetheless, the overall allowances for credit losses remained well-managed at $5 billion. Despite several larger impairments, the gross impaired loans (GIL) and the provisions for credit losses (PCL) remain below long-term averages, with an expectation for PCL impaired loans between 20 to 25 basis points for the year.
Canada's ability to get inflation under control is slightly ahead compared to other Western countries. The outlook suggests that if Canada can begin to ease interest rates in 2024, it could significantly assist the economy in achieving a soft landing, especially important given the structure of mortgage resets in the upcoming years.
In a drive to operate more efficiently, the company plans to further moderate discretionary expenses and scrutinize headcount, aiming to address structural cost base adjustments more explicitly into 2024.
Investors can anticipate the effective tax rate to persist into Q4 and potentially maintain within a range of 19% to 20% for the foreseeable future, aligning with the company's previous financial trends.
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Good morning, ladies and gentlemen, and welcome to RBC's Conference Call for the Third Quarter 2023 Financial Results. Please be advised that this call is being recorded. I would now like to turn the meeting over to Asim Imran, Head of Investor Relations. Please go ahead, Mr. Imran.
Thank you, and good morning, everyone. Speaking today will be Dave McKay, President and Chief Executive Officer; Nadine Ahn, Chief Financial Officer; and Graeme Hepworth, Chief Risk Officer. Also joining us today for your questions, Neil McLaughlin, Group Head, Personal & Commercial Banking; Doug Guzman, Group Head, Wealth Management & Insurance; and Derek Neldner, Group Head, Capital Markets. As noted on Slide 1, our comments may contain forward-looking statements, which involve assumptions and have inherent risks and uncertainties. Actual results could differ materially. I would also remind listeners that the bank assesses its performance on a reported and adjusted basis and considers both to be useful in assessing underlying business performance. To give everyone a chance to ask questions, we ask that you limit your questions and then requeue. With that, I'll turn it over to Dave.
Good morning, everyone, and thank you for joining us. Before we begin, I want to acknowledge the tragic events in the Northwest territories B.C. And Hawaii, with the ongoing wildfires. Our care and concern is with all those in these areas, and we're supporting community relief efforts and are here to help affected clients and employees. Moving now to our results. Today, we reported third quarter earnings of $3.9 billion or adjusted earnings of $4 billion, up 11% from last year. Pre-provision, pretax earnings were up 7% year-over-year. Revenue grew 19% to $14.5 billion, as our performance yet again demonstrated the strength of our diversified business model which produced revenue growth across our businesses. Personal & Commercial Banking revenue increased 7% from last year. Capital Markets had another strong quarter with over $1 billion of pre-provision, pretax earnings, gaining share across global markets and investment banking amidst declining fee pools. Wealth Management revenues were up 10% from last year and insurance revenue net of PBCAE was up 22% year-over-year. Expenses were up 23% year-over-year, largely due to the acquisition-related costs, FX and share-based compensation. Excluding these items and growth in variable compensation, expenses were up 9%. We also added a further $120 million of PCL on performing loans this quarter, and we remain well provisioned for a softer economic outlook. We ended the quarter with a CET1 ratio of over 14%, while maintaining a diversified funding profile. Our strong balance sheet and premium ROE are important elements of our value creation model. Before I provide updates on our growth and cost strategies, I will speak to what remains a complex and challenging environment from a macro, operating and regulatory perspective. On the macro front, consumer spending remains resilient. At the same time, it appears the magnitude of interest rate hikes is having its intended effect of [ reigning ] in persistently elevated inflation. The increase in the price of goods and services has slowed to 2% and 4%, respectively. While immigration levels in labor markets also remain strong, we are seeing evidence of slowing labor markets as evidenced by slowing wage growth, lower job postings and an increase in Canadian unemployment. Consequently, our base case forecasts a softer economic outlook. We expect slowing growth and lower inflation due to the lagging impact of monetary policy combined with a slowdown in China and elevated climate and geopolitical risks. The length of time, central banks will have to be in a hold pattern before decreasing interest rates will be a key determinant of the impact on consumers and businesses and the economy. We are operating in a structurally uncertain macro backdrop. Furthermore, the operating environment is changing at a faster pace than we've seen for over a decade, particularly in the U.S. banking sector. U.S. banks are facing increasing regulatory and funding requirements, which were exacerbated by quantitative tightening and other actions, taking liquidity out of the U.S. banking system. Nearly $2 trillion sits in the Federal Reserve's overnight reserve -- reverse repurchase facility, including a significant increase in usage by money market funds. A higher cost of doing business is reducing profitability for U.S. regional banks led by higher funding costs and pressure to reduce lending capacity to protect capital and liquidity. City National is not immune to these factors with both loan growth and profitability being impacted by the higher cost of attracting deposits and continued investments in this operational infrastructure. While we expect these cost pressures to continue for City National, we expect to drive future benefits from its asset-sensitive balance sheet. Furthermore, we are well positioned to benefit from our diversified U.S. business mix, including our top 10 capital markets and wealth management platforms which generated over 90% of U.S. pretax pre-provision earnings over the last 12 months. Given the current operating environment and economic backdrop, I will now speak to the actions we are taking to optimize structural efficiencies to support our strategy of creating long-term value. While we have a strong foundation to do so, we have not been satisfied with our recent operating leverage, and so we've heightened our focus on expense control. We have acted by slowing discretionary spend, prioritizing investments and moderating hiring to benefit from natural attrition. Our actions to date have resulted in a 1% reduction in FTE, excluding the partial sale of RBC Investor Services and our summer student program. We expect to further reduce FTE by approximately 1% to 2% next quarter through attrition and targeted reductions. We will continue to monitor the changing landscape and are ready to accelerate further tactical actions as deemed appropriate. In addition, we are also maintaining our discipline around capital allocation as highlighted by the partial sale of RBC Investor Services. We remain focused on driving the bank forward including the planned acquisition of HSBC Canada. The transaction once approved and closed is expected to drive attractive financial returns while positioning RBC as a bank of choice for newcomers and commercial clients with international needs. We're also investing to create even more value, including leveraging our leading Borealis AI Institute to expand our capabilities and artificial intelligence. We're expanding in-market use cases in credit adjudication, cybersecurity, client offers and through our Aiden trading platform. I will now speak to key growth drivers across our segments. Starting with Canadian Banking, our largest business. We had our best-ever quarter for [indiscernible] RBC client acquisition with record volumes from newcomers and new partnerships, including ICICI Bank Canada. Personal deposits were up 14% from last year. Our stable, low-cost, low beta deposit franchise allows us to efficiently fund our loan growth. Our attractive funding structure is also expected to provide a relatively smooth revenue stream, which Nadine will speak to you shortly. We continue to see a shift in deposit mix towards term products as new and existing clients continue to value our higher-yielding offerings. We also continue to enhance our franchise by expanding our offerings and partnerships, an important part of our client-centric model. We're excited to be the official financial services partner of the 2024 Taylor Swift Eras Tour in Canada. Earlier this quarter, we launched our new loyalty partnership with METRO in Quebec, while also opening our innovative ShopPlus platform in Avion Rewards to all Canadians. Many of our Canadian banking clients are members of our internationally recognized award-winning program and we expect to grow this membership base by 50% in the next 3 to 5 years. On to mortgage growth, which moderated to 5% from last year and we expect industry origination activity to continue along this trend. We remain focused on the trade-offs between spreads and new mortgage originations as intense pricing competition is limiting expansion in asset betas. We will remain disciplined to ensure new originations continue to meet internal hurdles of economic value. Business loan growth remained strong, up 14% from last year as we continue to see balanced growth, including solid growth in agriculture and supply chain sectors. With inventory levels remaining below pre-pandemic levels, there is a continued runway for growth. Moving to our global diversified wealth and asset management franchises, which are key contributors to our premium return on equity. Starting with Canadian Wealth Management, assets under administration were up 7% from last year, increasing to a record level of approximately $550 billion. On Slide 30, we provide new disclosures on our leading adviser productivity, which remains significantly higher than peer averages. U.S. Wealth Management AUA was up 7% from last year, to a record level of approximately USD 575 billion. We also added over 20 new advisers this quarter, a key source of growth. RBC Global Asset Management AUM increased 3% from last year despite unusual conditions where market outperformance was heavily weighted towards a narrow band of U.S. technology stocks. Our clients chose us as a trusted adviser, largely due to our performance and investment expertise. Nearly 85% of our AUM have outperformed the benchmark on a 3-year basis, a challenging period for markets. Furthermore, we are confident that our leading money in franchise is well positioned for any client-driven reversal of GIC inflows back to investment products. We added to our alternative product suite this quarter by launching the RBC Global Infrastructure Fund, which exceeded commitment targets. Capital Markets had a strong quarter, as we benefited from the growing strength of our diverse business model. While industry-wide fee pools remain muted, our businesses showed continued momentum and delivered market share gains to drive outperformance. Our cross-platform teams are building on their valued position as trusted advisers to our clients across geographies and products. In Corporate Banking and Investment Banking, we continued to advance the globalization of our business and deepen our sector and product coverage of our franchise. These investments are reflected in our participation in key mandates across diversified industry groups, translating it into a move to 9th in global league tables on a year-to-date basis, up from 10th last year. Going forward, we are seeing increased client conversations and the buildup of a healthy pipeline. In Global Markets, we also delivered strong market share gains across several core products and focused areas for accelerated growth. Our strong market share in the spread business worked well for us this quarter. Furthermore, investments we have made in our macro business have also positioned us to support our clients. We are pleased with the strategic investments in talent and technology and the changes we have made to our organizational structure are producing results. In conclusion, our investments in our people, technology, products and services continue to create more value for our clients that are driving strong volume growth and client activity across our businesses. We also remain committed to delivering more value for our shareholders by efficiently allocating investments and capital within our stated risk appetite. Nadine, over to you.
Thank you, Dave, and good morning, everyone. Starting on Slide 8. We reported earnings per share of $2.73 this quarter. Adjusted diluted earnings per share of $2.84 was up 11% from last year as broad-based revenue growth was partly offset by higher expenses and increases in PCL on impaired loans off of low levels a year ago. Before focusing on more detailed drivers of our earnings, I will highlight the continued strength of our balance sheet. Starting with our strong capital ratios on Slide 9. Our CET1 ratio improved to 14.1%, up 40 basis points from last quarter, mainly reflecting net internal capital generation, share issuances under DRIP and the impact of the partial sale of RBC Investor Services. Looking ahead, we do not expect there to be a material impact from the implementation of the fundamental review of the trading book or IFRS 17 in fiscal Q1 2024. We continue to expect that our CET1 ratio will remain above 12% following the close of the planned HSBC Canada transaction in the first calendar quarter of 2024, pending regulatory approvals.
Moving to Slide 10. All-bank net interest income was up 7% year-over-year or up 6% excluding trading revenue. These results reflect our sensitivity to higher interest rates as well as the benefit from higher volumes, particularly in Canadian Banking. All bank-net interest margin, excluding trading results, was down 1 basis point from last quarter as margin expansion in Canadian Banking was more than offset by NIM compression in other lines of business. On to Slide 11. We walk through this quarter's key drivers of Canadian Banking NIM, which was up 3 basis points from last quarter. The embedded advantages of our structural low-beta core deposit franchise continued to come through this quarter. The latent benefit of recent interest rate hikes has resulted in a widening of deposit spreads. NIM also benefited from changes in asset mix, including strong growth in credit card balances. Importantly, NIM headwinds associated with the flows from non-maturity deposits into GICs abated this quarter. However, we continue to be impacted by the tightening of mortgage spreads as competition remains highly intense. Going forward, we continue to expect to see the structural benefits of our latter deposit portfolio come through. The increase in swap rates seen over the past year should result in reinvestment rates that are higher than those rolling off, which in turn should provide tailwinds. However, as we've seen in past quarters, there are other factors that impact quarterly changes in margins including changes in product mix, both in assets and funding. With respect to competitive pricing, we assume intense competition for deposits and mortgages will continue. Any changes in the time and extent of these assumptions could have an impact on the trajectory of net interest income. Turning to City National. NIM was down 11 basis points from last quarter, including the benefits from hedging, mainly reflecting an adverse funding mix shift into interest-bearing deposits as well as rising deposit betas. These headwinds more than offset the benefit of Fed rate hikes on City National's asset-sensitive balance sheet. Moving to Slide 12. Non-interest expenses were up 23% from last year. Approximately 10% of this growth was driven by a combination of acquisition-related costs and macro-driven factors such as FX and share-based compensation. Beyond these factors, growth in variable compensation added a further 4% to the overall growth in expenses. The core drivers of organic expense growth were investments in people and technology. Salaries excluding the impact of RBC Brewin Dolphin, were up 17% from last year, as investments in our people reflected FTE growth of 6% year-over-year as well as inflationary impacts of salary increases announced last year. We also incurred a higher level of severance, which I will speak to you shortly. The growth in FTE was prevalent in Canadian Banking, where FTE was up over 1,500 year-over-year and up 2,500 from the end of fiscal 2021. Investments in product innovation also added to the segment's expense growth. In Capital Markets, expense growth was driven by higher variable compensation commensurate with the rebound in revenues as well as ongoing technology investments and build out of products. At City National, we continue to make investments in the operational infrastructure in support of the bank's next leg of growth, including higher professional fees and staff costs. On to Slide 13. Amidst the ongoing challenging operating environment, I want to reiterate Dave's comments on our heightened focus on cost containment. Firstly, we are in the process of reducing our employee base. FTE, excluding the impact of summer students, is down 3% quarter-over-quarter. This was largely driven by the impact of the partial sales of RBC Investor Services operations. Excluding the sale, much of the FTE reductions to date have come in Canadian Banking, which was down 2% quarter-over-quarter, excluding the impact of summer students, as attrition and the slowdown in hiring are running their course. Additionally, over the last 2 quarters, we have seen aggregate severance costs of nearly $70 million. Moreover, we expect to further reduce FTE by approximately 1% to 2% next quarter, resulting in additional severance costs being recognized in Q4. Another lever at our disposal is the managing of discretionary spend, which has already begun to slow. Looking forward, we see further opportunity to reduce discretionary spend across various work streams, including business development, advertising and professional services. Moving to our segment performance, beginning on Slide 14. Personal & Commercial Banking reported earnings of $2.1 billion this quarter with Canadian Banking pre-provision pretax earnings up 5% year-over-year. Canadian Banking net-interest income was up 9% from last year due to higher spreads and solid average volume growth of 7%. Non-interest income was down 1% year-over-year partly due to a $66 million impact of retrospective HST on payment card clearing services announced in the Government of Canada's 2023 budget and enacted in Q3 2023. Excluding this, non-interest income was up 4%, driven by higher service charges and foreign exchange revenue, reflecting increased client activity. Year-to-date, operating leverage for this segment was nearly 1%. Turning to Slide 15. Wealth Management's earnings were down 18% from last year, including the decline in profitability at City National on the back of the challenging expense environment, rising funding costs and higher provisions for credit losses. The remaining businesses within Wealth Management saw combined earnings growth of 5%, underpinned by higher net interest income in our International Wealth Management business, as well as solid asset growth in our North American wealth and asset management businesses amidst challenging market conditions. Wealth Management earnings also benefited from the gain on the partial sale of RBC Investor Services operations. Turning to Slide 16. In Capital Markets, we earned pre-provision, pretax earnings of $1 billion, reflecting the benefits of our diversified business model and market share gains across both Global Markets and Investment Banking. Corporate and investment banking revenue was up 74% from last year as the prior year included the impact of loan underwriting markdowns. Excluding this, revenue was up a strong 30% year-over-year, underpinned by higher debt originations across all regions, share gains in M&A and improved equity origination. Lending and other revenue was up 6% from last year, reflecting strong results in transaction banking supported by margin expansion as well as solid securitization financing activity. Global Markets revenue was up 18% from last year, reflecting an increase in fixed income trading revenue on the back of good client flow and improvement in the credit trading environment. These factors were partly offset by lower equity trading revenues, amidst lower volatility. Turning to Insurance on Slide 17. Net income increased to $227 million, up 22% from a year ago, primarily due to favorable investment related experience. The insurance business generated gains related to movements on interest rates on assets backing reserves. To conclude, our results this quarter were largely underpinned by the strength of our leading Canadian deposit franchise as well as broad-based client-driven revenue growth. Looking forward, our full management team remains committed to rationalizing expenses with the goal of driving positive operating leverage. With that, I'll turn it over to Graeme.
Thank you, Nadine, and good morning, everyone. Starting on Slide 19, I'll discuss our allowances in the context of the macroeconomic environment. As Dave noted earlier, during the quarter, we saw labor markets start to soften. However, unemployment rates remain exceptionally low, which has contributed to persistent consumer demand, economic growth and inflation. Accordingly, Central Bank continued to tighten monetary policy. The markets are now contemplating a higher for longer interest rate environment. For this backdrop, we added provisions on performing loans for the fifth consecutive quarter. This quarter's provisions reflect increasing levels of delinquencies and credit downgrades, a higher [ weighting ] ascribed to our more pessimistic scenarios and ongoing portfolio growth. Provisions on performing loans were predominantly in the City National and Capital Markets, reflecting the more challenging conditions in the United States. Allowances on performing loans for our retail portfolios were largely unchanged this quarter as the negative drivers were offset by an improvement in our baseline forecast for housing prices. In total, our allowances for credit losses on loans increased by $182 million this quarter to $5 billion. Moving to Slide 20. Provisions on impaired loans were up $58 million or 2 basis points relative to last quarter. While provisions continue to normalize from pandemic lows, our PCL ratio of 23 basis points remained below historical averages. In Canadian Banking, provisions were stable this quarter with lower provisions in the commercial portfolio, offset by modestly higher provisions on personal loans and residential mortgages. Expected losses in the retail portfolio continued to be delayed due to strong employment and elevated levels of consumer deposits. We do expect credit trends in retail to weaken, the labor markets soften and more clients are impacted by higher mortgage payments. These credit trends will be led by credit cards and unsecured lines of credit, consistent with the traditional credit cycle. In Capital Markets, provisions of $158 million were up $45 million compared to last quarter. Given the relatively large size of our clients and loans in capital markets, loans can vary from quarter-to-quarter -- I'm sorry, losses can vary from quarter-to-quarter. This quarter, we took a large provision on three related financings in the Commercial Real Estate sector and a large provision on a loan in the Transportation sector. In Wealth Management, provisions were also higher this quarter and included a larger provision of City National on a commercial real estate loan secured by an office property. The office segment remains challenging, given the fundamental change in demand for office space post-pandemic. However, challenges within the commercial real estate sector are not exclusive to the office segment. Any property facing multiple headwinds is a greater risk in the current high rate environment. For example, the larger provision in capital markets this quarter was on loans secured by multifamily properties, a segment of commercial real estate that continues to perform very well in the aggregate. In this instance, the properties were not only impacted by the higher rate environment, but also by elevated unemployment rates and negative social economic change in the region. While we are now seeing the impairments and losses we have been expecting in the sector, we remain comfortable with our commercial real estate exposure. As I noted last quarter, the portfolio is well diversified and has been originated to sound underwriting standards in support of a strong client base. Additionally, loss rates on impaired loans are typically lower in commercial real estate as they benefit from the value of the properties held tangible collateral. And finally, losses are expected to be manageable relative to the size of the portfolio and the portfolio is well provisioned. Over the last several quarters, we have significantly increased reserves on performing loans and our IFRS 9 downside scenarios reflect the decline in commercial property values ranging from 15% to 40%. Moving to Slide 21. Gross impaired loans were up $391 million or 4 basis points this quarter. The increase was primarily driven by capital markets where new formations were higher largely due to the impairment of the commercial real estate loans I noted earlier. We have now seen four consecutive quarterly increases in gross impaired loans. However, our GIL ratio of 38 basis points remains below pre-pandemic levels. So to conclude, we continue to be pleased with the ongoing performance of our portfolios. Our retail portfolio continues to outperform expectations, supported by low unemployment rates and elevated consumer deposits. Despite some larger impairments during the quarter, our GIL and PCL ratios remain below long-term averages, highlighting the size and diversification of our loan portfolios. We are still expecting PCL impaired loans between 20 to 25 basis points for the year, consistent with the guidance I provided last fall. Looking forward, the impact of inflation and higher rates is expected to play out over a number of years, and we are still in the early stages of the current credit cycle. As we move further into the credit cycle, we expect to see losses driven by more systemic factors arising from the anticipated economic slowdown. Ultimately, the timing and magnitude of increased credit cost continues to depend on Central Bank's success in curbing inflation, while creating a soft landing to the economy. We continue to proactively manage risk through the cycle, and we remain well capitalized with a plausible yet more severe macroeconomic outcomes. And with that, operator, let's open the lines for Q&A.
[Operator Instructions] Our first question is from Sohrab Movahedi from BMO Capital Markets.
Neil, last quarter, I think in your segment, you were probably a little bit unpleasantly surprised by the movement from non-interest rate to term deposits. This quarter, I guess, a little bit pleasantly surprised, maybe not surprised, but that's what it looks like to me. I mean, when you think about this, have we stabilized? Or do you expect some variability around these types of net interest margins, at least on the funding side when you look ahead over the next couple of quarters anyway.
Thanks for the question, Sohrab. Yes, I mean last quarter, we had commented that the GIC book on -- for personal deposits have grown $15 billion quarter-over-quarter. So you heard, Nadine comment about that trend starting to lessen. In this quarter, it was about half of that. So that's I think, the trend we're on. Overall, I think we feel very comfortable that we can continue to win in gathering deposits. But where the rates are, there's still an incentive for that. Retail investor to place that in a term investment. So I think that's the trend. We are seeing across into those term deposits really every category as we monitor the flow of funds, really, every category of deposits are flowing in there. But I think important to call out, about half of that growth is coming from external deposits. So again, that strength of the platform to be able to gather those deposits.
Can I just ask you on the asset side, I think you've maybe noted the intense competition on mortgages and mortgage spreads in particular, I wonder if you could just share how mortgage spreads were in the quarter compared to, I don't know, recent quarters. And then I don't know if this is a stat that you could share with us, Neil. But if you had to think about the stock of your mortgage book between kind of existing mortgages and kind of net new mortgages, if you're actually seeing an improvement in the LTV of one versus the other or maybe put differently, are we seeing faster paydowns from savings on existing stock of mortgages?
Sure. So I'll start with the profitability question, the margin question on mortgages. Obviously, mortgage is a key relationship product for us, but we do price our mortgages to make sure we're meeting hurdle. And I think you heard that in the prepared comments off the top. Despite the competition that there was just the rapid volatility in swaps has impacted mortgages, I think, across the street. We said the market is competitive but we do look at it and expect some normalization as we saw that volatility in swaps start to abate. When we look at it overall in terms of profitability, we do look at the levers we have in the short-term and the long-term, and I think we feel very confident that we have levers over the medium-term if we need to pull them to manage the profitability there. In terms of your second question around LTV and paydowns, we are seeing, I'd say, some trends there where your clients are saying, "I'm going to make some lump sum payments come renewal" to take down the impact of those -- that payment shock. And then on LTVs, I'd say at origination, we are seeing, I'd say, a slight decrease of LTVs at origination but not something I would say worth calling out the portfolio overall.
The following question is from Doug Young from Desjardins Capital Markets.
Maybe this is for Dave. But big picture question. You talked a bit about interest rates and the impact at the beginning of your comments. Can you talk about the key impacts on Royal's results say NIMs or credit or whatever metric you want to talk about from a higher-for-longer rate environment and generally is the impact more positive? Is the impact neutral, negative? Just love to hear your thoughts. I get this question a lot, I'd love to hear your thoughts on this.
Yes. Thank you, for that question. And it was an important part of the overall economic construct of trying to forecast what type of [ lending ] we might have. And Canada differs from the United States and the construct of higher-for-longer. And if you look at the U.S. style mortgage, when you have so many U.S. mortgage holders who are in 30-year kind of fixed open mortgages, it gives them enormous flexibility in times of rising rates and persistently higher rates, those interest yields that they're paying their mortgage are kept low and they have disposable income to spend in the U.S. economy and you're seeing why the U.S. economy has a persistent inflation challenge more so than Canada. The reverse is true in Canada because we have 5-year terms, 4-, 5-year terms, we repriced that the amount of disposable income that's being pulled into debt servicing of mortgages, slows the Canadian economy down more quickly, which is why Canada is a little bit ahead of the curve than most Western countries in getting inflation under control. But going forward, the period of time that the Bank of Canada has to hold at these rates then to make sure we've brought inflation down to our targets is critical. As you know, we have -- the industry has a significant portion of mortgages maturing in '24, '25, the rate resets. If rates hold, we'll pull more disposable income out of the economy and slow it even faster. So it's hard to predict how much spending will slow. We're starting to see spend slow right now. So it's important to contrast a bit the 2 economies and the amount of disposable income that will go to service mortgages given the structure of the industry. And therefore, for that reason, for business investment in community, it's more important for Canada to start easing than it is for the U.S. for those factors. So we watch closely, inflation rates, they're coming down. Core inflation rates are coming down nicely. And if we can start to ease in 2024, that's going to really help the economy get through this to a soft landing. Does that help?
It does. I'm more interested in how you think that kind of flows through your results and I'm sure you get these questions internally from the board and whatnot. But I'm just curious as to if we don't have that easing, what types of pressure, like obviously, there's benefits in certain aspects of your business, pressure is another -- like what's the ultimate impact on your business if we stay higher-for-longer? Is it more positive, neutral or negative than -- that's kind of where I was hoping to go.
Yes. Maybe I'll ask Nadine to jump in as well. But certainly, the focus is on medium to longer-term rates. So we're not looking so much at the short-term rate as we are looking for how market expects rates to evolve. So we set our mortgage rate swap curves in the 5-year curves and 4-year curves and therefore, markets expecting inflation to stay a bit higher, and therefore, we've seen rates go up recently in both markets, and therefore, how that expectation comes off, will certainly help clients deal with the mortgage resets. To Nadine's point, as the rates have gone up, it's helped our deposit book. Obviously, and the carry in our deposit book and the [ tractors ] in our deposit book, and it's a big part of the story of the NIM increase. So -- and we're trying to say, how do you balance short-term gain from the strengthening deposit book versus difficulties your clients could experience on the credit side with higher rates. And as a bank, we are constantly balancing those two areas. The other area that I'll comment and hand to Nadine, it's important to understand our asset betas. So I referenced asset betas in U.S. regional banking. The U.S. regional banks have done a better job than Canada in passing on the cost increases to customers through higher asset betas. The intense competition that Neil referenced in the Canadian market that we -- unable in many cases, to pass on some of these higher asset -- deposit betas through asset betas, including in the mortgage market. Starting to see some improvement along there as we're able to pass on some of these heightened costs from movement into GICs but the U.S. is ahead of us in balancing higher deposit betas with higher asset betas, and we're hopeful Canada will follow that trend as well, and that will help our results as we pass on the higher costs that we've talked about over the last 2 or 3 quarters. With that, I'll hand it to Nadine -- important construct.
Thank you. I think one of the things just to point out in terms of when you look at -- when we specifically speak to interest rate sensitivity, we've outlined on Slide 26, that we do benefit from increases in interest rates. So part of what we've been talking about is the expansion in our NIM this quarter around that structural deposit base as rates continue to stay high or persist high or continue to go higher, you'll continue to get that benefit -- latent benefit coming through on your structural deposit base as it relates to the margin expansion there. And as Neil pointed out, to the extent that from the asset side of things that we're managing and focusing on our margins there, you'll continue to see that overall margin expansion for the retail bank. I think some of the other areas that it factors into, we've talked about, Dave mentioned on the -- we've got another opposite side as it relates to the U.S. construct. And the question really is, based on your mix in the U.S., are you able to benefit from that asset sensitivity. And in City National, we are exposed on an asset sensitivity basis. Now the deposit betas have been rising. But as we become more sensitive from an interest rate standpoint on the liability side, we'll continue to be able to capture it on the asset side as well. So we do expect for, particularly our core banking and that they will benefit on the interest rates, we could talk a bit more about impacts, we've already seen inflation baked into our cost base. So I think it's really going to be a net-net benefit minus the impact for [ our society ].
A following question is from John Aiken from Barclays.
Graeme, I wanted to leave the nitpicking on commercial real estate to others. But on Slide 33, you go through the past due delinquencies in Canadian Banking. And not surprising, we're seeing personal start to uptick. But a little bit unusual is the decline that we saw -- that we've seen in credit cards over the last couple of quarters, can you talk to that? Is this just noise in the system? Or is there something fundamentally different that's happening in cards versus mortgages, HELOCs and other personal lending?
Yes. Thanks, John, for the question. I wouldn't say there's anything specifically happening in cards. I mean cards does have a seasonal effect to it. And so you're going to see it ebb and flow through the year. But overall, they're kind of -- what's driving all of this right now is a very strong employment backdrop. But the unsecured products overall, we do expect those to trend negatively. Why you see something like the personal lending, in particular, the RCL product trending more negatively? Now, is it more rate sensitive and directly rate sensitive, right? So there is a direct impact that flows through to the consumer on that. And as interest rates rise, you'll see that kind of continue to trend that way. We do expect cards to trend more negatively as we kind of work our way through this year and into next year because it is an unsecured client base that we think will be most impacted as we work our way through this cycle.
And I know that the -- your U.S. book is dramatically different than the Canadian book, but are we seeing similar trends on the U.S. delinquencies as we are in Canada?
Are you asking, John, on the retail side or just in general?
Yes. No, on the retail side, please.
We don't really have much of a retail book in the U.S. Our retail book in the U.S. is really tied to kind of a high net worth affluent client base. And so it's largely a mortgage book, and we really haven't seen any indicators of any negative trends there at all.
The following question is from Gabriel Dechaine from National Bank Financial.
My daughter wanted me to ask if the Avion card really helps you get the Taylor Swift ticket but I'll stick to a couple of questions on the Canadian bank here. The deposit flows, and we've all seen the improvement there and stabilization of pricing in mix. I'm just wondering, one of your major competitors is -- seems to be playing catch-up on GIC pricing in the last couple of months. And I'm wondering if that could be at all disruptive to what has been an improving trend? And then my second question is on the mortgages. And correct me if I'm wrong, but I don't believe your floating rate fixed payment mortgages negatively amortized. I'm wondering if that is correct, is there an accounting or capital impact because if I'm trying to simplify things, those borrowers aren't actually paying you as much as they should, it should otherwise be negatively amortizing.
Yes, listen. I'll jump in and maybe take the questions in sequence. So the first one is, yes, your daughter is correct. The Avion program does get you the ability to get in the queue to get Taylor Swift ticket. In terms of the GST pricing, yes, there has been, I'd say, competitive intensity has ticked up there. I think to your point, there has been one competitor who's jumped back in. But I think you see strong competitive pressures across the board. But I think price is one -- is only one side of it and just having the access and the sales force capability and the platform to reach those depositors is really differentiated, and we feel quite bullish about our ability to continue to win there. We have seen overall market share increases for the last 12 months in the GIC space. And so I think we're feeling quite strong there. In terms of your question on mortgages. The -- our variable rate mortgages -- sorry, our variable rate mortgages do not negatively amortize. So that is the contract we have. So in terms -- hopefully, that clarifies. There are different constructs across the street, but we don't do that. The other thing probably to keep in mind, I'd mentioned in the previous question, our GIC flow. The important part there is also just the new flow of clients that our GIC product is pulling in, in that platform. So we do also get a new client from that GIC origination.
Just to follow up on the negatively -- So if it did, what you would see is the loan balances would grow the excess payment that you're not receiving. I'm just -- there's no accounting or capital impact for your particular product line?
Just to be clear, the reason it doesn't go negative amortizing is the client actually has their payment reset.
The following question is from Meny Grauman from Scotiabank. And I just want to remind participants to limit yourself to one question. Please go ahead.
So the question I have is just for Neil, going back to the GIC trend that's improving or that growth is slowing. Just trying to better understand what is driving that from a high-level perspective, is it just that the clients that have moved money have moved it already? And so that's the fundamental question. Whether there's a risk that changes, if the rate environment continues to move higher, is there still a risk here that you could see a reacceleration?
Yes. Thanks for the question. Yes, I think there's a couple of factors. I think, to your point, in terms of the -- if you look at just -- we do monitor flows from the different products. If you look at, for example, in the core checking account, I think that would be one where we started to see a softening of balances there. And I think that rate environment has now been high for quite a while. And if you wanted to make that swap, I think a lot of that has already happened. We also see, as you break down that category, where do we see the movement. And it is coming from individuals with very high balances over $100,000. So that, I think, is probably dissipated. I think the other trend is just around confidence in terms of the retail investor. And we had been seeing negative net sales in our mutual fund platform, and that has I think, really gotten to the point where we're about flat. So as that confidence builds and the retail investor gets that money off the sidelines and decide to put it back into the market, I would say that would be the other trend.
Maybe I'll jump in, it's Dave. Just to build on that, we're still as we look at how customers in the U.S. and Canada are keeping core balances. And there still is -- the average balance across most of our customer segments are still higher than pre-pandemic. So while growth has stopped, we still see customers for a number of reasons. One, safety and security, just the shocks that we've been through, there's a conservatism built in there, inflation, whatever it happens to be, consumers are still carrying in Canada about what 19%, 20% higher average balances. So predicting that is important. In the U.S., when you look at the ratio of non-interest-bearing balances to total balances, historically, it's been about 15%. That ratio is up near 25%. So U.S. consumers are carrying a significant surplus liquidity in their core balances as well albeit coming down more quickly in the U.S. than Canada where it's flat. So there still is that surplus savings concept that gives you a cushion and a downturn and an ability to service debt even when it shocks to your personal situation, but also has that question, how does that money move back into mutual funds, in the GICs to stay on the core checking account, all those, we're trying to predict, but it's important to understand that concept.
Following question is from Ebrahim Poonawala from Bank of America.
I guess maybe Nadine, if you could just spend some time on expenses. So the Slide 12 is extremely helpful in terms of the walk to the $7.861 billion this quarter. As we think about the actions that you've laid out into 4Q, what's -- and then we have HSBC coming up in the first calendar quarter next year. Just talk to us how you're thinking about expense growth moving forward and the likelihood of driving positive operating leverage. I think what I'm struggling with is, should we see that $7.8 billion actually drift lower or else equal as we think about '24 and then HSBC Canada closes? Or is there still some more upward push to that number?
Thanks for the question, Ebrahim. A very important conversation. So we've been very vigilant and you see on Slide 13, where we started to break down some of the actions we've been taking since we had our conversation on the call last quarter. We are not done. We were moving forward, as we indicated in Q4 to further reduce our headcount by the 1% to 2%. Obviously, there's going to be some severance costs that comes with that in the fourth quarter. And so you're going to start to see the benefits of that run rate pushed through into 2024. We are looking to continue to moderate on our discretionary expense, and you saw that come down in terms of the increase in Q3, and then we're going to look to do that more as we go into 2024 as well. And we're going to evaluate where we're at from our headcount and look at where we can address our structural cost base more explicitly as well into 2024. So the expectation is that we are going to look to slow down significantly. Our growth in NIE into next year, just coupled with the actions we've been taking to date as well as what we're planning on a go-forward basis. Sorry, HSBC, obviously, we've been outlining our cost base, and we outlined in terms of the $1 billion as part of the integration there.
Understood. And just as a follow-up, when you think about operating leverage, was the response to the earlier question that we should see the Canadian NIM drift higher in this backdrop if the Bank of Canada holds rates?
Correct. Yes. We start to see the benefits of that structural deposit base and the rates continuing to persist up, marring any other shifts in mix we've been discussing.
Following question is from Paul Holden from CIBC.
So I want to continue with the interest rate conversation a little bit of a different angle versus Doug's question because this is an important one. Just as we're heading into 2024, I think the market expectation as for central banks, both in Canada and the U.S. to reduce rates, which traditionally would be a negative, I think, on NII. Is there anything different in this scenario just because of the dynamics we've seen over the last 6, 9 months that might mean central bank rate costs are less of a negative than you've historically seen?
I think you want to focus again on what we've seen from the rising interest rates to date and the latent benefit that we continue to get on our margin expansion. When we talk about interest rate decreases, and we referenced the sensitivity there, that's an immediate parallel shock in the curve overall. So we continue to benefit from the rates that we've already seen rising, that we managed our interest rate exposure, while we are exposed to a drop in interest rates, we will -- that will happen over time when we mitigate that through our hedges. I would say that the other benefits associated with drop in interest rates really will be related to refinancing on the mortgage book and then potentially releasing some of the pressure on the refinancing there for our customer base.
Okay. So if I understand you correctly, Nadine, then central bank rate reductions in 2024, if the long end of the curve stays where it is, is not necessarily that much of an NII or earnings negative?
Correct. You can tell us on our sensitivity that particularly for Canadian Banking, more of their interest rate sensitivities on the longer end of the curve past 2 years.
Following question is from Mario Mendonca from TD Securities.
Dave and Nadine, as I go through your presentation, it appears that the steps the bank is taking to address expenses, they seem incremental like taking FTE down another 1% or 2% talking about marketing and travel. That's my impression from the outside looking, and this seems very incremental. And wouldn't -- part of the reason why I'm offering that is when you look at City National, the business isn't profitable anymore. I mean a business you paid over $5 billion for in 2015 didn't make any money this quarter. So it seems like the issues are sort of -- they're much bigger than can be addressed by an incremental move on expenses. So I guess what I'm asking here is, is there something in place for a more drastic move to take expenses down to address City National, for example, or just the bank as a whole. I mean do you agree with me that the steps are incremental?
Yes, I'll start and then Nadine can fill in. So the overall FTE reduction, when you're a regulated institution, you're a big bank, takes a while to get all of the regulatory approvals in place to move forward for one. Two, I agree, it's an FTE reduction is a component of an overall expense reduction exercise that's much more significant. So as we target a much slower growth in Q4 and into next year, it's because of all the actions we're taking on all the other discretionary items that we haven't kind of outlined in the slide. So it is part of a bigger program and a more ambitious program that you'll hear more from us over the coming quarter. So it's fair. FTE, we did the first part through normal attrition and just slowing things down. We have accelerating that in Q4 with our approvals in place to do that, and we'll continue to look at that. Don't forget, we still have to manage one of the most complex transitions with HSBC next year, and we're carrying extra NI to do that. So that's kind of the macro story that, yes, it's part of a larger cost reduction program, it's designed to materially impact our cost trajectory. So don't just look at the FTE component of that. On City National, everything went against us this quarter in City National from credit loss on a real estate item that Graeme referenced to, the significant impact of deposit betas on the business and FHLB borrowings to rising costs to meet all kinds of expectations. So that business will benefit from asset repricing, fairly significantly over the coming quarter year. So that will turn it. This business is well below our expectations for this year. And it's been a drastic kind of turn since the financial challenges in the U.S. banking system in March where liquidity ran off and all regional banks are facing very similar NIM decreases, challenges on expenses and others. So we do have a program to that. On the expense side, we are moving forward with that. And you'll see us evolve positively, the performance of City National.
One quick thing then on the Basel III end game, you kind of described it as almost a negative for the bank that these higher capital requirements could impact the bank. But my impression was that it could affect U.S. banks, but that our Canadian banks as intermediate, I guess, their intermediate holding companies might be almost advantaged by that. What's your take? Is Basel III end game a negative to our -- to the Canadian banks in the U.S.?
Thank you, Mario. I'll respond to that. You're correct. It is not going to be an impact for RBC more broadly as the results back that we obviously managed under OSFI from a regulatory capital standpoint. I think it may be a question more around how you fund in the U.S. as it relates to our legal entity there in order to make sure that our capital ratios, et cetera, but it's quite a long implementation timeline, and I think there's a lot of discussions that are still going to be had as it relates ensuring that from a U.S. standpoint, they don't feel that they are anyway and duly penalized versus the rest of the world. So I think it's going to be a bit of a long implementation. But for Canada, for RBC in particular, would not impact us from where we're regulated from that perspective.
Our following question is from Lemar Persaud from Cormark Securities.
I appreciate the additional slides on NIE growth. Just thinking about that 1% to 2% FTE reduction for next quarter, how should we think about that impact in human resource costs because this quarter, FTE dropped 1% sequential, but these human resource costs, which includes your salaries and variable costs grew 4% sequentially. So is there -- I think the messaging was that there's a lag impact because of higher severance costs? Do I have that right? And when can we see the benefits of that?
So correct, Lemar. I think in terms of the headcount reduction that you saw in this quarter to Dave's comment, it was primarily managed through attrition. So that will start to play out one quarter's impact, is not going to be as significant. You'll start to see that play out more on Q4. Related to the 1% to 2%, we will have severance that would overwhelm any benefit as it relates to an actual reduction in salaries in the fourth quarter. So the run rate benefit will then start to persist in Q1 of 2024.
Okay. So we're going to see more of an impact as we move forward into next year. I think that's the...
Correct.
And then just following on that, more broadly, I think you guys are clear suggesting Q3 would be a transitional quarter in your actions to reduce expense growth. But how should we think about Q4? Because is there anything you guys are doing to limit the seasonal bump we typically think of in Q4?
Yes. I mean there are things that obviously are going to come in play from a timing standpoint in Q4 that we will not be able to avoid. However, we are very focused on our spend and particularly our discretionary spend, which sometimes you do see tick up in the fourth quarter. There are some types of fees, example, as well as some marketing that may come through. But we are focused on reducing our overall growth trajectory in the fourth quarter based on these actions we've taken to date. And you will expect to see that come down to more to mid-single digits in a growth trajectory.
Once again, we ask that you limit yourself to one question and then come back on the queue. The following question is from Nigel D'Souza from Veritas Investment Research.
I wanted to circle back on City National and maybe get some more insights on the deposit trends. When I look at the loan-to-deposit ratio, that's moved up substantially over the last 2 years. Deposits are pretty much back to where they were in 2021 but your loans have increased. Trying to get a sense of the runway here for that mix to shift? Could you give us a sense of how much non-interest-bearing deposits are remaining in terms of the mix at City National? And is there a need to continue to offer higher interest rates on interest-bearing deposits to maintain the liquidity at City National, given that the loan-to-deposit ratio has been higher?
Thank you for the question. So in terms of the deposit levels overall, we have seen stability to a slight increase in our deposits which is pleasant to see that we're still managing to hold. You're right. So what we're seeing is the mix shift mix. I mean, when we're looking at it from a non-interest-bearing, that has come down from Q1 of 45% to 37%. So that's basically giving you where that -- all that increase in beta is causing the compression in our NIM overall. We have been taking actions to rebalance some of the mix as related to our deposits. You bring in more of our sweep deposit balance, which comes at a lower cost than what you've seen some of the increase as it relates the CDS. And as you've seen that some of the loan growth has slowed down. So we expect that to continue and be able to manage our funding levels overall with not having to go into higher FHLB funding going forward.
Okay. But fair to say that you kind of have to give up some margin there to maintain the deposit...
I would say that we've given up margin already in the trajectory, but we're looking to improve that going forward as we've been bringing in some of the more lower cost -- relative lower cost deposits in the sweep balances, although they are high beta, but they're lower cost relative to some of the increases we've seen through 2023.
Following question is from Sohrab Movahedi from BMO Capital Markets.
Last one from me. Nadine, I've just looked at the last [ 40 ] quarters anyway, the effective tax rate on the adjusted at the total bank level, I don't think has ever been below 20%. How would you like us to model this over the next few quarters?
So happy you got your last question in there, Sohrab. In terms of the tax rate, what I can tell you from a guidance standpoint is that you can see that most of it was driven off of capital markets. We do expect this to persist into Q4. I would say as it relates going forward, you can probably keep it in that 19% to 20% range overall for RBC as an effective tax rate.
That's all the time we have for questions. I would now like to turn the meeting back over to Mr. McKay.
Thank you, operator, and thanks, everyone, for your questions. Just to kind of sum up the quarter, I think very strong performance from our customer franchises on revenue growth, as you saw, strength of diversification, whether it was in Canada and our ability to grow our commercial and consumer businesses, our wealth businesses and combined with our global businesses, we didn't talk at all, any of the questions about the real strength in capital markets this quarter, particularly in global markets and trading -- credit trading was very, very strong. We saw good market share gains in investment banking as well as our advisory businesses are really kicking in and strong corporate banking performance. So I think from that perspective, very strong capital markets operations, fairly strong U.S. wealth and our advisory and broker in the U.S. as well. So those global franchises were very strong. And the importance from all the questions on our deposit franchise, where it's U.S. dollar deposits and particularly Canadian dollar deposits, how they move, how do consumers behave, has a big impact on all banks, including ourselves. It's a core strength of ours and are generally low beta and particularly in comparison to peers. And that strength has led to NIM expansion, very important this quarter and will continue to benefit as a tailwind over the coming quarters and years. So very, very important to talk about that. And then I would say balance sheet strength. Diversification of our balance sheet, the global diversification of our balance sheet, customer diversification of our balance sheet. You saw some strong credit performance in a volatile world. I think continued strong performance and very, very excited about HSBC as we move forward and continue to plan for and wait for to hear on approvals but also plan for conversion and close in the coming quarters. So we feel very good about our customer momentum and what's in store for the coming quarters. Thanks very much, and we look forward to seeing you next quarter.
Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.